31

POST GRADUATE DIPLOMA IN

FINANCIAL MANAGEMENT

SEM - I

COST & MANAGEMENT

ACCOUNTING SYSTEM
 © UNIVERSITY OF MUMBAI

Prof. Suhas Pednekar

Vice-Chancellor,
Universityof Mumbai,

Prof. Ravindra D. Kulkarni Prof. Prakash Mahanwar

Pro Vice-Chancellor, Director,
Universityof Mumbai, IDOL, Universityof Mumbai,

Program Co-ordinator : Dr. Santosh Rathod

Associate Professor, Dept. of English,
IDOL, University of Mumbai, Mumbai

Course Co-ordinator : Samina Shaikh

IDOL, University of Mumbai, Mumbai

Course Writer : Mr. Abhiraj Shivdas

Alkesh Dinesh Mody Institute
Universityof Mumbai
: Prof. Manju Chowdhary
Borivali (E), Mumbai
: Mr. Subhash Dalvi
Alkesh Dinesh Mody Institute
Universityof Mumbai
: Prof. Shilpa Palande
R.J. Thakur College ofArts & Commerce,
Thane (W)

December 2021, Print 1

Published by : Director,
Institute of Distance and Open Learning ,
University of Mumbai,
Vidyanagari, Mumbai - 400 098.

DTP composed & : Mumbai UniversityPress

Printed by : Vidyanagari, Santacruz (E), Mumbai
 CONTENTS
Unit No. Title Page No.

Module I
1. Overview 01
Module II
2. Unit Costing 22
3. Contract Costing 33
4. Valutation of Materials Issues 65
5. Labour Cost Control 108
Module III
6. Marginal Costing 140
Module IV
7. Budgetary Control 159
8. Variance Analysis Standard Costing 194


 I

Syllabus
Post Graduate Diploma in Financial Management
Cost & Management Accounting System

Unit Syllabus
I Cost Accounting - Objective of costing system, cost concepts
and cost classification. Management Accounting Nature &
Scope, role of management accounting, tool and techniques of
management accounting. Distinction between financial
accounting, cost accounting and management accounting.
II Methods of Costing-Unit costing, job & batch cost, contract
costing and process costing. Classification of costs. Element of
costs-Material cost, labour cost and overheads.
III Breakeven Analysis - Cost Volume Profit Relationship -
Applications of Marginal Costing.
Techniques : Fixing Selling Price, Make a Buy, Accepting a
foreign order, Deciding sales mix.
IV Budgetary control & Variance analysis - Preparation of various
types of budgets, advantages & limitations, budgetary control
report to management.
Meaning and uses of standard costing; procedure of setting
standards; variance analysis, one way and two way analysis of
variance; overall cost variance; material variance; labour
variance and overhead variance.

Reference Books -

1) Homgren, Foster 7 Datar - Cost Accounting : A Managerial Emphasis

(Pearson)
2) Pillai & Bhagavathi - Cost Accounting (S. Chand)
3) M. N. arora - Cost and Management Accounting Theory and Problems
(HPH)


 Module - I

1
OVERVIEW
Unit Structure
1.1 Cost Concept
1.2 Evolution of Cost Accounting
1.3 Costing, Cost Accounting and Cost Accountancy
1.4 Objectives of Cost Accounting
1.5 Importance of Cost Accounting
1.6 Scope of Cost Accounting
1.7 Classification of Cost
1.8 Methods and Techniques of Costing
1.9 Role of Cost Accountant in Decision Making
1.10 Management Accounting, meaning, Objectives, Nature and Scope.
1.11 Tools and Techniques of Management
1.12 Distinguish between Cost Accounting, Financial Accounting and
Management Accounting
1.13 Role of Management Accountant in Decision Making

1.1 COST CONCEPT:

Cost is defined as the amount of expenses (actual or notional)

incurred on or attributable to specified thing or activity.

“Cost is the measurement in monetary terms of the amount of resources

used for the purpose of production of goods or rendering of
services”(Institute of Cost and Work Accounts (ICWA) India).

“A cost is the value of economic resources used as a result of producing

or doing the things costed.” (W M Harper)

This activity of the cost will reflect in the manufacturing of the

product or rendering of the services which will cover expenditures under
various heads.

1.2 EVOLUTION OF COST ACCOUNTING

For examples: salary, materials, other expenses etc. In the case of service
industry, they are interested in the cost of ascertaining the cost of the
services it renders. The cost per unit is arrived by dividing the total
expenditure incurred to the total number of production or the service
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rendered. This method can be used when there is only one product. If the
manufacturing company manufactures more than one product, it becomes
imperative to split the total cost among the number of products.

1.3 COSTING, COST ACCOUNTING AND COST

ACCOUNTANCY:

 Costing:
Costing is determining the costs of products/services and also
planning and controlling such costs. Costing is defined as, “the
techniques and processes of ascertaining costs” (The Chartered
Institute of Management Accountants (CIMA). Costing means
finding of cost by any process or technique. Principles and rules
which are determining the costing are as follows:
a. The cost of manufacturing a product.
b. The cost of providing a service.

 Cost Accounting:
Chartered Institute of Management Accountants, London (CIMA)
defines Cost Accounting as “the establishment of budgets,
standard costs and actual costs of operations, processes, activities
or products: and the analysis of variances, profitability or the
social use of funds”.

Cost Accounting is a specialized branch of accounting, which

involves classification, accumulation, assignment, and control of
costs. Cost accounting deals with the collection, analysis of
relevant cost data for interpretation and presentation for various
problems of management.

 Cost Accountancy:
CIMA defines Cost Accountancy 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 as well as presentation of information for the purpose
of managerial decision making”.

Cost Accountancy is a science as it is a knowledge which a cost

accountant should possess to carry out his duties and
responsibilities.It is an art as it required skills by the cost
accountant to apply principles of cost accountancy to various
managerial problems like price, expenditures etc. Practice refers to
the efforts taken by the Cost Accountant in the field of cost
accountancy. Along with the Theoretical knowledge, cost
accountant should possess sufficient practical training and
exposure to real life costing problems.

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1.4 OBJECTIVES OF COST ACCOUNTING:

The Objectives of Cost Accounting are as follows:

1. Ascertaining the Cost:It refers to the cost for a specific product or

activity with a reasonable degree of accuracy.
2. Determining the Selling Price: It helps in finalizing the cost of the
product after which the profit margin is added by the manufacturer and
thus the selling price of the product is fixed.
3. Cost Control and Cost Reduction: It helps in improving profitability
by controlling and reducing costs. This objective is important for
current scenario due to increase in competition in the business world.
4. Management in Decision Making: Taking Management decision in
respect of the price of the product for which the comparison of actual
and standard cost is required to analysis the causes of variation and to
take corrective decisions.
5. Ascertaining the Profit: It helps in ascertaining the profit of the
business by matching the cost with the revenue of that activity. The
purpose is to determine the profit or loss of any activity on an
objective basis.

6. To Provide basis of operating policies

7. To provide information about inefficient and carelessness
8. To provide information about actual situation of production
activity
9. To inform the principles and procedures to be followed in Costing
System
10. To prepare comparative analysis through data collection
11. To estimate cost
12. To disclose and minimize the waste

1.5 IMPORTANCE OF COST ACCOUNTING:

Cost accounting has many importance. Specially, the following parties are
benefitted from it.

1. Importance to management
Management is highly benefitted with the introduction of cost
accounting. It helps to ascertain the cost and selling price of the product.
Cost data help management to formulate the business policies. The
introduction of budgetary control and standard cost would be an aid to
analyse cost. It also helps to find out reasons for profit or loss. It provides
data to submit tender as well. Thus, cost accounting is an aid to
management.

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2. Importance to investors
Investors can obtain benefit fro the cost accounting. Investors want
to know the financial conditions and earning capacity of the business. An
investor must gather information about organization before making
investment decision and investor can gather such information from cost
accounting.

3. Importance of consumers
The aim of costing is to reduce the cost of production to minimize
the profit of business. Reduction in the cost is usually passed on the
consumers in the form of lower price. Consumers get quality goods at a
lower price.

4. Importance to Employees
Cost accounting helps to fix the wages of the workers. Efficient
workers are rewarded for their efficiency. It helps to induce incentive
wage plan in business.

5. Importance to Government
Cost accounting is one of the prime sources to provide reliable data
to internal as well as external parties. It helps government agencies to
determine excise duty and income tax. Government formulates tax policy,
industrial policy, export and import policy based on the information
provided by the cost accounting.

1.6 SCOPE OF COST ACCOUNTING

1. Costing: It is ascertainment of cost of products, processes, jobs

services etc. it is the most important function of cost accounting.
2. Cost Recording: It is a maintaining record of all the cost (expenses)
incurred during the process of the production of the final products/
services. Such records are kept on the basis of double entry system.
3. Cost Analysis: All the costs that are recorded are analyzed and
categorized separately. Example: Direct and Indirect Costs, Fixed and
Variable Costs, etc.
4. Cost Control: Cost Accounting, compares the actual cost and standard
cost, the difference between the two are analyzed and used for cost
control purpose.
5. Cost Report: Cost accounting generates periodical reports such as
weekly, monthly reports that is used by the management for taking
decisions. These reports are used for planning and controlling,
performance appraisal and management decision making.
6. Cost Audit: It is the verification of cost accounts and to check on the
progress of cost accounting plan. Its main focus is on the expenditure
and efficiency of performance.

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1.7 CLASSIFICATION OF COST:

The process of grouping costs according to their common

characteristics is known as Classification. It is systematic procedure of
placing the like items together according to their common features.
The different basis of classification of cost are as follows:
a. By Time
b. By Nature, or Elements
c. By degree of traceability of product
d. Association with the product
e. By changes in activity or volume
f. By function
g. Others

 Classification on the Basis of Time:

o Historical Costs: Costs which are ascertained after these have

been incurred is known as Historical Cost. Historical Cost is
Actual Cost. These costs are not available until after the
completion of the manufacturing operations or after rendering the
services.

o Pre-determined Costs: The cost which are ascertained in advance

of production on the basis of a specification of all the factors
affecting cost is known as Pre- Determined Costs. These costs are
used for planning and control purpose.

 Classification by nature or element:

Cost is composed by three elements i.e. Material, Labour and
Expenses.

o Material: the substance from which the final product is made is

known as material. According to CIMA, London, material cost is
“the cost of commodities supplied to an undertaking”.

 Direct Material: The cost which can be easily identified

with and allocated to cost units is known as Direct Material.
Direct Materials generally become a part of the finished
product. Eg. Clay in bricks, Leather in shoes, Steal in
machines, Cloths in garments, timber in furniture, etc.

 Indirect Material: The materials that cannot e easily

identified with the individual cost units is known as Indirect
Material. Eg. Lubricant Oil, Consumables, Nuts and bolts,
Coal, Small Tools, Office Stationery.

o Labour Cost: The efforts of the human to convert the materials

into finished product is called labour. The labour cost is, “the cost

5
 of remuneration (wages, salaries, commissions, bonuses etc.) of
the employees of an undertaking” (CIMA).

 Direct Labour: Wages paid to workers directly engaged in

converting the raw materials to finished goods is known as
Direct Labour. These wages can be identified with a
particular job or process. Eg. Machine Operator Shoe maker,
Carpenter, Weaver, Tailor etc.

 Indirect Labour: General Character and cannot be

conveniently identified with a particular cost unit. Indirect
Labour are not directly engaged in the production operations
but will only assist or help in production/ operations. Eg.
Supervisior, Inspector, Works Manager, Clerk, Peon,
Watchman etc.

o Expenses: Cost other than material and labour is termed as

expenses. It is defined as “the cost of services provided to an
undertaking and the notional cost of the use of owned assets”.
(CIMA).

 Direct Expenses: “Direct Expenses are those expenses

which can be identified with and allocated to cost centers or
units”. (CIMA). These are the expenses that are specifically
connected to the production of the final product/ services.
Eg. Hire of Plant for a particular job, Travelling expenses,
cost of Patent Rights, etc.

 Indirect Expenses: the cost that cannot be directly identified

with a particular job, process or work order and are common
to cost units or cost centers are known as Indirect Expenses.
Eg. Rent and rates, Depreciation, Lighting and Power,
Advertising, Insurance, etc.

 By degree of traceability of product

Cost can be distinguished in Direct Cost and Indirect Cost:
o Direct Cost: Costs which can be easily and conveniently
identified with a unit of product or other cost object. Examples
of Direct Cost, cost of raw materials and wages of machine
operator.

o Indirect Cost: Costs than cannot be easily and conveniently

identified with a unit of product or other cost object is known
as Indirect Cost. Examples: Depreciation of machinery,
insurance, lighting, rent, etc.

 Association with the product

o Product Cost: The cost which are necessary for the production
and which will not be incurred if there is no production is

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 known as Product Cost. Product cost consist of Direct
Materials, Direct Labour, and factory overheads.

o Period Cost: Cost which are not necessary for the production
and are incurred even if there is no production is known as
Period Cost. Example: Showroom rent, salary of company,
travel expenses etc. Administration and Selling expenses are
generally treated as period cost.

 By changes in activity or volume

Cost factors behave differently when the level of production rises
or falls. Certain cost changes in sympathy while other cost remains
the same. On the basis of behavior, costs are classified into fixed,
variable and semi variable.

o Fixed Cost: The cost remains constant over a specific range of

activity for a specific time period i.e. it does not increase or
decrease when the volume of production changes. Eg. Building
rent, salaries etc.

o Variable Cost: The cost tends to vary in direct proportion to

the volume of output i.e. the when the volume of output
increases the total variable cost also increases and when the
output decreases, the total variable cost also decreases, but the
total variable cost per unit remains fixed.

The Characteristics of Variable Cost:

 Variability of the total amount in direct proportion to the volume of
output.
 Fixed amount per unit in the face of changing volume.
 Easy and reasonably accurate allocation and apportionment to
departments
 This cost can be controlled by functional managers.

o Semi- Variable Cost or Semi Fixed Cost:The cost include both

fixed and variable cost i.e. these are partly fixed and partly
variable. A semi fixed cost will have a fixed component below
which it will not fall at any level of the output. Eg. Telephone
Bills, Electricity charges etc.

 By Function: A cost may be required to be determined functions like

manufacturing, selling, research etc. and on this basis functional costs
may be classified:
o Production Cost: It is the cost of all the items involved in the
production of a product or service. It refers to the cost incurred
from the purchasing of raw materials to the packaging of the
product.

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 o Administration Cost: Expenses which are incurred for general
management of an organization. These are in nature of indirect
cost and are also termed as administrative overheads.
Administration cost includes indirect expenses like salaries of
office staff, accountants and directors, rent, rates and depreciation
of building, postage and telephone.
o Selling and Distribution Cost: Selling costs are related to selling
of products and services an include all indirect costs in sales
management for the organization. Distribution costs are the costs
that has occurred due to handling of the products from the time it is
completed till it reaches the final consumer. Selling and
Distribution cost includes, salaries and commission of salesmen,
and sales manager, expenses of advertisement, rent of showroom,
etc. all the expenses related towards sales are included in the
selling and distribution cost.
o Research and Development Cost: It is the cost for undertaking
research to improve quality of a present product or improve
process of manufacturing, develop products etc.

1.8 METHODS AND TECHNIQUES OF COSTING

The methods of costing are referred to the techniques and process

employed in the ascertainment of costs. The method of costing to be
applied in a concern depends upon the type and nature of manufacturing
activity.

 Job Costing: Job costing is also known as Specific Order Costing or

Production order Costing or Job lot costing. This method is undertaken
where the work is undertaken as per customers specific requirements.
A job, big or small comprises of a specific quality of a product or
service to be provided as per customers specifications. This method is
used in printing repair shops, interior decorations, painting etc.

 Contract Costing: Contract Costing is a variation of job costing and

principles of job costing is applied to this method. The cost unit here is
a contract which is of a long duration and may continue over more
than one year. It is used in construction of roads, dams, ships,
buildings etc.

 Batch Costing: The cost of a batch of identical products is ascertained

and each batch of products is a cost unit for which costs are
ascertained. This method is used in production of cars, toys,
readymade garments, shoes etc.

 Process Costing: Process Costing is used in mass production and in

continuous processes of manufacturing, Costs are accumulated for
each process or department. To arrive at a cost per unit, the total cost
of a process is divided by the number of units produced. The finished

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 product of one process is transferred to the next process until the final
product is manufactured. Examples: chemical works, sugar mills, soap
manufacturing, textile mills etc.

 Operating Cost: In this method a refinement and a more detailed

application of process is involve in costing. A process consists of
number of operations. This process analysis minute costs and ensure
greater accuracy and better control.

Techniques of Costing
Along with different methods of costing the following techniques are
used to ascertain cost:
 Historical Costing: The actual costs are ascertained only after they
have been incurred. This is a conventional method of cost
ascertainment.
 Absorption Costing:It is a traditional method where both the fixed
and variable methods are charged to product. This is in complete
contrast to marginal costing where only variable costs are charged to
products. Until recently this was the only technique used by cost
accountants, now a days it has many restrictions.
 Marginal Costing: Marginal Cost separates fixed cost and variable
cost. It regards only variable cost as the cost of products and fixed cost
is treated as period cost. This technique helps and guides management
in taking various policy decision under different conditions of business
such as decision regarding the pricing of the product, suspension or
continuance of a particular product etc.
 Standard Costing: The ascertainment and use of standard cists ad
measurement and analysis of variances. Standard cost is pre-
determined as target of performance and actual performance is
measured against standards.
 Uniform Costing: The use of the same costing principles, methods
and/or practices by several undertakings with a view to achieve
uniformity in approach and system.

1.9 ROLE OF COST ACCOUNTANT IN DECISION

MAKING
Cost Accountant plays an important role in an organization. It is
really imperative that organizations pays attention on the job of cost
analysist. Cost Accountancy deals in the preparation of various reports for
the information of internal management for the smooth running of the
business. All the important decision taken by the management for the
future of the company’s progress is prepared by the cost accountants.
Cost Accountants perform following duties:
1. To analyse material, labour and overhead expenses.
2. To reconcile daily productions with accounting transactions.

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3. To co-ordinate with research and development department for the new
products.
4. To assist the controller in developing the cost improvement
opportunities.
5. To prepare new product costing as well as to do gross profit analysis
for the marketing in order to determine the feasibility before
presenting the samples and pricing to the final consumers.

1.10 MANAGEMENT ACCOUNTING, MEANING,

OBJECTIVES, NATURE AND SCOPE.

INTRODUCTION:
Management accounting is the study of managerial aspect of
financial accounting, "accounting in relation to management function". It
shows how the accounting function can be re-oriented so as to fit it within
the framework of management activity. The primary task of management
accounting is, therefore, to redesign the entire accounting system so that it
may serve the operational needs of the firm. If furnishes definite
accounting information, past, present or future, which may be used as a
basis for management action. The financial data are so devised and
systematically development that they become a unique tool for
management decision.

Definition:
The Institute of Chartered Accountants of England states “Any
form of accounting which enables a business to be conducted more
efficiently can be regarded as management accounting”.

“Management Accounting may be defined as the application of

accounting techniques to the provisions of information designed to assist
all levels of management in planning and controlling the activities of the
firm”.

The Institute of Cost and Works Accountants of India defines

Management Accounting as “a system of collection and presentation of
relevant economic information relating to an enterprise for planning,
controlling and decision-making”.

Objectives of Management Accounting:

Main functions of Management Accounting are as follows:

1. Planning - Information and date provided by management accounting

helps management to forecast and prepare short-term and long term
plans for the future activities of the business and formulate corporate
strategy. For this purpose management accounting techniques like
budgeting, standard costing, marginal costing.

2. Coordinating: Management accounting techniques of planning also

help in coordinating various business activities. For example, while

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 preparing budgets for various departments like production, sales,
purchases, etc., there should be full coordination so that there is no
contradiction. By proper financial reporting, management accounting
helps in achieving coordination in various business activities and
accomplishing the set goals.

3. Controlling: Controlling is a very important function of management

and management accounting helps in controlling performance by
control techniques such as standard costing, budgetary control, control
rations, internal audit, etc.

4. Communication: Management accounting system prepares reports for

presentation to various levels of management which show the
performance of various sections of the business. Such communication
in the form of reports to various levels of management helps to
exercise effective control on various business activates and
successfully running the business.

5. Financial analysis and interpretation: In order to make accounting

data easily understandable, the management accounting offers various
techniques of analyzing, interpreting and presenting this data in non-
accounting language so that every one in organization understands it.
Ratio analysis, cash flow and funds flow statements trend analysis,
etc., are some of the management accounting techniques which may be
used for financial analysis and interpretation.

6. Qualitative Information: Apart from monetary and quantitative data,

management accounting provides qualitative information which helps
in taking better decisions. Quality of goods, customers and employees,
legal judgments, opinion polls, logic, et, are some of the expels of
qualitative information supplied and used by the management
accounting system for better management.

7. Tax Policies: Management accounting system is responsible for tax

policies and procedures and supervises and coordinates the reports
prepared by various authorities.

8. Decision – Making: Correct decision making is crucial to the success

of a business. Management accounting has certain special techniques
which help management in short team and long term decisions. For
example, techniques like marginal costing, differential costing,
discounted cash flow, et., help in decisions such as pricing of products,
make or buy, discontinuance of a product line, capital expenditure, etc.

Nature of Management Accounting

The task of management accounting involves furnishing of

accounting data to the management for basing its decisions on it. It also
helps, in improving efficiency and achieving organizational goals. The
following are the main characteristics of management accounting:
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1. Providing Accounting Information: Management according is based
on accounting information. The collection and classification of data is
the primary function of accounting department. The information so
collected is used by the management for taking policy decisions.
Management accounting involves the presentation of information in
away it suits managerial needs. The accounting data is used for
reviewing various policy decisions. Management accounting is a
service function and it provides necessary information to different
levels of management.

2. Cause and effect analysis: Financial accounting is limited to the

preparation of profit and loss account and finding out the ultimate
result, i.e., profit or loss management accounting goes a step further.
The ‘cause and effect’ relationship is discussed in management
accounting. If there is a loss, the reasons for the loss are probed. If
there is a profit, the factors different expenditures, current assets,
interest payables, share capital, etc. So the study of cause and effect
relationship is possible in management accounting.

3. Use of Special Techniques and concepts: management accounting

uses special techniques and concepts to make accounting data more
useful. The techniques usually used include financial planning and
analysis, standard costing, budgetary control, marginal costing, project
appraisal, control accounting, etc. The type of technique to be used
will be determined according to the situation and necessity.

4. Taking Important Decisions: Management accounting helps in

taking various important decisions. It supplies necessary information
to the management which may base its decisions on it. The historical
data is studied to see its possible impact on future decisions. The
implications of various alternative decisions are also taken into
account while taking important decisions.

5. Achieving of Objectives: In management accounting, the accounting

information is used in such a way that it helps in achieving
organizational objectives. Historical data is used for formulating plans
and setting up objectives. The recording of actual performance and
comparing it with targeted figures will give an idea to the management
about the performance of various departments. In case there are
deviations between the standards set and actual performance of various
departments corrective measures can be take at one. All this is possible
with the help of budgetary control and standard costing.

6. Increase in Efficiency: The purpose of using accounting information

is to increase efficiency of the concern. The efficiency can be achieved
by setting up goals for each department. The performance appraisal
will enable the management to pin point efficient and inefficient spots.
An effort is made to take corrective measures so that efficiency is
improved. The constant review of working will make the staff cost –
conscious. Every one will try to control cost on one’s own part.
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7. Supplies Information and not decision: The management accountant
supplies information to the management. The decisions are to be taken
by the top management. The information is classified in the manner in
which it is required by the management. management accountant is
only to guide and not to supply decisions. ‘How is the data to be
utilized’ will depend upon the caliber and efficiency of the
management.

8. Concerned with forecasting: The management accounting is

concerned with the future. It helps the management in planning and
forecasting. The historical information is used to plan future course of
action.

Scope of Management Accounting

1. Financial Accounting: Financial Accounting deals with the historical

data. The recorded facts about an organization are useful for planning
the future course of action. Though planning is always for the future
but still it has to be based on past and present data. The control aspect
too is based on financial data. The performance appraisal is based on
recorded facts and figures. So management accounting is closely
related to financial accounting.

2. Cost Accounting: Cost Accounting provides various techniques for

determining cost of manufacturing products or cost of providing
service. It uses financial data for finding out cost of various jobs,
products or processes. The systems of standard costing, marginal
costing, differential costing and opportunity costing are all helpful to
the management for planning various business activities.

3. Financial Management: Financial Management is concerned with the

planning and controlling of the financial resources of the firm. It deals
with raising of funds and their effective utilization so to maximize
earnings. Finance has become so important for every business that all
managerial activities are connected with it. Financial viability of
various propositions influence decisions on them. Therefore
management accounting includes and extends to the operation of
financial management also.

4. Budgeting and Forecasting: Budgeting means expressing the plans,

policies and goals of the enterprise for a definite period in future. The
targets are set for different departments and responsibility is fixed for
achieving these targets. The comparison of actual performance with
budgeted figures will give an idea to the management about the
performance of different departments. Forecasting, on the other hand,
is a prediction of what will happen as a result of a given set of
circumstances. Both budgeting and forecasting are useful for
management accountant in planning various activities.

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5. Inventory Control: Inventory is used to denote stock of raw
materials, goods in the process of manufacture and finished products.
Inventory has a special significance in accounting for determining
correct income for a given period. Inventory control is significant as it
involves large sums. The management should determine different
levels of stocks, ie. minimum level, maximum level, re- ordering level
for inventory control. The control of inventory will help in controlling
costs of products. Management accountant will guide management as
to when and from where to purchase and how much to purchase. So
the study of inventory control will be helpful for taking managerial
decisions.

6. Reporting to Management: One of the functions of management

accountant is to keep the management informed of various activities of
the concern so as to assist it in controlling the enterprise. The reports
are presented in the form of graphs, diagrams, index numbers or other
statistical techniques so as to make them easily understandable. The
management accountant sends interim reports to the management and
these reports may be monthly, quarterly, half – yearly. The reports
may cover profit and loss statement, cash and found flow statements,
stock reports, absentee reports and reports on orders in hand, etc.
These reports are helpful in giving a constant review of working of the
business.

7. Interpretation of Data: The management accountant interprets

various financial statements to the management. These statements give
an idea about the financial and earning position of the concern. These
statements may be studied in comparison to statements of earlier
periods or in comparison with the statements of similar other concerns.
The significance of these report is explained to the management in a
simple language. If the statements are not properly interpreted then
wrong conclusions may be drawn. So interpretation is also important
as compiling of financial statements.

8. Control procedures and Method: Control procedures and methods

are needed to use various factors of production in a most economical
way. The studies about cost, relationship of cost and profits are useful
for using economic resources efficiently and economically.

9. Internal Audit: Internal audit system is necessary to judge the

performance of every department. The actual performance of every
department and individual is compared with the pre-determined
standards. Management is able to know deviations in performance.
Internal audit helps management in fixing responsibility of different
individuals.

10. Tax Accounting: In the present complex tax systems, tax planning is
an important part of management accounting. Income statements are
prepared and tax liabilities are calculated. The management is
informed about the tax burden from central government, state
14
 government and local authorities. Various tax returns are to be filed
with different departments and tax payments are to be made in time.
Tax accounting comes under the purview of management accountant’s
duties.

11. Office services: Management accountant may be required to control

an office. He will be expected to deal with data processing, filing,
copying, duplicating, communicating etc. He will also be reporting
about the utility of different office machines.

1.11 TOOLS AND TECHNIQUES OF MANAGEMENT

 Financial Planning:Financial planning is the act of deciding in

advance about the financial activities necessary for the concern to
achieve its primary objectives. It includes determining both long term
and short term financial objectives of the enterprise, formulating
financial policies and developing the financial procedure to achieve
the objectives.

The role of financial policies cannot be emphasized to achieve the

maximum return on the capital employed. Financial policies may relate to
the determination of the amount of capital required, sources of funds,
govern the determination and distribution of income, act as a guide in the
use of debt and equity capital and determination of the optimum level of
investment in various assets.

 Analysis of Financial Statements: The analysis is an attempt to

determine the significance and meaning of the financial statement data
so that a forecast may be made of the prospects for future earnings,
ability to pay interest and debt maturities and profitability of a sound
dividend policy.

The techniques of such analysis are comparative financial

statements, trend analysis, cash funds flow statements and ratio analysis.
This analysis results in the presentation of information which will help the
business executives, investors and creditors.

 Historical Cost Accounting: The historical cost accounting provides

past data to the management relating to the cost of each job, process
and department so that comparison may be made with the standard
costs. Such comparison may be helpful to the management for cost
control and for future planning.

 Standard Costing: Standard costing is the establishment of standard

costs under most efficient operating conditions, comparison of actual
with the standard, calculation and analysis of variance, in order to
know the reasons and to pinpoint the responsibility and to take
remedial action so that adverse things may not happen again. This
aspect is necessary to have cost control.

15
 Budgetary Control: The management accountant uses the tool of
budgetary control for planning and control of the various activities of
the business. Budgetary control is an important technique of directing
business operations in a desired direction, i.e., achieves a satisfactory
return on investment.

 Marginal Costing: The management accountant uses the technique of

marginal costing, differential costing and break even analysis for cost
control, decision-making and profit maximisation.

 Funds Flow Statement: The management accountant uses the

technique of funds flow statement in order to analyse the changes in
the financial position of a business enterprise between two dates. It
tells wherefrom the funds are coming in the business and how these
are being used in the business. It helps a lot in financial analysis and
control, future guidance and comparative studies.

 Cash Flow Statement: A funds flow statement based on increase or

decrease in working capital is very useful in long-range financial
planning. It is quite possible that there may be sufficient working
capital as revealed by the funds flow statement and still the company
may be unable to meet its current liabilities as and when they fall due.
It may be due to an accumulation of inventories and an increase in
trade debtors. In such a situation, a cash flow statement is more useful
because it gives detailed information of cash inflows and outflows.
Cash flow statement is an important tool of cash control because it
summarises sources of cash inflows and uses of cash outflows of a
firm during a particular period of time, say a month or a year. It is very
useful tool for liquidity analysis of the enterprise.

 Decision Making: Whenever there are different alternatives of doing a

particular work, it becomes necessary to select the best out of all
alternatives. This requires decision on the part of the management. The
management accounting helps the management through the techniques
of marginal costing, capital budgeting, differential costing to select the
best alternative which will maximise the profits of the business.

 Revaluation Accounting: The management accountant, through this

technique assures the maintenance and preservation of the capital of
the enterprise. It brings into account the impact of changes in the
prices on the preparation of the financial statements.

 Statistical and Graphical Techniques: The management accountant

uses various statistical and graphical techniques in order to make the
information more meaningful and presentation of the same in such
form so that it may help the management in decision-making. The
techniques used are Master Chart, Chart of Sales: and Earnings,
Investment Chart, Linear Programming, Statistical Quality Control,
etc.

16
 Communicating: The success or failure of the management is
dependent on the fact, whether requisite information is provided to the
management in right form at the right time so as to enable them to
carry out the functions of planning, controlling and decision-making
effectively.

The management accountant will prepare the necessary reports for

providing information to the different levels of management by proper
selection of data to be presented, organisation of data and selecting the
appropriate method of reporting.

Relationship between Financial Accounting and Management

Accounting

Financial accounting and management accounting are two major

sub-systems of accounting information system. Both are concerned with
revenues and expenses, assets and liabilities and cash flows. Both
therefore involve financial statements. But the major differences between
the two arise because they serve different audiences. The main points of
difference between the two are as follows:

Financial Accounting Management Accounting

Financial accounting information Management accounting
is mainly intended for external information is mainly meant for
users like investors, shareholder, internal user, i.e., management
creditors, Govt. authorities etc.
Under company law and tax law, Management accounting is optional
financial accounting is obligatory though its utility makes it highly
to satisfy various statutory desirable to adopt it.
provisions.
Financial accounting shows the Management accounting provides
profit / loss of the business as a detailed information about
whole. It does not show the cost individual products, plants,
and profit for individual products, departments or any other
processes or departments, etc. responsibility centre.
It is concerned with recording It is future oriented and concentrates
transactions, which have already on what is likely to happen in future
taken place, i.e., it represents past though it may use past data for
or historical records. future projections.
Financial reports, i.e., Profit and Management accounting reports are
Loss account and Balance Sheet prepared frequently, i.e, these may
are prepared usually on a year to be monthly, weekly or even daily
year basis. depending on managerial
requirements

17
Companies are required to prepare Management accounting is not
financial accounts according to bound by accountings standards. It
accounting standards issued by the may use any practice which
Institute of chartered accountants generates useful information to
of India. management.
Financial accounting prepares In Management accounting special
general purpose statements Profit purpose reports are prepared, eg,,
& Loss account and Balance sheet performance report of sales
which are used by external users. manager or any other department
manager which are used by top
level Management.
Financial statements, i.e., P&L Management accounting statements
A/c and Balance sheet are are for internal use and thus neither
published for general public use published for general public use nor
and also sent to share holders. these are required to be audited by
These are required to be audited chartered accountants.
by the chartered Accountants.
Financial accounting provides Management accounting may apply
information in terms of money monetary or non monetary units of
only. measurements for example
information may be expressed in
terms of Rs. or units of quantity,
machine hours, labour hours, etc.

Relationship between Cost Accounting and Management Accounting

The distinction between cost accounting and management

accounting may be made on the following points:

Cost Accounting Management Accounting

Scope of cost accounting is limited Scope of management accounting
to providing cost information for is broader than that of cost
managerial uses. accounting as it provides all types
of information, i.e., cost
accounting as well as financial
accounting information for
managerial uses.
Main emphasis is on cost Main emphasis is on planning,
ascertainment and cost control to controlling and decision – making
ensure maximum profit. to maximize profit.
Various techniques used by cost Management accounting also uses
accounting include standard all these techniques used in cost
costing and variance analysis, accounting but in addition it also
marginal costing and cost volume uses techniques like ratio analysis,

18
 profit analysis, budgetary control, funds flow statement, statistical
uniform costing and inter-firm analysis operations research and
comparison, etc. certain techniques from various
branches of knowledge like
mathematics, economics, etc.
which so ever can help
management in its tasks
Evolution of cost accounting is Evolution management accounting
mainly due to the limitations of is due to the limitations of cost
financial accounting accounting. In fact, management
accounting is an extension of the
managerial aspects of cost
accounting.
Maintenance of cost records has Management accounting is purely
been made compulsory in selected voluntary and its use depends upon
industries as notified by the Govt. its utility to management.
from time to time.
It is based on data derived from It is based on data derived from
financial accounts cost accounting, financial
accounting and other sources.
In the organizational set up, cost Management accounting is
accountant is placed at a lower generally placed at a higher level
level in hierarchy than the of hierarchy than the cost
management accounting accounting
Cost accounting system can be Management accounting cannot be
installed without management installed without a proper system
accounting of cost accounting.

The Management Accountant

Management accounting provides significant economic and

financial data to the Management and the Management Accountant is the
channel through which this information efficiently and effectively flows to
the Management.

The Management Accountant has a very significant role to perform

in the installation, development and functioning of an efficient and
effective management accounting system. He designs the frame work of
the financial and cost control reports that provide each managerial level
with the most useful data at the most appropriate time. He educates
executives in the need from control information and ways of using it. His
position is unique with respect to information about the organization.
Apart from top management no one in the organization perhaps knows
more about the various functions of the organization than him. He is as the
chief intelligence officer or financial advisor or financial controller of the
management. He gathers information, breaks it down, sifts it out and
organizes it into meaningful categories. He separates relevant and
19
irrelevant information and then ranks relevant information according to
degree of importance to management. He reports relevant information in
an intelligible form to the management and sometimes also to those who
are interested in the information outside the company. He also compares
the actual performance with the planned one and reports and interprets the
results of operations to all levels of management and to the owners of the
business.

Functions of the Management Accountant

It is the duty of the management accountant to keep all levels of
management informed of their real position. He has, therefore, varied
functions to perform. His important functions can be summarized as
follows:
1. Planning: He has to establish, coordinate and administer as an integral
part of management, an adequate plan for the control of the operations.
Such a plan would include profit planning, programmes of capital
investment and financing sales forecasts, expense budgets and cost
standards.
2. Controlling: he has to compare actual performance with operating
plans and standards and to report and interpret the results of operations
to all levels of management and the owners of the business. This is
done through the compilation of appropriate accounting and statistical
records and reports.
3. Coordinating: He consults all segments of management responsible for
policy or action. Such consultation might concern any phases of the
operation of the business having to do with attainment of objectives
and the effectiveness of the organization structures and policies.
4. Other Functions:
a. He administers tax policies and procedures.
b. He supervises and coordinates the preparation of reports to
government agencies.
c. He ensures fiscal protection for the assets of the business through
adequate internal control and proper insurance coverage.
d. He carries out continuous appraisal of economic and social forces,
and the government influences, and interprets their effect on the
business.

Questions

Short Answers
1) Nature of Cost Accounting
2) Scope of Cost Accounting
3) Objectives of Cost Accounting
4) Define Management Accounting

20
5) List few functions of Management accounting
6) State two differences between Management accounting & financial
accounting
7) State two differences between Management accounting and cost
accounting
8) What are the duties of a management accountant?
9) Name any 5 techniques of management accounting.
10) State any 3 objectives of management accounting

Long Answers:
1) Explain the meaning, nature and scope of Cost Accounting.
2) Explain the various ways of classification of cost.
3) Define management accounting & explain its objectives.
4) Discuss in detail the nature & scope of management accounting
5) Management accounting is nothing more than the use of financial
information for management purposes. Explain this statement &
clearly distinguish between management accounting and financial
accounting.
6) Who is a management accountant? Explain his role & functions in an
organisation.



21
 Module - II

2
UNIT COSTING
Unit Structure :

2.1 Introduction
2.2 Definition of Unit or Output Costing
2.3 Objectives of Unit Costing
2.4 Limitations of Unit Costing
2.5 Elements of Cost under Unit Costing
2.6 Tenders or Quotations
2.7 Methods of unit or output costing
2.8 Job Costing
2.9 Documents Used in a Job order Cost System
2.10 Advantages of Job Order Costing
2.11 Limitations of Job Order Costing
2.12 Definition
2.13 Types of Costs in Batch Costing
2.14 Key Differences between Job Costing and Process Costing

2.1 INTRODUCTION

Different industries follow different methods to establish the cost

of their product. This varies by the nature and specifics of each business.
There are different principles and procedures for performing the costing.
However, the basic principles and procedures of costing remain the same.
Some of the methods are mentioned below:

 Unit costing
 Job costing
 Contract costing
 Batch costing
 Operating costing
 Process costing
 Multiple costing
 Uniform costing

In this module we shall understand Unit Costing.

22
2.2 DEFINITION OF UNIT OR OUTPUT COSTING

“Production cost accounting or unit cost accounting is such a

method of cost ascertainment which is based on production unit. It is
applicable where the production work is done continuously and the units
are of same types of manufactured identical” - Herold J. Wheldon

From the above definition we can understand that Unit Costing is

used in the industries with the following characteristics:

1. Production should be uniform or homogeneous and a continuous

affair;
2. The units of production should be identical
3. The cost units should be physical and natural
4. Per unit cost has to be determined, for example per ton, per meter, per
kg, etc.

Brick making, mining, cement manufacturing, flour mills are

examples of industries using Unit Costing.

Under Unit Costing, generally no apportionment of cost is done

because all the expenses are made on a similar type of production. But
where production is done for a various grades or for various sizes, their
expenses have to be apportioned on the basis of size or grades in detail.

2.3 OBJECTIVES OF UNIT COSTING:

 To know the total cost of production and per unit cost within specific
period.
 To classify cost under related categories such as Prime Cost, works
cost, cost of Production, etc. and have a detailed analysis in order to
determine per unit cost.
 To determine the effect of each element of cost to have control over
costs.
 To compare the cost during two or more periods.
 To make efforts for cost control on the basis of comparative analysis.
 To determine proposed setting price to earn desired profit.
 To determined tender price on the basis of cost data and future
prospects.

2.4 LIMITATIONS OF UNIT COSTING:

Unit or output costing is very much important method for

ascertaining the total cost and cost per unit, but it is not free from certain
limitations. These are as under:

23
 Limitations of historical cost: unit or output costing, being basically of
historical nature, suffers from all the defects of historical costing.
 Useful only for homogeneous products: this costing method can be
used only for homogeneous products and not for heterogeneous
products.
 Not sufficient for cost control: this costing system simply determines
total cost and per unit cost of the products which is by itself not
sufficient for cost control.
 Arithmetical accuracy cannot be checked: under this system, generally
a statement is prepared which does not from a part of the double entry
system. Therefore, arithmetical accuracy cannot be checked under this
system

2.5 ELEMENTS OF COST UNDER UNIT COSTING:

In output costing in order to determine total cost and per unit cost,
collection of various elements of cost is done as follows –

Materials – The quantity and value of material consumed is

determined by preparing a Material Abstract. The materials which are
issued from stock are valued on an appropriate basis.

Labour – As required, wages analysis sheet is prepared so that

direct and indirect labour cost cab be determined.

Direct Expenses – In addition to material and labour, there are

certain other expenses incurred which are termed as direct expenses.

Overheads – The overheads are debited to production for the

period for which the cost us being determined. These overheads expenses’
are taken from the financial records. There are certain expenses which
cannot be determined before the end of the accounting period.

2.6 TENDERS OR QUOTATIONS:

Very often a producer in response to an advertisement in the press

is required to submit a tender or to quote prices for the supply of the
commodities he produces or for completing a job. A tender has to be
prepared very carefully as the receipts of orders depend upon the
acceptance of quotations or tenders supplied by the manufacturer. The
preparation of tenders requires information regarding prime cost, works,
administration and selling overheads and profit of the preceding period.

The manufacturer has to ascertain and find out the possible

changes in prices of material, rates of wages and other costs. He has to
ascertain the amount of variable, semi-variable and fixed overheads on the

24
basis of past experience. He must also have a reasonable amount of profit
by taking into consideration the market condition.

In preparation of estimates or tenders, overheads are generally

estimated as percentages i.e. works overheads on wages and
administration, selling and distribution overheads on works cost basis.

2.7 METHODS OF UNIT OR OUTPUT COSTING:

Unit or output costing is used to determine the cost per unit of

production in a specific period of time. For this, the following methods are
used:

• Cost sheet
• Manufacturing account

2.7.1 Cost sheet :

Cost sheet is "a document which provides for the assembly of the
estimated detailed cost in respect of a cost center pool a cost unit". It is a
period's document of cost designed to exhibit the total cost and the unit
cost of products in an analytically and detailed form. In other words, a cost
sheet presents cost information in such a manner that it can show cost of
total production, quantity produced and cost of production per unit.

Cost sheet is an operating statement. It analyses and classifies the

expenses on different items for a particular period in a tabular form. It may
be prepared weekly, monthly, quantity, half yearly or yearly at any
convenient interval of time. Similarly, it may be prepared on the basis of
actual or estimated cost depending on the purpose to be achieved. It is
online memorandum statement, not an account. It does not form a part of
the double entry system.

Elements of Cost Sheet:

1. Direct Material
2. Indirect Material
3. Direct Labour
4. Indirect Labour
5. Direct Expenses
6. Indirect Expense

All the elements described above have been discussed in detail in the
Cost Sheet Module. Students are advised to refer to the same.

2.7.2 Manufacturing Account

When the data related with the cost of goods manufactured of a

commodity are presented is a conventional form of account i.e. in T shape
25
from, and then it is known as Manufacturing Account. Generally, a
manufacturing concern prepares this account to exhibit cost of production
or cost of goods manufactured.

Preparation of manufacturing account

A manufacturing account is based on the principle of national

account. Therefore, it shows opening stock of work-in-progress and other
direct and indirect costs of goods manufactured (i.e. factory costs) on its
debit side and closing side and closing stock of work-in-progress and sale
of scrap or wastage on its credit side. Generally, the balancing figure takes
palace in credit side which is called "cost of goods manufactured or cost of
production C/D". This account show the cost production which is
transferred to the trading account.

Manufacturing account for manufacturing profit and loss

When a manufacturing account is prepared to ascertain
manufacturing profit and loss, then trading value of manufacturing cost is
kept in credit side instead of cost of production. In other words, all items
on debit and credit side will be the same as mentioned above. But, trading
price or trading value of cost of production will be shown on the credit
side and balancing figure will be put on debit side of this account as
"manufacturing profit" or "manufacturing loss".

Illustration
The accounts of Kool Kool Company Ltd. show for 20X6:
Materials Rs 350,000;
Labour Rs 270,000;
Factory Overheads Rs 81,000
and Administration Overheads Rs 56,080.

26
 What price should the company quote for a refrigerator? It is
estimated that Rs 1,000 in material and Rs 700 in labour will be required
for one refrigerator. Absorb factory overheads on the basis of labour and
administration overheads on the basis of works cost. A profit of 12½ % on
selling price is required.

Solution:

Statement of Cost

Particulars Rs.
Materials 350,000
Labour 270,000
Prime Cost 620,000
Factory Overheads 81,000
Works Cost 701,000
Administration Overheads 56,080
Total Cost of Production 757,080
Percentage of Factory Overheads to Labour:
=(81,000/270,000)*100 = 30%

Percentage of Administration Overheads to Works Cost:

=(56,080/701,000)*100 = 8%

Statement of Selling Price of a Refrigerator

Particulars Rs.
Materials 1,000
Labour 700
Prime Cost 1,700
Factory Overheads (30% on Labour) 210
Works Cost 1,910
Administration Overheads (8% of Works Cost) 152.80
Total Cost of Production 2062.80
Add Profit (1/8 on Sales or 1/7 of Cost) 294.69
Selling Price per Refrigerator 2,357.49

 Determine whether unit costing would be appropriate in the following

industries
a. Brick Making
b. Oil Exploration
c. Cement
d. Original Equipment Manufacturer
e. Garments
f. Jewelry making

27
 Write Short notes on:
1. Unit Costing
2. Advantages of Unit Costing

 When would Unit Costing be appropriate to determine costs over other

methods?

2.8 JOB COSTING

A method of costing in which cost of each ‘job’ is determined is

known as Job Costing. Here job refers to a specific work or assignment or
a contract where the work is performed according to the customer’s
instructions and requirements. The output of each job consists of normally
one or less number of units. In this method, each job is considered as a
distinct entity, for which cost is ascertained. Job Costing is applied when:

 The execution of the jobs is on the basis of client’s specification(s).

 All the jobs are heterogeneous in many respects, and each job requires
separate treatment.
 There is a difference in WIP (Work in progress), of each period.

Job Costing is best suited for the industries where specialized products
are manufactured as per customer needs and demands. Some examples of
those industries are Furniture, Ship Building, Printing Press, Interior
Decoration etc.

2.9 DOCUMENTS USED IN A JOB ORDER COST

SYSTEM:

The following are the important documents used in a Job Order

Cost System:

(I) Production Order or Manufacturing Order:

This is a works order authorizing the production department to
produce a specified quantity of a product which constitutes the job.

(II) Cost Sheet:

For recording costs, very often a separate record called a cost sheet
is used. The cost sheet and the works order may also be combined, when
costs are recorded on the production order itself.

(III) Other Documents:

The other documents which are used as control mechanism by the
dispatching function are: Material Requisitions, Tool Orders, Time
Tickets, Inspection Order, etc.

28
2.10 ADVANTAGES OF JOB ORDER COSTING:

i) Profitability of each job can be individually determined.

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

2.11 LIMITATIONS OF JOB ORDER COSTING:

1) It is expensive to operate as it requires considerable detailed clerical

work.
2) With the increase in the clerical work, chances of errors are increased.
3) Job order costing cannot be efficiently operated without highly
developed production control system. The job costing requires
intricate factory organization system.
4) The costs as ascertained are historical as they compiled after incidence
and therefore does not provide control of cost unless it is used with
standard costing system.

2.12 BATCH COSTING

Definition :
Batch Costing is the identification and assignment of those costs
incurred in completing the manufacture of a specified batch of
components. Having arrived at the batch cost, the unit cost is simply
derived by dividing it by the number of components in the batch.

When orders are received from different customers, there are

common products among orders; then production orders may be issued for
batches, consisting of a predetermined quantity of each type of product.
Batch costing method is adopted in such cases to calculate the cost of each
such batch.

29
 Cost per unit is ascertained by dividing the total cost of a batch by
number of items produced in that batch. In order to do that a Batch Cost
Sheet is prepared. The preparation of Batch Cost Sheet is similar to that of
Job Cost Sheet. This method is mainly applied in biscuits manufacture,
garments manufacture, spare parts and component manufacture,
pharmaceutical enterprises etc.

Batch costing is a form of specific order costing.

 Within each batch are a number of identical units but each batch will
be different.
 Each batch is a separately identifiable cost unit which is given a batch
number in the same way that each job is given a job number.
 Costs can then be identified against each batch number. For example
materials requisitions will be coded to a batch number to ensure that
the cost of materials used is charged to the correct batch.
 When the batch is completed the unit cost of individual items in the
batch is found by dividing the total batch cost by the number of items
in the batch.
 Batch costing is very common in the engineering component industry,
footwear and clothing manufacturing industries.
 The selling prices of batches are calculated in the same ways as the
selling prices of jobs, i.e. by adding a profit to the cost of the batch.

Economic Batch Quantity

Production is usually done in batches and each batch can have any
number of units of Component in it. The optimum quantity for a batch is
that quantity for which the setting up and carrying costs are minimum,
such an optimum quantity is known as Economic Batch Quantity or
Economic lot size.

Determination of the economic lot size is important in industries

where batch costing is employed.

Need for Determining Economic Lot Size:

The need for determining economic lot size arises as:

i) Every time a component/product is to be made, setting up of the tool is
involved. Because of this some loss in production time will be there.
Therefore, maximum number of units is produced once the machine is
set in order to reduce the cost per unit,

ii) Such large production at one run will lead to accumulation of

inventory and the costs related thereto,

30
iii) Thus there is a quantity for which reduced cost of production is just
offset by costs of carrying the quantity inventory. The determination of
most economical batch quantity requires consideration of many related
factors of costs and economies.
The factors that influence the decision in this respect are:
(a) Set up cost,
(b) Manufacturing cost,
(c) Interest on capital,
(d) Storage cost, and
(e) Rate of consumption.

2.13 TYPES OF COSTS IN BATCH COSTING:

There are two types of costs involved in Batch Costing:
(i) Set up costs
(ii) Carrying costs.

If the batch size is increased, set up cost per unit will come down
and the carrying cost will increase. If the batch size is reduced, set up cost
per unit will increase and the carrying cost will come down. Economic
Batch quantity will balance both these opponent costs.

Economic Batch Quantity can be determined with the help of a

table, graph or mathematical formula.

2.14 KEY DIFFERENCES BETWEEN JOB COSTING

AND PROCESS COSTING

The following are the major differences between job costing and
process costing:

1. The costing method which is used for the ascertainment of the cost of
each job is known as Job Costing. Conversely, by process costing, we
mean the costing technique used to determine the cost of each process.
2. Job Costing is performed where the products produced of a specialized
nature, whereas Process Costing is used where standardized products
are produced.
3. In Job Costing, the cost is calculated for each job, but in Process
Costing first of all the cost of each process is calculated which is then
dispersed over the number of units produced.
31
4. In job costing the cost center is the job itself while the process is the
cost center in case of process costing.
5. In job costing each job requires special treatment. On the other hand,
no such special treatment is required for each process in process
costing.
6. There is no transfer of cost in job costing, from one job to another.
However, the cost of the last process is transferred to the next process
in the process costing.
7. The possibility of cost reduction is very less in Job Costing. In contrast
to Process Costing, the scope of cost reduction is comparatively high.
8. In Job Costing, the cost is ascertained after the completion of the job,
but in Process Costing, the cost of each job is determined.

In situations where a company has a mixed production system that

produces in large quantities but then customizes the finished product prior
to shipment, it is possible to use elements of both the job costing and
process costing systems, which is known as a hybrid system.

State whether the statements are true or false. (Answers in

parentheses)
 Under Batch Costing, a batch is regarded as a single cost unit (True)
 Batch costing is used when items of a identical nature are produced in
a batch (True)
 Batch costing can be used only in large organizations (False)
 Economic batch quantity is nothing but economic ordering quantity of
materials (False)
 Set up cost can vary depending on the size of the batch (False)
 Under job costing, the job itself is a cost unit (True)

Determination of Economic Batch Quantity

Monthly demand for a product 500 units

Setting up cost per batch Rs. 60
Cost of manufacturing per unit Rs. 20
Rate of Interest 10% p.a.

EBQ = (2DS/C)1/2
=
((2*500*12*60)/(0.1*20))1/2
= 600 units




32
 3
CONTRACT COSTING
Unit Structure :

3.1 Meaning
3.2 Special Features of Contract Costing
3.3 Types of contracts
3.4 Recording Cost on Contract or Costing Procedure
3.5 Treatment of Profit or Loss on Contract A/c
3.6 Process Costing
3.7 Characteristics of Process Costing
3.8 Advantages & Disadvantages
3.9 Process Losses

3.1 MEANING

Contract Costing is a special type of job costing where the unit of

cost is a single contract. Contract itself is a cost centre and is executed
under the customer's specifications. Contract Costing is defined by the
ICMA Terminology as "that form of specific order costing which applies
where work is undertaken to customer's special requirements and each
order is of long duration. The work is usually of constructional nature."

Contract Costing is also termed as ''Terminal Costing." The

principles of job costing are also applicable to contract costing and are
used by such concerns of builders, public works contractors,
constructional and mechanical engineering firms and ship builders etc.
who undertake work on a contract basis.

3.2 SPECIAL FEATURES OF CONTRACT COSTING

The following are the special features of Contract Costing:

(1) The cost unit is a specific contract.
(2) Each contract takes a long time to complete.
(3) The work being of a constructional nature, the same is executed at
customer's site, as per his specifications.
(4) Bulk of the materials purchased and delivered direct to the contract site
or obtained from the central stores through the requisition slips.
(5) Generally specific portions of the contract are given to sub-contractors.
33
(6) Most of costs which are normally treated as indirect can be identified
specifically with a particular contract and are charged to it as direct
costs.
(7) Overheads constitute only a very small proportion of the cost of the
contract. However, indirect costs consist mainly of administrative cost
of the central office.
(8) Scale of operations and cost control becomes difficult due to theft of
materials, labour time utilization, pilferages etc.
(9) The pay roll is prepared either at the site or at a central administrative
office.

3.3 TYPES OF CONTRACTS

There are three types of contract which are mentioned below:

a. Fixed price contract: The contract that is executed with the fixed price
which is agreed by the contract and the contractee is called the fixed price
contract. Under this contract, no modification is made in the agreed
contract price irrespective of the changes in the price level of material and
labour in feature. In such type of contract, the contractor is benefited when
the price of material and labour decrease. In contrary to this, the contractee
is benefited if the price of material and labour increase.

b. Fixed price contract with escalation and de-escalation clauses:

Escalation clause is a of agreement that that aims to reduce the risks that is
causes due to the changes in the price of materials, labour and other
services. Under this, the contract price is adjusted in accordance, with the
changes in the price of material, labour and other services. The additional
cost raised due to the increase in price is born by the contracted. Similarly,
the contract price is reduced if the cost decreases below a certain
percentage. It is called de-escalation or reverse clause. Escalation clause
safe guides the interest of both the contractor and contractor against
unfavorable price change in future. Such clause may also apply where
material and labour utilization exceeds a particular limit. In this case,
however, contractor will have to prove that excessive utilization is not
because of decrease in efficiency. The contractor allows a rebate in the
bills presented by him to the extent of the decrease in price.

c. Cost plus contract: The contract in which the contract price is

determined by adding a certain percentage of profit on cost is known as
cost plus contract. The cost plus contract is adopted to overcome with
problem of fixing the contract price caused due to nature of contract,
duration of completion of contract, uncertainly of material, change in the
price level, new technology etc. this type of contract is mostly followed by
the government for production of special articles not usually
manufactured, urgent repairs of vehicles, roads bridge etc. under this types
of contract, the contract starts the work and payment is made by the

34
contracted gradually on the basis of the cost incurred in the work
completed plus certain percentage of profit.

3.4 RECORDING COST ON CONTRACT OR COSTING

PROCEDURE

In contract costing, costs are allocated, collected and accumulated

according to the contract works. Each contract is treated as a separate
entity in which each contract account may be maintained separately or in
general ledger itself for the purpose of costing and cost control. The
following are the costing procedure for different costs relating to the
important expenses:

a. Materials
The procedures of recording materials in a contract account are as
follows:

Item Treatment
Stock of Materials The opening stock is debited and closing
stock is credited
Purchase of Materials The material purchased for the contract is
debited to the contract account
Transfer of Materials Material transferred to the contract from
other contracts is debited while material
transferred out is credited
Sale of Materials The material sold from the contract is
credited in the selling price
Profit/Loss on sale The profit on sale is credited whereas loss is
debited to the contract account
Loss of Material Loss of material due to theft, fire, damage
etc is credited. Claim accepted by insurance
company is credited like sales

b. Plant and Machinery

The machinery used for a contract is recorded in a contract account
through two ways. They are

i. The cost of machinery and equipment to be used for a longer period or

purchase for the contract is shown in the debit side of a contract
account. The book value of the machinery and equipment is shown in
credit side. The book value is calculated by deducting the depreciation
from the cost of the machinery and equipment.
ii. If the machinery and equipment is used for a short time in the contract,
the amount of depreciation charged is only debited in the contract
35
 account. In such a situation, the purchase price in the debited side and
the book value in the credit side are not shown. This is generally done,
if the plant and equipment are not used till the end of te accounting
period.

The treatments of plant and machinery in a contract account under

different conditions have been presented below:

Item Treatment
Plant at beginning The value of plant at the beginning is
debited whereas the plant at the end is
credited
Purchase of Machinery The machinery purchased for the contract is
debited to the contract account
Transfer of Machinery Machine transferred to the contract from
other contracts is debited while machine
transferred out is credited
Sale of Machinery The value of machinery sold from the
contract is credited in the selling price or
market value
Profit/Loss on sale The profit on sale is credited whereas loss is
debited whereas loss suffered is credited
Loss of Machine Loss of machine due to theft, fire, damage
etc is credited. Claim accepted by insurance
company is credited like sales

c. Labour:
In the case of contract costing, all labour engaged at site and the
salaries and wages paid to the labour and workers are treated as direct
labour cost is debited to Contract Account.

d. Direct Expenses:
Most of the expenses like electricity, insurance telephone, postage,
sub-contracts, Architect's fees etc. can also be treated as direct cost is
debited to Contract Account.

e. Overhead Cost:
In the case of contract costing overheads incurred only an
insignificant part of the total cost of contract account. The nature office
and administrative expenses of a particular contract may be apportioned
on suitable basis.

f. Cost of extra work:

Sometimes, in case of a contract, some additional work o
variations of the work originally contracted for may be required by the

36
contractee. Since the additional work required will not be covered by the
terms and condition of original contract, it will be the subject of a separate
charge., if the additional work required by the contractee is quite
substation, it should be treated as a separate contract and dealt with in a
separate account to be opened for it. But in case the additional work is not
substantial, the expenses incurred on extra work should be debited to
contract account as 'cost of extra work' and the extra amount which the
contractee has agreed to pay to the contractor should be added to the
original contract price.

Some other terms used in Contract Costing

1. Sub-Contracts: Sub-Contracts refer to some portions of the specified

work connected with the main contract, to be done by the sub-
contractor. For example, the work of painting, special flooring, steel
work etc. may be given to the sub-contractors. Usually sub-contract
has been undertaken on cost-plus basis and the cost of such sub-
contract should be treated as a direct charge and is debited to Contract
Account.

2. Work Certified: In the case of the small contracts which are

completed within the shorter period, the contractor pays the contract
price on the completion of the contract. In the case of contracts of long
duration, the contract agreement provides interim payment to the
contractor. It is done on the basis of certificates issued by the
contractee's Surveyor, Architect or Engineer. At the same time
Contractee usually does not pay to the full value of the work certified.
A portion of amount say 20% or 30% thereof shall be retained by the
Contractee. The money so retained is called as "Retention Money."
This retention money is intented to ensure that the contractor to
complete the work as scheduled and according to specifications.
Money retained could also be used for imposing penalties for faulty or
delayed work. This amount will be settled on completion of the
contract.
3. Work Uncertified: If the progress of a work is unsatisfactory or the
work has not reached the stipulated stage, though certain work is
completed, such work does not qualify for a certificate by the
Contractee's Architect or Surveyor is termed as "Work Uncertified." It
is valued at cost and credited to Contract Account and debited to Work
in Progress Account.
4. Work in Progress: Work in progress includes the amount of work
.certified and the amount of work uncertified. The work in progress
account will appear on the asset side of the balance sheet. The amount
of cash received from the contractee and reserve for contingencies will
be deducted out of this amount.

37
3.5 TREATMENT OF PROFIT OR LOSS ON
CONTRACT ALC.
The accounting treatment of profits or loss of contracts in the
following stages :
(A) Profit or Loss on incomplete contracts
(B) Profits or Loss on completed contracts
(A) Profit or Loss on Incomplete Contracts
To determine the profits to be taken to Profit and Loss Account in
the case of incomplete contracts, the following situations may arise :
(i) Completion of Contract is Less than 25%: In this case no profit
should be taken to Profit and Loss Account.
(ii) Completion of Contract is up to 25% or more but Less than 50%: In
this case one-third of the notional profit, reduced in the ratio of cash
received to work certified, should be transferred to Profit and Loss
Account. It can be expressed as:
1/3 x Notional Profit x Cash Received/ Work Certified
(iii) Completion of Contract is up to 50% or more but Less than 90%: In
this case two-third of the notional profit reduced by proportion of
cash received to work certified is transferred to Profit and Loss
Account. The equation is
2/3 x Notional Profit x Cash Received/ Work Certified
(iv) Completion of Contract is up to 90% or more than 90%, i.e., it is
nearing completion: In this case the profit to be taken to Profit and
Loss Account is determined by determining the estimated profit and
using anyone of the following formula :

a. Estimated profit x Work Certified/Contract price

b. Estimated profit x Work Certified/Contract price x Cash
received/Work Certified
OR
Estimated profit x Cash Received/Contract Price
c. Estimated Profit x Cost of work done to date/Estimated Total Cost
d. Estimated Profit = Cost of work done to date/Estimated Total Cost
x Cash received/Work Certified
e. Normal Profit = Work Certified/Contract Price

(B) Profits or Loss on Completed Contracts

When a contract is completed, the overall profit or loss on the

contract is transferred to the Profit and Loss Account.

Illustration
The following are the expenses on a contract which commences on
1st Jan. 2013
38
 Particulars Amt Rs.
Materials Purchased 1,00,000
Materials on hand 5,000
Direct Wages 1,50,000
Plant issued 50,000
Direct Expenses 80,000

The contract price was Rs. 15,00,000 and the same was duly
received when the contract was completed in August 2013. Charge
indirect expenses at 15% on wages. Provide Rs. 10,000 for depreciation on
plant and prepare the contract account and the contractee's account.

Solution:
Contract Account
Particulars Amt Rs. Particulars Amt Rs.
To Material 1,00,000 By Materials on Hand 5,000
Purchased
To Direct Wages 1,50,000 By Plant on Hand 40,000
(50,000-10,000)
To Direct Expenses 80,000 By Contractor’s A/c 15,00,000
(Contract Price)
To Indirect Expenses 22,500
(15% on wages)
To Depreciation on 10,000
plant
To Profit & Loss A/c 11,82,500
Total 15,45,000 Total 15,45,000

Contract Account
Particulars Amt Rs. Particulars Amt Rs.
To Contract A/c 15,00,000 By Bank 15,00,000
Total 15,00,000 Total 15,00,000

Illustration
The following information is available from the books of a
contractor relating to a contract for Rs 75 lakhs. The Contractee pays 90%
of the value of the work done as certified by the architect.

39
 Particulars 2006 2007 2008
Materials 9,00,000 11,00,000 6,30,000
Wages 8,50,000 11,50,000 8,50,000
Direct Expenses 35,000 1,25,000 45,000
Indirect Expenses 15,000 20,000 -
Work Certified 17,50,000 56,50,000 75,00,000
Work Uncertified - 1,00,000 -
Plant Issued 1,00,000 - -

The value of plant at the end of 2006, 2007 & 2008 was Rs.
80,000, Rs. 50,000 and Rs. 20,000 respectively.

Prepare Contract Account, Work in Progress Account, and

Contractee’s Account

Show the relevant figures in the Balance Sheet

Solution

Contract Account for the year 2006

Particulars Amt Rs. Particulars Amt Rs.
To Materials 9,00,000 By WIP A/c:
To Wages 8,50,000 - Work Certified 17,50,000
To Direct Expenses 35,000 - Plant at Site 80,000
To Plant 1,00,000
To Indirect Expenses 15,000 By P&L A/c 70,000
Total 19,00,000 Total 19,00,000

Contract Account for the year 2007

Particulars Amt Rs. Particulars Amt Rs.
To WIP A/c: By WIP A/c:
- Work 17,50,000 - Work Certified 56,50,000
Certified
- Plant at Site 80,000 - Work 1,00,000
uncertified
To Materials 11,00,000 - Plant at Site 50,000
To Wages 11,50,000

40
To Direct Expense 1,25,000
To Indirect Expenses 20,000
To P&L A/c 9,45,000
To WIP A/c (Reserve) 6,30,000
Total 58,00,000 Total 58,00,000

Contract Account for the year 2008

Particulars Amt Rs. Particulars Amt Rs.

To WIP A/c: By Contractee’s A/c 75,00,000
- Work Certified 56,50,000 By Plant 20,000
- Work 1,00,000
Uncertified
- Plant at Site 50,000
(Less): Reserve (6,30,00)
To Materials 6,30,000
To Wages 8,50,000
To Direct Expense 45,000
To P&L A/c (Profit) 8,25,000
Total 75,20,000 Total 75,20,000

WIP Account
Year Particulars Amt Rs. Year Particulars Amt Rs.
2006 To Contract 18,30,000 2006 By Balance 18,30,000
A/c c/d

2007 To balance b/d 18,30,000 2007 By Contract 18,30,000

A/c
To Contract 58,00,000 By Contract 6,30,000
A/c A/c
By balance c/d 51,70,000
Total 76,30,000 Total 76,30,000

2008 To balance b/d 51,70,000 2008 By Contract 51,70,000

A/c

41
 Contractee’s Account

Year Particulars Amt Rs. Year Particulars Amt Rs.

2006 To Balance c/d 15,75,000 2006 By cash 15,75,000
2007 To balance c/d 50,85,000 2007 By balance 15,75,000
b/d
By Cash 35,10,000
Total 50,85,000 Total 50,85,000
2008 To Contract A/c 75,00,000 2008 By balance 50,85,000
b/d
By Cash 24,15,000
Total 75,00,000 Total 75,00,000

Balance Sheet as on 31st December 2006

Particulars Amt Rs. Amt Rs.
Work In Progress
- Work Certified 17,50,000
- Work uncertified -
- Plant at Site 80,000
Less: Reserve -
18,30,000
Less: Cash Received 15,75,000 2,55,000

Balance Sheet as on 31st December 2007

Particulars Amt Rs. Amt Rs.
Work In Progress
- Work Certified 56,50,000
- Work uncertified 1,00,000
- 57,50,000
Less: Reserve 6,30,000
51,20,000
Less: Cash Received 50,85,000 35,000

Plant at Site 50,000

42
Illustration

The following particulars relate to the houses which a firm of

builders had in course of construction under contract:

Particulars House A House B

WIP on 1.1.2008 (excluding Rs. 800 14,000 -
estimated profit which was taken to P&L A/c
in 2007)
Materials purchased 23,000 16,600
Wages 20,000 14,000
Electrical Services and Fittings 1,400 300
Road Making Charges 8,000 -
Contract Price (including road making) 60,000 40,000
Cash received up to 31.12.2008 60,000 24,000
Percentage of cash received to work certified 100% 66.67%
Value of materials in hand on 31.12.2008 400 540
Completed work not certified - 2,500
Value of plants used on sites 12,000 6,000
Period of plants remained on site during the 10 months 8 months
year

Total Establishment expenses incurred during the year – Rs.

12,240. These are to be charged to the two contracts in proportion of
wages.
Deprecation on plant to be charged @ 10% p.a.
Prepare two contract accounts (in columnar form) showing
profit/loss for each contract and sums which you consider appropriately
transferable to P&L A/c
Contract Account for year ended 31.12.2008

Particulars House A House B Particulars House House

A B
To Balance b/d 14,800 - By Balance b/d
To Materials 23,000 16,600 Work certified 60,000 36,000
To Wages 20,000 14,000 Work uncertified - 2,500
To Electrical 1,400 300 By Materials in hand 400 540
services and
Fittings

43
 To road making 8,000 By P&L A/c (Loss) 15,000
charges
To Establishment 7,200 5,040
expenses
To Depreciation on 1,000 400
Plant
To Notional Profit - 2,700
c/d
Total 75,400 39,040 Total 75,400 39,040
To P&L A/c 1,200 By Notional Profit 2,700
b/d
To Balance c/d 1,500
(Reserve)
Total 2,700 Total 2,700

Working:

As work done on House B > 50%, profit taken to P&L A/c is

Rs. 2,700* 2/3*66.67%
= Rs. 1,200

Illustration
Paramount Engineers are engaged in construction and erection of a
bridge under a long-term contract. The cost incurred up to 31. 03. 2003
was as under:

Fabrication Rs. in lakhs

Direct Materials 280
Direct Labour 100
Overhead 60
440
Erection cost to date 110
550

The contract price is Rs. 11 crores and the cash received on

account till 31.03.2003 was Rs. 6 crores.

A technical estimate of the contract indicates the following degree

of completion of work:

Fabrication - Direct Materials - 70%, Direct labour and overheads 60%;

Erection - 40%.

You are required to estimate the profit that could be taken to profit
and loss account against this partly completed contract as at 31.03.2003.
44
Solution

Estimated Cost and Profit on Completion of Contract

Particulars Cost incurred Completion Estimated cost on
up to 31.3.03 % completion of
Rs Lakhs 100%
Rs. Lakhs
Direct Materials 280 70% 400.00
Direct Labour 100 60% 166.67
Overhead 60 60% 100.00
Erection 110 40% 275.00
Total 550 941.67

Contract price 1100.00

Profit on Completion 158.33

Profit on cost of Rs.9.41.67 lakhs is Rs.158.33 lakhs. Therefore, profit on

cost to date of Rs.550 lakhs.

Work Certified = 550 x 158.33 / 941.67 = Rs. 92.48 lakhs

= Cost + Profit
= Rs. 550 + Rs. 92.48 = Rs. 642.48 lakhs

Degree of completion of contract is:

= 642.48 x 100 / 1,100 = 58.41 %

The contract is more than· half complete.

Profit to be taken to Profit and Loss Account of the year is:

2 / 3 x Notional Profit x Cash Received / Work Certified

= 2 x 92.48 x 600
3 x 642.48

= Rs. 57.58 lakhs

Illustration:
Kapoor Engineering Company undertakes long term contracts
which involves fabrication of pre-stressed concrete blocks and erection of
the same on consumer’s side.

45
 The following information is supplied regarding contract 666
which is incomplete on 31. 3. 2016

Fabrication Rs.
Direct Materials 2,80,000
Direct Labour 90,000
Overhead 75,000
4,45,000
Erection cost to date 15,000
Total 4,60,000
Contract price 8,19,000
Cash received on account 6,00,000

A technical estimate of completion of work:

Fabrication - Direct Materials - 80%, Direct labour and overheads - 75%;
Erection - 25%.
You are required to prepare
1. Estimated profit on completion of contract
2. Estimated profit to date on contract
Solution:
Estimated Profit to date and Profit on Completion of Contract no. 666
Particulars Cost incurred Completion % Estimated cost on
up to 31.3.03 completion of 100%
Rs Lakhs Rs. Lakhs
Direct Materials 2,80,000 80% 3,50,000
Direct Labour 90,000 75% 1,20,000
Overhead 75,000 75% 1,00,000
Erection 15,000 25% 60,000
Total 550 6,30,000
Estimated Profit 1,89,000
on Completion
Contract price 8,19,000

Estimated profit to date

= Profit on whole contract x Costs incurred/Total contract cost
=1,89,000 x 4,60,000/6,30,000
= Rs. 1,38,000

46
Alternatively, Profit to date can also be calculated as:

Estimated profit on whole contract x Cash received/contract price

= 1,89,000 x 6,00,000/8,19,000
= Rs. 1,38,462

Choose the correct answer (Answer highlighted in BOLD)

1. Contract costing is a basic method of

(a) Historical costing (b) Specific order costing
(c) Standard costing (d) Process costing

2. Contract costing is usually applicable in

(a) Constructional Works (b) Textile Mills
(c) Cement Industries (d) Chemical Industries

3. In contract costing, determination of work in progress include:

(a) Work Certified (b) Work Uncertified
(c) Retention Money (d) Both a and b

4. Work Certified is valued at

(a) Cost price (b) Market price
(c) Cost or market price whichever is less (d) Estimate price

5. The degree of completion of work is determined by comparing the work

certified with
(a) Contract price (b) Work in progress
(c) Cash received on contract (d) Retention money

6. In contract costing credit is taken only for a part of the profit on

(a) Completed contract (b) In complete contract
(c) Cost-plus contract (d) Work Certified

7. Escalation Clause in a contract to prefect the interest of

(a) Contractor (b) Contractee
(c) Surveyor (d) Contractee's Architect

8. In contract costing payment of cash to the contractor is made on the

basis of
(a) Uncertified work (b) Certified work
(c) Work in progress (d) Estimated value

9. Materials returned under material return note credited to

(a) Contract account (b) Work in progress account
(c) Plant and machinery account (d) Profit and loss account

10. Cash received on contract is credited to

(a) Contract Account (b) Plant Account
(c) Work in Progress Account (d) Contractee's Account
47
True or False:

1. Contract costing is a form of job costing – True

2. Cost – plus contract and fixed – price contract are one and same –
False
3. The contractor is compensated for increase in costs by escalation cause
– True
4. The actual cost of the contract includes abnormal costs – False
5. Profit is generally recognized only after the entire work is completed –
False
6. If a contract is 40% complete, 40% of the notional profit is credited to
P&L Account – False
7. Work certified is valued at cost – False

Fill in the blanks

1. _____ is the person f whom the contract job is undertaken

2. Cost of closing stock appears on the ____ side of the Contract A/c
3. Value of work certified but not paid is known as ____ money
4. Cash received Rs. 4,80,000 being 80% of work certified: value of
work certified is _____

Answers
1. Contractee
2. Credit
3. Retention
4. Rs. 6,00,000

3.6 PROCESS COSTING

Meaning
Process Costing is a method of costing. It is employed where each
similar units of production involved in different series of process from
conversion of raw materials into finished output. Thus, .unit cost is
determined on the basis of accumulated costs of each operation or at each
stage of manufacturing a product.

Charles T. Horngren defines process costing as "a method of

costing deals with the mass production of the like units that usually pass
the continuous fashion through a number of operations called process
costing." Textiles, chemical works, cement industries, food processing
industries etc. are the few examples of industries where process costing is
applied.

3.7 CHARACTERISTICS OF PROCESS COSTING

1. Continuous or mass production where products pass through distinct

processes or operations.
48
2. Each process is deemed as a separate operations or production centres.
3. Products produced are completely homogenous and standardized.
4. Output and cost of one process are transferred to the next process till
the finished product completed.
5. Cost of raw materials, labour and overheads are collected for each
process.
6. The cost of a finished unit is determined by accumulated of all costs
incurred in all the process divided by the number of units produced.
7. The cost of normal and abnormal losses usually incurred at different
stages of production is added to finished goods.
8. The interconnected processes make the final output of by-product or
joint products possible.

3.8 ADVANTAGES & DISADVANTAGES

Advantages :
The main advantages of process costing are:

(1) Determination of the cost of process and unit cost is possible at short
intervals.
(2) Effective cost control is possible.
(3) Computation of average cost is easier because the products produced
are homogenous.
(4) It ensures correct valuation of opening and closing stock of work in
progress in each process.
(5) It is simple to operate and involve less expenditure.

Disadvantages :
(1) Computation of average cost does not give the true picture because
costs are obtained on historical basis.
(2) Operational weakness and inefficiencies on processes can be
concealed.
(3) It becomes more difficult to apportionment of joint costs, when more
than one type of products manufactured.
(4) Valuation of work in progress is done on estimated basis, it leads to
inaccuracies in total costs.
(5) It is difficult to measure the performance of individual workers and
supervisors.

49
Illustration-

Following figures show the cost of A product passes through three

processes. In March 1000 units were produced. Prepare the process
accounts and find out per unit of each process.
(All Figures in Rs.)

Process I Process II Process III

Raw Materials 50,000 30,000 20,000
Wages 30,000 25,000 25,000
Direct Expenses 7,000 3,000 5,000

Overhead expenses were Rs 12,000 and it should be apportioned on the

basis of wages.

Solution
Process I Account
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Raw 1,000 50,000 By Process II 1,000 91,500
Materials A/c
(Output
transferred at
Rs 91.50 per
Unit)
To Wages 30,000
To Direct 7,000
Expenses
To Overheads 4,500
(6/16*12000)

Total 1,000 91,500 Total 1,000 91,500

50
 Process II Account

Particulars Units Amount Particulars Units Amount

Rs. Rs.
To Process II A/c 1,000 91,500 By Process II 1,000 1,53,250
(Transferred from A/c
Process I) (Output
transferred at
Rs 153.25 per
Unit)
To Raw Materials 30,000
To Wages 25,000
To Direct 3,000
Expenses
To Overheads 3,750
(5/16*12000)

Total 1,000 1,53,250 Total 1,000 1,53,250

Process III Account

Particulars Units Amount Particulars Units Amount

Rs. Rs.
To Process III A/c 1,000 1,53,250 By Finished 1,000 2,07,000
(Transferred from Stock
Process II) (Output
transferred @
Rs 207 per
unit)
To Raw Materials 20,000
To Wages 25,000
To Direct Expenses 5,000
To Overheads 3,750
(5/16*12000)

Total 1,000 2,07,000 Total 1,000 2,07,000

51
3.9 PROCESS LOSSES:

Process Losses may be defined as the loss of material occur at

different stages of manufacturing process. The following are the types of
losses unavoidable during the course of processing operations such as:

(1) Normal Process Loss

(2) Abnormal Process Loss
(3) Abnormal Process Gain
(4) Spoilage
(5) Defectives

(1) Normal Process Loss: The cost of normal process loss in practice is
absorbed by good units produced under the process. This is known as
Normal Process Loss or Normal Wastage. For example, evaporation,
scrap, stamping process etc. The amount realized by the sale of normal
process loss units should be credited to process account.

(2) Abnormal Process Loss: The cost of an abnormal process loss unit is
equal to the cost of good unit. . The total cost of abnormal process loss
is credited to process account from which it arises. This is known as
Abnormal Process Loss. Such loss may be caused by breakdown of
machinery, false production planning, lack of effective supervision,
substandard materials etc., Cost of abnormal process loss is not treated
as cost of the product. In fact, the total cost of abnormal process loss is
debited to Costing Profit and Loss Account.

Computation of Abnormal Loss:

Value of Abnormal Loss = Normal Cost of Normal Output * Units of Abnormal Loss
Normal Output

Where:
Quantity of Abnormal Loss = Normal Output - Actual Output
Normal Output = Input - Normal Loss
If actual output is less than normal output to balance represents Units of
Abnormal Loss.

(3) Abnormal Process Gain: Abnormal Process Gain may be defined as

unexpected gain in production under normal conditions. The process
account under which abnormal gain arises is debited with abnormal gain.
The cost of abnormal gain is computed on the basis of normal production.

(4) Spoilage: Normal Spoilage (i.e., which is inherent in the operation)

costs are included in costs either by charging the loss due to spoilage to
the production order or by charging it to production overhead so that it is
spread over all the products. Any value realized from the sale of spoilage
is credited to production order or production overhead account as the case
may be. The cost of abnormal spoilage is charged to Costing Profit and
52
Loss Account. When spoiled work is the result of rigid specification, the
cost of spoiled work is absorbed by good production while the cost of
disposal is charged to production overhead.

(5) Defectives: Defectives that are considered inherent in the process and
are identified as normal can be recovered by using the following method.
 Charged to goods products
 Charged to general overheads
 Charged to departmental overheads
 If defectives are abnormal, they are to be debited to Costing Profit
and Loss Account.

Equivalent Production

Equivalent Production represents the production of a process in

terms of completed units. In other words, it means converting the
uncompleted production into its equivalent of completed units. The term
equivalent unit means a notional quantity of completed units substituted
for an actual quantity of incomplete physical units in progress, when the
aggregate work content of the incomplete units is deemed to be equivalent
to that of the substituted quantity, (e.g. 100 units of 70% completed = 70
completed units).

The principle applies when operation costs are being apportioned

between work- in-progress and completed output. Thus in each process an
estimate is made of the percentage completion of any work-in-progress. A
production schedule and a cost schedule will then be prepared.

The work-in- progress is inspected and an estimate is made of the

degree of completion, usually on a percentage basis. It is most important
that this estimate is as accurate as possible because a mistake at this stage
would affect the stock valuation used in the preparation of final accounts.
The formula of equivalent production is:

Equivalent units of work-in-progress = Actual no. of units in

progress of manufacture X Percentage of work completed

For example, if 70% work has been done on the average on 200
units still in process, then 200 such units will be equal to 140 completed
units. The cost of work-in-progress will be equal to 140 completed units.

Calculation of Equivalent Production:

Following steps are worth noting in its calculation under different
methods:
Method I:
Under this method opening work-in-progress is stated in equivalent
completed units by applying the percentage of work needed to complete
53
the unfinished work of the previous period. Then number of units started
and completed (i.e. units started less closing stock) are added. Further
equivalent completed units of closing work-in-progress are also added to
get the equivalent production.

Method II:
Under this method units completed during the period (i.e. units
started + opening stock units—closing stock units) are added to the units
of closing stock completed during the period and out of the total units,
opening stock units completed in previous year are deducted to get the
units of equivalent production.

Method III:
Under this method units of uncompleted input are added to the
units of incomplete work in opening stock and out of the total units,
incomplete work in closing stock are deducted to have units of equitant
production.

Often 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 which
method of valuation of work-in-progress is used.

valuation of work-in-progress can be made in the following ways

depending upon the assumptions made regarding the flow of costs:

(a) Average Cost Method,

(b) FIFO,
(c) LIFO and
(d) Weighted Average Method.

These are discussed one by one:

(a) Average Cost Method:

According to this method opening inventory of work-in-progress

and its costs are merged with production and cost of the current period
respectively. An average cost per unit is determined by dividing the total
cost by the total equivalent units, to ascertain the value of the units
completed and units in process.

This method is useful when prices fluctuate from period to period.

The closing valuation of work-in-progress in the old period is added to the
cost of the new period and an average rate obtained which tends to even
out price fluctuations. In calculating the equivalent production opening
units will not be shown separately as units of opening work-in-progress
are taken to be included in the units completed and transferred.

54
(B) FIFO Method:

According to this method, the units first entering the process are
completed first after taking into consideration the percentage of work to be
done and shown separately in the statement of equivalent production. Thus
the units completed during a period would consist partly of units which
were incomplete at the beginning of the period and partly of the units
introduced during the period.

The cost of completed units is affected by the value of opening

inventory which is based on the cost of previous period. This method is
satisfactory when prices of raw materials and rates of direct labour and
overheads are relatively stable.

Work-in-progress at the end of the period becomes the opening

work-in-progress for the next period; the closing work- in-progress will be
valued at costs ruling during the new period, while the opening work-in-
progress will be valued at costs ruling during the old period. Thus, where
costs are more or less the same in each period, this system is adequate.

(C) Last in First-out (LIFO) Method:

According to this method, units lastly entering in the process are

first to be completed. This assumption will definitely have a different
impact on the cost of completed units and closing inventory of work in
progress. The completed units will be shown at their current cost and the
closing inventory of work-in-progress will continue to appear at the cost
of opening inventory of work-in-progress along with current cost of work
in progress, if any.

(D) Weighted Average Method:

When two or more dissimilar products are manufactured in the

same process, a simple average process cost may give misleading results.
In such a case, a close study of production and costs of each type of
product is required to be made and the relative importance of one as
compared to others should be indicated in terms of points to be used as a
common denominator.

In order to find out the cost of production under weighted average

method, statements of weighted average production in terms of points and
cost for each type of product should be prepared. The computation of
weighted average process cost sheet will be easy, if due consideration to
weights or points are given.

Illustration:
From the following details prepare statement of equivalent
production, statement of cost, statement of evaluation and Process
Account by following average cost method:
55
Opening WIP (2000 Units)
Materials (100% Complete) Rs. 7,500
Labour (60% Complete) Rs. 3,000
Overhead (60% Complete) Rs. 1,500
Units introduced into the process – 8,000

There are 2,000 units in the process. The stage of completion is estimated
to be:
Materials 100% Complete
Labour 50% Complete
Overhead 50% Complete
8,000 units are transferred to the next process
The Process costs for the period are:

Materials: Rs. 1,00,000

Labour: Rs. 78,000
Overheads: Rs. 39,000

Statement of Equivalent Production

Production Units Materials Labour &

Overheads
% Equiv. % Equiv.
Completion Units Completion Units
Finished & 8,000 100 8,000 100 8,000
Transferred
Closing WIP 2,000 100 2,000 50 1,000
Total 10,000 10,000 9,000
Statement of Cost

Material Labour Overheads

(Rs.) (Rs.) (Rs.)
Cost of Opening WIP 7,500 3,000 1,500
Cost incurred during the 1,00,000 78,000 39,000
process
1. Total Cost 1,07,500 81,000 40,500
2. Equivalent Units 10,000 9,000 9,000
3. Cost per unit 10.75 9.00 4.50
(1/2)
4. Total Cost per 24.25
unit

56
 Statement of Evaluation

a) Value of output transferred

8,000 units at Rs. 24.25 1,94,000
b) Value of Closing WIP
Materials 2,000 @ 10.75 21,500
Labour 1,000 @ 9.00 9,000
Overheads 1,000@ 4.50 4,500 35,000
Total 2,29,000

Process Account

Particulars Units Amount Particulars Units Amount

Rs. Rs.
To Opening 2,000 12,000 By Finished 8,000 1,94,000
WIP Stock
transferred to
next process
To Materials 8,000 1,00,000 By WIP A/c 2,000 35,000
To Labour 78,000
To Overheads 39,000

Total 10,000 2,29,000 Total 10,000 2,29,000

From the following details prepare statement of equivalent
production, statement of cost, statement of evaluation and Process
Account by following FIFO method:

Opening WIP (2000 Units)

Materials (100% Complete) Rs. 5,000

Labour (60% Complete) Rs. 3,000
Overhead (60% Complete) Rs. 1,500
Units introduced into the process – 8,000

There are 2,000 units in the process. The stage of completion is estimated
to be:

Materials 100% Complete

Labour 50% Complete
Overhead 50% Complete
8,000 units are transferred to the next process

57
The Process costs for the period are:

Materials: Rs. 96,000

Labour: Rs. 54,600
Overheads: Rs. 31,200

Statement of Equivalent Production

Production Units Materials Labour &
Overheads
% Equiv. % Equiv.
Completion Units Completion Units
Opening WIP 2,000 - - 40 800
Completely 6,000 100 6,000 100 6,000
processed during
the period (8,000
– 2,000)
Closing WIP 2,000 100 2,000 50 1,000
Total 10,000 8,000 7,800

Statement of Cost

Cost incurred Equivalent Cost Per

during the Production Unit (Rs.)
period (Units)
Rs.
Materials 96,000 8,000 12
Labour 54,600 7,800 7
Overheads 31,200 7,800 4
Total 1,81,800 23

Statement of Evaluation
Opening WIP (Current Cost) Rs. Rs.
Materials -
Labour ---- 800 units @ Rs. 7 5,600
Overheads ---- 800 units @ Rs. 4 3,200 8,800

Closing WIP
Materials ---- 2,000 Units @ Rs. 12 24,000

58
 Labour ---- 1,000 units @ Rs. 7 7,000
Overheads ---- 1,000 units @ Rs. 4 4,000 35,000

Units completely processed during the 1,38,000

period ---- 6,000 units @ Rs. 23
Total 1,81,800

Process Account

Particulars Units Amount Particulars Units Amount

Rs. Rs.
To Opening 2,000 9,500 By Finished 8,000 1,56,300
WIP Stock
transferred to
next process
(9,500+8,800+
1,38,000)
To Materials 8,000 96,000 By WIP A/c 2,000 35,000
To Labour 54,600
To Overheads 31,200

Total 10,000 1,91,300 Total 10,000 1,91,300

From the following information for the month of May 2016,

prepare process cost accounts for Process II by using FIFO method to
value equivalent production

Direct Materials added in Process II (Opening 2000 units @ Rs.

WIP) 25,750
Transfer from Process I 53,000 units @ Rs.
4,11,500
Transfer to Process III 48,000 units
Closing stock of Process II 5,000 units
Units scrapped 2,000
Directs material added in Process II Rs. 1,97,600
Direct Wages Rs. 97,600
Direct overheads Rs. 48,800

59
Degree of completion:

Opening Stock Closing Stock Scrap

Materials 80% 70% 100%
Labour 60% 50% 70%
Overheads 60% 50% 70%

Solution

Statement of Equivalent Production

Production Units Material A Material B Labour & Overheads
% Equiv. % Equiv. % Equiv.
Completio Units Completi Units Completion Units
n on
Opening WIP 2,000 - - 20 400 40 800
Completely 46,000 100 46,000 100 46,000 100 46,000
processed
during the
period (48,000
– 2,000)
Normal Loss 2,500
(2,000+53,000-
5,000)*5%
Closing WIP 5,000 100 5,000 70 3,500 50 2,500

55,500 51,000 49,900 49,300

Abnormal 500 100 500 100 500 100 500
Gain
55,000 50,500 49,400 48,800

Statement of Cost
Cost incurred Equivalent Cost Per
during the Production Unit (Rs.)
period (Units)
Rs.
Material – A 4,11,500
Transfer from Process I
Less: Scrap Value of Normal (7,500)
Loss (2,500*3)
4,04,000 50,500 8
Material – B 1,97,600 49,400 4
Labour 97,600 48,800 2
Overheads 48,800 48,800 1
Total 7,48,000 15

60
 Statement of Evaluation

Opening WIP (for completion) Rs. Rs.

Material – B 400 units @ Rs. 4 1,600
Wages ---- 800 units @ Rs. 2 1,600
Overheads ---- 800 units @ Rs. 1 800 4,000

Closing WIP
Material A ---- 5,000 Units @ Rs. 8 40,000
Material B ---- 3,500 Units @ Rs. 4 14,000
Wages ---- 2,500 units @ Rs. 2 5,000
Overheads ---- 2,500 units @ Rs. 1 2,500 61,500

Units completely processed during the 6,90,000

period ---- 46,000 units @ Rs. 15

Abnormal Gain 500 Units @ Rs. 15 7,500

Process II Account

Particulars Units Amount Particulars Units Amount

Rs. Rs.
To Balance b/d 2,000 25,750 By Normal 2,500 7,500
Loss
To Process I A/c 53,000 4,11,500 By Process 48,000 7,19,750
III A/c
(6,90,000 +
4,000 +
25,750)
To D. Materials 1,97,600 By balance 5,000 61,500
c/d
To D. Wages 97,600
To Overheads 48,800
To Abnormal 500 7,500
Gain
Total 55,500 7,88,750 Total 55,500 7,88,750

61
Following information is available regarding process X for the month
of May 2016

Production Record:

Units in Process as on 01.05.2016 4,000

(All materials used; 25% complete for labour and
overhead)
New units introduced 16,000
Units completed 14,000
Units in process as on 31.5.2016 6,000
(All materials used; 33.33% complete for labour and
overhead)

Cost Record:
Work in Process as on 01.05.2016 Amount Rs.
Materials 6,000
Labour 1,000
Overhead 1,000

Cost during the month Amount Rs.

Materials 25,600
Labour 15,000
Overhead 15,000

Presuming that Average Cost method of inventory is used, prepare:

1. Statement of Equivalent Production
2. Statement showing cost for each element
3. Statement of Apportionment of Cost
4. Process cost account for Process A

Statement of Equivalent Production

Production Units Materials Labour &

Overheads
% Equiv. % Equiv.
Completion Units Completion Units
Completed 14,000 100 14,000 100 14,000
WIP 6,000 100 6,000 33.33 2,000
Total 10,000 20,000 15,000

62
 Statement showing cost for each element
(All figures in Rs.)
Particulars Materials Labour Overhead Total
Cost of Opening WIP 6,000 1,000 1,000 8,000
Cost incurred during the 25,600 15,000 15,000 55,600
month
Total Cost (A) 31,600 16,000 16,000 63,600
Equivalent Units (B) 20,000 16,000 16,000
Cost per equivalent 1.58 1.00 1.00 3.58
unit (‘C)= (A/B)

Statement of Apportionment of Cost

Particulars Rs. Rs.
Value of output transferred (A) (14,000 50,120
units @ Rs. 3.58)

Value of Closing WIP

Material – 6,000 units @ Rs. 1.58 9,480
Labour – 2,000 units @ Rs. 1 2,000
Overheads - 2,000 units @ Rs. 1 2,000 13,480

Total Cost 63,600

Process X Account

Particulars Units Amount Particulars Units Amount

Rs. Rs.
To Opening 4,000 8,000 By Completed 14,000 50,120
WIP units
To Materials 16,000 25,600 By Closing 6,000 13,480
WIP
To Labour 15,000
To Overheads 15,000

Total 20,000 63,600 Total 20,000 63,600

63
Exercise

Choose the correct option(s) for the following questions: (Answers are
highlighted in bold)

1. Total costs incur in a production process is divided by total number of

output units for calculating the

 cost of indirect labor

 cost of direct labor
 cost of direct material
 unit costs

2. Costs that are incurred in last department where product has been
processed and will be carried to next department where further
processing will be done are called

 partial work costs

 transferred-in costs
 transferred-out costs
 weighted average costs

3. Costing method which calculates per equivalent unit cost of all

production related work done till calculate date is classified as

 weighted average method

 net present value method
 gross production method
 average value method

4. If beginning work in process equivalent units are 2500 units, work

done in current period equivalent units are 3800 units and ending work
in process equivalent units are 5000 then complete equivalent units in
current period are
 1800 units
 1500 units
 1300 units
 1500 units

5. Equivalent units of production are equal to the

 units completed by a production department in the period.
 number of units worked on during the period by a production
department.
 number of whole units that could have been completed if all
work of the period had been used to produce whole units.
 identifiable units existing at the end of the period in a production
department.

64
True or False:

i. Process costing is most appropriate when manufacturing large

batches of homogenous products. (True)

ii. Equivalent units are computed to assign costs to partially

completed units (True)

iii. The FIFO method combines beginning inventory and current

production to compute cost per unit of production. (False)

iv. The weighted average costing method assumes that units in

beginning inventory are the first units transferred. (False)



65
 4
VALUATION OF MATERIALS ISSUES
Unit Structure:

4.1 Introduction
4.2 Valuation of Material Issues - Following Aspects
4.3 Materials: Inventory Control
4.4 Labour Cost Accounting

4.1 INTRODUCTION

All receipts and issues of materials are the important aspects to continuous
flow of production. A systematic procedure should be adopted for movement
of materials from one place to another place. Materials received and
stored are issued on the basis of stores requisition, bills of materials, stock
in balance, proper authorization and pricing material issues etc. It is clear
that ascertainment of accurate material cost, fixing of material issue and
effective cost control are the primary objective in order to fulfill the needs of
management. For this reasons the following aspects considered to be the
subject matter of valuation of materials issues.
1. Valuation of total cost of materials purchased.
2. Material Issue Procedure.
3. Important methods of pricing of materials issued.

4.2 VALUATION OF TOTAL COST OF MATERIALS

PURCHASED

Material costing is very important in terms of the valuation of the cost

of materials consumed by the production department as well as in terms of
the estimation of the value of materials in stock. For costing purposes, the
material cost is worked out by the actual cost incurred by taking price
quoted by supplier as the basis subtracting the discounts and adding any
other expenses not covered. In practice discounts may be allowed by the
supplier in the following ways such as : (a) Trade Discount. (b) Quantity
Discount and (c) Cash Discount.
a. Trade Discount: Trade Discount is allowed by the seller to the buyer
who has to resell the goods. This allowance is to compensate the buyer
for the cost of storage, breaking bulk, selling repacking the goods etc.
b. Quantity Discount: This discount refers to the allowance which is
allowed by the supplier to the buyer to encourage large orders.
66
 Placing the large orders from the buyers gives savings in costs which
arise from large-scale production to the supplier. Part of the savings
allowed by supplier to the buyer by means of a quantity discount.
c. Cash Discount: Cash Discount is allowed by the supplier to a buyer to
encourage prompt payment of cash within the stipulated period.

2.MATERIALS ISSUE PROCEDURE

Issues of materials are based on production program. Based on this
and the bill of materials work orders are printed, listing for each material
quantity to be issued against each component requiring that material. The
storekeeper is very much concerned with the material control, as he is
responsible for the issue of materials based on the proper authorization of
material requisition and bills of materials.

Materials Requisition:
Purchase or Material Requisition is also known as Intent for Materials.
This is a document prepared by the production department for requisition
of materials is known as Materials Requisition. The storekeeper is
authorized to issue the materials based on the proper authority to avoid the
misappropriation of material. The store keeper is responsible to maintained a
record of serial number on requisition, issues and stock balances are up to
date are must be posted in stores ledger.

Bill of Materials:
Bill of materials is a document which shows a complete listing for
each material, quantity to be issued against each component requiring that
materials for a particular job order or process. Bill of Materials is prepared by
the production department before the quantity of the components to be
manufactured. This is helpful for the purpose of initiate material requisition
and estimation of cost materials to collect quotations.

3.METHOD OF PRICING OF MATERIALS ISSUES

In the relation to the estimation of the cost of the product for pricing
decisions, material issues assumes a key role. Material
price usually refers to the price quoted and accepted in the purchase
orders. Materials are issued from the stores to work orders based on the
material requisition. But stock of materials consists of different
consignment received at different dates and prices. There are different
methods used for pricing the materials issues may be summarized in the
following categories:

(A) Actual Price Method (or) Cost Price Method

(1) First In First Out (FIFO).
(2) Last In First Out (LIFO).
(3) Specific Price Method.
(4) Base Stock Method.
(5) Highest In First Out (HIFO).

67
(B) Average Cost Method
(1) Simple Average Method.
(2) Weighted Average Method.
(3) Periodic Simple Average Method.
(4) Periodic Weighted Average Method.
(C) Standard Price Method.
(D) Inflated Price Method.
(E) Market Price Method (or) Replacement Price Method.

A. Actual Price Method

In this method, the materials issued are priced at their actual cost and
this involves identification of each lot purchased. This method is suitable
only in the case of materials purchased for a specific job. There are several
methods frequently used under actual cost price method which will be
discussed in details:

(1) First In First Out (FIFO): First In First Out is also known as FIFO.
Under this method, the pricing of issue is based on an assumption made
that the oldest stock is issued first. Therefore at the time of issue, the rate
pertaining to that will be applied until the whole lots is exhausted.

Advantages
(1) It is simple and easy to adaptability.
(2) It is beneficial when the prices are falling.
(3) As actual prices are issued, it reflects on profit no loss in the pricing.
(4) This method is very useful for slow moving materials.

Disadvantages
(1) Calculation becomes complicated due to fluctuation of material
prices.
(2) More chances of clerical errors due to complicated
calculations.
(3) Under fluctuating prices, one requisition involves more than one
price.
(4) In times of raising prices this method tends to show the production at
low cost since the cost of replacing the material will be higher.

Illustration: 1
From the following particulars, prepare the Stores Ledger Account
showing how the value of the issues would be recorded under FIFO
methods.
01.12.2003 Opening Stock 1,000 Units at Rs. 6 each
05.12.2003 Purchased 500 Units at Rs. 24.50 each
07.12.2003 Issued 750 Units
10.12.2003 Purchased 1,500 Units at Rs. 24 each
68
 12.12.2003 Issued 1,100 Units
15.12.2003 Purchased 1,000 Units at Rs. 25 each
17.12.2003 Issued 500 Units 18.12.2003 Issued 300 Units
25.12.2003 Purchased 1,500 Units at Rs. 26 each
29.12.2003 Issued 1,500 Units

Solution:

(2) Last In First Out (LIFO): This method is just opposite to First In First
Out method. The basic assumption here is that the most recent receipts
are issued first. The price of the materials to be issued would be the
cost price of the last lots of materials purchased.

69
Advantages
1. It is beneficial when the period of raising prices.
2. Under this method, latest prices are issued thereby leading to lower
reported profits hence savings in taxes.
3. When there are wide fluctuations in price levels this methods tends
to minimize unrealized gains or losses in inventory.

Disadvantages
(1) This method involves more clerical work which leads to complicated
calculations.
(2) Under this method more than one price is to be adopted for the same
issue lot of material.
(3) Due to wide fluctuation of prices, comparison of cost of similar jobs
is very difficult.

Illustration: 2
Solve the illustration No.1, under LIFO method.

70
(3) Specific Price Method: Specific Price Method is one of the methods of
actual price method. In this method adopted where the materials are
purchased for particular job or operation and the issue is charged with the
actual cost price. This method is suitable only in the case of special purpose
materials are purchased for a particular job. This method has been widely
used in job order industries which carry out individual jobs or contract
against specific orders.

Advantages -
(1) This method is simple and easy to operate.
(2) This method is useful where the job costing is in operation.
(3) Under this method, the actual material cost can be easily
identified.
(4) This method is desirable because actual cost of materials is
charged to production and therefore no profit no loss.

Disadvantages
(1) This method involves considerable amount of clerical work.
(2) If the purchases and issues are numerous, it is difficult to
identification of issues for a particular job.
(3) Base Stock Method: Under this method pricing is determined on
the basis of assumption made here is that a certain minimum quantity
of materials maintained in stock. This minimum quantity is known
as Base Stock or Safety Stock. This quantity cannot be used unless
an emergency arises. The minimum stock is in the nature of fixed
assets because it is created out of the first lot of the material
purchased. Therefore it always valued at the actual cost price of
the first lot and is carried forward as fixed assets. This method is
usually applied with FIFO or LIFO.

Illustration: 3
From the following details of stores receipts and issues of materials in
a manufacturing unit, prepare the stores ledger using Base Stock Method of
valuing the issues; assume base stock 200 tons.
1.1.2003 Purchased 500 tons at Rs. 2 per ton
10.1.2003 Purchased 300 tons at Rs. 2.10 per ton
15.1.2003 Issued 600 tons
20.1.2003 Purchased 400 tons at Rs. 2.20 per ton
25.1.2003 Issued 300 tons
27.1.2003 Purchased 500 tons at Rs. 2.10 per ton
31.1.2003 Issued 200 tons

71
Closing Stock= 600 tons (200 x Rs. 2 + 400 x Rs. 2.10) = Rs. 1,240

72
Illustration:
Solve illustration 3 Under Base Stock - LIFO method

Solution:

(5) Highest In First Out (HIFO): This method is based on the assumption
that the stock of materials should always be valued at the lowest possible
price. Accordingly materials purchased at the highest price should be used for
making the issue. This method is useful because issues are based on actual
cost. It aims at recovering the highest cost of materials when the market is
constantly fluctuating. But at the same time this method involves too many
complicated calculations. And also this method has not been adopted
widely.

Illustration: 4
From the following details of stores receipts and issues of material
"XYZ" in a manufacturing unit, prepare the Stores Ledger using Highest In
First Out Method (HIFO):

2003 January 1 Opening stock 4,000 units at Rs. 5

4 Purchased 1,000 units at Rs. 7 per unit
8 Purchased 1,200 units at Rs. 8 per unit
12 Issued 1,000 units

73
 15 Purchased 700 units at Rs. 10 per units
19 Purchased 300 units at Rs. 8 per unit
23 Issued 800 units
25 Purchased 509 units at Rs. 10 per unit
31 Issued 400 units

Solution:
Stores Ledger Account
(Highest In First Out (HIFO) Method)

74
B. Average Cost Method
In this method, the issues to the production department are split into
equal batches from each shipment at stock. It is a realistic method reflecting
the price levels and stabilizing the cost price. The following various methods of
averaging issue prices may be used:
(1) Simple Average Method
(2) Weighted Average Method
(3) Periodic Simple Average Method
(4) Periodic Weighted Average Method

(1) Simple Average Method: Under this method, price of issue materials is
determined by dividing the total of the prices of the materials in stock, i.e.,
adding of different prices by the number of different prices. Then, this average
price is applied to the issues to production. This method is simple and easy to
operate. The value of closing stock becomes unrealistic. The following
formula is applied for calculation of material issue price under simple average
method:

Issue Price = Total of Unit Prices of Materials in Stock

Number of Prices

Illustration: 5
From the following prepare stores ledger account using Simple Average
Method for the month of January 2003:

January 1 Opening balance 500 units at Rs. 2 per unit

3 Issued 100 units
4 Issued 100 units
8 Issued 100 units
13 Purchased 400 units at Rs. 3 per unit
14 Purchased 200 units at Re. 1 per unit
16 Issued 150 units
20 Purchased 400 units at Rs. 4 Per unit
24 Issued 250 units
25 Purchased 500 units at Rs. 5 per unit
26 Issued 300 units
28 Purchased 200 units at Rs. 2 per unit
31 Purchased 200 units at Rs. 4 per unit

75
Solution:
Stores Ledger Account (Simple
Average Method)

Date Receipts
Issues Balance

Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.

Rs. Rs. Rs. Rs. Rs. Rs.

01.01.2003 500 2 1,000 500 2 1,000

03.01.2003 100 2 200 400 2 800
04.01 .2003 100 2 200 300 2 600
08.01.2003 100 2 200 200 2 400
13.01.2003 400 3 1,200 200 2 400
400 3 1,200
14.1.2003 200 1 200 200 2
400
400 3 1,200
200 1 200
16.01.2003 150 2 300 650 1,500
20.01.2003 400 4 1,600 1,050 3,100
24.01.2003 250 2.5 625 800 2,475
25.01.2003 500 5. 2,500 1,300 4,975
26.01.2003 300 3.25 975 1,000 4,000
28.01.2003 200 4 400 1,200 4,400
31.01.2003 200 4 800 1,400 5,200

Working Notes
1. Issue rate on 3rd, 4th and 8th at Rs. 2 per unit
2. Issue rate on 16th = (2+ 3 + 1)/3 = Rs. 2
3. Issue rate on 24th = (2+ 3 + 1 + 4)/4 = Rs. 2.5
4. Issue rate on 26th = (3 + 1 + 4 + 5)/4 = Rs. 3.25

(2) Weighted Average Method: Under this method, the price of materials
issue is determined by dividing the total cost of materials in stock by the
total quantity of material in stock. Here weighted average rate is calculated
based on both quantity and price of the materials in stock. As more issues are
made, a new average rate is computed and this average rate is applied to
the subsequent issues. The material issue price is calculated by the formula
given below:

76
Illustration: 6
From the following particulars, prepare stores Ledger Account on
weight Average basis:

2003
March I Opening balance 200 units at Rs. 2 per unit
10 Purchased 300 units at Rs. 2.40 per unit 15 Issued 250 units
18 Purchased 250 units at Rs. 2.60 per unit 20 Issued 200 units
25 Purchased 300 units at Rs. 2.50 per unit
31 Purchased 100 units at Rs. 2 per unit

Solution:
Stores Ledger Account (Weighted Average Method

Receipts Issues Balance

Date Qty. Rate Amt. Qty. Rate Amt Qty. Rate A mt .

Rs. Rs. Rs. . Rs. Rs. Rs.

01.03.2003 200 2 400 200 2 400

10.03.2003 300 2.40 720 200 2 400
300 2.40 720
15.03.2003 250 2.24 560 250 560
18.03.2003 250 2.60 650 500 1,210
20.03.2003 200 2.42 484 300 726
25.03.2003 300 2.50 750 600 1,476
31.03.2003 100 2 200 700 1,676

Working Notes
Issue Price = Value of materials in stock / quantity in stock
1. Issue rate on 15th = (400 + 720)/(200 + 300) = Rs. 2.24
2. Issue rate on 20th = (560 + 650)/(250 + 250)= Rs. 2.42

(3) Periodic Simple Average Method: Under this method, the simple
average rate is calculated for a particular period ignoring the rate of opening
stock. The issue price is calculated by totaling the unit price of all
materials purchased during a particular period by the total number of
prices during that period. Thus this rate is applied to the issue to
production for a particular period say a month and not at the occasion of
each issue of materials.

77
 Illustration: 7
From the following detail of stores receipts and issues of material
"EXE" in a manufacturing unit, prepare the Stores Ledger using Periodic
Simple Average Method.

2003 Jan.1Opening Stock 200 units at Rs. 2 per unit

Jan. 5 Purchased 400 units at Rs. 3 per unit
Jan. 10 Issued 250 units
Jan. 16 Purchased 500 units at Rs. 3 per unit
Jan. 20 Issued 300 units
Jan. 31 Purchased 200 units at Rs. 4 per unit
Feb. 10 Issued 500 units
Feb. 15 Purchased 400 units at Rs. 4.50 per unit
Feb. 20 Issued 300 units
Feb. 25 Purchased 200 units at Rs. 6 per unit

Working Notes
1. Issue rate in Jan=(3+3+4)/3= Rs.4.66
2. Issue rate in Feb = (4.50 + 6)/2 = Rs. 5.25

(4) Periodic Weighted Average Method: This method is similar to the

periodic simple average method. In this method issue rate is calculated by
total cost of materials purchased during a period by the total quantity of
materials purchased during that period. Here both quantity and prices of
materials in stock during a particular period are taken into account for
calculation of periodic weighted average rate. Under this method the issue rate
is determined for a particular period ignoring the rate and quantity of
opening stock. A new average rate is computed at the end of each period
say a month and this average rate is applied to subsequent issues.

78
Illustration: 8

Solve the illustration No.6, under Periodic Weighted Average Method.

Solution:
Stores Ledger Account (Periodic Simple Average Method

Receipts Issues Balance

Date Qty. Rate Amt. Qty. Rate Amt. Qty. Rate Amt.
Rs. Rs. Rs. Rs. Rs. Rs.

01.01.2003 200 2 400 200 -

05.01.2003 400 3 1,200 400
10.01.2003 250 350
16.01.2003 500 3 1,500 850
20.01 .2003 300 550
31.01.2003 200 4 800 750
1,300 3,900 550 3.18 1,749 750 3.18 2,385
Febi Balance 750 3.18 2,385 750
10.02.2003 500 250
15.02.2003 400 4.50 1,800 650
20.02.2003 300 350
25.02.2003 200 6 1,200 550
1,350 5,385 800 5 4,000 550 5 2,750

Working Notes
1. Issue rate in Jan = (1200 + 1500 + 800)/(400 + 500 + 200) = Rs. 3.18
2. Issue rate in Feb = (1800 + 1200)/(400 + 200) = Rs. 5
Ignoring Opening Stock of Jan. & Feb. C.

Standard Price Method

Under this method, standard price of material issues are calculated on
the basis of detailed analysis of market prices and trends. The standard price
also referred to as predetermined price is fixed for a definite period of six
months or more. Accordingly the material issue is done on the basis of
standard price irrespective of actual rate. The difference between actual price
and standard price is treated as material variance. At the end of the period,
new standard price is fixed for a further period.

Illustration: 9
From the following particulars, prepare a stores Ledger Account
by Standard Price Method of issue of materials. The standard price of a
material is fixed at Rs. IO per unit.

79
 2003
Mar. 1 Opening stock of materials 1,000 units
at Rs. 15 per unit
3 Purchased 500 units at Rs.10 per unit
7 Issued 500 units
12 Purchased 1,000 units at RS.15
15 Purchased 800 units at Rs.10
19 Issued 700 units
22 Issued 500 units
27 Purchased 600 units at Rs.12
29 Issued 300 units
30 Purchased 100 units at Rs.14
31 Issued400units

Solution:
STORES LEDGER ACCOUNT
(Standard Price Method)
Receipts Issues Balance
Date Qty. Rate Amt Qty. Rate Amt. Qty. Rate Amt
Rs. . Rs. Rs. Rs. Rs. . Rs.

2003 1,000 15 15,000

Mar. I
3 500 10 5,000 1,500 20,000
7 500 10 5,000 1,000 15,000
12 1,000 15 15,000 2,000 30,000
15 800 10 8,000 2,800 38,000
19 700 10 7,000 2,100 31,000
22 500 10 5,000 1,600 26,000
27 600 12 7,200 2,200 33,200
29 300 10 3,000 1,900 30,200
30 100 14 1,400 2,000 31,600
31 400 10 4,000 1,600 27,600

D. Inflated Price Method

This method is used to cover material losses on account of
obsolescence, deterioration, and materials handling expenses. Under this
method cost of materials issue, such losses and expenses are directly
charged to material cost. Therefore, when the issue of materials is made, the
price is to inflated to cover all the losses and expenses.

E. Market Price Method

This method is also known as Replacement Rate Method. Under
this method issue materials that are valued at the market rate prevailing
at the time issue. It therefore follows that when prices increase the stock
on hand is continuously under estimated because receipts are cost at actual
and issued at higher rates. This method is most suitable when quotations or
tenders have to be made because they are to be quoted at competitive prices.
80
Besides this system requires continuous monitoring of market price for all
materials and hence it is very unwieldy.

4.3 MATERIALS: INVENTORY CONTROL

4.3.1 Store and Storekeeping

Stores play a vital role in the operation of a company.
Generally un-worked material is stored and the place where it is stored is
called Store Room. It is in direct touch with the user departments in its
day-to-day activities. The chief aim of the stores is to ensure the smooth
flow of production without any interruption. Stores generally include raw
materials, work in progress and finished goods.

Effective storekeeping and inventory control are

indispensable to the control of material cost. Further, stores often equated
directly with money, as capital is blocked in inventories.

4.3.2 Purpose of Storekeeping

1. Storekeeping helps to examine carefully all goods and materials
on receipts.
2. It is essential to arrange for a systematic and efficient storing of
materials.
3. Storekeeping ensure accurate and prompt distribution of materials to
user departments as per issue requisition note.
4. It is essential because stores often equated directly with money, as
capital is blocked in inventories.

4.3.3 Functions of the Storekeeper

The store is a service department headed b y the
storekeeper who holds the responsible position in the organisation of the
stores department. He is as much responsible for the articles incharge as a
cashier for the cash. Important functions of the storekeeper are given
below:
(1) He must receive raw materials, components, tools,
equipment and other items and account for them properly.
(2) He must provide adequate and proper storage and
preservation to the various items.
(3) He must check, and provide proper classification and codification of
materials.
(4) Issue the materials as per material issue requisition duly signed by an
authorized person.
(5) He has to take steps to prevent leakage, theft, wastage and
deterioration.

(6) He must ensure good storekeeping

81
(1) He should not permit any person without authorization.
(2) He should maintain proper records in order to know desired
quantities available.
(3) He must provide adequate information to the top executives
for verifications and effective decision making.

4.3.4 Stores Layout

In order to achieve the objectives of effective inventory control,
well planned layout of stores should be required. A planned stores layout
will facilitate easy movement of materials, good housekeeping, sufficient
space for materials handling. It ensures effective utilization of storage space
and judicious use of storage equipments. The stores department should be
equipped with shelves, racks, pallets and proper preservation from rain, light
and other such elements. An ideal location of stores should facilitate the
volume and variety of goods to be handled. In order to bring down the
transport cost it should be close to roads or railway stations. And also as
far as possible, the stores department should be near to the receiving
department. In the case of large organizations usually stores attached to
each consuming department, whereas receiving is done centrally.

4.3.5 Types of Stores

The types of stores depend on the size, types and policy of the
organization. Organization of stores varies from concern to concern. As per
the requirement of the firm the stores organization may be classified into:
Centralized Stores.
Decentralized Stores.
Combination of both, i.e., Centralized Stores with Sub Stores.

a. Centralized Stores: This system is suitable to small-scale industries

where it is desirable to centralize the materials in one department. Under this
system, the store room will be most conveniently situated where it is
near to all the departments.
Advantages of Centralized Stores
(1) Well planned layout of stores.
(2) Effective utilization of floor space.
(3) Better supervision of stores is possible.
(4) Effective material handling is possible.
(5) Lot of manual work may be eliminated.
(6) Better control is possible.
(7) Less investment is required
(8) Ensures minimum wastages.
(9) Facilitates prompt flow of materials.
(10) Better forecasting is possible.

82
Disadvantages
(1) Increases transportation costs.
(2) Delay and inconvenience because of over-crowding of materials.
(3) Greater risk of loss in case of fire.
(4) Break down in transport will affect continuous flow of
production.
(5) Increases cost of materials handling.

b. Decentralized Stores: Under this system each department has its own
stores. It is suitable to large concern where there are several
departments each using a different type of material from its own stores.
In this system all the disadvantages of centralized stores can be
eliminated.

c. Combination of both: This system is also termed as imprest System or

stores control. Centralized Stores with Sub Stores is usually adopted in
large factories where departments are situated at a distance from the
central stores. In order to minimize the cost of transportation and
materials handling, this type of organization would be located nearer to
the receiving department. Under this system material receipts are stored
in the central stores and issues are made to the sub-stores. Under imprest
system of stores control sub stores which are located nearer to the
central stores for the purpose of draw supplies from central stores
and issue the required quantity to production. To maintain the
stocks at the predetermined level, the sub-stores make requisition from
the central stores.

Fixation of Stock Level

Material control involves physical control of materials, preservation
of stores, minimization of obsolescence and damages through timely
disposal and efficient handling. Effective stock control system should
ensure the minimization of inventory carrying cost and materials holding
cost. Level of stock is the important aspect of inventory control. Stock
level may be overstocking or under-stocking. Overstocking requires large
capital with high cost of holding. In the case of under-stocking, production
and overall performance of the concern as a whole will affect. Thus, fixation
of stock level is essential to maintain sufficient stock for the smooth flow of
production and sales. The following are the important techniques usually
adopted in different industries:

Maximum Stock Level

Minimum Stock Level.
Danger Level.
Re-Order Level.
EconomicOrderingQuantity(EOQ). Average of Stack Level.

a. Maximum Stock Level: The maximum stock level indicates the

maximum quantity of an item should not be allowed to increase. The
maximum quantity of an item can be held in stack at any time. The
83
 following factors can be considered while fixing the maximum stock
levels:
1) Availability of capital.
2) Availability of floor space.
3) Cost of storage.
4) Possibility of fluctuation of prices in raw materials.
5) Cost of insurance.
6) Economic order of quantity.
7) Average rate of consumption.
8) Re-order level and lead time.
9) Seasonal nature of supply.
10) Risk of obsolescence, depletion, evaporation etc.

The maximum stock level can be calculated by the following

formula:
Maximum Stock Level = Re-Order Level + Re-Ordering Quantity
(Minimum Consumption x Minimum Re-
Ordering Period)

b. Minimum Stock Level: Minimum stock level indicates the minimum

quantity of material to be maintained in stock. Accordingly, the
minimum quantity of an item should not be allowed to fall. The
minimum stock is also known as Safety Stock or Buffer Stock. The
following formula is adopted for calculation of minimum stock level:
MinimumStockLevel=Re-OrderLevel-(Normal
Consumption x Normal Re-Order Period)

c. Danger Level: It is the stock level below the Minimum Level. This
level indicates the danger point to affect the normal production. When
materials reach danger level, necessary steps should be taken to restock
the materials. If there is any emergency, special arrangements should
be made for fresh issue. Generally this level is fixed above the minimum
level but below the reordering level. The formula for determination
of danger level is:
Danger Level = Average Rate of Consumption x Emergency Supply
Time
d. Re-order Level: Re-order level is also termed as Ordering Level. It
indicates when to order, i.e., orders for its fresh supplies. This is
the stock level between maximum and the minimum stock levels. The
re-order stock level is fixed on the basis of economic order quantity, lead
time and average rate of consumption. Calculation of re-order level is
adopted by the following formula:
Re-order Level =Minimum Level + Consumption during the time to
get fresh delivery
(Or)
Re-order Level = Maximum Consumption x Maximum Reordering
Period

e. Economic Order Quantity (EOQ): Economic Order Quantity is one

of the important techniques used to determine the optimum quantity or
84
 number of orders to be placed from the suppliers. The main
objectives of economic order quantity is to minimize the cost of
ordering, cost of carrying materials and total cost of production. Ordering
costs include cost of stationery, salaries of those engaged in receiving and
inspecting, general office and administrative expenses of purchase
departments Carrying costs are incurred on stationery, salaries,
rent, materials handling cost, interest on capital, insurance cost, risk of
obsolescence, deterioration and wastage of materials and evaporation.
Economic Order Quantity can be calculated by the following formula:
EOQ = (2AB/CS)1/2
Where EOQ = Economic Order Quantity;
A = Annual Consumption
B = Buying cost per order
C = Cost per Unit
S = Storage and Carrying cost per annum

f. Average Stock Level: Average stock level is determined on the basis of

minimum stock level and re-order quantity. This is calculated with the
help of the following formula:
Average Stock Level = Minimum Stock Level + 1/2 of Re-order
Quantity
(or)
(Minimum Level + Maximum Level)/2

Illustration: 1
From the following particulars calculate the
Maximum Stock Level.
Minimum Stock Level.
Re-ordering Level.
Average Stock Level.
17 Normal consumption = 600 units per week.
18 Maximum consumption = 840 units per week.
19 Minimum consumption = 480 unit per week.
20 Re-order quantity = 7200 units.
21 Re-order period = 10 to 15 weeks.
22 Normal reorder period = 12 weeks.

Solution:
Re-order Level = Maximum Consumption x Maximum Re-order Period 21
840x15 =12600units
Minimum Stock Level
27 Re-order Level - (Normal Consumption x Normal Reorder
Period)
28 12600- (600x12)
29 12600- 7200=5400 units
Maximum Stock Level = Re-order Level + Re-order Quantity -
(Minimum Consumption x Minimum Re-order Period) =
12 60 0+ 7 200 - (480 x1 0)
= 19800 -4800 = 15000 units.
85
 Average Stock Level = (Minimum Stock Level + Maximum Stock
Level)/2
= (5400 + 15000)/2
= 20400/2
= 10200 units

Illustration 2:
The following information available in respect of a material X: Re-
order quantity = 1800 units
Maximum Consumption = 450 units per week
Minimum Consumption = 150 units per week
Normal Consumption = 300 units per week
Re-order period = 3 to 5 weeks
Calculate the following:
a) Re-order Level
b) Minimum Stock Level
c) Maximum Stock Level

Solution:
(a) Re-order Level:
=Maximum Consumption x Maximum Re-order Period
= 450 x 5= 2250 units

(b) Minimum Stock Level:

= Re-order Level - (Normal Consumption x Normal Re-
order Period)
= 2250 - (300 x 4)
= 2250 - 1200 = 1050 units.

(c) Maximum Stock Level:

= Re-order Level + Re-order Quantity -
(Minimum Consumption x Minimum Re-
order Period)
2250 + 1800-(150x3)
= 4050 - 450 = 3600 units.

(d) Normal Re-order Period:

= (Minimum re-order period + Maximum re-order period)/2
= 3 weeks + 5 weeks /2
= 4 weeks

Illustration 3:
A company uses a particular material in a factory which is
20000 units per year. The cost per unit of material is Rs. 10. The cost
of placing one order is Rs. 100 and the inventory carrying cost 20% on
average inventory. From the above information calculate Economic
Order Quantity.

86
Solution:
EOQ = (2AB/CS)1/2
= (2 x 200000 x 100/10 x 20%)1/2
= 1,414 units

Illustration 4:
A Ltd. Co. is committed to supply 24000 bearings per annum to B Ltd.
on a steady basis. It is estimated that it costs 10 paise as inventory holding
cost per bearing per month and that the set up cost per run of bearing
manufacture is Rs. 324.

(1) What should be the optimum run size for bearing manufacture?
What would be the interval between two consecutive optimum runs? (3) Find
out the minimum inventory cost per annum

Solution:
(1) EOQ = (2AB/CS)1/2
= (2 x 24000 x 324/10)1/2 =
3,600 units
(2) Number of set up per annum = Annual Production/Economic run size
= 24,000/3,600
= 6.67 times
Interval between two consecutive optimum runs = 12 x 3/20 = 1.8
months
(3) Minimum Inventory cost per year = ((24,000/3,600) x 324)) +
((3,600/2) X 1.2)
= Rs. 2,160 + Rs. 2,160 = Rs. 4320

4.3.6 The ABC Analysis

ABC Analysis is one of the important techniques which is based on
grading the items according to the importance of materials. This
method is popularly known as Always Better Control. This is also
termed as Proportional Value Analysis - In inventory control, this technique
helps to analyze the distribution of any characteristic by money value of
importance in order to determine its importance. Accordingly, materials
are grouped into three categories on the basis of the money value of
importance of materials.
(1) High Value Materials - A
(2) Medium Value Materials - B (3)
Low Value Materials - C

The items, which are of high value and less than 10 per cent of the
total consumption or inventory, can be called as 'A' grouped materials. It is
required to exercise selective control and focus more attention because
of high value items. Similarly, 70 per cent of materials in total
consumption or inventory which lies 10 per cent of the inventory value can

87
be grouped under 'C' categories. The materials which have moderate value
that lies between the high value materials and low value materials are
grouped under 'B' category. The following table shows more explanation
about ABC Analysis:
Percentage to total
Percentage to total inventory inventory cost
Category
A
B Less than 10 70to 80
C 10 to 20 15to 25
70 to 80 Less than 10

Advantages of ABC Analysis

(1) Exercise selective control is possible.
(2) Focus high attention on high value items is possible.
(3) It helps to reduce the clerical efforts and costs.
(4) It facilitates better planning and improved inventory
turnover.
(5) It facilitates goods storekeeping and effective materials handling.

4.3.7 Classification and Codification

In order to ensure the effective inventory control, it should be
carried out with the classification and codification of materials. Codification is
the process of representing each item by a number, the digits of which
indicate the group, the sub group, the type and the size and shape of the
items. The codification process could be obtained by the nature of materials
in grouping all items of the same metal content say ferrous and non-ferrous
etc. The system of codification could be built by the end use of items, that is,
items grouped according to maintenance, spinning, weaving, packing,
foundry, machine shop etc.

Advantages of Codification
(1) Codes ensure the secrecy of materials.
(2) It is essential for mechanical accounting.
(3) Easy identification of material is possible.
(4) It ensures effective material control.
(5) It minimizes length in description of materials.
(6) Effective materials handling is possible.
(7) It helps in avoiding duplication of materials.
(8) Codification facilitates less clerical work.
(9) Cost reduction is possible.

Methods of Coding
The following are the three important Methods of Codification:
(1) Numerical Method.
(2) Alphabetical Method.
(3) Numerical Cum Alphabetical Method.

1. Numerical Method: Under this method, each number or numerical

digit is allotted to each item or material. Accordingly, each code
88
 should uniquely indicate one item. For example, in printing press
following codes may be assigned:
Paper145Ink 155 Gum 165

There are various universal decimal classification of codification

used in libraries may be indicated for identification of items.

2. Alphabetical Method: In this method alphabets or letters are used for

codification of each category of materials. Accordingly each letter or
alphabet is allotted for each item or material. For example, 'C' for copper,
'S' for steel and so on.

3. Numerical cum Alphabetical Method: This method is done by a

combination of numerical and alphabetical method. Under this method
both numerical along with alphabet is allotted for each item. For
example, IR 5 may indicate Ink Red of Grade 5, Steel wire 6 may be
denoted by SW 6 etc.

4.3.8 Inventory System

The chief aims of inventory control is as follows:
(1) To maintain a balanced inventory.
(2) To ensure the smooth flow of production.
(3) To keep the investment in inventory as low as possible.

Accordingly stock verification is an important aspect to ensure and

maintain a balanced inventory. The following are the two systems of stock
verification adopted in different industries:
(1) Periodic Inventory System.
(2) Perpetual Inventory System.
(3) Continuous Stock Verification.

1. Periodic Inventory System: Under this system, quantity and value of

materials are checked and verified at the end of the accounting period
after having a physical verification of the units in hand.

2. Perpetual Inventory System: The Perpetual Inventory System is also

known as Automatic Inventory System. This is one of the important
methods adopted for verification inventories to know the physical
balances. According to ICMA London defines Perpetual Inventory
System as a method of recording stores balances after every receipt and
issue to facilitate regular checking and to obviate closing down for
stock taking.

Advantages of Perpetual Inventory System

(1) It facilitates rigid control over stock of materials.
(2) It gives up to date details about materials in stock.
(3) Not necessary to stop production for stock taking.

89
It assists to minimize pilferage and fraudulent practices.
1. It enables to reconcile the stock records and document for
accuracy.
2. It helps to take the important decisions for corrective
actions.

Perpetual Inventory Records

Perpetual Inventory represents a system of records maintained by the
organization. The records are of two types, viz.:
(a) Bin Cards
(b) Stores Ledger

A constant comparison of the quantity balances of these two set of

records is made and the balances are reconciled.
a. Bin Cards: Bin Card is only quantitative record of stores receipt,
issue and balance and is kept by the Storekeeper for each item of
stores.
b. Stores Ledger: Stores ledger is both quantitative and monetary
value record of stores receipt, issue and balance and is prepared by
the Cost Accounting Department.

3. Continuous Stock Verification: Since Verification of physical inventory

is an essential feature of a sound system of material control, a system of
continuous stock taking is introduced. Continuous stock taking ensures
that the balances of all items of stocks are checked at least three to four
times in a year by physical verification. It avoids long and costly
procedure of closing down the stores for stock taking on periodical
basis. Stock discrepancies are detected on timely basis and preventive
measures can be taken. The correctness of the physical stocks as
reflected in the books is ensured and thus the monthly accounts
represent a true and fair view of the business. Continuous Stock
Verification not only serves as an essential tool of material control but
also will help in proper presentation of accounting information to the
management.

Material Storage Losses

The investment in materials constitutes a major portion of current
assets, so it is essential to exercise effective stores control. Stores control
helps to avoid losses from misappropriation, damage, deterioration etc.
Generally material storage losses arising during storage may be classified
as:
(1) Normal Loss (1)
Abnormal Loss

1. Normal Loss: Normal Losses arise during the storage of materials

due to the avoidable reasons of pilferage, theft, careless of materials
handling, clerical errors, improper storage, wrong entries etc.

90
2. Abnormal Loss: Abnormal Losses arise during the storage of materials
due to unavoidable causes of evaporation, shrinkage, bulk losses due to
accident, fire, etc.

Accounting Treatment of Normal Loss and Abnormal Loss

The following are the accounting treatment of normal and
abnormal loss of materials arising during storage:
1. Normal Loss: (a) Inflate the issue price. (b) Charge to stores overheads.
(c) Treat it as a separate item of overheads to be recovered as a
percentage of materials consumed.
2. Abnormal Loss: Abnormal losses are directly charged to Costing Profit
and Loss Account.
3. If the loss is due to error in documentation it should be corrected through
adjustment entries.

Inventory Turnover Ratio

Inventory Turnover Ratio may be defined as "a ratio which measures
the number of times a firm's average inventory is sold during a year." It is
a ratio which is useful to measure the firm's inventory performance. High
rate of inventory turnover ratio denotes that materials are fast moving
stock. A low turnover rate indicates the locking up of working capital in
undesirable items. The Inventory turnover ratio is calculated by the
following formula:

Material Turnover Ratio = Cost of material used / Average value of material

in stock
Material Turnover in days = Days during the period / Inventory Turnover
Ratio

4.4 LABOR COST ACCOUNTING

Introduction
Labour cost is one of the important elements of production. Wage,
salaries and other incentives of employee remuneration constitute a ver y
large component of operatin g costs. Remuneration of employees is
a vital factor not only affecting the cost of production but also industrial
relations of the organization

No organization can expect to attract and attain qualified and

motivated employees unless it pays them fair remuneration. Employee
remuneration therefore influences vitally the growth and profitability of the
company. For employees remuneration is more than a means of satisfying
their physical needs. Wages and salaries have significant influence on our
distribution of income, consumption, savings, employment and prices. Thus
employee remuneration is a very significant issue from the viewpoint of
employers, employees and the nation as whole.

91
Objectives of an Ideal Wage System
An ideal wage system is required to achieve the following objectives:
1. The wage system should establish a fair and equitable remuneration.
2. A sound wage system helps to attract qualified and efficient worker
by ensuring an adequate payment.
3. It assists to improve the motivation and moral of employees which
in turn lead to higher productivity.
4. It enables effective control of labour cost.
5. An Ideal wage system helps to improve union-management relations. It
should reduce grievances arising out of wage inequities.
6. It should facilitate job sequences and lines of promotion
wherever applicable.
7. An ideal system seeks to project the image of a progressive employer and
to comply with legal requirements relating to wages and salaries.

Principles of an Ideal Wage System

The following principles should be adopted for an ideal wage system
1. Differences in pay should be based on differences in job requirements.
2. Follow the principle of equal pay for equal work.
3. The scheme should be based on work study, and the work contents
of various jobs should be stabilized.
4. Recognize individual differences in ability and contributions.
5. The scheme should not be very costly in operation.
6. The scheme should be flexible.
7. The scheme should encourage productivity.
8) The scheme should not undermine co-operation amongst the workers.
(H) The scheme should be sufficient to ensure for the worker and his
family reasonable standard of living.
Method of Remuneration
There are two basic methods of wage payment: (1) Time Wage System and
(2) Piece Wage System. Under time wage system, wages are paid on the basis
of time spent on the job irrespective of the amount of work done. This is known
as Time Rate or Day Wage System. The unit of time may be a day, a week,
a fortnight or a month. Under piece wage system, remuneration is based on
the amount of work done or output of a worker. This is known as "Piece Rate
System" or "Payment by Result." Thus, a workman is paid in direct
proportion to his output. A variety of bonus and premium plans have been
designed to overcome the drawbacks of two basic methods of wage payments.
A system of incentive plans also takes into consideration the primary
principles of these two basic plans known as Incentive or Bonus or
Premium Plan.
92
 The following are the important methods of remuneration which may be
grouped into:
(1) Time Rate Systems
(2) Piece Rate Systems
(3) Bonus System (or) Incentives Schemes.
(4) Indirect Monetary Incentives. These may be further classified as
under:

Time Rate Systems:

At Ordinary Levels At
High Wage Levels
Guaranteed Time Rates.

Piece Rate Systems:

Straight Piece Rate
PieceRateswithGuaranteedTimeRateDifferential Piece Rates:
Taylor's Differential Piece Rate System Merrick Differential Piece
Rate System Gantt Task and Bonus Plan.

Bonus System or Incentive Schemes: Halsey

Premium Plan
Halsey-Weir Premium Plan
Rowan Plan
BarthVariableSharingPlan
Emerson Efficiency Plan
Bedaux Point Premium System
Accelerating Premium Plan
Group or Collective Bonus Plans.

Indirect Monetary Incentives:

Non-Monetary Incentives:

Comparison between Time Rate and Piece Rate System

Time Rate System Piece Rate System

Under this system earnings of a In this system earnings of a
worker are calculated on the basis worker are calculated on the
of time spent on the job basis of number of units
Produced.
In this system, minimum Under this system, no
guaranteed time rate guarantee of minimum
is paid to every worker. payment to every worker.
Under time rate system, Remuneration of workers
remunerations are not directly directly linked with
linked with productivity. productivity.

93
 Under this system emphasis is on Under piece rate system there is
high quality of work. no consideration for the quality
of work.
Under time rate system, strict In this system, close
supervision is essential. supervision is not required.
This method may lead to trade Under this method the attitude of
unions to support it. trade unions is not to cooperate
with the schemes.
More idle time arises in time Compared with time rate
rate systems. system there is no
change of idle time in piece
rate schemes.

Time Wage System

a. Time Rate at Ordinary Levels: This is also termed as "Day Wage
System" or "Flat Rate System." Under this system, wages are paid to the
workers on the basis of time spent on the job irrespective of the quantity of
work produced by the workers. Payment can be made at a rate per day or a
week, a fortnight or a month. The formula for calculation of payment of
time rate of ordinary levels is as follows:
Remuneration or Earnings = Hours Worked X Rate per Hour Time wage
system is suitable under the following conditions:
1. Where the units of output are difficult to measurable, e.g.,
watchman.
2. Where the quality of work is more important, e.g., artistic
furniture, fine jewellery, carving etc.
3. Where machinery and materials used are very
sophisticated and expensive.
4. Where supervision is effective and close supervision is possible.
5. Where the workers are new and learning the job.
6. Where the work is of a highly varied nature and standard of
performance cannot be established.

Advantages
1. It is simple and easy to calculate.
2. Earning of workers are regular and fixed.
3. Time rate system is accepted by trade unions.
4. Quality of the work is not affected.
5. This method also avoids inefficient handling of materials and
tools.

94
Disadvantages
No distinction between efficient and inefficient worker is made and
hence they get the same remuneration.
Cost of supervision is high due to strict supervision used for high
productivity of labour.
Labour cost is difficult to control due to more payment may be made
for the lesser amount of work.
No incentive is given to efficient workers. It will depress the
efficient workers.

There are no specific standards for evaluating the merit of different

employees for promotions

b. Time Rate at High Levels: Under this system, efficient workers are paid
higher wages in order to increase production. The main object of this
method designed to remove the drawbacks of time rate at ordinary levels.
This system is simple and easily understandable. When higher rate of
wages are paid, it not only reduces labour turnover but also increases
production and efficiency.

c. Guaranteed Time Rates: Under this method, the wage rate is calculated by
considering to changes in cost of living index. Accordingly, the wage
rate is varied for each worker according to the change in cost of living
index. This system is suitable during the period of raising prices.

9 Piece Rate System

This is also known as "Piece Wage System" or "Payment by Result."
Under this system, wages of a worker are calculated on the basis of
amount of work done or output of a worker. Accordingly, a worker is
paid in direct proportion to his output.

Advantages
(1) It facilitates direct relation between efforts and reward.
(2) This system encourages the efficient workers to increase
production.
(3) Under this system efficient workers are recognized and
rewarded.
(4) It helps to reduce the cost of supervision and idle time.
(5) Tenders or quotations can be prepared confidently and
accurately.

Disadvantages
(1) Where a concern is producing large quantities, it is difficult to fix a
piece rate.
(2) In order to maximize their earnings, workers working with high speed
may affect their health.
(3) The quality of output cannot be maintained.
95
(4) This system is not encouraging to the inefficient workers.
(5) Temporary delays or difficulties may affect the earnings of the
workers.

Piece Rate System is Suitable Where

Quality and workmanship are not important.
(1) Work can be measured accurately.
(2) Quantity of output directly depends upon the efforts of the worker.
(3) Production of standardized goods in a factory.
(4) Job is of a repetitive nature.

There are three important methods of pa ying labour

remuneration falling under this type: (a) Straight Piece Rate (2) Piece
Rates with Guaranteed Time Rates and (c) Differential Piece Rates.

(a) Straight Piece Rate: Under this system, workers are paid according to
the number of units produced at a given rate per unit. Thus, total earning of
each worker is calculated on the basis of his output irrespective of the time
taken by him. The following formula is used for measuring piece work
earning:

Straight Piece Work Earnings =Units Produced x Rate per Hour

= Piece Rates with Guaranteed Time Rates: Under this method,
the worker earning from piece work less than the guaranteed minimum
wage, will get the fixed amount of guaranteed time rate. A guaranteed rate
would be paid per hour rate or day rate or week rate.

= Differential Piece Rates: This system is designed to provide for

variation of piece rates at different levels of output. Accordingly increase in
wages is proportionate to increase in output. Under this system, efficient
workers get ample reward and at the same time inefficient workers are
motivated to earn more. The following are the three important types of
differential piece rates:
Taylor's Differential Piece Rates System.
Merrick's Differential Piece Rates System. Gantt
Task Bonus Plan.

(a) Taylor's Differential Piece Rates System

E W Taylor, who is the father of scientific management, introduced this
plan. Under this system, two piece rates are applicable on the basis of
standard of performance established. Accordingly one is high rate and the
other one is lower rate. Thus high piece rate is applicable for standard and
above the standard performance and lower piece rate for those workers with
below the standard performance.

Illustration: 1
Calculate the earnings of workers A and B under Straight Piece Rate
System and Taylor's Differential Piece Rate System from the following
particulars:

96
 Standard time allowed 50 units per hour. Normal time rate per hour Rs.
100. Differentials to be applied.
80% of Piece rate below standard.
120% of Piece rate at or above standard.
In a day of 8 hours A produced 300 units and B produced 450 units.

Solution:
Calculation of Piece Rates:
Standard production per hour = 50 units.
Standard production for 8 hours = 50 x 8 = 400 units. Rate per
hour = Rs. 100.
Piece Rate per unit = Rs. 100/50 = Rs. 2 per unit Straight Piece Rate
System
Afor200units@ Rs.2=200x2=Rs.400
Bfor250 units @ Rs. 2 = 250x2 = Rs. 500 Differential
Piece Rate System
Low piece rate at 80 % differential = 2 x 80/100 = Rs. 1.60
High piece rate at 120 % differential = 2 x 120/1 00 = Rs. 2.40
Standard production in 8 hours = 8 x 50 units per hour = 400 units
A Produced 300 units (below standard)
Therefore low Piece rate of Rs.1.60 applicable } Rs.480
B Produced 450 units (above standard)
Therefore high Piece rate of Rs. 240 applicable }Rs.1,080

(b) Merrick Differential Piece Rate System

This is also termed as Multiple Piece Rate system. This plan is 'designed to
overcome the drawback of Taylor's Differential Piece Rate System. Under this
method, three piece rates are applied with different levels of performance.
Accordingly

Performance Differential Piece Rate

(1) Less than 83% Normal Piece Rate (or) Basic Piece Rate
(2) From 83% to 100% 110% of Normal Piece Rate
(3) More than 100% 120% of Normal Piece Rate

Illustration: 2
From the following particulars calculate the total earning of the
three workers under Merrick Differential Piece Rate System.
Normal rate per hour Rs. 5 per unit
Standard production per hour 10 units
In an 8 hours/day:
A produced 70 units.
B produced 90 units.
C produced 65 units.
D produced 110 units.

97
Solution:
A’s level of performance = Actual output / Standard output x 100 =70/80x
100=87.5%
B’s level of performance = 90/80 x 100 = 112.5%
C’s level of performance = 65/80 x 100 = 81.25%
D’ s level of performance = 110/80 x 100 = 137.5%
Piece Rate applicable
Up to 83 % - Normal piece rate
83% to 100% - 110% of Normal Piece rate
Above 100% - 120% of Normal Piece rate
A’ s earnings = 70x5x 110/100 = Rs 385
B’s earnings = 90 x 5 x 120/1 00 = Rs 540
C’searnings=65x5= Rs325
A’searnings=110x5x120/100=Rs660
(c) Gantt's Task Bonus Plan

This system is designed by Henry L. Gantt. Under this system, standard time
for every task is fixed through time and motion study. The main feature of
this system is a good combination of time rate, differential piece rate and
bonus. In this system day wages are guaranteed to all workers. Wages
under this system are calculated as follows:
Performance Earnings
(Output)
(1) Output Below Standard Time Rate (Guaranteed)
Wages of Time Rate plus Bonus of
(2) Output at Standard 20% of the Time Rate
(3) Output at Above Standard High Piece Rate on worker's output

Illustration: 3
From the following particulars, calculate total earnings of each worker
under Gantt's Task and Bonus Scheme:
Standard production per week per worker is 2000 units, piece work rate
Rs. 5 per unit
Actual production during the month:
A-1000 units
B - 2000 units
C- 2500 units

Solution:
Standard production per month =2000 units
Piece work rate = Re. 0.50 per unit
Therefore, guaranteed time rate = 2000/0.5 = Rs 4000 per month
Level of Efficiency:
A= 1000/2000x100=50%
B = 2000/2000 x 100 = 100%
C = 2500/2000 x 100 = 125%

98
Earnings:
Under Gantt's Task and Bonus Plan wages are computed as follows:
Output Rate
Below Standard Guaranteed Time Wages
Given piece wages plus bonus At
Standard of 20%
High piece rate on worker's
Above Standard whole output.

The earnings of the worker w ill be as follows :

A (50% below
the standard) Rs. 4000 (Guaranteed monthly = wages)
B (100% efficiency) 2000 units x Re. 0.50 per unit + = Bonus of
C (125% efficiency 20%
above standard) = Rs. 1000 +20% of Rs. 1000 = Rs.
1000 + 200 = Rs. 1200
2500 units x Re. 0.50 + Bonus = of20%
Rs. 1250 + 20% of Rs. 1250
= Rs.1500

Bonus or Incentives Schemes

Incentive schemes of wage payment are also known as Premium
Bonus Plans. introduced in order to increase production with ensuring
proper industrial climate. Wage incentive plans may be of two types:

(1) Individual Incentive Plans and (2) Group Incentive Plans.

Under individual incentive plans, remuneration can be measured
on the performance of the individual worker. In the case of the group
incentive scheme earnings can be measured on the basis of the
productivity of the group of workers or entire work force of the
organization. Various types of incentive schemes are combinations of time
and piece rate systems. The following are the important individual incentive
plans discussed below:

(1) Halsey Premium Plan: This Plan was developed by F. A. Halsey.

This system also termed as Split Bonus Plan or Fifty-Fifty Plan. Under
this plan, standard time is fixed for each job or operation on the basis of
past performance. If a worker completes his job within or more than the
standard time then the worker is paid a guaranteed time wage. If a worker
completes his job within or less than the standard time, then he gets a bonus
of 50% of the time saved plus normal earnings. Under this method, the
total earnings is calculated as follows:
Guaranteed Time Wages + Bonus of 50% Total Earning = of Time Saved
(or)
Total Earnings=TxR+50%(S- T)R
Where
T- Time Taken
R-Hourly Rate
S-Standard Time 50
99
 .'. Total Earnings =Time Taken x Hourly Rate + -- (Time Saved
x Hourly Rate) 100

Illustration: 4
Calculate the total earnings of the worker under Halsey Premium
Plans:
Standard Time 12 hours
Hourly Rate Rs. 3
TimeTaken 8 hours

Solution:
Earnings under Halsey Premium
Plan: Standard
Time :: 12 hours
Time Taken = 8 hours
Standard Time -
Time Saved = Time Taken
= 12- 8=4 hours
hour = Rs.3
Rate per
Total TxR+50%(S- n
Earnings = R 50
= 8x3+--(4x3)
1 00
= 24+6=Rs.30
Total Earnings = Rs. 30

Merits
(1) It is simple to understand.
(2) Total earnings of each worker can be easy to calculate.
(3) Both employer and employee get equal benefit of time saved.
(4) This system not only benefits efficient worker but also provides
average worker to get guaranteed minimum wages.
(5) This system is based on time saved and it can reduce the labour
cost.

Demerits
(1) Lack of co-operation among the employees.
(2) Under this system establishment of standard is very
difficult.
(3) Earnings are reduced at high level of efficiency.
(4) The Halsey - Weir Scheme: Under this system, the worker gets the
bonus of 30% of the time saved instead of 50% of time saved under
Halsey Plan. Except for this, Halsey Plan and Halsey-Weir Systems
are similar in all other respects.

100
Illustration: 5
From the following particulars calculate total earnings of a worker
under Halsey-Weir Plan:

Standard
Time = 10 hours
TimeTaken = 8 hours
Rs.2 per
Hourly Rate = hour

Solution:
Earnings under Halsey-Weir Premium Plan:
Standard Time = 10 hours
TimeTaken = 8 hours
Time Saved = Standard Time - Time Taken
10-8 =2 hours
Rate per hour = Rs. 2
Total earnings = TxR+30% (S - T) R
= 8x2+ 30/100(10 -8)x2
= 16+1.20
Total Earnings = Rs.17.20

(3) Rowan Plan: This plan was introduced by James Rowan of England. It
was similar to the Halsey Plan in many respects except that it differs in
calculation of bonus. Under this system. bonus is determined as the
proportion of the time taken which the time saved bears to the standard time
allowed. Under this system the following formula is applied to calculation
of bonus:
Time Saved
Bonus = Standard x Time Wages
Time

Total Time Hourly Time Saved x T x

Earnings = x +R
Taken Rate Standard Time
Standard Time

Time Saved = Time Taken

Time Time Hourly
Wages = Taken x Rate

Illustration: 6
From the following information, calculate total earnings of a worker
under Rowan System:
Standard
Time = 10 hours
Time Taken = 8 hours
Rate per
hour = Rs.3

101
Solution:
Calculation of total earnings under Rowan Plan:
Standard Time
Time Taken
Time Saved
Rate per hour
Total Earnings =
10 hours
= 8 hours
= Standard Time - Time Taken =
10- 8 =2hours
= Rs. 3 per hour
Time Saved
= TxR+ xTx R
Standard Time

= 8 x 3+ 2/10 x 8 x 3 24 +
4.8 = Rs. 28.8

Illustration: 7
Calculate the earnings of a worker under (a) Halsey Premium Plan and
(b) Rowan Premium Plan:

Time Allowed or Standard Time Time Taken Rate

per hour
= 5 6 ho u rs
= 4 8 ho u rs
= Rs.2

Solution:
(a) EarningunderHalseyPremiumPlan:Standard
Time = 56 hours
Time Taken = 48 hours
Hourly Rate = Rs.2
Time Saved = 56 -48
= 8 hours
Total Earnings = T x R + 50/1 00 x (S - T)R
48 x 2 + 50/100 (56 – 48) 2 = Rs = 104
Total Earnings = T x R+ (S – T/S) x T x R = 48
x 2 + (56-48/56) x 48 x 2
= 96 + 13.71
= Rs.109.7
[ADS: (a) Earning under Halsey plan = Rs. 104
(b) Earnings under Rowan Plan = Rs. 109.71J

(4) Emerson's Efficiency Sharing Plan: Under this plan, earning of a

worker is by combining guaranteed day wages with a differential piece
rate. Accordingly the level of efficiency is determined on the basis of
establishment of standard task for a unit of time. If the level of worker's
efficiency reaches 67% the bonus is paid to him at a normal rate. The rate of
102
bonus increases in a given rate as the output increases from 67% to 100%
efficiency. Above 100% efficiency, the bonus increases to 20% of the
wage earned plus additional bonus of 1% is added for each increase of 1% in
efficiency.

Illustration: 8
From the following particulars calculate total earnings of a worker
under Emerson's Efficiency Sharing Plan:
Standard output per day of 8 hours is 16 units
Actual output of a worker for 8 hours is 20 units
Rate per hour is Rs. 2.50

Solution:
Calculation of earnings under Emerson's Sharing Plan:
Actual Output
Level of performance = x100
Standard Output
20 units
= 16 unitsx 100= 125%
Bonus Payable
At 100% efficiency = 20% of time
wages
Further increase of 1% in the bonus is given for every 1% increase in the
efficiency.
.'. For next 25% efficiency @ 1%
for
= 25% of
Time each 1% increase in efficiency Wages
Total Bonus payable = 45% of Time Wages.

Earning
Time Wages for 8 hours @ Rs. 2.50 per hour = Rs. 20.
Add: 45% bonus of time wages = 45/1 00 x 20 = Rs. 9
Total Earning = Rs. 20 + Rs. 9 = Rs. 29

(5) Barth Variable Sharing Plan: This scheme introduced to attract

newly recruited and skilled employees who are motivated to learn woi'k. It
provides sufficient incentives to inefficient workers who are motivated to
increase productivity. Earning under this method is calculated by
applying the following formula:
Earnings = Rate per hour x (Standard Time x Time Taken)1/2

Illustration: 9
From the following particulars calculate earnings of a worker under Brath
Variable sharing plan:
Standard
Time = 12 hours
TimeTaken 8 hours
Rate per
hour =Rs.5
103
Solution:
Calculation of earnings under Barth Variable sharing plan: Earnings =
Rate per hour x (Standard Time x Time Ta ken)1/2
=5x (12x8)1/2
= Rs.48.98

(6) Bedaux Point Premium System: This plan was introduced by

Charles E.Bedaux in 1911. Under this plan, standard time fixed for each
operation or job is expressed in terms of Bedaux point or'S.' For example,
a standard time of 360 B means the operation or job should be completed
within 360 minutes. The chief advantage of this plan is that it can be
applied to any kind of a job. Under this system, worker is paid at the time
for actual hours worked, and 75% of the wages for the time saved are
paid as bonus to the worker and 25% to the foremen, supervisors etc. The
following is the formula for calculation of total wages of a worker:
Totalearnings =SxR+75%ofR(S-T)

Illustration: 10
From the following particulars, calculate total earnings of a worker under
Bedaux Point Premium System:
Standard
Time = 360 B
TimeTaken = 240B
Rate per
hour = Re. 1

Solution:
Calculation of total earnings under Bedaux Point System:
Standard Time = 360 B's
= 360 /60
= 6 hours
Time Taken = 240 B's
= 240/60 = 4 hours
Rate per hour = Re.1
Total earnings = SxR+75%of R (S-T)
360x 1 + 75% x 1 (360 - 2 4 0 )
= 360 +75% x120
= Rs. 360 + Rs. 90 = Rs. 450

(7) Accelerating Premium Bonus Plan: Under this plan, bonus is

determined on the basis of time saved unlike a fixed percentage under Halsey
Plan and as a decreasing percentage under Rowan Plan. The bonus is paid
to workers at an increased rate according to more and more time saved.
This provides increasing incentives to efficient workers.

Group or Collective Bonus Plan

The incentive schemes explained so far are applicable to individual
performance depending directly on production. However. it is not the
individual worker who produce the goods or services (operation) alone but
group of several other workers are required to jointly perform a single
104
operation. It is, therefore, essential that a group incentive scheme be
introduced. Bonus is calculated for a group incentive scheme. The bonus is
calculated for a group of workers and the total amount is distributed among
the group of workers on anyone of the following basis:
(a) Equally by all the workers of the group.
(b) Pro rata on the time rate basis.
(c) Pre determined percentage basis.
(d) Specified proportion basis.

Types of Group Incentive Plans

The following are the important types of group incentive bonus plans:
(1) Budgeted Expenses Bonus Plan
(2) Priest Man Bonus Plan
(3) Towne's Gain-sharing Plan
(4) Scanlon Plan

(1) Budgeted Expenses Bonus Plan: Under this method, bonus is

determined on the basis of savings in actual expenditure compared with
total budgeted expenditure.
(2) Priest Man Bonus Plan: Under this plan, standard performance is
fixed by the management and committee of workers. The group of
workers get bonus when actual performance exceeds the standard performance
irrespective of individual's efficiency or inefficiency.
(3) Towne's Gain-sharing Plan: Under this plan, bonus is calculated on
the basis of savings in labour cost. The group of workers get bonus when
actual costs is less than the standard costs, one-half of the savings is
distributed among workers including foremen in proportion with the
wages earned.
(4) Scanlon Plan: Scanlon Plan is designed with the chief aim of reducing
the cost of operations in order to increase the production efficiency. This plan
is generally applicable in industries where the operation cost is high. Under
this scheme, bonus is determined on the basis of standard costs or wastages
and percentage of the reduction in operation cost.

Indirect Monetary Incentives

Incentive schemes are regarded beneficial to both employers and
workers. In this regard, under indirect monetary incentives by giving them a
share of profit and introducing co-partnership schemes or as they have
become partners in the business in order to make a very profitable
enterprise.

Profit Sharing: Profit sharing and bonus is also known as Profit sharing
bonus. Under this scheme, there is an agreement between the employer and
employee by which employee receives a share, fixed in advance of the
profits. Accordingly profit sharing bonus refers to the distribution of
profit on the basis of a certain percentage of one's monthly earnings. The
amount to be distributed depends on the profits earned by an enterprise. The
proportion of the profits to be distributed among the employees is determined

105
in advance.

Co-partnership: This system provides not only a worker to become

partner in the business but also to share in the profits of the concern.
There are different degrees of partnership and share of responsibilities
allowed to the workers to take part in its control.

Non-Monetary Incentive Schemes: Under this system, employees are

provided better facilities, instead of additional monetary payments. Some
of the examples of non-monetary incentives are free education for children,
rent free accommodation, medical facilities, canteen facilities, welfare
facilities, and entertainment facilities etc.

EXERCISES
1. From the following particulars, calculate total earnings of the worker
under Halsey Premium Plan:
Time allowed for job 20 hours
Timetaken 15 hours
Rate per hour Rs. 1.50 per hour
[Ans: Total earning = Rs. 26.25]

2. From the following particulars, calculate total earnings of the worker

under Rowan Plan:
Standard time 20 hours
Timetaken 16 hours
Hourly rate Rs. 2 per hour
[Ans: Total earnings Rs. 38.40]

3. A worker takes 9 hours to complete a job on daily wages and 6 hours

on a scheme of payment by result. His daily rate is 75 paise an hour: the
material cost of the product is Rs. 4 and the overheads are recovered at
150% of the total direct wages. Calculate the factory cost of the product
under:
(a) Piece work plan; (b) Rowan plan; and (c) Halsey plan. [Ans:
Piece work plan Rs. 20.88
Rowan plan Rs. 19
Halsey plan Rs. 18.07]

4. A workman's wage for a guaranteed 44 week is Rs. 0.19 per hour. The
week time produce of one article is 30 minutes and under incentive
scheme the time allowed is increased by 20%. During one week the
workman manufactured 100
articles. Calculate his gross wages under each of the
following methods of remuneration:
a. Time rate
b. Piece work with a guaranteed weekly wage
c. Rowan premium bonus
d. Halsey premium bonus, 50% to workman
[Ans:(1) Rs. 8.36 (2) Rs. 11.40 (3) Rs. 10.59 (4) Rs. 9.88

106
5. An employee working under a bonus scheme saves in a job for which
the standard time is 60 hours. Calculate the rate per hour worked and
wages payable to a worker if incentive bonus of 10% on the hourly rate is
payable when standard time (namely, 100% efficiency) is achieved, and a
further incentive bonus of 1% on hourly rate for each 1% in excess of that
100% efficiency is payable.
Assume that the normal rate payment is Rs. 5 per hour. [Ans: Wages
payable to workers = Rs. 325]

6. A worker takes hours to complete a job on daily wages and hours on a

scheme of payment by results. His day rate is 75 paise an hour, the
material cost on the product is Rs. 4 and the overheads are recorded at
150% of the total direct wages.
Calculate the factory cast of the product under:
(a) Piece work plan (b) Rowan plan (c) Halsey plan
[Ans: Piece work Rs. 15.25 ,Halsey Rs. 18.5, Rowan plan Rs.
19.00]

7. Jobs are issued to operation X, to make 89 units to operation y, to

make 204 units, for which a time allowance of 20 standard minutes and
15 standard minutes per units respectively, is credited for every hour
saved bonus is paid at 50% of the basic rate which is Rs. 2 per hour for
both the employee. The basic working week is 42 hours. Hours in excess
are paid at double the normal rate.

X completes his units in 45 hours and Y completes his units in 39

hours (but works a full week). Due to defective material 6 units of X and
4 units of Y are subsequently scrapped although all units produced are
paid for.
You are required to calculate for each of X and Y:
a. The amount of bonus payable
b. Total gross wages payable and
c. The wages cost per good unit made.
[Ans: Bonus payable: X Rs. 18; Y Rs. 12 Gross wages: X Rs.
114;YRs.90
Wage cost per unit: Y Rs. 62; Rs. 42]



107
 5
LABOUR COST CONTROL
Unit Structure :

5.1 Introduction
5.2 Types of Labour Cost
5.3 Control of Labour Cost
5.4 Organisation for Control of Labour Cost
5.5 Overheads

5.1 INTRODUCTION

Labour cost is the second important element of cost of production.

Wages, salaries and other forms of remunerations represent a major
portion of the total cost of a product or services. The growth and
profitability of the concern depends upon proper utilization of human
resources or labour forces which in turn needs proper accounting and
control of cost. Thus, control of labour cost is a very significant issue from
the viewpoint of management.

5.2 TYPES OF LABOUR COST

The labour cost can be classified into two types :

(1) Direct Labour Cost.
(2) Indirect Labour Cost.

(1) Direct Labour Cost: Any labour cost that is specially incurred for
or can be readily charged to or identified with a specific job, contract,
work order or any other unit of cost is termed as direct labour cost. Wages
for supervision, wages for foremen, wages for labours who are actually
engaged in operation or process are the examples of direct labour cost.

(2) Indirect Labour Cost: Indirect labour is for work in general. The
importance of the distinction lies in the fact that whereas direct labour can
be identified with and charged to the job, indirect labour cannot be so
charged and has, therefore to be treated as part of the factory overheads to
be included in the cost of production. For example, salaries and wages of
supervisors, storekeepers and maintence labour etc.

5.3 CONTROL OF LABOUR COST

Control of labour cost is a significant influence on the growth,

profitability and cost of production. Labour cost may become unduly high
rate due to inefficiency of labour, ineffective supervision, ideal time,
108
unusual overtime work etc. The primary objective of management
therefore is to efficiently utilize the labour as economically as possible.

Techniques of Labour Cost Control

In order to achieve the effective utilization of manpower resources,
the management has to apply proper system of labour cost control. The
labour cost control may be determined on the basis of establishment of
standard of efficiency and comparison of actuals with standards. The
management applies various techniques for the effective control of labour
costs as under:
(1) Scientific method of production planning.
(2) Use of labour budgets.
(3) Establishment of labour standards.
(4) Proper system of labour performance report.
(5) Effective system of job evaluation and job analysis.
(6) Devise a proper system of control over ideal time and unusual
overtime work.
(7) Establish a fair and equitable remuneration system.
(8) Effective cost accounting system.

5.4 ORGANISATION FOR CONTROL OF LABOUR

COST

The objectives of proper control on labour cost is effectively

achieved through the functions of various departments responsible for
controlling labour cost in an organisation. The following are the important
departments for control over labour costs:

(1) Personnel Departments.

(2) Engineering and Works Study Department.
(3) Time Keeping Departments.
(4) Pay Roll Department.
(5) Cost Accounting Department.

(1)Personnel Department
Personnel department plays a very important role in control of
labour costs. It is primarily concerned with the recruitment of labour on
the basis of employee placement requisition and imparting training to
them. And thereafter placing them to the job for which they are best
suited. In order to achieve the efficient utilization of manpower resources,
this department is responsible to execution of labour policies which have
been laid down by top management.

(2) Engineering and Works Study Department

Engineering department is primarily concerned with maintaining
control over working conditions and production methods for each job,
process, operation or departments. It is performed by undertaking the
following functions:

109
 (I) Preparation of plan and specification of each job.
(2) Maintaining required safety and efficient working conditions.
(3) Making time and motion studies.
(4) Conducting job analysis, job evaluation and merit rating.
(5) Setting fair and equitable piece rate or time wage system.
(6) Conducting research and experimental work.
In order to maintain control over working conditions and production
methods carrying a detailed study of the following operations is
necessary:
(a) Method Study
(b) Motion Study
(c) Time Study
(d) Job Analysis
(e) Job Evaluation
(f) Merit Rating.

a. Method Study: It is one of the important components of work study.

The chief aim of this study is to find a scheme of least wastage.
Method Study is defined as "a systematic and scientific evaluation of
existing and proposed plans and performance of any work system and
the evaluation of improvement, through analytical process of critical
examination."
b. Motion Study: Frank Gilbreth, who is the real founder of Motion
Study. According to him motion study may be defined as the "science
of eliminating wastefulness resulting from ill-directed and inefficient
motions. The following are the important objectives of the motion
study:
(1) Effective utilisation of material, machine and labour.
(2) Elimination of wastage of time and labour.
(3) Maintaining higher standards of safety and health.
(4) Reducing unnecessary movements in order to minimize
wastages.
(5) Better design of work place layout for effective production
process.
(6) Ensure fair remuneration with job satisfaction.

c. Time Study: Time study is also called work measurement. Time study
may be defined as "the art of observing and recording the time
required to do each detailed element of an industrial operation."

Uses of Time Study

(1) It assists in setting standard time for each operation.
(2) It facilitates effective labour cost control.
(3) It helps to ascertain ideal time and over time to men and
machines.
(4) It is useful to establish fair and suitable wage rates and
incentives.
(5) It facilitates effective utilization of resources.

110
d. Job Analysis: Job Analysis is a formal and detailed study of jobs. Job
analysis may be defined as "the process of determining by observation
and study the task, which comprise the job, the methods and
equipment used and the skills and attitudes required for successful
performance of the job."

Advantages of Job Analysis

The following are the important advantages of job analysis:

(1) It is useful in classifying job and interrelationship among them.

(2) If facilitates forecasting of manpower requirements.
(3) It helps in effective utilization of manpower resources.
(4) Effective employee development programme can be established.
(5) Enables in determining performance standards of each process or
job.

e. Job Evaluation: Job evaluation may be defined as "a process of

analyzing and describing positions, grouping them and determining
their relative value by comparing the duties of different positions in
terms of their different responsibilities and other requirements." Job
evaluation is determined on the basis of job description and job
analysis. The primary purpose of job evaluation is developing
appropriate wage and salary structure with internal pay equity between
jobs.

f. Merit Rating: Merit rating may be defined as "a systematic evaluation

of an employee's performance on the job in terms of the requirement
of the job." Merit rating is a system of measuring both qualitatively
and quantitatively of an employee's capacity in relation to his job. The
following are the personal qualities of an employee which are usually
considered for determining merit and worth of labour as:

(1) Academic qualification and knowledge.

(2) Skill and experience.
(3) Attitude to the work.
(4) Quality of work done.
(5) Initiative intelligence.
(6) Accuracy.
(7) Judgment.
(8) Leadership.
(9) Adaptability and Co-operation.
(10) Leadership and self-confidence.
(11) Reliability and Integrity.
(12) Discipline.

Importance of Merit Rating: The following are some of the important

advantages of merit rating:

111
 (1) It assists in determining fair rates of wages for each worker on
the basis of his I her performance.
(2) It helps to know the suitability of the worker for a particular job.
(3) This method helps in removing grievances and it improves
labour-management relations.
(4) Enables to ascertaining an employee's merit for grant of
promotion or demotion or transfer or increment etc.
(5) If facilitates effective labour cost control.

Distinction between Job Evaluation and Merit Rating:

The following are the important points of differences between Job

Evaluation and Merit Rating:

1. Job evaluation is the assessment of the relative worth of jobs within a

company and merit rating is the assessment of the relative worth of the
man behind the job.

2. Job evaluation and its accomplishments are means to setup a rational

wage and salary structure whereas merit rating provides a scientific
basis for determining fair wages for each worker based on his ability
and performance.

3. Job evaluation simplifies wage administration by bringing uniformity

in wage rates whereas merit rating is used to determine fair rate of pay
for different workers.

(3)Timekeeping Department

This department is concerned with following two important

activities: (1) Timekeeping and (2) Time Booking

Timekeeping: It refers to recording of each worker's time of coming in

and going out of the factory during engagement of the factory. It is
essential for the purpose of attendance and determination of wage payable
to each worker.

Objectives of Timekeeping: The following are the important

objectives of timekeeping:

(1) Preparation of payrolls

(2) Ensuring discipline in attendance
(3) Apportionment of overhead on the basis of labour hours
(4) Effective utilization of human resources
(5) Minimization of labour costs
(6) Ascertaining ideal labour time and ideal machine time.

Methods of Timekeeping: The following are the two important

methods of timekeeping:

112
 i) Manual Method:
(a) Attendance Register Method.
(b) Token or Disc Method.

ii) Mechanical Method:

a. Time recording clocks.
b. Dial Time Records.
c. Key Recorder System.

Manual Method: The choice of the manual method adopted by the

factory depends upon its size, number of workers employed, nature of the
business and policy of a firm. Under manual methods, there are two
important methods which are in use: (a) Attendance Register Method and
(b) Token or Disc Method.

(a) Attendance Register Method: Under this method, an Attendance

Register is maintained by the Timekeeper in the time office. This
register may be filled in by the Timekeeper when the worker gets
inside the factory and the time of departure, normal time and overtime.
Workers may be required to sign both at the time of arrival and time of
departure. This method is very simple and most suitable to small-scale
industries. It is very difficult to operate when the number of workers is
large.

(b) Token or Metal Disc Method: In this method, each worker is given a
metal disc or a token bearing his identification number. All the tokens
or discs are hung on a board serially at the entrance of the gate in the
factory. As the worker enters the gates of the factory, he removes his
disc from the board and drops it into a box. This process is continued
until the scheduled time expires. Latecomers may drop their tokens in
a separate box or handover personally to the timekeeper. In the case of
absentees the tokens are not removed from the board. Based on the
above process, the Timekeeper records the attendance in the register
known as Muster Roll for the purpose of pay rolls.

This method is simple and economical. But it suffers from certain

disadvantages given below:

(a) There is chance to remove the disc of fellow worker's token from
the board to ensure his presence.

(b) Difficult to ascertain about overtime work, early leaving, ideal time
etc.

(c) Lack of accuracy regarding the exact time of arrival of a worker

which may result in many disputes.

(d) Unless there is strict supervision, the timekeeper may include

dummy or ghost workers in the Muster Rolls.

113
Mechanical Method

In order to achieve the accuracy and reliability of recording of time

of workers, the following different mechanical devices are used:
(1) Time Recording Clocks.
(2) Dial Time Records.
(3) Key Recorder System.

Time Recording Clocks: Under this system, each worker is' given a time
card for a week or fortnight. These time or clock cards are serially
arranged in a tray at the entrance to the factory. When the worker enters
the factory, he takes his allotted card from the tray and puts it in the time
recording clock that records the exact arrival time at the space provided on
the card against the particular day. This process is repeated for recording
time of departure for lunch, return from lunch, leaving the factory after his
day's work. Late arrivals, early leavings and over time are printed in red
so as to distinguish these from normal period spent in the factory. This
method is very popular for correct recording of attendance.

Dial Time Records: This is a machine which is used for recording correct
attendance time of arrival and departure of worker automatically. This
recorder has a number of holes about the circumference. Each hole
represents worker's number which corresponds to identification of allotted
clock numbers. At the time of arrival and departure of worker, by
operating this machine, the dial arm into a hole and the time is
automatically recorded on an attendance sheet placed inside. This machine
is most suitable in small-scale industries.

Key Recorder System: In this machine there are a number of keys, each
key denotes worker's number. When the time of arrival and departure the
worker inserts his allotted key in the key hole and gives a turn, the ticket
time and clock time are recorded on a sheet of paper. This method is
economical and easy to operate.

Time Booking

It refers recording the time of each worker for each department, operation,
process or job during engagement of the factory. It is useful for the
purpose of cost analysis and effective cost control.

Objectives of Time Booking: The following are the main objectives of

time booking:
(1) To ascertain the cost of each job, operation or process.
(2) To ascertain the cost of ideal time.
(3) Apportionment of overhead based on the suitable basis.
(4) To establish the fair and suitable wage system.
(5) To ensure the proper utilization of attendance time.
(6) To ensure the effective cost control and cost reduction.

114
 Methods of Time Booking: In order to achieve the effective
utilization of manpower resources, recording the correct time of workers
and labour cost control is essential to adopt various methods of time
booking. The following are the important methods used for time booking:
(1) Daily Time Sheet
(2) Weekly Time Sheet
(3) Job Cards or Job Tickets
(a) Job Card For Each Worker (b) Job Card For Each Job
(c) Combined Time and Job
Card (d) Piece Work Card

(1) Daily Time Sheet: This is one of the important methods which is
used for a daily record of the work done by each worker. This record
indicates that the nature of work, actual time spent by the worker on each
job or operation. The daily time sheet is allotted to each worker on which
the record is made by the worker himself or by the official incharge. This
method is suitable only for small-scale industries.

(2) Weekly Time Sheet: This system may be done as in the case of
daily time sheet. Under this method, instead of recording time on daily
time sheets, worker is given a weekly time sheet on which recording by
the worker on each job for a week. This method is useful for those
concerns where the workers usually carry on a few jobs in a week.

(3) Job Card or Job Tickets: This method is adopted for recording of
time booking for a worker's time spent on a job. A job card is prepared for
each job giving detailed particulars of the work to be carried out by the
worker. Job cards are classified into four types:
(a) Job Card for Each Worker
(b) Job Card for Each Job
(c) Combined Time and Job Card
(d) Piece Work Card.

(a) Job Card For Each Worker: Under this system, job card is issued to
each worker at the beginning of each day or week. The job card is
used to record the time of starting and finishing the each job or work.
It indicates the nature of work, time spent by the worker for each job
or operation, idle time, total hours, rates and remuneration of
different jobs during a scheduled time.

(b) Job Card for Each Job: In this system, separate card is prepared and
allotted to each job. The job card is used to each job passes along
with the job from worker to worker. As soon as the worker receives
the job card he records the time of starting and finishing the job or
operation. This system is useful not only for correct calculation of
wages for each job but also it shows the details of the work to be
done by the worker.

115
 (c) Combined Time and Job Card: Under this system, job card is
prepared on the basis of attendance time and actual time spent by the
worker. This system is useful to ascertain idle time, time taken and
time booking on account of pay rolls.

(d) Piece Work Card: This system is adopted where the piece wage
payment is applicable. Accordingly wage payment is made on the
basis of quantity of output produced by the worker. A piece work
card is allotted to each worker on which recording the quantity of
work to be done by each worker. For determination of piece wage
payment, the time spent by the worker is not taken into account. This
method is suitable only for small-scale industries.

I. Idle Time

Idle Time is that time during which the workers spend their time
without giving any production or benefit to the employer and concern. The
idle time may arise due to non-availability of raw materials, shortage of
power, machine breakdown etc.

Types of Idle Time: It refers that any loss of time is inherent in every
situation which cannot be avoided. Any costs associated with the normal
idle time are mostly fixed in nature. The normal idle time arises due to the
following reasons:
(1) Time taken for personal affairs.
(2) Time taken for lunch and tea break.
(3) Time taken for obtaining work.
(4) Time taken for changing from one job to another.
(5) Waiting time for getting instructions, tools and or raw materials,
spare parts etc.
(6) Time taken by the workers to walk between factory gate and
place of work.

II. Abnormal Idle Time

Abnormal idle time refers that any loss of time which may occur due
to some abnormal reasons. Abnormal idle time can be prevented through
effective planning and control. The abnormal idle time may arise due to
the following avoidable reasons:
(1) Faulty planning.
(2) Lack of co-operation and co-ordination.
(3) Power failure.
(4) Time lost due to delayed instructions.
(5) Time lost due to inefficiency of workers.
(6) Time lost due to non-availability of raw materials, spare parts,
tools etc.
(7) Time lost due to strikes, lock outs and lay-off.

116
Accounting Treatment of Normal Idle Time and Abnormal Ideal Time

Normal Idle Time: Normal idle time wages is treated as a part of cost
of production. Thus, in case of direct workers an allowance for normal
idle time is built into labour cost rates. In the case of indirect workers,
normal idle time wage is spread over ,all the products or jobs through the
process of absorption of factory overheads.

Abnormal Idle Time: Abnormal idle time cost is not included as a

part of production cost and is shown as a separate item in the Costing
Profit and Loss Account. So that normal cost are not distributed.

Over Time: The term "over time" refers to when a worker works
beyond the normal working hours or scheduled time is known as
'overtime.' According to Factories Act, the wage rate of overtime work to
be paid at double the normal rate of wages. The extra amount of
remuneration is paid to the worker in addition to normal rate of wages is
said to be overtime premium.

Effect of Over Time Payment on Productivity: The following are the

effects of over time payment on productivity:

(1) Overtime premium is an extra payment over normal wages and

hence will increase the production cost.

(2) The efficiency of workers during overtime work may fall and
hence output may be reduced.

(3) To earn more, workers may not concentrate on work during

normal hours, and thus the output during normal hours may fall.

(4) Reduced output and increased premium will increase the cost of
production.

Accounting Treatment of Overtime Wages

The following are the ways of charging of overtime premium:

(I) If overtime is resorted to at the desire of the customer then

overtime premium is charged to concerned job directly.

(2) If overtime is required to cope with general production schedule

or for meeting urgent orders, the overtime premium should be
treated as overhead cost of particular department or cost center
which works overtime.

(3) If overtime is worked on account of abnormal conditions such as

flood, earthquake etc. that should be charged to costing profit
and loss account.

117
 Control of Overtime: Control of overtime is essential to minimize the
cost of production and increase the overall performance of the efficiency.
Effective control of overtime can be possible through the following ways:

(1) Effective sound planning of production

(2) Adequate supervision
(3) Ensuring availability of raw materials, spare parts
(4) Encouraging productivity
(5) Reducing labour turnover
(6) Ensuring effective system of repairs and maintenance, material
handling and smooth flow of production
(7) Fair and equitable remuneration to efficient and inefficient
workers.

Casual Workers: Casual workers are those who are engaged casually
whenever there is extra load of work or due to planned maintenance
during off season.

System of Control: In order to achieve the effective control of casual

workers the following system to be adopted:

(1) Assess work load, for example, planned maintenance during off
season.
(2) Assess manpower requirement.
(3) Obtain prior sanction for number of workers giving the period
for which engagement is to be done.
(4) Obtain periodical report on performance and compare with the
plan to ensure that there is no lagging behind.
(5) Provide for automatic termination after the period for which
sanction is given expenses.

Out Workers: Out workers are those who are engaged in production
operations outside the factory. For example, works carried on construction
and electricity.

Control of Out Workers: The following are the important aspects to

be considered for effective control of out workers:

(1) Keep a log book at reception.

(2) Record complaint specifying date and time of receipt of
complaint.
(3) Keep proper complaint slips and send the same to technical
department.
(4) Prepare duty sheets in duplicate to note down time on and time
off.
(5) Summarise time spent by each service man daily.
(6) Summarise chargeable amount and non-chargeable amount.
(7) Advise accounts department for billing.

118
(4) Pay Roll Department

This is one of the important departments which is responsible for

computation, preparation and payment of wages to all employees of the
entire organization. Wage Sheet or Pay Roll is prepared on the basis of the
Piece Work Card or Time Card or both. It is a statement which shows the
detailed records of the employees' remunerations such as gross wages,
various reductions and net wages for particular period.

In order to ensure the proper determination and preparation of wage

sheet, the pay roll department should be taken a special care. A systematic
procedure for payment of wages should be adopted to preventing of frauds
and irregularities in wage payments. Effective supervision and strict
control are essential to ensure that the worker is not paid twice or no
dummy names of workmen have been entered in the pay roll.

Labour Turnover: Labour Turnover may be defined as "the rate of

changes in labour force, i.e., the percentage of changes in the labour force
of an organization during a specific period. Higher rate of labour turnover
indicates that labour is not stable and there are frequent changes in the
labour force in the organization. It will affect the efficiency of the workers
and overall profitability of the firm. The determinant result of labour
turnover is expressed in terms of percentage.

Methods of Measurement of Labour Turnover: The following are the

important methods of measuring labour turnover:
(a) Separation Method
(b) Replacement Method
(c) Flux Method.

(a) Separation Method: Under this method, labour turnover is

calculated by dividing the total number of separation (number of
employees left or discharged) during the period by the average
number of workers on the pay roll. Thus the formula is :

Labour turnover = Number of separations during the period x 100

Average number of workers during the period

(b) Replacement Method: In this method, labour turnover is

measured by dividing the number of replacement of workers
during the period by average number of workers during the
period. Thus formula may be expressed as:

Labour turnover = Number of workers replaced during the period x 100

Average number of workers during the period

(c) Flux Method: Under this method, labour turnover is measured by

dividing the total number of separation and replacement of

119
 workers by the average number of workers during the period.
Thus the formula is :

Labour turnover = Number of separations + number of replacements x 100

Average number of workers during the period

Illustration: 1

From the following information, calculate labour turnover ratio and

turnover flux rate

No. of workers as on 1" Jan. 2003 = 7,600

No. of workers as on 31" Dec. 2003 = 8,400
During the year, 80 workers left while 320 workers were
discharged, 1,500 workers were recruited during the year of these, 300
workers were recruited because of exits and the rest were recruited in
accordance with expansion plans.

Solution
Labour Turnover Ratio
(1) Replacement Method:
(A) Due to Exit:
No. of Replacement = 300
Average No. of Workers = 7600 + 8400/2 = 8000
Labour turnover = Number of workers replaced x 100
Average number of workers during the period
= 800/3000 x 100 = 3.75%

(B) Due to new recruitment =

Number of new recruitment = 1200 workers

Labour turnover = Number of new recruitment x 100

Average number of workers during the period

=1200/8000 x 100 = 15%

Labour turnover = Number of accession x 100

Average number of workers during the period

=1500/8000 x 100 = 18.75%

(2) Flux Method

Labour turnover = Number of separations + number of replacements x 100
Average number of workers during the period
= 400 + 300/8000 = 8.75%

Causes for Labour Turnover: The causes for labour turnover can be
classified into two categories:
120
 (1) Avoidable Causes
(2) Unavoidable Causes.

(1)Avoidable Causes
(1) Lack of job involvement
(2) Lack of co-operation among the employees
(3) Lack of smooth relationship between employer and employees
(4) Dissatisfaction with wages and incentives
(5) Bias attitude of Management
(6) Poor working conditions
(7) Dissatisfaction with promotion, recognition, transfer etc.
(8) Lack of Co-ordination
(9) Non-availability of adequate protection, proper instructions,
accommodation etc.

(2) Unavoidable Causes

(1) Retirement or Death of employer
(2) Marriage in the case of female workers
(3) Permanent disability due to accident or illness
(4) Dismissal or discharged due to inefficiency or disciplinary
ground
(5) Dissatisfaction with job
(6) Shortage of power, raw materials etc.
(7) Personal responsibilities
(8) Personal betterment with regard to new job
(9) Change in nature of business and plant location.

Effect of Labour Turnover:

(1) Increased cost of recruitment, training and placement
(2) Increased cost of production
(3) Decrease in output due to inefficient or newly recruited workers
(4) Higher accident rate due to negligence or mishandling of
machines
(5) Low team spirit due to lack of co-operation and co-ordination
between the workers and employers.

Cost of Labour Turnover:

The chief aim of the preventive costs which are incurred in order to
keep the workers satisfied and reduce the labour turnover rate as much as
possible. These preventive costs which include the following:
(a) Cost of providing medical facilities, canteen and other welfare
facilities
(b) Cost of administration

121
 (c) Cost of providing better working conditions
(d) Cost of pension, gratuity, provident fund and other retirement
benefits.

Replacement Costs:

These costs include the following:

(a) Cost of recruitment, training and placement
(b) Increase wastages and scrap
(c) Cost of repairs and maintenance including machine breakdowns
(d) Cost of compensation on account of accidents
(e) Loss of output due to inefficiency or newly recruited workers.

Exercise
From the following particulars calculate labour turnover rate by
applying:

(1) Separation Method; (2) Replacement Method; and (3) Flux

Method.
No. of workers on the pay roll
At the beginning of the month =900
At the end of the month = 1100

During the month 10 workers left, 40 workers were discharged and

150 workers were recruited. Of these 25 workers are recruited in the
vacancies of those leaving while the rest were engaged for an expansion
scheme.
[Ans: (1) Separation Method = 5%, (2) Replacement Method =
25% and (3) Flux Method = 7.5%]

5.5 OVERHEADS

Meaning and Definition

Aggregate of all expenses relating to indirect material cost,
indirect labour cost and indirect expenses is known as Overhead.
Accordingly, all expenses other than direct material cost, direct wages and
direct expenses are referred to as overhead.

According to Wheldon, Overhead may be defined as "the cost of

indirect material, indirect labour and such other expenses including
services as cannot conveniently be charged to a specific unit."

Blocker and Weitmer define overhead as follows:

"Overhead costs are operating cost of a business enterprise which
cannot be traced directly to a particular unit of output. Further such costs
are invisible or unaccountable."

122
Importance of Overhead Cost
Nowadays business is a dynamic organism. Advancement of
technological development and innovation, economic situations and social
considerations are the important factors for modernization of industries at
mass production to meet its more demand. The overhead charges are
heavily increased and they represent major portion of total cost. Therefore,
it assumes greater importance for cost control and cost reduction.

Classification of Overheads
Classification of overheads is the process of grouping of costs based
on the features and objectives of the business organization. The following
are the important methods on which the overheads are classified:
(3) On the basis of Nature.
(4) On the basis of Function.
(5) On the basis of Variability.
(6) On the basis of Normality.
(7) On the basis of Control.

2 On the Basis of Nature

One of the important classifications is on the basis of nature or
elements. Based on nature the aggregate of all indirect material cost,
indirect labour cost and indirect other expenses are known as overheads.
Accordingly, overheads are grouped into (a) Indirect Material Cost (b)
Indirect Labour Cost and (c) Indirect Expenses.

1 Indirect Material Cost: Indirect materials do not form part of the

finished products. Indirect materials are indirectly or generally used
for production which cannot be identified directly. For example, oil,
lubricants, cotton waste, tools for repairs and maintenance etc. are
indirect materials.

2 Indirect Labour Cost: Indirect labour is for work in general. The

importance of the distribution lies in the fact that whereas direct labour
can be identified with and charged to the job, indirect labour cannot be
so charged and has, therefore, to be treated as part of the factory
overheads to be included in the cost of production. Examples are
salaries and wages of supervisors, storekeepers, maintenance labour
etc.

3 Indirect Expenses: Any expenses that are not specifically incurred for
or can be readily charged to or identified with a specific job. These are
the expenses incurred in general for more than one cost centre.
Examples of indirect expenses are rent, insurance, lighting, telephone,
stationery expenses ·etc.

(J) On the Basis of Function

The classification of overheads on the basis of the various function of
the business concern is known as function wise overheads. Here there are
four important functional overheads such as:

123
 ( a) Production Overhead (b) Administration Overhead
(c) Selling Overhead (d) Distribution Overhead

(a) Production Overhead: Production overhead is also termed as

manufacturing overhead or works overhead or factory overhead. It is the
aggregate of all indirect expenses which are incurred for work in operation
or factory. These costs are normally incurred during the period when the
production process is carried on. For example, factory rent, factory light,
power, factory employees' salary, oil, lubrication of plant & machinery,
etc.

Administrative Overhead: Administrative expenses are incurred in

general for management to discharge its functions of planning organizing,
controlling, co-ordination and directing. These expenses are not
specifically incurred and cannot be identified with the specific job. It is
also termed as office cost. For example, office rent, rates, printing,
stationery, postage, telegram, legal expenses etc. are the office and
administrative costs.

Selling Overheads: Selling expenses are overheads which are incurred

for promoting sales, securing orders, creating demand and retaining
customers. For example, salesmen's salaries, advertisement, rent and rates
of show room, samples, commission etc.

Distribution Overhead: Distribution overhead are incurred for

distribution of products or output from producers to the ultimate
consumers. For example, warehouse staff salaries, expenses of delivery
van, storage expenses, packing etc.

(7) On the Basis of Variability

One of the important classifications is on the basis of variability.
According to this, the expenses can be grouped into (a) Fixed Overhead
(b) Variable Overhead and (c) Semi-Variable Overhead.

b Fixed Overhead: Fixed cost or overhead incurred remain constant due

to change in the volume output or change in the volume of sales. For
example, rent and rates of buildings, depreciation of plant, salaries of
supervisors etc.

c Variable Overhead: Variable overhead may be defined as "they tend

to increase or decrease in total amount with changes in the volume of
output or volume of sales." Accordingly the change is in direct proportion
to output. Indirect materials, Indirect labour, repair and maintenance,
power, fuel, lubricants etc. are examples of variable overhead costs.

d Semi-Variable Overheads: Semi-variable overheads are incurred

with a change in the volume of output or turnover. They neither
remain fixed nor do they tend to vary directly with the output. These
costs remain fixed upto a certain volume of output but they will vary at
124
 other part of activity. Semi-variable overheads are mixed cost, i.e.,
partly fixed and partly variable. For example, power, repairs and
maintenance, depreciation of plant and machinery telephone etc.

a On the Basis of Normality

Overheads are classified into normal overheads and abnormal
overheads on the basis of normality features. According to this normal
overheads are incurred in achieving the target output or fixed plan. On the
other hand, abnormal overhead costs are not expected to be incurred at a
given level of output in the conditions in which the level of output is
normally produced. For example, abnormal idle time, abnormal wastage
etc. Such expenses are transferred to Profit and Loss Account.

On the Basis of Control

It is one of important classifications of overhead on the basis of
control. Based on control it is grouped into controllable overhead and
uncontrollable overhead. Controllable overhead are which can be
controlled by the action of a specified number of undertaking. For
example, idle time, wastages etc. can be controlled. Uncontrollable
overheads cannot be controlled by the action of the executive heading the
responsibility centre. For example, rent and rates of building cannot be
controlled.

Usefulness of Overhead Classification

It ensures effective cost control.
It helps the management for effective decision making.
The application of marginal costing is essentially for profit planning,
cost control, decision making etc. are based on the classification of
overheads.
On the basis of classification of fixed and variable cost, flexible budgets
are prepared at different levels of activity.
It facilitates fixing of selling price.
Cost classification is useful for break-even analysis. Break-even
analysis mainly depends on overall cost and profit which can be
useful for making or buying decision.
It helps to find out the unit cost of production.

Codification of Overhead
Codification is a process of representing each item by a number, the
digits of which indicate the group, the subgroup, the type and the
dimension of the item.
Advantages of Codification
1. It enables systematic grouping of similar items and avoids
confusion caused by long description of the items.
2. It serves as the starting point of implication and standardization.

125
 3. It helps in avoiding duplication of items and results in the
minimisation of number of items, leading to accurate records.
4. It helps in allocation and apportionment of overheads to different
cost centres.
5. It assists the grouping of overheads for cost control.
6. It helps in reducing clerical efforts to the minimum.

Methods of Codification

There are different methods used for codification. The following are
the three important methods used:
Numerical Codes Method.
Decimal Codes Method.
Codes with a Combination of Numbers and Alphabets.

(1) Numerical Method: Under this method, numerical codes are

assigned to each item of expenses. For example,
100 Indirect labour.
400 Power.
500 Maintenance.
800 Fixed charges.

Decimal Codes: Under this method, the whole numbers are allotted
to indicate master group and the decimals indicate the sub-group. For
example,

Factory Overheads:
Indirect materials.
Consumable stores.
Lubricating oils.

Codes with a Combination of Numbers and Alphabet : Under this

method the alphabet indicates the main group and the type of expenses is
indicated by the numerical. For example,
R1 - Repairs to machinery.
R2 - Repairs to plant.
R3 - Repairs to furniture.

Procedure or Steps in Overhead

Overheads are incurred for work in general. Overhead is added tQ

the prime cost in order to measure the total cost of production or cost of
goods sold. For allocation and apportionment of overhead in the cost of
production or cost of goods sold the following procedures are involved:
Classification of Overhead
Collection of Overhead
Overhead Analysis:

126
(a) Distribution of overhead to production and service departments, i.e.,
Allocation and Apportionment of overhead to cost centre.

(b) Re-distribution of overhead from service department to production

department, i.e.,

Allocation and Apportionment of service centres to production

centres or departments.

1 Absorption of overhead by cost units, i.e., computation of overhead

absorption rates.

Classification Overhead: We have already discussed the classification

of overhead in the preceding pages, and the discussion on other
procedures would follow in this chapter and the subsequent one.

Collection of Overhead: The production overheads or factory overheads

are collected and identified under separate overhead code numbers or
standing order numbers. These overheads are collected from different
sources and documents. The following are the important sources and
documents :

Overhead Expenses Sources and Documents Used

(1) Indirect Materials Materials Requisition

(2) Power and light Meter Reading
(3) Indirect wages Time Cards, Pay Rolls, Wage Analysis
(4) Salaries Salaries Sheet
(5) Depreciation Plant Register, Machinery Register
(6) Rates Lease
(7) Rates Local Government Assessment
(8) Office Stationery Supplier's Invoices
(9) Postage Postage Book

(3) Overhead Analysis: (a) Allocation and Apportionment of Overhead to

Cost Centres

The first step of overhead analysis is distribution of overhead to

production department and service department. Before analysing
overhead, we should know the concept of Allocation, Absorption and
Apportionment.

Allocation: Cost allocation refers to the allotment of whole item of

cost to cost centres. The technique of charging the entire overhead
expenses to a cost centre is known as cost allocation.

Absorption: Cost absorption refers to the process of absorbing all

overhead costs allocated to apportioned over particular cost centre or
production department by the unit produced.
127
 Apportionment: Apportionment is the process of distribution factory
overheads to cost centres or cost units on an equitable basis. The term
apportionment refers to the allotment of expenses which cannot be
identified wholly with a particular department. Such expenses require
division and apportionment over two or more cost centres in proportion to
estimated benefits received.

Allocation Vs Apportionment
Allocation deals with whole amount of factory overheads while
apportionment deals with proportion of item of cost or proportion to
cost centres.
The item of factory overhead directly allocated and identified with
specific cost centers. Whereas apportionment requires suitable and
equitable basis. For example, factory rent may be allocated to the
factory and has to be apportioned among the producing and service
departments on an equitable basis.
Basis of Apportionment
Overhead apportionment depends upon matching with principles.
Accordingly the basis for apportionment should be related to the basis on
which the expenditure is incurred. The following are the usual basis
adopted for apportionment of overhead :

Basis of Apportionment
Overhead Cost Basis of Distribution

No. of light points, floor space

(1) Lighting - or meter reading
(2) Rent, Rates and Taxes - Floor Area
(3) Insurance of building }
Depreciation of
building, Area of floor
Heating
(4) Depreciation of plant }
and Machinery and - Book value
Equipments
E S I, Canteen,
(5) Safety, }
compensation,
supervision - No. of employees
welfare, fringe
benefits
(6) Delivery Van, }
Internal
Transport - Weight, volume ton
(7) Audit fees - Sales or Total Cost
Storekeeper's Weight, value of materials or
(8) expenses - Number of requisitions
(9) Power - H. P. Hours or K. W. Hours

128
Illustration: 1
A departmental store has several departments. What bases would you
recommend for apportioning the following items of expenses to its
departments :
a Fire Insurance of building
b Sales commission
c Advertisement
d Salesmen's salaries
e Commission paid to salesmen
f Show room expenses
g Depreciation on plant
h Rent of finished goods, warehouse
i Factory power
j Delivery Van expenses

Solution:

Items Basis of Apportionment

(I) Fire Insurance Building Floor space or Value
(2) Sales Commission Sales value
(3) Advertisement Sales value
(4) Salesmen's Salaries Sales value
(5) Commission paid to Salesmen Sales value
(6) Show room expenses Sales value or Total cost
(7) Depreciation on plant Value of plant
Rent of finished goods
(8) warehouse Floor space or Area
(9) Factory power H.P. Power (or) K.W. hours
(10) Delivery Van expenses Weight, Volume

Illustration: 2
A factory has three production departments and two service
departments. The following figures have been extracted from the financial
books :

Rs.

Supervision 6,000
Repairs of Plant and Machinery 3,000
Rent 8,000
Light 2,000
Power 3,000
Employer's contribution to ESI 600
Canteen Expenses 1,000

129
 The following further details have been extracted from the books of
the respective departments :

Particulars A B C D E
Direct Wages (Rs.) 4,000 3,000 2,000 2,000 1,000
Area of Square feet 2,000 1,000 500 500 100
No. of Employees 50 40 20 20 10
Value of Machinery 10,000 5,000 3,000 3,000 1,000
Light Points 80 60 30 30 20
H.P. of Machines 200 100 50 50 20

Solution:
Primary Overhead Distribution Summary

Basis of Total Production Department Service Dept.

Particulars Apportionment Rs. Departments Department

A B C D E

No. of
Supervision Employees 6,000 2,142 1,715 857 857 429
5:4:2:2:1
Repairs of Plant } Value Machinery 3,000 1,364 681 409 409 137
and Machinery 10:5:3:3:1
Area of square
Rent feet 8,000 3,902 1,951 976 976 195
20:10:5:5:1
Light Light points 2,000 727 545 273 273 182
8: 6: 3 : 3: 2
Power H.P. of Machines 3,000 1,429 714 357 357 143
20:10:5:5:2
Employers Direct Wages 600 200 150 100 100 50
Contribution to
ESI 4: 3 : 2 : 2: 1
No. of
Canteen Expenses Employees 1,000 357 286 143 143 71
5:4:2:2:1

Total 23,600 10,121 6,044 3,115 3,115 1,207

(b) Re-apportionment (Re-distribution): Re-distribution of overhead

from various service departments to production departments is known as
Re-apportionment or Secondary distribution. Accordingly, allocation and
apportionment of overheads from service departments or centres to
production centres or departments. The following are the important bases
adopted for apportionment of secondary distribution:

130
 Service Department Basis of Apportionment

Purchase Department Number of Purchase Orders or Number of

(1) Maintenance and Repairs Purchase Requision or Value of Materials

(2) Department Hours worked

(3) Stores Department No. of Requisition or Value of Materials
(4) Personnel Department No. of Employees or Direct wages
(Canteen, Welfare, Medical,
Employer's liability)
No. of Employee or Labour Hours or Direct
(5) Time Keeping Department Wages
(6) Pay roll Department No. of Employees or Direct Wages
(7) Accounts Department No. of Employees
Direct Labour Hours or Machine Hours or
(8) Tool Room Direct Wages

Service Department Basis of Apportionment

(9) Transport Department Car hours, Truck hours, Tonnage handled

(10) Power House K.W. Hours
(11) Fire Insurance Stock Value

Methods or Re-apportionment or Re-distribution

The following are the important methods of re-distribution of service

department overheads to production department:

Direct Re-distribution Method

Step Distribution Method
Reciprocal Service Method - this method further grouped into:
(a) Repeated Distribution Method
(b) Simultaneous Equiation Method
(c) Trial and Error Method

(1) Direct Re-distribution Method: Under this method, the cost of service
department is directed to re-distribution to the production departments
without considering the services rendered by one service department to
another service department.

Illustration: 3
Ramesh Ltd. has three production departments A, Band C and six
service departments. The following figures are extracted from the records
of the company :

131
Production Departments

A Rs.16,000
B Rs.1O,OOO
C Rs.12,OOO
Total Rs.38,OOO

Service Departments

Stores Rs.2,000
Timekeeping Rs.3,000
Maintenance Rs. 1,000
Power Rs.2,000
Walfare Rs. 1,000
Supervision Rs.2,000
Total Rs.49,000

The other information available in respect of the production departments:

Production
Particulars Departments

A B C
No. of Employees 40 30 20
No. of Stores Requisition 30 20 10
Horse Power of Machines 500 500 600
Machine Hours 2500 1500 1000

You are required to apportion the costs of various service

departments to production departments.

Solution:
Departmental Overhead Re-distribution Summary

Expenses Basis Total Production Departments

Rs. A B C
Rs. Rs. Rs.

As per primary } - 38,000 16,000 10,000 12,000

Departmental
summary
Service
Departments
Stores No. of Stores
Requisitioned 2,000 1,000 667 333
30: 20 : 10
No. of
Timekeeping Employees
132
 40:30:20 3,000 1,333 1,000 667
Machine
Maintenance Hours 1,000 500 300 200
25: 15: 10
Power Horse Power 2,000 625 625 750
5:5:6
No. of
Welfare Employees 1,000 445 333 222
40:30:20
No. of
Supervision Employees 2,000 889 667 444
40: 30: 20

Total 49,000 20,792 13,592 14,616

(2) Step Method: Under this method the cost of most serviceable
department is first distributed to production departments and other service
departments. Thereafter, the next service department is distributed and
later the last service department until the cost of all the service
departments are redistributed to the production department.

Illustration: 4
A manufacturing company has two production departments A and B
and three Service Departments - Timekeeping, Stores and Maintenance.
The departmental summary showed the following expenses for Dec. 2003.

Production Departments: Rs.

A 32,000
B 10,000
Service Departments:
Timekeeping 8,000
Stores 10,000
Maintenance 6,000
Total Overhead Expenses 66,000

The following information about departments is available and is used

as a basis for distribution:

Particular Production Service Departments

Departments

A B Timekeeping Stores Maintenance

No. of
Employees 20 15 10 8 5
No. of Stores
Requisitions 12 10 - - 3
Machine Hours 1200 800 - - -
133
 You are required to apportion these costs to production departments :

Solution:

Departments Primary
Distribution
Rs.

Timekeeping 8000 (-) 8,000

Stores 10,000 3,334 (-) 13,334

Maintenance 6,000 2,500 1,600 (-) 10,100
A 32,000 1,333 6,400 6,060 45,793
B 10,000 833 5,334 4,040 20,207
Total 66,000 66,000

Basis of Apportionment:
Timekeeping: 20 : 15 : 8 : 5 (No. of Employees)
Stores: 12 : 10 : 3 ( No. of Stores Requisition)
Maintenance: 12 : 8 (Machine Hours)

(3) Reciprocal Service Method: This method recognizes the fact that if a
service department receives services from other department, the services
should be charged in the receiving department. Thus, the cost of inter
departmental services is taken into account on reciprocal basis. The
following are the three important methods available for dealing with
reciprocal distribution:
Simultaneous Equation Method.
Repeated Distribution Method.
Trial and Error Method.

(4) Simultaneous Equation Method: Under this method, the true cost
of total overhead of each service department is ascertained with the help of
Simultaneous or Algebraic Equation. The obtained result reapportioned to
production department on the basis of given percentage.

(5) Repeated Distribution Method: Under this method, the total

overhead costs of the service departments are distributed to service and
production departments according to given percentage of the service
departments are exhausted, in tum repeatedly until the figures become too
small to matter.

(6) Trail and Error Method: In this method, the cost of a service
centre is apportioned to another service centre. Then, the cost of another
service centre along with the apportioned cost from the first centre is again
apportioned back to the first service centre. This process is repeated till the
amount to be apportioned becomes zero or negligible.

134
Illustration: 5

The following particulars related to a manufacturing company has

three production departments : P, Q, and R and two service departments X
and Y:

Production Departments:
1. Rs.2,000
2. Rs.1,500
3. Rs.1,000

Service Departments:
Rs. 500
Rs. 400

The service department expenses are charged on a percentage basis as

follows:

Productions Service
Departments Departments
Service
Depts. : P Q R S T

10
S 20% 30% 40% %
T 30% 30% 20% 20%

Prepare a statement showing the distribution of the two service

departments expenses to three production departments under (1)
Simultaneous Equation Method and (2) Repeated Distribution Method.

Solution:

(1) Simultaneous Equation Method:

Let X be the total expenses of Departments S Let Y
be the total expenses of Department T
X = 500 + 0.20 Y
Y = 400 + 0.10 X
X = 500 + 0.20 (400 +
O.10X) X
= 500 + 80 + 0.02X

X - 0.20X = 580
(or) 0.98 X = 580
X = 5591.83

B = 400 + 0.10 (592)

= 400 + 59
Y = 459

135
Departmental Overhead Distribution Summary
Partic Production Service
ulars Departments Departments
P Q R S T
Rs. Rs. Rs. Rs. Rs.

Overhead as per
Summary 2,000 1,500 1,000 500 400
Department S 118 178 237 (-) 592 59
Department T 138 137 92 92 (-) 459

Total 2,256 1,815 1,329 - -

Repeated Distribution
Method

Service
Particulars Production Departments Departments
P Q R S T
Rs. Rs. Rs. Rs. Rs.

Total Department
overhead as per
Primary Distribution 2,000 1,500 1,000 500 400
Service Department S 100 150 200 (-) 500 50
Service Department T 135 135 90 90 (-) 450
Service Department S 18 27 36 (-) 90 9
Service Department T 3 3 3 - (-) 9
Total 2,256 1,815 1,329 - -

Illustration: 6

You are supplied with the following information and required to work
out the production hour rate of recovery of overhead in Departments X, Y
and Z.
Production Deptts. Service Deptts.

Particulars Total X Y Z P Q
Rs. Rs. Rs. Rs. Rs. Rs.
Rent 12,000 2,400 4,800 2,000 2,000 800
Electricity 4,000 800 2,000 500 400 300
Indirect Labour 6,000 1,200 2,000 1,000 800 1,000
Depreciation 5,000 2,500 1,600 200 500 200
Sundries 4,500 910 2,143 847 300 300
Estimated working
Hours 1,000 2,500 1,400

136
Expenses of Service Department P and Q are apportioned as under :

X y z P Q
P 30% 40% 20% 10%
Q 10% 20% 50% 20%

Solution:
Departmental Overhead Distribution Summary

Production Deptts. Service Deptts.

Particulars Total X Y Z P Q
Rs. Rs. Rs. Rs. Rs. Rs.

Rent 12,000 2,400 4,800 2,000 2,000 800

Electricity 4,000 800 2,000 500 400 300
Indirect Labour 6,000 1,200 2,000 1,000 800 1,000
Depreciation 5,000 2,500 1,600 200 500 200
Sundries 4,500 910 2,143 847 300 300

Total 31,500 7,810 12,543 4,547 4,000 2,600

Repeated Distribution Method

Service
Production Depts. Depts.

Particulars Total X Y Z P Q

Total Departmental
Overheads as per 7.810 12.543 4.574 4.000 2.600
Primary distribution
Exp. of P Dept 1.200 1.600 800 (-4.000) 400

Total 9.010 14.143 5,437 - 3.000

Exp. of Q Dept. 300 600 1.500 600 (-3000)
Total 9.310 14.743 6.847 600 -
Exp. of P Dept. 180 240 120 (-600) 60

Total 9.490 14.983 6.967 - 60

Exp. of Q Dept. 6 12 30 12 (-60)
Total 9,496 14.995 6.997 12 -
Exp. of P Dept 4 5 3 (-12) -
Total 31.500 9.500 15.000 7.000 - -
Working hours 1.000 2.500 1,400
Rate per hour Rs.9.53 Rs.6 Rs.5.00

137
(ii) Simultaneous Equations Method

Let p be the expenses of Service Dept. P and

Let q be the expenses of Service Dept. Q

1
Then p = 1,000 + q (service 20% of q will be apportioned to dept. P)
and 5

q=2,600+
q = 2.600 + 1/ 10(4,000 + 1/5 q) (putting the value of p)
q = 2,600 + 400 + 1/50 q

q= 3,000 + 1/50 q

50q = 1,50,000 + q
49q = 1,50.000
q = 3,061

P = 4.000 + 1/5(3061) = 4612

Departmental Overhead Distribution Summary

x y z P Q
Rs. Rs. Rs. Rs. Rs.

Total (given) 7,810 12,543 4,547 4,000 2,600

Exp. of P Dept. Rs. 4,612 1,384 1,845 922 (-4,612) 461
Exp. of Dept. Q Rs. 3,061 306 612 1,531 612 (-3,061)
9,500 15,000 7,000 -
Estimated Working Hours 1,000 2,500 1,400

Rate Per Hour Rs. 9.50 6.00 5.00

QUESTIONS

(d) The following particulars were obtained from the books of a light
Engineering Company for the half year ended 30th September, 2003.
Calculate the departmental overhead rate for each of the production
departments assuming the overheads are recovered as a percentage of
direct wages.

138
 Production Service
Particulars Departments Departments
A B C X Y
Rs. Rs. Rs. Rs. Rs.
Direct wages 7,000 6,000 5,000 1,000 1,000
Direct materials 3,000 2,500 2,000 1,500 1,000
Employees 200 150 150 50 50
Electricity 8,000 6,000 6,000 2,000 3,000
Light points 10 15 15 5 5
Assets value 50,000 30,000 20,000 10,000 10,000
Area occupied 800 600 600 200 200

The expenses for 6 months were:

Stores overhead Rs. 400 Depreciation Rs. 6,000

Repairs &
Motive power Rs. 1500 Maintenance Rs. 1,200
Electric lighting 200 General overheads Rs. 10,000
Labour welfare Rs. 3000 Rent and Taxes Rs. 600

Apportion the expenses of Department X in the ratio of 4 : 3 : 3 and that of

department Y, in proportion of direct wages, to departments A, B, and C
respectively.

[ ADS: Total overheads cost: A - Rs.11,396, B - Rs.8663, C - Rs.7341

Dept. overhead rate: A - 162.8%, B - 144.4%, C - 146.8%]



139
 Module - III

6
MARGINAL COSTING

Unit Structure :
6.1 Marginal Costing
6.2 Features of Marginal Costing
6.3 Limitations of Marginal Costing
6.4 Cost Volume Profit Relationship
6.5 Application of Marginal Costing Techniques
6.6 Fixing Selling Price
6.7 Decision Regarding Sales Mix
6.8 Accepting Foreign Order/Exploring New Markets

6.1 MARGINAL COSTING

• Marginal Costing is a technique of controlling by bringing out the

relationship between profit & volume.
• The ICMA has defined the marginal cost 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.
• Thus it is clear that increase/decrease in one unit of output increases /
reduces the total cost from the existing level to the new level. This
increase / decrease in variable cost from existing level to the new
level is called as marginal costing
•
Units Produced 100 Units 101 Units 99 Units
Total Cost Rs.200 Rs.202 Rs.198
Cost Per Unit Rs.2 Rs.2 Rs.2

Cost can be classified in to Fixed Cost & Variable Cost.

Fixed Cost – This expenditure remains same – irrespective of output.
Total fixed costs will remain fixed but fixed cost per unit will be variable.

Variable Cost – As against fixed cost – variable cost as the name suggest
varies directly with output. They vary in the proportion to proportion to
with the output. Total variable costs will be variable but variable cost per
unit will be fixed.

Marginal costing is based on this concept of fixed and variable

costs. It refers to segregating these 2 costs. In simple words marginal cost
140
means the change in the total costs due to change in output y one unit –
single unit.

Marginal costing is also known as direct costing, contributory

costing & incremental costing.

6.2 FEATURES OF MARGINAL COSTING

• Elements of cost are differentiated between fixed costs & variable

costs
• Only the variable or marginal cost is considered while calculating
product cost
• Stock of F/G & WIP are valued at variable cost
• Contribution is the difference between sales & marginal cost
• Fixed cost do not find place in the product cost
• It is a technique of cost recording and cost reporting
• Profitability of various products is determined in terms of marginal
contribution

Advantages of Marginal Costing

Constant in Nature – marginal cost remains constant per unit of output
whereas fixed cost remains constant in total

Pricing Decisions – It assists the management in fixing the prices based

on marginal costing

Determination of Profits – It is very important in determination of profits

especially in export oriented firm

Break Even Point – The point where neither profits nor losses have been
made is known as BEP. It can be determined only on the basis of marginal
costing.

Fixing responsibility – Responsibility cab be fixed easily using the

technique of marginal costing.

Cost Control – Marginal costing helps management in cost control.

Classification of costs in to fixed and variable helps in greater control in
costs

Cost reporting – the reporting of the management is more meaningful as

the reports are based on sales figures rather than production

Decision making – Marginal costing helps the management in taking a

number of business decisions like make or buy, discontinuance of a
particular product, replacement of machines etc.

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6.3 LIMITATIONS OF MARGINAL COSTING

Difficult to separate fixed and variable cost- marginal costing needs

costs to be classified in to fixed and variable. Now there are many costs,
the classification of which is difficult. The segregation becomes difficult
and cannot be done with precision

Over emphasis on sales – this technique depends upon sales and does not
consider production. However business depends upon production and
sales.

Fixed costs ignored – it ignores fixed costs in the value of finished goods
and work in progress. The understating of costs affects profit and loss a/c
and also the balance sheet

Not suitable for long term - Marginal costing is suitable for short run. It
is desirable that in long term profit should be based of full cost basis and
not on marginal costs.

Cost control – at times marginal costing is not an effective tool for cost
control. Infact budgetary control and standard costing are more effective
tools in controlling costs

Not applicable to contract costing – marginal costing is not applicable to

contract costing, since it ignores fixed cost in valuation of work in
progress. This will not serve the purpose.

Not acceptable for tax – Income tax authorities does not accept marginal
costing for inventory valuation

Marginal Cost Statement

Sales Xx
Less – Variable Cost Xx
Contribution Xx
Less – Fixed Cost Xx
Profit Xx

Contribution
Contribution is the profit before adjusting fixed costs. It is known as
contribution because it contributes towards recovery of the fixed costs and
profits. Contribution = Sales – Variable Cost OR Contribution = Fixed
cost + Profit

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Contribution Profit
It includes fixed cost and profit Fixed Cost are excluded
It is a concept used in marginal It is a concept that decides the
costing profit or loss of the business
concern
It is equal to fixed cost at break- It is an excess of sales over break-
even point even point
Contribution = Sales – Variable Profit = Contribution – Fixed Cost
Cost

Profit/Volume Ratio = It is known as PV Ratio. It expresses the

relationship between contribution & sales. It is also known as contribution
to sales ratio. It is expressed in percentage. It is the indicator of the rate at
which the organization is earning profits.
PV Ratio = (Contribution/Sales)*100
PV Ratio = (Change in Profits/Change in Sales)*100

Break-Even Analysis
An enterprise must operate beyond the break- even point, otherwise it will
suffer loss. Break- even point is a level of production and sales, where –

- There is no profit or no loss

- Total sales and total cost is the same
- Contribution equals fixed cost

Break-even point may be expressed in terms of number of units or

rupees of sales or percentage of capacity operation. The study of cost-
volume-profit relationship is requently referred to as “Break-even
Analysis” It is an analysis that can be used to determine the probable
profit at any level of operation.

Basic assumptions for BEP analysis

- Cost can be split in to fixed and variable components
- Fixed cost remains constant irrespective of level of activity
- Variable cost changes with change in volume of output
- Selling price does not change with change in volume
- There is no change in general price level
- Efficiency of workers does not change with change in volume of
output
- The plant capacity can be predicted

A change in any of the above factors will alter the break-even

point. Thus break even analysis must be interpreted in the light of
limitations of underlying assumptions, especially with respect to price and
sales mix factors.

The break-even analysis refers to a system of determination of that

level of activity where total cost equals total sales. The broader

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interpretation refers to that system of analysis which determines the
probable profit at any level of activity. The relationship among cost of
production, volume of production, the profit and the sale value is
established by break-even analysis. Hence, this analysis is also designated
as Cost-Volume Profit Analysis.

Angle of Incidence
The angle at which the Total sales Line intersects the Total Cost
Line is known as angle of incidence. Higher angle of incidence shows a
chance of earning higher profits after break-even point because the gap
between the total sales line and the total cost line will be wider, that is
profit margin will be higher. However, it also indicates higher degree of
risk because, the angle on the opposite side is also equal. Risk and profit
are always co-related to each other. Higher the risk, higher is the chances
of making profits.

BEP (Units) = Fixed Cost / Contribution per unit

BEP (Rs.) = Fixed Cost / PV Ratio
MARGIN OF SAFETY
It indicates the strength of a business. High margin of safety
indicates that profits will be earned even if the selling price falls. However
the lower margin of safety means that is walking a tight rope. Fall in
selling price can put company in to losses.

Margin of Safety = Profit / PV Ratio

6.4 COST VOLUME PROFIT RELATIONSHIP

CVP analysis is the analysis of variable cost, volume and profit. It

explores the relationship between costs, revenue, activity levels and the
resulting profits. It aims at measuring variations in cost and volume.
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The above three factors depends upon many factors like
- Volume of production
- Efficiency of employees
- Size of plant
- Method of production
- Cost of raw materials
- Price levels
- Others

Volume of production depends upon

- Cost of the product
- Size of plant
- Availability of inputs
- Price levels
- Others

Profits of any firm depends upon cost and volume. Cost volume
profit analysis helps the management to correctly analyse the effects of
changes of cost and volume on the profits of the firm.

CVP Analysis is useful for the following

1- Estimating profits at different levels
2- Development of flexible budgets
3- Helps the management in decision making
4- Evaluating the effect of costs on profitability
5- Help in fixing in the selling price

6.5 APPLICATION OF MARGINAL COSTING

TECHNIQUES

1. PROFIT PLANNING:
Profit planning is the planning of future operations to attain
maximum profit. Under the technique of marginal costing, the
contribution ratio, i.e., the ratio of marginal contribution to sales,
indicates the relative profitability of the different products of the
business whenever there is any change in volume of sales, marginal
cost per unit, total fixed costs, selling price, and sales-mix etc. Hence
marginal costing is an useful tool in planning profits as it ensures
sufficient return on capital employed.

2. PRICING OF PRODUCTS:
Sometimes pricing decisions have to be taken to cater to a
recessionary market or to utilise spare capacity where only marginal cost
is recovered. For export market, sometimes full cost is loaded to the sale
price to remain competitive. Sometimes special prices are to be offered
with expansion in mind, fixation of price below cost can be made on a
short-term basis.

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It may be advisable to fix prices equal to or below marginal cost
under the following cases:

(i) To maintain production and employees occupied.

(ii) To keep plant in use in readiness to go ‘full team ahead’.
(iii) To prevent loss of future orders.
(iv) To dispose of perishable product.
(v) To eliminate competition of nearer rivals.
(vi) To popularize a new product.
(vii) To keep the sales of a conjoined product which is making a
considerable amount of profit.
(viii) Where prices have fallen considerably or a loss has already been
made.

3. INTRODUCTION OF A PRODUCT:
When a new product is introduced without incurring any additional
fixed cost the additional contribution helps to increase profitability.

4. SELECTION OF PRODUCT MIX:

The most-profitable product mix can be determined by applying
marginal costing technique. Fixed cost remaining constant, the most
profitable product-mix is determined on the basis of contribution only.
That product-mix which gives maximum contribution is to be considered
as best product mix.

5. PROBLEM OF KEY/LIMITING FACTOR:

A key factor is a factor which limits the volume of production and
profit of business. It may be scarcity of any factor of production such as
material labour, capital, plant capacity etc. Usually, when there is no key
or limiting factor, the product is selected on the basis of highest P/V ratio
of the product. But with key factor the selection of product will be on the
basis of contribution per unit of limiting/key factor of production.

6. ALTERNATIVE METHOD OF MANUFACTURE:

When alternative use of production facilities or alternative methods
of manufacturing a product are being considered, the alternative which
gives the maximum marginal contribution is selected.

7. MAKE-OR-BUY DECISION:
A company may have idle capacity which may be utilised for
making a component or a product, instead of buying them from outside
sources. In taking such ‘make-or-buy’ decision, a comparison should be
made between the variable (or marginal) cost of manufacture of the
product and the supplier’s price for it.

It will be advantageous to manufacture than to purchase an item if

the variable cost is lower than the purchase price provided that the
decision to manufacture does not result in substantial increase in fixed
146
costs and that the existing manufacturing facilities cannot be otherwise
utilised more profitably.

When there is no idle capacity and accordingly making the item in

the factory involves putting aside other work, the loss of contribution from
displaced work should also be considered along with marginal cost of
manufacture. Again, if the decision to manufacture involves increase in
fixed cost, it should also be added to marginal cost for the purpose of
comparison with purchase price of component.

So, the decision will be to purchase if the marginal cost of

manufacture plus traceable fixed costs plus the loss of contribution is more
than the purchase price.

8. ACCEPTING ADDITIONAL ORDERS AND EXPLORING

FOREIGN MARKET:
Sometimes goods are sold at a price above total cost (i.e., at a
profit) and still there remains some spare or unused capacity. In such
circumstances, extra order may be accepted or goods may be sold in a
foreign market at a price above marginal cost but below total cost.

This will add to the profits as, after full recovery of the fixed cost,
any contribution—either from additional orders or from selling in the
foreign market—will make extra profit. In this way the spare plant
capacity can be used to earn additional profit.

9. INCREASING OR DECREASING DEPARTMENTS OR

PRODUCTS:
Sometimes general fixed costs are apportioned to departments or
products for ascertaining total cost but it may give misleading results.
However, specific fixed costs traceable to departments or products should
be deducted from individual contribution to get the Net contribution. If the
net contribution of a department or product is positive, then it should not
be discarded.

10. CLOSING DOWN/SUSPENDING ACTIVITIES:

While taking a decision in this line, the effect of fixed cost and
contribution will have to be analysed. If the contribution is more than the
difference in fixed costs by working at normal operations, and when the
plant or product is closed down or suspended, then it is desirable to
continue operation

Practical Sums

6.6 FIXING SELLING PRICE

Problem No.1
With a view to increase the volume of sales, Ambitious enterprises
has in mind a proposal to reduce the price of its product by 20%. No
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change in total fixed costs or variable costs per unit is estimated. The
directors, however, desire the present level of profit to be maintained.
Following information has been provided:

Sales 50000 units Rs.500000

Variable Costs Rs.5 per unit
Fixed Costs Rs.50000

Advise management on the basis of the various calculations made from

the data given.

Solution
Marginal Cost Statement
Sales 500000
Less – Variable Costs 250000
Contribution 250000
Less – Fixed Costs 50000
Profit 200000

Present Profit Volume Ratio = (Contribution/Sales) * 100

= (250000/500000)*100 = 50%

Future Profit Volume Ratio = (Contribution per unit/Selling price per

unit)* 100
= (3/8)*100 = 37.50%

Sales required to maintain present profit = (Fixed Cost + Desired Profit) /

PV Ratio
= (50000+200000)/37.50%
=Rs.6,66,667 or 83333 Units

Problem No.2
A firm is selling X product, whose variable cost per unit is Rs.10
and fixed cost is Rs.6000. It has sold 1000 articles during one month at
Rs.20 per unit. Market research shows that there is a great demand for the
product if the price can be reduced. If the price can be reduced to Rs.12.50
per unit, it is expected that 5000 articles can be sold in the expanded
market. The firm has to take a decision whether to produce and sell 1000
units at the rate of Rs.20 or to produce and sell for the growing demand of
5000 units at the rate of Rs.12.50. Give your advice to the management in
taking decision.

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Solution
Comparative Profit Statement
Existing Situation Proposed situation
Sales 1000 units Sales 5000 units
@Rs.20 per unit @Rs.12.50 per unit
Sales 20000 62500
Less – Variable Cost 10000 50000
Contribution 10000 12500
Less – Fixed Cost 6000 6000
Profit 4000 6500

The above analysis shows that the proposal to manufacture and sell
5000 units will be profitable. The profit will increase by more than 50%.
However the management should also consider interest on increased
capital outlay and increase in fixed costs, if any, before arriving at final
decision.

Problem No.3
Quality products limited, manufactures and markets a single
product. The following data are available.
Materials Rs.16 per unit
Conversion Costs (variable) Rs.12 per unit
Fixed Cost Rs.5 Lakhs
Present sales 90000 units
Capacity utilization 60%
Dealer’s Margin Rs.4 per unit
Selling Price Rs.40

There is acute competition. Extra efforts are necessary to sell. Suggestions

have been made for increasing sales:
1. By reducing sales price by 5%
2. By increasing dealer’s margin by 25% over the existing rate

Which of these two suggestions you would recommend, if the company

desires to maintain the present profit? Give reasons.

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Solution

6.7 DECISION REGARDING SALES MIX

Problem No.1
Garden products limited manufacture the “Rainpour” garden spray.
The accounts of the company for the year 1991 are expected to reveal a
profit of Rs.1400000 from the manufacture of “Rainpour” after charging
fixed costs of Rs.1000000/- the “Rainpour” is sold for Rs.50 per unit and
has a variable unit cost of Rs.20. Units sold 80000.

Market sensitivity test suggests the following responses to price charges

Alternatives Selling price reduced by Quantity sold
increased by
A 5% 10%
B 7% 20%
C 10% 25%

Evaluate these alternatives and state which, on profitability

consideration, should be adopted for the forthcoming year, assuming cost
structure unchanged from 1991.

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Solution

Problem No.2
Following information has been made available from the cost
records of United Automobiles Ltd., manufacturing spare parts.

Direct Materials X Rs.8 per unit, Y Rs.6 per unit

Direct wages X 24 hrs @25 paise per hour, Y 16 hrs@25 paise
per hour
Variable Overheads ….. 150% of wages
Fixed Overheads ……..Rs.750/-
Selling price X Rs.25 & Y Rs.20

The directors want to be acquainted with the desirability of adopting any

one of the following alternative sales mixes in the budget for the next
period.
a. 250 units of X and 250 units of Y, b.400 units of Y only
c. 400 units of X and 100 units of Y, d. 150 units of X and 350
units of Y

State which of the alternative sales mixes you would recommend to the
management.

Problem No.3
151
Vinak limited which produces 3 products furnishes you the following data
for 1991-92

A B C
Selling price per unit (Rs.) 100 75 50
Profit Volume Ration (%) 10 20 40
Maximum sales potential (units) 40000 25000 10000
Raw material content as % age of 50 50 50
variable costs (%)

The fixed expenses are estimated at Rs.680000. The company uses

a single raw material in all the three products. Raw material is in short
supply and the company has a quota for the supply of raw materials of the
value of Rs.18,00,000 for the year 1991-92 for the manufacture of its
products to meet its sales demand.
You are required to
- Set a product mix which will give the maximum overall profit
keeping the short supply of raw materials in view
- Compute that maximum profit

6.8 ACCEPTING FOREIGN ORDER/EXPLORING NEW

MARKETS
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Problem No.1

A company annually manufactures 10000 units of a product at a

cost of Rs.4 per unit and there is home market for consuming the entire
volume of production at the sale price of Rs.4.25 per unit. In the year
1987, there is a fall in the demand for home market which can consume
10000 units only at the sale price of Rs.3.72 per unit. The analysis of the
cost per 10000 units is as follows:
Materials Rs.15000
Wages Rs.11000
Fixed Overheads Rs.8000
Variable Overheads Rs.6000

The foreign market is explored and it is found that this market can
consume 20000 units of the product if offered at a sale price of Rs.3.55 per
unit. It is also discovered that for additional 10000 units of the product
(over initial 10000 units) the fixed overheads will increase by 10 percent.
Is it worthwhile to try to capture the foreign market?

Solution:

Problem No.2
Due to industrial depression, a plant is running, at present, at 50%
of its capacity. The following details are available. Cost of Production
(per unit) is as follows.
Direct Material Rs.2
Direct Labour Rs.1
Vriable o/h Rs.3
Fixed O/h Rs.2
Total Cost Rs.8

Production per month 20000 units,

Total cost of production Rs.160000
Sale Price Rs.140000
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Loss Rs.20000

An exporter offers to buy 5000 units per month at the rate of

Rs.6.50 per unit and the company hesitates to accept the offer for fear of
increasing its already large operating losses. Advise whether the company
should accept or decline this offer.

Problem No.3
A factory produces 24000 units. The cost sheet gives the following
information
Direct Material Rs.120000
Direct wages Rs.84000
Direct wages Rs.48000
Variable overheads Rs.28000
Semi variable overheads Rs.28000
Fixed overheads Rs.80000
Total Cost Rs.360000

The product is sold at Rs.20 per unit.

The management proposes to increase the production by 3000
units for sales in the foreign market. It is estimated that the semi-variable
overheads will increase by Rs.1000. But the product will be sold at Rs.14
per unit in the foreign market, However no additional capital expenditure
will be incurred. The management seeks your advice as a cost accountant.
What will you advise them?

154
MAKE OR BUY DECISIONS
Problem No.1
A radio manufacturing company finds that while it costs Rs.6.25
each to make component X 273 Q, the same is available in the market at
Rs.5.75 each, with an assurance of continued supply. The breakdown of
cost is
Materials Rs.2.75 each
Labour Rs.1.75 each
Other variable costs Rs.0.50 each
Depreciation and other fixed cost Rs.1.25 each
Total Cost Rs.6.25 each

a. Should you make or buy

b. What would be your decision if the supplier offered the
component at Rs.4.85 each

Solution
a. The variable cost of manufacturing a component is Rs.5 calculated
as follows
Materials Rs.2.75
Labour Rs.1.75
Other variable costs Rs.0.50
Total Rs.5

155
 The market price is Rs.5.75. This is more than the variable cost by
Rs.0.75. It is therefore not profitable to procure from outside because in
any case the fixed cost will continue to be incurred. However it the surplus
capacity released on account of procuring the component from outside
could be put to a more profitable use. It may be better to buy from outside
rather than manufacturing the component.

b. In case the supplier is prepared to supply the component at Rs.4.85,

there is saving of 15 paise in the variable cost too. Hence, it is
profitable to procure from outside. The surplus capacity released may
be put to some other profitable use.

Problem No.2
Auto Parts Limited has an annual production of 90000 units for a
motor component. The component’s cost structure is as follows.
Materials Rs.270 per unit
Labour (25% fixed) Rs.180 per unit
Variable Expenses Rs.90 per unit
Fixed Expenses Rs.135 per unit
Total Rs.675 per unit

a. The purchase manager has an offer from a supplier who is willing to

supply the component at Rs.540. Should the component be purchased
and production stopped?
b. Assume the resources now used for this components manufacture are
to be used to produce another new product for which the selling price
is Rs.485/-

In the latter case material price will be Rs.200 per unit. 90000 units
of this product can be produced, at the same cost basis as above for labour
and expenses. Discuss whether it would be advisable to divert the
resources to manufacture that new product, on the footing that the
component presently being produced would, instead of being produced, be
purchased from the market?

156
157
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

158
 MODULE IV

7
BUDGETARY CONTROL
Unit Structure :

7.1 Introduction
7.2 Objectives
7.3 Definition
7.4 Type of Budget
7.5 Fixed Budget V/S Flexible Budget
7.6 Budgetary Control

7.1 INTRODUCTION

Budgets are an important tool of profit planning. The main purpose

of budgetary control is to present a general view of budgeting an a device
of planning and the preparation of various types of budgets. Let us study
in this chapter how the technique of Budgetary control is employed to
control costs.

7.2 OBJECTIVES

The first stage in planning and control system is setting the

objectives which are defined as the broad and long range desired state or
position in the future. They are motivational or directional in nature and
are expressed in qualitative terms. The fundamental objectives are
identification of the line of business, customer satisfaction, employees
welfare and so on. Thus, they are the basic policies.

The second stage in the planning process is specifying the goals.

The term goal, as an element in planning, represents targets, specific in
quantitative terms to be achieved in a specific period of time.

7.3 DEFINITION

According to CIMA has defined budgets as - “financial and / or

quantitative statement, prepared and approved prior to a defined period of
time of the policy to be pursued during that period for the purpose of
attaining a given objective, it may include income, expenditure and the
employment of capital.

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7.4 TYPE OF BUDGET

With reference to planning and control refers to a comprehensive

and coordinated budgets generally known as master budget. In operational
terms overall budgets has several components. A master budget normally
consists of three types of budgets.
i) Operating budgets
ii) Financial budgets
iii) Special decision budgets

Another classification of a master budget is -

1) Fixed / static budget and
2) Flexible / variable / sliding budgets.

i) Operating budgets - It relates to the physical activities / operations of

a firm such as sales, production, purchasing, debtors collection and
creditors payment schedules. In specifics terms, on operating budget has
the following components -
1) Sales Budget
2) Production Budget
3) Purchase budget
4) Direct labour budget
5) Manufacturing expense budget and
6) Administrative and selling expenses budget and so on.
ii) Financial budgets - It is concerned with expected costs receipts /
disbursement, financial position and results of operation. It has the
following components :
1) Budgeted income statement
2) Budgeted statement of retained earnings
3) Cash Budget and
4) Budgeted balance sheet
i) Operational Budgets

1) Sales Budget - The Sales Budget is the most important budget and
forms on the basis on which all other budgets are build up. This budget is
a forecast of the quantities and values of sales to be achieved in a budget
period. Every effort should be made to ensure that its figure are as made to
ensure that its figure are as accurate as possible because this is usually the
starting budget on which all the other budgets are built up. The Sales
Manager should be made directly responsible for the preparation and
executive of this budget. While preparing sales budget, the following
factors are to be taken into consideration -
1) Past sales figures and trends
2) Relative Products Profitability
3) Pricing policies
4) Production capacity
5) Market Research studies
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FORMAT OF SALES BUDGET
ABC CO. LTD.
Sales budget for the period ending
Product wise
Months / Details Product A Product A
Quantity Value Quantity Value
Jan
---
----
----
Dec

2) Production budget :
Production budget is a forecast of the total output of the whole
organization broken down into estimates of output of each type of product
with a scheduling of operations by weeks and months to be performed and
a forecast of the closing finished stock. The budget may be expressed in
quantitative. i.e. weights, units etc. or financial rupees or both. This budget
is prepared after taking into consideration the estimated opening stock, the
estimated sale and the desired closing finished stock of each product.

FORMAT OF PRODUCTION BUDGET

XYZ CO. LTD.
For the period ending

Items / Month J F M A M J J A S O N D
1) Units required for sale
2) Add : Closing stock of
finished goods. (1 + 2)
3) Total Required (Units)
4) Less : - Opening Stock
of Finished Goods (units)
5) Production units to be
completed (3-4)
6) Add : Equivalent Units
in closing W.I.P.
7) Less : Equivalent units
in opening W.I.P.
8) Total Equivalent units to
be completed (5+6-7)

3) Purchase Budget : When we prepared the production budget, it is

necessary to determine the different in puts required to carry out the
production activities. The purchase budget shows the number of units of
161
material either direct or indirect and the services to be purchased during
the budget period. It also contains the monetary value of units of materials
to be purchased for producing the goods and services as per the production
budget. The following factor has to consider while preparing the purchase
budget.

1) Sales and Production budgets

2) Expected changes in prices of raw materials
3) Storage facilities
4) Inventory level, economic ordering quantity.
5) Nature of availability of raw material.

FORMAT OF PURCHASE BUDGET

XYZ CO. LTD.
For the period ending
Particulars A B Total
Direct Material (Kg)
a) Direct Material usage
b) Budgeted closing Direct Material
inventory
c) Total Requirements (a + b)
d) Opening Direct Material Inventory
e) Purchase of Direct Material (c-d)
f) Cost Per Kg (`)
g) Cost of Purchases (e × f)

4) Direct Labour Budget - This budget shows the number of employees

and or number of labour hours i.e. skilled, semi-skilled, unskilled for the
production required to produce or sell, the budgeted output and or
budgeted sales. The following Factors are to be considered while
preparing direct labour budget as -

1) Output and sales

2) Capital expenditure programmes
3) Research and Development activities.

This budget also provides the monetary value of labour as well as

appropriate wages rate are used.

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FORMAT OF DIRECT LABOUR BUDGET
For the year ended
Particulars A B Total
a) Budgeted production requirements
units
b) Direct Labour Hours per unit
c) Total Direct Labour Hours (a × b)
d) Direct Labour Cost Per Hours (`)
e) Total Direct Labour Cost (`) (c × d)

5) Manufacturing expenses Budget : This budget gives an estimate for

the work overhead expenses to be incurred in a budget period to achieved
the production target. It includes the cost of indirect labour indirect
material and indirect work expenses. It may be classified into fixed cost,
variable cost and semi variable cost also. In preparing this budget, fixed
overheads can be estimated on the basis of past information, and variable
expenses are estimated on the basis of budgeted output.

6) Administrative and selling expenses Budget : The administrative

budget provides an estimate of the expenses of all the central offices and
of management salaries. It can be prepared with the help of past
experience and anticipated changes. Such expenses may be fixed and
related to the different executives.

Selling expenses budget is a forecast of selling and distribution

expenses for the company’s products during the budget period. This
budget is closely connected with the sales budget as the selling and
distribution expenses will be in proportion to sales.

ii) Financial Budget :

Cash Budget : This budget provides an estimate for the anticipated
receipts and payments of cash during the budget period. This budget is
prepared by the Chief Accountant under the guidance of management
because whenever there is any requirement of financial help arranged by
the management people to meet the production and sales programmes.
This budget is prepared in two parts i.e. (i) Receipts and (ii) Payment.

i) Receipts include cash sales, collection from debtors, dividend

received, & any other receipts.
ii) Payments include payment to creditors, cash purchases, income tax
paid, purchase of assets and any other miscellaneous expenses.

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FORMAT OF CASH BUDGET
For the year ended

Particulars J F M A M J J A S O N D

A) Opening Cash Balance

B) Receipts :
- Cash Sales
- Collection from debtors
- Sale of fixed assets
- Collection of BIR
- Loan Received
- Interest on Investment
Issue of Shares /
Debentures
Total (A + B)
C) Less : Payment
- Cash Purchases
- Payment to suppliers
- Payment of BIP
- Dividend paid
- Expenses paid
- Taxes paid
- Interest on loan
- Purchase of fixed assets
- Repayment of loans
Total Payment (C)
Closing Balance of
Cash (A + B - C)

iii) Special decision on budget :

Master budget - it can be classified as a fixed budget and flexible
budget. The master budget is a consolidated summary of the various
functional budgets. It is defined as “a summary of the budget schedules in
capsule form made for the purpose of presenting on one report, the
highlighting of the budget forecast”. This budget is prepared by the budget
164
committee on the basis of coordinated functional budgets and became the
target for the company during the budget period when the committee
finally approves it.

i) Fixed Budget : The fixed budget can be defined as a budget prepared

for given level of activity. It does not take into consideration any changes
in expenditure arising out of changes in the level of activity.

ii) Flexible Budget : Flexible budget is defined as, designed to change in

accordance with the level of activity actually attained. Thus, a flexible
budget gives different budgeted costs for different levels or 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 upon the accuracy with, which the expenses can be classified.

7.5 FIXED BUDGET V/S FLEXIBLE BUDGET

Fixed Budget Flexible Budget

1) It is prepared for unchanged It is prepared to show change in
irrespective of level of capacity or relation to the level of activity
volume. attended by recognizing the
different between fixed, semi fixed
and variable costs.
2) It is fixed or rigid and cannot be It is not fixed or rigid. It can be
change or adjusted to actual recast on the basis of volume of
volume of activity. activity.
3) Full costs one related to one Cost are analysed by behaviour
level of activity only. and variable costs are allowed to
adjusted as per the level of
activity.
4) Under fixed budget cost Under flexible budget it gives a
ascertainment or price fixation do clear idea about cost
not give a correct picture. ascertainment, price fixation or
tendering quotation.
5) If the level of activity change It provides a meaningful basis for
then the comparison of actual comparison of the actual
performance will not be performance with the budgeted
meaningful with the budgeted targets.
targets

7.6 BUDGETARY CONTROL

Budgetary Control is defined as, “the establishment of budgets

relating the responsibilities of executive to the requirements of a policy
and the continuous comparison of actual with budgeted results, either to

165
secure by individual action the objective of that policy or to provide a
basis for its revision.”

7.6.1 Advantages of Budgetary Control :

There are a number of benefits / Advantages of Budgetary Control
are as follows :
1) Budget control by formalizing their responsibilities for planning,
compels managers to thing ahead to anticipate and prepare for
changing conditions.
2) It co-ordinates the activities of various departments and functions of
the business.
3) It increase the production efficiency through proper communication
with the employees and management and also motivate the employees
to maximize the production and profits also.
4) It ensures that working capital is available for the efficient operation of
the business.
5) It provides the night direction of capital expenditure in the most
profitable manner.
6) A budget motivates the employees to attain the given goals.
7) It also help in obtaining the bank credit whenever required.
8) It creates cost consciousness and introduces an attitude of mind in
which waste and efficiency thrive.

7.6.2 Limitations of Budgetary Control :

1) The budgets are based on estimates. The strength and weakness of
budgetary control system depends to a large extent, on the accuracy
with which estimates are made. So, it is always remember that the
budget is prepared on estimated and not on actual accuracy.

2) The budget programme must be dynamic and continuously with the

change business conditions. It cannot be fixed for all the times, as the
business circumstances change, the result is also change.

3) Budgetary control is only a tool of management. Sometimes it is

believed that the introduction of a budget programme is sufficient to
ensure its success. It is necessary that the entire organization must
participate enthusiastically in the programme for the realization of
budgetary goals.

4) Preparation of budget, it requires a maximum amount of time and

efforts. While budgeting is not a major expenditure for a large or
medium size organizations, smaller companies may find it difficult to
justify the cost involved.

166
 Illustration :
Case Study :
1) Cash Receipts :
The estimated monthly sales for a company is as follows :

Month Sales
January 8000
February 14000
March 12000
April 20000
May 25000
June 10000

Sales are 20% cash and 80% for credit each month. Of the credit
sales 70% are collected in the month following and the balance in the
second month following. Calculate the amount of cash sales collection
from debtors in each month from January to June.

Solution :
Particulars Jan Feb March April May June
Total Sales 8000 14000 12000 20000 25000 10000
20% cash Sales (-) 1600 2800 2400 4000 5000 2000
80% Credit Sales 6400 11200 9600 16000 20000 8000
Out of 80% Credit Sales
70% collect next month -- 4480 7840 6720 11200 14000
30% next to next month -- -- 1920 3360 2880 4800
Total Collection from Debtors -- 4480 9760 10080 14080 18800
Cash Sales 1600 2800 2400 4000 5000 2000
Collection from Debtors -- 4480 9760 10080 14080 18800

Illustration No. 2
Cash Payment
In a firm the forecasts relating to wages factory expenses and
administrative expenses are as follows :

Particulars Dec Jan Feb March

Wages 20000 20000 30000 30000
Factory expenses 8000 8000 12000 12000
Administrative Expenses 10000 10000 5000 5000

167
 The time lag in payment of wages is 1/8 months, in case of factory
expenses ¼ month and that of administrative expenses is ½ months.
Estimate the amount of wages, factory expenses and administrative
expenses in each month from January to March.

i) Estimation of wage Payment (O/S 1/8)

Particulars Dec Jan Feb March

Wages 20000 20000 30000 30000
Paid 7/8 in the same month 17500 17500 26250 26250
1/8 paid in the next month -- 2500 2500 3750
Total wages paid during the 17500 20000 28750 30000
month

Note : If outstanding or time lag is given 1/8, it means 1/8 paid in the next
month and the remaining 7/8 is paid to be paid in the same month.

ii) Estimation of Factory Expenses (O/S ¼ month)

Particulars Dec Jan Feb March

Factory Expenses 8000 8000 12000 12000
¾ paid in the same month 6000 6000 9000 9000
¼ paid in the next month -- 2000 2000 3000
Total Factory expenses paid 6000 8000 11000 12000
during the month

Note : ¼ month time lag or outstanding, it means ¼ to be paid in the next

month ¾ to paid in the same month.

iii) Estimation of Administrative Expenses (O/S ½ month)

Particulars Dec Jan Feb March

Administrative Expenses 10000 10000 5000 5000
½ paid in the same month 5000 5000 2500 2500
½ paid in the next month -- 5000 5000 2500
Total Administrative expenses 5000 10000 7500 5000
paid during the month

Note : ½ month time lag or outstanding, it means ½ to be paid in the same

month and ½ to paid in the next month.

168
Illustration 3 :
The following are the estimated sales of a company for 8 months
ending in 31.08.2011.

Month Estimated Sales (in units)

January 2011 6000
February 2011 6500
March 2011 4500
April 2011 4000
May 2011 5000
June 2011 6000
July 2011 7000
August 2011 6000

As a matter of policy, the company the closing balance of finished

goods and raw materials as follows. Stock items closing Balance of a
month finished goods - 50% of the estimated sales for the next month.

Raw Material - Estimated consumption for the next month.

Each unit of production requires 2 kgs of Raw Materials costing `5 per
kgs.

Prepare production budget (in units) and Raw material purchase

budget (in unit and cost) of the company for the half year ending on
30.06.2011.

Solution :
Production Budget (in units) for the half year ending 30.06.2011.

Month Sales Closing Balance 50% of Opening Production

(in units) Estimated Sales for Balance (2+3-4)
next month
1 2 3 4 5
Jan 6000 3250 3000 6250
Feb 6500 2250 3250 5500
Mar 4500 2000 2250 4250
April 4000 2500 2000 4500
May 5000 3000 2500 5500
June 6000 3500 3000 6500
July 7000 3000 3500 6500
Total 32000 32500

Production Budget (in costs of units) for the half year ending
30.06.2011.
169
 Month Production Consumption 2kg Opening Closing / Rate per Amount
(in units) Per Units Balance Purchases Kg (5 × 6)
2×2 Opening
Balance
1 2 3 4 5 6 7
Jan 6250 6250 × 2 = 12500 12500 11000 5 55000
Feb 5500 5500 × 2 = 11000 11000 8500 5 42500
Mar 4250 4250 × 2 = 8500 8500 9000 5 45000
April 4500 4500 × 2 = 9000 9000 11000 5 55000
May 5500 5500 × 2 = 11000 11000 13000 5 65000
June 6500 6500 × 2 = 13000 13000 13000 5 65000
July 6500 6500 × 2 = 13000 13000 -- -- --
3,27,500

Illustration 4 :
A company estimate sales of Product ‘A’ during the last five
months of 2008 as under.

Month Units
August 2160
September 3120
October 2440
November 2080
December 1960

Inventory of product ‘A’ at the end of every month is to be equal to

50% of sales estimate for the next month. Closing inventory of July was
maintained on the above basis. There was no work in progress at the end
of any month. Every unit of product requires two types of material in the
following quantities.

Material x - 5 Ltr.
Material y - 6 Ltr.

Material equal to 25% of the requirement for the next month

consumption are kept as closing stock. The stock position on 31st July was
as under.

Material x - 3200 Ltr.

Material y - 2800 Ltr.

The purchase price of materials x `3 per ltr. And material y `2 per

ltr. There was no closing stock of material x & y on 30th November 2008.
From the above prepare the following budget for the period August to
November.

170
1) Production budget
2) Material Consumption budget
3) Purchase Budget showing quantity and value.

Production on Budget (Units)

Particulars Aug Sept Oct Nov Dec
Units Required to Sale
Add : Closing Stock 2160 3120 2440 2080 1960
(50% of next month sales) 1560 1220 1040 980
Total Units Required 3720 4340 3480 3060
(-) Opening Stock
(50% of current Sales) 1080 1560 1220 1040
Production units 2640 2780 2260 2020

Material Consumption Budget (in Units)

Particulars Aug Sept Oct Nov
1) Material x (5 Ltrs. × units) 13200 13900 11300 10100
from Production Budget
2) Material y (6 Ltrs. × units) 15840 16680 13560 12120
Total Material Consumption 29040 30580 24860 22220

Purchase Budget (Quantity & Value)

Particulars Aug Sept Oct Nov

x y x y x y x y
Material Consumption 13200 15840 13900 16680 11300 13560 10100 12120
(+) Closing Stock 3475 4170 2825 3390 2525 3030 1225 1470
(25% of next month
Consumption)
(-) Opening Stock 3200 2800 3475 4170 2825 3390 2525 3030
given and 25% of
current months)
Purchase of Material 13475 17210 13250 15900 11000 13200 8800 10560
(Ltrs.)
Price Per Ltr. 3 2 3 2 3 2 3 2
Purchase Price 40425 34420 39750 31800 33000 26400 26400 21120

Note : It is assumed that sales unit for December 1960.

 Closing Stock (25% of next consumption) in taken as. For material
Production units 1960
 1960 × 50% = 980 units
 Material Consumption

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Material x = 980 × 5 = 4900
Material y = 980 × 6 = 5880

 Closing Stock x = 4900 × 25% = 1225

y = 5880 × 25% = 1470

Illustration 5 :
The budgeting department of HL Ltd. Provides the following
information.

You are required to prepare a comprehensive quarter wise budget

for the next year.

Balance Sheet as on 31.03.2013

Liabilities Amount Assets Amount

Share Capital 31,77,428 Fixed Assets 48,00,000
Retained earnings 18,96,400 (-) Acc. Depn. 12,00,000 36,00,000
Creation 44,000
Taxes Payable 74,000 Inventories
Direct Material 1,35,828
Finished goods 1,60,000 2,95,828

Debtors 11,20,000
(-) Provision
For bad debtors 64,000 10,56,000
Cash 2,40,000
51,91,828 51,91,828

Note :
1) Direct material include 6300 kgs of material A @ `5.88 per kg and
12600 kgs of material B `7.84 per kg and Finished goods include 4000
units @ `40 per unit.
2) Budget assumption. Selling Price `60 per unit and quarterly sales
forecast in units as follows.

Quarter Next year Year following next year

First 20,000 30,000
Second 30,000
Third 40,000
Fourth 20,000

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3) Inventory Policy :
- Finished goods 20% of the following quarter’s requirement at the end
of each quarter.
- Raw Material 30% of the following quarter’s requirement at the end of
each quarter.
- The firm wishes to have 9200 Kgs. Of each type of direct material on
hand as on 31st March of the next year.

4) Manufacturing Cost per unit -

Direct Material -
1kg of A @ `5.88 5.88
2kg of B @ `7.84 15.68 21.56
Direct Labour 0.5 × Direct Labour 4.00
Hour @ `8
Overheads
Variable (0.5 × direct labour hours @ `12) 6.00
Fixed (`844000 per year / Normal level 8.44
of activity 100000 units) 14.44
Total 40.00

The quarterly fixed manufacturing cost of `211000 include

depreciation totaling `50000.

5) Selling distribution costs

Commission & distribution `6 per unit sold
Advertising `10,000 per quarter
Administrative `20,000 per quarter.

Prepare :
1) Quarter wise Sales Budget
2) Production Budget (units)
3) Quarterly manufacturing Cost Budget
4) Quarterly Administrative & Selling Cost budget.

Solution 9 :
1) Quarterly Sales Budget -

Particulars First Second Third Fourth

Units Sales 20,000 30,000 40,000 20,000
Selling price (Per Unit) 60 60 60 60
Total Sales Revenue 12,00,000 18,00,000 24,00,000 12,00,000

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2) Production Budget (in units) -

Particulars First Second Third Fourth

Sales 20,000 30,000 40,000 20,000
Add : Closing Stock 6,000 8,000 4,000 6,000
(20%) of the next quarter
Total Requirement of 26,000 38,000 44,000 26,000
finished goods
(-) Opening Stock 4,000 6,000 8,000 4,000
Required Production 22,000 32,000 36,000 22,000

1) Quarterly Manufacturing Cost Budget -

Particulars First Second Third Fourth

Required Production (in 22,000 32,000 36,000 22,000
units)
Variable cost
A (`5.88 per units) 1,29,360 1,88,160 2,11,680 1,29,360
B (`15.68 per units) 3,44,960 5,01,760 5,64,480 3,44,960
Direct Labour (`4 per 88,000 1,28,000 1,44,000 88,000
units)
Overheads (`6 per units) 1,32,000 1,92,000 2,16,000 1,32,000
Total Variable cost (A) 6,94,320 10,09,920 11,36,160 6,94,320
Fixed Assets :
Depreciation 50,000 50,000 50,000 50,000
Other Overheads 1,61,000 1,61,000 1,61,000 1,61,00
Total Fixed Cost 2,11,000 2,11,000 2,11,000 2,11,000
Total Cost (A+B) 9,05,320 12,20,920 13,47,160 43,78,720

Total Fixed Cost is calculated in another way i.e.

Fixed Overheads `8.44 per unit.
 Variable cost remain the same as above fixed cost only changed.

Particulars First Second Third Fourth

Variable Cost (A) 6,94,320 10,09,920 11,361,60 6,94,320
(+) Fixed Cost (B) 1,85,680 2,70,080 3,03,840 1,85,680
(`8.44 per unit)
Total Cost (A+B) 8,80,000 12,80,000 14,40,000 8,80,000

174
4) Quarterly Administrative & Saving Expenses Budget -

Particulars First Second Third Fourth

Units Sold 20,000 30,000 40,000 20,000
Variable Cost 2,20,000 1,80,000 2,40,000 1,20,000
Commission of distribution (`6
per unit) (A)
Fixed Cost
Advertising 10,000 10,000 10,000 10,000
Administrative 20,000 20,000 20,000 20,000
Total Fixed Cost (B) 30,000 30,000 30,000 30,000
Total (A + B) 1,50,000 2,10,000 2,70,000 1,50,000

Illustration 6 :
From the following data prepare a cash budget according to
Adjusted Profit & Loss method and Budget Balance Sheet.

Balance Sheet as on 31st December 2015

Liabilities Amount Assets Amount
Share Capital 50,000 Premises 25,000
General Reserve 10,000 Machinery 12,500
Profit & Loss A/c 5,000 Debtors 20,000
Creditors 25,000 Closing Stock 10,000
Bills Payable 5,000 Bills Receivable 2,500
Outstanding Rent 1,000 Prepaid Commission 500
Bank 25,500
96,000 96,000

Projected Trading & Profit & Loss A/c for the year ending
31.12.2015

Particulars Amount Particulars Amount

To Opening Stock 10,000 By Sales 1,00,000
To Purchase 75,000 By Closing Stock 7,500
To Octroi 1,000
To Gross Profit C/d 21,500
1,07,500 1,07,500
To Interest 1,500 By Gross Profit b/d 21,500
To Salaries 3,000 By Sundry Receipts 2,500
To Depreciation 3,750
(10% on Premises and
Machinery)
To Rent 3,000
(-) O/s 1,000
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 (Previous year)
O/S 2,000
(C.Y.) 500 2,500
To Commission 1,500
(+) Prepaid 500 2,000
(Previous Year)
To Office Expenses 1,000
To Advertisement Expenses 500
To Net Profit C/d 9,750
24,000 24,000
To Dividend 4,000 By Balance of Profit 5,000
(Last year)
To Additions to Reserves 2,000 By Net Profit b/d 9,750
To Balance C/d 8,750
14,750 14,750
Closing balance of Certain items :
Share Capital `60,000
10% Debentures `15,000
Creditors `20,000
Debtors `30,000
Bills Payable `6,000
Bills Receivable `2,000
Furniture `7,500
Plant `25,000
(both these assets are purchased at the end of the year)
Solution :
Cash Budget for the year ending 31.12.2015
Particulars ` `
Opening Balance as on 1.1.2015 25,500
Add : Net Profit for the year 9,750
Depreciation 3,750
Decrease in Bills Receivable 500
Increase in Bills Payable 1,000
Issue of share Capital 10,000
Issue of Debentures 15,000
Decrease in Prepaid Commission 500
Decrease in Stock 2,500 43,000
68,500

176
 Less : Purchase of Plant 25,000
Purchase of furniture 7,500
Increase in debtors 10,000
Decrease in Creditors 5,000
Decrease in Outstanding Rent 500
Dividends Paid 4,000 (52,000)
16,500

Budgeted Balance Sheet as on 31.12.2015

Liabilities Amount Assets Amount

Share Capital 60,000 Premises 25,000
10% Debentures 15,000 (-) Depreciation 2,500 22,500
General Reserve 12,000 Machinery 12,500
(10,000 + 2000) (-) Depreciation 1,250 11,250
Profit & Loss A/c 8,750 Furniture 7,500
Creditors 20,000 Debtors 30,000
Bills Payable 6,000 Bills Receivable 2,000
Outstanding Rent 500 Plant 25,000
Closing Stock 7,500
Bank (Balancing Figure) 16,500
1,22,250 1,22,250

Illustration 7 :
Jay Company making for a stock in the first quarter of the year is
assisted by its bankers with overdraft accommodation. The following are
the relevant budget figures.

Month Sales Purchase Wages

November 1,20,000 83,000 9,800
December 1,28,000 96,000 10,000
January 72,000 1,62,000 8,000
February 1,16,000 1,64,000 4,000
March 84,000 1,79,000 10,400

Budgeted cash at Bank, 1st January, 2004 is `17,200. Credit terms

of sales on payment by the end of the month following the month of
supply. On an average, one half of sales are paid on the due date while the
other half are paid during the next month. Creditors are paid during the
month following the month of supply. You are required to prepare a Cash

177
Budget for the quarter, 1st January - 31st March, 2004, showing the
budgeted amount of bank facilities required at each month.

Solution : Cash Budget for quarter ending 31.3.2004.

Particulars Jan Feb Mar

A. Opening Balance 17,200 37,200 (28,800)
B. Receipts
Received from Debtors 1,24,000 1,00,000 94,000
Total (A + B) 1,41,200 1,37,200 65,200
C. Payment
Paid to Creditors 96,000 1,62,000 1,64,000
Wages 8,000 4,000 10,400
Total (C) 1,04,000 1,66,000 1,74,400
Closing Balance (A+B-C) 37,200 (28,800) (1,09,200)

Working Note :

Particulars Nov Dec Jan Feb Mar

1) Sales 1,20,000 128000 72000 116000 84000
50% Received in the following 60000 64000 36000 58000
Month
50% Received in the next to next 60000 64000 36000
month
Total Collection from Debtors 124000 100000 94000
2) Purchases 83000 96000 162000 164000 179000
Paid in the next Month -- 83000 96000 162000 164000
3) Wages 9800 10000 8000 4000 10400

No Information is given so it is assumed that the wages are paid in the

same month.

Illustration 8 :
From the following information prepare a cash Budget for Six
months ended 31st December, 2014 of India Co. Ltd.

178
 Estimated Revenue & Expenditure

Month - Year Total Material Wages Production Selling

Sales Overheads Overheads
June 2014 11000 8000 2000 1500 350
July 2014 10000 10000 2000 1600 400
August 2014 11000 7000 2000 1650 450
September 2014 12000 7000 2300 1650 400
October 2014 13000 6000 2300 1700 450
November 2014 14000 6000 2400 1750 450
December 2014 15000 8000 2400 1800 500

Cash balance on 1st July was `5000. A new machine is to be

installed at `15,000 on credit, to be repaid in two equal installments in
September 2014 & October 2014. Sales commission at 5% on total sales is
to be paid within the month following actual sales. `500 being the amount
of second call may be received in September 2014. Share premium
amounting to `1000 is also obtainable with second call. Period of credit
allowed by supplier is 1 month. Period of credit allowed to customers is 1
month. Delay in payment of overheads is 1 month. Delay in payment of
wages is ½ month. Assume cash sales to be 50% of total sales.

Solution :
Cash Budget

Particulars July Aug Sept Oct Nov Dec

A) Opening Balance 5000 3100 (1000) (7400) (14350) (12000)
Add : Receipts
Cash Sales 5000 5500 6000 6500 7000 7500
Collection from Debtors 5500 5000 5500 6000 6500 7000
Second Call -- -- 500 -- -- --
Share Premium -- -- 1000 -- -- --
Total B 10500 10500 13000 12500 13500 14500
(A+B) 15500 13600 12000 5100 (850) 2500
Less : Payments
Paid to creditors 8000 10000 7000 7000 6000 6000
Wages 2000 2100 2250 2300 2350 2400
Production overheads 1500 1600 1650 1650 1700 1750
Selling overheads 350 400 450 400 450 450
Commission 550 500 550 600 650 700
Machine Installment -- -- 7500 7500 -- --
Total (C) 12400 14600 19400 19450 11150 11300
Closing Balance
(A+B-C) 3100 (1000) (7400) (14350) (12000) (8800)

179
 Working Note :

Particulars June July Aug Sept Oct Nov Dec

Sales 11000 10000 11000 12000 13000 14000 15000
1) 50% Cash Sales 5500 5000 5500 6000 6500 7000 7500
2) Credit Sales 5500 5000 5500 6000 6500 7000
Collection from
Debtors
3) Commission @ 5% -- 550 500 550 600 650 700
to be paid in next
month on total Sales
4) Wages 2000 2000 2200 2300 2300 2400 2400
50% pad in same 1000 1000 1100 1150 1150 1200 1200
50% paid in next month 1000 1000 1100 1150 1150 1200
Total Wages paid 1000 2000 2100 2250 2300 2350 2400

Note : All other expenses, i.e. payment to creditors, production and selling
overheads, credit period is given 1 month, i.e. to be paid in the next
month, it means June paid in July, July paid to August and so on.

Illustration 9 :
Prepare a Cash Budget for the 3 months ending 30th June from the
following information.
a)
Month Sales Materials Wages Overheads
February 140000 96000 30000 17000
March 150000 90000 30000 19000
April 160000 92000 32000 20000
May 170000 100000 36000 22000
June 180000 104000 40000 23000

b) Credit terms are - sales / debtors - 10% sales are on cash, 50% of the
credit sales are collected next month and the balance in the following
month.
c) Creditors - Materials 2 months
Wages ¼ month
Overheads ½ month
d) Cash and Bank balance on 1st April is expected to be `60,000.
e) Plant & Machinery will be installed in February at a cost of
`960000. The monthly installments of `12000 are payable from
April onwards.

180
 f) Dividends @ 5% on preference share capital of 1200000 will be paid
on 1st June.
g) Advance to be received for sale of vehicles `80,000 in June.
h) Dividends from investments amounting to `20,000 are expected to be
received in June.
i) Income tax (advance) to be paid in June is `15000.
Cash Budget from April to June

Particulars April May June

A) Opening Balance 60000 47500 46000
Add : B) Receipts
Cash Sales 16000 17000 18000
Collection from Debtors 130500 139500 148500
Dividend Received -- -- 20000
Advance Received from sale of -- -- 80000
Machinery
Total B 146500 156500 266500
(A+B) 206500 204000 312500
Less : Payments :
Payment to creditors 96000 90000 92000
Wages 31500 35000 39000
Overheads 19500 21000 22500
Installment of Machinery 12000 12000 12000
Income Tax Paid -- -- 15000
Dividend Paid -- -- 60000
Total (C) 159000 158000 240500
Closing Balance (A+B-C) 47500 46000 72000

Working Note :

Particulars Feb Mar April May June

Sales 140000 150000 160000 170000 180000
1) 10% Cash Sales 14000 15000 16000 17000 18000
- Credit Sales 126000 135000 144000 153000 162000
50% Collected in the next -- 63000 67500 72000 76500
month
50% collected next to next -- 63000 67500 72000
month
2) Total Collection from -- 63000 130500 139500 148500
Debtors

181
3) Purchases 96000 90000 92000 100000 104000
2 months credit -- -- 96000 90000 92000
Wages 30000 30000 32000 36000 40000
¾ paid in same month 22500 22500 24000 27000 30000
¼ paid in next month -- 7500 7500 8000 9000
4) Total Wages paid 22500 30000 31500 35000 39000
5) Overheads 17000 19000 20000 22000 23000
½ paid in same month 8500 9500 10000 11000 11500
½ paid in next month -- 8500 9500 10000 11000
Total Overheads Paid 8500 18000 19500 21000 22500

Illustration 10 :
M/s Anushree Enterprises is currently working at 50% capacity
and produces 10000 units.

At 60% working raw material cost increases by 2% and selling

price falls by 2%.

At 80% working raw material cost increases by 5% and selling

price falls by 5%.

At 50% capacity working the product costs `18 per unit and is sold
at `20 per unit.

The unit cost of `18 is made up as follows :

Material `10
Wages `3
Factory Overheads `3 (40% fixed)
Administrative Overheads `2 (50% fixed)
Prepare a statement showing the estimated profit of the business
when it is operated at 60% and 80% capacity.

It may be noted the fixed overhead remain constant upto 100%

capacity. Increase in raw material cost and decrease in selling price are to
be calculated with reference to the figure given for 50% capacity usage.

182
Solution :
Flexible Budget

50% 60% 80%

10000 Units 12000 Units 16000 Units
Per ` Per ` Per `
Particulars
Unit Unit Unit
Sales (A) 20.00 200000 19.60 235200 19.00 304000
(-) Variable Cost
Direct Material 10.00 100000 10.20 122400 10.50 168000
Wages 3.00 30000 3.00 36000 3.00 48000
Factory Overheads 1.80 18000 1.80 21600 1.80 28800
Adm. Overheads 1.00 10000 1.00 12000 1.00 16000
Total Variable Cost (B) 15.80 158000 16.00 192000 16.30 260800

Contribution 4.20 42000 3.60 43200 2.70 43200

C=A-B
(-) Fixed Costs
Factory O/H 1.20 12000 1.00 12000 0.75 12000
Adm. O/H 1.00 10000 0.83 10000 0.63 10000
Total Fixed
Cost (D) 2.20 22000 1.83 22000 1.38 22000
Profit (E = C - D) 2.00 20,000 1.77 21200 1.32 21200

Working Note :
1) Capacity - Production
50% - 10000
 50=10000
60 ? 12000 units
80
50 = 10000 10000 
50
80 = ? 16000 units

2) At 60% level units 12000

i) Raw material cost increase by 2%
 At 50% level Raw Material
 Increased by 2%
 10+2% = 10.20 per units.
ii) Selling price falls by 2%
At 50% level selling price per unit `20
Decrease by 2%
 20 - 2% = 19.60
183
3) At 80% level - units 16000
i) Raw material cost at 50% level `10 per unit
increase by 5%
 10 + 5% = `10.50 per unit
ii) Selling price per unit fail by 5%
At 50% level selling price per unit `20
 20 - 5% = `19 per unit.
4) Factory Overheads Partly fixed partly variable
 At 50% level given
`3 (40% Fixed)
 1.20 per unit fixed
1.80 per unit variable
 Variable cost changes as per units changed &
fixed cost 1.20 × 10000 = 12000
it is fixed at all the levels of activity.
Note : Same for Administrative overheads

Illustration No. 11
The following information relates to the productive activities of
S.K. Ltd. for three months ending on 31st March, 2012.

Particulars `
Fixed Expenses :
Management Salaries 210000
Rent & Taxes 140000
Depreciation of machinery 175000
Sundry Office Expenses 222500
747500
Semi variable Expenses (at 50%) Capacity)
Plant Maintenance 62500
Indirect Labour 247500
Salesmen’s Salaries 72500
Sundry 65000
447500
Variable Expenses (at 50% Capacity)
Material 600000
Labour 640000
Salesman’s Commission 95000
1335000

184
 It is further noted that semi variable expenses remain constant
between 40 and 70% capacity, increase by 10% of the above figures
between 70 and 85% capacity and increase by 15% of the above figures
between 85 and 100% capacity.

Fixed expenses remain constant whatever the level of activity may

be. Sales at 60% capacity are 25,50,000, 80% capacity `34,00,000 and
100% capacity `42,50,000.

Assuming that all items produced are sold you are required to
prepare a flexible budget at 60,80 & 100% capacity.

Solution :

In the books of S.K. Ltd.

Flexible Budget

Particulars 50% 60% 80% 100%

A) Variable Expenses
- Material 600000 720000 960000 1200000
- Labour 640000 768000 1024000 1280000
- Salesmen’s Commission 95000 114000 152000 190000
Total (A) 1335000 1602000 2136000 2670000
B) Semi Variable Expenses
Plant Maintenance 62500 62500 68750 71875
Indirect Labour 247500 247500 272250 284625
Salesmen’s Salaries 72500 72500 79750 83375
Sundry 65000 65000 71500 74750
Total (B) 447500 447500 492250 514625
C) Fixed Expenses
Management Salaries 210000 210000 210000 210000
Rent & Taxes 140000 140000 140000 140000
Depreciation of Machinery 175000 175000 175000 175000
Sundry Office Expenses 222500 222500 222500 222500
Total (C) 747500 747500 747500 747500
Total Costs (D)
(A+B+C) 2530000 2797000 3375750 3932125
Sales (E) -- 2550000 3400000 4250000
Less : Profit (F=D-E) -- (247000) 24250 317875

185
Working Note :

1) Variable expenses changed as per the level of activity changed.

For e.g. At 50% Capacity given Material `600000 =50%
60
600000   720000
50
 Material at 60% `720000

2) Semi variable Expenses -

It is constants between 40 & 70% capacity.
 for 40%, 50%, 60% & 70%, it is remain same.

Then income by 10% between 70 % 85% capacity.

 for e.g. plant maintenance for 50% capacity = 62500 increased by
10%

 62500+10% = 68750

 from 70% upto 85% capacity increase by 10% of each semi variable
expenses.

3) Fixed expenses remain constant at whatever the level of activity, it

means at all the levels it remain same, as fixed.

Exercises :

A) Theory Questions -

1) What is a budget? What are the objectives of budgets.

2) What is Budgetary control?
3) Types of Budget, explain in detail.
4) Distinguish between fixed budget & flexible budget.
5) Define Master Budget.
6) What are the advantages and disadvantages of Budgetary
Control?
7) Write a note on Cash Budget.
8) Explain in detail flexible budget.
9) Write a note on manufacturing overheads budget.
10) Define variable, semi-variable and fixed cost.
11) What is financial Budgets?
12) Note on Operational Budget?

186
B) Multiple Choice Questions -
1) The classification of fixed and variable cost has a special
significance in the preparation of
a) Flexible budget b) Cash Budget
c) Capital Budget d) Zero based budget

2) When a flexible budget is used, then increase in actual production

level within a relevant range would increase.
a) Total Cost b) Variable Cost
c) Fixed Cost d) Both (a) and (b)

3) When a flexible budget is used a decrease in actual production level

within a relevant range would
a) Decrease variable cost per unit
b) Decrease variable cost
c) Increase total fixed costs
d) Increase variable cost per unit

4) If the activity level is reduced from 90% to 70%, in the fixed cost
a) Will decrease by 20% b) Will increase by 20%
c) Per unit will decrease d) Per unit will increase

5) A budget that gives a summary of all the functional budget is known

as
a) Capital budget b) Flexible budget
c) Master budget d) Fixed budget

6) Which of the following may be considered on independent item

in the preparation of the master budget?
a) Direct material budget b) Indirect labour budget
c) Production budget d) Capital expenditure budget

7) A master budget comprises

a) The budget profit & loss account
b) Budget cash flow, budget profit & loss, budget balance sheet
c) Budgeted cash Flow
d) Entire sets of budgets prepared

8) In the process of preparing normal budget, which of the

following is prepared last?
a) Sales budget b) Cash budget
c) Direct labour budget d) Cost of goods

9) In which budget do you add credit sales and deduct cash

received from debtors?
a) Cash budget b) Debtors budget
c) Creditors budget d) Sales budget

187
10) Of the four costs shown below, which would not be included in
the cash budget of an insurance firm?
a) Depreciation of fixed assets
b) Commission paid to agents
c) Office salaries
d) Capital cost of a new compute

11) Which one of the following items would not be included in a cash
budget?
a) Capital repayments of loans
b) Depreciation changes
c) Dividend payments
d) Proceeds of sale of fixed assets

12) Which of the following item is not included in a cash budget?

a) Loan repayments b) depreciation charge
c) Tax paid d) Wages paid

Answer :
1-a, 2-d, 3-b, 4-d, 5-c, 6-d, 7-b, 8-b, 9-b, 10-a
11-b, 12-b

C) State whether True or False.

1) Master budget is a budget which is designed to remain unchanged
irrespective of the level of capacity.
2) A functional budget is the summary budget incorporating its
component functional budgets.
3) Current budget is a budget which is established for use unaltered over
a long period of time.
4) Functional budget is a budget which is established for use over a short
period of time.
5) Fixed budget refers to budget for fixed assets.
6) The process of creating a formal plan and translating goals into
a quantitative format is process costing.
7) Budget is a statement of the policy to be pursued for the
purpose pursued for the purpose of attaining a given objective.
8) Flexible budgeting involves a careful differentiation between fixed
and variable expenses.
9) A flexible budget is a budget for semi variable overhead costs only.
10) Sales budget provides the necessary input data for Direct labour
budget.
Answer : True - 7,8
False - 1,2,3,4,5,6,9,10

188
Practical Problem :
1) For production of 50000 electrical tubes the following are
budgeted expenses.

Particulars (`)Cost Per Unit

Direct Material 6.00
Direct Labour 3.00
Direct Expenses 1.00
Variable Expenses 2.50
Fixed Overheads (`15000) 3.00
Selling expenses (10% fixed) 3.00
Administrative expenses (`20000 fixed) 1.00
Distribution expenses (20% fixed) 1.00
Total Cost of sales 20.50

Prepare a budget for production of 30000, 40000 and 60,00 units

of electric tubes.

2) From the information given below prepare flexible budget for 60% and
80% capacities and fix the total overhead rates as a percent on direct
wages at these capacities.

Variable Overheads 75% capacity

Indirect Material 750
Indirect Labour 2250

Semi-Variable Overheads
Electricity (40% Fixed, 60% Variable) 3750
Repairs & Maintenance 375
- 80% Fixed
- 20% Variable

Fixed Overheads
Salaries 10000
Insurance 500
Depreciation 2500
Estimated Direct Wages 4025

3) The following data are available of a manufacturing company for a

year
Fixed Expenses `
Salaries & Wages 1520
Rent, Rates & Taxes 1056
Depreciation 1184
Sundry Administrative Expenses -1040

189
Variable Expenses at 50% Capacity
Material `3472
Labour 3264
Other Expenses 1264

Semi variable Expenses remain constant between 45% and 65% of

capacity, increasing by 10% between 65% and 80% capacity and by 20%
between 80% and 100% capacity.

Sales at various levels are

50% Capacity - `16000
60% Capacity - `19200
75% Capacity - `24000
90% Capacity - `28800
100% Capacity - `32000

Prepare a Flexible budget for the year and forecast the profit at
50%, 60%, 75% and 100% of capacity.

4) From the following information and the assumption that the balance in
hand on 1st January is 72500, prepare cash Budget.

Month Sales Materials Wages Selling / Production

Distribution cost
Cost
Jan 72000 25000 10000 4000 6000
Feb 97000 31000 12100 5000 6300
Mar 86000 25500 10600 5500 6000
April 88600 30600 25000 6700 6500
May 102500 37000 22000 8500 8000
June 108700 38800 23000 9000 8200

Assume that 50% are cash sales. Assets are to be acquired in the
month of Feb. and April. Therefore provision should be made for the
payment of `40,000 and `25000 for the same. An application has been
made to the Bank for the grant of loan of `30,000 and it is hoped that it
will be received in the month of may. It is anticipated that a dividend of
`40000 will be paid in June. Debtors are allowed 1 months credit. Sales
commission @ 5% on cash sales and 2% on cash collection from debtors
is to be paid. Creditors grant one month credit.

5) The following information is extracted from the various functional

budgets prepared for a concern whose financial year starts from 1st April.

190
 i)

Particulars Jan Feb Mar April May June July Aug Sept
Sales 3000 3500 3000 2500 2250 3250 3500 3750 4000
Material 1250 1500 1500 1250 900 1500 1500 2000 1500
Wage 500 550 550 500 450 450 500 500 550
Overhead
Manufacturing 400 450 450 400 350 350 400 400 450
Administrative 150 200 200 150 150 150 200 200 200
Selling 200 200 200 250 200 150 150 150 200
Distribution 150 200 200 150 100 100 150 200 200

ii) Plant to be purchased for `3000. The price to be paid in six equal
installment the first installment to start in June.
iii) A provision of `250 per month has to be made for machinery
purchased in the previous period.
iv) A commission of 10% is required to be paid on sale in the month
following the actual sales.
v) Cash sales would amount to `200 per month on which no
commission is paid.
vi) Dividend to shareholders amounting to `5000 is to be paid on 1st July.
vii) Interest on investment amounting to `4000 will be received on 1st
August.
viii) Income tax paid in August `4000.
ix) Balance of call on ordinary shares to be received on 1st April `2000.

The period of credit allowed to debtors and allowed by creditors

are 3 months and 2 months respectively and payment of wages and
overheads expenses are made one month in arrears.

The estimated cash balance on 1st April was `5000.

Prepare a monthly cash budget for six months from April to

September assuming suitable figures for loan overdraft whenever required.

6) Prepare Cash Budget for January - June from the following

information.

191
1) The estimated sales and expenses are as follows :

Month Sales Wages Misc. Expenses

November 100000 15000 13500
December 110000 15000 13500
January 60000 12000 11500
February 50000 12000 15000
March 75000 12000 12000
April 120000 15000 13500
May 100000 13500 13500
June 100000 13500 13500

2) 20% of the sales are on cash and the balance on credit.

3) The firm has a gross margin of 25% on sales.
4) 50% of the credit sales are collected in the month following the
sales, 30% in the second month and 20% in the third month.
5) Material for the sales of each month is purchased one month in
advance on a credit for two months.
6) Wages are paid after ⅓ month. Expenses are paid after 1 month.
7) Debentures worth `20,000 were sold in January.
8) The firm maintains a minimum cash balance of `20,000. funds can be
borrowed at 12% p.a. in multiples of `1000, the interest being payable
on monthly basis.
9) Cash balance at the end of December is `30,000

7) A newly started SMG Co. Ltd. wishes to prepare cash budget from
May. You are required to prepare a cash budget for the first six months
from the following estimated revenue and expenses.

Month Sales Materials Wages Production Selling

May 10000 10000 2000 1600 400
June 11000 7000 2200 1650 450
July 12000 7000 2300 1650 400
August 13000 6000 2300 1700 450
September 14000 6000 2400 1750 450
October 15000 8000 2400 1800 500
i) Cash balance on 1st May was `5000.
ii) A new machine is to be installed at `15000 on credit to be repaid by
two equal installment in July and August.
iii) Sales commission at 2.5% on total sales is to be paid within the
month following actual sales.
iv) `5000 being the amount of second call may be received in July,
share premium amounting to `1000 is also obtainable with second call.
192
v) Period of credit allowed by suppliers is to be 2 months.
vi) Period of credit allowed to customers is to be one month.
vii) Delay in payment of overheads is one month.
viii)Delay in payment of wages is 15 days (i.e. ½ month)
ix) Assume cash sales to be 50% of total sales.

8) Prepare cash budget of a company for April, May and June 2015 in a
columnar form using the following information.

Month (2015) Sales Purchases Wages Expenses

January (Actual) 160000 90000 40000 10000
February (Actual) 160000 80000 36000 12000
March (Actual) 150000 84000 44000 12000
April (Budgeted) 180000 100000 48000 12000
May (Budgeted) 170000 90000 40000 12000
June (Budgeted) 160000 70000 36000 10000

You are further informed that :

a) 10% of the purchases and 20% of the sales are for cash.
b) The average collection period of the company is ½ month and the
credit purchases are paid off regularly one month.
c) Wages are paid half monthly and rent of `1000 is paid monthly.
d) Cash and Bank Balance as on 1st April is `30000 and the company
wants to keep it on the end of every month of this figure, the excess
cash being put in fixed deposits.



193
 8
VARIANCE ANALYSIS STANDARD
COSTING
Unit Structure :

8.1 Introduction
8.2 Definition of Standard Costing
8.3 Types of Standards
8.4 Variance Analysis
8.5 Advantages of Standard Costing
8.6 Limitation / Disadvantages of Standard Costing
8.7 Distinguish between Standard Costing & Budgetary Control

8.1 INTRODUCTION

In corporate sector, there is a separation of ownership from

management. The owners do not manage the business and the managers
are not the owners. Even in non-corporate sector, with gigantic business
affairs, it is almost impossible for the owners to manage the business
themselves.

Accordingly, owners are compelled to delegate authority to the

managers. Since the managers have no proprietary interest in the business,
it is quite possible that they may tend to be inefficient and a bit careless
and because of this, the sales may come down, cost and rejection may
increase resulting thereby in substantial loss or profit.

For this reason, the owners full and rightly so, that the performance
of various managers should be subjected to some degrees of stringent
control. There is a need to follow carrot and stick approach.

Control always presupposes some yard stick or standard.

Accordingly, well before the period commences, detailed standards are
laid down for various managers. These standards clearly show what is
expected of the concerned managers. For example, in respect of sales, we
lay down for sales manager, the types of products to be sold, the quantity
of each of them to be sold and the price to be charged. At the end of the
relevant period the actual results are compared with the expected ones (the
standards) and the difference known as variance is analysed to throw light
on the precise factors responsible for the variation. As far as the
examination is concerned, this is the end. in real life, further investigation
is undertaken, if the variance amount is varied significant and corrective

194
actions are taken so as to prevent adverse past from repeating itself in
future.

8.2 DEFINITION OF STANDARD COSTING

According to ICWA standard costing is defined as “the preparation

of standard costs and applying them to measure the variance of actual
costs from standard cost and analysing the causes of variations with a view
to maintain maximum efficiency in production.”

It is nothing but the difference between the standard and actual

costing.

According to ICWA standard cost is defined as “a pre-determined

cost based on a technical estimate for material, labour and overheads for a
selected period of time and for a prescribed set of working conditions.

Use of Standard Costing :

1) Analysis of variance is useful for cost control, cost reduction and
increase of profitability. The wastage is checked and inefficiency
does not go undetected.
2) The standard provide incentive and motivation to work, as every
workman tries to achieve the standard set for him. This helps in
the increase the efficiency and productivity.
3) Cost information is kept ready under this system. The promptness of
cost information helps in various other fields of costing, e.g. fixation
of selling prices, valuation of work in progress and so on.
4) The principle of ‘management by exception’ is facilitated in
application by the variance analysis and reporting. The top level
management feels interested in going through the causes of
variances only to know the weak points for corrective action.
5) It also helps in budgetary control and in decision making.

From the above it is very much cleat that, standard costing system
involves the following steps or procedure :

i) Preparation and use of standard costs

ii) Comparison of standard costs with Actual costs and
iii) Analysis of variances as to their causes.

8.3 TYPES OF STANDARDS

Standard means a predetermined specification. The specification of

standards is determined in cost of quantity as well as price. Therefore the
two basis types of standards -
- Quantity Standard &
- Price Standard
195
 To produce a particular product raw material is required as well as
consider the rate of raw material is also essential.

Total Standard Cost :

The total standard cost is made up of -

 Standard Direct Material Cost

 Standard Direct Labour Cost
 Standard Overheads (Fixed & Variable)

Standard Direct Material Cost -

Quantity standard are fixed by production engineers. Standard are
fixed of the quantity of input required for obtaiing a unit of output.

For example A production engineer may determine that 150 units

of raw material are required to produced 130 units of output. This
automatically determine the standard waste or scrap. The standard
Quantity for a given actual output is calculated as under -

Standard Input
Standard Quantity  SQ  for Actual Output= ×Actual Output
Standard Output

Standard Direct Labour Cost :

Standard Direct Labour Cost means fixing the standard time and
also the standard Rate of wages.

Standard Time - It means the time expected to be required for the workers
to complete a job or to produce one unit of output.

Standard wages of all worker are determined by the accounts manager

with the co-operation of the personal manager. The standard wages may
be fixed on the basis of historical data or expected rates of wages.

Standard Hours - (SH) - A hypothetical hour which represents the amount

of work which should be performed in one hour under standard condition
according to CIMA.

Standard Hours
Standard Hours  SH  for Actual Output= ×Actual Output
Standard Output

Standard Overheads - Standard Overheads means the standard Rate for

Absorption of overheads. It may be for per unit or per hour, depending
upon the method of absorption.

Therefore,

Budgeted Overheads(BO)
Standard Overhead Rate(Per hour)=
Budgeted Hours(BH)

196
 Budgeted Overhead (BO)
Standard Overhead Rate(Per Unit)=
Budgeted Quantityof Output(BQ)

The above formula also can be used to calculate separately, the

standard fixed overheads and variable overheads.

8.4 VARIANCE ANALYSIS

Variance represents the difference between Actual cost and

Standard cost. If actual cost (AC) is less than (SC) standard cost, this sign
of efficiency and the difference is termed as “favourable” variance (F). IF
the AC is more than SC this is sign of inefficiency and the difference is
turned as “unfvourable” variance (A) / adverse.

They need not necessarily be good or bad from the point of view of
firm. Such a qualitative evaluation can be made only after the underlying
cause of the variance has been determined.

Variance as a control device, are calculated to assign responsibility

for deviations from the standard cost and thus, to control the cost. For the
purpose of control, variances are classified as controllable and
uncontrollable cost variances.

If a variance can be traced with the responsibility of a particular

individual, it is said be a controllable variance. If variance stems from
causes beyond the control of responsible individual, it is said to be
uncontrollable.

The three elements of the costs of such enterprises.

i) Material variances
ii) Labour variances
iii) Ovherhead Variances

Cost variances

8.4.1 Material Variances :

1) Material Cost Variances (MCV) -
Material Cost variances is the difference between the standard cost
of materials that should have been incurred in manufacturing the actual
197
output and the cost of materials that has been actually incurred. It is
nothing but the difference between the standard cost of material specified
for the output achieved and the Actual Cost of direct material used.

MCV Standard Cost for Standard Quantity  Actual cost for Actual Quantity
 SQ  SP  AQ  AP 

Where, SQ = Standard Quantity

SP = Standard Price
AQ = Actual Quantity
AP = Actual Price

MCV is favourable when the actual cost is less than the standard
cost and vice-versa.

It is further dividend into

a) Material Price Variance (MPV)
b) Material Usage Variance (MUV)

2) Material Price Variance (MPV) -

Material Price Variance is that portion of material cost variance
which is due to the difference between the standard price specified for the
Actual Output and the actual price paid. MPV will occur when then the
actual price paid for the purchase of materials is different from the
standard price.

MPV=  Standard Price - Actual Price  × Actual Quantity

= SP  AP   AQ

Where,
SP = Standard Price
AP = Actual Price
AQ = Actual Quantity

When actual price exceeds standard price, the variance is

unfavourable, and the standard price is greater than the actual price then
MPV is favourable.

3) Material Usage Variance (MUV) :

Material usage variance is that portion of material cost variance,
which is due to the difference between the standard quantity specified for
the actual output and the actual quantity used for actual output.

It is the second component of MCV it measures how well the

material are utilised in production. This variance occurs when actual usage
of material differ from standard usage.

198
MUV=  Standard Quantity - Actual Quantity  × Standard Price
= SQ  AQ   SP

When the actual consumption of material is more than the standard

quantity required for producing the actual output, then MUV is favourable
and vice-versa.

4) Material Mix Variance (MMV) :

Material Mix Variance is that portion of material usage variance
which is due to difference between the standard mixture specified for
actual output and the Actual Mixture.

It is possible that a product may use more than one type of raw
material or combination of materials. This combination is called as
Material Mix. It is necessary to compute standard mixture of each input
for actual output known as Revised Standard Quantity (RQ).

Thus it is assumed that to Produced ‘A’ product material input x, y,

z is required, then the revised quantity of input x is calculated as

Total Quantity of Actual Mix

Revised Quantity of x = Standard Quantity of x
Total Quantity of Standard Mix
 MMV=  Revised Quantity - Actual Quantity ×Standard Price
= RQ  AQ   SP

When the actual mix is less than the standard mix then MMV is
favourable and when the actual mix is more than the standard mix than
MMV is adverse.

5) Material Yield Variance (MYV) :

Material Yield Variane is that portion of material usage variance
which is due to the difference between standard yield specified and the
actual yield.

MYV=  Standard Quantity - Revised Quantity ×Standard Price

= SQ  RQ   SP

When the revised quantity is less than the standard quantity then
MYV is favourable and when the revised quantity is more than the
standard quantity then MYV is adverse. It shows the abnormal loss or
abnormal gain arising in a process.

Verification :
MCV  MUV  MPV
MUV  MYV  MMV

199
8.4.2 Labour Variances :
1) Labour Cost Variances -
It is the second component of standard cost. Labour cost variance
is the difference between the standard cost of labour specified for output
achieved and the actual cost of direct labour used. It is calculated as

LCV   SH  SR  AH  AR 

Where,
SH = Standard Hours
SR = Standard Rate
AH = Actual Hours
AR = Actual Rate

When the actual cost of labour is less than the standard cost then
LCV is favourable and when the actual cost is more than the standard cost
then LCV is adverse. This variance is caused by the variation in the
efficiency of labour and wage rate. LCV is further divided in 2 points.

- Labour Efficiency Variance (LEV)

- Labour Rate Variance (LRV)

2) Labour Efficiency Variance (LEV) (Time Variance) :

LEV is that portion of LCV which is due to the difference between
the standard hours specified for the actual output and the actual hours used
for the production of actual output.

LEV =  Standard Hours - Actual Hours  × Standard Rate

= SH  AH   SR

When the actual hours is less than the standard hours then LEV is
favourable and vice-versa. The labours are used for production purpose
either it is of one kind or may be different kinds. If only one kind of labour
is used and the variance show the difference then it is due to yield. On the
other hand if different kinds of labour is used and the variance shows the
difference due to the mix. Therefore labour efficiency variance is again
divided into

- Labour Yield Variance

- Labour Mix Variance

3) Labour Rate Variance (LRV)

Labour Rate Variance is that portion of labour cost variance which
is due to the difference between the standard rate specified for the actual
output and the actual rate paid.

LRV =  Standard Rate - Actual Rate  × ActualHour

= SR  AR   AH
200
 When the actual rate is less than the standard rate then LRV is
favourable and when the actual rate is more than the Standard Rate the
LRV is adverse. LRV may be caused by several factors such as changes in
basic wage rate, different method of wage payment, overtime and so on.

4) Labour Mix Variance (LMV) :

Labour Mix Variance is that portion of the Labour Efficiency
Variance which due to the different between the Standard Mix Specified
for the actual output and the Actual Mix. Mostly this variance is arises
when two or more types of workers are used. It is necessary to compute
the standard mix of each type of worker. Which is known as Revised
Standard Hour, before calculating the actual variance.

It is assumed that to produce a material 3 types of labour are

required A, B & C.

Total Hours of Actual Mix

 Revised Hours of A= ×Standard Hours of A
Total Hours of Standard Mix

LMV=  Revised Hours - Actual Hours ×Standard Rate

= RH  AH   SR

When the Actual Mix is less than the standard mix then the Labour
Mix Variance is favourable and when the actual mix is more than the
standard then Labour Mix Variance is adverse.

5) Labour Yield Variance (LYV) :

Labour Yield Variance is that portion of the Labour Efficiency
Variance (LEV) which is due to the difference between the Standard Yield
specified and the actual yield.

LYV=  Standard Hours - Revised Hours ×Standard Rate

= SH  RH   SR
When the revised hours are less than the standard hours then the
LYV in favourable & when the revised hours are more than the standard
hours then the LYV is adverse.

Verification :
LCV = LEV + LRV
LEV = LYV + LMV

8.4.3 Overhead Variances :

At the outset, it may be noted that unlike direct materials and
labour, the manufacturing overhead is not entirely variable with the level
of production. Therefore, standard costs for factory overheads are based
upon budgets and not on standards.

201
 Overheads means the total indirect costs. It is nothing but variation
in absorption or recovery of overheads. i.e. under absorption or over
absorption.

Overheads are absorbed on the basis of Standard Overhead Rate

(SR) such rate may be calculated per hour

Budgeted Overheads

Budgeted Hours

Standard Hours for Actual Output (SH) :

Budgeted Hours
SH   ActualOutput
Budgeted Output
Standard Overheads  SO  =SH×SR
Recovered Overheads  RO  =AH×SR
Budgeted Overheads  BO  =BH×SR
Actual Overheads = AH×AR

Standard Rate Per Unit :

S tan dard Quantity for ActualHours  SQ

Budgeted Quantity
SQ   ActualHours
Budgeted Hours
S tan dard Overheads SO   SQ  SR
Re cov ered Overheads RO   AQ  SR
ActualOverheads AO  AR

Total Overheads Variance :

i) Total Overheads Variance (TOV) is the difference between the

standard overheads specified for the output achieved and the Actual
Overheads.

TOV=Standard Overheads for standard Hours - Actual Overheads for Actual Hours
 SH  SR  AH  AR 

202
 When the actual overheads are less than the standard overheads
then total overheads variance is favourable and when the actual overheads
are more than the standard overheads then total overheads variance is
adverse.

ii) Total Overheads Volume Variance (TVV) is the portion of total

overheads variance due to difference between the standard volume of
output and the budgeted volume of output.

TVV=  Standard Hours - Budgeted Hours   Standard Rate

 SH  BH  SR

When the budgeted hours are less than the standard hours then the
total overheads volume variance is favourable and vice-versa.

It is further divided into

1) Total Overheads Efficiency Variance (TEFV)
2) Total Overheads Capacity Variance (TCV)

iii) Total Overheads Expenditure Variance (TEXV) is the portion of total

overheads variance due to the difference between the budgeted
expenditure specified and the actual expenditure.
TEXV=Budgeted Overheads forBudgeted Hours  ActualOverheads for ActualHours
 BH  SR    AH  AR 

When the actual overheads are less than the budgeted overheads
then total overheads expenditure variance is favourable and when the
actual overheads are more than the budgeted overheads then the total
overheads expenditure is adverse.

iv) Total Overheads Efficiency Variance (TEFV), is the portion of total

overheads volume variance due to the difference between the standard
volume of output specified and the actual volume of output.

TEFV=  Standard Hours - Actual Hours   Standard Rate

 SH  AH  SR

When the actual hours are less than the standard hours than the
total overheads efficiency variance is favourable and when the actual
hours are more than the standard hours then the total overheads efficiency
variance in adverse.

v) Total Overheads capacity variance (TCV) is the portion of total

overheads volume variance due to the difference between the actual
volume of output specified and the budgeted volume of output.

TCV=  ActualHours - Budgeted Hours   Standard Rate

 AH  BH  SR

203
 When the actual hours are less than the budgeted hours then the
total overheads capacity variance is favourable and when the actual hours
are more than the budgeted hours then the total overheads capacity
variance is adverse.

Verification
TOV = TVV + TEXV
TVV = TEFV + TCV

8.4.4 Fixed Overheads Variances :

i) Total Fixed Overheads Variance (FOV) is difference between the

standard Fixed Overheads specified for the output achieved and the actual
fixed overheads.

FOV=Standard Fixed Overheads for standard Hours - Actual Fixed Overheads for Actual Hours
 SH  SR  AH  AR 

When the actual overheads are less than the standard overheads
then the fixed overheads variance is favourable and when the actual
overheads are more than the standard overheads then the fixed overheads
variance is adverse.

This variance is caused by the variations in the volume of actual

production and the amount of fixed expenses actually incurred. Therefore,
it is classified into -

- Volume Variance and

- Expenditure Variance

ii) Fixed Overheads volume variance (FVV) is the portion of the total
fixed overheads variance due to the difference between the standard
volume of output and the budgeted volume of output.
FVV=  Standard Hours - Budgeted Hours   Standard Rate
 SH  BH   SR

When the budgeted hours are less than the standard hours then the
Fixed Overheads variance is favourable and when the budgeted hours are
more than the standard hours then the fixed overheads variance is adverse
it is further divided into
- Fixed Overheads Efficiency Variance
- Fixed Overheads Capacity Variance

204
iii) Fixed Overheads Expenditure Variance - (FEV) - is the portion of total
fixed overheads variance due to the difference between the budgeted
expenditure specified and the actual expenditure.

FEXV=Budgeted Fixed Overheads for Budgeted Hours - Actual Fixed Overheads for Actual Hours
 BH  SR  AH  AR 

When the actual fixed overheads are less than the budgeted fixed
overheads then fixed overheads expenditure variance is favourable and
vice versa.

iv) Fixed Overheads Efficiency variance (FEFV) is the portion of fixed

overheads volume variance, due to the difference between the standard
volume of output specified and the actual volume of output.

FEFV=  Standard Hours - ActualHours   Standard Rate

 SH  AH   SR

When the actual hours are less than the standard hours then the
fixed overheads efficiency variance is favourable and when the actual
hours are more than the standard hours then the fixed overheads efficiency
variance is adverse.

v) Fixed overheads Capacity variance (FCPV) - is the portion of fixed

overheads volume variance, due to the difference between the actual
volume of output specified and the budgeted volume of output.

FCPV=  Actual Hours - Budgeted Hours   Standard Rate

 AH  BH   SR

When the actual hours are less than the budgeted hours then the
fixed overheads capacity variance is favourable and when the actual hours
are more than the budgeted hours then the fixed overheads capacity
variance is adverse.

Varification -
FOV = FVV + FEV
FVV = FEFV + FCPV

8.4.5 Variable Overheads Variances :

i) Total Variable Overheads Variances (VOV) is the difference between

the standard variable overheads specified for the output achieved and the
actual variable overheads.

205
VOV=S tandardVariableOverheads forS tandardHours - Actual VariableOverheads forActual Hours
 SH  SR AH  AR

When the actual overheads are less than the standard overheads
then the variable overheads variance is favourable and when the actual
overheads are more than the standard overheads then the variable
overheads variance is adverse it is further classified as -

- Efficiency Variance
- Expenditure Variance

ii) Variable Overheads Efficiency Variances (VEFV) - is the portion of

the total variable overheads variance, due to the difference between the
standard volume of output specified and the actual volume of output.

VEFV=  Standard Hours - ActualHours   Standard Rate

 SH  AH   SR

When the actual hours are less than the standard hours then
variable overheads efficiency variance is favourable and when the actual
hours are more than the standard hours then the variable overheads
efficiency variance is adverse.

iii) Variable Overheads Expenditure Variance (VEXV) is the portion of

variable overheads variance due to the difference between the recovered
expenditure and the actual expenditure.

VEXV=  Standard Rate - Actual Rate   ActualHours

 SR  AR   AH

When the actual variable overheads are less than the recovered
variable overheads then the variable overheads expenditure variance is
favourable and when the actual variable overheads are more than the
recovered variable overheads then the variable overheads expenditure
variance is adverse.

Verification -
VOV = VEFV + VEXV

Illustration -
Material Variances -

Illustration No. 1 - From the following particulars in respect of a product

‘x’ in which raw materials ‘A’ and ‘B’ are used, calculate.

206
i) MCV, ii) MPV, iii) MUV, iv) MMV v) MYV

Material (Input) Standard Actual

Tons Rate Tons Rate
A 120 10.00 140 9.50
B 80 7.50 60 9.00
200 200
Loss 20 18
Net Production 180 182

Solution :

Standard Input
SQ=Standard Quantity for Actual Output = ×Actual Output
Standard Output
120
SQ for A=
   182  121.33
180
80
SQ forB  182  80.89
180
TotalQuantityof  Actualmix
RQRe vised Quantity forMaterial A 
TotalQuantityof Standard mix
×Standard Quantityof  A
200
RQof  A  ×120=120
200
200
RQof B ×80=80
200

A B
SQ = 121.33 80.89
SP = 10.00 7.50
AP = 9.50 9.00
AQ = 140 60
RQ = 120 80

207
MCV   SQ  SP    AQ  AP 
 A  121.33  10    140  9.50 
 1213.31330
 116.70  A 
B  80.89  7.50    60  9 
 606.68540
 66.68  F 
MCV  A  B
 116.70  A   66.68  F 
MCV  50.02  A 

MPV   SP  AP   AQ
 A  10  9.50   140
 0.50  140
 70  F 
B 7.50  9.00   60
  1.50   60
 90  A 
MPV  A  B
 70  F   90  A 
MPV  20  A 

MUV   SQ  AQ   SP
 A  121.33  140   10
  18.67   10
 186.7  A 
B  80.89  60   7.50
 20.89  7.50
 156.68  F 
MUV  A  B
 186.70  A   156.68  F 
MUV  30.02  A 

208
MYV   SQ  RQ   SP
 A  121.33  120   10
 1.33  10
 13.3  F 
B  80.89  80   7.50
 0.89  7.50
 6.68  F 
MYV  A  B
 13.3  F   6.68  F 
 19.98  F 

MMV   RQ  AQ   SP
 A  120  140   10
  20   10
 200  A 
B  80  60   7.50
 20  7.50
 150  F 
MMV  A  B
 200  A   150  F 
 50  A 

Verification,

MCV = MPV + MUV

50.00  A   20  A   30.02  A 
50.02  A  50.02  A 

MUV = MYV + MMV

30.02  A  19.98  F   50  A 
30.02  A  30.02  A 

Illustration No. 2
The Standard Material cost for 100 Kgs of Chemical D is made up
of :

Chemical A = 30Kg @ `4 per kg

Chemical B = 40Kg @ `5 per kg
Chemical C = 80Kg @ `6 per kg

209
 A batch of 500kg of chemical D was produced from a mix of :

Chemical A = 140Kg at a cost of `588

Chemical B = 220Kg at a cost of `1056
Chemical C = 440Kg at a cost of `2860

How do the yield, mix and the price factor contribute to the
variance in the actual cost per 100kg of chemical D over the standard
cost?

Solution :

A B C
SQ 30 40 80
SP 4 5 6
AQ 140 44 88
28   100
500
AP 588 4.8 6.50
4.2 
140
RQ 32 42.67 85.33

Total Actual Mix = A + B + C

140+220+440
= 800

Total Standard Mix = A + B + C

30+40 +80
= 150

 Actual Mix is given for 500Kg

 Standard Mix is also taken for 500 Kg
150  5  750

Total Quantity of Actual Mix

RQof  A= ×Standard Quantity of A
Total Quantity of Standard Mix
800
=  30  32
750
800
RQof B=  40  42.67
750
800
RQof C=  80  85.33
750

210
MCV   SQ  SP    AQ  AP 
 A  30  4    28  4.20 
 120  117.60
 2.40  F 
B  40  5    44  4.80 
 200  211.20
 11.2  A 
C  80  6    88  6.50 
 480  572
 92  A 
MCV  A  B  C
 2.40  F   11.2  A   92  A 
MCV  100.8  A 

MPV   Sp  AP    AQ 
 A  4  4.2   28
  0.20   28
 5.6  A 
B  5  4.8   44
 0.20  44
 8.8  F 
C  6  6.50   88
  0.50   88
 44  A 
MPV  A  B  C
 5.60  A   8.8  F   44  A 
 40.8  A 

MUV   SQ  AQ   SP
 A  30  28   4
 2  4
 8  F 
B  40  44   5
  4   5
 20  A 

211
C  80  88   6
  8   6
 48  A 
MUV  A  B  C
 8  F   20  A   48  A 
 60  A 

MYV   SQ  RQ   SP
 A  30  32   4
  2   4
 8  A 
B  40  42.67   5
  2.67   5
 13.35  A 
C  80  85.33   6
  5.33   6
 31.98  A 
MYV  A  B  C
 8  A   13.35  A   31.98  A 
 53.33  A 

MMV   RQ  AQ   SP
 A  32  28   4
  4   4
 16  F 
B  42.67  44   5
  1.33   5
 6.65  A
C  85.33  88   6
  2.67   6
 16.02  A
MMV  A  B  C
 16  F   6.65  A   16.02  A 
 6.67  A

212
MCV  MPV  MUV
100.8  A   40.8  A   60  A 
100.8  A   100.8  A 

MUV  MYV  MMV

60  A   53.33  A   6.67  A 
60  A   60  A 

Solution No. 3 :
Sunflower chemical industries provide the following information
from their records. For making 10Kg of CIMCO, Standard material
requirement is :

Material Quantity (Kg) Rate Per Kg (`)

A 8 6
B 4 4

During the year 2012, 1000 Kg of CIMCO were produced the

actual consumption of material is as under

Material Quantity (Kg) Rate Per Kg (`)

A 750 7
B 500 5

Calculate all material variances.

Solution :
Note : Standard is given for 10 KG & actual consumption is given for
1000 Kg

 for calculating RQ, standard converted into for 1000 Kg

Particulars A B
SQ 800 400
SP 6 4
AQ 750 500
AP 7 5
RQ 833 417

213
Standard Quantity for Actual Output SQ

Standard Input
SQ= ×Actual Output
Standard Output
Actualmix
RQRe vised Quantity for A  ×Standard Quantityof  A
Standard mix
1250
 A  ×800=833
1200
1250
B ×400=417
1200

ActualMix750  500  1250

Standard Mix  800  400  1200

MCV   SQ  SP    AQ  AP 
 A  800  6   750  7 
 4800 5250
 450  A 
B  400  4    500  5 
 1600 2500
 900  A 
MCV  A  B
 450  A   900  A   1350  A 

MPV   SP  AP   AQ
 A  6  7   750
  1  750
 750  A
B  4  5   500
  1  500
 500  A 
MPV  A  B
 750  A  500  A 
 1250  A

214
MUV   SQ  AQ   SP
 A  800  750   6
 50  6
 300  F 
B  400  500   4
  100   4
 400  A 
MUV  A  B
 300  F   400  A 
 100  A 

MYV   SQ  RQ   SP
 A  800  833   6
  33   6
 198  A 
B  400  417   4
  17   4
 68  A 
MYV  A  B
 198  A   68  A 
 266  A

MMV   RQ  AQ   SP
 A  833  750   6
 83  6
 498  F 
B  417  500   4
  83   4
 332  A 
MMV  A  B
 498  F   332  A 
 166  F 

215
Verification :

MCV  MPV  MUV

1350  A   1250  A   100  A 
1350  A   1350  A 

MUV  MYV  MMV

100  A   266  A   166  F 
100  A   100  A 

Labour Variances :
Illustration No. 4

A gang of workers usually consists of 10 skilled, S semi-skilled

and 5 unskilled labour in a factory. They are paid at standard hourly rates
of `5.00, `3.20, and `2.80 respectively. In a normal working week of 40
hours, the gang is expected to produce 1000 units of output. in a certain
week, the gang consisted of 13 skilled, 4 semi-skilled and 3 unskilled
labour. Actual wages were paid at the rates of `4.80, `3.40 and `2.60
respectively. Two hours were lost due to abnormal idle time and 960 units
of output were produced. You are required to calculate.

i) LCV, ii) LRV, iii) LEV, iv) LYV, v) LMV

Solution :
Standard is given for 1000 units of output and actual data is given
for 960 units of output.

Standard Hours
SH=Standard hours for ActualOutput= ×Actual Output
Standard Output
Total ActualHours
RH Re vised Hoursof skilled worker 
TotalStandard Hours
×Standard Hoursof skilled worker

(A) Skilled (B) Semi skilled (C) un skilled

SH 40 40 192
 960  10  384  960  5  192
100 100
SR 5 3.20 2.80
AH 38  13  494 38  4  152 38  3  114
AR 4.80 3.40 2.60
RH 40 40 40
  40  10   400   40  5   200   40  5   200
40 40 40

216
LCV   SH  SR    AH  AR 
Skilled  A    384  5    494  4.80 
 1920  2371.20
 451.20  A
SemiSkilled  B   192  3.20    152  3.40 
  614.40   516.80
 97.60  F 
Unskilled  C    192  2.80    114  2.60 
 537.60  296.40
 241.20  F 

LCV  A  B  C
 451.20  A   97.60  F   241.20  F 
 112.40  A 

LEV   SH  AH   SR
A  384  494   5
  110   5
 550  A 
B  192  152   3.2
 40  3.2
 128  F 
C  192  114   2.80
 78  2.80
 218.4  F 
LEV  A  B  C
 550  A   128  F   218.40  F 
 203.60  A

217
LRV   SR  AR   AH
A  5  4.80   494
 0.20  494
 98.80  F 
B  3.20  3.40   152
  0.20   152
 30.40  A 
C  2.80  2.60   114
 0.20  114
 22.8  F 
LRV  A  B  C
 98.80  F   30.40  A   22.8  F 
 91.20  F 

LYV   SH  RH   SR
A  384  400   5
  16   5
 80  A
B  192  200   3.2
  8   3.2
 25.6  A 
C  192  200   2.8
  8   2.8
 22.4  A 
LYV  A  B  C
 80  A  25.6  A   22.4  A 
 128  A 

218
LMV   RH  AH   SR
A  400  494   5
  94   5
 470  A 
B  200  152   3.20
 48  3.20
 153.60  F 
C  200  114   2.80
 86  2.80
 240.8  F 
LMV  A  B  C
 470  A   153.60  F   240.8  F 
 75.6  A

Verification :
LCV  LEV  LRV
112.40  A   203.60  A  91.20  F 
112.40  A   112.40  A 
LEV  LYV  LMV
203.60  A   128  A   75.6  A 
203.60  A   203.60  A 

Illustration No. 5
The following details are available from the records of xyz Co,
engaged in manufacturing Article x for the month ended on April, 2014.

The standard labour hours and rates of payment were as follows :

Particulars Hours Per hour (SR) Total

Skilled (A) 10 3 30
Semi - Skilled (B) 8 1.50 12
Unskilled (C) 16 1 16
58

219
 The actual production was 1000 articles ‘x’ for which the actual
hours worked and rates are given below :

Particulars Hours (AH) Per hour (AR) Total

Skilled (A) 9,000 4 36,000
Semi - Skilled (B) 8,400 1.50 12,600
Unskilled (C) 20,000 0.90 18,000
37,400 66,600

Solution :
Standard given for a single product and actual data given for 1000
articles.

 Standard also take for 1000 articles

ActualOutput
SH  S tan dard Hours for ActualOutput   S tan dard Hours
S tan dard Output
1000
A  10  10000
1
1000
B  8  8000
1
1000
C  16  16000
1
34,000

Actual Mix
RH=Revised Standard hours for labour A= ×SH of A
Standard Mix
Standard Mix=10+8+16=34

Production 1000 units

 S tan dard Mix  34  1000  34000

 ActualMix 37400

37400
 RH of  A   10000  11000
34000
37400
RH of B   8000  8800
34000
37400
RH of C   16000  17600
34000

220
LCV   SH  SR    AH  AR 
A  10000  3    9000  4 
 30000  36000
 6000  A 
B  8000  1.50    8400  1.50 
 12000  12600
 600  A 
C  16000  1   20000  0.90 
 16000  18000
 2000  A 
LCV  A  B  C
 6000  A   600  A   2000  A 
 8600  A 

LEV   SH  AH   SR
A  10000  9000   3
 1000  3
 3000  F 
B  8000  8400   1.50
  400   1.50
 600  A 

C  16000  20000   1

  4000   1
 4000  A 
LEV  A  B  C
 3000  F   600  A  4000  A 
 1600  A 

221
LRV   SR  AR   AH
A  3  4   9000
  1  9000
 9000  A 
B  1.50  1.50   8400
 0  8400
 NIL
C  1  0.90   20000
 0.10  20000
 2000  F 
LRV  A  B  C
 9000  A   NIL  2000  F 
 7000  A 

LYV   SH  RH   SR
A  10000  11000   3
  1000   3
 3000  A
B  8000  8800   1.50
  800   1.50
 1200  A
C  16000  17600   1
  1600   1
 1600  A
LYV  A  B  C
 3000  A  1200  A   1600  A 
 5800  A

222
LMV   RH  AH   SR
A  11000  9000   3
 2000  3
 6000  F 
B  8800  8400   1.50
 400  1.50
 600  F 
C  17600  20000   1
 2400  A   1
 2400  A 
LMV  A  B  C
 6000  F   600  F   2400  A 
 4200  F 

Verification :

LCV  LEV  LRV

8600  A   1600  A   7000  A
8600  A   8600  A 
LEV  LYV  LMV
1600  A   5800  A   4200  F 
1600  A   1600  A 

Both Material & Labour Variances

Illustration No. 6 :
The Standard Cost of a product Material Cost 2Kg @ `2.50 each `5
per unit Wages : 2 hours @ `1.00 each `2.00 per unit. The actual which
have emerged from business operations are as follows :

Production 8000 units

Material Consumed 16500 Kg @ `2.40 each `39,600.
Wages paid 18000 hours @ `1.20 each `21600.

You are required to compute material and labour Variances.

Solution :
Note : Standard is given for a product & the actual data is given for 8000
units. So the standard is also converted into 8000 units of production.
SQ = 2Kg per unit × 8000 = 16000 Kgs
5
SR / SP = 2Kgs `5 per unit :  2.5
2
223
AQ = 16500
AP = 2.40

SH = 2 hours per unit × 8000 = 16000 hours

2hours
SR 1
2 perunit
AH  18000
AR  1.20

MCV   SQ  SP    AQ  AP 
  16000  2.5    16500  2.40 
 40000  39600
 400  F 
MPV   SP  AP   AQ
  2.5  2.40   16500
 0.10  16500
 1650  F 
MUV   SQ  AQ   SP
  16000  16500   2.5
  500   2.5
 1250  A 

MCV  MPV  MUV

400  F   1650  F   1250  A 
400  F   400  F 

LCV   SH  SR    AH  AR 
  16000  1   18000  1.20 
 16000  21600
 5600  A 
LEV   SH  AH   SR
  16000  18000   1
  2000   1
 2000  A

224
LRV   SR  AR   AH
  1  1.20   18000
  0.20   18000
 3600  A 

LCV  LEV  LRV

5600  A   2000  A   3600  A 
5600  A   5600  A 

Illustration No. 7 :
The following details relating to a product available to you.

Material 50Kg @ 40 per Kg

Labour 400 hours @ `1 per hour
Actual Cost
Material 4900 Kg @ 42 per Kg
Labour 39600 hours @ `1 per hour
Actual Production 100 units
Calculate all material and labour variances

Solution :
Standard is given for a product and actual is given for 100 units.

Material - SQ = 50 × 100 = 5000

SR = 40
AQ = 4900
AR = 42
Labour - SH = 400 × 100 = 40000
SR = 1
AH = 39600
AR = 1

MCV   SQ  SP    AQ  AP 
  5000  40    4900  42 
 200000  205800
 5800  A 

MPV   SP  AP   AQ
  40  42   4900
  2   4900
 9800  A 

225
MUV   SQ  AQ   SP
  5000  4900   40
 100  40
 4000  F 

MCV  MPV  MUV

5800  A   9800  A   4000  F 
5800  A   5800  A 

LCV   SH  SR    AH  AR 
  40000  1   39600  1
 40000  39600
 400  F 
LEV   SH  AH   SR
  40000  39600   1
 400  1
 400  F 
LRV   SR  AR   AH
  1  1  39600
 0  39600
 NIL

LCV  LEV  LRV

400  F   400  F   NIL
400  F   400  F 

Illustration No. 8 :
XYZ Ltd. operates an standard costing system. The budgeted
overheads for the current year were fixed at `520000 with a predetermined
overheads recovery rate of `8 per direct labour hour. The actual direct
labour hours for the year amounted to 72000 against which only 71500
hours should haves been spent for the production completed during the
year. The actual overhead rate worked out at `7.75 per direct labour hour.
You are required to compute all possible overheads variances.

Solution :

Standard Overheads  SO  =SH×SR

=71500×8=572000

226
Recovered Overheads  RO  =AH×SR
=72000×8=576000

` 520000
Budgeted Overheads BO    65000  BH 
8

ActualOverheads AO   AH  AR
 72000  7.75
 558000

TOV  SO  AO
 572000  558000  14000  F 
TVV  SO  BO
 572000  5,20,000
 52000  F 
TEV  BO  AO
 520000  558000
 38000  A 
TEFV  SO  RO
 572000  576000
 4000  A 
TCV  RO  BO
 576000  520000
 56000  F 

Verification :
TOV  TVV  TEV
14000  F   52000  F   38000  A 
14000  F   14000  F 
TVV  TEFV  TCV
52000  F   4000  A  56000  F 
52000  F   52000  F 

Illustration No. 9
Fixed Overheads Variance

From the following information, compute fixed overhead cost,

Expenditure and Volume Variance : Normal Capacity is 10000 hours,
Budgeted Fixed Overhead Rate is `20 per Standard Hour.

227
 Actual level of capacity utilised is 8800 standard hours. Actual
fixed overhead is `104000

Solution :

SH = 8800
Standard Overhead Rate (SR) = 20
Budgeted Hours (BH) = 10000
Actual Fixed Overhead (AFO) = 104000

FOV   SH  SR   AFO
  8800  20   104000
 176000  104000
 72000  F 

Fixed Overheads Expenditure Variance

FDEV   BH  SR   ActualFO
  10000  20   104000
 200000  104000
 96000  F 

Fixed Overheads Volume Variance (FVV)

 S tan dard FO  Budgeted FO
  8800  20    10000  20 
 176000  200000
 24000  A 

Verification :

FOV  FOEV  FVV

72000  F   96000  F   24000  A 

Illustration No. 10
(Variable Overheads Variances)

The following data is given

Particulars Budgeted Actual

Production (in units) 4,000 3,600
Man hours to produce above 80,000 70,000
Variable Overheads (`) 1,00,000 91,500

228
 The standard time to produce one unit of the product is 200 hours.
Calculate variable overheads variances.

Solution :

SH=Standard Hours for Actual Production

=200  3600=72000
Budgeted Overheads 100000
SR=   1.25Per Hour
Budgeted Hours 80000
ActualOverheads 91,500
AR    1.307PerHour
ActualHours 70,000
AH  70000

Variable Overhead Variance (VOV)

  SH  SR    AH  AR 
 72000  1.25   70000  1.307 
 90000  91500
 1500  A 

Variable Overhead Efficiency Variance (VEFV)

  SH  AH   SR
 72000  70000   1.25
 2000  1.25
 2500  F 

Variable Overhead Expenditure Variance (VEXV)

  SR  AR   AH
  1.25  1.307   70000
  0.057   70000
 4000  A 

Verification
VOV  VEFV  VEXV
1500  A   2500  F   4000  A 
1500  A   1500  A 

8.5 ADVANTAGES OF STANDARD COSTING

The following are the advantages of Standard Costing -

1) Analysis of variance is useful for cost control, Cost reduction and
increase of profitability.

229
2) The standard provide incentive and motivation to work, as every
workman tries to achieve the standard set for him; which helps in the
increase of efficiency and productivity.
3) Cost information is kept ready under this system. The promptness of
cost information helps in various other fields of costing e.g. fixation
of selling prices, valuation of work in progress, etc.
4) It helps in budgetary control and in decision making.
5) On account of valuation of opening and closing stock of the standard
price, the profits are balanced and the Profit & Loss A/c can be
prepared at easy intervals if required.

8.6 LIMITATION / DISADVANTAGES OF STANDARD

COSTING

1) Setting up standard is a difficult task. Establishment of current

standard is all more difficult something which is a standard for Mr. A
may not be a standard for Mr. B.
2) Standard, once set are not changed for a considerable period. This
make the standard rigid and un-realistic in certain industries which
face fluctuations in product pricing due to frequent changes in the
price of material and labour. Revision of standards is not easy and the
revision costs high.
3) Standards set low are ridiculed at, and standards set high cause
frustration and disbelief in the minds of workers.
4) This method of costing is hardly used by small manufactures who
constitute a majority group among businessmen.
5) When production takes more than one accounting period. It is very
difficult to apply this method.

8.7 DISTINGUISH BETWEEN STANDARD COSTING &

BUDGETARY CONTROL :

Standard Costing Budgetary Control

1. It involves estimation of costs It is concerned with all functional
of products and services. Its areas of the business and it also
scope is limited to costs only. includes estimation of revenue as
well as income. It covers all the
areas or activities such as
production, sales, purchases,
research & development and so
on.

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 2. Control is exercised by Control is exercised by
comparing actual costs with comparing Actual with budgeted
standard costs of actual output figures.
3. It is more intensive in nature It is more extensive in nature
with its focus on costs. with its focus on entire business
4. Standard costing is a projection It is a projection of financial
of cost accounts accounts.
5. It requires standardization of It does not involve
production standardization of products.
6. In standard costing both Budgets concentrate only on
positive and negative variances negative variances, i.e. when
are considered actual costs are more than
budgeted.

I) Theory Question :
1) Distinguish between Standard Costing & Budgetary Control.
2) What are the advantages and disadvantages of Standard Costing?
3) What is standard costing? Explain in short importance of
standard costing.
4) Explain in detail material variances.
5) Write short note on material cost variances.
6) Write a note on Labour variances.
7) What is Standard Costing? Explain in details the types of
standards.
8) Write a note on Standard hours.
9) What are the limitations of Standard Costing?
10) Explain in details overheads variances.
11) What is the difference between variable overheads variances and
fixed overheads variances?

II) Multiple Choice Questions :

1) The Standard which can be attained under the most favourable
conditions possible -------------------.
a) Ideal Standard b) Expected Standard
c) Current Standard d) Normal Standard

2) A Standard which is established for use unaltered for an

indefinite period is called --------------------
a) Current Standard b) Ideal Standard
c) Basic Standard d) Expected Standards

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3) The cost of product as determined under Standard Cost System is ------
--------------.
a) Fixed Cost b) Historical Cost
c) Direct Cost d) Predetermined Cost

4) The amount of work achievable in an hour, at standard efficiency

levels is ------------------
a) an ideal standard
b) The direct labour usage per hour
c) A standard hour
d) The direct labour efficiency variance

5) While calculating variances from standards costs, the difference

between the actual and the standard price multiplied by the actual
quantity yields a ---------------------.
a) Yield variance b) Volume variance
c) Mix Variance d) Price variance

6) While evaluating deviations of actual cost from standard cost, the

technique used is, --------------------.
a) Regression analysis b) Variance analysis
c) Linear Progression d) Trend analysis

7) The labour cost variances may be expressed as ----------------.

a) Budgeted labour cost - Actual labour cost
b) (Standard wage rate × Output achieved) - Actual wage cost
c) (Standard hours - Actual hours) × Actual wage rate
d) (Standard hours - Actual hours) × Standard wage rate

8) When the variance is due to the difference between actual

overhead and applied overhead it is called ------------------.
a) Volume variance b) Total Overhead variance
c) Spending Variance d) Efficiency variance

9) If the number of standard allowed hours equal the planned activity

level of hours, then the fixed overheads volume variance is -----------.
a) Zero
b) Favrourable
c) Unfavourable
d) Equal to fixed overhead expenditure variance

10) The difference between budgeted fixed overhead costs and applied
fixed overhead costs is known as
a) Fixed overhead costs variances
b) Fixed overheads expenditure variance
c) Fixed overhead volume variance
d) Fixed overhead efficiency variance

Ans. 1-a, 2-c, 3-d, 4-c, 5-d, 6-b, 7-b, 8-b, 9-a, 10-c.

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III) State whether the following statements are True or False.
1) A basic standard is the standard which is “established for use over a
short period of time.”
2) A basic standard is the standard “which can be attained under the most
favourbale conditions possible.”
3) Material yield variance is equal to (Standard Quantity-Actual
Quantity) × Standard Price
4) Material yield variance is further divided into a) material usage
variance and b) material mix variance.
5) Revised Standard Quantity for each input is required to be computed
for calculating material yield variance.
6) Labour cost variance is further divided into a) Labour yield variance
and b) Labour Rate Variance.
7) Overhead variance is nothing but the variation in absorption or
recovery of overheads.

Ans. True - 7
False - 1,2,3,4,5,6
Practical Problem :
1) Standard material for 100 Kg Chemical x is given below :
90 Kgs of material A at `8 per Kgs `720
80 Kgs of material B at `16 per Kgs `1280
50 Kgs of material C at `24 per Kgs. `1200
220
(-) 20 Standard Loss -
200 `3200
Actual Production is 4000 units of Chemical x and actual material
usage is as follows :
2000 Kgs of material A at `7.60 per Kgs `15200
1700 Kgs of material B at `16.80 per Kgs `28560
900 Kgs of material C at `26 per Kgs. `23400
67160
Calculate all material variances.
2) A manufacturing company uses the following standard mix of their
compound in one batch of 200 Kgs of its production line :
100 Kgs of material x at standard price of `2
60 Kgs of material y at standard price of `3
40 Kgs of material z at standard price of `4
The actual mix for a batch of 240 Kgs was as follows :
120 Kgs of material x at the price of `3
80 Kgs of material y at the price of `2.5
20 Kgs of material z at the price of `3
Calculate the different material variances.

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3) The standard material required to manufacture one unit of product A is
5 Kgs and the standard price per kgs of material is `3.00. The cost
accounts, records, however, reveal that 16000 Kgs,of material costing
`52000 were used for producing 3000 units of product A. Calculate
the material variances.
4) Using the following information, calculate labour variances.
Gross direct wages `3000
Standard hours produced 1600
Standard rate per hour - `1.50
Actual hours paid 1500 hours out of which hours not worked.
(Abnormal idle time) are 50.
5) From the following records of the SS Manufacturing Company you are
required to compute material and labour variances.
Input - 200 Kg of material yields a standard output of 20000 unit
standard price per Kg of Material `20
Actual quantity of material issued & used by production
department 20000 Kg
Actual price per kg of material `21
Actual output 18,00,000 units
Number of Employees 400
Standard wage rate per employee per day `4
Standard daily output per employee per day 200 units
Total number of Days worked 50 days
Idle time paid for and included in above half day.
Actual wage rate per day `4.50
6) The following details relating to a product are made available to you :
Standard cost per unit
Material 100 kg @ `20 per kg
Labour 800 hours @ `2 per hour
Actual Cost
Material 9800 Kgs @ `21 per kg
Labour 79200 hours @ `2 per hour
Actual production 200 units
You are required to calculate :
i) Material cost variance
ii) Material Price variance
iii) Material Usage variance
iv) Labour cost variance
v) Labour Rate Variance
vi) Labour Efficiency Variance

7) The following standards have been set to manufacture a

product :
Direct Material
4 units of A at `4 per unit
6 units of B at `3 per unit
30 units of C at `1 per unit

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 Direct labour 3 hours @ `8 per hour.
Total standard Prime Cost.
Manisha Ltd. manufactured and sold 12000 units of the product
during the year.
Direct material cost were as follows :
25000 units of A at `4.40 per unit
36000 units of B at `2.80 per unit
177000 units of C at `1.20 per unit

The company worked 17500 direct labour hours during the year. For
2500 of these hours, the company paid `12 per hour while for the
remaining the wages were paid at the standard rate. Calculate all possible
variances of material and labour.

8) Koran Chemical Co. gives you the following standard and actual data
of Chemical Gem Co.
Standard Data
4500 Kg of Material A @ `2 per kg - 9000
3600 Kg of Material B @ `1 per kg - 3600
8100 12600

24000 skilled hours @ `2.10 50400

12000 unskilled hours @ `1.2 14400 64800
900 Normal loss
7200 77400

Actual Data
4500 Kgs of Material A @ `1.90 per Kgs. 8550
3600 Kgs of Material B @ `1.1 per Kgs 3960
8100 12510

24000 skilled hours @ `2.2 52800

12000 unskilled hours @ `1.25 15000 67800
500 Actual Loss
7600 80310

You are required to calculate :

i) Material cost variance
ii) Material price variance
iii) Material yield variance
iv) Material usage variance
v) Material mix variance
vi) Labour cost variance
viii)Labour rate variance
viii)Labour mix variance


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