Cost and Management Accounting (VJuly 2016)

CHARTERED ACCOUNTANCY PROFESSIONAL
[CAP]-II
Study Material
Cost
&
Management Accounting
Education Department
The Institute of Chartered Accountants of Nepal
(a)
Publisher: The Institute of Chartered Accountants of Nepal (ICAN)
Satdobato, Lalitpur, P.O. Box : 5289, Kathmandu
Tel: 977-1-5530832, 5530730, Fax: 9771-1-5550774
E-mail: [email protected], Website: www.ican.org.np
© The Institute of Chartered Accountants of Nepal
This study material has been prepared by The Institute of Chartered Accountants of Nepal. Permission of
the council of the institute is essential for reproduction of any portion of this paper.
All right reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording or
otherwise, without prior permission, in writing, from the publisher.
Price: 400.00
First Edition: April, 2011
Second Edition: December, 2014
Third Edition: July, 2016
(b)
PREFACE
This study material on the subject of “Cost & Management Accounting” has been
exclusively designed and developed for the students of Chartered Accountancy
Professional [CAP]-II Level. It aims to acquaint students with a comprehensive
knowledge of costing concepts and detail procedures and documentation involved in
cost ascertainment systems, and to provide with an understanding of the application of
above knowledge to basic planning, control and decision-making.
It broadly covers the chapters of Cost concepts and costing methods, Material Control,
Labor Control, Overhead Control Cost Accounts System, Cost Control Accounts
(Integrated and Non-integrated Accounting System), Methods of Costing, Cost concepts
for Decision Making, Costing for planning and Control – Budgets, Uniform Costing and
Inter firm comparison, Cost Control And Cost Reduction, and Cost Audit.
Students are requested to accustom with the syllabus of the subject and read each topic
thoroughly for understanding on the chapter. We believe this material will be of great
help to the students of CAP-II. However, they are advised not to rely solely on this
material. They should update themselves and refer recommended text-books given in
the CA Education Scheme and Syllabus along with other relevant materials in the
subject.
Last but the most, we acknowledge the efforts of CA. Radheshyam Shrestha, who has
meticulously assisted for preparation and updating this study material. Similarly, we are
also thankful to CA. Prabin K. Jha and CA. Bisesh Bibhu Acharya, who has reviewed
this study material for building in this comprehensive shape.
Due care has been taken to make every chapter simple, comprehensive and relevant for
the students. In case students need any clarification, creative feedbacks or suggestions
for further improvement on the material, they may be forwarded to the Education
Department.
July, 2016
Education Department
The Institute of Chartered Accountants of Nepal
(c)
Contents
Chapter 1: Cost Concepts and Costing Methods (1-37)
1.1 Evolution of Cost Accounting ..................................................................................................... 2
1.2 Definition of Costing, Cost Accounting and Cost Accountancy ................................................. 2
1.3 Objectives of Cost Accounting .................................................................................................... 3
1.4 Importance of Cost Accounting................................................................................................... 4
1.5 Cost Concept and Terms ............................................................................................................. 5
1.6 Elements of Cost ....................................................................................................................... 14
1.7 Cost Sheet and Component of Total Cost ................................................................................. 16
1.8 Classification of Cost ................................................................................................................ 22
1.9 Methods of Costing ................................................................................................................... 25
1.10 Techniques of Costing ............................................................................................................... 27
1.11 Cost and Accounting System..................................................................................................... 28
1.12 Relationship Between Cost Accounting, Financial Accounting, Management
Accounting and Financial Management .................................................................................... 32
Chapter 2: Material Control (38-115)

2.1 Concept of Material Control ...................................................................................................... 39
2.2 Objectives of System of Material Control ................................................................................. 39
2.3 Requirement of Material Control .............................................................................................. 40
2.4 Material Purchase Procedure ..................................................................................................... 40
2.5 Storage of Materials .................................................................................................................. 51
2.6 Issue of Materials ...................................................................................................................... 59
2.7 Maintenance of Inventory Records............................................................................................ 63
2.8 Techniques of Material (Inventory) Control.............................................................................. 65
2.9 Pricing Methods ........................................................................................................................ 84
2.10 Stock Valuation Material Returns and Losses ........................................................................... 95
2.11 Just in Time (JIT) .................................................................................................................... 104
2.12 Material Requirement Planning (MRP) ................................................................................... 106
Chapter 3: Labor Control (116-180)

3.1 Concept of Labor Control........................................................................................................ 117
3.2 Labor Cost Control .................................................................................................................. 117
3.3 Attendance and Payroll Procedures ......................................................................................... 124
3.4 Treatment of Holiday and Leave Pay, Idle Time, Overtime.................................................... 129
3.5 Labor Turnover........................................................................................................................ 136
3.6 Incentive System ..................................................................................................................... 141
3.7 Method of Wage Payment ....................................................................................................... 145
3.8 System for Incentive Schemes for Indirect Workers ............................................................... 164
3.9 Absorption of Wages ............................................................................................................... 166
3.10 Accounting for Labors............................................................................................................. 172
(d)
Chapter 4: Overhead Control (181-242)
4.1 Introduction ............................................................................................................................. 182
4.2 Classification of Overheads ..................................................................................................... 182
4.3 Accounting and Control of Manufacturing Overheads............................................................ 189
4.4 Accounting and Control of Administrative Overheads ........................................................... 190
4.5 Accounting and Control of Selling and Distribution Overheads ............................................. 194
4.6 Steps for the Distribution of Overheads .................................................................................. 198
4.7 Methods of Absorbing Overheads to Various Products or Jobs .............................................. 215
4.8 Treatment of Under-absorbed and Over-absorbed Overheads in Cost Accounting ................ 223
4.9 Activity Based Cost Allocations.............................................................................................. 229
4.10 Treatment of Certain Items in Costing .................................................................................... 236
Chapter 5: Unit Costing (243-257)

5.1 Unit Costing (Single or Output Costing) ................................................................................. 244
5.2 Cost Sheet ................................................................................................................................ 245
5.3 Production Statement .............................................................................................................. 252
Chapter 6: Cost Book Keeping (258-291)

6.1 Introduction ............................................................................................................................. 259
6.2 Non-integrated Accounting System......................................................................................... 259
6.3 Integrated Accounting System ................................................................................................ 266
6.4 Comparative Journal Entries between Integral and Non-integral Accounting System............ 268
6.5 Reconciliation of Cost and Financial Accounts....................................................................... 280
Chapter 7: Method of Costing (292-389)

7.1 Introduction ............................................................................................................................. 293
7.2 Job Costing .............................................................................................................................. 293
7.3 Batch Costing .......................................................................................................................... 301
7.4 Contract Costing ...................................................................................................................... 304
7.5 Process Costing ....................................................................................................................... 327
7.6 Joint Products and By-Products............................................................................................... 351
7.7 Operating Costing.................................................................................................................... 368
Chapter 8: Cost Concepts for Decision Making (390-435)

8.1 Cost Behavior .......................................................................................................................... 391
8.2 Methods of Separating Fixed and Variable Costs ................................................................... 395
8.3 Cost Sheet for Marginal Costing ............................................................................................. 397
8.4 Costs-Volume Profit Analysis ................................................................................................. 397
8.5 Key Factor / Limiting Factor ................................................................................................... 413
8.6 Cost Indifference Point ............................................................................................................ 423
8.7 Marginal Costing and Differential Costing ............................................................................. 424
8.8 Marginal Costing and Absorption Costing .............................................................................. 426
Chapter 9: Budget (436-473)

9.1 Budgeting and Budgetary Control System .............................................................................. 437
9.2 Steps in Budgetary Control ..................................................................................................... 437
(e)
9.3 Types of Budget ...................................................................................................................... 439
9.4 Fixed and Flexible Budgeting ................................................................................................. 463
9.5 Budgeting Process ................................................................................................................... 465
Chapter 10: Standard Costing (474-489)

10.1 Introduction ............................................................................................................................. 475
10.2 Definition of Standard Cost ..................................................................................................... 475
10.3 Need for Standard Cost ........................................................................................................... 475
10.4 Uses of Standard Cost ............................................................................................................. 476
10.5 Definition of Standard Costing ................................................................................................ 476
10.6 Preliminaries of Establishing a System of Standard Costing .................................................. 477
10.7 Advantages and Limitations of Standard Costing ................................................................... 477
10.8 Distinction between Budgetary Control and Standard Costing ............................................... 478
10.9 Types of Standards .................................................................................................................. 480
10.10 Setting Standards ..................................................................................................................... 481
10.11 Direct Material Cost Variance ................................................................................................. 483
10.12 Labor Cost Variance Analysis ................................................................................................. 486
Chapter 11: Uniform Costing and Inter Firm Comparison (490-495)

11.1 Uniform Costing ...................................................................................................................... 491
11.2 Essentials Requisites for the Installation of Uniform Costing System .................................... 491
11.3 Objectives of Uniform Costing ............................................................................................... 491
11.4 Advantages of Uniform Costing .............................................................................................. 492
11.5 Limitations of Uniform Costing .............................................................................................. 493
11.6 Inter-Firm Comparison ............................................................................................................ 493
Chapter 12: Cost Control and Cost Reduction (496-502)

12.1 Introduction ............................................................................................................................. 497
12.2 Distinction between Cost Control and Cost Reduction ........................................................... 498
12.3 Advantages of Cost Reduction ................................................................................................ 498
12.4 Cost Reduction Plan and Program ........................................................................................... 499
12.5 Scope of Cost Reduction ......................................................................................................... 500
12.6 Value Analysis ........................................................................................................................ 501
Chapter 12: Cost Control and Cost Reduction (503-511)

13.1 Introduction ............................................................................................................................. 504
13.2 Important Aspect of Cost Audit............................................................................................... 504
13.3 Purpose of Cost Audit ............................................................................................................. 505
13.4 Types of Cost Audit ................................................................................................................ 505
13.5 Advantages of Cost Audit ....................................................................................................... 506
13.6 Functions of Cost Auditor ....................................................................................................... 507
Some of the Solved Problems from recent CA Examinations 512-623
(f)
CHAPTER 1
COST CONCEPTS AND COSTING METHODS
CHAPER 1 : COST CONCEPTS AND COSTING METHODS
1.1 EVOLUTION OF COST ACCOUNTING

Cost accounting has long been used to help managers understand the costs of running a business. Modern
cost accounting originated during the industrial revolution, when the complexities of running a large scale
business led to the development of systems for recording and tracking costs to help business owners and
managers make decisions.
During the seventeenth century in France, the Royal Wallpaper Manufacturing had a Cost Accounting
System. Some iron masters and potters in eighteenth century in England too begun to produce Cost
Accounting information before the Industrial Revolution.
Modern Cost Accounting was developed during the nineteenth century as a response to management
information needs arising out of conditions resulting from the Industrial Revolution. Mechanization of
production and distribution led to the creation of excess capacity among competing groups of producers.
This excess capacity forced its owners to wage commercial warfare against one another, producing waves
of industrial bankruptcies, particularly during the second half of the nineteenth century. One of the factors
underlying this situation was soon recognized as a lack of cost information as a result of which firms were
undercutting each other's prices without any knowledge of the consequences on their own economics. By
the end of nineteenth century, firms in competitive industries formed trade associations to exchange cost
information and eventually developed uniform cost accounting systems for the purpose.
During World War I and II the social importance of cost accounting grew with the growth of each
country's defense expenditure. In the absence of competitive markets for most of the material and
equipment required during the war, the governments in several countries placed cost plus contracts under
which the price to be paid was the cost of production plus an agreed rate of profit. The reliance on cost
information by the parties to defense contracts continued after World War II as well. But during World
War II, many Governments also brought down legislation which had the effect of placing almost a
blanket control over prices.
In the early industrial age, most of the costs incurred by a business were what modern accountants call
"variable costs" because they varied directly with the quantity of production. Money was spent on labor,
raw materials, power to run a factory, etc. in direct proportion to production. Managers could simply total
the variable costs for a product and use this as a rough guide for decision-making processes.
Some costs tend to remain the same even during busy periods, unlike variable costs which rise and fall
with volume of work. Over time, the importance of these "fixed costs" has become more important to
managers. Examples of fixed costs include the depreciation of plant and equipment, and the cost of
service departments such as maintenance, tooling, production control, purchasing, quality control, storage
and handling, plant supervision and engineering. In the early twentieth century, these costs were of little
importance to most businesses. However, in the twenty-first century, these costs are often more important
than the variable cost of a product, and allocating them to a broad range of products can lead to bad
decision making. Managers must understand fixed costs in order to make decisions about products and
pricing.
1.2 DEFINITION OF COSTING, COST ACCOUNTING AND COST ACCOUNTANCY

The Institute of Cost and Management Accountants of England defines these terminologies as follows:
Costing is "the technique and process of ascertaining costs."
[2] ©The Institute of Chartered Accountants of Nepal (ICAN)

Cost Accounting is defined as "the process of accounting for cost which begins with the recording of
income and expenditure or the bases on which they are calculated and ends with the preparation of
periodical statements and reports for ascertaining and controlling costs."
Cost Accountancy has been 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 therefrom for the purpose of managerial decision
making.
Previously, cost accounting was merely considered to be a technique for the ascertainment of costs of
products or services on the basis of historical data. In course of time, due to competitive nature of the
market, it was realized that ascertaining of cost is not as important as controlling costs. Hence, cost
accounting started to be considered more as a technique for cost control as compared to cost
ascertainment. Due to the technological developments in all fields, cost reduction has also come within
the ambit of cost accounting. Cost accounting is, thus, concerned with recording, classifying and
summarizing costs for determination of costs of products or services, planning, controlling and reducing
such costs and furnishing of information to management for decision making.
Cost accounting, thus, provides information to management for all sorts of decisions. It serves multiple
purposes on account of which it is generally indistinguishable from management accounting or so-called
internal accounting. Wilmot has summarized the nature of cost accounting as “the analyzing, recording,
standardizing, forecasting, comparing, reporting and recommending” and the role of a cost accountant as
“a historian, news agent and prophet.” As a historian, he should be meticulously accurate and sedulously
impartial. As a news agent, he should be up to date, selective and pithy. As a prophet, he should combine
knowledge and experience with foresight and courage.
1.3 OBJECTIVES OF COST ACCOUNTING

The main objectives of Cost Accounting are as follows:
i. Ascertainment of Cost:
This was considered to be the primary objective of cost accounting in the initial stages of its development.
However, in modern times this has assumed the secondary objective of cost accounting. Cost
ascertainment involves the collection and classification of expenses at the first instance. Those items of
expenses which are capable of charging directly to the products manufactured are allocated. Then the
other expenses which are not capable of direct allocation are apportioned on some suitable basis. Thus the
cost of production of goods manufactured is ascertained. In this process, cost accounts involves
maintenance of different books to record various elements of cost. Cost of production is ascertained by
using any of the costing technique such as historical costing, marginal costing, etc.
There are two methods of ascertaining costs, viz., Post Costing and Continuous Costing.
Post Costing means, analysis of actual information as recorded in financial books. It is accurate and is
useful in the case of "Cost plus Contracts" where price is to be determined finally on the basis of actual
cost.
Continuous costing, aims at collecting information about cost as and when the activity takes place so that
as soon as a job is completed the cost of completion would be known. This involves careful estimates
being prepared of overheads. In order to be useful, costing must be a continuous process.
©The Institute of Chartered Accountants of Nepal (ICAN) [3]

Cost ascertained by the above two methods may be compared with the standard costs which are the target
figures already complied on the basis of experience and experiments.
ii. Determination of selling price:
Every business organisation aims at maximising profit by assigning the right selling price for the product.
Total cost of production constitutes the basis on which selling price is fixed by adding a margin of profit.
Cost accounting furnishes both the total cost of production as well as cost incurred at each and every
stage of production. Though the selling price of a product is influenced by market conditions which are
beyond the control of any business, it is still possible to determine the selling price within the market
constraints taking other factors into consideration before fixing price such as market conditions the area
of distribution, volume of sales, etc. But cost plays the dominating role in price fixation. For this purpose,
it is necessary to rely upon cost data supplied by cost Accountants.
iii. Cost control and cost reduction:
Cost accounting helps in attaining aim of controlling and reducing the cost by using various techniques
such as Budgetary Control, Standard costing, and inventory control. Each item of cost [viz. material,
labour, and expense] is budgeted at the beginning of the period and actual expenses incurred are
compared with the budget to control on the cost. . Cost control is exercised at different stages in a factory,
viz., acquisition of materials, recruiting and deployment of labour force, during the production process
and so on. The control techniques enable the management in knowing the operating efficiency of a
business, losses due to wastage of matrial, idle time of worker, poor supervision etc.
Ascertaining the profit of each activity:
The profit of any activity can be ascertained by matching cost with the revenue of that activity. Cost
accounting provides detailed costing information to the mangaement to enable them to maintain effective
control over stores and inventory, to increase efficiency of the organisation and to check wastage and
losses. It facilateds delegation of responsibility for important tasks and rating of employees. The purpose
under this step is to determine costing profit or loss of any activity on an objective basis.
iv. Assisting management in decision making:
The management of every business constantly rely upon the reports on cost data in order to know the
level of efficiency relating to purchase, production, sales and operating results. Financial accounts
provide information only at the end of the year because closing stock value is available only at the end of
the year. But cost accounts provide the value of closing stock at frequent intervals by adopting a
“continuous stock verification” system. Using the value of closing stock it is possible to prepare final
accounts and know the operating results of the business. Cost data to a great extent helps in formulating
the policies of a business and in decision-making. As every alternative decisions involve investment of
capital outlay, costs play an important role in decision-making. Therefore availability of cost data is a
must for all levels of management. Some of the decisions which are based on cost are (a) make or buy
decision, (b) manufacturing by mechanisation or automation, (c) whether to close or continue operations
in spite of losses.
1.4 IMPORTANCE OF COST ACCOUNTING

Management of business concerns expects, from cost accounting, detailed cost information in respect of
its operations to equip their executives with relevant information required for planning, scheduling,
controlling and decision making. To be more specific, management expects from cost accounting –
information and reports to help them in the discharge of the following functions:

a. Control of material cost: Cost of material usually constitute a substantial portion of the total cost of a
product. Therefore, it is necessary to control it as far as possible. Such control may be exercised by
(i) Ensuring un-interrupted supply of material and spare for production. (ii) By avoiding excessive
locking up of funds/ capital in stocks of materials and stores. (iii) Also by the use of techniques like
value analysis, standardization etc to control material cost.
b. Control of labor cost: It can be controlled if workers complete their work within the standard time
limit. Reduction of labor turnover and idle time also helps in controlling labor cost.
c. Control of overheads: Overheads consists of indirect expenses which are incurred in the factory,
office and sales department; they are part of production and sales cost. Such expenses may be
controlled by keeping a strict check over them.
d. Measuring efficiency: For measuring efficiency, cost accounting department should provide
information about standards and actual performance of the concerned activity.
e. Budgeting: Now-a-days detailed estimates in terms of quantities and amounts are drawn up before
the start of each activity. This is done to ensure that a practicable course of action can be chalked out
and the actual performance corresponds with the estimated or budgeted performance. The preparation
of the budget is the function of Costing Department.
f. Price determination: Cost accounts should provide information which enables the management to fix
remunerative selling prices for various items to products and services in different circumstances.
g. Curtailment of loss during off season: Cost Accounting can also provide information which may
enable reduction of overhead, by utilizing idle capacity during off season or by lengthening the
season.
h. Expansion: Cost Accounts may provide estimates of production of various levels on the basis of
which the management may be able to formulate its approach to expansion.
i. Arriving at decisions: Most of the decisions in a business undertaking involve correct statements of
the likely effects of alternative decisions on profits. Cost Accounts are vital help in this respect.
1.5 COST CONCEPT AND TERMS

COST
Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term
“cost” in a proper perspective.
In general, “cost” means the amount of expenditure (actual or notional) incurred on, or attributable to a
given thing.
However, the term “cost” cannot be exactly defined. Its interpretation depends upon the following factors:
The nature of business or industry
The context in which it is used
In a business where selling and distribution expenses are quite nominal, the cost of an article may be
calculated without considering the selling and distribution overheads. At the same time, in a business
where the nature of a product requires heavy selling and distribution expenses, the calculation of cost
without taking into account the selling and distribution expenses may prove very costly to a business. The
cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost

includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is
termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use
of term cost, without understanding the circumstances can be misleading.
Different costs are found for different purposes. The work-in-progress is valued at factory cost while
stock of finished goods is valued at office cost. Numerous other examples can be given to show that the
term “cost” does not mean the same thing under all circumstances and for all purposes. Many items of
cost of production are handled in an optional manner which may give different costs for the same product
or job without going against the accepted principles of cost accounting. Depreciation is one of such items.
Its amount varies in accordance with the method of depreciation being used. However, endeavor should
be, as far as possible, to obtain an accurate cost of a product or service.
a. Product Costs –
The costs which are a part of the cost of a product rather than an expense for the period in which they are
incurred are called as “product costs.” They are included in inventory values. In financial statements, such
costs are treated as assets until the goods they are assigned to are sold. They become an expense at that
time. These costs may be fixed as well as variable Under marginal costing, variable manufacturing costs
and under absorption costing, total manufacturing costs, constitute product costs.
The three different purposes for computing product costs are as follows:
i. Preparation of financial statements: One of the purposes for computing product cost is to prepare
financial statements where accounting for inventorial costs is made under asset until products they
are related to are sold.
ii. Product pricing: It is an important purpose for which product costs are used. Based on this, sales
price for product would be determined. .
iii. Contracting with government agencies; This also helps contractors to enter into cost plus contract
with government and other business entities, where modality for billing is agreed at a fixed
percentage over cost. Government agencies and other business entities, in such situations would
like know how cost are determined so as, not to allow contractors to recover research and
development and marketing costs under such cost plus contracts.
b. Period Costs
The costs which are not associated with production are called period costs. They are treated as an expense
of the period in which they are incurred. They may also be fixed as well as variable. Such costs include
general administration costs, salaries of salesmen and commission, depreciation on office facilities etc.
They are charged against the revenue of the relevant period. Differences exist in the opinions regarding
whether certain costs should be considered as product or period costs. Some accountants feel that fixed
manufacturing costs are more closely related to the passage of time than to the manufacturing of a
product. Thus, according to them variable manufacturing costs are product costs whereas fixed
manufacturing and other costs are period costs. However, their view does not seem to have been yet
widely accepted.
c. Decision-Making Costs and Accounting Costs

Decision-making costs are special purpose costs that are applicable only in the situation in which they are
compiled. They have no universal application. They need not tie into routine-financial accounts. They do
not and should not confirm the accounting rules. Accounting costs are compiled primarily from financial
statements. They have to be altered before they can be used for decision-making. Moreover, they are

historical costs and show what has happened under an existing set of circumstances. Decision-making
costs are future costs. They represent what is expected to happen under an assumed set of conditions. For
example, accounting costs may show the cost of a product when the operations are manual whereas
decision-making cost might be calculated to show the costs when the operations are mechanized.
d. Relevant and Irrelevant Costs

Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get
affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail
sales shop, this will affect the wages payable to the workers of the shop. This is relevant in this
connection since they will disappear on closing down of the shop. But prepaid rent of the shop or
unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be
ignored.
e. Shutdown and Sunk Costs

A manufacturer or an organization may have to suspend its operations for a period on account of some
temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this
period, though no work is done yet certain fixed costs, such as rent and insurance of buildings,
depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant
are known as shutdown costs.
Sunk costs are historical or past costs. These are the costs which have been created by a decision that was
made in the past and cannot be changed by any decision that will be made in the future. Investments in
plant and machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered
by decisions made at the later stage, they are irrelevant for decision-making.
An individual may regret his decision for purchasing or constructing an asset but this action could not be
avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset will be
matched against the proceeds from sale of the asset for the purpose of determining gain or loss. The
person may decide to continue to own the asset. In this case, the cost of asset will be matched against the
revenue realized over its effective life. However, he/she cannot avoid the cost which has already been
incurred by him/her for the acquisition of the asset. It is, as a matter of fact, sunk cost for all present and
future decisions.
Example
Jolly Ltd. purchased a machine for Rs. 30,000. The machine has an operating life of five year without any
scrap value. Soon after making the purchase, management feels that the machine should not have been
purchased since it is not yielding the operating advantage originally contemplated. It is expected to result
in savings in operating costs of Rs. 18,000 over a period of five years if the machine is not sold and kept
in use, alternatively, the machine can be sold immediately for Rs. 22,000.
To take the decision whether the machine should be sold or be used, the relevant amounts to be compared
are Rs. 18,000 in cost savings over five year and Rs. 22,000 that can be realized in case it is immediately
disposed. Rs. 30,000 invested in the asset is not relevant since it is same in both the cases. The amount is
the sunk cost. Jolly Ltd., therefore, should sell the machinery for Rs. 22,000 since it would result in an
extra profit of Rs. 4,000 as compared to keeping and using it.
f. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs
Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or
department) with which they are directly related is discontinued. Unavoidable costs are those which will

not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. For
example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be
eliminated. It will simply mean that certain other products will have to absorb a large amount of such
overheads. However, the salary of people attached to a product or the bad debts traceable to a product
would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of
one department of a store might result in decrease in delivery expenses but not in their altogether
elimination.
It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a
segment of a business.
g. Imputed or Hypothetical Costs
These are the costs which do not involve cash outlay. They are not included in cost accounts but are
important for taking into consideration while making management decisions. For example, interest on
capital is ignored in cost accounts though it is considered in financial accounts. In case two projects
require unequal outlays of cash, the management should take into consideration the capital to judge the
relative profitability of the projects.
h. Differentials, Incremental or Decrement Cost
The difference in total cost between two alternatives is termed as differential cost. In case the choice of an
alternative results in an increase in total cost, such increased costs are known as incremental costs. While
assessing the profitability of a proposed change, the incremental costs are matched with incremental
revenue. This is explained with the following example:
Example
A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows:
Selling price per unit Rs. 10
Variable cost per unit Rs. 5
Fixed costs Rs. 4,000
The management is considering the following two alternatives:
i. To accept an export order for another 200 units at Rs. 8 per unit. The expenditure of the export
order will increase the fixed costs by Rs. 500.
ii. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the
market at Rs. 6 per unit. This will result in reducing the present fixed costs from Rs. 4,000 to Rs.
3,000.
Which alternative the management should accept?
Solution
Statement showing profitability under different alternatives is as follows:
Proposed situations
Particulars Present situation
Rs. Rs.
Option 1 Option 2
Sales. 10,000 11,600 10,000

Less:

Variable purchase costs 5,000 6,000 5,400
Fixed costs Profit 4,000 9,000 4,500 10,500 3,000 8,400
1,000 1,100 1,600
Observations:
i. In the present situation, the company is making a profit of Rs. 1,000.
ii. In the proposed situation (i), the company will make a profit of Rs 1,100. The incremental costs
will be Rs. 1,500 (i.e. Rs. 10,500 - Rs. 9,000) and the incremental revenue (sales) will be Rs.
1,600. Hence, there is a net gain of Rs. 100 under the proposed situation as compared to the
existing situation.
iii. In the proposed situation (ii), the detrimental costs are Rs. 600 (i.e. Rs. 9,000 to Rs. 8,400) as there
is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of
Rs. 600 as compared to the present situation.
Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt
alternative (ii).
The technique of differential costing which is based on differential cost is useful in planning and
decision-making and helps in selecting the best alternative.
In case the choice results in decrease in total costs, these decreased costs will be known as detrimental
costs.
i. Out-of-Pocket Costs
Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will
vary depending upon the nature of the decision made. For example, a company has its own trucks for
transporting raw materials and finished products from one place to another. It seeks to replace these
trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not
to be considered but the management should take into account the present expenditure on fuel, salary to
drive and maintenance. Such costs are termed as out-of-pocket costs.
j. Opportunity Cost
Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using
the facilities in the manner originally planned. For example, if a building is proposed to be utilized for
housing a new project plant, the likely revenue which the building could fetch, if rented out, is the
opportunity cost which should be taken into account while evaluating the profitability of the project.
Suppose, a manufacturer is confronted with the problem of selecting anyone of the following alternatives:
a. Selling a semi-finished product at Rs. 2 per unit
b. Introducing it into a further process to make it more refined and valuable
Alternative (b) will prove to be remunerative only when after paying the cost of further processing; the
amount realized by the sale of the product is more than Rs. 2 per unit. Also, the revenue of Rs. 2 per unit
is foregone in case alternative (b) is adopted. The term “opportunity cost” refers to this alternative
revenue foregone.

k. Traceable, Untraceable or Common Costs

The costs that can be easily identified with a department, process or product such as the cost of direct
material, direct labor etc. are termed as traceable costs. The costs that cannot be identified so are termed
as untraceable or common costs. In other words, common costs are the costs incurred collectively for a
number of cost centers and are to be suitably apportioned for determining the cost of individual cost
centers. For example, overheads incurred for a factory as a whole, combined purchase cost for purchasing
several materials in one consignment etc.
Joint cost is a kind of common cost. When two or more products are produced out of one material or
process, the cost of such material or process is called joint cost. For example, when cotton seeds and
cotton fibers are produced from the same material, the cost incurred till the split-off or separation point
will be joint costs.
l. Production, Administration and Selling and Distribution Costs
A business organization performs a number of functions, e.g., production, selling and distribution,
research and development. Costs are to be ascerrtained for each of these functions. The Chartered
Institute of Management Accountants, London, has defined each of the above costs as follows:
i. Production Cost
This is the cost of sequence of operations which begins with supplying materials, labor and services and
ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labor,
direct expenses and factory overheads.
ii. Administration Cost
These are cost of formulating policies, directing the organization and controlling operations of an
undertaking which is not directly related to any production, selling, distribution, research or development
activities or functions.
iii. Selling Cost
It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing
orders.
iv. Distribution Cost
It is the cost of sequence of operations beginning with making the packed product available for dispatch
and ending with making the reconditioned returned empty package, if any, available for reuse.
v. Research Cost
It is the cost of searching for new or improved products, new application of materials, or new or improved
methods.
vi. Development Cost
The cost of process which begins with the implementation of the decision to produce a new or improved
product or employ a new or improved method and ends with the commencement of formal production of
that product or formal employment of the new or improved method.
vii. Pre-Production Cost
The part of development cost incurred in making a trial production as preliminary to formal production is
called pre-production cost.

m. Conversion Cost
The cost of transforming direct materials into finished products excluding direct material cost is known as
conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and
factory overheads.
COST UNIT AND COST CENTER

As mentioned above cost means the amount of expenditure (actual or notional) attributable to a given
thing. In order to determine the cost, the technique of costing involves the following:
• Collection and classification of expenditure according to cost elements
• Allocation and apportionment of the expenditure to the cost centers or cost units or both
Cost Unit
While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be
identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost
unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of
quantity of product, service or time in relation to which costs may be ascertained or expressed.
Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of
cost:
(i) Brick works per 1000 bricks made
(ii) Collieries per ton of coal raised
(iii) Textile mills per yard or per lb. of cloth manufactured or yarn spun
(iv) Electrical companies per unit of electricity generated
(v) Manufacturing Units Per case, per box, per unit
(vi) Transport companies per passenger km.
(vii) Steel mills per ton of steel made
Cost Center
According to the Chartered Institute of Management Accountants, London, cost center means “a location,
person or item of equipment (or group of these) for which costs may be ascertained and used for the
purpose of cost control.” Thus, cost center refers to one of the convenient units into which the whole
factory or an organization has been appropriately divided for costing purposes. Each such unit consists of
a department, a sub-department or an item or equipment or machinery and a person or a group of persons.
Sometimes, closely associated departments are combined together and considered as one unit for costing
purposes. For example, in a laundry, activities such as collecting, sorting, marking and washing of clothes
are performed. Each activity may be considered as a separate cost center and all costs relating to a
particular cost center may be found out separately.
Cost centers may be classified as follows:
i. Productive, unproductive and mixed cost centers
ii. Personal and impersonal cost centers
iii. Operation and process cost centers

Productive cost centers are those which are actually engaged in making products. Service or unproductive
cost centers do not make the products but act as the essential aids for the productive centers. The
examples of such service centers are as follows:
i. Administration department
ii. Repairs and maintenance department
iii. Stores and drawing office department
Mixed costs centers are those which are engaged sometimes on productive and other times on service
works. For example, a tool shop serves as a productive cost center when it manufactures dyes and jigs to
be charged to specific jobs or orders but serves as servicing cost center when it does repairs for the
factory.
Impersonal cost center is one which consists of a department, a plant or an item of equipment whereas a
personal cost center consists of a person or a group of persons. In case a cost center consists of machines
or persons which carry out the same operation on repetitive basis, it is termed as operation cost center. If a
cost center consists of a continuous sequence of operations, it is called process cost center.
In case of an operation cost center, cost is analyzed and related to a series of operations in sequence such
as in chemical industries, pharmaceutical industries, oil refineries and other process industries. The
objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside
the factory.
PROFIT CENTER AND INVESTMENT CENTER

Profit Center
It is defined as an activity center of a business organization. Chief of such a center is fully responsible for
all costs, revenues and profitability of its operation. The main objective of profit center is to maximize the
center’s profit. Creation of profit centers facilitates management control and implementation of the
objectives of responsibility accounting. A profit center may have a number of cost centers.
Investment Center
It is defined as a center which is concerned with earning an adequate return om investment. The main
objective of an Investment center is to maximize the earnings in relation to investment / capital employed.
COST ESTIMATION AND COST ASCERTAINMENT

Cost estimation is the process of pre-determining the cost of a certain product job or order. Such pre-
determination may be required for several purposes. Some of the purposes are as follows:
i. Budgeting
ii. Measurement of performance efficiency
iii. Preparation of financial statements (valuation of stocks etc.)
iv. Make or buy decisions
v. Fixation of the sale prices of products

Cost ascertainment is the process of determining costs on the basis of actual data. Hence, the computation
of historical cost is cost ascertainment while the computation of future costs is cost estimation.
Both cost estimation and cost ascertainment are interrelated and are of immense use to the management.
In case a concern has a sound costing system, the ascertained costs will greatly help the management in
the process of estimation of rational accurate costs which are necessary for a variety of purposes stated
above. Moreover, the ascertained cost may be compared with the pre-determined costs on a continuing
basis so that proper and timely steps be taken for controlling costs and maximizing profits.
COST ALLOCATION AND COST APPORTIONMENT

Cost allocation and cost apportionment are the two procedures which describe the identification and
allotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the items of
cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions of
items of cost to cost centers or cost units. Thus, the former involves the process of charging direct
expenditure to cost centers or cost units whereas the latter involves the process of charging indirect
expenditure to cost centers or cost units.
For example, the cost of labor engaged in a service department can be charged wholly and directly the
concerned cost center but the canteen expenses of the factory cannot be charged directly and wholly to
any cost center but are to be apportioned among more than one cost centers at a predetermined rate.
Charging of costs in the former case will be termed as “allocation of costs” whereas in the latter, it will be
termed as “apportionment of costs.”
COST REDUCTION AND COST CONTROL

The Institute of Cost and Management Accountants London define Cost Control as "the guidance and
regulation, by executive action of the cost of operating an undertaking". The word 'guidance' indicates a
goal or target to be guided; 'regulation' indicates taking action where there is a deviation from what is laid
down; executive action denotes action to 'regulate' which must be initiated by executives i.e. persons
responsible for carrying out the job or the operation; and all this is to be exercised through modern
methods of costing in respect of expenses incurred in operating an undertaking.
To exercise cost control, broadly speaking the following steps should be observed:
i. Determine clearly the objective, i.e. pre-determine the desired results;
ii. Measure the actual performance;
iii. Investigate into the causes of failure to perform according to plan; and
iv. Institute corrective action.
The target cost and/or targets of performance should be laid down in respect of each department or
operation and these targets should be related to individuals who, by their action, control the actual and
bring them into line with the targets. Actual cost of performance should be measured in the same manner,
in which the targets are set up, i.e. if the targets are set up operation-wise, and then the actual costs should
also be collected operation-wise and not cost center or department-wise as this would make comparison
difficult.

Cost Reduction, may be defined "the achievement of real and permanent reduction in the unit cost of
goods manufactured or services rendered without impairing their suitability for the use intended or
diminution in the quality of the product."
Cost reduction should not be confused with cost saving. Cost saving could be temporary affair and may
be at the cost of quality. Cost reduction implies the retention of the essential characteristics and quality of
the product and thus it must be confined to permanent and genuine savings in the cost of manufacturing,
administration, distribution and selling, brought about by elimination of wasteful and inessential elements
from the design of the product and from the techniques carried out in connection therewith. In other
words, the essential characteristics and quality of the products are retained through improved methods and
techniques and thereby a permanent reduction in unit cost is achieved. The definition of cost reduction
does not, however, include reduction in expenditure arising from reduction in taxation or similar
Government action or the effect of price agreements.
The three fold assumptions involved in the definition of cost reduction may be summarized under:
i. There is a saving in unit cost.
ii. Such saving is of permanent nature.
iii. The utility and quality of the goods and services remain unaffected, if not improved.
Therefore, Cost reduction and cost control are two different concepts. Cost control is achieving the cost
target as its objective whereas cost reduction is directed to explore the possibilities of improving the
targets. Thus, cost control ends when targets are achieved whereas cost reduction has no visible end. It is
a continuous process. The difference between the two can be summarized as follows:
i. Cost control aims at maintaining the costs in accordance with established standards whereas cost
reduction is concerned with reducing costs. It changes all standards and endeavors to improve
them continuously.
ii. Cost control seeks to attain the lowest possible cost under existing conditions whereas cost
reduction does not recognize any condition as permanent since a change will result in lowering the
cost.
iii. In case of cost control, emphasis is on past and present. In case of cost reduction, emphasis is on
the present and future.
iv. Cost control is a preventive function whereas cost reduction is a correlative function. It operates
even when an efficient cost control system exists.
1.6 ELEMENTS OF COST

Following are the three broad elements of cost:
Material
The substance from which a product is made is known as material. It may be in a raw or a manufactured
state. It can be direct as well as indirect.

a. Direct Material
The material which becomes an integral part of a finished product and which can be conveniently
assigned to specific physical unit is termed as direct material. Following are some of the examples of
direct material:
All material or components specifically purchased, produced or requisitioned from stores
Primary packing material (e.g., carton, wrapping, cardboard, boxes etc.)
Purchased or partly produced components
Direct material is also described as process material, prime cost material, production material, stores
material, constructional material etc.
b. Indirect Material
The material which is used for purposes ancillary to the business and which cannot be conveniently
assigned to specific physical units is termed as indirect material. Consumable stores, oil and waste,
printing and stationery material etc. are some of the examples of indirect material.
Indirect material may be used in the factory, office or the selling and distribution divisions.
Labor
For conversion of materials into finished goods, human effort is needed and such human effort is called
labor. Labor can be direct as well as indirect.
a. Direct Labor
The labor which actively and directly takes part in the production of a particular commodity is called
direct labor. Direct labor costs are, therefore, specifically and conveniently traceable to specific
products.
Direct labor can also be described as process labor, productive labor, operating labor, etc.
b. Indirect Labor
The labor employed for the purpose of carrying out tasks incidental to goods produced or services
provided, is indirect labor. Such labor does not alter the construction, composition or condition of the
product. It cannot be practically traced to specific units of output. Wages of storekeepers, foremen,
timekeepers, directors’ fees, salaries of salesmen etc, are examples of indirect labor costs.
Indirect labor may relate to the factory, the office or the selling and distribution divisions.
Expenses
Expenses may be direct or indirect.
a. Direct Expenses
These are the expenses that can be directly, conveniently and wholly allocated to specific cost centers
or cost units. Examples of such expenses are as follows:
Hire of some special machinery required for a particular contract.
Cost of defective work incurred in connection with a particular job or contract etc.
Direct expenses are sometimes also described as chargeable expenses.

b. Indirect Expenses
These are the expenses that cannot be directly, conveniently and wholly allocated to cost centers or
cost units. Examples of such expenses are rent, lighting, insurance charges etc.
The term overhead includes indirect material, indirect labor and indirect expenses. Thus, all indirect costs
are overheads.
A manufacturing organization can broadly be divided into the following three divisions:
Factory or works, where production is done.
Office and administration, where routine as well as policy matters are decided.
Selling and distribution, where products are sold and finally dispatched to customers
Overheads may be incurred in a factory or office or selling and distribution divisions. Thus, overheads
may be of three types:
a. Factory Overheads
They include the following things:
Indirect material used in a factory such as lubricants, oil, consumable stores etc.
Indirect labor such as gatekeeper, timekeeper, works manager’s salary etc.
Indirect expenses such as factory rent, factory insurance, factory lighting etc.
b. Office and Administration Overheads

Indirect materials used in an office such as printing and stationery material, brooms and dusters etc.
Indirect labor such as salaries payable to office manager, office accountant, clerks, etc.
Indirect expenses such as rent, insurance, lighting of the office
c. Selling and Distribution Overheads

Indirect materials used such as packing material, printing and stationery material etc.
Indirect labor such as salaries of salesmen and sales manager etc.
Indirect expenses such as rent, insurance, advertising expenses etc.
1.7 COST SHEET AND COMPONENT OF TOTAL COST

Cost Sheet
Cost sheet is a document that compiles detailed component wise cost in respect of cost centers and cost
units. It analyzes and classifies, in a tabular form, the expenses on different items for a particular period.
Additional columns may also be provided to show the cost of a particular unit pertaining to each item of
expenditure and the total per unit cost.

Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of estimated
data (estimated cost sheet), depending on the technique employed and the purpose to be achieved.
Components of Total Cost
a. Prime Cost
Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as
basic, first or flat cost.
b. Factory Cost
Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of
indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as
works cost, production or manufacturing cost.
c. Office Cost
Office cost is the sum of office and administration overheads and factory cost. This is also termed as
administration cost or the total cost of production.
d. Total Cost
Selling and distribution overheads are added to the total cost of production to get total cost or the
cost of sales.
Various components of total cost can be depicted with the help of the table below:
Components of total cost
Direct material
Direct labor Prime cost or direct cost or first cost
Direct expenses
Works or factory cost or production cost or
Prime cost plus works overheads
manufacturing cost
Works cost plus office and administration overheads Office cost or total cost of production
Office cost plus selling and distribution overheads Cost of sales or total cost
A typical format of the Cost Sheet is given below
Cost Sheet for the period.........................................

Production ............................... units
S.No Particulars Amount (Rs.) Amount (Rs.)
A Direct Materials Opening Stock
Add: Purchases of material
Carriage inwards
Less : Closing Stock

B Direct Wages
C Direct Expenses
Prime Cost ( A + B + C )
D Factory Overheads- Indirect materials
Loose Tools
Indirect wages
Rent and Rates ( Factory)
Lighting and heating ( Factory)
Power and fuel
Repairs and Maintenance
Drawing offi ce expenses
Research and experiment
Depreciation – Plant ( Factory)
Insurance – ( Factory)
Work Manager’s salary
Factory Cost/Works Cost ( Prime Cost + D )
E Office and Administrative Overheads

Rent and Rates – offi ce
Salaries – offi ce
Insurance of offi ce building and equipments
Telephone and postage
Printing and Stationery
Depreciation of furniture and offi ce equipments
Legal expenses
Audit fees
Bank Charges
Cost of Production ( Factory Cost + E )
F Selling and Distribution Overheads

Showroom rent and rates
Salesmen’s salaries and commission
Traveling expenses
Printing and Stationery – Sales Department
Advertising

Bad debts
Postage
Debt collection expenses
Carriage outwards
Cost and Management Accounting
Depreciation of delivery van
Debt collection expenses
Samples and free gifts
Cost of Sales ( Cost Of Producation + F )
Profi t/Loss
Sales ( IV + V)
A glance at the above cost sheet will reveal that it works out the total cost of production/service in a
phased manner. In other words, total costs are segregated into elements like Prime Cost, Factory or Works
Cost, Cost of Production, Cost of Sales and finally the profi t/loss is worked out by comparing the total
cost with the selling price. Appropriate adjustments are made for opening and closing stock of Work in
Progress and also opening and closing stock of finished goods. The format of cost sheet may be suitably
changed according to the requirements of each firm
Example
Following information has been obtained from the records of left center corporation for the period from
June 1 to June 30, 2013.
Cost of raw materials on June 1,2013 30,000
Purchase of raw materials during the month 4,50,000
Wages paid 2,30,000
Factory overheads 92,000
Cost of work in progress on June 1, 2013 12,000
Cost of raw materials on June 30, 2013 15,000
Cost of work in progress on June 30, 2013 0
Cost of stock of finished goods on June 1, 2013 60,000
Cost of stock of finished goods on June 30, 2013 55,000
Selling and distribution overheads 20,000
Sales 9,00,000
Administration overheads 30,000
Prepare a statement of cost.
Solution
Statement of cost of production of goods manufactured for the period ending on June 30, 2013.
Particular Rs. Rs.
Opening stock of raw materials 30,000

Add: purchases 450,000

Total 480,000
Less: Closing stock of raw materials (15,000)
Value of raw materials consumed 465,000
Wages 230,000
Prime Cost (a) 695,000
787,000
Add: Opening stock of work in progress 12,000
799,000
Less: Closing stock of work in progress 0
Factory Cost (b) 799,000
Add: Administration overhead 30,000
Cost of production of goods manufactured 829,000
Add: Opening stock of finished goods 60,000
889,000
Less: Closing stock of finished goods 55,000
Cost of production of goods sold (c) 834,000
Add: Selling and distribution overheads 20,000
Cost of sales (d) 854,000
Profit 46,000
Sales (e) 900,000
Example 2
From the following information, prepare a cost sheet showing the total cost per ton for the period ended
on December 31, 2013.
Raw materials 33,000 Rent and taxes (office) 500

Productive wages 35,000 Water supply 1,200
Direct expenses 3,000 Factory insurance 1,100
Unproductive wages 10,500 Office insurance 500
Factory rent and taxes 2,200 Legal expenses 400
Factory lighting 1,500 Rent of warehouse 300
Factory heating 4,400 Depreciation--
Motive power Haulage 3,000 Plant and machinery 2,000
Director’s fees (works) 1,000 Office building 1,000
Directors fees (office) 2,000 Delivery vans 200
Factory cleaning 500 Bad debt 100

Sundry office expenses 200 Advertising 300

Estimating Expenses 800 Sales department salaries 1,500
Factory stationery 750 Up keeping of delivery vans 700
Office stationery 900 Bank charges 50
Loose tools written off 600 Commission on sales 1,500
The total output for the period has been 10,000 tons.
Solution
Cost sheet for the period ended on December 31, 2013
Rs. Rs.
Raw materials 33,000
Production wages 35,000
Direct expenses 3,000
Prime cost 71,000
Add--works overheads:
Unproductive wages 10,500
Factory rent and taxes 2,200
Factory lighting 1,500
Factory heating 4,400
Motive power Haulage 3,000
Directors’ fees (works) 1,000
Factory cleaning 500
Estimating expenses 800
Factory stationery 750
Loses tools written off 600
Water supply 1,200
Factory insurance 1,100
Depreciation of plant and machinery 2,000 29,550
Work Cost 100,550
Add: office overhead
Directors’ fees (office) 2,000
Sundry office expenses 200
Office stationery 900
Rent and taxes (office) 500
Office insurance 500
Legal expenses 400
Depreciation of office building 1,000
50 5,550
Bank charges
Cost of production 106,100
Add: selling and distribution overhead
Rent of warehouse 300
Depreciation on delivery vans 200
Bad debts 100

Advertising 300
Sales department salaries 1,500
Commission on sales 1,500
Upkeep of delivery vans 700 4,600
Cost of sales 110,700
Cost per ton= Rs. 110,700/10,000 tons = Rs. 11.07
1.8 CLASSIFICATION OF COST

Costs can be classified or grouped according to their common characteristics. Proper classification of
costs is very important for identifying the costs with the cost centers or cost units. The same costs are
classified according to different ways of costing depending upon the purpose to be achieved and
requirements of a particular concern. The important ways of classification are:
By variability - According to this classification, costs are classified into three groups viz., (a)
Variable, (b) Fixed and (c) Semi-Variable Costs
(a) Variable cost: The cost which varies directly in proportion with every increase or decrease in the
volume of output or production is known as variable cost. Some of its examples are as follows:
Wages of laborers
Cost of direct material
Power
In some circumstances, variable costs are classified into the following:
Discretionary cost
Engineered cost
The term discretionary cost is generally linked with the class of fixed cost. However, in the circumstances
where management has predetermined that the organization would spend a certain percentage of its sales
for the items like research, donations, sales promotion etc., discretionary costs will be of a variable
character.
Engineered variable costs are those variable costs which are directly related to the production or sales.
These costs exist in those circumstances where specific relationship exists between input and output. For
example, in an automobile industry there may be exact specifications as one radiator, two fan belts; one
battery etc. that is required per car. In such a case if more than one car is to be produced, various inputs
will have to be increased in the direct proportion of the output.
Thus, an increase in discretionary variable costs is due to the authorization of management whereas an
increase in engineered variable costs is due to the volume of output or sales.
(b) Fixed Cost: The cost which does not vary but remains constant within a given period of time and a
range of activity in spite of the fluctuations in production is known as fixed cost. Some of its examples
are as follows:
Rent or rates
Insurance charges
Management salary

Fixed costs are also referred to as “period costs” and variable costs as “direct costs”. Fixed costs can be
further classified into:
Committed fixed costs
Discretionary fixed costs
Committed fixed costs consist largely of those fixed costs that arise from possession of plant, equipment
and also setting up of abasic organization structure. For example, once a building is erected and a plant is
installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance
and salaries of the key personnel etc. without impairing an organization’s competence to meet its long-
term goals.
Discretionary fixed costs are those which are set at fixed amount for specific time periods by the
management in budgeting process. These costs directly reflect the top management’s policies and have no
particular relationship with volume of output. These costs can, therefore, be reduced or entirely
eliminated as demanded by the circumstances. Examples of such costs are research and development
costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are
also termed as managed or programmed costs.
(c) Semi-Variable Cost: The cost which does not vary proportionately but simultaneously does not
remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost.
Some of its examples are as follows:
Depreciation
Repairs
By Nature of Element – Under this classification the costs are divided into three categories i.e. material
cost, labor cost and expenses. This type of classification is useful to determine the total cost.
By Function - Under this classification, costs are divided according to the function for which they have
been incurred. Some of the examples are:
Production cost – Production cost are cost incurred for sequence of operations which begins with
supplying materials labor and services and ends with primary packing of the product.
Selling cost – Selling cost are cost incurred for seeking to create and stimulate demand (sometimes
termed 'marketing') and of securing orders.
Distribution cost – Distribution cost are cost incurred for sequence of operations which begins with
making the packed product available for dispatch and ends with making the reconditioned returned empty
package, if any available for re-use.
It also includes expenditure incurred in transporting products to central or local storage. It also includes
moving products, to and from prospective customers in case of goods sold on sale or return basis. In the
gas, electricity and water industry distribution means pipes, mains and services which may be regarded as
the equivalent of packing and transportation.
Administrative cost – Administrative cost arecost incurred for formulating the policy, directing the
organization and controlling the operations of an undertaking which is not related directly to production,
selling and distribution, research or development activity or function.

By Degree of Traceability to the Product :

a. Direct Cost: The expenses incurred on material and labor which are economically and easily
traceable with a product, service or job is considered as direct costs. In the process of manufacturing
or production of articles, materials are purchased, laborers are employed and paid at a fixed rate, and
certain other expenses are incurred that are directly related to the product being produced. Such costs
are called direct costs.
b. Indirect Cost: The expenses incurred for items that are not directly chargeable to production are
known as indirect costs, for example, salaries of timekeepers, storekeepers and foremen are indirect
cost being not directly related to production. Also expenses incurred for running the administration
departments of the entity, being not directly linked with product being produced, are also termed as
indirect costs.
By controllability: According to this basis cost may be classified into Controllable and Uncontrollable
Costs
a. Controllable Cost: Controllable costs are those costs which can be influenced by the decisions of
specific members of the undertaking.
b. Uncontrollable Cost: It is the costs that cannot be influenced by decision of such specific members
are termed as uncontrollable costs.
A business organization is usually divided into a number of responsibility centers, each of which is in
charge of a specific member or level of management. The officer in charge of a particular department can
control costs only of those matters which come directly under his control, not of other matters. For
example, the expenditure incurred by tool room section is controlled by the foreman in charge of that
section but the share of the tool room expenditure which is apportioned to a machine shop cannot be
controlled by the foreman of that shop. Thus, the difference between controllable and uncontrollable costs
is only in relation to a particular individual or level of management. The expenditure which is controllable
by an individual may be uncontrollable by another individual.
The distinction between controllable and uncontrollable costs is not very sharp and is sometimes left to
individual judgment. In fact no cost is uncontrollable; it is only in relation to a particular individual that
we may specify a particular cost to be either controllable or uncontrollable.
By normality – According to this basis cost may be categorized as follows:

a. Normal cost - It is the cost which is normally incurred at a given level of output under the conditions
in which that level of output is normally attained. These form part of Product Cost.
b. Abnormal cost – It is the cost which is not normally incurred at a given level of output in the
conditions in which the level of output is normally attained. In other words, it is the cost which is
incurred over the normal cost at a given level of output under normal condition. These are directly
charged to Costing Profit and loss Account.

1.9 METHODS OF COSTING

Costing can be defined as the technique and process of ascertaining costs. The principles in every method
of costing are same but the methods of analyzing and presenting the costs differ with the nature of
business. The various methods of costing are as follows:
1. Job Costing
The system of job costing is used in situations where production is not highly repetitive and, in addition,
consists of distinct jobs so that the material and labor costs can be identified by order number. This
method of costing is very common in commercial foundries and drop forging shops and in plants making
specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate
expenditure is charged thereto.
2 Contract Costing
Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a
small contract. The term is usually applied where large-scale contracts are carried out. This system of
costing is used for large contracts like ship-building, printing, building construction etc, Job or contract
costing is also termed as terminal costing.
3 Cost plus Costing

Cost plus Contracts are contracts where in addition to cost, an agreed sum or percentage is added to cover
overheads and profit to be paid to the contractor. The system of costing, for such contracts, is termed as
cost plus costing. The term cost here includes materials, labor and expenses incurred directly in the
process of production. The system is used generally in cases where government happens to be the party to
give contract.
4 Batch Costing
This method is employed where orders or jobs are arranged in different batches after taking into account
the convenience of producing articles. The unit of cost is a cost of batch or a group of identical products
instead of a single job order or contract. This method is particularly suitable for general engineering
factories and pharmaceutical industries which produce components in convenient economic batches.
5 Process Costing
If a product passes through different stages, each distinct and well defined, it is desired to know the cost
of production at each stage. In order to ascertain the same, process costing is employed under which a
separate account is opened for each process.
This system of costing is suitable for the extractive industries, e.g., chemical manufacture, paints, foods,
explosives, soap making etc.
6 Operation Costing
Operation costing is a further refinement of process costing. The system is employed in following types
of industries:
a. The industry in which mass or repetitive production is carried out

b. The industry in which articles or components have to be stocked in semi-finished stage to facilitate
the execution of special orders, or for the convenience of issue for later operations
The procedure of costing is broadly the same as process costing except that in this case, cost unit is an
operation instead of a process. For example, the manufacturing of handles for bicycles involves a number
of operations such as those of cutting steel sheets into proper strips, molding, machining and finally
polishing. The cost to complete these operations may be found out separately.
7 Unit Costing (Output Costing or Single Costing)

In this method, cost per unit of output or production is ascertained and the amount of each element
constituting such cost is determined. In case where the products can be expressed in identical quantitative
units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets
are prepared in which various items of expense are classified and the total expenditure is divided by the
total quantity produced in order to arrive at per unit cost of production. The method is suitable in
industries like brick making, collieries, flour mills, paper mills, cement manufacturing etc.
8 Operating Costing
This system is employed where expenses are incurred for provision of services such as those tendered by
bus companies, electricity companies, or railway companies. The total expenses regarding operation are
divided by the appropriate units (e.g., in case of bus company, total number of passenger/kms.) and cost
per unit of service is calculated.
9 Departmental Costing
The ascertainment of the cost of output of each department separately is the objective of departmental
costing. In case where a factory is divided into a number of departments, this method is adopted.
10 Multiple Costing (Composite Costing)

Under this system, the costs of different sections of production are combined after finding out the cost of
each and every part manufactured. The system of ascertaining cost in this way is applicable where a
product comprises many assailable parts, e.g., motor cars, engines or machine tools, typewrites, radios,
cycles etc.
As various components differ from each other in a variety of ways such as price, materials used and
manufacturing processes, a separate method of costing is employed in respect of each component. The
type of costing where more than one method of costing is employed is called multiple costing.
It is to be noted that basically there are only two methods of costing viz. job costing and process costing.
Job costing is employed in cases where expenses are traceable to specific jobs or orders, e.g., house
building, ship building etc. In case where it is impossible to trace the prime cost of the items for a
particular order because of the reason that their identity gets lost while manufacturing operations, process
costing is used. For example, in a refinery where several tons of oil is produced at the same time, the
prime cost of a specific order of 10 tons cannot be traced. The cost can be found out only by finding out
the cost per ton of total oil produced and then multiplying it by ten.
It may, therefore, be concluded that the methods of batch contract and cost plus costing are only the
variants of job costing whereas the methods of unit, operation and operating costing are the variants of
process costing.

1.10. TECHNIQUES OF COSTING

Besides the above methods of costing, following are the types of costing techniques which are used by
management for controlling costs and making important managerial decisions. As a matter of fact, they
are not independent methods of cost such as job or process costing but are basically costing techniques
which can be used as an advantage with any of the methods discussed above.
1. Marginal Costing
Marginal costing is a technique of costing in which allocation of expenditure to production is restricted to
those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable
overheads. Fixed overheads are excluded in cases where production varies because it may give
misleading results. The technique is useful in manufacturing industries with varying levels of output.
2. Direct Costing
The practice of charging all direct costs to operations, processes or products and leaving all indirect costs
to be written off against profits in the period in which they arise is termed as direct costing. The technique
differs from marginal costing because some fixed costs can be considered as direct costs in appropriate
circumstances.
3. Absorption or Full Costing

The practice of charging all costs both variable and fixed to operations, products or processes is termed as
absorption costing.
4. Uniform Costing
A technique where standardized principles and methods of cost accounting are employed by a number of
different companies and firms is termed as uniform costing. Standardization may extend to the methods
of costing, accounting classification including codes, methods of defining costs and charging
depreciation, methods of allocating or apportioning overheads to cost centers or cost units. The system,
thus, facilitates inter- firm comparisons, establishment of realistic pricing policies, etc.
5. Standard Costing
Standard costing is a system under which the cost of a product is determined in advance, on certain pre-
determined standards. With reference to the example given in post costing, the cost of a product can be
calculated in advance if one is in a position to estimate in advance the material labor and overheads that
should be incurred on the product. All this requires an efficient system of cost accounting. However, this
system will not be useful if a vigorous system of controlling costs and standard costs are not in force.
6. Historical Costing
Historical costing can be of the following two types:

Post Costing
Post costing means ascertainment of cost after the production is completed. This is done by analyzing the
financial accounts at the end of a period in such a way so as to disclose the cost of the units which have
been produced.
For instance, if the cost of product is to be calculated on this basis, one will have to wait till the materials
are actually purchased and used, labor actually paid and overhead expenditure actually incurred. This
system is used only for ascertaining the costs but not useful for exercising any control over costs, as one
comes to know of things after they had taken place. It can only serve as
guidance for future production when conditions in future continue to be the same.
Continuous Costing
Under this method, cost is ascertained as soon as a job is completed or even when a job is in progress.
This is done usually before a job is over or product is made. In the process, actual expenditure on
materials and wages and share of overheads are also estimated. Hence, the figure of cost ascertained in
this case is not exact. But it has an advantage of providing cost information to the management promptly,
thereby enabling it to take necessary corrective action on time. However, it neither provides any standard
for judging current efficiency nor does it disclose what the cost of a job ought to have been.
1.11 COST ACCOUNTING SYSTEM

A cost accounting system is a system that accumulates costs, assigns them to cost objects such as
products, jobs, processes etc. and reports cost information. In addition to this, a proper cost accounting
system assists management in planning and control of business operations, in analyzing product
profitability and in accomplishing business objectives through optimum utilization of available resources.
The cost accounting system depends upon the nature of business and the product manufactured. Before a
suitable system of cost accounting is installed it is necessary to undertake a preliminary investigation so
as to know the feasibility of installing cost accounting system to such business. While introducing a
system of cost accounts it should be borne in mind that cost accounting system must suit the business.
The underlying principles, procedures and objects of all costing system are the same, but the application
of these principles and methods may vary with the circumstances. Basically, two main questions are
involved in installing a cost accounting system: (i) factors influencing cost accounting system, and (ii)
features of cost accounting systems.
Factors influencing the cost accounting system:

As in the case of every other form of activity, it should be considered whether it would be profitable to
have a cost accounting system. The benefits from such a system must exceed the amount to be spent on it.
This would depend upon many factors including the nature of the business and quality of the
management. Management which is prone to making decisions on the basis of pre-conceived notions
without taking into account the information and data placed before it cannot derive much benefit from a
costing system. On the other hand management which is in the habit of studying information thoroughly
before making decisions would require and take benefit from the cost accounting system.
Before setting up a system of cost accounting the under mentioned factors should be studied.
a. The objective of costing system, for example whether it is being introduced for fixing prices or for
introducing and strengthening a system of cost control.

b. The areas of operation of business wherein the managements' action will be most beneficial. For
instance, in a concern which is anxious to expand its operations, increase in production would
require maximum attention. On the other hand for a concern which is not able to sell the whole of its
production, the selling effort would require greater attention. The system of costing in each case
should be designed to highlight, in significant areas, factors considered important for improving the
efficiency of operations in that area.
c. The general organization of the business, with a view of finding out the manner in which the system
of cost control could be introduced without altering or extending the organization appreciably.
d. The technical aspects of the concern and attitude and behavior that will be successful in winning
sympathetic assistance or support of the supervisory staff and workmen.
e. The manner in which different variable expenses would be affected with expansion or cessation of
different operations.
f. The manner in which cost and financial accounts could be inter-locked into a single integral
accounting system and in which results of separate sets of accounts, cost and financial, could be
reconciled by means of control accounts.
g. The maximum amount of information that would be sufficient and how the same should be secured
without too much clerical labor, especially the possibility of collection of data on a separate printed
form designed for each process; also the possibility of instruction as regards filling up of the forms
in writing to ensure that these would be faithfully carried out.
h. How the accuracy of the data collected can be verified? Who should be made responsible for
making such verification in regard to each operation and the form of certificate that should be given
to indicate that the verification has indeed been carried out?
i. The manner in which the benefits of introducing cost accounting could be explained to various
persons in the concern, especially that in-charge of production department and awareness created for
the necessary of promptitude, frequency and regularity in collection of costing data.
Features of Cost Accounting System:

The essential features which a good Cost Accounting system should posses are as follows:
a. Cost Accounting system should be tailor-made, practical, simple and capable of meeting the
requirements of a business concern.
b. The data to be used by the Cost Accounting System should be accurate; otherwise it may distort the
output of the system.
c. Necessary cooperation and participation of executives from various departments of the concern is
essential for developing a good system of Cost Accounting.
d. The cost of installing and operating the system should justify the results.
e. The system of costing should not sacrifice the utility by introducing meticulous unnecessary details.
f. A carefully phased program should be prepared by using network analysis for introduction of the
system.
g. Management should have a faith in the costing system and should also provide a helping hand for its
development and success.

Main Considerations for introduction of a costing system in a manufacturing entity

In view of the above difficulties and suggestions, following should be the main considerations while
introducing a costing system in a manufacturing organization:
a. Product
The nature of a product determines to a great extent the type of costing system to be adopted. A product
requiring high value of material content requires an elaborate system of material control. Similarly, a
product requiring high value of labor content requires an efficient time keeping and wage systems. The
same is true in case of overheads. The range of products manufactured and sold also determine the
method of costing to be selected. Accordingly range of products must be analysed in terms of size,
models, fashions, area of market, competitors and whether the products are made to customers
specification or for stocking and selling
b. Organization
The existing organization structure should be disturbed as little as possible. It becomes, therefore,
necessary to ascertain the size and type of organization before introducing the costing system. The scope
of authority of each executive, the sources from which a cost accountant has to derive information and
reports to be submitted at various managerial levels should be carefully gone through.
c. Objective
The objectives and information which management wants to achieve and acquire should also be taken
care. For example, if a concern wants to expand its operations, the system of costing should be designed
in a way so as to give maximum attention to production aspect. On the other hand, if a concern were not
in a position to sell its products, the selling aspect would require greater attention.
d. Technical Details
The system should be introduced after a detailed study of the technical aspects of the business. Efforts
should be made to secure the sympathetic assistance and support of the principal members of the
supervisory staff and workmen. Technical considerations that influence the installation of cost accounts
are as follows :
(a) Size and layout of the factory
(b) The existence of production and service departments
(c) Flow of production
(d) Capacity of machines and degree of mechanisation
(e) Existence of laboratories
(f) Internal transport and material handling equipments
(g) Production control techniques
(h) Inspection and testing of materials and finished goods
e. Informative and Simple

The system should be informative and simple. In this connection, the following points may be noted:

(i) It should be capable of furnishing the fullest information required regularly and systematically, so that
continuous study or check-up of the progress of business is possible.
(ii) Standard printed forms can be used so as to make the information detailed, clear and intelligible.
Over-elaboration which will only complicate matters should be avoided.
(iii) Full information about departmental outputs, processes and operations should be clearly presented
and every item of expenditure should be properly classified.
(iv) Data, complete and reliable in all respects should be provided in a lucid form so that the measurement
of the variations between actual and standard costs is possible.
f. Method of maintenance of cost records

A choice has to be made between integral and non-integral accounting systems. In case of integral
accounting system, no separate sets of books are maintained for costing transactions but they are
interlocked with financial transactions into one set of books.
In case of non-integral system, separate books are maintained for cost and financial transactions. At the
end of the accounting period, the results shown by two sets of books are reconciled. In case of a big
business, it will be appropriate to maintain a separate set of books for cost transactions.
g. Elasticity
The costing system should be elastic and capable of adapting to the changing requirements of a business.
It may, therefore, be concluded from the above discussion that costing system introduced in any business
will not be a success in case of the following circumstances:
i. If it is unduly complicated and expensive
ii. If a cost accountant does not get the cooperation of his/her staff
iii. If cost statements cannot be reconciled with financial statements
iv. If the results actually achieved are not compared with the expected ones
Practical Difficulties in installation of a costing system

The important difficulties in the installation of a costing system and the suggestions to overcome them are
as follows:
a. Lack of Support from Top Management
Often, the costing system is introduced at the behest of the managing director or some other director
without taking into confidence other members of the top management team. This results in opposition
from various managers as they consider it interference as well as an uncalled check of their activities.
They, therefore, resist the additional work involved in the cost accounting system.
This difficulty can be overcome by taking the top management into confidence before installing the
system. A sense of cost consciousness has to be instilled in their minds.

b. Resistance from the Staff

The existing financial accounting staff may offer resistance to the system because of a feeling of their
being declared redundant under the new system.
This fear can be overcome by explaining the staff that the costing system would not replace but
strengthen the existing system. It will open new areas for development which will prove beneficial to
them.
c. Non-Cooperation at Other Levels

The foreman and other supervisory staff may resent the additional paper work and may not cooperate in
providing the basic data which is essential for the success of the system.
This needs re-orientation and education of employees. They have to be told of the advantages that will
accrue to them and to the organization as a whole on account of efficient working of the system.
d. Shortage of Trained Staff

Costing is a specialized job in itself. In the beginning, a qualified staff may not be available. However,
this difficulty can be overcome by giving the existing staff requisite training and recruiting additional
staff if required.
e. Heavy Costs
The costing system will involve heavy costs unless it has been suitably designed to meet specific
requirements. Unnecessary sophistication and formalities should be avoided. The costing office should
serve as a useful service department.
1.12 RELATIONSHIP BETWEEN COST ACCOUNTING, FINANCIAL ACCOUNTING,

MANAGEMENT ACCOUNTING AND FINANCIAL MANAGEMENT
Cost Accounting is a branch of accounting, which has been developed because of the limitations of
Financial Accounting from the point of view of management control and internal reporting. Financial
accounting performs admirably, the function of portraying a true and fair overall picture of the results of
activities carried on by an enterprise during a period and its financial position at the end of the year. Also,
on the basis of financial accounting, effective control can be exercised on the property and assets of the
enterprise to ensure that they are not misused or misappropriated. To that extent financial accounting
helps to assess the overall progress of a concern, its strength and weaknesses by providing the figures
relating to several previous years.
Data provided by Cost and Financial Accounting is further used for the management of all processes
associated with the efficient acquisition and deployment of short, medium and long term financial
resources. Such a process of management is known as financial management. The objective of financial
management is to maximize the wealth of shareholders by taking effective investment, financing and

dividend decisions. Investment decisions relate to the effective deployment of scarce resources in terms of
funds while the financing decisions are concerned with acquiring optimum finance for attaining financial
objectives. The last and very important ‘Dividend decision’ related to the determination of the amount
and frequency of cash which can be paid out of profits to shareholders.
Management Accounting refers to managerial processes and technologies that are focused on adding
value to organizations by attaining the effective use of resources, in dynamic and competitive contexts.
Hence, Management Accounting is distinctive form of resource management which facilitates
management’s ‘decision making’ by producing information for managers within an organization.

Self Examination Questions

1. What is Cost Accounting? Explain its important objectives.
2. Discuss briefly some of the factors which a Cost Accountant should consider before installing a costing system
in a manufacturing concern.
3. State and explain the main difference between the financial accounting and Cost Accounting.
4. Write short notes on: (a) Conversion cost (b) Sunk cost (c) Differential cost (d) Opportunity Cost (e) Out of
pocket cost.
5. Distinguish between:
a. Cost centre and cost unit
b. Cost control and cost reduction
c. Period cost and product cost
d. Controllable and non controllable cost
e. Estimated cost and standard cost
f. Variable cost and direct cost
6. Financial accounts provide information:
i. To management to able it to fix prices
ii. For the maintenance of efficient control over efficient control over assets and liabilities.
iii. For assessing the financial position and profitability of the firm
iv. For locating factors leading to wastages and losses
v. For cost control
State which of the above will properly complete the sentence.
7. Cost accounting:
a. Should better be treated as investment.
b. Is not needed if prices are beyond the control of the firm
c. Will not be necessary if financial accounts provide the necessary analysis.
d. Is nothing but a post mortem of past costs
e. Is useful only in such organizations which have profit as the aim
f. Enables the firms to compute the cost beforehand.
State which of the above will properly complete the sequence.
8. Write brief answers to the following:
a. While introducing a cost accounting system, to what should most attention be paid to, production or sales?
b. Are direct expenses more important than indirect expenses?
c. Is prompt reporting better than accurate reporting?
d. If the selling price for a product is not within the control of the firm, why should it have a system of cost
accounting?

9. Below is given a list of industries and also the methods of costing and cost unit. Give the correct number of
methods of costing and unit of cost against each industry.
Industry Methods Of Costing Unit of Cost

(i) Nursing Home (a) Process 1. Each job
(ii) Road transport (b) Job 2. Bed per week or per day
(iii) Steel(owning iron (c) Multiple 3.Per ton
Ore mines)
(iv)Coal (d) Single 4.Each contract
(v) Bicycle (e) Operating 5.Each unit
(vi) Bridge construction (f) Contract 6.Per ton-kilometer
(vii) Interior decoration
(viii)Advertising
(ix) Furniture
(x) Sugar company having own sugarcane fields
10. Among the following statements indicate which are true:

a. Cost accounting can be used only in manufacturing concerns.
b. Cost accounting is a branch of financial accounting.
c. A prosperous business concern does not need a costing system.
d. Cost audit is a part of cost accountancy.
e. All costs are controllable.
f. Direct costs are those which are incurred for and conveniently identified with a particular cost centre or cost
unit.
g. Fixed cost per unit remains fixed.
h. Interest on capital, payment for which is not actually made, is an example of imputed cost.
i. Prime cost is the total of direct materials, direct wages and production overheads.
11. Fill in the blanks.

a. On the basis of the behavior of cost, overheads are classified into ……………
b. One of the functions of cost accounting is proper matching of ……………
c. A cost which requires payment to outside parties is known as ………….
d. In ……… costing, the cost of a group of products is ascertained.
e. ……….. costs are hypothetical notional costs.
f. ………unit costs remain constant with changes in volume while…… unit costs fluctuate with volume.
g. ……….is a cost center which consists of person or group of persons.
h. The ascertainment of costs after they have been incurred is known as ……….

i. ……….is a cost which cannot be influenced by the action of a specified member of an undertaking.
j. The method of costing used in job order industries is known as ……..
k. ……….. costs are those which follow the item into inventory, and …….. costs are charged against current
income.
12. Select the correct answer in each of the following multiple choice questions
a. The main purpose of cost account is to:
i. Maximize profit
ii. Help in inventory valuation
iii. Provide information to management for decision making
iv. Aid in the fixation of selling price.
b. One of the most important tools in cost planning is :
i. Direct cost
ii. Budget
iii. Cost sheet
iv. Marginal costing
c. Increase in total variable cost is due to:
i. Increase in fixed cost
ii. Increase in sales
iii. Increase in production
d. An example of fixed cost is :
i. Direct material cost
ii. Works manager’s salary
iii. Depreciation of machinery
iv. Chargeable expenses
e. Cost of goods produced includes:
i. Production cost and finished goods inventory
ii. Production cost and work-in-progress
iii. Production cost, work-in-progress and finished goods inventory
f. Conversion cost is equal to the total of:
i. Material cost and direct wages
ii. Material cost indirect wages
iii. Direct wages and factory overhead
iv. Material cost and factory overhead
g. Costs which are ascertained after they have been incurred are known as :
i. Imputed costs
ii. Sunk costs

iii. Historical costs
iv. Opportunity costs
h. Prime cost plus variable overhead is known as:
i. production cost
ii. marginal cost
iii. total cost
iv. cost of sales
13. A company manufactures garments. The following costs are incurred by the company. You are required to group
the costs which are listed below into following classifications:
a. Direct material
b. Direct labour
c. Direct expenses
d. Indirect production overheard
e. Research and development cost
f. Selling and Distribution cost
g. Administration Cost
h. Finance Cost
i. Lubricant and sewing machines
j. Back up disk for general office computer
k. Maintenance contract for office photocopier
l. Road license for delivery vehicle.
m. Market research prior to new product launch
n. Cost of painting advertisement slogans in delivery vans
o. Trade magazine
p. Upkeep of delivery vehicles
q. Wages of operative in cutting department
r. Interest on bank overdraft
s. None of above
Answer to Self Examination Question

6. (ii), (iii);
7. (i), (iii), (iv)
8. (a) Depends, which has more problems (b) No, not always; (c) Report should be prompt and reasonably
accurate; (d) for measuring efficiency and control.
9. (i)e,2; (ii) e,6; (iii) a, 3; (iv) d,3; (v) c, 5; (vi) f, 4; (vii) b,1; (viii) b, 1; (ix) c, 5; (10) a, 3;
10. True statements are (d), (f), (h).
11. (a) fixed and variable (b) costs (c) out of pocket (d) batch (e) imputed (f) variable, fixed (g) personal cost center
(h) historical costing (i) uncontrollable cost (j) job costing (k) product, period
12. (a) (iii); (b) (ii); (c) (iii); (d) (ii); (e) (ii); (f) (iii); (g) (iii); (h) (ii)
13. a. xi; b. ii; c. xi; d. I; e. v; f. iv, vi, viii; g. ii, iii; h. x;

CHAPTER 2
MATERIAL CONTROL
CHAPER 2 : MATERIAL CONTROL
2.1 CONCEPT OF MATERIAL CONTROL

Materials constitute a very significant proportion of total cost of finished product in most of the
manufacturing industries. The substantial proportion of material cost in the total cost demands more and more
attention of the management towards this element. A proper recording and control over material cost is thus
essential. Material control may be defined as a system which ensures availability of the required quantity
of material of proper quality at the proper time and at the same time avoidance of unnecessarily blocking
up of capital in stores. The system of material control should be so comprehensive that it covers the whole
procedure from the point when order is placed with the suppliers up to the stage until the materials are
consumed in production.
2.2 OBJECTIVES OF SYSTEM OF MATERIAL CONTROL:

The objectives of system of material control are the following:
i. Ensuring that no activity, particularly production, suffers from interruption from want of
materials and stores – it should be noted that this requires constant availability of every item that
may be needed howsoever small its cost may be. Lubricating oil may cost much less than the
main raw material but, from the point of view of uninterrupted production, both have equal
importance.
ii. Seeing to it that all the materials and stores are acquired at the lowest possible price considering
the quality that is required and considering other relevant factors like reliability in respect of
delivery, etc.
iii. Minimization of the total cost involved, both for acquiring stocks (apart from the price paid to
the supplier) and for holding them.
iv. Avoidance of unnecessary losses and wastages that may arise from deterioration in quality due
to defective or long storage or from obsolescence.
v. Maintenance of proper records to ensure that reliable information is available for all items of
materials and stores that not only helps in detecting losses and pilferages but also facilitates
proper production planning.
The fulfillment of the objectives mentioned above will require that standard lists of all the materials and
stores required for the firm's work be drawn up with the weekly consumption figures. Also the lead time
for each item has to be determined which will then enable the firm to ascertain the minimum quantity for
each items. It is also necessary to fix maximum quantity so that capital is not locked up unnecessarily and
the risk of obsolescence is minimized. Costs are minimized through the use of ABC analysis (which
means classification of the various items of material and stores into three categories viz. A, B and C
considering the investment involved in each of the categories.

2.3 REQUIREMENT OF MATERIAL CONTROL

Material control requirements are as follows:-
i. Proper co-ordination of all departments involved viz., finance, purchasing, receiving, inspection,
storage, accounting and payment.
ii. Determining purchase procedure to see that purchases are made, after making suitable enquiries,
at the most favorable terms to the firm.
iii. Use of standard forms for placing the order, noting receipt of goods, authorizing issue of the
materials etc.
iv. Preparation of budgets concerning materials, supplies and equipment to ensure economy in
purchasing and use of materials.
v. Operation of a system of internal check so that all transaction involving material supplies and
purchases are properly approved and automatically checked.
vi. Storage of all materials and supplies in a well designed location with proper safeguards.
vii. Operation of system of perpetual inventory together with continuous stock checking so that it is
possible to determine at any time the amount and value of each kind of material in stock.
viii. Operation of a system of stores control and issue so that there will be delivery of materials upon
requisition to departments in the right amount at the time they are needed.
ix. Development of system of controlling accounts and subsidiary records which exhibit summary
and detailed material costs at the stage of material receipt and consumption.
x. Regular reports of materials purchased, issues from stock, inventory balances, obsolete stock,
goods returned to vendors and spoiled or defective units.
It may also be added that information about availability of materials and stores should be continuously
available so that production may be planned properly and the required material purchased in time.
2.4 MATERIAL PURCHASE PROCEDURE

In order to ensure that materials and stores are always available, that the price paid is not unnecessarily
high and investment in materials and stores is at a reasonably low figures, there must be a separate
Purchasing Department if at all the size of the concern permits it. This department will work under an
officer designated as the Purchase Manager or the Supply Manager.
Centralized and Decentralized purchases: Centralized purchases means all purchases of factory
requirement are made by the single unit/department headed by a single personnel (manager/officer
depending upon the size of the entity). On the other hand, Decentralized purchases indicate a scenario
where various persons are authorized to make purchases for their requirements.
The main advantage of centralized purchasing is that the purchase officer will automatically develop into
an expert and will be able to make purchases at the most opportune time and from the best sources. He
can also ensure utilization of trade discounts and use of transport economies.
Generally, if purchasing is not centralized, that is to say, if various persons are authorized to make
purchases for their requirements, there remains a probability that some of them may indulge in reckless

buying. They may buy things or stores which strictly are not required. Purchases in small lots will also
mean that discounts and economies in transport
ansport will not be available. Also nobody can then become an
expert in buying – these days there are many rules and regulations that have to be followed for obtaining
supplies of some articles.
It can be said that centralized purchasing will be suitable if (a) the company operates a single plant, (b)
when there are two or more plants not very far away from one another, requiring the same general
general-type
raw materials. However, there is no advantage in centralized purchasing if different materials and store
stores
are required by different plants.
Materials purchase department in a business house is confronted with the following issues:
i. What to purchase?
ii. When to purchase?
iii. How much to purchase?
iv. From where to purchase?
v. At what price to purchase?
To overcome the above

ve listed issues, the purchase department follows the procedure involving following
steps:

a. Receiving purchase requisitions:

Since the materials and stores purchased will be used by the production departments, there should be
constant co-ordination between the purchase and production departments.
A purchase requisition is a form used for making a formal request to the purchasing department to
purchase materials. This form is usually filled up by the store keeper for regular materials and by the
departmental head for special materials (that not stocked as regular items). The requisition form is duly
signed by either works manager or plant superintendent, in addition to the one originating it.
At the beginning a complete list of materials and stores required should be drawn up, the list should have
weekly consumption figures. It should be reviewed periodically so that necessary deletion and addition
may be made. If there is any change in rate of consumption per week (say, due to extra shift being
worked), the purchase department should be informed about the new figures. Once an item has been
included in the standard list, it becomes the duty of the purchases department to arrange for fresh supplies
before existing stocks are exhausted. But if the production department requires some new material, it
should make out a purchase requisition (also called “indent”) well in time and send it to the purchase
department for necessary action.
Control over buying – for control over buying of regular store materials it is necessary to determine their
maximum, minimum, reorder level and economic order quantities. The use of economic order quantities
and various levels constitutes an adequate safeguard against improper indenting of regular materials. In
respect of special materials, required for a special order or purpose, it is desirable that the technical
department concerned should prepare materials specifications list specifying the quantity, size and order
specifications of materials to be drawn from the store and those to be specially procured.
In all cases, the starting point in the process for purchasing is the issue of a proper purchase requisition
(form is given below). Student may note that the forms suggested in this booklet as well as in the text
books are illustrative in nature. The actual form may differ under different circumstances). Its purpose is
to request and authorize the purchase department to order to procure the materials specified in stated
quantities. It should normally be made out in triplicate.
The original copy is sent to the purchasing department, the duplicate is kept by the storekeeper or the
department which initiates the requisition and the triplicate is sent to the authorizing executive.

A specimen form of purchase requisition for reordering regular stock items

b. Exploring the sources of material supply and selecting suitable material suppliers / Vendor:
A source for supply of each material is selected upon receipt of purchase requisition. Purchase department
in each business house usually maintains a list of suppliers for each group of materials required by their
concern. In general, minimum of three quotations are invited from such suppliers. On receiving required
number of quotations a comparative statement is prepared. Price of material
material; quantity; quality offered;
time of delivery; mode of transportation; terms of payment; reputation of supplier; etc. are the main
factors that are taken into consideration while selecting the eventual supplier. In addition to the above
listed factors, purchase
chase manager also obtains other necessary information from the statement of
quotations such as past records, buyer guides etc. that are also taken into consideration while selecting
material suppliers.
Illustration: 1
After inviting tenders two quotations
ns are received as follows (a) Rs. 1.20 per unit (b) Rs. 1.10 per unit
plus Rs. 3,000 fixed charge to be added irrespective of the units ordered. Advise with your arguments
with whom orders should be placed and what quantity is to be ordered.
The following additional information may be of interest:
Present stock 35,000 units
Average monthly requirement 10,000 units
Maximum level 80,000 units
Minimum level 30,000 units
[44] ©The Institute of Charte

Chartered Accountants of Nepal (ICAN)
Solution:
The difference in the two tenders is Rs.0.10 per unit. To cover up fixed cost of Rs. 3,000, the units to be
ordered against second should be less than 30,000 units. At this point, the prices under both quotations
will be equal.
If order is less than 30,000 units, it will be profitable to place order against first quotation. If ordered
quantity is more than 30,000 units the second quotation will be more advantageous.
From the additional information it appears that the present ordering quantity is 45,000 units (i.e.
maximum level – present stock), it will therefore, be advantageous to order with second quotation.
• 45,000 units @ Rs. 1.20 = Rs. 54,000
• 45,000 units @ Rs.1.10 + Rs. 3,000 = Rs. 52,500
c. Preparation and execution of purchase orders:

Having decided on the best quotation that should be accepted, the purchase manager or concerned officer
proceeds to issue the formal purchase order. It is a written request to the supplier to supply certain
specified materials as specified rates and within a specified period.
Copies of purchase order are sent to:
i. The supplier;
ii. Store or the order indenting department;
iii. Receiving department; and
iv. Accounting department
A copy of the purchase order, along with relevant purchase requisitions, is maintained separately in the
purchase department’s file to facilitate the follow-up, monitoring delivery and also for approving the
invoice for payment.
d. Receiving and inspection of materials

In big factories there is a separate department for receipt of goods. In smaller factories, this task may be
entrusted to the storekeeper.
The receiving department or section is responsible for taking charge of the incoming materials, checking
and verifying their quantities, inspecting them as regards their grade, quality or other technical
specifications and if found acceptable, passing them on to the stores (or other departments for which these
might have been purchased).
In large organization, a special inspection wing is often attached to the receiving department and, where it
is not so, technical appraisal of the incoming supplies is carried out by the general inspecting staff. In case
the quality is not the same as ordered, the goods are not accepted. If everything is in order and supply is
considered suitable for acceptance, the receiving department prepares a receiving report or material
inward note or goods received note. It is prepared in quadruplicate, the copies being distributed as under:
i. First copy is sent to the purchase department for verifying supplier's bill for payment.
ii. Second copy is sent to the store or to the indenting department.
iii. Third copy is sent to the store ledger clerk in the cost department.

iv. Fourth and the last copy is retained for use by the receiving department.
A good plan would be that the receiving clerk sends all the three copies (meant for others) along with the
materials to the store or the department that placed the order. The materials are then physically inspected
and the particulars thereof as recorded in the receiving report are verified. If the quantity and quality are
in order, the delivery of the same is accepted and copies of the report are signed; two copies of the report
are forwarded to the purchase department and the third is kept on the file as documentary evidence of the
quantities of store received for storage or use, as the case may be. The Purchase department in turn, enters
the purchase price and forwards one copy to the Accounts Department and the second to the Cost
Department.
After this, a "Goods Received Note" should be prepared. Its form is given below;
Material outward return note- Sometimes materials have to be returned to suppliers after these are
received in the factory. Such returns may occur before or after preparing of the receiving report. If the
return takes place before preparing of the receiving report such material obviously would not be included
in the report and hence will not debited in the stores books and ledgers. In that case no adjustment in the
account books would be necessary. But if the material is returned after its entry in the receiving report, a
suitable document must be drawn up in support of the credit entry so as to exclude, from the stores of
material account, the value of materials returned back. This document usually takes the form of a material
outward return note.
The material outward return note is drawn up by the stores or the dispatch Department, five copies of it
are usually prepared; two for the supplier (one of which is to be sent back by the supplier after he has
signed the same), one for store, one for cost ledger and one copy to be retained in the material outward
return book.

i. Costing of incoming materials:

From the point of view of proper Cost Accounting, expenses incurred for purchasing, receiving and
storing of materials should be treated as cost of material purchased. This will ensure that the job or
products which use a particular material will be charged with the total amount spent upon purchasing,
receiving and storing that particular material.
All cost up to the point when materials and stores are ready for issue should be added to the cost.
Expenses incurred after this point should be treated as overheads or indirect expenses. This means that the
price charged by the supplier less any trade discount obtained should be added to transportation expenses,
import duty or dock dues (in case of imports) and other incidental charges to arrive at the cost of material.
Whereas indirect expenses like, the storekeeper's wages or the rent of the godown, purchase office
expenses, receiving department expenses etc which are common in nature are allocated to material
applying certain predetermined rate.
There are some instances specific to certain industries where such indirect expenses are allocated to
various jobs on products on the basis of quantities of materials used. The following illustration pertaining
to Sugar factory will be helpful to understand the concept.
Illustration: 2
A sugar factory has a permanent 'cane' staff consisting of one superintendent @ Rs. 8,000 p.m. and two
assistants @ Rs. 3,000 p.m. each. Two-thirds of the time is devoted to cane development and the rest to
cane purchase for crushing during the season, usually of 120 days. During season 150 weighing clerks
have to be employed @ Rs. 120 per day. The price paid is Rs. 800 per ton plus a commission of 2 percent
to the farmers' cooperative society. Average freight per ton works out @ Rs.10. Average quantity of cane
crushed per day is 1,500 tons. The annual depreciation and repairs of weighing machines is Rs. 36,000.
Ascertain the cost of cane per ton for costing purposes.
Solution:
Statement showing cost of cane (per ton) Rs.
Price paid to farmers per ton of cane 800.00
Commission @ 2% 16.00
Freight 10.00
Cane purchase staff: [12(8,000+2x3,000)x2/3]/[(120 x 1,500)] 0.622
Weighing clerk: (150*120)/1,500 12.00
Depreciation and Repairs of weighing machines 36,000/(120 x1,500) 0.20
838.22
Materials handling Charges: The question of expenses incurred in purchasing, receiving, storing and
issuing materials and stores is important. As a rule, such expenses should be charged by way of
marking up the price of the materials concerned. For example, in a cotton textile factory, the
issue price of cotton, in general, shall include:
• The purchase price;
• The incoming freight and other charges;

• Storing expenses including rent of godown, wages to godown keeper, etc. and
• Expenses to cover movement from godown to the mill.
This is so because, generally, purchase of cotton will be kept separate from other purchases. The same
practice can be easily followed in case of sugarcane purchased by a sugar factory except that there will be
no storing expenses.
But in most of the other cases only a few of the expenses can be added conveniently to the cost of
material. Incoming freight, import or other duty, dock dues, etc., can be easily added and thus charged
directly to the cost of products or jobs using the materials. Other expenses for buying, receiving, storing
and issuing will be treated as overheads. If the factory is small, these expenses will be part of the total
factory expenses to be recovered by an overall charge. If the factory is big, material handling charges will
be treated as a separate item of overheads to be recovered differently from general factory overheads. If a
large number of items are handled – no one being of pre-eminent importance – the recovery will be by
way of percentage charge on the value of materials issued. For instance, if total material handling
expenses comes to Rs. 10,000 for a six-month period and the total value of materials issued to the factory
comes to Rs. 200,000 for the same period, the charge comes to 5 percent i.e. [(10,000/200,000) x 100]. If
a job consumes materials worth Rs. 5,000 then five percent of this namely, Rs. 250 will be added to the
cost of the job for material handling charges.
It is possible that some of the materials may be bulky as will be the case in an engineering concern.
Special arrangements, like cranes, may have to be made for handling and storing such bulky materials.
The cost of storing materials and for operating these cranes, say for a month should be ascertained. The
cost of operating a crane will consist of the wages of the workers operating it, power consumed, insurance
charges, repairs and maintenance, depreciation, etc. The total cost should be divided by the total tonnage
handled; this will give the cost of handling one ton of bulky materials. When such materials are issued for
production, the cost of handling will be added to the value of materials. For example, suppose a crane
costs Rs.1,000 to operate and it handles 2,500 tons of materials a month. This gives a rate of Rs. 0.40 per
ton. If, 20 tons of materials are issued for a job, Rs 20 x 0.40 or Rs. 8 will be added to the cost of
materials.
It should be noted that a percentage charge by way of recovery of purchasing expenses will also have to
be added in addition to the charge for handling and storing.
ii. Control over investment in stocks or inventory control: It is necessary that excessive stock should
not be carried. For this purpose, the stores ledger will prove to be of great benefit. Management
can find out where there is over-investment or not by regularly working out the ratio between the
total value of stores carried and the value of stores issued during a particular period, say, a
month. If the ratio goes up, it means that investment in stocks is going up. For example, if value
of stores issued in January comes to Rs. 15,000 and the total value of all items in stock is Rs.
37,500, the ratio is 37,500/15,000 or Rs. 2.50. It means that, taking all items together, stocks are
sufficient to last for 21/2 months. If the ratio for February worked out similarly is, say, 3.1, it
means that more money is locked up in inventory. What is the proper ratio will depend upon the
average period of delivery. If goods can be replenished within a period of 8 weeks, the ratio
should not be much above 2 (if worked out monthly).
Another example, if (a) it takes six weeks to replenish on an average (b) the value of issue during a period
of six weeks is Rs.300,000 and (c) the total of inventory comes to Rs. 900,000, the ratio is
900,000/300,000. This shows investment in stocks at too high a level. This ratio should not be much
above 1.

To get better results it would be better to split up the total inventory into its natural categories like (a) raw
materials (b) chief stores, e.g., coal, and (c) sundry consumable stores. The ratios should then be worked
out separately for each category. This will indicate where exactly over-stocking has occurred.
Even this is not enough. The account of each item should be gone through and separate lists should be
complied of items:
• Of which there are large stocks but which were not used at all during the year and are not likely
to be used; and
• Of which the stock are too large compared to the demand likely to arise in the coming months.
Total stocks of items covered by (a) and excessive stocks of items covered by (b) should be immediately
disposed off. Delay will only mean deterioration in quality and consequent loss in the amount realized.
An exception to the above rule is spares for machinery in use. The fact that a particular part has not been
required for a number of years is no guarantee that it will not be required in future also. Thus, as long as a
machine is in use, its spares should be kept in stock and not disposed off. Spares of machines no longer in
use should be disposed off unless they can be used for other purposes.
Particular Amount Rs. Amount Rs.

A. Calculation of material cost
Material purchase cost (Quantity X Per Unit Cost) XXX
Less: Trade Discount XXX
Purchase cost after discount XXX
Add: Excise Duty XXX
Purchase cost after excise duty XXX
Add: VAT XXX
Purchase cost after VAT XXX
Add: Containers cost XXX
Add: Sales tax on containers (if any) XXX
Total Invoice Value XXX
Add: Insurance Charges XXX
Add: Freight Charges / Delivery Charges XXX
Less: Resale value of containers or returnable amount of containers XXX
Total Material Cost XXX
B) Usuable Quantity or Effective Quantity:

Total Purchase Quantity XXX
Less: Normal Loss in transit XXX
Less: Normal Loss in storage XXX
Effective / Usable Quantity XXX

C) Net Cost Per Unit = A / B XXX
Note: The cost incurred upto the point of procuring and storing materials should constitute the cost of
material purchased. It is also called “Landed Cost of Materials”.
Illustration: 3
A factory has received one consignment containing two important materials X and Y and the invoice
pertaining to the same discloses the following information:
Rs.
Material 'X' 1,000 tons @ Rs. 2 per ton 2,000.00
Material 'Y' 1,200 tons @ Rs. 1.60 per ton 1,920.00
Insurance 98.00
Freight etc., 110.00
Sales tax 196.00
Due to mishandling in the factory store, loss of 20 tons of Material 'X' and 12 tons of Material 'Y' was
recorded. What rate you would adopt for issuing these materials to jobs. If a provision of 20 percent is to
be made for probable risk of obsolescence, what would be the new rate?
Solution
Statement of Cost of materials
Material X Material Y
Rs. Tons Rs. Tons
Payment to the Supplier 2,000 1,000 1,920 1,200
Add:
Insurance 50 48
Freight 50 60
Sales Tax 100 96
Total 2,200 1,000 2,124 1,200
Less: Loss of tons due to mishandling - 20 - 12
2,200 980 2,124 1,188
Rate of Issue 2200/980 = 2.24 2124/1188 = 1.79
If a Provision of 20% is to be made for probable risk
of obsolescence, then new rates will be :
Rate calculated as above 2.24 1.79

Add: 20% of obsolescence 0.45 0.36
New Rate 2.69 2.15

Note: Insurance, freight and sales tax have been apportioned as below:
• Insurance in the ratio of material cost i.e. 200:192
• Freight in the ratio of weight of material i.e. 10:12
• Sales tax in the ratio of material cost i.e. 200:192
e. Checking and passing of bills for payment:

The invoice received from supplier is sent to stores accounting section to check authenticity and
mathematical accuracy. The quantity and price are also checked with reference to goods received note
and purchase order respectively. The stores accounting section will, after checking its accuracy, finally
certify and pass the invoice for payment. Based on which, payment is made to supplier.
2.5 STORAGE OF MATERIALS

Proper storing of materials is also one of the most important functions. It is not enough only to purchase
material of the required quality. If the purchased material subsequently deteriorates in quality because of
bad storage, the loss will be even more than what purchase of bad quality materials would incur. Apart
from the preservation of the quality, the store keeper also must ensure safe custody of the material. It
should be the function of store-keeper that the right quantity of materials always should be available in
stock.
Duties of store keeper:

These can be briefly set out as follows:
• To exercise general control over all activities in Stores Department.
• To ensure safe keeping both as to quality and quantity of materials.
• To maintain proper records.
• To initiate purchase requisitions for replacement of stock of all regular stores items whenever the
stock level of any item of store approaches the minimum limit fixed in respect thereof.
• To initiate action for stoppage of further purchasing when the stock level approaches the maximum
limit.
• To check and receive purchased materials forwarded by receiving department and to arrange for their
storage at appropriate places.
• To reserve a particular material for a specific job when so required.
• To issue material only in required quantities against authorized requisition notes/material lists.
• To check book balances with actual physical stock at frequent intervals so as to detect wrong issues,
pilferage, etc if any.

Minimizing the cost of purchasing and store-keeping:

There are two types of costs which are involved in making a purchase and keeping the goods in the store.
For placing each order, a certain amount of labor is required and therefore, it will involve a certain sum of
money as cost. It should be noted that the cost of making a purchase not only included the cost incurred
by the purchasing department but it also includes the cost of receiving and inspecting the goods. These
costs naturally increase if the number of order is large; there can be saving if the number of orders is
reduced. The other type of cost is concerned with keeping the goods in stock. It comprises the money
invested, the loss which is likely to take place if the goods are kept, the expenses incurred on looking after
the items etc. Larger the stock, higher will be this type of cost. In order to reduce this cost, it is necessary
to bring down level of stock. It may be noted that the number of orders can be cut down only, if the
quantity of each order is increased, but if that is done, the average quantity on hand will increase and,
therefore, interest and the cost of store keeping will be higher. It is therefore necessary to have the
balance between these two costs and to keep total of the two at the minimum level. With this objective in
view, the economic order quantity is worked out. But different items for stock have to be treated
differently. The name given to such classification is the "ABC analysis, or selective Inventory Control.
Different classes of stores:

Broadly speaking, there are three classes of stores viz., central or main stores, sub-stores and departmental
stores. The central stores are the most common of all and are prevalent in practice; factories generally
have one central store under the control of one store keeper. Such a store is centrally situated and is easily
accessible to all departments. If receipts and issues of different items of stores are not large and various
departments are close to each other, one central store for all purposes is sufficient.
In big organizations, particularly in the case of collieries, tea gardens, big construction companies etc.
where the work spots/project sites are distributed over a large area, sub-stores are created. A sub-store is
in fact a branch of the central store. It is generally created to facilitate easy accessibility to the various
work spots or consumption centers. Only the essential items, as well as those required urgently, are kept
in them. The issues to sub-stores are not treated as consumption but only as a transfer, from the one store
(central) to other sub-stores. The control in the matter of ordering or receiving rests with the central stores
and the sub-stores do not generally receive any item directly.
Departmental stores are created normally to minimize the time spent on drawing from stores. For
example, a week's supply may be drawn at one time and kept in a departmental store at a place marked
for the purpose. Such stores, however, are essential where one or more production departments work in
multiple shifts and the central store works for only one shift; also for the storage of work in progress and
semi-finished components where these are large in number or in bulk. Unlike a sub store, in the
departmental store, the control rests with the department in charge. The materials are generally issued in
bulk to the department store and it is the responsibility of the department-in-charge to keep proper
accounts as regards issues and stock. If the bulk of materials are required for only one department, it is
usually stored near the department under the charge of a superintendent concerned.
Stores Location:
The location of the store should be carefully planned. It should be near to the material receiving
department so that transportation charges are kept at a minimum. At the same time, it should be easily
accessible to all other departments of the factory. A carefully planned location of stores department will
be a great help in avoiding delays in movement of materials to the departments for which they are needed.

Stores layout:
The stores should be adequately provided with the necessary racks, drawers and other suitable receptacles
for storing materials. Each place (for example, a drawer or a corner) where materials are kept is called a
bin. Each bin should be serially numbered and for every item a separate bin is allocated. All receipts of
items of same type should be kept in allotted bins, for convenience of access. The number of the bin
should be entered in the Store Ledger concerned accounts.
Classification and codification of materials:

Proper classification and codification of various items of stores is essential for good system of store
keeping. Materials in the store may be classified either on the basis of their nature or on the basis of their
usage. Former method is commonly used for classifying materials as construction material, consumable
stores, spare parts, lubricating oil etc.
Codification of classified material can be done by using alphabetic, numerical or alphanumeric
approaches. Under codification each item of stores is given a distinctive code number. Numerical system
of codification is commonly used. Under this method, the whole numbers are used to indicate the main
group and the decimals to indicate primary, secondary and other groups. For example, in Printing Press,
the following codes may be assigned:
Paper: 130
Ink: 131
Gum: 132
If there are various grades, sizes or colors of say ink, these may be assigned the following codes:
Ink Red: 131.1
Ink Blue: 131.2
Ink Black: 131.3
Ink Green: 131.4
Above method is suitable where the number of items is very large and also where punched card
accounting is in use.
Stores record:
The record of stores may be maintained in three forms:
i. Bin Cards
ii. Stock Control Cards
iii. Stores Ledger
The first two forms of accounts are records of quantities received, issued and those in balance, but third
one is an account of their cost also. Usually, the account is kept in both the forms, the quantitative record
in the stores and quantitative cum financial record in the Cost Department.
i. Bin Cards and Stock control Cards:
These are essentially similar, being only quantitative records of stores. Bin cards are kept attached to the
bins or receptacles or quite near thereto along with the materials so that these also assist in the

identification of stock. The stock control cards, on the other hand, are kept in cabinets or trays or loose
binders. There is no difference in the form and contents of Bin Cards and Stock control Cards.
On receipt of goods, as evident from the Goods Received Note, the storekeeper enters the goods on a bin
card, which is an account to record receipt, issue and balance in terms of quantity. The format of Bin Card
is given bellow:
Advantages of Bin Cards:

• There would be fewer chances of mistakes being made as entries will be made at the same time as
goods are received or issued by the person actually handling the materials.
• Control over stock can be more effective, in as much as comparison of the actual quantity in hand at
any time with the book balance is possible.
• Identification of the different items of materials is facilitated by reference to the Bin card, the bin or
storage receptacle.
Disadvantages of Bin Cards:
• Store records are dispersed over a wide area.
• The cards are liable to be smeared with dirt and grease because of proximity to material and also
because of handling materials.

• People handling materials are not ordinarily suitable for the clerical work involved in writing Bin
Cards.
The 'ORDERED' columns are meant to show how much quantity is still on order. When the storekeeper
receives a copy of the ordered placed to a supplier, s/ he should enter the number and date of the order in
the first column and the quantity in the second. The third column is not filled until the goods are actually
received – until then it will indicate that such and such quantity of goods is still receivable.
Similarly, the 'RESERVED' columns show the quantity which must be kept aside for a particular job.
Reservation will be made for important jobs under the authority of a pre designated officer say, the
Superintendent of a department.
Two bin system: Under this system each bin is divided into two parts – one, smaller part should stock the
quantity equal to the minimum stock or even the re-ordering level, and other to keep the remaining
quantity. Issues are made out of larger part; but as soon as it becomes necessary to use quantity out of the
smaller part of the bin, fresh order is placed. When the fresh stock is received, care will be exercised to
see that a quantity equal to the minimum quantity is segregated."Two-bin system" is supplemental to the
record of respective quantities on the bin card and the stores ledger card.
Illustration: 4
The following information regarding coal is obtained from the stores records of a factory:
August:
• Opening Balance: 200 tons
• Aug 02 Issued on Requisition No. 237: 57 tons
• Received from supplier by chalan No 74 on August 5: 120 tons. The supply was expected on this
date.
• Aug 8 Issued on requisition No. 341: 92 tons
Examination by the stock verifier on August 13 has revealed shortage of 5 tons. The maximum amount of
stock of coal permissible at any time is 200 tons and minimum 50 tons. The ordering level is 100 tons.
Draw up the Bin Card for coal with all necessary details.

Solution:
Bin Card
Bin No. 23 Description: Coal
Department: Coal Max. limit: 200 tons
Stores ledger Folio: 51 Min. limit: 50 tons
Symbol: C – 25 Ordering level: 100 tons
Received Issued Balance Remarks

Date Chalan Quantity Date Requisition Quantity Quantity Checked
August No. Tons August Tons Tons
1 Opening 200 - - - 200
balance
2 - - 2 237 57 143
- - 4 285 83 60
5 Chalan 120 - - - 180
No.74
- - 8 341 92 88
- - 12 364 30 58
- - 13 Shortage 5 53 - Shortage
ii. Stores Ledger:

A Modern Stores Ledger is a collection of cards or loose leaves specially ruled for maintaining a record
of both quantity and cost of stores received, issued and those in stock. It being a subsidiary ledger to the
main cost ledger, it is maintained by the Cost Account Department. It is posted from goods Receipt Notes
and Materials Requisition. The advantages of writing up Stores Ledger mechanically are:
• It enables distribution of work among a number of clerks due to which receipts and issues are posted
quickly and regularly.
• It enables stock records to be centralized in case of an organization having a number of depots.
• The accuracy of posting can be mechanically tested more conveniently.
• The records are clearer and neater. Also the recurring cost of maintaining them is much less than
those kept manually.
• If up to date records are available, the management will be able to exercise greater control over
quantities held in stock from time to time which may result in great deal of saving in both the amount
of investment in stock and their cost.
Now-a-days, mostly a duplicate record of issue and receipt of materials is kept with Bin Cards and Stores
Ledger. The form of the store ledger in general given below:

Illustration: 5
At the beginning of October 2013, Quality Brush Company had in stock 10,000 brushes value at Rs. 10
each. Further purchases were made during the month as follows:
7th October 4,000 Brushes @ Rs.12.50
Issues to shop floor were as follows:
16th October 16,000 Brushes
You are required:
i. to prepare a store ledger card for the month of October on the assumption that materials were
issued on the First-in- First –out principle; and
ii. to state the value of closing stock at the end of October if issue are priced by the weighted
average method.
Solution
i. Store Ledger card for the month of October on First In First Out Basis
Quality Brush Company
Stores Ledger Account (FIFO Method)
Receipts Issues Balance
Date Qty Rate Value Qty Rate Value Qty Rate Value
Oct. Units Rs. Rs. Units Rs. Rs. Units Rs. Rs.

1 10,000 10.00 100,000
7 4,000 12.50 50,000 - - - 10,000 10.00 100,000
4,000 12.50 50,000
14 6,000 15.00 90,000 - - - 10,000 10.00 100,000
4,000 12.50 50,000
6,000 15.00 90,000
16 10,000 10.00 100,000 4,000 15.00 60,000
4,000 12.50 50,000
2,000 15.00 30,000
24 8,000 16.50 132,000 - - - 4,000 15.00 60,000
8,000 16.50 132,000
28 4,000 15.00 60,000 2,000 16.50 33,000
6,000 16.50 99,000
31 2,000 16.50 33,000
ii. Value of closing stock according to the weighted average method.
Rate on the 14th October = (10,000 x 10) + (4,000 x 12.50) + (6,000 x 15)
10,000+4000+6000
= Rs.12.
Issue on 16th =16,000x Rs.12 =Rs.192,000
Balance = 4,000x Rs12 = Rs. 48,000
(4,000 x 12) + (8,000 x 16.50)

Rate on 24th Oct. =
4,000+8,000
= Rs.15
Issue on 28th =10,000x Rs.15 =Rs.150,000
Value of closing stock according to Weighted Average Method = 2,000 x 15
= Rs. 30,000.
Treatment of shortage in stock taking:

At the time of stock taking generally discrepancies are found between physical stocks shown in the bin
card and stores ledger. These discrepancies are in the form of shortages or losses. The causes for these
discrepancies may be classified as avoidable and unavoidable.

Losses arising from unavoidable causes should be taken care of by setting up a standard percentage of
loss based on the study of the past data. The issue prices may be inflated to cover the standard loss
percentage. Alternatively, issues may be made at the purchase price but the cost of the loss or shortage
may be treated as overheads.
Actual losses should be compared with the standard and excess losses should be analyzed to see whether
they are due to normal or abnormal reasons. If they are attributable to normal causes, an additional charge
to overheads should be made on the basis of the value of materials consumed. If they arise from abnormal
causes, they should be charged to the costing profit and loss account. Avoidable losses are generally
treated as abnormal losses.
Losses or surpluses arising from errors in documentation, posting etc., should be corrected through
adjustment entries.
2.6 ISSUE OF MATERIALS

Issue of material must not be made except under properly authorized requisition slip. Generally, it is
signed by the foreman but in case of important materials signature of higher authority would probably be
necessary. Issue of material must be made on the basis of first in first out, which is out of earliest lot on
hand. If care is not exercised in this regard, quality of earliest lot of material may deteriorate for having
been kept for a long period.
Material Requisition Note (MRN): It is the voucher of authority as regards issue of materials for use in
the factory or in any of its departments. Where a 'Materials List" has been prepared, either the whole of
the materials would be withdrawn on its basis or separate materials requisitions would be prepared by the
person or department and the material drawn up to the limit specified in the list. The requisition notes are
made out in triplicate. The copies are distributed in the following manner:
One copy for Store-keeper,
One copy for Cost Department, and
One copy for the Department requiring it
If no material list is prepared, it is desirable that the task of preparation of Material Requisition Notes be
left to the Planning Department. If there is no Planning Department, the Requisition Notes should be
prepared by the person or department that requires the materials. A specimen form of the Material
Requisition is shown below:

Bills of Materials (BOM): It is also known as material specification list or simply material List. It is a
schedule of standard quantities of materials required for any job or other unit of production. A
comprehensive Materials List should rigidly lay down the exact description and specifications of all
materials required for a job or other unit of production and also required quantities so that if there is any
deviation from the standard list, it can easily be detected. The materials list is prepared by Engineering or
Planning Department in a standard form. The number of copies prepared varies according to the
requirement of each business, but four is the minimum number. A copy of it is usually sent to each of the
following department;
i. Stores Department
ii. Cost Accounts Department
iii. Production Control Department
iv. Engineering or Planning Department
The advantages of using "bill of materials", by the above departments may be summed up as follows:-
Stores Department:
i. A bill of materials serves as an important basis of preparing material purchase requisitions by
stores department.
ii. It acts as an authorization for issuing total material requirement.

iii. The clerical activity is reduced as the stores clerk issues the entire/ part of the material
requirement to the users if the details of material asked are present in the bill of materials.
Cost Account Department:
i. Bill of material also help Cost Account department in preparing an estimate/budget of material
cost for the designated job/process/operation.
ii. It may be used as device for controlling cost of material used. This is done after determining
material variances and ascertaining the reasons for their occurrence.
Production Control department:
i. Bill of materials may be used by Production Control Department for controlling usage of
materials.
ii. Its usage saves time which otherwise would have been wasted for preparing separate requisitions
of material.
Engineering or Planning Department:
i. Engineering department prepares the materials list in a standard form. A copy of list is sent to
stores, cost accounts and production control department.
Following is the format of Bill of Material.

Transfer of material: The surplus material arising on a job or other units of production may
sometime be unsuitable for transfer to Stores because of its bulk, heavy weight, brittleness or some other
reasons. It may, however, be possible to find some alternative use for such materials by transferring it to
some other job instead of returning it to the Store Room.
It must be stressed that generally transfer of material from one job to another is irregular, if not improper;
in so far it is not conducive to correct allocation and control of material cost of jobs or other units of
production. It is only in the circumstances envisaged above that such direct transfer should be made. At
the time of material transfer a Material Transfer Note should be made in duplicate, the disposition of the
copies of this note are as follows:
i. One copy for the cost department, and
ii. One copy for the department making the transfer
No copy is generally required for stores as no entry in the store records would be called for. The cost
Department would use its copy for the purpose of making the necessary entries in the cost ledger accounts
for the jobs affected.
The form of the Material Transfer Note is shown below:
Return of material:Sometimes, it is not possible before hand to make any precise estimate of the material
requirements for units of production. Besides, at times due to some technical or other difficulty, it is not
practicable to measure exactly the quantity of material required by a department. In either case, material
may have to be issued from stores in bulk, often in excess of the actual quantity required. Where such a
condition exists, it is of utmost importance from the point of view of materials control that any surplus
material left over on the completion of a job should be promptly hand over to the storekeeper for safe and
proper custody.

Unless this is done, the surplus material may be misappropriated or misapplied for some purpose, other
than that for which it was intended. The material cost of the job against which the excess material was
originally drawn would be overstated unless the job is given credit for the surplus arising thereon.
The surplus material, when it is returned to the storeroom, should be accompanied by a document known
either as a shop credit note or alternatively as a stores debit note. This document should be made out by
the department returning the surplus material and it should be in triplicate to be used as follows:
• One copy for the Store Room;
• One copy for the Cost Department, and
• One copy (book copy) for the department returning the surplus material
The form of Shop Credit Note is given below:
2.7 MAINTENANCE OF INVENTORY RECORDS
Perpetual Inventory: The Chartered Institute of Management Accountants (CIMA) defines perpetual
inventory as" a system of records maintained by the stores department which reflects the physical
movement of stock and their current balance." It in fact comprises: (i) Bin Card, and (ii) Stores Ledger.
A perpetual inventory is usually checked by a program of continuous stock taking. Continuous stock
taking means the physical checking of store records with actual stock. Perpetual inventory is essential for
material control. The success of perpetual inventory depends upon the following:
i. The stores ledger (showing quantities and amount of each item).
ii. Stock control Cards (or Bin Cards)
iii. Reconciling the quantity balance shown by (a) & (b) above.
iv. Checking the physical balances of a number of items every day systematically and by rotation.
v. Explaining promptly the causes of discrepancies, if any, between physical balances and book
figures.

vi. Making corrective entries, where called for, after step (e) and
vii. Removing the causes of discrepancies referred to in step (e).
Advantages: The main advantages of perpetual inventory are as follows:

i. Physical stocks can be counted and book balances adjusted as and when desired without waiting
for the periodic stock-taking that are carried in entirety.
ii. Quick compilation of Profit and Loss Account (for interim period) due to prompt availability of
stock figures.
iii. Discrepancies are easily located and thus corrective action can be promptly taken to avoid their
recurrence.
iv. A systematic review of perpetual inventory reveals the existence of surplus, dormant, obsolete and
slow-moving materials, so that remedial measures may be taken in time.
v. Fixation of various stock levels and checking of actual balances in hand with these levels assist the
storekeeper in maintaining stocks within limits and in initiating purchase requisitions for correct
quantity at the proper time.
Continuous Stock verification – The checking of physical inventory is an essential feature of every
sound system of material control. Such a checking may be periodical or continuous. Annual stock-taking,
however, has certain inherent shortcomings which tend to affect the usefulness of such physical
verification. For instance, since all the items have to be covered (physically verified) during last week of
annual year end, either the production department has to be shut down during those days to enable
thorough checking of stock or else the verification must be of a limited character. Moreover, in the case
of periodical checking there is the problem of finding an adequately trained contingent. It is likely to be
drawn from different departments where stock-taking is not the normal work and they are apt to discharge
such temporary duties somewhat perfunctorily. The element of surprise, that is essential for effective
control is wholly absent in the system. Then if there are stock discrepancies, they remain undetected until
the end of the period. It means that the figures of stock during the period continue to be supplied
incorrectly. Often, the discrepancies are not corrected.
The system of continuous stock-taking consists of counting and verifying number of items daily
throughout the year so that during the year all items of stores are covered three or four times. The stock
verifiers are independent of the stores, and the stores staffs have no foreknowledge as to the particular
items that would be checked on any particular day. But it must be seen that each item is checked a
number of times in a year.
A suggested Stock Verification Sheet is given as follows:

Advantages: the advantages of continuous stock-taking are:
i. Closure of normal functioning is not necessary.

ii. Whole time specialized staff can be engaged for the purpose since the work is spread throughout
the year. In smaller concerns, duties may be assigned to various officers of middle rank by rotation
for checking some of the items, say of 20 items. This won’t be difficult because the store ledger
card and the bin card will bear the bin number. The officers concerned shall only walk up to the
particular bin number, count, weigh or measure the article lying there and enter the quantity on the
form provided for the purpose. The rest of the work (comparison with book figures) can be done
by the stores ledger clerk.
iii. Stock discrepancies are likely to be brought to the notice and corrected much earlier than under the
annual stock-taking system.
iv. The system generally has a sobering influence on the stores staff because of the element of surprise
present therein.
v. The movement of stores items can be watched more closely by stores auditors so that chances of
obsolescence buying are reduced.
vi. Finalization of accounts can be done quickly. Interim accounts are possible quite conveniently
2.8 TECHNIQUES OF MATERIAL (INVENTORY) CONTROL
The main objective of inventory control is to achieve maximum efficiency in production and sales with
minimum investment in inventory. Inventory comprises of stocks of materials, components, work-in-
progress, and finished products and stores and spares. The techniques commonly applied for inventory
control are as follows:
Techniques of Inventory control:

i. Setting of various stock levels:
(a) Minimum Level

It indicates the lowest figures of inventory balance, which must be maintained in hand at all times, so that
there is no stoppage of production due to non-availability of inventory.
The main consideration for the fixation of minimum level of inventory is as follows:
i. Information about maximum consumption and maximum delivery period in respect of each
item to determine its re-order level.
ii. Average rate of consumption for each inventory item.
iii. Average delivery period for each item. This period can be calculated by averaging the
maximum and minimum period.
The formula used for its calculation is as follows:
Minimum level of inventory = Re-order level – (average rate of consumption x average time
required to obtain fresh delivery)
(b) Maximum Level

It indicates the maximum figure of inventory quantity held in stock at any time.
The important considerations which should govern the fixation of maximum level for various inventory
items are as follows;
i. The fixation of maximum level of an inventory item requires information about its re-order level
that depends upon maximum rate of consumption and maximum delivery period for each of the
stock items. It in fact is the product of maximum consumption of inventory item and its maximum
delivery period.
ii. Knowledge about minimum consumption and minimum delivery period for each inventory items
should also be known.
iii. The determination of maximum level also requires the figure of economic order quantity.
iv. Availability of funds storage space, nature of items and their price per unit are also important for
the fixation of maximum level.
v. In the case of imported materials due to their irregular supply, the maximum level should be high.
Maximum Level of inventory = Re-order level + Re-order quantity – (Minimum rate of

consumption x Minimum time of inventory delivery)
(c) Re-order level (ROL)

This level lies between minimum and the maximum levels in such a way that before the material ordered
is received into the stores, there is sufficient quantity on hand to cover both normal and abnormal
consumption situations. In other words, it is the level at which fresh order should be placed for
replenishment of stock.

Re-order level = Maximum re-order period x Maximum usage (or) = Minimum level + (Average
rate of consumption x Average time to obtain fresh supplies).
(d) Average Inventory Level

The level indicates the average stock held by the concern. It is calculated with the help of the following
Average Stock Level= (Maximum level + Minimum level)/ 2
A more refined method of measuring average stock level is one involving re-order quantity. The formula
is
Average Stock Level = Minimum level + ½ Re-order quantity
(e) Danger Level

It is level of stock below which the material stock should never be allowed to fall in normal
circumstances. It is slightly less than the minimum level, and at such a point the purchase manager should
make special efforts to acquire required material and stores.
This is the level at which normal issues of raw material inventory are stopped and emergency issues are
only made.
Danger Level = Average consumption x Lead time for emergency purchases
Note: Lead Time is the time taken by in processing the order by purchasing firm and then executing it
by the supplying firm. The firm shall maintain inventory during this period.
Illustration: 6
(Fixation of stock levels) - Two components A & B are used as follows:
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Reorder quantity: A = 300 units, B = 500 units
Reorder period: A = 4 to 6 weeks, B= 2 to 4 weeks
Calculate for each components (a) Reorder level, (b) Minimum level (c) Maximum level (d) Average
stock Level.
Solution:
• Re-order level = Maximum re-order period x Maximum usage.
A = 75 x 6 =450 units
B =75 x 4 =300 units
• Minimum level = Re-order level – (average usage x average period)

A = 450 – (50 x 5) = 200 units
B = 300 – (50 x 3) = 150 units

• Maximum Level = Re-order level + Re-order quantity – (Minimum consumption x

Minimum re-order period)
A = (450 + 300) – (25 x 4) = 650 units
B = (300 + 500) – (25 x 2) = 750 units
• Average Inventory Level = (maximum level + Minimum level)/ 2

A = (650 + 200)/2 = 425 units
B = (750 + 150)/2 = 450 units
It can also be calculated by using the formula: Minimum level + ½ Re-order quantity
A = 200 + ½ x 300 = 350 units
B = 150 + ½ x 500 = 400 units
Illustration: 7
If the minimum stock level and average stock level of raw material A are 4,000 and 9,000 units
respectively, find out its reorder quantity.
Solution
Average Inventory Level = Minimum level + ½ Re-order quantity
i.e. 9,000 = 4,000 + ½ Re-order quantity
½ Re-order quantity = 9,000 – 4,000 =5,000
Re-order quantity = 10,000 units
Illustration: 8
A company uses three raw materials A, B and C for a particular product for which the following data
apply:
Raw Usage Re-order Price per Delivery period ( in weeks) Re-order Minimum
Material Per unit of quantity kg. level (kgs) level (kgs)
product (kgs)
Minimum Average Maximum
A 10 10,000 0.10 1 2 3 8,000
B 4 5,000 0.30 3 4 5 4,750
C 6 10,000 0.15 2 3 4 2,000
Weekly production varies from 175 to 225 units, averaging 200 units of the said product. What would be
the following quantities?
• Minimum stock of A?
• Maximum stock of B?
• Re-order level of C?
• Average stock level of A?
Solution
• Minimum Stock of A
= Re-order level – (Average rate of consumption x Average time required to obtain fresh delivery)
= 8,000 – (200 x 10 x 2)
=4,000 kgs.

• Maximum stock of B
= Re-order level + Re-order quantity – (Minimum consumption x Minimum re-order period)
=4,750 + 5,000 – (175 x 4 x 3)
=9,750 – 2,100
= 7,650 kgs
• Re-order level of C
= Maximum re-order period x Maximum usage
= 4 x 225 x 6
=5,400 kgs.
Or,
= Minimum level + (Average rate of consumption x Average time to obtain fresh supplies).
= 2,000 + [(200 x 6) x 3]
= 5,600 kgs.
• Average Inventory Level of A = (maximum level + Minimum level)/ 2

= (4,000 + 16,250)/2
= 10,125 kgs.
Or,
= Minimum level + ½ Re-order quantity
=4,000 + ½ x 10,000
= 9,000 kgs.
Working note
Maximum stock of A = Re-order level + Re-order quantity – (Minimum consumption x Minimum re-
order period) = 8,000 + 10,000 – [(175 x 10) x 1} = 16,250 kgs.
ii. ABC Analysis

It is a system of inventory control. It exercises discriminating control over different items of stores,
classified on the basis of investment involved.
In any inventory, which contains more than one stocked item, some items, willbe more important to
organization than others. Some items might have a very high usage rate, so if they ran out many customers would
be disappointed. Other items might be of particularly high value, so excessively high inventory levels would
be particularly expensive. One common way of discriminating between different stock items is to rank them by
the value of their usage. Items with a particular high value of usage are deemed to warrant careful control,
whereas those with low usage values need not be controlled quite so rigorously.
Maintaining inventory through counting, placing orders, receiving stock, and so on, takes personnel time and
costs money. When there are limits on these resources, the logical move is to try to use the available resources
to control inventory in the most efficient way; to achieve this, an ABC analysis is one way to control the inventory
effectively. ABC analysis is based on the Pareto p rincip le, after the nineteenth-century Italian
philosopher who illustrated graphically the fact that a small proportion of the population owned most of the
wealth in Italy. It is sometimes also called the 80:20 rule, as 20% of population owned 80% of wealth.
In the context of an inventory system this suggests that there are a few items that contribute significant weight age
as compared to total inventory costs, whereas there are a large number of items whose contributions as compared

to total inventory cost are relatively low. This is also known as t h e 80-20 p h e n o me n o n , as approximately
20 percent of items contribute 80 percent of the cost and the remaining 80 percent of items account for only 20
percent of costs. Obviously, it is important to maintain tight controls on the 20% and moderate controls on
the rest, in other words, it means that 80% of inventory items need 20% of the attention, while the remaining
20% of items need 80% of the attention, Thus controlling the cost of only a few items willcontribute to
effective control of a large amount of costs; clerical costs are reduced and inventory costs will be well-controlled.
Therefore, ABC analysis is a useful and appropriate technique for classifying inventory items according to
the importance of theircontribution to annual cost of the entire inventory system. Inventory has been divided
into the following categories:
(i) "A" Category of items consists of only a small percentage i.e., about 10% of the total items handled by
the stores but require heavy investment about 70% of inventory value, because of their high prices or heavy
requirement or both.
(ii) "B" Category of items is relatively less important, they may be 20% of the total items of material
handled by stores. The percentage of investment required is about 20% of the total investment in
inventories.
(iii) "C" Category of items does not require much investment; it may be about 10% of total inventory
value but they are nearly 70% of the total items handled by store.
The ABC" method can be used for material, purchased parts, subassemblies, component parts, or products,
depending on what form of inventory the company usually carries. The procedure for an ABC analysis starts
by taking each item and multiplying the number of units used in a year by the unit cost. This gives the total
annual use of items in terms of usage value. If the items are listed in order of decreasing annual usage by
value, "A" items willbe at the top of the list and "C" items will be at the bottom of the list. The unit cost of an
item is not the sole determinant of the classification.
Each organization should tailor its inventory system to its own peculiarities. Organizations may choose to group
their inventory into more than three classifications, but the principle is the same: highvalue items receive
the most attention and low value items the least. A comparison of A, B, and C classes are contained in the table
below.
Comparison of A, B and C Classes

Frequency of Size of Safety
Class Degree of Control Types of Records Lot Size
Review Stocks
Accurate and
A Tight Low Continuous Small
Complete
B Moderate Good Medium Occasional Moderate
C Loose Simple Large Infrequent Large

These classifications can be used to determine where to allocate inventory system operating costs and
where care should be taken to minimize costs. Using this classification, the following points should be
considered:
i. Very strict control should be placed on class A items. These items should be ordered in Economic
Order Quantity (EOQ) batches. Accurate service levels should be specified to determine exactly what
the safety stock level should be. Cooperation with vendors should be explored, so that the variance in
lead times is reduced and consequently the level of safety stock is also reduced.
ii. For B items, moderate control should be used, Generally, the approach should be to allow some
deviation from the optimal EOQ and safety stock levels so as to reduce the operation costs.
iii. C items have low usage value because of low demand, or low costs. Therefore, strict control is not
important, as it is economic to hold these items in quantities large enough to make the possibility of
stock-out negligible. This might mean that particular item might not be ordered in EOQ batches,
but ordered annually or semi-annually. The general concept is to ensure that low cost items willnot cause
an expensive production or service system to stop.
Illustration: 9
A factory uses 4,000 varieties of inventory. In terms of inventory holding and inventory usage, the
following information is compiled:
No. of varieties of % % value of inventory % of inventory usage
Inventory holding (average) (in end-product)
3,875 96.875 20 5
110 2.750 30 10
15 0.375 50 85
4,000 100.00 100 100
Classify the items of inventory as per ABC analysis with reasons.
Solution
Classification of the items of inventory as per ABC analysis:
A Category: 15 number of varieties of inventory items should be classified as "A" category items
because of the following reasons:
• Constitute 0.375% of the total number of varieties of inventory handled by factory stores, which is
minimum as per given classification in the table.
• 50% of total use value of inventory holding (average) which is maximum according to the given
table.
• Highest in consumption about 85% of inventory usage (in end-product).
B Category: 110 numbers of varieties of inventory items should be classified as "B" category item
because of the following reasons.
• Constitute 2.750% of the total number of varieties of inventory items handled by stores of factory.
• Requires moderate investment of about 30% of total use value of inventory holding (average).
• Moderate in consumption about 10% of inventory usage (in end-product).
C Category: 3.875 number of varieties of inventory items should be classified as "C" category items
because of the following reasons:
• Constitute 96.875% of total varieties of inventory items handled by stores of factory.

• Requires about 20% of total use value of inventory holding (average).

• Minimum inventory consumption i.e. about 5% of inventory usage (in end-product).
Advantages of ABC analysis

1. It ensures that, without there being any danger of interruption of production for want of materials or
stores, minimum investment will be made in inventories of materials or stocks to be carried.
2. The cost of placing orders, receiving goods and maintaining stocks is minimized especially if the
system is coupled with the determination of proper economic order quantities.
3. Management time is saved since attention need be paid only to some of the items rather than all the
items as would be the case if the ABC system was not in operation.
4. With the introduction of the ABC system, much of the work connected with purchases can be
systematized on a routine basis to be handled by subordinate staff.
Concepts similar to ABC Technique:

FSN Analysis: As per FSN analysis, the items are classified into Fast Moving, Slow Moving and Non-
Moving items. This analysis classifies items on the basis of their rate of consumption in the company. It
should be noted that high value non-moving items are liability. However, low value fast moving items
should be kept in ample quantities.
VED Analysis: The stores when subjected to analysis based on criticality can be classified into Vital,
Essential and Desirable items. This analysis is termed as VED Analysis.
(a) Vital: Items whose non-availability cannot be tolerated.
(b) Essential: Items whose non-availability can be tolerated only for few days.
(c) Desirable: Items whose non-availability can be tolerated for a long period.
iii. Determination of Economic Order Quantity:

The quantity to be ordered at one time is known as 'ordering quantity' and should be determined with
good care. If it is small, a number of orders will have to be placed in a year involving costs in terms of
clerical labor, material handling, etc. Also there will be loss in terms of price and transport costs. Large
orders avoid these losses and will lead to economy in transport costs and price concessions. But there will
be costs in terms of interest payments for the money locked up and in terms of storing costs. An order
should be large enough to enable the firm to earn proper discounts and to take advantage of bulk transport
but it should not be too large to involve too heavy payment of interest. The size of the order for which
both ordering and carrying cost are minimum is known as economic order quantity. If the price to be paid
is stable, the optimum quantity to be ordered or economic order quantity (EOQ) can be determined by the
formula.

EOQ =

Where,
A = Annual usage unit
O = Ordering cost per order
C = Annual carrying cost of one unit, i.e. carrying cost percentage x cost of one unit.

In other words, it refers to the size of order which gives maximum economy in purch
purchasing any material. It
also referred as optimum or standard ordering quantity. Graphically it can be represented as a point where
Total Annual Cost of inventory is minimum. This also refers to a point where annual cost of ordering is
equal annual inventory carrying cost, as depicted below.
As is clearly depicted in the graph above, EOQ is attained at a point where total ordering cost is equal to
total carrying cost.
Assumptions underlying E.O.Q. : The calculation of economic order of material to be ppurchased 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
he quantity of material ordered is received immediately i.e. the lead time is zero.
The famous mathematician Wilson derived the formula which is used for determining the size of order for
each of purchases at minimum ordering and carrying costs
Illustration: 10
Calculate the EOQ from the following information. Also state the number of orders to be placed in a year.
Consumption of materials per annum: 10,000 kg.
Ordering cost per order: Rs. 50
Cost per kg of raw materials: Rs.2
Storage costs: 8% on average inventory

Solution:
i. Calculation of Economic quantity of the inventory

EOQ =

Where,
C = Annual carrying cost of one unit, i.e. carrying cost percentage x cost of one unit
= Rs 2 * 8% = 0.16

= (
%)
= 2,500 kg.
ii. No. of orders to be placed in a year = Total consumption of materials per annum/ EOQ
= 10,000 kg./2,500 kg = 4 Orders per year.
Illustration: 11
RST Limited has received an offer of quantity discount on its order of materials as under:
Price Per Ton (Rs.) Order size ( in tones)
9,600 Less than 50
9,360 50 and less than 100
8,640 300 and above
The annual requirement for the material is 500 tons. The ordering cost per order is Rs.
12,500 and the stock holding cost is estimated at 25% of the material cost per annum.
Required:
(i) Compute the most economical purchase level.
(ii) Compute EOQ if there are no quantity discounts and the price per ton is Rs.10,500.
Solution
Order No. of Cost of Ordering cost Carrying cost Total cost
size orders purchase A x (A/Q) x Rs.12,500 (Q/2) x C x 25% (3+4+5)
(Q) A/Q per unit cost
(Units) (Units)

(1) ( 2) (3) (4) (5) (6)
40 12.5 48,00,000 1,56,250 48,000 50,04,250

(500 x 9600) (40/2) x 9,600 x0.25
50 10 46,80,000 1,25,000 58,500 48,63,500

(500 x 9360) (50/2) x 9,360 x0.25
100 5 45,60,000 62,500 1,14,000 47,36,500

(500 x 9120) (100/2) x9,120 x
0.25
200 2.5 44,40,000 31,250 2,22,000 46,93,250
(500 x 8,880) (2/200) x 8,880 x
0.25
300 1.67 43,20,000 20,875 3,24,000 46,64,875
(500 x 8,640) (300/2) x 8640 x
0.25
500 1 43,20,000 12,500 5,40,000 48,72,500
(500 x 8,640) (500/2) x 8,640 x
0.25
The above table shows that the total cost of 500 units including ordering and carrying cost is minimum
(Rs. 46,64,875) where the order size is 300 units. Hence the most economical purchase level is 300 units.
(ii) Calculation of EOQ when no quantity discount and price per ton is Rs 10,500

EOQ =

,
=√ ,
= 69 tons.
Where,
A = Annual usage unit i.e. 500
O = Ordering cost per order i.e Rs 12,500
C = Annual carrying cost of one unit,
i.e. carrying cost percentage x cost of one unit given specifically Rs 10,500
= 0.25 x 10,500= 2,625
Illustration: 12
M/s. Tubes Ltd. are the manufacturers of picture tubes for T.V. The following are the details of their
operation during 2013.
Average monthly market demand 2000 Tubes
Ordering cost Rs. 100 per order
Inventory carrying cost 20% per annum
Cost of tubes Rs. 500 per tube
Normal usage 100 tubes per week
Minimum usage 50 tubes per week

Maximum usage 200 tubes per week

Lead time to supply 6-8 weeks
Compute from the above:

• Economic order quantity. If the supplier is willing to supply quarterly 1500 units at a discount of 5%,
is it worth accepting?
• Maximum level of stock.
• Minimum level of stock.
• Re-order level
Solution
1) Calculation of EOQ
A = Annual usage of tubes = Normal usage per week x 52 weeks
= 100 tubes x 52 weeks = 5,200 tubes.
O = Ordering cost per order = Rs. 100 per order
C = Cost per tube = Rs. 500/-
c = Inventory carrying cost per unit per annum = 20% x Rs. 500/- per unit per annum.
= 100

EOQ =

=

= Rs. 102 tubes (approx.)
If the supplier is willing to supply 1,500 units at a discount of 5% is it worth accepting?

Discounted Price =500 x 95% = 475
Total cost (when order size is 1,500 units)
= Cost of 5,200 units + Ordering cost + Carrying cost
,
= 5,200 units x Rs. 475 + ( ) x Rs. 100 + (1500/2) x Rs. 475 x 20%
,
= Rs.24,70,000 + Rs. 346.67 + Rs. 71,250 = Rs.25,41, 596.67
Total cost (when order size is 102 units)

,
= 5,200 units x Rs. 500 + ( ) x Rs. 100 + (102/2) x Rs. 500 x 20%)

=Rs. 26,00,000 + Rs. 5,098.03 + Rs.5,100

= Rs. 26,10,198.03
Since, the total cost under quarterly supply of 1,500 units with 5% discount is lower than that when order
size at EOQ, the discount offer should be accepted. While accepting this offer consideration of capital
blocked on order size of 1,500 units per quarter has been ignored.
(2) Maximum level of stock

= Re-order-level + Re-order quantity – Min usage x Min. re-order period
= 1,600 units + 102 units – (50 units x 6 weeks) = 1,402 units.
(3) Minimum level of stock

= Re-order level – Normal usage x Average reorder period
= 1,600 units – (100 units x 7 weeks) = 900 units.
(4) Reorder level

= Maximum consumption x Maximum re-order period
= 200 units x 8 weeks = 1,600 units.
Illustration: 13
X Limited is committed to supply 24,000 bearings per annum to Y Ltd on steady basis. It is estimated that
it costs 10 paisa as inventory holding cost per bearing per month and that the set-up cost per run of
bearing manufacture is Rs. 324.
i. What would be the optimum run size for bearing manufacture?

ii. Assuming that the Company has policy of manufacturing 6,000 bearings per run, how much extra
costs the company would be incurring as compared to the optimum run suggested in (a) above?
iii. What is the minimum inventory holding cost?
Solution
(a) Optimum production run size (Q) =
Where, A = No. of units to be produced within one year.
O = Set-up cost per production run
O = Carrying cost per unit per annum


=

.
=
.∗
= 3,600 bearings
(b) Total cost (of maintaining the inventories) when production run sizes (Q) are 3,600 and 6,000
bearings respectively:
Total cost = total set up cost + total carrying cost.
For optimum production run size (Q) i.e. 3,600

Total set up cost = (No of production run ordered) x (Set-up cost per production run)
= (24,000/3,600) x Rs. 324 = 2,160
Total carrying cost = ½ Q x I= ½ x 3,600 x Rs.0.10 x Rs. 12 = Rs 2,160
Total cost = Rs 2,160 + Rs 2,160 = Rs 4,320 ------ (1)
For production run size of 6,000

Total set up cost = (No of production run ordered) x (Set-up cost per production run)
= (24,000/6,000) x Rs. 324 = 1,296
Total carrying cost = ½ Q x I = ½ x 6,000 x Rs.0.10 x Rs. 12 = Rs 3,600
Total cost = Rs 1,296 + Rs 3,600 = Rs 4,896 ------- (2)
Extra cost incurred = equ (2) – equ (1)

= 4,896 – 4,320
= Rs 576.00
(c) Minimum Inventory holding cost (when Q = 3,600 bearings)

=½ Q x I
=½ x 3,600 bearings x Rs. 0.10 x Rs. 12
= Rs. 2,160
Illustration: 14
Sriram enterprise manufactures a special product "B". The following particulars were collected for the
year 2013:
• Monthly demand of B – 1,000 units
• Cost of placing an order Rs. 100
• Annual carrying cost per unit Rs. 15
• Normal usage 50 units per week.
• Minimum usage 25 units per week.
• Maximum usage 75 units per week.
• Re-order period 4 to 6 week.
Compute from the above: (1) Re-order quantity (2) Re-order level (3) Minimum level (4) Maximum level
(5) Average stock level.

Solution

1) Re-order quantity of units used =

Note:
A = Annual demand of input units for 12,000 units of "B".
= 52 weeks x normal usage of input units per week
= 52 weeks x 50 units of input per week
= 2,600 units.
O = Cost of placing an order Rs 100.
C = Carrying Cost per unit per annum Rs 15.

=

= 186 units (approx.)

Re-order level = Maximum re-order period x Maximum usage.
= 6 weeks x 75 units
= 450 units
Minimum level = Re-order level – (average usage x average period)

= 450 units – 50 units x 5 weeks
= 200 units
Maximum Level = Re-order level + Re-order quantity – (Minimum consumption x Minimum re-order
period)
= 450 units + 186 units – 25 units X 4 weeks
= 536 units
Average Inventory Level = (Maximum level + Minimum level)/ 2

= (200 units + 536 units)/2
= 368 units.
Concept of Safety Stock

Safety stock refers to the buffer stock maintained with a view to meet some unanticipated increase in
usage of material.
The reason beyond maintaining safety stock is that the demand for materials may fluctuate and delivery
of inventory may also be delayed and in such a situation the firm can face the problem of stock out.
Illustration: 15
IPL Ltd. uses a small casting in one of its finished products. The castings are purchased from foundry.
IPL Ltd. purchases 54,000 castings per year at a cost of Rs 800 per casting. The castings are used evenly

throughout the year in the production process on a 360-day-per-year basis. The company estimates that it
costs Rs 9,000 to place a single purchase order and about Rs 300 to carry one casting in inventory for a
year. The high carrying costs result from the need to keep the castings in carefully controlled temperature
and humidity conditions., and high cost of insurance.
Delivery from the foundry generally takes 6 days, but it can take as much as 10 days. The days of
delivery time and percentage of their occurence are shown in the following tabulation:
Delivery time (days): 6 7 8 9 10
% of occurence: 75 10 5 5 5
Required:
(i) Compute the Economic Order Quantity (EOQ).

(ii) Assume the company is willing to assume a 15% risk of being out of stock. What would be the
safety stock? The re-order point?
(iii) Assume the company is willing to assume a 5% risk of being out of stock. What would be the
safety stock? The re-order point?
(iv) Assume 5% stock-out risk. What would be the total cost of ordering and carrying inventory for
one year?
(v) Refer to the original data. Assume that using process re-engineering the company reduces its
cost of placing a purchase order to only Rs 600. In addition, company estimates that when the
waste and inefficiency caused by inventories are considered, the true cost of carrying a unit in
stock is Rs 720 per year.
(a) Compute the new EOQ.
(b) How frequently would the company be placing an order, as compared to the old purchasing
policy?
Solution:
(i) Computation of Economic Order Quantity (EOQ)

Annual Requirement (A) = 54000 castings
Cost per casting (C) = Rs 800
Ordering Cost (O) = Rs 9000 per order
Carrying cost per casting p.a. (C) = Rs 300

EOQ =

"
=

= 1800 castings

(ii) Safety Stock (Assuming a 15% risk of being out of Stock)

Safety stock for one day
= 54000/360 castings
= 150 castings
Re-order point = Minimum stock level + Average lead time # Average consumption
= 150 + 6 # 150
= 1050 castings
(iii) Safety Stock ( Assuming a 5% risk of being out of Stock)

Safety stock for three days
= 150 # 3
= 450 castings
Re-order point = Minimum stock level + Average lead time # Average consumption
= 450 + 6 # 150 Castings
= 450 castings + 900 castings
= 1350 castings
(iv) Total ordering cost = (54000/1800) # Rs 9000 =Rs 270,000

Total carrying cost = (450 + ½ # 1800) # Rs 300 = Rs 405000
(v) (a) Computation of new EOQ:

EOQ =

=
$
= 300 castings
(b) Total number of orders to be placed in a year are 180. Each order is to be placed after 2 days
(1 year = 360 days). Under old purchasing policy each order is placed after 12 days.
Illustration: 16
The following information is available in respect of a particular item of inventory of a manufacturing
firm.
Daily Usage (tonnes) Probability Lead Time (days) Probability

2 0.2 25 0.2
3 0.6 35 0.5
4 0.2 45 0.3
Find out:
(a) Optimum level of safety stock
(b) Probability of stock out given that:
(i) Carrying cost is Rs 2000 per tonne per year, and
(ii) Stock out cost is Rs 8000 per tonne.

Solution:
Expected usage per day = 0.2 # 2 + 0.6 #3 +0.2 #4 = 3 tonnes
Expected lead time = 0.2 # 25 + 0.5 # 35 + 0.3 #45 = 36 days
Total expected usage = 3 # 36 = 108 tonnes
The different levels of safety stock may be identified by finding out the maximum usage as follows:
Daily Usage Lead Time (Days) Maximum Usage (Tonnes) Safety Stock (Tonnes)
2 Tonnes 25 50 Nil
35 70 Nil
45 90 Nil
3 Tonnes 25 75 Nil
35 105 Nil
45 135 27
4 Tonnes 25 100 Nil

35 140 32
45 180 72
The firm may have safety stock of 27, 32 or 72 Tonnes. The optimum level of safety stock may be
determined as follows:
Safety Stock Cost of Probability Expected Carrying Total Cost
Stock Out Stock Out cost of Cost (Rs.) (Rs.)
(Tonnes) (Tonnes) (Rs.) stock out
(Rs.)
72 0 0 0 0 144,000 144,000
32 40 320,000 0.2 # 0.3 = 0.06 19,200 64,000 83,200
27 5 40,000 0.2 # 0.5 = 0.10 4,000 54,000 79,600
45 360,000 0.2 # 0.3 = 0.06 21,600
0 27 216,000 0.6 X 0.3= 0.18 38,880 0 99,040
32 256,000 0.2 # 0.5 = 0.10 25,600
72 576,000 0.2 # 0.3 = 0.06 34,560
The total cost is least when the safety stock is maintained at 27 tonnes. If so, the total stock maintained
108 + 27 = 135 and the stock out will occur only when the usage is 140 tonnes or 180 tonnes. Probability
for such stock out is (0.06+0.10=0.16)
iv. Review of slow and non-moving items:

Sometimes, due to high value of slow moving and non-moving raw materials, it appears that the concern
has blocked huge sum of money unnecessarily in raw materials. To overcome this problem, it is necessary
to dispose-off, as early as possible, the non-moving items or make arrangements for their exchange with
the inventories required by the concern. Besides this, no new requisition should be made for the purchase
of slow moving items, till the existing stock is exhausted. Computation of inventory turnover ratio may
help in identifying slow moving items.

v. Use of control ratios:
(i) Input output ratio:

Inventory control can also be exercised by the use of input output analysis. Input-output ratio is the ratio
of the quantity of input of material to production and the standard material content of the actual output.
This type of ratio analysis enables comparison of actual consumption and standard consumption, thus
indicating whether the usage of material is favorable or adverse.
(ii) Inventory turnover ratio:

Computation of inventory turnover ratios for different items of material and comparison of the turnover
rates provides a useful guidance for measuring inventory performance. High inventory turnover ratio
indicates that the material in question is a fast moving one. A low turnover ratio indicates over–
investment and locking up of working capital in inventories. Inventory turnover may be calculated using
the following formulae:-
Cost of materials consumed during the period

Inventory turnover ratio (ITR) =
Cost of average stock held during the period
Where,
Average Stock = ½ (Opening Stock + Closing Stock)
The above ratio is also sometimes expressed in terms of days and called Inventory holding period.
Inventory holding period may be calculated using the following formulae:-
365 days
Inventory holding period =
Inventory turnover ratio
By comparing the number of days in case of two different materials, it is possible to know which is fast
moving and which is slow moving. On this basis, attempt should be made to reduce the amount of capital
locked up and prevent over-stocking of the slow moving items.
Steps for minimizing losses on account of slow moving or obsolete stock
i. Periodic reports should be prepared showing the position of different items of stores showing
quantities and values of opening stock, purchases, issues and closing stock.
ii. Periodic turnover ratios should be calculated by the stores department to locate slow moving
stocks
iii. In order to locate obsolescence of items on account of changes in the method of production or
substitution by cheaper materials, a well designed information system should be introduced in the
organization. On getting information about certain items becoming obsolete, the stores department
should immediately stop purchase of all such items.
iv. In order to ensure that obsolete items are immediately disposed of, there should be a well defined
system laying down the authorities entitled to dispose of such goods and the manner of disposal.

Illustration: 17
The following data are available in respect of material X for the year ended 31st December 2013.
Rs.
Opening stock 90,000
Purchases during the year 270,000
Closing stock 110,000
Calculate:
(i) Inventory turnover ratio, and
(ii) The number of days for which the average inventory is held.
Solution
Cost of stock of raw material consumed

Inventory turnover ratio =
Average stock of raw material
= Rs. 250,000/Rs. 100,000

= 2.5 times
Average number of days for which the average inventory is held

365 days
=
Inventory turnover ratio
= 365days/2.5
= 146
Working note:
Note 1: Rs.
Opening stock of raw material 90,000
Add: Material purchases during the year 270,000
Less: Closing stock of raw material 110,000
Cost of stock of raw material consumed 250,000
Note 1:
Average Stock = (Opening Stock + Closing Stock)/2
=(90,000 + 110,000) / 2
= Rs 100,000
2.9 PRICING METHODS
i. Valuation of material receipts
The invoices of material purchased from market sometime includes items such as trade discount, quantity
discount, freight, duty, insurance, cost of containers, sales tax, excise duty, cash discount etc. Under such
a situation the general principle is that all cost incurred up to the point of procuring and storing materials
should constitute the cost of materials purchased. The amounts of trade discount, quantity discount and
VAT (under credit scheme) are deducted from the invoice of material purchased. The transport charges

(carriage and freight), sales tax, insurance, cost of containers, customs and excise duty should be included
in the invoice cost of material. The cash discount is considered as financial gain, so it is kept outside the
domain of material cost. In case the containers are returnable, impact of their resale value should also be
taken in the invoice price of material to correctly ascertain the cost of material purchased. The cost of
material purchased so determined may be used for the entry of material in the Stores Ledger.
Illustration: 18
An invoice in respect of a consignment of chemicals A and B provides the following information:
Rs.
Chemical A: 10,000 lbs. at Rs. 10 per lb. 100,000
Chemical B: 8,000 lbs. at Rs. 13 per lb. 104,000
Custom duty @ 10% 20,400
Transportation 3,840
Total cost 228,240
A shortage of 500 lbs. in chemical A and 320 lbs. in chemical B is noticed due to normal breakages. You
are requested to determine the rate per lb. of each chemical, assuming a provision of 2% for further
deterioration.
Solution:
Statement showing computation of effective quantity of each chemical available for use
Chemical A (lbs.) Chemical B (lbs.)
Quantity purchases 10,000 8,000
Less: shortage due to normal breakages 500 320
9,500 7,680
Less: Provision for deterioration 2% 190 153.6
Quantity available 9,310 7,526.4
Statement showing computation of rate per lb of each chemical

Chemical A (Rs.) Chemical B (Rs.)
Purchase price 100,000 104,000
Add: Custom duty (10%) 10,000 10,400
Transportation (in the relation of quantity purchased
i.e. 5:4) 2,133 1,707
Total cost 112,133 116,107
Rate per lb. A: = Rs. 112,133/9,310 lbs = Rs.12.04
Rate per lb. B: = Rs. 116,107/7,526.4 lbs = Rs.15.43
Illustration: 19
At what price per unit would Part No A 32 be entered in the Stores Ledger, if the following invoice was
received from a supplier:
Invoice Rs.
200 units Part No. A 32 @ Rs.5 1,000.00
Less: 20% discount 200.00

800.00
Add: VAT @ 13% 104.00
904.00
Add: Packing charges for non-returnable boxes) 50.00
954.00
Notes:
2% discount will be given for payment in 30 days.
Solution
200 units net cost after trade discount Rs. 800
Add: Packing charges Rs. 50
Total cost per 200 units Rs. 850
Cost per unit = Rs. 850/200 units = Rs. 4.25
ii. Valuation of material issues
Materials issued from stores should be priced at the value at which they are carried in stock. But the value
attached to stock of any item of material; at any particular point of time may be the result, not of one
purchase rate or price but of different purchase rates or prices. In other words, the same material may
have been acquired at different prices and its stock at any particular point of time may comprise materials
of more than one lot so that there would be a problem of determining the appropriate rate at which to
price out the issues of materials.
Several methods of pricing material issues have evolved in an attempt to satisfactorily answer the
problem. These methods may be grouped and explained as follows:-
1. Cost Price Methods:
a) Specific price method: This method is useful, especially when 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. To use this method, it is necessary to store
each lot of material separately and maintain its separate account. The advantages and disadvantages
are:
Advantages:
i. The cost of materials issued for production purposes to specific jobs represent actual and correct
costs.
ii. This method is best suited for non standard and specific products.
Disadvantage:
This method is especially difficult to operate, especially when purchases and issues are numerous.
b) First-in First-out method: It is a method of pricing the issues 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 or the items longest in stock are issued first. Therefore each issue of material only recovers the
purchase price which does not reflect the current market price. This method is considered suitable in
times of falling prices because the material cost charged to production will be high while the

replacement cost of materials will be low. But in the case of rising prices, if this method is adopted,
the charge to production will be low as compared to the replacement cost of material (as in the
current period) in future without having additional capital resources. The advantages and
disadvantages of the method may be stated as follows:
Advantages:
i. It is simple to understand and easy to operate.
ii. Material cost charged to production represents actual cost with which the cost of production
should have been charged.
iii. In the case of falling prices, the use of this method gives better results.
iv. Closing stock of material will be represented very closely at current market price.
Disadvantages:
i. If the prices fluctuate frequently, this method may lead to clerical error.
ii. Since each issue of material to production is related to a specific purchase price, the costs charged
to the same job are likely to show a variation from period to period.
iii. In the case of rising prices, the real profits of the concern being low, they may be inadequate to
meet the concern's demand to purchase raw materials at the ruling price.
Illustration: 20
The following is a history of the receipts and issue of motives in a factory during February 2014.
Date Particulars Quantity and Amount
1 Opening balance 500 kg. @ Rs. 25
8 Issue 250 kg
13 Receipts 200 kg @ Rs. 24.50
14 Refund from a work order 15 kg. @ Rs. 24.00
16 Issue 180 kg
20 Receipts 240 kg @ Rs. 24.37
24 Issue 304 kg.
Issues are to be priced on the principles of FIFO. Stock verifier of the factory noted on 15th a shortage of
5 kg. Write out the complete Store Ledger Account in respect of the above motives for February 2014.
Solution:
Stores Ledger Account for February, 2014
Motive………. Code No…… ……… Maximum Quantity……….
Minimum Quantity………..
Date Receipt Issue Balance
G.R Qty. (kg) Rate Amt. Qty. Rate Amt. Qty. Rate Amount
No. Rs. Rs. (kg) Rs. Rs. (kg) Rs. Rs.
1 500 25.00 12,500
8 250 25.00 6,250 250 25.00 6,250
13 - 200 24.50 4,900 250 25.00
200 24.50 11,150
14 - 15 24.00 360 250 25.00
200 24.50
15 24.00 11,510
16 180 25 4,500 *65 25.00

200 24.50
15 24.00 6,885
20 240 24.37 5848.80 65 25.00
200 24.50
15 24.00
240 24.37 12,733.80
24 65 25.00 216 24.37 5,263.92
200 24.50
15 24.00
24 24.37 7,469.88
*Shortage of 5 kg valued on FIFO basis, is noted on 15th February, 2014.
c) Last-in First-out method (LIFO): "It is the price paid for the material last taken into the stock
from which the material to be priced could have been drawn." (CIMA). Under this method, the price
of the latest consignment is used. During the inflationary period or period of rising prices, the use of
LIFO would help to ensure that the cost of production is determined on a basis that approximates the
current one. This method is also useful specially when there is a feeling that due to the use of FIFO
or average methods, the profit shown and tax paid are too high. The advantages and disadvantages
are as follows:
Advantages:
i. The issue will be priced at the prevailing market rate, more or less, around the date of issue. This
has the advantage of ascertaining the cost of material at about the prevailing market price and the
cost thus ascertained will enable the prices to be fixed on competitive basis.
ii. The use of this method during the period of rising prices will not reflect undue high profit in the
income statement as it will under the first-in-first-out or average method. In fact, the profit
shown here will be relatively lower since the cost of production will take into account the rising
trend of material prices.
iii. In case of falling prices profit tends to rise due to lower material cost, yet the finished products
appear to be more competitive and are at market prices.
iv. Over a period, the use of LIFO helps to iron out the fluctuations in profits.
v. In case of rising prices, LIFO method has the advantage of showing a lower profit which help in
saving tax to some extent.
Disadvantages:
i. Calculation under this method becomes complicated and cumbersome when frequent purchases
are made at highly fluctuating rates.
ii. The inventory is shown at the oldest market price so it does not reflect the current situation.
iii. This method of valuation is not acceptable to the income tax authorities.
iv. At the time of falling prices, there will be need of writing off stock value considerably to stick to
the principle of stock valuation, i.e. lower of cost or net realizable value.
Illustration: 21
A manufacturing company issues materials to jobs on the LIFO basis. At the end of each quarter all
materials are valued at the cost of the last delivery. The company made the following purchase of a
commodity X:
12th January 2013 - 12 gross @ Rs. 40 per gross

21st January - 12 gross @ Rs. 45 per gross

28th February - 12 gross @ Rs. 50 per gross
15th March - 12 gross @ Rs. 60 per gross
Issues to jobs were made as follows:
20th January - 10 gross
17th February - 10 gross
18th March - 10 gross
Write up the Store Ledger Account for the quarter ending 31st March, 2013.
Solution
Stores Ledger Account (LIFO Method)
Material………. Code No…… ……… Maximum Quantity……….
2013 G.R Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amount
No (kg) Rs. Rs. (kg) Rs. Rs. (kg) Rs. Rs.
Jan12 12 40.00 480 12 40.00 480
20 10 40.00 400 2 40.00 80
21 - 12 45.00 540 2 40.00 80
12 45.00 540
Feb17 - 10 45.00 450 2 40.00 80
2 45.00 90
28 12 50.00 600 2 40.00 80
2 45.00 90
12 50.00 600
Mar 15 12 60.00 720 2 40.00 80
2 45.00 90
12 50.00 600
12 60.00 720
18 10 60 600 2 40.00 80
2 45.00 90
12 50.00 600
2 60.00 120
31 18 890
Closing stock Rs. 890
d) Base stock method: Under this method, a minimum quantity of stock is always to be held in stores
as fixed asset. The minimum stock is known as base stock and it should not be issued unless there is
an emergency. The stock in excess of base stock would be issued in accordance with one of the
methods of pricing of issue e.g. LIFO, FIFO, and Average etc. Thus it is not an independent method
in itself.
Illustration: 22
During the month of October, 2013 the following receipts and issues of materials took place in the stock
of ABC Ltd.
Receipts Issue
Units Rate (Rs.) Units

October 1 balance 100 2.00 -

October 7 80 1.50 -
October 9 60 2.00 -
October 11 - - 140
October 13 - - 20
October 15 40 2.50 -
October 24 - - 40
October 25 - - 20
October 28 80 1.50 -
On 31st October, a shortage of 10 units was found. Record the above in the Stores Ledger assuming that
the Company maintains its ledger on the LIFO method with a Base Stock of 80 units.
Solution
Stores Ledger Account (LIFO Method, Base Stock 80 units)
Material………. Code No…… ……… Maximum Quantity……….
2013 Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amount
Oct. (kg) Rs. Rs. (kg) Rs. Rs. (kg) Rs. Rs.
1 100 2.00 200 100 2.00 200
7 80 1.50 120 100 2.00 200
80 1.50 120
9 60 2.00 120 100 2.00 200
80 1.50 120
60 2.00 120
11 60 2.00 120 100 2.00 200
80 1.50 120
13 20 2.00 40 80 2.00 160
15 40 2.50 100 80 2.00 160
40 2.50 100
24 40 2.50 100 80 2.00 160
25 80 2.00 160
28 80 1.50 120 80 2.00 160
80 1.50 120
28 20 1.50 30 80 2.00 160
60 1.50 90
31 10 1.50 15 80 2.00 160
Shorta 50 1.50 75
ge
Note: On 25th October, requisition is received for 20 units. On this date there were 80 units in the stock. If
20 units are issued, then units of base stock will be reduced, therefore, 20 units will be issued not on 25th
October but on 28th October when 80 units will be received.

2. Average Price Methods:
(a) Simple average price method: Under this method, materials issued are valued at average price,
which is calculated by dividing the total of unit prices of each purchase by the number of unit rate. It is an
average of prices without having regard to the quantities involved. It should be used when prices do not
fluctuate very much and the materials are received in uniform lots of similar quantity.
Advantage:
i. It is simple to understand and easy to operate
ii. Issue price cannot be affected considerably by the fluctuations in prices of purchase.
iii. Average cost method is suitable for the condition when different lots of purchases get mixed up so
that the identification is not possible.
iv. Where the quantity of each purchase is stable but the prices fluctuate, average cost method suits the
condition.
Disadvantages:
i. Material issue cost does not represent actual cost price. Since the materials are issued at a price
obtained by averaging cost prices, a profit or loss may arise from such types of pricing.
ii. This method will give incorrect result where the prices of material fluctuate considerably.
iii. Such a price determination is unscientific.
Illustration: 23
From the following information prepare a stores ledger account following the Simple Average Price
Method.
Date: January, 2013 Particulars Rate per unit (Rs.)
1 Received 500 units 20
15 Issued 700 units -
Solution
Stores ledger Account
(Simple average Method)
Jan. (kg) Rs. Rs. (kg) Rs. Rs. (kg) Rs. Rs.
1 500 20.00 10,000 500 20.00 10,000
10 300 24.00 7,200 500 20.0024 10,000
300 .00 7,200
15 700 22.00 15,400 100 1,800
20 400 28 11,200 500 13,000
25 300 26.00 7,800 200 5,200
27 500 22 11,000 700 16,200

31 200 25 5,000 500 11,200

Average price for different issues has been calculated as follows:
Jan 15 700 units = (20+24)/2 = Rs. 22 per unit
(b) Weighted average price method: This method gives due weightage to quantities purchased and the
purchase price while determining the issue price. The average issue price here is calculated by
dividing the total cost of materials in the stock by total quantity of materials prior to each issue.
Advantages:
i. This method stabilizes costs when prices rapidly fluctuates,
ii. This is free from objections by the Income Tax Authorities,
iii. It is most acceptable methods of pricing issue.
Disadvantages:
Material cost does not represent actual cost price and therefore, a profit or loss will arise out of such a
pricing method.
Illustration: 24
From the following information prepare a stores ledger account following the weighted average method.
Date: January, 2013 Particulars Rate per unit (Rs.)
Solution:
Stores ledger Account
(Weighted average Method)
Jan. (kg) Rs. Rs. (kg) Rs. Rs. (kg) Rs. Rs.
1 500 20.00 10,000 500 20.00 10,000
10 300 24.00 7,200 800 21.50 17,200
15 700 21.50 15,050 100 2,150
20 400 28 11,200 500 26.70 13,350
25 300 26.70 8,010 200 5,340
27 500 22 11,000 700 23.34 16,340
31 200 23.34 4,468 500 11,672
(c) Periodic simple average price method: This method is similar to simple average price method
except that the average price is calculated at the end of the concerned period. In other words, the price
paid during the period for different lots of materials purchased are added up and the total is divided by the

number of purchases made during the period. The rate so computed is then used to price all the issues
made during the period, and also for valuing the closing inventory of the period.
Advantages:
i. It is simple to operate, as it avoids calculation of issue price after every receipt.
ii. This method can usefully be employed in costing continuous processes where each individual
order is absorbed into the general cost of producing large quantities of articles.
Disadvantages:
i. This method cannot be applied in jobbing industry where each individual job order is absorbed
into the general cost of producing large quantities of articles.
ii. This method is unscientific as it does not take into consideration the quantities purchased at
different prices.
iii. This method also suffers from all those disadvantages of simple average cost method.
(d) Periodic weighted average price method: This method is like weighted average price method,
except that the calculations of issue prices are made periodically (say, a month). The rate so arrived is
used for the issues made during that period and also for valuing the inventory at the end of the period.
Advantages:
i. This method is superior to the periodic simple average price method as it takes into account the
qualities also.
ii. It overcomes or evens out the effect of fluctuations.
iii. In addition to above, the method also possesses all the advantages of the simple weighted average
price method.
Disadvantage:
This method is not suitable for job costing because each job is to be priced at each stage of completion.
(e) Moving simple average price method: Under this method, the rate for material issues is determined
by dividing the total of the periodic simple average prices of a given number of periods by the numbers of
periods. For determining the average. Suppose a six month period is decided upon and moving, average
rate for the month of June is to be calculated. Under such a situation, we have to make a list of the simple
average prices from January to June, add them up, and divide the total by six. To calculate the moving
average rates for July have to omit simple average rate pertaining to January and add the rate relating to
July and divide the total by six.
Advantage:
This method evens out price fluctuations over a longer period, thus stabilizing the charges to work in
progress.
Disadvantage:
A profit or loss arises by the use of moving simple average cost.
(f) Moving weighted average price method: Under this method, the issue rate is calculated by dividing
the total of periodic weighted average price of a given number of periods by the number of periods.

3. Market Price Methods:
(a) Replacement price method: Replacement price is defined as the price at which it is possible to
purchase an item, identical to that which is being replaced revalued. Under this method, materials issued
are valued at the replacement cost of the items. This method pre-supposes the determination of the
replacement cost of materials at the time of each issue; viz., the cost at which identical materials could be
currently purchased. The product cost under this method is at current market price, which is the main
objective of the replacement price method.
Advantage:
Product cost reflects the current market prices and it can be compared with the selling prices.
Disadvantage:
The use of the method requires the determination of market price of material before each issue of
material. Such a requirement creates problems.
(b) Realizable price method: Realizable price means a price at which the material to be issued can be
sold in the market. This price may be more or may be less than the cost price at which it was originally
purchased. Like replacement price method, the stores ledger would show profit or loss in this method too.
4. Notional Price Method:
(a) Standard price method: Under this method, materials are priced at some predetermined rate or
standard price irrespective of the actual purchase cost of the materials. Standard cost is usually fixed after
taking into consideration of the following factors:
i. Current prices
ii. Anticipated market trends, and
iii. Discounts available and transport charges etc.
Standard prices are fixed for each material and the requisitions are priced at the standard price. This
method is useful for controlling material cost and determining the efficiency of purchase department. In
the case of highly fluctuating prices of materials, it is difficult to fix their standard cost on long-term
basis.
Advantages:
i. The use of the standard price method simplifies the task of valuing issue of materials.
ii. It facilitates the control of material cost and the task of judging the efficiency of purchase
department.
iii. It reduces the clerical work.
Disadvantages:
i. The use of standard price does not reflect the market price and thus results in a profit or loss.
ii. The fixation of standard price becomes difficult when prices fluctuate frequently.
(b) Inflated price method: In case material suffers loss in weight due to natural or climatic factors, e.g.
evaporation, the issue price of the material is inflated to cover up the losses.

(c) Re-use Price Method: When materials are rejected and returned to the stores or a processed
material is put to some other use, then such materials are priced at a rate quite different from the
price paid for them originally. There is no final procedure for valuing use of material.
2.10 STOCK VALUATION OF MATERIAL RETURNS AND LOSSES:

Valuation of Materials Returned to the Vendor: Materials which do not meet quantity, dimensional
and other specifications and are considered to be unfit for production are usually returned to the vendor.
The price of materials to be returned to vendor should include its invoice price plus freight, receiving and
handling charges etc. Strictly speaking, the materials returned to vendors should be returned at the stores
ledger price and not at invoice price. But in practice invoice price is only considered, the gap between the
invoice price and stores ledger price is charged as overhead.
In stores ledger the defective or substandard materials are shown in the issue column at the rate shown
in the ledger, and the difference between issue price and invoice cost is debited to an inventory
adjustment account.
Valuation of materials returned to stores: When materials requisitioned for a specific job or work-in
progress are found to be in excess of the requirement or are unsuitable for the purpose, they are returned
to the stores. There are two ways of treating such returns.
i. Such returns are entered in the receipt column at the price at which they were originally issued,
and the materials are kept in suspense, to be issued at the same price against the next requisition.
ii. Include the materials in stock as if they were fresh purchases at the original issue price.
Valuation of Shortages during physical Verification: Materials found short during physical
verification should be entered in the issue column and valued at the rate as per the method adopted i.e.
FIFO or any other.
Selection of pricing method

No hard and fast rule of procedure has been laid down to select a method of pricing issues of material.
However, the ultimate choice of a method of selection may be based on the following considerations.
i. The method of costing used and the policy of management.
ii. The frequency of purchases and issues.
iii. The extent of price fluctuations.
iv. The extent of work involved in recording, issuing and pricing materials.
v. Whether cost of materials used should reflect current or historical conditions.

Material Losses
Material losses do occur in every type of manufacturing organization. Those losses may be in the form of
waste, spoilage or defective work. There is no uniformity in the terminology and accounting treatment of
these items.
Treatment of Normal and Abnormal Loss of Materials

Whichever method may be adopted for pricing materials, certain differences between the book balance
and the value of physical stock are bound to occur. These differences, which may be a gain or loss, should
be transferred to Inventory Adjustment Account pending investigation. If, upon investigation, they are
regarded as normal, they should be transferred to Overhead Control Account; if abnormal, they should be
written off to the Costing Profit and Loss Account.
In the case of normal losses, an alternative method is also preferred where issue price per unit of material
is adjusted so as to cover normal loss. This alternate method can be better with the help of the example
considered. Suppose 1,000 meters of gunny cloth are purchased at Rs.2 per meter. It is expected that 1%
would be the normal loss due to issues being made in small lots. The inflated price would be Rs. 2.02.
The rate of Rs. 2.02 per meter of gunny cloth covers the cost of a normal loss as well.
Accounting and control of Waste, Scrap, Spoilage and defectives

i. Waste
It represents that portion of the basic raw material which has been lost in the manufacturing process and
which has no recoverable value, e.g. gases, dust smoke, unsaleable residue, losses on account of
shrinkage or evaporation etc. Waste may be visible – remnants of basic raw materials – or invisible; e.g.,
disappearance of basic raw materials through evaporation, smoke etc. shrinkage of material due to natural
causes may also be a form of a material wastage.
Normal waste is absorbed in the cost of net output, whereas abnormal waste is transferred to costing
profit and loss account. In other words, waste within the normal limits should be distributed over good
output. Thus per unit cost would be increase. Whereas, waste beyond the normal limits should be
transferred to costing profit and loss account so as to avoid any fluctuations in the cost of production.
For effective control of waste, normal allowances for yield and waste should be made from past
experience, technical factors and special features of the material process and product. Actual yield and
waste should be compared with anticipated figures (in the form of a waste report as depicted below) and
appropriate actions should be taken where necessary. Responsibility should be fixed on purchasing,
storage, and maintenance production and inspection staff to maintain standards. A systematic procedure
for feedback of achievement against laid down standards should be established.

ii. Scrap
It has been defined as the incidental residue from certain types of manufacture usually of small amount
and low value, recoverable without further processing. Scrap may arise on account of turnings, borings,
trimmings etc from metal on which machine operations are carried out. By products of small value which
are sold without further processing are also treated as scrap. It should be noted that ‘Scrap’ is always
physically available while waste may or may not be present in the form or residue.
Scrap may be treated in cost accounts in the following ways:-
i. Where the value of scrap is negligible, it may be excluded from costs. In other words, the cost of
scrap is borne by good units and income from sale of scrap is treated as other income. However,
the method fails to secure effective control over scrap as detailed records are not kept and scraps
are not identified to jobs or processes.
ii. The sales value of scrap net of selling and distribution cost, is deducted from overheads to reduce
the overhead rate. A variation of this method is to deduct the net realizable value from material
cost. This method is followed when scraps cannot be segregated job or process-wise.
iii. When scrap is identifiable with a particular job or process and its value is significant, the value
realized from sale of scrap is credited to the particular job or process or operation concerned. The
method has an advantage of indentifying scrap with each operation, process or job.

Control over scrap starts from beginning i.e. from the stage of product designing till the final product is
produced. Thus suitable materials, proper equipment and personnel would help in getting maximum
quantity of finished product from a given raw material.
A standard allowance for scrap should be fixed and actual scrap should be collected, recorded and
reported indicating the cost center responsible for it. A periodical scrap report (as depicted below) would
serve the purpose.
iii. Spoilage
It is the term used for materials which are badly damaged in manufacturing operation and they cannot be
rectified economically and hence taken out of process to be disposed of in some manner without further
processing. Spoilage may be either normal or abnormal.
Normal spoilage is inherent in the operation and therefore, cost thereof is charged to the cost of
production or production overhead, so that it is spread over all products. Any value realized from spoilage
is credited to cost of production or production overhead as the case may be.
The cost of abnormal spoilage is charged to costing profit and loss account. When spoiled work is the
result of rigid specification, the cost of spoiled work is absorbed by good units while the cost of disposal
is charged to production overhead.

To control spoilage, allowance for normal spoilage should be fixed and actual spoilage should be
compared with standard set. A systematic procedure of reporting would help control over spoilage. A
spoiled report (as depicted below) should highlight the normal and abnormal spoilage, the department
responsible, the causes of spoilage and the corrective action taken, if any.
iv. Defectives
It signifies those units of portions of production which can be rectified and turned out as good units by the
application of additional material, labor, or other service. For example, some mudguards produced in a
bicycle factory may have dents; or there may be duplication of pages or omission of some pages in a
book. Defectives arise due to substandard materials, bad supervision, bad planning, poor workmanship,
inadequate equipment and careless inspection. To some extent defectives may be unavoidable but usually,
with proper care it should be possible to avoid defect in the goods produced.
Reclamation of loss from defective units: In the case of defective materials, it is necessary to take steps to
reclaim as much of the loss as possible. For this purpose:
i. All defective units should be sent to a place fixed for the purpose;
ii. These should be dismantled;
iii. Goods and serviceable parts should be separated and taken into stock;

iv. Parts which can be made serviceable by further work should be separated and sent to the workshop
for the purpose and taken into stock after the defects have been removed; and
v. Parts which cannot be made serviceable should be collected in one place for being melted or sold.
Printed forms should be used to record quantities for all purposes aforementioned.
Treatements of Defectives
Defectives are generally treated in two ways: either they are brought up to the standard by incurring
further costs on additional material and labor or where possible, they are sold as inferior products
(seconds) at lower prices. The following illustration is given to explain the accounting procedure followed
in either case.
Total expenses of manufacture Rs. 5,000
Output good: 450 units
Defective: 50 units
Cost of rectifying defectives Rs. 50
Cost per unit of production = (Rs.5,000+ Rs.50)/500 = Rs. 10.10 per unit
If defectives are not rectified but sold as ‘seconds’ say, @ Rs. 8 each then cost of goods produced will be
= (Rs.5,000 - Rs.400)/450 = Rs. 10.22 per unit
Control –When defectives are found, the Inspector will make out the Defective Work Report, giving
particulars of the department, process or job, defective units, normal and abnormal defectives, cost of
rectification etc. On receipt of the Defective Work Report, it may be decided to rectify the defective
work; all costs of rectification are collected against the rectification work order, precaution will be taken
to see that number of defectives is within normal limits. Defectives are generally treated in two ways,
either they are brought up to the standard by incurring further costs on additional material and labor or
where possible, they are sold as inferior production (seconds) at lower prices.
Distinction between spoilage and defectives:

The difference between spoilage and defectives is that while spoilage cannot be repaired or reconditioned,
defectives can be rectified and transferred, either back to standard production or to seconds.
Treatment of defectives and spoilage in Cost Accounting

Under cost accounts, normal spoilage costs i.e. (which is inherent in the operation) are included in cost
either by charging the loss due to spoilage to the production order or charging it to production overhead

so that it is spread overall products. Any value realized from the sale of spoilage is credited to production
order or production overhead account, as the case may be. The cost of abnormal spoilage (i.e., arising out
of causes not inherent in manufacturing process) is charged to the Costing Profit and Loss Account. When
spoiled work is the result of rigid specifications the cost of spoiled work is absorbed by good production
while the cost of disposal is charged to production overheads.
The problem of accounting for defective work is the problem of accounting of the costs of rectification or
rework.
The possible ways for the treatment of defectives work are as below:
(i) Defectives that are considered inherent in the process and are identified as normal can be
recovered by using the following methods:
a. Charged to good products – The loss is absorbed by good units. This method is used
when ‘seconds’ have a normal value and defective rectified into ‘seconds’ or ‘first’ are
normal;
b. Charged to general overheads – When the defective caused in one department are
reflected only on further processing, the rework costs are charged to general overheads;
c. Charged to Department overheads – if the department responsible for defectives can be
identified then the rectification costs should be charged to that department.
d. Charged to Costing Profit and Loss Account – If defectives are abnormal and are due to
causes beyond the control of organization, the rework cost should be charged to Costing
Profit and Loss Accounts
(ii) Where defectives are easily identifiable with specific jobs, the work costs are debited to the job.
Procedure for the control of Spoilage and Defectives

To control spoilage, allowance for a normal spoilage should be fixed up and actual spoilage should be
compared with standard set. A systematic procedure of reporting would help control over spoilage. A
spoilage report (as below) would highlight the normal and abnormal spoilage, the department responsible,
the causes of spoilage and the corrective action taken if any

Control of defectives may cover the following two areas:
• Control over defective produced

• Control over reworking costs
For exercising effective control over defectives produced and the cost of reworking, standards for normal
percentage of defectives and reworking costs should be established.
Actual performance should be compared with the standards set. Defective Work Report (as shown on
below page should be fed back to the respective Centers of control).
Losses due to obsolete stores-

Obsolescence is defined as “ loss in the intrinsic value of an asset due to its supersession. In other words it
is a process of being obsolete and failing into disuse or becoming out of date. Materials may become
obsolete under any of the following circumstances:
i. where it is a spare part or a component of a machinery used in manufacture and that machinery
becomes obsolete;
ii. where it is used in the manufacture of a product which has become obsolete.
iii. where the material itself is replaced by another material due to either improved quality or fall in
price.
In all three cases, the value of the obsolete material held in stock is a total loss and immediate steps
should be taken to dispose it off as the best available price. The loss arising out of obsolete materials
being abnormal loss does not form part of the cost of manufacture. Losses due to obsolescence can be

minimized through careful planning and keeping stock of spares at the optimal level. Stores records
should be continuously gone through to see whether any item is likely to become obsolete. There will be
such likelihood if an item has not been used for a long time. This however does not apply to spare parts of
machines still in use.
Consumption of Materials
Any product that is manufactured in a firm entails consumption of resources like material and labour etc.
The management for planning and control must know the cost of using these resources in manufacturing.
The consumption of materials take place say when the material is used in the manufacture of a product. It
is important to note that the amount of material consumed in a period by a cost object need not be equal to
the amoung of material available with the concern. For example, during any period the total of raw
material stock available for use in production may not be equal to the amount of material actually
consumed and assigned to the cost object of production. The difference between the material available
and material consumed represents the stock of material at the end of the period.
Identification of materials
For the identification of consumption of materials with products of cost centres the following points
should be noted:
i. It is required that the concern should follow coding system for all materials so that each material is
identified by unique code number.
ii. It is required that each product of a cost centre should be given a unique code number so that the
direct material issued for production of particular product of a cost centre can be collected against
the code number of that product.
iii. However it may not be possible to allocate all materials directly to individual product of a cost
center e.g. maintenance materials, inspection and testing material etc. The consumption of these
material are collected for cist centre and then charged to individual product by adopting suitable
overhead absorption rate of the cost center.
Cost of Cost Center
Overhead absorption rate of cost centre =
Base Relating to Cost Center I.e Labour/ Machine Hour
iv. Each issue of material should be recorded.One way of doing this is to use a material requisition
note. This note shows the details of materials issued for a product of cost center and the cost center
which is tobe charged with cost of material.
v. A material return note is required for recording the excess materials returned to the store. This note
is required to ensure that the original product of cost centre is credited with the cost of material
which was not used and that the stock records are updated.
vi. A material transfer note is required for recording the transfer of materials from one product cost
center to other or from one cost center to another.
vii. The cost of material issued would be determined according to stock valuation method used.

Monitoring Consumption Material
For monitoring consumption of materials a storekeeper should periodically analyse the various material
requisition, material return notes, and material transfer notes. Based on this analysis, a material abstract or
material issue analysis sheet is prepared, which shows a glance of the value of material consumed in
manufacturing each product. This statement is also useful for ascertaining the cost of material issued for
each material.
The material abstract statement serves a useful purpose. It in fact shows the amoung of material to be
debited to various product and overhead. The total amount of stores debited to various product and
overhead should be the same as the total value of stores issued in a period.
Basis for consumption entries in Financial Accounts: Every manufacturing organization assigns
material costs to products for two purposes. Firstly, for external financial accounting requirements in
order to allocate the material costs incurred during the period between cost of goods produced and
inventories; secondly to provide useful information for managerial decision making requirements. In
order to meet external financial accounting requirements, it may not be necessary to accurately trace
material costs to individual products. Some products costs may be overstated and others may be
understated but this may not matter for financial accounting purposes as long as total of individual
materials costs assigned to cost of production and inventories are equal to total cost of materials.
In financial Accounts the external transactions are recorded i.e. transaction between the firm and other
entities are recorded in a manner that facilitates periodical reporting of assets, liabilities, revenue and
expenditures for a firm as a whole or for each business segment or geographical segment in which firm
operates. In Cost Accounting the internal transactions are recorded i.e., transactions between cost centers
within the firm are recorded in a manner that facilitates analysis of costs for assigning them to cost units.
The consumption entries in financial accounts are made on the basis of total cost of purchases of materials
after adjustment for opening and closing stock of materials. The stock of materials is taken at cost or net
realizable value whichever is less.
2.11 JUST IN TIME (JIT)
Just-In-Time is a purchasing and inventory control method in which materials are obtained just in time for
production to provide finished goods just in time for sale. There are two aspects of JIT: (i) JIT
Production, and (ii) JIT Purchasing. JIT with regard to production means producing only what is needed,
when it is needed, in the quantity just needed. A JIT manufacturing system requires making goods or
services only when the customer, internal or external, requires it. According to CIMA official
Terminology:
“JIT is a technique for the organization of work flows, to allow rapid, high quality, flexible production
whilst minimizing manufacturing waste and stock level”. Further, CIMA defines JIT production as “a
system which is driven by demand for finished products, whereby each component on a production line is
produced only when needed for the next stage”.

JIT purchasing requires better coordination with suppliers so that materials arrive immediately prior to
their use. Firms using JIT purchasing enter long term contracts with them to enable vendors to plan their
annual production. Under JIT purchasing, EOQ is much lower as compared to EOQ under conventional
purchasing. JIT purchasing provides significant savings in cost.
JIT aims to achieve the following objectives:
(i) Zero inventory

(ii) Zero breakdown
(iii) 100% on time delivery service
(iv) Elimination of non-value added activities
(v) Zero defects
JIT is a demand-pull system. Demand for customer output (not plans for using input resources) triggers
production. Production activities are “pulled” not “pushed” into action. The major differences between
JIT manufacturing and traditional manufacturing are as follows:
JIT Traditional
1 Pull system 1. Push system
2. Insignificant or Zero inventories 2. Significant inventories
3. manufacturing cells (work centers) 3. Process structure
4. multifunction labor 4. Specialized labor
5. Total quality management (TQM) 5. Acceptable quality level(AQL)
6. Simple cost accounting 6. complex cost accounting
JIT production and JIT purchasing reduces or eliminates inventory and the costs associated with carrying
the inventory. JIT emphasizes that workers immediately correct the system making defective units
because they have no inventory. With no inventory to draw from for delivery to customers, JIT relies on
high quality materials and production. It is required that the companies that use just-in-time
manufacturing must eliminate all the sources of failure in the system. Production people must be better
trained so that they can carry out their works without errors. Suppliers must be able to produce and
deliver defect free materials or components just when they are required, and equipment must be
maintained so that machine failures are eliminated.
JIT applies to raw materials inventory as well as to work-in-progress inventory. The goals are that both
raw materials and work –in-progress are held to absolute minimums. JIT is used to complement other
materials planning and control tools, such as EOQ and safety stock levels. In JIT system, production of an
item does not commence until the organization receives an order. When an order is received for a finished
product, productions people give orders for raw materials. As soon as production is complete to fill the
order, production ends. In theory, there is no need for inventory in JIT because no production takes place
until the organization knows that it will sell them. In practice, however, companies using JIT inventory
generally, have a backlog of orders of stable demand for their products to assure continued production.

The fundamental objective of JIT is to produce and deliver what is needed, when it is needed, at all stages
of the production process.- JIT to be fabricated, sub-assembled, assembled and dispatched to the
customer. Although, in practice there are no such perfect plans, JIT is an ideal and therefore a worthy
goal. The benefits are low inventory, high manufacturing cycle rates, high output per employee, minimum
floor space requirements, minimum indirect labor, and perfect in-process control. An associated
requirement of a successful JIT operation is the pursuit of perfect quality in order to reduce, to an absolute
minimum, delays caused by defective product units.
2.12 MATERIAL REQUIREMENT PLANNING (MRP)
Traditionally material requirements were determined by continuously reviewing stock levels whenever
stock level fell below a pre-specific level (the reorder point) a pre-determined quantity was ordered each
time. This approach assumes that the replenishment of any one stock item can be planned independently
of all other. However, the demand for a particular stock item is a function of assemblies and sub-
assemblies of which they are part. Material Requirement Planning (MRP) originated in the early 1960s as
a computerized approach for coordinating the planning acquisition and production of materials.
MRP is a computerized production scheduling system which takes the forward schedule of final product
requirements (the master production schedule) and translates it progressively into the numbers of sub-
assemblies, components and raw materials required at each stage of manufacturing cycle. It is a
management information system providing a basis for production decisions when what is manufactured
has a composite structure and when lead items are important features. Obviously, the ability of the system
to deliver what is required in the correct place at the correct time will be dependent on the quality of
information which is put into the computer model.
Aims of Material Requirement Planning:
The aims of MRP to make use of computers in order to:
1. Determine for final products namely, what should be produced and at what time.
2. Ascertaining the required units of production of sub-assemblies.
3. Determining the requirement for materials based on an up-to-date bill of materials file (BOM)
4. Computing inventories, work-in-progress, batch sizes and manufacturing and packaging lead times.
5. Controlling inventory by ordering bought-in components and raw materials in relation to the orders
received or forecast rather than the more usual practice of ordering from stock-level indicators.
Benefits:
The benefits of MRP are that a detailed forecast of the inventory position is highlighted period by period.
It is usually used to plan a future time period (i.e. forward planning system) of a manufacturing operation
like a month, quarter or even a year into the future.
Purpose of MRP
1. The purpose of MRP is to determine the requirement and to schedule for the manufacturing and
purchasing of items in order to accomplish the needs set out in the master production schedule.
2. The MRP system ensure that materials and components are available in required quantities at the
requested time to make it possible to manufacture the end items as given by the master production
schedule.
3. The output of MRP is in the form of action notices, which are inputs to the manufacturing execution
function of shop floor control.
Data requirement to operate MRP system
The core data requirements for operating a MRP include the following:
1. The master Production schedule: This schedule specify the quantity of each finished unit of
products to be produced and the time at which each unit will be required.
2. The Bill of Material file: The bill of material file specifies the sub-assemblies, components and
materials required for each finished good.
3. The inventory file: This file maintains details of items in hand for each sub-assemblies
components and materials required for each finished goods.
4. The routing file: This file specifies the sequence of operations required to manufacture
components, sub-assemblies and finished goods.
5. The master parts file: This file contains information on the production time of sub-assemblies
and components produced internally and lead times for externally acquired items.
Method of operation of MRP system
A MRP system is a computer based inventory information system which is used to plan and control raw
materials and component parts inventories.
Like all computer based information systems, MRP system can be divided into following:
(i) Pre-requisite information,

(ii) System input,
(iii) System processing,
(iv) System output
Pre-requisite information and system input:
(i) The master production schedule (MPS) file states the production goal, generally for a week time, in
terms of desired units of production. MRP system first focused on the forecasted units of production

and timing of finished goods demand and then determines the demand for materials, components and
sub-assemblies
assemblies at each stages of production. This makes MRP a push system in which once the
schedule production starts,
s, the output of each department is pushed through the system to the next
department for processing or into inventory to be retrieved later.
(ii) The bill of materials (BOM) file contains information about how the production of the finished goods
is undertaken. A bill of materials structure is used:
a. To assess all the raw materials and components parts required to complete a product and
b. To describe the multiple levels of assembly or manufacturing necessary to complete a unit of
finished product.
In a figure given
en below a typical BOM structure file is presented for three end products FG1, FG2 and
FG3. The MRP system breaks the requirements for each product by working into its primary sub sub-
components (SC)/ sub-assemblies
assemblies (SA), and these in turn are further separate
separated into second, third and so
on levels of sub-components,
components, until at the lower level in the hierarchy, only purchased items ( i.e.,
backward each end products direct materials –DM) DM) exist. It is apparent form the figure below that four
direct materials (DM1, DM2,M2, DM3 and DM4) are purchased for finished goods. For both FG1 and FG2
the materials are used to manufacture the components that are assembled into the end product. For FG3
no intermediary components are produced.
FG1
FG2
SC3 SC2 FG3
SC1
SC1
DM2 DM4
DM1 DM3
DM1 DM4
DM2
FG = Finished Goods
SC = Sub Components
DM = Direct Materials
(iii) The inventory records file of the MRP system defined current levels of finished goods, raw
materials, and component parts inventory at the beginning of some planning period. During the
planning period, the organization may receivee units of raw materials, component parts, sub sub-
assemblies, and even finished goods inventory from suppliers, vendors, and subcontractors. These

planned inventory receipts and delivery lead times are included in the inventory records file so that
their addition
tion can be appropriately considered in the time bucket of their arrival.
System processing and system output:
Once the MRP system knows what it is expected to produce (via the MPS file), how it should produce it
(via the BOM file), and with what it has to produce it (via the inventory record file), the system
arithmetically combines the information to determine when the production should take place in the future
planning period. To accomplish this, a process called requirements explosion is conducted.
Thee program starts with the finished goods demand (from the MPS) and ‘explodes’ the demand
requirements backward in time to schedule the desired production of the finished goods from raw
materials and component parts with ‘time-phased’
phased’ adjustments for lead ttime requirements.
The information provided by system processing includes the following:
1. Gross requirements i.e. the demand for the components or assembly as computed from firm
customers’ orders and forecasts.
2. Determine the net requirement after taking intoo account scheduled receipts, projected stock levels and
items already allocated from the current inventory.
3. Conversion of the net requirements to a planned order quantity using an appropriate lot size.
4. Planning orders in appropriate periods by backward sc scheduling from the required usage date by the
appropriate lead time required to fulfil orders.
Example;
The BOM file provides the following information for product A.
Product A
B (4 C (2
units) units)
D (2 units) E ( 1 unit) D (3units) F (2 units)
The lead time for the finished product, sub-assemblies,

assemblies, components and raw materials aand their demand
are as follows:

Lead Time Demand

Product Day Day
A 1 10 50A
B 2 8 20B (spares)
C 1 6 15D (spares)
D 3
E 4
F 1
The statement showing schedule of order placement for satisfying the demand -
Day 1 2 3 4 5 6 7 8 9 10
A Required 50
Order 50
Placement
B Required 20 200
Order 20 200
Placement
C Required 100
Order 100
Placement
D Required 40+15 400 300
Order 55 400 300
Placement
E Required 20 200
Order 20 200
Placement
F Required 200
Order 200
Placement
The above procedure helps the managers to see how well the desired MPS file objectives of finished
goods will be achieved in the future planning period.
Further to assist the management to comply with the MRP plan, the MRP system also provides detailed
inventory planning and control reports on inventory status.
Pre-requisites for successful operation of MRP
(i) Strict adherence to the schedule: The successful operation of MRP system requires a strict adherence
to the latest production and purchasing schedules. Workers must be educated to understand the
importance of schedule adherence, and controls should be in place to ensure this adherence.

(ii) Accurate data base: Data accuracy is vital to the system. If a plan is based on inaccurate data it may
be impossible to adherence to the schedule. For example, if the bill of materials file is not updated to
reflect any changes in product composition it will be impossible to adhere to the schedule.
SUMMARY OF FORMULAE
Level Setting (Maintenance of various Stock Levels)
Maximum Level = Reorder Level (ROL) + Reorder Quantity (ROQ) – Minimum Lead Time x
Minimum Consumption
Minimum Level = Reorder Level (ROL) – (Average Lead Time x Average Consumption)
Reorder Level (ROL) = Maximum Lead Time x Maximum Consumption
Danger Level = Average Consumtion x Lead time for emergency purchase
Average Stock Level = (Maximum level + Minimum level)/ 2
Minimum Level + 1/2 Reorder Quantity

EOQ =

Where,
C = Carrying cost per unit per annum.
Inventory Turnover Ratio = Mateial Consumed / Average Inventory
Total Inventory Cost = Purchase Cost + Ordering Cost + Carrying Cost


1. When and why you recommend the LIFO method of pricing material issue?
2. ‘It should be the management’s endeavor to increase inventory turnover but to reduce labor
turnover’. Explain.
3. Discuss briefly the considerations governing the fixation of maximum and minimum level of
inventory.
4. Distinguish between (a) Perpetual Inventory system and continuous stock taking (b) Bill of material
and material requisite note.
5. Write short note on ABC analysis.
6. What is Economic Order Quantity?
7. ‘To be able to calculate basic EOQ, certain assumptions are necessary.’ List down these
assumptions.
8. Distinguish between (a) Scrap and Wastage and (b) spoilage and defectives.
9. Differentiate between ‘Bin Card and ‘Stores Ledger’.
10. Discuss the accounting treatment of spoilage and defective.
11. Write short notes on: (a) Re-order level (b) Re-order quantity (c) Maximum stock level and (d)
Minimum stock level.
12. What is the function of a store keeper and how should s/he organize the store?
13. Explain methods of pricing of materials and state which of these methods is, in your opinion the
most accurate?
14. What are the main objectives of material control? Explain the important requirement to attain these
objectives.
15. State how would you treat the following in cost records:
a. Pricing of material returned to stores; and
b. Pricing of material returned to suppliers.
16. The rate of interest is 12%, the price per unit is Rs. 50, the number of units required in a year is
5,000 and the cost of placing one order and receiving the goods once is Rs. 54. How much should be
purchased at a time?
17. State whether the following statements are true or false:
a. ABC system of stock control enables the management to exercise a selective control of inventory and
concentrate on more important items.
b. The formula for EOQ may be disregarded where a future and continuous supplies of goods is not
assured.
c. If a store ledger is being maintained, there is no need to maintain bin cards.
d. Material transfer note is the document through which defective raw materials are sent back to the
suppliers.
e. Continuous stock taking should not be resorted to since it results in disruption of work.
f. The term ‘materials’ and ‘inventory’ should not be used synonymously.
g. Bin card shows the quantity of a material at any movement of time.
h. Simple average method of pricing is the simplest and perhaps one of the best methods.
i. When maximum stock level is fixed, the stock in hand should never exceed this level.
j. The economic order quantity is the re-order quantity.
k. In ABC analysis ‘A’ group of items consist of those materials, the value of which is not high but
which are used in large quantity.
l. In LIFO method of pricing, the effect of current market prices is reflected in the cost of production.
m. A list of all materials and parts required for a particular job is called production order.
n. The bin card and stores ledger are written up with the same documents.
o. ABC analysis is based on the principle of “management by exception”.
18. Fill in the blanks:
a. Bin card is maintained by the …….
b. Material turnover is a ratio ……to……….
c. Under the ………..method, a new issue price is determined after each purchase.
d. The formula for fixing minimum stock level is ………………….
e. The two perpetual inventory records are ………… and ……….
f. Two avoidable reasons for the difference between physical quantity of material and that shown by
the bin card may be ….. and ……
g. Under the ……………… method, materials are issued to production at a predetermined price.
h. ………..items should be stored as near as possible to the department requiring them.
i. Two important opposing factors in fixing the economic order quantity are ……… and…….
j. …….. is a document which authorizes and records the issue of materials for use.
k. ……..is a document which records the returns of unused materials.
l. Surpluses and deficiencies in the course of stock-taking may arise due to ….and….and ….
19. Select the correct answer in each of the following multiple choice questions:
a. Direct material is a
i. Fixed cost
ii. Variable cost
iii. Semi-variable cost
b. In most of the industries, the most important element of cost is

i. Material
ii. Labor
iii. Overheads
c. Which of the following is considered to be the normal loss of materials?
i. Loss due to accident
ii. Pilferage
iii. Loss due to breaking the bulk
iv. Loss due to careless handling of materials
v. All of these.
d. In which of the following methods of pricing, costs lag behind the current economic values?
i. LIFO
ii. FIFO
iii. Replacement
iv. Weighted Average
e. Continuous stock taking is a part of
i. Annual stock taking
ii. Perpetual inventory
iii. ABC analysis
f. In which of the following methods, issues of materials are priced at predetermined rate?
i. Inflated price method
ii. Standard price method
iii. Replacement price method
iv. Specific price method
g. When material prices fluctuate widely, the method of pricing that gives absurd results is
i. Simple average price
ii. Weighted average price
iii. Moving average price
iv. Inflated price
h. When prices fluctuate widely, the method that will smooth out the effect of fluctuations is
i. Simple average
ii. Weighted average
iii. FIFO

iv. LIFO
20.
a. Lead time is 5 weeks; average weekly consumption is 28 units. What should be the re-ordering
level?
b. Price per unit is Rs. 150, annual consumption is 2,000 units, it costs Rs. 300 to place an order and
receive the goods and interest and other charges are 20% of cost. What should be the quantity of
each order?
21. The following is the record of an item in a store ledger
Units Amount Units Amount
Rs. Rs. Rs. Rs.
Jan 1 To bal b/d 10,000 20,000 Jan15 By issue 14,000 30,000
Jan 10 To purchase 5,000 12,000 Feb 8 ,, ,, 6,000 15,000
Feb 3 ,, ,, 20,000 55,000 Mar 15 ,, ,, 22,000 60,000
Mar 10 ,, ,, 10,000 30,000 Mar 31 By bal c/d 3,000 12,000
45,000 117,000 45,000 117,000
Comment upon the method followed to price the issue. Find out the value of closing stock assuming issue
to have been made for period on (i) FIFO basis, (ii) LIFO basis, and (iii) Weighted average basis.
22. In a printing press, a form of 8 pages was fitted upside down and this was discovered only after
5,000 sheets had been printed. The total print was for 10,000 sheets, the cost per 1,000 sheets being
Rs. 50. Would it be correct to say that the loss is Rs. 250?
Answer to self evaluation questions
16. 300 units
17. True a, b, f, g, h, l. n & o.
18. (a) Store keeper (b) materials consumed during the period, average stock, (c) Standard price (d)
bin card, stores ledger (e) pilferage, posting in the wrong bin card (f) bulky (g) Cost of ordering,
Cost of carrying stock (h) Material requisition note (i) Materials return note (j) evaporation,
absorption of moisture, pilferage.
19. (a) (ii); (b) (1); (c) (ii), (d) (ii); (e) (ii); (f) (ii); (g) (i); (h) (ii).
20 (a) 140 units (b) 200 units
21 (i) Rs. 9,000 (ii) Rs. 7,500 (iii) Rs. 8,497
22. No wages of machine man should be added. It is a loss of overhead.

CHAPTER 3
LABOR CONTROL
CHAPER 3 : LABOR CONTROL
3.1 CONCEPT OF LABOR CONTROL

Labor cost after material cost is another significant element of cost not only because the wage bill in a
modern organization is generally substantial but also because it has certain peculiar characteristics which
other element of cost does not have. The efficiency of production depends upon the successful utilization
of labor force and for that, proper accounting and control of labor are needed. Skill of labors helps in
lowering down the cost of units produced besides raising the quantity and quality of output.
Labor can be direct as well as indirect. Direct labor is that which can be charged to specific cost units
directly. Indirect labour is one the direct allocation of which is not possible. If allocation of wages to
different jobs or products on a convenient basis can be done and paid to workers engaged directly in
fabrication of products, the wages are direct. The wages are indirect when the workers are not directly
engaged in the manufacturing of products and wages cannot be identified to particular jobs or products.
If we know how much time a worker spent on each of the various jobs he undertook during the given
period, say the past week, then for the past week his wages would be treated as direct; but if, for the same
worker, we cannot identify the time spent by him with particular jobs or products or which cannot be
allocated but which can be apportioned to, or absorbed by cost centers or cost units, then such wages will
have to be treated as indirect. Indirect wages are a part of factory expenses. For example, wages paid to
watchmen, repair staffs and supervisors are indirect. Wages of workers put on definite jobs or products
will be direct and constitute the second significant element of cost, the first being materials.
Sometimes it is difficult to distinguish between direct and indirect labor. A worker might be engaged in
doing a particular work concerned with manufacturing a commodity and after an hour the same worker
might be placed on a different job concerned with, say, repairing. In such a case, the wage paid for the
first hour should be treated as direct and for the rest of the period, indirect. It is to be noted that the
classification of labor between direct and indirect also depends upon the criteria laid down by the
management for the work and the nature of the industry. The distinction must be observed because direct
labor is a part of Prime Cost of Production whereas indirect labor is treated as Factory Overhead and
therefore, included under Works or Factory Cost.
Labor constitutes significant element of cost to produce an article. It is subject to wastage like any other
factors of production. Therefore, it requires showing that records should account for every amount paid
out for labor. Without an accurate record, it would be impossible for the manager to trace excessive labor
costs for a job. The wastage in labor might then be remedied by re-arrangement of plant, etc., or the
elimination of certain unnecessary operations on the part of the worker.
3.2 LABOR COST CONTROL

Labor costs are associated with human being. To control labor costs one has to understand why human
being work and what factors motivate them to give best performance. Control over labor costs does not
imply control over the size of the wage bill; it also does not imply that wages of each worker should be
kept as low as possible. Actually if a policy of low wages is adopted, it may burn out to be expensive
since the ill-paid workers will be dissatisfied and turn out low output. Low wages are, therefore, often
dear wages. The aim should be to keep the wages cost per unit of output as low as possible. This can only
be brought about by giving workers optimum wages and then harnessing their energies to optimize

output. A well motivated team of workers can bring about wonders. Each concern should, therefore,
constantly strive to raise the productivity of labor. The efforts for the control of labor costs should begin
from the very beginning. There has to be a concerted effort by all the concerned departments. In a large
organization, generally the following departments are involved in the control of labor costs:
1. Personnel Department – This department is assigned the duty of recruiting worker, training them and
maintaining their record. It is the duty of this department to ensure that the persons recruited possess
the qualifications and qualities necessary to perform the concerned jobs to the best of their abilities.
2. Engineering and Work Study Department – This department prepares plans and specifications for
each job, supervises production activities, conducts time and motion studies, undertakes job analysis,
sets piece rate, conducts job evaluation and merit rating etc.
3. Time-keeping Department – This department is primarily concerned with maintenance of attendance
records of the employees and the time spent by them on various jobs, etc.
4. Payroll Department – This department is responsible for preparation of payroll of the employees.
5. Cost Accounting Department – This department is responsible for accumulation and classification
etc. of all type of costs. All such data pertaining to labor costs are also collected, analyzed and
allocated to various jobs, processes, departments, etc, by this department.
Some of the terms mentioned above have been explained below
Time Study
Time study involves determination of standard time for an operation by direct time measurement.
Generally more than 10 time observations are made for each labor operation and an average time is
computed. The standard time is fixed after giving due consideration to factors such as absolutely essential
labor movements, proper tool and trained skilled labor force.
Motion Study
Motion Study is concerned with determination of standardized method for performing different
operations. It aims at improving the method of working by economizing efforts and reducing fatigue
while maintaining and improving efficiency.
Job Analysis
Job analysis involves preparation of a description and classification of each job, with a list of
qualifications needed by workers to perform the work satisfactorily. The US Department of Labour has
defined the Job Analysis as follows
“ Job analysis is the process of determining, by observations and study, and reporting pertinent
information relating to the nature of a specified job. It is the determination of the task which comprise the
job and the skills, knowledge, abilities and responsibilities required of the workers for successful
performance and which differentiates the job from all others”
Such a job analysis helps the personnel department to assess its labor requirement and assign the best
available worker to each job.

A proper system of time and motion studies together with job analysis helps management in reducing cost
through proper planning and controlling output and wages.
Job Evaluation
Job evaluation is a systematic and orderly process of determining the worth of a job in relation to other
jobs. Every job has its own characteristics. Depending upon these characteristics job demand is of varying
degrees , qualifications, skill, experience etc., on the part of operators performing the jobs. For example,
some jobs require physical ability, others may need a high degree of mental ability, while a third category
may need skill, experience and high education. job evaluation is the process of review, analysis and
systematic classification of a job in accordance with its characteristics i.e., varying factors it demands
from the employees. In other words job evaluation grades all jobs with reference to their main
characteristics so that the relative merit of each job in terms of work value may be determined. Proper job
evaluation helps in devising a wage structure which is acceptable to the workers as well as the
organization.
Purposes: Job evaluation helps following purposes:
1. It helps in devising an acceptable wage.

2. It helps to proper placement of workers in job.
3. It helps the personnel department to recruit the right person for a job since requirement of each
job are clearly indicated.
4. It helps in formulating the internal training plan.
5. It helps to avoid wage and other discrimination for similar jobs in same organization or a group
of organization under the same management.
Advantages to the Employer:
1. By bringing uniformity in wage rates, it brings about simplification of wage administration.

2. Wage rate can be reviewed easily if a job evaluation machinery exists in the organization.
3. Disputes and grievances regarding wage rates are settled which result in uninterrupted ongoing
of work.
4. By job evaluation proper and rational wage structure can be formulated and implemented. With
the result, better workers join the firm more willingly.
5. Supervisors are treated in the essential function of judging, controlling and helping the workers.
Advantages to the Employee:
1. Workers are rewarded on the basis of their performances. It provides effective motivation to
workers.
2. By job evaluation, right worker is put in the right place, with the result there is reduction in the
labor turnover.

Limitations of Job Evaluation
There are certain limitations. It cannot be applied easily to scientific and research pursuits. It is seen that
workers are not available at the wage suggested by the job evaluation.
Steps of Job Evaluation:
In job evaluation there are some major steps to be carried out in sequence: (1) Invention and construction
(2) Job Standardization (3) Job review and analysis, comprising determination of relative values of jobs
and grouping of jobs into classes for which minimum and maximum remuneration are established.
Invention and construction involve the timely development, design and production of the right type of
jigs, tolls, gauge and auxiliaries required for performing the jobs. Job standardization is the development
and standardization of the most suitable arrangements, motions and times for production based on time
and motion study. Job Review and Analysis includes job review, job analysis and job classification. Job
review is to identify person needed to fill the job and conditions which affect the rate of pay of the person
needed to fill it. Job analysis is analysis and synthesis of the data obtained by job review in order to
determine degree of duties, skills, exertion, responsibilities, conditions etc. needed in relation to the job.
Job classification is the procedure of sorting the standard job-description specifications into a small
number of groups.
Methods of Job Evaluation
There are mainly three method of Job classification: (1) Ranking Methods, (2) Grading Method (3) The
Point System and (4) The Factor Comparison Method.
(1) Ranking Method: Under this system different jobs are graded from the highest to the lowest ranks on
some basis. The hierarchy for each job group is thus outlined and pay scales are determined. Its greatest
merit is simplicity, which is also its great limitation that is the measurement is quite crude. Besides, there
is no pre-determined scale of value for the rates to be used. This method is useful in a small unit where
jobs are a few and are known to raters.
(2) Grading or Job Classification Method: In this method individual jobs are classified into a number of
grades or classes, for example: skilled, semi-skilled, unskilled, assistant, foreman, foreman executives and
work manager etc. For each class or grade a general specification is prepared, indicating the types of
responsibility and work that may be included. Salary or wage ranges are thereafter fixed for each class or
sub-class. Each job is reviewed to place the job in its appropriate grade. The chief merit of the method is
its simplicity but this is useful only in small units, since in large organization job-specifications are quite
complicated.
(3) The Point-rating Method: Under this method of evaluation jobs are analyzed into its various
characteristics or factors and then evaluated in terms of points. Points are allocated to each of the factor or
characteristics. The factors may be (i) Education or mental application, (ii) Physical application of effort,
(iii) Experience, expertise or skill, (iv) Responsibility for achievement and failures etc. (v) Job-hazards or

complex nature of job and (vi) Working conditions. These factors are outlined in a manual which also
prescribes the weightage to be applied to each such factor. Wages scales or ranges are fixed for each of
these grades.
(4) The Factor Comparison Method: Under this method, certain key jobs are selected and each selected
job is further analyzed into (i) Mental application (ii) Physical application (ii) Skill required (iv)
Responsibility and (v) Working condition. (These are also factors in point rating method). Each factor is,
thereafter, valued and aggregate values are compared to determine relative worth of each job.
It is to be noted that first two methods are simple and suitable for application in small factories. The last
two methods are analytical in approach. But jobs involving high degree of mental applications or hazards
cannot be accurately evaluated in fixed factor points.
Merit Rating (Performance Apraisal)
Merit rating or performance appraisal is a device for evaluating work performance in a systematic
manner. It is a tool for appraising the relative qualities of the employees or workers. Merit rating can be
defined as all the formal procedures used in working organizations to evaluate the personalities and
contributions and potential of group members.
It is different to job-evaluation. While job evaluation is the process of analysis and classification of jobs
according to their characteristics, Merit Rating refers to the evaluation of the merits of persons and their
classification into groups of that basis. The method of merit ratings lies, broadly, in keeping an
individual’s records of performance and assessing these performances through some norms or standards.
The intention is to suitably reward an employee on the basis of his merit. Merit rating provides a system
of incentive without applying the detailed procedure of work study and is particularly useful for
remember rating, on relative merits, indirect workers whose performance is difficult to measure.
In rating the merit i.e., qualities of the individual employee concerned, certain factors are taken into
consideration. Following are the examples of factors in common use.
(1) Quality of work done (2) Quantity of work done
(3) Sense of responsibility (4) initiative
(5) Reliability and integrity (6) Knowledge, skill, experience and aptitude of work
(7) Cooperation and discapture (8) Sense of judgment
(9) Attendance and punctuality (10) Extra-ordinary personal characteristics
Each factor is assigned a point value or point rating and each employee is rated according to the extent or
degree of factors he possesses.

Advantages of Merit Rating
Merit rating develops better undertaking or work and men. Followings are main objectives and merits of
Merit Rating or Performance Appraisal.
1. It increases better productivity of workers, as the very fact that merit rating is in existence,
encourages workers to more exertion.
2. It encourages employee in his growth and development by appraising all phases of his performance
and then by following constructive discussion and guidance.
3. It uncovers special abilities of the employees.
4. It promotes the employee’s job satisfaction and morale by letting him know that his supervisors are
interested in his progress and development.
5. Merit rating eliminates guesswork and prejudice in evaluating relative qualities of the employees.
6. It serves as systematic guide to the supervisors in planning the employee’s further training.
7. It helps in planning personal moves and placement that will utilize capability of each employee.
8. It provides employees an opportunity to talk to supervisor about job problem, interest, future etc.
9. It helps in fixation of fair and equitable pay rates.
10. It cultivates a spirit of competition among workers and these results in better performance.
Thus merit rating improves labor relations, reduces labor turnover and stimulates competition among the
workers resulting in increased production.
Shortcomings and Limitations of Merit Rating
(1) Merit rating is mostly based on opinions; it may tend to be erroneous, which may lead to
dissatisfaction and unrest.
(2) Labor-incentive offered on the basis of merit rating may not be regarded enough.
(3) It is quite possible that some irrelevant factors may be given importance or there may be biased
rating by supervisors.
(4) Raters may depend upon past rating record which may influence present rating
Difference between job evaluation and merit rating
The following are the points of difference between job evaluation and merit rating
1. Job evaluation is the assessment of relative worth of jobs in a business while merit rating is the
assessment of the relative worth of the man behind the jobs. Thus job evaluation rates the jobs while
merit rating rates the employees.
2. The objective of job evaluation is to set up a rational wage and salary structure. However, merit
rating provides a scientific basis for determining fair wages for each worker based in his ability and
performance.

3. Job evaluation simplifies wage administration by rationalizing and bringing uniformity in the wage
rates while merit rating helps in determining fair rate of pay to different workers on the basis of their
relative performance.
3.2.1 Important Factors for the Control of Labor Cost:

To exercises an effective control over labor costs, the essential requisite is efficient utilization of labor
and allied factors. The main points which need consideration for controlling labor costs are the following:
i) Assessment of manpower requirements.
ii) Control over time-keeping and time-booking.
iii) Time and Motion Study.
iv) Control over idle time and overtime.
v) Control over labor turnover.
vi) Wage systems.
vii) Incentive systems.
viii) Systems of wage payment and incentives.
ix) Control over casual, contract and other workers.
x) Job Evaluation and Merit Rating.
xi) Labor productivity.
3.2.2 Collection of Labor Costs:

The task of collecting labor costs is performed by the Cost Accounting Department which maintain
separate record for wages paid to direct and indirect labor. It is the duty of this department to ascertain the
effective wages per hour in each department and to analyze the total payment of wages of each
department into:
i. The amount included in the direct cost of goods produced or jobs completed;
ii. The amount treated as indirect labor and thus included in overheads; and
iii. The amount treated as the cost of idle time and hence loss.
Through this, process costs of various jobs are ascertained. Naturally for this, the proper recording of time
spent by the workers is essential. Labor cost per hour may be collected through the use of the form given
below:

3.3 ATTENDANCE AND PAYROLL PROCEDURES
3.3.1 Attendance Procedure

a) Time-keeping
It refers to correct recording of employees’ attendance time. Students may note the difference between
‘time keeping’ and ‘time booking’. The latter refers to break up of time on various jobs while the former
implies a record of total time spent by the workers in a factory.
Objective of Time-keeping:
Correct recording of employees’ attendance time is of utmost importance where payment is made on the
basis to time worked. Where payment is made by results viz; straight piece work, it would still be
necessary to correctly record attendance for the purpose of ensuring that proper discipline and adequate
rate of production are maintained. In fact the various objectives of time-keeping are as follows:
i. For preparation of payrolls

ii. For calculating overtime
iii. For ascertaining and controlling labor cost.
iv. For ascertaining idle time.
v. For disciplinary purposes.
vi. For overhead distribution.
Methods of time-keeping:
There are two methods of time keeping. They are the manual methods and the mechanical methods. The
choice of a particular method depends upon the requirements and policy of a firm. But whichever method
is followed, it should make a correct record of the time incurring the minimum possible expenditure and
should minimize the risk of fraudulent payments of wages.
i. Manual method: The manual methods of time-keeping are as follows:
a) Attendance Register Method: It is the oldest method of recording time. Under this method, an
attendance register is kept in the time office adjacent to the factory gate or in each department for
workers employed therein. The attendance register contains such columns as the name of the worker,
the worker’s number, and the department in which he is working, the rate of wages, the time of
arrival and departure, normal time and the overtime. The time of arrival and departure, may be noted
down by an employee known as time-keeper.
This method is simple and inexpensive and can be used in small firms where the number of workers
is not large. This method may lead to dishonest practice of recording wrong time because there is
possibility of collusion between some of the workers and the time keeper. However, for recording the
time of workers who work at customer’s premises and places which are situated at a distance from
the factory, this may be the only suitable method.
b) Metal disc method: Under this method, each worker is allotted a metal disc or a token with a hole
bearing his identification number. A board is kept at the gate with pegs on it and all tokens are hung
on the board. These boards can be maintained separately for each department so that the workers
could remove their tokens from the board without undue delay. As the workers enter the factory gate,
they remove their respective discs or tokens and place them in a box or tray kept near the board.

Immediately after the scheduled time for entering the factory, the box is removed and the late comers
will have to give their tokens to the time-keeper personally so that the exact time of their arrival
could be recorded. The discs or tokens still left on the board represent the absentee workers. Later the
time-keeper records the attendance in a register known as Daily Muster Roll which is subsequently
passed on to the Pay Roll Department.
This method is simple because illiterate workers can very easily recognize their tokens and put them
in the box. This method is better than attendance register method and is useful when the number of
employees is not large. But it has certain disadvantages of its own as given below:
i. There are chances that a worker may try to remove his companion’s token from the board in
order to get his presence marked when he is absent.
ii. There are chances of disputes regarding the exact time of arrival of a worker because the
time-keeper marking the attendance can commit mistakes deliberately or through
carelessness. There is no authentic proof of the presence or absence of the workers.
iii. There are chances of inclusion of dummy or ghost workers by the time-keeper in the
attendance register or Daily Muster Roll.
ii. Mechanical methods: The mechanical methods that are generally used for the recording of time of
workers may be as follows:
(a) Time Recording Clocks: The time recording clock is mechanical device which automatically
records the time of the workers. This method has been developed to obviate some of the
difficulties experienced in case of manual methods and this method is useful when the number of
workers is fairly large. Under this method, each worker is given a Time Card usually of one
week duration. Time cards are serially arranged in a tray, puts it in the time recording clock
which prints the exact time of arrival in the proper space against the particular day. This process
is repeated for recording time of departure for lunch, return from lunch and time of leaving the
factory in the evening. Late arrivals, early leavings and overtime are printed in red to attract the
attention of the management.
A time card may also give such particulars as hourly rate, total gross wages, less deduction and
net wages payable. If these particulars are included in the time card, it would be known as
combined time and payroll card divided into two parts, the upper part being the record of time
and the lower one serving as the wage ticket. Wages are calculated on the basis of the time
recorded in the upper portion and are entered in the lower portion by the payroll department.
The main advantage of this method is that there are no chances of disputes arising in connection
with recording of time of the workers because time is recorded by the time recording clock and
not by the time-keeper. There is no scope for partiality or carelessness of the time-keeper as it is
in case of manual methods. But this method suffers from the following defects:
i. There are chances that a worker may try to get his friend’s time card from the tray in
order to get him marked present in time when he is actually late or get his presence
marked when he is absent. This drawback can be removed if the time-keeper does not
show carelessness.
ii. Sometimes, the time recording clock goes out of order and the work of recording of
time is dislocated.

b) Dial Time Records: The dial time recorder is a machine which has a dial around the clock. This
dial has a number of holes (usually about 150) and each hole bears a number corresponding to the
identification number of the worker concerned. There is one radial arm at the centre of the dial. As
a worker enters the factory gate, he is to press the radial arm after placing it at the hole of his
number and his time will automatically be recorded on roll of a paper inside the dial time recorder
against the number. The sheet on which the time is recorded provides a running account of the
worker’s time. This machine allows greater accuracy and can itself transcribe the number of hours
to the wages sheets. This machine can also calculate the wages of the workers and thus avoids
much loss of time. However, the high installation cost of the dial time recorder and its use for only
a limited number of workers are the drawbacks of this method.
c) Attendance Control System :

With the advent of modern technology especially development of computers and software, there
are many ready to use business time keeping solutions that provide foolproof time booking
options. These are time keeping devices connected to computer that require either thump
impression, card swipe, card scan etc. Depending upon the technology selected by the factory,
the workers have to put their thump or card as the case may be, impression on the designated
device at the time of arrival, lunch break, day end etc , the computer connected to the device
would automatically register the time.
In organizations that also has an Enterprise Resource Planning (ERP) system, the time thus
recorded are directly linked with payroll where first level of analysis is carried out by the system
on real time basis without any human intervention. These devices can also calculate the wages
of the workers and thus avoids much loss of time. Considering the time saving that use of these
devices bring, the benefit realized far outweighs the cost of installation of such system.
Requisites of a Good Time-keeping System:

A good time-keeping system should have following requisites:
1. System of time-keeping should be that proxy for another should not be allowed under any
circumstances.
2. There should also be a provision of recording of time of piece workers so that regular attendance
and discipline may be maintained. This is necessary to maintain uniformity of flow of
production.
3. Time of arrival as well as time of departure of workers should be recorded so that total time of
workers may be recorded and wages may be calculated accordingly.
4. As far as possible, method of recording of time should be mechanical so that chances of disputes
regarding time may not arise between workers and the time-keeper.
5. Late-comers should record late arrivals. Any relaxation by the time-keeper in this regard will
encourage indiscipline.
6. The system should be simple, smooth and quick. Unnecessary queuing at the factory gate should
be avoided. Sufficient clocks should be installed keeping in view the number of workers so that
workers may not have to wait for a long period for recording their time of arrivals and
departures.
7. A responsible officer should pay frequent visits at the factory gate to see that proper method of
recording of time is being followed.

b) Time-Booking
The clock card is required, essentially, for the correct determination of the amount of wages due to a
worker on the basis of time he has put in the factory. It merely records day by day and period by period
the total time spent by each individual worker in the factory. But it does not show how that time was put
to use in the factory- how an individual worker utilized his time in completing jobs entrusted to him and
how long he was kept waiting for one reason or another due to lack of work, lack of material and
supplies, lack of instruction, machine breakdowns, power failures and the like. These are all vital pieces
of information necessary for the proper collection of cost data and for effective controlling of costs. For
the collection of all such information, a separate record, generally known as Time (or Job) card, is kept.
The time (or job) card may be of two types –

i) containing analysis of time with reference to each job, and
ii) containing analysis of time with reference to each worker.
In case of job card made out for a particular job, a separate job card is employed in respect of each job
undertaken; where a job involves several operations, a separate entry is made in respect of each operation.
Thus the job card would record the total time spent on a particular job or operation. If a number of people
are engaged on the same job or operation, the time of all those workers would be booked on the same
card. One obvious advantage of this method is that it provides complete data on the labor content of job
or operation collectively so that the computation of labor cost is greatly facilitated. But this method has
drawbacks as well. Since a worker’s job timing is scattered over a number of job cards the time spent on
all these jobs and idle time must be abstracted periodically for finding each worker’s total time spent on
different jobs and the time for which he remained idle during the period. The total of these two times (job
and idle) must obviously equal his total attendance time, as shown by his attendance records, clock card
or attendance register. Thus, it would be seen that if the job cards are made out according to job or
operation, a separate summary has to be prepared for reconciling each worker’s job and idle time with his
gate time. It would be quite obvious that such reconciliation is of great importance from the point of view
of labor costs.
If on the other hand, one job (or time) card were to be issued for each worker, it would greatly facilitate
reconciliation of the worker’s job time with his gate time. Under this system, a card would be issued to
each worker for each day or for each week and the time which he spends on different jobs (and also any
idle time) would be recorded in the same card so that the card would have a complete history on it as to
how his time had been spent during the period. Since all the details would be on one card the total time
accounted for in the job card would be readily tallied with the total time put in the Gate Card or
attendance register. Total job time on a job, in such situation, will be ascertained and aggregated
periodically from each job cards. It would thus be seen that according to either of the method a process of
abstraction and reconciliation is necessary. Specimens of two types of job cards are given below:

Reconciliation of gate and job cards – An advantage of the introduction of job card is that it enables a
reconciliation to be made of the time spent by the worker in each department with the time paid for as per
the attendance record. Reconciliation also helps in locating idle time for each worker. The two sets of
records serve separate purposes. Where payment to labor is on the time rate basis, the Gate Card is a
record of the hours of work that should be paid for. Since the Gate Card merely records the hours during
which the worker has been within the premises of the factory and it does not contain any details as to how
those hours have been put to use by the worker in his department, a job card must be prepared to provide
the necessary information. As we have already seen, the job card may be prepared either worker-wise or
job-wise.
Objectives of Time-Booking
Objectives of time-booking are as follows:
i. To ensure that time paid for, according to time keeping, has been properly utilized on different
jobs or work orders.

ii. To ascertain the cost of each job or work order.

iii. To provide a basis for the apportionment of overhead expenses over various jobs/work orders
when the method for the allocation of overhead depends upon time spent on different jobs.
3.3.2 Payroll procedure:

Preperation of Payroll sheet: The hours worked by each employee as reflected on the completed clock
cards are entered by an accounting department employee (or employees) on the payroll sheet or payroll
summary. All employees authorized for employment by the personnel department are first listed on the
payroll sheet. Hours and hourly rates are then transferred from the clock cards, and total earnings are
computed. Should a clock card for an employee not listed on the payroll sheet be found, investigation of
its propriety is required. Likewise, there should be an explanation for any missing clock cards.
After the gross earnings (that is total amount earned by an employee before any deductions are taken into
consideration) have been calculated for every employee, deductions are entered in the payroll sheet, and
net pay of each employee is determined. Under a computerized system, each employee’s payroll data
would be input into the computer and it would prepare the entire payroll sheet. Payroll deductions are of
two kinds, nontax and tax. Nontax deductions are made at the request of the employee or are required by
union contracts. Among the more common examples are union dues, insurance, contributions to
retirement funds, contributions to charities. Tax deductions are made in compliance with Income Tax Act.
Paying the wages: The payroll sheet, is the basis for the preparation of a payroll voucher, by the
accounting department, authorizing disbursements for the net amounts payable to employees. If the
number of employees is large, payments are usually made from a special payroll account. Using a
separate payroll account contributes to good internal control, since the audit trail of payroll activities is
easier to follow when a separate account for payroll disbursements is used by a company. In each pay
period an amount to cover the net payroll is transferred from the company’s general account to a special
payroll account. Checks payable to the individual employees are then drawn against the payroll account.
In a computerized system, the employees’ pay checks would be printed out by the computer based on the
information within the computer, prepared payroll sheet. In addition to providing a better means of
control, use of a separate account for payroll simplifies record keeping by reducing the number of checks
that will clear through the general account.
Precautions to ensure proper payment of the payroll should be taken. Payments should be made only to
the employees themselves after proper identification. As a control, payroll checks should not be given to
factory supervisors or department heads for distribution to the employees under their jurisdiction, since
they were probably involved in the process of accumulating the hours worked by their employees. Rather,
an individual (or individuals) having no record-keeping functions associated with the payroll (such as the
time-keeping function and the preparation of payroll function) should be assigned the job of distributing
paychecks. Unclaimed paychecks should be investigated to determine why they have not been picked up
by employees.
3.4 TREATMENT OF HOLIDAY AND LEAVE PAY, IDLE TIME, OVERTIME

3.4.1 Holiday and Leave pay
Wages paid on account of paid holidays and leave can be included as departmental overheads. In such a
case, it is necessary to record such wages separately from “worked for wages”. Such segregation can be

made possible by providing a separate column in the payroll for holiday and leave wages in the same way
as there are column for dearness allowance, provident fund deductions, etc. If, however, separate or
additional column cannot be provided for this purpose, it would be necessary to analyze the payroll
periodically to ascertain how much of the total payment pertains to “worked for wages” and how much is
attributed to leave and holiday wages.
Illustration: 1
From the following data calculate the labor hour rate of a worker X:
Basic pay Rs. 5,000 p.m.
Dearness Allowance Rs. 1,500 p.m.
Fringe benefits Rs. 300 p.m.
Number of working days in a year is 300. Twenty days are availed off as holiday on full pay in a year.
Assume a day of 8 hours.
Solution
(i) Effective working days in a year 300

Less: leave days on full pay 20
Effective working days 280 days
Total effective working hours (280 days x 8 hrs) 2,240
(ii) Total wages paid in a year Rs.

Basic pay 60,000
D.A. 18,000
Fringe benefits 3,600
81,600
(iii) Hourly rate: Rs. 81,600/2,240 Hours Rs.36.43 (approx)
Night shift allowance: In some cases, workers get extra payment if they work at night. Since the extra
payment is not for any particular job, such a payment should be treated as part of overheads.
3.4.2 Idle Time

It is a time during which no production is carried out because the worker remains idle even though they
are paid. Idle time can be normal idle time or abnormal idle time.
Normal idle time: It is inherent in any work situation and cannot be eliminated.
Abnormal idle time: Apart from normal idle time, there may be factors which give rise to abnormal idle
time.
Machines and men cannot be expected to work continuously. In the midst of operations, a machine may
have to be stopped for some adjustments being made. Each morning and on the resumption of work in the
post-lunch period, some time will be lost before a job can be started. There may also be some waiting
time in between the finishing of one job and the starting of another. Similarly, even if a plant operates
with a reasonable degree of efficiency, some allowance may be required for loss of time due to occasional

power failure, machines or tool break down, delay in delivery of material and stores or of tools etc. All
such reasonable time losses are normal idle time. Normal idle time of direct workers can be treated as a
part of the direct cost. This can be done by inflating the wage rates for costing purposes. Suppose 10
minutes per hour of work are treated as normal idle time. If a worker put in 3 hours on a job, his wages
for 3 ½ hours can be charged to the job. Alternatively, the cost of normal idle time may be treated as a
part of factory overheads.
Losses in excess of the normal idle time are not properly chargeable as overheads; abnormal losses on
accounts of idle time should be written off by being directly debited to the Costing Profit and Loss
Account. It is obvious that for establishing abnormal idle time, the normal time required for each product
or job will have to be determined.
Accurate Recording of the idle time in the departments is of great importance from the point of view of
cost finding and cost control. For controlling cost, careful analysis and recording of idle time under
significant heads is essential. In order to facilitate identification, the major causes which account for idle
time may be grouped under the following two heads:
1. Normal causes: Some idle time is inherent in every situation. The time lost between factory gate
and the place of work, the interval between one job and another, the setting up time for the machine,
normal fatigue etc. result in normal idle time.
2. Abnormal causes: Idle time may also arise due to abnormal factors like lack of coordination, power
failure, breakdown of machines, non-availability of raw materials, strikes, lockouts, poor
supervision, fire, flood etc. The causes for abnormal idle time should be further analyzed into
controllable and uncontrollable. Controllable abnormal idle time refers to that time which could
have been put to productive use had the management been more alert and efficient. All such time
which could have been avoided is controllable idle time. However, time lost due to abnormal
causes, over which management does not have any control e.g. breakdown of machines, flood etc.
may be characterized as uncontrollable idle time.
Treatment of idle time in cost accounting: Normal idle time is treated as a part of the cost of production.
Thus, in case of direct workers an allowance for normal idle time is built into the labor cost rates. In the
case of indirect workers, normal idle time is spread all over the products or jobs through the process of
absorption or factory overheads.
Abnormal idle time cost is not included as a part of production cost and is shown as a separate item in the
costing profit and loss account so that the normal costs are not disturbed. This also helps in drawing the
attention of the management towards the exact losses due to abnormal idle time Further, Abnormal idle
time should be further categorized into controllable and uncontrollable. For each category, the break-up
of cost due to various factors should be separately shown. This would help the management in fixing
responsibility for controlling idle time.
Management should aim at eliminating controllable time and on a long-term basis reducing even the
normal idle time. This would require a detailed analysis on the causes leading to such idle time.
Depending upon the particular causes, proper managerial action would be required to reduce the impact
of such idle time. Basic control can be exercised through periodical reports on idle time showing a
detailed analysis of the causes for the same, the departments where it is occurring and the persons
responsible for it, along with a statement of the cost of such idle time.

Illustration: 2
‘X’ an employee of ABC co. gets the following emoluments and benefits:
Basic pay Rs. 4000 p.m.
Dearness allowance Rs.1000 p.m.
Bonus Rs. 10% of salary and D.A.
Other allowances Rs. 500 p.m.
Employee’s contribution to P.F. 10% of salary and D.A.
‘X’ works for 2400 hours per annum, out of which 400 hours are non-productive and treated as normal
idle time. You are required to find out the effective hourly cost of employee ‘X’.
Solution:
i. Earning of employee ‘X’

Per month Per annum
Basic pay 4,000 48,000
Dearness allowance 1,000 12,000
Bonus 500 6,000
Employee’s contribution to Provident fund 500 6,000
Other allowance 500 6,000
6,500 78,000
ii. Effective working hours:

Annual working hours 2,400
Less: Normal idle time 400
Effective working hours 2,000
iii. Effective hourly cost of ‘X’: Rs. 78,000/2,000 39.00
3.4.3 Overtime
Work done beyond normal working hours is known as ‘overtime work.’ Overtime has to be paid in Nepal
at one and half times the rate of wages according to the Labor Act, 2048 (B.S.). This act lays down that a
worker is entitled to overtime when he works for more than 8 hours on any day or more than 48 hours in a
week.
Occasional overtime is a healthy sign since it indicates that the firm has the optimum capacity and that the
capacity is being fully utilized. But persistent overtime is rather a bad sign because it may indicate either:
(a) that the firm needs larger capacity of men and machine or (b) that men have got into the habit of
postponing their ordinary work towards the evening so that they can earn extra money in the form of
overtime wages.

Overtime work may arise in a department in one of the following circumstances:

i. The customer may agree to bear entire charge of overtime because of urgency of work.
ii. Overtime may be called for to make up any shortfall in production due to some unexpected
development.
iii. Overtime work may be necessary to make up a shortfall in production due to some fault of
management.
iv. Overtime may be resorted to secure the production in excess of the normal output to take
advantage of an expanding market or of rising demand.
Overtime Premium: Overtime payment is the amount of wages paid for working beyond normal working
hours. The rate for overtime work is higher than the normal time rate; usually it is at one and half times or
double the normal rates. The extra amount so paid over the normal rate is called overtime premium.
Effect of overtime payment on productivity: Overtime work should be resorted to only when it is
extremely essential because it involves extra cost. The overtime payment increases the cost of production
in the following ways:
i. It is an extra payment in addition to the normal rate.

ii. The efficiency of operators during overtime work may fall and thus output may be less than
normal output.
iii. In order to earn more the workers may not concentrate on work during normal time and thus the
output during normal hours may also fall.
iv. Reduced output and increased premium of overtime will bring about an increase in costs of
production.
Treatment of overtime premium in Cost Accounting:
i. If overtime is resorted to at the desire of the customer, then overtime premium may be charged to
the job directly.
ii. If overtime is required to cope with general production programs or for meeting urgent orders, the
overtime premium should be treated as overhead cost of the particular department or cost center
which works overtime.
iii. If overtime is worked in a department due to the fault of another department, the overtime
premium should be charged to the latter department.
iv. Overtime worked on account of abnormal conditions such as flood, earthquake etc., should not be
charged to cost, but to Costing Profit and Loss Account.
Steps for controlling overtime: To keep overtime to its minimum, it is necessary to exercise proper
control over the overtime work. The suitable procedure which may be adopted for controlling overtime
comprises the following steps:
i. Ensure that the output during normal hours is maintained to ensure that overtime is not granted
when normal output is not obtained during normal hours without any special reason.
ii. Statement concerning overtime work is prepared along with justifications for putting up before the
competent authority.
iii. Prior sanction about overtime should be obtained from competent authority.
iv. Actual rate of output produced during the overtime period should be compared with normal rate of
output.

v. Periodical reports on overtime wages should be sent to top management for taking corrective
action.
vi. If possible an upper limit may be fixed for each category of workers in respect of overtime.
Illustration: 3
It is seen from the job card for repair of the customer’s equipment that a total of 154 labor hours have
been put in as detailed below:
Worker ‘A’ paid at Rs. Worker ‘B’ paid at Rs. Worker ‘C’ paid at Rs.
200 per day of 8 hours 100 per day of 8 hours 300 per day of 8 hours
Sunday 10½ hours 8 hours 10½ hours
Monday 8 hours 8 hours 8 hours
Tuesday 10½ hours 8 hours 10½ hours
Wednesday 9½ hours 8 hours 9½ hours
Thursday 10½ hours 8 hours 10½ hours
Friday - 8 hours 8 hours
Total 49 hours 48 hours 57 hours
The workers are to be paid dearness allowance on the basis of living index figures relating to each month
which works out @ Rs.960 for the relevant month for the unit. The dearness allowance is payable to all
workers at a fixed rate, irrespective of their wage rate, if they are present or are on leave with wages on all
working days.
Saturday is a weekly holiday and each worker has to work for 8 hours on all weekdays and 4 hours on
Fridays; the workers are however paid full wages for Friday (8 hours for 4 hours worked).
Workers are paid overtime according to the Labor Act for hours worked in excess of normal working
hours on each day excluding holidays (including 4 hours work to be put on Friday).
The total numbers of hours work out to 192 in the relevant month. The company’s contribution to
provident fund is absorbed into overheads.
Work out the wages payable to each worker assuming overtime incentives are being paid double the
normal rate.
Solution
i. Worker A will get wages for 54 hours as mentioned below:
Actual hours worked = 49

Total Normal Weekly Hours = 44 (8 hours for 5 days and 4 hours for Friday)
Overtime Worked =5
Equivalent Normal Hours = 10 [Since overtime incentives are paid double the normal rate]
Total hours to be paid = 44+10 = 54 Hours
ii. Worker B will get wages for 52 hours i.e. actually worked plus 4 hours extra on Friday.

iii. Worker C will get wages for 70 hours as mentioned below.

Actual hours worked = 57
Total Normal Weekly Hours =44 (8 hours for 5 days and 4 hours for Friday)
Overtime Worked = 13
Equivalent Normal Hours =26 [Since overtime incentives are paid double the normal rate]
Total hours to be paid = 44+26 = 70 Hours
Wages payable
A B C
Basic wages per hour (Rs.) Rs 200/8 =25 Rs 100/8= 12.5 Rs 300/8= 37.5
Dearness allowance per hour (Rs.) Rs 960/192= 5 Rs 960/192= 5 Rs 960/192= 5
Hourly rate (Rs.) 30 17.5 42.5
Normal hours 44 44 44
Overtime hours 5 4 13
Normal wages (Rs.) 1,320 770 1,870
Overtime wages (Rs.) 300 140 1,105
Total Wages payable (Rs.) 1,620.00 910.00 2,975.00
Illustration: 4
In a factory the basic wage rate is Rs. 10 per hour and overtime rates are as follows:
Before and after normal working hours: 175% of basic wage rate
Saturdays and holidays: 225% of basic wage rate
During the previous year, the following hours were worked:
Normal time: 100,000 hours

Overtime before and after working hours 20,000 hours
Overtime on Saturdays and holidays 5,000 hours
Total 125,000 hours
The following hours have been worked on job ‘Z’:

Normal 1,000 hours
Overtime before and after working hours 100 hours
Overtime on Saturdays and holidays 25 hours
Total 1,125 hours
You are required to calculate the labor cost chargeable to jobs ‘Z’ and overhead in each of the following
instances.
1. Where overtime is worked regularly throughout the year as a policy due to the labor shortage.
2. Where overtime is worked irregularly to meet the requirement of production.
3. Where overtime is worked at the request of the customer to expedite the job.
Solution:
Computation of Average Inflated Wage Rate (including overtime premium)
Basic wage rate Rs. 10 per hour
Overtime wages rate before and after working Rs. 10 x 175% =Rs.17.50 per hour
hours

Overtime wages rate for Saturdays and holidays Rs. 10 x 225% =Rs.22.50 per hour
Annual wages for the previous year for normal time 100,000 hours x Rs. 10 Rs. 1,000,000
Wages for overtime before and after working hours 20,000 hours x Rs. 17.50 Rs. 350,000
Wages for overtime on Sundays and holidays 5,000 hours x Rs. 22.50 Rs. 112,500
Total wages for 125,000 hours Rs. 1,462,500
Average inflated wage rate Rs. 1,462,500/125,000 Rs. 11.70 hours
hours
i. Where overtime is worked regularly as a policy due to labor shortage, the overtime premium is
treated as a part of labor cost and job is charged at an inflated wage rate. Hence, Labor cost
chargeable to job Z = total hours x inflated wage rate
= 1,125 hours x Rs. 11.70 = Rs. 13,162.50
ii. Where overtime is worked irregularly to meet the requirements of production, basic wage is
charged to the job and overtime premium is charged to factory overheads as under:
Labor cost chargeable to Job Z: 1,125 hours @ Rs. 10 per hour=Rs. 11,250.00
Factory overhead: [100 hours x (Rs.17.50 – 10)] =Rs. 750.00
[25 hours x (Rs.22.50 – 10) =Rs. 312.50
Total factory overhead = Rs. 1,062.50
iii. Where overtime is worked at the request of the customer, overtime premium is also charged to
the job as under:
Job Z: 1,125 hours @ Rs. 10 per hour =Rs. 11,250.00
Overtime premium [100 hours x (Rs.17.50 – 10)] =Rs. 750.00
[25 hours x (Rs.22.50 – 10) =Rs. 312.50
Total =Rs. 12,312.50
3.5 LABOR TURNOVER

Labor turnover in an organization is the rate of change in the composition of labor force during a
specified period measured against a suitable index. Simple ways to describe it are "how long employees
tend to stay" or "the rate of traffic through the revolving door." Turnover is measured for individual
companies and for their industry as a whole. If an employer is said to have a high turnover relative to its
competitors, it means that employees of that company have a shorter average tenure than those of other
companies in the same industry. High turnover can be harmful to a company's if skilled productivity
workers are often leaving and the worker population contains a high percentage of novice workers.
The standard of usual labor turnover in the industry or locality or the labor turnover rate for a past period
may be taken as the index or norm against which actual turnover rate is compared. There are three
methods of calculating labor turnover which are given below:
Number of Employees replaced

i. Replacement Method = X 100
Average Number of Employees on Roll
Number of Employees Separated During This Year

ii. Separation Method = X 100
Average Number of Employees On Rolls During This Year
iii. Flux Method = Number of Employees separated + Number of employees Replaced X 100

Average Number of Employees on Rolls During the Period
Labor turnover due to new recruitment:

Workers joining a business concern on account of its expansion do not account for labor turnover. But
these newly recruited workers are certainly responsible for a change in the composition of labor force,
due to this feature, some cost accountants measure workers to the extent of new (excluding replacement),
joining the labor force as follows:
No. Of New workers joining in a period ( Excluding Replacement)

X 100
Average Number of Workers on the Roll in a period
The total numbers of workers joining, including replacements, are called accessions. The labor turnover
rate, in such a case, may also be computed in respect of total number of workers joining (accessions) the
business concern, during a given period both on account of replacements and because of expansion. It can
be determined as follows:
.

x 100

When numbers of accessions are considered for measuring labor turnover rate by flux method, it can be
computed by using any one of the following expressions:
Labor Turnover Rate ( Flux No. of Separations + No. of Replacements + No. of New Recuitments
X 100
Methos) =
Average Number of Worker
OR
.
.

X 100

The above rate of labor turnover indicates the percent of total number of workers separated, number of
workers required and number of new workers recruited and joined the concern on account of its
expansion, etc as compared to average number of workers.
If in the above computations, the data given is for a period other than a year, the labor turnover rate so
computed may be converted into equivalent annual labor turnover rate by the following formula:

Equivalent annual labor turnover rate = X 100

Causes of labor turnover:

The main causes of labor turnover in an organization/industry can be broadly classified under the
following three heads:
i. Personal causes

These causes are those which induce or compel workers to leave their jobs; such causes include the
following:
ii. Change of jobs for betterment
iii. Premature retirement due to ill health or old age.
iv. Domestic problems and family responsibilities.
v. Discontent over the jobs and working environment.
In all above cases the employee leaves the organization at his will and therefore, it is difficult to suggest
any possible remedy in the first three cases. But the last one can be overcome by creating conditions
leading to a healthy environment. For this, officers should play a positive role and make sure that their
sub-ordinates work under healthy working conditions.
ii. Unavoidable causes
Those causes are those under which it becomes obligatory on the part of management to ask one or more
of their employees to leave the organization; such causes are summed up as listed below:
i. Seasonal nature of the business;
ii. Shortage of raw material, power, slack market of the product etc;
iii. Change in the plant location;
iv. Disability, making a worker unfit for work;
v. Disciplinary measures;
vi. Marriage (generally in the case of women).
iii. Avoidable causes

Those causes are those which require the attention of management on a continuous basis so as to keep the
labor turnover ratio as low as possible. The main causes under this case are indicative below:
i. Dissatisfaction with job, remuneration, hours of work, working conditions, etc.
ii. Strained relationship with management, supervisors or fellow workers;
iii. Lack of training facilities and promotional avenues;
iv. Lack of recreational and medical facilities;
v. Low wages and allowances.
Proper and timely management action can reduce the labor turnover appreciably so far as avoidable
causes are concerned.
Effects of labor turnover
High labor turnover increases the cost of production in the following ways:
i. Even flow of production is disturbed;
ii. Efficiency of new workers is low; productivity of new but experienced worker is
low in the beginning;
iii. There is increased cost of training and induction;
iv. New worker cause increased breakage of tools, wastage of materials, etc.
In some companies, the labor turnover rates are as high as 100%; it means that on the average, all the
work is being done by new and inexperienced workers. This is bound to reduce efficiency and production
and increases the cost of production.
Two types of costs which are associated with labor turnover are:

(a) Preventive costs: These include costs incurred to keep the labor turnover at a low level, i.e. cost
of medical services, welfare schemes and pension schemes. If a company incurs high preventive
costs, the rate of labor turnover is usually low.
(b) Replacement costs: These are the costs which arise due to high labor turnover. If men leave soon
after they acquire the necessary training and experience of good work, additional costs will have
to be incurred on new workers, i.e. cost of employment, training and induction, abnormal
breakage and scrap and extra wages and overheads due to the inefficiency of new workers.
It is obvious that a company will incur very high replacement costs if the rate of labor turnover is high.
Similarly, only adequate preventive costs can keep labor turnover at low level. Each company must,
therefore, workout the optimum level of labor turnover keeping in view its personnel policies and
behavior of replacement cost and preventive costs at various levels of labor turnover rates.
Remedial steps to minimize labor turnover –
The following steps are useful for minimizing labor turnover.
1. Exit interview: An interview be arranged with each outgoing employee to ascertain the reasons of his
leaving the organization.
2. Job analysis and evaluation: Before recruiting workers, job analysis and evaluation may be carried
out to ascertain the requirement of each job.
3. Scientific system of recruitment, placement and promotion: The organization should make use of
scientific system of recruitment, selection, placement and promotion for employees.
4. Enlightened attitude of management: the management should introduce the following steps for
creating a healthy working atmosphere:
a. Service rules should be framed, discussed and approved among management and
workers before their implementation.
b. Provide facilities for education and training of workers.
c. Introduce a procedure for settling worker’s grievances.
5. Use of committee: Issue like control over workers, handling their grievances etc., may be dealt by a
committee, comprising of members from management and workers.
Illustration: 5
The management of AB Limited is worried about its increasing labor turnover in the factory and before
analyzing the causes and taking remedial steps, they want to have an idea of the profit foregone as a result
of labor turnover in the last year.
Last year sales amounted to Rs. 8,303,300 and P/V ratio was 20 %. The total number of actual hours
worked by the Direct Labor force was 445,000. As a result of the delays by the personnel department in
filling vacancies due to labor turnover, 100,000 potentially productive hours were lost. The actual direct
labor hours included 30,000 hours attributable to training new recruits, out of which half of the hours
were unproductive.
The costs incurred consequent on labor turnover revealed, on analysis, the following:
Rs.

Settlement cost due to leaving 43,820

Recruitment costs 26,740
Selection costs 12,750
Training costs 30,490
Assuming that the potential production lost as a consequence of labor turnover could have been sold at
prevailing prices. Find the profit foregone last year on account of labor turnover.
Solution
Determination of contribution foregone
Actual hours worked (given) 445,000
Less: unproductive training hours 15,000
Actual productive hours 430,000
The potentially productive hours lost are 100,000
., ,
Sales lost for 100,000 hours =
! , .
x 100,000 = Rs. 1,931,000
.",#",
Contribution lost for 100,000 hours = x 20 = Rs. 386,200 …………(i)
"
Statement showing profit foregone last year on account of labor turnover of AB Limited
Rs.
Contribution foregone as per (i) above 386,200
Settlement cost due to leaving 43,820
Recruitment costs 26,740
Selection costs 12,750
Training costs 30,490
Profit foregone 500,000
Illustration: 6
The Cost Accountant of Y Limited has computed labor turnover rates for the quarter ended 31st March
2013 as 10%, 5% and 3% under ‘Flux method’, ‘replacement Method’ and ‘Separation Method’
respectively. If the number of workers replaced during that quarter is 30, find out the number of workers
(i) recruited and joined and (ii) workers left and discharged.
Solution:
Working notes:
Average number of workers on roll:

$%&'() *+ (&,-*.((/ )(,-01(2
Labor turnover rate under replacement method =
34()05( 6%&'() *+ (&,-*.((/ *6 )*--
x 100
7
Or =
" 34()05( 6%&'() *+ (&,-*.((/ *6 )*--
8 "
Or Average numbers of workers on roll = 7
= 600
(i) Number of workers (employees) recruited and joined:
(Flux Method)
.
.

Labor turnover rate =

x 100
" ".

Or,
"
= 9
9,
Or, No. of accessions = - 18
"
= 42
Therefore, under Flux method number of workers recruited and joined is 42.
(ii) Number of workers left and discharged:

.

Labor turnover rate = x 100

.

Or,
"
= 9
Or, Number of separations = 18.
Hence number of workers left and discharged comes to 18.
3.6 INCENTIVE SYSTEM
Important factors necessary for introducing an incentive system: An incentive can be defined as the
stimulation for effort and effectiveness by offering monetary inducement or enhanced facilities. It may be
monetary in the form of a bonus or non-monetary tending to improve living and working conditions. It
may be provided individually or collectively. In the first case, the employee gets a reward for his efforts
directly and in the second, a group of employees share the reward arising out of their combined effort in
equitable production.
The main factors that should be taken into account before introducing a scheme of incentives are stated
below:
i. The need for producing goods of high quality or those requiring very good workman ship or finish
and the manner this can be ensured needs to be taken into account before introducing a scheme of
incentive. An incentive scheme should be introduced only if a system of quality control is required
to ensure/maintain high quality of goods; else, workers may be paid on time basis.
ii. The need to maximize production also requires incentives to be given to workers. But sometimes
workmanship is more important than quantity of output; in such cases, incentive schemes of wage
payment are not suitable.

iii. Where the quantity of work done cannot be measured precisely, incentive schemes cannot be
offered.
iv. The role of management and workers in achieving greater efficiency should also be taken in
account before determining on the incentive scheme. For example, when the work is repetitive,
workers should be offered good incentives to achieve high efficiency; but in case management is
constantlyrequired to plan the work, as in the case of job work, the management should share the
fruits of extra efficiency achieved.
v. Whether the quantity of output is within the control of the worker and if so, to what extent.
Sometimes, as in the case of chain assembly work the output is not dependent on the effort put in
by workers; incentive schemes in such cases are not suitable.
vi. The exactitude with which standards of performance can be laid down. Fixation of standard is
necessary for the introduction of a scheme of incentives. When this requires heavy expenditure,
incentive schemes will be costly.
vii. The effect of an incentive scheme for one set of workers on other workers. If for instance, an
incentive scheme makes it possible for unskilled workers to earn high wages, the wage rates for
skilled workers must also be raised (if they are paid on time basis) to avoid dissatisfaction among
them. In that event, the incentive scheme may raise labor cost instead of lowering it.
viii. The system of wage payment prevailing in other areas and industries or similar occupations. If
possible, there should be uniformity.
ix. The attitude of labor and trade unions towards incentive schemes. Workers usually like to have a
certain guaranteed time-basis wage but also like to earn extra through an incentive scheme.
On the whole, the system of wage payment should be such as would increase production without lowering
quality. This will increase surplus and will enable the employer to pay higher wages which, in turn, will
lead to higher output.
Main principles for a sound system of wage incentive: The objective of wage incentives is to improve
productivity and increase production so as to bring down the unit cost of production. In order to make the
incentive scheme effective and useful, the following general principles have to be considered while
designing a sound system of wage incentives.
i. The reward for a job should be linked with the effort involved in that job and the scheme should be
just and fair to both employees and employers. This involves the following:
(a) The standard required of the workers should be carefully set, if possible through proper time
and motion studies.
(b) If the work is of repetitive type, the entire benefit of the time saved should be available to
the worker but, in the case of non-standardized work or where precise standards cannot be
set, the benefit of the time saved, if any, should be shared by the employer, the supervisor
and the worker.
ii. The scheme should be clearly defined and be capable of being understood by the employees easily.
The standards set should be such that they can be achieved even by average employees. While
standards are being set, the workers concerned should be consulted.
(a) As far as possible, no limit should be placed on the amount of additional earnings; otherwise
it will dampen the initiative of the workers. In this regard, what is important is not what
actually prevails but what the workers think – if they think, even wrongly, that the employer
will stop wages from rising beyond a certain limit, the incentive scheme may not be really
effective.
(b) The scheme should be reasonable and stable, and should not be changed or modified too
often without consulting the employees.

(c) The scheme should take care that the employees are not penalized for reasons beyond their
control.
(d) The scheme should provide for inspection of output so that only good pieces qualify for
incentives. It would even be better not to introduce any incentive scheme if workmanship is
of vital importance in sales.
(e) The management should ensure that there is no cause for complaint by the workers that they
are sitting idle, say for want of tools or materials. Management has to see that there is, as far
as practicable, no interruption of production.
(f) The operation of the scheme should not entail heavy clerical costs. In fact the scheme should
facilitate the introduction of budgetary control and standard costing.
(g) It should be capable of improving the morale of the employees and it should be in
conformity with the local trade union agreements and other government regulations.
(h) There should be a guaranteed wage on time basis which generally works as a good
psychological boost to incentive scheme.
(i) Last, but not least, the effect of incentive scheme on those who cannot be covered should be
gauged and taken note of. Sometimes, highly skilled workers have perforce to be paid on
time basis whereas semiskilled or unskilled workers may be put on incentive scheme. If the
latter earn more than former, the incentive schemes on the whole prove harmful.
Essential characteristics of a good incentive system:
i. It should be acceptable, both to the employer and to the employee. It should be positive and
not unnecessarily punitive and so operated as to promote confidence.
ii. It should be strong both ways i.e. it should have a standard task and a generous return. The
latter should be in direct proportion to employee’s efforts.
iii. It should be unrestricted as to the amount of earning.
iv. It should be reasonable, apart from being simple, for employee to figure out his incentive in
relation to his individual performance, as far as practicable.
v. It should be flexible and intimately related to other management controls.
vi. It should automatically assist supervision and, when necessary, aid team work.
vii. It should have employee’s support and in no way should it be paternalistic.
viii. It should have managerial support in so far as production material, quality control,
maintenance and non-financial incentives are concerned.
ix. It should not be used temporarily and dropped in recession times as means of wage
reduction.
Procedure for laying down an incentive system: An incentive is a reward for efforts made, hence
correct measurement of the effort involved is a prerequisite for any incentive system. Measurement of
effort is made by time and motion study by specialists appointed for the purpose. The levels of efficiency
that must be attained to qualify for incentives are then fixed on a consideration of the factors mentioned
above. Having drawn up the broad outlines of the scheme, the next step is to educate the workers as
regards the benefits of the proposed scheme. This is done through joint consultation with the leading
employees or with union representatives. The scheme is then publicized extensively with the specimen,
calculations of the rewards that would arise under it. After the basic scheme has been accepted by all, a
decision on two vital points will have to be made. An incentive system tends to increase the rate of
production and consequently increases spoilage. But the very purpose of the scheme would be defeated if
spoilage increases beyond a certain limit. It is, therefore, necessary that the method of treating the spoiled
work should be agreed upon in advance. The prevention of spoiled work can be encouraged either by

making the worker do the job again in his own time or by paying the worker at the time rate for the period
covered by spoiled work not giving him credit at all for the spoiled work; of these, the first method is
more commonly employed since it is both equitable and deterrent.
The incentive should be paid promptly at short intervals of time. This would give the worker immediate
satisfaction of having earned something by the extra effort he had put in. If payment is delayed the effect
of the incentive would be greatly diminished.
Labor Utilization
For identifying utilization of labor a statement is prepared (generally weekly) for each department/cost
centre. This statement should show the actual time paid for, the standard time (including normal idle
time) allowed for production and the abnormal idle time analyzed with causes thereof.
Distinction between Direct and Indirect Labor Cost : Any labor cost that is specifically incurred for
or can be readily charged to or identified with a specific job, contract, work order or any other unit of
cost, is termed as direct labor cost. It includes: (i) all labor that is engaged in converting raw materials
into manufactured articles in the case of manufacturing industries, and (ii) other forms of labor, which
although not immediately engaged in converting raw unit of production and hence, can be readily
identified with the unit of production (Example: A helper attending solely as a machine operator in the
case of manufacturing industries: the entire contingent of labor and staff employed in a construction job
or project). Any labor that does not meet the above test is indirect, e.g. men generally employed in
machine shop such as tool setters, fitters, workers in tool room, stores etc. Their wages are charged as
indirect expenses.
Thus, direct labor is for a specific job or product while indirect labor is for work in general, in a printing
press, for example, wages paid to compositors will be direct while wages paid to the cleaners of machines
will be indirect.
The distinction between direct and indirect labor also depends upon the method manufacture in each firm
or industry. Labor which is direct in one unit may, sometimes, be indirect in another where the work or
process or method of manufacture is different in nature. The importance of the distinction lies in the fact
that whereas direct labor can be identified with and charged to the job, indirect labor cannot be so charged
and has therefore to be treated as part of the factory overheads to be included in the cost of production on
some suitable basis of apportionment and absorption.
Identification of utilization of labor with cost centers: For identification of utilization of labor with the
cost centre a wage analysis sheet is prepared. Wage analysis sheet is a columnar statement in which total
wages paid, are analyzed according to cost centre, jobs, work orders etc. The data for analysis is provided
by wage sheet, time card, piece work cards and job cards.
The preparation of such sheet serves the following purposes:
i. It analyses the labor time into direct and indirect labor by cost centers, jobs, and work
orders.
ii. It provides details of direct labor cost such as wages, overtime to be charged as
production cost of cost centre, jobs or work orders.
iii. It provides information for treatment of indirect labor cost as overhead expenses.

Identification of labor hours with work order or batches or capital job: For identification of labor
hours with work order or batches or capital jobs or overhead work orders, the following points are to be
noted:
i. The direct labor hours can be identified with the particular work order or batches or capital
job or overhead work orders on the basis of details recorded on source document such as
time sheet or job cards.
ii. The indirect labor hours cannot be directly identified with the particular work order or
batches or capital jobs or overhead work orders. Therefore, they are traced to cost centre and
then assigned to work order or batches or capital jobs or overhead work orders by using
overhead absorption rate.
3.7 METHOD OF WAGE PAYMENT
There exist several systems of employee wage payment and incentives, which can be classified under the
following heads:
a. Time rate system:

It is perhaps the oldest system of remunerating labor. It is also known by other names such as time work,
day work, day wages and day rates. Under this system, the worker is paid by the hour, day, week, or
month. The amount of wages due to a worker is arrived at by multiplying the time worked (as shown by
the gate card) by the appropriate time rate. The time rate here is fixed after taking into account the rates
relevant in the particular industrial locality for similar trade and skill. The rate may be either fixed or may
be a progressive one, starting from a minimum and rising up to a maximum, in stages, through periodical
increments.
Merits:
(i) Simple to understand and to calculate wages.
ii) Reduces temptation on the part of workers to increase the output at the cost of quality.
Demerits:
i. No monetary incentive to raise the level of production.
ii. No distinction between the slow and the efficient worker.
iii. The tendency is for the fall in output which would raise the cost per unit (because both labor and
fixed expenses will be spread over a smaller number of units)
iv. A firm cannot be sure of labor costs per unit under this method and, hence, may suffer a loss on
quotations if already submitted.
In the following cases, time rates are to be preferred;

i. Persons whose services cannot be directly or tangibly measured, e.g., general helpers, supervisory
and clerical staff etc.
ii. Workers engaged on highly skilled jobs or rendering skilled services, e.g., tool making, inspection
and testing.
iii. Where the pace of output is independent of the operator, e.g., automatic chemical plants.

b. High wage plan:

This plan was first introduced by Ford Motor Company (in USA) in order to induce workers to exercise
extra effort in their work. Under this plan, a worker is paid a wage rate which is substantially higher than
the rate prevailing in the area or in the industry. In return, he is expected to maintain a very high level of
performance, both quantitative and qualitative. As a result, high rate men are not as costly or expensive as
they might appear at first sight.
High wage plan is suitable where high quality of work and also increased productivity are required. The
advantages which may accrue from the implementation of this plan are:
i. It is simple and inexpensive to operate.
ii. It helps in attracting highly skilled and efficient workers by providing suitable incentive.
iii. It reduces the extent of supervision.
iv. Increased productivity may result in reduction of unit labor cost.
c. Measured day work:

According to this method the hourly rate of the time worker consists of two parts viz, fixed and variable.
The fixed element is based on the nature of the job i.e. the rate for this part is fixed on the basis of job
requirements. The variable portion varies for each worker depending upon his merit rating and the cost of
living index. The aggregate of fixed and variable part for a day is termed as measured day’s work rate of a
worker.
As the rate is based on two different elements, there are separate time rates not only for each worker but
also for each job. This method does not find much favor with workers due to the following:
i. The rates fixed are not easily understood by the workers.
ii. Merit rating tends to be arbitrary and unless changed at rapid intervals, the ratings will not
reflect the correct ranking of the qualities of a worker.
d. Differential time rate:

According to this method, different hourly rates are fixed for different levels of efficiency. Up to a certain
level of efficiency the normal time or day rate is paid. Based on efficiency level, the hourly rate increases
gradually. The following table shows different differential rates:
Up to, say 75% efficiency Normal (say Rs. N per hour)

From 76% to 80% efficiency 1.10 x N
From 101% to120% efficiency 1.40 x N
As this method is linked with the output and efficiency of workers, therefore, it cannot be strictly called
as a time rate method of wage payment. This method in fact is similar to differential piece work system.
e. Payment by result:
Under this system the payment made has a direct relationship with the output given by a worker. The
attendance of the worker or the time taken by him for doing a job has no bearing on the payment. The
system of payment by results may be classified into the following four categories:
i. Systems in which the payment of wages is directly proportionate to the output given by
workers.

ii. Systems in which the proportion of the wage payment to the worker increases progressively
with increase in production.
iii. Systems in which payment rate decreases with the increase in output.
iv. Systems with earnings varying in proportions which differ at different levels of production.
f. Straight piece work system:

Under this system of wage payment, each operation, job or unit of production is termed a piece. A rate
of payment, known as the piece rate or piece work rate is fixed for each piece. The wages of the worker
depend upon his output and rate of each unit of output; it is in fact independent of the time taken by him.
The wages paid to a worker are calculated as:
Wages = Number of units produced X Piece rate per unit

Considerable care and judgment are called for fixing the piece rate. If the rate fixed is too high or too low,
it would operate to the disadvantage of either the employer or the employee. Any attempt on the part of
the management to revise a piece rate, erroneously set too high, is likely to lead to friction and conflict
with labor. If on the other hand, it is too low, it would fail in its objective. The only way all this may be
avoided is by employing scientific methods of job evaluation and time and motion study for the purpose
of setting the rates.
Advantages:
i. The system is simple to operate and also easy to understand.
ii. The incentive provided is quite effective as the workers get the full benefit of any increase
in production and the employer also gains by saving on overhead costs.
iii. Labor cost per unit being constant, these can be calculated in advance and quotations can be
confidently submitted.
Disadvantages:
i. The quality of output usually suffers.
ii. Maintenance of detailed statistics as regards production of individual workers is necessary.
iii. Maintenance of satisfactory discipline in the matter of arrival and departure of workers
becomes somewhat difficult.
iv. In the anxiety to produce as large a quantity as possible, workers may damage the machines
and may also increase wastage of materials.
v. Skilled workers and supervisors (who are often paid on time basis) may resent higher wages
to unskilled workers paid on the piece basis.
g. Differential piece work system:

This system provide for higher rewards to more efficient workers. The main feature of all differential
piece-work systems is that several piece rates on a slab scale are fixed for a job or operation which is put
on piece-work. For different levels of output below and above the standard, different piece rates are
applicable. Taylor Differential Piece work System and Merrick Differential Piece Rate System are two
important differential piece work systems discussed briefly as below:
i. Taylor’s differential piece work system –

The Taylor’s Differential Piece Rate System aims at rewarding efficient workers by providing increased
piece rate beyond certain level of output. Under this system two widely differing piece-rates are
prescribed for each job. The lower rate is 83% of the normal rate and the higher rate is 125% of the

normal piece rate. In other words the higher rate is 150% of the lower rate. The lower rate is given to a
worker when his efficiency level is less than 100%. The higher rate is offered at efficiency level of either
100% or more. Due to the existence of the two piece rates, the system is known as differential piece rate
system.
Note: Some authors also use 80% and 120% of the piece rates as lower and higher rates respectively at
the efficiency levels, as indicated in the above paragraph.
Advantage:
i. It is simple to understand and operate.
ii. The incentive is very good and attractive for efficient workers.
iii. It has a beneficial effect where overheads are high as increased production has the effect of
reducing their incidence per unit of production.
This system is quite harsh to workers, as a slight reduction in output may result in a large reduction in the
wages earned by them. This system is no longer in use in its original form, though the main idea behind it
is used in many wage schemes.
llustration:Using Taylor’s differential piece rate system, find the earnings of the Ram, Shyam and Hari
from the following particulars:
Standard time per piece : 20 minutes

Normal rate per hour : Rs. 9.00
In a 8 hour day: - Ram produced : 23 units
Shyam produced : 24 units
Hari produced : 30 units
Solution:
Earnings under Taylor’s differential piece rate system
Workers Ram Shyam Hari
Standard output per day (units) 24 24 24
Actual output per day 23 24 30
Efficiency (%) 95.83% 100% 125%
[23/24 x100 ] [24/24x100 ] [30/24x100 ]
*Earning rate per unit 83% of the piece 125% of the piece 125% of the piece
rate rate rate
Earning rate per unit (Rs.) 2.49 3.75 3.75
(Refer to working note) (83% of Rs. 3) (125% of Rs. 3) (125% of Rs. 3)
Earnings (Rs.) 57.27 90 112.50
(23 units x Rs. (24 units x Rs. (30 units x Rs.
2.49) 3.75) 3.75)
*Under Taylor’s Differential piece rate system, two widely differing price rates are prescribed for each
job. The lower rate is 83% of the normal piece rate and is applicable if efficiency of the worker is below
100%. The higher piece rate is 125% of the normal piece rate and is applicable if work completed is at
efficiency level of 100% and above.

Working Note:
Standard Output per day (units) = (8 hours X 60 min) / 20 minutes
= 24 units
Standard Output Per hour (units) = 60minites / 20 minutes

= 3 minute
Normal rate per hour = Rs. 9.00

:/.#. :/.#.
Normal rate per unit = = = Rs. 3
;<0620)2 ,)*2%1<=*6 ,() >*%) %6=</
ii. Merrick differential piece rate system:

Under this system three rates for a job are fixed. None of the fixed rates is below the normal. These three
piece rates are as below:
Efficiency Piece rate applicable
Up to 83% Normal rate
Above 83% and up to 100% 10% above normal rate
Above 100% 20% or 30% above normal rate.
This system is an improvement over Taylor’s Differential Piece Rate System.
Illustration: 8
Refer to the statement of previous illustration and compute the earnings of workers under Merrick
Differential Piece Rate System.
Solution:
Workers Ram Shyam Hari
Earning rate per unit 10% above the 10% above the 20% or 30% above
(Refer to previous illustration) normal rate normal rate the normal rate
Earning rate per unit (Rs.) 3.30 3.30 3.60 or 3.90
Earnings (Rs.) 75.90 79.20 108 or 117

(23 units x Rs. (24 units x Rs. (30 units x Rs.
3.30) 3.30) 3.60) or (30 units x
3.90)
Gantt task and bonus system:

This system is a combination of time and piece work system. According to this system a high standard or
task is set and payment is made at time rate to a worker for production below the set standard. If the
standards are achieved or exceeded, the payment to the concerned worker is made at a higher piece rate.
The piece rate fixed under this system also includes an element of bonus the extent of 20%. The figure of
bonus to such workers is calculated over the time rate of the workers.
Thus in its essence, the system consists of paying a worker on time basis if he does not attain the standard
and on piece basis, if he does.
Wages payable to workers under this plan are calculated as under:

Output Payment
(i) Output below standard Guaranteed time rate.
(ii) Output at standard Time rate plus bonus of 20% (usually of time rate)
(iii) Output above standard High piece rate on worker’s whole output.
It is so fixed, so as to include a bonus of 20% of the time rate.
Advantages:
1. It provides good incentive for efficient workers and at the same time protects the less
efficient by guaranteeing the time rate.
2. It is simple to understand and operate.
3. It encourages better supervision and planning.
Disadvantages:
The guaranteed time rate may have the effect of weakening the urge of slower worker to increase his
output.
Illustration: 9
In a factory the standard time allowed for completing a given task (50 units), is 8 hours. The guaranteed
time wages are Rs. 20 per hour. If a task is completed in less than the standard time, the high rate of Rs. 4
per unit is payable. Calculate the wages of a worker, under the Gantt system, if he completes the task in
(i) 10 hours (ii) 8 hours and (iii) 6 hours. Also ascertain the comparative rate of earnings per hour under
the three situations.
Solution:
(i) When the worker performs the task in 10 hours, his earnings will be at the time wage rate i.e. 10
hours x Rs. 20 per hour = Rs. 200.
(ii) When the worker performs the task in standard time i.e. 8 hours, his earning will be:
8 hours x Rs. 20 = Rs. 160
Bonus @ 20% of time wages = Rs. 32
Total earnings = Rs. 192
(iii)When the worker performs the task in less than the standard time his earning will be at piece rate
i.e. 50 units x Rs. 4 per hour = Rs. 200
The comparative rate of earnings per hour under the above three situations is:
(i) Rs. 200/10 hours = Rs. 20 per hour
(ii) Rs. 192/8 hours = Rs. 24 per hour
(iii) Rs 200/6 hours = Rs. 33.33 per hour
Emerson’s efficiency system:

Under this system minimum time wages are guaranteed. But beyond a certain efficiency level, bonus in
addition to minimum day wages is given.

A worker who is able to attain efficiency, measured by his output equal to 2/3 rd of the standard
efficiency, or above, is deemed to be an efficient worker deserving encouragement. The scheme thus
provides for payment of bonus at a rising scale at various levels of efficiency, ranging from 66.67% to
150%. For a performance below 66,67% only time rate wages without any bonus are paid. Above 66 2/3
% to 100% efficiency, bonus varies between 0.01% and 20%. Above 100% efficiency bonus of 20% of
basic wages plus 1% increase in efficiency is admissible. This system is superior to one to the differential
piece rate in so far as it encourages the slow worker to do a little better than before. Also it does not pre-
suppose a high degree of average performance. Wages on time basis are guaranteed.
Illustration: 10
From the following information you are required to calculate the bonus and earnings under Emerson
Efficiency System. The relevant information is as under:
Standard working hours : 8 hours a day

Standard output per hour in units : 5
Daily wage rate : Rs. 50
Actual output in units
Worker A : 25 units
Worker B : 40 units
Worker C : 45 units
Solution:
Statement showing bonus and earnings under Emerson efficiency system
Workers A B C
Actual output in units 25 40 45
Standard outputs in units 40 40 40
Efficiency level (%) 62.5% 100% [40/40 x 112.50% [45/40 x
[25/40 x 100] 100] 100 ]
Rate of bonus No bonus 20% 32.50%
(20% +12.5%)
Time wages (Rs.) 50 50 50
Bonus (Rs.) Nil 10 16.25
(20% of Rs.50) (32.5% of Rs.50)
Total earnings (Rs.) 50 60 66.25
Point scheme or Bedeaux system:

Under this scheme, firstly the quantum of work that a worker can perform is expressed in Bedeaux points
or B’s. The points represent the standard time in terms of minutes required to perform the job. The
standard number of points in terms of minutes is ascertained after a careful and detailed analysis of each
operation or job. Each such minute consists of the time required to complete a fraction of the operation or
the job, and also an allowance for rest due to fatigue.
Workers who are not able to complete tasks allotted to them within the standard time are paid at the
normal daily rate. Those who are able to improve upon the efficiency rate are paid a bonus, equal to the
wages for time saved as indicated by excess of B’s earned (standard minutes for work done) over actual
time. Workers are paid 75% of the time saved.

Illustration: 11
Calculate the earnings of worker from the following information under Bedeaux system:
Standard time for product A – 30 seconds plus relaxation allowance of 50%.
Standard time for product B - 20 second plus relaxation allowance of 50%
During 8 hours day for:
Actual output of product for A 500 units
Actual output of product for B 300 units
Wage rate Rs.10 per hour
Solution
Bedeaux point per unit of product A

= 45/60
= 0.75 B’s
Bedeaux point per unit of product B

= 30/60
= 0.50 B’s
Total production in terms of B’s:

=500 x 0.75 + 300 x 0.50
= 525 B’s
Standard B’s (8 hours x 60) = 480 B’s

No. of B’s saved (525 B’s – 480 B’s) = 45 B’s
Earnings of the worker under Bedeaux system = Hours worked x rate per hour + 75% of time saved
= 8hr x Rs 10 + 75% x (45) x (Rs. 10/60)
= Rs.80 + Rs. 5.63
= Rs.85.63.
Hayne’s system:
Under this system also, the standard is set in minutes. The standard time for the job is expressed in terms
of the standard man-minutes called as “MANIT”. Manit stands for man-minute. In the case of repetitive
work the time saved is shared between the worker and the foreman in the ratio 5:1. If the work is of non-
repetitive nature, the worker, the employer and the foreman share the value of time saved in the ratio of
5:4:1. Each worker is paid according to hourly rate for the time spent by him on the job.
Accelerated premium system:

Under this system earnings increase with output. The rate of increase of earnings increases progressively
with output; in fact the earnings increase in greater proportion than the increase in production. This
system acts as a strong incentive for skilled workers to earn high wages by increasing output and for
production beyond standard.
Premium bonus methods:

Under these methods, standard time is established for performing a job. The worker is guaranteed his
daily wages (except in Barth System), if his output is below and up to standard. In case the task is

completed in less than the standard time, the saved time is shared between the employee and the
employer. There are two types of time-sharing plans in use viz., constant sharing plans and variable
sharing plans.
Halsey and Halsey Weir systems:

Under Halsey system a standard time is fixed for each job or process. If there is no saving on this standard
time allowance, the worker is paid only his day rate. He gets his time rate even if he exceeds the standard
time limit, since his day rate is guaranteed. If, however, he does the job in less than the standard time, he
gets a bonus equal to 50% of the wages of time saved; the employer benefits by the other 50% . The
scheme also is sometimes referred to as the Halsey fifty percent plan.
Formula for calculating wages under Halsey system

=Time taken x Time rate + 50% of time saved x Time rate.
The Halsey Weir System is the same as the Halsey System except that the bonus paid to workers is 30%
of the time saved.
Advantages:
i. Time rate is guaranteed while there is opportunity for increasing earnings by increasing
production.
ii. The system is equitable in as much as the employer gets a direct return for his efforts in
improving production methods and providing better equipment.
Disadvantages:
i. Incentive is not so strong as with piece rate system. In fact the harder the worker works, the
lesser he gets per piece.
ii. The sharing principle may not be liked by employees.
Illustration: 12
Calculate the earnings of a worker under Halsey System. The relevant data is as below:
Time rate (p.h.) Re. 40

Time allowed 8 hours
Time taken 6 hours
Time saved 2 hours
Solution
Calculation of total earnings:
= 6 hrs x Rs. 40 + ½ x (2 hrs x Rs. 40)

= Rs. 240 + Rs. 40
= Rs. 280
Of his total earnings, Rs. 240 is on account of the time worked and Re. 40 is on account of his share of
the premium bonus.

Rowan system:
According to this system a standard time allowance is fixed for the performance of a job and bonus is
paid if time is saved. Under Rowan System the bonus is that proportion of the time wages as time saved
bears to the standard time.
Formula for calculating wages under Rowan system
= Time taken x Rate per hour + Time taken x Time saved x Rate per hour
Time allowed
Advantages:
i. It is claimed to be a fool-proof system in as much as a worker can never double his earning
even if there is bad rate setting.
ii. It is admirably suitable for encouraging moderately efficient workers as it provides a better
return for moderate efficiency than under the Halsey Plan.
iii. The sharing principle appeals to the employer as being equitable.
Disadvantages:
i. The system is a bit complicated.

ii. The incentive is weak at a high production level where the time saved is more than 50% of
the time allowed.
iii. The sharing principle is not generally welcomed by the employees.
Illustration: 13
Calculate the earnings of a worker under Rowan System. The relevant data is given as below:
Time rate (per hour) Rs. 40
Time allowed 8 hours
Time taken 6 hours
Time saved 2 hours
Solution
Calculation of total earnings:
= Time taken x Rate per hour + Time taken x Time saved x Rate per hour
Time allowed
9 >*%)/
= 6 hours x Rs. 40 + x 2 hours x 40
>*%)/
= Rs. 240 + Rs. 60

= Rs. 300
Barth system:
The formula for calculating the remuneration under this system is as follows:
Earnings = Hourly rate x √@ABCDBED ℎGHE@ I ℎGHE@ JGEKLD

The system is particularly suitable for trainees and beginners and also for unskilled workers. The reason is
that for low production efficiency, the earnings are higher than in the piece work system but as the
efficiency increases, the rate of increase in the earnings falls.
Illustration: 14
A factory having the latest sophisticated machines wants to introduce an incentive scheme for its workers,
keeping in view the following:
1. The entire gains of improved production should not go to the workers.

2. In the name of speed, quality should not suffer.
3. The rate setting department being newly established is liable to commit mistakes.
You are required to devise a suitable incentive scheme and demonstrate by an illustrative numerical
example how your scheme answers to all the requirements of the management.
Solution:
Rowan Scheme of premium bonus (variable sharing plan) is a suitable incentive scheme for the workers
of the factory. If this scheme is adopted, the entire gains due to time saved by a worker will not pass to
him.
Another feature of this scheme is that a worker cannot increase his earnings or bonus by merely
increasing its work speed. The reason for this is that the bonus under Rowan Scheme is maximum when
the time taken by a worker on a job is half of the time allowed. As this fact is known to the workers,
therefore, they work at such a speed which helps them to maintain the quality of output too.
Lastly, Rowan System provides a safeguard in the case of any loose fixation of the standards by the rate-
setting department. It may be observed from the following illustration that in the Rowan Scheme the
bonus paid will be low due to any loose fixation of standards. Workers cannot take undue advantage of
such a situation. The above three features of Rowan Plan can be discussed with the help of the following
illustration:
(i) Time allowed = 4 hours

Time taken = 3 hours
Time saved = 1 hour
Rate = Rs. 40 per hour
M=&( <0N(6
Bonus = x time saved x rate
M=&( 3--*O(2
>*%)/
= x1 hour x Rs. 40 = Rs. 30
! >*%)/
In the above illustration time saved is 1 hour and, therefore, total gain is Rs. 40. Out of Rs. 40
according to Rowan Plan only Rs. 30 is given to the worker in the form of bonus and the remaining
Rs. 10 remains with the management. In order words a worker is entitled for 75 percent of the time
saved in the form of bonus.

(ii) The figures of bonus in the above illustration when the time taken is 2 hours and 1 hour respectively
are as below:
M=&( <0N(6
Bonus = x time saved x rate
M=&( 3--*O(2
P >*%)/
= x 2 hour x Rs. 40 = Rs. 40
! >*%)/
" >*%)/
= x 3 hour x Rs. 40 = Rs. 30
! >*%)/
The above figures of bonus clearly show that when time taken is half of the time allowed, the bonus is
maximum. When the time taken is reduced from 2 to 1 hour, the bonus figure fell by Rs. 10. Hence, it is
quite apparent to workers that it is of no use to increase speed of work. This feature of Rowan Plan thus
protects the quality of output.
(iii) If the rate –setting department erroneously sets the time allowed as 10 hours instead of 4 hours, in the
above illustration, then the bonus paid will be as follows:
>*%)/
= x 7 hour x Rs. 40 = Rs. 84
" >*%)/
The bonus paid for saving 7 hours thus is Rs. 84 which is approximately equal to the wages of 2 hours
only in spite of the fact that time allowed was erroneously determined at 250% . In order words the bonus
paid to the workers is low. Hence workers cannot take undue advantage of any mistake committed by the
time setting department of the concern.
Illustration: 15
a) Bonus paid under the Halsey Plan with bonus at 50% for the time saved equals the bonus paid under
the Rowan System. When will this statement hold good? (Your answer should contain the proof)
b) The time allowed for a job is 8 hours. The hourly rate is Rs. 8. Prepare a statement showing :
i. The bonus earned
ii. The total earning of labor and
iii. Hourly earnings
Under the Halsey System with 50% bonus for time saved and Rowan System for each hour saved
progressively.
Solution:
(a) Bonus under Halsey Plan

= Standard wage rate x (50/100) x Time saved … (i)
Bonus under Rowan Plan

M=&( <0N(6
= Standard wage rate x x time saved
M=&( 3--*O(2
Bonus under Halsey Plan will be equal to the Bonus under Rowan Plan when the following condition
holds good

= Standard wage rate x 50/100 x Time saved
M=&( <0N(6
= Standard wage rate x x time saved
M=&( 3--*O(2
M=&( <0N(6
Or ½ =
M=&( 3--*O(2
Or, Time taken = ½ of time allowed
Hence when the time taken is 50% of the time allowed, the bonus under Halsey and Rowan Plans is
equal.
(b) Statement of Bonus, total earnings of labor and hourly earnings under Halsey and Rowan
Systems
Time Basic Bonus system under Total earnings Hourly earnings
system under system under
allowed Taken Saved Wages Halsey Rowan Halsey Rowan Halsey Rowan
A B C=A- D E= F=Rs. G= D+E H= D+F I= G/B J=H/B
B 8*C*50% 8*B/A*C
8 8 - 64 - - 64 64 8.00 8
8 7 1 56 4 7 60 63 8.57 9
8 6 2 48 8 12 56 60 9.33 10
8 5 3 40 12 15 52 55 10.40 11
8 4 4 32 16 16 48 48 12.00 12
8 3 5 24 20 15 44 39 14.67 13
8 2 6 16 24 12 40 28 20.00 14
8 1 7 8 28 7 36 15 36.00 15
Illustration: 16
Mr. A is working by employing 10 skilled workers. He is considering the introduction of some incentive
scheme – either Halsey Scheme (with 50% bonus) or Rowan Scheme – of wage payment for increasing
the labor productivity to cope with the increased demand for the product by 25%. He feels that if a
proposed incentive scheme could bring about an average 20% increase over the present earnings of the
workers, it could act as sufficient incentive for them to produce more and he has accordingly given this
assurance to the workers.
As a result of assurance, the increase in productivity has been observed as revealed by the following
figures for the current month:
Hourly rate of wages (guaranteed) Rs. 20.00
Average time for producing 1 piece by one worker at the previous performance (This 2 hours
may be taken as time allowed)
No. of working days in a month 25
No. of working hours per day for each worker 8
Actual production during the month 1,250 units
Required:
1. Calculate effective rate of earnings per hour under Halsey Scheme and Rowan Scheme.
2. Calculate the savings to Mr. A in terms of direct labor cost per piece under the schemes.
3. Advise Mr. A about the selection of the scheme to fulfill his assurance.

Solution
Working Notes:
1. Total time wages of 10 workers per month = No. of working days in the month x No. of working
hours per day of each worker x Hourly rate of wages x No. of workers.
= 25 days x 8 hours x Rs. 20 x 10 workers = Rs. 40,000
2. Time saved per month:

Time allowed per piece by a worker: 2
hours
No. of units produced during the month by 10 workers: 1,250 pieces
Total time allowed producing 1,250 pieces: (1,250 x 2 hours) 2,500 hours
Actual time taken to produce 1,250 pieces:(25 daya x 8 hrs x 10 worker) 2,000 hours
Time saved (2,500 hours – 2,000 hours): 500 hours
3. Bonus under Halsey Scheme to be paid to 10 workers:

Bonus = 50% of time saved x hourly rate of wages
= 50% x 500 hours x Rs. 20 = Rs. 5,000
Total wages to be paid to 10 workers are (Rs. 40,000 + Rs. 5,000) Rs. 45,000, if Mr. A considers
the introduction of Halsey incentive scheme to increase the labor productivity.
4. Bonus under Rowan Scheme to be paid to 10 workers:

M=&( M0N(6
Bonus = x time saved X standard wages rate
M=&( 3--*O(2
P, >*%)/
= x 500X Rs. 20 = Rs. 8,000
P,7 >*%)/
Total wages to be paid to 10 workers are (Rs. 40,000 + Rs. 8,000) Rs. 48,000, if Mr. A considers
the introduction of Rowan incentive scheme to increase the labor productivity.
Answer to 1.(i) Effective hourly rate of earnings under Halsey Scheme (refer to working notes 1, 2
and 3)
M*<0- <=&( O05(/ *+ " O*)N()/M*<0- '*6%/ %62() Q0-/(. ;1>(&(
=
M*<0- >*%)/ O*)N(2
:/.! , :/.7,
= = Rs. 22.5
P, >*%)/
Answer to 1.(ii) Effective hourly rate of earnings under Rowan Scheme

(refer to working notes 1, 2 and 4)
M*<0- <=&( O05(/ *+ " O*)N()/M*<0- '*6%/ %62() :*O06 ;1>(&(
=
M*<0- >*%)/ O*)N(2
:/.! , :/.,
= = Rs. 24.0
P, >*%)/
Answer to 2 (i)Savings in terms of direct labor cost per piece under Halsey scheme:
(Refer to Working Note 3)
Labor cost per piece (under time wage scheme) = 2 hours x Rs. 20 = Rs. 40
M*<0- O05(/ ,0=2 %62() <>( /1>(&( :/.!7,

Labor cost per piece (under Halsey scheme) = =
M*<0- 6%&'() *+ %6=</ ,)*2%1(2 ",P7
= Rs.36.00

Savings per piece = Rs. 40 – Rs. 36 = Rs. 4.00
Answer to 2 (ii)Savings in terms of direct labor cost per piece under Rowan scheme:
(Refer to Working Note 4)
Labor cost per piece (under time wage scheme) = 2 hours x Rs. 20 = Rs. 40
:/.!,
Labor cost per piece (under Rowan scheme) = = Rs.38.40
",P7 %6=</
Savings per piece = Rs. 40 – Rs. 38.40 = Rs. 1.60
Answer to 3: From the labor cost per piece under Halsey scheme (Rs. 36.00) and Rowan scheme (Rs.
38.40), it is quite clear that Halsey Scheme brings about more saving than Rowan Scheme to the Concern.
But Halsey Scheme does not fulfill the assurance given to the workers about 20% increase in their
earnings as it secures only 12.5% [i.e. (5000/40,000) x 100] increase.
On the other hand, Rowan scheme secures 20% [i.e (800/48,000) x 100] increase in the earnings and it
fulfills the assurance. Therefore, Rowan Scheme may be adopted.
Illustration: 17
Wages negotiations are going on with the recognized labor union and the management wants you as the
Cost Accountant to formulate an incentive scheme with a view to increase productivity.The case of three
typical workers A, B and C who produce respectively 180, 120 and 100 units of the company’s product in
a normal day of 8 hours is taken up for the study.
Assuming that day wages would be guaranteed at Rs 15 per hour and piece rate would be based on a
standard hourly output of 10 units, calculate the earnings of each of the three workers and the labor cost
per 100 pieces under (i) Day wages, (ii) Piece rate, (iii) Halsey scheme, and (iv) the Rowan scheme.
Also calculate under the above schemes the average cost of labor for the company to produce 100 pieces.
Solution
Calculation of earnings of each of the three workers and the labor cost per 100 pieces under different
wage schemes.
(i) Day wages:

Name of workers Day wages (Rs.) Actual output (units) Labor cost per 100
pieces (Rs.)
A (Rs 15 x 8hrs) = 120.00 180 66.66
B (Rs 15 x 8hrs) = 120.00 120 100.00
C (Rs 15 x 8hrs) = 120.00 100 120.00
Total 360.00 400 -
M*<0- O05(/ ,0=2
Average cost of labor for the company to produce 100 pieces = x 100
M*<0- *%<,%<
:/.9
= x 100
!
= Rs. 90

(ii) Piece rate

Name of workers Piece rate (Rs.)Actual output Wages earned Labor cost per 100
(units) (Rs.) pieces (Rs.)
A 1.5 180 270 150
B 1.5 120 180 150
C 1.5 100 150 150
Total 400 600.00 -
:/.9
Average cost of labor for the company to produce 100 pieces = x 100
!
= Rs. 150
iii. Halsey Scheme

Name of Actual Std. time for Actual time Time Bonus Hrs. Total wages Labor cost
workers output actual output for actual saved (50% of time including per 100
(units) Hrs. output Hrs. Hrs. saved Hrs) Bonus* pieces
Rs. Rs.
A 180 18 8 10 5 195 108.33
B 120 12 8 4 2 150 125.00
C 100 10 8 2 1 135 135.00
400 480
Average cost of labor for the company to produce 100 pieces = (Rs. 480/400) x 100
= Rs. 120
*Total wages = (Actual hours worked + bonus hours) x Rate per hour
Hence, total wages of A are = (8+5) x Rs. 15 = Rs. 195
Similarly, the total wages of B and C are Rs. 150 and Rs. 135 respectively.
iv. Rowan Scheme

Name Actual Std. time Actual Time Bonus Wages Bonus Total wages Labor
of workers output for actual time saved Hrs. * paid for @ 15 including cost per
(units) output for Hrs. actual per Bonus 100
Hrs. actual Hrs. @ Bonus Rs. pieces
output Rs 15 hr. Rs. Rs.
Hrs. per hr.
Rs.
(1) (2) (3) (4) (5) (6) (7) (8) (9)= (7)+(8) (10)
A 180 18 8 10 4.44 120.00 66.6 186.6 103.67
B 120 12 8 4 2.67 120.00 40 160.00 133.40
C 100 10 8 2 1.60 120.00 24 144.00 144.00
490.60
i. Average cost of labor for the company to produce 100 pieces = (Rs. 490.6/400) x 100 = Rs.
122.65
ii. *Bonus Hours = Time taken x (Time saved/ Time allowed)
iii. Hence, Bonus hours of A
= (8 hours x 10 hours) / 18 hours
= 4.44 hours
iv. Similarly, Bonus hours of B and C are 2.67 hours and 1.6 hours respectively.

Illustration: 18
During first week of April 2013 the workman Mr. Kalyan manufactured 300 articles. He receives wage
for a guaranteed 48 hours week at the rate of Rs. 16 per hour. The estimated time to produce one article
is 10 minutes and under incentive scheme the time allowed is increased by 20%. Calculate his gross
wages according to:
i. Piece work with a guaranteed weekly wage,
ii. Rowan premium bonus and Halsey premium bonus: 50 % to workman.
Solution
Gross wages due to Mr. Kalyan
(i) Piece-work with a guaranteed weekly wage Rs. Rs
Wages for 48 hours, (48 hours x Rs 16 x 125%)
(Being more than the guaranteed wage of Rs. 192 for 48 hours) 960.00
Rate per hour worked: Rs. 960 ÷ 48 20.00
(125% of the normal piece rate since efficiency is more than 100%)
ii. Rowan Premium Bonus Plan
Wages for 48 hours @ Rs.16 per hour 768.00

Bonus = Wages for time worked X (Time saved ÷ Standard time)
= 768 x ((60-48) ÷60) 153.60 921.60
Rate per hour worked: Rs.921.60 ÷ 48 = Rs. 19.20
iii. Halsey Premium Bonus Plan
Wages for 48 hours 768.00

Bonus: 50% of the wages for time saved [16 X 50% X 12] 96.00 864.00
Rate per hour worked Rs. 864 ÷ 48 = 18.00
Working notes:
Standard time for producing 300 articles:
Estimated time for one article 10 minutes
Add: 20% increase under incentives scheme 2 minutes
Total for one articles 12 minutes
Total for 300 articles 3,600 minutes or 60 hours
Time taken 48 hours

Time saved 12 hours
Group System of wage payment: Certain jobs or operations are required to be performed collectively by
a number of workers. Under such cases each man’s work depends on the work performed by one or more
of his colleague and as such it is not possible to measure separately the output of each worker.
The workers constituting a group or a team here are considered as a composite unit and the combined
output of such a unit is measured for the purpose of wage calculation. The methods usually used for
distributing wages to each worker are the following:
i. Equally, if all the workers of the group are of the same grade, skills and have same rate of pay
and have worked for same duration.
ii. Pro-rata to the time-rate of each worker where the time spent by the individual worker is the
same.
iii. On the basis of the time rates and attendance of each worker.
iv. On a specified percentage basis; the percentage applicable to a worker is pre-determined on the
basis of the skill, rate of pay etc.
v. In a group of unskilled workers, a method of distribution is to pay the unskilled workers at their
time rates. The balance amount remaining out of the total earnings after payment to the unskilled
workers is distributed among the skilled workers by any of the methods discussed above.
Group Bonus – Group bonus refers to the bonus paid for the collective efforts made by a group of
workers. The amount of bonus is distributed among the individual members of the group on some agreed
basis.
Group Bonus Schemes – Under a group bonus scheme, bonus is paid to a team/group of employees
working together. Such a scheme is introduced generally where individual efficiency cannot be
established for the payment of bonus. For example, in the construction work, it is the team work of
masons and laborers which produces results. If any incentive is to be offered, it should be offered to the
team as a whole and not to an individual. Group bonus is based on the combined output of the team as a
whole. The quantum of bonus is determined on the basis of the productivity of the team and the bonus is
shared by individual workers in specified proportions, often in the proportion of wages on time basis.
Objectives of Group Bonus Schemes:

The objectives of a group bonus scheme are the following:
i) To create collective interest and team spirit among workers.

ii) To create interest among supervisors to improve performance.
iii) To reduce wastage in materials and idle time.
iv) To achieve optimum output at minimum cost.
v) To encourage individual members of the group where only the output of the team as a whole can
be measured.
Advantages of Group Bonus Schemes:

i) They create a sense of team spirit since all the workers in a group realize that their personal
incentives are dependent upon group effort.

ii) A spirit of healthy competition amongst various groups doing identical jobs is also created. This
result is the elimination of excessive waste of materials.
iii) The operators and supervisors also feel interested in raising the production to higher levels.
iv) The scheme is usually easier to understand and entails less costing and accounting work. It is
easier to set up group activity targets, since the performance unit is large.
Schemes of group bonus

There are five schemes of group bonus as discussed below:
i) Priestman’s Production Bonus: This method was adopted by Priestmen Bros. Ltd, in 1917.
According to this method when the actual production in units or points exceeds the standard fixed,
a bonus is paid to the workers as additional wages equivalent to the percentage of actual output
over the standard output.
ii) Cost efficiency Bonus: Under this scheme, the amount of bonus is calculated when the cost is
reduced below the normal established targets. Targets of cost, for example material cost, labor cost
and overhead cost etc., per unit are fixed. If the measurement of actual performance shows a saving
in the total labor and material cost or a reduction in the total cost per unit, a fair percentage of the
saving is distributed among the staff. Three popular schemes usually used for calculating the
amount to be distributed to workers as Bonus are as below :
a. Nunn-Bush Plan: According to this plan a norm of direct labor cost is fixed and
expressed as a percentage of the sales value. The amount calculated at this percentage is
credited to a fund. The actual labor cost is debited to this fund and the balance
remaining to the credit of this fund is distributed as bonus to all the workers and
employees.
b. Scanlon Plan: Here also a fund is created for the normal cost of wages and salaries.
This fund is debited with the actual labor costs. Two-thirds to three-fourths of the credit
balance, if any, is distributed as bonus, the balance is kept as reserve for future set-
backs.
c. Rucker Plan: This plan is quite similar to Nunn-Bush Plan except that the percentage
for crediting the fund is based on the total value added by manufacturer (i.e. the total
cost less the value of the material) and not on total sales value.
iii) Town Gain Sharing Plan: Under this plan bonus is dependent upon a saving in the labor cost as
compared to standard. The bonus is calculated at 50% of the saving achieved.
iv) Budgeted Expense Bonus: Bonus is determined in advance and paid as a percentage of savings
affected in the actual total expenses as compared to the budgeted expense. It is payable to indirect
workers also.
v) Waste reduction Bonus: Bonus becomes payable under this scheme if the team of workers brings
about a reduction in the percentage of material wastages as compared to the standard set. It is
applicable to industries where the material cost assumes a greater proportion of the total cost.
Many time group bonus schemes do not enjoy the approval of workers. Some workers tend to feel
that their personal incentives are low merely because some members of the group are lazy or
inefficient. Such workers believe that it is better to provide incentives on individual basis, if it is
possible.

3.8 SYSTEM OF INCENTIVE SCHEMES FOR INDIRECT WORKERS

Since the setting of work standards and measurement of output in the case of indirect workers is not
an easy task in respect of maintenance, internal transport, inspection, packing and cleaning, therefore
the introduction of a system of payment by results for indirect workers is difficult. In spite of the
aforesaid difficulty, it has been felt necessary to provide for incentives to indirect workers, due to the
following reasons:
1. Payment of incentive bonus to direct workers and time rate to indirect workers leads to
dissatisfaction and labor unrest.
2. Indirect workers are as much entitled to bonus as direct workers.
3. Bonus payment to indirect workers creates team spirit.
4. An incentive system for indirect workers assists in maintaining the efficiency of services such as
plant repairs, stores maintenance, material handling etc.
5. The efficiency of direct workers is reduced where their work is dependent upon the service
rendered by the indirect workers.
A few examples of incentive schemes to indirect workers are as below:
i. Incentive to supervisors and foremen: Supervisors and foremen are an important link between
the management and the workers. Incentive payment to these persons would assist in
maintaining all round efficiency. Incentive to supervisors and foremen may be provided in the
form of non-financial benefits.
Incentive can also be provided to these workers in the form of Bonus. The extent of bonus which
will be distributed as incentive will depend on the savings affected over the standards.
ii. Incentive to maintenance and repairs staff: Under mass production work, repair and
maintenance duties can be considered as routine and repetitive for which percentage of
efficiency can be evaluated. In case such an evaluation is not possible or practicable, a group
bonus system may be established, on the basis of reduction in breakdown or on the number of
complaints.
Illustration: 19
A, B and C were engaged on a group task for which a payment of Rs. 7,250 was to be made. A’s
time basis wages are Rs. 80 per day, B’s Rs. 60 per day and C’s Rs.50 per day. A worked for 25
days; B worked for 30 days; and C for 40 days. Distribute the amount of Rs. 7,250 among the
three workers.
Solution
Total wages on time basis Rs.
A 25 @ Rs.80 2,000
B 30 @ Rs.60 1,800
C 40 @ Rs.50 2,000
5,800
Payment for task bonus (Rs. 7,250 – Rs. 5,800) 1,450 (25% of the time basis wages)

Earnings of each worker

Worker Wages on time basis Group task bonus 25% Total
Rs. Rs.
A 2,000 500 2,500
B 1,800 450 2,250
C 2,000 500 2,500
5,800 1,450 7,250
Profit-sharing and Co-partnership schemes

A profit-sharing scheme implies that the net profit of business would be shared between the workers and
the shareholder or the partners in a pre-determined ratio. Co-partnership, on the other hand, implies that
the workers shall own the business jointly with the shareholders. In this case, usually the workers share of
profits is given in the form of shares.
Some employers in our country originally introduced profit-sharing schemes with a view of stimulating
interest among workers for increasing production. But the schemes have not been successful on account
of unwillingness on the part of the management to consult workers. Even a demand for copies of final
accounts of the business to be shown to them has been considered by some employees to be an
unwarranted interference. At present, payment of compulsory bonus is governed by the payment of Bonus
Act which has specified certain percentage of profit to be distributed to employees.
Though profit sharing has become a normal feature of the industrial life in this country, co-partnership is
comparatively unknown. Nevertheless it must be pointed out that in England and other western countries,
a number of successful concerns have been allotting shares to their workers in proportion to their shares
of bonus. Some of them have advanced loans to them to purchase shares. Both these forms of benefit
have been quite popular with labor.
Advantages:
1. Employees are made to feel that they too have a stake in the wellbeing of the undertaking and have
a contribution to make in earning of profits by improving production and operations.
2. Labor turnover may be reduced, particularly if a minimum period of service is laid down as a
condition for participating in such schemes.
Disadvantages:
1. Profit may fluctuate from year to year; there is thus an element of uncertainty in such schemes.
2. Profit depends upon many factors of which labor efficiency is only one. Insufficiency of bonus may
lead to dissatisfaction instead of promoting good relations, if the good work done by labor is
nullified by other factors.
3. The reward may be too remote to sustain continued interest and sustain zeal for work among labor.
4. There may be doubt and suspicion about the profit disclosed.
5. Since all are entitled to participate in such schemes, there is no recognition of individual merit.
6. The individual share of profit may be too meager to be appealing.
Treatment in Costing: In foreign countries bonus is an ex-gratia payment and hence it is regarded as an
appropriation of profit not to be included in costs. In fact trade unions there do not look upon bonus with
favor. In Nepal however, every establishment that makes a profit shall allocate an amount equal to ten
percent of the net profit made during a fiscal year (% for government entities will be as approved) for
payment of bonus to its employees. Hence bonus must be treated as part of costs in Nepal. There can be

two methods of dealing with bonus. In case the bonus are paid to indirect worker, it may be treated as part
of overheads; . In the case of direct workers, the bonus payable may be estimated beforehand and wage
rates for costing purposes will be suitably inflated by including the bonus that would be paid.
Suppose, a worker gets Rs. 8,000 p.m. as wages and it is expected that he will be paid two month’s wages
as bonus. His total earning will be Rs. 112,000 (Rs. 96,000 + Rs. 16,000). If the worker works for 2,200
hours in a year the wage rate for costing purposes will be Rs. 51 i.e. Rs. 112,000/2,200 hours.
Illustration: 20
A skilled worker in XYZ Limited is paid a guaranteed wage rate of Rs. 30 per hour. The standard time per
unit for a particular product is 4 hours. P, a machine man, has been paid wages under the Rowan
Incentive Plan and he had earned an effective hourly rate of Rs. 37.50 on the manufacture of that
particular product.
What could have been his total earnings and effective hourly rate had he been put on Halsey Incentive
Scheme (50%)?
Solution
Let T hours be the total time worked in hours by the skilled worker (machine man P); Rs. 30/- is the rate
per hour; standard time is 4 hours per unit and effective hourly earnings rate is Rs. 37.50 then
(Under Rowan incentive plan)

M=&( ;04(2
Earnings = Hours worked x Rate per hour + x Time taken x Rate per hour
M=&( 3--*O(2
!RM
Rs. 37.5 T = T x Rs. 30 + x T x Rs. 30
!
Rs. 37.5 = Rs. 30 + (4 – T) x Rs. 7.5
Or, Rs. 7.5 T =Rs. 22.5
Or, T = 3 hours
(Under Halsey incentive plan)

"
Total earnings = Hours worked x Rate per hour + x Time saved x Rate per hour
P
"
= 3 hours x Rs. 30 + x 1 hour x Rs. 30 = Rs. 105
P
M*<0- (0)6=65/ :/." 7
Effective hourly rate = = = Rs. 35
Q*%)/ <0N(6 >*%)/
3.9 ABSORPTION OF WAGES
Elements of wages:
In common parlance, the term ‘wages’ represents monetary payment which an employee receives at
regular intervals for the services rendered. Strictly speaking, however, from the point of view of the
employer and the cost to the industry, wages should be taken to include also non-monetary benefits which
an employee receives by virtue of employment. Such non-monetary benefits may include:
1. Medical facilities.

2. Educational and training facilities;

3. Recreational and sports facilities;
4. Housing and social welfare; and
5. Cost of subsidized canteen and co-operative societies.
Such benefits are generally given in an industrial establishment. In some cases the provision of benefits is
compulsory. Therefore, while computing the wage cost per worker, the monetary value of such non-
monetary benefits should also be taken into account.
The monetary part of a worker’s remuneration includes the basic wages, dearness allowance, overtime
wages, other special allowance, if any, production bonus, employer’s contribution to the provident fund,
contribution to pension fund, leave pay, etc.
The basic wage is the payment of work done, measured in terms of hours attended or the units produced,
as the case may be. The basic wage rate is not normally altered unless there is a fundamental change in
the working conditions or methods of manufacture. Dearness allowance is an allowance provided to cover
the increase in cost of living one period to another. This allowance is calculated either as percentage of
the basic wage or as a fixed amount for the days worked. In either case, the percentage or the fixed
amount is subject to revision whenever the cost of living index rises or falls by a certain figure as agreed
to by the employer with the labor union. When permanent rise in the cost of living index occurs, a part of
the dearness allowance is often absorbed in the basic wage.
Overtime allowance is an allowance paid for the extra hours worked at the rates laid down by the Labor
Act. In certain industries, where special allowance for the working conditions, tool maintenance, etc. are
paid they are also considered as part of wages.
Production bonus is an incentive payment made to workers for efficiency that results in production above
the standard. There are different methods of computing incentives.
At present, payment of compulsory bonus is governed by the payment of Bonus Act which has specified
certain percentage of profit to be distributed to employees.
Contributions to provident fund are compulsory. Under the provident fund scheme, the employer
contributes to the provident fund a sum equal to 10 % of the basic wages which are then matched equally
(10% of basic) by concerned employee and deposited into retirement (like Provident) fund accounts. The
payments by the employer under these schemes are payable at the time, wages are paid for the relevant
period; these payments form a part of the wages for the period.
Component of wages cost or wages for costing purposes: In addition to wages (including allowances,
such as D.A.) that are paid to workers, a firm may have to spend on many other items (such as incentives
or bonuses). Further, the worker does not spend all the time for which he is paid on productive work. This
is because he is entitled to weekly holiday and various type of leave. There is also a certain amount of
unavoidable idle time. The question is: to what extent such additional payment or cost in respect of labor
can be charged directly to unit of cost as part of direct labor cost? Of course, in the case of indirect labor,
all such payments as also the wages paid to them, must be treated as part of overheads. But in the case of
direct workers, two alternatives are possible. The additional charges may be treated as overheads.
Alternatively, the wage rates being charged to job may be computed by including such payments;
automatically then, such payments will be charged to the work done along with wages of the worker. (It
should be remembered that such wage rate will be only for costing purposes and not for payment to

workers). The total of wages and additional payment should be divided by effective hours of work to get
such wage rates for costing purposes.
Illustration: 21
A worker is paid Rs. 4,000 per month as basic salary and a dearness allowance of Rs. 2,000 p.m. There is
a provident fund @ 10 % and the employer also contributes the same amount as the employee. The
Employee Insurance premium is 1.5% of wages of which 0.5% is paid by the employees. It is the firm’s
practice to pay 2 months’ wages (basic salary onlu) as bonus each year.
The number of working days in a year is 300 of 8 hours each. Out of these the worker is entitled to 15
days leave on full pay. Calculate the wage rate per hour for costing purposes.
Solution Rs
Wages paid to workers during the year 72,000
Add: Provident Fund @ 10% 7,200
Employees Insurance premium @ 1% 720
Bonus at 2 months’ wages 8,000
Total 87,920
Effective hours per year = 285 x 8 = 2,280
Wage rate per hour (for costing purpose): Rs. 87,920/2,280 hours = Rs. 38.56
Holiday and leave wages: One alternative to account for wages paid on account of paid holiday
and leave can be to include them as departmental overheads. In such a case, it is necessary to
record such wages separately from ‘worked for wages’. Such as segregation can be made
possible by providing a separate column in the payroll for holiday and leave wages in the same
way as there are columns for dearness allowance, provident fund deductions, etc. If, however, a
separate or additional column cannot be provided for this purpose it would be necessary to
analyze the payroll periodically to ascertain how much of the total payment pertains to ‘worked
for wages ‘ and how much is attributed to leave and holiday wages.
Another way could be to inflate the wage rate for costing purposes to include holiday and leave
wages. This can be done only in the case of direct workers.
Illustration: 22
Calculate the labor hour rate of a worker X form the following data:
Basic pay Rs. 4,000 per month
D.A Rs. 2000 per month
Fringe benefits Rs. 1000 per month
Number of working days in a year is 300. 20 days are availed off as holidays on full pay in a
year. Assume a day of 8 hours.
Solution
(i) Effective working days in a year 300
Less: Leave days on full pay 25
Effective working days 280 days

Total effective working hours (280 days x 8 hours) 2,240
(ii) Total wages paid in a year Rs.

Basic pay 48,000
DA 24,000
Fringe benefits 12,000
84,000
(iii) Hourly rate: Rs. 84,000/2,240 hours = Rs. 37.50
Night shift allowance: In some cases, workers get extra payment if they work at night.
Since the extra payment is not for any particular job, therefore such a payment should be
treated as part of overheads.
Principles of remuneration: The term ‘remuneration’ has been defined as the reward for
labor and service. It is the result of the agreement between the employer and the employee,
whereby for a specified work or service rendered by the employee the employer agrees to
pay a specified sum of money. Apart from this an employee by virtue of the fact that he is
an employee becomes entitled to certain non-monetary benefits.
The method of remuneration adopted varies from industry and in certain cases, even among
different units in the same industry. Whatever be the variation, the method of fixing
remuneration payable to the various categories of employees has to be based on certain
accepted principles. These are:
i. Wage-rates in an industry should be fixed in conformity with the general wage-levels in
the geographical area i.e. the rate should be more or less the same for similar efforts and
skill. The wage-level in an area would in turn depend upon demand for labor, the
availability of labor, the cost of living in the area, the wage levels in neighboring
industrial area, and the capacity of the particular industry to pay.
ii. Wage-rates should be related to the degree of skill, effort, initiative and responsibility
that the employee is expected to assume in respect of the various jobs he may be called
upon to perform. There should be generally equal pay for equal work.
iii. Wage-rates should guarantee a minimum wage regardless of the existence of factors
particularly when the working conditions are difficult and dangerous.
iv. Wage-rates are considered satisfactory only if they enable the workers to maintain a
reasonable standard of living.
v. Separate wage rates should be fixed for different classes of employees since each class
expects to maintain a different standard of living; also the education, physical and
mental efforts and responsibility required for performing different jobs are not the
same.
vi. It should be possible for worker to increase his earnings through extra effort and by
increasing output. If he alone is responsible, he should have the full benefits of the
increased productivity. Otherwise, if increased output has resulted from co-operation
between management and workers both should share the benefit.
It is important these basic principles should be recognized in fixing the wage rate of workers;
otherwise, there will be dissatisfaction among the employees and, consequently, there will be

higher labor turnover. Satisfactory employer –employee relationship is a primary necessity for
industrial development and this has to be ensured to a very great degree, by satisfactory schemes
of remunerating labor.
The aim should be to keep labor cost per unit of output (or service) as low as possible. It is not
the same as keeping wages at low levels. There is a definite correlation between wages and
productivity; high wages often lead to such an increase in productivity that wages per unit of
output fall. However, this rule is also subject to diminishing returns – a point is reached at which
any further increase in wage rates does not bring about a corresponding increase in efficiency.
But generally, higher wages result in lower cost per unit.
Wages affect the national economy through cost of goods produced. If an increase in wages
outpaces the corresponding increase in productivity, goods become costlier and cannot compete
with those of other countries in the world markets.
From the point of view of an expert it is necessary to keep wages in check like other costs. The
safe rule is to link up wages with productivity.
Absorption rates of labor cost:

Labor cost as stated above include monetary compensation and non-monetary benefits to
workers. Monetary benefits include basic wages, D.A. overtime pay, incentive or production
bonus, contribution to employee provident fund, House Rent Allowance, Holiday and vacation
pay etc. The non-monetary benefits include medical facilities, subsidized canteen services,
subsidized housing, education and training facilities. Accounting of monetary and non-monetary
benefits to indirect workers does not pose any problems because the total of monetary and non-
monetary benefits are treated as overhead and absorbed on the basis of rate per direct labor
hours, if overheads are predominantly labor oriented.
For direct workers, the ideal method is to charge jobs or units produced by supplying per hour
rate calculated as below:
Rate per hour = Total of estimated monetary benefits and cost of non - monetary benefits
Budgeted direct labor hours – Normal idle time
Another alternative method is to treat the monetary benefits other than basic wages and dearness
allowance as well as cost of non-monetary benefits as overheads.
Efficiency Rating ProceduresEfficiency is usually related with performance and may be computed by
comparing the time taken with the standard time allotted to perform the given job/task. If the time taken
by a worker on a job is equal or less than the standard time, then he is rated efficient. In case he takes
more time than the standard time he is rated as inefficient. It may be computed as follows:
Efficiency in % = Time taken x 100

Time allowed as per standard
For efficiency rating of employees the following procedures may be followed:

Determining standard time performance standards:

The first step is to determine the standard time taken by a worker for performing a particular job/task. The
standard time can be determined by using Time & Motion Study or Work Study Techniques. While
determining the standard time for a job/task a heterogeneous group of workers is taken and contingency
allowances are added for determining standard time.
Measuring Actual Performance of workers:

For computing efficiency rating, it is necessary to develop a procedure for recording the actual
performance of workers. The system developed should record the output of each worker along with the
time taken by him.
Computation of efficiency rating:

The efficiency rating of each worker can be computed by using the above mentioned formula.
Need for efficiency rating:

1. As discussed earlier, when a firm follows a system of payment by results, the payment has a direct
relationship with the output given by a worker. The firm, for making payment to worker, is required
to ascertain his efficiency level. For instance, under Taylor’s differential piece work system the
lower rate i.e. 83% of piece rate is given to a worker when his efficiency rating is less than 100%
and higher rate viz., 125% of piece rate is offered at efficiency level of either 100% or more.
Similarly, under Emersion efficiency plans, bonus is paid at rising scale at various level of
efficiency, ranging from 66.67% to 150%.
2. The efficiency rating also helps the management in preparing labor requirement budget or preparing
manpower requirements. For example, let us assume that P. Ltd. manufactures two products by
using one grade of labor and the following estimates are available:
Product A Product B
Budgeted production (units) 3,480 4,000
Standard hours allowed per product 5 4
It is further worked out that the efficiency rating (efficiency ratio) for productive hours worked by direct
workers in actually manufacturing the production is 80%. The exact standard labor requirement, then, can
be worked out as follows:
Product A Product B Total

Budgeted production 3,480 4,000
(units)
Standard hours allowed 17.400 16,000 33,400
for budgeted production (3,480 units x 5 hrs.) (4,000 units x 4 hrs)
Since efficiency ratio is given as 80% therefore, standard labor hours required will be 41,750 hours
(33,400 hours x 100/80). Here, since workers collective efficiency ratio is 80%, in order to produce 1
product, the worker, in general, has to work for 6.25 hours (i.e. 5x100/80).

Labor productivity: Productivity is generally determined by the input/output ratio. In the case of labor it is
calculated as below:
Standard time for doing actual amount of work

Actual time taken to do work
Labor productivity is an important measure for measuring the efficiency of individual workers. It is an
index of efficiency and a sign of effectiveness in the utilization of resources - men, materials, capital,
power and all kinds of services and facilities. It is measured by the output in relation to input.
Productivity can be improved by reducing the input for a certain quantity or value of output or by
increasing the output from the same given quantity or value of input.
Factors for increasing labor productivity: The important factors which must be taken into consideration
for increasing labor productivity are as follows:
1. Employing only those workers who possess the right type of skill.
2. Placing a right type of man on the right job.
3. Training young and old workers by providing them the right types of opportunities.
4. Taking appropriate measures to avoid the situation of excess or shortage of labor at the shop floor.
5. Carrying out work study for the fixation of wage rate and for the simplification and standardization
of work.
3.10 ACCOUNTING FOR LABORS
The cost account department is responsible for the accumulation and classification of all labor costs. This
department uses time cards, job cards and payrolls for calculation of labor cost of various jobs, work
order processes etc.
Wages Analysis Sheet or Wages Abstract: The cost account department prepares the wage abstract in
order to determine the direct labor costs, indirect labor costs, departmental labor costs and difference
between budgeted labor costs and actual labor costs and to inform the management of the effectiveness of
its labor policies. In effect, the labor costs as recorded in the wage sheet are analyzed in the wage abstract.
The wages abstract is like material abstract and it is prepared with the help of time cards, job cards and
wages sheet. Columns may be provided in the wage abstract for wages to be charged as factory,
administration and selling and distribution overhead. A standard Wage Abstract will be as follows:

Accounting Entries:
Individual job accounts are debited from the wages abstract and the total amount charged to various jobs
is debited to work-in-progress account. The amount of wages which cannot be conveniently apportioned
to jobs is debited to overheads. Wages paid for normal idle time are debited to overheads or charged
proportionately to jobs and wages paid for abnormal idle time are debited to Costing Profit and Loss
Account. Thus the entries in the cost ledger are:
On payment of wages, the entry is:-
Wages control Account Dr.
To Cost Ledger Control Account
Bank or cash account is not credited, in an non integrated system where separate records are kept for
financial accounting and cost accounting purpose (explained in detail under Chapter 5), accounting for
transaction affective real accounts are made through Cost Ledger Control Account.
On charging of wages to WIP
Work-in-progress control Account Dr.
(With total labor costs of various jobs)
Overhead Control Account Dr.
To Wages control Account
(Being the transfer of direct wages to work in progress and indirect wages to overheads)
The accounting entries regarding labour have been explained in detail under Chapter 5 – Control
Accounts.

SUMMARY OF FORMULAE
1. Wage Payment and Incentive System:
(a) Time Rate System:
Earnings = Hours Worked x Rate per Hour
(b) Straight Piece Rate System:
Earnings = Number of Pieces x Rate per Piece
(c) Differential Piece Rate System
i) Taylor Differential Piece Rate System:
Efficiency
Less than 100% 83% of Normal Piece Rate
Either 100% or more than 100% 125% of Normal Piece Rate
ii) Merrick Differential Piece Rate System:
Efficiency
Upto 83% Normal Piece Rate
Above 83% and upto 100% 110% of Normal Piece Rate
Above 100% 120% of Normal Piece Rate
(d) Combination of Time and Piece Rate
i) Gantt Task and Bonus System:
Efficiency
Below 100% Guaranteed Time Rate
At 100% 120% of Time Rate
Above 100% High Piece Rate on worker’s
whole output
ii) Emerson’s Efficiency System:
Efficiency
Upto 66.67% Only Guaranteed Time Wage Rate
Above 66.67% and upto 100% (Actual Hours Worked x Time Rate per Hour) +
An increase in bonus according to degree of
efficiency on the basis of (Actual efficiency
attained – 66.67%) x Time Wages.
Note: Bonus can be maximum upto 20%
Above 100% (Actual Hours Worked x Time Rate per Hour) +
Bonus @ 20% of Time Wages + Additional
Bonus of 1% of each 1% increase in efficiency.
(e) Beadaux System:
Earnings = Hours Worked x Rate per Hour + (75% x Bedaux points saved/60 x Rate per
hour)
(f) Premium Bonus Plan
i) Halsey Premium Plan:
Earnings = Actual Hours Worked x Time Rate + (50% x Time Saved x Time Rate)
i.e. AH x R + 50% x (SH – AH) x R
ii) Rowan System:
Earnings = Actual Hours Worked x Time Rate + (Actual Hours / Time Allowed x Time

Saved x Time Rate)

i.e. AH x R + AH / SH x (SH – AH) x R
iii) Barth System:
Earnings = Rate per Hour x √Standard Hours x Actual Hours
2. Labour Turnover Ratio
$%&'() *+ (&,-*.((/ /(,0)0<(2 2%)=65 <>( ,()=*2
(a) Separation Method = x 100
34()05( 6%&'() *+ (&,-*.((/ 2%)=65 <>( /0&( ,()=*2
$%&'() *+ (&,-*.((/ )(,-01(2 2%)=65 <>( ,()=*2

(b) Replacement Method = x 100
34()05( 6%&'() *+ (&,-*.((/ 2%)=65 <>( /0&( ,()=*2
$%&'() *+ ;(,0)0<=*6/$%&'() *+ :(,-01(&(6</

(c) Flux Method = x 100
34()05( 6%&'() *+ (&,-*.((/ 2%)=65 <>( /0&( ,()=*2
$%&'() *+ ;(,0)0<=*6/$%&'() *+ 311(//=*6/

= x 100
34()05( 6%&'() *+ (&,-*.((/ 2%)=65 <>( /0&( ,()=*2


1. Describe briefly the functions of the following departments in relation to labor:
i. Personal department
ii. Engineering department
iii. Cost accounting department
i. Time keeping and Time booking
ii. Time study and motion study
3. What is idle time? Explain the causes leading to idle time and its treatment in cost accounts.
4. What do you mean by overtime premium? What are the causes of overtime and how would you
treat it in cost accounts?
5. What do you understand by labor turnover? How is it measured? What are the causes? What step
should be taken to check the increasing rate of labor turnover?
6. Explain the factors to be considered in introducing an incentive system.
7. Define job evaluation and distinguish it from merit rating. Explain the merits and objectives of
job evaluation.
8. (a) For reducing the labor cost per unit, which of the following factors is the most
important?
i. Low wage rates
ii. Higher input-output ratio
iii. Strict control and supervision
iv. Longer hours of work
(b)Which of the following statements are true?
i. Productivity of workers can be improved only if they are supervised closely.
ii. It is no use paying higher wages to labor because they would spend their money on
drinking and smoking.
iii. A well satisfied team of workers can raise productivity to a large extent.

i. Manpower planning requires a planned assessment of ………….
ii. Sunk costs are costs that are……………
iii. Time and motion study refers to………
iv. Job evaluation is an assessment of the relative value of ….. in an industry. It does not
analyze the individual merits of each worker.
10. In case of each of the sentences given below, which statement will correctly complete the
sentence?
i. The input output ratio in case of labor means the ratio of (a) the value of output to the
wages paid. (b) Standard time of the production to the actual time paid for. (c)
Abnormal idle time to normal idle time (d) Number of workers employed to the
sanctioned strength.
ii. Job specification is (a) the list of operations to be performed for completing the
concerned job (b) the requirement in terms of goods to be produced or work to be done.
(c) The list of qualities and qualifications which the employees concerned should have
to do the job well. (d) The name of the employees who will be assigned to a job.
iii. Job evaluation aims at (a) comparing a job with others so as to ascertain the proper
scale of remuneration for the job, (b) assessing the profitability of the job, (c) assessing

the requirement in terms of personnel required, (d) establishing the hierarchical position
of the holders of the job.
iv. Time and motion study is essential for (a) rational promotion policy (b) completing a
job on time (c) determining the standard-time and correct method of completing a task
(d) determining prices of products.
11. With which of the following statement do you agree?

i. Time keeping and time booking are one and the same.
ii. There is no need to record attendance of piece-rate workers since attendance is not relevant
for ascertaining the amount of wages to be paid.
iii. Time booking gives analysis of the time spent by workers on various jobs.
iv. Time keeping record gives us the standard time of workers.
v. A job card shows the arrival and departure time of workers.
vi. The idle time report should show normal idle-time separately from abnormal idle time.
12. Calculate the number of hours worked as overtime by the following workers in a week
considering provision of Labour Act:
Ram Shyam
Monday 8 8
Tuesday 7 9
Wednesday 4.5 8
Thursday 8 7
Friday 10 9
Saturday 9 9
46.5 50
13. Three workers A, B and C are put on a common task for which the total remuneration is Rs.
5,600. A works for 40 hours, B works for 60 hours and C works for 40 hours on the job. The
hourly rate is Re. 25 of A per hour; B gets Re. 20 per hour while C’s remuneration is Re. 15 per
hour. What should each man get?
14. The following particulars are available to you in respect of a worker:
Job No. Time allowed Time Taken

1844 26 hours 20 hours
1826 30 hours 20 hours
Idle time (waiting) 8 hours
48 hours
The basic rate is Rs. 100 per day of 8 hours in addition there is a dearness allowance of Rs. 600
per week of 48 hours. Calculate the wage of the worker on (i) Time basis (ii) Piece rate basis (iii)
Halsey Plan basis and (4) Rowan Plan Basis.
15. State which of the statement given under each of the following will complete the sentence
properly.
a. Attendance of workers on piece rate system (a) need not be recorded since attendance is
not relevant for ascertaining wages to be paid, (b) should be recorded to enforce
discipline, (c) should be recorded not only for discipline but also for payment of wages
for idle time

b. Piece rate should be determined (a) on the basis of time and motion studies (b) on the
basis of work done on time basis (c) having regard to the profitability.
c. Wages should preferably be (a) paid on time basis, (b) on piece rate system (c) the
same as paid to other workers (d) such as to guarantee a minimum but dependent on
results shown by the worker.
d. For costing purpose the wage rate per hour should comprise (a) basic wage and
dearness allowance, (b) as above plus all other expenses paid on behalf of or in respect
of workers, (c) as in (b) but dividing the total for a period by the effective hours of
work.
e. The benefit of time saved by a worker against the standard should (a) go wholly to the
employees (b) shared by the employer and the employee if the work is standardized, (c)
be shared by the two if it is not standardized, (d) go wholly to the employer.
f. Labor turnover means (a) the ratio of total sales to the labor cost, (b) the rate of change
in the composition of the labor force, (c) the ratio of number of those who leave to the
number freshly employed.
16. From the following data, calculate the labor turnover rate by applying:
(i) Separation method (ii) Accession method (iii) Flux method
Number of workers on payroll:

At the beginning of the month 1,800
At the end of the month 2,200
During the month 20 workers left, 80 workers were discharged and 500 workers
recruited. Of these 50 workers were recruited in the vacancies of those separated while
the rest were engaged due to expansion.
17. A worker is paid 10% bonus on the hourly rate of he completes his work in the allotted time and
a further 1% o hourly rate for each 1% in excess of 100% efficiency. His hourly rate is Rs 15 per
hour and he completes a job in 45 hours whereas the time allowed for it was 50 Hours. Ascertain
the wages earned by this worker.
18. The company has a suggestion box scheme and an award equivalent to one and a half month of
saving in labor cost is passed on to the employee whose suggestion is accepted. Suggestion of an
employee to use a Jig for a manufacturing operation of a component is accepted. The cost of the
Jig which has a life of one year is Rs. 1,000 and the use of the Jig will reduce the standard time
by 8 minutes.
Compute from the following data, the amount of award payable to the employees who has given
the suggestion.
i. Number of pieces to be produced in the year ; 15,000
ii. Standard time per piece before use of Jig : 80 Minutes
iii. Average wage rate of workmen Rs. 160 per day of 8 hours
iv. Average efficiency of workmen : 80%
19. The existing incentive system of a certain factory is :

Normal working week: 5 days of 9 hours each plus overtime of 3 hours for
3 days

Rate of Payment : For day work Rs. 20 per hour. For overtime Rs 30
per hour
Additional bonus payable: Rs 25 per day if worker is not resorting to overtime
Rs 40 per day, if worker resorts to overtime.
Average output per operative for 54 hour week i.e. normal working hours plus 3 hours
for 3 days late sitting for 3 days – 120 articles
In order to increase output and eliminate overtime it was decided to switch on to a

system of payment by result. The factory considering the introduction of some incentive
scheme or to make payment on piece work basis. Assuming that 135 articles are
produced in a 45 hour week and the additional bonus under the existing scheme will be
discontinued in the proposed incentive scheme. You are required to calculate:
(i) Weekly earning

(ii) Labour cost per article for an operative under the following system.
i. Existing time rate system
ii. Straight piece work system
iii. Rowan system
iv. Halsey System
The following information is obtained

Time Rate ( as usual) : Rs 20 per hour
Basic time allowed : for 15 articles 5 hours
Piece Work Rate : Add 20% to price
Premium bonus : Add 50% to time.
20. The unit has a strength of 20 workmen who worked for 300 working days of 8 hours each with
half an hour break based on earlier years trend, it is forcasted that average absenteeism per
workman would be 8 days, in addition to the eligibility of 30 days annual leave.
The following details regarding actual working of the unit are available for the year ending July 15,
2012.
i. The factory worked 2 extra days to meet the production targets, but one additional paid
holiday had to be declared.
ii. There was a severe breakdown of a major equipment leading to a loss of 300 man hours.
iii. Total overtime hours ( in addition to 2 extra days worked) amounted to 650 hours.
iv. The actual average absenteeism per workman was 8 days.
v. Basic rate is Rs 10 per hour and overtime is paid at double rate.
You are required to calculate.

(a) Actual working hour of the unit.
(b) In cost accounting, how would you treat wages of workmen for (ii) & (iii) above?
21. A job can be executed either through workman A or B. A takes 32 hours to complete the job
while B finishes it in 30 hours. The standard time to finish the job is 40 hours.

The hourly wage rate is same for both the workers. In addition workman A is entitled to receive
bonus accounting to Halsey plan (50%) sharing while B is paid bonus as per Rowan plan. The
works overhead are absorbed on the job at Rs 7.5 per labour hour worked. The factory cost of
the job comes to Rs. 2,600 irrespective of the workman engaged.
Find out the hourly wage rate and cost of raw material input. Also show cost against each
element of the cost included in factory cost.
Answer to Self Examination Questions

8. (a) ii ; (b) iii
9. (i) The total requirements of manpower at various levels of organization.
(ii) arise out of past decisions and cannot be done away with since such decision s cannot
be reversed.
(iii) a study to establish the proper method of performing a job and to determine the
standard time of the same.
(iv) Jobs
10. (i) b; (ii) c; (iii) a; (iv) d; (v) c;
11. (iii) and (iv)
12. Ram – None,
Shyam 2 hours
13. A. Rs. 1,500; B. Rs. 1,800; C. Rs. 900 [ hourly payment *1.5]
14. (i) Rs. 1,200; (ii) Rs. 1,400; (iii) Rs. 1,300 and (iv) 1,342.85
15. (i) c; (ii) a; (iii) d; (iv) c; (v) c; (vi) b;
16 (i) 5% ; (ii) 25% ; (iii) 30%;
17 Rs. 810
18 Rs. 6,250 [ Time saved 2,500 hours]
19 (a) (i) Rs 1,340 (ii) Rs. 11.17
(b) (i) Rs 1,080 (ii) Rs 8
(c) (i) Rs 1,200 (ii) Rs. 8.88
(d) (i) Rs 1,125 (ii) Rs 8.33
20 (a) Rs. 39,800 (b) The wages of workmen for (ii) would be charged to Costing Profit and Loss
Account and for (iii) should be charged to factory overhead.
21 Hourly wage rate is Rs. 10 and cost of raw material input is Rs. 2,000.

CHAPTER 4
OVERHEAD CONTROL
CHAPER 4 : OVERHEAD CONTROL
4.1 INTRODUCTION
Cost pertaining to a cost center or cost unit may be broadly divided into two portions i.e. direct and
indirect. The indirect portion of the total cost constitutes the overhead cost, which is the aggregate of
indirect material cost, indirect wages and indirect expenses. The term ‘indirect’ denotes that which cannot
be allocated but can be apportioned to or absorbed by cost centers or cost units. Broadly speaking, any
expenditure over and above prime cost is known as overhead.
4.2 CLASSIFICATION OF OVERHEADS
i. Classification of overheads by Function-

overheads are conveniently divided into three major heads, which are:
(i) Factory or Manufacturing overheads

(ii) Office and Administrative Overheads, and
(iii) Selling and Distribution overheads.
The division is made according to the service obtained from the expenses. If activity of selling benefits
from the money spent, it is selling expense; and if the money is spent in the workshop itself for producing
the goods, it is a factory expenses. For example, stationery used in the factory office will be a factory
expense, stationery used in the sales office will be a selling expense and stationery used in the general
office will be office and administrative expense.
In small factories, no distinction may be made between office and administrative expenses and selling and
distributive expenses. A big factory on the other hand, may, however, further sub-divide the main types of
overheads. For example, the works or factory expenses may be subdivided into materials handling
charges, labor overheads and general factory administration expenses etc. Similarly, office and
administrative expenses may be separated into administrative expenses comprising of salaries paid to the
executive officers and other expenses such as air condition expenses etc incurred so as to enable workers
to work.
Further, selling and marketing expenses will mean the expenses incurred in order to obtain an order from
the customer, for example, advertisement and showroom expenses. Distributive expenses will mean the
expenses incurred to move the goods from the company’s godown to the customer’s premises i.e. godown
expenses, packing and carriage outwards.
A detailed classification of such expenses is given below:
(i) Factory or Manufacturing Expenses:

• Stores overheads (expenses connected with purchasing and handling of materials);
• Labor overheads (expenses connected with labor); and
• Factory administration overheads (expenses connected with administration of the factory)
(ii) Office and Administration Expenses:

• Administrative expenses (expenses incurred on managerial personnel – their salaries, costs of

facilities provided to them and salaries of other office staff); and
• Office expenses (expenses incurred on the routine office work).
(iii) Selling and Distribution Expenses:

• Selling expenses (expenses incurred to persuade customers to purchase the firm’s production
and/ or engage its services so as to maintain and expand the market); and
• Distribution expenses are those which are incurred to execute orders. One should note that many
people use the two terms “selling” and “distribution” as synonymous.
Following are the definitions given by the Institute of Cost and Management Accountants of England:
Production Cost –The cost of sequence of operations which begins with supplying materials, labor and
services and ends with the primary packing of the product.
Selling Cost –The cost of seeking to create and stimulate demand, sometimes also termed as marketing,
and of securing orders.
Distribution Cost – The cost of ‘sequence’ of operations which begins with making the packed product
available for dispatch and ends with making the reconditioned returned empty package, if any, available
for re-use. This also includes expenditure incurred in moving articles to central or local storage including
expenditure incurred in moving articles to and from prospective customers for goods sold on sale or
return basis. In the gas, electricity and water industries ‘Distribution’ means pipes, mains and services
which may be regarded as equivalent to packing and transportation.
Administration Cost- These are cost of formulating policies, directing the organization and controlling the
operations of an undertaking which are not related directly to production, selling, distribution, research or
development activity or function.
Research and Development Expenses – The terminology defines “research expenses” as “the expenses of
searching for new or improved products, new application of materials, or new or improved methods.”
Similarly, development expenses are defined as “the expenses of the process which begins with
implementation of the decision to produce a new or improved product.”
If research is conducted in the methods of production, the research expenses should be charged to the
production overhead; while the expenditure becomes a part of the administration overhead if research
relates to administration. Similarly, market research expenses are charged to the selling and distribution
overhead. Development costs incurred in connection with a particular product should be charged directly
to that product. Such expenses are usually treated as “deferred revenue expenses,” and recovered as a cost
per unit of the product when production is fully established.
General research expenses of a routine nature incurred on new or improved methods of manufacture or
the improvement of the existing products should be charged to general overhead. Even in this case, if the
amount involved is substantial it may be treated as deferred revenue expenditure, and spread over the
period during which the benefit would accrue. Expenses on fundamental research, not relating to any
specific product, are treated as a part of the administration overhead. Where research proves a failure, the

cost associated with it should be excluding from costs and charged to the costing Profit and Loss
Account.
Expenses that are not taken into account –The under mentioned expenses are usually not included in
overheads or, for that matter in cost:
• Expenses or income of purely financial nature like dividends received, rent received,
cash discount allowed, etc.
• Expenses or profits of capital nature like profit or loss on sale of investments, plant and
equipment, etc.
• Items not representing actual costs but dependent on arbitrary decisions of the
management, e.g., an unreasonably high salary to the managing director, providing for
deprecation at a rate exceeding the economic rate.
• Appropriation of profits for dividends, payment of income tax and transfers to reserves.
ii. Classification of overheads by nature-

On a change in the level of activity different expenses behaves differently. On this consideration,
expenses are classified under the following three categories:
1. Fixed or Constant: These are expenses that are not affected by any variation in the volume of
activity, e.g., managerial remuneration, rent, that part of depreciation which is dependent purely
on efflux of time, etc. Fixed or constant expenses remain the same from one period to another
except when they are deliberately changed, e.g., on increments being granted to staff or
additional staff being engaged.
2. Variable: Expenses that change in proportion to the change in the volume of activity; when
output goes up by 10% the variable expenses also go up by 10%. Correspondingly, on a decline
of the output, these expenses also decline proportionately e.g., power consumed; consumable
stores; repairs and maintenance and depreciation ( on account of wear and tear) are dependent on
the use of assets.
Variable expenses are generally constant per unit of output or activity. Suppose variable
expenses amount to Rs. 10,000 for a production of 2,000 units i.e., Rs. 5 per unit. When output
goes up to 2,200 units, with an increase of 10%, the variable expenses amount to Rs. 11,000 i.e.,
10,000 plus 10%, however, the cost per unit will be the same as before.
3. Semi variable: The expenses that either (a) do not change when there is a small change in the
level of activity but change whenever there is a slightly big change and the changes are in small
steps; or (b) change in the same direction as change in the level of activity but not in the same
proportion. An expense for example, may not change if output goes up or comes down by 5%
but may change by 3% when there is an increase in production between 5% and 10%. Similarly,
another item of expense may change by 1% for every 2% change in activity. Examples of such
expenses are: delivery van expenses, telephone charges, depreciation as a whole.
4. Semi variable expenses usually have two parts – fixed and variable. For instance, the amount of
depreciation usually depends on two factors –one on time (fixed) and the other on wear and tear
(variable). The two together make depreciation (as a whole) semi-variable. A careful study can

make it possible for all semi-variable expenses to split up into two parts. Fundamentally,
therefore, there are only three types of expenses as shown in the chart below:
One must note that fixed expenses remain unchanged up to the limit of the present capacity. If output
goes beyond the capacity limit, fixed expenses will record a jump. Suppose a factory works one shift and
produces 10,000 units in the shift. For all levels of output of 10,000 units, fixed expenses will remain
unchanged; if the output goes beyond 10,000 units, a second shift will become necessary and this will
mean a big increase in fixed expenses such as salary for foremen, lighting etc.
Methods of segregating Semi variable costs into fixed and variable costs –
The segregation of semi-variable costs into fixed and variable costs can be carried out by using the
following methods:
a) Graphical method
b) High points and low points method
c) Analytical method
d) Comparison by period or level of activity method
e) Least squares method
a) Graphical method: Under this method, a large number of observations regarding the total costs at
different levels of output are plotted on a graph with the output on the X-axis and the total cost on the
Y-axis. Then, by judgment, a line of “best-fit”, which passes through all or most of the points, is
drawn. The point at which the line cuts the Y-axis indicates the total fixed cost component in the total
cost; if a line is drawn at this point parallel to the X-axis, this indicates the fixed cost. The variable
cost, at any level of output, is derived by deducting this fixed cost element from the total cost. The
following graph illustrates this:

b) High points and low points method: Under this method the difference between the total cost at
highest and lowest volume is divided by the difference between the sales value at the highest and
lowest volume. The quotient thus obtained gives us the rate of variable cost in relation to sales
value. The fixed cost is the remainder. See the following illustration.
Particular Sales value Total cost

Rs. Rs.
At the highest volume 140,000 72,000
At the lowest volume 80,000 60,000
Difference 60,000 12,000
Thus, Variable Cost =(Rs. 12,000/Rs. 60,000)

=1/5 or 20% of sales value
Taking the value at highest volume

The Variable cost = 20% of Rs 140,000
= Rs. 28,000 (at highest volume)
Fixed cost: = Rs.72,000 - Rs.28,000 i.e. (20% of Rs. 1,40,000)
=Rs. 44,000
Alternatively:
Taking the value at lowest volume
= Rs. 60,000-Rs. 16,000(20% of Rs. 80,000)
= Rs.44,000
(c) Analytical method- Under this method an experienced cost accountant tries to judge empirically what
proportion of the semi –variable cost would be variable and what would be fixed. The degree of
variability is ascertained for each item of semi-variable expenses. For example, some semi-variable
expenses may vary to the extent of 20% while others may vary to the extent of 80%, although it is

very difficult to estimate the extent of variability of an expense, the method is easy to apply. (Go
through the following illustration for clarity)
Illustration: 1
Suppose, last month the total semi-variable expenses amounted to Rs. 3,000. If degree of variability
is assumed to be 70%, then variable cost = Rs. 2,100 [ i.e. 70% of Rs 3,000]. Fixed cost, in that case,
would be Rs. 900 [Rs. 3,000 – Rs. 2,100 = Rs.900].
Now in the future months, the fixed cost will remain constant, but the variable cost will vary
according to the change in production volume. Thus, if in the next month production increases by
50%, the total semi-variable expenses will be:
Fixed cost of Rs. 900, plus variable cost viz., Rs. 3,150 i.e., (Rs. 2,100 (V.C.) plus 50% increase of
V.C. i.e. Rs. 1,050) i.e., Rs. 4,050.
(d) Comparison by period or level of activity method- Under this method, the variable overhead may be
determined by comparing two levels of output with the amount of expenses at those levels. Since the
fixed element does not change, the variable element may be ascertained with the help of the
following formula.
ℎ ℎ

ℎ ℎ
Suppose the following information is available:

Production units Semi-variable expenses
A. January 100 260
B. February 140 300
Difference = A - B 40 40
! $!.&'

The variable cost = = = Re. 1 per unit
"# &' !
Thus in January, the variable costs will be 100 x Rs. 1 = Rs. 100 and the fixed cost element will be
(Rs. 260 – Rs. 100) or Rs. 160. In February, the variable cost will be 140 x Re. 1 = Rs. 140, whereas
the fixed cost element will remain the same i.e. Rs. 160.
(e) Least squared method: This is the best method to segregate semi-variable costs into its fixed and
variable components. This is a statistical method and is based on finding out a line of best fit for a
number of observations.
The method uses the linear equation y = mx + c, where m represents the variable element of cost per unit,
‘c’ represents the total fixed cost, ‘y’ represents the total cost, ‘x’ represents the volume of output. The
total cost is thus split into its fixed and variable elements by solving this equation. By using this method,
the expenditure against an item is determined at various levels of output and values of x and y is fitted in
the above formula to find out the values of m and c. The following illustration may be helpful to
understand this method.

Level of Activity
Capacity % 60% 80%
Volume (Labor hours) x 150 200
Semi-variable expenses (maintenance of plant) = y Rs. 1,200 Rs. 1,275
Substituting the values of x and y in the equation, y = mx + c, at both levels of activity,we get 1,200
= 150 m + c
1,275 = 200 m + c
On solving the above equation, we get
fixed cost (c) = Rs.975
variable cost(m) = Rs. 1.50 per labor hour.
Advantages of classification of overheads into Fixed and Variable: The primary objective of segregating
semi-variable expenses into fixed and variable is to ascertain marginal costs. Besides this, it has the
following advantages also.
a) Controlling expenses: The classification of expenses into fixed and variable components helps in
controlling expenses. Fixed costs are generally policy costs, which cannot be easily reduced.
They are incurred irrespective of the output and hence are more or less non controllable.
Variable expenses vary with the volume of activity and the responsibility for incurring such
expenditure is determined in relation to the output. The management can control these costs by
giving proper allowances in accordance with the output achieved.
b) Preparation of budget estimates: The segregation of overheads into fixed and variable cost helps
in the preparation of flexible budget. It enables a firm to estimate costs at different levels of
activity and make comparison with the actual expenses incurred.
Suppose in October, 2013 the output of a factory was 1,000 units and the expenses were:
Rs.
Fixed 5,000
Variable 4,000
Semi-variable (40% fixed) 6,000
15,000
In November, 2013 the output was likely to increase to 1,200 units. In that case the budget
or estimate of expenses will be:
Rs.
Fixed 5,000
Variable 4,800
$!.&,''' ),*'' !
[ ]
),''' !
Semi-variable
40% (fixed) of Rs. 6,000 = 2,400
$!.+,,'' ),*'' !
Variable: = 4,320 6,720
),''' !
16,520

It would be a mistake to think that with the output going up from 1,000 units to 1,200 units the
expenses would increase proportionately to Rs. 18,000. This would be wrong budgeting.
c) Decision making: The segregation of semi variable cost between fixed and variable overhead
also helps the management to take many important decisions. For example, decisions regarding
the price to be charged during depression or recession or for export market. Likewise, decisions
on make or buy, shut down or continue, etc., are also taken after separating fixed costs from
variable costs. In fact, when any change is contemplated, say, increase or decrease in production,
change in the process of manufacture or distribution, it is necessary to know the total effect on
cost (or revenue), which would be impossible unless a correct segregation of fixed and variable
costs are made. The techniques of marginal costing, cost volume profit relationship and break-
even analysis are all based on such segregation.
4.3 ACCOUNTING AND CONTROL OF MANUFACTURING OVERHEADS
We have already seen that overheads are by nature those costs which cannot be directly related to a
product or to any other cost unit. Yet for working out the total cost of a product or a unit of service, the
overheads must be included. Thus we have to find out a way by which the overheads can be distributed
over various units of production.
One method of working out the distribution of overheads over the various products could be to ascertain
the amount of actual overheads and distribute them over the products. This however, creates a problem
since the actual amount of overheads can be known only after the financial accounts are closed. If we wait
that long, the cost sheets lose their main advantages and utility to the management. All the decisions for
which cost sheets are prepared are immediate decisions that cannot be postponed till the actual overheads
are known. Therefore, some method has to be found by which overheads can be included in the cost of
the products, as soon as prime cost, the cost of raw materials, labor and other direct expenses, is
ascertained. One method is to work out pre-determined rates for absorbing overheads. These rates are
worked out before an accounting period begins by estimating the amount of overheads and the level of
activity in the ensuing period. Thus, as soon as the prime cost of a product or a job is available, the
various overheads are charged by these rates. Of course, this implies that the overheads are charged on an
estimated basis. Later, when the actual overheads are known, the difference between the overheads
charged to the products and actual overheads is worked out and adjusted.
Manufacturing Overheads: Generally manufacturing overheads form a substantial portion of the total
overheads. It is important, that such overheads should be properly absorbed over the cost of production.
The following procedure may be adopted in this regard. The steps given below shows, how factory
overhead rates are estimated and how these overheads are absorbed while determining cost. Further the
steps also points out the ways to compare actual overhead with the absorbed amount.
a) Estimation and collection of manufacturing overheads: The first stage is to estimate the amount of
overheads, keeping in view the past figures and adjusting them for known future changes. There are
four main sources available for collection of factory overheads viz. (a) invoices (b) stores requisition
(c) wage analysis book (d) journal entries.
b) Cost allocation: The term ‘allocation’ implies relating overheads directly to the various departments.
The estimated amount of various items of manufacturing overheads should be allocated to various

cost centers or departments. The salary of the works manager cannot be directly allocated to any one
department since he looks after the whole factory. It is, therefore, obvious that many overhead items
will remain unallocated after this step.
c) Cost apportionment: At this stage, those items of estimated overheads (like salary of works manager)
which cannot be directly allocated to the various departments and cost centers are apportioned.
Apportionment implies “allotment of proportions of items of cost to cost centers and departments”. It
implies that the unallocable expenses are to be spread over various departments or cost centers on an
equitable basis. After this stage, all the overhead costs would have been either allocated to or
apportioned over the various departments.
d) Re-apportionment: The next stage is to re-apportion the overhead costs of service departments over
production departments. Service departments are those departments which do not directly take part in
the production of goods. Such departments provide ancillary services. Examples of such departments
are boiler house, canteen, stores, time office, dispensary etc. The overheads of these departments are
to be re-apportioned over the production departments since service departments operate primarily for
the purpose of providing services to production departments. At this stage, all the factory overheads
are collected under production departments.
e) Absorption: The production department overheads are absorbed over production units. The overhead
expenses can be absorbed by estimating the overhead expenses and then working out an absorption
rate. When overheads are estimated, their absorption is carried out by adopting a pre-determined
overhead absorption rate. This rate can be calculated by using any one method as discussed in this
chapter at the end.
As the actual accounting period begins, each unit of production automatically absorbs a certain
amount of factory overheads through pre-determined rates. During the year a certain amount will be
absorbed over the various products. This is known as the total amount of absorbed overheads.
f) Treatment of over and under absorption of overheads: After the year end, the total amount of actual
factory overheads is known. There is bound to be some difference between the actual amount of
overheads and the absorbed amount of overheads. The difference has to be adjusted keeping in view
of such differences and the reasons therefore.
Students will thus see that the whole discussion as above is meant to serve the following two
purposes:
a. To charge various products and services with an equitable portion of the total amount of factory
overheads; and
b. To charge factory overheads immediately as the product or the job is completed without waiting
for the figures of actual factory overheads.
4.4 ACCOUNTING AND CONTROL OF ADMINISTRATIVE OVERHEADS
Definition : According to I.C.M.A. Terminology, Administrative overhead is defined as “The sum of

those costs of general management and of secretarial accounting and administrative services, which
cannot be directly related to production, marketing, research or development functions of the enterprise. “

According to this definition, administrative overhead constitutes the expenses incurred in connection with
the formulation of policy directing the organization and controlling the operations of an undertaking.
These overheads are also collected and classified in the same way as the factory overheads.
Accounting of Administrative overheads: There are three distinct methods of accounting of

administrative overheads, which are briefly discussed below:
a. Apportioning Administrative Overheads between Production and Sales Departments:

According to this method administrative overheads are apportioned over production and sales
departments. The reason for the apportionment of overhead expenses over these departments recognizes
the fact that administrative overhead are incurred for the benefit of both of these departments. Therefore
each department should be charged with proportionate share of the same when this method is adopted,
administrative overhead lose their identity and get merged with production and selling and distribution
overheads.
Disadvantages:
a) It is difficult to find suitable bases of administrative overhead apportionment over production

and sales departments.
b) Lot of clerical work is involved apportioning overheads.
c) It is not justified to apportion total administrative overheads only over production and sales
departments when other equally important department like finance is also there.
b. Charging to Profit and Loss Account;

According to this method administrative overheads are charged to Costing Profit and Loss Account. The
reason for charging to Costing Profit & Loss are firstly, the administrative overhead are concerned with
the formulation of policies and thus are not directly concerned with either the production or the selling
and distribution functions. Secondly, it is difficult to determine a suitable basis for apportioning
administrative overheads over production and sales departments. Lastly, these overheads, in general, are
the fixed costs. In view of these arguments, administrative overheads should be charged to Profit and
Loss Account.
Disadvantages:
a) Cost of products is understated as administrative overheads are not charged to costs.
b) The exclusion of administrative overheads from cost of products is against sound accounting
principle.
c. Treating Administrative Overheads as a separate addition to Cost of Production/Sales :

This method considers administration as a separate function like production and sales and, as such costs
relating to formulating the policy, directing the organization and controlling the operations are taken as a
separate charge to the cost of jobs or a product sold along with the cost of other functions. The basis
which are generally used for apportionment are :
a) Works cost
b) Sales value or quantity
c) Gross profit on sales
d) Quantity produced
e) Conversion cost, etc.

Control of Administrative Overheads: Mostly administrative overheads are of fixed nature, and they
arise as a result of management policies. These fixed overheads are generally non-controllable. But at the
same time these overheads should not be allowed to grow disproportionately. Some degree of control has
to be exercised over them. The methods usually adopted for controlling administrative overheads are as
follows:
i. Classification and analysis of overheads by administrative departments according to their

functions and a comparison with the accomplished results: According to this method the expenses
incurred by each administrative department are collected for each standing order number for each
class of expenditure. These are then compared with similar figures of the previous period in
relation to accomplishment. Such a comparison will reveal efficiency or inefficiency of the
concerned department. However, this method provides only a limited degree of control and
comparison does not give useful results if the level of activity is not constant during the period
under comparison. To overcome this difficulty, overhead absorption rates may also be compared
from period to period; the extent of over or under absorption will reveal the efficiency or otherwise
of the department. It may be possible to compare the cost of a service department with that of
similar services obtainable from outside and a decision may be taken whether it is economical to
continue the department or entrust the work to outsiders.
ii. Control through Budgets – According to this method, administration budgets (monthly or
annually) are prepared for each department. The budgeted figures are compared with actual ones to
determine variances. The variances are analyzed and responsibility assigned to the concerned
department to control these variances.
iii. Control through Standard –Under this method, standards of performance are fixed from each
administrative activity, and the actual performance is compared with the standards set. In this way,
standards serve not only as yardstick of performance but also facilitate control of costs.
Illustration: 2
In an engineering company, the factory overheads are recovered on a fixed percentage basis on direct
wages and the administrative overheads are absorbed on a fixed percentage basis on factory costs.
The company has furnished the following data relating to two jobs undertaken by it in a period:
Job 101 (Rs.) Job 102 (Rs.)
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Selling price 166,650 128,250
Profit percentage on the total cost 10% 20%
Required:
i) Computation of percentage recovery rate of factory overheads and administrative overheads.
ii) Calculation of the amount of factory overheads, administrative overheads and profit for each of
the two jobs.
iii) Using the above recovery rates fix the selling price of job 103. The additional data being:
Direct materials Rs. 24,000
Direct wages Rs.20,000
Profit percentage on selling price 12.5%

Solution
i) Let factory overhead recovery rate as percentage of direct wages be F and administrative
overhead recovery rate, as percentage of factory cost be A.
Factory cost of Jobs:
Job 101 = Rs. 96,000 + Rs. 42,000 F
Job 102 = Rs. 67,500 + Rs. 30,000 F
Total cost of production of Jobs:

Job 101 = (Rs. 96,000 + Rs. 42,000 F) + (Rs. 96,000 + Rs. 42,000 F) A = Rs. 151,500
Job 102 = (Rs. 67,500 + Rs. 30,000 F) + (Rs. 67,500 + Rs. 30,000 F) A = Rs. 106,875
(Refer to working note)
On solving above relations: F= 0.60 and A = 0.25
Hence, percentage recovery rates of factory overheads and administrative overheads are 60% and
25% respectively.
Working note:
Job 101 Job 102
Total cost of production (Rs.) 151,500 106,875
(Rs. 166,650/110%) (Rs. 128,250/120%)
ii) Statement of Jobs, showing amount of factory overheads, administrative overheads and profit
Job 101 Job 102

Rs. Rs.
Prime cost 96,000 67,500
Factory overheads: 60% of direct wages 25,200 18,000
Factory Cost 121,200 85,500
Administrative overheads: 25% of factory cost 30,300 21,375
Total cost 151,500 106,875

Profit (balancing figures) 15,150 21,375
Selling price 166,650 128,250
Selling price of Job 103

Rs.
Direct materials 24,000
Direct Wages 20,000
Prime cost 44,000
Factory overheads: 60% of direct wages 12,000

Factory Cost 56,000

Administrative overheads: 25% of factory cost 14,000
Total cost 70,000
Profit (balancing figures) 10,000
Selling price (Total cost/87.5%) 80,000
4.5 ACCOUNTING AND CONTROL OF SELLING AND DISTRIBUTION OVERHEADS
Selling cost (or selling overhead) is the expense incurred for the purpose of promoting the marketing and
sales of different products. Distribution expenses, on the other hand, are expenses relating to delivery and
dispatch of goods sold. From the definitions, it is clear that the two types of expenses represent two
distinct types of functions. Some concerns however group these two overhead expenses into one
composite class, namely, selling and distribution overhead, for the purpose of Cost Accounting.
i. Accounting of Selling and Distribution Overheads
The collection and accumulation of each expense is made by means of appropriate standing order
numbers in the usual way. Where it is decided to apportion a part of the administrative overhead to the
selling division the same should also be collected through appropriate standing order numbers.
As in the case of administrative overheads, it is not easy to determine an entirely satisfactory basis for
computing the overhead rate for absorbing selling overheads. The bases usually adopted are : (a) Sales
value of goods; (b) Cost of goods sold ; (c) Gross Profit on sales; and (d) Number of orders or units sold.
It is considered that the sale value is ordinarily the most logical basis, there being some connection
between the amount of sales and the amount of expenses incurred to achieve them. The cost of
production, however, is not so satisfactory since it is difficult to conceive of any relationship, even
remote, between the cost of production of any article and its selling cost. Articles having a high cost of
production may require little effort in their sale and vice versa.
The basis of gross profit on sales results in a larger share of the selling overhead being applied to goods
yielding a large margin of profit and vice versa. The basis therefore follows the principle of ‘ability to
pay; it may not reflect costs or incurred efforts.
An estimated amount basis – The best method for absorbing selling and distributing expenses over
various products is to separate fixed expenses from variable expenses. Apportion the fixed expenses
according to the benefit derived by each product and thus ascertaining the fixed expenses per unit. We
give below some the fixed expenses and the basis of apportionment:
Expenses Basis
Salaries in the Sales Department and of the Estimated time devoted to the sale of various products
sales men
Advertisement Actual amount incurred for each product since these
days it is usual to advertise each product separately;
common expenses, such as in an exhibition, should be
apportioned on the basis of advertisement expenditure

on each product.
Show Room expenses Average space occupied by each product.
Rent of finished goods go downs and Average quantities delivered during a period.
Expenses on own delivery vans
If a suitable basis for apportioning expenses does not exist it may be apportioned in the proportion of
sales of various products.
The total of fixed expenses apportioned in this manner, divided by the number of units sold or likely to be
sold, will give the fixed expenses per unit. To this should be added the variable expenses which will be
different for each product. These expenses are, packaging, freight outwards, insurance in transit,
commission payable to salesmen, rebate allowed to customers, etc. all these items will be worked out per
unit for each product separately. These items added to fixed expenses per unit will give an estimated
amount of the selling and distribution expenses per unit.
ii. Control of Selling and Distribution Overheads:

Control of selling and distribution expenses is a difficult task. The reasons for this are as follows:
a) The incidence of selling and distribution overheads depends mainly on external factors, such as
distance of market, extent and nature of competition, terms of sales, etc. which are beyond the
control of management.
b) These overheads are dependent upon the customer’s behavior, their liking and disliking, tastes,
etc. therefore, as such control over the overheads may result in loss of customers.
c) These expenses being of the nature of policy costs are not amenable to control.
In spite of the above difficulties, the following methods may be used for controlling them.
a. Comparison with past performance
According to this method, selling and distribution overheads are compared with the figures of the
previous period. Alternatively, the expenses may be expressed as a percentage of sales, and the
percentages may be compared with those of the past period. This method is suitable for small
concerns.
b. Budgetary Control
A budget is set up for selling and distribution expenses. The expanses are classified into fixed and
variable. If necessary, a flexible budget may be prepared indicating the expenses at different levels of
sales. The actual expenses are compared with the budgeted figures and in the case of variances
suitable actions are taken.
c. Standard Costing
Under this method, standards are set up in relation to the standard sales volume. Standards may be set
up for salesmen, territories, products etc. Once the standards are set up, comparison is made between
the actual and standards: variances are enquired into and suitable action taken.
Illustration: 3
A company which sells four products, some of them unprofitable, proposes discontinuing the sale of one
of them. The following information is available regarding income, costs and activity for the year ended 15
July 2013.

Products
A B C D
Sales (Rs.) 300,000 500,000 250,000 450,000
Cost of Sales (Rs.) 200,000 450,000 210,000 225,000
Area of Storage (sq.ft) 50,000 40,000 80,000 30,000
Number of parcels sent 100,000 150,000 75,000 175,000
Number of invoices sent 80,000 140,000 60,000 120,000
Selling and distribution overheads and the basis of allocation are:

Rs. Basis of allocation to
products
Fixed Costs:
Rent and Insurance 30,000 Sq.ft.
Depreciation 10,000 Parcel
Salesmen’s salaries & expenses 60,000 Sales Volume
Administrative wages and salaries 50,000 No. of invoices
Variable Costs:
Packing wages & materials 20 paisa per parcel
Commission 4% of sales
Stationery 10 paisa per invoice
You are required to prepare Profit and loss statement, showing the percentage of profit or loss to sales
for each product.
Solution
Statement of Profit or loss on various products during the year ended July 15, 2013
Product
Total Rs. A Rs. B Rs. C Rs. D Rs.
Sales 1,500,000 300,000 500,000 250,000 450,000
Variable costs:
Cost of sales 1,085,000 200,000 450,000 210,000 225,000
Commissions 4% of sales 60,000 12,000 20,000 10,000 18,000
Packing wages & materials @ 20
paisa per parcel 100,000 20,000 30,000 15,000 35,000
Stationery @ 10 paisa per invoice
40,000 8,000 14,000 6,000 12,000
Total variable costs 1,285,000 240,000 514,000 241,000 290,000

Contribution (Sales – Variable costs) 215,000 60,000 (14,000) 9,000 160,000
Fixed Costs:
Rent & Insurance 30,000 7,500 6,000 12,000 4,500
Depreciation 10,000 2,000 3,000 1,500 3,500
Salesmen’s salaries & exp. 60,000 12,000 20,000 10,000 18,000
Adm. Wages and salaries 50,000 10,000 17,500 7,500 15,000
Total Fixed costs 150,000 31,500 46,500 31,000 41,000
Profit or loss (contribution – fixed cost) 65,000 28,500 (60,500) (22,000) 119,000
Percentage of profit or loss on sales 4.3 9.5 (12.1) (8.8) 26.4

Concepts related to capacity
a) Rated capacity:
It refers to the capacity of a machine or a plant as indicated by its manufacturer. In fact this capacity is the
maximum possible productive capacity of a plant. It is also known as the installed capacity of a plant.
Due to the loss of operating time of a plant it is difficult to achieve this rated capacity. In other words, it is
only a theoretical capacity, and is therefore, seldom achieved.
b) Practical capacity:
It is defined as actually utilized capacity of a plant. It is also known as operating capacity. This capacity
takes into account loss of time due to repairs, maintenance, minor breakdown, idle time, set up time,
Saturdays and holidays, stock taking etc. Generally, practical capacity is taken between 80% and 90% of
the rated capacity. It is also used as a base for determining overhead rates. Practical capacity is also called
net capacity and available capacity.
c) Normal capacity:
It is the capacity of a plant which is expected to be utilized over a long period based on sales expectancy.
The determination of this capacity considers the average utilization of plant capacity during one full
business cycle which may extend to over 2 to 3 years. It is also known as average capacity and is used to
compute overhead recovery rate.
d) Capacity based on sales expectancy:

It is the capacity of a plant utilized based on sales expectancy.
e) Actual capacity:
It is the capacity actually achieved during a given period. This capacity may lie between practical
capacity and capacity based on sales expectancy.
f) Idle capacity:
It is that part of the capacity of a plant, machine or equipment which cannot be effectively utilized in
production. In other words, it is the difference between the practical or normal capacity and capacity
utilization based on expected sales. For example, if the practical capacity of production of a machine is to
the tune of 10,000 units in a month, but is used only to produce 8,000 units, because of public demand of
the product, then in such a case, 2,000 units will be treated as idle capacity of the machine.
The idle capacity may arise due to lack of product demand, non-availability of raw material, shortage of
skilled labor, absenteeism, shortage of power, fuel or supplies, seasonal nature of product etc.
Idle capacity cost:

Costs associated with idle capacity are mostly fixed in nature. These include deprecation, repairs and
maintenance charges, insurance premium, rent, rates, management and supervisory costs. These costs
remain unabsorbed or unrecovered due to under utilization of plant and service capacity.
-. /.0 .10 1

Idle capacity cost = X Idle capacity
2.1 31 4#
Treatment of Idle capacity costs:

Idle capacity costs can be treated in product costing, in the following ways:

i. If the idle capacity cost is due to unavoidable reasons such as repairs, maintenance,
changeover of job etc, a supplementary overhead rate may be used to recover the idle
capacity cost. In this case, the costs are charged to the production capacity utilized.
ii. If the idle capacity is due to avoidable reasons like faulty planning, power failure, etc. the
cost should be charged to profit and loss account.
iii. If the idle capacity cost is due to seasonal factors, then, the cost should be charged to the
cost of production by inflating overhead rates.
g) Idle facility:
The term ‘facility’ has a wider connotation which may also include production capacity. Facilities may be
provided by fixed assets such as building space, plants equipment capacity, etc. or by various service
functions such as material services, production services, personal services etc. If a firm fails to make full
use of the facilities at its disposal, the firm may be said to have idle facilities. Thus idle facilities refer to
that part of the facilities which remain unutilized due to any reason such as non availability of raw
material, power, lack of demand etc. In cost accounting idle facilities are treated in the same way as those
of idle capacity.
4.6 STEPS FOR THE DISTRIBUTION OF OVERHEADS
The various steps for the distribution of overheads have been discussed in detail as below:
Estimation and Collection of Manufacturing Overheads

The amount of factory overheads is required to be estimated. The estimation is usually done with
reference to past data adjusted for known future changes. The overhead expenses are usually collected
through a system of standing orders.
Standing Orders:
In every manufacturing business, expenses are incurred on direct materials and direct labor in respect of
several jobs or other units of production, manufacture of which is undertaken. The incurring of these
expenses is authorized by production orders or work orders. The work order numbers are not ordinarily
fixed or permanent. They are generally allotted in a serial order according to the number of manufacturing
jobs undertaken by the business. In addition, indirect expenses are incurred in connection with the
rendering of services to the production departments, or to the manufacturing process. The term “Standing
Order” denotes sanction for indirect expenses under various heads of expenditure.
In large factories, usually the classification of indirect expenditures is combined with a system of
Standing Orders (sometimes also referred as Service “Orders”). It is a system under which a number is
allotted to each item of expense for the purpose of identification, and the same is continued from year to
year. All the indirect expenditure in such a case is charged to one or the other of the Standing Orders and
periodical summaries, giving total of each Standing Order, are prepared for comparison with budgets, as
well as for apportioning them among the various departments. The extent of such analysis and the
nomenclature adopted are settled by the management according to the needs of the industry.
Codification of Overheads:
Coding is a technique of intelligently describing in numbers/letters or a combination of both, the lengthy
description of numerous cost accounting heads for ease of recording and controlling of the cost data
generated. Codes are developed after accepting/developing a coding system.

Objectives of Codification:
The important objectives of codification of overheads are as follows:
1. To group items of similar nature, which are amenable to apportionment of overhead expenses on the
same basis.
2. To facilitate the task of allocation and apportionment of overheads over different departments or cost
centers.
3. To carry out an analysis of overhead expenses for control purposes.
4. To reduce the task of maintaining a huge number of accounts.
5. To help the task of machine accounting system in large organization.
Methods of Codification:
The important methods of codification of overheads are as follows:
a) Straight Numbering System : Under this system each type of expenditure is allotted a fixed number,
for example
1. Standing order number; 10 for indirect material
2. Standing order number; 11 for indirect labor
b) Number Blocks: According to this method, a block of numbers is generally earmarked to indicate the
major heads of expenditure e.g. 1-50 for service labor, 51-100 for maintenance: 101-150 for fringe
benefits etc.
c) Combination of Systems and Numbers: Under this method a combination of symbol alphabet and a
number is used to represent a code. Here symbol alphabet stands for building and machines
respectively. In other words :
1. R1 – Repair of buildings.
2. R2 – Repair of machines.
d) Field Method or Numerical Code: Under this method codes used are numeric in nature and each
code number usually consist of several (say nine) digits. Out of which, the first two digits indicate the
nature of expenses viz. variable or fixed. The next three digits indicate head of expense: the next two
digits stand for the analysis of expenses and last two digits indicate the cost centre, where expenses
have been incurred. For example in code 101200105 ; 10 stands for variable cost : 120 for idle time;
01 for waiting of materials and 05 for lathe shop or ;
Code Particulars
a. 10/120/105 Variable/Idle time/Waiting for Mat/Lathe Shop
There size of codes ( whether it is 9 digit or more or less) depends upon the depth of information required
to be recorded and also the capability of the system in use.
e) The Mnemonic Method: Under this method English alphabets are used as codes. For example R.F.B.
may be used as a code for repairing factory building.
Out of the above five methods, the field method is considered to be most suitable for the purpose of
codification of overhead expenses in large size business organization. The main plus point of this
method is that a code given to an item of expense represents four of its characteristics as mentioned
above. Also another feature of this method is that a large number of items of overhead expenses can

be accommodated under this type of codification. Lastly this method is easy to operate in case
mechanical system of accounting is in vogue in the concern.
i. Allocation of overheads over various Departments or Departmentalization of Overheads:

Most of the manufacturing processes functionally are different and are performed by different
departments in the factory. For example, some of the departments are engaged in actual production of
goods whereas others are mainly engaged in providing ancillary services.
Hence, it may, sometimes, become necessary to sub-divide a manufacturing organization into several cost
centers, so that a closer distribution of expenses and a more detailed control can be exercised. It is thus
obvious that the principal object of setting up cost centers is to collect data, in respect of similar activities,
more conveniently. This avoids a great deal of cost analysis. When costs are collected by setting up cost
centers, several items can be ascertained definitely and the element of estimation is reduced considerably.
There are two main types of cost centers such as “machine or personal” depending on whether the process
of manufacture is carried on at a center by man or machine. For the convenience of recording of
expenditure, cost centers are sometimes allotted a code number.
Advantages of Departmentalization: The collection of overheads department wise gives rise to the
following advantages:
1. Expenses that are directly related to specific departments can be estimated almost on an exact
basis and, to that extent, the accuracy of estimation of overheads will be higher.
2. For the purpose of controlling expenses in a department, it is obviously necessary that the figures
in relation to each department should be separately available. It is one of the main principles of
control that one should know for each activity how much should have been spent and how much
is actually spent. If information about expenses is available only for factory as a whole, it will
not be possible to know which department has been over spending.
3. From the point of view of ascertaining the cost of each job, the expenses incurred in the
departments through which the job or the product has passed should be known. It is only then
that the cost of the job or the product can be charged with the appropriate share of indirect
expenses. It is not necessary that a job must pass through all the departments or that the work
required in each department should be the same for all jobs. It is, therefore, necessary that only
appropriate charge in respect of the work done in the department is made. This can be done only
if overheads for each department are known separately.
4. A suitable method of costing can be followed differently for each department e.g., batch costing
when a part is manufactured, but single or output costing when the product is assembled.
ii. Apportioning overhead expenses over various departments and re-apportioning service
department overheads over production department:
After the allocable overheads are allocated to concerned departments, expenses that are incurred
collectively for several departments, e.g. rent, power, lighting, insurance and depreciation etc, have to be
apportioned over each of the departments,. For distributing these overheads over different departments
benefiting thereby, it is necessary at first to determine the proportion of benefit received by each
department and then distribute the total expenditure proportionately on that basis. But the same basis of
apportionment cannot be followed for different items of overheads since the benefit of service to a
department in each case has to be measured differently. Some of the basis that is generally adopted for the
apportionment of expenses is stated below:

Basis Expense Items

Area or cubic measurement of department Rent, rates, lighting & building
maintenance
Direct labor hours or, where wage rates are more or Supervision
less uniform, total direct wages of department.
Number of employees in department Supervision
Cost of material used by departments Material handling charges
Value of assets Depreciation and insurance
Horse power of machines Power
Other basis of apportioning overhead costs: We have considered already that the benefit received by the
department generally is the principal criterion on which the costs of service departments or common
expenses are apportioned. But other criteria are equally valid.
Three of them are mentioned below:
i. Analysis or Survey of existing conditions: At times it may not be possible to determine the advantage
of an item of expenses without undertaking an analysis of expenditure. For example, lighting
expenses can be distributed over departments only on the basis of the number of light points fixed in
each department.
ii. Ability to pay: It is a principle of taxation which has been applied in cost accounting as well for
distributing the expenditure on the basis of income of the paying department, on a proportionate
basis. For example, if a company is selling three different products in a territory, it may decide to
distribute the expenses of the sales organization to the amount of sales of different articles in these
territories. This basis, though simple to apply, may be inequitable since the expenditure charged to an
article may have no relation to the actual effort involved in selling it. Easy selling lines thus may
have to bear the largest proportion of expenses
iii. Efficiency or Incentives: Under this method, the distribution of overheads is made on the basis of pre-
determined levels of production or sales. When distribution of overhead cost is made on this basis
and if the level of production exceeds the pre-determined level of production the incidence of
overhead cost gets reduced and the total cost per unit of production or of sales gets lowered. The
opposite is the effect if the assumed levels are not reached.
A single concern may have only one criterion under consideration predominantly or may use all
(including the service or benefit criterion) for different phases of its activity.
Inter-departmental service costs: At first, expenses of all departments are complied without making a
distinction between production and service departments. Then the expenses of the service departments are
apportioned among the production departments on a suitable basis. This is because ultimately the
overhead are to be absorbed over goods produced or jobs completed in the production departments.
The re-apportionment of service department expenses over the production departments may be carried out
by using any one of the following methods:

1. Direct re-distribution method:

Service department costs under this method are apportioned over the production departments only,
ignoring the services rendered by one service department to the other. To understand the application of
this method goes through the illustration which follows.
Illustration: 4
XL Ltd. has three production departments and four service departments. The expenses for these
departments as per Primary Distribution Summary are as follows:
Production Departments:
Rs. Rs.
A 30,000
B 26,000
C 24,000 80,000
Service Department:
Rs. Rs.
Stores 4,000
Time keeping and accounts 3,000
Power 1,600
Canteen 1,000 9,600
The following information is also available in respect of the production department:

Department A Department B Department C
Horse power of Machine 300 300 200
Number of workers 20 15 15
Value of stores requisition in (Rs) 2,500 1,500 1,000
Apportion the cost of service departments over the production departments.
Solution
Secondary Overhead Distribution Statement
Items of cost (as per primary Basis of Total Production Departments
distribution summary stores) apportionment
Rs. A (Rs.) B (Rs.) C (Rs.)
Cost as per primary distribution 80,000 30,000 26,000 24,000
summary
Stores Value of stores 4,000 2,000 1,200 800
requisition (5:3:2)
Time-keeping and Accounts No. of workers 3,000 1,200 900 900
(4:3:3)
Power H.P. of M/C’s (3:3:2) 1,600 600 600 400
Canteen No. of workers 1,000 400 300 300
(4:3:3)
89,600 34,200 29,000 26,400

2. Step Method or Non-reciprocal method:

This method gives cognizance to the service rendered by service department to another service
department. Therefore, as compared to previous method, this method is more complicated because a
sequence of apportionments has to be selected here. The sequence here begins with the department that
renders service to the maximum number of other service departments. In other words the cost of the
service department which serves the largest number of other service and production departments is
distributed first. After this, the cost of service department serving the next largest number of departments
is apportioned.
This process continues till the cost of last service department is apportioned. The cost of last service
department is apportioned among production departments only.
Some authors are of the view that the cost of service department with largest amount of cost should be
distributed first. Refer to the illustration which follows to understand this method.
Illustration: 5
Suppose the expenses of two production departments A and B and two service departments X and Y are as
under:
Amount Apportionment Basis

Rs. Y A B
X 2,000 25% 40% 35%
Y 1,500 - 40% 60%
A 3,000
B 3,200
Solution
Overhead Distribution
Departments X (Rs.) Y (Rs.) A (Rs.) B (Rs.)
Amount as given above 2,000 1,500 3,000 3,200
Expenses of X Dept. apportioned over Y, A and B
Dept. in the ratio (5:8:7)
(2,000) 500 800 700
Expenses of Y Dept. apportioned over A and B Dept.
in the ratio (2:3)
- (2,000) 800 1,200
Nil Nil 4,600 5,100
3. Reciprocal Service Method :

This method recognizes the fact that where there are two or more service departments they may render
services to each other and, therefore, these inter-departmental services are to be given due weight while
re-distributing the expenses of the service departments.
The methods available for dealing with reciprocal services are:

i) Simultaneous equation method:

According to this method firstly, the costs of service departments are ascertained. These costs are then re-
distributed to production departments on the basis of given percentages. (Refer to the following
illustration to understand the method)
Illustration: 6
Service Department expenses:
Rs.
Boiler House 3,000
Pump Room 600
3,600
The allocation is:

Production Department Boiler House Pump Room
A B
Boiler House 60% 35% - 5%
Pump Room 10% 40% 50% -
Solution
The total expenses of the two service departments will be determined as follows:
Let B stands for Boiler House and P stands for Pump Room expenses.
Then,
B = Rs. 3,000 + 1/2 P
P = Rs. 600 + 1/20 B
Substituting the value of B:

P = 600 + 1/20 (3,000 + 1/2 P)
= 600 + 150 + 1/40 P
=750 + 1/40 P
Or, 40 P = 30,000 + P [hint: Multiplying by 40 ]
Or, 39 P = 30,000
Or, P = Rs. 769 (approx).
The total expenses of the Pump Room is Rs. 769 and that of the Boiler House is Rs. 3,385 i.e Rs. 3,000 +
½ x Rs. 769
The expenses will be allocated to the production departments as under:

Rs. Rs.
Boiler house (60% and 35% of Rs. 3,385) 2,031 1,185
Pump Room (10% and 40% of Rs. 769) 77 307
2,108 1,492
Total of expenses apportioned to A and B is Rs. 3,600
Illustration: 7
RST Ltd. has two production departments: Machining and Finishing. There are three service
departments: Human Resource (HR), Maintenance and Design. The budgeted costs in these service
departments are as follows:
HR Maintenance Design
Rs. Rs. Rs.
Variable 1,00,000 1,60,000 1,00,000
Fixed 4,00,000 3,00,000 6,00,000
5,00,000 4,60,000 7,00,000
The usage of these Service Departments’ output during the year just completed is as follows:
Provision of Service Output (in hours of service)
Providers of Service
Users of Service HR Maintenance Design
HR - - -
Maintenance 500 - -
Design 500 500 -
Machining 4,000 3,500 4,500
Finishing 5,000 4,000 1,500
Total 10,000 8,000 6,000
Required:
(i) Use the direct method to re-apportion RST Ltd.’s service department cost to its production
departments.
(ii) Determine the proper sequence to use in re-apportioning the firm’s service department cost by step-
down method.
(iii) Use the step-down method to reapportion the firm’s service department cost.
Solution
(i) Apportionment of Service Department Overheads amongst production departments using Direct
Method:
Production Depts. Service Depts.
Machining Finishing HR Maintenance Design
Rs. Rs. Rs. Rs. Rs.

Overhead as per 500,000 460,000 700,000
primary distribution

Apportionment 5,25,000 1,75,000

design 4,500 : 1,500
Maintenance 3,500 : 2,14,667 2,45,333
4,000
HR 4,000 : 5,000 2,22,222 2,77,778
9,61,889 6,98,111
(ii) The proper sequence for apportionment of service department overheads is First HR, Second
Maintenance, and Third Design. The sequence has been laid down based on service provided.
(iii) Apportionment of Service Department overheads amongst production departments using step-down
method.
Production Depts. Service Depts.
Machining Finishing HR Maintenance Design
Rs. Rs. Rs. Rs. Rs.

Overhead as per 500,000 460,000 700,000
primary distribution
Apportionment HR 200,000 250,000 (-)500,000 25,000 25,000
8 : 10 : - : 1 : 1
Maintenance 7 : 8: -: 1 2,12,188 2,42,500 - (-)4,85,000 30,312
Design 3 : 1 5,66,484 1,88,828 (-)7,55,312
9,78,672 6,81,328
ii) Repeated distribution method:

Under this method, service department’s costs are distributed to other service and production departments
on agreed percentages and this process continues to be repeated, till the figures of service departments are
either exhausted or reduced to too small a figure (Refer to the following illustration to understand this
method)
Illustration: 8
PH Limited is a manufacturing company having three production departments, ‘A’, ‘B’ and ‘C’ and two
services departments, ‘X’ and ‘Y’. The following is the budget for December 2012:-
Total A Rs. B Rs. C Rs X Rs. Y Rs.
Rs.
Direct material 1,000 2,000 4,000 2,000 1,000
Direct wages 5,000 2,000 8,000 1,000 2,000

Factory rent 4,000

Power 2,500
Depreciation 1,000
Other overheads 9,000
Additional information
Area (sq.ft) 500 250 500 250 500
Capital value of assets (Rs. Lacs) 20 40 20 10 10
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25
A technical assessment of the apportionment of expenses of service department is as under:
A% B% C% X% Y%
Service Department ‘X’ 45 15 30 - 10
Service Department ‘Y’ 60 35 - 5 -
Required:
(i) A statement showing distribution of overheads to various departments.
(ii) A statement showing redistribution of service departments expenses to production departments.
(iii) Machine hour rate of production departments ‘A’, ‘B’ and ’C’
Solution
(i) Overhead distribution summary
Basis Total Rs. A Rs. B Rs. C Rs X Rs. Y Rs.
Direct material Direct - - - - 2,000 1,000
Direct wages Direct - - - - 1,000 2,000
Factory rent Area 4,000 1,000 500 1,000 500 1,000
Power HP x M/c 2,500 500 800 800 150 250
hrs.
Depreciation Cap. value 1,000 200 400 200 100 100
Other overheads M/c hrs. 9,000 1,000 2,000 4,000 1,000 1,000
2,700 3,700 6,000 4,750 5,350
(ii) Redistribution of Service Department’s expenses
A Rs. B Rs. C Rs X Rs. Y Rs.

Total overheads 2,700 3,700 6,000 4,750 5,350
Dept. X overhead apportioned in the ratio (45:15:30: - : 10) 2,138 712 1,425 -4,750 475
Dept. Y overhead apportioned in the ratio (60:35:-: 5 :-:) 3,495 2,039 - 291 -5,825
Dept. X overhead apportioned in the ratio (45:15:30: - : 10) 131 44 87 -291 29
Dept. Y overhead apportioned in the ratio (60:35:-: 5 :-:) 17 10 - 2 -29
Dept. X overhead apportioned in the ratio (45:15:30: - : 10) 1 - 1 -2 -
8,482 6,505 7,513 - -
(iii) Machine hour rate:
Machine hours 1,000 2,000 4,000
Machine hour rate (Rs.) 8.48 3.25 1.88
(Rs.8,482/1000 hrs) (Rs. 6,505/ 2,000 hrs) (Rs. 7,513/4,000 hrs)

iii) Trial and Error method:

According to this method the cost of one service Cost Center is apportioned to another service Cost
Center. The cost of another service center plus the share received from the first Cost Center is again
apportioned to the first cost center. This process is repeated till the amount to be apportioned becomes
negligible (Refer to the following illustration to understand this method)
Illustration: 9
The ABC Company has the following account balances and distribution of direct charges on 31st.
December 2012.
Total Production Department Service Department
M/C Shop Packing General Stores &
Plant Maintenanc
e
Allocated overheads Rs. Rs. Rs. Rs. Rs.
Indirect labor 14,650 4,000 3,000 2,000 5,650
Maintenance 5.020 1,800 700 1,020 1,500
Material
Misc. supplies 1,750 400 1,000 150 200
Superintendent’s salary 4,000 - - 4,000 -
Cost and payroll salary 10,000 - - 10,000 -
Overheads to be apportioned
Power 8,000
Rent 12,000
Fuel and heat 6,000
Insurance 1,000
Taxes 2,000
Depreciation 100,000
164,420 6,200 4,700 17,170 7,350
The following data were compiled by means of the factory survey made in the previous year:
Floor space Radiator No. of Investments H.P. Hours
Square feet sections Employees Rs.
M/C Shop 2,000 45 20 640,000 3,500
Packing 800 90 10 200,000 500
General Plant 400 30 3 10,000 -
Stores & 1,600 60 5 150,000 1,000
Maintenance
4,800 225 38 1,000,000 5,000
Expenses charged to the stores and maintenance departments are to be distributed to the other by the
following percentages:
Machine shop 50%; Packing 20%; General Plant 30% ; general plant overheads is distributed on the
basis of number of employees :
a) Prepare an overhead distribution statement with supporting schedules to show computations and
basis of distribution including distribution of the service department expenses to production
department.
b) Determine the service department distribution by the method of continued distribution carry
through 3 cycles. Show all calculations to the nearest rupee.

Solution
(a)
Overhead distribution statement
Production Department Service Department
M/C Shop Packing General Plant Stores &
Maintenance
Rs. Rs. Rs. Rs.
Allocated
overheads
Indirect labor 4,000 3,000 2,000 5,650
Maintenance 1,800 700 1,020 1,500
Material
Misc. supplies 400 1,000 150 200
Superintendent’s - - 4,000 -
salary
Cost and payroll - - 10,000 -
salary
Total 6,200 4,700 17,170 7,350
Apportioned 77,720 25,800 2,830 22,650
expenses ( see
schedule below)
Total 83,920 30,500 20,000 30,000
(b)
Distribution of Service Department Expenses
Production Department Service Department
M/C Shop Packing General Stores &
Plant Maintenance
Rs. Rs. Rs. Rs.
Total expense as per (a) 83,920 30,500 20,000 30,000
Transfer from Stores and Maintenance 15,000 6,000 9,000 -30,000
Transfer from General Plant 16,571 8,286 -29,000 4,143
Transfer from Stores and Maintenance 2,072 829 1,242 -4,143
Transfer from General Plant 710 355 -1,242 177
Transfer from Stores and Maintenance 88 36 53 -177
Transfer from General Plant 35 18 -53 -
Total 118,396 46,024 - -
Working Note:
Schedule of Apportioned Expenses
Item Basis M/C Shop Packing General Plant Stores &
Maintenance
Rs. Rs. Rs. Rs.
Power H.P. Hours 5,600 800 - 1,600
Rent Floor space 5,000 2,000 1,000 4,000
Fuel and heat Radiator 1,200 2,400 800 1,600
sections

Insurance Investments 640 200 10 150

Taxes Investments 1,280 400 20 300
Depreciation Investments 64,000 20,000 1,000 15,000
Total 77,720 25,800 2,830 22,650
Illustration: 10
A & T Ltd. an engineering company having 25 different types of automatic machines furnishes you with
the following data for 2012-13 in respect of machine 'B'.
1. Cost of machine Rs. 50,000

Life 10 years scrap value is nil.
2. Overhead expenses are: Rs.

• Factory rent 50,000 p.a.
• Heating and lighting 40,000 p.a.
• Supervision 1,50,000 p.a.
• Reserve equipment for machine 'B 5,000 p.a.
• Area of the factory 80,000 sq.ft.
• Area occupied by machine 'B' 3,000 sq.ft.
• Power cost 50 paisa per hour while under operation
3. Wages of operator is Rs. 120 per day of 8 hours including all fringe benefits. He attends to one
machine when it is being set up and two machines while under operation.
4. Estimated production hours 3,600 p.a.

Estimated set-up time 400 hours p.a.
Prepare schedule of comprehensive machine-hour rate and find the cost of the following jobs:
Job 1102 Job 1308
Set up time (Hours) 80 40
Operation time (Hours) 130 160
Solution
A&T Ltd.
Statement showing comprehensive Machine Hour Rate for Machine B
Standard Charges per annum Basis Rs.
Rent (3,000/80,000 X 50,000) Area 1,875
Lighting and Heating (3,000/80,000 X 40,000) Area 1,500
Supervision (150,000/25) No. of Machines 6,000
Reserve and equipment Actual 5,000
14,375

Total hours planned – 4000

Standing charges rate per hour (14,375 /4,000) Rs.3.59
Two-tier Rate
Set-up cost per Operation cost per
machine hour machine hour
Standing charges rate per hour Rs.3.59 Rs.3.59
Power - 0.50
Depreciation (presumed variable cost) (50000/10) X (50000/10) X
1/4000hour = 1.25 1/4000hour = 1.25
Machine hour rate 4.84 5.34
Labor (Rs120 /8 hr) = 15.00 (Rs 120/8 hr *2
machine) =7.50
Comprehensive M/C hour rate 19.84 12.84
Statement showing Machine Overheads Charged to Jobs

Job 1102 Job 1308
Rate (Rs.) Hrs Rs. Hrs. Rs.
Set-up 19.84 80 1,587.20 40 793.60
Operation 12.84 130 1,669.20 160 2,054.40
3,256.40 2,848.00
Illustration: 11
The Novelties Ltd. is not keen on making special efforts to push the sales of a product B, one of three
main products it deals in, since product B is not considered to be as profitable as the other two. The
selling prices and cost of the three products are: -
Direct Labor
Product Selling price Direct material Department X Department Y Department Z
Rs. Rs. Rs. Rs. Rs.
A 340 50 40 10 10
B 290 30 10 40 10
C 320 40 10 10 40
Overhead rates for each department per rupee of direct labor are as follows:-
Department X Department Y Department Z
Rs. Rs. Rs.
Variable overhead 1.2 0.4 1.0
Fixed overhead 1.2 2.0 1.4
Total 2.4 2.4 2.4

What will be your advice about the profitability of product B? Give reasons.
Solution
Novelties Ltd.
Statement of Cost and Contribution of various Products
Products A B C
Rs. Rs. Rs.
Direct Material 50 30 40
Direct Labor 60 60 60
Variable Overhead (Working Note 1) 62 38 56
Total variable cost 172 128 156
Selling price 340 290 320
Contribution 168 162 164
Fixed overhead (Working Note 2) 82 106 88
Profit 86 56 76
P/V Ratio 49.4% 55.9% 51.3%
The attitude of Novelties Ltd. towards product B seems to be based on wrong considerations. The above
statement shows that product B gives contribution only slightly less than that of others in terms of rupees.
However, in terms of percentage, it has highest profit volume ratio.
It appears that due to inequitable apportionment of fixed overhead cost, the profit of product B is low as
compared to products A and C. This is probably the reason of indifference of company towards product
B. But that is not the right approach; as long as product gives good contribution, its production should be
encouraged.
Working Notes:
Dept. X Dept. Y Dept. Z Total
Rs. Rs Rs Rs
1. Variable overhead product:
A 40 x 1.20 10 x 0.40 10 x 1 62
B 10 x 1.20 40 x 0.40 10 x 1 38
C 10 x 1.20 10 x 0.40 40 x 1 56
2. Fixed overhead product:
A 40 x 1.20 10 x 2 10 x 1.40 82

B 10 x 1.20 40 x 2 10 x 1.40 106

C 10 x 1.20 10 x 2 40 x 1.40 88
Absorbing overheads over cost units, products etc.: Collection of figures of overheads for the factory
as a whole or for various departments is not enough. It is clearly necessary to ascertain how much of the
overheads is debitable to the cost of the various jobs, products etc. This process is called absorbing the
overhead to cost units. We take up below the various implications of this process. However, if only one
uniform type of work is done, the task is easy and under such a situation the overhead expenses to be
absorbed may be calculated by dividing actual overheads by the number of units of work done or
estimated overheads by the estimated output.
i. Normal and pre-determined overhead rates:

Various items of overhead expenses generally are not incurred uniformly throughout the accounting
period e.g. insurance premium are paid annually, rates and taxes quarterly, etc. The monthly total of
overhead expenses for each department or cost center, therefore, may fluctuate from month to month. As
such, monthly totals cannot be regarded as satisfactory. Since it is necessary to absorb the overhead costs,
for each lot or batch produced, to cost of production as soon as its manufacture is complete, an estimate of
the total amounts of annual overhead expenses must be made in advance. Likewise, an advance estimate
of the annual volume of production (in terms of the amount of direct wages, number of direct labor hours,
etc.) must be made and, on that basis, a pre-determined overhead rate is calculated.
The overhead rate of expenses for absorbing them to production may be estimated on the following three
bases.
1. The figure of the previous year or period may be adopted as the overhead rate to be charged to
production in the current year. The assumption is that the value of production as well as overheads
will remain constant or that the two will change, proportionately.
2. The overhead rate for the year may be determined on the basis of estimated expenses and anticipated
volume of production activity. For instance, if expenses are estimated at Rs. 10,000 and output at
4,000 units, the overhead rate will be Rs. 2.50 per unit.
3. The overhead rate for a year may be fixed on the basis of the normal volume of the business. If, in
the example given above, the normal capacity is 5,000 units, the overhead rate will be Rs. 2.
The first method is rather crude and is not likely to yield satisfactory results unless the undertaking is
small and output and expenses are fairly constant over the period. In large concerns, conditions are rarely
static and, hence, expenses fluctuate from one period to another. Therefore, so far as a large enterprise is
concerned, the overhead rates of the past periods may not have much relevance for the purpose of arriving
at the cost of production in the current period.
The second method is based on the assumption that all expenses shall have to be recovered irrespective of
the volume of output. From such an assumption, it follows that, if in any period there is a large idle or
unused capacity, the entire amount of the overhead expenses shall have to be absorbed over the reduced
volume of the output. A sizeable portion of the overhead expenses is made up of the fixed charges, if
those fixed charges have to be included in the costs of the reduced output the incidence of overheads per

unit of production would necessarily be high. Similarly, if the volume of output in any period exceeds the
normal level, the incidence of fixed overheads per unit will be comparatively lower. The effect of this
method is that during periods of falling production (and perhaps of falling prices), the cost of production
would be higher and correspondingly, during a period of rising production and perhaps rising prices, the
cost of production would be low. This would be illogical.
Idleness or a level of activity above the normal capacity is abnormal and should not affect costs; the
Costing Profit and Loss Account is the place where the effect of such abnormal factors should be shown.
It is also possible that when output falls and total cost per unit goes up (if expenses are absorbed over
actual output), the firm may demand a price above the market price and may find itself without
customers. On this consideration, the most appropriate basis for the computation of predetermined rate of
overhead cost is the normal capacity of production.
Estimation on this basis as suggested in the third method has many advantages over the other two
methods. It enables not only the computation of correct costs but also true cost to be recovered. In a
competitive economy, the concept of costs is essentially that of normal costs. Normal costs should be the
yard stick against which the efficiency or otherwise, of the competing unit should be measured. A cost
that is correct need not necessarily be true. True costs are in sense notional costs and the term “normal” is
derived from the concept of normal costs. Hence, the use of normal overhead rates has a twofold
advantage. It enables the true as well as correct costs to be calculated; at the same time by highlighting
differences between the amount of overhead expenses actually incurred and those absorbed in production,
it provides useful guidance to the management in taking decisions as regards production and sales.
ii. Blanket and departmental overhead rates:

Blanket overhead rate refers to the computation of one single overhead rate for the whole factory. It is to
be distinguished from departmental overhead rate which refers to a separate rate for each individual cost
centre or department. The use of blanket rate may become relevant giving desired result in case of
factories that produces only one major product from a continuous process (e.g. Chemical factories) or also
where the work performed in every department is fairly uniform or standardized. Where, however, the
product lines are varied or machinery is used to a varying degree in different departments, that is, where
conditions throughout the factory are not uniform, the use of departmental rates is to be preferred. The
working condition in the last mentioned case would be such that varying amount of expenses would be
continually incurred by several service departments and hence, the incidence of overhead cost of each
department would be different. Since not all products would ordinarily undergo the same type and would
pass through different type of operations in different departments, the charging of a single overhead rate
in such a case would give misleading results.
It may therefore, be concluded that a blanket rate should be applied-

1. Where only one major product is being produced.
2. Where several products are produced, but
a. all products pass through all departments, and
b. all products are processed for the same length of time in each department.
Where these conditions do not exist, departmental rates should be used.

4.7 METHODS OF ABSORBING OVERHEADS TO VARIOUS PRODUCTS OR JOBS
Before we describe various methods, it would be better to know how to judge whether a method will give
good results or not. The method selected for charging overheads to products or jobs should be such as will
ensure:
1. that the total amount charged (or recovered) in a period does not differ materially from the actual
expenses incurred in the period. In other words, there should not be any significant over or under
recovery of overhead; and
2. that the amount charged to individual jobs or products is equitable. In case of factory overhead, this
means :
a. that the time spent on completion of each job should be taken into consideration;
b. that a distinction should be made between jobs done by skilled workers and those done by
unskilled workers. Usually the latter class of workers needs more supervision, causes greater wear
and tear of machines and tools and wastes a larger quantity of materials. Hence jobs done by such
worker should bear a correspondingly higher burden for overheads; and
c. that jobs done by manual labor and those done by machines should be distinguished. It stands to
reason that no machine expenses should be charged to jobs done by manual labor.
In addition, the methods should

1. be capable of being used conveniently; and
2. yield uniform result from period to period as far as possible; any change that is apparent should
reflect a change in the underlying situation such as substitution of human labor by machines.
Several methods are commonly employed either individually or jointly for computing the appropriate
overhead rate to be employed. The more common of these are:
1. Percentage of direct materials.
2. Percentage of prime cost.
3. Percentage of direct labor cost.
4. Labor hour rate.
5. Machine hour rate.
i. Percentage of direct material and prime cost

Suppose for a given period, actual figures are estimated as follows:
Direct materials Rs. 2,00,000
Direct labor Rs. 1,00,000
Factory overheads Rs. 90,000
The percentage of factory overheads to direct materials will be 45%, to prime cost 30% and to direct labor
90%. If, on a job, material cost is Rs. 10,000 and direct labor is Rs. 7,000 the cost after absorbing factory
overhead, will be as follows:
a) Rs.17,000 + 45% of Rs. 10,000 or Rs. 21,500.
b) Rs. 17,000 + 30% of Rs. 17,000 or Rs. 22,100 and
c) Rs. 17,000 + 90% of Rs. 7,000 or Rs. 23,300.
One can see how, with a different method, the works cost comes out to be different. Of these methods, the
first and second are generally considered to be unsuitable on account of the following reasons:

a) Manufacturing overhead expenses are mostly a function of time i.e. Time is the determining
factor for the incurrence and application of manufacturing overhead expenses. That they are so
would be clear if we recall that overhead expenses, specially manufacturing expenses, can in the
ultimate analysis be regarded as expenditure incurred in providing necessary facilities and
services to workers employed in the productive process. The question of facilities and service
made available to workers naturally is dependent on the length of time during which workers
make use of the facilities. It may, therefore, be said that the job or product on which more time
has been spent would entail larger manufacturing expenses than the job requiring less time. The
factor is ignored altogether by the first method and largely by the second method.
b) Overheads are neither related to the prime cost nor to direct material cost except to a very small
extent. Thus, if the percentage of material cost is used when there are two jobs requiring the
same operational time but using material having varying prices, their manufacturing overhead
cost would be different whereas this should not normally be so.
The method of absorbing overhead costs on the basis of prime cost also does not take into
consideration the time factor. The fact that the amount includes labor cost in addition to material
cost does not render the prime cost to be more suitable, in fact, the results are liable to be more
misleading because of the cumulative error of using both the labor and material cost as the basis
of allocation of overhead expenses, on neither of which they are already dependent.
c) Since material prices are prone to frequent and wide fluctuations, the manufacturing overheads,
if bases on material cost or prime cost, also would fluctuate violently from period to period.
d) The skill of the workers involved and whether machines were used or not, are ignored when
these methods are used.
Percentage of materials cost may, however, be used for the limited purpose of absorbing material
handling and storage overhead.
ii. Percentage of direct labor cost:

This method also fails to give full recognition to the element of time which is of prime importance in the
accounting for and treatment of manufacturing overhead expenses except in so far as the amount of wages
is a product of the rate factor multiplied by the time factor. Thus, the time factor is taken into
consideration only indirectly or partially in the computation of the overhead percentage rate. This method
therefore cannot be depended upon to produce a very accurate result where same type of work is
performed in same time by different type of workers, skilled and unskilled, with varying rates of pay.
Also no distinction is made between jobs done by manual labor and those done by machines.
In spite of the inaccuracies which may arise under this method it is widely used in actual practice because
it is simple and does not involve much calculation. If on the other hand, a more scientific method is
employed e.g. the direct labor hour rate or the machine hour rate, more complexities in the overhead
accounting procedure would be introduced, though the selected method will give proper allowance to
time element. Thus, the advantage of elimination of a small error in practice may involve a heavy price on
account of introduction of complexities.
Advantages :
1. The method is simple and economical to apply.
2. The time factor is given recognition even if indirectly.

3. Total expenses recovered will not differ much from the estimated figure since total wages paid are
not likely to fluctuate much.
Disadvantages:
1. It gives rise to certain inaccuracies due to time factor not being given full importance.
2. Where machinery is used to some extent in the process of manufacture, an allowance for such a
factor is not made.
3. It does not provide for varying skills of workers.
iii. Labor hour rate:

This method is an improvement on the percentage of direct wage basis, as it fully recognizes the
significance of the element of time in the incurring and absorption of manufacturing overhead expenses.
This method is admirably suited to operations which do not involve any large use of machinery. To
calculate labor hour rate, the amount of factory overheads is divided by the total number of direct labor
hours. Suppose factory overheads are estimated at Rs. 90,000 and labor hours at 150,000. The overhead
absorption rate will be Rs. 0.60. If 795 direct labor hours are spent on a job, Rs. 477 will be absorbed as
overhead. It can be calculated for each category of workers.
iv. Machine hour rate:

Under machine hour rate method, manufacturing overhead expenses are charged to production on the
basis of number of hours machines are used on jobs or work orders. There is a basic similarity between
machine hour and direct labor hour rate method insofar as both are based on time factor. The choice of
one or the other method is conditioned by the actual circumstance of individual case. In respect of
departments or operations in which machines predominate and the operators perform relatively a passive
part; the machine hour rate is more appropriate. This is generally the case for operations or processes
performed by costly machines, which are automatic or semi-automatic and where operators are essential
merely for feeding them rather than for regulating the quantity of the output. In such case, the machine
hour rate is to be derived by dividing overhead expenses for a specific machine or group of machines for
a period by the operating hours of the machine or the group of machines for the period. Usually, the
computation is made on the basis of estimated expenses or normal expenses for the coming period. Thus
the machine hour rate usually is a predetermined rate. It is desirable to work out a rate for each individual
machine; where a number of similar machines are working in a group; there may be single rate for the
whole group.
There are two methods of computing the machine hour rate. According to the first method, only the
expenses directly or immediately connected with the operation of the machine are taken into account e.g.,
power, depreciation, repairs and maintenance, insurance, etc. the rate is calculated by dividing the
estimated total of these expenses for a period by the estimated number of operational hours of the
machines during the period.
It will be obvious, however, that in addition to the expenses stated above there may still be other
manufacturing expenses such as supervision charges, shop cleaning and lighting, consumable stores and
shop supplies, shop general labor, rent and rates, etc. incurred for the department as a whole and, hence,
not charged to any particular machine or group of machines. In order to see that such expenses are not left
out of production costs, one should include a portion of such expenses to compute the machine hour rate.
Alternatively, the overheads not directly related to machines may be absorbed on the basis of Productive
Labor Hour Rate Method or any other suitable method.

Advantages of Machine Hour Rate

i. Where machinery is the main factor of production, it is usually the best method of charging
machine operating expenses to production.
ii. The under-absorption of machine overheads would indicate the extent to which the machines
have been idle.
iii. It is particularly advantageous where one operator attends to several machines (e.g. automatic
screw manufacturing machine), or where several operators are engaged on the machine e.g. the
belt press used in making conveyer belts
Disadvantages:
i. Additional data concerning the operation time of machines, not otherwise necessary, must be
recorded and maintained.
ii. In general, department rates for all the machines in a department may be suitable; however
computation of a separate machine hour rate for each machine or group of machines would mean
further additional work.
Note:
Some people even prefer to add the wages paid to the machine operator in order to get a comprehensive
rate of working a machine for one hour.
If all expenses are not allocated to machines, it will be necessary to calculate another rate for charging the
general department expenses to production. This second rate can be calculated on the basis of direct labor
hours. In effect therefore, both the machine hour and the direct labor hour rate will be applied, though
separately.
Illustration: 12
A machine costing Rs. 100,000 is expected to run for 10 years. At the end of this period its scrap value is
likely to Rs. 1,000. Repairs during the whole life of the machine are expected to be Rs. 54,000 and the
machine is expected to run 4,380 hours per year on the average. Its electricity consumption is 15 units
per hour, the rate per unit being Rs 5. The machine occupies one-fourth of the area of the department and
has two points out of a total of ten for lighting. The foreman has to devote about one sixth of his time to
the machine. The monthly rent of the department is Rs. 15,000 and the lighting charges amount to Rs.
1,200 per month. The foreman is paid a monthly salary of Rs. 9,600. Find out the machine hour rate,
assuming insurance is @1% p.a. and the expenses on oil, etc., are Rs. 900 per month.
Solution
i. Fixed expenses per month Rs.
Rent (one fourth of the total) [15,000/4] 3,750.00
Lighting (one fifth of the total) [1,200/5] 240.00
Foreman’s salary (one sixth of the total[9,600/6]) 1,600.00
Sundry expenses – oil, waste etc. 900.00
Insurance (1% on the value of the machine per year) 83.33
Total constant expenses per month 6,573.33

ii. Calculation of hours per month

Total number of hours per annum 4,380
Total number of hours per month 365
Rs. Per Annum Rs. Per Hour

Fixed expenses per hour = Rs.6,573.33/365 hours 18.00
Variable expenses per hour:
Depreciation:
Cost of machine 100,000
Less: Scrap value 1,000
99,000
Depreciation per annum 9,900
Depreciation per hour = Rs. 9,900/4,380 hours 2.26
Repairs for the machine per annum= Rs. 54,000/ 10 years 5,400
For one hour = Rs. 54,000/(4,380 hours x 10 years)
1.23
Electricity for one hour = 15 units @ Rs 5 75.00
Machine hour rate 96.49
Illustration: 13
Gemini Enterprises undertakes three different jobs A, B and C. All of them require the use of a special
machine and also the use of a computer. The computer is hired and the hire charges work out to be Rs
420,000 per annum. The expenses regarding the machine are estimated as follows:
Rent for a quarter – Rs 17,500

Depreciation per annum – 200,000
Indirect expenses per annum – 150,000
During the month of operation, the following details were taken from the job register.
JOBS
A B C
Number of hours the machine was used -
a) Without the use of computer 600 900 -
b) With the use of computer 400 600 1,000
You are required to compute the machine hour rate:

a) For the firm as a whole for the month when the computer was used and when the computer was
not used.
b) For the individual jobs A,B & C
Solution
Working Note
(i) Total machine hours used 3,500
(600+900+400+600+1,000)
(ii) Total machine hours without the use of computers 1,500

(600+900)

(iii) Total machine hours with the use of computers 2,000

(400+600+1,000)
(iv) Total overheads of machine per month

Rent (Rs. 17,500/ 3 months) 5,833.33
Depreciation (Rs. 200,000/12 months) 16,666.67
Indirect expenses (Rs. 150,00/12 months) 12,500.00
_____________35,000
(v) Computer hire charges per month 35,000.00
(Rs. 420,000/12 months)
(vi) Overhead for using machine w/o computer 15,000.00

{(Rs. 35,000/3,500 hours) X 1,500 hours}
(vii) Overhead for using machine with computer 55,000.00

{(Rs. 35,000/3,500 hours) X 2,000 hours}+Rs 35,000
a) Machine hour rate of Gemini Enterprises for the firm as a whole for a month
1. When computer was used : Rs 55,000/ 2,000 hours = Rs 27.50 per hour
2. When computer was not used: Rs 15,000/1,500 hours = Rs. 10 per hour
b) Machine hour rate of Gemini Enterprises for individual jobs
Rate per
Jobs Hour A B C
Overheads Hrs Rs Hrs Rs Hrs Rs
Without Computer 10 600 6000 900 9000 0 0
With Computer 27.5 400 11000 600 16500 1000 27500
Total 1000 17000 1500 25500 1000 27500
Machine Hour 17 17 27.5
Illustration: 14
A machine shop has 8 identical drilling machines manned by 6 operators The machine cannot be worked
without an operator wholly engaged on it. The original cost of all these machines works out to be Rs 8
Lakhs. These particulars are furnished for a 6 months period.
Normal Available hours per month 208

Absenteeism (without pay) hours 18
Leave (with pay) hours 20
Normal idle time unavoidable –hours 10
Average rate of wages per worker for 8 hours a day Rs. 200
Production bonus estimated 15% of wages
Value of power consumed Rs. 8,050
Supervision and indirect cost Rs. 3,300

Lighting and electricity Rs. 1,200

These particulars are for a year:
Repair and maintenance including consumables - 3% of value of machines
Insurance Rs. 40,000
Depreciation 10% of original cost
Other sundry expenses Rs 12,000
General management expenses allocated Rs 54,530
You are required to work out a comprehensive machine hour rate for the machine shop.
Solution
Computation of comprehensive machine hour rate of machine shop

Rs.
Operators wages 171,000
(refer to working note 2)
Production bonus 25,650
( 15% of wages)
Power consumed 8,050
Supervision and indirect labour 3,300
Lighting and electricity 1,200
Repair and maintenance [ 800,000X3/100X(6/12)] 12,000
Insurance [ 40,000 X 6/12] 20,000
Depreciation [ 800,000X10%X6/12] 40,000
Sundry Expenses [ 12,000 X 6/12] 6,000
General Management Expenses [ 54,350 X 6/12] 27,265
314,465
Total Overheads Of Machine Shop

Machine Hour Rate=
Hours of Machine Operations
314,465
=
5,760
= Rs 54.59
Working Notes:
1. Computation of hours, for which 6 operators are available for 6 months
Normal available hours p.m. per operator 208

Less: Absenteeism hours (18)
Less: Leave Hours (20)
Less: Idle time hours (10)
Utilisable hours per operator p.m. 160
Total utilizable hours for 6 operators for 6 months are = 160 X 6 X 6 = 5,760 hours

As machine cannot be worked without an operator wholly engaged on them therefore, hours for which 6
operators are available for 6 months are the hours for which machines can be used. Hence 5.760 hours
represent total machine hours.
2. Computation of operator’s wages

56 *''
Average rate of wages : = Rs 25 per hour
7 89:;6
Hours per month for which wages are to be paid to a worker ( 208 hours – 18 hours) = 190 hours
Total wages paid to 6 operators for 6 months

= 190 hours X 6 X Rs 25
= Rs 171,000
Illustration: 15
Job No. 198 was commenced on October 10, 1998 and completed on November 1, 1998 Materials used
were Rs. 600 and labor charged directly to the job was Rs. 400. Other information is as follows:
Machine No. 215 used for 40 hours, the machine hour rate being Rs. 3.50.
Machine No. 160 used for 30 hours, the machine hour rate being Rs. 4.00. 6 welders worked in the job
for five days of 8 hours each: the direct labor hour per welder is 20 P.
Expenses not included for calculating the machine hour or direct labor hour rate totaled Rs. 2,000, total
direct wages for the period being Rs. 20,000. Ascertain the works costs of job No.198.
Solution:
Rs Rs
Materials 600.00
Direct labor 400.00
1,000.00
Factory overheads:
Machine No. 215 : 40 hours at Rs. 3.50 140.00
Machine No. 160 : 30 hours at Rs. 4.00 120.00
240* hours of welders @ 20 paisa per hour 48.00
General** 10% of wages 40.00 348.00
Works cost 1,348.00

*6 x 5 x 8 = 240
**Un-apportioned expenses Rs.2,000 which works out at10% of direct wages.

4.8 TREATMENT OF UNDER-ABSORBED AND OVER-ABSORBED OVERHEADS IN

COST ACCOUNTING:
Actual overhead rate
When the absorption is based on actual overhead, it is known as actual absorption rate. This can be
calculated only after the end of the accounting period when all cost and production figures have been
collected. This method has the following disadvantages:
1. Product cannot be determined until some considerable time after the end of the accounting
period. This may not help in controlling cost and in fixing selling prices.
2. There are likely to be variations in the overhead incurred because of the seasonal nature of some
overhead costs, change in volume of production and efficiency of the factory for different
periods.
3. Some overhead costs are of fixed nature, such as depreciation, supervision, property taxes, etc.
These overhead costs being constant give a different per unit cost when divided by differing
production volumes. Also, some overheads like fire insurance premium are paid in advance but
this should be charged to all work done/products manufactured during the year. How should the
absorption be done? It creates an inequitable situation.
Predetermined overhead rate or Standard rate
Because of the limitations of the actual overhead rate stated above, a predetermined or standard overhead
rate is generally used by companies. This is a rate calculated in advance of the period in which it is to be
used by dividing the estimated period overhead to be absorbed by the estimated period production.
Production may be measured on any of the absorption bases, such as prime cost, labor hours, etc.
The primary objective of predetermined overhead rate is to provide a reasonably constant unit cost and to
avoid unit cost fluctuation caused by seasonal overhead cost fluctuations, changes in volume, or
accounting methods.
Secondly, predetermined overhead rates also make possible the immediate costing of job or products
completed during the month. When a job is finished, the absorption rate is multiplied by the absorption
ase to find out the total amount to be charged to the product or job. Under, a process costing system
predetermined overhead rate is used to charge overhead to the output of the process in question.
Thirdly, predetermined rates contribute effectively to standard costing and budgetary control programs as
these programs use estimated costs and standard cost to measure production activities.
Supplementary Overhead Rate

Supplementary overhead rate is one of the methods of disposal of under or over-absorption of overheads.
If the amount of under or over-absorption is considerable; the cost of job or process is adjusted by means
of supplementary levy of the overhead. Supplementary rate is calculated by dividing the amount of under

or over absorption by the actual base. Under-absorption is set right by a plus rate while over-absorption is
adjusted by minus rate. The Supplementary rate may also be calculated as a percentage of the amount
absorbed.
Under this method, the balance of over and under-absorbed overheads may be charged to cost of work-in-
progress and finished stock and cost of sales proportionately. This is done with the help of Supplementary
rate of overhead. If there has been a mistake in either working out the proper rate or selecting the proper
method, it should be permissible to amend the cost and arrive at new (but correct) figures of cost. To the
extent the goods have already been sold, the difference in the two figures of cost (as already arrived at
and the new correct one) should be debited or credited to the Cost of Sales Account or even to the Costing
Profit and Loss Account. The goods remaining unsold should be costed at the correct rate. The corrective
rate should be applied also to work-in-progress.
Overhead expenses are usually applied to production on the basis of pre-determined rates. Production
overheads are to be determined in advance as follows for fixing selling price, quote tender price and to
formulate budget etc.
<!0 .1 /.0! . .0

Pre-determined overhead rate =
=00 >. ! 0. .0
The actual overhead rate will rarely coincide with the pre-determined overhead rate, due to variation in
pre-determined overhead rate and actual overhead rate. Such a variation may arise due to any one of the
following situations:
i. Estimated overheads for the period under consideration may remain the same or they
coincide with actual overheads but the number of units produced during the period is either
more or less in comparison with budgeted figure. In the former case actual overhead rate
will be less and in the latter case, actual overhead rate will be more than the pre-determined
overhead rate, hence over-absorption and under-absorption will occur respectively.
ii. Similarly, if the number of units actually produced during the period remains the same as
budgeted figure but the actual overheads incurred are more or less than the estimated
overheads for the period, then a situation of under-absorption or over-absorption will arise
respectively.
iii. If changes occur in different proportion both in the actual overheads and in the number of
units produced during the period, then a situation of under or over-absorption (depending
upon the situation) will arise.
iv. If the changes in the numerator (i.e. in actual overheads) and denominator (i.e. in number of
units produced) occur uniformly (without changing the proportion between the two) then a
situation of neither under nor over-absorption will arise.
Such over or under-absorption as arrived at under different situations may also be termed as overhead
variance. The amount of over-absorption being represented by a credit balance in the account and
conversely, the amount of under-absorption being a debit balance.

As regards the treatment of such debit or credit balances, the general view is that if the balances are small
they should be transferred to the Costing Profit and Loss Account and the cost of individual products
should not be increased or reduced as these would be representing normal cost.
Where, however the difference is large and due to wrong estimation, it would be desirable to adjust the
cost of products manufactured, as otherwise the cost figures would convey a misleading impression. Such
adjustments usually take the form of supplementary rates where there is a debit balance in the overhead
account and a credit in the other case.
Now, the production of any period can be identified in three forms, goods finished and sold, goods
finished but held in stock (not yet sold) and semi-finished goods (work in progress). So far as the first
category of goods is concerned, it is arguable that the post-mortem of the costs of individual products
long after they have been sold may have some academic utility but it is frequently devoid of any practical
significance. Therefore, it is suggested that the total variance concerning goods finished and sold should
be adjusted by transferring the amount to the Cost of Sale Account, the costs of the individual items of
such goods not being affected. As regards the variance pertaining to goods finished and held in stock (ie.
Not yet sold) , it would be necessary to adjust the value of the stock; similarly the value of work-in-
progress should be adjusted.
However, over or under recovery of overheads due to abnormal reasons (such as abnormal over or under
capacity utilization) should be transferred to the Costing Profit and Loss Account.
Illustration: 17
A light engineering factory fabricates machine parts to customer. The factory commenced fabrication of
12 Nos. machine parts to customers’ specifications and the expenditure incurred on the job for the week
ending 21 August, 1998 is given below:
Rs. Rs.
Direct materials (all items) 78.00
Direct labor (manual) 20 hours @ Rs. 1.50 per hour 30.00
Machine facilities:
Machine No. 1: 4 hours @ Rs. 4.50 18.00
Machine No. 2: 6 hours @ Rs. 6.50 39.00 57.00
Total 165.00
Overhead at Rs 0.80 per hour on 20 manual hours 16.00
Total cost 181.00
The overhead rate of Rs. 0.80 per hour is based on 3,000 man hours per week; similarly, the machine
hour rates are based on the normal working of Machine Nos. I and II for 40 hours out of 45 hours per
week.
After the close of each week, the factory levies a supplementary rate for the recovery of full overhead
expenses on the basis of actual hours worked during the week. During the week ending 21st August, 1998 ,

the total labor hours worked was 2,400 and Machine Nos. I and II had worked for 30 hours and 32 ½
hours respectively.
Prepare a Cost Sheet for the job for the fabrication of 12 Nos. machine parts duly levying the
supplementary rates.
Solution:
Cost sheet for the week ending, August 21, 1998
Fabrication of 12 Nos. machine parts (Job No….)
Date of commencement: 16 August 1998
Date of completion; august 21, 1998
Rs. Rs.
Materials 78.00
Labor 20 hours @ Rs. 1.50 30.00
Machine facilities:
Overhead at Rs 0.80 per hour on 20 manual hours 16.00
181.00
Supplementary rates
Overheads 20 hours @ 20 paisa per hour 4.00
Machine facilities:
Cost 200.00
Working notes:
i. Supplimentary charge of Overhead
Overhead budgeted: 3,000 hours @ 80 P. or Rs. 2,400
Actual hours 2,400
Actual rate per hour Rs. 2,400/2,400 = Re. 1
Supplementary charge =( Rs 1- Rs 0.8)= Rs 0.2 or 20 paisa per hour
ii. Supplimentary Charge of Machine facilities:

Machine No. 1 Machine No. 2
Budgeted (40 x Rs. 4.50) = Rs. 180 (40 x Rs. 6.50) = Rs. 260
Actual number of hours 30 32.5
Actual rate per hour Rs. 6 Rs. 8
Supplementary rate per hour (Rs. 6 – Rs. 4.50) =Rs 1.5 Rs. 8 – Rs 6.50= Rs 1.5
Illustration: 17
In a factory, overheads of a particular department are recovered on the basis of Rs. 5 per machine hour.

The total expenses incurred and the actual machine hours for the department for the month of August
were Rs. 80,000 and 10,000 hours respectively. Of the amount of Rs. 80,000, Rs. 15,000 became payable
due to an award of the Labor Court and Rs. 5,000 was in respect of expenses of the previous year booked
in the current month (August). Actual production was 40,000 units, of which 30,000 units were sold. On
analyzing the reasons, it was found that 60% of the under-absorbed overhead was due to defective
planning and the rest was attributed to normal cost increase. How would you treat the under-absorbed
overhead in the cost accounts?
Solution:
Under-absorbed overhead expenses during the month of August
Rs. Rs.
Total expenses incurred in the month of August: 80.000.00
Less: The amount paid according to labor court award
(assumed to be non-recurring) 15,000
Expenses of previous year 5,000 20,000
Net overhead expenses incurred for the month 60,000
Overhead recovered for 10,000 hours @ Rs. 5 per hour 50,000
Under-absorbed overheads 10,000
Treatment of under-absorbed overhead in the Cost Accounts

It is given in the question that 40,000 units were produced out of which 30,000 units were sold. It is also
given that 60% of the under-absorbed overhead was due to defective planning and the rest was attributed
to normal cost increase.
Rs.
1. 60% of under-absorbed overhead is due to defective planning. This being abnormal
should be debited to profit and loss account (60% of Rs. 10,000) 6,000.00
2. Balance 40% of under-absorbed overhead should be distributed over, finished goods
and cost of sales by supplementary rate (40% of Rs. 10,000) 4,000.00
10,000.00
Rs. 4,000 may be distributed over finished goods and cost of sales as follows:
Finished goods * Rs. 1,000
Cost of sales * Rs. 3,000
Working notes:
Under-absorbed overhead; Rs. 4,000

Unit produced 40,000
Rate of under absorbed overhead recover Re.0.10 per unit
Amount of under-absorbed overheads charged to:

Finished goods (10,000 x 0.10 paisa) = Rs. 1,000

Cost of sales: (30,000 x 0.10 paisa) = Rs. 3,000
Illustration: 18
In a manufacturing unit, factory overhead was recovered at a pre-determined rate of Rs. 25 per man day.
The total factory overhead expenses incurred and the man-days actually worked were Rs. 41.50 lakh and
1.5 lakh man-days respectively. Out of the 40,000 units produced during a period, 30,000 were sold.
On analyzing the reasons, it was found that 60% of the unabsorbed overheads were due to defective
planning and the rest were attributable to increase in overhead costs.
How would unabsorbed overheads be treated in Cost Accounts?
Solution:
Computation of unabsorbed overheads
Man-days worked 150,000 man days
Rs.
Overhead actually incurred 4,150,000
Less: overhead absorbed @ Rs. 25 per man-day (Rs. 25 x 150,000) 3,750,000
Unabsorbed overheads 400,000
Unabsorbed overheads due to defective planning (i.e.60% of Rs. 400,000) 240,000
Balance of unabsorbed overheads 160,000
Treatment of unabsorbed overheads in Cost Accounts
i. The unabsorbed overheads of Rs. 2,40,000 due to defective planning to be treated as abnormal
and therefore be charged to Costing Profit and Loss Account.
ii. The balance unabsorbed overheads of Rs. 1,60,000 be charged to production i.e. 40,000 units at
the supplementary overhead absorption rate i.e., Rs. 4 per unit (Refer working note)
Rs.
Charged to costing profit and loss account as part of the cost of unit sold 120,000
(30,000 units @ Rs. 4 per unit)
Add: To closing stock of finished goods 40,000
(10,000 units x Rs. 4 per unit)
Total 160,000
Working note:
Supplementary overhead absorption rate = Rs.160,000/40,000 units = Rs. 4 per unit

4.9 ACTIVITY BASED COST ALLOCATIONS:
Under activity based cost allocation overheads are attributed to products on an activity base.
Traditionally, overhead costs are grouped together under cost centre and then absorbed into product costs
on some basis such as direct labor hours. Activity based costing identifies the activities which cause cost
to be incurred and searches for fundamental cost drivers of these activities. Once the activities and there
cost driver have been identified this information can be used to assign overheads to cost object (e.g.
products) which have actually cause cost to be incurred.
There are normally four levels of activities. These are as follows:

i. Unit level activities: These are those activities for which the consumption of resources can be
identified with the number of units produced e.g. direct material and direct labor.
ii. Batch level activities: The activities such as setting up of a machine or processing a purchase
order are performed each time a batch of goods is produced. The cost of batch related activities
varies with number of batches made, but is common (or fixed) for all units within the batch.
iii. Product level activities: These are the activities which are performed to support different
products in product line e.g., parts administration, product specification or purchasing may be
related to the existence of a particular product line.
iv. Faculty level activities: These are the activities which cannot be directly attributed to individual
products. These activities are necessary to sustain the manufacturing process and are common
and joint to all products manufactured. E.g., Ground maintenance, plant security and property
taxes.
Steps for Activity Based Cost Allocation

The various steps for activity based cost allocation are as follows:
1. Identify the activities: Activities are comprised of units of works or tasks e.g. purchase of
materials may be identified as separate activity. This activity consist of different tasks such
as receiving a purchase request, identifying suppliers, preparing purchase orders, mailing
purchase orders and performing follow up. The final choice of activities depends on two
factors.
a. Total cost of activity must be significant to justify separate treatment.

b. Ability of a single cost driver to provide a satisfactory determinant of the cost of
activity e.g., selecting a number of purchase orders as a cost driver may provide
correct information for purchasing cost but fail to provide information relating to
receiving and issuing. Therefore, it will be appropriate that material procurement,
receiving and issuing are considered as separate activities.
2. Identify the cost centre (cost pool) of each of the activities identified in Step 1: After the
activities have been identified the cost of resources consumed over a specified period must
be assigned to each activity. Many resources may be directly attributable to specific activity
centers but others (such as lighting and heating costs) may be shared by several activities.
For example, heating costs might be apportioned to activity centers on the basis of floor
area.

3. Selecting the cost driver for each activity identified in step 1: The cost driver explains why
resources are consumed by a particular activity and therefore why activity incurs cost e.g.,
Machine set up (Activity) the number of set-ups (Batch size) is the cost driver.
4. Calculate a cost driver rate for each activity cost centre (cost pool) in the same way as
overhead rate is calculated in traditional system.
-4/# 4. 4!

Cost drive rate = (cost pool)
-4/# 0./.
?4 ! 4!

e.g. Rate per set up =
@1 ! !
5. Apply the activity cost driver rates to products (cost units) to arrive at activity based
overhead cost: The last stage involves applying cost drivers rates to products. Therefore,
the cost driver must be measured in a way that enables it to be identified with individual
products.
Illustration: 19
A company manufactures three products – A, B and C the direct costs of which is as follows:
Products A Rs. B Rs. C Rs.
Direct material 67.92 63.27 56.79
Direct labor( Rs. 3 per hour):
Machining 13.08 14.73 17.01
Assembly 24.00 27.00 31.20
Total direct cost 105.00 105.00 105.00
The following information is also available

Product A B C Total
Machine time (hrs) 10.00 9.00 8.00
Direct labor (hrs)
Machining 4.36 4.91 5.67
Assembly 8.00 9.00 10.40
Production (units) 50,000 30,000 16,250
Total machine hours 500,000 370,000 130,000 900,000
Total labor hours:
Machining 218,000 147,300 92,137 457,437
Assembly 400,000 270,000 169,000 839,000
1,296,437
The overhead expenses of the company are as follows:

Total
Production Overhead Rs. ‘000 Rs. ‘000
Indirect labor:
Machining 900
Assembly 600
Purchasing/order processing 600

Factory management 100 2,200

Power:
Machining 400
Assembly 100 500
Indirect materials
Machining 200
Assembly 200
Purchasing 100
Factory management 100 600
Depreciation:
Machining 600
Assembly 300
Purchasing 200
Building 400 1,500
Security 100
Ground maintenance 100
Total production overhead 5,000
For Activity Based Cost Allocation the following further information are given:
i. Production information
High volume Medium volume Low volume
Large batches Medium batches Small batches
Few purchase Medium purchase Many purchase
Orders placed Orders placed Orders placed
Medium components Many components
Few customer Medium customer Many customer
Orders placed Orders placed Orders placed
Typical batch size 2,000 600 325 -

Number of production runs 25 50 50 125
No. of inspections 25 50 50 125
Purchase order placed 25 100 200 325
Customer order received 10 100 200 310
ii. Production- related activities

Total
Analysis of indirect labor Rs. ‘000 Rs. ‘000
Machining
Supervision 100
Set-up 400
Quality control 400 900
Assembly
Supervision 200
Quality control 400 600
Purchasing/order processing
Resource procurement 300

Customer liaison/expediting 300 600

Factory management
General administration 100
2,200
iii. Activities
1. Machining
2. Machine set-up
3. Machining quality control
4. Assembly
5. Assembly quality control
6. Resource procurement
7. Customer liaison/expediting
8. Factory management
Required:
a. You are required to calculate product costs for three products on the basis of
traditional method of cost allocation.
b. You are required to calculate product costs for three products on the basis of
Activity Based method of cost allocation.
Solution
a. Calculation of product cost according to traditional method of cost allocation.
Statement showing product cost under Traditional Methods
Product A Rs. B Rs. C Rs.
Direct costs 105.00 105.00 105.00
Production overheads:
Machining 30.00 27.00 24.00
(10 hrs x Rs. 3) (9 hrs x Rs. 3) (8 hrs x Rs. 3)
Assembly 21.92 24.66 28.50
( 8 hrs x Rs.2.74) ( 9 hrs x Rs. 2.74) (10.40 hrs x Rs. 2.74)
156.92 156.66 157.50
Working Note
i. Statement showing allocation of production overheads to department
(Rs. ‘000)
Particulars Total Production Departments Service Departments
Machining Assembly Purchasing/order Factory
processing
Indirect labor 2,200 900 600 600 100
Power 500 400 100 - -
Indirect materials 600 200 200 100 100
Depreciation 1,500 600 300 200 400
Security 100 - - - 100
Ground maintenance 100 - - - 100
5,000 2,100 1,200 900 800

ii. Reapportionment of service department expenses over production departments by using

labor hour basis
(Rs. ‘000)
Total Machining Assembly Purchasing/order Factory
processing
Total overheads 5,000 2,100 1,200 900 800
(refer to (i) above)
Purchasing/order processing - 318 582 -900 -
department overheads
apportioned over production
departments in the ratio of
(457,437: 839,000)
Factory management - 282 518 - -800
overheads allocated in the
ratio of (457,437: 839,000)
5,000 2,700 2,300 00 00
iii. Computation of absorption rate
@1 /.0 4!

Machining Department: (Based on total machine hours) =
@1 4 .!
$!.*,A'','''
= = Rs. 3 per machine hours
B'',''' 4 .!
@1 /.0 4!

Assembly Department: (Based on total assembly labor hours) =
@1 !!>1# 1>. .!
$!.*,+'','''
= = Rs. 2.74 per machine hours
7+B,''' 1>. .!
b. Calculation of product cost on the basis of Activity Based Cost allocation method.
Statement showing the product cost under Activity Based Cost Allocation Method
Product A Rs. B Rs. C Rs.
Direct costs: (A) 105.00 105.00 105.00
Overhead:
Per machine hour 15.90 14.31 12.72
(10 hrs x Rs. 1.59) (9 hrs. x Rs. 1.59) (8 hrs x Rs. 1.59)
Per set-up 2.14 7.13 13.17
(Rs. 4,280/2,000) (Rs. 4,280/600) (Rs. 4,280/325)
Per machine inspection 2.14 7.13 13.17
(Rs. 4,280/2,000) (Rs. 4,280/600) (Rs. 4,280/325)
Per Assembly: 8.00 9.00 10.40
(Rs. 1 x 8 hrs) (Rs. 1 x 9 hrs) (Rs. 1 x 10.40 hrs)
Per Assembly inspection 2.38 7.93 14.65
(Rs. 4,760/2,000) (Rs. 4,760/600) (Rs. 4,760/325)

Per Order placed 0.82 5.49 20.26

$!.),,&, *D $!.),,&, )'' $!.),,&, *''
[ ] [ ] [ ]
D',''' +',''' ),,*D'
Per Order received

0.35 5.75 2.124
$!.),A*, )' $!.),A*, )'' $!.),A*, *''
[ ] [ ] [ ]
D',''' +',''' ),,*D'
Total overhead (B) 31.73 56.74 105.61
Total product cost 136.73 161.74 210.61
i. Statement showing allocation of production overheads to Activities

(i) Identify (ii) Identify (iii) Reallocate factory Total
cost driver the cost of mgmt costs prorata to
activities other costs
Rs.‘000 Rs. ‘000
Rs. ‘000
1. Machining: Machine 230 1,430
Supervision running time 100 (Rs.1,200/Rs.4,200) x
Power 400 Rs. 800
Indirect materials 100
Depreciation 600
1,200
2. Machine set-up: No. of set-ups 85 535
Indirect labor (batch size) 400 (Rs. 450/Rs.4,200) x
Indirect materials 50 Rs. 800
450
3. Machining quality control: No. of 85 535
Indirect labor inspections 400 (Rs. 450/Rs.4,200) x
Indirect materials (batch size) 50 Rs. 800
450
4. Assembly: Direct labor 135 835
Supervision hours worked 200 (Rs. 700/Rs.4,200) x
Power 100 Rs. 800
Depreciation 300
700
5. Assembly quality control: No. of 95 595
Indirect labor inspections (Rs. 500/Rs.4,200) x
Indirect materials (batch size) 400 Rs. 800
100
500
6. Resource No. of orders 85 535
procurement: placed 300 (Rs. 450/Rs.4,200) x
Indirect labor (product/batch 50 Rs. 800

Indirect materials size) 100

Depreciation 450
7. Customer No. of orders 85 535
liaison/expediting: received (Rs. 450/Rs.4,200) x
Indirect labor (product) 300 Rs. 800
Depreciation 100
450
8. Factory management: (see No obvious
note below): driver
Indirect labor (size of 100
Indirect materials business?) 100
Depreciation 400
Security 100
Ground maint. 100
800 800 0
5,000 0 5,000
There is no obvious driver for the common costs collected under the heading ‘factory management’ so
they have been reallocated to other activity cost pools on the basis of their total costs.
ii. Calculation of overhead absorption rate on the basis of cost drivers
@1 /.0 4! $!.),&+','''

1. Machine rate per machine hour = =
@1 4 .! B'',''' 4 .!
= Rs. 1.59 per machine hour
@1 /.0 4! $!.D+D,'''

2. Rate per machine set-up = = = Rs. 4,280 per batch
@1 !E ! )*D
@1 /.0 4! $!.D+D,'''

3. Rate per machine inspections = = = Rs. 4,280 per batch
@1 ! 4! )*D
@1 /.0 4! $!.D+D,'''

4. Assembly rate per direct labor hour = = = Rs.1 per labor hr.
@1 !!>1# .! 7+B,'''
@1 /.0 4! $!.DBD,'''

5. Rate per assembly inspections = = = Rs. 4,760 per batch
@1 ! 4! )*D
@1 /.0 4! $!.D+D,'''

6. Rate per order placed= = = Rs. 1,646 per order
@1 .0. 140 +*D
@1 /.0 4! $!.D+D,'''

7. Rate per order received= = = Rs. 1,726 per order
@1 .0. 140 +)'

Verification of overhead charged:

Product Overheads (Rs.) Production (units) Total ( Rs. ‘000)
A 31.73 50,000 1,580
B 56.74 30,000 1,700
C 105.61 16,250 1,720
5,000
c. Comparison of product cost under two methods:

A B C
Traditional Method 156.92 156.66 157,50
Activity based costing method 136.73 161.74 210.61
Product C with a low total production volume, many purchase and customer orders, and frequent small
production run has significantly higher cost under ABC than under the traditional method. The opposite is
the case with the product A, which has a high total production volume, relatively few orders and large
production runs.
4.10 TREATMENT OF CERTAIN ITEMS IN COSTING
Treatment of interest and financial charges: There is controversy whether financial charges, especially
interest, should be included in the costs or not. The following arguments are generally advanced in favor
of interest to be included in overhead expenses.
(1) Computation of total cost is impossible unless interest is taken into account. Interest is an element of cost
and therefore, should be included in cost. This is especially true in business where raw materials in
different stages can be used. Thus a timber merchant, if he buys standing trees and seasons the timber
himself, would incur a large amount of costs as interest. Another merchant who buys the timber already
seasoned would automatically have to pay a higher price, obviously, this price includes interest.
(2) Interest is the cost to be paid for the use of capital; capital is also a factor of production as labor.
Thus, if wages are included in the cost of production, why not interest?
(3) If interest is not included in cost calculation, a number of managerial decisions may be taken
wrongly. Thus, where a decision involves replacement of labor with expensive machinery, the
question of interest assumes importance, since, if interest is not included, the cost accounting may
conclude that machinery is cheaper.
(4) Inclusion of interest also allows comparison of profit on different jobs. Thus, if a job takes 3 months
and another takes 6 months the cost of the jobs must include a charge by way of interest before profit
can be compared.

(5) In inventory control, interest is an important item to be considered. Where large stocks are kept, the
advantage of one time purchase is offset by increase in interest charges.
(6) While submitting tenders for cost plus contracts, etc. interest must be taken into account.
However, many cost accountants argue that interest should not be included in cost accounts since it is
not an item of cost and would vary with different methods of financing. Some of the arguments are
listed below:
1. Payment of interest depends entirely on the financing policies and financing pattern. A firm
working with proprietor’s capital only will have no interest to pay whereas a firm working with
borrowed capital will have to pay a large amount of interest. In reality, whether a firm raises a
certain sum of money from the proprietor or borrows from the outside does not make any
difference as far as production efficiencies are concerned. If we compare the two firms and
include interest as an item of cost, the firm, which works on the proprietor’s capital, will show
very favorable results. Actually, this is a wrong conclusion.
However, this argument can be met by including a notional amount of interest, irrespective of
the fact whether the funds belong to the owners or to the outsiders. Thus, an amount of notional
interest may be charged on the total capital whether it is borrowed or not.
2. Another practical difficulty arises in the calculation of the amount of capital on which interest
should be worked out. While the fixed capital is readily ascertainable, working capital keeps on
changing. Again, the difficulty becomes pronounced since the working capital would be used by
different departments, and allocation of the total interest charges will have to be made over
various departments at different points of time.
If notional interest is to be charged, the problem of determining a proper rate of interest also
arises. In the money and capital markets, there is a number of rates depending upon different
factors like risk, period of maturity, band rate etc.
3. By including interest on the proprietor’s capital and by taking that figure in the cost of
production, we would obviously be including profit since the closing stock will be valued at a
higher figure.
It appears that there are practical difficulties in including interest as part of the normal cost.
However, excluding it altogether may lead to wrong managerial decisions which are not
desirable. It is therefore, suggested that while interest may be excluded from the regular cost
sheet, cost calculations for other purposes for decision making should include a proper amount
of notional interest where the interest will be material.
Depreciation: Depreciation “is the diminution in the intrinsic value of an asset due to use and/or the lapse
of time.” We know that each fixed asset loses its intrinsic value due to their continuous use as such the
greater the use the higher is the amount of depreciation. The loss in the intrinsic value may also arise even
if the asset in question is not in service.

In Cost Accounting depreciation is charged to the cost of production. The various reasons for including
the depreciation charge in Cost Accounting are as follows:
i. To show a true and fair picture of Balance Sheet.
ii. To ascertain the true cost of production.
iii. To keep the asset intact by distributing losses in its value over a number of years.
iv. To keep the capital intact and to make a provision of the resources for the replacement.
v. To provide for depreciation before distribution of profit as required under the Companies Act.
Packing expenses: Cost of primary packing necessary for protecting the product or for convenient
handling, should become a part of the prime cost. The cost of packing to facilitate the transportation of
the product from the factory to the customer should become a part of the distribution cost. If the cost of
special packing is at the request of the customer, the same should be charged to the specific work order or
the job. The cost of fancy packing necessary to attract customers is an advertising expenditure. Hence, it
is to be treated as a selling overhead.
Fringe benefits: These are the additional payments or facilities provided to the workers apart from their
salary and direct cost-allowances like house rent, dearness and city compensatory allowances. These
benefits are given in the form of overtime, extra shift duty allowance, holiday pay, pension facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability of employees towards the
organization. If the amount of fringe benefit is considerably large, it may be recovered as direct charge by
means of a supplementary wage or labor rate; otherwise these may be collected as part of production
overheads.
Expenses on removal and re-erection of machines: Expenses are sometime incurred on removal and re-
erection of machinery in factories. Such expenses may be incurred due to factors like change in the
method of production; an addition or alteration in the factory building, change in the flow of production,
etc. All such expenses are treated as production overheads. When amount of such expenses is large, it
may be spread over a period of time.
If such expenses are incurred due to faulty planning or some other abnormal factor, then they may be
charged to costing Profit and Loss Account.
Bad debts: There is no unanimity among different authors of Cost Accounting about the treatment of bad
debts. One view is that ‘bad debts’ should be excluded from cost. According to this view bad debts are
financial losses and therefore, they should not be included in the cost of a particular job or product.
According to another view it should form part of selling and distribution overheads, especially when they
arise in the normal course of trading. Therefore bad debts should be treated in cost accounting in the same
way as any other selling and distribution cost. However extra ordinarily large bad debts should not be
included in cost accounts.

Training expenses: Training is an essential input for industrial workers. Training expenses in fact
includes wages of workers, costs incurred in running training department, loss arising from the initial
lower production, extra spoilage etc. Training expenses of factory workers are treated as part of the cost
of production. The training expenses of office, sales or distribution workers should be treated as office;
sales or distribution overhead as the case may be. These expenses can be spread over various departments
of the concern on th basis of the number of workers on roll.
Canteen expenses: The loss incurred by the firm in running the canteen should be regarded as a
production overhead. If the canteen is meant only for factory workers therefore this loss should be
apportioned on the basis of the number of workers employed in each department. If office workers also
take advantage of the canteen facility, a suitable share of the loss should be treated as office overhead.
Carriage and cartage expenses: It includes the expenses incurred on the movement (inward and
outwards) and transportation of materials and goods. Transportation expenses related to direct material
may be included in the cost of direct material and those relating to indirect material (stores) may be
treated as factory overheads. Expenses related to the transportation of finished goods may be treated as
distribution overhead.
Expenses for welfare activities: All expenses incurred on the welfare activities of employees in a
company are part of general overheads. Such expenses should be apportioned between factory, office,
selling and distribution overheads on the basis of number of persons involved.
Night shift allowance: Workers in the factories, which operate during night time are paid some extra
amount known as ‘night shift allowance’. This extra amount is generally incurred due to the general pressure
of work beyond normal capacity level and is treated as production overhead and recovered as such.
If this allowance is treated as part of direct wages, the jobs/production carried at night will be costlier than
jobs/production performed during the day. However, if additional expenditure on night shift is incurred to
meet some specific customer order, such expenditure may be charged directly to the order concerned. If
night shifts are run due to abnormal circumstances, the additional expenditure should be charged to the
costing profit and loss account.
SUMMARY OF FORMULAE
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Overhead Absorption Rate / Overhead Recovery Rate = RH6S6 9T UV69;WGS9P
R:NXLGLN JKL;MLHN T9; GML YL;S9N

Predetermined Overhead Rate =
R:NXLGLN RH6S6 T9; GML WL;S9N
JKL;MLHN Q96G T9; GML LPGS;L THQG9;Z T9; H WL;S9N

Blanket Overhead Rate =
F9GHI RH6L T9; GML WL;S9N
JKL;MLHN HII9QHGLN HWW9;GS9PLN G9 LHQM NLWH;G[LPG

Multiple Overhead Rate =
\9;;L6W9PNSPX RH6L


1. Define Overhead. Explain various classifications of overheads according to functions.
2. Explain the various methods of distribution of Semi variable expenses into fixed and variable
expenses.
3. What do you understand by classification, allocation and apportionment in relation to overhead
expenses?
4. (a) Explain the different methods of apportionment of service department costs over production
department.(b) What are the methods of secondary distribution of overheads? Explain the details
three methods available for dealing with reciprocal services, giving examples for each.
5. What do you understand by absorption of overheads? How does it arise? How it is treated in cost
account?
6. What do you mean by under and over absorption of overheads? How does it arise/ How it is treated
in cost accounts?
7. How you would treat the following items in cost accounts?
a. Idle capacity costs
b. Research and development costs
c. Bad debts
d. Fringe benefits
e. Training expenses
8. A factory produces three products A, B and C. Which of the following costs are prime costs and
which are overheads? In case of overheads classify them by function.
a. Salary of the Accountant
b. Temporary labor employed to increase production in order to meet unusual demand of
product C
c. Uniform of sanitary workers
d. Raw material, godown, Keeper’s salary
e. Dividend received on investment
f. Freight on purchase of raw material
g. Remuneration of legal advice
h. Consultation fee of advertisement designer
i. Rent of godown for storing finished goods
j. Rent of godown for storing raw materials
k. Salary paid to wife of managing director. She is designated as whole time director but does
not come to the factory at all.
l. Loss due to accident falling of the roof of a section of the factory.
m. Primary packing to keep the product crisp.
n. Secondary packing with the name of the company.
o. Packing of boxes of finished product in wooden crates for transportation.
p. Income from the sale of the bags in which raw material were procured.
q. Depreciation of pattern and dies.
r. Bad debts
s. Cost of stolen materials
t. Commission paid to salesman as a percentage of sales price
u. Expenses incurred for repair and maintenance of water supply lines, sewage pipes etc.
v. Royalty paid on the basis of sales
w. Amount paid to lawyer for appearing before a Labor Tribunal.
x. Allowance paid to customers for late deliveries of goods

y. Carriage inward
9. Classify the following costs into fixed, semi-variable and variable costs:
a. Salary of the managing director
b. Salary of foreman
c. Raw material cost
d. Wages of permanent worker
e. Commission to salesman as percentage to sales
f. Depreciation of plant
g. Rent of factory
h. Power consumption in the production process
i. Canteen expenses
j. Salary of the store keeper.
10. A firm tells you:
a. That it is using a machine which has nil value in books;
b. That a machine acquired in 1983 had to be discarded in 1989, a sum of Rs.1,000 being
realized against the book figure for Rs. 6,500;
c. That a machine while being brought to the factory for the first time from supplier’s godown,
fell accidently: a sum of Rs.4,000 was spent on its repairs and
d. That it has to carry out extensive overhaul of its plant and machinery every five years.
e. How will costs be affected by the above mentioned factors?
a. The salary paid to the private secretary to the general manager is an item of …………
expenses.
b. Service department expenses are collected like those of production department but are
then………. Over the ……….. Department.
c. Under the step ladder system expenses of the department …… are apportioned to all other
departments; thus one by one all ……….. Departments are dealt with.
d. Under the cycles method expenses of a ………. Department are ……. To all other
departments; this is done repeatedly till the amount for a department becomes…………..
when it will be …….. only to……..departments.
e. The ………. System of apportionment of overhead takes into account profitability of the
various departments.
12. Indicate which of the following statements are true:
a. Factory overhead and’ other expenses’ are synonymous terms.
b. Department which assist producing departments indirectly are called service departments.
c. Variable overhead vary with time.
d. When actual overheads are more than absorbed overhead, it is known as over absorption.
e. Cost of indirect materials is apportioned to various departments.
f. A blanket overhead rate is a single overhead rate computed for the entire factory.
g. Under absorption of overheads mean that actual overheads are more than absorbed
overheads.
h. The application of predetermined overhead rates is a reason for the difference in costing and
financial profit or loss.
i. Apportionment of the overhead is the allotment of whole items cost to cost center or cost unit.
j. Machine hour rate is separately computed for each machine.
k. Administration overheads are usually absorbed as a percentage of prime cost.
l. Under-absorption of overhead results in understatement of cost.
13. In the following multiple choice question select the correct answer:

a. Director’s remuneration and expenses form a part of :

b. Production overhead
c. Administration overhead
d. Selling overhead
e. Distribution overhead
f. Salary of the foreman should be classified as a:
g. Fixed overhead
h. Variable overhead
i. Semi-fixed or Semi-variable overhead
j. Absorption means:
i. Charging of overheads to cost centers
ii. Charging of overheads to cost unit.
iii. Charging of overheads to cost centers or cost unit.
k. Which of the following is a service department?
i. Refining department
ii. Machining department
iii. Receiving department
iv. Finishing department
l. When the amount of under or over absorption is significant, it should be disposed off by:
i. Transferring to Costing Profit and Loss account
ii. The use of supplementary rate
iii. Carrying over as a deferred charge to the next accounting year.
Answer to Self Examination Questions

8. Prime cost:- b, f, p, y
Factory overheads:- c, d, j, q, u
Administration overheads:- a, g, w
Selling overheads:- h, n, r, t, v
Distribution overheads:- i, o
Costing profit and loss account:- e, k, l, s, x
9. Fixed: a, b, g, i and j
Semi-fixed: Partly d, f
Variable: c, partly d, e, f
10. (a) Usual depreciation should be included in overheads as notional depreciation.
(b) and (c) abnormal losses.
(d) One fifth of cost should be included on overhead each year.
11. (i) Administrative
(ii) Apportioned, production
(iii) Receiving the least amount of service from other service department’s service.
(iv) Service, apportioned, small, apportioned, production
(v) Ability to pay
12. True statements are (b), (f), (g), (h), (i)
13. (a) ii; (b) iii; (c) ii; (d) iii; (e) ii.

CHAPTER 5
UNIT COSTING
CHAPER 5 : UNIT COSTING
5.1 UNIT COSTING (SINGLE OR OUTPUT COSTING)
Unit costing is a simple method of ascertaining cost per unit where there is one or uniform product. In
other words, “single or output cost system is used in the business where a standard product is turned out
and it is desired to find out the cost of basic unit of production” It is applied where the manufacturing
process is a simple one and the product also is generally single (may be a few but of same kind not
varying in grades or quality). The industries where this method of costing is used are collieries, quarries,
brick-making, breweries, etc. The unit of cost is the unit in which ultimate production is measured e.g. per
ton of coal, per 100 bricks or per article of the single product.
For calculating cost per unit, a statement of cost is prepared. The technique of preparing this statement
has been explained in the first chapter. This statement shows prime cost, works cost, cost of production,
cost of goods sold and cost of sales. Profit may be ascertained if selling price is known or estimated. It is
a periodical statement which is prepared weekly, fortnightly, monthly, quarterly or annually.
Various components of cost are arranged to ascertain above costs. The total of Direct Material, direct
wages and other Direct Expenses is called Prime Cost. When Factory expense or overheads are added to
prime Cost, the total becomes Factory Cost. Thereafter Office and Administrative overheads are added to
Factory Cost. The total at this level is known as Cost of Production or Office Cost. Selling and
Distribution overheads are added to office cost, the total becomes Total Cost or Final Cost. The
difference between Total Cost and Sales is Profit. In order to calculate profit, the opening and closing
stocks of finished goods are adjusted so that cost of goods sold may be arrived at. The statement of profit
will be as below:
Statement of Profit
Particular Amount
Cost of Production or Office Cost --------
Add: Opening stock of finished goods -------
Less: Closing stock of finished goods (------)
Cost of goods sold --------
Add: Selling and distribution overheads -------
Cost of Sales --------
Profit --------
Sales --------

5.2 COST SHEET
It is similar to Statement of Cost, but it includes and shows certain other information relating to cost. It
shows cost per unit of each item of cost and also their percentage to total cost.
According to CIMA London, Cost Sheet is ‘A statement which provides for the assembly of the detailed
cost of a center or cost unit’ It is also a periodical statement.
The expenditure which has been incurred upon product for a period is extracted from the financial books
and the store records and set out in a memorandum statement. If this statement is confined to the
disclosure of the costs of unit produced dividing the period, it is termed as Cost Sheet, but where the
statement records total cost, profit and sales, it is usually known as Statement of Cost or Production
Account.
If information derived from the books is set out usually in the form of a statement, it is cost sheet. But
where it is set out in the form of an account recording the cost incurred, there being separate accounts to
show also sales and profit, it would be known as Production or Manufacturing Account.
It is desirable that besides total expenditure incurred, cost per unit of output in case of each element of
cost should be calculated and also the percentage contribution of each item to the cost of production
should be indicated. Further, the cost sheet should give ‘cost per unit’ in the previous period also, if
available for the purpose of comparison. Opening and closing block of finished goods may be put in a
subsidiary statement, which together with the total cost of production and sales will reveal profit. The
opening stock, purchases and closing stock of raw material should not be shown separately, but suitably
adjusted to give one figure of raw materials consumed or used. Financial items like interest, discount etc.
should be ignored.
Element of Cost:
Although elements of cost have been discussed in detail in previous chapters, these are again briefed for
convenience and recapitulation.
(1) Direct Materials:

Since there will be only one product and process of manufacture is also simple, the raw material if any is
directly charged to the production of the period in total.
Material consumed:
Particular Amount
Opening stock of Raw Materials
Add: Purchases
Add: Carriage inward and other incidental charges
Less: Closing stock of direct material
Less: Scrap of raw material (abnormal)
Less: Materials returned or transferred to other departments.

(2) Direct Labor:

The labor costs are collected periodically through pay rolls which are prepared separately for each section
of work. The cost of abnormal idle time should be deducted.
(3) Other Direct and Chargeable Expenses:

Expenses other than direct material and direct labor is chargeable expenses e.g. excise duty, royalty,
expenses on designs pattern and models etc.
(4) Prime Cost:

The total of Direct Materials Consumed, Direct Labor and Other Direct or Chargeable Expenses is known
as Prime Cost.
(5) Works Expenses or Overheads:

Factory expenses or manufacturing expenses have been discussed in detail in a separate chapter. In unit
costing, these expenses related to the product are added to Prime Cost. These are (i) Indirect materials like
oil, dusters, lubricants etc., (ii) Indirect labor like wages to foreman, storekeeper, watchman, factory
clerks etc., (iii) Steam, fuel or electric power, (iv) Lighting, heating and water in the factory, (v) Rent,
insurance and rates of factory, (vi) Repairs and depreciation of machines plant, factory building and lose
tools, (vii) Factory stationery, (viii) Factory research expenses, (ix) Expenses related to factory
establishment (x) Drawing office salary, (xi) Welfare expenses and workman’s compensation, insurance,
etc.
(6) Scrap or Wastage:

In the production of anything some wastage or scrap materials is obtained. Sometimes some of the units
produced may be defective and such units or scrap or wastage is sold. The amount thus obtained should
be deducted from factory expenses or from works cost. If however, the materials (when about to be used)
are found to be defective and then sold, the value of materials used should be reduced by the cost of such
materials. The loss on sale of such defective materials should be debited to the Costing Profit and Loss
Account.
(7) Work-in-Progress:
In any factory or workshop there are always some units which are not yet complete, but on which some
work has been done. Such work is known as work-in-progress or work-in-process. The valuation of such
work-in-progress is made on the basis of the value of material already used, the amount of wages paid for
the work concerned and a proper share of factory expenses. Since various units will be at different stages
of production, the value of work-in-progress will have to be estimated for each stage separately.
The work-in-progress in the beginning is to be added to the current costs of production and that at the end
of the period has to be deducted from the manufacturing cost. This may be done when factory expenses
have been added to the prime cost. It may look as follows:
Rs.
Prime Cost 120,000
Factory Expenses (works Overheads) 80,000
Gross Works Cost 200,000
Add: Work-in-progress in the beginning 15,000
215,000

Less: Work-in-progress at the end 20,000

Works Cost 195,000
After this office expenses will be added as usual and the total cost of production of the finished units is
ascertained.
There is an alternate method also. This will be if the analysis of the value of work-in-progress is known.
Suppose the figures are available as under:
Work-in-progress in the beginning Work-in-progress at the end

(Rs.) (Rs.)
Materials 3,000 4,000
Labor 2,000 2,500
Factory Expenses 1,500 2,000
Total 6,500 8,500
In this case when we ascertain the value of materials used, we add Rs.3,000 for materials included in
work-in-progress in the beginning and deduct Rs. 4,000 for materials included in work-in-progress (WIP)
at the end. This will give cost of materials used on finished units produced. The figure for materials used
may then be as follows (figures assumed):
Rs.
Opening Stock 25,000
Materials in WIP in the beginning 3,000
Add: Purchases 120,000
148,000
Less: Closing stock of materials 28,000
Materials included in WIP at the end 4,000 32,000
Materials used 116,000
Similar treatment will be given to labor and factory expenses, that is to say, in each case the amount
included in WIP in the beginning will be added and that included in WIP at the end deducted. Needless to
say there will be no necessity then to do anything further about WIP.
8. Office and Administrative Expenses:

Works cost or manufacturing cost is increased by office and administrative expenses. These are for
example, (i) Staff and Management salaries, (ii) Directors Fees, (iii) Stationery, Printing, Postage,
Telephone, Fax and miscellaneous office –expenses, (iv) Office rent, tax, insurance, light and water etc.,
(v) Counting house or computer and accounting expenses (vi) Repairs, depreciation and insurance of
office building, furniture and equipment.
9. Cost of Production or Office Cost:

When office and administration overheads are added to works cost, the total shows cost of production.
10. Cost of Goods Sold:

If all goods produced are not sold, the cost of goods sold should be ascertained:
Calculation of Cost of Goods Sold

Particular Amount
Cost of production
Add: Opening stock of finished goods ---
Less: Closing stock of finished goods ---
Cost of Goods Sold
11. Selling and Distribution Expense:

These are added to Cost of Goods sold. The total is known as ‘Cost of Sales’.
12. Profit: Profit is difference between sales and cost of sales.
Calculation of Profit
Particular Amount
Cost of Goods Sold
Add: Selling and Distribution Expenses ---
Cost of Sales
Profit
Sales
Treatment of Defective or Rejected Production:

The defective production are those production that is not as perfect as the saleable product but is capable
of being rectified and brought to required degree of perfection provided some additional expenditure
overheads. The cost of rectification is treated to be additional works overheads. On the other hand, the
production that has been totally rejected and cannot be rectified, the amount so realized by sale of these
goods is used to reduce the cost of factory cost.
Specimen 1: Cost Sheet (Simple)
For the month ending ….20……

(Output in Tons) (Unit = one ton)
Particulars Cost per ton Total cost
(Rs.) (Rs.)
Direct Materials - -
Direct Wages or direct Labor - -
Direct or Chargeable Expenses - -
A. Prime Cost - -
Works on cost or Factory on cost or Works overheads
(may be percentage of Direct Labor)
B. Works cost - -
Office on cost or office overheads - -
(may be a percentage of works cost or work on cost)

C. Cost of Production or Office Cost - -

Selling and distribution expenses - -
D. Total Cost - -
Profit (may be a percentage of total cost or selling price) - -
(E) Selling Price - -
Specimen 2: Comparative Cost Sheet
Three months ending Three months ending

31-3-20… 31-6-20…
Output (…..Units) Particulars Output (…..Units)
Total (Rs.) Cost per Total Cost per
Unit (Rs.) (Rs.) Unit
(Rs.)
Direct Materials
Direct Wages or direct Labor
Direct or Chargeable Expenses
A. Prime Cost
Works on cost or Factory on cost or Works
overheads
B. Works cost
Office on cost or office overheads
C. Cost of Production or Office Cost
Selling and distribution expenses
D. Total Cost
Profit
E. Selling Price
Specimen 3: Cost Sheet (detailed)

Particulars Cost per Total cost
ton (Rs.) (Rs.)
Material Consumed
Raw materials on 1st April (opening)
Add: Purchases during the period
Add: Carriage Inward
Less: Raw Materials on 31st March (closing )
Direct Wages
Direct or Chargeable Expenses
(A) Prime Cost
Works or Factory on cost:
Indirect wages
Depreciation on Machinery etc.
Depreciation on Factory Building etc.
Fuel, Electric Power etc.
(B) Gross Works cost
Add: Opening WIP

Less: Closing WIP

Less: Sale of Scrap etc.
(C) Works or Factory cost
Office on cost:
Office salaries
Office rent
Depreciation of office building and furniture etc.
Repairs to Office Building, furniture etc.
General Expenses etc.
(D) Total Cost of Production
Add: Opening stock of Finished Goods
Less: Closing stock of Finished Goods
(E) Cost of Goods Sold
Selling and distribution expenses
(F) Cost of Sales
Profit
Selling Price
Illustration: 1
From the following particulars prepare a Cost Sheet showing the cost per item and total cost per ton for
the period ended 31st Asadh 2072
Rs. Rs.
Raw Materials 33,000 Rent and Taxes- Office 500
Productive Wages 35,000 Water Supply 1,200
Unproductive Wages 10,500 Factory Insurance 1,100
Factory Rent and Taxes 7,500 Office Insurance 500
Factory Lighting 2,200 Legal Expenses 400
Factory Heating 1,500 Direct Expenses 3,000
Motor Power 4,400 Rent of Warehouse 300
Haulage 3,000 Depreciation of Plant and Machinery 2,000
Directors Fees – Works 1,000 Depreciation of Office Building 1,000
Directors Fees –Office 2,000 Depreciation of Delivery Vans 200
Factory Cleaning 500 Bad Debts 100
Sundry Office Expenses 200 Advertising 300
Factory Stationery 750 Sales Department – Salary 1,500
Office Stationery 900 Upkeep of Delivery Van 700
Loose Tools Written off 600 Bank Charges 50
Commission on Sales 1,500
Note: The total output for the period has been 15,000 tons
Solution:
Cost Sheet for the period ended 31st Asadh 2072
(Output – 15,000 tons)
Cost per ton (Rs.) Cost per ton (Rs.)
Raw Materials 2.200 33,000

Productive Wages 2.333 35,000

Direct Expenses 0.200 3,000
Prime Cost 4.733 71,000
Works Expenses:
Unproductive Wages 0.700 10,500
Factory Rent and Taxes 0.500 7,500
Factory Lighting 0.147 2,200
Factory Heating 0.100 1,500
Motor Power 0.294 4,400
Haulage 0.200 3,000
Directors Fees – Works 0.067 1,000
Factory Cleaning 0.033 500
Factory Stationery 0.050 750
Loose Tools Written off 0.040 600
Water Supply 0.080 1,200
Factory Insurance 0.073 1,100
Depreciation of Plant and Machinery 0.133 2.417 2,000 36,250
Work Cost 7,150 107,250

Office Expenses:
Directors Fees –Office 0.133 2,000
Sundry Expenses 0.013 200
Office Stationery 0.060 900
Rent and Taxes 0.033 500
Office Insurance 0.033 500
Legal Expenses 0.027 400
Bank Charges 0.004 50
Depreciation of Office building 0.067 0.370 1,000 5,550
Cost of Production 7.520 112,800
Selling and Distribution Expenses
Rent of Warehouse 0.020 300
Depreciation of Delivery Vans 0.013 200
Bad Debts 0.007 100
Advertising 0.020 300
Sales Department – Salaries 0.100 1,500
Upkeep of Delivery Van 0.047 700
Commission on Sales 0.100 0.100 1,500 4,600
Total Cost 7.827 117,400
Illustration: 2
Prepare a Cost Sheet showing cost per cabinet and profit per cabinet from the following particulars. The
cabinets manufactured are classed ‘No.1’ and No.2’. There is no opening or closing stock of cabinets.
No.1 No.2
Materials Rs. 12,400 13,232
Labor Rs. 22,540 25,358

No. Sold 520 780

Selling Price (per unit) Rs. 150 110
Works Overhead comes to 100 per cent on labor and Office Overheads to 25 per cent on Works Cost.
What is the total profit for the year as per above particulars?
Solution:
Cost Sheet Rs.
Particulars Cabinet No.1 Cabinet No.2
(Output – 520) (Output – 780)
Total Cost Cost per Total Cost Cost per
of No.1 Cabinet of No.2 Cabinet
No.1 No 2
Materials 12,400 23.85 13,232 16.96
Labor 22,540 43.35 25,358 32.51
Prime Cost 34,940 67.20 28,590 49.47
Works on Cost (100% on labor) 22,540 43.35 25,358 32.51
Works Cost 57,480 110.55 63,948 81.98
Office On Cost (25% on Works Cost) 14,370 27.63 15,987 20.50
Cost of Production 71,850 138.18 79,935 102.48
Profit 6,150 11.82 5,865 7.52
Sales 78,000 150.00 85,800 110.00
5.3 PRODUCTION STATEMENT

The production or output statement shows sales, stocks, and profit besides the cost in a statement format.
The difference between a cost sheet and production statement is that a cost sheet merely records the costs
incurred during the period, whereas a production statement records sales, stocks, and profit in addition to
the costs incurred.
Production account
Production Account is a statement of cost or cost sheet in a ledger account form, showing during a given
period, total cost and per unit cost incurred during the period and their components, as also the profit or
loss for that period.
According to Glover and Williams, ‘The term Production Account is used to denote a particular form of
Manufacturing Account, prepared in conjunction with the financial account in order to show the actual
cost of producing the goods manufactured during the period under review. These accounts may be drawn
up at short intervals e.g. monthly.’
It should be noted that Production Account is prepared in the form in which Trading Account is prepared.
It has normally two parts. The first part gives total cost as well as cost per unit. The second part gives the
cost of goods sold and sales.

Specimens of production A/c

Specimen 1
Production Account (For 3 months ended)
Output …. Tons
Particulars Qty. Amt per Total Particulars Qty. Amt per Total
ton ton
Tons Rs. Rs. Tons Rs. Rs.
To Material consumed By WIP at end
To Wages
To Indirect Charges By Cost of
To Factory Overheads Production
To Office Overheads
To General Exp. Etc.
To WIP at the beginning
To Cost of Production b/d By Sales

To Opening Stock of By Closing Stock of
Finished Goods Finished goods
To Profit
Specimen 2
Production or Manufacturing and Profit & Loss Account for the
year ending 31 Asadh 20….
Particulars Rs. Particulars Rs.
To opening Stock of Raw Materials By Prime Cost c/d
To Purchases of Raw Materials
To Carriage on Purchases
Less: Closing Stock of Raw Materials
= Cost of Materials consumed
To Direct Wages
To Prime Cost b/d By Works Cost c/d

To Indirect Wages
To Manufacturing Expenses
To Rent, Rates and Insurance
To Light & Power
To Repairs to Premises
To Repairs to Plant & Machinery
To Depreciation of Plant & Machinery
To Work-in-Progress at beginning
Less: Work-in-Progress at end
To Works Cost b/d By Cost of Production c/d

To Salaries
To Rent, Rates and Insurance (Office)
To Light & Power (Office)

To Repairs to Premises (Office)

To Office Expenses
To Opening Stock of Finished Goods By Cost of Goods Sold c/d

To Cost of Production b/d
Less: Closing Stock of Finished Goods
To Cost of Goods Sold b/d By Sales of Finished Goods

To Carriage on Sales
To Profit c/d
Illustration: 3
From the following particulars make out a monthly cost sheet or production account of the Coke and By-
Products Company showing cost per ton and percentage of cost used in each item of output on January,
2015
Tons Rate per ton (Rs) Amount (Rs.)
Coal used 5,000 12.50
Coke produced 3,500 25.00
Tar produced 210 50.00
Sulphate of Ammonia produced 49 150.00
Benzol produced 48 65.00
Raw Materials used 8,750
Wages paid 3,585
Repairs and Renewals 2,815
General Charges 4,050
Solution:
Cost Sheet or Production Account of Coke and By-Products Company
(For the month ended 31st January 2015)
Particulars Cost Qty Amt % to Particulars Cost Qty Amt % to
per ton Tons Rs. Coal per Tons Rs. Coal
Rs. used ton used
Rs.
To Coal used 12.5 5,000 62,500 100 By Coke 25 3,500 87,500 70
Produced
To Raw materials 8,750 By Tar Produced 50 210 10,500 4.2
To Wages 3,585 By Sulphate of 150 49 7,350 0.98
Ammonia
produced
To Repairs & By Benzol 65 48 3,120 0.96
Renewals produced
To General 2,815 By Loss in - 1,193 - 23.86
Charges Weight
Total Cost

To P & L A/c 4,050

(Profit 81,700
Transferred)
26,770
- 5,000 108,47 100 - 5,000 108,47 100

0 0
Illustration: 4
From the following balances of a manufacturing company, you are required to prepare Production
Account; number of articles produced is 4,000.
Rs.
Stock of Materials at beginning 35,000
Stock of Materials at end 4,900
Purchase of Material 52,500
Factory Wages 95,000
Factory Expenses 17,500
Establishment Expenses 10,000
Completed Stock at start Nil
Completed Stock at end 35,000
Sales 189,000
Solution
Production Account
(Output – 4,000 articles)
Particulars Cost per Total Rs. Particulars Cost Total Rs.
article per
Rs. article
Rs.
To Material consumed By Cost of Production 51.275 205,100
Opening Stock of RM 35,000 c/d
Add: Purchases 52,500
87,500
Less: Stock at end 4,900 20,650 82,600
To Factory Wages 23,750 95,000
Prime Cost 44,000 177,600
To Factory Expenses 4,375 17,500
Factory Cost 48,775 195,100
To Establishment
Expenses 2,500 10,000
51.275 205,100 51.275 205,100
To Cost of Production By Closing Stock of
b/d 51.275 205,100 Finished articles 35,000
To Profit 18,900 189,000
224,000 224,000

Illustration: 5
Given below is the Cloth and Yarn Manufacturing Accounts of Arvind Mills for the year ended 31st
Asadh 2072
Rs. Rs.
To opening stock By sales of 224,000 kg of waste,
Yarn 44,800 kg 33,600 being that portion of
Cloth 88,200 kg 88,200 1,153,600 kg of cotton as per
121,800 contra which could not be
To Cotton consumed 1,153,600 kg 901,250 utilized in yarn manufacture 28,000
To spinning wages 57,050 By Yarn Sales 168,000 kg 189,000
To Weaving wages 91,700 By Cloth Sales 756,000 kg 897,750
To Stores consumed in spinning
which increased yarn by 5,600 By Closing Stock:
kg in weight 41,300 Yarn 140,000 kg 148,750
To Stores and sizing materials Cloth 190,400 kg 214,200
consumed in weaving which
increased cloth by 186,200 kg
in weight 148,400
To Spinning fuel 36,050
To Weaving fuel 22,400
To Gross Profit 57,750
1,477,700 1,477,700
In the above Manufacturing Account (where the closing stock of yarn and cloth is taken at actual cost), it
is contended by the Income Tax Authorities that the closing stock is valued below cost price, in order to
suppress the gross profit actually made.
For the satisfaction of the authorities you are required to prepare from the above Manufacturing Account
a separate Yarn Production Account and separate Cloth Production Account showing the following
details:
a) Gross Profit of the Department.
b) Total Quantity produced (including the Opening Balance)
c) Total cost of Production (including the value of Opening Stock which was at cost)
d) Cost of production per kg (including the quantity of the opening stock in total quantity, and the
cost of opening stock in the total cost).
In manufacturing cloth 672,000 kg of Yarn was consumed which to be adjusted at the actual cost is
arrived at in the manner.
Solution
Yarn Production Account
Particulars Qty (kg) Amount Particulars Qty (kg) Amount
(Rs.) (Rs.)
To Opening Stock 44,800 33,600 By sales 224,000 28,000
To Cotton consumed 1,153,600 901,250 By Cost of Production
To Stores consumed in including opening
spinning 5,600 41,300 stock (Rs. 1.0625 per 980,000 1,041,250
To Spinning wages 57,050 kg)

To Spinning fuel 36,050

1,204,000 1,069,250 1,204,000 1,069,250
To Cost of Production By Sales of Yarn 168,000 189,000
including opening By Cloth A/c (at cost
stock (Rs. 1.0625 per @ 1.0625) 672,000 714,000
kg) 980,000 1,041,250 By Closing stock on
To Gross Profit 10,500 31 Asadh at Cost 140,000 148,750
980,000 1,051,750 980,000 1,051,750
Cloth Production Account

Particulars Qty (kg) Amount Particulars Qty (kg) Amount
(Rs.) (Rs.)
To Opening Stock 88,200 88,200 By Cost of Production
To Cotton consumed 672,000 714,000 including opening
To Stores consumed 186,200 148,400 stock (Rs. 1.1250 946,400 1,064,700
To Weaving wages 91,700 per kg)
To Weaving fuel 22,400
946,400 1,064,700 946,400 1,064,700
To Cost of Production 946,400 1,064,700 By Sales 756,000 897,750
To Gross Profit 47,250 By Closing stock on 31
Asadh at Cost 190,400 214,200
946,400 1,111,950 946,400 1,111,950
(a) Gross profit

Yarn Rs. 10,500
Cloth Rs.47,250
(b) Total quantity produced including opening stock
Yarn Rs. 980,000 kg
Cloth Rs.946,400 kg
(c) Total cost of production including opening stock
Yarn Rs. 1,041,250
Cloth Rs.1,064,700
(d) Cost per kg including opening stock
Yarn Rs. 1.0625
Cloth Rs.1.1250

CHAPTER 6
COST BOOK KEEPING
CHAPER 6 : COST BOOK KEEPING
6.1 INTRODUCTION
To operate business operations efficiently and successfully, it is necessary to make use of an appropriate
accounting system. Such a system should state in clear terms whether cost and financial transactions
should be integrated or kept separately (Non-integrated). Where cost and financial accounting records are
integrated, the system so evolved is known as integrated or integral accounting. In case cost and financial
transactions are kept separately, the system is called Non-Integrated Accounting or Cost control System.
While non-integrated system of accounting necessitates reconciliation between financial and cost
accounts, no reconciliation between two sets of accounts is required under integrated accounting.
6.2 NON-INTEGRATED ACCOUNTING SYSTEM

In cost accounting the cost books are basically maintained under the following two systems:
(a) Non-integrated cost accounting.
(b) Integrated cost accounting.
The system is called non-integral when cost and financial transactions are kept separately. On the
contrary when the cost and financial transactions are integrated the accounting system is known as
integrated or integral. Under non-integral accounting system separate ledgers are maintained for cost and
financial transaction.
The financial accounting department maintains the following financial ledgers:

a. General ledger: It contains all real, nominal and personal accounts except trade debtors and creditors
account.
b. Debtors Ledger: It has personal accounts of trade debtors.
c. Creditors ledger: It has personal accounts of trade creditors.
6.2.1 Principal Ledgers in Cost Departments

The cost accounting department maintains the following cost ledgers:
a. Stores ledger: This ledger contains all stores accounts. A separate account is opened for
each item of stores.
b. Work-in-progress ledger: All cost of materials, wages and overhead for each job or
manufacturing in progress are posted to the respective job accounts in this ledger.
c. Finished goods/ stock ledger: This ledger records details of finished goods and jobs.
d. Cost ledger: This is main ledger and records impersonal accounts that are accounts relating
to income and expenditure.
6.2.2 Principal Accounts to be Maintained

The following accounts are maintained in cost ledger.
1. Cost Control Accounts
These accounts are maintained to exercise control over the three subsidiary ledgers discussed above and
also to complete double entry in cost accounts. They summarize all detailed information contained in the
subsidiary ledger and also help in reconciliation of cost and financial accounts. The important cost control
accounts are as follows:
(a) Stores Ledger Control Account - The purpose of stores ledger is to maintain item-wise record of raw
materials and other stores. In cost ledger, a Stores Ledger Control Account is prepared relating to
this subsidiary ledger. The total material received in stores ( which can be found in purchase journal

also) is shown on the debit side of Stores Ledger Control Account and the total materials issued out
of Stores (which can be found in materials abstract) is credited in the account. The balance of this
account shall tally with the total of balances of the individual stores account in the Stores Ledger.
Sometimes separate ledgers are kept for raw materials and other stores. In that case there will be two
separate control account namely Material Ledger Control Account and Stores Ledger Control
Account.
(b) Work-in-progress ledger control account – for every job, product or process, material, labor and
factory expenses are incurred. All such costs are debited to different accounts relating to different
jobs or products. These accounts are kept in a job or work-in-progress ledger. A work-in-progress
ledger control account is prepared in the cost ledger. The cost of production of completed jobs will
be credited to this account and the total expenses incurred on all the jobs will be debited so as to
show the total work in progress at any time. The balance of this account must be equal to the total of
individual balances of job or process accounts in the job ledger. The work-in-progress ledger control
account is referred to as Work-in Progress Account also.
(c) Finished goods ledger control account – In finished goods ledger, a separate account is opened for
recording the quantity and price of each finished product manufactured or job completed. In cost
ledger, a finished goods ledger control account is maintained. It is also known as Stock Ledger
Control Account. It gives the total value of finished goods in stock at a particular time.
(d) General Ledger Adjustment Account – In cost ledger a General Ledger Adjustment Account is
opened to record all items of income and expenditure. This account is also referred to as cost ledger
control account (in costing books). Personal accounts are shown in financial accounts and not in
cost accounts. The General Ledger Adjustment Account completes the double entry in the cost
ledger and hence all such accounts which pertain to fixed assets or cash or outsiders are posted to
this account. All expenditures are shown on the credit side of this account; and the result (benefits)
of such expenditure in the form of sale is shown on the debit side of this account. The balance
represents the value of stores, stock-in-hand and the amount of work-in-progress.
(e) Cost Ledger Control Account (in financial books) – Since the costing department does not act in
isolation from the financial department and all the purchases and sales are recorded through
financial books, a Cost Ledger Control Account must be opened in the financial books. This is only
a memorandum account. In this account all the items of revenue and expenditure affecting the Cost
Accounts are recorded. This account is just the reverse or contrast of the General Ledger
Adjustment Account in the Cost Ledger and therefore, the balance of this account should tally with
the balance of its counterpart in the cost ledger.
2. Other Accounts
a) Wages Control Account: Total wages (direct and indirect) paid are debited to this account. Direct
wages are transferred to WIP Control Account and indirect wages are transferred to respective
overhead control account.
b) Production Overhead Control Account: Indirect manufacturing expenses like indirect material cost,
indirect wages and indirect expenses are debited to this account. The amount of manufacturing
overhead recovered is credited to this account and debited to WIP ledger control account. Any
balance of this account represents balance of over/under absorbed overhead, which is transferred to
profit and loss account.
c) Administrative Overhead Control Account: This account is debited with administration overhead
incurred. Administrative overhead recovered is credited to this account and debited to WIP ledger

control account. Any balance of this account represents balance of over/under absorbed overhead,
which is transferred to profit and loss account.
d) Selling and Distribution Overhead Control Account: This account is debited with selling and
distribution overhead incurred. For selling and distribution overhead recovered, this account is
credited and cost of sales is debited.
e) Cost of Sales Account: This account is debited with cost of goods sold and selling and distribution
overhead incurred, for selling and distribution overhead recovered. This account is closed by
transferring it to profit and loss account.
f) Costing Profit & Loss Account: This account is debited with cost of goods sold, underabsorbed
overhead and abnormal losses. This account is credited with sales value, overabsorbed overhead
and abnormal gains. The balance of this account depicts profit or loss as per cost books, which is
reconciled with financial profit and loss account. If there is profit, costing profit and loss account is
debited and general ledger adjustment account is credited. If there is loss, costing profit and loss
account is credited and general ledger adjustment account is debited.
Sometimes, following additional accounts are also opened:

a) Overhead Suspense Account – Sometimes, while valuing semi-finished jobs, factory overheads are
not included. Similarly, while valuing closing stock of finished goods, office and administrative
overheads are not included. In such cases normally, at the end of an accounting period, the estimated
amount of such overheads is debited to works or office overheads suspense account and credited to
works or Office overhead account as the case may be. In the beginning of the next accounting period,
the entries are reversed to close the suspense accounts.
b) Capital Orders – For each item of capital nature work to be performed in the factory itself, for
example, producing tools and equipment, certain expenditures shall be incurred in the form of
materials, wages and other expenses. Such expenditures should be recorded in capital order account
and later to be capitalized.
c) Service Orders –If repairs and maintenance work is done in the factory, the cost is debited to Repairs
and Maintenance Account and later transferred to various overheads account, because the
expenditure might have been incurred on production, administration and selling and distribution
departments.
No separate account is maintained for direct expenses since they are directly charged to work-in-progress
account. When the finished goods are sold, they are transferred to cost of sales account. In the last, a
costing profit and loss account can be prepared with the help of all the above accounts.
6.2.3 Accounting for Cost items
Materials:
Some transactions relating to materials, such as purchase of materials and purchase returns influence both
financial and cost ledgers. Some transactions namely, issues of materials from stores, transfer of materials
from one job to another, return of excess material to stores, influence cost ledgers only.

Labor Cost:
All wages are recorded in the cost accounting books through the wages control account and the general
ledger adjustment account.
Overhead:
The overhead – production, administration and selling and distribution are absorbed to products or jobs
on some equitable basis. Production overhead is absorbed on the basis of direct material cost, direct labor
cost or labor hours, or machine hour or rate per unit. The production overhead account is credited with the
account of overhead absorbed and the work-in-progress account is debited to recover administrative
overhead for the production. Alternatively, administrative overhead is directly transferred to the profit and
loss account and is not charged to production. Similarly, selling and distribution overhead may be charged
to production by crediting selling and distribution overhead and debiting the cost of sales account.
The amount of under-absorption and over-absorption is transferred to the costing profit and loss account.
Alternatively, it may be carried forward to the next accounting period.
Illustration: 1
During the physical verification of stores of X Ltd, It was found that 100 units of raw material ‘Wye’
returned to the supplier have not been recorded. Its purchase invoice price is Rs. 5 per unit while the
current standard cost is Rs. 4.80 per unit. Pass necessary journal entry to record the adjustment in the cost
ledger of X Ltd.
Solution:
General Ledger Adjustment account Dr. Rs. 500
To Stores Ledger Control Account Rs. 480
To Material price variance account Rs. 20
(Being recording of materials returned to supplier, earlier ignored)
Illustration: 2
Pass journal entries in the cost books, maintained on non-integrated system, for the following:
Issue of materials: Direct Rs. 550,000, Indirect Rs. 150,000
Allocation of wages; Direct Rs. 200,000, Indirect Rs. 40,000
Under/Over absorbed overhead: Factory (over) Rs. 20,000
Administration (under) Rs. 10,000
Solution
Journal entries in the cost books maintained on non-integrated system:
Rs. Rs.
i. Work-in-progress Ledger Control A/c Dr. 550,000
Factory Overhead control A/c Dr. 150,000
To stores ledger control account A/c 700,000
(Being issue of materials)

ii. Work-in-progress Ledger Control A/c Dr. 200,000

Factory Overhead control A/c Dr. 40,000
To Wages control account 240,000
(Being allocation of wages and salaries)
iii. Factory Overhead Control A/c Dr. 20,000

To costing profit and loss account A/c 20,000
(Being transfer of over absorption of overhead)
iv Costing profit and loss account Dr. 10,000

To Administrative Overhead Control A/c 10,000
(Being transfer of under absorption of overhead)
Illustration: 3
A company operates on historic job cost accounting system, which is not integrated with the financial
accounts. At the beginning of a month, the operating balances in cost ledger were:
Particulars Rs. In lakhs

Stores ledger Control Account 80
Work-in-progress control account 20
Finished goods Control Account 430
Building Construction Account 10
Cost Ledger Control Account 540
During the month, the following transactions took place:
Materials ------ Purchased 40
Issued to production 50
Issued to general maintenance 6
Issued to building construction 4
Wages ------- Gross wages paid 150
Indirect wages 40
For building construction 10
Work Overhead – Actual amount incurred (excluding items shown above) 160
Absorbed in building construction 20
Under absorbed 8
Royalty paid 5
Selling distribution and Administration Overheads 25
Sales 450
At the end of the month, the stock of raw material and work-in-progress was Rs. 55 lakh and Rs. 25 lakh
respectively. The loss arising in the raw material account is treated as factory overheads. The building
under construction was completed during the month. Company’s gross profit margin is 20% on sales.
Prepare the relevant control accounts to record the above transactions in the cost ledger of the company.

Solution:
Cost Ledger Control Account
(Rs. In lakhs)
The costing P & L account 450 By balance b/d 540
To Building Construction A/c 44 By Stores ledger control A/c 40
To Balance c/d 483 By Wages Control A/c 150
By Works Overhead Control A/c 160
By Royalty A/c 5
By Selling, Distribution and
Administration Overheads A/c 25
By Costing P & L A/c 57
Total 977 Total 977
Stores Ledger Control Account

(Rs. In lakhs)
To Balance b/d 80 By WIP Control A/c 50
To Cost Ledger Control A/c 40 By Works Overhead Control A/c 6
By building construction A/c 4
By Works Overhead Control A/c
(loss) 5
By balance c/d 55
Total 120 Total 120
Work-in-Progress Control Account

(Rs. In lakhs)
To Balance b/d 20 By Finished Goods Control A/c 333
To Stores Ledger Control A/c 50 By balance c/d 25
To Wages Control A/c 100
To Works Overhead Control A/c 183
To Royalty A/c 5
Total 358 Total 358
Finished Goods Control Account

(Rs. In lakhs)
To Balance b/d 430 By Cost of Goods sold A/c 360
(See working note)
WIP Control A/c 333 By balance c/d 403
Total 763 Total 763

Cost of Sales Account

(Rs. In lakhs)
To Cost of Goods sold A/c 360 By costing P/L A/c 385
To Selling, Distribution and
Administration Overheads A/c 25
Total 385 Total 385
Costing P & L Account

(Rs. In lakhs)
To Cost of sales A/c 385 By Cost Ledger Control A/c 450
To Works Overhead Control A/c 8
To Cost Ledger Control A/c (Profit)
57
Total 450 Total 450
Building Construction Account

(Rs. In lakhs)
To Balance b/d 10 By Cost Ledger Control A/c 44
To Stores Ledger Control A/c 4
To wages Control A/c 10
To Works Overhead control A/c 20
Total 44 Total 44
Works Overhead Control Account

(Rs. In lakhs)
To Stores Ledger Control A/c 6 By Building Construction A/c 20
To Wages Control A/c 40 BY WIP Control A/c 183
To Cost Ledger Control A/c 160 By Costing P& L A/c 8
To Stores Ledger Control A/c (loss) 5
Total 211 Total 211
Wages Control Account

(Rs. In lakhs)
To Cost Ledger Control A/c 150 By Works Overhead control A/c 40
By Building Construction A/c 10
BY WIP Control A/c 100
Total 150 Total 150

Royalty Account
(Rs. In lakhs)
To Cost Ledger Control A/c 5 BY WIP Control A/c 5
Total 5 Total 5
Cost of Goods sold Account

(Rs. In lakhs)
To Finished Good Control A/c 360 BY Cost of Sales A/c 360
Total 360 Total 360
Selling, Distribution and Administration Overhead Account

(Rs. In lakhs)
To Cost Ledger Control A/c 25 BY Cost of Sales A/c 25
Total 25 Total 25
Trial Balance
(Rs. In lakhs)
Particulars Dr. Cr.
Stores Ledger Control Account 55
WIP control Account 25
Finished Goods Control Account 403
Cost Ledger Control Account 483
Total 483 483
Working Note:
If selling price is Rs. 100, cost price is = Rs. 80
If selling price is Rs. 450, cost price will be = (Rs. 80/100) x Rs. 450 = Rs. 360 lakhs.
6.3 INTEGRATED ACCOUNTING SYSTEM
In integrated accounting system, the concept of a separate profit and loss account for financial and costing
purposes is discarded in favor of a unified account which will serve both financial and costing purposes.
Such a system of accounting is referred to as the “integrated” or “integral” cost accounting system. A
single book-keeping system which contains both financial and cost accounts is known as an integral
accounting system. An integrated accounting system has the following advantages:
There is no problem of reconciliation as there will only be one profit amount.
This system is economical and easy to understand. Duplication of work and labor are avoided.
Cost data can be presented promptly and regularly.
All cost data and accounts automatically checked and thus cost figures are accurate.
The following factors should be considered before establishing an integrated cost accounting system:
Degree of integration:

The degree of integration should be determined. Some business firms may integrate up to the stage of
prime cost or factory cost. On the other hand, many undertakings integrate the whole of the records.
Control accounts
In place of classifying expenditure according to its nature, control accounts may be prepared for each of
the elements of cost, such as:
• Material Control Account
• Direct Labor Control Account
• Factory Overhead Control Account
• Administrative Overhead Control Account
• Selling and Distribution Overhead Control Account
Some of the above control accounts should be separated into fixed and variable depending on the
circumstances.
Cost accumulation purposes

Full details about the cost data are provided in the cost accounting department so as achieve the following
objectives;
• To provide the necessary costing data
• To form the basis of journal entries so that the control accounts can be cleared to suitable revenue
accounts resulting into a cost of sales accounts
• Provision for accrued expenses, prepayments and stocks should be dealt with by transfers to
suitable suspense accounts, so that the balance remaining in each control account represents the
charges for the period.
6.3.1 Principal Accounts to be maintained

Under integrated accounting system, the following accounts are mainly kept.
(a) Stock Control Account

This account is prepared for each of the following cost items.
Raw material: This account has opening stock and purchases on the debit side and material issues on
credit side.
WIP: This account is debited with opening stock and factory overhead and credited with cost of
goods finished. The closing stock, if any, will be carried forward to the next year.
Finished stock: This account is known as the finished goods account also. It is debited with goods
finished and credited with the cost of sales.
The above stock accounts are usually used in place of the stock and purchase account which is
maintained in the financial books.
(b) Cost of Sales Account

The cost of goods sold is debited to this account and the finished goods account is credited.
(c) Assets Account

Separate accounts are kept for different assets possessed by the firm, such as plant, furniture, building
etc. These individual asset accounts are prepared in the usual way. Any capital expenditure incurred
is debited.

(d) Debtors and Creditors Control Account

The creditors account mentions the transactions and their amounts with creditors and suppliers. The
balance in creditors account should tally with the stock Control Ledger.
(e) Prepayments Account and Outstanding Account

An expense account will show the prepaid amount made, if any. The prepaid amount is debited to the
prepaid account and credited to overhead control accounts. Thus, the expense which is related to the
period is charged to the wip account. In case of an expense due but not paid, the expense due account
is debited and cash account is credited or it can be adjusted through the overhead control account.
(f) Direct Wages and Overhead Costs Control Account

When these costs are incurred, the appropriate control account is debited and the cash account
credited. For example, the total direct wages paid will be debited to the direct labor control account.
At the end of a period, they are transferred to wip accounts by crediting the appropriate control
accounts and debiting the wip account. It is possible that actual payments for a period may not tally
with the expenditure to be charged for the period and, therefore, adjustments should be made.
(g) Departmental or Cost Centre Account

Under integrated account, an account is kept for each department or cost centre. This helps in
knowing the cost of a department and controlling costs associated with different departments.
(h) Cash Account

In this account all cash receipts are debited and cash disbursements are credited.
6.4 COMPARATIVE JOURNAL ENTRIES BETWEEN INTEGRAL AND NON INTEGRAL

ACCOUNTING SYSTEM
Journal entries which are recorded in integral and non-integral accounting systems are given in the
following pages.
Distinction between ‘Interlocking’ and ‘Integration’ of Cost and Financial Accounts

When independent sets of books are maintained for cost and financial accounts, they are ‘interlocked’ by
control accounts maintained in the two sets of books. Cost Ledger Control Account is maintained in the
financial books and a General Ledger Adjustment Account in the costing books. Thus, a link is
established between the two sets of books. In costing books, all entries pertaining to fixed assets, cash, or
outsiders are posted in General Ledger Adjustment Account. In case it is desired to integrate the two trial
balances into one, the Cost Ledger Control Account and General Ledger Adjustment Account can be
omitted because they are ‘contra’ accounts.
Integration requires maintenance of only one set of books in which all transactions are recorded. By
eliminating cost ledger, all the control accounts are maintained in general ledger.
Integration of account is preferable than the system of interlocking. Although integration (maintaining
one set of accounts) offers better scope for economy and efficiency in accounting, sometimes, it is
desirable to have separate sets of accounts because of organizational problems involved in the
maintenance of one set of books. Cost Accounting has assumed considerable significance in the planning

and control of business operations and hence the need for a separate costing department is felt by the
management. Therefore, generally ‘integral’ system can be employed, with advantages, only in small
units.
Journal entries to be recorded under Non-integral and Integral system

Items Non-Integral System Integral System
Financial books Cost books
1. Purchase of materials Purchases A/c Dr. Stores ledger Control A/c Dr. Stores Ledger Control A/c Dr.
on credit To Bought Ledger To General Ledger Adjustment (or creditors) A/c
To Bought Ledger Control A/c To Creditors A/c
(or creditors) A/c
2. Issue of materials for No entry Work-In-Progress Ledger Work-in-Progress A/c Dr.
production Control A/c Dr. To Cash A/c
To Stores Ledger Control A/c
3. Payment of wages Wages A/c Dr. Wages A/c or (Wages Control Wages A/c (Wages control A/c) Dr.
To Cash A/c) Dr. To Cash A/c
To Insurance To General Ledger Adjustment
To Tax
4. Analysis and No entry Work in progress A/c Dr. Work in Progress Control A/c Dr.
distribution of (for direct labor) Factory Overhead A/c Dr.
wages Factory OH Control A/c Dr. Administration Overhead Dr.
(for factory indirect labor) S&D Overhead A/c Dr.
Adm. Overhead Control A/c Dr. To Wages Control A/c
(for office indirect labor)
S&D Overhead Control A/c Dr.
(for selling and distribution
indirect labor)
To Wages Control A/c
5.Payment for indirect Expenses A/c Dr. Factory / Adm./ Selling &Dis. Factory/ Office/ Selling&
expenses, for To Cash Overhead A/c Dr. Distribution
example, power, To Creditors To General Ledger adj A/c Overhead A/c Dr.
repairs etc. To Cash
To Creditors
6. Recording of factory No Entry Work in progress Control A/c Work in progress Control A/c Dr.
overheads at Dr. To Factory Overhead
predetermined To Factory Overheads Control Control A/c
rates A/c
7. Factory overheads No entry Factory Overhead Control A/c Factory Overhead A/c Dr.
over- absorbed Dr. To P&L A/c
To Costing P&L A/c
(or alternatively the balance
may be carried forward)
8. Jobs completed No entry Stock Ledger Control A/c Dr. Stock Ledger Control A/c Dr.
To WIP Ledger Control A/c To Work in Progress Ledger
Control A/c
9. Interest paid Interest A/c Dr. No entry Interest A/c Dr.
To cash To Cash
10. Rent of own No entry Works Overhead A/c Dr. Works Overheads A/c Dr.

premises To General Ledger Adjustment To Rent (notional) A/c
A/c
11. Abnormal idle time No entry Costing P&L A/c Profit &Loss A/c Dr.
To Wages A/c To Wages A/c
(or alternatively the balance
may be carried forward)
12. Sales(credit) Sales Ledger Control (or General Ledger Adjustment A/c Sales Ledger Control (Debtors) A/c
debtors) A/c Dr. Dr. Dr
To Sales A/c To Cost of Sales A/c To Sales A/c
Illustration: 4
The following transactions are extracted from the books of XYZ ltd. You are requested to pass journal
entries under Integrated Account System:
Rs.
Purchase of raw materials on credit 400,000
Carriage inward 3,000
Paid to creditors 300,000
Stores issued 250,000
Productive waged paid 200,000
Unproductive wages paid 70,000
Works overheads incurred 360,000
Materials issued for repairs 2,000
Selling expenses paid 10,000
Office expenses paid 4,000
Works overhead absorbed 410,000
Cost of completed jobs 860,000
Solution:
Journal Entries
Particular Debit Credit
(i) Stores Ledger Control A/c Dr. 4,00,000
To creditors A/c 4,00,000
(Being Raw Material Purchased in Credit)
(ii) Stores Ledger Control A/c Dr. 3,000
To cash A/c 3,000
(Being carriage inward paid)
(iii) Creditors A/c Dr. 3,00,000
To cash A/c 3,00,000
(Being cash paid to creditors)
(iv) Work in progress Control A/c Dr. 2,50,000
To stores Ledger Control A/c 2,50,000

(Being material issued to Production)

(v) Wages Control A/c Dr. 2,00,000
To Cash A/c 2,00,000
(Being direct wages paid)
(vi) Works Overhead Control A/c Dr. 70,000
To Cash 70,000
(Being unproductive wages paid)
(vii) Works Overhead Control A/c Dr. 3,60,000
To cash 3,60,000
(Being work expenses incurred)
(viii) Works overhead Control A/c Dr. 2,000
To Stores Ledger Control A/c 2,000
(Being material issued for repair)
(ix) Selling and Distribution overhead control A/c Dr. 10,000
To Cash 10,000
(Being selling expenses paid)
(x) Office overhead control A/c Dr. 4,000
To Cash 4,000
(Being office expenses)
(xi) Work in progress Control A/c Dr. 4,10,000
To work overhead control A/c 4,10,000
(Being works overhead absorbed)
(xii) Finished stock Control A/c Dr. 8,60,000
To WIP Control A/c 8,60,000
(Being cost of completion transfer to finished stock)
Illustration: 5
Journalize the following transactions in the integrated books of accounts:
(a) Credit purchase Rs.12,00,000
(b) Production wages paid 7,00,000
(c) Stocks issued to production orders 8,00,000
(d) Work expenses charged to production 4,50,000
(e) Finished goods transferred from production orders 18,00,000
(f) Administration expenses charged to production 1,50,000
(g) Work expenses outstanding 1,20,000
(h) Work expenses paid 4,60,000

Solution:
Journal Entries under Integral System of Accounting
Particulars Dr.(Rs.) Cr.(Rs.)

(a) Stores Ledger Control Account Dr. 12,00,000
To Sundry Creditors Account 12,00,000
(Being purchases of goods on credit)
(b) Wages Control Account Dr. 7,00,000

To Cash Bank Account 7,00,000
(Being wages paid in cash/cheque)
(c) Work in progress Control account Dr. 8,00,000

To stores ledger account 8,00,000
(Being stores issued against production order)
(d) Work in progress Control Account Dr. 4,50,000 4,50,000

To Production Overhead Control A/c
(Being the Work Expenses allocated to
Production/Jobs)
(e) Finished Goods Ledger Control A/c Dr. 18,00,000 1,80,000

To Work in progress Ledger Control A/c
(Being goods finished during the year transferred)
(f) Work in progress Control Account Dr. 1,50,000

To Administrative Overhead Control A/c 1,50,000
(Being administration expenses charged to
production)
(g) Production Overhead Control A/c Dr. 1,20,000

To Outstanding Works Overhead Account 1,20,000
(Being works expenses incurred during the period
but still unpaid)
(h) Overhead Control Account Dr. 4,60,000

To Cash Bank Account 4,60,000

(Being works expenses paid in Cash/ Bank during

the period)
Illustration: 6
Record the following transactions in the ledger under the integral system and prepare the trial balance.
Trial balance at the beginning of the period is as follows:
Dr. (Rs.) Cr.
Bank Balance Rs.1,500
Stock:
Finished goods 2,000
Work in progress 3,250
Raw materials 3,000
Creditors 1,000
Debtors 500
Fixed assets 51,000
Depreciation provision 1,250
Capital account 55,000
Profit and loss account 4,000
Total 61,250 61,250
Transactions during the year
were:
Rs. Rs.
Materials purchased on credit 5,000
Materials issued to production:
Direct 3,500
Indirect 500 4,000
Payment to creditors 3,000
Wages paid:
Direct 5,000
Indirect 1,000 6,000
Finished goods produced 15,000
Cost of finished goods sold 16,000
Sales value 20,000
Receipt from debtors 17,500
Overhead incurred:
Factory 3,000
Office 500
Selling and distribution 500 4,000
Depreciation (in addition to 250
overheads)
Solution
Bank Account
Rs. Rs.
To Balance b/d 1,500 By Purchase ledger control A/c 3,000
To Sales ledger control A/c 17,500 By Wages control account 6,000
By Factory overheads 3,000

By Office overheads 500

BY Selling and distribution overheads 500
By balance c/d 6,000
19,000 19,000
Finished goods ledger control Account

Rs. Rs.
To Balance b/d 2,000 By Cost of sales A/c 16,000
To Work-in-progress A/c 15,000 By balance c/d 1,500
To Office overheads A/c 500
17,500 17,500
Work-in-progress control Account

Rs. Rs.
To Balance b/d 3,250 By finished goods ledger control A/c 15,000
To Stores ledger A/c 3,500 By balance c/d 1,500
To wages control A/c 5,000
To Factory overheads A/c 4,750
16,500 16,500
Stores ledger control Account

Rs. Rs.
To Balance b/d 3,000 By WIP ledger control A/c 3,500
To Purchase ledger control A/c 5,000 By factory overheads A/c 500
8,000 8,000
Purchases ledger control Account (Creditors Account)

Rs. Rs.
To Bank 3,000 By balance b/d 1,000
To Balance c/d 3,000 By Stores ledger control account 5,000
6,000 6,000
Sales ledger control Account (Debtors Account)

Rs. Rs.
To Balance b/d 500 By Bank 17,500
To cost of sales A/c 20,000 By balance c/d 3,000
20,500 20,500
Factory Overheads Account

Rs. Rs.
To Stores ledger control A/c 500 By WIP ledger A/c 4,750
To Wages control A/c 1,000
To bank 3,000
To Depreciation provision 250
4,750 4,750

Wages control Account

Rs. Rs.
To Bank 6,000 By work-in-progress A/c 5,000
By Factory overheads 1,000
6,000 6,000

Rs. Rs.
To Finished goods ledger control A/c 16,000 By Sales ledger control A/c 20,000
To Profit and Loss A/c 4,000
20,000 20,000
Office Overheads Account

Rs. Rs.
To Bank 500 By Finished goods ledger control A/c 500
500 500
Selling & Distribution Overheads Account

Rs. Rs.
To Bank 500 By Profit and Loss A/c 500
500 500
Provision for depreciation Account

Rs. Rs.
To Balance c/d 1,500 By Balance b/d 1,250
By Factory overheads 250
1,500 1,500
Profit and Loss Account

Rs. Rs.
To Selling and Distribution overhead A/c 500 By Cost of sales A/c 4,000
To Net profit 3,500
4,000 4,000
Profit and Loss Appropriation Account

Rs. Rs.
By Profit and Loss A/c 3,500
7,500 7,500
Share Capital Account

Rs. Rs.
55,000 55,000
Fixed Assets Account

Rs. Rs.
To Balance b/d 51,000 By Balance b/d 51,000
51,000 51,000
Trial Balance
Dr. Cr.
Purchase ledger control account 3,000
Sales ledger control account 3,000
Provision for depreciation 1,500
Bank 6,000
Finished goods ledger control account 1,500
Work-in-progress ledger control account 1,500
Stores ledger control account 4,000
Share capital 55,000
Fixed assets 51,000
Total 67,000 67,000
Illustration: 7
BPR Limited keeps books on integrated accounting system. The following balance appear in the books as
on April 1, 2006.
Dr (Rs.) Cr. (Rs.)
Stores Control A/c 40,950 -
Work-in-progress a/c 38,675 -
Finished Goods A/c 52,325 -
Bank A/c 22,750
Creditors A/c - 18,200
Fixed Assets A/c 147,875 -
Debtors A/c 27,300 -
Share capital A/c - 182,000
Provision for depreciation A/c - 11,375
Provision for doubtful debts A/c - 3,725
Factory Overhead Outstanding A/c - 6,250
Pre-paid Administration overheads A/c 9,975 -
Profit & Loss A/c - 72,800
Total 317,100 317,100
The transaction for the year ended March 31, 2007, were as given below:
Direct wages 197,925 -
Indirect wages 11,375 209,300
Purchase of materials (on credit) 227,500
Material issued to production 250,250
Material issued for repairs 4,550
Goods finished during the year (at cost) 489,125
Credit Sales 682,500
Cost of goods sold 500,500

Production Overhead absorbed 109,200

Production overheads paid during the year 91,000
Production overheads outstanding at the end of the year 7,775
Administration overheads paid during the year 27,300

Selling overheads incurred 31,850
Payment to creditors 229,775
Payment received from debtors 659,750
Depreciation of Machinery 14,789
Administration overheads outstanding at the end of the year 2,225
Provision for doubtful debts at the end of the year 4,590
Required:
Write up accounts in the integral ledger of BPR Ltd and prepare a Trial Balance.
Solution
Stores control Account
Rs. Rs.
To Balance b/d 40,950 By WIP A/c 250,250
To Creditors A/c 227,500 By Production overheads A/c 4,550
268,450 268,450
Wages control Account

Rs. Rs.
To Bank 197,925 By work-in-progress A/c 197,925
To Bank 11,375 By Production overheads 11,375
209,300 209,300
Work-in-progress Account
Rs. Rs.
To Balance b/d 38,675 By finished goods A/c 489,125
To Stores control A/c 250,250 By balance c/d 106,925
To wages control A/c 197,925
To production overheads A/c 109,200
596,050 596,050
Production Overheads Account

Rs. Rs.
To Stores ledger control A/c 4,550 By WIP ledger A/c 109,200
To Wages control A/c 11,375 By Profit and Loss a/c 14,309
(Under-absorbed overheads written
off)
To bank (91,250 – 6,250) 84,750
To production overheads o/s 7,775
To Depreciation provision 14,789
123,239 123,239

Finished goods Account

Rs. Rs.
To Balance b/d 52,325 By Cost of sales A/c 500,500
To Work-in-progress A/c 489,125 By balance c/d 80,450
To Admn. overheads A/c 39,500
580,950 580,950
Administration Overheads Account

Rs. Rs.
To pre-paid administration account 9,975 By Finished goods A/c 39,500
To administration o/s account 27,300
To Bank 2,225
39,500 39,500

Rs. Rs.
To Finished goods A/c 500,500 By Sales A/c 532,350
To Selling Overheads A/c 31,850
532,350 532,350
Sales Account
Rs. Rs.
To Cost of sales A/c 532,350 By Debtors A/c 682,500
To Profit and Loss account 150,150
682,500 682,500
Provision for depreciation Account

Rs. Rs.
By Production overheads A/c 14,789
26,164 26,164

Rs. Rs.
To provision for doubtful debts 865 By Balance b/d 72,800
To production overheads 14,039 By Sales A/c 150,150
To Balance c/d 208,046
222,950 222,950
Production Overheads Outstanding Account

Rs. Rs.
To Bank 6,250 By Balance b/d 6,250
To Balance c/d 7,775 By Profit and Loss A/c 7,775
14,025 14,025

Prepaid Administration Overheads Account

Rs. Rs.
To Balance b/d 9,975 By Administration Overheads A/c 9,975
9,975 9,975
Provision for Doubtful Debts Account

Rs. Rs.
By Profit & Loss A/c 865
4,590 4,590
Fixed Assets Account

Rs. Rs.
To Balance b/d 147,875 By Balance b/d 147,875
147,875 147,875
Debtors Account
Rs. Rs.
To Balance b/d 27,300 By bank A/c 659,750
To Sales 682,500 By Balance c/d 50,050
709,800 709,800
Creditors Account
Rs. Rs.
To Bank 229,775 By Balance b/d 18,200
To Balance c/d 15,925 By Stores Control A/c 227,500
245,700 245,700
Bank Account
Rs. Rs.
To Debtors 659,750 By Balance b/d 22,750
By Direct Wages 11,375
By Production overheads (84,750 + 6,250) 91,000
By Indirect Wages 11,375
By Creditors A/c 229,775
By Adm. Overheads A/c 27,300
BY Selling and distribution overheads 31,850
659,750 659,750
Trial Balance
Particular Debit Credit
Creditors A/c 15,925
Debtors A/c 50,050
Provision for depreciation 26,164
Bank 47,775

Finished goods account 80,450

Work-in-progress account 106,925
Stores control account 13,650
Share capital 182,000
Fixed assets 147,875
Production Overheads Outstanding A/c 7,775
Outstanding Adm.Overheads A/c 2,225
Provision for Doubtful Debts 4,590
446,725 446,725
6.5 RECONCILIATION OF COST AND FINANCIAL ACCOUNTS
Need for Reconciliation

When a manufacturing firm uses an integrated accounting system, i.e. no separate cost and financial
accounts, the question of reconciliation does not arise. But in many manufacturing concerns, cost and
financial accounts are maintained separately and independently of each other. In such a case, profit
disclosed by one accounting system tends to differ from that of the other accounting system. This creates
problems and the need arises of reconciling the two accounting systems to arrive at one profit figure.
Reasons for differences in profit

Differences in the profits presented in cost and financial books may be due to the following reasons:
A) Items Appropriated or Charged to Profit but Not Found in Cost Accounts
Company tax
Transfer to general reserve or any other fund to accumulated profits, for example, dividend
equalization reserve
Dividend paid on the share capital
Additional provisions for depreciation on plant, etc. and for bad debts
Amounts written off as goodwill, preliminary expenses, underwriting commissions, debenture
discount, capital issue expenses
Appropriation for the purpose of repayment of loans or debentures
B) Purely Financial Matters Not Found in Cost Accounts

Interest received on bank deposits
Interest, dividends, etc. received on investments
Rents received
Losses on the sale of investments, machinery, buildings etc.
Profit on the sale of fixed assets
Transfer fees received
Interest on bank loans, mortgages, debentures and other borrowed money
Interest on proprietor’s capital
Damages payable
Penalties payable

C) Treatment of Items in Cost Books and Financial Books

In cost accounts overheads are recovered on the basis of a predetermined rate. In this way recovered
overhead may not agree with the actual overhead incurred. Profit in cost books may be comparatively (as
to financial books) higher or lower depending on the under-absorption or over-absorption of overhead.
Reconciliation is necessary to eliminate differences in profits. If the amount of over- or under-absorption
is transferred to the costing and profit and loss accounts, then financial profit will tally with the costing
profit.
D) Differences in the Valuation of Stock and WIP

In financial books, stock is valued at cost or market price whichever is lower. In cost accounting different
methods of valuation of stock are in practice such as FIFO, LIFO, Average Costing, Weighted Average
Costing, etc. Besides wip in cost accounts is often valued on a prime cost basis and sometimes variable
manufacturing overhead is included therein. In financial accounting, wip may be valued after taking into
account administrative expenses also. Similarly, finished goods in financial accounting are valued at cost
or market price whichever is lower. On the contrary, in cost accounting, finished stock is generally valued
at total cost of production. Since the value of stocks (raw material, wip, finished goods) in the financial
accounts and cost accounts differs, the profits also differ from financial to cost accounting.
E) Other Reasons
Depreciation
In financial accounts, depreciation may be calculated on straight line method or diminishing balance
method. But, in cost accounting; depreciation can be calculated in terms of machine hour or any other
base.
Abnormal Losses and Gains

Abnormal losses and gains (discussed earlier (may be transferred to costing profit and loss account or
alternatively may not be considered and excluded totally from cost accounts. In the first situation
(transfer to costing and profit and loss account) there will be no difference between financial profit
and costing profit. But in the second situation (exclusion from cost accounts) financial profit (losses)
will differ from costing profit (loss) and adjustments will be required.
Reconciliation Procedure
Reconciliation of cost and financial accounts is done on the principle of bank reconciliation statement.
One may begin with profit as per the financial books or cost books and thereafter items causing
differences in profit may be added or deducted depending on the circumstances. After all such items have
been considered, profit as per other books may be arrived at. This reconciliation may be achieved through
a mere statement (Reconciliation Statement) or preparing a Memorandum Reconciliation Account. Both
these approaches are discussed below:
Reconciliation Statement
The following steps are required to be completed to prepare a Reconciliation Statement.
Profit as per any set of books (cost or financial) may be taken as a starting point. This profit plus making
all suitable adjustments (in terms of causes of difference in profit) will finally result into profit figure as
per the other set of books.
The effect of a particular cause of difference should be determined on the profits shown by the other set
of books.

In case, the cause has decreased the profit shown by other set of books, the amount of such decrease
should be deducted from the profit as per the former set of books which has been taken as the starting
point.
Completion of the above steps will give the profit as per the other set of books.
Memorandum Reconciliation Account

This reconciliation procedure is in the form of an account. The debit side (Dr.) of the Memorandum
Reconciliation Account shows items to be deducted from the profit as per any set of books taken as a
starting point. The credit side of this account shows profit figure accepted as a starting point as well as
items to be added to this profit figure. The difference between the credit side and debit side will give
profit as per the other set of books. A pro-forma of Memorandum Reconciliation Account is shown in
Fig.
Illustration: 8
In a factory, works overheads are absorbed at 60% of Labor cost and Office overheads are 20 % of Works
Cost. Prepare(i) Cost sheet, (ii) Trading and Profit and Loss Account and (iii) Reconciliation Statement if
Total Expenditure consists of Material Rs. 2,00,000; Wages Rs. 1,50,000; Factory Expenses Rs. 1,00,000
and Office Expenses is Rs. 85,000. 10% of the Output is Stock at the end and Sales are Rs.520,000.
Solution:
Cost Sheet
Particulars Amount
Rs.
Material 2,00,000
Wages 1,50,000
Prime Cost 3,50,000
Factory Overhead (60% of Rs. 1,50,000) 90,000
Works Cost 4,40,000
Office Overheads (20% of works cost) 88,000
Cost of Production 5,28,000
Cost of goods sold Rs.

,,∗
4,75,200

Profit 44,800
Sales 5,20,000
Profit as per accounts= Rs. 44,800
Trading and Profit and Loss Account

Dr. Cr.
Particulars Amt. Particulars Amt.
Rs. Rs.
To Material 2,00,000 By Sales 5,20,000
To Wages 1,50,000 By Closing Stock
5,28,000 ∗ 10
100

To Gross profit c/d 2,22,800 52,800

5,72,800 5,72,800
To Factory Expenses 1,00,000 By Gross Profit b/d 2,22,800
To Office Expenses 85,000
To Net Profit c/d 37,800
2,22,800 2,22,800
Rs.
Profit as per cost accounts 44,800
Add: Overcharged in Cost accounts:
Office overheads (88,000 -85,000) 3,000
Less: Undercharged in Cost accounts: 47,800
Factory Overhead (100,000-90,000) 10,000
Profit as per financial records 37,800
Illustration: 9
The following information is available from the financial books of a company having a normal production
capacity of 60,000 units for the year ended 31st March , 2014.
i) Sales Rs. 10,00,000 (50,000 units)
ii) There was no opening and closing stock of finished units.
iii) Direct material and direct wages cost were Rs. 5,00,000 and Rs. 2,50,000 respectively.
iv) Actual factory expenses were Rs. 1,50,000 60% of which fixed.
v) Actual administrative expenses were Rs. 45,000 which are completely fixed.
vi) Actual selling and distribution expenses were Rs. 30,000 of which 40% are fixed.
vii) Interest and dividends received Rs. 15,000.
You are required to:
(a) Find out profit as per financial books for the year ended 31st March 2014.
(b) Prepare the cost sheet and ascertain the profit as per cost accounts for the year ended 31st March
, 2014 assuming that the indirect expenses are absorbed on the basis of normal production
capacity and 2014 assuming that the indirect expenses are absorbed on the basis of normal
production capacity; and
Prepare a statement reconciling profits shown by financial and cost books.
Solution:
(a) Computation of Profit as per Financial Books
(For the year ended 31st March, 2014)
To Direct Material 5,00,000 By Sales (50000 units) 10,00,000
To Direct Wages 2,50,000 By Interest and Dividends 15,000
To Factory Expenses 1,50,000
To Administrative Expenses 45,000
To Selling and Distribution 30,000

Expenses
To Profit 40,000
10,15,000 10,15,000
(b) Cost Sheet (for the year ended 31st March, 2014)
Rs. Rs.
Direct Materials 500,000
Direct Wages 250,000
Prime Cost 750,000
Factory Overheads
Variable Factory Overhead ( Rs 150,000 *0.4) 60,000
Fixed Factory Overhead (Rs. 150,000*0.6 *5/6 ) 75,000 135,000
Works Cost 885,000
Administrative Expenses Rs. 45,000 * 5/6 37,500
Cost of Production 922,500
Selling and Distribution Overheads:
Variable Selling Cost ( Rs 30,000 *0.6) 18,000
Fixed Selling Cost (Rs 30,000 * 0.4*5/6) 10,000 28,000
Profit 49,500
Sales 1,000,000
(c) Statement of Reconciliation

(Reconciliation Profit shown by Financial and Cost Accounts)
Rs. (+) Rs.(-)
Profit as per cost accounts 49,500
Add: Income from Interest and dividends excluded in cost accounts 15,000
Less:
Factory Overheads undercharged in Cost Accounts 15,000
Adm. Overhead undercharged in Cost Accounts 7,500
Selling and Distribution Overhead undercharged in Cost Accounts
(Rs. 30,000 – Rs. 28,000) 2,000
Profit as per Financial Accounts 40,000
64,500 64,500
Illustration: 10
M Ltd. furnished the summary of the trading, profit and loss account for the year ending 31st December,
2014.
Rs. Rs.
To Raw materials 139,600 By Sales (12,000 units) 480,000
To Direct Wages 76,200 By finished stock (200 units) 8,000
To Production Overheads 42,600 By Work-in-progress:
Materials 28,200
Wages 11,796
Production OHs 7,999 47,995

To selling and distribution OHs 42,700 By interest on securities (gross) 6,000

To Administration OHs 39,100
To preliminary exp. w/o 2,200
To Goodwill w/o 2,501
To Dividend (net) 3,000
To income tax 4,100
To Net profit 189,994
541,995 541,995
The company manufactures a standard unit. Scrutiny of cost records for the same period shows that:
i) Factory overheads have been allocated to the production at 20% on prime cost.
ii) Administration overheads have been charged at Rs. 3 per unit on units produced.
iii) Selling and distribution expenses have been charged at Rs. 4 per unit on units sold.
You are required to prepare a statement of cost and work out profit as per cost accounts and to reconcile
the same with that shown in the financial accounts.
Solution
M Limited
Statement of Cost and Profit
(For the year ending Dec. 31st, 2014)
(Production 12,000 units)
Rs.
Materials consumed 139,600
Direct Wages 76,200
Prime Cost 215,800
Factory overheads @ 20% of prime cost 43,160
258,960
Less: Closing work-in-progress
Materials 28,200
Wages 11,796
Production overheads 7,999 47,995
Works cost 210,965
Administration overheads @ Rs. 3 per unit on 12,200 units 36,600
Cost of production 247,565
Less;:Cost of finished goods stock (see working note 1) 4,058
Selling & distribution overheads @ Rs. 4 on 12,000 units 48,000
Profit as per cost account 188,493
Sales 12,000 units @ Rs. 4 per unit 480,000
Working Notes:
1. Total cost of production is Rs. 247,565. Of 12,200 units, 200 units are in stock. Hence the stock
.,
of finished goods has to be valued at = Rs. 4,058
,
2. Administrative overheads are absorbed on the basis of units produced; hence they have been
considered a part of the production.

Statement Reconciling Profit as per Cost Account and Profit as per financial Account
Rs. (+) Rs. (-)
Profit as per cost account 188,493 -
Less:
Administrative Overheads under-absorbed 2,500
Preliminary expenses 2,200
Goodwill written off 2,501
Dividend 3,000
Tax 4,100
Add:
Production overheads over-absorbed 560
Selling overheads over-absorbed 5,300
Interest on securities 6,000
Closing stock over-valued in financial accounts 3,942
(at selling price instead of cost)
204,295 14,301
Profit as per financial account 189,994
Illustration: 11
A manufacturing company disclosed a net loss of Rs.347,000 as per their cost accounts for the year ended
March 31, 2014. The financial accounts however, disclosed a net loss of Rs. 510,000 for the same period.
The following information was revealed a result of scrutiny of the figures of both the sets of accounts.
Rs.
Factory overheads under absorbed 40,000
Administration Overheads Over-absorbed 60,000
Depreciation charged in Financial Accounts 325,000
Depreciation charged in Cost Accounts 275,000
Interest on investment not included in cost accounts 96,000
Income tax provided 54,000
Interest on loan funds in financial accounts 245,000
Transfer fees (Credit in financial books) 24,000
Stores adjustment (credit in financial books) 14,000
Dividend received 32,000
Solution
Memorandum Reconciliation Account
Dr. Rs. Cr. Rs.
Net loss as per costing books 347,000 By administration Overheads over 60,000
recovered in cost accounts
To Factory overhead under 40,000 By interest on investment not 96,000
absorbed in Cost Account included in Cost Accounts
To Depreciation under charged in 50,000 By transfer fees in financial books 24,000
cost account
To Income tax not provided in 54,000 By stores adjustment 14,000
cost accounts (Credit in financial books)
To interest on loan funds in 245,000 By dividend received in financial 32,000
financial accounts books

By net loss as per financial books 510,000

736,000 736,000
Illustration: 12
The financial books of a company reveal the following data for the year ended 31st March 2014:
Rs.
Opening stock:
Finished goods 875 units 74,375
Work-in-progress 32,000
1.4.2013 to 31.3.2014
Raw material consumed 780,000
Direct labor 450,000
Factory Overheads 300,000
Goodwill 100,000
Dividend paid 85,000
Bad debts 12,000
Interest received 45,000
Rent received 18,000
Sales 14,500 units 2,080,000
Closing stock; Finished goods 375 units 41,250
Work-in-process 38,667
The cost record provide as under:
i) Factory overheads are absorbed at 60% of direct wages.
ii) Administration overheads are recovered at 20% of factory cost.
iii) Selling and distribution overheads are charged at Rs. 4 per unit sold.
iv) Opening stock of finished goods is valued at Rs. 104 per unit.
v) The company values work-in-progress at factory cost for both financial and cost profit
reporting.
Required:
(a) Prepare statements for the year ended 31st March 2014 show –
(i) The profit as per financial records
(ii) The profit as per costing records.
(b) Present a statement reconciling the profit as per costing records with the profit as per Financial
Records.
Solution
(As per financial records)
(For the year ended March 31, 2014)
Particular Rs. Particular Rs.
To opening stock of finished goods 74,375 By Sales 2,080,000
To Work-in-process 32,000 By closing finished stock 41,250
To Raw materials consumed 780,000 By Work-in-progress 38,667
To Direct Wages 450,000 By rent received 18,000
To Production Overheads 300,000 By interest received 45,000

To selling and distribution OHs 61,000

To Administration OHs 295,000
To bad debts 12,000
To Goodwill w/o 100,000
To Dividend paid 85,000
To net profit 33,542
2,222,197 2,222,197
Statement of Profit as per costing records

(For the year ended March 31, 2002)
Rs.
Sales revenue (A) (14,500 units) 2,080,000
Cost of Sales:
Opening stock (875 units x Rs. 104) 91,000
Add: cost of production of 14,000 units (refer to working note 2) 1,792,000
. ,, ! "#$% 48,000
Less: closing stock:
, "#$%
Production cost of goods sold (14,500 units) 1,835,000
Selling and distribution overheads (14,500 units x Rs. 4) 58,000
Cost of sales (B) 1,893,000
Profit (A) – (B) 187,000
Working Notes:
1. Number of units produced:
Sales 14,500 units
Add: Closing stock 375 units
Total 14,875 units
Less; opening stock 875 units
Unit Produced 14,000 units
2. Cost Sheet
Rs.
Raw materials consumed 780,000
Direct labor 450,000
Prime cost 1,230,000
Factory overheads (60% of direct wages) 270,000
Factory Cost 1,500,000
Add: Opening WIP 32,000
Less: Closing WIP 38,667
Factory cost of goods produced 1,493,333
Administration overheads (20% of factory cost) 298,667
Cost of production of 14,000 units (refer working note 1) 1,792,000
. ,,
Cost of production per unit = = Rs. 128
, "#$%

Illustration: 13
The following figures are available from financial accounts for the year ended 31st December 2014:
Rs.
Direct material consumption 250,000
Direct wages 100,000
Administrative overheads 250,000
Bad debts 20,000
Preliminary expenses written off 10,000
Legal charges 5,000
Dividend received 50,000
Interest on deposit received 10,000
Sales 120,000 units 700,000
Closing stock:
Finished stock – 40,000 units 120,000
The cost accounts reveal:
Direct material consumption; Rs.. 280,000
Factory overhead recovered at 20% on prime cost.
Administrative overhead at Rs.3 per unit of production
Selling and distribution overhead at Rs. 4 per unit sold.
Prepare:
1. Costing profit and loss account.
2. Financial profit and loss account.
3. Statement reconciling the profits disclosed by the costing profit and loss account and financial
profit and loss account.
Solution
Costing Profit and Loss Account
(for the year ended 31st December, 2014)
Rs. Rs.
To Direct Materials 280,000 By Sales 700,000
To Direct wages 100,000 By Net loss 422,000
Prime cost 380,000
To Factory overhead
(20% on prime cost) 76,000
Gross factory cost 456,000
Less: work-in-progress 80,000
376,000
To administration overhead
(Rs. 3 per units produced) 480,000
To cost of production of 160,000 units 856,000
Less: closing stock of finished goods ( 40,000 units) 214,000
Cost of production of goods sold 642,000
To selling overheads 480,000
1,122,000 1,122,000


(for the year ended 31st December, 2014)
(as per financial books)
Rs. Rs.
To materials consumed 250,000 By Sales 700,000
To wages 100,000 By dividend received 50,000
To factory expenses 380,000 By interest on deposit 10,000
To administrative expenses 250,000 By closing stock:
Finished stock 120,000
To selling and distribution expenses 480,000
To legal charges 5,000
To bad debts 20,000
To preliminary expenses 10,000 By Net loss 535,000
1,495,000 1,495,000
Rs. Rs.(+) Rs.(-)
Loss as per cost account 422,000
Add: Over-charging materials in cost accounts 30,000
Over-absorption of administration OH
Charged 480,000
Actual (250,000) 230,000
Dividend and interest received not included in cost accounts
60,000
Less: Under absorption of factory overheads:
Actual 380,000
Charged (76,000) 304,000
Bad-debts not included in cost accounts 20,000
Preliminary expenses and legal charges written-off in financial
accounts 15,000
Over-valuation of closing stock in cost accounts 94,000
Total 320,000 855,000

Loss as per financial account 535,000


1. “Non-integrated accounting is one of the systems of Cost Control accounting to keep cost books”.
Explain
2. What is the purpose of preparing General Ledger Adjustment Account or Cost Ledger control
Account? How entries are recorded in this account?
3. What is control account? Mention the main control accounts and explain their utility.
4. What is integrated accounting? State its advantages.
5. Why is it necessary to reconcile the profits between Cost Accounting and Financial Accounting?
6. The following trial balance results from entries in a cost ledger:
Rs Rs.
General Ledger Adjustment Account 115,900
Stores Ledger Account 37,900
Work-in-progress Account 54,300
Finished Goods Account 23,500
Factory Overheads Account 500
Administration Expenses Account 300
116,200 116,200
Explain that each balance represents in each of the above transactions and traditions out of which it
has arisen. Show (assumed) details of the work-in-progress account.
7. State whether the following statements are true or false:
a. The stock ledger contains individual accounts of each of material.
b. The stock ledger control account in the cost ledger shows the total balance of all stores in hand at
a point of time.
c. The balance in the stores ledger control account should agree with the total of the schedule of the
balances extracted from the stores ledger.
d. The balance in the work-in-progress account is always equal to the total of the prime cost of
individual unfinished job accounts.
e. Since it is convenient to apportion the overheads when the job is complete no overhead may be
charged to unfinished jobs and the balance may be carried in a suspense account.
f. A capital order account books the cost of repairs carried on by the company itself.
Answer to self examination questions

6. (a) it represents the balance of all transactions relating to fixed assets, cash, suppliers and customers.
(b) It represents the total of balance of each item of store in hand.
(c) It represents the total of the prime cost of individual unfinished accounts.
(d) It represents the value of all finished goods in hand.
(e) It represents the amount of factory overheads to be carried forward due to under absorption of
this amount being the share of overheads on incomplete jobs.
(f) It represents the amount over-absorbed on account of administration overheads.
7. False: a and f; True: b, c, d and e.

CHAPTER 7
METHOD OF COSTING
(JOB AND BATCH COSTING, CONTRACT
COSTING, PROCESS COSTING AND
OPERATING COSTING)
CHAPER 7 : METHOD OF COSTING
7.1 INTRODUCTION
Today business and industry needs costing systems to meet their individual requirements. Costing experts
believe that it may not be possible to devise a single costing system to fulfill everybody’s needs. They
have developed different methods of costing for different industries depending upon the type of
manufacture and their nature. Mainly the industries can be grouped into two basic types:
1. Industries doing job work.
2. Industries engaged in mass production of a single product or identical production.
A concern engaged in the execution of specification order is characterized as a firm producing several items
distinguishable from one another by respective specifications and other details. Such a concern is thought of
involved in performing job works. Production under job work is strictly according to customer’s
specifications and each lot, job or production order is unique. Examples of jobs order type of production are:
ships building, roads, bridges, machine tools, iron foundries, wood working shops etc. Here each job or unit
of production is treated as a separate identity for the purpose of costing. The methods of costing and for
ascertaining cost of each job are known as job costing.
The continuous or process type of industry is characterized by the continuous production of uniform
products according to standard specifications. In such a case, the successive lots are generally
indistinguishable as to size and form and, even if there is some variation in specifications, it is of minor
character. Examples of process type of industry are chemical and pharmaceutical products, paper/food
products, canning, paints, and varnish oil etc. Here the methods of Costing used for the purpose of
ascertaining costs are: process costing, single costing, operating costing etc.
7.2 JOB COSTING

According to this method, costs are collected and accumulated according to jobs, contracts, products or
work orders. Each job or unit of production is treated as a separate entity for the purpose of costing. Job
costing is carried out for the purpose of ascertaining cost of each job and takes into account the cost of
materials, labor and overheads. The job costing method is also applicable to industries in which
production is in batches since batch production basically is of the same character as the job order
production, the difference being mainly one in the size of different orders. The method then may also be
described as “Batch Costing”.
The job costing method of costing may be regarded as the principal method of costing since the basic
object and purpose of all costing is to analyze and ascertain cost of each unit of production so that it may
be possible to control and regulate cost and to determine the profitability or otherwise of each work order
or product line. The basic principles enunciated for the job costing method are, therefore, valid essentially
for all types of industry. For example, printing; furniture hardware; ship-building; heavy machinery;
interior decoration, repairs and other similar work.
The job costing method essentially involves preparation of a separate cost sheet for each job, disclosing
cost of material issued for the job, labor charges incurred (on the basis of bill of material and time cards
respectively); when the job is completed, overhead charges are added for ascertaining total expenditure.
Job Costing may be in the following cases:
• When jobs are executed for different customers according to their specifications.

• When no two orders are alike and each order/job needs special treatment.
• Where the work-in progress differs from period to period on the basis of the number of jobs in
hand.
Specimen of Job (or work) Account with assumed figures is given below:
7.2.1 Procedure of Job Cost accounting.

a. Accounting for Materials:
An essential requirement of job cost accounting is that direct materials and their costs must be traced
to and indentified with specific job or work order. Where a bill of material is prepared, it provides the
basis for the preparation of these store requisitions. But when, the entire quantity of materials
specified in the bill of materials is drawn in one lot or in installments, the bill itself could be made to
serve as a substitute for the stores requisition.
After the materials have been issued and the stores requisitions have been priced, it is usual to enter
the value of the stores requisition in a material abstract or analysis book. It serves to analyze and
collect the cost of all direct materials according to job and departmental standing orders or expense
code numbers.
From the abstract book, the summary of materials cost of each job is posted to individual job cost
sheets or cards in the Work-in-Progress ledger. The postings are usually made weekly or monthly.
Similarly, at periodical intervals, from the material abstract books, summary cost of indirect material
is posted to different standing orders or expense code numbers in the Overhead Expenses ledger. If

any special material has been purchased for a particular job, it is generally the practice to charge such
special material direct to the job concerned without passing it through the Stores Ledger, as soon as it
is purchased.
If any surplus material is left over in the case of any job, unless it can be immediately and
economically used on some other job, the same is returned to the store room with a proper supporting
document/stores Debit Note or Shop credit, and the relevant job account is credited with the value of
excess material returned to the store room.
If the surplus material is utilized on some other job, instead of being returned to the store room first,
a material transfer note is prepared. The transfer note would show the number of the transfer to job as
well as transferee job (or jobs) so that, on that basis, the cost thereof can be adjusted in the Work-in-
Progress Ledger.
b. Accounting for Labor:

All direct labor cost must be analyzed according to individual jobs or work orders. Similarly,
different types of indirect labor cost also must be collected and accumulated under appropriate
standing order or expenses code number.
The analysis of labor according to jobs or work orders is, usually, made by means of job time cards
or sheets. All direct labor is booked against specific jobs in the job time cards or sheets. All the idle
time also is booked against appropriate standing order expense code number either in the job time for
each job or on a separate idle time for each worker (where the job time card is issued job-wise). The
time booked or recorded in the job time and idle time cards is valued at appropriate rates and entered
in the labor abstract on analysis book. All direct labor cost is accumulated under relevant job or work
order numbers, and the total or the periodical total of each job or work order is then posted to the
appropriate job cost card or sheet in Work-in-Progress ledger. The postings are usually made at the
end of each week or month.
The abstraction of idle time costs under suitable standing order or expenses code numbers is likewise
done and the amounts are posted to the relevant departmental standing order or expense code number
in the Overhead Expenses Ledger at periodical intervals. As regards other items of indirect labor cost
these are collected from the payroll books for the purpose of posting against standing order or
expenses code numbers in the Overhead Expenses ledger.
c. Accounting for Overhead:

Manufacturing overheads are collected under suitable standing order numbers and selling and
distribution overheads against cost accounts numbers. Total overhead expenses so collected are
apportioned to service and production departments on some suitable basis. The expenses of service
departments are finally transferred to production departments. The total overhead of production
departments is then applied to products on some realistic basis, e.g. machine hour; labor hour;
percentage of direct wages; percentage of direct materials; etc. It should be remembered that the use
of different methods will lead to a different amounts being computed for the works overhead charged
to a job hence to different total cost.
The problem of accurately absorbing, in each individual job or work order, the overhead cost of
different cost centre or department involved in the manufacture is difficult under the job costing

method. It is because the cost or the expenses there of cannot be traced or identified with job or work
order. In such circumstances, the best that can be done is to apply suitable overhead rate to each
individual article manufactured or to each production order. This is eventually and arbitrary method.
d. Price of a job:
Price of a job may be arrived by adding the desired percentage of profit to the total cost of the job.
e. Treatment of spoiled and defective work:

Spoiled work is the quantity of production that has been totally rejected and cannot be rectified.
Defective work on the other hand refers to production that is not as perfect as the saleable product but
is capable of being rectified and brought to the required degree of perfection provided some
additional expenditure is incurred.
Normally, all the manufacturing operations are not fully successful; they result in turning out a
certain amount of defective work. Nonetheless, over a period of time it is possible to work out a
normal rate of defectives for each manufacturing process which would represent the number of
defective articles which a process shall produce in spite of due care. Defects arise in the following
circumstances:
(1) Where a percentage of defective work is allowed in a particular batch as it cannot be avoided.
(2) Where defect is due to bad workmanship.
(3) Where defect is due to the Inspection department wrongly accepting incoming material of poor
quality.
i. In the first case, when a normal rate of defectives has already been established, if the actual
number of defectives is within the normal limit or is near there to the cost of rectification will
be charged to the whole job and spread over the entire output of the batch. If, on the other
hand, the number of defectives units substantially exceeds the normal, the cost of rectification
of the number which exceeds the normal will be written off as a loss in the Costing Profit and
Loss account.
ii. In the second case, when the defective work is due to bad workmanship the cost of
rectification will be abnormal cost i.e. not a legitimate element of the cost. Therefore, the cost
of rectification shall be written off as a loss, unless by an arrangement, it is to be recovered as
a penalty from the workman concerned. It is possible, however that the management did
provide for a certain proportion of defectives on account of bad workmanship as an
unavoidable feature of production. If that be the new case, the cost of rectifying to the extent
provided for by the management will be treated as a normal cost and charged to the batch.
iii. In the third case the defect being due to negligence of the Inspection Department, the cost of
rectification will be charged to the department and will not be considered as cost of
manufacture of batch. Being an abnormal cost, it will be written off to the Costing Profit and
Loss Account.

Illustration: 1
The manufacturing cost of a work order is Rs. 1,000. 8% of the production against that order spoiled
and the rejection is estimated to have a realizable value of Rs. 20 only. The normal rate of spoilage is
2%. Record this in the costing journal.
Solution:
Actual loss is Rs.60, i.e. Rs. 80 less Rs. 20 recoverable as materials. Of this net loss of Rs. 15 is
normal; Rs. 45 is the abnormal loss to be debited to the Costing profit and Loss account. The
accounting entries necessary for recording the above facts would be:
Rs. Rs.
Materials Control Account Dr. 20
Overhead Control account Dr. 15
Costing Profit and Loss Account Dr. 45
To Work-in Progress Control Account 80
In the case of defectives, being inherent in the manufacturing process, the rectification cost may be
charged to the specific jobs in which they have arisen. In case defectives cannot be identified with
jobs, the cost of rectification may be treated as factory overheads. Abnormal defectives should be
written off to the costing Profit and Loss Account.
Illustration: 2
A shop floor supervisor of a small factory presented the following cost for Job no.303, to determine
the selling price.
Per unit
(Rs.)
Materials 70
Direct wages18 hours @ Rs. 2.50 45
(Dept. X 8 hrs; Dept Y 6 hrs; dept Z 4 hrs)
Chargeable expenses 5
120
Add: 33.33% for expenses cost 40
160
Analysis of Profit and Loss Account ( for the year 2014)
Rs Rs.
Material used 150,000 Sales less return 250,000
Direct wages:
Dept. X: 10,000

Dept Y: 12,000
Dept. Z: 8,000 30,000
Special Stores items 4,000
Overheads:
Dept. X: 5,000
Dept Y: 9,000
Dept. Z: 2,000 16,000
Works Cost 200,000
Gross profit c/d 50,000
Gross profit b/d 50,000
Sales expenses 20,000
Net profit 30,000
50,000 50,000
It is also noted that average hourly rates for the three Departments X, Y & Z are similar. You are
required to:
i. Draw up a job cost sheet.
ii. Calculate the entire revised cost using 2014 actual as basis.
iii. Add 20% to total cost to determine selling price.
Solution:
Job Cost Sheet
Customer Details…………… Job No……..
Date of commencement……. Date of completion……..
Particulars Amount
Rs.
Direct Materials 70
Direct Wages:
Dept. X Rs. 2.50 x 8 hrs = Rs. 20.00
Dept. Y Rs. 2.50 x 6 hrs. = Rs. 15.00
Dept. Z Rs. 2.50 x 4 hrs = Rs. 10.00 45
Chargeable expenses 5
Prime cost 120

Overheads:
Rs 50,00
Dept. X = x Rs 20
Rs 10,000
=Rs 10
23.75
Rs 9,000
Dept. Y = x Rs 15
Rs 12,000
=Rs 11.25
Rs 2,000
Dept. Z = x Rs 10
Rs 8,000
=Rs 2.50
Works cost 143.75
Rs 20,000 14.38
Selling Expense = x Rs 143.75
Rs 2,00,000
Total cost 158.13
Profit (20% of total cost) 31.63
Selling price 189.76
Illustration: 3
A factory incurred the following expenditure during the year 2007:
Rs
Direct material consumed 12,00,000
Manufacturing Wages 7,00,000
Manufacturing overhead:
Fixed 3,60,000
Variable 2,50,000
6,10,000
25,10,000
In the year 2008, following changes are expected in production and cost of production.
(i) Production will increase due to recruitment of 60% more workers in the factory.
(ii) Overall efficiency will decline by 10% on account of recruitment of new workers.
(iii) There will be an increase of 20% in Fixed overhead and 60% in Variable overhead.
(iv) The cost of direct material will be decreased by 6%.
(v) The company desire to earn a profit of 10% on selling price.
Ascertain the cost of production and selling price.

Solution
Budgeted Cost Sheet for the year 2008
Amount (Rs) Amount (Rs)
Direct material consumed 1,200,000
Add: 44% due to increased output 528,000
Less: 6% for decline in price 103,680 1,624,320
Direct wages (manufacturing) 700,000
Add: 60% increase 420,000 1,120,000
Manufactured Overhead:
Fixed Manufacturing Expense 360,000
Add: 20% increase 72,000 432,000
Variable Manufacturing Expense 250,000
Add: 60% increase 150,000 400,000
Cost of production 3,576,320
Add: 1/9 of Cost or 10% on selling price 397,369
Selling price 3,973,689
Working Note
1. Let the production be 100
Production will increase by 60% due to recruitment,
Then Production unit = (100 + 60% of 100) = 160
but efficiency will decline by 10%.
The new production unit would be (160 – 10% of 160) = 144%
So increase in production by (144% -100%) = 44%.
Note: If we consider that variable overhead once will change because of increase in production (From
2,50,000 to 4,00,000) then with efficiency declining by 10% it shall be 3,60,000 and then again as
mentioned in point No. (iii) of this question it will increase by 60% then variable overhead shall be Rs
3,60,000 × 160% = 5,76,000. Hence, total costs shall be Rs 37,52,320 and profit shall be 1/9th of Rs
37,52,320 = 4,16,924. Thus, selling price shall be 41,69,244.
Alternative Solution:
Students may use a combined factor to arrive at the figures in respect of materials and variable overheads
as under:
2007 production 100
Increase in 2008 2008:60%= 160%
Efficiency decline 10% 160 × 90% = 144%
Materials 12,00,000 × 144% = Rs 17,28,000
Variable overheads 2,50,000 × 144% = Rs 3,60,000

Note: Variable overhead is a product cost and consequently if the output increases by 44%, the variable
overheads will also go up proportionately with the increase in output. The other 60% increase given in
the question is the increase in expense or rate or price of the overhead items like increase tariff, increase
in the prices of consumables.
7.2.2 Advantages of Job Costing

i. Profitability of each job can be individually determined.
ii. It provides a basis for estimating the cost of similar jobs which are to be taken in future.
iii. It provides the detailed analysis of the cost of material, labor and overheads for each job as and
when required.
iv. Plant efficiency can be controlled by confining attention to costs relating to individual jobs.
v. Spoilage and defective work can be identified with a specific job and responsibility for the same
may be fixed on individuals.
vi. By adopting pre-determined overhead rates in job costing, all the advantages of budgetary control
can be obtained
vii. Job costing is essential for cost-plus contract where contract price is determined directly on the
basis of cost.
7.2.3 Limitations of Job Costing

i. It is expensive to operate as it requires considerable detailed clerical work.
ii. With the increase in the clerical work the chances of errors are increased.
iii. Job order costing cannot be efficiently operated without highly developed production control
system. The job costing required intricate factory organization system.
iv. The costs as ascertained are historical as they are compiled after incidence and therefore do not
provide control of cost unless it is used with standard costing system.
7.2.4 Job Ticket

Job Ticket is a slip or card accompanying a job order and used for giving instructions or for recording
time spent on the work. A "job ticket" may also be a synonym for a work order, which is also known as a
job order, job ticket, work ticket or service ticket is a document received by an organization from an
external customer, or another department internal to that organization, describing work to be completed
and/or products to be purchased or manufactured. A work order is sometimes used as an invoice when
working with external customers.
7.3 BATCH COSTING

7.3.1 Meaning of Batch costing:
This is a form of job costing. Under job costing, executed job is used as a cost unit whereas under batch
costing, a lot of similar units which comprises the batch may be used as a cost unit for ascertaining cost.
In the case of batch costing separate cost sheets are maintained for each batch of products by assigning a
batch number. Cost per unit in a batch is ascertained by dividing the total cost of a batch by number of
items produced in that batch. Such a method of Costing is used in the case of pharmaceutical or drug
industries, readymade garments, industries manufacturing electronic parts of T.V., radio sets etc.
Illustration: 4
A jobbing factory has undertaken to supply 200 pieces of a component per month for the ensuing six
months. Every month a batch order is opened against which materials and labor hours are booked at
actual. Overheads are levied at a rate per labor hour. The selling price contracted for is Rs. 8 per piece.
From the following data present the cost and overall position of the order for 1,200 pieces.
Batch Output Material Cost Direct Wages Direct labor
Month Hours
Rs. Rs.
January 210 650 120 240
February 200 640 140 280
March 220 680 150 280
April 180 630 140 270
May 200 700 150 300
June 220 720 160 320
The other details are:

Month Chargeable expenses (Rs.) Direct labor hours
January 12,000 4,800
February 10,560 4,400
March 12,000 5,000
April 10,580 4,600
May 13,000 5,000
June 12,000 4,800
Solution
Jan. Feb. March April May June Total
Batch output Units 210 200 220 180 200 220 1230
Sale value Rs. 1,680 1,600 1.760 1.440 1.600 1,760 9.840
Material cost Rs. 650 640 680 630 700 720 4.020
Direct wages Rs. 120 140 150 140 150 160 860
Chargeable Rs. 600 672 672 621 780 800 4,145

expenses
Total cost Rs. 1.370 1,452 1,502 1.391 1,630 1,680 9,025
Profit per Rs. 310 148 258 49 -30 80 815
batch
Total cost per Rs. 6.52 7.26 6.83 7.73 8.15 7.64 7.34
unit
Profit per unit Rs. 1.48 0.74 1.17 0.27 -0.15 0.36 0.66
Overall position of the order for 1,200 units
Sales value of 1,200 units @ Rs. 8 per unit Rs. 9,600
Total cost of 1,200 units @ Rs. 7.34 per unit Rs. 8,808
Profit Rs. 792
7.3.2 Economic Batch Quantity:

In batch costing the most important problem is the determination of optimum size of the batch (how much
to produce) or Economic Batch Quantity.
The determination of economic batch quantity involve two types of costs viz., (i) set up cost (or
preparation cost) and (ii) carrying cost. With the increase in the batch size, there is an increase in the
carrying cost but the set up cost per unit of product is reduced; this situation is reversed when the batch
size is reduced. Thus there is one particular batch size for which both setup and carrying costs are
minimum. This size is known as economic or optimum batch quantity.
Economic batch quantity can be determined with the help of a table, graph or mathematical formula. The
mathematical formula usually used for its determination is as follows:

EBQ =

Where, D= Annual demand for the product

S= Setting up cost per batch
C= Carrying cost per unit of production
I = Rate of interest
Illustration: 5
Monthly demand for a product 500 units
Setting up cost per batch Rs. 60
Cost of manufacturing per unit Rs. 20
Rate of interest 10% p.a.
Determine economic batch quantity.

Solution

EBQ= = = 600 units

.
7.3.3 Difference Between Job Costing and Batch Costing

Under Job Costing, costs are collected and accumulated according to job. Each job or unit of production
is treated as separate entity for the purpose of costing. Job costing may be employed when jobs are
executed for different customers according to their specification.
Batch costing is a form of job costing, a lot of similar units which comprises the batch may be used as
cost unit for ascertaining cost. Such a method of costing is used in case of pharmaceutical industry,
readymade garments, industries manufacturing parts of TV, radio sets, etc.
7.4 CONTRACT COSTING
A contract usually takes several years to get it completed. If the profit on such contracts is recorded only
after the completion, then wide fluctuations may noted in the profit figures of contractors from year to
year. To avoid these fluctuations in the reported profits and to reflect the revenue in the accounting period
during which the activity is undertaken, the profit in respect of each contract in progress is transferred to
the profit and loss account of the year by calculating the notional profit. The portion of notional profit to
be transferred to the profit and loss account depends on the stage of completion of a contract. To
determine such a profit figure the knowledge of various concepts as discussed below is essential in
contract costing.
7.4.1 Meaning of Contract Costing:

Contract or terminal costing, as it is termed, is one form of application of the principles of job costing. In
fact a bigger job is referred to as a contract. Contract costing is usually adopted by building contractors
engaged in the task of executing Civil Contracts i.e. firms engaged in construction of bridges, dams,
roads, buildings, etc.. Contract costing have the following distinct features:
i. The major part of the work in connection with each contract is ordinarily carried out at the site of
the contract.
ii. The bulk of the expenses incurred by the contractor are considered as direct.
iii. The indirect expenses mostly consist of office expenses of the yards, stores and works.
iv. A separate account is usually maintained for each contract.
v. The number of contracts undertaken by a contractor at a time is not usually very large.
vi. The cost unit in contract costing is the contract itself.
vii. The time of completion is generally more than one year.
7.4.2 Parties in Contract

(a) Contractor: The person who executes contract is called contractor.

(b) Contractee: Contractee is the person who grants contract to the contractor. Such contractee is
also called as contractor’s client.
(c) Certifier or Evaluator: The person who examines the progress of contract periodically both by
inspecting the documents and site visit is known as certifier or evaluator. The evaluator then certifies
the value of work done upto a point of time. He works on behalf of contractee.
7.4.3 Types of Contract

(a) Fixed Price Contracts:
Under this contract, a fixed price of contract is agreed upon between the contractor and contractee.
(b) Contracts with Escalation Clause
Escalation Clause: If during the period of execution of a contract, the prices of materials or labor
etc. rise beyond a certain limit, the contract price will be increased by an agreed amount. Inclusion
of such a clause in a contract deed is called an “Escalation Clause”.
Hence, contracts with escalation clause refers to such contract where contract price is fixed with a
provision that it will be increased with increase in price of materials, wage rates and other major
costs and reduced with decline in costs.
(c) Cost plus Contracts:
Under Cost plus Contract, the contract price is ascertained by adding a percentage of profit or lump
sum fee of profit to the total cost or of the work. Such type of contracts are entered into when it is
not possible to estimate the Contract Cost with reasonable accuracy due to unstable condition of
material, labor services, etc.
Cost plus contracts have the following advantages and disadvantages:
Advantages:
(i) The Contractor is assured of a fixed percentage of profit. There is no risk of
incurring any loss on the contract.
(ii) It is useful especially when the work to be done is not definitely fixed at the time of
making the estimate.
(iii) Contractee can ensure himself about ‘the cost of the contract’, as he is empowered
to examine the books and documents of the contractor to ascertain the veracity of
the cost of the contract.
Disadvantages: The contractor may not have any inducement to avoid wastages and effect
economy in production to reduce cost.
7.4.4 Distinction between job costing system and contract costing system
It is considered that contract costing is comparatively simpler in operation than job costing system. The
accumulation, analysis, apportionment, allocation and control of cost are simplified in contract costing.
Most of the expenses are chargeable direct to Contract Account but direct allocation to such an extent is
not possible in Job Costing. Normally the number of jobs in hand at any time in a concern may be large,

only a few contracts may be undertaken at a time. As contracts may run for long periods, there arises the
problem of assessment and crediting of profits on incomplete contracts at the end of accounting period.
A ‘contract’ differs from a job only in size. We generally reserve the word ‘contract’ for those jobs which
require all the attention or most of it to be devoted to it. Work is done for a customer who agrees to pay a
fixed sum of money at the completion of the work. Usually, however, the contractee pays a portion of the
work done progressively. A contract may be for the construction of a building, a road, a ship or a
complicated piece of machinery, etc. Since the number of contracts in hand is never likely to be large, it is
not necessary to maintain separate books of account for costing purposes. Financial books are sufficient
but they will have to be remodeled to give the required information. For example, if two contracts are
being undertaken simultaneously, wages or materials will have to be separately recorded for each;
otherwise it will be difficult to know the total cost of completing a particular contract. It will even be
better if, in the account opened to record the cost of a contract, columns are provided to classify the
expenditure.
7.4.5 Specific aspects of Contract Costing

Sub-Contract: Sub-contract costs are also debited to the Contract account.
Extra work: The extra work amount payable by the contractee should be added to the contract price. If
extra work is substantial, it is better to treat it as a separate account. If it is not substantial, expenses
incurred should be debited to the contract account as “Cost of extra work.”
Cost of work certified: All building contractors received payments periodically known as “running
payments” on the basis of the architect’s or surveyor’s certificates. But payments are not equal to the
value of the work certified; a small percentage of the amount due is retained as security for any defective
work which may be discovered later within the guarantee period.
Mathematically :
Cost of work certified = Cost of work to date – (Cost of work uncertified + Material in hand + Plant at
site)
The amount retained is called retention money. The full value of the work certified should be credited to
the Contract Account and debited to the account of the contractee. Since the cash received from him will
be less the balance in his account will be shown as an asset in the balance sheet.
Work uncertified: It represents the cost of the work which has been carried out by the contractor but has
not been certified by the contractee’s architect it is always shown at cost price. The cost of uncertified
work may be ascertained as follows:
Rs.
Total cost to date …..
Less: Cost of work certified ……
Material in hand ……
Plant at site …… …...
Cost of work uncertified ……

Retention money: A contractor does not receive full payment of the work certified by the surveyor.
Contractee retains some amount (say 10% to 20%) to be paid, after sometime, when it is ensured that
there is no fault in the work carried out by contractor. If any deficiency or defect is noticed in the work, it
is to be rectified by the contractor before the release of the retention money. Retention money provides a
safeguard against the risk of loss due to faulty workmanship.
Cash received: It is ascertained by deducting the retention money from the value of work certified i.e.
Cash received = Value of work certified – Retention money
Work-in-progress: In Contract Accounts, the value of the work-in-progress consists of (i) the cost of
work completed, both certified and uncertified; (ii) the cost of work not yet completed; and (iii) the
amount of profit taken as credit. In the Balance Sheet, the work-in-progress is usually shown under two
heads, viz., certified and uncertified. The cost of work completed and certified and the profit credited will
appear under the head ‘certified’ work-in-progress, while the completed work not yet certified and the
cost of labor, material and expenses or work which has not yet reached the stage of completion are shown
under the head “uncertified” work-in-progress.
Notional profit: It represents the difference between the value of work certified and cost of work
certified. It is determined:
Notional profit = Value of work certified – (Cost of work to date – cost of work not yet certified)
Estimated profit: It is the excess of the contract price over the estimated total cost of the contract.
7.4.6 Recording of contract costs:

a. Material Cost:
All materials supplied from the stores or purchased directly for the contract are debited to the concerned
contract account. In the case of transfer of excess material from one contract to another contract, their
costs would be adjusted on the basis of material transfer note, signed both by the transferee and the
transferor foreman. In case the return of surplus material appears uneconomical on account of high cost of
transportation, the same is sold and the concerned contract account is credited with the sale of price. Any
loss or profit arising there from is sent a loss and as such, the same is transferred to the Profit and Loss
Account. Any theft, or destruction of material by fire represent a loss and such, the same is transferred to
the Profit and Loss Account. If any stores’ items are used for manufacturing tools, the cost of such stores
items are charged to the work expenses account. If the contractee has supplied some materials without
affecting the contract price, no accounting entries will be made in the contract account, only a note may
be given about it.
b. Labor cost:
Labor actually employed on the site of the contract is regarded as direct (irrespective of the nature of the
task performed) and the wages paid to them are charged to the concerned contract directly or on the basis
of a wage analysis sheet (if concurrently a number of contracts are carried on and laborers are required to
devote their time on two or more contracts.)
c. Direct expenses:
Direct expenses (if any) are directly charged to the concerned contract.

d. Indirect expenses:
Indirect expenses (such as expenses of engineers, surveyors, supervisors etc.) may be distributed over
several contracts as a percentage of cost of materials, or wages paid or of the prime cost. If however, the
contracts are big, the labor hour method may be used for the distribution of expenses.
e. Plant and Machinery:
The value of the plant in a contract may be either debited to contract account and the written down value
thereof at the end of the year entered on the credit side for closing the contract account, or only a charge
(depreciation) for use of the plant may be debited to the contract account.
7.4.7 Profit/loss on incomplete contracts:

To determine the profit to be taken to Profit and Loss Account, in the case of incomplete contracts, the
following four situations may arise:
(i) Completion of contract is less than 25 per cent: In this case no profit should be taken to profit
and loss account.
(ii) Completion of contract is up to 25 per cent or more than 25 per cent but less than 50 per cent: In
this case one-third of the notional profit, reduced in the ratio of cash received to work certified,
should be transferred to the Profit and Loss Account. Mathematically
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(iii) Completion of contract is up to 50 per cent or more than 50 per cent but less than 90 per cent :
In this case, two-third of the notional profit, reduced by proportion of each received to work
certified, is transferred to the Profit and Loss Account. Mathematically :
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(iv) Completion of contract is up to 90 per cent or more than 90 per cent i.e. it is nearing
completion: In this case, the profit to be taken to Profit and Loss Account is determined by
determining the estimated Profit and using any one of the following formulas:
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a. ()*+,
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b. ()*+, x
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Or
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c. ()*+,
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d. ()*+, x
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e.
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(This formula may be preferably used in the absence of estimated profit figure)
It is preferable to use formula (b) in the absence of specific instructions.

Note: In case of loss, the above formulae are not applicable. As per prudence concept, all the loss shall
be treated as Net Loss and full amount is directly transferred to Profit & Loss Account.
Illustration: 1
Compute a conservative estimate of profit on contract (which has been 90% complete) from the following
particulars:
Rs.
Total expenditure to date 22,50,000
Estimated further expenditure to complete the
contract (including contingencies) 2,50,000
Contract Price 32,50,000
Work certified 27,50,000
Work uncertified 1,75,000
Cash received 21,25,000
Solution
i. Computation of notional profit
Particular Rs.
Value of work certified 27,50,000
Less: cost of work certified (22,50,000 - 1,75,000) 20,75,000
Notional profit 6,75,000
ii. Computation of estimated profit
Particular Rs.
Contract price 32,50,000
Less: cost of work to date 22,50,000
Estimated further exp. to complete the contract 2,50,000
Estimated profit 7,50,000

Illustration: 2
The following expenses were incurred on a contract:
Rs.
Material purchased 600,000
Material drawn from stores 100,000
Wages 225,000
Plant issued 75,000
Chargeable expenses 75,000
Apportioned indirect expenses 25,000
The contract was for Rs. 2,000,000 and it commenced on January 1, 2014. The value of the work
completed and certified up to 30th November, 2014 was Rs. 1,300,000 of which Rs. 1,040,000 was
received in cash, the balance being held back as retention money by the contractee. The value of work
completed subsequent to the architect’s certificate but before 31st December, 2014 was Rs. 60,000. There
were also lying on the site materials of the value of Rs. 40,000. It was estimated that the value of plant as
at 31st December, 2014 was Rs. 30,000.
Solution:
Contract Account
Particular Rs. Particular Rs.

To material purchased 600,000 By work-in-progress:
To stores issued 100,000 Work certified 1,300,000
To wages 225,000 Work uncertified 60,000
To Plant 75,000 Material unused 40,000
To chargeable expenses 75,000 Plant less depreciation 30,000
To indirect expenses 25,000
To Profit and loss account, 2/3 of profit on
176,000
cash basis
To, Work-in-progress balance of profit c/d 154,000
1,430,000 1,430,000
To , Balance b/d: Work certified 1,300,000
Uncertified 60,000
Material at site 40,000
Plant at site 30,000
Less: Reserve 154,000
1,276,000

Working Note:
Computation of Profit
2 Cash Received
Profit to be shown = X Notional profit X
3 Work Certified
2 1,040,000
= X (1,430,000 - 1,100,000) X
3 1,300,000
= Rs 176,000
An alternative method of presentation can be to deduct the balance of profit to be carried down (Rs.
154,000 in above case) from the work certified before it is entered in the contract account. It will be Rs.
1,146,000 in the illustration given above. Of course, the reserve to be so deducted from the work certified
will have to be first ascertained by considering the value of the work certified.
7.4.8 Escalation and de-escalation clause:

Escalation clause is often provided in a long-term contracts under which the settled contract price is
subject to enhancement on any likely increase in price or utilization of materials and labor etc. Following
are circumstances when this safeguard is provided to the contractor that the contract price would be
suitably enhanced:
i. When the market price of materials used for the contract work are anticipated higher beyond a
limit in the future.
ii. When quantity of materials used for the contract is anticipated more than estimated quantity due
to the nature of the contract, the correct estimate was not possible unless the work has been
sufficiently progressed. It may also be due to availability of inferior grades of raw materials
resulting in more scraps and spoilage.
iii. When labor rates are anticipated to increase or where labor usages cannot be correctly estimated
on account of the nature of the contract.
Thus an escalation clause is meant to safeguard the interest of the contractor against unforeseen rise in
cost. There may be a De-escalation clause or Reserve Clause to provide for any future decrease in price
etc., so that benefit may be passed on to the contractee.
Illustration (Contracts with Escalation Claim): 3

ABB Ltd undertook a contract for Rs 5,00,000 on 1st July 2014. On 30th June 2015, when the accounts
were closed, the following details about the contract were gathered:
Rs.
Materials Purchased 1,00,000
Wages paid 45,000
General expenses 10,000

Plant purchased 50,000

Materials on hand 30.06.2015 25,000
Wages accrued 30.06.2015 5,000
Work Uncertified 15,000
Cash Received 1,50,000
Depreciation of plant 5,000
The above contract contained an escalation clause which reads as follows: “In the event of prices of
materials and rates of wages increase by more than 5%, the contract price will be increased accordingly
by 25% of the rise in cost of materials and wages beyond 5% in each case.”
It was found that since the date of signing the agreement the price of materials and wages rates increased
by 25%. The value of work certified does not take into account the effect of above clause. Prepare the
contract account.
Solution
Contract Account
For the year ending 30th June 2015
Particulars Amount Particulars Amount
To Materials 1,00,000 By WIP:
To Wages 50,000 Work Certified 2,00,000
To General Expenses 10,000 Work Uncertified 15,000
To Plant Depreciation 5,000 By Materials on hand 25,000
To Profit & Loss A/c 20,000 By Contract Escalation 5,000
(WN 2) (WN 1)
To Balance c/d 60,000
2,45,000 2,45,000
Working Notes:
1. Calculation of Escalation Claim
Total Increase Upto 5% Beyond 5%
Materials 15,000 3,000 12,000
(effect of increase in price)
(Rs 1,00,000-Rs 25,000)X25/125
Wages 10,000 2,000 8,000
(Effect of changes in wage rates)
(Rs 50000 X 25/125)
Total Increase 25,000 5,000 20,000

Increase in contract price = 25% of Increase in Material and wages beyond 5%.
= 25% of Rs 20,000
= Rs 5,000
2. Calculation of profit to be transferred
Since the contract is completed between 25% and 50%, one third of the notional profit as restricted
by the proportion of cash received to work certified is transferred.
1 Cash Received
= X Notional Profit X
3 Work Certified
1 150,000
= X 80,000 X
3 200,000
= Rs 20,000
Illustration: 4
A contractor prepares his accounts for the year ending 31st December each year. He commenced a
contract of 1st April, 2014.
The following information relates to the contract as on 31st December, 2014:
Rs.
Material issued 251,000
Labor charges 565,600
Salary to Foreman 81,300
A machine costing Rs. 260,000 has been on the site for 146 days, its working life is estimated at 7 years
and its final scrap value at Rs. 15,000.
A supervisor, who is paid Rs. 8,000 p.m., has devoted one-half of his time in this contract. All other
expenses and administration charges amount to Rs. 136,500.
Material in hand at site costs Rs. 35,400 on 31st December, 2014.
The contract price is Rs. 2,000,000. On 31st December, 2014 two-third of the contract was completed.
The architect issued certificates covering 50% of the contract price, and the contractor has been paid Rs.
750,000 on account.
Prepare Contract A/c and show how much profit or loss should be included in financial accounts to 31st
December, 2014.

Solution:
Contract Account
Dr. Cr.
Rs. Rs.
To Material issued 251,000 By machine ( see note 1) 246,000
To labor charges 565,600 By material (in hand) 35,400
To foreman salary 81,300 By works cost 1,049,000
To Machine 260,000
To Supervisor’s salary 36,000
(Rs. 8,000 x 9)/2
To Adm. Charges 136,500
1.330,400 1.330,400
To Work cost 1,049,000 By work certified 1,000,000
To Notional profit 213,250 By Work uncertified (See Note 2) 262,250
1,262,250 1,262,250
To profit and loss A/c 106,625 By Notional Profit 213,250
To Work-in-progress 106,625
213,250 213,250
Notes:
1. Machine: [(Rs. 260,000 – Rs. 15,000)/7] x 146/365 = Rs. 14,000
Hence, value of machine after the period of 146 days is Rs.260,000 – Rs. 14,000 = Rs. 246,000
2. The work cost of two-third of the contract is Rs. 1,049,000

Therefore, cost of 100% of the contact is (Rs.1,049,000/66.67) x 100
= Rs.1,573,500
If cost of 50% of the contact which has been certified by the architect is ( Rs 1,573,500 /2) = Rs. 786,750
then balance cost of the contract, which has been completed but not certified by the architect, is (Rs
1,049,000 – Rs 786,750) = Rs. 262,250.
Illustration: 5
The following particulars are obtained from the books of Vinayak construction Ltd. as on 15 July 2014:-
Plant and equipment at cost Rs. 490,000
Vehicle at cost Rs. 200,000

Details of contract, which remain uncompleted as on 15 July 2014:
Contract Nos.
V. 20 V. 24 V. 25
(Rs. Lakh) (Rs. Lakh) (Rs. Lakh)
Estimated final sale value 8.00 5.60 16.00
Estimated final cost 6.40 7.00 12.00
Wages 2.40 2.00 1.20
Materials 1.00 1.10 0.44
Overheads (excluding depreciation) 1.44 1.46 0.58
Total cost to date 4.84 4.56 2.22
Value certified by architects 7.20 4.20 2.40
Progress payment received 5.00 3.20 2.00
Depreciation of Plant and Equipment and vehicle should be charged at 20 % to the three contracts in
proportion to work certified.
You are required to prepare statement showing contract-wise and total:

(i) Profit /Loss to be taken to the profit and loss account for the year ended 15th July 2014.
(ii) Work-in-progress as would appear in the Balance Sheet as at 15th July 2014.
Solution
Vinayak Construction Co. Ltd.
(i) Statement of Profit/Loss to be taken to Profit and Loss Account
(for the year ended 15 July 2014)
Figures in lakhs of Rs.
V20 V24 V25 Total
A. Percentage of completion
Estimated sales value 8.00 5.60 16.00 -
Work certified 7.20 4.20 2.40 -
Percentage of completion (Note 1) 90 75 15 -
B. Estimated results on completion

Estimated sales value 8.00 5.60 16.00 -
Estimated costs 6.40 7.00 12.00 -
Estimated profits (loss) 1.60 (1.40) 4.00 -
C. Results to date
Work Certified 7.20 4.20 2.40 13.80

Costs to date (excluding depreciation) 4.84 4.56 2.22 11.62

Depreciation (Note 2) 0.72 0.42 0.24 1.38
5.56 4.98 2.46 13.00
Total cost
Notional profit (loss) 1.64 (0.78) (0.06) 0.80
Profit/(loss) to be taken to profit and loss account (Note 3) 1.00 (1.40) (0.06) (0.40)
Reserve for contingencies (Note 4) 0.64 0.62* - 1.26
*Charged against profit and loss account.
(ii) Statement of work-in-progress as would appear in Balance Sheet on 15 July 2014

Figures in lakhs of Rs.
V20 V24 V25 Total
Work certified 7.20 4.20 2.40 13.80
Less: Reserve for contingencies 0.64 0.62 - 1.26
Less: payment received 5.00 3.20 2.00 10.20
1.56 0.38 0.40 2.34
Work-in-progress
Working Notes:
1. Percentage of completion = (Work certified /Estimated sales value) x 100
2. Total cost of plant, equipment and vehicle = Rs.490,000+Rs.200,000 = Rs. 690,000.
Depreciation @ 20% thereof Rs.138,000. Depreciation has been apportioned on the basis of
amount of work certified.
3. Contract V20 is almost complete therefore the profit to be taken to profit and loss account has
been calculated by applying the formula: Cash received / Contract price.
4. Total loss on Contract V24 is estimated at Rs. 1.40 lakhs. The current year loss is Rs. 0.78 lakhs.
This should be charged to P&L A/C. Besides this Rs. 0.62 lakhs should be charged further to
profit and loss account for the likely loss as per conservatism concept.
7.4.9 Progress payment and balance sheet entries

It is usual for the contractee to pay a certain percentage (say 80% or 90%) of the value of a definite stage
of work completed. The payment is made after the contractee is satisfied that such stage has been
completed. Surveyors or architects issue certificates for this purpose. Suppose the architect certifies that
work of the value of Rs. 200,000 (out of the total contract price of Rs. 500,000) has been completed. Then
if the contractee has agreed to pay 90%, he will pay Rs. 180,000. The balance of Rs. 20,000, known as
Retention Money, will be paid when the whole contract is complete. Retention is a sort of guarantee that
the contractor will not run away in the middle of the job, as he might have the temptation to do if he sees
nothing but loss in the completion of the contract.

Payment received can be dealt with in two ways. The value of the work done can be debited to the
Contractee’s account and credited to the Contract Account. Cash received will, of course, stand to the
credit of the Contractee’s Account. Thus in the above example the following entries may be passed.
Rs. Rs.
Contractee’s Account Dr. 200,000
To Contract Account 200,000
(Being the value of work certified as per architect’s certificate)
Bank Account Dr. 180,000
To Contractee’s Account 180,000
(Being cash received 90% of value of work certified by retaining
10% as retention money)
In the Balance Sheet the contractee’s Account will be shown at Rs. 20,000 on the asset side. Care will
have to be exercised to see that in the following year the value of work certified for the purpose of
passing entries does not include Rs, 200,000 in respect of which entry has already been passed.
The second and more popular method to deal with the payment received is to credit the amount to the
account of the contractee. The value of the work completed is debited to the Work-in-progress Account
and credited to Contract Account. Or it may be carried down as a balance in the Contract Account itself.
In the Balance Sheet, the credit to the contractee is deducted from the value of work completed, the
balance being shown as an asset. In the following year, the Work-in-progress Account will be transferred
to the debit of the Contract Account and the entries to be passed in respect of work done at the end of the
next year will be for the amount of total work done, including the amount already certified at the end of
the previous year.
When Work-in-progress (WIP) is not complete at the end of the accounting period, this account is
opened. WIP Account shows value of work certified and cost of work uncertified. The entry will be:
WIP Account Dr. [(i) Value of work certified and (ii) Value of work uncertified]
To Contract Account
For profit not transferred to P/L Account (Reserved profit)
Contract Account Dr.

To WIP Account
Work-in-progress Account
To Contract Account By Contract Account (Reserved Profit)
• Value of Work Certified By Balance c/d
• Value of Work Uncertified

Work-in Progress is shown in the asset side of the Balance Sheet. Cash received from the contractee is
deducted therefrom. Plant at site and materials at site will also appear as assets in the Balance Sheet.
Balance Sheet
Liabilities Amount Assets Amount
Work-in-Progress
Less: Cash received
Plant at site
Materials at site
WIP along with materials and plant at site are carried to the next year’s Contract Account as opening
balance.
The contractor opens a personal account of the contractee and credits cash received from him.
Cash/Bank Account Dr.
To Contractee Account
Contractee Account
To Balance c/d By Cash/Bank
Illustration: 6 (Contract Account along with Balance Sheet)

A company undertook a contract for construction of a commercial complex. The construction work
commenced on 16.07.2014 and the following data is available for the year ended on 15.07.2015.
Particulars Amount (Rs)

Contract Price 3,50,00,000
Work Certified 2,00,00,000
Progress payment Received 1,50,00,000
Material issued to site 75,00,000
Planning and estimating costs 10,00,000
Direct Wages Paid 40,00,000
Material returned from site 2,50,000
Plant Hire Charges 17,50,000
Wages related costs 5,00,000
Site office expenses 6,78,000
Head office expenses apportioned 3,75,000
Direct expenses incurred 9,02,000
Work not certified 1,49,000

The contractor owns a plant which originally cost Rs 20 lakhs has been continuously in use in this
contract throughout the year. The residual value of the plant after 5 years of life is expected to be Rs 5
lakhs. Straight line method of depreciation is in use.
As on 15.07.2015, the direct wages due and payable amounted to Rs 2,70,000 and the materials at site
were estimated at Rs 2,00,000.
Required:
i) Prepare contract account for the year ended 15.07.2015.
ii) Show the calculation of profit to be taken to the profit and loss account for the year.
iii) Show the relevant balance sheet entries.
Solution
i) Contract Account
For the year ended 15.07.2015
Particulars Amount (Rs) Particulars Amount (Rs)

To Material Issued 7,500,000 By Material at site 200,000
To Planning & Estimation 1,000,000 By Material Returned 250,000
To Direct Wages paid 4,000,000 By Work-in-progress:
To Direct Wages payable 270,000 Work Certified 20000000
To Plant Hire Charges 1,750,000 Work Uncertified 149000 20,149,000
To Wages Related Costs 500,000
To Site Office Costs 678,000
To HO Expenses Apportioned 375,000
To Direct Expenses 902,000
To Plant Depreciation 300,000
To Notional Profit 3,324,000
20,599,000 20,599,000
To P & L 1,662,000 By Notional Profit b/d 3,324,000
To Reserve 1,662,000
3,324,000 3,324,000
ii) Extracted Balance Sheet

As on 15.07.2015
Particulars Amount Particulars Amount
Profit for the year 16,62,000 Material at site 2,00,000
Wages Accrued 2,70,000 Material returned 2,50,000
Plant 17,00,000

Work in progress:
Work Uncertified 1,49,000
2,01,49,000
Less: Cash Received 1,50,00,000
51,49,000
Less: Reserve 16,62,000 34,87,000
Working Note:
i. Calculation of Depreciation
2000000 -500000
Depreciation on Plant =
5 years
= Rs 300,000
ii. T/f to Profit and Loss Account:

The percentage of the work completed is more than 50% and less than 90%.
Hence,
3 !"
Transfer to P/L Account =
#$% & ' "

= 3324000

= 16,62,000
Illustration: 7 (Estimated Profit Method)

Brock Construction Ltd. commenced a contract on November 1, 2013. The total contract was for Rs.
39,37,500. It was decided to estimate the total profit on the contract and to take to the credit of P/L A/c
that proportion of estimated profit on cash basis, which work completed bore to the total contract. Actual
expenditure for the period November 1, 2013 to October 31, 2014 and estimated expenditure for
November 1, 2014 to March 31, 2015 are given below:
November 1, 2013 to November 1, 2014 to
October 31, 2014 (Actual) Rs. March 31, 2015 (Estimated) Rs.
Material issued 6,75,000 12,37,500
Labor: Paid 4,50,000 5,62,500
Prepaid 25,000 -
Outstanding - 2,500
Plant purchased 3,75,000 -

Expenses: Paid 2,00,000 3,50,000

Outstanding 50,000 25,000
Plant returns to store 75,000 3,00,000
(historical cost) (on March 31, 2014) (on March 31, 2015)
Work certified 20,00,000 Full
Work uncertified 75,000
Material at site 75,000 37,500
The plant is subject to annual depreciation @ 33% on written down value method. The Contract is likely
to be completed on March 31, 2015.
Required:
Prepare the contract A/c. Determine the profit on the contract for the year November 2013 to October
2014 on prudent basis, which has to be credited to P/L A/C.
Solution
Brock Construction Ltd Contract A/C (November 1, 2013 to Oct 31, 2014)
Amount
Particulars Particulars Amount (Rs)
(Rs)
By plant returned to store

To Materials issued 6,75,000
on 31/03/04
To Labor paid 4,50,000 Cost 75,000
Less: Prepaid 25,000 4,25,000 Less: Dep (1/3) 10,417 64,583
To Plant purchased 3,75,000 By WIP Certified 20,00,000
To Expenses paid 2,00,000 By WIP Uncertified 75,000
By plant at site as on
+ Outstanding 50,000 2,50,000
31/10/04
To Notional profit c/d 6,89,583 Cost 3,00,000
Less: dep(1/3) 1,00,000 2,00,000
By materials at site 75,000
24,14,583 24,14,583
By Notional profit 6,89,583
To P/L A/C: 1,04,136 b/d

2,34,305 x (17,50,000 /
20,00,000) x (20,00,000
/ 39,37,500)
To work-in-progress
5,85,447
(Profit in reserve)
6,89,583 6,89,583
Brock Construction Ltd Contract A/C (1 November, 2013 to March 31, 2015)
(For computing estimated profit)
Amount
Particulars Amount (Rs) Particulars
(Rs)
By plant returned to store
To Materials issued (6,75,000 +
19,12,500 on 31/03/04 (Rs 75,000- 64,583
12,37,500)
Rs 10,417)
To Labor paid and outstanding By plant returned to
10,15,000 1,72,222
(4,25,000 + 5,87,500 + 2500) stores on 31/3/05:
To Plant purchased 3,75,000 Cost 300,000
To expenses (2,50,000 +
5,75,000 Less: Dep.(1/3) 100,000
3,25,000)
To estimated profit 2,34,305 Dep.5 months 27,778
By Contractee a/c 39,37,500
By Material at site 37,500
42,11,805 42,11,805
Illustration: 9 (Contract Account for more than one year)

M/s Asian Construction Company Ltd. took a contract for Rs 60,00,000 expected to be completed in three
years. The following particulars relating to the contract are available:
2006 2007 2008
Rs. Rs. Rs.
Materials 6,75,000 10,50,000 9,00,000
Wages 6,20,000 9,00,000 7,50,000
Cartage 30,000 90,000 75,000
Other Expenses 30,000 75,000 24,000
Cumulative Work Certified 13,50,000 45,00,000 60,00,000
Cumulative uncertified 15,000 75,000 -

Plant costing Rs 3,00,000 was bought at the commencement of the contract. Depreciation was to be
charged at 25% per annum on WDV method. The contractee pays 75% of the value certified as and when
certified and makes the final payment on completion of the contract.
You are required to make a contract account and contractee account as they would appear in each of the
three years. Also, show how the work in progress and other items should appear in the balance sheet.
Solution
Contract Account (2006)

To Materials 6,75,000 By Plant at site 2,25,000
To Wages 6,20,000 By Work-in-progress c/d:
To Cartage 30,000 Work Certified 13,50,000
To Other Expenses 30,000 Work Uncertified 15,000 13,65,000
To Plant 3,00,000 By Net Loss t/f to P/L Account 65,000
Total 16,55,000 Total 16,55,000

To WIP b/d: By Plant at site 1,68,750
Work Certified 13,50,000 By Work-in-progress:
Work Uncertified 15,000 13,65,000 Work Certified 45,00,000
To Plant b/d 2,25,000 Work Uncertified 75,000 45,75,000
To Materials 10,50,000
To Wages 9,00,000
To Cartage 90,000
To Other Expenses 75,000
To Notional Profit c/d 10,38,750
47,43,750 47,43,750
To Profit & Loss Account 5,19,375 By, Notional Profit b/d 10,38,750
To Reserve on WIP 5,19,375
Total 10,38,750 Total 10,38,750

To WIP b/d: By WIP Reserve 5,19,375
Work Certified 45,00,000 By Plant at site 1,26,562
Work Uncertified 75,000 45,75,000 By Contractee A/c 60,00,000
To Plant b/d 1,68,750

To Materials 9,00,000
To Wages 7,50,000
To Cartage 75,000
To Other Expenses 24,000
To Profit & Loss Account 1,53,187
Total 66,45,937 Total 66,45,937
Contractee Account

Year 2006:
To Balance c/d 10,12,500 By Bank A/c 10,12,500
Total 10,12,500 Total 10,12,500
Year 2007:
By Balance b/d 10,12,500
To Balance c/d 33,75,000 By Bank 23,62,500
Total 33,75,000 Total 33,75,000
Year 2008:
To Contract A/c 60,00,000 By Balance b/d 33,75,000
By Bank 26,25,000
Total 60,00,000 Total 60,00,000
Balance Sheet (Extract – 2006)

Liabilities /Capital Rs. Assets Rs.
Capital XXX Plant at site 2,25,000
Less: Loss during the year 65,000 WIP:
13,65,000
Less: Cash Received: 10,12,500 3,52,500

Add: Profit during the year 5,19,375 WIP:


45,75,000
Less: WIP Reserve 5,19,375
Less: Cash Received: 33,75,000 6,80,625

Add: Profit during the year 1,53,157
Illustration: 9
One of the building contracts currently engaged un by a construction company commenced 15 months
ago and remain unfinished. The following information relating to the work on the contract has been
prepared for the year just ended:
Amount
(Rs in thousands)
Contract Price 2,500
Value of work certified at the end of year 2,250
Cost of work not yet certified at the end of year 40
Costs incurred:
Opening balances
Cost of work completed 300
Materials on site (physical stock) 10
During the year:
Materials delivered to site 610
Wages 580
Hire of plant 110
Other expenses 90
Closing balance:
Materials on site (physical stock) 20
As soon as materials are delivered to site, they are charged to the contract account. A record is also kept
of materials as they are actually used on the contract. Periodically a stock check is made and any
discrepancy between book stock and physical stock is transferred to a general contract material
discrepancy account. This is absorbed back to each contract, currently at the rate of 0.5% of materials
booked. The stock check at the year end revealed a stock shortage of Rs 5,000.

In addition, to the direct charges listed above, general overheads are charged to contracts at 5% of the
value of work certified. General overheads of Rs 15,000 had been absorbed into the cost of work
completed at the beginning of year.
It has been estimated that further costs to complete the contract will be Rs 2,20,000. This estimate
includes the cost of materials on site at the end of the year just finished and also a provision for
rectification.
Required: Determine the profitability of the above contract and recommend how much profit (to the
nearest ‘000) should be taken for the year just ended. (Provide a detailed schedule of costs)
Solution
Contract Account
Particulars Rs (‘000) Particulars Rs (‘000)

To Opening cost of work completed By Materials on site c/d 20
To Opening Materials 300 By Abnormal Loss (Shortage of
To Materials delivered to site 10 Stock) 5
To Wages 610 By Work in Progress
To Hire of Plant 580 Work Certified 2250
To Other Expenses 110 Work Uncertified 40
To Stock Discrepancy (WN1) 90
To General Overheads 3
To Notional Profit c/d 97.5
514.5
2315 2315
To Costing P & L 449 By Notional Profit b/d 514.5
To WIP Reserve (Bal. fig.) 65.5
Total 514.5 Total 514.5
Working Notes:
1. Calculation of Stock Discrepancy
Cost of Materials Booked Amount (Rs
‘000)
Opening Balance of Materials at site 10
Add: Materials delivered to site 610
Less: Closing Balance of Materials at site 20
Less: Stock Shortage 5
Materials Booked 595
Stock discrepancy (595 X 0.5%) 3

2. Calculation of General Overheads to be charged to contract account:

Value of Work Certified (A) 2250
General overheads to be charged as a % of value of work certified (B) 5%
General Overheads to be charged 112.5
Less: Absorbed in Opening cost of work completed 15
General overheads to be charged to contract 97.5
3. Calculation of profit to be taken to Costing P & L Account:

Contract Price (A) 2500
Cost incurred till date 1775.5
Add: Further Estimated Costs 220
Total Estimated Costs (B) 1995.5
Total Estimated Profit (A-B) 504.5
T/f to P/L Account = 504.5 X1775.5/1995.5

= 449 9To nearest ‘000)
7.5 PROCESS COSTING
A distinct stage in manufacturing or production activity wherein raw material is converted from one form
into another is known as process.
Process costing is a method of Costing used in industries where the material has to pass through one or
more processes for being converted into a final product. It is defined as “a method of Cost accounting
whereby costs are charged to processes or operations and averaged over units produced”. Such type of
costing method is useful in the manufacturing of products like steel, soap, chemicals, rubber, vegetable
oil, paints, varnish etc. where the production process is continuous and the output of one process becomes
the input of the following process till completion.
7.5.1 Basic features:

Industries, where process costing can be applied, have normally one or more of the following features:
1. Each plant or factory is divided into a number of processes, cost centers or departments, and
each such division is a stage of production or a process.
2. Manufacturing activity is carried on continuously by means of one or more process run
sequentially, selectively or parallel.
3. The output of one process becomes the input of another process.
4. The end product usually is of like units not distinguishable from one another.
5. it is not possible to trace the identity of any particular lot of output to any lot of input materials.
For example, in the sugar industry, it is impossible to trace any lot of sugar bags to a particular
lot of sugarcane fed or vice versa.
6. Production of a product may give rise to Joint and/or By product.

Costing procedure:
The cost elements of each process comprises the cost of:
i. Materials-
Materials and supplies which are required for each process are drawn against material requisitions from
stores. Each process for which the above drawn materials will be used should be debited with the cost of
materials consumed on the basis of the information received from the Cost Accounting department. The
finished product of first process generally become the raw materials of second process; under such a
situation the account of second process, be debited with the cost of transfer from the first process and the
cost of any additional material required under this second process.
ii. Labor-
Each process account should be debited with the labor cost or wages paid to labor for carrying out the
processing activities. Sometimes the wages paid are apportioned over the different process after selecting
appropriate basis.
iii. Direct expenses-
Each process account should be debited with direct expenses like depreciation, repairs, maintenance,
insurance etc. associated with it.
iv. Overheads of production-
Expenses like rent, power expenses, lighting bills, gas and water bills etc. are known as production
overheads. These expenses cannot be allocated to a process. The suitable way-out to recover them is to
apportion them over different processes by using suitable basis. Usually, these expenses are estimated in
advance and the processes debited with these expenses on a pre-determined basis.
Operation Costing
It is defined as the refinement of process costing. It is concerned with the determination of the cost of
each operation rather than the process. In those industries where a process consists of distinct operations,
the method of costing applied or used is called operation costing. Operation costing offers better scope for
control. It facilitates the computation of unit operation cost at the end of each operation by dividing the
total operation cost by total output units.
Difference between Job Costing and Process Costing

Job Costing Process Costing
1. Production is carried on by specific order. 1. Production is a continuous flow and the
products are homogeneous.
2. Costs are determined by jobs or batches of 2. Costs are compiled on time basis i.e. for
products production for a given accounting period for
each process
3. Various jobs are separate and independent. 3. Processes are related to each other products
also lose their individual entity.
4. Unit cost of a job is calculated by dividing 4. The unit cost of a process, which is

the total cost by units produced in the lot or computed by dividing the total cost for the
batch. period into the output of the process during
that period, is an average cost (after
adjusting opening and closing WIP) for the
period.
5. Costs are calculated when a job is completed. 5. Costs are calculated at the end of the period
6. There may not be opening or closing WIP in under each process.
an accounting period. 6. Production in process costing is continuous
7. There is normally no transfer from one job to and therefore there is normally WIP at
another. It will be only when there is surplus beginning and closing.
or excess production. 7. Transfer from one process to another is a
8. Each product unit is different and therefore usual feature.
more managerial attention is needed for 8. Production is standardized and stable the
proper control. control is, therefore easier.
Illustration: 10
From the following data, prepare process accounts indicating the cost of each process and the total cost.
The total units that pass through each process were 240 for the period.
Process A Process B Process C
Rs. Rs. Rs.
Materials 1,500 500 200
Labor 800 2,000 600
Other expenses 260 720 250
Indirect expenses amounting to Rs. 850 may be apportioned on the basis of wages. There was no opening
or closing stock.
Solution
Process ‘A’ Account
Per unit Total Per unit Total
Rs. Rs. Rs. Rs.
To material 6.25 1,500 By transfer to Process
‘B’ A/c
To Labor 3.34 800 11.50 2,760
To Other expenses 1.08 260
To Indirect expenses 0.83 200
11.50 2,760 11.50 2,760

Process ‘B’ Account

Rs. Rs. Rs. Rs.
To be transferred from By transfer to Process
Process ‘A’ A/c ‘C’ A/c
11.50 2,760 27.00 6,,480
To material
2.08 500
To Labor
8.34 2,000
To Other expenses
3.00 720
To Indirect expenses
2.08 500
27.00 6,480 27.00 6,480
Process ‘C’ Account

Rs. Rs. Rs. Rs.
To be transferred from By finished stock
Process ‘A’ A/c A/c transfer
27.00 6,480 32.00 7,680
To material
0.83 200
To Labor
2.54 600
To Other expenses
1.04 250
To Indirect expenses
0.59 150
32.00 7,680 32.00 7,680
7.5.2 Treatment of Normal Process Loss, Abnormal Process Loss and Abnormal Gain
Loss of material is inherent during processing operation. The loss of material under different processes
arises due to reasons like evaporation or a change in the moisture content etc. Process loss is defined as
the loss of material arising during the course of a processing operation and is equal to the difference
between the input quantity of the material and its output. There are two types of material losses viz. (i)
Normal loss and (ii) Abnormal loss.
(i) Normal process loss: It is defined as the loss of material which is inherent in the nature of
work. Such a loss can be reasonably anticipated from the nature of the material, nature of
operation, the experience and technical date. The cost of normal process loss in practice is
absorbed by good units produced under the process. The amount realized by the sale of
normal process loss units should be credited to the process account.
Notes:

1. The value of scrap is credited on the basis of sales value; not on the basis of cost per
unit.
2. In case of process costing, normal loss is calculated on the basis of predetermined
percentage.
(ii) Abnormal process loss: It is defined as the loss in excess of the pre-determined loss. This
type of loss may occur due to the carelessness of workers, a bad plant design or operation
etc. Such a loss cannot obviously be estimated in advance. But it can be kept under control
by taking suitable measures. The cost of an abnormal process loss unit is equal to the cost of
a good unit. The total cost of abnormal process loss is credited to the process account from
which it arises. Cost of abnormal process loss is not treated as a part of the product. In fact,
the total cost of abnormal process is debited to costing profit and loss account.
Abnormal gain: sometimes, loss under a process is less than the anticipated normal figure. In other
words, the actual production exceeds the expected figures. Under such a situation the difference
between actual and expected loss or actual and expected production is known as abnormal gain. So,
abnormal gain may be defined as unexpected gain in production under normal conditions. The
process account under which abnormal gain arises is debited with the abnormal gain. The cost of
abnormal gain is computed on the basis of normal production.
9$&2 $&:; <2= $' >$12 ?$
Cost per Unit =
9$&2 @- &:>$12 ?$ @- &
To be clearer about the above concepts we consider the following illustration.
Illustration: 11
A product passes through three phases. The output of each process is treated as the raw material of the
next process to which it is transferred and output of the third process is transferred to finished stock.
1st Process 2nd Process 3rd Process
Rs. Rs. Rs.
Material issued 40,000 20,000 10,000
Labor 6,000 4,0000 1,000
Manufacturing overhead 10,000 10,000 15,000
st
10,000 units have been issued to the 1 process and after processing, the output of each process is as
under
Output Normal Loss
Process No. 1 9,750 units 2%
No stock of materials or of work-in-progress was left at the end. Calculate the cost of the finished articles.

Solution:
Process No. 1 Account
Units Rs. Units Rs.
To material 10,000 40,000 By normal wastage 200
To labor 6,000 By Abnormal wastage 50 286
(cost per unit, Rs. 5.714)
To overhead 10,000 By Process No. 2 9,750 55,714
(Transfer of completed units)
10,000 56,000 10,000 56,000
Note: The cost of the abnormal wastage:
Normal output = 10,000 units- 200 units = 9,800 units

Cost per unit of normal output =

:
=Rs. 56,000 / 9,800 units = Rs.5.714

Cost of 50 units (Abnormal Loss) = Rs. 5.714 x 50 = Rs.286
Process No.2 Account
Units Rs. Units Rs.
To Process no.1 9,750 55,714 By Normal wastage 488 -
To Material 20,000 (5% of 9,750)
To Labor 4,000 By Process no. 3 9,400 91,051
To Overhead 10,000 (cost per unit Rs. 9.686)
To Abnormal gain
@Rs. 9.686 138 1,337
9,888 91,051 9,888 91,051
Note: The cost per unit is obtained by dividing Rs. 89,714 by 9,262 units, i.e. 9,750 units less 488 units.
Process No.3 Account
Units Rs. Units Rs.
To Process No.2 9,400 91,051 By Normal Wastage 940
To Materials 10,000 By Abnormal Wastage 460 6,364
To Labor 1,000 (Cost per unit Rs.13.836)
To Overhead 15,000

By Finished stock 8,000 1,10,687

9,400 1,17,051 9,400 1,17,051
Note: The calculation of the cost of abnormal wastage:
Normal output = 9,400 units -940 units =8,460 units
Cost per unit of normal output =Rs. 1,17,051 ÷ 8,460 =Rs.13.836
Cost of 460 units is = Rs.6,364
7.5.3 Inter-process Profits

In some process industries the output of one process is transferred to the next process not at cost but at
market value or cost plus a percentage of profit. The difference between cost and the transfer price is
known as inter-process profits. The advantages and disadvantages of using inter-process profit, in the case
of process type industries are as follows:
Advantages:
1. Comparison between the cost of output and its market price at the stage of completion is facilitated.
2. Each process is made to stand by itself as to the profitability.
Disadvantages:
1. The use of inter process profits involves complication.
2. The system shows the profits which are not realized because of stock not sold out.
Illustration: 12
A Ltd. produces product ‘AXE' which passes through two processes before it is completed and
transferred to finished stock. The following data relate to October 1998.
Process Finished
Particulars I II stock
Rs. Rs. Rs.
Opening stock 7,500 9,000 22,500
Factory overheads 10,500 4,500
Closing stock 3,700 4,500 11,250
Inter process profit included in opening stock 1,500 8,250
Output of Process I is transferred to Process II at 25% profit on the transfer price.
Output of Process II is transferred to finished stock at 20% profit on the transfer price. Stock in
process is valued at prime cost. Finished stock is valued at the price at which it is received from
process II. Sales during the period are Rs. 140,000.
Prepare Process cost accounts and finished goods account showing the profit element at each stage.

Solution:
Process I Account
Total Cost Profit Total Cost Profit
Rs. Rs. Rs. Rs. Rs. Rs.
Opening stock 7,500 7,500 - Transfer to
Process II A/c 54,000 40,500 13,500
Direct materials 15,000 15,000 -
Direct wages 11,200 11,200 -
33,700 33,700 -
Less Closing
stock 3,700 3,700
Prime Cost 30,000 30,000 -
Overheads 10,500 10,500 -
Process cost 40,500 40,500 -
Profit 33.33% of
total
Cost 13,500 - 13,500
54,000 40,500 13,500 54,000 40,500 13,500
Process II account

Opening Stock 9,000 7,600 1,500 Transfer to
finished
Transferred from Stock A/c 1,12,500 75,750 36,750
Process I 54,000 40,500 13,500
Direct materials 15,750 15,750 -
Direct wages 11,250 11,250 -
90,000 75,000 15,000
Less Closing 4,500 3,750 750
stock
Prime cost 85,500 71,250 14,250
Overheads 4,500 4,500 -
Process Cost 90,000 75,750 14,250
Profit 25% on 22,500 - 22,500

Total Cost
1,12,500 75,750 36,750 1,12,500 75,750 36,750
Finished Stock Account

Opening Stock 22,500 14,250 8,250 Sales 1,40,000 82,500 57,500
Transferred from
Process II 1,12,500 75,750 36,750
1,35,000 90,000 45,000
Less Closing stock
11,250 7,500 3,750
Finished stock- 1,23,750 82,500 41,250
Cost profit 16,250 - 16,250
1,40,000 82,500 57,500 1,40,000 82,500 57,500
Working Notes:
Let the transfer price be 100 then profit is 25, i.e. cost price is Rs. 75.
1. If cost price is Rs. 75 then profit is Rs.25

If cost is Rs. 40,500 then profit is Rs. x 40,500 = Rs.13,500
A
2. If cost is Rs. 80 then price is Rs. 20

If cost is Rs. 90,000 then profit is Rs. x 90,000 = Rs. 22,500

B
Illustration: 13
Product A passes through three processes before it is transferred to finished stock. The following
information is obtained for the month of July:
Process I Process II Process III Finished Stocks
Rs. Rs. Rs. Rs.
Opening stock 5,000 8,000 10,000 20,000
Direct materials 40,000 12,000 15,000 -
Direct wages 35,000 40,000 35,000 -
Manufacturing overhead 20,000 24,000 20,000 -
Closing stock 10,000 4,000 15,000 30,000
Profit % on transfer price to next process 25% 20% 10% -
Inter- process profit for opening stock - 1,395 2,690 6,534
Stocks in process are valued at prime cost and finished stock has been valued at the price at which it is
received from process III. Sales during the period were Rs. 400,000.

Prepare and compute:

(a) Process cost accounts showing profit element at each stage,
(b) Actual realized profit, and
(c) Stock valuation for Balance Sheet purpose
Solution
(a) Process I Account
To opening stock 5,000 5,000 - By transferred 120,000 90,000 30,000
to process II
To Direct Materials 40,000 40,000 -
To Direct Wages 35,000 35,000 -
80,000 80,000 -
Less: Closing stock c/d 10,000 10,000 -
Prime cost 70,000 70,000 -
To Mfg. overhead 20,000 20,000 -
Process cost 90,000 90,000
To Gross profit (25% on - 30,000
transfer price, 33.33% on 30,000
cost)
120,000 90,000 30,000 120,000 90,000 30,000
Process II Account
To opening stock 8,000 6,605 1,395 By transferred 250,000 1,69,303 80,697
to process III
To transferred from 120,000 90,000 30,000
Process I
180,000 148,605 31,395
Less: Closing stock 4,000 3,302 698
c/d
Prime cost 176,000 145,303 30,697
Process cost 200,000 169,303 30,697
To Gross profit (20% 50,000 - 50,000
on transfer price,
25% on cost)
250,000 1,69,303 80,697 250,000 1,69,303 80,697

Process III Account

To opening stock 10,000 7,310 2,690 By transferred 350,000 235,648 114,352
to finished
stock account
Process II
310,000 226,613 83,387
Less: Closing stock 15,000 10,965 4,035
c/d
Prime cost 295,000 215,648 79,352
Process cost 315,000 235,648 79,352
To Gross profit 35,000 - 35,000
(10% on transfer
price, 11.1% on
cost)
350,000 235,648 114,352 350,000 235,648 114,352
Finished Stock Account

To opening stock 20,000 13,466 6,534 By 400,000 228,916 171,084
Sales
Process III
370,000 249,114 120,886
Less: Closing stock c/d 30,000 20,198 9,802
340,000 228,916 111,084
To Gross profit 60,000 - 60,000
400,000 228,916 171,084 400,000 228,916 171,084
(b) Computation of actual realized profit

Apparent Profit Unrealized Profit Actual Realized Profit
Op. Stock Cl. Stock Net
Rs. Rs. Rs. Rs. Rs.
Process I 30,000 - - - 30,000
Process II 50,000 1,395 698 +697 50,697
Process III 35,000 2,690 4,035 -1,345 33,655
Finished Stock 60,000 6,534 9,802 -3,268 56,732
Total 175,000 10,619 14,535 -3,916 171,084

(c) Stock Valuation for Balance Sheet:

Cost of stock: Rs.
Process I 10,000
Process II 3,302
Process III 10,965
Finished Stock 20,198
Total 44,465
Working note
Computation of Cost of Closing Stock and Unrealized profit included therein:
Process I: Nil,
Process II: Cost of Closing Stock = (Cost/Total) x Closing Stock
= (148,605/180,000) x 4,000 = Rs. 3,302
Process III: Cost of Closing Stock = (Cost/Total) x Closing Stock
= (2,26,613/3,10,000) x 15,000 = Rs. 10,965
Finished stock: Cost of Closing Stock = (Cost/Total) x Closing Stock
= (2,49,114 / 3,70,000) x 30,000 = Rs. 20,198
7.5.4 Equivalent Production Units

In the case of process type of industries it is possible to determine the average cost per unit by dividing
the total cost incurred during a given period of time by the total number of units produced during the
same period. But this is hardly the case in most of the process type industries where manufacturing is a
continuous activity. The reason is that the cost incurred in such industries represents the work carried on
opening work-in-progress, closing work-in-progress and completed units. Thus to ascertain the cost of
each completed unit it is necessary to ascertain the cost of work-in-progress in the beginning and at the
end of the process.
The valuation of work-in-progress presents a good deal of difficulty because it has units under different
stages of completion from those in which work has just begun to those which are only a step short of
completion. Work-in-progress can be valued on actual basis, i.e. materials used on the unfinished units
and the actual amount of labor expenses involved. However, the degree of accuracy in such a case cannot
be satisfactory. An alternative method is based on converting partly finished units into equivalent finished
units.
Equivalent production means converting the incomplete production units into their equivalent completed
units. Under each process, an estimate is made of the percentage completion of work-in progress with
regard to different elements of costs. viz. material, labor, and overheads. It is important that the estimate
of percentage of completion should be as accurate as possible. The formula for computing equivalent
completed units is:

Equivalent completed units = (Actual number of units in the process of manufacture) x (Percentage of
work completed)
For instance, if 25% of work has been done on the average of units still under process, then 200 such
units will be equal to 50 completed units and the cost of work in progress will be equal to the cost of 50
finished units.
7.5.5 Valuation of work-in-progress:

For the valuation of work-in-progress following these methods are available:
(1) First in first out method-

Under this method the units completed and transferred include completed units of opening work-in-
progress and subsequently introduced units. Proportionate cost to complete the opening work-in-progress
and that to process the completely processed units during the period are derived separately. The cost of
opening work in progress is added to the proportionate cost incurred on completing the same to get the
complete cost of such units. Complete cost of such units plus cost of units completely processed
constitute the total cost of unit transferred.
Illustration: 14
Opening work in progress 1,000 units (60% complete) Cost Rs. 1,100. Units introduced during the period
10,000 unit; Cost Rs. 19,300 transferred to next process - 9,000 units.
Closing work-in-progress- 800 units (75% complete). Normal loss is estimated at 10 % of total input
including units in process at the beginning. Scraps realize Re.1 per unit. Scrapped are 100% complete.
Compute equivalent production and cost per equivalent unit. Also evaluate the output.
Solution:
FIFO Method
i. Statement of equivalent production per unit
Particulars Input Particulars Output Equivalent Production

units units % of work Equivalent
Done during Units
Current
period
Op. work in Opening WIP- Completed this
1,000 1,000 40 400
process year
Units introduced 10,000 Completed 8,000 100 8,000
Normal loss 1,100 - -
Closing WIP- Completed This
800 75 600
year
Abnormal loss 100 100 100
11,000 9,100

ii. Calculation of Cost Per unit
Particular Amount
Cost of the Process (for the period) Rs. 19,300
Less: Scrap value of normal loss Rs. 1,100
Total Cost Rs 18,200
Cost per equivalent unit (Rs. 18,200/9,100 units) Rs 2
iii. Statement of evaluation
Equivalent Cost per

S.No Particulars Amount
Units Equivalent unit
Rs. Rs.
1 Opening WIP
Complete cost of 1,000 units of op.WIP (60%) 1,000 1.9 1,100
Add: Cost of opening WIP ( 40%) 400 2 800
2 Completely processed units 8,000 2 16,000
3 Abnormal loss 100 2 200
4 Closing WIP 600 2 1,200
(2) Last-in first-out Method:
According to this method units lastly entering in the process are the first to be completed. This
assumption has a different impact on the costs of the completed units and the closing inventory of work-
in-progress. The completed units will be shown at their current cost and the closing inventory of work-in-
progress will continue to appear at the cost of the opening inventory of Work-in-progress..
Illustration: 15
From the following information relating to the month of April 98, calculate the equivalent production
units and the value of finished production and work-in-progress, using the LIFO method.
Opening work-in-progress on 1st April, 5,000 units; 50% complete.
Cost
Rs.
Materials 6,000
Labor 8,000
Overheads 8,000
_____
22,000

Units introduced into the process: 10,000

Cost
Rs.
Materials 30,000
Labor 52,000
Overheads 70,000
_______
1,52,500
During the period 7,500 units were completed and transferred to the next process. Closing work-in-
progress on 30th April, 7,500 units, 50% complete.
Solution:
(i) Computation of Equivalent Production Units
(LIFO method)
Units Particulars Equivalent production

% of Equivalent
Units out
completion units
5,000 Opening work-in-progress
Units introduced into the process
Units completed and transferred, of the units
7,500 100 7,500
10,000 introduced during the period
- Of the units introduced during the period 2,500 50 1,250
- Of the opening work-in-progress 5,000 - -
15,000 8,750
Since the units in the opening work in process were already 50% complete; no work has been done on
these units during the period.
(ii) Calculation of Cost Per Unit of Equivalent Production
Rs 152,500
Cost per unit of equivalent production =
8,750
= Rs 17.43
(iii) Valuation of finished production and WIP
1. Finished production: 7,500 x Rs. 17.43 = Rs. 130,725
2. Closing WIP: Rs. 22,000 + (1,250 x Rs. 17.43) = Rs 43,787.50
(3) Average Cost Method –

Under this method, the cost of opening wip and cost of the current period are aggregated and the
aggregate costing divided by output in terms of completed units. The equivalent production in this case
consists of work-load already contained in opening work-in process and work-load of current period.

Refer to illustration solved by FIFO method – under average cost method, the solution will be as follows:
Statement of Equivalent production per unit
Particulars Input Particulars Output Equivalent Production

% of work
Done during Equivalent
units units
Current Units
period
Completed and Transfer to
Op. work in process 1,000 9,000 100 9,000
Next process
Units introduced 10,000 Normal loss 1,100 - -
Closing WIP- Completed
800 75 600
This year
Abnormal loss 100 100 100
11,000 11,000 9,700
ii. Calculation of Costs Per Unit

Opening work-in-process 1,100
Cost of units introduced 19,300
20,400
Less: scrap value realized on normal loss 1,100
19,300
Cost per equivalent unit Rs. 19,300 ÷ 9,700 units = Rs. 1.99 approx.
Statement of Evaluation
Particulars Equivalent Cost per Amount
units equivalent Rs.
unit (Rs.)
i. Transferred to next process 9,000 1.99 17,900
ii. Abnormal loss 100 1.99 199
iii. Closing work-in-process 600 1.99 1,194
19,303
Illustration: 16
Following information is available regarding process A for the month of February, 2009:
Production Record Units

Units in process as on 1.2.2009 4,000

(all materials used , 25% complete for labor and overhead)

New units introduced 16,000
Units completed 14,000
Units in process as on 28.2.2009 6,000
(all materials used, 33.33% completed for labor and overhead)
Cost Records
Work-in-process as on 1.2.2009 Rs.
Material 6,000
Labor 1,000
Overhead 1,000
8,000
Cost during the month
Material 25,600
Labor 15,000
Overhead 15,000
55,600
Presuming that average method of inventory is used, prepare:

i. Statement of equivalent production.
ii. Statement showing cost for each element.
iii. Statement of apportionment of cost.
iv. Process cost account for process A.
Solution
i. Statement of equivalent production
(Average cost method)
Particulars Materials Labor Overhead
Input Output Units % Equivalent % Equivalent % Equivalent
completion units completion units completion units
(units)
20,000 Completed 14,000 100 14,000 100 14,000 100 14,000
WIP 6,000 100 6,000 33.33 2,000 33.33 2,000
20,000 20,000 20,000 16,000 16,000

ii. Statement showing cost for each element

Particulars materials Labor Overhead Total
Cost of opening WIP (Rs.) 6,000 1,000 1,000 8,000
Cost incurred during the month (Rs.) 25,600 15,000 15,000 55,600
Total cost (Rs.): (A) 31,600 16,000 16,000 63,600
Equivalent units: (B) 20,000 16,000 16,000
Cost per equivalent unit (Rs.) : (C) = (A/B) 1.58 1 1 3.58
iii. Statement of apportionment of cost

Rs. Rs.
Value of output transferred: (a) 14,000 units@ Rs.3.58 50,120
Value of closing WIP: (b)
Materials 6,000 units @ Rs. 1.58 9,480
Labor 2,000 units @ Re. 1.00 2,000
Overhead 2,000 units @ Re. 1.00 2,000 13,480
Total cost : (a + b) 63,600
iv. Process cost Account for Process A:

Dr.
Cr.
Units Rs. Units Rs.
To opening WIP 4,000 8,000 By completed units 14,000 50,120
To materials 16,000 25,600 By closing WIP 6,000 13,480
To Labor 15,000
To overhead 15,000
20,000 63,600 20,000 63,600
Illustration: 17
X Ltd. produces a chemical, which requires processing in 3 departments. In the second department
materials are added doubling the number of units. The following information relates to the operation of
department No. 2 for the month of September: -
Units received from department No. 1 10,000
Units transferred to department No. 3 16,000

The balance of the units were still in process, 100% complete as to material and 50% complete as to labor
and overhead.
Rs.
Cost transferred from department No. 1 120,000
Cost added by the department:
Material 35,200
Labor 36,000
Factory overhead 28,800
Prepare a cost of production statement for department No. 2 for September.
Solution
(a) Cost of Production Statement for Department No. 2 for September
Units Amount
Rs. RS.
Cost transferred from Department No. 1 10,000 120,000
Cost added by Department:
Materials 10,000 35,200
Labor 36,000
Factory Overhead 28,800 100,000
Total 20,000 220,000
Less: cost of work in process (W.N. ii) 4,000 38,240
cost of production of the units transferred to Department No. 3 16,000 181,760
Working Notes:
(i) Statement f Equivalent Production and Costs
Total Equivalent Units
Units
Material % Material % Labor and %
A B Overhead
Completed and 16,000 16,000 100 16,000 100 16,000 100
transferred to Dept. 3
Work in progress 4,000 4,000 100 4,000 100 2,000 50
20,000 20,000 20,000 18,000
Total
Material A Material B labor Overheads

Total Cost ( Rs.) 120,000 35,200 36,000 28,800
Cost per unit ( Rs.) 6.00 1.76 2.00 1.60

(ii) Valuation of Work-in-progress

Rs.
Material A 4,000 @ Rs.6.00 = 24,000
Material B 4,000 @ Rs.1.76= 7,040
Labor 2,000 @ Rs.2.00= 4,000
Overhead 2,000 @ Rs.1.60 = 3,200
Total 38, 240
Illustration: 18
Following details are related to the work done in Process ‘A’ of XYZ Company during the
month of March, 2007:
Opening work-in-progress (2,000 units) Rs.
Materials 80,000
Labor 15,000
Overheads 45,000
Materials introduced in Process ‘A’ (38,000 units) 14,80,000
Direct labor 3,59,000
Overheads 10,77,000
Units scrapped: 3,000 units
Degree of completion:
Materials 100%
Labor and overheads 80%
Closing work-in-progress : 2,000 units
Degree of Completion:
Materials 100%
Labor and overheads 80%
Units finished and transferred to Process ‘B’ : 35,000
Normal Loss:
5% of total input including opening work-in-progress
Scrapped units fetch Rs. 20 per piece.
You are required to prepare:
(i) Statement of equivalent production;

(ii) Statement of cost;

(iii) Statement of distribution cost; and
(iv) Process ‘A’ Account, Normal and Abnormal Loss Accounts.
Solution
(i) Statement of Equivalent Production
Equivalent production
Input Units Output Units Material Labor & Overheads
% Units % Units
Opening WIP 2,000 Completed and 35,000 100 35,000 100 35,000
Transfer to
Process ‘B’
Units 38,000 Normal loss 2,000 - -

introduced (5% of 40,000
Abnormal loss 1,000 100 1,000 80 800
Closing WIP 2,000 100 2,000 80 1,600

40,000 40,000 38,000 37,400
(ii) Statement of Cost

Details Cost at the Cost added Total cost Equivalent Cost per
Units unit
beginning of
process
Rs. Rs. Rs. Rs. Rs.
Materials 80,000 14,80,000 15,60,000 38,000 40
(20 x 2,000
=40,000)
15,20,000
Labor 15,000 3,59,000 3,74,000 37,400 10
Overheads 45,000 10,77,000 11,22,000 37,400 30
80

(iii) Statement of distribution of cost:

(a) Completed and transferred to process ‘B’ = 35,000 units @Rs. 80 = Rs. 28,00,000.
(b) Abnormal loss : 1,000 units:
Materials 1,000 units @ 40 = Rs. 40,000
Labor and Overheads 800 units @ 40 = Rs. 32,000
Rs. 72,000
(c) Closing WIP : 2,000 units
Materials 2,000 units @ 40 = Rs. 80,000
Labor and Overheads 1,600 units @ 40 = Rs. 64,000
Rs. 1,44,000
(iv) Process ‘A’ Account
Dr. Cr.
Particulars Units Amount Particulars Units Amount
To Opening 2,000 1,40,000* By Normal 2,000 40,000
WIP Loss
Material 14,80,000 By 1,000 72,000
introduced 38,000 Abnormal loss
Direct labor 3,59,000 Process ‘B’ 35,000 28,00,000
A/c
transfer to next
process
Overheads 10,77,000 By Closing 2,000 144,000
WIP
40,000 30,56,000 40,000 30,56,000
*Materials + Labor + Overheads = Rs. (80,000 + 15,000 + 45,000) = Rs.1,40,000.
V. Normal Loss Account

Dr. Cr.
To Process ‘A’ 2,000 40,000 By By Cost 2,000 40,000
A/c Ledger Control
A/c

VI. Abnormal Loss Account

Dr. Cr.
To Process ‘A’ 1,000 72,000 By Cost 1,000 20,000
A/c Ledger Control
A/c
By Costing 52,000
Profit and Loss
A/c
1,000 72,000 1,000 72,000
Illustration: 19
Product A passes through three processes. In January 2014, the following information is obtained in
respect of process II.
Opening Stock: 2,800 units valued at Rs 1,200 made up of Rs 700 for materials, Rs 150 for labour and Rs
350 for overhead.
Degree of completion: Material 60%, Labour 60%, Overhead 60%.
Transfer from Process I: 14,000 units @ Rs 0.20 each.
Transfer to Process III: 12,000 units.
Rs.
Direct Materials added in Process II 1,560
Direct Labour amounted to 2,000
Production overheads incurred 4,400
Units scrapped: 2,000 on completion of Process II.
Closing Stock: 2,800 units.
Degree of completion: Material 80%, Labour 60%, Overhead 60%.
Note: 10% loss during production considered normal loss. Units scrapped realized Rs 0.40 each.
Prepare a statement of cost of Process II and show the unit cost of units transferred to Process III. (Using
FIFO Method).
Solution
Statement of Equivalent Production (FIFO Method)
Input Particulars Output Material I Material II Labour &
Overhead
2,800 Opening WIP 2,800 0% 0 40% 1,120 60% 1,680
14,000 Put & Processed 9,200 100% 9,200 100% 9,200 100% 9,200
Normal Loss 1,400 - - - - - -
Abnormal Loss 600 100% 600 100% 600 100% 600
Closing WIP 2,800 100% 2,800 80% 2,240 60% 1,680
16,800 16,800 12,600 13,160 13,160

Calculation of Cost Per Units
Labour &
Material I Material II
Particular
Overhead
Current Cost (14000 units X Rs 0.2) = Rs 2800 Rs 1560 Rs 6400
(-) Scrap Value (1400 units X Rs 0.4) =Rs -560

Total Net Cost 2,240 1,560 6,400
Units 12,600 13,160 13,160
Cost Per Unit 0.178 0.119 0.486
Total Cost p.u. 0.7826
Statement showing apportionment of costs

Rs
Value of opening WIP 1200
Add: Current cost of completing one unit of opening WIP
Material II = 1120 units x 0.1185 133
Labour & Overhead = 1680 units x 0.4867 817
Value of 2800 completed units 2150
Add: Current cost of completing 9200 units (9200 units x 0.7826) 7200
Value of 12000 completed units transferred to Process III 9350
Valuation of Closing WIP:

Materials I (2800 units x 0.1778) = 498
Materials II (2240 units x 0.1185) = 562
Labour & Overheads (1680 units x 0.4867) = 817
1580
Abnormal Loss
Value of Abnormal Loss (600 x 0.7826) = Rs 470
Unit Put and Processed in the process

= 12,000 units – 2,800 units
=9,200 units

7.6 JOINT PRODUCTS AND BY- PRODUCTS
Meaning of Joint Products and By- Products:

Agricultural product industries, chemical process industries, sugar industries, and extractive industries are
some of the industries where two or more products of equal or unequal importance are produced either
simultaneously or in the course of processing operation of a main product. In all such industries, the
management is faced with the problems such as, valuation of inventory, pricing of product and income
determination, problem of taking decision in matters of further processing of by-products and/or joint
products after a certain stage etc. In fact the various problems relate to apportionment of common costs
incurred for various products and aspects other than mere apportionment of costs incurred up to the point
of separation. Before taking up above the problems, we first define the various necessary concepts.
a. Joint products-
Joint products represent “two or more products separated in the course of the same processing operation
usually requiring further processing, each product being in such proportion that no single product can be
designated as a major product”. In other words, two or more products of equal importance, produced,
simultaneously from the same process, are known as joint products. For example, in the oil industry,
gasoline, fuel oil, lubricants, paraffin, coal tar, asphalt and kerosene are all produced from crude
petroleum. These are known as joint products.
b. Co-products-
Joint products and co products are used synonymously in common parlance, but strictly speaking a
distinction can be made between two. Co-products may be defined as two or more products which are
contemporary but do not emerge necessarily from the same material as the same process. For instance,
wheat and gram produced in two separate farms with separate processing of cultivation are the co-
products. Similarly timber boards made from different trees are co-products.
c. By- products-
These are defined as “products recovered from material discarded in a main process, or from the
production of some major products, where the material value is to be considered at the time of the
severance from the main product.” Thus by-products emerge as a result of processing operation of
another product or they are produced from the scrap or waste of materials of a process. In short a
byproduct is a secondary or subsidiary product which emanates as a result of manufacture of the main
product. Examples of by products are molasses in the manufacture of sugar, tar, ammonia and benzole
obtained on the carbonization of coal and glycerine obtained from the manufacture of soap.
Distinction between Joint Product and By-product- The main points of distinction as apparent from the
definitions of joint and by products are:
Joint products are of equal importance whereas by products are of small economic value.
Joint products are produced simultaneously but the by products are produced incidentally in addition to
the main products.

Apportionment of joint costs:

Joint product costs occur in many industries such as petroleum, oil refinery, meat making, textiles, dairy,
flour mill, saw mill, and many other process industries and top management of business concerns require
the Accountants to give their opinion for many managerial decisions such as to process further or to sell
at split-off stage. To answer this question they require apportionment of joint costs over different products
produced.
The main problem faced in the case of joint products/by products is the apportionment of the total cost
incurred up to the point of separation of joint product/or by products. For costs incurred after the split off
point there is no problem, as these costs can be directly allocated to individual joint products or by
products. Thus the apportionment of joint costs over different products produced involves the following
two cases:
1. When two or more products are simultaneously produced and there is by-product.
2. When there are both joint products and by products.
Method of apportioning the joint cost over joint products:

Proper apportionment of joint cost over the Joint Products is of considerable importance, as this affects:
a) Valuation of closing inventory
b) Pricing of products
c) Profit or loss on the sale of different products.
The commonly used methods for apportioning total process costs up to the point of separation over the
joint products are as follows:
(i) Physical unit method-

This method is based on the assumption that the joint products are capable of being measured in the same
units. Accordingly joint costs here are apportioned on the basis of some physical base, such as weight or
measure expressed in gallons, tons etc. In other words, the basis used for apportioning joint cost over the
joint products is the physical volume of material present in the joint products at the point of separation.
Any loss arising during the stage of processing is also apportioned over the products on the same basis.
This method cannot be applied if the physical units of the two joint products are different. The main
defect of this method is that it gives equal importance and value to all the joint products.
Illustration: 20
A coke manufacturing company produces the following products by using 5,000 tons of coal @ Rs. 15 per
ton into a common process.
Coke 3,500 tons
Tar 1,200 tons
Sulphate of ammonia 52 tons
Benzol 48 tons
Apportion the joint cost amongst the product on the basis of the physical unit method.

Solution:
Production
Coke Tar Sulphate Benzol Wastage Total
Output (tons) 3,500 1,200 52 48 200 5,000
Wastage (tons) 146 50 2 2 200
(Apportioned on the
basis of weights)
Total weight (tons) 3.646 1,250 54 50 5,000
Joint cost (in Rs.) @
Rs. 15 per ton
54,690 18,750 810 750 75,000
Working Note
1. Apportionment of wastage of 200 tons over the four products is as follows:

Coke : x 3,500 tons = 146 tons

C,B
Tar : x 1,200 tons = 50 tons

C,B
Sulphate of ammonia =2 tons
Benzol =2 tons
(ii) Average unit cost method –

Under this method, total process cost (upto the point of separation) is divided by total units of joint
products produces. On division of the total cost, average cost per unit of production is obtained.
This is a simple method. The effect of application of this method is that all joint products will have
uniform cost per unit. If this method is used as the basis for price fixation, then all the products may have
more or less the same price. Under this method customers of high quality items are benefitted as they
have to pay less price on their purchase.
Illustration: 21
Find out the cost of joint products A, B and C using average unit cost method from the following data:
(a) Pre-separation Joint Cost Rs. 60,000
(b) Production data :
Products Units produced
A 500
B 200
C 300
-------
1,000

Solution:
9$&2 E$ -& $& 3.
,
Average cost per unit = = =Rs. 60

@- & ;$"=" ,
=- &
The joint costs apportioned @ Rs. 60 are as follows:
Products Units Costs per unit Value

A 500 Rs. 60 Rs. 30,000
B 200 Rs. 60 Rs. 12,000
C 300 Rs. 60 Rs. 18,000
--------------
Rs. 60,000
(iii) Survey method:

This method is also known as point value method. It is based on technical survey of all the factors
involved in the production and distribution of products. Under this method joint cost are apportioned over
the joint products, on the basis of percentage/point value, assigned to the products according to their
relative importance. The percentage or points used for the purpose are usually computed by management
with the help of technical advisers. This method is considered to be more equitable than other methods.
(iv) Contribution margin method:

According to this method, joint costs are segregated into two parts – variable and fixed. The variable costs
are apportioned over the joint products on the basis of units produced (average method) or physical
quantities. In case the products are further processed after the point of separation, then all variable cost
incurred after the point of separation will be added to the variable costs determined earlier. In this way total
variable cost is arrived which is deducted from their respective sales values to ascertain their contribution.
The fixed costs are then apportioned over the joint products on the basis of the contribution ratios.
Illustration: 22
Find out the cost of joint products A and B using contribution margin method from the following method
Sales
A: 100 kg @ Rs. 60 per kg.
B : 120 kg @ Rs. 30 per kg.
Joint costs
Marginal cost Rs. 4,400
Fixed cost Rs. 3,900
Solution:
i. The marginal cost (variable cost) of Rs. 4,400 is apportioned over the joint products A and B in the
ratio of their physical quantity i.e. 100:120


Marginal cost for Product A: Rs. 4,400 x = Rs.2,000

Marginal cost for Product B : Rs.4,400 x =Rs.2,400

Computation of contribution margin ratio

Products Sales revenue Marginal cost Contribution
(Rs.) (Rs.) (Rs.)
A 6,000 2,000 4,000
B 3,600 2,400 1,200
Contribution ratio is 40:12.
ii. The fixed cost of Rs. 3,900 is apportioned over the joint products A and B in the ratio of their
contribution margin i.e. 40 : 12.
(Refer to working note)
Product A : Rs. 3900 x (40/52) =Rs. 3,000
Product B : Rs. 3900 x (12/52) + Rs. 900
(v) Market value method:

This is the most popular and convenient method because it makes use of a realistic basis for apportioning
joint costs. Under this method, joint costs are apportioned after ascertaining “what the traffic can bear”. In
other words, the products are made to bear a proportion of the joint cost on the basis of their ability to
absorb the same. Market value means weighed market value i.e. units produced x price of a unit of joint
product.
(a) Market value at the point of separation:

This method is used for the apportionment of joint cost up to the split off point. It is difficult to apply this
method if the market value of the products at the point of separation is not available. It is a useful method
where further processing costs are incurred disproportionately.
To determine the apportionment of joint costs over joint products, a factor known as multiplying factor is
determined. This multiplying factor on multiplication with the sales values of each joint product gives rise
to the proportion of joint cost.
For example, a concern incurs a joint cost of Rs. 64,500 in production two products A (200 units), B (200
units) and earns a sales revenue of Rs. 86,000 by selling @ Rs. 170 per unit of product A and B @260 per
unit of product B. the multiplying factor in this case is obtained by dividing the total joint cost by total
sales revenue and finally multiplying the figure so obtained by 100. The multiplying factor based on the
data can be compared as follows:
3.C,
Multiplying factor: x 100% = 75%

3.B,
Joint cost apportioned over product A= Sales revenue of product A x75%

= 34,000 x 75%

= Rs.25,500
Joint cost apportioned over product B= Sales revenue of product B x 75%
= Rs. 52,000 x 75%
= Rs.39,000.
Alternatively – This joint cost may be apportioned in the ratio of sales values of different joint products.
(b) Market value after processing –

Here the basis of apportionment of joint cost is the total sales value of finished products and involves the
same principle as discussed in (a) above. Suppose that in the example given in Part (a) above, if sales
prices of products A and B after further processing is Rs. 200 and Rs. 300 respectively the joint cost
apportioned over Product A and B is as follows :
The pre-separation costs of Rs. 64,500 will be apportioned in the ratio of (2:3) as follows:
Market sales value after further processing
Rs.
A: 200 units x Rs. 200 = 40,000
B: 200 units x Rs. 300 = 60,000
100,000
Joint cost apportioned
3.C
,
A= Rs. 64,500 * = Rs. 25,800

3.,
3.
,
B= Rs. 64,500 * = Rs. 38,700

3.,
The use of this method is unfair where further processing costs after the point of separation are
disproportionate or when all the joint products are not subjected to further processing. The net realizable
value method which is discussed as below overcomes the shortcoming of this method.
(c) Net realizable value method:
From the sales value of joint products (at finished stage) following are deducted to arrive at Net
Realizable Value
(i) Estimated profit margins.
(ii) Selling and distribution expenses, if any, and
(iii) post-split off costs
The resultant figure so obtained is known as net realizable value of joint products. Joint costs are
apportioned in the ratio of net realizable value. Suppose that in the example given in part (a) above if

further processing costs for products A and B are Rs. 4,000 and Rs. 32,000 respectively the Joint cost
may be apportioned to products A and B as follows:
Products Sales revenue Further Net realizable Joint cost
processing cost value (Rs.) apportioned ratio
(Rs.)
(Rs.)
(a) (b) (c)= (a)-(b)
A 34,000 4,000 30,000 3/5
B 52,000 32,000 20,000 2/5
Joint cost apportioned over product A = Rs. 64,500 *3/5 = Rs. 38,700
Joint cost apportioned over product B = Rs. 64,500 *2/5 = Rs. 25,800
This method is extensively used in many industries.
Illustration: 23
Organic Chemical purchases salt and processes into more refined products such as Caustic Soda, Chlorine
and PVC. In the month of July, Inorganic Chemicals purchased salt for Rs. 40,000. Conversion cost of
Rs.60,000 were incurred up to the split off point, at which time two scalable products were produced.
Chlorine can be further processed into PVC.
The July production and sales information is as follows:
Production Sales quantity Selling price
(tons) (tons) (per ton)
Caustic Soda 1,200 1,200 Rs.50
Chlorine 800 - -
PVC 500 500 Rs.200
All 800 tons of Chlorine are further processed, at an incremental cost of Rs.20,000 to yield the 500 tons
of PVC. There was no beginning or ending inventories of Caustic Soda, Chlorine or PVC in July.
There is active market for Chlorine. Inorganic Chemicals could have sold all its July production at Rs.75
per ton.
Required:
(1) To calculate how joint cost of Rs.1,00,000 would be apportioned between Caustic Soda and
Chlorine under each of the following methods.
(a) Sales value at split off.
(b) Physical measure(method) and
(c) Estimated net realizable value.

(2) Lifetime Swimming Pool offers to purchase 800 tons of Chlorine in August at Rs.75 per ton.
This sale of Chlorine would mean that no PVC would be produced in August. How the
acceptance of this offer for that month of August would affect the operating income?
Solution:
1. (a) Sales value at split off method
Products Sales in tons Selling price per Sales revenue Joint cost
ton (Rs.) (Rs.) apportioned
(Rs.)
(a) (b) (c)=(a) x (b)
Caustic Soda 1,200 50 60,000 50,000
Chlorine 800 75 60,000 50,000
1,20,000 1,00,000
FGHIJ KGLMH NGOH

Apportioned joint cost= * sales revenue of each product
FGHIJ OIJP QIJRP
3.,
Joint cost apportioned to Caustic Soda = * Rs.60,000 = Rs.50,000

3.,
,
3.,
Joint cost apportioned to Chlorine = * Rs.60,000= Rs.50,000

3.,
,
(b) Physical measure method
Products Sale in tons Joint cost apportioned**

Caustic Soda 1,200 60,000
Chlorine 800 40,000
2,000 1,00,000
FGHIJ KGLMH NGOH

** Apportioned joint cost = * Physical units of each product
FGHIJ STUOLNIJ RMLHO
3.,
Joint cost apportioned to Caustic Soda = * 1,200 tonnes = Rs.60,000

,
&$--
3.,
Joint cost apportioned to Chlorine = * 800 tonnes = Rs.40,000

,
&$--

(c) Estimated net realizable value

Products Sales revenue Further Net realizable Apportioned ***
(Rs.) processing cost value (Rs.) joint cost
(Rs.)
(a) (b) (c)=(a)-(b)
Caustic Soda 60,000 - 60,000 42,857
Chlorine 1,00,000 20,000 80,000 57,143
1,40,000 1,00,000
FGHIJ KGLMH NGOH

Apportioned joint cost = x Net realizable value of each product
FGHIJ MPH VPIJLOIWJP QIJRP
3.,
Apportioned joint cost for Caustic Soda= x Rs.60,000= Rs.42,857

3.,C
,
3.,
Apportioned joint cost for Chlorine = x Rs.80,000= Rs. 57,143.

3.,C
,
2.
Incremental revenue from further processing of Chlorine into PVC Rs.40,000
(500 tons x Rs.200 – 800 tons x Rs.75)
Less: Incremental cost of further processing of Chlorine into PVC Rs.20,000
Incremental operating income from further processing Rs.20,000
The operating income of Inorganic Chemicals will be reduced by Rs.20,000 in August if it sells 800 tons
of Chlorine to Lifetime Swimming Pool Products, instead of further processing of Chlorine into PVC for
sale.
Illustration: 24
S Ltd. Produces 200,000: 30,000: 25,000: 20,000 and 75,000 units of its five products A, B, C, D and E
respectively in a manufacturing process and sells them at Rs. 17, Rs. 13, Rs. 8, Rs. 10 and Rs. 14 per unit.
Except product D remaining products can be further processed and then can be sold at Rs. 25, Rs.17,
Rs.12, and Rs. 20 per unit in case of A,B,C and E respectively.
Raw material costs Rs. 3,590,000 and other manufacturing expenses cost Rs. 547,000 in the
manufacturing process which is absorbed on the products on the basis of their ‘net realizable value’. The
further processing costs of A, B, C and E are Rs. 1,250,000; Rs. 150,000; Rs. 50,000 and Rs. 150,000
respectively. Fixed costs are Rs. 473,000.
You are required to prepare the following in respect of the coming year:

a. Statement showing income forecast of the company assuming that none of its products are to be
further processed.
b. Statement showing income forecast of the company assuming that products A, B, C and E are to
be processed further.
Can you suggest any other production plan whereby the company can maximize its profits? If
yes, then submit a statement showing income forecast arising out of adoption of that plan.
Solution
a. Statement showing income forecast of the company assuming that none of its
products are further processed
Products
A B C D E Total
Sales revenue 3.400,000 390,000 200,000 200,000 1,050,000 5,240,000
(200,000 (30,000 (25,000 (20,000 (75,000
units x Rs. units x Rs. units x Rs. units x Rs. units x Rs.
17) 13) 8) 10) 14)
Less: 2,625,000 252,000 175,000 140,000 945,000 4,137,000
apportioned
joint cost
(Refer to W.N.
1)
Excess of 775,000 138,000 25,000 60,000 105,000 1,103,000
revenue over
joint
manufacturing
cost
Less: fixed cost 473,000
Profit 630,000
b. Statement showing income forecast of the company assuming that products A,

B, C and E are further processed (Refer to working note)
Products
A B C D E Total
Sales revenue 5,000,000 510,000 300,000 200,000 1,500,000 75,10,000
(X)
Less: apportioned 2,625,000 252,000 175,000 140,000 945,000 4,137,000
joint cost
(Y)
Further 1,250,000 150,000 50,000 - 150,000 1,600,000

processing cost
(Z)
Total 3,875,000 402,000 225,000 140,000 1,095,000 5,737,000
manufacturing
cost
(K) = (Y) +(Z)
Excess of 1,125,000 108,000 75,000 60,000 405,000 1,773,000
revenue over
total
manufacturing
cost
Profit 1,300,000
Suggested production plan for maximizing profits:

On comparing the figures of excess of revenue over cost of manufacturing in the above statements one
observes that the concern is earning more after further processing of A, C and E products but is losing a
sum of Rs. 30,000 in the case of product B (if it is processed further). Hence the best production plan will
be to sell A, C and E after further processing and B and D at the point of split off. The profit statement
based on this suggested production plan is as below:
Profit statement based on suggested production plan
Products
A B C D E Total
Sales revenue 5,000,000 390,000 300,000 200,000 1,500,000 75,10,000
(X)
Less: apportioned 2,625,000 252,000 175,000 140,000 945,000 4,137,000
joint cost
(Y)
Further 1,250,000 - 50,000 - 150,000 1,450,000
processing cost
(Z)
Total 3,875,000 252,000 225,000 140,000 1,095,000 5,787,000
manufacturing
cost
(K) = (Y) +(Z)
Excess of 1,125,000 138,000 75,000 60,000 405,000 1,803,000
revenue over
total
manufacturing

cost
Profit 1,330,000
Hence the profit of the company has increased by Rs. 30,000.
Working Note:
Statement showing apportionment of joint costs on net realizable value basis
Products Sales value Post separation Net realizable Apportioned joint
value costs
Rs. Rs. Rs. Rs.
(1) (2) (3) =(1) –(2) (4)
A 5,000,000 1.250,000 3,750,000 2,625,000
(Rs. 200,000 units x Rs. 25)
B 510,000 150,000 360,000 252,000
(30,000 units x Rs.17)
C 300,000 50,000 250,000 175,000
(25,000 units x Rs. 12)
D 200,000 - 200,000 140,000
(20,000 units x Rs. 10)
E 1,500,000 150,000 1,350,000 945,000
(75,000 units x Rs. 20)
5,910,000 4,137,000
Total joint cost = Raw material costs + manufacturing expenses =Rs. 3,590,000 + Rs. 547,000
= Rs. 4,137,000
9$&2 E$ -& $&
Apportioned joint cost = x Net realizable value of each product
9$&2 -& 2 XY2 !2=
3.C,A,
Apportioned joint cost for Product A = x Rs. 3,750,000 = Rs. 2,625,000

3. ,Z
,
Similarly, the apportioned joint cot for products B, C, D and E are Rs. 252,000; Rs. 175,000; Rs. 140,000
and Rs. 945,000 respectively.
Illustration: 25
Pokemon Chocolates manufactures and distributes chocolate products. It purchases Cocoa beans and
processes them into two intermediate products:
• Chocolate powder liquor base

• Milk-chocolate liquor base.

These two intermediate products become separately identifiable at a single split off point. Every 500
pounds of cocoa beans yields 20 gallons of chocolate - powder liquor base and 30 gallons of milk-
chocolate liquor base.
The chocolate powder liquor base is further processed into chocolate powder. Every 20 gallons of
chocolate-powder liquor base yields 200 pounds of chocolate powder. The milk-chocolate liquor base is
further processed into milk-chocolate. Every 30 gallons of milk-chocolate liquor base yields 340 pounds
of milk chocolate.
Production and sales data for October 2014 are:

• Cocoa beans processed 7,500 pounds
• Costs of processing Cocoa beans to split off point (including purchase of beans)
= Rs. 7,12,500
Production Sales Selling price

Chocolate powder 3,000 pounds 3,000 pounds Rs. 190 per pound
Milk chocolate 5,100 pounds 5,100 pounds Rs. 237.50 per pound
The October, 2014 separable costs of processing chocolate-powder liquor into chocolate powder are Rs.
3,02,812.50. The October 2014 separable costs of processing milk chocolate liquor base into milk-
chocolate are Rs. 6,23,437.50.
Pokemon fully processes both of its intermediate products into chocolate powder or milk chocolate.
There is an active market for these intermediate products. In October, 2014, Pokemon could have sold the
chocolate powder liquor base for Rs. 997.50 a gallon and the milk-chocolate liquor base for Rs. 1,235 a
gallon.
Required:
(i) Calculate how the joint cost of Rs. 7,12,500 would be allocated between the chocolate powder and
milk-chocolate liquor bases under the following methods:
(a) Sales value at split off point
(b) Physical measure (gallons)
(c) Estimated net realizable value, (NRV) and
(d) Constant gross-margin percentage NRV.
(ii) What is the gross-margin percentage of the chocolate powder and milk chocolate liquor bases under
each of the methods in requirements (i) ?
(iii) Could Pokemon have increased its operating income by a change in its decision to fully process both
of its intermediate products ? Show your computations.
Solution
(i) Comparison of alternative joint-cost allocation methods

Sales value at split-off point method

Chocolate powder Milk chocolate liquor Total
liquor base base
Sales value of products at Rs 2,99,250 Rs 5,55,750 Rs 8,55,000
split off
Weights 0.35 0.65 1.00
Joint cost allocated Rs 7,12,500 x 0.35 Rs 7,12,500 x0.65
= Rs 2,49,375 = Rs 4,63,125
i. Chocolate Powder Liquor base = 20/ 200 * 3,000 pounds
= 300 Gallon
Cost of Chocolate Powder Liquor Base = 300 x 997.50 = Rs 2,99,250
ii. Milk Chocolate Liquor Base = 30 /340 x 5100 Pounds

= 450 Gallon
Cost of Milk Chocolate Liquor Base = 450 x1235 = Rs 5,55,750
Physical measure method

liquor base base
Output 300 gallons 450 gallons 750 gallons
Weight 300/750= 0.40 450/750 = 0.60 1.00
Joint cost allocated Rs 7,12,500 x 0.40 Rs 7,12,500 x 0.60 Rs 7,12,500
=Rs 2,85,000 = Rs 4,27,500
Net realizable value method

liquor base base
Final sales value of 3,000 lbs x Rs 190 5,100 lbs x Rs 237.50 Rs 17,81,250
production = Rs 5,70,000 = Rs 12,11,250
Less separable costs Rs 3,02,812.50 Rs 6,23,437.50 Rs 9,26,250
Net realisable value at Rs 2,67,187.50 Rs 5,87,812.50 Rs 8,55,000
split off point
Weight 2,67,187.50/8,55,000 5,87,812.5/8,55,000
= 0.3125 = 0.6875
Joint cost allocated Rs 7,12,500 x 0.3125 Rs 7,12,500 x 0.6875 Rs 7,12,500
= Rs 2,22,656.25 = Rs 4,89,843.75

Constant gross margin % NRV method

liquor base base
Final sales value of production Rs 5,70,000 Rs 12,11,250 Rs 17,81,250
(Chocolate Powder) (Milk Chocolate)
*Less Gross Margin 8% Rs 45,600 Rs 96,900 Rs 1,42,500
Cost of goods available for sale Rs 5,24,400 Rs 11,14,350 Rs 16,38,750
Less Separable costs Rs 3,02,812.50 Rs 6,23,437.50 Rs 9,26,250
Joint cost allocated Rs 2,21,587.50 Rs 4,90,912.50 Rs 7,12,500
* Calculation of Gross Profit Margin
Sales value of total production

= Rs 17,81,250
Deduct joint and separable cost (Rs 712,500+Rs 926,250)
= Rs 16,38,750
Gross Margin
= Rs 1,42,500
Gross margin % ( Rs 1,42,500/ Rs 17,81,250 )
8%
(ii) Chocolate powder liquor base (calculations in Rs)

Sales value at Physical Estimated net Constant
split off Measure realizable gross –
value margin NRV
Final sale value of Chocolate powder. 5,70,000 5,70,000 5,70,000 5,70,000
Less: separable costs 3,02,812.50 3,02,812.50 3,02,812.50 3,02,812.50
Less: Joint costs 2,49,375 2 2,85,000 2,22,656.25 2,21,587.50
Gross Margin 17,812.50 (17,812.50) 44,531.25 45,600
Gross Margin % 3.125% (3.125%) 7.8125% 8%
Milk chocolate liquor base (calculations in Rs)

Sales value at Physical Estimated net Constant
split off Measure realizable gross –
value margin NRV

Final sale value of Chocolate powder. 12,11,250 12,11,250 12,11,250 12,11,250

Less: separable costs 6,23,437.50 6,23,437.50 6,23,437.50 6,23,437.50
Less: Joint costs 4,63,125 4,27,500 4,89,843.75 4,90,912
Gross Margin 1,24,687.50 1,60,312.50 97,968.75 96,900.50
Gross Margin % 10.29% 13.23% 8.08% 8%
(iii) Further processing of Chocolate powder liquor base into Chocolate powder
(calculations in Rs)
Incremental revenue ( 5,70,000 – (997.50 x 300)) 2,70,750
Incremental costs 3,02,812.50
Incremental operating income (32,062.50)
Further processing of Milk chocolate liquor base into milk chocolate (calculations in Rs)
Incremental revenue(12,11,250 – 5,55,750) 6,55,500.00
Incremental cost 6,23,437.50
Incremental operating income 32,062.50
The above computations show that Pokemon Chocolates could increase operating income by Rs
32,062.50 if chocolate liquor base is sold at split off point and milk chocolate liquor base is processed
further.
Methods of apportioning joint cost over by-products:

The following methods may be adopted for the accounting of by-products and arriving at the cost of
production of the main product:
(a) Market value or value on realization:
The realization on the disposal of the by-product may be deducted from the total cost of production so as
to arrive at the cost of the main product. For example, the amount realized by the sale of molasses in a
sugar factory goes to reduce the cost of sugar produced in the factory.
When the by-product requires some additional processing and expenses are incurred in making it saleable
to the best advantage of the concern, the expenses so incurred should be deducted from the total value
realized from the sale of the by-product and only the net realization should be deducted from the total cost
of production to arrive at the cost of production of the main product. Separate accounts should be
maintained for collecting additional expenses incurred on:
(i) Further processing of the by-product, and
(ii) Selling, distribution and administration expenses attributable to the by-product

(b) Standard cost in technical estimates:

By-products may be valued at standard costs. The standard may be determined by averaging costs
recorded in the past and making technical estimates of the number of units of original raw material going
into the main product and the number forming the by-product or by adopting some other consistent basis.
This method may be adopted where the by-product is not saleable in the condition in which it emerges or
comparative prices of similar products are not available.
(c) Comparative price:

Under this method, the value of the by-product is ascertained with reference to the price of a similar or an
alternative material. Suppose in a large automobile plant a blast furnace not only produces the steel
required for the car bodies but also produces gas which is utilized in the factory. This gas can be valued at
the price which would have been paid to a gas company if the factory were to buy it from outside sources.
(d) Re-use basis:

In some cases the by-product may be of such a nature that it can be reprocessed in the same process as
part of the input of the process. In that case the value put on the by-product should be same as that of the
materials introduced into the process. If, however, the by-product can be put into an earlier process only,
the value should be the same as for the materials introduced into the process.
Treatment of By-product Cost in Cost-Accounting:

By-product cost can be dealt in cost accounting in the following ways:
(i) When they are of small total value : When the by-products are of small total value, the
amount realized from their sale may be dealt in any one of the following two ways
a. The sales value of the by-products may be credited to the Profit and Loss Account and
no credit be given in the Cost Accounts. The credit to the Profit and Loss Account here
is treated either as miscellaneous income or as additional sales revenue
b. The sale proceeds of the by-product may be treated as deductions from the total costs.
The sale proceeds in fact should be deducted either from the production cost or from the
cost of sales.
(ii) When the by-products are of considerable total value: Where by-products are of
considerable total value, they may be regarded as joint products rather than as by-products.
To determine exact cost of by-products the costs incurred up to the point of separation,
should be apportioned over by-products and joint products by using a logical basis. In this
case, the joint costs may be divided over joint products and by-products by using relative
market values; physical output method (at the point of split off) or ultimate selling prices (if
sold).
(iii) Where they require further processing: In this case, the net realizable value of the by-
product at the split-off point may be arrived at by subtracting the further processing cost
from the realizable value of by-products.
If total sales value of by-products at split-off point is small, it may be treated as per the provisions
discussed above under (i)
In the contrary case, the amount realized from the sale of by-products will be considerable and thus it may
be treated as discussed under (ii)

7.7 OPERATING COSTING

7.7.1 Meaning of Operating Costing:
It is a method of ascertaining costs of providing or operating a service. This method of costing is applied
by those undertaking which provide services rather than production of commodities. The emphasis under
operating costing is on the ascertainment of cost of services rather than on the cost of manufacturing a
product. This costing method is usually made use of by transport companies, gas and water works
department, electricity supply companies, canteens, hospitals, theatres, schools etc.
For computing the operating cost, it is necessary to decide first, about the unit for which the cost is to be
computed, this may often require the study of some technical and operating data, for finding out the
factors which have a bearing on cost. The cost units usually used in the following service undertakings
are as follows:
Transport service – Passenger km., quintal km., or tonne km.
Supply service – Kw hr., Cubic meter, per kg., per litre.
Hospital – Patient per day, room per day or per bed, per operation etc.
Canteen – Per item, per meal etc.
Cinema - Per ticket.
Composite units i.e. tons kms., quintal kms., etc. may be computed in two ways.
(i) Absolute (weighted average) tons-kms, quintal kms, etc.
(ii) Commercial (simple average) tons-kms., quintal kms, etc.
(i) Absolute (weighted average) tons-kms.

Absolute tons-km., are the sum total of tons-km., arrived at by multiplying various distances by respective
load quantities carried.
(ii) Commercial (simple average) tons-kms.

Commercial tons-kms., are arrived at by multiplying total distance kms., by average load quantity.
Note: To understand the concept of absolute tons-kms, and commercial tons-kms, students should refer to
the following illustration.
Illustration: 26
A lorry starts with a load of 20 tons of goods from station A. It unloads 8 tons at station B and rest of
goods at station C. It reaches back directly to station A after getting reloaded with 16 tons of goods at
station C. The distance between A to B, B to C, and from C to A are 80 kms, 120 kms, and 160 kms,
respectively. Compute ‘Absolute tons-kms.,’ and “Commercial tons-kms”
Solution:
Absolute tons-kms. = 20 tons x 80 kms + 12 tonnes x120 kms + 16 tonnes x 160 kms
= 5,600 tons-km

Commercial tons-kms = Average load x total kilometers travelled

(
\\)
= tons x 360 kms

=5,760 tons-kms.
7.7.2 Collection, classification and ascertainment of cost:

For preparing a cost sheet under operating cost, costs are usually accumulated for a specified period i.e., a
month, a quarter or a year etc.
All of the accumulated costs should be classified under the following three heads:
1. Fixed costs or standing charges.
2. Variable costs or running charges.
3. Semi-variable costs or maintenance costs.
Note: In the absence of information about semi-variable costs, the costs may be shown under two heads
only, i.e., fixed and variable.
Under operating costing, the per unit cost of service may be calculated by dividing the total cost for the
period by the total units of service in the period.
Treatment of depreciation and interest – Depreciation if related to effluxion of time may be treated as
fixed. If it is related to the activity level, it may be treated as variable.
If information about interest is explicitly given, it may be treated as fixed cost.
Illustration: 27
You have been given a permit to run a bus on a route 20 Km. long. The bus costs you Rs. 90,000. It has to
be insured @ 3% pa and the annual tax will be Rs. 1,000. Garage rent is Rs. 100 p.m. Annual repairs will
be 1,000 and the bus is likely to last for 5 years at the end of which the scrap value is likely to be Rs.
6,000.
The driver’s salary will be Rs. 150 p.m. and the conductor’s Rs. 1,00 pm together with 10% of the takings
as commission (to be shared equally by both). Stationery will cost Rs. 50 p.m. The manager cum
accountant’s salary will be Rs. 350 p.m. Diesel and oil be Rs. 25 per hundred kilometers. The bus will
make 3 round trips for carrying on the average 40 passengers on each trip. Assuming 15% profit on
takings, calculate the bus fare to be charged from each passenger. The bus will work on the average 25
days in a month.

Solution
Operating Cost Statement
Bus No.: DLP 4179
Carrying capacity: 40
Per annum Rs. Per 100 passenger
km Rs.
A B C
1. Standing Charges:
Depreciation (90,000 – 6,000) ÷5 16,800
Tax 1,000
Insurance 2,700
Stationery 600
Manager’s salary 4,200
Total 25,300 1.756
2. Maintenance charges:
Garage rent 1,200
Repairs 1,000
Total 2,200 0.152
3. Operating or running charges:
Diesel and oil 9,000
Driver’s salary 1,800
Conductor’s salary 1,200
Total 12,000 0.833
Grand Total (1 +2 + 3) 2.741
Loading @ 25/75 0.91
Fire per passenger-km. 3.65
Working Notes:
1. Number of kms. Run in a month: 3 x 2 x 20 x 25 = 3,000
2. Diesel & oil: 3,000 x 25/100 = Rs. 750

Cost of Diesel & Oil per annum Rs 750 x 12 mth = Rs 9,000
3. Number of passenger-kms. Per month: 3,000 x 40 = 120,000

Per annum: 120,000 x 12 = 1,440,000
4. Loading – if taking is Rs. 100, 10 will have to be given as commission and 15 must remain as
profit; the cost must therefore be 75. On 75 the loading must be 25 to make the taking equal to
100.

Illustration: 28
SMC is a public school having five buses each plying in different directions for the transport of its school
students. In view of a larger number of students availing of the bus service the buses work two shifts daily
both in the morning and afternoon. The buses are garaged in the school. The work load of the students
has been so arranged that in the morning the first trip picks up senior students and the second trip plying
an hour later picks up the junior students. Similarly in the afternoon, the first trip takes the junior
students and an hour later the second trip takes the senior students home.
The distance traveled by each bus one way is 8 kms. The school works 25 days in a month and remains
closed for vacations in May, June and December. Bus fee, however is payable by the students for all 12
months in a year.
The details of expenses for a year are as under:
Driver’s salary Rs. 450 per month per driver
Cleaner’s salary Rs. 350 per month
(Salary payable for all 12 months)
(one cleaner employed for all five buses)
License fee, taxes, etc., Rs. 860 per bus per annum
Insurance Rs. 1,000 per bus per annum
Repairs and maintenance Rs. 3,500 per bus per annum
Purchase price of the bus Rs. 1,50,000 per bus
Life 12 years
Scrap value Rs. 30,000
Diesel cost Rs. 2.00 per liter
Each bus gives an average mileage of 4 km per liter of diesel.
Seating capacity of each bus is 50 students.
The seating capacity is fully occupied during the whole year.
Students picked up and dropped within a range up to 4 kms of distance from the school are charged half
fare and fifty per cent of the students traveling in each trip are in this category. Ignore interest. Since the
charges are to be based on average cost you are required to:
(i) Prepare a statement showing the expenses of operating a single bus and the fleet of five buses
for a year.
(ii) Work out the average cost per student per month in respect of-
a) Students coming from a distance of up to 4 kms, from the school and
b) Students coming from a distance beyond 4 kms from the school.

Solution:
SMC Public School
Operating Cost Statement
(i)
Particulars Rate Per Bus Per Fleet of 5 buses p.a.
annum
Rs. No Rs. No Rs.
Driver’s salary 450 p.m. 1 5,400 5 27,000
Cleaner’s salary 350 p.m. 1/5 840 5 4,200
License fee, taxes etc. 860 p.a. 860 5 4,300
Insurance 1,000 p.a. 1,000 5 5,000
Repairs and maintenance 3,500 p.a. 3,500 5 17,500
Depreciation 10,000 p.a. 10,000 5 50,000
Diesel (see Note 1) - 7,200 36,000
Total 28,800 144,000
Cost per month 2,400 12,000
(ii) No of students on half fee basis ( See note 2) 150 750
a) Cost per student ( half fee basis) Rs. 16 16
b) Cost per student ( full fee basis) Rs. 32 32
Working Notes:
Calculation of diesel cost per bus:
Number of trips of 8 kms. Each/day :8
Distance travelled per day by a bus :8 x 8km/trip = 64 km
Distance travelled during a month :64 x 25 = 1,600 km.
Distance travelled p.a. except May, June and December being vacation :1,600 x 9 =14,400 km.
Mileage :4 km/liter
Diesel required :14,400/4 =3,600 liter
Cost of diesel :3,600 liter. X Rs.2 per liter = Rs. 7,200 p.a. per bus
Calculation of number of students per bus:
Bus capacity: 50 students
Half fare 50% i.e., 25 students
Full fare 50% i.e., 25 students
Full fare students as equivalent to half fare students i.e. 50 students
Total number of half fare students per trip 75 students

Total number of half fare students in two trips 150 students

On full fare basis number of students in two trips 75 students.
Illustration: 29
Mr. X owns a bus which runs according to the following schedule:
(i) Kathmandu to barabise and back the same day:
Distance covered 150 kms. one way
Days run 10
Seating capacity occupied 90%
(ii) Kahmandu to Khairani and back the same day:
Distance covered 120 kms. one way
Days run 10
(iii) Kathmandu local
Distance covered per day 40 kms. one way
Days run 4
(iv) Following are the other details:
i. Cost of the bus Rs. 60,00,000
ii. Depreciation at 20% p.a.
iii. Salary of driver Rs. 35,000 per month
iv. Salary of conductor Rs. 35,000 per month
v. Salary of part time accountant Rs. 16,000 per month
vi. Insurance Rs. 1,68,000 p.a.
vii. Diesel consumption 4 kms. per liter @ Re. 100 per liter
viii. Road tax Rs. 60,000 p.a.
ix. Lubricant oil 1,000 per 100 kms
x. Repair and maintenence Rs .50,000 per month
xi. Permit fee Rs. 28,400 per month
The bus has the capacity of 50 persons. Passenger tax is 20% of the total takings.
Calculate the bus fare to be charged from each passenger to earn a profit of one third on total takings.
Solution
(a) Operation cost statement (Passenger kms.239,000)
(A) Fixed Charges

Per month (Rs.)
Driver's salary 35,000
Conductor's salary 35,000
Accountant's salary 16,000
Insurance 14,000

Road tax 5,000

Permit fees 28,400
Total fixed charges 1,33,400
(B) Running Expenses:

Depreciation (60,000x20)/(100x12) 1,00,000
Repairs and maintenance 50,000
Petrol (5,560/4 x Rs 100) 1,39,000
Lubricating oil (10 x 5,560)/100 55,600
Passenger tax (see working note 3) 2,04,900
Total running expenses 5,49,500
6,82,900
Profit one third on takings 3,41,400
(C) Total takings 10,24,300
(D) Total Passenger-kms. 239,000
(E) Cost per passenger-km. 4.30 (approx)
Fare from Kathmandu to Barabise per passenger: 150x4.3 = Rs. 645

Fare from Kathmandu to Khaireni per passenger: 120x4.3 = Rs. 516
Working notes:
1.Computation of total kms run:
Kathmandu to Barabise and back 10x150x2 = 3,000 kms.
Kathmandu to Khaireni and back 10x120x2 = 2,400 kms.
Local 4x40 = 160 kms.
Total 5,560 kms
2. Computation of passenger-kms.
(i) Kathmandu to Barabise: 10 days x 150 kms x 2 x 50 passengers x 90% passenger kms =135,000
(ii) Kathmandu to Khaireni: 10 days x 120 kms x 2 x 50 passengers x 80% passenger kms
= 96,000
(iii) Kathmandu local: 4 days x 40 kms. x 50 passenger-kms = 8,000

Total passenger-kms. 239,000
3. In order to calculate the amount of passenger the amount of passenger tax, the total takings
will have to be calculated:
Let the total takings be 'X'

Passenger tax will be: 20% of X = X/5
Profit will be : one third of X = X/3
Total undertaking = Fixed Charge + Running Expense + Passenger Tax + Profit
X = Rs.4,78,000 + X/5 + X/3
From the equation:
Passenger tax will be Rs. 2,04,900 and profit will be Rs.3,41,400.
Illustration: 30
From the following data pertaining to the year 2007/08 prepare the cost sheet showing the cost of
electricity generated per k.w.h. by Butawal Thermal Power Station.
Total units generated 1,000,000 k.m.h.
Rs.
Operating labor 50,000
Repairs & maintenance 50,000
Lubricants, spares and stores 40,000
Plant supervision 30,000
Coal consumed per k.w.h. for the year is 2.5 kg @ Rs. 0.02 per kg. Depreciation charges @ 5% on
capital cost of Rs. 200,000.
Solution
Power House Cost Statement
Total units generated 1,000,000 k.w.h.
Per annum Per k.w.h.
Rs. Rs.
Fixed costs:
Plant supervision 30,000
Depreciation (5% of Rs. 200,000 p.a.) 10,000

Total fixed cost: (A) 60,000 0.06

Variable Costs:
Operating labor 50,000 0.05
Lubricating, spares & stores 40,000 0.04
Repairs & maintenance 50,000 0.05
Coal cost (Refer to working note) 50,000 0.05
Total variable cost: (B) 190,000
Total Cost [(A) + (B)] 250,000 0.25
Working Note:
Coal cost 1,000,000 k.w.h. x 2.5 kg x 0.02 per kg. =Rs. 50,000
Illustration: 31
From the following information relating to hotel, calculate the room rent to be charged to give a profit of
25% on cost excluding interest.
(i) Salary of staff Rs 80,000 p.a.
(ii) Wages of the room attendant: Rs.2 per day
There is a room attendant for each room. He is paid wages only when the room is
occupied.
(iii) Lighting, heating and power:
• The normal lighting expenses for a room for the whole month are Rs. 50, when
occupied.
• Power is used only in winter and the charges are Rs.20 for a room, when occupied.
(iv) Repairs to building Rs. 10,000 p.a.
(v) Linen etc:. Rs.4,800 p.a.
(vi) Sundries: Rs. 6,600 p.a.
(vii) Interior decoration and furnishing: Rs. 10,000 p.a.
(viii) Depreciation @ 5% is to be charged on buildings costing Rs. 400,000 and 10% on
equipments.
(ix) Interest to be charged @ 5% on investment in buildings and equipments amounting to Rs.
500,000.
(x) There are 100 rooms in the hotel, 80 percent of the rooms are generally occupied in summer
and 30 percent in winter. The period of summer and winter may be considered to be of 6
months in each case. A month may be assumed of 30 days.
Solution
Operating cost statement showing room rent per day

(Room days 19,800)
Per annum
(A) Total cost Rs.
i. Staff salaries 80,000

ii. Room attendant's wages (see working note 2) 39,600

iii. Lighting, heating and power (see working note 3) 36,600
iv. Repair to buildings 10,000
v. Linen etc. 4,800
vi. Sundries 6,600
vii. Interior decoration and furnishing 10,000
viii. Deprecation: -
Building @ 5% 20,000
Other equipments@10% 10,000 30,000
(i.e., 10% of 5,00,000-4,00,000)
ix. Interests on Investments 5% on Rs. 5,00,000 25,000
Total 242,600
(B) Profit@25% on cost excluding interest, i.e., 25% on Rs.
2,17,600 54,400
(C). Total rent to be charged for all rooms 2,97,000
(D) Room days 19,800
(E) Room rent per day (C/D) 15
Working notes:
1.Room days:
Summer: 100 rooms x 6 months x 30 days x 80/100 14,400
Winter: 100 rooms x 6 months x 30 x 30/100 5,400
Total 19,800
2. Room attendant's wages:

Summer: Rs. 2 x 100 rooms x 80% x 30 days x 6 months 28,800
Winter: Rs. 2 x 100 rooms x 30% x 30 days x 6months 10,800
Total 39,600
3. Lighting, heating and power:

Lighting:
Summer: Rs. 50 x 6 months x 100 rooms x 80% 24,000
Winter: Rs. 50 x 6months x 100 rooms x 30% 9,000
Power:
Winter: Rs. 20 x 6 months x 100 rooms x 30% 3,600
Total 36,600

Illustration: 32
A practicing Chartered Accountant now spends Rs. 0.90 per km. on taxi fares for his clients' work. He is
considering two other alternatives, the purchase of a new small car or an old bigger car. The estimated
cost figures are:
Items New small car Old bigger car
Purchase price Rs. 35,000 Rs. 20,000
Sale price after 5 years Rs. 19,000 Rs. 12,000
Repair and servicing, per annum Rs. 1,000 Rs. 1,200
Taxes and insurance, per annum Rs, 1,700 Rs. 700
Petrol consumption, per liter 10 kms. 7kms
Petrol price, per liter Rs. 3.50 Rs. 3.5
He estimates that he does 10,000 km. annually. Which of the three alternatives will be cheaper? If his
practice expands and he has to do 19,000 km. per annum, what should be his decision? At how many km.
per annum will the cost of the two car break-even and why? Ignore interest and income tax.
Solution
Item New Small Car Old Bigger Car Taxi
Fixed cost per annum: Rs. Rs. Rs.
Depreciation 3,200 1,600
Repairs & servicing 1,000 1,200
Taxes & insurance 1,700 700
Total Fixed Cost 5,900 3,500
Variable cost per annum:
(a) Petrol 10,000 km. 3,500 5,000
(b) Petrol 19,000 km. 6,650 9,500
Total cost:
(a) 10,000 km. 9,400 8,500 9,000
(b) 19,000 km. 12,550 13,000 17,100
An old bigger car is the cheapest for his present practice. However, if his practice expands, a new small
car will be the cheapest.
The difference in the variable costs of running the two cars is 15 paisa. The difference of fixed costs is
Rs.2,400. Hence, the break-even point between the two cars is 16,000 kms. ( i.e. 2,400/0.15)
At 16,000 km. per annum, the costs of the two cars will break-even. This has been verified below:
New Car Old Car
Fixed costs 5,900 3,500
Variable costs 5,600 8,000
RS. 11,500 11,500

Illustration: 33
A company runs a holiday home. For this purpose, it has hired a building at a rent of Rs 10,000 per
month alongwith 5% of total taking. It has three types of suites for its customers, viz., single room,
double rooms and triple rooms.
Following information is given:
Type of suite Number Occupancy percentage

Single room 100 100%
Double rooms 50 80%
Triple rooms 30 60%
The rent of double rooms suite is to be fixed at 2.5 times of the single room suite and that of triple rooms
suite as twice of the double rooms suite.
The other expenses for the year 2006 are as follows:
(Rs)
Staff salaries 14,25,000
Room attendants’ wages 4,50,000
Lighting, heating and power 2,15,000
Repairs and renovation 1,23,500
Laundry charges 80,500
Interior decoration 74,000
Sundries 1,53,000
Provide profit @ 20% on total taking and assume 360 days in a year.
You are required to calculate the rent to be charged for each type of suite.
Solution
(i) Total equivalent single room suites
Nature of suite Occupancy Equivalent single room suites
Single room suites 100 × 360 × 100% = 36,000 36,000 × 1 = 36,000
Double rooms suites 50 × 360 × 80% = 14,400 14,400 × 2.5 = 36,000
Triple rooms suites 30 × 360 × 60% = 6,480 6,480 × 5 = 32,400
Total 1,04,400
(ii) Statement of total cost:

(Rs)
Staff salaries 1,425,000
Room attendant’s wages 450,000
Lighting, heating and power 215,000
Repairs and renovation 123,500
Laundry charges 80,500

Interior decoration 74,000

Sundries 153,000
Building rent (10,000 × 12 + 5% on total taking) 120000 + 5% on total taking
Total cost 26,41,000 + 5% on total taking
Profit 20% on total taking
Total taking 26,41,000 + 25% of Total Taking
Let x be rent for single room suite

Then 1,04,400
x = 26,41,000 + 25% of (1,04,400 x)
or 1,04,400 x = 26,41,000 + 26,100 x
or 78,300x = 26,41,000
or x = 33.73
(ii) Rent to be charged for single room suite = Rs 33.73
Rent for double rooms suites Rs 33.73 × 2.5 = Rs 84.325
Rent for triple rooms suites Rs 33.73 × 5 = Rs 168.65
Standard load-
An alternative unit for the distribution of transport cost is the standard load. Where the goods to be
transported are of varying weight, the calculation of actual number of ton-kilometers is not an easy
matter. For example, if a business delivers its own products by its own transport, the cost per ton-
kilometers may be most misleading, for an article may have is selected as a unit, i.e., the load which a
lorry would carry. This would have reference both to bulk and weight and would give an efficient method
for distributing the cost of transport over different departments. Thus, if the turnover of various
departments is reduced to ‘standard load’ by first calculating their weight and then the bulk of article
produced, the costs of distributing the product would be easily ascertained.
This principle also can be extended for associating cost with convenient units of service rendered by an
organization so that the management is able to judge whether the organization is running efficiently and
in the manner in which the service requires to be improved or be made more economical. The cost of
generation of electricity on the same principle is correlated with units generated and also with units sold;
in hospitals the cost of their maintenance is co-related units of available –bed days.
Multiple Costing
It refers to the method of costing followed by a business wherein a large variety of articles are produced,
each differing from the other both in regard to material required and process of manufacture. In such
cases, cost of each article is computed separately by using, generally, two or more methods of costing.
For instance, for ascertaining the cost of a bicycle, cost of each part will be ascertained by using batch or
job costing method and, then the cost of assembling the parts will be ascertained by using batch or job
costing method and, then the cost of assembling the parts will be ascertained by following the method of
single or output costing.


1. Define the main features of job costing. Mention enterprises which use job costing.
2. Describe the procedure of Cost accumulation under job order costing.
3. Describe the main features of industrial units using job costing.
4. Explain the nature and use of batch costing. Describe the concept of the economical batch with the
help of any suitable example.
5. Why is a portion of profit on uncompleted contracts transferred to the profit and Loss account? How
would you determine the amount of profit to be transferred to the profit and loss account?
6. What are the main features of cost-plus contracts?
7. Raw materials ‘X’ costing Rs. 100 per kg and Y costing Rs. 60 per kg are mixed in equal
proportions for making product ‘A’. The loss of material in processing works out to 25% of the
output. The production expenses are allocated at 50% of direct material cost. The end product is
priced with a margin of 331/3% over the total cost. Material Y is not easily available and substitute
raw material ‘Z’ has been found for ‘Y’ costing Rs. 50 per kg. It is required to keep this proportion
of this substitute material in the mixture as low as possible and at the same time maintain the selling
price of the end product at existing levels and ensure the same quantum of profit as present.
You are required:
To compute what should be the ratio of mix of the raw materials X and Z.
8. Mr. Bansal has a factory. He specializes in the manufacture of small tables of standard size. He can
make 15,000 small tables in a year. The cost per table works out as under for the year and he made
and sold 10,000 tables.
Rs.
Materials 180
Labor 60
Overhead (fixed Recovered @50% Of material cost.) 90
Total cost 330
Prices are fixed by adding a margin of 10% of the total cost arrived at the above.
In the current year, due to the fall in the cost of materials, the total cost worked out as under:-
Rs.
Materials 120
Labor 60
Overhead recovered 50% of material cost 60
Total cost 240
Mr. Bansal maintained his standard margin of 10% on the total cost. Sales were at the same level as
in the last year.
You are asked to
(a) Determine the profit or loss for the current year.
(b) Compute the price which should have been charged in the current year to yield the same profit or
loss at last year.

9. In a factory in a month 3 new jobs were commenced. The materials and labor used in them were
as follows:
Job 1 Job 2 Job 3
Rs. Rs. Rs.
Materials 4,000 4,500 2,700
Labor 5,100 8,300 1,400
Works overhead is charged at 60% of labor and office expenses@10% of works cost. Jobs 1 and 2 were
completed but job 3 was still in progress. Prepare the job Accounts.
10. Answer which of the following statements are true.

(a) Job cost sheet may be used for estimating profit of jobs.
(b) Job costing cannot be used in conjunction with marginal costing.
(c) In cost plus contracts, the contractor runs a risk of incurring a loss.
(d) Batch costing is a variant of jobs costing.
(e) In job costing method, a cost sheet is prepared for each job.
(f) A production order is an order received from a customer for a particular job.
(g) In contract costing, the contract which is complete up to one fourth of the total contract, one
fourth of the profit should be transferred to Profit& Loss account.
(h) In contract costing profit of each contract is computed when the contract is completed.
(i) Batch costing may be used in a boiler house.
11. Select the correct answer in the following multiple choice questions.
a. The principal factors to be considered in designing a cost system include:
i. Manufacturing process
ii. Desire of management
iii. Nature of business
iv. Company organization structure.
v. All of the above.
b. The most suitable cost system where the products differ in type of materials and work
performed is:
vi. Job costing
vii. Process costing
viii. Operating costing
ix. None of these
12. An expenditure of Rs. 4,85,000 has been incurred on a contract till 31st March, 1998 and value of
the work certified is Rs.5,50,000. The cost of work performed but not yet certified is Rs. 15,000. The
profit of Rs. 30,000 had been taken to the credit of Profit & loss account till 31st March, 1997. The
estimated future expenses are Rs. 1,00,000. The estimated total expenses is to include a provision of
2-1/2 per cent for contingencies. The contract price is Rs. 7,00,000 and the payment received till
date is Rs. 5,00,000.Calculate the profit to be taken to the credit of Profit and Loss account for the
year ended on 31st March, 1998.
13. Describe the essential feature of operating costing and state where it can be usefully implemented.
14. Explain units of cost used in service undertakings. How are they computed?

15. A transport service company is running 4 boxes between towns which are 50 kms apart. Seating
capacity of each bus is 40 passengers. The following particulars were obtained from their books for
April 1998 –
Rs.
Wages of drivers, conductors and cleaners 2,400
Salaries of officers and Supervisory staff 1,000
Diesel oil and other oil 4,000
Repairs and maintenance 800
Taxations, Insurances etc. 1,600
Depreciation
2,600
Interest and other charges 2,000
Total cost 14,400
Actual passengers carried were 75% of the seating capacity. All the buses run on all days of the
month. Each bus made one round trip per day. Find out the costs per passenger-km.
16. A lorry capable of carrying 5 tons of goods normally carries 80% of the load on the outward
journey and 40% of the bad on inward journey. The journey is 300kms for one side. It takes two
days to complete the return trip. In a year of 300 days, compute the tons kms.
17. Dr. Sanjeev Sharma and Dr. (Mrs.) Sharma hire a building to run a nursing home. The building has
8,000 square feet of area consisting of 40 rooms of 150 square feet each. The rest is general area.
The monthly rent has been agreed at Rs. 10 per square feet. Lighting and heating expenses come to
Rs. 10,000 per month. The staff would consist of the following:
5 doctors @Rs. 20,000 p.m.
10 nurses@ Rs.8,000 p.m.
6 general helpers @Rs. 2,500 p.m.
It is expected that 90% of the rooms will always remain occupied. If a margin of 25% on total taking
is desired, ascertain the rent to be charged per day assuming month of a 30 days.
Answers to self examination questions

2. X:Z =3:2
3. (a) Rs.2,40,000; (b) 303
4. Cost at the end of the month: Rs. 13,376; Rs. 19,558 and Rs.4,100
5. True statements are (d) and (e)
6. Correct answers are a(v); b(i)
7. Rs. 48,751
8. 2,70,000 tones Kms.
9. Rs.351.85

COST SHEET
(Additional Numericals)
Illustration: 1
Cherry Blossom Polish Company Ltd. manufactures black and brown polish in one standard size of tin
retailing at Rs. 1.08 and Rs. 1.20 respectively. Following data are supplied to you for the year ended 31st
December 2014:
Rs.
Direct material:
Polish 738,000
Tin 288,000
Production overhead 367,200
Administrative and selling overhead 122,400
Sales for the year were: Black 14,40,000 tins and Brown 6,00,000 tins. The opening and closing stocks
were:
Black Brown
Opening stock 48,000 160,000
Closing stock 108,000 60,000
The opening stock of black and brown polish was valued at its cost of production of 80.4 paisa per tin
and 86.4 paisa per tin respectively. The cost of raw materials for brown polish is 10% higher than that
for black but there is no difference in the cost of tins. Direct wages for brown are 8% higher than those
for black polish and production overheads are considered to vary with direct wages. Administrative and
selling overhead is absorbed at a uniform rate per tin of polish sold.
You are required to prepare a statement showing the cost and profit per tin of polish.
Solution
Statement of Cost and Profit
For the year ended 31st December 2014
Black Brown
Total Rs. Per tin Paisa Total Rs. Per tin Paisa
Direct Materials:
Polish (Note 2) 540,000 36.0 198,000 39.60
Tins (Note 3) 216,000 14.4 72,000 14.40
Direct wages (Note 4) 180,000 12.0 64,800 12.96
Prime Cost 936,000 62.4 334,000 66.96
Add: Production overheads (Note 5) 270,000 18.0 97,200 19.44
Production Cost 1,206,000 80.4 432,000 85.40
Add: Opening Stock 38,592 138,240
1,244,592 80.4 570,240 86.40
Less: Closing Stock 86,832 51,840
Production Cost of Sales 1,157,760 80.4 518,400 86.40

Add: adm. and selling OH (Note 6) 86,400 6.0 36,000 6.00

Cost of Sales 1,244,160 86.4 554,400 92.4
Profit 311,040 21.6 165,600 27.6
Sales 1,555,200 108 720,000 120
Working Notes:
1. Output for the period has been calculated as follows:
Black (in tins) Brown (in tins)
Sales 1,440,000 600,000
Add: Closing Stock 108,000 60,000
1,548,000 660,000
Less: Op. Stock 48,000 160,000
1,500,000 500,000
2. The cost of raw materials (polish) per tin has been calculated as follows:
Let x be per tin cost of Raw Materials in case of black polish.
Total cost of materials for black polish will be 1,500,000x
Total cost of materials for brown polish will be: 500,000 X x X (11/10) = 550,000x
Thus, 1,500,000x + 550,000x = 738,000
2,050,000x = 738,000 or, x = 0.36 per tin
The cost of raw material for black polish is 36 paisa per tin, and for brown polish is 36 X 110%
= 39.6 paisa per tin.
3. The cost of tins per tin of polish is 14.4 paisa i.e. (Rs. 288,000/2,000,000)
4. The cost of direct wages per tin has been calculated as follows:
Let x be the cost of wages per tin for black polish.
Total direct wages for black polish will be 1,500,000x
Total direct wages for brown polish will be 500,000 X (108/100) X x =540,000x
Thus 1,500,000x + 540,000x =244,800 or 12 paisa per unit;
Cost of labor for black polish per tin is 12 paisa
Cost of labor for brown polish per tin is 12.96 paisa {i.e. 12 X(108/100)}
5. Production overhead varies with direct wages:

Percentage of production overhead to direct wages =Total prod. overhead/Total direct wages
X100 = (367,200/244,800) X100 =150%

6. Administration and selling overhead per tin of product sold:

= Total overheads/ Total tins sold
= 122,400/2,040,000 = 6 paisa per tin of polish sold.
Illustration: 2
Raw materials ‘AXE’ costing Rs. 150 per kg. and ‘BXE’ costing Rs. 90 per kg. are mixed in equal
proportions for making product ‘A’. The loss of material in processing works out to 25% of the product.
The production expenses are allocated at 40% of direct material cost. The end product is priced with a
margin of 20% over the total cost.
Material ‘BXE’ is not easily available and substitute raw material ‘CXE’ has been found for ‘BXE’
costing Rs. 75 per kg. It is required to keep the proportion of this substitute material in the mixture as low
as possible and at the same time maintain the selling price of the end product at existing level and ensure
the same quantum of profit as at present.
You are required to compute the ratio of the mix of the raw materials ‘AXE’ and ‘CXE.
Solution
Working Notes:
(i) Computation of material mix ratio:

Let 1 kg. of product A requires 1.25 kg. of input of materials A X E and B X E
Raw materials are mixed in equal proportions.
Then raw material A X E = 1.25/2 =625 kg.
Then raw material B X E = 1.25/2 =625 kg.
(ii) Computation of selling price / kg. of product A

Rs.
Raw material A X E 625 kg. x 150 = Rs. 93.75
Raw material B X E 625 kg. x 90 = Rs. 56.25 150.00
Production expenses (40% of material cost) 60.00
Total cost 210.00
Add: profit 20% of total cost 42.00
Computation of proportions of materials A X E and C X E in ‘A’

Let material C X E required in product A be m kg.

Then for producing 1 kg of product ‘A’, material A X E requirement = (1.25 - m) kg.

To maintain same level of profit and selling price as per Working note (ii), it is required that the total cost
of material in 1 kg. of product A should not exceed Rs. 150,
i.e., m kg. x Rs. 75 + (1.25 - m) kg. x 150 = Rs. 150
or 75 m + 187.5 – 150 m = 150
or 75 m = 37.5
or m = 0.5 kg.
Raw material A X E requirement in product A = 1.25 – .5 = .75 kg.
So, proportion of material A X E and C X E = .75 : .50 i.e. 3 : 2.
Illustration: 3
ABC Ltd. makes two types of polish, one for floors and one for cars. It sells both types to industrial users
only, in one-liter containers. The specifications for the two products per batch of 100-liters are:
Materials Floor polish Car polish
Delta 120 liters 100 liters
Gamma 20 kg 10 kg
Containers cost per 100 Rs. 100 Rs. 100
Direct labor:
Manufacturing 12 man hours 16 man hours
Primary packing 5 man hours 5 man hours
During the six months to end of 30th June, the company expects to sell 15,000 liters of floor polish at Rs. 9
per liter and 25,000 liter of car polish at Rs. 7 per liter. Materials are expected to cost Re. 1 a liter for
Delta and Rs. 8 a kg for Gamma.
Manufacturing wages in the industry look like being stable at Rs.6 per hour and packing wages at Rs. 4
per hour, throughout the period.
Flexible overhead expense budgets are operated for manufacturing and packing departments based on
the number of man hours worked. These budgets for six months to end of June are:
Manufacturing Department Primary Packing Department

Rs. Rs.
5,000 man hours 40,000 1,700 man hours 26,000
General administration overheads are budgeted at Rs. 37,000. At the beginning of the period 1st January
packed stocks will be:
Floor Polish 2,000 liters.
Car Polish 3,000 liters.

By end of the period 30th June, it is desired to maintain the packed stocks of the products at 3,000 liters
and 4,000 liters respectively. The following are required:
(1) A statement of the standard prime cost per 100 liters of each product.
(2) A sales and production budget (in quantities) of the six months to 30 June.
A profit forecast for the period. Show separate gross profit for the two products but do not attempt to
allocate overhead between them. No overheads are included in stock valuations.
Solution
1. Statement of Standard Prime cost per 100 liters
Particulars Floor Polish (Rs.) Car Polish (Rs.)
Materials:
Delta 120 x 1 =120 100 x 1 = 100
Gamma 20 x 8 =160 10 x 8 =80
Labor
Manufacturing 12 x 6 =72 16 x 6 =96
Packing 5 x 4 = 20 5 x 4 = 20
Containers 100 100
472 396
2. Sales and production Budget (in liters)

Particulars Floor Polish Car Polish
Sales 15,000 25,000
Add: Desired closing stock 3,000 4,000
18,000 29,000
Less: opening stocks 2,000 3,000
Production Requirement 16,000 26,000
3. Profit forecast for the period

Particulars Floor Polish (Rs.) Car Polish (Rs.) Total (Rs.)
Sales 15,000 x 9 =135,000 25,000 x 7 =175,000
Less: Prime cost 150 x 472 = 70,800 250 x 396 = 99,000
Gross Profit 64,200 76,000 140,200
Less: Common stocks Manufacturing Rs. 50,800 (Note 1)
Packing Rs. 30,000 (Note 2) 80,800
59,400
Less :General and administration Overhead 37,000
Net Profit 22,400

Working Notes:
(i) Computation of manufacturing Hours and Overhead:
Manufacturing Hours = (16000 x12/100) +(26,000 x 16/100) = 1,920 + 4,160 = 6.080
Manufacturing Overhead = 50,000 + 80/100 x 10,000 = 50,800
(ii) Computation of Packing Hours and Overhead:

Packing hours = (16000 x5/100) +(26,000 x 5/100) = 800 + 1,300 = 2,100 Hrs.
Overhead for 2,100 hours = Rs. 30,000

CHAPTER 8
COST CONCEPTS FOR DECISION MAKING
CHAPER 8 : COST CONCEPTS FOR DECISION MAKING
8.1 COST BEHAVIOR
The costs that vary with a decision should only be included in decision analysis. For many decisions that
involve relatively small variations from existing practice and/or are for relatively limited periods of time,
fixed costs are not relevant to the decision. This is because either fixed costs tend to be impossible to alter
in the short term or managers are reluctant to alter them in the short term.
Marginal costing is a very useful technique of decision making for the management. The information
provided by the total cost method is not sufficient in solving the management problems. Marginal costing
is used to provide a basis for the interpretation of cost data to measure the profitability of different
products, processes and cost centers in the course of decision making. It can therefore be used in
conjunction with the different methods of costing such as job costing, process costing etc., or even with
other techniques such as standard costing or budgetary control.
In marginal costing cost ascertainment is made on the basis of the nature of cost. It gives consideration to
behavior of costs. In other words, the technique has developed from a particular conception and
expression of the nature and behavior of costs and their effect upon the profitability of an undertaking.
In the total cost method, as opposed to marginal costing method, the classification of costs is based on
functional basis. Under this method the total cost is the sum total of the cost of direct material, direct
labor, direct expenses, manufacturing overheads, administration overheads, selling and distribution
overheads. In this system, other things being equal, the total cost per unit will remain constant only when
the level of output or mixture is the same from period to period. Since these factors are continually
fluctuating, the actual total cost will vary from one period to another. Thus, it is possible for the costing
department to say one day that an item costs Rs. 20 and the next day it costs Rs. 18. This situation arises
because of changes in volume of output and the peculiar behavior of fixed expenses included in the total
cost. Such fluctuating manufacturing activity, and consequently the variations in the total cost from
period to period or even from day to day, poses a serious problem to the management in taking sound
decisions. Hence, the application of marginal costing has been given wide recognition in the field of
decision making.
Ascertainment of Marginal Cost
Under marginal costing, fixed expenses are treated as period costs and are therefore, charged to profit and
loss account. In order to ascertain the marginal cost, we classify the expenses as under:
1. Variable expenses: Apart from prime costs which are variable, the overhead expenses that change
in proportion to the change in the level of activity are also variable expenses. Thus when
expenses go up or come down in proportion to a change in the volume of output, such that, with
every increase of 20% in output, expenses also go up by 20% or vice versa, these expenses are
known as variable expenses. Variable expenses fluctuate in total with fluctuations in the level of
output but tend to remain constant per unit of output. Examples of such expenses are raw
material, power, commission paid to salesmen as a percentage of sales etc.
2. Fixed expenses: Fixed expenses or constant expenses are those which do not vary in total with the
change in volume of output for a given period of time. Fixed cost per unit of output will,
however changes in the level of production. Examples of such expenses are managerial

remuneration, rent, taxes, etc. There may, however, be different levels of fixed costs at different
levels of output, as for example, where after certain level of output extra expenditure may be
needed. In the case of introduction of additional shift working, fixed expenses will be incurred,
say, for the appointment of additional supervisors. Fixed expenses are treated as period costs and
therefore charged to profit and loss account.
3. Semi-variable expenses: These expenses (also known as semi-fixed expenses) do not change
within the limits of a small range of activity but may change when the output reaches a new level
in the same direction in which the output changes. Such increases or decreases in expenses are
not in proportion to output. An example of such an expense is delivery van expense. Semi-
variable expenses may remain constant at 50% to 60% level of activity and may increase in total
from 60% to 70% level of activity. These expenses can be segregated into fixed and variable by
using any one of the method as given under next heading. Depreciation of plant and machinery
depends partly on efflux of time and partly on wear and tear. The former is fixed and the later is
variable.
The total cost is arrived at by merging these three types of expenses. A graphical presentation of the total
cost on the basis of the data presented in the following table is given below. From this graphical
presentation, the behavior of costs in relation to output can be studied.
Example:
160
} - Variable
120
80
}- Semi-variable
in Thousands
40
20
20 40 60 80 100
Rs.
Output in thousands units }- Fixed

Figure 1
Output in Units Total expenses (Rs.) Cost per Unit ( Rs.)

20,000 60,000 3.00
40,000 90,000 2.25
60,000 120,000 2.00
80,000 150,000 1.875
You may observe from the above table that cost per unit goes down as the total number of units
produced increases. This is due to the fact that fixed costs remain constant and semi variable costs do
not increase in the same proportion as the increase in output.

Marginal cost equation
The contribution theory explains the relationship between the variable cost and selling price. It tells us
that selling price minus variable cost of the units sold is the contribution towards fixed expenses and
profit. If the contribution is equal to fixed expenses, there will be no profit or loss and if it is less than
fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output, therefore if
the firm does not produce any unit, the loss will be there to the extent of fixed expenses. These points can
be described with the help of following marginal cost equation:
SxU–V=F+P
Where,
S = Selling price per unit
V = Variable cost per unit
U = Units
F = Fixed Expenses
P = Profit
If three out of the above four factors of the equation viz., sales revenue; total variable cost, fixed cost and
profit are given, the fourth can be computed.
Illustration: 1
A firm produces 500 units. The selling price is Rs. 4/- and variable cost is Rs. 2 per unit. Fixed expenses
amount to Rs. 800. Find the profit.
Solution:
Marginal cost equation is S x U – V x U = F + P. Since S, V and F are given, the profit can be calculated
as below:
500 units (S-V)-F = P
500 units (Rs. 4- Rs. 2) – Rs. 800 = P
Rs. 1,000 – Rs. 800 = P or P = Rs. 200
Advantages of marginal costing

1. The marginal cost remains constant per unit of output whereas the fixed cost remains constant in
total. Since marginal cost per unit is constant from period to period within a short span of time, firm
decision on pricing policy can be taken. If fixed cost is included, the unit cost will change from day
to day depending upon the volume of output. This will make decision making task difficult.

2. Overheads are recovered in costing on the basis of pre-determined rates. If fixed overheads are
included on the basis of pre-determined rates, there will be under-recovery of overheads if production
is less or if overheads are more. There will be over-recovery of overheads if production is more than
the budget or actual expenses are less than the estimate. This creates the problem of treatment of such
under or over-recovery of overheads. Marginal costing avoids such under or over recovery of
overheads.
3. Advocates of marginal costing argues that under the marginal costing technique, the stock of finished
goods and work-in-progress are carried on marginal cost basis and the fixed expenses are written off
to profit and loss account as period cost. This shows the true profit of the period.
4. Marginal costing helps in the preparation of break-even analysis which shows the effect of increasing
or decreasing production activity on the profitability of the company.
5. Segregation of expenses as fixed and variable helps the management to exercise control over
expenditure. The management can compare the actual variable expenses with the budgeted variable
expenses and take corrective action through analysis of variances.
6. Marginal costing helps the management in taking a number of business decisions like make or buy,
discontinuance of a particular product, replacement of machine, etc.
Limitations of Marginal Costing

1) It is difficult to classify exactly the expenses into fixed and variable category. Most of the expenses
are neither totally variable nor wholly fixed. For example, various amenities provided to workers
may have no relation either to volume of production or time factor.
2) Contribution of a product itself is not a guide for optimum profitability unless it tis linked with the
key factor.
3) Sales staff may mistake marginal cost for total cost and sell at a price; which will result in loss or low
profits. Hence, sales staff should be cautioned while giving marginal cost.
4) Overheads of fixed nature cannot altogether be excluded particularly in large contracts, while valuing
the work-in-progress. In order to show the correct position fixed overheads have to be included in
work-in-progress.
5) Some of the assumptions regarding the behavior of various costs are not necessarily true in a realistic
situation. For example, the assumption that fixed cost will remain static throughout is not correct.
Fixed cost may change from one period to another. For example, salaries bill may go up because of
annual increments or due to change in pay rate etc. The variable costs do not remain constant per unit
of output. There may be changes in the prices of raw materials, wage rates etc. after a certain level of
output has been reached due to shortage of material, shortage of skilled labor, concessions of bulk
purchases.
6) Marginal costing ignores time factor and investment. For example, the marginal cost of two jobs may
be the same but the time taken for their completion and the cost of machines used may differ. The
true cost of a job which takes longer time and uses costlier machine would be higher. This fact is not
disclosed by marginal costing.

8.2 METHODS OF SEPARATING FIXED AND VARIABLE COSTS
Semi-variable costs should be separated into their fixed and variable elements for marginal costing
purposes. This process is a difficult one. The following are the methods employed to segregate the semi-
variable costs into fixed and variable costs.
8.2.1 High and low method: This method is based on the analysis of past records of costs. The
overheads at the highest level of activity and at the lowest level of activity are analyzed and the variability
rate of costs is determined as under.
Illustration: 2
Machine hours Maintenance cost (Rs.)
High 4,000 6,000
Low 2,400 5,200
Difference 1,600 800
Variable cost per machine hour = Rs. 800/ 1,600 hours = Rs. 0.50
Substituting the variable cost in either high or low activity, we get the fixed costs as under:
Machine hours Total costs (Rs.) Variable rate Total variable cost Fixed cost
Per hour (Rs.) (Rs.) (Rs.)
A B C D =A x C E=B-D
4,000 6,000 0.50 2,000 4,000
2,400 5,200 0.50 1,200 4,000
With this information, we can estimate the expenditure for the future period.
Suppose for a period, the estimate machine hours are 6,000, the total costs will be as under
Variable costs of 6,000 hours @ Rs. 0.50 per hour = Rs. 3,000
Fixed costs = Rs. 4,000
Total cost = Rs. 7,000
One major drawback of the above method is that it assumes that the variable portion of semi-variable cost
has linear relationship. In other words, the variable element of cost for an item per unit is constant. This
may not always be true because, as we have already seen, increase or decrease in cost may not be
proportionate to the level of activity.
8.2.2 Scatter graph method: This method is also known as regression line or the line of best fit. Here
again we take the past data but unlike the high-low method, we use all the data pertaining to the year or a
period. On the horizontal axis (X – axis), we plot the machine hours or output or sales as the case may be.
On the vertical axis (Y – axis), we take the values of expenses. Plot the given data on a graph. After
plotting all the points, a straight line is drawn through the points with same number of points on each
side. While drawing the regression line, abnormal costs are excluded. The point where the straight line
intersects the Y axis determines the fixed expenses.
Illustration: 3
The maintenance expenses of A co. Ltd., for six months are as under:
Month Machine Hours Semi-variable maintenance expenses (Rs.)
January 400 2,800

February 300 2,600

March 200 2,400
April 600 3,200
May 500 3,000
June 800 3,600
The major drawback of this method is that even if there is a slight bias in drawing the straight line, there
will be a change in the fixed expenses as read from the graph.
8.2.3 The method of least squares: This method uses a mathematical approach to determine the
components of variable and fixed expenses. It is an accurate method. The steps involved in the
determination of the fixed expenses under this method are illustrated by taking the same example as given
under the regression line method.
Illustration: 4
Month Units Semi-variable Square of units Units x Semi variable
produced expenses expenses (Rs.)
(X) (Y) (X2) (XY)
January 400 2,800 160,000 1,120,000
February 300 2,600 90,000 780,000
March 200 2,400 40,000 480,000
April 600 3,200 360,000 1,920,000
May 500 3,000 250,000 1,500,000
June 800 3,600 640,000 2,880,000
Total Σx =2,800 Σy = 17,600 Σx2 = 1,540,000 Σxy =8,680,000
N = No. of months i.e. 6
The procedure for determining variable and fixed expenses involves the following steps:

A. Monthly average output = Σx/N or 2,800 units/6months = 467 units

B. Monthly average expenses = Σy/N or Rs, 17,600/6 = Rs. 2,934
C. Monthly average of square of units =Σx2/N or 1,540,000 units/ 6 months = 256,667 units
D. Monthly average of the product of units and expenses = Σxy/N =Rs.8,680,000/6 months
= Rs.1,446,667
( )
Variable cost (V) per unit =

Fixed cost (F) =B – (A x V)
.,,( .,)

Variable cost = = Rs.1.9827 ( say Rs. 2 per unit)
, ()

Fixed cost = Rs. 2,934 – ( 467 units x Rs. 2) = Rs. 2,000
A careful and close scrutiny of the semi-variable expenses is required. This task is performed by the
analyst. He estimates the degree of variability of the semi- variable expenses at various levels of
operations. For example, 70% of the semi-variable cost is variable at a given level of output and 30% is
fixed. This is not an accurate method because an element of arbitrariness of business enters into the
analysis.
8.3 COST SHEET FOR MARGINAL COSTING
Particular Amount
Sales XXX
Less: variable Cost XXX
Contribution XXX
Less: Fixed Cost XXX
Profit XXX
8.4 COSTS-VOLUME PROFIT ANALYSIS
Cost-volume profit analysis (as the name suggests) is the analysis of three variables viz., cost, volume and
profit. Such an analysis explores the relationship existing amongst costs revenue, activity levels and the
resulting profit. It aims at measuring variations of cost with volume. In the profit planning of a business,
cost-volume-profit (CVP) relationship is the most significant factor.
The CVP analysis is an extension of marginal costing. It makes use of principles of marginal costing. It is
an important tool of planning. It is quite useful in making short run decisions.
8.4.1 Profit Volume Ratio:

The profit volume (P/V) ratio is the relationship between the contribution and sales value. It is expressed
as a percentage shown as under:
!

X 100 = P/V ratio in percentage.
" #"

It can also be termed as (contribution/sales) ratio and can also be expressed as under:
$%
x 100 Where, S = Sales value, V = Variable expenses
$
The P/V ratio is considered to be the indicator of the profitability of the business. In the case of a firm
enjoying steady business conditions over a period of years, the P/V ratio will also remain steady.
Improvement of P/V ratio
Since the P/V ratio represents the percentage of gross margin to sales, an improvement in P/V ratio will
lead to increased profitability. P/V ratio can be improved:
i. By reducing the variable cost,
ii. By increasing the selling price, or
iii. Where the firm produces a number of products, by increasing the output of those units
having a higher P/V ratio and by reducing the volume of output of those units which yield a
lower P/V ratio.
Illustration: 5
A firm produces 500 units. The selling price is Rs. 4/- and variable cost is Rs.2/- per unit fixed expenses
amount to Rs. 800. Determine the P/V ratio.
Solution
$% . –.
P/V ratio = x 100 = x 100 = 50%
$ .
The P/V ratio can also be calculated by taking the total figures relating to a period. Taking again the same
illustration, since the output for a period is 500 units, the P/V ratio can also be calculated as under:
Sales value : 500 units x Rs. 4 = Rs. 2,000

Less: Variable expenses: 500 units x Rs.2 = Rs. 1,000
Total contribution Rs. 1,000
.,'''
P/V ratio = x 100 = 50%
.,'''
Uses of P/V Ratio

1. Given the P/V ratio, we can determine the variable cost for any volume of sales. For example,
suppose the P/V ratio of a firm having two units is 25% and the sales value of these units are:
Unit A: Rs. 80,000; and Unit B: Rs. 120,000. Other things being equal, the variable cost
represents (100-25) = 75% of sales. Hence the variable costs of the two units are :
Unit A: Rs. 80,000 x (75/100) = Rs. 60,000
Unit B: Rs. 120,000 x (75/100) = Rs. 90,000
2. The P/V ratio of each product, factory, sales area, etc, can be calculated to measure the
efficiency or to choose a most profitable line. The overall profitability of the firm can be
improved by increasing the sales/output of a product giving a higher P/V ratio.

3. We can determine break-even point and the level of output required to earn a desired profit and
also to decide more profitable sales-mix.
8.4.2 Break-even Point (BEP): The break-even point to a business is the point or a business situation
at which there is neither a profit nor a loss to the concern. In other words, it is at this point where the
contribution equals fixed expenses.
(") "*""
BEP (in Rs.) = +

,
(") "*""
BEP (In Units) =
! *" -
Illustration: 6
If variable expenses are Rs. 8,000 and fixed expenses Rs. 4,000, the breakeven point for sales of Rs.
12,000 can be determined with the help of the following equation:
At breakeven point, Sales – Variable expenses = Fixed expenses.
Also by using the P/V ratio, we can find the sales value required to breakeven as under:
$"% !" .,'''..,'''

P/V ratio = x 100 = x 100 = 33.33%
$" .,'''
(") "*"" .,'''

BEP = + = = Rs. 12,000
.%
,
Assumptions underlying break even analysis

1. Both revenue and cost functions are linear over the range of activity under consideration.
2. Cost can be easily classified into fixed and variable categories.
3. Prices of output and input remain unaltered.
4. Productivity of the factors of production will remain the same.
5. The state of technology and the process of production will remain unchanged.
6. There will be no significant change in the level of opening and closing inventory.
7. The company manufactures a single product.
8. In the case of multi-product company, the sales-mix remains unchanged.
Illustration: 7
The selling price of a product is Rs. 5 per unit. The variable cost is Rs. 3 per unit. The fixed expenses are
Rs. 2,000 per month. Find the sales volume required to break-even.
Solution
..
P/V ratio = x 100 = 40%
.
(") .,'''
BEP (Sales value) = + = = Rs. 5,000
'%
,
$" #" 01 .,'''

No. of units required to break-even = = = 1,000 units.
$"2 * " *" .
The number of units required to break-even can also be calculated as under:

Contribution per unit: Rs. 5 – Rs. 3 = Rs. 2.

Contribution required to break-even is equal to fixed expenses at break-even point.
(") "*"" .,'''

So units required to break-even = = = 1,000 units.
! *" .
Another formula for calculating the sales value at break-even points is as under:
( $
Where, F = Fixed expenses, S = Sales, V= Variable expenses,
$%
Notice that the aforesaid formula has been obtained as below:
(") "*""

We know that BEP = +

,
$%
And P/V ratio =
$
$% ( $
Hence, BEP = F ÷ =
$ $%
8.4.3 Sales Mix

Sales mix is the relative proportion of each product line to the total sales of various products sold by an
enterprise. If there are no constraints or limitations management should try to maximize the sales of the
products with higher P/V ratio. However, a sales mix results because there are limits to the quantities of
any given product that can be produced and there may also be certain market limitations on how much
can be sold.
When different products have their own different production facilities, selling prices, variables costs and
fixed costs separately, cost-volume-profit analysis can be done for each product separately. But, in many
situations, this is not found and different products share common facilities and have common fixed costs.
In such a situation CVP analysis is performed by averaging the data using the sales mix as weights. The
break-even point is computed for a specified sales mix and break-even chart and P/V graph are
constructed for any specified sales mix. But any one break-even chart or P/V graph will show a constant
sales mix for the total sales of different products, covering the cost and revue lines as well. The sales
necessary to achieve desired or target level of operating profit can be computed on the basis of specified
sales mix. If the sales mix changes, CVP analysis, break-even point, desired sales for target, costs and
revenue lines will also change accordingly.
To illustrate the computation of break-even point in a sales mix situation, an example is given here.
Assume, for a company, the fixed costs are Rs. 675,000. Further, assume that the units sales volume, units
selling prices, unit variable costs, unit contribution margins for products A, B and C are as follows:
Products Sales volume Unit Selling Unit Variable Contribution Margin %
(Units) Price (Rs.) Cost (Rs.) per unit (Rs.) (P/V Ratio)
(Rs.)
A 20,000 50 20 30 60
B 10,000 50 30 20 40
C 10,000 50 40 10 20
40,000

Break-even points (in units) will be computed using a weighted average contribution margin as follows:
Products Sales Mix (%) Contribution Margin per Weighted contribution
unit (Rs.) margin (Rs.)
A 50% x 30 15
B 25% x 20 5
C 25% x 10 2.5
Total weighted contribution margin 22.50
BEP (Units) = Fixed cost / Weighted Contribution Margin

= Rs. 675,000/Rs. 22.50
=30,000 units
The detail composition of sales and contribution margins at this level (30,000 units) are as follows:
Products Sales Mix (%) Total units Units of Contribution Total
Products per unit (Rs.) contribution
(Rs.)
A 50% x 30,000 15,000 30 450,000
B 25% x 30,000 7,500 20 150,000
C 25% x 30,000 7,500 10 75,000
Contribution margin 675,000
BEP (sales in Rupees) can also be calculated. For this, first, total P/V ratio is required and then divides
the fixed costs by total P/V ratio. Using the above information, calculation is shown below:
Products
A B C Total
Sales (units) 20,000 10,000 10,000 40,000
Selling price (Rs.) per unit
Sales (Rs.) 50 50 50
Less: Variable costs (Rs.) 1,000,000 500,000 500,000 2,000,000
Contribution Margin 400,00 300,000 400,000 1,100,000
Contribution Margin (Rs.) 600,000 200,000 100,000 900,000

Less: Fixed cost 675,000
Profit before tax 225,000
Total P/V Ratio = Total contribution/total sales = Rs.900,000/Rs.2,000,000 = 45%

Break-even sales (Rs.) = Fixed cost/Total P/V Ratio = 675,000/45% = Rs. 1,500,000

Rs 1,500,000 as break-even sales can be verified by computing break-even sales of individual products as
follows:
Products Break-even Units Selling Price (Rs.) Break-even sales (Rs.)
A 15,000 50 750,000
B 7,500 50 375,000
C 7,500 50 375,000
Total Break-even sales 1,500,000
If there is any change in the above sales mix, the break-even point, P/V ratio, amount of profit before tax
may change. For instance, assume that the quantities sold of products A, B and C is 5,000 units, 20,000
units and 15,000 units respectively. Further, assume there are no changes with regard to fixed costs,
variable cost per unit and selling price per unit. The change in the sales-mix will influence the factors of
CVP analysis as shown below.
Products Sales Volume Sales Mix % Contribution Total Sales Revenue
(Units) per unit (Rs.) contribution (Rs.)
(Rs.)
A 5,000 12.5% 30 150,000 250,000
B 20,000 50% 20 400,000 1,000,000
C 15,000 37.5% 10 150,000 750,000
Contribution margin 700,000
Less: Fixed Cost 675,000
Profit before tax 25,000
Total P/V Ratio = Total contribution/total sales = Rs.700,000/Rs.2,000,000 = 35%
Break-even sales (Rs.) = Fixed cost/Total P/V Ratio =Rs. 675,000/35% = Rs. 1,928,571
Break-even point in units will be computed using a weighted average contribution-margin, as stated
earlier.
Products Sales Mix (%) Contribution Margin Weighted contribution
per unit (Rs.) margin (Rs.)
A 12.5% 30 3.75
B 50% 20 10.00
C 37.5% 10 3.75
Total weighted contribution margin 17.50
BEP (Units) = Fixed cost / Weighted Contribution Margin = Rs. 675,000/Rs. 17.50
=38,571 units
It can be observed that due to change in sales mix profit before tax is considerably lower (Rs. 25,000)
although the amount of sales revenue is the same. The total contribution is less than the earlier ones. P/V
ratio has decreased (35%0 and break-even point in units has increased to 38,571 units. These differences
are due to changes in sales mix.

On the need of promoting products having different P/V ratios, Anderson and Sollenberger advise:
“One way to encourage the sales force to sell more of the high contribution margin lines is to compute
sales commissions on the contribution margin and not on sales revenue. If sales commissions are based on
sales revenue, a sales force may have a high volume of sales of less profitable product lines and still earn
a satisfactory commission. But if sales commission is related to contribution margin, the sales force is
encouraged to strive for greater sales of more profitable products, and, in doing so will help to improve
total company profits”.
Illustration: 8
The budgeted results of A Ltd are as under:
Products Sales value (Rs.) P/V ratio (%) Sales mix (%)
X 250,000 50 20
Y 400,000 40 32
Z 600,000 30 48
Total 1,250,000 100
Fixed overheads for the period are Rs. 502,200.
The management is worried about the results. You are required to prepare:
(a) A statement showing the amount of loss, if any, being incurred at present and recommend a
change in the sale value of each product as well as in the total sales value maintaining the same
sales-mix, which will eliminate the said loss.
(b) Recommend the additional sales of any individual product to recover the loss.
Solution
Statement of Profitability
Products Sales value (Rs.) P/V ratio (%) Contribution (Rs.)
X 250,000 50 125,000
Y 400,000 40 160,000
Z 600,000 30 180,000
Total 1,250,000 465,000
Less: Fixed overheads (502,200)
Profit/(Loss) (37,200)
Statement of additional sales required to eliminate the above loss

Or
Additional sales value of each product for maintaining the same sales mix.
Product Sales mix % Additional sales Rs. P/V ratio % Additional contribution Rs.
A B C D E=CxD
X 20 20,000 50 10,000
Y 32 32,000 40 12,800
Z 48 48,000 30 14,400
100,000 37,200

Statement of additional sales of Individual Product

Particulars Situation
Increase in Increase in Increase in
sales of X sales of Y sales of Z
Rs. Rs. Rs.
Present sales 1,250,000 1,250,000 1,250,000
Add: Additional sales
Rs. 37,200/0.5 74,400 - -
Rs 37,200/0.4 - 93,000 -
Rs.37,200/0.3 - - 124,000
Total Sales 1,324,400 1,343,000 1,374,000
Present contribution 465,000 465,000 465,000
Additional Contribution
Rs. 37,200 x 50% 37,200 - -
Rs 37,200 x 40% - 37,200 -
Rs.37,200 x 30% - - 37,200
Total contribution 502,200 502,200 502,200
Less: Fixed overheads 502,200 502,200 502,200
Profit/Loss Nil Nil Nil
8.4.4 Overall P/V Ratio and Break Even Point:

For a company selling various products in Various Sales Mix Ratio, the overall P/V Ratio and BEP can
be calculated by using the following formulae:
A. Where either Individual Sales of each product or Individual Sales Mix Ratio of each
product and Total Sales of all the products are given
! 3 1 )
(a) Overall P/V ratio = x 100
$" 3 4" 1 )
(") 3 1 )

(b) Overall B.E.P. = + x 100
5#"
,
B. Where Sales Mix Ratio is given with reference to value
(a) Overall P/V ratio = Weighted P/V Ratio of Product 1 + Weighted P/V Ratio of Product 2 +
…..+ Weighted P/V Ratio of Product N
Note: Weighted P/V Ratio of a product = Sales Mix Ratio x Individual P/V Ratio
(") 3 1 )
(b) Overall B.E.P. = + x 100
5#"
,
(c) Individual B.E.P. (in value) for a product = Individual Sales Mix Ratio x Overall B.E.P. (in
value)
6)#) .0.1.( #")
(d) Individual B.E.P. (in Qty.) for a product =
$"2 1 " 3 1 )
(e) Overall B.E.P. (in Qty.) = Individual B.E.P. (in Qty.) of Product 1 + Individual B.E.P. (in
Qty.) of Product 2 +………+ Individual B.E.P. (in Qty.) of Product N

Illustration: 9
The budgeted income statement by product lines on Multi Products Ltd. for 2014 is as follows:
Product A Product B Product C
Sales Rs 200,000 Rs 500,000 Rs 300,000
Variable Expenses:
Cost of goods sold 90,000 270,000 150,000
Selling 30,000 90,000 45,000
Fixed Expenses:
Selling 36,000 90,000 54,000
Administrative 16,000 40,000 24,000
Income before tax 28,000 10,000 27,000
Income tax @ 40% 11,200 4,000 10,800
Net Income 16,800 6,000 16,200
All products are manufactured in the same facilities under common administrative control. Fixed
expenses are allocated among the products in proportion of their budgeted sales volume.
Required:
(a) Compute the budgeted breakeven point of the company as a whole from the data provided.
(b) What would be the effect on Budgeted Income if half of the budgeted sales volume of product B
were shifted to product A and C in equal rupee amounts, so that the total budgeted sales in
rupees remain the same.
(c) What would be the effect of the shift in the product mix suggested in (b) above on the budgeted
breakeven point of the whole company?
Solution
(a) Calculation of Budgeted BEP for the company as a whole
! 3 1 )
Overall P/V Ratio = x 100
$" 3 4" 1 )
.','''7','''7','''
= x 100
,''','''
= 32.5%
(") ,'''7','''7.,'''
Overall BEP = + = = Rs 800,000
5#" .%
,
(b) Statement showing the effect on Budgeted Income if half the sales of Product B is shifted
equally to Products A and C.
Particulars Product A Product B Product C Total
Rs. Rs. Rs. Rs.
Sales (A) 325,000 250,000 425,000 1,000,000
Cost of goods sold 146,250 135,000 212,500 493,750

Selling Expenses 48,750 45,000 63,750 157,500

Fixed Expenses @ 18% 58,500 45,000 76,500 180,000
Administrative @ 8% 26,000 20,000 34,000 80,000
Total Cost (B) 279,500 245,000 386,750 911,250
Income Before Tax (A-B) 45,500 5,000 36,250 88,750
Less: Tax 18,200 2,000 15,300 35,500
Net Income 27,300 3,000 22,950 53,250
The original income is Rs 39,000 hence, the income will increase by Rs 14,250 as a result of the
proposed change.
(c) Effect of shift in the product mix on Budgeted BEP.

!
Overall P/V Ratio = x 100
$"
','''7','''7.,'
= x 100 = 34.875%
,''','''
(") ','''

Overall BEP = + x 100 = x 100 = Rs 745,520
5#" .. %
,
Thus, breakeven point will stand reduced to sales of Rs 745,520 from Rs 800,000 as a result of
shift in the total production mix.
8.4.5 Break-even Chart

The break-even chart is a graphical representation of cost-volume profit relationship. It depicts the
following:
1. The profitability of undertaking at different levels of output.
2. The point at which neither profit is made nor loss is incurred. This is known as break-even point.
3. The relationship between marginal cost, fixed expenses and the contribution.
4. The margin of safety represents the difference between the total sales value and the sales value at
the break-even point.
General conclusions from Break-even Chart

1. The location of the BEP is determined by the magnitude of fixed costs.
2. The location of BEP measures the margin of safety of the business.
3. The magnitude of the angle of incidence is determined by the magnitude of the variable cost and
hence the need to control the variable costs. This will help to maintain the rate at which profit
grows.
4. For assessing the efficiency and stability of the business, both the location of BEP and angle of
incidence has to be studied.
5. Fixed costs play a dominant role in the profit structure and hence business with low fixed costs
can weather a slump more successfully than those with large fixed costs.

Construction of Break-even Chart: A break-even chart has two sides viz., X – axis and Y-axis. It is
constructed on a graph sheet after selecting a suitable scale. On the Y-axis it is usual to show the costs
and revenues. On the X-axis it is shown: (i) Sales value either – in units or in value or in percentage
capacity. (ii) Production volume either – in units or in value or in percentage capacity.
From the data given, first the fixed expenses line parallel to X-axis (horizontal axis) is drawn. Then the
variable expenses line from the point which represents the fixed expenses on the Y-axis is drawn. This
line also represents total cost. Then the sales value line starting from the point of origin (zero) and ending
at the maximum point of sales is drawn. The point at which the total cost line intersects the sales value
line is the break-even point.
Illustration: 10
Output units 10,000 20,000 30,000 40,000
Fixed expenses Rs. 5,000 5,000 5,000 5,000
Variable expenses Rs. 8,000 16,000 24,000 32,000
Sales Rs. 10,000 20,000 30,000 40,000
Find the break-even point both by calculation and by drawing a break-even chart.
Solution
Break-even point by calculation:
Rs.
Selling price 1.00 per unit
Less: Variable cost 0.80 per unit
Contribution 0.20 per unit
P/V ratio = (C/S) x 100 = (Re. 0.20/Re.1.00) x 100 = 20%
( .,'''
Sales at BEP = + = x 100 = Rs. 25,000
'
,
( .,'''
Sales units at BEP = = = 25,000 units
! *" ".'.'
Graphical solution is as follows:

CHAPER 8 : COST CONCEPTS FOR DECISION
CISION MAKING
The graphical solution shown in above chart can be redrawn in such a way so as to show that below the
break-even point the entire fixed expenses are not absorbed, by the sales. This is done by drawing another
variable expense line starting from the point of origin. The loss area shows the value of fixed expenses
not recovered by the sales volume less than break-even
even point volume. As may be seen from the graph, till
the firm reaches break-even
even point, the fixed expenses are gradually recovered. At the BEP all the fixed
expenses are fully recovered and over and above this point the firm starts making profit.
Limitation of break-even chart

1. The variable cost line need not necessarily be a straight line because of the possibility of
operation of law of increasing returns or law of decreasing returns.
2. Similarly, the selling price will not be a constant factor. Any increase or decrease in output is
likely to have an influence on the selling price.
3. When a number of products are produced separate break break-even charts will have to be calculated.
This poses a problem of apportionment of fixed expenses to each product.
4. Break-even charts ignore the capital employed
mployed in business which is one of the important guiding
factors in the determination of profitability.
Uses of Break-even chart:

The break-even
even chart can be used to show the effect or changes in any of the profit factors, namely:
(a) Changes in the volume of sales,
(b) Changes in the variable expenses,
(c) Changes in the fixed expenses,
(d) Changes in the selling price.
8.4.6 Margin of Safety

The margin of safety represents the difference between the sales at break
break-even point and the total sales. It
can be expressed as a percentage as well as in value.

i) First Formula:
Margin of Safety + Breakeven Sales = Total Sales
i.e. Margin of Safety = Total Sales – Breakeven Sales
ii) Second Formula:

Profit = Margin of Safety X P/V Ratio
i.e. Margin of Safety = Profit ÷ P/V ratio
The size of the margin of safety shows the strength of the business. If the margin of safety is small, it may
indicate that the firm has large fixed expenses and is more vulnerable to changes in sales. In other words,
if the margin of safety is large, a slight fall in sales may not affect the business very much but if it is small
even a slight fall in sales may adversely affect the business.
Taking the figures given in above illustration, it can be observed that the margin of safety is Rs. 15,000
that is 40,000 units less 25,000 units required to break even, valued at the selling price of Re.1. The
margin of safety can also be calculated as under:
1 3 8 $"
or Profit ÷ P/V ratio.
!
.,''' .','''
= = Rs. 15,000
,.,'''
Margin of safety in terms of percentages can be calculated by using the following formula:
9 2 3 3": !" " ; .,'''

= x 100 = x 100 or 37.5% of sales.
" .','''
The possible steps to improve the margin of safety are:

1. Increase in the selling price. Provided the demand is inelastic so as to absorb the increased
prices.
2. Reduction in fixed expenses.
3. Reduction in variable expenses.
4. Increasing the sales volume provided capacity is available.
5. Substitution or introduction of a product mixes such that more profitable lines are introduced.
Illustration: 11
Titan Engineering is operating at 70 percent capacity and presents the following information;
Break-even point Rs. 200 crores
P/V ratio 40 percent
Margin of safety Rs. 50 crores
Titan's management has decided to increase capacity level to 95 percent with the following
modifications:
(i) The selling price will be reduced by 8 percent.
(ii) The variable cost will be reduced by 5 percent on sales.
(iii) The fixed cost will increase by Rs. 20 crores, including depreciation on additions, but
excluding interest on additional capacity.
(iv) Additional capital of Rs. 50 crores will be needed for capital for capital expenditure and
working capital.

Required:
A. Indicate the sales figure, with the working, that will be needed to earn Rs. 10 crores over and above
the present profit and also meet 20 percent interest on the additional capital.
B. What will be the revised?

i. Break-even point
ii. P/V Ratio
iii. Margin of safety
Solution
Present sales and profit
Total sales = Break-even sales + margin of safety
= Rs. 200 crores + Rs. 50 crores = Rs. 250 crores
P/V Ratio = 40 %
Variable cost = 60 % sales = Rs. 250 crores x 60 % = Rs. 150 crores
Fixed cost = Break-even sales x P/V Ratio
= Rs. 200 crores x 40% = Rs. 80 crores
Total cost = Rs. 150 crores + Rs. 80 crores = Rs. 230 crores
Profit = Total sales – Total cost
= Rs. 250 crores – Rs. 230 crores = Rs. 20 crores.
(A) Revised sales Rs. in crores

Present fixed cost 80
Increase in fixed cost 20
Interest 20% on additional
capital (Rs. 50 crores x 20%) 10
Total revised fixed cost 110
Assuming that the present selling price is Rs. 100 Rs.

Revised selling price will be 8 % less 92.00
New variable cost ( reduced from 60% to 55% of sales 50.60
Contribution 41.40
New P/V ratio =(41.40/92.00) x100 = 45 %
Revised required sales = (Revised fixed cost + expected profit)/ P/V Ratio
= (Rs. 110 crores + Rs. 30 crores)/ 45% = Rs. 311.11 crores

(B)
(i) Revised break-even point = fixed cost/sales P/V Ratio = Rs.110 crores/45%
=Rs. 244.44 crores.
(ii) Revised P/V Ratio = 45 %
(iii) Revised margin of safety = Revised sales – Revised break-even sales.
= Rs. 311.11 crores – Rs. 244.44 crores
=Rs. 66.67 crores
Illustration: 12
SV Ltd, a multi-product company, furnishes you the following data relating to the year 2007:
First half of the year Second half of the year
Sales Rs. 45,000 Rs. 50,000
Total cost Rs. 40,000 Rs. 43,000
Assuming that there is no change in prices and variable costs and that the fixed expenses are incurred
equally in the two half year periods, calculate for the year 2007:
(i) The profit volume ratio
(ii) Fixed expenses
(iii) Break-even sales
(iv) Percentage of margin of safety.
Solution
(a)
Position of sales and total costs of SV Ltd for 2007
Sales (Rs.) Total costs (Rs.)
Second half 50,000 43,000
First half 45,000 40,000
Difference 5,000 3,000
(i)
The difference in cost represents variable costs; hence contribution on sale of Rs. 5,000 is Rs. 2,000, i.e.
increase in sales minus the increase in total cost.
Therefore, P/V Ratio is 2,000/5,000 x 100 = 40%
(ii)
On the basis of figure relating to the first half of the year:
Sales Rs. 45,000
P/V Ratio = 40%
Contribution: 45,000 x 40/100 Rs. 18,000
Profit ( i.e. Rs. 45,000- 40,000) Rs. 5,000
Fixed expenses for half year Rs. 13,000

Fixed expenses for the whole year: Rs. 26,000
(iii)
Break-even sales = Fixed cost/ P/V Ratio x 100 = Rs. 65,000
(iv)
Total sales for the whole year: Rs.
(50,000 + 45,000) 95,000
Break-even sales 65,000
Margin of safety 30,000
% of margin of safety = 30,000/95,000 x100 = 31.58 %
Angle of incidence: This is the angle at which the sales line cuts the total cost line. Management’s aim
will be to have as large an angle of incidence as possible because a large angle of incidence shows a high
rate of profit. A narrow angle would show that even fixed overheads are absorbed and profit accrues at a
relatively low rate of return, indicating that variable costs form a large part of cost of sales.
8.4.7 Desired or Target Profit

Sometimes, management faces two decisions: (i) to increase sales volume through reduction in selling
prices, and (ii) to increase selling prices in case the P/V ratio is low, with the expectation that a higher
profit will be earned. These decisions should be taken carefully after studying the profit pattern and other
factors; otherwise the result can be harmful particularly for those companies whose P/V ratios are already
low. Also, if reduction in selling prices does not increase the sales volume, the price reduction will result
only in lower profits. Price cuts, like increase in variable unit costs, decrease the contribution margin. On
a unit basis, price decreases may appear to be insignificant, but when the unit differential is multiplied by
thousands of units, the total effect may be significant. Perhaps, many more units will have to be sold to
make up the loss in profit or to earn a target profit.
Assume Company A hopes to increase its profits by selling more units, and sell more, it plans to reduce
its prices by 10%. The present price and cost structure and the desired one is given below:
Present price and cost Rs. Desired price and cost Rs.
Selling price 50 45
Variable cost 25 25
Contribution margin 25 20
Contribution margin % 50% 44.4%

At present, the contribution margin being 50%, Company A will break-even when sales are twice the
fixed costs. This means that if fixed costs are 100,000, 4,000 units must be sold to earn revenue of Rs.
200,000. But when the price is reduced to recover Rs. 100,000 in fixed costs, sales revenue must amount
to Rs. 225,000. Not only must the revenue be higher but with a lower price per unit, more units must be
sold to obtain that revenue; 5,000 units must be sold just to break even. To overcome the effect of the cut
in price, sales volume in physical units must be increased by 25%.
5,000 units to be sold at a lower price to break-even

4,000 units to be sold at present price to break-even
1,000 increase in number of units = 1,000/4,000 = 25%
And, sales revenue must be increased by 12.5% as follows:

Rs. 225,000 sales revenue at new break-even point
Rs.200,000 sales revenue at present break-even point
Rs. 25,000 increase in sales revenue = Rs. 25,000/Rs. 200,000 = 12.5%
The increase in sales volume required to overcome the effect of a price reduction is relatively greater
when the rate of the contribution margin per unit is relatively low. If a product makes only a small
contribution, then a reduction in selling price makes it all the more difficult to recover the fixed costs and
to earn profits.
Similarly, a business firm may think of increasing the selling price if the P/V ratio is low. However,
increase in selling price may reduce the sales volume.
Suppose a company has the following present and proposed costs and selling price structure:
Present Proposed
Selling price per unit Rs. 100 Rs. 120
Variable cost per unit 70 70
Contribution per unit 30 50
P/V ratio 30% 41.67%
Increase in contribution - 20
Decrease in the present sales volume without effecting the present = 20/50 = 40%
If there is a 20% increase in the selling price, the sales volume should not decline by more than 40%, if
decline in sales volume is less than 40% the profit position would be improved. Thus any company with a
P/V ratio of 30% can raise its selling price by 20% and absorbed a 40% reduction in sales volume without
reduction in net income regardless of the amount of fixed costs involved.
8.5 KEY FACTOR / LIMITING FACTOR
Under the marginal costing, profitability is ascertained as aggregate of contribution from all products
sold. With an objective to maximize profit those products which yield highest contribution are sold in
maximum quantities. It is generally assumed that there will be no limitation which may create restriction
in increasing quantities of one or more products. But in practice, there may be number of factors which
may create limitations. These may be shortage of material, labor, plant capacity or sales. These are called
key factors or limiting factors.
Contribution per unit of key factor must be considered to decide upon the priority of products to be
produced and sold. To decide upon the priority of products, the following basis may be used:

Limiting Factors Basis for deciding upon the priority of products

(a) Maximum Sales (in units) Contribution per unit
(b) Maximum Sales (in value) P/V Ratio
(c) Raw Material Contribution per unit of raw material required to
produce one unit of a product
(d) Labour Hour Contribution per unit of labour hour required to
(e) Machine Hour Contribution per unit of machine hour required to
(f) If there is heavy demand for the product P/V Ratio
(g) If there is low demand for the product Low BEP
Thus where a business produces a variety of products, the objective should be to produce and sell a mix
of products which gives the greatest contribution per unit of the limiting factor or key factor. For the
purpose of maximizing profits the products should be listed in order of their respective contributions per
unit of the limited factor. With the priorities thus established, the resources should first be applied to
producing and selling the utmost volume of products with the highest unit contribution, and then to the
product with the next highest contribution and so on until the capacity of plant is exhausted.
Illustration: 13
The following particulars are extracted from the record of a company.
Per unit
Product A Product B
Sales Rs. 100 Rs. 120
Consumption of Materials 2 kg 3 kg
Materials Cost Rs. 10 Rs. 15
Direct Wages Cost Rs. 15 Rs. 10
Direct Expenses Rs. 5 Rs. 6
Machine hours used 3 hours 2 hours
Overhead Expenses:
Fixed Rs. 5 Rs. 10
Variable Rs. 15 Rs. 20
Direct wages per hour is Rs. 5. Comment on profitability of each product (both use the same raw
material) when:
i. Total sales potential in units is limited.
ii. Total sales potential in value is limited.
iii. Raw material is in short supply.
iv. Production capacity (in term of machine hours) is the limiting factor.

Solution
Statement Showing contribution and P/V Ratio
Per unit
Product A Product B
(Rs.) (Rs.)
Sales (a) 100 120
Materials 10 15
Direct Wages 15 10
Direct Expenses 5 6
Variable Overhead 15 20
Total marginal cost (b) 45 51
Contribution per unit (a) – (b) 55 69
Contribution per kg of material (contribution ÷ kg) 27.5 23
Contribution per machine hour (Contribution ÷ hours) 18.33 34.50
P/V Ratio [( C x 100)/S] 55% 57.5%
On the basis of key factor technique, profitability of each product will be determined on the basis of per
unit limiting factor. If contribution per unit of limiting factor is higher, the product is more profitable.
When material is key factor, per kg raw material is more in A product (Rs.55 ÷ 2 kg). Similarly when
machine hour is key factor per hour contribution is more in product B (Rs. 69 ÷ 2 hours).
If sale potential is limited, the more profitable product is that whose per unit contribution is more i.e.
product B. But when total sales value is a key factor the profitable product will be that which shows
higher P/V ratio i.e. product B.
Limiting Factor Ranking a product Ranking based on

First Second
i. Sales B A Per unit contribution
ii. Sales value B A P/V ratio
iii. Raw Material A B Contribution per kg of material
iv. Production capacity B A Contribution per machine hour
Illustration: 14
Panchwati Cement Ltd. produces ‘43 grade’ cement for which the company has an assured market. The
output for 2004 has been budgeted at 1,80,000 units at 90% capacity utilization. The cost sheet based on
output (per unit) is as follows:
Rs.
Selling price 130
Direct material 30
Component ‘EH’ 9.40
Direct wages @ Rs. 7 per hour 28
Factory overhead (50% fixed)` 24
Selling and distribution overheads (75% variable) 16
Administrative overhead (fixed) 5

The factory overheads are applied on the basis of direct labor hours.
To utilize the idle capacity and to improve the profitability of the company, the following
Proposals were put up before the Board of Directors for consideration:
(i) An order has been received from abroad for 500 units of product ’53 grade’ cement
per month at Rs. 175 per unit. The cost data are:
Direct material Rs. 56 per unit, direct labor 10 hours per unit, selling and
distribution overhead applicable to this product order is Rs. 14 per unit and variable
factory overhead are chargeable on the basis of direct labor hours.
(ii) The company at present manufactures component ‘EH’, one unit of which is
required for each unit of product ‘43 grade’. The cost details for 15,000 units of
component ‘EH’ are as follows:
Rs.
Direct labor 52,500
Variable overheads 25,500
Fixed overheads 33,000
Total 1,41,000
The component ‘EH’ however is available for purchase at the market at Rs. 7.90 per unit.
(iii) In the event of company deciding to purchase the component ‘EH’ from market, the company has two
alternatives for the use of the capacity so released, which are as under:
(a) Rent out the released capacity at Re. 1 per hour.
(b) Manufacture component ‘GYP’ which can be sold at Rs. 8 per unit. The cost
data of this component for 15,000 units are:
Rs.
Direct labor 31,500
Factory variable overheads 13,500
Other variable overheads 25,500
Total 1,12,500
Required:
(i) Prepare a statement showing profitability of the company envisaged in the budget.
(ii) Evaluate the export order and state whether it is acceptable or not.
(iii) Make an appraisal of proposal to manufacture component ‘EH’ and state whether the component
‘EH’ should be manufactured in the factory or purchased from the market. Assume that no alternative use
of spare capacity is available.

(iv) Evaluate the alternative use of the spare capacity and state whether to manufacture or buy the
component ‘EH’ and if your decision is to buy the component ‘EH’, which of the two alternatives for the
use of spare capacity will you prefer?
Solution
(i) Profitability as per original Budget
Rs (‘000s) Rs(‘000s)
Sales(1,80,000 units x Rs 130) (A) 23,400
Direct Material (1,80,000 units x Rs 30) 5,400
Component ‘EH’ ( variable cost = Rs 7.20 per unit) 1,296
Direct wages (1,80,000 units x Rs 28) 5,040
Variable factory overheads (1,80,000 units x Rs 24 x
50% ) 2,160
Variable selling & distribution (1,80,000 units x Rs 16
x 75% ) 2,160
Fixed factory overheads 2,160
Total variable cost (B) 16,056
Contribution (A – B) 7,344
Fixed selling & distribution overheads 720
Component ‘EH’ @2.20(Fixed cost per unit) 396
Fixed administrative overhead 900 4,176
Profit 3,168
(ii) Export order

Particular Rs per Unit
Direct material 56
Direct labor (10 hours x Rs 7 per hour) 70
Variable factory overhead ( Rs 3 x 10 labor hours) 30
Selling and distribution overheads 14
Total variable cost 170
Selling price (export) 175
Contribution 5
Since the product earns contribution of Rs.5 per unit, it should be accepted.

Total units 500(per month) = 6000 units (per annum)

Therefore additional contribution (6000 units x Rs 5) = Rs.30,000
Calculation of Excess Labour hours
Particular
hours
Total hours on product ‘43 grade’ (1,80,000 units x 4) = 7,20,000 Hrs
Total hours on component ‘EH’ (1,80,000 units x 0.5*) =90,000 Hrs
Total hours utilized at 90% capacity = 7,20,000 hours + 90,000 hours = 8,10,000 hours
100% capacity hours = (8,10,000 hours x 100)/90 = 9,00,000 Hrs
Balance hours available = 90,000 hours p.a
Hours required for export order =60,000 hours.
Both contribution per unit of export order and availability of capacity confirm its acceptance.
*Direct Labor cost/ (No of units produced x Labor rate per hour )
= Rs 52,500/(15,000 units x Rs 7 per hour) = 0.5 Hrs
(iii) Component ‘EH’ make or buy

(Per 15,000 units) make (Rs.) buy(Rs.)
Direct material 30,000
Direct labor 52,500
Variable factory overhead 25,500
Total 1,08,000 1,18,500
Per unit 7.20 7.90
If the company makes the component the out of pocket cost is Rs.7.20 per unit whereas if the component
is bought , the out of pocket cost is Rs.7.90.
Decision : If the capacity remains idle it is profitable to make.
(iv) Alternative use of the spare capacity

Units required = 1,80,000 units and hours required = 1,80,000 0 .5 = 90,000 Hrs
Cost of buying component ‘EH’ = (1,80,000 units x Rs 7.90) =Rs 14,22,000
Cost of making component ‘EH’ = (1,80,000 units x Rs 7.20) = Rs 12,96,000
Hence , excess cost of buying = Rs.1,26,000

Rent income (90,000 hours x Re1)= Rs.90,000

Contribution per unit from making component ‘GYP’ = Rs 8 – (Rs 1,12,500/ 15,000 Units) = Rs 0.5 per
unit.
Direct labor cost per unit of ‘GYP’ = Rs 31,500 / 15,000 Units = Rs. 2.10 per unit.
No. of labor hours required for one unit of ‘GYP’ = Rs 2.10/ Rs 7 = = 0.3 Hrs
No. of units of ‘GYP’ in 90,000 hours = 90,000 hours / 0.3 hours = 3,00,000
Contribution from component ‘GYP’ = 3,00,000 x Rs 0.50 = Rs 1,50,000
Since the contribution from ‘GYP’ is greater than the extra variable cost of buying component ‘EH’,
component ‘GYP’ should be manufactured and component ‘EH’ should be purchased.
Illustration: 15
The annual fixed cost of Perfect Piston Ltd is Rs. 15 lakhs and it is currently operating at 60% capacity of
100,000 piston. Selling price of the piston is Rs 200 and variable cost of the pistion is Rs 180
The company desires to respond to an export enquiry for 30,000 pistons of the type of it is currently
manufacturing. The Company's aim is to improve capacity utilization and avoid loss.
You have to take note of the following benefits that will accurate to the export transactions while
determining the F.O.B price to be quoted.
(i) Export incentive by way of cash assistance at 10% of F.O.B. value of exports.
(ii) Reimbursement of excise duty on manufacturing inputs by way of 5% drawback of duty on
F.O.B. value of exports.
(iii) Entitlement of import license to the extent of 10% on F.O.B. value of exports. The import
license can either be sold at a premium of 100% or it can be utilized to import certain
critical auto components that will yield a 30% profit on cost.
Recommend the bare minimum price that the company should quote, in order to breakeven, assuming:
(a) it sells the import license in the market.
(b) it imports components against the license and sells them for profit.
Solution
Working note:
Perfect Piston Ltd.'s present operating results:
Contribution per piston =Selling price – Variable cost = Rs. 200 –Rs. 180 = Rs. 20
Total contribution ( 60,000 piston x Rs. 20) Rs. 12 lakhs
Less: Annual fixed costs Rs. 15 lakhs
Loss Rs. 3 lakhs
The increase in capacity utilization and the resultant export sales enable recovery this loss.

(a) Determination of bare minimum price to break-even when import license is sold in the
market
Rs.
Variable cost per piston 180
Add: Amount per piston towards recovering the present loss
(Rs.300,000.30,000 piston) 10
Cost per piston 190
Less: Realization through export benefits:
Cash assistance: 10% on FOB
Drawback of duty: 5% on FOB
Premium on license: 10% on FOB
25% on FOB
i;e; 20% of the cost per piston of Rs. 190 38
Bare minimum FOB price to be quoted 152
(b)
Determination of bare minimum price to break-even when import license is used to import auto
components and sell them for profit
Rs.
Cost per piston, as above 190
Less: export benefits:
Cash assistance: 10% on FOB
Drawback of duty: 5% on FOB
Profit on sale of import: 3% on FOB
18% on FOB
i;e; 15.25% of the cost per piston: Rs. 190 x15.25% 28.98
Bare minimum FOB price to be quoted 161.02
Illustration: 16
Bibek Ltd. operating at 75% level of activity produces and sells two products A & B. The cost sheets of
these two products are as under:
Product A Product B
Unit produced and sold 600 400
Rs. Rs.
Direct materials 2 4
Direct labor 4 4
Factory overheads (40% fixed) 5 3
Selling and administration overheads (60% fixed) 8 5
Total cost per unit 19 16
Selling price per unit 23 19

Factory overheads are absorbed on the basis of machine hour, which is the limiting (key) factor. The
machine hour rate is Rs. 2 per hour.
The company receives an offer from Canada for the purchase of product A at a price or Rs. 17.50 per
unit.
Alternatively, the company has another offer from the Middle East for the purchase of product B at a
price of Rs. 15.50 per unit.
In both the cases, a special packing charge of fifty paisa per unit has to be borne by the company.
The company can accept either of the two export orders and in either the company can supply such
quantities as may be possible to produce by utilizing the balance of 25% of its capacity.

(i) A statement showing the economic of the two export proposals giving your
recommendations as to which proposal should be accepted, and
(ii) A statement showing the overall profitability of the company after incorporating the export
proposal recommended by you.
Solution
(i) Economics of the two Export Proposals
Order from Canada for Order from
Product A Middle East for
Product B
Marginal cost per unit:
Materials 2.00 4.00
Labor 4.00 4.00
Variable Factory Overheads 3.00 1.80
Variable selling and distribution overheads 3.20 2.00
Special packing charges 0.50 0.50
Total variable cost 12.70 12.30
Export price per unit 17.50 15.50
Contribution per unit 4.80 3.20
Since machine hour is the limiting (key) factor, the contribution should be linked with the machine hours.
This has been worked out as follows:
Order from Canada for Order from
Product A Middle East for
Product B
Machine hours per unit 2.5 hours 1.5 hours

Contribution per machine hour Rs. 1.92 Rs. 2.13

Product B yields a better contribution per machine hour. The order from the Middle East should therefore
be accepted as compared to the Canadian offer.
Working Notes:
A B Total
Factory overheads per unit Rs.5 Rs.3
Machine hour rate per hour Rs2 Rs2
Machine hour per unit 2.5 1.5
Unit produced 600 400
Machine hour utilized 1,500 600 2,100
Level of activity 75%
Minimum hours at 100% activity = 2,100/75 x 100 = 2,800 hours.
Capacity hours available for export 2,800 – 2,100 = 700 hours.
(ii) Statement of overall profitability

Product A Product B Total
Units 600 867
Rs. Rs.
Materials 1,200 3,468 4,668
Labor 2,400 3,468 5,868
Variable Factory Overheads 1,800 1,561 3,361
Fixed Factory Overheads 1,200 480 1,680
Variable selling and distribution overheads 1,920 1,734 3,654
Fixed selling and distribution overheads 2,880 1,200 4,080
Special packing charges - 234 234
Total cost 11,400 12,145 23,545
Sales 13,800 14,839 28,639
Profit 2,400 2,694 5,094
Working Notes:
1. Number of units of B
Sales in the home market 400
Export market 467
Total 867

2 Sales value of B:
400 units in home market @ Rs.19 Rs. 7,600
467 units for export @ Rs. 15.50 Rs. 7,239
Total Rs14,839
8.6 COST INDIFFERENCE POINT

Cost indifference point refers to that level of activity at which the total cost (i.e. fixed cost + Variable
Cost) of the two alternatives is the same. Management is indifferent as to the choice out of two
alternatives at this point.
i.e. Variable Cost + Fixed Cost of Product A = Variable Cost + Fixed Cost of Product B
Formulae:
<=8>? @ABC DE?>F GHC>FEIC=J> <=8>? @ABC DE?>F GHC>FEIC=J>
Cost Indifference Point =
KIF=ILH> MABC N>F DE=C DE?>F GHC>FEIC=J> KIF=ILH> MABC N>F DE=C DE?>F GHC>FEIC=J>
Interpretation
Activity Level Alternative to be Chosen
Below Indifference Point Alternative with Lower Fixed Costs
Above Indifference Point Alternative with Lower Variable Costs
Equal to Indifference Point Any Alternative
Illustration: 17
Samundra Group Ltd. has the choice of buying Machine X or Machine Y or Machine Z. Following are
the cost details:
Machine X Machine Y Machine Z
Fixed Cost Rs 300,000 Rs 580,000 Rs 1,000,000
Variable Cost Rs 140 Rs 70 Rs 40
Required:
(a) Compute the Cost Indifference Points for each of the pair of machines.
(b) What do the Cost Indifference Point suggest as a course of action in this regard?
(c) If the management expects to produce 8700 units, which machine would be most economical.
Solution
(a) Cost Indifference Point =
<=8>? @ABC DE?>F GHC>FEIC=J> <=8>? @ABC DE?>F GHC>FEIC=J>
KIF=ILH> MABC N>F DE=C DE?>F GHC>FEIC=J> KIF=ILH> MABC N>F DE=C DE?>F GHC>FEIC=J>
OB .','''OB '','''
CIP between Machine X and Machine Y = = 4000 units
OB ''
OB ,''','''OB .','''
CIP between Machine Y and Machine Z = = 14000 units
OB ''
OB ,''','''OB '','''
CIP between Machine X and Machine Z = = 7000 units
OB ''
(b) Interpretation of Cost Indifference Point

From 0 to 4000 units: Machine X

From 4001 to 14000 units: Machine Y

Above 14000 units: Machine Z
(c) For 8700 units, Machine Y would be most economical.
8.7 MARGINAL COSTING AND DIFFERENTIAL COSTING
Differential cost is the change in the costs which may take place due to increase or decrease in output,
change in sales volume, alternate method of production, make or buy decisions, change in product mix
etc. So, differential cost is the result of an alternative course of action. For example, difference in costs
may arise because of replacement of labor by machinery and difference in costs of two alternative course
of action will be differential cost. It may be remembered that differential cost may be increase or decrease
in costs. Suppose, present cost is Rs. 250,000 when the work is done by labor and the expected cost is Rs.
225,000 when the work is done by machinery. In this case differential cost will be decrease in costs Rs,
25,000 (i.e. 250,000 – 225,000) and the decision of replacement of labor by machinery should be
implemented by the firm because differential cost of Rs. 25,000 decrease in cost will increase the profits
of the firm by Rs. 25,000.
Differential costs are often taken as marginal costs or incremental costs. But this is not the case. In
differential cost analysis, costs are calculated on the basis of absorption or total costing technique, but in
marginal costing technique costs are calculated on the basis of variable costs only and fixed costs are not
taken. But if the alternate course of action does not involve any extra fixed costs, change in variable costs
will become differential costs and there will be no difference between marginal costs and differential costs.
Difference between Differential Costing and marginal Costing

Differential costs are often confused with marginal costs, so it is better to compare the two to remove the
confusion. The points of similarity and difference between the two are summarized as follows:-
Similarity
1. Both are technique of cost analysis and cost presentation.
2. Both are used for taking managerial decisions such as effect on profits by following change
in sales volume, product mix, price or method of production.
3. Marginal costs and differential costs are the same when there is no change in fixed costs on
account of increase or decrease in output.
Difference
1. Under marginal costing techniques, fixed costs are not added to get the marginal cost of a
product whereas differential cost analysis takes into consideration changes in fixed costs due to
change in output.
2. Differential costing is helpful in taking the managerial decisions and is not incorporated in
accounting records. In other words, differential costs are calculated separately as analysis
statement. On the other hand, marginal costs may be incorporated in the accounting records.
3. Marginal costs are calculated on the basis of contribution approach where as differential costs
may be ascertained on the basis of both absorption costing as well as marginal costing.
4. In marginal costing, contribution margin, contribution per unit of limiting factor and profit-
volume ratio are the main yardsticks for evaluating the managerial decisions whereas in
differential cost analysis, differential costs are compared with the incremental or decrement
revenues to determine whether alternative course of action should be followed or not.

Practical application of Differential Cost Analysis

Differential cost analysis is usually made for facilitating managerial decisions of the following types: -
1. Whether or not price should be reduced for increased level of sales.
2. Whether or not factory should operate at full capacity.
3. Whether a change in production should be followed.
4. Determination of the most profitable levels of production.
5. Whether to make or buy a spare part.
6. Whether a new product should be introduced or not.
7. Whether a particular market should be tapped or not.
8. Whether a product should be discontinued to avoid the present loss.
9. Whether or not an investment in a particular asset will be worthwhile.
Illustration: 18
Modern Sewing Machines Company manufactures hand operated sewing machines. Prepare a schedule
showing the differential costs and increments in revenue at each state from the following data. At what
volume the company should set its level of production?
Output Selling price per Total Semi-fixed Total variable Total Fixed Cost
(No. in lakhs) machine (Rs.) Cost (Rs. In lakh) Cost (Rs. In lakh) (Rs. In lakh)
0.60 240 30 83.6 28.4
1.20 220 30 163.6 28.4
1.80 200 34 255.6 28.4
2.40 180 34 315.6 28.4
3.00 160 40 355.6 28.4
3.60 140 40 380.6 28.4
Solution
Schedule showing the differential costs and incremental revenues
Output Selling Sales Incremental Semi- Variable Fixed Total Differential
(No. in price per value Revenue fixed Cost (Rs. Cost Cost Cost (Rs.
lakh) machine (Rs. In (Rs. In Cost In lakh) (Rs. In (Rs. In In lakh)
(Rs.) lakh) lakh) (Rs. In lakh) lakh)
lakh)
0.60 240 144 - 30 83.6 28.4 142 -
1.20 220 264 120 30 163.6 28.4 222 80
1.80 200 360 96 34 255.6 28.4 318 96
2.40 180 432 72 34 315.6 28.4 378 60
3.00 160 480 48 40 355.6 28.4 424 46
3.60 140 504 24 40 380.6 28.4 449 25
It is in the interest of a firm to increase the output so long as incremental revenue exceeds differential
costs. But if the differential cost is more than the incremental revenue, it is not advisable to increase the
output because it will reduce the profitability. The company should set its level of output at 3.0 lakh units
because up to this level incremental revenue exceeds differential cost.

Illustration: 19
Assuming that the rated capacity of the factory is 50,000 units, what should be the most profitable level of
output?
Output up to 25,000 Output up to 40,000 Output up to 50,000
units units units
Rs. Rs. Rs.
Fixed cost 25,000 35,000 40,000
Variable cost per unit 2 2 1.90
Sales revenue per unit 4 3.50 3.20
Solution
The most profitable level of output can be determined by comparing incremental revenue and differential
costs as follows: -
Level of Selling Total Variable Fixed Total cost Incremental Differential
output price per sales cost (Rs.) cost (Rs.) (Rs.) revenue cost
(units) unit (Rs.) value (Rs.) (Rs.)
(Rs.)
25,000 4.00 100,000 50,000 25,000 75,000 - -
40,000 3.50 140,000 80,000 35,000 115,000 40,000 40,000
(140,000 – (115,000 –
100,000) 75,000)
50,000 3.20 160,000 95,000 40,000 135,000 20,000 20,000
(160,000 - (135,000 -
140,000) 115,000)
Incremental revenue and differential costs are equal at 40,000 and 50,000 units of outputs, so it is not
advisable to increase the output to these levels as there will be no addition to profits. Thus, it is advisable
to restrict the output to 25,000 units as it will give a profit of Rs. 25,000 (i.e. total sales value Rs. 100,000
– total cost Rs. 75,000)
8.8 MARGINAL COSTING AND ABSORPTION COSTING

Under absorption costing, fixed factory overheads (and also office and administrative expenses if the firm
treats them as part of production costs) are added to the cost of production and the value of closing stock
is determined accordingly. But if marginal costing is adopted, the value of closing stock will consist only
of variable expenses and no part of fixed expenses will be included. There will be no effect on profits if
the whole of the output is sold but if part of remains unsold, profit under marginal costing will be lower
than under absorption costing. The reversal will be the case if opening stock exceeds closing stock.
The difference between Marginal Costing and Absorption Costing can be narrated as below:
1. Calculation of Manufacturing Overhead Rates: In absorption costing absorption rate include
both fixed and variable manufacturing overhead. In marginal costing rates include only variable
manufacturing overhead.
2. Valuation of Inventory: In absorption costing valuation is on product cost i.e. Prime cost +
applied fixed and variable manufacturing overheads. In marginal costing it will be at prime cost
+ applied variable manufacturing overhead.

3. Classification of overhead: In absorption costing the overhead may be classified as factory,

administrative, selling and distribution. But in marginal costing overheads are classified as
variable and fixed.
4. Operating profit: Under absorption costing Gross profit = Net sales – manufacturing cost of
goods sold. Manufacturing costs = Prime cost + fixed and variable manufacturing overheads. But
in marginal costing, marginal income or contribution = net sales – variable manufacturing cost of
goods sold – variable administrative, selling and distribution overheads.
5. Net operating profit: Under absorption costing, net operating profit = gross profit –
administrative selling and distribution overheads (fixed and variable combined). Under marginal
costing net operating profit = marginal income or contribution – fixed manufacturing overhead –
fixed administrative overhead – fixed selling and distribution overhead.
6. Difference of profit: When production volume exceeds sales volume the net profit under
absorption costing will exceed marginal costing net profit. The net profit will be equal when
production volume is equal to sales volume. When production volume is less than sales volume,
absorption costing net profit will be less than marginal costing net profit.
7. Reconciliation of net profit: Net operating profit under marginal costing = net operating profit –
fixed overhead cost in closing inventory under absorption costing + Fixed overhead cost in
opening inventory under absorption costing.
8. Uses: Absorption costing is widely used for cost control purpose whereas marginal costing is
used for managerial decision-making and control.
Illustration: 20
The under mentioned costs are incurred in each of the three years, 2000, 2001,2002 when output
annually is 10,000 units.
Rs.
Materials 600,000
Labor 350,000
Variable Factory Overheads 150,000
Fixed Factory Overheads 200,000
Total 1,300,000
In 2000 only 8,000 units were sold; in 2001 sale was 10,500 units and in 2002, 11,500 units. The selling
price is uniform at Rs. 150 per unit.
Solution
The closing stocks are 2,000 units at the end of the 2,000, 1,500 units at the end of 2001 and nil at the
end of 2002.The statements showing profits or losses for the three years under the two systems will be
as follows;
Statement of Profit or Loss under Absorption Costing

2000 (Rs.) 2001 (Rs.) 2002 (Rs.)
Opening Stock @ Rs. 130 - 260,000 195,000
Cost of Goods produced 1,300,000 1,300,000 1,300,000
1,300,000 1,560,000 1,495,000

Less: Closing stock @ Rs. 130 260,000 195,000 -

Cost of Goods Sold 1,040,000 1,365,000 1,495,000
Profit 160,000 210,000 230,000
Sales 1,200,000 1,575,000 1,725,000
Statement of Profit or Loss under Marginal Costing

2000 (Rs.) 2001 (Rs.) 2002 (Rs.)
Opening Stock @ Rs. 110 - 220,000 165,000
Cost of Goods produced (variable) 1,100,000 1,100,000 1,100,000
1,100,000 1,320,000 1,265,000
Less: Closing stock @ Rs. 110 220,000 165,000 -
880,000 1,155,000 1,265,000
Add: Fixed Factory Overheads 200,000 200,000 200,000
Total 1,080,000 1,355,000 1,465,000
Profit 120,000 220,000 260,000
Sales 1,200,000 1,575,000 1,725,000
Taking the three years period, there being no opening and closing stocks, the total profit under the two
systems is the same, viz., Rs. 600,000.
From the above, we have seen that the net profits under absorption costing and marginal costing are
not the same because of the following reasons:
1. Over and Under Absorbed Overheads

In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in
forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not
written off to costing profit and loss account, the actual amount incurred is not shown in it. In
marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution
and hence, there will be some difference in net profits.
2. Difference in Stock Valuation

In marginal costing, work in progress and finished stocks are valued at marginal cost, but in
absorption costing, they are valued at total production cost. Hence, profit will differ as different
amounts of fixed overheads are considered in two accounts.
The profit difference due to difference in stock valuation is summarized as follows: -

• When there is no opening and closing stocks, there will be no difference in profit.
• When opening and closing stocks are same, there will be no difference in profit, provided the
fixed cost element in opening and closing stocks are of the same amount.
• When closing stock is more than opening stock, the profit under absorption costing will be
higher as comparatively a greater portion of fixed cost is included in closing stock and carried
over to next period.

• When closing stock is less than opening stock, the profit under absorption costing will be less as
comparatively a higher amount of fixed cost contained in opening stock is debited during the
current period.
Illustration: 21
Wonder Ltd. manufactures a single product ZEST. The following figures relate to ZEST for one-year
period.
Activity Level 50% 100%
Sales and production (units) 400 800
Rs. lakhs Rs. lakhs
Sales 8.00 16.00
Production costs:
Variable 3.20 6.40
Fixed 1.60 1.60
Selling and administration costs
Variable 1.60 3.20
Fixed 2.40 2.40
The normal level of activity for the year is 800 units. Fixed costs are incurred evenly throughout the year,
and actual fixed costs are the same as budgeted. There were no stocks of ZEST at the beginning of the
year.
In the first quarter, 220 units were produced and 160 units were sold.
Required
(a) What would be the fixed production costs absorbed by ZEST if absorption costing were
used?
(b) What would be the under/over-recovery f overheads during the period?
(c) What would be the profit using absorption costing?
(d) What would be the profit using marginal costing?
(e) Why is there a difference between the answers to (c) and (d)?
Solution
(a)
Fixed production cost absorbed Rs.
Budgeted fixed production costs 160,000
Budgeted output (normal level of activity 800 units)
Therefore, the absorption rate: 160,000/800 = Rs. 200 per unit
During the first quarter, the fixed production cost absorbed by ZEST would be
( 220 units x Rs. 200) 44,000

(b)
Under/over-recovery of overheads during the period Rs.
Actual fixed production overhead (1/4 of Rs. 160,000) 40,000
Absorbed fixed production overhead 44,000
Over-recovery of overheads 4,000
(c)
Profit for the quarter (Absorption costing) Rs. Rs.
Sales revenue (160 units x Rs.2,000) :(A) 320,000
Less: Production costs
Variable (220 units x Rs.800) 176,000
Fixed overheads absorbed (220 units x Rs.200) 44,000
Total (220 units x Rs. 1,000) 220,000
Less: closing stock ( 60 units x Rs. 1,000) 60,000
Production cost of 160 units 160,000
Variable selling and administration cost (160 units x Rs. 400) 64,000
Fixed selling and administration cost (1/4 of Rs. 240,000) 60,000
Total cost of sales of 160 units; ( B) 284,000
Unadjusted profit: (A –B) 36,000
Add overhead over absorbed 4,000
Actual profit 40,000
(d)
Profit for the quarter (Marginal costing) Rs. Rs.
Sales revenue (160 units x Rs.2,000) :(A) 320,000
Less: Production costs
Variable (220 units x Rs.800) 176,000
Less: closing stock ( 60 units x Rs. 800) 48,000
Variable Production cost of 160 units 128,000
Add:Variable selling and administration cost 64,000
Total variable cost of sales of 160 units; ( B) 192,000
Contribution (A-B) 128,000
Less: fixed production cost incurred 40,000
Fixed sell. and admn. costs incurred 60,000 100,000
Actual profit 28,000
Illustration: 22
Your company has a production capacity of 200,000 units per year. Normal capacity utilization is
reckoned as 90%. Standard variable production costs are Rs. 11 per unit. The fixed costs are Rs. 360,000

per year. Variable selling costs are Rs.3 per unit and fixed selling costs are Rs. 270,000 per year. The
unit-selling price is Rs.20. In the year just ended on 31st December 2007, the production was 160,000
units and sales were 150,000 units. The closing inventory on 31st December2007 was 20,000 units. The
actual variable production costs for the year were Rs. 35,000 higher than the standard.
(i) Calculate the profit for the year

(a) by the absorption costing method, and
(b) by the marginal costing method
(ii) Explain the difference in the profit.
Solution
Statement of profit
(Absorption Costing Method)
Production costs Rs.
Variable (160,000 x 11 = 1,760,000 + 35,000) 1,795,000
Fixed 180,000 x 2 360,000
Production cost of goods manufactured during the year 2,155,000
Less: closing stock 20,000 (2,155,000 x 20,000/160,000 269,375
1,885,625
Add: Opening Stock (10,000 x 13) 130,000
Cost of production of goods sold 2,015,625
Add: Selling overheads:
Variable (150,000 x 3) 450,000
Fixed 270,000
Cost of sales 2,735,625
Profit 264,375
Sales (150,000 x 20) 3,000,000
Opening stock has been valued at Rs. 11 per unit plus Rs. 2 for fixed cost calculated at normal
capacity.
(i) (b)
Statement of profit
(Marginal Costing Method)

Production costs Rs.

Variable (160,000 x 11 = 1,760,000 + 35,000) 1,795,000
Less: closing stock 20,000 (1,795,000 x 20,000/160,000 224,375
1,570,625
Add: Opening stock (10,000 x 11) 110,000
Add: Variable selling costs 450,000
Variable production and selling costs 2,130,625
Sales 3,000,000
Contribution (3,000,000 – 2,130,625) 869,375
Fixed costs:
Production costs 360,000
Selling costs 270,000 630,000
Profit (869,375 – 630,000) 239,375
(ii) Causes of difference in profit

Profit under absorption costing 264,375
Profit under Marginal costing 239,375 25,000
The profit under absorption costing is more than that under traditional costing on account of the following
reasons:
• Valuation of closing stock: The closing stock has been under-valued by Rs. 45,000 in case of
marginal costing.
• Valuation of opening stock: The opening stock has been under-valued by Rs. 20,000 in case of
marginal costing.
The reconciliation of profits ascertained according to the two methods can be done as follows:
Profit under absorption costing 264,375
Less: closing stock under valued in marginal costing 45,000
219,375
Add: Opening stock under valued in marginal costing 20,000
Profit under marginal costing 239,375

Limitations of Absorption Costing

The following are the criticisms against absorption costing:
You might have observed that in absorption costing, a portion of fixed cost is carried over to the
subsequent accounting period as part of closing stock. This is an 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 and vice versa.
Further, absorption costing is dependent on the levels of output which may vary from period to period,
and consequently cost per unit changes due to the existence of fixed overhead. Unless fixed overhead
rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison
and control.
The cost to produce an extra unit is variable production cost. It is realistic to the value of closing stock
items as this is a directly attributable cost. The size of total contribution varies directly with sales
volume at a constant rate per unit. For the decision-making purpose of management, better
information about expected profit is obtained from the use of variable costs and contribution approach
in the accounting system.


1. Is marginal costing and absorption costing same?
2. Distinguish between Marginal costing and Differential Costing.
3. Discuss the significance of the following terms in relation to marginal costing:
(a) Profit volume ratio
(b) Break-even point
(c) Margin of safety
(d) Angle of incidence
4. “The effect of a price reduction is always to reduce the P/V ratio to raise the break-even point and
to shorten the margin of safety.” Explain with the suitable illustration.
5. Choose the correct answer from the following multiple choice questions:
i. To obtain the bread-even point in rupees sales value, total fixed costs are divided by:
a. Variable cost per unit
b. Contribution margin per unit
c. Fixed cost per unit
d. Profit volume ratio
ii. Margin of safety is referred to as:
a. Excess of actual sales over fixed expenses
b. Excess of actual sales over variable expenses
c. Excess of actual sales over break-even sales
d. Excess of budgeted sales over fixed costs.
iii. Contribution margin is known as:
a. Marginal income
b. Gross profit
c. Net income
d. Net profit
iv. The break-even analysis may be described as:
a. Comparison between production and sales
b. Comparison to make out capacity utilization
c. Comparison between target set and actual achievement
d. Comparison between sales and costs.
v. An increase in sales price:
a. Does not affect the break-even point
b. Lowers the net profit
c. Increases the break-even point
d. Lowers the break-even point
vi. Profit under traditional costing and marginal costing system will be the same if:
a. There is no opening and closing stock
b. There is opening stock and no closing stock
c. There is closing stock and no opening stock
d. There is opening and closing stock.
vii. A decrease in sales price:
a. Does not affect the break-even point
b. Lowers the net profit

c. Increases the break-even point

d. Lowers the break-even point
viii. Fixed cost per unit decreases when:
a. Production volume increases
b. Production volume decreases
c. Variable cost per unit decreases
d. Prime cost per unit decreases
ix. Within a relevant range, the amount of variable costs per unit:
a. Differs at each production level
b. Remains constant at each production level
c. Increases as production is increases
d. Decreases as production is increases
i. Given the following notations, what is the break-even sale in rupees?
$1
a.
( /%
%
b.
$1(
(
c.
% /$1
(
d. ($1% )/$1
6. The ratio of variable cost to sales is 70%. The break-even point occurs at 60% of the capacity
sales. Find the capacity sales when the fixed costs are Rs. 90,000. Also compute profit at 75% of
the capacity sales. (Ans.: Capacity sales Rs. 500,000, Profit at 75% capacity Rs. 22,500)
7. Profit volume ratio of a company is 50%, while its margin of safety is 40%. If the sales volume of
the company is Rs. 50 lakhs, find out its break-even point and net profit. (Ans.: Break-even
sales 30 lakhs and net profit Rs. 10 lakhs)
8. X Limited has earned contribution of Rs.200,000 and net profit of Rs.150,000 on sales of Rs.
800,000. What is its margin of safety? (Ans.: Rs. 600,000)
9. If margin of safety is Rs. 240,000 (40% of sales) and P/V ratio is 30% of AB Limited, calculate its
(a) break-even sales and (b) amount of profit on sales of Rs.900,000 (Ans.: Break-even sales
Rs. 360,000, Profit Rs. 162,000)
10. B and Company has recorded following data in the two most recent periods:
Total cost of production (Rs.) Volume of Production (units)
14,600 800
19,400 1,200
What is the best estimate of the firm’s fixed costs per period? (Ans.: Rs. 5,000)

CHAPTER 9
COSTING FOR PLANNING AND CONTROL –
BUDGETS
CHAPER 9 : COST FOR PLANNING AND CONTROL - BUDGETS
9.1 BUDGETING AND BUDGETARY CONTROL SYSTEM

Budgets, by definition, have to be prepared in advance; and for this reason, they are often referred to in
terms of their being part of a feed forward system. Feedback is a term frequently heard both in accounting
and ordinary use. Feed forward, on the other hand tends to be less frequently heard, yet this word
incorporates the most important aspect of budgeting: looking at situations in advance, thinking about the
impact and implications of things in advance and attempting to take control of situations in advance.
Budgets
A budget is a plan expressed in quantitative and money terms. Budgets need to be prepared and approved
in advance of the period in which they are to be used. Budgets can include some or all of income,
expenditure, and the capital to be employed. Moreover, a budget can be drawn up for an entire
organization, any segment of the organization such as a department or sales territory or division, or for a
significant activity such as the production and sale of a specific product. We should also add that a budget
can include non monetary as well as monetary information in it.
The Institute of Cost and Management Accountants (CIMA), England defined a budget as ″A financial
and/or quantitative statement prepared and approved prior to defined period of time, of the policy to be
pursued during that period for the purpose of attaining a given objective.”
Budgetary Control
Budgets are simply exercises in calculation unless they are used. When we use a budget, we do so as part
of a system of budgetary control. That is, we have some basic ideas of what we want to do, we prepare
budgets to help us achieve those ideas; and then once we have done whatever it is that we wanted to do,
we check to see if we kept to our budget.
Budgetary control is defined by the Institute of Cost and Management Accountants (CIMA) 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".
Budgetary control thus relates to the establishment of budgets relating the responsibilities of budget
holders the needs of a policy. Budgetary control also relates to the continuous comparison of actual with
budgeted results: it does this to try to ensure that the objectives of that policy are achieved; or to provide a
basis for the change of those objectives.
In summary, a budget is a statement setting out the monetary, numerical or non quantitative aspects of an
organization’s plans for the coming week or month or year. Budgetary control is the analysis of what
happened when those plans came to be put into practice, and what the organization did or did not do to
correct for any variations from these plans.
9.2 STEPS IN BUDGETARY CONTROL

The following steps should be taken in a sound system of budgetary control:-
(i) Organization Chart:

CHAPER 9: COST FOR PLANNING AND CONTROL - BUDGETS
Before successful installation of a budgetary control, it is necessary that a concern should have a definite
plan of organization. Authority and responsibility of each executive should be clearly defined. An
organization chart for budgetary control is given as follows:
Chief Executive
Budget Officer
Sales Manager Production Purchasing Personnel Accountant
Manager Manager Manager
(Sales Budget (Cost Budget,
including (Production and (Materials (Labor Budget) master Budget)
advertising and plant utilization Budget)
selling and budget)
distribution cost)
The organization chart shows that chief executive is the head of the budgetary control system. He
delegates his authority to the budget officer who sees that all budgets are coordinated and down in time.
The other managers will prepare the budgets shown against them in the chart.
(ii) Budget Centers:
A budget center is a section of the organization of an undertaking defined for the purpose of budget
control. Budget centers should be established for cost control and all budgets should be related to cost
centers. Budget centers will disclose the sections of the organization where planned performance is not
achieved.
(iii) Budget Manual:
The Institute of Cost and Management Accountants, England defined a budget manual as “ a document
which sets out, inter alia, the responsibilities of the persons engaged in the routine of and the forms and
records required for budgetary control”. Thus it is written document which guides the executives in
preparing various budgets. Budgets are to be drawn keeping in view the objectives of this organization
given in the budget manual.
(i) Budget controller or Budget Officer:
The chief executive should appoint some person known as Budget Controller or Budget Officer who
should be given the specific duty of administering the budget. His rank should be equal to other
functional managers. As his work will deal with the preparation, co-ordination of budgets involving
figures, he will usually be a person with accountancy knowledge. He should see that the functional
managers draw the budgets in time. He is also to chase the budgets and to see that the actual performance
is going in lines with the budgeted performance and to issue timely warning when the actual performance
differs substantially. He should hold in revising the budgets if there are fundamental changes in the
circumstances after the budgets have been prepared.
(ii) Budget Committee:
The budget controller is assisted by the Budget Committee. The Budget Committee will include General
Manager (or any other chief executive), sales Manager, Works Manager, Purchase Officer, Personnel
Manager, Departmental Manager and Budget Controller. The General Manager generally acts as
Chairman of the Committee. The functional manager will prepare the budgets and submit to the

committee for approval. It is the duty of the Budget Committee to make necessary adjustments in the
budgets, co-ordinate all the budgets, and finally approve the budgets.
(iii) Budget period:
The budget period is the period for which a set of budgets is prepared: typically the budget period is of
one year's duration, and will be designed to coincide with an organization’s financial, or fiscal, year.
There is no reason why a budget period has to be one year, but typically it is.
On the other hand, if we are dealing with a project, then the budget will clearly be linked to that project.
A three month project will have a budget covering the whole project and will thus be a three months
budget.
Most organizations will divide their budget period into calendar months (or periods); whereas others have
thirteen period years (all of an equal four week period). In certain situations, the budget period will be
analyzed according to some particular feature of the work in that situation: for example, stockbrokers
have their year divided into "accounts" of two and three weeks' duration. These divisions of a budget
period are control periods.
(iv) Determination of Limiting factor:
Key factor is also known as principal budget factor, limiting or governing factor. The limiting factor is
anything that limits the activity of an entity. Examples of limiting factors are shortages of supply of a
resource and a restriction on sales at a particular price. That is, the limiting factor is the one factor that
dominates all other factors: the limiting factor can be any factor that is important to the carry out the
organization’s activities .
Each of the following can be the limiting factor, depending on the circumstances of the case,:
i. Cash
ii. Raw materials
iii. Skilled labor
iv. Land
v. Equipment
9.3 TYPES OF BUDGETS

Different types of budgets are discussed as under:
On the basis of Coverage:
i. Functional Budgets:
A functional budget is a budget which relates to any of the functions of an undertaking e.g. sales,
production, research and development, cash etc. the functional budgets include (a) Sales Budget including
Selling and Distribution Cost Budget (b) Production Budget which may consist of Raw Material Budget,
Labor Budget, Plant Utilization Budget (c) Purchase Budget (d) Administration Cost Budget (e) Capital
Expenditure Budget (f) Research and Development cost Budget (g) Cash Budget.
ii. Master Budget:
The Master Budget is a consolidated summary of the various functional budgets. It has been defined as “a
summary of the budget schedule in capsule form made for the purpose of presenting, on one report, the

highlights of the budget forecast”. The Institute of Cost and Management Accountant, England has
defined this budget as “the summary budget incorporating its component functional budgets and which is
finally approved, adopted and employed”.
The master budget is prepared by the budget committee on the basis of coordinated functional budgets
and become the target for the company during the budget period when it is finally approved by the
committee. This budget summarizes functional budgets to produce a Budgeted Profit and Loss Account
and Budgeted Balance Sheet as at the end of the budget period as is clear from the form given below.
On the basis of Capacity
i. Fixed Budget:
The fixed budget can be defined as a budget prepared for a given level of activity. It does not take into
consideration any changes in expenditure arising out of changes in the level of activity. Thus it does not
provide for any changes in expenditure arising out of changes in the anticipated conditions and activity
differs from the budgeted level of activity. These budgets will prove useful when the actual level of
activity corresponds to the budgeted level of activity.
ii.Flexible Budget:
The Institute of Cost and Management Accountant, England has defined this budget as “a budget
designed to change in accordance with the level of activity actually attained. Thus, a flexible budget gives
different budgeted costs for different levels of activity. A flexible budget is prepared after making an

intelligent classification of all expenses between fixed, semi-variables and variable because the usefulness
of such a budget depends upon the accuracy with which the expenses can be classified. Such a budget is
used in the following cases:
a) Where the level of activity during the year varies from period to period, due either to seasonal
nature of the industry or to variation in demand.
b) Where the business is a new one and it is difficult to foresee the demand.
c) Where the undertaking is suffering from shortage of a factor of production such as materials,
labor, plant capacity etc. The level of activity depends upon the availability of such a factor of
production.
Illustration: 1
The expenses budgeted for production of 10,000 units in a factory is furnished below:
Per unit
Rs
Materials 70
Labor 25
Variable Factory overheads 20
Fixed Factory overheads (Rs. 100,000) 10
Variable Expenses (Direct) 5
Selling Expenses (10% fixed) 13
Distribution Expenses (20% fixed) 7
Administration Expenses (Rs. 50,000) 5
Total cost of sales per unit 155
You are required to prepare a budget for the production of 8,000 units.
Solution:
FLEXIBLE BUDGET
Particulars Output 10,000 units Output 8,000 units
Per Unit (Rs) Amount (Rs) Per Unit (Rs) Amount(Rs)
Material 70.00 700,000 70.00 560,000
Labor 25.00 250,000 25.00 200,000
Direct Variable Expenses 5.00 50,000 5.00 40,000
Prime Cost 100.00 1,000,000 100.00 800,000
Factory Overheads:
Variable Overheads 20.00 200,000 20.00 160,000
Fixed Overheads 10.00 100,000 12.50 100,000

Works Cost 130.00 1,300,000 132.50 1,060,000

Administration Expenses: Fixed 5.00 50,000 6.25 50,000
Cost of production 135.00 1,350,000 138.75 1,110,000
Selling Expenses:
Fixed- 10% of Rs. 13 1.30 13,000 1.63 13,000 (same
as for 10,000
units)
Variable- 90% of Rs. 11.70 117,000 11.70 93,600
13
Distribution Expenses: 1.40 14,000 1.75 14,000
Fixed – 20% of Rs. 7 (same as for
10,000 units
5.60 56,000 5.60 44,800
Variable – 80% of Rs.
7
Total Cost of Sales 155.00 1,550,000 159.43 1,275,400
On the Basis of Conditions

i.Basic Budget:
A basic budget has been defined as “a budget which is prepared for use unaltered over a long period of
time.” This does not take into consideration current conditions and can be attainable under standard
conditions.
ii.Current Budget:
A current budget can be defined as “a budget which is related to the current conditions and is prepared for
use over a short period of time.” This budget is more useful than a basic budget, as the targets lays down
will be corrected to current conditions.
On the basis of Period
i. Long-term Budget:
A long term budget can be defined as “a budget which is prepared for periods longer than a year.” These
budgets help in business forecasting and forward planning, capital expenditure budget and research and
development budget are example of long term budgets.
ii. Short-term Budget:
This budget is defined as “a budget which is prepared for a period less than a year and is very useful to
lower levels of management for control purposes.” Such budgets are prepared for those activities the
trend in which it is difficult to foresee over longer periods. Cash Budget and material Budget are example
of short term budgets.

Important Functional Budgets

Some of the important functional budgets are discussed below:
(a) Sales Budget:
The Sales Budget is the most important budget and forms the basis of all the other budgets are built up.
This budget is a forecast of the quantities and values of sales to the achieved in a budget period. Every
effort should be made to ensure that its figures are as accurate as possible because this is usually the
starting budget (sales being limiting factor) on which all the other budgets are built up. The Sales Manger
should be made directly responsible for the preparation and execution of this budget. In the preparation of
sales budget, the sales manager should take into consideration the following factors:-
i. Past sales figures and trends: The compiler of the sales budget should be assisted by
graphs recording sales of the previous year and the general sales trend (upward or
downward) should be noticed from graph. The record of previous year’s sales is the
most reliable basis as to future sales as the past performance is based on actual business
conditions. But in addition to past sales other factors affecting future sales, e.g. seasonal
fluctuations, growth of market, trade cycles etc, should be considered in the preparation
of the sales budget.
ii. Salesman’s Estimates: In preparing the sales budget, the sales manager should
consider the estimates of sales received from salesmen because they can make more
accurate estimates being in direct contact with the customers. However, it should be
seen that salesmen’s estimates should neither be over-optimistic nor too conservative.
iii. Plant Capacity: The sales budget should be within the plant capacity available and
should ensure proper utilization of plant facilities. Proposed plant extensions should be
allowed for in the preparation of the sales budget.
iv. Availability of Raw materials and Other Supplies: Adequate supply of raw materials
and other supplies should be ensured before preparing the sales estimates. Sales
estimates should be adjusted according to the availability of raw materials if the raw
materials are in short supply.
v. General Trade Prospects: The profitability of the sales going up or down depends on
the general trade prospects. In this connection valuable information may be gathered
from financial papers and business magazines.
vi. Orders on hand: In boom periods or where production is a very lengthy process, the
value of orders on hand may have considerable influence on the amount of sales to be
budgeted.
vii. Seasonal Fluctuations: In the preparation of the sales budget, seasonal fluctuations
should be considered because sales are affected by these fluctuations. In order to have
an even flow of production, effort should be made to minimize the effect of seasonal
fluctuation on sales by giving special concessions or added inducements during the off
season.
viii. Financial Aspect: The sales budget should be within the financial capacity of the
concern. Sales expansion usually requires an increase in capital outlay. Thus, if any big
sales expansion is planned, it must be ensured that facilities are available to finance the
operations.

ix. Adequate Return on Capital Employed: The sales volume budgeted should produce
an adequate return on the capital employed.
x. Competition: The nature and degree of competition within the industry should be
considered in the preparation of the sales budget to have a realistic sales budget capable
of being achieved in the face of competition.
The sales manager, after taking into consideration the above factors, should prepare the sales budget in
terms of quantities and amount and the sales estimates must be analyzed for products, periods and
territories. The sales budget should include an estimate of selling and distribution costs in addition to an
estimate of the total proceeds. The specimen of the sales budget is given as follows.
SALES BUDGET
For the year …………….
Months North Zone South Zone East Zone Total Previous Year’s
Actual
Product X Y X Y X Y X Y X Y
Q Rs Q Rs Q Rs Q Rs Q Rs Q Rs Q Rs Q Rs Q Rs Q Rs
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Total
Less:
S&D
exp.
Total
Net
Sales
Proceeds

Illustration: 2
In this budget for the period ahead 'X' Ltd. is considering two possible sales forecasts for its three
products as follows:
Product
A B C
I. Sales (Units) 22,000 40,000 6,000
Selling price per unit Rs. 10 Rs. 6 Rs.7.50
II. Sales (Units) 30,000 50,000 7,000
Selling price per unit Rs. 9 Rs. 5.50 Rs.7.50
Variable costs per unit are expected to be the same at the different levels of possible sales. The variable
costs per unit are as follows:
A B C
Rs. Rs. Rs.
Direct materials 3.00 2.00 4.00
Direct labor 2.00 1.50 1.00
Variable overheads 1.00 0.50 1.00
Fixed overheads are expected to total Rs. 100,000. These are expected to be unaffected by the possible
changes in activity which are being considered. Due to recent high labor turnover problems, direct labor
will be restricted to a maximum of Rs. 130,000 in the period. It can be assumed that all labor is of the
same grade and is freely transferable between products. Other resources are expected to be generally
available.
Taking each of the possible sales forecast in turn
(i) Say what the principal budget factor is for each of the forecasts.
(ii) For each forecast calculate the sales budget that you would recommend maximizing profits.
(iii) What profit would you expect from sales budget?
Assume that the products will be sold according to the selling price estimated as per forecast and no
interchange of the forecast is allowed.
Solution
(i)
Forecast I Products Total
A B C Rs.
Sales quantity (units) 22,000 40,000 6,000
Labor cost per unit (Rs.) 2 1.50 1
Total labor cost (Rs.) 44,000 60,000 6,000 110,000
Labor available (Rs.) 130,000
Sales is the principal budget factor in case of Forecast 1

Forecast II Products Total

A B C Rs.
Sales quantity (units) 30,000 50,000 7,000
Labor cost per unit (Rs.) 2 1.50 1
Total labor cost (Rs.) 60,000 75,000 7,000 142,000
Labor available (Rs.) 130,000
Labor is the principal budget factor in case of Forecast 1I
(ii) Sales Budget

Forecast I Forecast II
(Sales being the principal budget factor) (Labor being the principal budget factor)
Products Units to be SP per unit Amount Units to be SP per unit Amount
sold Rs. Rs. sold Rs. Rs.
( See W.N.2)
A 22,000 10 220,000 30,000 9 270,000
B 40,000 6 240,000 42,000 5.5 231,000
C 6,000 7.5 45,000 7,000 7.5 52,500
505,000 553,500
(iii) Expected profit from each sales budget

Forecast I Products Total
A B C Rs.
Selling price per unit (Rs.) 10 6 7.5
Variable cost per unit (Rs.) 6 4 6
Contribution per unit (Rs.) 4 2 1.50
Sales (units) 22,000 40,000 6,000
Total contribution (Rs.) 88,000 80,000 9,000 177,000
Less Fixed cost 100,000
Profit 77,000
Forecast II Products Total

A B C Rs.
Selling price per unit (Rs.) 9 5.5 7.5
Variable cost per unit (Rs.) 6 4 6
Contribution per unit (Rs.) 3 1.50 1.50
Sales (units) 30,000 42,000 7,000
Total contribution (Rs.) 90,000 63,000 10,500 163,500
Less Fixed cost 100,000
Profit 63,500
Working Notes:
1. Ranking of products when labor is the limiting factor:
Products A B C
Rs. Rs. Rs.
(i) Selling Price per unit 9 5.50 7.50
(ii) Variable cost per unit:
Direct material per unit 3 21 4
Direct labor per unit 2 1.50 1
Variable overhead per unit 1 0.50 1
6 4 6
Contribution per unit (i) – (ii) 3 1.50 1.50
Ranking 1 2 1
2. The above ranking shows that product B is the least profitable. Hence, 30,000 units of product A and
7,000 units of product C (as per forecast II) would be manufactured by utilizing labor cost worth Rs.
67,000 ( 30,000 x Rs.2 + 7,000 x Rs. 1). Since the total available labor cost is for Rs. 130,000, the
remaining labor cost of Rs. 63,000 (Rs. 130,000 – Rs.. 67,000) will be utilized for manufacturing 42,000
units ( Rs. 63,000/Rs.1.50) of product B.
(b) Production Budget:

Production budget is a forecast of the total output of the whole organization broken down into estimates
of output of each type of product with a scheduling of operations (by weeks and months) to be performed
and forecast of the closing finished stock. This budget may be expressed in quantitative (weight, units
etc.) or financial units or both. This budget is prepared after taking into consideration the estimated
opening stock, the estimated sales and desired closing finished of each product. Suppose, if the estimated

opening stock of product X is 2,000 units and the estimated sales is 15,000 units and the closing stock of
the product is estimated to be 2,500 units, the estimated production will be 15,000 + 2,500 – 2,000 (Sales
+ closing stock – opening stock) = 15,500 units. The works manager is responsible for the total
production budget and departmental managers are responsible for the departmental production budget. In
preparing the production budget, the following factors are considered:
The time lag between the production in the factory and sales to the customer should be considered so as to
allow for the time required for the dispatch of goods from the factory to the place of the customer.
ii. The stock of goods to be maintained at both at the factory godown and at the sales centers.
iii. The level of production needed to meet the sales program. Monthly production targets should be
fixed and it should be seen that production is kept more or less at a uniform level throughout the
year. Planning the level of production involves the answering of four questions i.e. (a) What is to
be produced? (b) When is it to be produced? (c) How is it to be produced? (d) Where is it to be
produced?
iv. The material labor and plant requirements should be ascertained to have the desired production to
meet the sales program.
The sales and the production budgets are inter-dependent because production budget is governed by the
sales budget and the sales budget largely determined by the production capacity and by production costs.
Illustration: 3
A company manufactures two products A and B. The sales manager forecasts the sales in units as
follows:
Jan. Feb. March April May June July
Product A 28 28 24 20 16 16 18
Product B 10 12 16 20 24 24 20
It is assumed that there will be no work-in-progress at the end of any month and finished units equal to
half the sales for the following months will be kept in stock. Prepare the production budget for each
month.
Solution
Closing stock of finished goods is equal to half of sales for the next month, so opening stock is half of the
budgeted sale for the same month.
PRODUCTION BUDGET (in number of units)
Month Product A Product B
Sales Closing Opening Production Sales Closing Opening Production
Stock Stock Stock Stock
+ - + -
January 28 14 14 28 10 6 5 11
February 28 12 14 26 12 8 6 14

March 24 10 12 22 16 10 8 18
April 20 8 10 18 20 12 10 22
May 16 8 8 16 24 12 12 24
June 16 9 8 17 24 10 12 22
July 18 9 9 18 20 10 10 20
Illustration: 4
A single product company estimated its sales for the next year quarter wise as under:
Quarter Sales (Units)
I 30,000
II 37,500
III 41,250
IV 45,000
The opening stock of finished goods is 10,000 units and the company expects to maintain the closing stock
of finished goods at 16,250 units at the end of the year. The production pattern in each quarter is based
on 80% of the sales of the current quarter and 20% of the sales of the next quarter.
The opening stock of raw materials in the beginning of the year is 10,000 kg. and the closing stock at the
end of the year is required to be maintained at 5,000 kg. Each unit of finished output requires 2 kg. of raw
materials.
The company proposes to purchase the entire annual requirement of raw materials in the first three
quarters in the proportion and at the prices given below:
Quarter annual requirement in quantity Purchase of raw materials % to total Rs. Price per kg.
I 30% 2
II 50% 3
III 20% 4
The value of opening stock of raw materials in the beginning of the year is Rs. 20,000. You are required
to present the following for the next year, quarter wise:
(i) Production budget (in units).
(ii) Raw material consumption budget (in units).
(iii) Raw material purchase budget (in quantity and value).
(iv) Priced stores ledger card to the raw material using First in First out method.
Solution
Working note:
Total annual production (in units)
Sales in 4 quarters 153,750 units
Add: closing balance 16,250 units

170,000 units
Less: opening balance (10,000 units)
Total number of units to be produced in the next year 160,000
(i) Production Budget (in units)

Quarters
I II III IV Total
Units Units Units Units Units
Sales 30,000 37,500 41,250 45,000 153,750
Production in current quarter 24,000 30,000 33,000 36,000
(80% of sale of current quarter)
Production for next quarter 7,500 8,250 9,000 12,250*
Total production 31,500 38,250 42,000 48,250 160,000
*
Total production for the year = 160,000
Total cumulative production up to third quarter ( 31,500+38,250 + 42,000)= 111,750
Production for the forth quarter (160,000- 111,750) = 48,250
Balance production in fourth quarter ( 48,250 – 36,000) = 12,250
(ii) Raw material consumption budget in quantity

Quarters
I II III IV Total
Units to be produced in each quarter (A) 31,500 38,250 42,000 48,250 160,000
Total raw materials consumption @ 2 kg per unit = 63,000 76,500 84,000 96,500 320,000
{(A) x 2}
(iii) Raw material purchase budget in quantity

Raw material required for production (kg) 320,000
Add: Closing balance of raw material 5,000
325,000
Less: Opening balance (kg) 10,000
Material to be purchased (kg) 315,000

Raw material purchase budget in value

Quarters % of annual Quantity of raw material to be Rate Amount
purchased
requirement per (Rs.)
(qty) for purchasing kg
raw material (kg) (Rs.).
1 2 3 4 5=3 x 4
I 30 94,500 (315,000 kg. x 30%) 2 189,000
II 50 157,500 (315,00 kg x 50%) 3 472,500
III 20 63,000 (315,000 kg. x 20%) 4 252,000
Total 315,000 913,500
(iv)
Priced Stores Ledger Card
(Of the raw material using FIFO method) (Value and Kg. in thousands)
Quarter
I II III IV
Kg Rate Value Kg Rate Value Kg Rate Value Kg Rate Value
Rs. Rs. Rs. Rs. Rs. Rs. Rs. Rs.
Op. bal. (A) 10 2 20 41.5 2 83 122.5 3 367.5 38.5 3 115.5
Purchases (B) 94.5 2 189 157.5 3 472.5 63 4 252 - - -
Consumption(C) 63 2 126 41.5 2 83 84 3 252 38.5 3 115.5
- - - 35 3 105 - - - 58 4 232
Balance (D) 41.5 2 83 122.5 3 367.5 38.5 3 115.5 5 4 20
D= A+B-C 63 4 252
Illustration: 5
ABC Ltd. makes two types of polish, one for floors and one for cars. It sells both types to industrial users
only, in one-liter containers. The specifications for the two products per batch of 100-liters are:
Materials Floor polish Car polish
Delta 120 liters 100 liters
Gamma 20 kg 10 kg
Containers cost per 100 Rs. 100 Rs. 100

Direct labor:
Manufacturing 12 man hours 16 man hours
Primary packing 5 man hours 5 man hours
During the six months to end of 30th June, the company expects to sell 15,000 liters of floor polish at Rs. 9
per liter and 25,000 liter of car polish at Rs. 7 per liter. Materials are expected to cost Re. 1 a liter for
Delta and Rs. 8 a kg for Gamma.
Manufacturing wages in the industry look like being stable at Rs.6 per hour and packing wages at Rs. 4
per hour, throughout the period.
Flexible overhead expense budgets are operated for manufacturing and packing departments based on
the number of man hours worked. These budgets for six months to end of June are:
Manufacturing Department Primary Packing Department

Rs. Rs.
General administration overheads are budgeted at Rs. 37,000. At the beginning of the period 1st January
packed stocks will be:
Floor Polish 2,000 liters.
Car Polish 3,000 liters.
By end of the period 30th June, it is desired to maintain the packed stocks of the products at 3,000 liters
and 4,000 liters respectively. The following are required:
(1) A statement of the standard prime cost per liters of each product.
(2) A sales and production budget (in quantities) of the six months to 30 June.
A profit forecast for the period. Show separate gross profit for the two products but do not attempt to
allocate overhead between them. No overheads are included in stock valuations.
Solution
(1) Statement of Standard Prime cost per 100 liters
Rs. Rs
Materials
Delta 120 x1 =120 100 x 1 = 100
Gmma 20 x 8 = 160 10 x 8 = 80
Labor
Manufacturing 12 x 6 = 72 16 x 6 = 96
Packing 5 x 4 = 20 5 x4 =20
Containers 100 100
Rs. 472 396

(2) Sales and Production Budget ( In liters)

15,000 25,000
Sales
Add: Desired closing stocks 3,000 4,000
18,000 29,000
Less: Opening stocks 2,000 3,000
Production requirement 16,000 26,000
(3)
Profit forecast for the period
Floor Polish Car Polish Total
Rs. Rs. Rs.
Sales 15,000 x 9 135,000 25,000 x 7 175,000
Less: Prime cost 150 x 472 70,800 250 x 396 99,000
Gross profit 64,200 76,000 140,200
Less: common cost – Manufacturing (Note 50,800
1)
Packing (Note 2) 30,000
59,400
Less: General and adm. overhead 37,000
Net profit 22,400
Working notes:
1. Computation of manufacturing hours and overhead
Manufacturing hours: (16,000 x 12/100) + (26,000 x 16/100) = 1,920 + 4,160 = 6,080
Manufacturing overhead fro 6080 hrs is 50,000 + 80/1,000 x10,000 = 50,800
2. Computation of packing hours and overhead

Packing hours: (16,000 x 5/100) + (26,000 x 5/100) = 800+1,300 = 2,100 Hrs.
Packing Overheads for 2,100 hrs = Rs. 30,000
(c) Cost of Production Budget: After determining the volume of output, the cost of procuring the
output must be obtained by preparing a cost of production budget. This budget is an estimate of cost of
output planned for a budget period and may be classified into material cost budget, labor cost budget and
overhead budget because cost of production includes materials, labor and overheads.

i. Materials Budget: In drawing up the production budget, one of the first requirements to be
considered is materials. As we know, materials may be direct or indirect. This materials budget
deals with the requirement and procurement of direct materials. Indirect materials are dealt with
under the works overhead budget. This budget should be related to the production budget and the
period of the budget should be of short duration because this budget has an important bearing on
the cash budget. The preparation of materials budget include:
a. The preparation of estimates of different types of raw materials needed for various
productions.
b. Procuring or purchasing raw materials in required quantities at the required time.
In preparing the materials budget, the following factors are considered:-
a) Raw materials required for the budgeted output.
b) The percentage of raw materials to total cost of production should be calculated on the basis
of previous records. On the basis of this percentage, a rough total value of raw materials
required for the budgeted output will be ascertained.
c) Consideration must be given to the company’s stocking policy. Figures related to
anticipated raw materials stocks to be held at different times, should be known.
d) Consideration must be given to the time lag between the placing of order for the purchase of
materials and the receipt of materials.
e) The seasonal nature, in the availability of raw materials should be considered.
f) The price trend in the market.
Materials budget can be classified into material requirement budget and material procurement
budget. The former gives information about the quantity of material required during the budget
period to attain the production target; while the latter provides, the information about the
materials to be acquired from the market during the budget period. Material procurement budget,
takes into consideration the inventory of materials and the materials on order at the beginning of
the budget period and the anticipated inventory of materials and the materials to be on order on
the closing date of the budget period.
ii. Direct labor Budget: This budget gives an estimate of the requirement of direct labor essential
to meet the production target. This budget may be classified into labor requirement budget and
labor recruitment budget. The former is developed on the basis of requirements of the production
budget and gives detailed information regarding the different classes of labor, e.g. fitters,
welders, turners, millers, grinders, drillers, etc., required for each department, their scales of
pay and hours to be spent. This budget is prepared with a view to enabling the personnel
department to carry out programs of training and transfer and to find out sources of labor needed
so that every effort may be made to remove difficulties arising in production through lack of
suitable personnel. Labor recruitment budget is prepared on the basis of labor requirement
budget after taking into consideration the available workers in each department, the expected
changes in labor force during the budget period due to labor turnover. This budget gives
information about the personnel’s specification for the jobs for which workers are to be
recruited, the degree of skill and experience required and rates of pay. In preparing the labor cost
budget, the question of overtime should not be overlooked because workers are to get higher rate

of wages if they work on overtime. Regular overtime should be avoided by engagement of

additional workers and extension of plant.
iii. Manufacturing Overhead Budget: This budget gives an estimate of the works overhead
expenses to be incurred in a budget period to achieve the production target. The budget includes
the cost of indirect labor, indirect material and indirect works expenses. This budget may be
classified into fixed cost, variable cost and semi variable cost. It can also be broken into
departmental overhead budgets to facilitate control. In preparing this budget, fixed works
overheads can be estimated on the basis of past information after taking into consideration the
expected changes which may occur during the budget period. Variable expenses are estimated on
the basis of the budgeted output because these expenses are bound to change with the change in
output.
Illustration: 6
Your company manufactures two products A and B. A forecast of the number of the units to be sold in
first seven months of the year is given below:
Product A Product B
January 1,000 2,800
February 1,200 2,800
March 1,600 2,400
April 2,000 2,000
May 2,400 1,600
June 2,400 1,600
July 2,000 1,800
It is anticipated that (i) there will be no work-in-progress at the end of any month, (ii) finished units equal
to half the sales for the next month will be in stock at the end of each month (including the previous
December).
Budgeted production and production costs for the whole year are as follows:-
Product A Product B
Production (units) 22,000 24,000
Rs. Rs.
Per unit: direct materials 12.50 19.00
Direct labor 4.50 7.00
Total factory overhead apportioned 66,000 96,000
Prepare for the six months ending 30th June, a production budget for each month and a summarized cost
budget.

Solution
PRODUCTION BUDGET
(For six months ending 30th June)
Jan. Feb. March April May June Total
(Units) (Units) (Units) (Units) (Units) (Units)
Product A
Sales 1,000 1,200 1,600 2,000 2,400 2,400 10,600
Add: Closing stock (half the 600 800 1,000 1,200 1,200 1,000 5,800
sales for next month)
Less: Opening stock (half (500) (600) (800) (1,000) (1,200) (1,200) (5,300)
the sales for current month)
Budgets production 1,100 1,400 1,800 2,200 2,400 2,200 11,100
Product B
Sales 2,800 2,800 2,400 2,000 1,600 1,600 13,200
Add: Closing stock 1,400 1,200 1,000 8,00 800 900 6,100
Less: Opening stock (1,400) (1,400) (1,200) (1,000) (800) (800) (6,600)
Budgets production 2,800 2,600 2,200 1,800 1,600 1,700 12,700
Closing stock of previous month becomes the opening stock of current month.
SUMMARIZED PRODUCTION COST BUDGET

Product A Product B
Output 11,100 units Output 12,700 units
Per unit Amount Per unit Amount Total
Rs. Rs. Rs. Rs. Rs.
Direct Materials 12.50 138,750 19.00 241,300 380,050
Direct Labor 4.50 49,950 7.00 88,900 138,850
Prime cost 17.00 188,700 26.00 330,200 518,900
Factory Overheads [1] 3.00 33,300 [2] 4.00 50,800 84,100
20.00 222,000 30.00 381,000 603,000
Notes:

Factory overheads per unit =


, ,
Product [1] A = =Rs.3 Product [2] B = =Rs.4
, ,
Illustration: 7
From the following information relating to 2008 and conditions expected to prevail in 2009, prepare a
budget for 2009. State the assumption you have made.
2008 Actual: Rs.
Sales 100,000 (40,000 units)
Raw materials 53,000
Wages 11,000
Variable Overheads 16,000
Fixed Overheads 10,000
2009 Prospect:
Sales 150,000 (60,000 units)
Raw Materials 5% price increase
Wages 10% increase in wage rates
5% increase in productivity
Additional Plant One lathe Rs. 25,000
One drill Rs. 12,000
Solution
In the year 2009, additional plant worth (Rs.2,5000 + Rs. 12,000) Rs. 37,000 will be used but no
information about depreciation has been given in the question. Let us assume that the rate of depreciation
is 10% p.a. :-
Rs.
Fixed overheads ( as given) 10,000
Depreciation (10% on Rs. 37,000) 3,700
Total fixed overheads 13,700
Output in 2008 40,000 units
Expected Output in 2009 60,000 units
Increase in Output = 60,000 – 40,000 = 20,000 units
% Increase in output = (20,000/40,000) x 100 = 50%

Budgeted Raw Materials for 2009

Rs.
Consumption of Materials in 2008 53,000
Add: 50% increase due to increase in output 26,500
79,500
Add 5% increase due to increase in prices of materials
79,500 x (5/100) = 3,975
83,475
Budgeted Wages for 2009
Rs.
Wages in 2008 11,000
Add 50% increase in output 5,500
16,500
Add: 10% increase due to increase in wage-rate 1,650
18,150
Less: saving due to 5% increase in productivity 18,150 x (5/105) = 864
17,286
Budget for the year 2009

Actual for 2008 Budgeted for 2009
Sales and output in units 40,000 60,000
Rs. Rs.
1. Sales 100,000 150,000
Raw Materials 53,000 83,475
Wages 11,000 17,286
Variable Overheads @ 40 p. per unit 16,000 24,000
Fixed Overheads 10,000 13,700
2. Total cost 90,000 138,461
3. Profit (1 – 2) 10,000 11,539

Illustration: 8
The following are the details of the Budget and the actual cost in a factory for six months from January to
June 2007. From the figures given below you are required to prepare the production cost budget for the
period from January to June 2008:
January to June 2007

Budget Actual
Material cost Rs. 40,00,000 Rs. 39,90,000
(2,000 MT @ Rs. 2,000) (@ Rs. 2,100)
Labor cost Rs. 8,00,000 Rs.7,99,920
(@ Rs. 20 per hour) (@ Rs. 22 per hour)
Variable overheads Rs. 2,40,000 Rs. 2,16,000
Fixed overheads Rs. 4,00,000 Rs. 4,20,000
In the first half of 2008 production is budgeted for 25,000 units. Material cost per ton will increase from
last year's actual by Rs. 100 but is proposed to maintain the consumption efficiency of 2007 as budgeted.
Labor efficiency will be lower by another 1% and labor rates will be Rs. 22 per hour.
Variable and Fixed overheads will go by 20% over 2007 actual.
You are required to prepare the production cost budget for the period January – June 2008 giving all the
workings.
Solution
Production Cost Budget
(for the 6 months ending 30th June, 2008)
Production 25,000 units
Total cost (Rs.) Unit cost (Rs.)
Material cost (Note 1) 55,00,000 220.00
Labor cost (Note 2) 11,22,000 44.88
Variable overheads ( Note 3) 3,60,000 14.40
Fixed overheads ( Note 4) 5,04,000 20.16
Total 74,86,000 299.44
Working Notes:
(i) Material cost:
Consumption per unit 2,000/20,000 = 0.10 MT
Consumption for 25,000 units = 2,500 MT
Cost of 2,500 MT @ Rs. 2,200 per MT = Rs. 55,00,000
(ii) Labor cost:

2007: total budgeted labor hours 800,000/20 = 40,000 hrs.
Labor hour budget for each unit = 40,000/20,000 = 2 hrs.
Actual time paid for 799,920/22 = 36,650 hrs.
Less: Standard labor hours for 18,000 units 36,000 hrs
Extra time taken 360 hr.
2008: Time required for 25,000 units 50,000 hrs

Add: 2% for lower efficiency 1,000 hrs
51,000 hrs.
51,000 hrs. @ Rs. 22 per hour Rs. 11,22,000
(iii) Variable Overheads:

Rate per unit in 2007 = 240,000/20,000 = Rs. 12/-
Cost for 25,000 @ 1980 rates = Rs. 300,000
Add: 20 % Rs. 60,000
Rs. 360,000
(iv) Fixed overhead:
Actual in 1980 = Rs. 420,000
Add:20% Rs. 84,000
504,00
iv. Administration Expenses Budget: This budget covers the expenses incurred in framing
policies, directing the organization and controlling the business operations, In other words, the
budget provides an estimate of the expenses of all the central offices and management salaries.
The budget can be prepared with the help of past experience and anticipated changes. Budgets
may be prepared for each administration department so that responsibility for increasing such
expenses may be fixed and related to the different executives.
v. Capital expenditure Budget: the capital expenditure budget gives an estimate of the amount of
capital that may be needed for acquiring the fixed assets required for fulfilling production
requirement as specified in the production budget. The budget is prepared after taking into
consideration the available productive capacities, probable reallocation of the existing assets and
possible improvement in production techniques. Separate budgets may be prepared for different
items of fixed assets such as plant and equipment budget, building budget etc. the capital

expenditure budget is an important budget providing for the acquisition of assets, necessitated by
the following factors:
a. Replacement of existing assets.

b. Purchase of additional assets to meet a proposed increase in production due to increase
in demand.
c. Purchase of additional assets because of starting up of new lines of production.
d. Installation of an improved type of machinery so as to reduce cost of production.
e. Thus the capital expenditure budget enables one to know what new fixed assets are
needed and at what time.
vi. Research and Development Budget: A good business concern should conduct research to find
new products and to find new ways so as to make improvement in the quality of old products.
For this purpose, some amount out of revenues is kept aside every year and a research and
development budget in prepared taking into consideration the research projects in hand and the
new projects to be taken up. Thus, this budget provides an estimate of the expenditure to be
incurred on research during the budget period.
vii. Cash Budget: This budget gives an estimate of the anticipated receipts and payments of cash
during the budget period. This budget is prepared by the Chief Accountant for the guidance of
the management so that arrangement may be made with the bank to provide the necessary money
to meet the production and sales program of an organization. The Budget is prepared in two parts
– one showing the estimated cash receipts on account of cash sales, credit collection, and
miscellaneous receipts and the other showing the estimated disbursement s on account of cash
purchases amount payable to creditors, wages payable to workers indirect expenses payable,
income tax payable etc. In short every factor which will affect the receipts and payments of cash
must be taken into account in the preparation of this budget.
The importance of preparing a cash budget may be more in some traders than in other e.g. in
trades where there are wide seasonal fluctuations or where long contracts are undertaken. The
negotiation of a bank loan or overdraft can be easily carried through because cash requirements
are estimated sufficiently in advance and potential financial strains and crisis are avoided by
making timely arrangements with the bank.
Illustration: 9
Prepare a cash budget in respect of 6 months from July to December from the information
relating to a Public Company gives in table as under:
Month Sales Materials Wages Overheads

(Credit)
Rs. 000 Rs. 000 Rs. 000 Prod. Adm. Selling Dist. R.& D.
Rs.
Rs. 000 Rs. Rs. Rs.
April 100 40 10.0 4.4 3,000 1,600 800 1,000

May 120 60 11.2 4.8 2,900 1,700 900 1,000

June 80 40 8.0 5.0 3,040 1,500 700 1,200
July 100 60 8.4 4.6 2,960 1,700 900 1,200
August 120 70 9.2 5.2 3,020 1,900 1,100 1,400
Sep. 140 80 10.0 5.4 3,080 2,000 1,200 1,400
Oct. 160 90 10.4 5.8 3,120 2,050 1,250 1,600
Nov. 180 100 10.8 6.0 3,140 2,150 1,350 1,600
Dec. 200 110 10.6 6.4 3,200 2,300 1,500 1,600
Cash balance on July was expected to be Rs. 150,000. Expected Capital Expenditure:
Plant and machinery to be installed in August at a cost of Rs.40,000 will be completed on August
1, payable Rs. 2,000 per month from completion date. Under a hire-purchase agreement Rs.
4,000 is to be paid each month.
Cash sales of Rs. 2,000 per month are expected. No commission is payable. A sales commission
of 5 percent on credit sales is to be paid within the month following the sales.
Period of credit allowed by suppliers 3 months
Period of credit allowed to customers 2 months
Delay in payment of overheads 1 month
st
Delay in payment of wages 1 week of the following month
Income tax of Rs. 100,000 is due to be paid on October 1. Preference share dividend of Rs. 10
percent on Rs. 200,000 is to be paid on November 1.
10 percent calls on equity share capital of Rs. 400,000 are due to the company on July 1 and
September 1.
Dividend from investment amounting to Rs. 30,000 is expected on November 1.
Solution
Cash Budget
Rs.
MONTHS
July August September October November December
Op. Balance 150,000 244,560 235,800 263,980 189,900 233,680
Receipts:
Cash sales 2,000 2,000 2,000 2,000 2,000 2,000
Cash from debtors 120,000 80,000 100,000 120,000 140,000 160,000

(2 months prior
credit sale realized)
Dividend Income
-- -- -- -- 30,000 --
Call money on
40,000 -- 40,000 -- -- --
Equity Shares
Total 312,000 326,560 377,800 385,980 361,900 395,680
Payments:
Creditors (3 months 40,000 60,000 40,000 60,000 70,000 80,000
prior credit
purchase paid)
Wages (Previous
month) 8,000 8,400 9,200 10,000 10,400 10,800
Commission on
prev. month’s
Credit Sales 4,000 5,000 6,000 7,000 8,000 9,000
Total Overheads
(Previous month) 11,440 11,360 12,620 13,080 13,820 14,240
Plant and -- -- 40,000 -- -- --
Machinery
-- 2,000 2,000 2,000 2,000 2,000
Research and Devt.
Hire purchase
Installment 4,000 4,000 4,000 4,000 4,000 4,000
Income Tax -- -- -- 100,000 -- --
Preference Dividend -- -- -- -- 20,000 --
Total Payment 67,440 90,760 113,820 196,080 128,220 120,040

Closing Balance 244,560 235,800 263,980 189,900 233,680 275,640
9.4 FIXED AND FLEXIBLE BUDGETING

Fixed Budgeting
The Institute of Cost and management Accounts (UK) defines a fixed budget as the budget which is
designed to remain unchanged irrespective of the level of activity actually attained. It is base on the single
level of activity. A fixed budget performance report compares data from actual operation with the single
level of activity reflected in the budget. Fixed budget do not changed when production level changes.
However, in practice, fixed budgeting is rarely used. The main reason is that actual output is often
significantly different from the budgeted output. In such a case the budget cannot be used for the purpose
of cost control. The performance report may be misleading and will not contain very useful information.
For example, if actual production is 12,000 units in place of the budgeted 10,000 units, the cost incurred

cannot be compared with the budgeted, which relates to the different levels of activity. Since, the fixed
budgeting units are overlooked a cost to cost comparison without considering the units may give
misleading results. The performance report prepared under fixed budgeting merely discloses whether
actual costs were higher or lower than budgeted costs. Therefore, the fixed budget is unable to provide
useful information when actual output differs significantly from expected or budgeted output. The fact,
the cost and expenses are affected by fluctuations in volume limits the use of the fixed budget. Clearly,
the idea of comparing performance at one activity level with a plan that was developed at some other
activity level is nonsense from the viewpoint of judging how efficiently the manager has produced any
given output.
A fixed budget can be usefully employed when budgeted output is close enough to the actual output. If
output can be estimated within close limits, the fixed budget can be good basis for performance
measurement. Maximum managerial control may be exercised by making comparisons with actual
operating figures.
Flexible Budgeting
A flexible budget is prepared for a range that is for more than one level of activity. It is a set of alternative
budgets to different expected levels of activity. The flexible budget is also known by other names, such as
variable budget, dynamic budget, sliding scale budget, step budget, expenses formula budget and
expenses control budget. The underlying principle of flexible budget is that every business is dynamic,
ever-changing and never static. Thus, a flexible budget might be developed that would apply to a
“relevant range” of production say 8,000 to 12,000 units. Under this approach, if actual production slips
to 9,000 units from the projected 10,000 units, the manger has specific tool (that is the flexible budget),
that can be used to determine budgeted cost at 9,000 units of output. The flexible budget provides a
reliable basis for comparison because it is automatically geared to changes in production activity. A
flexible budget has the following important features:
1. It covers a range of activity (output).
2. It is flexible, that is easy to change with variation in production levels.
3. It facilitates performance measurement and evaluation.
Planning or budgeting for a range of activity rather than for a single level of activity is always preferable
due to the uncertainty about the changes in activity levels. In flexible budgeting, that range of activity is
selected which is likely to occur. Most often one activity level at each extreme of the activity range is
selected, with one or more in between. Among different activity levels the most likely activity level is
made the basis for planning business operations. Flexible budgeting makes it easy to adjust plans to
changing production level without any delay. The flexibility involved in this budget makes a very useful
decision making tool for management.
Steps in flexible budgeting
The following steps (stages) are involved in developing a flexible budget:
1. Deciding the range of activity to which the budget is to be prepared.
2. Determining the cost behavior patterns (fixed, variable and semi-variable) for each element of
cost to be included in the budget.
3. Selecting the activity levels (generally in terms of production) to prepare budget at those levels.

4. Preparing the budget at activity levels selected by associating the activity level with
corresponding costs. The corresponding costs to be attached with each activity level are
determined in terms of their behavior, i.e., fixed, variable and semi-variable.
Advantages of Flexible Budgeting
Flexible budgeting is budgeting that is automatically tailored to any levels of activity. Although it is most
often associated with the control of overhead, a flexible budget may also include direct materials and
direct labor. “Welsch” has listed three specific uses of the flexible budget.
1. To facilitate development of the department expense budgets for inclusion in the profit plans.
2. To provide expenses goals for managers of responsibility centers during the period covered by
the profit plan.
3. To provide adjusted budget allowance for comparison purposes (against actual expenses) in the
monthly performance reports.
In general, flexible budgeting has the following important advantages:
1. Accurate budgeting: The use of flexible budgets may result in the preparation of more accurate
budgets. Flexible budgeting techniques require that consideration is to be given to the output
factor in budget preparation. Since all costs do not behave in the same manner (as some costs
rise faster than others when production increases) a budget giving consideration to the volume
(output) factor is bound to be more accurate than one where volume is not considered.
2. Accurate performance measurement: The flexible budgeting technique incorporates changes in
activity level and compares actual results with the budget in terms of output achieved. This
facilitates more meaningful comparison and evaluation between actual and budgeted data as
comparable data are compared.
3. Coordination: Flexible budgeting results in coordination between all activities/departments of a
business. Production is planned in relation to expected sales; materials and labor are acquired to
meet expected production requirements. Facilities are provided to achieve budgetary goals, and
funds are made available for the investments necessary to have higher output.
4. Control tool: Flexible budgeting is an effective management control tool. Comparisons between
the budgeted costs ( at the actual production level) and actual costs on the basis of analyzing cost
variances and fixing responsibility for the same. In fact, managers themselves feel motivated in
controlling costs for which they are responsible. This contributes to cost control throughout the
organization.
9.5 BUDGETING PROCESS

The budgeting process or program varies widely from one organization to another. Differences in
management style, organization objectives, structure of competition and similar factors affect the
procedures companies adopt in budget preparations. However, there are a set of guidelines (procedures)
which are used in the budgeting process by a large number of organizations. These common steps can be
listed as follows:
1. Obtaining estimates of sales, production levels, expected costs, and availability of resources
from each sub-unit/division/department: The department heads or managers are required to
provide estimates of future conditions and activities that will have an impact on the company.

2. Coordinating estimates: In many organizations, the budget committee evaluates the different
plans submitted by the various organizational units to determine the potentiality of plans in the
overall interest of the company and to estimate what resources are available and can be fairly
allocated among the various units of the organization.
3. Communicating the budget to responsible managers and the concerned department:- After
individual budget plans have been approved in the light of organizational goals and availability
of resources, the budget should be communicated to departments and responsible managers.
Changes and modifications incorporated in the final budget should be made known to managers
to obtain their cooperation and support for the budgets.
4. Implementing the budget plan:- The final budget is presented to the managers concerned and
adopted as the plan of operation for the coming budget period.
5. Reporting interim progress towards budgeted objectives:- as a feedback in the budgeting
process, performance reports are prepared to inform departmental managers and top
management about the performance achieved in terms of budgeted figures, such an investigation
may call for a need to revise the budget during the year. This feedback of information can also
be used as a basis for preparing the next year’s budget.
The Budget period
The budget period is an important factor in developing comprehensive budgeting program. The length of
the budget period depends on the type of business, the length of the manufacturing cycle from raw
material to finished product, the ease of difficulty of forecasting future market conditions and other
factors; however, a business enterprise generally prepares a short-range budget and long-range budget.
Short-range Budget
Short-range budget may cover periods of three, six or twelve months depending on the nature of the
business. Most manufacturing firms use one year as the planning period. Whole sale and retail firms
usually employ a six-month budget which is related to their selling seasons. In determining the period of
the short-range budget, the following factors should be considered:
1. The budget period should be long enough to cover complete production of various products.
2. For business of a seasonal nature, the budget period should cover at least one entire seasonal
cycle.
3. The budget period should be long enough to allow for the financing production well in advance
of the actual needs.
4. The budget period should coincide with the financial accounting period to compare actual results
with budgeted estimates and thus to facilitate better interpretation of the performance.
Long-range Budget
A long-range budget or planning is defined as a systematic and formalized process for directing and
controlling future operations towards a desired objective for a periods extending beyond one year. Such
budget cover specific areas, such as future sales, future production, long-term capital expenditures,
extensive research and development programs, financial requirement, profit forecast. They evaluate the
future implications associated with present decisions and help management in making present decisions
and select the most profitable alternative.

There are many factors which are duly considered while preparing long term budgets, such as market
trends, economic factors, growth of population, consumption pattern, industrial production, national
income, government economic and industrial policy. Quantitative sales can be budgeted for a three to five
years period. After forecasting sales, a budgeted profit and loss account can be prepared relating
anticipated sales to corresponding costs and thus net operating profit can be forecasted. Likewise, balance
sheet for many years can be prepared to forecast cash, inventory levels, account receivable, account
payable, liabilities etc. The forecasted profit and loss account and balance sheet for a long-range is very
useful tool in accomplishing the objectives of the organization as a whole.
Budget Centers
An organization is usually broken down into different budget centers for administrative and control
purposes. A budget center is the lowest level in an organization for which detailed costs are budgeted,
separately from those of other budget centers. The main factor is setting up budget center is one of the
fixing responsibility for action and inaction. To ensure adequate cost control, the budget center should
fulfill the following conditions:
1. The budget of a particular budget center should specify precisely the cost controllable by the
person responsible for that center.
2. Cost for which responsibility is joint, for example, work carried out by a maintenance
department should be kept separate from cost which can be controlled by one manager.
3. Costs that are apportioned between two or more budget centers should also be controlled and for
such cost one person should be made responsible.
Advantages of Budgetary Control

The important advantages of a budgetary control are as follows:
1. The most important advantage of a budgetary control is to enable management to conduct
business in the most efficient manner. An effort is made for achieving the maximum efficiency
by avoiding wastages of all types.
2. It lays down an objective for the business as a whole. Even though a monetary reward is not
offered, the budget becomes a game – goal to achieve or a target to shoot at – and hence it is
more likely to be achieved or hit than if there was no predetermined goal or target. The budget is
an impersonal policeman that maintains ordered effort and brings about efficiency in result.
3. Every one working in the concern knows what exactly to do because budgetary control lays
emphasis on the staff organization. It ensures that individual responsibilities are clearly defined
and that the requisite authority commensurate with the responsibility is delegated so that buck
passing may be prevented when the budgeted results are not achieved.
4. Budgetary control takes the help of different levels of management in the preparation of the
budget. Budget finally approved represents the judgment of the entire organization and not
merely that of an individual or a group of individuals. Thus, it ensures team work.
5. Management by exception is possible because the comparison of actual and budgeted results
point out weak spots so that remedial action is taken against weak spots which are not in
conformity with the budgeted performance.
6. It ensures effective utilization of men, materials, machines and money because production is
planned according to the availability of these items.
7. It is helpful in reviewing current trends in the business and in determining future policy of the
business because current and future trends are studied in the preparation of the budget.
8. Budget act as a measure of efficiency of department and persons working in the organization
because budgets provided a yardstick against which actual performance of departments and
employees can be compared.
9. Budgetary control creates conditions for setting up a system of standard costing.
10. It helps in promoting a feeling of cost consciousness and in restricting expenditure to the
minimum. Thus, wasteful expenditure is avoided and expenditure beyond budgeted figure is not
incurred without prior approval of the higher authority.
11. It enhances the standing and credit of the undertaking with the government and the banks
because an efficient technique of cost control is used.
12. Functions of planning, coordination and control can be better performed with the help of
budgetary control.
Limitation of Budgetary Control
The budgetary control as management device suffers from the following limitations:
1. It may be impossible to achieve the budgeted targets as estimates and forecast relating to future
made in the budget can never be perfectly accurate for the simple reason that future is
unpredictable.
2. In rapidly changing conditions it may not be possible to achieve the budgeted targets. Budgets
may have to be revised from time to time but frequent revisions may prove to be a costly affair.
3. Budgets may serve as constraints on managerial initiative because every execution tries to
achieve the budgeted targets. It tends to bring about rigidity in control.
4. Coordination of various budgets is expensive, so small organization cannot afford the
employment of budgetary control as a cost control technique.
5. Budgetary control may lead to conflicts among functional executives because every executive
may try to get a larger share of budgetary allocation, shirk responsibility and blame others for
pitfalls.
Requisites for Success of Budgetary Control
The following are the main requisites of success of budgetary control in a concern:
1. Proper implementation of budget: After the preparation of the budget, it must be properly
implemented. Proper implementation of the budget requires the support and active participation
of the top management which is only possible when they are convinced with the utility of this
tool.
2. Proper recording of operation; In order to make the budgetary control system effective in a
concern proper recording of various operations such as purchase, sale, production etc, must be
recorded properly and accurately. If it is not done, then inaccurate information when compared
with the target will lead to wrong conclusions and decisions.
3. Frequent comparison: In order to make the budgetary control system effective, a concern must
have frequent comparison of actual with targets. This is necessary to check adverse happenings
especially when the work is in process, otherwise it may be too late.
4. Co-operation of executives and employees: For achieving cooperation through the activities of
executives and employees is a must for the success of the budgetary control system in a concern.
Budgetary control creates coordination among the various departments by uniting their activities.
This is only possible when cooperation from all departments is forth coming.

Zero Base Budgeting (ZBB)

After a budgeting system has been in operation for some time, there is a tendency for next year's budget
to be justified by reference to the actual levels being achieved at present. In fact this is part of the
financial analysis discussed so far, but the proper analysis process takes into account all the changes
which should affect the future activities of the company. Even using such an analytical base, some
businesses find that historical comparisons, and particularly the current level of constraints on resources,
can inhibit really innovative changes in budgets. This can cause a severe handicap for the business
because the budget should be the first year of the long range plan. Thus, if changes are not started in the
budget period, it will be difficult for the business to make the progress necessary to achieve longer term
objectives.
One way of breaking out of this cyclical budgeting problem is to go back to basics and develop the budget
from an assumption of no existing resources (that is, a zero base). This means all resources will have to be
justified and the chosen way of achieving any specified objectives will have to be compared with the
alternatives. For example, in the sales area, the current existing field sales force will be ignored, and the
optimum way of achieving the sales objectives in that particular market for the particular goods or
services should be developed. This might not include any field sales force, or a different-sized team, and
the company then has to plan how to implement this new strategy.
The obvious problem of this zero-base budgeting process is the massive amount of managerial time needed
to carry out the exercise. Hence, some companies carry out the full process every five years, but in that year
the business can almost grind to a halt. Thus, an alternative way is to look in depth at one area of the
business each year on a rolling basis, so that each sector does a zero base budget every five years or so.
9.6 CONTROL RATIOS:

The following control ratios are used by the management to know whether the deviations of the actual
performance from the budgeted performance are favorable or unfavorable. If the ratio is 100% or more,
the performance is considered as favorable and if the ratio is less than 100% the performance is
considered as unsatisfactory.
a) Capacity usage ratio: the relationship between the budgeted number of working hours and the
maximum possible number of working hours in a budget period. Example,
i. Budgeted number of working hours after deducting the hours expected to be lost
because of surplus capacity = 4,000
ii. Maximum possible number of working hours in a budget period before deduction of
surplus capacity = 5,000
!"# $%
Capacity usage ratio = x 100
&'(# )%%#* !"# $%
,
= x 100 =80%
+,
In ascertaining both the levels of hours, normal idle time should be deducted.
b) Standard capacity employed ratio: This ratio indicates the extent to which facilities were
actually utilized during the budgeted period. Example,
Actual hours worked 3,600
Budgeted hours 4,000

,-'* $% !" .,
Standard capacity employed ratio = x 100 = x 100 = 90%
$% ,
c) Level of activity ratio: This may be defined as the number of standard hours equivalent to work
produced expressed as a percentage of the budget of standard hours. Example,
Actual production converted into standard hours 5,600
Budgeted production converted into standard hours 6,000
+,
Level of activity ratio = x 100 = 93.33%
,
The level of activity is arrived at by comparing the actual production with the anticipated
production as shown in the budget. The standard capacity employed ratio takes no account of
either actual or estimated production but only measures working of machine hours.
d) Efficiency ratio: This ratio may be defined as standard hours equivalent of work produced
expressed as a percentage of the actual hours spent in producing the work. Example:
Standard hours work produced 5,600
Actual hours worked 5,000
+,
Efficiency ratio = x 100 =112%
+,
This ratio is an indicator of the efficiency attained in production over a period. Efficiency has
gone up 12% in the above case, since this ratio is 112%.
e) Calendar ratio: This ratio may be defined as the relationship between the number of working
days in a period and the number of working days in the relative budgeted period. Example:
Actual working days 26
Budgeted working days 25

Calendar ratio = x 100 = 104%
+
This ratio indicates whether all the budgeted working days in a budget period have been
available in actual practice. If the ratio is more than 100%, more days have been available in
actual practice and vice versa if the ratio is less than 100%.
Illustration: 10
Under a system of budgetary control certain "ratios" are used to illustrate the effective use of the
resources. Calculate these ratios from the following data in respect of a four-week period. In this
period there was a special one-day holiday due to national event.
Standard working 8 hours per day (5 days a week)
Maximum capacity 50 employees
Actual working 40 employees
Actual hours expected to be worked per four weeks 6,400 Hours
Standard hours expected to be earned per four weeks 8,000 Hours
Actual hours worked in the four week period 6,000 Hours
Standard hours worked in the four week period 7,000 Hours
Solution
Efficiency Ratio = Standard hours/ Actual hours x 100
= 7,000/6,000 x 100

= 117%
Activity Ratio = Standard Hours/Budgeted Hours x 100
=7,000/6,400 x 100
= 109%
Calendar Ratio = Available-working days/ Budgeted working days x 100
={(4 x 5) - 1}/(4 x 5) x 100
=95%
Capacity Usage Ratio = Budgeted Hours/ Maximum possible hours in the budget period x 100
=6,400/8,000 x 100
= 80%
Capacity Utilization Ratio = Actual hours/Budgeted hours x100
=6,000/6,400 x 100
= 94%


1. Define budgetary control and explain its objectives.
2. Define how functional budgets are built up, taking any one specific example.
3. Explain the difference between fixed budget and flexible budget.
4. Explain three control ratios used for performance evaluation.
5. Distinguish between conventional budgeting and zero base budgeting
6. Choose the correct answer for the following multiple choice questions:
a. Information to prepare a flexible budget includes
i. Total fixed costs and total variable costs
ii. Total fixed costs, total variable costs and capacity base
iii. Unit fixed costs and unit variable costs
iv. Total fixed costs, variable cost per unit, several levels of activity.
b. The scarce factors of production is known as
i. Key factor
ii. Limiting factor
iii. Critical factor
iv. All of the above
c. Which of the following is a budget designated to furnish budgeted costs for any level of activity
actually attained?
i. Fixed budget
ii. Flexible budget
iii. Master budget
iv. Production budget
d. Flexible budgets are useful for
i. Planning purpose only
ii. Planning, performance evaluation and feedback control
iii. Control of performance only
iv. Nothing at all
7. The following data are available in a manufacturing company for a yearly period
Rs. (lakhs)
Fixed expenses:
Wages and salaries 9.5
Rent, rates and taxes 6.6
Depreciation 7.4
Sundry administrative expenses 6.5
Semi-variable expenses at 50% capacity:
Maintenance and repairs 3.5
Indirect Labor 7.9
Sales department salaries etc. 3.8
Sundry administrative salaries 2.8

Variable expenses at 50% capacity
Materials 21.7
Labor 20.4
Other expenses 7.9
Total cost 98.0
Assume that fixed expenses remain constant for all level of production; semi-variable expenses remain
constant between 45% and 65% capacity, increasing by 10% between 65% and 80% capacity and by 20%
between 80% and 100% capacity.
Sales at various level Rs. (Lakhs)

50% capacity 100
60% capacity 120
75% capacity 150
90% capacity 180
100% capacity 200
Prepare a flexible budget for the year and forecast the profit at 60%, 75%, 90% and 100% capacity.
Ans: 60% 70% 90% 100%
Profit (Rs. In lakh) 12.0 25.2 38.4 48.4

CHAPTER 10
STANDARD COSTING
CHAPER 10 : STANDARD COSTING
10.1 INTRODUCTION
Planning and control inter alia are the functions of top management. Planning involves determination of
objectives of a business and it also refers to the manner in which these objectives are to be achieved. Thus
it refers to both problems solving (identification of alternatives) and decision – making (selection from
alternatives). Plans can be value only if they are achieved. The control function comes into play to
measure the extent to which the plans are achieved so that the actual results do not fully confirm to the
plans; efforts can be made to correct adverse tendencies. Control implies a system which provides for
establishment of plan, operation of the plan, automatic feedback from the system and automatic
regulatory action so that any deviation is corrected. Standard costing can be of immense use to the
management in achieving the two aforesaid important spheres of functions. In the planning stage,
standard costing can assist the managers with much of the necessary data. At the control stage, it can be
used to find the extent and place where such inefficient exist, and also to suggest ways for combating
them by bringing them to the attention of those who have authority to control them.
10.2 DEFINITION OF STANDARD COST
Standard cost is defined as a “pre-determined cost which is calculated from management’s standards of
efficient operation and the relevant necessary expenditure. It may be used as a basis for price fixing and
for cost control through variance analysis.”
Standard cost is pre-determined operating cost. It refers to quantities of materials and labor expected to be
used, prices expected to be paid for materials and labor during the coming year and factory expense
applicable to production based on good performance and practical capacity operation of the factory.
The standard cost of a product has been defined by Blocker and Weltmer “ as a pre-determined cost based
upon engineering specification and representing highly efficient production for quantity standards and
forecasts of future market trends for price standards with a fixed amount expressed in dollars for material,
labor and overhead for an estimated quantity of production”. It may be seen from this definition that
engineering specifications are the basis for quantity standards for materials and time standards for labor
while budgets are of importance in determining material price standards, labor rate standards and
overhead standards.
10.3 NEED FOR STANDARD COSTS:
Since standard costs are pre-determined costs computed before the production takes place, they are
preferable to actual costs. Moreover, certain conditions resulting from mass production make standard
costs necessary and strongly advisable. Some of such conditions are:
a) Historical costs may be too expensive to compute. For example, in a manufacturing concern
producing about 100,000 parts, divided into various lots, imagine the time and clerical labor
involved in arriving at the actual cost lot by lot then averaging it to determine the cost per unit.
b) The unit costs computed on historical data may vary from day to day and they are of no use to
the sales department in setting selling prices. For example, if the historical costs per unit of

product is a week are Rs. 1.05, 0.99, 1.27, 1.18, 1.42, 1.56, the selling price cannot be varied
from day to day to match the costs.
c) Historical costs are not known until after the completion of the month or even a longer period.
But in many cases, to take a decision, the cost of a product has to be calculated even before the
production begins.
d) Historical costs may not be adequate for the measurement of efficiency. Standard costs are well
suited for measuring operating efficiency because they represent what the costs should be. The
management, consequently, knows immediately whether the performance is satisfactory.
10.4 USES OF STANDARD COST
a) Use of standard costs is an effective way for planning and controlling costs.
b) Pricing decisions and decisions involving submission of quotations, answering tenders etc., are
also facilitated by the use of standard costs.
c) Identification and measurement of variances from standards has been made possible with the use
of standard cost, with a view to improve performance or to correct loose standards, if any.
d) Facilitates management by exception.
10.5 DEFINITION OF STANDARD COSTING:
Standard costing is defined by the ICMA, London, “as the presentation and use of standard costs, their
comparison with actual costs and the analysis of variances to their causes and points of incidence.”
Standard costing, thus, is a system of costing which can be used in conjunction with any method of
costing, like job costing, process costing etc. Standard costs are pre-determined by using a careful
analysis of production methods, physical conditions and price factors. They represent achievable targets
and help to build up budgets gauge performance and obtain product costs. The actual costs will vary from
month to month or even from day to day.
The basic objective, therefore, of standard costing system is to assist the departmental head by identifying
and describing the variances over which he has control. Thus, a set of standard developed under the
standard costing system outlines how a task must be compared with standard cost to determine the
variances. The variances, thus arrived at, are analyzed further with a view to discovering better ways of
adhering to standards or of altering the standards so as to accomplish the objectives. Under this system,
the cost is pre-determined for each element, namely, material, labor and overhead and for each line of
product manufactured or service rendered. It, therefore, involves:
a) The setting of standards,
b) Ascertainment of actual costs,
c) Comparison of actual and standard costs to determine the variance, and
d) Investigation of variance and taking appropriate action thereon wherever necessary.

10.6 PRELIMINARIES OF ESTABLISHING A SYSTEM OF STANDARD COSTING:
The following preliminary steps should be considered before a system of standard costing can be set into
operation in an organization:
a) The establishment of cost centers with clearly defined areas of responsibility.
b) Classification and coding of accounts for collection and comparison actual costs with standard
costs.
c) Selectin of s suitable type of standard for operation.
10.7 ADVANTAGES AND LIMITATIONS OF STANDARD COSTING
Advantages of Standard Costing

1. Exact degree of efficiency in various operations can be ascertained through comparison of
actual and standard cost. The variances between actual and standard costs reveal the weaknesses
and inefficiencies. This enables management to remove causes of inefficiency.
2. Management by exception is possible, since it is possible to separate the efficient from inefficient
operation. Variance analysis helps management to concentrate on those areas where corrective
measures are to be taken in time. They do not go to the masses of details. They are attracted
towards faults which should not be overlooked.
3. Efficiency is consolidated and if necessary, the standards are revised after identifying exact
causes of deviations of actual costs from standard costs.
4. There can be effective delegation of authority since the people concerned are told what they have
to achieve and by what they will be judged. Control itself becomes effective.
5. The effect of idle capacity or fluctuations in output or sales is also highlighted. Variances due to
idle capacity and fluctuation in sales are ascertained in the standard costing system which
provides very useful information to the management.
6. Standard costing is immense benefit for cost audit since if variances are satisfactorily explained,
the accuracy of costing can be safety assumed.
7. The cost accounting itself is reduced since all rates are fixed and do not have to be calculated
again and again. Also, automatically the effect of efficiency or inefficiency is revealed.
8. Standard costing can be used in formulating production and price policies in advance. Standard
costs are the best basis for establishing policies in as much as such standards which usually
eliminate the effect of fluctuating volume and again avoid any cost-increase due to waste or
inefficiency.
9. Standard costs provide basis of incentive schemes to workers and supervisors. The system
determines standard labor costs of a product and with help of these, incentive schemes are
formulated.
10. Standard costing simplifies the cost control procedure as the figures for control purposes are
easily and directly obtained. Thus there is saving in the accounting computation. Moreover, the
standard cost of materials and rates of labor and overheads are available which make accounting
calculation easier.

11. Standard costing helps in business planning, budgeting and marginal costing. Standard costing
are pre-determined costs and are therefore very useful in planning and budgeting. Standard
costing can be very easily and suitably used for budgetary planning. These help in estimating the
effect in cost-price-volume relationship.
12. Standard costs are used for inventory valuation. Once the standards have been set, it is the
standard costs, not the ‘actual’ or ‘historical’ costs, which are entered in the accounts for the
purpose of valuing material-stock, work-in-progress and finished goods consequently the cost of
goods sold in the trading account, because the standard cost and the gross profit is ‘at standard’.
Limitations of Standard Costing

Standard costing may not prove a success in certain organization due to difficulty in fixing up reliable and
workable standards. If standards are not correctly established, the cost control and variance analysis will
not be effective. Conclusions drawn on such variances will be doubtful and it will be detrimental to the
system and will be worse than having no standards at all.
Thus the basic limitation is that fixation of standard cost is somewhat difficult in practice. Moreover, the
standards fixed may become rigid in course of time or even in short period. Standards cannot be revised at
every frequent change in the manufacturing condition
Some worth mentioning points of limitations of standard costing are narrated below:
1. It is expensive technique because it requires technically skilled staff. Small concern may not find
standards easy to establish due to their limited resources. But, it must be noted that once the
standard are established, the advantages achieved will be far more cost involved in the
beginning.
2. Business conditions are rapidly changing and therefore standard costs once fixed may not be
reliable even for a short period. Standards are to be revised frequently so as to make these
comparable with actuals. But the revision will create the problem of inventory adjustment.
3. In small concerns, where production is not carefully scheduled standard costing may not be
suitable. The system is also not very useful in industries dealing with non-standardized products.
For example, it cannot be successfully used in repairs jobs, which are carried on according to
customer’s requirement. In those contracts and jobs also, standard costing is not suitable, where
the work is carried on for more than one accounting year.
10.8 DISTINCTION BETWEEN BUDGETARY CONTROL AND STANDARD COSTING
Budgeting is for entire activity. Budgetary control means laying down in monetary and quantitative terms
what exactly has to be done and how exactly it has to be done over a coming period and then to ensure
that actual results do not diverge from the planned course more than necessary.
Standard costing is a system which seeks to control the cost of each unit or batch through determination
beforehand of what should be the cost and then its comparison with actual cost. Thus standard cost is pre-
determined or budgeted cost of a unit of a product or job.

In both systems there are some common basic principles:

i. In both systems the performance target or standard is predetermined.
ii. The actual performance is ascertained and both have appraisal of the actual performance.
iii. In both systems there is comparison of actual performance and costs against budget or standard.
There is computation and analysis of variances between the actual cost and budgeted or standard
cost.
iv. Both need revision of standard or budget whenever necessary in the light of attainment.
Yet both have some specific differences as narrated below:

1. Budgetary control deals with the operation of a department or the business as a whole in the
terms of revenue and expenditure. Standard costing is used in manufacturing or producing of a
product or in rendering a service. Hence budgetary control is more extensive because it is
concerned with entire organization while standard costing is related to product and its cost, and
therefore more intensive.
2. Budgetary control seeks to keep in focus the total amount involved and total activity to be
carried on. Standard costing provides control to be exercised in the cost of production.
3. Budgets prepared under Budgetary control system are for specific periods and are based on totals
of amounts while in standard costing , the standard costs are worked out generally per unit of
production or service.
4. Basically a budget under budgetary control is projection of financial accounts while standard
cost is merely a projection of cost accounts.
5. Budgetary control is generally applicable to all business establishments, while standard costing
can be usefully applied in manufacturing concerns producing standard products and services.
6. Budgetary control is an effective tool in control of all types of expenses while standard costing is
very effective tool in the matter of control of elements of costs like direct costs (direct material,
direct labor, etc.) and overheads
7. Budgetary control is an effective tool to plan and exercise control over capital expenditure,
finance and cash forecast etc., whereas standard costing can offer no help.
8. Budgets provide ceiling or limits of expenses beyond which the actual expenditure should be
normally go up otherwise the planned profit will be reduced. On the other hand standard costs
are usually minimum targets which are to be achieved by the actual performance. Thus the
former puts more emphasis on revenue and expenditure not crossing the budget, while the
standard costing lays importance to costs approaching the standard costs.
9. Budgets are prepared for all the activities and the functions of an establishment such as
purchasing, production, research and development, capital and financing, selling and distribution
etc., whereas standard costing relates only to production and its manufacturing cost.
10. .Variance analysis is more intensive and searching in case of standard costing in comparison to
budgetary system. In standard costing, even if standards are achieved, further analysis is carried
on to achieve efficiency. If expenditure exceed the budget it simply shows that situation is
unsatisfactory but if actual cost of production exceeds standard cost, the variances are analyzed
in detail to search out the possible improvements.

Considering the basic principles and approach, standard costing and budgetary control are somewhat
inter-related, but basically these two are independent. A system of budgetary control may be efficiently
and effectively operated even if there is no standard costing system in use in a concern. Standard costing
may also be operated without budgetary control, but introduction of standard costing will more facilitated
if budgetary system is in operation. Budgetary control will provide basic framework required in the
fixation of realistic standards. If both techniques are adopted simultaneously, there will be very effective
cost control machinery. Thus budgetary control and standard costing are essentially complementary to
each other. Both provide cost control and improve efficiency.
10.9 TYPES OF STANDARDS
The value of standards costing system depends upon the reliability of the standards set up. To complete
the standards we must know what degree of accuracy is necessary. There are four different bases or
standard which should be considered. These standards have been discussed below.
a. Basic or Bogey standards:

These standards are used only when they are likely to remain constant or unaltered over a long period.
According to this standard, a base year is chosen for comparison purposes in the same way as statisticians
use price indices. Since basic standard do not represent what should be attained in the present period,
current standards should also be prepared if basic standards are used. Basic standards are, however, well
suited to business having a small range of products and long production runs. Basic standards are set, on a
long-term basis and are seldom revised. When basic standards are in use, variances are not calculated as
the difference between standard and actual cost. Instead the actual cost is expressed as a percentage of
basic cost. The current cost is also similarly expressed and the two percentages are compared to find out
how much the actual cost has deviated from the current standard. The percentages are next compared with
those of the previous periods to establish the trend of actual and current standard from basic cost.
b. Ideal standards:
These represent the level of performance attainable when prices for material and labor are most favorable,
when the highest output is achieved with the best equipment and layout and when the maximum
efficiency in utilization of resources results in maximum output with minimum cost. These types of
standards are criticized on three grounds:
i. Since such standards would be unattainable, no one would take them seriously.
ii. The variances disclosed would be variances from the ideal standards, These would not
therefore, indicate the extent to which they could have been reasonably and practically
avoided.
iii. There would be no logical method of disposing of these variances.
c. Normal standards:
These are standards that may be achieved under normal operating conditions. The normal activity has
been defined as “the number of standard hours which will produce at normal efficiency sufficient goods
to meet the average sales demand over a term of years.” These standards are, however, difficult to set

because they require a degree of forecasting. The variances thrown out under this system are deviations
from normal efficiency, normal sales volume, or normal productive volume. If the actual performance is
found to be abnormal, large variances may result and necessitate revision of standards.
d. Current standards:
These standards reflect the management’s anticipation of what actual costs will be for the current period.
These are the costs which the business will incur if the anticipated prices are paid for the goods and
services and the usage corresponds to that believed to be necessary to produce the planned output. The
variances arising form expected standards represent the degree of efficiency in usage of the factors of
production, valiance in prices paid for materials and services and difference in the volume of production.
10.10 SETTING STANDARDS
In a big establishment, generally a standard cost committee is set-up which is entrusted the work of
setting up standard costs. This committee is normally consists of production manager, Purchase manager,
sales manager and cost accountants etc. out of these executives, the function of the Cost Accountant is of
great importance because he alone can provide all necessary data relating to cost and he has to coordinate
the activities of the standard cost committee.
Standard cost is divided into three main heads: 1. Direct Materials, 2. Direct labor, 3. Direct and indirect
overhead expenditure. Standard for each of these elements of cost are set.
1. Direct material cost standard: This standard consist of two basic elements. Standard material
quantity or usage and standard material price
a) Material quantity or usage standard: The standard quantities of direct materials, which are
required to manufacture a product, are normally decided or fixed by production manager and
engineers. For this purpose material specification, standard ratio of their mix (when more than
one direct material is needed), product design and quality should be kept in consideration.
Moreover, normal wastage or scrap should also be kept in a view while deciding quantity or
usage of direct material.
b) Material price standard: For determining material standard consumed, the cost accountant will
have to decide standard price in consultation with the purchase manager. The standard price may
be based on past average prices of raw material or on current prices or on expected future prices.
It is desirable that prevailing current prices should be adjusted to suit future price-variations.
While determining expected prices following points should be taken into consideration.
i. Prices of opening stock in hand
ii. Prices for which contracts have been undertaken to obtain material
iii. Expected price-changes
iv. Price-rebate and discounts which can be availed.
2. Direct labor cost standards: There are two elements of standards direct labor –(a) Standard labor
time, and (b) Standard labor rate

(a) Standard labor time: Standard labor time is to be set for each grade of labor and also foe each
operation involved in the production. It is set with the help and advice of the work-study
engineers. With the technique of motion and time study, the standard time for performance of
labor is fixed. Due allowance should be made for fatigue, tool setting and other normal delays.
(b) Standard labor rate: Rate of wages to be paid to workers should be very properly decided.
Wages paid to efficient and skilled workers having technical knowledge may be higher than
those for unskilled and non-technical workers. There may be workers under a contract, then rate
approved by the contract may usually become the standard.
The standard labor hours multiplied by standard labor rate become standard labor cost.
3. Overhead cost standards: Overheads may be classified into indirect material, indirect labor, fixed
overheads and other variable overheads. Indirect material cost is determined per machine or
production hour. Indirect labor cost is determined per machine or production hour or percentage of
direct labor. Fixed expenses are total amount for the period of budgeted production hours. Variable
overhead cost is determined on the basis of cost per unit of output or cost per production hour.
The total fixed overhead cost remains fixed and remain unchanged by changes in the volume of
production. For this purpose, it is necessary to ascertain budgeted fixed overheads for the period and
the budgeted units or standard hours for the period.
Standard cost for variable overheads, once calculated, remains the same per unit or per hour
irrespective of volume of production because standard for variable cost tends to vary directly with the
volume of production, while calculating its standard unit cost, due consideration should be given to
past records and future trend of prices.
It is to be noted that standards fixed should be comprehensive and realistic. They should be related to
the specific period and to the stipulated working conditions. The standard need not be ‘ideal’ but
should be easily attainable. The attainable standard is a normal standard fixed on the basis of average
efficiency of men, machine and material. It provides reasonable allowances for wastage of material
and idle time. On the other hand an ideal standard is based on minimum prices of material and
maximum efficiency of men and machinery. It may be said that an ideal standard is most favorable
but can rarely be achieved in practice.
It is necessary that the standard cost should be related to a common measurement unit. This common
unit is normally a time unit and is called standard hour. It is the quantity of production units which
can be completed in one hour. After fixing standards hour for each product, the standard for the
different items of cost of production are related to standard hour. Thus the standard hour may be
defined as ‘a hypothetical hour representing the amount of work which should be performed on an
hour under standard conditions.’

Computation of Variances:
Let us now proceed to study with illustration the method of computation of major variances. In all the
problems illustrated in the following pages, ‘F’ means favorable variance and ‘A’ means adverse
variance.
10.11 DIRECT MATERIAL COST VARIANCE
The total direct material cost variance for actual output can basically be divided into two types, namely
(a) price variance and (b) usage variance. The method of calculating these variances is as under:
Total material cost variance = Standard cost –Actual cost
Price variance = Actual quantity (Standard price – Actual price)
Usage variance = Standard price (Standard quantity - Actual quantity)
Illustration: 1
The standard and actual figures of product ‘Z’ are as under:
Standard Actual
Material quantity 50 unis 45 units
Material price per unit Re.1.00 Re.0.80
Calculate material cost variances.
Solution
The variances may be calculated as under:
a) Standard cost = std qty x std price = 50 units x Re. 1.00 = Rs. 50
b) Actual cost = Actual qty x Actual price = 45 units x Rs. 0.80 = Rs. 36
Variances
i. Price variance = Actual qty (std. price – Actual price)
= 45 units (Re 1.00 – Re. 0.80) = Rs. 9 (F)
ii. Usage variance = Std. price (Std.qty – Actual qty)
= Re. 1 ( 50 units – 45 units) = Rs. 5 (F)
iii. Material cost variance (Total variance) =Standard cost – Actual cost
= Rs. 50 – Rs. 36 = Rs. 14 (F)
* Mix variance: If two or more materials are mixed in a process, an optimum or standard mixture is
decided upon by the production planning department. If the actual mix is different from the standard mix,
a variance arises. This part of the usage variance attributable to the change in mix is called the mix
variance. The procedure and formula for calculating the mix variance is as under:
i. Calculate the standard cost per unit of the standard mix.
ii. Calculate the standard cost per unit of the actual mix.
iii. Multiply the difference between (a) and (b) with the total actual quantity.
Thus, Mix variance
= Total actual qty. (Std. cost per unit of std. mix – Std. cost per unit of actual mix)

* Yield variance: In some industries the finished product can be related to the raw material input in terms
of units. Weight, volume, etc. and consequently the standard loss of material can be readily computed.
This relationship is known as the yield. When the standard yield is given and the actual consumption
deviates from standard consumption, the difference is known as yield as yield variance as yield variance.
Yield variance is just another way at the sub-usage variance.
Illustration: 2
The standard quantity of material required is 4 kgs Per unit of actual output. The relevant figures are as
under:
Material A B C D
Standard mix % 30% 40% 20% 10%
Price per kg (Rs.) 1.25 1.50 3.50 3.00
Actual qty. used (Kg) 1,180 1,580 830 440
Actual price per kg (Rs.) 1.30 1.80 3.40 3.00
Actual output 1,000 units
Calculate price variance, mix variance, sub-usage variance and total material cost variance.
Solution
i. Since the actual output is 1,000 untis, the standard quantity of materials required for the actual
output is 1,000 units x 4 kgs = 4,000 kgs.
ii. Statement showing computation of standard cost, standard cost of actual quantity and actual
cost.
Material Std. cost Actual Std. qty in Actual qty Std. cost Std cost of Actual cost
per kg cost per kg. Rs. in kg. Rs. (Std. qty x actual qty (actual qty
Rs. kg price) (actual qty x actual
Rs. Rs. x std. price) Rs.
price) Rs.
a b c d e=axc f=axd g =b x d
A 1.25 1.30 1,200 1,180 1.500 1,475 1,534
B 1.50 1.80 1,600 1,580 2,400 2,370 2,844
C 3.50 3.40 800 830 2,800 2,905 2,822
D 3.00 3.00 400 440 1,200 1,320 1,320
4,000 4,030 7,900 8.070 8,520
iii. Standard cost per unit of the standard mix = Rs. 7,900/ 4,000 kgs = Rs. 1,975
iv. Standard cost per unit of the actual mix = Rs. 8,070/ 4,030 kgs = Rs. 2,002
Variances:
i. Price variance = Actual qty. (Std. price –actual price)
= Rs. 8,070 – Rs. 8,520 = Rs. 450 (A)
ii. Mix variance = Total actual qty. (Std. cost per unit of std. mix – Std. cost per
unit of actual mix)
= 4,030 Kgs (Rs.1.975 – Rs.2.002) = Rs. 110 (A)

iii. Sub usage variance = Std. price per unit of std.mix (Total std. qty. – Total actual
qty.)
= Rs. 1,975 (4,000 = 4,030) = Rs.60 (A)
iv. Total material cost variance = Std. cost – Actual cost = Rs. 7,900 – Rs. 8,520
= Rs. 620 (A)
Proof: Price variance + Mix variance + sub-usage variance = Total variance
Rs. 450 (A) + Rs. 110 (A) + Rs. 60 (A) = Rs. 620 (A)
Note: ‘Mix variance’ and sub usage variance are sub-part of total usage variance which may be
calculated as below:
v. Usage variance = Std. price (Std. qty – Actual qty.)
= Std. cost – standard cost of actual qty.
= Rs. 7,900 – Rs. 8,070 = Rs. 170 (A)
Illustration: 3
The standard set for a chemical mixture of a firm is as under;
Material Standard mix % Standard price per kg (Rs.)
A 40 60
B 60 30
The standard loss in production is 10%. During a period, the actual consumption and price paid for a good
output lf 182 kg. are as under:
Material Quantity in kg. Actual price per kg (Rs.)
A 90 18
B 110 34
Calculate the variance.
Solution
Take the good output of 182 kgs. The standard quantity of material required for 182 kg of output is
=182/90 x 100 = 202.22 Kgs.
Standard showing the standard and actual costs and standard cost of actual mix
Standard cost Actual cost Std. cost of actual quantity
Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
Kg. Rs. Rs. Kg. Rs. Rs. Kg. Rs. Rs.
A (40%
of
202.22
kg) 80.89 20 1,617.80 90 18 1,620 90 20 1,800
B(60%
of
202.22
kg) 121.33 30 3,639.90 110 34 3,740 110 30 3,300
Total 202.22 26 5,257.70 200 26.40 5,360 200 25.50 5,100
input
(-) Loss

20.22 -- 18 --
Total
output 182.00 28.89 5,257.70 182. 29.45 5,360 -- -- --
Standard yield in actual input is 90% of 200 kg i.e. 180 kg.
Variances:
i. Price variance = Actual qty. (Std. price –actual price)
= Rs.5,100 – Rs. 5,360 = Rs. 260 (A)
ii. Mix variance = Total actual qty. of input (Std. cost per unit of std. mix – Std.
cost per unit of actual mix)
= 200 Kgs (Rs.26 – Rs.25.50) = Rs. 100 (F)
iii. Total usage variance = Std. price (Std. qty. – Actual qty.)
= Standard cost – Standard cost of actual quantity
= Rs. 5,257.70 - Rs. 5,100 = Rs.157.70 (F)
iv. Yield variance = Standard price of yield. (Actual yield – Std. yield)
= Rs.28.89 (182 -180) = Rs. 57.70 (F)
v. Total variance = Std. cost – Actual cost = Rs. 5,257.70 – Rs.5,360
= Rs. 102.30 (A)
Note: (iii) and (iv) above are sub parts of total usage variance
Proof: Price variance + Mix variance + Yield variance = Total variance
Rs. 260 (A) + Rs. 100 (F) + Rs. 57.70 (F) = Rs. 102.30 (A)
10.12 LABOR COST VARIANCE ANALYSIS
The two basic variances that can be calculated in respect of direct labor are (a) rate variance and (b)
efficiency variance.
The formula’s for calculating labor variances are as under:

Total labor cost variance = Std. labor cost – Actual labor cost
Rate variance = Actual time (Std. rate – Actual rate)
Efficiency variance = Std. rate (Std. time – Actual time)
Illustration: 4
The standard and actual figures of a firm are as under:
Standard time for the job 1,000 hours
Standard rate per hour Re. 0.50
Actual time taken 900 hours
Actual wage paid Rs. 360
Compute the variances
Solution
(i) Std. labor cost (1,000 hours x Re.0.50) Rs. 500
(ii) Actual wages paid Rs. 360

(iii) Actual rate per hour: Rs. 360 ÷ 900 hours = Re. 0.40
Variances:
i. Rate variance = Actual time. (Std. rate –actual rate)
= 900 hours ( Re. 0.50 – Re. 0.40) = Rs. 90 (F)
ii. Efficiency variance= Std. rate per hour (Std. time – Actual time)
= Re. 0.50 (1,000 hours – 900 hours) = Rs. 50 (F)
iii. Total labor cost variance = Std. labor cost – Actual labor cost
= Standard cost – Standard cost of actual quantity
= Rs. 500 - Rs. 360 = Rs.140 (F)
• Gang composition variance or Labor mix variance: A change in the standard gang
composition may also result in a variance which can be measured as shown in the following
illustration.
Illustration: 6
Given the following data, compute the variances.
Skilled Semi-skilled Unskilled
Number of workers in standard gang
Standard rate per hour
Actual number of workers in the gang
Actual rate of pay per hour (Rs.)
In a 40- hour week, the gang as a whole produced 900 standard hours
Solution
In a 40 hour week, the standard gang should have produced 1,000 std. hours as shown below:
Skilled 16 No. of worker x 40 hours = 640
Semi-skilled 6 No. of workers x 40 hours = 240
Unskilled 3 No. of workers x 40 hours = 120
1,000 hours
However, the actual output is 900 standard hours. Hence to find out the total labor cost varianc, the
standard cost (or cost charged to production) is to be computed with reference to 900 standard hours. This
is done in the following statement:
Statement showing the standard cost, actual cost and standard cost of actual time for actual output,
i.e. 900 Standard hours
Gang Standard cost Actual cost Standard cost of actual time
Hours Rate Amount Hours Rate Amount Hours Rate Amount Rs.
Rs. Rs. Rs. Rs. Rs.
Skilled {(640*900)/1,000} 3 1,728 14*40 4 2,240 560 3 1,680
= 576 =560
{(240*900)/1,000} 2 432 9*40 =360 3 1,080 360 2 720

= 216
{(120*900)/1,000} 1 108 2*40 =80 2 160 80 1 80
= 108
900 2.52 2,268 1,000 3.48 3,480 1,000 2.48 2,480
Variances:
i. Rate variance = Actual time (Std. rate –actual rate)
= (Standard cost of actual time – actual cost)
= Rs. 2,480 – Rs. 3,480 = Rs. 1,000 (A)
ii. Gang variance = Total actual time (Std. rate of std. gang – Std. rate of actual gang)
= 1,000 (Rs.2.52 – Rs.2.48) = Rs. 40 (F)
iii. Sub-efficiency variance = Std. rate (Total std. time. – Total actual time)
= Rs. 2.52 (900 hours -1,000 hours) = Rs.252 (A)
iv. Total labor cost variance = Std. labor cost – Actual labor cost
= Rs. 2,268 – Rs. 3,480 = Rs. 1,212 (A)
The gang composition variance may also be known as labor mix variance and is part of efficiency
variance which may be computed as under:
v. Efficiency variance = Std. rate (Std. time – Actual time)
= Std. cost – standard cost of actual time.
= Rs. 2,268 – Rs. 2,480 = Rs. 212 (A)
Labor idle time variance:

This variance arises due to the difference between actual labor hours worked and the actual labor hours
paid (idle time hours). This is computed by multiplying the difference between hours worked and paid by
the standard labor rate. It may be written as follows:
Standard labor rate (actual hours worked – actual labor hour paid)
OR
Standard labor hour rate x idle time hours
Illustration: 7
A firm gives you the following data:
Standard time per unit 2.5 hours
Actual hours worked 2,000 hours
Standard rate of pay Rs. 2 per hour
25% of the actual hours has been lost as idle time.
Actual output 1,000 units
Actual wages Rs. 4,500
Calculate the idle time variance.
Solution
Standard cost charged to production = (1,000 units x 2.5 hours x Rs. 2) = Rs. 5,000
Actual wages paid Rs. 4,500

Actual wages rate per hour (Rs. 4,500 ÷ 2,000 hours) Rs. 2.25
Std. wage rate per hour Rs. 2.00
Abnormal idle time (25% of 2,000 hours) = 500 hours
i. Wage rate variance = Actual time (Std. rate –actual rate)

= 2,000 hours (Rs. 2 - Rs. 2.25) = 500 (A)
ii. Efficiency variance = Std. rate (Std. time – Actual time*)
= Rs. 2 (2,500 hrs. – 1,500 hrs.) = Rs. 2,000 (F)
iii. Idle time variance = Idle time x Std. rate
= 500 hours x Rs. 2 = Rs. 1,000 (A)
iv. Total variance = Std. labor cost – Actual labor cost
= Rs. 5,000 – Rs. 4,500 = Rs. 500 (F)
* Actual time less idle time.

CHAPTER 11
UNIFORM COSTING AND INTER FIRM
COMPARISON
CHAPER 11 : UNIFORM COSTING AND INTER FIRM COMPARISION
11.1 UNIFORM COSTING
Meaning of uniform costing is not a distinct method of costing. In fact, when several undertakings start
using the same costing principles and/or practices they are said to be following uniform costing.
Sometimes trade and business associations bring uniformity in costing principles and practices among all
industries. Uniform costing is not a separate method of cost accounting like process or job costing,
standard costing or marginal costing. It only points to a situation where a number of business firms are
applying similar costing principles and practices. The basic idea behind uniform costing is that the
different concerns in an industry should adopt a common method of costing and apply uniformly the same
principles and techniques for better cost comparison and common good. The principles and methods of
compilation, analysis, apportionment and absorption of overheads differ from one concern to another in
the same industry; but if a common or uniform pattern is adopted by all, it helps mutually in cost control
and cost reduction. Therefore, it is necessary that a uniform method of costing should be adopted by the
member unit of an industry.
11.2 ESSENTIALS REQUISITES FOR THE INSTALLATION OF UNIFORM COSTING

SYSTEM
A successful system of uniform costing has the following requirements:
i. The firms in the industry should be willing to share/furnish relevant data or information.
ii. A spirit of cooperation and mutual trust should prevail among the participating firms.
iii. Mutual exchange of ideas, methods used, and special achievements made, research and
knowhow etc. should be frequent.
iv. Bigger firms should take the lead towards sharing their experiences and knowhow with the
smaller firms to enable the latter to improve the performance.
v. Uniformity must be established with regard to several points before the introduction of uniform
costing in an industry. In fact, uniformity should be with regard to following points :
1. Size of the various units covered by uniform costing
2. Production method
3. Accounting methods, principles and procedures used
11.3 OBJECTIVES OF UNIFORM COSTING
The main objectives of uniform costing are as follows: -

a. To facilitate the comparisons of cost and performance of different units in the same industry; it
provides objective basis.
b. To eliminate unhealthy competition among the different units of an industry
c. To improve production capacity level and labor efficiency by comparing the production cost of
different units with each other.
d. To provide relevant cost information/data to the government for fixing and regulating prices of the
products.
e. To bring standardization and uniformity in the operation of participating units.
f. To reduce production, administration, selling and distribution costs, and to exercise control on
fixed costs.

Areas of uniformity: Uniform costing requires uniformity in cost accounting principles and procedures
especially in the following areas:
1. General classification of accounts: Uniformity in classification and codification of accounts should
be maintained.
2. Method of overhead allotment: The basis on which the various overheads should be allotted to
producing and servicing department should be followed by all members of the industry groups
using uniform costing.
3. Method of overhead absorption: Uniformity in the method of overhead absorption is most
important.
4. Scrap and losses: The general method of treatment to be accorded to scrap and losses should be
specified. The method of dealing with income from the sale of waste products should be specified.
5. Joint Costs: The treatment of joint costs is also very important and a uniform method should be
followed. It should also be decided as to which costs should or should not be included in cost.
Uniform Cost Manual: The designing and applications of uniform costing require that the uniform cost
manual containing instructions, clarifications, rules and guidelines about cost determination, cost analysis
and cost control should be developed and circulated among the business enterprises that have decided to
use uniform costing. A uniform cost manual usually contains the following matters
1. Introduction: The introduction of the manual describes the statement of objectives of the system,
scope of the system, advantages to be achieved and its basic features;
2. Accounting organization: It contains a scheme of organization for designing and operating the cost
accounting system.
3. Accounting system: it contains general principles of accounting, a coding system terminology,
classification and description of accounts.
4. Cost accounting system: It describes method of costing (job, process, standard costing etc.), system
of integration in accounts, relation between cost and financial accounts, items to be included or
excluded in stocks, classification of labor cost and treatment of labor related costs such as idle time,
overtime, holidays and shift allowances, etc., classification, collection, apportionment and absorption
of overhead, calculation of depreciation, treatment of under and over absorption.
5. Presentation of information: This section clearly describes how the cost information should be
presented. It contains forms and contents of statements to be prepared, forms of reports to
management, forms of report to shareholders, detailed operation and production costs, cost ratios,
financial ratios and other supplementary information.
11.4 ADVANTAGES OF UNIFORM COSTING

The advantages accruing from the use of uniform costing system are as follows:
1. The management of each firm will be saved from the exercise of developing and introducing a cost
system of its own.
2. A costing system devised by mutual consultation and after considering the difficulties and
circumstances prevailing in different firms is readily adopted and successfully implemented.
3. It facilitates comparison of cost figures of various firms to enable the firms to identify their weak
and strong points besides controlling costs.
4. Optimum achievements of efficiency are attempted by all the firms by utilizing the experience of
other concerns in the industry.

5. Standing in the industry of each firm will be known by making a comparison of its cost data with
others.
6. Services of cost consultants or experts may be available jointly to each firm in the industry by
sharing their experiences and expenses.
7. Research and development benefits of bigger firms may be made available to smaller firms.
8. It helps in the reduction of labor turnover, as a uniform wage system is the precondition of a
uniform costing system.
9. It helps trade associations in negotiating with the government for any assistance or concession in the
matters of taxation, exports, subsidies, duties and prices determination etc.
10. Unhealthy competition is avoided among the firms in the same industry in framing pricing policies
and submitting tenders.
11. Prices fixed on the basis of uniform costing are representative of the whole industry and thus are
reliable.
12. Uniform costing provide a basis for the comparative assessment of the performance of two firms in
the same industry but in different sectors.
13. It helps the government in regulating the prices of essential commodities such as bread, sugar,
cement, steel etc.
14. Small business firms are not able to maintain a full costing system as it is costly and complicated. If
the business associations and federations develop some costing principles for the benefit of all
business concerns, much cost likely to be incurred on designing and establishing a costing system is
likely to be saved.
11.5 LIMITATIONS OF UNIFORM COSTING
1. Sometimes it is not possible to adopt uniform standards, methods and procedures of costing in
different firms due to differing circumstances in which they operate. Hence, the adoption of
uniform costing becomes difficult in such firms.
2. Disclosure of cost information and other data is an essential requirement of a uniform costing
system. Many firms do not wish to share such information with their competitors in the same
industry.
3. Small firms in an industry believe that uniform costing system is only meant for big and medium
size firms, because they cannot afford it.
4. It induces monopolistic trend in the business, due to which prices may be increased artificially
and supplies withheld.
11.6 INTER-FIRM COMPARISON
Meaning of Inter-Firm Comparison: It is technique of evaluating the performance, efficiency, costs and
profits of firms in an industry. It consists of voluntary exchange of information/data concerning costs,
prices, profits, productivity and overall efficiency among firms engaged in similar type of operations for
the purpose of bringing improvement in efficiency and indicating the weaknesses. Such a comparison will
be possible where uniform costing is in operation.
An inter-firm comparison indicates the efficiency of production and selling, adequacy of profits, weak
spots in the organization, etc. and thus demands from the firm's management an immediate suitable
action. Inter-firm comparison may enable the management to challenge the standards which it has set for

itself and to improve upon them in the light of the current information gathered from more efficient units.
Such a comparison may be carried out in electrical industry, printing firms, cotton spinning firms,
pharmaceuticals, cycle manufacturing, etc.
Requisites of inter-firm comparison system: The following requisites should be considered while
installing a system of inter-firm comparison:-
a. Centre for Inter-comparison – For collection and analyzing data received from member units, for
doing a comparative study and for dissemination of the results of study a Central body is necessary.
The functions of such a body may be :-
i. Collection of data and information from its members;
ii. Dissemination of results to its members;
iii. Undertaking research and development for common and individual benefit of its members;
iv. Organizing training programmes and publishing magazines.
b. Membership – Another requirement for the success of inter-firm comparison is that the firms of
different sizes should become members of the centre entrusted with the task of carrying out inter-firm
comparison.
c. Nature of information to be collected - Although there is no limit to information, yet the following
information useful to the management is in general collected by the centre for inter-firm comparison.
i. Information regarding costs and cost structures.
ii. Raw material consumption
iii. Stock of raw material, wastage of materials, etc.
iv. Labor efficiency and labor utilization.
v. Machine utilization and machine efficiency.
vi. Capital employed and Return on capital.
vii. Liquidity of the organization.
viii. Reserve and appropriation of profit.
ix. Creditors and debtors.
x. Methods of production and technical aspects.
d. Method of collection and presentation of information – The Centre collects information at fixed
intervals in a prescribed form from its members. Sometimes a questionnaire is sent to each member;
the replies of the questionnaire received by the Centre constitute the data. The information is
generally collected at the end of the year as it is mostly related with final accounts of Balance Sheet.
The information supplied by firms is generally in the form of ratios and not in absolute figures. The
information collected as above is stored and presented to its members in the form of a report. Such
reports are not made available to non-members.
Advantages of inter-firm comparison:

The main advantages of inter-firm comparison are as follows:
1. Such a comparison gives an overall view of the industry as a whole to its members- the present
position of the industry, progress made during the past and the future of the industry.
2. It helps a concern in knowing its strengths or weaknesses in relation to others so that remedial
measures may be taken.
3. It ensures an unbiased specialized reporting on particular problems of the concern.
4. It develops cost consciousness among members of the industry.
5. It helps government in effecting price regulation.
6. It helps to improve the quality of products manufactured and to reduce the cost of production. It is
thus advantageous to the industry as well as to the society.

Limitations of Inter-firm comparison

The following are the limitations in the implementation of a scheme of inter-firm comparison:
1. Top management feels that confidentiality of the firm would be compromised.
2. Middle management is usually not convinced with the utility of such a comparison.
3. In the absence of a suitable cost accounting system, the figures supplied may not be reliable for the
purpose of comparison.
4. Suitable basis for comparison may not be available.
However, the above limitations are basically due to differences in the nature of participating business
firms and use of accounting methods. Therefore, a uniform cost accounting system should be established
in every participating firm and business firms should be educated about the advantages and uses of inter
firm comparison.
Self-Examination Questions
1. Define uniform costing. Explain its objectives.
2. What are the requisites for the installation of a Uniform Costing System?
3. What are the advantages of uniform costing? State its limitations.
4. Enumerate the points on which uniformity is essential before introducing Uniform costing system.
5. Explain the concept of "uniform costing". What is uniform costing manual?
6. What do you mean by inter-firm comparison? Give its advantages and installation.
7. Describe the requisites to be considered while installing a system of inter-firm comparison by an

industry.

CHAPTER 12
COST CONTROL AND COST REDUCTION
CHAPER 12 : COST CONTROL AND COST REDUCTION
12.1 INTRODUCTION
The continuous rise in the prices of raw materials, increase in wage rates and cost of services tends to
increase the cost of production. It may not be possible to increase the selling prices of finished goods
proportionately because of the prevalence of stiff competition or Government controls. If a corresponding
increase in selling prices of the finished products is not achievable, the increase in cost of production will
result in the reduction of profit margin.
The survival of the products in the international sphere is linked with the ability to maintain an adequate
share of the export market. This can only be achieved by increased productivity and efficiency in
industry. Any improvement in efficiency will lead to reduced cost of production and will improve
competitive power.
In the social sphere, duty has been cast on the industries to serve the society by providing goods of proper
quality at reasonable prices. This emphasizes the need to explore avenues for reduction In the cost of
production to satisfy the social obligation of providing goods and services to the common man at a low cost.
It thus becomes essential to take maximum advantage of every technique of cost reduction. A planned
program of cost reduction is a valuable aid to industry in increasing productivity. It enables the
management to locate potential areas where savings can be effected. Cost reduction embraces two
aspects, namely (a) reduction in unit cost resulting from reduction in expenditure in respect of a given
volume of output and/or (b) reduction in unit cost by an increase in productivity, that is, an increase in
yield or rate of output for a given expenditure. In practice, however, cost reduction will ultimately be
achieved by a combination of these influences and it will hardly be possible to pinpoint the extent of
contribution which each factor will make to the overall savings.
The extent to which potential saving can be achieved through cost reduction program will vary from
organization to organization depending upon the levels of efficiency already attained. However,
considerable scope for cost reduction does not exist in every business and a systematic approach to the
problem and an appreciation of the many factors having a bearing upon unit cost, can ensure that the
maximum benefits will result.
Apart from the long-term cost structure decision, as discussed above, there are certain other managerial
decisions which affect structure of a product for many years, if not for its total life. Thus, the basic design
of the product, the subcontracting policy, etc. may give rise to certain costs which may not be reversible
in the short run.
Some costs can be reduced by exercising day to day control. In this chapter we shall be concentrating
primarily on such costs since the cost structure arising from basic decisions is something which an
accountant can scarcely alter.
Meaning of Costing Reduction

Cost reduction may be defined as the achievement of real and permanent reduction in the unit cost of
goods manufactured or services rendered without impairing their suitability for the use intended or
diminution in the quality of the product.

Cost reduction, therefore, should not be confused with cost saving and cost control. Cost saving could be
a temporary affair and may be at the cost of quality. Cost reduction implies the retention of essential
characteristics and quality of the product and thus it must be confined to permanent and genuine savings
in the costs of manufacture, administration, distribution and selling, brought about by elimination of
wasteful and inessential elements from the design of the product and from the techniques and practices
carried out in connection therewith. In other words, the essential characteristics and quality of the
products are retained through improved methods and techniques used and thereby a permanent reduction
in unit cost is achieved. The definition of cost reduction does not, however, include reduction in
expenditure arising from reduction or similar government action or the effect of price agreements.
The threefold assumption involved in the definition of cost reduction may be summarized as under:-
1. There is a saving in unit cost.
2. Such saving is of permanent nature.
3. The utility and quality of goods and services remain unaffected, if not improved.
12.2 DISTINCTION BETWEEN COST CONTROL AND COST REDUCTION
Cost control is operated through setting standards of targets and comparing actual performance therewith,
with a view to identity deviations from standards or norms and taking corrective action in order to ensure
that future performance conforms to standards or norms.
Cost reduction, on the other hand, is a continuous process of critical cost examination, analysis and
challenge of standards. Each aspect of the business viz, products, process, procedures, methods,
organization, personnel, etc. is critically examined and reviewed with a view of improving the efficiency
and effectiveness and reducing the costs. Even in an organization where efficient cost control is in
operation, there is always room for cost reduction.
Cost control lacks the dynamic approach which planned cost reduction demands. In cost reduction plan,
standards which are the basis of control are constantly challenged for improvement.
Budgetary control and standard costing are essential tools and techniques of cost control. There are
several distinct tools and techniques of cost reduction such as value engineering work study,
standardization, simplification, variety reduction, quality measurement and research, operations research,
market research, job evaluation, merit awards, incentives, improvement in design, mechanization,
automation, etc.
12.3 ADVANTAGES OF COST REDUCTION

The advantages accruing from cost reduction programs can be discussed under three heads:
a) In so far as an individual company is concerned, cost reduction results in profit
improvement. The more the profits, the more stable the company becomes. It enhances the
share value, improves investment opportunities and facilities collection of capital.
b) Society will be benefited by reduced prices which may be possible by savings from cost
reduction programs. Competitive position will improve and the industry as a whole will
strive to improve productivity and pass on the advantage of such programs to the society.
Workers and staff of the industry may also be benefited through increased wages and
improved welfare amenities.
c) The country also stands to gain immensely by cost reduction programs. Industry will be able
to maintain the international parity in prices of exportable commodities and consequential
increase in export will result in increased foreign exchange savings. Also internal revenue
will increase through more tax revenues.

12.4 COST REDUCTION PLAN AND PROGRAM
In order to derive maximum benefit, an overall companywide cost reduction plan is formulated by
establishing an overall objective towards which the detailed administration of the scheme should lead. At
the outset it may not be possible for a company to exactly settle the degree of cost reduction to be
achieved. However, it may be possible to set a reasonable target in general terms. Examples of such
targets are an overall rate of saving per annum of expected saving expressed as a percentage of total cost.
Within the framework of the plan, a detailed cost reduction program is prepared. In drawing up the
detailed program it will be necessary to proceed as follows:
i. To discover the sources of high costs or waste.

ii. To develop and apply appropriate remedies. A survey of the whole business should be conducted. This
will determine the characteristics of the business and the relative importance of various operating key
factors such as labor force, material usage and handling, factory layout, plant and equipment, working
conditions, etc. The relative costs are also analyzed to re-establish priorities to be included in cost
reduction program. For this purpose it would be desirable to scrutinize cost records of the following
kinds:
a) Trading results by products or product group
b) Product cost and main cost element ratios for product groups
c) Departmental analysis of overheads
d) Product cost standards and variances
e) Budgeted and actual performance
f) Labor cost and capacity utilization reports
g) Stores consumption analysis
Such an analysis will reveal whether a particular product cost or the cost of material or labor content of
the particular product offers scope for reduction. Accordingly priorities can be established for inclusion in
the cost reduction program depending upon the need for cost reduction and the extent of savings likely to
arise.
iii) Study of procedure: A critical study of the existing procedures, methods of operations be processes
involved in the manufacture should be made with a view to eliminate unnecessary operations or simplify
and improve them to reduce ultimately the cost of production. Such a study in general seeks to establish:
(a) The need for the task being performed.
(b) The precise nature of the task.
(c) The most efficient method of performing the task.
iv) Control over the program: The progress of cost reduction program should be subjected to close
control by a time-table co-coordinating the many varied phases of the overall plan. Control is exercised
through regular reports.
Significance of Cost Reduction Cell

A program of cost reduction cannot be implemented by single person. The active participation of
management is required. The cost reduction program needs an efficient cell to achieve results. The
formulation of a detailed and coordinated plan of cost reduction demands systematic approach to the
problem and a decision to embark on such a program should therefore be followed by the creation of an
organized cell for the purpose.

The scope of cost reduction is so vast that it will often demand the attention of a number of experts from
different fields. It is, therefore, advisable to direct the operations of cost reduction program through the
medium of a broad-based cell. The cell can play a very important role in ensuring that profit is
maximized. The principal advantage of this method is that the people concerned are given a definite
assignment and positive results may, therefore, be expected.
The cost reduction cell should include representatives from all major divisions of the business and may
therefore be composed of production manager, work study engineer, sales executive and cost accountant.
The composition of the cell however depends upon the problem to be investigated. If the problem taken
up affect many divisions of the business, then it is only logical to have representatives from each division.
The members of the cell are often released from their normal duties during the period they are engaged on
specific assignment of cost reduction. This type of cost reduction cell proves to be quite effective as it
ensures concerted action.
An example: In an engineering firm, a particular process used to indicate 10% to 12% defectives. The
process used to consume mostly imported raw materials and as a result, cost of defectives rose to Rs. 4
lacs per annum in that particular process alone. The matter was referred to the cost reduction committee
which, after as detailed study, suggested a change in the design of the conveyor system by installing
additional heaters in the heating chamber. The capital cost of installation of additional heaters amounted
to Rs. 1.25 lacs.
The implementation of cost reduction plan resulted in the following:

Defectives were brought down to about 2% from 12%;
Savings of Rs. 3 to Rs. 3.5 lacs per annum;
Saving in machine capacity; and
Saving in foreign exchange.
12.5 SCOPE OF COST REDUCTION
Cost reduction is attainable in almost all areas of business activities. There is perhaps no situation which
cannot be improved. It covers a wide range like new layout, product design, production methods,
materials and machines in factories as well as in offices, innovation in marketing, etc. It also extends to
specific activities like purchasing, handling, packaging, shipping, warehousing, marketing, use of
administrative facilities and even utilization of financial resources.
Excessive cost may result in every organization from:

Lack of information about raw materials, processes, products, components etc.
Lack of utilization of ideas generated from performance and economic analysis.
Honest but wrong beliefs that certain things are impossible for achievement.
Temporary circumstances like features developed under pressure or modifications made to meet
certain circumstances.
Habits and attitudes of confirming to one conventional method.
It is not necessary for management to proceed in any specific sequence in considering the various aspects of
cost reduction and it may be necessary to start the campaign in more than one direction at the same time.
Tools and Techniques of Cost Reduction

The various tools and techniques used for cost reduction are as follows:

1. Standard Costing
2. Budgetary Control
3. Inventory Control
4. Production planning and Control
5. Value Analysis
6. Market Research
7. Design improvement
8. Standardization and simplification
9. Uses of Automatic Machine
10. Job Evaluation and Merit Rating
11. Quality Control
12. Training Scheme
13. Work Study
14. Coding and Classification etc.
12.6 VALUE ANALYSIS
Value analysis or value engineering is a technique applied to analyze all aspects of an existing product or
component to determine the minimum cost necessary for specific function requirements. This may result
in various alterations being made to the product with object of reducing costs.
Advantages of Value Analysis

The primary advantage of value analysis is reduction in product cost. Some other advantages are the
following:
1. Value analysis improves sale and customer satisfaction since it determines the exact requirements of
customers and product designing is done accordingly.
2. The quality of the product is improved.
3. The latest methods of production and technology are used in product manufacture.
4. By simplification and standardization of design and method, problems and complexities in
production methods are eliminated.
5. It coordinates all managerial functions and builds up a spirit of cooperation and team work.
6. It helps in accomplishing effective utilization of production resources like capital, employees,
materials, time, etc.
Procedure of Value Analysis

Value Analysis basically centers around determining the essential characteristics of a product that the
customer requires and determining the most economical method of producing it by balancing cost with
the utility of the product. The following are the steps involved in value analysis:
1. Collecting relevant information: All necessary information about a product is first gathered,
such as physical characteristics, materials specification, product costs like materials, labor and
overhead, market, competitive products, production methods.
2. Deciding alternatives: All alternatives are to be developed and the most appropriate alternative
is to be decided upon in terms of suitability of method and costs involved. That alternative is
considered best which gives the best satisfaction to customers and reduces the cost.

3. Approval for the accepted alternative: Management should approve the best alternative and
give authority for the development of the modified or revised product.
4. Execution Production drawings and models are developed and production is done accordingly.
5. Follow-up: Finally, the extent of cost reduction that has been achieved should be investigated.
Illustration: 1
The following information has been gathered from a manufacturing company.
Expected price of product = Rs. 400 per unit

Expected production cost = Rs.250 per unit
Required:
(a) Value of product or value ratio.
(b) Value of product if cost is reduced to Rs.200 per unit due to value analysis and
function remain the same.
(c) Value of product if cost remains same but function increased to Rs. 425 per unit
due to value.
(d) Value of product if function improved by Rs. 25 per unit and cost reduced by 25
per unit due to value analysis.
Solution
(a) Value = Function / cost = Rs. 400/ Rs. 250 = 1.60 times
(b) Function constant, cost reduction
Value = function/cost Rs. 400/ Rs. 200 = 2.0 Times
(c) Function improved, cost constant
Value = Function/ cost = Rs. 425/Rs.250 = 1.70 times
(d) Function improved, cost reduced
Value = function / cost = Rs.425/Rs.225 = 1.89 times.
Self Examination Question

1. What is cost reduction? Explain its scope.
2. Distinguish between cost control and cost reduction.
3. Write in brief about the organization for cost reduction.
4. Explain the concept of value analysis as a technique of cost reduction.

CHAPTER 13
COST AUDIT
CHAPER 13 : COST AUDIT
13.1 INTRODUCTION:
The term 'audit' concerns the examination of books of accounts and necessary vouchers to ascertain the
accuracy of accounting transactions. According to the Institute of Cost and management Accountants
(UK) cost audit is defines "as the verification of cost accounts and a check on the adherence to the cost
accounting plans." The cost audit therefore comprises:
(a) Verification of the cost accounting records such as the accuracy of the cost accounts, cost
reports, cost statements, cost data, costing techniques, and
(b) Examining these records to ensure that they adhere to the cost accounting principles, plans,
procedures and objectives.
In other words, the cost auditor ensures that the cost accounting plan is in accordance with the objectives
established by the management and in conformity with appropriate system of cost accounting. Cost
Accounting system may be different for different objectives. For example, a cost accounting system
designed to exercise control over cost may be different from the one which is necessary for fixing price.
The cost auditor also examines whether the methods laid down for a ascertaining costs and other relevant
decisions are being properly followed in actual practice. He also establishes the correctness or otherwise
of the figures in the costing books and records by the processes of vouching, verification, reconciliation,
costing etc. He also ensures the correct treatment and determination of abnormal losses or gains or
treatment of certain expenses as direct or indirect. Lastly, he satisfies himself on the correct
apportionment of the overhead costs on different jobs, processes or cost centers.
13.2 IMPORTANT ASPECTS OF COST AUDIT:
Cost audit offers valuable assistance to the management in its decision-making process by examining the
reliability of cost accounting data and information. Due to the assistance provided by cost audit,
management is in a position to know what price is to be fixed for a product, whether the wastages are
avoidable, whether to re-organize sales or inventory systems, to make the work more efficient and so on.
Also, cost audit is of great help in maintaining internal control and internal check and can be of advantage
even to the statutory financial auditor. Cost audit, apart from having all the normal ingredients of audit,
i.e. Vouching, verification etc., has within its domain elements of Efficiency Audit and Propriety Audit as
well.
i. Efficiency audit: It is directed towards the measurement of whether corporate plants have been
effectively executed. It is concerned with the utilization of the resources in economic and most
remunerative manner to achieve the objectives of the concern. It comprises studying the plans of
organization, comparing actual performance with the plans and investigating the reasons for
variances to take remedial actions. For example, the effective utilization of capital in an
organization can be gauged by determining the return on capital employed.
ii. Propriety Audit: It is concerned with the executive actions and plans bearing on the finances and
expenditure of the company. The cost auditor has to judge:
a. Whether the planned expenditure is designed to give optimum results;
b. Whether the size and channels of expenditure were designed to produce the best results; and
c. Whether the return from expenditure on capital as well as current operations could be
bettered by some other alternative plan of action.

13.3 PURPOSE OF COST AUDIT:
The purpose of any cost audit is to examine whether the methods laid down for ascertaining costs and
other decisions are being properly implemented and whether the Cost Accounting plan has been adhered
to or not. Broadly, the purposes of cost audit can be classified as (i) protective and (ii) constructive
Protective purpose of Cost Audit: Under this, cost audit aims at examining that there is no undue wastage
or losses and the costing system brings out the correct and realistic cost of production or processing. The
benefit of this protective function is derived by the organization, its owners and consumers.
Constructive purpose of Cost Audit: cost audit has a constructive purpose as well. Cost auditor plays a
constructive role by providing management of the company with information useful in regulating
production; choosing economical methods of operation, reducing operations costs and re-formulating
plans etc., on the basis of his findings during the course of cost audit.
13.4 TYPES OF COST AUDIT:
Cost audit is basically carried out at the instance of the management for obvious advantages. Apart from
this, different other circumstances also sometimes occasion audit of cost accounts. The different types of
cost audit that we come across may be the following:
i. Cost audit on behalf of the management – The principal object of this audit is to see that the cost
data placed before the management is verified and reliable and they are prepared in such detail as
will serve the purpose of management in taking appropriate decision. The detailed objectives
include:
a. Establishing the accuracy of the costing data, as for example, cost of materials used,
allocation of wages into direct and indirect and on different products, functions and cost
centers.
b. Ensuring that the objectives of cost accounting are being achieved through appropriate
collection, segregation, analysis and compilation of data.
c. Ascertaining abnormal losses and gains along with the relevant causes, expressed in
financial terms in a manner that the person responsible for such loss or gain is identified.
d. Determination of per unit cost of production in a precise by practicable manner.
e. Establishing proper overhead rates for absorption of overheads by various units of costs so
that the cost is properly ascertained and there is no significant over or under-recovery of
expenses.
f. Fixation of the contracted price and the determination of additional or supplementary charge
that can be raised against customers for alteration, etc
g. Improving the quality of the cost accounting system by obtaining audit observations and
suggestions of the cost auditor.
ii. Cost audit on behalf of a customer – In case of cost plus contracts, often the buyer or the
contractee insists on a cost audit to satisfy him about the correct ascertainment of cost. More
often than not, the provision for a cost audit in such a circumstance is put in the relevant contract
or agreement with the stipulation that the supplier or the contractee will extend all co-operations
to the cost auditor. The cost of production arrived at for this purpose may differ from the cost of
production ascertained for internal control purposes.

iii. Cost audit on behalf of Government – Sometimes the Government is approached with requests
for subsidies, protection etc. Before taking a decision, the Government may prefer to have the
cost of production of the product determined on the basis of cost audit to satisfy itself whether
the need is genuine or a made up or the industry seeking assistance is generally efficiently run.
The Government, at its own may also initiate cost audit, in public interest to establish the fair
price of any product.
iv. Cost audit by trade association – Where activities of a trade association include maintenance of
price of the products manufactured by the member units or where there is a pooling or
contribution arrangement the trade association may require the accuracy of costing information
submitted by the member units checked. The trade association may seek full information on the
costing system, level of efficiency, utilization of capacity, etc.
Circumstances under which a Cost Audit Ordered:

Apart from the aforesaid reasons for going in for cost audit, the undernoted circumstances may warrant
the introduction of cost audit.
(a) Price fixation – The need for fixation of retention price in the case of materials of national
importance like steel, cement etc., may cause a necessity for cost audit. Also, to check excessive
profiteering, cost audit may be useful in knowing the true cost of production.
(b) Cost variation within the industry – Where the cost of production varies significantly from unit to
unit in the same industry, cost audit may be necessary to find the reasons for such differences.
(c) Inefficient management - Where a factory is run inefficiently and uneconomically, institution of cost
audit may be necessary. It may be particularly useful for the government before taking up any
further action.
(d) Tax assessment – Where a duty or tax is levied on products based on the cost of production, the
levying authorities may ask for cost audit to determine the correct cost of production.
(e) Trade disputes – Cost audit may be useful in setting trade disputes about claim for higher wages,
bonus, etc.
13.5 ADVANTAGES OF COST AUDIT

Cost audit will prove to be useful to the management, society, shareholders, the Government and the
statutory auditor. The advantages are as under:
a) To the management –
i. The management will get reliable data for its day-to-day operations like price fixing, control,
decision making etc.
ii. A close and continuous check on all wastage will be kept through a proper system of reporting to
the management.
iii. Inefficiencies in the working of the company will be brought to light to enable corrective action
being taken.
iv. Management by exception becomes possible through allocation of responsibilities to individual
managers.

v. The system of budgetary control and standard costing will be facilitated.

vi. A reliable check on the valuation of closing stock and work-in-progress can be established.
vii. It helps in the detection of errors and fraud.
(b) To the Society -
i. Cost audit is often introduced for the purpose of fixation of price. The prices so fixed are based
on the correct costing data and so the consumers are saved from exploitation.
ii. Since price increase by the industry is not allowed proper justification so as to increase in cost of
production consumers can maintain their standard of living.
(c) To Shareholders -
Cost audit ensures that proper records are kept for purchases and utilization of materials and
expenses incurred on wages, overheads, etc. it also ensures that the unit has been run
economically and efficiently. It also makes sure that the valuation of closing stocks and work-in-
progress is on a fair basis. Thus, the shareholders are assured of a fair return on their investment
(d) To the government -
i. Where the government enters into a cost-plus contract, cost audit helps the Government to fix
the price of the contract.
ii. Cost audit helps the fixation of selling prices of essential commodities and thus undue
profiteering is checked.
iii. Cost audit enables the government to focus its attention on inefficient units.
iv. Cost audit enables the government to decide in favor of giving protection to certain industries.
v. Cost audit facilitates settlement of trade disputes brought to the government.
vi. Since cost audit ensures efficient running of the business and correct and accurate use of cost
data, a healthy competition is generated among the various units in an industry. This imposes an
automatic check on inflation.
(e) Statutory Auditor - Statutory Auditor is also benefitted if cost system has been set up in an
organization. The statutory auditor can determine scope of his audit and make audit program
after evaluating cost accounting system used in organization.
13.6 FUNCTIONS OF COST AUDITOR:

The Institute of Cost and Works Accountants of India has detailed the principal functions of the cost
auditor by way of comparison with the functions of the auditor of the financial accounts. The principal
functions of the cost auditor, according to the aforesaid Institute are as follows:
Inventory:
(a) Is the size of the inventory adequate or in excess compared with the production
program?
(b) Is the provisioning drill most economical?
(c) Does it ensure optimum order size?
(d) Does it take into account the storage cost on the one hand, and carrying cost on the
other?
(e) Does it take note of lead time of the various items or groups of items?
(f) Does the receipt and issue system cause any bottleneck in production?

(g) Does it involve too many forms and too much paper work?
(h) Is there any room for reduction of inventory cost consistent with production need?
(i) Is the inventory as per the priced store ledger and as certified by the management
physically correct?
(j) Is the same amount of attention and care given to monies translated into materials
things like raw materials, stores and supplies and all kinds as given to liquid cash?
(k) Does the issue of raw material make the production in accordance with the standard
scheme or otherwise or covered by authorized schedule?
(l) Is the expenditure of consumable stores within the standard? If not, why?
Opening and Closing Stocks:

(1) The Cost Auditor will see the following;
(a) that the opening stock is not unduly large as compared with the volume of production
during the year;
(b) that the opening stock against various jobs really represent the actual physical stock in
the production shop and is not merely accounting figure;
(c) that the responsibility of shop foreman in-charge of the stock held in the production
shop is clear and properly documented; that he maintains proper record of actual
consumption vis-à-vis the actual withdrawal from the stock.
(2) Valuation and correct indication of closing stock in the trading and profit and loss account and in
balance sheet is important, the cost auditor will examine and certify:
(a) that the physical verification is correctly carried out.
(b) that the valuation is correct with reference to the actual cost of production and
recognized policy for valuation.
(c) that the volume of closing stock is commensurate with the volume of production and
that it does not reflect any failure or bottleneck in sales budget or production budget;
(d) that the volume of unmoved stores is not abnormal in comparison with normal rate of
yearly consumption. The cost auditor will recommend disposal of such unmoved stores
with consequent release of capital unnecessarily locked up to the advantage of the
financial resources of the concern.
Store issue procedure in shops:

The cost auditor will see:
(a) that withdrawal of material from stores to production shop is scientific or covered by
authorized schedule and permits receipts to be located;
(b) that there is no possibility of loss or pilferage of stock lying in the production sections;
(c) that surplus materials and scrap arising in production shops are returned to stores,
correctly and without delay for which necessary credit is given to unit cost of
production. If transferred to other jobs, proper transfer voucher has been prepared and
copies sent to the account, stores, etc.

Work-in-progress:
The cost auditor will see the following:
(a) that the work-in-progress has been physically verified and that it agrees with the
balance in the incomplete cost cards;
(b) that the valuation of the work-in-progress is correct with reference to the stage of
completion of each job or process and the value in job cost cards or process cost sheet.
(c) that there is no over-valuation of opening work-in-progress or closing work-in-progress,
thereby artificially pushing up and down net profits or net assets as the case may be;
(d) that the volume of value of work-in-progress is not disproportionate as compared with
finished out-turn.
Labor:
(1) Proper utilization of labor and increase in productivity are not receiving attention. Several
productivity teams have emphasized importance of higher productivity. It is, therefore, essential
to assess the performance efficiency of the labor and compare it with the standard performance,
so that labor utilization could be progressively improved. The labor force in Nepalese industries
is generally very high as compared to similar types of industries in other developed countries.
Our aim should be to reach that level though not immediately but over sometime. A study of this
nature would give an idea where the inefficiency lies so that timely and adequate steps could be
taken to ensure maximum utilization of labor and to reduce the labor cost.
(2) Cost of labor is allocated to different jobs with reference to time or job cards.
Capacity utilization:
The cost auditor will see:
(a) that the idle capacity of any production shop or of transport facilities for distribution is
not excessive;
(b) that the production volume and overall machine time utilized are commensurate. In
other words; the machine hours utilized has given the optimum output.
Overheads and Indirect Expenditure:

The cost auditor will see and certify:
(a) that allocation of indirect expenditure over production, sale and distribution is logical
and correct;
(b) that compared with the value of production in a production shop, the overhead charges
are not excessive;
(c) that the actual indirect expenditure does not exceed budgets or standard expenditure
significantly and that any variations are satisfactory explained and accounted for;
(d) that the relation of indirect expenditure in keeping with the load on individual
production shop is appropriate;

(e) correctness of appropriate allocation of overhead expenditure (both production and

sales) will be certified by Cost Auditor.
(f) That allocation of overheads between finished products and unfinished products is in
accordance with correct principles.
Financial Audit and Cost Audit

Financial audit is the audit of financial accounts whereas cost audit is the audit of cost accounts.
Financial audit aims to know whether the financial statements, namely, profit and loss account and
balance sheet present a true and fair view of the business result and state of affairs of a business
enterprise or not. On the other hand, cost audit aims to determine the correctness of cost figures of
each activity after proper analysis. Cost audit focuses on propriety of expenditure and efficiency of
performance.
Financial audit is related with only historical figures and data after the expenditures have been
incurred and accounts have been prepared. Cost audit is performed with the help of budgets and
therefore has a futuristic focus.
Efficiency Audit and Cost Audit

Efficiency audit ensures that the resources flow into the most remunerative channels, namely. (a)
Every rupee invested in capital or in other field gives optimum returns and (b) The financial auditor
does not comment on the performance efficiency of the company.
Since an appraisal of the extent of efficiency of utilization of factors of production is done in cost
audit, it is rightly called "efficiency audit."
The following are the evidences to prove that Cost audit is efficiency audit:
i. The cost auditor has to report the financial position of the company, giving inter alia—
financial ratios like profit as % of capital, profit as % of net sales, current assets
expressed as % of current liabilities, cost of production as % of capital employed, and
working capital as % of cost of production. These ratios are useful for assessment of
operational efficiency and comparing the financial health of one undertaking with
another as well as for measurement of internal efficiency.
ii. The cost audit report reflects the installed capacity and actual capacity utilized as well
as analysis of the reasons for shortfall in actual capacity utilized as compared to
installed capacity.
iii. Cost Audit Report, an analytical study of the consumption of raw materials per unit of
production both in quantity and in value is made.
iv. The cost auditor is expected to comment on the consumption of power and fuel in total
as well as per unit of output.
v. The cost auditor has to report on the direct labor cost per unit of output of the product
under cost audit along with brief explanation for variation in cost, as compared to the
two preceding years.
vi. The details of expenditure under overheads, with reasons for significant variation in
expenditure as compared to preceding two years, particularly increase in overhead
expenditure without corresponding increase in turnover or output of the product under
cost audit has to be commented to Cost Audit Report;


1. What are the areas of activity which a cost audit program is expected to cover?
2. Distinguish between Cost audit and financial audit
3. 'Cost audit is a necessity and not a luxury and is viewed as a barometer to measure the
operational performance, the effectiveness of utilization and working results.' Illustrate.
4. Explain the advantages of cost audit.
5. Is it correct to say that cost audit is efficiency audit? Give arguments.
6. What areas are covered in cost audit?
7. Discuss the purpose of cost audit and circumstances under which a cost audit is desirable.
8. What as a cost auditor will you verify in the area of work-in progress?
9. Define cost audit. How is it useful to:

(i) Management (ii) Society (iii) Share holders (iv) Government

Some of the solved problems from recent CA Examinations
SOME OF THE SOLVED PROBLEMS FROM RECENT CA EXAMINATIONS

Problem 1: (Material Control)
A company manufactures a product from a raw material, which is purchased at Rs.60 per kg. The
company incurs a handling cost of Rs. 360 plus freight of Rs.390 per order. The incremental carrying
cost of inventory of raw material is Re. 0.50 per kg. per month. In addition, the cost of working capital
finance on the investment in inventory of raw material is Rs. 9 per kg. per annum. The annual production
of the product is 100,000 units and 2.5 units are obtained from one kg. of raw material.
Required:
i.Calculate the Economic Order quantity of raw materials.
ii.Advise how frequently orders for procurement should be placed.
iii.If the company proposes to rationalize placement of orders quarterly basis, what percentage of
discount in the price of raw materials should be negotiated?
(CA Inter, November 2001, ICAI)
Solution
i. 2.5 units = 1 kg of raw material
100,000 units = (1 kg x 100,000) ÷ 2.5 = 40,000 kgs.
Annual consumption requirement or (A) = 40,000 kgs
Handling cost and freight per order or (O) = Rs. 360 + Rs. 390 = Rs. 750
Carrying cost per unit p. a. + Cost of investment p.a. = (0.50 x 12) + Rs. 9, or C = Rs.15

Economic Order Quantity = EOQ = = , . =2,000 kgs.
.
ii. Frequency of orders
Annual consumption = 40,000 kg
EOQ = 2,000 kg
No. of orders for one year or 360 days = (40,000/2,000) = 20
Frequency of orders = 0.6 month or 18 days (i.e. 360/20)
iii. It is given that the company proposes to rationalize placement of orders on quarterly basis ( i.e. 4
orders in one year). Annual consumption is 40,000 kg
Quantity per order = 40,000/4 = 10,000 kg
Total cost when order size is 10,000
Ordering cost (4 orders x Rs. 750) = Rs. 3,000
Carrying cost (5,000 x Rs. 15) = Rs. 75,000
Rs. 78,000 (a)
Increase in cost due to quarterly orders = (a) – (b) = Rs. 48,000
(This increase to be compensated by discount)
Annual requirement = 40,000 kg
Reduction per kg in the purchase price of raw material (Rs. 48,000/40,000) = Rs. 1.20 per unit.
Percentage of discount = (Rs. 1.20/Rs. 60) x 100 = 2%
Problem 2: (Labor Control)
From the following information; calculate labor turnover rate and labor flux rate:

No. of workers as on 01.01.2000 = 7,600

No. of workers as on 31.12.2000 = 8,400
During the year, 80 workers left while 320 workers were discharged. 1,500 workers were recruited
during the year, of these, 300 workers were recruited because of exists and the rest were recruited in
accordance with expansion plans.
(CA Inter, May 2001, ICAI)
Solution:
Labor Turnover Rate:

i. Separation Method = x 100
! "#
$ %&
= x 100 = = 5%
(,( %$, )/ $,
+

ii. Replacement Method = = x 100
! "#
& &
= x 100 = = 3.75%
(,( %$, )/ $,
"+,

iii. New Recruitment = x 100
!
,
= x 100 = 15%
(,( %$, )/
% +

iv. Flux Method = x 100
! "#
%, ,-
= x 100 = . 100 = 23.75%
(,( %$, )/ $,
Problem 3: (Overhead Control)

In a chemical manufacturing company, three products A, B and C emerge at a single split of stage in
department P. Product A is further processed in Department Q; product B in Department R and product
C in Depa/rtment S. There is no loss in further processing of any of the three processing of any of the
three products. The cost data for a month are as under.
Rs.
Cost of raw materials introduced in Department P 1,268,800
Direct Wages Department
P 384,000
Q 96,000
R 64,000
S 36,000
Factory overheads of Rs. 464,000 are to be apportioned to the department on direct wages basis. During
the month under reference, the company sold all three products, after processing them further as under.
Products A B C
Output sold (kg) 44,000 40,000 20,000

Selling price per kg (Rs.) 32 24 16

There is no opening or closing stock. If these products were at the split off stage, that is without further
processing, the selling prices would have been Rs. 20, Rs. 22 and Rs. 10 each per kg respectively for A, B
and C.
Required:
i. Prepare a statement showing the apportionment of joint costs to joint products.
ii. Present a statement showing product wise and total profit for the month under reference as
per the company’s current processing policies.
iii. What processing decision should have been taken to improve the profitability of the
company?
iv. Calculate the product wise and total profit arising from your recommendation in (iii) above.
(CA Inter, May 2002, ICAI)

Solution:
i. Statement showing the apportionment of joint costs
Particulars Products
A B C Total
Output sold (kg) 44,000 40,000 20,000
S.P. per kg at split off stage (Rs.) 20 22 10
Sales value at split off stage (Rs.) 880,000 880,000 200,000 1.960,000
Joint costs incurred in Dept. P (Rs.) 880,000 880,000 200,000 1.960,000
(Apportioned on sales value basis at
the split off point (Ratio 22: 22: 5)
ii. Statement showing product wise total profit for the month (current position)
Particulars Products
A B C Total
Output sold (kg) 44,000 40,000 20,000
S.P. per kg after further processing (Rs.) 32 24 16
Sales value after further processing (Rs.) (a) 1,408,000 960,000 320,000 2,688,000
Joint costs at split off point (Rs.) 880,000 880,000 200,000 1.960,000
Further processing costs (See working note) 172,000 115,200 64,800 352,800
Total costs (Rs.) 1,052,800 995,200 264,800 2,312,800
Profit Loss (a) – (b) Rs. 355,200 35,200 55,200 375,200
iii. Processing decision to improve the profitability of the company: Products ‘A’ & ‘C’
should be sold after further processing as both the products are generating profit after
further processing. However, product B should be sold at split-off point as further
processing cost of this product is more than its sales value.
iv. Product wise total profit arising from the recommendation at ‘iii’ above: Profit after
further processing
Product A Rs. 355,200
Product C Rs. 55,200
Total profit after further processing Rs. 410,400

Working Note:
Statement showing department wise costs
Particulars Departments
P Q R S
Raw materials (Rs.) 1,268,800
Wages (given) (Rs.) 384,000 96,000 64,000 36,000
Overhead apportioned (Rs.) 307,200 76,800 51,200 28,800
(96: 24: 16: 9)
Total costs 1,960,000 172,800 115,200 64,800
It is noted from the above statement that costs incurred in Dept. P are the joint costs at split off of
products A, B and C. The joint costs at split off point are Rs. 1,960,000. However, costs incurred in Dept.
Q, R and S are further processing costs of products A, B and C are Rs. 172,800, Rs. 115,200 and Rs.
64,800 respectively.
Problem 4: (Contract Costing)

A construction company undertook a contract at an estimated price of Rs. 108 lakhs, which includes a
budget profit of Rs. 18 lakhs. The relevant data for the year ended 31.3.2002 are as under:
(Rs. 000)
Materials issued to site 5,000
Direct wages paid 3,800
Plant hired 700
Site office costs 270
Materials returned from site 100
Direct expenses 500
Work Certified 10,000
Progress payments received 7,200
A special plant was purchased specifically for this contract at Rs. 800,000 as after use on this contract till
the end of 31.2.2002, it was valued at Rs. 500,000. The cost of materials at site at the end of the year was
estimated at Rs. 1,800,000. Direct wages accrued as on 31.3.2002 were Rs. 110,000.
Required:
Prepare the Contract account for the year ended 31st March, 2002 and compute the profit to be taken to
the profit and loss account.
(CA PE II, Nov. 2002, ICAI)
Solution
Contract Account for the year ended 31st March, 2002
Particulars Rs.000 Particulars Rs.000
To material issued to site 5,000 By material at site 1,800
To Direct wages 3,800 By material returned 100
To wages accrued 110 By cost of contract 8,780
To plant hired 700
To Site office cost 270

To Direct expenses 500

To depreciation 300
10,680 10,680
To Cost of contract 8,780 By work certified 10,000
To profit and loss account 1,200
To Reserved Profit 20
10,000 10,000
Working Notes:
1 "#
1. Percentage of contract completion = x 100
1
+#
= x 100 = 92.53%
$ +#
2. Profit to be taken to profit and loss account: Since the work done is more than
90%, the profit to be taken to profit and loss account can be computed by using
following formula:
1 ! 2#

= Estimated (Budgeted) profit x x
2# 1 1
, ,
= 1,800 x x = Rs. 1.200 thousand
, ,$
Problem 5: (Activity-Based Cost Allocation)
Family Store wants information about the profitability of individual product lines: Soft drinks, Fresh
produce and Package food. Family Store provides the following data for the year 2002-03 for each
product line.
Soft drinks Fresh produce Package food
Revenues Rs. 793,500 Rs. 2,100,600 Rs. 1,209,900
Cost of goods sold Rs. 600,000 Rs. 1,500,000 Rs. 900,000
Cost of bottles returned Rs. 12,000 Re.0 Re.0
Number of purchase orders placed 360 840 360
Number of deliveries received 300 2,190 660
Hours of shelf-stocking time 540 5,400 2,700
Items sold 126,000 1,104,000 306,000
Family Store also provides the following information for the year 2002-03
Activity Description of activity Total cost Cost-allocation base
Bottles returns Returning of empty Rs. 12,000 Direct tracing to soft-
bottles drink line
Ordering Placing of orders for Rs. 156,000 1,560 purchase orders
purchases
Delivery Physical delivery and Rs.252,000 3,150 deliveries
receipt of goods
Shelf stocking Stocking of goods on Rs. 172,800 8,640 hours of shelf-
store shelves and on- stocking time
going restocking

Customer support Assistance provided to Rs. 307,200 1,536,000 items sold

customers including
check-out
Required:
(i) Family Store currently allocates support cost (all costs other than cost of goods sold) to product
lines on the basis of cost of goods sold of each product line. Calculate the operating income and
operating income as a % of revenues for each product line.
(ii) If Family Store allocate support costs (all costs other than cost of goods sold) in product lines
using an activity based costing system, calculate the operating income and operating income as
a % of revenues for each product line.
(iii) Comment on your answer in requirements (i) and (ii)
(CA PE II, May. 2003, ICAI)
Solution
(i) Statement of operating income and operating income as a percentage of revenues for
each product line (when support costs are allocated to product line on the basis of cost
of goods sold of each product)
Soft drinks Fresh produce Package food Total
Rs. Rs. Rs. Rs.
Revenues (A) 793,500 2,100,600 1,209,900 410,4000
Cost of goods sold (B) 600,000 1,500,000 900,000 3,000,000
Support Cost (30% of B)
(W.N.1, 2) (C) 180,000 450,000 270,000 900,000
Total Cost(D)= (B) + (C) 780,000 1,950,000 1,170,000 3,900,000
Operating income 13,500 150,600 39,900 204,000
(E) = (A) –(D)
Operating Income as % of
Revenue (E/A) x 100 1.70% 7.17% 3.30% 4.97%
(ii) Statement of operating income and operating income as a percentage of revenues for
each product line (when support costs are allocated to product line using an activity-
based costing system)
Soft Fresh Package Total
drinks produce food Rs.
Rs. Rs. Rs.
Revenues (A) 793,500 2,100,600 1,209,900 4,104,000
Cost of goods sold 600,000 1,500,000 900,000 3,000,000
Bottles Returns 12,000 - - 12,000
Ordering cost at Rs. 100 per delivery 36,000 84,000 36,000 156,000
Delivery cost at Rs. 80 per delivery 24,000 175,200 52,800 252,000
Shelf-stocking @ Rs.20 per shelf-stocking hours
Customer Support cost @ re. 0.20 per item sold 10,800 108,000 54,000 172,800
25,200 220,800 61,200 307,200
Total Cost(B) 708,000 2,088,000 1,104,000 3,900,000

Operating income 85,500 12,600 105,900 204,000
(C) = (A) –(B)

Operating Income as % of Revenue 10.78% 0.60% 8.75% 4.97%

(iii) Activity based costing system of distribution of support cost is more reliable than the
traditional costing system. It tracks cost precisely on how individual product-lines use the
resources.
Working Notes:
1. Total support cost: Rs.
Bottles Returns 12,000
Ordering 156,000
Delivery 252,000
Shelf-Stocking 172,800
Customer support Cost 307,200
900,000
3+
2. Percentage of support cost to goods sold: = x100
3+ +
- ,
= x 100 = 30%
&, ,
3. Cost of each activity cost driven:
Activity Total Cost Cost allocation base Cost-driven rate
(1) (2) (3) (4) = (2) + (3)
Ordering 156,000 1,560 purchase orders Rs. 100 per order
Delivery 252,000 3,150 Deliveries Rs, 80 per delivery
Shelf-Stocking 172,800 8,640 Stocking hours Rs. 20 per stocking
hour
Customer Support 307,200 1,536,000 Items sold Re. 0.20 per item sold
Problem 6: (Process Costing)

From the following information for the month of October 2003, Prepare Process III Cost Accounts:
Opening WIP in Process III 1,800 units at Rs. 27,000
Transfer from process II 47,700 units at Rs. 536,625
Transfer to Warehouse 43,200 units
Closing WIP of Process III 4,500 units
Units scrapped 1,800 units
Direct materials added in Process III Rs. 177,840
Direct wages Rs. 87,840
Production Overheads Rs. 43,920
Opening Stock Closing Stock Scrap
Materials 80% 70% 100%
Labor 60% 50% 70%
Overheads 60% 50% 70%
The normal loss in process was 5% of the production and scrap was sold @ Rs. 6.75 per unit.
(CA PE II, November. 2003, ICAI)
Solution

Statement of Equivalent Production

Process III (FIFO Method)
Input Output Equivalent Production
Material A Material B Labor &
Overheads
Details Qty Details Qty Qty % Qty % Qty %
(units) (units) (units) (units) (units)
Op WIP 1,800 Scrap 2,250 - - - - - -
Process II 47,700 Units
completed
op. Stock 1,800 - - 360 20% 720 40%
New 41,400 41,400 100% 41,400 100% 41,400 100%
Cl. Stock 4,500
49,950 45,900 44,910 44370
Abn. gain 450 450 100% 450 100% 450 100%
49,500 49,500 45,450 44,460 43,920
Notes:
• It is presumed that FIFO Method is followed
• Normal loss should be 2,250 units. But actual loss is 1,800 units. Therefore, 450units are
abnormal gain.
• Scrap is 5% of production = 5% of (1,800 + 47,700 – 4,500) = 2,250 units.
Statement of cost of each element
Elements of cost Cost Equivalent Cost per
(Rs.) production unit (Rs.)
(units)
Material A
Transfer from previous process Rs. 556,625
Less: Scrap value of normal
loss 2,250 units x Rs. 6.75 Rs. 15,187 521,438 45,450 11.4728
Material B 177,840 44,460 4.00
labor 87,840 43,920 2.00
Overheads 43,920 43,920 1.00
Total 831,038 18.4728
Statement of Apportionment of Cost
Items Element Equivalent Cost per Cost (Rs.) Total(Rs.)

Production unit (Rs.)
(Units)
Opening WIP for completion Material A - - - -
Material B 360 4 1,440
Labor 720 2 1,440
Overheads 720 1 720 3,600

Units introduced and Material A 41,400 11.4728 474,973

completed during the period Material B 41,400 4 165,600
Labor 41,400 2 82,800
Overheads 41,400 1 41,400 764,773
Closing WIP Material A 4,500 11.4728 51,628

Material B 3,150 4 12,600
Labor 2,250 2 4,500
Overheads 2,250 1 2,250 70,978
Abnormal Gain Material A 450 11.4728 5,163
Material B 450 4 1,800
Labor 450 2 900
Overheads 450 1 450 (8,313)
831,038
Process III A/c

Dr
Cr.
Particulars Units Rs. Particulars Units Rs.
To balance b/d 1,800 27,000 By Normal Loss@ Rs. 6.75 2,250 15,187
To Process II A/c 47,700 536,625 By finished goods (Note 1) 43,200 795,373
To Direct Materials 177,840 By Closing WIP 4,500 70,978
To Direct wages 87,840
To prod. Overheads 43,920
To Abnormal gain a/c 450 8,313
49,950 881,538 49,950 881,538
Working Notes:
1. Finished Goods
Cost already incurred on Opening stock Rs. 27,000
Cost incurred to complete opening stock Rs. 3,600
Units introduced and completed Rs. 764,773
Rs. 795,373
Problem 7: (Operating Costing)
EPS is a Public School having 25 buses each plying in different directions for the transport of its school
students. In view of large number of students availing of the bus service, the buses work two shifts daily
both in the morning and in the afternoon. The buses are garaged in the school. The work load of the
students has been so arranged that in the morning, the first trip picks up senior students and the second
trip plying an hour later picks junior students. Similarly, in the afternoon, the first trip takes the junior
students and an hour later the second trip takes the senior students home.
The distance traveled by each bus, one way is 16 kms. The school works 24 days in a month and remains
closed for vacation in May and June. The bus fee however is payable by the students for all the 12 months
in a year.

The details of expenses for the year 2003-2004 are as under:

Driver’s salary payable for all the 12 months Rs. 5,000 per month per driver.
Cleaner’s salary payable for all the 12 months Rs. 3,000 per month per cleaner (one cleaner has been
employed for every 5 buses)
License Fees, taxes etc. Rs. 2,300 per bus per annum
Insurance premium Rs. 15,600 per bus per annum
Purchase price of the bus Rs. 1,650,000 each
Life of the bus 16 years
Each has given an average of 10 kms per liter of diesel. The seating capacity of each bus is 60 students.
The seating capacity is fully occupied during the whole year.
The school follows different differential bus fees based on distance travelled as under:
Students picked up and dropped Bus fee Percentage of students availing
within the range of distance from this facility
the school
4 kms 25% of full 15%
16 kms Full 55%
Ignore interest. Since the bus fees have to be base on average cost, you are required to:
(i) To prepare a statement showing the expenses of operating a single bus and the fleet of 25 buses
for a year.
(ii) Work out average cost per students per month in respect of:
a. Students coming from a distance of up to 4 kms from the school;
b. Students coming from a distance of up to 8 kms from the school; and
c. Students coming from a distance of up to 16 kms from the school.
(CA PE II, May. 2004, ICAI)
Solution
EPS Public School
(i) Statement showing the expenses of operating a single bus and the fleet of 25 buses for a
year
Particulars Per bus per Fleet of 25 buses
annum (Rs.) per annum (Rs.)
Running cost: (A)
Diesel (Note 1) 56,832 1,420,800
Repairs and maintenance Cost (B) 16,400 410,000
Fixed Charges:
Driver’s salary 60,000 1,500,000
Cleaner’s salary 7,200 180,000
License fee and taxes etc 2,300 57,500
Insurance 15,600 390,000

Depreciation 9Rs. 1,650,000 – 150,000) ÷ 16 93,750 2,343,750

Total fixed charges 178,850 4,71,250
Total Expenses (A + B + C) 252,082 6,302,500
(ii) Average cost per student per month in respect of students coming from distance of :
a. 4 kms from the school (Rs.252,082/354)÷ 12 = Rs. 59.34
b. 8 kms from the school ( Rs. 59.34 x 2) = Rs.118.68
c. 16 kms from the school (Rs.59.34 x 4) = Rs.237.36
Working Notes:
1. Calculation of Diesel cost per bus:
Number of trips made by a bus each day (two in the morning and two in the
4
evening)
32 kms
Distance travelled in one trip both ways (16 kms x 2 trips)
128 km
Distance travelled per day by a bus: (32 kms x 4 shifts)
3,072 kms
Distance travelled during a month (128 kms x 24 days)
30,720 kms
Distance travelled per year (3,072 kms x 10 months)
3,072 liters
Number of liters of diesel required per bus per year (30,732 kms/10 km)
Rs. 56,832
Cost of Diesel per bus per year 93,072 liters x Rs. 18.50)
2. Calculation of number of students per bus:
Bus capacity of 2 trips 120 students
1/4th fare students (15% of 120) 18 students
½ of students (30% of 120) 36 students
Equivalent 1/4th fare students 72 students
Full fare students (55% of 120) 66 students
Equivalent 1/4th fare students = 66 x 4 264 students
Total students (in terms of ¼ th fare students) = 18 + 72 + 264 354 students
Problem 8: (Cost Sheet)
Popeye Company is a metal and wood cutting manufacturer, selling products to the home construction
market. Consider the following data for the month of October, 2004:
Rs.
Sandpaper 5,000
Material handling cost 175,000
Lubricants and Coolants 12,500
Miscellaneous indirect manufacturing labor 100,000
Direct manufacturing labor 750,000
Direct materials, October 1, 2004 100,000
Finished goods, October 1, 2004 250,000

Finished goods, October 31, 2004 375,000

Work-in-progress, October1, 2004 25,000
Work-in-progress, October 31, 2004 35,000
Plant leasing costs 135,000
Depreciation – plant equipment 90,000
Property taxes on plant equipment 10,000
Fire Insurance on plant equipment 7,500
Direct materials purchased 1,150,000
Sales revenues 3,400,000
Marketing promotions 150,000
Marketing salaries 250,000
Distribution costs 175,000
Customer service costs 250,000
Required:
(i) Prepare an income statement with a separate supporting schedule or cost of goods
manufactured.
(ii) For all manufacturing items, indicate by V or F whether each is basically a variable cost or
a fixed cost (where the cost object is product unit).
(CA PE II, November 2004, ICAI)
Solution
(i) Statement showing cost of sales, and income for the month of October, 2004
Rs. Rs.
Add: Direct material purchased 1,150,000
Total 1,250,000
Less: Closing stock of direct materials 125,000
Direct material consumed 1.125,000
Direct manufacturing wages 750,000
Direct expenses -

Manufacturing overheads:
Sandpaper 5,000
Material handling cost 175,000
Lubricants and Coolants 12,500
Miscellaneous indirect manufacturing labor 100,000
Plant leasing costs 135,000
Depreciation – plant equipment 90,000
Property taxes on plant equipment 10,000
Fire Insurance on plant equipment 7,500 535,000
Works Cost 2,410,000

Add: Opening stock of WIP 25,000
Add: Closing stock of WIP 35,000 (-) 10,000
2,400,000
Add: Opening stock of finished goods 250,000
Less: Closing stock of finished goods 375,000 (-) 125,000
Cost of production of goods sold 2,275,000

Add: Marketing costs:
Marketing promotions 150,000
Marketing salaries 250,000
Distribution costs 175,000
Customer service costs 250,000 825,000
Cost of sales 3,100,000

Sales revenues 3,400,000
Profit/ operating income 300,000
(ii) Manufacturing items Variability

Direct materials V
Direct manufacturing labor V
Sandpaper SV
Material handling costs SV
Lubricants and Coolants SV
Miscellaneous indirect manufacturing labor F
Plant leasing cost F
Depreciation on plant equipment F
Property taxes on plant equipment F
Fire insurance on plant equipment F
Problem 9: (Cost Control Account – Non-integrated System)

The following figures have been extracted from cost records of a manufacturing unit:
Rs.
Stores: Opening balance 32,000
Purchase of materials 158,000

Transfer from WIP 80,000

Issue to WIP 160,000
Deficiencies found in stocktaking 6,000
WIP Opening balance 60,000
Direct wages applied 65,000
Overheads applied 240,000
Closing balance of WIP 45,000
Finished products: Entire output is sold at a profit of 10% on actual cost from WIP. Wages incurred Rs.
70,000, Overhead incurred Rs. 250,000.
Items not included cost records: Income from investment Rs. 10,000, Loss on sale of capital assets Rs.
20,000.
Draw up Stores Control Account, Work-in-progress Control Account, Costing Profit and Loss Account,
Profit and Loss Account and Reconciliation Statement.
(CA PE II, May 2005, ICAI)
Solution
(a) Costing Books (non-integrated system)
Dr. Stores Control Account Cr.
To balance b/d 32,000 By work-in-progress Control A/c 160,000
To General ledger Adjustment A/c 158,000 By works overhead control A/c 20,000
To Work-in-progress Control A/c 80,000 By Costing Profit and Loss Account 6,000
270,000 270,000
Dr. Work-in-Progress Control Account Cr.

To balance b/d 60,000 By Stores Control A/c 80,000
To Stores Control A/c 160,000 By Cost of Sales A/c
To Direct Wages Control A/c 65,000 (Costing Profit and Loss A/c) 400,000
To Works Overhead Control A/c 240,000 By balance c/d 45,000
525,000 525,000
Dr. Work overhead Control Account Cr.

To General ledger Adjustment A/c 250,000 By Work-in-progress Control A/c 240,000
To Stores Control A/c 20,000 By Costing Profit and Loss A/c 30,000
270,000 270,000

Dr. Costing Profit and Loss Account Cr.

To Work-in-progress Control A/c By General ledger Adjustment A/c 440,000
(Cost of Sales) 400,000 (Rs. 400,000 x 1.10)
To Stores Control A/c (Shortage) 6,000
To Works Overhead Control A/c
(Under Recovery) 30,000
To Profit 4,000
440,000 440,000
Financial Books
Dr. Profit and Loss Account Cr.
To Opening Stock: By sales 440,000
Stores 32,000 By Income from investment 10,000
WIP 60,000 By Closing Stock:
To Purchases 158,000 Stores 84,000
To Wages incurred 70,000 WIP 45,000
To Overheads incurred 250,000 By Loss 11,000
To loss on sale of capital assets 20,000
590,000 590,000
Rs Rs.
Profit as per Cost Account 4,000
Add: Income from investment recorded in Financial Accounts 10,000
14,000
Less: Under absorption of wages in Cost Account 5,000
Loss on sale of capital assets recorded in Financial Accounts 20,000 (25,000)
Loss as per Financial Accounts (11,000)
Problem 10: (Machine Hour Rate)
From the details furnished below you are required to compute a comprehensive machine hour rate:
Rs.
Original purchase price of the machine
(subject to depreciation at 10% per annum on original cost) 324,000
Normal working hours for the month 200 hours
(The machine works to only 75% of capacity)
Wages of machine man Rs. 125 per day of 8 hours
Wages for helper(machine attendant) Rs. 75 per day of 8 hours
Power cost for the month for the time worked 15,000
Supervision charges apportioned for the machine center for the month 3,000
Electricity and lighting for the month 7,500
Repairs & maintenance (machine) including consumable stores per month 17,500

Insurance of Plant and Building for the year (apportioned) 16,250

Other general expenses per month 27,500
The workers are paid a fixed dearness allowance of Rs. 1,575 per month. Production bonus payable to
workers in terms of an award is equal to 33.33% of basic wages and dearness allowance. Add 10% at the
basic wages and dearness allowance against leave wages and holidays with pay to arrive at a
comprehensive labor wage for debit to production.
(CA PE II, November 2005, ICAI)
Solution
Computation of comprehensive Machine Hour Rate
Per month (Rs.) Per Hour
(Rs.)
Fixed Cost:
Supervision charges 3,000
Electricity and lighting 7,500
Insurance of Plant and Building (16,250 x 1/12) 1,354.17
Other General Expenses (27,500 x 1/12) 2,291.67
Depreciation (32,400 x 1/12) 2,700.00
16,845.84 112.31
Variable Cost:
Repairs and maintenance 17,500 116.67
Power 15,000 100.00
Wages of machine man 44.91
Wages of helper 32.97
Comprehensive machine hour rate 406.86
Effective machine working hour’s p.m. 200 hrs. x 75% = 150 hrs.
Wages per machine hour

Machine man Helper
Rs. Rs.
Wages for 200 hours (Rs. 125 x 25) 3,125
(Rs. 75 x 25) 1,875
DA 1,575 1,575
4,700 3,450
Production bonus (1/3 of above) 1,567 1,150
6,267 4,600
Leave wages (10%) 470 345
6,737 4,945
Effective wages rate per machine hour (150 hrs in all) 44.91 32.97
CAP II, December 2009, ICAN

Problem 11: (BEP and decision making)
A company manufactures and sells three models of a product. The selling price and cost data are
collected and presented to you for analysis here in below:
Description Model X (Rs.) Model Y (Rs.) Model Z (Rs.)

Unit selling price 800 1,200 2,000

Unit variable costs:
Direct Materials 160 240 400
Direct labor 160 320 480
Overhead 80 160 240
Selling 160 160 160
Product percentage of Total Sales 10% 50% 40%
The following information is also relevant:
• The company incurs advertisement cost Rs. 8 million, fixed administrative cost Rs. 8 million,
and fixed manufacturing cost Rs. 16 million in addition.
• The company has the capacity of producing 100,000 units of all models and is currently
utilizing its 80% capacity.
You are required to calculate/answer the following:
a) The profit from the given data.
b) The total BEP sales from the given data.
c) The company is considering increasing the advertising budget by Rs.8 million to increase the
total unit sales to full capacity. The product mix would remain same. Is the campaign desirable?
d) The company is considering of providing additional sales commission to sales force of each
product at the rate of 2% to increase the total unit sales to 90% of its capacity. The product mix
would remain same. Is the commission desirable?
e) The company is considering altering the production process by installing new machine which
will reduce the direct material, direct labor, and variable overhead to 75% of their current level
and will increase the fixed manufacturing cost by Rs. 16 million. What is the minimum level of
total sales (in units) for which this would be desirable?
Solution
a) Profit (Rs.) = (combined unit contribution margin x total sales unit) – Total Fixed Costs
= (472 x 80,000) – 32,000,000 = 5,760,000
b) Total BEP sales (Rs.) = (Total fixed cost/combine P/V ratio)

= 32,000,000/30.73% = Rs. 104,121,475.05 or 100,338,643
c) Desirability of advertising campaign

Additional advertising cost = Rs.8,000,000
Total fixed cost after additional advertising cost = Rs. 40,000,000
Total sales unit after advertising campaign (full capacity) = 100,000
Profit (Rs.) = (combined Unit CM x total sales) – Total Fixed Costs
= (472 x 100,000) – 40,000,000 = Rs. 7,200,000
Since the advertising campaign causes initial profit to increase, the campaign is desirable.
d) Desirability of sales Commission:
Model X Model Y Model Z
Existing contribution margin/unit (Rs.) 240 320 720
Less: Additional Sales Commission @ 2% 16 24 40
New CM/Unit (Rs.) 224 296 680
Sales Mix 10% 50% 40%

New combined CM/Unit (Rs..) = (224 x 10% + 296 x 50% +680 x 40%) = Rs. 442.40
New total Sales unit (90% of capacity) = 90,000
Profit (Rs.) = (New combine unit CM x New Total Sales) – Total fixed costs
= (442..4 x 90,000) -32,000,000 = Rs. 7,816,000
Since additional sales commission causes initial profit to increase, the commission is desirable.
e) Minimum level of sales for which the alteration of production process as indicated is desirable:
Model X Model Y Model Z
Existing contribution margin/unit (Rs.) 240 320 720
Add: 25% of unit VC excluding selling exp. 100 180 280
New CM/Unit (Rs.) 340 500 1,000
Sales Mix 10% 50% 40%
New combined CM/Unit (Rs..) = (340 x 10% + 500 x 50% +1,000 x 40%) = Rs. 684
New total fixed cost after additional fixed manufacturing cost of Rs. 16 million = 48,000,000
The required minimum level of sales = (New total fixed cost + initial profit level)/ New combine
unit CM = (48,000,000 + 5,760,000)/684 = Rs. 78596 units
Below the calculated level of minimum required sales, the change is not desirable.
Working notes
Calculations of required values

Description Model X Model Y Model Z
(Rs.) (Rs.) (Rs.)
A Unit selling price (Rs.) 800 1,200 2,000
Unit variable costs:
Direct Materials 160 240 400
Direct labor 160 320 480
Overhead 80 160 240
Selling 160 160 160
B Total Variable cost/unit 560 880 1,280
C Contribution Margin/unit (A-B) 240 320 720
D P/V Ratio (C/A) x 100 30% 26.67% 36%
E Product % of Total sales 10% 50% 40%
F Combine CM/Unit (Rs.) = (240 x10% + 320 x 50% + 720 x 40%) = 472
G Combine P/V ratio = (30% x 10% + 26.67% x 50% + 36% x 40%) = 30.73%
H Total sales unit (80% of 100,000) = 80,000
I Total fixed costs (Rs.):
Advertising = 8,000,000
Administrative = 8,000,000
Manufacturing = 16,000,000
32,000,000

Problem 12: (Flexible Budgeting)
Kathmandu Limited having a capacity of 6 lakhs units has prepared the following cost sheet:
Per unit (Rs.)
Direct Materials 2.50
Direct Wages 1.00
Factory Overheads (50% fixed) 2.00
Selling and administration Overheads (One-third variable) 1.50
Selling price 9.00
During the year 2008, the sales volume achieved by the company was 5 lakh units. The company has
launched an expansion program, the details of which are as under:
i) The capacity will be increased to 10 lakh units.
ii) The additional fixed overheads will amount to Rs. 4 lakhs up to 8 lakh units and will
increase by Rs. 2 lakhs more beyond 8 lakh units.
iii) The cost of investment on expansion is Rs. 8 lakhs which is proposed to be financed through
bank borrowings carrying interest at 15% per annum.
iv) The average depreciation rate on the new investment is 10% based on straight line method.
After the expansion is put through, the company has two alternatives for operating the expanded
plant as under:
i) Sales can be increased up to 8 lakh units by spending Rs. 1 lakhs on special advertisement
campaign to explore new market, or
ii) Sales can be increased to 10 lakh units subject to the following:
a. By an overall price reduction of Rs. 1 per unit on all the units sold.
b. By increasing the variable selling and administration expenses by 5%.
c. The direct material costs would go down by 1% due to discount on bulk buying.
i) Construct a flexible budget at the level of 5 lakhs, 8 lakhs and 10 lakh units of production
and advice which level of output should be chosen for operation.
ii) Calculate the break-even point both before and after expansion.
Solution
(i) Flexible Budget
Rs. In lakh
Output levels (Units) 5 lakhs 8 lakhs 10 lakhs
Sales 45 72 80
Direct materials (@ 2.50 per unit, but at level of 10 lakhs discount 12.50 20.00 24.75
of 1% is to be allowed)
Direct Wages 5.00 8.00 10.00
Selling and Administration Overheads (at the level of 10 lakhs 2.50 4 5.25
variable selling and administration overhead increases by 5%)
Total variable costs 25 40 50

Contribution 20 32 30
Fixed Costs:

Fixed Factory Overhead 6 6 6

Selling and Administration Expenses 6 6 6
Additional fixed cost due to expansion - 4 6
Interest @ 15% on 8 lakhs - 1.20 1.20
Depreciation @ 10% on 8 lakhs - 0.80 0.80
Special advertisement ---- 1.00 -----
Total Fixed Costs 12 19 20
Profit 8 13 10
Therefore, activity to be chosen is 8 lakhs units since it provides the highest profit of Rs. 13 lakhs.
i) Break-even points:
Output levels (Units) 5 lakhs 8 lakhs 10 lakhs

P/V Ratio (contribution margin per unit/price 4/9 5/9 3/8
per unit)
Break-even points (Rs. In lakh) 27 42.75 53.33
Working (BEP = Fixes Cost/PV Ratio) 12 x (9/4) 19 x (9/5) 20 x (8/3)
BE in lakh of units 3 lakh 4.75 lakh 6.67 lakh
Working (BEP = fixed Cost/CM per unit) 12/4 19/4 20/3
Problem 13: (Material Control)
Raw materials ‘X’ costing Rs. 100 per kilogram and ‘Y’ costing Rs. 60 per kilogram are mixed in equal
proportion for making product ‘A’. The loss of materials in processing works out to 25 % of the output.
The production expenses are allocated at 50% of direct material cost.
The end product is priced with margin of 33.33 % over the total cost. Material Y is not easily available
and substitute raw material ‘Z’ has been found for ‘Y’ costing Rs. 50 per kilogram. It is required to keep
the proportion of this substitute material in the mixture as low as possible and at the same time maintain
the selling price of the end product at the existing level and ensure the same quantum of profit as at
present.
You are required to compute what should be the ratio of mix of the raw materials X and Z.
Solution
(i) Output of product A (assumed) 1.00
Process loss 25% of output 0.25
Input of raw material X and Y 1.25
X and Y are mixed in equal proportion for making product A, therefore 0.625 kg of X and 0.625
kg of Y will be mixed to produce one kg of product A.

(ii) Statement of cost and profit for producing one kg of A.

Rs.
Raw material X (0.625 x Rs. 100) 62.50
Raw material Y (0.625 x Rs. 60) 37.50
Material cost 100.00
Add production expenses at 50% of material cost 50.00
Total cost 150.00
Add: Profit at 33.33% over total cost 50.00
(iii) Ratio of mix of raw material X and Z:

Minimum quantity of Z is to be mixed and maintain the same selling price and same amount of
profit. For this purpose, total material cost in one kg of product A should be the same i.e. Rs. 100
only. Cost of Z is Rs. 50 per kg. Suppose quantity of Z material is Z.
Z x Rs. 50 + (1.25 – Zkg) x Rs. 100 = Rs. 100
50Z + 125 – 100Z = 100
50Z – 100Z = 100 – 125
-50Z = - 25
Z = 0.5
X will be 1.25 – 0.5 kg i.e. 0.75 kg
Ratio will be 3:2 between X and Z (i.e. 0.75 kg and 5 kg). it can be proved as below:
Statement of cost
Rs.
Raw material X 0.75 kg at Rs. 100 75
Raw material Z 0.50 kg at Rs. 50 25
Total material cost 100
Production expenses 50% 50
Total cost 150
Profit 33.33% of total cost 50
Selling price 200
Problem 14: (labor Control, Incentive scheme)
A company has pressure to increase its production by 25% to meet the increased demand. To increase the
productivity of its 10 workers, the company has given assurance to them of average 20% increase in their
pay through introduction of some incentive scheme; either Halsey Scheme with 50% bonus or Rowan
scheme.
The company observes the following figures for this month after the assurance:
Guaranteed hourly wage rate Rs. 25
Time allowed for producing a unit (calculated on the basis of previous performance) 2 hours.

Number of working hours per day 8 hours

Number of working days in this month 25 days
Actual production during this month 1,250 units
You are required to calculate:
i) Effective rate of earnings per hour under Halsey Scheme and Rowan Scheme.
ii) Savings to the company in terms of direct cost per unit under each scheme.
Solution
i) Calculation of effective hourly rate of earning
Under Halsey Scheme = (Total time wages of 10 workers + Total bonus)/total actual hours
worked = (50,000 + 6,250)/2,000 = Rs. 28, 125
Under Rowan Scheme = (Total time wages of 10 workers + Total bonus)/Total actual hours
worked = (50,000 + 10,000)/2,000 = Rs. 30
ii) Calculation of savings in terms of direct labor cost per unit

Direct labor cost per unit:
Under Time wage = 2 hours x Rs. 25 = Rs. 50
Under Halsey = (50,000 + 6,250)/ 1,250 = Rs. 45
Under Rowan = (50,000 + 10,000)/ 1,250 = Rs. 48
Saving under Halsey Scheme = 50 – 45 = Rs. 5
Saving under Rowan Scheme = 50 – 48 = Rs. 2
Working notes:
A. Total time wages of 10 workers per month = working days in a month x working hours per day x
Hourly wage rate x No. of workers =25 x 8 x 25 x 10 = Rs. 50,000
B. Time saved per month:

• Time allowed per piece per worker = 2 hours
• Actual units produced by 10 workers in the month = 1,250 units
• Total time allowed to produce 1,250 units (1,250 x 20 = 2,500 hours
• Actual time taken ( 25 days x 8 hours x 10 workers) = 2,000 hours
• Time saved per month (2,500 – 2,000) = 500 hours
C. Total bonus under Halsey Scheme = (50% of time saved) x Hourly wages rate
= 500 x 0.50 x 25 = Rs. 6,250
Bonus percentage = 12.50%
D. Total bonus under Rowan Scheme = (Time saved/ Time allowed ) x Time wages
= (500/2,500) x 50,000 = Rs. 10,000
Bonus percentage = 20%
Problem 15: (Process Costing)
Kathmandu Chemical Company Limited carries on production operation in two processes. Material first
passed through process I, where a compound is produced. A loss in weight takes place at the start of

processing. The following data which can be assumed to be representative, relates to the month just
ended:
Quantities Kg.
Material Input 200,000
Opening work-in-process (half processed) 40,000
Work completed 160,000
Closing work-in-process (two-third completed) 30,000
Costs Rs
Material Input 75,000
Process cost 102,000
Opening work-in-process:
Materials 20,000
Process costs 12,000
Normal process loss in quantity may be assumed to be 20% of material input. Any quantity of the
compound can be sold for Rs. 1.60 per kg. Alternatively, it can be transferred to process II for further
processing and packing to be sold as supercomp for Rs .2.00 per kg. Further materials are added in
process II which yield 2 kgs of supercomp for every kg of the process I compound used.
Of the 160,000 kgs per month of work completed in process I, 40,000 kgs are sold as compound and
120,000 kgs passed through process II for sale as supercomp Process II has facilities to handle up to
160,000 kgs of compound per month, if required. The monthly cost incurred in process II (other than the
cost of the compound) is:
120,000 kgs of compound inputs 160,000 kgs of compound inputs
(Rs.) (Rs.)
Materials 120,000 160,000
Processing cost 120,000 140,000
i) Determine using average cost method, the cost per kg of compound in process I and the
value of both completed and closing work-in-process for the month just ended.
ii) Advise whether it is worthwhile to process 120,000 kgs. of compound further?
Solution
i) Process I
Statement of Equivalent Production
Input Output Equivalent Units
Particulars Units Particulars Unit(kg) Material Conversion Cost
(kg) Unit % Unit %
completion completion
Opening 40,000 Normal loss 40,000 - - - -
WIP
New 200,000 Units 160,000 160,000 100 160,000 100
Material introduced
Introduced and
completed

Abnormal 10,000 10,000 100 10,000 100

loss
Closing 30,000 30,000 100 20,000 2/3rd.
WIP
240,000 240,000 200,000 190,000
Process I
Statement of Cost for each Element
Element of cost Cost of Cost in Total Cost Equivalent Cost per kg.
Opening WIP Process (Rs.) Units (kg) (Rs.)
(Rs.) (Rs.)
Material 20,000 75,000 95,000 200,000 0.475
Conversion 12,000 102,000 114,000 190,000 0.600
Cost
32,000 177,000 209,000 1.075
Statement of Apportionment of Cost

Units Elements Equivalent Cost per unit Cost Total Cost
completed units (Rs.) (Rs.) (Rs.) (Rs)
Works Material 160,000 0.475 76,000
completed Conversion cost 160,000 0.600 96,000 172,000
Value of WIP Material 30,000 0.475 14,250
completed Conversion cost 20,000 0.600 12,000 26,250
Note: The work of abnormal loss can also be found out like “work completed” but it has not been asked
in the question.
ii) There can be two approaches to this problem:

Approach I
Total Cost and Revenue approach
Statement showing comparative data to decide whether 120,000 kg of compound should
be processed further
Alternative I Alternative II
Sell immediately after process I Process further
Sales 120,000 x Rs. 1.60 Rs. 192,000 Sales 240,000 x Rs. 2 480,000
Less: Cost from process I 129,000 Cost from Process I
120,000 x Rs. 1.075 120,000 x Rs. 1.075 129,000
Material in process II 120,000
Processing cost in Process II
120,000 369,000
Net Revenue 63,000 111,000
Approach II
Incremental Cost and Incremental Revenue

Incremental revenue:
Sales 120,000 x Rs. 2 Rs.240,000
120,000 x (Rs. 2 – Rs. 1.60) Rs. 48,000 Rs. 288,000
Incremental cost:
Material in Process II Rs. 120,000
Processing cost in Process II Rs. 120,000 Rs. 240,000
Rs. 48,000
Conclusion: Since there is an incremental profit of Rs. 48,000 (288,000 – 240,000) due to the decision to
process, the company should opt for the processing of the compound.
Problem 16: (Production Budget and EOQ)
National Limited is engaged in the manufacture of two product A and B. Product A uses one unit of
component P and two units of component Q. Product B uses two units of component P, one unit of
component Q and two units of component R. Component are which is in the factory uses one unit of
component Q. Component P & Q are purchased from the market.
The firm has prepared the following forecast of sales and inventory for the next year.
Products
A B
Sales Units 8,000 15,000
Inventories:
At the end of the year Units 1,000 2,000
At the beginning of the year Units 3,000 5,000
The production of the both the products and the assembling of the component R will be spread out
uniformly throughout the year.
The firm at present orders its inventory of components P and Q in quantities equivalent to 3 months
consumption. The firm has been advised that savings in the provisioning of components can arise by
changing over to the ordering system based on economic ordering quantities. The firm has compiled the
following data relating to two components.
P Q
Component usage per annum 30,000 48,000
Price per unit Rs. 2.00 Rs. 0.80
Order placing costs per order Rs.15.00 Rs. 5.00
Carrying costs per annum (%) 20 20
i) Prepare a Production Budget and requirements of components for the next year.
ii) Find the Economic order quantity.
iii) Based on the economic order quantity calculated in (ii) above, calculate the savings arising
from switching over to the new ordering system both in terms of cost and reduction in
working capital.
Solution
i) Statement showing production budget of products A and B

Products in Units
A B
Closing inventory 1,000 2,000
Add; Sales 8,000 15,000
9,000 17,000
Less: Opening inventory 3,000 5,000
Production 6,000 12,000
Budget requirement of components P, Q and R

P Q R
For A:
1 unit of P x 6,000 6,000
2 units of Q x 6,000 12,000
For B:
2 units of P x 12,000 24,000
1 unit of Q x 12,000 12,000
2 units of R x 12,000 24,000
For R: 1 unit of Q x 24,000 24,000
30,000 48,000 24,000
ii)
+ 4,
EOQ =
5 ,
& , $,
Component P = = 1,500 units. Component Q = = 3,000 units.
% .$ %
iii)
Existing system
Component P Component Q
a. Present order quantity (equivalent to 3 months 30,000 x ¼ 48,000 x ¼
consumption) = 7,500 units = 12,000 units
b. Average stock (a/2) 3,750 units 6,000 units
c. Investment in inventory (b x Rs. 2 for P and Re. 0.80 for Rs. 7,500 Rs. 4,800
Q)
d. Total Investment Rs. 12,300
e. Carrying cost ( 20% of 12,300) Rs. 2,460
f. Number of order 30,000/7,500 = 48,000/12,000
4 =4
g. Ordering cost = No. of order x ordering cost per order 4 x 15 = 60 4 x 15 = 60
h. Total cost = (e + g) Rs. 2,580
After switching over to the new ordering system

Component P Component Q
a. Economic order quantity (EOQ) 1,500 units 1,500 units

b. Average stock (a/2) 750 units 1,500 units

c. Investment in inventory (b x Rs. 2 for P and Re. 0.80 for Rs. 1,500 Rs. 1,200
Q)
d. Total Investment Rs. 2,700
e. Carrying cost ( 20% of 12,300) Rs. 540
f. Number of order 30,000/1,500 = 48,000/3,000
20 = 16
g. Ordering cost = No. of order x ordering cost per order Rs.300 Rs. 240
h. Total cost = (e + g) Rs. 1,080
Saving in cost = 2,580 – 1,080 = Rs. 1,500

Reduction in Working Capital = 12,300 – 2,700 = Rs. 9,600
Problem 17: (Distribution of Overheads)
One of your clients, a jobbing engineer, has until now based his quotations on cost of materials and labor
plus a percentage to cover overheads and profit. He has now accepted your advice to relate costs to
departments (viz., X, Y and Z) through which the work passes. In pursuance of this policy to charge
overheads to jobs on the basis of departmental direct labor hours, he has compiled the following cost
data from records for the year ending 31 Asadh 2066.
Expenses Rs. Suggested base for
apportionment to Departments
Consumable stores 500 Direct labor hours
Rent, rates and insurance 3,000 Floor area
Depreciation 2,500 Plant value
Indirect labor 4,000 Direct labor hours
Repair and renewals 1,000 Technical estimate, i.e. 3:3:4
respectively
Labor amenities 1,500 No. of employees
Employee Insurance 400 No. of employees
Works Manager’s salary 3,600 Equally
General Administration 6,000 Ratio of quotations in previous
years, i.e. 5:4:3
Sundry expenses 400 12:7:1
Departments X Y Z
Direct labor hours 5,000 3,000 2,000
Wages rate per hour (Re.) 0.60 0.50 0.40
No. of employees 20 20 10
Floor area in square feet 3,000 2,000 1,000
Value of plant (Rs.) 15,000 9,000 6,000
i) Calculate the hourly overhead rates to be charged for work in each department.
ii) Prepare a quotation for a job to which the following data relates:
Material Rs. 300
Direct labor:
X =20 hours
Y =15 hours

Z = 10 hours
Profit is 20% of selling price.
Solution
i) Statement showing overhead distribution and hourly overhead rate
Expenses Ratio Total Dept. X Dept. Y Dept. Z
Rs. Rs. Rs. Rs.
Consumable stores 5:3:2 500 250 150 100
Rent, rates and insurance 3:2:1 3,000 1,500 1,000 500
Depreciation 5:3:2 2,500 1,250 750 500
Indirect labor 5:3:2 4,000 2,000 1,200 800
Repairs and renewals 3:3:4 1,000 300 300 400
Labor amenities 2:2:1 1,500 600 600 300
Employee Insurance 2:2:1 400 160 160 80
Works manager’s salary Equally 3,600 1,200 1,200 1,200
General administration 5:4:3 6,000 2,500 2,000 1,500
Sundry expenses 12:7:1 400 240 140 20
Total Rs. 22,900 10,000 7,500 5,400
Labor Hours 5,000 3,000 2,000
Labor rate per hour (Rs.) 2.00 2.50 2.70
ii) Statement showing quotation for the job

Rs. Rs.
Material 300
Labor:
Department X 20 hours x Re, 0.60 12.00
Department Y 15 hours x Re. 0.50 7.50
Department Z 10 hours x Re. 0.40 4.00 21.50
Overhead:
Department X 20 hours x Rs, 2.00 40.00
Department Y 15 hours x Rs. 2.50 37.50
Department Z 10 hours x Rs. 2.70 27.00 104.50
Total cost 428.00
Profit 20% of S.P. or 25% fo Cost 107.00
Intermediate, December 2009, ICAN
Problem 18: (Joint Costing)
Naya Nepal Ltd. produces 200,000; 30,000; 25,000; 20,000 and 75,000 units of its five products
A, B, C, D and E respectively in a manufacturing process and sells them at Rs. 17, Rs.13, Rs. 8,
Rs. 10 and Rs. 14 per unit. Except product D remaining products can be further processed and
then can be sold at Rs. 25; Rs. 17; Rs. 12 and Rs. 20 per unit in case of A, B, C, D and E
respectively.

Raw material costs Rs. 3,590,000 and other manufacturing expenses costs Rs. 547,000 in the
manufacturing process which are absorbed on the products on the basis of their net realizable
value. The further processing costs of A, B, C and E are Rs. 1,250,000; Rs.150,000; Rs.50,000
and Rs.150,000 respectively. Fixed costs are Rs.473,000.
i) Statement showing income forecast of the company assuming that none of its products
is to be further processed.
ii) Statement showing income forecast of the company assuming that products A, B,
C and E are further processed.
Is there any other production plan whereby the company can maximize its profit? If yes, then
submit a statement showing income forecast arising out of adoption of that plan.
Answer:
i) Statement showing income forecast of the company
Assuming that none of its products is further processed
Products A B C D E
Units 200,000 30,000 25,000 20,000 75,000
Rate 17 13 8 10 14
Sales Revenue 3,400,000 390,000 200,000 200,000 1,050,000 5,240,000
Less: 2,625,000 252,000 175,000 140,000 945,000 41,37,000
Apportioned
Joint Cost
Excess of 775,000 138,000 25,000 60,000 105,000 1,103,000
Revenue over
joint cost of
manufacturing
Less: Fixed 473,000
Cost
Profit 630,000
Statement showing income forecast of the company;

Assuming that products A, B, C and E are further processed.
A B C D E Total
Units 200,000 30,000 25,000 20,000 75,000
Rate 25 17 12 10 20
Sales 5,000,000 510,000 300,000 200,000 1,500,000 7,510,000
Revenue
Less: Further 1,250,000 150,000 50,000 - 150,000 1,600,000
processing
cost
Less: 2,625,000 252,000 175,000 140,000 945,000 41,37,000
Apportioned

Joint Cost
Total 3,875,000 402,000 225,000 140,000 1,095,000 5,737,000
manufacturing
cost
Excess of 11,25,000 108,000 75,000 60,000 405,000 1,773,000
revenue over
joint cost of
manufacturing
Less: Fixed 473,000

Cost
Profit 1,300,000
Suggested Production plan for maximizing profits

On comparing the figures of excess of revenue over cost of manufacturing on the above
statements it is observed that the company is earning more after further processing of A,C and E
products but is losing Rs. 30,000 in case of product B. Hence, the best production plan will be to
sell A, C and E after further processing and B, D at the point of spilt off. The profit statement
based on this suggested production plan is as below:
A B C D E Total
Units 200,000 30,000 25,000 20,000 75,000
Rate 25 17 12 10 20
Sales Revenue 5,000,000 390,000 300,000 200,000 1,500,000 7,390,000
Less: Further 1,250,000 50,000 - 150,000 1,450,000
processing cost
Less: 2,625,000 252,000 175,000 140,000 945,000 41,37,000
Apportioned
Joint Cost
Total 3,875,000 252,000 225,000 140,000 1,095,000 5,587,000
manufacturing
cost
Excess of 11,25,000 138,000 75,000 60,000 405,000 1,803,000
revenue over
joint cost of
manufacturing
Less: Fixed 473,000

Cost
Profit 1,330,000
Working Notes:
i) Statement showing Net realizable value and Apportionment of joint costs

Products Sales Value Post Net Realizable Apportioned

Separation Value Rs. joint costs Rs
Rs.
Cost Rs. (1)-(2)=(3) (4)
(1)
(2)
A 5,000,000 1,250,000 3,750,000 2,625,000`
(200,000 units *Rs.25)
B 510,000 150,000 360,000 252,000
(30,000 units * 17)
C 300,000 50,000 250,000 175,000
(25,000 units *12)
D 200,000 - 200,000 140,000
(25,000 units *10)
E 1,500,000 150,000 1,350,000 945,000
(75,000 units * 20)
5,910,000 4,137,000
Total Joint Costs = Raw materials + Manufacturing Expenses
= Rs. 3,590,000 + Rs. 547,000
= Rs. 4,137,000
ii) Apportionment of joint costs
Product Net Realizable value Joint cost apportionment Apportioned
Joint cost
789:; <8=>9 ?8@9
*NRV of each product
789:; ABC
A 3,750,000 ,&,
*3,750,000
,- ,
B 360,000 ,&,
*360,000
,- ,
C 250,000 ,&,
*250,000
,- ,
D 200,000 ,&,
*200,0000
,- ,
E 1,350,000 ,&,
*1,350,000
,- ,
5,910,000 4,137,000
Problem 19: (flexible Budgeting)
A manufacturing company has an installed capacity of Rs. 120,000 units per annum. The cost
structure of the product is as under:

Variable cost per unit Rs.

Materials 8
Labor (subject to a minimum of Rs. 56,000 per month) 8
Overheads 3
Fixed overheads- Rs. 168,750 per annum; Semi-variable overheads- Rs. 48,000 per annum at
60% capacity, which increases by Rs. 6,000 per annum for increase of every 10% of the capacity
utilization of any part thereof, for the year as a whole.
The capacity utilization expected for next year is estimated at 60% for two months, 75% for six
months and 80% for the remaining part of the year. If the company is planning to have a profit
of 25% on selling price, calculate the selling price per unit assuming that there is no opening
and closing stock.
Solution
Capacity 60% 75% 80% Total
Rs. Rs. Rs. Rs.
Material 96,000 3,60,000 2,56,000 7,12,000
Wages 1,12,000 3,60,000 2,56,0000 7,28,000
Overheads 36,000 1,35,000 96,000 2,67,000
Semi variable overheads 60,000
Fixed overheads 1,68,750
Total 19,35,750
Profit 25% on Selling Price (or 1/3 rd on cost) 6,45,250
Total 25,81,000
Total units 89,000
Selling price per unit (2,581,000/89,000) 29
Working Notes:
i) Calculation of Capacity utilization
No. of months 2 6 4 Total

Capacity utilization 60% 75% 80%
Production/month 6,000 7,500 8,000
Total production. 12,000 45,000 32,000 89,000
Total Production% (89,000/120,000) 74.16
ii) Calculation of Semi variable cost

Amount (Rs.)
Variable cost up to 60% capacity 48,000
Increase in semi variable cost for increase on production @ Rs. 6000 for every 10% 12,000
or part thereof
Total for 75% and 80% capacity 60,000
Problem 20: (Cost Sheet)

The books of New Life Company present the following data for the month of Jestha 2066. The direct labor
cost Rs. 17,500 which is 175% of works overheads. Cost of goods sold excluding administrative expenses
Rs. 56,000. Inventory details showed the following:
Particulars Jestha 1 Jestha 30
Raw Materials 8,000 10,600
WIP 10,500 14,500
Finished Goods 17,600 19,000
Further review of books disclosed that the selling expense is Rs. 3,500. General administrative expenses
are Rs. 2500 and the sale for the month is Rs. 75,000.
(i) Compute the value of materials purchased.
(ii) Prepare a cost statement showing the various elements of cost and also the profit earned.
Solution
i) Computation of the value of the materials purchased
Particulars Rs.
Add: Closing stock of finished goods 19,000
Total 75,000
Less: Opening stock (17,600)
Cost of goods manufactured 57,400
Add: Closing WIP 14,500
Less: Opening WIP (10,500)
Works Cost 61,400
Less: Factory Overheads 10,000
{17500/175} *100
Prime cost 51,400
Less : Direct Labor (17,500)
Add: Closing stock of Raw materials 10,600
Raw materials available 44,500
Less: Opening stock of Raw materials (8,000)
Value of materials purchased 36,500
ii) Cost statement showing the various elements of cost and profit earned

Rs.
Direct labor cost 17,500
Prime cost 51,400
Add: Factory overheads 10,000
Works cost 61,400
Add: Opening WIP 10,500
Less: Closing WIP (14,500)
Cost of goods manufactured 57,400
Add: Opening Finished Goods 17,600
Less: Closing Finished Goods (19,000)
Cost Of Goods Sold 56,000
Add: General administrative expenses 2,500
Add: Selling Expenses 3,500
Profit 13,000
Sales 75,000
Problem 21: (Material control)

From the following data for the year ended 31st December 2008 calculate the inventory turnover ratio
of the two items and put forward your comments on them.
Material A Material B
Opening stock 1/1/2008 Rs. 10,000 Rs. 9,000
Purchase during the year Rs. 52,000 Rs. 27,000
Closing stock 31/12/2008 Rs. 6,000 Rs. 11,000
Solution
First of all it is necessary to find out the cost of material consumed
Cost of materials consumed Material A Material B
Opening stock Rs. 10,000 Rs.9,000
Add: purchases 52,000 27,000
62,000 36,000
Less: closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory : (opening stock +closing stock)/2 8,000 10,000
Inventory turnover ratio : ( consumption/average inventory) 7 times 2.5 times
Inventory turnover (no. of days):(no. of days in a year/ I.T. ratio) 52 days 146 days
Comments: Material A is faster moving than material B.

Problem 22: (BEP and Decision making)
Raman Ltd. operating at 80% level of activities furnishes the following information for 2007- 08.
Production
A B C
Selling price/unit Rs. 10 12 20
Profit as a percentage on selling price % 25 20
33
&
Units produced and sold 10,000 15,000 5,000
Fixed costs Rs. 40,000 45,000 25,000
During the year 2008-09 the variable cost are expected to increase by 10%. There will, however, be no
change in fixed costs, the selling prices and the units to be produced and sold. The sales potential for
each of products is unlimited.
(i) You are required to prepare a statement showing the PV ratio, Break-even point and
Margin of safety for 2007-08 and 2008-09 for the company as a whole.
(ii) The company intends to increase the production of only one of the three products to reach
the full capacity level by utilizing the spare capacity available. Assuming that all the three
products take the same machine time, advice with reasons as to which of the three products
should be produced so that the overall profitability is maximized.
Solution
i) Cost Statement of M/s Raman Ltd.
Year 2007-08
Per Unit A B C Total
Rs.
Selling price Rs. 10.00 12.00 20.00
Profit % 25 33.33 20
Profit Rs. 2.50 4.00 4.00
Fixed expenses Rs. 4.00 3.00 5.00
Contribution Rs. 6.50 7.00 9.00
PV/ratio & 65 58.3 45
Quantity Units 10,000 15,000 5,000
Total sales value Rs. 1,00,000 1,80,000 1,00,000 3,80,000
Total contribution 65,000 1,05,000 45,000 2,15,000
P/V ratio Rs. 56.58
Total fixed expenses 1,10,000
Break Even Sales 1,94,415
Margin of Safety 1,85585
Cost statement of M/s Raman Ltd.

Year 2008-09

A B C
Selling Price Rs. 10.00 12.00 20.00
Variable cost/unit Rs. 3.50 5.00 11.00
Variable cost/unit Rs. 3.85 5.50 12.10
(after effecting an
Increase of 10%)
Contribution Rs. 6.15 6.50 7.90
PV/ratio % 61.50 54.17 39.50
Total contribution 61,500 97,500 39,500 1,98,500
Revised PV/ratio % 52.24%
Fixed expenses Rs. 1,10,000
Break Even Sales 2,10,567
Margin Of Safety 1,69,433
ii) Product ‘C’ yields highest contribution per unit and hence it should be produced to
utilize spare capacity.
Problem 23: (Reconciliation of non-integrated accounting)
Following figures are extracted from the financial accounts of Serve More Ltd. for the year ended 31st
Ashad 2066.
Amount Rs. Amount Rs.
Sales (20,000 units) 5,000,000
Materials 2,000,000
Wages 1,000,000
Factory Overheads 900,000
Administrative Overheads 520,000
Finished Goods (1,230 units) 300,000
Work In Progress
Materials 60,000
Labor 40,000
Factory Overheads 40,000 140,000
Interest paid on capital 40,000
In the costing records, Factory overheads is charged at 100% of wages, Administrative overhead
10% of factory cost and selling and distribution overhead at the rate of Rs. 20 per unit sold.
Ascertain the profit as per Financial and Cost Records and reconcile them.
Solution

Serve More Ltd.

Profit and Loss account
For the year ended 31 Ashad 2066
Particulars Amount. Rs. Particulars Amount (Rs.)
To Opening stock - By Sales (20,000 units) 5,000,000
To Materials 30,00,000 By Closing Stock(1230) 300,000
To Wages 1,000,000 By WIP 140,000
To Factory Overheads 900,000
To Administrative Overheads 520,000
To Selling and administrative overhead 360,000
To Goodwill written off 400,000
To Interest on Capital 40,000
To Net profit 220,000
5,440,000 5,440,000
Cost profit and loss statement

(For the Year Ended 31st Ashad 2066)
Particulars Amount
(Rs.)
Materials 2,000,000
Wages 1,000,000
Prime Cost 3,000,000
Add: Factory overheads @ 100% of wages 1,000,000
Less: Closing WIP (140,000)
Factory Cost 3,860,000
Administrative overheads @ 10% of factory cost 386,000
Total cost of production 4,246,000
Less: Closing Stock Of finished goods(1,230 units) (246,000)
Cost of production (20,000 units) 4,000,000
Selling and distribution Expenses @ 20 per unit 400,000
Cost of sales(20,000 units) 4,400,000
Sales Revenue (20,000 units) 5,000,000
Profit 600,000
Reconciliation statement

Profit as per cost records 600,000

Add: Factory OH over absorbed 100,000
(Rs. 1,000,000-900,000)
Selling and administrative expenses over absorbed 40,000
(Rs. 400,000-360,000)
Difference in valuation of closing stock of finished goods 54,000 194,000
(Rs. 300,000 – 246,000)
794,000
Less: Administrative overheads under absorbed 134,000
(Rs. 520,000 – 386,000)
Interest on capital 40,000 (574,000)
Profit as per financial records 220,000
Working Notes:
Cost of the closing stock as per the cost accounting
Cost of production of 21,230 units 4,246,000
Cost per unit 200
Cost of 1,230 units @ Rs. 200 per unit 246,000
Alternatively, it can be valued excluding the administrative overheads.
1. Problems from recent CA Exams.

May, 2001
1. a. What are the advantages of departmentalization of overheads?

b. A Company has three production departments X, Y and Z and two service departments A
and B. The expenses incurred by the service departments during the month are:
c. Explain the concept of differential costing.
2. a. From the following information show the entries for Material X to be made in stores
Ledger using:
(i) the Weighted Average Method
(ii) the Last-in-First-out Method
Jan. Units Value in Rs.
1 Balance in hand 500 1,000

4 Purchased 200 500
8 Issued 300
9 Purchased 100 220

15 Issued 200
18 Purchased 100 200
26 Issued 300
b. Calculate the earnings of two workers A and B for every 200 units of output from the
following information:
Standard conversion cost of product : Rs. 60 per unit
Over head 150% of wages cost (wage rate) : Worker A : Rs. 10 per hour
Worker B : Rs. 12 per hour
Time taken to complete 200 units by worker A is 400 hours and by worker B is 380 hours.
There is an incentive system based on the reduction of labor and overhead cost in the
following Scale:
Reduction up to Earns a Bonus
15% 10% of wages
20% 20% of wages
25% 25% of wages
3. a. What is meant by Equivalent Production Units in Process Costing?
b. A product passes through three processes AA, BB and CC. 20,000 units @ Rs. 2 per unit
were issued to Process AA. The other direct expenses are as under:
Process AA (Rs.) Process BB (Rs.) Process CC (Rs.)
Direct Labor 10,000 20,000 15,000

Direct Expenses 2,500 5,575 4,015
The wastage in Process AA and Process BB are 5% and in Process CC 10%. The wastage
in various processes are sold at the following rates:
Process AA @ Re. 1 per unit

Process BB @ Rs. 5 per unit
Process CC @ Rs. 7 per unit
The overhead charges were 150% of direct labor. The output of each process is
immediately transferred to the next process and output of process CC is transferred to
finished stock.
You are required to show the Process accounts.
4. a. Raj Limited manufactures 'X' Lubricant. The accounts of the Company showed a profit Rs.
1,400,000 from the manufacture of 'X' after charging fixed costs of Rs. 1,000,000. The item
is sold for Rs. 80 per unit and has a variable cost of Rs. 50 per unit. Market sensitivity tests
suggest the following responses to price changes:
Alternatives Selling Price Quantity Sold

reduced by increased by
A 5% 10%
B 7% 15%

C 10% 20%
D 12% 30%
E 15% 35%
Evaluate the alternatives and recommend the best alternative.
b. Define 'Investment Centre' and 'Profit Centre'.
5. a. What is 'Zero-Base-Budgeting'? State its important steps.

b. The following details are available:
A B
Standard Mixture 70% 30%

Standard Price per ton (Rs.) 2,400 650
Standard Loss 10% of Input
For the month of January 2001, the actual are as follows:

A B
Opening Stock in tons 100 60

Closing stock in tons 130 70
Purchases in tons 350 150
Amount paid for purchases (Rs.) 7,00,000 75,000
Actual production 460 tons
Calculate material price variance, material mix variance and material yield variance.
6. a. How profit-volume ratio can be improved?
b. From the following information, write-up Control accounts in the General Ledger and
prepare the Trial Balance:
Opening balances: Share Capital 5,00,000

Reserves 3,00,000
Plant & Machinery 5,00,000
Sundry Creditors 3,00,000
Sundry Debtors 3,00,000
Bank 50,000
Cash 50,000
Stock 2,00,000
Transactions during the year were as follows:

Rs.
Purchase of Stores 12,00,000

Stores issued to Production 12,00,000
Stores in hand 1,00,000

Wages (Direct) incurred 7,00,000

Direct wages charged to production 6,50,000
Manufacturing expenses incurred 4,00,000
Manufacturing expenses charged to production 3,75,000
Selling and distribution expenses 2,00,000
Finished Stock production (at cost) 20,00,000
Sales 30,00,000
Closing Stock 1,00,000
Payment to Creditors 10,00,000
Receipts from Debtors 20,00,000
Cost and Financial records are integrated and books are kept accordingly.
7. a. The following are the estimated costs for product A:

Material per unit Rs. 12
Labor cost per unit Rs. 16
Variable expenses per unit Rs. 8
Fixed manufacturing expenses Rs. 72,000
Fixed selling expenses Rs. 2,16,000
i) If the selling price is Rs. 60 per unit, how many units have they to sell to make a
profit of 20% on Sales?
ii) If the demand for the product is 10,000 units, what selling price is to be charged to
make a Profit of Rs. 50,000?
b. The budgeted working conditions for a Cost Centre are as follows:
Normal working hours per week: 42 hours, Number of machines 24

Normal weekly loss of hours on maintenance: 5 hours per machine
Number of weeks worked per annum: 50
Estimated annual overheads Rs. 1,50,000.
Estimated direct wage rate: Rs. 5 per hour
Actual results in respect of 8 week period are:
Wages incurred Rs. 20,000

Overheads incurred Rs. 22,000
Machine hours produced 2,000
Calculate:
i) Overhead rate per machine hour

ii) Amount of under or over absorption of wages and overheads.
December, 2001
1. a. Enumerate the factors which are to be considered before installing a system of Cost
Accounting in a manufacturing organization.

b. Explain the concept of 'Cost plus Contract'. What are its advantages and disadvantages?
c. A Company produces and sells five types of dolls for children using one common material,
which is available as per requirements at Rs. 4 per kg. Skilled labor required for production
is in short supply and is currently limited to 17,500 hours per month at Rs. 30 per hour.
Variable production overhead is Rs. 10 per labor hour and fixed production costs amount to
Rs. 80,000 p.m. variable selling and distribution overhead is 10% of Sales value, while
fixed selling, distribution and administration cost is Rs. 70,000 p.m. Further details are as
under:
Doll Current Demand Selling Price Raw Materials Direct Labor hours
Units per unit Rs. required per unit required per unit
in kgs. hours
A 4,800 90 5 1.0
B 5,000 80 4 0.9
C 4,000 60 3 0.7
D 6,000 40 2 0.5
E 4,500 100 6 1.2
Required:
i. Optimum product-mix you would recommend.
ii. Profit likely to be earned as per mix suggested by you in (i)
iii. The Company has just received an export-order for 5,000 units of E to be supplied
within a month. It will be possible to manufacture this quantity only by engaging
labor on overtime paying double the normal rate. An extra amount of Rs. 12,000 has
to be incurred on production overhead. If the company want 10% profit on sales,
what price it should quote?
2. a. Discuss the advantages and disadvantages of 'first-in-first-out' (FIFO) method of pricing of

material issues.
b. A firm produces a product, which has a monthly demand of 2,500 units. The product
requires a special component, which is purchased at Rs. 2. For every finished product, one
unit of special component is required. The ordering cost is Rs. 15 per order and the holding
cost is 20% p.a.
The firm at present orders its inventory requirement in quantities equivalent to 3 months'
consumption. The firm has been advised to change the present ordering system to the
system based on Economic Order Quantity. Required to calculate:
i. Economic Order Quantity.

ii. The Savings arising from switching over to the system based on Economic Order
Quantity.
3. a. Discuss the accounting treatment of idle time wages and overtime wages in cost
accounting.

b. Briefly explain the methods of separating semi-variable costs into their fixed and variable
elements.
c. PH Ltd. is a manufacturing company having three production departments A, B and C and

two service departments X and Y. Budgeted overheads allocated/ apportioned by the cost
accountant for the next year are given below:
Total A B C X Y
O/H allocated/ Rs 3,21,000 62,00 1,45,00 74,00 16,000 24,000

apportioned 0 0 0
Budgeted capacity – 4,500 10,000 7,400 – –
machine hours
A technical assessment of the apportionment of expenses of service departments is as

under:
A B C X Y
% % % % %
Service dept. X 20 40 20 – 20
Service dept. Y 10 60 20 10 –
Calculate the overhead rates of each production department after completing the
distribution of service department costs to production departments.
4. a. Discuss the accounting treatment of by-product cost in cost accounting.
b. Explain:
i. Absolute ton-kms
ii. Commercial ton-kms.
c. A Cement Company presently brings limestone to its factory from a nearby quarry and the
rate paid for transportation of limestone from the quarry located 6 km away from the
factory is Rs. 45 per ton.
The company is considering a proposal to buy its own truck and has the option of buying
either a 8 ton capacity or a 5 ton capacity truck.
The following information is available:
8 ton truck 5 ton truck
Purchase price
Rs. 850,000 Rs. 700,000
Life in years 5 5
Scrap value at the end of 5th year Rs. 50,000 Rs. 30,000

Km per liter of diesel 3 4

Repair/maintenance p.a. per truck Rs. 48,000 Rs. 36,000
Other fixed expenses p.a. Rs. 36,000 Rs. 24,000
Lubricants and sundries per 100 km Rs. 20 Rs. 20
Each truck will daily make 5 trips (to and fro) on an average of 24 days in a month.
Cost of diesel is Rs. 20 per liter.
Salary of drivers - Rs. 3,000 per month - Two extra drivers will be employed to work as
relievers.
The capacity of the Cement Plant is 9,600 tons per month of limestone crushed.
Prepare a Comparative Cost Sheet on the basis of above data showing Transport Cost per
ton of operating 8 ton and 6 ton truck at full capacity utilization.
5. a. What is Differential Costing? Mention some of its applications.

b. A single product company furnishes the following data:
Year I Year II
Sales Rs. 24,00,000 ?

P/V ratio 1 30%
33 %
3
Margin of safety 25% 40%
While there was no change in the volume of sales in year II, the selling price was reduced
Calculate the Sales, Fixed Costs and profit for the year II.
c. The operating data relating to two months of a firm are given below:
Month I Month II
Sales unit 300 340
Sales value Rs. 12,000 ?
Prime cost Rs. 4,500 ?
Overheads Rs. 6,000 Rs. 5,900
There is a reduction in fixed overheads by Rs. 500 in the second month. If the variable
costs increase by 20% in the second month, what should be the quantity to be sold in the
second month to earn the same profit per unit as in month I?
6. a. What are the limitations of an Inter-firm Comparison system?

b. Explain:
i. Efficiency audit
ii. Propriety audit

c. The details of a single product manufacturing company for the last one month are as
follows:
Actual data:
Production 10,000 units

Direct materials (1,10,000 kg) Rs. 5,50,000
Direct wages (19,800 hours) Rs. 3,12,500
Variable overheads Rs. 4,10,000
Analysis of variances:
Direct Materials
Price Rs. 5,000 (F)
Usage Rs. 25,000 (A)
Direct wages (Labor)

Rate Rs. 15,500 (A)
Efficiency Rs. 3,000 (F)
Variable overheads Rs. 10,000 (A)
You are required to calculate
i. Standard price/kg of material

ii. Standard quantity of material per unit
iii. Standard wage rate per labor hour
iv. Standard hours of labor per unit
v. Standard variable overhead per unit
7. Distinguish clearly between the following:
i. Cost Centre and Cost unit

ii. Cost control and Cost reduction
iii. Product cost and Period cost
iv. Job evaluation and Merit rating
June, 2002
1. a. State the objectives of Cost Accounting.
b. Discuss the effect of labor turnover on cost of production.
c. The working results of a company for the year 2001 are as under:
Direct materials Rs. 20 per unit

Direct wages Rs. 50 per unit
Variable overheads Rs. 15 per unit
Selling Price Rs. 156.25 per unit
Fixed Overheads Rs. 843,750 per annum

Sales Rs. 3,125,000 per annum
It is expected that during the year 2002, the material prices and variable overheads will go
up by 10% and 5% respectively. The overall direct labor efficiency will increase by 12%
and the wage rates will go up by 5%. The fixed overheads are expected to increase by
Rs.156,250.
The Marketing Manager states that the market will not absorb any increase in the selling
price. He feels that if the advertisement expenditure is sanctioned, the sales quantity will
increase as under:
Advertisement Expenses Rs. 100,000 242,500 400,000 575,000

Additional Sales units 2,000 4,000 6,000 8,000
Required:
(i) Present a statement of profitability for the year 2001.
(ii) Evaluate the alternative proposals put forth by the Marketing Manager and
determine the best output and sales level to be implemented.
(iii) Prepare a statement of profitability for the year 2002 after incorporating the
proposals chosen by you in (ii) above.
2. a. Explain perpetual inventory records and continuous stock taking.

b. Distinguish between allocation and apportionment of overheads.
c. The details of budget prepared by a single product manufacturing company for April 2002
are as under:
No. of units of the product to be manufactured 45,000

Budgeted consumption of direct materials 1,80,000 kg
Planned purchase of direct materials 2,00,000 kg
Budgeted value of purchase of direct materials Rs. 16,00,000
Direct labor hours required per unit of finished output 2 hours
Direct Wages budget Rs. 4,95,000
Standard Variable overhead rate per hour Rs. 6
The actual data for April 2002 are as under:

No. of units actually produced 48,000
Cost of direct materials issued at actual price Rs. 15,67,500
Actual Cost of direct materials actually purchased Rs. 18,48,000
Average actual price per kg of direct material Rs. 8.25
Actual direct labor cost for the month Rs. 5,40,600
Actual variable overheads incurred during the month Rs. 6,88,500
Actual variable overhead rate per hour Rs. 6.75
Compute the following variances:

(i) Direct material usage variance.

(ii) Direct materials price variance at the point of purchase and consumption.
(iii) Direct labor efficiency and rate variances.
(iv) Variable overheads efficiency and expense variances.
3. a. State the methods of apportionment of joint costs to joint products.
b. Outline the limitations of break even analysis.

c. From the records of a manufacturing company, the following budgeted details are available:
Rs. Rs.
Direct materials 1,99,000
Direct Wages
Machine Shop 12,000 hours 63,000
Assembly Shop 10,000 hours 48,000 1,11,000
Works overheads
Machine Shop 88,200
Assembly Shop 51,800 1,40,000
Selling overheads 81,000
Distribution overheads 62,100
The company follows absorption costing method.
Required:
(i) Prepare a schedule of overhead rates from the figures available stating the basis of
overhead recovery rates used under the given circumstances.
(ii) Work out a cost estimate for the following job based on overhead rates so computed:
Direct materials : 25 kgs @ Rs. 16.80 per kg

15 kgs @ Rs. 20.00 per kg
Direct labor : Machine shop 30 hours
Assembly shop 42 hours
4. a. Explain the need for reconciliation between cost and financial accounts.
b. What are the objectives of uniform costing.
c. In a company, raw material is introduced in Process A and the finished output of Process A
Becomes the input of Process B. The finished output of Process B is in turn transferred to
the warehouse. The following information has been gathered for a period:
Process A Process B
Raw Materials @ Rs. 10 per kg 10,000 Kg –

Direct materials Rs. 60,000 20,000
Direct wages Rs. 80,000 60,000

Production overheads Rs. 40,000 30,000

Output 8,800 Kg 8,400 Kg
Normal Loss 10% 5%
Normal loss realisation per Kg. Rs. 2 Rs. 3
You are required to prepare the process accounts and abnormal effectives account.
5. a. A company uses a purchased component in an assembly. It follows a policy of economic

order quantity for procurement of the component. The purchase price of the component is
Rs. 800 each and the cost of carrying one unit is 15% per annum. The cost of placing an
order is Rs. 150. The company has estimated the total cost of carrying and order placement
at Rs. 36,000. The supplier has offered a discount of 3% on the purchase price if the entire
requirement of the component is covered in two purchase order in a year.
Required:
(i) Find the economic order quantity.
(ii) Calculate the total cost of the component procurement and storage if the discount
offer is accepted. Compare this cost with the total cost of EOQ.
(iii) What further discount, if any should be negotiated for minimizing the cost.
b. A company is in the process of introduction of wage incentive system. It has taken up the
study of the output of three workers A, B and C. Each worker produces an identical
product, but the output varies. They respectively produce 44, 36 and 24 units in a shift of 8
hours. The daily wages are guaranteed at Rs. 5 per hour and the piece rate is based on a
standard output of 4 units per hour.
The company is considering the wage calculations under (i) Time rate system (ii) Piece rate
system, (iii) Halsey system and (iv) Rowan system.
Calculate under each of the aforesaid four systems for each worker:
(i) The total earnings per shift of 8 hours.

(ii) The effective earnings per hour worked.
(iii) The wage cost per unit of output.
6. a. State the difference between standard costing and budgetary control.

b. Select a suitable cost unit and also indicate the method of costing used in the following
industries.
(i) Hospital
(ii) Sugar manufacture
(iii) Interior decoration
(iv) Bicycle manufacture

c. A contractor undertook a building contract on 1.1.2001. Data relating to the contract for the
year ended 31.3.2002 are as under.
Rs. Lacs
As on 1.4.2001
Work not certified 10
Materials at site 2
1.4.2001 to 31.3.2002
Materials Issued 60
Wages paid 36
Work certified 165
Materials returned 5
Plant hire 7
Direct expenses 9
Plant issued on 1.4.2001 50
Payment received 150
As on 31.3.2002
Materials at site 5
Work no certified 16
The plant is expected to have a scrap value of Rs. 10 lacs at the end of its life of 10 years.
The contract price is Rs. 200 lacs.
Required:
(i) Prepare contract account for the year ended 31st March 2002
(ii) Show the calculation of profit to be taken to profit & loss account.
(iii) Show the relevant Balance Sheet entries as at 31st March 2002
7. a. State the purposes of cost audit.

b. What are the prerequisites of integrated accounting system.
c. A license to ply a mini-bus between stations A and B covering a distance of 25 km. has
been obtained. The mini-bus will make 8 round trips in a day for 25 days in a month. It has
a seating capacity of 30 passengers and on an average 60% occupancy is expected
throughout. The purchase price of the bus is Rs. 600,000. It has a life of 10 years with a
salvage value of Rs. 10,000 at the end of its life. The details of the operating expenses are
as under:
Insurance Rs. 12,000 per annum

Garage rent Rs. 2,000 per quarter
Road Tax Rs. 3,000 per annum
Repairs Rs. 4,000 per quarter
Administration Rs. 1,000 per month
Driver's salary Rs. 3,000 per month
Conductor's salary Rs. 2,000 per month
Tyres and Tubes Rs. 3,000 per quarter
Diesel Rs. 12 per liter
Oil and Sundries Rs. 20 per 100 Km run

The mini-bus consumes a liter of diesel for every 4 km of run. Passenger tax is 20% on total
revenue (takings). The company requires a profit of 20% on takings.
You are required to prepare an annual cost sheet showing the cost per passenger km and the
one way fare per passenger from station A to B.
December, 2002
1. a. Discuss the essentials of a good Cost Accounting System.
b. Discuss the treatment of under-absorbed and over-absorbed overheads in cost

accounting.
c. The standard cost of product is as under.
Materials 20 lbs. M.S. Pate Rs. 15

Labor 15 hours @ Rs. 3/hr 45
Overheads 15 hours @ Rs. 5/hr 75
Rs. 135
Standard labor hours per month are 30,000 for the month of October, 2002 which was
the first month of production, the number of units completed were 1800. A further 400
units were half completed with respect to materials, labor & overheads.
Other particulars available for the month of October, 2002 are:
Materials issued 44,000 lbs

Materials Purchased 50,000 lbs @ Re 1
Wages Paid 29,500 hours @ Rs. 2.5/hr
Overheads Rs. 154,000
Analyze the variances in as much detail as possible and compute the manufacturing cost
per unit.
2. a. Discuss the reasons for disagreement of profits as per cost accounts and financial
accounts.
b. The following balances are extracted from a company's cost-ledger as at July 01, 2002
Dr. Cr.
Raw materials-control a/c 76254
Work-in-progress control a/c 19118
Finished stock control a/c 38970
Nominal ledger control a/c38970 134342
13432 134342
Further transactions took place during the following quarter, as follows:

Rs.
Rs.
Factory Overheads allocated to work-in-progress 17,679
Goods finished (at cost)
55,251
Raw materials purchased
33,633
Direct wages allocated to work-in progress
13,095
Row materials issued to production
24,435
Cost of goods sold
62,084
Raw materials credited by suppliers
1,254
Customers' returns (at cost) of finished goods stock 4,284
Inventory audit – raw materials losses
1,854
Work-in progress rejected (With no scrap value) 2,652
Yes are required to prepare the following accounts/statement;
(i) Raw materials control account

(ii) Work-in-progress control account
(iii) Finished goods stock control account
(iv) Nominal ledger control account
(v) Costing P/L account
(vi) Trial Balance
3. A manufacturing company makes a product by two process and the data below relate to the
second process for the month of October, 2002.
A work-in-progress balance of 1200 units brought forward from September was valued at cost as
follows:
Direct materials, complete Rs. 16,200

Direct wages, 60% complete 10,260
Production overheads, 60% complete 10,800
During October, 4000 units were transferred from the first process to the second process at a cost
of Rs. 11.25 each, this input being treated as direct material within the second process.
Other costs incurred during the month in the second process were
Additional direct material Rs. 7,245

Direct Wages Rs. 49,44750
Production overheads 53,307

3200 completed units were transferred to finished goods store. A loss of 520 units, being normal,
occurred during the process. The first-in-first out method of pricing is used.
Work-in-progress at the end of October consisted of 500 completed units awaiting transfer to
finished goods store and a balance of unfinished units which were complete as regards direct
material and 50% complete as regards direct wages and production overheads.
a. Prepare for the month of October, 2002 the account for the Process II.
b. Present a statement for the management, setting out the:
(i) Cost per unit of the finished product, by elements of cost and total.
(ii) Cost of production transferred to finished goods.
(iii) Cost of production of completed units awaiting transfer to finished goods.
(iv) Cost of uncompleted units in closing work-in-progress, by elements of cost
and in total.
4. a. A manufacturing company is currently operating at 80% capacity has received an
export order form Middle East, which will utilize 40% of the capacity of the plant. The
order has to be taken in full and executed at 10% below the current domestic prices or
rejected totally.
The current sales and cost data are given below:
Sales : Rs. 32 lakhs

Direct materials : Rs. 11,60 lakhs
Direct Labor : Rs. 4.80 lakhs
Variable overheads : Rs. 1.20 lakhs
Fixed overheads : Rs. 10.40 lakhs
The following alternatives are available to the management.
(i) Continue with domestic sales and reject the export order.
(ii) Accept the export order and allow the domestic market to starve to the extent
of excess demand.
(iii) Increases the capacity so as to accept the export order and maintain the
domestic demand by:
(a) Purchasing additional plant and increasing 15% capacity and thereby
increasing fixed overheads by Rs. 1,95,000.
(b) Working overtime at one half-time the normal rate to meet balance of
the required capacity
You are required to evaluate each of the above alternatives and suggest the best one:
b. How do you deal with the following in Cost Accounts?
(i) Research and Development Expenses
(ii) Fringe benefits
5. a. A Company has three production departments A, B, C and two service departments Y

and Z. The following figures are extracted from the records of the company:

Rs.
Rent & Rates 25,000
General Lighting 3,000
Indirect Wages 7,500
Power 7,500
Depreciation of Machinery 25,000
Sundries 10,000
The following further details are available:
Total A B C Y
Z
Floor Space (Sq. ft) 10,000 2500 3000 2000 500
2000
Light points 60 15 20 10 5
10
Direct Wages (Rs.) 25,000 7500 5000 5000 2500
5000
H.P. of Machines 150 30 50 60 –
10
Value of Machinery 500000 100000 150000 200000 10000
40000
Working Hours 4332 5674 6837
The expenses of Y and Z are allocated as follows:

A B C Y Z
'Y' 25% 35% 30% – 10%
'Z' 30% 40% 20% 10% –
What is the total cost of an article if its raw material cost is Rs. 250 labor cost is Rs. 120 and it
passes through departments A, B & C for 8, 10 and 6 hours respectively?
b. Describe the points on which uniformity is essential before introducing uniform costing
system?
6. a. A manufacturing company manufactures two products AB and CD by mixing the

following raw-materials in the proportion given below:
Raw Materials Product product

AB CD
A 70% –
B 30% –
C – 60%
D – 40%
The finished weight of products AB and CD are equal to the weight of their ingredients.
During the month of November, 2002 it is expected that 600 tons of AB and 2000 tons
of CD will be sold.

Actual and budgeted inventory for the month of November, 2002 are as follows.
Materials Actual Inventory Budgeted Inventory
(Nov. 1, 2002) (Nov. 30, 2002)
Qty (tons) Qty (tons)
A 150 200
B 100 400
C 2000 3000
D 2500 2000
Product AB 100 50
Product CD 500 600
The purchase price of materials for November, 2002 is expected to be as follows:

Material Cost per ton (Rs.)
A 500
B 400
C 100
D 200

(i) Production Budget for the month of November.
(ii) Material Requirement Budget for the month of November.
(iii) Material Purchase Budget indicating expenditure for materials for the months of
November.
b. Distinguish Between:
(i) Time Keeping and Time Booking
(ii) Time Study and Motion Study
7. a. From the details given below, calculate:

(i) Re-order level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level
The relevant data is as under:

Cost of placing a purchase order: Rs. 250
Number of units to be purchased during the year 50,000
Purchase price per unit inclusive of transportation cost Rs. 125
Annual storage cost per unit Rs 15
Details of land time:

Average : 10 days
Maximum : 15 days
Minimum : 5 days
For Emergency Purchase : 3 days

Rate of consumption:
Average : 150 units per day
Maximum : 200 units per day
b. From the following data per training to the year 2001 – 2002, prepare a cost sheet
showing the cost of electricity generated per Kwh by a Thermal Power Station.
Total units generated 10,00,000 Kwh

Rs.
Operating Labor 500,000
Repairs & Maintenance 500,000
Lubricants, spare & stores 450,000
Plant Supervision 250,000
Administration Overheads 250,000
Coal Consumed per Kwh for the year is 2.5 Kg @ Rs. 0.3 per Kg. depreciation charge
is 10% on Capital cost of Rs. 2,500,000
December, 2002
1. a. Enumerate the factors which are to be considered before installing a system of Cost
Accounting in a manufacturing organization.
b. Explain the concept of "Cost plus Contract." What are its advantages and
disadvantages?
c. A company produces and sells five types, of dolls for children using one common
material, which is available as per requirements at Rs. 4, per kg. Skilled labor, required
for production is in short supply and is currently limited to 17,500 hours per month at
Rs. 30 per hour. Variable production overhead is Rs. 10 per labor hour and fixed
production costs amount to Rs. 80,000 p.m. variable selling and distribution overhead is
10% of Sales value, while fixed selling, distribution and administration cost is Rs.
70,000 p.m. Further details are as under:
12
Doll Current Selling Price Raw Materials Direct Labor

Demand Per unit Required per hours required
units Rs. Unit in kgs per unit hours
A 4,800 90 5 1.0
B 5,000 80 4 0.9
C 6,000 60 3 0.7
D 4,500 40 2 0.5
E 100 6 1.2
Required:
(i) Optimum product-mix you would recommend.
(ii) Profit likely to be earned as per mix suggested by you in (i)
(iii) The Company has just received an export-order for 5,000 units of E to be supplied
within a month. It will be possible to manufacture this quantity only by engaging labor

on overtime paying double the normal rate. An extra amount of Rs. 12,000 has to be
incurred on production overhead. If the company wants 10% profit on sales, what price
it should quote?
2. a. Discuss the advantages and disadvantages of 'first-in-first-out' (FIFO) method of pricing

of material issues.
b. A Firm produces a product, which has a monthly demand of 2,500 units. The product
requires a special component, which is purchased at Rs. 2 For every finished product,
one unit of special component is required. The ordering cost is Rs. 15 per order and the
holding cost is 20% p.a.
The firm at present orders its inventory requirement in quantities equivalent to 3

months' consumption. The firm has been advised to change the present ordering system
to the system based on Economic Order Quantity. Required to calculate:
(i) Economic Order Quantity.
(ii) The Savings arising from switching over to the system based on Economic Order
Quantity.
3. a. Discuss the accounting, treatment, of idle time wages and overtime wages in cost
accounting.
b. Briefly explain the methods of separating semi-variable costs into their fixed and
variable elements.
c. PH Ltd. Is a manufacturing company having three production departments A, B

and C and two service departments X and Y. Budgeted overheads allocated/
apportioned by the cost accountant for the next year are given below:
Total A B C X Y
O/H allocated/
Apportioned Rs. 321,000 62,000 145,000 74,000 16,000 24,000
Budgeted capacity
Machine hours – 4,500 10,000 7,400 – –
A technical assessment of the apportionment of expenses of service departments is as

under:
A B C X Y
% % % % %
Service dept. X 20 40 20 – 20
Service dept. Y 10 60 20 10 –
Calculate the overhead rates of each production department after completing the
distribution of service department costs to production departments.
4. a. Discuss the accounting treatment of by product cost in cost accounting.

b. Explain

(i) Absolute ton-kms

(ii) Commercial ton-kms.
c. A Cement Company presently brings limestone to its factory from a nearby quarry, and
the rate paid for transportation of limestone form the quarry located 6 km away from
the factory is Rs. 45 per ton.
The following information's are available.
8 ton truck 5 ton truck

Purchase price Rs. 850,000 Rs. 700,000
Life in years 5 5
Scrap value at the end of 5th year Rs. 50,000 Rs. 30,000
Km per liter of diesel 3 4
Repair/maintenance p.a. per truck Rs. 48,000 Rs. 36,000
Other fixed expenses p.a. Rs. 36,000 Rs. 24,000
Lubricants and sundries per 100 km Rs. 20 Rs. 20
Each truck will daily make 5 trips (to and fro) on an average of 24 days in a month.
Cost of diesel is Rs. 20 per liter.
Salary of drivers- Rs. 3,000 per month – Two extra drivers will be employed to work as
relievers.
The capacity of the cement Plant is 9,600 tons per month of limestone crushed.
Prepare a Comparative Cost Sheet on the basis of above data showing. Transport Cost
per ton of operating 8 ton and 6 ton truck at full capacity utilization.
5. a. What is Differential Coating? Mention some of the applications.

b. A single products company furnishes the following data:
Year I Year II
Sales Rs. 2,400,000 ?
P/V ratio 33½ % 30%
Margin of safety 25% 40%
While there was no change in the volume of sales in year II, the selling price was
reduced. Calculate the Sales, fixed Costs and Profit for the year II
c. The operating date relating to two months of a form are given below.
Month I Month II
Sales units 300 300
Sales value Rs. 12,000 ?
Prime cost Rs. 4,500 ?

There is a reduction in fixed overheads by Rs. 500 in the second month. If the variable
costs increase by 20% in the second moth, what should be the quantity to be sold in the
second month to earn the same profit per unit an in month I?
June, 2003
1. a. What is Cost Accounting? Write about the types of information provided by Cost
Accounting that facilitates management in discharging management functions.
b. The necessary particulars noted out of the accounts of the last year of a firm are stated
below:
Sales revenues of the 1st 6 months of the last year was Rs. 6,00,000 and of the 2nd 6 months
was Rs. 4,00,000.
P/V ratio was 60%
Safety margin on the total sales of the year was 25%.
Required: 1. BEP Sales (in Rs.)

2. Annual fixed costs
c. Write about the advantages of marginal costing.
2. a. What is continuous stock taking? What are its advantages?

b. The extracts from the store ledger are given below:
Stock on 1.1.2059 was 200 units costing Rs. 460
Procurements:
5.11.2059 — 400 units costing Rs. 800

16.11.2059 — 300 units costing Rs. 720
24.11.2059 — 500 units costing Rs. 1,190
Issues:
10-11-2059 — 300 units

20-11-2059 — 500 units
30-11-2059 — 400 units
50 units were returned on 23.11.2059 from the work order out of the earliest purchase lot
included in the issue made on 20.11.2059.
Required: Store ledger by using
1. LIFO method and

2. Weighted average Price method.

3. a. What is uniform costing system? Write about the objective of uniform costing system.
b. The details of the staff force of a firm are stated below:
i. Staff force in the beginning of the last year was 125
ii. Staff force at the end of the last year was 175.
15 workers discharged on disciplinary cause.
20 workers left their job because of dispute with the management of the firm.
The annual expenses associated with the staff force during the period were:
i. Human resource development — Rs. 90,000

ii. Loss of output because of delay in hiring new staff — Rs. 60,000
iii. Training expenses for the whole staff force — Rs. 30,000
iv. Cost of recruitments — Rs. 45,000
Required: 1. Labor turnover on account of unavoidable cause

2. Labor turnover cost
3. Preventive labor turnover cost
Required: Ascertain earning of the worker by using

1. Straight piece rate system
2. Rowan Premium Plan
3. a. A manufacturing concern has been producing products through two Production Departments
and two Service Departments. The overheads for the month ended Falgun 30, 2059 are given
below:
Rs.
Maintenance materials 50,000
Indirect labor 40,000
General overhead 40,000
Depreciation 90,000
Rent 50,000
The data reflecting the operational aspects of the month for the departments of the manufacturing
concern are compiled below:
Production departments Service Departments

Assembly Making Store Power House
Direct wages (in Rs.) 1,00,000 50,000 25,000 25,000
Book value of assets (in Rs.) 4,00,000 1,00,000 1,00,000 4,00,000

Space used (in sq.mt.) 8,000 7,000 5,000 5,000

No. of requisition made 24 15 6 5
DLH 40,000 20,000 10,000 10,000
The patterns of the percentage sharing of the cost of Service Departments are stated below:
Production departments Service Departments

Assembly Making Store Power House
Store Department in % 50 30 – 20
Power House Department % 40 50 10 –
Required: 1. Overhead distribution summary

2. Re-apportionment by applying Simultaneous Equation Method
3. Total cost for a unit of output requiring direct material cost of Rs. 40 and
direct wage of Rs. 30 with processing of 2 DLH in Assembly Dept and 3
DLH in Making Dept.
b. A firm produces products through Crushing Process and Finishing Process.

The normal losses of each process are 5% in Crushing and 10% in Finishing Process.
Scrap value recovered out of the sale of the normal loss quantities of Crushing Process and
Finishing Process are Rs. 3 per unit and Rs. 5 per unit respectively.
Main raw material issued to Crushing Process was 20,000 units at Rs. 2 per unit.
Crushing Process (Rs.) Finishing Process (Rs.)

Subsidiary Materials 55,000 80,000
Direct labor 50,000 60,000
Other overall expenses 29,000 31,000
Actual outputs realized during the period were 18,000 units from Crushing Process and
16,500 units from Finishing Process.
Required: 1. Crushing Process Account showing cost per unit of output.

2. Finishing Process Account showing cost per unit of output.
5. a. The contract work that started on and from Kartik 1, 2058 reported the following details on
Chaitra 31, 2058.
Rs.
Raw materials 2,00,000
Wages paid 1,00,000
Expenses paid at site 50,000


Wages payable on 31.12.2058 20,000
Plant at site on closing day 1,44,000
(at book value)
Plant returned to Head Office 54,000
on closing day (at book value)
Cash received as progress payment 3,20,000
(80% of work certified)
Contract Price 6,00,000
Insurance compensation of Rs. 15,000 was received for the material costing Rs. 20,000 destroyed by
fire.
The rate depreciation charged was 20% p.a.
Required: Contract Account showing the reasonable profit required to be transferred

to Profit and Loss Account of the year.
b. Every day five buses are providing up and down trips service in a 40 km. one way distance
route. Each bus has 25 seats capacity for passengers. Given below are the necessary details
obtained from the daily log sheet maintained for 30 days a month for 5 buses.
Rs.
Salary of Office Staff 36,000
Wages of drivers, conductors, cleaners 96,000
Garage charges 12,000
Interest, taxes, insurance etc. 1,20,000
Repair and maintenance 48,000
Diesel costs 57,600
Depreciation at the rate of Rs. 25 per running Km.
Lubricating oil mobil per running kilometer on an average is Rs. 1.00
Each bus runs on an average with 80% of the seat capacity.
Required: Statement reporting cost on the basis of behavioral pattern show bus fare per
passenger kilometer.
6. a. What are the objectives of Budgetary Control System? Also write about the components of
functional budget.
b. The input material mix for 8 units of output along with the cost of input material are
reported below:
Material "x" – 6 kg at Rs. 10 per kg

Material "y" – 4 kg at Rs. 12 per kg
The standard time for one unit of output is 2 DLH.
Standard wage rate is Rs. 15 per DLH.

The actual input materials consumptions for realizing 1,600 units and procurement costs of
the input materials of that month are mentioned below:
Material "x" – 1,300 kg at Rs. 9 per kg

Material "y" – 900 kg at Rs. 13 per kg
3,000 DLH was used for which wage payment was made at the rate of Rs. 16 per DLH.
Required: 1. Material Price Variance

2. Material Mix Variance
3. Material Usage Variance
4. Labor Efficiency Variance
5. Labor Rate of Pay Variance
7. a. A business enterprise has been maintaining integrated accounting system. The transaction
for the last month is given below:
Rs.
Material purchased (60% cash) 300,000
Material supplied to production 250,000
Wages paid and charged to production 150,000
Work expenses paid & charged to production 90,000
Selling and distribution expenses paid 50,000
Cost of finished goods 400,000
Sales revenue (20% credit sales) 650,000
Required: Journal entries by giving narrations in the books of the enterprise
b. Define labor turnover. Write about the causes of labor turnover.
December, 2003
1. a. Discuss the types and methods of costing.
b. When you had completed your audit of the ABC Company, Management asks for your
assistance in arriving at a decision whether to continue manufacturing a part or to buy it
from an outside supplier. The part, which is named PCB, is a component used in some of the
finished products of the company.
From your audit working papers and from further investigation, you develop the following
data as being typical of the company's operations:
a. The annual requirement for PCB is 5,000 units. The lowest quotation from a supplier
was Rs. 8 per unit.

b. PCBs have been manufactured in the precision machinery department. If they are
purchased from an outside supplier, certain machinery will be sold and will realize its
books value.
c. The following were the total costs of the precision machinery department during the
year under audit when 5,000 PCBs were made:
Amount in Rs.
Material 67,500
Direct Labor 50,000
Indirect Labor 20,000
Light and Heat 5,500
Power 3,000
Depreciation 10,000
Property Tax and insurance 8,000
Payroll Tax and others benefits 9,800
Others 5,000
d. The following precision machinery department cost apply to the manufacture of

PCBs:
Material Rs. 17,500

Direct Labor 28,000
Indirect Labor 6,000
Power 300
Other 500
The sale of the equipment used for PCB would reduce the following costs by the
amounts indicated - depreciation Rs. 2,000; property tax and insurance Rs. 1,000.
e. The following additional precision machinery department costs would be incurred if

PCBs were purchased from outside supplier: freights 50 paisa per unit; indirect labor
for receiving, materials handling, inspections etc. Rs. 5,000.
Required:
1. Advise the management.
2. Discuss the consideration in addition to the cost factors that you would bring to its
attention when assisting management to arrive at a decision whether to make or buy
PCBs. Include in your discussion the considerations that might be applied to the
evaluation of the outside supplier.
2. a. What is Inventory Control? Explain the techniques of Inventory Control.
b. The following information is recovered from the books of ABC Manufacturing Co.:

Normal Overhead Rates 1.50

Actual hours operated 10,000.00
Allowed hours for actual Production 10,500.00
Allowed overheads for budgeted hours 35,000.00
Actual Overheads 36,000.00
Calculate:
(i) Overheads Budget Variance (ii) Volume Variance (iii) Efficiency Variance (iv)
Capacity Variance (v) Total overhead cost variance.
3. Three joint products are produced by passing raw materials through two consecutive Processes.
Output from process 1 is transferred to process 2 from which the three joint products are produced
and immediately sold. The data regarding the processes for Shrawan, 2060 is given below:
Process I Process II
Direct material 1,250 kg. at Rs. 4 per kg. Rs. 5,000

Direct Labor Rs. 3,125 Rs. 3,450
Normal Loss 10% of input Nil
Scrap value of loss Rs. 2 per kilos
Output 1,150 kilo Joint products
A - 450 Kgs
B - 400 Kgs
C - 300 Kgs
There were no opening closing stocks in either process and the selling prices of the output from
process 2 were: Joint product A: Rs. 18 per Kg.; Joint product B: Rs. 15 per kg; Joint product C:
Rs. 10 per kg.
a. Prepare an account for process 1 together with any loss or Gain accounts you consider
necessary to record the months activities.
b. Calculate the profit attributable to each of the joint produced by apportioning the total cost
from process 2: (i) According to weight of output. (ii) By the market value of production.
4. a. A transport company has provided the following estimated figures.
i. Cost price of a micro-bus is Rs. 1,500,000 with 300,000 running kilometers during
life time.
ii. Diesel & oil cost for one kilometer is Rs. 12.
iii. Annual garage & registration charges are Rs. 24,000
iv. Driver's salary per month is Rs. 10,000
The micro-bus is expected to operate for 25 days a month with 20 passengers in 2 round
trips of 40 kilometers long route.
Required: Cost per passenger kilometer by showing standing and running chares.

b. The scenarios of the labor force of an industry are as follows:

Labor force of beginning - 195
Labor force of ending - 205
5 workers were discharged on disciplinary ground. The registrations submitted by 10

workers were accepted.
Annual expenditure associated with human resource are:
i. Medical expenses - Rs. 40,000

ii. Recruitment expenses - Rs. 20,000
iii. Loss of output on account of replacement - Rs. 30,000
iv. Training cost for the entire manpower - Rs. 50,000
Required: a. Labor
b. Labor turnover ratio on account of unavoidable circumstances
c. Cost per labor turnover
d. Preventive cost per labor turnover
e. Replacement cost per labor turnover
5. a. The positions of production and service departments of a manufacturing concern are given
below:
Production Departments Service

A B Department
Capital value of assets
(Rs. in lakhs) 8 4 3
Space used (sq. meters) 5,000 4,000 1,000
Direct labor hours 4,000 2,000 2,000
Horse power of machine 200 150 50
Number of staff 25 20 5
The particulars of the expenses incurred are:
Rent, rates and taxes – Rs. 20,000

Canteen – Rs. 10,000
Power – Rs. 24,000
Depreciation – Rs. 30,000
General Overhead – Rs. 16,000
Production departments A and B consumed service of service department in the ratio of 5:3.
Required: a. Primary distribution

b. Re-apportionment of service department's cost
c. Overhead per Direct labor hour of production departments.

b. Discuss briefly about the principle accounts normally maintained under Non-Integrated
Accounting System. Also differentiate integrated accounting system from Non-Integrated
Accounting System.
6. a. XY Ltd. is manufacturing and selling two products: X and Y at selling price of Rs. 3 and Rs.
4 respectively. The following sales strategy has been outlined for the year 2060.
i. Sales planned for the year will be Rs. 360,000 in the case of X and Rs. 175,000 in the
case of Y.
ii. To meet competition, the selling price of X will be reduced by 20% and that of Y by
12½%.
iii. Break-even is planned at 60% of the total sales of each product.
iv. Profit for the year to be achieved is planned at Rs. 34,560 in the case of X and Rs.
8,750 in the case of Y. This would be possible by launching a cost reduction program
and reducing the present annual fixed expenses of Rs. 67,500 allocated at Rs. 54,000
to X and Rs. 13,500 to Y.
You are required to present the proposal in financial terms giving clearly the number of
units to be sold X and Y to break even as well as the total number of units of X and Y to be
sold during the year.
b. What is budgetary control system? What are the silent features of budgetary control system?
a. Relevant cost and Opportunity cost.
b. Waste and Scrap.
c. Cost Center and Profit Center.
d. Operation cost and Operating cost.
June, 2004
1. a. Explain the differences between cost accounting, financial accounting and management
accounting.
b. How is prime cost different from marginal cost? State the elements of cost included in two
types of cost.
c. A Ltd. produces two products for which details are as follows:
Products A (Rs.) Product B (Rs.)
Sales price/unit 12.00 7.50

Direct materials cost/unit 6.00 4.00
Direct labor hours/ unit 2hr. 1 hr.
Standard hourly rates 4 4
Variable overhead / unit 1 1

Fixed o/h budgeted 100,000
Total direct labor hours available 200,000 minimum production of product A is 30,000 units
and B is 100,000 units.
Assume that materials are freely available and that materials and available direct labor can
be freely used for either of products, subject to the minimum production as stipulated above.
Suggest the best production program by outlining the steps along with the statements for the
purpose and show the net profit expected from this program.
2. a. A factory has recently replaced an old machine by a modern machine.
The technical board of the factory endorsed the recommendation made by the technical
committee for the curtailment of the previously set up time of 0.50 hour by 20% for
realizing 4 units of output.
The current wage rate per hour is Rs. 40. A worker of the factory produced 360 units
working for 6 hours a day for 5 days after the regulation of the revised hours.
Required: Earning of the worker based on:
(1) Straight piece rate system

(2) Differential piece rate system ranging lowest of 83% and highest of 125%.
(3) Halsey Premium Plan
(4) Rowan Premium Plan
b. What do you understand by the term 'predetermined rate of recovery' of overheads? What
are the bases that are usually advocated for such predetermination? How do over-absorption
and under-absorption of overheads arise and how are they disposed of in cost accounts?
3. a. What is 'Job Costing'? In which type of industries this system would be suitable? Give a
specimen of cost sheet.
b. A truck with a load capacity of 10 ton carries goods between two urban areas having a
distance of 50 km.
The truck operates a round trip each day for 25 days a month.
Full load is available on outward trip and only 60% load on return trip.
The estimated life of the truck is 10 years. The other details are listed below:
Cost of truck Rs. 7,200,000

Driver's wage Rs. 8,000 per month
Cleaner's wage Rs. 4,000 per month
Insurance & taxes Rs. 60,000 per year
Mobil oil and grease per 100 km Rs. 120 per liter (average)
Diesel Rs. 4,000 per trip one way
Required:

i. Cost per to kilometer by showing standing charges and running expenses.

ii. Truck fare per ton kilometer if 20% profit on fare is to be earned.
4. a. A company is considering the possibility of purchasing from a supplier a component it now

makes. The supplier will provide the components in the necessary quantities at a unit price
of Rs. 9.00. Transportation and storage costs will be negligible.
The company produces the components from single raw materials in economic lots of 2000
units at a cost of Rs. 2 per unit. Average annual demand is 20,000 units. The annual holding
costs are Rs. 0.25 per unit and the minimum stock level is set at 400 units. Direct labor cost
for the components are Rs. 6 per unit, fixed manufacturing overhead is charged at a rate of
Rs. 3 per unit based on a normal activity of 20000 units. The company also hires the
machine on which the components are produced at a rate of Rs. 2 per month.
Should the company make the components?
b. What is defective unit? How rectifying expenses of defective units are brought into account?
5. a. A company produces a standard product. Estimate cost per unit are as follows:
Raw Material - Rs. 2

Wages - Rs. 1
Variable overhead - Rs. 2.50
The semi variable costs are:
Indirect Materials - Rs. 117.50
Indirect Labor - Rs. 78
Repairs - Rs. 285
The variable costs per unit included in semi-variable costs are:
Indirect Material - Rs. 0.025
Labor - Rs. 0.04
Repair - Rs. 0.05
The fixed costs are:
Factory - Rs. 2,000
Administration - Rs. 3,000
Selling & Distribution - Rs. 2,500
At present company is operating at 70% of normal capacity and producing 700 units of the
products. The selling price is Rs. 5 per unit. Prepare flexible budget for 80%, 100% and
110% of normal capacities from the above information.
b. An industry produces goods on batch basis which need to be processed by crushing and then
by finishing to realize finished goods.
Input quantity of 10,00 units costing Rs. 25,000 was introduced in crushing process.
Crushing Finishing
Process Process
Subsidiary materials in Rs. 21,300 18,650

Direct wages in Rs. 20,000 17,000

Work expenses in Rs. 10,000 9,000
Normal loss 5% 10%
Disposal of normal loss per 100 units in Rs. 60 150
Output in units 9,400 8,500
Required: Process Account.
6. a. The standard time fixed for one unit of output is 5 DLH. The standard wage rate per DLH is
Rs. 15. The workshop recorded output of 4,000 units with a total wage payment of Rs.
312,600 for 19,600 DLH attended in the workshop by 50 workers. The work of productive
workers were hampered for 2 hours on account of electricity interruption.
Required: i. Labor rate of pay variance

ii. Labor sub-efficiency variance
iii. Labor idle time variance
iv. Labor cost variance
b. Differentiate between cost reduction and cost control.
c. From the following information, calculate overhead variances.
Budget Actual
No. of working days 20 22
Man-hour per day 80 840
Output per man hour (unit) 1.0 0.9
Overhead cost 16,000 16,800
Budget overheads - Rs. 16,000
Actual overheads - 16,800
7. Write short notes on (any FOUR):
a. Escalation clause
b. Co-product, By-product and waste
c. Control Accounts
d. Uniform costing system
e. Job evaluation
December, 2004
1. a. Briefly explain the types of costing usually used for ascertaining the cost.
b. Briefly explain the various methods of costing.
c. You are given the following information by Mr. George, Finance Controller in X Ltd., a
manufacturing company:
Particulars Rs.
Sales 10,00,000

Net Profit 1,18,000

Selling & Distribution overhead 25,000
Closing stock of finished goods 110,000
Opening stock of finished goods 90,000
Closing work in progress 15,000
Opening work in progress 12,000
From the information given above, Mr. George needs your help to calculate the following:
i. Cost of sales;
ii. Cost of goods sold;
iii. Cost of production;
iv. Factory cost;
v. Prime cost; and
vi. Raw material consumed
2. a. After inviting tenders, Bhadra Company Pvt. Ltd. received two quotations as follows:
Supplier A – Rs. 2.20 per unit;
Supplier B – Rs. 2.10 per unit plus Rs. 2,000 fixed charges irrespective of units ordered.
i. Calculate the order quantity for which the purchase price per unit will be the same.
ii. Considering all factors regarding production requirements and availability of finance,
the purchase officer wants to place an order for 15,000 units. Which supplier should
he select?
b. From the following details of stores receipts and issues of material "EXE" in a
manufacturing unit prepare the Stock Ledger using Weighted Average method of valuing
the issues:
Poush 1. Opening Stock 2,000 units @ Rs. 5.00 each

Poush 3. Issued 1,500 units to production
Poush 4. Received 4,500 units @ Rs. 6.00 each
Poush 8. Issued 1,600 units to production
Poush 9. Returned to stores 100 units by Production Department (from the issues of
Poush 3).
Poush 19. Returned to supplier 200 units out of the quantity received on Poush 4
Poush 24. Issued to production 2,100 units
Poush 29. Issued to production 2,800 units

(Use rates up to two decimal places)
3. a. From the following particulars, find the most profitable product mix and prepare a statement
of profitability of that product mix:
Product A Product B Product C
Units budgeted to be produced and sold 1800 3000 1200
Selling Price per unit (Rs) 60 55 50
Direct Materials 5 kg. 3 kg. 4 kg.
Direct Labor 4 hrs. 3 hrs. 2 hrs.
Variable Overheads Rs. 7 Rs. 13 Rs. 8
Fixed overheads Rs. 10 Rs. 10 Rs. 10
Cost of Direct Materials per kg. Rs. 4 Rs. 4 Rs. 4
Direct Labor Hour Rate Rs. 2 Rs. 2 Rs. 2
Maximum Possible Units of Sales 4,000 5,000 1,500
All the three products are produced from the same direct material using the same type of
machines and labor. Direct labor, which is the key factor, is limited to 18,600 hours.

b. A Company uses three raw materials A, B and C for a particular product for which the
following data apply:
Raw Usage Re-order Price Delivery period (in weeks) Reorder Minimum
Materials per quantity per Minimum Average Maximum Level Level
unit (Kgs.) Kg. (Kgs.) (Kgs.)
produc
t
(Kgs.)
A 10 10,000 0.10 1 2 3 8,000
B 4 5,000 3.30 3 4 5 4,750
C 6 10,000 0.15 2 3 4 2,000
Weekly production varies from 175 to 225 units, averaging 200 units of the said product.
What would be the following quantities?
i. Minimum Stock of A?
ii. Maximum Stock of B?
iii. Re-order level A?
iv. Average stock level of A?
4. From the data given below, calculate:

a. Individual material price variances for the two materials X and Y assuming that price
variances are calculated at the time of purchase.
b. Individual material usage variances for materials X and Y assuming that there was no work
in progress either at the commencement or at the end of the period.
Material "X" Material "Y"
Qty Value Qty Value
Raw material purchase 2,000 4,000 5,000 6,250
Issue to works 2,150 – 3,950 –
Works stock of material:
Opening 300 – 1,000 –
Closing 200 – 1,250 –
Standard price – Material X – Rs. 1.90 per kg.

Material Y – Rs. 1.30 per kg.
Standard Usage –
Product Material X Material Y
A 1 Kg. 1 Kg.
B 0.5 Kg. 1 Kg.

Output during the period –

Product A – 1,130 units
Product B – 2,550 units
5. a. In an engineering concern, the employees are paid incentive bonus in addition to their
normal wages at hourly rates. Incentive bonus is calculated in proportion of time taken to
time allowed, of the time saved. The following details are made available in respect of
employees X, Y and Z for a particular week:
X Y Z
Normal Wages (Rs. per hour) 4.00 5.00 6.00
Completed Units of production 6000 3000 4800
Time allowed (per 100 units) 0.8 hr. 1.5 hr. 1 hr.
Actual time taken (hours) 42 40 48
You are required to work out for each employee:

i. The amount of bonus earned.
ii. The total amount of wages received.
iii. The total wages cost per 100 units of output.
b. Briefly explain treatment of Normal Process Loss, Abnormal Process Loss and Abnormal
gain.
6. The following budgeted cost information are available from the records of a manufacturing
concern:
Rs. in Lakhs
Direct Materials 61.20
Direct Wages:
Rolling Shop (120,000 hours) 6.00
Milling Shop (240,000 hours) 14.40 20.40
Work Overheads (Allocation on Labor Hours):
Rolling Shop 9.60
Milling Shop 28.80 38.40
Administration overheads 24.00
Selling Overheads 28.80
Distribution Overheads 14.40
The concern follows absorption method of costing. On the basis of above data, prepare a schedule
of overhead rates.
The Sales Division of the concern requires a cost estimate for a product for which following
information are available:
Direct Material: Material X 120 Kg. @ Rs. 30 per Kg.
Material Y 72 Kg. @ Rs. 55 per Kg.
Direct Labor: Rolling Shop 40 hours @ Rs. 6 per hour

Milling Shop 70 hours @ Rs. 5 per hour
You are required to work out the Cost Estimate showing cost per unit using the above information
and the overheads rates so computed.
7. Write short notes on the following about their treatment in costing:
a. Packing expenses
b. Depreciation
c. Research and Development Expenses
d. Fringe Benefits
June, 2005
1. a. What are the limitations of the Financial Accounting System? How cost Accounting System
overcomes such limitations?
b. Perfect Pistons Ltd. produces piston at it company. The company has a machine capacity of
10,000 hours to produce the components P, Q and R, which are required for manufacturing
of pistons. The machine hours however does not seem to be sufficed to produce these
components. The other relevant data are given under:
Components P Q R
Requirement in units 2500 4000 2000
Variable costs:
Direct material 35 25 25
Direct wages 10 8 10
Direct expenses 10 20 10
Fixed overhead 7 6 11
Total production cost 62 59 56
Direct expenses related to the machine hour, which cost Rs. 10 per hour.
The Purchase Manager informed that supply of the above components can be obtained at the
following prices from outside:
P : 60
Q : 59
R : 52
The production manager has come up with another idea of operating second shift to meet the
required production of the components. The company has however to pay 25% extra over the
normal wages for second shift operations.
You are now required to compute:
i. Which component and in what quantities should be manufactured
in the 10,000 hours of the machine hours available?

ii.Whether it would be profitable to manufacture the balance of

components required on a second shift basis instead of buying
from outside.
2. a. What do you understand by Inter-firm comparison? Why it is essential?
b. Sky Manufacturing Ltd. has three production departments and two service departments. From
the following figures extracted from the records of the company, calculate the overhead rate per
labor hour.
Production Dept. Service Dept.

Items Total X Y Z D E
Direct Material (Rs.) 60,000 20,000 10,000 19,000 6,000 5,000
Direct Wages (Rs.) 40,000 15,000 15,000 4,000 2,000 4,000
Machine Value (Rs.) 250,000 60,000 100,000 40,000 25,000 25,000
Floor Area (Sq.ft.) 50,000 15,000 10,000 10,000 5,000 10,000
Horse Power of 150 50 60 30 5 5
machines
No. of light points 50 15 10 10 5 10
Labor hours 15,000 5,000 5,000 2,000 1,000 2,000
The other expenditure incurred are:
Rs.
Indirect Material 15,000
Indirect Wages 10,000
Depreciation on Machines 25,000
Depreciation on building 5,000
Rent, rates and taxes 10,000
Electric power for the machines 15,000
Electric power for lighting 500
General Expenses 15,000
The expenses of service department D and E are apportioned as follows:

X Y Z D E
D 40 20 30 10
E 30 30 40
OR
ABC Ltd. operates a cost accounting system, which is not integrated with financial
accounting system.

At the beginning of January 2004, the opening balance in cost ledger was:
Stores ledger control account 95,400
Work in progress control account 137,350
Finished goods control account 66,250
Cost ledger control account 299,000
During the month the following transactions took place:

Materials:
Purchases 49,700
Issue to production 61,400
Issue to general maintenance 1,650
Issue to construction of manufacturing equipment 7,850
Gross factory wages paid 134,500
Out of above wages, Rs. 12,500 was incurred on the construction of manufacturing
equipments, Rs. 35,750 was indirect wages and the balance was direct.
Production overhead: Actual amount incurred excluding items shown above, was Rs.
152,350, Rs. 30,000 was absorbed by the manufacturing equipment under construction and
under absorbed overheads written off at the end of the month amounted to Rs. 7,550.
Royalty payments: One of the components produced is manufactured under license and Rs.
2,250 shall be paid to the inventory for the month's production of that particular component.
Selling overhead Rs. 24,000

Sales Rs. 420,000
The company's gross profit margin is 20% on factory cost. At the end of January 2004,
stocks of work in progress had increased by Rs. 12,000. The manufacturing equipment
under the construction was completed within the month and transferred out of the cost
ledger at the end of the month.
You are required to prepare the relevant control accounts, costing profit and loss account,
and any other accounts you consider necessary to record the above transactions in cost
ledger for January 2004.
3. a. A company employs two workmen, Harish and Gopal who produces same product. Both
Harish and Gopal have same normal wage. Harish is paid bonus according to Rowan
System, while Gopal is paid bonus according to the Halsey system. The time allowed to
make the product is 200 hours. Harish takes 120 hours while Gopal takes 160 hours to
complete the products.
The factory overhead rate is Rs. 10 per hour. The cost of material for both Harish and Gopal
is same. The factory cost of the product for Harish is Rs. 14,560 and Gopal is Rs. 15,200.

i. To find the normal rate of wages;

ii.To find the cost of materials
b. A company manufactures a product, currently utilizing 80% of the capacity with a turnover
of Rs. 1,600,000 at Rs. 50 per unit. The other relevant data are as follows:
Direct Material: Rs. 15.00 per unit
Direct Labor : Rs. 12.50 per unit
Semi Variable Cost (including variable cost of Rs. 7.50 per unit) Rs. 360,000
Fixed Cost is Rs. 180,000

You are required to calculate:
i. Break-event point in terms of quantity, amount and operation level;
ii. Number of units to be sold to earn a profit of 8% on sales;
4. a. Define Budgetary Control System and discuss the objective of introducing budgetary
control system in an organization?
You are provided with the following data of the company.
Budgeted Sales
Product Price per unit Quantity
A 20 1,280
B 12 3,200
C 16 1,920
Actual Sales
Units Amount
A 650 12,350
B 3,900 50,700
C 1,950 29,250
The other relevant data are :

Standard Cost Actual Cost
A 16 18
B 10 12
C 13 13
You are required to compute following variances:
i. Total sales margin variance
ii. Sales margin quantity variance
iii. Sales margin mix variance

iv. Total cost variance
5. a. The RP builder Ltd., engaged in contract works, who prepares its account on 31st December
each year has the following Trial Balance for the year end 31st December 2004.
Dr. Cr.
Share Capital-shares for Rs. 10 each 36,000
Profit and Loss Account as on 1st Jan. 2004 2,500
Provision for depreciation on plant and tools 6,300
Contractee's account, contract no. 202 128,000
Creditors 8,020
Land and Building (at cost) 8,220
Plant and Tool (at cost) 5,200
Bank Balance 4,400
Contract No. 202:
Material issued 50,000
Direct labor 93,000
Expenses 4,000
Plant and tools at site at cost 16,000
180,820 180,820
Contract no. 202 with a contract price of Rs. 240,000 began on 1st Jan. 2004 and contractee pays
80% of the work completed and certified. The cost of work done since certification is estimated
to be Rs. 1,600.
After the trial balance was extracted on 31st Dec. 2004, plant costing Rs. 3,200 was returned to
the stores and material sat site on that date were valued at Rs. 3,000.
Provision is to be made for substandard cost amounting to Rs. 600 incurred on Contract on 202
and for depreciation of all plant and tools @ 12.5% on cost. Prepare contract no. 202 account
showing the computation of profit, if any, for which credit may be taken in 2004 and prepare the
Balance Sheet of the construction company on 31st Dec. 2004.
b. The cost incurred by a City Taxi Cab for the month of April 2005 are as follows:-
Driver's salary Rs. 7,840
Tyres, tubes and mobil @ Rs. 448 per 500 km.
Repair and lubricants @ Rs. 4.80 per 10 km.
Petrol @ Rs. 1.84 per kilometer

The annual route license renewal charge for the current year was Rs. 9,600. The taxi was
purchased at a cost of Rs. 576,000 five years before. the normal usable life of the taxi was
expected to be 12 years.
The taxi was insured and annual insurance premium payable was 8% p.a.
The total kilometer driven during April was 10,000 with 80% passenger occupancy.
Required:
A statement showing taxi fare per effective kilometer with a provision of 20% for profit on taxi
fare by classifying expenses into standing charges and running expenses.
6. Distinguish between
a. Joint Product and By-product
b. Standard Costing and Budgetary Control System
c. Differential Costing and Marginal Costing
d. Spoilage and Defective
December, 2005
1. a) What is Cost Accounting? Explain its main objectives.

b) What are the major factors to be considered for introducing an incentive system?.
c) You are provided with following information for the year 2004:
Sales: 900,000
Margin of safety: 25%
P/V ratio: 33.33%
For the year 2005, the company estimates that the sales value will go down due to decrease in
selling price. However, there will be no changes in variable costs. The company proposes to
reduce its fixed cost through an intensive cost reduction program. These changes will alter the
result as for 2005 as following:
Margin of safety: 40%
PV ratio: 30%
You are required to prepare a comparative statement for the year 2004 and 2005 showing:
i. Sales;
ii. Variable cost;
iii. Contribution;
iv. Fixed cost;
v. Profit
2. a) What is Integrated Accounting System? List out advantages of this system.

b) You are provided with following information of company Z :

Budgeted Actual
Sales quantity:
Product A 2,000 1,800
Product B
3,000 3,500
Sales price:
Product A Rs. 12 Rs. 14
Product B
Rs. 8 Rs. 7
Cost per unit:
Product A Rs. 9 Rs. 10
Product B Rs. 6 Rs. 5
You are required to calculate the following variances:

i. Sales volume variance
ii. Sales price variance
iii. Sales mix variance
iv. Sales quantity variance
v. Total sales value variance
vi. Sales volume margin variance
vii. Sales price margin variance
viii. Sales mix margin variance
ix. Sales quantity margin variance
x. Total sales margin variance
3. a) Define Budgetary Control System and discuss the objectives of introducing budgetary control
system in an organization?
b) A factory engaged in the manufacture of modern toys has ten year old equipment depreciated on
straight line method. The useful life of the equipment was estimated to be 20 years with a
residual value of Rs. 3 lacs (original cost of the equipment being 23 lacs). The output of the
equipment is 1,200 units per hour.
The production manager now proposes to install new equipment worth Rs. 50 lacs, which has an
estimated life of 15 years and a residual value of Rs. 5 lacs. The payment terms for the new
equipment include a part exchange provision of Rs. 6 lacs in respect of the existing equipment.
The output of the new equipment is 3,000 units per hour.
Other comparative annual cost data relating to the two equipments are as under:
Existing equipment (Rs.) New Equipment (Rs.)
Wages 1,00,000 1,20,000
Repair and maintenance 10,000 42,000
Consumables 3,30,000 4,90,000
Power 1,20,000 1,50,000
Allocation of fixed cost 60,000 80,000
Total hours run per year 2,400 2,400

You are required to prepare a comparative schedule showing cost per 1,000 units after
considering interest @ 10% on net cash outflow for procuring the new equipment and also for
providing for the yearly recovery of the loss suffered in the transactions of exchange of old
equipment.
4. a) Zenith Ltd. manufactures iron rods. The Purchase Manager of the company has decided to place
orders for minimum quantity of 225 units of a particular item to get discount of 10% on the
purchase price. From the records it was found that in the last year, 5 orders each of size 160 units
has been placed. The Finance Manager argues that this is the most economical purchase that can
be made. The following additional information has been provided:
Ordering cost : NPR 250 per order
Inventory carrying cost : 20% of inventory value per annum
Cost per unit: NPR 200
As a Cost Accountant, analyze the decision of Purchase Manager making assumption that total
material requirement will be as in the last year. What will be financial impact of this decision?
What is your suggestion? Explain.
b) ABC Co. three manufacturing departments X, Y and Z and one service department S. The
following figures are available for one month having 25 working days of 8 hours each day. All
these departments work for all the days and with full attendance.
Expenditure Departments
Total S X Y Z
Power and lighting 1100 240 200 300 360
Supervisor's salary 2000
Rent 500
Welfare 600
Others 1200 200 200 300 400
Total 5400
Supervisor's salary 20% 30% 30% 20%
Number of workers 10 30 40 20
Floor area (Sq.ft.) 500 600 800 600
Service department 50% 30% 20%
allocation
Calculate labor hour rate for each departments X, Y and Z.
5. a) what do you understand by the term 'Sunk Cost'?

b) A worker takes 6 hours to complete a job under a scheme of payment by results. The standard
time allowed for the job is 9 hours. His wages rate is Rs. 1.50 per hour. Material cost of the job
is Rs. 16 and the overheads are recovered at 150% of the total direct wages. Calculate the factory
cost of job under;
i. Rowan; and
ii. Halsey systems of incentive payments.
c) With the following data for a 60% activity, prepare a budget at 80% and 100% activity.
Production at 60% capacity - 600 units.
Materials Rs. 100 per unit.
Labor Rs. 40 per unit.

Expenses Rs. 10 per unit.

Factory Expenses Rs. 40,000 (40% fixed)
Administration expenses of Rs. 30,000 (60%) fixed
OR
5. ABC limited operates process costing. During the month of January 2004, 10,000 units costing
NPR 3 per unit was introduced in process II. There was no work in progress at the beginning. The
other information is given below:
Expenses debited to the process:
i. Direct Material NPR 19,600
ii. Labor NPR 23,316
iii. Overheads NPR 44,689
Normal loss in process : 1% of input
Closing work in progress : 350 units and degree of completion is as follows:
Material 100%
Labor and Overheads 50%
Finished output : 9,500 units
Degree of completion of abnormal losses:
Material 100%
Labor and Overhead 80%
Unit scrapped as normal loss were sold at Re 1 per unit;
All the units of abnormal losses were sold at Rs. 2.50 per unit.
i. Statement of Equivalent Production;
ii. Statement of cost of finished goods, abnormal loss and closing work in progress;
iii. Process II account;
iv. Abnormal Loss account.
a) Cost Unit and Cost Center
b) Joint Product and By-product
c) Cost Control and Cost Reduction
d) Standard Cost and Estimate Cost
June, 2006
1. The Board of Directors of Ray Brand Battery Company Ltd. is working for launching a new re-
chargeable battery. An expert team on preliminary study made breakdown of revenues and costs for
one year projecting Rs. 15, 00,000 initial investments.
1st six months 2nd six months
(Rs.) (Rs.)
Sales : 15,000 batteries 12,00,000
25,000 batteries 20,00,000
Cost of goods sold 8,50,000 12,50,000
Gross profit 3,50,000 7,50,000

Administrative, selling and distribution overheads 3,77,000 5,37,000

Pre-tax profit (27,000) 2,13,000
Tax at 40% - 85,200
After tax profit (27,000) 1,27,800
Required:
a) Variable cost ratio
b) Annual fixed costs
c) BEP sales in number of batteries for a year
d) The sales volume in rupee to earn 15% return on investment.
e) Income statement showing annual sales revenue, variable costs, contribution margin, fixed costs,
pre-tax profit, tax on profit and after tax profit by incorporating the recently conducted
consumers opinion survey outcomes that indicated Rs. 60,000 outlay for advertisement with 3
percent reduction in sales price with 20 percent sales volume up.
f) Safety margin under the existing preliminary study outcomes and under the survey outcomes.
g) Which option is desirable and why?
2. a) How depreciation, packing expenses and expense on removal and re-erection of machine cost
are treated in cost accounting?
b) A building constructional contractor engaged in building construction work for a negotiated
price of Rs. 1,500,000 extracts the following particulars from financial records.
Year I (Rs.) Year II (Rs.)
Materials purchased 2,40,000 3,00,000
Wages 2,20,000 1,80,000
Chargeable expenses 60,000 75,000
Overheads 25,000 45,500
Plant introduced 2,00,000 50,000
Materials at site 20,000 25,000
Work certified 6,00,000 12,80,000
Work uncertified 40,000 65,000
The progress payment made was 90%

Depreciate the plant by 20% p.a. on original cost.
Required: a) Contract Account for year I and II
b) Balance Sheet of year II
OR
The following data relate to process Q of a Multiprocessing Company:
i. Opening work in process 4,000 units
Materials 100% Rs. 24,000
Labor 60% Rs. 14,400
Overheads 50% Rs. 7,600
ii. Received during the month of Shrawan 2062, from 40,000 units

process – P
iii. Expenses incurred in Process Q during the month:
Materials Rs. 99,000
Labor Rs. 1,58,200
Overheads Rs. 59,120
iv. Closing work in process: 3000 units
Materials 100%
Labor 50%
Overheads 40%
v. Units Scrapped : 4,000 units
Materials 100%
Labor 80%
Overheads 70%
vi. Normal loss : 5% of current
inputs
vii. Completed units are transferred to warehouse.
You are required to prepare (using FIFO method) :
i. Equivalent unit’s statement.
ii. Statement of cost per equivalent unit and total cost.
iii. Process Q account.
iv. Any other account necessary.
3. (a) Lotus Co. Ltd. made available the budgeted and actual sales of the last year.
Products Budgeted Sales Actual Sales
Quantity Amount (Rs.) Quantity Amount
(Units) (Units) (Rs.)
x 3,000 12,000 4,000 18,000
y 5,000 18,000 6,000 24,000
Required: a) Sales volume variance

b) Sales price variance
c) Sales mix variance
d) Sales quantity variance
b) Janta Nepal Limited is a leading cable manufacturing company. The company has three
production departments A, B and C and two service departments P and Q. You are required to
work out the production hour rate of recovery of overheads in departments A, B and C, using
simultaneous equation method for apportionment of service department cost to production
departments.
Particulars Total A (Rs.) B (Rs.) C (Rs.) P (Rs.) Q (Rs.)
Rent 12,000 2,400 4,800 2,000 2,000 800
Electricity 4,000 800 2,000 500 400 300

Indirect labor 6,000 1,200 2,000 1,000 800 1,000

Depreciation 5,000 2,500 1,600 200 500 200
Sundries 4,500 910 2,143 847 300 300
Total 31,500 7,810 12,543 4,547 4,000 2,600
Estimated working hours 1,000 2,500 1,400
Expenses of service departments P and Q are apportioned as under :

A B C P Q
P 30% 40% 20% - 10%
Q 10% 20% 50% 20% -
4. The cost structure of an article, the selling price of which is Rs. 45,000 is as follows:
Direct material 50%
Direct labor 20%
Overheads 30%
An increase of 15% in the cost of materials and of 25% in the cost of labor is anticipated. These
increased costs in relation to the present selling price would cause a 25% decrease in the amount of
present profit per article.
i. Prepare a statement of profit per article at present, and
ii. The revised selling price to produce the same percentage of profit to sales
iii.
5. Write short notes on:
a) Blanket overhead recovery rate
b) Re-order level
c) Integrated accounting system and its advantages
d) Direct cost
e) Cost reduction
6.
a) Write down the advantages of Inter firm comparisons.
b) Explain with reason for including the interest on capital in cost account.
c) What are the reasons for using breakeven chart in decision making?
d) You are cost consultant of a manufacturing company. The company can sell only fifty
percentages of goods in domestic market. Now the company has received an export offer, which
can be met by utilizing the additional capacity. While pricing the product, the cost accountant of
the company suggested using differential pricing while the factory manager is of the view to use
usual price as in domestic market. As a consultant, suggest the management team for pricing the
goods for export offer with reasons.
e) You are manager of a factory which has a labor problem for demand of incentive scheme and
you have two alternatives for providing incentives to the workers viz. Halsey and Rowan
premium plan. Which method you will prefer and why?

December, 2006
1. The information relating to Pokhara Stores for the first two weeks of September 2006 is as under:
Date Particulars Qty. Price per kg (in
(in kgs.) Rs.)
01.09.2006 Opening Stock 100 5

05.09.2006 Purchase 200 6
06.09.2006 Issue 250
08.09.2006 Purchase 500 7
10.09.2006 Issue 400
12.09.2006 Purchase 600 8
14.09.2006 Issue 500
Required:
i. Calculate using FIFO (First in first out) and Moving Weighted Average Method of inventory
accounting:
a) The value of material consumed during the period
b) The value of closing stock as on 14.09.06
ii. Explain why the closing stock as on 14.09.06 is different under the two methods of pricing of
materials.
2. A company undertook a contract for construction of a commercial complex. The construction work
commenced on 16.07.05 and the following data is available for the year ended on 15.07.06:
Particulars Amount (Rs.)
Contract Price 3,50,00,000
Progress payment received 1,50,00,000
Material issued to site 75,00,000
Planning and estimating costs 10,00,000
Direct Wages Paid 40,00,000
Material returned from site 2,50,000
Plant Hire Charges 17,50,000
Wage related costs 5,00,000
Site office costs 6,78,000
Head office expenses apportioned 3,75,000
Direct expenses incurred 9,02,000
Work not certified 1,49,000
The contractor owns a plant which originally cost Rs. 20 lakhs has been continuously in use in this
contract throughout the year. The residual value of the plant after 5 years of life is expected to be Rs.
5 lakhs. Straight line method of depreciation is in use.
As on 15.7.06 the direct wages due and payable amounted to Rs. 2,70,000 and the materials at site
were estimated at Rs. 2,00,000.
Required:
i. Prepare the contract account for the year ended 15.07.06.
ii. Show the calculation of profit to be taken to the profit and loss account for the year.

iii. Show the relevant balance sheet entries.
OR
2. a) The following information is available relating to a job:
Standard time per output – 2.5 hours
Actual hours worked – 2,000 hours
Standard rate of pay – Rs. 2 per hour
Actual output – 1,000 units
Actual wages – Rs. 4,500
Idle Time – 25% of actual hours
Calculate:
i. Labor cost variance
ii. Labor rate variance
iii. Labor efficiency variance
iv. Labor idle time variance
b) Nepal Stores has an option of buying Machine A or Machine B. The following data is available:
Particulars Machine A Machine B
Actual output in units 10,000 10,000
Fixed costs Rs. 30,000 Rs. 16,000
Net profit ratio 30% 24%
The market price of the finished product is expected to be Rs. 10 per unit.
You have to calculate:
i. Breakeven point for each of the machine (in value and units)
ii. The level of sales at which both machines will earn equal profits.
iii. If the expected level of production is between 6,500 units to 10,000 units, as a cost
accountant, which machine would you suggest and why?
3. Gulf Petro lube, in the course of refining of crude oil obtains four joint products A, B, C and D. The
total cost till the split off point was Rs. 97,600. The output and sales in the year 2006 were as
follows:-
Product Output (Gallons) Sales (Rs.) Separate Costs
A 5,00,000 1,15,000 30,000
B 10,000 10,000 6,000
C 5,000 4,000 Nil
D 9,000 30,000 1,000
Required : i.
i. Calculate the net income for each of the products if the joint costs are apportioned on the basis of net
realizable values at split off point of the different products.
ii. What would be the net income of the company form each product if it decides to sell the
products at split off point itself at the following sale price.

Product Price
A Rs. 0.15
B Rs. 0.50
C Rs. 0.80
D Rs. 3
Assume joint cost being apportioned on the market value of the products at the time of split off.
iii. In case the company expects to operate at the same level of production and sales in the year
2007, could the company increase the net income by altering its processing decisions? If so,
what would be expected overall net income? Which products should be processed further and
which should be sold at split off point? Assume that all costs incurred after the split off are
variable and joint costs are apportioned on the basis of net realizable value at split off point.
4. The information relating to Electric and Electronics Centre for manufacturing of 10,000 units of
socket box during the year 2006 are as under:
Cost items Amount in Rs.
Material 90,000
Direct Wages 60,000
Power and Consumable Stores 12,000
Factory indirect wages 15,000
Lighting of Factory 5,500
Defective work (cost of rectification) 3,000
Clerical salaries and management expenses 30,000
Depreciation (office building) 3,500
Selling expenses 5,500
Sale proceeds of scrap 2,000
Depreciation (Factory) 1,500
Factory Repairs and Maintenance 10,000
The selling price of the product is Rs. 31.60 per unit. All the units produced were sold.
You are required to prepare cost sheet showing various elements of costs including costs per unit.
i. Operating Costing and Operation Costing
ii. Cost Control and Cost Reduction
iii. Treatment in cost accounts for Spoilage and Defectives
iv. Cost accounting and financial accounting
6. Write short notes on the following:
i. Cost associated with labor turnover.
ii. Prerequisite for installation of Uniform Costing System
iii. Treatment of shortages in stock taking
iv. Reasons for including interest and financial charges in cost accounting.
v. Discretionary Costs
June, 2007

1. S. Engineering Ltd. produces 200,000; 30,000; 25,000; 20,000 and 75,000 units of five products
Excel, Supreme, Ordinary, Power and Eco respectively in a manufacturing process and sells them at
Rs. 17, Rs. 13, Rs. 8, Rs. 10 and Rs. 14 per unit. Except product Power remaining products can be
further processed and then can be sold at Rs. 25, Rs. 17, Rs. 12 and Rs. 20 per unit in case of Excel,
Supreme, Ordinary and Eco respectively.
Raw material costs Rs. 3,590,000 and other manufacturing expenses cost Rs. 547,000 in the
manufacturing process which is absorbed on the products on the basis of their 'Net realizable value'.
The further processing costs of Excel, Supreme, Ordinary and Eco are Rs. 1,250,000, Rs. 150,000,
Rs. 50,000 and Rs. 150,000 respectively. Fixed costs are Rs. 473,000.
a) Statement showing income forecast of the company assuming that none of its products are to be
further processed.
b) Statement showing income forecast of the company assuming that products Excel, Supreme,
Ordinary and Eco are to be processed further.
Can you suggest any other production plan whereby the company can maximize its profits? If yes,
then submit a statement showing income forecast arising out of adoption of that plan.
2.
i. The purchase department of Nepal Limited has received an offer of quality discount on its orders
of materials as under:
Price Per Tones Tones

Rs. 1200 Less than 500
Rs. 1180 500 and less than 1,000
Rs. 1160 1,000 and less than 2,000
Rs. 1140 2,000 and less than 3,000
Rs. 1120 3,000 and above
The annual requirement of the material is 5,000 ton. The delivery cost per order is Rs. 1,200 and
the stock holding cost is estimated at 20% of the material cost per annum.
You are required to advise the purchase department the most economic purchase level.
ii. From the following data for the year ended 31st Ashad 2063, calculate the inventory turnover
ratio of the two items and put forward your comments on them,
Material A Material B
Opening stock 01/04/2062 Rs. 10,000 Rs. 9,000
Purchase during the year Rs. 52,000 Rs. 27,000
Closing stock 31/03/2063 Rs. 6,000 Rs. 11,000
3.

a) In Himalayan Engineering Company, the factory overheads are recovered on a fixed percentage
basis on direct wages and the administrative overheads are absorbed on a fixed percentage basis
on factory cost.
The company has furnished the following data relating to two jobs undertaken by it in a period.
Job A Job B
Direct Material 60,000 40,000
Direct Wages 40,000 30,000
Factory overhead 24,000 18,000
Selling price 1,63,680 1,21,440
Profit % on total cost 10% 15%
Required:
i. Computation of percentage of recovery rate of administrative overheads and the amount of
administrative overhead and profit for each job.
ii. Using the above recovery rates, fix the selling price of job Z. The additional data being:
Direct Materials = Rs. 1,20,000

Direct Wages = Rs. 90,000
Profit % on selling price = 20%
b) Explain the benefits of DPP (Direct Product Profitability) and prepare a statement of Direct
Product Profit of product AXE from the following data:
Bought in price = Rs. 10 per unit

Gross margin = 60% of the selling price
Warehouse costs = Rs. 5 per unit
Transport cost = Rs. 3 per unit
Store cost = Rs. 4 per unit
OR
3. a) The fertilizer dealer Co. is deciding on the economic order quantity for two brands of lawn
fertilizers, Oxy A and Hydro B. The following information is collected: 7
Fertilizer
Oxy A Hydro B
Annual Demand 5,000 Bags 3,200 Bags
Relevant ordering cost per purchase order Rs. 956.25 Rs. 1237.50
Annual relevant carrying cost per bag Rs. 425 Rs. 550
Required:
i. Compute EOQ for Oxy A and Hydro B.

ii. For the EOQ, what is the sum of the total annual relevant ordering costs and total annual
relevant carrying costs for Oxy A & Hydro B?
iii. For the EOQ, compute the number of deliveries per year for Oxy A & Hydro B.
b) You have been given a permit to run a bus on 20 km long route. The bus costs you Rs. 90,000. It
has to be insured @ 3% p.a. and the annual tax will be Rs. 1,000. Garage rent is Rs. 100 p.m.
Annual repairs will be Rs. 1,000 and the bus is likely to last for 5 years at the end of which the
scrap value is likely to be Rs. 6,000.
The driver's salary will be Rs. 150 p.m. and the conductors Rs. 100 together with 10% of the
takings as commission (to be shared equally by both). Stationery will cost Rs. 50 p.m. the
manager-cum-accountant's salary will be Rs. 250 p.m.
Diesel and oil be Rs. 25 per hundred kilometers. The bus will make three round trips for carrying
on the average 40 passengers on each trip. Assuming 15% profit on takings, calculate the bus
fare to be charged from each passenger. The bus will work on the average 25 days in a month.
4. The monthly budget for manufacturing overhead of Pashupati Limited for two levels of activity were
as follows:
Capacity 60% 100%

Total manufacturing overhead (Rs.) 9,800 12,000
Wages (Rs.) 1,200 2,000
Consumable stores (Rs.) 900 1,500
Maintenance (Rs.) 1,100 1,500
Power and fuel (Rs.) 1,600 2,000
Depreciation (Rs.) 4,000 4,000
Insurance (Rs.) 1,000 1,000
Budgeted yearly production at 60% capacity level is 7,200 units and at 100% level 12,000 units.

i. Indicate which of the items are fixed, variable and semi-variable;
ii. Prepare a budget for 80% capacity; and
iii. Find the total manufacturing overhead, both fixed and variable, per unit of output at 60%, 80%
and 100% capacity.
a) Direct Product Profitability (DPP)

b) Inter-firm comparison
c) Direct material yield variance
d) Cost-Plus Contracts
e) P/V Ratio

a) Overheads Apportionment and Absorption

b) Shut Down Costs and Sunk Cost
c) Rated Capacity & Practical Capacity
d) Normal Process Loss and Abnormal Process Loss
e) Standard Costing and Uniform Costing
December, 2007
1. Kathmandu Manufactures normally produce 8,000 units of their product in a month in their machine
shop. For the month of January, they had planned for a production of 10,000 units. Owing to sudden
cancellation of contract in the middle of January, they could only produce 6,000 units in January.
Indirect manufacturing costs are carefully planned and monitored in the machine shop and the
foreman of the shop is paid a 10% of the savings as bonus when in any month the indirect
manufacturing cost incurred is less than the budgeted provision.
The foreman has put in a claim that he should be paid a bonus of Rs. 88.50 for the month of January.
The works manager wonders how anyone can claim a bonus when the company has lost a sizeable
contract. The relevant figures are as under:
Indirect manufacturing costs Expenses for a Planned for Actual in

normal month January January
Salary of foreman 1,000 1,000 1,000
Indirect labor 720 900 600
Indirect material 800 1,000 700
Repairs and maintenance 600 650 600
Power 800 875 740
Tools consumed 320 400 300
Rates and taxes 150 150 150
Depreciation 800 800 800
Insurance 100 100 100
Total 5,290 5,875 4,990
Do you agree with the works manager? Is the foreman entitled to any bonus for the performance in
January? Substantiate yours answers with the facts and figures.
2.

a) The finished product of a manufacturing company passes through three processes, Process I,
Process II and Process III. The normal wastage in each process is 5%, 7% and 10% respectively
for the processes I, II and III respectively (calculated with reference to the number of units fed
into each process). The scrap generated out of wastage has a sale value of Rs. 0.70, Rs. 0.80 and
Rupee 1 per unit in the process I, II and III respectively.
The output of each process is transferred to the next process and the finished output emerges
from the process III are transferred to stock. There was no stock of work-in-process in any
process in a particular month.
The details of cost data for the month are given below:
Process I Process II Process III
Materials Used (Rs.) 120,000 40,000 40,000
Direct Labor Cost (Rs.) 80,000 60,000 60,000
Production Expenses (Rs.) 40,000 40,000 28,000
Output in Units (Actual) 38,000 34,600 32,000
Process I was fed with 40,000 units of raw input at a cost of Rs. 320,000.
You are required to prepare Process I, II and III accounts.
b) In order to make posting in the stores ledger, what values (rate per kg.) would you adopt in
respect of materials M1 and M2 included in the following purchase invoice?
Rs. Rs.
350 Kgs. of M1 at Rs. 3 per kg. (one case) … … 1,050
600 Kgs. of M2 at Rs. 5 per kg. (three cases) … … 3,000

Less: Trade Discount @ 15% … … 450
2,550
3,600
Cash Discount @ 2.50% for payment within 30 days: 90
3,510
Carriage: 190
Cost of 4 cases (non-refundable) @ Rs. 12.50 each: 50
3,750
3. A job costing system is in use in a factory. The following cost data are available from the books for
the year ended 31st March, 2005.
Direct Material 900,000

Direct Wages 750,000
Profit 609,000
Selling & Distribution Overhead 525,000
Administrative Overhead 420,000
Factory Overhead 450,000

Required:
a) Prepare a cost sheet indicating the prime cost, works cost, production cost, cost of sales and
sales value.
b) In 2005-06, the factory has received an order for a number of jobs. It is estimated that the
direct materials would be Rs. 1,200,000 and direct labor would cost Rs. 750,000. What
would be the price for these jobs if the factory intends to earn the same rate of profit on
sales, assuming that the selling and distribution overhead has gone up by 15%? The factory
recovers factory overhead as a percentage of distribution overheads as a percentage of direct
wages and administrative and selling & distribution overheads as a percentage of works
cost, based on the cost rate prevalent in the previous year.
OR
3. A factory has three production departments. The policy of the factory is to recover the production
overheads of the entire factory by adopting a single blanket rate based on the percentage of total
factory overheads to total factory wages. The relevant data for a month are given below:
Department Direct Direct Factory Direct Labor Machine

Materials (Rs.) Wages Overheads (Hrs.) (Hrs.)
(Rs.) (Rs.)
Budget
Machinery 6,50,000 80,000 3,60,000 20,000 80,000
Assembly 1,70,000 5,50,000 1,40,000 1,00,000 10,000
Packing 1,00,000 70,000 1,25,000 50,000 -
Actual
Machinery 7,80,000 96,000 3,90,000 24,000 96,000
Assembly 1,36,000 2,70,000 84,000 90,000 11,000
Packing 1,20,000 90,000 1,35,000 60,000 -
The details of one of the representative jobs produced during the month are as under:
Job No. CW 555

Department Direct Direct Wages Direct Labor Machine
Materials (Hrs.) (Hrs.)
Machinery 1,200 240 60 180
Assembly 600 360 120 30
Packing 300 60 40 -
The factory adds 30% on the factory cost to cover administration and selling overheads and profit.
Required:
a) Calculate the overhead absorption rates as per the current policy of the company and
determine the selling price of the Job no. CW 555.
b) Suggest any suitable alternative method (s) of absorption of the factory overheads and
calculate the overhead recovery rates based on the method (s) so recommended by you.

c) Determine the selling price of Job CW 555 based on the overhead application rates
calculated in (b) above.
4. In a manufacturing concern 20 workmen work in a group. The concern follows a group incentive
bonus system whereby each workman belonging to a group is paid a bonus on the excess output over
the hourly production standard of 250 pieces, in addition to his normal wage at hourly rate. The
excess of production over the standard is expressed as a percentage and two-thirds of this percentage
is considered to be the share of the workman and is applied on the notional hourly rate of Rs. 6.00
(considered only for the purpose of computation of bonus). The output data for a week are stated
below:
Days Man hours worked Output (In pieces

Monday 160 48,000
Tuesday 172 53,000
Wednesday 164 40,000
Thursday 168 52,000
Friday 160 46,000
Saturday 160 42,000
Total 984 281,000

i) Work out the amount of bonus for the week and the average rate at which each workman is
to be paid the same.
ii) Compute the total wages including bonus payable to Hari Yadav who worked for 48 hours
at an hourly rate of Rs. 2.50 and to Asim Karki who worked for 52 hours at an hourly rate of
Rs. 3.00.

a) Standard Load
b) Optimum Batch Quantity
c) ABC Analysis as a technique of Inventory Control
d) Equivalent Production Units in Process Costing
e) Scrap
6. Distinguish between/Describe:
a) Circumstances under which cost audit is ordered and purpose of cost audit.
b) What is flexible budget? Briefly explain how it is prepared.
c) What are the arguments put forth for and against the inclusion of interest in cost? Explain in
brief.
d) Costing, Cost Accountancy & Cost Accounting.
e) Inventory Turnover Ratio & Labor Turnover Ratio.

June, 2008
1.
a) The sales turnover and profit of Annapurna Co. Ltd is given as follow:
Sales Profit
Year 2006 10 lacs 1 lacs
Year 2007 20 lacs 3 lacs
You are required to compute the P/V ratio and fixed cost of the company.
b) ABC Company produces a single product which is sold by it presently in the domestic market at
Rs 75 per unit. The present production and sales is 20,000 units per month representing 50% of
the capacity available. The cost data of the product are as under:
Variable cost per unit Rs. 50
Fixed Cost per unit Rs. 25 at present production level
To improve the profitability, the management has three proposals on hand as under:
i) to accept an export supply order for 15,000 units per month at a reduced price of Rs 60 per
unit, incurring additional variable costs of Rs 5 per unit towards export packing, duties etc.
ii) to increase the domestic market sales by selling to a domestic chain stores 15,000 units at Rs
55 per unit, retaining the existing sales at the existing price;
iii) to reduce the selling price for the increased domestic sales as advised by the sales
department as under:
Reduced selling price Increase in sales (units)

unit by Rs.
5 5,000
8 15,000
11 17,500
Prepare a table to present the results of the above proposals and give your comments and advise
on the proposals.
2.
a) 1,200 kgs of a material were charged to Process I at the rate of Rs 2 per kg. The direct labor
accounted for Rs 200 and other departmental expenses amounted to Rs 7,060. The normal loss is
10% of the input whereas the net production was 1,000 kgs. If the process scrap is saleable at Re
1 per kg. Calculate the value of normal loss and abnormal loss and show the ledger account of
Process I.
b) A wholesaler supplies 30 CDs every day to various retailers. CDs are purchased in lots of 120
each of Rs 1,200 per lot. Every order incurs a handling charge of Rs 60 plus a freight charge of
Rs 250 per lot. Multiple and fractional lots can also be ordered and all orders are filled the next
day. The incremental cost is Rs 0.60 per year to store CDs in inventory. The wholesaler finances

inventory investment by paying its holding company a quarterly interest rate of 6% for borrowed
funds. Compute:
i) How many CDs shall be ordered to minimize the annual inventory cost? Assume that there
are 250 days in a year.
ii) How frequently should order be made?
OR
2.
a) Annapurna Ltd. has been encountering a problem due to high labor turnover in its factory. The
management is concerned about the reason for labor turnover and its remedial course of action.
However, the management wants to know the profit foregone by the company due to labor
turnover last year. You are provided with following information and required to work out the
profit foregone due to labor turnover last year.
The sales of the last year amount to Rs. 8,303,300 and P/V ratio during the period is 20 percent.
The total number of actual worked by the direct labor force was 4.45 lacs hours. As a result of
the delays by the company in filling vacancies due to labor turnover, 100,000 potentially
productive hours were lost. The actual direct labor hours included 30,000 hours attributable to
train new recruits, out of which half of the hours were unproductive.
The other costs incurred in consequent to labor turnover is as follows:
Settlement cost for leaving by labor Rs 43,820
Selection cost Rs 12,750
Recruitment cost Rs 26,740
Training cost Rs 30,490
Calculate the profit foregone due to turnover assuming that the potential production lost due to
labor turnover would have sold at prevailing price.
b) Two Products A and B are obtained in a crude form and require further processing at a cost of
Rs. 5 for A and Rs 4 for B per unit before sale. Assuming a net margin of 25 percent on cost,
their sale prices are fixed at Rs 13.75 and Rs 8.75 per unit respectively. During the period, the
joint cost was Rs 88,000 and the outputs were:
A: 8,000 units
B: 6,000 units
Ascertain the joint cost per unit.
3. ZED Ltd. uses standard costing system in manufacturing of its single product M. The standard cost
per unit of M is as follows:
Direct materials: 2 units @ 6 per unit 12.00

Direct labor; 1 hour @ 4.40 per hour 4.40
Variable overhead: 1 hour @ Rs 3 per hour 3.00
Total 19.40
During August 2007, 6,000 units of M were produced and the related data are as under:
Direct Material acquired 19,000 units @ 5.70 per unit
Direct Labor: ? Hours @ Rs? per hour Rs 27,950
Variable overhead incurred Rs 20,475
The variable overhead efficiency variance is Rs 1,500 adverse. Variances overhead are based on
direct labor hours. There were no stocks of raw material in the beginning.

You are required to compute the missing figures and work out all the relevant variances.
4. From the details furnished below you are required to compute a comprehensive machine-hour rate:
Original purchase price of the machine Rs. 324,000

(subject to depreciation at 10% per annum
on original cost)
Wages of Machine man Rs. 125 per day (of 8 hours)
Wages for Helper (machine attendant) Rs. 75 per day (of 8 hours)
Power cost for the month for the time worked Rs. 15,000
Supervision charges apportioned for the Rs. 3,000
machine centre for the month
Electricity & Lighting for the month Rs. 7,500
Repairs & maintenance (machine) including Rs. 17,500
Consumable stores per month
Insurance of Plant & Building (apportioned) Rs. 16,250
for the year
Other general expense per annum Rs. 27,500
The workers are paid a fixed dearness allowance of Rs. 1,575 per month. Production bonus payable
to workers in terms of an award is equal to 33.33% of basic wages and dearness allowance. Add 10%
of the basic wage and dearness allowance against leave wages and holidays with pay to arrive at a
comprehensive labor-wage for debit to production.
5. Distinguish between the following:
a) Cost control and cost reduction

b) Bin card and stores ledger
c) Job costing and batch costing
d) Cost audit and statutory audit.
6.
a) Specify the methods of costing and cost units applicable to the following industries:
• Toy making
• Cement
• Radio
• Bicycle
• Ship building
• Hospital
b) Discuss the step method and reciprocal service method of secondary distribution of overheads.
c) Discuss the essentials of a good Cost Accounting System.
d) Discuss the treatment of idle time and overtime premium in Cost Accounting.
December, 2008

1.
a) The joint cost of making 80 units of product A, 120 units of product B and 160 units of product
C is Rs 49,500. The selling prices of products A, B and C are Rs 40, Rs 30 and Rs 20
respectively.
Required:
Apportionment of joint cost among the products on the basis of (i) physical unit (ii) sales value
and (iii) selling price
b) The cost accountant of Y Ltd. has computed labor turnover rates for the quarter ended 31st
March, 2008 as 10%, 5% and 3% respectively under ‘Flux method’. ‘Replacement method’ and
‘Separation method’.
If the number of workers replaced during that quarter is 30, find out the number of
i) workers recruited and joined, and
ii) workers left and discharged.
c) Pashupati Electronics Ltd. furnishes the following information for 10,000 TV valves
manufactured during the year, 2008.
Rs. Rs.
Materials 90,000 Clerical Salaries and
Direct wages 60,000 Management expenses 33,500
Power and consumable stores 12,000 Selling expenses 5,500
Factory indirect wages 15,000 Sale proceeds of scraps 2,000
Lighting of factory 5,500
Defective work
(cost of rectification) 3,000 Plant repairs, Maintenance and
Depreciation 11,500
The net selling price was Rs. 31.60 per unit and all the units were sold.
As from 1st January, 2009 the selling price would be reduced to Rs. 31.00 per unit. It
was estimated that production could be increased in 2009 by 50% utilizing spare
capacity.
Rates for materials and direct wages will increase by 10%.

i) Cost sheet for the year, 2008, showing various elements of cost per unit, and
ii) Estimated cost and profit for 2009 assuming that 15,000 units will be produced and sold
during the year. Factory overheads are recovered as a percentage of direct wages and office
and selling expenses as a percentage of works cost. (Apply the same respective percentages
as in the previous year.)
2. A company has two production departments and two service departments. The data relating to a
period are as under:
Production Departments Service Departments
PD1 PD2 SD1
SD2
Direct materials (Rs.) 80,000 40,000 10,000 20,000

Direct wages (Rs.) 95,000 50,000 20,000 10,000

Overheads (Rs.) 80,000 50,000 30,000 20,000
Power requirement at
normal capacity
operations (Kwh.) 20,000 35,000 12,500 17,500
Actual power consumption

during the period (Kwh.) 13,000 23,000 10,250 10,000
The power requirements of these departments are met by a power generation plant. The said plant
incurred an expenditure, which is not included above, of Rs. 1,21,875 out of which a sum of Rs.
84,375 was variable and the rest fixed,. After apportionment of power generation plant costs to the
four departments, the service department overheads are to be redistributed on the following basis:
PD1 PD2 SD1

SD2
SD1 50% 40% -
10%
SD2 60% 20% 20% -

(i) Apportion the power generation plant costs to the four departments.
(ii) Re-apportion service department costs to production departments.
(iii) Calculate the overhead rates per direct labor hour of production departments, given that
the direct wage rates of PD1 and PD2 are Rs. 5 and Rs. 4 per hour respectively.
3.
a) The budgeted income statement by product lines of Hulas Biscuit Factory Private
Limited for 2064/065 is as follows:
Particulars Glucose Coconut Cream Cracker
Amount in Rs.
Sales 2,000,000 5,000,000 3,000,000
Variable Costs
Cost of goods sold 900,000 2,700,000 1,500,000
Selling costs 300,000 900,000 450,000
Fixed Costs
Administrative costs
360,000 900,000 540,000
Other costs 160,000 400,000 240,000
Profit before tax 280,000 100,000 270,000

Income tax @ 30% 84,000 30,000 81,000
Profit after tax 196,000 70,000 189,000
All products are manufactured in the same facilities under common administrative
control. Fixed costs are allocated among the products in proportion to their budgeted
sales volume:
(i) Compute the budgeted break-even point of the company from the information
provided above.
(ii) What would be the effect of budgeted income if half of the budgeted sales
volume of coconut is shifted to glucose and cream cracker in equal rupee amount
so that the total sales in rupee remains the same?
b) XYZ Company sells its product at NPR 15 per unit. In a period, if it produces and
sells 8,000 units, it incurs a loss of NPR 5 per unit. If the volume is raised to 20,000
units, it earns a profit of NPR 4 per unit. Calculate breakeven point both in terms of
rupees as well as in units.
OR
4. Trading and Profit & Loss Account of LG Electronics Limited for the year ended on 32nd Ashad 2065
is as follows:
Dr. Cr.
To Materials consumed 23,010,000 By Sales (30,000 units) 48,750,000
To Direct wages 12,057,500 By Finished goods
To Production Overheads 6,922,500 Stock (1,000 units) 1,300,000
To Administration Overheads
3,103,750 By Work-in-progress:
To Selling and Materials 552,500
Distribution
Overheads 3,688,750 Wages 260,000
To preliminary Expenses Production
written off 227,500 Overheads 162,500 975,000
To Goodwill written off 455,000
To Fines 32,500 By Dividends
To Interest on Mortgage 130,000 received 3,900,000

To Loss on Sale of machine

162,500 By Interest on
To Taxation 1,950,000 bank deposits 650,000
To Net Profit for the year 3,835,000
55,575,000 55,575,000
The Cost Accounting records of LG Electronics Limited show the following:

Production overheads have been charged to work-in-progress at 20% on Prime cost. Administration
Overheads have been recovered at Rs. 97.5 per finished Unit. Selling and distribution Overheads
have been recovered at Rs. 130 per Unit sold. The Under- or Over-absorption of Overheads has not
been transferred to costing P/L A/c.
Required:
a) Prepare a Performa Costing Profit & Loss account, indicating net profit.
b) Prepare Control accounts for production overheads, administration Overheads and selling &
distribution Overheads.
c) Prepare a statement reconciling the profit disclosed by the cost records with that shown in
financial accounts.
5. A license to ply a mini-bus between stations A and B covering a distance of 25 km. has been
obtained. The mini-bus will make 8 round trips in a day for 25 days in a month. It has a seating
capacity of 30 passengers and on an average 60% occupancy is expected throughout. The purchase
price of the bus is Rs. 600,000.It has a life of 10 years with a salvage value of Rs. 10,000 at the end
of its life. The details of the operating expenses are as under:
Insurance Rs.12,000 per annum
Garage rent Rs. 2,000 per quarter
Road Tax Rs. 3,000 per annum
Repairs Rs. 4,000 per quarter
Administration Rs. 1,000 per month
Driver’s salary Rs. 3,000 per month
Conductor’s salary Rs. 2,000 per month
Tyres and Tubes Rs. 3,000 per quarter
Diesel Rs. 12 per liter
Oil and Sundries Rs. 20 per 100 km run
The mini-bus consumes a liter of diesel for every 4 km of run. Passenger tax is 20% on total (Gross)
taking. The company requires a profit of 20% on total taking. You are required:
a) To prepare an annual cost sheet showing the cost per passenger km and the one way fare per
passenger from station A to B.
b) Explain:
(i) Absolute ton-km
(ii) Commercial ton-km.
6. Distinguish between the following:

f) Controllable costs and uncontrollable costs

g) Cost driver and cost pool.
h) Profit Centre and investment centre
i) Spoilage and defective
7. Write short notes on following:
f) Circumstances under which cost audit is ordered and the purpose of cost audit.
g) Principles to be followed while taking credit for profits on incomplete contracts.
h) Limitations of uniform costing.
i) Gantt task and bonus system of wage payment and incentive.
June, 2009
1.
a) Under mentioned information have been taken from the records of Kathmandu Limited for the month
ending Ashad, 2065. The company applies First-in-fist-out (FIFO) method to value its equivalent
production.
Direct materials added in Process III
(Opening WIP) 20,000 units at Rs. 257,500
Transfer from Process II 530,000 units at Rs. 4,115,000

Transferred to Process IV 480,000 units
Closing stock of Process III 50,000 units
Units scrapped 20,000 units
Direct material added in Process III Rs. 1,976,000
Direct wages Rs. 976,000
Production Overheads Rs. 488,000
Opening Stock Closing Stock Scrap
Materials 80% 70% 100%
Labor 60% 50% 70%
Overheads 60% 50% 70%
The normal loss in the process was 5% of production and scrap was sold at Rs. 3 per unit. You
are required to prepare Process Cost accounts for Process III.

b) Nepal Copper Wires Limited has received an offer of quantity discount on its order of copper
wire as under:
Price per ton Tons number
Rs. 96,000 Less than 50
Rs. 93,600 50 and less than 100
Rs. 91,200 100 and less then 200
Rs. 88,800 200 and less than 300
Rs. 86,400 300 and above
The annual requirement for the copper wire is 500 tons per annum. The ordering cost per order is
Rs. 125,000 and the stock holding cost is estimated at 25% of the material cost per annum.
Based on above stated information, you are required to compute the most economical purchase
level. Also, compute Economic Order Quantity (EOQ) if there is no quantity discounts and the
price per ton is Rs. 105,000.
2. The Best Limited has furnished you the following information from the financial books for the year
ended 15th July, 2008:
Profit & Loss Account

For the year ended 15th July 2008
Particulars Rs. Rs.
Opening stock of finished goods: Sales 10,250 units 3,587,500
500 units @ Rs. 175 each 87,500 Closing stock of finished goods:
Materials consumed 1,300,000 250 units @ Rs. 250 each 62,500
Wages 750,000
Gross Profit c/d 1,512,500
3,650,000 3,650,000
Factory overheads 473,750 Gross Profit b/d 1,512,500
Administration overheads 530,000 Interest 1,250
Selling expenses 275,000 Rent Received 50,000
Bad Debts 20,000
Preliminary expenses 25,000
Net Profit 240,000
1,563,750 1,563,750
The analysis of the cost sheet of the company reveals the following:

i) the cost of materials as Rs. 130 per unit;

ii) the labor cost as Rs. 75 per unit;
iii) the factory overheads are absorbed at 60% of labor cost;
iv) the administration overheads are absorbed at 20% of factory cost;
v) selling expenses are charged at Rs. 30 per unit;
vi) the opening stock of finished goods is valued at Rs. 225 per unit.

a) The cost sheet showing the number of units produced and the cost of production, by elements of
costs, per unit and in total.
b) The statement of profit or loss as per cost accounts for the year ended 15th July, 2008.
c) The statement showing the reconciliation of profit or loss as shown by the cost accounts with the
profit as shown by the financial accounts.
3. Hey Ram Limited produces and sells a single product. Sales budget for the calendar year 2008 by
quarter is as follows:-
Quarter Number of units to be sold

I 12,000
II 15,000
III 16,500
IV 18,000
The year 2008 is expected to open with an inventory of 4,000 units of finished product and
close with an inventory of 6,500 units.
Production is customarily scheduled to provide for two-third of the current quarter's sales demand
plus one-third of the following quarter's demand. Thus production anticipates sales volume by about
one month.
The standard cost details for one unit of the product is as follows:-
Rate
Direct materials 10 lbs Rs. 50 paisa per lb
Direct labor 1 hour 30 minutes Rs. 4 per hour
Variable overheads 1 hour 30 minutes Re 1 per hour
Fixed overheads 1 hour 30 minutes Rs. 2 per hour based on a budgeted
production volume of 90,000 direct
labor hours for the year.

a) Prepare a production budget for 2008, by quarters, showing the number of units to be produced,
and total cost of direct material, direct labor, variable overheads and fixed overheads.
b) If the budgeted selling price per unit is Rs. 17, what would be the budgeted profit for the year as
a whole?
c) In which quarter of the year, is the company expected to break even?
OR
3. From the details furnished below you are required to compute a comprehensive machine-hour rate:
Original purchase price of the machine (subject Rs. 3,240,000
to depreciation at 10% per annum on original
cost)
Wages of Machine man Rs. 250 per day (of 8 hours)
Wages for Helper (machine attendant) Rs. 150 per day (of 8 hours)
Power cost for the month for the time worked Rs. 150,000
Supervision charges apportioned for the machine Rs. 30,000
centre for the month
Electricity & Lighting for the month Rs. 75,000
Repairs & maintenance (machine) including Consumable stores per Rs. 175,000
month
Insurance of Plant & Building (apportioned) Rs. 162,500
for the year
Other general expense per annum Rs. 275,000
The workers are paid a fixed dearness allowance of Rs. 3,150 per month. Production bonus payable
to workers in terms of an award is equal to 33.33% of basic wages and dearness allowance. Add 10%
of the basic wage and dearness allowance against leave wages and holidays with pay to arrive at a
comprehensive labor-wage for debit to production.
4. Alok Vidhyashram is a Public School having 25 buses each plying in different directions for the
transport of its school students. In view of large number of students availing of the bus service, the
buses work two shifts daily both in the morning and in the afternoon. The buses are garaged in the
school. The work load of the students has been so arranged that in the morning, the first trip picks up
senior students and the second trip plying an hour later picks up junior students. Similarly, in the
afternoon, the first trip takes the junior students and an hour later the second trip takes the senior
students home.
The distance travelled by each bus one way is 16 kms. The school works 24 days in a month and
remains closed for vacation in May and June. The bus fee, however, is payable by the students for all
the 12 months in a year.
The details of expenses for the year 2008-2009 are as under:
Driver's salary payable for all the 12 months Rs. 5,000 per month per driver.

Cleaner's salary payable for all the 12 months Rs. 3,000 per month per cleaner (one cleaner has been
employed for every five buses)
License fees, taxes etc. Rs. 2,300 per bus per annum
Insurance premium Rs. 15,600 per bus per annum
Purchase price of the bus Rs.1,650,000 each
Life of the bus 16 years
Each bus gives the average of 10 kms per liter of diesel. The seating capacity of each bus is 60
students. The seating capacity is fully occupied during the whole year.
The school follows differential bus fees based on distance travelled as under:
Students picked up and dropped within the Bus fee Percentage of
range of distance from the school students availing this
facility
16 kms Full 55%
Ignore interest. Since the bus fees have to be based on average cost.
a) Prepare a statement showing the expenses of operating a single bus and the fleet of 25
buses for a year.
b) Work out average cost per student per month in respect of:
i) Student coming from a distance of up to 4 kms from the school;
ii) Student coming from a distance of up to 8 kms from the school; and
iii) Student coming from a distance of up to 16 kms from the school
a) Committed fixed costs and discretionary fixed costs
b) Normal loss and abnormal loss
c) Profit centre and investment centre
d) Controllable costs and uncontrollable costs
e) Product costs and period costs
6. Answer the followings:
a) Discuss ABC analysis as a system of Inventory Control.
b) Discuss the step method and reciprocal service method of secondary distribution of overheads.

c) Discuss the essentials of a good Cost Accounting System.

d) Discuss the treatment of idle time and overtime premium in Cost Accounting.
e) What are the limitations of inter-firm comparison system?
June 2009 (CAP-II)
1.
a) From the following information relating to a hotel, calculate the room rent to be charged per day
to give a profit of 25% on cost excluding interest.
i) Salary of staff Rs. 80,000 p.a.
ii) Wages of the room attendant: Rs. 2 per day
There is a room attendant for each room. He is paid wages only when the room is
occupied.
iii) Lighting, heating and power:
• The normal lighting expenses for a room for the whole month are Rs. 50, when occupied.
• Power is used only in winter and the charges are Rs. 20 for a room, for the whole month
when occupied.
iv) Repairs to building Rs. 10,000 p.a.
v) Linen etc.: Rs. 4,800 p.a.
vi) Sundries: Rs. 6,600 p.a.
vii) Interior decoration and furnishing: Rs. 10,000 p.a.
viii) Depreciation @ 5% is to be charged on buildings costing Rs. 400,000 and 10% on
equipments.
ix) Interest to be charged @ 5% on investment in buildings and equipments amounting to Rs.
500,000.
x) There are 100 rooms in the hotel, 80 percent of the rooms are generally occupied in
summer and 30 percent in winter. The period of summer and winter may be considered to
be of 6 months in each case. A month may be assumed of 30 days.
b) Brock Construction Ltd. commenced a contract on November 1, 2007. The total contract was for
Rs. 3,937,500. It was decided to estimate the total profit on the contract and to take to the credit
of Profit and Loss A/c that proportion of estimated profit on cash basis, which work completed
bore to the total contract. Actual expenditure for the period November 1, 2007 to October 31,
2008 and estimated expenditure for November 1, 2008 to March 31, 2009 are given below:
November 1, 2007 to November 1, 2008 to
October 31, 2008(Actual) Rs. March 31, 2009
(Estimated) Rs.
Material issued 675,000 1,237,500
Labor: Paid 450,000 562,500
Prepaid 25,000 -
Outstanding - 2,500
Plant purchased 375,000 -
Expenses: Paid 200,000 350,000
Outstanding 50,000 25,000
Plant returns to store 75,000 300,000

(historical cost) (on March 31, 2008) (on March 31, 2009)
Work certified 2,000,000 Full
Material at site 75,000 37,500
The plant is subject to annual depreciation @ 33% on written down value method. The contract
is likely to be completed on March 31, 2009.
Required:
Prepare the contract A/c. Determine the profit on the contract for the year November 2007 to
October 2008 on prudent basis, which has to be credited to Profit and Loss A/c.
2.
a) At the beginning of October 2007, Quality Brush Company had in stock 10,000 brushes value at
Rs. 10 each. Further purchases were made during the month as follows:
Issues to shop floor were as follows:
You are required:
i) to prepare a store ledger card for the month of October on the assumption that materials
were issued on the First-in- First-out principle; and
ii) to state the value of closing stock at the end of October if issue are priced by the weighted
average method.
b) During first week of April 2009 the workman Mr. Kalyan manufactured 300 articles. He
receives wage for a guaranteed 48 hours week at the rate of Rs. 4 per hour. The estimated time to
produce one article is 10 minutes and under incentive scheme the time allowed is increased by
20%. Calculate his gross wages and rate per hour according to:
i) Piece work with a guaranteed weekly wage,
ii) Rowan premium bonus, and
iii) Halsey premium bonus: 50 % to workman.
3.
a) RST Ltd. has two production departments: Machining and Finishing. There are three service
departments: Human Resource (HR), Maintenance and Design. The budgeted costs in these
service departments are as follows:
HR Maintenance Design
Rs. Rs. Rs.
Variable 100,000 160,000 100,000
Fixed 400,000 300,000 600,000
500,000 460,000 700,000
The usage of these Service Departments’ output during the year just completed is as follows:
Provision of Service Output (in hours of service)
Providers of Service

Users of Service HR Maintenance Design

HR - - -
Maintenance 500 - -
Design 500 500 -
Machining 4,000 3,500 4,500
Finishing 5,000 4,000 1,500
Total 10,000 8,000 6,000
Required:
i) Use the direct method to re-apportion RST Ltd.’s service department cost to its production
departments.
ii) State the proper sequence to be used in re-apportioning the firm’s service department cost
by step-down method.
iii) Use the step-down method to reapportion the firm’s service department cost.
b) Annapurna Cement Factory is located in Dharan. The required limestone for the factory is
brought from two different mines A and B. The distance from mine A and cement factory is 10
Km while distance from mine B to the factory is 15 Km. A fleet of lorries of 5 ton carrying
capacity is used for the transport of limestone. The regular data shows that the average speed of
lorries in both mines are 30 Km. per hour. The lorry takes 10 minutes to unload the limestone at
the factory. At mine A loading time is 30 minutes and at mine B loading time is 20 minutes.
You are given that the depreciation, driver wages, insurance and taxes is Rs 9 per hour operated.
Fuel, oil, tyres and maintenance cost is Rs 1.20 per Km. Draw up a report showing the cost per
ton- kilometer of carrying mineral from each mine.
4. Perfect Piston Ltd. produces 60,000 pistons per annum for its parent company Perfect Motor Ltd. The
pistons are sold to Perfect Motors at Rs. 200 per unit. The variable cost per piston is Rs. 180. The
annual fixed cost of Perfect Piston Ltd is Rs. 15 lakhs and it is currently operating at 60% capacity.
The company desires to respond to an export enquiry for 30,000 pistons of the type of it is currently
manufacturing. The company's aim is to improve capacity utilization and avoid loss.
You have to take note of the following benefits that will occur in the export transactions while
determining the F.O.B. price to be quoted.
a) Export incentive by way of cash assistance at 10% of F.O.B. value of exports.
b) Reimbursement of excise duty on manufacturing inputs by way of 5% drawback of duty on
F.O.B. value of exports.
c) Entitlement of import license to the extent of 10% on F.O.B. value of exports. The import
license can either be sold at a premium of 100% or it can be utilized to import certain critical
auto components that will yield a 30% profit on cost.
Recommend the bare minimum price that the company should quote, in order to breakeven,
assuming:
i) It sells the import license in the market.
ii) It imports components against the license and sells them for profit.

OR
The following particulars are available from the records of a manufacturing company.
For 2,000 Units For 5,000 Units
Direct Material Rs 10,000 Rs 25,000
Direct Labor 20,000 50,000
Direct Expenses 8,000 20,000
Depreciation 5,000 5,000
Establishment of Expenses 8,000 8,000
The difference in maintenance costs between 2,000 and 5,000 units is Rs 6,000. The total cost of
maintenance for 5,000 units is Rs 18,000. Similarly, the difference in selling and distribution
expenses is Rs 5 per unit and total cost at 2,000 units is Rs 16,000. Unit selling price amounted to Rs
33.75.
Required:
i) Segregate the mixed cost into variable and fixed by using high and low point method.
ii) Find out the total cost for 4,000 and 6,000 units.
iii) Calculate the P/V Ratio, Break Even Point in units, Margin of safety in Rupees for sale of
4,900 units and target profit at a sales volume of Rs 162,000.
5. The following are the details of the Budget and the actual cost in a factory for six months from
January to June 2008. From the figures given below you are required to prepare the production cost
budget for the period from January to June 2009:
January to June 2008

Budgeted Actual
Material cost Rs. 4,000,000 Rs. 3,990,000
( 2,000 MT @ Rs. 2,000) ( 1,900 MT @ Rs. 2,100)
Labor cost Rs. 800,000 Rs.799,920
(@ Rs. 20 per hour) (@ Rs. 22 per hour)
Variable overheads Rs. 240,000 Rs. 216,000
Fixed overheads Rs. 400,000 Rs. 420,000
In the first half of 2009, production is budgeted for 25,000 units. Material cost per ton will increase
from last year's actual by Rs. 100 but is proposed to maintain the consumption efficiency of 2008 as
budgeted.
Labor efficiency will be lower by another 1% and labor rates will be Rs. 22 per hour.
Variable and Fixed overheads will go by 20% over 2008 actual.
You are required to prepare the production cost budget for the period January – June 2009 giving all
the workings.
OR
A factory currently producing 10,000 units working at a 50% capacity level desires to estimate the
profit if operated at 60% and 80% capacity also. The details of present operation per unit reveal the
following:

Selling Price Rs. 200

Material 100
Labor 30
Factory overheads (40% Fixed) 30
Administration Overhead (50% Variable) 20
At 60% working, raw material cost increase by 2% and selling price falls by 2%.
At 80% capacity, raw materials cost increase by 5% and selling price falls by 5%.
Required:
Flexible budget for all the three capacity level operation
6. Briefly explain ANY TWO of the following:

a) Importance of Cost Accounting to business concerns.
b) Reasons for disagreement of profits as per Cost Accounting and Financial Accounting.
c) Difference between Cost control and Cost reduction.
7. Answer ANY TWO of the following:
a) Advantages of Cost Audit to Government and Management;
b) Advantages of inter-firm comparison;
c) Limitations of uniform costing.
************************

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CHARTERED ACCOUNTANCY PROFESSIONAL

© The Institute of Chartered Accountants of Nepal

Chapter 2: Material Control (38-115)

Chapter 3: Labor Control (116-180)

Chapter 5: Unit Costing (243-257)

Chapter 6: Cost Book Keeping (258-291)

Chapter 7: Method of Costing (292-389)

Chapter 8: Cost Concepts for Decision Making (390-435)

Chapter 9: Budget (436-473)

Chapter 10: Standard Costing (474-489)

Chapter 11: Uniform Costing and Inter Firm Comparison (490-495)

Chapter 12: Cost Control and Cost Reduction (496-502)

Chapter 12: Cost Control and Cost Reduction (503-511)

Some of the Solved Problems from recent CA Examinations 512-623

1.1 EVOLUTION OF COST ACCOUNTING

1.2 DEFINITION OF COSTING, COST ACCOUNTING AND COST ACCOUNTANCY

[2] ©The Institute of Chartered Accountants of Nepal (ICAN)

1.3 OBJECTIVES OF COST ACCOUNTING

©The Institute of Chartered Accountants of Nepal (ICAN) [3]

1.4 IMPORTANCE OF COST ACCOUNTING

[4] ©The Institute of Chartered Accountants of Nepal (ICAN)

1.5 COST CONCEPT AND TERMS

©The Institute of Chartered Accountants of Nepal (ICAN) [5]

c. Decision-Making Costs and Accounting Costs

[6] ©The Institute of Chartered Accountants of Nepal (ICAN)

d. Relevant and Irrelevant Costs

e. Shutdown and Sunk Costs

©The Institute of Chartered Accountants of Nepal (ICAN) [7]

Sales. 10,000 11,600 10,000

[8] ©The Institute of Chartered Accountants of Nepal (ICAN)

Variable purchase costs 5,000 6,000 5,400

Fixed costs Profit 4,000 9,000 4,500 10,500 3,000 8,400

1,000 1,100 1,600

©The Institute of Chartered Accountants of Nepal (ICAN) [9]

k. Traceable, Untraceable or Common Costs

[10] ©The Institute of Chartered Accountants of Nepal (ICAN)

COST UNIT AND COST CENTER

©The Institute of Chartered Accountants of Nepal (ICAN) [11]

PROFIT CENTER AND INVESTMENT CENTER

COST ESTIMATION AND COST ASCERTAINMENT

[12] ©The Institute of Chartered Accountants of Nepal (ICAN)

COST ALLOCATION AND COST APPORTIONMENT

COST REDUCTION AND COST CONTROL

©The Institute of Chartered Accountants of Nepal (ICAN) [13]

1.6 ELEMENTS OF COST

[14] ©The Institute of Chartered Accountants of Nepal (ICAN)

©The Institute of Chartered Accountants of Nepal (ICAN) [15]

b. Office and Administration Overheads

c. Selling and Distribution Overheads

1.7 COST SHEET AND COMPONENT OF TOTAL COST

[16] ©The Institute of Chartered Accountants of Nepal (ICAN)

Components of Total Cost

A typical format of the Cost Sheet is given below

Cost Sheet for the period.........................................

©The Institute of Chartered Accountants of Nepal (ICAN) [17]

E Office and Administrative Overheads

F Selling and Distribution Overheads

[18] ©The Institute of Chartered Accountants of Nepal (ICAN)

©The Institute of Chartered Accountants of Nepal (ICAN) [19]

Add: purchases 450,000