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Subject: 101 Accounting for Business Decision

Notes and Problems on

UNIT 3 : Cost Accounting

UNIT 4 : Cost Control

By Prof. Purvi Shah


Unit 3 : Basic Concepts & Terms of Cost Accounting

3.1 Introduction
Management process involves decision making & control . Both this functions require
information relating to cost. Costing is a process & technique to give costing
information to managers for their decision making & control.

3.2
A) Basic Cost Terminology
a) Cost: It may be defined as the amount of expenditure (actual or notional)
incurred on or attributable to a given things or to ascertain the cost of a given
thing. In other words cost is the amount of resources used for something which
must be measured in terms of money. For example: Cost of preparing one cup tea
is the amount incurred on the elements like material, labour and other expenses,
similarly cost of offering any services like banking is the amount of expenditure
for offering that service.
b) Costing : It is defined as the technique and process of ascertaining costs
Costing involves in classification, recording, allocation, appropriation of
expenses incurred to facilitate the determination of cost of the product or service.
Thus costing involves Collection & analysis of relevant cost data for
interpretation & presentation to management for decision making & control.
It is a set of procedures used in refining raw data into useful information for:
- Managerial decision making
- Ascertaining products/services cost
- Ascertaining products/services profitability
c) Cost Accounting is the process of accounting of costs. It primarily deals with
collection, analysis of relevant cost data for interpretation and presentation for
various problems of management. It is concerned with actual cost incurred and
estimation of future cost.
d) Cost Accountancy: It is basically application of costing and cost accounting
principles, methods and techniques in the ascertainment of the costs and analysis
of savings/or excess as compared with previous experience or with standards

B) Objectives of Cost Accounting:


i. Ascertainment of Cost per unit of production
ii. Determination of selling price.
iii. Ascertainment of cost/ profit for each division
iv. To inform about inefficiency and carelessness
v. Provides information for preparation of accounts and other reports
vi. To provide data for cost reduction
vii. To facilitate cost estimates
viii. Assistance in management decision making
ix. Provide information about costing principles and procedures to be
followed in costing system
C) Significance of Costing
Company having proper cost accounting system helps management in following
ways:
Profitability analysis of individual Jobs, Products & Services can be done. By this
analysis management can take decision of discounting unprofitable lines.
Analysis of cost behavior of various items of expenditure helps to make future
estimates of cost with reasonable accuracy.
It locates difference between actual results & expected results. This is useful for
managerial control.
For setting prices of different products & for designing pricing policy costing data
is very much useful.
Useful for assessing effect of decrease in output or of shutdown on profitability.
Useful for initiating actions for efficient use of available resources.
Performance of managers can be judged on basis of cost saving & cost reduction
by them. Costing data is very much useful for this.
Costing data is useful for knowing effect of
-- Improvement of productivity
-- Modernization of plant
-- New management techniques on costs & profits of company.
By using technique of Activity Based Costing (ABC) unprofitable & non value
added activities can be corrected or eliminated.
It is essential for management to assess the effect of various strategies on cost of
final products/services. This is readily and continuously provided by costing
department.

3.3 Important Aspects of Cost


a) Cost
Resource sacrificed or forgone to achieve specific objective. It is measured in
monetary terms. It is an amount paid to acquire goods or services. An actual cost is
the cost incurred (historical cost) as distinguished from budgeted (or forecasted) cost

b) Cost Object
To guide their decisions, managers want to know how much a particular thing such as
product, machine, service or process costs. This is called cost object. It is an activity
or
operation in which resources like material, labour etc. are consumed. Cost may pertain
to more than one cost objects simultaneously e.g. material cost may be a part of
product cost as well as production department cost.

c) Cost Unit
It is a unit of product, service or combination of them in relation to which costs are
ascertained or expressed.
Selection of cost unit depends on:
Nature of business
M.I.S.
Requirements of costing system.
Ex. Of cost unit are:
Industry Cost unit
Automobile No.
Biscuit Kg.
Breweries Crate
Cigarettes Packs
Chemicals Lit/Kg/Ton
Textile Meters
d) Cost Ascertainment
It is the process of determining actual costs of process, product or activity after
these costs have been incurred, in the past.
Management is always interested to know exact cost for particular product, activity
or process, so that cost control & cost reduction becomes easy.

e) Cost estimation
It is the process of determining future costs in advance before any production or
activity starts.
Cost estimation is useful for
- Managerial control
- Filing tender
- Deciding price of product or price of job.
- Preparing budgets .
f) Cost Allocation
It is the process of allocating a particular cost item to product, process or cost center
e.g. salary of store keeper is allocated to stores department or cost of boiler
attendant is allocated to Boiler House .

g) Cost Apportionment
It is the process of charging common cost items to two or more cost centers on some
equitable basis .
e.g. Electricity expenses are apportioned on basis of light points used by cost
centers. Factory rent is apportioned on basis of floor area of different cost centers

h) Cost Absorption
It is charging cost from cost centers to products or services by means of absorption
rate. This rate is calculated with reference to some base such as machinehour,
Labor- hour etc.

i) Cost Management
Term is widely used in business today.
It is used to describe approaches & activities of managers in short-run & long-run
planning & control decisions that increase value for customers & lower costs of
products & services.
It is broad focused & not merely confined to continuous reduction of costs.
Planning & control of costs is linked with revenue & profit planning e.g. to
enhance revenues & profit managers often deliberately incur additional costs for
advertising & product innovation
Cost management is not practiced in isolation. It is an integral part of general
management strategies & the implementation.
Three features of cost management are:
(i) Calculating cost of products, services & other cost objects.
(ii) Obtaining information for planning, control and performance evaluation.
(iii) Analyzing relevant information for making decision

3.4 Decision Centers

(a) Cost Center


Center in organization where cost is incurred
Cost is collected each cost center wise
Generally departments are considered as cost centers.
Departmental head is responsible for cost incurred in his cost center.
Cost Center can be location, person, item, equipment or group of them.
Manager responsible for cost center can initiate any actions to control, reduce
or manage costs in his cost center
Targets & budgets are set in terms of cost only.
Efficiency of persons working in a cost center is judged by cost saved by him.
It is useful for better managerial control
Types of cost centers are:
Impersonal ( Plating or Paint Shop )
Personal ( Sales mgt, Purchase mgt. )
Production ( Making, Banking, Packing )
Service (Personnel, Canteen, Stores)
Cost center head is accountable for increase in costs

(b) Revenue Center


Center where revenue is generated
Sales division of company is revenue center
Revenue center head can decide
- Prices
- Discounts
- Sales mix
- Pricing Strategies/Policies.
Revenue center head is accountable for reduction in revenue

(c) Profit Center: It is defined as, a segment of the business entity by which both
revenues are received and expenses are incurred or controlled.
Center at which profit is generated and cost are assigned
Generally divisions of company are treated as Profit Centers
Profitability of firm is analysed as per each profit center
Targets for the center are in terms of profit
Divisional or profit Center head is responsible for achieving profit targets
He has powers & responsibilities for deciding
- price structure
- Sales volume
- Cost control actions
He generally reports to Board of a company
He plays key role in profit management of company
Profit center head is accountable for reduction in profits.
The profit center concept is used for evaluation of performance.
(d) Investment Center
Center which decides investments to be made
Investment Center head is responsible for
- Making investment in assets
- Managing assets
- Expansion/diversification
- Disposal of old assets
He has to achieve target in terms of R.O.I.
This is more responsible center than profit center.
He generally reports to Board of a company
He plays key role in investment management of company
Investment center head is accountable for reduction in R.O.I.

3.5 Cost Components

(I) Prime Cost


It is total of Materials, Labour & Expenses directly related to production. They
are called as direct material, direct labour, direct expenses respectively.

Prime Cost = (Direct Material cost) + (Direct Labour cost) + Direct Expenses
cost)
(a) Direct Material
Material which directly goe
s into the product that is which can be directly identified with the material
e.g. sugar used in Cadbury chocolate, quantity of glass in glass bottle, quantity
of milk in cup of tea etc.
It includes all materials consumed in process of manufacture up to its primary
packing. It consists of raw materials, bought outs & primary packing material.

Direct Material = (Raw material)+(Bought outs)+(Primary Packing material)


(i) Raw material is the material on which processing is carried out in the
factory e.g. steel sheets used to manufacture Indica car.
(ii) Bought outs are the components & parts readily bought from outside & are
fitted in the product e.g. bought outs for Tata Motors Ltd. include A.C. or
Speedometer fixed in Indica.
(iii) Primary Packing Material is the packing material required for presenting
product to customer e.g. wrapper used by Parles biscuits.

(b) Direct Labour


It includes all remuneration & other benefits paid to workmen who are directly
involved in manufacturing of a product. E.g wages paid to the workers.
e.g. if 3 workers are involved in manufacturing a table for 8 days & each is
paid Rs.100 per day plus benefits Rs.20 per day then direct labour cost is:
8 x 3 x [100+20] = Rs.2, 880
Direct Labour = (Wages) + (Benefits)

(c) Direct Expenses


Expenses incurred specifically for a particular job, process, service cost center
e.g. cost of drawings & Designs for Maruti 800 is added to cost of Maruti 800 &
for Alto is added to cost of Alto., Royalties payable on use of patents,
copyrights, consultation fees paid to architects, surveyors etc.

Direct Expenses = Expenses for particular job, product or process

(II) Overheads
It is total of Material, Labour & Expenses not directly related to production

Overheads = (Indirect Material) + (Indirect Labour) + (Indirect Expenses)

(a) Indirect Material


The material which is not present in product but is required to accelerate rate
of production e.g. machine oil, , welding rods etc.

Indirect Material = Total expenses on all indirect material

(b) Indirect Labour


Salaries & benefits given to employees who are not involved in the Process
of production but these employees are required to accelerate the rate of
production e.g. supervisors, executives, security guards.

(c) Indirect Expenses


These expenses are not directly related to a particular product, process, or
job. They are common expenses for all the products. e.g. electricity,
telephone, computer, traveling etc.

3.6 Cost Classification

1) Element wise
Costs can be collected under 3 main elements viz Material, Labour, Expenses.
When these costs can be identified easily with cost unit, operation or cost center they
are called direct or traceable costs.
When these costs cannot be allocated but can be apportioned to cost centers or cost
units they are called overheads.

2) Function wise
a) Production Cost: It is the cost of operating manufacturing division. Includes all direct
labour, direct material direct expenses & manufacturing overheads. All costs starting
with supply of material till production of finished goods are included in this cost.
Production manager controls this cost.
b) Factory/Works overheads
All indirect costs incurred in the factory for production of goods is termed as
factory/works overheads. Such costs are concerned with the running of the factory or
plant. These include indirect material, indirect labour and indirect expenses incurred
in the factory. Some examples are as follows:
Indirect factory materials:
i. Grease, oil, lubricants, cotton waste etc.
ii. Small tools, brushes for sweeping, sundry supplies etc.
iii. Cost of threads, gum, nails, etc.
iv. Consumable stores
v.Factory printing and stationery
Indirect factory wages
(i) Salary of factory manager, foremen, supervisors, clerks etc.
(ii) Salary of storekeeper
(iii) Salary and fee of factory directors and technical directors
(iv) Contribution to ESI, PF., Leave pay etc. of factory employee.
Indirect factory expenses
(i) Rent of factory buildings and land
ii) Insurance of factory building, plant, and machinery
(iii) Municipal taxes of factory building
(iv) Depreciation of factory building, plant and machinery, and their repairs
and maintenance charges
(v) Power and fuel used in factory
(vi) Factory telephone expenses.

c) Administration cost: is incurred for carrying the administration functions of


organization
These expenses are related to the management and administration of the business.
Some examples are as follows:
Office printing and stationery, Cost of brushes, dusters etc. for cleaning office
building and equipment's, Postage and stamps. Salary of office manager, clerks, and
other employees, Salary of administrative directors, Salaries of legal adviser, Salaries
of cost accountants and financial accountants, Salary of computer operator. Rent,
insurance, rates and taxes of office building, Office lighting, heating and cleaning,
Depreciation and repair of office building, furniture, and Equipment etc., Legal
charges, Bank charges, Trade subscriptions, Telephone charges, Audit fee etc.

d) Selling & Distribution Cost: All the costs related to distribution, marketing, sales &
after sales services of companys product are included in these costs.
These expenses represent the aggregate of indirect material, indirect labour, and
indirect expenses incurred by the selling and distribution department of the
organisation.
Some of the examples of selling overheads are as follows:
Indirect material
(i) Catalogues, price list (ii) Printing and stationery
(iii) Postage and stamps (iv) cost of sample
Indirect wages
(i) Salaries of sales managers, clerks and other employees
(ii) Salaries and commission of salesmen and technical representatives
(iii) Fees of sales directors
Indirect expenses
(i) Advertising
(ii) Bad debts
(iii) Rent and insurance of showroom
(iv) Legal charges incurred for recovery of debts
(v) Travelling and entertainment expenses
(vi) Expenses of sending samples
(vii) Market research expenses. Indirect costs incurred in relation to the procurement
of sale orders are termed as selling overheads.
Distribution overheads
Indirect costs incurred in relation to the execution of the sales order is termed as
distribution overheads. Some of the examples of distribution overheads are as follows:
Indirect material
(i) Cost of packing material
(ii) oil, grease, spare parts etc. for maintaining delivery vans
Indirect wages
(i) Salaries of godown employees
(ii) Wages of drivers of delivery vans
(iii) Wages of packers and dispatch staff.

e) Research & Development cost include all cost searching new products & process
and improving existing products & processes.

3) Behaviour wise
a) Variable costs: are those costs which tend to vary in accordance with level of
activity within relevant range of activity & within given period of time. There is
linear relationship between volume and variable costs. They are constant per unit.
Ex: Direct material cost, direct labour cost, transport, sales commission, fuel etc.
b) Fixed Costs: are those costs which are unaffected by changes in level of activity
during given period of time. They remain constant in total regardless of changes
in output & for certain period of time. Ex: Depreciation, interest on term loans,
insurance, property taxes.
c) Semi variable costs: They are neither perfectly variable nor absolutely fixed in
relation to changes in volume. They change in same direction as volume but not
indirect proportion. Ex: Telephone, Electricity, Maintenance cost.

4) Control wise
a) Controllable costs are those which can be controlled by specific action of a particular
member of organization e.g. sales & marketing expenses can be controlled by
marketing manager of a company, also cost like telephone, printing, stationary etc.
can be controlled.
b) Uncontrollable costs are those which cannot be controlled by action of a particular
manager.
e.g. depreciation & interest cost are uncontrollable by action of any particular
manager. These costs are generally incurred by actions of top management.

5) Normality wise
a) Normal costs are those incurred in normal course of business e.g. normal losses or
wastages. These costs must be considered while calculating cost of a product, process
or service.
b) Abnormal costs. it is an unusual cost whose occurrence is usually not regular and is
unexpected. This cost arises due to some abnormal situation of production. Abnormal
cost arises due to idle time, unexpected heavy breakdown of machinery etc. They are
not taken into consideration while computing cost of production or for decision
making.

6) According to time
a) Historical costs: These are the costs which are incurred in the past, i.e. in the past
year, past month etc. They are ascertained after the period is over. Though it has
limited importance, still they can be used for estimating the trends of the future.
b) Predetermined Cost: These costs relating to the product are computed in advance
of production, on the basis of a specification of all the factors affecting cost a and
cost data. Pre-determined cost may be either standard or estimated.

7) On basis of Management Decision making:


1) Opportunity Costs

It is the value of a benefit sacrificed in favour of an alternative course of action.


It represents income foregone by rejecting alternatives. They are therefore not
incorporated into formal accounting system because they do not incorporate cash
receipts or cash outflows.
Opportunity costs are very much relevant while examining alternative proposals or
projects. Every manager is trying to use limited resources available to him. If
resources are applied to alternative B instead of A then opportunity cost is the
potential benefits foregone from alternative A. The concept is useful to the
management in decision making among alternatives.
Examples:
For e.g. a manufacturer invest Rs.5,00,000 in purchasing Plant and machinery instead
if he would have invested in shares and debentures he would have earned interest and
dividends. Thus the loss of interest and dividend that would be earned is the
opportunity cost. Thus opportunity cost is the sacrifice involved in accepting the
alternative course of action.
2) Imputed or Notional costs or Implicit Cost
It is hypothetical or notional. It does not involve any cash outlay. It is computed only
for decision making. It is used for evaluating performance of profit centers where
managers are having responsibility of managing revenues & expenses in their
respective centers. e.g.: interest on funds internally generated, payment for which is
not actually made. These are non-cash items. E.g. rent of owned property, salary of
owner, interest on owned capital etc.
3) Out of pocket cost or Explicit cost:
These are the cost which requires cash payment to be made to the outsiders such as
wages, rent, raw material suppliers etc. Whereas non cash payment costs such as
depreciation is not included in the out of pocket cost. This cost concept is significant
for management in deciding whether or not a particular project will earn return at
least equal to the cash expenditure on that project. Such cost is relevant for price
fixation during recession or when make or buy decision is to be made.

4) Sunk Cost
It is historical cost incurred in past. A sunk cost is the cost that has already been
incurred. Generally known as unavoidable cost, it refers to the past cost since these
amounts cannot be changed once the cost is incurred. They are the cost which have
been incurred by a decision made in the past and cannot be changed or avoided by
any decisions that is made in future. These costs are not relevant for decision making
about the future. E.g. the book value of an asset cannot be currently used for making
a decision to replace it.

e.g. While considering replacement of a plant, depreciated book value of old asset is
irrelevant as amount is sunk cost.

5) Product Cost:
The costs which are included in the manufacturing of the product are called product
cost. Thus it includes all the cost starting from the manufacturing activity i.e.
inventory cost till the product is sold, i.e. finished product.
6) Period cost:
It is described as the cost which is associated with a particular period or time. These
are not related to the products delivered to the customers. Such costs are charged to
the profit and loss A/c of that period. E.g. of period cost are Rent, salaries, traveling
expenses etc.
Product cost can be carried forward to next accounting period as part of unsold
finished stock whereas period cost is to be written off during the same accounting
period in which it is incurred.

7) Capital cost:
Capital expenditure provides benefits to the future periods. Capital cost is treated as
purchase of an asset for e.g. purchase of land and building, furniture, etc.
8) Revenue Cost:
It is the cost which is incurred to benefit the current period and is classified as an
expense. For e.g. Salaries, rent, printing and stationary, postage, etc.
9) Relevant cost:.
It is anticipated, future cost which differs among different alternatives under
consideration. e.g. many times fixed costs are irrelevant in decision making.
Relevant costs may also be defined as the cost which are affected and changed by a
decision. The 2 features of relevant cost are:
a. Relevant costs are only future costs that are cost which are expected to be incurred in
future.
b. Relevant cost is only incremental (additional). Incremental cost refers to the increase
in cost between two alternatives.
10) Irrelevant costs are those costs that would not be affected by the decisions of the
management. For e.g. when a manufacturer decided to close a certain unit of
manufacturing, the wages associated with it is a relevant cost as the wage payment
would siege with the closure of the firm, but the rent which has already been paid
under the lease agreement cannot be recovered, hence it is a irrelevant costs

11) Differential cost:


The are also known as incremental cost. It is the difference in total cost between any
two alternatives. Diffencential costs are equal to the additional variable expenses
incurred in respect of the additional output, plus the increase in fixed cost, if any. It is
also known as (incremental cost).
12) Controllable and Uncontrollable cost:
According to ICMA (London) Controllable cost is defined as, cost which can be
influenced by the action of a specified member of an undertaking. And
uncontrollable cost is cost which cannot be influenced by the action of a specified
member of an undertaking.
E.g. of controllable cost are indirect labour, lubricants, cutting tools, power, raw
material cost, etc.
13) Joint cost:
When two or more products are produced from a single raw material, we get either
two main products form it or one may be a main product and other by product. But
the cost to produce is the combine cost. For e.g. kerosene, fuel oil, gasoline and other
oil products are derived from crude oil. Joint costs are the total costs incurred up to
the point of separation. Joint cost can be apportioned to different products only by
means of suitable basis.
14) Standard Cost:
Standard cost are those cost which are planned or predetermined cost estimates for a
unit of output in order to produce a basis of comparison with actual costs. Standard
costs are used to prepare budgets.
15) Shut down cost:
These costs are the costs which are incurred if the operations are shut down and they
will disappear of the operations are continued. Shut down cost are always fixed cost.
16) Marginal cost:
It is the variable cost of one unit of product or a service i.e. a cost which would be
avoided if the unit was not produced. It consists of all direct cost and fixed overheads.
Fixed costs are not considered while determining the cost of the product. Thus
marginal cost is the additional cost of producing additional units. It remains the same
per unit irrespective of the volume of output.
17) Conversion cost:
It is the total cost of converting a raw material into finished product. This term is
used to denote the sum of direct Labour and overhead costs in the production of a
product.
Methods of Costing:

Job Costing Contract Costing


1 It is that form of costing where work is It is a form of costing that is applicable where
undertaken as per customers special work is undertaken to customers special
requirement requirements. Each order is of longer
duration

2 Each cost are collected and accumulated Specialist sub-contractors are hired for
for each Job, work order or project electrical fittings, welding work, glass work,
separately plumbing work, etc.

3 Individual Jobs are identifiable and each Each contract becomes the cost unit
job becomes the cost centre
4 Each job has its own characteristics and Under contract costing most of expenses are
requires special attention direct in nature
5 Production is not done in anticipation of In case of incomplete contract, only
demand proportionate profit is taken to Profit and
Loss Account
6 Applicability : Printing press, Applicability: This method is used by
Construction of Building, bridges, ship builders, civil engineering contractors,
building, furniture making, machine construction and mechanical engineering
tool mfg., repairs of shops, painting firms etc.
job, Interior decorator, machine tool
mfg., foundries, Engg. workshop

Batch Costing Process Costing


1 This method of costing is used where This is method is applied where standardized
similar articles are manufactured in goods are produced. It is a method where cost
batches either for sale or use within the are ascertained at the stage of every process
undertaking and also after completing the finished
products.
2 The cost of a batch or group of identical It is used where production follows a series
products is ascertained. of sequential production

3 Each batch of the product are unit cost Finished products are uniform in all respects
where the cost are ascertained such as shape, size, weight, quality, colour,
chemical content etc. Thus unit cost is
calculated by dividing total cost by number
of units produced
4 In Batch costing is products are Cost follow the flow of production whereby
produced as per anticipation in demand cost incurred in earlier process are transferred
to the following process along with the
output.
5 When the batch is completed the cost is Unit cost is a process. Output of one process
totaled and total cost is divided by the is input for another process.
total quantity produced. For eg. Cost per
dozen, per kg, per ton etc.
6 Applicable for: Mfg. of nuts, bolts, Applicable: Mines, quarries, cotton wool and
screws, pins etc., bakery products, jute textiles, chemicals, soap making, paper
readymade garments, drugs and plastics, oil refining, food processing
pharmaceuticals, spare parts, shoes industry, dairy, sugar mfg., confectionaries,
component parts etc. cement, Flour mill, Gas Etc.

Operating / Service costing Unit/ output/ single costing


1 This form of costing applies where This method of costing is applied where the
standardized services are provided by products and services result form a series on
an undertaking or by service cost center continuous or repetitive operations or
within an organization. processes

2 It is applied to determine the cost of It is known as single method costing because


providing a service industries produced single variety of product
in most cases.

3 A uniform service is rendered to the It is called unit costing because cost units are
customers identical.
4 The processes and stages involved in The production of goods are undertaken on
converting the basic materials and continuous basis and in anticipation of
facilities tot eh ultimate service demand
rendered are standardize, repetitive and
continuous.
5 Applicable For: Transport The end products are always uniform and
Undertaking: air, water and Road, identical.
Municipal services such as supply of
water and electricity, Hotel- Loading
and boarding, Hospitals, educational
institutions, service department,
Cinemas, sports , water pumping, fire
extinguisher etc.
6 Applicable: Quarries, flour mills, paper mills,
textile mills, brickmaking, stationary items
mfg., dairy products etc.
3.7 Cost Sheet
Detailed statement showing actual cost of products, job order, contract etc.
Significance :
a) It shows total cost of product & average cost per unit
b) Different elements of total cost are highlighted
c) Useful for cost control
d) Locates inefficient areas & products
e) Useful for controlling wastages
f) It is a basis for preparing budgets & tenders
g) Selling prices of products can be fixed on the basis of cost shown by cost
sheet.
h) Shows stocks of each product.
i) Useful for fixing responsibilities of diff. managers.

Format of Cost Sheet

Op. Stock ( Raw material)


+ Purchases ( Incl. fright I/W)
- Clo. Stock (Raw material)
= Materials Consumed (a)
Direct Labour (b)
Direct Expenses (c)

Prime Cost (a+b+c)

+ Factory overheads (net of scrap)


+ Op. Stock (WIP)
- Clo. Stock (WIP)
-
= Factory or Works Cost

+ Administration overheads

= Cost of Production of Goods Produced

+ Op. stock of finished goods


- Clo. Stock of finished goods

= Cost of Prodn. of goods Sold

+ Selling & Distribution. Overheads

= Cost of Sales

+ Profit
= Sales (Net of taxes)

Items to be excluded from cost: Expenses of pure Finance nature for e.g.

1 Incomes a. Interest received , Interest received on investment


b. Dividend received on investment
c. Rent received
d. Commission received
e. Share Transfer fees received
f. Profit from sale of assets
g. Profit on sale of Investments
2. Expenses a. Interest paid, Interest paid on debentures
b. Commission paid to the partner and salary paid to the partner
c. Underwriting commission paid
d. Trade discount / Cash discount given
e. Discount on issue of shares,
f. Interest on Capital/ Bank overdraft/ Loan
g. Provision for Bad & Doubtful debts
h. Profit and loss on sale of investment /companys property
i. Brokerage paid
j. Donations
k. Normal loss of material is not taken into account
3. Profit and Loss l. Income Tax paid / Advance payment of income tax
Appropriations a. Dividends distribution tax, dividend paid, Interim dividend
paid,
b. Transfer to Sinking fund/ General Reserve,
c. Excessive Depreciation/ Goodwill / other Fictitious assets
written off
d. Payment of Sales Tax
e. Provision for taxation

Preliminary expenses written off: (Asset created by an accounting entry


(and included under assets in the balance sheet) that has no tangible existence or
realizable value but represents actual cash expenditure. The purpose of creating a
fictitious asset is to account for expenses (such as those incurred in starting a
business) that cannot be placed under any normal account heading. Fictitious assets
are written off as soon as possible against the firm's earnings.)

Items that should be included in Direct Expenses:


a. Royalties if charged as a rate per unit
b. Hire charges of the plant/special machinery if used for a specific job
c. Sub-contract or outside work, if the jobs are sent out for special processing
d. Chargeable expenses, chargeable expenses outstanding
e. Salesmans commission if it is based on the value of units sold
f. Cost of making design, drawings, pattern for a specific Job
g. Engineers fees
h. Surveyors fees
i. Architects fees

Treatment of Special or Irregular Items


1) An expenses in connection with acquisition of specific material are to be added with
purchase price of that material, but if these expenses are incurred for various material
procured together then they are included in factory overheads
2) All stores expenses are included in factory overhead
3) Normal material loss included in material cost
4) Abnormal material loss excluded from costing.
5) Amount realized from sale of scrap is deducted from factory overhead
6) Cost of defective products due to normal reasons is factory overheads & due to
abnormal reasons is deleted from cost sheet
7) Expenses related to return of excess material is a factory overheads
8) Primary Packing Material is direct material cost secondary packing material is S
& D overheads
9) Overtime for specific job is added to direct labour & general overtime added to
factory overheads
10) General drawings & design charges is factory overheads & for specific job is direct
expense
11) Royalty for use of patent, copyright is direct expense & for right to sell is S & D
overheads.

Some of the Items Included Under Different Heads


a) Prime Cost
Direct Material
- Raw Material
- Bought outs
- Primary packing
Direct Labour
Wages & benefits given to workers identified with products.
Direct Expenses
Patents, Royalties, designs, moulds, Patterns for products.
b) Factory Overheads
1) Grease, oil, lubricants, & other consumables
2) Stores/spares
3) Supervisor, store supervisors salary
4) Factory/ Works Managers Salary
5) Sweepers salary
6) Security watchman salary of factory
7) Indirect Wages
8) Factory rent, rates and taxes
9) Factory building Insurance
10) Factory Fuel and Water
11) Repairs & Maintenance of Plant and Machinery / Factory Building
12) Depreciation on Plant and Machinery/ Factory building
13) Power/fuel
14) Water/Steam
15) Postage and Telephone expenses
16) Printing and Stationary

c) Administration Overheads
1) Office stationary
2) Counting House Salaries
3) Salary Manager/M.D/ General Manager
4) Salary Executives and Staff
5) Telephone charges
6) Salaries and Wages
7) Office rent, rates , taxes and Insurance
8) Office Heat/light/A.C.
9) Auditor fees, Directors fees , Legal expenses
10) Subscription to Trade Journals
11) Computer expenses (EDP)
12) Sundry / Miscellaneous office expenses
13) Office conveyance
14) Depreciation on Office Building
d) Selling Overheads
1) Catalogue/price list
2) Salesmen Salary & benefits
3) Commission on sales
4) Advertisement
5) Bad debts
6) Rent/Taxes of Sales and Marketing Dept.
7) Traveling expenses
8) Branch establishment
9) Market Research
10) Samples
e) Distribution Overheads
1) Secondary packing
2) Stores/spares
3) Godown employees salary
4) Wages of drivers, Packers, dispatch clerks
5) Warehouse rent/rates/Insurance
6) Carriage outward
7) Transit Insurance
8) Delivery Vans maintenance
9) Misc. selling expense

3.8 FINANCIAL ACCOUNTING Vs COST ACCOUNTING

Financial Accounting Cost Accounting

1) Gives overall costs & profits of Co. 1) Gives costs & profits for each product,
Process, Job etc.

2) Emphasis on reporting 2) Emphasis on control

3) Limited use for decision making 3) Extensive use for decision making

4) Not useful for fixing responsibility 4) Useful for fixing responsibility

5) Focus is on historical cost data 5) Focus is on present & future cost data

6) For all companies financial records 6) Except in few cases statutory


must follow the provisions of Co. Act requirements are not mandatory
& Income Tax Act .

7) Management, employees, shareholders 7) Only management is interested in


Govt., lenders, are interested in costing records.
Financial information .

8) Anybody can have access to financial 8) Outsiders have no access to costing


Statements of companies records.

9) Records must be maintained in 9) Records can be maintained as per


format specified by companies Act. Requirements of management.

10) Only monetary information is recorded 10) Both monetary and non-monetary is
recorded

Illustrations on Cost Sheet


1. Raw material cost is Rs. 15 lakhs. Bought outs are Rs. 5 lakhs. Primary packing
material is Rs. 2 lakhs. Direct Labour is 25% of material cost & Direct expenses are
10% of material cost. What is prime cost.

2. From following particulars . Prepare a cost sheet for year end 31-3-2007.
Rs.
Stock of finished goods (31/3/07) 66,000
Stock of raw materials (1/4/06) 40,000
Work-in-progress (1/4/06) 75,000
Purchase of raw materials 5,75,000
Carriage inwards 12,500
Factory, rent taxes 27,250
Other production expenses 13,000
Stock of goods (31/3/07) 15,000
Wages 75,000
Managers salary (2:2:1 for Fty:Adm:S&D) 1,60,000
Factory employees salary 80,000
Power expenses 19,500
General expenses 12,500
Sale of the year 13,60,000
Stock of raw materials ( 31/3/07) 50,000
Work in-progress ( 31/3/07) 60,000
Salesmens Commission 32,000

3. Following particulars are available in respect of cost structure for the product 731 for
the quarter ended on 31st December, 2006
Rs.
Opening stock of raw materials 15,000
Purchases of raw materials 75,000
Freight & insurance on materials 6,000
Carriage inwards on materials 4,000
Return of material to suppliers 5,000
Closing stock of materials 20,000
Normal loss of materials 2,000
Accidental loss of materials 6,000
Productive wages paid 52,000
Wages outstanding 4,000
Factory Expenses 20,000
Office & Adm. Exp. 32,000
Office Rent 4,000
Office Exp. Prepaid 2,000
Selling expense 20,000
Distribution Expenses 5,000
The selling price is fixed by profit of 20% on selling price. Prepare a cost sheet.

4. Classify the following items into:


i. Factory overhead
ii. Administration overhead
iii. Selling and Distribution overhead
iv. Items excluded from cost sheet with reason
Sr. No Particulars Sr. No. Particulars
1. Wages 21. Wages of operatives in cutting department
2. Advertisement 22. Lubricants, cotton waste etc
3. Works managers salary 23. Road licenses for delivery vans
4. Income tax 24. Chief accountants salary
5. Travelling Expenses 25. Wages of storekeeper in materials stores
6. Fuel and Power 26. Warehouse wages
7. Factory lighting 27. Bad debts
8. Parcels sent to customers 28. Agents commission
9. Interest on capital 29. Donation
10. Printing and stationary 30. Discount Allowed
11. Showroom expenses 31. Hire charges of Plant used for special purpose
12. Carriage outward 32. Counting house salaries
13. Rent, rates and insurance of 33. Drawing office expenses
warehouse 34. Technical Directors fees
14. Directors salary 35. Laboratory expenses
15. Postage and telephone 36. Workmens Compensation
16. Office lighting 37. Subscription to Trade Journals
17. Deprecation on plant machinery 38. General Establishment expenses
18. Delivery van charges 39. Drivers wages and other distribution expenses.
19. Plant repairs and maintenance 40. Sales tax
20. Carriage Inward, octroi, customs

5. The following figures relate to a job work of a manufacturing business which were
completed in the 2nd Week of June 2015. Compute the total cost by preparing a cost
sheet with this information

Direct Materials Rs. 2000


Direct Labour Rs. 1600
Direct Chargeable expenses Rs. 400

Charge works overheads at 50% of the direct labour and office overheads at 10%
on works cost. What shall be the job price if 10% profit is determined on the
supply price.

6. A factory uses a job costing system. The following cost data are available from the
books for the year ended 31st March 2015
Amount in Rs.
Direct Materials 9,00,000
Direct Wages 7,50,000
Profit 6,09,000
Selling and Distribution overheads 5,25,000
Administration Overheads 4,20,000
Factory Overheads 4,50,000
Required:
b. Prepare a Cost sheet indicating the Prime Cost, Works Cost, production Cost ,
cost of Sales and Sales Value
c. In 2015-16 the factory has received an order for a number of Jobs. It is estimated
that the direct materials would be Rs. 12, 00,000 and direct Labour would cost
Rs. 7, 50,000. What would be the price for these jobs if the factory intends to
earn the same rate of profit on sales, assuming that the selling and distribution
overhead has gone up by 15%. The factory recovers factory overheads as a
percentage of direct wages and administration and selling and distribution
overheads a percentage of works cost based on the cost rates prevalent in the
previous year.

Unit 4: Accounting of Material Cost

4.1 Introduction
Material is an important component of cost. In most of the industries material cost is
around 60 to 70 % of total product cost. It is therefore top priority of management to
control material cost.
This unit covers all stages of material cost control & various techniques to control
material cost.

4.2 Material Purchase


I) Purchase procedure is different for different organizations depending upon type,
volume & quantities of various materials required by business. However all
organizations follow same basic steps in purchasing of materials. Following steps are
involved in purchase:
1. Purchase requisition
As a good management practice purchase of any material is to be done only purchase
department.
Two types of materials are required in a company material required for production
materials required by other departments for non-production activities.
Purchase requisition is a formal request by any department to purchase department for
purchase of material.
Purchase requisition for production materials is raised by stores department where as
for other materials it is raised by respective departments as & when material is
required by them
Following is the format of purchase Requisition
Purchase Requisition

No: 1285/07 Date: 1/6/07 Dept: Production

Sr. No. Particulars Qty. Delivery Schedule.


1. Steel Sheets (MS 5 mm) 4 6/6
2. Angles (3 x 12 mm) 50 18/6
3. Channels (20 mm x 6 mm) 20 20/6

(Requested by) (Checked by) (Approved by)


Now a days purchase requisition is generated on computer & same is communicated to
purchase department. This saves time & cost involved in the procedure.

2. Purchase Order
Based on purchase requisition, purchase department initiates actions for purchase.
Quotations are called from different suppliers and one which is best suited to
organization is accepted.
Once supplier is fixed Purchase Order is raised on him. Purchase Order is the
document which gives all details relating to quantity, quality delivery schedule &
other terms of supply.
Purchase Order is a legal document which binds both company & vendor to the terms
specified in purchase order.
Format of purchase order.

Purchase Order

Date ________________ Purchase Order No. __________


Supplier _____________ Requisition No. _____________

Please supply the following items on the terms and conditions mentioned below:
Sr. No. Particulars Qty. Rate P.U.(Rs.) Total Cost
1. Paint (Code No. ZX 103) 80 lit 300 24,000
2. Acetone (1 Normal) 200 lit 1,500 30,000
3. Caustic soda (0.2 N) 100 lit 1,800 18,000
Basic Price 72,000
+Packing & Forwarding 1,500
+Excise 8,500
+Sales Tax 10,000
TOTAL 92,000
Terms & Conditions :
i) Delivery within 15 days
ii) Credit One Month

S/d
( Purchase Manager )

II) Functions of Purchase department:


To develop appropriate no. of vendors who will consistently supply desired material
in right quantity.
To ensure that right material is available in right quantity at right time
To draft purchase agreements & contracts.
To negotiate with suppliers.
To fix business terms with suppliers & ensure that these are regularly followed by
them.
To ensure that suppliers are paid in time by accounts department.
To remove defaulting suppliers from list of approved suppliers.

III) Qualities of Purchase Manager


He must know technical specifications of materials to be purchased.
Expert in negotiations.
Knowledge of purchase procedure
Aware with market condition
Know government policies, taxes & procedures
Aware of international market
Know legal aspects related to contracts & agreements
Effective communication skills
Good management qualities
Thorough understanding of products & material requirements for various products.

4.3 Material Receipt


On the basis of purchases order material is dispatched by supplier which is received
inside company
Materials received in company are divided into 2 groups materials to be inspected
and materials to be received without inspection
Materials to be inspected are received in materials inspection department where they
are inspected for quality & technical parameters. Material Inspection Note is prepared
by this department. If materials are accepted, they are sent to stores to be received by
stores keeper. If materials are rejected they are sent back to supplier along with Debit
Note or Goods returned Note for reduction in payment to be made to supplier.
Materials accepted by inspection department & materials which do not require any
inspection are directly received in stores by stores keeper. He prepares document
known as Goods Received Note (G.R.N.) Copies of G.R.N. are send to purchase
department & accounts department for payment to supplier.

4.4 Material Issue


Material received in stores is properly stacked at appropriate location so than it is not
damaged and can be easily located as & when required.
When production department requires materials, document known as Stores
Requisition Note (S.R.N.) or Material Requisition Note( MRN) is raised & on
authority of this document material is issued to production
Excess material lying with production is returned back to stores along with document
Materials Return Note (M.R.N.)
Any material transferred from one unit to other unit is accounted for by document
Materials Transfer Note (M.T.N.)
Any Receipt, issue & balance quantity of materials is entered in document known as
Bin Card. This is an important document for stock control.

BIN CARD

Bin Card Shows Quantity details.


Where balance quantity shows maximum minimum or reorder level, appropriate
actions are initiated by stores keepers.
Quantity for each different material separate Bin Card is maintained.

BIN CARD
MATERIAL : MAX LEVEL:
CODE NO: MIN. LEVEL:
LOCATION: REORDER LEVEL:
RECEIPTS ISSUES BALANCE REMARKS

DT. GRN QTY. DT SRN QTY. QTY.


NO.

4.5 Methods of Pricing of issues


Materials to be issued to production are to be properly priced, so that exact material
cost which goes into the product can be known.
(a) FIFO
First in first out
Materials purchased first are issued at that rate
Issued in order in which they are received in stock.
Method is acceptable under standard accounting practices
Closing inventory is valued at most recent market price
When prices are rising closing valuation is more resulting in higher profits,
higher taxes & dividend.
Method is useful when frequency of material issue is less & market price is
stable.
Acceptable to income-tax department.
(c) LIFO
Last in first out
Materials purchased last are issued first.
Issues are made at the current market prices
The cost of production reflects the current cost which can be correlated with
the current sales revenue.
Fixation of selling price is facilitated, since the cost of product is more
realistic
Closing stock may not reflect the true market price
Frequent changes in prices may lead to distortion in cost calculations.

( c ) Simple Average:
Simple of the prices according to the lots available in stock are worked out for
fixing the price of issue
For every new purchase a new average price is worked out
While calculating the simple average prices of the lots that have been
exhausted are not considered.
Issues are made in the same manner as First in First Out and the prices of the
lots are accordingly averaged for the purpose of issue.
Issue price= Total units prices of the materials in stock / Number of prices

(d) Weighted Average Cost. (WACO)


Issue price is recalculated every time when material is received
Weighted price = P1Q1 + P2Q2 / Q1 + Q2
Method tends to smooth out fluctuations in prices.
More clerical work is involved.
When prices are rising closing, stock is valued less as compared to FIFO &
when decreasing it is valued more as compared to FIFO
Document used for material pricing is stores ledger

STORES LEDGER
Shows Quantity & amount
Useful to costing department
Used for inventory valuation & material costing

FOLIO NO: MAX. LEVEL:


MATERIAL STORES LEDGER MIN. LEVEL:
CODE NO: RECORDER
LEVEL:
RECEIPTS ISSUES BALANCES
DT GR QTY RAT AM DT MRN QTY RAT AMT QTY RAT AMT
. N . E T . . NO. . E . . E .
NO.
Illustration 1

1. Following is the record of receipts and issues of certain material in the factory during the
week of April 2015

1 /4 /15 Opening stock 50 tonnes @ Rs. 10 per tonne.


1 / 4 /15 Issued 30 tonnes
2 / 4 / 15 Received 60 tonnes @ Rs. 10.20 per tonne.
3 /4 / 15 Issued 25 tonnes (Stock verification reveals loss of one tonne)
4 / 4/ 15 Received back 10 tonnes (previously issued at rs.9.15 per tonne)
5 / 4 /15 Issued 40 tonnes
6/ 4/ 15 Received 22 tones @ Rs.10.30 per tonne
7 / 4 /15 Issue 38 tonnes
Use LIFO method and show at what prices you will issue the materials

2. A Ltd. Furnishes the following store transactions for September 2015

Sept
1 Opening Balance 25 units value Rs. 162.50
4 Issues Req. No. 85 8 units
6 Receipts from B & Co GRN No. 26 50 units @ Rs.5.75
per.unit
7 Issues Rq. No. 97 12 units
10 Returns to B & Co. 10 units
12 Issues Req. No. 108 15 units
13 Issues Req. No. 110 20 units
15 Receipts from M& Co. GRN No. 33 25 units @ Rs. 6.10
per.unit
17 Issues Req. No.121 10 units
19 Received replacement from B& Co. GRN No. 38 10 units
20 Returned from department material of B & Co. MRN 5 units
No.4
22 Transfer from Job 182 to Job 187 in the Dept. MTN 6 5 units
26 Issues Req. No 146 10 units
29 Transfer from Dept. A to Dept. B MTN 10 5 units
30 Shortage in stock taking 2 units
Write up the priced stores leger on FIFO method and discuss how would you treat the
shortage in stock taking.

3. The following particulars have been extracted in respect of material X. Prepare a stores
ledger A/c showing the receipts & issues, pricing the material issued on the basis of
a. Simple average method
b. Weighted average method

Receipts
1-10-2014 Opening stock 200 units Rs. 3.50 per unit
3-10-2014 Purchased 300 units Rs. 4.00 per unit
13-10-2014 Purchased 900 units Rs. 4.30 per unit
23-10-2014 Purchased 600 units Rs. 3.80 per unit
Issued
5-10-2014 Issued 400 units
15-10-2014 Issued 600 units
25-10-2014 Issued 600 units

4. From the following information, prepare Store Ledger using First In First Out [FIFO],
Last In First Out [LIFO] and Weighted Average Method of pricing the issues.

December 1st Balance in hand 1000 units @ Rs.1 each.


December 15th Received 3000 units costing Rs.3, 300
January 12th Received 2000 units costing Rs.2400
January 30th Issued 2000 units
February 17th Issued 3400 units.

4.6 Material Stock Control


This involves holding inventory of raw materials at levels such that there is neither
overstocking nor there is production stoppage. It is a systematic regulation of stock
level. It covers following areas:
Ordering & Purchasing
Receipt & Storage
Issues to production
Following are requirements for better stock control:
Materials are purchased only by purchase department only.
Purchase through proper authority of respective department head.
Purchase planning
Purchasing material of proper quality & specification
Standardization of materials
Proper receipt & inspection of materials
Proper storage of materials
Accurate documentation & accounting
Maintenance of BIN cards & Stores Ledger
Material issue only against authority
Continuous stock checking
Use of latest inventory techniques
Proper classification & codification
Proper procedures for dealing with shortages/discrepancies.

4.7 Different Inventory Levels

Reorder level
- Level at which new order should be raised.
- At this point stores initiates purchase requisition
- It is between maximum & minimum level.
- Reorder level = maximum usage X maximum lead time

Minimum level:
- Lower limit of stock.
- Below this level stock of any stock item should not normally be allowed to fall.
- Also called safety or buffer stock level.
- Main object of establishing this level is to protect against stock-out of a stock-item.
- It is fixed by considering average rate of consumption and lead time.
- Minimum level =Recorder level (Av. or Normal usage X Av.or normal lead time


Maximum level
- Represents upper stock limit.
- Stocks not allowed to rise beyond this level.
- If the stocks go beyond this level, there is overstocking of materials &
- funds are blocked on which more interest is required to be paid.
Maximum level=Recorder level + Recorder Qty. or E.O.Q. (Min. usage X min. lead time)

Average stock level


- Av. level = Max. level + Min level / 2 OR

= Minimum level + (E.O.Q)

- This is the average inventory carried by company.

Problems

1. Two materials P & Q are used as follows


Usage : Maximum : 100 per week each
Minimum : 30 per week each
Average : 65 per week each
Recorder quantity : P : 350 Q : 600
Recorder period : P : 4 to 6 weeks Q : 2 to 4 weeks

Decide : (a) Recorder level


(b) Maximum level
(c) Minimum level
(d) Av. level of stock
Solution :
(a) Re order level = max. usage per week x max. recorder period
(P) = 100 x 6 = 600 units
(Q) = 100 x 4 = 400 units

(b) Max. level =(Recorder level) +(Recorder Quantity)-[Min. usage x Min. Re. period]
( P) = 600 + 350 - [ 30 x 4 ] = 830 units
(Q) = 400 + 600 - [ 30 x 2 ] = 940 units

(c) Min. level.= (Recorder level)-(Normal or av. usage x Normal or av. recorder period)
(P) = 600 - ( 65 x 5 ) = 275 units
(Q) = 400 - ( 65 x 3) = 205 units

(d) Average level = [ maxm. Level + min. level ] / 2


(P) = ( 830 + 275 ) / 2 = 552.5 units
(Q) = (940 + 205 ) / 2 = 572.5 units

Average level = Min. level + ( Recorder Qty. )


(P) = 275 + x 350 = 450 units
(Q) = 205 + x 600 = 505 units

2. From following information calculate Re-order quantity


Average usage = 100 units per week
Minimum recorder period = 6 weeks
Maximum usage = 150 units
Average re-order period = 8 weeks
Average stock level = 1,000 units .

4.8 Economic Order Quantity


Inventory cost has 3 components
- cost of ordering inventory
- cost of holding/carrying inventory.
- Stock out costs. [This is added in ordering cost.]
Ordering cost includes:
- Preparation of Purchase order
- Cost of receiving goods
- Documentation processing cost
- Transport costs
- Chasing orders
- Rejecting faulty goods
- Additional costs of frequent or small qty. orders.
Carrying cost includes
- Storage costs i.e. rent, lighting, heating, A.C. etc.
- Stores staff
- Equipment maintenance & running
- Material handling costs
- Audit, stock talking, perpetual inventory costs
- Interest on funds blocked
- R.O.I. lost on funds blocked
- Obsolescence, deterioration, pilferage etc.
- Insurance
- Security.
Stock out costs are the costs associated with running out of stock. They include:
- Lost contribution through lost sale
- Loss of future sale
- Loss of goodwill.
- Prodn. loss
- Labour idle cost & overtime
- Extra cost for urgent purchases.

Total Inventory Cost = Ordering Cost + Carrying Cost


When Ordering Cost is high means more orders are given carrying cost is low as less
inventory is carried. When ordering cost is low carrying cost is high

E.O.Q. is that order Qty when. Ordering Cost = Carrying cost & Total Inventory Cost is
Minimum
E.O.Q. = 2AO / C
A = Annual Consumption
B = Ordering Cost per order
C = Carrying Cost per unit per year
No. of orders p.a. = Annual consumption / Ordered Quantity
Inventory Carried = Ordered Quantity / 2

Illustration 1 :
Annual consumption is 20,000 units. Purchase price per unit Rs. 100. Ordering cost per
order Rs. 1,000 inventory carrying cost per unit is 10% . Decide : E.O.Q.

Solution:
E.O.Q. = 2AO
C
A = Annual Consumption (units) = 20,000
O = Ordering Cost per order (Rs.) = 1,000
C = Carrying cost (Rs. ) = 10 [ 10% of 100 ]
Putting these valued in above formula

E.O.Q. = 2 x 20,000 x 1,000


10
= 2,000 units.
Illustration 2 :
A factory requires 1500 units of an item per month each costing Rs.27. The cost per order is
Rs. 150 and the inventory carrying charges work out to 20% of the average inventory. Find
out the economic Order Quantity and the number of orders per year.

Ans.: EOQ = 100 Units and No of order per year = 18 order per annum

Illustration 3 :
From following information calculate:
(a) E.O.Q. (b) Annual carrying cost (c) Annual ordering cost
Annual consumption 3, 20,000 units
Price per unit Rs. 10
Carrying cost per unit is 10% .
Ordering cost per order Rs. 400

(b) Annual Carrying Cost = (Av. units in stocks) x (Carrying cost Per unit)

(c) Annual ordering Cost = (No. of orders) x (Ordering cost per order )

Illustration 4 :
Hemant Enterprises manufactures a special product TIM. The following particulars
were collected for the year 2014:

a) Monthly demand of TIM 1000 units


b) Cost of placing an order Rs. 100
c) Annual carrying cost per unit Rs. 15
d) Normal Usage 50 units per week
e) Minimum usage 25 units per week
f) Maximum usage 75 units per week
g) Re-order period 4 to 6 weeks
Compute from the above:
3. Re-order quantity
4. Re-order level
5. Minimum Level
6. Maximum Level
7. Average stock level

Illustration 5: Min. & Max. consumption is 25 & 75 units per week respectively. Reorder
quantity is 300 Units. Material is received within 4 to 6 weeks .
Calculate Max. Min. & Recorder level

Illustration 6: From following particulars calculate maximum, minimum, reorder & average
stock levels :
1) Cost of placing a purchased order Rs. 20
2) No. of unit sot be purchased during year 5,000
3) Annual cost of storage per unit Rs. 5
4) Lead time : Max. 15 days , Min. 6 days & average 10 days .
5) Consumption max. 20 units per day & average 15 units per day.

Illustration 7: Annual Consumption = 24,000 units


Ordering Cost per order = Rs. 100
Carrying Cost = 20%
Per unit price = Rs. 10
Decide EOQ & Total inventory Cost.

4.9 ABC Analysis


- Items of inventory are classified according to value of use
- Inventory is divided into 3 classes
Category % in total Qty. % in total value
A 5 10 80 - 85
B 10 15 10 - 15
C 80 85 5 10
- A items - max. control - physical checking weekly/fortnightly
- B items - moderate control - physical checking Quarterly
- C items - min. control - physical checking yearly & on sample basis

Just In Time
Major focus is on producing in response to needs of marketing rather than as per plans
& forecasts.

Instead of pushing inventory into the production system emphasis is on pull form
market

Inventory is procured right on time & not before

Main advantage- inventory is reduced practically to nil

Also wastages during storage & due to over production are eliminated

Unit 4 : Overheads
Introduction

In every business two types of costs are involved, direct & indirect . Direct costs are
related to output but indirect costs i.e. overheads are incurred even if output is reduced
or there is no output.
It is thus important for management to pay more attention to overhead costs. In order
to control these costs it is necessary to classify properly allocate them on equitable
basis to different products, processes or activities. This unit deals with various aspects
of overhead accounting and control & their equitable allocation.
4.1 Meaning of Overheads

Total cost of indirect material, indirect labour & indirect expenses


When expense is for specific product it is called as chargeable expense but when
expense is for all products it is treated as overhead.
e.g. Machine hired for specific product is charged to that product but it is for
general purpose it is treated as overheads.

4.2 Classification of Overheads

Element wise : Indirect Material, Indirect labour, Indirect expenses

Function wise: Production, Administration, Selling, Distribution, Research &


Development.

Behaviourwise : Fixed, Variable, Semi-variable.

4.3 Allocation & Apportionment of Overheads

Where a cost can be clearly identified with a cost centre or cost unit, then it can be
allocated to that particular cost centre or cost unit. Allocation is the process by which
cost items are charged direct to a cost unit or cost centre.
Thus Allocation means charging overheads to particular product, process, or activity

Some costs cannot be identified as arising from the activities of one specific
department or function. Non allocable costs must be apportioned on some logical
basis to the cost centres. Thus Apportionment means division of overheads among
two or more cost centers or departments using appropriate base. Choice of base is a
matter of judgment with reference to particular circumstances of each company.
Following bases are generally used.

Sr. Types of Overheads Basis of Overheads


No Apportionment
1 Repairs and maintenance to Plant and Machinery Plant/ Machine VALUE, Direct
Labour Hours, Machine hour,
Direct Wages
2 Rent, Rates and Taxes Floor area occupied by each
department
3 Lighting No of Light points
4 Power Horse power(H.P) or K.W
5 Depreciation of Plant and Machinery Book value or original cost of
the asset
6 Depreciation on building, building repairs Floor area occupied
7 Insurance, repairs and maintenance of Plant and Book value
vehicles
8 Personnel / personnel dept. expenses, staff welfare, No of employees or Number of
canteen wages, accident insurance, medical and first workers employed
aid, pensions, supervision, recreation, time office,
wages department, profit sharing payment.
9 Stores Number of stores requisition,
Value of material issued, value
of material stored
10 Indirect Wages Direct Labour Cost
11 Fire Insurance Capital Cost of Plant and
Machinery, value of stock
12 Purchase department expenses Number of purchase orders,
value of purchases
13 Sundries / General overheads/ INDIRECT WAGES Direct Wages

Personnel, Stores, Canteen etc. are service centers providing service to production
departments. Service departments may provide service to other service
departments & to itself. These overheads are also to be apportioned on the basis of
services taken by various departments.

4.4 Distribution of Overheads

Primary distribution of overheads means allocating total overheads of company to all


the cost centers using appropriate base.
Secondary distribution of overheads means allocating overheads of service cost
centers in proportion to the services taken by various production cost centers from
service cost centers

Company
O/Hs
(100)

Primary Distribution

P1 P2 P3 S1 S2
(40) (20) (20) (12) (8)

secondary distribution
4.5 Absorption of Overheads
Process of distribution of overheads allocated to a particular department or cost
center over the units produced.
Done by applying overhead absorption rate
Rate = Budgeted or actual overheads / Budgets or actual Hours
Selling & distribution overheads rate is calculated with reference to sales
quantity or sales value.
Overhead absorption rate is useful to calculate overheads to be absorbed in a
particular product e.g. if overhead rate is Rs. 50 per labour hour & product
requires 3 labour hours, then overheads to be absorbed in product cost is 3x 50 =
Rs.150.
Predetermined overhead rates: These rates are determined in advance to be
applied in future period for product costing. At the end of the period actual
overheads are found and compared with overheads absorbed on basis of pre
determined rates & over / under absorbed overheads are determined to correct
pre-determined rate. At the end of year under & over absorbed overheads are
adjusted to costing P & L A/C.

Illustrations on Overheads

Illustration 1:
A,B,C are production departments &X,Y are service departments.
Overhead expenses for July,2007
Rent Rs. 12,000
Depreciation Rs. 50,000
Repairs Rs. 5,000
Traveling Rs. 15,000
Supervision Rs. 68,000
Other details:
Department A B C X Y
Area(sq.mtr.) 500 300 100 50 50
Machine cost(lacs) 5 2 2 1 -
Employee(Nos.) 10 5 20 5 10
No. of Hours. 200 150 100 - -
X [ distribution %] 20 30 40 - 10
Y [ distribution %] 40 20 30 10 -
Decide overhead absorption rate per hour
If direct material cost is Rs. 2,500 ,direct labour Rs.1,500 & direct expenses are
Rs.200 & product passes through Dept A for 0.5 hours, B for 1.2 hours & C for
1.5 hours decide cost of product.
Solution:
[ A ] Primary distribution of overheads
Expense Total Amt. Basis of Dept. A Dept.B Dept.C Dept.X Dept. Y
(Rs.) allocation (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
1.Rent 12,000 Area 6,000 3,600 1,200 600 600
2.Depreciation 50,000 m/c cost 25,000 10,000 10,000 5,000 -
3.Repairs 5,000 m/c cost 2,500 1,000 1,000 500 -
4.Traveling 15,000 Employees 3,000 1,500 6,000 1,500 3,000
5.Supervision 68,000 Employees 13,600 6,800 27,200 6,800 13,600
TOTAL 1,50,000 50,100 22,900 45,400 14,400 17,200
Working Notes:

Allocation :
1) Rent : Ratio is 500 : 300 : 100: 50 : 50 total
i.e. 5 : 3 : 1 : 0.5: 0.5
For Dept. A = 5/10 x 12,000 = 6,000
B = 3/10 x 12,000 = 3,600
C = 1/10 x 12,000 = 1,200
X = 0.5/10 x 12,000 = 600
Y = 0.5/10 x 12,000 = 600
2) Depreciation : Ratio is 5: 2: 2:1: - Total = 10
For A = 5/10 x 50,000 = 25,000
B = 2/10 x 50,000 = 10,000
C = 2/10 x 50,000 = 10,000
X = 1/10 x 50,000 = 5,000
Y = Nil
3) Repairs (same as above )
For A = 5/10 x 5,000 = 2,500
B = 2/10 x 5,000 = 1,000
C = 2/10 x 5,000 = 1,000
X = 1/10 x 5,000 = 500
Y = Nil.
4) Traveling :
Ratio 10:5 :20 :5 :10
For A = 10/50 x 15,000 = 3,000
B = 5/10 x 15,000 = 1,500
C = 20/50 x 15,000 = 6,000
X = 5/5 x 15,000 = 1,500
Y = 10/50 x 15,000 = 3,000
5) Traveling (same as above)
For A = 10/50 x 68,000 = 13,600
B = 5/50 x 68,000 = 6,800
C = 20/50 x 68,000 = 27,200
X = 5/ 50 x 68,000 = 6,800
Y = 10/50 x 68,000 = 13,600
[B] Secondary distribution of overheads
There are many methods of this distribution. We are going to use repeated distribution
method which is most logical .
A B C X Y
Total overheads 1,50,000 50,100 22,900 45,400 14,400 17,200
Distribution X 2,880 4,320 5,760 (14,400) 1,440
(as per given %)
Distribution Y 7,456 3,728 5,592 1,864 (18,640)
(as per given %)
Repeated distribution of X 373 559 746 (1,864) 186
(as per given %)
Repeated distribution of Y 74 37 56 19 (186)
(as per given %)
Repeated distribution of X 4 6 7 (19) 2
(as per given %)
Distribution of Y 1 - 1 - (2)
1,50,000 60,888 31,550 57,562 - -
NOTE : 1) In allocation figures are to be rounded off to nearest complete rupee & total is
to be adjusted accordingly
2) Do not continue process indefinitely . When small figure is left in service
departments it is logical allocated to production departments without
applying actual % ages given in problems.
[C] Deciding overhead absorption rate: Deptt.A Deptt B Deptt. C
Total overheads (Rs.) (a) 60,888 31,550 57,562
Total Hrs. worked (Nos.) (b) 200 150 100
Overhead Rate / Hour (Rs. [a/b] 304.44 210.33 575.62
[D] Deciding cost of a product , Amt. (Rs. )
Direct material 2,000
+ Direct labour 1,500
+ Direct Expenses 200
= Prime Cost (I) 3,700
Overheads in Deptts.
A - 304.44 x 0.5 152.22
+ B - 210.33 x 1.2 252.40
+ C - 575.62 x 1.5 863.43
= Total Overheads (II) 1,268.05
Total Cost (I + II ) 4,968.05

Problems :

1. Company has 3 production departments A, B and C and two service departments X &
Y , The following data are extracted from the records of the company for a particular
given period : Amt. Rs.
1. Rent and rates 25,000
2. General lighting 3,000
3. Indirect Wages 7,500
4. Power 7,500
5. Depreciation on machinery 50,000
6. Sundries 50,000
Addition Data, Department wise
Departments
Particulars Total A B C X Y
Direct wags (Rs.) 50,000 15,000 10,000 15,000 7,500 2,500
Horsepower of
Machines used 150 60 30 50 10 -
Cost of machinery 12,50,000 3,00,000 4,00,000 5,00,000 25,000 25,000
(Rs.)
Production hours - 6,226 4,028 4,066 -
Worked
Floor space used 10,000 2,000 2,500 3,000 2,000 500
(Sq. mt.)
Lighting points 60 10 15 20 10 5
(nos.)
Service Departments Expenses Allocation
Departments A B C X Y
X 20% 30% 40% - 10%
Y 40% 20% 30% 10% -
You are required to :
(a) Compute the overhead rate of production departments using the repeated
distribution method :
(b) Hence, determine the total cost of a product whose direct material cost and
direct labor cost are respectively Rs. 250 and Rs. 150 and which would
consume 4 hours , 5 hours and 3 hours in departments A, B & C
respectively.

2. Department A B C X Y
Overheads Rs. Lacs) 8 10 6 0.75 0.25
Overhead 20 40 30 - 10
Distribution(%) 30 30 30 10 -
Hours worked 2,000 2,000 2,000 - -
Decide overheads absorption rate per hour.

3. Company has manufacturing I , II & III & Service department S1, S2,. Details of
Overheads & its allocation & other particulars are : I II III S1 S2
Overheads (Rs. Lakhs) 5.0 10.0 8.0 1.0 1.50
Allocation (%) 30 40 20 - 10
20 30 30 20 -
Labour Hours 5,000 6,000 7,000

Decide Overhead rate per labor hour

4. A company has two production departments A & B and two service departments S1 &
S2 . The budgeted expenses of the total company for 2005 is given below:
Supervision 24,00,000
Power 60,00,000
Electricity 12,00,000
Indirect wages 12,00,000
Administrative salaries 8,00,000
Depreciation of equipment 36,00,000
Depreciation of Building 36,00,000
Telephone expenses 6,00,000
Canteen expenses 8,00,000
Stores expenses 6,00,000

Following additional information is available


Dept A Dept. B S1 S2
Total No. of employees 80 65 25 20
No. of workers 70 55 10 Nil.
No. of Managers/ 4 2 1 1
Supervisors
Area in Sq. if 20,000 20,000 5,000 2,000
HP of machines 500 400 100 Nil
Cost of equipment 22 lakhs. 34lakhs. 5 lakhs . 2lakhs.
No. of items stocked 8,000 5,000 Nil Nil
No. of phone lines 10 10 5 5
Machines hours worked. 24,000 18,000 Nil Nil

Department S1 & S2 provide services to other departments in the following ratio :

A B S1 S2
S1 60% 30% - 10%
S2 40% 50% 10% -

(a) Allocate the common expenses using appropriate allocation basis.


(b) Allocate the service department costs to production departments using step
method.
(c) Calculate the cost per unit of a product whose material cost is Rs. 120
direct labour cost is Rs. 80 , and it requires 2.5 hours and 1.5 hours in
department A & B respectively.

Reference Books:

1. Cost Accounting Mr. Tulsian


2. Cost Accounting Mr. Jawaharlal
3. Management Accounting Prof. A.P.Rao
4. Cost Accounting / Management Accounting - Mr. Ravi Kishore
5. Cost and Management Accounting - M.N Arora
6. Management Accounting Mr. Khan and Jain ( Tata McGraw Hill)
7. Management Accounting Madhu Viz