Cost and Management Accounting

Unit 3-Costing Methods BBA LLB II Sem

UNIT 3
METHODS OF COSTING

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 Cost and Management Accounting
Unit 3-Costing Methods BBA LLB II Sem

UNIT COSTING:

This is also known as single or output costing. This method is suitable

for industries where the manufacture is continuous and units are
identical. This method is applied in industries like mines, quarries,
cement works, brick works, etc.

Costing procedure: In order to ascertain cost of products, a statement

known as ‘cost sheet’ is prepared periodically.

Cost sheet: CIMA defines cost sheet as “a document which provides for
the assembly of the detailed cost of a cost Centre or cost unit”.

Thus cost sheet is a periodical statement of cost designed to show in

detail the various elements of costs of goods produced like prime cost,
factory cost, cost of production and total cost.

Methods of preparing cost sheets:

A cost sheet is prepared according to the elements of cost i.e.,

materials, labour, overheads

• Materials: Materials are purchased time to time. To the cost of

materials purchased all the expenses relating to the materials are
added. e.g., carriage inwards, octroi, custom duty etc.

• Labour: A distinction is to be made between direct labour and

indirect labour. Direct labour cost which is also known as productive

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 Cost and Management Accounting
Unit 3-Costing Methods BBA LLB II Sem

wages, is taken in the Prime cost. Indirect labour cost or unproductive

wages are added to the Factory overhead

 Overheads: overheads are classified into three categories

 Factory overheads
 office overheads
 selling and distribution overheads

PROCESS COSTING:

A process refers to a stage of production. If a product passes through

different stages, each distinct and well defined, then in order to
ascertain the cost at each stage or process, the process costing is used.
Under this method, a separate process account is prepared and all costs
incurred in that process are charged.

Normally the finished product of one process becomes the raw material
of the subsequent process and a final product is obtained in the last
process. As the products are manufactured in continuous process, this
is also known as continuous costing. Process costing method is
generally followed in textile units, chemical industries, refineries,
tanneries, paper manufacture, etc.

Characteristics of process costing:

 A cost of production report is used to collect, summarize and

compute total and unit costs.
 Production is accumulated and reported by departments.
 Costs are posted to departmental work in process accounts.
 Production in process at the end of a period is restated in terms of
completed units.
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 Cost and Management Accounting
Unit 3-Costing Methods BBA LLB II Sem

 Total cost charged to a department is divided by total computed

production of the department in order to determine a unit cost
for a specific period.
 Costs of completed units of a department are transferred to the
next processing department in order to arrive at the total costs of
the finished products during a period. At the same time, costs are
assigned to units still in process.

Process costing procedure:

The essential stages in process procedure are:

 The factory is divided into a number of processes and an account

is maintained for each process.
 Each process account is debited with material cost, labour cost,
direct expenses and overheads allocated
 The output of a process is transferred to the next process in the
sequence.
 The finished output of the last process is transferred to the
finished goods account.

CONTRACT COSTING:

When the job is big and spread over long period of time, the method of
contract costing is used so Contract costing is the tracking
of costs associated with a specific contract with a customer. Contract
costing is also called terminal costing as it terminates with the
discharge of contract work. A separate account is kept for each
individual contract. Civil engineering contractors, constructional and
mechanical engineering firms, builders, etc. use this method.

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 Cost and Management Accounting
Unit 3-Costing Methods BBA LLB II Sem

In contracts, when it is agreed to pay an agreed sum or percentage to

cover overheads and profit to the contractors, it will be termed as ‘cost
plus costing’. The term cost here refers to the prime cost. Usually
government contracts are assigned in this basis.

FEATURE OF CONTRACT COSTING:

The main features of contract costing are mentioned in the following

points:

a. Contracts are execute or performed at the site which are generally

out of the contract's premises.

b. Most of the contracts involve jobs having large size and amount.

c. The duration of the completion of a contract may go beyond one

accounting year.

d. Each contract is treated as a separate unit of cost for the purpose of

cost ascertainment.

e. The contracts are executed as per the agreed specifications provided

by the contractor.

f. Most of the items of costs incurred in a contract are direct in nature

since a contract is carried out are the site.

g. The contractor carried out the work on behalf of the contractee

against a certain amount. The agreed amount is called the contract
price.

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 Cost and Management Accounting
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h. The contractee pays amount to the contractor on the basis of the

work certified out of the completed work by the engineer of the
contractee

Preparation of a contract account

Under the contract costing, a separate account is opened for each

contract so as to ascertain the position of profit or loss. Such account is
called a contract account. All the expenses incurred in the contract like
material, wages, direct expenses, plant and machinery etc. are debited
whereas material returned, and material at end, plant at end, work in
progress or contract price in case of completion of the contract etc. are
credited in the contract account. The difference between the debit and
credit represents the loss or profit. The profit earned under the
completion of the contract is regarded as net profit or net loss in case
of loss. The profit earned from the contract which is in progress or not
completed is called notional profit. When loss takes place in such a
situation, it is called net loss. It is because that a loss can never be
notional, it is always real

a. When contract is totally competed: some contracts are small and

can be completed within a year. In such a case, total contract price is
show on the credit side of the contract account as contracture's
account. In this case, if credit is heavy then balancing figure on debit
side is called profit and if the debit side is heavy, then the balance
figure on credit side will be called a loss.

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 Cost and Management Accounting
Unit 3-Costing Methods BBA LLB II Sem

b. When contract is incomplete: large contract take number of years

for completion. In this situation, amount of work certified and
uncertified are found in the contract. Such amount of work certified
and uncertified should be shown on the credit side of the contract
account under the head work-in progress account.

1. Work certified: the value of work completed and certified by

contractee's engineers and architects is called work certified. As per
provision of the contract, a fixed percentage of such work certified is
paid by contractee to contractor. Some percentage of work certified is
retained money. The work certified included the portion of notional
profit therefore, if the cost of certified is lower than the work certified,
the different amount is called profit, if the amount of cost of work
certified is higher than the work certified, the different will be loss.

2. Work uncertified: on the date of preparation of contract account,

there may be some competed but uncertified work. The work of
contract which is completed but not certified by the engineers is called
work uncertified. It is always recorded at cost price and not on contract
prices so as to avoid any profit element in it. The work uncertified never
includes the portion of notional profit.

Methods-of-transferring-profit

The profit earned against the completion of a contract is assumed to be

the net profit and transferred to profit and loss account. Generally, a
contract is completed in a long-period of time and the profit/loss is to
be calculated at the end of each accounting period. Out of the national

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profit i.e. the profit earned during the work in progress, only some
portion is to be transferred to profit and loss account. The during the
work in progress, only some portion is to be transferred to profit and
loss account. The remaining part of the notional profit is transferred to
reserve. There are some factors which are to be considered to transfer
the proportion of notional profit to profit and loss account and
reserved. They are:

a. Work certified: the work of a contract completed by a contractor is

supervised and certified by the engineer of the contractee. The portion
of the work completed and certified by the contractee is called the
work certified. The work completed but not certified due to different
treasons is called the work uncertified. Work certified is one of the
bases of transferring the national profit to the-profit-and-loss-account.

b. Cash received: the contractor received cash from the contractee

depending on the level of work completed. He/she received cash on the
basis of work certified. The whole amount of work certified is not paid
to the contractor. The portion of work certified that is not paid to the
contractor is known as retention money.

Some other items used in costing account

a. Labour cost: All the workers engaged at the site of a particular

contract, irrespective of the nature of the work performed by items, are
treated as direct workers and the amount of wages paid to them as
direct wages. Such wages are to be charged to the particular contract
directly. In case a worker (generally the supervisory staff) is engaged at
two or more contracts, his total wages may be apportionment to
different contract on the basis of time devoted to each contract or on
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some other equipment basis' wages accrued or outstanding at the end

of the accounting period should appear on the debit side of the
contract account.

b. Direct expenses: All expenses (other than material cost and direct
wages)

Which have been incurred specifically for a particular contract are

direct expenses and shall be debited to contract a/c. Example of direct
expenses are: hire charges of special plant (not owned), carriage on
materials purchase, travelling expenses relating to contract, etc.

c. Indirect expenses: There are certain expenses, which cannot be

directly charged to a particular contract e.g., salary of general manager,
salary of architect engaged at a number of contract simultaneously,
salary of storekeeper, expenses of store and office expenses. Since
these expenses are incurred for the business as a whole, they are to be
apportioned to the different contract on some equitable basis.

d. Cost of sub-contracts: generally, the work of a specialized character

e.g., road construction, installation of lifts, electrical fittings, is passed
on to some other contractor by the main contractor. In such cases, the
work performed by the sub-contractor forms a direct charged to be
contractor concerned and the sub-contractor price paid shall be
debited to contract account.

e. Cost of extra work: sometimes, in case of a contract, some additional

work may be required by the contractee. Since the additional work
required will not be covered by the terms and condition of original
contract, it will be the subject of a separate charge., if the additional

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 Cost and Management Accounting
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work required by the contractee is quite substation, it should be

treated as a separate contract and dealt with in a separate account to
be opened for it. But in case the additional work is not substantial, the
expenses incurred on extra work should be debited to contract account
as 'cost of extra work' and the extra amount which the contractee has
agreed to pay to the contractor should be added to the original
contract price.

f. Contract price: the contract price is the agreed price at which the
contractor undertakes to execute to contractor. The contractor account
is credited with the contract price if it has been completed. In such a
case, the amount of contract price is debited to the 'contractee's
personal account and credited to the 'contract account'. No entry is
passed in respect of the contract price in case of incomplete contracts.

g. Retention money: generally, the terms of the contract provide that

the whole of the amount shown by the archive's certificate shall not be
paid to the contractor but a specified percentage or portion money (say
10% or 20%) thereof shall be retained by the contractee till the contract
is complete. The money so retained is known as 'Retention money'.
The cash received from the contractee is credited to his personal
account. The value of work (certified and uncertified) is debited to
work-in progress account. The work-in-progress account is shown as an
asset in the balance sheet after deducting the amount received from
the contractee. In the beginning of the next year the work-in-progress
account is transferred to the debit side of the contract account. On
completion of the contract, the contractee's account is debited and
contract account is credited by total contract price.

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 Cost and Management Accounting
Unit 3-Costing Methods BBA LLB II Sem

Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to

products in a more logical manner than the traditional approach of
simply allocating costs on the basis of machine hours. Activity based
costing first assigns costs to the activities that are the real cause of the
overhead. It then assigns the cost of those activities only to the
products that are actually demanding the activities.

Steps in developing ABC system:

1. Identify the main activities performed in the organization

2. Identify the factors which influence the cost of each activity
3. Collect the accurate data on various direct and indirect costs
4. Establishing the demands made by particulars products on
activities
5. Trace the cost of activities to products according to a product’s
demand for each activity.

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