Book by Icmai

MANAGEMENT
ACCOUNTING
(Book 1)
Term 2
Introduction to Cost Accounting
Study Note - 1
INTRODUCTION TO COST ACCOUNTING
This Study Note includes

1.1 Definition, scope, objectives and significance of Cost Accounting, its relationship with
Financial Accounting and Management Accounting
1.2 Cost Objects, Cost Centres and Cost Units – Elements of Cost
1.3 Classification of Costs
1.1 DEFINITION, SCOPE, OBJECTIVES AND SIGNIFICANCE OF COST ACCOUNTING, ITS RELATIONSHIP
WITH FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING
Way back to 15th Century, no accounting system was there and it was the barter system prevailed.
It was in the last years of 15th century Luca Pacioli, an Italian found out the double entry system of
accounting in the year 1494. Later it was developed in England and all over the world upto 20th
Century. During these 400 years, the purpose of Cost Accounting needs are served as a small branch
of Financial Accounting except a few like Royal wallpaper manufactory in France (17th Century), and
some iron masters & potters (18th century).
The period 1880 AD- 1925 AD saw the development of complex product designs and the emergence
of multi activity diversified corporations like Du Pont, General Motors etc. It was during this period that
scientific management was developed which led the accountants to convert physical standards into
Cost Standards, the latter being used for variance analysis and control.
During the World War I and II the social importance of Cost Accounting grew with the growth of each
country’s defence expenditure. In the absence of competitive markets for most of the material required
for war, the governments in several countries placed cost-plus contracts under which the price to be
paid was cost of production plus an agreed rate of profit. The reliance on cost estimation by parties to
defence contracts continued after World War II.
In addition to the above, the following factors have made accountants to find new techniques to
serve the industry :-
(i) Limitations placed on financial accounting
(ii) Improved cost consciousness
(iii) Rapid industrial development after industrial revolution and world wars
(iv) Growing competition among the manufacturers
(v) To control galloping price rise, the cost of computing the precise cost of product / service
(vi) To control cost several legislations passed throughout the world and India too such as Essential
Commodities Act, Industrial Development and Regulation Act...etc
Due to the above factors, the Cost Accounting has emerged as a speacialised discipline from the
initial years of 20th century i.e after World War I and II.
In India, prior to independence, there were a few Cost Accountants, and they were qualified mainly
from I.C.M.A. (now CIMA) London. During the Second World War, the need for developing the
profession in the country was felt, and the leadership of forming an Indian Institute was taken by some
The Institute of Cost Accountants of India 1

Cost Accounting
members of Defence Services employed at Kolkata. However, with the enactment of the Cost and
Works Accountants of India Act, 1959, the Institute of Cost and Works Accountants of India (Now called
as The Institute of Cost Accountants of India) was established at Kolkata. The profession assumed further
importance in 1968 when the Government of India introduced Cost Audit under section 233(B) of the
Companies Act, 1956. At present it is under Section 148 of the Companies Act, 2013.
Many times we use Cost Accounting, Costing and Cost Accountancy interchangeably. But there are
differences among these terms. As a professional, though we use interchangeably we must know the
meaning of each term precisely.
Cost Accounting : Cost Accounting may be defined as “Accounting for costs classification and analysis
of expenditure as will enable the total cost of any particular unit of production to be ascertained
with reasonable degree of accuracy and at the same time to disclose exactly how such total cost is
constituted”. Thus Cost Accounting is classifying, recording an appropriate allocation of expenditure
for the determination of the costs of products or services, and for the presentation of suitably arranged
data for the purpose of control and guidance of management.
Cost Accounting can be explained as follows :-
Cost Accounting is the process of accounting for cost which begins with recording of income and
expenditure and ends with the preparation of statistical data.
It is the formal mechanism by means of which cost of products or services are ascertained and
controlled.
Cost Accounting provides analysis and classification of expenditure as will enable the total cost of any
particular unit of product / service to be ascertained with reasonable degree of accuracy and at the
same time to disclose exactly how such total cost is constituted. For example it is not sufficient to know
that the cost of one pen is ` 25/- but the management is also interested to know the cost of material
used, the amount of labour and other expenses incurred so as to control and reduce its cost.
It establishes budgets and standard costs and actual cost of operations, processes, departments or
products and the analysis of variances, profitability and social use of funds.
Thus Cost Accounting is a quantitative method that collects, classifies, summarises and interprets
information for product costing, operation planning and control and decision making.
Costing : Costing is defined as the technique and process of ascertaining costs.
The technique in costing consists of the body of principles and rules for ascertaining the costs of
products and services. The technique is dynamic and changes with the change of time. The process
of costing is the day to day routine of ascertaining costs. It is popularly known as an arithmetic process.
For example If the cost of producing a product say ` 200/-, then we have to refer material, labour and
expenses accounting and arrive the above cost as follows:
Material ` 100
Labour ` 40
Expenses ` 60
Total ` 200
Finding out the breakup of the total cost from the recorded data is a daily process. That is why it
is called arithmetic process/daily routine. In this process we are classifying the recorded costs and
summarizing at each element and total is called technique.
Cost Accountancy: Cost Accountancy is defined as ‘the application of Costing and Cost Accounting
principles, methods and techniques to the science, art and practice of cost control and the ascertainment
of profitability’. It includes the presentation of information derived there from for the purposes of managerial
decision making. Thus, Cost Accountancy is the science, art and practice of a Cost Accountant.
2 The Institute of Cost Accountants of India

(a) It is a science because it is a systematic body of knowledge having certain principles which a cost
accountant should possess for proper discharge of his responsibilities.
(b) It is an art as it requires the ability and skill with which a Cost Accountant is able to apply the
principles of Cost Accountancy to various managerial problems.
(c) Practice includes the continuous efforts of a Cost Accountant in the field of Cost Accountancy.
Such efforts of a Cost Accountant also include the presentation of information for the purpose of
managerial decision making and keeping statistical records.
Objectives of Cost Accounting
The following are the main objectives of Cost Accounting :-
(a) To ascertain the Costs under different situations using different techniques and systems of costing
(b) To determine the selling prices under different circumstances
(c) To determine and control efficiency by setting standards for Materials, Labour and Overheads
(d) To determine the value of closing inventory for preparing financial statements of the concern
(e) To provide a basis for operating policies which may be determination of Cost Volume relationship,
whether to close or operate at a loss, whether to manufacture or buy from market, whether
to continue the existing method of production or to replace it by a more improved method of
production....etc
Scope of Cost Accountancy
The scope of Cost Accountancy is very wide and includes the following:-
(a) Cost Ascertainment: The main objective of Cost Accounting is to find out the Cost of product /
services rendered with reasonable degree of accuracy.
(b) Cost Accounting: It is the process of Accounting for Cost which begins with recording of expenditure
and ends with preparation of statistical data.
(c) Cost Control: It is the process of regulating the action so as to keep the element of cost within the
set parameters.
(d) Cost Reports: This is the ultimate function of Cost Accounting. These reports are primarily prepared
for use by the management at different levels. Cost reports helps in planning and control,
performance appraisal and managerial decision making.
(e) Cost Audit: Cost Audit is the verification of correctness of Cost Accounts and check on the
adherence to the Cost Accounting plan. Its purpose is not only to ensure the arithmetic accuracy
of cost records but also to see the principles and rules have been applied correctly.
To appreciate fully the objectives and scope of Cost Accounting, it would be useful to examine the
position of Cost Accounting in the broader field of general accounting and other sciences. i.e Financial
Accounting, Management Accounting, Engineering and Service Industry.
Financial Accounting and Cost Accounting: Financial Accounting is primarily concerned with the
preparation of financial statements, which summarise the results of operations for selected period of
time and show the financial position of the company at particular dates. In other words Financial
Accounting reports on the resources available (Balance Sheet) and what has been accomplished with
these resources (Profit and Loss Account). Financial Accounting is mainly concerned with requirements
of creditors, shareholders, government, prospective investors and persons outside the management.
Financial Accounting is mostly concerned with external reporting.
Cost Accounting, as the name implies, is primarily concerned with determination of cost of something,
which may be a product, service, a process or an operation according to costing objective of

Cost Accounting
management. A Cost Accountant is primarily charged with the responsibility of providing cost data for
whatever purposes they may be required for.
The main differences between Financial and Cost Accounting are as follows:
Financial Accounting Cost Accounting

(a) It provides the information about the business (a) It provides information to the management
in a general way. i.e Profit and Loss Account, for proper planning, operation, control and
Balance Sheet of the business to owners and decision making.
other outside partners.
(b) It classifies, records and analyses the (b) It records the expenditure in an objective
transactions in a subjective manner, i.e manner, i.e according to the purpose for
according to the nature of expense. which the costs are incurred.
(c) It lays emphasis on recording aspect without (c) It provides a detailed system of control for
attaching any importance to control. materials, labour and overhead costs with
the help of standard costing and budgetary
control.
(d) It reports operating results and financial (d) It gives information through cost reports to
position usually at the end of the year. management as and when desired.
(e) Financial Accounts are accounts of the (e) Cost Accounting is only a part of the financial
whole business. They are independent in accounts and discloses profit or loss of each
nature. product, job or service.
(f) Financial Accounts records all the (f) Cost Accounting relates to transactions
commercial transactions of the business connected with Manufacturing of goods
and include all expenses i.e Manufacturing, and services, means expenses which enter
Office, Selling etc. into production.
(g) Financial Accounts are concerned with (g) Cost Accounts are concerned with internal
external transactions i.e. transactions transactions, which do not involve any cash
between business concern and third party. payment or receipt.
(h) Only transactions which can be measured in (h) Non-Monetary information likes No of Units /
monetary terms are recorded. Hours etc are used.
(i) Financial Accounting deals with actual (i) Cost Accounting deals with partly facts and
figures and facts only. figures and partly estimates / standards.
(j) Financial Accounting do not provide (j) Cost Accounts provide valuable information
information on efficiencies of various workers/ on the efficiencies of employees and Plant &
Plant & Machinery. Machinery.
(k) Stocks are valued at Cost or Market price (k) Stocks are valued at Cost only.
whichever is lower.
(l) Financial Accounting is a positive science as (l) Cost Accounting is not only positive science
it is subject to legal rigidity with regarding to but also normative because it includes
preparation of financial statements. techniques of budgetary control and
standard costing.
(m) These accounts are kept in such away to (m) Generally Cost Accounts are kept
meet the requirements of Companies Act voluntarily to meet the requirements of the
2013 as per Sec 128 & Income Tax Act, 1961 management, only in some industries Cost
Sec 44AA. Accounting records are kept as per the
Companies Act.

Cost Accounting and Management Accounting:

Management Accounting is primarily concerned with management. It involves application of
appropriate techniques and concepts, which help management in establishing a plan for reasonable
economic objective. It helps in making rational decisions for accomplishment of these objectives. Any
workable concept or techniques whether it is drawn from Cost Accounting, Financial Accounting,
Economics, Mathematics and Statistics, can be used in Management Accountancy. The data used
in Management Accountancy should satisfy only one broad test. It should serve the purpose that it is
intended for. A Management Accountant accumulates, summarizes and analysis the available data
and presents it in relation to specific problems, decisions and day-to-day task of management. A
Management Accountant reviews all the decisions and analysis from management’s point of view
to determine how these decisions and analysis contribute to overall organizational objectives. A
Management Accountant judges the relevance and adequacy of available data from management’s
point of view.
The scope of Management Accounting is broader than the scope of Cost Accountancy. In
Cost Accounting, primary emphasis is on cost and it deals with its collection analysis relevance
interpretation and presentation for various problems of management. Management Accountancy
utilizes the principles and practices of Financial Accounting and Cost Accounting in addition to other
management techniques for efficient operations of a company. It widely uses different techniques from
various branches of knowledge like Statistics, Mathematics, Economics, Laws and Psychology to assist
the management in its task of maximising profits or minimising losses. The main thrust in Management
Accountancy is towards determining policy and formulating plans to achieve desired objective of
management. Management Accounting makes corporate planning and strategy effective.
From the above discussion we may conclude that the Cost Accounting and Management Accounting
are interdependent, greatly related and inseparable.
Advantages of Cost Accounting
Cost Accounting has manifold advantages, a summary of which is given below. It is not suggested that
having installed a system of Cost Accounting, a concern will expect to derive all the benefits stated
here, the nature and the extent of the advantages obtained will depend upon the type, adequacy
and efficiency of the cost system installed and the extent to which the various levels of management
are prepared to accept and act upon the advice rendered by the cost system.
The Cost Accounting System has the following advantages:-
(i) A cost system reveals unprofitable activities, losses or inefficiencies occurring in any form such as
(a) Wastage of man power, idle time and lost time.
(b) Wastage of material in the form of spoilage, excessive scrap etc., and
(c) Wastage of resources, e.g. inadequate utilization of plant, machinery and other facilities.
(ii) Cost Accounting locates the exact causes for decrease or increase in the profit or loss of the
business. It identifies the unprofitable products or product lines so that these may be eliminated
or alternative measures may be taken.
(iii) Cost Accounts furnish suitable data and information to the management to serve as guides in
making decisions involving financial considerations.
(iv) Cost Accounting is useful for price fixation purposes. Although sale price is generally related more
to economic conditions prevailing in the market than to cost, the latter serves as a guide to test
the adequacy of selling prices.
(v) With the application of Standard Costing and Budgetary Control methods, the optimum level of
efficiency is set.
(vi) Cost comparison helps in cost control. Comparison may be period to period, of the figures in
respect of the same unit or factory or of several units in an industry by employing Uniform Costs
and Inter- Firm Comparison methods. Comparison may be made in respect of cost of jobs,
process or cost centres.

Cost Accounting
(vii) A cost system provides ready figures for use by the Government, wage tribunals and boards, and
labour and trade unions.
(viii) When a concern is not working to full capacity due to various reasons such as shortage of
demands or bottlenecks in production, the cost of idle capacity can readily worked out and
repealed to the management.
(ix) Introduction of a cost reduction programme combined with operations research and value
analysis techniques leads to economy.
(x) Marginal Costing is employed for suggesting courses of action to be taken. It is a useful tool for
the management for making decisions.
(xi) Determination of cost centres or responsibility centres to meet the needs of a Cost Accounting
system, ensures that the organizational structure of the concern has been properly laid
responsibility can be properly defined and fixed on individuals.
(xii) Perpetual inventory system which includes a procedure for continuous stock taking is an essential
feature of a cost system.
(xiii) The operation of a system of cost audit in the organization prevents manipulation and fraud
and assists in furnishing correct and reliable cost data to the management as well as to outside
parties like shareholders, the consumers and the Government.
Limitations of Cost Accounting system
Like any other system of accounting, Cost Accountancy is not an exact science but an art which
has developed through theories and accounting practices based on reasoning and commonsense.
Many of the theories cannot be proved nor can they be disproved. They grownup in course of time
to become conventions and accepted principles of Cost Accounting. These principles are by no
means static, they are changing from day to day and what is correct today may not hold true in the
circumstances tomorrow.
Large number of Conventions, Estimates and Flexible factors: No cost can be said to be exact as they
incorporate a large number of conventions, estimations and flexible factors such as :-
(i) Classification of costs into its elements.
(ii) Materials issue pricing based on average or standard costs.
(iii) Apportionment of overhead expenses and their allocation to cost units/centres.
(iv) Arbitrary allocation of joint costs.
(v) Division of overheads into fixed and variable.
Cost Accounting lacks the uniform procedures and formats in preparing the cost information of a
product/ service. Keeping in view this limitation, all Cost Accounting results can be taken as mere
estimates.
Installation of Cost System or Cost Accounting System
From what has been stated in the preceding sections, it will be seen that there cannot be a readymade
cost system suitable for a business. Such system has to be specially designed for an undertaking to
meet its specific needs. Before installing a cost system proper care should be taken to study and taken
into account all the aspects involved as otherwise the system will be a misfit and full advantages will
not be realized from it. The following points should be looked into and the prerequisites satisfied before
installing a cost system:-
(i) The nature, method and stages of production, the number of varieties and the quantity of each
product and such other technical aspects should be examined. It is to be seen how complex or
how simple the production methods are and what is the degree of control exercised over them.
(ii) The size, layout and organisation of the factory should be studied.

(iii) The methods of purchase, receipt, storage and issue of materials should be examined and
modified wherever considered necessary.
(iv) The wage payment methods should be studied.
(v) The requirements of the management and the policy adopted by them towards cost control
should be kept in view.
(vi) The cost of the system to be installed should be considered. It is needless to emphasize that the
installation and operation of system should be economic.
(vii) The system should be simple and easy to operate.
(viii) The system can be effectively run if it is appropriate and properly suited to the organisation.
(ix) Forms and records of original entry should be so designed and to involve minimum clerical work
and expenditure.
(x) The system should be so designed that cost control can be effectively exercised.
(xi) The system should incorporate suitable procedure for reporting to the various levels of
management. This should be based on the principles of exception.
1.2 COST OBJECT, COST CENTERS AND COST UNITS – ELEMENTS OF COST
Cost: Cost is a measurement, in monetary terms, of the amount of resources used for the purpose of
production of goods or rendering services.
Cost in simple, words, means the total of all expenses. Cost is also defined as the amount of expenditure
(actual or notional) incurred on or attributable to a given thing or to ascertain the cost of a given thing.
Thus it is that which is given or in sacrificed to obtain something. The cost of an article consists of actual
outgoings or ascertained charges incurred in its production and sale. Cost is a generic term and it is
always advisable to qualify the word cost to show exactly what it meant, e.g., prime cost, factory cost,
etc. Cost is also different from value as cost is measured in terms of money whereas value in terms of
usefulness or utility of an article.
Elements of Cost
Elements of Cost
Material Labour Expenses
Direct Materail Direct Labour Direct Expenses
Indirect Material Indirect Labour Indirect Expenses
Direct Material + Direct Labour + Direct Expenses = Prime Cost

Indirect Material+ Indirect Labour + Indirect Expenses = Overheads
Direct Material Cost
Direct material cost can be defined as ‘The Cost of material which can be attributed to a cost object
in an economically feasible way’. Direct materials are those materials which can be identified in
the product and can be conveniently measured and directly charged to the product. Thus, these

Cost Accounting
materials directly enter the product and form a part of the finished product. For example, timber in
furniture making, cloth in dress making, bricks in building a house. The following are normally classified
as direct materials :-
(i) All raw materials, like jute in the manufacture of gunny bags, pig iron in foundry and fruits in canning
industry.
(ii) Materials specifically purchased for a specific job, process or order, like glue for book binding,
starch powder for dressing yarn.
(iii) Parts or components purchased or produced, like batteries for transistor-radios.
(iv) Primary packing materials like cartons, wrappings, card-board boxes, etc.
Indirect Material Cost

Materials, the costs of which cannot be directly attributed to a particular cost object. Indirect materials
are those materials which do not normally form a part of the finished product. It has been defined as
“materials which cannot be allocated but which can apportioned to or absorbed by cost centres or
cost units”. These are:
(i) Stores used in maintenance of machinery, buildings, etc., like lubricants, cotton waste, bricks and
cements.
(ii) Stores used by the service departments, i.e., non-productive departments like Power House, Boiler
House and Canteen, etc., and
(iii) Materials which due to their cost being small, are not considered worthwhile to be treated as
direct materials.
Direct Labour / Employee Cost

The cost of employees which can be attributed to a cost object in an economically feasible way. In
simple words, it is that labour which can be conveniently identified or attributed wholly to a particular
job, product or process or expended in converting raw materials into finished goods. Wages of such
labour are known as direct wages. Thus it includes payment made to the following groups of labour:
(i) Labour engaged on the actual production of the product or in carrying out of an operation or
process.
(ii) Labour engaged in adding the manufacture by way of supervision, maintenance, tool setting,
transportation of material etc.
(iii) Inspectors, analysts etc., specially required for such production.
Indirect Labour/ Employee Cost

The labour / employee cost which cannot be directly attributed to a particular cost object. The wages
of that labour which cannot be allocated but which can be apportioned to or absorbed by cost
centres or cost units is known as Indirect Labour. In other words paid to labour which are employed
other than on production constitute indirect labour costs. Example of such labour are: charge-hands
and supervisors; maintenance workers; men employed in service departments, material handling and
internal transport; apprentices, trainees and instructors; clerical staff and labour employed in time
office and security office.
Direct or Chargeable Expenses
Direct expenses are expenses relating to manufacture of a product or rendering a service which can
be identified or linked with the cost object other than direct material cost and direct employee cost.
Direct expenses include all expenditure other than direct material or direct labour that is specifically

incurred for a particular product or process. Such expenses are charged directly to the particular
cost account concerned as part of the prime cost. Examples of direct expenses are: (i) Excise duty;
(ii) Royalty; (iii) Architect or Supervisor’s fees; (iv) Cost of rectifying defective work; (v) Travelling
expenses to the city; (vi) Experimental expenses of pilot projects; (vii) Expenses of designing or drawings
of patterns or models; (viii) Repairs and maintenance of plant obtained on hire; and (ix) Hire of special
equipment obtained for a contract.
Overhead
Overheads comprise of indirect materials, indirect employee cost and indirect expenses which are
not directly identifiable or allocable to a cost object. Overheads may defined as the aggregate of
the cost of indirect material, indirect labour and such other expenses including services as cannot
conveniently be charged directly to specific cost units. Thus overheads are all expenses other than
direct expenses. In general terms, overheads comprise all expenses incurred for or in connection with,
the general organization of the whole or part of the undertaking, i.e., the cost of operating supplies
and services used by the undertaking and includes the maintenance of capital assets.
Prime Cost
The aggregate of Direct Material, Direct Labour and Direct Expenses. Generally it constitutes 50% to
80% of the total cost of the product, as such, as it is primary to the cost of the product and called Prime
Cost.
Cost Object
Cost object is the technical name for a product or a service, a project, a department or any activity
to which a cost relates. Therefore the term cost should always be linked with a cost object to be more
meaningful. Establishing a relevant cost object is very crucial for a sound costing system. The Cost
object could be defined broadly or narrowly. At a broader level a cost object may be named as a
Cost Centre, where as at a lowermost level it may be called as a Cost Unit.
Cost Centre
CIMA defines a cost centre as “a location, a person, or an item of equipment (or a group of them) in
or connected with an undertaking, in relation to which costs ascertained and used for the purpose of
cost control”. The determination of suitable cost centres as well as analysis of cost under cost centres
is very helpful for periodical comparison and control of cost. In order to obtain the cost of product or
service, expenses should be suitably segregated to cost centre. The manager of a cost centre is held
responsible for control of cost of his cost centre. The selection of suitable cost centres or cost units
for which costs are to be ascertained in an undertaking depends upon a number of factors such as
organization of a factory, condition of incidence of cost, availability of information, requirements of
costing and management policy regarding selecting a method from various choices. Cost centre
may be production cost centres operating cost centres or process cost centres depending upon the
situation and classification.
Cost centres are of two types-Personal and Impersonal Cost Centre. A personal cost centre consists of
person or group of persons. An impersonal cost centre consists of a location or item of equipment or
group of equipments.
In a manufacturing concern, the cost centres generally follow the pattern or layout of the departments
or sections of the factory and accordingly, there are two main types of cost centres as below :-
(i) Production Cost Centre: These centres are engaged in production work i.e engaged in converting
the raw material into finished product, for example Machine shop, welding shops...etc
(ii) Service Cost Centre: These centres are ancillary to and render service to production cost centres,
for example Plant Maintenance, Administration...etc
The number of cost centres and the size of each vary from one undertaking to another and are
dependent upon the expenditure involved and the requirements of the management for the purpose
of control.

Cost Accounting
Responsibility Centre
A responsibility centre in Cost Accounting denotes a segment of a business organization for the
activities of which responsibility is assigned to a specific person. Thus a factory may be split into a
number of centres and a supervisor is assigned with the responsibility of each centre. All costs relating
to the centre are collected and the Manager responsible for such a cost centres judged by reference
to the activity levels achieved in relation to costs. Even an individual machine may be treated as
responsibility centre for cost control and cost reduction.
Profit Centre
Profit centre is a segment of a business that is responsible for all the activities involved in the production
and sales of products, systems and services. Thus a profit centre encompasses both costs that it incurs
and revenue that it generates. Profit centres are created to delegate responsibility to individuals and
measure their performance. In the concept of responsibility accounting, profit centres are sometimes
also responsible for the investment made for the centre. The profit is related to the invested capital.
Such a profit centre may also be termed as investment centre.
Cost Unit
Cost Unit is a device for the purpose of breaking up or separating costs into smaller sub divisions
attributable to products or services. Cost unit can be defined as a ‘Unit of product or service in relation
to which costs are ascertained’. The cost unit is the narrowest possible level of cost object.
It is the unit of quantity of product, service of time (or combination of these) in relation to which costs
may be ascertained or expressed. We may, for instance, determine service cost per tonne of steel,
per tonne-kilometre of a transport service or per machine hour. Sometimes, a single order or contract
constitutes a cost unit which is known as a job. A batch which consists of a group of identical items
and maintains its identity through one or more stages or production may also be taken as a cost unit.
A few examples of cost units are given below:
Industry / Product Cost Unit
Automobile Number of vehicles
Cable Metres / kilometres
Cement Tonne
Chemicals / Fertilizers Litre / Kilogram / tonne
Gas Cubic Metre
Power - Electricity Kilowatt Hour
Transport Tonne-Kilometre, Passenger-Kilometre
Hospital Patient Day
Hotel Bed Night
Education Student year
Telecom Number of Calls
BPO Service Accounts handled
Professional Service Chargeable Hours
Cost Allocation
When items of cost are identifiable directly with some products or departments such costs are charged
to such cost centres. This process is known as cost allocation. Wages paid to workers of service
department can be allocated to the particular department. Indirect materials used by a particular
department can also be allocated to the department. Cost allocation calls for two basic factors - (i)
Concerned department/product should have caused the cost to be incurred, and (ii) exact amount
of cost should be computable.

Cost Apportionment
When items of cost cannot directly charge to or accurately identifiable with any cost centres, they are
prorated or distributed amongst the cost centres on some predetermined basis. This method is known
as cost apportionment. Thus we see that items of indirect costs residual to the process of cost allocation
are covered by cost apportionment. The predetermination of suitable basis of apportionment is very
important and usually following principles are adopted - (i) Service or use (ii) Survey method (iii) Ability
to bear. The basis ultimately adopted should ensure an equitable share of common expenses for the
cost centres and the basis once adopted should be reviewed at periodic intervals to improve upon
the accuracy of apportionment.
Cost Absorption
Ultimately the indirect costs or overhead as they are commonly known, will have to be distributed over
the final products so that the charge is complete. This process is known as cost absorption, meaning
thereby that the costs absorbed by the production during the period. Usually any of the following
methods are adopted for cost absorption - (i) Direct Material Cost Percentage (ii) Direct Labour Cost
Percentage (iii) Prime Cost Percentage (iv) Direct Labour Hour Rate Method (v) Machine Hour Rate,
etc. The basis should be selected after careful maximum accurancy of Cost Distribution to various
production units. The basis should be reviewed periodically and corrective action whatever needed
should be taken for improving upon the accuracy of the absorption.
Conversion Cost
This term is defined as the sum of direct wages, direct expenses and overhead costs of converting raw
material to the finished products or converting a material from one stage of production to another
stage. In other words, it means the total cost of producing an article less the cost of direct materials
used. The cost of indirect materials and consumable stores are included in such cost. The compilation
of conversion cost is useful in a number of cases. Where cost of direct materials is of fluctuating nature,
conversion cost is used to cost control purpose or for any other decision making. In contracts/jobs
where raw materials are on account of the buyers conversion cost takes the place of total cost in the
books of the producer. Periodic comparison/review of the conversion cost may give sufficient insight
as to the level of efficiency with which the production unit is operating.
Cost Control
Cost Control is defined as the regulation by executive action of the costs of operating an undertaking,
particularly where such action is guided by Cost Accounting.
Cost control involves the following steps and covers the various facets of the management:
Planning: First step in cost control is establishing plans / targets. The plan/target may be in the form of
budgets, standards, estimates and even past actual may be expressed in physical as well as monetary
terms. These serves as yardsticks by which the planned objective can be assessed.
Communication: The plan and the policy laid down by the management are made known to all those
responsible for carrying them out. Communication is established in two directions; directives are issued
by higher level of management to the lower level for compliance and the lower level executives report
performances to the higher level.
Motivation: The plan is given effect to and performances starts. The performance is evaluated, costs are
ascertained and information about results achieved are collected and reported. The fact that costs
are being complied for measuring performances acts as a motivating force and makes individuals
endeavor to better their performances.
Appraisal and Reporting: The actual performance is compared with the predetermined plan and
variances, i.e deviations from the plan are analyzed as to their causes. The variances are reported to
the proper level of management.

Cost Accounting
Decision Making: The variances are reviewed and decisions taken. Corrective actions and remedial
measures or revision of the target, as required, are taken.
Advantages of Cost Control
The advantages of cost control are mainly as follows
(i) Achieving the expected return on capital employed by maximising or optimizing profit
(ii) Increase in productivity of the available resources
(iii) Reasonable price of the customers
(iv) Continued employment and job opportunity for the workers
(v) Economic use of limited resources of production
(vi) Increased credit worthiness
(vii) Prosperity and economic stability of the industry
Cost Reduction
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 maximised either by increasing sales or by reducing
costs. In a competition less market or in case of monopoly products, it may perhaps be possible to
increase price to earn more profits and the need for reducing costs may not be felt. Such conditions
cannot, however, exist paramount and when competition comes into play, it may not be possible to
increase the sale price without having its adverse effect on the sale volume, which, in turn, reduces
profit. Besides, increase in price of products has the ultimate effect of pushing up the raw material
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 method devised to cut down expenditure and thereby reduce the cost of products.
In short, cost reduction would mean maximization of profits by reducing cost through economics and
savings in costs of manufacture, administration, selling and distribution.
Cost reduction may be defined as the real and permanent reduction in the unit costs of goods
manufactured or services rendered without impairing their suitability for the use intended. As will be
seen from the definition, the reduction in costs should be real and permanent. Reductions due to
windfalls, fortuities receipts, changes in government policy like reduction in taxes or duties, or due
to temporary measures taken for tiding over the financial difficulties do not strictly come under the
purview of cost reduction. At the same time a programme of cost reduction should in no way affect
the quality of the products nor should it lower the standards of performance of the business.
Broadly speaking reduction in cost per unit of production may be affected in two ways viz.,
(i) By reducing expenditure, the volume of output remaining constant, and
(ii) By increasing productivity, i.e., by increasing volume of output and the level of expenditure
remains unchanged.
These aspects of cost reduction are closely linked and they act together - there may be a reduction in
the expenditure and the same time, an increase in productivity.

Cost Control vs. Cost Reduction: Both Cost Reduction and Cost Control are efficient tools of management
but their concepts and procedure are widely different. The differences are summarised below:
Cost Control Cost Reduction

(a) Cost Control represents efforts made towards (a) Cost Reduction represents the achievement
achieving target or goal. in reduction of cost.
(b) The process of Cost Control is to set up a (b)
Cost Reduction is not concern with
target, ascertain the actual performance maintenance of performance according to
and compare it with the target, investigate standard.
the variances, and take remedial measures.
(c) Cost Control assumes the existence of (c) Cost Reduction assumes the existence of
standards or norms which are not challenged. concealed potential savings in standards
or norms which are therefore subjected
to a constant challenge with a view to
improvement by bringing out savings.
(d) Cost Control is a preventive function. Costs (d) Cost Reduction is a corrective function. It
are optimized before they are incurred. operates even when an efficient cost control
system exists. There is room for reduction in the
achieved costs under controlled conditions.
(e) Cost Control lacks dynamic approach. (e) Cost Reduction is a continuous process of
analysis by various methods of all the factors
affecting costs, efforts and functions in an
organization. The main stress is upon the why
of a thing and the aim is to have continual
economy in costs.
1.3 CLASSIFICATION OF COST
Types of costing have been designed to suit the needs of individual business conditions. The basic
principles underlying all these methods are the same i.e. to collect and analyze the expenditure
according to the elements of costs and to determine the cost of each Cost Centre and or Cost Unit.
Classification of cost is the arrangement of items of costs in logical groups having regard to their nature
or purpose. Items should be classified by one characteristic for a specific purpose without ambiguity.
Scheme of classification should be such that every item of cost can be classified. In view of the above,
cost classification may be explained as below:
As per Cost Accounting Standard 1 (CAS-1), the basis for cost classification is as follows:
(a) Nature of expense
(b) Relation to Object – Traceability
(c) Functions / Activities
(d) Behaviour – Fixed, Semi-variable or Variable
(e) Management decision making
(f) Production Process
(g) Time Period
Classification of cost is the process of grouping the components of cost under a common designation
on the basis of similarities of nature, attributes or relations. It is the process of identification of each item
and the systematic placement of like items together according to their common features.

Cost Accounting
(a) Classification by Nature of Expense

Costs should be gathered together in their natural grouping such as Material, Labour and Other Direct
expenses. Items of costs differ on the basis of their nature. The elements of cost can be classified in the
following three categories. 1. Material 2. Labour 3. Expenses
Cost Classification by nature
Material Labour Expenses
Material Cost: Material cost is the cost of material of any nature used for the purpose of production
of a product or a service. It includes cost of materials, freight inwards, taxes & duties, insurance ...etc
directly attributable to acquisition, but excluding the trade discounts, duty drawbacks and refunds on
account of excise duty and vat.
Labour Cost: Labour cost means the payment made to the employees, permanent or temporary for
their services. Labour cost includes salaries and wages paid to permanent employees, temporary
employees and also to the employees of the contractor. Here salaries and wages include all the
benefits like provident fund, gratuity, ESI, overtime, incentives...etc
Expenses: Expenses are other than material cost or labour cost which are involved in an activity.
(b) Classification by Relation to Cost Centre or Cost Unit:
If expenditure can be allocated to a cost centre or cost object in an economically feasible way then
it is called direct otherwise the cost component will be termed as indirect. According to this criteria for
classification, material cost is divided into direct material cost and indirect material cost, Labour cost
is divided into direct labour and indirect labour cost and expenses into direct expenses and indirect
expenses. Indirect cost is also known as overhead.
Cost Classification by relation to cost centre
Direct Indirect
Material Labour Expenses Material Labour Expenses
Direct Material Cost: Cost of material which can be directly allocated to a cost centre or a cost object
in an economically feasible way.
Direct labour Cost: Cost of wages of those workers who are readily identified or linked with a cost centre
or cost object.
Direct Expenses: Expenses other than direct material and direct labour which can be identified or
linked with cost centre or cost object.
Direct Material + Direct labour + Direct Expenses = Prime Cost
Indirect Material : Cost of material which cannot be directly allocable to a particular cost centre or
cost object.

Indirect Labour : Cost of wages of employees which are not directly allocable to a particular cost
centre.
Indirect expenses: Expenses other than of the nature of material or labour and cannot be directly
allocable to a particular cost centre.
Indirect Material + Indirect Labour + Indirect Expenses = Overheads
(c) Classification by Functions:
A business enterprise performs a number of functions like manufacturing, selling, research...etc.
Costs may be required to be determined for each of these functions and on this basis functional costs
may be classified into the following types:-
(i) Production or Manufacturing Costs
(ii) Administration Costs
(iii) Selling & Distribution cost
(iv) Research & Development costs
Cost classification by function
Production Administration Research & Selling Distribution

Development
(i) Production or Manufacturing Costs: Production cost is the cost of all items involved in the production of
a product or service. These refer to the costs of operating the manufacturing division of an undertaking
and include all costs incurred by the factory from the receipt of raw materials and supply of labour and
services until production is completed and the finished product is packed with the primary packing.
The followings are considered as Production or Manufacturing Costs:-
(1) Direct Material
(2) Direct Labour
(3) Direct Expenses and
(4) Factory overhead, i.e., aggregate of factory indirect material, indirect labour and indirect
expenses.
Manufacturing cost can also be referred to as the aggregate of prime cost and factory overhead.
(ii) Administration Costs: Administration costs are expenses incurred for general management of an
organization. These are in the nature of indirect costs and are also termed as administrative overheads.
For understanding administration cost, it is necessary to know the scope of administrative function.
Administrative function in any organization primarily concerned with following activities :-
(1) Formulation of policy
(2) Directing the organization and
(3) Controlling the operations of an organization. But administrative function will not include control
activities concerned with production, selling and distribution and research and development.
Therefore, administration cost is the cost of administrative function, i.e., the cost of formulating policy,
directing, organizing and controlling the operations of an undertaking (Administrative cost will include

Cost Accounting
the cost of only those control operations which are not related to production, selling and distribution
and research and development). In most of the cases, administration cost includes indirect expenses
of following types:
(1) Salaries of office staff, accountants, directors
(2) Rent, rates and depreciation of office building
(3) Postage, stationery and telephone
(4) Office supplies and expenses
(5) General administration expenses.
(iii) Selling & Distribution Costs: Selling costs are indirect costs related to selling of products are services
and include all indirect costs in sales management for the organization. Distribution costs are the costs
incurred in handling a product from the time it is completed in the works until it reaches the ultimate
consumer.
Selling function includes activities directed to create and stimulate demand of company’s product
and secure orders. Distribution costs are incurred to make the saleable goods available in the hands
of the customer.
Following are the examples of selling and distribution costs:
(1) Salaries and commission of salesmen and sales managers.
(2) Expenses of advertisement, insurance.
(3) Rent, rates, depreciation and insurance of sales office and warehouses.
(4) Cost of insurance, freight, export, duty, packing, shipping, etc.,
(5) Maintenance of Delivery vans.
(iv) Research & Development Costs: Research & development costs are the cost for undertaking
research to improve quality of a present product or improve process of manufacture, develop a new
product, market research...etc. and commercialization thereof.
R&D Costs comprises of the following:-
(1) Development of new product.
(2) Improvement of existing products.
(3) Finding new uses for known products.
(4) Solving technical problem arising in manufacture and application of products.
(5) Development cost includes the costs incurred for commercialization / implementation of research
findings.
Pre-Production Costs:
These are costs incurred when a new factory is in the process of establishment, a new project is
undertaken, or a new product line or product is taken up but there is no established or formal production
to which such costs may be charged. Preproduction costs are normally treated as deferred revenue
expenditure and charged to the costs of future production.
(d) Classification based on Behaviour – Fixed, Semi-variable or Variable
Costs are classified based on behaviour as fixed cost, variable cost and semi-variable cost depending
upon response to the changes in the activity levels.
Cost classification by behaviour
Fixed Variable Semi-variable

Fixed Cost: Fixed cost is the cost which does not vary with the change in the volume of activity in the
short run. These costs are not affected by temporary fluctuation in activity of an enterprise. These are
also known as period costs. Example: Rent, Depreciation...etc.
Variable Cost: Variable cost is the cost of elements which tends to directly vary with the volume of
activity. Variable cost has two parts (i) Variable direct cost (ii) Variable indirect costs. Variable indirect
costs are termed as variable overheads. Example: Direct labour, Outward Freight...etc.
Semi-Variable Costs: Semi variable costs contain both fixed and variable elements. They are partly
affected by fluctuation in the level of activity. These are partly fixed and partly variable costs and vice
versa. Example: Factory supervision, Maintenance...etc.
(e) Classification based on Costs for Management Decision Making
Ascertainment of cost is essential for making managerial decisions. On this basis costing may be
classified into the following types.
Marginal Costing: Marginal Cost is the aggregate of variable costs, i.e. prime cost plus variable
overhead. Marginal cost per unit is the change in the amount at any given volume of output by which
the aggregate cost changes if the volume of output is increased or decreased by one unit. Marginal
Costing system is based on the system of classification of costs into fixed and variable. The fixed costs
are excluded and only the marginal costs, i.e. the variable costs are taken into consideration for
determining the cost of products and the inventory of work-in-progress and completed products.
Differential Cost: Differential cost is the change in the cost due to change in activity from one level to
another.
Opportunity Cost: Opportunity cost is the value of alternatives foregone by adopting a particular
strategy or employing resources in specific manner. It is the return expected from an investment other
than the present one. These refer to costs which result from the use or application of material, labour
or other facilities in a particular manner which has been foregone due to not using the facilities in the
manner originally planned. Resources (or input) like men, materials, plant and machinery, finance etc.,
when utilized in one particulars way, yield a particular return (or output). If the same input is utilized in
another way, yielding the same or a different return, the original return on the forsaken alternative that
is no longer obtainable is the opportunity cost. For example, if fixed deposits in the bank are proposed
to be withdrawn for financing project, the opportunity cost would be the loss of interest on the deposits.
Similarly when a building leased out on rent to a party is got vacated for own purpose or a vacant
space is not leased out but used internally, say, for expansion of the production programme, the rent
so forgone is the opportunity cost.
Replacement Cost: Replacement cost is the cost of an asset in the current market for the purpose
of replacement. Replacement cost is used for determining the optimum time of replacement of an
equipment or machine in consideration of maintenance cost of the existing one and its productive
capacity. This is the cost in the current market of replacing an asset. For example, when replacement
cost of material or an asset is being considered, it means that the cost that would be incurred if the
material or the asset was to be purchased at the current market price and not the cost, at which it was
actually purchased earlier, should be take into account.
Relevant Costs: Relevant costs are costs which are relevant for a specific purpose or situation. In the
context of decision making, only those costs are relevant which are pertinent to the decision at hand.
Since we are concerned with future costs only while making a decision, historical costs, unless they
remain unchanged in the future period are irrelevant to the decision making process.
Imputed Costs: Imputed costs are hypothetical or notional costs, not involving cash outlay computed
only for the purpose of decision making. In this respect, imputed costs are similar to opportunity costs.
Interest on funds generated internally, payment for which is not actually made is an example of
imputed cost. When alternative capital investment projects are being considered out of which one or
more are to be financed from internal funds, it is necessary to take into account the imputed interest
on own funds before a decision is arrived at.

Cost Accounting
Sunk Costs: Sunk costs are historical costs which are incurred i.e. sunk in the past and are not relevant
to the particular decision making problem being considered. Sunk costs are those that have been
incurred for a project and which will not be recovered if the project is terminated. While considering
the replacement of a plant, the depreciated book value of the old asset is irrelevant as the amount is
sunk cost which is to be written-off at the time of replacement.
Normal Cost & Abnormal Cost: Normal Cost is a cost that is normally incurred at a given level of output
in the conditions in which that level of output is achieved. Abnormal Cost is an unusual and typical
cost whose occurrence is usually irregular and unexpected and due to some abnormal situation of the
production.
Avoidable Costs & Unavoidable Costs: Avoidable Costs are those which under given conditions of
performance efficiency should not have been incurred. Unavoidable Costs which are inescapable
costs, which are essentially to be incurred, within the limits or norms provided for. It is the cost that must
be incurred under a programme of business restriction. It is fixed in nature and inescapable.
Uniform Costing: This is not a distinct system of costing. The term applies to the costing principles and
procedures which are adopted in common by a number of undertakings which desire to have the
benefits of a uniform system. The methods of Uniform Costing may be extended so as to be useful in
inter-firm comparison.
Engineered Cost: Engineered Cost relates to an item where the input has an explicit physical relationship
with the output. For instance in the manufacture of a product, there is a definite relationship between the
units of raw material and labour time consumed and the amount of variable manufacturing overhead
on the one hand and units of the products produced on the other. The input-output relationship can
be established the form of standards by engineering analysis or by an analysis of the historical data. It
should be noted that the variable costs are not engineered cost but some administration and selling
expenses may be categorized as engineered cost.
Out-of-Pocket Cost: This is the portion of the cost associated with an activity that involve cash payment
to other parties, as opposed to costs which do not require any cash outlay, such as depreciation
and certain allocated costs. Out-of-Pocket Costs are very much relevant in the consideration of price
fixation during trade recession or when a make-or-buy decision is to be made.
Managed Cost: Managed (Programmed or Discretionary) Costs all opposed to engineering costs, relate
to such items where no accurate relationship between the amount spent on input and the output can
be established and sometimes it is difficult to measure the output. Examples are advertisement cost,
research and development costs, etc.,
Common Costs: These are costs which are incurred collectively for a number of cost centres and are
required to be suitably apportioned for determining the cost of individual cost centres. Examples are:
Combined purchase cost of several materials in one consignment, and overhead expenses incurred
for the factory as a whole.
Controllable and Non-Controllable Costs: Controllable Cost is that cost which is subject to direct
control at some level of managerial supervision. Non-controllable Cost is the cost which is not subject
to control at any level of managerial supervision.
(f) Classification by nature of Production or Process:
Cost Classification by nature of Production or Process
Batch Process Operation Operating Contract Joint

Cost Cost Cost Cost Cost Cost

Batch Costing: Batch Costing is the aggregate cost related to a cost unit which consists of a group of
similar articles which maintains its identity throughout one or more stages of production. In this method,
the cost of a group of products is ascertained. The unit cost is a batch or group of identical products
instead of a single job, order, or contract. This method is applicable to general engineering factories
which produces components in convenient economical batches.
Process Costing: When the production process is such that goods are produced from a sequence
of continuous or repetitive operations or processes, the cost incurred during a period is considered
as Process Cost. The process cost per unit is derived by dividing the process cost by number of units
produced in the process during the period. Process Costing is employed in industries where a continuous
process of manufacturing is carried out. Costs are ascertained for a specified period of time by
departments or process. Chemical industries, refineries, gas and electricity generating concerns may
be quoted as examples of undertakings that employ process costing.
Operation Cost: Operation Cost is the cost of a specific operation involved in a production process
or business activity. The cost unit in this method is the operation, instead of process. When the
manufacturing method consists of a number of distinct operations, operation costing is suitable.
Operating Cost: Operating cost is the cost incurred in conducting a business activity. Operating cost
refer to the cost of undertakings which do not manufacture any product but which provide services.
Industries and establishments like power house, transport and travel agencies, hospitals, and schools,
which undertake services rather than the manufacture of products, ascertain operating costs. The
cost units used are Kilo Watt Hour (KWH), Passenger Kilometer and Bed in the hospital....etc. Operation
costing method constitutes a distinct type of costing but it may also be classed as a variant of Process
Cost since costs in this method are usually compiled for a specified period.
Contract Costing: Contract cost is the cost of contract with some terms and conditions between
contractee and contractor. This method is used in undertakings, carrying out, building or constructional
contracts like constructional engineering concerns, civil engineering contractors. The cost unit here is a
contract, which may continue over more than one financial year.
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.
When a production process is such that from a set of same input two or more distinguishably different
products are produced together, products of greater importance are termed as Joint Products and
products of minor importance are termed as By-products and the costs incurred prior to the point of
separation are called Joint Costs. For example in petroleum industry petrol, diesel, kerosene, naphtha,
tar is produced jointly in the refinery process.
By-product Cost: By-product Cost is the cost assigned to by-products till the split-off point.
(g) Classification by Time:
A cost item is related to a specific period of time and cost can be classified according to the system of
assessment and specific purpose as indicated in the following ways :-
Classification by Time
Historical Pre-determined
Cost Cost
Standard Cost Estimated Cost

Cost Accounting
Historical Costs: Historical Costs are the actual costs of acquiring assets or producing goods or services.
They are post-mortem costs ascertained after they have been incurred and they represent the cost of
actual operational performance. Historical Costing follows a system of accounting to which all values
are based on costs actually incurred as relevant from time to time.
Predetermined Costs: Pre-determined Costs for a product are computed in advance of production
process, on the basis of a specification of all the factors affecting cost and cost data. Predetermined
Costs may be either standard or estimated.
Standard Costs: A predetermined norm applies as a scale of reference for assessing actual cost,
whether these are more or less. The Standard Cost serves as a basis of cost control and as a measure
of productive efficiency, when ultimately posed with an actual cost. It provides management with
a medium by which the effectiveness of current results is measured and responsibility of deviation
placed. Standard Costs are used to compare the actual costs with the standard cost with a view to
determine the variances, if any, and analyse the causes of variances and take proper measure to
control them.
Estimated Costs: Estimated Costs of a product are prepared in advance prior to the performance
of operations or even before the acceptance of sale orders. Estimated Cost is found with specific
reference to product in question, and the activity levels of the plant. It has no link with actual and
hence it is assumed to be less accurate than the Standard Cost.
Techniques of Costing:
A. Marginal Costing
B. Standard Costing
C. Budgetary Control
D. Uniform Costing
A. Marginal costing
Marginal Costing is the ascertainment of marginal costs and of the effect on profit of changes in
volume or type of output by differentiating between fixed costs and variable costs. Several other terms
in use like Direct Costing, Contributory Costing, Variable Costing, Comparative Costing, Differential
Costing and Incremental Costing are used more or less synonymously with Marginal Costing.
The term direct cost should not be confused with direct costing. In absorption Costing, direct cost
refers to the cost which is attributable to a cost centre of cost unit (e.g., direct labour, direct material
and direct expenses including traceable fixed expenses, i.e., the fixed expense which are directly
chargeable). In Direct Costing (or Marginal Costing), factory variable overhead is taken as a direct
cost while in the Absorption Cost Method, it is Indirect Cost.
B. Standard Costing
Standard Costing is defined as the preparation and use of standard cost, their comparison with
actual costs and the measurement and analysis of variances to their causes and points of incidence.
Standard Cost is a predetermined cost unit that is calculated from the management’s standards of
efficient operation and the relevant necessary expenditure. Standard Costs are useful for the cost
estimation and price quotation and for indicating the suitable cost allowances for products, process
and operations but they are effective tools for cost control only when compared with the actual costs
of operation. The techniques of standard costing may be summarised as follows :-
(i) Predetermination of technical data related to production. i.e., details of materials and labour
operations required for each product, the quantum of inevitable losses, efficiencies expected,
level of activity, etc.
(ii) Predetermination of standard costs in full details under each element of cot, viz., labour, material
and overhead.

(iii) Comparison of the actual performance and costs will the standards and working out the variances,
i.e., the differences between the actual and the standards.
(iv) Analysis of the variances in order to determine the reasons for deviations of actuals from the
standards.
(v) Presentation of information to the appropriate level of management to enable suitable action
(remedial measures or revision of the standard) being taken.
C. Budgetary Control
Budgetary Control may be defined as the process of continuous comparison of actual costs and
performance with the pre-established budgets in relation to the responsibilities of the executives to the
specific budgets for the achievement of a target in accordance with the policy of the organisation and
to provide a basis for revision of budget. Therefore, Budgetary Control involves mainly establishment
of budgets, continuous compassion of actual with budgets for achievement of targets, revision of
budgets in the light of changed circumstances.
The classification of budgets into various categories certainly helps to make the budgetary control
more effective because the maximum use is made of the functional budgets. Functional Budgets over
the goals to be attained by the functional executives and thus assume the greatest significance.
D. Uniform Costing
Uniform Costing may be defined as the application and use of the same costing principles and
procedures by different Organizations under the same management or on a common understanding
between members of an association. It is thus not a separate technique or method. It simply denotes
a situation in which a number of organizations may use the same costing principles in such a way as
to produce costs which are of the maximum comparability. From such comparable costs valuable
conclusions can be drawn. When the Uniform Costing is made use of by the different concerns
the same management it helps to indicate the strengths and/or weaknesses of those concerns. By
studying the findings, appropriate corrective steps may be taken to improve the overall efficiency of
the organizations. When used by the member concerns of a trade association Uniform Costing helps to
reduce expenditure on a comparative marketing, to determine and follow a uniform pricing policy, to
exchange information between the members for comprised and improvement and so on.
Inter-firm Comparison as the name denotes means the techniques of evaluating the performances,
efficiencies, deficiencies, costs and profits of similar nature of firms engaged in the same industry or
business. It consists of exchange of information, voluntarily of course, concerning production, sales
cost with various types of break-up, prices, profits, etc., among the firms who are interested of willing
to make the device a success. The basic purposes of such comparison are to find out the work points
in an organization and to improve the efficiency by taking appropriate measures to wipe out the
weakness gradually over a period of time.
SELF EXAMINATION QUESTIONS:

1. Define profit centre.
2. State the objective of Cost Accounting.
3. ''Cost may be classified in a variety of ways according to their nature and the information needs of
the management” Discuss.
4. State the benefits accrue out of Cost Accounting.
5. Write short notes on the following:
(a) Out of Pocket Cost.
(b) Sunk Cost
(c) Opportunity Cost
(d) Imputed Costs

Cost Accounting
Multiple Choice Questions:

1. Batch Costing is suitable for-
A. Sugar Industry B. Chemical Industry C. Pharma Industry D. Oil Industry
2. Joint Cost is suitable for-

A. Infrastructure Industry B. Ornament Industry. C. Oil Industry D. Fertilizer Industry
3. Cost units of Hospital Industry is-

A. Tonne B. Student per year C. Kilowatt Hour D. Patient Day
4. Cost units of Automobile Industry is-

A. Cubic meter B. Bed Night C. Number of Call D. Number of vehicle
5. Depreciation is a example of-

A. Fixed Cost B. Variable Cost C. Semi Variable Cost D. None of these
[Ans: C, C, D, D, A]
State whether the following statement is True (or) False:

1. Differential Cost is the change in the cost due to change in activity from one level to another.
2. Cost unit of Hotel industry is student per year.
3. Multiple Costing is suitable for the banking Industry.
4. Direct Expenses are expenses related to manufacture of a product or rendering of services.
5. Profit is result of two varying factors sales sales and variable cost.
[Ans: T, F, F, T, F ]
Fill in the blanks:

1. Differential cost is the change in the cost due to change in _____________ from one level to another.
2. Management accounting is primarily concerned with __________________.
3. In Cost Accounting stock are valued at ___________ only.
4. Profit is the resultant of two varying factors viz _______________ and _______________.
5. ___________ cost are historical costs which are incurred in the past.
[Ans: (1) activity; (2) management; (3) cost; (4) sales, cost; (5) sunk.
Match the following:
1 Historical Cost A Specific Situation

2 Opportunity Cost B Student year
3 Relevant Cost C Imputed Cost
4 Cost unit for education D Value of alternative foregone
5 Notional Cost E Sunk cost
[Ans: (1) - (E); (2) - (D); (3) - (A); (4) - (B); (5) - (C).

Cost Ascertainment - Elements of Cost
Study Note - 2
COST ASCERTAINMENT - ELEMENTS OF COST
2.1 Material Costs (CAS - 6)

2.2 Employee Costs (CAS - 7)
2.3 Direct Expenses (CAS - 10)
2.4 Overheads (CAS - 3)
2.1 MATERIAL COST (CAS-6)
Material is any substance (Physics term) that forms part of or composed of a finished product. i.e
material refers to the commodities supplied to an undertaking for the purpose of consumption in the
process of manufacturing or of rendering service or for transformation into products. The term ‘Stores’
is often used synonymously with materials, however, stores has a wider meaning and it covers not
only raw materials consumed or utilized in production but also such other items as sundry supplies,
maintenance stores, fabricated parts, components, tools, jigs, other items, consumables, lubricants......
etc. Finished and partly finished products are also often included under the term ‘Stores’. Materials
are also known as Inventory. The term Materials / Inventory covers not only raw materials but also
components, work-in-progress and finished goods and scrap also.
Material cost is the significant constituent of the total cost of any product. It constitutes 40% to 80% of
the total cost. The percentages may differ from industry to industry. But for manufacturing sector the
material costs are of greatest significance. Inventory also constitutes a vital element in the Working
Capital. So it is treated as equivalent to cash. Therefore the analysis and control on Material Cost is
very important.
Objectives of Material Control System:

Material Control: The function of ensuring that sufficient goods are retained in stock to meet all
requirements without carrying unnecessarily large stocks.
The objectives of a system of material control are as following:-
(a) To make continuous availability of materials so that there may be uninterrupted flow of materials
for production. Production may not be held up for want of materials.
(b) To purchase requisite quantity of materials to avoid locking up of working capital and to minimise
risk of surplus and obsolete stores.
(c) To make purchase competitively and wisely at the most economical prices so that there may be
reduction of material costs.
(d) To purchase proper quality of materials to have minimum possible wastage of materials.
(e) To serve as an information centre on the materials knowledge for prices, sources of supply, lead
time, quality and specification.

Cost Accounting
(f) Study of Material can be better explained as follows:
Material
Purchase & Storage Issue

Receipt
Control
Requisites of Material Control System:

(a) Coordination and cooperation between the various departments concerned viz purchase,
receiving, inspection, storage, issues and Accounts and Cost departments.
(b) Use of standard forms and documents in all the stages of control.
(c) Classification, coordination, standardization and simplification of materials.
(d) Planning of requirement of material.
(e) Efficient purchase organization.
(f) Budgetary control of purchases.
(g) Planned storage of materials, physical control as well as efficient book control through satisfactory
storage control procedures, forms and documents.
(h) Appropriate records to control issues and utilization of stores in production.
(i) Efficient system of Internal Audit and Internal Checks.
(j) System of reporting to management regarding material purchase, storage and utilization.
Purchase Flow:
The main functions of a purchase department are as follows :-
(a) What to purchase? – Right Material with good quality
(b) When to purchase? – Right Time
(c) Where to purchase? – Right Source
(d) How much to purchase? – Right Quantity
(e) At what price to purchase? – Right Price
To perform these functions effectively, the purchasing department follows the following procedure:-
(a) Receiving purchase requisitions.
(b) Exploring the sources of supply and choosing the supplier.
(c) Preparation and execution of purchase orders.
(d) Receiving materials.
(e) Inspecting and testing materials.
(f) Checking and passing of bills for payment.

Purchase Organization:
Purchasing involves procurement of materials of requisite quantity and quality at economic price. It
is of extreme importance particularly to a manufacturing concern because it has bearing on all vital
factors of manufacture such as quantity, quality, cost, efficiency, economy, prompt delivery, volume
of production and so on. Purchase department in a business concern can be organized into two types
i.e Centralized Purchasing System and De-centralized Purchasing System. Purchasing process in most
of the organisation is a centralised function because the advantages of a centralised purchasing out
weight its disadvantages. Lets us see the merits and demerits of both the systems.
Merits of a centralised & De-merits of decentralized purchase organization:
(a) When materials are purchased favourable terms (Trade discount, Economies of transport...etc)
can be obtained because the quantity involved will be large. In case of decentralized system
these benefits cannot be realized.
(b) Specialised purchasing officer can be appointed with the specific purpose of highly efficient
purchases functions of the concern. In case of decentralized purchase system, the business entity
cannot afford a specialized purchasing officer in every location.
(c) Effective control can be exercised over the stock of materials because duplication of purchase
of the same materials may easily be avoided in centralized purchase system, where as in
decentralized purchase system, duplication of purchase of same material cannot be avoided.
(d) Under centralized purchase system effective control can be exercised on the purchases of all the
materials as the purchase function is channelized through one track which would make the system
of receiving, checking and inspection efficient. Where as in decentralized purchase system it is
very difficult to exercise controls.
(e) Under centralized system of purchase materials, components and capital equipments can be
suitably standardised so that the maximum purchasing benefits be availed of, storage facilities can
be improved and available production facilities can be greatly utilized to the maximum possible
extent. Under decentralized purchase system standardization of materials, storage facilities.....etc
is very difficult to achieve.
(f) Under centralized system of purchase closer cooperation between the financial and purchasing
departments can be achieved which may not be easy under decentralized purchase system.
De-Merits of a centralized & Merits of decentralized purchase organization :
(a) In may take unnecessarily long time to place a purchase order under centralized purchase system
because to collect the relevant data from various departments/ branches/locations may take
more time, These delays can be avoided under decentralized purchase system.
(b) In case of centralized purchasing system, branches at different places cannot take advantage of
localized purchasing, whereas under decentralized purchase system localization savings can be
realized.
(c) Due to the Chances of misunderstanding / miscommunication between the branch and the
centralized purchasing office may result in wrong purchase of material also. Whereas under
decentralized purchase system, the chances of miscommunication/ misunderstanding is very
limited.
(d) Centralized system will lead to high initial costs because a separate purchasing department for
purchase of materials is to be setup. No such costs are required to be incurred in the decentralized
system.
(e) Replacement of a defective item may take long time resulting in strain on smooth production flow
under centralized system of purchase. No such delay in decentralized system.
Now let us see the various material control documents in detail.

Cost Accounting
Purchase Requisition:
Purchases Requisition is a request made to the Purchase Department to procure materials of given
description and of the required quality and quantity within a specified period. It is a formal request
and it authorizes the Purchase Department to issue a Purchase Order to secure materials intended for
periodic requirements of a given material or materials to provide guidance to the Purchase Department
to estimate the future requirements in order to secure maximum purchase benefits in the form of higher
discount and better credit terms. The extent and range of materials requirements provide a basis for
preparation of a purchase budget. The actual requirements of a given period can be summarised
from the purchases requisition and compared with the purchase budget in order to determine the
variances and the reasons thereof. This form is prepared by storekeeper for regular items and by the
departmental head for special materials not stocked as regular items.
The Purchase Requisition is prepared in three copies. Original will be sent to Purchase department,
Duplicate copy will be retained by the indenting (request initiating) department and the triplicate will
be sent to approver for approving the purchase requisition.
Purchase Requisition provides the three basic things :-
(a) What type of material is to be purchased?
(b) When to be purchased?
(c) How much is to be purchased?
The specimen form of Purchase Requisition is as shown below :
Modern Ltd
Purchase Requisition or Indent
Purchase Req Type: Special / Regular :
Purchase Req No : Purchase Requisition Date :
Department :
S.No Material Code Description Quantity Material Required by date Remarks

of the Goods Required
Requested by Approved by
For use in Purchase Dept.

Quotations from
(1) PO Placed : Yes /No

(2) PO No:
(3)

Purchase Order:
Purchase Order (PO) is a request made in writing to selected supplier to deliver goods of requisite
quality, quantity, (as per the purchase requisition) at the prices, terms and conditions agreed upon. It is
a commitment on the part of the purchaser to accept the delivery of goods contained in the Purchase
Order if the terms included therein, are fulfilled. Purchase Order contains the following details :-
(a) Purchase Order No; (b) PO Date; (c) Supplier Name and Address; (d) Material Code; (e) Material
description; (f) Grade & Other particulars of the material; (g) Quantity to be supplied; h) Price; i) Place
of delivery; j) Taxes; k) Terms of Payment (Credit period) .....etc
Usually a purchase order is made in five copies, one each for suppliers, Receiving/Stores Department,
Originating Department, Accounts Department and filing. Thus we see that all the departments
concerned with the materials are informed fully about all the details of every purchases and it becomes
easier for everyone to follow up on any relevant matter.
Modern Ltd
Purchase Order

To PO No:
Supplier XXXXXX PO date:
Quotation
Reference:
Address PR No:

Please supply the following items in accordance with the instructions mentioned there in
on the following terms and conditions.

Material Rate per Delivery
S.No Material Code Quantity Amount Remarks
Description Unit Date

Packing &
Freight
Taxes
Total Amount

Delivery: Goods to be delivered at
Delivery date:
Payment Terms:
Authorised signatory

Cost Accounting
Receipt & Inspection of Materials:

Goods Received cum Inspection Note:
The stores department will receive the material after the gate entry. It will compare the quantities
received with the PO Quantity. It is a valuable document as it forms the basis of accounting entry in
the stores ledger and stock records. It is the document basis for quality control department to carry
inspection of the material in warded.
It also forms the basis of payments to be made to the supplier in respect of the materials supplied by
him. Suppliers invoices are checked with goods received notes which such for actual receipt of the
goods supplied by the supplier. One copy of such note is also sent to Inspection Department who after
inspection of materials approves the note for Stores Department to receive the materials. Outstanding
Goods Received Notes which are not linked with supplier’s bills enable the Accounts Department to
estimate at the year end the liability for goods purchased for which supplier’s bills not received.
The specimen copy of the Goods Received cum Inspection Note as below:
New India Ltd

Goods Received cum Inspection Note

Received from : GRN No:
GR Date:
Received at : PO Ref No:
Gate Entry
No:

S.No Material Material Quantity Quantity Qty Rejected Reason for Remarks
code Description Received Accepted Rejection

Prepared by Inspected by

Received by Storekeeper

Purchase Quantity:
Important requirement for an efficient system of purchase control is to ensure that only the correct
quantity of materials is purchased. The basic factors to be considered while fixing the ordering quantity
are as follows :-
(a) There should be no overstocking.
(b) Materials should always be available in sufficient quantity to meet the requirements of production
and to avoid plant shut down.
(c) Purchases should be made in economic lots.
Other factors to be considered are quantity already ordered, availability of funds, business cycle... etc.

Purchase department in manufacturing concerns is usually faced with the problem of deciding the
quantity of various items, which they should purchase basing on the above factors. If purchases of
material are made in bulk then inventory cost will be high. On the other hand if the order size is small
each time then the ordering cost will be very high. In order to minimise ordering and carrying costs it is
necessary to determine the order quantity which minimises these two costs.
Economic Order Quantity: (EOQ)

The total costs of a material usually consist of Buying Cost + Total Ordering Cost + Total Carrying Cost.
Economic Order Quantity is ‘The size of the order for which both ordering and carrying cost are
minimum’.
Ordering Cost: The costs which are associated with the ordering of material. It includes cost of staff
posted for ordering of goods, expenses incurred on transportation, inspection expenses of incoming
material....etc
Carrying Cost: The costs for holding the inventories. It includes the cost of capital invested in inventories.
Cost of storage, Insurance.....etc
The assumptions underlying the Economic Ordering Quantity (EOQ): The calculation of economic
order of material to be purchased is subject to the following assumptions:-
(a) Ordering cost per order and carrying cost per unit per annum are known and they are fixed.
(b) Anticipated usage of material in units is known.
(c) Cost per unit of the material is constant and is known as well.
(d) The quantity of material ordered is received immediately i.e lead time is Zero.
The famous mathematician ‘WILSON’ derived the formula used for determining the size of order for
each purchases at minimum ordering and carrying costs, which is as below :-
Economic Ordering Quantity = 2AO

C
Where,
A = Annual demand /Consumption
O = Ordering Cost per order
C = Carrying Cost per unit per annum.
Graphical representation of EOQ:
Carrying Cost
EOQ
Cost
Ordering Cost
Quantity

Cost Accounting
Illustration 1
Calculate the Economic Order Quantity from the following information. Also state the number of orders
to be placed in a year.
Consumption of materials per annum : 10,000 kg
Order placing cost per order : ` 50
Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory
Solution:
2×A×O
EOQ =
C
A = Units consumed during year = 10,000 Kg.
O = Order cost per order = `50
C = Inventory carrying cost per unit per annum 2 × 8% = ` 0.16
2 ×10,000 (units)× ` 50
EOQ =
` 0.16
EOQ = 2,500 kg.
Total consumptio n of materials per annum

No. of orders to be placed in a year =
EOQ
10,000 kg
=
2,500 kg
= 4 Orders per year
Illustration 2
The average annual consumption of a material is 18,250 units at a price of ` 36.50 per unit. The storage
cost is 20% on an average inventory and the cost of placing an order is ` 50. How much quantity is to
be purchased at a time?
Solution:
2 ×18,250 (units)× ` 50
EOQ =
20% of ` 36.50
18,25,000
=
7.3
= 500 Units

Material Storage & Control:

Once the material is received, it is the responsibility of the stores-in-charge, to ensure that material
movements in and out of stores are done only against the authorized documents. Stores-in-charge
is responsible for proper utilization of storage space & exercise better control over the material in
the stores to ensure that the material is well protected against all losses such as theft, pilferage, fire,
misappropriation ...etc.
Duties of store keeper:
The duties of store-keeper are as follows :-
(a) To exercise general control over all activities in stores department.
(b) To ensure safe storage of the materials.
(c) To maintain proper records.
(d) To initiate purchase requisitions for the replacement of stock of all regular materials, whenever the
stock level of any item in the store reaches the Minimum Level.
(e) To initiate the action for stoppage of further purchasing when the stock level approaches the
Maximum Level.
(f) To issue materials only in required quantities against authorized requisition documents.
(g) To check and receive purchased materials forwarded by the receiving department and to
arrange for storage in appropriate places.
Different classes of stores:-

Broadly speaking, there are three classes of stores
(a) Central Stores
(b) Decentralized stores
(c) Sub-Store (Imprest Store)
Centralized stores:
The usual practice in most of the concerns is to have a central store. Separate store to meet the
requirements of each production department are not popular because of the heavy expenditure
involved. In case of centralized stores materials are received by and issued from one stores department.
All materials are kept at one central store. The advantages and disadvantages of this type of store are
set out as follows:
Advantages of centralized stores:
(a) Better control can be exercised over stores because all stores are housed in one department. The
risk of obsolescence of stores can be minimised.
(b) The economy of staff-experts, or clerical, floor space, records and stationery are available.
(c) Better supervision is certainly possible.
(d) Obsolescence of the stores items can be kept under strict vigil and control.
(e) Centralized material handling system can be put into operation thus further economising on
space, personnel and equipments.
(f) Investment in stocks can be minimized.

Cost Accounting
Disadvantages of centralized stores:

(a) The transportation costs of the materials may increase because the movements of the stores may
be for a greater distance since the storing is centralized.
(b) If the user departments are far away from the stores there may be delay in receipt of the stores by
those departments.
(c) Breakdown of inter-departmental transport system may hold up the entire process, and similarly
labour problem in the centralized stores may bring the entire concern to standstill.
(d) There is greater chance of losses through fire, burglary or some other unhappy incidents.
(e) It may not be safe to have some hazardous elements bunched together in the centralized stores.
Decentralized stores:
Under this type of stores, independent stores are situated in various departments. Handling of stores is
undertaken by the store keeper in each department. The departments requiring stores can draw them
from their respective stores situated in their departments. The disadvantages of centralized stores can
be eliminated, if there are decentralized stores. But these types of stores are uncommon because of
heavy expenditure involved.
Central stores with sub-stores:
In large organizations, factories / workshops may be located at different places which are far from the
central stores. So in order to keep the transportation costs and handling charges to the minimum level,
sub-stores should be situated near to the factory. For each item of materials a quantity is determined
and this should be kept in the stock at the beginning of any period. At the end of a period, the store
keepers of each sub-store will requisition from the central stores the quantity of the materials consumed
to bring the stock up to the predetermined quantity. In short this type of stores operates in a similar way
to a petty cash system, so this system of stores is also known as the imprest system of stores control.
Advantages:
(a) It ensures the prompt issue of stores.
(b) It confines the advantages of centralized stores with sub-stores and at the same time it does not
sacrifice the centralized control.
(c) It reduces handling cost of materials.
(d) It avoids the maintenance of elaborate inventory records.
Control of the Stores:
Classification and Codification of Material:
In case of large organizations the number and types of materials used is considerable and unless each
item is distinguished and stored separately it would be impossible to find them out when they are
required for production or any other operation. It may happen that either one type of material is in
excess or another type may be altogether non-existent. It is therefore, essential that a proper system of
classification and codification.
Classified into different categories according to their nature or type, viz., mild steel, tool steel, brass,
bronze, copper, glass, timber, etc., and then again within such broad classification into rounds; bars,
strips; angles, etc. There are two steps in the classification and codification of materials - determination
of the number of items, their nature, other characteristics and classification of the items of comparable
nature or type into suitable groups or classes.

Various classes of coding are in practice and the common types are stated below:
(a) Alphabetical Scheme: Alphabetics are only used for codification. Like Mild Steel Sheets are coded
as MSS.
(b) Numeric Scheme : In this scheme numericals are used instead of alphabets, For example If steel
is given main code of 300 mild steel may be coded as 310 and mild steel sheet may be coded as
311, mild steel bar may be coded as 3112.
(c) Decimal Scheme: It is similar to the numeric scheme in which the groups are represented by
number and digits after the decimal indicate sub-groups of items. For example, where the steel is
coded as 3.00 mild steel may be coded as 3.10 and mild steel sheet can be coded as 3.11 and
mild sheet bar as 3.12 and so on.
(d) Block Scheme: In this case block of number are allotted for classification of specific groups such
as for material classification the block of number 1 to 999 may be reserved, for raw materials; 1000
to 1999 for stores and spares; 2000 to 2999 for finished goods.
(e) Combination Scheme : Here the code structure takes in account both alphabetic and numeric
schemes and strikes a balance between the two. Mild steel by coded as MS and the sheets, bars,
strips, rounds of mild steel may be coded as MS01, MS02, MS04 and so on. This code is most com-
monly used because this system has got the advantage of both the alphabetic and numeric
systems and is quite flexible in nature.
Advantages of Classification & Codification of materials:
(a) The procedure assists in the easy identification and location of the materials because of their
classification.
(b) It minimises the recording of the nature/ type of the materials with detailed description on every
document relating to the transaction of materials.
(c) Codification is a must in the case of mechanisation of the stores accounting.
(d) The method is simple to operate and definitely saves time and money in respect of both physical
location/ identification of materials as well as recording of the materials.
After the material classification and codification is done for all the materials, for each material code
we have to fix the Minimum Level, Maximum Level, Re-order Level and Re-order Quantity. It is the
storekeeper’s responsibility to ensure inventory of any material is maintained between the Minimum
Level and Maximum Level.
Maximum Level:
The Maximum Level indicates the maximum quantity of an item of material that can be held in stock
at any time. The stock in hand is regulated in such a manner that normally it does not exceed this level.
While fixing the level, the following factors are to be taken into consideration:
(a) Maximum requirement of the store for production purpose, at any point of time.
(b) Rate of consumption and lead time.
(c) Nature and properties of the Store: For instance, the maximum level is necessarily kept low for
materials that are liable to quick deterioration or obsolescence during storage.
(d) Storage facilities that can be conveniently spared for the item without determinant to the
requirements of other items of stores.
(e) Cost of storage and insurance.
(f) Economy in prices: For seasonal supplies purchased in bulk during the season, the maximum level
is generally high.

Cost Accounting
Valuation of Material Issues:

Principles of valuation of issue of materials as per CAS-6 (Limited Revision, 2017) are as follows :-
(a) Issues shall be valued using appropriate assumptions on cost flow such as FIFO, LIFO, and Weighted
average rate. The method of valuation shall be followed on a consistent basis.
(b) Where materials are accounted at standard cost, the price variances related to materials shall be
treated as part of material cost.
(c) Any abnormal cost shall be excluded from the material cost.
(d) Wherever the material cost includes the transportation costs, determination of transportation cost
shall be based on CAS-5, i.e Equalized Transportation Costs.
(e) Material cost may include imputed costs not considered in Financial Accounts.
(f) Self manufactured components and sub-assemblies item shall be valued including the direct
material, direct labour, direct expenses, factory overheads, share of administrative overheads
relating to the production but excluding share of other administrative overheads, finance cost
and marketing overheads. In case of captive consumption, the valuation shall be in accordance
with Cost Accounting Standard-4.
(g) The material cost of normal scrap / defectives which are rejects shall be included in the material
cost of goods manufactured. The material cost of actual scrap / defectives, not exceeding the
normal shall be adjusted in the material cost of good production. Material cost of abnormal
scrap/ defectives should not be included in material cost but treated as loss after giving credit to
the realisable value of such scrap / defetives.
Materials issued from stores should be priced at the price at which they are carried in inventory.
Material may be purchased from different suppliers at different prices in different situations, where as
consumption may happen the entire inventory at a time or at different lots....etc. So issue of materials
should be valued after considering the following factors:-
(a) Nature of business and production process.
(b) Management policy relating to the closing stock valuation.
(c) Frequency of purchases and price fluctuations.
Several methods of pricing of material issues have been evolved; these may be classified into the
following:-
Cost Price Method
(a) First in First out
(b) Last-in-first out
(c) Base Stock Method
Specific price method
(a) Average Price Method
(b) Simple Average Price Method
(c) Weighted Average Price Method
(d) Moving Simple Average Method
(e) Moving Weighted Average Method
Market Price Methods
(a) Replacement Method
(b) Realisable Price Method

Notional Price Methods:

(a) Standard Price Method
(b) Inflated Price Method
We may now briefly discuss all the above methods
(1) First in – First Out Method:
It is a method of pricing the issue of materials in the order in which they are purchased. In other
words the materials are issued in the order in which they arrive in the store. This method is considered
suitable in times of falling price because the material cost charged to production will be high while the
replacement cost of materials will be low. In case of rising prices this method is not suitable.
Advantages of FIFO:-
(a) It is simple and easy to operate.
(b) In case of falling prices, this method gives better results.
(c) Closing stocks represents the market prices.
Disadvantages:-
(a) If the prices fluctuate frequently, this method may lead to clerical errors.
(b) In case of rising prices this method is not advisable.
(c) The material costs charged to same job are likely to show different rates.
(2) Last-in-First Out Method:
Under this method the prices of last received batch (lot) are used for pricing the issues, until it is
exhausted and so on. During the inflationary period or period of rising prices, the use of LIFO would
help to ensure the cost of production determined approximately on the above basis is approximately
the current one. Under LIFO stocks would be valued at old prices, but not represent the current prices.
Advantages:-
(a) The cost of materials issued will be either nearer to and/or will reflect the current market price.
(b) In case of falling prices profit tends to rise due to lower material cost
Disadvantages:
(a) The computations become complicated if too many receipts are there.
(b) Companies having JIT system will face this problem more.
(3) Base Stock Method:
A minimum quantity of stock under this method is always held at a fixed price as reserve in the stock, to
meet a state of emergency, if arises. This minimum stock is known as Base Stock and is valued at a price
at which the first lot of materials is received and remains unaffected by subsequent price fluctuations.
The quantity in excess of the base stock may be valued either on the LIFO basis or FIFO basis. This
method is not an independent method as it uses FIFO or LIFO. Its advantages and disadvantages
therefore will depend upon the use of the other method.
(4) Specific Price Method:
This method is useful, especially when the materials are purchased for a specific job or work order, and
as such these materials are issued subsequently to that specific job or work order at the price at which
they were purchased. The cost of materials issued for production purposes to specific jobs represent
actual and correct costs. This method is specific for non-standard products. This method is difficult to
operate, especially when purchases and issues are numerous.

Cost Accounting
(5) Simple Average Price Method:

Under this method materials issued are valued at average price, which is computed by dividing the
total of all units rate by the number of units.
Material Issue Price = Total of unit prices of each purchase / Total No of Units
This method is useful, when the materials are received in uniform lots of similar quantity and prices do
not fluctuate considerably.
(6) Weighted Average Price Method:
This method removes the limitation of Simple Average Method in that it also takes into account the
quantities which are used as weights in order to find the issue price. This method uses total cost of
material available for issue divided by the quantity available for issue.
Issue Price = Total Cost of Materials in stock / Total Quantity of Materials in stock
(7) Moving Simple Average Price Method:
Under this method the rate for material issue is determined by dividing the total of the periodic simple
average prices of a given number of periods by the number of periods. For determining the moving
simple average price, it is necessary to fix up first period to be taken for determining the average.
Suppose a three monthly period is decided upon and moving average rate for the month of April is to
be computed. Under such situation, we have to make a simple list of the simple average price from
January to March, add them up, and divide the total by three. To compute the moving average for
May, we have to omit simple average rate pertains to January and add the rate relating to the April
and divide the total by three.
(8) Moving Weighted Average Price Method:
Under this method, the issue, rate is computed by dividing the total of the periodic weighted average
price of a given number of periods by the number of periods.
(9) Replacement Method:
Replacement price is defined as the price at which it is possible to purchase an item, identical to that
which is being replaced or revalued. Under this method, materials issued are valued at replacement
cost of the items. Advantage of this method is issue cost reflects the current market price. But the
difficult involved under this method is determination of market price of material before each issue.
(10) Realisable Price method:
Realisable price means a price at which the material to be issued can be sold in the market. This price
may be more or less than the cost price, at which it was originally purchased.
(11) Standard Price Method:
Under this method, materials are priced at some predetermined rate of standard price irrespective of
the actual purchase cost of the materials. Standard cost is usually fixed after taking into consideration
the current price, anticipated market trends. This method facilitates the control of material cost and
task of judging the efficiency of purchase department. But it is very difficult to fix the standard price
when the prices fluctuates frequently.
(12) Inflated Price Method:
In case of materials that suffers loss in weight due to natural or climatic factors ex: evaporation...etc the
issue price of the materials is inflated to cover up the losses.

Illustration 5
Prepare a statement showing the pricing of issues, on the basis of
(a) Simple Average and
(b) Weighted Average methods from the following information pertaining to Material-D
2016 March 1 Purchased 100 units @ `10 each
2 Purchased 200 units @ ` 10.2 each.
5 Issued 250 units to Job X vide M.R.No.12
7 Purchased 200 units @ `10.50 each
10 Purchased 300 units @ `10.80 each
13 Issued 200 units to Job Y vide M.R.No.15
18 Issued 200 units to Job Z vide M.R.No.17
20 Purchased 100 units @ `11 each
25 Issued 150 units to Job K vide M.R.No.25
Solution:
(a) Simple Average Method:
Stores Ledger Account
Receipts Issue Balance
Qty. Price Value Qty. Price Value Qty. Value
Date
Amount (`) Amount (`) Amount (`) Amount (`) Amount (`)
2016
March 1 100 10 1000 -- -- -- 100 1000
March 2 200 10.2 2040 -- -- -- 300 3040
March 5 -- -- -- 250 10.10 (1) 2525 50 515
March 7 200 10.5 2100 -- -- -- 250 2615
March 10 300 10.8 3240 -- -- -- 550 5855
March 13 -- -- -- 200 10.50 (2) 2100 350 3755
March 18 -- -- -- 200 10.65 (3) 2130 150 1625
March 20 100 11 1100 -- -- -- 250 2725
March 25 -- -- -- 150 10.90 (4)
1635 100 1090
Working Notes:
1. Calculation of Price for Issue on March 5th

= (10 + 10.2) / 2 = `10.10
= (10.2 + 10.5 + 10.8) / 3 = `10.5
= (10.5 + 10.8) / 2 = `10.65
= (10.8 + 11) / 2 = `10.90

Cost Accounting
(b) Weighted Average Method:

Date
2016
March 1 100 10 1000 -- -- -- 100 1000
March 2 200 10.2 2040 -- -- -- 300 3040
March 5 -- -- -- 250 10.13 (1) 2533 50 507
March 7 200 10.5 2100 -- -- -- 250 2607
March 10 300 10.8 3240 -- -- -- 550 5847
March 13 -- -- -- 200 10.63 (2) 2126 350 3721
March 18 -- -- -- 200 10.63 (3) 2126 150 1595
March 20 100 11 1100 -- -- -- 250 2695
March 25 -- -- -- 150 10.78 (4) 1617 100 1078
Working Notes:
1. Calculation of price for Issue on March 5th
= 3040/300 = `10.13
= 5847/550 = `10.63
= 3721/350 = `10.63
= 2695/250 = `10.78
Illustration 6
The stock of material held on 1-4-2015 was 400 units @ 50 per unit. The following receipts and issues were
recorded. You are required to prepare the Stores Ledger Account, showing how the values of issues
would be calculated under Base Stock Method, both through FIFO AND LIFO base being 100 units.
2-4-2015 Purchased 100 units @`55 per unit
6-4-2015 Issued 400 units
10-4-2015 Purchased 600 units @ `55 per unit
20-4-2015 Purchased 500 units @ `65 per unit.
15-6-2015 Purchased 300 units @ ` 80 per unit

Solution:
Stores Ledger Account [under Base Stock through FIFO Method]

Qty. Price Value Qty. Price Value Qty. Price Value
Date Amount Amount Amount Amount (`) Amount Amount
(`) (`) (`) (`) (`)
1-4-2015 -- -- -- -- -- -- 100 50 5,000
300 50 15,000
2-4-2015 100 55 5,500 -- -- -- 100 50 5,000
300 50 15,000
100 55 5,500
6-4-2015 -- -- -- 300 50 15,000
100 55 5,500 100 50 5,000
10-4-2015 600 55 33,000 -- -- -- 100 50 5,000
600 55 33,000
13-4-2015 -- -- -- 400 55 22,000 100 50 5,000
200 55 11,000
20-4-2015 500 65 32,500 -- -- -- 100 50 5,000
200 55 11,000
500 65 32,500
25-4-2015 -- -- -- 200 55 11,000 100 50 5,000
400 65 26,000 100 65 6,500
10-5-2015 800 70 56,000 -- -- -- 100 50 5,000
100 65 6,500
800 70 56,000
12-5-2015 -- -- -- 100 65 6,500 100 50 5,000
400 70 28,000 400 70 28,000
13-5-2015 -- -- -- 200 70 14,000 100 50 5,000
200 70 14,000
15-5-2015 500 75 37,500 -- -- -- 100 50 5,000
200 70 14,000
500 75 37,500
12-6-2015 -- -- -- 200 70 14,000 100 50 5,000
200 75 15,000 300 75 22,500
15-6-2015 300 80 24,000 -- -- -- 100 50 5,000
300 75 22,500
300 80 24,000

Cost Accounting
Stores Ledger Account [under Base Stock through LIFO Method]

Date Amount Amount Amount Amount Amount Amount
(`) (`) (`) (`) (`) (`)
1-4-2015 -- -- -- -- -- -- 100 50 5,000
300 50 15,000
2-4-2015 100 55 5,500 -- -- -- 100 50 5,000
300 50 15,000
100 55 5,500
6-4-2015 -- -- -- 100 55 5,500
300 50 15,000 100 50 5,000
10-4-2015 600 55 33,000 -- -- -- 100 50 5,000
600 55 33,000
13-4-2015 -- -- -- 400 55 22,000 100 50 5,000
200 55 11,000
20-4-2015 500 65 32,500 -- -- -- 100 50 5,000
200 55 11,000
500 65 32,500
25-4-2015 -- -- -- 500 65 32,500 100 50 5,000
100 55 5,500 100 55 5,500
10-5-2015 800 70 56,000 -- -- -- 100 50 5,000
100 55 5,500
800 70 56,000
12-5-2015 -- -- -- 500 70 35,000 100 50 5,000
100 55 5,500
300 70 21,000
13-5-2015 -- -- -- 200 70 14,000 100 50 5,000
100 55 5,500
100 70 7,000
15-5-2015 500 75 37,500 -- -- -- 100 50 5,000
100 55 5,500
100 70 7,000
500 75 37,500
12-6-2015 -- -- -- 400 75 30,000 100 50 5,000
100 55 5,500
100 70 7,000
100 75 7,500
15-6-2015 300 80 24,000 -- -- -- 100 50 5,000
100 55 5,500
100 70 7,000
100 75 7,500
300 80 24,000

13. Treatment of Variance Detected at Stock Taking:

If the variances are due to normal causes, i.e., due to normal dry age, shrinkage, evaporation, etc.,
these are valued at the ruling ledger rates of the items of material concerned and the amount is taken
as an item of stores overhead and recovered from production as a percentage of direct material cost
consumed. If the variances are due to abnormal causes, viz., theft, fraud, misappropriation etc., these
are valued by writing off to Costing Profit and Loss Account.
Illustration 7
Prepare a Stores Ledger Account from the following information adopting FIFO method of pricing of
issues of materials.
2016 March 1. Opening Balance 500 tonnes @ `200
3. Issue 70 tonnes
4. Issue 100 tonnes
5. Issue 80 tonnes
13. Received from suppliers 200 tonnes @ `190
14. Returned from Department A 15 tonnes.
16. Issued 180 tonnes
20. Received from supplier 240 tonnes @ `195
24. Issue 300 tonnes
26. Issue 115 tonnes
27. Returned from Department B 35 tonnes
Solution:
Stores Ledger Account [FIFO Method]

Date Amount Amount Amount Amount Amount Amount (`)
(`) (`) (`) (`) (`)
2016
March 1 -- -- -- -- -- -- 500 200 1,00,000
March 3 -- -- -- 70 200 14,000 430 200 86,000
March 4 -- -- -- 100 200 20,000 330 200 66,000
March 5 -- -- -- 80 200 16,000 250 200 50,000
March 13 200 190 38,000 -- -- -- 250 200 50,000
200 190 38,000
March 14 15 200 3,000 -- -- -- 250 200 50,000
200 190 38,000
15 200 3,000
March 16 -- -- -- 180 200 36,000 70 200 14,000
200 190 38,000
15 200 3,000

Cost Accounting
March 20 240 195 46,800 -- -- -- 70 200 14,000

200 190 38,000
15 200 3,000
240 195 46,800
March 24 -- -- -- 70 200 14,000 -- -- --
200 190 38,000 -- -- --
15 200 3,000 -- -- --
15 195 2,925 225 195 43,875
March 25 320 200 64,000 -- -- -- 225 195 43,875
320 200 64,000
March 26 -- -- -- 115 195 22,425 110 195 21,450
320 200 64,000
March 27 35 195 6,825 -- -- -- 110 195 21,450
320 200 64,000
35 195 6,825
March 28 100 200 20,000 -- -- -- 110 195 21,450
320 200 64,000
35 195 6,825
100 200 20,000
Illustration 8
From this information provided as under, you are required to prepare a statement showing how the
issues would be priced if LIFO method is followed.
2016 Feb: 1. Opening Balance 100 units at `10 each.
2. Received 200 units at `10.50 each.
4. Issued 400 units to Job A vide M.R.No.015.
6. Issued 120 to Job B vide M.R.No.020.
7. Received 400 units at `11 each.
8. Issued 200 units to Job B vide M.R.No.031
17. Issued 400 units to Job D vide M.R.No.040.

Solution:
Stores Ledger Account [LIFO Method]

Date Amount Amount Amount Amount (`) Amount Amount
(`) (`) (`) (`) (`)
2016
Feb 1 -- -- -- -- -- -- 100 10.00 1,000
Feb 2 200 10.50 2,100 -- -- -- 100 10.00 1,000
200 10.50 2,100
Feb 3 300 10.60 3,180 -- -- -- 100 10.00 1,000
200 10.50 2,100
300 10.60 3,180
Feb 4 -- -- -- 300 10.6 3,180 100 10.00 1,000
100 10.50 1,050 100 10.5 1,050
Feb 6 -- -- -- 100 10.50 1050 -- -- --
20 10.00 200 80 10.00 800
Feb 7 400 11.00 4,400 -- -- -- 80 10.00 800
400 11.00 4,400
Feb 8 -- -- -- 200 11.00 2200 80 10.00 800
200 11.00 2,200
Feb 12 300 11.40 3,420 -- -- -- 80 10.00 800
200 11.00 2,200
300 11.40 3,420
Feb 13 200 11.50 2,300 -- -- -- 80 10.00 800
200 11.00 2,200
300 11.40 3,420
200 11.50 2,300
Feb 17 -- -- -- 200 11.50 2300 80 10.00 800
200 11.40 2280 200 11.00 2,200
100 11.40 1,140
Illustration 9
Prepare Stores Ledger Account showing pricing of material issues on Replacement Price basis from the
following particulars.
Opening balance 400 units at `4 each
10-3-2016 Received 100 units at `4.10 each
15-3-2016 Issued 300 units to Job XY vide M.R.No.14 17-3-2016 Received 200 units at `4.30 each
20-3-2016 Issued 250 units to Job AB vide M.R.No.20
25-3-2016 Received 400 units @ `4.50 each

Cost Accounting
26-3-2016 Issued 200 units to Job JK vide M.R.No.27 27-3-2016 Received 100 units @`4.60 each.
30-3-2016 Issued 300 units to Job PQ vide M.R.No.32.
Replacement Price on various dates : 15-3-2016 `4.20
20-3-2016 `4.40
26-3-2016 `4.60 &
30-3-2016 `4.80.
Solution:
Stores Ledger Account [Replacement Price Basis]
Date Receipts Issue Balance

Amount Amount Amount Amount Amount Amount
(`) (`) (`) (`) (`) (`)
2016
Mar 1 -- -- -- -- -- -- 400 4.00 1,600
10-3-2016 100 4.10 410 -- -- -- 500 4.02 2,010
15-3-2016 -- -- -- 300 4.20 1260 200 3.75 750
17-3-2016 200 4.30 860 -- -- -- 400 4.03 1,610
20-3-2016 -- -- -- 250 4.40 1,100 150 3.40 510
25-3-2016 400 4.50 1,800 -- -- -- 550 4.20 2,310
26-3-2016 -- -- -- 200 4.60 920 350 3.97 1,390
27-3-2016 100 4.60 460 -- -- -- 450 4.11 1,850
30-3-2016 -- -- -- 300 4.80 1,440 150 2.7310 410
Illustration 10
Stocks are issued at a standard price and the following transactions occurred for a specific material:
1st January Opening Stock 10 tonnes at `240 per ton

4th January Purchased 5 tonnes at `260 per ton
5th January Issued 3 tons
12th January Issued 4 tons
13thJanuary Purchased 3 tons at `250 per ton
19thJanuary Issued 4 tons
26thJanuary Issued 3 tons
30thJanuary Purchased 4 tons at `280 per ton
31stJanuary Issued 3 tons.
The debit balance of price variation on 1st January was `20. Show the stock account for the material
for the month of January, indicating how you would deal with the difference in material price variance,
when preparing the Profit and Loss Account for the month.

Solution:
(240 × 10) + 20
Standard Price =
10
= ` 242

Date Qty. Price Value Qty. Price Value Qty. Value
1st January -- -- -- -- -- -- 10 2,400
4th January 5 260 1,300 -- -- -- 15 3,700
5th January -- -- -- 3 242 726 12 2,974
12th January -- -- -- 4 242 968 8 2,006
13th January 3 250 750 -- -- -- 11 2,756
19th January -- -- -- 4 242 968 7 1,788
26th January -- -- -- 3 242 726 4 1,062
30th January 4 280 1,120 -- -- -- 8 2,182
31st January -- -- -- 3 242 726 5 1,456
Material price variance is ` 246 which is to be transferred to debit of costing P & L A/c.
Working :
Stock at standard price = 5 x 242 = 1,210

Material Price Variance = 1,210 – 1,456 = 246 (A)
Illustration 11
Receipts and issues of an item of stores are made as follows: There was no balance before 9th
January.
Receipts Issues
Quantity Price (`) Quantity
January 9th 10 17.0
19th 25 10.0
20th 10
29th 20
30th 15 8.0
February 13th 20 12.0
27th 10 16.9
28th 40
March 30th 20 20.0
31st 20
(i) What is the simple average of February receipts ?

Cost Accounting
(ii) What are the moving monthly simple average price for January -February and February-March?
(iii) If a weighted average is used for pricing issues how does the value of the balance in stock change
during January?
(iv) If a weighted average price is calculated at the end of each month and is then used for pricing
the issued of that month, what will be the value of the month-end balance?
Solution:
(i) Simple Average Price of February Receipts.

Simple Average Price of February Receipts = (12 + 16.9) / 2 = ` 14.45
(ii) Simple Average Price of January Receipts
Simple Average Price of January Receipts = (17 + 10 + 8) / 3 = ` 11.67
Moving monthly average for Jan-Feb = (11.67 + 14.45) / 2 = ` 13.06
Moving monthly average for Feb-March = (14.45 + 20) / 2 = ` 17.225
(iii) Stores Ledger Account (under weighted average method for January)

Date Amount (`) Amount (`) Amount (`) Amount (`) Amount (`)
Jan 9th 10 17 170 -- -- -- 10 170
Jan 19th 25 10 250 -- -- -- 35 420
Jan 20th -- -- -- 10 12 120 25 300
Jan 29th -- -- -- 20 12 240 5 60
Jan 30th 15 8 120 -- -- -- 20 180
(iv) Calculation of the Value of month-end balance
Date Quantity Value

Jan 9th 10 170
Jan 19th 25 250
Jan 30th 15 120
50 540
(-) Issues 30 (10.8) 324
Jan-Balance 20 216
Feb 13th 20 240
Feb 27th 10 169
Feb Balance 50 625
(-) Issues 40 (12.5) 500
10 125
March 30th 20 400
30 525
(-) Issues 20 (17.5) 350
Balance 10 175

Cost Accounting
Principles of Measurement of Employee Cost: The principles to be followed for measurement of employee
cost are:
Principles of Measurement of Employee Cost
Direct Cost Indirect Cost
Employee costs which

Time Basis Cost Centre Basis
cannot be directly
traceable either to a cost
If directly traceable to a cost If directly object or a cost centre
object - classification on the identifiable with a
basis of time consumed for cost centre
the cost object
Measurement of Employee Cost: Inclusions and Exclusions:

The following items are to be ‘included’ for the purpose of measuring employee cost:
(i) Any payment made to an employee either in cash or kind
(ii) Gross payments including all allowances payable and includes all benefits
(iii) Bonus, ex-gratia, sharing of surplus, remuneration payable to Managerial personnel including
Executive Directors and other officers
(iv) Any amount of amortization arising out of voluntary retirement, retrenchment, termination, etc
(v) Variance in employee payments/costs, due to normal reasons (if standard costing system is followed)
(vi) Any perquisites provided to an employee by the employer
The following items are to be ‘excluded’ for the purpose of measuring employee cost:
(i) Remuneration paid to Non-Executive Director
(ii) Cost of idle time [ = Hours spent as idle time x hourly rate]
(iii) Variance in employee payments/costs, due to abnormal reasons ( if standard costing system is
followed)
(iv) Any abnormal payment to an employee – which are material and quantifiable
(v) Penalties, damages paid to statutory authorities or third parties
(vi) Recoveries from employees towards benefits provided – this should be adjusted/reduced from the
employee cost
(vii) Cost related to labour turnover – recruitment cost, training cost and etc
(viii) Unamortized amount related to discontinued operations.
Illustration 23
Measurement of Employee Cost
Basic pay `5,00,000; Lease rent paid for accommodation provided to an employee `2,00,000, amount
recovered from employee `40,000, Employer’s Contribution to P.F. `75,000, Employee’s Contribution to
P.F. `75,000; Reimbursement of Medical expenses `67,000, Hospitalisation expenses of employee’s family
member borne by the employer `19,000, Festival Bonus Rs.20,000, Festival Advance `30,000. Compute
the Employee cost.

Solution:
Computation of Employee Cost
Particulars Amount (`)

Basic Pay 5,00,000
Add Net cost to employer towards lease rent paid for accommodation 1,60,000
provided to an employee
[ = lease rent paid less amount recovered from employee]
= [2,00,000 (-) 40,000]

Add Employer’s Contribution to PF 75,000
Add Reimbursement of Medical Expenses 67,000
Add Hospitalisation expenses of employee’s family member paid by the 19,000
employer
Add Festival Bonus 20,000
Employee Cost 8,41,000
Note:
(i) Festival advance is a recoverable amount, hence not included in employee cost.
(ii) Employee’s contribution to PF is not a cost to the employer, hence not considered.
Illustration 24
Measurement of Employee Cost (with special items)
Gross pay `10,30,000 (including cost of idle time hours paid to employee `25,000); Accommodation
provided to employee free of cost [this accommodation is owned by employer, depreciation of
accommodation `1,00,000, maintenance charges of the accommodation `90,000, municipal tax paid
for this accommodation `3,000], Employer’s Contribution to P.F. `1,00,000 (including a penalty of `2,000
for violation of PF rules), Employee’s Contribution to P.F. `75,000. Compute the Employee cost.
Solution:
Gross Pay ( net of cost of idle time) =[10,30,000 (-) 25,000] 10,05,000
Add Cost of accommodation provided by employer 1,93,000
= Depreciation (+) Municipal Tax paid (+) maintenance charges = 1,00,000 +

90,000 + 3,000 = 1,93,000
Add Employer’s Contribution to PF excluding penalty paid to PF authorities [ = 98,000
1,00,000 (-) 2,000]
Note:
(i) Assumed that the entire accommodation is exclusively used by the employee. Hence, cost of
accommodation provided includes all related expenses/costs, since these are identifiable/traceable
to the cost centre.
(ii) Cost of idle time hours is assumed as abnomal. Since it is already included in the gross pay, hence
excluded.

Cost Accounting
(iii) Penalty paid to PF authorities is not a normal cost. Since, it is included in the amount of contribution,
it is excluded.
Illustration 25
Measurement of Employee Cost (with special items)
Trial Balance as on 31.3.2017 (relevant extracts only)
Particulars Amount (`) Particulars Amount (`)

Materials consumed 25,00,000
Salaries 15,00,000 Special Subsidy received from 2,75,000
Government towards Employee
salary
Employee Training Cost 2,00,000 Recoverable amount from Employee 35,000
out of perquisites extended
Perquisites to Employees 4,50,000
Contribution to Gratuity Fund 4,00,000
Lease rent for accommodation 3,00,000
provided to employees
Festival Bonus 50,000
Unamortised amount of Employee cost 90,000
related to a discontinued operation
Solution:

Salaries 15,00,000
Add Net Cost of Perquisites to Employees 4,15,000
= Cost of Perquisites (-) amount recoverable from employee
= 4,50,000 (-) 35,000

Add Lease rent paid for accommodation provided to employee 3,00,000
Add Festival Bonus 50,000
Add Contribution to Gratuity Fund 4,00,000
Less Special subsidy received from Government towards employee salary (2,75,000)
Note:
(i) Recoverable amount from employee is excluded from the cost of perquisites.
(ii) Employee training cost is not an employee cost. It is to be treated as an Overhead, hence, not
included.
(iii) Special subsidy received is to be excluded, as it reduces the cost of the employer.
(iv) Unamortized amount of employee cost related to a discontinued operation is not an includible
item of cost.

Cost Accounting
10. Time keeping refers to

A. Time spent by workers on their job
B. Time spent by workers in factory
C. Time spent by workers without work
D. Time spent by workers on their job
[Ans: C,A,A,B,C,D,A,C,A,B]
State whether the following statements are True (or) False:
1. Direct employee cost shall be presented as a seperate cost head in the financial statement.
2. As per the Payment of Bonus Act, 1965 the maximum limit of bonus is 20% of gross earning.
3. Flux method is means for measurement of labour turnover.
4. Is overtime premium is directly assigned to cost object?
5. Idle time represents the wages paid for the time cost during which the workkers not work.
[Ans.: 1. False; 2. True; 3. True; 4. True; 5. True.]
Fill in the Blanks:
1. In a company there were 1200 employee on the rolls at the beginning of a year and 1180 at
the end. During the year 120 persons left services and 96 replacements were made. The labour
turnover to flux method is _________ %.
2. In ___________ systems, two piece rates are set for each job.
3. In ___________ Systems, basic of wages payment is the quantity of work.
4. The formula for computing wages under time rate is _______________.
5. In Halsey plan, a worker gets bonus equal to ________________ of the time saved.
6. Under Grantt Task and Bonus Plan, no bonus is payable to a worker, if his efficiency is less than
______________.
7. Wages sheet is prepared by ______________ department.
8. Cost of normal idea time is charged to _______________.
9. Ideal time arises only when workers are paid on ______________ basis.
10. Normal idle time costs shuld be change to _________ which that due to abnormal reasons should
be change to _______________.
[Ans: 9.08, Gaylor’s differential piece rate, Piece rate, Hour worked × rate per hour, 50%, 100%,
Pay Roll Department, Factory Overhead, Time, Production overhead + Costing P/L A/c]
1 Labour turnvoer A 8.33% of Salary
2 Barth variable sharing plan B Work beyond normal working hours
3 Minimum bonus C Merit rating
4 Overtime Premium D Replacement method
5 Assessment of employee with respect to a job E Total Earnings = R× S×H
[Ans.: 1. D; 2. E; 3. A; 4. B; 5. C.
2.3 DIRECT EXPENSES (CAS – 10)
Direct expense or chargeable expense is that which can be allocated to a cost centre or cost unit
and indirect expense is that which needs to be apportioned. There may be items of expense direct
in relation to some cost centre. Thus rent and rates, heating & lighting, depreciation & insurance are

often allocated or charged directly to the appropriate service cost centre, the totals of service
department cost are however, apportioned to other cost centres before being absorbed by cost units
as overheads. These costs are direct costs of the first cost centre, but indirect costs of other production
cost centres, as well as being indirect cost of cost units.
Direct expenses as defined in CAS-10 (Limited Revision 2017), ‘Expenses relating to manufacture of a
product or rendering a service, which can be identified or linked with the cost object other than direct
material cost and direct employee cost’.
The more a factory is departmentalized, the greater will be the proportion of expenses which can
be classified as direct. Thus cost of medicines, first aid, and other expenses in connection with the
medical service are direct expenses of medical service department, but if there is no medical service
department, the expenses would have been distributed to all the cost centres at the very beginning.
The following expenses may be treated as direct expenses:-
(a) Cost of patents, royalty payment;
(b) Hire charges in respect of special machinery or plant;
(c) Cost of special patterns, cores, designs or tools;
(d) Experimental costs and expenditure in connection with models and pilot schemes;
(e) Architects, surveyors and other consultants fee;
(f) Travelling expenses to sites;
(g) Inward charges and freight charges on special material.
A direct expense in relation to a product forms part of the Prime Cost. Indirect expenses are treated as
Overheads. In relation to products, direct material is a material that becomes a part of it and can be
physically traced in some form in the finished products, where as the direct expenses are cost providing
services or other kinds of special charges, but no trace of them can be obtained in the finished product
like raw material. Both the direct material and direct expenses forms part of the Prime Cost.
General principles of measurement of Direct Expenses as per CAS-10:

(a) Identification of direct expenses shall be based on traceability in an economically feasible manner.
(b) Direct expenses incurred for bought out resources shall be determined at invoice price including
all taxes and duties and any other expenditure directly attributable there to net of trade discounts,
taxes and duties refundable or to be credited.
(c) Direct expenses paid/incurred in lump-sum or which are in the nature of one time payment shall
be amortized on the basis of estimated output or benefit to be derived from such expenses.
(d) Finance cost incurred in connection with self generated or procured resources shall not form part
of the direct expenses.
(e) Any subsidy or grant or incentive or any amount received or receivable with respect to any direct
expenses shall be reduced for ascertainment of the cost of the cost object.
(f) Penalties / damages paid to statutory authorities or other third parties shall not be form part of the
direct expenses.
(g) Any change in the cost accounting principles applied for measurement of the direct expenses
should be made only if it is required by law or for compliance with the requirements of a Cost
Accounting Standard or a change would result in a more appropriate preparation or presentation
of Cost Statement of the organization.
(h) Credit / recoveries relating to direct expenses, material and quantifiable shall be deducted to
arive at the net direct expenses.
(i) Any abnormal portion of direct expenses where is material and quantifiable shall not form part of
the direct expenses.

Cost Accounting
The Cost Statement shall disclose the following items of Direct Expenses as per CAS-10 (Limited Revision
2017):
(a) The basis of distribution of direct expenses to cost objects / cost units.
(b) Quantity and rates of items of direct expenses as applicable.
(c) Where direct expenses are accounted at standard cost the price and usage variance.
(d) Direct expenses representing procurement of resources and expenses incurred in connection with
resources generated.
(e) Direct expenses paid or payable to related parties.
(f) Direct expenses incurred in foreign currency.
(g) Any subsidy / incentive and any such payment received from direct expenses.
(h) Credits or recoveries relating to the direct expenses.
(i) Any abnormal portion of direct expenses.
(j) Penalties and damages excluded from the direct expenses.
(k) Disclosure shall be made only when material, significant and quantifiable. Disclosures shall be
made in the body of the Cost Statement or as a foot note or as a separate schedule.
Cost Accounting Standard-10 (Limited Revision 2017) : Direct Expenses

Direct Expenses: Expenses relating to manufacture of a product or rendering a service, which can be
identified or linked with the cost object other than direct material cost and direct employee cost.
Examples of Direct Expenses are royalties charged on production, job charges, hire charges for use of
specific equipment for a specific job, cost of special designs or drawings for a job, software services
specifically required for a job, travelling Expenses for a specific job.
Measurement of Direct Expenses: Inclusions and Exclusions:

The following items are to be ‘included’ for the purpose of measuring employee cost:
(i) Costs which are directly traceable/identifiable with the cost object
(ii) Expenses incurred for the use of bought in resources
(iii) Price variance if such expenses are accounted for at standard cost
The following items are to be ‘excluded’ for the purpose of measuring employee cost:
(i) If not traceable/identifiable should be considered as overheads
(ii) Finance cost is not a direct expense
(iii) Imputed cost (example, if the owner of a company engages himself for facilitating the production
or gets actively engaged in production or rendering of services, this would be an imputed cost)
(iv) Recoveries, credits, subsidy, grant, incentive or any other which reduces the cost
(v) Penalty, damages paid to statutory authorities
Illustration 1: Measurement of Direct Expenses

Royalty paid on sales `30,000; Royalty paid on units produced `20,000, hire charges of equipment used
for production `2,000, Design charges `15,000, Software development charges related to production
`22,000. Compute the Direct Expenses.

Solution:
Computation of Direct Expenses
Royalty paid on Sales 30,000
Add Royalty paid on units produced 20,000
Add Hire charges of equipment used for production 2,000
Add Design Charges 15,000
Add Software development charges related to production 22,000
Direct Expenses 89,000
Note:
(i) Expenses are related to either manufacturing of the product or rendering of service
(ii) These costs are directly identifiable and can be linked with the cost object and are not related to
direct material cost or direct employee cost. Hence, these are considered as Direct Expenses.
Illustration 2: Measurement of Direct Expenses – allocation to cost object products (in a multi-product
situation)
A manufacturing unit produces two products X and Y. The following information is furnished:
Particulars Product X Product Y

Units produced ( Qty) 20,000 15,000
Units Sold (Qty) 15,000 12,000
Machine Hours utilised 10,000 5,000
Design charges 15,000 18,000
Software development charges 24,000 36,000
Royalty paid on sales `54,000 [@ `2 per unit sold, for both the products]; Royalty paid on units
produced `35,000 [@ `1 per unit purchased, for both the products], Hire charges of equipment used in
manufacturing process of Product X only `5,000, Compute the Direct Expenses.
Solution:
Computation of Direct Expenses
Particulars Product X Product Y

Royalty paid on Sales (15000*2) (12000*2) 30,000 24,000
Add Royalty paid on units produced (20000*1) (15000*1) 20,000 15,000
Add Hire charges of equipment used in manufacturing process of 5,000 —
Product X only
Add Design Charges 15,000 18,000
Add Software development charges related to production 24,000 36,000
Direct Expenses 94,000 93,000
Note:
(i) Royalty on production and royalty on sales are allocated on the basis of units produced and units
sold respectively. These are directly identifiable and traceable to the number of units produced
and units sold. Hence, this is not an apportionment.
(ii) No adjustments are made related to units held, i.e. closing stock.

2.4 OVERHEADS (CAS - 3)
An overhead is the amount which is not identified with any product. The name overhead might have
come due to the reason of over and above the normal heads of expenditure. It is the aggregate of
indirect material, indirect labour and indirect expenditure. The generic term used to denote indirect
material, indirect labour and indirect expenses. Thus overheads forms a class of cost that cannot be
allocated or absorbed but can only be apportioned to cost units.
In earlier days, overheads were not given much importance, because the prime cost constitutes 50-80%
of the total cost. However, with the modern trend towards the mechanisation, automation, and mass
production, overhead costs have grown considerably in size and in many undertakings the proportion
of overhead costs to the total costs of products is appreciably high. High overheads do not indicate
inefficiency if the increase in overheads is due to the following likely causes:
(a) Improved methods of managerial control like Accountancy, Production Control, Work Study, Cost
and Management Accountancy...etc. In the process of reducing costs of other elements, viz. direct
material and direct labour, overhead costs are likely to increase.
(b) Large scale production or mass production.
(c) Use of costly machines and equipments increases the amounts of depreciation, maintenance
expenditure and similar other items of overhead costs.
(d) Less human efforts are necessary with automatic machines. A major portion of the cost is allocated
direct to machines, thus increasing the machine overhead costs.
(e) Increased efficiency and productivity of labour has the effect of pushing up the overhead to direct
labour ratio.
According to CIMA, overhead costs are defined as, ‘the total cost of indirect materials, indirect labour
and indirect expenses’. Thus all indirect costs like indirect materials, indirect labour, and indirect expenses
are called as ‘overheads’. Examples of overhead expenses are rent, taxes, depreciation, maintenance,
repairs, supervision, selling and distribution expenses, marketing expenses, factory lighting, printing
stationery etc. As per CAS-3, overheads are defined as follows ‘Overheads comprise costs of indirect
materials, indirect employees and indirect expenses which are not directly identifiable or allocable to
a cost object in an economically feasible manner’
Overhead Accounting
The ultimate aim of Overhead Accounting is to absorb them in the product units produced by the firm.
Absorption of overhead means charging each unit of a product with an equitable share of overhead
expenses. In other words, as overheads are all indirect costs, it becomes difficult to charge them to
the product units. In view of this, it becomes necessary to charge them to the product units on some
equitably basis which is called as ‘Absorption’ of overheads. The important steps involved in Overhead
Accounting are as follows:-
(a) Collection, Classification and Codification of Overheads.
(b) Allocation, Apportionment and Reapportionment of overheads.
(c) Absorption of Overheads.
As mentioned above, the ultimate of Overhead Accounting is ‘Absorption’ in the product units. This
is extremely important as accurate absorption will help in arriving at accurate cost of production.
Overheads are indirect costs and hence there are numerous difficulties in charging the overheads to
the product units.

Cost Accounting
Study of Overheads can be better understood from the following diagram:
Overheads
Collection Apportionment Absorption (or)

& Allocation Recovery
1. Methods
2. Causes of under (or) over
absorption
Primary Secondary 3. Methods of disposal of
under (or) over
Classification
1. Repetitive distribution
2. Simultaneous equation
3. Trail & Error
By Nature By Function By Element By Behaviour
1. Rent 1. Manufacturing 1. Material 1. Fixed

2. Depreciation 2. Office & 2. Labour 2. Variable
Administration.
3. Such other or 3. Selling & 3. Expenses 3. Semi-variable (or)
similar nature Distribution Semi fixed
(a) Collection, Classification and Codification of Overheads: -

These concepts are discussed below:-
Collection of Overheads:
Document Overhead Costs Nature

Stores Issue note, purchase Indirect material Consumables, lubricants etc.
voucher
Payroll sheets, time sheets Indirect labour Wages, salaries, contribution
to statutory benefits, bonus,
incentives, idele time
Cash books Indirect material, Indirect labour & All type of costs
indirect expenses
Subsidiary records – journal Indirect material, Indirect labour & For provisions of costs that are not
indirect expenses actually paid for
Other reports Indirect expenses Depreciation, scrap, wastage
etc.
Overheads collection is the process of recording each item of cost in the records maintained for the
purpose of ascertainment of cost of each cost centre or unit.

The following are the source documents for collection of overheads:-

(i) Stores Requisition
(ii) Wages Sheet
(iii) Cash Book
(iv) Purchase Orders and Invoices
(v) Journal Entries
(vi) Other Registers and Records
Source document and the nature of overheads are enumerated as below.
For the purpose of overhead accounting, collection of overheads is very important. It is necessary to
identify the indirect expenses and the above mentioned source documents are used for this. Proper
collection of overhead expenses will help to understand accurately the total overhead expenses.
Classification of Overheads
Classification is defined by CIMA as, ‘the arrangement of items in logical groups having regard to
their nature (subjective classification) or the purpose to be fulfilled (Objective classification). In other
words, classification is the process of arranging items into groups according to their degree of similarity.
Accurate classification of all items is actually a prerequisite to any form of cost analysis and control
system. Classification is made according to the following basis:
Based on Elements: Indirect Materials, Indirect labour and Indirect expenses.
Based on Functions of the organisation: Manufacturing overheads, Administrative overheads, Selling
and Distribution overheads, Research & Development overheads.
Based on the Behaviour: Fixed Overheads, Variable Overheads & Semi variable overheads.
Classification according to Elements
According to this classification overheads are divided according to their elements. The classification is
done as per the following details:-
Indirect Materials
Materials which cannot be identified with the given product unit of cost centre is called as indirect
materials. As per CAS-3 indirect material cost is defined as ‘Materials, the cost of which cannot be
directly attributed to a particular cost object’. For example, lubricants used in a machine is an indirect
material, similarly thread used to stitch clothes is also indirect material. Small nuts and bolts are also
examples of indirect materials.
Indirect Labour
As per CAS-3, indirect employee cost is the employee cost, which cannot be directly attributed to a
particular cost object. Wages and salaries paid to indirect workers, i.e. workers who are not directly
engaged on the production are examples of indirect wages.
Indirect Expenses
As per CAS-3, Indirect Expenses are expenses, which cannot be directly attributed to a particular cost
object. Expenses such as rent and taxes, printing and stationery, power, insurance, electricity, marketing
and selling expenses etc. are the examples of indirect expenses.
Functional Classification
Overheads can also be classified according to their functions.
This classification is done as given below:-

Cost Accounting
Manufacturing Overheads
As per CAS-3, Indirect Cost involved in the production process or in rendering service. Manufacturing
overheads has different names such as Production Overheads, Works Overheads, Factory Overheads.
Indirect expenses incurred for manufacturing are called as Manufacturing Overheads. For example,
factory power, works manager’s salary, factory insurance, depreciation of factory machinery and
other fixed assets, indirect materials used in production etc. It should be noted that such expenditure is
incurred for manufacturing but cannot be identified with the product units.
Manufacturing is a separate function like administration, selling and distribution. The term manufacturing
stands for activities, which begin with receipt of order and end with completion of finished product.
Manufacturing Overhead represents all manufacturing costs other than direct materials and direct labour.
These costs cannot be identified specifically with or traced to cost object in an economically feasible
way. In other words, manufacturing overhead are indirect manufacturing costs. The term overhead is
peculiar and therefore, there is a growing tendency to prefer the term indirect manufacturing cost to
overhead. Following synonyms have been used for Manufacturing Overhead:-
(i) Factory overhead;
(ii) Manufacturing overhead;
(iii) Factory on cost;
(iv) Works on cost;
(v) Factory burden and;
(vi) Manufacturing expenses.
Given below are a few examples of different items included in different groups of manufacturing
overhead:
Indirect Material Cost: Glue, thread, nails, rivets, lubricants, cotton waste, etc.
Indirect Labour Cost: Salaries and wages of foremen and supervisors, inspectors, maintenance, labour,
general labour; idle time etc.
Indirect Services Costs: Factory Rent, factory insurance, depreciation, repair and maintenance of plant
and machinery, first aid, rewards for suggestions for welfare, repair and maintenance of transport system
and apportioned administrative expenses etc.
Manufacturing Overhead further explains in apportionment, allocation and absorption.
Administrative Overheads
Indirect expenses incurred for running the administration are known as Administrative Overheads. As per
CAS-3, Administrative Overheads are defined as Cost of all activities relating to general management
and administration of an organisation.
As per the functional classification, Administration Overheads comprise of those indirect costs which
are related to the general administrative function in the company. Such functions are related to policy
formulation, directing the organisation and controlling the operations of the company. Administration
overheads are incurred for the benefit of organisation as a whole. Controlling them is difficult for they
do not vary with most of the variables viz. production or sales. Examples of such overheads are, office
salaries, printing and stationery, office telephone, office rent, electricity used in the office, salaries of
administrative staff etc. The size as well as control over these overheads depends largely on decisions of
management. Organisations growing very fast face the problem of controlling Administrative Overheads.
Multi-location set up leads to duplication of many administrative costs.
Collection and Absorption of Administration Overheads
The collection of overheads is done firstly by nature of the expenses through the chart of accounts.
Administrative departments in an organisation could be Corporate Office, Finance and Accounts,

Company Secretary, Human resources, Legal, General Administration. The overheads that are common
to all these departments are apportioned on some suitable basis e.g. in the following manner:
(a) For Office rent, rates & taxes - Floor space as the basis,
(b) For Depreciation on office building - Floor space as the basis
(c) For Legal fees - No of cases handled as the basis
(d) For Salaries of common staff - Ratio of salaries of departments as the basis
(e) For Typist pool - No of documents typed as the basis
Absorption of the Administrative Overheads into cost units is very difficult. Many times it is advised that
these overheads may not be absorbed into product units because of the difficulty and non-relevance
of them with production activity. Normally, the Administrative Overheads are totalled together and
then using a suitable basis, a rate of recovery is arrived at to absorb the same. It could be mostly a
percentage of Works cost or factory cost. Based on the principle of ‘charging what the traffic can bear’,
the absorption could be on the basis of a percentage of gross profit. Whatever method selected, it will
be arbitrary and could lead to erroneous conclusions. A Cost Accountant has to use all the experience
and history of the organisation before he selects a particular method to adopt.
Treatment of Administration Overheads

There are three different ways of treating the administration overheads as follows:-
1) Apportion between Production and Selling & Distribution functions:
This treatment is based on the logic that the administrative functions are for the entire company
and these functions facilitate both production as well as selling. In other words, the absorption of
Administration Overheads would happen through Production and Selling Overheads. This means
these overheads lose their identity. The problem is of course, selection of basis to divide these
overheads over the two principal functions of production and selling.
2) Transfer to P & L Account
This method agrees that administrative costs are all time based costs and as such bear no relation
what is produced or what is sold. These are mainly of fixed nature. Hence there is no point in dividing
them further to be included in the cost of production or cost of selling. They should be simply charged
to the P & L Account. However, this may lead to undervaluation of stocks.
3) Treating as a separate addition to cost of production & sales
In this method, administration is treated as a separate function and is added as a separate line in
the cost computation sheet for a job or an order. Here again, the basis for inclusion as a part of
cost of a job is a difficult choice. Generally, a percentage of factory cost is taken as a basis. A care
needs to be taken to ensure that the Administration Overheads are charged equitably to Cost of
Sales, FG stock and WIP as well.
Controlling Administration Overheads

Given the nature of these expenses, they cannot be controlled at the lower level of management.
They can be better controlled by top management as they pertain to formulating policy and
directing the organisation. The first step in the control mechanism is proper classification of expenses
& departmentalisation. The actual expenses are collected for each department and then compared
with a bench mark. Deviation are analysed and causes for increase are mitigated by fixing responsibility
on the departmental head.

Cost Accounting
The control benchmarking can be done with respect to:

(i) Figures of the previous year. Expenses could be compared with the figures of previous year and
increase or decrease are analysed. However, comparison with previous year may not help as the
condition may have totally changed from one year to the other.
(ii) Use of budgets. Budgets are estimates for the current year, and they take into account the changed
conditions. They also built in the year’s complete plan which would factor all changes in the cost
structure. It is advisable to compare budgeted overheads with actual for control purpose.
(iii) Use of standards. Although very scientific, this method is difficult to operate. Administrative activities
(being very subjective) cannot be standardised. On a certain level it can be applied e.g. the time
taken to process a voucher by accountant can be standardised, or time taken for processing a
payment could be standardised.
Selling and Distribution Overheads

As per CAS-3, Selling Overheads, also known as Selling Costs, are the expenses related to sale of products
and include all Indirect Expenses in sales management for the organization. Overheads incurred for
getting orders from consumers are called as Selling Overheads. On the other hand, overheads incurred
for execution of order are called as Distribution Overheads. As per CAS-3, Distribution Overheads, also
known as Distribution Cost, are the cost incurred in handling a product from the time it is ready for
dispatch until it reaches the ultimate consumer. Examples of Selling Overheads are sales promotion
expenses, marketing expenses, salesmen’s salaries and commission, advertising expenses etc. Examples
of Distribution Overheads are warehouse charges, transportation of outgoing goods, packing, commission
of middlemen etc.
The magnitude of S & D Overheads in the total cost would depend on many factors such as nature of
the product, type of customers, spread of market, statutory restrictions etc. A consumer product needs
heavy expense on advertising. A sale to institutions rather than individual customers needs a different
selling effort. Distribution Costs will increase if the spread of the market is large. Some activities cannot
be advertised at all such as a Doctor, a Cost Accountant. The total magnitude of S & D Costs and the
proportion of selling and distribution efforts will decide the treatment thereof and control mechanisms
to be used. For some of selling expenses there may not be a direct relationship with the product. If a
company incurs expense on advertising, it may be difficult to relate to a specific product unless it’s a
product advertisement. But further, there may be a substantial time lag between the expense and the
benefit arising out of that. In case of Distribution Costs many of them may be possibly linked to the product.
Collection and Absorption of S&D Overheads

While classifying the S & D Costs are properly bifurcated and coded accordingly. This could be done by
having separate account codes for Selling Overheads such as: advertising, sale commission, travelling
expense, communication, exhibition, market survey, free samples, credit & collection costs, bad debts,
and Distribution expenses such as: transportation vehicle related expenses, warehousing and storage
at different places, depreciation. Depending upon the size of the organization, there may be proper
departmentalization of S&D activities. The departments could be:
- Sales head office
- Sales regional offices
- Depots
- Direct selling department
- Dealers management
- Credit and collection (commercial)

The costs are collected through various source documents under the above heads and for the above
departments. For absorption, the basis to be used will have practical difficulties, as one will have to look
for a relationship between the expenses and the cost unit. Some expenses like sales commission, shipping
costs, and direct selling expenses can be absorbed directly. The other expenses can be absorbed on
the basis of either sales value, cost of goods sold, gross profit or number of units sold. Out of these the
sales value method is the most commonly used.
Control over S & D Expenses
The S & D Expenses are related to sales and distribution activity which is externally focused. The extent of
these expenses depend mainly on external factors like consumer profile, changing habits, technology
improvements etc. Controlling these expenses does not mean capping them. It aims at increasing the
effectiveness of these expenses e.g. getting maximum sales per rupee of S & D Expenses. For control
purpose, a great care should be taken to ensure correct classification and collection of S & D Overheads.
The collected expenses must be analysed to assess the effect of them on sales. Such analysis could be
done as follows:
(a) Analysis of sales and S & D Expenses by geographical locations – This could be regions, zones,
domestic and international etc.
(b) Analysis by type of customers - This could be done as institutional, government, retail etc.
(c) Analysis by products or services – This may be done as range of products, the application of products,
brands etc.
(d) Analysis by salesmen.
(e) Analysis by channel of distribution – This analysis pertains to wholesalers, retailers, commission agents
etc.
The analysis of sales, profits and S & D expenses on the basis of above factors will give a good insight into
the performance as well as control over expenses. All these three parameters may be compared with
l Previous year;
l Budget for the current year or
l Standards for the current year
Research and Development Overheads
Research Cost is defined as the cost of searching for new or improved products, new applications of
material, or new or improved methods, process, systems or services. In the modern days, firms spend
heavily on Research and Development. Expenses incurred on research and development is known as
Research and Development Overheads. Research may be of the following types:
(i) Pure or basic research to gain general know-how regarding the production or market, not directed
towards any particular product.
(ii) Applied research which applies the basic knowledge in practice. i.e improvement of existing
products, new process, exploring of new products, improved measures of safety, etc.
Development cost is the cost of the process which begins with the implementation of the decision to
use scientific or technical knowledge to produce a new or improved product or to employ a new or
improved method, process, system, etc. and ends with the commencement of formal production of
that product by that method. Development starts where the research ends. Development cost is the
expenditure incurred for putting the results of research on a practical commercial basis.
Special features of Research & Development Costs
The features are as follows:-
(a) Expenditure is incurred ahead of the actual production and may not be charged to current
production.

Cost Accounting
(b) The amount of expenditure may often substantial.

(c) The expenditure may at times be entirely in fructuous, yielding no tangible results.
(d) Benefit of the expenditure may be realized over a number of years.
(e) Difficulty in fixation of standards for control.
Collection of R&D Overheads
Accumulation of Research and Development Overheads is essential for the following reasons:-
(a) For review cost to date.
(b) For planning the activities subsequent to research.
(c) For evaluation of performance with relation to past performance or for inter-firm comparison.
The collection of R&D Overheads is made through the following documents. Material requisitions, labour
time cards, invoices, vouchers (royalty, patent, license. etc). Research & Development expenditure
may be identified by its nature i.e basic or applied research or development by the elements of cost,
by business sector, by project. Each Research & Development project is allotted a project work order
number. Separate series of work orders or codes should be used to distinguish from regular work orders.
R & D overheads can be accumulated as follows:-
(a) All expenditure under the direct elements (direct material, labour and expenses)must be charged
to the work orders.
(b) Expenses like supervisor salary, material handling charges, maintenance of equipments can be
directly allocated to particular research work order.
(c) Items of general overheads like depreciation of building, depreciation of maintenance equipment,
share of purchase department expenses may be suitably apportioned to the research work order.
Accounting of R&D Overheads
Accounting of Research & Development Cost arise due to the following causes:-
(a) The expenditure is in the nature of pre-production costs and there is a considerable time lag between
the incidence and expenditure and realization of benefit.
(b) There is no immediate production, or the production is so small that it becomes difficult to charge
such costs to products.
It is because of these difficulties that the accounting of Research and Development Costs has been a
subject of some controversy. Three methods are available for charging Research and Development
Costs as:
(a) Charging off to the current year Profit & Loss Account.
(b) Capitalization so that cost may be amortized on a long term basis.
(c) Deferment and charge-off to costs of the next two or three years-a short/medium term amortization.
Research and Development may be regarded as a function of production and the Research &
Development Costs may be charged to costs to be recovered through the general overhead rates.
There are many arguments for and against charging the Research & Development Costs in current
revenue. The arguments in support of this method are as follows:-
(a) All research & development expenses may not result in new processes or saleable products.
(b) Some of the research & development projects may result in failures.
(c) These expenses may be incurred simply to maintain the present competitive position of the concern.

(d) It is difficult to assess the period over which the know-how or knowledge acquired may be spread
over.
(e) It may be more advantageous to recover a substantial portion of the cost immediately, as the life
of the new products are uncertain.
(f) In certain cases, the effect of these research costs on future revenues may be doubtful.
The classification used for cost collection is mostly combination of elemental and functional. The
behavioural classification cannot be used for booking of costs; it is used only for analysis and decision
making.
Elements Material Labour Expense

Factory or Nuts & bolts, Salaries & wages to Factory lighting &
production or consumables, foremen, supervisors, heating, factory rent,
manufacturing or lubricants, welding inspectors, maintenance power & electricity,
works overheads electrodes, cleaning labour, idle time factory insurance,
materials, nails, depreciation on
threads, ropes etc. machinery, repairs
Administrative Printing & stationery, Salary of office staff, General office rent,
Overheads office supplies managers, directors, insurance,
and other telephones, fax,
administrative travel, legal fees,
departments as IT, depreciation on
audit, credit, taxation office assets
Selling Price lists, catalogues, Salaries of sales staff & Sales office expenses,
Overheads mailings, advertising managers, commission travelling,
material such as on sales, bonus on subscription to sales
leaflets, danglers, schemes magazines, bad
samples, free gifts, debts, rent &
exhibition material insurance of
showrooms, cash
discount, brokerage,
market research
Distribution Secondary packing, Salaries of delivery staff Carriage outwards,
overheads material items used in such as drivers, forwarding
delivery vans dispatch clerk, logistic expenses, rent &
manager insurance of
warehouses &
depots, insurance,
running expenses &
depreciation of
delivery vans
Classification based on behaviour

Fixed Overheads
The amount of overhead tends to remain fixed for all volumes of production within a certain range.
Examples of Fixed Overheads are Audit fee, Interest on capital, Depreciation of plant & machinery,
Insurance, Rent of buildings, etc. A fixed overhead represents constant expenditure incurred during
a period without regarding to the volume of production during that period. Even when production
completely ceases in a particular period, this constant amount of expenditure will continue to be incurred
partially, if not wholly. Therefore the Fixed Overheads are also known as Period Costs. Sometimes these
costs are also termed as Shutdown or Stand-by Costs.

Cost Accounting
Features of Fixed Costs

Fixed Costs are stated to be by and large uncontrollable, in the sense they are not influenced by the
action of a specified member of an undertaking. For example, the supervisor has practically no control
over the fixed costs like depreciation of plant & machinery. The production supervisor can only see that
the maximum possible utilization of the assets is made.
The fixed overhead amount is constant per period; the cost per unit of production varies with the volume.
This variation is inverse since with increase in production, cost per unit decreases as the same amount
of fixed overheads is spread over larger units of production.
Factors affecting the Fixed Overheads
When a plant or a department is completely idle and there is no production, several items of Fixed
Overheads disappear. Fixed Overheads are thus, of two types, viz. a lower standing fixed cost when
production is nil and a higher running fixed cost when the plant is running. For instance, maintenance
expenditure incurred at plant shutdown has to be increased to a higher level when production starts.
Any long term change in the productive capacity of an undertaking also affects the basic characteristic
of fixed overhead. Fixed costs are constant for short term periods only, within a limited range of capacity.
Another factor that affects the fixed nature of fixed overhead is the change in basic price level.
Graphical representation of Fixed Costs is depicted as below:
Total Fixed Overhead

Cost (`)
Overhead (`)
Fixed Overhead per unit
X
O Volume of Production
Fixed Costs may be broadly classified into three basic types:-

(i) Fixed costs that have no casual relationship with the volume of output and are incurred mainly as
results of policy decisions of the management. Research, development, design, employee training,
advertisement and marketing expenses are examples of this expenditure. Accountants term such
costs as discretionary fixed costs (also known as programmed costs or managed costs).
(ii) Fixed costs that do not change significantly in the short term such as depreciation, rent, etc.
(iii) Fixed costs that are fixed for short period for a particular capacity, but change considerably when
there is a long-term change in the volume or capacity.
Variable Overheads
Variable Costs are those which vary in total direct proportion to the volume of output. These costs per
unit remain relatively constant with changes in production. Thus Variable Costs fluctuate in total amount
but tend to remain constant per unit as production activity changes. Examples are indirect material,
indirect labour, lubricants, cost of utilities, etc.
The variable overhead costs seldom reveal the characteristics of perfect variability. i.e an expenditure
which varies directly with variation in the volume of output. They simply tend to vary rather than vary

directly in direct proportion of output. We come across three types of variable overhead expenses in
actual practice as explained below:-
(i) 100% variable expenses. For all production the variable expenditure remains constant.
(ii) The expense per unit of production is low at lower ranges of output but gradually increases as
production goes up.
(iii) The expenses per unit of production are more at lower ranges of output but gradually decrease
with the decrease with the increase in production.
Nature of variable expenses is shown as below:-
Overhead (`) Y
Total variable overhead
Per unit variable overhead

X
O Output or volume in units
The relationship of fixed and variable overheads with the volume of output is exhibited in the following
table. The range of output is considered as 5000-10000 units. Variable overheads are taken at `2 per
unit and fixed overheads are assumed to be at the level of `25000. Can you check for yourself how the
graph will look like for the following figures?
Output Fixed Variable Total Overheads per unit

units Overheads Overheads Overheads
Fixed Variable Total
5000 25000 10000 35000 5.00 2.00 7.00
6000 25000 12000 37000 4.17 2.00 6.17
7500 25000 15000 40000 3.33 2.00 5.33
8000 25000 16000 41000 3.13 2.00 5.13
9000 25000 18000 43000 2.78 2.00 4.78
10000 25000 20000 45000 2.50 2.00 4.50
Semi-Variable Overheads:
These are a sort of mixed or hybrid costs, partly fixed and partly variable costs. For example Telephone
expenses, include a fixed portion of annual charge plus variable charge according to the calls. Thus
total telephone expenses are semi-variable.
Semi-variable overheads are of two types:-
(i) The expenses which change with the change in volume of output, but the variation cost is less than
proportionate to change in output. Examples are power & fuel, lighting, repairs and maintenance
of buildings, etc.

Cost Accounting
(ii) The costs tend to remain constant within certain range of output, then jump up and remain constant
for another range and so on.
Y
Semi-variable overheads
Overhead (`)
X
Output or Volume in units
Semi variable cost need to be classifed into fixed and variable due to the following reasons:
(a) Effective Cost Control: Fixed costs are in the nature of policy costs or discretionary costs and as
such can be controlled by the management. However variable costs can be controlled at lower
levels. Separation of two elements facilitate the fixation of responsibility, preparation of overhead
budget and exercise effective control.
(b) Decision Making: The classification is very useful in management decisions relating to utilization of
capacity. If cost information is to be of use in such problems, it is essential that fixed and variable
costs which behave differently with changes in volume should be segregated.
(c) Preparation of Break-even Charts: Separation of fixed and variable cost is essential for the study of
cost volume profit relationship and for the preparation of breakeven charts and profit charts.
(d) Marginal Costing: The basic requirement of the technique of Marginal Costing is the separation
of fixed and variable costs. While the latter are taken into consideration for the determination of
Marginal Cost and contribution, the fixed costs are treated separately.
(e) Method of Absorption Costing: Separate method may be adopted for determination of rates for
fixed and variable costs for absorption in production. Further a separate fixed overhead rate also
serves as a measure of utilization of the facilities of the undertaking; any under recovery or under
absorption denotes the idle or surplus capacity or production efficiency.
(f) Flexible Budget: In a Flexible Budget, the budgeted amounts vary with the levels of activity & fixed
cost remains constant. It is the variable cost that varies. Breakup of overhead cost into fixed and
variable is therefore necessary for establishment of budget and for the purpose of variance analysis.
Methods of classification of semi variable cost in fixed and variable
(a) Graphical Method – The costs at number of levels are plotted on a graph, x-axis represents the
volume and y-axis represents the amount of expenditure. A straight line known as regression line or
line of best fit is drawn between the points, plotted in such a manner that there are equal number
of points on both the sides of a line and as far as practicable, pairs of points on either side are in
equal distance from the line. Points falling far beyond the line are erratic and are not considered.
If the regression line is drawn carefully so that most of the plotted points are on the line or not far
from it, the scatter chart provides a fairly accurate method for the separation of fixed and variable.
(b) Simultaneous Equations – This uses the straight line equation of y = m x + c where y represents total
cost, m is variable cost per unit, x is the level of output and c is fixed costs. The total costs at two
different volumes are put into these equations which are solved for the values of m and c.
(d) High and Low Method – The highest and lowest levels of output and costs are taken and the
differential is found. This difference arises only due to variable costs. The remaining portion will be

fixed costs. Under this method the variable cost per unit will be computed first and then the fixed
cost will be derived. Variable cost per unit is computed by dividing the difference in cost at highest
level and lowest level with the difference in volume between highest and lowest level.
(d) Least Square Method – This statistical tool uses straight line equation and finds the line of best fit to
solve the equations. Also known as Simple Regression Method. Under this method first the mean
of volume and mean of costs are computed. The deviations in volume (x) from the mean and
deviation in cost (y) from mean are computed.
Codification of Overheads
It is always advisable to codify the overhead expenses. Codification helps in easy identification of
different items of overheads. There are numerous items of overheads and a code number to each one
will facilitate identification of these items easily. Codification can be done by allotting numerical codes or
alphabetical codes or a combination of both. Whatever system is followed, it should be remembered that
the system is simple for understanding and easy to implement without any unnecessary complications.
Cost Centre codes Department name

1100 Turning department
1200 Grinding Department
1300 Components manufacturing
1400 Assembly
2100 Maintenance
2200 Quality control
2300 Stores
3100 HR & Administration
3200 Accounts
You may observe the logic in giving the codes. All codes starting with 1 are production departments,
all codes starting with 2 are factory related services and all codes starting with 3 are general services.
This coding helps collection of costs on functional basis and also to identify an item of expense directly
to a department or cost centre.
Allocation, Apportionment and Reapportionment of Overheads
After the collection, classification and codification of overheads, the next step is allocation and
apportionment of overheads into the product units. The following steps are required to complete this
process.
Departmentalization
Before the allocation and apportionment process starts, the first step in this direction is ‘Departmentalization’
of overhead expenses. Departmentalization means creating departments in the firm so that the overhead
expenses can be conveniently allocated or apportioned to these departments. For efficient working and
to facilitate the process of allocation, apportionment and reapportionment process, an organization is
divided into number of departments like, machining, personnel, fabrication, assembling, maintenance,
power, tool room, stores, accounts, costing etc and the overheads are collected, allocated or
apportioned to these departments. This process is known as ‘departmentalization’ of overheads which
will help in ascertainment of cost of each department and control of expenses.
Allocation
CIMA defines Cost Allocation as, ‘the charging of discrete, identifiable items of cost to cost centres
or cost units’. In simple words complete distribution of an item of overhead to the departments or

Cost Accounting
products on logical or equitable basis is called allocation. Where a cost can be clearly identified with
a cost centre or cost unit, then it can be allocated to that particular cost centre or unit. In other words,
allocation is the process by which cost items are charged directly to a cost unit or cost centre. For
example, electricity charges can be allocated to various departments if separate meters are installed,
depreciation of machinery can be allocated to various departments as the machines can be identified,
salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly
allocated to boiler house division. Thus allocation is a direct process of identifying overheads to cost
units or cost centres. So the term allocation means allotment of whole item of cost to a particular cost
centre or cost object without any division.
Apportionment
Cost Apportionment is the allotment of proportions of items to cost centers. Wherever possible, the
overheads are to be allocated. However, if it is not possible to charge the overheads to a particular
cost centre or cost unit, they are to be apportioned to various departments on some suitable basis. This
process is called as ‘Apportionment’ of overheads. The basis for apportionment is normally predetermined
and is decided after a careful study of relationships between the base and the other variables within
the organisation. The Cost Accountant must ensure that the selected basis is the most logical. A lot of
quantitative information has to be collected and constantly updated for the purpose of apportionment.
The basis selected should be applied consistently to avoid vitiations. However, there should be a periodical
review of the same to revise the basis if needed.
In simple words, distribution of various items of overheads in portions to the departments or products on
logical or equitable basis is called apportionment.
A general example of various bases that may be used for the purpose of apportionment is shown below:
Overhead item Basis

Rent and building Floor space occupied by each department
General Lighting No. of light points in each department
Telephones No. of extensions in a department
Depreciation of factory building Floor space
Material handling No. of material requisitions or Value of material issued
The above list is not exhaustive and depending upon peculiarities of the organisation, it could be
extended. This allocation and/or apportionment is called as primary distribution of overheads.
Distinction between Allocation & Apportionment
Although the purpose of both allocation and apportionment is identical, i.e to identify or allot the costs
to the cost centres or cost unit, both are not the same.
Allocation deals with the whole items of cost and apportionment deals with proportion of items of cost.
Allocation is direct process of departmentalization of overheads, where as apportionment needs a
suitable basis for sub-division of the cost.
Whether a particular item of expense can be allocated or apportioned does not depends on the nature
of expense, but depends on the relation with the cost centre or cost unit to which it is to be charged.
Principles of Apportionment of Overhead Cost
(i) Services Rendered
The principle followed in this method is quite simple. A production department which receives
maximum services from service departments should be charged with the largest share of the
overheads. Accordingly, the overheads of service departments are charged to the production
departments.

(ii) Ability to Pay

This method suggests that a large share of service department’s overhead costs should be assigned
to those producing departments whose product contributes the most to the income of the business
firm. However the practical difficulty in this method is that, it is difficult to decide the most paying
department and hence difficult to operate.
(iii) Survey or Analysis Method
This method is used where a suitable base is difficult to find or it would be too costly to select a
method which is considered suitable. For example, the postage cost could be apportioned on a
survey of postage used during a year.
(iv) Efficiency Method
Under this method, the apportionment of expenses is made on the basis of production targets. If the
target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target
is not achieved, the unit cost goes up, disclosing there by, the inefficiency of the department.
Illustration 1
A factory has 3 production departments (P1, P2, P3) and 2 service departments (S1 & S2). The following
overheads & other information are extracted from the books for the month of January 2016.
Expense Amount (`)

Rent 6,000
Repair 3,600
Depreciation 2,700
Lighting 600
Supervision 9,000
Fire Insurance for stock 3,000
ESI contribution 900
Power 5,400
Particulars P1 P2 P3 S1 S2
Area sq ft 400 300 270 150 80
No. of workers 54 48 36 24 18
Wages 18,000 15,000 12,000 9,000 6,000
Value of plant 72,000 54,000 48,000 6,000
Stock Value 45,000 27,000 18,000
Horse power of plant 600 400 300 150 50
Allocate or apportion the overheads among the various departments on suitable basis.
Solution:
The primary distribution of overheads is as follows:- Amount (`)
Expense Total Basis P1 P2 P3 S1 S2

Rent 6,000 Area sq ft 2,000 1,500 1,350 750 400
Repair 3,600 Plant value 1,440 1,080 960 120 -
Depreciation 2,700 Plant value 1,080 810 720 90 -

Cost Accounting
Lighting 600 Area sq ft 200 150 135 75 40

Supervision 9,000 No of workers 2,700 2,400 1,800 1,200 900
Fire Insurance for stock 3,000 Stock value 1,500 900 600 - -
ESI contribution 900 Wages 270 225 180 135 90
Power 5,400 Horse power 2,160 1,440 1,080 540 180
Total 31,200 11,350 8,505 6,825 2,910 1,610
Secondary Distribution of Production Overheads

After the primary distribution as shown above is over, the next step is to re-distribute the service department
costs over the production departments. This also needs to be done on some suitable basis, as there
may not be a direct linkage between services and production activity. The products actually do not
pass through the service departments. So does it mean that the service cost is not a part of cost of
production? It very much is the part of production cost! Hence the loading of service costs onto the
production departments is necessary. This process is called secondary distribution of overheads.
The basis for secondary distribution is dependent on:-
(i) The nature of service given e.g. it may be maintenance department or stores.
(ii) Measurement of service based on surveys or analysis.
(iii) General use indices
In the above Illustration No. 1, the costs of S1 (`2910) and that of S2 (`1610) will have to be loaded on
to the totals of P1, P2 and P3.
Some examples of the bases that can be used to distribute cost of different service departments:
Service department Basis

Quality No of inspection done
Maintenance No of maintenance calls or
Material usage for maintenance or
Time spent on maintenance
Stores Indirect material cost or
No of issue slips or
Quantity of material issued or
Value of stock handled
Canteen, welfare No workers
Internal transport No. of trucks or trolleys used or
Tonne-miles consumed
Payroll office No. of labour hours
Purchase office No of purchase orders or
Value of material purchased
Again this is not an exhaustive list and could differ from company to company. Many times percentage
estimation is also done for such distribution if the service cannot be measured on the basis of any of the
above bases. It may be decided that the cost of S1 is to be distributed as P1-40%, P2-25% and P3-35%.
Such arbitrary method should be avoided as far as possible.

Methods of Secondary Distribution

(a) Direct Distribution Method
This method is based on the assumption that one service department does not give service to other
service department/s. Thus between service departments there is no reciprocal service exchange.
Hence under this method, service costs are directly loaded on to the production departments. This is
simple, but the assumption may not be correct. Can we say that the canteen service is not available
to other service departments like labour office or stores or maintenance department? This is incorrect
and thus the method should not be used as far as possible.
In the above example consider that if the S1 and S2 costs are to be distributed on assumption of services
rendered as S1 to P1- 40%, P2-30% and P2-10% and the S2 costs are on the basis of 5:3:2, then the table for
redistribution of S1 and S2 costs over the production departments P1, P2 and P3 will be as given below.
Department Total Basic P1 P2 P3

Overheads as per primary distribution 26,680 11,350 8,505 6,825
Distribution of S1 2,910 40%;30%;30% 1,164 873 873
Distribution of S2 1,610 5:3:2 805 488 322
Total 31,200 13,319 9,861 8,020
(b) Step Distribution Method
This method does away with the assumption made under above method, but only partly. It recognises
that a service department may render service to the other service department, but does not receive
service from it. In above example, S1 may render services to S2 but not vice versa, i.e. S2 may not render
service to S1. In such situation, cost of that service department will be distributed first which render services
to maximum number of other service departments. After this, the cost of service department serving
the next large number of departments is distributed. This process is continued till all service departments
are over. Because it is done in steps, it is called as Step Method of Distribution.
Illustration 2
A manufacturing company has two production departments Fabrication and Assembly and 3 service
departments as Stores, Time Office and Maintenance. The departmental overheads summary for the
month of March 2016 is given below:
Fabrication - `24000
Assembly - `16000
Stores - `5000
Time office - `4000
Maintenance - `3000
Other information relating to the department was:
Production departments Service departments

Particulars
Fabrication Assembly Stores Time office Maintenance
No of employees 40 30 20 16 10
No of stores requisition slips 24 20 6
Machine Hours 2400 1600

Apportion the costs of service departments to the production departments.

Cost Accounting
Solution:
We will have to determine the sequence in which the service departments should be selected for
distribution and the bases on which each of them will be distributed. The following logical bases are
decided based on the additional information given:
Time office - No of employees
Stores - No of stores requisitions
Maintenance - Machine hours
Also, it can be easily noticed that the time office serves maximum departments (i.e. both production
departments, stores & maintenance departments). Stores serve the next larger number of departments
(i.e. both production departments and maintenance department).
Maintenance department serves only production departments. Hence the sequence for distribution
will be time office, stores and maintenance. This is shown in the following table:
Amount (`)
Particulars Total Basis Fabrication Assembly Time Stores Maintenance
office
As per primary 52,000 as given 24,000 16,000 4,000 5,000 3,000
distribution
Time office 4,000 no of 1,600 1,200 (4,000) 800 400
employees
Stores 5,800 no of req. 2,784 2,320 (5,800) 696
slips
Maintenance 4,096 Machine 2,458 1,638 (4,096)
hours
Total 30,842 21,158
Please notice when we distribute the time office costs first, the charge to stores department is `800.
This makes the total cost of stores to be distributed as `5800 (5000+800).Same is the logic for `4096 of
Maintenance department.
(c) Reciprocal Service Method: This method takes cognizance of the fact that service departments may
actually give as well as receive services from and to the other service departments on reciprocal basis.
Such inter-departmental exchange of service is given due weight in the distribution of the overheads.
There are two methods used for distribution under this logic. One is called Repeated Distribution Method
and the other Simultaneous Equation Method.
(d) Repeated Distribution Method: This is a continuous distribution of overhead costs over all departments.
The decided ratios are used to distribute the costs of service departments to the production and other
service departments. This is continued till the figures of service departments become ‘nil’ or ‘negligible’.
Illustration 3
The summary as per primary distribution is as follows:
Production departments A- `2400; B- `2100 & C- `1500
Service departments X – `700; Y- `900
Expenses of service departments are distributed in the ratios of:
X dept. : A- 20%, B- 40%, C- 30% and Y- 10%
Y dept. : A- 40%, B- 20%, C- 20% and X- 20%
Show the distribution of service costs among A, B and C under repeated distribution method.

Solution:
Amount (`)
Production departments Service departments
Particulars
A B C X Y
As per primary distribution 2400 2100 1500 700 900
Service dept X 140 280 210 (700) 70
Service dept Y 388 194 194 194 (970)
Service dept X 38.8 77.6 58.2 (194) 19.4
Service dept Y 7.76 3.88 3.88 3.88 (19.4)
Service dept X 0.776 1.552 1.164 (3.88) 0.388
Total 2975.336 2657.032 1967.244 0 0.388
It can be noticed that the undistributed balance in service department is very negligible and thus can
be ignored for further distribution
(e) Simultaneous Equations Method: Under this method, simultaneous equations are formed using the
service departments’ share with each other. Solving the two equations will give the total cost of service
departments after loading the inter- departmental exchange of services. These costs are then distributed
among production departments in the given ratios.
In the above Illustration No. 3, service dept X gives 10% of its service to Y and receives 20% of Y’s service.
Let ‘x’ be the total expenses of dept X (its own + share of Y) and
‘y’ be the total expenses of dept Y (its own + share of X)
This can be expressed as:
‘x’ = 700 + 20% of ‘y’ and
‘y’ = 900 + 10% of ‘x’
i.e. x = 700 + 0.2y and
y = 900 + 0.1x
Multiplying both equations by 10, we get
10x = 7000 + 2y i.e. 10x –2y = 7000 and
10y = 9000 + x i.e. -x+10y = 9000
Now multiplying 2nd equation by 10, and then adding the two equations we get,
98y = 97000
Thus y = 990 and x = 898
Based on this we distribute the service department costs over production departments.
Redistribution Statement
Department
A B C X Y
Primary Distribution 2400 2100 1500 700 900
X 180 359 269 (898) 90
Y 396 198 198 198 (990)
Total 2976 2657 1967 — —

Cost Book Keeping
Study Note - 4
COST BOOK KEEPING & COST SHEET
4.1 Cost Accounting Records, Ledgers and Cost Statements

4.2 Items excluded from Cost and Normal and Abnormal Items/Cost
4.3 Integral Accounts
4.4 Reconciliaton of Cost Accounting Records with Financial Accounts
4.5 Infrastructure, Educational, Healthcare and Port Services
4.1 COST ACCOUNTING RECORDS, LEDGERS AND COST STATEMENTS
COST STATEMENT
In the preceding sections, we have dealt with the basic concepts of costs and the various elements of
costs. We have also seen the different steps followed in determination of cost of a product or rendering
a service. Treatment of various costs has been discussed at length. You are by now very well aware
that the term cost has wide connotations and would not mean anything in isolation. Costs must be
understood if they are to be controlled. Measurement of costs is the first step in the process of control
simply because you cannot control unless you measure. Measurement of cost would mean different
when applied to different industries.
The cost has to be measured with respect to the cost centers first and then at a broader level with
respect to the cost unit. The journey towards the aim of determining cost of a product or service may
take various routes. But the logic is same i.e. collect all relevant costs in the process of converting raw
material into finished product and accumulate the total costs.
To put in simple words, to generate any product or service, resources are needed called as inputs.
Theses inputs are used in a process of conversion. The end result is the output which could either be a
product or a service. The resources consume costs. While determining total cost of resources, the costs
of all resources used (directly or indirectly) in the process are accumulated. This requires establishing
the relationship between the resource and the product or service.
Process - One or many

Input/resources operations - independent Output - Finished
or sequential
Basic law Labour, staff, facilities, utilities
The process of accumulating costs will differ according to the nature of business and the activities carried
out. The common way to accumulate costs is to prepare cost sheets.

Cost Accounting
Cost Accumulation
The logic of Cost Accumulation is to track costs in the same sequence as the resources get used. See
the following flow of activities:
(a) Raw material & other material are purchased and stored
(b) The material is used up in process of conversion
(c) People or machines work upon the material while in the process
(d) The process results into some products that are finished
The cost data needs to be collected along this whole chain that ends when a final product is produced.
The cost accumulation is done based on the source documents which are used in booking the costs.
Depending upon the type of business, a cost unit is determined for which costs must be accumulated.
The departmentalisation of the business organisation is done to suit the production process. For example,
in a fruit processing industry, the costs would be accumulated as per different process involved i.e.
cutting, pulp formation, blending, purifying and final packing. As the physical flow of material happens
from one process to the other, costs are also passed on from one process to the next in line.
As we know all the direct element of cost together make Prime Cost. Sequentially, production overheads
are added to get Factory Cost or Works Cost. Then Administration overheads are added to the Factory
Cost to get Cost of Production. Once the product is ready for sale, the selling and distribution overheads
are added to get Cost of Sales or Cost of Goods Sold. When this is deducted from Sales revenue we
get profit or loss.
Process of accumulation of cost comprises of:
l Identification of costs to the cost centers or departments.
l Apportionment of service costs to production costs.
l Absorption of costs into cost units.
Cost Collection
Cost Collection is the process of booking costs against a particular Cost Account code under a particular
cost center or directly under a cost unit, as the case may be. Source documents are used to generate
the record of the costs incurred or to be incurred. These source documents are properly authorised and
numbered. They act as the primary source of entry. In additions to these documents there could be
other documents and reports such as allocation sheets, labour utilisation reports, idle time & overtime
analysis, scrap reports etc which help in identifying costs. Let us see how the costs are collected.
Material costs
These costs are identified with cost unit with the help of ‘stores issue summary’. In case of job costing,
there will be job-wise summary prepared on the basis of ‘material issue notes’. In case of contracts,
the summary will be made contract-wise. At times instead of procuring & storing material, it may be
procured and directly used on contract site. ‘Purchase Invoice’ may be the basis to capture such direct
material costs. In case of process industry, the material is issued to different processes. Here, the costs
input to a process may be collected based on the cost of materials processed in the previous process. A
process-wise summary of material issues is maintained. Some material may get added to a process but
may not become part of final product. The cost of such material is apportioned on the output of that
process. The indirect material costs may be gathered on the basis of consumable issues, scrap reports,
standard parts list etc. Care should be taken to account for material losses. Normal material losses are

Cost Book Keeping
to be apportioned to the good units produced, whereas, abnormal losses should be excluded from
computation of cost of good units and should be directly taken to P & L Account.
Labour Cost
Salaries and wages summary prepared after the monthly payroll run is the main basis for labour cost
collection. The summary shows department-wise break up, so that the Direct Labour Cost of production
department is separately known and that for the other indirect departments is also available to be
charged as overheads. In case of contracting business, labour force is usually dedicated to various
sites. The cost of labour used on different contracts can be found based on wages sheet maintained
for each contract site. In addition, the idle time reports, overtime reports are used for booking of the
costs of idle time & overtime. In case labourers are common to various jobs or contracts or processes, an
estimate of the time that they spend on each of them is made and the costs are allocated accordingly.
Expenses
Accounting entries in cash book or journal proper help to collect the expenses. Direct expenses which
are job or contract or process specific may be collected on the basis of vouchers. The indirect expenses
are collected and then apportioned in a summarised form using apportionment sheets.
Collection of Budgeted costs

The cost calculation for the selected cost unit could be either of actual cost or budgeted cost. While
actual costs are collected on the basis of documents explained above, the budgeted costs are
computed using the standard bill of material, and predetermined overhead rates. For budgeted direct
material, a bill of material is prepared for each product (including sub-assemblies). This is a quantitative
estimate. Based on the estimates a budgeted material price is considered to value the material cost.
Estimated labour hours are costed using estimated Labour Hour Rates. Pre-determined overheads are
also computed considering the base selected for absorption. Thus an estimate of total cost with full
composition may be made.
Cost Accountant & Cost Data collection

The Cost Accountant must play a pivotal role in ensuring that the process of cost data collection is
very strong. The cost analysis and reporting will not be useful for managerial decision-making if the
data collection process is wrong. Presence of a strong and robust Costing System is needed to ensure
comprehensive data collection process. The Costs Account may carry out periodical checks to evaluate
the system and also may do the Internal Audit. He can use all his expertise in the process of establishing
cost estimates which will help in decision making.
Cost data collected must be reported in proper format to make it more informative and meaningful. As
can be understood, the report must serve the purpose for which it was sought. A complete cost sheet
may not be always necessary. The production manager may require the cost of production only. The
cost report should be able to give this figure separately broken up into all its elements. The sales and
marketing cost may be given for each channel of distribution, customers, regions etc in addition to the
product-wise break up.
The cost data should be collected in a manner that will make available cost information to all those
who are responsible for the costs. A cost sheet should give the figures of each element of cost broken
up into direct and indirect and also according to functions like production, administration and selling
& distribution. It is therefore logical that the format of the Cost Sheet is derived from the requirements
for which it is to be used. Apart from exhibiting the total cost deducted logically, it should highlight
other cost also, so that comparison with budget can be made, variances analysed and cost could be
controlled to increase profits.

Cost Accounting
Cost Sheet Formats & Preparation

The cost concept itself being subjective, there is no standard format in which the collected costs can
be presented. It has to suit the type of business, need of the details, and management’s requirement
of control over costs. Yet a simple way to show the Total Cost of any cost unit is shown below:
Specimen Cost Sheet
Period From …………………… Cost Units

To ……………………………………… …………
Cost Items Amount (`) Amount (`)
Direct Material
Opening Stock xxxxx
Add: Purchases xxxxx
Add: Incidental charges xxxxx
Less: Closing Stock xxxxx xxxxx
Direct Labour xxxxx
Direct Expenses xxxxx
PRIME COST xxxxx
Add: Production Overheads xxxxx
Add: Opening work in process xxxxx
Less: Closing work in process xxxxx xxxxx
FACTORY COST OR WORKS COST xxxxx
Add: Administrative Overheads xxxxx
COST OF GOODS MANUFACTURED xxxxx
Add: Opening Finished goods stock xxxxx
Less: Closing Finished goods stock xxxxx xxxxx
COST OF FINISHED GOODS SOLD xxxxx
Add: Selling & Distribution overheads xxxxx
COST OF GOODS SOLD xxxxx
You can observe the logical way in which the cost flow has been shown in the above chart. The focus
in this specimen is on elements and functions split further into direct and indirect costs with respect to
the cost units. Although the formats could be different, the contents of a cost sheet must be understood
and interpreted correctly so that one can analyse it for control and decision making. For example if it
has to be prepared for a process industry, the format would reflect the portion up to factory cost for
each process separately. Then the administration costs will be added together. The cost per unit will be
computed for every process separately. The stock for processes subsequent to process one will mean
stocks transferred from earlier processes and stocks transferred to the next processes. The objective here
is to compute the cost per process. The cost sheet format here could be:

Cost Book Keeping
Specimen Cost Sheet
Period From ………………… To ………………………………… Cost Units …………

Cost Items Amount (`) Amount (`)
Direct Material
Opening Stock xxxxx
Add: Purchases xxxxx
Add: Incidental charges xxxxx
Less: Closing Stock xxxxx xxxxx
Direct Labour xxxxx
Direct Expenses xxxxx
PRIME COST xxxxx
Add: Production overheads xxxxx
Add: Opening work in process xxxxx
Less: Closing work in process xxxxx xxxxx
FACTORY COST OR WORKS COST xxxxx
Add: Administrative Overheads xxxxx
COST OF GOODS MANUFACTURED xxxxx
Add: Opening Finished goods stock xxxxx
Less: Closing Finished goods stock xxxxx xxxxx
COST OF FINISHED GOODS SOLD xxxxx
Add: Selling & Distribution overheads xxxxx
COST OF GOODS SOLD xxxxx
Depending on number of processes, the working will be shown up to factory cost. Subsequently, the
administration, selling & distribution overheads are added like that shown in the first format. Some process
companies may prepare a different cost sheet for each process. When it is available process wise, control
of process costs and process losses could be better controlled by the concerned process managers.
Important Components of Cost Sheet
(a) Cost sheet has reference to the job or contract or a batch or production or a service undertaken
to be rendered. If the completion of the job at hand relates to more than one accounting period,
it is better that separate columns are provided to mention figures for those period. The job or batch
reference should also be mentioned on the header.
(b) If there is an estimate made for the costs, a separate column must be provided for estimated costs
against which the actual costs should be plotted to get ready comparison. This will make cost sheets
more user-friendly and meaningful.
(c) In certain cases, material may not form any significant portion of the total cost and as such may
be treated as an overhead item. In such cases, the Prime Cost will mainly constitute as labour and
other expenses.
(d) Treatment of raw material stocks should be carefully understood. As the costs are to be linked to
the units produced, the material consumption, completion of earlier period’s semifinished goods
and the finished goods sold needs to be properly computed.
Raw Material Consumed: Opening Stock + Purchases – Closing Stock
One has to go into the depth of this arithmetical formula. Where do we get the figure of purchases
from? It is from the suppliers invoices for purchase of stockable material. It also should include all charges
incidental to purchase of goods like carriage, insurance, customs duty etc. which is directly associated
with the incoming material.

Cost Accounting
As we know that the stocks are always valued at cost or market price whichever is less. This norm has
to be applied to the rates of all the items of material in stock, and then the total valuation of stock is
done. The stock ledger records all receipts and issues of the quantity and rate of material items. The
valuation of material issues has to be properly done based on correctly chosen method of issue pricing.
This summary figure as per the issue column should exactly match with the raw material consumed figure
as included in the cost sheet.
The normal losses on account of material shortages must be included in the cost of raw material
consumed. Care should be taken to remove the abnormal losses there from.
(e) Treatment of work in process is another important step. If the format is carefully seen, it will be noticed
that the cost of WIP stocks is adjusted specifically after adding Factory Overheads! Why adjusted?
And why at that stage only? Please note that Cost Sheet is prepared for a period of time for a cost
unit. At the beginning of that period, if the job has been carried forward from the previous period,
there may be some partly finished work that is carried forward. At the same time there may be
partly finished production at the end of current period. These stocks must be adjusted to reflect
the cost consumed during the current period. Further, the work in process is normally valued at
Factory Cost. It does not include Administration Overheads as the production of goods is not yet
fully complete. Administration costs are absorbed at the stage of finished production. Hence the
adjustment of WIP stocks is to be done before adding the Administration Overheads.
(f) Similarly, the adjustment for the opening and closing stocks of finished goods should be done. This
has to be done after the stage of cost of production.
(g) One could have separate columns for total costs and per unit costs side by side. This will help have
a quick glance at the per unit figures. Management at operating level will find this very helpful.
Illustration 1
Following data is available from the cost records of a company for the month of March 2017:
(1) Opening stock of job as on 1st March 2017
Job no. A 99: Direct Material `80, Direct Wages `150 and Factory Overheads `200
Job no. A 77: Direct Material `420, Direct Wages `450 and Factory Overheads `400
(2) Direct material issued during the month of February 2017 was:
Job no A 99 `120
Job no A 77 `280
Job no A 66 `225
Job no A 55 `300
(3) Direct labour details for March 2017 were:
Job no Hours Amount (`)
A 99 400 600
A 77 200 450
A 66 300 675
A 55 100 225
(4) Factory Overheads are applied to jobs on production according to direct labour hour rate which
is `2 per hour.
(5) Factory Overhead incurred in March 2017 were `2100.

Cost Book Keeping
(6) Job numbers A 99 & A 77 were completed during the month. They were billed to the customers at
a price which included 15% of the price of the job for Selling & Distribution expenses and another
10% of the price for Profit.
Prepare:
(a) Job cost sheet for job number A 77 and A 99.
(b) Determine the selling price for the jobs.
(c) Calculate the value of work in process.
Solution:
Remarks :
(1) The Factory Overheads actually incurred are ` 2100. This amount to be apportioned on the basis
of labour hours. So the rate to be considered as ` 2.1per unit = (2100/1000) and not `2 per unit. If
we consider the above mentioned point the calculations for Job Sheets & for the work in progress
will change accordingly.
(2) Work in progress is to be calculated for the incomplete jobs hence job no. A 66 and A 55 should
only be included in the calculations of work in progress.
Job Cost Sheets for the month of March 2017 Amount (`)
Cost Items Job A 77 Job A 99

Direct Material issued 280 120
Direct labour spent 450 600
Prime Cost 730 720
Factory Overheads @ ` 2.1 per hour (200×2.1) 420 (400×2.1) 840
Add: Opening WIP (Material + Labour + Overheads) 1,270 430
Factory Cost 2,420 1,990
Add: Selling & Distribution Overheads (Note 1) 484 398
Cost of Sales 2,904 2,388
Profit (Note 1) 323 265
Billing price for the job 3,227 2,653
Note 1
S&D and profit are given in indirect way. 480 300
Assume Selling price as 100 320 200
Less: S & D @ 15% (15)
Less: Profit @ 10% (10)
Balance has to be the Factory Cost 75
S & D price will be 15/75 of Factory Costs
Profit will be 10/75 of Factory Cost

Cost Accounting
Computation of Work in Process for March 2017 Amount (`)
Items
Opening balance as on 1 March
st
Job A 99 430
Job A 77 1,270 1,700
Material issued during the month of March Job A 99 120
Job A 77 280
Job A 66 225
Job A 55 300 925
Direct Labour Job A 99 600
Job A 77 450
Job A 66 675
Job A 55 225 1,950
Factory Overheads on 1000 hours @ ` 2.1 2,100
Factory Cost 6,675
Less: Factory Cost of completed jobs Job A 77 2,420
Job A 99 1,990 4,410
Closing work in process as on 28 March 2017
th
2,265
Another way to calculate WIP is

Job A 66 and A 55 are in progress & WIP includes only incomplete Jobs.
Direct Material (225+300) 525
Direct Labour (675+225) 900
Factory Overheads [2.1 *(300+100)] 840
Total WIP 2,265
Illustration 2
Prepare Cost Sheet for an engineering company which produces standard components in batches of
1000 pieces each. A batch passes through three processes viz. Foundry, Machining & Assembly.
The materials used for a batch number 001 were: Foundry 1300 tonnes @ `50 per tonne of which 50
tonnes were sent back to stores.
Other details
Process Direct Labour Overheads

Foundry 200 Hrs @ ` 10 ` 15 per Labour Hour
Machining 100 Hrs @ ` 5 ` 20 per Labour Hour
Assembly 100 Hrs @ ` 15 ` 10 per Labour Hour
A comparison of actual costs with estimated cost discloses that material and overheads have exceeded
the estimates by 20% whereas the estimated labour cost is 10% more than the actual. Show the variances
with respect to the estimates

Cost Book Keeping
Solution:
Cost sheets for the Batch number 001
Standard batch size 1000 pieces
Actual Estimated Variance F/A

Direct material issued (1250 x 50) 62,500 52,083 (10,417) A
Direct labour spent
Foundry - 200 x 10 2,000 2,200 200 F
Machining - 100 x 5 500 550 50 F
Assembly - 100 x 15 1,500 1,650 150 F
Prime Cost 66,500 56,483 (10,017) A
Factory Overheads applied
Foundry - 200 x 15 3,000 2,500 (500) A
Machining - 100 x 20 2,000 1,667 (333) A
Assembly - 100 x 10 1,000 833 (167) A
Factory Cost 72,500 61,483 (11,017) A
Cost per unit (Factory Cost/1000) 72.5 61.48 11.02
Illustration 3
An advertising agency has received an enquiry for which you are supposed to submit the quotation.
Bill of material prepared by the production department for the job states the following requirement of
material:
Paper 10 reams @ `1800 per ream
Ink and other printing material `5000
Binding material & other consumables `3000
Some photography is required for the job. The agency does not have a photographer as an employee.
It decides to hire one by paying `10000 to him. Estimated job card prepared by production department
specifies that service of following employees will be required for this job:
Artist (`12000 per month) 80 hours
Copywriter (`10000 per month) 75 hours
Client servicing (`9000 per month) 30 hours
The primary packing material will be required to the tune of `4000. Production Overheads 40% of direct
cost, while the S & D Overheads are likely to be 25% on Production Cost. The agency expects a profit
of 20% on the quoted price. The agency works 25 days in a month and 6 hours a day.

Cost Accounting
Solution:
Quotation for a Printing Job
Items Amount (`) Amount (`)

Direct material required:
Paper 10 x 1800 18,000
Ink & other printing material 5,000
Binding material & consumables 3,000
Primary packing material 4,000 30,000
Direct labour spent
Artist [12,000/(25 x 6)] x 80 6,400
Copy writer [10,000 / (25 x 6)] x 75 5,000
Client Servicing [9,000 / (25 x 6)] x 30 1,800 13,200
Photographer’s charges 10,000
Prime Cost 53,200
Factory Overheads applied @ 40% on Direct Cost 21,280
Production Cost 74,480
S & D overheads applied @ 25% on Production Cost 18,620
Total Cost 93,100
Profit (20% on price i.e. 25% on cost) 23,275
Price to be quoted 1,16,375
Illustration 4
The following figures were extracted from the Trial Balance of a company as on 31st December 2016.
Particulars Debit Credit

Amount (`) Amount (`)
Inventories
Raw Material 1,40,000
WIP 2,00,000
FG 80,000
Office Appliances 17,400
Plant and Machinery 4,60,500
Buildings 2,00,000
Sales 7,68,000
Sales Returns 14,000
Material purchased 3,20,000
Freight on materials 16,000
Purchase returns 4,800

Cost Book Keeping
Direct labour 1,60,000

Indirect labour 18,000
Factory supervision 10,000
Factory repairs & upkeep 14,000
Heat, light & power 65,000
Rates & taxes 6,300
Misc factory expenses 18,700
Sales commission 33,600
Sales travelling 11,000
Sales Promotion 22,500
Distribution department salaries & wages 18,000
Office salaries 8,600
Interest on borrowed funds 2,000
Further details are given as follows:

Closing inventories are Material `180000, WIP `192000 & FG `115000.
Accrued expenses are Direct Labour `8000, Indirect Labour `1200 & interest `2000.
Depreciation should be provided as 5% on Office Appliances, 10% on Machinery and 4% on Buildings.
Heat, light and power are to be distributed in the ratio of 8:1:1 among factory, office and distribution
respectively.
Rates & taxes apply as 2/3rd to the factory and 1/3rd to office.
Depreciation on building to be distributed in the ratio of 8:1:1 among factory, office and distribution
respectively
Prepare a Cost Sheet showing all important components and also a condensed P & L Account for the
year.
Solution:
Particulars Amount (`) Amount (`)

Direct Materials
Opening stock 1,40,000
Add: Purchases 3,20,000
Add: Freight 16,000
Less: Returns (4,800)
Less: Closing Stock (1,80,000) 2,91,200
Direct Labour 1,60,000
Add: Accrued 8,000 1,68,000
Prime Cost 4,59,200

Cost Accounting
Factory Overheads:
Accrued indirect labour 1,200
Factory supervision 10,000
Repairs & upkeep 14,000
Heat, Light & power 52,000
Rates & taxes 4,200
Misc. Factory expenses 18,700
Depreciation on plant & machinery 46,050
Depreciation on buildings 6,400
1,70,550
Add: Opening WIP 2,00,000
Less: Closing WIP (1,92,000) 1,78,550
Factory Cost 6,37,750
Administration Overheads
Heat Light & power 6,500
Rates & taxes 2,100
Depreciation on buildings 800
Depreciation on office appliances 870
Office salaries 8,600
18,870
Add: Opening FG stock 80,000
Less: Closing FG Stock (1,15,000) (16,130)
Cost of Production of saleable units 6,21,620
Selling & Distribution overheads
Heat & light 6,500
Depreciation on buildings 800
Sales commission 33,600
Sales travelling 11,000
Sales promotion 22,500
Distribution department expenses 18,000 92,400
Cost of Sales 7,14,020
Condensed P & L Account for the year ended 31-12-2016

Sales Income 7,68,000
Less: Returns (14,000) 7,54,000
Cost of Sales as above 7,14,020
Interest on borrowings (2,000 + 2,000) 4,000
Net Profit 35,980

Cost Book Keeping
Illustration 5
PR Ltd. manufactures and sells a typical brand of Tiffin Boxes under its on brand name. The installed
capacity of the plant is 1,20,000 units per year distributable evenly over each month of calendar year.
The Cost Accountant of the company has informed the following cost structure of the product, which
is as follows:
Raw Material ` 20 per unit.
Direct Labour ` 12 per unit
Direct Expenses ` 2 per unit
Variable Overheads ` 16 per unit.
Fixed Overhead ` 3,00,000.
Semi-variable Overheads are as follows:
` 7,500 per month upto 50% capacity & Additional ` 2,500 per month for every additional 25% capacity
utilization or part thereof.
The plant was operating at 50% capacity during the first seven months of the calendar year 2016, at
100% capacity in the remaining months of the year.
The selling price for the period from 1st Jan, 2016 to 31st July, 2016 was fixed at ` 69 per unit. The firm
has been monitoring the profitability and revising the selling price to meet its annual profit target of
` 8,00,000. You are required to suggest the selling price per unit for the period from 1st August 2016 to
31st December 2016.
Prepare Cost Sheet clearly showing the total and per unit cost and also profit for the period.
1. from 1st Jan. to 31st July, 2016
2. from 1st Aug. to 31st Dec, 2016.
Solution:
Cost Sheet for the period Amount (`)
Particulars 50% capacity utilization (10000 100% capacity utilization –

units P.M) – 35000 units, seven 50000 units, Five months
months 1st Jan to 31st July, 2016 1st Aug to 31st Dec, 2016
Raw Materials 7,00,000 10,00,000
Direct Labour 4,20,000 6,00,000
Direct Expenses 70,000 1,00,000
Variable overheads 5,60,000 8,00,000
Fixed Overheads 1,75,000 1,25,000
Semi-Variable Overheads 52,500 62,500
Total Costs 19,77,500 26,87,500
Profit 4,37,500 3,62,500
Sales 24,15,000 30,50,000
Selling Price Per Unit 69.00 61.00
Cost Per Unit 56.50 53.75

Cost Accounting
Illustration 6
X Ltd. Provides you the following figures for the year 2015-16:

Direct Material 3,20,000
Direct Wages 8,00,000
Production Overheads (25% variable) 4,80,000
Administration Overheads (75% Fixed) 1,60,000
Selling and Distribution Overheads (2/3rd Fixed) 2,40,000
Sales @ ` 125 per unit 25,00,000
For the year 2016-17, it is estimated that:
1. Output and sales quantity will increase by 20% by incurring additional Advertisement Expenses of
` 45,200.
2. Material prices will go up 10%.
3. Wage Rate will go up by 5% along with, increase in overall direct labour efficiency by 12%.
4. Variable Overheads will increase by 5%.
5. Fixed Production Overheads will increase by 33 1/3 %
Required:
(a) Calculate the Cost of Sales for the year 2015-2016 and 2016-2017.
(b) Find out the new selling price for the year 2016-2017.
(i) If the same amount of profit is to be earned as in 2015-2016.
(ii) If the same percentage of profit to sales is to be earned as in 2015-2016.
(iii) If the existing percentage of profit to sales is to be increased by 25%.
(iv) If Profit per unit ` 10 is to be earned.
Solution:
(a) Statement showing the Cost of Sales Amount (`)
Particulars For 20000 units For 24000 units

A. Direct Materials 3,20,000 4,22,400
[`3,20,000 x 110% x 120%]
B. Direct wages 8,00,000 9,00,000
[` 8,00,000 x (105/100) x (100/112) x 120%]
C. Prime Cost 11,20,000 13,22,400
D. Add: Production Overheads
Variable Production Overheads 1,20,000 1,51,200
[` 4,80,000 x 25%] [`1,20,000 x 105% x 120%]
Fixed Production Overheads 3,60,000 4,80,000
[` 4,80,000 x 75%] [` 3,60,000 x 133%]
E. Works Cost (C + D) 16,00,000 19,53,600

Cost Book Keeping
F. Add: Administration Overheads

Variable Admn. Overheads 40,000 50,400 [` 40,000 x 105% x 120%]
Fixed Admn. Overheads 1,20,000 1,20,000
G. Cost of Goods Produced 17,60,000 21,24,000
H. Add: Selling and Distribution
Overheads
80,000 1,00,800 [` 80,000 x 105% x 120%]
Variable Selling & Distribution OHs
Fixed Selling & Distribution OHs 1,60,000 1,60,000
Additional Advertisement Exp. 45,200
I. Cost of Sales [G + H] 20,00,000 24,30,000
(b)
(i) New Selling Price = (` 24,30,000 + ` 5,00,000)/24,000 units = ` 122.08
(ii) New Selling Price = (` 24,30,000 + 25% or ` 24,30,000)/24,000 units = ` 126.5625
(iii) New Selling Price = (` 24,30,000 + 1/3rd or ` 24,30,000)/24,000 units = ` 135
(iv) New Selling Price = (` 24,30,000 + (24,000 x ` 10) / 24,000 units = ` 111.25
Illustration 7
The following are the costing records for the year 2017 of a manufacturer:
Production 10,000 units; Cost of Raw Materials ` 2,00,000; Labour Cost ` 1,20,000; Factory Overheads
` 80,000; Office Overheads ` 40,000; Selling Expenses ` 10,000, Rate of Profit 25% on the Selling Price.
The manufacturer decided to produce 15,000 units in 2017. It is estimated that the cost of raw materials
will increase by 20%, the labour cost will increase by 10%, 50% of the overhead charges are fixed and
the other 50% are variable. The selling expenses per unit will be reduced by 20%. The rate of profit will
remain the same.
Prepare a Cost Statement for the year 2017 showing the total profit and selling price per unit.
Solution:
Statement of Cost & Profit (Cost Sheet)
(Output 10,000 units) Amount (`)
Particulars Cost per unit Total Cost
Raw Materials 20 2,00,000
Labour 12 1,20,000
PRIME COST 32 3,20,000
Add: Factory Overhead 8 80,000
WORKS COST 40 4,00,000
Add: Office Overhead 4 40,000
COST OF PRODUCTION 44 4,40,000
Add: Selling Expenses 1 10,000
COST OF SALES 45 4,50,000
Add: Profit (25% on Selling Price or 33.33% on Cost of Sales) 15 1,50,000
SELLING PRICE 60 6,00,000

Cost Accounting
Statement of Cost & Profit (Cost Sheet)
(Output 15,000 units) Amount (`)
Particulars Cost per unit Total Cost

Raw Materials (` 20 x 120% x 15,000) 24.00 3,60,000
Labour (` 12 x 110% x 15,000) 13.20 1,98,000
PRIME COST 37.20 5,58,000
Add: Factory Overhead (` 80,000 x 50% + ` 4 x 15,000) 6.67 1,00,000
WORKS COST 43.87 6,58,000
Add: Office Overhead (` 40,000 x 50% + ` 2 x 15,000) 3.33 50,000
COST OF PRODUCTION 47.20 7,08,000
Add: Selling Expenses (` 1 x 80% x 15,000) 0.80 12,000
COST OF SALES 48.00 7,20,000
Add: Profit (25% on Selling Price or 33.33% on Cost of Sales) 16.00 2,40,000
SELLING PRICE 64.00 9,60,000
4.2 ITEMS EXCLUDED FROM COST AND NORMAL AND ABNORMAL ITEMS/COST
Items Excluded from Cost Accounts

There are certain items which are included in financial accounts of a manufacturing concern but shall
not to be included in cost accounts since they are not related to cost of production. These items fall
into three categories:-
Appropriation of profits:
(i) Appropriation to sinking funds.
(ii) Dividends paid
(iii) Taxes on income and profits
(iv) Transfers to general reserves
(v) Excess provision for depreciation of buildings, plant etc. and for bad debts
(vi) Amount written off – goodwill, preliminary expenses, underwriting commission, discount on
debentures issued; expenses of capital issue etc.
(vii) Capital expenditures specifically charged to revenue
(viii) Charitable donation
Matters of pure finance

(a) Purely financial charges:-
(i) Losses on sale of investments, buildings, etc.
(ii) Expenses on transfer of company’s office
(iii) Interest on bank loan, debentures, mortgages, etc.
(iv) Damages payable

Cost Book Keeping
(v) Penalties and fines

(vi) Losses due to scrapping of machinery
(vii) Remuneration paid to the proprietor in excess of a fair reward for services rendered.
(b) Purely financial incomes:-

(i) Interest received on bank deposits
(ii) Profits made on the sale of investments, fixed assets, etc.
(iii) Transfer fees received
(iv) Rent receivable
(v) Interest, dividends, etc. received on investments.
(vi) Brokerage received
(vii) Discount, commission received
Abnormal gains and losses:-

(i) Losses or gains on sale of fixed assets.
(ii) Loss to business property on account of theft, fire or other natural calamities.
In addition to above abnormal items (gain and losses) may also be excluded from cost accounts.
Alternatively, these may be taken to costing profit and loss account.

Cost Accounting Techniques
Study Note - 6
COST ACCOUNTING TECHNIQUES
6.1 Marginal Costing

6.2 Budget and Budgetary Control
6.1 MARGINAL COSTING
Marginal Cost is defined as “the amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit.” Marginal Cost also means
Prime Cost plus Variable Overheads. Marginal Cost is a constant ratio which may be expressed in
terms of an amount per unit of output. On the other hand, fixed cost which is not normally traceable to
particular unit denotes a fixed amount of expenditure incurred during an accounting period. Fixed cost
is, therefore, also called time cost, period cost, standby cost, capacity cost, or constant cost. Variable
cost or marginal cost is also termed as direct cost, activity cost, volume cost or out-of-pocket cost.
From the above definition and analysis of marginal cost, we can understand that is the cost which
varies according to the variations in the volumes of output. However, by definition marginal cost is the
change in the total cost for addition of one unit. It is to be noted that for an economist marginal cost
and variable cost would be different. But for an accountant both marginal cost and variable cost are
same and are interchangeably used. Therefore, for our study, we use marginal cost and variable cost
synonymously.
Marginal Costing:
Marginal costing is “the ascertainment of marginal costs and of the effect on profit of changes in volume
or type of output by differentiating between fixed costs and variable costs.” Several other terms in use
like direct costing, contributory costing, variable costing, comparative costing, differential costing and
incremental costing are used more or less synonymously with marginal costing.
It is a process whereby costs are classified into fixed and variable and with such a division so many
managerial decisions are taken. The essential feature of marginal costing is division of total costs into fixed
and variable, without which this could not have existed. Variable costs vary with volume of production
or output, whereas fixed costs remains unchanged irrespective of changes in the volume of output. It
is to be understood that unit variable cost remains same at different levels of output and total variable
cost changes in direct proportion with the number of units. On the other hand, total fixed cost remains
same disregard of changes in units, while there is inverse relationship between the fixed cost per unit
and the number of units.
Features of Marginal Costing:
The main features of Marginal Costing may be summed up as follows:
1. Appropriate and accurate division of total cost into fixed and variable by picking out variable
portion of semi variable costs also.
2. Valuation of stocks such as finished goods, work-in-progress is valued at variable cost only.
3. The fixed costs are written off soon after they are incurred and do not find place in product cost
or inventories.

Cost Accounting
4. Prices are based on Marginal Cost and Marginal Contribution.

5. It combines the techniques of cost recording and cost reporting.
Advantages or Merits or Applications of Marginal Costing:
1. Marginal costing system is simple to operate than absorption costing because they do not involve
the problems of overhead apportionment and recovery.
2. Marginal costing avoids, the difficulties of having to explain the purpose and basis of overhead
absorption to management that accompany absorption costing. Fluctuations in profit are easier
to explain because they result from cost volume interactions and not from changes in inventory
valuation.
3. It is easier to make decisions on the basis of marginal cost presentations, e.g., marginal costing
shows which products are making a contribution and which are failing to cover their avoidable
(i.e., variable) costs. Under absorption costing the relevant information is difficult to gather, and
there is the added danger that management may be misled by reliance on unit costs that contain
an element of fixed cost.
4. Marginal costing is essentially useful to management as a technique in cost analysis and
cost presentation. It enables the presentation of data in a manner useful to different levels of
management for the purpose of controlling costs. Therefore, it is an important technique in cost
control.
5. Future profit planning of the business enterprises can well be carried out by marginal costing. The
contribution ratio and marginal cost ratios are very useful to ascertain the changes in selling price,
variable cost etc. Thus, marginal costing is greatly helpful in profit planning.
6. When a business concern consists of several units and produces several products and evaluation
of performance of such components can well be made with the help of marginal costing.
7. It is helpful in forecasting.
8. When there are different products, the determination of number of units of each product, called
Optimum Product Mix, is made with the help of marginal costing.
9. Similarly, optimum sales mix i.e., sales of each and every product to get maximum profit can also
be determined with the help of marginal costing.
10. Apart from the above, numerous managerial decisions can be taken with the help of marginal
costing, some of which, may be as follows:-
(a) Make or buy decisions,
(b) Exploring foreign markets,
(c) Accept an order or not,
(d) Determination of selling price in different conditions,
(e) Replace one product with some other product,
(f) Optimum utilisation of labour or machine hours,
(g) Evaluation of alternative choices,
(h) Subcontract some of the production processes or not,
(i) Expand the business or not,
(j) Diversification,
(k) Shutdown or continue,
Limitations of Marginal Costing:
a. The separation of costs into fixed and variable present’s technical difficulties and no variable cost
is completely variable nor is a fixed cost completely fixed.

b. Under the marginal cost system, stock of finished goods and work-in-progress are understated.
After all, fixed costs are incurred in order to manufacture products and as such, these should form
a part of the cost of the products. It is, therefore, not correct to eliminate fixed costs from finished
stock and work-in-progress.
c. The exclusion of fixed overhead from the inventories affects the Profit and Loss Account and
produces an unrealistic and conservative Balance Sheet, unless adjustments are made in the
financial accounts at the end of the period.
d. In marginal costing system, marginal contribution and profits increase or decrease with changes in
sales volume. Where sales are seasonal, profits fluctuate from period to period. Monthly operating
statements under the marginal costing system will not, therefore, be as realistic or useful as in
absorption costing.
e. During the earlier stages of a period of recession, the low profits or increase in losses, as revealed
in a magnified way in the marginal costs statements, may unduly create panic and compel the
management to take action that may lead to further depression of the market.
f. Marginal costing does not give full information. For example, increased production and sales may
be due to extensive use of existing equipments (by working overtime or in shifts), or by an expansion
of the resources, or by the replacement of labour force by machines. The marginal contribution
fails to reveal these.
g. Though for short-term assessment of profitability marginal costs may be useful, long term profit is
correctly determined on full costs basis only.
h. Although marginal costing eliminates the difficulties involved in the apportionment and under
and over-absorption of fixed overhead, the problem still remains so far as the variable overhead
is concerned.
i. With increased automation and technological developments, the impact on fixed costs on products
is much more than that of variable costs. A system which ignores fixed costs is therefore, less effective
because a major portion of the cost, such as not taken care of.
j. Marginal costing does not provide any standard for the evaluation of performance. A system of
budgetary control and standard costing provides more effective control than that obtained by
marginal costing.
Limitations of Absorption Costing:
1. Being dependent on levels of output which vary from period to period, costs are vitiated due to
the existence of fixed overhead. This renders them useless for purposes of comparison and control.
(If, however, overhead recovery rate is based on normal capacity, this situation will not arise).
2. Carryover of a portion of fixed costs, i.e., period costs to subsequent accounting periods as part
of the cost of inventory is a unsound practice because costs pertaining to a period should not be
allowed to be vitiated by the inclusion of costs pertaining to the previous period.
3. Profits and losses in the accounts are related not only to sales but also to production, including the
production which is unsold. This is contrary to the principle that profits are made not at the stage
when products are manufactured but only when they are sold.
4. There is no uniformity in the methods of application of overhead in absorption costing. These
problems have, no doubt, to be faced in the case of marginal costing also but to a less extent
because of the exclusion of fixed costs, as different assumptions made in the matter of application
of fixed overhead will not arise in the case of marginal costing.
5. Absorption costing is not always suitable for decision making solutions to various types of problems of
management decision making, where the absorption cost method would be practically ineffective,
such as selection of production volume and optimum capacity utilisation, selection of production
mix, whether to buy or manufacture, choice of alternatives and evaluation of performance can
be had with the help of marginal cost analysis. Sometimes, the conclusion drawn from absorption
cost data in this regard may be misleading and lead to losses.

Cost Accounting
Differences between Absorption Costing and Marginal Costing:
Absorption Costing Marginal Costing

1. Both fixed and variable costs are considered for Only variable costs are considered for product
product costing and inventory valuation. costing and inventory valuation.
2. Fixed costs are charged to the cost of production. Fixed costs are regarded as period costs. The
Each product bears a reasonable share of fixed profitability of different products is judged by
cost and thus the profitability of a product is their P/V ratio.
influenced by the apportionment of fixed costs.
3. Cost data are presented in conventional Cost data are presented to highlight the total
pattern. Net profit of each product is determined contribution of each product.
after subtracting fixed cost along with their
variable cost.
4. The difference in the magnitude of opening The difference in the magnitude of opening
stock and closing stock affects the unit cost of stock and closing stock does not affect the unit
production due to the impact of related fixed cost of production.
cost.
5. In case of absorption costing the cost per unit In case of marginal costing the cost per unit
reduces, as the production increases as it is fixed remains the same, irrespective of the production
cost which reduces, whereas, the variable cost as it is valued at variable cost.
remains the same per unit.
Difference in profit under Marginal and Absorption Costing:

• No opening and closing stock: In this case, profit/loss under absorption and marginal costing will
be equal.
• When opening stock is equal to closing stock: In this case, profit/loss under two approaches will be
equal provided the fixed cost element in both the stocks is same amount.
• When closing stock is more than opening stock: In other words, when production during a period
is more than sales, then profit as per absorption approach will be more than that by marginal
approach. The reason behind this difference is that a part of fixed overhead included in closing
stock value is carried forward to next accounting period.
• When opening stock is more than the closing stock: In other words when production is less than
the sales, profit shown by marginal costing will be more than that shown by absorption costing.
This is because a part of fixed cost from the preceding period is added to the current year’s cost
of goods sold in the form of opening stock.
Differential Cost Analysis

Differential Cost is the change in the costs which results from the adoption of an alternative course
of action. The alternative actions may arise due to change in sales volume, price, product mix (by
increasing, reducing or stopping the production of certain items), or methods of production, sales, or
sales promotion, or they may be due to ‘make or buy’ or ‘take or refuse’ decisions. When the change
in costs occurs due to change in the activity from one level to another, differential cost is referred to as
incremental cost or decremental cost, if a decrease in output is being considered, i.e. total increase in
cost divided by the total increase in output. However, accountants generally do not distinguish between
differential cost and incremental cost and the two terms are used to mean one and the same thing.
The computation of differential cost provides an useful method of analysis for the management for
anticipating the results of any contemplated changes in the level or nature of activity. When policy
decisions have to be taken, differential costs worked out on the basis of alternative proposals are of
great assistance.

The determination of differential cost is simple. Differential cost represents the algebraic difference
between the relevant costs for the alternatives being considered. Thus, when two levels of activities
are being considered, the differential cost is obtained by subtracting the cost at one level from the
cost of another level.
The essential features of differential costs are as follows:-

1. The basis data used for differential cost analysis are costs, revenue and the investment factors
which are relevant in the problem for which the analysis is undertaken.
2. Total differential costs rather than the costs per unit are considered.
3. Differential cost analysis is made outside the accounting records.
4. As the differences in the costs at two levels are considered, absolute costs at each level are not
as relevant as the difference between the two. Thus, items of costs which do not change but are
identical for the alternatives under consideration, are ignored.
5. The differentials are measured from a common base point or position.
6. The stage at which the difference between the revenue and the cost is the highest, measured from
the common base point, determines the choice from amongst a number of alternative actions.
7. In computing differential costs, historical or standard costs may be used but they should be adjusted
to the requirements of future conditions.
8. The elements and items of cost to be considered in differential cost analysis will depend upon the
nature of the problem and the alternatives being considered.
Differential Costs Analysis and Marginal Costing:

Although the techniques of differential costs analysis are similar to those of marginal costing, the two
should not be confused. The points of similarity and difference between differential costs analysis and
marginal costing are summarized below:
Similarity:
a. Both the techniques of cost analysis and cost presentation.
b. Both are made use of by the management in decision making and in formulating policies.
c. The concepts of differential costs and marginal costs mainly arise out of the difference in the
behaviour of fixed and variable costs.
d. Differential costs compare favourably with the economist’s definition of marginal cost, viz. that
marginal cost is the amount which at any given volume of output is changed if output is increased
or decreased by one unit.
Difference:
a. Differential cost analysis can be made in the case of both absorption costing as well as marginal
costing.
b. While marginal costing excludes the entire fixed costs, some of the fixed costs may be taken into
account as being relevant for the purpose of differential cost analysis.
c. Marginal costs may be embodied in the accounting system whereas differential costs are worked
out separately as analysis statements.
d. In marginal costing, margin of contribution and contribution ratio are the main yardsticks for
performance evaluation and for decision making. In differential cost analysis, differential costs are
compared with the incremental or decremental revenues, as the case may be.

Cost Accounting
Practical Application of Differential Costs:

They are useful in managerial decisions, which are enumerated below:
(i) Determination of most profitable levels of production and price.
(ii) Acceptance of offer at a lower price or offering a quotation at lower selling price in order to
increase capacity.
(iii) It is used to decide whether it will be more profitable to sell a product as it is or to process it further
into a different product to be sold at an increased price.
(iv) Determining the suitable price at which raw material may be purchased.
(v) Decision of adding a new product or business segment.
(vi) Discontinuing a product or business segment in order to avoid or reduce the present loss or increase
profit.
(vii) Changing the product mix.
(viii) Make or buy decisions.
(ix) Decision regarding alternative capital investment and plant replacement.
(x) Decision regarding change in method of production.
Tools and Techniques of Marginal Costing:
1. Contribution:
In common parlance, contribution is the reward for the efforts of the entrepreneur or owner of a
business concern. From this, one can get in his mind that contribution means profit. But it is not so.
Technically or in Costing terminology, contribution means not only profit but also fixed cost. That is
why; it is defined as the amount recovered towards fixed cost and profit.
Contribution can be computed by subtracting variable cost from sales or by adding fixed costs
and profit.
Symbolically, C = S-V  (1)
Where C = Contribution
S = Selling Price
V = Variable Cost
Also C = F+P  (2)
Where F = Fixed Cost
P = Profit
From (1) and (2) above, we may deduce the following equation called Fundamental Equation of
Marginal Costing i.e.
S-V = F+P  (3)
Contribution is helpful in determination of profitability of the products and/or priorities for profitabilities
of the products. When there are two or more products, the product having more contribution is
more profitable.
For example: The following are the three products with selling price and cost details:
Particulars A B C
Selling price (`) 100 150 200
Variable cost (`) 50 70 100
Contribution (`) 50 80 100

In the above example, one can say that the product ‘C’ is more profitable because, it has more
contribution. This proposition of product having more contribution is more profitable is valid, as long
as, there are no limitations on any factor of production. In this context, factors of production means,
the factors that are responsible for producing the products such as material, labour, machine hours,
demand for sales etc.,
Limiting Factor (or) Key Factor:
In the above example, we find that product having more contribution is more profitable. However, when
there is a limitation on any input factor, the profitability of the product cannot simply be determined
by finding out the contribution of the unit, but it can be found out by ascertaining the contribution per
unit of that factor of production which is limited in the given situation. Such factor of production which
is limited in the question is called key factor or limiting factor.
Continuing the above example, it may be explained as follows:
The three products take same raw material. A takes 1 kg, B requires 2 kgs, C requires 5 kgs and the raw
material is not abundant.
Then profitability of the above products is determined as follows:
Contribution
Profitability = 1 Key Factor 2
A B C
50 / 1 = ` 50 80 / 2 = ` 40 100 / 5 = ` 20
Now, product A is more profitable because it has more contribution per kg of material.
The key factor can also be called as scarce factor or Governing factor or Limiting factor or Constraining
factor etc., whatever may be the name, it indicates the limitation on the particular factor of production.
From the above, it is essentially understandable that contribution is helpful in determination of profitability
of the products, priorities for profitability of the products and in particular, profitabilities when there are
limitation on any factor.
2. Profit Volume Ratio (P/V Ratio) or Contribution Ratio:
First of all, a ratio is a statistical or mathematical tool with the help of which a relationship can be
established between the variables of the same kind. Further, it may be expressed in different forms
such as fractional form, quotient, percentage, decimal form, and proportional form.
For example:
Gross profit ratio: It may be expressed as follows:
 Gross profit is ¼th of sales
 Sales is 4 times that of gross profit
 Gross profit ratio is 25%
 Gross profit is 0.25 of sales and lastly
 Gross profit and sales are in the ratio of 1:4
So, P/V ratio or contribution ratio is association of two variables. From this, one may assume that it is the
ratio of profit and sales. But it is not so. It is the ratio of Contribution to Sales.
Contribution
Symbolically, P/V ratio = ×100  (1)
Sales
C
⇒ P/V ratio = ×100
S

Cost Accounting
⇒ Contribution = Sales x P/V ratio  (2)

Contribution
⇒ Sales =  (3)
P
Ratio
V
When cost accounting data is given for two periods, then:
P/V ratio = Change in Contribution ×100
Change in Sales
Change in Profit
P/V ratio = ×100
Change in Sales
It is to be noted that the above two formulas are valid as long as there are no changes in prices,
means input prices and selling prices.
Usually, Sales = Cost + Profit
i.e. it can also be written as Sales = Variable Cost + Fixed Cost + Profit and this is called general
sales equation.
Since Sales consists of variable costs and contribution, given the variable cost ratio, P/V ratio can
be found out. Similarly, given the P/V ratio, variable cost ratio can be found out.
For example, P/V ratio is 40%, then variable cost ratio is 60%, given variable cost ratio is 70%, then
P/V ratio is 30%. Such a relationship is called complementary relationship. Thus P/V ratio and variable
cost ratios are said to be complements of each other.
P/V ratio is also useful like contribution for determination of profitabilities of the products as well as
the priorities for profitabilities of the products. In particular, it is useful in determination of profitabilities
of the products in the following two situations:
i. When sales potential in value is limited.
ii. When there is a greater demand for the products.
Break Even Point:
When someone asks a layman about his business he may reply that it is alright. But a technical man may
reply that it is break even. So, Break Even means the volume of production or sales where there is no profit
or loss. In other words, Break Even Point is the volume of production or sales where total costs are equal
to revenue. It helps in finding out the relationship of costs and revenues to output. In understanding the
breakeven point, cost, volume and profit are always used. The break even analysis is used to answer
many questions of the management in day to day business.
The formal break even chart is as follows:
Y Total Sales
b Total Cost
Cost & Revenue
Angle of Incidence
FC
a
O X
Unit
a = Losses b = Profits

When no. of units are expressed on X-axis and costs and revenues are expressed on Y-axis, three lines
are drawn i.e., fixed cost line, total cost line and total sales line. In the above graph we find there
is an intersection point of the total sales line and total cost line and from that intersection point if a
perpendicular is drawn to X-axis, we find break even units. Similarly, from the same intersection point a
parallel line is drawn to X-axis so that it cuts Y-axis, where we find Break Even point in terms of value. This
is how, the formal pictorial representation of the Break Even chart.
At the intersection point of the total cost line and total sales line, an angle is formed called Angle of
Incidence, which is explained as follows:
Angle of Incidence:
Angle of Incidence is an angle formed at the intersection point of total sales line and total cost line in
a formal break even chart. If the angle is larger, the rate of growth of profit is higher and if the angle is
lower, the rate of growth of profit is lower. So, growth of profit or profitability rate is depicted by Angle
of Incidence.
Break Even Analysis (or) Cost-Volume-Profit Analysis (CVP analysis):
From the breakeven charts breakeven point and profits at a glance can be found out. Besides,
management makes profit planning with the help of breakeven charts. It can clearly be understood by
way of charts to know the changes in profit due to changes in costs and output. Such profit planning is
made with the variables mainly cost, profit and volume, such an analysis is called breakeven analysis.
Throughout the charts relationship is established among the cost, volume and profit, it is also called Cost-
Volume-Profit Analysis (CVP analysis). That is why it is popularly said by S.C.Kuchal in his book “Financial
Management - An Analytical and Conceptual Approach”, that Cost-volume-profit analysis, break
even analysis and profit graphs are interchangeable words. The analysis is further explained as follows:
The change in profit can be studied through Break even charts in different situations in the following
manner:
(i) Increase in No. of Units
Y Total Sales
Total Cost
Cost & Revenue
Angle of Incidence
FC
O
X
Unitso

‘……’ line indicates increase in total cost and total sales.
In the above chart, if we clearly observe we find that there is no change in BEP even if there is
increase or decrease in No. of units.

Cost Accounting
(ii) Increase in Sales due to increase in selling price.

NTS = New Total Sales line
Y NTS
Total Sales
Total Cost
Cost & Revenue

Angle of Incidence
FC
O BEP X
Units
‘……’ line indicates changes in break even point and changes in sales.
From the above chart, we observe that profit is increased by increasing the selling price and also,
if there is change in selling price, BEP also changes. If selling price is increased then BEP decreases.
If selling price is decreased then BEP increases. Thus, we say that there is an inverse relationship
between selling price and BEP.
(iii) Decrease in variable cost:
Y NTS
Total Sales
Total Cost
Cost & Revenue
Angle of Incidence
FC
O BEP X
Units
‘……’ line indicates decrease in total cost and decrease in B.E.P

From the above chart, we observe that when variable costs are decreased, no doubt, profit is
increased. If there is change in variable cost then BEP also changes. If variable cost is decreased
then BEP also decreases. If variable cost is increased then BEP also increases. Thus there is direct
relationship between variable cost and BEP.

(iv) Change in fixed cost:
Total Sales
Y
Total Cost
Cost & Revenue

Additional Profit
Angle of Incidence
FC
O
Units X
‘……’ line indicates decrease in fixed cost and total cost and also decrease in BEP.
NTC = New Total Cost Line
NFC = New Fixed Cost Line
From the above chart also we find that there is increase in profit due to decrease in fixed cost. If
fixed cost is increased then BEP also increases. If fixed cost is decreased then BEP also decreases.
Thus there is a direct relationship between fixed cost and BEP.
Non linear Break Even Chart:
Loss
Total
Costs
Profit
Revenues and Costs
Fixed Costs
Sales
Lower Max Upper

BEP profit BEP
In some cases on account of non-linear behaviour of cost and sales there may be two or more break
even points. In such a case the optimum profit is earned where the difference between the sales and
the total costs is the largest. It is obvious that the business should produce only upto this level. This is
being illustrated in the above chart.

Cost Accounting
Cash Break-Even Point:

When break-even point is calculated only with those fixed costs which are payable in cash, such a
break-even point is known as cash break-even point. This means that depreciation and other non-cash
fixed costs are excluded from the fixed costs in computing cash break-even point. Its formula is-
Cash break even point = Cash fixed costs / Contribution per unit.
COMPUTATION OF BREAK EVEN POINT:

F× S
Break Even Point in value = ... (1)
S−V
F× S ... (2)
=
c
F× S ... (3)
=
F +P
F ... (4)
=
P.V. Ratio
F
or =
C
S
F
or =
S−V
S
F
= ... (5)
V
1−
S
Break Even Point (in units) = Fixed Cost / Contribution per unit
Proof for basic breakeven:
Let, V be the variable cost per unit
U be the volume of output i.e., No. of units
P be the Profit
F be the Fixed Cost
S be the Selling Price
By substituting the notations in general sales equation:
Sales = Fixed cost + Variable cost + Profit
SU = F + VU + P
At Break Even, SU = F +VU (Since P = 0)
 SU – VU = F
 U(S – V) = F
F
 U = S-V
OR

No. ofUnits = Fixed Cost
Contributionper Unit

Break even sales

F× S
SU (Sales) =
S−V
Uses and applications of Break even Analysis (Or) Profit Charts (Or) Cost Volume Profit Analysis:
The important uses to which cost-volume profit analysis or break-even analysis or profit charts may be
put to use are:
a. Forecasting costs and profits as a result of change in Volume determination of costs, revenue and
variable cost per unit at various levels of output.
b. Fixation of sales Volume level to earn or cover given revenue, return on capital employed, or rate
of dividend.
c. Determination of effect of change in Volume due to plant expansion or acceptance of order, with
or without increase in costs or in other words, determination of the quantum of profit to be obtained
with increased or decreased volume of sales.
d. Determination of comparative profitability of each product line, project or profit plan.
e. Suggestion for shift in sales mix.
f. Determination of optimum sales volume.
g. Evaluating the effect of reduction or increase in price, or price differentiation in different markets.
h. Highlighting the impact of increase or decrease in fixed and variable costs on profit.
i. Studying the effect of costs having a high proportion of fixed costs and low variable costs and
vice-versa.
j. Inter-firm comparison of profitability.
k. Determination of sale price which would give a desired profit for break-even.
l. Determination of the cash requirements as a desired volume of output, with the help of cash break-
even charts.
m. Break-even analysis emphasizes the importance of capacity utilization for achieving economy.
n. During severe recession, the comparative effects of a shutdown or continued operation at a loss
are indicated.
o. The effect on total cost of a change in the fixed overhead is more clearly demonstrated through
break-even charts.
Limitations of Break-even Analysis:
a. That Costs are either fixed or variable and all costs are clearly segregated into their fixed and
variable elements. This cannot possibly be done accurately and the difficulties and complications
involved in such segregation make the break-even point inaccurate.
b. That the behavior of both costs and revenue is not entirely related to changes in volume.
c. That costs and revenue patterns are linear over levels of output being considered. In practice, this
is not always so and the linear relationship is true only within a short run relevant range.
d. That fixed costs remain constant and variable costs vary in proportion to the volume. Fixed costs
are constant only within a limited range and are liable to change at varying levels of activity and
also over a long period, particularly when additional plants and equipments are introduced.
e. That sales mix is constant or only one product is manufactured. A combined analysis taking all the
products of the mix does not reflect the correct position regarding individual products.

Cost Accounting
f. That production and sales figures are identical or the change in opening and closing stocks of the
finished product is not significant.
g. That the units of production on the various product range are identical. Otherwise, it is difficult to
find a homogeneous factor to represent volume.
h. That the activities and productivity of the concern remain unchanged during the period of study.
i. As output is continuously varied within a limited range, the contribution margin remains relatively
constant. This is possible mainly where the output is more or less homogeneous as in the case of
process industries.
Margin of Safety:
It is the sales point beyond the breakeven point. Margin of safety can be obtained by subtracting break
even sales from Total sales. It is useful to determine financial soundness of business enterprise. If margin
of safety is high, then the financial position of the enterprise is sound.
Margin of Safety = Total Sales – Break Even Sales  (1)
Total Sales = Break Even Sales + Margin of Safety Sales  (2)
 Margin of safety can also be computed as follows:
Margin of Safety = Profit / P/V ratio  (3)
A relative measure to the margin of safety is its ratio to total sales.
 Margin of safety ratio is the ratio of Margin of safety sales to Total sales.
Margin of safety ratio = [Margin of safety / Total sales] x 100  (4)
 Margin of safety ratio and Break even sales ratios are complements of each other.
 If the sales amount, P/V ratio and M/S ratio are given, then profit can be computed as
follows:
Profit = Total sales x P/V ratio x M/S ratio  (5)
Apart from the above formulae, various formulae that are used in the chapter to find out different results
are as follows:
Profit = (Sales x P/V ratio) – Fixed Cost
 
Fixed Cost + desired profit 
Sales value to earn desired profit =  and
 P ratio 
 V 
 Fixed Cost + desired profit 

Required units to earn desired profit =  Contribution per unit 
 
Fixed cost = (Sales x P/V ratio) – Profit
Total sales = Break even sales + Margin of safety sales
Break even sales = Total sales – Margin of safety sales
Margin of safety sales = Total sales – Break even sales
Fixed cost = Break even sales x P/V ratio
 
Fixed Cost − Shut down costs 
Shut down sales = 
 P ratio 
 V 

 Fixed Cost − Shut down costs 

Shut down Units =  
 Contribution per unit 
The level at which profits are same or the level at which costs are same for two methods or two alternatives
 Difference in fixed costs 
i.e., Indifference Point =  Difference in variable costs per unit 
 
Practical Problem:
Illustration 1:
The sports material manufacturing company budgeted the following data for the coming year.
Amount (`)
Sales (1,00,000 units) 1,00,000
Variable cost 40,000
Fixed cost 50,000
Find out
(a) P/V Ratio, B.E.P and Margin of Safety
(b) Evaluate the effect of
(i) 20% increase in physical sales volume
(ii) 20% decrease in physical sales volume
(iii) 5% increase in variable costs
(iv) 5% decrease in variable costs
(v) 10% increase in fixed costs
(vi) 10% decrease in fixed costs
(vii) 10% decreases in selling price and 10% increase in sales volume
(viii) 10% increase in selling price and 10% decrease in sales volume
(ix) ` 5,000 variable cost decrease accompanied by ` 15,000 increase in fixed costs.
Solution:
(a) P/V ratio, B.E.P and Margin of Safety
Contribution = Sales – Variable cost
= 1,00,000 – 40,000
= ` 60,000
P/V Ratio = (Contribution / Sales) x 100
= (60,000 / 1,00,000) x 100
= 60%
B.E.P sales = Fixed cost / PV ratio
= 50,000 / 60%
=` 83,333

Cost Accounting
Margin of Safety = Total sales – B.E.P sales

= 1,00,000 – 83,333
= `16,667
(b) Amount (`)
Contribution P/V ratio BE Sales Margin of safety

(i) Increase in volume by 1,20,000 – 48,000 (72,000 / 1,20,000) x 100 (50,000 / 60%) 1,20,000 – 83,333
20% = 72,000 = 60% = 83,333 = 36,667
(ii) Decrease in volume by 80,000 – 32,000 (48,000 / 80,000) x 100 (50,000 / 60%) 80,000 – 83,333
20% = 48,000 = 60% = 83,333 = (3,333)
(iii) 5% increase in variable 1,00,000 – 42,000 (58,000 / 1,00,000) x 100 (50,000 / 58%) 1,00,000 – 86,207
cost = 58,000 = 58% = 86,207 = 13,793
(iv) 5% decrease in variable 1,00,000 – 38,000 (62,000 / 1,00,000) x100 (50,000 / 62%) 1,00,000 – 80,645
cost = 62,000 = 62% = 80,645 = 19,355
(v) 10% increase in fixed 1,00,000 – 40,000 (60,000 / 1,00,000) x 100 (55,000 / 60%) 1,00,000 – 91,667
cost = 60,000 = 60% = 91,667 = 8,333
(vi) 10% decrease in fixed 1,00,000 – 40,000 (60,000 / 1,00,000) x 100 (45,000 / 60%) 1,00,000 – 75,000
costs = 60,000 = 60% = 75,000 = 25,000
(vii) 10% decreases in selling 99,000 – 44,000 (55,000 / 99,000) x 100 (50,000 / 99,000 – 90,009
price and 10% increase = 55,000 = 55.55% 55.55%) = 8,991
in sales volume = 90,009
(viii) 10% increase in selling 99,000 – 36,000 (63,000 / 99,000) x 100 (50,000 / 99,000 – 78,579
price and 10% decrease = 63,000 = 63.63% 63.63%) = 20,421
in sales volume = 78,579
(ix) ` 5,000 variable cost 1,00,000 – 35,000 (65,000/1,00,000) x 100 (65,000 / 65%) 1,00,000 – 1,00,000
decrease accompanied = 65,000 = 65% = 1,00,000 =0
by ` 15,000 increase in
fixed costs.
Illustration 2:
Two businesses AB Ltd and CD Ltd sell the same type of product in the same market. Their budgeted
profits and loss accounts for the year ending 30th June, 2016 are as follows: Amount (`)
AB Ltd CD Ltd
Sales 1,50,000 1,50,000
Less: Variable costs 1,20,000 1,00,000
Fixed Cost 15,000 1,35,000 35,000 1,35,000
Profit 15,000 15,000
You are required to calculate the B.E.P of each business and state which business is likely to earn greater
profits in conditions.
(a) Heavy demand for the product
(b) Low demand for the product.

Solution:
Statement Showing Computation of P/V ratio, BEP and Determination of Profitability in Different conditions:
Particulars AB Ltd CD Ltd

I. Sales 1,50,000 1,50,000
II. Variable cost 1,20,000 1,00,000
III. Contribution 30,000 50,000
IV. P/V ratio [(30,000/1,50,000) x 100] 20% 33 1/3%
[(50,000/1.50,000) x 100]
V. Fixed cost 15,000 35,000
VI. Profit 15,000 15,000
VII. Breakeven sales (V/IV) 75,000 1,05,000
From the above computation, it was found that the product produced by CD Ltd is more profitable in
conditions of heavy demand because its P/V ratio is higher. On the other hand, in the condition of low
demand, the product produced by AB Ltd is more profitable because its BEP is low.
Illustration 3 :
A factory is currently working to 40% capacity and produces 10,000 units. At 50% the selling price falls by
3%. At 90% capacity the selling price falls by 5% accompanied by similar fall in prices of raw material.
Estimate the profit of the company at 50% and 90% capacity production.
The cost at present per unit is:
Material ` 10
Labour `3
Overheads ` 5(60% fixed)
The selling price per unit is ` 20/- per unit.
Solution:
Statement Showing Computation of Profit at 50% and 90% Capacity as well as at Current Capacity:
40% 50% 90%

Particulars Amount (`) Amount (`) Amount (`)
Unit Total Unit Total Unit Total
I. Selling price 20.00 2,00,000 19.40 2,42,500 19.00 4,27,500
II. Variable cost
Material 10.00 1,00,000 10.00 1,25,000 9.50 2,13,750
Labour 3.00 30,000 3.00 37,500 3.00 67,500
Variable OH 2.00 20,000 2.00 25,000 2.00 45,000
15.00 1,50,000 15.00 1,87,500 14.50 3,26,250
III. Contribution 5.00 50,000 4.40 55,000 4.50 1,01,250
IV. Fixed cost 3.00 30,000 30,000 30,000
V. Profit 20,000 25,000 71,250
VI. F× S  1,20,000 1,32,273 1,26,667
B.E. sales  
 C 

Cost Accounting
Illustration 4 :
The sales turnover and profit during two periods were as follows:
Amount (`)
Period Sales Profit

1 2,00,000 20,000
2 3,00,000 40,000
What would be probable trading results with sales of `1,80,000? What amount of sales will yield a profit
of ` 50,000?
Solution:
P/V ratio = (Change in profit / Change in sales) x 100
= (20,000 / 1,00,000) x 100 = 20%
= (2,00,000 x 0.2) – 20,000 = ` 20,000
Sales required to earn desired profit = Fixed cost + desired profit
P/V ratio
= (20,000 + 50,000) / 20% = ` 3,50,000
Illustration 5 :
The following results of a company for the last two years are as follows:
Amount (`)
Year Sales Profit

2014 1,50,000 20,000
2015 1,70,000 25,000
You are required to calculate:
(i) P/V Ratio
(ii) B.E.P
(iii) The sales required to earn a profit of ` 40,000
(iv) Profit when sales are ` 2,50,000
(v) Margin of safety at a profit of ` 50,000 and
(vi) Variable costs of the two periods.
Solution:
(i) P/V ratio = (Change in profit / Change in sales) x 100
= (5,000 / 20,000) x 100 = 25%
Fixed cost = (Sales x P/V ratio) – Profit = (1,50,000 x 25%) – 20,000 = ` 17,500
(ii) Break even sales = Fixed cost / PV ratio = 17,500 / 25% = ` 70,000
(iii) Sales required to earn a profit of ` 40,000 = Fixed cost + desired profit
P/V ratio
= (17,500 + 40,000) / 25% = ` 2,30,000

(iv) Profit at sales ` 2,50,000 = (Sales x P/V ratio) – Fixed cost

= (2,50,000 x 25%) – 17,500 = ` 45,000
(v) Margin of safety at profit of ` 50,000 = Profit / PV ratio
= 50,000 / 25% = ` 2,00,000
(vi) Variable cost for 2011 = 1,50,000 x 75% = ` 1,12,500
Variable cost for 2012 = 1,70,000 x 75% = ` 1,27,500
Illustration 6:
SV Ltd a multi product company furnishes you the following data relating to the year 2015:
Amount (`)
First Half of the year Second Half of the year

Sales 45,000 50,000
Total cost 40,000 43,000
Assuming that there is no change in prices and variable cost and that the fixed expenses are incurred
equally in the two half year period, calculate for the year, 2015
(i) The P/V Ratio, (iii) Break-even sales
(ii) Fixed Expenses (iv) Percentage of Margin of safety.
Solution:
(i) P/V ratio = [(7,000 – 5,000) / (50,000 – 45,000)] x 100 = 40%
(ii) Fixed expenses for first half year : = (Sales x PV ratio) – Profit
= (45,000 x 0.4) – 5,000 = ` 13,000
Fixed expenses for the year = 13,000 + 13,000 = ` 26,000
(iii) Break even sales = 26,000 / 40% = ` 65,000
(iv) Margin of safety = (50,000 + 45,000) – 65,000 = ` 30,000
Margin of safety ratio = [30,000 / (50,000 + 45,000)] x 100 = 31.58%
Illustration 7 :
S Ltd. furnishes you the following information relating to the half year ended 30th June, 2015.
Fixed expenses ` 45,000
Sales value `1,50,000
Profit ` 30,000
During the second half the year the company has projected a loss of `10,000.
Calculate:
(1) The B.E.P and M/S for six months ending 30th June, 2015.
(2) Expected sales volume for the second half of the year assuming that the P/V Ratio and Fixed
expenses remain constant in the second half year also.
(3) The B.E.P and M/S for the whole year for 2015.

Cost Accounting
Solution:
(1) P/V ratio = (Fixed cost + Profit) / Sales
P/V ratio : = [(45,000 + 30,000) / 1,50,000] x 100 = 50%
BE sales for I half year = 45,000 / 50% = ` 90,000
Margin of safety for I half year = 1,50,000 – 90,000 = ` 60,000
For II half year:
0.5 = [45,000 + (-) 10,000] / Sales
0.5 sales = 35,000
⇒ Sales = ` 70,000
(3) BE sales for 2015 = (45,000 + 45,000) x 50% = 1,80,000
Margin of safety for 2015 = (1,50,000 + 70,000) – 1,80,000 = ` 40,000
Illustration 8:
The following is the statement of a Radical Co. for the month of June.
Amount (`)
Products Total
L M
Sales 60,000 60,000 1,20,000
Variable costs 42,000 30,000 72,000
Contribution 18,000 30,000 48,000
Fixed cost 36,000
Net Income 12,000
You are required to compute the P/V ratio for each product and then compute the P/V Ratio, Break-
even Point and net profit for the following assumption.
(i) Sales revenue divided 60% to Product L & 40% to Product M.
(ii) Sales revenue divided 40% to Product L & 60% to Product M.
Also calculate the profit estimated on sales upto ` 1,80,000/- p.m. for each of the sales mix provided
above.
Solution:
Computation of P/V ratio
Particulars L M Total
P/V ratio = (C/S) x 100 30% 50% 40%

(i) For Assumption I:

Statement showing computation of P/V ratio, Break even point and profit: Amount (`)
Sr. No. Particulars L M Total
I. Sales 72,000 48,000 1,20,000
II. Variable cost (L - 70%); (M – 50%) 50,400 24,000 74,400
III. Contribution (L – 30%); (M – 50%) 21,600 24,000 45,600
IV. Fixed cost 36,000
V. Profit 9,600
P/V ratio (45,600 x 1,20,000) / 100 = 38% 30% 50% 38%
Break even sales = 36,000 / 38% = ` 94,737
(ii) For Assumption II:
Statement showing computation of P/V ratio, Break even point and profit: Amount (`)
I. Sales 48,000 72,000 1,20,000
II. Variable cost (L - 70%); (M – 50%) 33,600 36,000 69,600
III. Contribution (L – 30%); (M – 50%) 14,400 36,000 50,400
V. Profit 14,400
P/V ratio (50,400 x 1,20,000) / 100 = 42% 30% 50% 42%
Break even sales = 36,000 / 42% = ` 85,714
Illustration 9 :
Accelerate Co. Ltd., manufactures and sells four types of products under the brand names of A, B, C and
1 2 2 1
D. The sales Mix in value comprises 33 %, 41 %, 16 and 8 %,of products A, B, C & D respectively.
3 3 3 3
The total budgeted sales (100% are `60,000 p.m). Operating costs are:
Variable Costs:
Product A 60% of selling price
Product B 68% of selling price
Product C 80% of selling price
Product D 40% of selling price
Fixed Costs: ` 14,700 p.m.
(a) Calculate the break - even - point for the products on overall basis and
(b) Also calculate break-even-point, if the sales mix is changed as follows the total sales per month
remaining the same. Mix: A - 25% : B - 40% : C - 30% : D - 5%.
Solution:
Particulars A(`) B(`) C(`) D(`) Total(`)
I. Sales 20,000 25,000 10,000 5,000 60,000
II. Variable cost 12,000 17,000 8,000 2,000 39,000
III. Contribution 8,000 8,000 2,000 3,000 21,000
V. Profit 6,300
P/V ratio = (C/S) x 100 40% 32% 20% 60% 35%

Cost Accounting
(a) Break even sales

Break even sales = 14,700 / 35% = ` 42,000
(b) Amount (`)
Particulars A B C D Total
I. Sales 15,000 24,000 18,000 3,000 60,000
II. Variable cost 9,000 16,320 14,400 1,200 40,920
III. Contribution 6,000 7,680 3,600 1,800 19,080
V. Profit 4,380
P/V ratio = (C/S) x 100 40% 32% 20% 60% 31.8 %
Break even sales = 14,700 / 31.8% = ` 46,226
Illustration 10 :
Present the following information to show to management:
(i) The marginal product cost and the contribution p.u.
(ii) The total contribution and profits resulting from each of the following sales mix results.
Amount (`)
Particulars Product Per unit

Direct Materials A 10
Direct Materials B 9
Direct wages A 3
Direct wages B 2
Fixed Expenses – ` 800
(Variable expenses are allotted to products at 100% Direct Wages)
Sales Price ----- A ` 20
Sales Price ----- B `15
Sales Mixtures: (a) 100 units of Product A and 200 of B.
(b) 150 units of Product A and 150 of B.
(c) 200 units of Product A and 100 of B.
Solution:
(i)
Statement of Marginal Product cost Amount (`)
Sr. No. Particulars A B

I. Selling price 20.00 15.00
II. Variable cost
Direct material 10.00 9.00
Direct wages 3.00 2.00
Variable OHs (100% of direct wages) 3.00 2.00
16.00 13.00
III. Contribution (I – II) 4.00 2.00

(ii) Profit at Mix (a): Amount (`)
Sr. No. Particulars A B Total

I. No. of units 100 200
II. ‘C’ per unit 4 2
III. Total contribution (II x I) 400 400 800
IV. Fixed cost 800
V. Profit (III - IV) Nil
Profit at Mix (b): Amount (`)

III. Total contribution (II x I) 600 300 900
IV. Fixed cost 800
V. Profit (III - IV) 100
Profit at Mix (c): Amount (`)

III. Total contribution (I x II) 800 200 1000
IV. Fixed cost 800
V. Profit (III - IV) 200
here ‘C’ means ‘Contribution’ .
Illustration 11:
The following particulars are extracted from the records of a company:
PER UNIT
PRODUCT A PRODUCT B
Sales (`) 100 120
Consumption of material 2 Kg 3 Kg
Material cost (`) 10 15
Direct wages cost (`) 15 10
Direct expenses (`) 5 6
Machine hours used 3 Hrs 2 Hrs
Overhead expenses:
Fixed (`) 5 10
Variable (`) 15 20
Direct wages per hour is ` 5
(a) Comment on profitability of each product (both use the same raw material) when :
1) Total sales potential in units is limited;
2) Total sales potential in value is limited;
3) Raw material is in short supply;
4) Production capacity (in terms of machine hours) is the limiting factor.
(b) Assuming raw material as the key factor, availability of which is 10,000 Kgs. and each product
cannot be sold more than 3,500 units find out the product mix which will yield the maximum profit.

Cost Accounting
Solution:
(a) Statement showing computation of contribution per unit of different factors of production and
determination of profitability
Amount (`)
Sr.No. Particulars A B
I. Sales 100 120
II. Variable cost
Material 10 15
Labour 15 10
Direct expenses 5 6
Variable OH 15 20
45 51
III. Contribution (I - II) 55 69
IV. P/V ratio (III - I) 55% 57.5%
V. Contribution per kg of material 55/2 69/3
= 27.5 = 23
VI. Contribution per machine hour 55/3 69/2
= 18 1/3 = 34.5
From the above computations, we may comment upon the profitability in the following manner.
1. If total sales potential in units is limited, product B is more profitable, it has more contribution per
unit.
2. When total sales in value is limited, product B is more profitable because it has higher P/V ratio.
3. If the raw material is in short supply, Product A is more profitable because it has more contribution
per Kg of material.
4. If the production capacity is limited, product B is more profitable, because it has more contribution
per machine hour.
(b) Statement showing optimum mix under given conditions and computation of profit at that mix:
Amount (`)
Sr.No. Particulars A B Total

I. No. of units 3,500 1,000
II. Contribution per unit 55 69
III. Total contribution 1,92,500 69,000 2,61,500
IV. Fixed cost (3500 x 5) (3500 x 10) 17,500 *35,000 52,500
V. Profit 2,09,000
* Fixed cost is taken at maximum capacity (3,500 x 10)
Working Notes: Kg.

Available material = 10,000
(-) utilized for A (3,500 x 2) = 7,000
= 3,000
Units of B = 3,000 / 3 = 1,000

Illustration 12 :
A company has a capacity of producing 1 lakh units of a certain product in a month. The sales
department reports that the following schedule of sales prices is possible.
VOLUME OF PRODUCTION SELLING PRICE PER UNIT
% `
60 0.90
70 0.80
80 0.75
90 0.67
100 0.61
The variable cost of manufacture between these levels is 15 paise per unit and fixed cost ` 40,000.
Prepare a statement showing incremental revenue and differential cost at each stage. At which volume
of production will the profit be maximum?
Solution:
Statement showing computation of differential cost, incremental revenue and determination of
capacity at which profit is maximum: Amount (`)
Capacity Units Sales V. Cost Fixed cost Total Cost Differential Incremental
% @ (`) 0.15 Cost Revenue
60% 60,000 54,000 9,000 40,000 49,000 -- --
70% 70,000 56,000 10,500 40,000 50,500 1,500 2,000
80% 80,000 60,000 12,000 40,000 52,000 1,500 4,000
90% 90,000 60,300 13,500 40,000 53,500 1,500 300
100% 1,00,000 61,000 15,000 40,000 55,000 1,500 700
From the above computation, it was found that the incremental revenue is more than the differential
cost up to 80% capacity, the profit is maximum at that capacity.
Illustration 13:
A company is at present working at 90 per cent of its capacity and producing 13,500 units per annum.
It operates a flexible budgetary control system. The following figures are obtained from its budget.
90% 100%
Amount (`) Amount (`)
Sales 15,00,000 16,00,000
Fixed expenses 3,00,500 3,00,600
Semi-fixed expenses 97,500 1,00,500
Variable expenses 1,45,000 1,49,500
Units made 13,500 15,000
Labour and material costs per unit are constant under present conditions. Profit margin is 10 per cent.
(a) You are required to determine the differential cost of producing 1,500 units by increasing capacity
to 100%
(b) What would you recommend for an export price for these 1,500 units taking into account that
overseas prices are much lower than indigenous prices?

Cost Accounting
Solution:
Computation of material and labour cost:
Particulars Amount (`) Amount (`)

Sales at present 15,00,000
(-) Profit @ 10% 1,50,000
Total cost 13,50,000
(-) All costs other than material & labour
Fixed expenses 3,00,500 5,43,000
Semi fixed expenses 97,500
Variable expenses 1,45,000
Material & Labour cost 8,07,000
(a) Statement showing differential cost of 1500 units:

Material & Labour (8,07,000 x 1500/13500) 89,667
Fixed expenses (3,00,600 – 3,00,500) 100
Semi fixed expenses (1,00,500 – 97,500) 3,000
Variable expenses (1,49,500 – 1,45,000) 4,500
Differential cost 97,267
(b) Differential cost per unit = 97,267 / 1,500 = ` 64.84
The minimum price for these 1,500 units should not be less than ` 64.84
Illustration 14 :
The operating statement of a company is as follows: Amount (`)
Sales (80,000 @ `15 each) 12,00,000
Costs:
Variable: (`)
Material 2,40,000
Labour 3,20,000
Overheads 1,60,000
7,20,000
Fixed Cost 3,20,000 10,40,000
PROFIT 1,60,000
The capacity of the plant is 1 lakh units. A customer from U.S.A. is desirous of buying 20,000 units at a net
price of `10 per unit. Advice the producer whether or not offer should be accepted. Will your advice
be different, if the customer is local one.

Solution:
Statement showing computation of profit before and after accepting the order:
Amount (`)
Sr. Particulars Present Position Order Value Total

No. (Before accepting) (20,000) (After
80,000 accepting)
1,00,000
I. Sales 12,00,000 2,00,000 14,00,000
II. Variable Cost
Material 2,40,000 60,000 3,00,000
Labour 3,20,000 80,000 4,00,000
Variable OH 1,60,000 40,000 2,00,000
7,20,000 1,80,000 9,00,000
III. Contribution (I - II) 4,80,000 20,000 5,00,000
IV. Fixed cost 3,20,000 -- 3,20,000
V. Profit (III - IV) 1,60,000 20,000 1,80,000
As the profit is increased by ` 20,000 by accepting the order, it is advised to accept the same. If the
order is from local one, it should not be accepted because it will adversely affect the present market.
Illustration 15 :
A company manufactures scooters and sells it at `3,000 each. An increase of 17% in cost of materials
and of 20% of labour cost is anticipated. The increased cost in relation to the present sales price would
cause at 25% decrease in the amount of the present gross profit per unit.
At present, material cost is 50%, wages 20% and overhead is 30% of cost of sales.
You are required to :
(a) Prepare a statement of profit and loss per unit at present and;
(b) Compute the new selling price to produce the same percentage of profit to cost of sales as
before.
Solution:
Let X and Y be the cost and profit respectively.
X + Y = 3,000 → (1)
Material = X x 50/100 = 0.5X
Labour = X x 20/100 = 0.2X
Overheads = X x 30/100 = 0.3X
After increase of cost:
Material = 0.5 X x 117/100 = 0.585 X
Labour = 0.2X x 120/100 = 0.240 X
Overheads = 0.300 X
= 1.125 X

Cost Accounting
Profit = Y x 75/100 = 0.75Y

∴ New Equation 1.125X + 0.75Y = 3,000 → (2)
Multiplying Eq. (1) by 0.75 0.75X + 0.75Y = 2,250
0.375X = 750
X = 750/0.375 = ` 2,000
Y = 3,000 – 2,000 = ` 1,000
Statement of cost & profit per unit at present:
Amount (`)
Material = 2,000 x 50% = 1,000
Labour = 2,000 x 20% = 400
Overheads = 2,000 x 30% = 600
= 2,000
(+) profit @ 50% of cost = 1,000
=
3,000
Computation of new selling price to get same percentage of profit:

Amount (`)
Material = 1,000 x 117/100 = 1,170
Labour = 400 x 120/100 = 480
Overheads = 600
Cost = 2,250
(+) Profit @ 50% = 1,125
New selling price = 3,375
Illustration 16 :
An umbrella manufacturer marks an average net profit of ` 2.50 per piece on a selling price of `14.30
by producing and selling 6,000 pieces or 60% of the capacity. His cost of sales is
Amount (`)
Direct material 3.50
Direct wages 1.25
Works overheads (50% fixed) 6.25
Sales overheads (25% variable) 0.80
During the current year, he intends to produce the same number but anticipates that fixed charges
will go up by 10% which direct labour rate and material will increase by 8% and 6% respectively but he
has no option of increasing the selling price. Under this situation, he obtains an offer for further 20% of
the capacity. What minimum price you will recommend for acceptance to ensure the manufacturer
an overall profit of `16,730.

Solution:
Computation of profit at present after increase in cost:

I. Selling price 14.30
II. Variable cost
Material (3.5 x 106/100) 3.710
Labour (1.25 x 108/100) 1.350
Works overhead 3.125
Sales overhead 0.200
Total 8.385
III. Contribution per unit (I-II) 5.915
IV. Total contribution (6,000 x 5.915) 35,490
V. Fixed cost
Works OH 3.125 24,585
Sales OH 0.600 [3.725 x 6,000 = 22,350 x 110/100]
VI. Profit (iv - v) 10,905
Computation of selling price of the order: (`)
Variable cost of order (2,000 x 8.385) = 16,770
(+) required profit (16,730 – 10,905) = 5,825
Sales required = 22,595
Selling price of order = 22,595/2,000 = 11.2975 (or) ` 11.30
Illustration 17 :
The Dynamic company has three divisions. Each of which makes a different product. The budgeted
data for the coming year are as follows:
Amount (`)
A B C
Sales 1,12,000 56,000 84,000
Direct Material 14,000 7,000 14,000
Direct Labour 5,600 7,000 22,400
Direct Expenses 14,000 7,000 28,000
Fixed Cost 28,000 14,000 28,000
61,600 35,000 92,400
The Management is considering to close down the division C’. There is no possibility of reducing fixed
cost. Advise whether or not division C’ should be closed down.

Cost Accounting
Solution:
Statement showing computation of profit before closing down of division C:
Amount (`)
Sr. No. Particulars A B C Total

I. Sales 1,12,000 56,000 84,000 2,52,000
II. Variable cost
Direct Material 14,000 7,000 14,000 35,000
Direct Labour 5,600 7,000 22,400 35,000
Direct expenses 14,000 7,000 28,000 49,000
III. Total Variable Cost 33,600 21,000 64,400 1,19,000
IV. Contribution (i - iii) 78,400 35,000 19,600 1,33,000
V. Fixed cost 70,000
Statement showing computation of profit after closing ‘C’:

Amount (`)

I. Sales 1,12,000 56,000 1,68,000
II. Variable cost
Direct Labour 5,600 7,000 12,600
Direct expenses 14,000 7,000 21,000
III. Total Variable Cost 33,600 21,000 54,600
IV. Contribution (i - iii) 78,400 35,000 1,13,400
V. Fixed cost 70,000
From the above computations, it was found that profit is decreased by (`63,000 - `43,400) ` 19,600 by
closing down division ‘C’, it should not be closed down. In other words, as long as if there is a contribution
of ` 1, from division ‘C’, it should not be closed down.
Illustration 18 :
Mr. Young has ` 1,50,000 investment in a business. He wants a 15% profit on his money. From an analysis
of recent cost figures he finds that his variable cost of operating is 60% of sales; his fixed costs are `75,000
per year. Show supporting computations for each answer.
(a) What sales volume must be obtained to break-even?
(b) What sales volume must be obtained to his 15% return on investment?
(c) Mr. Young estimates that even if he closed the doors of his business he would incur `25,000 expenses
per year. At what sales would be better off by locking his sales up?

Solution:
P/V ratio (V. cost ratio 60%) = 40%

(a) Break even sales = 75,000 / 40% = ` 1,87,500
(b) Required sales to get desired income = (75,000 + 22,500) / 40% = ` 2,43,750 = ` 2,43,750
(c) Shut down sales = Fixed cost – shut down cost
P/V Ratio
= (75,000 – 25,000) / 40% = ` 1,25,000
Illustration 19 :
The manager of a Co. provides you with the following information:
Amount (`)
Sales : 4,00,000
Costs: Variable
(60% of sales)
Fixed cost : 80,000
Profit before tax : 80,000
Income-tax (60%)
Net profit : 32,000
The company is thinking of expanding the plant. The increased fixed cost with plant expansion will be
`40,000. It is estimated that the maximum production in new plant will be worth `2,40,000. The company
also wants to earn additional income `3,200 on investment. On the basis of computations give your
opinion on plant expansion.
Solution:
Statement showing computation of profit before and after plant expansion:
Amount (`)
Sr. Particulars Present Expansion Total

No. (Before expansion) value (After expansion)
I. Sales 4,00,000 2,40,000 6,40,000
II. Variable cost (60%) 2,40,000 1,44,000 3,84,000
III. Contribution (i - ii) 1,60,000 96,000 2,56,000
IV. Fixed cost 80,000 40,000 1,20,000
V. Profit before tax (iii - iv) 80,000 56,000 1,36,000
VI. Profit after tax (V x 0.40) 32,000 22,400 54,400
From the above computations, it was found that the profit is increased by ` 22,400 by expanding the
plant, which is much higher than the expected income of ` 3,200, one’s opinion should be in favour of
plant expansion.

Cost Accounting
MULTIPLE CHOICE QUESTIONS:
1. If sales are ` 90,000 and variable cost to sales is 75%, contribution is

A. ` 21,500
B. ` 22,500
C. ` 23,500
D. ` 67,500
2. Variable cost
A. Remains fixed in total
B. Remains fixed per unit
C. Varies per unit
D. Nor increase or decrease
3. If sales are ` 150,000 and variable cost are ` 50,000. Compute P/V ratio.
A. 66.66%
B. 100%
C. 133.33%
D. 65.66%
4. Marginal Costing technique follows the following basic of classification
A. Element wise
B. Function Wise
C. Behaviour wise
D. Identifiability wise
5. P/V ratio will increase if the
A. There is an decrease in fixed cost
B. There is an increase in fixed cost
C. There is a decrease in selling price per unit.
D. There is a decrease in variable cost per unit.
6. The technique of differential cost is adopted when
A. To ascertain P/V ratio
B. To ascertain marginal cost
C. To ascertain cost per unit
D. To make choice between two or more alternative courses of action
7. Difference between the costs of two alternative is known as the
A. Variable cost
B. Opportunity cost
C. Marginal cost
D. Differential cost

8. Contribution is ` 300,000 and sales is ` 1,500,000. Compute P/V ratio.

A. 15%
B. 20%
C. 22%
D. 17.5%
9. Variable cost to sales ratio is 40%. Compute P/V ratio.
A. 60%
B. 40%
C. 100%
D. None of the these
10. Fixed cost is 30,000 and P/V ratio is 20%. Compute breakeven point.
A. ` 160,000
B. ` 150,000
C. ` 155,000
D. ` 145,000
[Ans: B, B, A, C, D, D, D, B, A, B]
State whether the statesments are True or False:
1. Contribution= Sales * P/V ratio.
2. Margin of Safety = Profit / P/V ratio
3. P/ V ratio remains constant at all levels of activity.
4. Marginal Costing follows the behaviours wise classification of costs.
5. At breakeven point, contribution available is equal to total fixed cost.
6. Breakeven point = Profit / P/V ratio.
7. Marginal cost is aggregate of Prime Cost and Variable cost.
8. Variable cost remains fixed per unit.
9. Contribution margin is equal to Sales – Fixed cost.
10. Variable cost per unit is variable.
[Ans: T, T, T, T, T, F, F, T, F, F]

Cost Accounting
Fill in the Blanks:
1. Variable cost per unit is ______________.
2. Marginal cost is the ___________ of sales over contribution.
3. P/V ratio is the ratio of __________________ to sales.
4. If variable cost to sales ratio is 60%, P/V ratio is _____________.
5. ___________ + Variable overhead = Marginal Cost.
6. When sales are ` 300,000 and variable cost is ` 180,000, P/V ratio will be ____________.
7. Variable cost remains __________________.
8. Margin of safety is _____________.
9. Breakeven point is ____________.
10. Contribution margin equals to _____________________.
[Ans: Fixed, Excess, Contribution, 40, Prime cost, 40%, fixed per unit, Actual sales-
Sales at breakeven point, Total Fixed cost/ P/V ratio, Sales – Variable cost.]
Column A Column B
1. Indifference point (in units) A Difference in Fixed Cost/ Difference in P/V ratio
2. Breakeven point (in Value) B Fixed Cost / Contribution per unit
3. Variable cost per unit C Total sales less BEP sales
4. P/V ratio D Marginal Cost
5. Prime cost + Variable overhead E Fixed Cost / P/V ratio
6. Breakeven point (in Quantity) F Difference in Fixed Cost/ Difference in
contribution per unit
7. Indifference point (in Value) G Total contribution /Total Sales Value *100
8. Shut Down point (in Quantity) H Avoidable Fixed Cost/ P/V Ratio
9. Shut Down point (in value) I Fixed
10. Margin of Safety J Avoidable Fixed Cost/ Contribution per unit
[Ans: F, E, I, G, D, B, A, J, H, C]

Cost Accounting
6.2 BUDGET AND BUDGETARY CONTROL
The literary meaning of the word Budget is a statement of income and expenditure of a certain period.
In principle, the meaning is same in the context of business also. An individual will have his own budget,
a family, a local authority, state and country etc. All will have their respective budgets. So also the
business concern must have its budget so as to attain their objectives.
CIMA defines a budget as, “A budget is a financial and/or quantitative statement, prepared prior to
a defined period of time, of the policy to be pursued during that period for the purpose of attaining a
given objective.”
Features of Budget
An analysis of the above definition reveals the following as features of the budget.
(i) A Budget must be expressed either in quantitative form i.e., the number of units of different products
or it may be expressed in rupees of each product or it may be quantitative and financial form i.e.,
the number of units and rupees of each product etc.,
(ii) It must be prepared before the time for which it is required, for example, if budget is required for
the year 2013-14, it must be prepared in the year 2012-13.
(iii) Budget must be prepared for a definite period.
(iv) Budget must be prepared in accordance with the policies of the business enterprise.
(v) Budgets are prepared normally for attaining organisational objectives, because policies are
formulated to achieve the objectives and those are translated into quantitative and financial form.
Objectives of the Budget:

(i) A budget is a blue print for the desired plan of action. Since budgets are prepared in accordance
with the policies of various functions of the organisation such as purchase, production sales etc.,
these will be helpful as plan of action to discharge the above functions.
(ii) Budgets are useful for forecasting the operating activities and financial position of a business
enterprise.
(iii) Budgets are helpful in establishing divisional and departmental responsibilities.
(iv) Budgets provide a means of coordination for the business as a whole. When the budgets are
established various factors such as production capacity, sales responsibilities, procurement of
material, deployment of labour etc., are balanced and synchronised so that all the activities are
processed according to the objective. Thereby Budgets are very much useful in coordination of
factors and functions.
(v) Budget ensures good business practice because they plan for future.
(vi) Budgets are means of communication. The complex plans that are laid down by the top
management are to be passed on to the operative personnel, those who actually put the plans
into action. Budgets are very much helpful in processing such information to the lowest personnel
in the organisation.
(vii) Budgets are devised to obtain more economical use of capital and all other inputs.
(viii) Budgets are more definite assurance of earning of the proper return on capital invested.
(ix) Budgets facilitate centralised control with delegated responsibilities and authorities. Budgets
are instruments of managerial control by means of which the management can measure the
performances in every part of the business concerns and corrective action can be taken soon
after deviations are found out.

Limitations of Budgets:
(i) Budgets fail if estimates are not accurate:
Budgets mainly depend upon the accuracy of the estimates. So estimates should be made on
the basis of all the information available. Though forecasting is not an exact science, accurate
estimates can be made by using advanced statistical techniques. Thus preparation of budgets
involves certain amount of judgment and proper interpretation of reports.
(ii) Risk of Rigidity:
Budgeting process creates a sense of rigidity in the minds of people who are working in the
organisation. But in the modern business world, which is more dynamic in nature, such rigidity will
create problems. Therefore budgeting process should also be dynamic in nature, so that it can be
updated according to the situation.
(iii) Budgeting is an expensive process:
The installation and implementation of the budgeting process involves too much time and costs.
Therefore small organisations can not afford to it. Even for large organisations cost benefit analysis
should be conducted before installing such a system. It can be adopted only if the benefits exceed
the costs.
(iv) Budgeting is not a substitute for management:
Budgeting is only a tool for management. Installation of Budgeting system does not relieve the
managers from their duties. It involves only in effective management of the resources of the
organisation. It is only a misconception to think that the introduction of budgeting is alone sufficient
to ensure success and to guarantee future profits. It is only a means for achieving the end.
(v) Continuous monitoring is required:
Installation of budgeting system does not imply that it is effectively implemented. Management
must continuously monitor the operating system (whether the goals intended) how far the plans
and budgets are helpful in achieving the goals of the organisation.
Classification of Budgets:
(A) On the basis of time:
(i) Long term budget: Though there is no exact definition of long term budget, yet we can say
that a budget prepared covering a period of more than a year can be taken as long term
budget. Of course, it may be for 3 years, 5 years, 10 years and even 20 years etc.,
(ii) Short term budget: It is a budget prepared for a period covering a year or less than a year.
(B) On the basis nature of expenditure and receipts:
(i) Capital Budget: It is a budget prepared for capital receipts and expenditure such as obtaining
loans, issue of shares, purchase of assets, etc.,
(ii) Revenue Budget: A Budget covering revenue receipts and expenses for a certain period is
called Revenue Budget. Examples: Sales, other incomes, purchases, administrative expenses
etc.,
(C) On the basis of functions:
Functional Budget: If budgets are prepared of a business concern for a certain period taking each
and every function separately such budgets are called functional budgets. Example: Production,
Sales, purchases, cost of production, cash, materials etc.

Cost Accounting
The following are the various functional budgets, some of which are briefly explained here under:
(i) Sales Budget: The sales budget is a forecast of total sales, expressed in terms of money or quantity
or both. The first step in the preparation of the sales budget is to forecast as accurately as possible,
the sales anticipated during the budget period. Sales forecasts are usually prepared by the sales
manager assisted by the market research personnel.
Factors to be considered in preparing Sales Budget:-

As business existence depends upon the sales it is going to make and therefore it is an important one to
be prepared meticulously. It is the forecast of what it can reasonably sell to its customers during the period
for which budget is prepared. The company’s profit mostly depends upon the ability to sell its products
to customers. In the present era it is indispensable to establish the demand for the product even before
it is produced. It is the sales order book that the company’s continuity depends upon. Also, a reasonable
degree of accuracy must be there in preparing a sales budget unless its sales are accurately forecast,
production estimates will also become erroneous. A good amount of experience must be necessary to
prepare the sales budget. Yet the following factors must be considered in preparing the sales budget:
(a) The locality of the market i.e., domestic or export
(b) The target customers i.e., industry or trade or a section or group of general public etc.,
(c) The product portfolio i.e., the number of products offered and their popularity among the target
customers.
(d) The market share of each product and its influence on the product portfolio and the total market
(e) The effectiveness of existing marketing policy on the current sales volume and value.
(f) The market share of competitor’s products and their effect on the company’s sales.
(g) Seasonal fluctuation in sales.
(h) Expenditure on advertisement and its impact on sales.
(ii) Production Budget: The production budget is a forecast of the production for the budget period.
Production budget is prepared in two parts, viz. production volume budget for the physical units of
the products to be manufactured and the cost of production or manufacturing budget detailing
the budgeted cost under material, labour, and factory overhead in respect of the products.
Factors to be considered in Production Budget:
Next to the sales budget, the main function of a business concern is the production and for this, a budget
is prepared simultaneously with the sales budget. It is the forecast of production during the period for
which the budget is prepared. It can also be prepared in two parts viz., production volume budget for
the physical units i.e., the number of units, the tonnes of production etc., and the cost of production
or manufacture showing details of all elements of the manufacture. While preparing the production
budget, the following factors must be taken into consideration:-
(a) Production plan:-
Production planning is an important part of the preparation of the production budget. Optimum
utilisation of plant capacity is taken by eliminating or reducing the limiting factors and thereby
effective production planning is made.
(b) The capacity of the business concern:-
It is to be ensured that the capacity of the organisation will coincide the budgeted production or
not. For this purpose, plant utilisation budget will also be necessary. The production budget must
be based on normal capacity likely to be achieved and it should not be too high or too low.

(c) Inventory Policy:-

While preparing the production budget it is also necessary to see to what extent materials are
available for producing the budgeted production. For that purpose, a purchase budget or a
purchase plan must also be studied. Similarly, on the other hand, it is also necessary to verify the
extent to which the inventory of finished goods is to be carried.
(d) Sales budgets must also be considered before preparing production budget because it may so
happen that the entire production of the concern may not be sold. In such a case the production
budget must be in line with the sales budget.
(e) A plan of the sequence of operations of production for effective preparation of a production
budget should always be there.
(f) Last, but not the least, the policy of the management should also be considered before preparing
the production budget.
Objectives and Advantages of Production budget:
• Optimum utilisation of the productive resources of the organisation;
• Maintaining low inventory which results in risk of deterioration and fall in prices;
• Focus on the factors that are necessary to frame policies and plan sequence of operations;
• Projection of policies framed, on the basis of past performance, into the future to get the desired
results;
• To see that right materials are provided at right place and at right time;
• Helps in scheduling of production so that delivery dates are met and customer satisfaction is gained;
• Helpful in preparation of projected profit and loss statement, which is useful in evaluation of
performance and profitability.
(iii) Materials Budget: The material budget includes quantities of direct materials; the quantities of each
raw material needed for each finished product in the budget period is specified. The input data
for this budget is obtained by applying standard material usage rates by each type of material to
the volume of output budgeted.
(iv) Purchase Budget: The purchase budget establishes the quantity and value of the various items of
materials to be purchased for delivery at specified points of time during the budget period taking
into account the production schedule of the concern and the inventory requirements. It takes into
account the requirements for the entire budget plan as per the sales, materials, maintenance,
research and development, and capital budgets. Purchases may be required to be made in respect
of direct and indirect materials, finished goods for resale, components and parts, and purchased
services. Before incorporation in the purchase budget, these purchase requirements should be
suitably ascertained. Purchase budget also includes material procurement budget.
(v) Cash Budget: Cash Budget is estimated receipts and expenses for a definite period, which usually
are cash sales, collection from debtors and other receipts and expenses and payment to suppliers,
payment of wages, payment of other expenses etc.
(vi) Direct Labour Budget.
(vii) Human Resources Budget.
(viii) Selling and Distribution cost budget.
(ix) Administration Cost Budget.
(x) Research and Development Cost Budget etc.

Cost Accounting
Master Budget: Master budget is the budget prepared to cover all the functions of the business
organisation. It can be taken as the integrated budget of business concern, that means, it shows the
profit or loss and financial position of the business concern such as Budgeted Profit and Loss Account,
Budgeted Balance Sheet etc. Master budget, also known as summary budget or finalized profit plan,
combines all the budgets for a period into one harmonious unit and thus, it shows the overall budget
plan. The master budget incorporates all the subsidiary functional budgets and the budgeted Profit
and Loss Account and Balance Sheet. Before the budget plan is put into operation, the master budget
is considered by the top management and revised if the position of profit disclosed therein is not found
to be satisfactory. After suitable revision is made, the master budget is finally approved and put into
action. Another view regards the budgeted Profit and Loss Account and the Balance Sheet as the
master budget.
(D) On the basis of capacity:

(i) Fixed or Rigid budget: When budgets are prepared for a fixed or standard volume of activity, they
are called static or rigid or fixed budgets. They do not change with the changes in the volume
of the output. These are prepared normally 3 months in advance of the year. However these will
not be much helpful in comparing the actual activity, as these are prepared at a fixed volume of
output. It, however, does not mean that the fixed budget is a rigid one, not to be changed at all.
Though not adjusted to the actual volume attained, a fixed budget is liable to revision if due to
business conditions undergoing a basic change or due to other reasons, actual operations differ
widely from those planned in the fixed budget.
Fixed budgets are most suited for fixed expenses. In case of discretionary costs situations where
the expenditure is optional and has no relation with the output, e.g. expenditure on research and
development, advertising, and new projects. A fixed budget has only a limited application and
is ineffective as a tool for cost control. Fixed budgets are useful where the plan permits maximum
stabilization of production, as for example, for concerns which manufacture to build up inventories
of finished products and components.
(ii) Flexible Budget: A flexible budget is a budget that is prepared for different levels of activity or
capacity utilization or volume of output. If the budgets are prepared in such a way so as to change
in accordance with the volume of output, they are called flexible budgets. These can be prepared
from fixed budget which are also called revised budgets. These are much helpful in comparison with
actual because the exact deviations are found for which timely corrective action can be taken.
The basic idea of a flexible budget is that there shall be some standard of cost and expenditures.
Thus, a budget prepared in a manner to give budgeted costs for any level of activity is known as
flexible budget. Such budget is prepared after considering the variable and fixed elements of costs
and the changes, which may be expected for each item at various levels of operations. Thus a
flexible budget recognises the difference in behaviour between fixed and variable costs in relation
to fluctuations in production or sales and is designed to change appropriately with such fluctuations.
In flexible budget, data relating to costs, expenditures may progressively be changed in any month
in accordance with actual output achieved. While preparing flexible budgets, estimates of costs
and expenditures on the basis of standards determined are made from minimum to maximum level
of operations.

Difference between Fixed and Flexible Budgets:
Fixed / Rigid Budget Flexible Budget

(i) It does not change with actual volume of It can be recasted on the basis of activity level
activity achieved. Thus it is known as rigid or to be achieved. Thus it is not rigid.
inflexible budget.
(ii) It operates on one level of activity and under It consists of various budgets for different levels
one set of conditions. It assumes that there will of activity.
be no change in the prevailing conditions,
which is unrealistic.
(iii) Here as all costs like – fixed, variable and Here analysis of variance provides useful
semi-variable are related to only one level of information as each cost is analysed according
activity so variance analysis does not give useful to its behaviour.
information.
(iv) If the budgeted and actual activity levels Flexible budgeting at different levels of activity
differ significantly, then the aspects like cost facilitates the ascertainment of cost, fixation of
ascertainment and price fixation do not give a selling price and tendering of quotations.
correct picture.
(v) Comparison of actual performance with It provides a meaningful basis of comparison
budgeted targets will be meaningless specially of the actual performance with the budgeted
when there is a difference between the two targets.
activity levels.
Principal Budget Factor:
Budgets cover all the functional areas of the organisation. For the effective implementation of the
budgetary system, all the functional areas are to be considered which are interlinked. Because of these
interlinks, certain factors have the ability to affect all other budgets. Such factor is known as principle
budget factor.
Principal Budget factor is the factor the extent of influence of which must first be assessed in order to
ensure that the functional budgets are reasonably capable of fulfillment. A principal budget factor
may be lack of demand, scarcity of raw material, non-availability of skilled labour, inadequate working
capital etc. If for example, the organisation has the capacity to produce 2500 units per annum. But the
production department is able to produce only 1800 units due to non-availability of raw materials. In this
case, non-availability of raw materials is the principal budget factor (limiting factor). If the sales manger
estimates that he can sell only 1500 units due to lack of demand. Then lack of demand is the principal
budget factor. This concept is also known as key factor, or governing factor. This factor highlights the
constraints with in which the organisation functions.
BUDGETARY CONTROL
Budgetary control is defined as “the establishment of budgets relating the responsibilities of executives
to the requirements of a policy and the continuous comparison of actual with budgeted results, either
to secure by individual action the objective of that policy or to provide a basis for its revision.”
From the above definition, the steps for Budgetary Control can be drawn as follows: -
(i) Establishment of Budgets:
Budgetary control primarily aims at preparation of various budgets such as sales Budget, production
budget, overhead expenses budget, cash budget etc.,
(ii) Responsibilities of executives:
The budgetary control system is designed to fix responsibilities on executives through preparation of
budgets.

Cost Accounting
(iii) Policy making:

The established policies of the organisation are designed as budgets so as to fix responsibility on
executives.
(iv) Comparison of actuals with budgets:
After establishing the budgets, the actuals are compared with them and any deviations, if any are
called variances.
(v) Achieving the desired result:
The desired result of the budgetary control system is comparison of actuals with the budgeted results
and the causes of variances, if any, are analysed.
(vi) Reporting to Top Management:
After the causes of Variances are analysed, the variances and their causes are reported to top
management so that the remedial action can be taken.
Advantages of Budgetary Control:
(i) Budgetary control aims at maximisation of profits through optimum utilisation of resources.
(ii) It is a technique for continuous monitoring of policies and objectives of the organisation.
(iii) It helps in reducing the costs, thereby helps in better utilisation of funds of the organisation.
(iv) All the departments of the organisation are closely coordinated through establishment of plans
resulting in smooth functioning of the organisation.
(v) Since budgets fix the responsibilities of the executives, they act as a plan of action for them there
by reducing some of their work.
(vi) It facilitates analysis of variances, thereby identifying the areas where deficiencies occur and proper
remedial action can be taken.
(vii) It facilitates the management by exception.
(viii) Budgets act as a motivating force to achieve the desired objective of the organisation.
(ix) It assists delegation of authority and is a powerful tool of responsibility accounting.
(x) It helps in stabilizing the conditions in industries which face seasonal fluctuations.
(xi) It helps as a basis for internal audit.
(xii) It provides a suitable basis for introducing the payment by results system.
(xiii) It ensures adequacy of working capital to the organisation.
(xiv) It aids in performance analysis and performance reporting system.
(xv) It aids in obtaining bank credit.
(xvi) Budgets are forerunners of standard costs in the sense that they create necessary conditions to suit
setting up of standard costs.
Responsibility Accounting:
One of the recent developments in the field of management accounting is the responsibility accounting,
which is helpful in exercising cost control. ‘Responsibility Accounting is a system of accounting that
recognizes various responsibility centers throughout the organization and reflects the plans and actions
of each of these centers by assigning particular revenues and costs to the one having the pertinent
responsibility. It is also called profitability accounting and activity accounting.
It is a system in which the person holding the supervisory posts as president, function head, foreman,
etc are given a report showing the performance of the company or department or section as the case
may be. The report will show the data relating to operational results of the area and the items of which
he is responsible for control. Responsibility accounting follows the basic principles of any system of cost

control like budgetary control and standard costing. It differs only in the sense that it lays emphasis
on human beings and fixes responsibilities for individuals. It is based on the belief that control can be
exercised by human beings, so responsibilities should be fixed for individuals.
Principles of responsibility accounting are as follows:
(a) A target is fixed for each department or responsibility center.
(b) Actual performance is compared with the target.
(c) The variances from plan are analysed so as to fix the responsibility.
(d) Corrective action is taken by higher management and is communicated.
Performance Budgeting:
Performance Budgeting is synonymous with Responsibility Accounting which means thus the responsibility
of various levels of management is predetermined in terms of output or result keeping in view the authority
vested with them. The main concepts of such a system are enumerated below:
(a) It is based on a classification of managerial level for the purpose of establishing a budget for each
level. The individual in charge of that level should be made responsible and held accountable for
its performance over a given period of time.
(b) The starting point of the performance budgeting system rests with the organisation chart in which
the spheres of jurisdiction have been determined. Authority leads to the responsibility for certain
costs and expenses which are forecast or present in the budget with the knowledge of the manager
concerned.
(c) The costs in each individual’s or department’s budget should be limited to the cost controllable
by him.
(d) The person concerned should have the authority to bear the responsibility.
Illustration 1:
Prepare a Production Budget for three months ending March 31, 2016 for a factory producing four
products, on the basis of the following information.
Type of Product Estimated Stock on Jan. Estimated Sales during Desired closing stock on
1, 2016 Jan. to Mar. 2016 31.3.2016
A 2,000 10,000 3,000
B 3,000 15,000 5,000
C 4,000 13,000 3,000
D 3,000 12,000 2,000
Solution:
Production Budget for the 3 Months ending 31st March 2016
Particulars Product A Product B Product C Product D

Sales 10,000 15,000 13,000 12,000
Add: Closing Stock 3,000 5,000 3,000 2,000
13,000 20,000 16,000 14,000
Less: Opening Stock 2,000 3,000 4,000 3,000
Production (Units) 11,000 17,000 12,000 11,000

Cost Accounting
Illustration 2:
Budgeted production and production costs for the year ending 31st December are as follows:
PRODUCT- X PRODUCT -Y
Production (units) 2,20,000 2,40,000
Direct material/unit ` 12.5 `19.0
Direct wages/unit ` 4.5 `7.0
Total factory overheads for each type of product (variable) ` 6,60,000 `9,60,000
A company is manufacturing two products X and Y. A forecast about the number of units to be sold in
the first seven months is given below:
MONTH JAN FEB MAR APRIL MAY JUNE JULY

Product – X 10,000 12,000 16,000 20,000 24,000 24,000 20,000
Y 28,000 28,000 24,000 20,000 16,000 16,000 18,000
It is anticipated that:
(a) There will be no work-in-progress at the end of any month.
(b) Finished units equal to half the sales for the next month will be in stock at the end of each month
(including December of previous year).
Prepare for 6 months ending 30th June a Production Budget and a summarised cost of production budget.
Solution:
Production Budget for 6 Months ending 30th June (Product X)
Particulars Jan Feb Mar Apr May Jun

Sales 10,000 12,000 16,000 20,000 24,000 24,000
Add: Closing Stock 6,000 8,000 10,000 12,000 12,000 10,000
16,000 20,000 26,000 32,000 36,000 34,000
Less: Opening
Stock 5,000 6,000 8,000 10,000 12,000 12,000
Production (units) 11,000 14,000 18,000 22,000 24,000 22,000
Total Production of X for 6 months = 11,000 + 14,000 + 18,000 + 22,000 + 24,000 + 22,000 = 1,11,000 units.
Production Budget for 6 Months ending 30th June (Product Y)

Sales 28,000 28,000 24,000 20,000 16,000 16,000
Add: Closing Stock 14,000 12,000 10,000 8,000 8,000 9,000
42,000 40,000 34,000 28,000 24,000 25,000
Less: Opening Stock 14,000 14,000 12,000 10,000 8,000 8,000
Production (units) 28,000 26,000 22,000 18,000 16,000 17,000
Total production of Y for 6 months = 28,000 + 26,000 + 22,000 + 18,000 + 16,000 + 17,000 = 1,27,000 units.

Summarised Cost of Production Budget for 6 Months Ending 30th June

Amount (`)
Particulars Product X (1,11,000 units) Product Y (1,27,000 units) Total

Materials 13,87,500 24,13,000 38,00,500
Direct Wages 4,99,500 8,89,000 13,88,500
Variable Factory Overhead (wn) 3,33,000 5,08,000 8,41,000
Summarised cost of Production 22,20,000 38,10,000 60,30,000
Working Notes:
1. Computation of Variable Factory Overhead
 6,60,000 
For Product X =  × 1,11,000  = 3,33,000
 2,20,000 
 9,60,000 
For product Y=  × 1,27,000  = 5,08,000
 2,24,000 
Illustration 3 :
Draw a Material Procurement Budget (Quantitative) from the following information:
Estimated sales of a product 40,000 units. Each unit of the product requires 3 units of material A and 5
units of material B.
Estimated opening balances at the commencement of the next year:
Finished product = 5,000 units
Material A = 12,000 units
B = 20,000 units
Material on order:
Material B = 11,000 units
The desirable closing balance at the end of the next year:
Finished product = 7,000 units
B = 25,000 units
Material on order:
B = 10,000 units
Solution:
Production = Sales + Closing Stock - Opening Stock
= 40,000 + 7,000 - 5,000
= 42,000 units

Cost Accounting
Raw Materials Purchase Budget
Particulars Product A Product B

Material Required 1,26,000 2,10,000
(42,000 x 3) (42,000 x 5)
Add: Closing Stock 15,000 25,000
Add: Closing Stock on order 8,000 10,000
1,49,000 2,45,000
Less: Opening Stock 12,000 20,000
Less: Opening Stock on order 7,000 11,000
Raw Material Purchase 1,30,000 2,14,000
Illustration 4:
From the following figures prepare the raw material purchase budget for January, 2017:
Materials
A B C D E F
Estimated Stock on Jan 1 16,000 6,000 24,000 2,000 14,000 28,000
Estimated Consumption 1,20,000 44,000 1,32,000 36,000 88,000 1,72,000
Standard Price per Unit 25 p. 5 p. 15 p. 10 p. 20 p. 30 p.
Solution:
Raw Materials Purchase Budget For January 2015
Type A B C D E F Total
Estimated Consumption (units) 1,20,000 44,000 1,32,000 36,000 88,000 1,72,000
Add: Estimated stock on Jan 31, 20,000 8,000 28,000 4,000 16,000 32,000
2017 (units)
1,40,000 52,000 1,60,000 40,000 1,04,000 2,04,000
Less: Estimated stock on Jan1, 2017 16,000 6,000 24,000 2,000 14,000 28,000
(units)
Estimated purchase (units) 1,24,000 46,000 1,36,000 38,000 90,000 1,76,000 6,10,000
Rate per unit (`) 0.25 0.05 0.15 0.10 0.20 0.30
Estimated purchases (`) 31,000 2,300 20,400 3,800 18,000 52,800 1,28,300
Illustration 5 :
A company manufactures product - A and product -B during the year ending 31st December 2016, it is
expected to sell 15,000 kg. of product A and 75,000 kg. of product B at `30 and `16 per kg. respectively.
The direct materials P, Q and R are mixed in the proportion of 3: 5: 2 in the manufacture of product A,
Materials Q and R are mixed in the proportion of 1:2 in the manufacture of product B. The actual and
budget inventories for the year are given below:

Opening Stock Expected Closing stock Anticipated cost per Kg.

Kg. Kg. `
Material – P 4,000 3,000 `12
Material –Q 3,000 6,000 10
Material – R 30,000 9,000 8
Product - A 3,000 1,500 —
B 4,000 4,500 —
Prepare the Production Budget and Materials Budget showing the expenditure on purchase of materials
for the year ending 31-12-2016.
Solution:
Production Budget for the Products A & B

Sales 15,000 75,000
16,500 79,500
Less: Opening Stock 3,000 4,000
Production 13,500 75,500
Material Purchase Budget for the Year ending Dec 31st 2016
Particulars P Q R Total
Material required for product A in the ratio of 3:5:2 4,050 6,750 2,700 13,500
Material required for product B in the ratio of 1:2 - 25,167 50,333 75,500
Total requirement 4,050 31,917 53,033
Add: Closing Stock 3,000 6,000 9,000
7,050 37,917 62,033
Less: Opening Stock 4,000 3,000 30,000
Purchases (in units) 3,050 34,917 32,033
Cost per Kg. 12 10 8
Total Purchase cost (`) 36,600 3,49,170 2,56,264 6,42,034

Cost Accounting
Illustration 6:
The following details apply to an annual budget for a manufacturing company.
QUARTER 1st 2nd 3rd 4th

Working Days 65 60 55 60
Production (Units per working day) 100 110 120 105
Raw material purchases (% by weight of annual total) 30% 50% 20% —
Budgeted purchase price/Kg.( `) 1 1.05 1.125 —
Quantity of raw material per unit of production 2 kg. Budgeted closing stock of raw material 2,000 kg.
Budgeted opening stock of raw material 4,000 kg. (Cost ` 4,000)
Issues are priced on FIFO Basis. Calculate the following budgeted figures.
(a) Quarterly and annual purchase of raw material by weight and value.
(b) Closing quarterly stocks by weight and value.
Solution:
Material Purchase Budget
Particulars Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total

Production 6,500 6,600 6,600 6,300 26,000
(65x100) (60x110) (120x55) (60x105)
Material Required (Production x 2) 13,000 13200 13,200 12,600 52,000
Add: Closing Stock 2,000
54,000
Less: Opening Stock 4,000
Purchases by Weight 15,000 25,000 10,000 - 50,000
Computation of Purchases by Value

Purchases (Weight) 15,000 25,000 10,000 -
(50,000 x 30%) (50,000 x 50%) (50,000 x 20%)
Cost per Kg. 1 1.05 1.125 -
Purchases (`) 15,000 26,250 11,250 - 52500
Budget Showing Closing Quarterly Stocks by Weight and Value
Particulars Quarter 1 Quarter 2 Quarter 3 Quarter 4

Opening Stock 4,000 6,000 17,800 14,600
Purchases 15,000 25,000 10,000 -
19,000 31,000 27,800 14,600
Material consumed 13,000 13,200 13,200 12,600
Closing Stock by Weight 6,000 17,800 14,600 2,000
Closing Stock by Value (`) 6,000 18,690 16,080 2,250
(6,000 x 1) (17,800 x 1.05) {(10,000 x 1.125)+ (2,000 x 1.125)
(4,600 x 1.05)}

Illustration 7 :
You are required to prepare a Selling Overhead Budget from the estimates given below:
Amount (`)
Advertisement 1,000
Salaries of the Sales Dept. 1,000
Expenses of the Sales Dept.(Fixed) 750
Salesmen’s remuneration 3,000
Salesmen’s and Dearness Allowance - Commission @ 1% on sales affected
Carriage Outwards: Estimated @ 5% on sales
Agents Commission: 7½% on sales
The sales during the period were estimated as follows:
(a) `80,000 including Agent’s Sales `8,000
(b) `90,000 including Agent’s Sales `10,000
(c) `1,00,000 including Agent’s Sales `10,500
Solution:
Selling Overhead Budget
(`)
Sales 80,000 90,000 1,00,000

(A) Fixed overhead:
Advertisement 1,000 1,000 1,000
Salaries of the sales dept. 1,000 1,000 1,000
Expenses of the sales dept. 750 750 750
Salesmen remuneration 3,000 3,000 3,000
Total (A) 5,750 5,750 5,750
(B) Variable overhead:
Commission 720 800 895
(72,000 x 1%) (80,000 x 1%) (89,500 x 1%)
Carriage outwards (5% on sales) 4,000 4,500 5,000
Agents Commission 600 750 788
(8,000 x 7.5%) (10,000 x 7.5%) (10,500 x 7.5%)
Total (B) 5,320 6,050 6,683
Grand Total (A+B) 11,070 11,800 12,433

Cost Accounting
Illustration 8:
ABC Ltd. a newly started company wishes to prepare Cash Budget from January. Prepare a cash budget
for the first six months from the following estimated revenue and expenses.
Amount (`)
Overheads
Month Total Sales Materials Wages
Production Selling & Distribution
January 20,000 20,000 4,000 3,200 800
February 22,000 14,000 4,400 3,300 900
March 28,000 14,000 4,600 3,400 900
April 36,000 22,000 4,600 3,500 1,000
May 30,000 20,000 4,000 3,200 900
June 40,000 25,000 5,000 3,600 1,200
Cash balance on 1st January was `10,000. A new machinery is to be installed at `20,000 on credit, to
be repaid by two equal installments in March and April, sales commission @5% on total sales is to be
paid within a month following actual sales.
`10,000 being the amount of 2nd call may be received in March. Share premium amounting to `2,000
is also obtained with the 2nd call. Period of credit allowed by suppliers — 2months; period of credit
allowed to customers — 1month, delay in payment of overheads 1 month. Delay in payment of wages
½ month. Assume cash sales to be 50% of total sales.
Solution:
Cash Budget for the First 6 Months

Opening Balance (A) 10,000 18,000 29,800 27,000 24,700 33,100
Add: Receipts (B)
Cash Sales (50%) 10,000 11,000 14,000 18,000 15,000 20,000
Collection from debtors - 10,000 11,000 14,000 18,000 15,000
Share call money (including share - - 12,000 - - -
premium)
Total (A+B) 20,000 39,000 66,800 59,000 57,700 68,100
Less: Payments
Materials - - 20,000 14,000 14,000 22,000
Wages 2,000 4,200 4,500 4,600 4,300 4,500
Overheads - 4,000 4,200 4,300 4,500 4,100
Sales Commission - 1,000 1,100 1,400 1,800 1,500
Installment of Machinery purchase - - 10000 10000 - -
Total Payments(C) 2,000 9,200 39,800 34,300 24,600 32,100
Closing Balance (A+B-C) 18,000 29,800 27,000 24,700 33,100 36,000
Note: According to credit terms wages to be taken at half of the current month plus half of the previous
month.

Illustration 9:
Prepare a Cash Budget for the three months ending 30th June, 2016 from the information given below:
(a) Amount (`)
MONTH SALES MATERIALS WAGES OVERHEADS

February 14,000 9,600 3,000 1,700
March 15,000 9,000 3,000 1,900
April 16,000 9,200 3,200 2,000
May 17,000 10,000 3,600 2,200
June 18,000 10,400 4,000 2,300
(b) Credit terms are:
Sales / Debtors : 10% sales are on cash, 50% of the credit sales are collected next month and the balance
in the following month.
Creditors: Materials 2 months
Wages 1/4 month
Overheads 1/2 month.
(c) Cash and bank balance on 1st April, 2016 is expected to be ` 6,000.
(d) Other relevant information are:
(i) Plant and machinery will be installed in February 2016 at a cost of ` 96,000. The monthly
installment of `2,000 is payable from April onwards.
(ii) Dividend @ 5% on preference share capital of ` 2,00,000 will be paid on 1st June.
(iii) Advance to be received for sale of vehicles ` 9,000 in June.
(iv) Dividends from investments amounting to ` 1,000 are expected to be received in June.
Solution:
Cash Budget for the 3 Months Ending 30th June 2016 (Amount in `)
Particulars April May June
Opening Balance 6,000 3,950 3,000
Add: Receipts :
Cash Sales 1,600 1,700 1,800
Collection from debtors [see note(1)] 13,050 13,950 14,850
Advance for sale of vehicles - - 9,000
Dividends from Investments - - 1,000
Total (A+B) 20,650 19,600 29,650
Less: Payments
Materials 9,600 9,000 9,200
Wages (see note2) 3,150 3,500 3,900
Overheads 1,950 2,100 2,250
Installment of Plant & Machinery 2,000 2,000 2,000
Preference Dividend - - 10,000
Total (C) 16,700 16,600 27,350
Closing Balance (A+B-C) 3,950 3,000 2,300

Cost Accounting
Working Notes:
(i) Computation of Collection from Debtors (Amount in `)
Month Credit
Total Sales Feb Mar Apr May June
Sales
Feb 14,000 12,600 - 6,300 6,300 - -
Mar 15,000 13,500 - - 6,750 6,750 -
Apr 16,000 14,400 - - - 7,200 7,200
May 17,000 15,300 - - - - 7,650
13,050 13,950 14,850
(ii) Wages payment in each month is to be taken as three-fourths of the current month plus one-fourth
of the previous month.
Illustration 10:
For production of 10,000 units the following are budgeted expenses:
Amount (`)
Per Unit
Direct Materials 48
Direct Labour 24
Variable Overheads 20
Fixed Overheads (`1,20,000) 12
Variable Expenses (Direct) 4
Selling Expenses (10% fixed) 12
Administration Expenses (`40,000 fixed) 4
Distribution Expenses (20% fixed) 4
128
Prepare a budget for production of 7,000 units and 9,000 units.
Solution:
Flexible Budget
10000 Units 7000 Units 9000 Units

Particulars
CPU Total CPU Total CPU Total
A) Marginal Cost:
Direct Material 48 4,80,000 48 3,36,000 48 4,32,000
Direct Labour 24 2,40,000 24 1,68,000 24 2,16,000
Variable Expenses 4 40,000 4 28,000 4 36,000
Variable overheads 20 2,00,000 20 1,40,000 20 1,80,000
Selling expenses (90% of ` 12) 10.80 1,08,000 10.80 75,600 10.80 97,200
Distribution expenses (80% of ` 4) 3.20 32,000 3.20 22,400 3.20 28,800
Total (A) 110.00 11,00,000 110.00 7,70,000 110.00 9,90,000

B) Fixed Cost:
Fixed Overheads 12.00 1,20,000 1,20,000 1,20,000
Selling expenses 1.20 12,000 12,000 12,000
Administration overheads 4.00 40,000 40,000 40,000
Distribution expenses 0.80 8,000 8,000 8,000
Total (B) 18.00 1,80,000 1,80,000 1,80,000
Grand Total (A+B) 128.00 12,80,000 9,50,000 11,71,000
Illustration 11 :
Draw up a flexible budget for overhead expenses on the basis of the following data and determine the
overhead rates at 70%, 80% and 90%
Amount (`)
Plant Capacity At 80% capacity

Variable Overheads:
Stores including spares 4,000
Semi Variable:
Power (30% - Fixed: 70% -Variable) 20,000
Repairs (60%- Fixed: 40% -Variable) 2,000
Fixed Overheads:
Depreciation 11,000
Insurance 3,000
Salaries 10,000
Total overheads 62,000
Estimated Direct Labour Hours 1,24,000
Solution:
Flexible Budget at Different Capacities and Determination of Overhead Rates
Amount (`)
Particulars 70% 80% 90%

(A) Variable Overheads:
Indirect labour 10,500 12,000 13,500
Stores including spares 3,500 4,000 4,500
Total (A) 14,000 16,000 18,000
(B) Semi Variable Overheads:
Power (See Note) 18,250 20,000 21,750
Repairs (See Note) 1,900 2,000 2,100
Total (B) 20,150 22,000 23,850
(C) Fixed Overheads:
Depreciation 11,000 11,000 11,000
Insurance 3,000 3,000 3,000
Salaries 10,000 10,000 10,000
Total (C) 24,000 24,000 24,000
Grand Total (A+B+C) 58,150 62,000 65,850

Cost Accounting
Labour Hours 10,8,500 1,24,000 1,39,500

 7  9
1,24,000 × 8  1,24,000 × 8 
   
Overhead rate per hour (`) = 0.536 = 0.50 = 0.472
 58,150   62, 000   65,850 

 1,08,500     1,39,500 
   1, 24, 000   
Working Notes: Semi Variable Overheads:

70% 90%
Power:
Variable  7  9
14,000 × 8  =12,250 14,000 × 8  =15,750
   
Fixed 6,000 6,000
Total 18,250 21,750
Repairs:
Variable  7  9
 800 × 8  = 700  800 × 8  = 900
   
Fixed 1,200 1,200
Total 1 900 2 100
Illustration 12:
From the following information relating to 2014 and conditions expected to prevail in 2015, prepare a
budget for 2015.
2014 Actual: Amount (`)

Sales (40,000 units) 1,00,000
Raw materials 53,000
Wages 11,000
Variable Overhead 16,000
Fixed Overheads 10,000
2015 Prospects:
Sales (60,000 units) 1,50,000
Raw Materials 5% increase in prices
Wages 10% increase in wage rate
5% increase in productivity
Additional plant: One Lathe ` 25,000
One Drill `12,000
10% Depreciation to be considered.

Solution:
Budget Showing Costs and Profits for the Year 2015
I. Sales 1,50,000
II. Costs:
 6 105 
Raw Materials  53,000 × × 83,475
 4 100 
 110 6 100 
Wages 11,000 × × × 17,285
 100 4 105 
 6
Variable Overheads 16,000 ×  24,000
 4
  10  
Fixed Overheads 10,000  3,70,000 ×  13,700
  100 
1,38,460
iii. Profit (i – ii) 11,540
Illustration 13:
Production costs of a factory for a year are as follows:
Amount (`)
Direct Wages 80,000

Direct Materials 1,20,000
Production Overheads: Fixed 40,000
Variable 60,000
During the forthcoming year it is anticipated that:
a. The average rate for direct labour remuneration will fall from `0.80 per hour to `0.75 per hour.
b. Production efficiency will be reduced by 5%
c. Price per unit of direct material and of other materials and services which comprise overheads will
remain unchanged, and
d. Production in the coming year will increase by 33 1 % . Draw up a production cost budget.
3
Solution:
Production Cost Budget for the Forthcoming Year

 1  0.75  100 
i. Wages 80,000 × 133 %  ×  1,05,263
 3  0.80  95 
 1 
ii. Materials 1,20,000 × 133 %  1,60,000
 3 
 1 
iii. Variable Overheads 60,000 × 133 %  80,000
 3 
iv. Fixed Overheads 40,000
Production cost 3,85,263

Cost Accounting
Illustration 14:
A company manufactures two products, A and B and the budgeted data for the year are as follows:
Amount (`)
Product A Product B
Sales price per unit 100 75
Direct material per unit 20 10
Direct wages per unit 5 4
Total works overhead 10,105 9,009
Total marketing overhead 1,200 1,100
The sales manager forecasts the sales in units as follows:
Product A (units) Product B (units)

January 28 10
February 28 12
March 24 16
April 20 20
May 16 24
June 16 24
July to January (next year) Per month 18 20
It is assumed that (i) there will be no work in progress at the end of any month, and (ii) finished units
equal to half the sales for the following month will be kept in stock.
Prepare (a) A Production Budget for each month and (b) A Summarized Profit and Loss Statement for
the year.
Solution:
(a) Production Budget (in number of units)
JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC TOTAL
Product –A
Sales 28 28 24 20 16 16 18 18 18 18 18 18 240
Add: Closing Stock 14 12 10 8 8 9 9 9 9 9 9 9
42 40 34 28 24 25 27 27 27 27 27 27
Less: Opening Stock
14 14 12 10 8 8 9 9 9 9 9 9
Production 28 26 22 18 16 17 18 18 18 18 18 18 235
Product- B
Sales 10 12 16 20 24 24 20 20 20 20 20 20 226
Add: Closing Stock 6 8 10 12 12 10 10 10 10 10 10 10
16 20 26 32 36 34 30 30 30 30 30 30
Less: Opening Stock
5 6 8 10 12 12 10 10 10 10 10 10
Production 11 14 18 22 24 22 20 20 20 20 20 20 231

(b) Summarised Product Cost Budget

Amount (`)
Output Particulars Product A 235 units Product B 231 units Total
Direct Material : A @ ` 20 4,700
B @ ` 10 2310 7,010
Direct Labour : A @ ` 5 1,175
B @ ` 4 924 2,099
Works overheads 10,105 9009 19,114
Total production Cost 15,980 12243 28,223
Cost per unit 68 53
(15,980/235) (12,243/231)
Summarised Profit and Loss Statement for the Year

Amount (`)
Particulars Product A Product B Total

Sales 24,000 16,950 40,950
Less: 16,320 11,978
Production Cost of goods sold (240 x 68) 1,200 1,100
(226 x 53)
Marketing Overheads
Total (ii) Cost (ii) 17,520 13,078 30,598
Profit (i - ii) 6,480 3,872 10,352
Illustration 15 :
Three Articles X, Y and Z are produced in a factory. They pass through two cost centers A and B. From
the data furnished compile a statement for budgeted machine utilization in both the centers.
(a) Sales budget for the year
Annual Budgeted Sales Opening stock of

Product Closing stock
(units) finished products (units)
X 4800 600 Equivalent to 2 months sales
Y 2400 300 --DO--
Z 2400 800 --DO--
(b) Machine hours per unit of product
Cost centers
Product
A B
X 30 70
Y 200 100
Z 30 20

Cost Accounting
(c) Total number of machines
Cost Centre: A 284

B 256
Total 540
(d) Total working hours during the year: Estimated 2500 hours per machine.
Solution:
Calculation of Units of Production of Different Products
Particulars Product X Product Y Product Z

Sales 4800 2400 2400
Add: Closing Stock 800 400 400
5600 2800 2800
Less: Opening stock 600 300 800
Production 5000 2500 2000
MACHINE UTILISATION BUDGET
A B
Particulars
X Y Z Total X Y Z Total
(i) Production (Units) 5000 2500 2000 5000 2500 2000
(ii) Hours per unit 30 200 30 70 100 20
(iii) Total Machine Hours 1,50,000 5,00,000 60,000 7,10,000 3,50,000 2,50,000 40,000 6,40,000
(iv) Number of Machines 60 200 24 284 140 100 16 256
Required
Illustration 16 :
The monthly budgets for manufacturing overhead of a concern for two levels of activity were as follows:
Amount (`)
Capacity 60% 100%

Budgeted production (units) 600 1,000
Wages 1,200 2,000
Consumable stores 900 1,500
Maintenance 1,100 1,500
Power and fuel 1,600 2,000
Depreciation 4,000 4,000
Insurance 1,000 1,000
9,800 12,000
You are required to:
(i) Indicate which of the items are fixed, variable and semi-variable;
(ii) Prepare a budget for 80% capacity and
(iii) Find the total cost, both fixed and variable per unit of output at 60%, 80% and 100%capacity.

Solution:
(i) Fixed  Depreciation and insurance.
Variable  Wages and consumables stores.
Semi-variable Costs  Maintenance, Power and fuel.
Seggregation Of Semi Variable Costs
 1,500 − 1,100 
Maintenance =   = ` 1 per unit variable and
 400 
`500 fixed (i.e., 1,100-600)

 2,000 − 1,600 
Power and fuel =   = ` 1 per unit variable and
 400 
`1000 (i.e.,1,600-600) is fixed.
(ii) Budget for 80% capacity(output 800 units):
Amount (`)
Wages @`2 per unit 1,600
Consumables stores @ ` 1.50 per unit 1,200
Maintenance: ` 500 + `. 1.00 per unit 1,300
Power & fuel ` 1,000 + `.1 per unit 1,800
Depreciation 4,000
Insurance 1,000
Total cost: 10,900
(iii)
Capacity 60% 80% 100%

Units 600 800 1000
Total Per
Total (`) Per unit Total (`) Per unit
(`) unit
Fixed Costs:
Depreciation 4,000 4,000 4,000
Insurance 1,000 1,000 1,000
Maintenance 500 500 500
Power and fuel 1,000 1,000 1,000
6,500 10.83 6,500 8.125 6,500 6.50
Variable costs:
Wages @ `2perunit 1,200 1,600 2,000
Consumable stores @ ` 1.50 per unit 900 1,200 1,500
Maintenance @ `.1 Per unit 600 800 1,000
Power and fuel @ `.1 per unit 600 800 1,000
3,300 5.50 4,400 5.500 5,500 5.50
16.33 13.625 12.00

Cost Accounting
MULTIPLE CHOICE QUESTIONS:

1. Budgets are shown in ……. Terms
A. Qualitative
B. Quantitative
C. Materialistic
D. both (b) and (c)
2. Which of the following is not an element of master budget?
A. Capital Expenditure Budget
B. Production Schedule
C. Operating Expenses Budget
D. All above
3. Which of the following is not a potential benefit of using a budget?
A. Enhanced coordination of firm activities
B. More motivated managers
C. Improved interdepartmental communication
D. More accurate external financial statements
4. Which of the following is a long-term budget?
A. Master Budget
B. Flexible Budget
C. Cash Budget
D. Capital Budget
5. Materials become key factor, if
A. quota restrictions exist
B. insufficient advertisement prevails
C. there is low demand
D. there is no problem with supplies of materials
6. The difference between fixed cost and variable cost assumes significance in the preparation of
the following budget.
A. Master Budget
B. Flexible Budget
C. Cash Budget
D. Capital Budget
7. The budget that is prepared first of all is …
A. Master budget
B. Budget, with key factor
C. Cash Budget
D. Capital expenditure budget

8. Sales budget is a …
A. expenditure budget
B. functional budget
C. Master budget
D. None of these
9. A flexible budget requires a careful study of
A. Fixed, semi-fixed and variable expenses
B. Past and current expenses
C. Overheads, selling and administrative expenses.
D. None of these.
10. The basic difference between a fixed budget and flexible budget is that a fixed budget…….
A. is concerned with a single level of activity, while flexible budget is prepared for different levels
of activity
B. Is concerned with fixed costs, while flexible budget is concerned with variable costs.
C. is fixed while flexible budget changes
D. None of these.
[Ans: D, B, D, D, A, B, B, B, A,A]
States whether the statements are True or False:

1. Budget is a means and budgetary control is the end result.
2. To achieve the anticipated targets, Planning, Co-ordination and Control are the important main
tasks of management, achieved through budgeting and budgetary control.
3. A key factor or principal factor does not influence the preparation of all other budgets.
4. Budgetary control does not facilitate introduction of ‘Management by Exception’.
5. Generally, budgets are prepared to coincide with the financial year so that comparison of
the actual performance with budgeted estimates would facilitate better interpretation and
understanding.
6. A flexible budget is one, which changes from year to year.
7. A flexible budget recognises the difference between fixed, semi-fixed and variable cost and is
designed to change in relation to the change in level of activity
8. Sales budget, normally, is the most important budget among all budgets.
9. The principal factor is the starting point for the preparation of various budgets.
10. A budget manual is the summary of all functional budgets.
[Ans. 1. True 2. True 3. False 4. False 5. True 6. False 7. True 8. True 9. True 10. False.]

Cost Accounting
Fill in the Blanks:
1. Budgets are ______ plans.
2. The key factor in a budget does not remain the _____ every year.
3. Cash budget is a part of _____________ budget.
4. ____________ budgets are subsidiary to master master budget.
5. _______________ leads to budgeting and budgeting leads to budgetary control.
6. _________ Control involves checking and evaluation of actual performance.
7. The document which describes the budgeting organisation, procedure etc is known as
________________.
8. A budget is a ________ to management.
9. The principle budget factor for consumer goods manufacture is normally ________.
10. A budget is a projected plan of action in __________________.
[Ans. Action, Same, Financial, Functional, Forecasting, Budgetary, Budget

manual, Aid, Sales Demand, Physical units & monetary terms]
Column A Column B
1. Master budget denotes the summary of A Financial means.
2. A flexible budget takes into the account. B A specified period.
3. A budget is expressed in terms of. C Flexible Budget
4. Which budget is prepared for a longer period. D Mater Budget
5. Budget is generally prepared for how long. E Fixed, variable and semi variable costs.
6. Which budget is prepared for more than one F Functional Budget
level of activity
7. The summary of all functional budgets. G Principle Key factor
8. Which budget is prepared at first. H Capital Expenditure Budget
9. Which budget shows utilisation of liquid cash I Decision Package
10. Zero based budgeting J Cash Budget
[Ans: F, E, A, H, B, C, D, G, J, I]

MANAGEMENT
ACCOUNTING
(Book 2) TERM 2
STUDY NOTES
Cost and Management Accounting
Study Note - 1
COST AND MANAGEMENT ACCOUNTING
This Study Note includes:

1.1 Introduction
1.2 Management Accounting - Definition
1.3 Significance of Management Accounting
1.4 Role of Management Accounting in Management Process
1.5 Functions of Management Accounting
1.6 Limitations of Management Accounting
1.7 Relationship between Management Accounting and Cost Accounting
1.1 INTRODUCTION
Accounting involves collection, recording, classification and presentation of financial data. The word ‘Account-
ing’ can be classified into three categories: (A) Financial Accounting (B) Management Accounting and (C) Cost
Accounting.
Branches of Accounting
Financial Accounting Management Accounting Cost Accounting
FINANCIAL ACCOUNTING:
Financial Accounting has come into existence with the development of large-scale business in the form of joint-
stock companies. As public money is involved in share capital, Companies Act has provided a legal framework to
present the operating results and financial position of the company. Financial Accounting is concerned with the
preparation of Profit and Loss Account and Balance Sheet to disclose information to the shareholders. Financial
accounting is oriented towards the preparation of financial statements, which summarises the results of operations
for select periods of time and show the financial position of the business on a particular date. Financial Accounting
is concerned with providing information to the external users. Preparation of financial statements is a statutory
obligation. Financial Accounting is required to be prepared in accordance with Generally Accepted Accounting
Principles and Practices. In fact, the corporate laws that govern the enterprises not only make it mandatory to
prepare such accounts, but also lay down the format and information to be provided in such accounts. In sharp
contrast, management accounting is entirely optional and there is no standard format for preparation of the
reports. Financial Accounts relate to the business as a whole, while management accounts focuses on parts or
segments of the business.
CONCEPT OF MANAGEMENT ACCOUNTING:
Management Accounting is a new approach to accounting. The term Management Accounting is composed
of two words — Management and Accounting. It refers to Accounting for the Management. Management
Accounting is a modern tool to management. Management Accounting provides the techniques for interpretation
of accounting data. Here, accounting should serve the needs of management. Management is concerned with
decision-making. So, the role of management accounting is to facilitate the process of decision-making by the
management. Managers in all types of organizations need information about business activities to plan, accurately,

Cost and Management Accounting and Financial Management
for the future and make decisions for achieving the goals of the enterprise. Uncertainty is the characteristic of
the decision-making process. Uncertainty cannot be eliminated, altogether, but can be reduced. The function
of Management Accounting is to reduce the uncertainty and help the management in the decision making
process. Management accounting is that field of accounting, which deals with providing information including
financial accounting information to managers for their use in planning, decision-making, performance evaluation,
control, management of costs and cost determination for financial reporting. Managerial accounting contains
reports prepared to fulfil the needs of managements.
1.2 MANAGEMENT ACCOUNTING - DEFINITION
Different authorities have provided different definitions for the term ‘Management Accounting’. Some of them
are as under:
“Management Accounting is concerned with accounting information, which is useful to the management”. —
Robert N. Anthony
“Management Accounting is concerned with the efficient management of a business through the presentation to
management of such information that will facilitate efficient planning and control”. —Brown and Howard
“Any form of Accounting which enables a business to be conducted more efficiently can be regarded as
Management Accounting” —The Institute of Chartered Accountants of England and Wales
The Certified Institute of Management Accountants (CIMA) of UK defines the term ‘Management Accounting’ in
the following manner:
“Management Accounting is an integral part of management concerned with identifying, presenting and
interpreting information for:
1. Formulating strategy
2. Planning and controlling activities
3. Decision taking
4. Optimizing the use of resources
5. disclosure to shareholders and others, external to the entity
6. disclosure to employees
7. safeguarding assets
From the above definitions, it is clear that the management accounting is concerned with that accounting
information, which is useful to the management. The accounting information is rearranged in such a manner
and provided to the top management for effective control to achieve the goals of business. Thus, management
accounting is concerned with data collection from internal and external sources, analyzing, processing, interpreting
and communicating information for use, within the organization, so that management can more effectively plan,
make decisions and control operations. The information to be collected and analysed has been extended to its
competitors in the industry. This provides more meaningful clues for proper decision-making in the right direction.
The information in the management accounting system is used for three different purposes:
1. Measurement
2. Control and
3. Decision-making1.3 SIGNIFICANCE OF MANAGEMENT ACCOUNTING
1.3 SIGNIFICANCE OF MANAGEMENT ACCOUNTING
The various advantages that accrue out of management accounting are enumerated below:
(1) Delegation of Authority: Now a day the function of management is no longer personal, management
accounting helps the organisation in proper delegation of authority for the attainment of the vision and
mission of the business.

(2) Need of the Management: Management Accounting plays the role in meeting the need of the management
(3) Qualitative Information: Management Accounting accumulates the qualitative information so that
management would concentrate on the actual issue to deliberate and attain the specific conclusion even
for the complex problem.
(4) Objective of the Business: Management Accounting provides measure and reports to the management
thereby facilitating in attainment of the objective of the business.
1.4 ROLE OF MANAGEMENT ACCOUNTING IN MANAGEMENT PROCESS
An enterprise would operate, successfully, if it directs all its resources and efforts to accomplish its specified
objective in a planner manner, rather than reacting to events.
Organisation has to be both efficient and effective. Organisation is effective when the planned objective is
achieved. However, the firm is efficient only when the objective is achieved, with minimum cost and resources,
both in physical and monetary terms. The role of Management Accounting is significant in making the firm both
efficient and effective. Management Accounting has brought out clear shift in the objective of accounting. From
mere recording of transactions, the emphasis is on analyzing and interpreting to help the management to secure
better results. In this way, Management Accounting eliminates intuition, which is not at all dependable, from the
field of business management to the cause and effect approach.
It is well known the basic functions of management are:
1. Planning,
2. Organising,
3. Controlling,
4. Decision-making and
5. Staffing
Function of Management
Planning Organising Controlling Decision Making Staffing
Management accounting plays a vital role in the managerial functions performed by the managers.
(1) Planning: Planning is the real beginning of any activity. Planning establishes the objectives of the firm and
decides the course of action to achieve it. It is concerned with formulating short-term and long-term plans to
achieve a particular end. Planning is a statement of what should be done, how it should be done and when
it should be done. While planning, management accountant uses various techniques such as budgeting,
standard costing, marginal costing etc for fixing targets. For example, if a firm determines to achieve a
particular level of profit, it has to plan how to reach the target. What products are to be sold and at what
prices? The Management Accountant develops the data that helps managers to identify more profitable
products. What are the different ways to improve the existing profits by 25%? Management Accounting
throws various alternatives to achieve the goal.
(2) Organising: Organising is a process of establishing the organizational framework and assigning responsibility to
people working in the organization for achieving business goals and objectives. The organizational structure
may not be the same in all organizations, some may have centralized, while others may be decentralized
structures. The management accountant may prepare reports on product lines, based on which managers
can decide whether to add or eliminate a product line in the current product mix.

(3) Controlling: Control is the process of monitoring, measuring, evaluating and correcting actual results to
ensure that a firm’s goals and plans are achieved. Control is achieved through the process of feedback.
Feedback allows the managers to allow the operations continue as they are or take corrective action, by
some rearranging or correcting at midstream. The use of performance and control reports serve the function
of controlling. For example, a production supervisor may receive weekly or daily performance reports,
comparing actual material cost with planed costs. Significant variances can be isolated for corrective action.
In the normal course, periodical reports are submitted, appraising the performance against the targets set.
Reports for action are given to the top management, following the principle of management by exception.
Performance and control reports do not tell managers what to do. These feedback reports identify, where
attention is needed to help managers to determine the required course of action.
(4) Decision-making: Decision-making is a process of choosing among competing alternatives. Decision-making
is inherent in all the above three functions of management-planning, organizing and controlling. There may
be different methods or objectives. The manager can plan or choose only one of the competing plans.
Similarly, in organizing, decision can be made whether the organizational structure should be centralized or
decentralized. In control function, manager can decide whether variance is worthy to investigate or not.
(5) Staffing: Staffing is the process of recruitment, selection, development, training, compensation and
overseeing employee in an organisation. Staffing, like all other managerial functions, is the duty which is vest
on the management to perform. The role of the management accounting in this regard is manning the entity
structure through proper and effective selection, appraisal, and development of the personnel to fill the role
assigned to the employer. Moreover, the management accountants have to reduce the labour turnover
and to control the overall employee cost.
1.5 FUNCTIONS OF MANAGEMENT ACCOUNTING
The primary objective of Management Accounting is to maximize profits or minimize losses. This is done through the
presentation of statements in such a way that the management is able to take corrective policy or decision. The
manner in which the Management Accountant satisfies the various needs of management is described as follows:
(1) Storehouse of Reliable Data: Management wants reliable data for Planning, Forecasting and Decision-making.
Management accounting collects the data from various sources and stores the information for appropriate
use, as and when needed. Though the main source of data is financial statements, Management Accounting
is not restricted to the use of monetary data only. While preparing a sales budget, the management
accountant uses the past data of the products sold from the financial records and makes projections based
on the consumer surveys, population figures and other reliable information to estimate the sales budget. So,
management accounting uses qualitative information, unlike financial accounting, for preparing its reports,
collecting and modifying the data for the specific purpose.
(2) Modification and Presentation of Data: Data collected from financial statements and other sources is not
readily understandable to the management. The data is modified and presented to the management in such
a way that it is useful to the management. If sales data is required, it can be classified according to product,
geographical area, season-wise, type of customers and time taken by them for making payments. Similarly,
if production figures are needed, these can be classified according to product, quality, and time taken for
manufacturing process. Management Accountant modifies the data according to the requirements of the
management for each specific issue to be resolved.
(3) Communication and Coordination: Targets are communicated to the different departments for their
achievement. Coordination among the different departments is essential for the success of the organisation.
The targets and performances of different departments are communicated to the concerned departments
to increase the efficiency of the various sections, thereby increasing the profitability of the firm. Variance
analysis is an important tool to bring the necessary matters to the attention of the concerned to exercise
control and achieve the desired results.
(4) Financial Analysis and Interpretation: Management accounting helps in strategic decision making. Top
managerial executives may lack technical knowledge. For example, there are various alternatives to produce.
There is always a choice for the sales mix. Management 344 Accounting for Managers Accountant gives
facts and figures about various policies and evaluates them in monetary terms. He interprets the data and
gives his opinion about various alternative courses of action so that it becomes easier to the management
to take a decision.

(5) Control: It is absolutely essential that there should be a system of monitoring the performance of all
divisions and departments so that deviations from the desired path are brought to light, without delay
and are corrected then and there. This process is termed as control. The aim of this function ‘control’ is to
facilitate accomplishment of the goals in an efficient manner. For the discharge of this important function,
management accounting provides meaningful information in a systematic and effective manner. However,
the role of accountant is misunderstood. Many consider the accountant as a controller of their performance.
Many accountants themselves misunderstand their own role as controllers. The real role of control is effective
communication and assists the managers in achieving their goals, as efficiently as possible.
(6) Supplying Information to Various Levels of Management: Every level of management requires information for
decision-making and policy execution. Top-level management takes broad policy decisions, leaving day-
to-day decisions to lower management for execution. Supply of right information, at proper time, increases
efficiency at all levels.
(7) Reporting to Management: Reporting is an important function of management accounting to achieve the
targets. The reports are presented in the form of graphs, diagrams and other statistical techniques so as to
make them easily understandable. These reports may be monthly, quarterly, and half-yearly. These reports
are helpful in giving constant review of the working of the business.
Storehouse of Reliable Data
Modification and Presentation of Data
Communication and Coordination
Financial Analysis and Interpretation
Control
Supplying Information to Various Levels of Management
Reporting to Management
1.6 LIMITATIONS OF MANAGEMENT ACCOUNTING
Despite the development of Management Accounting as an effective discipline to improve the managerial
performance, some of the limitations are as under:
(1) Accuracy is not Ensured: Management Accounting is largely based on estimates. It does not deal with
actual, alone, and thus total accuracy is not ensured under Management Accounting.
(2) A Tool in the Hands of Management: Management Accounting is definitely a tool in the hands of management,
but cannot replace management.
(3) Strength and Weakness: Management Accounting derives information from Financial Accounting, Cost
Accounting and other records. The strength and weakness of these basic information providers become the
strength and weakness of Management Accounting too.
(4) Costly Affair: The installation of Management Accounting is a costly affair so all the organizations, in particular,
small firms cannot afford.

(5) Lack of Knowledge and Understanding: The emergence of Management Accounting is the fusion of a number
of subjects like statistics, economics, engineering and management theory. Any inadequate grounding in
any one or more of the subjects is bound to have an unfavourable effect on the consideration and solution
of the problems, relating to management performance.
(6) Evolutionary Stage: Comparatively, Management Accounting is a new discipline and is still very much in
a stage of evolution. Therefore, it comes across the same difficulties or obstacles, which a relatively new
discipline has to face.
(7) Psychological Resistance: Adoption of a system of Management Accounting brings about a radical change
in the established pattern of the activity of the management personnel. It calls for rearrangement of personnel
as well as their activities. This is bound to encounter opposition from some quarter or other.
1.7 RELATIONSHIP BETWEEN MANAGEMENT ACCOUNTING AND COST ACCOUNTING

.7 R E L A T I O N S H I P
BETWEEN MANAGEMENT ACCOUNTING AND COST ACCOUNTING
Relationship between Management Accounting and Cost Accounting:
Management Accounting is primarily concerned with the requirements of the management. It involves application
of appropriate techniques and concepts, which help management in establishing a plan for reasonable
economic objective. It helps in making rational decisions for accomplishment of management objectives. Any
workable concept or techniques whether it is drawn from Cost Accounting, Financial Accounting, Economics,
Mathematics and statistics, can be used in Management Accountancy. The data used in Management
Accountancy should satisfy only one broad test. It should serve the purpose that it is intended for. A management
accountant accumulates, summarises and analysis the available data and presents it in relation to specific
problems, decisions and day-to-day task of management. A management accountant reviews all the decisions
and analysis from management’s point of view to determine how these decisions and analysis contribute to
overall organisational objectives. A management accountant judges the relevance and adequacy of available
data from management’s point of view.
The scope of Management Accounting is broader than the scope of Cost Accountancy. In Cost Accounting,
primary emphasis is on cost and it deals with its collection, analysis, relevance interpretation and presentation for
various problems of management. Management Accountancy utilizes the principles and practices of Financial
Accounting and Cost Accounting in addition to other management techniques for efficient operations of a
company. It widely uses different techniques from various branches of knowledge like Statistics, Mathematics,
Economics, Laws and Psychology to assist the management in its task of maximising profits or minimizing losses. The
main thrust in Management Accountancy is towards determining policy and formulating plans to achieve desired
objective of management. Management Accountancy makes corporate planning and strategy effective.
From the above discussion we may conclude that the Cost Accounting and Management Accounting are
interdependent, greatly related and inseparable.
Self Learning Questions:
1. Define management accounting and state its significance?

2. Discuss the role of management accounting in management process.
3. Describe the functions of management accounting.
4. List down the limitation of management accounting.
5. State the relationship between management accounting and cost accounting.


1. Planning and control are done by
A. top management
B. lowest level of management
C. all levels of management
D. None of the above
2. Decision-making concerns the
A. Past
B. Future
C. Past and future both
3. The comparison of actual results with expected results is referred to as
A. Feedback
B. Controlling
C. None
4. Decision-making is involved in the following function/s of management
A. Planning
B. Organizing
C. Controlling
D. All the above functions
5. This function works like a policeman to ensure the performance of the employees:
A. Controlling
B. Planning
C. Organizing
D. None of these
6. The use of management accounting is
A. Compulsory
B. Optional
C. Mandatory as per the law
7. Management Accounting relates to
A. Collection of data from different sources
B. Modification of data to meet the specific needs
C. Presentation of data
D. All of the above
8. Division of Accounting is divided into
A. 2
B. 3
C. 4
[Ans: 1. (a) 2. (b) 3. (a) 4. (d) 5 (a) 6. (b) 7. (d) 8. (b)]

Match the followings:
Column A Column B
1 Management Accounting is a tool to. A Effective and efficient
2 Management accounting is composed of. B Planning, Organising, Controlling and Decision
making
3 Organisation has to be both C Maximisation of profit and minimisation of losses.
4 Objective of management Accounting D Management
5 Function of Management E Management and Accounting
[Ans: D, E, A, C, B]
True or False:
1. Any form of accounting, which enables a business to be conducted more efficiently can be regarded as
Management Accounting.
2. Standard formats are used in management accounting for preparation of reports.
3. In Management Accounting, Generally Accepted Accounting Principles and Practices of Accounting
govern the preparation of reports.
4. It is optional for a company to have financial accounting
5. Management Accounting reports are public documents
[Ans: 1. True, 2. False, 3. False, 4. False, 5. False]
Fill in the blanks:

1. Decision-making is a process of choosing among ___________ alternatives.
2. Management Accounting tailors ___________information to meet the specific needs of management.
3. Management Accounting is ___________in its orientation.
4. The accounting information system for financial accounting and __________accounting is same.
5. Management accounting a ________ tools to management.
[Ans: Competing, Financial, Futuristic, Management, Modern]

Decision Making Tools
Study Note - 2
DECISION MAKING TOOLS

2.1 Marginal Costing
2.2 Tools and Techniques of Marginal Costing
2.3 Differential Cost Analysis
2.4 Differences between Absorption Costing and Marginal Costing
2.5 Application of Marginal Costing in Decision Making
2.6 Transfer Pricing
2.7 Objectives of Inter Company Transfer Pricing
2.8 Methods of Transfer Pricing
2.1 MARGINAL COSTING
The cost of a product or process can be ascertained using different elements of cost using any of the following
two techniques viz.,
1. Absorption Costing
2. Marginal Costing
Absorption Costing
Under this method, the cost of the product is determined after considering the total cost i.e., both fixed and
variable costs. Thus this technique is also called traditional or total costing. The variable costs are directly charged
to the products where as the fixed costs are apportioned over different products on a suitable basis, manufactured
during a period. Thus under absorption costing, all costs are identified with the manufactured products.
Limitations of Absorption Costing:

1. Being dependent on levels of output which vary from period to period, costs are vitiated due to the existence
of fixed overhead. This renders them useless for purposes of comparison and control. (If, however, overhead
recovery rate is based on normal capacity, this situation will not arise).
2. Carryover of a portion of fixed costs, i.e., period costs to subsequent accounting periods as part of the cost
of inventory is a unsound practice because costs pertaining to a period should not be allowed to be vitiated
by the inclusion of costs pertaining to the previous period.
3. Profits and losses in the accounts are related not only to sales but also to production, including the product
which is unsold. This is contrary to the principle that profits are made not at the stage when products are
manufactured but only when they are sold.
4. There is no uniformity in the methods of application of overhead in absorption costing. These problems have,
no doubt, to be faced in the case of marginal costing also but to a less extent of fixed overhead will not arise
in the case of marginal costing.
5. Absorption costing is not always suitable for decision making solution to various types of problems of man-
agement decision making, where the absorption cost method would be practically ineffective, such as se-
lection of production volume and optimum capacity utilization, selection of production mix, whether to buy
or manufacture, choice of alternatives and evaluation of performance can be had with the help of marginal
cost analysis. Sometimes, the conclusion drawn from absorption cost data in this regard may be misleading
and lead to losses.

Cost & Management Accounting and Financial Management
Marginal Costing
Marginal costing is “the ascertainment of marginal costs and of the effect on profit of changes in volume or type
of output by differentiating between fixed costs and variable costs.” Several other terms in use like direct costing,
contributory costing, variable costing, comparative costing, differential costing and incremental costing are used
more or less synonymously with marginal costing.
It is a process whereby costs are classified into fixed and variable and with such a division so many managerial
decisions are taken. The essential feature of marginal costing is division of total costs into fixed and variable,
without which this could not have existed. Variable costs vary with volume of production or output, whereas
fixed costs remains unchanged irrespective of changes in the volume of output. It is to be understood that unit
variable cost remains same at different levels of output and total variable cost changes in direct proportion with
the number of units. On the other hand, total fixed cost remains same disregard of changes in units, while there is
inverse relationship between the fixed cost per unit and the number of units.
Features of Marginal Costing:
The main features of Marginal Costing may be summed up as follows:
1. Appropriate and accurate division of total cost into fixed and variable by picking out variable portion of semi
variable costs also.
2. Valuation of stocks such as finished goods, work-in-progress is valued at variable cost only.
3. The fixed costs are written off soon after they are incurred and do not find place in product cost or inventories.
4. Prices are based on Marginal Cost and Marginal Contribution.
5. It combines the techniques of cost recording and cost reporting.
Advantages or Merits or Applications of Marginal Costing:
1. Marginal costing system is simple to operate than absorption costing because they do not involve the
problems of overhead apportionment and recovery.
2. Marginal costing avoids, the difficulties of having to explain the purpose and basis of overhead absorption to
management that accompany absorption costing. Fluctuations in profit are easier to explain because they
result from cost volume interactions and not from changes in inventory valuation.
3. It is easier to make decisions on the basis of marginal cost presentations, e.g., marginal costing shows which
products are making a contribution and which are failing to cover their avoidable (i.e., variable) costs.
Under absorption costing the relevant information is difficult to gather, and there is the added danger that
management may be misled by reliance on unit costs that contain an element of fixed cost.
4. Marginal costing is essentially useful to management as a technique in cost analysis and cost presentation.
It enables the presentation of data in a manner useful to different levels of management for the purpose of
controlling costs. Therefore, it is an important technique in cost control.
5. Future profit planning of the business enterprises can well be carried out by marginal costing. The contribution
ratio and marginal cost ratios are very useful to ascertain the changes in selling price, variable cost etc. Thus,
marginal costing is greatly helpful in profit planning.
6. When a business concern consists of several units and produces several products and evaluation of
performance of such components can well be made with the help of marginal costing.
7. It is helpful in forecasting.
8. When there are different products, the determination of number of units of each product, called Optimum
Product Mix, is made with the help of marginal costing.
9. Similarly, optimum sales mix i.e., sales of each and every product to get maximum profit can also be
determined with the help of marginal costing.
10. Apart from the above, numerous managerial decisions can be taken with the help of marginal costing, some
of which, may be as follows:-

(a) Make or buy decisions,

(b) Exploring foreign markets,
(c) Accept an order or not,
(d) Determination of selling price in different conditions,
(e) Replace one product with some other product,
(f) Optimum utilisation of labour or machine hours,
(g) Evaluation of alternative choices,
(h) Subcontract some of the production processes or not,
(i) Expand the business or not,
(j) Diversification,
(k) Shutdown or continue.
Limitations of Marginal Costing:
(a) The separation of costs into fixed and variable present’s technical difficulties and no variable cost is completely
variable nor is a fixed cost completely fixed.
(b) Under the marginal cost system, stock of finished goods and work-in-progress are understated. After all, fixed
costs are incurred in order to manufacture products and as such, these should form a part of the cost of the
products. It is, therefore, not correct to eliminate fixed costs from finished stock and work-in-progress.
(c) The exclusion of fixed overhead from the inventories affects the Profit and Loss Account and produces an
unrealistic and conservative Balance Sheet, unless adjustments are made in the financial accounts at the
end of the period.
(d) In marginal costing system, marginal contribution and profits increase or decrease with changes in sales
volume. Where sales are seasonal, profits fluctuate from period to period. Monthly operating statements
under the marginal costing system will not, therefore, be as realistic or useful as in absorption costing.
(e) During the earlier stages of a period of recession, the low profits or increase in losses, as revealed in a
magnified way in the marginal costs statements, may unduly create panic and compel the management to
take action that may lead to further depression of the market.
(f) Marginal costing does not give full information. For example, increased production and sales may be due to
extensive use of existing equipments (by working overtime or in shifts), or by an expansion of the resources, or
by the replacement of labour force by machines. The marginal contribution fails to reveal these.
(g) Though for short-term assessment of profitability marginal costs may be useful, long term profit is correctly
determined on full costs basis only.
(h) Although marginal costing eliminates the difficulties involved in the apportionment and under and over-
absorption of fixed overhead, the problem still remains so far as the variable overhead is concerned.
(i) With increased automation and technological developments, the impact on fixed costs on products is much
more than that of variable costs. A system which ignores fixed costs is therefore, less effective because a
major portion of the cost, such as not taken care of.
(j) Marginal costing does not provide any standard for the evaluation of performance. A system of budgetary
control and standard costing provides more effective control than that obtained by marginal costing.
2.2 TOOLS AND TECHNIQUES OF MARGINAL COSTING
1. Contribution:
In common parlance, contribution is the reward for the efforts of the entrepreneur or owner of a business concern.
From this, one can get in his mind that contribution means profit. But it is not so. Technically or in Costing terminology,
contribution means not only profit but also fixed cost. That is why; it is defined as the amount recovered towards
fixed cost and profit.

Contribution can be computed by subtracting variable cost from sales or by adding fixed costs and profit.
Symbolically, C = S – V → (1)
Where C = Contribution
S = Selling Price
V = Variable Cost
Also C = F + P → (2)
Where F = Fixed Cost
P = Profit
From (1) and (2) above, we may deduce the following equation called Fundamental Equation of Marginal Costing
i.e., S – V = F + P → (3)
Contribution is helpful in determination of profitability of the products and / or priorities for profitabilities of the
products. When there are two or more products, the product having more contribution is more profitable.
For example: The following are the three products with selling price and cost details:
Particulars A B C
Selling Price (`) 100 150 200
Variable Cost (`) 50 70 100
In the above example, one can say that the product ‘C’ is more profitable because, it has more contribution.
This proposition of product having more contribution is more profitable is valid, as long as, there are no limitations
on any factor of production. In this context, factors of production means, the factors that are responsible for
producing the products such as materials, labour, machine hours, demand for sales etc.,
Limiting Factor (or) Key Factor:
In the above example, we find that product having more contribution is more profitable. However, when there
is a limitation on any input factor, the profitability of the product cannot simply be determined by finding out
the contribution of the unit, but it can be found out by ascertaining the contribution per unit of that factor of
production which is limited in the given situation. Such factor of production which is limited in the question is called
key factor or limiting factor.
Continuing the above example, it may be explained as follows:
The three products take some raw material. A takes 1 kg, B requires 2 kgs, C requires 5 kgs and the raw material is
not abundant.
Then profitability of the above products is determined as flows:
Contribution
Profitability =
Key Factor
A B C
50 / 1 = ` 50 80 / 2 = ` 40 100 / 5 = ` 20
Now, product A is more profitable because it has more contribution per kg of material.
Key factor can also be called as scarce factor or Governing factor or Limiting factor or Constraining factor etc.,
whatever may be the name, it indicates the limitation on the particular factor of production.
From the above, it is essentially understandable that contribution is helpful in determination of profitability of the
products, priorities for profitability of the product and in particular, profitabilities when there are limitation on any
factor.

2. Profit Volume Ratio (P/V Ratio) or contribution Ratio:

First of all, a ratio is a statistical or mathematical tool with the help of which a relationship can be established
between the variables of the same kind. Further, it may be expressed in different forms such as fractional form,
quotient, percentage, decimal form, and proportional form.
For Example:
Gross Profit Ratio: It may be expressed as follows:
● Gross profit is ¼th of sales
● Sales is 4 times that of gross profit
● Gross profit ratio is 25%
● Gross profit is 0.25 of sales and lastly
● Gross profit and sales are in the ratio of 1 : 4
So, P/V ratio or contribution ratio is association of two variables. From this, one may assume that it is the ratio of
profit and sales. But it is not so. It is the ratio of Contribution to Sales.
 Contribution 
Symbolically, P/V ratio =   × 100 → (1)
 Sales 
C
● P/V ratio = ( × 100)
S
● Contribution = Sales × P/V ratio → (2)
 Contribution 
● Sales =   → (3)
 P / V Ratio 
When cost accounting data is given for two periods, then:
Change in Contribution
P/V ratio = ( × 100)or
Change in Sales
Change in Profit
P/V ratio = ( × 100)
Change in Sales
It is to be noted that the above two formulas are valid as long as there are no changes in prices, means input
prices and selling prices.
Usually, Sales = Cost + Profit.

i.e., it can also be written as Sales = Variable Cost + Fixed Cost + Profit and this is called general sales equation.
Since Sales consists of variable costs and contribution, given the variable cost ratio, P/V ratio can be found out.
Similarly, given the P/V ratio, variable cost ratio can be found out.
For example, P/V ratio is 40%, then variable cost ratio is 60%, given variable cost ratio is 70%, then P/V ratio is 30%.
Such a relationship is called complementary relationship. Thus P/V ratio and variable cost ratios are said to be
complements of each other.
P/V ratio is also useful like contribution for determination of profitabilities of the products as well as the priorities
for profitabilities of the products. In particular, it is useful in determination of profitabilities of the products in the
following two situations:
(i) When sales potential in value is limited.
(ii) When there is a greater demand for the products.

Break Even Analysis:

When someone asks a layman about his business he may reply that it is alright. But a technical man may reply that
it is break even. So, Break Even means the volume of production or sales where there is no profit or loss. In other
words, Break Even Point is the volume of production or sales where total costs are equal to revenue. It helps in
finding out the relationship of costs and revenues to output. In understanding the breakeven point, cost, volume
and profit are always used. The break even analysis is used to answer many questions of the management in day
to day business.
The formal break even chart is as follows:

a = Losses b = Profits
When no. of units are expressed on X-axis and costs and revenues are expressed on Y-axis, three lines are drawn
i.e., fixed cost line, total cost line and total sales line. In the above graph we find there is an intersection point of
the total sales line and total cost line and from that intersection point if a perpendicular is drawn to X-axis, we find
break even units. Similarly, from the same intersection point a parallel line is drawn to X-axis so that it cuts Y-axis,
where we find Break Even point in terms of value. This is how, the formal pictorial representation of the Break Even
chart.
At the intersection point of the total cost line and total sales line, an angle is formed called Angle of Incidence,
which is explained as follows:
Angle of Incidence:
Angle of Incidence is an angle formed at the intersection point of total sales line and total cost line in a formal
break even chart. If the angle is larger, the rate of growth of profit is higher and if the angle is lower, the rate of
growth of profit is lower. So, growth of profit or profitability rate is depicted by Angle of Incidence.
Break Even Analysis (or) Cost-Volume-Profit Analysis (CVP analysis):
From the breakeven charts breakeven point and profits at a glance can be found out. Besides, management
makes profit planning with the help of breakeven charts. It can clearly be understood by way of charts to know the
changes in profit due to changes in costs and output. Such profit planning is made with the variables mainly cost,
profit and volume, such an analysis is called breakeven analysis. Throughout the charts relationship is established
among the cost, volume and profit, it is also called Cost-Volume-Profit Analysis (CVP analysis). That is why it is
popularly said by S. C. Kuchal in his book “Financial Management - An Analytical and Conceptual Approach”,
that Cost-volume-profit analysis, break even analysis and profit graphs are interchangeable words. The analysis is
further explained as follows:
The change in profit can be studied through Break even charts in different situations in the following manner:

i) Increase in No. of Units
Units
‘……’ line indicates increase in total cost and total sales.
In the above chart, if we clearly observe we find that there is no change in BEP even if there is increase or decrease
in No. of units.
ii) Increase in Sales due to increase in selling price.
NTS = New Total Sales line
‘……’ line indicates changes in breakeven point and changes in sales.

From the above chart, we observe that profit is increased by increasing the selling price and also, if there is
change in selling price, BEP also changes. If selling price is increased then BEP decreases.
If selling price is decreased then BEP increases. Thus, we say that there is an inverse relationship between selling
price and BEP.

iii) Decrease in variable cost:
‘……’ line indicates decrease in total cost and decrease in B.E.P

From the above chart, we observe that when variable costs are decreased, no doubt, profit is increased. If there
is change in variable cost then BEP also changes. If variable cost is decreased then BEP also decreases. If variable
cost is increased then BEP also increases. Thus there is direct relationship between variable cost and BEP.
iv) Change in fixed cost:
‘……’ line indicates decrease in fixed cost and total cost and also decrease in BEP.
NTC = New Total Cost Line
NFC = New Fixed Cost Line
From the above chart also we find that there is increase in profit due to decrease in fixed cost. If fixed cost
is increased then BEP also increases. If fixed cost is decreased then BEP also decreases. Thus there is a direct
relationship between fixed cost and BEP.

Non linear Break Even Chart:
In some cases on account of non-linear behaviour of cost and sales there may be two or more break even points.
In such a case the optimum profit is earned where the difference between the sales and the total costs is the
largest. It is obvious that the business should produce only upto this level. This is being illustrated in the above chart.
Cash Break-Even Point:
When break-even point is calculated only with those fixed costs which are payable in cash, such a break-even
point is known as cash break-even point. This means that depreciation and other non-cash fixed costs are excluded
from the fixed costs in computing cash break-even point. Its formula is-
Cash breakeven point = Cash fixed costs / Contribution per unit.
Profit Volume Chart:

Profit-volume chart prominently exhibits the relationship between profit and sales volume. The normal break-even
charts suffer from one limitation. Profit cannot be read directly from the chart. It is essential to deduct total cost
from sale to know the profit figure. The profit graph overcomes the difficulty by plotting profit directly against an
activity. These charts are easy to understand and their preparation involves drawing sales curve and profit curve.
The point at which profit line cuts the sales line is called break-even point. Taking the methods and objects under
consideration, the profit-volume chat can be further divided into following categories i.e.,
(a) Simple Profit-Volume Chart:
Its preparation involves the following steps:

1. Finding out profit at any two levels of activity,
2. Drawing sales line,
3. Drawing profit line,

Simple Profit-Volume chart is shown below:
b. Profit volume chart showing different breakeven point at different price levels is shown below:

Sequential Profit Graph:

Sometimes, a company manufactures more than one product of varying profitability. A change in the profitability
of one product will lead to a change in the profitability as a whole. Profit-volume chart can be prepared for a
group also. This chart shows relative profitability of different products. It is also called profit-volume graph for a
group of products, sequential profit graph or profit path chart. Its main advantage is that it exhibits the relative
profitability of different products at a glance. This graph is also useful to show average slope and marginal slope.
Methods of drawing ‘Profit Path’:
In sequential profit graph or profit graph for a group of products, a line “profit plan” is drawn in order to draw total
profit line. For drawing profit path, a statement is prepared showing cumulative sale and cumulative profit. The line
‘Profit path’ is drawn with the aid of columns for cumulative same and cumulative profit.
Steps in drawing Profit volume graph (or) sequential profit graph:
• First prepare a marginal cost statement to know the P/V ratios.
• Prepare a statement to find out cumulative sale and cumulative profit.
• Draw a profit path with the help of columns, cumulative sale and cumulative profit.
• Draw total profit line for group of products.
COMPUTATION OF BREAK EVEN POINT:

F×S
Break Even Point in value = ….. (1)
S-V
F×S
= ….. (2)
C
F×S
= ….. (3)
S +P
F
= ….. (4)
P. V. Ratio
F
Or =
C
S

F
Or =
S-V
S
F
= ….. (5)
V
1−
S
Break Even Point (in units) = Fixed Cost / Contribution per unit
Proof for basic breakeven:
Let, V be the variable cost per unit
U be the volume of output i.e., No. of units
P be the Profit
F be the Fixed Cost Where,
S be the Selling Price F = Fixed Cost
By substituting the notations in general sales equation: V = Variable Cost
Sales = Fixed cost + Variable cost + Profit S = Sales
SU = F + VU + P P = Profit
At Break Even, SU = F +VU (Since P = 0) C = Contribution
→ SU – VU = F
→ U(S – V) = F
F
→U=
S-V
OR
Fixed Cost
No. of Units Contribution per Unit
Contribution Per Unit
Break even sales
F×S
SU (Sales) =
S-V
Uses and applications of Break even Analysis (Or) Profit Charts (Or) Cost Volume Profit Analysis:
The important uses to which cost-volume profit analysis or break-even analysis or profit charts may be put to use
are:
(a) Forecasting costs and profits as a result of change in Volume determination of costs, revenue and variable
cost per unit at various levels of output.
(b) Fixation of sales Volume level to earn or cover given revenue, return on capital employed, or rate of dividend.
(c) Determination of effect of change in Volume due to plant expansion or acceptance of order, with or without
increase in costs or in other words, determination of the quantum of profit to be obtained with increased or
decreased volume of sales.
(d) Determination of comparative profitability of each product line, project or profit plan.
(e) Suggestion for shift in sales mix.
(f ) Determination of optimum sales volume.
(g) Evaluating the effect of reduction or increase in price, or price differentiation in different markets.
(h) Highlighting the impact of increase or decrease in fixed and variable costs on profit.

(i) Studying the effect of costs having a high proportion of fixed costs and low variable costs and vice-versa.
(j) Inter-firm comparison of profitability.
(k) Determination of sale price which would give a desired profit for break-even.
(l) Determination of the cash requirements as a desired volume of output, with the help of cash breakeven
charts.
(m) Break-even analysis emphasizes the importance of capacity utilization for achieving economy.
(n) During severe recession, the comparative effects of a shutdown or continued operation at a loss are indi-
cated.
(o) The effect on total cost of a change in the fixed overhead is more clearly demonstrated through break-even
charts.
Limitations of Break-even Analysis:
(a) That Costs are either fixed or variable and all costs are clearly segregated into their fixed and variable
elements. This cannot possibly be done accurately and the difficulties and complications involved in such
segregation make the break-even point inaccurate.
(b) That the behavior of both costs and revenue is not entirely related to changes in volume.
(c) That costs and revenue patterns are linear over levels of output being considered. In practice, this is not
always so and the linear relationship is true only within a short run relevant range.
(d) That fixed costs remain constant and variable costs vary in proportion to the volume. Fixed costs are constant
only within a limited range and are liable to change at varying levels of activity and also over a long period,
particularly when additional plants and equipments are introduced.
(e) That sales mix is constant or only one product is manufactured. A combined analysis taking all the products
of the mix does not reflect the correct position regarding individual products.
(f) That production and sales figures are identical or the change in opening and closing stocks of the finished
product is not significant.
(g) That the units of production on the various product range are identical. Otherwise, it is difficult to find a
homogeneous factor to represent volume.
(h) That the activities and productivity of the concern remain unchanged during the period of study.
(i) As output is continuously varied within a limited range, the contribution margin remains relatively constant.
This is possible mainly where the output is more or less homogeneous as in the case of process industries
2.3 DIFFERENTIAL COST ANALYSIS
Differential Cost is the change in the costs which results from the adoption of an alternative course of action.
The alternative actions may arise due to change in sales volume, price, product mix (by increasing, reducing or
stopping the production of certain items), or methods of production, sales, or sales promotion, or they may be due
to ‘make or buy’ or ‘take or refuse’ decisions. When the change in costs occurs due to change in the activity from
one level to another, differential cost is referred to as incremental cost or decremental cost, if a decrease in output
is being considered, i.e. total increase in cost divided by the total increase in output. However, accountants
generally do not distinguish between differential cost and incremental cost and the two terms are used to mean
one and the same thing.
The computation of differential cost provides an useful method of analysis for the management for anticipating
the results of any contemplated changes in the level or nature of activity. When policy decisions have to be taken,
differential costs worked out on the basis of alternative proposals are of great assistance.
The determination of differential cost is simple. Differential cost represents the algebraic difference between the
relevant costs for the alternatives being considered. Thus, when two levels of activities are being considered, the
differential cost is obtained by subtracting the cost at one level from the cost of another level.

The essential features of differential costs are as follows:-

1) The basis data used for differential cost analysis are costs, revenue and the investment factors which are rel-
evant in the problem for which the analysis is undertaken.
2) Total differential costs rather than the costs per unit are considered.
3) Differential cost analysis is made outside the accounting records.
4) As the differences in the costs at two levels are considered, absolute costs at each level are not as relevant
as the difference between the two. Thus, items of costs which do not change but are identical for the alterna-
tives under consideration, are ignored.
5) The differentials are measured from a common base point or position.
6) The stage at which the difference between the revenue and the cost is the highest, measured from the com-
mon base point, determines the choice from amongst a number of alternative actions.
7) In computing differential costs, historical or standard costs may be used but they should be adjusted to the
requirements of future conditions.
8) The elements and items of cost to be considered in differential cost analysis will depend upon the nature of
the problem and the alternatives being considered.
Differential Costs Analysis and Marginal Costing:
Although the techniques of differential costs analysis are similar to those of marginal costing, the two should not
be confused. The points of similarity and difference between differential costs analysis and marginal costing are
summarized below:
Similarity:
(a) Both the techniques of cost analysis and cost presentation.
(b) Both are made use of by the management in decision making and in formulating policies.
(c) The concepts of differential costs and marginal costs mainly arise out of the difference in the behaviour of
fixed and variable costs.
(d) Differential costs compare favourably with the economist’s definition of marginal cost, viz. That marginal cost
is the amount which at any given volume of output is changed if output is increased or decreased by one
unit.
Difference:
(a) Differential cost analysis can be made in the case of both absorption costing as well as marginal costing.
(b) While marginal costing excludes the entire fixed costs, some of the fixed costs may be taken into account as
being relevant for the purpose of differential cost analysis.
(c) Marginal costs may be embodied in the accounting system whereas differential costs are worked out sepa-
rately as analysis statements.
(d) In marginal costing, margin of contribution and contribution ratio are the main yardsticks for performance
evaluation and for decision making. In differential cost analysis, differential costs are compared with the in-
cremental or decremental revenues, as the case may be.
Practical Application of Differential Costs:
They are useful in managerial decisions, which are enumerated below:
(i) Determination of most profitable levels of production and price.
(ii) Acceptance of offer at a lower price or offering a quotation at lower selling price in order to increase
capacity.
(iii) It is used to decide whether it will be more profitable to sell a product as it is or to process it further into a
different product to be sold at an increased price.
(iv) Determining the suitable price at which raw material may be purchased.
(v) Decision of adding a new product or business segment.

(vi) Discontinuing a product or business segment in order to avoid or reduce the present loss or increase profit.
(vii) Changing the product mix.
(viii) Make or buy decisions.
(ix) Decision regarding alternative capital investment and plant replacement.
(x) Decision regarding change in method of production.B
2.4 DIFFERENCES BETWEEN ABSORPTION COSTING AND MARGINAL COSTING

DIFFERENCE BETWEEN AB
Absorption Costing Marginal Costing
1. Both fixed and variable costs are considered for Only variable costs are considered for product
product costing and inventory valuation. costing and inventory valuation.
2. Fixed costs are charged to the cost of production. Fixed costs are regarded as period costs. The
Each product bears a reasonable share of fixed cost profitability of different products is judged by their
and thus the profitability of a product is influenced by P/V ratio.
the apportionment of fixed costs.
3. Cost data are presented in conventional pattern. Net Cost data are presented to highlight the total
profit of each product is determined after subtracting contribution of each product.
fixed cost along with their variable cost.
4. The difference in the magnitude of opening stock and The difference in the magnitude of opening stock
closing stock affects the unit cost of production due to and closing stock does not affect the unit cost of
the impact of related fixed cost. production.
5. In case of absorption costing the cost per unit reduces, In case of marginal costing the cost per unit
as the production increases as it is fixed cost which remains the same, irrespective of the production
reduces, whereas, the variable cost remains the same as it is valued at variable cost.
per unit.
Difference in profit under Marginal and Absorption Costing:
• No opening and closing stock: In this case, profit/loss under absorption and marginal costing will be equal.
• When opening stock is equal to closing stock: In this case, profit/loss under two approaches will be equal
provided the fixed cost element in both the stocks is same amount.
• When closing stock is more than opening stock: In other words, when production during a period is more
than sales, then profit as per absorption approach will be more than that by marginal approach. The reason
behind this difference is that a part of fixed overhead included in closing stock value is carried forward to
next accounting period.
• When opening stock is more than the closing stock: In other words when production is less than the sales,
profit shown by marginal costing will be more than that shown by absorption costing. This is because a part
of fixed cost from the preceding period is added to the current year’s cost of goods sold in the form of open-
ing stock.
2.5 APPLICATION OF MARGINAL COSTING IN DECISION MAKING
One of the basic functions of management is to make decisions. Decision making process generally involves
selecting a course of action from among various alternatives. Some of the important areas where marginal costing
techniques are generally applied can be giving as follows:
1. Selection of a Profitable Sales mix or Profitable Product mix:
In case of a multi-product concern, there may arise a problem of the selection of the suitable or profitable sales
mix i.e., the determination of the ratio in which various products are produced and sold. For the purpose of
determining the profitable sales mix, the amount of contribution available under each alternative of sales mix is
to be considered and the sales mix giving maximum total contribution will be selected. But the various problems
arising out of change in the sales mix e.g., limiting factors etc., must be properly considered.

Illustration 1:
Pankaj Ltd., engaged in the manufacture of the two products ‘A’ and ‘B’ gives you the following information:
Product A Product B
` `
Selling Price per unit 60 100
Direct materials per unit 20 25
Direct wages per unit @ ` 0.50 per hour 10 15
Variable overhead 100% of direct wages
Fixed overhead ` 10,000 per annum
Maximum capacity 1,000 units
Show the contribution of each of the products A and B and recommend which of the following sales mix should
be adopted:
(a) 300 units of product A and 600 units of product B;
(b) 450 units of product A and 450 units of product B;
(c) 600 units of product A and 300 units of product B.
Solution:
Statement of Marginal Cost
Product A Product B
` `
Direct Materials 20.00 25.00
Direct Wages 10.00 15.00
Variable Overhead (100% of direct wages) 10.00 15.00
Marginal Cost 40.00 55.00
Selling price 60.00 100.00
Contribution per unit 20.00 45.00
Calculation of Total Contribution:

Sales alternative (a): 300 units of ‘A’ and 600 units of ‘B’
Contribution:
`
Product A : 300 units × ` 20 6,000
Product B : 600 units × ` 45 27,000
Total Contribution 33,000
Less: Fixed Overhead 10,000
Profit 23,000
Sales alternative (b): 450 units of ‘A’ and 450 units of ‘B’
Contribution:
`
Product A : 450 units × ` 20 9,000
Product B : 450 units × ` 45 20,250
Profit 19,250

Sales alternative (c): 600 units of ‘A’ and 300 units of ‘B’
Contribution:
`
Product A : 600 units × ` 20 12,000
Product B : 300 units × ` 45 13,500
Profit 15,500
Hence sales mix under alternative (a) is more profitable as it gives maximum total contribution and profit.
2. Problem of Limiting Factors:

Limiting factor (also known as ‘key factor’) is a factor which limits production and/or sales and thus prevents the
manufacturing concern from earning unlimited profits. The limiting factors or key factors may be shortage of raw
material, shortage of skilled labour and machine capacity, market for sales etc. In case of the existence of a key
factor, a problem may arise as to which product should be pushed more in order to maximise profits. Selection of
the profitable product shall be made on the basis of the contribution per unit of limiting factor. The profitability of
a product with reference to limiting factor can be assessed as follows:
Profitability = Contribution / Limiting Factor per unit
Illustration 2:
In a factory producing two different kinds of articles, the limiting factor is the availability of labour. From the following
information, show which product is more profitable:
Product A Product B
Cost per unit Cost per unit
` `
Materials 5.00 5.00
Labour:
6 Hours @ ` 0.50 3.00
3 Hours @ ` 0.50 1.50
Overhead:
Fixed (50% of labour) 1.50 0.75
Variable 1.50 1.50
Total Cost 11.00 8.75
Selling Price 14.00 11.00
Profit 3.00 2.25
Total Production for the month (Units) 500 600
Maximum capacity per month is 4,800 hours.

Give proof in support of your answer.

Solution:
Statement of Profitability
Product A Product B
` `
Materials 5.00 5.00
Labour 3.00 1.50
Variable Overhead 1.50 1.50
Marginal Cost per unit 9.50 8.00
Selling Price per unit 14.00 11.00
No. Of Labour Hours per unit (Limiting Factor) 6 3
Contribution per Labour Hour ` 4.50 ` 3.00
6 Hrs. 3 Hrs.
` 0.75 `1.00
Product B is more profitable as it gives higher contribution per labour hour (limiting factor).
Proof:
Product A Product B
Maximum capacity per month 4,800 Hrs. 4,800 Hrs.
Maximum capacity (in units) 4,800 Hrs. 4,800 Hrs.
6 Hrs. 3 Hrs.
Total Hours 800 units 1,600 units
Hours Per Unit
Statement of Cost and Profit
` `
Materials 4,000 8,000
Labour @ ` 0.50 per labour hour for 4,800 hours. 2,400 2,400
Overhead:
Fixed (50% of labour) 1,200 1,200
Variable 1,200 2,400
Total cost 8,800 14,000
Profit 2,400 3,600
Sales 11,200 17,600
3. Make or Buy Decisions:
Sometimes a manufacturer has to decide as to whether a certain component or spare part should be manufactured
in the factory (having unused installed capacity) or bought from the market. In taking such a ‘make or buy ‘
decision, the marginal cost of the component or spare part should be compared with the market price. If the
marginal cost is lower than the market price, the component or spare part should be manufactured in the factory
itself. However, the manufacturer must take into consideration any increase in fixed costs or any Limiting factor
which may arise if the production is undertaken in the factory. If the purchase price is lower than the marginal cost
and provided regular supply and proper quality of the component are guaranteed by outside supplier, it should
be purchased from outside supplier.

Illustration 3:
A mobile manufacturing company finds that while it costs ` 6.25 each to make a component X – 2370, the same is
available in the market at ` 5.75 with an assurance of continued supply. The break-down of cost is:
Direct materials ` 2.75 each

Direct labour ` 1.75 each
Other variables ` 0.50 each
Depreciation and other fixed cost ` 1.25 each
Total ` 6.25 each
(a) Should you make or buy?
(b) What would be your decision if the supplier offers the component at ` 4.85 each?
Solution:
Calculation of Marginal Cost of Component X – 2370
Per unit
`
Direct Material 2.75
Direct Labour 1.75
Other Variables 0.50
Marginal Cost 5.00
(a) Since the marginal cost per unit of ` 5 is lower than the market price of ` 5.75, it is recommended to manufac-
ture the component in the factory.
(b) Since the purchase price of ` 4.85 is lower than the marginal cost, the component should be bought from
outside supplier provided proper quality and regular supply are guaranteed.
4. Diversification of Production:
Sometimes a manufacturer may intend to add a new product to the existing product or products to utilize the idle
capacity, to capture a new market or for some other purpose. In such a case, the manufacturer or management
is interested in knowing the profitability of the new product before its production can be undertaken. It is advisable
e to undertake the production of the new product if it is capable of contributing something towards fixed costs
and profit after meeting out its variable Cost of sales. Fixed costs are not to be considered on the assumption that
the new product ca n be manufactured by existing resources without incurring any additional fixed costs. But if
the introduction of a new product involves some specific or identifiable fixed costs (which arise due to the new
product), these should be deducted from the contribution of the new product before making any decision.
But if the introduction of a new product involves some specific or identifiable fixed costs (which arise due to the
new product), these should be deducted from the contribution of the new product before making any decision.
Illustration 4:
The following data are available in respect of product ‘A’ manufactured by Pankaj Ltd.:
`
Sales 2,50,000
Direct materials 1,00,000
Direct wages 50,000
Variable overhead 25,000
Fixed overhead 50,000

The company now proposes to introduce a new product ‘B’ so that sales may be increased by ` 50,000. There will
be no increase in fixed costs and the estimated variable costs of the product ‘B’ are:
`
Direct materials 24,000
Direct wages 11,000
Overhead 7,000
Advise whether product B will be profitable or not.
Solution:
Statement of Marginal Cost under proposed position
Product A (`) Product B (`) Total (`)

Direct materials 1,00,000 24,000 1,24,000
Direct wages 50,000 11,000 61,000
Variable overhead 25,000 7,000 32,000
Marginal Cost 1,75,000 42,000 2,17,000
Sales 2,50,000 50,000 3,00,000
Contribution 75,000 8,000 83,000
Less: Fixed Overhead 50,000 - 50,000
Profit 25,000 8000 33,000
Assuming that spare capacity cannot be used for any other purpose (except for producing product ‘B’), it is ad-
visable to undertake the production of product ‘B’ which shall give a contribution of ` 8,000 towards fixed costs
and profit.
5. Fixation of Selling price:
Marginal costing techniques assist the management in the fixation of the selling price of different products. Mar-
ginal cost of a product is the guiding factor in the fixation of selling price. Generally, the selling price of a product is
fixed at a level which not only covers the marginal cost but also contributes something towards fixed costs. Hence,
under normal circumstances for a long period, the fixation of selling price is done on the basis of the total cost of
sales (i.e., by adding some margin of profit to the total cost).
But in times of cut-throat competition, trade depression, in accepting additional orders for utilizing unused capac-
ity and in exploring foreign markets, the manufacturer may be ready to sell hi s products at a price below total cost
but not at a price below marginal cost. For fixing the price at a level below total cost of sales, the manufacturer
shall take into account the overall profitability or P/V Ratio of the business concern. Thus, the fixation of selling price
becomes easy where marginal cost, overall P/V Ratio and the level of profits expected, are known. In case of ex-
ports to foreign markets, the effect of various direct and indirect benefits such as cash compensatory assistance,
subsidies, import entitlements and other special favours or benefits from the Government should also be taken into
account.
Further, pricing at or below marginal costs may be considered desirable for a Shorter period under certain special
circumstances given below:
(i) To introduce a new product in the market or to popularize it.
(ii) To drive out weaker competitors from the market.
(iii) To maintain production in order to avoid retrenchment of employees.
(iv) To keep the plant and machinery in gear.
(v) To avoid the loss of future markets.
(vi) To sell the goods of perishable nature.
(vii) To push up the sales of other conjoined profitable products.

Illustration 5:
P. Co. Ltd., has an overall P/V Ratio of 60%. If the variable cost of a product is ` 20, what will be its selling price?
Solution:
Overall P/V Ratio of the company = 60%
Contribution Sales - Variable Cost

P/V Ratio = =
Sales Sales
If selling price is assumed to be 100.

Contribution = 60
Variable Cost = 100 – 60 = 40
Thus, when variable cost is 40, selling price = 100
100
When variable cost is 1 selling price will be =
40
100
When variable cost is 20, selling price will be = × 20 = ` 50.
40
Export Market vs. Home Market:

A firm engaged in supplying goods in the home market and having surplus production capacity, may think of
utilising it to meet export orders at a price lower than that prevailing in the home market. Such a decision is made
only when the local sale is earning a profit i.e., when it fixed costs have already been recovered by the local sales.
In such cases, if the export price is more than the marginal cost, it is advisable to enter the export market. Any
reduction in the selling price in the local market to utilise the surplus capacity may adversely affect the normal
local sales.
However, dumping in the export market at a lower price even below marginal cost in order to capture future
market, has no adverse effect on local sales.
Illustration 6:
Indo-US Company has a capacity to produce 5,000 articles but actually produced only 2,000 articles for home
market at the following costs:
`
Materials 40,000
Wages 36,000
Factory Overheads:
Fixed 12,000
Variable 20,000
Administration overhead (Fixed) 18,000
Selling and Distribution overhead:
Fixed 10,000
Variable 16,000
1,52,000

The home market can consume only 2,000 articles at a selling price of ` 80 per article. An additional order for the
supply of 3,000 articles is received from a foreign customer at ` 65 per article. Should this order be accepted or
not?
Solution:
Calculation of Present Profitability
Particulars ` `
Sales (2,000 Articles @ ` 80 per article) 1,60,000
Less: Marginal Cost:
Materials 40,000
Wages 36,000
Variable Overheads:
Factory 20,000
Selling and Distribution 16,000 1,12,000
Contribution 48,000
Less: Fixed overheads:
Factory 12,000
Office 18,000
Selling & Distribution 10,000 40,000
Profit 8,000
Since there is a profit of ` 8,000 at the existing level of 2,000 articles sold in the home market, the fixed costs are
fully recovered.
6. Alternative Methods of Manufacture:
Sometimes a manufacturer is faced with the problem of the application of alternative methods of manufacture
i.e., whether machine work or hand work, employment of hand-driven machine or power-driven machine or
employment of one machine or another machine etc. For the purpose of selecting the method of production to
be adopted, a comparison of the amount of contribution available under different methods of manufacture shall
be made. The alternative providing the maximum contribution per unit shall be considered to be more profitable.
However, the limiting factor. If any, involved in the method of production, must be given proper consideration.
7. Operate or Shut down Decision:
In case of a multi-product concern, it may be found that the production of some of its products is being carried
on at a loss. Under such a position, the production of non-profitable products shall have to be discontinued. But if
the choice is out of two or more products, the decision shall be taken with reference to the amount of contribution
or P/V Ratio of these products. Production of the product giving the least amount of contribution or least PN Ratio
should be discontinued on the assumption that production capacity thus freed can be used to produce other
profitable products.
8. Maintaining a Desired Level of Profit:
Sometimes the management may be interested in maintaining a desired level of profits under the conditions of
a change in the sales price. The volume of sales required to earn a desired level of profits can be ascertained by
applying marginal costing techniques. For ascertaining the sales required earning a desired level of profits, the
following formulae are applied:
Total Fixed Cost + Desired Profits
(i) Number of Units to be sold to earn Desired Profits =

(ii) Sales value required to earn Desired Profits =
P / V Ratios

Illustration 7:
A company produces and markets industrial containers and packing cases. Due to competition, the company
proposes to reduce the selling price. If the present level of profit is to be maintained, indicate the number of units
to be sold if the proposed reduction in selling price is:
(a) 5%; (b) 10%; (c) 15%.
The following additional information is available:
` `
Present Sales Turnover (30,000 units) 3,00,000
Variable Cost (30,000 units) 1,80,000
Fixed Cost 70,000 2,50,000
Net Profit 50,000
Solution:
Calculation of Contribution
Present Anticipated Conditions (Reduction in Selling

Conditions Price)
5% Reduction 10% Reduction 15% Reduction
` ` ` `
Selling price per unit 10.00 9.50 9.00 8.50
 `1,80,000  6.00 6.00 6.00 6.00

Less: Variable cost per unit  
 30,000 units 
Contribution per unit 4.00 3.50 3.00 2.50

Number of units to be sold to earn desired profits =
`70,000 + ` 50,000
(i) Under Present Conditions = = 30,000 units
`4
`70,000 + ` 50,000
(ii) At a Price Reduction of 5% = = 34,286 units
` 3.50
`70,000 + ` 50,000
(iii) At a Price Reduction of 10% = = 40,000 units
`3
`70,000 + ` 50,000
(iv) At a Price Reduction of 15% = = 48,000 units
` 2.50
9. Alternate Courses of Action:

Sometimes the management has to select a course of action from amongst various alternative courses. Each
course of action has its own merits and limitations. The course of action to be selected should ensure maximum profit
to the business concern. The appraisal of the various courses of action available is possible through the analysis of
contribution. The course of action ensuring highest contribution is generally adopted by the management.

Illustration 8:
Excel Ltd. manufactures and markets a single product. The following data are available:
` Per unit
Materials 16
Conversion costs (variable) 12
Dealer’s Margin 4
Selling Price 40
Fixed cost : ` 5 lakhs
Present Sales: 90,000 units
Capacity untilisation: 60 per cent
There is acute competition. Extra efforts are necessary to sell. Suggestions have been made for increasing sales:
(a) By reducing the sales price by 5 per cent.
(b) By increasing dealer’s margin by 25 per cent on the existing rate.
Which of these two suggestions you would recommend if the company desires to maintain the present profit. Give
reasons.
Solution:
Statement of Profitability (90,000 units)
Per unit Total

Marginal Cost: ` `
Materials 16 14,40,000
Conversion Cost 12 10,80,000
Dealer’s Margin 4 3,60,000
Total Marginal Cost 32 28,80,000
Sales 40 36,00,000
Contribution 8 7,20,000
Less: Total Fixed Cost 5,00,000
Total Profit 2,20,000
Ascertainment of the effect of various suggestions:

Suggestion (a)
`
Revised Selling Price (` 40 – 5% of ` 40) 38
Dealer’s Margin at existing rate of 10% on sales (since it is variable) 3.80
Suggestion (b)
`
Selling Price (no change) 40
Dealer’s Margin (Existing rate ` 4 + 25% of ` 4) 5

Statement of Revised Profitability
Suggestion (a) Suggestion (b)

` `
Materials 16.00 16.00
Conversion Cost 12.00 12.00
Dealer’s Margin 3.80 5.00
Variable Cost per unit 31.80 33.00
Selling price per unit 38.00 40.00
Sales (in units) to maintain the existing profitability of ` 2,20,000:

Required Sales (in units) =
` 5,00,000 + ` 2,20,000
As per suggestion (a) = = 1,16,129 units
`6.20
` 5,00,000 + ` 2,20,000
As per suggestion (b) = = 1,02,857 units
`7
The company should adopt suggestion (b) since it ensures the present profitability of ` 2,20,000 at a lower level of
production activity of 1,02,857 units as compared to 1,16,129 units under suggestion (a). It is given that competition
is acute.
10. Profit Planning:
Profit planning is one of the important functions of management. It relates to the attainment of maximum profit. Profit
planning requires the management to have the proper knowledge of the inter relationship of selling prices, sales
volume, variable cost, and fixed costs. Marginal costing helps the management in ascertaining the profit position
at the various levels of operation through the technique of cost volume profit analysis. Thus, the management can
plan its operations at the optimum level where profits are maximum.
Illustration 9:
Ambitious Enterprises is currently working at 50% capacity and produces 10,000 units.
At 60% working, raw material cost increases by 2% and selling price fall by 2%. At 80% working, raw material cost
increases by 5% and selling price fall by 5%.
At 50% capacity working, the product costs ` 180 per unit and is sold at ` 200 per unit.
The cost of ` 180 is made up as follows:
`
Material 100
Wages 30
Factory overheads 30 (40% Fixed)
Administration overheads 20 (50% Fixed)
Prepare a Marginal cost Statement showing the estimated profit of the business when it is operated at 60 per cent
and 80 per cent capacity.

Solution:
Statement of Marginal Cost
50% Capacity 60% Capacity 80% Capacity

10,000 units 12,000 units 16,000 units
` ` `
Materials 10,00,000 12,24,000 16,80,000
Wages 3,00,000 3,60,000 4,80,000
Variable Overheads
Factory 1,80,000 2,16,000 2,88,000
Administration 1,00,000 1,20,000 1,60,000
Total Marginal cost 15,80,000 19,20,000 26,08,000
Sales (10,000 × ` 200) 20,00,000 (12,000 × ` 196) 23,52,000 (16,000 × ` 190) 30,40,000
Total contribution 4,20,000 4,32,000 4,32,000
Less: Fixed Cost 2,20,000 2,20,000 2,20,000
Profit 2,00,000 2,12,000 2,12,000
Calculation of Variable and Fixed Overhead at 50 per cent capacity
Factory Overhead Administration Overhead

` `
Total Overhead (10,000 units) 3,00,000 2,00,000
Less: Fixed Overhead 1,20,000 1,00,000
(40%) (50%)
Variable Overhead 1,80,000 1,00,000
Variable Overhead per unit
`1,80,000 `1,00,000
10,000 units 10,000 units
` 18 ` 10
2.6 TRANSFER PRICING
Introduction and Meaning:

In the modern days, production is on the mass scale due to technological advancement and upgradation.
Organisations grow in course of time and for such growing organisations, decentralization becomes absolutely
necessary. It becomes inevitable for such organisations to establish separate divisions and departments to ensure
smooth working. Transfer pricing has become necessary in highly decentralized companies where number of
divisions/ departments are created as a part and parcel of the decentralized organisation. Transfer pricing is one
of the tools in the hands of management for measuring the performance of divisions or departments.
A ‘Transfer Price’ is that notional value at which goods and services are transferred between divisions in a
decentralized organisation. Transfer prices are normally set for intermediate products, which are goods, and
services that are supplied by the selling division to the buying division. In large organisations, each division is
treated as a ‘profit center’ as a part and parcel of decentralization. Their profitability is measured by fixation of
‘transfer price’ for inter divisional transfers.
The transfer price can have impact on the division’s performance and hence lot of care is to be taken in fixation
of the same. The following factors should be taken into consideration before fixing the transfer prices.

(1) Transfer price should help in the accurate measurement of divisional performance.
(2) It should motivate the divisional managers to maximize the profitability of their divisions.
(3) Autonomy and authority of a division should be ensured.
(4) Transfer Price should allow ‘Goal Congruence’ which means that the objectives of divisional managers
match with those of the organisation.2.7 OBJECTIVES OF INTER COMPANY TRANSFER PRICING
2.7 OBJECTIVES OF INTER COMPANY TRANSFER PRICING
The following are the main objectives of intercompany transfer pricing scheme:
1. To evaluate the current performance and profitability of each individual unit: This is necessary in order to de-
termine whether a particular unit is competitive and can stand on its working. When the goods are transferred
from one department to another, the revenue of one department becomes the cost of another and such
inter transfer price affects the reported profits.
2. To improve the profit position: Intercompany transfer price will make the unit competitive so that it may maxi-
mize its profits and contribute to the overall profits of the organisation.
3. To assist in decision making: Correct intercompany transfer price will make the costs of both the units realistic
in order to take decisions relating to such problems as make or buy, sell or process further, choice between
alternative methods of production.
4. For accurate estimation of earnings on proposed investment decisions: When finance is scarce and it is
required to determine the allocation of scarce resources between various divisions of the concern taking into
consideration their competing claims, then this technique is useful.2.8 METHODS OF TRANSFER PRICING
2.8 METHODS OF TRANSFER PRICING
It is the notional value of goods and services transferred from one division to other division. In other words, when
internal exchange of goods and services take place between the different divisions of a firm, they have to be
expressed in monetary terms. The monetary amount for those inter divisional exchanges is called as ‘transfer
price’. The determination of transfer prices is an extremely difficult and delicate task as lot of complicated issues
are involved in the same. Inter division conflicts are also possible. There are several methods of fixation of ‘Transfer
Price’. They are discussed below.
1. Pricing based on cost.
a) Actual cost
b) Cost plus
c) Standard cost
d) Marginal cost
2. Market price as transfer price.
3. Negotiated pricing.
4. Pricing based on Opportunity cost.
1. Pricing based on cost: - In these methods, ‘cost’ is the base and the following methods fall under this category.
(a) Actual Cost: - Under this method the actual cost of production is taken as transfer price for inter divisional
transfrers. Such actual cost may consist of variable cost or sometimes total costs including fixed costs.
(b) Cost Plus: - Under this method, transfer price is fixed by adding a reasonable return on capital employed
to the total cost. Thereby the measurement of profit becomes easy.
(c) Standard Cost: - Under this method, transfer price is fixed on the basis of standard cost. The difference
between the standard cost and the actual cost being variance is absorbed by transferring division. This
method is simple and easy to follow, but the constant revision of standards is necessary at regular intervals.

(d) Marginal Cost: - Under this method, the transfer price is determined on the basis of marginal cost. The
reason being fixed cost is in any case unavoidable and hence should not be charged to the buying
division. That is why only marginal cost will be taken as transfer price
2. Market price as transfer price: - Under this method, the transfer price will be determined according to the
market price prevailing in the market. It acts as a good incentive for efficient production to the selling division
and any inefficiency in production and abnormal costs will not be borne by the buying division. The logic used
in this method is that if the buying division would have purchased the goods/services from the open market,
they would have paid the market price and hence the same price should be paid to the selling division.
One of the variation of this method is that from the market price, selling and distribution overheads should be
deducted and price thus arrived should be charged as transfer price. The reason behind this is that no selling
efforts are required to sale the goods/services to the buying division and therefore these costs should not be
charged to the buying division. Market price based transfer price has the following advantages:
1. Actual costs are fluctuating and hence difficult to ascertain. On the other hand market prices can be
easily ascertained.
2. Profits resulting from market price based transfer prices are good parameters for performance evalua-
tion of selling and buying divisions.
3. It avoids extensive arbitration system in fixing the transfer prices between the divisions.
However, the market price based transfer pricing has the following limitations:
1. There may be resistance from the buying division. They may question buying from the selling division if in
any way they have to pay the market prices.
2. Like cost based prices, market prices may also be fluctuating and hence there may be difficulties in
fixation of these prices.
3. Market price is a rather vague term as such prices may be ex-factory price, wholesale price, retail price
etc.
4. Market prices may not be available for intermediate products, as these products may not have any
market.
5. This method may be difficult to operate if the intermediate product is for captive consumption.
6. Market price may change frequently.
7. Market prices may not be ascertained easily.
3. Negotiated Pricing: - Under this method, the transfer prices may be fixed through negotiations between the
selling and the buying division. Sometimes it may happen that the concerned product may be available in
the market at a cheaper price than charged by the selling division. In this situation the buying division may be
tempted to purchase the product from outside sellers rather than the selling division. Alternatively the selling
division may notice that in the outside market, the product is sold at a higher price but the buying division is
not ready to pay the market price. Here, the selling division may be reluctant to sell the product to the buying
division at a price, which is less than the market price. In all these conflicts, the overall profitability of the firm
may be affected adversely. Therefore it becomes beneficial for both the divisions to negotiate the prices
and arrive at a price, which is mutually beneficial to both the divisions. Such prices are called as ‘Negotiated
Prices’. In order to make these prices effective care should be taken that both, the buyers and sellers should
have access to the available data including about the alternatives available if any. Similarly buyers and
sellers should be free to deal outside the company, but care should be taken that the overall interest of the
organisation is not affected.
• The main limitation of this method is that lot of time is spent by both the negotiating parties in fixation of
the negotiated prices.
• Negotiating skills are required for the managers for arriving at a mutually acceptable price, otherwise
there is a possibility of conflicts between the divisions.
4. Pricing based on opportunity cost: - This pricing recognizes the minimum price that the selling division is ready to
accept and the maximum price that the buying division is ready to pay. The final transfer price may be based
on these minimum expectations of both the divisions. The most ideal situation will be when the minimum price
expected by the selling division is less than the maximum price accepted by the buying division. However in
practice, it may happen very rarely and there is possibility of conflicts over the opportunity cost.

It is very clear that fixation of transfer prices is a very delicate decision. There might be clash of interests between
the selling and buying division and hence while fixing the transfer price, overall interests of the organisation
should be taken into consideration and overall ‘Goal Congruence’ should be given utmost importance rather
than interests of the selling or buying division.
Illustration 10:
The following information relates to budgeted operations of Division P of a manufacturing company.
Particulars Amount in `
Sales – 50,000 units @ ` 8 4,00,000
Less: Variable Costs @ ` 6 per unit 3,00,000
Contribution margin 1,00,000
Less: Fixed Costs 75,000
Divisional Profits 25,000
The amount of divisional investment is ` 1, 50,000 and the minimum desired rate of return on the investment is the
cost of capital of 20%.
Calculate
(i) Divisional expected ROI and
(ii) Divisional expected RI
Solution:
(i) ROI = ` 25,000 / 1,50,000 × 100 = 16.7%
(ii) RI = Divisional Profits – Minimum desired rate of return = 25,000 – 20% of 1,50,000 = (` 5,000)
Illustration 11:
A company has two divisions, X and Y. Division X manufactures a component which is used by Division Y to
produce a finished product. For the next period, output and costs have been budgeted as follows.
Particulars Division X Division Y

Component units 50,000 ---
Finished units --- 50,000
Total variable costs – Rupees 2,50,000 6,00,000
Fixed Costs Rupees 1,50,000 2,00,000
The fixed costs are separable for each division. You are required to advise on the transfer price to be fixed for
Division X’s component under the following circumstances.
A. Division A can sell the component in a competitive market for ` 10 per unit. Division Y can also purchase the
component from the open market at that price.
B. As per the situation mentioned in (A) above, and further assume that Division Y currently buys the component
from an external supplier at the market price of ` 10 and there is reciprocal agreement between the external
supplier and another Division Z, within the same group. Under this agreement, the external supplier agrees
to buy one product unit from Division Z at a profit of ` 4 per unit to that division, for every component which
Division B buys from the sup.

Solution:
Transfer price decisions can be taken on the following basis.
A. Transfer Price: - Marginal Cost + Opportunity Cost i.e. ` (5 + 5) = ` 10
Note: Marginal Cost = ` 2, 50,000 / 50,000 units = ` 5
Opportunity cost ` 5 are computed on the basis that the Division X will sacrifice ` 5 if they sell the product to
Division Y.
B. In this situation, the transfer price will be worked out as under:
Transfer price = Marginal Cost + Contribution + Profit foregone by Division Z
= ` (5 + 5 + 4) = ` 14
In situation (B), if Division Y purchases from Division X, it will not purchase from external supplier. Hence, the
supplier will stop purchasing from Division Z, which will result in a loss of profit to Division Z @ ` 4 per unit, and
therefore this amount will be recovered from the transfer price.
Illustration 12:
A company fixes the inter-divisional transfer prices for its products on the basis of cost plus an estimated return on
investment in its divisions. The relevant portion of the budget for the Division X for the year 2015 -16 is given below:
Particulars Amount in (`)

Fixed Assets 5,00,000
Current Assets (other than debtors) 3,00,000
Debtors 2,00,000
Annual fixed cost for the division 8,00,000
Variable cost per unit of product 10
Budgeted volume of production per year (units) 4,00,000
Desired Return on Investment 28%
You are required to determine the transfer price for Division X.
Solution:
Computation of Transfer Price per unit for division X
Particulars Amount in (`)

Variable cost 10.00
Fixed cost (8,00,000 / 4,00,000) 2.00
Total Cost 12.00
Add: Desired return (10,00,000 × 28%) ÷ 4,00,000 0.70
Transfer Price 12.70
Illustration 13:
XYZ Ltd which has a system of assessment of Divisional Performance on the basis of residual income has two Divisions,
Alfa and Beta. Alfa has annual capacity to manufacture 15,00,000 numbers of a special component that it sells to
outside customers, but has idle capacity. The budgeted residual income of Beta is ` 1,20,00,000 while that of Alfa is
` 1,00,00,000. Other relevant details extracted from the budget of Alfa for the current years were as follows:

Particulars
Sale (outside customers) 12,00,000 units @ ` 180 per unit
Variable cost per unit ` 160
Divisional fixed cost ` 80,00,000
Capital employed ` 7,50,00,000
Cost of Capital 12%
Beta has just received a special order for which it requires components similar to the ones made by Alfa. Fully
aware of the idle capacity of Alfa, beta has asked Alfa to quote for manufacture and supply of 3,00,000 numbers
of the components with a slight modification during final processing. Alfa and Beta agree that this will involve an
extra variable cost of ` 5 per unit.
You are required to calculate,
The transfer price which Alfa should quote to Beta to achieve its budgeted residual income.
Solution:
(i) Contribution required at Budgeted Residual Income
`
Fixed cost 80,00,000
Profit on 7,50,00,000 × 12% 90,00,000
Residual Income 1,00,00,000
Total Contribution required 2,70,00,000
Contribution derived from existing units = 12,00,000 × 20 = ` 2,40,00,000
Contribution required on 3,00,000 units = 2,70,00,000 – 2,40,00,000 = ` 30,00,000
Contribution per unit = 30,00,000 / 3,00,000 = ` 10
Increase in Variable cost = ` 5
∴ Transfer price = V.C + Desired Residual Income + Increase in VC
= 160 + 10 + 5
= ` 175
(ii) If Beta can buy from outside at less than the Variable cost of manufacture, i.e. ` 165, then only the decision to
transfer price of ` 175, will be sub-optimal for the group as whole.
Illustration 14:
Transferor Ltd. has two processes – Preparing and Finishing. The normal output per week is 7,500 units (completed)
at a capacity of 75%.
Transferee Ltd. had production problems in preparing and require 2,000 units per week of prepared material for
their finishing process.
The existing cost structure of one prepared unit of Transferor Ltd. at the existing capacity is as follows.
Material: ` 2.00 (variable 100%)
Labour: ` 2.00 (variable 50%)
Overheads: ` 4.00 (variable 25%)
The sale price of a completed unit of Transferor Ltd. is ` 16 with a profit of ` 4 per unit.
Contrast the effect on the profits of Transferor Ltd. for 6 months (25 weeks) of supplying units to Transferor Ltd. with
the following alternative transfer prices per unit.

(i) Marginal Cost

(ii) Marginal Cost + 25%
(iii) Marginal cost + 15% return on capital employed. (Assume capital employed ` 20 lakhs)
(iv) Existing Cost
(v) Existing Cost + a portion of profit on the basis of preparing cost / total cost × unit profit
(vi) At an agreed market price of ` 8.50.
Assume no increase in the fixed costs.
Solution:
Transferred units (25 × 2,000) = 50,000
Existing profit (7500 × 25 × 4) = ` 7,50,000
Effect on profit if transfer price is:
(i) Marginal cost
`
Material 2.00
Labour 1.00
Overheads 1.00
4.00
At this transfer price there is no effect on profit of transferor Ltd.
(ii) Increase of Profit ` 50,000
(iii) Profit per unit = 4 + {(2000000 x 15% x 0.5)/50000} = ` 7
Under this price profit of transferor Ltd is increases by ` 1,50,000 i.e., 50,000 x (7-4)
(iv) Profit increases by 50,000 x (8-4) = ` 2,00,000
(v) Transfer price:
`
{8 + (8/12)4} 10.67
(-) profit 4.00
6.67
Profit increases by 50000 x 6.67 = ` 3,33,500/-
(vi) Transfer price = 8.50
Profit increase by 4.5 x 50000 = ` 2,25,000
Illustration 15:
Division A is a profit centre that produces three products X, Y and Z and each product has an external market.
The relevant data is as:
X Y Z
External market price per unit (`) 48 46 40
Variable cost of production (division A) (`) 33 24 28
Labour hours per unit (division A) 3 4 2
Maximum external sales units 800 500 300

Up to 300 units of Y can be transferred to an internal division B.

Division B has also the option of purchasing externally at a price of ` 45 per unit.
Determine the transfer price for Y the total labour hours available in division A is:
(a) 3800 hours
(b) 5600 hours
Solution:
Computation of contribution per labour hour from external sales:
X Y Z
Market price (`) 48 46 40
Variable cost (`) 33 24 28
Labour hours required 3 4 2
Contribution per labour hour (`) 5 5.50 6
Priority III II I
Computation of transfer price when
(a) The capacity is 3800 hours:
Hours required for Z = 300 x 2 = 600
Y = 500 x 4 = 2000
X = 800 x 3 = 2400
5000
The existing capacity is not sufficient to produce the units to meet the external sales. In order to transfer 300 units
of Y, 1200 hours are required in which division A will give up the production of X to this extent.
`
Variable cost of Y 24
(+) contribution lost by giving up production of X to the extent of 1200 hours = 1200 x 5 = ` 6,000
∴ Opportunity cost per unit = (6000/300) 20
Required transfer price 44
(b) If the capacity is 5600 hours:
`
Variable cost 24
Contribution lost by giving up X to the extent of 600 hours (being opportunity cost) = 600 x 5 = 3000
Opportunity cost per unit = (6000/300) 10
Required transfer price 34

Illustration 16:
Rana manufactures a product by a series of mixing of ingredients. The product is packed in company’s made
bottles and put into an attractive carton. One division of company manufactures the bottles while another division
prepares the mix that does the packing.
The user division obtained the bottle from the bottle manufacturing division. The bottle manufacturing division has
obtained the following quotations from an external source for supply of empty bottles.
Volume no of bottles For 8,00,000 bottles For 12,00,000 bottles

Total price offer (`) 14,00,000 20,00,000
The estimated cost is:

Total Cost (`) 10,40,000 14,40,000
The sales value and the end cost in the mixing/packing division are:

Total sales value (`) 91,20,000 1,27,80,000
Total Cost **(`) 10,40,000 96,80,000
** Excluding cost of bottles
There is a considerable discussion as to the proper transfer price from the bottle division to the marketing division.
The divisional managers salary is an incentive bonus based on profits of the centres.
You are required to show for the given two levels of activity the profitability of the two divisions and the total
organisation based on appropriate transfer price determined on the basis of:
(i) Shared profit related to the cost
(ii) Market price
Solution:
Statement showing Computation of transfer price on the basis of profit shared on cost basis:
Particulars Output (8,00,000) Output (12,00,000)

(`) (`)
Sales 91,20,000 1,27,80,000
Costs:
Product manufacturing division 64,80,000 96,80,000
Bottle manufacturing division 10,40,000 14,40,000
75,20,000 1,11,20,000
Profit 16,00,000 16,60,000
Share of bottle manufacturing division 2,21,276 2,14,964
Product manufacturing division 13,78,724 14,45,036
Transfer price 12,61,276 16,54,964
Transfer price per bottle 1.5777 1.379

Profitability on the basis of market price:
Particulars Output (8,00,000) Output (12,00,000)

(`) (`) (`) (`)
Bottle manufacturing division
Sale value 14,00,000 20,00,000
(-)cost 10,40,000 14,40,000
Profit 3,60,000 5,60,000
Product manufacturing division
Sale value 91,20,000 1,27,80,000
(-)cost of product 64,80,000 96,80,000
Cost of bottle 14,00,000 78,80,000 20,00,000 1,16,80,000
Profit 12,40,000 11,00,000
Total profit 16,00,000 16,60,000
Transfer price 1.75 1.67
Illustration 17:
PH Ltd. manufactures and sells two products, namely BXE and DXE. The company’s investment in fixed assets is
`2 lakh. The working capital investment is equivalent to three months’ cost of sales of both the products. The fixed
capital has been financed by term loan lending institutions at an interest of 11% p.a. Half of the working capital is
financed through bank borrowing carrying interest at the rate of 19.4%, the other half of the working capital being
generated through internal resources.
The operating data anticipated for 2015-16 is as under:
Product BXE Product DXE

Production per annum (in units) 5,000 10,000
Direct Material/unit:
Material A (Price ` 4 per kg) 1 Kg 0.75 Kg
Material B (Price ` 2 per kg) 1 Kg 1 Kg
Direct labour hours 5 3
Direct wage rate ` 2 per hour. Factory overheads are recovered at 50% of direct wages. Administrative overheads
are recovered at 40% of factory cost. Selling and distribution expenses are ` 2 and ` 3 per unit respectively of BXE
and DXE. The company expects to earn an after tax profit of 12% on capital employed. The income tax rate is 50%.
Required:
(i) Prepare a cost sheet showing the element wise cost, total cost profit and selling price per unit of both the
products.
(ii) Prepare a statement showing the net profit of the company after taxes for the 2015-16.

Solution:
(a) Cost sheet
BXE DXE Total

Units Total Units Total
` ` ` ` `
Direct material 6 30,000 5 50,000 80,000
Direct wages 10 50,000 6 60,000 1,10,000
Prime Cost 16 80,000 11 1,10,000 1,90,000
Factory Overheads 5 25,000 3 30,000 55,000
Factory cost 21 1,05,000 14 1,40,000 2,45,000
Office Overheads 8.40 42,000 5.60 56,000 98,000
Cost of production 29.40 1,47,000 19.60 1,96,000 3,43,000
Selling & Distribution overheads 2.00 10,000 3.00 30,000 40,000
Cost of sales 31.40 1,57,000 22.60 2,26,000 3,83,000
Profit as % on
Fixed capital 21,818 26,182 48,000
Working capital 9,420 13,560 22,980
Sales/S.P. 37.6476 1,88,238 26.5742 2,65,742 4,53,980
Working notes
`
Return after tax [{383000 x 0.25} + 2,00,000] 12% 35,490
∴ Sales 3,83,000 + 35,490 x (1/50%) 4,53,980
(b) Statement showing net profit:
`
Sales 4,53,980
(-) Cost of Sales (3,83,000)
Gross Profit 70,980
(-) Interest {22000 + (95750/2) 19.4%} (31,288)
Profit Before Tax 39,692
(-) Tax @ 50% (19,846)
Profit After Tax 19,846

Practical Problems
Illustration 1:
The sports material manufacturing company budgeted the following data for the coming year.
`
Sales (1,00,000 units) 1,00,000
Variable cost 40,000
Fixed cost 50,000
Find out
(a) P/V Ratio, B.E.P and Margin of Safety
(b) Evaluate the effect of
(i) 20% increase in physical sales volume
(ii) 20% decrease in physical sales volume
(iii) 5% increase in variable costs
(iv) 5% decrease in variable costs
(v) 10% increase in fixed costs
(vi) 10% decrease in fixed costs
(vii) 10% decreases in selling price and 10% increase in sales volume
(viii) 10% increase in selling price and 10% decrease in sales volume
(ix) ` 5,000 variable cost decrease accompanied by ` 15,000 increase in fixed costs.
Solution:
(a) P/V ratio, B.E.P and Margin of Safety
Contribution = Sales – Variable cost
= 1,00,000 – 40,000
= ` 60,000
P/V Ratio = (Contribution / Sales) x 100
= (60,000 / 1,00,000) x 100
= 60%
B.E.P sales = Fixed cost / PV ratio
= 50,000 / 60%
=` 83,333
Margin of Safety = Total sales – B.E.P sales
= 1,00,000 – 83,333
= `16,667

(b)
Contribution P/V ratio BE Sales Margin of safety

(`) (`) (`)
(i) Increase in volume by 20% 1,20,000 – 48,000 (72,000 / 1,20,000) x (50,000 / 60%) 1,20,000 – 83,333
= 72,000 100 = 60% = 83,333 = 36,667
(ii) Decrease in volume by 20% 80,000 – 32,000 (48,000 / 80,000) x (50,000 / 60%) 80,000 – 83,333
= 48,000 100 = 60% = 83,333 = (3,333)
(iii) 5% increase in variable cost 1,00,000 – 42,000 (58,000 / 1,00,000) x (50,000 / 58%) 1,00,000 – 86,207
= 58,000 100 = 58% = 86,207 = 13,793
(iv) 5% decrease in variable 1,00,000 – 38,000 (62,000 / 1,00,000) (50,000 / 62%) 1,00,000 – 80,645
cost = 62,000 x100 = 62% = 80,645 = 19,355
(v) 10% increase in fixed cost 1,00,000 – 40,000 (60,000 / 1,00,000) x (55,000 / 60%) 1,00,000 – 91,667
= 60,000 100 = 60% = 91,667 = 8,333
(vi) 10% decrease in fixed costs 1,00,000 – 40,000 (60,000 / 1,00,000) x (45,000 / 60%) 1,00,000 – 75,000
= 60,000 100 = 60% = 75,000 = 25,000
(vii) 10% decreases in selling 99,000 – 44,000 = (55,000 / 99,000) x (50,000 / 55.55%) 99,000 – 90,009
price and 10% increase in 55,000 100 = 55.55% = 90,009 = 8,991
sales volume
(viii) 10% increase in selling price 99,000 – 36,000 (63,000 / 99,000) x (50,000 / 63.63%) 99,000 – 78,579
and 10% decrease in sales = 63,000 100 = 63.63% = 78,579 = 20,421
volume
(ix) `5,000 variable cost 1,00,000 – 35,000 (65,000/1,00,000) x (65,000 / 65%) = 1,00,000 –
decrease accompanied = 65,000 100 = 65% 1,00,000 1,00,000 = 0
by `15,000 increase in fixed
costs.
Illustration 2:
Two businesses AB Ltd and CD Ltd sell the same type of product in the same market. Their budgeted profits and loss
accounts for the year ending 30th June, 2016 are as follows:
AB Ltd (`) CD Ltd (`)

Sales 1,50,000 1,50,000
Less: Variable costs 1,20,000 1,00,000
Fixed Cost 15,000 1,35,000 35,000 1,35,000
Profit 15,000 15,000
You are required to calculate the B.E.P of each business and state which business is likely to earn greater profits
in conditions.
(a) Heavy demand for the product
(b) Low demand for the product.
Solution:
Statement Showing Computation of P/V ratio, BEP and Determination of Profitability in Different conditions:
Particulars AB Ltd CD Ltd

(i) Sales 1,50,000 1,50,000
(ii) Variable cost 1,20,000 1,00,000

(iii) Contribution 30,000 50,000

(iv) P/V ratio [(30,000/1,50,000) x 100] 20%
[(50,000/1.50,000) x 100] 331/3%
(v) Fixed cost 15,000 35,000

(vi) Profit 15,000 15,000
(vii) Breakeven sales (V/IV) 75,000 1,05,000
From the above computation, it was found that the product produced by CD Ltd is more profitable in conditions
of heavy demand because its P/V ratio is higher. On the other hand, in the condition of low demand, the product
produced by AB Ltd is more profitable because its BEP is low.
Illustration 3:
A factory is currently working to 40% capacity and produces 10,000 units. At 50% the selling price falls by 3%. At
90% capacity the selling price falls by 5% accompanied by similar fall in prices of raw material. Estimate the profit
of the company at 50% and 90% capacity production.
The cost at present per unit is:
`
Material 10
Labour 3
Overheads 5 (60% fixed)
The selling price per unit is ` 20/- per unit.
Solution:
Statement Showing Computation of Profit at 50% and 90% Capacity as well as at Current Capacity:
Particulars 40% 50% 90%

` ` `
Unit Total Unit Total Unit Total
(i) Selling Price 20.00 2,00,000 19.40 2,42,500 19.00 4,27,500
(ii) Variable Cost
Material 10.00 1,00,000 10.00 1,25,000 9.50 2,13,750
Labour 3.00 30,000 3.00 37,500 3.00 67,500
Variable OH 2.00 20,000 2.00 25,000 2.00 45,000
15.00 1,50,000 15.00 1,87,500 14.50 3,26,250
(iii) Contribution 5.00 50,000 4.40 55,000 4.50 1,01,250
(iv) Fixed Cost 3.00 30,000 30,000 30,000
(v) Profit 20,000 25,000 71,250
(vi) 1,20,000 1,32,273 1,26,667
B.E. Sales  F×S 

 C 

Illustration 4:
The sales turnover and profit during two periods were as follows:
Period Sales (`) Profit (`)

1 2,00,000 20,000
2 3,00,000 40,000
What would be probable trading results with sales of `1,80,000? What amount of sales will yield a profit of ` 50,000?
Solution:
= (20,000 / 1,00,000) x 100 = 20%

= (2,00,000 x 0.2) – 20,000 = ` 20,000
Fixed Cost + Desired Profit

Sales required to earn desired profit = = (20,000 + 50,000) / 20% = ` 3,50,000
P / V Ratio
Illustration 5:
The following figures for profit and sales obtained from the accounts of X Co. Ltd.

2014 20,000 2,000
2015 30,000 4,000
Calculate:
(a) P/V Ratio
(b) Fixed cost
(c) B.E. Sales
(d) Profit at sales ` 40,000 and
(e) Sales to earn a profit of ` 5,000.
Solution:
(a) P/V ratio = (Change in profit / Change in sales) x 100
= (2,000 / 10,000) x 100 = 20%
(b) Fixed cost = (Sales x P/V ratio) – Profit

= (20,000 x 0.2) – 2,000 = ` 2,000
(c) Break even sales = Fixed cost / PV ratio

= 2,000 / 20% = ` 10,000
(d) Profit at sales ` 40,000 = (Sales x P/V ratio) – Fixed cost

= (40,000 x 20%) – 2,000 = ` 6,000

(e) Sales required to earn desired profit of ` 5,000 = = (2,000 + 5,000) / 20% = ` 35,000
P / V Ratio

Illustration 6:
The following results of a company for the last two years are as follows:

2014 1,50,000 20,000
2015 1,70,000 25,000
You are required to calculate:
(i) P/V Ratio
(ii) B.E.P
(iii) The sales required to earn a profit of ` 40,000
(iv) Profit when sales are ` 2,50,000
(v) Margin of safety at a profit of ` 50,000 and
(vi) Variable costs of the two periods.
Solution:
(i) P/V ratio = (Change in profit / Change in sales) x 100
= (5,000 / 20,000) x 100 = 25%
= (1,50,000 x 25%) – 20,000 = ` 17,500
(ii) Break even sales = Fixed cost / PV ratio
= 17,500 / 25% = ` 70,000
(iii) Sales required to earn a profit of ` 40,000 =
P / V Ratio
= (17,500 + 40,000) / 25% = ` 2,30,000
(iv) Profit at sales ` 2,50,000 = (Sales x P/V ratio) – Fixed cost
= (2,50,000 x 25%) – 17,500 = ` 45,000
(v) Margin of safety at profit of ` 50,000 = Profit / PV ratio
= 50,000 / 25% = ` 2,00,000
(vi) Variable cost for 2011 = 1,50,000 x 75% = ` 1,12,500
Illustration 7:
The Reliable Battery Co. furnishes you the following income information:
Year 2015
First Half (`) Second Half (`)
Sales 8,10,000 10,26,000
Profit earned 21,600 64,800
From the above you are required to compute the following assuming that the fixed cost remains the same in both
periods.
1. P/V Ratio
2. Fixed cost
3. The amount of profit or loss where sales are ` 6,48,000
4. The amount of sales required to earn a profit of ` 1,08,000

Solution:
1. P/V ratio = [(64,800 – 21,600) / (10,26,000 – 8,10,000)] x 100 = 20%

2. Fixed cost = (Sales x P/V ratio) – Profit = (8,10,000 x 20%) – 21,600 = ` 1,40,400
3. Profit/Loss when sales are ` 6,48,000 = (Sales x P/V ratio) – 1,40,400
= (6,48,000 x 20%) – 1,40,400 = 1,29,600 – 1,40,400
= ` 10,800 (loss)
4. Amount of sales to earn profit of ` 1,08,000 = (1,40,400 + 1,08,000) / 20%
= 2,48,400 / 20% = ` 12,42,000
Illustration 8:
The following figures relate to a company manufacturing a varied range of products:
Total Sales (`) Total Cost(`)

Year ended 31-12-2014 22,23,000 19,83,600
Year ended 31-12-2015 24,51,000 21,43,200
Assuming stability in prices, with variable cost carefully controlled to reflect pre-determined relation.
(a) The profit volume ratio to reflect the rates of growth for profit and sales and
(b) Any other cost figures to be deduced from the data.
Solution:
31-12-2014 (`) 31-12-2015 (`)

Sales 22,23,000 24,51,000
(-) cost 19,83,600 21,43,200
Profit 2,39,400 3,07,800
Change in profit = 3,07,800 – 2,39,400 = ` 68,400

Change in sales = 24,51,000 – 22,23,000 = ` 2,28,000
(a) P/V ratio = (68,400 / 2,28,000) x 100 = 30%

(b) Fixed cost = (22,23,000 x 30%) – 2,39,400 = ` 4,27,500
(c) Break even sales = 4,27,500 / 30% = ` 14,25,000
(d) M/S for 2014 = 22,23,000 – 14,25,000 = ` 7,98,000
M/S for 2015 = 24,51,000 – 14,25,000 = ` 10,26,000
(e) Variable cost for 2014 = 22,23,000 x 70% = ` 15,56,100
(f) % of fixed cost in 2014 = (4,27,500 / 22,23,000) x 100 = 19.23%
% of fixed cost in 2015 = (4,27,500 / 24,51,000) x 100 = 17.44%

Illustration 9:
SV Ltd a multi product company furnishes you the following data relating to the year 2015:
First Half of the year (`) Second Half of the year (`)
Sales 45,000 50,000
Total cost 40,000 43,000
Assuming that there is no change in prices and variable cost and that the fixed expenses are incurred equally in
the two half year period, calculate for the year, 2015
(i) The P/V Ratio,
(ii) Fixed Expenses
(iii) Break-even sales
(iv) Percentage of Margin of safety.
Solution:
(i) P/V ratio = [(7,000 – 5,000) / (50,000 – 45,000)] x 100 = 40%
(ii) Fixed expenses for first half year = (Sales x PV ratio) – Profit
= (45,000 x 0.4) – 5,000 = ` 13,000
Fixed expenses for the year = 13,000 + 13,000 = ` 26,000
(iii) Break even sales = 26,000 / 40% = ` 65,000
(iv) Margin of safety = (50,000 + 45,000) – 65,000 = ` 30,000
Margin of safety ratio = [30,000 / (50,000 + 45,000)] x 100 = 31.58%
Illustration 10:
S Ltd. furnishes you the following information relating to the half year ended 30th June, 2015.
(`)
Fixed expenses 45,000
Sales value 1,50,000
Profit 30,000
During the second half the year the company has projected a loss of `10,000.
Calculate:
(1) The B.E.P and M/S for six months ending 30th June, 2015.
(2) Expected sales volume for the second half of the year assuming that the P/V Ratio and Fixed expenses remain
constant in the second half year also.
(3) The B.E.P and M/S for the whole year for 2015.
Solution:
(1) P/V ratio : = [(45,000 + 30,000) / 1,50,000] x 100 = 50%
BE sales for I half year = 45,000 / 50% = ` 90,000
Margin of safety for I half year = 1,50,000 – 90,000 = ` 60,000
For II half year:
0.5 = [45,000 + (-) 10,000] / Sales
0.5 sales = 35,000
⇒ Sales = ` 70,000
(3) BE sales for 2015 = (45,000 + 45,000) x 50% = 1,80,000
Margin of safety for 2015 = (1,50,000 + 70,000) – 1,80,000 = ` 40,000

Illustration 11:
The following is the statement of a Radical Co. for the month of June.
Products Total
L ( `) M (`) (`)
Sales 60,000 60,000 1,20,000
Variable costs 42,000 30,000 72,000
Contribution 18,000 30,000 48,000
Fixed cost 36,000
Net Income 12,000
You are required to compute the P/V ratio for each product and then compute the P/V Ratio, Breakeven Point
and net profit for the following assumption.
(i) Sales revenue divided 60% to Product L & 40% to Product M.
(ii) Sales revenue divided 40% to Product L & 60% to Product M.
Also calculate the profit estimated on sales upto ` 1,80,000/- p.m. for each of the sales mix provided above.
Solution:
Computation of P/V ratio
Particulars L M Total
P/V ratio (C/S) x 100 30% 50% 40%
(i) For Assumption I:

Statement showing computation of P/V ratio, Breakeven point and profit:

(i) Sales 72,000 48,000 1,20,000
(ii) Variable cost (L - 70%); (M – 50%) 50,400 24,000 74,400
(iii) Contribution (L – 30%); (M – 50%) 21,600 24,000 45,600
(iv) Fixed cost 36,000
(v) Profit 9,600
P/V ratio (45,600 x 1,20,000) / 100 = 38% 30% 50% 38%
Break even sales = 36,000 / 38% = ` 94,737
(ii) For Assumption II:

Statement showing computation of P/V ratio, Breakeven point and profit:

(i) Sales 48,000 72,000 1,20,000
(ii) Variable cost (L - 70%); (M – 50%) 33,600 36,000 69,600
(iii) Contribution (L – 30%); (M – 50%) 14,400 36,000 50,400
(v) Profit 14,400
P/V ratio (50,400 x 1,20,000) / 100 = 42% 30% 50% 42%
Break even sales = 36,000 / 42% = ` 85,714

Illustration 12:
Accelerate Co. Ltd., manufactures and sells four types of products under the brand names of A, B, C and D. The
1 2 2 1
sales Mix in value comprises 33 %, 41 %, 16 %, and 8 % of products A, B, C & D respectively.
3 3 3 3
The total budgeted sales (100% are `60,000 p.m.). Operating costs are:
Variable Costs:
Product A 60% of selling price
Product B 68% of selling price
Product C 80% of selling price
Product D 40% of selling price
Fixed Costs: ` 14,700 p.m.
(a) Calculate the break - even - point for the products on overall basis and
(b) Also calculate break-even-point, if the sales mix is changed as follows the total sales per month remaining the
same. Mix: A - 25% : B - 40% : C - 30% : D - 5%.
Solution:
Particulars A (`) B (`) C (`) D (`) Total (`)

(i) Sales 20,000 25,000 10,000 5,000 60,000
(ii) Variable cost 12,000 17,000 8,000 2,000 39,000
(iii) Contribution 8,000 8,000 2,000 3,000 21,000
(v) Profit 6,300
P/V ratio (C/S) x 100 40% 32% 20% 60% 35%
(a) Break even sales

Break even sales = 14,700 / 35% = ` 42,000
(b)
Particulars A (`) B (`) C (`) D (`) Total (`)

(i) Sales 15,000 24,000 18,000 3,000 60,000
(ii) Variable cost 9,000 16,320 14,400 1,200 39,000
(iii) Contribution 6,000 7,680 3,600 1,800 21,000
(v) Profit 4,380
P/V ratio (C/S) x 100 40% 32% 20% 60% 31.8%
Break even sales = 14,700 / 31.8% = ` 46,226
Illustration 13:
Present the following information to show to management:
(i) The marginal product cost and the contribution p.u.
(ii) The total contribution and profits resulting from each of the following sales mix results.

Particulars Product Per unit (`)

Direct Materials A 10
Direct Materials B 9
Direct wages A 3
Direct wages B 2
Fixed Expenses – ` 800

(Variable expenses are allotted to products at 100% Direct Wages)
Sales Price ----- A ` 20
Sales Price ----- B `15
Sales Mixtures: a) 100 units of Product A and 200 of B.
b) 150 units of Product A and 150 of B.
c) 200 units of Product A and 100 of B.
Solution:
(i) Statement of Marginal Product cost
Particulars A (`) B (`)

(i) Selling Price 20.00 15.00
(ii) Variable cost
Direct wages 3.00 2.00
Variable OHs (100% of direct wages) 3.00 2.00
16.00 13.00
(iii) Contribution (i – ii) 4.00 2.00
(ii) Profit at Mix (a):
Sr. No. Particulars A (`) B (`) Total (`)

(i) No. of units 100 200
(ii) ‘C’ per unit 4 2
(iii) Total contribution (ii x i) 400 400 800
(iv) Fixed cost 800
(v) Profit (iii - iv) Nil
Profit at Mix (b):

(iii) Total contribution (ii x i) 600 300 900
(iv) Fixed cost 800
(v) Profit (iii - iv) 100
Profit at Mix (c):


(iii) Total contribution (i x ii) 800 200 1000

(iv) Fixed cost 800
(v) Profit (iii - iv) 200
here ‘ C ‘ means ‘ Contribution’ .
Illustration 14:
The following particulars are extracted from the records of a company:
PER UNIT
PRODUCT A PRODUCT B
Sales (`) 100 120
Consumption of material 2 Kg 3 Kg
Material cost (`) 10 15
Direct wages cost (`) 15 10
Direct expenses (`) 5 6
Machine hours used 3 Hrs 2 Hrs
Overhead expenses:
Fixed (`) 5 10
Variable (`) 15 20
Direct wages per hour is ` 5

(a) Comment on profitability of each product (both use the same raw material) when:
1) Total sales potential in units is limited;
2) Total sales potential in value is limited;
3) Raw material is in short supply;
4) Production capacity (in terms of machine hours) is the limiting factor.
(b) Assuming raw material as the key factor, availability of which is 10,000 Kgs. and each product cannot be sold
more than 3,500 units find out the product mix which will yield the maximum profit.
Solution:
(a) Statement showing computation of contribution per unit of different factors of production and determination
of profitability
Particulars A (`) B (`)

(i) Sales 100 120
(ii) Variable cost
Materials 10 15
Labour 15 10
Direct expenses 5 6
Variable OH 15 20
45 51
(iii) Contribution (i – ii) 55 69
(iv) P/V ratio (iii – i) 55% 57.5%
(v) Contribution per kg of material 55/2 = 27.5 69/3 = 23
(vi) Contribution per machine hour 55/3 = 18 /3
1
69/2 = 34.5

From the above computations, we may comment upon the profitability in the following manner.
1. If total sales potential in units is limited, product B is more profitable, it has more contribution per unit.
2. When total sales in value is limited, product B is more profitable because it has higher P/V ratio.
3. If the raw material is in short supply, Product A is more profitable because it has more contribution per Kg of
material.
4. If the production capacity is limited, product B is more profitable, because it has more contribution per
machine hour.
(b) Statement showing optimum mix under given conditions and computation of profit at that mix:
(i) No. of units 3,500 1,000
(ii) Contribution per unit 55 69
(iii) Total contribution 1,92,500 69,000 2,61,500
(iv) Fixed cost (3500 × 5) (3500 × 100) 17,500 35,000 52,500
(v) Profit 2,09,000
* Fixed cost is taken at maximum capacity (3,500 x 10)

Working Notes: Kg.
Available material = 10,000
(-) utilized for A (3,500 x 2) = 7,000
= 3,000
Units of B = 3,000 / 3 = 1,000
Illustration 15:
A company has a capacity of producing 1 lakh units of a certain product in a month. The sales department reports
that the following schedule of sales prices is possible.
VOLUME OF PRODUCTION SELLING PRICE PER UNIT

% (`)
60 0.90
70 0.80
80 0.75
90 0.67
100 0.61
The variable cost of manufacture between these levels is 15 paise per unit and fixed cost ` 40,000. Prepare a
statement showing incremental revenue and differential cost at each stage. At which volume of production will
the profit be maximum?
Solution:
Statement showing computation of differential cost, incremental revenue
and determination of capacity at which profit is maximum:
Capacity Units Sales V. Cost @ ` 0.15 Fixed Cost Total cost Differential Cost Incremental
Revenue
% (`) (`) (`) (`) (`)
60% 60,000 54,000 9,000 40,000 49,000 --- ---
70% 70,000 56,000 10,500 40,000 50,500 1,500 2,000
80% 80,000 60,000 12,000 40,000 52,000 1,500 4,000
90% 90,000 60,300 13,500 40,000 53,500 1,500 300
100% 1,00,000 61,000 15,000 40,000 55,000 1,500 700

From the above computation, it was found that the incremental revenue is more than the differential cost up to
80% capacity, the profit is maximum at that capacity.
Illustration 16:
The operating statement of a company is as follows:
` `
Sales (80,000 @ `15 each) 12,00,000
Costs:
Variable:
Material 2,40,000
Labour 3,20,000
Overheads 1,60,000
7,20,000
Fixed Cost 3,20,000 10,40,000
PROFIT 1,60,000
The capacity of the plant is 1 lakh units. A customer from U.S.A. is desirous of buying 20,000 units at a net price of
` 10 per unit. Advice the producer whether or not offer should be accepted. Will your advice be different, if the
customer is local one.
Solution:
Statement showing computation of profit before and after accepting the order:
Sr. Particulars Present Position (Before Order Value Total (After accepting
No. accepting) 80,000 (`) (20,000) (`) 1,00,000) (`)
(i) Sales 12,00,000 2,00,000 14,00,000
(ii) Variable cost
Materials 2,40,000 60,000 3,00,000
Labour 3,20,000 80,000 4,00,000
Variable OH 1,60,000 40,000 2,00,000
7,20,000 1,80,000 9,00,000
(iii) Contribution (i – ii) 4,80,000 20,000 5,00,000
(iv) Fixed Cost 3,20,000 3,20,000
(v) Profit (iii – iv) 1,60,000 20,000 1,80,000
As the profit is increased by ` 20,000 by accepting the order, it is advised to accept the same. If the order is from
local one, it should not be accepted because it will adversely affect the present market.
Illustration 17:
A company manufactures scooters and sells it at ` 3,000 each. An increase of 17% in cost of materials and of 20%
of labour cost is anticipated. The increased cost in relation to the present sales price would cause at 25% decrease
in the amount of the present gross profit per unit.
At present, material cost is 50%, wages 20% and overhead is 30% of cost of sales.
(a) Prepare a statement of profit and loss per unit at present and;
(b) Compute the new selling price to produce the same percentage of profit to cost of sales as before.

Solution:
Let X and Y be the cost and profit respectively.
X + Y = 3,000 → (1)
Material = X x 50/100 = 0.5X
Labour = X x 20/100 = 0.2X
Overheads = X x 30/100 = 0.3X
After increase of cost:

Material = 0.5 X x 117/100 = 0.585 X
Labour = 0.2X x 120/100 = 0.240 X
Overheads = 0.300 X
= 1.125 X
Profit = Y x 75/100 = 0.75Y
∴ New Equation 1.125X + 0.75Y = 3,000 → (2)
Multiplying Eq. (1) by 0.75 0.75X + 0.75Y = 2,250
0.375X = 750
X = 750/0.375 = ` 2,000
Y = 3,000 – 2,000 = ` 1,000
Statement of cost & profit per unit at present:
(`)
Material = 2,000 x 50% 1,000
Labour = 2,000 x 20% 400
Overheads = 2,000 x 30% 600
2,000
(+) profit @ 50% of cost 1,000
3,000
Computation of new selling price to get same percentage of profit:
(`)
Material = 1,000 x 117/100 1,170
Labour = 400 x 120/100 480
Overheads 600
Cost 2,250
(+) Profit @ 50% 1,125
New selling price 3,375
Illustration 18:
An umbrella manufacturer marks an average net profit of ` 2.50 per piece on a selling price of `14.30 by producing
and selling 6,000 pieces or 60% of the capa city. His cost of sales is
(`)
Direct wages 1.25
Works overheads (50% fixed) 6.25
Sales overheads (25% variable) 0.80

During the current year, he intends to produce the same number but anticipates that fixed charges will go up
by 10% which direct labour rate and material will increase by 8% and 6% respectively but he has no option of
increasing the selling price. Under this situation, he obtains an offer for further 20% of the capacity. What minimum
price you will recommend for acceptance to ensure the manufacturer an overall profit of `16,730.
Solution:
Computation of profit at present after increase in cost:
Sr. No. Particulars (`)

(i) Selling price 14.30
(ii) Variable cost
Material (3.5 x 106/100) 3.710
Labour (1.25 x 108/100) 1.350
Works overhead 3.125
Sales overhead 0.200
8.385
(iii) Contribution per unit (I-II) 5.915
(iv) Total contribution (6,000 x 5.915) 35,490
(v) Fixed cost
Works OH 3.125 24,585
Sales OH 0.600 (3.725 x 6,000 = 22,350 x 110/100)
(vi) Profit (iv - v) 10,905
Computation of selling price of the order:
`
Variable cost of order (2,000 x 8.385) 16,770
(+) required profit (16,730 – 10,905) 5,825
Sales required 22,595
Selling price of order = 22,595/2,000 = 11.2975 (or) ` 11.30
Illustration 19:
The Dynamic company has three divisions. Each of which makes a different product. The budgeted data for the
coming year are as follows:
A (`) B (`) C (`)

Sales 1,12,000 56,000 84,000
Direct Labour 5,600 7,000 22,400
Fixed Cost 28,000 14,000 28,000
61,600 35,000 93,400
The Management is considering to close down the division C’. There is no possibility of reducing fixed cost. Advise
whether or not division C’ should be closed down.

Solution:
Statement showing computation of profit before closing down of division C:
Sr. No. Particulars A (`) B (`) C (`) Total (`)

(i) Sales 1,12,000 56,000 84,000 2,52,000
(ii) Variable cost
Direct Materials 14,000 7,000 14,000 35,000
Direct Labour 5,600 7,000 22,400 35,000
Direct Expenses 14,000 7,000 28,000 49,000
(iii) Total Variable Cost 33,600 21,000 64,400 1,19,000
(iv) Contribution (i – iii) 78,400 35,000 19,600 1,33,000
(v) Fixed Cost 70,000
(vi) Profit (iv – v) 63,000
Statement showing computation of profit after closing ‘C’:

(i) Sales 1,12,000 56,000 1,68,000
(ii) Variable cost
Direct Materials 14,000 7,000 21,000
Direct Labour 5,600 7,000 12,600
(iii) Total Variable Cost 33,600 21,000 54,600
(iv) Contribution (i – iii) 78,400 35,000 1,13,400
(v) Fixed Cost 70,000
(vi) Profit (iv – v) 43,400
From the above computations, it was found that profit is decreased by ` 19,600 by closing down division ‘C’, it
should not be closed down. In other words, as long as if there is a contribution of ` 1, from division ‘C’, it should not
be closed down.
Illustration 20:
Mr. Young has ` 1,50,000 investment in a business. He wants a 15% profit on his money. From an analysis of recent
cost figures he finds that his variable cost of operating is 60% of sales; his fixed costs are `75,000 per year. Show
supporting computations for each answer.
a) What sales volume must be obtained to break-even?
b) What sales volume must be obtained to his 15% return on investment?
c) Mr. Young estimates that even if he closed the doors of his business he would incur `25,000 expenses per year.
At what sales would be better off by locking his sales up?
Solution:
P/V ratio (V. cost ratio 60%) = 40%
a) Break even sales = 75,000 / 40% = ` 1,87,500
b) Required sales to get desired income = (75,000 + 22,500) / 40% = ` 2,43,750
c) Shut down sales = Fixed cost – shut down cost = P/V Ratio = (75,000 – 25,000) / 40%
= ` 1,25,000

Illustration 21:
The manager of a Co. provides you with the following information:
`
Sales 4,00,000
Costs: Variable (60% of sales)
Fixed cost 80,000
Profit before tax 80,000
Income-tax
Net profit 32,000
The company is thinking of expanding the plant. The increased fixed cost with plant expansion will be ` 40,000. It
is estimated that the maximum production in new plant will be worth `2,40,000. The company also wants to earn
additional income ` 3,200 on investment. On the basis of computations give your opinion on plant expansion.
Solution:
Statement showing computation of profit before and after plant expansion:
Present (Before Expansion Value Total (After

Sr. No. Particulars
expansion)(`) (`) expansion) (`)
(i) Sales 4,00,000 2,40,000 6,40,000
(ii) Variable cost (60%) 2,40,000 1,44,000 3,84,000
(iii) Contribution (i – ii) 1,60,000 96,000 2,56,000
(iv) Fixed Cost 80,000 40,000 1,20,000
(v) Profit before tax (iii – iv) 80,000 56,000 1,36,000
(VI) Profit after tax (V × 0.40) 32,000 22,400 54,400
From the above computations, it was found that the profit is increased by ` 22,400 by expanding the plant, which
is much higher than the expected income of ` 3,200, one’s opinion should be in favour of plant expansion.
Illustration 22:
A manufacturer with overall (interchangeable among the products) capacity of 1,00,000 machine hours has
been so far producing a standard mix of 15,000 units of product A, 10,000 units of product B and C each. On
experience, the total expenditure exclusive of his fixed charges is found to be ` 2.09 lakhs and the cost ratio
among the product approximately 1, 1.5, 1.75 respectively per unit. The fixed charges comes to ` 2 per unit. When
the unit selling prices are ` 6.25 for A, ` 7.5 for B and `10.5 for C. He incurs a loss.
Mix-I Mix-II Mix-III

A 18,000 15,000 22,000
B 12,000 6,000 8,000
C 7,000 13,000 8,000
As a management accountant what mix will you recommend?
Solution:
Let variable cost per unit of A, B, C be ` X, ` 1.5X and ` 1.75X respectively.
A = 15,000 x X = 15,000 X
B = 10,000 x 1.5X = 15,000 X
C = 10,000 x 1.75X = 17,500 X
Total variable cost = 47,500 X

So, we can say,

47,500 X = 2,09,000
or, X = 4.4
Variable cost per unit of A = X = ` 4.4
Variable cost per unit of B = 1.5 (4.4) = ` 6.6
Variable cost per unit of C = 1.75 (4.4) = ` 7.7
Statement showing computation of loss at present mix
Particulars A (`) B (`) C (`) Total (`)

(i) Selling price 6.25 7.50 10.50
(ii) Variable Cost 4.40 6.60 7.70
(iii) Contribution 1.85 0.90 2.80
(iv) No. of units at present mix 15,000 10,000 10,000
(v) Total contribution 27,750 9,000 28,000 64,750
(vi) Fixed cost (35,000 × 2) 70,000
(vii) Loss 5,250
Computation of Profit/(loss) at Mix I:

(i) No. of units 18,000 12,000 7,000
(ii) Contribution per unit 1.85 0.90 2.80
(iii) Total contribution 33,300 10.800 19,600 63,700
(iv) Fixed Cost (15,000 + 10,000 + 10,000) × 2 70,000
(v) Loss 6,300
Computation of Profit/(loss) at Mix II:

(i) No. of units 15,000 6,000 13,000
(iii) Total contribution 27,750 5,400 36,400 69,550
(iv) Fixed Cost (15,000 + 10,000 + 10,000) × 2 70,000
(v) Loss 450
Computation of Profit/(loss) at Mix III:

(i) No. of units 22,000 8,000 8,000
(iii) Total contribution 40,700 7,200 22,400 70,300
(iv) Fixed Cost (15,000 + 10,000 + 10,000) × 2 70,000
(v) Profit 300
As management accountant, one should recommend Mix III because there is profit of ` 300 against loss at other
mixes including present mix.

Illustration 23:
A Co. has annual fixed costs of ` 1,40,000. In 2015 sales amounted to `6,00,000, as compared with ` 4,50,000 in
2014, and profit in 2015 was ` 42,000 higher than that in 2014.
(i) At what level of sales does the company break-even?
(ii) Determine profit or loss on a forecast sales volume of ` 8,00,000
(iii) If there is a reduction in selling price by 10% in 2016 and the company desires to earn the same amount of profit
as in 2015, what would be the required sales volume?
Solution:
= (42,000 / 1,50,000) x 100
= 28%
(i) Break even sales = Fixed cost / PV ratio
= 1,40,000 / 28%
= ` 5,00,000
(ii) Profit = (8,00,000 x 0.28) – 1,40,000
= 2,24,000 – 1,40,000
= ` 84,000
(iii) Profit in 2015 being desired profit = (6,00,000 x 0.28) – 1,40,000
= 1,68,000 – 1,40,000
= ` 28,000
Assuming same quantity of sales as in 2015 is also made in 2016, then sales would be ` 6,00,000 x 90/100 = ` 5,40,000
Consequently contribution is ` 1,08,000 (1,68,000 – 60,000)
New P/V ratio = (1,08,000 / 5,40,000) x 100 = 20%
Required sales to get the same profit as in 2012 = (1,40,000 + 28,000) / 20% = 8,40,000
(or)
2015 2016
SP 100 SP 90
C 28 V 72
V 72 C 18
P/V ratio = (18/90) x 100 = 20%.
Illustration 24:
A Co. currently operating at 80% capacity has the following; profitability particulars:
` `
Sales 12,80,000
Costs:
Direct Materials 4,00,000
Direct labour 1,60,000
Variable Overheads 80,000
Fixed Overheads 5,20,000 11,60,000
Profit: 1,20,000

An export order has been received that would utilise half the capacity of the factory. The order has either to be
taken in full and executed at 10% below the normal domestic prices, or rejected totally.
The alternatives available to the management are given below:
a) Reject order and Continue with the domestic sales only, as at present;
b) Accept order, split capacity equally between overseas and domestic sales and turn away excess domestic
demand;
c) Increase capacity so as to accept the export order and maintain the present domestic sales by:
i) buying an equipment that will increase capacity by 10% and fixed cost by `40,000 and
ii) Work overtime a time and a half to meet balance of required capacity.
Prepare comparative statements of profitability and suggest the best alternative.
Solution:
Statement showing computation of profit at present and at proposed two alternatives;
Sr. No. Particulars Present 80% Foreign 50% Domestic 50% = 100% 50% Foreign + 80% Domestic =
130%
(i) Sales 12,80,000 15,20,000 20,00,000
(ii) Variable cost
Direct material 4,00,000 5,00,000 6,50,000
Direct wages 1,60,000 2,00,000 2,60,000
Variable OH 80,000 1,00,000 1,30,000
Addl. OT cost --- --- 20,000
(iii) Total Variable cost 6,40,000 8,00,000 10,60,000
(iv) Contribution (i – ii) 6,40,000 7,20,000 9,40,000
(v) Fixed Cost 5,20,000 5,20,000 5,60,000
(VI) Profit (iv – v) 1,20,000 2,00,000 3,80,000
As the profit is more at the Alternative III, i.e. accepting foreign order fully and maintaining present domestic sales
fully, it is the best alternative to be suggested.
20%
Overtime cost = (80,000 × ) = ` 20,000.
80%
Illustration 25:
A Company has just been incorporated and plan to produce a product that will sell for ` 10 per unit. Preliminary
market surveys show that demand will be around 10,000 units per year.
The company has the choice of buying one of the two machines ‘A’ would have fixed costs of ` 30,000 per year
and would yield a profit of ` 30,000 per year on the sale of 10,000 units. Machine rB’ would have fixed costs `18,000
per year and would yield a profit of ` 22,000 per year on the sale of 10,000 units. Variable costs behave linearly for
both machines.
Required to:
a) Break-even sales for each machine
b) Sales level where both machines are equally profitable
c) Range of sales where one machine is more profitable than the other.

Solution:
Statement showing computation of Break Even sales for each machine and other required information:

(i) Selling price (`) 10 10
(ii) No. of units (`) 10,000 10,000
(iii) Sales (`) (i × ii) 1,00,000 1,00,000
(iv) Fixed cost (`) 30,000 18,000
(v) Profit (`) 30,000 22,000
(vi) Contribution (`) 60,000 40,000
(vii) Variable cost (S – C) (`) 40,000 60,000
(vii) Variable cost per unit (`) (vii / ii) 4 6
(ix) Contribution per unit (`) (vi / ii) 6 4
1. Break even sales:
A = 30,000 / 6 = 5,000 units (or) ` 50,000
B = 18,000 / 4 = 4,500 units (or) ` 45,000
2. Sales level where both machines are equally profitable (or) Breakeven level (or) indifference level
= difference in Fixed cost / difference in VC per unit.
= (30,000 – 18,000) / (6 – 4)
= 12,000 / 2
= 6,000 units
3. For sales level of 6,000 and above units, Machine A would be more profitable because its variable cost per unit
is less. For sales level below 6,000 units, Machine B would be more profitable because its fixed cost is less than
the fixed cost of Machine A
Illustration 26:
A practicing Cost Accountant now spends ` 0.90 per k.m. on taxi fares for his client’s work. He is considering to
other alternatives the purchase of a new small car or an old bigger car.
Item New Small Car Old bigger Car

Purchase price (`) 35,000 20,000
Sale price after 5 years (`) 19,000 12,000
Repairs and servicing per annum (`) 1,000 1,200
Taxes and insurance p.a. (`) 1,700 700
Petrol consumption per liter (K.m.) 10 7
Petrol price per liter (`) 3.5 3.5
He estimates that he does 10,000 K.m. annually. Which of the three alternatives will be cheaper? If his practice
expands he has to do 19,000 Km p.a. which is cheaper? Will cost of the two cars break even and why? Ignore
interest and Income-tax.

Solution:
Statement showing computation of comparative cost of three alternatives
Taxi (`) New Small car (`) Old Bigger Car (`)
Fixed Costs:
Depreciation (1,35,000 – 19,000/5); --- 3,200 1,600
(2,00,000 – 12,000/5)
Repairs & Servicing --- 1,000 1,200
Taxes & Insurance --- 1,700 700
5,900 3,500
Variable cost:
Petrol per km. 0.90 0.35 0.5
Cost at 10,000 kms. 9,000 9,400 8,500
(10,000 × 0.9) [5,900+(10,000×0.35)] [3,500+(10,000×0.5)]
Cost at 19,000 kms. 17,100 12,550 13,000
(19,000 × 0.9) [5,900+(19,000×0.35) [3,500+(19,000×0.5)]
(i) At 10,000 kms, old bigger car is cheaper.
(ii) At 19,000 kms, new smaller car is cheaper.
The distance at which cost of two cars is equal is = (5,900 – 3,500) / (0.5 – 0.35) = 16,000 Kms
Indifference point for firm’s old bigger car and taxi = 3500 / 0.4 = 8,750 kms
Indifference point for firm’s new small car and taxi = 5,900 / 0.55 = 10,727 kms
Illustration 27:
There are two plants manufacturing the same products under one corporate management which decides to
merge them.
PLANT - I PLANT - II
Capacity operation 100% 60%
Sales (`) 6,00,00,000 2,40,00,000
Variable costs (`) 4,40,00,000 1,80,00,000
Fixed Costs (`) 80,00,000 40,00,000
You are required to calculated for the consideration of the Board of Directors
a) What would be the capacity of the merged plant to be operated for the purpose of break-even?
b) What would be the profitability on working at 75% of the merged capacity.
Solution:
Statement showing computation of Breakeven of merged plant and other required information:
(` in lakhs)
Sr. Plant I Plant II Merged Plant
No. Particulars (100%)
Before (100%) After (100%) Before (60%) After (100%)
(i) Sales 600 600 240 400 1000
(ii) Variable cost 440 440 180 300 740
(iii) Contribution (i – ii) 160 160 60 100 260
(iv) Fixed Cost 80 80 40 40 120
(v) Profit (iii – iv) 80 80 20 60 140

(a) Breakeven sales of merged plant = (120 x 1,000) / 260 = 461.5384615 lakhs
For 1,000 - 100%
For 461.5384615 - ?
= (100 / 1000) x 461.5384615 = 46.15384615%
(b) Sales at 75% capacity = 1,000 x (75/100) = 750 lakhs
Profit = (750 x 0.26) – 120 = 75 Lakhs
Illustration 28:
The particulars of two plants producing an identical product with the same selling price are as under:
PLANT - A PLANT - B
Capacity utilisation 70% 60%
(` in lakhs) (` in lakhs)
Sales 150 90
Variable Costs 105 75
Fixed costs 30 20
It has been decided to merge plant B with Plant A. The additional fixed expenses involved in the merger amount
to is ` 2 lakhs.
Required:
1) Find the break-even-point of plant A and plant B before merger and the break-even point of the merged
plant.
2) Find the capacity utilisationsation of the integrated plant required to earn a profit of ` 18 lakhs.
Solution:
Statement showing computation of profit before and after merger and other required information:
(` in lakhs)
Sr. Particulars Plant A Plant B Merged (100%)

No.
Before (70%) After (100%) Before (60%) After (100%)
(i) Sales 150 214.2857 90 150 364.2857
(ii) Variable cost 105 150.0000 75 125 275.0000
(iii) Contribution 45 64.2857 15 25 89.2857
(iv) Fixed Cost 30 30.0000 20 20 52.0000
(v) Profit / (Loss) 15 34.2857 (5) 5 37.2857
Break even before (30×150)/45 = 100 lakhs (20×90)/15)=120 lakhs 52 × 364.2857/89.2857 =
merger 212.16 lakhs
P/V Ratio = (89.2857 / 364.2857) x 100 = 24.5098 %

Required sales = (52 + 18) / 0.245098 = 285.6
For 364.2857 - 100
For 285.6 - ?
Capacity = (100 / 364.2857) x 285.6 = 78.4%

Illustration 29:
A company engaged in plantation activities has 200 hectors of virgin land which can be used for growing jointly
or individually tea, coffee and cardamom, the yield per hector of the different crops and their selling prices per
Kg. are as under:
Yield in Kgs. Selling price per Kg. (`)

Tea 2,000 20
Coffee 500 40
Cardamom 100 250
The relevant data are given below:
Tea Coffee Cardamom

Labour charges ` 8 10 120
Packing materials ` 2 2 10
Other costs ` 4 1 20
14 13 150
b) Fixed costs per annum:
`
Cultivation and growing cost 10,00,000
Administrative cost 2,00,000
Land Revenue 50,000
Repairs and maintenance 2,50,000
Other costs 3,00,000
Total Cost 18,00,000
The policy of the company is to produce and sell all three kinds of products and the maximum and minimum area
to be cultivated per product is as follows:
Hectors
Maximum Minimum
Tea 160 120
Coffee 50 30
Cardamom 30 10
Calculate the most profitable product mix and the maximum profit which can be achieved.
Solution:
Statement showing computation of contribution per hectare and determination of priority for profitability:
Tea (`) Coffee (`) Cardamom (`)

(i) Sales realisation per hectare 40,000 20,000 25,000
(ii) Variable cost 28,000 6,500 15,000
(iii) Contribution 12,000 13,500 10,000
(iv) Priority II I III

Statement showing optimum mix under given conditions and computation of profit at that mix:
Particulars Tea (`) Coffee (`) Cardamom (`) Total (`)

Minimum area to be produced (hectars) 120 30 10 160
Remaining land (hectars) 20 (ii) 20 (i) 40
(i) No. of hectares 140 50 10 200
(ii) Contribution per hectares (`) 12,000 13,500 10,000
(iii) Total Contribution (`) 16,80,000 6,75,000 1,00,000 24,55,000
(iv) Fixed Cost (`) 18,00,000
(v) Profit (`) 6,55,000
Illustration 30:
A Co. running an adequate supply of labour presents the following data requests your advice about the area
to be allotted for the cultivation of various types of fruits which would result in the maximization of profits. The
company contemplates growing Apples Lemons Oranges and Peaches.
APPLES LEMONS ORANGES PEACHES

Selling price per box (`) 15 15 30 45
Seasons yield box per acre 500 150 100 200
Cost in Rupees:
Material per acre 270 105 90 150
Growing per acre labour 300 225 150 195
Picking & Packing per box 1.5 1.5 3 4.5
Transport per box 3.00 3.00 1.5 4.5
The fixed costs in each season would be:
Cultivation & Growing `56,000: Picking `42,000
Transport - `10,000: Administration-`84,000
Land Revenue - `18,000
The following limitations are also placed before you:
a) The area available is 450 acres, but out of this 300 acres are suitable for growing only Oranges and Lemons
.The balance of 150 acres is suitable for growing for any of the four fruits viz., Apples, Lemons, Oranges and
Peaches.
b) As the products may be hypothecated to banks, area allotted for any fruit should be demarcated in complete
acres and not in fractions of an acre.
c) The marketing strategy of the company requires the compulsory production of all the four types of fruits in a
season and the minimum quantity of any type to be 18,000 boxes.
Calculate the total profits that would accrue if your advice is accepted.
Solution:
Statement showing computation of contribution per acre and determination of priority for profitability:
Sr. No. Particulars APPLES (`) LEMONS (`) ORANGES (`) PEACHES (`)
(i) Sales value per acre (`) 7,500 2,250 3,000 9,000
(ii) Variable cost
Material 270 105 90 150

Growing labour 300 225 150 195

Pickings & Packing labour 750 225 300 900
Transport 1,500 450 150 900
2,820 1,005 690 2,145
(iii) Contribution 4,680 1,245 2,310 6,855
Priority II IV III I
Particulars Apples (`) Lemons (`) Oranges (`) Peaches (`) Total (`)
Minimum production in boxes 18,000 18,000 18,000 18,000
Area utilized for these minimum 36 120 180 90 426
Remaining area 24 24
(i) No. of area 36 120 180 114 450
(ii) Contribution per acre 4,680 1,245 2,310 6,855
(iii) Total contribution 1,68,480 1,49,400 7,15,800 7,81,470 15,15,150
(iv) Fixed cost 2,10,000
(v) Profit 13,05,150
Illustration 31:
A market gardener is planning his production for next season and he asked you, as a cost consultant, to recommend
the optimum mix of vegetable production for the coming year. He has given you the following data relating to
the current year:
POTATOES TOMATOES PEAS CARROTS

Area occupied in acres 25 20 30 25
Yield per acre in tons 10 8 90 12
Selling Price per ton (`) 1,000 1,250 1,500 1,350
Variable Cost per acre:
Fertilizer 300 250 450 400
Seeds 150 200 300 250
Pesticides 250 150 200 250
Direct Wages 4,000 4,500 5,000 5,700
Fixed Overhead per annum: `5,40,000
The land which is being used for the production of carrots and peas can be used for either crop but not for
potatoes and tomatoes. The land being used for potatoes and tomatoes can be used for either crops but not
carrots and peas. In order to provide an adequate market service, the gardener must produce each year at least
40 tons of each of potatoes and tomatoes and 36 tons of each peas and carrots .You are required to present a
statement to show :
(a) (1) The profit for the current year:
(2) The profit for the production mix you would recommend;
(b) Assuming that the land could be cultivated in such a way that any of the above crops could be produced and
there was no market commitment. You are required to:
(1) Advice the market gardener on which crop he should concentrate his production.
(2) Calculate the profit if he were to do so, and
(3) Calculate in rupees the breakeven - point of sales.

Solution:
Statement showing computation of contribution and determination of priority for profitability:
Particulars Potatoes Tomatoes Peas Carrots

(i) Sales per acre (`) 10,000 10,000 13,500 16,200
(ii) Variable cost (`) 4,700 5,100 5,950 6,600
(iii) Contribution (`) 5,300 4,900 7,550 9,600
(iv) Priority III IV II I
(a)
(1) Statement showing computation of profit for current year:
Sl. No. Particulars Potatoes Tomatoes Peas Carrots Total

I No. of acres 25 20 30 25 100
II Contribution per acre (`) 5,300 4,900 7,550 9,600
III Total contribution (`) 1,32,500 98,000 2,26,500 2,40,000 6,97,000
IV Fixed cost (`) 5,40,000
V Profit (`) 1,57,000
(2) Statement showing optimum mix under given conditions and computation of profit at that mix:
Sl. No. Particulars Potatoes Tomatoes Peas Carrots Total

Minimum production in tons 40 40 36 36 100
Area required for this (acre) 4 5 4 3 16
Remaining area (acre) 36 --- --- 48 84
I No. of acres 40 5 4 51
II Contribution per acre (`) 5,300 4,900 7,550 9,600
III Total contribution (`) 2,12,000 24,500 30,200 4,89,600 7,56,300
V Profit (`) 2,16,300
(b) (1) If the land is suitable for growing any of the crops and there is no market commitment, the gardener is
advised to concentrate his production on carrots.
(2) & (3):
Sl. No. Particulars `

I Sales (16,200 x 100) 16,20,000
II Contribution (9,600 x 100) 9,60,000
III Fixed cost 5,40,000
IV Profit 4,20,000
Break even sales = (5,40,000 x 16,20,000) / 9,60,000 = ` 9,11,250
Illustration 32:
Small Tools Factory has a plant capacity adequate to provide 19,800 hours of machine use. The plant can produce
all A type tools or all B type tools or a mixture of these two type. The following information is relevant

A B
Selling price (`) 10 15
Variable cost (`) 8 12
Hours required to produce 3 4
Market conditions are such that not more than 4,000 A type tools and 3,000 B type tools can be sold in a year.
Annual fixed costs are ` 9,900.
Compute the product mix that will maximise the net income to the company and find that maximum net income.
Solution:
Statement showing computation of contribution per machine hour and determination of priority for profitability:
Sl. No. Particulars A B

I Selling price (`) 10 15
II Variable cost (`) 8 12
III Contribution (`) 2 3
IV Contribution per machine hour (`) 2/3 = 0.67 3/4 = 0.75
Priority II I
Sl. No. Particulars A B Total

I No. of units 2,600 3,000
II Contribution per unit (`) 2 3
III Total contribution (`) 5,200 9,000 14,200
IV Fixed cost (`) 9,900
V Profit 4,300
Available hours 19,800
(-) Hours for B (3,000 x 4) 12,000
7,800
Units of A = 7,800 / 3 = 2,600
Illustration 33:
Taurus Ltd. produces three products A, B and C from the same manufacturing facilities. The cost and other details
of the three products are as follows:
A B C
Selling price per unit (`) 200 160 100
Variable cost per unit (`) 120 120 40
Fixed expenses/month (`) 2,76,000
Maximum production per month (units) 5,000 8,000 6,000
Total hours available for the month 200
Maximum demand per month (units) 2,000 4,000 2,400
The processing hour cannot be increased beyond 200 hrs per month.
(a) Compute the most profitable product-mix.
(b) Compute the overall break-even sales of the co., for the month based in the mix calculated in (a) above.

Solution:
(a) Statement showing computation of contribution per hour and determination of priority for profitability:
Sl. No. Particulars A B C

I Selling price (`) 200 160 100
II Variable cost (`) 120 120 40
III Contribution (`) 80 40 60
IV No. of units per hour assuming only one product is 5,000/200 8,000/200 6,000 / 200
made during the month = 25 = 40 = 30
V Contribution per hour (`) 25×80 = 2,000 40×40 =1,600 30×60 =1,800
Priority I III II
Statement showing optimum mix under the given conditions and computation of profit at that mix:
Sl. No. Particulars A B C Total

I No. of units 2,000 1,600 2,400
II Sales (`) 4,00,000 2,56,000 2,40,000 8,96,000
III Total contribution (`) 1,60,000 64,000 1,44,000 3,68,000
IV Fixed Cost (`) 2,76,000
V Profit (`) 92,000
(b) Break even sales = (2,76,000 x 8,96,000) / 3,68,000 = ` 6,72,000

Notes:
Available hours 200

(-) Hours for A (2,000/25) 80
120
(-) Hours for C (2,400/30) 80
40
Units of B = 40 x 40 = 1,600
Illustration 34:
A factory budget for a production of 1,50,000 units. The variable cost per unit is ` 14 and fixed cost is ` 2 per unit.
The company fixes its selling price to fetch a profit of 15% on cost.
(a) What is the breakeven point?
(b) What is the profit volume ratio?
(c) If it reduces its selling price by 5% how does the revised selling price affect the BEP and the profit volume ratio?
(d) If a profit increase of 10% is desired more than the budget what should be the sale at the reduced prices?
Solution:
`
Variable cost 14
Fixed cost 2
Total cost 16
(+) Profit @ 15% 2.40
Selling price 18.40


I Selling price 18.40
II Variable cost 14.00
III Contribution 4.40
IV Total contribution (1,50,000 x 4.4) 6,60,000
V Fixed cost (1,50,000 x 2) 3,00,000
VI Profit 3,60,000
(a) BEP = 3,00,000 / 4.4 = 68,182 units
(b) P/V ratio = (4.4 / 18.4) x 100 = 23.91%
(c)

I Selling price (18.4 × 95%) 17.48
II Variable cost 14.00
III Contribution 3.48
IV P/V ratio (3.48 / 17.48) × 100 19.908%
V Breakeven point = 3,00,000 / 3.48 86,207 units
(d) Desired profit = 3,60,000 x (110/100) = ` 3,96,000
Sales required = (3,00,000 + 3,96,000) / 3.48 x 17.48 = ` 34,96,000.
Illustration 35:
VINAYAK LTD. which produces three products furnishes you the following information for 2015-16:
PRODUCTS
A B C
Selling price per unit (`) 100 75 50
Profit volume ratio % 10 20 40
Maximum sales potential units 40,000 25,000 10,000
Raw Material content as % of variable cost 50 50 50
The expenses - fixed are estimated at `6,80,000. The company uses a single raw material in all the three products.
Raw material is in short supply and the company has a quota for the supply of raw materials of the value of `
18,00,000 for the year 2011-12 for the manufacture of its products to meet its sales demand.
You are required to:-
a. Set a product mix which will give a maximum overall profit keeping the short supply of raw material in view.
b. Compute that maximum profit.
Solution:
Statement showing computation of contribution per rupee of material and determination of priority for profitability:
Sl. No. Particulars A B C

I Selling price (`) 100 75 50
II Contribution (`) 10 15 20
III Variable cost (`) 90 60 30
IV Raw material cost (`) 45 30 15
V Contribution per rupee of material (`) (10/45)=0.22 (15/30)=0.50 (20/15)=1.33
Priority III II I

Sl. No. Particulars A B C Total

I No. of units 20,000 25,000 10,000
II Contribution per unit (`) 10 15 20,000
III Total contribution (`) 2,00,000 3,75,000 2,00,000 7,75,000
IV Fixed Cost (`) 6,80,000
V Profit (`) 95,000
Available material 18,00,000

(-) Material for C (10,000 x 15) 1,50,000
16,50,000
(-) Material for B (25,000 x 30) 7,50,000
9,00,000
No. of units of A = 9,00,000 / 45 = 20,000 units
Illustration 36:
A review, made by the top management of Sweet and Struggle Ltd. which makes only one product, of the result
of two first quarters of the year revealed the following:
Sales in units 10,000

Loss (`) ` 10,000
Fixed Cost (for the year `1,20,000) 30,000 Quarter
Variable cost per unit `8
The finance Manager who feels perturbed suggests that the company should at least break-even in the second
quarter with a drive for increased sales. Towards this the company should introduce a better packing which will
increase the cost by ` 0.50 per unit.
The Sales Manager has an alternate proposal. For the second quarter additional sales promotion expenses can
be increased to the extent of ` 5,000 and a profit of `5,000 can be aimed at for the period with increased sales.
The production manager feels otherwise. To improve the; demand the selling price per unit has to be reduced by
3%. As a result the sales volume can be increased to attain a profit level of ` 4,000 for the quarter.
The Managing Director asks for as a Cost Accountant to evaluate these three proposals and calculate the
additional units required to reach their respective targets help him to make a decision.
Solution:
Computation of selling price:
Particulars `
Variable cost (10,000 x 8) 80,000
Fixed cost 30,000
Total cost 1,10,000
(+) Profit / (loss) (10,000)
Sales 1,00,000
Selling price = 1,00,000 / 10,000 = `10/-
Statement showing computation of additional units required to attain the target of respective managers:

Sl. No. Particulars FM SM PM

I Selling price 10.00 10.00 9.70
II Variable cost 8.50 8.00 8.00
III Contribution 1.50 2.00 1.70
IV Fixed cost 30,000 35,000 30,000
V Target BE sales Profit of ` 5,000 Profit of ` 4,000
VI No. of units (30,000/1.5) = 20,000 (35,000+5,000)/2 = 20,000 (30,000+4,000)/1.70 = 20,000
VII Additional Units 10,000 10,000 10,000
Illustration 37:
A limited company manufactures three different products and the following information has been collected from
the books of accounts.
PRODUCTS
S T Y
Sales Mix 35% 35% 30%
Selling price (`) 30 40% 20
Variable Cost (`) 15 20% 12
Total fixed cost (`) 1,80,000
Total Sales (`) 6,00,000
The company has currently under discussion, a proposal to discontinue the manufacture of product Y and replace
it with product M, when the following results are anticipated.
PRODUCTS
S T M
Sales Mix 50% 25% 25%
Selling price (`) 30 40% 30
Variable Cost (`) 15 20% 15
Total fixed cost (`) 1,80,000
Total Sales (`) 6,40,000
Will you advise the company to changeover to production of M? Give reasons for your answer.
Solution:
Statement showing computation of profit before replacing product Y with M
Sl. No. Particulars S (35%) T (35%) Y (30%) Total

I Sales (`) 2,10,000 2,10,000 1,80,000 6,00,000
II Variable cost (`) 1,05,000 1,05,000 1,08,000 3,18,000
III Contribution (`) 1,05,000 1,05,000 72,000 2,82,000
V Profit (`) 1,02,000

Statement showing computation of profit after replacing product Y with M:
Sl. No. Particulars S (50%) T (25%) M (25%) Total

I Sales (`) 3,20,000 1,60,000 1,60,000 6,40,000
II Variable cost (`) 1,60,000 80,000 80,000 3,20,000
III Contribution (`) 1,60,000 80,000 80,000 3,20,000
V Profit (`) 1,40,000
As the profit is increased by ` 38,000 by replacing Product ‘Y’ with ‘M’, it is advisable to changeover to the
production of M.
Illustration 38:
The following figures have been extracted from the accounts of manufacturing undertaking, which produces a
single product for the previous (base) year.
Units produced and sold 10,000
Fixed overhead (`) 20,000
Variable overhead cost per unit:
Labour `4
Material `2
Overheads ` 0.8
Selling Price `10 per unit
In preparing the budget for the current (budget) year the undernoted changes have been envisaged:
Units to be produced and sold 15,000

Fixed overheads increased by ` 5,000
Fall in labour efficiency 20%
Special additional discount for Bulk purchased of material 2½ %
Variable overheads percentage reduced by 1¼ %
Fall in selling price per unit 10%
Calculate:
(i) the no. of units which must be sold to break even in each of the two years
(ii) the no. of units which would have to be sold to double the profit of the base year under base year conditions
(iii) the no. of units which will have to be sold in the budget year to maintain the profit level of preceding year.
Solution:
(i) Statement showing computation of break even units in two years and other required information:
(Amount in `)
Base/Previous Year Current/Budget Year
I Selling price 10.00 9.00
II Variable cost
Material 2.00 (2×97.5 / 100) 1.95
Labour 4.00 (4 / 0.8) 5.00
Variable Overhead 0.80 (0.8 × 98.75%) 0.79
6.80 7.74
III Contribution 3.20 1.26

IV Total contribution (10,000 × 3.2) 32,000 (15,000 × 1.26) 18,900

V Fixed cost 20,000 25,000
Profit 12,000 (6,100)
Break Even units (20,000/3.2) = 6,250 units (25,000/1.26) = 19,841 units
(ii) No. of units required to double the profit of base year under
base year conditions = 20,000 + 24,000 / 3.2 = 13,750 units
(iii) No. of units required in current year to get base year
Profit = (25,000 + 12,000) / 1.26 = 29,365 units
Illustration 39:
VINAK Ltd. operating at 75% level of activity produces and sells two products A and B. The cost sheets of these two
products are as under:-
Product A Product B
Units produced and sold 600 400
Direct materials (`) 2.00 4.00
Direct labour (`) 4.00 4.00
Factory overheads (40% fixed) (`) 5.00 3.00
Selling and administration overheads (60% fixed) (`) 8.00 5.00
Total cost (`) 19.00 16.00
Selling price per unit (`) 23.00 19.00
Factory overheads are absorbed on the basis of machine hour which is the limiting factor. The machine hour rate
is `2 per hour. The company receives an offer from Canada for the purchase of Product A at a price of `17.50 per
unit.
Alternatively the company has another offer from the Middle East for the purchase of Product B at a price of
`15.50 p.u.
In both cases, a special packing charge of fifty paise per unit has to be borne by the company.
The company can accept either of the two export orders and in the either case the company can supply such
quantities as may be possible to produce by utilising the balance of 25% of its capacity.
You are required to prepare:
(1) A statement showing the economics of the two export proposals giving your recommendation as to which the
proposal should be accepted, and
(2) A statement showing the overall profitability of the company after incorporating the export proposal
recommended by you.
Solution:
(1) Statement showing economics of two products: (Amount in `)

I Selling price 17.5 15.5
II Variable cost
Direct Labour 4.00 4.00
Factory OH 3.00 1.80
Selling & Distribution OH 3.20 2.00

Packing cost 0.50 0.50

12.70 12.30
III Contribution 4.80 3.20
IV Contribution per hour (4.8/2.5) = 1.92 (3.2/1.5) = 2.13
The order from middle east for product B is to be accepted because it has more contribution per machine hour.
Machine hours at present capacity (75%) = (600 x 2.5) + (400 x 1.5) = 2,100 hrs
Machine hours at 100% capacity = 2,100 x 100/75 = 2,800 hrs
Hours of balance capacity (25%) = 2,800 – 2,100 = 700 hours
No. of units of B that can be manufactured in those 700 hrs = 700/1.5 = 467 units.
(2) Statement showing computation of profit after incorporating the export order:
A B
Home Export Total Total
I No. of units 600 400 467 867
II Contribution per unit (`) 23-12.2=10.80 19-11.8=7.2 =3.2
III Total contribution (`) 6,480 2,880 1,494.4 4,374.4 10,854.4
IV Fixed cost (`) (2+4.8)×600=4,080 4.2×400=1,680 --- 1,680 5,760.0
V Profit (`) 2,400 1,200 1,494.4 2,694.4 5,094.4
Illustration 40:
Your company has a production capacity of 2,00,000 units per year. Normal capacity utilisation is reckoned at
90%. Standard Variable Production costs are ` 11p.u. The fixed costs are ` 3,60,000 per year. Variable selling costs
are ` 3p.u. and fixed selling costs are `2,70,000 per year. The unit selling price is `20. In the year just ended on 30th
June, 2012, the production was 1,60,000 units and sales were 1,50,000 units. The closing inventory on 30-6-2012 was
20,000 units. The actual variable production costs for the year was ` 35,000 higher than the standard.
Calculate:
(1) The profit for the year
(a) by absorption costing method
(b) by the marginal cost method.
(2) Explain the difference in profits.
Solution:
(1) (a) Statement showing computation of profit under absorption costing

Standard variable production = 1,60,000 x 11 17,60,000
(+) Variance 35,000
Actual variable production costs 17,95,000
Fixed production cost recovered (1,60,000 x ` 2*) 3,20,000
21,15,000
(+) Under recovery of fixed production overheads (3,60,000 – 3,20,000) 40,000
Production cost of goods manufactured 21,55,000
(+) Opening Stock (10,000 x 13) * 1,30,000
(-) Closing stock (21,55,000/1,60,000 x 20,000) 2,69,375

(+) Selling expenses

Variable 1,50,000 x 3 = 4,50,000
Fixed = 2,70,000 7,20,000
27,35,625
Profit 2,64,375
Sales (1,50,000 x 20) 30,00,000
Variable cost = 11.00
(+) Fixed production cost per unit
(3,60,000/2,00,000 x 90%) = *2.00
= 13.00
(b) Statement showing computation of profit under marginal costing
Particulars ` `
I Sales 30,00,000
II Variable cost
Production (17,60,000 + 35,000) 17,95,000
(+) Opening (10,000 x 11) 1,10,000
19,05,000
(-) Closing stock (17,95,000/1,60,000 x 20,000) 2,24,375 16,80,625
Selling expenses (1,50,000 x 3) 4,50,000
21,30,625
III Contribution (I-II) 8,69,375
IV Fixed cost (3,60,000 + 2,70,000) 6,30,000
V Profit (III-IV) 2,39,375
(2) The difference in profit shown by absorption costing and marginal costing is due to valuation of costs i.e., stocks
are valued at total production cost in absorption costing and at variable production cost in marginal costing.
The difference in profits can be explained as follows:
Absorption Costing Marginal Costing Profit is (less)/more in absorption costing

Opening stock 1,30,000 1,10,000 (-) 20,000
Closing stock 2,69,375 2,24,375 (+) 45,000
Illustration 41:
From the following data calculate:
(1) B.E.P expressed in amount of sales in rupees.
(2) Number of units that must be sold to earn a profit of `60,000 per year
(3) How many units must be sold to earn a net income of 10% of sales.
Sales price ` 20 per unit; variable manufacturing costs ` 11 p.u.; fixed factory overheads ` 5,40,000 p.a.; variable
selling costs ` 3 p.u. Fixed selling costs ` 2,52,000 per year.

Solution:
Particulars (`)
I Selling price 20.00
II Variable cost (11+3) 14.00
III Contribution per unit (i - ii) 6.00
BEP in units = (2,52,000 + 5,40,000) / 6 = 1,32,000

a) BEP sales = 1,32,000 x 20 = 26,40,000
b) No. of units = (7,92,000 + 60,000) / 6 = 1,42,000
c) Let ‘S’ be the no. of units required
Sales = S x 20 = 20S
Desired profit = 20S x 10% = 2S
F.C + Desired Profit

Required units =
Contribution per unit
S = (7,92,000 + 2S) / 6
4S = 7,92,000
S = 1,98,000
Illustration 42:
The Board of Directors of KE Ltd. manufacturers of three products A, B and C have asked for advice on the
production mixture of the company.
(a) You are required to present a statement to advice the directors of the most profitable mixture of the products
to be made and sold.
The statement should show:
i) The profit expected on the current budgeted production, and
ii) The profit which could be expected if the most profitable mixture was produced.
(b) You are also required to direct the director’s attention to any problem which is likely to arise if the mixture in (a)
(ii) above were to be produced.
The following information is given:-
Data for standard Costs, per unit:
Product A Product B Product C

Direct material (`) 10 30 20
Variable overhead (`) 3 2 5
Direct Labour:
Department Rate per hour Hours Hours Hours

1 0.5 28 16 30
2 1.0 5 6 10
3 0.5 16 8 30

Data from current budget production
in thousands of units per year: 10 5 6

Selling price per unit: (`) 50 68 90
Fixed cost per year ` 2,00,000
Maximum sales forecast by the Sales director for the year 2013 in
12 7 9
thousands of units
However the type of labour required by Dept 2 is in short supply and it is not possible to increase the manpower of
this dept. beyond its present level.
Solution:
(a) Statement showing computation of contribution per hour in Dept. 2 and determination of priority for profitability
Sr. No. Particulars A (`) B (`) C (`)

I Selling price 50 68 90
II Variable cost
Direct Material 10 30 20
Variable OH 3 2 5
Direct labour in
Dept 1 14 8 15
Dept 2 5 6 10
Dept 3 8 4 15
III Total Variable Cost 40 50 65
IV Contribution (i - iii) 10 18 25
V Contribution per hour in Dept. 2 10/5 = 2 18/6 = 3 25/10 = 2.5
Priority III I II
Statement showing computation of profit at current budgeted production
Sr. No. Particulars A (`) B (`) C (`) Total

I No. of units 10,000 5,000 6,000
II Contribution per unit (`) 10 18 25
III Total contribution (`) 1,00,000 90,000 1,50,000 3,40,000
V Profit (`) 1,40,000
No. of hours in Dept. 2 = (10,000 x 5) + (5,000 x 6) + (6,000 x 10) = 1,40,000 hours
Statement showing optimum mix under given conditions and computation of profit at that mix
Sr. No. Particulars A (`) B (`) C (`) Total

I No. of units 1,600 7,000 9,000
II Contribution per unit (`) 10 18 25
III Total contribution (`) 16,000 1,26,000 2,25,000 3,67,000
V Profit (`) 1,67,000

Available hours = 1,40,000

(-) hours used for B (7,000 x 6) = 42,000
= 98,000
(-) hours for C (9,000 x 10) = 90,000
= 8,000
Units of A = 8,000/5 = 1,600 units
(b) The directors are to pay attention on the point that the sales of less no. of units of ‘A’ will adversely affect the
sales of product ‘B’ and ‘C’ (or) not.
Illustration 43:
An engineering company receives in enquiry for the manufacture of certain products, where costs estimated
as follows per product. Direct materials ` 3.10; Direct labour (5 hours) ` 2.05; Direct expenses ` 0.05 Variable
overheads 20 paise per hour.
The manufacture of these products will necessitate the provision of special tooling costing approximately ` 4,500.
The price per unit is ` 8.00. For an order to be considered profitable it is necessary for it to yield a target contribution
at the rate of ` 0.30 per Labour Hour (after tooling cost).
Find out:
a. The sales level at which contribution to profit commences.
b. The sales at which the contribution exceeds the target.
Solution:
Statement Showing Computation of Contribution
Sr. No. Particulars Amount (`)

I Selling Price 8.00
II Variable Cost
Direct Labour 2.05
Direct expenses 0.05
Variable OH (5 × 0.2) 1.00
III Total Variable Cost 6.20
Contribution (i – iii) 1.80
Break even units = 4,500 / 1.8 = 2,500 units.

Break even sales = 2,500 x 8 = ` 20,000
Target profit = ` 0.3 per hour i.e. ` 1.5 per unit (5 x 0.3)
Let ‘S’ be the required units.
Desired profit = 1.5 x S = 1.5S
Required units = 4,500 + 1.5S / 1.8
⇒ S = 4,500 + 1.5S / 1.8
⇒ S = 15,000 units
Required sales = 15,000 x 8 = ` 1,20,000.

Illustration 44:
The present output details of a manufacturing department are as follows:
Average output per week - 48,000 units from 160 employees.
(`)
Saleable value of the output 1,50,000
Contribution made by output towards fixed expenses and profit 60,000
The board of directors plan to introduce more mechanisation into the department at a capital cost of ` 40,000.
The effect of this will be to reduce the number of employees to 120, but to increase the output per individual
employees by 40%. To provide the necessary incentive to achieve the increased output, the board intends to
offer a 1% increase on the piece of work price of 25 paise per article for every 2% increase in average individual
output achieved. To sell the increased output, it will be necessary to decrease the selling price by 4%. Calculate
the extra weekly contribution resulting from the proposed change and evaluate for the board’s consideration,
the worth of the project.
Solution:
Statement Showing the Computation of Selling Price Per Unit

I Sales 1,50,000
II Contribution 60,000
III Variable cost 90,000
IV Direct Labour (48,000 x 0.25) 12,000
V Variable cost other than labour 78,000
VI Variable cost other than labour per unit (78,000/48,000) 1.625
VII Output per employee (48,000/160)(units) 300
VIII Selling price (1,50,000 / 48,000) 3.125
Statement showing computation of contribution after introduction of mechanization:

I No. of employees 120
II Output per employee (300 x 140/100) 420
III Total output 50,400
IV Selling Price (3.125 x 96/100) 3
V Sales 1,51,200
VI Variable cost
V.C other than labour (50,400 x 1.625)
Labour cost (50,400 x 0.25 x 120/100) 97,020
VII Contribution 54,180
From the above computation, it was found that there is no extra contribution due to increase of mechanization
and in fact contribution decreased by ` 5,820. There is no worth of project.

1. Distinguish between Marginal Costing and Absorption costing.

2. Discuss the importance of the following
a. Key factor
b. Breakeven point
c. Margin of safety
3. State the utility of marginal costing in price fixation during trade depression and for export purposes.
4. Define marginal costing and state the features of marginal costing
5. State the benefits accrue out of application of Marginal Costing
6. Discuss the overcomes of Marginal costing in brief.
7. What do you mean by Transfer pricing. State the objects in brief.
8. Explain the various methods of Transfer pricing
9. State the objective of Inter Company Transfer Pricing
10. What do you mean by Differential Cost Analysis. State its silent features.

1. The breakeven point is the point at which,
A. There is no profit, no loss
B. Contribution margin is equal to total fixed cost
C. Total fixed cost is equal to total revenue
D. All of the above.
2. A large margin of safety indicates
A. Over capitalization
B. The soundness of business
C. Overproduction
3. The selling price is `20 per unit, variable cost `12 per unit, and fixed cost `16,000, the breakeven-point
in units will be
A. 800 units
B. 2000 units
C. 3000 units
D. None of these

4. The P/V ratio of a product is 0.4 and the selling price is `40 per unit. The marginal cost of the product
would be,
A. `8
B. ` 24
C. ` 20
D. ` 25
5. Fixed cost per unit decreases when,
A. Production volume increases
B. Production volume decreases
C. Variable cost per unit decreases
D. Variable cost per unit increases.
6. Each of the following would affect the breakeven point except a change in the,
A. Number of units sold.
B. Variable cost per unit
C. Total fixed cost
D. Sales price per unit.
7. A decrease in sales price,
A. Does not affect the break-even-sales.
B. Lowers the net profit
C. Increases the break-even-point.
D. Lowers the break-even-point
8. Under the marginal costing system, the contribution margin discloses the excess of,
A. Revenue over fixed cost
B. Projected revenue over the break-even-point
C. Revenues over variable costs
D. Variable costs over fixed costs.
9. Cost volume-profit analysis allows management to determine the relative profitability of product by,
A. Highlighting potential bottlenecks in the production process
B. Keeping fixed costs to an obsolete minimum
C. Determine contribution margin per unit and projected profits at various levels production
D. Assigning costs to a product in a manner that maximizes the contribution margin.
10. Contribution margin is known as,
A. Marginal income
B. Gross profit
C. Net income
D. Net profit.

Column A Column B
1 Differential cost is adopted. A Contribution / Sales X 100
2 Contribution B Decision Making
3 P/V ratio C Profit/ Pv ratio
4 Differential costing D Differential Cost
5 Shut down point E To ascertain Pv ratio.
6 Marginal costing helps in the measuring of. F Fixed cost / Pv ratio
7 Margin of Safety G Fixed per unit
8 Difference between the costs of two alternatives is known as. H Divisional performance
9 Variable cost remain I Marginal Costing
10 Breakeven point J Avoidable fixed cost / Pv ratio
[Ans: 1-I, 2-E, 3-A, 4-B, 5-J, 6-H, 7-C, 8-D, 9-G, 10-F]
State the following statement is true or false:

1. Marginal cost includes prime cost plus fixed overheads.
2. Contribution is the difference between the selling price and the variable costs.
3. An increase in the volume of the production will result in reduction in unit variable cost.
4. The amount of profit under absorption costing and marginal costing is one and the same.
5. All variable costs are included in the marginal cost.
6. Margin of safety is the difference between actual sales and the sales and the break even point.
7. The difference between the budgeted output and the actual output is known as margin of safety.
8. The breakeven point will be lower if the selling price is increased but the amount of cost does not
change.
9. At breakeven point margin of safety is nil.
10. When fixed cost is deducted from total cost, we get marginal cost.
[Ans: 1-False; 2-True; 3-False; 4-False; 5-True; 6-True; 7-False; 8-False; 9-True; 10-True]
Fill in the blanks:

1. In cost accounting, marginal cost does not include _____________ .
2. In absorption costing,_______________ cost is added to inventory.
3. Sales minus variable cost = fixed costs plus________________ .
4. Profit volume ratio is contribution /__________________X 100
5. At breakeven point total revenue is equal to costs.
6. In marginal costing, fixed costs are charged to________ __________.

7. Margin of safety is the difference between________and ________________ .

8. In marginal costing, stock is valued at ___________.
9. When the production volume is nil, the loss will be equal to_________.
10. Constraint on various resources is also known as _____________ .
[Ans: 1.-Fixed Cost; 2.-Fixed; 3.-Porfit; 4.-Sales; 5.-Fixed; 6.-Costing Profit and loss account; 7.-Total Sales– BEP
Sales; 8.-Variable cost; 9.-Fixed cost; 10.-Key factor or Limiting factor]

Budgeting and Budgetary Control
Study Note - 3
BUDGETING AND BUDGETARY CONTROL
3.1 Budgetary Control and Preparation of Functional and Master Budgeting

3.2 Fixed, Variable, Semi-Variable Budgets
3.3 Zero Based Budgeting (ZBB)
3.1 BUDGETARY CONTROL AND PREPARATION OF FUNCTIONAL AND MASTER BUDGETING
BUDGETARY CONTROL
Budgetary control is defined as “the establishment of budgets relating the responsibilities of executives to the
requirements of a policy and the continuous comparison of actual with budgeted results, either to secure by
individual action the objective of that policy or to provide a basis for its revision.”
From the above definition, the steps for Budgetary Control can be drawn as follows: -
(i) Establishment of Budgets:
Budgetary control primarily aims at preparation of various budgets such as sales Budget, production budget,
overhead expenses budget, cash budget etc.,
(ii) Responsibilities of executives:
The budgetary control system is designed to fix responsibilities on executives through preparation of budgets.
(iii) Policy making:
The established policies of the organisation are designed as budgets so as to fix responsibility on executives.
(iv) Comparison of actuals with budgets:
After establishing the budgets, the actuals are compared with them and any deviations, if any are called variances.
(v) Achieving the desired result:
The desired result of the budgetary control system is comparison of actuals with the budgeted results and the
causes of variances, if any, are analysed.
(vi) Reporting to Top Management:
After the causes of Variances are analysed, the variances and their causes are reported to top management so
that the remedial action can be taken.
Advantages of Budgetary Control:
(i) Budgetary control aims at maximisation of profits through optimum utilisation of resources.
(ii) It is a technique for continuous monitoring of policies and objectives of the organisation.
(iii) It helps in reducing the costs, thereby helps in better utilisation of funds of the organisation.
(iv) All the departments of the organisation are closely coordinated through establishment of plans resulting in
smooth functioning of the organisation.
(v) Since budgets fix the responsibilities of the executives, they act as a plan of action for them there by reducing
some of their work.
(vi) It facilitates analysis of variances, thereby identifying the areas where deficiencies occur and proper remedial
action can be taken.

(vii) It facilitates the management by exception.

(viii) Budgets act as a motivating force to achieve the desired objective of the organisation.
(ix) It assists delegation of authority and is a powerful tool of responsibility accounting.
(x) It helps in stabilizing the conditions in industries which face seasonal fluctuations.
(xi) It helps as a basis for internal audit.
(xii) It provides a suitable basis for introducing the payment by results system.
(xiii) It ensures adequacy of working capital to the organisation.
(xiv) It aids in performance analysis and performance reporting system.
(xv) It aids in obtaining bank credit.
(xvi)Budgets are forerunners of standard costs in the sense that they create necessary conditions to suit setting up
of standard costs.
Preliminaries for the Adoption of a System of Budgetary Control:
For the successful implementation of a system of budgetary control certain pre-requisites are to be fulfilled. These
are enumerated below:
(i) There should be an organization chart laying out in clear terms the responsibilities and duties of each level of
executives, and the delegation of authority to the various levels. For complete success, a solid foundation in
this regard should be laid at the outset.
(ii) The objectives, plans and policies of the business should be defined in clear cut and unambiguous terms.
(iii) The output level for which budgets are fixed, i.e., the budgeted output, should be stated.
(iv) The particular budget factor which will be the starting point of the preparation of the various budgets should
be indicated.
(v) There should be an efficient system of accounting to record and provide data in line with the budgetary
control system.
(vi) For the establishment and efficient execution of the plan, a Budget Committee should be set up.
(vii) There should be a proper system of communication and reporting between the various levels of manage-
ment.
(viii) There should be a charter of programme. This is usually in the form of a budget manual.
(ix) The budgets should primarily be prepared by those who are responsible for performance.
(x) The budgets should be complete, continuous and realistic.
(xi) There should be an assurance from the top management executives of co-operation and acceptance of the
budgetary system.
Functional Budget:
If budgets are prepared of a business concern for a certain period taking each and every function separately
such budgets are called functional budgets.
Example: Production, Sales, purchases, cost of production, cash, materials etc.
The following are the various functional budgets, some of which are briefly explained here under:
(i) Sales Budget: The sales budget is a forecast of total sales, expressed in terms of money or quantity or both. The
first step in the preparation of the sales budget is to forecast as accurately as possible, the sales anticipated during
the budget period. Sales forecasts are usually prepared by the sales manager assisted by the market research
personnel.
Factors to be considered in preparing Sales Budget:-
As business existence depends upon the sales it is going to make and therefore it is an important one to be

prepared meticulously. It is the forecast of what it can reasonably sell to its customers during the period for which
budget is prepared. The company’s profit mostly depends upon the ability to sell its products to customers. In
the present era it is indispensable to establish the demand for the product even before it is produced. It is the
sales order book that the company’s continuity depends upon. Also, a reasonable degree of accuracy must be
there in preparing a sales budget unless its sales are accurately forecast, production estimates will also become
erroneous. A good amount of experience must be necessary to prepare the sales budget. Yet the following
factors must be considered in preparing the sales budget:
(a) The locality of the market i.e., domestic or export
(b) The target customers i.e., industry or trade or a section or group of general public etc.,
(c) The product portfolio i.e., the number of products offered and their popularity among the target customers.
(d) The market share of each product and its influence on the product portfolio and the total market
(e) The effectiveness of existing marketing policy on the current sales volume and value.
(f ) The market share of competitor’s products and their effect on the company’s sales.
(g) Seasonal fluctuation in sales.
(h) Expenditure on advertisement and its impact on sales.
(ii) Production Budget: The production budget is a forecast of the production for the budget period. Production
budget is prepared in two parts, viz. production volume budget for the physical units of the products to be
manufactured and the cost of production or manufacturing budget detailing the budgeted cost under material,
labour, and factory overhead in respect of the products.
Factors to be considered in Production Budget:
Next to the sales budget, the main function of a business concern is the production and for this, a budget is
prepared simultaneously with the sales budget. It is the forecast of production during the period for which the
budget is prepared. It can also be prepared in two parts viz., production volume budget for the physical units i.e.,
the number of units, the tonnes of production etc., and the cost of production or manufacture showing details of
all elements of the manufacture. While preparing the production budget, the following factors must be taken into
consideration:-
(a) Production plan:-
Production planning is an important part of the preparation of the production budget. Optimum utilisation
of plant capacity is taken by eliminating or reducing the limiting factors and thereby effective production
planning is made.
(b) The capacity of the business concern:-
It is to be ensured that the capacity of the organisation will coincide the budgeted production or not. For
this purpose, plant utilisation budget will also be necessary. The production budget must be based on normal
capacity likely to be achieved and it should not be too high or too low.
(c) Inventory Policy:-
While preparing the production budget it is also necessary to see to what extent materials are available for
producing the budgeted production. For that purpose, a purchase budget or a purchase plan must also be
studied. Similarly, on the other hand, it is also necessary to verify the extent to which the inventory of finished
goods is to be carried.
(d) Sales Policy:-
Sales budgets must also be considered before preparing production budget because it may so happen that
the entire production of the concern may not be sold. In such a case the production budget must be in line
with the sales budget.
(e) Sequence of Operations Policy:-
A plan of the sequence of operations of production for effective preparation of a production budget should
always be there.

(f) Management Policy:-

Last, but not the least, the policy of the management should also be considered before preparing the
production budget.
Objectives and Advantages of Production budget:
• Optimum utilisation of the productive resources of the organisation;
• Maintaining low inventory which results in risk of deterioration and fall in prices;
• Focus on the factors that are necessary to frame policies and plan sequence of operations;
• Projection of policies framed, on the basis of past performance, into the future to get the desired results;
• To see that right materials are provided at right place and at right time;
• Helps in scheduling of production so that delivery dates are met and customer satisfaction is gained;
• Helpful in preparation of projected profit and loss statement, which is useful in evaluation of performance and
profitability.
(iii) Materials Budget: The material budget includes quantities of direct materials; the quantities of each raw
material needed for each finished product in the budget period is specified. The input data for this budget
is obtained by applying standard material usage rates by each type of material to the volume of output
budgeted.
(iv) Purchase Budget: The purchase budget establishes the quantity and value of the various items of materials
to be purchased for delivery at specified points of time during the budget period taking into account the
production schedule of the concern and the inventory requirements. It takes into account the requirements
for the entire budget plan as per the sales, materials, maintenance, research and development, and capital
budgets. Purchases may be required to be made in respect of direct and indirect materials, finished goods for
resale, components and parts, and purchased services. Before incorporation in the purchase budget, these
purchase requirements should be suitably ascertained. Purchase budget also includes material procurement
budget.
(v) Cash Budget: Cash Budget is estimated receipts and expenses for a definite period, which usually are cash
sales, collection from debtors and other receipts and expenses and payment to suppliers, payment of wages,
payment of other expenses etc.
(vi) Direct Labour Budget.
(vii) Human Resources Budget.
(viii) Selling and distribution cost budget.
(ix) Administration Cost Budget.
(x) Research and development Cost Budget etc.
(xi) Master Budget: Master budget is the budget prepared to cover all the functions of the business organisation.
It can be taken as the integrated budget of business concern, that means, it shows the profit or loss and
financial position of the business concern such as Budgeted Profit and Loss Account, Budgeted Balance Sheet
etc. Master budget, also known as summary budget or finalized profit plan, combines all the budgets for a
period into one harmonious unit and thus, it shows the overall budget plan. The master budget incorporates
all the subsidiary functional budgets and the budgeted Profit and Loss Account and Balance Sheet. Before
the budget plan is put into operation, the master budget is considered by the top management and revised if
the position of profit disclosed therein is not found to be satisfactory. After suitable revision is made, the master
budget is finally approved and put into action. Another view regards the budgeted Profit and Loss Account
and the Balance Sheet as the master budget.

3.2 FIXED, VARIABLE, SEMI-VARIABLE BUDGETS

3.2 FIXED, VARIABLE, SEMI-VARIABLE BUDGETS
Fixed or Rigid Budget:

When budgets are prepared for a fixed or standard volume of activity, they are called static or rigid or fixed
budgets. They do not change with the changes in the volume of the output. These are prepared normally 3
months in advance of the year. However these will not be much helpful in comparing the actual activity, as these
are prepared at a fixed volume of output. It, however, does not mean that the fixed budget is a rigid one, not to
be changed at all. Though not adjusted to the actual volume attained, a fixed budget is liable to revision if due
to business conditions undergoing a basic change or due to other reasons, actual operations differ widely from
those planned in the fixed budget.
Fixed budgets are most suited for fixed expenses. In case of discretionary costs situations where the expenditure
is optional and has no relation with the output, e.g. expenditure on research and development, advertising, and
new projects. A fixed budget has only a limited application and is ineffective as a tool for cost control. Fixed
budgets are useful where the plan permits maximum stabilization of production, as for example, for concerns
which manufacture to build up inventories of finished products and components.
Flexible Budget:
A flexible budget is a budget that is prepared for different levels of activity or capacity utilization or volume of
output. If the budgets are prepared in such a way so as to change in accordance with the volume of output,
they are called flexible budgets. These can be prepared from fixed budget which are also called revised budgets.
These are much helpful in comparison with actual because the exact deviations are found for which timely
corrective action can be taken. The basic idea of a flexible budget is that there shall be some standard of cost
and expenditures. Thus, a budget prepared in a manner to give budgeted costs for any level of activity is known
as flexible budget. Such budget is prepared after considering the variable and fixed elements of costs and the
changes, which may be expected for each item at various levels of operations. Thus a flexible budget recognises
the difference in behaviour between fixed and variable costs in relation to fluctuations in production or sales and
is designed to change appropriately with such fluctuations. In flexible budget, data relating to costs, expenditures
may progressively be changed in any month in accordance with actual output achieved. While preparing flexible
budgets, estimates of costs and expenditures on the basis of standards determined are made from minimum to
maximum level of operations.
Difference between Fixed and Flexible Budgets:
Fixed Budget Flexible Budget

(i) It does not change with actual volume of activity It can be recasted on the basis of activity level to
achieved. Thus it is known as rigid or inflexible budget. be achieved. Thus it is not rigid.
(ii) It operates on one level of activity and under one set It consists of various budgets for different levels of
of conditions. It assumes that there will be no change activity.
in the prevailing conditions, which is unrealistic.
(iii) Here as all costs like – fixed, variable and semi-variable Here analysis of variance provides useful
are related to only one level of activity so variance information as each cost is analysed according to
analysis does not give useful information. its behaviour.
(iv) If the budgeted and actual activity levels differ Flexible budgeting at different levels of activity
significantly, then the aspects like cost ascertainment facilitates the ascertainment of cost, fixation of
and price fixation do not give a correct picture. selling price and tendering of quotations.
(v) Comparison of actual performance with budgeted It provides a meaningful basis of comparison of the
targets will be meaningless specially when there is a actual performance with the budgeted targets.
difference between the two activity levels.
Principal Budget Factor:

Budgets cover all the functional areas of the organisation. For the effective implementation of the budgetary
system, all the functional areas are to be considered which are interlinked. Because of these interlinks, certain
factors have the ability to affect all other budgets. Such factor is known as principle budget factor.

Principal Budget factor is the factor the extent of influence of which must first be assessed in order to ensure that
the functional budgets are reasonably capable of fulfilment. A principal budget factor may be lack of demand,
scarcity of raw material, non-availability of skilled labour, inadequate working capital etc. If for example, the
organisation has the capacity to produce 2500 units per annum. But the production department is able to
produce only 1800 units due to non-availability of raw materials. In this case, non-availability of raw materials is
the principal budget factor (limiting factor). If the sales manger estimates that he can sell only 1500 units due to
lack of demand. Then lack of demand is the principal budget factor. This concept is also known as key factor, or
governing factor. This factor highlights the constraints with in which the organisation functions.
Responsibility Accounting:
One of the recent developments in the field of management accounting is the responsibility accounting, which
is helpful in exercising cost control. ‘Responsibility Accounting is a system of accounting that recognizes various
responsibility centers throughout the organization and reflects the plans and actions of each of these centers by
assigning particular revenues and costs to the one having the pertinent responsibility. It is also called profitability
accounting and activity accounting.
It is a system in which the person holding the supervisory posts as president, function head, foreman, etc are given
a report showing the performance of the company or department or section as the case may be. The report
will show the data relating to operational results of the area and the items of which he is responsible for control.
Responsibility accounting follows the basic principles of any system of cost control like budgetary control and
standard costing. It differs only in the sense that it lays emphasis on human beings and fixes responsibilities for
individuals. It is based on the belief that control can be exercised by human beings, so responsibilities should be
fixed for individuals.
Principles of responsibility accounting are as follows:
(a) A target is fixed for each department or responsibility center.
(b) Actual performance is compared with the target.
(c) The variances from plan are analysed so as to fix the responsibility.
(d) Corrective action is taken by higher management and is communicated.
Performance Budgeting:
Performance Budgeting is synonymous with Responsibility Accounting which means thus the responsibility of
various levels of management is predetermined in terms of output or result keeping in view the authority vested
with them. The main concepts of such a system are enumerated below:
(a) It is based on a classification of managerial level for the purpose of establishing a budget for each level. The
individual in charge of that level should be made responsible and held accountable for its performance over
a given period of time.
(b) The starting point of the performance budgeting system rests with the organisation chart in which the spheres
of jurisdiction have been determined. Authority leads to the responsibility for certain costs and expenses which
are forecast or present in the budget with the knowledge of the manager concerned.
(c) The costs in each individual’s or department’s budget should be limited to the cost controllable by him.
(d) The person concerned should have the authority to bear the responsibility.
3.3 Zero Based Budgeting (ZBB)
3.3 ZERO BASED BUDGETING (ZBB)
It differs from the conventional system of budgeting mainly it starts from scratch or zero and not on the basis of
trends or historical levels of expenditure. In the customary budgeting system, the last year’s figures are accepted
as they are, or cut back or increases are granted. Zero based budgeting on the other hand, starts with the premise
that the budget for next period is zero so long the demand for a function, process, project or activity is not justified
for each rupee from the first rupee spent. The assumptions are that without such a justification no spending will be
allowed. The burden of proof thus shifts to each manager to justify why the money should be spent at all and to
indicate what would happen if the proposed activity is not carried out and no money is spent.

The first step in the process of zero base budgeting is to develop an operational plan or decision package. A
decision package identifies and describes a particular activity with a view to:
(i) Evaluate and allotted ranking the activity against other activities competing for the same scarce resources,
and
(ii) Decide whether to accept or reject or amend the activity.
For this purpose, each package should give details of costs, returns, purpose, expected results, the alternatives
available and a statement of the consequences if the activity is reduced or not performed at all.
The advantages of Zero based budgeting are:
(a) Out of date and inefficient operations are identified.
(b) Allows managers to promptly respond to changes in the business environment.
(c) Instead of accepting the current practice, it creates a challenging and questioning attitude.
(d) Allocation of resources is made according to needs and the benefits derived.
(e) It has a psychological impact on all levels of management which makes each manager to ‘pay his way’.
Areas where zero-base budgeting is applicable
Zero-base Budgeting is more suitably applicable to discretionary cost areas. These costs may have no relation to
volume or activity and generally arise as a result of management policies. Where standards are determinable,
those costs associated with the inputs should be controlled through the use of standard costing. On the other
hand, if output as a function of input cannot be specified. Zero-base Budgeting may be more suitably applied.
Thus, service or support-type activities are more suitable for Z.B.B.
PROCESS OF ZERO-BASE BUDGETING OR STEPS INVOLVED IN ZERO-BASE BUDGETING
The process of Zero-Base Budgeting involves the following steps:
1. Identification of ‘Decision units’
2. Preparation and development of decision packages.
3. Ranking of priority.
4. Approval and Funding
Identification of ‘Decision units’- A decision unit refers to a tangible activity or group of activities for which a single
manager has the responsibility for successful performance. Thus, decision unit is a programme or a project or a
segment of the organisation for which separate budgets are to be prepared.
Preparation of Decision Packages: Preparation of decision packages is a set of documents which identify and
describe activities of the unit in such a way that the management can evaluate and rank them against others
competing for resources (limited) and decide whether to approve or disapprove.
Ranking of Priority: The third step involved in Z.B.B. is the ranking of proposed alternatives included in decision
packages for various decision units or of various decision packages for the same decision unit.
Funding: Funding involves the allocation of available resources of the organisation to various decision units keeping
in mind the alternative which has been selected and approved through ranking process.
Illustration 1:
From the following figures prepare the raw material purchase budget for January, 2015:
Materials
A B C d e F
Estimated Consumption 1,20,000 44,000 1,32,000 36,000 88,000 1,72,000
Standard Price per unit 25 p. 5 p. 15 p. 10 p. 20 p. 30 p.

Solution:
Raw Materials Purchase Budget For January 2015
Type A B C D E F Total
Estimated Consumption (units) 1,20,000 44,000 1,32,000 36,000 88,000 1,72,000
Add: Estimated stock on Jan 31, 2015 20,000 8,000 28,000 4,000 16,000 32,000
(units)
1,40,000 52,000 1,60,000 40,000 1,04,000 2,04,000
Less: estimated stock on Jan1, 2015 (units) 16,000 6,000 24,000 2,000 14,000 28,000
Estimated purchase (units) 1,24,000 46,000 1,36,000 38,000 90,000 1,76,000 6,10,000
Rate per unit (`) 0.25 0.05 0.15 0.10 0.20 0.30
Estimated purchases (`) 31,000 2,300 20,400 3,800 18,000 52,800 1,28,300
Illustration 2:
A company manufactures product - A and product -B during the year ending 31st December 2015, it is expected
to sell 15,000 kg. of product A and 75,000 kg. of product B at `30 and `16 per kg. respectively. The direct materials
P, Q and R are mixed in the proportion of 3: 5: 2 in the manufacture of product A, Materials Q and R are mixed in
the proportion of 1:2 in the manufacture of product B. The actual and budget inventories for the year are given
below:
Opening Stock Expected Closing stock Anticipated cost per Kg.

Kg. Kg. `
Material – P 4,000 3,000 12
Material –Q 3,000 6,000 10
Material – R 30,000 9,000 8
Product - A 3,000 1,500 —
B 4,000 4,500 —
Prepare the Production Budget and Materials Budget showing the expenditure on purchase of materials for the
year ending 31-12-2015.
Solution:
Production Budget for the Products A & B

Sales 15,000 75,000
16,500 79,500
Less: opening Stock 3,000 4,000
Production 13,500 75,500
Material Purchase Budget for the Year ending Dec 31st 2015
Particulars P Q R Total
Material required for product A in the ratio of 3:5:2 4,050 6,750 2,700 13,500
Material required for product B in the ratio of 1:2 --- 25,167 50,333 75,500
Total requirement 4,050 31,917 53,033

Add: Closing Stock 3,000 6,000 9,000

7,050 37,917 62,033
Less: opening Stock 4,000 3,000 30,000
Purchases (in units) 3,050 34,917 32,033
Cost per Kg. 12 10 8
Total Purchase cost (`) 36,600 3,49,170 2,56,264 6,42,034
Illustration 3:
The following details apply to an annual budget for a manufacturing company.
Quarter 1st 2nd 3rd 4th

Working days 65 60 55 60
Production (units per working day) 100 110 120 105
Raw material purchases (% by weight of annual total) 30% 50% 20% —
Budgeted purchase price/Kg.(`) 1 1.05 1.125 —
Quantity of raw material per unit of production 2 kg. Budgeted closing stock of raw material 2,000 kg. Budgeted
opening stock of raw material 4,000 kg. (Cost ` 4,000)
Issues are priced on FIFO Basis. Calculate the following budgeted figures.
(a) Quarterly and annual purchase of raw material by weight and value.
(b) Closing quarterly stocks by weight and value.
Solution:
Material Purchase Budget

Production 6,500 6,600 6,600 6,300 26,000
(65 × 100) (60 × 110) (120 × 55) (60 × 105)
Material Required (Production x 2) 13,000 13,200 13,200 12,600 52,000
Closing Stock 2,000
54,000
Less: Opening Stock 4,000
Purchases by Weight 15,000 25,000 10,000 --- 50,000
Computation of Purchases by Value

Purchases (Weight) 15,000 25,000 10,000 ---
(50,000 × 30%) (50,000 × 50%) (50,000 × 20%)
Cost per Kg. 1 1.05 1.125 ---
Purchases (`) 15,000 26,250 11,250 --- 52,500

Budget Showing Closing Quarterly Stocks by Weight and Value
Particulars Quarter 1 Quarter 2 Quarter 3 Quarter 4

opening Stock 4,000 6,000 17,800 14,600
Purchases 15,000 25,000 10,000 -
19,000 31,000 27,800 14,600
Material consumed 13,000 13,200 13,200 12,600
Closing Stock by Weight 6,000 17,800 14,600 2,000
Closing Stock by Value (`) 6,000 18,690 16,080 2,250
(6,000 x 1) (17,800 x 1.05) {(10,000 x 1.125)+ (4,600 x 1.05)} (2,000 x 1.125)
Illustration 4:
You are required to prepare a Selling overhead Budget from the estimates given below:
Particulars (`)
Advertisement 1,000
Salaries of the Sales dept. 1,000
Expenses of the Sales dept.(Fixed) 750
Salesmen’s remuneration 3,000
Salesmen’s and dearness Allowance - Commission @ 1% on sales affected
Carriage outwards: estimated @ 5% on sales
Agents Commission: 7½% on sales
The sales during the period were estimated as follows:
(a) `80,000 including Agent’s Sales `8,000
(b) `90,000 including Agent’s Sales `10,000
(c) `1,00,000 including Agent’s Sales `10,500
Solution:
Selling Overhead Budget
Sales 80,000 90,000 1,00,000

(A) Fixed overhead:
Advertisement 1,000 1,000 1,000
Salaries of the sales dept. 1,000 1,000 1,000
Expenses of the sales dept. 750 750 750
Salesmen remuneration 3,000 3,000 3,000
Total (A) 5,750 5,750 5,750
(B) Variable overhead:
Commission (72,000 x 1%) = 720 (80,000 x 1%) = 800 (89,500 x 1%) = 895
Carriage outwards 4,000 4,500 5,000
Agents Commission (8,000 x 7.5%) = 600 (10,000 x 7.5%) = 750 (10,500 x 7.5%) = 788
Total (B) 5,320 6,050 6,683
Grand Total (A+B) 11,070 11,800 12,433

Illustration 5:
ABC Ltd. a newly started company wishes to prepare Cash Budget from January. Prepare a cash budget for the
first six months from the following estimated revenue and expenses.
Overheads
Month Total Sales (`) Materials (`) Wages (`)
Production (`) Selling & Distribution (`)
January 20,000 20,000 4,000 3,200 800
February 22,000 14,000 4,400 3,300 900
March 28,000 14,000 4,600 3,400 900
April 36,000 22,000 4,600 3,500 1,000
May 30,000 20,000 4,000 3,200 900
June 40,000 25,000 5,000 3,600 1,200
Cash balance on 1st January was `10,000. A new machinery is to be installed at `20,000 on credit, to be repaid
by two equal instalments in March and April, sales commission @5% on total sales is to be paid within a month
following actual sales.
`10,000 being the amount of 2nd call may be received in March. Share premium amounting to `2,000 is also
obtained with the 2nd call. Period of credit allowed by suppliers — 2months; period of credit allowed to customers
— 1month, delay in payment of overheads 1 month. delay in payment of wages ½ month. Assume cash sales to
be 50% of total sales.
Solution:
Cash Budget for the First 6 Months

opening Balance (A) 10,000 18,000 29,800 27,000 24,700 33,100
Add: Receipts (B)
Cash Sales (50%) 10,000 11,000 14,000 18,000 15,000 20,000
Collection from debtors --- 10,000 11,000 14,000 18,000 15,000
Share call money (including share premium) --- --- 12,000 --- --- ---
Total (A+B) 20,000 39,000 66,800 59,000 57,700 68,100
Less: Payments
Materials --- --- 20,000 14,000 14,000 22,000
Wages 2,000 4,200 4,500 4,600 4,300 4,500
overheads --- 4,000 4,200 4,300 4,500 4,100
Sales Commission --- 1,000 1,100 1,400 1,800 1,500
Instalment of Machinery purchase --- --- 10000 10000 --- ---
Total Payments(C) 2,000 9,200 39,800 34,300 24,600 32,100
Closing Balance (A+B-C) 18,000 29,800 27,000 24,700 33,100 36,000
Note: According to credit terms wages to be taken at half of the current month plus half of the previous month.

Illustration 6:
Prepare a Cash Budget for the three months ending 30th June, 2016 from the information given below:
(a)
MONTH SALES (`) MATERIALS (`) WAGES (`) OVERHEADS (`)

February 14,000 9,600 3,000 1,700
March 15,000 9,000 3,000 1,900
April 16,000 9,200 3,200 2,000
May 17,000 10,000 3,600 2,200
June 18,000 10,400 4,000 2,300
(b) Credit terms are:
Sales/debtors: 10% sales are on cash, 50% of the credit sales are collected next month and the balance in the
following month.
Creditors: Materials 2 months
Wages 1/4 month
Overheads 1/2 month.
(c) Cash and bank balance on 1st April, 2016 is expected to be ` 6,000.
(d) other relevant information are:
(i) Plant and machinery will be installed in February 2016 at a cost of `96,000. The monthly instalment of
`2,000 is payable from April onwards.
(ii) Dividend @ 5% on preference share capital of `2,00,000 will be paid on 1st June.
(iii) Advance to be received for sale of vehicles `9,000 in June.
(iv) Dividends from investments amounting to `1,000 are expected to be received in June.
Solution:
Cash Budget for the 3 Months Ending 30th June 2016 (Amount in `)
Particulars April May June

opening Balance 6,000 3,950 3,000
Add: Receipts :
Cash Sales 1,600 1,700 1,800
Collection from debtors [see note(1)] 13,050 13,950 14,850
Advance for sale of vehicles - - 9,000
Dividends from Investments - - 1,000
Total (A+B) 20,650 19,600 29,650
Less: Payments
Materials 9,600 9,000 9,200
Wages (see note2) 3,150 3,500 3,900
overheads 1,950 2,100 2,250
Instalment of Plant & Machinery 2,000 - 2,000 - 2,000
Preference dividend 10,000
Total (C) 16,700 16,600 27,350
Closing Balance (A+B-C) 3,950 3,000 2,300

Working Notes:
(i) Computation of Collection from Debtors (Amount in `)
Month Total Sales Credit Sales Feb Mar Apr May June
Feb 14,000 12,600 --- 6,300 6,300 --- ---
Mar 15,000 13,500 --- --- 6,750 6,750 ---
Apr 16,000 14,400 --- --- --- 7,200 7,200
May 17,000 15,300 --- --- --- --- 7,650
13,050 13,950 14,850
(ii) Wages payment in each month is to be taken as three-fourths of the current month plus one-fourth of the
previous month.
Illustration 7:
Draw up a flexible budget for overhead expenses on the basis of the following data and determine the overhead
rates at 70%, 80% and 90%
Plant Capacity At 80% capacity (`)

Variable Overheads:
Stores including spares 4,000
Semi Variable:
Power (30% - Fixed: 70% -Variable) 20,000
Repairs (60%- Fixed: 40% -Variable) 2,000
Fixed Overheads:
depreciation 11,000
Insurance 3,000
Salaries 10,000
Total overheads 62,000
Estimated Direct Labour Hours 1,24,000
Solution:
Flexible Budget at Different Capacities and Determination of Overhead Rates
Particulars 70% (`) 80% (`) 90% (`)

(A) Variable overheads:
Indirect labour 10,500 12,000 13,500
Stores including spares 3,500 4,000 4,500
Total (A) 14,000 16,000 18,000
(B) Semi Variable overheads:
Power (See note) 18,250 20,000 21,750
Repairs (See note) 1,900 2,000 2,100
Total (B) 20,150 22,000 23,850
(C) Fixed overheads:
Depreciation 11,000 11,000 11,000
Insurance 3,000 3,000 3,000

Salaries 10,000 10,000 10,000

Total (C) 24,000 24,000 24,000
Grand Total (A+B+C) 58,150 62,000 65,850
Labour Hours  7 1,24,000  9
1,24,000×  = 10,8,500 1,24,000×  = 1,39,500
 8  8 
overhead rate per hour (`)

58,150 62,000 65,850
= 0.536 = 0.50 = 0.472
1,08,500 1,24,000 1,39,500
Working notes: Semi Variable overheads:
70% 90%
Power:
Variable
 7  9
14,000×  = 12,250 14,000×  = 15,750
 8  8 
Fixed 6,000 6,000
Total 18,250 21,750
Repairs:
Variable
 7  9
 800×  = 700  800×  = 900
 8  8
Fixed 1,200 1,200
Total 1,900 2,100
Illustration 8:
The profit for the year of Push On Ltd. works out to 12.5% of the capital employed and the relevant figures are as
under:
(`)
Sales 5,00,000
direct Materials 2,50,000
direct Labour 1,00,000
Variable overheads 40,000
Capital employed 4,00,000
The new sales manager who has joined the company recently estimates for the next year a profit of about 23%
on capital employed, provided the volume of sales is increased by 10% and simultaneously there is an increase in
selling price of 4% and an overall cost reduction in all the elements of cost by 2%.
Find out by computing in detail the cost and profit for next year, whether the proposal of sales manager can be
adopted.

Solution:
Computation of Fixed Expenses
Particulars (`)
Sales 5,00,000
Less: Profit [4,00,000 x (12.5/100)] 50,000
Total Cost 4,50,000
Less: All costs other than Fixed Cost 3,90,000
Fixed Cost 60,000
Statement Showing Computation of Profit

If Salesman’s Proposal is Adopted
Particulars (`)
(i) Sales [500000 x 110% x 104%] 5,72,000
(ii) Variable Cost:
Direct Material [250000 x 110% x 98%] 2,69,500
Direct Labour [100000 x 110% x 98%] 1,07,800
Variable overheads [40000 x 110% x 98%] 43,120
4,20,420
(iii) Contribution [i - ii] 1,51,580
(iv) Fixed Cost [60000 x 98%] 58,800
(v) Profit [iii - iv] 92,780
 92,780 
% of profit on Capital Employed =  × 100  = 23.195%
 4,00,000 
From the above computation, it was found that the percentage of profit is 23.195% on Capital Employed by
adopting the sales manager’s proposal which is just more than 23% of expected, therefore the proposal can be
adopted.
Illustration 9:
A glass Manufacturing company requires you to calculate and present the budget for the next year from the
following information.
Sales: Toughened glass ` 3,00,000

Bent toughened glass ` 5,00,000
direct Material cost 60% of sales
direct Wages 20 workers @ `150 p.m.
Factory Overheads:
Indirect Labour: Works Manager ` 500 per month
Foreman ` 400 per month
Stores and spares 2½% on sales
depreciation on machinery `12,000
Light and power 5,600
Repairs and maintenance 8,000
other sundries 10% on direct wages
Administration, selling and distribution expenses `14,000 per year.

Solution:
Master Budget Showing Profit for Next Year
(`) (`)
Sales:
Toughened glass 3,00,000
Bent Toughened glass 5,00,000 8,00,000
Less: Cost:
Material @ 60% 4,80,000
direct Wages (20 x 150 x 12) 36,000 5,16,000
Gross Profit 2,84,000
Less: Factory Overheads:
Indirect Labour: Works Manager’s Salary [500 x 12] = 6,000
Foreman’s Salary [400 x 12] = 4,800 10,800
Stores & Spares 20,000
depreciation 12,000
Light & Power 5,600
Repairs & Maintenance 8,000
other Sundries 3,600
Administration & Selling expenses 14,000 74,000
Profit 2,10,000
Illustration 10:
Three Articles X, Y and Z are produced in a factory. They pass through two cost centers A and B. From the data
furnished compile a statement for budgeted machine utilization in both the centers.
(a) Sales budget for the year
Annual Budgeted Opening stock of finished
Product Closing stock
Sales (units) products (units)
X 4800 600 equivalent to 2 months sales
Y 2400 300 --do--
Z 2400 800 --do--
(b) Machine hours per unit of product

Cost centers
Product A B
X 30 70
Y 200 100
Z 30 20
(c) Total number of machines

Cost Centre:
A 284
B 256
Total 540
(d) Total working hours during the year: estimated 2500 hours per machine.

Solution:
Calculation of Units of Production of Different Products
Particulars Product X Product Y Product Z

Sales 4800 2400 2400
Add: Closing Stock 800 400 400
5600 2800 2800
Less: opening stock 600 300 800
Production 5000 2500 2000
MACHINE UTILISATION BUDGET
Particulars A B
X Y Z Total X Y Z Total
(i) Production (units) 5000 2500 2000 5000 2500 2000
(ii) Hours per unit 30 200 30 70 100 20
(iii) Total Machine Hours 1,50,000 5,00,000 60,000 7,10,000 3,50,000 2,50,000 40,000 6,40,000
(iv) Number of Machines Required 60 200 24 284 140 100 16 256
Illustration 11:
The monthly budgets for manufacturing overhead of a concern for two levels of activity were as follows:
Capacity 60% 100%

Budgeted production (units) 600 1,000
(`) (`)
Wages 1,200 2,000
Consumable stores 900 1,500
Maintenance 1,100 1,500
Power and fuel 1,600 2,000
depreciation 4,000 4,000
Insurance 1,000 1,000
9,800 12,000
(i) Indicate which of the items are fixed, variable and semi-variable;
(ii) Prepare a budget for 80% capacity and
(iii) Find the total cost, both fixed and variable per unit of output at 60%, 80% and 100%capacity.
Solution:
(i)
Fixed → Depreciation and insurance.
Variable → Wages and consumables stores.
Semi-variable Costs → Maintenance, Power and fuel.

Segregation of Semi Variable Costs
 1,500 -1,100 
Maintenance =   = ` 1 per unit variable and
 400 
` 500 fixed (i.e., 1,100-600)
 2,000 -1,600 
Power and fuel =   = ` 1 per unit variable and
 400 
`1,000 (i.e.,1,600 - 600) is fixed.
(ii) Budget for 80% capacity(output 800 units):
(`)
Wages @ ` 2 per unit 1,600
Consumables stores @ ` 1.50 per unit 1,200
Maintenance: ` 500+ ` 1.50 per unit 1,300
Power & fuel ` 1,000+ `1 per unit 1,800
depreciation 4,000
Insurance 1,000
Total cost: 10,900
(iii)
Capacity 60% 80% 100%

Units 600 800 1000
Total (`) Per unit Total (`) Per unit Total (`) Per unit
Fixed Costs:
Depreciation 4,000 4,000 4,000
Insurance 1,000 1,000 1,000
Maintenance 500 500 500
Power and fuel 1,000 1,000 1,000
6,500 10.83 6,500 8.125 6,500 6.50
Variable costs:
Wages @ ` 2 per unit 1,200 1,600 2,000
Consumable stores @ ` 1.50 per unit 900 1,200 1,500
Maintenance @ `1 Per unit 600 800 1,000
Power and fuel @ `1 per unit 600 800 1,000
3,300 5.50 4,400 5.500 5,500 5.50
16.33 13.625 12.00
Illustration 12:
X Chemical Ltd. manufacture two products AB and CD by making the raw material in the proportion shown:
Raw Material Product AB Product CD

A 80%
B 20%
C 50%
d 50%

The finished weight of products AB and CD are equal in the weight of in gradients. During the month of June, it is
expected that 60 tons of AB and 200 tons of CD will be sold.
Actual and budgeted inventories for the month of June as follows:
Actual Inventory (1st June) Quantity (Tons) Budgeted Inventory (30th June) Quantity (Tons)
A 15 20
B 10 40
C 200 300
D 250 200
Product AB 10 5
Product CD 50 60
The purchase price of materials for June is expected to be as follows:
Material Cost per ton

(`)
A 500
B 400
C 100
D 200
All materials will be purchased on 3rd of June, Prepare:

(a) The Production Budget for the month of June,
(b) The Material Requirement budget for June,
(c) The Material Purchase Budget indicating the expenditure for material for the month of June.
Solution:
(a) Production Budget
Particulars AB CD
Sales 60 200
Add: Closing stock 5 60
65 260
Less: opening stock 10 50
Production 55 210
(b) Material Requirement Budget
Particulars A B C D
Product AB 44 11 - -
Product CD - - 105 105
Material Required 44 11 105 105

(c) Purchase Budget
Particulars A B C D
Material Required 44 11 105 105
Add: Closing stock 20 40 300 200
64 51 405 305
Less: opening stock 15 10 200 250
Purchases (By weight) 49 41 205 55
Cost per ton 500 400 100 200
Purchases (By Rupees) 24500 16400 20500 11000
Total Purchases = ` 24500+16400+20500+11000 = ` 72400.
1. What do you mean by Budgetary control? State its advantages.

2. Discuss the preliminaries for the adoption of a system of Budgetary Control.
3. Discuss the factors to be considered on production budget.
4. Distinguish between flexible budget and fixed budget.
5. Write a short note as responsibility accounting and performance budgeting.
6. Write a short note on “Zero based budgeting”.
7. List down the steps involved in zero based budgeting.
8. Explain the various types of budget.

1. Budget period depends upon…
A. The type of budget
B. The nature of business
C. The length of trade cycles
D. All of these
2. A key factor is one which restricts…
A. The volume of production
B. The volume of sales
C. The volume of purchase
D. All of the above
3. Budget relating to the key factor is prepared…
A. After other budgets
B. With other budgets
C. Before other budgets
D. None

4. The budgets are classified on the basis of…

A. Time
B. Function
C. Flexibility
D. All
5. An example of long period budget is…
A. R& D budget
B. Master budget
C. Sales budget
D. Personnel budget
6. Sales budget shows the sales details as…
A. Month wise
B. Product wise
C. Area wise
D. All of the above
7. The main objective of budgetary control is…
A. To define the goal of the firm
B. To coordinate different departments
C. To plan to achieve its goals
D. All of the above
8. Fixed budget is useless for comparison when the level of activity…
A. Increases
B. Fluctuates both ways
C. Decreases
D. Constant
9. Usually the production budget is stated in terms of…
A. Money
B. Quantity
C. Both
D. None
10. Revision of budgets is
A. Unnecessary
B. Can’t determine
C. Necessary
D. Inadequate data
[Ans: D,A,C,D,A,A,C,B,C,C]

Column A Column B
1 A budget is a plan of action expressed in… A Definite period
2 A budget is tool which helps the management in B Management
planning and control of…
3 Budgetary control system acts as a friend, philosopher C Financial terms & Non‐financial terms
and guide to the…
4 Budget is prepared for a… D Decision making
5 Zero based Budgeting E All business activities
[Ans: E, C, B, A, D]
State whether the following statement is True or False:

1. Zero Based Budgeting cannot be used for Decision making.
2. There is necessity to revise the budget.
3. A budget is expressed in financial or Quantitative terms.
4. A budget is prepared for a specified period.
5. A flexible budget takes into account only fixed costs.
6. The master budget is prepared first and all other budgets are sub ordinate to it
7. The key factor should not be taken into account while preparing budgets.
8. A budget is a summary of all functional budgets.
9. A flexible budget is prepared for more than one level of activity.
10. Cash budget shows the expected sources and utilisation of cash.
[Ans: 1.False, 2.True, 3.True, 4.True, 5.False, 6.False, 7.False, 8.True, 9.True, 10.True]
Fill in the Blanks:

1. Budgetary control system facilitates centralized control with ___________.
2. Budgetary control facilitates easy introduction of the ____________.
3. Budgetary control helps the management in ______________.
4. Budgetary control system helps the management to eliminate ________________________.
5. Budgetary control provides a basis for ______________.
6. Budgetary control helps to introduce a suitable incentive and remuneration based on __.
7. Budgetary control __________ replace management in decision‐making.
8. The success of budgetary control system depends upon the willing cooperation of ______.
9. Recording of actual performance is __________________.
10. Revision of budgets is ___________________.
[Ans: 1. Centralised & Decentralised Activity, 2. Standard Costing, 3. Obtaining Bank Credit, 4. Under and Over
Capitalisation, 5. Remuneration Plans, 6. Inflationary Conditions, 7. Cannot, 8. All functional area of Management,
9. A step in Budgetary Control, 10. Necessary]

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MANAGEMENT

This Study Note includes

The Institute of Cost Accountants of India 1

2 The Institute of Cost Accountants of India

The Institute of Cost Accountants of India 3

Financial Accounting Cost Accounting

4 The Institute of Cost Accountants of India

Cost Accounting and Management Accounting:

The Institute of Cost Accountants of India 5

6 The Institute of Cost Accountants of India

Material Labour Expenses

Direct Materail Direct Labour Direct Expenses

Indirect Material Indirect Labour Indirect Expenses

Direct Material + Direct Labour + Direct Expenses = Prime Cost

The Institute of Cost Accountants of India 7

Indirect Material Cost

Direct Labour / Employee Cost

Indirect Labour/ Employee Cost

8 The Institute of Cost Accountants of India

The Institute of Cost Accountants of India 9

10 The Institute of Cost Accountants of India

The Institute of Cost Accountants of India 11

Advantages of Cost Control

The advantages of cost control are mainly as follows

(ii) Increase in productivity of the available resources

(iii) Reasonable price of the customers

(iv) Continued employment and job opportunity for the workers

(v) Economic use of limited resources of production

(vi) Increased credit worthiness

(vii) Prosperity and economic stability of the industry

(i) By reducing expenditure, the volume of output remaining constant, and

12 The Institute of Cost Accountants of India

Cost Control Cost Reduction

1.3 CLASSIFICATION OF COST

The Institute of Cost Accountants of India 13

(a) Classification by Nature of Expense

Cost Classification by nature

Material Labour Expenses

Cost Classification by relation to cost centre

Material Labour Expenses Material Labour Expenses

14 The Institute of Cost Accountants of India

Cost classification by function

Production Administration Research & Selling Distribution

The Institute of Cost Accountants of India 15

Cost classification by behaviour

Fixed Variable Semi-variable

16 The Institute of Cost Accountants of India

The Institute of Cost Accountants of India 17

Cost Classification by nature of Production or Process

Batch Process Operation Operating Contract Joint

18 The Institute of Cost Accountants of India

Standard Cost Estimated Cost

The Institute of Cost Accountants of India 19

20 The Institute of Cost Accountants of India

SELF EXAMINATION QUESTIONS:

The Institute of Cost Accountants of India 21

Multiple Choice Questions:

2. Joint Cost is suitable for-

3. Cost units of Hospital Industry is-

4. Cost units of Automobile Industry is-