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1.1 INTRODUCTION: After passing your senior secondary examination, if you set up a small manufacturing unit, say manufacturing of packing boxes, a problem will arise what price of each box you should quote to the buyer. Many factors are considered while fixing the price of a product/item such as competitors price etc. One of the basic factors is the cost of its production. Cost is essential not only to fix price but also to ascertain the margin of profit. Knowledge of the cost determination is also necessary to keep a check on the cost of product/control on wastages, etc. The accounting used to study the various aspects of cost is known as cost accounting. In this lesson, you will learn about meaning, importance, limitations etc. of cost accounting.

1.2 MEANING OF COST, COST ACCOUNTANCY AND COSTING The term cost means the amount of expenses [actual or notional] incurred on or attributable to specified thing or activity. As per Institute of cost and work accounts (ICWA) India, Cost is measurement in monetary terms of the amount of resources used for the purpose of production of goods or rendering services. To get the results we make efforts. Efforts constitute cost of getting the results. It can be expressed in terms of money; it means the amount of expenses incurred on or attributable to some specific thing or activity. The term cost is used in this very form. In reference to production/manufacturing of goods and services cost refers to sum total of the value of resources used like raw material and labour and expenses incurred in producing or manufacturing of given quantity. COST ACCOUNTANCY The terminology of cost accountancy published by the Institute of Cost and Management Accountants, London 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. It includes the presentation of information derived therefrom for the managerial decision-making. On analysis of the above definition, the following features of cost accountancy become evident : (a) Cost accountancy is used in the broadest sense when compared to cost accounting and costing. This is so because cost accountancy is concerned with the formulation of principles, methods and techniques to be applied for ascertaining cost and profit. (b) Having ascertained cost and profit, cost accountancy is concerned with presentation of information to management. To enable management to carry out its functions, reports must be promptly made available at the right time, to the right person and in a proper from. (c) The information so provided is to serve the purpose of managerial decision making such as introducing a new line of product, replacement of manual labour by machines, make or buy, decisions, etc.

COSTING: Costing includes the techniques and processes of ascertaining costs. The Technique refers to principles which are applied for ascertaining costs of products, jobs, processes and services. The `process refers to day to day routine of determining costs within the method of costing adopted by a business enterprise. Costing involves the classifying, recording and appropriate allocation of expenditure for the determination of costs of products or services; the relation of these costs to sales value; and the ascertainment of profitability. 1.3 MEANING OF COST ACCOUNTING: Cost accounting is the process of determining and accumulating the cost of product or activity. It is a process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and interpretation of cost. In other words, it is a system of accounting, which provides the information about the ascertainment, and control of costs of products, or services. It measures the operating efficiency of the enterprise. It is an internal aspect of the organisation. Cost Accounting is accounting for cost aimed at providing cost data, statement and reports for the purpose of managerial decision making. The Institute of Cost and Management Accounting, London defines Cost accounting is the process of accounting from the point at which expenditure is incurred or committed to the establishment of its ultimate relationship with cost centres and cost units. In the widest usage, it embraces the preparation of statistical data, application of cost control methods and the ascertainment of profitability of activities carried out or planned.

1.4 SCOPE OF COST ACCOUNING: The terms costing and cost accounting are many times used interchangeably. However, the scope of cost accounting is broader than that of costing. Following functional activities are included in the scope of cost accounting: 1. Cost book-keeping: It involves maintaining complete record of all costs incurred from their incurrence to their charge to departments, products and services. Such recording is preferably done on the basis of double entry system. 2. Cost system: Systems and procedures are devised for proper accounting for costs. 3. Cost ascertainment: Ascertaining cost of products, processes, jobs, services, etc., is the important function of cost accounting. Cost ascertainment becomes the basis of managerial decision making such as pricing, planning and control. 4. Cost Analysis: It involves the process of finding out the causal factors of actual costs varying from the budgeted costs and fixation of responsibility for cost increases. 5. Cost comparisons: Cost accounting also includes comparisons between cost from alternative courses of action such as use of technology for production, cost of making different products and activities, and cost of same product/ service over a period of time. 6. Cost Control: Cost accounting is the utilisation of cost information for exercising control. It involves a detailed examination of each cost in the light of benefit derived from the incurrence of the cost. Thus, we can state that cost is analysed to know whether the current level of costs is satisfactory in the light of standards set in advance.

7. Cost Reports: Presentation of cost is the ultimate function of cost accounting. These reports are primarily for use by the management at different levels. Cost Reports form the basis for planning and control, performance appraisal and managerial decision making. 1.5 OBJECTIVES OF COST ACCOUNTING There is a relationship among information needs of management, cost accounting objectives, and techniques and tools used for analysis in cost accounting. Cost accounting has the following main objectives to serve: 1. Determining selling price, 2. Controlling cost 3. Providing information for decision-making 4. Ascertaining costing profit 5. Facilitating preparation of financial and other statements. 1. Determining selling price The objective of determining the cost of products is of main importance in cost accounting. The total product cost and cost per unit of product are important in deciding selling price of product. Cost accounting provides information regarding the cost to make and sell product or services. Other factors such as the quality of product, the condition of the market, the area of distribution, the quantity which can be supplied etc., are also to be given consideration by the management before deciding the selling price, but the cost of product plays a major role. 2. Controlling cost Cost accounting helps in attaining aim of controlling cost by using various techniques such as Budgetary Control, Standard costing, and inventory control. Each item of cost [viz. material, labour, and expense] is budgeted at the beginning of the period and actual expenses incurred are compared with the budget. This increases the efficiency of the enterprise. 3. Providing information for decision-making Cost accounting helps the management in providing information for managerial decisions for formulating operative policies. These policies relate to the following matters: (i) Determination of cost-volume-profit relationship. (ii) Make or buy a component (iii) Shut down or continue operation at a loss (iv) Continuing with the existing machinery or replacing them by improved and economical machines. 4. Ascertaining costing profit Cost accounting helps in ascertaining the costing profit or loss of any activity on an objective basis by matching cost with the revenue of the activity. 5. Facilitating preparation of financial and other statements Cost accounting helps to produce statements at short intervals as the management may require. The financial statements are prepared generally once a year or half year to meet the needs of the management. In order to operate the business at high efficiency, it is essential for management to have a review of production, sales and operating results. Cost accounting provides daily, weekly or monthly statements of units produced, accumulated cost with analysis. Cost accounting system provides immediate information regarding stock of raw material, semifinished and finished goods. This helps in preparation of financial statements.

1.6 NEED FOR COST ACCOUNTING The need for cost accounting arises owing to the following : [A]To Overcome the Limitations of Financial Accounts Financial accounting records in an overall manner the results of the operations of a business, using conventional double entry book-keeping techniques. It suffers from the following limitations : (i) It provides only past data : Financial accounts provide out of date information to management. But management is interested in current data but not past data as it does not serve any purpose to it. Therefore it has been rightly pointed out that financial accounts provide only a post-mortem analysis of past activities. (ii) It reveals only over all result of the business : Financial accounts does not provide data for each and every product, process, department or operation separately. Instead it provides the financial information in a summary form for the entire organisation as a whole. (iii) It is static in nature : Modern business is dynamic but not static. Financial accounts does not incorporate the changes that take place within the business. (iv) It fails to take into account the impact of price level change : In the modern inflationary conditions the price level has significant impact over financial statement. Under financial accounts, assets are shown at the actual or historical cost. Consequently depreciation is also charged on actual or historical cost. This under charging of depreciation will distort the profit figure. (v) Possibility of manipulation of financial accounts : Very often financial accounts are manipulated at the whims and fancies of management so as to project better image in the minds of prospective investors. The chief forms of manipulating the financial accounts assume the form of over or undervaluation of inventory, excessive or inadequate provision for depreciation, creation of secret reserves, etc. (vi) It fails to exercise control over resources : Financial accounts fail to exercise control over materials, labour and other expenses incurred in a business enterprise. As a results, avoidable wastages and losses go unchecked under this system of accounts. (vii) It fails to provide adequate data for price fixation : Financial accounts fail to provide adequate cost data on the basis of which selling price is fixed. In the absence of fixation of prices in advance, it is not possible to supply quotations to the prospective customers. To that extent the income from such sales diminish. (viii) It fails to provide adequate data for management in carrying out its functions : Management of every organisation relies heavily on adequate cost data for formulating policies and in decisionmaking process. But financial accounts fails to provide such useful cost data to management. (ix) It does not provide a basis for cost comparison : Financial accounts does not help in cost comparison over a period of time or between two jobs or two operations. Thus a basis for judging the efficiency of an year with past year or worthfulness of two different jobs or operations cannot be appraised. (x) It does not make use of control techniques : Financial accounts fail to make use of certain important cost control techniques such as budgetary control and standard costing. Thus financial accounts do not facilitate measuring the efficiency of the business with the help of control techniques. (xi) It fails to ascertain break-even point : Financial accounting does not help in ascertaining the break-even point, i.e., the sale or output where the revenue equals the cost. Hence, the point of noprofit-no-loss cannot be made out under financial accounts.

[B]To Ensure Optimum Utilisation of Resources In todays business world, the resources available are very scarce. Hence every business unit must strive hard to obtain maximum output with the available input. In order to ensure the optimum utilisation of scarce resources, the value of input is measured against the value of output. This implies matching cost per unit of production against the value of output or selling price. But financial accounts does not provide the information relating to cost per unit of production. Hence the need for cost accounting was felt necessary. [C]To Achieve Overall Efficiency of Business Every businessman will make constant effort to improve his business. In order to formulate suitable policy and sound decision, he has to know answers to certain questions such as (a) What is the maximum profit which a business can make? (b) Is the profit earned by it is more or less compared to the earlier years? (c) Which product line is making more profit? (d) Has too much capital is blocked in raw materials? (e) Whether the cost of production has gone up compared to earlier years? (f) Should the selling price requires revision? Cost accounting serves as an useful tool in the hands of management in this direction. By analysing the cost of production of every unit, it helps management to know the answers to the above questions. 1.7 GROWTH AND DEVELOPMENT OF COST ACCOUNTING The history of cost accounting can be traced back to the fourteenth century. In the course of its evolution it passed through following stages. (1) In the first stage of its development, cost accounting was concerned only with the three prime cost elements, viz., direct material cost, direct labour cost and direct expenses. For recording the transactions relating to materials the important documents used were (a) stores ledger, (b) a material requisition note, and (c)materials received note. To account for labour cost, employee time card and labour cost card were devised by Mr. Metcalfe. Later on a distinction between manufacturing and non-manufacturing cost was made by Mr. Norton. Thus material cost, labour cost and manufacturing cost constituted prime cost. (2) Secondly, around the turn of the nineteenth century, the importance of nonmanufacturing cost (overheads) was recognised as one of the distinct element of cost. The method of charging nonmanufacturing cost to the production cost was devised under this stage. (3) Thirdly, the techniques of estimation and standards are devised. Instead of using actual cost, standard costs are used and by comparing with the actual cost the differences are noted, analysed and disposed off accordingly. This helps in knowing the efficiency of the business undertaking. (4) Fourthly, cost accounting methods were applied to all types of business undertakings. The costing principles and techniques were also extended to important functions of a business. (5) In modern times the development of electronic data processing has occupied significant stage in the growth of cost accounting system. 1.8 COST ACCOUNTING IN INDIAN CONTEXT The application of cost accounting methods in Indian industries was felt from the beginning of the twentieth century. The following factors have accelerated the system of cost accounting in our country.

(a) Increased awareness of cost consciousness by Indian industrialists with a view to ascertain costs more accurately for each product or job. (b) Growing competition among manufacturers led to fixation of prices at a lower level so as to attract more customers. (c) Economic policy of government which laid emphasis on planned economy with a view to achieve the targets led to cost reduction programmes by Indian industrialists. (d) Increased government control over pricing led the Indian manufacturers to give utmost importance to the installation of cost accounts. (e) The establishment of National Productivity Council in 1958 and the Statutory Recognition of Institute of Cost and Works Accountants of India in 1959 gave further encouragement to install cost accounting system in Indian industries.

1.9 DIFFERENCES BETWEEN COST ACCOUNTANCY, COSTING AND COST ACCOUNTING Points of Differences 1. Scope Cost Accountancy is It is broader in its It is narrow in its broadest in its scope. scope. scope. It is concerned with It is concerned with It is concerned with formulation of costing ascertainment of cost. recording of cost. principles, methods, techniques to be adopted by the business. It begings where cost It begin where costing accountancy ends. ends. Cost Accountancy Costing Cost Accounting




Periodicity of It is starting point. functioning Persons involved


The persons involved The persons involved The persons involved are the experts in the are cost accountants. are cost clerks. feild of cost accountancy such as management


1.10 COST CONTROL: According to Kohler, cost control represents the employment of management devices in the performance of any necessary operation so that pre-established objectives of quality, quantity and time may be attained at the lowest possible outlay for goods and services. The terminology published by ICMA, London, defines cost control as The guidance and regulation by executive action of the cost of operating an undertaking. Acccording to this definition, cost control aims at guiding the actuals towards the lines of target and regulates the actuals if they deviate from the targets. This guidance and regulation is done by the executive who is responsible for causing the deviation. This process will become clear by enumerating the steps involved in any cost control technique. (a) Fixation of targets in terms of cost and production performance. (b) Ascertaining the actual cost and production performance. (c) Comparison of actuals with the targets. (d) Analysing the variance by causes and the person responsible for it. (e) Taking remedial steps to set right unfavourable variations. Cost control is exercised through a variety of techniques such as inventory control, quality control, budgetary control, standard costing, etc. The advantages of cost control are as follows : (a) It helps in utilising the resources to the full extent. (b) It helps in reduction of prices which are benefited by customers. (c) It helps in competing successfully in the market. (d) It increases the profit earning capacity of the business. (e) It increases the goodwill of the business. 1.11 RELATIONSHIP BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING Cost accounting is very closely-related to financial accounting. Some authorities on the subject consider cost accounting to be the branch of financial accounting. But it may be said that cost accounts is complementary to financial accounts, i.e., a subject which is necessary to make financial accounts whole or complete. Financial accounts and cost accounts are both similar in certain respects. But in some other respects they differ from one another. These points of similarities and dissimilarities and enumerated below :

Points of Similarities (a) The fundamental principles of double entry is applicable in both the systems of accounts. (b) The invoices and vouchers constitute the common basis for recording transactions under both the systems of accounts. (c) The results of business are revealed by both the systems of accounts. (d) The causes for losses and wastages of a business are provided by both these systems of accounts. (e) The determination of future business policy is guided by both these systems of accounts. (f) A basis for comparison of expenses is being provided by both the accounting systems. (g) Accuracy of accounts is maintained under both the systems by means of exercising check over errors and commissions which might creep in either of accounts. BASIS OF DIFFERENCE FINANCIAL ACCOUTING COST ACCOUTING



It provide information about It provides information for the the enterprise in a general way guidance of management for i.e. profitability, assets, the proper planning, liabilities, owners fund etc. operation,co-ordination, control and decision making. OF P & L A/C and B/S are kept as These are kept as per the per the companies Act and requirement of the income tax act. management. Recently the companies act has made it obligatory to keep costing records in some manufacturing companies. These are kept in a subjective These are kept in objective manner i.e. according to the manner i.e. according to the nature of the expenditure. purpose for which costs are incurred. Items of cost are expressed in Items of costs are analysed, total. classified, apportioned and allocated in order to calculate the cost per unit. OF These reveals to the profit of It is only a part of financial the whole business. accounts. It shows the result of each operation, process, job or product so that unprofitable lines of business can be eliminated. Emphasis on recording only. It provides a detailed system of No importance to control cost control with help of aspect. standards and budgets. These are prepared at the end It is continuous system of of accounting year. accounting and submits the cost reports to the management weekly or monthly and as when desired. OF 1. These relate to 1. commercial transaction of business. These are concerned 2. with transactions relating to third party. These related manufacturing activities. to
















These are concerned with internal transactions.



Inventory is valued at cost or Inventory is valued at cost. market price whichever is less.



These deals with actual figures. These deal partly with actual figures and partly with estimates.

1.12 DIFFERENCES BETWEEN COST AND MANAGEMENT ACCOUNTING The American Accounting Association 1958, committee on management accounting defines management accounting as the application of appropriate techniques and concepts in processing the historical and projected economic data of an entity to assist management in establishing a plan for reasonable economic objectives and in the making of rational decisions with a view towards achieving these objectives. It includes the methods and concepts necessary for effective planning for choosing among alternative business actions, and for control through the evaluation and interpretation of performance. Its study involves consideration of ways in which accounting information may be accumulated, synthesised, analysed and presented in relation to specific problems, decisions and day-to-day tasks of business management. The terminology published by ICMA, London, defines management accounting as the application of professional knowledge and skill in the preparation and presentation of accounting information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of the undertaking. If we examine the above two definitions of management accounting it appears that both the systems of accounts serve the same purpose. However, they differ from one another in respect of the following : BASIS OF DIFFERENCE COST ACCOUTING MANAGEMENT ACCOUTING


Growth of Accounting The history of cost accounting This system of accounting dates back to fourteenth evolved in the middle of 20th century century. Hence it is of recent origin where compared to cost accounting.



The main objects of cost The main objective of accounts is to ascertain and management accounting is to control cost. provide useful information . to management for decisionmaking


Basis of recording

It is based on both present and It is concerned purely with the future transactions relating to future. transactions ascertainment. for cost



Cost accounts has narrow It has a wide scope in as much scope as it covers matters as it covers relating to ascertainment of areas of financial accounts , cost

and control of cost 5.

cost accounts, taxation, etc.

Observation of Cost accounts follow a definite It does not follow a definite principle and format principle for ascertaining cost principle and format Instead, and a format for recording. the data to be presented depends up on the need of the management.

1.13 ADVANTAGES OF COST ACCOUNTING A good costing system serves the needs of large sections of people. The advantages of cost accounting are discussed below. Advantages of Cost Accounting to Management 1. Fixation of responsibility: Whenever a cost centre is established, it implies establishing a kind of relationship between superior and subordinates. Thus responsibilities are fixed on every individual who is concerned with incurrence of cost. 2. Measures economic performance: By applying cost control techniques such as budgetary control and standard costing it helps in assisting the performance of business. 3. Fixation of price: By providing cost data it helps management to fix the selling price in advance. Hence, quotations can be supplied to prospective customers to secure orders. 4. Aids in decision-making: It helps management in making suitable decisions such as make or buy, replace manual labour by machines, shut down or continue operations based on cost reports. 5. Helps in the preparation of interim final accounts: By the process of continuous stock taking it enables to know the value of closing stock of materials at any time. This facilitates preparation of final accounts wherever desired. 6. Helps in minimising wastages and losses: Cost accounting system enables to locate the losses relating to materials, idle time and under utilisation of plant and machinery. 7. Facilitates comparison: It facilitates cost comparison in respect of jobs, process, and departments and also between two periods. This reveals the efficiency or otherwise of each job process or department. 8. Assists in increasing profitability: Costing reports provide information about profitable or unprofitable areas of operation. The management can discontinue that product line or that department which are responsible for incurring losses. Thereby only profitable line of activities alone are retained. 9. Reconciliation with financial accounts: A well maintained cost accounting system facilitates reconciliation with financial accounts to check the arithmetical accuracy of both the systems. 10. It guides future production policy: Cost data help management in determining future production policy. Any expansion or contraction of production for the future is based on past cost data.

Advantages to Employees 1. Cost accounting system enables employees to earn better wages through overtime wages and incentive systems of wage payment. 2. By providing better facilities it ensures job security to employees. 3. Employees benefit by merit rating techniques which is conducted by scientific process. Advantages to Creditors 1. It increases the confidence of creditors in the capital employed in the business. 2. The frequent preparation of reports and statements help in knowing solvency position of the business. Advantages to the Government 1. It helps government in formulating policies regarding export, import, taxation, price control measures, wage fixation, etc. 2. It helps in assessing excise duty, sales tax and income tax of the business. 3. Costing information helps in preparing national plans. Advantages to Society 1. Cost reduction and cost control programmes go to minimise cost of production of goods and services. A portion of the reduced cost of production is shared by customers by paying less price for goods and services. 2. It offers employment opportunities in the cost accounting department in the capacity of cost accountants and cost clerks. 1.14 LIMITATIONS OF COST ACCOUNTING 1. It is expensive : The system of cost accounting involves additional expenditure to be incurred in installing and maintaining it. However, before installing it, care must be taken to ensure that the benefits derived is more than the investment made on this system of accounting. 2. The system is more complex : As the cost accounting system involve number of steps ascertaining cost such as collection and classification of expenses, allocation and apportionment expenses, it is considered to be complicated system of accounts. Moreover the system makes use several documents and forms in preparing the reports. This will tend to delay in the preparation accounts. in of of of

3. Inapplicability of same costing method and technique : All business enterprises cannot make use of a single method and technique of costing. It all depends upon the nature of business and type of product manufactured by it. If a wrong technique and method is used, it misleads the results of business. 4. Not suitable for small scale units : A cost accounting system is applicable only to a large-sized business but not to a small-sized one. Hence, there is limitation to its application to all types of business. 5. Lack of accuracy : The accuracy of cost accounts get distorted owing to the use of notional cost such as standard cost, estimated cost, etc. 6. It lacks social accounting : Cost accounting fails to take into account the social obligation of the business. In other words, social accounting is outside the purview of cost accounts.

1.17 SELF ASSESSMENT: Q.1. Define the term cost, costing and cost accountancy. Q.2. Define cost accounting and bring out the differences between cost accounts and Financial accounts. Q.3. Mention two objects of cost accounting. Q.4. Mention two limitations of costing. Q.5. Cost accounting has become an essential tool of modern management. Comment Q.6. Define costing. How does it differ from financial accounting? Explain its importance under present Circumstances Q.7. Define costing. Discuss briefly the objectives and advantages of costing Q.8. State the advantages of costing. How it aids the management and what objections are raised against cost accounts? Q.9. Differentiate between costing, cost accounting and cost accountancy. Q.10. State how cost accounting helps business to maintain the business smoothly.


2.1 PURPOSES OR OBJECTS OF COST ACCOUNTS Costing serves number of purposes among which the following are considered to be most important. 1. Ascertainment of cost : This was considered to be the primary objective of cost accounting in the initial stages of its development. However, in modern times this has assumed the secondary objective of cost accounting. Cost ascertainment involves the collection and classification of expenses at the first instance. Those items of expenses which are capable of charging directly to the products manufactured are allocated. Then the other expenses which are not capable of direct allocation are apportioned on some suitable basis. Thus the cost of production of goods manufactured is ascertained. In this process, cost accounts involves maintenance of different books to record various elements of cost. Cost of production is ascertained by using any of the costing technique such as historical costing, marginal costing, etc. 2. Cost control : At one time cost control was considered as secondary objective of cost accounts. But in modern times it constitutes the primary purpose because of its utmost importance in all business undertakings. Cost control is exercised at different stages in a factory, viz., acquisition of materials, recruiting and deployment of labour force, during the production process and so on. As such we have material cost control, labour cost control, production control, quality control and so on. However, control over cost is exercised through the techniques of budgetary control and standard costing. The control techniques enable the management in knowing the operating efficiency of a business. 3. Determination of selling price : Every business organisation aims at maximising profit. Total cost of production constitutes the basis on which selling price is fixed by adding a margin of profit. Cost accounting furnishes both the total cost of production as well as cost incurred at each and every stage of production. No doubt other factors are taken into consideration before fixing price such as market conditions the area of distribution, volume of sales, etc. But cost plays the dominating role in price fixation. 4. Frequent preparation of accounts and other reports : The management of every business constantly rely upon the reports on cost data in order to know the level of efficiency relating to purchase, production, sales and operating results. Financial accounts provide information only at the end of the year because closing stock value is available only at the end of the year. But cost accounts provide the value of closing stock at frequent intervals by adopting a continuous stock verification system. Using the value of closing stock it is possible to prepare final accounts and know the operating results of the business.

5. To provide a basis for operating policy : Cost data to a great extent helps in formulating the policies of a business and in decision-making. As every alternative decisions involve investment of capital outlay, costs play an important role in decision-making. Therefore availability of cost data is a must for all levels of management. Some of the decisions which are based on cost are (a) make or buy decision, (b) manufacturing by mechanisation or automation, (c) whether to close or continue operations in spite of losses.

2.2 FUNCTIONS OF COST ACCOUNTANT The functions of cost accountant may be enumerated under the following : Traditional Functions The traditional functions comprise of the routine functions of cost accountant. Such functions are as follows : (a) To establish various cost centres in the organisation. (b) To ascertain the cost of every product, job or process both in terms of total and per unit of product. (c) To design suitable system for defining responsibilities and controlling cost. (d) To provide necessary data to enable management in fixing the price. (e) To prepare reports on wastages of material, loss of labour time, idle capacity of machines so as to improve profitability of business. (f) To implement cost control techniques such as budgetary control and standard costing. (g) To prepare cost schedules to assist management in making decisions and in formulating policies. (h) To design suitable forms for organising an effective system of reporting which ensures provision of adequate cost data to all levels of management. (i) To assist management in the valuation of closing stock of raw materials and work-in-progress so that too much of capital is not locked up in unnecessary inventories. (j) To prepare periodical cost statements and profit and loss account. Modern Functions In recent times the functions of a cost accountant are not only confined to ascertain and control cost but extend far beyond these functions. This is on account of the additional responsibilities arising from the various branches of accounting, works organisation, office management and administration, methods of statistical analysis, systems analysis, O and M studies, modern principles of management, use of computers, etc. These modern functions are as follows : (i) Supervising the functions of mechanised accounting. (ii) Organisation of internal audit in the field of accounting. (iii) To work in close co-ordination with various departmental managers so as to implement cost reduction programmes and methods of improvement. (iv) To undertake cost audit programmes as per the directives issued by the government and the provisions of the Indian Companies Act of 1956. As regards the role of cost accountant in an industry, in has been beautifully summarised by Mr. Wilmot in his article on the cost accountants place in management. According to him, the role of cost accountant is that of a historian, news agent, and prophet. As historian he must be meticulously accurate, i.e., while supplying cost information to management he has to furnish in greater detail with carefulness and exactness. As news agent, he must be up-do-date, selective and provide full cost information to the needy person. As a prophet he must combine knowledge and experience with foresight and courage. 2.3 INSTALLATION OF COST ACCOUNTING SYSTEM

At the outset it is to be understood that a common cost accounting system cannot be installed for all types of business undertakings. The cost accounting system depends upon the nature of business and the product manufactured. Before a suitable system of cost accounting is installed it is necessary to undertake a preliminary investigation so as to know the feasibility of installing cost accounting system to such business. While introducing a system of cost accounts it should be borne in mind that cost accounting system must suit the business. There should not be any attempt to make the business suit the system. One more consideration that is of practical importance is that the benefits derived from cost accounting system must be more than the investment made on it. This means the system must be simple and it must lead to savings through the control of materials, labour and overheads when compared to expenses incurred in maintaining it. For the successful functioning of the costing system, the following conditions are essential : (a) There must be an efficient system of material control. (b) A sound and well designed method of wage payment must be set up. (c) The existence of sound basis for collection of all indirect expenses and a basis for its apportionment to various production departments. (d) The integration of cost and financial accounts to facilitate reconciliation of profit as shown by these two systems of accounts. (e) The use of printed forms so as to facilitate quick compilation of cost reports. (f) The duties and responsibilities of cost accountant must be made clear. 2.4.FACTORS TO BE CONSIDERED BEFORE INSTALLING A COST ACCOUNTING SYSTEM The following factors are to be considered before installing a cost accounting system : 1. History of business unit : The history of a business unit implies the duration of its existence, position in the industry, the rate of growth, policy and philosophy of management and the like. The history of business unit serves as the basis for designing the cost accounts in respect of necessity, simplicity, and investment involved in installing cost accounts. 2. Nature of the industry : The nature of business such as manufacturing, mining, trading, etc. determines the costing techniques to be applied. Similarly, the type of product manufactured also determine the method of costing that is to be employed. In other words, there is no all purpose technique and method of costing that can be applied universally. 3. Product range : The range of products manufactured and sold also determine the method of costing to be selected. Accordingly range of products must be analysed in terms of size, models, fashions, area of market, competitors and whether the products are made to customers specification or for stocking and selling.

4. Technical considerations : Technical considerations that influence the installation of cost accounts are as follows : (a) Size and layout of the factory (b) The existence of production and service departments (c) Flow of production (d) Capacity of machines and degree of mechanisation (e) Existence of laboratories (f) Internal transport and material handling equipments (g) Production control techniques (h) Inspection and testing of materials and finished goods. 5. Organisational factors : The problem of installing cost accounting is somewhat difficult in case of an existing business when compared to new business. However, the existing set up of the organisation should be least disturbed should the need arise. In order to fix up responsibility to the

executives it may be necessary to group the departments. The organisational factors to be considered are : (a) size and the type of organisation such as line, line and staff, functional and committee organisation, (b) the levels of management, viz., top level, middle level and bottom level management, (c) extent of delegation and responsibility, (d) extent of centralisation and decentralisation, (e) extent of departmentation, (f) availability of modern office equipments, and (g) number of managerial and supervisory staff. 6. Selling and distribution method : The chief factors to be considered with regard to distribution process are the warehousing facilities, external transport, market research and other promotional measures, terms of sale and procurement of orders from customers. 7. Accounting aspects : The factors to be considered in respect of accounting are : (a) number of financial records, (b) existing forms, (c) registers used, and (d) number of copies required. 8. Area of control to be exercised : The areas where cost control is to be exercised is to be identified so that each manager may take action relevant to his activities. If material control occupies significant area of control, it must be given topmost priority for exercising control over materials. 9. Reporting : The cost accounting system to be installed must ensure frequency and promptitude in reporting cost data to all levels of management. It must also to be pointed out that duplication of reporting is to be avoided. Further, only those information which are relevant for the management in a particular context alone should be reported. 10. Uniformity : The practice of adopting uniform costing facilitates inter-firm comparison among various firms belonging to the same industry. Further it also has the benefit of adopting common costing practice if a holding company has number of subsidiaries. 11. Use of electronic data processing : In modern days it has become a common practice to use electronic data processing equipments and computers. In this situation it is essential to ensure that the equipment meets the needs of the system but not the other way round. 12. Practical considerations : The cost accounting system to be installed must be flexible in operation and must be capable of adaptation to changing conditions. The system must be periodically scrutinised so as to make necessary changes owing to development in business. 2.5 PRACTICAL DIFFICULTIES IN INSTALLING COST ACCOUNTING In addition to the above problems, a cost accountant will encounter the following practical difficulties at the time of installation of cost accounting system : 1. Lack of support from management : Wherever costing system is installed. It is essential to seek the support of various departmental managers. Very often the managers show hostile attitude towards the costing system. They feel that this system will interfere in their routine work and probably as a means of checking their efficiency. Under such circumstances it is better to convince them about the utility of costing system for the business as a whole. 2. Resistance by existing accounting staff : Very often the existing accounting staff resist the installation of the cost accounting system on two grounds. Firstly, they feel that the new system of accounting might lead to excess work. Secondly, they are afraid of their job security. But this difficulty may be overcome by encouraging them about the usefulness of cost accounting as a supplement to financial accounts and the generation of more employment opportunities from the installation of cost accounting system.

3. Non-cooperation from middle and bottom level management : At times the middle and bottom level managers such as foremen, supervisors and inspectors also fail to extend their wholehearted

cooperation fearing additional work which may be entrusted to them. This problem may be overcome by suggesting them about the simplicity of the system and the existence of a separate cost accounting department to look after costing matters. However, they may be required to provide necessary reports concerning their area of activity so as to enable functioning of cost accounting department efficiently. 4. Lack of trained staff : This was no doubt a problem in olden days. Today this problem is overcome, thanks to the establishment of The Institute of Cost and Works Accountant of India in our country which offers professional course in costing and also offers training facilities through various companies to the candidates undergoing the course. In spite of this facility, it is somewhat difficult to get the competent and experienced staff at the time of installation. This problem can be overcome by paying attractive salaries to the cost accountants. 5. Heavy expenses in installing and maintaining the system : The setting up of a separate costing department with staff often poses a problem. In addition to installation, the operating expenses in the form of printing and stationery, heating and lighting, depreciation and insurance, rent and rates are to be incurred. However, as was mentioned earlier, the system of cost accounting must be a useful investment, i.e., benefits derived from it must be more than the investment made on it. If this is not possible, for the time being the system must be discarded.

2.6 REQUISITES OR ESSENTIALS OF COST ACCOUNTING SYSTEM The following are the essentials of an ideal cost accounting system : 1. Accuracy : The system of cost accounting must provide for accuracy in terms of both cost ascertainment and presentation. Otherwise it will prove to be misleading. 2. Simplicity : Cost accounting system involves detailed analysis of cost. To avoid complications in the procedure of cost ascertainment an elaborate system of costing should be avoided and every care must be taken to keep it as simple as possible. 3. Elasticity : The cost accounting system should be capable of adopting itself to the changing situations of business. It must be capable of expansion or contraction depending upon the needs of the business. 4. Economy : The costs of operating costing system must be less. It must result in increased benefit when compared to the expenditure incurred in installing it. 5. Comparability : The records to be maintained must facilitate comparison over a period of time. The past records must serve as a basis to guide the future. 6. Promptness : An ideal costing system is one which provides cost data in an analytical form to the management. So all the departments of a factory must analyse and record the relevant items of cost promptly in order to furnish cost information on a regular basis to various levels of management. This helps in checking up the progress of the business on a regular basis. results frequently, it is desirable to prepare accounts periodically. Constant comparison of actual result with standard result enables to spot out areas of inefficiency. This can be set right by taking remedial measures. 8. Reconciliation with financial accounts : The system of cost accounts must be capable of reconciling with financial accounts so as to check accuracy of both the system of accounts. 9. Uniformity : The various forms and documents used under costing system must be uniform in size and quality of paper. Printed forms must be used to avoid delay in the preparation of reports. This also reduces the burden of clerical staff. Forms of different colours can be used to distinguish different documents.

10. Equity : The basis of apportioning indirect expenses to products, departments or jobs must be fair and equitable. 2.7 ORGANISATION OF COST ACCOUNTING DEPARTMENT The organisation of cost accounting department depends upon the size of the concern. Whatever may be the structure of cost accounting department in a factory, it is established to serve the following purposes : (i) To compile cost data in order to meet the statutory requirement wherever applicable, (ii) To provide necessary cost data to management to carry out its functions efficiently, and (iii) To ensure efficiency and economy in the functioning of cost accounting department. To achieve the above purposes cost accounting department usually performs the following functions :

(1) Designing and installation of appropriate method of costing. (2) Accumulation of cost data by process, department and product. (3) Analysis of such cost by elements of cost. (4) Estimation of cost of production. (5) Reporting of cost information to all levels of management. (6) Advising management in relation to investment based on cost information. In a small and medium-sized concern, the cost accounting department may be set up as a section of financial accounting system. The cost accountant who is incharge of cost accounting department may be authorised to report to the chief accountant. In large-sized concern, a separate cost accounting department is established under the supervision of a full-fledged cost accountant. The cost accounting department is equipped with sufficient staff each to look after different facets of cost accounting function. While important functions such as budgeting, cost analysis, etc. are performed by cost accountant, cost recording, cost reporting and such other functions are performed by cost clerks. The cost accounting department may be organised either on the principle of centralisation or decentralisation. Under centralised system, the functions of cost accounting departments relating to all firms belonging to same industry is performed at a common central place. The extent of centralisation of cost accounting department depends upon the following factors : (a) The philosophy of management regarding divisional responsibility. (b) The ready availability of cost data from each firm. (c) Size of the firm. (d) The area of operations of every firm. (e) The economy involved in centralisation process Advantages of Centralised Cost Accounting Department 1. It facilitates full utilisation of services of costing staff. 2. It permits mechanisation of accounting which is not possible under decentralisation system. 3. It reduces paper work and economise stationery costs. 4. It facilitates prompt reporting. Under decentralisation system a separate cost accounting department is set up for each and every firm under the supervision of a competent cost accountant. This system has certain advantages. (a) It tends to increase the initiative of the cost accountants of every firm as the responsibility to control lies in their hands. (b) It eliminates duplication of recording and reporting. (c) It increases the speed of functioning of cost accounting department. 2.8 RELATIONSHIP OF COST DEPARTMENT TO OTHER DEPARTMENTS

1. Cost accounting department and production department : It can well be said that production department and cost department are interwoven together as the former cannot function efficiently without the existence of the latter. The production process is concerned with the utilisation of materials, money and human resources. The cost department helps in estimating the material cost, labour cost and other expenses for manufacturing a product. It also helps in controlling these costs so as to minimise the cost or production. In fact, the main objective of cost accounting system is to reduce the cost of production of goods or services manufactured and rendered by business units. The other areas where cost accounting department is helpful in manufacturing process are : (a) Engineering department which is concerned with designing a product, (b) Research and development department which is concerned with development of a new product, (c) Production planning and control department which ensures completion of production within the time schedule, and (d) Quality control section, which ensures quality of products. All these departments heavily rely on cost accounting department because costs to be incurred in these departments have a direct impact over the functioning of these departments. 2. Cost accounting department and personnel department : The personnel department which is concerned with proper recruitment, selection, training, time-keeping, fixation of wage rate and preparation of payroll, will work with close co-ordination of cost department. Each and every function performed by personnel department is again influenced by additional cost to be incurred on such function as for example promotion of employees leads to incurrence of additional wages.

3. Cost accounting department and finance department : The finance department is concerned with receiving and disbursement of cash. The allocation of investments on fixed and working capital entirely depends upon the cost reports submitted to it by the cost department. Judicious utilisation of available capital is possible only when priority is given for more important areas of investment. This is facilitated by furnishing prompt report by cost department. 4. Cost accounting department and purchase department : In majority of firms purchase of raw materials at right quantity, of right quality, from right supplier, at a right time not only ensures ready supply but also at a reasonably low price. Any purchase of substandard quality of materials will lead to dissatisfaction among customers and consequently it leads to loss of orders. Further, purchase of materials at high rate will increase the cost of production tremendously. Delay in getting supplies of materials lead to delay in executing customers orders. In these respects cost accounting department can assist purchase department to ensure efficient purchasing. Cost department also help in reducing (a) waste of materials, (b) the risk from theft, and (c) excessive investment in inventories. 5. Cost accounting department and marketing department : Marketing department relies on cost information in order to (a) estimate future product cost for fixing the selling price, (b) in knowing the expenses incurred in marketing the products so that if the amount exceeds the target, control measures can be taken to reduce such expenses, (c) to consider alternative selling methods and promotional measures, and (d) to make further investment in warehousing and distribution process. Cost department provides all such information as is required by the marketing department for its efficient functioning. 6. Cost accounting department and financial accounting department : The existence of cost accounting department makes the financial accounting department a complete organisation by furnishing additional cost data to the chief accountant. Cost department enable financial accounts department in carrying out the latters function furnishing necessary data in respect of the following : (a) Supply of material cost, labour cost and expenses to facilitate preparation of manufacturing account.

(b) Provision of the value of closing stock frequently to facilitate the preparation of interim final accounts. (c) Assist financial accounting department in matters relating to taxation, insurance and in solving legal matters. (d) Enables financial accounting department to settle the bills by duly approving them. (e) Helps financial accounting department in budgeting. 2.9 CRITICISMS OR OBJECTIONS LEVELLED AGAINST COST ACCOUNTS Despite several benefits offered by cost accounts, critics have levelled the following criticisms against it : 1. Cost accounting is merely a system of estimates and probabilities : Though the main purpose of cost accounting is to ascertain the cost of production with a reasonable degree of accuracy, yet absolute accuracy is not possible owing to the two reasons. (a) Indirect expenditures are absorbed on the basis of predetermined rates instead of actual rates, and (b) The material cost and labour cost is inflated so as to cover the normal loss and wastage of materials and normal idle time of workers. 2. Cost accounting is unnecessary in such business enterprises which make large profit : It is argued that industries which earn large amount of profit need not have a system of cost accounting. This statement is absolutely wrong. Earning of more profit by industry does not necessarily mean that its cost of production is lowest and there is no scope for further reduction in the cost. Profit represents the difference between the selling price and the cost of a product. Profit earned by a business may be high because of increased price prevailing in the market. Two or more than two products manufactured by business may earn profit for one line of product and loss by other. The profit earned by one product may outweigh the loss suffered by other product thus resulting in overall profit. So it is wrong t judge the efficiency of the business on the basis of overall profitability of the business. If necessary steps are taken to reduce or eliminate losses suffered by a second line product, the industry would earn more amount of profit. It is in this context that a system of costing is felt. 3. It is unnecessary : This criticism is levelled owing to lack of understanding of the objectives and advantages of costing. In the present-day competitive world, every manufacturer must know the cost of production for each article so that he can fix selling price on a reliable and reasonable basis. Further he can also compare his selling price thus fixed with the price prevailing in the market. Cost ascertainment involves application of certain principles and techniques. Having ascertained the cost, control techniques are used to keep the costs under check and thereby increase the profit. Thus it can be said that cost accounting is necessary in most of the concerns.

4. It is expensive : This criticism is true as long as the benefits derived from this system is not commensurate with the investment made on it. But by carefully designing the system so as to suit the business, the criticism can be nullified. 5. Competition governs price and hence there is no need for costing system : Some critics contend that in these days of competition prices are determined by the forces of demand and supply as against fixation of selling price by adding a desired margin of profit on the cost price. This argument is incorrect. Even in this situation cost accounts disclose the margin of profit that is earned by comparing the market price and cost of production. It impresses upon management the need to reduce cost by increasing the volume of production or by elimination of losses and wastages if any. If the cost price tend to be higher than the market price, it is desirable to abandon such product line and pay attention to profitable line of products.

6. There is no need for costing where production efficiency is high : The statement is misleading as without a yardstick to measure the efficiency it is not possible to appraise the efficiency of a business. Cost accounting system offers number of techniques such as standard costing, budgetary control, inter-firm comparison and so on. The cost of production can also be compared between two periods of time to know whether business is currently running efficiently when compared to previous year. In case of inefficient operation remedial measures can be taken to improve the business. 7. Other objections : Some other objections that are raised against the installation of cost accounting system are follows : (a) It is a mere matter of forms and rulings : Often it is argued that the cost accounting system degenerates into a matter of mere forms and rulings. This is not the defect of cost accounting system but the way in which the system is maintained. No doubt different forms are necessary under costing system but they must be simplified and altered to meet the changing condition. (b) Failure in many cases : The system of cost accounting is often condemned as defective inasmuch as it has failed to produce the desired result. The defect does not lie in the costing system but for some other reasons such as indifferent attitude of the management, lack of adequate facilities, noncooperations or opposition from employees. These defects can be overcome by reversing the above trend. (c) For want of necessity : It is contended by some that costing is of recent origin and that its application was not felf in the past. Though it was not used earlier, still many industries prospered. So it is felt by some critics that the installation of costing involves unnecessary expenditure. However it is to be remembered that todays business functions in a competitive conditions and every manufacturer must know the actual cost of production in order to reduce the selling price. Many industrial failures in the past may be attributed to the lack of knowledge on the part of management relating to the actual cost of production thereby selling product below cost.

2.10 SELF ASSESSMENT Q.1. Define Cost Accounts and its importance.

Q.2 What are the pre-requisites required to install a cost accounting system in a business. Q.3. Define the Cost accounting system? Q.4. A Good system of costing must place the same emphasise on cost control as on cost ascertainment. Comment on this statement. Q.5. Cost accounting is a system of foresight like pre-natal care, but financial accounting is just a post-mortem examination. Critically examine this statement. Q.6 Cost accounting has become an essential tool of management. Mention the steps to be taken while installing cost accounting system in a manufacturing concern. Q.7. Cost accounting has become an essential tool of modern management. Comment Q.8. An efficient system of costing is essential factor for industrial control under modern conditions of business and as such may be regarded as an important part in the efforts of any management to secure business stabilityElaborate. Q.9. A good costing system is an involvable aid to management. Discuss. Q.10. How cost accounting is superior over financial accounting? Explain the techniques of costing and their application and suitability.


3.1 Concept of Cost Cost accounting is concerned with cost and therefore is necessary to understand the meaning of term cost in a proper perspective. In general, cost means the amount of expenditure (actual or notional) incurred on, or attributable to a given thing. However, the term cost cannot be exactly defined. Its interpretation depends upon the following factors:

1. 2.

The nature of business or industry The context in which it is used

In a business where selling and distribution expenses are quite nominal the cost of an article may be calculated without considering the selling and distribution overheads. At the same time, in a business where the nature of a product requires heavy selling and distribution expenses, the calculation of cost without taking into account the selling and distribution expenses may prove very costly to a business. The cost may be factory cost, office cost, cost of sales and even an item of expense. For example, prime cost includes expenditure on direct materials, direct labor and direct expenses. Money spent on materials is termed as cost of materials just like money spent on labor is called cost of labor and so on. Thus, the use of term cost without understanding the circumstances can be misleading. Different costs are found for different purposes. The work-in-progress is valued at factory cost while stock of finished goods is valued at office cost. Numerous other examples can be given to show that the term cost does not mean the same thing under all circumstances and for all purposes. Many items of cost of production are handled in an optional manner which may give different costs for the same product or job without going against the accepted principles of cost accounting. Depreciation is one of such items. Its amount varies in accordance with the method of depreciation being used. However, endeavor should be, as far as possible, to obtain an accurate cost of a product or service. 3.2 Cost Unit and Cost Center The technique of costing involves the following: 1. 2. Collection and classification of expenditure according to cost elements Allocation and apportionment of the expenditure to the cost centers or cost units or both

Cost Unit While preparing cost accounts, it becomes necessary to select a unit with which expenditure may be identified. The quantity upon which cost can be conveniently allocated is known as a unit of cost or cost unit. The Chartered Institute of Management Accountants, London defines a unit of cost as a unit of quantity of product, service or time in relation to which costs may be ascertained or expressed. Unit selected should be unambiguous, simple and commonly used. Following are the examples of units of cost: (i) Brick works (ii) Collieries (iii) Textile mills (iv) Electrical companies (v) Transport companies (vi) Steel mills Cost Center According to the Chartered Institute of Management Accountants, London, cost center means a location, person or item of equipment (or group of these) for which costs may be ascertained and used for the purpose of cost control. Thus, cost center refers to one of the convenient units into which the whole factory or an organization has been appropriately divided for costing purposes. Each such unit consists of a department, a sub-department or an item or equipment or machinery and a person or a group of persons. Sometimes, closely associated departments are combined together and considered as one unit for costing purposes. For example, in a laundry, activities such as collecting, per 1000 bricks made per ton of coal raised per yard or per lb. of cloth manufactured or yarn spun per unit of electricity generated per passenger km. per ton of steel made

sorting, marking and washing of clothes are performed. Each activity may be considered as a separate cost center and all costs relating to a particular cost centre may be found out separately. Cost centres may be classified as follows: 1. 2. 3. Productive, unproductive and mixed cost centres Personal and impersonal cost centres Operation and process cost centres

Productive cost centres are those which are actually engaged in making products. Service or unproductive cost centres do not make the products but act as the essential aids for the productive centres. The examples of such service centres are as follows: 1. 2. 3. Administration department Repairs and maintenance department Stores and drawing office department

Mixed costs centres are those which are engaged sometimes on productive and other times on service works. For example, a tool shop serves as a productive cost center when it manufactures dies and jigs to be charged to specific jobs or orders but serves as servicing cost center when it does repairs for the factory. Impersonal cost center is one which consists of a department, a plant or an item of equipment whereas a personal cost center consists of a person or a group of persons. In case a cost center consists of those machines or persons which carry out the same operation, it is termed as operation cost center. If a cost center consists of a continuous sequence of operations, it is called process cost center. In case of an operation cost center, cost is analyzed and related to a series of operations in sequence such as in chemical industries, oil refineries and other process industries. The objective of such an analysis is to ascertain the cost of each operation irrespective of its location inside the factory.

3.3 Cost Estimation and Cost Ascertainment Cost estimation is the process of pre-determining the cost of a certain product job or order. Such predetermination may be required for several purposes. Some of the purposes are as follows: 1. 2. 3. 4. 5. Budgeting Measurement of performance efficiency Preparation of financial statements (valuation of stocks etc.) Make or buy decisions Fixation of the sale prices of products

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

costs on a continuing basis and proper and timely steps be taken for controlling costs and maximizing profits. 3.4 Cost Allocation and Cost Apportionment Cost allocation and cost apportionment are the two procedures which describe the identification and allotment of costs to cost centers or cost units. Cost allocation refers to the allotment of all the items of cost to cost centers or cost units whereas cost apportionment refers to the allotment of proportions of items of cost to cost centers or cost units Thus, the former involves the process of charging direct expenditure to cost centers or cost units whereas the latter involves the process of charging indirect expenditure to cost centers or cost units. For example, the cost of labor engaged in a service department can be charged wholly and directly but the canteen expenses of the factory cannot be charged directly and wholly. Its proportionate share will have to be found out. Charging of costs in the former case will be termed as allocation of costs whereas in the latter, it will be termed as apportionment of costs. 3.5 Cost Reduction and Cost Control Cost reduction and cost control are two different concepts. Cost control is achieving the cost target as its objective whereas cost reduction is directed to explore the possibilities of improving the targets. Thus, cost control ends when targets are achieved whereas cost reduction has no visible end. It is a continuous process. The difference between the two can be summarized as follows: 1. Cost control aims at maintaining the costs in accordance with established standards whereas cost reduction is concerned with reducing costs. It changes all standards and endeavors to improve them continuously. Cost control seeks to attain the lowest possible cost under existing conditions whereas cost reduction does not recognize any condition as permanent since a change will result in lowering the cost. In case of cost control, emphasis is on past and present. In case of cost reduction, emphasis is on the present and future. Cost control is a preventive function whereas cost reduction is a correlative function. It operates even when an efficient cost control system exists.


3. 4.

3.6 Elements of cost Cost of production/manufacturing consists of various expenses incurred on production/manufacturing of goods or services. These are the elements of cost which can be divided into three groups : Material, Labour and Expenses.

Elements of cost Material Labour Expenses

Material To produce or manufacture material is required. For example to manufacture shirts cloth is required and to produce flour wheat is required. All material which becomes an integral part of finished

product and which can be conveniently assigned to specific physical unit is termed as Direct Material. It is also described as raw material, process material, prime material, production material, stores material, etc. The substance from which the product is made is known as material. It may be in a raw or manufactured state. Material is classified into two categories: _ Direct Material _ Indirect Material _ Direct material Direct Material is that material which can be easily identified and related with specific product, job, and process. Timber is a raw material for making furniture, cloth for making garments, sugarcane for making sugar, and Gold/ silver for making jewellery, etc are some examples of direct material. _ Indirect material Indirect Material is that material which cannot be easily and conveniently identified and related with a particular product, job, process, and activity. Consumable stores, oil and waste, printing and stationery etc, are some examples of indirect material. Indirect materials are used in the factory, the office, or the selling and distribution department Labour Labour is the main factor of production. For conversion of raw material into finished goods, human resource is needed, and such human resource is termed as labour. Labour cost is the main element of cost in a product or service. Labour can be classified into two categories: _ Direct Labour, and _ Indirect labour

_ Direct labour Labour which takes active and direct part in the production of a commodity. Direct labour is that labour which can be easily identified and related with specific product, job, process, and activity. Direct labour cost is easily traceable to specific products. Direct labour costs are specially and conveniently traceable to specific products. Direct labour varies directly with the volume of output. Direct labour is also known as process labour, productive labour, operating labour, direct wages, manufacturing wages, etc. Cost of wages paid to carpenter for making furniture, cost of a tailor in producing readymade garments, cost of washer in dry cleaning unit are some examples of direct labour. _ Indirect labour Indirect labour is that labour which can not be easily identified and related with specific product, job, process, and activity. It includes all labour not directly engaged in converting raw material into finished product. It may or may not vary directly with the volume of output. Labour employed for the purpose of carrying out tasks incidental to goods or services provided is indirect labour. Indirect labour is used in the factory, the office, or the selling and distribution department. Wages of storekeepers, time-keepers, salary of works manager, salary of salesmen, etc, are all examples of indirect labour cost. Expenses All cost incurred in the production of finished goods other than material cost and labour cost are termed as expenses. Expenses are classified into two categories: Direct expenses, and Indirect expenses (An item of overheads) Direct expenses

These are expenses which are directly, easily, and wholly allocated to specific cost center or cost units. All direct cost other than direct material and direct labour are termed as direct expenses. Direct expenses are also termed as chargeable expenses. Some examples of the direct expenses are hire of special machinery, cost of special designs, moulds or patterns, feed paid to architects, surveyors and other consultants, inward carriage and freight charges on special material, Cost of patents and royalties. 1. Cost center means a location, person, or item of equipment or group of these for which costs may be ascertained and used for the purpose of cost control. 2. Cost object is anything for which a separate measurement of cost is desired. It may be a product, service, project, or a customer.

Indirect expenses These expenses cannot be directly, easily, and wholly allocated to specific cost center or cost units. All indirect costs other than indirect material and indirect labour are termed as indirect expenses. Thus, Indirect Expenses = Indirect cost Indirect material Indirect labour. Indirect expenses are treated as part of overheads. Rent, rates and taxes of building, repair, insurance and depreciation on fixed assets, etc, are some examples of indirect expenses.

OVERHEADS : MEANING The term overhead has a wider meaning than the term indirect expenses. Overheads include the cost of indirect material, indirect labour and indirect expenses. This is the aggregate sum of indirect material, indirect labour and indirect expenses. Overhead = Indirect material + Indirect labour + Indirect expenses Overheads are classified into following three categories: _ Factory/works/ production overheads _ Office and administrative overheads _ Selling and distribution overheads _ Factory/works overheads All indirect costs incurred in the factory for production of goods is termed as factory/works overheads. Such costs are concerned with the running of the factory or plant. These include indirect material, indirect labour and indirect expenses incurred in the factory. Some examples are as follows: Indirect materials: (i) Grease, oil, lubricants, cotton waste etc. (ii) Small tools, brushes for sweeping, sundry supplies etc. (iii) Cost of threads, gum, nails, etc. (iv) Consumable stores (v) Factory printing and stationery Indirect wages (i) Salary of factory manager, foremen, supervisors, clerks etc. (ii) Salary of storekeeper (iii) Salary and fee of factory directors and technical directors

(iv) Contribution to ESI, PF., Leave pay etc. of factory employee. Indirect expenses 1. Rent of factory buildings and land (ii) Insurance of factory building, plant, and machinery (iii) Municipal taxes of factory building (iv) Depreciation of factory building, plant and machinery, and their repairs and maintenance charges (v) Power and fuel used in factory (vi) Factory telephone expenses. _ Office and administrative overheads These expenses are related to the management and administration of the business. They are incurred for the direction and control of an undertaking. These represent the aggregate of the cost of indirect material, indirect labour, and indirect expenses incurred by the office and administration department of an organisation. Some examples are as follows: Office printing and stationery, Cost of brushes, dusters etc. for cleaning office building and equipments, Postage and stamps. Salary of office manager, clerks, and other employees, Salary of administrative directors, Salaries of legal adviser, Salaries of cost accountants and financial accountants, Salary of computer operator. Rent, insurance, rates and taxes of office building, Office lighting, heating and cleaning, Depreciation and repair of office building, furniture, and Equipment etc., Legal charges, Bank charges, Trade subscriptions, Telephone charges, Audit fee etc.

_ Selling and distribution overheads Selling and distribution overheads are incurred for the marketing of a commodity, for securing order for the articles, dispatching goods sold or for making efforts to find and retain customers. These expenses represent the aggregate of indirect material, indirect labour, and indirect expenses incurred by the selling and distribution department of the organisation. These overheads have two aspects (i) procuring orders (ii) executing the order. Based upon this concept the selling and distributions are studied separately. I. Selling overheads Indirect costs incurred in relation to the procurement of sale orders are termed as selling overheads. Some of the examples of selling overheads are as follows: Indirect material (i) Catalogues, price list (ii) Printing and stationery (iii) Postage and stamps (iv) cost of sample Indirect wages (i) Salaries of sales managers, clerks and other employees (ii) Salaries and commission of salesmen and technical representatives (iii) Fees of sales directors Indirect expenses (i) Advertising (ii) Bad debts (iii) Rent and insurance of showroom (iv) Legal charges incurred for recovery of debts (v) Travelling and entertainment expenses (vi) Expenses of sending samples (vii) Market research expenses.

II. Distribution overheads Indirect costs incurred in relation to the execution of the sales order is termed as distribution overheads. Some of the examples of distribution overheads are as follows: Indirect material (i) Cost of packing material (ii) oil, grease, spare parts etc. for maintaining delivery vans Indirect wages (i) Salaries of godown employees (ii) Wages of drivers of delivery vans (iii) Wages of packers and dispatch staff. Indirect expenses (i) Packing expenses (ii) Godown rent, insurance, depreciation, and repair etc. (iii) Freight carriage outwards and other transport charges. (iv) Running expenses of delivery vans, repair, and depreciation. (v) Insurance in transit etc.

3.7 Classification of Cost Cost may be classified into different categories depending upon the purpose of classification. Some of the important categories in which the costs are classified are as follows: 1. Fixed, Variable and Semi-Variable Costs The cost which varies directly in proportion with every increase or decrease in the volume of output or production is known as variable cost. Some of its examples are as follows: 1. 2. 3. Wages of laborers Cost of direct material Power

The cost which does not vary but remains constant within a given period of time and a range of activity inspite of the fluctuations in production is known as fixed cost. Some of its examples are as follows: 1. 2. 3. Rent or rates Insurance charges Management salary

The cost which does not vary proportionately but simultaneously does not remain stationary at all times is known as semi-variable cost. It can also be named as semi-fixed cost. Some of its examples are as follows: 1. 2. Depreciation Repairs

Fixed costs are sometimes referred to as period costs and variable costs as direct costs in system of direct costing. Fixed costs can be further classified into:

1. 2.

Committed fixed costs Discretionary fixed costs

Committed fixed costs consist largely of those fixed costs that arise from the possession of plant, equipment and a basic organization structure. For example, once a building is erected and a plant is installed, nothing much can be done to reduce the costs such as depreciation, property taxes, insurance and salaries of the key personnel etc. without impairing an organizations competence to meet the long-term goals. Discretionary fixed costs are those which are set at fixed amount for specific time periods by the management in budgeting process. These costs directly reflect the top management policies and have no particular relationship with volume of output. These costs can, therefore, be reduced or entirely eliminated as demanded by the circumstances. Examples of such costs are research and development costs, advertising and sales promotion costs, donations, management consulting fees etc. These costs are also termed as managed or programmed costs. In some circumstances, variable costs are classified into the following: 1. 2. Discretionary cost Engineered cost

The term discretionary costs is generally linked with the class of fixed cost. However, in the circumstances where management has predetermined that the organization would spend a certain percentage of its sales for the items like research, donations, sales promotion etc., discretionary costs will be of a variable character. Engineered variable costs are those variable costs which are directly related to the production or sales level. These costs exist in those circumstances where specific relationship exists between input and output. For example, in an automobile industry there may be exact specifications as one radiator, two fan belts, one battery etc. would be required for one car. In a case where more than one car is to be produced, various inputs will have to be increased in the direct proportion of the output. Thus, an increase in discretionary variable costs is due to the authorization of management whereas an increase in engineered variable costs is due to the volume of output or sales. 2. Product Costs and Period Costs The costs which are a part of the cost of a product rather than an expense of the period in which they are incurred are called as product costs. They are included in inventory values. In financial statements, such costs are treated as assets until the goods they are assigned to are sold. They become an expense at that time. These costs may be fixed as well as variable, e.g., cost of raw materials and direct wages, depreciation on plant and equipment etc. The costs which are not associated with production are called period costs. They are treated as an expense of the period in which they are incurred. They may also be fixed as well as variable. Such costs include general administration costs, salaries salesmen and commission, depreciation on office facilities etc. They are charged against the revenue of the relevant period. Differences between opinions exist regarding whether certain costs should be considered as product or period costs. Some accountants feel that fixed manufacturing costs are more closely related to the passage of time than to the manufacturing of a product. Thus, according to them variable manufacturing costs are product costs whereas fixed manufacturing and other costs are period costs. However, their view does not seem to have been yet widely accepted. 3. Direct and Indirect Costs

The expenses incurred on material and labor which are economically and easily traceable for a product, service or job are considered as direct costs. In the process of manufacturing of production of articles, materials are purchased, laborers are employed and the wages are paid to them. Certain other expenses are also incurred directly. All of these take an active and direct part in the manufacture of a particular commodity and hence are called direct costs. The expenses incurred on those items which are not directly chargeable to production are known as indirect costs. For example, salaries of timekeepers, storekeepers and foremen. Also certain expenses incurred for running the administration are the indirect costs. All of these cannot be conveniently allocated to production and hence are called indirect costs. 4. Decision-Making Costs and Accounting Costs Decision-making costs are special purpose costs that are applicable only in the situation in which they are compiled. They have no universal application. They need not tie into routine-financial accounts. They do not and should not conform the accounting rules. Accounting costs are compiled primarily from financial statements. They have to be altered before they can be used for decisionmaking. Moreover, they are historical costs and show what has happened under an existing set of circumstances. Decision-making costs are future costs. They represent what is expected to happen under an assumed set of conditions. For example, accounting costs may show the cost of a product when the operations are manual whereas decision-making cost might be calculated to show the costs when the operations are mechanized. 5. Relevant and Irrelevant Costs Relevant costs are those which change by managerial decision. Irrelevant costs are those which do not get affected by the decision. For example, if a manufacturer is planning to close down an unprofitable retail sales shop, this will affect the wages payable to the workers of a shop. This is relevant in this connection since they will disappear on closing down of a shop. But prepaid rent of a shop or unrecovered costs of any equipment which will have to be scrapped are irrelevant costs which should be ignored. 6. Shutdown and Sunk Costs A manufacturer or an organization may have to suspend its operations for a period on account of some temporary difficulties, e.g., shortage of raw material, non-availability of requisite labor etc. During this period, though no work is done yet certain fixed costs, such as rent and insurance of buildings, depreciation, maintenance etc., for the entire plant will have to be incurred. Such costs of the idle plant are known as shutdown costs. Sunk costs are historical or past costs. These are the costs which have been created by a decision that was made in the past and cannot be changed by any decision that will be made in the future. Investments in plant and machinery, buildings etc. are prime examples of such costs. Since sunk costs cannot be altered by decisions made at the later stage, they are irrelevant for decision-making. An individual may regret for purchasing or constructing an asset but this action could not be avoided by taking any subsequent action. Of course, an asset can be sold and the cost of the asset will be matched against the proceeds from sale of the asset for the purpose of determining gain or loss. The person may decide to continue to own the asset. In this case, the cost of asset will be matched against the revenue realized over its effective life. However, he/she cannot avoid the cost which has already been incurred by him/her for the acquisition of the asset. It is, as a matter of fact, sunk cost for all present and future decisions. Example

Jolly Ltd. purchased a machine for $. 30,000. The machine has an operating life of five yea$ without any scrap value. Soon after making the purchase, management feels that the machine should not have been purchased since it is not yielding the operating advantage originally contemplated. It is expected to result in savings in operating costs of $. 18,000 over a period of five years. The machine can be sold immediately for $. 22,000. To take the decision whether the machine should be sold or be used, the relevant amounts to be compared are $. 18,000 in cost savings over five yea$ and $. 22,000 that can be realized in case it is immediately disposed. $. 30,000 invested in the asset is not relevant since it is same in both the cases. The amount is the sunk cost. Jolly Ltd., therefore, sold the machinery for $. 22,000 since it would result in an extra profit of $. 4,000 as compared to keeping and using it.

7. Controllable and Uncontrollable Costs Controllable costs are those costs which can be influenced by the ratio or a specified member of the undertaking. The costs that cannot be influenced like this are termed as uncontrollable costs. A factory is usually divided into a number of responsibility centers, each of which is in charge of a specific level of management. The officer incharge of a particular department can control costs only of those matte$ which come directly under his control, not of other matte$. For example, the expenditure incurred by tool room is controlled by the foreman incharge of that section but the share of the tool room expenditure which is apportioned to a machine shop cannot be controlled by the foreman of that shop. Thus, the difference between controllable and uncontrollable costs is only in relation to a particular individual or level of management. The expenditure which is controllable by an individual may be uncontrollable by another individual. 8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs Avoidable costs are those which will be eliminated if a segment of a business (e.g., a product or department) with which they are directly related is discontinued. Unavoidable costs are those which will not be eliminated with the segment. Such costs are merely reallocated if the segment is discontinued. For example, in case a product is discontinued, the salary of a factory manager or factory rent cannot be eliminated. It will simply mean that certain other products will have to absorb a large amount of such overheads. However, the salary of people attached to a product or the bad debts traceable to a product would be eliminated. Certain costs are partly avoidable and partly unavoidable. For example, closing of one department of a store might result in decrease in delivery expenses but not in their altogether elimination. It is to be noted that only avoidable costs are relevant for deciding whether to continue or eliminate a segment of a business. 9. Imputed or Hypothetical Costs These are the costs which do not involve cash outlay. They are not included in cost accounts but are important for taking into consideration while making management decisions. For example, interest on capital is ignored in cost accounts though it is considered in financial accounts. In case two projects require unequal outlays of cash, the management should take into consideration the capital to judge the relative profitability of the projects.

10. Differentials, Incremental or Decrement Cost The difference in total cost between two alternatives is termed as differential cost. In case the choice of an alternative results in an increase in total cost, such increased costs are known as incremental costs. While assessing the profitability of a proposed change, the incremental costs are matched with incremental revenue. This is explained with the following example:

Example A company is manufacturing 1,000 units of a product. The present costs and sales data are as follows: Selling price per unit Variable cost per unit Fixed costs $. 10 $. 5 $. 4,000

The management is considering the following two alternatives: 1. 2. To accept an export order for another 200 units at $. 8 per unit. The expenditure of the export order will increase the fixed costs by $. 500. To reduce the production from present 1,000 units to 600 units and buy another 400 units from the market at $. 6 per unit. This will result in reducing the present fixed costs from $. 4,000 to $. 3,000.

Which alternative the management should accept? Solution Statement showing profitability under different alternatives is as follows: Particulars Present situation $. $. 10,000 9,000 1,000 Proposed situations 11,600 10,000 6,000 5,400 10,500 8,400 4,500 3,000 1,100 1,600

Sales. Less: 5,000 Variable purchase costs 4,000 Fixed costs Profit Observations 1. 2.

In the present situation, the company is making a profit of $. 1,000. In the proposed situation (i), the company will make a profit of $. 1,100. The incremental costs will be $. 1,500 (i.e. $. 10,500 - $. 9,000) and the incremental revenue (sales) will be $. 1,600. Hence, there is a net gain of $. 100 under the proposed situation as compared to the existing situation.


In the proposed situation (ii), the detrimental costs are $. 600 (i.e. $. 9,000 to $. 8,400) as there is no decrease in sales revenue as compared to the present situation. Hence, there is a net gain of $. 600 as compared to the present situation.

Thus, under proposal (ii), the company makes the maximum profit and therefore it should adopt alternative (ii). The technique of differential costing which is based on differential cost is useful in planning and decision-making and helps in selecting the best alternative. In case the choice results in decrease in total costs, this decreased costs will be known as detrimental costs.

11. Out-of-Pocket Costs Out-of-pocket cost means the present or future cash expenditure regarding a certain decision that will vary depending upon the nature of the decision made. For example, a company has its own trucks for transporting raw materials and finished products from one place to another. It seeks to replace these trucks by keeping public carriers. In making this decision, of course, the depreciation of the trucks is not to be considered but the management should take into account the present expenditure on fuel, salary to drive$ and maintenance. Such costs are termed as out-of-pocket costs. 12. Opportunity Cost Opportunity cost refers to an advantage in measurable terms that have foregone on account of not using the facilities in the manner originally planned. For example, if a building is proposed to be utilized for housing a new project plant, the likely revenue which the building could fetch, if rented out, is the opportunity cost which should be taken into account while evaluating the profitability of the project. Suppose, a manufacturer is confronted with the problem of selecting anyone of the following alternatives: 1. 2. Selling a semi-finished product at $. 2 per unit Introducing it into a further process to make it more refined and valuable

Alternative (b) will prove to be remunerative only when after paying the cost of further processing, the amount realized by the sale of the product is more than $. 2 per unit. Also, the revenue of $. 2 per unit is foregone in case alternative (b) is adopted. The term opportunity cost refers to this alternative revenue foregone. 13. Traceable, Untraceable or Common Costs The costs that can be easily identified with a department, process or product are termed as traceable costs. For example, the cost of direct material, direct labor etc. The costs that cannot be identified so are termed as untraceable or common costs. In other words, common costs are the costs incurred collectively for a number of cost centers and are to be suitably apportioned for determining the cost of individual cost centers. For example, overheads incurred for a factory as a whole, combined purchase cost for purchasing several materials in one consignment etc. Joint cost is a kind of common cost. When two or more products are produced out of one material or process, the cost of such material or process is called joint cost. For example, when cottonseeds and cotton fibers are produced from the same material, the cost incurred till the split-off or separation point will be joint costs.

14. Production, Administration and Selling and Distribution Costs A business organization performs a number of functions, e.g., production, illustration, selling and distribution, research and development. Costs are to be curtained for each of these functions. The Chartered Institute of Management accountants, London, has defined each of the above costs as follows: 1. Production Cost The cost of sequence of operations which begins with supplying materials, labor and services and ends with the primary packing of the product. Thus, it includes the cost of direct material, direct labor, direct expenses and factory overheads. 2. Administration Cost The cost of formulating the policy, directing the organization and controlling the operations of an undertaking which is not related directly to a production, selling, distribution, research or development activity or function. 3. Selling Cost It is the cost of selling to create and stimulate demand (sometimes termed as marketing) and of securing orders. 4. Distribution Cost It is the cost of sequence of operations beginning with making the packed product available for dispatch and ending with making the reconditioned returned empty package, if any, available for reuse. 5. Research Cost It is the cost of searching for new or improved products, new application of materials, or new or improved methods. 6. Development Cost The cost of process which begins with the implementation of the decision to produce a new or improved product or employ a new or improved method and ends with the commencement of formal production of that product or by the method. 7. Pre-Production Cost The part of development cost incurred in making a trial production as preliminary to formal production is called pre-production cost. 15. Conversion Cost The cost of transforming direct materials into finished products excluding direct material cost is known as conversion cost. It is usually taken as an aggregate of total cost of direct labor, direct expenses and factory overheads.


Costing can be defined as the technique and process of ascertaining costs. The principles in every method of costing are same but the methods of analyzing and presenting the costs differ with the nature of business. The methods of job costing are as follows: 1. Job Costing The system of job costing is used where production is not highly repetitive and in addition consists of distinct jobs so that the material and labor costs can be identified by order number. This method of costing is very common in commercial foundries and drop forging shops and in plants making specialized industrial equipments. In all these cases, an account is opened for each job and all appropriate expenditure is charged thereto. 2. Contract Costing Contract costing does not in principle differ from job costing. A contract is a big job whereas a job is a small contract. The term is usually applied where large-scale contracts are carried out. In case of ship-builders, printers, building contractors etc., this system of costing is used. Job or contract is also termed as terminal costing. 3. Cost Plus Costing In contracts where in addition to cost, an agreed sum or percentage to cover overheads and fit is paid to a contractor, the system is termed as cost plus costing. The term cost here includes materials, labor and expenses incurred directly in the process of production. The system is used generally in cases where government happens to be the party to give contract. 4. Batch Costing This method is employed where orders or jobs are arranged in different batches after taking into account the convenience of producing articles. The unit of cost is a batch or a group of identical products instead of a single job order or contract. This method is particularly suitable for general engineering factories which produce components in convenient economic batches and pharmaceutical industries. 5. Process Costing If a product passes through different stages, each distinct and well defined, it is desired to know the cost of production at each stage. In order to ascertain the same, process costing is employed under which a separate account is opened for each process. This system of costing is suitable for the extractive industries, e.g., chemical manufacture, paints, foods, explosives, soap making etc. 6. Operation Costing Operation costing is a further refinement of process costing. The system is employed in the industries of the following types: 1. The industry in which mass or repetitive production is carried out


The industry in which articles or components have to be stocked in semifinished stage to facilitate the execution of special orders, or for the convenience of issue for later operations

The procedure of costing is broadly the same as process costing except that in this case, cost unit is an operation instead of a process. For example, the manufacturing of handles for bicycles involves a number of operations such as those of cutting steel sheets into proper strips molding, machining and finally polishing. The cost to complete these operations may be found out separately. 7. Unit Costing (Output Costing or Single Costing) In this method, cost per unit of output or production is ascertained and the amount of each element constituting such cost is determined. In case where the products can be expressed in identical quantitative units and where manufacture is continuous, this type of costing is applied. Cost statements or cost sheets are prepared in which various items of expense are classified and the total expenditure is divided by the total quantity produced in order to arrive at per unit cost of production. The method is suitable in industries like brick making, collieries, flour mills, paper mills, cement manufacturing etc. 8. Operating Costing This system is employed where expenses are incurred for provision of services such as those tendered by bus companies, electricity companies, or railway companies. The total expenses regarding operation are divided by the appropriate units (e.g., in case of bus company, total number of passenger/kms.) and cost per unit of service is calculated. 9. Departmental Costing The ascertainment of the cost of output of each department separately is the objective of departmental costing. In case where a factory is divided into a number of departments, this method is adopted. 10. Multiple Costing (Composite Costing) Under this system, the costs of different sections of production are combined after finding out the cost of each and every part manufactured. The system of ascertaining cost in this way is applicable where a product comprises many assailable parts, e.g., motor cars, engines or machine tools, typewrite$, radios, cycles etc. As various components differ from each other in a variety of ways such as price, materials used and manufacturing processes, a separate method of costing is employed in respect of each component. The type of costing where more than one method of costing is employed is called multiple costing. It is to be noted that basically there are only two methods of costing viz. job costing and process costing. Job costing is employed in cases where expenses are traceable to specific jobs or orders, e.g., house building, ship building etc. In case where it is impossible to trace the prime cost of the items for a particular order because of the reason that their identity gets lost while manufacturing operations, process costing is used. For example, in a refinery where several tons of oil is being produced at the same time, the prime cost of a

specific order of 10 tons cannot be traced. The cost can be found out only by finding out the cost per ton of total oil produced and then multiplying it by ten. It may, therefore, be concluded that the methods of batch contract and cost plus costing are only the variants of job costing whereas the methods of unit, operation and operating costing are the variants of process costing. 3.9 TECHNIQUES OF COSTING Besides the above methods of costing, following are the types of costing techniques which are used by management only for controlling costs and making some important managerial decisions. As a matter of fact, they are not independent methods of cost finding such as job or process costing but are basically costing techniques which can be used as an advantage with any of the methods discussed above. 1. Marginal Costing Marginal costing is a technique of costing in which allocation of expenditure to production is restricted to those expenses which arise as a result of production, e.g., materials, labor, direct expenses and variable overheads. Fixed overheads are excluded in cases where production varies because it may give misleading results. The technique is useful in manufacturing industries with varying levels of output. 2. Direct Costing The practice of charging all direct costs to operations, processes or products and leaving all indirect costs to be written off against profits in the period in which they arise is termed as direct costing. The technique differs from marginal costing because some fixed costs can be considered as direct costs in appropriate circumstances. 3. Absorption or Full Costing The practice of charging all costs both variable and fixed to operations, products or processes is termed as absorption costing. 4. Uniform Costing A technique where standardized principles and methods of cost accounting are employed by a number of different companies and firms is termed as uniform costing. Standardization may extend to the methods of costing, accounting classification including codes, methods of defining costs and charging depreciation, methods of allocating or apportioning overheads to cost centers or cost units. The system, thus, facilitates interfirm comparisons, establishment of realistic pricing policies, etc. Systems of Costing It has already been stated that there are two main methods used to determine costs. These are: 1. Job cost method Process cost method

It is possible to ascertain the costs under each of the above methods by two different ways: 1. 2. Historical costing Standard costing

Historical Costing Historical costing can be of the following two types in nature: 1. 2. Post costing Continuous costing

Post Costing Post costing means ascertainment of cost after the production is completed. This is done by analyzing the financial accounts at the end of a period in such a way so as to disclose the cost of the units which have been produced. For instance, if the cost of product A is to be calculated on this basis, one will have to wait till the materials are actually purchased and used, labor actually paid and overhead expenditure actually incurred. This system is used only for ascertaining the costs but not useful for exercising any control over costs, as one comes to know of things after they had taken place. It can serve as guidance for future production only when conditions in future continue to be the same. Continuous Costing In case of this method, cost is ascertained as soon as a job is completed or even when a job is in progress. This is done usually before a job is over or product is made. In the process, actual expenditure on materials and wages and share of overheads are also estimated. Hence, the figure of cost ascertained in this case is not exact. But it has an advantage of providing cost information to the management promptly, thereby enabling it to take necessary corrective action on time. However, it neither provides any standard for judging current efficiency nor does it disclose what the cost of a job ought to have been. Standard Costing Standard costing is a system under which the cost of a product is determined in advance on certain pre-determined standards. With reference to the example given in post costing, the cost of product A can be calculated in advance if one is in a position to estimate in advance the material labor and overheads that should be incurred over the product. All this requires an efficient system of cost accounting. However, this system will not be useful if a vigorous system of controlling costs and standard costs are not in force. Standard costing is becoming more and more popular nowadays.

3.9 SELF ASSESSMENT Q.1. Define the term cost. Q.2. Explain the different elements of cost. Q.3. How can you classify the cost on the basis on function. Q.4. Classify the cost of different basis. Q.5. Explain the different methods of costing. Q.6. Define different techniques of costing. Q.7. Write short notes on: 1. Differential cost 2. Tracable cost 3. Product cost 4. Period cost 5. Abnormal cost Q.8. Define the cost include in decision making of management.

CHAPTER- 4 COST SHEET 4.1 INTRODUCTION: You are running a factory which manufactures electronic toys. You incur expenses on raw material, labour and other expenses which can be directly attibuted to cost and which cannot be directly attributed but are incurred upto their sales. You need to know the composition of cost at different stages. This will help you in the analysis of cost of a product so that same can be used for its proper management. In this lesson you will learn about cost sheet and its various components. 4.2 COST SHEET : MEANING AND ITS IMPORTANCE Cost sheet is a statement, which shows various components of total cost of a product. It classifies and analyses the components of cost of a product. Previous periods data is given in the cost sheet for comparative study. It is a statement which shows per unit cost in addition to Total Cost. Selling price is ascertained with the help of cost sheet. The details of total cost presented in the form of a statement is termed as Cost sheet. Cost sheet is prepared on the basis of : 1. Historical Cost 2. Estimated Cost Historical Cost

Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost prepared after incurring the actual cost is called Historical Cost Sheet. Estimated Cost Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting the tender price of a job or a contract.
Cost sheet is a document that provides for the assembly of an estimated detailed cost in respect of cost centers and cost units. It analyzes and classifies in a tabular form the expenses on different items for a particular period. Additional columns may also be provided to show the cost of a particular unit pertaining to each item of expenditure and the total per unit cost. Cost sheet may be prepared on the basis of actual data (historical cost sheet) or on the basis of estimated data (estimated cost sheet), depending on the technique employed and the purpose to be achieved. The techniques of preparing a cost sheet can be understood with the help of the following examples.

4.3 Importance of Cost Sheet The importance of cost sheet is as follows: _ Cost ascertainment The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet helps in ascertainment of cost for the purpose of determining cost after they are incurred. It also helps to ascertain the actual cost or estimated cost of a Job.

_ Fixation of selling price To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps in fixing selling price of a product or service by providing detailed information of the cost. _ Help in cost control For controlling the cost of a product it is necessary for every manufacturing unit to prepare a cost sheet. Estimated cost sheet helps in the control of material cost, labour cost and overheads cost at every point of production. _ Facilitates managerial decisions It helps in taking important decisions by the management such as: whether to produce or buy a component, what prices of goods are to be quoted in the tender, whether to retain or replace an existing machine etc. 4.4 COMPONENTS OF TOTAL COST The Components of cost are shown in the classified and analytical form in the cost sheet. Components of total cost are as follows: _ Prime Cost It consists of direct material, direct wages and direct expenses. In other words Prime cost represents the aggregate of cost of material consumed, productive wages, and direct expenses. It is also known as basic, first, flat or direct cost of a product. Prime Cost = Direct material + Direct Wages + Direct expenses

Direct material means cost of raw material used or consumed in production. It is not necessary that all the material purchased in a particular period is used in production. There is some stock of raw

material in balance at opening and closing of the period. Hence, it is necessary that the cost of opening and closing stock of material is adjusted in the material purchased. Opening stock of material is added and closing stock of raw material is deducted in the material purchased and we get material consumed or used in production of a product. It is calculated as : Material Consumed = Material purchased + Opening stock of material Closing stock of material. Illustration 1 Calculate prime cost from the following particulars for a production unit: Rs. Cost of material purchased 30,000 Opening stock of material 6,000 Closing stock of material 4,000 Wages paid 3,000 Rent of hire of a special machine for production 5,000

Solution: Statement showing Prime Cost Details Amount (Rs.) Direct Material: Material Consumed Opening stock of material Add : Material Purchased Material available for consumption Less : Closing stock of material Material consumed Direct Labour : Wages Direct Expenses: Rent of hire a special machine Prime cost 6,000 30,000 36,000 (4,000) 32,000 3,000 5,000 40,000

_ Factory Cost In addition to prime cost it includes works or factory overheads. Factory overheads consist of cost of indirect material, indirect wages, and indirect expenses incurred in the factory. Factory cost is also known as works cost, production or manufacturing cost.

Factory Cost = Prime cost + Factory overheads Illustration 2 Calculate factory cost from the following particulars: Rs. Material consumed 60,000 Productive wages 20,000 Direct Expenses 5,000 Consumable stores 2,000 Oil grease/Lubricating 500 Salary of a factory manager 6,000 Unproductive wages 1,000 Factory rent 2,000 Repair and Depreciation on Machine 600 Solution: Statement showing Factory cost Details


Direct Material: Material Consumed Direct Labour: Productive wages Direct Expenses Prime cost Add : Factory overheads Indirect Material: Consumable stores Oil grease/lubricants Indirect Labour: Unproductive wages Salary of a factory Manager Indirect Expenses: Factory rent 2,000 1,000 6,000 2,000 500

60,000 20,000 5,000 85,000



Repair and Depreciation on Machine Factory cost

600 2,600 97,100

Adjustment for stock of work-in-progress In the process of production, some units remain to be completed at the end of a period. These incomplete units are known as work-in-progress. Normally, the cost of incomplete units include direct material, direct Labour, direct expenses, and average factory overheads. Hence, at the time of computing factory cost, it is necessary to make adjustment of opening and

closing stock of work in progress to arrive at the net Factory cost/works cost. Illustration 3 From the following information calculate the works cost. Rs. Direct material 80,000 Direct Labour 22,000 Direct Expenses 5,000 Factory overheads 12,000 Work-in-progress: Opening stock 13,000 Closing stock 7,000 Solution: Statement showing Factory cost Details Amount (Rs.) Direct Material: Material Consumed Direct Labour: Productive wages Direct Expenses Prime cost Factory overheads Factory Cost (Gross) Add: Opening stock of work-in-progress 80,000 22,000 5,000 1,07,000 12,000 1,19,000 13,000 1,32,000 Less: Closing stock of work-in-progress Works or Factory cost (Net) (7,000) 1,25,000

COST OF PRODUCTION: If office and administrative overheads are added to factory or works cost, total cost of production is arrived at. Hence the total cost of production is calculated as: Total Cost of production = Factory Cost + office and administration overheads

Illustration 4 From the following information calculate the total cost of production Rs. Direct material 90,000 Direct Labour 32,000 Direct Expenses 9,000

Factory overheads Office and administration overheads SOLUTION Statement showing cost of production Details

25,000 18,000

Amount (Rs.)

Direct Material: Material Consumed Direct Labour: Productive wages Direct Expenses PRIME COST Factory overheads FACTORY COST Office and administration overheads TOTAL COST OF PRODUCTION

90,000 32,000 9,000 1,31,000 25,000 1,56,000 18,000 1,74,000

Cost of goods sold It is not necessary, that all the goods produced in a period are sold in the same period. There is stock of finished goods in the opening and at the end of the period. The cost of opening stock of finished goods is added in the total cost of production in the current period and cost of closing stock of finished goods is deducted. The cost of goods sold is calculated as: Cost of goods sold = Total cost of production + Opening stock of Finished goods Closing stock of finished goods

Illustration 5 From the following information calculate the cost of goods sold. Rs. Total Cost of Production 1,22,000 Opening stock of finished goods 12,000 Closing stock of finished goods 16,000 Solution: Cost of goods sold = Cost of Production + Opening stock of Finished goods - closing stock of Finished goods Cost of goods sold = Rs.1,22,000 + 12,000 16,000 = Rs.1,18,000

Total Cost i.e, Cost of Sales If selling and distribution overheads are added to the total cost of production, total cost is arrived at. This cost is also termed as cost of Sales. Hence the total cost is calculated as: Total Cost = Cost of Goods sold + Selling and distribution overheads

Components of Total Cost 1. Prime Cost Prime cost consists of costs of direct materials, direct labors and direct expenses. It is also known as basic, first or flat cost. 2. Factory Cost Factory cost comprises prime cost and, in addition, works or factory overheads that include costs of indirect materials, indirect labors and indirect expenses incurred in a factory. It is also known as works cost, production or manufacturing cost. 3. Office Cost Office cost is the sum of office and administration overheads and factory cost. This is also termed as administration cost or the total cost of production. 4. Total Cost Selling and distribution overheads are added to the total cost of production to get total cost or the cost of sales. Various components of total cost can be depicted with the help of the table below: Components of total cost Direct Direct Direct expenses Prime cost plus works overheads material labor Prime cost or direct cost or first cost Works or factory cost or production cost or manufacturing cost

Works cost plus office and administration Office cost or total cost of production overheads Office cost plus selling and distribution Cost of sales or total cost overheads

Illustration 6 From the following information calculate the total cost. Rs. Direct material 1,60,000 Direct Labour 52,000 Direct Expenses 19,000 Factory overheads 45,000

Office and administration overheads Selling and distribution overheads Solution: Statement showing total cost

28,000 33,000


Amount (Rs.)

Direct Material: Direct Labour: Direct Expenses PRIME COST Factory overheads FACTORY COST Office and administration overheads TOTAL COST OF PRODUCTION Selling and distribution overheads Total cost = cost of sales

1,60,000 52,000 19,000 2,31,000 45,000 2,76,000 28,000 3,04,000 33,000 3,27,000

Sales If the profit margin is added to the total cost, sales are arrived at. Excess of sales over total cost is termed as profit. When total cost exceeds sales, it is termed as Loss. Sales = Total Cost + Profit Sometimes profit is calculated on the basis of given information in percentage of cost or sales. In such a situation, the amount is assumed 100 in which the percentage is calculated. Then the Profit is calculated in the following ways: Case 1 If Cost is Rs.10,000 and profit on cost 10%. Assume the cost is Rs.100 and profit on cost is Rs.10. Hence Profit on cost of Rs.10,000 is 10,000 10/100 = Rs.1,000 Thus the sales value is Rs 11000 (10,000 + 1000) Case 2 If Cost is Rs.10,800 and profit on sales price is 10%. Assume sales price is Rs.100. cost price is Rs.90 [i.e. Rs.100 Rs.10]. When profit on cost of Rs.90 is Rs.10. Hence profit on cost of Rs.10,800 is 10,800 10/90 = Rs.1,200 10,800 + 1200 = 12,000 sales value Case 3 If sales price is Rs.12,100 and profit on cost is 10%. Assume Cost price is Rs.100. Sales price is Rs.110 [i.e.100 + 10]. If sales price is Rs.110, profit is Rs.10. Profit on sales price of Rs.12,100 is 12,100 10/110 = Rs.1,100 profit

Illustration 7 From the following information, calculate the value of goods sold. Rs. Total Cost of Production 1,45,000 Opening stock of finished goods 22,000 Closing stock of finished goods 6,000 Selling and distribution overheads 25,000 Profit 22,000 Solution Statement showing Sales Details Amount (Rs.) Total cost of production Add : Opening stock of finished goods 1,45,000 22,000 1,67,000 Less Closing stock of finished goods Cost of Goods sold Selling and distribution overheads Total Cost Profit Sales (6,000) 1,61,000 25,000 1,86,000 22,000 2,08,000

There is no prescribed format of a Cost sheet. It may change from industry to industry. A specimen format of a Cost Sheet is given as under: Particulars Total (Rs.) A. Materials Consumed : Purchases Add : Opening Stock of Raw material Expenses on Purchases Less : Closing Stock of Raw Material Direct Material consumed B. Direct Labour (Wages) C. Direct Expenses D. Prime Cost (A + B + C) E. Factory/Works Overheads Add : Opening Stock of Work-in-Progress Less : Closing Stock of Work-in-Progress

.............. .............. .............. .............. ..............

.............. .............. .............. .............. .............. .............. ..............

F. Works/Factory Cost (D + E) G. Office and administration overheads H. Total Cost of Production (F + G) Add : Opening Stock of finished Goods Cost of Goods available for sale Less : Closing Stock of finished Goods

.............. .............. .............. .............. .............. ..............

I. Cost of production of goods Sold or cost of good sold J. Selling and Distribution Overheads K. Total Cost (I + J) = Cost of Sales L. Profit M. Sales (K + L)

.............. .............. .............. .............. ..............

4.5 PREPARATION OF COST SHEET The various components of cost explained above are presented in the form of a statement. Such a statement of cost consists of prime cost, works cost, cost of production of goods, cost of goods sold, total cost and sales and is termed as cost sheet. The Preparation of a cost sheet can be understood with the help of following illustration: Illustration 8 Following information has been obtained from the records of left center corporation for the period from June 1 to June 30, 1998. Cost of raw materials on June 1,1998 Purchase of raw materials during the month Wages paid Factory overheads Cost of work in progress on June 1, 1998 Cost of raw materials on June 30, 1998 Cost of stock of finished goods on June 1, 1998 30,000 4,50,000 2,30,000 92,000 12,000 15,000 60,000

Cost of stock of finished goods on June 30, 1998 55,000 Selling and distribution overheads Sales Administration overheads Prepare a statement of cost. 20,000 9,00,000 30,000

Solution Statement of cost of production of goods manufactured for the period ending on June 30, 1998. 30,000 4,50,000 materials -----------4,80,000 15,000 4,65,000 2,30,000 6,59,000 92,000 7,87,000 12,000 7,99,000 --7,99,000 30,000 8,29,000 60,000 8,89,000 55,000 8,34,000 20,000 8,54,000 46,000 9,00,000

Opening stock Add-- purchase



Less-- closing stock of raw material Value of raw materials consumed Wages Prime cost Factory overheads Add-- opening stock of work in progress Less-- closing stock of work in progress Factory cost Add-Administration overhead Cost of production of goods manufactured Add--opening stock of finished goods Less-- closing stock of finished goods Cost of production of goods sold Add-- selling and distribution overheads Cost of sales Profit Sales

Illustration 9 From the following information, prepare a cost sheet showing the total cost per ton for the period ended on December 31, 1998. Raw materials Productive wages Direct expenses Unproductive wages Factory rent and taxes Factory lighting Factory heating Motive power Haulage Directors fees (works) 33,000 35,000 3,000 10,500 2,200 1,500 4,400 3,000 1,000 Rent and taxes (office) Water supply Factory insurance Office insurance Legal expenses Rent of warehouse Depreciation-Plant and machinery Office building 500 1,200 1,100 500 400 300 2,000 1,000

Directors fees (office) Factory cleaning Sundry office expenses Expenses Factory stationery Office stationery Loose tools written off

2,000 500 200 800 750 900 600

Delivery vans Bad debt Advertising Sales department salaries Up keeping of delivery vans Bank charges Commission on sales

200 100 300 1,500 700 50 1,500

The total output for the period has been 10000 tons. Solution Cost sheet for the period ended on December 31, 1998 Raw materials Production wages Direct expenses Prime cost Add--works overheads: Unproductive wages Factory rent and taxes Factory lighting Factory heating $. 33,000 35,000 3,000 71,000 10,500 7,500 2,200 1,500 4,400

Motive power Haulage Directors fees (works) Factory cleaning Estimating expenses Factory stationery Loses tools written off Water supply Factory insurance Depreciation of plant and machinery Works Add-office Directors fees Sundry office Office Rent and taxes Office Legal Depreciation of office Bank charges cost overhead (office) expenses stationery (office) insurance expenses building

3,000 1,000 500 800 750 600 1,200 1,100 37,050 2,000 1,08,050 2,000 200 5,550 900 500 500 1,13,600 400 1,000 4,600 50 300 1,18,200 200 100 300 1,500 1,500 700

Office cost Add-- selling and distribution overheads Rent of warehouse Depreciation on delivery vans Bad debts Advertising Sales department salaries Commission on sales Upkeep of delivery vans

Total cost Cost per ton $. 1,18,200/10,000 = $. 11.82

4.6 SOLVED ILLUSTRATION HARD COPY 4.7 SELF ASESSMENT: 1. What is meant by cost sheet? Explain the importance of Cost Sheet. 2. Define various components of total cost. 3. Explain the importance of cost sheet. 4. Prepare the format of Cost Sheet. 5.Write short note on following: 1. Factory cost 2. Prime cost 3. Cost of sales 4. Production Cost 5. Cost of Goods Sold 6. Compute the cost of material consumed from the following data: Opening stock of raw material Rs.9,000 Purchases of raw material Rs.1,27,000 Closing stock of raw material Rs.12,000 7. Compute Prime cost from the data given below: Direct Material Expenses on purchases Rent of special machine taken on hire for production Productive wages 8. From the following information., prepare cost sheet. Direct material Direct Labour Direct Expenses Factory overheads Office and administration overheads 20% of works cost Selling and distribution overheads Opening stock of finished goods Closing stock of finished goods Profit on Sales 10% Rs. 1,60,000 45,000 15,000 35,000 45,000 25,000 10,000 Rs. 1,80,000 20,000 40,000 65,000



In the previous lesson you have learnt about the cost sheet and its various components. You must have noticed that cost of material is the major constituent of cost. It requires speical mention so that its cost can be controlled properly. This will involve the proper handling of the store material and the pricing of materials issued to various jobs untertaken. In this lesson you will learn about materials and stores i.e. about stores and the level of stock and their valuations. 5.2 MEANING AND CLASSIFICATION AND CODIFICATION The substance from which the product is made is termed as material. It may be in a raw or a manufactured state. It forms an integral part of finished product. Materials are used for manufacturing goods. In most cases material is an important constituent of total cost. Hence, material cost is the main component of the cost of production. Materials may be direct or indirect:

Direct materials Direct material means cost of raw material used or consumed in production. It is not necessary that all materials purchased in a particular period is used in production (in that period itself). Indirect materials Indirect Material is that material which cannot be easily identified and related with a particular product, job, and process. Stores and material are used interchangeably. However, both the terms differ. A store has a wider meaning than materials. Store is a place in which the materials are stored. Different types of materials are kept in the stores. It includes raw material, tools, equipments, repair, and maintenance of parts factory supplies, components, Fixtures, Jigs etc. Sometimes, it also includes finished goods, and semi finished goods within the scope of this term. Thus items kept in the store are called stores. 5.3 Classification and codification The storekeeper keeps the material in the store. The duties of storekeeper include accepting, identifying, classifying, and placing of materials. Efficient storage requires the consideration of the following : Checking of material He should verify the materials received with consignment note, inspection report and materials received report. Therefore, he should send the copy of materials received report received by him, after due verification to the Accounts Department for payment purposes. Classification and codification Classification and codification of materials is necessary for keeping the material in store. All items in the stores department are properly classified and codified to prevent mixing of one type of materials with the other and minimise the cost of retrieval. Materials are classified according to nature in appropriate categories, e.g., Materials related with engineering are classified as bronze, copper, steel, and mild steel etc., and each category is further classified suitably. To save time in handling of materials, a written document known as material manual, is prepared in which description and code number to each store item is given. Following are the methods of coding of materials: 1. Alphabetical method 2. Numerical method 3. Alphabetical-cum-Numerical method Alphabetical method In this method first alphabet letters are used for codification of each category of materials. For example, steel wire is coded as SW or steam coal is coded as SC etc. Numerical method This method is used where materials accounting is to be mechanised by use of punched cards or computers. For numerical coding a list is prepared for various departments and allotting to each of them a suitable number. The first two digits of the code number represent the department for which the materials are meant and other two digits state the name of material as mentioned in the standard list or materials manual. For example, if code is 2341 it means Material No.41 [copper wire] is to be used in Department No.23. Alphabetical-cum-Numerical method In this method, a combination of these two methods is used for coding of materials. For example, a steel wire of gauge 4mm quality A stored in rack/ bin No.22, is given the code number SW4A/22. Such a method gives exact information than any of the above two methods. Codification of materials helps in two ways: (i) In absence of coding the title of an account may have to be written a number of times. This results in avoidable clerical work, particularly in case of lengthy account titles.

(ii) Secrecy about the exact nature of the transaction from the office employees is maintained. 5.4 PURCHASING AND PROCUREMENT OF MATERIAL Purchasing and procurement is used to denote the function of and the responsibility for procuring materials, supplies, and services. Recently, the term "supply management" has increasingly come to describe this process as it pertains to a professional capacity. Employees who serve in this function are known as buyers, purchasing agents, or supply managers. Depending on the size of the organization, buyers may further be ranked as senior buyers or junior buyers.

FACTORS FOR PURCHASING The importance of purchasing in any firm is largely determined the four factors: availability of materials, absolute dollar volume of purchases, percent of product cost represented by materials, and the types of materials purchased. Purchasing must concern itself with whether or not the materials used by the firm are readily available in a competitive market or whether some are bought in volatile markets that are subject to shortages and price instability. If the latter condition prevails, creative analysis by top-level purchasing professionals is required. If a firm spends a large percentage of its available capital on materials, the sheer magnitude of expense means that efficient purchasing can produce a significant savings. Even small unit savings add up quickly when purchased in large volumes. When a firm's materials costs are 40 percent or more of its product cost (or its total operating budget), small reductions in material costs can increase profit margins significantly. In this situation, efficient purchasing and purchasing management again can make or break a business. Perhaps the most important of the four factors is the amount of control purchasing and supply personnel actually have over materials availability, quality, costs, and services. Large companies tend to use a wide range of materials, yielding a greater chance that price and service arrangements can be influenced significantly by creative purchasing performance. Some firms, on the other hand, use a fairly small number of standard production and supply materials, from which even the most seasoned purchasing personnel produce little profit, despite creative management, pricing, and supplier selection activities. THE ROLE OF PURCHASING There are two basic types of purchasing: purchasing for resale and purchasing for consumption or transformation. The former is generally associated with retailers and wholesalers. The latter is defined as industrial purchasing. Purchasing can also be seen as either strategic or transactional. Also, the words "direct" and "indirect" have been used to distinguish the two types. Strategic (direct) buying involves the establishment of mutually beneficial long-term relationship relationships between buyers and suppliers. Usually strategic buying involves purchase of materials that are crucial to the support of the firm's distinctive competence. This could include raw material and components normally used in the production process. Transactional (indirect) buying involves repetitive purchases, from the same

vendor, probably through a blanket purchase order. These orders could include products and services not listed on the bill of materials, such as MRO goods, but are used indirectly in producing the item. Some experts relate that the purchasing function is responsible for determining the organization's requirements, selecting an optimal source of supply, ensuring a fair and reasonable price (for both the purchasing organization and the supplier), and establishing and maintaining mutually beneficial relationships with the most desirable suppliers. In other words, purchasing departments determine what to buy, where to buy it, how much to pay, and ensure its availability by managing the contract and maintaining strong relationships with suppliers. In more specific terms, today's purchasing departments are responsible for: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. coordinating purchase needs with user departments identifying potential suppliers conducting market studies for material purchases proposal analysis supplier selection issuing purchase orders meeting with sales representatives negotiating contract administration resolving purchasing-related problems maintenance of purchasing records

These functions obviously entail no insignificant amount of responsibility. As the role of purchasing grows in importance, purchasing departments are being charged with even more responsibilities. Newer responsibilities for purchasing personnel, in addition to all purchasing functions, include participation in the development of material and service requirements and related specifications, conducting material and value-analysis studies, inbound transportation, and even management of recovery activities such as surplus and scrap salvage, as well as its implications for environmental management. In the 1970s and 1980s purchasing fell under the rubric of "materials management." Many corporations and individual facilities employed executives who held the title "materials manager," responsible for purchasing and supply management, inventory management, receiving, stores, warehousing, materials handling, production planning, scheduling and control, and traffic/transportation. Today, the term materials management has expanded to include all activities from raw material procurement to final delivery to the customer, to management of returns; hence, the newer title supply chain management. As purchasing personnel became even more central to the firm's operations they became known as "supply managers." As supply managers, they are active in the strategic-planning process, including such activities as securing partnering arrangements and strategic alliances with suppliers; identification of threats and opportunities in the supply environment; strategic, long-term acquisition plans; and monitoring continuous improvement in the supply chain.

A study by found that strategic purchasing enables firms to foster close working relationships with a limited number of suppliers, promotes open communication among supply chain partners, and develops a long-term strategic relationship orientation for achievement of mutual goals. This implies that strategic purchasing plays a synergistic role in fostering value-enhancing relationships and knowledge exchange between the firm and its suppliers, thereby creating value. In addition, supply managers are heavily involved in cross-functional teams charged with determining supplier qualification and selection, as well ensuring early supplier involvement in product design and specification development. A comprehensive list of objectives for purchasing and supply management personnel would include: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. to support the firm's operations with an uninterrupted flow of materials and services: to buy competitively and wisely (achieve the best combination of price, quality and service); to minimize inventory investment and loss; to develop reliable and effective supply sources; to develop and maintain healthy relations with active suppliers and the supplier community; to achieve maximum integration with other departments, while achieving and maintaining effective working relationships with them; to take advantage of standardization and simplification; to keep up with market trends; to train, develop and motivate professionally competent personnel; to avoid duplication, waste, and obsolescence; to analyze and report on long-range availability and costs of major purchased items; to continually search for new and alternative ideas, products, and materials to improve efficiency and profitability; and to administer the purchasing and supply management function proactively, ethically, and efficiently.

DETERMINING REQUIREMENTS In progressive firms, purchasing has a hand in new product development. As a part of a product development team, purchasing representatives have the opportunity to help determine the optimal materials to be used in a new product, propose alternative or substitute materials, and assist in making the final decision based on cost and material availability. Purchasing representatives may also participate in a make-or-buy analysis at this point. The design stage is the point at which the vast majority of the cost of making an item can be reduced or controlled. Whether or not purchasing had an impact on a product's design, the purchasing agent's input may certainly be needed when defining the materials-purchase specifications. Specifications are detailed explanations of what the firm intends to buy in order to get its product to market. Generally specified is the product itself, the material from which it is to be made, the process for making it, minimum levels of quality, tolerances (a range in which a specified characteristic is acceptable, e.g., an outer diameter must be a certain size, 25 millimeters), inspection and test standards, and a specific function the product must perform.

If the product requires a standardized component, the specifications are easily communicated by specifying a trade or brand name. However, a custom part can complicate the situation considerably; if incorrectly manufactured, such a product can severely damage a relationship, resulting in unnecessary costs and possible legal action. It is the buyer's responsibility to adequately communicate the specifications to the supplier so that there is no misunderstanding. SUPPLY SOURCING Part of the sourcing decision involves determining whether to purchase a part from an outside supplier or produce the part internally. This is typically known as a make-or-buy decision. If the buyer chooses to purchase the part externally, then he must find qualified suppliers who are willing to make and sell the product to his or her firm under the specified conditions. Buyers have a number of places to go to locate sources of supply, some obvious and some indirect. The most obvious sources would include the Yellow

Figure 1 Determining Requirements Pages, other purchasing departments, and direct marketing. Purchasing departments typically have a number of trade publications to which they subscribe, such as Purchasing, Iron Age, and Purchasing World, which are filled with advertisements for a multitude of suppliers. Also, being a subscriber usually puts the buyer's name on a mailing list so that flyers, postcards, and other varieties of direct marketing find their way into the purchasing department's hands. Other sources of supply include manufacturer directories and trade registers. The best known of these is Thomas' Register of American Manufacturers, frequently referred to simply as the Thomas Register. With 125,000 trade and brand names, 151,000 U.S. and Canadian company listings, and 6,000 catalogs, it is a valuable tool for buyers. Practically every purchasing department has access to this source, either through the 34-volume book series or CD-ROMs. Suppliers also may be found at trade exhibits, in supplier catalogs, or via recommendations from other knowledgeable sources, such as salesmen and engineers. Probably the most important and frequently used source will soon be the World Wide Web; countless firms maintain Web pages and are listed in online catalogs and directories. Many firms find themselves in a situation where a suitable supplier cannot be found. In this situation, the firm is forced to develop a supplier. Supplier development is sometimes referred to as "reverse marketing," which entails finding the supplier with the most potential for success and providing the resources necessary for the supplier to manufacture the needed product. This could include training

in production processes, quality, and management assistance, as well as providing temporary personnel, tooling, and even financing. When the product being purchased is fairly standard and readily available, most firms choose to utilize the competitive bidding process of supplier selection. This involves little or no negotiation. A request for bids is sent to a limited number of qualified suppliers asking for a price quote for the product, given the terms and conditions of the contract. The contract generally goes to the lowest bidder. For government bid requests, the contract legally must go to the lowest bidder qualified to fulfill the contract.


The materials requisition, illustrated below, is a written order to the storekeeper to deliver materials or supplies to the place designated or to give the materials to the person presenting a properly executed requisition. It is drawn by someone who has the authority to requisition materials for use in the department. The authorized employee may be a production control clerk, or department head, a supervisor, a group leader, an expeditor, or a materials release analyst. In a computerized system, the computer program will often prepare the requisition in the form of a tabulating card. The materials requisition is the basic form used to withdraw materials from the storeroom. Its preparation results in entries in the issued section of the materials ledger card and in postings to the job order cost sheets, production reports or the various expense analysis sheets for individual departments. All withdrawals result in debits to work in process or to control accounts for factory overhead, marketing expenses, or administrative expenses, and in credits to materials.

Materials Requisitioned Journal:

With the posting to the materials ledger cards, the job order cost sheets, the production reports, and the expense analysis sheets completed, it is still necessary to post the materials withdrawals to the proper ledger control accounts. This task is greatly facilitated by the use of a materials requisitioned journal. This journal is a form of materials summary. At the end of the month, the total of the various columns are posted directly to the ledger accounts, except for the sundries column from which items are posted individually.

Tabulating cards as materials requisitions:

Tabulating cards are convenient input or output devices for computer operations to produce the card, the computer is instructed by the console operator to perform certain materials issuance transactions for jobs or products. The card serves as authority for the storekeeper to issue the materials, internal computer operations will update the material data bank and eventually produce output reports including totals that will be entered in the general ledger accounts, unless those accounts are also part of the EDP system. Indirect materials or supplies for factory or office use will also be stored in the inventory data bank of the computer. When such materials are needed, a request will inform the computer as to type, quantity, and requesting department. Supplies requisitioned for marketing and administrative departments would be charged to their respective departments.

Bill of Materials:

The bill of materials, a kind of master requisition, is a printed or duplicated form that lists all the materials and parts necessary for a typical job or production run. Time is saved and efficiency is promoted through the use of a bill of materials. When a job or production run is started, all the materials listed on the bill of materials are sent to the factory or are issued on a prearranged time schedule. As the bill of materials is a rather cumbersome medium for posting purpose, however, data processing improves the procedure by simultaneously. Preparing tabulating cards for materials requisitions. While the storekeeper issues the materials as stated on the bill of materials, the tabulating cards can be processed in the materials ledger section and in the cost department at almost the same time as the materials are used in the factory. A computer program will provide the print outs of the bill of materials and process the information internally to update the accounting records.

Materials Purchasing Forms:

The principle forms required in purchasing are the purchase requisition form and thepurchase order form.

Purchase Requisition Form:

The purchase requisition originates with (1) stores or where house clerk who observes that quantity on hand is at a set ordering minimum, (2) a materials ledger clerk who may be responsible for notifying the purchasing agent when to buy , (3) a works manager who foresees the need for special materials or unusual quantities, (4) a research or engineering department employee who needs materials or supplies of a special nature, or (5) a computer that has been programmed to produce replenishment advice for the purchasing department. For standard materials, little information other than the stock number may be needed, and thepurchasing agent uses judgment concerning where to buy and the quantity to order. For other purchases requests, it may be necessary to give meticulous descriptions, blueprints, catalog numbers, weights, standards, brand names, exact quantities to order, and suggested prices. Below is an example of the purchase requisition:

Example/Sample of purchase requisition form: Purchase Requisition

No. Mo | Day | Yr 07615

To Purchasing Department Deliver to _________________ Date Required___________________ Dept No. ________________ Acct. No. _______________ Suggested Supplier________________________________________________________________


Item No.


Unit Price


Budget Control

Allowance for period ____ Balance Available___

Ordered By____

Amt This Purchase___ Remaining Balance___

Approved By___

One copy remains with the originating employee, and the original is sent to the purchasingdepartment for execution of the request.

Purchase Order Form:

The purchase order, signed by the purchasing agent or other official, is a written authorization to a vendor to supply specified quantities of described goods at agreed terms and at a designated time and place. As a convenience, the vendors order forms may be used; but in typical practice, the order forms are prepared by the purchasing company, and the form is adapted to the particular needs of the purchaser. As a matter of record and for accounting control, a purchase order should be issued for every purchase of materials, supplies, or equipment. When a purchase commitment is made by mail, telephone, or a sales representative, the purchase order serves as confirmation to the vendor and places the required documents in the hands of those concerned in the purchasing company. The purchases order gives the vendor a complete description of the goods and services desired, the terms, the prices, and the shipping instruction. When necessary, the description may refer to attached blueprints and specification pages. The original and an acknowledgment copy are sent to the vendor. The acknowledgment copy is a necessary form for contract procedure, because other copies are distributed. The vendor is asked to sign and return the copy to the purchaser, indicating that the order was received and will be delivered according to the specifications enumerated in the purchases order.

es a space for the inspection department to note either the complete approval of the shipment or the quantity rejected and the reason for the rejection, in inspection does not take place immediately after receipt of the materials, the receiving report is distributed as follows: 1. 2. The receiving department keeps one copy and sends another copy to the purchasing department as notice of the arrival of the materials All other copies go to the inspection department, and are distributed when inspection is completed. After inspection, one copy of the receiving report, with the inspection result noted thereon, is sent to the accounting department, where it is matched with the purchase order and the venders invoice and the paid. Other copies go to various departments such as materials and production planning. One copy accompanies the materials, so that the storekeeper knows the quantity and the kind of materials received.

Invoice Approval and Data Processing:

By the time materials reach the receiving department, the company unusually will have received the invoice from the vendor. This invoice and a copy of the purchase order are filled in the accounting department. When the receiving report with its inspection reports arrives, the receiving report and the invoiceare compared to see that materials received meet purchase order specifications as to items, quantities, price extensions, discount and credit terms, shipping instruction, and other possible conditions. I the invoice is found to be correct or has been adjusted because of rejects as noted by the inspection department, the invoice clerk approves it, attaches it to the purchase order and the receiving report, and sends these papers to another clerk for the preparation of the voucher.

Invoice approval is an important step in materials control procedure, since it certifies that the goods have been received as ordered and the payment can be made. The invoice approval information is often built into a rubber stamp and each invoice is stamped. The verification procedure is handed by responsible invoice clerks, thus assuring systematicexamination and handling of the paper work necessary for adequate control of materials purchases. The preparation of the voucher is based on the information taken from the invoice approval stamp. The voucher data are entered first in the purchases journal and are posted to the subsidiary records. They are then entered in the cash payments journal according to the due date for payment. The original voucher and two copies are sent to the treasurer for issuance of the check. The treasurer mails the check with the original voucher to the vendor, files a voucher copy, and returns one voucher copy to the accounting department for the vendors file. Purchase transactions entered in the purchases journal affect the control accounts and the subsidiary records as shown in the chart below:

General Ledger Control Transaction Debit Materials purchased for Materials stock Materials purchased for a particular job or Work in process department Materials and supplies purchased for factory Materials overhead purposes Credit Accounts Payable Entry in the received section in the materials ledger card Entry in the direct materials section of the production or the job order Entry in the received section of the materials ledger card Entry in the received section of the materials ledger card or in the proper columns of the marketing or administrative expenses analysis sheets Subsidiary Records

Accounts Payable

Accounts Payable

Materials Supplies purchased for Marketing marketing and expenses control Accounts Payable administrative office Administrative
expenses control

Factory Overhead Marketing Purchases of services or expenses control Accounts Payable repairs
Administrative expenses control

Entry in the proper account columns of the expenses analysis sheet

Purchase of equipment Equipment Correcting Invoices:

Accounts Payable

Entry on the equipment ledger card

When the purchases order, receiving report, and invoice are compared, various adjustments may be needed as a result of the circumstances described below:


Some of the materials ordered are not received and are not entered on the invoice. In this case no adjustment is necessary, and the invoice may be approved for immediate payment. On the purchase order the invoice clerk will make a notation of the quantity received in place of





the quantity ordered. If the vendor is out of stock or otherwise unable to deliver specified merchandise, and immediate ordering from other sources may be necessary. Items ordered are not received but are entered on the invoice. In this situation the shortage is noted on the invoice and is deducted from the total before payment is approved. A letter to the vendor explaining the shortage is usually in order. The seller ships a quantity larger than called for on the purchase order. The purchaser may keep the entire shipment and add the excess to the invoice, if not already invoiced; or the excess may be returned or held, pending instructions from the seller. Some companies issue a supplementary purchase order that authorizes the invoice clerk to pay the over shipment. Materials of a wrong size are quality, defective parts, and damaged items are received. If the items are returned, a correction on the invoice should be made before payment is approved. It may be advantageous to keep damaged or defective shipments if the seller makes adequate price concessions, or the items may be held subject to the seller's instructions. It may be expedient for a purchaser to pay transportation charges, even though delivered prices are quoted and purchases are not made on this basis. The amount paid by the purchaser is deducted on the invoice, and the paid freight bill is attached to the invoice as evidence of payment.

5.6 SELF ASSESSMENT Q.1. Define the term material. Why is it important element of cost. Q.2. Define the procedure of procuring material from supplier. Q.3. What are the things required to material procurement? Q.4. Define the role of invoice in cost of material. Q.5. Define the term material Requisition Form. What is its role in material purchasing? Q.6. What do you mean by store keeping? What are the cost of store keeping? Q.7. How can you correct the incorrected invoice? Q.8. Write short notes: 1. Purchase order form 2. Material ledger 3. Invoice 4. Material cost


6.1 Meaning:

For Inventory valuation, cost may mean historical, current or standard cost. Historical costs represents the cost actually incurred at the time of acquisition. Current replacement cost represents the replacement price on the date of its consumption. Standard cost represents the predetermined cost that should be incurred at a given level of efficiency and capacity utilization.

6.2 Inventory Systems:

Periodic Inventory System: It is a method of ascertaining inventory by taking an actual physical count of all inventory items on hand at a particular date on which information about inventory is required. The cost of goods sold is calculated as a residual figure (which includes lost goods also) as follows:

Cost of Goods sold= Opening inventory + Purchases Closing stock

Perpetual Inventory System: It is a method of recording inventory balances after each receipt and issue in order to ensure accuracy of perpetual inventory records, physical stocks should be checked and compared with recorded balances. The discrepancies should be investigated and adjusted properly in accounts. The closing inventory is calculated as a residual figure (which includes lost goods also) as follows:

Closing Inventory = Opening Inventory + Purchases cost of goods sold

Methods of Control of inventories: The various methods for assigning the cost between sold and unsold goods include the following: 1. First in first Out (FIFO) Method 2.Average cost Method 3.Last In First Out (LIFO) method 4.Base stock method 5.Specific Identification Method 6.Standard cost 7.Adjusted Selling Price 8. Latest Purchase Price 9.Next In First Out Method ( NIFO) Method

10. Highest In first Out (HIFO) Method

FIFO Method:

FIFO method is based on the assumption that the goods which are received first are issued first. This assumption is made for the purpose of assigning cost and not for physical flow of goods. The goods sold, therefore ,consists of the earliest lots and are valued at the price paid for such lots. The ending inventory consists of the latest lots and is valued at the price paid for such lots. The ending inventory is stated in the Balance Sheet at a value nearer the current market price. Advantages of FIFO Method A good system of stock management requires that the oldest units are issued first and stock consists of the latest purchases. This system is found in the FIFO method of pricing the issues. No profit or loss occurs merely on the use of this method. The stock of material represents the recent purchases, hence its value is based on present price. Disadvantages of FIFO Method Under this method, the objective of matching of cost with revenues is not achieved. If the prices of materials are rising fast, the current production cost may be understated. If the sales price is fixed, then sales revenue is not generating enough income to cover the cost of purchases of raw material. It involves difficult calculation and hence increasing the possibility of clerical mistake. Comparison between similar jobs is very difficult if

material issued to the jobs is of different prices. The FIFO method is suitable, where the size and cost of raw material units are large, materials are identified and belonging to a particular lot and not more than two or three different prices of material are on hand at one time.
LIFO Method: It is based on the assumption that the goods which are received last are issued first. This assumption is made for the purpose of ascertaining cost and not for the purpose of physical flow of goods.

Therefore the goods sold consists of the latest lots and are valued at the price paid for such lots. The ending inventory consists of the earliest lots and is valued at the price paid for such lots. The ending inventory is understated in the Balance Sheet at old cost. Advantages of LIFO Method This method takes current market prices while issuing materials to different jobs. Actual cost of materials is charged to production, therefore no profit or loss results on account of this method. This method helps in reducing the burden of income tax during the period of price rise. It provides a better matching of current cost with current revenues. Disadvantages of LIFO Method The profit of a firm is manipulated with this method in operation. This method involves considerable amount of clerical work because of complications in calculating prices. The stock in hand is valued at a price which might have become out of date when compared with the current stock prices. Thus the financial position of the business until is wrongly stated.

Basis of Distinction 1.Basic Assumption


LIFO last are

Goods received first are issued Goods received first issued first

2.Cost of Goods sold

Cost of goods sold represents Cost of goods sold represents cost of earlier purchases cost of recent purchases B/S shows the ending B/S is distorted because inventory at a value nearer the ending inventory is current market price understated at old cost Ending Inventory represents Ending Inventory represents cost of recent purchases cost of earlier purchases Higher income is reported Lower income is reported

3.Distortion in Balance sheet

4.Ending Inventory

5. In case of Rising Prices




No. of units

Cost unit(Rs.)

per Amt(Rs.)

1 Jan. 5 Jan. 10 Jan. 15 Jan. 20 Jan. 25 Jan. Total

Purchase Purchase Purchase Purchase Purchase Purchase

500 1000 2000 1000 3000 2000 9500 Inventory

3 4 5 6 4 7

1500 4000 10000 6000 12000 14000 47500

Units 1000 500 1000 2000 1500 6000

11 Jan. 14 Jan. 16 Jan. 21 Jan. 30 Jan.

Sales Sales Sales Sales Sales Total

Cost of goods sold & Inventory under FIFO


Quantity sold Quantity break up 1000 500 500



Total Amt(Rs.)

11 Jan.

X3 X4 X4 X5 X5 X6

1500 2000 2000 5000 5000 6000 6000 27500


14 Jan. 16 Jan 21 Jan.

500 1000 2000

500 1000 1000

2000 5000 11000

30 Jan. Total Sales Inventory


1500 6000




1500 2000

X4 X7 9500

6000 14000





Quantity sold 1000 500 1000 2000 1500

Quantity Rate break up 1000 500 1000 2000 1500 6000 X5 X5 X6 X4 X7


Thus, cost of goods Total Amt(Rs.) sold under FIFO= 27,500 5000 2500 6000 8000 10500 Inventory under FIFO = 20,000

11 Jan. 14 Jan. 16 Jan 21 Jan. 30 Jan. Total Sales Inventory

5000 2500 6000 8000 10500 32000



500 1000 500 1000 500

X3 X4 X5 X4 x7

1500 4000 2500 4000 3500 47500


Cost of goods sold & Inventory under LIFO



Thus, cost of goods sold under LIFO= Inventory under LIFO =

32,000 15,500


Weighted Average Price method:

The Weighted Average Price method is based on the assumption that each issue of goods consists of a due proportion of the earlier lots and is valued at the weighted average price. Weighted Average Price is calculated by dividing the total cost of goods in stock by the total quantity of goods in stock. This weighted average price is used for pricing all the issues until a new lot is received then a new weighted average price is calculated. 6.3 STOCK LEVELS The store is divided into different sections, each is meant for one particular type of material. Each section has some containers for keeping different varieties of that particular type of material. These containers are termed as Bins or Racks, Each bin/rack should be appropriately numbered and indexed for easy identification. For example, the store has a separate section for bolts. The different sizes of bolts are kept in the different bins. To facilitate the location of section and various materials, it is better if location plans are exhibited at the entrance of the store room STOCKS LEVELS: Maximum and minimum stock Level To avoid over and under investment in materials, the management decides the maximum quantity of materials to be kept in the store. The limits of minimum/maximum quantity set by the management should be strictly observed by the storekeeper. Maximum stock Level The maximum level is the largest quantity of a certain material which should be kept in the store at any point of time. Maximum stock level is computed as follows: Maximum stock level = Reorder level + Reorder quantity [Minimum consumption x Or minimum reorder period] Maximum stock level = Economic order quantity + Minimum stock

Minimum stock Level The minimum stock level is the lowest quantitative balance of material which must be kept at all times so that the assembly line may not be stopped on account of non-availability of materials. It is decided by taking into account the followings: 1. Re-order level 2. Average stock level Minimum stock level is computed as follows: Minimum stock level = Re-order level [Normal consumption average Reorder period

Re-order level It is the point at which if material in store is reached, the order of further supply of material must be placed. This point is fixed between maximum level and minimum level. This point automatically initiates the process of placing a fresh order. Re-order level depends on the following factors: (i) Maximum usage (ii) Time interval i.e. the anticipated time lag between the date of issuing orders and the receipt of materials. Re-order level = Maximum re-order period Maximum usage Average stock level

This level indicates the average stock held by the firm. It is calculated with the help of following: Average stock level = 1/2 [Maximum stock level + Minimum stock level] Or Average stock level = Minimum stock level + 1/2 Re-order Quantity Illustration The following information received from Monika industries in respect of Material No.ST45: Normal consumption 400 units per week Maximum consumption 600 units per week Minimum consumption 200 units per week Re-order period 6 to 8 weeks Re-order Quantity 2000 units Calculate: (a) Re-order level (b) Maximum level (c) Minimum level (d) Average stock level Solution (a) Re-order level = Maximum reorder period Maximum usage = 600 8 = 4800 units (b) Maximum stock level = Reorder level + Reorder quantity [Minimum consumption Minimum reorder period] = 4800 + 2000 [ 200 6] = 6800 1200 = 5600 units (c) Minimum stock level = Reorder level [Normal consumption average Reorder period] = 4800 [400 7] = 4800 2800 = 2000 units. (d) Average stock level = 1/2 [Maximum stock level + Minimum stock level] = 1/2 [5600 + 2000] = 7600/2 = 3800 units. Or Average stock level = Minimum stock level + 1/2 Re-order Quantity = 2000 + 1/2 [2000] = 2000 +1000 = 3000 units Note : The number of units of the average stock as per the alternative method need not be same 6.4 ECONOMIC ORDER QUANTITY The economic order quantity (EOQ) is the size of the purchase order which gives maximum economy in purchasing material. It is also termed as standard order quantity. It is fixed after taking into consideration the following points: (i) Ordering cost Cost of placing a order refers to the cost incurred for acquiring materials. It depends upon number of orders placed and the number of items ordered. If the order size is larger in quantity, orders placing cost per unit is lower and if order size is smaller in quantity, order placing cost per unit is higher: It includes cost of preparing and placing an order, cost of transportation, cost of receiving and inspecting the materials.

(ii) Carrying cost It is the cost that is incurred in maintaining a given level of stock. It includes cost of handling materials, insurance premium, cost of storage space, obsolescence losses etc., larger size of stock, higher the stock carrying cost per unit per annum and vice versa. EOQ is calculated as follows: EOQ = 2AB C Where, A = Annual consumption B = Buying cost per order C = Carrying cost per unit per annum EOQ = Economic order Quantity Illustration Satyam, a machine manufacturer, purchases 3600 units of a certain component for his annual usage. The order placing cost is Rs.200 and cost of carrying one unit for a year is Rs. 4. Calculate the economic order quantity. Solution EOQ = 2AB C where A = 3600 units B = Rs 200 C = Rs 4 = 2 *3600* 200 4 = 14,40,000 4 = 3,60,000 = 600 units 6.5 SOLVED ILLUSTRATION HARD COPY

6.6 SELF ASSESSMENT 1. State the meaning of materials and stores. 2. Explain the Classification and codification of storage of materials. 3. State the meaning of Bin and racks. 4. Explain the different stock levels. 6. The following information received from Rohit industries in respect of Material No.CW45 : Normal consumption 800 units per week Maximum consumption 1200 units per week Minimum consumption 400 units per week Re-order period 4 to 6 weeks Re-order Quantity [EOQ] 3000 units Calculate: (a) Re-order level (b) Maximum level (c) Minimum level (d) Average stock level

7. Life Care, a machine manufacturer purchases 1600 units of certain component for his annual usage. The order placing cost is Rs.200 and cost of carrying one unit for a year is Rs.4. Calculate the economic ordering quantity (EOQ). 8. Jindal Machine Ltd maintains its stores ledger on the FIFO method. Following is a summary of the receipts and issues of raw materials during the month of June 2006: June 2006 01 Opening balance 400 units @ Rs.20 per unit 04 Material requisition No. 17, 100 units. 06 Purchase order No.28, 200 units @ 22 per unit. 13 Purchase order No.31, 400 units @ 21 per unit 16 Material requisition No. 19, 600 units. 21 Material requisition No. 22, 50 units. 23 Purchase order No.36, 500 units @ 23 per unit. 26 Material requisition No.27, 450 units. 28 Purchase order No.42, 200 units @ 26 per unit. 29 Material requisition No.30, 200 units. 30 Shortage 15 units6. State the meaning of Economic order quantity (EOQ). 9. Mohit Steel Ltd maintains its stores ledger on the LIFO method. Following is a summary of the receipts and issues of raw materials during the month of July 2006: July 2006 0l Opening balance 600 units @ Rs. 18 per unit 06 Material requisition No. 09, 200 units. 08 Purchase order No.55, 400 units @ 22 per unit. 11 Purchase order No.59, 600 units @ 20 per unit 13 Material requisition No. 12, 900 units. 17 Material requisition No. 16, 250 units. 22 Purchase order No.68, 400 units @ 25 per unit. 25 Material requisition No.21, 550 units. 27 Purchase order No.76, 1400 units @ 26 per unit. 29 Material requisition No.23, 400 units. 31 Shortage 05 units UNIT- 3 CHAPTER- 7 LABOUR AND LABOUR COST 7.1 MEANING OF LABOUR AND LABOUR COST Labor Like materials, labor is also one of the prime inputs of production system. All manufacturing concerns require the labor for carrying out their production activities. The labor consists of workers who are essential to convert materials into finished products. The workers operate machine and perform other tasks to help convert materials into final outputs. The labor can be either direct or indirect. The labor who is directly engaged in the conversion process is called direct labor and who is not is called indirect labor. The labor, however, should be properly utilized and satisfactorily paid in order to minimize labor turnover and labor cost. Unlike materials, labor is complex to deal with. Dissatisfied and discontented labor always results in high labor costs and low quality outputs. Therefore there should be proper planning, accounting and controlling of labor. Labor Cost

The payment made to the labor in exchange for its service is called labor cost, which constitutes a major part of the total cost of production. Labor cost is also commonly called wages. Labor cost or wages is one of the major elements of cost. Labor cost represents the expense incurred on both direct and indirect labor. However, labor cost is more than just wage as it includes the total amount of financial benefits given by the concern to all its workers and employees for their time and effort used in producing goods and services. It is, in fact, the financial compensation provided to the workers for their physical and mental contribution for converting raw materials into finished outputs.Labor cost includes monetary and non-monetary (fringe) benefits. Monetary benefits include basic wages, dearness allowance, employer's contribution to provident find, production bonus, pension and gratuity. Fringe benefits include subsidized food, subsidized housing, subsidized education, medical facilities and holiday pay. Two types of labour are accounted for labor cost Direct - Could be traced and can be linked to a specific Indirect It could not be associated with job for a specific product . any specific product

Elements for cost of labour 1. 2. 3. 4. 5. 6. 7. Salary or wages Workers / Employees taxes Employer taxes and fringe benefits Shift premiums Overtime Idle time Incentive plans


Like material control, cost accountant has also genuine interest to control over the labor cost, but he can not control labor like material control. Both decreasing the number of laborers and wages will increase the cost of laborers because less no. of worker with fewer wages will produce less output and its cost will be more. Suppose, you have to make your building, if you appoint only two laborer but it require for laborer for saving the labor cost, it will be reverse effect be because no. of days will increase and its is also risk of losing of other stock like cement etc. So, optimum use of workers is the way to control the cost of labor. There are also many factors which affect labor cost control.






Correct assessment of manpower requirement will decrease the cost of labor because they are actually we need, if laborers are more than these no., its excess cost will be suffer by co. and overall cost of labor will increase. To assess of manpower requirement is the duty of personnel department. So, it should be do its duty with best way. Time and motion study

In this study, supervisor records time spent on each job and correct record will reduce excess paid for overtime to workers. Control over idle time and overtime

Idle time is time when worker is not doing any production activity due to delay of receiving the material or electricity cut or any other things. This is loss of business and it will increase the cost of labor. By continuing supply of raw material, review and repair of machines and continue supply of electricity can reduce idle time loss. But some time, these factors are also not under our own control. So, we have to depend on others. Overtime cost also can be optimized by providing good amount for this. Wage system

Wages should be at competitive price. High and low rate of wages will disturb workers and increase cost of laborers. It also is on the basis of time or unit produced. Control over labor turnover

Labor turnover means losing of laborers due to not providing good wages or incentive or any other reason. It will increase the cost of training of new workers and also errors in production. So labor turnover should minimize as soon as revealed. 7.4 MEANING OF LABOUR TURNOVER Labor turnover measures the hiring and and termination of employment in a given firm. While it is inevitable that some employees leave a company, high turnover rates lead to high expenses and low productivity. Therefore, a company should aim to provide a good work environment for its employees to achieve a low labor turnover rate.

Labour turnover refers to the movement of employees in and out of a business. However, the term is commonly used to refer only to wastage or the number of employees leaving.
High labour turnover causes problems for business. It is costly, lowers productivity and morale and tends to get worse if not dealt with.

DEFINITION: Labor turnover indicates the number of employees being hired to replace the employees who have left the firm for any reason, including resignation, discharges and layoffs. By definition, labor turnover is concerned with individuals who work for firms rather than self-employed individuals. High labor turnover is generally considered to be bad industrial practice, because it results in inefficiency and demoralization of the labor force


Employee turnover is the difference in the rate of employees leaving a company and new employees filling up their positions. Nowadays, it is becoming a major problem among most of the companies, especially in low paying jobs. There are many aspects that play a significant role in the employee turnover rate of a particular company. Such aspects can stem from both the company as well as the employees. The employers generally give more importance to the employee turnover rate, as it is a very expensive aspect of the business. When employees leave the company, the employer has to incur a considerable amount of direct and indirect expense. These costs normally include advertising expenses, headhunting fees, resource management expenses, loss of time and productivity, work imbalance, and employee training and development expenses for new joiners. The company may quarterly calculate employee turnover rates to meliorate the factors causing the turnover. If the company determines the most common causes of employee turnover, it would certainly be able to take the necessary steps for recruiting and retaining well-qualified personnel.

A. Salary Scale This is the most common cause of the employee turnover rate being so high. Employees are in search of jobs which pay well. If the companies which they are working in don't offer good salaries, they tend to hunt for jobs that pay them considerably well. In order to resolve this problem, the employers should make it a point to offer salaries that would be competitive enough to retain and attract wellqualified and talented personnel. Unsatisfactory performance appraisals is also one of the reasons for employees leaving a company. B. Benefits Employees always flock to companies who offer more benefits. There are many employees who are not aware of the benefits that are provided to them in their compensation package. The employers need to reduce their bureaucratic procedures in order for the employees to receive the best available benefits without any difficulty. They should make a note of what all benefits other organizations are providing, which may attract their current employees. C. Advancements and Promotion Policies This is the prime reason why many mid-level executives leave the company. Due to no potential opportunity for advancements or promotions, they prefer other companies which may provide them with higher posts and increased compensation packages. The companies need to evaluate and modify their promotion policies in a fair way which would enable promotions for candidates only on the basis of employee performance. D. Working Environment This is also one of the main causes for employee turnover. Employees prefer to work in an environment which is suitable for them. This is the most common reason why they jump from company to company in just a few months. If they find an appropriate work environment in a specific company, they may work in the same organization for several years. E. Working Procedures The companies should analyze and alter their work procedures and policies in a way which would enable employees to use their full potential and even gain significant work experience. There are many cases where employees have left the company due to no projects or assignments which do not require their full potential. Employees would certainly leave if their don't get experience and are just placed on the 'bench'.

These are some of the principal causes of employee turnover which can surely be avoided by the organizations after taking some necessary steps to better their in-house services towards employees. However, there are many more causes which contribute to employee turnover; such as lack of employee motivation, work pressure, job stress, partiality and favoritism, employee egos and attitudes, poor employee management, etc. 7.6 COST OF LABOUR TURNOVER
The costs associated with employee turnover can be both direct and indirect. Direct costs include cost of leaving, which includes stationary cost, transition cost and replacement cost. On the other hand, indirect cost includes low morale, unnecessary overtime payment to other employees, reduction in performance of other employees due to low morale and productivity loss. Moreover, there are other costs such as time taken to recruit and select a new employee and most importantly costs of new employees. You may like to know more on causes of employee turnover. High rates of labour turnover are expensive in terms of: - Additional recruitment costs - Lost production costs - Increased costs of training replacement employees - Loss of know-how and customer goodwill - Potential loss of sales (e.g. if there is high turnover amongst the sales force) - Damage that may be done to morale and productivity (an intangible cost)


Labor turnover measures the ratio between the number of employees who leave the company and the total number of employees working for the company. A simple method to calculate labor turnover is to divide the number of employment separations by the total number of employees. To get the answer as a percentage, multiply the number by 100 Formula for Employee Turnover rate:

For example, If a business has 150 leavers during the year and, on average, it employed 2,000 people during the year, the labour turnover figure would be 7.5%


Money and benefits are important, but studies show most employees leave for other reasons. Obviously, a certain degree of turnover is unavoidable, but with a small amount of effort organizations can make a major difference. Your retention plan should address the following key components. 1. Hire the best and avoid the rest. Cisco CEO John Chambers said, "A world-class engineer with five peers can out produce 200 regular engineers." At Yahoo they would rather leave a position open than hire the wrong person. Instead of waiting for people to apply for jobs, top organizations spend time looking for high-caliber people whether they have a job opening or not. Redesign your orientation program for new employees. The old saying, "You don't get a second chance to make a good first impression" is true in this case. Organizations experience the highest level of turnover during the first 90 days on the job. The purpose of onboarding is to quickly assimilate the new person into the organization, so make the first critical days stand out as a positive experience. This is a great opportunity to make new hires feel proud to have chosen your organization. Provide flexible work schedules adapted to the needs of the individual. In todays workplace, flexibility rules. A one-size-fits-all approach has long since lost its effectiveness. Workers will migrate to a company whose benefit packages and schedules help them meet the demands of their lives, whether they are single parents, adults who care for aging parents, older workers, younger workers, part-time workers, or telecommuters. Provide career development. For many people, learning new skills and advancing their career is just as important as the money they make. In a study by Linkage, Inc. more than 40 percent of the respondents said they would consider leaving their present employer for another job with the same benefits if that job provided better career development and greater challenges. Create an early warning detection system. Ask employees to let you know if they hear of people who are thinking about quitting. Advance notice will give you an opportunity to try to prevent the departure. One practice Applebee's put in place is the "Turnover Alert Form." It is designed to identify and prevent discontented managers from quitting. In those situations, Applebees brings the managers in to meet with the CEO and possibly other executives. They want to identify and repair anything that might be causing job dissatisfaction. Look for triggers. Focus on individuals going through some form of change such as marriage, pregnancy, divorce, a child's graduation, mergers, or other important events that could influence job satisfaction and/or persuade or force employees to leave the organization prematurely. Identify and weed out poor managers. The relationship with the employees front -line manager is the most common reason people leave. As part of LaRosa's employee retention strategy, all workers evaluate their bosses twice a year using a special report card. It asks the employees to give their managers a letter grade from A to D in four categories. Any score less than a "B" requires a specific comment from the employee. After it's completed, they tabulate the comments and design action plans for improvement.








Times study is concerned with the determination of the amount of time required to perform a unit of work. It consists of process of observing and recording the time required to perform each element of an operation so as to determine the reasonable time in which the work should be completed. According to ILO, Time study is a work measurement techniques for recording the times and rates of working for the elements of a specified job carried out under specified conditions and for analyzing the data so as to obtain the time necessary for carrying out the job at a defined level of performance.

Use of Time Study: The utility of the time study comes in: Determining the work content and thereby setting wages and incentive Arriving at cost standards per unit of output for the various jobs used for cost control and budgeting for deciding on sales price. Comparing the work efficiency of different operators Arriving at job schedules for production planning purposes Manpower planning Aiding in the method study Product design by providing basic data on costs of alternative materials and methods required to manufacture the product. Work Measurement : Meaning and Definition Work measurement goes hand in hand with method design. Whereas the method design are directed towards the study of the components of a single or multiple operation of a system. It is a technique by which the actual time consumed in performing an operation is computed and ultimately serves as suitable time standard. It is the study of work content of a job so as to lay down a fair days work. It seeks provide a quantitative assessment of the human work in a specified job and to establish the proper time for the effective performance of that job. Work measurement has been defined as the application of techniques designed to determine the time required by or defined level of performance to do a specified job. The time is called standard or allowed time. According to British Standard Institute, The application of techniques designed to establish the time for a qualified worker to carry out a specified job at a defined level of performance. Qualified worker is a representative average of those workers. Who are fully trained and able satisfactorily to perform any and all phases of work involved, in accordance with the requirement of the job under consideration? Normal pace is the effective rate of performance of conscientious, self paced, qualified worker when working neither fast nor slow and giving due considerations to physical, mental or visual requirements of the specific job. Specific job is in the best possible method of a job under consideration.

7.10 Motion Study: Meaning and Definition Motion study is formal engineering analysis of motions perform to accomplish work. The motion or movements of limbs of a worker play a major part in the fabrication or the manufacture of the products. By carefully observing a worker while he is doing an operation, a number of movements made by him which appear to be unnecessary and unproductive can be identified and eliminated. According to Alford and Beatty, Motion study consist of dividing work into the most fundamental elements possible; studying these elements separately and in relation to one another and from these studied elements, when timed, building methods of least waste. Analysis of an operation when carried out in terms of individual motions of a worker is known as motion analysis. Motion study techniques for methods analysis are an important contribution of the Gilbert to industrial management. The purpose of motion study is to design as improved method which eliminates unnecessary motions and employs human efforts more productively. In doing so the principles of motion economy proves to be very helpful.

7.11 MERIT RATING Merit rating is the technique of evaluating actual performance of the employees in job. It is alone to measure the individual performance and efficiency of the workers who are working on similar jobs. In this system, a number of traits are measured to know an employee's worth. The personal qualities of employees which are usually appraised through merit rating are as follows: 1. 2. 3. 4. 5. 6. 7. Knowledge, skill and experience of the work. Quality of work done. Quantity of work done. Attendance and punctuality. Co-operation and discipline. Reliability and integrity. Self-confidence and sense of judgment etc. Merit rating is the comparative analysis and evaluation of the merit of the employees within an enterprise. The difference in the performance level, between employees, who are entrusted with similar jobs, are analysed and studied under this method.

Advantages of merit rating are numerous. Employees can be merit-rated for promotion and incremental payments. A proper wage system and incentive scheme can be developed by merit rating. An employees suitability for a particular job can be established, thereby resulting in effective use of manpower. The right worker can be found for the right job. Merit rating develops a healthy competition amongst the workers as a result of increased production. It helps each employee to know their own level of performance. Most importantly, merit rating increases output and improves labour-management relations. Evaluation of individual merits of the employees is known as merit rating. Systematic analysis & classification of jobs on the basis of their characteristics is defined as job evaluation whereas the evaluation of the merits of the workers & on the basis of that, the classification of the workers is known as merit rating. By keeping the performance records of every worker & by assessing their performances in terms of some norms or standards, merit rating is done by organization. The objects of merit rating are: 1. 2. 3. 4. for each individual worker, assessment of the standard of performance providing a basis for rewarding for high merit without detailed work study being applied providing a basis for determining the remuneration of the indirect workers, the performances of whom cannot be easily determined choosing suitable worker for a job; job evaluation mentions the job requirement of the worker, while merit rating mentions what qualities the worker should possesses. The selection will be perfect if these two fit in each other providing basis for increment, promotion etc finding out the abilities & defects of each worker improving labour relations & reducing labour turnover.

5. 6. 7.

The limitations of merit rating are: 1. 2. labour unrest may arise due to wrong rating there may not be any relevancy of the factors considered for merit rating

3. 4. 5.

previous records of the employees may influence the rating & thereby justice may be lost employees may oppose the rating or may not recognize the same workers may not be satisfied with the incentives allowed on the basis of merit rating

For merit rating purpose, the following factors may be usually examined in the employee : Attendance, discipline, co-operation, knowledge, skill, experience, aptitude, sense of responsibility & judgment, quantity & quality of output etc.

7.12 JOB EVALUATION: Job Analysis is a process to identify and determine in detail the particular job duties and requirements and the relative importance of these duties for a given job. Job Analysis is a process where judgements are made about data collected on a job. The Job; not the person An important concept of Job Analysis is that the analysis is conducted of the Job, not the person. While Job Analysis data may be collected from incumbents through interviews or questionnaires, the product of the analysis is a description or specifications of the job, not a description of the person. Job analysis is primary tool in personnel management. In this method, a personnel manager tries to gather, synthesize and implement the information available regarding the workforce in the concern. A personnel manager has to undertake job analysis so as to put right man on right job. There are two outcomes of job analysis : 1. 2. Job description Job specification 1. JOB DESCRIPTION is an organized factual statement of job contents in the form of duties and responsibilities of a specific job. The preparation of job description is very important before a vacancy is advertised. It tells in brief the nature and type of job. This type of document is descriptive in nature and it constitutes all those facts which are related to a job such as : 1. 2. 3. 4. 5. 6. Title/ Designation of job and location in the concern. The nature of duties and operations to be performed in that job. The nature of authority- responsibility relationships. Necessary qualifications that are required for job. Relationship of that job with other jobs in a concern. The provision of physical and working condition or the work environment required in performance of that job.

Advantages of Job Description 7. 8. 9. 10. 11. 12. It helps the supervisors in assigning work to the subordinates so that he can guide and monitor their performances. It helps in recruitment and selection procedures. It assists in manpower planning. It is also helpful in performance appraisal. It is helpful in job evaluation in order to decide about rate of remuneration for a specific job. It also helps in chalking out training and development programmes.

2. JOB SPECIFICATION is a statement which tells us minimum acceptable human qualities which helps to perform a job. Job specification translates the job description into human

qualifications so that a job can be performed in a better manner. Job specification helps in hiring an appropriate person for an appropriate position. The contents are : 13. 14. 15. 16. 17. 18. 19. Job title and designation Educational qualifications for that title Physical and other related attributes Physique and mental health Special attributes and abilities Maturity and dependability Relationship of that job with other jobs in a concern.

Advantages of Job Specification 20. 21. 22. 23. 24. 25. It is helpful in preliminary screening in the selection procedure. It helps in giving due justification to each job. It also helps in designing training and development programmes. It helps the supervisors for counseling and monitoring performance of employees. It helps in job evaluation. It helps the management to take decisions regarding promotion, transfers and giving extra benefits to the employees.

Purpose of Job Analysis The purpose of Job Analysis is to establish and document the 'job relatedness' of employment procedures such as training, selection, compensation, and performance appraisal.
Determining Training Needs Job Analysis can be used in training/"needs assessment" to identify or develop:

1. 2. 3. 4.

training content assessment tests to measure effectiveness of training equipment to be used in delivering the training methods of training (i.e., small group, computer-based, video, classroom...)

Compensation Job Analysis can be used in compensation to identify or determine:

1. 2. 3. 4. 5.

skill levels compensable job factors work environment (e.g., hazards; attention; physical effort) responsibilities (e.g., fiscal; supervisory) required level of education (indirectly related to salary level)

Selection Procedures Job Analysis can be used in selection procedures to identify or develop:

1. 2. 3. 4. 5.

job duties that should be included in advertisements of vacant positions; appropriate salary level for the position to help determine what salary should be offered to a candidate; minimum requirements (education and/or experience) for screening applicants; interview questions; selection tests/instruments (e.g., written tests; oral tests; job simulations);

6. 7.

applicant appraisal/evaluation forms; orientation materials for applicants/new hires

Performance Review Job Analysis can be used in performance review to identify or develop:

1. 2. 3. 4. 5.

goals and objectives performance standards evaluation criteria length of probationary periods duties to be evaluated

Advantages of Job Analysis 1. 2. 3. 4. 5. 6. 7. Job analysis helps the personnel manager at the time of recruitment and selection of right man on right job. It helps him to understand extent and scope of training required in that field. It helps in evaluating the job in which the worth of the job has to be evaluated. In those instances where smooth work force is required in concern. When he has to avoid overlapping of authority- responsibility relationship so that distortion in chain of command doesnt exist. It also helps to chalk out the compensation plans for the employees. It also helps the personnel manager to undertake performance appraisal effectively in a concern.


Time keeping is the process to determine the duration of tie for completion of given task or an activity. METHODS OF TIME KEEPING: There are two methods of time-keeping. They are the manual methods and the mechanical methods. The choice of a particular method depends upon the requirements and policy of a firm. But whichever method is followed, it should make a correct record of the time incurring the minimum possible expenditure and should minimize the risk of fraudulent payment of wages. The manual methods of time-keeping are as follows: Attendance Register Method: It is the oldest method of recording time. Under this method, an attendance register is kept in the time office adjacent to the factory gate or in each department for workers employed therein. The attendance register contains such columns as the name of the workers, the worker number, the department in which he is working, the rate of wages, the time of arrival and departure, normal time and overtime. The time of arrival and departure, may be noted down by an employee known as time keeper. If the workers are illiterate, they may make a record of time themselves in the presence of a time keeper or foreman. This method is simple and inexpensive and can be used in small firms where the number of workers is not large. This method may lead to dishonest practice of recording wrong time becuase there is possibility of collusion between some of the workers and the time keeper. Metal Disc Method: Under this method, each worker is allotted metal disc or a token with a hole bearing his identification number. A board is kept at the gate with pegs on it and all tokens are hung on this board. These boards can be maintained separately for each department so that the workers could remove their

tokens from the board without undue delay. As the workers enter the factory gate, they remove their respective discs or tokens and place them in a box or tray kept near to the board. Immediately after the scheduled time for entering the factory the box is removed and the late comers will have to give their tokens to the time-keeper personally so that the exact time of their arrival could be recorded. The discs or tokens still left on the board represent the absentee workers. Later the time keeper records the attendance in a register known as Daily Muster Roll which is subsequently passed on to the Pay Roll Department.

7.14 IDLE TIME Generally idle time means that time for which the employer pays, but from which he obtains no production. Otherwise it is the difference between the time for which workers are paid but the workers do not work. So it is a loss to the organisation. It can be minimized but, cannot be controlled during idle time, the workers remain due and contribute nothing towards production. It is the difference between actual hour and actual hour worked. There are two types of idle times: 1. 2. Normal idle time: The normal idle time is that idle time which cannot be fully avoided but effective effort should be made to reduce it. Abnormal idle time: Abnormal idle time arises due to various causes which can be avoided. Abnormal idle time can be avoided if proper precautions are taken. Thus the factors which are responsible for controlling and avoiding idle time must be taken care of. Normal idle time is permitted but abnormal idle time should be avoided. Treatment of the Cost of Normal Idle Time a) It must be charged as indirect expenses in factory. For example, if a laborer gets Rs. 1 per hr and he spend 8 hrs in factory and his total wage will be Rs. 8 but he utilized his productive time 7 hrs, then direct labor cost will be 8 hrs X Rs. 1 = Rs. 8 and 1hr will be overhead of idle time and Rs. 1 per hr idle time will be written in factory expenses in cost sheet. b) We can also increase the cost of labor rate. with following way

If a labor works for 8 hrs, he gets = Rs. 1 per hr If a labor works for 7 hrs, he gets = Rs. 1 / 8 X 7 = Rs. 1.14 per hr Now labor cost will increase by 0.14 paise 7.15 OVERTIME According to the Factories Act, overtime work is represented by any work beyond 9 hours in a day or 48 hours in a week & is paid at double the normal rate. Even where the Act is not applicable, on the basis of the agreement between the workers & the employer, overtime work is paid at a rate higher than the normal wages rate. Overtime work is not a normal feature- under extraordinary circumstances it is undertaken & before it is undertaken a responsible officer should authorize it after considering carefully the causes for which it has been necessary & also the desirability for which it has been undertaken; the under mentioned disadvantages are involved with the overtime work: (a) As it is paid at a higher rate, excess labour cost is involved. (b) Less output is provided by the overtime work; because by the end of normal working time workers are already exhausted. (c) It acts upon the workers health.

(d) In order to earn extra income, there is a tendency among the workers to keep pending the work so that they can do the same in the overtime hours. (e) Discontent may arise in some section of the workers, if the overtime work is not rationally distributed amongst the workers. (f) In many cases, extra lighting cost is involved. (g) Due to continuous work for a long time, more strain is put on the machinery. (h) Once introduced it cannot be easily discontinued due to the workers resistance. In spite of the above mentioned disadvantages, overtime work has some advantages also, which are mentioned below: (a) From the same resources (i.e. men & machines) more work is obtained, particularly where shortage in the supply of suitable men & machines is involved. (b) It is possible that the production delay due to any reason can be made up favorably & thus delivery schedules can be maintained. (c) If customers can be charged at a higher rate, without extra cost to the organization, extra earnings can be provided to the workers. (d) Opportunities in the market can be availed of. (e) During overtime work, materials of peculiar nature, which are subject to spoilage unless utilized quickly, can be utilized. Treatment of Overtime Wages in Cost Accounts: Overtime wage consists in 2 parts: - (a) payment made at normal rate, & (b) payment made at extra rate over the normal rate i.e. the overtime premium. The treatment of overtime wages depends upon the circumstances in which it arises:(a) Where due to general pressure of work overtime is caused, the payment made at normal rate should be debited to the job order or standing order number on which the worker has been employed & the premium should be debited to the overhead account of the department. Alternatively & where appropriate, after taking into consideration the estimated direct wages at normal wages & overtime premium, calculation of a comprehensive rate may be done & throughout the period all jobs may be charged to that rate. (b) Where specifically at the customers request the overtime is worked to expedite delivery, in that case total payment should be charged to the job as direct wage. (c) Where due to delay of work in another department, overtime work has to be undertaken in a department, the overtime premium should be charged to the department by which delay had been caused. (d) Where a seasonal industry undertakes overtime work so that it can cope with busy season work, the overtime premium should be charged to general overhead or alternatively, may be debited to deferred overhead account & throughout the cycle gets absorbed by the production. (e) Where in order to avail special market opportunity, overtime work has to be undertaken, because the market price which will be received shall be high, the total payment should be charged to

production as direct wage. (f) Where due to abnormal conditions like major breakdown, prolonged power cut, natural calamity etc., overtime job has to be undertaken, it should not be considered for cost accounts. On the contrary, in that case, the overtime wage should be charged to costing profit & loss account. (g) Where for the purpose of utilizing the surplus perishable materials which are obtained from one job for utilization in another job, overtime work is undertaken, in that case, to the job in which the material is utilized, the normal payment is to be debited & to the general overhead, the premium should be charged. Control: Overtime premium should be controlled effectively & for that purpose the following steps should be taken: (a) To enquire, why it is necessary to undertake overtime work? Who is responsible for creating such necessity? Is it due to lack of supervision, faulty planning, workers inefficiency or improper maintenance of plant? Is it due to the fact that any order has been accepted which can be executed during overtime? Is it due to any abnormal reason? (b) Determine the desirability of allowing overtime work on the basis of the answer. If it is desired to be undertaken, under the signature of a responsible officer, it has to be specially authorized. (c) The causes which are within control should be removed so that in future necessity does not recur. (d) If, due to shortage of staff or machine, overtime work is going to be a permanent affair, extra men should be recruited & new machine should be installed, if practicable. 7.16 WAGES INCENTIVE METHODS
1. Wage as monetary reward is paid to an employee for the services rendered by him. One of the important components of any wage plan is the incentive bonus paid to the operative personnel. Here are a good number of incentive plans that have been devised. All the incentive plans are based on the fundamental factors such as the standard time, time actually worked, time saved and the output level attained. Some of the wage incentive plans have been discussed below. They are: 1) Halsey Premium Wage Plan 2) The Roman Plan 3) Straight Piecework Plan 4) Taylor Differential Piecework Plan 5) DGant Incentive Plan 6) Emerson Premium Plan 7) 100 percent Time Premium Plan 8) The Bedaux Plan



Under Halsey premium Plan method, standard time for doing each job or operation as fixed and the worker is given wages for the actual time taken at the agreed rate per hour and a bonus equal to one half on the wages of time saved.

It takes into account the total time saved by the employee, and is a useful method for computing the incentive, when accurate performance standards have not been established. The value of time saved by the employee is computed and the earning is shared by the employee and the organization. The total earnings of the worker is computed by the formula given below: E = rT + P ( S T ) r Suppose, a worker should produce 50 units in 8 hours and he is paid at the rate of Rs 3 per hour. If he produces 100 units in 8 hours his total earnings for the day would be Where r = Rs 3 T = 8 hours P = 50% S = 8 x 100 / 50 = 16 hours E = Total earnings the worker E = 3 x T + 1 / 2 (16 8) x 3 = 24 + x 8 x 3 = 24 + 12 = Rs 36 2. Rowan Plan: It was devised in Glasgow, Scotland. In this plan the bonus is calculated on the basis of the time worked. Thus the premium paid to the worker is a percentage of the time worked. If we consider our previous example, then the total earnings of the worker under the Rowan Plan would be: E = rT + S T / S x Rt = 3 x 8 + 16 8 / 16 x 3x 8 = 24 + 8 / 16 x 24 = 24 + 12 = Rs 36. Thus the total earnings of the employee would be Rs 36/It is worth noting that this plan is not easy to understand by the operative personnel and it also involves more clerical work. 3. Straight Piecework Plan:

This is a common system and is easily understandable. The rate per unit, at which the worker should be paid for the number of units produced, is determined by past records. If we consider our previous example again, the total earnings would be: E =rN Here r is the price rate and is equal to 48 paise Therefore, E = 0.48 x 100 = Rs 48

4. Taylors Differential Piece Rate Plan: Taylors piece rate plan can be applied when the job is clearly defined and when the conditions are such that it would be possible for the average worker to attain the performance target. The important features of Taylors plan are: 1) It does not guarantee a day rate; 2) It calls for two piece rates; A high one when the worker attains or exceeds the standard and a low one when he fails to attain the standard. It means a worker would be paid high for achieving the standard and would receive a low pay in case he fails to achieve the standard. The one advantage of Taylors incentive plan is that it motivates the worker to exceed or at least maintain the standard. At the same time it also places a heavy responsibility on management to establish the work standard carefully so that the worker would not feel that he is unjustly penalized. The formula for computing his earnings under this system is same as the straight piece rate system, the only difference is that it provides for two rates, namely E = rN when the worker fails to attain the standard E = r1 N when the worker exceeds or attains the work standard. 4. DGant Incentive Plan: This incentive plan was given by Henry L Gant and it is the only incentive plan that pays an incentive (bonus) percentage multiplied by the value of standard plan. Just like Taylors Differential Piece Rate plan it also provides for a substantial differential between standard and substandard work. However, it does guarantee a day rate to the workers. The Gants system allows various premium percentage for bonus payments, however, Gant often used 33 1/3 %. The Gant system allows the worker to draw more than what he would receive under straight piece work plan or 100% premium plan. The formula used for the computation of the total earnings under the Gant plan is given by E= r. S + p. rS Using the original problem the total earnings of the worker in this case would be equal to,

E = 3 x 16 + 1/3 x 3 x 16 = 4 + 16 = 64



Q.1 Define the labour cost. Q.2. What do you mean by labour turnover? How can we calculate it? Q.3. Explain the term overtime? What are the different causes of overtime? Q.4. Explain different methods of payment of wages to labour. Q.5. What is the meaning of idle time? What is the role of idle time in payment of wages? Q.6. practical questions in hard copy

UNIT 4 CHAPTER 8 OVERHEAD 8.1 MEANING OF OVERHEAD In the previous chapter we have discussed various concepts of costs. One of the classi cation of costs is on the basis of Nature in which costs are classi ed as Direct and Indirect. Direct co sts are those which are identi able with a cost object or a cost center while Indirect costs are n ot traceable to cost object or cost center. In other word, indirect costs cannot be linked with the product offered by the rm. If a rm manufactures only one product, all costs are direct but if more than one products are offered, the indirect costs incurred are not traceable with a particular product. So, while direct costs are allocable to a job, process, service, cost unit or a cost center, indirect costs cannot be so allocated. These indirect costs are called as Overhead costs. According to CIMA, overhead costs are de ned as, the total cost of indirect materials, indirect labor and indirect expenses. Thus all indirect costs like indirect materials, indirect labor, and indirect expenses are called as overheads. Examples of overhead expenses are rent, taxes, depreciation, maintenance, repairs, supervision, selling and distribution expenses, marketing expenses, factory lighting, printing stationery etc. In subsequent paragraphs, we will be discussing various aspects of overhead accounting The indirect costs or fixed expenses of operating a business (that is, the costs not directly related to the manufacture of a product or delivery of a service) that range from rent to administrative costs to marketing costs Overhead refers to all non-labor expenses required to operate your business. These expenses are either fixed or variable:

DEFINITION OF OVERHEADS Overheads is the aggregate of indirect materials cost, indirect labour cost and indirect expenses which cannot be conveniently identified with and directly allocated to a particular cost centre or cost object. ExampleIndirect Material Cost Indirect Labour Cost Indirect Expenses Distribution Of Overheads 8.2 DISTRIBUTION OF OVERHEAD Step 1 -> Classification of Overheads Step 2 -> Collection of Overheads Step 3 -> Allocation of Overheads Step 4 -> Apportionment of Overheads Step 5 -> Re-apportionment of service department overheads Step 6 -> Absorption of Overheads 8.3 CLASSIFICATION OF OVERHEAD
Overhead costs may be classified according to: 1. Functions 2. Elements 3. Behavior

1. Classification according to Functions The main groups of overhead on the basis of this classification are as follows:

(a) Production overhead: Also termed as factory overhead, works overhead or manufacturing overhead, it means indirect expenditure incurred in connection with production operations. Examples of these overhead

are: lubricants, consumable stores, indirect wages, factory power and light, depreciation of plant and machinery, repairs and maintenance, etc.

(b) Administration overhead: These overheads are of general nature and consist of all costs incurred in the direction, control and administration (including secretarial, accounting and financial control) of an undertaking. Examples are: general management salaries, audit fees, legal charges, postage and telephone, stationery and printing, office rent and rates, office lighting, and salaries of office staff etc. These overheads are also known as office overheads or general overheads.

(c) Selling and distribution overhead: Selling overhead is the cost of seeking to create and stimulate demand or of securing orders. Examples: advertising, salaries and commission of sales personnel, showroom expenses, traveling expenses, bad debts, catalogues and price lists, etc. Distribution overhead comprises all expenditure incurred from the time product is completed in the factory till it reaches its destination or customer. It includes packing cost, carriage outward, warehousing costs, etc.

(d)Research and Development Overheads : In the modern days, rms spend heavily on research and development. Expenses incurred on research and development are known as Research and Development overheads.

2. Element-wise classification Under this method, the classification is done according to the nature and source of the expenditure.

(a) Indirect materials: Material costs which cannot be allocated but which are to be apportioned to or absorbed by cost centres or cost units. Examples are stationery, coal, lubricants, tools for general use, etc.

(b) Indirect wages: Indirect wages are those which cannot be allocated but which are to be apportioned to or absorbed by cost centres or cost units. Examples are wages of sweeper, idle time wages, maintenance and repair wages, foremans pay, chowkidars pay, etc.

5. Indirect expenses: Expenses which cannot be allocated but which are to be apportioned to or absorbed by cost centres or cost units are indirect expenses. For example, power, depreciation, insurance, taxes, rates and rent, etc. 3. Classification according to Behavior or Variability
Different overhead costs behave in different ways when volume of production changes. On the basis of behavior, overheads may be classified into:

1. Fixed overhead: These overheads remain unaffected or fixed in total amount by fluctuations in volume of output. Examples are rent and rates.

2. Variable overhead: This is the cost which, in aggregate, tends to vary in direct proportion to changes in the volume of output. Examples are indirect materials, indirect labor.

3. Semi-variable overhead: semi-variable overhead costs vary in part with the volume of production and in part they are constant, whenever there is a change in volume of production. Examples are supervisory salaries, depreciation, repairs and maintenance, etc.

Illustration A supervisor is needed for every 10 operators. An operator can produce 100 units everyday. If the production requirement is 500 units, the organisation needs 5 operators and a supervisor. For every 100 units increase in the production level an additional operator is needed. However, the supervisor who is already present would be sufficient to manage 10 operators. Therefore the supervisor cost is fixed till the production level reaches a requirement of 1,000 units. Immediately on crossing 1,000 units an additional supervisor would have to be employed as there would be more than 10 operators. At that point, the supervisor cost behaves as if it is a variable cost. From thereon till the next 9 operators are engaged, the supervisor cost becomes a fixed cost again. Since the behaviour of the cost keeps varying only during certain changes of production levels, we say it is a semi-variable cost.

Analysing Semi-Variable Expenses The behavior of Fixed expenses and Variable expenses can be generalised and thus it would be possible to study these two types of costs in general.

No Tools to analyse Semi-Variable Expenses A generalised study of semi-variable expenses would not be possible since we may not find the same characteristics in all situations. Some of them may vary for every 5% change in the level of activity, some others for every 25% change in activity level etc. Because, it would be difficult to visualise a common thought process for semi-variable expenses in all situations, we do not find tools to analyse semi-variable expenses.

Semi-Variable Overheads = Fixed Part + Variable Part Since, it would be difficult to study the behaviour of semi-variable expenses, they are assumed to be made up of two component parts. A fixed part and a variable part. The fixed part is analysed as if it is a fixed expenditure and the variable part is analysed as if it is a variable expenditure. What proportion of the semi-variable expenditure is treated as fixed and what proportion is treated as variable is dependent on the situation in consideration. There is no universal rule for this segregation.


heading and a unique Standing Order Number(S.O.N.) or Cost Account Number(C.A.N.). Sources Material Requisitions Wages analysis Book

Invoices Cost Journal Subsidiary Records

Material Requisitions Situations arise In the normal course of doing business where items in your Inventory will be used within your company and not sold. This could include items that you not only sell, but also use within your own business too. These can also be items that you are removing from inventory to send to a customer as a sample or display item. To remove these items from inventory use the Material Requisitions function found in the Inventory application. Enter the requisition number, wh requested the requisition, date placed and date needed. There is also a section for notes regarding these items. Select the item and the quantity that you are removing from inventory and enter the General Ledger account where it will be expensed to. For example removing paper from inventory for your use would go to office supplies and removing samples to send to customers might be a selling expense account. Once the item information is entered print the Material Requisition and send it to the warehouse for fulfillment. Once fulfilled call up the requisition and enter the filled about and any backordered amounts. Once your requisitions have been fulfilled run the material requisitions journal and post these items. During posting the items are removed from inventory and expensed to the account you indicated. Should you need to return an item to inventory you can use the Material Requisition Return the same way as the requisition only this time you would be using the Inventory General Ledger account number to return the item to. The back ordered allocation report can be run to show those items that you are waiting to pull from inventory but are currently not in stock. WAGES ANALYSIS BOOK It is book kept by HR manager to kept record for the wages payable to different types of workers working in the concern such as skilled, semi-skilled and unskilled workers along with the rates allocated to different workers, to analysis total cost incurred in total wages of workers.

INVOICES An invoice or bill is a commercial document issued by a seller to the buyer, indicating the products, quantities, and agreed prices for products or services the seller has provided the buyer. An invoice indicates the buyer must pay the seller, according to the payment terms. The buyer has a maximum amount of days to pay these goods and are sometimes offered a discount if paid before.
In the rental industry, an invoice must include a specific reference to the duration of the time being billed, so rather than quantity, price and discount the invoicing amount is based on quantity, price, discount and

duration. Generally speaking each line of a rental invoice will refer to the actual hours, days, weeks, months, etc being billed. From the point of view of a seller, an invoice is a sales invoice. From the point of view of a buyer, an invoice is a purchase invoice. The document indicates the buyer and seller, but the term invoiceindicates money is owed or owing. In English, the context of the term invoice is usually used to clarify its meaning, such as "We sent them an invoice" (they owe us money) or "We received an invoice from them" (we owe them money).

A journal entry is a formal accounting entry used to identify a business transaction. The entry itemizes accounts that are debited and credited, and should include some description of the reason for the entry. A journal book is maintained for the cost transaction held in concern. SUBSIDIARY RECORDS:

8.5 ALLOCATION OF OVERHEAD CIMA de nes cost allocation as, the charging of discrete, identi able items of cost to cost centers or cost units. Where a cost can be clearly identi ed with a cost center or cost unit, then it can be allocated to that particular cost center or unit. In other words, allocation is the process by which cost items are charged directly to a cost unit or cost center. For example, electricity charges can be allocated to various departments if separate meters are installed, depreciation of machinery can be allocated to various departments as the machines can be identi ed, salary of stores clerk can be allocated to stores department, cost of coal used in boiler can be directly allocated to boiler house division. Thus allocation is a direct process of identifying overheads to the cost units or cost center. Overheads are common costs incurred for the benefits of a number of costs centers or cost units. Therefore, they cannot be identified and allocated directly to a particular unit of output. As such, they are to be allocated among the units of output of a particular department or a number of departments or cost centers. Allocation of overheads is the process of charging overhead costs to a particular department or cost center. It is the allotment or assignment of an overhead cost to a particular cost unit. If the overhead cost is associated with a single department or cost center, the whole amount is charged or distributed among the units of output of that particular department. For example, the whole amount of repair and maintenance expenses for a machine is charged or allocated to that department where the machine has been installed.

Overhead allocation involves allocating all costs to inventory that are incurred to put goods in a salable condition. For raw materials, this is the purchase price, inbound transportation costs,

insurance, and handling costs. If inventory is in the work-in-process or finished goods stages, then an allocation of the overhead costs shown below must be added: Depreciation of factory equipment Factory administration expenses Indirect labor and production supervisory wages Indirect materials and supplies Maintenance, factory and production equipment Officer salaries related to production Production employees benefits Quality control and inspection Rent, facility and equipment Repair expenses Rework labor, scrap and spoilage Taxes related to production assets Uncapitalized tools and equipment Utilities

You can allocate overhead costs by any reasonable measure, but you must be consistently apply the overhead across reporting periods. Common bases for overhead allocation are direct labor hours or machine hours used during the production of a product. Overhead Allocation Example A company manufactures and sells Product A and Product B. Both require considerable machining to complete, so it is appropriate to allocate overhead costs to them based on total hours of standard machine time used. In March, Product A manufacturing required a total of 4,375 hours of machine time. During the same month, all units of Product B manufactured required 2,615 hours of machine time. Thus, 63% of the overhead cost pool was allocated to Product A and 37% to Product B. This example results in a reasonably accurate allocation of overhead to products, especially if the bulk of expenses in the overhead pool relate to the machining equipment used to complete the products. However, if a significant proportion of expenses in the overhead cost pool could be reasonably assigned to some other allocation measure, then these costs could be stored in a separate cost pool and allocated in a different manner. For example, if Product A was quite bulky and required 90% of the storage space in the warehouse, as opposed to 10% for Product B, then 90% of the warehouse-related overhead costs could be reasonably allocated to Product A.

BASES OF ALLOCATION: An allocation base is the basis upon which an entity allocates overhead costs. It takes the form of a quantity, such as machine hours used, kilowatt hours consumed, or square footage occupied.
The typical allocation process in a multi-department company is:

1. 2.

Allocate service department costs to operating departments. Assign operating department costs (including the allocations from service departments) to products and services.

The allocation base should be a cause, or driver, of the cost being allocated. A good indicator that an allocation base is appropriate is when changes in the allocation base roughly correspond to changes in the actual cost. Thus, if machine usage declines, so too should the actual cost incurred to operate the machine.

Here are several examples of appropriate allocation bases:

1. 2. 3.

The computer services department allocates its expenses based on the number of personal computers used by each operating department, or by the number of service calls to each operating department. The janitorial department allocates its expenses based on the square footage occupied by each operating department. The human resources department allocates its expenses based on the number of employees working in each operating department.
Most organizations use a very small number of allocation bases to allocate overhead costs, though a detailed activity-based costing system may use quite a large number of them. Managers should be aware of every allocation base being used, since it is the basis for overhead charges being assigned to their departments. They may alter the activities of their departments to reduce their use of each allocation base, thereby reducing the costs assigned to their departments.

OVERHEAD RATE: The overhead rate is the total of indirect costs (known as overhead) for a specific reporting period, divided by an allocation measure. The cost of overhead can be comprised of either actual costs or budgeted costs. There are a wide range of possible allocation measures, such as direct labor hours, machine time, or square footage used.
A company uses the overhead rate to allocate its indirect costs to products or projects, so that it can price them appropriately to cover all of its costs and thereby generate a profit. If the overhead rate is not included in the cost of a product, then there is a risk that the company will significantly underprice its products or services, and eventually go bankrupt. The overhead rate can be expressed as a proportion, if both the numerator and denominator are in dollars. For example, ABC Company has total indirect costs of $100,000 and it decides to use the cost of its direct labor as the allocation measure. ABC incurs $50,000 of direct labor costs, so the overhead rate is calculated as: $100,000 Indirect costs $50,000 Direct labor The result is an overhead rate of 2.0. Alternatively, if the denominator is not in dollars, then the overhead rate is expressed as a cost per allocation unit. For example, ABC Company decides to change its allocation measure to hours of machine time used. ABC has 10,000 hours of machine time usage, so the overhead rate is now calculated as: $100,000 Indirect costs 10,000 Machine hours The result is an overhead rate of $10.00 per machine hour. A company with low indirect costs will have a lower overhead rate, which makes it more competitive with other firms that must apply a larger amount of overhead cost to their products and services.


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METHODS FOR ALLOCATING THE OVERHEAD COST Overhead consists of every other activity or material that you use to do business. Overhead is your businesss indirect costs and is not easily managed. Figuring out indirect costs is one of the biggest challenges in cost allocation and there are two methods that are used to allocate overhead in todays business world. Direct Method ABC Method DIRECT METHOD: The first method is the direct method which uses a single cost driver to determine overhead costs. A cost driver is any activity in a business used to determine cost. Examples of cost drivers are labor hours or machine hours. A predetermined overhead rate (POHR) is used and multiplied by the use of the cost driver for any given product that a firm produces. For example, the POHR for a steel manufacturer may be $3.00 per labor hour. This rate is used in every process throughout the company to determine overhead, which is used to determine the firms costs. Unfortunately this method has a major drawback. Companies often make more than one product and some products are made in higher volume than others. Using the direct method with one cost driver to determine overhead subsidizes the lower volume products. High volume products carry too much

of the overhead burden and become overpriced while the low volume products are under-priced. The activities used to make low volume products are usually more specialized and time consuming. However since there is only one cost driver to determine the overhead cost, specialized activity costs, such as inspections, are spread throughout every product manufactured at the firm. High volume products that need little to no specialized oversight are forced to share costs not associated with them. Therefore, costs are being misallocated and prices are not accurately set. ABC METHOD The second method of cost allocation, Activity Based Costing (ABC), accurately determines a firms costs. In its simplest form, ABC uses many cost drivers in determining overhead. Firms closely monitor operations to determine which products use the various activities conducted by the firms operations. A single product may have cost drivers such as: number of batches produced, number of inspections per batch, and cost per machine setup. Cost drivers are then properly allocated to the products, and resources are measured as they are consumed by activity and product. ABC is a more accurate method of overhead costing because it measures a firms consumption of resources by using multiple cost drivers. Using multiple cost drivers is advantageous because higher volume products cease to subsidize the lower volume products. Products that do not require certain activities are not forced to share the burden of costs as they would in the direct method of costing. For example if a firm produceslow grade steel at high volume with little need for inspection, and high grade steel at lower volume with high need for inspection, the high grade steel will carry the burden of the inspection cost. The low grade steel does not use inspection activity and therefore should not be required to include the cost in its overhead allocation. The advantages of using ABC are clear. ABC allows for more accurate costing and pricing of goods and services. With this knowledge firms can lower prices on the products they make most, and be more price competitive in the market. This is especially true for firms that practice cost leadership as a part of their overall business strategy. But this method is not limited to cost leadership alone, ABC works for product differentiation also. Low volume goods and services are no longer under-costed and under-priced when using this method. Businesses can be confident that they are costing premium products correctly and can earn deserved profits for them. The overall advantage to using ABC is that firms get the most for their money and maximize profits in the long term. There are disadvantages to using ABC, however. ABC is very complex. Managerial accountants have been perfecting this method of costing for years. It is also often difficult to figure out what a firms cost drivers are. Moreover, monitoring firm activities and assigning cost drivers can be a very time consuming and costly endeavor. Oftentimes, accounting experts are required to initiate and manage the system. This is especially true for service industry firms. Such businesses may conduct hundreds of activities in a given business day and pinpointing which activities are the most important can be very mind-numbing. Most firms implementing ABC use 15 to 20 cost drivers at the most. Though using Activity Based Costing may seem daunting, it is a very useful method to track costs. If properly implemented, ABC can be very cost effective and profitable. Overhead allocation is one of the more confusing and complex issues facing many businesses. Yet, figuring out how to best determine overhead is very important to a firms profitability. While using the direct method of cost allocation is simple, its simplicity makes it very inaccurate and costly to the bottom line. ABC is complex, but if used properly, can pay off greatly in a businesses long term.

8.6 OVERHEAD APPORTIONMENT Wherever possible, the overheads are to be allocated. However, if it is not possible to charge the overheads to a particular cost center or cost unit, they are to be apportionedto various departments on some suitable basis. This process is called as Apportionment of overheads. For example, if separate meters are provided in each department, the electricity expenses can be allocated to various departments. However if separate meters are not provided, electricity expenses will have to be apportioned to the departments on some suitable basis like number of light points. Similarly rent will have to be apportioned to various departments on the basis of oor space, insurance of machinery on the basis of value of machinery, power on the basis of horsepower etc. A statement showing the apportionment of overheads is called as Primary Distribution Summary of overheads. Distribution of an overhead cost to several departments or cost centers is known as apportionment of overheads. It is the process of charging or apportioning costs to a number of cost centers or cost units. If a given cost is common to two or more departments or cost centers, such cost should be apportioned or divided among these departments on an equitable basis. For example, the amount of factory rent should be apportioned to all the departments. Similarly, the amount of remuneration of the general manager should be distributed to the production, administration and marketing departments as the general manager is associated with all these departments. BASIS OF APPORTIONMENT: COMMON ITEMS OVERHEAD OF PRODUCTION BASIS OF APPORTIONMENT

1. Factory rent, rates and taxes 2. Insurance of factory building 1. 2. 1. 1. 2. 1. 2. 1. 1. 1. Insurance of Plant & Machinery Depreciation of Plant & Machinery Insurance of stock Supervison Canteen Staff Welfare expense Compensation to workers PF Contribution Stores Overhead/ Keeping Overhead Material Handling charges Lighting and Heating

Floor area occupied

Capital Cost of Plant & Machinery

Insured Value of stock No. Of Workers


Value of Direct Material Weight of Direct Material No. Of light points or floor area occupied

The determination of a suitable basis is of primary importance and the following principles are useful guides to a cost accountant:

Service or use or benefit derived: If the service rendered by a particular item of expense to different departments, can be measured, overhead can be conveniently apportioned on this basis. Thus the cost of maintenance may be apportioned to different departments on the basis of machine hours or capital value of the machines, rent charges to be distributed according to the floor space occupied by each department. Ability to pay method: Under this method, overhead should be distributed in proportion to the sales ability, income or profitability of the departments, territories, basis of products etc. Efficiency method: Under this method, the apportionment of expenses is made on the basis of production targets. If the target is exceeded, the unit cost reduces indicating a more than average efficiency. If the target is not achieved, the unit cost goes up, disclosing thereby, the inefficiency of the department. Survey method: In certain cases it may not be possible to measure exactly the extent of benefit which the various departments receive as this may vary from period to period. A survey is made of the various factors involved and the share of overhead costs to be borne by each cost center is determined. Thus the salaries of foreman serving two departments can be apportioned after a proper survey which may reveal that 30% of such salary should be apportioned to one department and 70% to the other department. Allocation Vs Apportionment 1) Allocation deals with whole amount of factory overheads while apportionment deals with proportion of item of cost or proportion to cost centers. 2) 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. 8.7 RE-APPORTIONMENT OF OVERHEAD:

Re-apportionment is a process where service centers costs are transferred to production centers. Redistribution of overhead from various service departments to production departments is known as Reapportionment or Secondary distribution. Accordingly, allocation and apportionment of overheads from service departments or centers to production centers or departments. The following are the important bases adopted for apportionment of Secondary distribution : - As discussed above, one of the important step in overhead accounting is Departmentalization of overheads. The departments are broadly divided into Production Departments and Service Departments. Production Departments are the departments where actual production takes place while Service Departments are the departments which render services to the Production Departments. Stores Department, Maintenance Department, Human Resource Department, After Sales Service Departments are some of the examples of Service Departments. In Primary Distribution Summary, the overheads are apportioned to all the Departments, i.e. Production and Service. For the purpose of absorption it is necessary that the overheads of the service departments are reapportioned to the production departments. This process is called as preparation of Secondary Distribution Summary of overheads. The following example will clarify this point. Suppose, there are ve departments in a manufacturing rm, P1, P2, and P3 are the production departments and S1 and S2 are the service departments. The following results are available from the Primary Distribution Summary. Particulars Dept. P1 Dept. P2 Dept. P3 Dept. S1 Dept. S2

From Primary Distribution Summary 1,50,000 1,75,000 1,25,000 75,000 50,000

In the secondary distribution summary, the overheads of S1 and S2 will have to be charged to Production Departments, P1, P2, and P3. This will have to be done on some suitable basis. The matter becomes complicated if S1 and S2 are rendering services to each other in addition to the services rendered to the production departments.
Cost centers are two types: a) Production Cost Centers: They are cost centers where finished products are manufactured b) Service Cost Centers: They are cost centers that support the production cost centers in manufacture of a product Ex: Stores, Engineering, Purchase etc. The costs of service departments must be charged to production departments which directly come in contact with cost units, because our ultimate object is to charge overheads to cost units,. The method of re-apportionment of service department costs is similar to apportionment of overheads discussed earlier. Some of the important bases of apportionment of service department costs to production departments are as follows: Service department Bases of apportionment 1. Store-keeping department Number of material requisitions, or value/quantity of materials consumed in each department. Value of materials purchased for each department, or number of purchase orders placed. Number of employees, or total labour or department

2. Purchase department

3. Time-keeping department and payroll machine hours. 4. Personnel department department. 5. Canteen, welfare and recreation services 6. Maintenance department 7. Internal transport service 8. Inspection department 9. Drawing office

Rate of labour turnover, or number of employees in each

Number of employees, or total wages.

Number of hours worked in each department. Value or weight of goods transported, or distance covered. Direct labour hours or machine operating hours. No. of drawings made or man hours worked.

Thus, the costs of service departments are apportioned on the basis of service rendered, i.e., the benefits received by the beneficiary departments

Methods of re-apportionment The following are the methods used to re-apportion service department costs to production departments. Scenario No service between service cost centers Method for re-apportionment Direct re-distribution method

Non reciprocal service between service Step ladder method cost centers 1) Repeated distribution Reciprocal service between service cost 2) Trial & Error centers 3) Simultaneous Equation method

method method

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.

Apportionment to Production Departments Only In this case, cost of each service department is apportioned only to production departments without apportioning it to other service departments.

Apportionment to Production as well as Service Departments

Quite often, a service department renders services not only to production department but also to other service departments. For example, power house supplies electricity not only to production departments but also to service departments like canteen, maintenance departments, etc. 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 departments untill the cost of all the service departments are redistributed to the production department. This method is used when a service department renders services to other service departments but does not receive services of the other service departments. In this method, the service departments are arranged in descending order of their serviceability. The cost of the most serviceable department, i.e. the department which serves the largest number of departments is first apportioned to other service departments. The service department which serves the next largest number of departments is taken up next and its cost is apportioned to other service and production departments excepting the first service department. In the same way, while apportioning the cost of the third service department in this order, the first two service departments are ignored. This process is continued till the cost of the last service department is apportioned. It should be noted that the cost of the last service department is apportioned only to production departments.

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 :

a) b) c)

Simultaneous Repeated Trail


Equation Distribution Error

Method. Method. Method.

a) 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 re-apportioned to production department on the basis of given percentage. In this method, the following algebraic equations help in finding out cost of service departments. X = a + bY Y = a + bX

b) 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 turn repeatedly until the figures become too small to matter. In this method the following steps are taken to apportion the service departments costs: 1. The costs of the first service department are apportioned in the normal way according to the given percentages. This will close the account of the first service department. 2. Then apply the given percentages for the apportionment of second service department costs which include their own cost plus amount apportioned from the first service department. 3. The same procedure should be followed in the case of all other service departments. This completes the first cycle of apportionment.












c) Trial 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.

8.8 CALCULATION OF OVERHEAD The word overhead when mentioned, is generally linked with business. Families and individuals have overhead costs also. A familys overhead costs or an individuals overhead costs are in fact more expansive than a businesss overheads. For personal overhead, items like entertainment costs, credit card costs are taken. Your personal overhead costs are those costs which you pay on a monthly basis and do not differ in a significant amount. If you know your monthly overhead then it can help you in setting a budget for yourself or your family which will be based upon how much income you carry in monthly when compared with your monthly overhead.

Steps to calculate overhead 1. Find out what your monthly average gas bills and electricity bills are. These can be in different bills or in one combined bill. Add up the entire amount you have paid for gas bills and electricity in the last one year. Divide the total amount of these bills by 12 (number of months per year). You will get the average electric and gas bill per month. Compute your average monthly water bill in the same method in which you have calculated your average monthly gas and electric bills in step one. It will be better to calculate an average over 12 months for the utilities as the costs differ from month to month. Collect your credit card bills for the previous year for those credit cards on which you owe money. Sum up the total amount you have paid every month for all of your cards. Divide this amount you have obtained now by 12. From this you will have your monthly average credit card expenditure. Compute your known fixed cost like car payments, day care costs, rent payments and automobile gas expense for duration of one month. This expenditure is your known monthly expenditure. Fix a budget for expenditure. For example, set your budget for your grocery purchases, and your entertainment expenses. This will be your expected monthly budgeted expenditure. Sum up together your average monthly gas and electric bills, your average monthly water bill, your known monthly expenditure, your average monthly credit card cost and your monthly budgeted expenses. This total expenditure is your personal or your familys overhead costs which needs to be considered in your budgeting on a monthly basis when you are determining your own or your familys monthly budget.



4. 5. 6.


Question 1 A machine shop cost centre contains three machines of equal capacities. Three operators are employed on each machine, payable Rs. 20 per hour each. The factory works for fortyeight hours in a week which includes 4 hours set up time. The work is jointly done by operators. The operators are paid fully for the fortyeight hours. In additions they are paid a bonus of 10 per cent of productive time. Costs are reported for this company on the basis of thirteen fourweekly period. The company for the purpose of computing machine hour rate includes the direct wages of the operator and also recoups the factory overheads allocated to the machines. The following details of factory overheads applicable to the cost centre are available: Depreciation 10% per annum on original cost of the machine. Original cost of the each machine is Rs. 52,000. Maintenance and repairs per week per machine is Rs. 60. Consumable stores per week per machine are Rs. 75. Power : 20 units per hour per machine at the rate of 80 paise per unit. Apportionment to the cost centre : Rent per annum Rs. 5,400, Heat and Light per annum Rs. 9,720, and foremans salary per annum Rs. 12,960. Required: (i) Calculate the cost of running one machine for a four week period. (ii) Calculate machine hour rate. Computation of cost of running one machine for a four week period Rs. Standing charges Per annum Rent 5,400 Heat and light 9,720 Formans salary 12,960 28,080


SELF ASSESSMENT Q.1. Explain the term overhead. How can you classify overhead in different parts. Q.2. Explain the procedure of distribution of overhead? Q.3. What is the meaning of allocation and absorption? Differentiate both the terms. Q.4. Explain the term Apportionment and re-apportionment. Q.5. Define the different methods of Re-apportionment? Q.6. What is overhead rate? How is it calculated? Q.7.PRACTICAL QUESTIONS IN HARD COPY


Overhead absorption means charging overheads to products. Let us suppose that the production department produce two product. Then it is necessary to distribute the total cost that particular department on the some specific basis. Overhead absorption to products may be done on the following basis: Raw material consumed Wages Prime cost Units produced Labour hours Machine hours Appropriate base is chosen considering the relevance of the absorption base to the products. In case incidence of overhead is related to machine hours consumed, then only machine hours should be used as absorption basis. In case of labour intensive production, direct wages or labour hours may be chosen as absorption base. Labour hours are considered only when labour rates vary widely. Prime cost does not reflect proper relationship between products and cost. When raw materials or any other elements of prime cost dominate, absorption on the basis of prime cost ratio more or less resembles the allocation on the basis of such element although overheads are not linked to that element. Units produced generally do not have any relationship with the incidence of overhead. It is necessary to link overheads to production with reference to consumption of services.

Once departmentalisation of overhead has been completed, the total cost of each production department comprises of the following: (i) Costs allocated and apportioned to production departments. (ii) Costs of service departments re-apportioned to production departments.

The total overhead cost pertaining to a production department or cost centre is then charged to or absorbed in the cost of the products or cost units passing through that centre. This is known as absorption. Absorption of overheads is also known as levy, recovery or application of overheads.


There are two steps in the absorption of overheads:

1. Computation of Overhead Absorption Rate. Absorption rates are computed for the purpose of absorption of overheads in costs of the cost units. This is calculated by: Overhead absorption rate = Total overheads of cost centre Total units in base It should be noted that only one rate is computed for any single group of overheads.

2. Application of rates to cost units. In order to arrive at the overhead cost of each cost unit, the overhead rate is multiplied by the number of units of base in the cost unit. Thus:

Overhead absorbed = No. of units of base in the cost unit Overhead rate.


Various methods of absorption discussed below are used to determine the overhead absorption rate for production overhead.

1. Direct Materials Cost Percentage Rate: Under this method, the amount of overheads to be absorbed by a cost unit is determined by the cost of direct materials consumed in producing it. Thus,

Overhead rate =

Production overheads

100 Direct materials

2. Direct Labor Cost Percentage Rate: The overhead rate under this method is computed by dividing the production overhead by the direct labour cost.

Overhead rate =

Production overheads 100 Direct labour cost


Production overheads = Rs. 40,000 Direct labour cost = Rs. 1,00,000

Overhead rate =

40,000 100 = 40%


Thus a job for which direct wages are Rs. 200 will absorb production overheads of Rs. 80 i.e. 40% of Rs. 200. 7. Prime Cost Percentage Rate: This method is based on the premise that both materials and labor give rise to factory overheads and thus the total of the two, i.e., prime cost should be taken as the base for absorption of factory overheads. In a way, this is a combination of the material cost and labor cost methods.Overhead rate in this method is calculated by dividing the production overhead by prime cost.

Overhead rate =

Production overheads 100 Prime Cost


Production overhead = Rs. 40,000 Prime cost = Rs. 2,50,000

Overhead rate =

40,000 100 = 16% 2,50,000

Thus, if prime cost of a job is Rs. 500, production overheads to be absorbed by that job should be Rs. 80, i.e., 16% of Rs. 500.

Although overheads are related more to labour cost than material costs, this method gives equal
4. Direct Labor Hour Rate: This is a rate per hour and not a percentage rate. It is obtained by dividing the total production overhead by the total number of direct labor hours for the period.

Overhead rate =

Production overhead

Direct labour hours

Example Production overhead = Rs. 40,000 Direct labour hours = 50,000 hours

Overhead rate

Rs. 40,000 = 80 paise per hour. 50,000 hours

Thus, if a job takes 20 labour hours for production, Rs. 16 (i.e., 20 hours @ 80 paise) will be charged to that job for production overhead

Computation of Machine Hour Rate

The following steps are taken for the computation of machine hour rate: (i) The factory overheads are first apportioned to production departments as discussed earlier under allocation and apportionment. (ii) Overheads of the department are further apportioned to different machines or groups of machines. For this purpose each machine or a group of machines is treated as a cost centre or a small department. Bases of apportionment of different expenses are given here. (iii) Specific overheads like power, depreciation, etc., should be directly allocated to the machine.

(iv) The overheads relating to the machine should be divided between (a) Fixed or standard charges, and (b) Variable charges. Fixed charges are those which remain constant irrespective of the

Treatment of depreciation: Depreciation is a semi-variable item. In the computation of machine hour rate, some accountants treat it as a fixed cost while others treat it as a variable cost. In fact, whether it is to be treated as fixed or variable cost, depends upon the method of computing depreciation. In this chapter, it has been mostly treated as a variable item.
Bases of Apportionment of Different Overhead to Machines Items of overhead Basis of apportionment

1. Rent and rates 2. Insurance 3. Supervision 4. Lighting

Ratio of floor area occupied by each machine. Insured value of each machine. Estimated time devoted by the supervisor to each machine. No. of light points used for each machine, or floor area occupied by each machine. Capital values/machine hours or multiple of both. Capital values/machine hours. Capital values/machine hours. consumable stores

5. Depreciation 6. Repairs and maintenance 7. Lubricating oil and other

Comprehensive (or composite) machine hour rate: When the direct wages of machine operators are included in machine hour rate, it is known as comprehensive machine hour rate. Thus in a comprehensive machine hour rate, overhead and direct wages are absorbed by a single rate.


Overhead rates may be

1. 2. These are described below.

actual or pre-determined; and blanket or multiple.

Actual and Pre-determined Rates Overhead absorption rate may be based on actual figures or estimated figures.

Actual Rate: It is calculated by dividing the actual overheads by actual base. Thus:

Actual overhead rate = Actual amount of overheads

Actual base

On account of certain limitations of actual rate, it is not always desirable to use it for the absorption of overheads.

Pre-determined Rate: This rate is determined in advance of the period in which it is to be used. It is computed by dividing the estimated or budgeted amount of overheads by the budgeted base. Thus Pre-determined rate = Budgeted amount of overhead Budgeted base

As compared to actual rate, a pre-determined rate is of greater practical utility. This is because a predetermined rate enables prompt preparation of tenders and quotations and fixation of selling prices. Cost control is also facilitated by comparing the actual overheads with the pre-determined overhead recovered. The use of pre-determined rates thus, helps in deriving some of the benefits of standard costing and budgetary control.
Blanket and Multiple Rates A blanket overhead rate is a single overhead rate for the entire factory. It is computed as follows:

Blanket rate =

Total overheads for the factory

Total number of units of base for the factory

Multiple rates means a number of separate rates for each department, cost centre etc. For instance, separate rates may be calculated for each of the following: (a) Production department

(b) Service department (c) Cost centre (d) Product (e) Fixed overhead and variable overhead. The following formula is used to calculate the multiple rates:

Overhead rate =

Overhead of department or cost centre Corresponding base


Capacity of a factory refers to its ability to produce with the resources and facilities available at its disposal. Plant capacity may be expressed in terms of any of the following: (a) Units of products: For example tons of steel, meters of cable, number of cars or scooters, number of passenger kilometers etc.

(b)Production hours or machine hours: For example, if in a factory there are 40 machines and each of these machines can be operated for 8 hours per day, the plant capacity in terms of production hours will be 40 8 = 320 production hours per day.

Capacity Levels The various types of capacity levels are: 1. Maximum Capacity: This is the maximum production capability of a plant which can be achieved only under perfect conditions, i.e., when there is no loss of operating time.

2. Practical Capacity: Also known as operating capacity, this is the maximum capacity less output or time lost due to unavoidable factors like plant repairs and maintenance, setting up time, holidays etc. and other normal losses.

3. Capacity Based on Sales Expectancy: This is a capacity which is based on expected sales and is determined after a careful study of the market conditions.

4. Actual Capacity: This is the capacity actually achieved during a particular period. This is known only after the period is over and may be below or above the capacity based on sales expectancy.

5. Normal Capacity: This is the long-term average of the capacity based on sales expectancy. In other words, the concept of normal capacity is based on the average utilization of plant capacity over a long period.

Idle Capacity

This is the difference between practical capacity and capacity based on sales expectancy or actual capacity. In other words, idle capacity is the production capacity lost due to reasons like lack of orders from customers, absenteeism, shortage of materials, etc. It is a temporary phenomenon and can be wiped out when difficulties causing idle capacity are overcome.

9.6 ADMINISTRATION OVERHEAD These are the indirect expenditure incurred in formulating the policy, directing the organisation and controlling the operations of an undertaking. These overheads are of a general character and are incurred for the business as a whole. They have little or no direct connection with production or sales activities
Absorption of Administration Overhead Office and administrative overheads generally constitute a small portion of the total cost as compared to production overhead. For the purpose of absorption of these overheads, a single (blanket) overhead rate is computed by any one of the following methods:

1. Percentage of works cost: Administration overhead is generally absorbed as a percentage of works cost. Such a rate is computed by the following formula: Overhead rate = Admn. Overhead 100 Works cost

2. Percentage of sales: Sometimes office and administration overheads are absorbed as a percentage of sales. Its formula is: Overhead rate = Administration overhead 100 Sales

3. As a percentage of conversion cost: Conversion cost is the cost of converting raw material into finished goods. It includes cost of direct labour and factory overheads. This method is rarely used. Overhead rate is calculated by the following formula:

Overhead rate =

Administration overhead Total conversion cost 100


Selling cost is the cost of seeking to create and stimulate demand (sometimes termed marketing) and of securing orders. These costs are thus incurred for increasing sales to the existing and potential customers. Examples are advertisement, samples and free gifts, show-room expenses, etc.

Distribution cost is the cost of the sequence of operations which begins with making the packed product available for dispatch and ends with making the re-conditioned returned empty packages, if any, available for re-use. Examples are carriage outwards, insurance of goods-in-transit, maintenance of delivery vans, warehousing, etc
Methods of Absorption

Various methods for absorption of selling and distribution overheads are as follows:

1. A rate per unit of sales: This method is employed when the company is selling one uniform type of product. The total selling and distribution overheads to be absorbed are divided by the number of units sold to arrive at a rate per unit.

2. A percentage of selling price: This method is recommended when the concern is selling more than one type of product. A percentage of selling and distribution overheads to selling price are ascertained from an analysis of past records. Overhead rate is calculated by the following formula:

Overhead rate =

Selling and distribution overheads

x100 Sales

3. A percentage of works cost: In this method, a percentage of selling overheads to works cost is ascertained. This percentage rate is applied for the absorption of selling and distribution overheads.

Overhead rate is calculated as follows Overhead rate = Selling and distribution overheads Total works cost 100


As stated earlier, overheads may be absorbed either on the basis of actual rates or pre-determined rates

Under-absorption: When the amount of overheads absorbed is less than the amount of overhead actually incurred, it is called under-absorption or under-recovery. This has the effect of under-stating the cost because the overheads incurred are not fully recovered in the cost of jobs, processes etc.

Over-absorption: When the amount of overhead absorbed is more than the amount of actual overheads incurred, it is known as over-absorption or over-recovery. It has the effect of over-stating the cost of jobs, processes, etc.

Causes of Under- or Over-absorption

Under- or over-absorption of overheads may arise due to one or more of the following reasons: 1. Faulty estimation of overhead costs. 2. Faulty estimation of the quantity of output. 3. Seasonal fluctuation in the amount of overheads in certain industries. 4. Unforeseen changes in the production capacity. 5. Unexpected changes in the method of production affecting changes in the amount of overheads.

Whatever be the reason, under- or over-absorption is caused mainly due to wrong estimation either of the overhead costs or of the base such as machine hours, production quantity, etc.
Accounting Treatment of Under- and Over-absorption

1. Use of supplementary rates: Where the amount of under or over-absorbed overhead is significant, a supplementary overhead absorption rate is calculated to adjust this amount in the cost. However, adjustment is made in the cost of (i) work-in-progress; (ii) finished stock, and (iii) cost of sales. In the case of under-absorption, the overhead is adjusted by a plus rate since the amount is to be added, whereas overabsorption is adjusted by a minus rate since the amount is to be deducted.

2. Writing off to Costing Profit and Loss Account: This method is used when the under or over-absorbed amount is quite negligible and it is not worthwhile to absorb it by supplementary rate. Under-absorption due to abnormal factors like idle capacity, defective planning etc. is also transferred to Costing Profit and Loss Account.

3. Carry over-to the next year: Under this method the under or over-absorbed amount is transferred to Overhead Reserve Account or Suspense Account for carry over to the next accounting year.


1. Interest on Capital

There is a considerable difference of opinion on the question as to whether interest on capital should be included in cost or not. This is so because whether a concern pays interest on capital or not, depends upon its method of capitalization. This means a company raising finance by equity capital does not have to pay interest whereas a company raising finance partly through debentures has to pay interest. If interest actually paid is included in cost, companies not paying any interest will have lower cost and companies paying interest will show higher cost of production. This makes the comparison of cost in different companies difficult. Therefore, for the sake of uniformity, either interest paid should be excluded from cost, or alternatively, interest on the total capital employed (both equity, and debenture capital) should be included in cost so that costs become comparable.
2. Rent or A Charge in Lieu of Rent When rent is paid, this is obviously a cost to be taken into account as production, administration or selling and distribution overhead, depending upon the use to which the building is put to. In many cases, however, the premises are owned by the business and no rent is payable. In such cases, a charge in lieu of rent should be made in cost accounts so that the true cost may be ascertained. The annual value of premises, as assessed for rating purposes, is normally a satisfactory amount to charge in lieu of rent. Unless such a notional charge is made, the costs will fail to be comparable. If premises are owned by some concerns and rented by others in the same industry, the costs will vary if no rent for owned premises is charged in the cost accounts.

3. Cash Discount

This is a form of interest on capital and is generally excluded from costs. In fact, as a general rule, all financial items are excluded from the costs.
8. Carriage Inwards This is directly connected with the purchase of materials and is generally included in the cost of materials purchased, thereby treating it as a direct cost. Alternatively, it may be treated as an item of factory overhead.

9. Packing Expenses Packing expenses may be of the following three types: (a) Packing which is necessary for handling of the product, e.g., medicines, oil, other liquid products must be packed to make them saleable. Such primary packing expenses are treated as direct material cost. (b) Fancy packing meant to attract customers, e.g., colorful attractive wrappers of cosmetics is a form of advertisement and should be treated as selling overhead. (c) Packing that facilitates transportation and handling of products to customers place, e.g., packing of TV sets or refrigerators, should be treated as distribution overhead.
6. Royalties and Patent Fees Royalties may be payable for: (a) Making use of a patent process or product in the course of manufacture; or (b) The right to sell the finished product. Royalties payable for making use of a patent process in manufacture should be treated as direct expenses (it is payable at a rate per unit) and included in prime cost. Royalties payable on the basis of sales should be regarded as selling cost.

7. Drawing and Design Office Costs

Drawing costs may be treated as direct expenses if drawings or designs are prepared for specific jobs. In case drawings are to be enclosed with sales tenders, it may be treated as selling overhead. Where drawing and designing office is used as a service department, its costs should be apportioned to production departments on the basis of technical estimates of services rendered or on any other suitable basis, like number of drawings made, man-hours worked, etc.
8. Canteen Expenses (Subsidy) Where a canteen runs on a subsidized basis, it is a welfare measure for the staff of the organisation. Such an expenditure on subsidy is an overhead cost and is apportioned to various departments on the basis of total wages or number of workers. When a canteen runs on a no profit no loss basis, there is no question of any expenditure being incurred.

9. Expenses on Removal and Re-erection of Machinery Sometimes machinery is shifted to a new site due to factors like change in the method of production, an addition or alteration in the factory building, change in the flow of production, etc. All costs incurred to dismantle the existing installation and its re-erection is treated as production overhead as they do not add to the value of the asset.

When amount of such costs is large, it may be treated as deferred revenue expenditure and spread over a period of time, say 3 to 5 years. If removal is due to faulty planning or some other abnormal factor, it is charged to Costing Profit and Loss Account.

It may not be out of place to mention that when a new machinery is installed, the entire cost of installation is capitalized along with cost of machinery.
10. Director's Fees and Salaries This is usually a part of administration overhead. Where separate directors are appointed for different functions like production, sales, etc., such costs should be allocated to the respective functional overheads. When there are no separate directors for different functions, directors remuneration may be apportioned to production, administration and selling and distribution on the basis of time devoted by the directors on each department.

11. Set-up Costs

After the completion of a particular job, machines may require setting up with a different set of tools for taking up the next job. The cost of setting up time is, therefore, normally charged to that particular job for which preparation is being made. But when setting up is frequent and the cost abnormally high, the situation demands proper measurement and control of set-up costs. In such cases, it may be preferable to treat such costs as production overheads for booking against all jobs equitably.
12. Research and Development Costs On account of certain special features of research and development costs, different accounting treatments for such expenditure are required for different circumstances. There is, therefore, no general agreement regarding the treatment of such costs in cost accounts. The following are the various methods of treating these costs in accounts: (a) Charging off to costs of current period as revenue expenditure. (b) Charging off to costs over a number of years. (c) Transfer to Costing Profit and Loss Account.

13. Bonus Payable to Employees Under the payment of Bonus Act 1965, it is obligatory to pay a minimum bonus of to employees irrespective of profit or loss in the firm. Such a minimum amount of bonus may be either treated as an overhead or alternatively, bonus payable to direct workers may be included in their wages and their wage rate inflated to cover the amount of bonus. Any bonus paid over and above the minimum amount of bonus should be treated as an appropriation of profit and thus transferred to Costing Profit and Loss Account of the period.

Some cost accountants prefer to treat the entire amount of bonus as overhead and apportion it to various departments on the basis of wages bill of each department.
14. Market Research Cost

Market research includes study of tastes and habits of customers, future trend of demand, potential markets, competitive products, trading practices and channels of distribution. The expenditure on market research is in the nature of policy costs and depends upon the policy of the management in

this regard. Many concerns do not spend any amount under this head while others spend heavy amounts on this item. Market research cost is normally treated as selling overhead.
15. Fringe Benefits Industrial workers usually enjoy certain benefits in addition to their wages, salaries and other allowances. These benefits, known as fringe benefits, are costs incurred by the employers, which are not related to the quantity of work done by workers. These can be monetary as well as non-monetary. List of such benefits is given below: Fringe Benefits (Individual) Monetary

Dearness Allowance Night Shift Allowance Sick Leave Pay Holiday Pay Gratuity, Pension

Provided Fund Employee State Insurance Annual Bonus Maternity Leave Pay

Fringe Benefits (Group) Subsidised Conveyance Subsidised Canteen Facilities Educational Facility

Non-Monetary Medical Care Free Housing

Total cost of employing each worker should be calculated after taking into account various elements of remuneration, contribution to P.F. and other fringe benefits. Inflated cost should be charged to the unit of production on appropriate basis. Another course is to treat all the expenses on these benefits as overheads and allocate them.

As regards expenditure on non-monetary benefits, it should be aggregated and allocated or apportioned over departments on the basis of quantum of benefits received.



9.11 SELF ASSESSMENT Q.1.What do you mean by overhead absoption? Q.2. Define the meaning of Absoption rate. Q.3. Explain the different methods of overhead absorption. Q.4. What do you mean by over / under absoption of overhead? What are its causes? Q.5. Define the effect of over / under absorption on overhead cost. Q.6. PARTICAL PROBLEMS IN HARD COPY


10.1 INTEGRATED ACCOUNTING SYSTEM Integrated (or Integral) Accounts is the name given to a system whereby cost and financial accounts are kept in the same set of books. Obviously, then there will be no separate sets of books for Costing and Financial purposes. Integrated Accounts will have to afford full information required for Costing as well as for Financial Accounts. In other words, information and data should be recorded in such a way as to enable the firm to ascertain the Cost (together with the necessary analysis) of each product, job, process, operation or any other identifiable activity. For instance, purchases are analysed by nature of material and its enduse. Purchase accounts are eliminated and direct postings are made to Stores Control Account, Work-in-Progress Account, or Overhead Account. Payroll is straightway analysed into direct laour and overheads. It also ensures the ascertainment of marginal cost, variances, abnormal losses and gains in fact, all information that management requires from a system of Costing for doing its work properly. The integrated accounts give full information in such a manner so that the profit and loss account and the balance sheet can be prepared according to the requirements of law and the management maintains full control over the liabilities and assets of its business 10.2 ESSENTIAL PRE-REQUISITES OF INTEGRATED ACCOUNTING SYSTEM The essential pre-requisites of integrated accounting system include the following: 1. The managements decision about the extent of integration of the two sets of books. Some concerns find it useful to integrate upto the stage of primary cost or factory cost while other prefer full integration of the entire accounting records. 2. A suitable coding system must be made available so as to serve the accounting purposes of financial and cost accounts. 3. An agreed routine, with regard to the treatment of provision for accruals, prepaid expenses, other adjustment necessary for preparation of interim accounts.

4. Perfect coordination should exist between the staff responsible for the financial and cost aspects of the accounts and an efficient processing of accounting documents should be ensured. Under this system there is no need for a separate cost ledger. Of course, there will be a number of subsidiary ledgers; in addition to the useful Customers Ledger and the Bought Ledger, there will be : (a) Stores Ledger; (b) Stock Ledger and (c) Job Ledger. 10.3 ADVANTAGES OF INTEGRATED ACCOUNTING Integrated Accounting is the name given to a system of accounting whereby cost and financial accounts are kept in the same set of books. Such a system will have to afford full information required for Costing as well as for Financial Accounts. In other words, information and data should be recorded in such a way so as to enable the firm to ascertain the cost (together with the necessary analysis) of each product, job, process, operation or any other identifiable activity. For instance, purchases are analysed by nature of material and its enduse. Purchases account is eliminated and direct postings are made to Stores Control Account, Work-in-Progress account, or Overhead Account. Payroll is straightway analysed into direct labour and overheads. It also ensures the ascertainment of marginal cost, variances, abnormal losses and gains. In fact all information that management requires from a system of Costing for doing its work properly is made available. The integrated accounts give full information in such a manner so that the profit and loss account and the balance sheet can be prepared according to the requirements of law and the management maintains full control over the liabilities and assets of its business. The main advantages of Integrated Accounting are as follows: (i) Since there is one set of accounts, thus there is one figure of profit. Hence the question of reconciliation of costing profit and financial profit does not arise. (ii) There is no duplication of recording of entries and efforts to maintain separate set of books. (iii) Costing data are available from books of original entry and hence no delay is caused in obtaining information. (iv) The operation of the system is facilitated with the use of mechanized accounting. (v) Centralization of accounting function results in economy. 10.4 WORKING MECHANICS OF INTEGRATED ACCOUNTING SYSTEM Before accepting this system, the management has to decide about the degree of integration that is planned. Some of the rms integrate accounts up to the stage of prime cost or fact ory cost. Sometimes the entire record is integrated. The following accounts are normally maintained under this system. A. Main Accounts: The following accounts are mainly kept. I. Stock Control Accounts: This accounts is prepared for the following items:

a. Raw Materials: Opening stock and purchases are debited to this account while the materials issued are credited. The balance represents the raw material on hand at the end of the period. b. Work-in-progress: The opening stock of work-in-progress and factory overheads are debited to this account while the cost of nished goods is credited. The closing stock, if any, is carried forward to the next period. c. Finished Stock: This account is known as nished goods account also. It is debited with the nished goods and credited with cost of sales. II. Cost of Sales Account: The Cost of goods sold is debited to this account and the nished goods account is credited. III. Assets Accounts: These accounts are opened for each of the xed assets possessed by the rm. For example, accounts are maintained for assets like Plant and Machinery, Furniture and Fixtures, Land and Building, Vehicles and other such xed assets owned by the rm. Transactions connected with the xed assets are entered in these accounts. For example, the purchases are debited while depreciation as well as any disposal of such assets is credited to these accounts. IV. Debtors and Creditors Control Account: Transactions connected with debtors and creditors are recorded in these accounts. The balance shown by debtors account should tally with the sales ledger while the balance shown by creditors account should tally with the purchase ledger. V. Prepaid Expenses and Outstanding Expenses Account: These accounts are maintained for recording any prepaid expenses or any expenses due but not paid, i.e. outstanding expenses. The prepaid amount is debited to the prepaid account and credited to overhead control accounts. Thus it is ensured that the expenses, which is related to the period only is charged to the work-in-progress account. In case of outstanding expenses, the outstanding expenses account is credited and the overhead control account is debited. At the time of actual payment, the expenses outstanding account is debited and corresponding credit is given to either cash account or bank account or it is adjusted through overhead control account. VI. Direct Wages and Overhead Costs Control Accounts: When these costs are incurred, the appropriate control accounts are debited and cash account is credited. Thus, when direct wages are paid, they are debited to direct labor control account and transferred to the work-in-progress account on the debit side. Appropriate overhead control account is credited. In case the actual payment do not tally with the expenditure related to that period, appropriate adjustment is made. VII. Cost Center Account: An account is kept for each department or cost center. This helps in knowing the cost of a department and controlling costs associated with different departments. VIII. Cash Account: All cash receipts and payments are recorded in this account 10.5 NON-INTEGRATED ACCOUNTING SYSTEM It is a system of accounting under which separate ledgers are maintained for cost and financial accounts by Accountants. Under such a system the cost accounts restricts itself to recording only those transactions which relate to the product or service being provided. Hence items of expenses which have a bearing with sales or, production or for that matter any other items which are under the factory management are the ones dealt with in such accounts. This leads to the exclusion of certain expenses like interest and, bad debts and revenue/income from other than the sale of product or service.

10.6 REASONS FOR DISAGREEMENT OF PROFITS AS PER COST AND FINANCIAL ACCOUNTS The various reasons for disagreement of profits shown by the two sets of books viz., cost and financial may be listed as below: 1. Items appearing only in financial accounts The following items of income and expenditure are normally included in financial accounts and not in cost accounts. Their inclusion in cost accounts might lead to unwise managerial decisions. These items are: (i) Income: (a) Profit on sale of assets (b) Interest received (c) Dividend received (d) Rent receivable (e) Share Transfer fees (ii) Expenditure (a) Loss on sale of assets (b) Uninsured destruction of assets (c) Loss due to scrapping of plan and machinery (d) Preliminary expenses written off (e) Goodwill written off (f) Underwriting commission and debenture discount written off (g) Interest on mortgage and loans (h) Fines and penalties (iii) Appropriation (a) Dividends (b) Reserves (c) Dividend equalization fund, Sinking, fund etc. 2. Items appearing only in cost accounts There are some items which are included in cost accounts but not in financial account. These are: (a) Notional interest on capital; (b) Notional rent on premises owned. 3. Under or over-absorption of overhead In cost accounts overheads are charged to production at pre-determined rates where in financial accounts actual amount of overhead is charged, the difference gives rise underor over-absorption; causing a difference in profits. 4. Different bases of stock valuation In financial books, stocks are valued at cost or market price, whichever is lower. In cost books, however, stock of materials may be valued on FIFO or LIFO basis and work-inprogress may be valued at prime cost or works cost. Differences in store valuation may thus cause a difference between the two profits. 5. Depreciation The amount of depreciation charge may be different in the two sets of books either because of the different methods of calculating depreciation or the rates adopted. In company accounts, for instance, the straight line method may be adopted whereas in financial accounts It may be the diminishing balance method. 10.7 NEED OF RECONCILITAION STATEMENT When cost and financial accounts are maintained separately, the

profit shown by one set of books may not agree with that of the other set. In such a situation, it becomes necessary to reconcile the results (profit / loss) shown by two sets of books. Causes for difference between profit shown by cost and financial accounts (i) There are certain items which appear in financial books only and are not recorded in cost accounting books e.g. loss on sale of fixed assets; expenses on stamp duty; interest on bank loan etc. Similarly, there may be some items which appear in cost accounts only and do not find a place in the financial books e.g. notional rent; national interest etc (ii) In cost accounts, overheads are generally absorbed on the basis of a pre-determined overhead rate, whereas in financial accounts actual expenditure on overheads is recorded, this will also cause a difference between the figure of profit shown under financial and cost account. (ii) Different methods of valuation of closing stock adopted in cost and financial accounts will also cause a difference in the results shown by the two sets of books. In financial accounts the method generally followed is cost or market price, whichever is less whereas in cost accounts different methods of pricing of material issues such as LIFO, FIFO, average etc are used. (iii) Use of different methods of depreciation is also responsible for the variation of profit shown by two sets of books. In financial accounts, depreciation may be charged according to written down value method whereas in cost accounts is may be charged on the basis of the life of the machine. (iv) Abnormal items not included in cost accounts also causes a difference in profit. If such items of expenses are included, cost ascertained will not be correct. BRIEF DETAIL OF ALL ITEM IS GIVEN BELOW: (i) Items included in financial accounts but not in cost accounts Appropriation of profits Income-tax

Pure financial items

(ii) Items included in cost accounts but not in financial accounts

(iii) Under / Over absorption of expenses in cost accounts (iv) Different bases of inventory valuation Motivation for reconciliation are: reliability of cost data

10.8 PERPARATION OF RECONCILITAION STATEMENT Performa of Reconciliation Statement Particulars Profit As per Cost Accountant (It can be of Financial Accountant then all treatment are reverse or inverse ) 1 Expenses Only Recorded by Financial Accountant


Incomes Only Recorded by Financial Accountant



Expenses over-recorded by Cost Accountant Or Expenses under-recorded by Financial Accountant


Expenses under-recorded by Cost Accountant Or Expenses over-recorded by financial Accountant Profit (Balancing Figure) if in (-) Loss (Balancing Figure ) if in (+) LOSS Total
*** *** *** ***



1. The following figures have been extracted from the Financial Accounts of a Manufacturing Firm for the first year of its operation: Rs. Direct Material Consumption 50,00,000 Direct Wages 30,00,000 Factory Overheads 16,00,000 Administrative Overheads 7,00,000 Selling and Distribution Overheads 9,60,000 Bad Debts 80,000 Preliminary Expenses written off 40,000 Legal Charges 10,000

Dividends Received Interest Received on Deposits Sales (1,20,000 units) Closing Stocks: Finished Goods (4,000 units) Work in Progress

1,00,000 20,000 1,20,00,000 3,20,000 2,40,000

The cost accounts for the same period reveal that the direct material consumption was Rs. 56,00,000. Factory overhead is recovered at 20% on prime cost. Administration overhead is recovered at Rs. 6 per unit of production. Selling and distribution overheads are recovered at Rs. 8 per unit sold. Prepare the Profit and Loss Accounts both as per financial records and as per cost records. Reconcile the profits as per the two records. Answer Profit and Loss Account (As per financial records) Rs. To Direct Material To Direct Wages To Factory Overheads To Gross Profit Rs. 50,00,000 By Sales 1,20,00,000 30,00,000 (1,20,000 units) 16,00,000 By Closing Stock 29,60,000 WIP 2,40,000 Finished Goods 3,20,000 _________ (4,000 units) _________ 1,25,60,000 1,25,60,000 7,00,000 By Gross Profit b/d 29,60,000 9,60,000 By Dividend 1,00,000 By Interest 20,000 80,000 40,000 10,000 12,90,000 30,80,000

To Administration Overheads To Selling and Distribution Overheads To Bad Debts To Preliminary Expenses written off To Legal Charges To Net Profit

________ 30,80,000

Statement of Cost and Profit (As per Cost Records)

Direct Material Direct Wages Prime Cost Factory Overhead Less: Closing Stock (WIP) Works Cost (1,24,000 units Administration Overhead (1,24,000 units @ Rs. 6/- p.u.) Cost of production of (1,24,000 units)

Total Rs. 56,00,000 30,00,000 86,00,000 17,20,000 1,03,20,000 (2,40,000) 1,00,80,000 7,44,000 1,08,24,000

Less: Finished Goods (4,000 units @ Rs. 87.29) Cost of goods sold (1,20,000 units) Selling and Distribution Overhead (1,20,000 @ Rs. 8/- p.u.) Cost of Sales Net profit (Balancing figure) Sales Revenue

3,49,160 1,04,74,840 9,60,000 1,14,34,840 5,65,160 1,20,00,000

Statement of Reconciliation of profit as obtained under Cost and Financial Accounts Rs. Rs. Profit as per Cost Records 5,65,160 Add: Excess of Material Consumption 6,00,000 Excess Factory Overhead 1,20,000 Excess Administration Overhead 44,000 Dividend Received 1,00,000 Interest Received 20,000 8,84,000 14,49,160 Less: Bad debts 80,000 Preliminary expenses written off 40,000 Legal charges 10,000 Over-valuation of Closing stock in cost books (Rs. 3,49,160 Rs. 3,20,000) 29,160 1,59,160 Profit as per Financial Records 12,90,000

2. The following information is available from the financial books of a company having a normal production capacity of 60,000 units for the year ended 31st March, 1995: (i) Sales Rs. 10,00,000 (50,000 units). (ii) There was no opening and closing stock of finished units. (iii) Direct material and direct wages cost were Rs. 5,00,000 and Rs. 2,50,000 respectively. (iv) Actual factory expenses were Rs. 1,50,000 of which 60% are fixed. (v) Actual administrative expenses were Rs. 45,000 which are completely fixed. (vi) Actual selling and distribution expenses were Rs. 30,000 of which 40% are fixed. (vii) Interest and dividends received Rs. 15,000. You are required to: (a) Find out profit as per financial books for the year ended 31st March, 1995; (b) Prepare the cost sheet and ascertain the profit as per cost accounts for the year ended 31st March, 1995 assuming that the indirect expenses are absorbed on the basis of normal production capacity; and (c) Prepare a statement reconciling profits shown by financial and cost books. Answer Working Note: Profit & Loss Account (for the year ended 31st March, 1995) To Direct Material To Direct Wages To Actual factory expenses To Actual administrative expenses To Actual selling and distribution expenses To Profit Rs. Rs 5,00,000 By Sales 10,00,000 2,50,000 50,000 units 1,50,000 By Interest and 45,000 Dividends 15,000 30,000 40,000 _______ 10,15,000 10,15,000


Profit as per financial books for the year ended 31st March, 1995 is Rs. 40,000 (Refer to working Note).

Cost Sheet (for the year ended 31st March, 1995) Direct Material Direct Wages Prime Cost Factory expenses: Variable : Rs. Fixed : Rs. 5,00,000 2,50,000 7,50,000 60,000 1,35,000 8,85,000 37,500 9,22,500

Rs.90,0005/6 Rs.45,0005/6

Works Cost : Administrative expenses : Cost of production Selling & distribution expenses Variable : Rs. 18,000 Fixed :Rs.12,0005/6 Cost of Sales Profit Sales revenue

28,000 9,50,500 49,500 10,00,000

Statement of Reconciliation (Reconciling profit shown by Financial and Cost Accounts) Profit as per Cost Accounts Add: Income from interest and dividends Less: Factory expenses undercharged in Cost Accounts (Rs. 1,50,000 Rs. 1,35,000) Administrative expenses undercharged in Cost Accounts (Rs. 45,000 Rs. 37,500) Selling & distribution expenses under-charged in Cost Accounts (Rs. 30,000 Rs. 28,000) Profit is per Financial Accounts Rs. 49,500 15,000 Rs.

64,500 15,000 7,500 2,000 40,000 24,500 _____

4. The financial books of a company reveal the following data for the year ended 31st March, 2002: Opening Stock: Rs. Finished goods 875 units 74,375 Work-in-process 32,000 1.4.01 to 31.3.02 Raw materials consumed 7,80,000 Direct Labour 4,50,000 Factory overheads 3,00,000 Goodwill 1,00,000 Administration overheads 2,95,000 Dividend paid 85,000 Bad Debts 12,000 Selling and Distribution Overheads 61,000 Interest received 45,000 Rent received 18,000 Sales 14,500 units 20,80,000

Closing Stock: Finished goods 375 units 41,250 Work-in-process 38,667 The cost records provide as under: - Factory overheads are absorbed at 60% of direct wages. - Administration overheads are recovered at 20% of factory cost. - Selling and distribution overheads are charged at Rs. 4 per unit sold. - Opening Stock of finished goods is valued at Rs. 104 per unit. - The company values work-in-process at factory cost for both Financial and Cost Profit Reporting. Required: (j) Prepare statements for the year ended 31st March, 2002 show - the profit as per financial records - the profit as per costing records. (ii) Present a statement reconciling the profit as per costing records with the profit as per Financial Records. Answer (i) Statement of Profit as per financial records OR Profit & Loss Account of the company (for the year ended March 31, 2002) To Opening stock of Finished goods To Work-in-process To Raw materials consumed To Direct labour To Factory overheads To Goodwill 1,00,000 To Administration overheads To Selling & distribution overheads To Dividend paid To Bad debts To Profit Rs. 74.375 32,000 7,80,000 4,50,000 3,00,000 2,95,000 61,000 85,000 12,000 33,542 22,22,917 Rs. By Sales 20,80,000 By Closing stock of finished goods 41250 By Work-in-Process 38,667 By Rent received 18,000 By Interest received 45,000

________ 22,22,917

Statement of Profit as per costing records (for the year ended March 31,2002) Rs. Sales revenue (A) (14,500 units) Cost of sales: Opening stock (875 units x Rs. 104) Add: Cost of production of 14,000 units (Refer to working note 2) Less: Closing stock Rs.17,92,000 X 375 units/ 14,000 units 20,80,000

91,000 17,92,000 48,000

Production cost of goods sold (14,500 units)

_______ 18,35,000

Selling & distribution overheads (14,500 units x Rs. 4) Cost of sales: (B) Profit: {(A) (B)}

58,000 ________ 18,93,000 1,87,000

Statement of Reconciliation (Reconciling the profit as per costing records with the profit as per financial records) Rs. Rs. Profit as per Cost Accounts 1,87,000 Add: Administration overheads over absorbed 3,667 (Rs. 2,98,667 Rs. 2,95,000) Opening stock overvalued (Rs. 91,000 Rs. 74,375) 16,625 Interest received 45,000 Rent received 18,000 83,292 2,70,292 Less: Factory overheads under recovery (Rs. 3,00,000 Rs. 2,70,000) 30,000 Selling & distribution overheads under recovery (Rs. 61,000 Rs. 58,000) 3,000 Closing stock overvalued (Rs. 48,000 Rs. 41,250) 6,750 Goodwill 1,00,000 Dividend 85,000 Bad debts 12,000 2,36,750 Profit as per financial accounts 33,542 Working notes: 1. Number of units produced Sales Add: Closing stock Total Less: Opening stock Number of units produced Units 14,500 375 14,875 875 14,000

2. Cost Sheet Raw materials consumed Direct labour Prime cost Factory overheads (60% of direct wages) Factory cost Add: Opening wori-in-process Less: Closing work-in-process Factory cost of goods produced Administration overheads (20% of factory cost) Cost of production of 14,000 units (Refer to working note 1) Cost of production per unit: Rs. 7,80,000 4,50,000 12,30,000 2,70,000 15,00,000 32,000 38,667 14,93,333 2,98,667


No.of units produced /Total Cost of Production Rs.17,92,000 / 14,000 units = Rs.128

A manufacturing company disclosed a net loss of Rs. 3,47,000 as per their cost accounts for the year ended March 31,2003. The financial accounts however disclosed a net loss of Rs. 5,10,000 for the same period. The following information was revealed as a result of scrutiny of the figures of both the sets of accounts. Rs. (i) Factory Overheads under-absorbed 40,000 (ii) Administration Overheads over-absorbed 60,000 (iii) Depreciation charged in Financial Accounts 3,25,000 (iv) Depreciation charged in Cost Accounts 2,75,000 (v) Interest on investments not included in Cost Accounts 96,000 (vi) Income-tax provided 54,000(vii) Interest on loan funds in Financial Accounts 2,45,000 (viii) Transfer fees (credit in financial books) 24,000 (ix) Stores adjustment (credit in financial books) 14,000 (x) Dividend received 32,000 Prepare a memorandum Reconciliation Account Answer Memorandum Reconciliation Accounts
Dr. Rs. To Net Loss as per Costing books 3,47,000 To Factory overheads under absorbed in Cost Accounts 40,000 To Depreciation under charged in Cost Accounts To Income-Tax not provided in Cost Accounts To Interest on Loan Funds in Financial Accounts By Administration overheads over recovered in cost accounts 60,000 By Interest on investment not included in Cost Accounts 50,000 54,000 By Transfer fees in Financial books By Stores adjustment (Credit in financial books) 14,000 By Dividend received in financial Books 32,000 By Net loss as per Financial books 5,10,000 7,36,000 Cr. Rs.

96,000 24,000

2,45,000 _______ 7,36,000

10.10 SELF ASSESSMENT 1. What do you understand by integral and non-integral system of accounting? What is a general ledger adjustment account? 2. What procedure you would adopt in order to reconcile, at the end of an accounting period, the overheads charged in cost accounts with that shown in the nancial accounting?

10. Explain the need of reconcilitation Statement. 11. What are the factors responsible for different balances in cost accounts and financial accounts? 12. PRACTICAL QUESTIONS IN HARD COPY