Cost Accounting

IcwaI stage II

Short Notes on important topics

Anand Kumar Srivastava

3/3/2011
 TOPICS
Ch-1 Cost concepts and classification of cost:
1. Direct expenses
2. Pre requisites for computation of accounts.
3. Installation of a cost system
4. Uniform costing
5. Profit centre
6. Supply chain analysis
7. Cost control
8. Cost reduction
9. Cost centre
10. Cost unit
11. Relevant cost

Ch-2 Material accounting:

1. Material transfer note
2. ABC analysis
3. Economic Order Quantity (EOQ)
4. Obsolescence in material accounting.
5. Perpetual inventory system
6. Treatment of scrap in cost accounting
7. VED analysis
8. Scrap, spoilage and defectives in engineering industries.
9. Just in Time Analysis.
10. FSND Analysis.

Ch-3 Labour accounting:

1. Labour turnover and its avoidable and unavoidable causes.
2. Job evaluation
3. Incentives to indirect worker
4. Accounting of idle time
5. Idle time
6. Idle capacity
7. Work measurement
8. Motion study

Ch-4 Overheads:
1. Administration overheads
2. Under and over absorbed overheads
3. Depreciation and obsolescence
4. Cost allocation and cost appropriation

Ch-5 Job /Batch /Contract costing:

1. Profit on incomplete contracts
2. Batch costing
3. Cost- plus- contract
4. Escalation clause in contract costing
Ch-6 Process costing, Joint and By products:
1. Equivalent production
2. Split off point
3. Joint cost
4. By product
5. Reverse cost method in by product cost accounting
6. Fundamental principle of process costing.
7. Inter process profit.

Ch-7 Operating costing:

1. Activities of operating costing

Ch-8 Integrated accounting system:

1. Integrated accounting system
2. Interlocking accounts

Ch-9 Reconciliation of cost and financial accounts:

Ch-10 Marginal costing:

1. Margin of safety
2. Profit volume ratio
3. Break Even Analysis
4. Differential cost analysis
5. Angle of incidence
6. Differential cost in decision making
7. Relevant cost
8. Application of marginal costing in price fixing
9. Sensitivity analysis
10. Cost- plus- pricing
11. Marginal costing for decision making
12. Cost volume profit analysis
13. Managerial decision making
14. Absorption costing

Ch-11 Activity based costing:

1. Activity based budgeting
2. Activity based management
3. Activity based costing
4. Activity based accounting
5. Cost driver

Ch-12 Budgetary control:

1. Principle budget factor
2. Flexible budget
3. Flexible budgeting
4. Budgetary control and its objectives
5. Zero base budgeting
6. Budget manual
 7. Fixed budget

Ch-13 Standard costing:

1. Standard cost /costing
2. Budgeted cost
3. Labour rate variance
4. Labour efficiency variance
5. Ideal standard
6. Average standard
7. Attainable standard
8. Variance analysis
9. Fixed production overhead variance
10. Sales value volume variance

Ch-14 Transfer pricing:

1. Limitation of market based transfer pricing
2. Transfer pricing methods

Ch-15 Uniform costing / Inter firm comparison:

1. Inter firm comparison
2. Uniform costing

A
1. Activity based costing:
Activity Based Costing is a method of apportionment of indirect costs to products. The conventional
method of apportionment of overheads to the products on the basis of either material cost or labour
cost has been found to be inappropriate in many cases. ABC is a better but costlier method of
apportionment of overheads. It is more rational but requires more time and resources.
In Activity Based Costing, the indirect costs are apportioned to the product on the basis of various
activities which are used to produce the product.

The objectives of Activity Based Costing are discussed below:

To remove and refine the traditional costing system and bring more accuracy in the
computation of costs of products and services.
To help in decision making by accurately computing the costs of products and services.
To identify various activities in the production process and further identify the value adding
activities.
 To distribute overheads on the basis of activities.
To focus on high cost activities.
To identify the opportunities for improvement and reduction of costs.
To eliminate non value adding activities.

Limitations:
Activity Based Costing is a complex system and requires lot of records and tedious
calculations.
For small organizations, traditional cost accounting system may be more benecial than ABC
due to the simplicity of operation of the former.
Sometimes it is difficult to attribute costs to single activities as some costs support several
activities.
There is a need of trained professionals who are limited in number.
This system will be successful if there is a total support from the top management.
Substantial investment of time and money is required for the implementation of this system.

1. Activity based Budgeting:

A budget is prepared in terms of money or quantities or both before the actual event.

Budget helps in planning for the future. It also helps in controlling as there is a continuous comparison
of actual with budget. Any deviation between the two is identified for taking suitable action. Activity
Based Budgeting involves identification of activities and dividing them in value adding and non value
adding activities. The non value adding activities are eliminated in due course of time. Activity Based
Budgeting, thus requires identification of activities of the organization, establishing the factors which
cause costs, the cost drivers and then collecting the costs of the activities in cost pools. It uses the
activity analysis to relate costs to activities. Identifies. It identifies cost improvement opportunities.

2. Activity Based Accounting:

Activity Based Accounting is a broader term which involves collection, recording, analysis, controlling
and reporting of activity related costs rather than costs related to departmental or cost centers. It
involves several activities like Activity Based Budgeting, Activities based Cost management based on
activities, performance measurement of activity, reducing the costs through elimination of non value
adding activities and also initiating innovative measure for reduction of costs.
3. Activity based Management:
The basic purpose of management is to ensure the optimum utilisation of resources in an effective
and efficient manner. The ABM is a tool of management that involves analyzing and costing activities
with the goal of improving efficiency and effectiveness. ABM focuses on managing the activities
themselves. In Activity Based Costing resources are traced to the activities for the purpose of
computing the costs while in Activity Based Management, resources are traced to activities for
evaluation of the activities themselves. In other words, efforts are made to improve the activities
further. Thus ABM is a set of actions that management can take to improve performance and
profitability.

4. Angle of Incidence:
The angle between total cost line and sales line is known as Angle of Incidence. It indicates the rate
of profit. If this angle is higher it is presumed that rate of profit on sale is higher. It can be easily seen
that the angle of incidence can be raised either by raising the slope of sales line or by lowering the
slope of total cost line or by both. (You must show it by drawing the break even chart. See also break
even chart in subsequent chapters.)
 5. Application of marginal costing in price fixing:
It is a general principal that the price should cover the total cost (Marginal costs + Fixed costs) as well
as desired profit. In a competitive market, price is not determined by the individual concern but by the
market forces. Thus, costing (particularly Marginal Costing) is helpful in price determination only in
short term and monopoly conditions. The various aspects price policy are:

1. Normal Price : Price in the long-term should be as much as to cover total cost and desired
profit. Thus the normal price should be: Normal Price = VC + C
2. Minimum Price: Normal price may not be useful (i) for new products (ii) when competition is
high and the competitors are cutting prices (iii)proposition. In such situations, a manufacturer is
generally faced with a problem of what should be the minimum price. Hence he must fix a
price, which must cover at least total cost. This is known as Minimum Price.
Minimum Price = VC + F
3. Quotation Price or Depression Price: Under some special circumstances price may be fixed at
below cost too. One situation may be to meet out severe competition in Quotation Pricing.
Such price must cover all variable costs and should yield some amount of contribution.
Similarly, during depression, slump or trade recession, goods cannot be sold at normal price or
minimum price due to lack of demand. If no sales are made, fixed cost may not be recovered
and loss will be equal to fixed costs. Under this situation too, profitability can be improved by
fixing a price equal to variable cost plus some portion of fixed overheads.
4. Special Price (Accepting Special Offer / Order/ Exploring New Market): Sometimes
management of a concern may face a problem of accepting or rejecting a special offer/ order
at a price which is below the existing cost. Similarly, there may be a possibility of capturing a
new market or attracting new customers or patronizing special customers if goods are sold at a
price below costs. Normally, such offer should be rejected, because total cost will not be
recovered. But if there is sufficient unutilized capacity and special offer may be met by
producing extra units without increasing the existing total capacity, then decision should be
based on the marginal cost rather than total cost, because extra production would not involve
any increase in fixed cost; only the marginal costs of extra units of production become relevant
point to be considered. The guiding principle is:
When price > Marginal Cost, accept the order.
When price < Marginal Cost, reject the order.
5. Price Changes: In connection with profit planning, quantity sold, marginal cost, fixed cost and
price are pillars of profit and profitability. Price changes may involve hike in price as well as reduction
in price. In both the cases, quantity sold will also be affected depending upon the degree of elasticity of
demand for production, which in turn may affect the profit position. Therefore, a careful analysis of the
possible change in demand must be made and its probable impact on profit should be estimated through
the techniques of marginal costing.

6. Absorption costing:
Under absorption costing:
1. Costs are classied as direct and indirect, direct costs are those costs which can be directly
attached or identified with the product and hence charged directly. Indirect costs i.e. overheads
are rst identied and collected and then apportioned to the product units on some suitable
basis.
2. The closing stock of nished goods under absorption costing is valued at total cost, i.e. xed
and variable.
3. The fixed overhead absorption may create some problems like over/under absorption. This
happens because of the overhead absorption rate which is pre determined.
4. Due to the inventory valuation, which is done at the full cost, the costs relating to the current
period are carried forward to the subsequent period. This will distort the cost of production.
 5. The total cost of production is charged to the product without distinguishing between the xed
and variable components. The selling price is thus xed on the basis of total costs.

7. Administration overheads:
Administration cost is the cost of running the administration of a firm.. Though these functions are not
directly related to production, selling and distribution, they facilitate these functions. The expenditure
incurred for carrying out these functions is called as Administration Overheads. Examples are,
general office expenses, office salaries, office lighting, audit fees.

TREATMENT IN COST ACCOUNTS:

There are three methods of treatment of administrative overheads in cost accounts:
1) Transfer to Costing Profit and Loss Account: Under this method, the administrations overheads
are treated as period costs and are written off to the Costing Profit and Loss Account. Thus
these costs are not charged to jobs or production units as they are not directly related to the
production. This is the main objection against this method because in this method the cost of
job is lower as the overheads are not charged to it but they are charged to costing profit and
loss a/c. The administrative overheads are considerable costs and hence these costs should
be charged to the cost units
2) Apportionment to manufacturing and selling divisions: Under this method, administration
overheads are divided between manufacturing and selling divisions on some suitable basis.
The main logic behind this method is that, many experts believe that there are only two
functions of a business firm and these are production and selling and other functions like
administration are auxiliary functions. Therefore the administration overheads should be
merged with manufacturing and selling divisions. The ultimate effect of this method is that the
administration overheads lose their identity. The main criticism of this method is that
administration is an equally important function of an undertaking and its merger with other
functions on some basis does not show the correct picture. Similarly as the administrative
overhead lose its identity; it is difficult to control the same.
3) Separate functional element of cost: Under this method, administration overhead is considered
as separate charge to the cost to make and sell. The assumption under this method is that
administration is a separate function. Accordingly, the cost of sales analysis sheet is prepared
to show the manufacturing cost and is ultimately charged to the particular job or order.

CONTROL OF ADMINISTRATION OVERHEADS: Administration overheads are mostly fixed in

nature. They can also be termed as policy cost as they arise out of a policy. Due to these reasons,
the administrative costs are fixed in nature and are uncontrollable. However control on these costs
can be exercised through preparation of budgets and use of standard costing. A budget can be
developed for these costs and actual costs can be compared with the budget. Responsibility
accounting principles can also be followed to control these overheads.

8. ABC Analysis : (also called Pareto analysis)

Normal principal of inventory control is that the cost of control should not be more than the cost of the
item itself. ABC analysis is a method of inventory control where attention is given to items according
to their value and not as per their quantities. It is not a control technique but it provides a sound basis
to decide where more control is required.
It is based on the principle of '' vital few, trivial many' or 'high value low volume'. In this technique, the
items of inventory are classied according to the value of items. Materials are classied as A, B and C
according to their value.
The A items constitute roughly about 5-10% of the total items while its value may be
about 80% of the total value of the inventory.
 Items in class B constitute intermediate position. These items may be about 20-25% of
the total items while the usage value may be about 15% of the total value.
Items in class C are the most negligible in value, about 65-75% of the total quantity but
the value may be about 5% of the total usage value of the inventory.
The numbers given above are just indicative, actual numbers may vary from situation to situation. The
principle to be followed is that the high value items should be controlled more carefully while items
having small value though large in numbers can be controlled periodically.
The ABC analysis resembles to Pareto analysis of Vilfredo Pareto of Italy, who observed that the 80%
of total wealth is in the hands of 20% of the people.
Advantages of ABC analysis :
1. Gives an idea of selective control so that effort can be concentrated only where it is required.
2. It reduces clerical and administrative costs or expenses of managing inventory.
3. Investment in inventory can be regulated to ensure optimum use of funds.
Application of ABC in deciding stock control system :
For A Class items : (i) very strict control (ii) very low safety stock (iii) controlled by senior manager.
For B Class items ;(i) Moderate control (ii) some safety stock (iii) controlled by middle level of
management. You can write for C class items.

Accounting treatment of Idle Time costs: Please see Idle time.

B
1. Batch costing:
Batch costing is used where units of a product are manufactured in batches and used in the assembly
of the nal product. Thus components of products like television, radio sets, air conditioners and
other consumer goods are manufactured in batches to maintain uniformity in all respects. Batch
number is given to each batch manufactured and accordingly the cost is worked out. A batch cost
sheet is prepared to show the total cost of the batch. One of the important aspects of batch type
production is to decide the batch size. If product is produced in large quantities, the impact of the
setting up cost will be lower as the setting up cost is xed per batch. But on the other hand if the
production quantity is large, the inventory carrying cost will be high as more inventory will have to be
carried over in the store. The carrying cost of the inventory includes cost of storage, risk of pilferage,
spoilage, obsolescence and interest on the investments blocked in the inventories. Therefore the size
of the batch should not be either too small or too large. On the basis of a tradeoff between large size
and small size, an appropriate size of the batch should be decided. This batch size is known as
Economic Batch Quantity.

Where, A =Annual requirements of the product

S =Setting up cost per batch
C =Carrying cost per unit of inventory per annum.

2. By product:
The term by- products is sometimes used synonymously with the term minor products. The by-
product is a secondary product, which additionally results from the manufacture of a main product. By
products are also produced from the same raw material and same process operations but they are
secondary results of operation. The main difference between the joint product and by- product is that
there is no intention to produce the by-product while the joint products are produced intentionally. The
sales value of bye products are considerably less than the that of main product.

3. Budget manual:
A budget manual is the list of directions given for the preparation and presentation of budgets of all
categories. It also contains the accountability and responsibility of the persons involved in preparation
and presentation of budgets.
The budget manual thus is a schedule, document or booklet, which contains different forms to be
used, procedures to be followed, budgeting organization details, and set of instructions to be followed
in the budgeting system. It also lists out details of the responsibilities of different persons and the
managers involved in the process.

A typical budget manual contains the following:

Objectives and managerial policies of the business concern.
Internal lines of authorities and responsibilities.
Functions of the budget committee including the role of budget officer.
Budget period
Principal budget factor
Detailed program of budget preparation
Accounting codes and numbering
Follow up procedures.

4. Budgetary control:
The written form of forecasts made in respect of various functional activities of a business is called
budget. When this budget is used to evaluate the actual performance or results, it is termed as
Budgetary Control. If we view the control function as to involve fixing targets, recording actual and
continuous comparison of actual with targets with a view to report for action.
Characteristics of budgetary control are:
a. Preparation of budgets either in physical terms and/or monetary terms in respect of production,
sales, distribution and finance in pursuance of goals, objectives, etc. set by the management.
b. Comparison of actual results with the budgeted results. The difference between the two is
invariably called as budget variance and a report styled as Budget Performance and Variation
Report is generally prepared and submitted.
c. Revision of budgets in the light of changed circumstances.
d. Institutions of corrective and remedial actions.

Objectives of budgetary control are:

i. To control departmental activities.
ii. To help in systematic planning of production and in formulation of policies and provide basis of
judgment to executives.
iii. To determine from time to time the amount of money needed for production.
iv. To control direct and indirect expenses by limiting the changes of wastage and by limiting the
allowable expenses for different departmental heads.
v. To compare the pre-planned targets with the amount of actual expenses.
vi. To control the income and expenses of production functions.
vii. To pre-determine the capital expenditures of the concern.
viii. To control research and development activities.
ix. To provide machinery for centralized control, where decentralized function is essential.
x. To determine the responsibility of departmental heads or executives and to make them
efficient.

5. Break Even Analysis:

Break even analysis attempts to study the revenue and costs in relation to sales volume of a business
unit and to determine that point where sales revenue just equals to total cost. This level of activity is
generally termed as Break Even Point (BEP). Production level below the BEP will result into loss,
while production above BEP will result in profits.
BEP (in units) = Fixed cost / Contribution (per unit)
BEP (in Rs) = Fixed cost / PV Ratio

Break Even point can also be shown on the graph paper as follows:

Explanation: On horizontal axis, production and sales volume is shown while on the vertical axis,
sales and costs in amount are shown.

Assumptions of Break Even Point: The concept of break even point is based on the following
Assumptions:
Production and sales are the same, which means that as much as is produced is sold out in
the market. Thus there is no inventory remaining at the end.
Fixed cost remains same irrespective of the production volume.
Variable cost varies with the production. It changes in the same proportion that of the
production. Hence it has a linear relationship with the production. In other words, variable cost
per unit remain the same.
Selling price per unit remains same irrespective of the quantity sold.

Limitation of Break Even Point:

It helps in decision making regarding production level however this is based on the assumption that
the variable cost per unit, sales price per unit and the fixed cost remains the same. If there is any
change in these variables, the BEP will give misleading results.

c
1. Cost Driver:-
According to CIMA, cost driver is any factor which causes a change in the cost of an activity, For
example, in a stores department, it may be observed that slow moving and obsolete stock is not
disposed off in time, the reason being the staff in the stores is not trained properly in this area.
Managers have to address this cost driver to correct the root cause of this problem and take proper
action. Activity Based Costing is based on the belief that activities cause costs and therefore a link
should be established between activities and product. The cost drivers thus are the links between the
activities and the cost.
Some functions and their cost drives are as follows :
1. R & D : (i) no. of projects (ii) persons in projects or (iii) hours in project. (You may think some
more)
2. Marketing : (i) no. of advertisements (ii) no. of samples distributed (iii) no. of sales executives
3. Customer service : (i) no. of customers visited (ii) no. of deliveries (iii) hours spent with him.

2. Cost volume profit analysis:

Cost volume profit analysis is an attempt to measure the effect of changes in volume, cost, selling
price and product mix on profits. Marginal costs are closely connected with volume and vary directly
and proportionately with variations in volume. On the other hand, fixed costs remain constant and are
not affected by the change in volume of production. Thus, the amount of profit on the sale of a
product depends upon volume of production and its costs. When an effort is made to establish this
relationship, that process is known as Cost Volume Profit Analysis.

3. Cost plus Contracts:

This type of contract is generally adopted when the probable cost of contract cannot be ascertained in
advance with reasonable accuracy. In this type of contract, the contractor receives his total cost plus
a profit, which may be a percentage of cost. These types of contracts give protection to the contractor
against fluctuations in profits as he is guaranteed about his profit irrespective of the actual costs.
However in order to avoid any dispute in future, it is always advisable to specify the admissible costs
in advance.
This type of contract is usually made for (i) production of specifically designed aircraft, ship etc (ii) for
urgent works (iii) for defense works.
Salient features of cost plus contracts:
1. Suitable where estimates of material and labour can not be estimated with reasonable
accuracy.
2. Suitable when contract is likely to take long duration to complete;
3. Suitable when prices of material, labour and other components of contract are not steady and
predictable.
4. The client is allowed to inspect and scrutinize the books, records and other documents of the
contractors at all times.
Advantages :
1. The work can be started immediately without any formal agreement between the two. The
drawings, designs and other specifications may be decided at a later stage.
2. Very handy in case of emergency where cost is not very important like floods, epidemics, time
bound commitments etc.
3. Big documentation is not required. Disputes regarding escalation of prices do not arise.
Disadvantages :
1. Both the parties do not know the total cost of the contract. No budgets can be prepared as the
fund requirement is not known.
2. Contractor does not care about the costs rather he is more interested that the total cost should
go up as his commission is based on the amount spent by him.
3. The final designs are not ready, changes in drawings may occur in any stage resulting in more
costs and time delays.
 4. Cost Allocation:
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 identied
with the departments. Thus allocation is a direct process of identifying overheads to the cost units or
cost center. Cost allocation is also known as cost assignment, cost identification or cost allotment.

5. Cost 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 apportioned to 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. A statement
showing the apportionment of overheads is called as Primary Distribution Summary of overheads.

6. Cost center:
A cost center is nothing but a location, person or item of equipment for which cost may be ascertained
and used for the purpose of cost control. Cost Center is dened as, a production or service, function,
activity or item of equipment whose costs may be attributed to cost units. The main object of
identifying a cost center is to facilitate collection of costs so that further accounting will be easy. A cost
center can be either personal or impersonal, similarly it can be a production cost center or service
cost center. A cost center in which a specic process or a continuous sequence of operations is
carried out is known as Process Cost Center.

7. Cost unit:
Cost unit may be defined as a quantitative unit of product or service in relation to which costs are
determined.
This ascertainment is done through means of costing process viz. allocation, apportionment and
absorption. Cost unit differ from industry to industry. It can be expressed as cost per thousand bricks,
cost per passenger- kilometer, cost per patient, cost per ton etc.

8. Cost control:
Cost control implies various actions taken in order to ensure that the cost do not rise beyond a
particular level
It means keeping the expenses within limits or control. Cost control has the following features:
Cost control is a continuous process. It involves setting standards and budgets for deciding
targets of different expenses and constant comparison of actual the budgeted and standards.
Cost control involves creation of responsibilities center with clearly defined authorities and
responsibilities.
It also involves, timely cost control reports showing the variances between standard and actual
performance.
Motivating and encouraging employees to accomplish budgetary goals is also one of the
essential aspects of cost control.
Actually cost control not only means monetary limits on cost but it also involves optimum
utilization of resources or performing the same job at same cost.

9. Cost Reduction:
Cost Reduction refers to permanent reduction in cost of a product or service without impairing the
quality and affecting its purpose for which it was intended to be used. In the competitive market
situations, it is utmost important for the organizations to look for activities and search for new
technology through research & development activities that can reduce the cost of a product. The goal
of cost reduction can be achieved in two ways, first is reducing the cost per unit and the second one
is increasing productivity. Reducing wastages, improving efficiency, searching for alternative
materials, and a constant drive to reduce costs, can effect cost reduction.
1. Difference between cost control and cost reduction :
Particulars Cost Control Cost Reduction
Meaning Cost should not go beyond certain It is permanent decrease in the unit cost of
point, limit or standard. goods and services, without reduction in
quality.
Emphasis Past performance is the standard Present performance is the standard from
from which control will be where reduction in future will be achieved.
measured. Past performance is not considered.
Approach Set norms are generally followed. New norms are identified.
Focus It is short term review with focus It is long term approach with focus on
on controlling or reducing cost in a permanent reduction in cost per unit.
particular period.
Function It is corrective function. It is preventive function.

d
2. Differential Cost Analysis: (See also relevant cost)
When decision is required among many alternatives, differential cost analysis is good tool to help the
manager to take decision. In this analysis, all the costs related to a particular option, are taken,
added up and compared. Normally, the option giving the minimum total cost is selected for adoption.
With reference to level of output, differential cost is the difference in total costs for two levels of
output. When a decision has to be made involving increase or decrease of n units of output, the
difference in costs between two policies may be considered to be the cost really incurred on account
of these n units of business. This may be called the differential costs of a given amount of business.
It is important in decision making when:
the decision requires introduction of a new line or increase in level of activity with the increase
in plant capacity.
the decision is of long term nature.
In some cases like closure of plant which is going into loss etc.
The differential cost analysis is not relevant cost analysis. If the salary of manager is same in all the
options, it will become irrelevant in relevant cost analysis. All items which are same among the
alternatives are not considered in relevant cost analysis. On the contrary, all related items are
considered in differential cost analysis whether they are same or not same, among the alternatives. It
may be noted that differential cost analysis and relevant cost analysis will favour the same option.

3. Depreciation and Obsolescence: (See also Obsolescence)

Depreciation is defined as The decrease in the value of a fixed asset due to use and/or the lapse of
time. Depreciation arises due to the wear and tear of the asset and it is the result of two factors, i.e.
usage and lapse of time. Generally, both the factors go together. There are several methods of
calculating depreciation. Two main methods are given below;
i. Straight line method: The value or cost of asset is distributed equally over the life of asset.
Here the rate remains fixed for each year. Value is total cost less residual value.
 ii. Reducing balance method: Here the rate of depreciation is the same throughout, but
depreciation is calculated on the balance of the assets remaining after charging depreciation
each year.

Obsolescence is defined as The loss in the value of assets due to some factors other than time''. The
condition of the asset is good but it is no longer useful. Audio cassettes or video cassettes are some
examples.
Causes of Obsolescence:
i. To bring into use a new and improved machine. So the old one is discarded.
ii. The product which a machine produces, may be in demand in the market. If that product is
discontinued, the machine becomes obsolete.
iii. If it is thought to give a better design and get-up to the product due to change in fashion, or out
of three products, viz., A,B,C it is decided to divert the resources of C product to the
production of A and B products, for reasons of economy, the machine producing unwanted
product would become obsolete.

4. Direct expenses:
Direct expense represents that part of cost which is other than material and labour. It is basically cost
of facilities or services which are used as helps to the production. These are also called 'chargeable
expenses'.
Direct expenses are those expenses (other than material and labour) which can be directly
associated with a particular job, process, service, cost center or cost unit. These expenses are also
called as chargeable expenses. Examples of these expenses are cost of drawing, design and layout,
royalties payable on use of patents, copyrights, Fees of architects etc. They form part of prime cost.
They do not physically form part of the final product like material cost.
In a factory, expenses that can be directly linked to production department also can be clubbed as
direct expenses. Examples are power and electricity charges based on the meter reading in the
production department. These are absorbed into prime cost.
In service industry, the direct expenses are related to the generation of service. For example, in a
transporting company provides transport service. The expenses on vehicle maintenance, petrol and
fuel etc can be directly linked to a vehicle and can thus be treated as direct expenses. For an
educational institution, the fees paid to a professor for the preparation of study material for a course,
may be treated as direct expenses for that course.

e
1. Escalation clause:
Escalation clause in a contract provides that if during the period of execution of a contract, the prices
of materials, rates of labour or other items of contract rise beyond a specified limit, the contractor
would be compensated for such rise in a predetermined manner.
In order to protect the contractor from the rise in the price, an escalation clause may be inserted in
the contract. As per this clause, the contract price is increased proportionately if there is a rise in input
costs like material, labor or overheads. The condition that may be laid down is that the contractor will
have to produce a proof regarding the rise in the price.
The object of this clause is to protect the interests of both the parties, the contractor is protected
against the price rise while the client is protect against the use of inferior quality of material when the
price rises. However, the escalation clause does not cover that part of increase in costs which is
caused due to inefficiency or wrong estimation.
Conversely, the de-escalation clause may also be provided for adjustment of price falls.

2. Equivalent production:
It may happen that at the end of a particular period, there may be some incomplete units in the
process. Further the degree of completion of the opening work in progress and closing work in
progress may be different. These incomplete units will create problems in nding out the cost per unit,
as all the units will not have the same degree of completion. In such cases, the equivalent units will
have to be worked out for the incomplete units. The concept of equivalent units states that 2 units,
each complete 50% will be treated as equivalent to 1 completed unit. This concept will have to be
implemented for solving the problem of incomplete units. For this, degree of completion will have to
be ascertained for each element of cost, i.e. material, labor and overheads.
The following methods of pricing are used for valuing the equivalent units.
First In First Out Method [FIFO ] : In this method, the assumption is that the incomplete units
from the opening stock are completed rst and then the units introduced in the process are
completed. The objective of the rst in rst out method is to value the inventory at the current
costs.
Average Method: Process costs are sometimes computed on the basis of average costs.
Where degree of completion of opening work in progress is not given, average method is used.
The average process cost is obtained by adding the cost of opening work in progress in the
cost of units introduced in the process during the current period and dividing this total cost by
total equivalent units obtained by adding the number of units completed and equivalent units of
the closing work in progress of each element, material, labor and overheads. The main object
of average method is to even out the uctuations in prices and hence is used when the prices
uctuate widely during a particular period.
Weighted Average Method: If a manufacturing unit is manufacturing two or more products,
which are quite dissimilar to each other, weighted average method is used. Under this method,
weighted average is computed and used in valuation of the incomplete units.

3. Economic Order Quantity (EOQ):

EOQ answers the question like How much to purchase at one time? there are costs attached to the
ordering quantity. These costs are of two types, ordering cost and carrying costs. Ordering cost is the
cost of placing an order. In other words, it can be said that when an order is placed, the company has
to incur certain costs at the time of order. These costs include costs like handling and transportation
costs, stationery costs, costs incurred for inviting quotations and tenders etc. The more is the
frequency of order, the more are these costs.
On the other hand, there are certain costs that are called as carrying costs. The cost of carrying
the inventory is the real out of pocket cost associated with having inventory on hand, such as
warehouse charges, insurance, lighting, losses due to handling, spoilage, breakage etc, and another
important component of carrying cost is the amount of interest lost due to the investment in the
inventory. Carrying costs will go on increasing if the quantity of material in inventory goes on
increasing. Both, the carrying costs and the ordering costs are variable costs, however their behavior
is exactly opposite of each other. If orders are more frequent, ordering costs will go on increasing but
as the material ordered will be in less quantity, the carrying costs will decrease. On the other hand, if
numbers of orders are reduced, the quantity per order will increase and the carrying cost will
increase. The ordering cost will come down due to reduction of number of orders. In this situation, the
most desirable quantity to be ordered is that quantity at which both, the ordering costs and carrying
costs will be minimum. This quantity is called as Economic Order Quantity. This quantity can be
calculated with the help of the following formula:

Where,
U =Annual demand /annual consumption in units
O =Cost of placing and receiving an order
IC =Carrying cost per unit per annum
The Economic Order Quantity is an important concept as it guides the Purchase Manager regarding
the quantity to be purchased of a particular material. However, this concept is based on some
assumptions.
These assumptions are as follows.
The concerned material will be available all the time without any difficulty.
The price of the material will remain constant.
Ordering cost and carrying costs are variable.
Impact of quantity discounts on the prices is negligible.

1. Fundamental principles of process costing:

Process Costing is also a method of costing which is used in those industries where the production is
in continuous process, i.e. the output of one process becomes the input of the subsequent process
and so on till the final product emerges from the last process. This method is employed where it is not
possible to trace the items of prime cost to a particular order because its identity is lost in the
continuous production.
The objective of process costing is to nd out the cost of each process by identifying the
direct costs with the particular process and apportioning the indirect costs i.e. overheads to each
process on some suitable basis. The units coming out the process as the nished output are uniform
in all the respects and hence the cost per unit is computed by dividing the total cost by the total
production units.

The principles of process costing are:

1) The production is in continuous ow and is uniform. All units coming out as nished
products are uniform with each other in all respects.
2) The product is manufactured in a continuous ow and hence individual units lose their identity.
3) The unit cost is obtained by dividing the total cost for a particular period by the total output.
This is the average cost of the product units.
4) Cost per process is ascertained and cost of each process is transferred to the subsequent
process until the nished product emerges.
5) In a particular process normal and abnormal losses emerge. Normal loss is a loss, which is
inevitable in any process and thus cannot be avoided or controlled. Any loss, which, Is over and
above, the normal loss is called as abnormal loss and is to be accounted for separately. Abnormal
gain and abnormal loss are to be accounted for in the process cost accounts.
6) Sometimes each process may be treated as profit center and so while transferring the cost
from one process to another, a percentage of prot is added in the cost of that process. This is
known as inter process prot and needs to be accounted for in the process cost accounts.
7) Though the cost per unit is computed by dividing the total cost by the number of units, there
can be a problem on incomplete units at the end of a particular accounting period. In such cases
equivalent units have to be worked out for computing the cost per unit.

2. Fixed budget:
According to CIMA, a fixed budget is a budget designed to remain unchanged irrespective of the level
of activity actually attained. A fixed budget shows the expected results for only one level of activity.
Once the budget has been determined, it is not changed even if the level of activity is changed.
When budgets are prepared for a fixed or standard volume of activity, they are called static or fixed
budgets. FB is used as an effective tool of cost control. Such a budget is helpful for fixed expenses. It
is also called static budget.
3. Flexible budget:
Flexible budgets are not fixed or rigid budgets. When budgets are designed for different volumes and
levels of any activity, they are called flexible budget. In the case of such budgets, revenues and costs
targets are set in respect of different levels of activity even from zero to hundred percent of production
volume. This helps a lot to change revenues and costs targets for the actual level of activity and thus
makes the comparison of budgeted and actual performances more logical and scientific.
The method of preparation and presentation of flexible budget is called flexible budgeting.
Flexible budget may be prepared in the following situations :
New business : New business has typical nature, it may be difficult to forecast the demand of a
product accurately.
Uncertain environment : Demand, supply of raw materials, prices and customer habits and attitudes
are uncertain.
Limiting factor analysis :When certain factors of market or of production are uncertain, the
preparation of flexible budget for different levels may help in taking decisions.

4. FSND Analysis:
Age of the inventory indicates the duration of inventory in the organization. It shows the moving
position of inventory during the year. This analysis divides the items of inventory into four categories
in the descending order of their usage rate as follows:
F stands for fast moving items and stocks of such items are consumed in a short span of
time. Stock of fast moving items must be observed constantly and replenishment orders be
placed in time to avoid stock out position.
S indicates slow moving items, existing stock of which would last for two years or so. These
items must be reviewed carefully before eliminating them.
N means normal moving items and such items are exhausted over a period of time, i.e. say
one year. The order levels and quantities for such items should be on the basis of a new
estimate of future demand to minimize the risks of a surplus stock.
D stands for dead stock which means that there will not be any further demand for the same.
It is necessary to identify these items and if there cannot be any alternative use for the same,
should be eliminated.

i
1. Integrated accounting system:
When the books relating to financial accounts and cost accounts are integrated in one book it is
called Integrated accounting system. It is a single book keeping system, which contains both
financial and cost accounts. The need for reconciliation between the profits shown by cost accounts
and financial accounts is eliminated totally as only one set of books of accounts is maintained.
The benefits of integrated accounting system are as follows:
1) As only one set of accounting records is kept, the need for reconciliation between the profits
shown by the two records is eliminated.
2) The duplication of work is eliminated, thus the cost of operating this system is reduced.
3) This method is simple to understand and easy to operate. Unnecessary complications are
eliminated.
4) Cost data can be available promptly and regularly.
5) There is a cross checking of various figures in cost as well as financial accounts. This ensures
accuracy of figures of cost and financial data.
6) Use of mechanized accounting methods can be made.
Cost and Financial Accounts are said to be interlocked, when independent set of books are
maintained for each of them. These accounts are interlocked through control accounts maintained in
the two sets of books. Cost Ledger Control Account is maintained in the financial books and a
General Ledger Adjustment Account is maintained is costing books. In this manner, connection
between the two sets of books is maintained.

2. Idle time:
Idle time does not simply mean that the workers are sitting idle. The plant, machines, equipments and
other accessories also become idle during that period, and the fixed cost continues to be incurred. As
such idle time need to be reduced as far as possible.
Idle time cost can be divided into two types: (i) Normal (ii) Abnormal. Normal idle time can be
further divided into (a) controllable (b) uncontrollable. Normal idle time is one which is directly related
to production. The cost of normal and controllable idle time should be charged as overhead expenses
to the production. If the responsibility for this type of idle time can be fixed upon a particular
department, the cost should be charged to the overheads of that department and absorbed in the
production cost of that department.
The Normal but uncontrollable idle time is one arising due to time lost between the factory and
place of work, between one job and the other, time lost in setting the machine, tea breaks etc. the
cost of this type should be charged to the job at an higher labour rate.
The idle time which is beyond control, is an abnormal one. Idle times due to strikes, lock-outs,
long spell of electric failure or machine breakdown, fire, flood, storm etc. are of abnormal nature.

The time when the worker does not work and remains idle, is the idle time. So the idle time
cost represents the wages paid for the time lost. The following are its causes:
Lack of proper planning: Proper planning ensures smooth and uniform production. If the
workers do not have material at the right time, or the machines are not kept fit for
working, the time goes waste. Sometimes, delay in the previous process delays the
operations of the following process.
Carelessness in supervision: If the foreman of a department does not take his duty
seriously, the labour working under him also becomes careless and spoils time in the
idle way.
Confrontation between labour and management: The confrontation between labour and
management arising from any cause, waste time in discussions, dialogues, strikes, etc.
and the wages paid, if any, for this period form the idle time cost.
Economic factors: Trade depression or severe competition lowers the production, and
so labour remains effectively unutilized.
Other reasons: the electricity may fail or the machine may breakdown for some or more
time. They make labour to remain idle for the time being. The time lost between one job
and the other are the normal causes leading to idle time.

3. Idle capacity:
Expenses incurred on account of loss in capacity usage is known as idle capacity cost. If a
plant has capacity to produce 2,000 articles, but it produces only 1,500 articles only as the
demand is limited in the market, the idle capacity is 500 articles. Idle time is a part of idle
capacity, as due to idle capacity, idle time does arise. Where idle capacity arises due to
abnormal causes, such as, trade depression, recession etc., and the plant remains unutilized
for a long time, the idle capacity is known as idle facility. Idle facility means that the factory has
the facilities of plant, machines etc., but these facilities are lying unused.

4. Incentive schemes for Indirect workers:

It is difficult to determine standards for the output of indirect workers and it is difficult to
measure the actual output of these workers. As such, they are generally from incentives
 benefits. But a careful thought would reveal that it is necessary to provide incentive to them for
the following reasons:
a.) Indirect workers are as good participants in manufacture as the direct workers are. Any
slackness in their service may not help the direct labour to achieve their targets.
b.) Denial of bonus to indirect workers, while direct workers are paid, causes discontentment
and unrest.
The introduction of incentive scheme to indirect section can be viewed with the following
advantages:
1.) It creates team spirit in the workers.
2.) Efficiency in the important services like plant repairs, store services, power, transport etc. is
very much called for. This efficiency cannot only be maintained but improved.
3.) The cost of production is reduced.

Incentive Methods- Suggestions: We can divide the indirect workers into two groups:
(i) Those who work directly with direct workers, and
(ii) Those who provide general services.
To the workers of first category, like internal workers, checkers, like maintenance
workers, canteen workers, sweepers etc., and bonus is suggested on a wider basis, such as
output of the whole factory.

5. Interlocking accounts: See under integrated accounts.

6. Inter firm comparison:
Inter firm comparison is the comparison between two firms (or some firms) which are operating under
the same industry. It can also be used when two departments under the same organization are
compared.
Thus, it is a technique of evaluation and is based upon comparison of productivity, efficiency, cost,
prot as yardstick among the different business units in a same industry.

The scheme of the internal comparison consists of two phases

a. Voluntary collection and exchange of information concerning costs, prices, prots, productivity
and overall efficiency among the participating rms engaged in a similar types of the operation.
b. Making systematic inter rm comparison of the available data for the purpose of improvement
in efficiency and indicating the weaknesses and the strong points.

7. Inter process profits:

Sometimes, while transferring the cost of one process to the subsequent one, some percentage of
prot is added in it. This is called as inter process prots. This is done when a process is treated as
prot center. In such cases, unrealized prot is to be computed and shown separately. The stocks at
the end and at the beginning contain an element of unrealized prots, which have to be written back
in this method. If the prot element contained in the closing inventory is more than the prot element
in the opening inventory, prot will be overstated and vice versa. Prot is realized only on the goods
sold, thus to obtain the actual prot the main task would be to calculate the prot element contained
in the inventories.

8. Installation of a cost system:

Cost accounting system is a system that keeps accounting of costs. It accumulates costs, assigns
them to cost objects and reports cost information. In addition to this, a proper cost accounting system
assists management in the planning and control of the business operations as well as in analyzing
product profitability. There are several other advantages of a well defined costing system in an
organization like generating information for decision making, supplying information to the
management for internal control, detailed analysis of costs like fixed costs, variable costs, controllable
costs, labor costs, material costs, overheads etc. However it is necessary that the cost accounting
system is properly installed in an organization. Costing system installed in an organization should be
simple to understand, easy to operate, highly reliable and suitable to the organization.

The following factors should be taken into consideration while designing a costing system:
1. Size of the firm: As the size of the firm and its business grows, the volume and complexity of
the cost data also grows. In such situation, the cost accounting system should be capable of
supplying such information.
2. Manufacturing Process: In some industries, there may be a continuous process of production
while in some batch or job type of production may be in operation. A cost accounting system
should be such that the manufacturing process is taken into consideration and cost data is
collected accordingly.
3. Nature and Number of Products: If a single product is produced, all costs like material, labor
and indirect expenses can be directly allocated to that product. But if more than one product is
manufactured, the question of allocation and apportionment as well as absorption of indirect
expenses arises and hence the cost accounting system should be designed accordingly as
more complex data will be required.
4. Management Control Needs: The designing of a cost accounting system in a business
organization is guided by the management control requirements. The costing system should
supply data to persons at different levels in the organization to take suitable action in their
respective areas.
5. Raw Materials: The nature of raw materials and the degree of waste therein influence the
designing of costing system. There are some materials which have a high degree of spoilage.
The costing system should be such that identification of spoilage, keeping records of materials,
pricing of the issues etc are taken into consideration.
6. Organization Structure: The structure of the organization also plays a vital role in designing a
costing system. The system should correspond to the hierarchy of the organization.
7. External Factors: External factors are also important in designing of a costing system. For
example, Cost Accounting Record Rules have been mandatory for certain types of industries.

Practical Difficulties in Installation of Costing system :

The practical difficulties expected at the time of installation of costing system are given below:
o Top Management of an organization may not give necessary support and recognition to
the costing system installed in an organization. Due to lack of support, this system may
not give desired results.
o There may be resistance from existing accounting staff due to fear of losing job
recognition and importance after the implementation of the system.
o Employees of other departments may not co-operate for installation of costing system
due to fear of increase in workload or revealing of inefficiency.
o The foremen, supervisors, workers and other operating level staff may resent the
introduction of costing system due to the fear on increasing of workload.
o Shortage of qualified and efficient staff may be another difficulty in installing and
operating a costing system.
o Sometimes firms resist a costing system due to the heavy cost of installation and
operating of the same. The cost may be more than the benefits of the same.

j
1. Joint costs:
All costs incurred up to the split off point are termed as joint costs or pre separation costs. Costs
incurred after the split off point are post separation costs and can be easily identified with the
products. Joint costs occur in many industries like petroleum, flour mills, saw mills, dairy etc. When a
process produces two or more products, such products may be called if all have equal importance. If
a product is less important such product may be termed as bye product.

2. Just in Time Inventory:

JIT is based on zero inventory theory. It assumes that inventory is juts waste and should not be
maintained at all. It requires highly mechanized systerm. This principle envisages that there should
not be any intermediate stage like storekeeping. Material purchased from supplier should directly go
to the assembly line, i.e.to the production department. There should not be any need of storing the
material. The benet of Just in time system are as follows:
Right quantities are purchased or produced at right time.
Cost effective production or operation of correct services is possible.
Inventory carrying costs are eliminated totally.
The stores function is eliminated and hence there is a considerable saving in the stores cost.
Losses due to breakage, wastage, pilferage etc are avoided.
The benefits can be obtained by giving more business to less number of suppliers who must have
high quality of material and its delivery. The features of JIT are as follows :
Long term stable relationships with suppliers.
Alternative suppliers.
Simple purchase agreements.
Small but more number of deliveries.

3. Job evaluation:
Job evaluation is a technique of analysis and assessment of jobs to determine their value within the
firm. It aims at providing a rational and equitable basis for differential salaries and wages for different
classes of workers.
Job evaluation has the following objectives:
It helps in developing a systematic and rational wage structure as well as job structure.
Job evaluation aims at removing the controversies and disputes relating to salary
between the employers and employees. Thus the employees and also the employer
remain satisfied.
Another important objective of job evaluation is to bring fairness and stability in the
wage and salary structure so as to ensure full cooperation of workers in implementing
various policies of the employers.
Job evaluation discloses characteristics and conditions relating to different jobs. This is
very useful at the time of recruiting of workers as only suitable workers can be
recruited.

Methods of job evaluation:

Job evaluation is the ranking, grading and weighting of the essential work characteristics of a job and
putting a monetary value to it.
Ranking: The job or work characteristics are graded from the highest to the lowest in
accordance with relative responsibility and skill.
Grading: Here the jobs are classified into number of grades or groups. A simple form of grading
may be Unskilled, Semi-skilled and Skilled or it may be in the form of workers, supervisors,
administrators. The value is attached to each job in accordance with work characteristics.
 Weighting: A job requiring skill and good qualifications has to be attached a greater weight than
the one of an unskilled type.

1. Limitation of market based transfer pricing: See Transfer pricing

2. Labour turnover:
In every industry, workers leave their jobs and new workers have to be appointed to replace them.
The ratio of replaced workers to the total number of workers is the Labour Turnover Ratio. If more
workers leave the factory, the turnover would be high, and vice versa. A high turnover is a costly affair
and must be avoided.
Measurement of labour Turnover:
The following methods are available to compare the labour turnover of the previous period with the
current one:
Addition Method: Under this method, number of employees added during a particular
period is taken into consideration for computing the labour turnover.
Labour Turnover =Number of additions / Average number of workers during the period X 100

Separations Method: In this method, instead of taking the number of employees added,
number of employees left during the period is taken into consideration.
Labour Turnover =Number of separations / Average number of workers during the period X 100

Replacement Method: In this method neither the additions nor the separations are taken
into consideration. The number of employees replaced is taken into consideration for
computing the labour turnover.
Labour Turnover =Number of replacements / Average number of workers during the period X 100

Flux Method: Under this method labour turnover is computed by taking into consideration
the additions as well as separations. The turnover can also be computed by taking
replacements and separations also.
Labour Turnover = [Number of additions +Number of separations] / Average number of
Workers during the period X 100
Labour Turnover = [Number of replacements +Number of separations] / Average number of
Workers during the period X 100

Avoidable and Unavoidable causes of labour turnover:

Avoidable Causes:
Dissatisfaction with the job
Dissatisfaction with the working hours
Dissatisfaction with the working environment
Dissatisfaction with monetary and non monetary incentives
Relationship with colleagues
Relationship with the superiors like supervisors
Other reasons such as lack of facilities like insurance, absence of promotion chances, lack
of proper training etc.
Unavoidable Causes:
Personal betterment
Retirement
Death
Illness or accident
Change in locality
Termination
Marriage
National service
Other reasons like lack of residential facilities, family commitments, attitude etc.

m
1. Margin of Safety: (See also break even chart)
Margin of safety is the difference between the actual sales and the breakeven sales. It indicates the
volume of sales, which directly contributes to profit, as fixed costs have already been covered by
Break-even point. The higher the safety margin the better it is.
Margin of Safety = Actual Sales Break-even Sales

2. Managerial decision making:

Managerial decision making is a very crucial function in any organization. Decision making should be
on the basis of relevant information. Through the marginal costing technique, information about the
cost behavior is made available in the form of fixed and variable cost. The segregation of costs
between fixed and variable helps the management in predicting the cost behavior in various
alternatives. Thus it becomes easy to take decisions. Marginal costing helps in comparative cost
analysis and thus the decision making becomes rational and based on facts rather than based on
intuition. Some of the crucial areas of decision making are mentioned below:
Make or buy decisions.
Accepting or rejecting an export offer.
Variation in selling price.
Variation in product mix.
Variation in sales mix.
Key factor analysis.
Evaluation of different alternatives regarding profit improvement.
Closing down / continuation of a division.
Capital expenditure decision.

3. Motion study:
Motion study aims at the elimination of unnecessary motions or the movements employed by
the worker in the performance of his function. Every motion has an effect on the time
consumed and causes fatigue to the worker. Minimum movement of men, machine and
materials is necessary for better output and better efficiency. Motion study is conducted just for
this purpose.
Motion study helps in proper scheduling of the operational functions, devising the proper
factory lay-out, minimizing the organizational functions, and setting up standards with the help
of Time study.
4. Marginal costing for decision making : (see also managerial decision making)
One additional unit of production is known as marginal unit, and the change in total cost on account of
adding or subtracting one additional unit is known as marginal cost. However this one unit may be a
product, a batch, an order, a stage of production, a process or even a department. The change in
total costs for any change in volume of production is fully accounted for by variable cost. Thus
marginal cost is sometimes described as variable cost. Variable cost consist of direct materials, direct
labour, variable expenses and all variable overheads. In other words, marginal cost should be taken
as equal to prime cost plus all variable overheads.
Marginal costing helps the management to determine the profitability of different units/ products of the
concern and to identify the forces acting as bottlenecks in achieving the profit goal. It provides useful
data and details for decision making particularly of short term nature.
Few managerial problems and areas of decisions, where marginal costing will be of immense help
are:
1. Achieving profit target
2. Increase in level of activity
3. Dropping / introducing a new line or product.
4. Evaluation of sales promotional schemes
5. Market expansion
6. Pricing policy, etc.

o
1. Operating costing:
This is method of costing to determine the cost of operations. When no items are produced but
services are offered, this method is used to determine the cost of such services
The main objective of operating costing is to compute the cost of the services offered by the
organization. It is also applied to the operations within the organization when one or more
departments provide services to production department. For this, it is necessary to decide the unit
operation cost in such cases. The next step is to collect and identify various costs under different
headings.
Fixed or standing charges
Semi fixed or maintenance charges
Variable or running charges.

Five activities of operating costing are:

1. Transport organization (unit : per ton km or per person km)
2. Electricity generation (per person per unit)
3. Hotels and canteens (per room per day)
4. Hospitals (per patient per day)
5. Educational institutions (per student per day)

2. Obsolescence in material costing:

Obsolescence is defined as The loss in the value of assets due to some factors other than time''. The
condition of the asset is good but it is no longer useful. Audio cassettes or video cassettes are some
examples.
Causes of Obsolescence:
iv. To bring into use a new and improved machine. So the old one is discarded.
v. The product which a machine produces, may be in demand in the market. If that product is
discontinued, the machine becomes obsolete.
vi. If it is thought to give a better design and get-up to the product due to change in fashion, or out
of three products, viz., A,B,C it is decided to divert the resources of C product to the
production of A and B products, for reasons of economy, the machine producing unwanted
product would become obsolete.

Obsolete materials become useless or obsolete due to change in the product, process, design or
method of production. In the case of slow moving materials as well as non moving materials, capital
remains blocked unnecessarily and also cost of storing continue to be incurred of these materials are
kept in the store in excess of the requirements. Management should make proper investigations into
slow moving and obsolete materials and try to minimize the capital investments in the same. It is
necessary to have an efficient Management Information System which will enable to generate regular
reports to examine the situations relating to these stocks so that the non-moving and obsolete stocks
can be disposed off in time. Perpetual inventory system is also advised to detect the obsolete stock.

p
1. Profit Volume Ratio:
It is also known as Contribution Ratio or Marginal Income Percentage. It is a ratio of Contribution to
Sales. Here profit does not indicate profit but represents contribution. Similarly, volume does not
signify the volume of sales but denotes value of sales. Since contribution is not affected by and fixed
expenses. Profit-volume ratio remains constant for varying levels of production. PVR is expressed
normally in percentage.
PV Ratio = C/S * 100

Advantages of PV Ratio (following problems can be solved):

A competitive study of the following items of facts can be made easier with the help of PVR:
a.) Line of product.
b.) Individual factors.
c.) Sales area.
d.) Separate companies.
e.) Method of sales.
Desired level of production, sales, profit etc.
Determining Price Policy and others managerial policies.

2. Profit on incomplete contract:

Several contracts take more time than one nancial year before they are complete. The questions
arises as to whether the prots on such contracts should be taken into consideration after the
completion of the contract or whether a portion of the same should be taken into accounts every year
on certain basis. If prot is taken into consideration after the completion of contracts and if in a single
year several contracts are completed, the prots shown will be very high while in another year, if none
of the contracts are completed, amount of prots shown will be very low. Thus there will be distortions
in the amount of prots. Therefore it becomes necessary to compute the amount of prot on partly
completed contracts and take credit of appropriate amount in the prot and loss account by using the
following guidelines.
Value of certified work only should be taken into consideration while determining the prot.
Value of work uncertied should not be taken into consideration.
In case of contracts which are less than 25% complete, no prots should be taken into
consideration
and consequently no credit should be taken to Prot and Loss Account.
In case of contracts which are more than 25% complete, but less than 50% complete, the
following
method should be used for computing the prot to be credited to the Prot and Loss Account.
1/3 X Notional Prot / Cash Received / Work Certied.

Notional prot is the difference between the value of work certied and cost of work certied. It is
computed in the following manner.
Notional Prot =Value of work certied [cost of work to date cost of work completed but not
certied ]

In case of contracts complete between 50% and 90% [more than 50% but less than 90%] the
following method is used for computing the prot to be credited to the Prot and Loss Account.
2/3 X Notional Pro t X Cash Received / Work Certied

In case of contracts completed 90% or more than that, it is considered to be almost complete.
In
such cases, the estimated total prot is rst determined by deducting the total costs to date and
additional expenditure necessary to complete the contract from the contract price. The portion of
prot so arrived is credited to the Prot and Loss Account by using the following formula.

Method I :- Estimated Prot X Work Certied / Contract Price

Method II:- Estimated Pro t X Work Certied / Contract Price X Cash Received / Work
Certied
Or Estimated Prot X Cash Received / Work Certied.
The method II is preferable to the rst one.
In case, additional expenditure to complete the contract not mentioned, the amount of prot to be
transferred to the Prot and Loss Account is determined using the following formula:

Notional Prot X Work Certied / Contract Price

If there is a loss, the total amount of loss should be transferred to the Profit and Loss Account
by
crediting the contract account.
It will be observed that in case of incomplete contract, amount of profit credited to the Profit
and
Loss Account is reduced proportionate to the work certified and cash received. The reason is
that this being unrealized profits should not be used for distribution of dividend. Similarly, the
principle of conservatism should also be applied in computing and crediting the profits.

3. Principal Budget Factor or Key Factor:

A key factor or a principal budget factor [also called as constraint or as limiting factor] is that factor
which is critical for the preparation of budget. Normally sales is the key factor or principal budget
factor but other factors like production, purchase, skilled labor may also be the key factors. The key
factor puts restrictions on the other functions and hence it must be considered carefully in advance. In
all conditions the key factor is the starting point in the process of preparation of budgets.
A typical list of some of the key factors is given below:
Sales: Consumer demand, shortage of sales staff, inadequate advertising
Material: Availability of supply, restrictions on import
Labour: Shortage of labour
Plant: Availability of capacity, bottlenecks in key processes
Management: Lack of capital, pricing policy, shortage of efficient executives, lack of know-how,
faulty design of the product etc.

4. Profit center:
Prot Center is any portion, area or segment of the business, where profit is measured. For knowing
profit, the measurement of revenues and costs are necessary.
A division of an organization may be called as prot center. It means a center responsible for adopting
ways and avenues to earn maximum possible profit on a product or any other activity of business.
The performance of prot center is evaluated in terms of the fact whether the center has achieved its
budgeted prots. Thus the prot center concept is used for evaluation of performance.

5. Perpetual Inventory System:

When the receipts and issues of stocks are recorded immediately at the time of each transaction,
such system is called perpetual inventory system. Under this system, a continuous record of receipt
and issue of materials is maintained by the stores department and the information about the stock of
materials is always available. Entries in the Bin Card and the Stores Ledger are made after every
receipt and issue and the balance is reconciled on regular basis with the physical stock. The main
advantage of this system is that it avoids disruptions in the production caused by periodic stock
taking. Similarly it helps in having a detailed and more reliable check on the stocks.
Advantages :
1. It keeps records up to date. 2. The materials are kept between minimum and maximum limits. If
they cross the limits, it is detected immediately. 3. The materials going out of stock is easily detected.
4. Up to date records help in proper insurance. 5. FSND analysis is easily possible.

1. Reconciliation of Cost and Financial accounts:

A reconciliation statement is prepared in cost accounts for reconciling the profits shown by the cost
accounts and financial accounts. This is required when the profits shown by both the methods are
different. In such a case, profit disclosed by one accounting system will differ from the profit shown by
the other and need for reconciliation will arise.
Some Reasons for difference in profit:
1. Items of financial nature not recorded in cost accounts.
2. Items charged to profit and loss account but not recorded in cost accounts.
3. Difference in method of charging depreciation
4. Under /Over absorption of overheads
5. Valuation of closing stock and work-in-progress.
6. Abnormal losses and gains.

2. Reverse cost method in By product cost accounting:

This method is based on the view that the sales value of the by-product contains an element of profit.
It is agreed that this element of profit should not be credited to the profit and loss account. Thus under
this method, sales value of the by-product is first reduced by, an estimated profit margin, selling and
distribution expenses and then the post split off costs and then the cost of the main product is thus
reduced by this net figure.
3. Relevant cost:
As the name indicates, the relevant cost is that cost which is relevant for decision making. When
decision is to be made among different alternatives, various items of costs related to all options are
written in the form of a table. All costs which are same for all options, are ignored because these do
not affect the decisions. Hence same costs under all options, are called irrelevant. Other costs which
are different for different alternatives are taken into consideration, these costs are relevant costs.
The relevant cost is a cost which is relevant in various decisions of management. Decision making
involves consideration of several alternative courses of action. Hence, costs which are going to be
affected matter the most and these costs are called as relevant costs. Relevant cost is a future cost
which is different for different alternatives. It can also be dened as any cost which is affected by the
decision on hand. Thus in decision making relevant costs plays a vital role. (See also differential
costs).

s
 1. Split off point:
This is a point up to which, input factors are commonly used for production of multiple products, which
can be either joint products or by-products. After this point, the joint products or by-products gain
individual identity. In other words, up to a certain stage, the manufacturing process is the same for all
the products and a stage comes after which, the individual processing becomes different and distinct.
(Show diagram).

2. Supply Chain Analysis:

Supply chain begins from the supplier from where the raw materials are obtained. The end point of
supply chain is the customer where all goods and services are given. Supply chain analysis is the
analysis of every point of supply chain beginning from source of raw materials and ending at
customer. It is very valuable analysis because the companies can also implement strategy, cut costs
and create value by enhancing their supply chain. It is not necessary that same firm should be part of
all points of supply chain. The term Supply Chain describes the ow of goods, services and
information from the initial sources of materials and services to the delivery of products to customers
regardless of whether those activities occur in the same organization or in other organization.
Customers expect improved performance from companies through the supply chain. They expect that
the companies should perform all these activities in an efficient manner so as to reduce costs and
also maintain quality of the products and the products be available easily for them.

3. Scrap, Spoilage And Defectives In Engineering Industries:

Scrap: Scrap is that loss which is visible, can be collected and is unusable, but is saleable. Thus, the
saleable portion of the unusable material is scrap. It has a recovery value, and may be sold or re-
used elsewhere. The scrap is always visible.
Scrap is a residual material resulting from a manufacturing process. It has a recovery value and is
measurable. The treatment of scrap in cost accounts is normally as per the following details:
If the value of scrap is negligible, the good units should bear the cost of scrap and any income
collected will be treated as other income.
If the value of scrap is considerable and identiable with the process or job, the cost of job will
be transferred to scrap account and any realization from sale of such scrap will be credited to
the job or process account and any unrecovered balance in the scrap account will be
transferred to the Costing Prot and Loss Account.
If scrap value is quite substantial and it is not identiable with a particular job or process, the
amount will be transferred to factory overhead account after deducting the selling cost. This
will reduce the cost of production to the extent of the scrap value.

Spoilage: Spoilage is that production which can not be repaired economically. It is that production that
fails to meet quality or dimensional requirements. It is so much damaged in manufacturing operations
that they are not capable of rectication. As these can not be rectified, they are sold in the market at
whatever price they can get. Rectication can be done at a cost which may not be economical. If the
spoilage is within limits, it is called as normal spoilage and anything exceeding this limit is called as
abnormal spoilage. The accounting treatment of spoilage is as follows:
The cost of normal spoilage is spread over to the good production by charging either to the
specic production order or to the product overheads.
The cost of abnormal spoilage is charged to the Costing Prot and Loss Account.

Defectives: The defectives are that production which can be rectified with reasonable cost. The
defectives are part of production units which do not conform to the standards of quality but can be
rectied with additional application of materials, labor and/or processing and made it into saleable
condition either as rsts or seconds depending upon the characteristics of the product. The
accounting treatment of defectives is the same like that of spoilage. The cost of normal defectives is
spread over the good units and the cost of additional processing is charged to a particular department
/ process if it is identiable with the same. If it cannot be identied, it is charged to factory overheads.
Cost of abnormal defectives is charged to the Costing Prot and Loss Account. The point of difference
from spoilage is that while spoilage cannot be rectified. Defectives can be rectified well within
reasonable costs.
Waste : It is that part of basic material which is lost in the manufacturing process in a natural way.
Some material may evaporate some may shrink, this is waste. Waste may be visible like pieces of
clothes in tailoring shop or evaporation of petrol during filling and storage. The waste has no market
value. If it has sale value it will not be called waste but will be called scrap. The scrap is always
visible.
t
1. Transfer pricing methods:
A Transfer Price is that notional value at which goods and services are transferred between divisions
in a decentralized organization. Transfer prices are normally set for intermediate products, which are
goods, and services that are supplied by the selling division to the buying division. Their protability is
measured by xation of transfer price for inter divisional transfers.

Following are the transfer pricing methods:

1. COST BASED PRICING:

Actual Cost of Production:- This is in fact the simplest method of xation of transfer price. In
this
method, the actual cost of production is taken as transfer price for inter divisional transfers.
Full Cost Plus:- In this method, the total cost of sales plus some percentage of prot is
charged
by the transferring division to the transferee division.
Standard Cost:- Standard cost is predetermined cost based on technical analysis for
material,
labour and overhead.
Marginal Cost Pricing:- Under this method, only the marginal cost is charged as transfer
prices.
As xed costs are in any case unavoidable and hence is not charged to the buying
division.

2. MARKET BASED PRICING:

Under this method, the transfer price will be determined according to the
market price prevailing in the market. It acts as a good incentive for efficient production to the
selling
division and any inefficiency in production and abnormal costs will not be borne by the buying
division. The logic used in this method is that if the buying division would have purchased the
goods/services from the open market, they would have paid the market price and hence the
same price should be paid to the selling division. One of the variation of this method is that
from the market price, selling and distribution overheads should be deducted and price thus
arrived should be charged as transfer price. The reason behind this is that no selling efforts are
required to sale the goods/services to the buying division and therefore these costs should not
be charged to the buying division.
Limitations of market based transfer pricing are as follows;
There may be resistance from the buying division. They may question buying from the
selling
 division if in any way they have to pay the market price?
Like cost based prices, market prices may also be uctuating and hence there may be
difficulties
in xation of these prices.
Market price is a rather vague term as such prices may be ex-factory price, wholesale
price, retail
price etc.
Market prices may not be available for intermediate products, as these products may not
have
any market.
This method may be difficult to operate if the intermediate product is for captive
consumption.

3. NEGOTIATED PRICING:
In this method the transfer prices may be fixed on the basis of Negotiated Prices that are fixed
through negotiations between the selling and the buying division. Sometimes it may happen
that the concerned product may be available in the market at a cheaper price than charged by
the selling division. In this situation the buying division may be tempted to purchase the
product from outside sellers rather than the selling division. Alternatively the selling division
may notice that in the outside market, the product is sold at a higher price but the buying
division is not ready to pay the market price. In all these conflicts, the overall profitability of the
firm may be affected adversely. Therefore it becomes beneficial for both the divisions to
negotiate the prices and arrive at a price, which is mutually beneficial to both the divisions.
Such prices are called as Negotiated Prices.

4. OPPORTUNITY COST PRICING:

This pricing recognizes the minimum price that the selling division is ready to accept and the
maximum price that the buying division is ready to pay. The nal transfer price may be based
on these minimum expectations of both the divisions.

2. Treatment of scrap in cost accounts: (see scrap above)

u
1. Uniform costing:
It is not a method of costing. It is simply the common idea among the different units of an industry to
adopt same principles, procedures and policies for determining the cost of a common product.
Uniform costing simply denotes that a number of undertakings in a same industry may use same
costing principles and procedures to arrive to cost, so that mutual comparison may be possible
among them. It is the adoption of identical costing principles and procedures by several units of the
same industry or by several undertakings by mutual agreement. Uniform costing facilitates valid
comparisons between organizations and helps in eliminating inefficiencies.

Objective Of Uniform Costing:

1. To help for meaningful and valid cost comparison among the members.
2 .To locate and eliminate inefficiencies in the rm by measuring own efficiency in terms of industry in
general and in terms of close rivals in particular.
3. To stop cut-throat competition and create healthy competition.
4. To improve the productivity of men, machine production technology and methodology.
5. To provide uniform data and information to Government for different purposes like tax policy,
subsidies, concessions, restrictions, etc.

2. Under Absorption and Over Absorption Overheads:

Absorption of overheads means charging share of overhead expenses to the products. As the
overhead expenses are indirect expenses, the absorption is to be made on some suitable basis. The
basis is the absorption rate. Unit of base selected can be based on direct material, direct labour or
prime cost.
Overhead Absorption Rate: Overhead Expenses / Unit of the base selected.

Where the actual overhead of a period is absorbed at actual rate, the overheads absorbed are equal
to the overheads incurred. So there is no under-recovery or over-recovery of overheads. But where
the predetermined rate is applied, as commonly done, the overheads absorbed may be more or less
than the actual overheads. If the amount applied overhead on predetermined rates absorbed is less
than the overheads actually incurred, it is Under- Absorption. Otherwise, it is Over- Absorption.

Under- absorption arises if:

i. Actual expenses exceed the estimated.
ii. Production is less than estimated.
iii. Hours worked are less than estimated.

Over absorption occurs if the above conditions are reversed. Both the under and over absorption may
arise due to any one or more of the following causes:
i. Error in estimating overheads.
ii. Error in estimating quantum of production.
iii. Seasonal fluctuation in overheads from time to time.
iv. Unforeseen changes in the productive capacity.

v
1. VED Analysis: (See also ABC analysis)
This analysis divides items into three categories in the descending order of their criticality as follows:

V stands for vital items and their stock analysis requires more attention. The reason is that if
these items are not available, the resulting stock outs will cause heavy losses due to stoppage
of production. Thus these items are required to be stored adequately to ensure smooth
operation of the plant.
E means essential items. Such items are considered essential for efcient running but without
these items, the system will not fail. Care must be taken to see that they are always in stock.
D stands for desirable items, which do not affect production immediately but availability of
these items will lead to more efciency and less fatigue.
Thus VED analysis can be very useful to capital intensive process industries.

w
1. Work measurement:
The Work Measurement aims at determining the effective time required to perform a job. The
ineffective, wasteful or avoidable time is separated from effective required time to complete the work.
The effective time so established in work measurement can be used for the following purposes:
Incentive wage schemes which require data about the time allowed and time taken for a
particular job.
Improving utilization of men, machines and materials.
Assisting in production control
Assist in setting labor standards
Cost control and reduction.
 The following stages are involved in work measurement.
i. Selection of work
ii. Measuring the actual time taken in the work done
iii. Making comparison between the standard time and the actual time.

z
1. Zero Base Budgeting:
Zero Base Budgeting is method of budgeting whereby all activities are revaluated each time budget is
formulated and every item of expenditure in the budget is fully justied. Thus the Zero Base
Budgeting involves from scratch or zero. Zero based budgeting [also known as priority based
budgeting]. It is an attempt to overcome the limitation of traditional budgeting where previous years
figures are taken as base for the preparation of budget. This approach requires that all activities are
justied and prioritized before decisions are taken relating to the amount of resources allocated to
each activity.
ZBB is superior to traditional budgeting in many ways as given below : (Advantages of ZBB)
a. It is not change of figures in old budget as is done in traditional budgets. The manager has to do
cost benefit analysis for every rupee he or she is demanding.
b. It highlights the area where fund is likely to be wasted and helps to eliminate them.
c. It is a system of management by objectives while traditional budgeting is system of management by
system.
d. It identifies inefficient operation and considers every time alternative ways of performing the same
task.
e. It is very suitable for R&D, Pollution control, Quality control etc.
Requirements :
1. It requires trained staff and managers.
2. It faces many problems in its implementation.
3. It is time consuming and costly.
4. It requires full support of top management.