BBA 201 MANAGEMENT AND COST ACCOUNTING

UNIT 2

Introduction
In the beginning the scope of accounting was limited to keeping of records of business transactions
and to prepare Profit & Loss Account from the view of financial results and Balance Sheet from the
view of financial position. In this system profit analysis was the main criterion for measuring the
efficiency of an enterprise. Later on, it was realised that along with profit analysis the cost analysis is
also equally important. In fact, cost computation, cost control and cost analysis have become very
useful and important aspects in this era of severe business competition and in this context a new
branch of accounting known as ‘Cost Accounting’ has emerged.

Cost Accounting is a specialised branch of general accounting in which detailed and

systematic information’s related to cost of goods or services are maintained in such a way as to
obtain detailed information about total and per unit cost and guidance for the analysis and control of
cost.

According to I.C.M.A. London – “Cost Accounting is the technique and process of ascertainment of
cost.”

Walter W. Bigg has defined cost accounting as follows: - “Cost Accounting is the provision of
such analysis and classification of expenditure as will enable the total cost of any particular unit of
production to be ascertained with reasonable degree of accuracy and at the same time to disclose
exactly how such cost is constituted.”

In the words of Harold J. Wheldon “Costing is the classifying, recording and appropriate
allocation of expenditure for the determination of the cost of products or services, and for the
presentation of suitably arranged data for the purpose of control and guidance of the management. It
concludes the ascertainment of the cost of the every order, job, contract, service or units as may be
appropriated. It deals with the cost of production, selling and distribution.”

Conclusively, cost accounting may be defined as body of concepts, methods, techniques and
procedure used to compute, analyse or estimate the costs profitability and performance of individual
products, services or departments and other segment of an enterprise.

Above analysis of definitions given by thinkers can be expressed in proper and real sense that
“Cost accounting is the process of accounting for cost from the points 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 the profitability of activities carried out planned.”

In Short “Cost accounting involves a study of those concepts, tools and techniques, which help
in ascertaining and analysis cost.” It is also concerned with the method of accounting for total cost
and per unit cost of product service, order, process or job.
Meaning and Definitions

(i) Cost- Cost is the amount of resource given up in exchange of some goods or services. It can
be expressed as a noun as well as a verb. As a noun, it can be defined as the amount of
expenditure (actual or notional) incurred on or attributable to a specified article, product or activity.

As a verb, it can be as an action to ascertain the cost of a specified thing or activity.

(ii) Costing- Costing is defined as “the technique and process of ascertaining costs”.

According to CIMA “an organisation’s costing system is the foundation of the internal financial
information system for managers. It provides the information that management needs to plan and
control the organisation’s activities and to make decisions about the future.”

(iii) Cost Accounting- Cost Accounting is defined as "the process of accounting for cost which
begins with the recording of income and expenditure or the bases on which they are calculated and
ends with the preparation of periodical statements and reports for ascertaining and controlling costs."

(iv) Cost Accountancy- Cost Accountancy has been defined as “the application of costing and
cost accounting principles, methods and techniques to the science, art and practice of cost
control and the ascertainment of profitability. It includes the presentation of information derived there
from for the purpose of managerial decision making.” Thus, cost accountancy is the science, art and
practice of a cost accountant.

It is science because it is a body of systematic knowledge having certain principles which a

cost accountant should possess for proper discharge of his responsibilities. It is an art as it requires
the ability and skill with which a cost accountant is able to apply the principles of cost accountancy to
various managerial problems.

DIFFERENCE BETWEEN COSTING, COST ACCOUNTING AND COST ACCOUNTANCY

Basis of Costing Cost Accounting Cost Accountancy

Difference
1. Meaning and It is concerned with It is concerned with It is concerned with the
relation ascertaining of cost. recording of cost. principles, techniques and
methods of costing adopted
by the business.
2. Scope It is very narrow in its It is narrow in its It is much wider in its scope.
scope. scope.
3. Point of It begins where It begins where It is the starting point of
functioning accountancy ends. costing ends. costing system.
4. Persons It is related with cost This work is related It involves cost accountant as
involved accountant. with cost clerks. well as management
accountant.
NATURE OF COST ACCOUNTING

The nature of cost accounting can be brought out under the following headings:

1. Cost accounting is a branch of knowledge: Though considered as a branch of financial

accounting, cost accounting is one of the important branch of knowledge, i.e., a discipline by
itself. It is an organised body of knowledge consisting of its own principles, concepts and
conventions. These principles and rules vary from industry to industry.

2. Cost accounting is a science: Cost accounting is a science as it is a body of systematic

knowledge relating to not only cost accounting but relating to a wide variety of subjects such
as law, office practice and procedure, data processing, production and material control, etc. It
is necessary for a cost accountant to have intimate knowledge of all these field of study in
order to carry on his day-to-day activities. But it is to be admitted that it is not a perfect
science as in the case of natural science.

3. Cost accounting is an art: Cost accounting is an art in the sense it requires the ability and
skill on the part of cost accountant in applying the principles, methods and techniques of cost
accountancy to various management problems. These problems include the ascertainment of
cost, control of costs, ascertainment of profitability, etc.

4. Cost accounting is a profession: In recent years cost accounting has become one of the
important professions which have become more challenging. This view is evident from two
facts. First, the setting up of various professional bodies such as National Association of
Accountants (NAA) in USA. The Institute of Cost and Management Accountants in UK, the
Institute of Cost and Works Accountants in India and such other professional bodies both in
developed and developing countries have increased the growing awareness of costing
profession among the people. Secondly, a large number of students have enrolled in these
institutes to obtain costing certificates and memberships for earning their livelihood.

SCOPE OF COST ACCOUNTING

Scope of cost accounting consists of the following functions:

(i) Costing: Costing is the technique and process of ascertaining costs of

products or services. The cost ascertainment procedure is governed by some cost
accounting principles and rules. Generally, cost is ascertained using historical costs,
standard costs, process cost, operation cost, etc.
(ii) Cost Accounting: This is a process of accounting for cost which begins
with the recording of expenditure and ends with the preparation of periodical
statement and reports for ascertaining and controlling cost. Cost Accounting
is a formal mechanism of cost ascertainment.
(iii) Cost Analysis: It involves the process of finding out the factors responsible for variance in
actual costs from the budgeted costs and accordingly fixation of responsibility for cost
differences. This also helps in taking better cost management and strategic decisions.
(iv) Cost Comparisons: Cost accounting also includes comparisons of cost involved in
alternative courses of action such as use of different technology for production, cost of
making different products and activities, and cost of same product/ service over a period of
time.
 (v) Cost Control: It involves a detailed examination of each cost in the light of
advantage received from the incurrence of the cost. Thus, we can state that
cost is analyzed to know whether cost is not exceeding its budgeted cost and
whether further cost reduction is possible or not.
(vi) Cost Reports: This is the ultimate function of cost accounting. These reports
are primarily prepared for use by the management at different levels. Cost
Reports helps in planning and control, performance appraisal and
managerial decision making.
(vii) Statutory Compliances: Maintaining cost accounting records as per the
rules prescribed by the statute to maintain cost records relating to
utilization of materials, labour and other items of cost as applicable to the
production of goods or provision of services as provided in the Act and these
rules.

CONCEPT OF COST:

According to the Chartered Institute of Management Accountants, cost is “the amount of

expenditure (actual or notional) incurred on or attributable to a specified thing or
activity.” Similarly, according to Anthony and Wilsch “cost is a measurement in monetary terms
of the amount of resources used for some purposes.”

Cost has been defined by the Committee on Cost Terminology of the American Accounting
Association as “the foregoing, in monetary terms, incurred or potentially to be incurred in the
realisation of the objective of management which may be manufacturing of a product or rendering of a
service.”

From the above, it may be stated that cost means the total of all expenses incurred for a product or a
service. Thus, cost of an article means the actual outgoings or ascertained changes incurred in its
production and sale activities. In short, it is the amount of resources used up in exchange for some
goods or services.

CLASSIFICATION OF COST:
Classification of costs implies the process of grouping costs according to their common
characteristics. A proper classification of costs is absolutely necessary to mention the costs with cost
centres. Usually, costs are classified according to their nature, viz., material, labour, over-head,
among others. An identical cost figure may be classified in various ways according to the needs of the
firms.

Costs can be classified into different categories for different purposes. Costs may be categorized
according to their: (1) function, (2) ease of traceability, (3) timing of charge against revenue, (4)
behavior in accordance with activity, and (5) relevance to decision making.

• Costs according to function include: manufacturing and non-manufacturing costs.

• Ease of traceability: direct and indirect costs.
• Timing: product and period costs.
• Behavior: variable, fixed, and mixed costs.
• Relevance: relevant, standard, opportunity, sunk, and controllable costs.
According to Function

1. Manufacturing costs - incurred in the factory to convert raw materials into finished goods. It
includes cost of raw materials used (direct materials), direct labor, and factory overhead.
2. Non-manufacturing costs - not incurred in transforming materials to finished goods. These
include selling expenses (such as advertising costs, delivery expense, salaries and
commission of salesmen) and administrative expenses (such as salaries of executives and
legal expenses).

According to Ease of Traceability

1. Direct costs - those that can be traced directly to a particular object of costing such as a
particular product, department, or branch. Examples include materials and direct labor. Some
operating expenses can also be classified as direct costs, such as advertising cost for a
particular product.
2. Indirect costs - those that cannot be traced to a particular object of costing. They are also
called common costs or joint costs. Indirect costs include factory overhead and operating costs
that benefit more than one product, department, or branch.

According to Timing of Charge against Revenue

1. Product costs - are inventoriable costs. They form part of inventory and are charged against
revenue, i.e. cost of sales, only when sold. All manufacturing costs (direct materials, direct
labor, and factory overhead) are product costs.
2. Period costs - are not inventoriable and are charged against revenue immediately. Period
costs include non-manufacturing costs, i.e. selling expenses and administrative expenses.

According to Behavior in Accordance with Activity

1. Variable costs - vary in total in proportion to changes in activity. Examples include direct
materials, direct labor, and sales commission based on sales.
2. Fixed costs - costs that remain constant regardless of the level of activity. Examples include
rent, insurance, and depreciation using the straight line method.
3. Mixed costs - costs that vary in total but not in proportion to changes in activity. It basically
includes a fixed cost potion plus additional variable costs. An example would be electricity
expense that consists of a fixed amount plus variable charges based on usage.

According to Relevance to Decision Making

1. Relevant cost - cost that will differ under alternative courses of action. In other words, these
costs refer to those that will affect a decision.
2. Standard cost - predetermined cost based on some reasonable basis such as past
experiences, budgeted amounts, industry standards, etc. The actual costs incurred are
compared to standard costs.
3. Opportunity cost - benefit forgone or given up when an alternative is chosen over the other/s.
Example: If a business chooses to use its building for production rather than rent it out to
tenants, the opportunity cost would be the rent income that would be earned had the business
chose to rent out.
 4. Sunk costs - historical costs that will not make any difference in making a decision. Unlike
relevant costs, they do not have an impact on the matter at hand.
5. Controllable costs - refer to costs that can be influenced or controlled by the manager.
Segment managers should be evaluated based on costs that they can control.

How is cost accounting different from financial accounting?

• In traditional accounting, the profit and loss is derived by deducting expenses from income
whereas in cost accounting the motive is to be cost effective by reducing costs of process,
production or project.

• Financial accounting views an organization in entirety whereas cost accounting segregates the
organization into various processes, projects or production units.

• Financial accounting is used to present the position of the organization to its stakeholders
whereas cost accounting is used for internal review of costs.

• Financial accounting is uniform across various businesses, however, cost accounting methods
vary based on the type of business.

Methods of Costing:

Methods to be used for the ascertainment of cost of production differ from industry to industry. It
primarily depends on the manufacturing process and also on the methods of measuring the
departmental output and finished products.

Basically, there are two methods of costing (as per CIMA Terminology) viz.:
(i) Specific Order Costing (or Job/Terminal Costing) and
(ii) Operation Costing (or Process or Period Costing.)

(i) Specific Order Costing (or Job/Terminal Costing)

1. Job Costing:

Under this method, costs are collected and accumulated for each job, work order or project
separately. Each job can be separately identified; so it becomes essential to analyse the cost
according to each job. A job card is prepared for each job for cost accumulation. This method is
applicable to printers, machine tool manufacturers, foundries and general engineering workshops.

2. Contract Costing:

When the job is big and spread over long periods of time, the method of contract costing is used. A
separate account is kept for each individual contract. This method is used by builders, civil
engineering contractors, constructional and mechanical engineering firms etc.

3. Batch Costing:

This is an extension of job costing. A batch may represent a number of small orders passed through
the factory in batch. Each hatch is treated as a unit of cost and separately costed. The cost per unit is
determined by dividing the cost of the batch by the number of units produced in a batch. This method
is mainly applied in biscuits manufacture, garments manufacture and spare parts and components
manufacture.

(ii) Operation Costing (or Process or Period Costing.)

1. Process Costing:

This is suitable for industries where production is continuous, manufacturing is carried on by distinct
and well defined processes, the finished products of one process becomes the raw material of the
subsequent process, different products with or without byproducts are produced simultaneously at the
same process and products produced during a particular process are exactly identical.

As finished products are obtained at the end of each process, it will be necessary to ascertain
not only the cost of each process but also cost per unit at each process. A separate account is
opened for each process to which all expenditure incurred thereon is charged.

The cost per unit is obtained by averaging the expenditure incurred on the process during a
certain period. Hence, this is known as average costing. As the products are manufactured in a
continuous process, this is also known as continuous costing. Process costing is generally followed in
Textile Industries, Chemical Industries, Tanneries, Paper Manufacture etc.

2. One Operation (Unit or Output) Costing:

This is suitable for industries where manufacture is continuous and units are identical. This method is
applied in industries like mines, quarries, oil drilling, breweries, cement works, brick works etc. In all
these industries there is natural or standard unit of cost. For example, a barrel of beer in breweries, a
tonne of coal in collieries, one thousand of bricks in brickworks etc.

The object of this method is to ascertain the cost per unit of output and the cost of each item of
such cost. Here cost accounts take the form of cost sheets prepared for a definite period. The cost
per unit is determined by dividing the total expenditure incurred during a given period by the number
of units produced during that period.

Techniques of Costing:

Following are the main techniques of costing:

1. Marginal Costing – It is the ascertainment of marginal cost differentiating between fixed cost and
variable cost. The ascertainment by differentiating between fixed costs and variable costs, of marginal
costs and of the effect on profit of changes in volume or type of output.

2. Standard Costing – The preparation and use of standard costs, their comparison with actual costs
and the analysis of variance to their causes and points of incidence. This permits the management to
investigate the reasons for these variances and take necessary corrective action.

3. Direct Costing – It is a practice of charging all direct costs into, variable and fixed cost relating to
operations process or products leaving all other cost to be written off against profits in which they
arise.
4. Absorption Costing – Absorption costing is also referred to as full costing. It is a costing technique
in which all manufacturing cost (fixed and variable) are considered as cost of production and are used
in determining the cost of goods manufactured and inventories. The fixed production costs are treated
as part of the actual production costs.

5. Uniform Costing – It is the use of the same costing principles and practices for common control or
comparison of cost by different business units. CIMA has defined uniform costing as “the use by
several undertakings of the same costing principles and or practices.” This helps to compare the
performance one business with the other and to derive the benefit of anyone’s better experience and
performance.

6. Budgetary Control – A Budget is used for controlling and co-ordination of business operations. A
Budget is a quantitative or financial statement prepared for definite period of time. Budgetary control
is a use of comprehensive system of budgeting to aid management in carrying out its functions of
planning, coordinating, and controlling operations. A budgetary control is one of the important tools of
control.

What is Material Costing?

Material costing is the process of determining the costs at which inventory items are recorded into
stock, as well as their subsequent valuation in the accounting records. We deal with these concepts
separately.

Material Costing for Initial Inventory Acquisition

A company must decide whether it will record acquired materials at their purchased prices, or if
additional costs will be added, such as freight in, sales taxes, and customs duties. The addition of
these other costs is allowable, but may require a certain amount of additional work. It is easier to
charge these additional costs to expense as incurred, so they appear immediately in the cost of
goods sold.

Overhead is not allocated to raw materials, since these items have not undergone any production
activities (with which overhead is associated). Overhead is only allocated to work-in-process and
finished goods inventory.

Material Costing for Subsequent Valuation

Once inventory has been received into stock, it is subject to the lower of cost or market (LCM) rule. In
essence, this rule states that the recorded cost of inventory should be at the lower of its recorded cost
or the market rate. From a practical perspective, this rule is usually only applied to those inventory
items having the largest extended costs. Its application to low-value items would not result in any
material changes, and so is avoided from an efficiency perspective.

A cost layering concept must also be applied to inventory. Cost layering refers to the order in which
inventory items are charged to the cost of goods sold when units are sold to customers. Several
possible cost layering concepts that can be used are noted below.
Specific Identification Method

The specific identification method assigns costs to specific units of inventory, and charge these costs
to expense when the specific units are sold. Usually only applies to expensive and unique inventory
items.

First In, First Out Method

The first in, first out method assigns costs based on the assumption that the earliest goods acquired
are the first ones sold. If prices are increasing, this tends to result in higher profits.

Last In, First Out Method

The last in, first out method assigns costs based on the assumption that the last goods acquired are
the first ones sold. If prices are increasing, this tends to result in lower profits. This method is not
allowed under international financial reporting standards.

Weighted Average Method

The weighted average method uses an average of the costs of all units in stock when charging costs
to the cost of goods sold.

Material cost accounting

“Adequate and proper control of materials and supplies, work in progress and finished goods
inventory from the time production is planned until goods are sold and shipped is an important feature
of a cost accounting system.” -Matz, Curry & Frank

Purchase of materials
The quality of the finished product depends upon the quality of raw materials used their in. And
improved craftsmanship can of course help in improving the quality of the product but it cannot
change the basic character of the raw material used. Therefore, it is essential that the purchase
department should make the purchases of the right quality and also at the right prices to avoid the
cost of production from being adversely affected.

Centralized & Decentralized Purchase | Suitability | Merits & Demerits | Differences

Centralized Purchase refers to purchasing of all the requirements under the central point of the
organization. Likewise, Decentralized Purchase refers to purchasing of requirements of each
production centre in an organization.

Important points to be considered

There is no hard and fast rule to follow either centralized purchase system or decentralized purchase
system. But the management should consider the following points before deciding either centralized
purchase or decentralized purchase for their purchase department.

1. The distance between the production centre and the storage.

2. The nature of materials used i.e., bulky, heavy, fragile etc.

3. The cost of transport.

4. Policy of the company with regard to the materials purchase.

Suitability of Centralized Purchase

1. One or more production centers or plants are closely located.

2. The plant uses one basic raw material or production centers for the production of standard
products.

Suitability of Decentralized Purchase

1. Production centers are located distantly.

2. The plants for producing different products produce different raw materials.

Both centralized and decentralized purchase system have its own merits and demerits. Hence, the
suitability of purchase system differs from one company to another.

Merits of Centralized Purchase

The following are the merits of centralized purchase.

1. Better material control

2. Better layout of storage space.

3. Utilization of high technical skill.

4. Minimum finance required.

5. Better supervision of materials usage.

6. Less clerical work.

7. No duplication of purchase.

8. Better facility for stores audit.

9. Quick stocktaking.

10. Lower cost of insurance.

Demerits of Centralized Purchase

The following are the demerits of centralized purchase.

1. High cost of internal transport.

2. Non-availability of materials for production in time.

3. Greater risk of obsolescence.

Merits of Decentralized Purchase

The following are the merits of decentralized purchase.

1. Less cost of internal transport.

2. Timely availability of materials.

3. Lower chance of obsolescence.

Demerits of Decentralized Purchase

The following are the demerits of decentralized purchase.

1. Poor layout of space.

2. More finance required.

3. Less technical skill is obtained.

4. More clerical work.

5. Duplicate purchase of materials.

6. Slow in stock taking process.

7. High cost of insurance.

Differences between Centralized Purchase & Decentralized Purchase

The list of differences between centralized purchase and decentralized purchase is given below.

Centralized Purchase Decentralized Purchase

1. Control on buying is exercised effectively Effective control is not possible.

Large scale benefits are not

2. Economy in large scale purchase is possible
available.

3. Better terms on purchase are possible. Bargaining power is very low.

Purchasing skill is available from the

4. Skills of the purchasing officer are high.
purchaser or purchasing officer.

Purchasing specialization is not

5. Purchasing specialization is obtained.
obtained.

There is a lot of difference in

6. Uniformity in purchase is followed.
purchase.
 Centralized Purchase Decentralized Purchase

Quality of the material is

7. Standard materials are purchased.
questionable.

8. Less finance is enough. More finance is required.

9. Need of less storage space. Need of more storage space.

Regulation of purchase policy is

10. It is easy to regulate purchase policy.
difficult.

11. Establishment cost is high. Establishment cost is low.

12. Delay in purchase is possible. Purchase of materials is very quick.

13. Internal transport cost is incurred. There is no internal transport cost.

Advantage of local market can be

14. Advantage of local market cannot be obtained.
enjoyed.

There is no such misunderstanding

15. There is a misunderstanding between production
since the concerned department
centre and purchase department.
purchases the materials.

16. There is a chance for favoritism in purchase. There is no favoritism in purchase.

There is no blocking of working

17. There is a blocking of working capital.
capital.

PURCHASE CYCLE

The top eight steps involved in purchasing cycle of materials.

Step # 1. Receiving and analysing purchasing requisition:

Purchase requisitions start with the department or person who will be the ultimate user. In the
material requirements planning environment, the planner releases a planned order authorising the
purchasing department to go ahead and process a purchase order.

The purchase requisition contains, at least, the following information:

a. Identity of originator, signed approval, and account to which cost is assigned.

b. Material specification.

c. Quantity and unit of measure.

d. Required delivery date and place.

e. Any other supplementary information required.

Step # 2. Selecting suppliers:

Identifying and selecting suppliers are important responsibilities of the purchasing department. For
routine items or those that have not been purchased in the past, a list of approved suppliers is kept. If
the item has not been purchased before or there is no acceptable supplier on file, a search must be
made.

If the order is of small value or for standard items, a supplier can probably be found in a catalogue,
trade journal, or directory.

Step # 3. Requesting quotations:

For major items, it is usually desirable to issue a request for quotation. This is a written inquiry that is
sent to many suppliers to ensure that competitive and reliable quotations are received. It is not a
sales order. After the suppliers have completed the quotations and returned it to the buyer, the
quotations are analysed for price, compliance to specification, terms and conditions of sale, delivery,
and payment terms.

For items where specifications can be accurately written, the choice is probably made on price,
delivery, and terms of sale. For items where specifications cannot be accurately written, the items
quoted will vary. The quotations must be evaluated for technical factors and price. Usually both the
issuing and purchasing departments are involved in the decision.

Step # 4. Determining the right price:

This is the responsibility of the purchasing department and is closely tied to the selection of suppliers.
The purchasing department is also responsible for price negotiation and will try to obtain the best
price from the supplier.

Step # 5. Issuing a purchasing order:

A purchase order is a legal offer to purchase. Once accepted by the supplier, it becomes legal
contract for delivery of the goods according to the terms and conditions specified in the purchase
agreement. The purchase order is prepared from the purchase requisition or the quotations and from
any other additional information needed.

A copy is sent to the supplier; copies are retained by purchasing and are also sent to other
departments such as accounting, the originating department, and receiving.

Step # 6. Following-up and delivery:

The supplier is responsible for delivering the items ordered on time. The purchasing department is
responsible for ensuring that suppliers do deliver on time. If there is doubt that delivery dates can be
met, purchasing must find out the problem in time and take corrective action.

This might involve expediting transportation, alternate sources of supply, working with the supplier to
solve its problems, or rescheduling production.

The purchasing department is also responsible for working with the supplier on any changes in
delivery requirements. Demand for items changes with time, and it may be necessary to expedite
certain items or push delivery back on some others. The buyer must keep the supplier informed of the
true requirements so that the supplier is able to provide what is wanted and when.

Step # 7. Receiving and accepting goods:

When the goods are received, the receiving department inspects the goods to ensure that correct
ones have been sent, are in the right quantity, and the bill of lading supplied by the carrier. The
receiving department then accepts the goods and writes up a receiving report noting any variance. If
further inspection is required, such as by quality control, the goods are sent to quality control or held
there for inspection.

If the goods are received damaged, the receiving department will advise the purchasing department
and hold the goods for further action. Provided the goods are in order and require no further
inspection, they will be sent to the originating department or to inventory.

A copy of the receiving report is then sent to the purchasing department noting any variance or
discrepancy from the purchase order. If the order is considered complete in all respects, the receiving
department closes out its copy of the purchase order and advises the purchasing department
accordingly.

If it is not, the purchase order is held open awaiting completion. If the goods have also been
inspected by the quality control department, they, too, will advise the purchasing department whether
the goods have been accepted or not.

8. Approving supplier’s invoice for payment:

When the supplier’s invoice is received, there are three pieces of information that should agree – the
purchase order, the receiving report, and the invoice. The items and the quantities should be the
same on all; the prices, and extensions to prices, should be the same on the purchase order and the
invoice.

All discounts and terms of the original purchase order must be checked against the invoice. It
is the job of the purchasing department to verify these and to resolve any difference. Once
approved, the invoice is sent to accounts payable for payment.
Concept of labour cost
Out of many resources held by an organization, human resources is the most significant one. The
success of an organization largely depends on skill and efficiency of person working in it. It is a critical
task of the management to manage human resource, which are different in nature and hence difficult
to control. Management tries to make the best use of available human resources and minimize the
total labour cost by making them more productive. On the other hand, workers may try to earn more
by putting lower efforts as much as possible. Due to these contradicting interests, the task of labour
management has become more and more difficult in the current days.

Labour cost refers to remuneration paid to the employees in from of wages, salary, and
bonus, allowances etc. for their time and effort used in producing goods or services. In other words,
monetary resources payable to the employee for their mental and physical sacrifice is called the
labour cost. The institute of cost and management accountants (ICMA), London has defined
labour cost as "the cost of remuneration of the employees of an undertaking". A significant amount
has to be sent to retain the employees in the organization and also to keep them satisfied so that they
contribute their best. Labour cost can be analyzed into the following:

a. Monetary benefits: salaries and wages, dearness or other allowances, production incentive or
bonus, overtime allowance, provident fund, payment for insurance scheme, old age pension,
retirement gratuity, salary in lieu of leave, profit linked bonus etc are the benefits that are provided to
the workers in monetary forms.

b. Non-monetary benefits or fringe benefits: subsidized food and housing, subsidized or free
transportation, clothing, education to employee's children, medical and recreational facilities etc. are
the benefits that are provided to the workers in non-monetary forms.

Types of labour cost

The labour cost can be classified into direct and indirect labour cost as mentioned below:

a. Direct labour cost: direct labour cost is that portion of wages and salaries, which can be
identified and charged to a single costing unit. It is the remuneration of the employees who are
directly connected with the manufacturing operations or the conversion of raw materials into
finished products. The important characteristic of direct labour costs is that, it can be indentified with
and allocated to workmen put on definite jobs or products in the factory. Direct labour cost is also
known as 'direct wages', 'productive wages', manufacturing wages', 'operating wages', factory wages'.
Direct labour cost is a part of the 'prime cost'.

b. Indirect labour cost: indirect labour cost is the remuneration of the employees who are not
directly connected with manufacturing operations. The indirect employees are not directly associated
with the conversion process but assist in the process by way of supervision, mamintance,
transportation of material, materials handling etc. their work benefits all the items being produced and
cannot be specifically identified with the individual product. These costs are accumulated and
apportioned to different cost centers on equitable basis and absorbed into supervisor, foremen,
storekeeper, clerical staff, etc., are the examples of indirect labour costs. Indirect labour cost is also
known as 'indirect wages', unproductive wages' and it is treated as a part of overhead.
Differences between direct and indirect labour cost

The differences between the direct and indirect labour costs are mentioned below:

Need of labour cost control

Labour costs may be very high due to inefficiency of about, idle time and unusual overtime, inclusion
of d dummy names in the pay rolls and other related factors. Inefficient use of labour not only
increases the cost of production but also adversely affects the quality of products. The primary
objective of the management, therefore, is to utilize the labour as economically as possible. It is
therefore necessary for the management to device a proper system of labour cost control.

Control overlabour costs require proper employment and efficient utilization of labour force. These
factors affect the cost and quality of the products of any industrial undertaking and ultimately its
profitability. Labour cost control involves employment of efficient workers, proper training of workers,
proper time keeping and booking and proper accounting for the wages paid to them.

Measurement of Labour Turnover

A high labour turnover rate can indicate several issues within a company, such as poor working
conditions, low wages, or a lack of opportunities for advancement.

It can also be caused by factors outside of the company’s control, such as the overall economy or
changes in the industry. Regardless of the cause, a high labour turnover rate can be costly for a
company.

Three principal methods can be used to measure labour turnover.

Separation Method

This method considers the number of employees who leave the company divided by the average
number of employees during the period.

The formula for separations rate is:

Labour turnover = (No. of separations in a period / Average no. of workers) x 100

LT = (NS / ANW) x 100

So, if a company currently has 100 employees and ten leave during the year, the separation rate
would be 10%.

Replacement Method

This method looks at the number of workers replaced during the month/year divided by the average
number of employees during the period.

The formula for replacement rate is:

Labour turnover = (No. of replacements in a period / Average no. of workers) x 100

LT = (NR / ANW) x 100

For example, if a firm has 200 employees and ten are replaced during the year, the replacement rate
would be 5%.

Flux Method

This method accounts for the number of employees who left and the number of replaced employees
divided by the average number of employees during the period.

The formula for flux rate is:

Labour turnover = ((No. of separations + No. of replacements) / Average no. of workers) x 100

LT = ((NS + NR) / ANW) x 100

For instance, if a business has 1000 employees and a hundred of them leave and a hundred are
replaced during the year, the flux rate would be 20%.

System of wages payment

The success of a concern largely depends upon the efficiency of labour and the efficiency of labour is
considerably affected by the amount of wages paid to them. Some persons are of the view that the
profit of a concern can be maximized only by reducing the wages rates payable to the workers. But
this view is not correct. It should be remembered that low-paid workers are usually inefficient leading
to wages of materials, costly use of tools, and frequent breakdown of machinery and loss of time as a
result of which the cost of production goes up. Reasonable and fair wage rates allowed to the workers
ultimately lead to more economic use of machines, tools, materials and time. Therefore, the
importance of the method of wages payment should never be under-estimated.

Method or systems of wages payment must process the following characteristics:

• Simple to operate and easy to understand.

• Guarantee a minimum wage to every worker.

• Acceptable to the employer and the employee.

• Flexible enough so that changes may be made according to the requirements.

• Ensure the establishment of industrial peace.

Piece rate system

In this method, wages are paid to the employees after completions of work. Under it, a worker is paid
on the basis of output, not the time taken by worker to perform the work. This is one of the simplest
and most commonly used systems of wages payment. In this system, the wages rate is expressed in
term of per unit of output, per job or per work-order. The amount of wages payable to a worker under
this method is to be calculated as follows:
Total wages = total output x wages rate per unit of output

This system is suitable in the following cases;

• Where a work is of a repetitive nature.

• Where the measurement of work is simple.

• Where the quality and accuracy of output is not very important.

• Where stick supervision is not possible.

Time rate system

Under this system, the amount of remuneration or the total wages payable to the workers depends on
the time for which he is employed. This is simple and common method of wages payment. In this
method, the worker is paid an hourly, daily, monthly or yearly rate of wages.

Thus, the worker is paid on the basis of time and not on his performance or unit of output. The
amount of wages payable to a worker under this method is to be calculated as follows:

Total wages = actual time taken x time rate

This method is suitable to be applied in the following circumstances;

• Where the quality of work is more importance than production.

• Where the volume of production is not within the control of labour.

• When it is difficult to fix the unit of output.

• The nature of work is such that there is no basis for incentive plan.

• Where the amount of output cannot be accurately measured, counted and standardized.

Premium plan: incentive wages payment system

Incentive plans have been developed to remove the defects of both time rate and piece rate systems
of wages payment. Under these plans, the advantages of time and piece-wages system. Are
combined, and incentives are provided to workers to work more efficiently. The characteristics of
these are as follows;

a. Incentives by way of bonus and others are given to efficient workers for the time saved.

b. A standard time is fixed and the worker is to perform the given work within the standard time. The
standard time is set after making time studies for the performance of specific job.

The incentive is compromise between the two extremities, on the one. If the workers are paid
according to time, they gain nothing if time is saved and on the other hand, if they are paid on the
basis of piece rate, employers get nothings if time is saved. Under incentive plans, the employer as
well as the worker share the benefit of time saved, and both labour and overhead costs are reduced.
The incentive plan should be selected according to the nature of work and other circumstances. It
should be accepted by the management as well as labour otherwise it does not functions
successfully. The payment of wages may be made according to any of the following plans.

Individual bonus plan

According to individual bonus plan, the bonus of each worker is calculated. Some methods of
calculated wages under individual bonus plan are discussed bellow.

a. Halsey premium plan

This plan wages originated by F.A. Halsey this scheme, an hourly rate is guaranteed to all workers.
A standard time is fixed for each unit, job or operation on the basis of time and motion studies and the
worker is paid the agree hourly rate of wages for the actual time taken plus a fixed percentage of
bonus on the time saved. Generally, the amount of bonus or premium payable to the workers is one-
half (50%) of the wages of the time saved. However, a company can increase or decrease the rate of
bonus.

The following for calculating bonus and total wages/ total earning of the workers under halsey
premium plan are:

Bonus = 50%(time saved x rate per hour)

Total earnings = (Time taken x rate per hour) + 50%(time saved x rate per hour)

Where, time saved = standard time – time taken

Advantages of halsey premium plan

The advantages of halsey premium plan are mentioned below.

a. It is simple to understand and operate.

b. Every worker is guaranteed minimum wages and even the inefficient workers feel secured.

c. It encourages efficiency among workers by inducing hem to finish their job before the standard
time.

d. The benefit from the time saved is shared equally by the employer and the worker.

e. Generally workers do not oppose this method of wages payment as it rewards time saved rather
than increased output.

Disadvantages of Halsey premium plan

The disadvantages of Halsey premium plan are mentioned below.

a. Workers are paid only half of the wages on the time saved. So, the workers may oppose this
method.
b. The worker may perform the work in hurry by neglecting the quality of output to save time and
earn higher bonus.

c. The standard time fixed for finishing a job not is scientific.

b. Rowan premium plan

This plan was developed by David rowan. This plan guarantees an hourly rate to all workers. A
worker is paid the fixed rate per hour for the actual time spent on the job a premium or bonus based
on the time saved. The amount of premium or bonus is not a fixed percentage of the wages of the
time saved but it various according to the extent of the time saved. The amount of bonus or premium
payable under this plan depends on the percentage of time saved by the workers. The bonus is
calculating such percentages out of the basis wages.

Bonus = (time saved/ standard time) x time taken x rate per hour

Total wages = ( time taken x rate per hour) + bonus

Advantages of rowan premium plan

The advantages of rowan premium plan are mentioned below.

a. This plan guarantees minimum wages and provided incentives for efficiency.

b. It does not induce to rush through worker for increased bonus earning because the bonus
increase at a decreasing rate with higher levels of efficiency. Thus, an automatic check for limiting
production of inferior quality of goods is earned.

c. The per unit fixed cost decrease with the increase in production

d. Under this method, the per unit cost decrease due to decrease in er unit labour cost.

Disadvantages of rowan premium plan

The disadvantages of rowan premium plan are mentioned below:

1. As the bonus is to be shared by employer and employees, it is not welcomed by employees. They
expect full benefit for their extra efficiency.

2. The calculation of earning under this method is comparatively complicated and time consuming.

3. The preparation of labour budget and estimated product labour cost are made difficult by the
varying labour costs under this plan.

4. Payment under this plan is much less than that under the Halsey plan by way of bonus below
50% of the time saved.

Overhead Costing

The third important element of costs of any product or service is overheads. Overheads may be
manufacturing or non-manufacturing. Later we briefly discuss the classification of overheads. Before
that let us see what are overheads? Defining overheads particularly focuses on the concept of direct
and indirect expenses which in turn depends on the traceability of the expenses with the product or
service. In other words, expenses that cannot be directly traceable to any product or service are
known as overheads. Simply, overheads are sum of all indirect expenses i.e.

Overheads = Indirect materials+ Indirect labour + Indirect expenses

Classification of overheads: In general, overheads may be classified as

Overheads

Element wise Function wise Behaviour wise

a) Indirect material a) Factory Overhead a) Variable overhead
b) Indirect labour b) Office & Administrative b) Fixed overhead
c) Indirect expenses Overhead c) Semi-variable overhead
c) Selling & Distribution
Overhead
The indirect portion of the total cost constitutes the overhead cost. Overhead cost is defined as “the
aggregate of indirect material costs, indirect wages and indirect expenses.” The term ‘indirect’
denotes that which cannot be allocated but which can be apportioned to cost centres or absorbed by
cost units. The overhead costs are also sometimes allocated to cost centres.

The overhead costs are incurred not for any particular job, work-order, process or unit but for the
business as a whole and include all costs other than direct material costs, direct wages and direct
expenses. Overhead costs are also denoted by ‘supplementary costs’ ‘non-productive costs’, ‘indirect
costs’, ‘oncost’, ‘burden’ etc. Of all the terms, ‘overhead’ is the most common and the Institute of Cost
and Management Accountants, London, does not recommend the use of the terms ‘oncost’ and
‘burden’.

Classification of Overheads:

Classification of costs refers to the process of grouping costs according to their common
characteristics.

Overhead costs may be grouped according to:

1. Functions,

2. Elements, and

3. Behaviour.

1. Function-Wise Classification:

It refers to the classification of overhead costs with reference to the various major activity divisions of
a concern.

The main groups of overhead on the basis of functions are:

(a) Factory Overhead;

(b) Office and Administration Overhead;

(c) Selling Overhead; and

(d) Distribution Overhead.

(a) Factory Overhead:

Factory overhead refers to all expenses other than direct material costs, direct wages and direct
expenses incurred in a factory in connection with manufacturing operations.

Examples of factory overhead are – Rent of factory building, municipal taxes and insurance of factory
building, depreciation of factory building, depreciation and insurance of factory plant and machinery,
repairs and maintenance of factory buildings and machinery, salary of factory manager and other
factory staff, factory power and lighting, cost of small tools, consumable stores, lubricating oil, cotton
waste, salary of store-keeper, expenses of store-keeping, fuel, gas, water, drawing office salaries,
factory stationery, cost of idle time, overtime wages (if not treated as direct cost), telephone charges
of factory, cost of training of new workers, labour welfare expenses etc.

(b) Administration Overhead:

Administration overhead refers to all expenses relating to the direction, control and administration (not
connected directly with production, sales or distribution) of an undertaking.

Examples of administration overhead are – General management salaries, salaries of general office
staff, office rent, depreciation of office building, rates and insurance of office building, office lighting
and air-conditioning, depreciation of office furniture and office machinery, repairs and maintenance of
office building, office furniture and office machinery, audit fees, legal charges, office stationery,
telephone charges of office, bank charges, directors’ fees, counting office salaries etc.

(c) Selling Overhead:

Selling overhead refers to all costs of seeking to create and stimulate demand or of securing orders.

Examples of selling overhead are – Sales office expenses, advertisement, salary of sales manager,
salaries of other selling staff, commission on sales, travelling expenses, expenses of travelling
agents, cost of price lists, catalogues and samples, bad debts, rent of show-room, depreciation of
showroom, rates and insurance of show-room, lighting and cleaning of show-room, expenses of
branch establishments, expenses of sales and publicity department, cost of training to salesmen,
postal expenses relating to sales, legal expenses for recovery of bad debts, cost of entertainment of
customers, market research expenses, cost of preparation of tenders etc.

(d) Distribution Overhead:

Distribution overhead refers to all expenses incurred from the time the product is finished in the
factory till its delivery to ultimate customers or consumers.

Examples of distribution overhead are – Rent of warehouse, depreciation of warehouse, insurance,

rates and lighting of warehouse, depreciation, running and maintenance of delivery vans, salary of
van men, carriage on sales, packing materials and packing charges, cost of after-sales service, salary
of warehouse- keeper, and the like.

2. Element-Wise Classification:

It refers to the classification of overhead with reference to the various elements on which costs are
incurred.

The main groups of overhead on the basis of elements are:

(a) Indirect material costs,

(b) Indirect wages, and

(c) Indirect expenses.

(a) Indirect Material Costs:

Material costs which cannot be allocated but which are to be apportioned to or absorbed by cost
centres or cost units, are known as ‘Indirect Material Costs’. Examples of indirect material costs are –
Consumable stores, cotton waste, small tools, lubricating oil, coal, fuel etc.

(b) Indirect Wages:

Indirect wages refer to the labour cost or wages which cannot be allocated but which are to be
apportioned to or absorbed by cost centres or cost units. Examples of indirect wages are – Salary of
foreman, salary of supervisory staff, salary of factory manager, salary of time-keeper, salary of store-
keeper, idle time wages, leave pay etc.

(c) Indirect Expenses:

Indirect expenses refer to expenses (other than indirect material costs and indirect wages) which
cannot be allocated but which can be apportioned to or absorbed by cost centres or cost units.
Examples of indirect expenses are – Factory rent and rates, depreciation of factory building,
insurance of factory building, depreciation of plant and machinery, factory lighting, repairs and
maintenance etc.

3. Behaviour-Wise Classification:

By ‘behaviour’, we mean the reaction of the expenditure for changes in the volume of output. Some
overhead costs increase with the increase in the volume of output, some remain constant irrespective
of the changes in the level of output, whereas some others do not vary upto a certain volume but vary
after that.

The main groups on the basis of behaviour or variability are:

(a) Fixed Overhead;

(b) Variable Overhead; and

(c) Semi-variable or Semi-fixed Overhead.

(a) Fixed Overhead:

Fixed overhead refers to expenses which tend to remain constant or unaffected (in aggregate) by
changes in the volume of output. For example, if the monthly salary of the Works Manager is
Rs.2,000 and the monthly output is 10,000 units and in a particular month the production falls down to
8,000 units, we cannot make a corresponding cut in the works manager’s salary.

The monthly expenditure of Rs.2,000 thus remains constant and is not affected by the fall in output.
Similarly, when the output increases, there is no increase in the monthly salary of the works manager.
The other examples of fixed overhead are- Rates and taxes on building, insurance of building, factory
rent, supervisor’s salary, etc.

The fixed overhead costs will continue to be incurred even when production completely ceases in a
particular period and are, therefore, also known as ‘Period Costs’, ‘Shut-down Costs’ or ‘Stand-by
Costs’.

(b) Variable Overhead:

Variable overhead refers to expenses which tend to change (in aggregate) directly with changes in
volume of output. Such expenses increase in aggregate as the output goes up and decrease
proportionately when the output falls. However, there may not always be a perfect mathematical
relation. The examples of variable overhead are- Indirect materials, fuel and power, carriage outward,
packing materials, lighting, internal transport, store losses, idle time etc.

(c) Semi-Variable Overhead:

Semi-variable or semi-fixed overhead costs refer to expenses which are partly fixed and partly
variable. These costs are fixed upto a certain volume of output. If, however, the output rises beyond
that limit, these costs shall increase in aggregate although the increase in the expenditure will not be
proportionate to the increase in output. Examples of semi-variable overhead costs are- Depreciation
of plant and machinery, repairs and maintenance, cost of supervision, service department wages,
postage and stationery etc.