advanced

cost and management

accounting

IV Semester – M.Com

Dr. v. saravanan,
M.Com., M.Phil., Ph.D.,

BHARATHIDASAN UNIVERSITY
CONSTITUENT COLLEGE OF
ARTS AND SCIENCE
NAGAPATTINAM
 UNIT - I
Introduction
Cost Accounting is a branch of accounting and has been developed due to limitations of financial
accounting. Financial accounting is primarily concerned with record keeping directed towards the
preparation of Profit and Loss Account and Balance Sheet. It provides information regarding the
profit and loss that the business enterprise is making and also its financial position on a particular
date. The financial accounting reports help the management to control in a general way the various
functions of the business but it fails to give detailed reports on the efficiency of various divisions.
The limitations of Financial Accounting which led to the development of cost accounting are as
follows.

Costing and Cost Accounting

The costing terminology of C.I.M.A ., London defines costing as the “the techniques and
processes of ascertaining costs”. These techniques consist of principles and rules which govern the
procedure of ascertaining cost of products or services. The techniques to be followed for the
analysis of expenses and the processes by which such an analysis should be related to different
products or services differ from industry to industry. These techniques are also dynamic and they
change with time.
The main object of traditional cost accounts is the analysis of financial records, so as to
subdivide expenditure and to allocate it carefully to selected cost centers, and hence to build up a
total cost for the departments, processes or jobs or contracts of the undertaking. The extent to which
the analysis of expenditure should be carried will depend upon the nature of business and degree of
accuracy desired. The other important objective of costing are cost control and cost reduction.
Cost Accounting may be regarded as “a specialized branch of accounting which involves
classification, accumulation, assignment and control of costs.” The costing terminology of C.I.M.A,
London defines cost accounting as “the process of accounting for costs from the point at which
expenditure is incurred or committed to the establishment of its ultimate relationship with cost
centers and cost units. In its widest usage, it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of profitability of activities carried out or
planned”.
Wheldon defines cost accounting as “classifying, recording and appropriate allocation of
expenditure for determination of costs of products or services and for the presentation of suitably
arranged data purposes of control and guidance of management”. It is thus a formal mechanism by
means of which costs of products or services are ascertained and controlled.
General Principles of Cost Accounting
The following may be considered as the General Principles of Cost Accounting:
1. A cost should be related to its causes: Cost should be related as closely as possible to their
causes so that cost will be shared only among the cost units that pass thorough the
department of which the expenses are related.
 2. A cost should be charged only after it has been incurred: While determining the cost of
individual units those costs which have actually been incurred should be considered. For
example, a cost unit should not be charged to the selling costs, while it is still in the factory.
Selling costs can be charged with the products which are sold.
3. The convention of prudence should be ignored: Usually accountants believe in historical
costs and while determining cost, they always attach importance to historical cost. In Cost
Accounting this convention must be ignored, otherwise, the management appraisal of the
profitability of the projects may be vitiated. According to W.M. Harper, “a cost statement
should, as far as possible, give facts with no known bias. If a contingency needs to be taken
into consideration it should be shown separately and distinctly”.
4. Abnormal costs should be excluded from cost accounts: Costs which are of abnormal
nature (eg. Accident, negligence etc.) should be ignored while computing the cost,
otherwise, it will distort costs figures and mislead management as to working results of their
undertaking under normal conditions.

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

6. Principles of double entry should be applied wherever necessary: Costing requires a greater
use of cost sheets and cost statements for the purpose of cost ascertainment and cost control,
but cost ledger and cost control accounts should be kept on double entry principle as far as
possible.
Objectives of Cost Accounting
Cost accounting aims at systematic recording of expenses and analysis of the same so as to
ascertain the cost of each product manufactured or service rendered by an organization. Information
regarding cost of each product or service would enable the management to know where to
economize on costs, how to fix prices, how to maximize profits and so on. Thus, the main
objectives of cost accounting are the following.
1. To analyse and classify all expenditure with reference to the cost of products and
operations.
2. To arrive at the cost of production of every unit, job, operation, process, department or
service and to develop cost standard.
3. To indicate to the management any inefficiencies and the extent of various forms of waste,
whether of materials, time, expenses or in the use of machinery, equipment and tools.
Analysis of the causes of unsatisfactory results may indicate remedial measures.
4. To provide data for periodical profit and loss accounts and balance sheets at such intervals,
e.g. weekly, monthly or quarterly as may be desired by the management during the financial
 year, not only for the whole business but also by departments or individual products. Also,
to explain in detail the exact reasons for profit or loss revealed in total in the profit and loss
accounts.
5. To reveal sources of economies in production having regard to methods, types of
equipment, design, output and layout. Daily, Weekly, Monthly or Quarterly information
may be necessary to ensure prompt constructive action.
6. To provide actual figures of costs for comparison with estimates and to serve as a guide for
future estimates or quotations and to assist the management in their price fixing policy.
7. To show, where Standard Costs are prepared, what the cost of production ought to be and
with which the actual costs which are eventually recorded may be compared.
8. To present comparative cost data for different periods and various volume of output and to
provide guidance in the development of business. This is also helpful in budgetary control.
9. To record the relative production results of each unit of plant and machinery in use as a
basis for examining its efficiency. A comparison with the performance of other types of
machines may suggest the necessity for replacement.
10. To provide a perpetual inventory of stores and other materials so that interim Profit and
Loss Account and Balance Sheet can be prepared without stock taking and checks on stores
and adjustments are made at frequent intervals. Also to provide the basis for production
planning and for avoiding unnecessary wastages or losses of materials and stores.
Last but not the least, to provide information to enable management to make short term
decisions of various types, such as quotation of price to special customers or during a slump, make
or buy decision, assigning priorities to various products, etc.

Cost Accounting and Financial Accounting-

Both financial accounting and cost accounting are concerned with systematic recording and
presentation of financial data. Financial accounting reveals profits and losses of the business as a
whole during a particular period, while cost accounting shows, by analysis and localization, the unit
costs and profits and losses of different product lines. The main difference between financial
accounting and cost accounting are summarized below.
1. Financial accounting aims at safeguarding the interests of the business and its proprietors
and others connected with it. This is done by providing suitable information to various
parties, such as shareholders or partners, present or prospective creditors etc. Cost
accounting on the other hand, renders information for the guidance of the management for
proper planning, operation, control and decision making.
2. Financial accounts are kept in such a way as to meet the requirements of the Companies
Act, Income Tax Act and other statues. On the other hand cost accounts are generally kept
voluntarily to meet the requirements of the management. But now the Companies Act has
made it obligatory to keep cost records in some manufacturing industries.
3. Financial accounting emphasizes the measurement of profitability, while cost accounting
aims at ascertainment of costs and accumulates data for this very purpose.
 4. Financial accounts disclose the net profit and loss of the business as a whole, whereas cost
accounts disclose profit or loss of each product, job or service. This enables the
management to eliminate less profitable product lines and maximize the profits by
concentrating on more profitable ones.
5. Financial accounting provides operating results and financial position usually gives
information through cost reports to the management as and when desired.
6. Financial accounts deal mainly with actual facts and figures, but cost accounts deal partly
with facts and figures, but cost accounts deal with facts and figures and partly with
estimates.
7. In case of financial accounts stress is on the ascertainment and exhibition of profits earned
or losses incurred in the business. On account of this reason in financial accounts, the
transactions are recorded, classified and analyzed in a subjective manner i.e. according to
the nature of expenditure. In cost accounts the emphasis is more on aspects of planning and
control and therefore transactions are recorded in an objective manner.
8. Financial accounts are concerned with external transactions i.e. transactions between the
business concern on one side and third parties on the other. These transactions form the
basis for payment or receipt of cash. While cost accounts are concerned with internal
transactions which do not form the basis of payment or receipt of cash.
9. The costs are reported in aggregate in financial accounts but costs are broken into unit basis
in cost accounts.
10. Financial accounts do not provide information on the relative efficiencies of various
workers, plants and machinery while cost accounts provide valuable information on the
relative efficiencies of various plants and machinery.
11. In financial accounts stocks are valued at cost or market price whichever is less, whereas
stocks are valued at cost price in cost accounts.
Importance of Cost Accounting
The limitations of financial accounting have made the management to realize the
importance of cost accounting. Whatever may be the type of business, it involves expenditure on
labour, materials and other items required for manufacturing and disposing of the product. The
management has to avoid the possibility of waste at each stage. It has to ensure that no machine
remains idle, efficient labour gets due incentive, by-products are properly utilized and costs are
properly ascertained. Besides the management, the creditors and employees are also benefited in
numerous ways by installation of a good costing system. Cost accounting increases the overall
productivity of an organization and serves as an important tool, in bringing prosperity to the nation,
thus, the importance of cost accounting can be discussed under the following headings:
a) Costing as an aid to management:- Cost accounting provides invaluable aid to management.
It provides detailed costing information to the management to enable them to maintain effective
control over stores and inventory, to increase efficiency of the organization and to check
wastage and losses. It facilitates delegation of responsibility for important tasks and rating of
employees. For all these the management should be capable of using the information provided
by cost accounts in a proper way. The various advantages derived by the management from a
good system of costing are as follows:
1. Cost accounting helps in periods of trade depression and trade competition. In periods of
trade depression, the organization cannot afford to have wastages which pass unchecked. The
management must know areas where economies may be sought, waste eliminated and
efficiency increased. The organization must wage a war not only for its survival but also
continued growth. The management should know the actual cost of their products before
embarking on any scheme of price reduction. Adequate system of costing facilitates this.
2. Cost accounting aids price fixation. Although the law of supply and demand determines the
price of the product, cost to the producer does play an important role. The producer can take
necessary guidance from his costing records in case he is in a position to fix or change the price
charged.
3. Cost accounting helps in making estimates. Adequate costing records provide a reliable basis
for making estimates and quoting tenders.
4. Cost accounting helps in channelizing production on right lines. Proper costing information
makes it possible for the management to distinguish between profitable and non-profitable
activities; profits can be maximized by concentrating on profitable operations and eliminating
non-profitable ones.
5. Cost accounting eliminates wastages. As cost accounting is concerned with detailed breakup
of costs, it is possible to check various forms of wastages or losses.
6. Cost accounting makes comparisons possible. Proper maintenance of costing records
provides various costing data for comparisons which in turn helps the management in
formulating future lines of action.
7. Cost accounting provides data for periodical Profit and Loss Account. Adequate costing
records provide the management with such data as may be necessary for preparation of Profit
and Loss Account and Balance Sheet at such intervals as may be desired by the management.
8. Cost accounting helps in determining and enhancing efficiency. Losses due to wastage of
materials, idle time of workers, poor supervision etc will be disclosed if the various operations
involved in the production are studied carefully. Efficiency can be measured, cost controlled
and various steps can be taken to increase the efficiency.
9. Cost accounting helps in inventory control. Cost accounting furnishes control which
management requires, in respect of stock of materials, work in progress and finished goods.
b) Costing as an aid to Creditors.
Investors, banks and other money lending institutions have a stake in the success of the
business concern are therefore benefitted immensely by the installation of an efficient
system of costing. They can base their judgment about the profitability and future prospects
of the enterprise on the costing records.
c) Costing as an aid to employees.
Employees have a vital interest in their employer’s enterprise in which they are employed.
They are benefited by a number of ways by the installation of an efficient system of costing.
They are benefited, through continuous employment and higher remuneration by way of
incentives, bonus plans, etc.
 d) Costing as an aid to National Economy
An efficient system of costing brings prosperity to the business enterprise which in turn
brings prosperity to the business enterprise which in turn results in stepping up of the
government revenue. The overall economic development o f a country takes place as a
consequence of increase in efficiency of production. Control of costs, elimination of
wastages and inefficiencies led to the progress of the industry and, in consequence of the
nation as a whole.
Cost units- The Chartered Institute of Management Accountants, London, defines a unit of cost as
“a unit of quantity of product, service or time in relation to which costs may be ascertained or
expressed”.
The forms of measurement used as cost units are usually the units of physical measurements like
number, weight, area, length, value, time etc.
Following are some examples of cost unit.
Industry/product Cost unit basis

Automobile Numbers
Brick works per 1000 bricks
Cement per Tonne
Chemicals Litre, gallon, kilogram, ton
Steel Tonne
Sugar Tonne
Transport Passenger-kilometre, tonne kilometer
Cost centre – According to Chartered Institute of Management Accountants, London, cost centre
means “a location, person or item of equipment (or group of these) for which costs may be
ascertained and used for the purpose of cost control”. Cost centre is the smallest organizational sub-
unit for which separate cost collection is attempted. Thus cost centre refers to one of the convenient
unit into which the whole factory organization has been appropriately divided for costing purposes.
Each such unit consists of a department or a sub-department or item of equipment or , machinery or
a person or a group of persons.
For example, although an assembly department may be supervised by one foreman, it may contain
several assembly lines. Some times each assembly line is regarded as a separate cost centre with its
own assistant foreman.
The selection of suitable cost centres or cost units for which costs are to be ascertained in an
undertaking depends upon a number of factors which are listed as follows.
1. Organization of the factory
2. Conditions of incidence of cost
3. Requirements of the costing system ie. Suitability of the units or centres for cost purposes.
4. Availability of information
5. Management policy regarding making a particular choice from several alternatives.
Profit centre – A profit centre is that segment of activity of a business which is responsible for
both revenue and expenses and discloses the profit of a particular segment of activity. Profit centres
are created to delegate responsibility to individuals and measure their performance.
Difference between Profit centre and Cost centre
The various points of difference between Profit centre and cost centre are as follows. Cost centre
is the smallest unit of activity or area of responsibility for which costs are collected whereas a profit
centre is that segment of activity of a business which is responsible for both revenue and expenses.
(i) Cost centres are created for accounting conveniences of costs and their control
whereas as a profit centre is created because of decentralization of operations i.e., to
delegate responsibility to individuals who have greater knowledge of local conditions
etc.
(ii) Cost centers are not autonomous whereas profit centres are autonomous.
(iii) A cost centre does not have target cost but efforts are made to minimize costs, but
each profit centre has a profit target and enjoys authority to adopt such policies as are
necessary to achieve its targets.
(iv) There may be a number of cost centres in a profit centre in a profit centre as
production or service cost centres or personal or impersonal but a profit centre may be a
subsidiary company within a group or division in a company.
Cost classification
Costs can be classified or grouped according to their common characteristics. Proper
classification of costs is very important for identifying the costs with the cost centers or cost units.
The same costs are classified according to different ways of costing depending upon the purpose to
be achieved and requirements of a particular concern. The important ways of classification are:
1. By Nature or Elements. According to this classification the costs are classified into three
categories i.e., Materials, Labour and Expenses. Materials can further be sub-classified as raw
materials components, spare parts, consumable stores, packing materials etc. This helps in
finding the total cost of production and the percentage of materials (labour or other expenses)
constituted in the total cost. It also helps in valuation of work-in-progress.
2. By Functions: This classification is on the basis of costs incurred in various functions of an
organization ie. Production, administration, selling and distribution. According to this
classification, costs are divided into Manufacturing and Production Costs and Commercial
costs.
Manufacturing and Production Costs are costs involved in manufacture, construction and
fabrication of products.
Commercial Costs are (a) administration costs (b) selling and distribution costs.
3. By Degree of Traceability to the Product : According to this, costs are divided indirect costs
and indirect costs. Direct Costs are those costs which are incurred for a particular product and
can be identified with a particular cost centre or cost unit. Eg:- Materials, Labour. Indirect
Costs are those costs which are incurred for the benefit of a number of cost centre or cost units
and cannot be conveniently identified with a particular cost centre or cost unit. Eg:- Rent of
Building, electricity charges, salary of staff etc.
4. By Changes in Activity or Volume: According to this costs are classified according to their
behavior in relation to changes in the level of activity or volume of production. They are fixed,
variable and semi-variable. Fixed Costs are those costs which remain fixed in total amount with
increase or decrease in the volume of the output or productive activity for a given period of
time. Fixed Costs per unit decreases as production increases and vice versa. Eg:- rent, insurance
of factory building, factory manager’s salary etc. Variable Costs are those costs which vary in
direct proportion to the volume of output. These costs fluctuate in total but remain constant per
unit as production activity changes. Eg:- direct material costs, direct labour costs, power, repairs
etc. Semi-variable Costs are those which are partly fixed and partly variable. For example;
Depreciation, for two shifts working the total depreciation may be only 50% more than that for
single shift working. They may change with comparatively small changes in output but not in
the same proportion.
5. Association with the Product: Cost can be classified as product costs and period costs.
Product costs are those which are traceable to the product and included in inventory cost, thus
product cost is full factory cost. Period costs are incurred on the basis of time such as rent,
salaries etc. thus it includes all selling and administration costs. These costs are incurred for a
period and are treated as expenses.
6. By Controllability: The CIMA defines controllable cost as “a cost which can be influenced by
the action of a specified member of an undertaking” and a non-controllable cost as “a cost
which cannot be influenced by the action of a specified member of an undertaking”.
7. By Normality: There are normal costs and abnormal costs. Normal costs are the costs which
are normally incurred at a given level of output under normal conditions. Abnormal costs are
costs incurred under abnormal conditions which are not normally incurred in the normal course
of production.Eg:- damaged goods due to machine break down, extra expenses due to
disruption of electricity, inefficiency of workers etc.
8. By Relationship with Accounting Period: There are capital and revenue expenses depending
on the length of the period for which it is incurred. The cost which is incurred in purchasing an
asset either to earn income or increasing the earning capacity of the business is called capital
cost, for example, the cost of a machine in a factory. Such cost is incurred at one point of time
but the benefits accruing from it are spread over a number of accounting years. The cost which
is incurred for maintaining an asset or running a business is revenue expenditure. Eg:- cost of
materials, salary and wages paid, depreciation, repairs and maintenance, selling and
distribution.
9. By Time..Costs can be classified as 1) Historical cost and 2) Predetermined Costs.
The costs which are ascertained and recorded after it has been incurred is called historical costs.
They are based on recorded facts hence they can be verified and are always supported by
evidences. Predetermined costs are also known as estimated costs as they are computed in
advance of production taking into consideration the previous periods’ costs and the factors
affecting such costs. Predetermined costs when calculated scientifically become standard costs.
Standard costs are used to prepare budgets and then the actual cost incurred is later-on
compared with such predetermined cost and the variance is studied for future correction.
Types, Methods and Techniques of Costing
The general fundamental principles of ascertaining costs are the same in every system of
cost accounting, but the methods of analysis and presenting the costs vary from industry to
industry. Different methods are used because business enterprises vary in their nature and in the
type of products or services they produce or render. Basically, there are two principal methods of
costing, namely (i) Job Costing, and (ii) Process costing.
1. Job costing: It refers to a system of costing in which costs are ascertained in terms of specific
jobs or orders which are not comparable with each other. Industries where this method of
costing is generally applied are Printing Process, Automobile Garages, Repair Shops, Ship-
building, House building, Engine and Machine construction, etc. Job Costing includes the
following methods of costing:
(a) Contract Costing: Although contract costing does not differ in principle from job costing, it is
convenient to treat contract cost accounts separately. The term is usually applied to the costing
method adopted where large scale contracts at different sites are carried out, as in the case of
building construction.
(b) Bach Costing: This method is also a type of job costing. A batch of similar products is regarded
as one job and the cost of this complete batch is ascertained. It is then used to determine the unit
cost of the articles produced. It should, however, be noted that the articles produced should not
lose their identity in manufacturing operations.
(c) Terminal Costing: This method is also a type of job costing. This method emphasizes the
essential nature of job costing, ie, the cost can be properly terminated at some point and related
to a particular job.
(d) Operation Costing: This method is adopted when it is desired to ascertain the cost of carrying
out an operation in a department, for example, welding. For large undertaking, it is frequently
necessary to ascertain the cost of various operations.
2. Process Costing: Where a product passes through distinct stages or processes, the output of one
process being the input of the subsequent process, it is frequently desired to ascertain the cost of
each stage or process of production. This is known as process costing. This method is used
where it is difficult to trace the item of prime cost to a particular order because its identity is
lost in volume of continuous production. Process costing is generally adopted in textile
industries, chemical industries, oil refineries, soap manufacturing, paper manufacturing,
tanneries, etc.
3. Unit or single or output or single output costing: This method is used where a single article
is produced or service is rendered by continuous manufacturing activity. The cost of the whole
production cycle is ascertained as a process or series of processes and the cost per unit is arrived
at by dividing the total cost by the number of units produced. The unit of costing is chosen
according to the nature of the product. Cost statements or cost sheets are prepared under which
various items of expenses are classified and the total expenditure is divided by total quantity
produced in order to arrive at unit cost of production. This method is suitable in industries like
brick-making, collieries, flour mills, cement manufacturing, etc. this method is useful for the
assembly department in a factory producing a mechanical article eg. Bicycle.
4. Operating Costing: This method is applicable where services are rendered rather than goods
produced. The procedure is same as in the case of single output costing. The total expenses of
the operation are divided by the units and cost per unit of services is arrived at. This method is
employed in Railways, Road Transport, Water supply undertakings, Telephone services,
Electricity companies, Hospital services, Municipal services, etc.
5. Multiple or Complete Costing: Some products are so complex that no single system of costing
is applicable. It is used where there are a variety of components separately produced and
subsequently assembled in a complex production. Total cost is ascertained by computing
component costs which are collected by job or process costing and then aggregating the costs
through use of the single or output costing system. This method is applicable to manufacturing
concerns producing Motor Cars, Aeroplanes, Machine tools, Type-writers, Radios, Cycles,
Sewing Machines, etc.
6. Uniform Costing: It is not a distinct method of costing by itself. It is the name given to a
common system of costing followed by a number of firms in the same industry. This helps in
comparing performance of one firm with that of another.
7. Departmental Costing: When costs are ascertained department by department, the method is
called “Departmental Costing”. Usually, for ascertaining the cost of various goods or services
produced by the department, the total costs will have to be analysed, say, by the use of job
costing or unit costing.
In addition to the above methods of costing, mention can be made of the following techniques
of costing which can be applied to any one of the above method of costing for special purposes
of cost control and policy making:
a) Standard or Predetermined Costs.
b) Marginal Costs
Elements of Cost- The management of an organization needs necessary data to analyze and
classify costs for proper control and for taking decisions for future course of action. Hence the
total cost is analyzed by elements of costs ie by the nature of expenses. The elements of costs
are three and they are materials, labour and other expenses. These can be further analyzed as
follows.
 By grouping the above elements of cost, the following divisions of cost are obtained.

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

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

1. Direct Materials are those materials which can be identified in the product and can be
conveniently measured and directly charged to the product. For example, bricks in houses,
wood in furniture etc. Hence all raw materials, materials purchased specifically for a job or
process like glue for book making, parts or components purchased or produced like batteries for
radios and tyres for cycles, and primary packing materials are direct materials.
2. Indirect Materials are those materials which cannot be classified as direct materials. Examples
are consumables like cotton waste, lubricants, brooms, rags, cleaning materials, materials for
repairs and maintenance of fixed assets, high speed diesel used in power generators etc.
3. Direct Labour is all labour expended in altering the construction, composition, confirmation or
condition of the product. Thus direct wages means the wages of labour which can be
conveniently identified or attributed wholly to a particular job, product or process or expended
in converting raw materials into finished goods. Thus payment made to groups of labourers
engaged in actual production, or carrying out of an operation or process, or supervision,
maintenance, tools setting, transportation of materials, inspection, analysis etc is direct labour.
4. Direct Expenses are expenses directly identified to a particular cost centre. Hence expenses
incurred for a particular product, job, department etc are direct expenses. Example royalty,
excise duty, hire charges of a specific plant and equipment, cost of any experimental work
carried out especially for a particular job, travelling expenses incurred in connection with a
particular contract or job etc.
5. Overheads may be defined as the aggregate of the cost of indirect materials, indirect labour and
such other expenses including services as cannot conveniently be charged direct ot specific cost
units. Overheads may be sub-divided into (i) Manufacturing Overheads; (ii) Administration
Overheads; (iii) Selling Overheads; (iv) Distribution Overheads; (v) Research and Development
Overheads.

Cost sheet or Statement of Cost: When costing information is set out in the form of a statement, it
is called “Cost Sheet”. It is usually adopted when there is only one main product and all costs
almost are incurred for that product only. The information incorporated in a cost sheet would
depend upon the requirement of management for the purpose of control.
 Materials
Materials: - The materials are a major part of the total cost of producing a product and are one of
the most important assets in majority of the business enterprises. Hence the total cost of a product
can be controlled and reduced by efficiently using materials.
The materials are of two types, namely:
(i) Direct materials: The materials which can be easily identified and attributable to the individual
units being manufactured are known as direct materials. These materials also form part of
finished products. All costs which are incurred to obtain direct materials are known as direct
material costs.
(ii) Indirect materials: Indirect materials, on the other hand, are those materials which are of small
value such as nuts, pins, screws, etc. and do not physically form part of the finished product.
Costs associated with indirect materials are known as indirect material costs.
Factory supplies, office supplies and selling supplies are generally termed as stores.
Purchasing Control and Procedure: Purchasing is an art. Wrong purchases increase the cost of
materials, store equipments and the finished goods. Hence it is imperative that purchases should be
effectively, efficiently and economically performed.
Dr. Walters defines scientific purchasing as the “Procurement by purchase of the proper
materials, machinery, equipment and supplies of stores used in the manufacture of a product,
adapted to marketing in the proper quantity and quality at the proper time and the lowest price
consistent with the quality desired”.
According to Alford and Beatty, “Purchasing is the procuring of materials, supplies,
machines tools and services required for the equipment, maintenance and operation of a
manufacturing plant”.
The major objectives of scientific purchasing it to purchase the right quantity at the best
price, materials purchased should suit the objective, production should not be held up,
unnecessarily capital should not be locked up in stores, best quality of materials should be
purchased and company’s competitive position and its reputation for fairness and integrity should
be safeguarded.
Only scientific purchasing will help in achieving the above objectives. With proper plans,
materials can be purchased at a lower price than competitors, turnover of investment in inventories
can be high, purchasing department can advise regarding substitute materials, new products, change
in trends, creating goodwill etc.
Methods of Purchasing
Purchasing can be broadly classified as centralized and localized purchasing.
(a) Centralized Purchasing: In a large organization, manufacturing units are many. In such
cases centralized purchasing is beneficial. The advantages of centralized purchasing are:
1. Specialized and expert knowledge is available.
2. Advantages arise due to bulk purchases.
 3. The cost of purchasing can be reduced and selling price can be lowered.
4. As there is good knowledge of market conditions, greater control can be exercised.
5. When materials have to be imported, it is advantageous to centralize the buying.
6. Economy and ease in compilation and consultation of results.
7. It can take advantage of market changes.
8. Investment in inventories can be reduced.
9. Other advantages include undivided responsibility, consistent buying policies.
Factors to be considered when decision regarding centralization has to be taken are
geographical separation of plants, homogeneity of products, type of material bought,
location of supplies etc.
(b) Decentralization of Purchases: The advantages of localized purchasing or decentralization
of purchases are:-
1. Each plant may have its own particular need. This can be given special attention.
2. Direct contact can be established with suppliers.
3. The time lag between indenting and receiving materials can be reduced.
4. Technical requirements of each plant can be ascertained.
Purchase Procedure: The steps usually followed for purchase of materials may be enumerated as
follows:-
1. Indenting for materials : The stores department prepares indents for the purchase of
materials for replenishment of stocks (regular indents) or for a special job(special indents)
and sends it to the purchase department. Regular indents are prepared periodically and
placed when the ordering level for different items of stocks are reached. The quantity
indented is equal to the ordering quantity fixed for each item. The special indents are based
on the demands received either from the planning or production department.
XYZ Co. Ltd.
MATERIAL PURCHASE INDENT
Date: For the Period:
Indent No: Demand Note No:
Regular/Special
Sl. Stores Last Pur.
Description Quantity Special remarks
No. Code No. Order No.

Store Keeper
For Purchase Dept. Use
Tender Nos.
Issued on.
2. Issue of tenders to suppliers: The purchase department issue tenders to suppliers or publish
them in papers. The suppliers quote their terms of price and delivery/payment. After the last
date for receipt of quotations is over, the tenders are opened and a comparative statement is
prepared. Tenders are prepared in triplicate. Of them, two are sent to the suppliers and one is
retained with the purchase department. The supplier mentions his terms in the original.
While considering the tenders, the reliability of the supplier has to be taken into account. The
quality of goods and time taken to deliver the goods on previous occasions should be checked.
The financial stability and capacity to deliver goods should be ensured.
Sometimes purchases may be made without inviting quotations. The circumstances are when
prices are controlled, or purchases are made under long term contracts, or catalogue prices are
available or when there is a cost plus contract. If purchase is made under cost plus profit basis,
the cost composition and reasonableness of price should be checked.
INVITATION TO TENDER
Indent No: Tender No:
Date: Date:
To
XYZ Co.Ltd.
…………….
…………….
Dear Sirs,
The stores mentioned below are required to be delivered at our works godown. The terms and
conditions of supply are mentioned overleaf. The first copy of this tender should be returned to us
duly filled in before………………….
A security deposit of Rs…………should also accompany your reply which will be returned if
we do not place an order with you.
Yours faithfully,

For ABC Co.Ltd.

Particulars Quantity Place of Date of Quantity Rate
Of stores/ required Delivery delivery which can Per Unit Price
Supplies required be supplied

We agree to supply the above on terms mentioned below.

Special conditions:
Place: For XYZ Co. Ltd.
3. Placing of purchase orders: Normally six copies of purchase order are made. The supplier,
stores, inspection department, store accounting section, purchase department and progress
department are sent one copy each.
The purchase order has legal and accounting significance. From legal point of view, it binds both
the parties to the terms of the contract. Form the accounting point of view; it signifies the
amount which has to be spent. It signifies the stores department to accept the goods and the
accounts department to accept the bill.
A.B.C. CO. LTD.
MATERIALS PURCHASE ORDER
Order No: Indent No: Store Receipt No:
Date: Quotation No: Inspection Note No:
To
……………….
……………….
This is in response to your quotation against our Tender No:…………….. The terms and
conditions mentioned overleaf will be applicable. Please supply the following items at the prices
indicated below:

Sl. Description Stores Specification Quantity Unit Price

No. Code
No.

Terms of Delivery: Please send bill to:

Terms of Payment:
Special Conditions: For A.B.C. Co. Ltd.

4. Inspection: The supplier delivers goods at the place specified. Two delivery challans are
prepared by the supplier one of which is returned. It is a proof of delivery. After receiving
the goods, the inspection department or production department or maintenance department
(as the case may be) is intimated.
The inspector checks that the materials are in accordance with the quality required, standard
expected, tolerances allowed etc. After inspection an inspection note is prepared in
triplicate, one copy is sent to the supplier, one to the stores, and one to the inspection
department.
5. Receiving Stores: The stores department prepares a Stores Receipt Note for the quantity of
stock accepted in inspection. After issuing of the Stores Receipt, the Storekeeper is
 responsible for the stocks. The stores receipt is the document for the posting of receipts in
Bin Card and the Stores Ledger. It is prepared in quadruplicate and sent to the supplier;
stores accounting section and purchase department and one copy are retained with the
stores. The supplier encloses this copy along with his bill. The stores accounting section
compares the note with the purchase order.
ABC CO. Ltd.
STORES RECEIPT NOTE
S.R. No: P.O.No: Inspection Note No:
Date: Date: Date:
Received form M/s under their delivery challan no: dated
the following items of stores against the above purchase order:

Stores Description Unit Quantity Price

Value
Code No:

Posted in:-
Bin Card ………………. Stores Ledger………………… Signature of
Storekeeper……………….

6. Checking and passing of bills for payment: Bills received by the purchase department are
forwarded to the stores accounting section to check the authenticity regarding quantity and
price and the arithmetical accuracy. Special items included in the bills eg:- freight, packing
charges are verified with the purchase order. The bill is later passed for payment.
Storekeeping: Store keeping is a service function. The storekeeper is a custodian of all the items
kept in the store. The stores should be maintained properly and cost minimized. The main
objectives of store keeping are:-
i) To protect stores against losses
ii) To keep goods ready for delivery/issue
iii) To provide maximum service at minimum cost.
The duties and functions of Store-keeper can be summarized as follows:
i) Materials should be received, unloaded, inspected and then moved to stores. The materials
have to be stored in appropriate places and records the receipts in proper books.
ii) The stores records should be maintained in an efficient and orderly manner so that materials
can be easily located and information can be obtained for various departments.
 iii) The stores should provide maximum protection and safety and accessibility and utilize
minimum space. Suitable storage devices should be installed.
iv) The materials should be given special covering to prevent damage due to atmospheric
conditions.
v) All issues should be properly recorded, efficiently, promptly and accurately. All issues
should be duly authorized and procedures laid down should be duly followed.
vi) The storekeeper is responsible for co-ordination with materials control according to the
type of production, size of the company, the organization structure etc.
vii) Ensure that all transactions are posted in the Bin Card see that the Bin Card is up-to-
date.
viii) All items should be in its proper place.
ix) Maintenance of stores at required levels.
x) Neatness in stores to facilitate physical verification.
xi) Co-ordination and supervision of staff in the stores department.
xii) Periodical review of various scales, measuring instruments, conversion ratios etc.
xiii) Protect stores from fires, rust, erosion, dust, theft, weather, heat, cold, moisture and
deterioration etc.
Requisitioning for Stores
One of the duties of the storekeeper is to send requisitions for materials for replenishment in time
so that the production is not held up due to shortage of materials. The storekeeper should also see
that there is no unnecessary blocking of capital due to overstocking of materials. For this he keeps a
check on the re-order level, economic ordering quantity, and the maximum and minimum quantity
which he is authorized to store in respect of each kind of material.
(a) Re-ordering Level
Re-ordering level is that point of level of stock of a material where the storekeeper starts the
process of initiating purchase requisition for fresh supplies of that materials. This level is
fixed somewhere between the maximum and minimum levels in such a way that the
difference of quantity of the material between the re-ordering level and minimum level will
be sufficient to meet the requirements of production until the fresh supply of the materials is
received.
Re-ordering Level= Minimum Level + Consumption during the time required to get the
fresh delivery
According to Wheldon,
Re-ordering Level= Maximum Level x Minimum re-order period.
Here, maximum re-order period means the maximum period taken to get the material once
the order for new material is placed. Wheldon has taken the maximum period and maximum
consumption during that period so that factory may not stop production due to shortage of
materials.
(b) Economic Ordering Quantity
The quantity of material to be ordered at one time is known as economic ordering quantity. This
quantity is fixed in such a manner as to minimize the cost of ordering and carrying the stock.
The total costs of a material usually consist of:
Total acquisition cost + total ordering cost + total carrying cost.
Since the acquisition cost per unit of material is same whatever is the quantity purchased, it is
usually excluded when deciding the quantity of a material to be ordered at one time. The only
costs to be taken care of are the ordering costs and carrying costs which vary with the quantity
ordered.
Carrying Cost: It is the cost of holding the materials in the store and includes:
1. Cost of storage space which could have been utilized for some other purpose.
2. Cost of bins and racks
3. Cost of maintaining the materials to avoid deterioration.
4. Amount of interest payable on the amount of money locked up in the materials.
5. Cost of spoilage in stores and handling.
6. Transportation cost in relation to stock.
7. Cost of obsolescence of materials due to change in the process or product.
8. Insurance cost
9. Clerical cost etc.
In India all these costs amount to 20 to 25 % of the cost of materials per year. Hence it
becomes necessary to reduce such carrying cost for efficient operations.
Ordering Cost: It is the cost of placing orders for the purchase of materials and includes:
1. Cost of staff posted in the purchasing department, inspection section and stores accounts
department.
2. Cost of stationary postage and telephone charges.

Thus, this type of costs includes cost of floating tenders, cost of comparative evaluation of
quotations, cost of paper work, and postage involved in placing the order, cost of inspection and
cost of accounting and making payments. In other words, the cost varies with the number of orders.

When the quantity of materials ordered is less, the cost of carrying will decrease but ordering cost
will increase and vice versa.

Q= 2AB
CS
Q = Quantity to be ordered
A = Consumption of the material concerned in units during a year.
B = Cost of placing one order including the cost of receiving the goods i.e. the cost of getting an item
into the firms inventory
CS = Interest payment including variable cost of storing per unit per year i.e holding costs of
inventory.

c) Minimum Level or Safety Stock level

The minimum level is the minimum quantity of the material which must be maintained in hand at
all times. The quantity is fixed so that the production is not held up due to shortage of the
 materials. In fixing this level, the following factors should be considered:
1. Lead time i.e. time lag between indenting and receiving of the material. It is the time
required to replenish the supply.
2. Rate of consumption of the material during the lead time.
3. Nature of the material. Minimum level is not required in case of a special material which is
required against customer’s specific order.
Formula for calculating minimum level or safety stock level given by Wheldon is as follows:
Minimum Stock Level = Re-ordering level – (Normal consumption x Normal Re-order period)
d) Maximum Level
It is the maximum of stock which should be held in stock at any time during the year. The quantity
is fixed so as to avoid overstocking as it leads to the following disadvantages.
1. Overstocking leads to increase in working capital requirement which could be profitable
used somewhere else.
2. Overstocking will need more godown space, so more rent will have to be paid.
3. It may also lead to obsolescence on account of overstocking.
4. There are chances that the quality of materials will deteriorate because large stock will
require more time before they are consumed.
5. There may be fear of depreciation in market values of the overstocked materials.
According to Wheldon,
Maximum Stock level = Reordering level + Re-ordering Quantity –
(Minimum consumption x Minimum re-ordering period)
e) Danger Level
This level means that level of stock at which normal issues of the material are stopped and issues
are made only under specific instructions. The purchase officer will make special arrangements to
get the materials which reach at their danger levels so that the production may not stop due to
shortage of materials.
Danger Level = Average consumption x Max.re-order period for emergency purchases.
f) Average Stock Level
The average stock level is calculated by the following formula:
Average Stock Level = Minimum Stock Level + ½ of Re-order Quantity.
Or ½ (Minimum Stock Level + Maximum Stock Level)

Stores (or Materials) records

In the stores the most important two records kept are bin cards and stores ledger.
(a) Bin Card. A bin card is a record of the receipt and issue of material and is prepared by the
store keeper for each item of stores. A bin card is also known as bin tag or stock card and is
usually kept in the rack where the material is kept. In a bin card not only the receipt and
issue of material is recorded, minimum quantity, maximum quantity and ordering quantity
are stated on the card. This helps the store keeper to send the material requisition for the
purchase of material in time.
(b) Stores Ledger: This ledger is kept in the costing department and is identical with the bin
card except that receipts, issues and balances are shown along with their money values. This
provides the information for the pricing of materials issued and the money value at any time
of each item of stores.
Perpetual Inventory System
The Chartered Institute of Management Accountants, London, defines the perpetual inventory as “a
system of records maintained by the controlling department, which reflects the physical movements
of stocks and their current balance”. Thus this is a system in which, with the help of Bin Cards and
Stores Ledger, the balance of stock is ascertained after every receipt and issue of materials. This is
helps in avoiding closing down of firm for physical verification.
Advantages of the Perpetual Inventory System
The following are the advantages of the perpetual inventory system:
1. It avoids the disruption of production for physical checking of all items of stores at the end
of the year.
2. The preparation of Profit and Loss Account and Balance Sheet is possible without physical
verification of stock.
3. A detailed and more reliable control on the materials in store is obtained.
4. As the work of recording and continuous stocktaking is carried out systematically and
without undue haste, the figures are more reliable.
5. Continuous stocktaking will make the storekeeper and the stores accountant more vigilant in
their work and they will try to keep the records accurate and up-to-date.
6. Planning of production can be done without any fear of shortage as the management is
constantly informed of the stores position.
7. An inbuilt system of internal check will be in operation as bin cards and the stores ledger
keep a check on each other.
8. Errors and shortage of stock are readily discovered and efforts are made to avoid the
shortage of stock in future.
9. The capital invested in the stores can be kept under control and efficiently used as stock can
be compared with the minimum and maximum levels.
10. It makes available correct stock figures for claim to be lodged with the insurance company
for loss on account of stock destroyed by fire.
ABC Analysis
Under ABC Analysis, the materials in stock are divided into three categories for the purpose of
control. Generally it is seen that the materials which constitute the least percentage of items in stock
may contribute to a large percentage of value and a large percentage of items may represent a
smaller percentage of value of items consumed. Between these two items are those items, the
percentage of which is more or less equal to their value in consumption. Items falling in the first
category are treated as ‘A’ items, of the second category as ‘B’ items and items of the third
category are taken as ‘C’ items. Such an analysis of material is known as ABC analysis. This
technique of stock control is also known as stock control according to value method or Always
Better Control method or Proportional Parts Value Analysis method. Thus, under this technique of
material control, materials are listed in ‘A’, ‘B’ and ‘C’ categories in descending order based on
money value of consumption.
Issue of materials
Materials issued from stores are debited to the jobs or work orders which received them and
credited to the materials account. These jobs are debited with the value of materials issued to them.
But what is the value of materials? Theoretically the value includes the invoice price less trade
discount, the freight, cartage, octroi and insurance on incoming materials, expenses of purchase,
receiving, storing and record keeping and carriage from the stores up to the process plant. However,
in practice, it involves minute calculations for including all these expenses and is a big task
compared to the benefit derived from it.
Moreover the price changes according to the market conditions and at any given time there will be
stock of materials purchased at different times at different prices. Hence the problem as to at what
price the materials should be issued?
There are many methods of pricing material issues. The most important being: FIFO, LIFO,
simple and weighed average methods.

1) First in First Out (FIFO)

Under this method material is first issued from the earliest consignment on hand and priced
at the cost at which that consignment was placed in the stores. In other words, materials
received first are issued first. The units in the opening stock of materials are treated as
if they are issued first, the units from the first purchase issued next, and so on until the
units left in the closing stock of materials are valued at the latest cost of purchases.
This method is most suitable in times of falling prices because the issue price of materials
to jobs or work order will be high while the cost of replacement of materials will be low.
But in case of rising prices this method is not suitable because the issue price of materials
to production will be low while the cost of replacement of materials will be high.
The following example will illustrate how issues of materials are valued under this method.
2) Last in Last Out (LILO)
Under this method, issues are priced in the reverse order of purchase i.e., the prices of the
latest available consignment is taken. This method is suitable in times of rising prices
because material will be issued from the latest consignment at a price which is
closely related to the current price levels. Valuing material issues at the price of the latest
available consignment will help the management in fixing the competitive selling prices of
the products.
4) Weighted Average Methods
In this method, price is calculated by dividing the total cost of materials in the stock from
which the materials to be priced could be drawn by the total quantity of materials in that
stock.

In the periods of heavy fluctuations in the prices of materials, the average cost method
gives better results because it tends to smooth out the fluctuations in prices by taking the
average of prices of various lots in stock.
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 UNIT - II
Labour
Labour cost is a second major element of cost. The control of labour cost and its accounting is very
difficult as it deals with human element. Labour is the most perishable commodity and as such
should be effectively utilized immediately.
Importance of Labour Cost Control
Labour is of two types (a) direct labour, (b) indirect labour. Direct Labour is that labour which is
directly engaged in the production of goods or services and which can be conveniently allocated to
the job, process or commodity or process. For example labour engaged in spinning department can
be conveniently allocated to the spinning process.
Indirect Labour is that labour which is not directly engaged in the production of goods and services
but which indirectly helps the direct labour engaged in production. The examples of indirect labour
are supervisors, sweepers, cleaners, time-keepers, watchmen etc. The cost of indirect labour cannot
be conveniently allocated to a particular job, order, process or article.
The distinction between direct and indirect labour must be observed carefully because payment of
direct labour is a direct expenditure and is a part of prime cost whereas payment of indirect labour
is an item of indirect expenditure and is shown as works, office, selling and distribution expenditure
according to the nature of the time spent by the indirect worker.
Management is interested in the labour costs due to the following reasons.
 To use direct labour cost as a basis for increasing the efficiency of workers.
 To identify direct labour cost with products, orders, jobs or processes for ascertaining the
cost of every product, order, or process.
 To use direct labour cost as a basis for absorption of overhead, if percentage of direct labour
cost to overhead is to be used as a method of absorption of overhead.
 To determine indirect labour cost to be treated as overhead and
 To reduce the labour turnover.
Hence control of labour cost is an important objective of management and the realization of
this objective depends upon the co-operation of every member of the supervisory force from
the top executive to foremen.
Time keeping
Time-keeping will serve the following purposes:
1. Preparation of Pay Rolls in case of time-paid workers.
2. Meeting the statutory requirements.
3. Ensuring discipline in attendance.
4. Recording of each worker’s time ‘in’ and ‘out’ of the factory making distinction between
normal time, overtime, late attendance, early leaving.
5. For overhead distribution when overheads are absorbed on the basis of labour hours.
Methods of Time-keeping
There are two methods of time-keeping. They are the manual methods and the
mechanicalmethods. Whichever method is used it should make a correct record of the time and the
method should be cost effective and minimize the risk of fraud.
The manual methods of time keeping are as follows:
 a) Attendance Register Method, and

b) Metal Disc Method

Attendance Register Method
This is the traditional method where an attendance register or muster roll is kept at the time office
near the factory gate or in each department. The timekeeper records the name of the worker, the
worker’s number, the department in which he is working, the rate of wages, the time of arrival and
departure, normal time and overtime. If the workers are literate, they may make a record of time
themselves in the presence of a time-keeper or foreman.
This method is simple and inexpensive and can be used in small firms where the number of workers
is not large. However recording the time of workers who work at customers’ premises and places
which are situated at a distance from the factory is not practical in this method.
Metal Disc Method
Under this method, each worker is allotted a metal disc or a token with a hole bearing his
identification number. A board is kept at the gate with pegs on it and all tokens are hung on this
board. These boards can be maintained separately for each department so that the workers can
remove the token without delay and put it in a tray or box kept near the board. Immediately after
the scheduled time for entering the factory, the box is removed and the latecomers will have to give
their tokens to the timekeeper and their exact time of arrival is recorded. The tokens or disc left on
the board will represent the absentee workers. Later the timekeeper records the attendance in the
attendance register and subsequently it is passed on to the Pay Roll Department.
Mechanical Methods
The mechanical methods that are generally used for the recording of time of workers may be as
follows:
(a) Time Recording Clocks
(b) Dial Time Records
Time Recording Clocks
The time recording clock is a mechanical device which automatically records the time of the
workers. Under this method, each worker is given a Time Card which is kept in a tray near the
factory gate and as the worker enters the gate, he picks up his card from the tray, puts it in the time
recording clock which prints the exact time of arrival in the proper space against the particular day.
This procedure is repeated for recording time of departure for lunch, return from lunch and time of
leaving the factory in the evening. Late arrivals and overtime are recorded in red to attract the
attention of the management.
Dial Time Records
Under this method, a dial time recorder machine us used. It has a dial with number of holes (usually
about 150) and each hole bears a number corresponding to the identification number of the worker
concerned. There is one radial arm at the centre of the dial. As a worker enters the factory gate, he
is to press the radial arm after placing it at the hole of his number and his time will automatically be
recorded on roll of a paper inside the dial time recorder against the number. The sheet on which the
time is recorded provides a running account of the worker’s time and it can calculate the number of
hours and prepare the wage sheets. However, the high installation cost of the dial time recorder and
its use for only a limited number of worker are the drawbacks of this method.
Time Booking
Time booking is the recording of time spent by the worker on different jobs or work orders carried
out by him during his period of attendance in the factory. The objects of time booking are:
1. To ensure that time spent by a worker in a factory is properly utilized on different jobs or
work orders.
2. To ascertain the labour cost of each individual job or work order.
3. To provide a basis for the apportionment of overhead expenses over various jobs or work
orders when the method for the allocation of overheads depends upon time spent on
different jobs.
4. To ascertain unproductive time or idle time so as to make efforts to keep it in limit.
5. To know the time taken to complete a particular job so that bonus can be paid as per the
incentive schemes.
6. To know the efficiency of workers, it is necessary to make the comparison of actual time
taken with time allowed for completing a particular task.
Following documents are generally used for time booking:
1. Daily Time Sheets
2. Weekly Time Sheets
3. Job Tickets or Job Cards.
Daily time sheets are given to each worker where he records the time spent by him on each job or
work order. Weekly time sheets record the same particulars for a week and hence one card is
required for a week. Job cards are used to keep a close watch on the time spent by a worker on each
job so that the labour cost of a job may be conveniently ascertained.

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

Normal Idle Time: This represents the time, the wastage of which cannot be avoided and,
therefore, the employer must bear the labour cost of this time. But every effort should be made to
reduce it to the lowest possible level. Examples of normal idle time are: time taken in going from
the factory gate to the department in which the worker is to work and back at the end of the day,
time taken in picking up the work for the day, time between the completion of one work and the
start of another work, time taken for personal needs like tea or toilet, time taken for machine
maintenance, time taken for waiting for instructions, printouts, machine set-up time etc.
Normal Idle Time is unavoidable cost as such should be included in cost of production. The cost of
normal idle time can be treated as an item of factory expenses and recovered as an indirect charge
or added to labour cost.
Abnormal Idle Time: It is that time the wastage of which can be avoided if proper precautions are
taken. Example: time wasted due:- to breakdown of machinery on account of inefficiency of the
works engineer, failure of the power supply, shortage of materials, waiting for instructions, waiting
for tools and raw materials, strikes or lock-outs in the factory.
It is a principle of costing that all abnormal expenses and losses should not be included in costs and
as such wages paid for abnormal idle time should not form part of the cost of production. Hence it
is debited to Costing Profit and Loss Account.
Over Time: - It is the work done beyond the normal working period in a day or week. For overtime
done, the workers are given double the wages for the overtime done. The additional amount paid on
account of overtime is known as overtime premium.
Overtime increases the cost of production and should not be encouraged as it has the following
disadvantages.
1. Overtime is paid at higher rate.
2. Overtime is done at late hours when workers have become tired and efficiency will it be as
much as during the normal working hours.
3. Workers will develop the habit of working slowly during normal hours and complete the
work using overtime to earn more wages.
4. Expenses like lighting, cost of supervision, and wear and tear of machines will increase
disproportionately.
Overtime should be recorded separately and thoroughly investigated to see that it is incurred only
when genuinely required.
The treatment of overtime depends on the situation. If overtime is incurred for because of the
sequence of jobs, then normal wages is charged to labour cost for the overtime also but if it is a
rush job, then the overtime wages is added to the cost of labour. On the other hand if overtime
arises due to any abnormal reason like breakdown of machinery or power failure, overtime
premium is excluded from the cost of production and is debited to the Costing Profit and Loss
Account.
System of Wage Payment
There is no single method of wage payment which is acceptable both to the employers and the
workers. The system of wages should result into higher production, improved quality of output and
a contented labour force.
There are two principal wage systems: (i) Payment on the basis of time spent in the factory
irrespective of the amount of work done. This method is known as time wage system. (ii) Payment
on the basis of the work done irrespective of the time taken by the worker. This method is called
piece rate system.
Other methods called premium plans or bonus and profit sharing schemes are used with either of
the two principal methods of wage payment.
Time Wage System
Under this method of wage payment, the worker is paid at an hourly, daily, weekly or monthly rate.
This payment is made according to the time worked irrespective of the work done.
This method is highly suitable for following types of work:
1. Where highly skilled and apprentices are working.
2. Where quality of goods produced is of extreme importance eg., artistic goods
3. Where the speed of work is beyond the control of the workers.
4. Where close supervision of work is possible.
5. Where output cannot be measured.
 The disadvantages of this method are:
1. Workers are not motivated.
2. Workers will get payment for idle time.
3. Efficient workers will become inefficient in the long run as all of them get same wages.
4. Employer finds it difficult to calculate labour cost per unit as it varies as production
increases and decreases.
5. Strict supervision is necessary to get the work done.
6. Inefficiency results in upsetting the production schedule and increases the cost per unit.
7. It will encourage a tendency among workers to go slow so as to earn overtime wages.
Thus this method does not establish a proportionate relationship between effort and reward and the
result is that it is not helpful in increasing production and lowering labour cost per unit.
Piece Rate System (payment by result)
Under this system of wage payment, a fixed rate is paid for each unit produced, job completed or an
operation performed. Thus, payment is made according to the quantity of work done no
consideration is given to the time taken by the workers to perform the work.
There are four variants of this system.
a) Straight piece rate system
b) Taylor’s differential piece rate system
c) Merrick’s multiple piece rate system
d) Gant’s task and bonus plan
(a) Straight piece rate system
Payment is made as per the number of units produced at a fixed rate per unit. Another method is
piece rate with guaranteed time rate in which the worker is given time rate wages if his piece rate
wages is less than the time rate.
Advantages
1. Wages are linked to output so workers are paid according to their merits.
2. Workers are motivated to increase production to earn more wages.
3. Increased production leads to decreased cost per unit of production and hence profit per unit
increases.
4. Idle time is not paid for and is minimized.
5. The employer knows his exact labour cost and hence can make quotations confidently.
6. Workers use their tools and machinery with a greater care so that the production may not be
held up on account of their defective tools and machinery.
7. Less supervision is required because workers get wages for only the units produced.
8. Inefficient workers are motivated to become efficient and earn more wages by producing more.
Disadvantages
1. Fixing of piece work rate is difficult as low piece rate will not induce workers to increase
production.
2. Quality of output will suffer because workers will try to produce more quickly to earn more
wages.
3. There may not be an effective use of material, because of the efforts of workers to increase the
production. Haste makes waste. Thus there will be more wastage of material.
4. When there is increased production, there may be increased wastage of materials, high cost of
supervision and inspection and high tools cost and hence cost of production might increase.
5. Increased production will not reduce the labour cost per unit because the same rate will be paid
for all units. On the other hand, increased production will reduce the labour cost per unit under
the time wage system.
6. Workers have the fear of losing wages if they are not able to work due to some reason.
7. Workers may work for long hours to earn more wages, and thus, may spoil their health.
8. Workers may work at a very high speed for a few days, earn good wages and then absent
themselves for a few days, upsetting the uniform flow of production.
9. Workers in the habit of producing quality goods will suffer because they will not get any extra
remuneration for good quality.
10. The system will cause discontentment among the slower workers because they are not able to
earn more wages.
This method can be successfully applied when:
1. The work is of a repetitive type.
2. Quantity of output can be measured.
3. Quality of goods can be controlled.
4. It is possible to fix an equitable and acceptable piece rate
5. The system is flexible and rates can be adjusted to changes in price level.
6. Materials, tools and machines are sufficiently available to cope with the possible increase in
production.
7. Time cards are maintained so that workers are punctual and regular so that production may
not slow down.
(b) Taylor’s Differential Piece Rate system
This system was introduced by Taylor, the father of scientific management to encourage the
workers to complete the work within or less than the standard time. Taylor advocated two
piece rates, so that if a worker performs the work within or less than the standard time, he is
paid a higher piece rate and if he does not complete the work within the standard time, he is
given a lower piece rate.
c) Merrick’s Multiple Piece Rate System
This method seeks to make an improvement in the Taylor’s differential piece rate system. Under
this method, three piece rates are applied for workers with different levels of performance. Wages
are paid at ordinary piece rate to those workers whose performance is less than 83% of the standard
output, 110% of the ordinary piece rate is given to workers whose level of performance is between
83% and 100% of the standard and 120% of the ordinary piece rate is given to workers who
produce more than 100% of the standard output.
This method is not as harsh as Taylor’s piece rate because penalty for slow workers is relatively
lower.
Premium and Bonus Plan
The object of a premium plan is to increase the production by giving an inducement to the workers
in the form of higher wages for less time worked.
Under a premium plan, a standard time is fixed for the completion of a specific job or operation at
an hourly rate plus wages for a certain fraction of the time saved by way of a bonus. The plan is
also known as incentive plan because a worker has the incentive to earn more wages by completing
the work in less time.
This system of wage payment is in between the time wage system and piece work system. In time
wage system, worker does not get any reward for the time saved and in piece work system, the
worker gets full payment for time saved whereas in a premium plan both the worker and the
employer share the labour cost of the time saved.
The following are some of the important premium plans.
(i) Halsey Premium Plan: Under this method, the worker is given wages for the actual
time taken and a bonus equal to half of wages for time saved. The standard time for
doing each job or operation is fixed. In practice the bonus may vary from 33⅓ % to
66⅔ % of the wages of the time saved.
Thus if S is the standard time, T the time taken, R the labour rate per hour, and % the
percentage of the wages of time saved to be given as bonus, total earnings of the worker
will be:
T x R + % (S-T) R
Under Halsey-Weir plan, the premium is set at 30% of the time saved.
The advantages of the Halsey Premium Plan are:
It is simple to understand and relatively simple to calculate.
1. It guarantees time wages to workers.
2. The wages of time saved are shared by both employers and workers, so it is helpful in
reducing labour cost per unit.
3. It motivates efficient workers to work more as there is increasing incentive to efficient
workers.
4. Fixed overhead cost per unit is reduced with increase in production.
5. The employer is able to reduce cost of production by having reduction in labour cost and
fixed overhead cost per unit. So, he is induced to provide the best possible equipment and
working conditions.
Disadvantages
1. Quality of work suffers because workers are in a hurry to save more and more time to get
more and more bonus.
2. Workers criticize this method on the ground that the employer gets a share of wages of the
time saved.

(ii) Rowan Plan: The difference between Halsey plan and Rowan Plan is the calculation of
the bonus. Under this method also the workers are guaranteed the time wages but the
bonus is that proportion of the wages of the time taken which the time saved bears to the
standard time allowed.
Total Earnings = T x R + S-T x T x R
S
Advantages
1. It guarantees time wages to workers
2. The quality of work does not suffer as they are not induced to rush through production as
bonus increases at a decreasing rate at higher levels of efficiency.
3. Labour cost per unit is reduced because wages of time saved are shared by employer and
employee.
4. Fixed overhead cost is reduced with increase in production.
Disadvantages
1. The Rowan plan is criticized by workers on the ground that they do not get the full benefit
of the time saved by them as they are paid bonus for a portion of the time saved.
2. The Rowan plan suffers from another drawback that two workers, one very efficient and the
other not so efficient, may get the same bonus.

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

Classification of Overheads
Overheads can be classified on the following basis:
i) Function-wise classification: Overheads can be divided into the following categories on
functional basis.
(a) Manufacturing or production overheads eg:- indirect materials like lubricants, cotton
wastes, indirect labour like salaries and wages of supervisors, inspectors,
storekeepers, indirect expenses like rent, rates and insurance of factory, power,
lighting of factory, welfare expenses like canteen, medical etc.
(b) Administration overheads eg:- indirect materials like office stationery and printing,
indirect labour salaries of office clerks, secretaries, accountants, indirect expenses
rent, rates and insurance of office, lighting heating and cleaning of office, etc.
(c) Selling and Distribution overheads eg:- indirect materials like catalogues, printing,
stationery, price list, indirect salary of salesmen, agents, travellers, sales managers,
indirect expenses like rent, rates and insurance of showroom, finished goods,
godown etc., advertising expenses, after sales service, discounts, bad debts etc.
ii) Behavior-wise classification: Overheads can be classified into the following categories as
per behavior pattern.
(a) Fixed overheads like managerial remuneration, rent of building, insurance of
building, plant etc.
(b) Variable overheads like direct material and direct labour.
(c) Semi-variable overheads like depreciation, telephone charges, repair and
maintenance of buildings, machines and equipment etc.
iii) Element-wise classification: Overheads can be classified into the following categories as
per element.
(a) Indirect materials
(b) Indirect labour
(c) Indirect expenses
Allocation and Apportionment of Overhead to Cost Centres (Depart-mentalisation of
Overhead)
When all the items are collected properly under suitable account headings, the next step is
allocation and apportionment of such expenses to cost centres. This is also known as
departmentalization or primary distribution of overhead.
A factory is administratively divided into different departments like Manufacturing or
Producing department, Service department, partly producing departments.
Allocation of Overhead Expenses
Allocation is the process of identification of overheads with cost centres. An expense which is
directly identifiable with a specific cost centre is allocated to that centre. Thus it is allotment of a
whole item of cost to a cost centre or cost unit. For example the total overtime wages of workers of
a department should be charged to that department. The electricity charges of a department if
separate meters are there should be charged to that particular department only.
Apportionment of Overhead Expenses
Cost apportionment is the allotment of proportions of cost to cost centres or cost units. If a cost is
incurred for two or more divisions or departments then it is to be apportioned to the different
departments on the basis of benefit received by them. Common items of overheads are rent and
rates, depreciation, repairs and maintenance, lighting, works manager’s salary etc.
Basis of Apportionment
Suitable bases have to be found out for apportioning the items of overhead cost to production and
service departments and then for reapportionment of service departments costs to other service and
production departments. The basis selected should be correlated to the expenses and the expense
should be measurable by the basis. This process of distribution of common expenses over the
departments on some equitable basis is known as ‘Primary Distribution’.
The following are the main bases of overhead apportionment utilized in manufacturing concerns:
Direct Allocation. Under direct allocation, overheads are directly allocated to the department for
which it is incurred. Example overtime premium of workers engaged in a particular department,
power, repairs of a particular department etc.
(i) Direct Labour/Machine Hours. Under this basis, overhead expenses are distributed to
various departments in the ratio of total number of labour or machine hours worked in
each department. Majority of general overhead items are apportioned on this basis.
(ii) Value of materials passing through cost centres. This basis is adopted for expenses
associated with material such as material handling expenses.
(iii) Direct wages. Expenses which are booked with the amounts of wages eg:- worker’s
insurance, their contribution to provident fund, worker’s compensation etc. are
distributed amongst the departments in the ratio of wages. Re-apportionment of Service
Department Costs to Production Departments

Service department costs are to be reapportioned to the production departments or the cost
centres where production is going on. This process of re-apportionment of overhead expenses is
known as ‘Service Distribution’. The following is a list of the bases of apportionment which may
be accepted for the service departments noted against
 Service Department Cost Basis of Apportionment
1. Maintenance Department -Hours worked for each department
2. Payroll or time-keeping department -Total labour or Machine hours or number of
employees in each department
3. Store keeping department - no. of requisitions or value of materials of
each department.
4. Employment or Personnel epartment.
- Rate of labour turnover or number of
employees in each department.
5. Purchase Department
6. Welfare, ambulance, canteen service, -no. of purchase orders or value of materials
recreation room expenses. -No. of employees in each department.
7. Building service department -Relative are in each department
8. Internal transport service or -Weight, value graded product handled, weight
overhead crane service and distance travelled.
9. Transport Department -crane hours, truck hours, truck mileage,
truck tonnage, truck tonne-hours, tonnage
10. Power House (Electric power cost) handled, number of packages.
–wattage, horse power, horse power machine
hours, number of electric points etc.

The following are the various methods of re-distribution of service department costs to production
departments.
1. Direct re-distribution method
2. Step distribution method
3. Reciprocal Services method
a. Simultaneous Equation
Method b. Repeated Distribution
Method c. Trial and Error
Method
Direct re-distribution
method
Under this method, the costs of service departments are directly apportioned to production
departments without taking into consideration any service from one service department to another
service department. Thus, proper apportionment cannot be done on the assumption that service
departments do not serve each other and as a result the production departments may either be
overcharged or undercharged. The share of each service department cannot be ascertained
accurately for control purposes. Budget for each department cannot be prepared thoroughly.
Therefore, Department Overhead rates cannot be ascertained correctly.
Step Distribution Method

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

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

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

(b) Repeated Distribution Method

Under this method, the totals are shown in the departmental distribution summary, are put out in
a line, and then the service department totals are exhausted in turn repeatedly according to the
agreed percentages until the figures become too small to matter.
ABSORPTION OF OVERHEAD
Absorption means the distribution of the overhead expenses allotted to a particular department
over the units produced in that department. Overhead absorption is accomplished by overhead
rates.
Methods of Absorption of Manufacturing Overhead
The following are the main methods of absorption of manufacturing or factory overheads.
(a) Direct Material Cost Method. Under this method percentage of factory expenses to value
of direct materials consumed in production is calculated to absorb manufacturing
overheads.

The formula is Overhead Rate = Production Overhead Expenses (Budgeted)

Anticipated Direct Material Cost

It is assumed that relationship between materials and factory expenses will not change. This
method is simple and can be adopted under the following circumstances:
(i) Where the proportion of overheads to the total cost is significant.
(ii) Where the prices of materials are stable.
(iii) Where the output is uniform ie. Only one kind of article is produced.
(b) Direct Labour Cost (or Direct Wages) Method. This is a simple and easy method and
widely used in most of the concerns. The overhead rate is calculated as under:
Overhead Rate= Production Overhead Expenses
Direct Labour Cost
If from past experience, the percentage of factory expenses to direct wages is 50%, then the
factory expenses in the next year is taken as 50% of the direct wages.
This method is suitable under the following situations:

(i) Where direct labour constitutes a major proportion of the total cost of production.
(ii) Where production is uniform.
(iii) Where labour employed and types of work performed are uniform.
(iv) Where the ratio of skilled and unskilled labour is constant.
(v) Where there are no variations in the rates of pay ie., the rates of pay and the methods are
the same for the majority of the workers in the concern.
In some concerns a separate rate is calculated for the fringe benefits and applied on the basis of
direct labour cost.
(c) Prime Cost Method. Under this method the recovery rate is calculated dividing the
budgeted overhead expenses by the aggregate of direct materials and direct labour cost of
all the products of a cost centre. The formula is
Overhead Recovery Rate = Production Budgeted Overhead Expenses
Anticipated Direct Materials and Direct Labour Cost

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

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

The following steps are required to be taken for the calculation of machine hour rate:
1) Each machine or group of machine should be treated as a cost centre.
2) The estimated overhead expenses for the period should be determined for each machine
or group of machines.
3) Overheads relating to a machine are divided into two parts i.e., fixed or standing charges
and variable or machine expenses.
4) Standing charges are estimated for a period for every machine and the amount so
estimated is divided by the total number of normal working hours of the machine during
that period in order to calculate an hourly rate for fixed charges. For machine expenses,
an hourly rate is calculated for each item of expenses separately by dividing the
expenses by the normal working hours.
5) Total of standing charges and machines expenses rates will give the ordinary machine
hour rate.
Some of the bases which may be adopted for apportioning the different expenses for the
purpose of calculation of machine hour rate are given below.
Some of the expenses and the basis of apportionment are given below.

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

the surrounding space.
2. Heating and Lighting - The number of points used plus cost of special lighting or
heating for any individual machine, alternatively according to floor area occupied by
each machine.
3. Supervision – estimated time devoted by the supervisory staff to each machine.
4. Lubricating Oil and Consumable Stores – On the basis of past experience.
5. Insurance – Insurable value of each machine
6. Miscellaneous Expenses – Equitable basis depending upon facts.

Machine Expenses
1. Depreciation – cost of machine including cost of stand-by equipment such as
spare motors, switchgears etc., less residual value spread over its working life.
2. Power – Actual consumption as shown by meter readings or estimated
consumption ascertained from past experience.
3. Repairs – Cost of repairs spread over its working life.
(f) Rate Per Unit of Production. This method is simple, direct and easy. It is suitable for
mining and other extractive industries, foundries and brick laying industries, where the
output is measured in convenient physical units like number, weight, volume etc. the rate is
calculated as under:

Overhead Rate= Overhead expenses (budgeted)

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

The method is more suitable for apportioning of administration, selling and distribution,
research, development and design costs of products. It can also be used with advantage for
the appropriation of joint products costs.
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 UNIT – III
PROCESS COSTING
Process costing is the method of costing applied in the industries engaged in continuous or
mass production. Process costing is a method of costing used to ascertain the cost of a product at
each process or stage of manufacturing.
According to ICMA terminology, “Process Costing is that form of operation costing which
applies where standardized goods are produced”.
So it is a basic method to ascertain the cost at each stage of manufacturing. Separate
accounts are maintained at each process to which expenditure incurred. At the end of each process
the cost per unit is determined by dividing the total cost by the number of units produced at each
stage. Hence, this costing is also called as “Average Costing” or “Continuous Costing”. Process
Costing is used in the industries like manufacturing industries, chemical industries, mining works
and public utility undertakings.

Characteristics of Process Costing

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

Advantages of Process Costing

1. It is easy to compute average cot because the products are homogeneous in Process Costing.
2. It is possible to ascertain the process costs at short intervals.
3. Process Costing is simple and less expensive in relation o job costing.
4. By evaluating the performance of each process effective managerial control is possible.
Disadvantages of Process Costing
1. Valuation of work in progress is difficult.
2. It is not easy to value losses, wastes, scraps etc.
3. The apportionment of total cost among joint products and by-products is difficult.
4. Process cost are not accurate, they are only average costs
5. Process costs are only historical.
Principles of Process Costing
The following points are considered while determining the cost under Process Costing.
1. Production activity should be divided into different processes or departments.
2. A separate account is opened for each process.
3. Both direct and indirect costs are collected for each process.
4. The quantity of output and costs are recorded in the respective process accounts.
5. The cost per unit is determined by dividing the total cost at the end of each process by the
number of output of each process.
6. Normal loss and abnormal loss are credited in the process account
7. The accumulated cost of each process is transferred to subsequent process along with
output. The output of the last process along with cost is transferred to the finished goods
account.
 8. In case of by-products and joint products their share in joint cost should be estimated and
credited to the min process.
9. When there is work in progress at the end of the period the computation of inventory is
made I terms of complete units.
Difference between Process Costing and Job Costing
Process Costing Job Costing
1. Production is continuous 1. Production is according to
2. Production is for stock customers’ orders
2. Production is not for stock
3. All units produced are identical or
homogeneous 3. Each job is different from the other
4. There is regular transfer of cost of one 4. There is no regular transfer of cost
process to subsequent processes from one job to another
5. Work in progress always exists 5. Work in progress may or may not
exist
Procedure for Process Costing
1. Each process is separately identified. Separate process account is opened for each process.
2. Along with ‘Particulars Column’, two columns are provided on both sides of the process
account – units (quantity) and amount (Rupees).
3. All the expenses are debited in the respective process account.
4. Wastage, sale of scrap, by-products etc are reordered on the credit side 0f the process
account.
5. The difference between debit and credit side shows the cost of production and output of that
particular process which is transferred to the next process.
6. The cost per unit in every process is calculated by dividing the net cost by the output.
7. The output of last process is transferred to the Finished Stock Account.
8. Incomplete units at the end of the each period ion every process s converted in terms of
completed units.

Specimen of Process Account

Process Account
Units Rs. Units Rs.
To Direct materials By Loss in weight
To Direct Wages (Normal
To Direct Expenses Loss)
To Indirect expenses By sale of Scrap
To Other Expenses (if any) By Next Process
Account(Transfer)
 Preparation of Process Accounts
The preparation of Process Account depends upon the following situations
1. Simple Process Account
2. Process costing with normal process loss
3. Process costing with abnormal process loss
4. Process costing with abnormal process gains
5. Inter – process profits.
Simple Process Account
Under this case it is very easy to prepare process account. A separate account is opened for
each process. All costs are debited to the process account. The total cost of the process is
transferred to the next process. At the end of each process the cost per unit is obtained by dividing
the total cost by the number of units.
Illustration 1: Product A requires three distinct processes and after the third process the product is
transferred to finished stock. Prepare various process accounts from the following information.
Total P1 P2 P3
Direct Materials 5000 4000 600 400
Direct Labour 4000 1500 1600 900
Direct Expenses 800 500 300
Production overheads 6000

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

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

Solution:
Process I Account
Units Rs. Units Rs.
To Direct materials 200 4000 By Process II
To Direct Wages 1500 Account(Transfer) 200 8250
To Direct Expenses 500 Cost per unit 8250 =
To Production overheads 2250 41.25
(1500x150%) 200 8250 200 200 8250
Process II Account
Units Rs. Units Rs.
To Process I A/c 200 8250 By Process III
To Direct materials 600 Account(Transfer) 200 13150
To Direct Wages 1600 Cost per unit 13150 =
To Direct Expenses 300 65.75
To Production overheads 2400 200
(1600x150%)
200 13150 200 13150
 Process III Account
Units Rs. Units Rs.
To Process II A/c 200 13150 By Finished stock A/c
To Direct materials 400 (Output Transferred ) 200 15800
To Direct Wages 900 Cost per unit 15800 = 79
To Production overheads 1350 200
(900x150%)

200 15800 200 15800

Process losses
The process loss is classified into two- normal process loss and abnormal process loss.

Normal process loss

This is the loss which is unavoidable on account of inherent nature of production process. It
arises under normal conditions. It is usually calculated as a certain percentage of input. Normal
process los includes either waste or scrap r both. Waste is unsalable and has no value. Loss in
weight is an example of waste. Loss in weight should be credited to the concerned process account.
It should be recorded only in terms of quantity.
Loss in weight = Opening Stock + output from the preceding process – (output of the
Concerned process + closing stock)
Illustration 2: From the following figures, show the cost of three processes of manufacture. The
production of each process is passed on to the next process immediately on completion.
Process Process Process
A B C
Wages and Materials 30400 12000 29250
Works Overhead 5600 5250 6000
Production ion units 36000 37500 48000
Stock on 1 July 2012 (units from preceding
process) 4000 16500
Stock on 31 July 2012 (units from preceding
process) 1000 5500
Solution:
Process A Account
Units Rs. Units Rs.
To Wages and Materials 36000 30400 By Process B A/c
To Works Overhead 5600 (Transfer ) 36000 36000
Cost per unit 36000 = 1
36000
36000 36000 36000 36000
Process B Account
Units Rs. Units Rs.
To Opening Stock (Re.1 p.u) 4000 4000 1500
By loss in weight (Bal. fig)
To Process A A/c (transfer) 36000 36000 By Closing stock @ Re.1 1000 1000
To Wages and Materials 12000 p.u
To Works Overhead 5250 By Process C A/c (Transfer ) 37500 56250
Cost per unit 56250 = 1.50
37500
40000 57250 40000 57250

Process C Account
Units Rs. Units Rs.
To Opening Stock (Rs.1.50 16500 24750 By loss in weight (Bal. 500
p.u) 37500 56250 fig) 5500 8250
To Process B A/c (transfer) 29250 By Closing
To Wages and Materials 6000 [email protected] 48000 108000
To Works Overhead By Finished stock A/c
(Transfer)
Cost per unit108000 =
2.25
54000 116250 48000 54000 116250

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

Process 1 Process 2 Process 3

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

Expenses incurred:
Rs Tons Rs Tons Rs Tons
Raw materials 120000 1000 28000 140 107840 1348
Manufacturing wages 20500 18520 15000
General expenses 10300 7240 3100
Prepare Process Cost Accounts showing the cost per ton of each product.
Solution:
Process 1 Account
Tons Rs. Tons Rs.
To Raw materials 1000 120000 By loss in weight (2%) 20
To Manufacturing wages 20500 By Sale of scrap (10%) 100 10000
To General expenses 10300 By Warehouse - transfer
(880x25%) 220 35200
By Process 2 660 105600
A/c(Transfer )
Cost per unit 140800 =
160
1000 150800 1000 150800
880

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

Process 3 Account
Tons Rs. Tons Rs.
To Process 2 A/c(Transfer ) 352 75680 By loss in weight (2%) 34
To Raw materials 1348 107840 By Sale of scrap (10%) 170 3400
To Manufacturing wages 15000 By Warehouse - transfer 198220
To General expenses 3100 Cost p unit 198220 1496
=132.5
1496
1700 201620 1700 201620
Abnormal Process Loss
Any loss caused by unexpected or abnormal conditions such as plant break don, substandard
materials, carelessness, accident etc. or loss in exceeds of the margin anticipated for normal process
loss can be called as abnormal process loss. It is controllable and avoidable. When actual loss in the
process is greater than the estimated normal loss, it is a case of abnormal loss. It may also be
determined by comparing actual output with expected or normal output. If actual output is les than
the normal output, the difference is abnormal loss.
Value of Abnormal loss = Normal cost of normal output x Units of Abnormal loss
Normal output
Normal cost of normal output = Total expenditure (i.e., total debit of process A/c) – Sale
Proceeds of scrap (i.e. Value of normal loss)
 Normal output = Input – Units of normal loss
Illustration 4: In process A 100 units of raw materials were introduced at a cost of Rs.1000. the
other expenditure incurred by the process was Rs. 602. Of the units introduced 10% are normally
lost in the course of manufacture and them posses a scrap value of Rs.3 each. The output of process
A was only 75 units. Prepare Process A A/c and Abnormal loss A/c.
Solution:
Process A A/c
Units Rs. Units Rs.
To Raw Materials 100 1000 By Normal loss-
To Other expenses 602 100x10% @Rs.3 each 10 30
By Abnormal loss 15 262*
(Bal.Fig) 75 1310
By Process B A/c
100 1602 100 1602
(transfer)

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

Value of Abnormal loss = Normal cost of normal output x Units of Abnormal loss
Normal output
= 1572 x 15 = Rs. 262
90
Abnormal Loss A/c
Units Rs. Units Rs.
To Process A 15 262 By Cash (scrap value of
loss @ Rs.3) 15 45
By Costing P&L A/c 217

15 262 15 262

Abnormal Gain (or Abnormal Effective)

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

Value of Abnormal Gain = Normal cost of normal output x Units of Abnormal gain
Normal output
 Normal cost of normal output = Total expenditure– Sale Proceeds of scrap
Normal output = Input – Units of normal loss

Units of Abnormal gain = Normal loss- Actual loss

Or = Actual output - Normal output

Illustration 5: Product X is obtained after it passes through three distinct processes. 2000 kg of
materials at Rs.5 per kg were issued to the first process. Direct wages amounted to Rs.900 and
production overhead incurred was Rs.500. Normal loss is estimated at 10% of input. This wastage
is sold at Rs.3 per kg. The actual output is 1850 kg. Prepare process I A/c and Abnormal Gain/
Abnormal loss A/c as the case may be.
Solution:
Process I Account
Kg Rs. Kg Rs.
To Materials 2000 10000 By Normal loss (Sale of
To Direct wages 900 scrap ) 200 600
To Production OH 500 By Process II - transfer 1850 111002
To Abnormal gain (Bal.) 501 3003
2050 11700 2050 11700

Abnormal Gain A/c

Kg Rs. Kg Rs.
To Normal loss (loss of 50 150 By Process I A/c 50 300
income) 150
To Costing P&L A/c (Bal.)

50 300 50 300

Working note:
1. (200+1850)-2000=50
2. (10000+900+500)-600 = Rs.6
1850-50
1850x6=11100
3. 50x6=30
Illustration 6: The product of a company passes through three distinct processes to completion –
A,B and C. from the past experience it s ascertained that los s incurred in each process as – A-2%,
B-5% and C-10%.
In each case the percentage of loss is computed on te number of units entering the process
concerned. The loss of each process possesses a scrap value. The los of processes A and B sold at
Rs.5 per 100 units and that of C at Rs.20 per 100 units.
The output of each process passes immediately to the next process and the finished units are
passed from process C into stock.

Process A Process B Process C

Materials consumed 6000 4000 2000
Direct labour 8000 6000 3000
Manufacturing expenses 1000 1000 1500
 20000 units have been issued to process A at a cost of Rs.10000. the output of each process
has been as under:
A-19500, B- 18800 and C - 16000.
There is no work in progress in any process. Prepare process accounts. Calculations should be made
to the nearest rupee.
Solution:
Process A Account
Units Rs. Units Rs.
To Units introduced 20000 10000 By Normal loss 400 20
To Materials 6000 By Abnormal loss (Bal.) 100 127
To Direct labour 8000 By Process B - transfer 19500 24853
To Manufacturing Expenses 1000
20000 25000 20000 25000

Process B Account
Units Rs. Units Rs.
To Process A A/c 19500 24853 By Normal loss 975 49
To Materials 4000 By Process C - transfer 18800 36336
To Direct labour 6000
To Manufacturing Expenses 1000
To abnormal gain 275 532
19775 36385 19775 36385
Process C Account
Units Rs. Units Rs.
To Process B A/c 18800 36336 By Normal loss 1880 376
To Materials 2000 By To abnormal loss 920 2309
To Direct labour 3000 By Finished stock A/c - 16000 40151
To Manufacturing Expenses 1500 transfer
18800 42836 18800 42836
Finished Stock A/c
Units Rs. Units Rs.
To Process C A/c 16000 40151

16000 40151 16000 40151

Abnormal Loss A/c
Units Rs. Units Rs.
To Process A 100 127 By Cash ([email protected] per
To Process C [email protected] 100) 1020 189
920 2309
By Costing P&L A/c 2247
1020 2436 1020 2436
 Normal loss A/c
Units Rs. Units Rs.
To Process A 400 20 By Abnormal Gain 275 14
To Process B By Cash/Debtors A/c 2980 431
975 49
To Process C
1880 376

3255 445 3255 445

Abnormal Gain A/c

Units Rs. Units Rs.

To Normal loss (loss of 275 14 By Process C A/c 275 532
income)
538
To Costing P&L A/c (Bal.)
275 532 275 532

Working note:
Process A:
Value of Abnormal loss = Rs.24980/19600 units x 100 units = Rs. 127.
Process B:
Value of Abnormal gain = Rs.35804/18525 units x 275 units = Rs. 532.
Process C:
Value of Abnormal loss = Rs.42460/16920 units x 920 units = Rs. 2309.
Work-in-Progress
In most of the firms manufacturing is on a continuous basis and the problem of work-in-
progress is quite common. The work-in-progress consists of direct materials, direct wages and
production overhead.
Equivalent Production
Equivalent production represents the production of a process in terms of completed units. In
other words, it means converting the incomplete units into its equivalent of completed units. It is
also known as effective production. For calculating equivalent production, work-in-progress needs
to be inspected. Then an estimate is made of the degree of completion, usually on a percentage
basis.

Steps and procedure of computation of Equivalent Production

1. Ascertain Equivalent Production in respect of opening work-in-progress, if any. In this case the
Equivalent Production is computed by taking into consideration the percentage of work required to
finish now in the process. The following formula is used.
Opening WIP (Units) x % of work needed to complete.
2. Find the units introduced and completed and add this to (1). It is calculated as follows:
Units completed and transferred – Opening work-in-progress.
3. Convert the equivalent production of closing work-in-progress and add to the above.
The formula is:
Closing work-in-progress (units) x% of work completed.
4. Obtain the total Equivalent Production terms of materials, labour and overhead separately (if
degree of completion is different). For this, ‘Statement of Equivalent Production’ is prepared.
5. Find out the net process costs, element wise- materials, labour and overheads.
6. Ascertain the cost per unit of Equivalent Production for each element of cost separately.
Material cost per unit= Material cost
Equivalent Production in respect of materials
Labour cost per unit = Labour cost
Equivalent Production in respect of labour
Overhead cost per unit = Overhead cost
Equivalent Production in respect of overhead
For this purpose ‘Statement of Cost is prepared’
7. Find out the value of opening work-in-progress, finished units and closing work-in-progress. The
formula is:
Equivalent Production in respect of materials x Material cost per unit
Equivalent Production in respect of labour x Labour cost per unit
Equivalent Production in respect of overhead x Overhead cost per unit

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

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

Labour 70% 10680

Overheads 70% 7120

Find out Equivalent Production, Cost per unit of equivalent production and prepare the
Process A A/c assuming that there is no opening work-in-progress and process loss.
Solution:
Statement of Equivalent Production
Input Output Equivalent Production
Labour &
Materials
Items Units Items Units Overhead
Units % Units %
Units Units completed &
introduced 3800 transferred 3000 3000 100 3000 100
Work in progress 800 640 80 560 70
3800 3800 3640 3560
Statement of Cost
Equivalent Production Cost per completed
Elements of cost Cost (Rs.)
(units) unit
Materials 7280 3640 2.00
Labour 10680 3560 3.00
Overheads 7120 3560 2.00
25080 7.00

Statement of Evaluation

Finished goods 3000x7 21000

Work-in-progress:
Materials 640x2 1280
Labour 560x3 1680
Overhead 560x2 1120
4080

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

3800 25080 3800 25080

II. When there is only closing work-in-progress but with process losses
In case of normal loss, nothing should be added as equivalent production. However,
abnormal loss should be considered as production of good units completed during the period.
Illustration 8: During January 2000 units were introduced into Process I. the normal loss was
estimated at 5% on input. At the end of the month, 1400 units had been produce and transferred to
the next process, 460 units were uncompleted and 140 units had been scrapped. It was estimated
that uncompleted units had reached a stage in production as follows:
Material 75% completed
Labour 50% completed
Overheads 50% completed
The cost of 20000 units was Rs.5800
Direct material introduced during the process Rs.1440
Direct wages Rs.3340
Production overheads incurred were Rs. 1670
Units scrapped realized Re.1 each.
Units scrapped passed through the process, so were 100% completed as regards material, labour
and overhead.
Find out Equivalent Production, Cost per unit and prepare the necessary accounts.
Solution:
Statement of Equivalent Production
Input Equivalent Production
Output Materials Labour &
Units
Units Overhead
Units % Units %
2000 Normal loss 100
Abnormal loss 40 40 100 40 100
Finished production 1400 1400 100 1400 100
Work in progress 460 345 75 230 50
2000 2000 1785 1670

Statement of Cost
Elements of cost Cost Equivalent Cost per completed
(Rs.) Production (units) unit
Materials
Cost of units introduced 5800
Direct Materials 1440
7240
Less: Scrap vale of normal loss 100
7140 1785 4
Direct wages 3340 1670 2
Overheads 1670 1670 1
Total 12150 5125 7

Statement of Evaluation
Production Cost Elements Equivalent Production Cost per unit Cost Total Cost
Abnormal Material 40 4 160
loss Labour 40 2 80
Overheads 40 1 40 280
Finished Material 1400 4 5600
production Labour 1400 2 2800
Overheads 1400 1 1400 9800
Work-in- Material 345 4 1380
progress Labour 230 2 460
Overheads 230 1 230 2070
12150
 Process I A/c
Units Rs. Units Rs.
To Units introduced 2000 5800 By Normal loss 100 100
To Materials 1440 By abnormal loss 280
40
To Labour 3340 By Finished production 9800
To Overhead 1670 By Balance c/d 1400
(Work-in-progress) 2070

460

2000 12250 2000 12250

Finished Production A/c
Units Rs. Units Rs.
To Process I A/c 1400 9800

Abnormal Loss A/c

Units Rs. Units Rs.
To Process I A/c 40 280 By Cash (sale @ Re.1 p.u) 40 40
By Costing P&L A/c (loss) 240

40 280 40 280

III. When there is opening as well as closing work in progress but with no process loss.
Sometimes in a continuous process there will be opening as well as closing work in
progress which are to be converted into equivalent of completed units for apportionment of process
costs. The procedure of conversion of opening work in progress will vary depending upon whether
average cost or FIFO or LIFO method of apportionment of costs is followed.

Illustration 9: From the following details, prepare statement of equivalent production, statement of
cost, statement of evaluation and process A/c by following FIFO method.
Opening work-in-progress (2000 units):
Materials (100% complete) Rs. 5000
Labour (60% complete) Rs. 3000
Overheads (60% complete) Rs. 1500
Units introdu4ed into the process Rs. 8000
There are 2000 units in progress and the stage of completion is estimated to be:
Materials 100%
Labour 50%
Overheads 50%
8000 units are transferred to the next process:
The process costs for the period are:
Materials Rs.96000
Labour Rs. 54600
Overheads Rs. 31200
Solution:
Statement of Equivalent Production

Equivalent Production
Output Labour &
Units Materials
Overhead
Units % Units %
Opening WIP 2000 800 40
Completed processed during the
period(8000-2000) 6000 6000 10 6000 100
Closing WIP 2000 2000 0 1000 50
Total 10000 8000 10 7800
0
Statement of Cost
Elements of cost Cost Equivalent Cost per
(Rs.) Production (units) completed unit
Materials 96000 8000 12
Labour 54600 7800 7
Overheads 31200 7800 4
Total 181800 23
Statement of Evaluation
Opening Work-in-progress (current cost)
Materials
Labour 800x7 5600
Overhead 800x4 3200 8800
Closing WIP
Materials 2000x12 24000
Labour 1000x7 7000
Overhead 1000x4 4000 35000
units completely processed during the period 6000@23 138000
181800
Process A/c
Units Rs. Units Rs.
To Opening WIP 2000 9500 By Finished stock transferred
To Materials 8000 96000 to next process 156300
8000
To Labour 54600 (9500+8800+138000) 35000
To Overhead 31200 By Closing WIP 2000

10000 191300 10000 191300

IV. When there is opening as well as closing work-in-progress but with losses.
Under this equivalent production units regarding opening and closing work in progress are
to be calculated with due adjustment for process losses.

Illustration 10: Following data are relating Process A for March 2012.
Opening WIP – 1500 units for Rs.15000
Degree of completion:
Materials 100%, Labour and overheads 33 1/3%
Input of materials 18500 units at Rs.52000
Direct labour Rs. 14000
Overheads Rs. 28000
Closing WIP - 5000 units.
Degree of completion: Materials 90% and labour and overheads 30%.
Norma process loss is 10% of total input (opening WIP units + units put in)
Scrap value Rs. 2 per unit.
Unit transferred to the next process 15000 units.
Compute equivalent units of production, cost per equivalent unit for each cost element and
cost of finished output and closing WIP. Also prepare Process and other accounts. Assume that
FIFO method is used by the company and the cost of opening WIP is fully transferred to the next
process.

Solution:
Statement of Equivalent Production and Cost
Input Output Units Equivalent Production
Units Materials Labour Overhead
Units % Units % Units %
1500 Opening WIP
18500 transfer 1500 1000 662/3 1000 66
Normal loss 2000 2/3

Finished goods 13500 13500 100 13500 100 13500

Closing WIP 30 100
5000 4500 90 1500 1500
30
20000 22000 18000 16000 16000
less: Abnormal 2000 2000 100 2000 100 2000
gain 100
20000 16000 14000 14000
52000
Materials 28000
4000 48000 14000
less: scrap value
Cost per Rs.2
Rs.3 Rs.1
equivalent unit
Statement of Evaluation
Opening Work-in-progress
Materials
Labour 1000x1 1000
Overhead 1000x2 2000 3000
Finished goods 13500x6 81000
Abnormal gain 2000x6 12000
Closing WIP
Materials 4500x3 13500
Labour 1500x1 1500
Overhead 1500x2 3000 18000
Process I A/c
Units Rs. Units Rs.
To Opening WIP 1500 15000 By normal loss 2000 4000
To Materials 18500 52000 By Finished stock
To Labour 14000 (18000+81000) 99000
To Overhead 28000 By Closing WIP 15000 18000
To Abnormal gain 2000 12000 5000

22000 121000 22000 121000

Normal loss A/c
Units Rs. Units Rs.
To Process I 2000 4000 By Abnormal Gain 2000 4000

Abnormal Gain A/c

Units Rs. Units Rs.
To Normal loss (loss of income) 2000 4000 By Process I A/c 2000 12000
To Costing P&L A/c (Bal.)
8000

2000 12000 2000 12000

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

Types of contracts
Generally there are three types of contracts:

1. Fixed price contracts: Under these contracts both parties agree to a fixed contract price.
2. Fixed price contract with Escalation clause
3. Cost plus contract: Under this contract no fixed price could be settled for a contract.

Contract Account
A contract account is a nominal account in nature. It is prepared to find out the cost of contract and
to know profit or loss made on the contract. A contractor may undertake a number of contracts at a
time. For each contract a separate account is opened. In the contract account all direct cost such
as material, labour and other direct expenses incurred during an accounting period are debited and
the indirect expenses are apportioned on an equitable basis. The differences between the two sides
are known as Notional profit or notional loss.
SPECIAL TERMS IN CONTRACT ACCOUNT
1. Work in Progress: It is the unfinished contract at the end of the accounting period and it
includes amount of work certified and amount of work uncertified. Work in progress is an
asset, shown in the balance sheet by deducting there from any advance received from the
contractee.
2. Work certified: The sales value of work completed as certified by the architect is known as
‘work certified’. In the case of contracts of long duration, the amount payable by the
customer to the contractor is based on the sales value of work done as certified by the
architect. At the end of the financial year, the total sales value of work done and certified
by the architect is credited to the contract account.
3. Work Uncertified: It means work which has been carried out by the contractor but has
not been certified by the architect. Sometimes, work which is complete remains
uncertified at the end of the financial year. The reasons for the same may be
 a. Work not sufficient enough to be certified
b. Work has not reached the stipulated stage to qualify for certification
It is always valued at cost and credited to the contract account.
4. Retention money: - Regardless of the amount of work certified, the contractor is paid
a specified percentage of the same and the balance is held or retained by the contractee.
This is because of the fact that the contractee has to safe guard himself against any
contingency arising from the non fulfillment of the terms of the contract by the contractor.
The unpaid balance of work certified or the amount held back or retained by the
contractee is known as
‘retention money’.
5. Sub contract: Sometimes the contractor enters into contracts with another contractor
to give a portion of work undertaken by him. In such cases the work performed by the
subcontractor s forms a direct charge to the contract concerned. Sub contract cost will be
shown on the debit side of the contract account.

6. Escalation clause: This is clause which is provided in the contract to cover up any
increase in the price of the contract due to increase in the prices of raw material or labour
or in the utilization of any other factors of production. If material and labour utilization
exceeds a particular limit, the customer agrees to bear the additional cost occasioned by
excessive utilization. Here, the contractor has to satisfy the customer that excessive
utilization is not the result of decreased efficiency.
SPECIMEN FORM OF CONTRACT ACCOUNT (Unfinished
contract)

Contract
A/C

To materials Xxx By work in progress:

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

To Profit and Loss A/C Xxx By Notional profit B/d Xxx

To WIP (B/F) Xxx
Xxx Xxx
======= ========
Treatment of Plant and Machinery:
One of the distinguishing features of a contract is the use of special plant and machinery. The cost
of these is capital expenditure, but yet, the usage of these should be reflected in the form of
depreciation. There are two distinct methods of charging depreciation.
1. At the time of issue of plant to contract the contract account is debited with the full value of
the plant. At the end of the period contract account is credited with the depreciated value.
This method is used when plant and machinery is used at the contract site for a long period.
2. In the second method, contract account is debited with an hourly rate of depreciation for the
number of hours the plant is used on the contract. A cost centre is set up for each machine.
An estimate is made is made of the cost such as maintenance, depreciation, driver’s wage
etc to be incurred. The total of this cost is divided by the number of hours that the machine
is expected to be used.
Profit on Incomplete Contract:
In the case of a small contract extending over the financial period, profit or loss on the same may be
ascertained by crediting it with the contract price due by the contractee. This procedure cannot be
adopted in the case of contracts extending beyond the accounting period, and taking a long time for
completion. If there is any profit upon the incomplete contract, it cannot be taken as actual profit.
The profit upon the incomplete contract is called notional profit.
For the purpose of determining the amount of profit to be transferred to profit and loss
account and making provision for future contingencies, the following guidelines may be kept in
mind.
1. When the work has not reasonably advanced (1/4 or less than ¼) : - No profit should be
taken to the credit of p/L account in the case of contracts which have just commenced and a
small portion of the work is complete.
2. Where the work is complete more than ¼ but less than ½ of contract price: In this case
1/3 of the notional profit as reduced by the percentage of cash received may be credited to
profit and loss account. The usual formula is
Notional profit x1/3 x Cash received
Work certified
The balance of notional profit shall be kept as reserve till the completion
3. If the contract completed is more than 1/2 but less than 90%: Here 2/3 rd of the notional
profit should be taken to profit and loss account.
Notional profit x2/3 x Cash received
Work certified
The balance of notional profit shall be transferred to work in progress as reserve. It is to be
noted that in order to find out how much portion of contract is completed, work certified
should be compared with contract price.
4. If the contract is nearing completion: Here, estimated profit may be ascertained by
deducting the total cost of contract to date plus estimated additional expenses to complete
the contract , from the contract price. It is calculated by using the following formula

Estimated profit x Cash received

Contract price

The loss on incomplete contract should be fully transferred to profit and loss account.
Example 1
The following was the expenditure on a contract for Rs. 6,00,000
Material 1,20,000
Wages 1,64,000
Plant 20,000
Overheads 8,600
Cash received on account of the contract was Rs. 2,40,000 being 80% of the work certified. The
Value of material in hand was Rs. 10,000. The plant has undergone 20% depreciation.
Solution:
CONTRACT ACCOUNT
Rs. Rs.
To materials 1,20,000 By material in hand 10,000
To Wages 1,64,000 By plant on hand 16,000
To Plant 20,000 By work certified
To overheads 8,600 (2,40,000x100/80) 3,00,000
To Notional profit 13,400

3,26,000 3,26,000
====== =====

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

To Balance c/d 6,253
---------- ---------
13, 400 13,400
Example 2
XY Ltd undertook a contract, the following was the expenditure on a contract for Rs. 6,00,000.
Material issued to contract Rs. 1,02,000
Plant issued for contract Rs. 30000
Wages Rs.1,62,000
Other expenses Rs. 10,000
Cash received on account of contract up to 31st march 2011 amounted to Rs. 2,56,000 being
80% of work certified. Of the plant and material charged to the contract plant costing Rs. 3000 and
material costing Rs. 4000/ were lost. On Ist March 2011, Plant which cost Rs. 2,000 was returned
to the store, the cost of work done but not certified was Rs. 3000 and material costing Rs. 2,500
were in hand on site. Provide 10% depreciation on plant, reserve 1/3 of profit received and prepare
contract account from the above particulars.
Solution
CONTRACT ACCOUNT

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

To Plant 30,000 Work certified
256000x100/80 3,20000
To wages 1,62,000 Work uncertified 3000 3,23,000
To other expenses 10,000 By P & L Account
Plant lost 3000
Material lost 4000 7000
By plant returned: 2,000
Less: depreciation 200 1,800
By material in hand 2,500
To Notional profit c/d (B. F) 52800 By plant at site(30000-3000-
2000) 25000
Less: depr 2500 22500
356800 356800
To P/L Account By notional profit B/d =========
28160
52800x2/3x80/100 52 800
24640
Reserve BF
52 800 52 800
======== =========

WORK IN PROGRESS ACCOUNT

To contract A/c 3 23,000 By Contract A/c (reserve) 24640
By Balance c/d 2,98,360
3,23,000 3,23,000
========== ==========

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

Example- 3
Mr. A has undertaken several contract works. He maintains a separate record for each contract.
From the records for the year ending 31-12-98, Prepare contract account for Contract No.50 and
find the amount transferred to profit and loss account.
Direct purchase of material 1,80,000
Material issued from stores 50,000
Wages 2,44000
Direct expenses 24,000
Machinery purchased 1,60,000
Establishment charges 54,000
The contract price was Rs. 15,00,000. Cash received up to 31-12-2008 was Rs. 6,00,000 which is
80% of work certified . Material at site Rs. 16,000. Depreciation for Machine Rs. 16,000.

Solution:
To materials: By material at site 16,000
Direct purchase 1,80,000 Machinery on hand (1,60,000- 1, 44,000
Issued from stores 50,000 16000)
Wages 2,44,000 Work certified 7, 50,000
Direct expenses 24,000
Machinery purchased 1,60,000
Establishment 54,000
Notional profit 1,98,000
9,10,000 9, 10,000
======= =======
To P/L account 1,05,600 By notional profit b/d 1,98,000
Work in progress A/c 92,400 1,98,000
1,98,000 =======
========
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 UNIT - IV

ACCOUNTING FOR MANAGEMENT- INTRODUCTION

Management accounting can be viewed as Management-oriented

Accounting. Basically it is the study of managerial aspect of financial
accounting,” accounting in relation to management function". It is developed
mainly to help the management in the discharge of its functions and for taking
various decisions.

The Report of the Anglo-American Council of Productivity (1950) has also

given a definition of management accounting, which has been widely accepted.
According to it, "Management accounting is the presentation of accounting
information in such a way as to assist the management in creation of policy and
the day to day operation of an undertaking".

According to the Institute of Chartered Accountants of England and Wales

“any form of accounting which enables a business to be conducted more
efficiently can be regarded as Management Accounting “

The term management accounting is composed of 'management' and

'accounting ‘It is the use of Accounting Information for discharging Management
functions, especially planning and decision making.

FUNCTIONS OF MANAGEMENT ACCOUNTING

The basic function of management accounting is to assist the management

in performing its functions effectively. The functions of the management are

planning, organizing, directing and controlling. Management accounting helps

in the performance of each of these functions in the following ways:

(i) Provides data: Management accounting serves as a vital source of data for
management planning. The accounts and documents are a repository of a vast
quantity of data about the past progress of the enterprise, which are a must for
making forecasts for the future.

Modifies data: The accounting data required for managerial decisions is properly
compiled and classified. For example, purchase figures for different months may
be classified to know total purchases made during each period product-wise,
supplier-wise and territory-wise.
(iii) Analyses and interprets data: The accounting data is analyzed
meaningfully for effective planning and decision-making. For this purpose the
data is presented in a comparative form. Ratios are calculated and likely trends
are projected.
(iv) Serves as a means of communicating: Management accounting provides a
means of communicating management plans upward, downward and outward
through the organization. Initially, it means identifying the feasibility and
consistency of the various segments of the plan. At later stages it keeps all
parties informed about the plans that have been agreed upon and their roles in
these plans.
(v) Facilitates control: Management accounting helps in translating given
objectives and strategy into specified goals for attainment by a specified time and
secures effective accomplishment of these goals in an efficient manner. All this is
made possible through budgetary control and standard costing which is an
integral part of management accounting.
(vi) Uses also qualitative information: Management accounting does not
restrict itself to financial data for helping the management in decision making
but also uses such information which may not be capable of being measured in
monetary terms. Such information may be collected form special surveys,
statistical compilations, engineering records, etc.
SCOPE OF MANAGEMENT ACCOUNTING
Management accounting is concerned with presentation of accounting
information in the most useful way for the management. Its scope is, therefore,
quite vast and includes within its fold almost all aspects of business operations.
However, the following areas can rightly be identified as falling within the ambit
of management accounting:
(i) Financial Accounting: Management accounting is mainly concerned with the
rearrangement of the information provided by financial accounting. Hence,
management cannot obtain full control and coordination of operations without a
properly designed financial accounting system.
(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost
analysis, differential costing and other cost techniques play a useful role in
operation and control of the business undertaking.
(iii) Revaluation Accounting: This is concerned with ensuring that capital is
maintained intact in real terms and profit is calculated with this fact in mind.
(iv) Budgetary Control: This includes framing of budgets, comparison of actual
performance with the budgeted performance, computation of variances, finding of
their causes, etc.
(v) Inventory Control: It includes control over inventory from the time it is
acquired till its final disposal.
(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers
and other statistical methods make the information more impressive and
intelligible.
(vii) Interim Reporting: This includes preparation of monthly, quarterly, half-
yearly income statements and the related reports, cash flow and funds flow
statements, scrap reports, etc.
(viii) Taxation: This includes computation of income in accordance with the tax
laws, filing of returns and making tax payments.
(ix) Office Services: This includes maintenance of proper data processing and
other office management services, reporting on best use of mechanical and
electronic devices.
(x) Internal Audit: Development of a suitable internal audit system for internal
control.
(xi)Management Information System [MIS]: Management Accounting serves as
a centre for collection and dissemination of information.MIS is an essential part
of Management Accounting.
MANAGEMENT ACCOUNTING AND FINANCIAL ACCOUNTING
Financial accounting and management accounting are closely interrelated
since management accounting is to a large extent rearrangement of the data
provided by financial accounting. Moreover, all accounting is financial in the
sense that all accounting systems are in monetary terms and management is
responsible for the contents of the financial accounting statements. In spite of
such a close relationship between the two, there are certain fundamental
differences. These differences can be laid down as follows:
(i) Objectives: Financial accounting is designed to supply information in the
form of profit and loss account and balance sheet to external parties like
shareholders, creditors, banks, investors and Government. Information is
supplied periodically and is usually of such type in which management is not
much interested. Management Accounting is designed principally for providing
accounting information for internal use of the management. Thus, financial
accounting is primarily an external reporting process while management
accounting is primarily an internal reporting process.
(ii) Analyzing performance: Financial accounting portrays the position of
business as a whole. The financial statements like income statement and balance
sheet report on overall performance or statues of the business. On the other
hand, management accounting directs its attention to the various divisions,
departments of the business and reports about the profitability, performance,
etc., of each of them.
(iii) Data used: Financial accounting is concerned with the monetary record of
past events. It is a post-mortem analysis of past activity and, therefore, out the
date for management action. Management accounting is accounting for future
and, therefore, it supplies data both for present and future duly analyzed in
detail in the 'management language' so that it becomes a base for management
action.
(iv) Monetary measurement: In financial accounting only such economic events
find place, which can be described in money. However, the management is
equally interested in non-monetary economic events, viz., technical innovations,
personnel in the organization, changes in the value of money, etc. These events
affect management's decision and, therefore, management accounting cannot
afford to ignore them.
(v) Periodicity of reporting: The period of reporting is much longer in financial
accounting as compared to management accounting. The Income Statement and
the Balance Sheet are usually prepared yearly or in some cases half-yearly.
Management requires information at frequent intervals and, therefore, financial
accounting fails to cater to the needs of the management. In management
accounting there is more emphasis on furnishing information quickly and at
comparatively short intervals as per the requirements of the management.
(vi) Precision: There is less emphasis on precision in case of management
accounting as compared to financial accounting since the information is meant
for internal consumption.
(vii) Nature: Financial accounting is more objective while management
accounting is more subjective. This is because management accounting is
fundamentally based on judgment rather than on measurement.
(viii) Legal compulsion: Financial accounting has more or less become
compulsory for every business on account of the legal provisions of one or the
other Act. However, a business is free to install or not to install system of
management accounting.
COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Cost accounting is the process of accounting for costs. It embraces the

accounting procedures relating to recording of all income and expenditure and
the preparation of periodical statements and reports with the object of
ascertaining and controlling costs. It is, thus, the formal mechanism by means of
which the costs of products or services are ascertained and controlled. On the
other hand, management accounting involves collecting, analyzing, interpreting
and presenting all accounting information, which is useful to the management. It
is closely associated with management control, which comprises planning,
executing, measuring and evaluating the performance of an organization. Thus,
management accounting draws heavily on cost data and other information
derived from cost accounting.

Today cost accounting is generally indistinguishable from the so-called

management accounting or internal accounting because it serves multiple
purposes. However, management accounting can be distinguished from cost
accounting in one important respect.

Management accounting has a wider scope as compared to cost

accounting. Cost accounting deals primarily with cost data while management
accounting involves the considerations of both cost and revenue. Management
accounting is an all inclusive accounting information system, which covers
financial accounting, cost accounting, and all aspects of financial management.
But it is not a substitute for other accounting functions. It involves a continuous
process of reporting cost, financial and other relevant data in an analytical and
informative way to management.

We should not be very much concerned with boundaries of cost accounting

and management accounting since they are complementary in nature. In the
absence of a suitable system of cost accounting, management accountant will not
be in a position to have detailed cost information and his function is bound to
lose significance. On the other hand, the management accountant cannot
effectively use the cost data unless it has been reported to him in a meaningful
and informative form.

OBJECTIVES OF MANAGEMENT ACCOUNTING

The primary objective is to enable the management to maximize profits or

minimize losses. The fundamental objective of management accounting is to
assist management in their functions.
The other main objectives are:

1. Planning and policy formulation: planning is one of the primary functions of

management. It involves forecasting on the basis of available information.

2. Help in the interpretation process: The main object is to present financial

information. The financial information must be presented in easily
understandable manner.

3. Helps in decision making: Management accounting makes decision making

process more modern and scientific by providing significant information relating
to various alternatives.

4. Controlling: The actual results are compared with pre determined objectives.
The management is able to control performance of each and every individual with
the help of management accounting devices.

5. Reporting: This facilitates management to take proper and timely decisions. It

presents the different alternative plans before the management in a comparative
manner.

6. Motivating: Delegation increases the job satisfaction of employees and

encourages them to look forward. so it serves as a motivational devise.

7. Helps in organizing: “return on capital employed” is one of the tools if

management accounting. All these aspects are helpful in setting up effective and
efficient organization.

8. Coordinating operations: It provides tools which are helpful in coordinating the

activities of different sections.

DISTINCTION BETWEEN FINANCIAL ACCOUNTING AND MANAGEMENT

ACCOUNTING

Financial accounting is concerned with the recording of day to day transactions

of the business. Management accounting is to provide the quantitative as well as
the qualitative to the management.

FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING

Objective
It gives the periodical reports to Its assist the internal management.
owners, creditors and government.
Nature
It concerned with historical records. It concerned with future plans and
 policies.
Subject matter
It deals the business as a whole. It deals only a limited coverage.
Flexibility
Here standards are fixed by external Standards are fixed by management
parties. itself.
Legal compulsion
Statutory for every business. Adopted on voluntary basis.
Periodicity of reporting
The period is longer Its prepared when its required.
Precision
Transactions are very accurate. Sometimes approximate figures are
used.
Unit of account
Recognizes whole business. Results of the divisions.
Coverage
Covers entire range of business in Non monetary items are considered.
monetary items.
Publication and audit
Its very essential for the use of public It.s for management only.
Accounting principles
It has principles and conventions No such principles.

LIMITATIONS OF MANAGEMENT ACCOUNTING

Management accounting, being comparatively a new discipline, suffers

from certain limitations, which limit its effectiveness. These limitations are as
follows:

1. Limitations of basic records: Management accounting derives its information

from financial accounting, cost accounting and other records. The strength and
weakness of the management accounting, therefore, depends upon the strength
and weakness of these basic records. In other words, their limitations are also
the limitations of management accounting.
2. Persistent efforts. The conclusions draws by the management accountant are
not executed automatically. He has to convince people at all levels. In other
words, he must be an efficient salesman in selling his ideas.

3. Management accounting is only a tool: Management accounting cannot

replace the management. Management accountant is only an adviser to the
management. The decision regarding implementing his advice is to be taken by
the management. There is always a temptation to take an easy course of arriving
at decision by intuition rather than going by the advice of the management
accountant.

4. Wide scope: Management accounting has a very wide scope incorporating

many disciplines. It considers both monetary as well as non-monetary factors.
This all brings inexactness and subjectivity in the conclusions obtained through it.

5. Top-heavy structure: The installation of management accounting system

requires heavy costs on account of an elaborate organization and numerous rules
and regulations. It can, therefore, be adopted only by big concerns.

6. Opposition to change: Management accounting demands a break away from

traditional accounting practices. It calls for a rearrangement of the personnel and
their activities, which is generally not like by the people involved.

7. Evolutionary stage: Management accounting is still in its initial stage. It has,

therefore, the same impediments as a new discipline will have, e.g., fluidity of
concepts, raw techniques and imperfect analytical tools. This all creates doubt
about the very utility of management accounting.

RECENT TRENDS IN MANAGEMENT REPORTING

Reporting is the process of communicating of information to those who

need such information relevant for decision making. Some trends in reporting are:

1. Financial reporting using IFRS

International Financial Reporting Standards [IFRS] is recognized as

global financial reporting standards. From 1st April 2011 Indian Accounting
Standards were merged with the new IFRS.IFRS ensures more transparency,
consistency and uniformity in accounting policies.

2. Interim Reporting

Interim Reporting is the reporting of financial results of any period that is

shorter than a fiscal year. SEBI guidelines require companies listed on Stock
Exchanges to publish their financial results on quarterly basis.
3. Segmental Reporting [AS-7]

It is the reporting of the operation segments of a company in the

disclosure accompanying financial statements. AS 17 requires to report a
segment if it has at least 10% of the revenue, 10% of the profit or loss, or 10% of
the combined assets of the company.

4. Corporate Governance Report

The SEBI regulates governance practices of companies listed on Stock

Exchanges. These regulations are notified under clause 49 of the Listing
Agreements of Stock Exchanges. It prescribes the standards to be followed in the
governance of the companies.

5. Reporting of Information Relating to Group Companies [AS 21]

AS 21 requires companies to prepare consolidated Financial

Statements. It is the presentation of subsidiary companies. The objective of
consolidation is to show the performance of the group as if it were a single entity.
The inter group transactions are eliminated in the consolidated Financial
Statements.

Meaning of Ratio

A ratio is a simple arithmetical expression of the relationship of one

number to another. It may be defined as the indicated quotient of two
mathematical expressions. According to Accountant’s Handbook by Wixon , Kell
and Bedford, a ratio is an expression of the quantitative relationship between two
numbers. In simple language ratio is one number expressed in terms of another
and can be worked out by dividing one number into the other. A ratio can be
expressed in the form of a fraction, number of times, percentage or in proportion.

Nature of Ratio analysis

Ratio analysis is a technique of analysis and interpretation of financial

statements. It is the process of establishing and interpreting various ratios for
helping in making certain decisions. It is not an end in itself and is only a means
of better understanding of financial strengths and weakness of a firm. A ratio will
be meaningful only when it is analysed and interpreted. The following are the
four steps involved in ratio analysis.

1. Selection of relevant data from the financial statements depending upon the
objective of the analysis.

2. Solution of appropriate ratios from the above data

3. Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the ratios of
some other firms or the comparison with ratios of the industry to which the firm
belongs.

4. Interpretation of the ratios.

Ratio analysis will be meaningful only when the analyst will consider the
following factors while interpreting ratios:

1. Accuracy of financial statements

2. Clear about the objective or Purpose of analysis

3. Selection of appropriate ratios that suits the need of the analyst

4. Use of appropriate standards while analyzing ratios

5. Calibre of the analyst

6. Analyst should understand that the ratios provide only a base

Use and Significance of Ratio analysis

Mainly the persons interested in the analysis of the financial statements

can be grouped under three heads (i) Owners or investors, (ii) Creditors and (iii)
Financial executives. The importance of analysis varies materially with the
purpose for which it is calculated. The primary information which seeks to be
obtained from these statements differs considerable reflecting the purpose that
the statement is to serve.

The significance of these ratios varies for these three groups as their
purpose differs widely. These investors are mainly concerned with the earning
capacity of the company whereas the creditors including bankers and financial
institutions are interesting in knowing the ability of enterprise to meet its
financial obligations timely. The financial executives are concerned with evolving
analytical tools that will measure and compare costs, efficiency, liquidity and
profitability with a view to making intelligent decisions.

{a} Managerial uses of Ratio analysis

1. Helps in decision making

2. Helps in financial forecasting and planning

3. Helps in communicating

4. Helps in co-ordination
5. Helps in control

{b}Utility to Share holders/ Investors

An investor is particularly interested to know about the Long term financial

position and profitability position. Ratio analysis will be useful to the investor in
making up his mind whether present financial position of the concern warrants
further investment or not.

{c}Utility to Creditors

The creditors or suppliers extend short term credit to the concern. They are
interested to know whether financial position of the concern warrants their
payments at a specified time or not.

{d}utility to the Employees

The employees are also interested in the financial position of the concern
especially profitability because their wage increases and amount of fringe benefits
are related to the volume of profits earned by the concern.

{e}Utility to government

Government is interested to know the overall strength of the industry.

Various financial statements published by industrial units are used to calculate
ratios for determining short term, long term and overall financial position of the
concerns. Ratio analysis also serves this purpose.

{f}Tax audit requirements

Clause 32 of the Income tax Act requires that the business should
calculate Gross Profit/turnover, Net Profit/turnover , stock in trade/ turnover
and Material consumed/finished goods produced ratios.

LIMITATIONS OF RATIO ANALYSIS

The ratio analysis is one of the most powerful tools of financial

management. Though ratios are simple to calculate and easy to understand, they
suffer from some serious limitations.

1. Limited use of a single ratio. A single ratio usually does not convey much
of a sense. To make a better interpretation a number of ratios have to be
calculated which is likely to confuse the analyst than help him in making any
meaningful conclusion.

2. Lack of adequate standards. There are no well accepted standards or

rules of thumb for all ratios which can be accepted as norms. It renders
interpretation of the ratios difficult.
 3. Inherent limitations of accounting. Like financial statements, ratios also
suffer from the inherent weakness of accounting records such as their historical
nature. Ratios of the past are not necessarily true indicators of the future.

4. Change of accounting procedure. Change in accounting procedure by a

firm often makes ratio analysis misleading. E.g., a change in the valuation
methods of inventories, from FIFO to LIFO increases the cost of sales and
reduces considerably the value of closing stocks which makes stock turnover
ratio to be lucrative and an unfavorable gross profit ratio.
5. Window dressing. Financial statements can easily be window dressed to
present a better picture of its financial and profitability position to outsiders.
Hence, one has to be very careful in making a decision from ratios calculated
from such financial statements. But it may be very difficult for an outsider to
know about the window dressing made by the firm.

6. Personal bias Ratio are only means of financial analysis and not an end
in itself. Ratios have to be interpreted and different people may interpret the
same ratio in different ways.

7. Incomparable. Not only industries differ in their nature but also the
firms of the similar business widely differ in their size and accounting procedures
etc. It makes comparison of ratios difficult and misleading. Moreover,
comparisons are made difficult due to differences in definitions of various
financial terms used in ratio analysis.

8. Absolute Figures Distortive. Ratios devoid of absolute figures may prove

distortive as ratio analysis is primarily a quantitative analysis and not a
qualitative analysis

9. Price level changes. While making ratio analysis, no consideration is

made to the changes in price levels and this makes the interpretation of ratios
invalid.

10. Ratios no substitutes. Ratio analysis is merely a tool of financial

statements. Hence, ratios become useless if separated from the statements from
which they are computed.

CLASSIFICATION OF RATIOS

The use of ratio analysis is not confined to financial manger only. There are
different parties interested in the ratio analysis for knowing the financial position
of the firm for different purposes. In view of various users of ratios, there are
many types of ratios which be calculated from the information given in the
financial statements. The particular purpose of the use determines the particular
ratios that might be used for financial analyses
 Ratios can be classified on the basis of function, significant and statement
of ratios or traditional classification of ratios.

On the basis of the functions performed ratios can be classified in to the

following types :-
FUNCTIONAL CLASSIFICATION OF RATIOS

LIQUIDITY RATIOS LONG TERM ACTIVITY RATIOS PROFITABILITY

SOLVENCY AND OR ASSET RATIOS
LEVERAGE MANAGEMENT
RATIOS

[A]1.Current Ratio Debt/Equity Inventory In relation to Sales

Ratio Turnover Ratio
1.Gross Profit Ratio

2.Liquid(Acid) Debt to total Debtors Turnover 2.Operating Ratio

Ratio or Quick capital ratio Ratio
Ratio

3.Absolute Liquid Interest Fixed Assets 3.Operating Profit

or Cash ratio coverage Ratio turnover Ratio Ratio

[B]1.Debtors Cash flow/Debt Total assets 4.Net profit Ratio

turnover Ratio ratio turnover ratio

2.Creditors Capital Gearing Working capital 5.Expense Ratio

Turnover ratio Ratio Turnover ratio

3.Inventory Payables turnover In relation to

turnover ratio ratio Investments

1.Return on
Investments

Capital employed 2.Return on capital

turnover ratio

3.Return on Equity
Capital

4.Return on Total
Resources

5.Earnings Per
share

6.Price Earning
ratio
ANALYSIS OF SHORT-TERM FINANCIAL POSITION OR TEST OF LIQUIDITY

The short term creditors of a company like suppliers of goods of credit and
commercial banks providing short-term loans are primarily interested in knowing
the company’s ability to meet its current or short term obligations as and when
these become due. The short term obligations of a firm can be met only when
there are sufficient liquid assets. Therefore, a firm must ensure that it does not
suffer from lack of liquidity or the capacity to pay its current obligations. Even a
very high degree of liquidity is not good for the firm because such a situation
represents unnecessarily excessive funds of the firm being tied up in current
assets. Two types of ratios can be calculated for measuring short term financial
position or short term solvency of the firm.

A. Liquidity Ratios B. Current assets movement or Efficiency Ratios

A. Liquidity Ratios

Liquidity refers to the ability of a concern to meet its current obligations as and
when these become due. The short term obligations are met by realizing amounts
from current, floating or circulating assets. The current assets should either be
liquid or near liquidity. These should be convertible into cash for paying
obligations of short term nature. The sufficiency or insufficiency of current assets
should be assessed by comparing them with short term (current) Liabilities. If
current assets can pay off the current liabilities, then liquidity position will be
satisfactory. The important liquidity ratios include

1. Current ratio

Current ratio may be defined as the relationship between current assets

and current liabilities. This ratio, also known as working capital ratio, is a
measure of general liquidity and is most widely used to make the analysis of a
short term financial position or liquidity of the firm. It is calculated by dividing
the total of current assets by total of the current liabilities.

Cu rrent Assets
Current ratio=
Cu rrent Lia bilites

Current assets include cash and those assets which can be converted into
cash within a short period of time, generally, one year, such as marketable
securities, bills receivables, sundry debtors, inventories, work-in-progress etc.
Prepaid expenses should also be included in current assts because they
represent payments made in advance which will not have to be paid in ear future.
Current liabilities are those obligations which are payable within a short period
of generally one year and include outstanding expenses, bills payable, sundry
creditors, accrued expenses, short term advances, income tax payable, dividend
payable, etc. Bank overdraft should also generally be included in current
liabilities because it represents short term arrangement with the bank and is
payable within a short period. But where bank overdraft is a permanent or long
term arrangement with the bank, it should be excluded.

A relatively high current ratio is an indication that the firm is liquid and
has the ability to pay its current obligations in time as and when they become
due. An increase in current ratio represents the improvement in the liquidity
position of the firm while a decrease in the current ratio indicates that there has
been deterioration in the liquidity position of the firm. As a convention a
minimum of 2: 1 is considered as the standard current ratio of a firm.

Illustration 1: On December 31, 2010 Company B had total asset of 150,000,

equity of 75,000, non-current assets of 50,000 and non-current liabilities of
0,000. Calculate the current ratio.

Solution
To calculate current ratio, we need to calculate current assets and current
liabilities first:
Current Assets = Total Asset − Non-Current Assets =150,000 − 50,000 = 100,000
Total Liabilities = Total Assets − Total Equity = 150,000 − 75,000 =75,000
Current Liabilities = 75,000 − 50,000 = 25,000
Current Ratio = 100,000 ÷ 25,000 = 4

Illustration 2

X Ltd. has a current ratio of 3.5:1 and quick ratio of 2:1. If excess of current
assets over quick assets represented by stock is Rs. 1, 50,000, calculate current
assets and current liabilities.

Solution
Let Current Liabilities = x
Current Assets = 3.5x
And Quick Assets = 2x
Stock = Current Assets – Quick Assets
1,50,000 = 3.5x – 2x
1,50,000 = 1.5x
x = Rs.1,00,000
Current Assets = 3.5x = 3.5 × 1,00,000 = Rs. 3,50,000.
2. Quick Ratio

Quick ratio, also known as Acid Test Ratio or Liquid Ratio, is a more
rigorous test of liquidity than the current ratio. The term liquidity refers to the
ability of a firm to pay its short term obligations as and when they become due.
Quick ratio may be defined as the relationship between quick/liquid assets and
current or liquid liabilities. An asset is said to be liquid if it can be converted into
cash within a short period without loss of value. In that sense cash in hand and
cash at bank are the most liquid assets. The other liquid assets include bills
receivable, sundry debtors, marketable securities and short term or temporary
investments. Prepaid expenses and Inventories cannot be termed as liquid asset
because they cannot be converted into cash without loss of value. A ratio of 1:1 is
considered as satisfactory quick ratio.

Qu ick / Liqu id Assets

Quick Ratio =
Cu rrent Lia bilites

Illustration 3

Calculate the current ratio from the following information:

Working capital Rs. 9,60,000; Total debts Rs.20,80,000; Long-term Liabilities

Rs.16,00,000; Stock Rs. 4,00,000; prepaid expenses Rs. 80,000.

Solution

Current Liabilities = Total debt- Long term debt

= 20,80,000 – 16,00,000

= 4,80,000

Working capital = Current Assets – Current liability

9,60,000 = Current Assets – 4,80,000

Current Assets = 14,40,000

Quick Assets = Current Assets – (stock + prepaid expenses)

= 14,40,000 – (4,00,000 + 80,000)

= 9,60,000

Current ratio = Current Assets / Current liabilities

= 14,40,000/4,80,000

= 3:1
Quick ratio = Quick Assets / Current liabilities

= 9,60,000/4,80,000

= 2:1

Illustration 4

Calculate quick ratio from the information

Stock Rs .60,000 ; Cash 40,000; Debtors 40,000; Creditors 50,000

Bills Receivable 20,000; Bills Payable 30,000; Advance Tax 4,000

Bank Overdraft 4,000; Debentures Rs. 2,00,000; Accrued interest Rs. 4,000.

Solution
Quick Assets = Current Assets – Stock – Advance Tax
Quick Assets = Rs. 1,68,000 – (Rs. 60,000 + Rs. 4,000) = Rs. 1,04,000
Current Liabilities = Rs. 84,000
Quick ratio = Quick Assets / Current Liabilities
= Rs. 1,04,000 : Rs. 84,000
= 1.23:1

3. Absolute Liquid Ratio or Cash Ratio

Absolute Liquid Ratio is calculated by dividing Absolute Liquid assets by

current Liabilities .Absolute Liquid Assets include cash in hand and at bank and
marketable securities or temporary investments. The acceptable norm for this
ratio is 50% or 0.5 :1 or 1 :2.

Illustration 5

Calculate Absolute Liquid ratio from the following information

Goodwill 50000 Cash at Bank 30000
Plant and machinery 400000 Inventories 75000
Trade investments 200000 Bank overdraft 70000
Marketable securities 150000 Sundry creditors 60000
Bills receivable 40000 Bills payable 90000
Cash in hand 45000 Outstanding expenses 30000
Solution

Absolu te Liqu id Assets

Absolute Liquid Ratio =
Cu rrent Lia bilites

Absolute Liquid assets = Mark. Securities+ Cash in hand and at Bank

= 150000+45000+30000 = 225000

Current Liabilities = BOD + Creditors + B/P+O/S Expenses

= 70000+60000+90000+30000 = 250000

Absolute Liquid Ratio = Absolu te Liqu id Assets

= 225000
= 0.9
Cu rrent Lia bilites 250000

Practice Problems

1. Find out current ratio.

Gross Debtors Rs. 20,000; Provision for Bad debts Rs. 3,000; Bills receivable
Rs. 13,000; Stock twice of net debtors; Cash in hand Rs. 16,000; Advance to
suppliers Rs. 15,000; Creditors for goods Rs. 27,000; Bills payable Rs. 8,000;
Outstanding expenses Rs. 15,000; Prepaid expenses Rs. 5,000 Investment (Long
term) Rs. 12,000;

[Ans. Current Ratio 2:1]

2. Find out current liabilities when current ratio is 2.5:1 and current assets
are Rs. 75,000.

[Ans. Current Liabilities Rs. 30,000]

3. The ratio of current assets (Rs. 6, 00,000) to current liabilities is 1.5:1. The
accountant of this firm is interested in maintaining a current ratio of 2:1 by
paying some part of current liabilities. You are required to suggest him the
amount of current liabilities which must be paid for this purpose.

[Ans. Rs. 2, 00,000]

4. A firm had current liabilities of Rs. 90,000. It then acquired stock-in-trade at a

cost of Rs. 10,000 on credit. After this acquisition the current ratio was 2:1.
Determine the size of current assets and working capital after and before the
stock was acquired.

[Ans. C.A. Rs. 2,00,000, Rs. 1,90,000; W.C. Rs. 1,00,000, Rs. 1,00,000]
 5.A Ltd. company has a current ratio of 3.5:1 and acid test ratio of 2:1. If
the inventory is Rs. 30,000, find out its total current assets and total current
liabilities.

[Ans. Current Assets Rs. 70,000; Current Liabilities Rs. 20,000]

6.Given: Current ratio 2.8; Acid test ratio 1.5; Working capital = Rs.
1,62,000.

Find out: Current assets;, Current liabilities; Liquid Assets.

[Ans. A) Rs. 2,52,000; (b) Rs. 90,000; (c) 1,35,000]

ANALYSIS OF SOLVENCY – SOLVENCY RATIOS

The term solvency refers to the ability of a firm to meet all liabilities in full
in the event of liquidation. It is the long- term liquidity of the firm. The Balance
sheet discloses the long term financial position in the form of sources and
applications of long term funds in the business. The important measures of
solvency and analysis of capital structure are

1. Debt-Equity Ratio

A firm uses both equity and debt for financing its assets. The ratio of these
two sources of funds is turned as Debt Equity Ratio.

Tot al borrow ed funds

Debt Equity Ratio =
Ow ned fund s

Total Borrowed funds include both long term and short term borrowings or
current liabilities. It is the aggregate of bonds, debentures, bank loans and all the
current liabilities.

Owned funds include equity capital, preference capital and all items of reserve
and surplus.

The standard norm of Debt-Equity ratio is 2:1. It indicates that total borrowed
fund can be two times of equity or owned funds. The intention is to maximize the
return of equity share holders by taking, advantage of cheap borrowed funds.

2. Capital Gearing Ratio

This ratio indicates the relationship between fixed interest bearing

securities and equity shareholders funds.

Fixed Income bearing securites

Capital Gearing Ratio =
Equ ity Shareholders funds
Fixed income bearing securities are Debentures, Bonds and Preference shares.

Equity shareholders funds include Equity share capital and Reserves and
Surpluses.

A firm is said to be highly geared when it uses more of fixed income bearing
securities like bonds, debentures and preference share capital.. It indicates the
risk perception of investors is high. If the ratio is less than one, the firm is said to
be low geared. The position of creditors is more safe when the firm is low geared.

3. Propreitory ratio/ Equity Ratio

It is the ratio of shareholders funds to Total Assets of the firm. It indicates

the relative contribution of owners or shareholders in financing total assets. This
ratio is also called net worth to Total Assets Ratio. This ratio establishes the
relationship between shareholder’s funds to total assets of the firm.

Sha rehold ers fu n d s

Proprietary ratio/ Equity Ratio
Tot a l Assets

Where shareholders funds = Equity share capital+ preference share capital+

undistributed profits+ reserves and surpluses

Total assets = Total resources of the concern

4. Solvency Ratio

It is the ratio of total borrowed funds to total assets (also equal to total
liabilities). It indicates the relative contribution of outsiders in financing the
assets of the firm. It is calculated as :-

Tot a l Borrow ed fu n d s
Solvency ratio =
Tot a l Assets

Or Solvency Ratio = 100- Equity Ratio

A high ratio indicates that the firm is depending more on outsiders’ funds
in financing assets. The position of creditors is not safe in the event of winding
up.

5. Ratio of Fixed assets to Net worth.

The ratio shows the relationship between net fixed assets and Net worth

Net Fixed Assets

i.e, Ratio of Fixed assets to Net worth =
Net Wor th
6. Funded Debt to capitalization

This ratio indicates the contribution of owners in financing fixed assets. If

the ratio is less than one, it is considered as ideal. It means that the whole of
fixed assets and a part of working capital are financed from shareholders funds.
If the ratio is more than one, it means that a part of the fixed assets is financed
using borrowed funds.

Lon g term d ebt

Funded Debt to capitalization =
Tota l Assets or Tot a l Lia bilites

Illustration 6

The following Balance sheets of ABC Limited is given. Calculate.

(a)Current Ratio
(b)Acid Test Ratio
(c)Debt- Equity Ratio
(d)Proprietary ratio
(e) Capital gearing ratio
(f)Fixed assets to shareholders Funds Ratio

Balance sheet as at 31st March 2012

Liabilities Amount Assets Amount

Equity share capital 150000 Fixed Assets 150000

5% Preference share capital 20000 Inventory 50000

General Reserve 25000 debtors 25000

Profit and Loss A/c 20000 cash 90000

6% Debentures 55000

Creditors 45000

315000 315000

Solution

(a)Current ratio = current assets / current liabilities = 165000/45000 = 3.67 :1

Current assets = inventory + debtors + cash = 50000+25000+90000 = 165000

[b] Liquid ratio = liquid liabilities / current liabilities

Liquid assets -= current assets – inventory = 165000-50000 = 115000

Liquid ratio = 165000/45000 = 2.56 :1

[c] debt equity ratio = outsiders funds / shareholders funds

Outsiders funds = debentures + creditors = 55000+45000 = 100000

Shareholders’ funds = equity capital + preference capital + reserves+ profit and

loss account

= 150000+20000+25000+20000 = 215000

Debt equity ratio = 100000/215000 = 0.46 :1

[d]Proprietary ratio = Shareholder’s Funds / Total Assets

Shareholder’s Funds = 215000 / 315000 = 0.68 :1

Fixed Income bearing Securities

[e] Capital gearing ratio =
Equity Shareholders fund

= 75000/195000 = 0.38 :1

Fixed Assets
[f] Fixed assets to shareholders funds =
Shareholders fund

= 150000/215000 = 0.69 :1

Activity Ratios

Activity ratios, sometimes referred to as operating ratios or management ratios,

measure the efficiency with which a business uses its assets, such as
inventories, accounts receivable, and fixed (or capital) assets. The more
commonly used operating ratios are the average collection period, the inventory
turnover, the fixed assets turnover, and the total assets turnover.

These ratios indicate the efficiency of management in the use of resources,

both short term and long term. The overall performance of a company is
evaluated on the basis of its ability to make sales using minimum resources.
Turnover ratios reflect the speed at which assets are utilized in effecting sales. A
higher turnover ratio means efficient use of funds by management in generating
more sales. The important turnover ratios are :
1. Inventory turnover ratio

2. Debtors turnover ratio

3. Creditors turnover ratio

4. Total assets turnover ratio

5. fixed assets turnover ratio

6. Working capital turnover ratio

1. Inventory turnover ratio

Inventory Turnover: This ratio measures the number of times a company's

investment in inventory is turned over during a given year. The higher the
turnover ratio, the better, since a company with a high turnover requires a
smaller investment in inventory than one producing the same level of sales with a
low turnover rate. Company management has to be sure, however, to keep
inventory at a level that is just right in order not to miss sales.

This ratio indicates the efficiency in turning over inventory and can be compared
with the experience of other companies in the same industry. It also provides
some indication as to the adequacy of a company's inventory for the volume of
business being handled. If a company has an inventory turnover rate that is
above the industry average, it means that a better balance is being maintained
between inventory and cost of goods sold. As a result, there will be less risk for
the business of being caught with top-heavy inventory in the event of a decline in
the price of raw materials or finished products.

Cost of good s sold

Inventory

Some companies calculate the inventory turnover by using sales instead of cost
of goods sold as the numerator. This may be less appropriate because sales
include a profit markup which is absent from inventory.

Inventory includes all types of stocks like raw materials, work in progress,
finished goods, consumable stores, spares etc. Inventory turnover ratio is the
relationship of cost of goods sold to average inventory. It is computed as:

Inventory turnover ratio = cost of goods sold/ average inventory

Cost of goods sold = net sales – gross profit

Cost of goods sold = opening stock +net purchases + direct expenses – closing
stock

Average inventory = opening inventory +closing inventory/2

DEBTORS TURNOVER RATIO

A concern may sell goods on cash as well as on credit. Credit is one of the
important elements of sales promotion. The volume of sales can be increased by
following a liberal credit policy.

The effect of a liberal credit policy may result in tying up substantial funds
of a firm in the form of trade debtors (or receivables). Trade debtors are expected
to be converted into cash within a short period of time and are included in
current assets. Hence, the liquidity position of concern to pay its short term
obligations in time depends upon the quality of its trade debtors.

Debtors turnover ratio or accounts receivable turnover ratio indicates the

velocity of debt collection of a firm. In simple words it indicates the number of
times average debtors (receivable) are turned over during a year.

Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors

The two basic components of accounts receivable turnover ratio are net
credit annual sales and average trade debtors. The trade debtors for the purpose
of this ratio include the amount of Trade Debtors & Bills Receivables. The
average receivables are found by adding the opening receivables and closing
balance of receivables and dividing the total by two. It should be noted that
provision for bad and doubtful debts should not be deducted since this may give
an impression that some amount of receivables has been collected. But when the
information about opening and closing balances of trade debtors and credit sales
is not available, then the debtors turnover ratio can be calculated by dividing the
total sales by the balance of debtors (inclusive of bills receivables) given. and
formula can be written as follows.

Debtors Turnover Ratio = Total Sales / Debtors

Accounts receivable turnover ratio or debtors turnover ratio indicates the

number of times the debtors are turned over a year. The higher the value of
debtors turnover the more efficient is the management of debtors or more liquid
the debtors are. Similarly, low debtors turnover ratio implies inefficient
management of debtors or less liquid debtors. It is the reliable measure of the
time of cash flow from credit sales. There is no rule of thumb which may be used
as a norm to interpret the ratio as it may be different from firm to firm.
Illustration 7

Credit sales 25,000; Return inwards1,000; Debtors 3,000; Bills Receivables

1,000.

Calculate debtors turnover ratio

Debtors Turnover Ratio = Net Credit Sales / Average Trade Debtors

= 24,000 / 4,000

= 6 Times

Average Collection Period Ratio:

Average Collection Period. This ratio measures how long a firm's average
sales remains in the hands of its customers. A longer collection period
automatically creates a larger investment in assets.

The average collection period is calculated in two steps. The first step is
calculating the average daily sales, which is done by dividing the total annual net
sales by 365 days. The second step is dividing the average daily sales into
accounts receivable.

Accounts
receivable

Average daily
sales

The Debtors/Receivable Turnover ratio when calculated in terms of days is

known as Average Collection Period or Debtors Collection Period Ratio.

The average collection period ratio represents the average number of days for
which a firm has to wait before its debtors are converted into cash.

Following formula is used to calculate average collection period:

(Trade Debtors × No. of Working Days) / Net Credit Sales

Illustration 8

Credit sales 25,000; Return inwards 1,000; Debtors 3,000; Bills Receivables
1,000.
Calculate average collection period.

Solution:

Average collection period can be calculated as follows:

Average Collection Period = (Trade Debtors × No. of Working Days) / Net Credit
Sales

4,000 × 360 / 24,000 = 60 Days

Debtors and bills receivables are added.

For calculating this ratio usually the number of working days in a year is
assumed to be 360.

This ratio measures the quality of debtors. A short collection period implies
prompt payment by debtors. It reduces the chances of bad debts. Similarly, a
longer collection period implies too liberal and inefficient credit collection
performance. It is difficult to provide a standard collection period of debtors.

Creditors / Accounts Payable Turnover Ratio:

This ratio is similar to the debtor’s turnover ratio. It compares creditors

with the total credit purchases.

It signifies the credit period enjoyed by the firm in paying creditors.

Accounts payable include both sundry creditors and bills payable. Same as
debtor’s turnover ratio, creditors turnover ratio can be calculated in two forms,
creditors turnover ratio and average payment period.

Following formula is used to calculate creditors turnover ratio:

Creditors Turnover Ratio = Credit Purchase / Average Trade Creditors

Average payment period ratio gives the average credit period enjoyed from the
creditors. It can be calculated using the following formula:

Average Payment Period = Trade Creditors / Average Daily Credit Purchase

Average Daily Credit Purchase= Credit Purchase / No. of working days in a year

Or

Average Payment Period = (Trade Creditors × No. of Working Days) / Net Credit
Purchase

(In case information about credit purchase is not available total purchases may be
assumed to be credit purchase.)
 The average payment period ratio represents the number of days by the
firm to pay its creditors. A high creditor’s turnover ratio or a lower credit period
ratio signifies that the creditors are being paid promptly. This situation enhances
the credit worthiness of the company. However a very favorable ratio to this effect
also shows that the business is not taking the full advantage of credit facilities
allowed by the creditors.

Fixed Assets Turnover: The fixed (or capital) assets turnover ratio measures
how intensively a firm's fixed assets such as land, buildings, and equipment are
used to generate sales. A low fixed assets turnover implies that a firm has too
much investment in fixed assets relative to sales; it is basically a measure of
Sales
productivity.
Fixed Assets

Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio
measures the efficiency and profit earning capacity of the concern.

Higher the ratio, greater is the intensive utilization of fixed assets. Lower ratio
means under-utilization of fixed assets. The ratio is calculated by using following
formula:

Fixed assets turnover ratio turnover ratio is also calculated by the following
formula:

Fixed Assets Turnover Ratio = Cost of Sales / Net Fixed Asset

If a business shows a weakness in this ratio, its plant may be operating below
capacity and the manage should be looking at the possibility of selling the less
productive assets.

Total Assets Turnover. This ratio takes into account both net fixed asset; and
current assets. It also gives an indication of the efficiency with which assets are
used; a low ratio means that excessive assets are employed to generate sales
and/or that some assets (fixed or current assets) should be liquidated or
Sales
reduced.
Tota l Assets

Working Capital Turnover Ratio:

Working capital turnover ratio indicates the velocity of the utilization of net
working capital.
This ratio represents the number of times the working capital is turned over in
the course of year and is calculated as follows:

Following formula is used to calculate working capital turnover ratio

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

The two components of the ratio are cost of sales and the net working capital. If
the information about cost of sales is not available the figure of sales may be
taken as the numerator. Net working capital is found by deduction from the total
of the current assets the total of the current liabilities.

Illustration 9

Cash 10,000
Bills Receivables 5,000
Sundry Debtors 25,000
Stock 20,000
Sundry Creditors 30,000
Cost of sales 150,000

Calculate working capital turnover ratio

Solution:-

Working Capital Turnover Ratio = Cost of Sales / Net Working Capital

Current Assets = 10,000 + 5,000 + 25,000 + 20,000 = 60,000

Current Liabilities = 30,000

Net Working Capital = Current assets – Current liabilities

= 60,000 − 30,000 = 30,000

So the working Capital Turnover Ratio = 150,000 / 30,000 = 5 times

The working capital turnover ratio measures the efficiency with which the
working capital is being used by a firm. A high ratio indicates efficient utilization
of working capital and a low ratio indicates otherwise. But a very high working
capital turnover ratio may also mean lack of sufficient working capital which is
not a good situation.

PROFITABILITY RATIOS

Profitability ratios may be classified in to two types :

[a] operating profitability ratios

[b]overall profitability ratios

[a] operating profitability ratios

In this type of analysis profit is related to the volume of operation or sales.

The important measures of operating profitability are :

1. Gross profit ratio

2. Operating profit ratio

3. Operating ratio

4. Net profit ratio

1. Gross Profit Ratio (GP Ratio)::

Gross profit ratio (GP ratio) is the ratio of gross profit to net sales expressed
as a percentage. It expresses the relationship between gross profit and sales.

The basic components for the solution of gross profit ratio are gross profit and
net sales. Net sales mean those sales minus sales returns. Gross profit would be
the difference between net sales and cost of goods sold. Cost of goods sold in the
case of a trading concern would be equal to opening stock plus purchases, minus
closing stock plus all direct expenses relating to purchases. In the case of
manufacturing concern, it would be equal to the sum of the cost of raw materials,
wages, direct expenses and all manufacturing expenses. In other words, generally
the expenses charged to profit and loss account or operating expenses are
excluded from the solution of cost of goods sold.

Following formula is used to calculate gross profit ratios:

[Gross Profit Ratio = (Gross profit / Net sales) × 100]

Illustration 10

Total sales = 520,000; Sales returns = 20,000; Cost of goods sold 400,000

Required: Calculate gross profit ratio.

Solution :

Gross profit = [(520,000 – 20,000) – 400,000]

= 100,000
Gross Profit Ratio = (100,000 / 500,000) × 100

= 20%

Gross profit ratio may be indicated to what extent the selling prices of goods per
unit may be reduced without incurring losses on operations. It reflects efficiency
with which a firm produces its products. As the gross profit is found by
deducting cost of goods sold from net sales, higher the gross profit better it is.
There is no standard GP ratio for evaluation. It may vary from business to
business. However, the gross profit earned should be sufficient to recover all
operating expenses and to build up reserves after paying all fixed interest charges
and dividends.

Causes/reasons of increase or decrease in gross profit ratio:

It should be observed that an increase in the GP ratio may be due to the following
factors.

1. Increase in the selling price of goods sold without any corresponding

increase in the cost of goods sold.

2. Decrease in cost of goods sold without corresponding decrease in selling

price.

3. Omission of purchase invoices from accounts.

4. Under valuation of opening stock or overvaluation of closing stock.

On the other hand, the decrease in the gross profit ratio may be due to the
following factors.

1. Decrease in the selling price of goods, without corresponding decrease in

the cost of goods sold.

2. Increase in the cost of goods sold without any increase in selling price.

3. Unfavorable purchasing or markup policies.

4. Inability of management to improve sales volume, or omission of sales.

5. Over valuation of opening stock or under valuation of closing stock

Hence, an analysis of gross profit margin should be carried out in the light of
the information relating to purchasing, mark-ups and markdowns, credit and
collections as well as merchandising policies.
Net Profit Ratio (NP Ratio):

Net profit ratio is the ratio of net profit (after taxes) to net sales. It is expressed
as percentage.

The two basic components of the net profit ratio are the net profit and sales.
The net profits are obtained after deducting income-tax and, generally, non-
operating expenses and incomes are excluded from the net profits for calculating
this ratio. Thus, incomes such as interest on investments outside the business,
profit on sales of fixed assets and losses on sales of fixed assets, etc are excluded.

Net Profit Ratio = (Net profit / Net sales) × 100

Illustration 11

Total sales = 520,000; Sales returns = 20,000; Net profit 40,000

Calculate net profit ratio.

Solution:
Net sales = (520,000 – 20,000) = 500,000
Net Profit Ratio = [(40,000 / 500,000) × 100]
= 8%

NP ratio is used to measure the overall profitability and hence it is very useful to
proprietors. The ratio is very useful as if the net profit is not sufficient, the firm
shall not be able to achieve a satisfactory return on its investment.

This ratio also indicates the firm's capacity to face adverse economic conditions
such as price competition, low demand, etc. Obviously, higher the ratio the better
is the profitability. But while interpreting the ratio it should be kept in mind that
the performance of profits also be seen in relation to investments or capital of the
firm and not only in relation to sales.

Operating Ratio:

Operating ratio is the ratio of cost of goods sold plus operating expenses to net
sales. It is generally expressed in percentage.

Operating ratio measures the cost of operations per Rs. of sales. This is closely
related to the ratio of operating profit to net sales.

The two basic components for the solution of operating ratio are operating cost
(cost of goods sold plus operating expenses) and net sales. Operating expenses
normally include (a) administrative and office expenses and (b) selling and
distribution expenses. Financial charges such as interest, provision for taxation
etc. are generally excluded from operating expenses.

Operating Ratio = [(Cost of goods sold + Operating expenses) / Net sales] × 100

Illustration 12

Cost of goods sold is 180,000 and other operating expenses are 30,000 and net
sales is 300,000.

Calculate operating ratio.

Solution:

Operating ratio = [(180,000 + 30,000) / 300,000] × 100

= [210,000 / 300,000] × 100

= 70%

Operating ratio shows the operational efficiency of the business. Lower

operating ratio shows higher operating profit and vice versa. An operating ratio
ranging between 75% and 80% is generally considered as standard for
manufacturing concerns. This ratio is considered to be a yardstick of operating
efficiency but it should be used cautiously because it may be affected by a
number of uncontrollable factors beyond the control of the firm. Moreover, in
some firms, non-operating expenses from a substantial part of the total expenses
and in such cases operating ratio may give misleading results.

Operating profit Ratio or Operating Margin Ratio

The operating profit of a business is the profit after meeting all operating
expenses incurred in the regular course of operations. It is a measure of
operating efficiency of a business. The ratio is calculated by dividing operating
profit or earnings before interest and taxes [EBIT] by Net Sales

Opera tin g prof it or EB IT

Operating profit Ratio = 1 0 0
Net Sales

Expense Ratio:

Expense ratios indicate the relationship of various expenses to net sales. The
operating ratio reveals the average total variations in expenses. But some of the
expenses may be increasing while some may be falling. Hence, expense ratios are
calculated by dividing each item of expenses or group of expense with the net
sales to analyze the cause of variation of the operating ratio.

The ratio can be calculated for individual items of expense or a group of

items of a particular type of expense like cost of sales ratio, administrative
expense ratio, selling expense ratio, materials consumed ratio, etc. The lower the
operating ratio, the larger is the profitability and higher the operating ratio, lower
is the profitability.

While interpreting expense ratio, it must be remembered that for a fixed

expense like rent, the ratio will fall if the sales increase and for a variable
expense, the ratio in proportion to sales shall remain nearly the same.

Following formula is used for the solution of expense ratio:

Particular Expense = (Particular expense / Net sales) × 100

Illustration 13

Administrative expenses are 2,500, selling expenses are 3,200 and sales are
25,00,000.

Calculate expense ratio.

Solution :
Administrative expenses ratio = (2,500 / 25,00,000) × 100
= 0.1%
Selling expense ratio = (3,200 / 25,00,000) × 100
= 0.128%

[b] OVERALL PROFITABILITY RATIOS

It is the analysis of profitability in relation to the volume of capital

employed or investment in the business. Management and shareholders are
interested in ascertaining the return on capital employed, return on
shareholders’ funds etc. the important tests applied to measure overall
profitability are :

1. Return on total assets

2. Return on capital employed

3. Return on shareholder’s equity

4. Return on equity capital

Return on Shareholders’ Investment or Net Worth Ratio:

It is the ratio of net profit to share holder's investment. It is the relationship

between net profit (after interest and tax) and share holder's/proprietor's fund.

This ratio establishes the profitability from the share holders' point of view. The
ratio is generally calculated in percentage.

The two basic components of this ratio are net profits and shareholder's funds.
Shareholder's funds include equity share capital, (preference share capital) and
all reserves and surplus belonging to shareholders. Net profit means net income
after payment of interest and income tax because those will be the only profits
available for share holders.

[Return on share holder's investment = {Net profit (after interest and tax) /
Share holder's fund} × 100]

Illustration 14

Suppose net income in an organization is 60,000 where as shareholder's

investments or funds are 400,000.

Calculate return on shareholders’ investment or net worth

Return on share holders’ investment = (60,000 / 400,000) × 100 = 15%

This means that the return on shareholders’ funds is 15 percent/Rs.

This ratio is one of the most important ratios used for measuring the
overall efficiency of a firm. As the primary objective of business is to maximize its
earnings, this ratio indicates the extent to which this primary objective of
businesses being achieved. This ratio is of great importance to the present and
prospective shareholders as well as the management of the company. As the ratio
reveals how well the resources of the firm are being used, higher the ratio, better
are the results. The inter firm comparison of this ratio determines whether the
investments in the firm are attractive or not as the investors would like to invest
only where the return is higher.

Return on Equity Capital (ROEC) Ratio

In real sense, ordinary shareholders are the real owners of the company.
They assume the highest risk in the company. (Preference share holders have a
preference over ordinary shareholders in the payment of dividend as well as
capital.
 Preference share holders get a fixed rate of dividend irrespective of the
quantum of profits of the company). The rate of dividends varies with the
availability of profits in case of ordinary shares only. Thus ordinary shareholders
are more interested in the profitability of a company and the performance of a
company should be judged on the basis of return on equity capital of the
company. Return on equity capital which is the relationship between profits of a
company and its equity, can be calculated as follows:

Formula of return on equity capital ratio is:

Return on Equity Capital = [(Net profit after tax − Preference dividend) /

Equity share capital] × 100

Equity share capital should be the total called-up value of equity shares.
As the profit used for the solutions are the final profits available to equity
shareholders as dividend, therefore the preference dividend and taxes are
deducted in order to arrive at such profits.

Illustration 15

Calculate return on equity share capital from the following information:

Equity share capital): 1,000,000 ; 9% Preference share capital: 500,000;

Taxation rate: 50% of net profit; Net profit before tax: 400,000.

Solution :

Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) /

1000,000 )× 100]

= 15.5%

This ratio is more meaningful to the equity shareholders who are interested to
know profits earned by the company and those profits which can be made
available to pay dividends to them. Interpretation of the ratio is similar to the
interpretation of return on shareholder's investments and higher the ratio better
is.

Return on Capital Employed Ratio (ROCE Ratio)

The prime objective of making investments in any business is to obtain

satisfactory return on capital invested. Hence, the return on capital employed is
used as a measure of success of a business in realizing this objective.
 Return on capital employed establishes the relationship between the profit
and the capital employed. It indicates the percentage of return on capital
employed in the business and it can be used to show the overall profitability and
efficiency of the business.

Capital employed and operating profits are the main items. Capital employed
may be defined in a number of ways. However, two widely accepted definitions
are "gross capital employed" and "net capital employed". Gross capital
employed usually means the total assets, fixed as well as current, used in
business, while net capital employed refers to total assets minus liabilities. On
the other hand, it refers to total of capital, capital reserves, revenue reserves
(including profit and loss account balance), debentures and long term loans.

Solution of Capital Employed:

Method--1. If it is calculated from the assets side, It can be worked out by adding
the following:

1. The fixed assets should be included at their net values, either at original
cost or at replacement cost after deducting depreciation. In days of
inflation, it is better to include fixed assets at replacement cost which is
the current market value of the assets.

2. Investments inside the business

3. All current assets such as cash in hand, cash at bank, sundry debtors,
bills receivable, stock, etc.

4. To find out net capital employed, current liabilities are deducted from the
total of the assets as calculated above.

Gross capital employed = Fixed assets + Investments + Current assets

Net capital employed = Fixed assets + Investments + Working capital .

Working capital = current assets − current liabilities.

Method--2. Alternatively, capital employed can be calculated from the liabilities

side of a balance sheet. If it is calculated from the liabilities side, it will include
the following items:

Share capital:
Issued share capital (Equity + Preference)
Reserves and Surplus:
General reserve
 Capital reserve
Profit and Loss account
Debentures
Other long term loans

Some people suggest that average capital employed should be used in order
to give effect of the capital investment throughout the year. It is argued that the
profit earned remain in the business throughout the year and are distributed by
way of dividends only at the end of the year. Average capital may be calculated by
dividing the opening and closing capital employed by two. It can also be worked
out by deducting half of the profit from capital employed.

Computation of profit for return on capital employed:

The profits for the purpose of calculating return on capital employed should
be computed according to the concept of "capital employed used". The profits
taken must be the profits earned on the capital employed in the business. Thus,
net profit has to be adjusted for the following:

 Net profit should be taken before the payment of tax or provision for
taxation because tax is paid after the profits have been earned and has no
relation to the earning capacity of the business.

 If the capital employed is gross capital employed then net profit should be
considered before payment of interest on long-term as well as short-term
borrowings.

 If the capital employed is used in the sense of net capital employed than
only interest on long term borrowings should be added back to the net
profits and not interest on short term borrowings as current liabilities are
deducted while calculating net capital employed.

 If any asset has been excluded while computing capital employed, any
income arising from these assets should also be excluded while calculating
net profits. For illustration, interest on investments outside business
should be excluded.

 Net profits should be adjusted for any abnormal, non recurring, non
operating gains or losses such as profits and losses on sales of fixed assets.

 Net profits should be adjusted for depreciation based on replacement cost,

if assets have been added at replacement cost.
 Return on Capital Employed=(Adjusted net profits /Capital employed)×100

Net profit before interest and tax minus income from investments.

Return on capital employed ratio is considered to be the best measure of

profitability in order to assess the overall performance of the business. It
indicates how well the management has used the investment made by owners
and creditors into the business. It is commonly used as a basis for various
managerial decisions. As the primary objective of business is to earn profit,
higher the return on capital employed, the more efficient the firm is in using its
funds. The ratio can be found for a number of years so as to find a trend as to
whether the profitability of the company is improving or otherwise.

Return on Total Assets

Return on total Assets is also called Return on Investment or ROI. It is

calculated by dividing operating profit by total tangible assets.

Return on total Assets = Operating Profit x100

Total Tangible Assets

A high ratio implies better overall performance of the business or efficient use of
total assets

MARKET TEST RATIOS

Market test ratios are used by shareholders and investors to evaluate the
performance of a company in the market place. These ratios include

 Dividend Yield Ratio

 Dividend Payout Ratio

 Earnings Per Share (EPS) Ratio

 Price Earnings Ratio (PE Ratio)

 Coverage Ratios

Dividend Yield Ratio:

Dividend yield ratio is the relationship between dividends per share and the
market value of the shares.
Share holders are real owners of a company and they are interested in real sense
in the earnings distributed and paid to them as dividend. Therefore, dividend
yield ratio is calculated to evaluate the relationship between dividends per share
paid and the market value of the shares.

Following formula is used for the solution of dividend yield ratio:

Dividend Yield Ratio = Dividend Per Share / Market Value Per Share

Illustration 16

For illustration, if a company declares dividend at 20% on its shares, each having
a paid up value of 8.00 and market value of 25.00.

Calculate dividend yield ratio:

Solution :

Dividend Per Share = (20 / 100) × 8

= 1.60

Dividend Yield Ratio = (1.60 / 25) × 100

= 6.4%

This ratio helps as intending investor is knowing the effective return he is going
to get on the proposed investment.

Dividend Payout Ratio:

Dividend payout ratio is calculated to find the extent to which earnings per
share have been used for paying dividend and to know what portion of earnings
has been retained in the business. It is an important ratio because ploughing
back of profits enables a company to grow and pay more dividends in future.

Following formula is used for the solution of dividend payout ratio

Dividend Payout Ratio = Dividend per Equity Share / Earnings per Share

A complementary of this ratio is retained earnings ratio. Retained earning ratio

is calculated by using the following formula:

Retained Earning Ratio = Retained Earning Per Equity Share / Earning Per
Equity Share
Illustration 17

Calculate dividend payout ratio and retained earnings from the following
data:

Net Profit 10,000 No. of equity shares 3,000

Provision for taxation 5,000 Dividend per equity share 0.40
Preference dividend 2,000
Payout Ratio = ( 0.40 / 1) × 100
= 40%
Retained Earnings Ratio = ( 0.60 / 1) × 100
= 60%

The payout ratio and the retained earning ratio are the indicators of the
amount of earnings that have been ploughed back in the business. The lower the
payout ratio, the higher will be the amount of earnings ploughed back in the
business and vice versa. A lower payout ratio or higher retained earnings ratio
means a stronger financial position of the company.

Earnings per Share (EPS) Ratio

Earnings per share ratio (EPS Ratio) is a small variation of return on equity
capital ratio and is calculated by dividing the net profit after taxes and preference
dividend by the total number of equity shares.

The formula of earnings per share is:

Earnings per share (EPS) Ratio = (Net profit after tax − Preference dividend)
/ No. of equity shares (common shares)

Illustration 18

Equity share capital ( 1): 1,000,000; 9% Preference share capital: 500,000;

Taxation rate: 50% of net profit; Net profit before tax: 400,000.

Calculate earnings per share ratio.

Solution:
EPS = 1,55,000 / 10,000
= 15.50 per share.

The earnings per share is a good measure of profitability and when

compared with EPS of similar companies, it gives a view of the comparative
earnings or earnings power of the firm. EPS ratio calculated for a number of
years indicates whether or not the earning power of the company has increased.

Price Earnings Ratio (PE Ratio)

Price earnings ratio (P/E ratio) is the ratio between market price per equity
share and earning per share.

The ratio is calculated to make an estimate of appreciation in the value of a

share of a company and is widely used by investors to decide whether or not to
buy shares in a particular company.

Following formula is used to calculate price earnings ratio:

Price Earnings Ratio = Market price per equity share / Earnings per share

Illustration 18

The market price of a share is 30 and earnings per share is 5.

Calculate price earnings ratio.

Solution:

Price earnings ratio = 30 / 5

=6

The market value of every one Rs. of earning is six times or 6. The ratio is
useful in financial forecasting. It also helps in knowing whether the share of a
company are under or overvalued. For illustration, if the earning per share of AB
limited is 20, its market price 140 and earnings ratio of similar companies is 8,
it means that the market value of a share of AB Limited should be 160 (i.e., 8 ×
20). The share of AB Limited is, therefore, undervalued in the market by 20. In
case the price earnings ratio of similar companies is only 6, the value of the share
of AB Limited should have been 120 (i.e., 6 × 20), thus the share is overvalued
by 20.

Price earnings ratio helps the investor in deciding whether to buy or not to buy
the shares of a particular company at a particular market price.

Generally, higher the price earnings ratio the better it is. If the P/E ratio falls, the
management should look into the causes that have resulted into the fall of this
ratio.
Coverage Ratios

It includes interest coverage ratio, preference share dividend coverage ratio and
equity dividend coverage ratio

Debt Service Ratio or Interest Coverage Ratio:

Interest coverage ratio is also known as debt service ratio or debt service
coverage ratio.

This ratio relates the fixed interest charges to the income earned by the business.
It indicates whether the business has earned sufficient profits to pay periodically
the interest charges. It is calculated by using the following formula.

Interest Coverage Ratio = Net Profit before Interest and Tax / Fixed Interest
Charges

Illustration 19

If the net profit (after taxes) of a firm is 75,000 and its fixed interest charges on
long-term borrowings are 10,000. The rate of income tax is 50%.

Calculate debt service ratio / interest coverage ratio

Solution:

Interest Coverage Ratio = (75,000 + 75,000 + 10,000) / 10,000

= 16 times

Income after interest is 7,5000 + income tax 75,000

The interest coverage ratio is very important from the lender's point of view. It
indicates the number of times interest is covered by the profits available to pay
interest charges.

It is an index of the financial strength of an enterprise. A high debt service ratio

or interest coverage ratio assures the lenders a regular and periodical interest
income. But the weakness of the ratio may create some problems to the financial
manager in raising funds from debt sources.

Preference share dividend cover = Profit after tax / Preference share dividend

Equity dividend cover = profit after tax – preference share dividend / equity
share dividend
Capital Gearing Ratio

Closely related to solvency ratio is the capital gearing ratio. Capital

gearing ratio is mainly used to analyze the capital structure of a company.

The term capital structure refers to the relationship between the various
long-term form of financing such as debentures, preference and equity share
capital including reserves and surpluses. Leverage of capital structure ratios are
calculated to test the long-term financial position of a firm.

The term "capital gearing" or "leverage" normally refers to the proportion of

relationship between equity share capital including reserves and surpluses to
preference share capital and other fixed interest bearing funds or loans. In other
words it is the proportion between the fixed interest or dividend bearing funds
and non fixed interest or dividend bearing funds. Equity share capital includes
equity share capital and all reserves and surpluses items that belong to
shareholders. Fixed interest bearing funds includes debentures, preference share
capital and other long-term loans.

[Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds]

Illustration 20

Calculate capital gearing ratio from the following data:

1991
Equity Share Capital 1992
Reserves & Surplus
300,000 500,000 200,000
Long Term Loans 400,000
250,000 300,000
6% Debentures
250,000 400,000

Solution:
Capital Gearing Ratio 1992 = (500,000 + 300,000) / (250,000 + 250,000)
= 8 : 5 (Low Gear)
1993 = (400,000 + 200,000) / (300,000 + 400,000)
6 : 7 (High Gear)
It may be noted that gearing is an inverse ratio to the equity share capital.
Highly Geared------------Low Equity Share Capital

Low Geared---------------High Equity Share Capital

 Capital gearing ratio is important to the company and the prospective
investors. It must be carefully planned as it affects the company's capacity to
maintain a uniform dividend policy during difficult trading periods. It reveals the
suitability of company's capitalization.
CONSTRUCTION OF FINANCIAL STATEMENTS FROM RATIOS
Ratios are worked out from financial statements ie, Profit and loss account
and Balance sheet. In a reverse approach, one can prepare the Financial
statements in a concise or summarized form from the ratios and additional
information.
In order to prepare Balance sheet or Profit and Loss account, students
must have a clear idea regarding the contents of a typical balance sheet and
profit and loss account. Using the given information and ratios students may
work out the missing figures in a logical sequence.
Illustration 21

From the following information you are asked to prepare a Balance sheet
1. Current liabilities 100000
2. Reserves and surplus 50000
3. Bills payable 40000
4. Debtors 35000
5. Current ratio 1.75
6. Acid test ratio 1.15
7. Fixed assets to proprietors fund 0.75
8. Ratio of fixed assets to current assets 3

Solution:

Balance Sheet

liabilities Rs assets Rs
Share capital 650000 Fixed assets 525000
Reserves and surplus 50000 Current assets
Current liabilities Stock 60000
Sundry creditors 60000 Debtors Cash 35000
Bills payable 40000 Miscellaneous 80000
Expenditure [bal.fig] 100000

800000 800000
 1. Current assets

Current ratio = current assets / current liabilities = 1.75

Current assets = 1.75 x current liabilities = 1.75 x 100000 = 175000

2.Liquid assets

Acid test ratio = liquid assets / current liabilities = 1.15

Liquid assets = 1.15x current liabilities = 1.15 x 100000 = 115000

3.stock

Stock = current assets – liquid assets

175000-115000 = 60000

4.cash balance = current assets – [ stock + debtors]

= 1750000-[60000+35000] = 80000

5. Fixed assets

Ratio of fixed assets to current assets = fixed assets / current assets = 3

Fixed assets = 3x current assets = 3x 175000 = 525000

6. Propreitors funds

Fixed assets to proprietors funds = fixed assets / proprietors funds = 0.75

Prop. Funds = fixed assets / 0.75 = 525000/0.75 = 700000

7. Share capital

Prop. Fund = s. capital + reserves and surplus

Share capital = prop. Funds – reserves and surplus = 700000-50000=650000

Sundry creditors = current liabilities – bills payable

= 100000-40000=60000

9. Miscellaneous expenditure

Balance on the asset side of balance sheet may be treated as miscellaneous

expenditure
Illustration 22

Prepare a balance sheet from the following data

a. Current ratio 1.4

b. Liquid ratio 1.0

c. Stock turnover ratio 8 [ based on closing stock]

d. Gross profit ratio 20%

e. Debt collection period 1.5 months

f. Reserves and surplus to capital 0.6

g. Fixed assets turnover ratio 1.6

h. Capital gearing ratio 0.5

i. Fixed assets to net worth 1.25

j. Sales for the year Rs.1000000

Solution

1. Cost of sales

GP = 20% of sales = 1000000x20/100 = 200000

Cost of sales = sales –GP = 1000000-200000=800000

2. Closing stock

STR = Cost of sales/ closing stock = 8 times

Closing stock = 800000/8 = 100000

3. Current assets and current liabilities

CR = 1.4 And LR = 1.0

Let current liabilities be x, current assets will be 1.4x and liquid assets
will be 1.4x and liquid liabilities will be 1x

Stock = current assets – liquid assets

100000 = 1.4x-1x

0.4x = 100000
 X = 100000/0.4 = 250000

Current liabilities = 250000

Current assets = 1.4x250000= 350000

4. Debtors

Debt collection period = debtors/credit sales x12 = 1.5

Debtors = 1000000x1.5/12 = 125000

5. Cash and bank

=liquid assets – debtors

LR = LA/CL = 1

Liquid assets are equal to current liabilities = 250000

Cash and bank = 250000-125000 = 125000

6. Fixed assets T/o ratio

= 1.6

Fixed assets = 800000/1.6= 500000

7. Net worth

Fixed assets /NW = 1.25

Net worth = 400000

8. Share capital

Res. And surplus to capital = 0.6

If capital is x reserves and surplus will be 0.6x and net worth will be 1.6x

400000= x+0.6x

X = 250000

Share capital = 250000

9. Reserves and surplus = 250000x0.6 = 150000

10. Long term debt

Capital gearing ratio =LT debt /Equity capl + R & S = 0.5

Long term debt = [250000+150000] x0.5 = 200000

Balance sheet

Liabilities Rs. Assets Rs

Share capital 250000 Fixed asset 500000

Reserves and surplus 150000 Stock 100000

Long term debt 200000 Debtors 125000

Current liabilities 250000 Cash and bank balance 125000

850000 850000
 MARGINAL COSTING
The basic objectives of Cost Accounting are cost ascertainment and cost
control. In order to help management in cost control and decision making, cost
accounting has developed certain tools and techniques. Marginal costing and
Break even analysis are important techniques used for cost control and decision
making.

Marginal Cost

The term Marginal cost means the additional cost incurred for producing
an additional unit of output. It is the addition made to total cost when the output
is increased by one unit.

Marginal cost of nth unit = Total cost of nth unit- total cost of n-1 unit.

Eg. When 100 units are produced, the total cost is Rs. 5000.When the output is
increased by one unit, i.e, 101 units, total cost is Rs.5040.Then marginal cost of
101th unit is Rs. 40[5040-5000]

Marginal cost is also equal to the total variable cost of production or it is

the aggregate of prime cost and variable overheads. The chartered Institute of
Management Accountants [CIMA] England defines Marginal as “the amount at
any given volume of output by which aggregate costs are changed if the volume of
output is increased or decreased by one unit

MARGINAL COSTING

It is the technique of costing in which only marginal costs or variable are

charged to output or production. The cost of the output includes only variable
costs .Fixed costs are not charged to output. These are regarded as ‘Period Costs’.
These are incurred for a period. Therefore, these fixed costs are directly
transferred to Costing Profit and Loss Account.

According to CIMA, marginal costing is “the ascertainment, by

differentiating between fixed and variable costs, of marginal costs and of the
effect on profit of changes in volume or type of output.

Under marginal costing, it is assumed that all costs can be classified into
fixed and variable costs. Fixed costs remain constant irrespective of the volume of
output. Variable costs change in direct proportion with the volume of output. The
variable or marginal cost per unit remains constant at all levels of output
FEATURES OF MARGINAL COSTING [ASSUMPTIONS IN MARGINAL
COSTING]

1. All costs can be classified into fixed and variable elements. Semi variable costs
are also segregated into fixed and variable elements.

2. The total variable costs change in direct proportion with units of output. It
follows a linear relation with volume of output and sales.

3. The total fixed costs remain constant at all levels of output. These are incurred
for a period and have no relation with output.

4. Only variable costs are treated as product costs and are charged to output,
product, process or operation

5. Fixed costs are treated as ‘Period costs’ and are directly transferred to Costing
Profit and Loss Account.

6. The closing stock is also valued at marginal cost and not at total cost.

7. The relative profitability of product or department is based on the contribution

it gives and not based on the profit

8. It is also assumed that the selling price per unit remains the same i.e, any
number of units can be sold at the current market price.

9. The product or sales mix remains constant over a period of time.

CONCEPT OF CONTRIBUTION

Contribution is the excess of sales over marginal cost. It is not purely

profit. It is the profit before recovery of fixed assets. Fixed costs are first met out
of contribution and only the remaining amount is regarded as profit.
Contribution is an index of profitability. It has a fixed relationship with sales.
Larger the sales more will be the contribution and vice versa.

Contribution = Sales – Marginal cost

Marginal cost equation

Sales-Marginal cost = Contribution

Contribution = Fixed costs + Profit

Therefore, Fixed cost = Contribution – Profit’

PROFIT VOLUME RATIO [P/V RATIO].

Contribution is an absolute measure of profitability but it cannot be used

for comparison of two products or departments. Therefore, the contribution is
related to volume of sales. It is called Contribution / Sales Ratio or Profit/Volume
Ratio [P/V Ratio]

P/V Ratio = Contribution x

Sales

When the P/V Ratio is higher, profitability of the product will also be higher. It is
an index of relative profitability of products or departments.

Sales = Contribution
P/V Ratio

Contribution = Sales x P/V Ratio

P/V Ratio can also be find out by the following formula :-

P/V Ratio = Change in Profit x100

Change in Sales

Or P/V Ratio = Fixed Cost x 100

Break even sales

Marginal cost statement

The Marginal cost statement is a profitability statement prepared according

to marginal costing principles. It is prepared in the following format.

Sales
Less: Variable/Marginal cost Xx
Direct Labour
Direct Expenses
Variable Factory overheads
Variable Administration overheads
Variable Selling and distribution overheads
Contribution
Less Fixed Costs
Profit
Illustration 1.

You are given the following information relating to a company for the year 2012

Output 20000 units

Selling price per unit Rs.12

Direct materials per unit Rs.5

Direct Labour per unit Rs.2

Variable overhears per unit Rs.1

Fixed cost per year Rs.60000

Calculate [1] Total Marginal cost [2] Contribution [3]Profit [4]P/V

Ratio

Solution:-

MARGINAL COST STATEMENT

Output 20000 Units Sales 12 240000
Less: Marginal Cost
Direct Materials 5 100000
Direct Labour 2 40000
Direct Expenses 1 20000
Total Marginal Cost 8 160000
Contribution 4 80000
Less: Fixed Costs 60000
Profit 20000

P/V Ratio = Contribution x 100 = 80000 x 100 = 33.33%

Sales 240000

Advantages of Marginal Costing

Following are the advantages of Marginal costing

1. It is simple to understand and easy to apply to any firm

2. There is no arbitrary apportionment of fixed cost in this system. Fixed costs
are transferred to costing profit and Loss account.

3. It also prevents the illegal carry forward in stock valuation of some proportion
of current years fixed cost.

4. The effect of different sales mix on profit can be ascertained and management
can adopt the optimum sales mix

5. It is used in control of cost by concentrating on variable cost of production.

6. It helps in profit planning by break even and cost volume profit analysis

7. It helps management to take a number of short term decisions like pricing,

output, closing down of department, sales mix, make or buy etc..

Disadvantages

Important disadvantages of marginal costing are ;

1. All Assumptions of marginal costing are not appropriate. The assumption fixed
cost remains constant for all levels may not hold good in the long run.

2. The assumption that changes in direct proportion with the volume of also do
not hold good under all circumstances.

3. It is difficult to segregate all costs into fixed and variable elements.

4. The exclusion of fixed costs in ascertaining cost of production may give

misleading results and lead to non recovery of total costs.

5. The exclusion of fixed costs from inventories affect profit and financial
statements may not reflect true and fair view of financial affairs.

Marginal costing and Absorption costing

Marginal costing is the practice of charging only variable costs to cost of

production, leaving fixed costs to be charged to the costing profit and loss
account.

In Absorption costing or Total costing all types of costs are charged to output or
process. While variable costs are wholly allocated to output or production, fixed
costs are apportioned and a portion is charged to output or production.

The profits disclosed under the two methods will be the same, provided there is
no closing stock. But in the event of closing stock, the profits disclosed will be
different under the two methods. This is due to the practice followed in stock
valuation. In marginal costing stock is valued at marginal cost, whereas in total
costing it is valued at total cost.

DIFFERENCE BETWEEN MARGINAL COSTING AND ABSORPTION COSTING

1. Marginal costing is the practice of charging only variable costs to products,

outputs or processes and absorption costing variable and fixed cost to products,
outputs or processes

2. There is no apportionment of fixed costs and they are charged to profit and
loss account under marginal costing. But fixed costs are apportioned and
charged to outputs or processes under absorption costing.

3. Under marginal costing, inventories or stocks are valued at marginal costs and
under absorption costing they are valued at total costs.

4. Under marginal costing, the profitability of a product or department is judged

on the basis of the contribution that it gives but under absorption costing it is
judged on the basis of the ultimate profit that it gives.

5. Under marginal costing, profit is ascertained by deducting fixed costs from

contribution and under absorption costing it is ascertained by deducting total
costs from sales.

BREAK EVEN ANALYSIS

Every business is interested in ascertaining the breakeven point. It is the

level of operation where total revenue or sales are equal to total cost. It is the
point of no profit or no loss. The contribution received at Breakeven point is just
sufficient to meet the fixed costs, leaving nothing as profit. The firm ceases to
incur losses at this point or it starts to earn a profit from this point. Breakeven
point can be expressed in algebraic method or graphical method.

Algebraic Method

Breakeven point may be expressed in terms of number of units to be produced,

or in terms of volume of sales or in terms of the capacity of operation. It can be
calculated by the following formula.

1.Break even point in units = Total Fixed costs

Contribution per unit

2.Break even point in value = Total Fixed costs or Total Fixed cost x sales
P/V Ratio Contribution

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3.Break even point (in % of capacity utilization) = Total Fixed Costs x 100
Contribution

Illustration 2

From the following information calculate

1. P/V Ratio

2. Breakeven point in Units

3. Breakeven point in Value

Given :

Selling price per unit Rs.20

Variable cost per unit Rs.12

Fixed costs Rs.32000

1. P/V Ratio = Contribution/Sales x 100 = 20-12/20x100 = 40 %

2. Breakeven point in units = Fixed costs/ Contribution per unit = 32000/8=

4000 units

3. Breakeven point in value = Fixed costs = 32000/40 x100 = Rs.80000

P/V Ratio

Target Profit

The Break even analysis can guide an organization to determine the

volume of sales required to earn a desired level of profit. The firm can decide
upon the target return or profit in advance. To achieve this profit, efforts would
be taken to increase the volume of sales. The volume of sales required to achieve
the desired level of profit may be computed as follows :-

Number of units to be sold = Fixed costs + desired Profit

Contribution per unit

Sales volume required = Fixed costs+ Desired Profits

P/V Ratio

Illustration 3

Product A is sold at a unit selling price of Rs. 40 and the variable cost incurred
per unit is Rs.32.The firm’s fixed cost are Rx.40000.Find out

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1. The number of units to be produced to break even

2. The number of units to be sold to earn a profit of Rs.10000

Solution

Contribution = SP-VC

= 40-32 = 8 per unit

1. Number of units to be produced to Break even

BEP= Fixed cost/ Contribution per unit = 40000/8 = 5000 units.

2. Number of units to be sold to earn a profit of Rs.10000

Fixed Cost + Desired Profit = 40000+10000/8 = 6250 units

Contribution per unit

Break Even Chart [Graphic Method]

It is the graphical presentation of breakeven point. It shows the

relationship between sales volume, variable and fixed costs. It also shows the
profit or loss at different levels of output or volume of sales.

Construction of Break even Chart

A Break even chart shows the total sales line, total cost line and the point of
intersection called the breakeven point. It is constructed using a database of
variable costs, fixed costs, total costs and sales at different levels of output.

The units of output or sales revenue are plotted along the X axis, using
suitable scale of measurement. The costs and sales are plotted along the Y axis.
The fixed costs line is plotted first. It forms a parallel line to the X axis indicating
that the fixed cost remain constant at all levels of output. The variable cost line is
plotted next, starting from zero it progresses continuously indicating that the
variable cost increase with the volume fixed cost line of sales. The total cost line
is plotted above the variable cost line. It starts from the fixed cost line on the Y
axis and follows the same pattern of variable cost line. The sales line is plotted
finally. It starts from the zero and progresses continuously, indicating that the
sales increase with larger units of output. The point of intersection of sales line
and total cost line indicates the Break even point. A vertical line drawn to the X
axis from this point shows the volume of output required to Break even.

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ANGLE OF INCIDENCE

It is the angle caused by the intersection of the total sales line and total
cost line at the Break even point. The width of the angle represents the rate of
profitability i.e, the larger the angle the greater will be the profit the business is
making on additional sales

MARGIN OF SAFETY

Margin of safety represents the strength of the business to face an adverse

market condition. It is the excess of actual sales over break even sales. Higher
the Margin of safety, better the position of the firm.

Margin of safety = Actual sales- Break even sales

Margin of safety = Profit / P/V Ratio

Or Profit = margin of safety x P/V Ratio

Illustration 5

Calculate BEP and Margin of safety from the following?

Sales 50000 units @ Rs.6 per unit

Prime cost Rs. 3 per unit

Variable overhead Rs. 1 per unit
Fixed costs Rs.75000 per annum
Solution :-
BEP = Fixed Cost = 75000 = 37500 units
SP- VC per unit 6-4
BEP in value = 37500 x 6 = 225000
Margin of safety = Actual sales – BE sales
= [50000x6]-225000= Rs.75000
Illustration 6
The following data have been obtained from the records of a manufacturing firm.
Period I Period II
Sales 300000 320000
Total cost 260000 272000

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Calculate

1. Break even sales

2. Profit when sales are Rs.360000.

3. Sales required to earn a profit of Rs.50000

Solution:

P/V Ratio = Change in Profit x 100

Change in Sales

Change in profit = 48000-40000= 8000

Change in Sales = 320000-300000 = Rs.20000

P/V Ratio = 8000/20000x 100 = 40%

Contribution = Sales x P/V Ratio

Period I = 300000 x 40/100 = Rs.120000

Fixed cost = Contribution – Profit = 120000- 40000 = Rs.80000

1. BEP = Fixed cost /P/V Ratio = 8000/40 x 100 = 200000

2. Profit when sales are Rs.360000

Contribution = 360000x40/100 = 144000

Profit = Contribution – Fixed cost = 144000-80000=Rs.64000

3.Sales required to earn a profit of Rs.50000

Contribution required = Fixed cost + Profit required = 80000+50000 = 130000

Sales = Contribution requires/ P/V ratio

= 130000/40x100 = Rs.325000

CASH BREAK EVEN POINT

Total fixed costs include depreciation. Depreciation is a non cash expense.

Therefore, cash break even point is the number of units to be produced to give a
contribution equal to cash fixed costs.

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Cash Break even point = Fixed cost – Depreciation
Contribution per unit

Illustration 7

Calculate cash Break even point for the following

Selling price per unit Rs.40

Variable cost per unit Rs.32

Fixed cost [including depreciation of Rs.20000] Rs.60000 per annum

Solution

Contribution per unit = S- VC = 40-32 = 8

Cash break even point = Fixed cost – depreciation

Contribution per unit

= 60000-20000/8 = 5000 units

COMPOSITE BREAK EVEN POINT

In the case of companies producing more than one product an over all or
composite break even point is calculated.

Composite Break even point = Total Fixed Costs

Composite P/V Ratio

Composite P/V Ratio = Total contribution x 100

Total Sales of all products

Cost-Volume Profit Analysis [ CVP Analysis]

It is the study of the impact of a change in cost , price and volume on

profit. Break even analysis is a narrow interpretation of cost volume profit
analysis. But it is mainly confined to finding out the Break even point. In CVP
analysis the relationship between cost, volume and profit is studied in detail. It
helps management in profit planning, decision making and cost control.

Assumptions in CVP analysis

The assumptions in CVP analysis are the same as that under marginal
costing.

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  Cost can be classified into fixed and variable components.

 Total fixed cost remain constant at all levels of output

 The variable cost change in direct proportion with the volume of output

 The product mix remains constant

 The selling price per unit remains the same at all the levels of sales

 There is synchronization of output and sales, i.e, what ever output is

produced , the same is sold during that period.

PROFIT VOLUME CHART OR [P/V CHART]

It shows the amount of profit or loss at different levels of output. When the
output is zero, total loss will be equal to fixed costs. The fixed costs are recovered
gradually when the volume of output is increased. When the output reaches the
Break even point, the whole fixed costs are recovered. The firm incurs no loss or
earns no profit. Thereafter, the firm makes a profit and the amount of profit
increases with the increase in sales volume.

CONSTRUCTION OF P/V CHART

The same data used for drawing a Break even chart may be used for
constructing a P/V chart. The following steps may be followed for constructing a
P/V chart.

1. Sales or units of output are plotted along the X axis

2. The Y axis is used for marking fixed costs losses and profits

3. Points of Profits or losses are marked at different levels of sales and these
points are joined to get the profit or loss line.

4. The point where the profit or loss line intersects the X axis is marked as
the Break even point.

5. The angle at the BEP measures the angle of incidence

6. The distance between BEP and actual sales on the X axis measures the
margin of safety

Illustration 7

Draw a Profit/ Volume graph from the following data and find out the BEP?

Accounting for Management Page

10610610
6
 Sales for the year [ 20000units] Rs.2000000

Variable Costs Rs.1600000

Fixed costs for the year Rs.200000

What would be the profits when the output is 22000 units?

.
MANAGERIAL USES OF MARGINAL COSTING AND BREAK EVEN
ANALYSIS

Marginal costing and Beak even analysis are very useful to

management. The important uses of marginal costing and Break Even
analysis are the following

1. Profit Planning

The first step in profit planning is the ascertainment of Break even

point. It is the level of operation when there is no profit no loss. Once BEP is
found out the management can decide upon the required level of sales to earn
a particular amount of profit.

2. Cost control

Cost control is an important function of management. In marginal

costing all costs are classified into fixed and variable elements. Fixed costs are
generally non controllable in nature. But variable costs can be controlled by
managerial actions.Therefore, managerial attention is drawn towards the
control of variable costs in marginal costing.

3. Decision making

Marginal costing helps to take important managerial decisions like ;-

1. Fixation of selling price under different market conditions

2. Whether to accept a special order or not

3. Whether to accept an export order or not

4. Selection of suitable product or sales mix

5. Make or buy decisions

6. Whether to discontinue a product or not

7. Closing down of a department

8. Merger of plant capacities

 9. Key factor or limiting factor

10. Shut down or continue

4. Fixation of selling price

Selling price is actually the profit plus cost. But under severe
competition or in a depressed market, it may not be possible to earn a uniform
profit on sales. Some times the price may be fixed even below the cost. In
marginal costing any product which gives the positive contribution is profitable
and recommended in the long run.

Illustration 8

ABC Ltd is working below the normal capacity due to adverse market conditions.
The present sales and costs of the firm are:

Normal capacity 5000 units

Actual output 3000 units

Direct Materials Rs.30000

Direct Labour Rs.12000

Variable overheads Rs.3000

Fixed overheads Rs.25000

Selling price per unit Rs.20

It is difficult to sell additional units in the market over the present level of output
. The company has received enquiries for supply of additional units below the
current market price. You are advises to suggest the minimum price to be
charged for additional units?
Calculation of Marginal cost

Direct Materials Rs.30000

Direct Labour Rs.12000

Variable overheads Rs.3000

Marginal Cost Rs.45000

Marginal cost per unit = 45000/3000 = Rs.15

Therefore, the minimum price to be charged is Rs.15.Any price above the

marginal cost will reduce the present loss by recovery of fixed costs.

Accepting Special Offer / Export Offer

 Sometimes a firm may receive an offer for supply of additional units at a
price lower than the current selling price. According to Marginal costing
technique, any price quoted above marginal cost can be accepted. This is because
the firm is already selling maximum units in the domestic market and making a
profit. If the new offer is accepted, the contribution from such offer is purely
profit and therefore the total profit of the firm is increased. However, before
accepting the offer, it should be confirmed that it is within the capacity and there
is no increase in fixed costs as a result of increasing the output

Illustration 10

MNP ltd is working at 60% of capacity producing 6000 units of output. The
following details are available from its cost records.

Direct materials Rs.24000

Direct labour Rs.12000

Variable overheads Rs.6000

Fixed overheads Rs.15000

The output is sold at a price of Rs 10 per unit. The company receives an offer to
export 4000 units @Rs.8.50 per unit. Should the export order be accepted

Solution

Output 60% of capacity 6000 Per unit Rs. Total’ Rs.

units

Sales 6000 units @ Rs.10 10 60000

Less: Marginal costs

Direct materials 4 24000

Direct labour 2 12000

Variable overhead 1 6000

Total marginal cost 7 42000

Contribution 3 18000

Less : Fixed over heads 15000

Profit 3000
 The marginal cost of the product is Rs. 7 per unit. Since the price quoted
by the exporters is higher than the marginal cost, the export offer should be
accepted. There is a contribution of Rs.1.50 per unit [ 8.50-7] from every unit of
export. Therefore, the total profit will increase by Rs.6000 [ 4000 units x1.50 ] by
accepting the offer as shown below.

Profitability statement [ after accepting export offer]

Capacity 100 % output Per unit Total

10000 units
Rs. Rs.

Sales: Domestic 6000@ 10 60000

Rs.10
8.5 34000
Export [email protected]

94000

Less: marginal cost

Direct materials 4 40000

Direct labour 2 20000

Variable overheads 1 10000

Total marginal cost 70000

Contribution 24000

Less; fixed costs 15000

Profit 9000

Selection of a Product/ sales mix

The marginal costing technique is useful for deciding the optimum

product/sales mix. The product which shows higher P/V ratio is more profitable.
Therefore, the company should produce maximum units of that product which
shows the highest P/V ratio so as to maximize profits.
Illustration 11

ABC Ltd produces and sells two products A and B. the cost and sales data are
given as

Product A product B

Selling price 20 30

Direct material 10 15

Direct labour 4 5

Fixed overheads Rs.1200

Variable overheads are absorbed at 50% of direct labour

The proposed sales mix are

a. 100 units of A and 200 units of B

b. 150 units of A and 150 units of B

c. 200 units of A and 100 units of B

Recommend which of the above sales mix the company should adopt

Solution

Marginal cost statement

PRODUCT A PRODUCT B
SELLING PRICE 20 30
Less: marginal costs
Direct materials 10 15
Direct labour 4 5
Variable overheads 2 2.5
[50% of direct labour]
16 22.5
Contribution 4 7.5
P/V ratio = 20% 25%
contribution/sales x 100
 Since product B gives a higher P/V ratio . sales mix with the highest units
of product B should be adopted . therefore the proposal [a], 100 units of A and
200 units of B is recommended. The profit will be the maximum as shown below

[a]100 units of A and 200 units of B

Contribution A 100 x 4 = 400

B 200x7.5 = 1500

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

1900

Less: fixed cost 1200

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

Profit 700

[b]150 units of A and 150 units of B

Contribution A 150 x 4 = 600

B 150x7.5 = 1125

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

1725

Less: fixed cost 1200

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

Profit 525

[c] 200 units of A and 100 units of B

Contribution A 200 x 4 = 800

B 100x7.5 = 750
---------------

1550

Less: fixed cost 1200

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

Profit 350
 UNIT – V

BUDGET AND BUDGETORY CONTROL

Meaning and definition of budget:
A budget is a plan of action for a future period. It simply means a financial plan expressed in terms
of money. The budget pertaining to any of the activities of business is always forward looking.
The term ‘budget’ has been derived from the French word, ”bougette”, which means a leather bag
into which funds are appropriated to meet the anticipated expenses.
The CIMA Official Terminology defines a budget as “ A quantitative statement, for a defined
period of time, which may include planned revenues, expenses, assets, liabilities and cash flows.”
Budgeting and Budgetary control:
Budgeting simply means preparing budgets. It is a process of preparation, implementation and the
operation of budget. Being a plan of action, a budget guides every manager in the decision making
process.
In the words of Rowland Harr, “Budgeting is the process of building budgets”.
Budgetary control is a system of using budgets for planning and controlling costs. The official
terminology of CIMA defines the term ‘budgetary control , as “ the establishment of budgets
relating to the responsibilities of executives to the requirement of a policy, and the continuous
comparison of actual with budgetary result, either to secure by individual action the objectives of
that policy or to provide a basis for its revision.” Thus, when plans are embodied in a budget and
the same is used as the basis for regulating operations, we have budgetary control. As such
budgetary control starts with budgeting and ends with control.
Objectives of Budget and Budgetary control:
The following points reveal the objectives of Budget and budgetary control:-
1. To aid the planning of annual operations
2. To co ordinate the activities of the various parts of the organization
3. To communicate plans to the various responsibility centre managers
4. To motivate managers to strive to achieve the organizational goals.
5. To control activities
6. To eliminates the wastes of all kinds
7. To provide a yard stick against which actual results can be compared
8. To evaluate the performance of managers.
9. To reduce the uncertainties
Meaning of Estimate, forecast and Budget:
An estimate is predetermination of future events either on the basis of simple guess work or
following scientific principles.
Forecast is an assessment of probable future events. Budget is based on the implication of a
forecast and related to planned events. To establish a realistic budget, it is necessary to forecast a
wide range of factors like sales volume, sales prices, material availability, wage rate, the cost of
overheads etc.
Steps involved in Budgetary Control:
The following steps may be considered necessary for a comprehensive budgetary control
programme:-
1. Laying down organizational goals or objectives
2. Formulating the necessary plans to ensure that the desired objectives are achieved.
3. Translating plans into budget
4. Relating the responsibilities of executives to the requirements of a policy.
5. Recording and reporting actual performance
6. Continuous comparison of actual with budgeted results
7. Ascertainment of deviations, if any
8. Focusing attention on significant deviations
9. Investigation into deviations to establish causes
10. Presentation of information to management, relating the variations to individual
responsibility.
11. Taking corrective action to prevent recurrence of variations.
12. Provide a basis for revision of budgets.

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

system depends up on the following essentials.

1. Support by top management: The wholehearted support of all managerial persons is very
necessary for the success of a budgetary control system.
2. Formal organization: The existence of a formal and sound organizational structure is of an
absolute necessity for an effective system of budgetary control.
3. Budget centers: For budgetary control purposes, the entire organization will be split into a
number of departments, area or functions, known as ‘centres’, and budgets will be prepared
for each such centers
4. Clear cut objectives and reasonably attainable goals:- If goals are too high to be
attained, the purpose of budgeting is defeated. On the other hand, if the goals are so low
that they can be attained very easily, there will be no incentive to special effort.
5. Participative budgeting: Every executive responsible for the implementation of budgets
should be given an opportunity to take part in the preparation of budgets.
6. Budget committee: The work of preparing a budget manual should be entrusted to a
Budget committee. The work of scrutinizing the budgets as well as approving of the same
should be the work of this committee.
7. Comprehensive budgeting: Budgeting should not be partial, it should cover all the
functions .
8. Adequate accounting system: There should be an adequate accounting system for the
successful budgetary control system, because those who are involved in the preparation of
estimates depend heavily on the accounting department.
9. Periodic reporting: - There should be a prompt and timely communication and reporting
system for the effective implementation of a budgetary control system.
Budget manual:
CIMA England, defines a budget manual as “ a document , schedule or booklets which sets out;
inter alia, the responsibilities of the persons engaged in the routine of and the forms and records
required for budgetary control”. In other words, it is a written document which guides the
executives in preparing various budgets.
Budget period: This may be defined as the period for which a budget is prepared and employed.
The budget period will depend on the type of business and the control aspects. There is no general
rule governing the selection of the budget period.
Classification of Budget
1. Classification according to time factor
2. Classification according to flexibility factor
3. Classification according to function.
I. Classification according to time factor: - On this basis, budgets can be of three types:
1. Long term budget – for a period of 5 to 10 years
2. Short term budgets – Usually for a period of one to two years
3. Current budgets - Usually covers a period of one month or so,
II. Classification according to flexibility: It includes
1. Flexible budgets and
2. Fixed budgets
Flexible budgets: It is a dynamic budget. It gives different budgeted cost for different levels of
activity. It is prepared after making an intelligent classification of all expenses between fixed ,
semi variable and variable because the usefulness of such a budget depends up on the accuracy
with which the expenses can be classified.
Steps in preparing flexible budgets:
1. Identifying the relevant range of activity
2. Classify cost according to variability
3. Determine variable cost
4. Determine fixed cost
5. Determine semi variable cost
6. Prepare the budget for selected levels of activity
Example 1
The expenses budgeted for production of 10,000 unit in a factory are furnished below:
Per unit in Rs
Material cost 70
Labour cost 25
Variable factory over head 20
Fixed over head (Rs. 1,00,000) 10
Variable expenses(Direct) 5
Selling expenses (20% fixed) 15
Distribution overhead (10% fixed) 10
Administration expenses (Rs, 50,000) 5
 Prepare a flexible budget for production of 8,000 units.

Solution:

Out put 10,000 units Out put 8,000 units

Per Total Per unit(Rs) Total(Rs.)
unit(Rs)
Material 70.00 7,00,000 70.00 5,60,000
Labour 25.00 2,50,000 25.00 2,00,000
Direct expe, (variable) 5.00 50,000 5.00 40,000
100.00 10,00,000 100.00 8,00,000
Factory overhead :
Variable 20.00 2,00,000 20.00 1,60,000
Fixed 10.00 1,00,000 12.50 1,00,000
130.00 13,00,000 132.50 10,60,000

Administrative expenses: 5.00 50,000 6.25 50,000

135.00 13,50,000 138.75 11,10,000

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

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

Fixed Budget
It is a budget which is designed to remain unchanged irrespective of the level of activity attained. It
does not change with the change in the level of activity. This type of budget are most suited for
fixed expenses. It is a single budget with no analysis of cost.
III. Classification according to function: It includes:

1. Functional budgets and

2. Master budgets
Functional budgets are those which are prepared by heads of functional department s for their
respective departments and are subsidiary to the master budget. Functional budget may be
Operating budgets or financial budget. Operating budgets are those budgets which relate to the
different activities or operations of a firm. These are the primary budgets. Financial budgets are
those which incorporate financial decisions of an organization. They show in detail the inflow and
outflow of cash and the overall financial position.
Master budget is the summary of all functional budgets. It summarizes sales, production, purchase,
labour, finance budgets etc. It is considered as the overall budget of the organization.

Different types of functional budgets:

1. Sales budget: It is forecast of total sales expressed in quantities and money. It is prepared
by the sales manager. While preparing sales budget we have to consider the past sales data ,
market conditions, general trade and business conditions etc
Illustration 1
A manufacturing company submits the following figures of product ‘Z’ for the first quarter of
2010.
Sales (in units)January 50,000
February 40,000
March 60,000
Selling price per unit Rs. 100
Sales target of 1st quarter 2011:
Sales quantity increase 20%
Sales price increase 10%
Prepare sales budget for the first quarter of 2011.
Solution:
SALES BUDGET
For the first quarter of 2011
Months Units Price per unit Value
January 60,000 110 66,00,000
February 48,000 110 52,80,000
March 72,000 110 79,20,000
1,80,000 1,98,00,000
============ ==========

2. Production budget: It is the forecast of the quantity of production for the budget period. It
is usually expressed in physical quantity.
Illustration 2

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

Sales targets: January 60,000 units

February 48,000 units
March 72,000 units
Stock position: 1-1-2010(% of January 2010 sale) - 50%
Stock position: 31-3-2010 40,000 units
Stock position: End January & February 50%
(% of subsequent month’s sales)
You are required to prepare production budget for the first quarter of 2010.
Solution

PRODUCTION BUDGET FOR THE FIRST QUARTER OF 2010

Month Sales(Units) +closing stock -Opening stock Production
(Units) (in Units (units)
January 60,000 24,000 30,000 54,000
February 48,000 36,000 24,000 60,000
March 72,000 40,000 36,000 76,000
1,90,000
=======

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

February 70,000 40,000 8,000 6,000

March 92,000 52,000 9,000 7,000
May 1,00,000 60,000 10,000 8,000
June 1,20,000 55,000 12,000 9,000
Other information:
1. Period of credit allowed by suppliers – two months
2. 25% of sale is for cash and the period of credit allowed to customers for credit sale is one
month.
3. Delay in payment of wages and expenses – one month.
4. Income tax of Rs.25,000 is to be paid in June 2000.
Solution:
CASH BUDGET FOR THE PERIOD ENDING JUNE 2000

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

Opening balance 25,000 53,000 81,000 -------

Receipts:
Cash sales 23,000 25,000 30,000 78,000
Cash from debtors 60,000 69,000 75,000 2,04,000
Total 83,000 94,000 1,05,000 2,82,000
======== ======= ======== ========
Payments:
Creditors
Wages 40,000 50,000 52,000 1,42,000
Expenses 8,000 9,000 10,000 27,000
Income Tax 7,000 7,000 8,000 22,000
Total --- ----- 25,000 25,000
55,000 66,000 95,000 2,10,000
========= ======= =======
Closing balance 53,000 81,000 ----
91,000

b. Adjusted Profit and Loss method: Under this method, profit is adjusted by adding back
depreciations, provisions, stock and work in progress, capital receipts, decrease in debtors, increase
in creditors etc. Similarly, dividends, capital payments, increase in debtors, increase in stock and
decrease in creditors are deducted. The adjusted profit will be the estimated cash available. Under
this method, the following information becomes necessary.

1. Expected opening balance

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

c. Balance sheet method: Under this method, a budgeted balance sheet is prepared for the
budgeted period, showing all assets and liabilities except cash. The two sides of the balance sheet
are then balanced. The balance then represents cash at bank or overdraft, depending upon whether
the assets total is more than that of the liabilities total or the latter is more than that of the former.
Advantages of Cash budget:
1. It helps to ascertain the shortage of cash
2. It helps to identify excess of cash, so that the surplus cash can be invested for a short period
3. It helps to ensure sufficient cash is available when required.
Recent trends in budgeting:
1. Zero Base Budgeting (ZBB): According to the official CIMA terminology, zero base
budgeting is, “ a method of budgeting which requires each cost element to be specifically
justified, as though the activities to which the budget relates were being undertaken for the
first time. Without approval, the budget allowance is zero” . Under ZBB the
programmes and activities get evaluated and ranked from zero base as if these were
launched for first time. In this technique of budgeting the unwanted projects and activities
get dropped and wanted and desirable activities and projects get included in the budget.
Features:
a. It starts from zero
b. All activities are identified in appropriate decision packages
c. All programmes are considered totally afresh
d. A detailed cost benefit analysis of each programme is undertaken
e. There is an officer responsible for each decision packages
f. Priorities are established and decision packages are ranked
Advantages of ZBB
1. It considers every time alternative ways of performing the same job. It helps the
management to get a critical appraisal of its activities.
2. It is helpful to the management in making optimum allocation of scarce resources
3. ZBB is particularly useful for service departments and Governments
4. It ensures active participation of managers in the budgeting process.
5. It promote high level of motivation at the level of unit managers
6. It focuses on output in relation to value for money.
7. It makes managers cost conscious and helps them in identifying priorities in the overall
interest of the organization.
Difference between Traditional budgeting and ZBB
Traditional budgeting ZBB
1. Begins with previous year’s 1. Begins with zero a based
budget 2. Focuses on goals and objectives
2. Focuses on money 3. Produces alternative level of
3. Produces a single level of expenditure and desired result
expenditure for an activity 4. Resources are allocated on the basis of
4. Resources are allocated not on the cost benefit analysis
basis of cost benefit analysis 5. Prepared once in every five years
5. Prepared annually
 2. Activity base budgeting: The CIMA official terminology defines activity based budgeting
as,” a method of budgeting based on an activity frame work and utilizing cost driver data in
the budget setting and variance feedback processes.” In the case of traditional budgeting,
budgets are established on the basis of budget centers. In the case of activity based
budgeting, however, the budget centres are activity based cost pools or cost centres in
relation to which budgets are prepared. Separate cost pools are established for each type of
activity.
3. Performance budgeting: - Performance oriented budgets are established in such a manner
that each item of expenditure related to a specific responsibility centre is closely linked with
the performance of that centre. The following matters will be specified very clearly in such
budgeting
a. Objectives of the organization and for which funds are requested
b. Cost of activities proposed for the achievement of these objectives
c. Quantitative measures to measure the performance
d. Quantum of work to be performed under each activity.
Advantages of performance budgeting:
1. It improves budget formulation process
2. It enhances accountability of the executives
3. It facilitate more effective performance audit
4. It presents clearly the purpose and objectives for which funds are required
Practical Problems:
I. ABC Company Ltd .has given the following particulars. You are required to prepare a
Cash budget for the three months ending 31st Dec. 2010.
Months Sales(Rs) Materials(Rs) Wages(Rs) Overhead(Rs)
August 20,000 10200 3,800 1,900
September 25,000 11000 3,900 2,100
October 23,000 9800 4,000 2,300
November 26,000 9000 4,200 2,400
December 30,000 10800 4,500 2,500
Credit items are:-
1. Debtors/Sales – 10% sales are on cash basis, 50% of the credit sales are collected
next month and the balance in the following month.
2. Creditors - - Materials 2 months
--Wages 1/5 month
-- Overhead ½ month
3. Cash balance on 1st October 2010 is expected to be Rs. 8,000
4. A machinery will be installed in August, 2010 at a cost of Rs. 1,00,000. The monthly
Installment of Rs. 5,000 is payable from October onwards.
5. Dividend at 10% on preference share capital of Rs. 3,00,000 will be paid on 1st
December ,2010
6. Advance to be received for sale of vehicles Rs. 20,000 in December
7. Income tax (advance) to be paid in December Rs. 5,000.
STANDARD COSTING
Meaning of ‘standard’ and ‘standard cost’: In the ordinary language, the term ‘standard’ means
a yardstick of measurement. The CIMA terminology defines this term as, “a benchmark
measurement of resources usage, set in defined conditions.”
Standard cost is a pre determined operating cost calculated from management’s standards of
efficient operation and the relevant necessary expenditure.
Need for Standard Costs: The need for standard cost arises for the following reasons.

1. Cost control
2. Measurement of efficiency
3. Fixation of selling price
4. Economy in cost of costing
Estimated cost: Pre determined costs may either be estimated or standard cost. Estimated cost is a
pre determined cost for a future period under normal conditions of operations. It is a prospective
costing. Cost estimation is made for submitting tenders or quoting price of a product or a unit of
services.
Definition of standard costing:
Standard costing is a technique of cost control. The CIMA official terminology defines it as “ a
control technique which compares standard costs and revenues with actual results to obtain
variances which are used to stimulated improved performance.”

In standard costing the actual costs incurred are compared with the standard costs. The difference
between the two is called variance.

Features: The following are the important characteristics of the standard costing system

1. Standard costs are set for various elements of total cost

2. It makes a comparison of actual cost with standard cost
3. Main objective of standard costing is to control cost
4. Variances are reported to management for the purpose of decision making
Standard costing and Budgetary control
Both standard costing and budgetary control are similar in principle since both are concerned with
setting performance and cost levels for control purposes. Neither of the two techniques can be
operated successfully without the other. Budgetary control and standard costing are inseparably
linked together.
Distinction between standard costing and budgetary control:

1. Budget is based on past performance, while standard is established on the basis of technical
estimates.
2. Budgets consider both income and expenditure whereas standards are for expenditure only.
3. Budgets projects financial accounts, while standard cost project cost accounts
4. In standard costing, variances are analyzed in detail, but such a detailed analysis of variance
is not possible in budgetary control.
5. Budget fix minimum limit while standard fix targets.
 6. Budgets are used for the forecasting men, money and materials, standards cannot be used
for forecasting.
7. Budgetary control technique is applicable to all types of businesses. However standard
costing is useful only for manufacturing organizations.
8. The standards are expressed in per unit of production whereas budgets are for specific
periods and are expressed in total.
9. Budgetary control does not require standardization of product. But standard costing
requires standardization of product.

Objectives of standard costing:

1. Performance measurement
2. Cost control
3. Stock valuation
4. Establishing selling prices
5. Profit planning and decision making
6. Basis of estimating
7. Assisting establishment of budgets

Basic requirements of standard costing:

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

1. Establishment of cost centres: - A cost centre is a location, person or item of equipment

for which costs may be ascertained and used for the purpose of cost control. Cost centres
are set up for cost ascertainment and cost control.
2. Classification and codification of accounts: - It facilitates quick collection and analysis of
cost information.
3. Establishment of standards: The success of the standard costing system depends up on the
reliability and accuracy of standards. Standards are always established scientifically.
4. Ascertainment of actual cost: Measuring the actual cost which is incurred in the next step
in the standard costing.
 5. Comparison of Standard cost and Actual cost.
6. Analysis of Variances
7. Reporting of variance

Types of standards
1. Basic standards: A standard established for use over a long period is known as the basic
standard. It remains unaltered over a long period. Its use is to show long term trends, and it
operates in a similar way to index numbers. It is also known as the ‘bogey, standard. This
standard is used for items or costs which are likely to remain constant over a long period.
2. Current standard: A standard established for use over a short period of time and related to
current conditions, is known as the ‘current standard’. This standard shows what the
performance should be under current conditions. Conditions during which period the
standard is used are known as current conditions.
3. Ideal standards & Expected standards:- Ideal standard is that which can be attained
under the most favourable conditions, while expected standard is that which is expected to
be attained during a specified budget period. It is a target which is attainable and can be
achieved if the expected conditions operate during the period for which the standard is set.
4. Normal standard: This standard is defined as “the average standard which it is anticipated
can be attained over a future period of time, preferably long enough to cover one trade
cycle.”It is difficult to follow normal standards in practice as it is not possible to forecast
performance with a reasonable degree of accuracy for a long period of time.
Analysis of Variances:
Variance is the difference between a standard cost and the comparable actual cost incurred during a
period. It is the deviation of actual cost from the standard cost. In other words, the deviation of the
actual cost or profit or sales from the standard cost or profit or sales is known as variance. If the
actual cost is less than the standard, the difference is known as favourable or positive variance and
it is symbol of efficiency. If the actual cost is more than the standard cost, the difference is known
as unfavorable variance. Analysis of variance means carrying out the appropriate investigation to
identify the reasons for the variance.
Another way of classifying variance may be controllable and uncontrollable variances. If a
variance is due to inefficiency of a cost centre, it is said to be controllable variance. Such variance
can be corrected by taking a suitable action. A variance due to external reasons like increase in
prices of material, labour etc it is a case of uncontrollable variances.
Types of variances
Analysis of variances may be done in respect of each element of cost and sales. It includes
1. Direct material variance
2. Direct labour variance
3. Overhead variance
4. Sales variance
MATERIAL VARIANCES
It includes:
a. Material Cost Variance (MCV): It is the difference between the standard cost of materials
allowed for the output achieved and the actual cost of materials used. It may be expressed as:
MCV=Standard cost of materials for actual output – Actual cost of materials used
Std. cost of material = std qty x std price per unit
Actual cost of material = Actual qty x actual price
b. Material Price Variance (MPV): It is that portion of the material cost variance which is due to
the difference between the standard cost of materials used for the output achieved and the actual
cost of materials used.
MPV = Actual qty x (std price – Actual price)
c. Material Usage Variance or Material Quantity Variance(MQV): It is that portion of
material cost variance which is due to the difference between the standard quantity of materials
specified for the actual output and the actual quantity of materials used.
MUV = Std price per unit (Std qty – Actual qty)
d. Material Mix Variance (MMV): It is that portion of the material usage variance which is due
to the difference between standard and actual composition of a mixture. It is calculated as the
difference between the standard price of the standard mix standard price of the actual mix.
In case of material mix variance, two situations may arise: Actual weight of mix and the A.
Standard weight of mix do not differ: - In this case material mix variance is calculated by
applying the following formula
MMV= Std price (Std qty x Actual qty)
If the standard is revised due to shortage of a particular type of material, the material mix
variance is calculated as follows:
MMV= Std price (Revised std qty – Actual qty)
B. Actual weight of mix differ from standard weight weight of mix:- In such a case, material mix
variance is calculated as follows:

Total weight of actual mix

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

Standard Actual
Qty Price Total Qty Price Total
Material A 10 3 30 15 4 60
Material B 15 4 60 25 3 75
Material C 25 2 50 35 2 70
----------------------- --------------------------
50 140 75 205
=== === === ====
Solution:
1. Material price variance:
Actual usage (Std price - Actual Price)
Material A = 15 (3 - 4) = Rs. 15 adverse
Material B = 25 (4 – 3) = Rs. 25 Favourable
Material C = 35 (2 – 2) = Nil
-------
Total Price variance Rs. 10 Favourable
==============
2. Material Usage variance:
Standard rate (Std usage – actual usage)
Material A = 3( 10 – 15 ) =Rs. 15 Adverse
Material B = 4 (15 – 25 ) =Rs. 40 Adverse
Material C = 2 (25 – 35) = Rs. 20 Adverse
----------------------
Total material usage Variance=Rs. 75 Adverse

3. Material Mix Variance:

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

=75/50 x Rs. 140 – Rs. 215

= Rs. 210 – Rs. 215 = Rs. 5 Adverse
Illustration 2. It is estimated that a product requires 50 units of material at the rate of Rs. 3 per
unit. The actual consumption of material for manufacturing the same product came to 60 units at
the rate of Rs. 2.9 per unit. Calculate
1. Material cost variance
2. Material price variance
3. Material usage variance
Solution:
1. Material cost variance = Std cost – Actual cost
Std cost = Std qty x Std price per unit = 50 x 3 = 150
Actual cost = Actual qty x Actual price per unit = 60 x 2.90 =174
Material Cost Variance = 150 – 174 = 24 un favourable
2. Material Price Variance = Actual qty x (Std price – actual price)
60 x (3 – 2.90) = 6 favourable
3. Material usage variance = Std price x (Std qty – Actual qty)
3x (50 -60 ) = Rs. 30 unfavourable
Labour Variance: When standard cost of labour differs from actual wage cost, the labour variance
arises. The following are the important types of labour variances

1. Labour cost variance: It is the difference between standard cost of labour allowed for
actual output achieved and the actual cost of labour.
LCV = Std cost of labour – Actual cost labour
2. Labour rate variance: It is that part of labour cost variance, which arises due to the
difference between standard rate specified and the actual rate paid.
LRV = Actual time x (Std rate – Actual rate)
3. Labour Efficiency Variance: It is that portion of labour cost variance which arises due to
the difference between standard labour hours specified for the activity achieved and the
actual labour hours expended.
LEV = Standard rate x (Standard time for actual output – Actual time)
It arises because of the following reasons:
a. Use of incorrect grade of labour
b. Insufficient training
c. Bad supervision
d. Incorrect instructions
e. Bad working conditions
f. Worker’s dissatisfaction
g. Defective equipment and machinery
h. Wrong item of equipments
i. Excessive labour turn over, and
j. Fixation of incorrect standards.

Illustration: I
Calculate labour cost variance from the following data:
Standard hours: 40
Rate : Rs. 3 per hour
Actual hours : 60
Rate : Rs. 4 per hour
Solution:
Labour cost Variance = Standard cost of labour – Actual cost of labour
= (40x3) – (60x4)
=120 – 240 =Rs. 120 Adverse

Illustration II
The standard and actual figures of a firm are as under
Standard time for the job : 1000 hrs
Standard rate per hour : Re.0.50
Actual time taken : 900 hours
Actual wages paid : Rs.360
Compute labour variances.
Solution:
Labour Cost Variance:= Standard cost of labour – Actual cost of labour
= (1000x0.50) – (900 x 0.40)
=500 – 360
= Rs. 140 Fav
Labour Mix Variance = Actual time x (Standard rate – Actual rate)
= 900x (0.50 – 0.40)
= Rs. 90 Fav
Labour efficiency Variance = Standard rate x (Standard time for actual output – Actual time)
=0.50 x (1000 – 900)
= Rs. 50 Fav.

Overhead Variances:
The term overhead, which comprises indirect materials, indirect labour and indirect expenses, may
relate to factory, office or selling and distribution. It is the sum of variable overhead variance and
fixed overhead variance. In other words, it is the difference between standard overhead cost
charged to production and the actual overhead cost incurred.
Variable overhead Cost variance: This represents the difference between the standard cost of
variable overhead allowed for actual output and the actual variable overhead incurred during the
period. Variable overhead cost variance is made up of variable overhead expenditure variance and
variable overhead efficiency variance.

It is computed by the application of the following formula:

a. When OH rate per unit is used

VOH Cost Variance = (Actual output x Std variable OH rate per unit) – Actual Variable OH
Std. VOH rate per unit = Std variable OH
--------------------
Std out put
b. When OH rate per hour is used
VOH Cost Variance =(Std hours for actual output x Std variable OH rate per hour) – Actual
VOH
Std VOH rate per hour = Std VOH
----------------
Std hours

Variable Over head Expenditure Variance:

It is the difference between the standard variable OH rate per hour and the actual variable OH rate
per hour, multiplied by the actual hours worked.

Variable OH expenditure Variance = (Actual hours worked x Std Variable OH rate per
hour) – Actual variable OH
OR
(Std output for actual hours x Std OH rate per unit) – Actual variable OH
Variable OH efficiency Variance: It is the difference between the variable overhead allowed for
production and the variable overhead absorbed through production.

Variable OH Efficiency Variance = Std Variable OH rate per hour (Std hours for actual
production – Actual hours)

If actual hours is less, it is favourable variance and vice versa.

Illustration

From the following data for the month of Feb., Calculate OH variances.

Budgeted production for the month - 150 units

Budgeted variable OHs - Rs. 3750
Std time for one unit - 10 hrs
Actual production for the month - 125 units
Actual variable OHs -Rs. 3 600/
Actual hours worked - 2250 hrs
Solution

Std OHs for actual production (125 units) = 3750/150 x 125

= Rs. 3125

Std OH rate per hour:

Total std hours = 150 units x 10 =1500 hrs

Rate per hour = 3750/1500 = Rs. 2.5

Actual OH rate per hour = 3600/2250 hrs = Rs. 1.6

Std. hours for actual production = 125 units x 10 hours = 1250 hrs

1. VOH Cost Variance = (Actual output x Std variable OH rate per unit) – Actual Variable OH
= (125 x 25) – 3600
=3125 – 3600 = 475 Adverse
2. Variable Overhead Expenditure Variance = (Actual hours worked x Std Variable OH rate
per hour) – Actual variable OH
= (2250 x2.5) – 3600
= Rs. 2025 F
3. Variable Overhead Efficiency Variance = Std Variable OH rate per hour(Std hours for
actual production – Actual hours)
=2.5 (1250 -2250)
= Rs. 2500 A
Fixed Over head variance:
It is the difference between standard fixed overhead allowed for actual output and the actual fixed
overhead incurred. Fixed overhead cost variance is calculated by using the following equation
Fixed OH cost Variance = Std. fixed OH for actual Output – Actual fixed OH
If actual OH is less, it is favourable variance and vice versa. Fixed OH cost variance is divided into
two – fixed overhead expenditure variance and fixed overhead volume variance.

Fixed OH Expenditure variance: It is the difference between budgeted fixed overhead and actual
fixed overhead.

Fixed Overhead expenditure variance = Budgeted fixed OH – Actual Fixed OH

Fixed OH volume Variance: It is the difference between Std fixed OH allowed for actual output
and the budgeted fixed overhead for the period.

Fixed Overhead Volume Variance = Std. fixed overhead for actual output – Budgeted fixed
Overheads.
Illustration:

From the following data relating to June 2011, Calculate fixed OH variances:
Budgeted hours for the month = 180 hrs
Budgeted output for the month = 9,000 units
Budgeted fixed overheads = Rs. 27,000
Actual production for the month = 9,200 units
Actual hours for production = 175 units
Actual fixed overheads = Rs. 28,000

Solution:

1. Fixed overhead cost variance = Std fixed overhead for actual output – Actual fixed overhead
= 27600 – 28000 = Rs. 400 A
2. Fixed Overhead expenditure Variance = Budgeted fixed overhead – Actual fixed overhead
= 27,000 - 28,000 = Rs. 1000 A
3. Fixed Overhead Volume Variance = Std fixed overhead for actual output – Budgeted fixed
overheads
= 27600 - 27000 = Rs. 600 F

Note: Std. overhead for actual output (9200 units) = 27000/9000 x 9200

= Rs. 27600
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