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UNIT I
LESSON 1
PURCHASE OF MATERIAL
CONTEXT OF THE LESSON
The lesson deals to familiarize with the procedure of purchase of material in the
organizations and the various methods for pricing of material issue along with
maintenance of stock register which highlights the receipt, issue and carrying inventories.
INTRODUCTION
Material is a most significant element in the finished product. About 60% of the total cost
is constituted by material cost.Material cost is divided into two categories: (a) Direct
Material cost (b) Indirect Material cost.
Direct material costs are directly traced with the finished product and the indirect material
costs are conveniently transferred to indirect cost or overhead. Further, indirect material
costs are present in Manufacturing, Administrative and Marketing costs. In the cost of
service rendered, the share of material cost is less than the other expenses.
Since the materials take major share, especially in the manufacturing of a product, it is
necessary to have proper control over materials. Control is exercised from the point of
purchase to the point of conversion. It involves activities such as purchase, storing,
issuing of the materials.
Purchasing of right quantity and quality of materials in right time at right cost from right
place is the responsibility of purchase officer. At what cost the materials enter in the
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ACM 602 Cost Analysis And Control
factory is a matter of concern for cost accountant. The total cost of a product is made up
of cost materials purchased and conversion cost.
There is less control over the purchase cost of materials, as price of materials is decided
by the supplier and the carriage inward expenses depend on the outside factors such as
transportation, Taxes, etc. After the materials enter the factory premises, the cost of
material management can be brought under control. If the materials are manufactured by
the organisation itself then separate account is maintained for the same.
The purchase cost can be minimized by judicious, prudent and optimum purchase of both
direct and indirect materials.
PURCHASE PROCEDURE
Purchasing is the process of acquiring the required raw material, general supplies, spares
and tools, office stationary and other items for the production of the product and
maintenance of the business. The key to success lies in efficient purchasing of the
material of right quantity, right quality, right time, right place, right source and delivery at
the right place. Hence it is very much essential that there should prevail an efficient
system of purchase within the organization.
Careful analysis and wise judgement should prevail while dealing with external factors
such as selection of suppliers and acceptance of price and other terms, with respect to
internal factors, such as quality, quantity, time of purchase etc. Purchase procedure may
differ from organisation to organization. The important steps in purchasing and receiving
of materials may be as follows, assuming that purchases are centralized:
Bills of Materials
It is circulated to: (a) Purchase Department, (b) Stores Department (c) Cost Accounts
Department and (d) Product Department
Purchase Requisition:
(i) Storekeeper: When materials reach ordering level, the storekeeper should
initiate purchase procedure.
(ii) Production Manager: For some specific material which will be required for
the manufacture of a new product.
(iv) Department heads: For any material required for his department.
Generally two copies of purchase requisition are prepared. The original copy is sent to
the purchasing department and duplicate copy is retained and filed by the requisitioner
for his own reference.
Selection of the Supplier: The purchasing department on receipt of the duly authorized
purchase requisition has to select the source of supply. The purchase department
generally maintains a list of supplier for each type of materials and selects a particulars
supplier after inviting quotations. Emphasis is made to buy the best quality of materials at
the lowest possible price after giving due consideration to delivery dates and other terms
and conditions of purchase.
After the selection of the supplier the next step in the purchase procedure is the
preparation of a purchase order. The purchase order is the form used by the purchasing
department authorizing the suppliers to supply the specified materials at the price and
terms mentioned therein. A purchase order should be carefully prepared as it forms a
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ACM 602 Cost Analysis And Control
basis of legal contract between the purchaser and the vendor concerned. Authority to
sign purchase orders should also be restricted to selected responsible officials.
Receipt of Materials
All the materials supplied by the supplier should be received by the Receiving
Department. This department receives the goods or material and verifies their quantities
and physical conditions. The quantity is checked against the purchase order copy and
their supplier’s advice note which is normally received along with the goods.
Goods received from the supplier should be inspected for quality to ensure that they
comply with size and other specifications stated on the purchase order. If any goods need
laboratory inspection it is necessary that the goods are passed to a laboratory which will
provide a report on the quality of goods.
Where materials received are damaged or are not in accordance with specifications,
these are usually returned to the supplier along with a Debit note, informing the supplier
that his account has been debited with the value of material being returned. The supplier
signifies his acceptance by the issue of a credit note. The rejected materials may be
returned to the supplier.
When the invoice is received by the purchasing department the invoices are numbered
serially and entered in the Invoice Register. The following documents are assembled in
support of the invoice: (a) Purchase Order (b) Goods Received Note (c) Inspection
Report, if not incorporated in the Goods Received Note, (d) Debit or Credit Note. After all
documentation work is over and payments are fully authorized by the concerned
departments, payments are made to the supplier and receipt is received in this regard.
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ACM 602 Cost Analysis And Control
The price at which material issued are to be charged when they are issued to the various
production department or cost centre for the purpose of production of the product is a
difficult problem. There may be certain circumstances when a particular or same type of
material may have been purchased in different lots at different dates at different prices.
At the time of issue it may even be possible that a same type of material being issued to
the production department may be priced at different prices on the same day due to the
method being adopted for pricing of issued material. This means that actual cost of
material issued to the production department may include different prices under the same
method of pricing the issue of material.
There are various methods of pricing of issued material which are being used by the
manufacturing concerns. These methods can be broadly classified as follows:
There are certain occasions when the materials are purchased to be utilized particularly
for a specific job or issues can be identified with a particular receipt. In these cases, the
actual purchase price can be charged. This method can be adopted when prices are
stable or when the materials are covered by price control orders. This method has very
limited application.
This method is based on the assumption that materials which are purchased first are
issued first. It uses the price of the first lot of materials purchased until all units from this
lot have been issued. In other words the, materials are issued at the oldest cost price
listed in the stores ledger account and thus, the materials in stock are valued at the price
latest purchased. It should be noted that this assumption of FIFO is only used for
accounting purpose i.e., the physical flow of materials need not necessarily be in the order
of the flow of cost; though normally materials would be expected to move out of stock on
approximately a FIFO basis because oldest stocks are usually consumed up first.
Advantages:
(I) It is good inventory management system since the oldest units are used first and
inventory consists of the latest stock.
Disadvantage:
(III) It does not present the true picture when many lots are purchased at different
prices. The calculation becomes complicated.
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ACM 602 Cost Analysis And Control
(V) High inflation creates problems in replacing used materials, this aspects is not
dealt with in FIFO.
(VI) Usually more that one price can be adopted for a particular issue.
(VII) Cost comparisons between two batches of production become difficult when
issues are priced differently.
Illustration1. Following data is available with respect to material M1 for the month of July
2013. Opening stock 300 units @ 26 per unit.
Purchase: Issues:
08/07/2013 200
09/07/2013 800 22
15/07/2013 500
16/07/2013 600 20
26/07/2013 800
27/07/2013 800 19 Prepare a stores
31/07/2013 700
ledger Account under
FIFO method
Solution: -
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ACM 602 Cost Analysis And Control
FIFO Method
Date Receipts Issue Balance
700 24 16,800
800 22 17,600
600 20 12,000
800 19 15,200
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ACM 602 Cost Analysis And Control
Illustration 2: Following particulars are available with respect to the material M4 for the
month of June 2013.Opening stock balance 800 Kgs at Rs. 12 per Kg. Stock verifier
reported a shortage of 10 kg on 29th June 2013 and surplus of 20 kgs on 25th June 2013.
2013 Particular
June
Prepare a stores ledger Accounts under FIFO method and ascertain (i) cost of material
issued during the month & (ii) closing stock on 30/06/2013
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ACM 602 Cost Analysis And Control
FIFO Method
Date Receipts Issue Balance
June13 Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.
1 - - - - - - 800 12 9,600
2 1000 14 14,000 - - - 800 12 9,600
1000 14 14,000
8 - - - 700 12 8,400 100 12 1,200
1000 14 14,000
14 900 12 10,800 - - - 100 12 1,200
1000 14 14,000
900 12 10,800
23 Return
40 14 560 - - - 140 14 1,960
850 12 10,200
25 Surplus
20 14 280 - - - 140 14 1,960
850 12 10,200
20 14 280
The principle adopted is that the material used in production is from the latest purchase.
The inventory is priced at the oldest costs. As the method applies the current cost of
material is changed to the cost units. It is also known as the replacement cost method. It
is the most significance method in matching cost with revenue in the income
determination procedure.
Advantages:
(I) It is simple and commonly used by the industry in practice for reaping the tax
benefits.
(II) It is a systematic method. It matches current costs with current revenues in a better
ways.
Disadvantages
(I) In case of high fluctuation in the rates of material, the method becomes
complicated
(II) More than one price may have to be taken into consideration for an issue.
(III) Due to variation in cost inter-firm and intra-firm comparison becomes difficult.
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ACM 602 Cost Analysis And Control
Illustration 3. Popline Company uses a raw material called pop for its production
purpose. The details are as below:
(d) Highest-in-first-out
In this method the costliest material is issued first, inventory is valued at the lowest
possible price. It is mainly used for monopoly products or cost plus contacts.
In base stock method a certain level of minimum stock of a material is always carried and
it is priced at the original cost (usually at the lowest purchase price). The portion of the
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ACM 602 Cost Analysis And Control
stock above this level is issued and priced under any one of the methods. The
disadvantage of this method is that the stock may be under valued and hence the
computation of return on capital will not be reliable.
The simple average is the average of prices ignoring the quantities involved. This method
is used when the prices are normally stable and the stock purchased are in equal
quantities or the value of stock is very small. It is ascertained by dividing the total rates of
material by the number of rates of material. A new average is worked out after every
receipt.
Illustration4. The following were the receipts and issue of material ‘Zed’ during March
2013
From the above, write the store ledger account on Simple Average Method.
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ACM 602 Cost Analysis And Control
March Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.
1 - - - - - - 1100 - 66,000
3 - - - 140 60 8,400 960 - 57,600
4 - - - 250 60 15,000 710 - 42,600
8 - - - 210* 60 12,600 500 - 30,000
13 400 59 23,600 - - - 900 - 53,600
14 30 58 1,740 - - - 930 - 55,340
16 - - - 350** 59 20,650 580 - 34,690
20 480 62 29,760 - - - 1,060 - 64,450
24 - - - 608*** 59.75 36,328 452 - 28,122
25 640 60 38,400 - - - 1092 - 66,522
26 - - - 524**** 61 31,964 568 - 34,558
28 24 60 1,440 - - - 592 - 35,998
31 150 64 9,600 - - - 742 - 45,598
* = All issue on 3rd, 4th, and 8th are on Rs. 60 ** 60+59+58/4 = 59
For determining the weighted average price the total quantities and total costs are taken
into account. After every purchase weighted average price is calculated by adding the
quantity received to the stock in hand and the cost is divided by the quantity to arrive at
the value. This method avoids price fluctuations and reduces the number of calculation
and gives an acceptable figure for stock.
Advantages
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ACM 602 Cost Analysis And Control
Disadvantage
Illustration 5. The following purchase has been extended in respect of material “Exe”.
Prepare store ledger account under “Weighted average method” of pricing material issue:
Receipts - Issues:
Oct. Particular
Oct. Particular
3 Purchased 500 units at Rs. 4
5 Issued 400 units
4 Purchased 100 units at Rs. 4.20
10 Issued 50 units
10 Purchased 50 units at Rs. 4.25
15 Issued 900 units
13 Purchased 800 units at Rs. 4.30
25 Issued 450 units
23 Purchased 850 units at Rs. 3.80
Oct. Qnty Rate Amt. Qnty Rate Amt. Qnty Rate Amt.
(a) Standard Price Method: The price of issue for each item is pre-determined for a
stated period taking into accounts all the factors affecting price, e.g., market trends,
transportation cost, etc. standard prices are determined for each material. All issues
and inventory are kept at the standard price. This price should be revised from period
to period. Standard can be basic or current standard. The basic standard is fixed for
long periods and gives the ideal price, it assists forward planning. Current standard
keeps costs of the product adjusted to prevailing trends in markets.
Advantages:
(III) It helps to determine purchase efficiency. It actual cost is more than the
standard than there is unfavorable purchasing efficiency and vice-versa.
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ACM 602 Cost Analysis And Control
Disadvantage
(I) It does not reflect the actual or expected cost but only a target.
(b) Inflated Price Method: In this method the cost of the material to be issued is inflated
by the amount of lost of material. Inflated price includes carrying costs, losses due to
evaporation etc. it aims to recover full costs of material purchase.
(c) Replacement Price Method: Material may be issued at the replacement price. The
replacement price is the cost of the same type of materials in the market at any given
time.
THEORETICAL QUESTIONS
1. Discuss the different methods of pricing the materials issued from stores for
production.
2. Discuss the merits & demerits of the following methods of valuation of inventories of
issued material:
Question 1. Prepare a store ledger account from the following transaction adopting the
FIFO method of pricing out issue
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ACM 602 Cost Analysis And Control
Receipts Issues
Date Qty. Rate Date Issue
Dec. Dec. 4 100
3 200 20.00 10 50
18 300 18.00 20 300
28 50 15.00 30 100
Question 2. From the following particulars prepare “Stores Ledger Account” showing
issue of material for the month of December under FIFO method
Receipts Issues
Date Qty. Rate Date Issue
Aug. Aug.
3 750 2.00 19 850
18 350 2.10 26 450
25 600 2.20 29 510
28 500 2.30 30 150
Question 3. With the help of the following particulars, prepare stores Account showing
issue of materials on the basis of LIFO:
Question 4. From the following information, write the stores ledger account based on
Opening stock on 1st may 2008, 1,100 units @ Rs. 60 per unit.
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ACM 602 Cost Analysis And Control
Question 5. From the following particulars, prepare stores ledger for the month of Jan.
2008, showing material issue process on the Weighted Average Price Method:
Receipts Issues
Date Qty. Rate Date Issue
Jan. Jan.
1 500 2.00 1 400
10 200 3.00 15 100
18 400 4.00 22 200
27 300 5.00 31 300
29 Return 10 unit issue on 15th Jan.
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ACM 602 Cost Analysis And Control
Lesson 2
MATERIAL COST
The term 'material' refers to all commodities that are consumed in the process of
manufacture. It is defined as "anything that can be stored, stacked or stockpiled."
Direct materials are those whose consumption may be identified with specific
production units and which usually become a part of the finished product. Direct
materials include not only the raw materials entering at the start of the production but all
of the following:
(1) Component parts used in a product, e.g., tyres and tubes in a car, picture tube in a
television set, etc.
(2) Any material used in production but wholly consumed in the production process, e.g.,
fertiliser used in growing plants.
(3) Any primary packing material, i.e., any container sold with the final product, e.g., cans
for tinned food and drink, bottles for beer, etc.
Indirect materials are those which cannot be conveniently identified with individual
cost units. Examples are coal, grease and oil, soap, sandpaper etc.
The term 'inventory' is used to cover the stocks of raw materials, components, work-in-
progress and finished goods. It has been defined by the Accounting Principles Board as
"the aggregate of those items of tangible personal property which (i) are held for sale in
the ordinary course of business, (ii) are in the process of production for such sales, or
(iii) are to be currently consumed in the production of goods or services to be available
for sale."
No cost accounting system can become effective without proper and efficient control of
materials. This is so because quite often material is the single largest element of cost,
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ACM 602 Cost Analysis And Control
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ACM 602 Cost Analysis And Control
For each type of product, there is a particular type of quality of material which is
needed and that quality alone should be purchased.
f) Information about materials: Not only should materials be available when required,
there should also be a system to give complete and up-to-date accounting information
about the availability of materials. Sometimes inadequate information about
availability of materials may cause new purchases to be made of materials already in
stock.
Ideally, material control must ensure that the following requirements are fully met:
7. The storage of all materials should be well planned, subject to adequate safeguards
and supervision.
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ACM 602 Cost Analysis And Control
8. The various stock levels like minimum, maximum, etc. should be fixed for each item
of material.
10. An efficient system of internal audit and internal check should be operated so that all
transactions involving materials are checked by reliable and independent persons.
11. There should be regular reporting to management regarding purchases, issues and
stock of materials. Special reports should be prepared for obsolete items, spoilage,
returns to suppliers, etc.
Various techniques commonly used for inventory control are listed below:
ABC technique is a value based system of material control. In this technique, materials
are analysed' according to their value so that costly and more valuable materials are
given greater attention and care. All items of materials are classified according to their
value—high, medium and low values, which are known as A, B and C items respectively.
ABC technique is sometime called Always Better Control method.
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ACM 602 Cost Analysis And Control
'A ' Items—These are high value items which may consist of only a small percentage of
the total items handled. On account of their high cost, these materials should be under
the tightest control and the responsibility of the most experienced personnel.
'B' Items—These are medium value materials which should be under the normal control
procedures.
'C' Items—These are low value materials which may represent a very large number of
items. These materials should be under simple and economical methods of control.
The point of classifying stock into A, B and C categories is to ensure that material
management focuses on A items where sophisticated controls should be installed. B
items may be given less attention and C items least attention.
Thus ABC technique is a selective control which aims at concentrating efforts on those
materials where attention is needed most. This is so because it is unwise to give equal
attention to all items in stock. The items are listed and ranked in the order of their
descending importance showing quantity and value of each item. This is illustrated below
with arbitrary percentage figures.
A 70 10 Strict control
B 25 30 Moderate control
C 5 60 Loose control
In the above table it is shown that 10% of the total items account for as much as 70% of
the total value. These are A category items which need very strict control because of
their high cost significance. The second types of items represent 30% of the total quantity
but account for 25% of the total value. These are B items which need routine type of
control. Finally, the items representing 60% of the total quantity account only for 5% of
total value. These C items are kept under simple physical control. The rules regarding
purchasing, storing and issuing of various categories of items should be formed
according to the value and importance of materials.
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ACM 602 Cost Analysis And Control
a) Closer and stricter control can be exercised on those items which represent large
amounts of capital invested.
b) Investment in inventory is regulated and funds can be utilised in the best possible way.
VED Analysis
VED analysis divides items into three categories in the descending order of their critically
as follows:
a) 'V' stands for 'vital items' and their stock analysis requires more attention, because
out-of- stock situation will result in stoppage of production. Thus, 'V' items must be
stored adequately to ensure smooth operation of the plant.
b) 'E' means 'essential items'. Such items are considered essential for efficient running
but without these items the system would not fail. Care must be taken to see that they
are always in stock.
c) 'D' stands for 'desirable items' which do not affect the production immediately but
availability of such items will lead to more efficiency and less fatigue.
VED analysis can be very useful to capital intensive process industries. As it analyses
items based on their importance and it can be used for those special raw materials which
are difficult to Procura.
FNSD Analysis
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ACM 602 Cost Analysis And Control
position of the particular item of inventory is satisfactory. If the age of any particular item
of inventory is high, indicates the slow moving of stock which may be due to lower
demand for the product inefficiency in stocking policy, excessive stocking etc. The
excessive investment in stocks mean high investment is locked-up in inventory which
leads to lower profitability of the firm due to excess carrying costs. FNSD analysis divides
the items into four categories in the descending order of their usage rate as follows:
a. 'F' stands for 'fast moving items' and stocks of such items are consumed in a short
span of time. Stocks of fast moving items must be observed constantly and
replenishment orders be placed in time to avoid stock-out situations.
b. 'N' means ' normal moving items' and such items are exhausted over a period of a
year. The order levels and quantities for such items should be on the basis of a new
estimated future demand, to minimize the risks of a surplus stock.
c. 'S' indicates 'slow moving items' existing stock of which would last for two years or
met at the current rate of usage but it is still expected to be used up. Slow moving
stock must reviewed very carefully before any replenishment orders are placed.
d. 'D' stands for 'dead stock' and for its existing stock no further demand can be
foreseen. Dead stock figures in the inventory represents money spent that cannot be
realized but it occupies useful space. Hence, once such items are identified, efforts
must be made to find alternative uses for it. Otherwise, it must be disposed off.
The prime objective of inventory management is to find out and maintain optimum level of
investment in inventory to minimize the total costs associated with it. The economic order
quantity (EOQ) is the optimum size of the order for a particular item of inventory calculated
at a point where the total inventory costs are at a minimum for that particular stock item. It
is an optimum size of either a normal outside purchase order or an internal production
order that minimizes total annual holding and ordering costs of inventory. Stock-out costs
are difficult to incorporate into this model. Since they are based on qualitative and
subjective judgment. The ordering costs are the costs of placing a separate order
multiplied by the number of separate orders placed in the period. The carrying costs can
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ACM 602 Cost Analysis And Control
be calculated based on the assumption that annual cost of carrying a particular stock item
on average, half the stock is on hand all the time in addition to the safety or buffer stock.
The fewer the orders, the lower costs of ordering, but the greater the size of the order the
greater the costs of carrying. The safety or buffer stock has no bearing on the EOQ, only
on the timing of orders. The EOQ is an optimum quantity of materials to be ordered after
consideration of the following three categories of costs:
d) Transport costs
g) Where goods are manufactured internally, the setup and tooling costs associated with
each production run.
Stock-out Costs The stock-out costs are associated with running out of stock which
include the following:
(a) Lost contribution through the lost sales caused by the stock-out
(g) Extra costs associated with urgent replenishment purchases of small quantities
Assumptions of EOQ
That replenishment is made instantaneously, le., the whole batch delivered at once.
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ACM 602 Cost Analysis and Control
The annual demand for an item is 3,200 units. The unit cost is Rs. 6 and inventory
carrying charges 25% p.a. If the cost of one procurement is Rs. 150, determine:
Solution:
Time between Two Consecutive Orders = 800 units= 4 orders in a year = 12 months/4
orders = 3 months
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ACM 602 Cost Analysis and Control
A particularly unrealistic assumption with the basic EOQ calculation is that the price
per item remains constant. Usually some form of discount can be obtained by
ordering increasing quantities. Such price discounts can be incorporated into the
EOQ formula, but it becomes much more complicated. A similar approach is to
consider the costs associated with the normal EOQ and compare these costs with
the costs at each succeeding discount point and then ascertain the best quantity to
order. Price discounts for quantity purchase have three financial effects, two of
which are beneficial and one adverse.
2. The large order quantity means that fewer orders need to be placed and
hence, ordering costs are reduced.
Adverse effects - Increased costs arise from the extra stock holding costs caused by
the average stock level being higher due to the larger order quantity.
Illustration 2.
From the following particulars with respect to a particular item of materials of a
manufacturing company, calculate the best quantity to order:
Ordering quantity (tons) Price per ton (Rs.)
The annual demand for the material is 4,000 tons. Stock holding costs are 20% of
material cost per annum. The delivery cost per order is Rs. 6.00.
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ACM 602 Cost Analysis and Control
Solution
Statement Showing the Optimum Ordering Quantity of Materials
1. Annual demand (Tons) 4,000 4,000 4,000 4,000 4000
5. Value per order (Order size X Price per ton) 1,200 1,475 4,640 11,400 22,40
6. Average (Value per order X 1 /2) 600 738 2,320 5,700 11,200
inventory
(Rs)
Total ordering and carrying cost (a) 240 244 494 1,152 2246
Annual cost of material (Annual demand X Price) 24,000 23,600 23,200 22,800 22400
(b)
Total Annual Cost (a) + (b) 24,240 23,844 23,694 23,952 24646
* The total minimum cost at 800 tons order size is Rs. 23,694. Therefore, the best quantity to be ordered is
800 tons
Theoretical Question
EXERCISES
1) A manufacturer buys certain parts from outside supplier at Rs.30 per unit. Total
annual needs are 800 units. Further details: Annual return on investment 10%.
Rent, insurance, taxes per unit per year Re.l. Cost of placing an order Rs.100.
Calculate EOQ. [Hint: A = 800, C = 1 + 10% of 30 = 1 + 3 = 4, O = 100]
2) Annual requirement: 1600 units. Material cost per unit: Rs.40. Cost of placing and
receiving one order: Rs.50. Annual carrying cost of inventory: 10% of inventory
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ACM 602 Cost Analysis and Control
value. Determine EOQ using (a) Tabular method (b) Algebraic method and (c)
Graphical method.
3) M.S. Company Ltd. buys its annual requirements of 36,000 units of Raw material
in 6 instalments. Each order costs Rs.25. Cost of each unit is Rs.10. Annual
inventory carrying cost is estimated at 20% per unit value. Find the annual
inventory cost as per existing policy. What difference does it make if EOQ is
followed?
Ordering cost = 40
Total = 5837.15
(5) EXE Limited has received an offer of quantity discounts on its order of materials
as under:
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ACM 602 Cost Analysis and Control
The annual requirement is 5000 units. The ordering cost per order is Rs.1200 and
the stock holding cost is estimated at 20% of material cost per year. Calculate
EOQ. What will be your answer if there are no discounts offered and the price per
tonne is Rs.1500?
[Hint: It is necessary to calculate total cost for each of order size such as 400,
500, 1000, 2000 & 3000 tonnes]
(6) A company uses Rs.50, 000 worth raw material every year. The administration
cost per purchase is Rs.50. The cost per unit is Re.l and the carrying cost is 20%
of the average inventory. There is an offer of 0.4 per cent discount if they
purchase five times per year instead of the present policy. Should this be
accepted
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ACM 602 Cost Analysis and Control
Lesson 3
DETERMINATIONS OF LEVEL
In order to guard against under-stocking and over-stocking, most of the large
companies adopt a scientific approach of fixing stock levels. These levels are- (i)
maximum level, (ii) minimum level, (iii) re-order level, and (iv) re-order quantity. By
adhering to these levels, each item of material will automaticity be held within
appropriate limits of control. These levels are not permanent and must be changed to
suit changing circumstances. Thus, changes wiII take place if consumption of material
is increased or decreased or if-in the light of a review of capital available, it is decided
that the overall inventory must be increased or decreased. Modern inventory
management makes use of operations research and statistical techniques in fixing
stock levels. However, given below is the description of various levels along with
formulae that are commonly used in their computations.
Some of the factors which influence stock levels are:
1. Anticipated rate of consumption.
2. Amount of capital available.
3. Availability of storage space.
4. Storage/warehousing costs.
5. Procurement costs.
6. Reliability of suppliers.
7. Minimum order quantities imposed by suppliers.
8. Risk of loss due to (a) obsolescence, (b) deterioration, (c) evaporationand (d)
fall in market prices, etc.
Maximum Level
This is that level above which stocks should not normaIIy be aIIowed to rise. The
maximum level may, however, be exceeded in certain cases, e.g., when unusuaIIy
favourable purchasing condition arise. It is computed by the foIIowing formula:
)
The following factors are taken into account in setting this level:
1. Rate of consumption of material.
2. Risk of obsolescence and deterioration.
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ACM 602 Cost Analysis and Control
Minimum Level
It is that level below which stock should not normally be allowed to fall. This is
essentially a safety stock and is not normally touched. In case of stock falling below
this level, there is a risk of stoppage in production and thus top priority should be
given to the acquisition of fresh supplies. It is computed by the following formula:
2.The time required to acquire fresh supplies under top priority conditions so that
stoppage in production can be avoided.
2.Minimum level.
3.Delivery time; i. e., the time normally taken from the time of initiating
A purchase requisition to the receipt of materials. This is also known as lead time.
4.Variations in delivery time.
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ACM 602 Cost Analysis and Control
Danger Level
Sometimes purchased materials are not received in time and stock level goes below
The minimum level. In order to meet such a situation a danger level is fixed. Danger
level is a level at which normal issues are stopped and materials are issued for
important jobs only. This level is generally fixed somewhat below the minimum level.
When stock reaches danger level, urgent action is needed for the replenishment of
stock so that stoppage in production can be avoided. Purchasing materials on an
urgent basis results in higher purchasing cost. Its formula is:
or
Illustration 1.
Illustration 2.
Fagoon India Ltd. provides the following information in respect of material :
36
ACM 602 Cost Analysis and Control
Rate of Consumption
Average : 15 units per day
Maximum 20 units per day
Yearly 5,000 units
Illustration 3.
If 500 units of material is introduced into the process or operation and the yield
of final product is 400 units, the input-output ratio is calculated as follows:
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ACM 602 Cost Analysis and Control
The stock turnover ratio indicates the movement of average stock holding of
each item of material in relation to its consumption during the accounting period.
The stock turnover ratio is calculated by applying the following formula:
Advantages - computation of stock turnover ratio will lead to the following benefits:
It highlights slow-moving or obsolete stocks where action is needed to reduce the
stock held!
It indicates whether the stock holding is consistent with the material required for
production.
It helps in location of excessive stocks and by avoiding unnecessary pile up of
stocks, the financial strain on the working capital of the organization can be
reduced.
Illustration 4.
From the following data for the year ended 31st March, 2009, calculate
Solution:
38
ACM 602 Cost Analysis and Control
Questions
1. A Company manufactures a special product which requires a component 'Alpha'.
The followingparticulars are collected for the year 2009:
Annual demand of Alpha 8,000 units
Cost of placing an order Rs. 200 per order
Cost per unit of Alpha Rs. 400
Carrying cost % p.a. 20%
The company has been offered a quantity discount of 4% on the purchase of
'Alpha' provided the order size is 4,000 components at a time.
Required:
Compute the economic order
quantity.
Advise whether the quantity discount offer can be accepted.
2. ZED Company supplies plastic crockery to fast food restaurants in metropolitan
city. One of its products is a special bowl, disposable after initial use, for serving
soups to its customers. Bowls are sold in pack of 10 pieces at a price of Rs. 50
per pack.
The demand for plastic bowl has been forecasted at a fairly steady rate of 40,000
packs every year. The company purchases the bowl direct from manufacturer at
Rs. 40 per pack within a three days lead time. Theordering and related cost is Rs.
8 per order. The storage cost is 10% per annum of average inventory investment.
Required:
(6) Calculate Economic Order Quantity.
(7) Calculate number of orders needed every year.
(8) Calculate the total cost of ordering and storage bowls for the year.
(9) Determine when the next order to be placed should. (Assuming that the
company does maintain a safety stock and that the present inventory level is 333
packs with a year of 360 working days
39
ACM 602 Cost Analysis and Control
4.Tubes Ltd. are the manufacturers of picture tubes for T.V. The following are the
details of their operation during 2009:
Average monthly market demand 2,000 tubes
Ordering cost Rs.100 per order
Inventory carrying cost 20% per annum
Cost of tubes Rs. 500 per tube
Normal usage 100 tubes per week
Minimum usage 50 tubes per week
Maximum usage 200 tubes per week
Lead time to supply 6-8 weeks
Compute from the above:
(10) Economic Order Quantity. If the supplier is willing to supply 1,500 units
quarterly at a discount of 5%, is it worth accepting?
(11) Maximum level of stock.
(12) Minimum level of stock.
(13) Reorder level
5.ZED Company supplies plastic crockery to fast food restaurants in metropolitan
city. One of its products is a special bowl, disposable after initial use, for serving
soups to its customers. Bowls are sold in pack of 10 pieces at a price of Rs. 50
per pack.
The demand for plastic bowl has been forecasted at a fairly steady rate of 40,000
packs every year. The company purchases the bowl direct from manufacturer at
Rs. 40 per pack within a three days lead time. The ordering and related cost is
Rs. 8 per order. The storage cost is 10% per annum of average inventory
investment.
Required:
(14) Calculate Economic Order Quantity.
(15) Calculate number of orders needed every year.
(16) Calculate the total cost of ordering and storage bowls for the year.
40
ACM 602 Cost Analysis and Control
(17)Determine when should the next order to be placed. (Assuming that the
company does maintain a safety stock and that the present inventory level is
333 packs with a year of 360 working days.
5. The following data are available in respect of material X for the year ended 31st
March, 2009:
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000
Calculate -
Inventory turnover ratio, and
The number of days for which the average inventory is held
Lesson 4
METHODS OF REMUNERATION OF LABOUR
CONTEXT OF THE LESSON
41
ACM 602 Cost Analysis and Control
This lesson deals with various types of labour cost and various method adopted for
payment of remuneration.
OBJECTIVES OF THE LESSON-
• Classification of labour cost
• Methods of remuneration on various bases.
INTRODUCTION
Labour is considered as one of the important factor of production in an industrial
organization. It is the employment of labour which help to convert the raw material into
finished products and services. Labour is the only factor which can give almost
unlimited productivity-its output can be increased whereas the output from other
factors is limited by their physical limitations. However, labour is complex and delicate
hence it should be handled very carefully and efficiently and should be remunerated
properly.
LABOUR COST
In the narrow sense, the term labour cost encompasses only wages paid to the
workers but it represents the various payment made to a worker arising out of his
employment in the orgnisation.
The total labour cost can be classified as follows:
(a) Direct labour cost
(b) Indirect labour cost.
42
ACM 602 Cost Analysis and Control
wages. Direct labour cost is that part of wages and salaries which can be identified
with and charged to a single costing unit. It is the cost which can be easily identified
and has a direct relationship with the product or process of operation.
INDIRECT LABOUR COST: - It refers to all expenses that are incurred on labour but
that does not alter the construction, confirmation, composition or condition of the
product, but which contributes or assist generally to such work and help in the
completion of the product and handling up to the point of dispatch. In other words,
labour employed for the purpose of carrying out tasks incidental or ancillary to goods
produced or services provided is regarded as indirect labour. Wages or salaries paid
to foreman, supervisors, inspectors, clerks, etc, are the example of indirect labour.
Need for distinguishing between direct and indirect labour cost: The distinction has to
be made:
(a) For calculating appropriate labour cost and thus provide a basis for strict
control;
(b) For facilitating calculation of labour efficiency.;
(c) For proper allocation of overheads;
(d) For introduction of incentive schemes;
(e) For inter-unit comparison; and
(f) For estimating total labour cost.
METHODS OF REMUNERATION
Time Rate System:
Time rate or day rate is related to the hours of wage and is commonly used. The wage
rate can be fixed on hourly, daily, weekly, monthly basis depending on the nature of
his skill. In this method the worker is remunerated for the time which he has devoted
or spent within the factory premises irrespective of the work he has done.
This method can be applied where:
(a) Quality of work is of greater significance;
(b) Output of a worker cannot be measured;
(c) Output of a worker is beyond his control;
(d) The work can be closely supervised;
43
ACM 602 Cost Analysis and Control
ADVANTAGES
The advantages of this system are:
(a) Easy to understand and simple to calculate;
(b) Widely accepted by trade unions as all workers are paid alike;
(c) Less clerical expenditure is involved;
(d) A steady income is guaranteed
(e) Tools and material are handled carefully and wastages are minimized, as
employees are in no hurry in completing the job as a result.
DISADVATAGES
(a) it does not motivate or encourage workers to take initiative;
(b) labour cost may increase thereby decreasing profit. This may be caused by
decrease in productivity;
(c) standard for labour are difficult to set;
(d) productivity may decrease thereby disturbing the production schedules,
creates production bottlenecks and increases cost per unit
(e) idle time may increase and even lead to inefficiency
(a) High Wage Plan: - A higher wage rate can be fixed as compared to the wage
rate prevailing in the area. This is generally applied to attract efficient workers in
order to increase the production. In order to enable the workers to achieve the
standard, suitable working environment and conditions are provided. This method
is also beneficial to employer as it lead to reduction in overheads.
Advantages of this methods are:
(a) It is simple and economical;
(b) Encourages and attract skilled workers for the job;
(c) Leads to increase in production;
(d) Decrease wages and overhead cost per unit.
(b) Different Time Rates: - This method is applied were workers have various
levels of efficiency and as such different rates are fixed. For the workers whose
efficiency is up to the standard level, to them normal wages are paid and for
44
ACM 602 Cost Analysis and Control
workers having efficiency beyond the standard level, the rate is gradually
increased.
(c) Measured day work (Graduated):- In this method the hourly rates are divided
into two parts. A certain part of the hourly rate is fixed which generally depends
upon the nature of the job and the other part is variable depending on the merit
rating and cost of living.
This system is very complicated and the calculation involved in this process
also increases when the workers change jobs on frequently basis. Merit rating
may be arbitrary. There is multiplicity of rates. It is difficult for the workers to
easily understand the system.
(d) Payment by results
It is a method of remunerating the workers in which payment mainly depends
on the output or units produced by the workers. The workers have an
opportunity to earn and increase his income by producing more units.
Merits: -
45
ACM 602 Cost Analysis and Control
(a) A worker expertise himself by continuously doing the same work on a regular
basis;
(b) It leads to increase the efficiency of the worker which leads to earn more
income;
(c) It reduces costs;
(d) Idle time automatically controlled;
(e) The reward is related to effort. Efficiency is recognized;
(f) Less supervision is required;
(g) Workers discover new techniques of producing goods which leads to increase
in production.
Demerits: -
(a) Quality is effected in order to increase production.
(b) Wastages of material may increase if not properly supervised.
(c) More supervision and inspection is required so that units produced achieve
the standard quality.
(d) Improper use of machine and tools in order to maximize output by the workers.
(e) If work stops due to machine break down, power failure etc, the workers may
feel insecure.
(f) In order to earn more the workers may highly stress themselves which may
affect their health adversely.
(g) This method is not preferred by inefficient and less efficient workers as there is
no guaranteed wages for the period.
(h) It is not easy to determine the piece rate.
Incentive scheme: -
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ACM 602 Cost Analysis and Control
Both time rate and piece rate system have their certain merits and demerits.
Incentives system attempts to combine the good aspects of both systems. The main
objective of incentive plan is to induce a worker to produce more and to earn a higher
wages. Producing more in the same period of time should result in higher pay.
47
ACM 602 Cost Analysis and Control
(c) Two piece rates are set for each job-the lower rate and the higher rate. The lower
piece rate is payable where a worker takes a longer time than the standard time to
complete the work. Higher rate is payable when a worker completes the work within
the standard time. In other-words, lower piece rate is payable to inefficient workers
and higher piece rate is payable to efficient workers. Usually these rates are 83% of
the piece work rate for inefficient workers and 175%, of the piece work rate for efficient
workers.
Illustration:1
Standard production = 8 units per hours
Working hours per day = 8 hours
Lower rate = Rs. 5 per unit
Higher rate = Rs. 8.75 per unit
Worker X produces = 7 units.
Worker Y produces = 9 units
Calculate wages of worker under Taylor’s Plan
Wages of worker X and Y under Taylor’s plan will be as follows.
Worker X — He has produced 7 units which is below standard. He will, therefore, be
paid at the lower rate of Rs. 5 per unit. His wages will be·7 units @ Rs. 5 = Rs. 35 .
Worker Y - He has produced 9 units which is above standard. He will, therefore, be
paid at the higher rate. His wages for 9 unit @ Rs. 8.75 will be Rs. 78.75. It will be
seen that there is a great difference between the wages of an efficient and an
inefficient worker.
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ACM 602 Cost Analysis and Control
Rates applicable:
Rates applicable-
A = Re. 0.20 per unit. (normal rate)
Earnings:
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ACM 602 Cost Analysis and Control
50
ACM 602 Cost Analysis and Control
Illustration:4
Standard output in 8 hours = 60 units
Actual output in 8 hours. = 72 units
Time rate = Rs. 2 per hour
Calculate earnings under Emerson`s plan.
Solution
Efficiency in % = 72/60* 100 = 120%
Bonus % = 20% + 20% = 40%
Time wages 8 hours @ Re. 2 = Rs. l6.00
Add: Bonus 40% of Rs. l6 = Rs. 6.40
Total earnings Rs. 22.40
In this Illustration, if the actual output of worker is up to 40 units, i.e. %
efficiency, he will not get any bonus and his wages will be simply time wages i.e., 8
hours X Rs. 2 = Rs. 16. The worker will start earning bonus if his output in 8 hours is
above 40 units. lf he produces 60 units i.e. when his efficiency is 100%, his total
earnings will be:
Total earnings = Time wages + Bonus
= (8 hrs. Rs. 2) + 20%
= 16 + 3.20 = Rs. 19.20
Advantages
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ACM 602 Cost Analysis and Control
Total earnings = Time rate × Time taken + 50% of [Time saved × Time rate]
Illustration:5
Standard time (or Allowed time) = 50 hours. ,
Wage rate per hour = Rs. 3
Actual time taken = 42 hours ·
Thus time saved = 50 hours - 42 hrs. = 8 hrs.
Earnings = Rs. 3 × 42 hours + 50% of (8 hrs. × Rs. 3)
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ACM 602 Cost Analysis and Control
Rowan Plan
This plan is also similar to Halsey Plan except in the calculation of bonus. The main
features the plan are as follows:
(a) Wages are paid on time basis for the actual time worked by the workers.
(b) A standard time is determined for each piece of work or job.
(c) If a worker completes his work in standard time or in more than standard time,
he is paid wages for the time actually taken by him
(d) If a worker completes his work in less than the Standard time he is entitled to a
bonus.
(e) Bonus is that proportion of wages of actual time taken which the time saved bears
to the standard time. Its formula is:
Bonus = Time saved / Time allowed × Time taken × Time rate
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ACM 602 Cost Analysis and Control
Illustration: 6
Standard time = 50 hours
Wage rate per hour = Rs. 3
Actual time taken = 42 hours.
Calculate earnings and bonus under Rowan Plan.
Time Saved = 50 hours - 42 hours = 8 hrs.
Bonus = 8/50 × 42 hours × Rs 3 = Rs. 20.l6
54
ACM 602 Cost Analysis and Control
conditions in one minute allowing for the relaxation needed. Workers get a bonus
which is equal to 75% of B’s saved.
Bonus =
Thus, if a person gets 90 B’s and hourly rate is Rs.1.20, then his bonus will be:
B’s saved =90-60 =30 B’s
Bonus = = 45 paise
If bonus is given to the extent of the value of the entire time saved, then the scheme
will be called the 100% Bedauxe Scheme. But if nothing is mentioned, it is assured
that it is 75% Bedauxe Scheme.
Under 75% Bedauxe Scheme, the labour cost increases till 100% efficiency and then
starts declining.
Hayne’s Scheme
Time wages are guaranteed. The standard time is set in terms of standard man
minutes called ‘manits’. A manit means a standard work performed in a standard
minute. Bonus is given for the time saved. The value of the time saved is shared by
the worker and foreman in the ratio of 5:1. If the worker is standardized and repetitive
in nature, otherwise, the ratio of sharing between worker, employer and supervisor
will be 5:4:1.
The labour cost falls until 100% efficiency is reached. Thereafter, it falls at a
decreasing rate if work is non-standardised or remains constant if the work is
standardised.
Misc. Illustrations
Illustration: 7
From the following information, calculate the bonus and earnings under Emerson
Efficiency Bonus Plan:
Standard output in 12 hours 48
Actual output in 12 hours 42
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ACM 602 Cost Analysis and Control
Earnings
= 9+0.71 = Rs.9.71
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ACM 602 Cost Analysis and Control
Bonus percentage =
= 20 +25 = 45%
Bonus
Earnings
=9 + 4.05 =Rs.13.05
Illustration : 8
In a factory guaranteed wages at the rate of Rs.1.80 per hour are paid in a 48 hour
week. It is estimated that to manufacture one unit of a particular product 20 minutes
are taken. The time allowed is increased by 25%.During one week Abraham produced
180 units of the product. Calculate his wages under each of the following methods (a)
Time rate,(b) Piece rate with a guaranteed weekly wage,(c)Halsey Premium bonus
and (d) Rowan Premium Plan
Solution:
(a) Time rate:
E = T×R
= 48 ×1.80 = Rs.86.40
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ACM 602 Cost Analysis and Control
E =T ×R + ×T × R
Practical Questions
Q.1 From the following particulars calculate the earnings of a worker under Rowen
Premium Bonus System and Halsey Premium Bonus System:
Hourly rate of wages(guaranteed) Rs.0.75
Standard time for producing one dozen articles 3 Hours
Actual time taken by the worker to produce 20 dozen articles 48 Hours
Ans. Rowen Rs.43.20;Halsey Rs.40.50.
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ACM 602 Cost Analysis and Control
Q.2 What earnings will workmen receive under Halsey Plan and Rowen Plan if he
executes a piece of work in 60 hours as against 75 hours allowed? His hourly rate is
Rs.2 and he is paid 50% of the time saved under Halsey Plan. He gets a dearness
allowance of Rs.8 per day of 8 hours worked in addition to his wages.
Ans. Under Halsey Plan Rs.195; Under Rowen Plan Rs.204
Q.3 Calculate the earnings under (a) Time rate (b)Piece rate (c)Halsey and
(d)Rowen methods, from the following information:
Standard time 40 hours
Time taken 30 hours
Wages are paid at Rs.1 per hour and a dearness allowance is paid at 50 paise per
hour worked.
Ans.(a)Rs.45;(b)Rs.55;(c)Rs.50;(d)Rs.52.50
Q.4 A workmen takes 9 hours to complete a job on daily wages and 6 hours on a
scheme of payment by result. His day rate is Rs.1.50 per hour. The material cost of
the product is Rs.24 and the work overhead is recovered @ 150% of the total direct
wage. Calculate the factory cost of the product (a) the piece -work plan, (b) the
Halsey plan and (c) the Rowen plan.
Ans. Factory cost-(a) Rs.46.50; (b) Rs.52.125 and (c) Rs.54.00
Lesson 5
Labour Turnover
Labour turnover is the movement of people into and out of the organization. It is usually
convenient to measure it by recording movements out of the firm on the assumption that a
leave is eventually replaced by a new employee. The term separation is used to denote an
59
ACM 602 Cost Analysis and Control
employee who leaves for any reason. Labour turnover is the rate of change in the number of
employees of a concern during a definite period. Labour turnover studies are helpful in
manpower planning. Just
as the high reading on a clinical thermometer is a sign to the physician that something is
seriously wrong with the human organism, so is a high index of labour turnover rate a warning
to management that something is wrong with the health of the organization. A high turnover
rate may mean poor personnel policies, poor supervisory practices or poor company policies.
Too lower a rate of turnover can also be a danger signal.
60
ACM 602 Cost Analysis and Control
measures to be adopted. .
Unavoidable Causes
(a) Personal betterment
(b) Family circumstances
(c) Climatic conditions
(d) Community conditions
(e) Health conditions
(f) Marriage (in case of women)
(g) Retirement and death
(h) Migratory nature of workers
(i) Dismissal or discharge due to incompetence, inefficiency, insubordination, indifferent
attitude towards work.
(J) Redundancy due to seasonal changes, shortage of materials and other resources, slack
of business, lack of planning and foresight of higher management.
Management can do little control over labour turnover in the above cases.
Measurers to Reduce Labour Turnover
All employees to have a certain degree of labour turnover, without it the company
would stagnate. The average age of employees would increase (meaning also that a
large number of employees might retire simultaneously); and there could be
insufficient new blood coming into the organization. No doubt many companies would
be content if their separation rates lay between 10 to 15 per cent, though few rates in
the private sector of industry and commerce are as Iow as
this. If an employing firm wishes to reduce its labour turnover because it considers it
as excessive for the area and the industry, it may take the following steps to reduce
labour turnover:
Pay Problems
(a) Increasing pay levels to meet competition.
(b) Improving pay structures to remove inequities.
(c) Altering pay systems to reduce excessive fluctuations
(d) Introducing procedures for relating rewards more explicitly to effort or performance.
Employees Leaving to Further their Career
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ACM 602 Cost Analysis and Control
(a) Providing better career opportunities and ensuring that employees are aware of
them.
(b) Extending opportunities for training.
(c) Adopting and implementing 'promotion from within' policies and introducing more
systematic and equitable promotion procedures.
(d) Deliberately selecting employees who are not likely to want to move much higher
than their initial job.
Employees Leaving Due to Conflict
(a) Introducing more effective procedures for consultation, participation and handling
grievances.
(b) Improving communications by such means as briefing groups.
(c) Using the conflict resolution and team-building techniques of organization
development.
(d) Reorganizing work and the arrangement of office or workshops to increase group
cohesiveness.
(e) Educating and training management in approaches to improving their relationships
with employees.
Induction Crisis
(a) Improving recruitment and selection procedures to ensure that job
requirements are specific accurately and that the people who are selected fit
the specification.
(b) Ensuring that candidates are given a realistic picture of the job, pay and
working condition
(c) Developing better induction and initial training programs.
Shortage of Labour
(a) Improving recruitment, selection and training for the people required.
(b) Introducing better methods of planning and scheduling work to smooth-out
peak loads.
Changes in Working Requirements
(a) Ensuring that selection and promotion procedures match the capacities of
individuals to the demands of the work they have to do.
(b) Providing adequate training or adjustment periods when working conditions
change.
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ACM 602 Cost Analysis and Control
(c) Adopting payment by result systems to ensure that individuals are not unduly
penalized when they are only engaged on short-runs.
Losses of Unstable Recruits
Taking more care to avoid recruiting unstable individuals by analyzing the
characteristics of applicants which are likely to cause instability and using this
analysis to screen recruits
Adequate Statistical Control
There should be a carefully worked out system of records for keeping the required
data. The management should have complete information about separations by
shops, departments, occupations, sex, age, race, nationality, length of service and
education. This information will help a critical analysis. It will also be possible to
collect statistical evidence to invite managerial attention to the problem. If
management is properly convinced about the magnitude of the problem, adequate
funds and attention may be provided for the solution of this problem.
Joint Control
Joint control can be exercised through committee representing management and
workers. These committees should cover the review of shop regulations, grievances,
etc. The formation of these committees will encourage mutual understanding and
general cooperation.
Use of Exist Interviews
Some companies arrange an exist interview, when an employee calls for his final
payment. A better means of getting necessary information may be an interview with
employees sometime after they have left. For this purpose, exit questionnaires may
be prepared. This step may lead to useful information, which may have profound
effect on reducing labour turnover.
Labour turnover
Labour turnover denotes the percentage change in the labour force of an organisation.
High percentage of labour turnover denotes that labour is not stable and there are
frequent changes in the labour force because of new workers engaged and workers
who have left the organisation. A high labour turnover is not desirable. The definitions
of labour turnover are given below:
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ACM 602 Cost Analysis and Control
This definition does not take into consideration the fact of surplus labour. This
definition will give incorrect result when the surplus workers are discharged because
labour turnover calculated in this way will be high.
This definition will not be applicable when the organisation is expanding. In such a
case, many new workers are engaged and there may be no separation; even then
labour turnover calculated will be high.
This definition will misguide when an organisation has reached its optimum size and
does not require expansion at all. In such a case, labour turnover, as per this
definition, will show half the actual percentage of labour turnover.
(4)Labour turnover according to replacement method
This definition takes into account the surplus labour. This definition will also give
correct labour turnover when the factory is expanding because all additions are not to
be taken; only workers replaced due to leavers are to be taken. Therefore, this
definition can be taken to be the most reliable definition out of all the definitions given
above.
Reduction of Labour Turnover
As already pointed out, normal labour turnover is advantageous because it allows
injection < fresh blood into the firm. But excessive labour turnover is not desirable
because it shows the labour force is not contended. Therefore, every effort should be
made to remove the avoidable causes which give rise to excessive labour turnover.
The following steps may be taken to reduce the labour turnover :
64
ACM 602 Cost Analysis and Control
(1) A suitable personnel policy should be framed for employing the right man for the
right job and giving a fair and equal treatment to all workers.
(2) Good working conditions which may be conducive to health and efficiency should
b provided.
(3) Fair rates of pay and allowances and other monetary benefits should be
introduced.
(6) An employee suggestion box scheme should be introduced whereby workers who
suggest improvements in the method of production should be suitably rewarded.
In addition to the above steps, the personnel department should prepare periodical
reports the labour turnover listing out the various reasons due to which workers have
left the organization. The report should be sent to the management with the necessary
recommendations so the corrective measures may be taken to reduce labour
turnover.
As "prevention is better than cure", preventive cost should be incurred to prevent
excessive labour turnover. This cost of labour turnover should be apportioned among
different departments on the basis of average number of employees in each
department and justifiably treated as overhead. If preventive cost is incurred for
reasons of image or status of the employer or non-economical corporate goals, it may
be debited to the Costing Profit and Loss Account. If preventive cost is incurred for a
particular department, it may be taken as overhead of that [department.
(ii) Replacement Costs. These costs are associated with replacement of workers
and include:
(1) Cost of recruitment of new workers.
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ACM 602 Cost Analysis and Control
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ACM 602 Cost Analysis and Control
Loss of Output due to delay in obtaining new workers - The experience has revealed
that sometime definitely elapses before any replaced worker joins the organization.
During this period, scheduled output is met by: (a) Carrying a surplus labour force,
(b) Working overtime, (c) If the scheduled output is not met, then there is direct loss
of profit. All these factors add to cost of labour turnover.
Cost of Tool and Machine Breakage
Tool and machine breakages arc more frequent when untrained or new labour is
employed. It adds to the cost of labour turnover, but it is practically a difficult exercise
to determine relationship between the intake of new labour and the cost of repairs.
Accident Frequency and Severity - When a new worker joins the factory, the chances
of accidents and mishaps increase considerably. This may lead to additional cost of
compensation, which finally adds to cost of labour turnover.
Cost of Scrap and Defective Work
When a new worker joins, the amount of scrap and defective work increases. When
the material used is of high value, the cost of scrap and defective work may have
serious repercussions upon the overall cost of production. The cost of defective work,
which is due to inexperience of new worker, should be taken as the cost of labour
turnover, loss of Goodwill or Disadvantageous
Labour Contracts
If new worker is not put to the job, it will be difficult to meet the scheduled program.
In the hurry to save the goodwill of the company, some disadvantageous labour
contracts may have to be entered into. All this adds to the cost of labour turnover.
The overall cost of labour turnover will appear in one or more of the items already
mentioned. This cost can be shown as cost per worker employed or replaced or as a
fraction of total cost of selling price. The most common way to express labour turnover
cost is as follows:
Illustration1.
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ACM 602 Cost Analysis and Control
Akash Ltd. suffer from high incidence of labour turnover each year. Measures to
combat the labour turnover are being considered by the management and it wants
you to calculate the profit foregone on account of labour turnover in the immediate
past year from following:
ABC Ltd. Income Statement for the year (Rs.)
ended 31st March, 2009
Sales 1,87,500
Variable cost:
Material 56,250
Direct labour 45,000
Variable overhead (varying with output) 48,750 1,50,000
Contribution 37,500
fixed overhead 22,500
profit before tax 15,000
The direct labour hours worked in the period were 24,000 of which 1,200 hours
pertained to new worker: on training, only 33 %% of the trainees time was
productive. There was some unavoidable delay in findiij replacements for the
workers that left, 360 productive hours were lost as a result. The other incident
costs due to workers leaving were:
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ACM 602 Cost Analysis and Control
Rs.
Settlement cost due to leaving 27,420
Recruitment costs 18,725
Selection costs 12,750
Training costs 16,105
Assuming that the potential production lost due to labour turnover could have been
sold at
prevailing prices, ascertain the profit foregone/lost last year on account of labour
turnover.
(C.A. Inter)
SOLUTION
Calculation of Actual Productive Hours
Actual hours worked 3,45,000
Less: Hours lost due to training workers (unproductive hours i.e of 15,000
30,000 hours)
Actual Productive Hours 3,30,000
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ACM 602 Cost Analysis and Control
Question
The management of Sunshine Ltd. wants to have an idea of the profit lost/foregone
as a result of labour turnover last year. Last year sales amounted to Rs. 66,00,000
and the P/ V Ratio was 20%. The total number of actual hours worked by the direct
labour force was 3.45 lakhs. As a result of the delays by the Personnel Department in
filling vacancies due to labour turnover, 75,000 potentially productive hours were lost.
The aetual direct labour hours included 30,000 hours attributable to training new
[recruits, out of which half of the hours were unproductive. The costs incurred
consequent on labour turnover revealed on analysis the following:
Settlement cost due to leaving 27,420
Recruitment costs 18,725
Selection costs 12,750
Training costs 16,105
Assuming that the potential production lost due to labour turnover could have been
sold at failing prices, ascertain the profit foregone/lost last year on account of labour
turnover.
LESSON 6
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ACM 602 Cost Analysis and Control
INTRODUCTION
In Cost Accounting, for the purpose of determination of cost and its control,the
analysis and collection of overheads, their allocation and apportionment to different
cost centers and absorption to products or services plays an important role. An
effectivesystem of distribution of overheads can lead for accuracy in determination of
cost of products and services. It is therefore, necessary to ensure that a standard
practices for allocation, apportionment and absorption of overheads should be
followed within the organization for preparation of cost statements.
DEFINITION:
OVERHEADS
Overheads comprise of cost of indirect materials, indirectlabour and indirect expenses
which are not directly identifiable or traceable and allocable to a cost object in an
economically feasible way
CLASSIFICATION OF OVERHEADS
Overheads canbe classified on the basis of functions to which the overheads are
related viz.
- Production overheads
- Administrative overheads
- Selling overheads
- Distribution overheads
Overhead can also be classified on the basis of behavior. On the basis of behavior
overhead can be classified as variable overheads, semi-variable overheads and fixed
overheads.
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ACM 602 Cost Analysis and Control
Variable overheads are those expenses which vary in same proportion to the change
of volume of production. For example, cost of utilities etc.
Fixed overheads are those expenseswhose values do not change with the change in
the volume of production. For example salaries, rent etc.
Semi-variable overheads are those expenses which are partly affected by change in
the production volume. A part of the overhead is variable and a part of the overhead
is fixed.
COLLECTION OF OVERHEADS
Collection of overheads refers to the pooling of various indirect items of expenses
from books of account and other records into certain logical groups having regards to
their nature and purpose.
Overheads are collected on the basis of predetermined groups which are termed as
cost pools. Homogeneity of the cost components in respect of their behavior and
character is to be considered whiledeveloping the cost pool. Variable and fixed
overheads should be collected in separate cost pools under a cost centre. A greater
degree of homogeneity in the cost pools are to be maintained to make the
apportionment of overheads more rationale and scientific.
ALLOCATION OF OVERHEADS
Allocation of overheads is a process of assigning a particular item of cost directly to a
cost centre.An item of expense which can be directly, wholly and exclusively related
to a cost centre is to be allocated to the cost centre. For example, depreciation of a
particular machine should be allocated to a particular cost centre if the machine is
directly attached to the cost centre.
APPORTIONMENT OF OVERHEAD
Apportionment of overhead is the process of distribution of overheads to more than
one cost centre on some equitable basis. Thus, a particular item of expense which is
not directly related to one cost centre but is related to more than one cost centre is
required to be distributed on various cost centre is known as apportionment of
overhead.
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ACM 602 Cost Analysis and Control
When an item of indirect expense is common to various cost centers, then it has to be
apportioned to the cost centers on an equitable basis. For example, the expenditure
on general repair and maintenance pertaining to a department can be allocated to that
department but has to be apportioned to various machines (Cost Centers) in the
department. If the department is involved in the production of a single product, the
whole repair & maintenance of the department may be allocated to the product.
The base(denominator) is selected on the basis of type of the cost centreand its
contribution to the products or services, for example, machine hours, labour hours,
quantity produced etc.
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ACM 602 Cost Analysis and Control
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Let x, ybe Store Dept and Repair & Maintenance Dept expenses respectively.
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ACM 602 Cost Analysis and Control
Secondary Distribution
Production Departments Service Departments
Expenses Basis of Total Machine Assembl Finishin Stores Repairs
allocation / (Rs.) Shop y Shop g &Maint.
apportionment Dept
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ACM 602 Cost Analysis and Control
The amount of total overheads absorbed by a product, service or activity will be the
sum total of the overheads absorbed from individual cost centres on pre-determined
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ACM 602 Cost Analysis and Control
basis. The difference between overheads absorbed on pre-determined basis and the
actual overheads incurred is the under- or over-absorption of overheads.
The under- or over- absorption of overheads is mainly due to variation between the
estimation and actual.
Production overheads
There are many ways to absorb overheads which are as follows:
DIRECT MATERIAL COST PERCENTAGE
Suitable in situations where:
• the material value has some relationship with the overheads;
• quality and prices of materials do not vary drastically;
• quantity and cost of materials in each product is almost the same and
• where processing is uniform
Unsuitable when:
• Overheads are time-based where there is little relationship with the cost of
material used hence products with high material content absorb more
overheads.
Example
=700%
Overhead absorbed by the job= 10 x700
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ACM 602 Cost Analysis and Control
Need to be careful to charge overheads with higher labour costs in the event of
different level of skill.
Example
=175%
=140%
Overhead absorbed by the job= 40(10+30) x140% =56
DIRECT LABOUR HOUR RATE
Suitable in labour intensive industry or where certain departments are still using
manual means. Uses time as a basis.
Disadvantages:
• It assumes that operations that take the same time are costed with the same
overheads irrespective of the operators different pay rates.
also, more businesses are deploying machines, hence this absorption method is
getting more unpopular.
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ACM 602 Cost Analysis and Control
=2.34 %
Overhead absorbed by the job= 20 hours x2.34 =46.80
Disadvantage:
If a cost centre uses different type of machines, then we cannot use a single
machine rate. A separate machine rate must be computed for each machine or
group of machines. Also, there is a need to keep records of the machine time for
each operation. This method therefore can be very tedious and increases clerical
work
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ACM 602 Cost Analysis and Control
Selling Overheads:
(i) Sales Employees cost
(ii) Rent
(iii) Traveling expenses
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ACM 602 Cost Analysis and Control
Distribution Overheads:
(i) Secondary Packaging
(ii) Freight & forwarding
(iii) Warehousing & storage
(iv) Insurance etc.
Some items of selling overheads and distribution overheads are directly identified
and absorbed to products or services and remaining part of selling and distribution
overhead along with the with share of administration overheads relating to selling
and distribution activities are to be apportioned to various products or jobs or
services on the basis of net actual sales value (i.e. Gross sales value less excise
duty, sales tax and other government levies).
SELF CHECK QUESTIONS
1.What are the various methods of absoption of factory overheads.
2. Discuss the method of apportionment and absorption of administrative overhead.
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ACM 602 Cost Analysis and Control
(i) All the factory overhead are apportioned to the various machines or
group of machines on some suitable basis.
(ii) Working hours of a machine are calculated for the period for which the
machine is to run.
(iii) The overheads of a machine cost centre are divided by the effective
machine hours, the machine hour rate pertaining to the machine or
group of machines is determined.
BASES OF APPORTIONMENT OF FACTORY OVERHEAD TO THE MACHINES
The following basis is generally adopted for apportionment of expenses which are
common to more than one machine:
(i) Rent, Rates and Taxes etc: Floor area occupied by the machine
(ii) Depreciation : Actual depreciation as per plant register
(iii) Lighting: Number of bulbs or wattage used for lighting by the machines
(iv) Heating: Floor area occupied by the machine or technical estimates
(v) Power: Horse power of the machine or technical estimate by meter reading
(vi) Repairs and Maintenance: Allocation as per actual repairs or according to
hours worked by the machines
(vii) Supervisory Expenses: Number of hours devoted by the supervisor on each
machine
(viii) Labour Welfare Expenses: In the ratio of number of employee engaged on
machines
(ix) Insurance: In the ratio of machine value keeping into consideration the
insurance period
(x) Lubricating oil, cotton waste and consumable stores: On the basis of
machine hour worked in the certain period or on the basis of size of machine
(xi) Interest included in hire purchase : Interest is treated as an overhead and
actual interest of the machine is charged as overhead for the particular
machine
COMPUTATION OF MACHINE HOUR RATE
In order to calculate the machine hour rate, the factory overhead is divided into (a)
Standing charges and (b) Machine or Variable expenses
(A) Standing Charges: Standing charges are those expenses which are not
related to the running of the machine and these expenses are bound to incur
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ACM 602 Cost Analysis and Control
even if the machine remains idle. The following expenses are generally
included in this category:
(i) Rent of the Factory,
(ii) Rates and Taxes,
(iii) Insurance premium of Factory building,
(iv) Insurance premium of Machines,
(v) Salary of Manager,Supervisor, Foreman etc.,
(vi) General Lighting,
(vii) Cotton Waste, Lubricants oil,
(viii) Consumable stores,
(ix) Sundry Supplies
(x) Operators Wages: Generally Operators wages is treated as direct
labour cost and is shown in Prime cost. However, if an operator
works on several machine then the wages should be shown as
standing charges
All the standing charges are totaled together and divided by the
working hours of the machine of the specified period thus obtaining
hourly rate of standing charges.
(B) Machine Expenses: Machine expenses are those expenses which are
incurred on running of the machines. These expenses are calculated for hourly
rate on individual basis. Generally following expenses are treated as machine
expenses:
(i) Depreciation of machine
(ii) Power Expenses
(iii) Repair and Maintenance charges
Treatment of Idle time and setting time:
The idle time in respect of a machine is generally deducted from the budgeted working
hours of a machine in order to calculate the effective machine hour. Similarly, if a
machine requires some setting time before it is ready for operation, the setting time
should be added in calculating effective hours of the machine.
ILLUSTRATION
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ACM 602 Cost Analysis and Control
1. Calculate Machine Hour Rate for recovery of overhead for a machine from the
following data. There is a group of 4 similar machines in the department.
Original cost of 4 Machines Rs. 76,800; Depreciation at 10% per annum on straight
line method; Maintenance cost average Rs. 8 per day of 8 hours for the group
machines.
Power 25 Paisa per running hour (per machine), Supervision for the machine group
Rs. 640 per month. Allocation of building depreciation for 4 Machines on a floor area
basis Rs. 80 per month.
Share of manufacturing overheads Rs. 240 per month for the group.
Normal working days in the year 300; Normal running : One shift of 8 hours, Each
machine remained idle for 20% of its normal running hours.
Solution ·
Computation of Machine Hour Rate
Base Period : 1 year Working Hours : 300 ×8 = 2,400 — 480 = 1,920
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ACM 602 Cost Analysis and Control
2. A Machine costing Rs. 28,700, excluding installation cost of Rs. 300, has an
anticipated life of 10 years with residual value of Rs. 500. It is depreciated on straight
line method. From the following particulars, compute machine hour rate on the basis
of anticipated working hours:
(i) Rent and Rates for the factory is Rs. 6,000 per annum and 10% of the effective
area is occupied by this machine.
(ii) Insurance for this machine is Rs. 450 per annum.
(iii) Repairs and Maintenance for the whole factory for the year is Rs. 2,000; 25% of
this amount relates to this machine.
(iv) Consumable Stores etc. attributable to this machine for the whole year is Rs. 110.
(v) Total of production services is Rs. 5,000; 20% of this amount is applicable to this
machine.
(vi) Power cost is Re. 0.50 per Working Hour.
(vii) The year contains 250 working days of 8 hours each but it is anticipated that the
machine will remain idle 20% of this time.
Solution
Total hours = 250 working days x 8 hours each day = 2000 hours
Less idle time being 20% of 2,000 hours = 400 hours
Effective working hours = 1600 hours
Particular Per year Per hour
(A).Standing Charges : Rs. Rs.
(i) Rent and Rates (Rs. 6,000 × 10%) 600.00
(ii) Insurance 450.00 450.00
(iii) Consumable Stores 110.00
(iv) Production service overheads (Rs. 5,000 × 20%) 1,000.00
Total Standing Charges Rs. 2,160.00
Standing Expenses per hour (Rs. 2, 160 / 1,600 hrs.) 1.35
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ACM 602 Cost Analysis and Control
4. The following annual charges are incurred in respect of a machine where manual
labour is almost niland where the work is done by means of five machines of exactly
similar type and specifications:
1. Rent and Rates (proportional to the floor space occupied) for the shop Rs. 48,000
2. Depreciation on each machine Rs. 5,000
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ACM 602 Cost Analysis and Control
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3. Prepare a Machine Hour Rate computation for the month of January, 2005 to
recover the overhead expenses from the information indicated below:
Per Annum (Rs.)
Rent of the Department (Space occupied by the machine 1/4) 1,200
Lighting (12 men in the department; 2 men are engaged on this machine) 576
Insurance 96
Cotton Waste, Oil, etc. 60
Salary of Foreman (one-third of foreman’s time is spent on this machine and the
remaining on other two machines) 9,000
Cost of machine is Rs. 27,500 and scrap value of machine is Rs. 500. It is assumed
from the past experience that:
(a) The machine will work 1,200 hours per annum.
(b) It will incur expenditure of Rs. 4,500 in respect of repairs and maintenance for
whole working life of machine. , .
(c) It will consume 5 units of power per hour at the rate of 10 Paisa per unit.
(d) The working life-time of the machine will be 15,000 hours.
Ans. Rs. 5.56 per hour.
4. The following annual expenses have been incurred in respect of a shop having 5
identical machines: Rs.
(i) Rent and Rates
4000
(ii) Power consumed by the shop @ 61/4 Paisa per unit
3,750
(iii) Repair and maintenance for the machines
1,000
(iv) Lighting charges for the lighting of the shop
500
(v) Attendant’s salary (There are two attendants and each is paid Rs. 50 per
month)
(vi) Supervisor’s salary (There is one supervisor for the 5 machines, his monthly
salary is Rs. 300)
(vii) Lubricants and cotton waste for the shop.
100
(viii) Hire-purchase installment for the machines (including Rs. 300 for interest)
2,300
(ix) Each machine consumes 10 units of power per hour.
(x) Depreciation on each machine Rs. 600 p.a.
Ans. Rs. 2.91 including Hire-purchase interest.
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ACM 602 Cost Analysis and Control
LESSON 7
Costing of Joint Product and By Product
CONTEXT OF THE LESSON
In case of processing industry some time more than one products are produced from
the common raw material which are classified into joint products or by-products on
the basis of significance of their value. In this lesson we will deal with the criteria for
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ACM 602 Cost Analysis and Control
differentiating between joint products and by products and the method of costing of
these products.
Coal mining washing and Coke production resulting in the production of Coal, Coke,
Gas, Benzene, and Tar and Ammonia.
Petroleum refining resulting in the production of Petrol, Kerosene, Diesel, Furnace oil
etc. In this industry a very large number of joint and by-products occur in cracking or
refining crude oil.
Agricultural Product industries such as vegetable oil - crushing of oil seeds resulting
in production of oil and cake. From the process of refining oil, soap stock arises which
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ACM 602 Cost Analysis and Control
could be further processed into soap and allied products. The refined oil can be further
hydrogenated to produce Vanaspati.
In sugar industry, the three by-products are bagasse, molasses and pressmud.
In Milk industry , the three joint products are Cream, Liquid Milk and Skim. The cream
is again processed into Butter and ghee. The liquid milk and skim is processed to
produce whole milk, full cream milk and standard milk.
Chemical industry: Processing of naphtha results in Ethylene, Propylene, Methane,
Ethane, Butane etc.
Terminology
Joint-Products:.
Multiple products deriving out of same raw materials through a common process
simultaneously which have substantial market value is termed as joint product Two or
more products separated in the course of processing, each having a sufficiently high
saleable value to merit recognition as a main product.
Example: Ethylene and Propylene arising from the cracking of Naphtha
By-Product:
A product, which is secondary to the main product and obtained during the course of
manufacture of recognized main product. It is called a by-product because it is less
significant as compared with the main product or products.
A product which is produced incidentally from the material used in the manufacturing
of main products, having either a net realizable value or a usable value which is
relatively low in comparison with the saleable value of the main products is termed as
by product.
By-product may be subjected to further processing after separation from the main
product, if such processing will increase the value added or promote the sale of the
main product. It is called a by-product because of the relatively lower importance or
lower market value or lower ultimate value at the end of the value chain it has,
compared with the main product or products.
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ACM 602 Cost Analysis and Control
Example: Groundnut crushing in which oil is the main product and cake is a by-
product. Cake is used as raw material for manufacture of cattle feed.
The productions of the by-products are incidental to the production of main product.
A by-product may get promoted to the status of joint product if the market perception
changes or a joint product could be relegated it the position of a by-Product in future.
The classification could vary over a period time. For example, in a Petroleum Refinery,
gas was earlier considered as a by-product. Now, it has assumed importance like
petrol, diesel, etc. and it is being treated as a joint product.
Scrap:
Scraps are discarded material which has some recovery value and are either disposed
of without further treatment (other than reclamation and handling), or reintroduced into
the production process in place of raw material.
Waste:
The discarded material or substances having no significant value (as distinct from
scrap) is treated as waste.
Joint Costs:
Joint Costs are the common cost of facilities or services employed in the output of two
or more simultaneously produced or otherwise closely related operations,
commodities or services. The costs incurred in the joint process cannot be separately
traced to the individual product outputs. The specific feature of joint products is that
they incur joint costs up to the stage of production, known as the split-off point, when
they become recognisable as separate products. The costs incurred in the joint
process cannot be separately traced to the individual product outputs.
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The following are the methods which are used for the apportionment of Joint cost:
Market Value Bases:
The total joint cost of production is apportioned among the joint products on the
basis of their relative sales value in this method.
The fundamental principle of this method is that joint products should absorb joint
costs according to their ability to pay as reflected by the market values of the
individual products.
The market value or the sales value for the purpose of joint cost can be as
follows-
(i) Market value after further processing i.e. the final sales value.
(ii) Net Realisable value i.e. the final sales value less the further
processing costs.
(iii) Gross Margin Percentage.
(iv) Market value at the point of separation.
(i). Market value after further processing i.e. the final sales value:
When there is a wide parity in selling prices of final products, this base is to be
adopted. While choosing a selling price, it is important to choose a representative
period considering the normal cycle of fluctuations which may be the daily
average of the past month or quarterly average or any suitable period.
Example 1
Joint production cost of the Products
Total Prod A Prod B Prod C
Raw Materials 1,20,000
Chemical 10,000
Labour 50,000
Manufacturing overhead 45,000
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ACM 602 Cost Analysis and Control
2,25,000
Apportioned on the basis of use of
services
- Administration Overhead 25,000 10,000 10,000 5,000
- Selling & Distribution 30,000 15,000 5,000 10,000
Overheads
Total cost 2,80,000
i) Unit produced 1150 400 400 350
ii) Sales Price per unit ( Rs) 250 300 200
iii) Sales Value ( Rs) 2,90,000 1,00,000 1,20,000 70,000
iii)Joint production cost 2,25,000 77,586 93,104 54,310
apportioned on the basis sales
value (Rs)
iv) Administration overhead (Rs) 25,000 10,000 10,000 5,000
v) Selling & Dist. Overheads ( 30,000 15,000 5,000 10,000
Rs)
vi) Total Cost 2,80,000 1,02,586 108,104 69,310
iv) Cost per Unit 256.47 270.26 198.03
(ii). Net Realisable value i.e. the final sales value less the further processing
costs: If a product require further processing after split-off point, then the further
processing cost has to be determined and deducted from the sales value to
arrive at the basis for apportionment of joint cost among the products.
Example 2
Apportionment of joint costs on the basis of net realisable value
Total Prod. A Prod.B Prod.C
I. Units produced 1150 400 400 350
II. Sale Price per unit (Rs.) 300 350 200
III. Sale Value 3,30,000 1,20,000 1,40,000 70,000
IV. Further Processing Cost 22,000 10,000 12,000 --
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ACM 602 Cost Analysis and Control
(iii). Gross Margin Percentage: When the products have same profitability on sales,
Joint costs shall be allocated on the basis of Gross Margin Percentage
Example 3
(iii). Apportionment of Joint Cost on the Basis of Gross Margin Percentage.
Total Prod A Prod B Prod C
Unit produced 1150 400 400 350
Sales Price per unit ( Rs) 300 350 200
Sales Value ( Rs) 3,30,000 1,20,000 1,40,000 70,000
Joint cost 2,25,000
Further Processing Cost 22,000
Gross Margin 83,000
Gross Margin Percentage 25%
Deduct Gross Margin @ 25% 83,000 30,000 35,000 18,000
Cost of Goods Sold 2,47,000 90,000 1,05,000 52,000
Less: Further Processing Cost 22,000 10,000 12,000 -
Joint Cost Allocated 2,25,000 80,000 93,000 52,000
The obvious assumption in this method is that all the products have the same
profitability ratio on sales.
(iv). Market value at the point of separation:
Joint costs apportionment on the basis of sales value of the products shall be
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ACM 602 Cost Analysis and Control
followed when no other rational basis for apportionment of joint cost is available
and joint products are sold without further processing at split off point.
Example 4:
Joint production cost of the Products:
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ACM 602 Cost Analysis and Control
Example 5
Joint Cost Rs 2, 80,000
Sales value of by-product Rs 15,000
Less: Further processing cost. Rs. 3,000
Administration & selling and Rs 2,000
Distribution Cost -------------
Amount to be credited to Joint Cost Rs 10,000
----------------
Joint Cost to be apportioned among joint products Rs 2, 70,000
NUMERICAL ILLUSTRATIONS
1 In a manufacturing concern in a certain product A yield by-products B and C. The
joint expenses of the manufacture are:
Material Rs. 10,200 Labour Rs. 11,500 and On cost Rs. 7,500
Subsequent expenses are as under:
Particular A B C
Material 2,500 1,200 1,400
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Selling prices are: A = 30,000; B = 20,000 C = 15,000. Estimated profits on turnover are A =
40% B = 30% C = 25%.
Show how would you apportion the joint expenses of manufacture and prepare necessary
accounts.
Solution: -
Apportionment of joint Expenses
Particular A B C
Selling Price 30,000 20,000 15,000
Less: Estimated Profit 12,000 6,000 3,750
Total cost 18,000 14,000 11,250
Less : Total Separate Expenses 5,900 3,700 4,450
Share in Joint Expenses( Rs29,000) 12,100 10,300 6,800
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ACM 602 Cost Analysis and Control
14,000 14,000
11,250 11,250
To Cost of Production 11,250 15,000
To Profit 3,750 By Sales
15,000 15,000
2. A factory providing articles X also Y and Z as by product. The joint cost of manufacturing
is:
Material 10,000
Labour 2,000
Factory and office Overhead 8,000
Total 20,000
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ACM 602 Cost Analysis and Control
Particular A B C
Material 1,500 1,300 1,000
Labour 200 150 100
Factory and office Overhead 800 550 400
Total 2,500 2,000 1,500
Sales value 20,000 15,000 10,000
Estimated profits on sales value 30% 25% 20%
Assume that selling and distribution expenses are in proportion to sales value.
Show how you would propose to apportion the joint cost f manufacture and prepare the
necessary accounts of X, Y and Z
Solution:
Apportionment of joint Expenses
Particular X Y Z Total
Sales 20,000 15,000 10,000 45,000
Less: Profit 6,000 3,750 2,000 11,750
(30%) (25%) (20%)
Total cost 14,000 11,250 8,000 33,250
Less : Total Separate Expenses 2,500 2,000 1,500 6,000
Share in Joint Expenses(Net Value) 11,500 9,250 6,500 27,250
The difference between Rs. 27,250 and in joint cost of Rs. 20,000, i.e., Rs. 7,250 is that of
selling and distribution cost which is further apportioned in the ratio of sales values n the
three products as under:
Particular X Y Z Total
Estimated joint cost 11,500 9,250 6,500 27,250
Less: selling and distribution cost 3,222 2,417 1,611 7,250
Share in joint cost
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ACM 602 Cost Analysis and Control
Z (By-Product) Account
To X (Main Product) A/c 4,889 By Sales 10,000
To Material 1,000
To Labour 100
To Factory and office
Overhead 400
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ACM 602 Cost Analysis and Control
3 Product P yields by-product Q and R. The joint expenses and subsequent expenses
are as follows :
Show how you would apportion the joint expenses and prepare the necessary accounts.
Solution:
Statement of Apportionment of Cost
P Q R
Particular Rs. Rs. Rs.
Material
Labor
O.H
P Account
Particular Amount Particular Amount
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ACM 602 Cost Analysis and Control
R Account
Particular Amount Particular Amount
To Joint Cost By Sales 18,000
Material 2,593
Labor 2,074
O.H. 2,333 7,000
To Separate Cost:
Material 1,800
Labor 1,700
O.H. 1,500 5,000
To Profit (50% of 18,000) 6,000
18,000 18,000
4. Three products, viz, Nima, Bima, Rima are prepared out of a single process. The joint
expenses are: Material Rs. 2, 20,000; Labour Rs. 1, 00,000 O.H. Rs. 80,000. Post
separation is:
Particular Nima Bima Rima
Other Material 30,000 20,000 15,000
Labour 20,000 30,000 10,000
O.H. 5,000 6,000 5,000
55,000 56,000 30,000
Sales value 5,00,000 3,00,000 2,00,000
Profit on Sales 50% 30% 25%
Prepare statement showing apportionment of joint expenses, and Account for each product.
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ACM 602 Cost Analysis and Control
Material
Labour
O.H.
Nima Account
Particular Amount Particular Amount
To Joint Cost By Sales 5,00,000
Material 88,275
Labour 40,125
O.H. 32,100 1,60,500
To Separate Cost:
Material 30,000
Labour 20,000
O.H. 5,000 55,000
To Selling Expenses 34,500
To Profit (50% of 5,00,000) 2,50,000
5,00,000 5,00,000
Bima Account
Particular Amount Particular Amount
To Joint Cost By Sales 3,00,000
Material 73,315
Labour 33,325
O.H. 26,660 1,33,300
To Separate Cost:
Material 20,000
Labour 30,000
O.H. 6,000 56,000
To Selling Expenses 20,700
To Profit (30% of 3,00,000) 90,000
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ACM 602 Cost Analysis and Control
3,00,000 3,00,000
Rima Account
Particular Amount Particular Amount
To Joint Cost By Sales 2,00,000
Material 58,410
Labor 26,550
O.H. 21,240 1,06,200
To Separate Cost:
Material 15,000
Labor 10,000
O.H. 5,000 30,000
To Selling Expenses 13,800
To Profit (25% of 3,00,000) 50,000
2,00,000 2,00,000
NUMERICAL QUESTION
Q.1.Product A yields bye-products B and C and the joint expenses of manufacture are:
Particular A B C
Show the manner in which you would apportion the joint expenses of manufacture. Also
prepares accounts showing cost of each product.
Ans. Share in joint expenses A Rs.18,000;B Rs.7,200;and C Rs.4,500;Cost of
Production A Rs.30,600;B Rs.14,700,and C Rs.8,000.
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Show how would you apportion the joint expenses of manufacture and prepare the
accounts.
Ans. Apportionment of joint expenses: A Rs.10, 360, B Rs.8,818, C Rs.5,822
Q.3.The joint products X,Y and Z are produced from a common process. The joint
expenses of manufacture are:
Rs.
Material 57,000
Labour 30,000
Overhead 2,100
Total 89,100
X Y Z
Rs. Rs. Rs.
Materials 24,000 12,000 6,000
Labour 12,000 9,000 3,000
Overhead 1,800 1,500 1,500
Show the manner in which you want to apportion the joint expenses of production.
Ans. Joint expenses will be apportioned in the ratio of 20:8:5; Total Cost A-Rs.91, 800,
B-Rs.44, 100 and C-Rs.24, 000.
Q.4.A Factory producing article A also yields B and C as by-products. The joint cost of
manufacture is:
Rs.
Materials 10,000
Labour 2,000
Overheads 8,000
Total 20,000
Subsequent costs are as follows:
A B C
Rs. Rs Rs.
Materials 1,500 1,300 1,000
Labour 200 150 100
Overheads 800 550 400
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Show how you would propose to apportion the joint costs of manufacture and prepare
the necessary statement in respect of A, B and C.
Ans. Share in joint cost of manufacture; A Rs.6, 743; B Rs.6, 595; C Rs.6, 662
Lesson -8
PROBLEMS OF EQUIVALENT PRODUCTION
Objectives
After this lesson you will be able to understand:
• Concept of equivalent production.
• Steps involved in values of Equivalent units.
• Preparation of various statements under equivalent production.
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ACM 602 Cost Analysis and Control
continuous, some part of freshly introduced units remain incomplete at the end of
that period. Thus, there is clear distinction as to:
(i) Cost ·of work done on opening WIP.
(ii) Cost of fresh units introduced and completed during the period and
(iii) Cost of closing WIP out of fresh units introduced.
There are four steps:
(a) Statement of Equivalent Production Units: This statement is prepared to
find out the equivalent units with respect to each element.
(b) Statement of Element-wise Cost per Unit: This is prepared to calculate
the cost per unit of Equivalent production for each element.
(c) Statement of Apportionment of Cost: This is prepared to calculate total
cost for remaining work done on opening WIP, cost of newly introduced and
completed units, and the cost of closing WIP.
(d) Relevant Process Account: This is prepared to show the complete picture
about the relevant process account.
(2) Average Method: Under this method, the cost of opening WIP is combined,
element-wise, with the cost of freshly introduced units and the average cost of units
completed during the period and the cost of closing WIP are calculated. Thus, there
is no distinction between units which are partially completed in the preceding period
and those units which are started and completed during the current period. The com-
bined cost of opening inventory and current production is divided by the total of (i)
Units completed and (ii) Equivalent production units of closing inventory, to get the
cost per unit of output. The costs, then are segregated among units completed and
the closing W.I.P.
(3) LIFO Method: Under this method it is presumed that, the newly introduced
units in the current period are taken up first and after their completion, the opening
WIP is taken up, to do the remaining part of work. Therefore, the closing WIP, if
any, is represented by the opening WIP or part thereof. Thus, at the end of the period
the closing WIP may comprise (i) opening WIP or a part thereof, (ii) part of newly
introduced units not completed.
(4) Weighted Average Method: This method is followed when different
products are manufactured in different quantities in a single process. Under this
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method, output of each product is expressed in points and cost of each type of
product is calculated on the basis of points.
Hints on Solving Problems
(1) The problem states the degree of completion of opening WIP. While calculating
equivalent units, the work on remaining part of opening WIP is important.
Therefore, the equivalent units for the rest of degree of completion is calculated. For
example, if 1200 units of opening WIP is completed to 60% of labour, then equivalent
Example -1 Rahej & Co. gives the following information about process 'A' for the
manufacturing of a chemical: opening WIP: 1500 units (Degree of Completion:
Material, 100%, Labour 60%, overhead 50%). Units introduced: 6000 units. Closing
WIP: 1000 units (Degree of completion: Material 100%, Labour 50%, over- head
25%.) Prepare statement of equivalent production units. (FIFO Method)
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Solution
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Statement of Evaluation
Process A Account
Example- 3 During a month. 2.000 units were introduced into Process I. The normal
loss was estimated at 5% on input. At the end of the month 1.400 units had been
produced and transferred to next process, 460 units were uncompleted and 140 units
had been scrapped. It was estimated that uncompleted units had reached a stage in
production as follows:
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to Rs. 1440. Production overhead incurred were Rs. 1670. Direct labour Rs. 3.340.
Units scrapped realised Re. I each. The units scrapped have passed through the
process. so were 100% completed as regards material. labour and overheads. You
are required to (a) prepare a Statement of Equivalent Production. (b) evaluate the cost
of abnormal loss, finished goods and closing stock. and (c) prepare the Process I
Account and Abnormal Loss Account.
Solution
Input Output Equivalent units
Units Units Material Labour Overhead
Qty. % Qty. % Qty. %
2.000 Normal loss 1OO - - - - - -
Abnormal loss 40 40 1OO 40 1OO 40 1OO
Finished production 1,400 1,400 1OO 1,400 1OO 1,400 1OO
Work-in-progress 460 345 75 230 50 230 50
-2.000 Total 2,000
Equivalent Production 1,785 1,670 1.670
Statements of Cost
Element of cost Equivalent
Cost (Rs.) production (units) Cost per Unit
A (A) (B) (A/B)
Materials: 5,800
Units introduced 1,440
Direct materials 7,240
Less: Scrap value 1OO
of loss (normal)
Material cost 7,140 1.785 4
Direct labour 3.34 1,670 2
Overhead 1,670 1,670 1
Total 12,150
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Statement of Evaluation
Example - 4
Opening work-in-progress (30% complete) 2,000 units
Put into the process during the month 20,000 units
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19,000
Equivalent
production
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4. OH & Co. manufactures a product in the process costing is followed and work -
in - progress stocks at the end of each month are valued at FIFO basis. At the
beginning of the month of June, the inventory of work in progress showed 400
units, 40% complete. valued as follows:-
Rs.
Material 3600
Labour 3400
Overheads 1000
Total 8000
In the month of June materials were purchased for as. 75,000 Wages and overheads
in the month amounted to Rs. 79.800 and Rs. 21,280 respectively. Actual issue of
material to production was Rs. 68,500. Finished stock in stock in the month was 2500
units. There was no loss in process.
At the end of the month the work in process inventory was 500 units,
60 per cent complete as to labour and overheads and 80 per cent
complete as to materials,
Prepare a Process Account for recording the month's transactions
and prepare- a process cost sheet showing total and unit costs.
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Degree of completion
For units scrapped
Material 100%
Labour 50%
Overhead 50%
For closing stock
Material 60%
Labour 50%
Overhead .50%
Scrap realised Re. 1.00 per unit
LESSON 9
COST CONTROL
The basic objective of accounting is to provide information which is useful for persons
inside the organisation(i.e. owners, management and employees) and for persons or
groups outside the organization (i.e. investors, creditors, government, consumers etc.)
According to Slavin and Reynolds Professors of Accounting, "Conceptually, accounting
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ACM 602 Cost Analysis and Control
is the discipline that provides information on which external and internal users of the
information may base decisions that result in the allocation of economic resources in
society." The needs of the majority of the users of accounting information can be
satisfied by financial accounting. Financial statements are concerned with the past
whereas management's main interest lies not in past but in future. It is mainly
concerned with planning and controlling. Preparation of various budgets, such as sales
budget, production budget, cash budget, capital expenditure budget etc. is an important
part of tailing and preparing various budgets is an important aspect of Cost
Accountancy. Controlling is the function of seeing that programmers laid down in
various budgets are being actually achieved actual performance is compared with the
budgeted performance, enabling the management to trcisecontrol in case of weak
performance.
Now-a-days managements are facing problems of survival because of acute
competition. Onlje organisations can meet the competition effectively and have a hold
on the market which area position to keep their cost minimum. Cost accounting can be
instrumental in this regard by titillating all inefficiencies and wastages by exercising cost
control. The Chartered Institute of Management Accountants, London defines cost
control as :"The regulation by executive action of the cost of operating an
undertaking particularly pre such action is guided by cost accounting." The
terms 'regulation' and 'executive action' indicate conscious attempt of regulating
the cost on the basis of predetermined leas about what cost should be.” It is only
when costs are predetermined i.e. a system of standard costing is in operation, that
cost control measures can give their best. Thus, cost control aims at reducing
inefficiencies and wastages and setting up predetermined costs and in achieving . Cost
control is exercised through setting standards or norms or targets and comparing actual
performance therewith with a view to ascertaining deviations from set targets or norms
or standards and taking corrective action to ensure that future performance conforms
to the set standards or norms or targets.
Elements of a Cost Control Scheme
The following are the elements (i.e. major steps) of a cost control scheme :
• Set down a norm or standard or target.
• Select a yardstick for measuring the standard or target.
• Ascertain the actual performance by applying *.,"'. yardstick which was used for
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performance so that management by exception may be carried out effectively. The aim
should be to bring to light the factors leading to increase in cost rather than to punish
people to take the remedial action to improve the performance in future.
4. Good performance should be handsomely rewarded so that workers may be
motivated towards better performance.
5. For an effective system of cost control, there should be effective budgetary control
and there should be proper setting of standards Budgets and standards should be fixed
with realism. Cooperation of all persons who are to achieve the budgeted results or
standards should be secured in preparing budgets or setting up standards to get their
willing involvement in achieving the desired results.
COST REDUCTION
Introduction
Profit is the resultant of two varying factors viz. sales and cost. The wider the gap
between these two factors, the larger is the profit. Thus, profit can be maximized either
by increasing sales
befelt. Such conditions cannot, however, permanently exist. When competition comes
into play, it may not be possible to increase the sale price without its having an
adverse effect on the sale volume which, in turn, reduces profit. Besides increase in
price—which, in turn, reduces profit— increase in prices of products has the ultimate
effect of pushing up the raw-materials' prices, wages of employees and other
expenses, all of which tend to increase costs. In the long run, substitute products may
come up in the market, resulting in loss of business. Avenues have, therefore, to be
explored and methods devised to cut down expenditure and thereby reduce the cost
of products. In short, cost reduction should mean maximisation of profits by reducing
costs through economies and savings in cost of manufacture, administration, selling
and distribution.
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ACM 602 Cost Analysis and Control
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ACM 602 Cost Analysis and Control
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ACM 602 Cost Analysis and Control
6. A cost reduction programme should not merely take into consideration reduction in
cost but it should also consider all other factors (i.e. social and legal aspects) which
will be affected by the programme of cost reduction.
7. A cost reduction programme should be evolved with the idea that even the most
efficient firms incur unnecessary costs, that is, there is always scope for cost reduction
in every firm.
8. There should not be any overlap between the cost reduction measures, that is,
there should not be double counting of cost reductions.
Distinction Between Cost Control and Cost Reduction
Cost control involves predetermination of targeted costs measuring the actual costs,
investigating into the causes of variations and instituting the corrective action,
whereas cost reduction is the achievement of real and permanent reduction in unit
cost of goods manufactured or services rendered without impairing their suitability or
diminution in the quality of product. Cost reduction in values saving in unit cost such
saving is of permanent nature and the utility of the goods and services remain
unaffected. Thus cost control and cost reduction are two efficient tools of management
but their concepts and procedures are widely different. The main points of differences
between the two are the following :
1. Aim. Cost control aims at achieving the predetermined costs, whereas cost
reduction aims at reduction of costs by finding new ways or methods to have
continuous economy on costs.
2. Exercise. Cost control is a routine exercise which is carried out for attainment of
operational efficiency whereas cost reduction aims at permanent and real savings by
a continuous search for improvement. Thus, cost control follows a conservative
procedure and lacks a dynamic approach whereas cost reduction is dynamic and
innovative in nature.
3. Concerned with. The process of cost control is to lay down a target, ascertain
actual performance, compare it with the target and take corrective action. On the other
hand, cost reduction is not concerned with maintenance of performance according to
the predetermined standards.
improvements in predetermined standards.
5. Function. The aim of cost control is to see that actual costs do not exceed the
predetermined costs ; so it is a preventive function. On the other hand, cost reduction
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ACM 602 Cost Analysis and Control
There is ample scope of cost reduction in this area because cost reduction is a top
management problem. Office should be reorganised if there is scope for improvement
in the efficiency of persons engaged in the office. Use of unnecessary forms should
be avoided to save the cost of stationery and
labour cost involved for compiling them. Efforts should be made to reduce the
expenses on telephone, lighting and travelling but not at the cost of efficiency. The
points to be examined in this area will be:
• The extent of use of job evaluation as a basis for reducing staff.
& Systematic supervision of the use of office machinery.
Personnel Management
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ACM 602 Cost Analysis and Control
Material Control
•Effective and economical purchase of materials.
•Adherence to EOQ.
•Keeping low inventory-less investment in stock.
•Effective check on goods received.
•Control over material storage and issues.
•Effective check on materials yield.
1. Cost reduction increases profit. It provides a basis for more dividends to the
shareholders, more bonusto the staff and more retention of profit for
expansion of the business which will create more employment and overall
industrial prospects.
2. 'Cost reduction will provide more money for labour welfare schemes and thus
improve management relationship.
3. Cost reduction will help in making goods available to the consumers at cheaper
rates. This will create more demand for the products, economies of large
scale production, more employment through industrialisation and all-round
improvement in the standard of living.
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Self-CheckQuestions
UNIT – IV
COST ANALYSIS FOR SHORT TERM DECISION
Lesson – 10
MARGINAL COSTING
Objectives
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ACM 602 Cost Analysis and Control
MARGINAL COSTING
Introduction
The term cost system refers to the technique and process of determining costs of a
product manufactured and service rendered. As has already been explained in earlier
Units different methods are applied in different organizations to determine the costs
depending upon the nature of the product, production method and business
conditions. Here comes uniform or output costing, job costing, process costing,
contract costing and operating costing. But whatever, the nature of the organization,
type of the product, method of costing adopted; there should be a technique from cost
control point of view which will reflect the relationship between cost, volume and profit.
Where absorption costing includes all costs, fixed and variable while determining the
cost of a product.Marginal costing basis on the principle that the cost of the product
increases only on account of variable cost after a certain stage. This is so because
fixed costs remain constant whatever is the level of production. Under marginal
costing technique, the fixed expenses are not allocated to cost units but are charged
against a ‘fund’ which is excess of the sales value over the total variable costs.
Absorption Costing
This system of costing includes fixed expenses in cost and thus both fixed and
variable expenses form a part of the total cost of production. This is a conventional
method and is also known as Total Costing, Full Costing. Conventional costing,
Orthodox Costing, Product Costing or Traditional Costing. Here all the costs i.e both
fixed and variable are allocated to cost units and total overheads are absorbed
according to activity level. This term can be applied (a) only when production costs
are considered. Here all the costs i.e. fixed and variable are changed to various
operations, processes or products including work in progress and finished production.
This is usually practiced method and is termed ‘Cost Plus’ costing wherein a fixed
percentage is added to the total cost of the product to arrive at the selling price.
a. Here the costs are matched with revenues during an accounting period.
b. Stock valuation complies with accounting standards by covering up even fixed
costs.
c. The analysis of production overheads reflects the proper utilization of production
resources.
d. This avoids segregation of costs into fixed and variable which certain times is
difficult regarding certain items like depreciation.
e. Cost plus pricing ensures coverage of all costs
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ACM 602 Cost Analysis and Control
The above limitations advocated a more important device of costing technique i.e.
marginal costing.
Marginal Costing
Unlike various methods of costing like uniform, job, process or contract, this is a
technique which can be used in conjunction with any of the methods which will help
in managerial decision making. Here cost ascertainment is made on the basis of
nature of cost or behavior of the cost and its effect upon the profitability of an
undertaking.
Marginal costing may be defined the ascertainment of marginal cost and the effect on
profit of changes in volume or type of output by differentiation between fixed costs and
variable costs. Marginal cost is defined as “the amount at any given volume of output
by which aggregate costs are changed if the volume of out put is increased by one
unit” thus it can be measured by total variable cost attributable to one unit. It is the
sum of prime cost and variable overhead and relates to a unit which may be a single
article, process, batch, an order, a stage, etc.
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ACM 602 Cost Analysis and Control
Marginal costing is not a technique without limitations. Following are the drawbacks
which are faced by it.
a. Classification of costs into fixed and variable is not an easy task as certain
expenses are neither fixed nor variable like depreciation.
b. Contribution is to be linked with certain key factor to provide guidance.
c. Certain situations like in depression when prices are set to under cut competitions
may not leave a reasonable contribution margin.
d. The fundamental assumption that variable cost per unit is constant may not hold
good for higher level of activity.
e. In the long run no cost is fixed.
f. Exclusion of fixed overheads from costs may lead to erroneous conclusions. It
may create problems in inter firm comparison, higher demand for salaries and
perks by employees and higher tax by Government.
g. It is not recognized by income tax authorities.
h. Exclusion of fixed over head from stock valuation is not accepted by accounting
practices.
The profit reflected through Marginal Costing are different when compared to those
arrived through Absorption Costing for the following reasons.
The profit remains constant under both the methods when sales and production levels
are constant for any period of time. When production, costs and prices remain
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ACM 602 Cost Analysis and Control
constant and sales fluctuate, the profit as per marginal costing method will be greater
than absorption costing methods. Where sales are constant but production fluctuates,
marginal costing provides for constant profit but profits fluctuate as per absorption
costing.
When production exceeds sales, profits are higher under absorption costing than
marginal costing and vice versa. This is because as fixed costs are treated aa part of
total cost, the value of closing stock is higher which reduces the cost of production
thereby increasing the profits.
The choice between marginal costing and absorption costing is made depending on
the following factors.
Illustration:
A company has a production company of 200,000 units per year. Normal capacity
utilization is reckoned at 90% standard variable production costs are Rs.11/- per unit.
Fixed costs are Rs.360000 per year. Variable selling costs are Rs.3 per unit and fixed
selling costs are Rs.270000 per year. Unit selling price is Rs.20/- when the production
was 160000 units and sales 150000 units. Closing inventing was 20000 units. Actual
variable production costs are Rs.35000 higher than the standard. Compute the Profit
under (a) Absorption costing (b) Marginal costing.
Solution:
Amount Rs.
Sales 150000 units @ Rs.20 per unit 30,00,000
Less:
Cost of production:-
(Variable production cost (160000 @ 111/-) 17,60,000
Increase in costs 35,000
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ACM 602 Cost Analysis and Control
Less:
Closing Stock (20000) at current cost =
21,55,000
------------- X 20,000 = 2,69,375
1,60,000 -------------
20,13,625 20,13,625
-------------
9,84,375
Less:
Selling Expenses variable 4,50,000
Fixed 2,70,000
-----------
7,20,000 7,20,000
Net Profit 2,64,375
Amount Rs.
Sales 30,00,000
Less:
Marginal Cost :-
Variable Production Cost 17,60,000
Additional Cost 35,000
Variable cost of opening stock 10000 @ Rs.11/- 1,10,000
-------------
19,05,000
Less:-
Closing Stock 17,95,000
20000 X -------------- = 2,24,375
1,60,000 -------------
16,80,625
Add:
Variable Selling Cost 1,50,000
@ Rs.3/- Contribution 4,50,000
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ACM 602 Cost Analysis and Control
Less:
Fixed Cost:
Production Cost 3,60,000
Selling Cost 2,70,000
------------
6,30,000 6,30,000
Break-even Analysis:
Break-even analysis which emerges from Marginal Costing gives an idea about the
impact of changing levels of production on profit. Several factors like level of
competition, introduction of a new product, trade cycles, scare resources, change in
the setting product, etc., may necessitate change in the level of production. This
should give a clear idea to management as to such level giving desired profit. One of
the technique used here is marginal costing. Break-even analysis in the narrow sense
mean determining the break-even point i.e. determine the level production where the
total cost is equal to total revenue where costs are just covered up. In the broader
sense, it means the system of analysis which determine the probable profit at any
level of production, thus establishing the relation between cost-volume and profit.
This can be done (i) Mathematically (ii) Graphically. Four important concepts have
are;
a. Contribution
b. Profit volume Ratio or P/v Ratio or Contribution/Sales.
c. Break-even Point
d. Margin of Safety.
Mathematical Method:
(a) Contribution: - This is the difference between sales and marginal cost and this
contributes to make up fixed cost leaving the balance as profit.
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ACM 602 Cost Analysis and Control
Or
then P/VRatio =
Higher profit volume more profit as same amount of fixed expenses are covered up
from any contribution
Profit
(vi) Margin of safety = ------------
P/v Ratio
Illustration (1):
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ACM 602 Cost Analysis and Control
Sales Profit
1st Year 3,00,000 40,000
2nd Year 3,40,000 50,000
C
(i) Profit volume Ratio = ---- x 100
S
S–V 20 -12 8
Or ------- x 100 = --------- x 100 = ---- x 100 = 40%
S 20 20
10,000
--------- x 100 = 25%
40,000
Illustration (2)
From the following particulars (i) Contribution (ii) P/v Ration (iii) Break-even Point in
units and Rupees (iv) Selling price per unit when break-even point is 25000 units.
Solution:
(i) Contribution = Selling Price per unit – Variable Expenses per unit
15 – 10 = 5
Contribution
(ii) Profit volume Ratio = ----------------- x 100
Sales
5
(ii) Profit volume Ratio = ----- x 100 = 33 1/3 %
15
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ACM 602 Cost Analysis and Control
150000 x 3 x 100
---------- = 4,50,000
100
S = C + V = 6 + 10 = Rs.16
Marginal cost equation can also be used to ascertain the output or sales volume to
get a desired amount of profit by using the following formula.
Illustration (3):
From the following figures calculate (i) P/v Ratio (ii) Break-even point (iii) Sales to earn
a profit of Rs.2,40,000.
Solution:
Contribution 12,00,000 – 7,50,000
(i) Profit volume Ratio = ---------------- x 100 = ---------------------------- x 100=
Sales 12,00,000
Fixed cost
(ii) Break-even point = --------------- =
P/v Ratio
3,60,000 3,60,000 x 200
------------ = -------------------- = 9,60,000
37.5% 75
(iii) Sales to earn a profit of Rs.2,40,000
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ACM 602 Cost Analysis and Control
= -------------------------- = Rs.16,00,000
37.5%
(d) Margin of Safety:
Margin of safety is the difference between actual sales and sales at break-even sales.
The assumption of marginal costing is that output will coincide with sales, so margin
of safety is also the excess production over the break-even point’s output. After break-
even, the volume of profit assures safety. Higher the margin of safety greater the
safety levels when can be achieved by increasing the level of production increasing
the selling price, reduction of costs and substituting the less profitable product with
more profitable product.
Profit
Margin of Safety = Actual sales – Break-even sales or ------------
P/v Ratio
Illustration:
The Profit volume Ratio of a company is 50% and margin of safety is 40%. You are
requested to workout the break-even point and the net profit of the sale volume is
Rs.50 lakhs.
Solution:
Sales 5,00,000
Less:
Margin of safety 40% 5,00,000 x 40 / 100 = 20,00,000 20,00,000
30,00,000
Break-even sales
Profit volume Ratio 50%
Contribution or Fixed Expenses at Break-even point
50
i.e. ------ x 30,00,000 = 15,00,000
100
Calculation of net profit at sales of Rs. 50,00,000
Sales x Profit volume Ratio = 50,00,000 x 50
-------------------- = 25,00,000 25,00,000
100
Less:
Fixed Expenses 15,00,000
Profit 10,00,000
(B)Graphical Method:
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ACM 602 Cost Analysis and Control
Break-even Charts
The relevant data for the costs, volume and profit may be plotted o9n a graph to find
out the break-even point. The graphic approach to CVP analysis is based on reporting
total sales revenue and total expenses as a function of sales volume. Unit sales
volume is plotted on the horizontal ‘X’ axis while sales revenue and fixed and variable
costs on the vertical ‘Y’ axis. The graph so resulting is called profit graph or CVP
graph. It is also called as break-even chart because from such a graph, the break
even point could be easily located. It is the point where the total sales line and total
cost line intersect. At any volume, the profit and loss is represented by the difference
between the total sales line and total cost line. The break-even chart gives a visual
picture of the importance of volume cost profit factors, and is a useful tool in presenting
this relationship to management.
The following are the steps to be followed while constructing a break-even chart:
Angle of Incidence
This is the angle formed at the break-even point at which the sales line cuts the total
cost line. This angle of incidence is an indication that profits are being made. Large
angle of incidence is an indication that profits are being made at a higher rate. On the
other hand, a small angle indicates a low rate of profit and suggests that variable costs
form the major part of cost of production. A large angle of incidence with a higher
margin of safety indicates the most favorite position of a business and even the
existence of monopoly conditions. `
Graphical Method:
A. Break-even Chart:
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ACM 602 Cost Analysis and Control
Sales
Cost and
Sales (Rs.)
BEP Totalcost
Angle of
Incidence
Fixed Cost
X
O
Volume of output
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ACM 602 Cost Analysis and Control
d. Plot the point of sales revenue at the total output. This will come in the positive
quadrant.
e. Join the two points plotted, i.e., the fixed cost point and the sales revenue point
by a straight line. As shown in the following graph, the fixed cost incurred at zero
output is Rs.38 (being plotted on the loss side) and the sales revenue earned for
300 units of sales is Rs.80 (being plotted in the profit area quadrant).
Profit-Volume Graph:
Y
Profit / Loss Line
80
Profits 60
40
20
0 X
20 50 100 150 200 250 300 Sales / Output
40
Losses 60
80
Summary
There are number of methods of costing that are adopted depending on the nature of
the product, service, organization like uniform costing, job costing, process costing,
operating costing and contract costing. But from the cost control point of view the
techniques of costing are marginal costing, budgeting control, standard costing, etc.,
Absorption costing includes all the costs, fixed and variable while ascertaining the cost
of the product, Marginal costing is based on the principle that the variable cost alone
will increase the cost of the product after certain stage as fixed cost is constant for
any volume of output. Fixed cost under Marginal costing is set off against a fund
called contribution which is the difference between sales and variable cost.
Absorption costing is cost plus pricing covering all the costs but it cannot be used as
a control device and value of inventing is inflated as fixed costs are included. In
Marginal costing, costs are segregated thus giving way to cost control techniques.
However, a choice between the two can be made depending on the system of financial
control. Profit under both the systems proves to differ due to change in the value of
stocks. Under Marginal costing, the normal equation is S – V = F + P and this is also
called contribution. At the point of break-even S – V = C which is just sufficient to
cover up fixed costs. A relates between profit, volume and sales is being brought out
by P/v Ratio which is equal to contributes/sales. Margin of safety is the area after the
break-even i.e. the difference between actual sales and break-even sales. A break
even analysis is prepared to find out the impact and incidence of various items and
can be arrived either mathematically or graphically. As a cost controlling device
Marginal costing enables management to bring out a relationship between Profit,
volume, sales keeping in view of the changing variable costs and constant fixed costs.
Self Check Questions
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ACM 602 Cost Analysis and Control
Lesson – 11
MARGINAL COSTING – A TOOL FOR DECISION MAKING
Structure
2.1 Introduction
2.2 Marginal Costing for Decision Making
2.2.1 Best Level of action
2.2.2 Dropping a product line
2.2.3 Selection of an optimum product mix
2.2.4 Make or Buy Decision
2.2.5 Achieving a Profit Target
2.2.6 Introducing a new Product line
2.2.7 Key or Limiting Factors
2.2.8 Accept or Reject
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ACM 602 Cost Analysis and Control
2.0 Objectives
2.1 Introduction
The level of activity which yields the maximum amount of profit is one of the
important areas of decision making. Marginal Costing helps in choosing such
level of activity where it is optimum as determined by the marginal cost which
is equal to marginal revenue.
Illustration (1)
The following details relate to a Manufacturer who sells his product at Rs.80/-
per unit. Following details relate to production budget.
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ACM 602 Cost Analysis and Control
A rebate of 10% and 15% is offered for purchase contracts of 85,000 units and
1,00,000 units respectively.
Also a price discount of 5% and 10% need to be offered for the purchase
contract of 85,000 units and 1,00,000 units respectively.
Levels of Output
75,000 Units 85,000 Units 1,00,000 Units
Sales 60,00,000 64,60,000 72,00,000
Less:
Marginal Costs
Material 22,50,000 22,95,000 25,50,000
Labour 7,50,000 8,50,000 10,00,000
Other operating Costs 6,00,000 7,20,000 8,20,000
Advertising 2,20,000 2,50,000 3,20,000
When more than one product is being produced and sold, all do not yield, the
same level of profitability. A firm has to choose those products with best
contribution. This may mean some of the products which are Less profitable
or loss yielding should be dropped. But this may mean the diversion of
capacities/resources of the dropped product towards those products which are
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ACM 602 Cost Analysis and Control
more profitable and which are going to be continued. If there is any key factor
like material or labour contribution in terms of the key factor should be the
criterion.
Illustration
Suggestion:- Product B with least contribution both in general or from the part
of key factor should be dropped. If these resources are diverted towards A
better performance of the unit is ensured.
When a factory produces more than one product a decision has to be made as
to the composition of each product produced. This depends on the profits
produced with each product mix and the one which yields the maximum profit
can be chooses as a suitable mix. The one with maximum contribution and
increased . Profit Volume Ratio is preferred to be the best.
Illustration:
A company produces two products A and B whose cost information is as
follows:
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ACM 602 Cost Analysis and Control
Product A Product B
Rs Rs
Direct Material (P/v) 10 9
Direct wages 3 2
Sales Price (P/v) 20 15
Fixed Expenses 800
Variable Expenses @ 100% on wages
Sales mixtures
(i) 100 units of A and 200 units of B
(ii) 150 units of A and 150 units of B
(iii) 200 units of A and 100 units of B
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ACM 602 Cost Analysis and Control
Illustration:
The purchase price is Rs. 25/- per unit and there will be cost reduction of Rs.
20,000 of the product is bought from outside in fixed costs.
The factory can be leased out for Rs. 75,000
Solution:
Analysis of Cost
To make To buy @ To buy @
Rs. Rs.25/- per Rs.25/- each
unit and leased out
Variable Cost 8,00,000
Cost of buying from 25,00,000 25,00,000
outside
Saving in fixed cost 1,00,000 (20,000) (20,000)
Rent received
- 75,000
It is profitable to make the component than buying it or leasing out the capacity.
Profit planning is one of the key areas for managerial decision making.
Marginal Costing equation here plays a vital role as profits depend on various
elements which determine this equation i.e. S – V = f + p. Thus the factors that
determine profits are sales, variable cost, fixed cost and sales mix if more than
one product is produced.
Illustration:
A firm had a profit goal of 10% on its investment of Rs.15,00,000. The fixed
costs are Rs.4,00,000, Variable cost per unit is Rs.15/-. The firm produces
50,000 units at Rs.25/- each and earns a profit of Rs. 1,00,000. How can
management achieve the profit target by varying different variables like fixed
cost, variable cost, selling price or number of units sold
Solution:
Target Profit = 15,00,000 x 10
------------------ = 1,50,000
100
(a) Change in fixed costs S – V = F + P
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ACM 602 Cost Analysis and Control
Thus fixed costs which are originally 4,00,000 have to be reduced by Rs.50,000
i.e. 12.5%
(b) Change in variable costs
S–V=F+P
50,000 x 25 – 50,000 x X = 4,00,000 + 1,50,000
12,50,000 – 50,000 X = 55,000 X
12,50,000 – 6,50,000 = 50,000 X
7,00,000 = 50,000 X
X = 7,00,000
----------- = 14
50,000
Variable cost to be reduced by Re.1/-
Selling price has to be raise by Re.1/- to achieve the desired level of profit.
S–V=F+P
X c 25 – X x 15 = 4,00,000 + 1,50,000
25X – 15X = 5,50,000
10X = 5,50,000
X = 55,000 units
The number of units produced and sold should be increased to 5000 units.
2.2.6 Introducing New Product Line
This may mean introducing the product line in addition to the existing line of
products and here decision may also involve issues like deciding the Model,
Share or type of the product. The Marginal Cost of new product and also the
likely increase in fixed cost should be kept in view while deciding such
introduction of new product line. Primarily C/S and also net profit of new
product should be ascertained. Also ROI on new product can be compared
with the old product.
Illustration:
A company produces 20,000 units as against the installed capacity of 30,000
units. The present cost structure is as follows:
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ACM 602 Cost Analysis and Control
Fixed costs include Rs.40,000 for depreciation. Product X is sold for Rs.30/-
per unit. It is proposed to produce product Y along with X. The installed
capacity of product Y will be Rs.15,000 units. An additional investment of
Rs.2,50,000 is required over and above existing Rs.5,00,000. A total of 10,000
units of Y will be produced and sold which is sold @ Rs.20/- per unit. Fixed
overheads of Rs.15,000 and 10% depreciation need to be provided, Rs.50,000
required for additional capital. Cost estimates for Y are Rs.14/- per unit. Is it
advisable to produce Y.
Solution
Statement of Profitability of each product.
Existing Product X New Product Y Total
Rs. Rs Rs.
Sales 6,00,000 2,00,000 8,00,000
Less: Material Cost 3,20,000 1,40,000 4,60,000
Contribution 2,80,000 60,000 3,40,000
Less: Fixed overheads 1,50,000 35,000 1,85,000
(including depreciation)
1,30,000 25,000 1,55,000
Contribution % 46.7% 30% 42.5%
Net Profit % 26% 10% 20%
When resources like raw material, labour, machine capacity or working capital
are scarce contribution should be ascertained from the point of requirement /
usage of such scare resource, and thus a decision has to be taken based on
it. If it is sales, however enough goods should be produced to meet the total
demand which can give positive contribution to cover up the fixed costs and
then to yield certain profits.
Frequently, the management is offered a special order for one of its products
or an export order when the firm has surplus capacity, when there is an export
order, a decision has to be taken after analyzing the effect of the incremental
costs and incremental revenue on the overall profits of the business while
taking a decision as to accept or reject, the contribution made is the criteria.
Illustration:
A company produces 1000 units of a product which is sold in the market
at Rs.20/- per unit. It’s installed capacity is 1500 units. It received an export
order for 500 units which can be sold at Rs.15/- per unit. It’s cost information
is as follows;
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ACM 602 Cost Analysis and Control
Material Rs.5/-
LabourRs. Rs.2-50
Variable Costs Rs.3/-
Fixed Expenses Rs.8,000
Solution:
Statement of Marginal Cost and Profitability
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ACM 602 Cost Analysis and Control
Apart from cost factor other economic and social factors like loss of
employment, reputation, in market should also be considered.
Wherever there are seasonal fluctuations or when raw material is scarce shut
down point is ascertained by using the formula :
Avoidable Expenses
---------------------------------------------
Contribution per unit of raw material
Illustration:
X Ltd operates at 50% of normal capacity expects a fall in sales to the tune of
5000 units per month. The Income statement shows the following position.
Sales (5000 units @ Rs.3/- per unit) Rs.15,000
Less: Variable Cost Rs.10,000
--------------
Rs. 5,000
Less: Fixed Costs Rs. 5,000
--------------
Profit Nil
Solution:
Thus plant should shut down when sales decline below Rs. 10,500.
(b) Permanent closure:
Some times a situation may arise demand discontinuance of the unit due to
uneconomical functioning, where minimum return also is not forth coming.
This amount to capital erosion day by day while taking a decision in this
regard the organization the management should compare the income
coming forth from following sources.
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ACM 602 Cost Analysis and Control
Apart from this the decision, other factors like compensation payable to
employees, loss on sale of plant and other fixed assets also need to be kept in
mind.
2.3 Summary
B Short Questions
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ACM 602 Cost Analysis and Control
C Essay Questions.
(1) What are the various areas of decision making where marginal
costing is used.
(2) A company has a capacity of producing 1,00,000 units of certain
product in a month. The sales department reports that the
following schedule of sale price is possible.
The variable cost is .15 per unit and fixed cost is Rs.40,000.
What volume of production ideal to manufacturer?
(3) The following information is presented to you by XY Ltd which
produces 2 products 1 and 2
1 2
Rs Rs
Direct Material (per unit) 20 18
Direct Labour (per unit) 6 4
Fixed expenses during the period Rs.1600
Variable expenses are allocated to products @ 100% of direct
wages.
Selling Price per unit 40 30
Proposed sales mixes
1. 100 units of 1 and 200 units of 2
2. 150 units of 1 and 150 units of 2
3. 200 units of 1 and 100 units of 2
Which is the most profitable sales mix? The proposed sales mix
to earn a profit of Rs.300 and Rs.600 with the total sales of 1 and
2 being 300 units.
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ACM 602 Cost Analysis and Control
.
.
Lesson 12
SERVICE COSTING (Operating Costing)
Service costing refers to the method of costing applied to determine the cost per unit
of service rendered by the service industries or centres. Unlike a product which can
be physically seen, the service cannot be seen but only can be experienced.
Rendering service means providing place utility, time utility, value utility, etc., to the
end user. For example, transporting goods from one place to another, transporting
passengers, supplying water, electricity, providing telephone, consultancy service etc.
Service may be within the organisation. For example, services such as repairs and
maintenance, internal transport, supply of steam, administration etc. are provided to
other departments in the .same organisation. Service may be external. For example,
services provided by public utilities such as city passenger transportation, railways,
airways, water supply, electricity supply to the public at large.
Rendering service does involve cost. The activities involved, consume resources.
Expenses are incurred to provide these resources. These expenses are collected
together and expressed per unit of service. The cost so determined is recovered
through a saleable unit of service rendered. The unit of service differs from industry
to industry. Following is the illustrative list of service units used:
• IndustryService Unit
• Passenger Transport
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ACM 602 Cost Analysis and Control
• Goods Transport
• Electricity supply
• Water supply
• Phone
• Hospital
• Hotel lodging
• Libraries
• Banking
• General insurance
• Life Insurance
• Consultancy
• Repairs & Maintenance
• Postal Service Per Passenger per KM, or per trip
• Per ton/Quintal per KM, or per carrier, voyage etc.
• Per unit consumed
• Per 1000 gallons
• Per call made
• Per bed per day
• Per operation per patient, Per x-ray, per test etc.
• Per bed per person per day.
• Per card per two books, per year
• Per Demand draft per Rs. 1,000 Interest rate per cent.
• Per year per vehicle, premium per year etc.
• Premium per month, or per year etc.
• Per hour, or per organisation per month
• Per vehicle, per building per month etc.
• Per card, per cover, per 10 gms, per parcel, per kg, etc.
TRANSPORT COSTING
Transport is one of the important" service industries. Transport costing is the method
of costing applied in transport industry to determine the cost per goods transport and
passenger transport. The unique feature of transport industry is the basis of charge to
the customer. Transport costing involves, therefore, a proper selection of basic unit of
service and attribution of cost to such unit.
Composite Unit: The cost unit in transport costing is a composite unit. For example, a
transport company, determines the cost of carrying a passenger for a distance of one
KM. Since there are two units of measurement, it is called composite unit. Similarly,
goods transport company, calculates the cost of carrying one ton of goods to a
distance of one KM. On the basis of this, if the charge is Re. 0.50 then, a passenger
travelling 100 KM has to give Rs. 50 for his journey.
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ACM 602 Cost Analysis and Control
Sometimes the passenger transport companies fix the charges on the basis of
"Stages" or "Points." In that case, the cost unit can be a "Stage" or "Point", each
consisting of fixed number of kilometers.
Classification of Transport Cost: The operating cost of a transport company is
classified into the following three categories:
Operating/ Running/ Variable Expenses: These are the expenses which vary in
proportion to the distance covered. These expenses are incurred only when the
vehicles are run. For example, cost of fuel, lubricants, wear and tear of tyres,
consumable stores, wages of drivers, conductors and cleaners, which are based on
time or distance or contracts, depreciation based on kilometers rup, commission on
takings etc.
Maintenance/Semi variable Expenses: These are expenses which vary partly to the
distance covered by vehicles. Repairs and maintenance, replacement of tyres and
tubes, overhauls, painting etc. These are neither fixed nor variable expenses.
(c) Fixed or Standing Charges: These are expenses which are incurred irrespective
of whether the vehicles are run or not. They are committed expenses for the specified
period and so have to be incurred. or example Licence, Insurance, Rent, Interest on
Capital, Salary of Manager, Administrative expenses, Monthly or weekly salaries of
drivers, conductors, cleaners etc., fixed depreciation and token' tax.
Collection of Cost: The Accounting section in the Administrative office of the Transport
Company is responsible for collecting cost information relating to operating
service .
Standing Charges are collected on the time basis and apportioned to each vehicleon
a suitable basis. Salary bills, rent receipt, tax receipt, insurance premium paid receipt,
etc. are the source documents.
Repairs and maintenance charges, painting overhauls collected according to Job
order numbers in the workshop, Replacement cost of tyres and tubes are recorded
on the basis of requisition and purchase receipts etc.
Operating expenses are collected on the basis of record in the "log sheets.”
Each vehicle is given a "log sheet" which contains detailed information about the
number of trips, distance covered, number of days run, number of passengers/goods
carried, tickets collected, accidents if any, repairs, services, fuel consumed, oil, grease
used etc.
When the transport service is internal within the organisation for other departments,
then the cost is apportioned among the departments on the basis of use of service,
say, percentage, or hours etc.
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ACM 602 Cost Analysis and Control
When the transport service is external, for the purpose of customers, then, cost
per passenger kilometer (or cost per ton kilometer) is calculated to form a basis for
charging. Operating Cost Sheet: A cost sheet is prepared with respect to each vehicle
or a group of vehicles for a specific period, say, a month, •in order to know the cost of
operating vehicle and the cost per unit. Costs are shown under there headings:
(a) Running Cost (b) Maintenance Cost (c) Standing Cost. The total of each of these
is the total operating cost
Cost Per Unit: Cost per unit may be, cost per passenger KM in case of passenger
transport or cost per ton KM in case of goods transport.
cost per passenger KM (Total Operating Cost for period)/(Effective passenger KMs
for the period )cost per ton KM (Total Operating Cost for period)/(Effective ton KMs
for the period )The numerator, i.e., total cost for the period is obtained from the
operating cost statement prepared for the period.
The denominator, i.e., Effective passenger KMs or Effective ton KMs is calculated as
below:
Passenger kms: Passenger KMs is "the product of effective kms (distance) travelled
by the vehicle during a period and the average passengers carried during that period."
Thus, it is the total KMs required to be travelled to carry each passenger to the
respective destination.
A trip denotes to and fro journey, i.e., onward and return journey together is referred
to as Trip.
Ton KMs: Ton KMs is "the product of effective KMs travelled during the period and
the average weight (ton) carried during the period." Thus, it is the total KMs required
to be covered to carry each unit of weight (ton) to the respective destination. The unit
of weight can be ton, quintals, kgs, etc.
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ACM 602 Cost Analysis and Control
Usually, carriage vehicles take full load, i.e., 100% capacity in the onward journey
and take lesser load or available load or nil, some times, in the return journey.
Therefore, it is necessary to calculate the effective ton with respect to each onward
and return journey, separately.
(a) Onward Journey:
(1) Vinay transport company has 4 trucks, each with capacity of 5 tons. Eachtruck
makes 6 trips a day between two places, 30 KMs apart. In the onward journey full load
of bricks and in the return journey on an average 20% of capacity is filled with
provisions. Trucks are laid down for repairs and rest, for 5 days in a month of 30 days.
Calculate the effective ton KMs.
Solution
(a) Onward Journey: Number of trucks x Distance each way x Number of trips a day
x Number of days x Full capacity.
= 4 x 30 x 6 x 25 x 5 = 90,000 ton kms ..
(2) Vivek travels has 4 buses, operating between two cities Mysore and Bangalore
which are 140 KMs apart. Each bus makes 2 trips a day. The seating capacity is 50
seats. On an average 80% occupancy is experienced.
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ACM 602 Cost Analysis and Control
Calculate (a) Distance travelled (b) Average passengers carried and (c) Passengers
Kilometer for the month of July 1999 in which each bus was laid down for 6 days for
repairs .
Solution:
Distance travelled = Number of vehicles x No. of trips x 2 x Distance x No. of days
Solution
Operating Cost Sheet for the month
Particulars Amount (Rs.)
(A) Standing Cost:
Insurance Rs. 4,800 + 12 months 400
Tax Rs. 2,400 + 12 months 200
General Supervision Rs. 4,800 + 12 months 400
. . Rs. 90,000 ,,nnnn Depreciation: - Rs. 9,000 +12 months 750
Total A 1,750
(B) Maintenance Cost:
Repairs & Maintenance 500
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ACM 602 Cost Analysis and Control
Total B 500
Running Cost:
Diesel oil etc.Rs. 15 per 50 Kms.
Note : 2,500 x 15 / 50 750
Driver's wages 500
Cleaner's wages 250
Total C 1,500
Grand Total (A+B+C) 3,750
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ACM 602 Cost Analysis and Control
= 47,500 kms
= 50,000 kms.
(ii) Load carried: Normal 100 quintals
- Wastage 10% (-10) quintals .-.
Net weight 90 quintals.
Total quintal = 47,500 x 90 = 42,75,000Q.Kms.
59,375
Diesel: 3 kms. – 1 Letter
47,500-((47,500 X 1)/3)X 3.75
(6) BMP (Bangalore Maha Nagar Palike) arranges for the removal of garbage by
means of its own transport system, Following vehicles are maintained:
No. of vehicles Cost (Rs.)(Per vehicle) Capacity
20 4,00,000 5 Tons
30 3,50,000 4 Tons
40 3,00,000 3 Tons
50 2,50,000 2 Tons
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ACM 602 Cost Analysis and Control
On an average each vehicle makes 8 trips a day. The garbage is taken from all parts
of the city to 4 garbage treatment plants situated outside the city limits. The estimated
average distance from any point to garbage plant is 20 Kms. While going out each
vehicle carries only 70% of the capacity and on return journey every vehicle will be
empty. On an average 10% of the vehicle are laid down for repairs and rest. The cost
details for the month of July, 1999 are as below:
Monthly Salary of Drivers Average Rs. 4,000 per driver
Monthly Salary of Workers Average Rs 2,000 per worker (a worker for each vehicle)
Office Salary per month Rs. 2,50,000
Consumable Stores Rs. 50,000
Diesel (Mileage 4 Kms. per litre) Rs. 10 per litre.
Lubricant Rs. 10,000
Replacement of Tyres and Tubes Rs. 75,000
Miscellaneous Expenses Rs. 25,000
Depreciation on vehicles at 5% p.a., Insurance 2% p.a. Annual tax Rs. 2,000 per
vehicle. Interest on capital total per year Rs. 1,50,000
You are required to calculate —
(a) Ton Kilometers
Solution
(a) Calculation of Kms and tonKms
Total Kms = Number of vehicles x % used x Number of trips per day x 2 x Distance
each way x Number of days 90
= (20 + 30 + 40 + 50) x -jgj x 8 x 2 x 20 x 31 = 12,49,920Kms.
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ACM 602 Cost Analysis and Control
(4) A private transport company has been given a route of 20 Kms long to run a bus.
The cost of the bus is Rs. 4,50,000. It is insured at 3% P.A. and the annual tax will
amount to Rs. 5,000. Garage rent is Rs. 500 P.M. Actual repairs will be Rs. 2,500 P.A.
and the bus is likely to last for 5 years.
The driver's salary will be Rs. 1,500 P.M. and the conductor's salary will be Rs. 1,200
P.M. in addition to 10% of the takings as commission to be shared equally by the
driver and the conductor.
Cost of stationery Rs. 150 P.M. Accountant's Salary Rs. 1,350 P.M. Petrol and Oil Rs.
50 per 100 Km. The bus will make 3 round trips carrying on an average 40 passengers
on each trip. The bus will run on an average 25 days in a month. Assuming 15% profit
on takings, calculate the bus fare to be charged from each passenger per KM. [Ans.
0.1717]
(5) (a) State the distinctive features of operating costing.
(b) The Union Transport Company has been given a 20 kilometer long route to ply a
van. The van costs the Company Rs. 1,00,000. It has been insured at 3% per annum.
The annual road tax amounts to Rs. 2,000. Garage rent is Rs. 400 per month. Annual
repair is estimated to cost Rs. 2,360 and the Van is likely to last for 5 years.
The salary of the driver and cleaner is R. 600 and Rs. 200 per month respectively in
addition to 10% of takings as commission to be shared equally by them. The
Manager's salary is Rs. 1,400 per month and stationery will cost Rs. 100 per month.
Diesel and oil will cost Rs. 50 per 100 kilometer. The van will make three round trips
per day carrying on an average 40 passengers in each trip. Assuming 15% profit on
takings and that the van will ply on an average 25 days in a month, prepare operating
cost statement on a full year basis and also calculate bus fare to be charged from
each passenger per kilometer.
(6) Prakash Transport Company has been given a route 20 km. long to run a bus. The
bus costs the company a sum of Rs. 50,000. It has been insured at 3% p.a. and the
annual tax will amount to Rs. 1,000. Garage rent is Rs. 100 p.m. Annual repairs will
be Rs. 1,000 and the bus is likely to last for 5 years.
The driver's salary will be Rs. 150 p.m. and the conductor's salary will be Rs. 100 p.m.
in addition to 10% taking as commission (to be shared by the driver and the conductor
equally. The cost of stationery will be Rs. 50 p.m. Manager-cum-Accountant's salary
is Rs. 350 p.m. Petrol and oil will be Rs. 25 per 100 km. The bus will make 3 round
trips carrying, on an average, 40 passengers on each trip. Assuming 15% profit on
takings, calculate the bus fare to be charged from each passenger. The bus will run
on an average 25 days in a month.
Mr. Eswar owns a bus which runs between Mysore and Bangalore and back for 10
days in a month. The distance is 150 kms. The bus completes a trip a day. The bus
goes another 10 days towards Hassan. The distance from Mysore to Hassan in 120
kms. This trip is also completed on the same day. For the rest 4 days, it runs in the
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ACM 602 Cost Analysis and Control
local city. Daily distance covered is 40 kms. Calculate the rate to be charged to earn
a profit of 33l/2% of his taking. The other information is:
Particular Rs.
Cost of the Bus 3,00,000
Depreciation 20% P.A.
Salary of driver 1,750 P.M.
Salary of Conductor 1,750 P.M.
Salary of Clerk 800 P.M.
Insurance 8,400 P.A.
9 Prakash Automobiles distributes its goods to regional dealers using a single Lorry.
The dealers premises are 40 kilometres away by road. The Lorry has a capacity on
return journey. The following information is available for a Four Weekly Period during
the year 1990:
Particulars Amount
Diesel consumption 8 kilometres per litre.
Diesel cost Rs. 13 per litre
Oil Rs. 100 per week
Driver's Wages Rs. 400 per week
Repairs Rs. 100 per week
Garage rent Rs. 150 per week
Cost of Lorry (Excluding Tyres) Rs. 4,50,000
Life of Lorry 80,000 Kilometers
Insurance Rs. 6,500 per annum
Cost of Tyres Rs. 6,250
Life of Tyres 25,000 kilometers
Estimated sale value of Lorry at end of its life Rs. 50,000
Vehicle Licence cost Rs. 1,300 per annum
Other overhead cost Rs. 41,600 per annum
The Lorry operates on a five-day week. Required:
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ACM 602 Cost Analysis and Control
(a) A statement to show the total cost of operating the vehicle for the four-weekly
period analysed into running costs and fixed costs.
(b) Calculate the vehicle cost per kilometre and per tonne kilometer.
(10) Mr. Jai owns fleet of taxis and the following information is available from the
records maintained by him.
Particulars Amount (Rs.)
Number of taxis 10
Cost of each taxi Rs. 20,000
Salary of manager 600 p.m.
Salary of accountant 500 p.m.
Salary of cleaner 200 p.m.
Salary of mechanic 400 p.m.
Garage rent 600 p.m.
Insurance premium 5% p.a.
Annual tax 600 per taxi
Driver's salary 200 p.m. per taxi
Annual repair1,000 per taxi
Total life of a taxi is about 2,00,000kms. A taxi runs in all 3,000 kms in a month of
which 30% it runs empty. Petrol consumption is one litre for 10 kms. @ Rs. 1.80 per
litre. Oil and other sundries are Rs. 5 per 100 kms.
Calculate the cost of running a taxi per km.
(11) Mr. Jaidka owns a fleet of taxis and the following information is available from
the records maintained by him:
(i) Number of taxis 10 (vii) Garage rent Rs. 600 p.m.
(ii) Cost of each taxi 20,000 (viii) Insurance premium 5%
(hi) Salary of manager 600 p.m. (ix) Annual tax Rs. 600 per taxi
(iv) Salary of accountant 500 p.m. (x) Driver's Salary 300 p.m.
per taxi
(v) Salary of cleaner 200 p.m. (xi) Annual repairs 1,000 per taxi
(vi) Salary of mechanic 400 p.m.
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Total life of a taxi is about 2,00,000kms. A taxi runs in all 3,000 kms. in a month of
which 30% it runs empty. Petrol consumption is one litre for 10 kms. @ Rs. 1.80 per
litre. Oil and other sundries are Rs. 5 per 100 kms.
Calculate the cost of running a taxi per km.
LESSON 13
STANDARD COSTING
Learning Objectives
Introduction
The vital aspect of managerial control is cost control. Hence, it is very important to
plan and control costs. Standard costing is a technique which helps to control costs
and business operations. It aims at eliminating wastes and increasing efficiency in
performance through setting up standards or formulating cost plans.
Meaning of Standard
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In the words of Backer and Jacobsen, “Standard cost is the amount the firm thinks a
product or the operation of the process for a period of time should cost, based upon
certain assumed conditions of efficiency, economic conditions and other factors.”
Definition
The CIMA, London has defined standard cost as “a predetermined cost which is
calculated from managements standards of efficient operations and the relevant
necessary expenditure.” They are the predetermined costs on technical estimate of
material labor and overhead for a selected period of time and for a prescribed set of
working conditions. In other words, a standard cost is a planned cost for a unit of
product or service rendered.
The technique of using standard costs for the purposes of cost control is known as
standard costing. It is a system of cost accounting which is designed to find out how
much should be the cost of a product under the existing conditions. The actual cost
can be ascertained only when production is undertaken. The predetermined cost is
compared to the actual cost and a variance between the two enables the management
to take necessary corrective measures.
Advantages
Standard costing is a management control technique for every activity. It is not only
useful for cost control purposes but is also helpful in production planning and policy
formulation. It allows management by exception. In the light of various objectives of
this system, some of the advantages of this tool are given below:
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ACM 602 Cost Analysis and Control
4. Cost control-- Every costing system aims at cost control and cost reduction. The
standards are being constantly analyzed and an effort is made to improve efficiency.
Whenever a variance occurs, the reasons are studied and immediate corrective
measures are undertaken. The action taken in spotting weak points enables cost
control system.
2. The process of setting standard is a difficult task, as it requires technical skills. The
time and motion study is required to be undertaken for this purpose. These studies
require a lot of time and money.
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3. There are no inset circumstances to be considered for fixing standards. The conditions
under which standards are fixed do not remain static. With the change in
circumstances, if the standards are not revised the same become impracticable.
4. The fixing of responsibility is not an easy task. The variances are to be classified into
controllable and uncontrollable variances. Standard costing is applicable only for
controllable variances.
For instance, if the industry changed the technology then the system will not be
suitable. In that case, we will have to change or revise the standards. A frequent
revision of standards will become costly.
Setting Standards
Normally, setting up standards is based on the past experience. The total standard
cost includes direct materials, direct labor and overheads. Normally, all these are fixed
to some extent. The standards should be set up in a systematic way so that they are
used as a tool for cost control.
There are several basic principles which ought to be appreciated in setting standards
for direct materials. While purchasing material, the quality and size should be
determined. The standard quality to be maintained should be decided. The quantity is
determined by the production department. This department makes use of historical
records, and an allowance for changing conditions will also be given for setting
standards. A number of test runs may be undertaken on different days and under
different situations, and an average of these results should be used for setting material
quantity standards.
The second step in determining direct material cost will be a decision about the
standard price. Material’s cost will be decided in consultation with the purchase
department. The cost of purchasing and store keeping of materials should also be
taken into consideration. The procedure for purchase of materials, minimum and
maximum levels for various materials, discount policy and means of transport are the
other factors which have bearing on the materials cost price. It includes the following:
• Cost of materials
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ACM 602 Cost Analysis and Control
• Ordering cost
• Carrying cost
The second largest amount of cost is labor. The benefit derived from the workers can
be assigned to a particular product or a process. If the wages paid to workers cannot
be directly assigned to a particular product, these will be known as indirect wages.
The time required for producing a product would be ascertained and labor should be
properly graded. Different grades of workers will be paid different rates of wages. The
times spent by different grades of workers for manufacturing a product should also be
studied for deciding upon direct labor cost. The setting of standard for direct labor will
be done basically on the following:
Standard labor time indicates the time taken by different categories of labor force
which are as under:
• Skilled labor
• Semi-skilled labor
• Unskilled labor
For setting a standard time for labor force, normally previous experience, past
performance records, test run result, work-study etc are taken in account. The labor
rate standard refers to the expected wage rates to be paid for different categories of
workers. Past wage rates and demand and supply principle may not be a safe guide
for determining standard labor rates. The anticipation of expected changes in labor
rates will be an essential factor. In case there is an agreement with workers for
payment of wages in the coming period, these rates should be used. If a premium or
bonus scheme is in operation, then anticipated extra payments should also be
included. Where a piece rate system is used, standard cost will be fixed per piece.
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The object of fixed standard labor time and labor rate is to device maximum efficiency
in the use of labor.
The next important element comes under overheads. The very purpose of setting
standard for overheads is to minimize the total cost. Standard overhead rates are
computed by dividing overhead expenses by direct labor hours or units produced. The
standard overhead cost is obtained by multiplying standard overhead rate by the labor
hours spent or number of units produced. The determination of overhead rate involves
three things:
• Determination of overheads
The overheads are classified into fixed overheads, variable overheads and semi-
variable overheads. The fixed overheads remain the same irrespective of level of
production, while variable overheads change in the proportion of production. The
expenses increase or decrease with the increase or decrease in output. Semi-variable
overheads are neither fixed nor variable. These overheads increase with the increase
in production but the rate of increase will be less than the rate of increase in
production. The division of overheads into fixed, variable and semi-variable categories
will help in determining overheads.
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a product, the factory will be a cost center. In fact, a cost center describes the product
while cost is accumulated. Cost centers enable the determination of costs and fixation
of responsibility. A cost center relating to a person is called personnel cost center, and
a cost center relating to products and equipments is called impersonal cost center.
2. Current Standards
A current standard is a standard which is established for use over a short period of
time and is related to current condition. It reflects the performance that should be
attained during the current period. The period for current standard is normally one
year. It is presumed that conditions of production will remain unchanged. In case there
is any change in price or manufacturing condition, the standards are also revised.
Current standard may be ideal standard and expected standard.
3. Ideal Standard
This is the standard which represents a high level of efficiency. Ideal standard is fixed
on the assumption that favorable conditions will prevail and management will be at its
best. The price paid for materials will be lowest and wastes etc. will be minimum
possible. The labor time for making the production will be minimum and rates of wages
will also be low. The overheads expenses are also set with maximum efficiency in
mind. All the conditions, both internal and external, should be favorable and only then
ideal standard will be achieved.
Ideal standard is fixed on the assumption of those conditions which may rarely exist.
This standard is not practicable and may not be achieved. Though this standard may
not be achieved, even then an effort is made. The deviation between targets and
actual performance is ignorable. In practice, ideal standard has an adverse effect on
the employees. They do not try to reach the standard because the standards are not
considered realistic.
4. Basic Standards
A basic standard may be defined as a standard which is established for use for an
indefinite period which may a long period. Basic standard is established for a long
period and is not adjusted to the preset conations. The same standard remains in
force for a long period. These standards are revised only on the changes in
specification of material and technology productions. It is indeed just like a number
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5. Normal Standards
The success of standard costing system will depend upon the setting up of proper
standards. For the purpose of setting standards, a person or a committee should be
given this job. In a big concern, a standard costing committee is formed for this
purpose. The committee includes production manager, purchase manager, sales
manager, personnel manager, chief engineer and cost accountant. The cost
accountant acts as a co-coordinator of this committee.
7. Accounting System
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Revision of Standards
For effective use of this technique, sometimes we need to revise the standards which
follow for better control. Even standards are also subjected to change like the
production method, environment, raw material, and technology.
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LESSON 14
MATERIAL AND LABOUR VARIANCE
Material Variances
In case of materials, the following may be the variances :
(a) Material Cost Variance
(b) Material Price Variance
(c) Material Usage or Quantity Variance
(d) Material Mix Variance
(e) Material Yield Variance.
The following chart shows the division and sub-division of material variances:
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Material Price Variance (MPV).It is that portion of the material cost variance
which is dueto the difference between the standard cost of materials used for the
output achieved and the actualcost of materials used. In other words, it can be
expressed as:
(c) Material Usage (or Quantity) Variance (MQV). It is that portion of the
material con variance which is due to the difference between the standard
quantity of materials specified for the actual output and the actual quantity of
materials used. It may be expressed as:
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ACM 602 Cost Analysis and Control
Note. Standard quantity means quantity of material which should have been
used (as per standard determined) for the actual output achieved.
(d) Material Mix Variance (MMV). It is that portion of the material usage variance
which is to the difference between standard and the actual composition of a mixture.
In other words, this variance arises because the ratio of materials being changed from
the standard ratio set. It is calculated as the difference between the standard price of
standard mix and standard price of actual mix.
(i) When actual weight of mix and the standard weight of mix do not differ.
In such a case, material mix variance is calculated .vith the help of the following
formula :
or
If the standard is revised due to shortage of a particular type of material, the material
mix variance is calculated as follows :
or
This formula is necessitated to adjust the total weight of standard mix to the total
weight of actual mix which is more or less than the weight of standard mix
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ACM 602 Cost Analysis and Control
(e) Material Yield (or Sub-usage) Variance (MYV). It is that portion of the material
usage variance which is due to the difference between the standard yield specified
and the actual yield obtained. This variance measures the abnormal loss or saving of
materials. This variance is particularly important in case of process industries where
certain percentage of loss of materials is inevitable. If the actual loss of materials
differs from the standard loss of materials, yield variance will arise. Yield variance is
also known as scrap variance. This loss may result in the following two situations :
(i) When standard and actual mix do not differ. In such a case, yield variance is
calculated with the help of the following formula :
ii) When actual mix differs from standard mix. In such a case, formula for the
calculation of yield variance is almost the same. But since the weight of actual mix
differs from that of the itandard mix, a revised standard mix is to be calculated to adjust
the standard mix in proportion to i actual mix and the standard rate is to be calculated
from the revised standard mix as follows :
(f) Material Revision Variance. Once a standard is set for a period, it is usually
followed for that period. But sometimes due to seriousness of the situation such
as a sudden rise in the pricesof materials, or due to the short supply of a particular
material, there may be need of revision of standard to cope with the situation.
Standards are revised with the hope that when the current difficulties are over,
original standard will continue to operate. Thus, revision of standards maybe for
a short period. Material revision variance is calculated as given below :
Material Revision Variance = St. Price (St. Usage - Revised St. Usage) For
calculation of material usage variance, revised standard usage or quantity will be
taken in stead of standard usage or quantity. Material usage variance will be
calculated as given below:
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ACM 602 Cost Analysis and Control
Material Usage Variance = St. Price (Revised St. Usage - Actual Usage) Other
material variances will be calculated in the same way as explained earlier. In case
there is material revision variance, material cost variance will be verified as given
below:
SOLUTION
Workings :
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ACM 602 Cost Analysis and Control
Material B:
Cost Variance
OR
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ACM 602 Cost Analysis and Control
The labour (quantities) efficiency means the number of hours that the appropriate grade of
writer will take to perform the necessary work. It is based on actual performance of worker or
group of workers possessing average skill and using average effort while performing manual
operations or working on machine under normal conditions. The standard time is fixed keeping
inmind the past performance records or work study. This is on the basis that is acceptable to
the worker as well as the management.
labour Cost Variance
He labour cost variance is also called 'labourtotalvariance'is the difference between the
standard direct labour cost and the actual direct labour cost incurred for the production
achieved.
(Standard labour hours produced X Standard rate per hour) - (Actual direct labour hours X
Actual rate per hour)
or
Standard cost for actual output - Actual cost
Labour Rate Variance
The labour rate variance is the difference between the actual direct labour rate per hour and
the standard direct labour rate per hour, multiplied by the actual hours paid, i.e., the rate per
hour paid the direct labour force more or less than standard use of higher/lower grade of skilled
workers than planned or wage inflation causes this variance.
Actual time (Standard rate - Actual rate)
labour Efficiency Variance
labour efficiency variance is the difference between the actual hours taken to produce the
actual output and the standard hours that this output should have taken, multiplied by
thestandard rate per hour. The possible cause for this variance is due to use of higher/ of skilled
workers than planned or the quality of material used, errors in allocating time to job.
Standard rate (Standard time for actual output - Actual time)
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ACM 602 Cost Analysis and Control
Standard cost p.u. (Standard output for actual time - Actual output)
Idle Time Variance
The idle time variance represents the difference between hours paid and hours worked, ie,Mij
hours multiplied by the standard wage rate per hour. This variance may arise due to illness,|
machine breakdown, holdups on the production line because of lack of material.
Idle hours X Standard rate
Net Efficiency Variance
This variance is calculated after deducting idle hours from actual hours. The efficiency
varianctless idle time variance is called 'net efficiency variance'.
Standard rate ( Standard time for actual output - Actual time worked)
or Standard rate (Standard time - Actual hours paid - Idle time)
Illustration 20.2
100 skilled workmen, 40 semiskilled workmen and 60 unskilled workmen were to work
for30weeksio get a contract job completed. The standard weekly wages were Rs. 60, Rs. 36
and Rs. 24 respective The job was actually completed in 32 weeks by 80 skilled, 50 semiskilled
and 70 unskilled workmen who I were paid Rs. 65, Rs. 40 and Rs. 20 respectively as weekly
wages.
Find out the labour cost variance, labour rate variance, labour mix variance and labour
efficiency variance.
Solution
Basic Data for Calculation of Labour Variances
Category of Standard Actual
workmen
Weeks Rate Amount Weeks Rate Amount
Calculation of LabourVarience
Direct Labour Cost Variance
Std. cost for actual output - Actual cost
2,75,20O - 2,66,400 = Rs. 8,800 (A)
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[Material Price Variance = Rs. 2,500 Adverse ; Material Usage Variance = Rs. 1,000
Adverse ; Material Cost Variance = Rs. 3,500 Adverse]
4. A manufacturing concern which has adopted standard costing furnishes the
following information : Standard :
Material for 70 kg.finished product 100 kgs.
Price of material Re. 1 per kg.
Actual:
Output 2,10,000kgs.
Material used 2,80,000kgs.
Cost of material Rs. 2,52,000
Calculate :(a) Material Usage Variance, (b) Material Price Variance and (c) Material
Cost Variance. [Material Usage Variance = Rs. 20,000 Fav. ; Material Price
Variance Rs. 28,000 Fav.; Material Cost Variance Rs. 48,000 Fav.]
5. Calculate variances from the standard for a particular month as disclosed
from the following figures
Standard In a particular month
Number of workers employed 600 550
Average wages per worker per month Rs. 250 Rs. 264
Number of working days in a month 25 24
Output in units 30,000 28,000
[Labour Cost Variance = Rs. 5,200 Adverse ; Rate of Pay Variance = Rs. 13,200
Adverse : Efficiency Variance = Rs. 8,000 Favourable]
7. The standard hours for manufacturing two products M and N are 15 hours per
unit and 20 hours per unit respectively. Both products require identical kind of
labour and the standard wage rate per hour is Rs. 5. In the year 2001, 10,000
units of M and 15,000 units of N were manufactured. The total labour hours
actually worked were 4,50,500and the actual wage bill came to Rs. 23,00,000.
This included 12,000 hours paid for @ Rs. 7 per hour and 9,400 hours paid for @
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ACM 602 Cost Analysis and Control
Rs. 7.50 per hour, the balance having been paid at Rs. 5 per hour. You are
required to compute the labour variances.
Ans. (Total Labour Cost Variance Rs. 50,000 Adverse ;Labour Rate Variance Rs.
47,500 Adverse ; Labour Efficiency Variance Rs. 2,500 Adverse)
8. From the following records of Apollo Bolt Nut Manufacturing Company, you
are required to compute material and labourvariances :
An input of 100 kgs.of material yields a standard output of 10,000 units.
Standard price per kg.of material = Rs. 20.
Actual quantity of material issued and used by production department 10,000
kgs. Actual price per kg.of material = Rs. 21 per kg. Actual output = 9,00,000
units Number of employees = 200
Standard wage rate per employee per day = Rs. 40 Standard daily output per
employee = 100 units Total number of days worked = 50 days
(Idle time paid for and included in the above half day for each employee) Actual
wage rate per day = Rs. 45.
Ans.[MCV = Rs. 30,000 (A); MPV = Rs. 10,000 (A) MQV = Rs. 20,000 (A), LCV =
Rs. 90,000 (A); LRV = Rs. 50,000 (A), LEV = Rs. 36,000 (A) ITV = Rs. 4,000 (A)].
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ACM 602 Cost Analysis and Control
LESSON 15
OVERHEAD VARIANCE
Variable Overhead Variance
For fixation of costs for overheads, a survey of overheads will be necessary and with the data
available for budgetary control, the overheads will be charged to various cost centres/products
etc. on the basis of standard costs. For this, after dividing the overheads into fixed and variable
the calculation of standard overhead rate for each cost centre / product is done. The number of
hours representing the capacity to manufacture is to be reduced by various idle facilities, etc.
The chlaof method of absorption (direct wage rate or machine hour) will depend upon the
circumstances. The main object is to establish a normal overhead rate based on total factory
overhead at normal capacity volume.
Variable Overhead
VariableCost Variance
Overhead Variable Overhead
The variable overhead costVariance
Expenditure variance represents the difference between
Efficiency the standard cost of
Variance
variable overhead allowed for actual output and the actual variable overhead incurred during
the period. The variance represents the under absorption or over absorption of variable
overhdi
(Actual output X Standard variable overhead rate p.u.) - Actual variable overhead cost
or
(Standard hours for actual output X Standard variable overhead rate per hour) -Actual
variable overhead cost
Variable Overhead Expenditure Variance
It is the difference between the actual variable overhead rate per hour and the standard
variable overhead rate per hour multiplied by the actual hours worked. The actual hours
worked mustkused not the actual hours paid because the latter may include idle time and it is
usually assumed that variable overhead will not be recovered in idle time.
(Standard variable overhead rate X Budgeted output) - Actual variable overheads
or (Standard hours for budgeted output X Standard variable overhead rate per hour) ■
Actual variable overheads
or Budgeted variable overheads - Actual variable overheads
Variable Overhead Efficiency Variance
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ACM 602 Cost Analysis and Control
The variable overhead efficiency variance is calculated by taking the difference in standard
output and actual output multiplied by the standard variable overhead rate.
Standard variable overhead rate (Standard output - Actual output)
Illustration
The budgeted variable overheads for March are Rs. 3,840. Budgeted production for the
month is 38,400 units. The actual variable overheads incurred were Rs. 3,830 and actual
production was 38,640 units,
Calculate variable production overhead variance.
Solution
Working
Standard Variable Overhead p.u.
Total standard Variable Overhead= Actual quantity X Std. variable overhead p.u.
= 38,640 units X Re. 0.10 = Rs. 3,864
Variable Production Overhead = Standard variable overhead - Actual variable overhead
= Rs. 3,864 - Rs. 3,830 = Rs. 34 (F)
Fixed Overhead Variances
Fixed overhead represents all items of expenditure which are more or less remain constant
irrespective of the level of output or the number of hours worked. The fixed overheads
variances are classified as follows:
Cost Variance
Expenditure Variance Volume Variance
Efficiency Variance Capacity Variance
(Actual output X Standard fixed overhead rate p.u.) - Actual fixed overheads
Or
(Standard hours for actual output X Standard fixed overhead rate per hour) -Actual fixed
overheads
Or
Recovered fixed overheads - Actual fixed overheads
Fixed Overhead Expenditure Variance
This variance is also called 'budget variance', obtained by comparing the total fixed overhead
cost actually incurred against the budgeted fixed overhead cost.
Budgeted fixed overheads - Actual fixed overheads
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ACM 602 Cost Analysis and Control
Normal capacity 10,000 standard hours, budgeted rate Rs. 1.70 per standard hour for variable
overhead and Re. 1 per standard hour for fixed overhead. Actual level 8,000 standard hours.
Solution
Calculation of Variable and Fixed Overhead Variances
l) Variable Overhead Cost Variance
Recovered variable overheads - Actual variable overheads
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ACM 602 Cost Analysis and Control
Sales Variances
All of the variances discussed previously have been concerned with costs; the effects
on profits due to adverse or favorable variances affecting direct materials, direct
labour or overheads. Some companies calculate cost variances only, but to obtain the
full advantages of standard costing. It is required to calculate sales variances. Sales
variances affect a business in terms of changes in revenue: changes which have been
caused either by a variation in sales quantities or in sales prices. There are two
distinctly separate systems of calculating sales variances, which show the effect of a
change in sales as regards:
(i) Sales margin variance (on the basis of profit), and
(ii) Sales value variance (on the basis of turnover).
Sales Variances Based on Profit
The sales variances based on profit are also called 'sales margin variances' which
indicates the deviation between actual profit and standard or budgeted profit.
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ACM 602 Cost Analysis and Control
(Actual quantity of sales X Standard price) - (Actual quantity of sales X Actual price)
Sales Volume Variance
It represents the difference between the actual units sold and the budgeted quantity
multiplied by either the standard profit per unit or the standard contribution per unit. In
absorption costing standard profit per unit is used, but in marginal costing, standard
contribution per unit must be used.
Standard profit p.u. (Actual quantity of sales - Standard quantity of sales)
Or
Standard profit on actual quantity of sales - Standard profit on standard quantity of
sales
Salesvolume variance can be further segregated into (a) Sales mix variance and (b)
Sales quantity I variance as given below :
Sales Mix Variance
The sales mix variance arise when the company manufactures and sells more than
one type of product.This variance will be due to variation of actual mix and budgeted
mix of sales.
Standard profit p.u. (Actual quantity of sales - Standard proportion for actual sales)
Or
Standard profit - Revised standard profit
Selling price Cost per No. of units Selling price Cost per No. of
per unit (Rs.) unit (Rs.) sold per unit (Rs.) unit (Rs.) units sold
A 50 32 10,000 48 30 12,000
B 40 24 14,000 42 25 12,000
C 30 18 16,000 31 20 15,000
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ACM 602 Cost Analysis and Control
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Illustration
Standcost Corporation produces three products : A, B and C. The master budget
called for the sale of 10,000 units of A at Rs. 12; 6,000 units of B at Rs. 15 and
8,000 units of C at Rs. 9. In addition, the standard variable cost for each product
was Rs. 7 for A, Rs. 9 for B and Rs. 6 for C. In fact, the firm actually produced and
sold 11,000 units of A at Rs. 11.50, 5,000 units of B at Rs. 15.10 and 9,000 units of
Cat Rs. 8.55.
Calculate Sales Value Variances.
Solution
Computation of Sales Variance
Product Budgeted Sales Actual Sales Std. Sales
(Actual Qty.
X Std. Rate)
= 6,996 (F)
= 18,750 (A)
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ACM 602 Cost Analysis and Control
Verification:
Sales Value Variance
= Sales price variance X sales volume variance
= 9,050 (A) + 6,000 (F) = Rs. 3,050 (A)
Sales Volume Variance
= Sales mix variance + Revised sales volume variance
= 5,750 (A) + 11,750 (F) = Rs. 6,000 (F)
The above sales variances have been calculated on the basis of value. Hence, they
are known as 'sales value variances'. Alternatively, they could have been calculated
on the basis of profit/ margin. In that case they would have been termed as 'sales
margin variances.
SELF CHECK QUESTION
1. Calculate overhead variances from the following data
Standard Actual
Fixed overheads (Rs.) 8,000 8,500
Variable overheads (Rs.) 12,000 11,200
Output in units 4,000 3,800
Ans. [Overhead Cost Variance Rs. 700 Adverse ; Variable Overhead Variance
Rs. 200 Fav. ; Fixed Overhead Variance Rs. 900 Adverse; Volume Variance Rs.
400 Adverse ; Fixed Overhead Expenditure Variance Rs. 500 Adverse]
2. From the following, compute the different overhead variances :
In a factory 10,000 units are budgeted to be produced in a month with budgeted
fixed expenses being Rs. 15,000 i.e. Rs. 1.50 per unit. The actual output during
the month was 11,000 units and actual fixed expenses being Rs. 15,500. The
increase in output was due to 5% increase in capacity. The budgeted working
days were 25 but factory worked for 27 days.Ans. [Overhead Variance Rs. 1,000
Fav. ; Expenditure Variance Rs. 500 Adverse ; Volume Variance Rs. 1,500 Fav. ;
Calendar Variance Rs. 1,200 Fav. ; Capacity Variance Rs. 810 Fav. ; Efficiency
Variance Rs. 510 Adverse]
3. A manufacturer operating a standard costing system had the following data in
respect of a month :
Standard Actual
Number of working days 25 27
Man hours per month 5,000 5,400
Output in units 500 525
Fixed Overheads (Rs.) 2,500 2,400
Calculate fixed overhead variances for the month.
Ans.[Total Fixed Overhead Variance Rs. 225 Favourable; Volume Variance Rs.
125 Favourable ; Expense
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ACM 602 Cost Analysis and Control
Variance Rs. 100 Favourable; Capacity Variance Nil ; Calendar Variance Rs. 200
Favourable ; Efficiency Variance Rs. 75 Adverse]
4. From the following data, calculate : (a) efficiency variance, (6) capacity
variance, (c) calendar variance, (d) volume variance and (e) expenditure
variance.
Item Budgeted Actual
No. of working days 20 22
Man hours per day 8,000 8,400
Output per man hour in units 1.0 0.9
Overhead (Rs.) 1,60,000 1,68,000
Ans.(a) Rs. 18,480 Unfav.; (6) Rs. 8,800 Fav.; (c) Rs. 16,000 Fav.(d) Rs. 6,320
Fav. ; and (e) Rs. 8,000 Unfav.]
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