Cost and Management Accounting

COST AND MANAGEMENT ACCOUNTING
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COURSE DESIGN COMMITTEE
Chief Academic Officer

Dr. Arun Mohan Sherry
M.Sc. (Gold Medalist), M.Tech.
(Computer Science -IIT Kharagpur), Ph.D.
NMIMS Global Access – School for Continuing Education
Content Reviewer
CA (Dr.) Purva Shah
Assistant Professor, NMIMS Global
Access - School for Continuing Education
Specialization: Finance and Taxation
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Author: Kanhaiya Singh

Reviewed By: CA (Dr.) Purva Shah
Copyright:
2020 Publisher
ISBN:
978-81-265-5117-0
Address:
4436/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
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Address V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India.
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C O N T E N T S
CHAPTER NO. CHAPTER NAME PAGE NO.
1 Management Accounting Fundamentals 1
2 Materials Cost Control 23
3 Labor Cost and Overhead Cost Control 51
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4 Cost Concepts, Cost Classification and Unit Cost Analysis 97
5 Cost Analysis: Job Order, Batch and Contract Costing 129

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6 Income Recognition Under Marginal and Absorption Costing 149
7 Process Costing and Joint Costing 167

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8 Standard Costing and Variance Analysis 195

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9 Management Accounting in Global Perspective 231
10 Case Studies 249
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C U R R I C U L U M
Management Accounting Fundamentals: Concept of Management and Cost Accounting: An Introduction,

Cost Accounting, Best Practices in Costing System, Management Accounting, Management Accounting
Information and Their Use, Practical Implications of Management Accountancy, Cost Management for
Competitive Advantage, Decision-Making Process in a Firm, Some Innovative Management Accounting
Practices, Management Accounting as Profession, Limitations of Management Accounting
Materials Cost Control: Functions of Material Control Department, Essential Features of Material Control
Process, Responsibilities of the Purchase Department, Materials Issue Process, Material Control Techniques,
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Material Pricing Methods, Quantity of Material Procurement, Material Management at Stores, Inventory
Control Techniques, Additional Solved Problems
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Labor Cost and Overhead Cost Control: The Issues Concerned with Labor Cost Control, Mechanism
of Labor Cost Control, Labor Attrition, Recording of Timings, Methods of Work Study, Methods of Wage
Payment, Overhead Cost Control
Cost Concepts, Cost Classification and Unit Cost Analysis: Cost Classification, Cost sheet, Valuation of
Closing Stock, Calculation of Cost and Selling Price, Preparation of Statement of Cost and Abridged Profit
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and Loss Account, Calculation of Work-in-Progress Figure Based on Cost Sheet
Cost Analysis: Job Order, Batch and Contract Costing: Job Order Costing, Batch Costing, Contract Costing
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Income Recognition Under Marginal and Absorption Costing: Marginal Costing, Absorption Costing,
Practical Application of Absorption and Marginal Costing
Process Costing and Joint Costing: Features of Process Costing, Difference Between Process and Job
Costing, Preparation of Process Account, Process Accounts with Scrap, Normal Loss, Abnormal Loss and
Abnormal Gain, Joint Products and By-Products, Difference Between Joint Product and By-Product, Joint
Costs, Methods of Costing of Joint Products
Standard Costing and Variance Analysis: Standard Costing, Need for Fixing Standards, Process of Standard
Costing, Uses of Standard Costing, Benefits of Standard Costing, Limitations of Standard Costing, Material
Yield Variance, Labor Cost Variances, Idle Time Variance, Labor Yield Variance, Labor Mix Variance,
Overhead Variances, Analysis of Variances, Sales Variances, Variances Based on Profits, Control Ratios
Management Accounting in Global Perspective: Activity as a Focus, Change in Focus, Management

Accounting and Developed Costing Systems, Modern Cost Management Systems
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C H A
1 P T E R
MANAGEMENT ACCOUNTING
FUNDAMENTALS
CONTENTS
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1.1 Concept of Management and Cost Accounting: An Introduction
1.1.1 Objectives of Management Accounting
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Self-Assessment Questions
1.2 Cost Accounting
1.3 Best Practices in Costing System
1.3.1 Practical Applications of Financial, Cost and
Management Accounting
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Activity
1.4 Management Accounting
1.4.1 Essential Features of Management Accounting
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1.5 Management Accounting Information and Their use

1.6 Practical Implications of Management Accountancy
Activity
1.7 Cost Management for Competitive Advantage
1.8 Decision-Making Process in a Firm
1.8.1 Planning
1.8.2 Directing
1.8.3 Controlling
Activity
1.9 Some Innovative Management Accounting Practices
1.10 Management Accounting as Profession
1.11 Limitations of Management Accounting
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1.12 Summary
1.13 Descriptive Questions
1.14 Answer Key
1.15 Suggested Books and E-References
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Management Accounting Fundamentals 3
INTRODUCTORY CASELET
ASHOKA AUTOMOBILES
Ashoka Automobiles is a Medium sized firm engaged in manufacturing

of automobile parts since 2010. It manufactures 6 parts that are used
in the assembly of different types of cars. The parts are given the names
as A B C D E and F. The selling price of these parts is currently revised
and fixed at Rs. 60, Rs. 80, Rs. 55, Rs. 120 and Rs. 155 respectively.
Part F being highest price is able to generate the highest revenue whereas
part C provides lowest revenue to the firm as it has the lowest selling
price. The figures of sales revenue are produced before the Managing
Director by the accountant periodically. The Managing Director often
gets upset to see the sales revenue figure of part C. He asked the accoun-
tant why the part C has the lowest revenue and therefore may not be
contributing to the profits of the firm therefore the production of part C
is discontinued. The accountant was not able to answer and justify
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the reason. However, he suggested to call the qualified Management
Accountant, recently appointed by the firm and he may be able to find out
the reason and justify the decision if the product C is to be discontinued.
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The Managing Director called the Management Accountant and sought
for his opinion. The Management accountant made a detailed analysis
considering the sales revenue figure, total cost of each product and con-
tribution given by the each product to the firm. He had taken last 3 years
data and made a detailed analysis on these parameters. After detailed
analysis, he found that the contribution made by the product F was the
least as compared to other 5 products and on the contrary contribution
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made by the product C was the highest among all the products. He came
to the Managing director with these findings and explained that the pro-
duction of product C should be further increased as it will contribute
more to the profits of the firm. On the other, production of product E
could be reduced or maintained at the current level as it gives the least
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contribution to the profits of the firm.

This was an eye opening outcome to the Managing Director and he
realized its importance. He also understood the role of a management
accountant in the firm. The Managing Director called a meeting to
implement the suggestion given by the Management Accountant.
QUESTIONS
1. How would you differentiate the decision making practices in

traditional accounting system and management accounting
system?
2. Analyze the role and significance of management accountant in
decision making process.
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4 COST AND MANAGEMENT ACCOUNTING
LEARNING OBJECTIVES
After reading this chapter, you will be able to understand:

>> Fundamental aspects of management accounting.
>> Relationship and linkages between financial accounting, cost
accounting and management accounting.
>> Need for management accounting.
>> Role of management accounting in decision-making strategies in
a firm.
>> Attainment of competitive advantage through the use of management
accounting.
>> Tools of management accounting for facilitating managerial
decisions.
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>> Limitations of management accounting.
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Competitive advantage
signifies:
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Before we start explaining the fundamentals of management accounting, let
us understand the importance of management accounting in bringing com-
• Cost optimization strategies petitive advantage to a business firm. There are many components beyond
• Maintaining quality of the
cost control and reduction that help in bringing efficiency and excellence in
product or service
the operations of a firm. The management accounting as a decision-making
• Determining competitive
tool is a mechanism to implement the needed strategies.
selling price of a product
• Achieving true cost
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excellence 1.1 CONCEPT OF MANAGEMENT AND COST
• Gaining competitive
advantage in the market
ACCOUNTING: AN INTRODUCTION
The traditional system of accounting information has undergone many
changes over the years, both domestically and internationally. In the past,
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QUICK TIP financial accounting was supposed to provide financial information about
the firm to the board members and a few stakeholders. With the passage
Financial accounting provides of time, the utility of financial accounting received wider acceptance as a
information to all stakeholders. good number of firms started getting listed, and shareholders at large started
evincing interest in assessing the financial position of a firm. Also, reporting
in financial accounting is a mandatory requirement. The costing assumes
significant importance as it enables a firm achieve competitive advantage.
The cost accounting basically deals with identifying cost per unit, cost alloca-
tion, and cost monitoring and control; determining selling price; etc. Various
cost control and cost reduction measures help a firm to improve its profitabil-
ity and thus achieve financial efficiency. Managerial accounting is a different
kind of mechanism that has been termed as a decision-making science. It is
an integral part of management process where the managers decide various
strategies based on financial accounting and cost accounting information
and data (Table 1.1). The process involves identification of relevant informa-
tion, measurement and analysis of data and its interpretation from a decision
point of view, initiation of monitoring and control, and communication across
various levels to achieve goals.
Thus, management accounting uses accounting information and other pro-
visions for arriving at various operational decisions to bring efficiency in the

functioning of a firm. The management accounting strategies have adopted

NOTE
new decision-making tools such as the value chain system, allocation of cost-
ing through activity-based costing (ABC), target costing and cost analysis for Cost accounting is the art of
pricing decisions, responsibility centers and linking balanced score card to identification and allocation
of costs.
organizational strategies. In the recent past, the role of managerial accoun-
tants has changed significantly in the decision-making process and resolving
day-to-day operating problems of a firm.
The difference between cost accounting and management accounting can be
explained as given in Table 1.2.
TABLE 1.1 A COMPARISON IN FINANCIAL ACCOUNTING NOTE

AND MANAGEMENT ACCOUNTING
Cost accounting differs from
Basis Financial Accounting Management Accounting Management accounting in
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Objectives It helps in finding out It helps in computing cost terms of:
results of accounting year of production/service in a • Budget allocation and
in the form of Profit and systematic manner to control budgetary control.
Balance Sheet.
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Loss Account and prepares cost. • Short-term goals and
long-term goals.
Reporting It is more attached with It is an internal reporting • Management functions and
reporting the results and system for an organization’s performance evaluation.
position of business to own management for • Cost allocation per unit and
persons and authorities decision-making. cost efficiency.
other than bodies such • Implementation of costing
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as government, creditors, decisions and cost decision
investors and owners. strategies.
Data analysis Data is historical in nature. Data is not only historical but
also futuristic in approach.
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Cost Major emphasis is on cost Classification is on the

classification classification based on type basis of functions, activities,
of transactions – salaries, products, process and on
repairs, insurance, stores, internal planning and control
etc. and information needs of the
organization.
Accounting Only those transactions It uses both monetary as well
transactions are recorded that can be as quantitative information.
expressed in monetary terms.
Effective It aims at presenting “true It aims at computing “true
purpose and fair” view of the profit and fair” view of the cost of
and loss position and production/services offered
financial position. by the firm.
Statutory Financial accounts are Management accounts are
requirements subject to statutory audit to subject to cost audit that
verify whether they disclose verifies whether the cost
a “true and fair view” of the accounts disclose “true
profit and loss as well as and fair view” of the cost of
financial position. production of the company.

TABLE 1.2 COMPARISON BETWEEN COST ACCOUNTING

AND MANAGEMENT ACCOUNTING
Basis Cost Accounting Management Accounting
Concerning issue It is mainly concerned with It evaluates the impact
allocation, distribution and and effect of costs on
accounting aspects operational decisions.
of costing.
Data The costing data is the It uses both the financial
basis of management accounting and cost
accounting decisions. accounting data.
Scope It has a narrow scope in It has broader scope in
business operations. analyzing managerial
decisions.
Term It is for short-term It is concerned with both,
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planning. the short- and long-term
planning.
Functions It assists only in It also helps in performance
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workers.
Approach It is a historical approach. It is a futuristic approach.
Interdependence It can be installed without It cannot be implemented
the management without the cost
accounting system. accounting system.
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1.1.1 OBJECTIVES OF MANAGEMENT ACCOUNTING

STUDY HINT
There are four broad objectives that management accounting accomplishes
• F inancial accounting
in an organization – planning, resource allocation, direction and motivation,
classifies business
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and monitoring and control. These are explained as follows:

transactions and prepares
financial statement to 1. Planning: Preparing a plan and ensuring its execution to achieve short-
show the liabilities and and long-term goals. This is basically done through budget preparations.
assets of a firm.
• Cost accounting involves 2. Allocation of resources: The resources in terms of raw materials,
in allocation of costs and workforce and other requirements to facilitate production and services
analyzing costing data. efficiently are allocated to various divisions/units duly assessing their
• Management accounting requirements.
focuses on cost efficiency 3. Direction and motivation: Once the resources are allocated in the
and operational decisions. required manner, there is a need to direct and motivate people for
• Financial accounting is optimum contribution. Since the efficiency is linked to various incentives,
reporting, cost accounting the managers at different levels are engaged in providing required
is implementation and
direction and motivate people to contribute in optimum manner.
management accounting
is decision making. 4. Monitoring and control: Proper monitoring at different intervals is
very much essential to achieve goals and keep the optimized cost.
The management reviews the targets in relation to the actual state
and assesses the reasons for the gap to take corrective measures in
future.

1. Interpretation means SELF-ASSESSMENT

QUESTIONS
a. Explanation of meaning and significance of the data in Financial
Statements.
b. Concerned with preparation and presentation of classified data
c. Systematic analysis of recorded data
d. Methodical classification of data given in Financial Statements
2. Planning, resource allocation, direction and motivation, and
monitoring and control are the four broad objectives of
a. Cost accounting
b. Management accounting
c. Financial accounting
d. Costing system
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1.2 COST ACCOUNTING
Cost accounting is a technique to optimize cost of production/services by
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using different costing techniques and reaching a competitive stage in a ! IMPORTANT CONCEPT
given business scenario. Before going deep into various aspects of costing,
let us understand the basic elements of cost: Cost accounting is a system of
accounts for determining the
1. Cost can be described as the resources that have been sacrificed or cost of products or services.
must be sacrificed to achieve a goal. This is a sort of investment made
to produce a product or service. As long as this product remains in the
firm, it is treated as an investment or asset.
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2. Costing is the systematic procedure of ascertaining the cost of a product

or service. Costing broadly deals with the cost of production, selling
and distribution.
3. Cost accounting is a system of accounts for determining the cost of
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products or services. It deals with preparing budgets; monitoring

standard costs and actual costs; and costing of processes, activities
or products. It also analyzes cost accounting information and data for
various managerial decisions.
Cost accountancy basically deals with the application of costing and cost
accounting principles and strategies. The essential functions of cost account-
ing are as follows:
1. Ascertaining the cost of production on per unit basis.
2. Determining selling price.
3. Controlling and reducing cost.
4. Arriving at division-wise, activity-wise and unit-wise detail of cost.
5. Finding out inefficiencies and other weaknesses in the processes,
making available relevant data for decision-making and estimating
future costs.

SELF-ASSESSMENT
3. Cost concept basically recognises
QUESTIONS
a. Fair Market value
b. Historical cost
c. Realisable value
d. Replacement cost
4. Arriving at division-wise, activity-wise and unit-wise detail of cost is
an essential function of
a. Management accounting
b. Financial accounting
c. Costing system
d. Cost accounting
5. Costing is specialized branch of accounting which deals with:
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a. Classification, recording, allocation, and control of asset
b. Classification, processing, allocation and directing
c. Classification, recording, planning and control of asset
d. Classification, recording, allocation and directing
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6. The basic objective of cost accounting is
a. Tax compliance
b. Financial Audit
c. Cost ascertainment
d. Profit analysis
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1.3 BEST PRACTICES IN COSTING SYSTEM

Following are some of the generally adopted best practices in the area
of cost accounting which make the cost accounting practices more
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professional.
1. Need to adopt a costing system that matches with the nature and size
QUICK TIP of the business and its business analysis needs.
An efficient costing system
2. Analyze costs and benefits of operations and adopt economical and
should explain proper cost of
material, labor and overheads.
beneficial operating system.
3. Costing system followed should be simple to operate.
4. An efficient costing system should explain proper cost of material,
labor and overheads.
5. It should be as accurate as possible.
6. It should facilitate effective monitoring and control.
1.3.1 PRACTICAL APPLICATIONS OF FINANCIAL, COST AND

MANAGEMENT ACCOUNTING
Having understood the differences between financial, cost and manage-
ment accounting in the preceding paragraphs in this chapter, let us get more

clarity on factors and components differentiating the following three

accounting systems through practical situations.
1. Financial accounting: It presents the position of assets, liabilities,
income and expenditure of a firm for comparative periods. It only
reflects the information as available in books of accounts. It represents
past financial data and provides consolidated information only.
2. Cost accounting: It helps in preparing product-wise statement of cost,
revenue and profit or losses by allocating various costs according to the
existing policy of the firm. It also indicates as to which of the product is
making profit or loss.
3. Management accounting: It analyzes different cost elements by
allocating them into most scientific manner so as to arrive at correct
contribution from different products. Based on an in-depth analysis
of costs, revenue, capacity utilization and contribution, it also decides
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whether to buy a particular product from the market or produce on
its own. It also suggests if various strategies can make a product
profitable and if not whether it will be wise to shut down a plant or
product.
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7. The nature of financial accounting is
a. Historical
SELF-ASSESSMENT
b. Forward looking
QUESTIONS
c. Analytical
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d. Social
8. Cost accounting emerged on account of
a. Competitive markets
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b. Statutory requirement
c. Wage rate solution
d. Limitations of financial accounting
9. The use of management accounting is
a. Optional
b. Compulsory
c. Legally
d. Compulsory to some and optional to others
10. Management accounting assists the management
a. Controlling
b. Direction
c. Planning
d. All of the above

ACTIVITY 1 Mark the following statements if they relate to cost accounting, manage-
ment accounting or financial accounting.
1. Reporting contribution margin
2. Prime cost
3. Explaining cost of materials, labor and overheads
4. Preparation of financial statements
5. Requires statutory audit of the financial statements
6. Determining selling price
7. Performance evaluation of Managers
8. Controlling and reducing cost
9. Determining cost of production per unit
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10. Internal reporting system for decision making
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1.4 MANAGEMENT ACCOUNTING
According to the Chartered Institute of Management Accountants, the defi-
NOTE nition of management accounting is prescribed as “the process of identifica-
Management accounting is a tion, measurement, accumulation, analysis, preparation, interpretation and
decision-making process based communication of information used by management to plan, evaluate and
on various accounting and control within an entity and to assure an appropriate use of and account-
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financial information and data ability for its resources. Management accounting also comprises the prepara-
analysis. tion of financial reports for non-management groups such as shareholders,
creditors, regulatory agencies and tax authorities.”
According to IMA “Management accounting is a profession that involves
partnering in management decision-making, devising planning and perfor-
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mance management systems, and providing expertise in financial reporting

and control to assist management in the formulation and implementation of
an organization’s strategy.”
On the basis of these two professional approaches of defining management
accounting, the following can be concluded:
1. Management accounting is a decision-making process based on various
accounting and financial information and data analysis.
2. It ensures adequate resources for different operational units.
3. It involves perfect monitoring and control through responsibility
management.
4. It primarily focuses on achieving future strategies and goals of the
organization.
1.4.1 ESSENTIAL FEATURES OF MANAGEMENT ACCOUNTING

Following are the features of management accounting that clearly define the
essentials of management accounting.

1. The data and information are derived from financial accounting and
cost accounting to arrive at decisions in management accounting. ! IMPORTANT CONCEPT
2. The focus of management accounting is to determine policy and Management accounting
formulate plans to achieve desired goals and objectives of the firm. has a future vision, uses
various tools and techniques
3. It focuses on corporate planning and strategies to make them effective to facilitate in planning for
and purposeful. achieving the desired goals
of a firm.
4. It involves short- and long-term planning.
5. It uses tools and techniques, such as sensitivity analysis, probability
techniques, decision tree and other tools, for planning and monitoring
and control to take business decisions.
6. It has a future vision and involves predictions.
7. For various analyses, it involves cost accounting system.
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8. It generates various reports for taking business decisions in different
scenarios.

INFORMATION AND THEIR USE
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The information generated based on management accounting practices and
techniques can be used in the following areas for bringing more efficiency in
the business operations.
1. Cost measurement: It measures full cost, including direct and indirect
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costs. Direct costs are costs that are identifiable or traceable and can be STUDY HINT
directly apportioned to the products or services. Indirect costs are not
Management accounting
allocated directly to the products or services. The measurement of full
information can be used in
cost serves different purposes and is used in different decisions.
cost measurement, monitoring
2. Monitoring and control: Another important use of management and control, and it facilitates
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accounting information is to monitor closely the cost aspect of decision-making of a firm.

a product or process and implement important effective control
measures to optimize the cost, while not compromising on quality.
This is basically done through the process of budget and budgetary
control. The targeted allocation of cost and actual is compared at
different time intervals.
3. Facilitates decision-making: It generates appropriate and required
information for future decision-making relative to various operations of
a firm. The decisions may involve making or buying, further processing,
shutting down operations, increasing production capacity, determining
selling price and other related decisions. Unlike financial accounting,
management accounting does not follow any prescribed format or pro
forma. The nature of format depends on the nature of information and
decision required for the firm. Different kinds of formats are used for
different purposes. The team involved in management accounting
information analysis uses its own judgment for designing a specific
format. Let us understand the broad uses of management accounting
information and analysis.

QUICK TIP 1.6 PRACTICAL IMPLICATIONS OF

The management accounting
MANAGEMENT ACCOUNTANCY
is a practical decision By its very nature, management accounting is a process of measuring, ana-
implementation process as: lyzing and reporting financial and non-financial information to facilitate
managers to take decisions to achieve desired goals of a firm. Managers use
• It focuses on goals of affirm.
management accounting information to choose, communicate and implement
• It prepares alternative
strategies to achieve goals. strategy. This information helps in coordinating product design, process-
• It monitors and control the ing and marketing decisions. The analysis and information of management
achievements and compare accounting is basically meant for internal uses. We can broadly describe the
with standards. role of management accounting as given in Table 1.3.
• It decides about producing/
outsourcing/discontinuing of
a product or process. TABLE 1.3 MANAGEMENT ACCOUNTING TOOLS
• It is practical approach AND THEIR SIGNIFICANCE
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towards efficiency. Component Uses
Strategy Creating value for the customers through proper planning
formulation and implementation of the strategies. The ultimate target
is to reduce costs and improve efficiency.
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Efficient The flow of goods, services and information enhances the
supply chain performance of the firm. Tools such as standard costing
and target costing are effective for cost control and cost
reduction and thus ensure increased customer satisfaction.
Decision- Techniques, such as marginal costing, help generate
making information that is useful for taking managerial decisions
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science such as make or buy, add or drop a product line, additional
working shift, capital expenditure decision and so on.
Analysis of Several tools such as budgets and budgetary control,
performance standard costing and marginal costing are used in
measuring actual performance.
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Responsibility Fixing responsibility by creating different centers such

centers as cost, profit, investment, etc.
SELF-ASSESSMENT 11. Which of the following are tools of management accounting?

QUESTIONS
a. Decision making
b. Standard costing
c. Budgetary control
d. All of the above
12. Management accounting is related with
a. The problem of choice making
b. Recording of transactions
c. Cause and effect relationships
a. a and b b. b and c
c. a and c d. All are false

The selling price of products A, B and C was Rs. 180, 165 and Rs. 220 per ACTIVITY 2
unit in a firm. The revenue generated by product A was the highest. The
cost of sale per unit for all the products was Rs. 165, Rs. 125 and Rs. 190
respectively. The CEO was at the loss to understand whether he should
stop product producing product B as it has the least share in total sales
revenue. Suppose the total quantity sold during the last financial year of
3 products was 1200 units, 1300 units and 1000 units. What would you
advice to the CEO as a management accountant?
1. What is the proportion of sales revenue of product B in total sales
revenue?
2. What is the contribution margin of product B?
3. What was the total profit contributed by all the products to the
firm?
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4. What was the percentage of profit of product B in total profit?
5. What would you recommend to CEO and why about product B?
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1.7 COST MANAGEMENT FOR
COMPETITIVE ADVANTAGE
The traditional systems and techniques of cost management have under-
gone a major change due to increased use of technology and global com-
petitiveness in the recent past. The mantra for survival of a firm in today’s
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world is an efficient customer service at the lowest cost with the highest
quality. These aspirations of consumers have been increasing day-by-day.
Therefore, the modern techniques of cost management lay more focus of
effective planning, proper resource allocation and adequate monitoring
and control. Let us understand the cost management system in today’s
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context:
1. The cost of the resources incurred in major operations of a firm receives
greater importance.
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2. Compare the cost of your product with that of industry’s nearest The mantra for survival of
a firm in today’s world is an
competitors and peer groups from time to time to ensure that your
efficient customer service
product is superior and cost-effective too.
at the lowest cost with the
3. Assess efficiency and effectiveness of all major operations and highest quality.
processes in the firm.
4. A continuous effort to identify non-value-added costs to eliminate and
optimize the cost of production.
5. Strengthen R&D activities for new innovations in products and
processes to optimize the cost of production.
6. Introduce online monitoring and control of different processes in
production.
7. ABC should be expanded as activity-based costing.

1.8 DECISION-MAKING PROCESS IN A FIRM

STUDY NOTE
The decision-making process in a firm from management accounting per-
Decision-making process in a spective can be depicted in Figure 1.1.
firm involves:
• P lanning 1.8.1 PLANNING
• Directing
• Controlling Table 1.4 represents different phases of planning process in a firm.
1.8.2 DIRECTING
The direction is a process of directing the operations for effective use of
resources. The different stages of direction are described in Table 1.5.
1.8.3 CONTROLLING
NOTE
The process of controlling can be defined as a process of monitoring and con-
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Controlling involves monitoring
trolling measures to achieve the desired goals effectively. The tools of moni-
and controlling measures
toring and control are described in Table 1.6.
to achieve the desired goals
effectively.
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Management decisions
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Directing
Planning Controlling
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Figure 1.1 Decision-making process in a firm.
TABLE 1.4 PHASES OF PLANNING

Phase Description
Strategy To select the best alternatives in terms of cost, quality and
competitive advantages to fix the optimum selling price of a
product or service and thus achieve goals.
Positioning Where to place the product in terms of geographical coverage
(existing market, new market, domestic or international), how
to organize and utilize resources at the best cost to bring more
efficiency and cost-effectiveness.
Budgets To prepare short-term and medium-term budgets based on
past data and information. The budgets are prepared
keeping in view the organizational goals.

TABLE 1.5 STAGES OF DIRECTION

Stage Description
Costing To provide necessary resources keeping in view the cost
of resources. Managers provide necessary directions from
time to time to optimize cost and bring in efficiency. Also
use and develop the appropriate and relevant costing
technique to identify and allocate correct costing to a
particular product.
Production Once the production target is decided, adequate resources
are provided in terms of raw materials, labor and other
inputs. The responsibility is fixed to produce required
production in time with minimum wastage at all levels.
Suitable directions are given from time to time to ensure
that production reaches to end customer in time and cost
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is optimized at all levels.
Analysis Once the required resources are provided and the
production process is monitored, an analysis is made to
compare the actual with pre-decided standards and to
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ascertain gaps to take further corrective actions.
TABLE 1.6 TOOLS OF MONITORING AND CONTROL

Tools Description
Monitor To ensure that the desired goals are achieved in time, a
regular monitoring is done at different intervals. The prime
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objective of monitoring is to ascertain whether the firm

operates in the desired manner and achieve its goals.
Scorecard For adequate and effective monitoring and control, strategic
management accounting has developed the concept of
balance scorecard to improve the quality of internal and
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external communication. This helps in effectively monitoring

the firm’s performance against the set goals.
Match the following: ACTIVITY 3
Column 1 Column 2
A. Make or Buy 1. Management decision
B. Marginal costing 2. Monitor
C. Investment center 3. Non Value added cost
D. Entry to International Market 4. Raw material
E. Fixing selling price 5. Decision making
F. Quality of communication 6. Analysis of Performance
G. Production target 7. Responsibility
H. Cost Elimination 8. Positioning
I. Achieving desired goal 9. Strategy
J. Business goals 10. Scorecard


1.9 SOME INNOVATIVE MANAGEMENT

ACCOUNTING PRACTICES
The management accounting policies and practices have changed a lot
depending on accounting and trade policies and practices across the globe.
Some of the new innovations in the field of management accounting are
briefly described in the following list:
1. Total quality management (TQM): TQM basically stresses and focuses
NOTE on maintaining the quality of a product and service. It has significant
Some new innovations in impact on the cost savings and bringing efficiency in a product or
management accounting: service. The practice of TQM is being followed in many firms across
the sectors. It may be either an automobile industry or any other
• TQM manufacturing firm. The main focus of TQM program is to measure
• Just-in-time approach and assess the costs and remove the cost of defects and wastage at the
• Value chain initial point itself. This is also known as zero defect approach. This will
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eliminate costs involved in quality control procedures besides providing
customer satisfaction. The focus is on taking preventive measures at
the initial stage. Therefore, the firms adopt this strategy to bring more
quality in the product and service along with cost effectiveness.
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2. Just-in-time: Just-in-time is an approach developed in modern
management accounting to control the inventory holding cost by
minimizing the level of inventory in hand. The program was imple
mented two decades back and firms realized greater benefits of this
in minimizing inventory holding costs. The approach suggests that all
inventories such as raw materials, working process and finished goods
should be held physically at the store at the lowest possible levels.
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This will reduce the cost of holding. There has to be perfect system of
measuring the requirement of inventory at different levels, considering
the demand for production process and also for supplying purposes.
The conditions should be ideal to reach the inventory in time at all
levels failing which there will be negative impact on production and
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supplies in time. This also reduces the wastage in the holding period.
3. Value chain: Many business firms define their mission to become one
of the prime brand in products or services line in which they operate.
Practically for such types of firms, the product or service line they are
in have more significance than any single step within the value chain.
Such firms innovate and concentrate on particular activities that allow
them to capture maximum value for their customers and themselves.
They use and adopt value chain system to better understand which
segments, distribution channels, price points, product differentiation,
selling propositions and value chain configurations will yield them
the greatest competitive advantage. In this approach, the following
analyses have been undertaken.
(a) Internal cost analysis: This is to assess different sources of
profitability and the related cost aspects for the purpose of creating
internal value in various processes.
(b) Internal differentiation analysis: This is to further investigate
and understand the sources of differentiation (including the cost)
within internal value-creating processes.

(c) Vertical linkage analysis: This is to identify the relationships

and relevant costs among external suppliers and customers so
as to maximize the value delivered to customers and to optimize
the cost.
There are many other innovations that have been discussed in this book.

AS PROFESSION
Often there is a perception in general that management accounting is
only or mainly concerned with finance professionals, but in real-life busi-
ness situation it is not so. The techniques and practices of management
accounting are more relevant in all areas of professional management, be
it finance, marketing, human resources (HR), strategies, operations, etc.
Here are some examples to show the relevance of managerial decisions in
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the following areas:
1. Finance: As a finance professional one should understand data analysis
and its significance in managerial decisions. The basic financial analysis QUICK TIP
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helps to undertake various managerial decisions. Until and unless one Management accounting is
has the depth of advanced techniques of management accounting, used for fixing prices
useful future decisions are difficult to take. Therefore, techniques of of a product.
ABC, target costing, standard costing, contribution analysis, etc., that
are integral components of modern management accounting need to
be well understood by finance professionals.
2. Marketing: Pricing of a product is of prime importance to the marketing
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team to compete in the market, and there are often arguments on this
issue between marketing and production departments. Therefore,
understanding the fundamentals of pricing is very important. Pricing
strategies is an important technique under the management accounting
system. Besides, there are other strategies for taking different
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managerial decisions based on management accounting principles,

which a marketing professional must be aware of.
3. Human resources: There is a tendency in practical business situations
that production department requires more manpower, skilled or non-
skilled, but HR department provides lesser number of workforce as the
HR head has to ensure that the per unit labor cost does not exceed the
standard cost. Likewise, the actual manpower cost has to be managed
within the overall budget.
4. Strategy and operations: A professional involved in strategies and
operations must also understand the various techniques and tools of
management accounting to take relevant decisions in the business’s
interest and also achieve competitiveness.
From the above, it is clear that understanding the fundamentals of manage-
ment accounting is important for all professionals and managers involved in
strategic decisions. It is all the more important to understand the planning
and budgeting techniques and exercises at all levels, irrespective of CEO or
division or unit head.

1.11 LIMITATIONS OF MANAGEMENT

ACCOUNTING
STUDY HINT Though management accounting has emerged as a operation decision-
making science in the last couple of decades, it has the following limitations.
Management accounting is
a decision-making tool. 1. Management accounting is based on data of financial and cost
accounting. Therefore, it works on available historical data for
suggesting future decisions. Accuracy, correctness and effectiveness
of managerial decisions largely depend on the quality of data and
information available to arrive at decisions. If financial data is not
accurate, the analysis will not be fair and the decisions and course of
actions will not be that accurate.
2. It is well understood that management accounting is more useful to the
management team involved in decision-making process as they have
adequate understanding of the practices of management accounting.
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More precisely, to understand the managerial analysis, an elementary
knowledge of data analysis is necessary to the person involved in the
decision-making process.
! IMPORTANT CONCEPT
The decisions arrived in
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3. The decisions arrived in management accounting are mostly based
on facts and figures. There is a tendency to make decisions based on
management accounting are individuals’ thinking and intuition, in which case decisions do not have
based on facts and figures. much impact. The decisions may be biased to some extent.
4. Management accounting analysis provides information based on the
requirement of management and not decision. Taking decisions and
finally implementing them are done by the top management.
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5. Last, the interpretation of financial information depends on the

individual judgment and perception. Ultimately, future course of action
is guided by the philosophy and understanding of the top leader.
Personal prejudices and biases affect the objectivity of decisions.
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SELF-ASSESSMENT
13. Management accountancy is a structure for
QUESTIONS
a. Costing
b. Accounting
c. Decision making
d. Management
14. Who coined the concept of management accounting?
a. R.N Anthony
b. James H. Bliss
c. J. Batty
d. American Accounting Association
15. Management accounting deals with
a. Quantitative information
b. Qualitative information
c. Both a and b
d. None of the above

1.12 SUMMARY
Management accounting uses the accounting information and other
rovisions for arriving at various operational decisions to bring efficiency
p
in the functioning of a firm. The management accounting strategies have
adopted new decision-making tools such as the value chain system, allo-
cation of costing through ABC, target costing and cost analysis for pricing
decisions, responsibility centers and linking balanced scorecard to orga-
nizational strategies. In the recent past, the role of managerial accoun-
tants has changed significantly in decision-making process and resolving
day-to-day operating problems of a firm. The financial accounting infor-
mation and reports are prepared and communicated in a standard format
following mandatory requirements to the outside stakeholders such as
general public, shareholders, bankers, creditors, suppliers, regulators
and government authorities, whereas the management accounting infor-
mation and analysis are tailor-made depending on the nature of opera-
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tional decisions required in a firm.
The importance of management accounting lies in taking managerial
decisions to achieve the goals of a firm. The top management usually
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decides various goals the firm wants to achieve in a particular year. Based
on these goals, the management arrives at various policy decisions. To
achieve the set goals, three important tools of management account-
ing are used – p
lanning, directing and control. The entire management
accounting techniques and systems are developed to efficiently manage
these tools and techniques.
Globalization has several implications and consequences on practicing
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management accounting professionals. The globalization has created

and developed more competitive environment. This has encouraged
professionals to implement and adopt accounting systems and prac-
tices that focus on accurate, more relevant data, and provide timely
information to the market and information seekers. Further, the large
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growth of multinational firms has helped to increase the transfer pric-

ing policies and practices. The transfer pricing is a mechanism in which
one division of a firm pays to another division of the firm for acquiring
intermediate products. Transfer pricing is also viewed from taxation
point of view. This is also viewed from international trade negotiations
angle to arrive at production and marketing decisions. Globalization
has increased at a faster pace with many changes in terms of business
practices, policies and systems. This has caused many innovative prac-
tices in the area of management accounting policies and practices.
1. Financial accounting: An accounting system developed on the basis KEY WORDS

of accounting principles to report financial results.
2. Cost accounting: An accounting system to identify and allocate
various costs to the products.
3. Management accounting: An accounting technique used by managers
for undertaking various strategies to achieve goals of a firm.

4. Planning: An exercise to achieve future goals by allocating

resources.
5. Directing: A process of providing appropriate direction and
guidelines to ensure smooth operations in an organization to
accomplish tasks in time.
6. Control: Timely monitoring and control of activities and taking
appropriate action.
7. Activity-based costing: Allocation of cost based on the steps involved
in each activity to assess the actual cost of a product.
8. Just-in-time: A process of inventory cost control to avoid holding
cost.
9. Value chain: A set of innovative activities and processes that provide
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maximum value to the customers and the firm.
10. Responsibility center: Fixing responsibility to the unit managers for
achieving the set goals in terms of revenue, cost and profit.
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1.13 DESCRIPTIVE QUESTIONS
1. Define and differentiate between financial accounting and cost
accounting.
2. Describe essential features of management accounting.
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3. How is management accounting a decision-making science? Explain
with a suitable example.
4. Explain in detail the decision-making process in a firm.
5. What are the new innovations and concepts in management
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accounting?
6. What are the limitations of management accounting?
1.14 ANSWER KEY
SELF-ASSESSMENT QUESTIONS
Topics Q. No. Answers

Concept of Management and Cost 1. a. Explanation of meaning
Accounting: An Introduction and significance of the data
in Financial Statements.
2. b. Management accounting
Cost Accounting 3. b. Historical cost
4. d. Cost accounting
5. a. Classification, recording,
allocation, and control
of asset


6. c. Cost ascertainment
Practical Applications of Financial, 7. a. Historical
Cost and Management Accounting
8. a. Competitive markets
9. a. Optional
10. d. All of the above
Practical Implications of 11. d. All of the above
Management Accountancy
12. c. Cause and effect relation-
ships
Limitations of Management 13. c. Decision making
Accounting
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14. b. James H. Bliss
15. a. Quantitative information
b. Qualitative information
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1.15 SUGGESTED BOOKS AND E-REFERENCES
SUGGESTED BOOKS
R.P Rustagi (2015). Fundamentals of Management Accounting, 4th
Edition. Taxmann’s.
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R.S.N. Pillai and V. Bagavathi (2010). Management Accounting. S. CHAND.
E-REFERENCES
“Definition of Management Accounting”. Institute of Management
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Accountants. 2008. Archived from the original on 20 October 2016.

Retrieved 4 December 2012.
“Consortium for Advanced Management International CAM-I”. www.
cam-i.org. Archived from the original on 7 October 2017. Retrieved
2 May 2018.

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C H A
2 P T E R
MATERIALS COST CONTROL
CONTENTS
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2.1 Introduction
2.2 Functions of Material Control Department
2.3
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Essential Features of Material Control Process
2.4 Responsibilities of the Purchase Department
2.5 Materials Issue Process
2.5.1 Bill of Materials
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2.5.2 Material Requisition Slip
Activity
2.6 Material Control Techniques
2.7 Material Pricing Methods
2.7.1 First in First Out Method
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2.7.2 Last in First Out Method

2.7.3 Highest in First Out Method
2.7.4 Average Cost Method
2.7.5 Weighted Average Cost Method
2.7.6 Periodic Average Cost Method
2.7.7 Standard Cost Method
2.7.8 Market Price
2.8 Quantity of Material Procurement
2.8.1 Economic Order Quantity
Activity
2.9 Material Management at Stores
Activity
2.10 Inventory Control Techniques
2.10.1 Perpetual Inventory System

2.10.2 ABC System of Inventory Control
2.10.3 Just-in-Time Inventory Approach
2.10.4 VED Analysis of Inventory Control
2.10.5 FSND Analysis
Activity
2.11 Additional Solved Problems
2.12 Summary
2.14 Answer Key
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Materials Cost Control 25
THE HINDUSTAN HEAVY ENGINEERING LTD.
The Hindustan Heavy Engineering Ltd. requires 4,000 units of a partic-

ular raw material per year. At the beginning of the current year, the pur-
chase department accepts the purchase price @ Rs. 90 per unit while the
accounting department estimates the incremented cost of processing an
order as Rs. 135 and the cost of storage to be Rs. 12 per unit. But the cost-
ing department is against the incremental processing cost of Rs. 135 per
unit rather according to it, this should have been Rs. 80. At the commence-
ment, the supplier offers 4,000 units @ Rs. 86 per unit. The material will
be delivered immediately and placed in the stores. One of the directors of
the company saw that due to present communication system, the incre-
mental cost of placing an order is zero but the accounting department’s
original estimate of Rs. 135 for placing an order for economic batch is
correct. After a series of discussions of the departmental heads, company
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reached to a decision not to buy 4,000 units at a time.
QUESTIONS
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1. Do you agree with the company’s decision? Why?
2. What
is the total cost when incremental cost of processing an order is
Rs. 135 per unit?
3. What
is the total cost when incremental cost of processing an order
is Rs. 86?
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NMIMS Global
Education

LEARNING OBJECTIVES

>> Importance of materials in a firm.
>> Arrangements for proper upkeep of materials.
>> Functions of stores department.
>> Process of materials receipt and issue.
>> Pricing techniques of materials issue.
>> Material control techniques.
>> Practical application of materials control measures and methods.
2.1 INTRODUCTION
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Materials are commodities which are consumed in the process of production.
It contains all types of material inputs used for the manufacturing process.
There are two kinds of materials. On one hand, there are direct materials which
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are directly consumed by a process and they can be identified and attributed
to the specific process of production. On the other hand, there are indirect
materials which are the supporting materials associated with a product like
packing materials or other relevant inputs to give a final shape to the product.
They also include the common inputs used in the production process, such as
lubricants, oils, grease, soap, etc. Material inventory control is very important
in a firm as the major component of cost of production of a product relates
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to the material cost. The materials should be managed in the most effective
manner not only to save the cost but also to ensure the optimum utilization of
the material inputs. Therefore, this chapter deals with various aspects of mate-
rial controls and materials management in a firm.
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2.2 FUNCTIONS OF MATERIAL CONTROL

DEPARTMENT
For having an effective control over the materials-related issues, a firm usu-
ally has a well-established material control department. Following are the
major functions of a material control department in a firm:
1. Procurement of raw materials, keeping in view the time to procure the
STUDY HINT materials, reasonableness of prices, quality of materials and quantity of
materials.
The overall responsibility
of materials’ price, quantity, 2. The raw materials are received and inspected to ensure the required
inventory control and recording quality as per pre-specifications.
lies with the production 3. Storage of raw materials and maintaining the records of material received
department.
in the store register. It also makes all the required arrangements to prevent
loss of materials due to leakage, pilferage, theft, mishandling, etc.
4. The raw materials are issued for the use of production on receiving
indent from the production department.
5. The department also ensures adequate inventory control through
maintaining the proper records.

6. It is also responsible for timely supply of the required materials and

ensuring that the production process does not stop for want of materials.
7. The overall responsibility of materials’ price, quantity, inventory control
and recording lies with the production department.
SELF-ASSESSMENT
1. The following is not a functions of a material control department:
QUESTIONS
a. procurement of raw materials b. marketing of the materials
c. reasonableness of prices d. quality and quantity of materials
2. Materials are commodities which are consumed in the process of
a.
production b. procuring raw materials
c.
pricing d. marketing
3. Material inventory control is very important in a firm as the major
component of cost of production of a product relates to the
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a.
warehouse cost b. advertising
c.
distribution cost d. material cost
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2.3 ESSENTIAL FEATURES OF MATERIAL
CONTROL PROCESS
To have a proper monitoring and control on inventory of material and its
management, following are the essential features which need to be devel-
oped in a firm:
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1. There has to be a perfect coordination and cooperation among the other

major departments, such as production, procurement, warehouse, etc.
2. The material control process should be well organized with inbuilt
supervision systems. It should be managed by a professional.
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3. For an effective materials control process, there has to be proper schedules

and formats of indent, placing orders and for maintaining other inventory
records. There has to be a dual control system to maintain all records both
in the soft form, as well as in the physical form.
4. An internal mechanism for verification and monitoring needs to be
developed for bringing more efficiency.
5. Modern and new techniques should be adopted, like bin cards, to have
timely monitoring and control over the inventory management.
6. The minimum inventory level and reorder level must be maintained.
7. The inventory recording system should be online with an inbuilt control
mechanism.
NOTE
8. The firm should develop a sound management information system
The perfect inventory manage-
(MIS) for better reporting, evaluation and control on various aspects of
ment system in a firm can help
inventory control.
to save the maximum cost if
9. The perfect inventory management system in a firm can help to save a well-organized system and
the maximum cost if a well-organized system and mechanism are mechanism are established.
established. This will reduce the cost at different levels.

10. The material purchase policy should be more planned and systematic.
There should be well-managed logistic systems to ensure that the
material is received well in time and at the most effective cost.
SELF-ASSESSMENT
4. There has to be a dual control system to maintain all records both in
QUESTIONS
the soft form, as well as in the
a. vapour form b. liquid form
c. physical form d. crystalline form
5. Modern and new techniques should be adopted, like bin cards, to
have timely monitoring and control over the
a. inventory management b. cost management
c. product management d. transport management
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2.4 RESPONSIBILITIES OF THE PURCHASE
DEPARTMENT
The major responsibilities of a purchase department are to ensure timely
QUICK TIP
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receipt of materials with required cost effectiveness and minimum material
Functions of Purchase wastage. Following are the major responsibilities of the purchase department:
department 1. Developing a mechanism for timely receipt of materials requirement
What to purchase - Required indents from all the departments to facilitate timely supply. The depart
and Right Materials with good ment may prepare detailed guidelines and appropriate indent formats.
quality
2. Once the indents for materials requirement are received, there should be
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When to Purchase - At the proper mechanism of recording and follow-up of the indents with pre-
required right time
determined time limits for control at different stages. This can be main
Where to purchase - The tained by allocating appropriate codes and description for different items.
nearest source
3. Empaneling the suppliers for requirements of different types of
How much to purchase -
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materials. This is done by inviting tenders and finalizing them based on

optimum quantity price, quality, discounts, reputation, etc. This is done very judiciously
At what Price - The Best price as the suppliers are not frequently changed.
without compromising on
quality 4. All the records of price, terms and conditions, discounts, etc., are
recorded in the book for individual suppliers. The agreements and
contracts are also properly filed.
5. Preparing purchase-order formats, which is contractual agreement,
should be prepared incorporating all terms and conditions as per the
agreement.
6. The orders for the purchase of relevant materials should be placed in
time to ensure that the materials are received on time. Once the orders
are placed, they should be followed at different levels.
7. Receiving materials at the store physically and storing them after due
inspection at appropriate places.
8. Returning back the defected pieces, if any, to the supplier and follow-
up for replacement or reducing the bill amount.
9. Verifying the invoices and sending them to accounts department for
payment to suppliers.

Raw material inputs are most significant in all manufacturing units. It is

estimated that nearly 60% of the total cost of production pertain to material
acquisition. Therefore, it is all the more important to have an adequate con-
trol on the cost of material acquisition. In view of this, the responsibilities of
the purchase department assume more significance.
2.5 MATERIALS ISSUE PROCESS

The efficient materials issue process in a firm is very much required to
ensure timely availability of materials by the concerned departments.
This helps in adequate utilization of resources and non-stoppage of work
due to timely availability of the raw materials. This also results in cost
minimization. For the effective management of material issue, certain sys-
tems are devised. We will discuss some of the important systems in the
following sections.
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2.5.1 BILL OF MATERIALS
Bill of materials is a detailed statement of materials which are required for the
different types of jobs. It also contains information about the quantity of materi- STUDY HINT
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als required and issued to the concerned department. This can be prepared in
the format given in Fig. 2.1. Material requisition slip
provides
a. Type of materials to be
purchased
Date of Issue and
Quantity Issued
b. Time to be purchased
Sl. Description Quantity Rate c. Quantity to be purchased
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No. Code No. of Goods Required Date Quantity (Rs.) Amount (Rs.)
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Received by ________________
Authorized by _______________ Checked by _________________
Storekeeper’s signature _______________ Cost clerk __________________
Figure 2.1: Bill Of Materials.
Format: Material Requisition Slip

Sl. No. Date:
Delivery Purchase Order
Material Job/
Code No. Description Size Quantity Dept. Date Place No. Rate Supplier
Authorized signature
Figure 2.2: Materials Requisition Slip.

2.5.2 MATERIAL REQUISITION SLIP

The purchase department prepares a specific format for supply of raw
material through a material requisition slip. This slip is sent to stores by
the different departments requiring the materials, furnishing all details
of the quantity. After receiving the requisition, the stores make necessary
arrangements to issue the materials. Figure 2.2 represents the commonly
used format for requisition slip.
ACTIVITY 1 Describe essential features of stores management in a firm.
2.6 MATERIAL CONTROL TECHNIQUES

Following is the mechanism through which adequate control over materials’
movement and right use of materials is ensured:
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1. Material inspection report: The materials at store are delivered
through a delivery note from the supplier side. The warehouse staff
physically checks the quantity and also inspects the quality of materials
IM for each item. A material receipt advice note is prepared to confirm the
receipt of materials with the remarks of defects, if any. This report is
called material inspection report.
2. Goods received advice: Once the materials are received and inspected,
the stores department prepares this advice to inform purchase
department, production department and accounts department about
the receipt of materials. The accounts department will arrange for
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payment to the supplier only after the receipt of this advice from the
stores department.
3. Materials transfer note: When a department requires certain
materials, it issues the material requisition slip. Accordingly, the stores
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department, while issuing the materials, issues materials transfer

note furnishing all the details of materials supplied to the concerned
department. It is also used for making necessary accounting entries.
4. Materials return note: Whenever the department has surplus
! IMPORTANT CONCEPT materials or if the material supplied is not according to the quality and
A copy of “materials return
specifications, the concerned department returns the material to the
note” is sent to the costing store through a transfer note furnishing all the details of the materials
department for making being returned to the stores. A copy of this note is sent to the costing
necessary accounting department for making necessary accounting adjustments.
adjustments.
2.7 MATERIAL PRICING METHODS
The following approaches of pricing are prevalent in the market and a firm
may adopt any of them according to their suitability.
2.7.1 FIRST IN FIRST OUT METHOD

Under the first in first out (FIFO) method of pricing, the materials received
first in the stores are issued first and accordingly the pricing is done. In other
words, the materials received in the first batch, are first issued and only
after all the items are issued from the first batch, the next batch is used.

Thus, the materials are issued at the old price under this method. Closing
stock is valued at the latest price. Following are the advantages of this method:
1. It is the simple method of pricing the materials as the materials received
STUDY HINT
are issued first at the old price.
Prevalent approaches of
2. It facilitates storage of materials in the store in chronological order
pricing:
according to their period of holding. · First in first out (FIFO)
3. It is easy to maintain and also cost effective. method
· Last in first out (LIFO) method
4. This method of valuation is accepted under the standard accounting · Highest in first out (HIFO)
practices. method
5. It is based on realistic and logical assumptions where materials received · Average cost method
first are issued first. · Weighted average cost
method
However, this method has the following limitations: · Periodic average cost
method
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1. Since the materials are priced at the old price, it does not reflect the
· Standard cost method
current market price and the cost of production is relatively lower.
· Market price method
2. It is practically very difficult to segregate the material in the store in
order of their receipts at store. There are more possibilities of getting
old and new materials mixed.
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3. When price of raw materials rise in the market, the cost of production
is underestimated.
4. In practice, more than one price are used to price the materials as some of
the items may be issued from the old stock while remaining from the new
stock. In that case, materials issued at one time will have different prices.
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5. When material price changes frequently, it is difficult to maintain

accurate pricing strategy.
This method of pricing materials provides higher profits to the firm as lower
cost of material is charged. This also results in lower pricing of the product.
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The firm is also required to pay higher taxes on account of higher profits.
2.7.2 LAST IN FIRST OUT METHOD

Under the last in first out (LIFO) method of pricing, the materials received
last are issued first. Therefore, materials issued carry the latest cost of mate-
rial acquisition. In practice, the stores department issues materials from the
latest stock received and price accordingly and once that is finished, the
materials are issued from earlier last received stock. The materials issued
are at the latest actual costs and closing stock valuation is on the oldest price.
Following are the advantages of this method:
1. The materials are priced at the current market price. The product
carries the latest cost and therefore a realistic price.
2. It is also simple to operate.
3. This method provides a hedge against price rise.
4. It does not carry any unrealized profits or loss.
The accounting standards do not allow this method of valuation for financial
reporting. Following are the limitations of this method:

1. Often, more than one price mechanism is adopted while issuing

materials from the stores.
QUICK TIP 2. Physical flow material has no relationship with the pricing. It means
In the inflationary conditions, materials can be issued from the earlier stocks.
profit will be lower to the firm
3. The closing stock is valued at the oldest price.
and consequently the tax
liability will also be lower. In the inflationary conditions, profit will be lower to the firm and conse-
quently the tax liability will also be lower.
2.7.3 HIGHEST IN FIRST OUT METHOD

In the highest in first out (HIFO) method, the materials where prices are
highest are issued first. It is not important that when these materials were
purchased. The concept behind this approach is that, in increasing and infla-
tionary market, the cost of material is immediately absorbed into the product
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cost to cover the risk of inflation. Since the material is issued at the highest
prices, the product costs also increases. However, this may affect the product
to gain competitive prices in the market. Therefore, this is not a practical
approach of material pricing.
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2.7.4 AVERAGE COST METHOD
Under this method, the materials are issued at the average price of the mate-
rial purchased. A simple average cost is taken of all the materials purchased
in the past, irrespective of the quantities and time to purchase. Suppose the
materials are purchased in five batches at prices of Rs. 17, 18, 19, 20 and 21,
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the average price in this case will be Rs. 19 per unit. All the materials will be
issued at this price. This method is very simple but practically it is not con-
sidered as it only considers the price and not the quantity of the materials
purchased. This method is useful when prices indicate a moderate increase
and fluctuations are not very wide.
N
2.7.5 WEIGHTED AVERAGE COST METHOD

In the weighted average cost method, we consider both the prices as well as
the quantities of the materials purchased. The weighted average is arrived
at by dividing the cumulative amount by the cumulative quantity purchased
at the time of issue of the materials. The materials are priced based on the
weighted average cost. This can be explained through the following example:
Suppose there are four invoices of materials that are purchased at the prices
given in Table 2.1. The weighted average cost will be as follows:
The material from the stores for subsequent issue will be priced at Rs. 11.33
per unit. Since the process of material issue is ongoing, the weighted average
price at any time will be based on the balance of quantity of material and the
rate of the material. The advantages of this method are as follows:
1. It considers the price fluctuations and smoothen the effect of price change.
2. This is more suitable where price fluctuations are higher.
3. The material price is recalculated with each batch of new purchase.
4. There are no unrealized profits or losses under this method.

TABLE 2.1: CALCULATION OF WEIGHTED AVERAGE COST

Price (Rs.) Quantity Total Cumulative Cost
10 1,000 10,000 10,000
11 1,400 15,400 25,400
12 1,200 14,400 39,800
12 1,500 18,000 57,800
Total 5,100 57,800 11.33
Following are the limitations of this method:

1. The material issue price is not the current price.
2. Where purchases are very frequent, this method becomes complicated
and tedious.
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3. The prices paid in the past on very higher side are reflected in the
average price. IM
2.7.6 PERIODIC AVERAGE COST METHOD
In this method, the average cost is calculated on the basis of the materials
received in particular time period rather than calculating the simple or the
weighted average cost every time the material is received. The average may be
calculated for the entire period. The average price may be arrived as follows:
Average price = Cost of opening stock + Total cost of materials received for
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all batches during the period divided by number of units in opening stock +
Total number of units received during the period
2.7.7 STANDARD COST METHOD

Under this method, the materials are priced at a pre-specified standard price
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determined for the issue of m aterials. If there is a difference between the

actual purchase price and the standard price, the same is adjusted to the
profit and loss account. The standard cost is pre-determined cost which is
set based on certain standards and past trend. It can be an effective method
as the responsibility for difference between the actual price of material pro-
cured and the standard price of the material is fixed on the purchase depart-
ment. However, a review of the prices in the market and the accordingly
revision of standard cost is very much required.
2.7.8 MARKET PRICE

This method is also known as the replacement cost method. Under this
method, materials are priced at the cost currently existing in the market as of
the date of issue of the materials. The material can be identical. The replace-
ment price can be explained in terms of the price of replacing the material
at the time of issue of the materials. In practice, this method is applicable as
it considers the hypothetical price which is not paid at the time of issue or
receipt of the materials. It may also have accounting p roblems.
There is no standard rule as which of the methods should be used for pricing
of materials. The firm may specifically choose any material pricing method

as suited to it. However, method of production process, nature of material

used by a firm, frequency of purchases, economic batch quantity, accounting
practices acceptable in valuation of inventory, etc., are the considerations
a firm may look into while considering material pricing policy.
SELF-ASSESSMENT 6. Under which of the following methods of pricing, the materials received
QUESTIONS
first in the stores are issued first and accordingly the pricing is done?
a. last in first out (LIFO) b. first in first out (FIFO)
c. highest in first out (HIFO) d. average cost method
7. Under which of the following methods of pricing, the materials
received last are issued first?
a. Weighted average cost method b. market price
c. last in first out (LIFO) d. standard cost method
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2.8 QUANTITY OF MATERIAL PROCUREMENT
NOTE There is another important parameter in material control process as how much
Cost of materials consist of
IM
quantity should be stored at a time to ensure that the production process does
not get affected and at the same time excess quantity of materials is avoided. The
Buying cost + Total ordering inventory holding also carries a cost in terms of interest, space, maintenance,
cost + Total Carrying cost spoilage, wastage, etc.; the higher the inventory level, the higher will be the
carrying costs. Therefore, a firm needs to adhere to all the strategies to avoid
excess holding of inventory and at the same time maintaining a level of inven-
tory which is adequate to run the production process. Some of the strategies are
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explained in the following section.
2.8.1 ECONOMIC ORDER QUANTITY

This is a technique to determine how much should be the quantity to hold
N
which is economic in terms of cost. This helps the purchase department to

assess the quantity to be purchased at any one time. This in essence is a mea-
surement of how much quantity is to be ordered at any one point of time. We
should understand that there are primarily different costs associated with
the ordering quantity apart from the purchase price. There are mainly two
types of costs. One is the ordering cost. The ordering cost can be explained in
terms of placing an order for purchase of materials. The other one is the car-
rying cost which is associated with carrying of inventory including interest.
Let us further understand these costs.
Ordering cost is the cost of placing an order, a firm has to incur certain costs
at the time of placing order for purchase. These costs basically include invit-
ing tenders, staff involved in this process, handling and transportation costs,
stationery costs, placing an order, follow-up costs, etc. Therefore, more the
frequency of the order, the more will be the ordering cost. Besides, there
are certain costs that are called as carrying costs. The cost of carrying the
inventory is the real out-of-pocket cost associated with having inventory on
hand, such as warehouse charges, insurance, lighting, losses due to handling,
spoilage, breakage, etc.; and another important component of carrying cost
is the amount of interest on holding the inventory. Obviously, higher the level
of quantity of material in the inventory, more will be the cost of holding it.

The above two costs, the carrying costs and the ordering costs, are variable QUICK TIP
costs, but their behavior is opposite of each other in the sense that with more
frequent orders, cost will go on increasing but as the material ordered will Economic Order Quantity is
be lesser in quantity, the carrying costs will decrease. While on the other the size where ordering and
hand, if the number of orders are minimized, the quantity per order will carrying costs are at minimum.
decrease but the carrying cost will increase. Remember, the ordering cost
will decrease on account of the reduced number of orders.
In addition to the above costs, there are other considerations, like capacity
and availability of storage facility, price fluctuations of the materials in the
market, type of material in terms material life, etc., which affect the materials’
holding level at a time.
Therefore, a firm has to arrive at the decision to order the most desirable
quantity which could be ordered. The optimum quantity could be the quan- ! IMPORTANT CONCEPT
tity at which both the ordering costs and the carrying costs will be optimum. a. Maximum
level denotes
This quantity is known as “economic order quantity (EOQ).” The EOQ can
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the maximum quantity of
be calculated with the help of the following formula: an item of materials that
could be hold in stock at
2AO
Economic order quantity (EOQ) = any time.
C
IM
where A is annual demand/annual consumption in terms of units, O is cost of
b. Minimum Level is the
lowest quantity of an item
placing an order and C is inventory carrying cost per unit per annum. of material which must
be maintained at all times
The above equation indicates the efficient quantity of units per order. We also
for ensuring continuity of
come to know that we can calculate the number of orders to be placed during
production all the time.
the period through the following equation:
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A
Numbers of orders to be placed =
EOQ
The EOQ is an important technique as it provides a fairly accurate level of
quantity to be purchased at one time or in one lot/batch. This concept is
based on the following assumptions:
N
1. The materials in question will be available all the time without any
barriers or restrictions.
2. The price of the materials, discount, credit period, transportation costs,
etc., will remain constant.
3. Ordering cost and carrying costs are variable and remain constant.
4. The impact of discount on quantity will be negligible.
The other important aspect of material procurement is to purchase the
ptimum level, that is, not in excess or not too little that it hampers the pro-
o
duction process. At the same time, the timing of the purchase of materials
also assumes significance. The following technique helps a firm to decide
both the level and the timings of the order.
There is a concept of maximum level which is the highest level of materials
procurement beyond which the inventory of materials should not be allowed.
This will help a firm to avoid overstocking of the materials. This level can be
fixed considering the consumption of materials and the time of reorder period.
Maximum level = Reorder level + Reorder quantity − (Minimum
consumption − Minimum reorder period)

Like maximum level of inventory, we may also fix minimum level of inventory.
This level is fixed to avoid shortage of material so that the production process
is not held up. Therefore, the minimum level is fixed. A firm should ensure
that the minimum quantity of stock holding does not fall below the minimum
level at any time. The minimum level is fixed in the following manner:
Minimum level = Ordering level − (Average material consumption
rate − Reorder period)
We can also fix the reorder level to ascertain that the next order is placed much
before the inventory becomes out of stock to have continuity in the production
process. Reorder level is fixed for deciding the time for placing the order. In
case the stock of materials reaches this level, fresh order is placed to ensure
that material is procured well within the time before the level of the material
falls to the minimum level. The reorder level can be fixed as follows:
Reorder level = Maximum usage of materials for specific period − Maximum
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reorder period
The firm can also fix the average level of material holding based on the aver-
age of the maximum and minimum level. This can be computed as follows:
IM
Maximum level of materials
+ Minimum level of materials
Average level of material holding =
2
SELF-ASSESSMENT 8. A firm needs to adhere to all the strategies to avoid excess holding of
QUESTIONS
M
a. inventory b. cash
c. mortgages d. jewelry
9. A firm should ensure that the minimum quantity of stock holding
does not at any time fall
N
a. above the minimum level b. below the maximum level

c. above the minimum level d. below the minimum level
ACTIVITY 2 Calculate the Economic Order Quantity from the following available data.
Calculate the number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg
Order cost per order: Rs. 50
Cost of raw materials: Rs. 2 per kg.
Storage cost : 8% on average inventory holding
Use EOQ formula, EOQ = 2,500 kgs, number of orders per annum = 4
2.9 MATERIAL MANAGEMENT AT STORES

The materials purchased by the purchase department are stored in a safe
and secured place known as the warehouse. From the stores, the materials
are issued to the production department. The storage of the raw materials

is an intermediate step in the material control. However, if a firm follows

“just-in-time” inventory system; there is no need for storing the materials.
In all other cases, the firm should make all the arrangement that takes care
of the safe and secure storage of the material inputs that are optimally used.
Generally, in practice this function is performed by the storekeeper in the
stores department. In general, the following functions are undertaken by
the storekeeper as regard to efficient management of materials:
1. Maintaining a buffer in case of emergency and ensuring timely availa
bility of materials.
2. Providing safety and security of the materials.
3. Maintaining just sufficient quantity to avoid over/under stocking of the
materials.
4. Designing and developing a proper system for ensuring control over usage,
with proper recording system of issues and receipts of material inputs.
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5. Minimizing material losses on account of mishandling, wastage,
evaporation, breakage, etc.
6. Proper upkeeping of records and documentation for recording the
receipts and issues.
IM
Explore the concept of bin card used in a firm. ACTIVITY 3
2.10 INVENTORY CONTROL TECHNIQUES

M
For effective inventory control, some important systems are described in the
following sections.
2.10.1 PERPETUAL INVENTORY SYSTEM

N
The continuous stock-taking system is known as perpetual inventory system.

According to the definition of CIMA (The Chartered Institute of Management
Accountants), perpetual inventory system is “the recording, as they occur,
of receipts, issues and the resulting balances of individual items of stock
in either quantity or quantity and value.” Under this system, a continuous
record of receipt and issue of materials is maintained by the stores depart-
ment and the information about the stock of materials is always available.
To further streamline the system, entries in the bin card and the stores ledger
are reconciled after every receipt and issue and the balance is verified peri-
odically with the physical stock. The advantages of this system are as follows:
1. It avoids disruptions in the production caused by periodic stock-taking.
2. It also helps in verifying the details and monitoring the stocks
periodically.
3. The records being maintained under this system are more realistic and
reliable.
4. The discrepancies in stock, if any, can be investigated fast and an
appropriate action be initiated promptly.

2.10.2 ABC SYSTEM OF INVENTORY CONTROL
QUICK TIP Under this system, the items of inventory are categorized according to the value
of usage of material inputs. Broadly, the materials are classified into three cate-
ABC Inventory Analysis gories, as A, B and C, according to their values. Items under category “A” consti-
An analytical method of tute the most important class of inventories in the overall proportion in the total
inventory control segregating value of inventory. The “A” items constitute between 5% and 10% of the total
the items based on the cost of items. However, their value may be in terms of nearly 80% of the total value of the
inputs highest cost items as
inventory. In category “B,” the items constitute intermediate position. Generally,
A followed by B and the least
items in this category may fall about 20%−25% of the total items. However, their
costs C category.
value in terms of usage may be about 15% of the total value.
In the last category “C,” the items or inventories are the items which have
negligible value, say about 65%−75% of the total quantity. In terms of value,
their cost may be around 5% of the total usage value of the inventory. The
numbers in percentage, as indicated here, are only indicative. In practice, the
actual numbers may depend on the policy of a firm. The philosophy behind
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this system is that the items having highest value should be controlled more
carefully as they involve higher cost of holding. On the other hand, items
having medium and small values in terms of costs, despite large in quantity,
IM
can be controlled periodically.
Under the management of ABC inventory system, the senior-level executives
are involved more particularly in managing the inventory categorized under
A category. A minimum level of safety stock is maintained in this category.
The controlling process is very rigid with maximum follow-up. The advan-
tages of ABC system are as follows:
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1. The system helps in minimum investment in stocks and inventory.
2. The technique of EOQ further helps in reducing the inventory carrying
and holding cost.
3. Since maximum attention is paid on the few selected items,
management and adequate control can be adhered to on overall
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inventory management with the least cost.
ACTIVITY 4 ased on the following information and data, calculate average value of
B
items under category A, B and C.
% of the Total Value % of the Total
Category No. of Items
No. of Items Amount (₹) Value Item
A 75 6 70,000 70
B 375 30 20,000 20
C 800 64 10,000 10
Average value of A: Rs.933 B: Rs.53 and C: Rs.12
2.10.3 JUST-IN-TIME INVENTORY APPROACH

Just-in-time inventory (JIT) approach of inventory management was devel-
oped by Japanese firms with the concept of no inventory holding and
therefore avoiding completely the inventory holding costs. This is the more
recent trend in inventory management. This principle focuses on total

elimination of the intermediate stages like storekeeping, maintenance,

etc. The materials ordered and purchased from supplier should directly
reach the assembly line exactly when they are required for the production
process. There is no need of storing the materials and then carrying them
to the assembly unit. The storing cost, wastage and spoilage can be saved
to a larger extent through this approach of inventory management. Even
the interest on materials’ carrying cost can also be controlled to a greater QUICK TIP
extent. However, it is very much important to have perfect logistics and Just In Time
transportation system for the effectiveness of this system. A slight delay in A strategy that focuses on -
the material receipt may cause huge losses as it will stop the production The right material
process. The major advantages of this system are as follows: At the right time
At the right place, and In
1. The inventory is ordered exactly in time keeping in view of the the exact amount, without
transportation time in carrying the inventory from supplier to the the safety net of inventory.
assembly line.
2. The quantity ordered is sufficient to meet the requirement of the process.
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3. It brings cost effectiveness in the production process as all the relative
operations are arranged accordingly.
4. Inventory carrying costs is almost zero.
IM
5. The storage arrangements are not required and therefore there is a lot
of savings in terms of space for warehouse, store staff, etc.
6. It also avoids losses and damages on account of breakage, wastage,
pilferage, etc.
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2.10.4 VED ANALYSIS OF INVENTORY CONTROL
The analysis known as vital, essential and desirable (VED) is based on NOTE
the degree of criticalness of the raw materials in a firm. According to this
VED Analysis
approach, the materials/items are divided into three categories, in the
descending order, depending on their criticalness in the following manner. V = Vital items
N
E = Essential items
“V” is an indication of vital items and their stock analysis requires prime
focus. The reason being non-availability of these items easily and therefore D = Desirable items
non-existent of these items in the store at the time if need will result in heavy
losses due to stoppage of production. Therefore, more and more attention is
paid to hold these items in adequate quantity to ensure smooth operations of
the production process.
“E” signifies the essential items required by a firm in the production process.
These items are considered essential for running production process effectively.
However, the assumption is that without these items, the production system will
not suffer. All the required steps and care should be taken that these items are
always available in stock to control any obstacles in the production process.
The last category “D” relates to desirable items. The items which do not affect
production immediately but availability of these items will ensure more effi-
ciency in the production process.
VED analysis can be an effective mechanism for inventory control, more par-
ticularly in capital intensive process firms. The focus can be laid to those
items which are highly important and difficult to procure. We can compare
VED analysis through Table 2.2.

TABLE 2.2: A COMPARISON OF VED ANALYSIS

Category Degree Suggested Strategy
V Most critical with high The percentage of stock to
opportunity cost. be held should be smaller.
E It may be quite critical material It can be relatively at high-
with substantial opportunity cost. er risk of shortage.
D Not very significant effect if not A higher risk can be taken.
available. Can be stored.
2.10.5 FSND ANALYSIS

The holding period of materials, which is known as age of the inventory,
is also an important element based on which the materials can be con-
S
trolled. This analysis categorized the materials based on their moment.
It shows the moving position of inventory during the year. This analysis
categorizes the items of inventory into four broad categories, in the
descending order, according to their usage rate. This is further explained
IM
as follows:
1. The category “F” denotes fast moving items and those stocks which are
consumed in a short span of time. Therefore, stock of fast moving items
needs to be kept under close observation and under constant watch.
The frequency of order should be determined depending on the period
of their usage and time for transit to avoid any shortage.
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2. The next category starts with “N” which means normal moving items
of the stock and these items are generally utilized over relatively a
longer period from 6 month to 1 year. The quantities of order for such
items are determined on the basis of a new estimate of future demand.
An effort is made to avoid the surplus stock.
N
3. Another term classified as “S” is an indication of slow moving items.

The stock-holding period in such cases is more than 1 year. The
holdings of these items are reviewed periodically and, in case they are
not required, they can be eliminated.
4. The last category of materials starts with “D” which stands for dead
stock. This means that there will not be any further demand for such
items. Therefore, the firm identifies such items and eliminates from the
stores or makes alternate arrangements.
SELF-ASSESSMENT
QUESTIONS 10. The continuous stock-taking system is known as
a. perpetual inventory system
b. ABC system of inventory control
c. Just-in-time inventory approach
d. VED analysis of inventory control
11. Under which system of inventory control, the items of inventory are
categorized according to the value of usage of material inputs?
a. VED analysis of inventory control

b. Just-in-time inventory approach

c. ABC system of inventory control
d. perpetual inventory system
12. Which approach of inventory management was devel oped by
Japanese firms with the concept of no inventory holding?
a. ABC system of inventory control
b. just-in-time inventory (JIT) approach
c. perpetual inventory system
d. VED analysis of inventory control
What is the VED analysis? Describe its utility to a firm. ACTIVITY 5
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2.11 ADDITIONAL SOLVED PROBLEMS IM
PROBLEM 2.1
1. State whether the following statements are correct. Also provide
reasons.
(a) Safety stock increases as demand increases.
(b) In ABC analysis, high cost items are most likely to fall in category A
and least cost items are likely to fall in category C.
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(c) To protect against stockouts, a large batch size is a must.
(d) EOQ is based on a balancing between inventory carrying costs and
shortage costs.
(e) Lead time is the time interval elapsing between the placement of
a replenishment order and the receipt of last installment of goods
N
against the order.

2. (a) Compute EOQ and the total variable cost for the following:
Annual demand 5,000 units

Unit price Rs. 20.00
Order cost Rs. 16.00
Storage rate 2% per annum
Interest rate 12% per annum
Obsolescence rate 6% per annum
(b) Determine
the total variable cost that would result for the items if
an incorrect price of Rs. 12.80 is used.
Solution:
1. (a) Not true. Safety stock is held for meeting the unpredictable
fluctuation in the demand and supply. It varies with the fluctuations
in demand and not with the level of demand.

(b)
Not true. The categorization of A, B and C is done on the basis
of their annual usage value (consumption value) and not on their
cost. X, Y and Z analysis is done on the basis of value of inventory
stored.
(c)
True. If the batch size is large, number of orders in a year will
be lower. Hence, stock moves to the lowest point (reorder level)
fewer times a year. Hence, danger of stockout will be less. Thus, to
protect against stockout, a large batch size is must.
(d)
Not true. EOQ is based on a balancing between ordering cost
and carrying cost of inventory. It does not take into account the
shortage cost.
(e)
Not true. Lead time is the time interval clasping between the
placement of a replenishment order and the receipt of the first
installment of goods against the order.
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2. (a) Carrying cost = Storage rate = 2%
Interest rate = 12%
Obsolescence rate = 6%
IM Therefore, total rate = 20% per annum
C = 20% of Rs. 20 = Rs. 4 per unit per annum
2AO 2 × 5,000 × 16
EOQ = = = 40,000 = 200 units
C 4
M
Total variable cost:

25 orders at Rs. 16 = 400

Now,
5,000
N
Ordering cost = = 25 orders at Rs. 16 = Rs. 400

200
200

Carrying cost of average inventory = = 100 units at Rs. 4 = Rs. 400
2
Therefore, total variable cost = Rs. 800

(b) If an incorrect price of Rs. 12.80 is used:
C = 20% of Rs. 12.80 = Rs. 2.56 per unit per annum

Therefore,
2 × 500 × 16
EOQ = = 250 units
2.56
Total variable cost:

Now,
5, 000
Ordering cost = = 20 orders at Rs. 16 = Rs. 320
250

250

Carrying cost of average inventory = = 125 units at Rs. 2.56 = Rs. 320
2
Therefore, total variable cost = Rs. 640

PROBLEM 2.2
Annual demand for a particular item of inventory is 10,000 units. Inventory
carrying cost per unit per year is 20% and ordering cost is Rs. 40 per order.
The price quoted by the supplier is Rs. 4 per unit. However, the supplier is
willing to give discount of 5% for orders of 1,500 or more. Is it worth to avail
of the discount offer?
Solution:
Measurement of Total Cost Under Both the Methods
(Without Discount and With Discount)
S
Particulars Without Discount (Rs.) With Discount (Rs.)
Selling price per unit 4.00 4 - 5% of 4 = 3.80
Carrying cost per 20% of 4 = 0.80
unit per year
IM
2AO 2 × 10, 000 × 40 20% of 3.80 = 0.76
EOQ = = = 10, 00, 000
C 0.80
= 1, 000 units
Minimum order 10,000 × 4 = 40,000
M
quantity
10, 000
= 10 orders
1, 000
10 × 40 = 400
1, 000
N
× 0.80 = 400
2
Purchase cost 40,800
Ordering cost 1,500 units
Carrying cost 10,000 × 3.80 = 38,000
10, 000
= 7 orders
1,500
7 × 40 = 280
1,500
× 0.76 = 570
2
Total cost 38,850
Savings, if the 40,800 - 38,850
discount offer is = Rs. 1,950
availed
Hence, the discount offer of 5% should be availed. Orders should be issued

at the rate of 1500 units.

PROBLEM 2.3

A materials manager has the following data for procuring a particular
item:
Annual demand = 1,000

Ordering cost = Rs. 800

Inventory carrying cost = 40%

Cost per item = Rs. 60

If the order quantity is more than or equal to 300, a discount of 10% is
given. For how much should the order be placed in order to minimize
total variable cost?
Solution:
1. Variable cost (without discount):
S
Carrying cost = 40% of 60 = Rs. 24
2AO 2 × 1, 000 × 800 16, 00, 000

EOQ = = 258 units

IM C
=
24
=
24
1, 000
Number of orders =
= 4 orders
258
Variable cost:
Purchase cost = 1,000 × 60 = 60,000
M
Ordering cost = 4 orders at 800 = 3,200

Carrying cost = 258/2 = 129 units at Rs. 24 = 3,096
Therefore, the total variable cost is Rs. 66,296 as shown above.
N
2. Variable cost (with discount):

Cost per unit = 60 − 10% = Rs. 54
Carrying cost (C) = 40% of 54 = Rs. 21.60
2AO 2 × 1, 000 × 800

EOQ = = = 272 units
C 21.60
3. Variable cost (if order quantity is 300 units):

Purchase cost: 900 units at Rs. 54 = 48,600
(3 orders at 300 units each)
100 units at Rs. 60 per unit = Rs. 6,000
The total materials cost will be
Rs. 48,600 + Rs. 6,000 = 54,600
Ordering cost = 4 orders at Rs. 800 = 3,200

Carrying cost = 300/2 = 150 × 21.60 = 3,240

Variable cost = 61,240

Variable cost without discount = 66,296
Saving, if discount is availed = 5,256
4. Variable cost [If the order quantity is 334 units (3 orders)]:
Purchase cost = 1,002 × 54 = 54,108
(3 orders at 334 units each)
Ordering cost = 3 × 800 = 2,400
334
Carrying cost = = 167 × 21.60 = 3, 607
2
Variable cost = 60,115
S
Variable cost without discount = 66,296
Saving, if discount is availed = 6,181

Remember: Order quantity should be 334 units as it has the maximum
savings in cost.
IM
PROBLEM 2.4
M/s Automotive Motors purchase 9,000 motor spare parts for its annual
requirements, ordering 1 month usage at a time. Each spare part costs
Rs. 20. The ordering cost per order is Rs. 15 and the carrying charges are 15%
M
of the average inventory per year. You have been asked to suggest a more
economical purchasing policy for the company. What advice would you offer
and how much would it save the company per year?
Solution:
N
Present cost:
C = 15% of Rs. 20 = Rs. 3
9, 000
Ordering one month usage at a time = = 750 units
12
Ordering cost = 12 orders at Rs. 15 = Rs. 180
Carrying cost of average inventory of 750/2 = 375 units at Rs. 3 = Rs. 1,125
Present cost (A) = Rs. 1,305
Economical purchasing policy:
2AO 2 × 9, 000 × 15
EOQ =
= = 90, 000 = 300 units
C 3
= 300 units
9, 000
Number of orders in a year = = 30
300
Ordering cost = 30 orders at Rs. 15 = 450

Carrying cost of average inventory of = 300/2 = 150 units at Rs. 3 = 450

Cost of economical purchasing policy (B) = 900
Therefore, saving per year = A - B = 1,305 - 900 = 405
PROBLEM 2.5
A manufacturer has to supply his customers 600 units of his product per year.
Shortages are not allowed and the inventory carrying cost amount to Rs. 0.60
per unit per year. The set up cost per run is Rs. 80. Compute:
1. The EOQ.
2. The minimum average yearly cost.
3. The optimum number of orders per year.
4. The optimum period of supply per optimum order.
S
Solution:
2AO 2 × 600 × 80
1. EOQ = = = 90, 000 = 400 units
0.60
IM C
1
2. Ordering cost = 600/400 = 1 orders
2
Say, 2 orders at Rs. 80 = Rs. 160

C = 400/2 = 200 × 0.60 = 120
Therefore, minimum average yearly cost = Rs. 280

M
1
3. Optimum number of orders = 600/400 = 1 orders = say 2 orders
2
4. Optimum period of supply per optimum order:
N
400 2
= × 12 = 8 months
600 3
Or
600 units ® 12 months
400 units ® ?
400
× 12 = 8 months
600
2.12 SUMMARY
The raw material inputs are most significant in all manufacturing units.
It is estimated that nearly 60% of the total cost of production pertain to

materials acquisition.
It is all the more important to have an adequate control on the cost of
material acquisition.

The efficient materials issue process in a firm is very much required to

ensure timely availability of materials by the concerned departments.
There has to be an appropriate material pricing policy at which the mate-
rials are issued from stores to the production department.
One of the important systems to maintain the store records is known as
the bin card.
It is the quantitative record of all receipt of the materials, issue of materi-
als and the balance of materials on a particular day.
This record is kept for each and every material and entries are made
daily after every receipt and issue.
It contains quantity and other details.
Bin card does not indicate the record, the amount of receipt or the issue;
it records only the quantity. All care should be taken to physically verify
S
the material quantity and reconcile the same with the quantity shown in
the bin card on daily basis.
Inventory control is one of the important aspects in effective material
management of inventory and its control.
IM
It is very much desirable to avoid the overstocking as well as under stock-
ing. As already explained, this can be ensured through assessment of
maximum level, minimum level and reorder level.
The inefficient management will result in higher cost and losses to the
firm.
M
1. Material control: To exercise effective control on material KEY WORDS

movement.
2. Material requisition slip: A slip devised for giving orders by the
N
departments to issue materials.

3. Bin card: Maintaining quantitative record of materials.
4. FIFO: Material priced on the basis of receipts in the stores first to be
issued first.
5. LIFO: The materials received in the last are issued first and priced
accordingly.
6. ABC: Categorization of materials inputs based on their importance.
7. JIT: An inventory management system where inventory are received
directly in the assembly just in time.
8. Bill of materials: A schedule of details materials received and
issued.
9. EOQ: Optimum level of quantity to be ordered at a time.
10. VED: Categorization of material inputs as vital, essential and desirable.


1. Why does a firm should have material control mechanism?
2. What are the main functions of material control department?
3. What is bill of material? Explain its significance.
4. What are the different pricing methods? Explain essential features of
important pricing m
ethods.
5. Differentiate between FIFO and LIFO of pricing techniques.
6. Explain the concept of just-in-time approach with its advantages and
limitations.
7. What is the prime objective of material control? Do you feel that material
cost control impact the cost of production, explain with example.
S
8. Describe important forms generally required use in connection with
purchasing and receiving of stores? Briefly describe them and design
any one of the forms that are used.
9. What is a purchase order? Prepare a specimen form of purchase order,
IMassuming the particulars to be filled in.
10. Enumerate the process of materials management at stores describing
advantages and disadvantages of stores system.
11. What is Re-ordering Level? How it is related with Maximum and
Minimum Stock Levels. What are the factors to be considered in fixing
Re-ordering Level and Quantity, explain with proper example.
M
12. It us said that “The Perpetual Inventory System is an Integral part of

material control”. Justify this statement by and explain the salient
features and the advantages of this system.
13. What is Economic Order Quantity? What are the precautions you will
N
keep in mind while calculating EOQ?

14. What are the important factors you would consider while selecting a
method of pricing material issues and why?
2.14 ANSWER KEY


Functions of Material Control 1 b. marketing of the materials
Department
2. a. production
3. d. material cost
Essential Features of Material 4. c. physical form
Control Process
5. a. inventory management


Material Pricing Methods 6. b. first in first out (FIFO)
7. c. last in first out (LIFO)
Quantity of Material Procurement 8. b. cash
9. d. below the minimum level
Inventory Control Techniques 10. a. perpetual inventory system
11. c. ABC system of inventory
control
12. b. just-in-time inventory
(JIT) approach
S
SUGGESTED BOOKS
Balakrishnan R. (2008). Managerial Accounting. Hoboken, NJ: Wiley.
Horngren C.T. (2014). Introduction to Management Accounting, 16th

Edition. US: Pearson Education.
IM
E-REFERENCES
“Definition of Management Accounting” (PDF). Institute of Management
Accountants. 2008. Archived (PDF) from the original on 20 October 2016.
Retrieved 4 December 2012.
M
“What is Management Accounting? - Definition - Meaning -

Example”. myaccountingcourse.com. Archived from the original on 6
October 2017. Retrieved 2 May 2018.
N

S
IM
M
N

C H A
3 P T E R
LABOR COST AND OVERHEAD

COST CONTROL
CONTENTS
S
3.1 Introduction
3.2 The Issues Concerned with Labor Cost Control
3.2.1
3.2.2
IM Classification of Labor Cost
Labor Cost Controls
3.2.3 Process and Production Planning
3.2.4 Labor Budget
3.2.5 Standard Labor Cost
3.2.6 Job Performance Report
M
3.2.7 Work Performance Incentives
3.3 Mechanism of Labor Cost Control
3.3.1 Personnel Management Department
3.4 Labor Attrition
3.4.1 Measurement of Labor Turnover
N
3.4.2 Factors Affecting Labor Turnover

3.4.3 Labor Turnover and its Cost to a Firm
3.4.4 Example on Labor Turnover
3.5 Recording of Timings
3.5.1 Methods of Time Recording
3.5.2 Maintaining of Time Records
3.6 Methods of Work Study
3.6.1 Method Study
3.6.2 Evaluation of Job
Activity
3.7 Methods of Wage Payment
3.7.1 Flat Time Rate System
3.7.2 Time Rate at High Day Rate Plan
3.7.3 Graduated Time Rate Plan
3.7.4 Piece Rate Method

3.7.5 Taylor’s Differential Piece Rate System
3.7.6 Gantt Task Bonus Plan
3.7.7 Halsey Premium Plan
3.7.8 Halsey–Weir Plan
3.7.9 Rowan Plan
3.7.10 Group Bonus Plan
3.7.11 Priestman’s Bonus Plan
3.7.12 Towne Profit Sharing Plan
3.7.13 Non-Monetary Incentives
3.8 Overhead Cost Control
3.8.1 Advantages of Classification of Overheads into Fixed
and Variable
S
3.8.2 Accounting and Control of Manufacturing Overheads
3.8.3 Allocation of Overheads over Various Departments or
Departmentalization of Overheads
3.8.4 Apportioning Overhead Expenses over Various
IM Departments
3.8.5 Other Basis of Apportioning Overhead Costs
3.8.6 Difference Between Allocation and Apportionment
3.8.7 Methods of Absorbing Overheads to Various Products
or Jobs
3.8.8 Types of Overhead Rates
M
Activity
Additional Solved Problems
3.9 Summary
N

3.11 Answer Key

Labor Cost and Overhead Cost Control 53
LABOR COSTING
Easyweld Welding Equipment Company

Hong Kong-invested industrial enterprises are now mainly located
in China, especially the Pearl River Delta, where around 55,200 such
enterprises operate. Easyweld Welding Equipment Company is one of
the Hong Kong-invested industrial enterprises and the company makes
welding equipment in Pun Yu District, Guangzhou.
There are 30 factory workers, one assistant supervisor and one supervi-
sor in the plant. Their daily work is to construct welding equipment on
an individual or group basis. The workforce comprises three levels of
workers and the classification is by work experience and skills level. The
remuneration structure is mainly based on the time worked.
S
Level 1
Fresh workers: Newly recruited workers are offered a probation period of
3 months. The daily wages are RMB 20 and the workers work 8 h a day and
6 full days a week. As the quality of work is of prime concern, the factory
IM
accounts for its labor cost on a time basis rather than on a piece-work basis.
Level 2
Workers with less than one year’s experience at the post: Once workers
have their employment confirmed after the 3-month probation period, they
are paid monthly salaries. The factory adopts a merit rating and the work-
ers’ salaries depend on their skill levels. Workers at a low to medium skill
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level are paid RMB 500-600 a month, while workers at a high skill level are
paid up to RMB 1,000 a month. In addition, a merit payment of RMB 50 a
month is offered to certain workers, depending on their attitude.
Level 3
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Workers with more than one year’s experience at the post: These workers,
which include the assistant supervisor and the supervisor, are paid RMB
1,000-1,500 a month. In addition, they are offered a group bonus. Since
product quality is of prime concern in engineering production, there is no
incentive scheme for pushing up production volume. Nevertheless, if there
is premium production in any one month, these level 3 workers are granted
a group bonus of RMB 3-8 per piece of welding equipment manufactured.
In order to maintain work quality, overtime work is not encouraged.
Under the Chinese Government Labor Ordinance, the factory pays
an overtime work premium that ranges from 25% to 50% basing on
the duration of overtime work. By regulations, all factory workers are
paid for time-and-a-quarter for overtime carried out between 6 pm and
10 pm on weekdays. They are paid time-and-a-half for overtime carried
out after 10 pm on weekdays and on Sundays. In addition, the factory
flexibly offers extra payment to workers so as to ensure the fulfillment
of minimum staff salary enforced by the labor ordinance. (A minimum
monthly salary of RMB 780 is set for the rural Guangzhou.)
For all levels of workers, the factory pays for food and accommodation on
top of the labor wages or salaries. Both the food costs and accommodation

NMIMS Global
Education

N O T E S
costs are around RMB 200 a month for each worker. The factory also pays
RMB 10 a month as social welfare contribution for each worker. This social
welfare contribution by employers is mandatory in China. A pension fund
contribution is not mandatory in China; it is established on mutually-agreed
basis by both employers and employees. The factory also contributes RMB
4 a month as medical insurance for each worker. In addition, the employer
and workers contribute an equal payment for social insurance; the amount
is around RMB 80-90 a month from each side.
In order to encourage staff development, the factory offers a work-
related education sponsorship of RMB 600–1,000 to workers. Workers
usually take work-related courses like electronic engineering, computer
aided design and/or software skills. In order to maintain the strength of
the labor force, workers can have their course fee reimbursed only after
completion of the course.
S
Bonus scheme for maintaining labor
High labor turnover is a significant problem in Guangdong. In recent
years, Easyweld has suffered a labor turnover rate of around 20% a year.
IM
Usually, this turnover happens when workers do not return to work after
the Chinese New Year (CNY) holidays. To remedy this situation, the fac-
tory offers an annual bonus to its level 3 workers. Half of the annual
bonus is paid before the CNY holidays, with the rest paid after the hol-
idays. This type of arrangement provides a useful financial incentive to
help the enterprise maintain its workforce.
Concluding remarks
M
Labor cost accounting involves the study of the behavior of labor, per-
formance measurement, time and motion studies, control on atten-
dance and government regulations. In modern industrial enterprises,
the worker’s wage is based upon job evaluation, merit rating, incentive
N
remuneration schemes and government ordinances. These elements are

reviewed in the labor cost accounting system of our case study of a Hong
Kong-invested industrial enterprise in China.
QUESTIONS
1. Summarize the case in the backdrop of importance of direct

labor cost.
2. Comment on the incentive schemes given by the company and
elaborate on their effectiveness.
3. Suggest certain other ways to reduce the labor turnout ratio in
Easyweld.

LEARNING OBJECTIVES

>> Different concepts of labor cost.
>> Mechanism of time recording of the workers.
>> Methods of wages to the workers.
>> Various incentives to the workers.
>> Production cost and incentives.
>> Labor turnover and its impact.
>> Techniques of job evaluation.
>> Concept of overheads.
>> Difference between direct costs and overheads.
S
>> Overhead allocation process.
>> Overhead absorption. IM
3.1 INTRODUCTION
As we have discussed that there are three major components involved in the
manufacturing process of a product in a firm, they are materials, labor and
overheads. We have discussed in detail about various material cost control
techniques in Chapter 2 of this book. Like the monitoring and control tech-
niques for optimizing the materials costs, there is a need to control and opti-
M
mize the labor costs. The labor inputs are another important element of cost
which has much impact on the overall production cost. Therefore, effective
control and cost reduction of labor cost assume significant importance. The
control of labor cost is a sensitive issue as it involves the human factor and
a slight mishandling may create a problem for the firm.
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Apart from the labor cost, there is another element which affects the cost of
a product to a certain extent. These are known as overheads. We know that
there are two types of costs. One is the direct cost which could be directly
attributed to the products like materials, labor and other direct expenses. On
the other hand, there are many items and common costs which cannot be
directly allocated to the product but they are very much consumed in com-
pletion of a product. These costs are often known as indirect expenses. As a
matter of business policy and practice, these costs are absorbed on certain
basis either the machine hours or the labor hours to arrive at the total costs
of a product. These overheads are classified into different categories such
as indirect materials, indirect wages and indirect expenses. The overhead
absorption policy makes a significant difference in arriving at the actual cost
of a product. This also affects the pricing of a product and ultimately the prof-
itability of a firm. This chapter covers the details of labor cost and overhead
cost control mechanism so as to minimize these costs. We will discuss various
aspects relating to cost control in both the areas. This chapter is divided in
two parts: (1) labor cost c ontrol and (2) overhead cost control. First, we will
discuss labor cost control techniques.

3.2 THE ISSUES CONCERNED WITH LABOR

COST CONTROL
In today’s global environment where competitiveness in terms of quality
STUDY HINT and cost of products assumes a significant role, an efficient management
Labor cost, also known as of workforce in relation to the labor cost and increased productivity pose
employee cost, is the total a greater challenge to the business firms. Therefore, the management
benefits and consideration accounting professionals should understand the mechanism of labor cost
paid for the services rendered control to optimize the productivity and, at the same time, to keep the work-
by the workers. force satisfied in terms of their compensation and other incentives. Labor
costs consist of monetary benefits, deferred monetary benefits and the
fringe benefits. Following are the important issues which affect the labor
costs to a greater extent. We will discuss them in the following sections.
3.2.1 CLASSIFICATION OF LABOR COST
S
Broadly, the labor cost is bifurcated into two categories, viz. the direct labor
QUICK TIP cost and the indirect labor cost. Labor cost also includes various remunera-
tions paid to the workers in terms of wages, allowances, provident fund con-
Labor cost can be classified as:
• D irect: The cost that can be
IM
tribution, subsidized benefits, medical facilities, group insurance, etc. The
direct labor cost is the amount of remuneration that can be identified and
directly attributed to a par attributed directly to a product or a service unit. It consists of significant
ticular product or service. amount in the total compensation payable to the workers. On the other hand,
• Indirect: Amount of wages the indirect labor cost is the remuneration payable to the workforce where
paid to workers who are not their skills and contributions are not directly related to the particular prod-
directly engaged rather they uct, such as the salaries and wages paid to supervisors, security staff, stores
facilitate the production
M
staff, etc. These are common and cannot be specifically allocated to a single
process.
product. We can also say that indirect wages are the wages paid to the work-
ers who facilitate the production rather than directly involved in the produc-
tion process. Apart from this, certain expenditure incurred on account of
machine repairing and maintenance, idle time, waiting time, etc., fall under
N
the category of indirect labor costs.

Remember, the direct labor cost payable as wages and salaries are charged
directly to the particular job or to a specific product. It is included in the
prime cost. Indirect labor costs are the form of overhead cost. Labor cost is
also classified as fixed and variable. A direct labor cost is variable in nature
and it can be controlled at the discretion of management. There are certain
fixed labor costs which cannot be controlled. Indirect labor cost can also be
controlled by fixing certain standards for the overheads and controlling them
with the actual cost.
3.2.2 LABOR COST CONTROLS

Labor costs can be controlled by recruiting the workers as per the budget,
proper time recording systems, allocating standard labor cost for the product
or job and proper maintenance of job profile of individual employees.
3.2.3 PROCESS AND PRODUCTION PLANNING

A firm can achieve sufficient control by properly planning the produc-
tion process in a more scientific manner. The production process planning
may involve activities like planning, scheduling, routing, machine loading,

product and process engineering, work study through well laid-down norms.
The important mechanism in this is time and motion study which helps in
fixation of standard time for a particular job. Once the standards are fixed,
monitoring process becomes easy to analyse the actual costs with the pre-
determined standards.
3.2.4 LABOR BUDGET

A firm prepares various budgets to have an effective control on various oper-
ations. The labor budget is prepared to forecast the budgeted expenditure on
workforce activities like recruitments, wages and salaries and other remu-
nerations. It helps in budgetary control. At the end of the particular time
period, an analysis can be made to assess the variances between budgeted
levels and actual costs under different components.
3.2.5 STANDARD LABOR COST
S
A firm may also determine the standards of labor cost on per unit basis
QUICK TIP
to compare with the actual labor cost. The standard labor cost is the cost, Standard labor cost is the cost
which is determined based on the past trends, industry practices, technolog- set as benchmark based on
IM
ical aspects, etc. This is determined under optimum working conditions and certain standards and mea
helps a firm to adhere adequate control in the future. The standards can also sured per unit of labor
be fixed based on time and motion study. This has been an effective way to employed.
monitor and control the labor costs.
3.2.6 JOB PERFORMANCE REPORT

M
A firm may also introduce individual job performance report which can be
used for performance evaluation periodically. This will indicate labor effi-
ciency and time utilization by the individual workers. This will be helpful in
measuring the efficiency and productivity of the individual workers.
N
3.2.7 WORK PERFORMANCE INCENTIVES

The incentives relating to work performance also play a major role in the
productivity improvement of the workers. There are two aspects in it:
one is the costs and the other is the increased productivity. A firm has
to decide the extent of incentives which brings efficiency in the produc-
tion process and compare it with the additional costs on such incentives.
Improving the labor productivity is one of the important ways to reduce
the labor cost per unit. In this area, the firm may introduce both the mon-
etary and the non-monetary incentives. There has to be a periodic review
of the incentive schemes to make required changes from time to time to
bring in more efficiency.
3.3 MECHANISM OF LABOR COST CONTROL

There is a proper mechanism which needs to be set up in a firm involving
different departments, such as personnel, human resources development,
engineering and accounting. These departments perform specific tasks
related to the workers performance and productivity.

3.3.1 PERSONNEL MANAGEMENT DEPARTMENT

The role of personnel management department is very significant in design-
ing the policies and systems to the workers in such a way that they con-
tribute to their maximum capacity. This department is basically responsible
for activities like recruitment, training, transfer, promotions, termination,
designing and developing various incentive schemes and maintaining per-
sonal records of the workforce. In fact, the labor cost control mechanism
commences right from the point of recruitment of workers where adequate
care should be taken to employ the workers according to the requirement
matching with the experience and qualification.
3.4 LABOR ATTRITION

This is also known as labor turnover. In other words, we can say the fre-
! IMPORTANT CONCEPT quency of labor exit from one industry to another. This is a major problem,
S
Labor attrition rate is the particularly in the factories. The workers have tendency to change the job
frequency of labor exit from frequently. The labor turnover can be defined as a change in the labor force
one organization to other in as compared to the total labor force. Labor attrition is prevalent in all types of
a given period of time. industries, but the degree of change may differ from one industry to another.
IM
Labor turnover is the rate of change in the number of workers and, if this is
too high in a particular firm as compared to others, it speaks of inefficient
personnel management policies. With the increased opportunities for jobs on
account of emergence of new services and products, the labor turnover has
been increasing. For a healthy organization, the labor turnover should not be
very high as it will have multidimensional effects on productivity, costs, cul-
ture, reputation of the firm, replacement costs, etc. This will also increase the
M
costs of induction and other training programs. Therefore, a well-organized

firm ensures that the labor turnover is minimum. However, a little degree of
labor turnover is desired to replace certain workers and induct new workers
to bring innovations and efficiencies in the process.
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NOTE 3.4.1 MEASUREMENT OF LABOR TURNOVER

Labor attrition rate should be It is necessary to measure the labor turnover rate from time to time to frame
lower to save the labor replace suitable policies to control higher turnover ratio. Following are the methods
ment cost and also to achieve which help in the measurement of labor turnover.
production efficiencies.
3.4.1.1 ADDITION RATE
Under this method, a number of employees inducted during a particular
time period are considered for the measurement of labor turnover ratio.
Following is the formula for computing addition rate:
Number of additions during the period

Labor turnover = × 100
Avera
age number of worker s during the period
3.4.1.2 SEPARATION RATE

In this method, the number of employees who left during a particular time
period are considered for measuring the separation rate. Following is the
formula for measurement of separation rate:

Number of separations during the period

Labor turnover = × 100
Aveerage number of workers during the period
3.4.1.3 REPLACEMENT RATE

Under this method, the number of employees replaced during a period is
taken into account for c omputing the labor replacement rate.
Labor turnover on account of replacement =
Number of replaccements during the period
´ 100
Average number of workers during the period
3.4.1.4 FLUX RATE
This is a slightly different method whereby labor turnover is computed by
considering the additions of workers during the period and also separations
NOTE
S
during the period. It can be computed through the f ollowing method: Under labor turnover, flux is a
method of calculating relation
Flux rate = ship additions plus separations
 Number of new joining + Number of separations during the period  and average workers.
 2
IM 
× 100
Remember, the average number is taken as the simple average.
3.4.2 FACTORS AFFECTING LABOR TURNOVER QUICK TIP

M
Once the firm is able to measure the turnover ratio, it will find out the causes The important tools for labor
of turnover. The labor turnover may happen on account of both the internal cost control are
and the external factors. We will discuss these factors. • Efficient production
planning
3.4.2.1 INTERNAL FACTORS FOR LABOR TURNOVER • Comparing with standard
N
cost
The following factors may cause labor turnover due to a firm’s own internal • Work performance report
inefficiencies. These causes can be avoided by taking appropriate action by • Lesser attrition
the management. The main causes among them are as follows: • Labor rate
• Better performance
1. Labor may not be satisfied with the type and process of job.
incentives
2. There may be problem with the scheduled working hours which may
not be suitable.
3. The working environment prevailing in the factory may not be
conducive.
4. Lack of cooperation among the workers.
5. Unhealthy relations with the superiors and management.
6. The remuneration policies may not be suitable as compared to other
firms. There may be lack of incentives and motivations.
7. This apart, there may be other causes like inadequate facilities in terms
of health insurance, inadequate safety measure, high risk in operations,
lack of suitable promotion policy, inadequate arrangements for training
and absence of other incentives.

3.4.2.2 EXTERNAL FACTORS

There can be many other reasons which may cause high labor turnover and
such reasons may not be within the control of management. The following
reasons may fall in this category:
1. Turnover due to retirement, death and other family and personal
reasons.
2. Continuous ill health, accident and other physical problems.
3. Location change of a worker.
4. Other social and family circumstances.
3.4.3 LABOR TURNOVER AND ITS COST TO A FIRM

The extent of labor turnover directly affects the cost of a product in a
S
firm. Higher the turnover of labor, higher will be the cost of product to
a firm. Therefore, a firm makes all the strategies to have effective per-
sonnel policies to minimize the labor turnover. The costs relating to the
labor turnover are categorized as preventive and replacement costs. Let
IM
us understand this.
3.4.3.1 PREVENTIVE COSTS

The labor turnover could be prevented in the beginning itself by designing
and framing appropriate policies and strategies. This concept lays impor-
tance that prevention is better than cure. The costs incurred for preventing
the labor turnover are known as preventive costs. These costs may include
M
cost of personnel management and good administration and involve the

expenditure incurred in maintaining good relationships between the man-
agement and the workers. There may be certain extra costs which may also
be required to incur, such as provision for better medical facilities, subsi-
dized canteen facilities, recreation facilities, etc., that motivate the workers.
N
There may also be additional expenditure which may be required to incur on

other welfare measures like sports facilities, transport, housing, etc. A firm
may also have to make provisions for pension, gratuity schemes and other
post retirement benefits.
3.4.3.2 REPLACEMENT COST

NOTE
Replacement costs include:
This cost occurs on account of getting a replacement for the workers who
left the organization for any of the reasons. The cost involved with replac-
• Lesser efficiency in initial stage ing an existing worker is called replacement costs. This may include the
• Loss of output due to delay cost of recruitment and training to new workers, loss of output on account
• Recruitment expenses of loss in efficiency of the old worker and the new worker, cost on account
• Induction training of increase in wastage and spoilage, loss on account of machine breakage,
etc. In practice, the preventive costs are measured and then apportioned to
concerned departments in proportion to the number of persons engaged by
each department. Replacement costs arising on account of fault of a partic-
ular department are charged directly to the concerned department. In case
the labor turnover is due to weak policy of the firm, such cost is treated as an
overhead and allocated to the different departments on the basis of number
of workers engaged by each department.

3.4.4 EXAMPLE ON LABOR TURNOVER
EXAMPLE 3.1
The following information is available from the records of personnel depart-
ment of XYZ & Co. for the month of January 2015. Total workers in the begin-
ning of the month were 1900, whereas at the end of the month were 2100.
During the month, 25 workers left the firm on account of their own prob-
lems while 40 workers were discharged. 280 workers were engaged during
the month in various departments. But out of them, only 30 were appointed.
Compute the labor turnover using different methods of labor turnover
measurement.
Solution:
We can compute the labor turnover under four different methods as follows:
1. Addition rate:
S
Labor turnover
Number of additions during the period
= × 100
=
280
× 100 = 14%
IM
2000
2. Separation rate:
Labor turnover
Number of separations during the period
M
= ´ 100
Aveerage number of workers during the period
65
= ´ 100 = 3.25%
2000
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3. Replacement rate:
Labor turnover on account of replacement
Number of replacements during the period
= ´ 100
Average number of workers during thhe period
30
= ´ 100 = 1.5%
2000
4. Flux rate:
Flux rate
 Number of new joining 
 + Number of separations during the period 
 
 2 
 
= × 100
 280 + 65 
  173
2
= × 100 = × 100 = 8.65%
2000 2000

Remember: The average number of workers has been computed by consider-

ing the (opening number of workers + closing number of workers)/2 = (1900 +
2100)/2 = 2000.
EXAMPLE 3.2
The following table provides particulars available in respect of labor cost
turnover.
Assessment of Labor Turnover
Particulars Amount (Rs. in ’00)

A. Preventive cost
(a) Personnel administration 10,000
(b) Medical services 6,000
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(c) Welfare 30,000
(d) Pension scheme 40,000
Total: 86,000
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B. Replacement cost
(a) Cost of selection and replacement 6,050
(b) Inefficiency of new labor-extra wages 4,000
(c) Inefficiency of new labor-overheads 2,000
(d) Training costs 3,950
(e) Loss of output 2,500
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(f) Cost of scrap, tool and machine breakdown, etc. 15,500

Total 34,000
Grand total 1,20,000
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Average employees during the period is 1,000. Compute the labor turnover cost.
Solution:
We know that labor turnover cost can be computed by dividing both the pre-
ventive cost and the replacement cost by the average number of workers
during the period.
1. Total preventive cost = 86,000/1,000 = Rs. 86
2. Total replacement cost = 34,000/1,000 = Rs. 34
3. Total labor turnover cost = 86,000 + 34,000 = Rs. 1,20,000
3.5 RECORDING OF TIMINGS

The proper and accurate time keeping is also very important to monitor the
labor cost for the purpose of attendance, calculating wages and salaries, allo-
cation of cost to different jobs and also complying with obligatory require-
ments. It is undertaken by a separate department known as time keeping
office. This department is mainly responsible for recording the attendance
time of each worker accurately. Thus, a firm is able to maintain punctual-
ity and discipline among the workers. This also encourages team spirit and
a sense of commitment among the workers. Besides, maintaining accurate

timings of the workers is mandatory requirement under the law. Following is

the significance of maintaining proper record of time for each of the worker:
1. The total number of hours worked by each workman can be ascertained
for the purpose of calculations of wages, salaries, incentives, etc. This
is more relevant in the firms where workers are paid wages as per the
time rate plan.
2. This is also required to keep a track on punctuality and discipline among
the workers. Each worker remains conscious about the punctuality
and timings.
3. There are certain mandatory requirements to receive benefits like
pension, gratuity, leave with pay, provident fund, promotion and salary
scale on the basis of continuity of service. In that case, attendance
records are required to properly verify to ascertain eligibility for such
benefits.
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4. In cases where the firm follows the policy of overhead allocation based
on labor hours, a proper record of time keeping is very much required
to measure the exact number of hours consumed for the product.
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5. There is also significance of maintaining time records for workers to
ascertain the standard time for work and thus calculate the idle time
spent by workers. We can also calculate the labor efficiency ratio by
maintaining proper time records.
3.5.1 METHODS OF TIME RECORDING ! IMPORTANT CONCEPT

Time recording is a process
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For proper maintenance of time records, the following methods are generally for maintaining daily
used by the firms: time record of the job of
individual workers and
3.5.1.1 CLOCK CARD employees to measure
their work involvement and
Clock card is a method wherein each worker punches the card provided
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performance.
as and when the worker comes in or goes out. The time and date is auto-
matically recorded in the card through the mechanized system. In this pro-
cess, a new card is prepared and replaced with the old card. This helps
in calculation of wages of workers on weekly basis. In case the wages are
paid on monthly basis, the new card is replaced on monthly basis. For this
purpose, the firm makes a provision of maintaining two types of racks. One
is known as “in-rack” and other is called “out-rack.” When a worker comes
in, the card is dropped in the in-rack and when a worker goes out, the card
is dropped in the out-rack. The card contains 31 lines or seven lines for
monthly and weekly cards, respectively. The clock card contains the follow-
ing columns:
1. Name and employee code.
2. Department.
3. Days in case of weekly cards and dates in case of monthly cards.
4. Time in and time out.
5. Total hours (normal hours and overtime hours).
6. Signature of the time keeper.

Following are the advantages of clock card:

1. Preparation of department-wise payrolls.
2. Computation of cost based on time.
3.5.1.2 ATTENDANCE REGISTER OR MUSTERS

Under this system, the workers are required to sign manually in the atten-
dance register maintained at the entrance gate and put the time of their
arrival and also departure. This system is useful in case the numbers of
workers are very small. Moreover, with the advent of technology, now a days,
this system is not in much use.
3.5.1.3 DISC METHOD

This is one of the traditional methods of recording time where a disc bears
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the identification number of each worker which has already been allotted to
the individual workers. On arrival, the worker picks up the disc from the tray
and drops it in the box against the number allotted. This is also followed at
the time of exit. The box is removed at the fixed time. Thus, the time keeper
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can know the arrival time and late time, if any. This process helps identifying
workers reporting on time or late. However, the disc system provides the
scope for subjectivity and also difficult to maintain where workers are large
in number.
3.5.2 MAINTAINING OF TIME RECORDS

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There is also a mechanism to record time through a daily time sheet which
is maintained for individual worker. This is more useful where workers are
engaged in different jobs during the day to measure the timings spent by
individual worker on a particular job. The time can be maintained either on
a daily basis by the worker where the concerned worker record time on his
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own or it can also be maintained on weekly basis. In that case, the worker
prepares time sheet on weekly basis about the work performed.
There is also a concept of maintaining job ticket. Job ticket is a sheet which is
provided to all workers where time for commencing the job is recorded, as well
as the time when the job is completed. The job tickets help to ascertain the time
taken for each job. Likewise, there is labor cost card which is used for the job
which involves several operations. This is useful for arriving aggregate labor
cost of the job or the product. There is also another system called time and job
card: This card contains the record of both the time taken for completion of the
job as well as the attendance time. This card serves both the purposes.
QUICK TIP
3.6 METHODS OF WORK STUDY
Methods of work study help in:
The workers are compensated in many ways as they need to be motivated
• I mproving methods of in different ways. The extent of incentives depends on their performance of
production work. Therefore, a firm is required to establish proper work study methods
• Evaluating job performance to compensate the workers in judicious manner. Generally, the standards are
• Incentivizing the workers fixed to complete a job and then it is compared with the actual time taken by
• Facilitating time and motion
the worker to complete the job. There are various methods of work study; we
study
will discuss some of them.

3.6.1 METHOD STUDY

The system of method study is used to improve the methods of production
and also to achieve the efficient use of the resources like manpower, machines
and materials. Method study has the following features:
1. This method is more appropriate where jobs are complex and operations
are costly.
2. It is necessary to have all the related information about a job, like
purpose, location, sequence, relationship with other works, methods
of working, operators, requirement of skilled workers, facilities
required, etc.
3. The working system are modified and redesigned after studying the
relevant aspects of the job in details. This may help a firm to change
the location and sequence of the work, methods of production and the
layout for the job, depending on the study results. This will bring more
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efficiency, effective way of completing a job and quality improvements.
4. There is need for close monitoring and follow-up to evaluate the
modified systems. Thus, method study is more significant for utilizing
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resources more efficiently and to achieve higher level of production
with reduced costs.
3.6.2 EVALUATION OF JOB

The job evaluation is necessary to establish a well-defined wage and salary
structure in a scientific manner. Therefore, the appropriate valuation of the
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job is important. The job evaluation is a technique to analyse and assess
jobs to determine their relative value. Thus, a firm can develop a ratio-
nal and justified approach for differential salaries and wages depending on
the job evaluation to the workers. Following are the main objectives of job
evaluation:
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1. To develop a systematic and rational wage and job structure.

2. To evaluate a job in more judicious manner to overcome controversies
and disputes relating to salary among the workers.
3. To ensure that workers are more satisfied in terms of fair process of
compensation.
4. To bring fairness and stability in the wage and salary structure.
5. To make the job evaluation more transparent.
Following are the job evaluation methods generally followed by the firms:
3.6.2.1 JOB RANKING METHOD

Under this method, jobs are ranked according to the importance on the basis
of skills required, education, experience requirements, working conditions,
etc. A ranking is done by comparing the other jobs. The different jobs are
rearranged in the similar order. The wage, salaries and other compensations
are decided on the basis of ranks. This method is simple and can be used
when the size of the organization is small.

3.6.2.2 POINT RANKING METHOD

The jobs under this method are analysed in terms of job factors or character-
istics. The job factors may include skills required, efforts involved, working
conditions, etc. Thereafter, each job factor is given weight or points based
on its value to the job. The jobs are ranked according to the total score and
placed under pre-decided grades.
3.6.2.3 GRADE DESCRIPTION METHOD

As a matter of policy, a firm decides, in advance, certain grades according to
education, experience, skills, etc., and the jobs are placed in suitable grade.
3.6.2.4 FACTOR COMPARISON METHOD

In this case, a firm identifies some key jobs and ranks them according to
different factors. The jobs are ranked and evaluated skills, responsibilities,
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working conditions, etc. The jobs are evaluated and compared with other
jobs and a factor scale is constructed.
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3.6.2.5 MERIT RATING
In essence, if we see, the job evaluation is concerned with the rating of the
job to establish rationality to design wages and salary structure in an orga-
nization. The merit rating is the process of comparative evaluation where
analysis of merits of individual worker assumes significance. Thus, the merit
rating aims at evaluation and ranking of individual worker. This helps in
designing and implementing rational promotional policies. The objectives of
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merit rating include the following:

1. To evaluate merit of workers for promotion, increment, reward and
NOTE other incentives.
• Labor cost is the total amount
2. To establish and develop a wage system and incentive scheme.
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payable to workers.
• The firm ensures optimum 3. To identify and allocate an appropriate and suitable job for the workers.
labor cost to be incurred.
4. To develop a self-designed system enabling a worker to evaluate own
• Actual labor cost per unit is merits and identifying areas needing improvements and developing
compared with standard labor capabilities and competencies.
cost.
• Labor cost can be controlled 5. To develop an inbuilt system to promote cooperation, quality of work,
through different methods. punctuality and regularity, skill development, etc.
• Higher labor attrition increases
the cost to the firm. 3.6.2.6 TIME AND MOTION STUDY
• Time recording mechanism The time study is an important technique which establishes time for a worker
helps to control the labor cost to carry our particular elements under specified conditions at a defined rate
and measure efficiency. of working recorded by direct observation of time using a time measurement
• Methods of work study helps in device to rate individual elements. This helps to design efficient incentive sys-
proper recognition and reward tems. Time study measures the time needs to be spent on the job as per the
to workers. pre-determined standards. However, for determining the standard time, motion
• Time and motion study adds to study is essential. The motion study precedes the time study. Motion study can
bring efficiency in production be explained in terms where a job is divided into fundamental elements or basic
process. operations to study in detail the elements and avoid undesired elements. Under
this study, a detailed investigation is made to study all movements in a job,
process or operation and find out the most scientific and systematic approach

of performing the job. The standard time is fixed giving due consideration to
normal idle time. The objectives of time and motion study are as follows:
1. Bringing more efficiency in the production process by removing
undesired motions in the process.
2. Designing and developing improved methods, techniques and processes
for completing the job.
3. Effective and efficient utilization of resources.
4. Developing conducive work environment through proper layout of plant.
3.6.2.6.1 ADVANTAGES OF MOTION STUDY
A well-designed motion study will have the following advantages:

1. Proper assessment of labor requirement.
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2. Promoting incentive systems by fixing suitable standard time.
3. More realistic labor budget and production budget.
4. Bringing improvements in labor productivity by designing more
scientific method for job performance.
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1. Which of the following departments conducts Time and motion study? SELF-ASSESSMENT
QUESTIONS
a. Time-keeping department b. Personnel department
c. Payroll department d. Engineering department
2. Clock Card is a method of
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a. time recording b. cost management

c. finance management d. management accounting
The management of Liberty Fabricators feels that there is an increased

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labor turnover during the last 2 years. They are concerned about this
unpleasant trend. They want to find out the reasons for this. They are also
worried about the financial implications on account of labor turnover and
loss in the production. Therefore, before analyzing the possible reasons
and taking remedial measures, they want to know about the profit fore- ACTIVITY 1
gone as a result of labor Turnover during the last year. As per the data, in
the last year sales was Rs. 83,03,300. The profit/volume ratio was 20%. The
total number of actual hours worked by the direct workers was 4.45 lakh.
On account of delays by the Administrative department in filling vacan-
cies on account of labor turnover, a total of 1 lakh productive hours were
lost. The Actual Direct Labor hours included 30,000 hours attributable to
training new recruits, out of which, half of the hours were unproductive.
The following costs were reported related to labor turnover.
(a) Settlement cost: Rs. 43,820 (b) Recruitment costs: Rs. 26,740
(c) Selection costs: Rs. 12,750 (d) Training costs: Rs. 30,490
Based on the above data, calculate the profit foregone by calculating the
amount of contribution lost and the additional cost that was incurred as a
result of the labor Turnover.
Hint: Actual productive hours = 4,30,000 and contribution loss = Rs. 386200.

3.7 METHODS OF WAGE PAYMENT

There is a specific department in a firm called payroll department which
is engaged in preparation of payroll based on time recording methods. The
department prepares the salary and wages of individual workers. Payroll
also indicates the gross wages payable, the deductions and the net wages
payable to each worker. The payrolls are prepared based on the wages pay-
ment system implemented, per se, by the firm. The flowing methods of wage
payment are explained here:
3.7.1 FLAT TIME RATE SYSTEM

NOTE Under this system, the workers are paid on an hourly, daily or weekly basis
Method of wage payment is very based on the time spent on the job. The overtime is paid as per the require-
crucial for: ments of the act. The workers under this system receive a fixed minimum
income irrespective of the output produced by them. The method is useful in
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• Providing
minimum wages job where quality is a concern, where individual worker has hardly any con-
• Offering
appropriate incentives trol over the job and the speed of p
roduction is governed by time.
• High
productivity
Wages = Number of hours worked × Wage rate per hour
• Reducing per unit cost of
production
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The benefit of this method to a worker is that the worker is assured of min-
imum income irrespective of the output produced. Therefore, the quality of
product becomes a focus. The limitation of this method is that it does not
offer any incentive to the efficient workers.
3.7.2 TIME RATE AT HIGH DAY RATE PLAN

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Under this system, the workers are paid at time rate but the rate is much
higher than that is normally paid in the industry. The thinking is that the
workers will work more efficiently. The workers who are efficient, skilled and
experienced are selected to work. The wages are paid according to the time
taken to complete a job. This method offers high incentives to workers who
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are talented. A very less degree of supervision is required in this method.

However, ensuring that high day rate is really brought, the desired results
are difficult.
Wages = Number of hours worked × High day rate per hour
3.7.3 GRADUATED TIME RATE PLAN

Under this method, wages are paid at different time rates. The wage rate
varies according to the efficiency of the workers. The normal wage rate is
paid for the standard efficiency and a higher rate for increased efficiency.
3.7.4 PIECE RATE METHOD

Under this method, the workers are paid as per the production performed by
them. A worker who produces higher output earns higher wages. This can
be a straight piece rate system where rate per unit is fixed and the worker is
paid according to this rate. There can also be a differential piece rate system
where standard rate per hour of production is increased as the output level
increases. The increase in rates may be proportionate to the increase in
output or proportionately more or less than that is pre-determined.

3.7.5 TAYLOR’S DIFFERENTIAL PIECE RATE SYSTEM

This system presumes that there are only two classes of workers, efficient and
inefficient. The model suggests that while efficient workers should be encour-
aged to the maximum possible extent, the inefficient workers should be penal-
ized. Therefore, two different rates have been suggested for the two different
classes of workers. According to this model, if the workers are efficient, they
should be paid at 120% of the normal piece rate and if they are inefficient, they
should be paid at 80% of the normal piece rate. The standards of production
are pre-fixed. If production is beyond the standard, it is regarded as efficient.
It can be further explained through the following example.
EXAMPLE 3.3
Suppose there are two workers in a firm, viz., X and Y. Following are the data
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available:
(a) Standard time allowed: 20 units per hour
(b) Normal time rate: Rs. 30 per hour
(c)
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Differential to be applied: 80% of piece rate when production is below
standard and 120% of piece rate when production is above standard.
In a particular day of 8 h, X produces 140 units while Y produces 165 units.
You are required to calculate earnings of X and Y based on Taylor’s differen-
tial piece rate system.
Solution:
We will calculate the wages of X and Y as follows:
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• Standard production per day is 20 units × 8 h = 160 units

• Worker X produces 140 units, that is, below standard.
Therefore, X’s wage will be at 80% of the normal piece rate.
1. X’s earnings:
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Normal piece rate = Rs. 30 per hour/20 units = Rs. 1.5 per unit
80% of the normal piece rate = Rs. 1.20 per unit
Earnings = Rs. 1.20 × 140 units = Rs. 168
Labor cost per unit = Rs. 168/140 units = Rs. 1.20
Y has produced more than the standard production of 160 units.
Y’s wages will be at 120% of normal piece rate.
2. Y’s earnings:
Normal piece rate = Rs. 30 per hour/20 units = Rs. 1.50 per unit
120% of normal piece rate = Rs. 1.80 per unit
Earnings = Rs. 1.80 × 165 units = Rs. 297
Labor cost per unit = Rs. 1.80
3.7.6 GANTT TASK BONUS PLAN

This model was developed combining time rate, bonus and piece rate plan.
The model suggests the f ollowing remuneration system given in Table 3.1.

TABLE 3.1 ASSESSMENT OF REMUNERATION UNDER

GANTT TASK BONUS PLAN
Output Payment
Below standard Guaranteed wage rate
Standard output 20% bonus of time rate = 120% of time rate
Above standard Standard high rate for the whole output
Therefore, the model provides sufficient opportunities to incentives the

workers. Following are the advantages of this plan:
1. The workers who are below average receive guaranteed time wages.
2. It differentiates efficient and non-efficient worker due to extra bonus
for efficiency.
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The limitation is that it segregates workers into two categories: efficient and
non-efficient. It is not a good policy for developing better relationship among
the workers.
We can further understand this through the following example:
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EXAMPLE 3.4
Suppose there are three workers, viz. X, Y and Z, who are engaged in a man-
ufacturing firm. The output of X, Y and Z during 40 h in a week was 96, 111
and 126 units, respectively. The guaranteed rate per hour is Rs. 10, low piece
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rate is Rs. 4 per unit and high piece rate is Rs. 6 per unit. The high task is 100
units per week.
Based on the above information, calculate total earnings and labor cost per
unit under Taylor and Gantt task bonus plan.
Solution:
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1. Taylor plan: (High task = 100 units)

X: 96 units × Rs. 4 per hour = Rs. 384
Remember, X will get the wages at low piece rate, output being below
the high task.
Y: 111 units × Rs. 6 per hour = Rs. 666
Y will get the wages at high piece rate since output is above the high task.
Z: 126 units × Rs. 6 per hour = Rs. 756
Z will be paid at high piece rate, output being above the high task.
2. Gantt task and bonus plan:
X = Rs. 10 × 40 h = Rs. 400
X will get guaranteed time rate, output being lower to the high task.
Y = Rs. 6 × 111 units = Rs. 666
Y will get high piece rate, output being above standard.
Z = Rs. 6 × 126 units = Rs. 756
Z will be paid at high piece rate, output being above standard.

3.7.7 HALSEY PREMIUM PLAN

The wages plan under this model was developed by F. A. Halsey, an engineer
in USA. Under this plan, a standard time is calculated for each unit or job and
50% of time saved is allowed as bonus. If the actual time taken by the worker
to perform a job is lesser than the standard, the worker becomes entitled for
bonus. The bonus is paid equal to wages of 50% of the time saved. A worker
remains assured of time wages if longer time is taken than the standard time.
We can calculate the wages under this model as follows:
Total earnings = H × R + [50%( S - H ) × R]
where H are the hours worked, R is the rate per hour and S is the standard
time.
Let us understand it from the following example:
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EXAMPLE 3.5
The time allowed for a job is 60 h. A worker consumed 48 h to complete the
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job. Time rate per hour is Rs. 15. What will be the total earnings of the worker?
Solution:
The total earnings of the worker will be:
Total earnings = H × R + 50%( S - H ) × R

Total earnings = 48 × Rs. 15 + [50%(60 - 48) × Rs. 15]
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Total earnings = Rs. 720 + Rs. 90 = Rs. 810
3.7.8 HALSEY-WEIR PLAN
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Under this method, only 33.33% of the time is saved instead of 50% as sug-
gested in the previous model. Accordingly, the formula for this method is
modified as follows.
Total earnings = H × R + 33.1%( S - H ) × R
where H is hours worked, R is rate per hour and S is standard time.
The advantages of this plan are as follows:
1. It guarantees time wages to the workers.
2. Differentiates between efficient and non-efficient workers and provides
incentives accordingly.
3. It reduces the labor cost.
4. When production increases, fixed overhead per unit gets reduced.
5. Overall production cost is minimized.
However, the major limitation is that the worker work in hurry to save more
time to get higher bonus.

3.7.9 ROWAN PLAN

This is the premium bonus plan where bonus hours are calculated in propor-
tion to the time taken, which the time saved bears to the time allowed and
they are paid for at time rate. The formula for computation of total earnings
is as follows:
(S - H)
Total earnings = H × R + ×H×R
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where H is hours worked, R is rate per hour and S is standard time.
The advantages of this plan are as follows:
1. The worker receives guaranteed time wages.
2. Since the bonus increases at decreasing rate and efficiency, it ensures
the quality of work receive importance at each level.
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3. The wages saved in terms of time is shared between workers and
employer both; it helps in reducing labor cost per unit.
4. It also helps in reducing fixed overhead per unit due to increased
IMproduction.
The limitation is that workers do not receive full advantage of the time saved
and a highly efficient worker is not adequately compensated.
3.7.10 GROUP BONUS PLAN

At times, the output in a firm is measured in terms of group performance. In
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such cases, group bonus system is implemented. The total amount of bonus
is determined according to productivity. This can be shared equally or in
agreed proportion between the group members. The advantages of this plan
are as follows:
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1. Developing team spirit among workers.

2. Most effective utilization of materials and time.
3. Group efforts receive better focus and help in productivity.
The group bonus plans can be budgeted expenses bonus where bonus is
determined based on the savings in actual total expenditure as compared
with the budgeted level of expenditure. Another category can be cost
effective bonus where standards are pre-decided for expenses like mate-
rial, labor and overheads. The actual expenditure against the standards
is measured and if there is a savings in actual expenditure, cost effective
bonus is applied and a proporation of such savings is distributed among
the workers.
3.7.11 PRIESTMAN’S BONUS PLAN

Under this method, the standards for output are pre-determined and if actual
production exceeds the standard level of output, a fixed percentage of bonus
is paid on the excess output. The amount of bonus is distributed among the
workers in the particular production unit. The limitation of this system is

that it does not differentiate between efficient and inefficient workers. This
NOTE
method is generally implemented in foundries.
• Time rate at high day is a method
of wage payment when workers
3.7.12 TOWNE PROFIT SHARING PLAN
are paid at time rate but the rate
Under this plan, the standards are fixed particularly for labor costs and then is high that motivates the worker
actual cost is compared with the fixed standards. If there is a saving in the to produce more.
costs, the saving is shared by the workers and the supervisors in agreed • Under graduated time rate plan,
proportion. The concept is that if there is a saving in the cost, not only the wages are paid at different time
workers but also the supervisory staff should also be rewarded since the cost rates.
reduction occurred due to joint efforts. • Taylor’s differential piece rate
method classify workers as effi
3.7.13 NON-MONETARY INCENTIVES cient and inefficient.
• Gantt task bonus plan is combi
Many firms introduce the system of non-monetary incentives. These nation of time rate, bonus and
incentives are given in addition to monetary incentives to encourage the piece rate plan.
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workers and motivate them to contribute more effectively. The benefits • Halsey premium plan allows
may not result in additional remuneration to workers but they certainly bonus on 50% time saved
help to improve better participation. Some of the usually practiced non- through efficiency.
monetary incentives include free education and training, medical bene-
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fits, subsidized canteen facilities, superannuation benefits like pensions,
• Rowan plan is the premium
bonus plan for the time saved.
gratuity, life assurance schemes, sports and recreation facilities, housing
• Group bonus plan measures per
facilities, etc.
formance of group of workers.
SELF-ASSESSMENT
3. Which of the following plans does not guarantee wages on time QUESTIONS
basis?
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a. Halsey plan
b. Rowan plan
c. Taylor’s differential piece rate system
d. Gantt’s task and bonus system
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4. On which basis a worker is paid under the high wage plan?

a. At a time rate higher than the usual rate
b. According to his efficiency
c. At a double rate for overtime
d. Normal wages plus bonus
5. Which department prepares wages sheet?
a. Time–keeping department
b. Personnel department
c. Payroll department
d. Engineering department
6. How do you measure over time?
a. Actual hours being more than normal time
b. Actual hours being more than standard time
c. Standard hours being more than actual hours
d. Actual hours being less than standard time

3.8 OVERHEAD COST CONTROL

Overheads are the expenditure which cannot be conveniently traced to
STUDY HINT or identified with any particular cost unit. Such expenses are incurred for
output generally and not for a particular work order, for example, wages
Overhead is the cost, which
paid to watch and ward staff, heating and lighting expenses of factory, etc.
is not identified with any
Overheads are also very important cost element along with direct materi-
product. It is a common cost
als and direct labor. Often in a manufacturing concern, overheads exceed
comprising of indirect material,
labor and expenses. The over
direct wages or direct materials and, at times, even both put together. On
heads are apportioned to the this account, it would be a grave mistake to ignore overheads either for the
cost units. purpose of arriving at the cost of a job or a product or for controlling total
expenditure.
Overheads also represent expenses that have been incurred in providing cer-
tain ancillary facilities or services which facilitate or make possible the carry-
ing out of the production process; by themselves these services are not of any
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use. For instance, a boiler house produces steam so that machines may run
and, without the generation of steam, production would be seriously ham-
pered. But if machines do not run or do not require steam, the boiler house
would be useless and the expenses incurred would be a waste. Overheads
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are incurred not only in the factory of production but also on administration,
selling and distribution.
3.8.1 ADVANTAGES OF CLASSIFICATION OF OVERHEADS

INTO FIXED AND VARIABLE
The primary objective of segregating semi-variable expenses into fixed and
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QUICK TIP variable is to ascertain marginal costs. Besides this, it also has the following
advantages:
Significance of “overheads”:
1. Controlling expenses: The classification of expenses into fixed and
• A ll the common costs are to
variable components helps in controlling expenses. Fixed costs are
be allocated into different
product units.
generally policy costs, which cannot be easily reduced. They are
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• It is required to know total incurred irrespective of the output and hence are more or less non
cost of a product. controllable. Variable expenses vary with the volume of activity and the
• It helps in controlling responsibility for incurring such expenditure is determined in relation
expenses. to the output. The management can control these costs by giving proper
• It is useful in decision allowances in accordance with the output achieved.
making. 2. Preparation of budget estimates: The segregation of overheads into
• It is required for budget fixed and variable part helps in the preparation of flexible budget. It
estimates. enables a firm to estimate costs at different levels of activity and make
comparison with the actual expenses incurred.
3. Decision making: The segregation of semi-variable cost between
fixed and variable overhead also helps the management to take many
important decisions. For example, decisions regarding the price to be
charged during depression or recession or for export market. Likewise,
decisions on make or buy, shut down or continue, etc., are also taken
after separating fixed costs from variable costs.
In fact, when any change is contemplated, say, increase or decrease in pro-
duction, change in the process of manufacture or distribution, it is necessary
to know the total effect on cost (or revenue) and that would be impossible

NOTE
without a correct segregation of fixed and variable costs. The technique of
marginal costing, cost-volume-profit relationship and break-even analysis • There are fixed and variable
are all based on such segregation. overheads.
• Fixed overheads are constant
3.8.2 ACCOUNTING AND CONTROL OF and uncontrollable for a given
period.
MANUFACTURING OVERHEADS
• Fixed overhead per unit
We have already seen that overheads are, by nature, those costs which cannot declines with increased
be directly related to a product or to any other cost unit, yet for working production.
out the total cost of a product or a unit of service, the overheads must be • Fixed overhead changes with
included. Thus, we have to find out a way by which the overheads can be the change in capacity.
distributed over the various units of production. • Variable overheads change
in proportion to change in
3.8.2.1 MANUFACTURING OVERHEADS production.
Generally, manufacturing overheads form a substantial portion of the total • Per unit variable overheads
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remain constant.
overheads. It is important that such overheads should be properly absorbed
over the cost of production. The following procedure may be adopted in this
regard. The steps given below show how factory overhead rates are estimated
and overheads absorbed on that basis and how actual amount is compared
!
with the absorbed amount.
IM IMPORTANT CONCEPT
1. Estimation and collection of manufacturing overheads: The first Manufacturing Overheads

(also known as factory
stage is to estimate the amount of overheads, keeping in view the past
overheads) are the indirect
figures and adjusting them for known future changes. There are four
expenses incurred during the
main sources available for the collection of factory overheads, viz.:
manufacturing process. The
(a) Invoices. expenses are incurred inside
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(b) Stores requisition. the factory for production.
(c) Wage analysis book.
(d) Journal entries.
2. Cost allocation: The term “allocation” refers to assignment or allotment
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of an entire item of cost to a particular cost center or cost unit. It implies

relating overheads directly to the various departments. The estimated
amount of various items of manufacturing overheads should be allocated
to various cost centers or departments. For example, if a separate
power meter has been installed for a department, the entire power cost
ascertained from the meter is allocated to that department. The salary of
the works manager cannot be directly allocated to any one department
since he looks after the whole factory. It is, therefore, obvious that many
overhead items will remain unallocated after this step.
3. Cost apportionment: There are some items of estimated overheads (like
the salary of the works manager) which cannot be directly allocated to
the various departments and cost centers. Such unallocable expenses
are to be spread over the various departments or cost centers on an
appropriate basis. This is called apportionment. Thus apportionment STUDY HINT
implies “the allotment of proportions of items of cost to cost centers or Absorption is a process of
departments.” After this stage, all the overhead costs would have been recovering overheads from
either allocated to or apportioned over the various departments. the respective cost centers/
production units. They are
4. Re-apportionment: Up to the last stage, all overheads are allocated
recovered on pre-determined
and apportioned to all the departments, both production and service
overhead absorption rate.
departments. Service departments are those departments which do

not directly take part in the production of goods. Such departments

provide ancillary services. Examples of such departments are boiler
house, canteen, stores, time office, dispensary, etc. The overheads of
these departments are to be shared by the production departments
since service departments operate primarily for the purpose of
providing services to production departments. The process of
assigning service department overheads to production departments is
called reassignment or re-apportionment. At this stage, all the factory
overheads are collected under production departments.
5. Absorption: After completing the distribution, as stated above, the
overheads charged to the department are to be recovered from the
output produced in respective departments. This process of recovering
overheads of a department or any other cost center from its output
is called recovery or absorption. The overhead expenses can be
absorbed by estimating the overhead expenses and then working out
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an absorption rate. When overheads are estimated, their absorption is
carried out by adopting a pre-determined overhead absorption rate.
This rate can be calculated by using any one method as discussed later
in the chapter.
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As the actual accounting period begins, each unit of production
automatically absorbs a certain amount of factory overheads through
pre-determined rates. During a year, a certain amount will be absorbed
over the various products. This is known as the total amount of absorbed
overheads.
6. Treatment of over- and under-absorption of overheads: After a year
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ends, the total amount of actual factory overheads is known. There is
bound to be some difference between the actual amount of overheads
and the absorbed amount of overheads. So the overheads are generally
either under-absorbed or over-absorbed. The difference has to be
QUICK TIP adjusted keeping in view of such differences and the reasons thereof. It
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serves the following two purposes:

Overheads: (a) To charge various products and services with an equitable portion
• Are allocated and appor of the total amount of factory overheads.
tioned to all departments in (b) To charge factory overheads immediately as the product or the
proportion to usage. job is completed without waiting for the figures of actual factory
• Are absorbed in proportion overheads.
to factory cost or any other
parameter.
3.8.2.2 DISTRIBUTION OVERHEADS
• Under or over overheads as
compared to standards are The various steps for the distribution of overheads have been discussed in
adjusted. detail as follows:
• Are re-apportioned
between service and 1. Estimation and collection of manufacturing distribution overheads:
production departments. The amount of factory overheads is required to be estimated. The
estimation is usually done with reference to past data adjusted for
known future changes. The overhead expenses are usually collected
through a system of standing orders.
2. Standing orders: In every manufacturing business, expenses are
incurred on direct materials and direct labor in respect of several jobs
or other units of production, manufacture of which is undertaken. The

incurring of these expenses is authorized by production orders or work

orders. The work order numbers are not ordinarily fixed or permanent.
They are generally allotted in a serial order according to the number of
manufacturing jobs undertaken by the business. In addition, indirect
expenses are incurred in connection with the rendering of services
to the production departments, or to the manufacturing process. The
term “standing order” denotes sanction for indirect expenses under
various heads of expenditure.
In large factories, usually the classification of indirect expenditures is com-
bined with a system of standing orders (sometimes also referred as “service
orders”). It is a system under which a number is allotted to each item of
expense for the purpose of identification and the same is continued from
year to year. All the indirect expenditure in such a case is charged to one or
the other of the standing orders and periodical summaries, giving total of
each standing order, are prepared for comparison with budgets, as well as for
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apportioning them among the various departments. The extent of such anal-
ysis and the nomenclature adopted are settled by the management according
to the needs of the industry.
3.8.3 ALLOCATION OF OVERHEADS OVER VARIOUS

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DEPARTMENTS OR DEPARTMENTALIZATION
OF OVERHEADS
Most of the manufacturing processes functionally are different and are per-
formed by different departments in the factory. Where such a division of
functions had been made, some of the departments should be engaged in
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actual production of goods and others in providing services ancillary thereto.
At this stage, the factory overheads which can be directly related to the vari-
ous production or service departments are allocated in this manner.
It may, sometime, become necessary to sub-divide a manufacturing organi-
zation into several cost centers so that a closer distribution of expenses and
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a more detailed control is practicable. It is thus obvious that the principal

object of setting up cost centers is to collect data, in respect of similar activi-
ties more conveniently. This avoids a great deal of cost analysis. When costs
are collected by setting up cost centers, several items can be ascertained defi-
nitely and the element of estimation is reduced considerably. For instance,
the allowance of the normal idle time or the amount to be spent on consum-
able stores, etc. There are two main types of cost centers, machine or per-
sonal, depending on whether the process of manufacture is carried on at a
center by man or machine. For the convenience of recording of expenditure,
cost centers are sometimes allotted a code number.
3.8.3.1 ADVANTAGES OF DEPARTMENTALIZATION

The collection of overheads department wise gives rise to the following
advantages:
1. Better estimation of expenses: Some expenses which relate to the
departments will be estimated almost on an exact basis and, to that
extent, the accuracy of estimation of overheads will be higher.
2. Better control: For the purpose of controlling expenses in a
department, it is obviously necessary that the figures in relation to

each department should be separately available. It is one of the main

principles of control that one should know for each activity how
much should have been spent and how much is actually spent. If
information about expenses is available only for factory as a whole,
it will not be possible to know which department has been over
spending.
3. Ascertainment of cost for each department: From the point of view
of ascertaining the cost of each job, the expenses incurred in the
departments through which the job or the product has passed should
be known. It is only then that the cost of the job or the product can
be charged with the appropriate share of indirect expenses. It is not
necessary that a job must pass through all the departments or that the
work required in each department should be the same for all jobs. It is,
therefore, necessary that only appropriate charge in respect of the work
done in the department is made. This can be done only if overheads for
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each department are known separately.
4. Suitable method of costing: A suitable method of costing can be
followed differently for each department, for example, batch costing
IMwhen a part is manufactured, but single or output costing when the
product is assembled.
3.8.4 APPORTIONING OVERHEAD EXPENSES OVER

VARIOUS DEPARTMENTS
! IMPORTANT CONCEPT
After the allocated overheads are related to the departments, expenses
The overheads are often incurred for several departments have to be apportioned over each
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common facilities used by
department, for example, rent, power, lighting, insurance and deprecia-
different departments. They
tion. For distributing these overheads over different departments benefit-
are apportioned on some
ing thereby, it is necessary at first to determine the proportion of benefit
suitable criteria such as:
received by each department and then distribute the total expenditure
• Office rent, rates and taxes – proportionately on that basis. But the same basis of apportionment cannot
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Floor space basis be followed for different items of overheads since the benefit of a service
• Depreciation on office to a department in each case has to be measured differently. Some of the
building – on the basis of basis that are generally adopted for the apportionment of expenses are
floor space stated in Table 3.2.
• Legal fees – number of
cases handled
• Salaries to common staff –
3.8.5 OTHER BASIS OF APPORTIONING OVERHEAD COSTS
Ratio of staff used by the We have considered already that the benefit received by the department gen-
departments erally is the principal criterion on which the costs of service departments
or common expenses are apportioned. But other criteria are equally valid.
Three of them are mentioned below:
1. Analysis or survey of existing conditions.
2. Ability to pay.
3. Efficiency or incentive.
A single concern may have only one criterion under consideration predomi-
nantly or may use all (including the service or benefit criterion) for different
phases of its activity.

TABLE 3.2 BASIS OF OVERHEADS ALLOCATION

Overhead Cost Bases of Apportionment
Rent and other building expenses Floor area or volume of
Lighting and heating department
Fire precaution service
Air-conditioning
Perquisites Number of workers
Labor welfare expenses
Time keeping
Personnel office
Supervision
Compensation to workers Direct wages
Holiday pay
ESI and P.F. contribution
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Perquisites
General overheads Direct labor hours, direct wages or
machine hour
Depreciation of plant and machinery
Repair and maintenance of plant and
IMCapital values
machinery
Insurance of stock
Power/steam consumption Technical estimates
Internal transport
Managerial salaries
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Lighting expenses Number of lighting points or area or

metered units
Electric power Horse power of machines, or
number of machine hours, or value
of machines or units consumed
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Material handling Weight of materials or volume of

Stores overhead materials or value of materials or
unit of material
3.8.5.1 ANALYSIS OR SURVEY OF EXISTING CONDITION

At times, it may not be possible to determine the advantage of an item of
expenses without undertaking an analysis of expenditure. For example,
lighting expenses can be distributed over departments only on the basis of
the number of light points fixed in each department.
3.8.5.2 ABILITY TO PAY

It is a principle of taxation which has been applied in cost accounting as well
as for distributing the expenditure on the basis of income of the paying depart-
ment, on a proportionate basis. For example, if a company is selling three dif-
ferent products in a territory, it may decide to distribute the expenses of the
sales organization to the amount of sales of different articles in this territory.
This basis, though simple to apply, may be inequitable since the expenditure
charged to an article may have no relation to the actual effort involved in

selling it. Easy selling lines thus may have to bear the largest proportion of
expenses while, on the other hand, these should bear the lowest charge.
3.8.5.3 EFFICIENCY OR INCENTIVES

Under this method, the distribution of overheads is made on the basis of
pre-determined levels of production or sales. When distribution of overhead
cost is made on this basis and if the level of production exceeds the pre-
determined level of production, the incidence of overhead cost gets reduced
and the total cost per unit of production or of sales is lowered. The opposite
is the effect if the assumed levels are not reached.
Thus the department whose sales are increasing is able to show a greater profit
and thereby is able to earn greater good-will and appreciation of the manage-
ment than it would have if the distribution of overheads was made otherwise.
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3.8.6 DIFFERENCE BETWEEN ALLOCATION
AND APPORTIONMENT
QUICK TIP The difference between the allocation and apportionment is important to
Allocation and Apportionment
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understand because the purpose of these two methods is the identification
of the items of cost to cost units or centers. However, the main difference
• When cost is identifiable, it is
allocation. between the above methods is given below:
• Apportionment is the case 1. Allocation deals with the whole items of cost which are identifiable with
when common cost is dis any one department. For example, indirect wages of three departments
tributed among the users. are separately obtained and hence each department will be charged by
• Allocation is direct process the respective amount of wages individually.
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of charging expenses while
apportionment is indirect.
On the other hand, apportionment deals with the proportions of an item
• Allocation is used in of cost, for example, the cost of the benefit of a service department will be
broader perspective. divided between those departments which has availed those benefits.
2. Allocation is a direct process of charging expenses to different cost
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centers, whereas apportionment is an indirect process because there is

a need for the identification of the appropriate portion of an expense to
be borne by the different departments benefited.
3. The allocation or apportionment of an expense is not dependent on its
nature, but the relationship between the expense and the cost center
decides that whether it is to be allocated or apportioned.
4. Allocation is a much wider term than apportionment.
QUICK TIP 3.8.7 METHODS OF ABSORBING OVERHEADS TO

VARIOUS PRODUCTS OR JOBS
Overheads can be absorbed
in proportion on the following The method selected for charging overheads to products or jobs should be
basis: such as will ensure the following:
• Direct materials 1. Total amount charged (or recovered) in a period does not differ
• Prime cost materially from the actual expenses incurred in the period.
• Direct labor cost/labor hour
2. Amount charged to individual jobs or products is equitable. In case of
rate
factory overhead, this means that:
• Machine hour rate
• Rate per unit of output (a) The time spent on completion of each job should be taken into
consideration.

(b)
A distinction should be made between jobs done by skilled workers
and those done by unskilled workers.
(c) Jobs done by manual labor and those done by machines should be
distinguished.
In addition, the methods should be capable of being used conveniently and
yield uniform result from period to period as far as possible; any change that
is apparent should reflect a change in the underlying situation such as sub-
stitution of human labor by machines.
Several methods are commonly employed, either individually or jointly, for
computing the appropriate overhead rate. The more common of these are as
follows:
1. Percentage of direct materials.
2. Percentage of prime cost.
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3. Percentage of direct labor cost.
4. Labor hour rate.
5. Machine hour rate.
6. Rate per unit of output.
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3.8.7.1 PERCENTAGE OF DIRECT MATERIAL COST
This method is based on the fact that both materials as well as labor contrib-
ute in raising factory overheads. Hence, the total of the two, that is, prime
cost should be taken as base for absorbing the factory overhead. The over-
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head rate in this method is computed by the following formula:

Total production overheads of a department
Overhead rate = × 100
Budgeted direct material cost of all products
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3.8.7.2 PERCENTAGE OF PRIME COST METHOD

This method is based on the fact that both materials as well as labor contrib-
ute in raising factory overheads. Hence, the total of the two, that is, prime
cost should be taken as base for absorbing the factory overhead. The over-
head rate in this method is computed by the following formula:

Prime cost
3.8.7.3 PERCENTAGE OF DIRECT LABOR COST

Formula to be used under this method is:

Direct labour cost
3.8.7.4 LABOR HOUR RATE

This method is an improvement on the percentage of direct wage basis, as it
fully recognizes the significance of the element of time in the incurring and
absorption of the manufacturing overhead expenses. This method is admirably

suited to operations which do not involve any large use of machinery. To

calculate labor hour rate, the amount of factory overheads is divided by the
total number of direct labor hours. Suppose factory overheads are estimated
at Rs. 90,000 and labor hours at Rs. 1,50,000. The overhead absorption rate will
be 0.60. If 795 direct labor hours are spent on a job, 477 will be absorbed as
overhead. It can be calculated for each category of workers. Formula to be used
under this method is as follows:

Direct labor hour rate =
Direct labor hours
3.8.7.5 MACHINE HOUR RATE

By the machine hour rate method, manufacturing overhead expenses are
charged to production on the basis of number of hours machines are used
on jobs or work orders. The machine hour rate is computed by the following
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formula:
Production overheads
Machine hour rate = × 100
Number of machine hours
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There is a basic similarity between the machine hour and the direct labor
hour rate method so far as both are based on the time factor. The choice of
one or the other method is conditioned by the actual circumstance of the
individual case. In respect to departments or operations in which machines
predominate and the operators perform relatively a passive part, the machine
hour rate is more appropriate.
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In such case, the machine hour rate method alone can be depended on to
correctly absorb the m anufacturing overhead expenses to different items of
production. Usually, the computation is made on the basis of the estimated
expenses or the normal expenses for the coming period. Thus, the machine
hour rate usually is a pre-determined rate. It is desirable to work out a rate
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for each individual machine; where a number of similar machines are work-
ing in a group, there may be single rate for the whole group.
3.8.7.6 RATE PER UNIT OF OUTPUT METHOD

This is the simplest of all the methods. In this method, overhead rate is deter-
mined by the following formula:
Amount of overheads
Number of units
3.8.8 TYPES OF OVERHEAD RATES

The overhead rates may be of the following types:
3.8.8.1 NORMAL RATE

This rate is calculated by dividing the actual overheads by actual base. It is
also known as the actual rate. It is calculated by the following formula:
Actual amount of overheads

Normal overhead rate =
Actual base

3.8.8.2 PRE-DETERMINED OVERHEAD RATE

This rate is determined in advance by estimating the amount of the over-
head for the period in which it is to be used. It is computed by the following
formula:
Budgeted amount of overheads
Pre-determined rate =
Budgeted base
The amount of overhead rate of expenses for absorbing them to production

may be estimated on the following three basis:
1. The figure of the previous year or period may be adopted as the overhead
rate to be charged to production in the current year. The assumption is
that the value of production as well as overheads will remain constant or
that the two will change proportionately.
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2. The overhead rate for the year may be determined on the basis of
estimated expenses and anticipated volume of production activity.

For instance, if expenses are estimated at Rs. 10,000 and output at 4,000
units, the overhead rate will be Rs. 2.50 per unit.
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3. The overhead rate for a year may be fixed on the basis of the normal
volume of the business.
3.8.8.3 BLANKET OVERHEAD RATE

STUDY HINT
Blanket overhead rate refers to the computation of one single overhead rate
for the whole factory. It is to be distinguished from the departmental over- Blanket Overhead rate is a rate
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head rate which refers to a separate rate for each individual cost center or when one single overhead
department. The use of blanket rate may be proper in certain factories pro- rate is fixed for the entire
ducing only one major product in a continuous process or where the work work place and overheads
performed in every department is fairly uniform or standardized. This over- are absorbed at this rate at a
head rate is computed as follows: common rate.
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Total overheads for the factory

Blanket rate =
Total number of units of base for the factory ! IMPORTANT CONCEPT
• O
verheads are common
A blanket rate should be applied in the following cases: indirect expenses associated
1. Where only one major product is being produced. with a product or process.
• O
verheads have to be
2. Where several products are produced, but
allocated to arrive at the total
(a)
All products pass through all departments. cost of a product.
(b)
All products are processed for the same length of time in each • O
verheads are absorbed in
department. Where these conditions do not exist, departmental proportion to some standard
rates should be used. basis among the
departments/units to recover
3.8.8.4 DEPARTMENTAL OVERHEAD RATE total overheads costs.
It refers to the computation of one single overhead rate for a particu- • A
ctual overheads could be
lar production unit or department. Where the product lines are varied or compared with the standard
machinery is used to a varying degree in the different departments, that overheads.
is, where conditions throughout the factory are not uniform, the use of • O
verheads could be direct or
indirect.

departmental rates is to be preferred. This overhead rate is determined

! IMPORTANT CONCEPT by the following formula:
• There are different types
Overhead of department or costt center
of methods for arriving Departmental overhead rate =
overhead absorption rate. Corresponding base
• Overheads are fixed and
flexible.
• Overheads can be under 7. The allotment of whole items of cost of centres or cost unit is
absorbed when absorption a. Cost allocation b. Cost apportionment
is lesser than the actual
c. Overhead absorption d. None of the above
overheads cost.
• When overhead cost 8. Overhead absorption signifies
absorbed more than the a. Charging or overheads to cost centers
required standard cost, it is
b. Charging or overheads to cost units
called over absorption of
overheads. c. Charging or overheads to cost centers or cost
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9. Which of the following methods of absorption of factory overheads
SELF-ASSESSMENT
QUESTIONS is suitable for a firm that produces single and uniform type of
IM product?
a. Percentage of direct wages basis b. Direct labor rate
c. Machine hour rate d. A rate per units of output
10. Charging to a cost center with overheads which relates to the
particular cost center is called as
a. Allocation b. Apportionment
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c. Absorption d. Allotment
11. In case the amount of overhead absorbed is lesser than the amount
of overhead actually incurred, it is known as
a. Under-absorption of overhead
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b. Over-absorption of overhead
c. Proper absorption of overhead
12. Under which you will classify the warehouse expenses?
a. Production overhead b. Selling overhead
c. Distribution overhead d. None of above
ACTIVITY 2 Watch the following data available from the production unit regarding
overheads and sales.
Overhead incurred: Rs. 1,50,000
Overhead recovered: Rs. 1,00,000
Cost of sales: Rs. 10,00,000
Finished goods: Rs. 8,00,000
Work in process: Rs. 7,00,000

Based on the above, calculate the following;

(a) Overheads under absorbed
(b) Under absorption rate
(c) Distribute under absorbed cost in cost of sale, finished goods, and WIP.
Hint: Under absorption rate = 0.20, under absorbed cost = Rs. 50,000.
ADDITIONAL SOLVED PROBLEMS
PROBLEM 3.1
Two workmen, A and B, produce the same product using the same material.
Their normal wage rate is also the same. A is paid bonus according to the Rowan
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system, while B is paid bonus according to the Halsey system. The time allowed
to make the product is 100 h. A takes 60 h while B takes 80 h to complete the
product. The factory overhead rate is Rs. 10 per man hour actually worked. The
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factory cost for the product for A is Rs. 7,280 and for B it is Rs. 7,600.
You are required:
1. To find the normal rate of wages.
2. To find the cost of materials.
3. To prepare a statement comparing the factory cost of the products as
made by the two workmen.
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Solution:
Remember: In this problem, we have to find out the normal rate of wages and
cost of materials by means of simultaneous equations.
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Cost of materials = M
Labor cost = L
Factory overheads (FOH): A = 60 × 10 = Rs. 600
B = 80 × 10 = Rs. 800
Factory cost of the product = M + L + FOH
A = Rs. 7,280

B = Rs. 7,600
Labor cost:
A: Time saved = 100 - 60 = 40 h
By Rowan system, we have
 TS   TS 
E = HW × RH +  × HW × RH or =  HW + × HW RH
 TA   RA 
 40 
=  60 + × 60 RH = 60 + 24 = 84 RH = Labor cost
 100 

B: Time saved = 100 - 80 = 20 h

By Halsey system, we have
E = HW × RH + (50% of TS × RH) = (HW + 50% of TS) RH
= (80 + 50% of 20) RH
= 80 + 10 = 90 RH = Labor cost
1. and 2.
M + 84 RH + 600 = 7,280
M + 90 RH + 800 = 7,600
By solving the above two equations, we get
RH = Rs. 20 per labor hour (normal rate of wages)
M = Rs. 5,000 cost of materials
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3. Factory cost of the products:
Labor cost:

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A: Rowan system
 TS   40 
E = HW × RH +  × HW × RH = 60 × 20 +  × 60 × 20
 TA   100 
= 1200 + 480 = Rs. 1,680
B: Halsey system
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E = HW × RH + [(50% of TS) × RH] = 80 × 20 + [(50% of 20 ) × 20]

= 1600 + 200 = Rs.1800
Products Manufactured By
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A B
(Rs.) (Rs.)
Materials 5,000 5,000
Labor cost 1,680 1,800
Factory overheads 600 800
Factory cost 7,280 7,600
PROBLEM 3.2
In an engineering factory, wages are paid on a weekly basis (48 h per
week) at a guaranteed hourly rate of Rs. 3.00. A study has revealed that
the time required to manufacture a product is 12 min. However, a con-
tingency allowance of 25% is to be added to this for normal idle time,
setting-up time, etc. During the first week of June 2014, Mr. X produced
224 pieces. Compute his wages for the particular week using the following
methods of wages payment:
1. Time rate.

2. Piece rate with a guaranteed time rate.

3. Rowan premium bonus scheme.
4. Halsey premium bonus scheme.
Solution:
1. Time rate:
Wages = HW × RH

= 48 × 3 = Rs. 144
2. Piece rate with a guaranteed time rate:

Time required to manufacture = 12 min
Add: Contingency allowance at 25% = 3
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Time allowed = 15 min
Hourly rate = Rs. 3.00
Therefore,
IM 150
Piece rate = 3 × = Rs. 0.75
60
Piece rate wages = NU × RU = 224 × 0.75 = Rs. 168

Guaranteed time wages = 48 × 3 = Rs. 144
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But he has to be paid Rs. 168 on the basis of piece rate.
3. Rowan system:
15
Time allowed for 224 pieces = 224 × = 56 h
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60
As,
Hours worked = 48
Time saved = 8
Therefore,
 TS   50 
E = HW × RH +  × HW × RH = 48 × 3 +  × 48 × 3
 TA   56 
= 144 + 20.57 = Rs. 164.57
4. Halsey system:
 50   50 
E = HW × RH +  × TS × RH = 48 × 3 +  × 8 × 3
 100   100 
= 144 + 12 = Rs. 156

PROBLEM 3.3
A worker takes 6 h to complete a job under a scheme of payment by results.
Standard time allowed for the job is 9 h. His wage rate is Rs. 1.50 per hour.
Material cost of the job is Rs. 16 and overheads are recovered at 150% of the
total direct wages. Calculate factory cost of the job under:
1. Rowan system of incentive payments.
2. Halsey system of incentive payments.
Solution:
TA = 9 h
TS = 3 h
HW = 6 h
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RH = 1.50
Rowan system:
 TS 3
IM E = HW × RH + 
 TA
 
× HW × RH = 6 × 1.50 +  × 6 × 50
 9 
= 9 + 3 = Rs. 12
Halsey system:
 50   50 
E = HW × RH +  × TS × RH = 6 × 1.50 +  × TS × RH
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 100   100 
= 9 + 2.25 = Rs. 11.25
Factory cost of job:
Under Rowan Under Halsey

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Method Method
(Rs.) (Rs.)
Materials 16.00 16.00
Direct wages (as calculated above) 12.00 11.25
Overheads at 150% of direct wages 18.00 16.87
Factory cost of job 46.00 44.12
PROBLEM 3.4
The Managing Director of All Found Limited is very much perturbed to
see that labor turnover is increasing every year. Before taking appropriate
action, he desires to know the profit foregone on account of labor turnover.
You are required to calculate the profit foregone on account of labor turnover
from the following:

All Found Ltd.
Income Statement for the Year Ended 31-12-2014

(Rs.) (Rs.)
Sales 2,00,000
Variable cost:
Material 50,000
Direct labor 40,000
Variable overhead 40,000
1,30,000
Contribution 70,000
Less: Fixed overhead 20,000
Profit before tax 50,000
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The direct labor hours (DLHs) worked in the concern during the period were
20,300 of which 500 h pertained to the new workers on training. Only 40% of
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the trainees’ time was productive. As replacement for the worker left was
delayed for sometime, 600 productive hours were lost.
The direct costs incurred by the Company as a consequence of labor separa-
tion and replacements were as follows:
1. Separation costs: Rs. 2,000.
2. Selection costs: Rs. 3,000.
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3. Training costs: Rs. 5,000.
Solution:
(Rs.)
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DLH worked 20,300

Less: Unproductive hours = 500 × 60% 300
Productive hours 20,000
Productive hours lost = 600 + 300 = 900
2, 00, 000
Sales value per production hour = = Rs. 10
20, 000
Loss of potential sale = 900 × 10 = 9,000

50, 000
Less : Material = × 9, 000 = 2, 250
2, 00, 000
40, 000
Direct labor = × 600 = 1,182
20,300
(For 300 h, wages already included in last year)

40, 000
Variable overhead = × 9, 000 = 1, 800 5,232
2, 00, 000
(Continued)

(Rs.)
Contribution foregone 3,768
Add: Separation, selection and training costs 10,000
Profit foregone on account of labor turnover 13,768
Alternatively, it can be worked out as follows:
Rs. 70, 000

Contribution per productive hour = = Rs. 3.50
20, 000 h
PROBLEM 3.5
The following particulars related to the production department of a factory
for the month of June 2014:
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(Rs.) (Rs.)
Material used 80,000
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Direct wages 72,000
Direct labor hours worked 20,000
Hours of machine operation 25,000
Overhead charges allocated to the department 90,000
Cost data of a particular work order carried out in the above department
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during June 2014 are given below:
(Rs.) (Rs.)
Material used 8,000
Direct wages 6,250
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Labor hours booked 3,300

Machine hours booked 2,400
What would be the factory cost of the work order under the following methods
of charging overheads?
1. Direct labor cost rate.
2. Machine hour rate.
3. Direct labor hour rate.
Solution:
Overheads incurred
Overhead charging rate =
Basis
90, 000
1. Direct labor cost rate = × 100 = 125%
72, 000
90, 000
2. Machine hour rate = = Rs. 3.60 per machine hour
25, 000

90, 000
3. Direct labor hour rate = = Rs. 4.50 per direct labour overhead
20, 000
Factory Cost of Work Order

Methods of Charging Overheads
Direct Machine Direct Labor
Labor Cost Hour Rate Hour Rate
Rate (Rs.) (Rs.) (Rs.)
Material used 8,000.00 8,000 8,000
Direct wages 6,250.00 6,250 6,250
Overheads 7,812.50 2,400 × 3.60 = 8,640 3,300 × 4.50 = 14,850
( = 125% of wages)
Factory cost of 22,062.50 22,890 29,100
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work order
PROBLEM 3.6
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The factory overhead costs of four production departments of a company
engaged in executing job orders for an accounting year are as follows:
(Rs.)
A 19,300
B 4,200
C 4,000
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D 2,000
Overhead has been applied as follows:

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Department A Rs. 1.50 per machine hour for 14,000 h

Department B Rs. 1.30 per DLH for 3,000 h
Department C 80% of direct labor cost of Rs. 6,000
Department D Rs. 2 per piece, for 950 pieces
Find out the amount of department-wise under- or over-absorbed factory

overheads. What are the methods that could be considered for disposal of
the resultant under- or over-absorbed factory overheads?
Solution:
Amount of Under- or Over-Absorbed Factory Overheads
Factory Factory Over-absorbed (+)

Overhead Overhead Under-absorbed
Absorbed Incurred (-)
Department (Rs.) (Rs.) (Rs.)
A: 14,000 × 1.50 = 21,000 19,300 (+) 1,700
B: 30,00 × 1.30 = 3,900 4,200 (-) 300

Factory Factory Over-absorbed (+)

Overhead Overhead Under-absorbed
Absorbed Incurred (-)
Department (Rs.) (Rs.) (Rs.)
C: 80% of 6,000 = 4,800 4,000 (+) 800
D: 950 × 2 = 1,900 2,000 (-) 100
Total 31,600 29,500 (+) 2,100
Methods for disposal of under- or over-absorption of factory overheads:

1. Apportionment through supplementary rates.
2. Transfer to costing profit and loss account.
3. Carry over to next year’s accounts.
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PROBLEM 3.7
You are given the following set of information from which you are requested
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to find out the profit or loss made on each brand showing clearly the follow-
ing elements:
1. Direct cost.
2. Works cost.
3. Total cost.
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Brands
A B C D
Actual production (units) 6,750 18,000 40,500 94,500
Direct wages (Rs.) 15,000 27,500 37,500 1,05,000
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Direct material cost (Rs.) 50,000 92,500 1,27,500 3,80,000

Selling price per unit (Rs.) 20 15 10 8
Factory overhead expenditure for the month was Rs. 1,62,000. Selling and
distribution cost should be assumed at 20% of work cost. Factory overhead
expenses should be allocated to each brand on the basis of units which
could have been produced in a month when single brand production was
in operation.
Solution:
Suppose D is taken as basis. Therefore,
1 unit of A = 6 units of D
1 unit of B = 3 units of D
1 unit of C = 2 units of D
1 unit of D = 1 unit of D

Brand of Toys Units Weightage

A 6,750 × 6 40,500
B 18,000 × 3 54,000
C 40,500 × 2 81,000
D 94,500 × 1 94,500
Rs. 1, 62, 000

Factory overhead per weight = = 0.60
2,70, 000
Factory overhead appointment:
A: 0.60 × 6 = 3.60 per unit × 6,750 = 24,300

B: 0.60 × 3 = 1.80 per unit × 18,000 = 32,400
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C: 0.60 × 2 = 1.00 per unit × 40,500 = 48,600
D: 0.60 × 1 = 0.60 per unit × 94,500 = 56,700
1,62,000
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3.9 SUMMARY
Labor cost is an important component in the cost of production. The issue
is equally important as it also involves the sentiments and psychology of
the people working over there. There are various issues including proper
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requirement and deployment of workers, recruitment process and pro-
viding appropriate job according to skills, knowledge and experiences.
This is the pre-employment process. Once, the worker joins the organi-
zation, the crucial issue and challenge are retaining the employee and
ensuring adequate involvement of individuals in the production process.
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Besides, boosting the morals of the workers through various incentives

and motivations is also the part of effective workforce management. This
calls for effective human resources policies and systems. The ultimate
object of a firm is to derive the maximum involvement and commitment
from the workforce on one hand while satisfying all genuine financial
needs of the workers. Therefore, various methods developed by the
experts for motivating and enthusing the employees keeping in view the
organization’s interest have been elaborately discussed in this chapter.
The numerical exercise and situation analysis provide a pragmatic view
to effectively manage the workforce and make them to contribute the
best of their strength willingly.
Another important element affecting the cost of a product to an extent is
indirect expenses involved in the production process at each level, be it
the production process, administrative stage or the selling and distribu-
tion activities. This is also called in management accounting as overheads.
The proper categorization of overheads is very important to allocate and
absorb them under the most relevant category as it directly affect the cost
of the product. A firm has to be very cautious in two aspects, one to iden-
tify all the relevant costs direct and indirect; and second, to allocate the
indirect costs appropriately for proper pricing of the product. Further,

the overhead absorption policy decided by the firm makes a significant

difference in arriving at the actual cost of a product. This also affects the
pricing of a product and ultimately the profitability of a firm. Therefore,
all the relevant aspects of overheads allocation, absorption and pricing
have been discussed in this chapter.
KEY WORDS 1. Indirect labor cost: Expenses incurred on the workers who are not
directly connected with the production process.
2. Labor turnover: The frequency of movement of the workers from
one organization to other.
3. Idle time: The time spent by the workers without work.
4. Clock card: A time recording mechanism of the workers.
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5. Piece rate system: A wage rate system where workers are paid on
the basis of output.
6. Incentive wages plans: A process which links incentives to the
production.
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7. Payroll department: A department in a firm involved in preparing
payrolls for workers.
8. Time rate system: A system of wage payment where wages to worker
are paid according to time spent in factory.
9. Group bonus plan: A plan whereby bonus for productivity is paid to
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all in a group.
10. Job evaluation: A process of measurement of performance of a
worker based on job.
11. Overhead: Indirect expenses incurred in production process.
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12. Factory overhead: The expenses in the production process.

13. Selling overheads: Expenses incurred on selling and distribution
process.
14. Absorption: The allocation of overheads.
15. Absorption rate: The rate at which overheads are absorbed as per
unit basis.
16. Direct labor hour rate: When actual overheads are divided by
actual labor hours.
17. Over absorption: When overheads absorbed in a product are more
than the actual overheads incurred.
18. Administration overheads: Expenses incurred in carrying out
administrative functions.


1. Differentiate between “direct” and “
indirect” labor costs through
examples.
2. Define the term “labor turnover.” Generally what could be the reasons
for higher labor turnover? Can labor turnover be prevented?
3. Explain different methods of labor turnover measurement.
4. Describe the types of costs associated with labor turnover with suitable
examples.
5. Explain the significance of recording timings of the workers. Also
describe the important methods of time recording in a firm.
6. What is job evaluation? Explain different methods of job evaluation.
7. What are the advantages and limitations of time rate and piece rate
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systems of wage payment? Under which situations, each system is
effective and more useful.
8. Explain and distinguish between Taylor’s differential piece rate plan
and Merrick’s plan.
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9. Explain with suitable examples the Halsey plan, Rowan plan and
Halsey-Weir plan of wage payment. How are they different?
10. What is time and motion study? Describe its process.
11. Explain the concept of overhead costs. Also differentiate between direct
expenses and overheads.
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12. Describe with examples different kinds of overheads.

13. Define overhead absorption rate. How will you calculate overhead
absorption rate?
14. On what basis, the overheads are apportioned in the different products
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and service.
15. Explain the concept of under or over absorption of overheads. How
does this impact the profits of a product?
16. How would you calculate the overhead absorption rate based on
machine hours or labor hours? Explain through suitable example.
3.11 ANSWER KEY

Methods of Work Study 1. d. Engineering department
2. a. time recording
Methods of Wage Payment 3. c. Taylor’s differential piece
rate system


4. a. At a time rate higher than
the usual rate
5. c. Payroll department
6. a. Actual hours being more
than normal time
Overhead Cost Control 7. a. Cost allocation
8. b. Charging or overheads to
cost units
9. d. A rate per units of output
10. a. Allocation
11. a. Under-absorption of
overhead
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12. c. Distribution overhead

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SUGGESTED BOOKS
Hussey R. and Ong A. (2012). Strategic Cost Analysis. Business Expert
Press.
Mitra J.K. (2017). Cost and Management Accounting I. Oxford University
Press.
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e-REFERENCES
The Institute of cost Accountants of India (www.icmai.in). Work Book:
Cost Accounting. Directorate of Studies, The Institute of Cost Accountants
of India.
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M.N. Arora (2016). Cost Accounting: Theory, Problems, and Solutions.

Himalaya Publishing house.

C H A
4 P T E R
COST CONCEPTS, COST CLASSIFICATION

AND UNIT COST ANALYSIS
CONTENTS
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4.1 Introduction
4.2 Cost Classification
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4.2.1 Classification of Cost According to its Components
4.2.2 Classification of Cost According to Nature
4.2.3 Classification of Cost According to Behavior
4.2.4 Classification of Cost According to Function
4.2.5 Classification of Cost Based on Conversion
4.2.6 Classification of Cost by Controllability
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4.2.7 Classification of Cost by Management Decisions

4.2.8 Classification of Cost Based on Expiry
Activity
4.3 Cost sheet
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4.3.1 Treatment and Adjustments of Certain

Cost Components
4.4 Valuation of Closing Stock
Activity
4.5 Calculation of Cost and Selling Price
Activity
4.6 Preparation of Statement of Cost and Abridged Profit
and Loss Account
4.7 Calculation of Work-in-Progress Figure Based on Cost Sheet
Activity

4.8 Summary
4.10 Answer Key
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Cost Concepts, Cost Classification and Unit Cost Analysis 99
SUPER HIT COMPANY
You are an owner of a firm. The firm is dealing in producing and mar-
keting of an electronic toy. The work is slightly technical and can be
handled by experienced persons. The person should have analytical and
problem-solving skills. You wish to have a management accountant for
your firm. Many candidates visit your office for this position. To under-
stand the basic skills amongst the candidates, the following information
is given and they are required to make analysis as desired by you.
The following data for the year ended March 2015 has been given to
candidates:
1. The conversion cost was Rs. 1,80,000 and it was three times the
prime cost.
2. Direct materials used were Rs. 2,07,500.
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3. The beginning work-in-progress was 50% of cost of ending WIP.
4. Assume that there are no beginnings or ending inventories under
direct materials.
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5. Cost of goods sold was 90% of the cost of goods manufactured.
6. Beginning finished goods inventory was Rs. 5,000.
QUESTIONS
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1. Prepare a statement of cost of goods manufactured for the year

2014–15.
2. Prepare a statement of cost of goods sold for the year 2014–15.
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NMIMS Global
Education

LEARNING OBJECTIVES

>> Different notions about cost concept.
>> Rationale behind cost classification for decision-making purposes.
>> Significance of statement of cost and cost sheet.
>> Utility of cost sheet in business decisions.
>> Cost flow and cost utility.
>> Fixing selling price based on cost calculations.
4.1 INTRODUCTION
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Before we understand various cost concepts, let us first understand the basic
differences in some of the common terminologies such as cost, expenses, rev-
enue, income and profit because some of these look similar but in practice
and management accounting systems, they are different.
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! IMPORTANT CONCEPT 1. Cost: In common language, cost is taken as expenditure incurred on
a particular product or service but in cost accounting terms, this is
Business decisions are mainly not so. According to the cost accounting system, cost is defined as the
taken on the basis of cost as resources sacrificed or given up to achieve a goal or defined purpose.
the optimization of cost can It can also be defined as the expenditure incurred or attributable to a
bring competitive advantages given object.
to the firm.
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2. Expense: An expense is an element of cost incurred and is measured
when an asset is sold or disposed of for generating revenue out of it.
As long as the product remains as an inventory, it is called value of
inventory or cost of inventory. The moment it is sold, the product cost
is recognized as an expense and is called “cost of goods sold (COGS).”
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3. Revenue: It is the total sales value a firm generates from sales of

products or service in a particular time period. It is also known as sales
revenue. The total revenue equals sales revenue plus receipts from sale
of other assets.
4. Income: Revenue minus expenditure is equal to income. Then,
depending on income we further classify income into different
categories.
5. Overhead: These are commonly shared costs such as maintenance,
depreciation, utilities and other common costs. The overheads are
allocated to different products based on certain criteria. This will be
explained further in the chapter.
Having understood the terminology, we now discuss the details of cost classi-
fication and costing systems. This is significant for the purpose of allocating
various costs to appropriate categories and also to undertake different kinds
of analyses for decision-making purposes. The commonly used and practiced
costing systems are as follows:
1. Historical costing: It indicates the trend and behavior of a particular
cost in the past, and on the basis and assumptions of that trend, different

kinds of results are obtained. This may not be a scientific method for
calculating future costs. The only use of this system is that it undertakes
past analysis based on the costs incurred in the past.
2. Marginal costing: It is a system where income from a product is
measured on the basis of allocation of variable costs. This system
assumes that fixed costs are period costs and charged to a particular
period in the profit and loss account. Therefore, while carrying
inventory to the next period, only variable costs are considered.
3. Absorption costing: In this system, both variable and fixed costs are QUICK TIP
absorbed in the products. This assumes the principle that all costs
should be charged to the product irrespective of the period. This has In technical terms, cost
been further elaborated in Chapter 5 of this book. is defined as the amount
sacrificed to achieve a goal
4. Uniform costing: It is a system which is used uniformly by many or amount incurred or
enterprises to follow similar approaches for cost measurement. It is attributable to a given project.
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convenient for inter-comparison among similar groups of firms. The Historical cost is incurred in
cost allocation methods are identical in nature. the past and is used for analysis
purpose to understand the
behavior of particular cost.
4.2 COST CLASSIFICATION
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There are different types of costs that are incurred on various activities carried
out in a firm. The costs are classified depending on their nature, functions
and behavior. Table 4.1 presents broad classification of various costs.
Now let us understand the significance of various cost classifications.
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TABLE 4.1 CLASSIFICATION OF COSTS

Basis of
Classification Types of Costs NOTE
Components Material, labor, overheads and other expenses 1. Costs are categorized in
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of cost different manners.

Nature of cost Direct and indirect 2. This helps in analyzing
managerial decisions to
Behavior of cost Fixed, variable and semi-variable, stepped plan for future.
fixed cost
3. Management looks costs in
Functions of cost Production or manufacturing, administrative, different perspective.
selling and distribution, research and development,
pre-production, conversion
Controllability Controllable and uncontrollable
Normality Normal and abnormal
Management Marginal, differential, imputed or notional, opportunity,
decision relevant, discretionary, sunk, replacement, abnormal,
shutdown, committed, capacity, urgent
Periodicity Historical and future
Expiry Expired and unexpired
Product/ Product/period
period cost

4.2.1 CLASSIFICATION OF COST ACCORDING

TO ITS COMPONENTS
1. Material cost: It is the cost of acquiring raw materials to be used for a
finished product or the materials consumed in the process. This helps to
produce a product for sale. It can be direct material that is consumed in
the manufacturing process and physically used for the finished product.
It can be traced out to the product. It can also be indirect material cost.
This is also required for the production process, but cannot be directly
attributed to the product. The expenses on cotton waste, lubricating
oil, etc., can be classified as indirect materials. If the cost of material is
insignificant, it can also be classified as indirect.
2. Labor cost: The amount paid to workers as wages and salaries are
classified as labor cost. It also involves all the benefits passed on by
the firm to the workers when wages are paid to the workers who are
directly involved in the production process, that is, converting raw
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materials into finished products is called direct labor cost. This involves
all kinds of workers, skilled and unskilled. There is another component
which may include salary/wages being paid to workers who do not
IMwork directly on the product, but their services are necessary for the
production process. This is termed as indirect labor cost. Wages and
salaries paid to supervisors, security guards, purchase and store staff,
etc., are indirect labor costs.
3. Expenses: The amount spent for completion of manufacturing process
other than materials and labor cost are categorized as expenses.
Direct expenses can be directly allocated to the specific process,
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product or service. The expenses that cannot be attributed directly

to a product are called indirect expenses, such as, factory rent, store
expenses, etc.
Some of the examples of direct expenses that are directly charged to the
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products may include:

1. Cost of patents, royalty, license fees, etc.
2. Cost of tools, cores, patterns, designs, etc.
3. Components and spare parts purchased for a special job.
4.2.2 CLASSIFICATION OF COST ACCORDING TO NATURE

QUICK TIP
The costs can be classified as direct and indirect costs. The costs that
Cost classification helps the are identifiable or attributable to a particular product/unit are direct
management to control the costs. The costs such as purchase of materials, wages to labor and direct
per unit cost of a product. expenses associated with a product or process are direct costs. Indirect costs
are not identifiable or attributable with the product/unit. These are allo-
cated, apportioned and absorbed in the production cost on the basis of
their use.
4.2.3 CLASSIFICATION OF COST ACCORDING TO BEHAVIOR

This classification is based on how changes occur in cost on account of
changes in output level. Some costs do not change up to a particular level of
production while others change.

1. Fixed costs: The costs that remain fixed up to a particular level of

production irrespective of changes in the production volume are
known as fixed costs. The peculiarity of fixed cost is that the total costs
remain same while per unit fixed cost comes down with the increased
level of production. Examples of fixed costs are depreciation, salaries,
insurance, rent, etc.
2. Variable costs: These costs change according to the volume of
production. If the production volume is higher, the variable cost will be
more and vice versa. This change occurs in proportion. The features
of variable costs are that per unit variable cost remains the same
whereas the total variable cost will change with production. Some of
the examples of variable costs are direct materials, direct labor and
direct expenses.
3. Semi-variable cost: When certain components of the total cost of a
unit/activity are fixed and remaining components depend on the
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use of that activity, it is called semi-variable cost. In other words,
semi-variable cost contains the features of both, fixed and variable
costs. In this case, the fixed part does not change while the variable
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component depends on the use. Telephone bill, electricity bill,
contractual salaries to supervisors, etc., can be examples of semi-
variable costs.
4. Stepped fixed cost: When costs are fixed up to a certain level of activity
and then increased by fixed amount with further rise in the level of
activities, it is called stepped fixed cost. For example, the fixed cost up
to 1,000 units of output of a product is Rs. 5,000 and thereafter for the
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next level up to 1,000 units, the cost will rise by Rs. 2,000.
4.2.4 CLASSIFICATION OF COST ACCORDING TO FUNCTION

The costs under this category are classified according to the functions on
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which they are incurred.

1. Production or manufacturing cost: All costs incurred in the production
process and producing a finished product are called production costs.
The elements of production cost mainly include direct materials, direct
labor, direct expenses and overheads in connection with the production
or manufacturing activities.
2. Administration cost: Costs that are incurred in managing general
administration activities and that cannot be directly related to production,
marketing and other activities are called administration cost.
3. Selling and distribution costs: The cost incurred on publicity,
advertising, salesman salaries and traveling expenses, etc., are
examples of selling costs. Costs incurred on delivering products and
other related activities are called distribution costs. Distribution
cost involves transport cost, packaging, etc. Sometimes in case of
electricity and gas, the distribution cost includes cost of distribution
of pipes, etc.
4. Finance cost: The costs associated with external borrowed funds such
as interest paid or accrued on borrowed funds.

5. Research and development cost: The costs incurred on research and

development activities for new innovation and techniques, which
result in increased efficiency of the products and processes, are called
research and development costs.
6. Pre-production cost: The preliminary cost incurred on trial, testing
and production before regular and normal production is called pre-
production cost. This is different from research and development cost
and basically incurred on testing a product before going into a final
product.
4.2.5 CLASSIFICATION OF COST BASED ON CONVERSION

STUDY HINT Conversion costs: The total of direct wages, direct expenses and overhead
costs for converting raw materials into finished products or converting mate-
Conversion costs do not
rials from one stage of production to the next stage are called conversion
include material costs.
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costs. These do not include material costs.
4.2.6 CLASSIFICATION OF COST BY CONTROLLABILITY

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Under this category, costs are classified as controllable and uncontrollable.
The costs that can be influenced by decisions of management and can be
controlled are known as controllable costs. It means the management can
reduce, minimize or avoid this cost base on its own decisions. Direct costs
generally fall under this category. The costs that cannot be influenced by the
decisions of the management are uncontrollable costs. Short-term commit-
ments such as salaries and maintenance are uncontrollable costs.
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4.2.7 CLASSIFICATION OF COST BY
MANAGEMENT DECISIONS
Costs are also classified for taking different types of managerial decisions in
the following manner.
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1. Marginal cost: The cost incurred in producing one additional unit is

called marginal cost. It is total variable cost as when we produce one
additional unit, variable cost alone is incurred as the fixed components
remain the same. A firm produces 100 units and the total cost to produce
the units is Rs. 1,000. Suppose one more (101th) unit is produced and
the cost increases to Rs. 1,005, the marginal cost will be Rs. 5 in this
case. Likewise, there is a concept of marginal revenue that provides
additional revenue by selling one more unit. Marginal revenue and
marginal cost both are significant for taking a decision to produce or
not to produce. The rule is as long as marginal revenue is equal or more
than the marginal cost, a firm goes on producing.
2. Opportunity cost: The amount sacrificed or foregone to achieve a
NOTE
better option is called opportunity cost. It is used when a firm needs to
Opportunity cost is the choice make a choice between more than one option and have to choose the
between different alternatives. best. If a firm has surplus funds for a short-term period, it has different
options to invest in. It chooses the best one by sacrificing or foregoing
the others (Box 4.1).

A CASE OF OPPORTUNITY COST BOX 4.1

ABC firm has an offer to produce a component. This component will require
1,000 hours of p rocessing on machine. At present, the machine is working
at its full capacity and produces Product X. The only way in which the offer
can be accepted is to reduce the output of Product X in which case there
will be a loss of revenue of Rs. 2,000. The offer also requires an additional
variable cost of Rs. 10,000.
If the firm accepts the offer, it has to sacrifice revenue of Rs. 2,000 from the
lost output of Product X. This is known as opportunity cost. It should be con-
sidered as part of the costs while negotiating for the new offer. Therefore, the
proposed offer should cover the additional costs of Rs. 10,000 plus Rs. 2,000
opportunity cost to ensure that the firm will not make any loss by accepting
the proposed offer.
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3. Differential cost: It is also known as incremental cost, which is
required to be incurred if a firm needs to choose other alternatives of QUICK TIP
production or any other changes in the level of production, etc. What All costs that involve cash
IM
will be the difference in the total cost if the firm wants to add or drop outflow are called out-of-
out a product? Such decisions are taken keeping in view the increased pocket costs.
costs. Even vital decisions to buy a product from market or to produce
on its own are also influenced by the differential cost concept.
4. Imputed or notional cost: When a firm utilizes its own resources such
as building and capital, the cost of these components is not accounted
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for. For example, rent on own building or interest on own capital in not
considered when we prepare profit and loss account. But these kinds
of costs are considered while taking managerial decisions because
in that scenario alternative investment decisions can be considered.
Therefore, the cost that does not appear in financial accounting but
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is considered only for managerial decisions is called imputed or

notional cost.
5. Discretionary cost: This cost is fixed in nature and incurred on the
basis of policy decisions of the management. It does not affect the
current level of production. The examples of discretionary costs are
providing training to employees, additional research and development
activities, advertisement costs, etc. Since all these costs to be incurred
or not to be incurred depend on the discretion of management, they are
called discretionary costs. These are also known as programmed costs
or managed costs or policy costs.
6. Out-of-pocket cost: All costs that involve cash outflow are called out-
of-pocket costs. There are certain costs like depreciation that does not
require any cash outflow and therefore is not termed out-of-pocket cost.
The significance of this cost is that it helps management in deciding the
level of cash to be arranged at different intervals.
7. Sunk cost: The cost committed in the past that may be by wrong ! IMPORTANT CONCEPT
managerial decisions does not yield any revenue in the present is
The sunk cost has no relevance
called sunk cost. Suppose a young engineer entrepreneur, who is
in taking managerial decisions.
enthusiastic and optimistic, wishes to establish a unit of production.

For this purpose, he avails a piece of land at a rent of Rs. 2 lakh per
annum. Later on, he realizes that half piece of the land is sufficient to
continue the required production for the next 3 years. But the land is
leased for 5 years. In this case, the rent being paid on the vacant piece
of land is called sunk cost. Sunk cost is not considered as the cost while
taking future decisions. In the example, suppose only half of the land is
lying vacant, for which an annual rent of Rs. 1 lakh is being paid, and
the engineer gets an offer from a third party for taking the vacant piece
of land for one year at a rent of Rs. 50,000, he should not consider that
he is paying Rs. 1 lakh, instead he is getting only Rs. 50,000 as rent from
the third party because it is a sunk cost. Therefore, whatever he gets is
additional revenue for him as otherwise also it is a committed cost that
is to be paid.
8. Relevant cost: All costs may not be relevant for taking future decisions
STUDY HINT as under different alternatives and scenarios certain existing costs
S
Abnormal cost is not may not be relevant. We can think of a firm deciding about acquiring
included in the production an automated plant that may not have any manual work. In this case,
cost but is adjusted in profit all existing costs relating to manual operations become irrelevant.
and loss account. Therefore, the management decides which of the costs are relevant and
IM they alone are considered for future decisions.
9. Replacement cost: The cost associated with replacing a present asset
is called replacement cost. Suppose a firm wishes to replace its existing
machinery and plant and if the cost is Rs. 20 lakh and the present
machine has a saleable value of Rs. 4 lakh, the replacement cost will be
Rs. 16 lakh.
M
10. Abnormal cost: When a cost occurs on account of reasons or
circumstances beyond control, not in normal or routine course, it is
called abnormal cost. There may be instances of additional production
cost due to fire in the plant, breakdown of machinery, power failure,
etc., that may cause an increase in the cost. The abnormal cost is
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not included in the production cost but is adjusted in profit and loss
account. It is because of the responsibility that the production manager
is responsible for normal loss only.
11. Shutdown cost: Sometimes a unit remains shut without any operations
for a temporary period on account of strikes by the workers, recession in
demand or any other reason. After some time, the unit starts functioning
NOTE
again. The costs, such as wages to security, depreciation and sheltering
When a unit is closed, it is called of plant, that are incurred during this period when the unit remains
shutdown cost. closed and the cost, such as oiling and overhauling of machines and parts,
incurred again when the unit starts functioning are called shutdown costs.
12. Capacity cost: A fixed cost in nature that is incurred in creating
certain facilities on long-term basis for smooth functioning of various
operations, such as plant, machinery, building warehouses and
distribution arrangements, is called capacity cost.
4.2.8 CLASSIFICATION OF COST BASED ON EXPIRY

All historical costs are classified either as expired costs or unexpired costs.
Unexpired costs are the costs incurred in acquiring resources and creating
facilities and capacities to generate revenues for a firm in future. These costs

are a part of assets in the balance sheet of a firm. The examples of unexpired
costs are costs of machinery and equipment. This cost becomes expired cost
when measured in terms of expenses to compare revenue. Therefore, as long
as an inventory of finished stock remains as closing inventory in the balance
sheet, it is unexpired cost but the moment it generates revenue for the firm, the
historical cost becomes expired cost. Remember while explaining the meaning
of cost in Chapter 1, we described cost as resources sacrificed to achieve a goal.
Therefore, cost incurred in creating facilities is unexpired cost.
1. Product and period costs: All costs that are accounted for in a particular
time period and not carried over to another time period with the product
are called period costs. These are recorded in the current year’s profit
and loss account. Product costs are attached to and carried over with the
particular product. For example, closing inventory, it remains product
cost till the finished goods inventory remains unsold and is shown in the
balance sheet. This concept will be explained better when we deal with
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absorption and marginal costing concept in Chapter 5 of this book.
2. Methods of costing: Different firms are engaged in a variety of product
operations. Therefore, there are different kinds of costing systems
IM
followed for different purposes. The main methods of costing include
unit costing, batch costing, job costing, contract costing, process costing,
service costing, joint costing and multiple costing. We will be covering
these methods in different units of this book in detail.
The ABC firm produced 10,000 units of a product X. The total fixed cost ACTIVITY 1
was Rs. 50,000 and variable cost per unit was Rs. 8. The fixed cost will
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remain same up to the production level of 20,000 units. The selling price
per unit was Rs. 17. During the year, the firm sold other assets worth
Rs. 2 lac. The firm received an order to produce 1000 additional units at a
selling price of Rs. 12 per unit. The firm accepted this additional order and
supplied the product. The firm sold 9500 units during the period.
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Answer the following questions;

1. What is the sales revenue of the firm?
2. What was the total revenue during the period?
3. How much the firm gained after selling additional 1000 units?
4. What will be the cost of remaining 500 units that could not be sold?
5. What was the cost involved in producing additional 1000 units?
4.3 COST SHEET

Cost sheet or the statement of cost is a comprehensive statement of cost that QUICK TIP
indicates the detailed cost and cost per unit of a product. Under different Prime cost is the direct cost
costing methods, this is known as unit costing method. The important com- of components and resources
ponents of cost sheet are as follows: used for a product.
1. Prime cost: It is the sum of total direct costs and includes cost of
material actually consumed for a product in a particular time period.
Direct labor cost including the amount payable (due but not paid) and
other direct expenses during the period. Therefore,

Direct material consumed + Direct labor cost + Direct expenses

= Prime cost
2. Factory cost or works cost: In the prime cost as discussed previously,
STUDY HINT if we add factory overheads, it will give you total factory cost. It means
that the cost of a product up to the process at factory. This is also known
Factory cost involves all
as factory cost gross. In this gross factory cost, if we add opening stock
overheads used during the
of work-in-progress (WIP) and subtract value of closing stock of WIP,
production process.
we will get the value of net factory cost. Thus,
rime cost + Factory overheads + Value of opening WIP - Value

P
of closing WIP = Factory cost (net)
3. Cost of production: So far we have arrived at factory cost as stated

previously but there are administrative expenses also attached to a
product and therefore these are also considered while arriving at the
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cost of production. Therefore, we add all administrative expenses in
the factory cost. Thus,
Cost of production = Factory cost + Administrative expenses

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This gives the total units produced during the period and the total cost
thereof. These units are also called “finished goods.” Remember every
firm has the opening stock of finished goods (which is the closing stock
of the last period) and also retains certain units as closing stock from
the total production. Therefore, to arrive at the net value of finished
goods that can be sold or are available for sale for the particular period,
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we add the units and value of opening finished stock and reduce the
number units and value of closing stock. Thus,
COGS or Cost of goods sold = Cost of production + Value of
opening finished stock – Value
of closing finished stock
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NOTE 4. Cost of sale: It can be noticed that COGS attaches the value of finished
stock available for sale and so far we have not considered the selling
Cost of sale includes selling and and distribution expenses that are required to be incurred in selling the
distribution expenses. available units for sale. To arrive at the cost of sale, all the connected
selling and distribution expenses are added to the value of COGS. Thus,
Cost of sale = COGS + Selling and distribution expenses
! IMPORTANT CONCEPT 5. Selling price: Once the final value of cost of goods is available per unit,
we add the profit margin to fix the selling price. Therefore,
Administrative cost is the
part of production cost. Selling price = Cost of sale per unit × Profit margin (percent) per unit.

Suppose the cost of sale per unit is Rs. 40 and as per firm policy, profit
margin is 15%, the selling price per unit will be Rs. 46. Sometimes, the
profit is calculated at the selling price. In that case, the percentage of
profit is increased on cost per unit.
Profit percent on sale

Profit = × 100
(100 - Profit percent on sale)


If a firm targets 25% profit on selling price, the profit percent on cost
will be
25
× 100 = 33.33%
75

Suppose the cost of sale per unit is Rs. 40 and the firm decides 15%
profit on the selling price, the profit percentage per unit will be
15
× 100 = 17.65%
85

The selling price per unit will be
40 + 17.65% = Rs. 47.06
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For a firm, following are the advantages of the cost sheet:
1. A firm can monitor the cost of product at each stage of production as
break-up figure of total cost as well as per unit cost is available in the
cost sheet statement.
IM
2. The cost sheet also provides information of the cost in a particular time
period. This helps a firm to compare the cost in different intervals of
time and check whether the cost escalation is justified.
3. Based on the trends of cost available over a period of time, future
projections can be made with certain accuracy.
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4. More importantly, it helps a firm to determine selling price in a more
reasonable manner as cost sheet considers all components of actual
costs.
NOTE
5. Cost sheet consists of all adjustments such as WIP, opening and closing
finished, scrap value from wastage, etc. The cost arrived at on the basis Cost sheet helps in determining
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of this is fairly accurate. selling price of a product.
4.3.1 TREATMENT AND ADJUSTMENTS OF

CERTAIN COST COMPONENTS
There are some specific cost related to transactions that need to be treated
separately in the cost sheet to arrive at a far more accurate cost of the
product. We will now examine such transactions and their adjustment in
cost sheet.
1. Value of scrap: Generally scrap or wastage occurs at two places, either
at the materials storage place or in the production process. The scrap
so occurs is sold and that is called scrap value. The scrap value reduces
the cost of production to an extent. Therefore, the value of scrap is
deducted from the direct material cost if the wastage had occurred at
material storage place and from the factory cost if the wastage occurred
in the production process. Thus, more accurate cost is obtained. If it is
not specified where the wastage occurred, the scrap value is deducted
from the factory cost as it is generally assumed that wastage happens
in the production process. Suppose the factory cost of a product is

Rs. 12.55 lakh and the scrap is sold for Rs. 2 lakh of a particular product,
in that case the treatment will be as follows:
Factory cost: Rs. 12.55 lakh
QUICK TIP
Less: Scrap value Rs. 2 lakh
When a sale is made on credit,
there happens to be bad debts. Net factory cost: Rs. 12.53 lakh
2. Loss of material: There may be instances of losses of raw material.

Such losses are categorized into two categories: normal loss that
occurs in natural process of materials handling and abnormal loss
that occurs due to fire, accidents, etc. Normal loss is automatically
charged to material cost as no separate treatment is needed, whereas
abnormal cost should be deducted from the value of raw material
purchased so that effective cost of raw material consumed could be
obtained.
S
3. Bad debts: When a sale is made on credit, there happens to be
bad debts. The amount of bad debt should be absorbed in selling
overheads. Sometimes, bad debts may occur on account of abnormal
reasons. In that case, the amount should be debited to profit and loss
IM account.
4. Trade discount: It is a part of sales revenue, and the discount offered
brings down the value of sales revenue to that extent that it should be
deducted from the sales revenue to obtain net sales value.
5. Packing charges: Treatment of packing charges depends on the
purpose of packing. If packing is essential, it should be added to
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material costs. If packing is for movement of stock from one place to
another during production process, it should be added to factory cost
and if it is for transportation purpose, it should be added to selling and
distribution expenses. If it is not specified, then it should be added to
selling expenses.
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6. Octroi, customs duty, etc.: All costs associated with the purchase of
materials including taxes, octroi, customs duty, etc., and carrying costs
are included in direct material costs.
7. Factory stores: A factory store is a storage room where necessary
production process equipment, lubricants and other components
required in a routine manner are stored. These components are stored
on an ongoing basis to continue the production process. Therefore, the
treatment of factory store overheads is done in the following manner:
Opening stock of factory stores

Add: New purchases during the period
Less: Closing value of factory stores components
= Net factory stores to be added to factory overheads
8. Donations: The treatment of donations is done depending on the

purpose of donations. If it helps in boosting the sales of the product, it
will be added to selling and distribution expenses otherwise it should
be accounted in profit and loss account.

9. Interest on capital: Not to be included in the cost sheet. It should be

accounted for in the profit and loss account.
The cost sheet is prepared in a particular format, separately showing differ-
ent components of costs under relative heads. The generally followed format
of cost sheet is prescribed in Figure 4.1.
Specimen of Cost Sheet

Cost Sheet of M/s............
Period No. of units:
Particulars Amount (Rs.) Amount (Rs.)

Direct materials
Opening stock
+ Purchases
+ Carriage inwards
− Purchase returns
− Closing stock
S
Direct wages
Direct expenses
I Prime cost
Add: Factory overheads – Indirect materials
Factory stores
Opening stock + Purchases – Closing stock
Indirect wages
IM
Rent and rates (Factory)
Lighting and heating (Factory)
Power and fuel
Repairs and maintenance
Drawing office expenses
Research and development
Depreciation – Plant (factory)
Insurance (Factory)
Work manager’s salary – Any other factory overheads
M
Add: Opening stock WIP

Less: Closing stock finished goods
II. Factory cost/Works cost
Add: Office and Administrative overheads
Rent and rates – Office
Office salaries
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Insurance of office building and equipment

Telephone and postage
Printing and stationery
Depreciation of furniture and office equipment
Legal expenses
Audit fees
Conveyance
Electricity
= Cost of production
Add: Opening finished goods
Less: Closing finished stock
III. Cost of goods sold (COGS)
Add: Selling and distribution overheads
Rent and rates – Showroom
Salesmen’s salaries and commission
Travelling expenses
Printing and stationery – Sales department
Advertising
Bad debts
Debt collection expenses
Carriage outwards
Depreciation of delivery van
Samples and free gifts
IV. Cost of sales
Profit/Loss
Sales revenue
Figure 4.1 Specimen of cost sheet.

SELF-ASSESSMENT
1. Which of the following items is not included in preparation of cost
QUESTIONS
sheet?
a. Carriage inward b. Purchase returns
c. Sales commission d. Interest paid
2. Which of the following items is not excluded while preparing a cost
sheet?
a. Goodwill written off
b. Provision for taxation
c. Property tax on Factory building
d. Transfer to reserves Interest paid
3. Which of the following are direct expenses?
A. The cost of special designs, drawings or layouts
B. The hire of tools or equipment for a particular job
S
C. Salesman’s wages
D. Rent, rates and insurance of a factory
a. (A) and (B)

IMb. (A) and (C)
c. (A) and (D)
d. (C) and (D)
4. What is prime cost?
a. Total direct costs only
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b. Total indirect costs only
c. Total non-production costs
d. Total production costs
5. Which of the following is not an element of works overhead?
N
a. Sales manager’s salary

b. Plant manager’s salary
c. Factory repairman’s wages
d. Product inspector’s salary
6. In Reconciliations Statements Expenses shown only in financial
accounts are
a. Added to financial profit
b. Deducted from financial profit
c. Ignored
d. Added to costing profit
4.4 VALUATION OF CLOSING STOCK

NOTE
The valuation of closing stock of finished goods can be done by the following
Under FIFO method of valuation, three different methods:
it is presumed that units of
finished stock received first 1. Valuation under first-in first-out (FIFO) method: Under FIFO method
(closing stock of last period) are of valuation, it is presumed that units of finished stock received first
sold first. (closing stock of last period) are sold first. Therefore, the total cost

of production is divided by the number of units produced during

the period and then it is multiplied by the units of closing inventory
during the current period since the units received as opening stock
are already out.
2. Valuation under last-in first-out (LIFO) method: Under this method,
it is assumed that units produced last are sold out first. Therefore, STUDY HINT
the closing stock units of current period consist of both, the units In average cost method, the
received as opening stock from the last process and remaining for closing inventory is valued at
this period. Suppose the closing units of finished stock in a particular an average rate.
time period are 1,000 and opening units of finished stock are 400. In
this case, while measuring the value of closing stock, the 400 units
will be valued at the opening stock valued carried over from the last
process and remaining 600 units will be valued at the current period
cost.
3. Average cost method: In this case, the closing inventory is valued at
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an average rate, that is, per unit cost of opening inventory plus per unit
cost of current closing inventory divided by two.
4. Weighted average method: Under this method, weighted cost of
IM
opening and closing inventory is considered. The value of closing
inventory can be arrived at in the following manner:
Value of closing inventory = Value of opening finished goods + Total cost

of production in the current period/Number of units under opening
finished stock + Number of units in current production × Number of
closing units of finished stock
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The calculation of the value of closing inventory under the previous
four methods has been explained in the following example to bring more
clarity.
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EXAMPLE 4.1
This is the hypothetical example for understanding valuation of closing fin-
ished stock under different methods. From the following data, find out of the
value of closing stock of finished goods using:
1. FIFO method.
2. LIFO method.
3. Simple average cost method.
4. Weighted average cost method.
Opening finished goods as on 9.1.2014 4,000

Value of opening finished stock on 9.1.2014 1,20,000
No. of units produced 89,000
Closing stock on 9.30.2014 5,000 units
Cost of production 25,71,000

Solution:
Valuation of Closing Stock
1. Valuation under FIFO method

Cost of current production No. of units of closing
= ×
Total no. of units produced finished good
in current period
25, 71, 000

= × 5, 000 = Rs. 1, 44, 438
89, 000 1,44,438
2. Valuation under LIFO method

Value of closing stock
S
a. Closing stock of finished goods
Value of old 4,000 units = Rs. 1,20,000
(carried as opening stock)
IM Add:
25,71,000
× 1, 000 = 28, 887 1,48,887
89, 000
1,000 units (= 5,000 - 4,000)
3. Valuation under average cost method
M
Per unit average cost
Rs. 1,20,000
Opening stock rate = = Rs. 30
4, 000 units
Cost of production
New units produce rate =
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Unit production
25,71,000
=
89,000
= Rs. 28.89
30.00 + 28.89
Average rate = = Rs. 29.44 (approx.) 1,47,200
2
This is to be multiplied by closing stock unit of finished
goods = 29.44 × 5,000 = Rs. 1,47,200 (approx.)
4. Valuation under weighted average method

Rs. 1,20,000 (opening stock) + Rs. 25,71,000
=
4, 000 units + 89, 000 units
= Rate Rs. 28.94 × 5, 000 = Rs. 1,44,677 (approx.)
The difference in valuation of finished stock is visible on account of different

valuation methods as explained previously.

Classify the following items into Prime cost, Factory cost, Administrative ACTIVITY 2
overheads and Selling & Distribution overheads as the case may be:
(a) Material shipped from the supplier
(b) Rent of showroom
(c) Salary paid to supervisor
(d) Closing WIP
(e) Research & development expenses
(f) Purchase returns
(g) Advertising expenses
(h) Closing stock – Raw material
(i) Bad debts
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(j) Depreciation on machine IM
4.5 CALCULATION OF COST AND
SELLING PRICE
The selling price of a product in a firm is calculated based on the total costs
QUICK TIP
incurred in the production and arrived at the per unit cost. In the per unit
cost of a product, the profit margin is added. The profit is added to cost of
sale to arrive at the sales figure.
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EXAMPLE 4.2
How to calculate selling price based on available cost details?
The cost of four different products for the month of January 2014 is available
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as follows:
1. Maintenance and repairs: Rs. 10,000

2. Machine operator’s wages: Rs. 2,000
3. Power: Rs. 50,000
4. Depreciation: Rs. 40,000
5. Supervision: Rs. 6,000
Other details are as follows:
Units Material Cost Production

Products (per hour) (per unit) (in units)
1 30 40 1,800
2 10 60 500
3 6 100 300
4 4 300 260
The policy of the firm for determining selling price is cost plus 20%.

Solution:
Computation of total cost:
Rs.
Power 50,000
Maintenance 10,000
Wages 2,000
Supervision 6,000
Depreciation 40,000
Total 1,08,000
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1. Total machine hours for production
Production Production Total Machine

Product (in units) Units (per hour) Hours
IM 1 1,800 30 60
2 500 10 50
3 300 6 50
4 260 4 65
M
Total 225
2. Machine cost (absorption rate) = Total machine cost/Total machine hours

= Rs. 1,08,000/225
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= Rs. 480 (per machine hour)
Statement of Product Cost and Selling Price
Output Machine Total Selling

(in units) Expenses Cost Price
Machine Total Per Material Per (Cost + 20%
(Per Hours Rs. @ Unit Cost Unit of Cost)
Product Hour) Total Utilized 480 (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
1 30 1,800 60 28,800 16 40 56 67.20
2 10 500 50 24,000 48 60 108 129.60
3 6 300 50 24,000 80 100 180 216.00
4 4 260 65 31,200 120 300 420 504.00

SELF-ASSESSMENT
7. In Reconciliations Statements Expenses shown only in cost
QUESTIONS
accounts are
c. Ignored
d. Deducted from costing profit
8. In Reconciliations Statements, transfers to reserves are
c. Ignored
d. Added to costing profit
9. In Reconciliations Statements, Incomes shown only in financial
accounts are
S
a.
Added to financial profit
b.
Deducted from financial profit
c.
Ignored
d.
Deducted from costing profit
IM
The following is the information available from the cost records of a firm: ACTIVITY 3
Opening raw materials Rs. 10,000

M
Materials purchased Rs. 10,000

Closing inventory Rs. 8,000
Direct labor cost Rs. 12,000
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Repairs & Utilities Rs. 11,400

Depreciation Rs. 4,000
Opening stock Rs. 10,000
Closing stock Rs. 15,000
Questions
1. Total Raw Materials consumed?
2. What is the Prime Cost?
3. How much will be the Factory Overheads?
4. How much is the Manufacturing Cost?
5. What will be the Cost of goods manufactured?

4.6 PREPARATION OF STATEMENT OF

COST AND ABRIDGED PROFIT AND
LOSS ACCOUNT
NOTE We can also prepare summarized profit and loss account based on the details
available in the statement of cost. This has been explained through the
Fixed cost changes with the level
following example.
of production.
EXAMPLE 4.3
The following details are available from the records of Harish & Company as
on December 31, 2013.
(Rs.) (Rs.)
Sales 76,800
S
Inventories:
Finished stock 8,000
Raw material 14,000
IMWork-in-progress 20,000
Office appliances 1,740
Plant and machinery 46,050
Buildings 20,000
Sales return and rebates 1,400
Materials purchased 32,000
M
Freight pad (materials) 1,600

Purchase returns 480
Direct labor 16,000
Indirect labor 1,800
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Factory supervision 1,000

Repairs and maintenance – factory 1,400
Heat, light and power 6,500
Rates and taxes 630
Miscellaneous factory expenses 1,870
Commission (sales) 3,360
Traveling expenses (sales) 1,100
Sales promotion expenses 2,250
Salaries and expenses (distribution) 1,800
Office salaries and expenses 860
Interest on borrowed funds 200
Additional information is:
a) Closing inventories:
Finished goods 11,500
Raw materials 18,000
Work-in-progress 19,200

(Rs.) (Rs.)
b) Accrued expenses on:
Direct labor 800
Indirect labor 120
Interest on borrowed funds 200
c) Depreciation to be provided on
Buildings 4%
Plant and machinery 10%
Office appliances 5%
d) Distribution of the following costs:
Heat, light and power to factory, office and
distribution in the ratio 8:1:1
Rates and taxes–two thirds to
S
factory and one third to office
Depreciation on buildings to
factory, office and selling in the ratio 8:1:1
IM
You are required to prepare a summarized profit and loss account statement
of Harish & Company as on December 31, 2013. Also prepare (a) cost of sales,
(b) selling and distribution expenses and (c) administration expenses.
Solution:
Summarized Profit and Loss Account of Harish & Company as on
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December 31, 2013
(Rs.) (Rs.)
Gross sales 76,800
Less: Sales return 1,400 75,400
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Less: Cost of sales (as per Statement 1) 71,402

Net operating profit 3,998
Less: Interest on borrowed funds 400
Net profit 3,598
Statement 1: Cost of sales
(Rs.) (Rs.)
Raw material consumed
Opening stock 14,000
Add: Purchases 32,000
Add: Freight on material 1,600
Less: Purchases returns 480
Less: Closing stock 18,000 29,120
Direct labor 16,800
Prime cost 45,920

(Rs.) (Rs.)
Factory overheads
Indirect labor 1,920
Factory supervision 1,000
Repairs and maintenance 1,400
Heat, light and power 5,200
Rates and taxes 420
Miscellaneous factory expenses 1,870
Depreciation of plant 4,605
Depreciation of building 640 17,055
Gross factory cost 63,775
Add: Opening work-in-progress 20,000
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Less: Closing work-in-progress 19,200 800
Factory cost 63,775
Add: Administration expenses as per Schedule 3 1,887
IMCost of production 65,662
Add: Opening stock of finished goods 8,000
Less: Closing stock of finished goods 11,500 350
Cost of production of goods sold 62,162
Add: Selling and distribution 9,240
Overheads as per Schedule 2
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Cost of sales 71,402
Statement 2: Selling and distribution expenses
(Rs.)
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Commission sales 3,360

Traveling expenses sales 1,100
Sales promotion expenses 2,250
Salaries and expenses (distribution) 1,800
Heat, light and power 650
Depreciation of building 80
9,240
Statement 3: Administrative expenses
(Rs.)
Office salaries and expenses 860
Depreciation of office appliances 87
Depreciation of building 80
Heat, light and power 650
Rates and taxes 210
1,887

4.7 CALCULATION OF WORK-IN-PROGRESS

FIGURE BASED ON COST SHEET
We can also calculate work-in-progress figure based on certain data/figure in
the cost sheet. This is explained through the following example.
EXAMPLE 4.4
On June 30, 2014, Raman & Company records revealed the following
information.
(Rs.)
Raw materials 6,20,000
Work-in-progress 0
S
Finished goods 11,90,000
Inventory as on January 1, 2014, consisted of the following:
Raw materials 3,00,000
Work-in-progress
IM 10,00,000
Finished goods 14,00,000
27,00,000
The gross profit margin is assumed 25% of sales. The sales for the first half
of year 2014 were Rs. 34,00,000, raw materials purchased were Rs. 11,50,000,
direct labor costs for this period were Rs. 8,00,000 and manufacturing over-
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heads were estimated 50% of direct labor costs. Calculate the work in-
progress figure.
Solution:
Raman & Company
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Statement of Cost and Profit for the Half Year Ended June 2014
(Rs.) (Rs.)
Raw materials consumed
Opening stock 3,00,000
Add: Purchases 11,50,000
Less: Closing stock 6,20,000 8,30,000
Direct labor 8,00,000
Prime cost 16,30,000
Works overheads (50% of direct labor) 4,00,000
20,30,000
Add: Opening work-in-progress 10,00,000
30,30,000
Less: Closing work-in-progress* 6,90,000
Factory cost/Cost of production** 23,40,000
Add: Opening stock of finished goods 14,00,000
Less: Closing stock of finished goods (11,90,000)

(Rs.) (Rs.)
Total cost 25,50,000
Profit (25% of sales) 8,50,000
Sales 34,00,000
Less: Profit (25% of sales) 8,50,000
Total cost 25,50,000
Add: Closing stock of finished goods 11,90,000
Less: Opening stock of finished goods (14,00,000)
Factory cost 23,40,000
Less: Cost before closing work-in-progress 30,30,000
Closing work-in-progress 6,90,000
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*Closing work-in-progress calculation. **As the figure of administrative overheads is
not available, it is presumed that there is no such cost.
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SELF-ASSESSMENT
10. Integral accounts eliminate the necessity of operating
QUESTIONS
a. Cost ledger control account
b. Store ledger control account
c. Overhead adjustment account
M
11. What entry will be passed under integrated system for purchase of
stores on credit?
a. Dr. Stores Cr. Creditors
b. Dr. Stores ledger control A/c Cr. Creditors
c. Dr. Stores ledger control A/c Cr. General ledger adjustment A/c
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12. What entry will be passed under integrated system for payment to
creditors for supplies made?
a. Dr. Creditors Cr. Cash
b. Dr. Creditors Cr. Stores ledger control A/c
c. No entry
13. The accounting entry in integrated accounts for recording sales will
be:
a. Dr. Cost ledger control account Cr. Profit and loss account
b. Dr. Sales account Cr. Profit and loss A/c
c. Dr. Cash A/c Cr. Sales A/c
14. What will be the accounting entry for absorption of factory overhead?
a. Dr. Works in progress control A/c Cr. Factory overhead control A/c
b. Dr. Factory overhead Cr. Factory overhead control A/c
c. No entry is required

Units produced and sold last year were 8560 and materials used was ACTIVITY 3
Rs. 2,95,000. During the current year raw materials price is supposed to
increase by 8% . The firm wants to produce 12,500 units during the current
year. Similarly, the labor cost which was Rs. 8 per unit during previous
year has since increases by 10%. Other Direct expenses will also increase
by 5% during the current year. The prime cost last year was Rs. 4,03,480.
Questions
1. What will be the cost of direct materials consumed during the current
year?
2. What will be the labor cost for the production?
3. What were the other direct expenses during the last year?
4. What will be the total direct expenses during the current year?
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5. What will be the total prime cost during the year?

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PROBLEM 4.1
The following details have been extracted from ABC Co.’s books of accounts
for the year ending March 31, 2014.
Stock of materials: Opening 1,88,000
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Closing 2,00,000
Materials purchased during the year 8,32,000
Direct wages paid 2,38,400
Indirect wages 16,000
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Salaries to administrative staff 40,000

Freights: Inward 32,000
Outward 20,000
Cash discount allowed 14,000
Bad debts written off 18,800
Repairs to plant and machinery 42,400
Rent, rates and taxes: Factory 12,000
Office 6,400
Travelling expenses 12,400
Salesmen’s salaries and commission 33,600
Depreciation written off: Plant and machinery 28,400
Furniture 2,400
Director’s fees 24,000
Electricity charges (factory) 48,000
Fuel (for boiler) 64,000
General charges 24,800
Manager’s salary 48,000

The time spent by manager is shared between the factory and the office in
the ratio of 20:80.
You are required to compute: (a) prime cost, (b) factory overhead, (c) factory
cost, (d) over head and (e) cost of sale.
Solution:
Cost Sheet of ABC Co. for the Year Ending 31st March, 2014
(Rs.)
Opening stock of materials 1,88,000
Add: Purchases 8,32,000
10,20,000
Add: Freight inward 32,000
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10,52,000
Less: Closing stock 2,00,000
Raw material consumed 8,52,000
IM
Direct wages 2,38,400
(i) Prime cost 10,90,400
(ii) Add: Factory overheads
Indirect wages 16,000
Repairs to plant and machinery 42,400
Rent, rates and taxes – Factory 12,000
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Depreciation – Plant and machinery 28,400

Electricity charges 48,000
Fuel 64,000
Manager’s salary (20%) 9,600 2,20,400
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(iii) Factory cost 13,10,800

(iv) Add: Overheads:
Salaries to administration staff 40,000
Freight outward 20,000
Rent, rates and taxes – Office 6,400
Travelling 12,400
Salesmen’s salaries and commission 33,600
Depreciation – Furniture 2,400
Director’s fees 24,000
General charges 24,800
Manager’s salary (80%) 38,400 2,02,000
(v) Cost of sale 15,12,800
Remember: The amount of cash discounts and bad debts will be subtracted
from sales revenue.

PROBLEM 4.2
The following data is available for the month of December, 2014. Direct labor
cost is Rs. 17,500, being 175% of works overheads. Cost of goods sold exclud-
ing administrative expenses is Rs. 56,000. Inventory accounts had the follow-
ing opening and closing balances:
(Rs.)
Particulars December 1 December 31
Raw materials 8,000 10,600
Works-in-progress 10,500 14,500
Finished goods 17,600 19,000
Other data are as follows:
S
(Rs.)
Selling expenses 3,500
General and administrative expenses 2,500
Sales for the month
IM 75,000
Compute:
1. The value of materials purchased during the month.
2. Prepare a cost statement showing the profit.
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Solution:
1. Assessment of the value of materials purchased:
(Rs.)
Cost of goods sold 56,000
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Add: Closing stock of finished goods 19,000

75,000
Less: Opening stock of finished goods 17,600
Cost of goods manufactured 57,400
Add: Closing stock of work-in-progress 14,500
71,900
Less: Opening stock of work-in-progress 10,500
Works cost 61,400
Less: Factory overheads (100/175 of direct labor cost) 10,000
Prime cost 51,400
Less: Direct labor 17,500
Raw material consumed 33,900
Add: Closing stock of raw materials 10,600
Raw materials available 44,500
Less: Opening stock of raw materials 8,000
Value of materials purchased 36,500

2. Statement of cost and profit:
(Rs.)
Raw material consumed [refer to statement (a) as above] 33,900
Direct labor cost 17,500
Prime cost 51,400
Add: Factory overheads 10,000
Works cost 61,400
Add: Opening work-in-progress 10,500
71,900
Less: Closing work-in-progress 14,500
Cost of goods manufactured 57,400
Add: Opening stock of finished goods 17,600
75,000
S
Less: Closing stock of finished goods 19,000
Cost of goods sold 56,000
Add: General and administration expenses 2,500
IM Add: Selling expenses 3,500
Cost of sales 62,000
Profit (balancing figure) 13,000
Sales 75,000
Remember: We have followed the reverse process for calculating the value of
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materials purchased.
4.8 SUMMARY
In a firm, business decisions are mainly taken on the basis of cost as
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the optimization of cost can bring competitive advantages to the firm.

Therefore, understanding cost concepts and their significance is of par-
amount importance. The cost classification is also important for taking
a variety of decisions as all costs are not relevant in all situations. Once
we understand the concept, cost control and monitoring and thereby
optimizing cost become more significant. In addition, from the financial
statements point of view, understanding the cost concepts and their util-
ity is important so that business analysis can be carried out. The concepts
of notional cost, opportunity cost, marginal cost and sunk cost certainly
help in taking vital business decisions in future. Product cost and period
cost concepts also help in deriving actual status of income statement
from managerial point of view.
The statement of cost or cost sheet is also an important statement. This helps
a firm to monitor the cost of product at each stage of production as break-up
figure of total cost as well per unit cost of a product or service. Cost sheet also
provides information of the cost in a particular time period. This helps a firm
to compare the cost in different intervals of time and can check whether the
cost escalation is justified. Cost sheet also helps in determining ideal selling
price of a product. In this unit, we have explained through cases different
kinds of business situations where costing decisions are very helpful.

1. Cost sheet: A statement of details of costs at different operating KEY WORDS

levels.
2. Prime cost: The aggregation of direct materials, direct labor and
other direct expenses.
3. Conversion cost: The cost incurred in converting raw material into
finished product.
4. Factory cost: Total cost incurred to produce a product till the factory
point.
5. Administrative expenses: The administrative expenses incurred in
supervision and managing other administrative tasks relating to a
product.
6. Selling and distribution expenses: The costs incurred in selling and
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marketing of a product.
7. Cost per unit: Total costs for the period divided by total number of
units.
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8. Work-in-progress: The inventory under use while the product is not
complete but under process of completion.
9. Cost of goods sold: All costs associated with a product except selling
costs.
10. Scrap: The wastage of a product which is sold as scrap. It generates
revenue for the product.
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1. Differentiate between cost and expenses with suitable examples.
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2. All costs are not relevant while taking managerial decisions. Explain.
3. Describe the concept of notional cost, sunk cost and opportunity cost.
How these concepts are relevant in taking future decisions?
4. The concept of marginal costing is very relevant in deciding the level of
production of a firm. Explain.
5. Describe FIFO and LIFO systems of valuation of finished closing
inventory. How do you explain the difference?
6. Differentiate between prime cost and cost of goods sold.
7. Why cost sheet is important for a business firm?
4.10 ANSWER KEY

Cost Sheet 1. d. Interest paid
2. c. Property tax on Factory building
3. a. (A) and (B)


4. a. Total direct costs only
5. a. Sales manager’s salary
6. b. Deducted from financial profit
Calculation of Cost and 7. a. Added to financial profit
Selling Price
8. b. Deducted from financial profit
9. a. Added to financial profit
Calculation of Work-in- 10 a. Cost Ledger control account
Progress Figure Based
on Cost Sheet
11. b. Dr. Stores ledger control A/c
Cr. Creditors
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12. a. Dr. Creditors Cr. Cash
13. c. Dr. Cash A/c Cr. Sales A/c
14. a. Dr. Works in progress control A/c
IM Cr. Factory overhead control A/c
SUGGESTED BOOKS
Mehta, B.K. (2019). Cost And Management Accounting. SBPD
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Publications.
Arora, M.N. (2016). Cost Accounting: Theory, Problems and Solutions.
Himalaya Publishing House.
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E-REFERENCES
Pillai, R.S.N. and Bagavathi (2010). Cost Accounting, Seventh edition.
S. Chand Publishing.
Rajasekaran, V. and Lalitha, R. (2010). Cost Accounting. Pearson India.

C H A
5 P T E R
COST ANALYSIS: JOB ORDER, BATCH

AND CONTRACT COSTING
CONTENTS
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5.1 Introduction
5.2 Job Order Costing
5.2.1
5.2.2
IMProcess of Job Order Costing
Advantages of Job Costing
5.2.3 Limitations of Job Costing
5.2.4 Assessment of Job Costing
Activity
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5.3 Batch Costing
5.3.1 Economic Batch Quantity
5.3.2 Assessment of Economic Batch Quantity
Activity
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5.4 Contract Costing

5.4.1 Features of Contract Costing
5.4.2 Process of Contract Costing
5.4.3 Cost Plus Contract
5.4.4 Work Certified
Activity
Additional Solved Problem
5.5 Summary
5.7 Answer Key

WEDDING CAKE
The following advice is offered on the website of a company that is

designing and making wedding cakes to order.
Costs involved in making a wedding cake
Wedding cakes come in all shapes, sizes and price ranges. Cost is calcu-
lated per slice depending on ingredients and labor involved in creating
your design. Average prices fall between $1.50 and $5.00 a slice, but an
elaborate creation can run three to four times higher! That means a five-
tier cake that feeds 200 guests will cost at least $300 and could run up to
$4,000 for a “couture” creation like those modeled in the bridal maga-
zines. You are primarily paying for the designer’s time, but the ingredi-
ents you choose can also influence the price. Check out ways to save for
ideas on taming this budget buster. Be prepared to leave a substantial
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(and usually non-refundable!) deposit to reserve your date. Many baker-
ies are booked up to two years in advance. Fortunately, you won’t have
to make your design selections this early. You are simply reserving the
date. Final payment is usually expected two weeks or more prior to the
IM
wedding. Ask your designer about delivery and set-up fees. Those costs
are often – but not always – covered by the per-slice cost. Make sure you
get a written breakdown of all services and fees!
Ways to save
Decide on a particular style and size of cake before asking for quotes.
You can always decide on a different design later, but you want to be
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sure that you are comparing the same costs.

Ask about slice size. You cannot compare per-slice costs unless the
pieces are the same size. You may get more for your money with a
2-inch rather than a 1-inch slice of cake.
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Be realistic. The magnificent cakes you see in the magazines are

sually in the $10- to $15-per-slice range. Ask about modifying
u
designs or substituting ingredients. For example, butter cream icing
is very tasty and quite a bit more affordable than the fondant style.
Substitute fresh arrangements for expensive sugar flowers. Ask your
baker to coordinate designs and duties with your florist.
Be aware of hidden costs when making price comparisons. You may
have to pay a fee to your reception site if you hire an outside designer.
Or, you may get a great deal on the cake only to find out later that
you’ll be paying almost as much again to cover the serving fee.
Order a smaller display cake and then serve your guest slices of
sheet cake or a “side cake.” You can do the traditional slicing of the
cake in front of your guests and then have the side cakes served from
a back room.
If you want to impress, consider ordering a smaller cake that will sit
on top of fake tiers.

Cost Analysis: Job Order, Batch and Contract Costing 131
Order a wedding cake that will feed at least half of your guests and
then offer several more-affordable desserts.
You pay for excessive variety in additional ingredient expenses,
design costs and service fees. Many couples are opting for sleeker,
less-expensive creations.
Source: Shane Co., Wedding Cake Designers, www.shaneco.com/weddings/cake_design-
ers.asp.
QUESTIONS
1. Why is job costing particularly suitable for a business making

wedding cakes?
2. What information would you expect to find in a job cost record
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for a wedding cake contract?
IM
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LEARNING OBJECTIVES
After reading this chapter, you will be able to:

>> Understand the concept of job costing in manufacturing units.
>> Understand measurement of costs in job costing system.
>> Determine economic batch quantity in batch costing system.
>> Understand the concept, measurement and estimation of cost
under contract costing system.
>> Understand the contract plus cost system.
>> Calculate the cost for certified and non-certified works under
contract costing.
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5.1 INTRODUCTION
Remember, we have discussed in Chapter 4 that different types of costing
systems are available and a firm uses a particular system of costing depend-
IM
ing on the nature of job and activities it is involved in. Different types of activ-
ities have different types of costing systems. It is important to understand
these costing systems to ascertain and assign fairly accurate cost to prod-
ucts and processes that help in taking different kinds of managerial deci-
sions in day-to-day operations as well as for taking future policy decisions.
Costing methods differ depending on the nature of the activity or process
for which they are applied. For example, processes of a manufacturing unit
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are quite different from those of a service unit. Further, the nature of activ-
ity changes costing methods. For example, different costing techniques are
used for ascertaining costs in job costing, batch-costing and contract costing.
Primarily, all systems of costing focus on product costing, and product cost-
ing helps to assess and estimate sales revenue. Once we know the expected
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sales revenue from a product, it is used for making different types of anal-
yses in a business firm, such as income and profit. This chapter is devoted
to understand the fundamentals and applications of job order costing, batch
costing and contract costing.
5.2 JOB ORDER COSTING

QUICK TIP A job is a customer-specific order that is accepted and carried out at dif-
• I dentify key cost ferent levels in a workplace through different processes and operations
components. for completion. Work involved in each unit’s process on a particular job is
• Tracking cost components. identifiable and cost associated with it can also be measured. Once a par-
• Performance measurements. ticular job is completed, the cost of all activities/units on this job is com-
• Monitor results. piled to arrive at the total cost for this job. The job order costing system
• Make adjustments. is basically used in printing works, automobile servicing, engineering
works, fabrication jobs, etc. Since the job is for a single order or contract,
it is assumed to be a single cost unit. Job orders are comparatively of
a short duration.

5.2.1 PROCESS OF JOB ORDER COSTING

The whole process of job order costing involves systematic planning
and procedure to complete tasks not only in time but also cost-effectively.
Basically, the job order costing process consists of the following five steps:
1. Receiving production/Job order
2. Acquiring materials
3. Organizing labor
4. Overhead costs
5. Completion of final job
All the above elements are to be organized in a systematic manner. The job
order is received from the customer.
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JOB COSTING
This method of costing is used in job order industries where production NOTE
is carried out as per customer requirements. In job order industries, pro-
• In the job costing system, an
IM
duction is not on a continuous basis. Rather, production is carried out only
when customer orders are received, and it is as per customer specifications. order or a unit, lot, or batch
Consequently, one job can be different from the other. The method of cost- of a product may be taken
ing used in such business organizations is job costing or job order costing. as a cost unit.
The objective of this method of costing is to work out the cost of each job by • In job costing, there is no
preparing a job cost sheet. A job may be a product, unit, batch, sales order, averaging of costs.
project, contract, service, specific program or any other cost objective that is • Job costing is customer-specific
order costing.
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distinguishable clearly and unique in terms of materials and other services
used. The cost of a completed job will be the sum of the costs of these com- • The cost of each job is different
ponents — materials used for the job, direct labor employed for the job and and measured based on
production overheads and other overheads, if any, charged to the job. materials and other inputs used
in the process.
Following are the features of job costing:
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1. It is a customer-specific order costing.

2. The job is carried out as per the specific requirements of the orders and
according to desired specifications.
3. It may involve a single unit or a batch of similar units.
4. It is concerned with the cost of an individual order or batch orders.
5. Cost details of all processes involved in job completion are collected
after the end of all processes.
6. The cost of each job is measured by collecting details of materials used,
labor and overheads from different processes.
7. The common overheads are apportioned to each job based on the
overhead absorption method.
8. Work-in-progress may or may not be at the end of the accounting period. ! IMPORTANT CONCEPT
9. Sometimes a job order may extend to the net accounting period. In Job costing and process
such cases, cost will be limited to only one particular accounting period. costing systems share the
same objective of estimating
10. Each job is treated as a separate accounting unit; therefore, separate
product costs.
production numbers are allocated.

5.2.2 ADVANTAGES OF JOB COSTING

The advantages of job order costing are as follows:
1. The cost data generated is useful for further analysis and control.
2. The firm can evaluate profit or loss made on each job and compare the
price tendered for the job.
3. The cost so arrived can be compared with standard costing.
4. If the firm is able to know the fair cost of a particular job, it can bargain
on the price of that job with the customer.
5. It helps in making a comparison with performance on other jobs.
6. As the expected cost data is available, the firm can take collective
measures to control the cost before the job is completed, as any
mistakes or excessive costs show up at an early stage.
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5.2.3 LIMITATIONS OF JOB COSTING
Following are the limitations of job costing:
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1. Since implementation of job costing needs all details of resources,
records and cost details, it is time consuming as well expensive.
2. Keeping detailed records of individual jobs is a complicated process.
3. It is useful only for small and short-term job orders where too many
processes or components are not involved.
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Let us now understand some practical applications of job costing through
the following examples.
5.2.4 ASSESSMENT OF JOB COSTING

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EXAMPLE 5.1
The following data has been taken from the books of RST Ltd. for the year
ending 31 March, 2014. The firm follows the job costing system.
Particulars Amount (Rs.)

Direct materials cost 180,000
Direct labor cost 150,000
Profit 121,800
Selling and distribution overheads 105,000
Administrative overheads 84,000
Factory overheads 90,000
You are required to compute:

1. The
job cost sheet detailing therein prime cost, works cost, production
cost, cost of sales and sales value.
2. or the year 2014–2015, the firm has received an order for a number
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of jobs. However, it is expected that the direct materials would cost
Rs. 2,40,000 and direct labor would cost Rs. 1,50,000. Compute the value
for these jobs assuming that the firm targets to earn the profit at same
rate as in 2013–2014 on sales. Also consider that the selling and distribution

overheads will increase by 15%. The firm recovers factory overhead as

a percentage of direct wages and administrative and selling and distribu-
tion overhead as a percentage of works cost, based on the cost rates that
existed the previous year.
Solution:
The job cost sheet is shown in the following table:
1. Job Cost Sheet of RST Ltd. as on 31 March, 2014
Particulars Amount (Rs.) Amount (Rs.)

Direct costs: Direct materials cost 1,80,000
Direct labor cost 1,50,000
Prime cost 3,30,000
Factory overheads 90,000
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Factory cost 4,20,000
Administrative overheads 84,000
Selling and distribution overheads
Cost of sales
IM 1,05,000
6,09,000
Profit 1,21,800
Sales 7,30,800
Remember:
a. Factory overheads to direct wages (as percentage of direct wages) =
M
Rs. 90,000/1,50,000 × 100 = 60%

b. Administrative overheads (as percentage of factory cost) =
Rs. 84,000/4,20,000 × 100 = 20%
c. Selling and distribution overheads (as percentage of factory cost) =
Rs. 1,05,000/4,20,000 × 100 = 25%
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2. Computation of Price Quotation for the Jobs

Amount Amount
Particulars (Rs.) (Rs.)
Direct costs: Direct materials cost 2,40,000
Direct labor cost 1,50,000
Prime cost 3,90,000
Factory overheads – 60% of Direct Labor Cost 90,000
Works cost 4,80,000
Administrative overheads – 20% of works cost 96,000
Selling and distribution overheads 28.75% of 1,38,000
works cost [25% + 15% = 28.75%]
Cost of sales [Cost of production + Selling and 7,14,000
distribution overheads]
Profit 16.67% of sales [20% on cost] 1,42,8000
Sales [Cost of sales + Profit] 8,56,800

SELF-ASSESSMENT
1. Which of the following is not a component of job order cost?
QUESTIONS
a. Direct material
b. Direct labor
c. Actual factory overheads
d. Applied factory overheads.
2. All of the following would most likely use a job order costing system
except
a. A dental practice
b. Auto repair shop
c. Appliance maker of small size
d. Architectural firm
3. Which of the following costs is not charged to Work in Process in a
normal cost system?
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a. Actual overheads
b. Actual direct materials
c. Actual direct labor
IM
d. Estimated indirect labor
4. Which of the following product costs would be charged to Work in
Process assuming a standard costing system?
a. Actual direct material costs
b. Actual overhead costs
c. Actual direct labor costs
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d. Applied overhead costs
ACTIVITY 1 The following information is available for a job number 1009 undertaken
by ABC firm.
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Materials 12.08
Direct Wages – 22 hours @ 25 paise per hour 5.50
Department wise allocation of wage hours
A – 10 hours
B – 4 hours
C – 8 hours
Prime Cost 17.58
Plus 33% on Prime Cost 5.86
23.44
The following additional information is also available.

Materials used Rs. 77,500. Direct wages paid by Departments A, B and C
was Rs. 5000, Rs. 6000 and Rs. 4000 respectively. Factory overheads for
Departments A, B and C were Rs. 2500, Rs. 4000 and Rs. 1000, respectively.
Selling cost was Rs. 30,000.

Questions:
1. What would be the direct labor hours for each department considering
total hours required to produce one unit and cost involved in that?
2. What would be the factory overheads per hour for different
departments which are to be adjusted based on total wage hours of
each department?
3. Calculate the prime cost.
5.3 BATCH COSTING QUICK TIP

When certain quantities of similar products are produced at one time, In batch costing:
this is known as batch production. The concept of batch costing is applied
• T he costing is carried
when certain quantities of similar and identical products are manufactured
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out when there is mass
together as one job. Batch production is carried and manufactured to meet
production, and the units are
the requirements of a specific order of a customer. homogeneous.
Generally, the concept of batch costing is applied in printing, packaging, • Products usually lose
IM
automobile and engineering components. The per unit cost in batch produc- their identity, as they are
tion is determined by the following formula: produced in the continuum.
• Production is made in small
Total cost of the batch lots of identical units.
Cost per unit = • The cost unit is a particular
No. of units produced in the batch
batch.
• Cost is ascertained for the
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5.3.1 ECONOMIC BATCH QUANTITY entire batch.
When a firm produces different line of (products) production in separate
batches, it becomes important to decide the optimum size of a batch. If the
NOTE
batch size is determined, it will have economies in production in terms of
inventory cost; therefore, a firm decides an optimum size of batch and also Quality control costs may be a
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the number of times each batch is to be produced. This is like the economic direct cost of the Manufacturing
order quantity (EOQ) concept in inventory control. When production is Department, but an indirect cost
undertaken in batches, the required setup changes for each batch; therefore, of an individual job.
there is a set-up cost involved in batch costing. The economic batch quantity
(EBQ) can be calculated through the following equation:
2AB
EBQ =
CS
where EBQ is the economic batch quantity, A is the annual production, B is

the cost of each setup, C is the cost of production per component and S is the
holding and other inventory carrying costs.
Total annual cost ofproduction = QUICK TIP

Annual cost of setup + Annual holding cost
• E conomic order quantity and
economic batch
5.3.2 ASSESSMENT OF ECONOMIC BATCH QUANTITY quantity are similar.
• Batch costing is used when
On the basis of the concept explained above, we can now understand
similar and identical
the assessment of economic batch order quantity through the following
products are produced.
example.

EXAMPLE 5.2
A firm accepted an order to supply 4,800 pistons per annum to another firm.
The inventory holding cost per piston per month is 20 paisa. The setup cost
per run of piston manufacturing is Rs. 648.
Compute:
1. Optimum run size for piston manufacturing.
2. Interval between two consecutive optimum runs.
3. Minimum inventory cost per annum.
Solution:
1. Calculation of optimum run size for piston manufacturing:
2 AB
Optimum run size =
CS
S
where A the annual supply of pistons is 4800, B the setup cost per pro-
duction run is Rs. 648, C the annual holding cost per piston Rs. 0.20 × 12
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months = Rs. 2.40 per annum.
2 × 4, 800 × 648
Optimum run size = = 2, 59, 20, 000
2.40
= 5,091 pistons per run
2. Interval between two consecutive optimum runs:

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48, 000 pistons

Number of production runs per annum =
5, 091 pistons
= 9.48 times
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= 9 times
365 days
Interval between two consecutive optimum runs =
9 times
= 41 days (approx.)
3. Minimum inventory cost per annum:
(Rs.)
Production run cost (9 times production run × Rs. 648) 5,832
Carrying cost (1/2 × 5,091 pistons × Rs. 0.20 × 6,109
12 months)
Minimum inventory 11,941
cost p.a.

5. In __________ costing, the cost of a group of products is ascertained SELF-ASSESSMENT

QUESTIONS
a . Process b. Job
c. Batch d. Service
6. Continuous costing is also called
a. Operation costing b. Process costing
c. Batch costing d. Contract costing
Identify following activities to mark whether they pertain to job or batch ACTIVITY 2
costing:
1. Printing press
2. Pharmaceutical industry
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3. Ship building
4. Interior decoration
5. Readymade garments
6. Manufacturing of tyre & tubes
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7. Furniture
8. Heavy machinery
9. Manufacturing electronic parts
10. Manufacturing of toys
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5.4 CONTRACT COSTING

Contract costing is like job costing where contract constitutes a unit of cost.
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Therefore, the fundamentals of job costing are also applicable to in contract STUDY HINT
costing. Practically, we can say that contract costing is an extension of job
costing where each contract is assumed as a completed job. In practice, the • I n contract costing,
contracts are generally
contract costing method is used in the projects that require longer time for
of large size. Therefore,
completion such as civil engineering works, ship building industry and con-
there are small number of
struction industry. Contract costing is used to measure cost and profit of a
contracts.
particular construction assignment. In contract costing, most of the expenses • A contract generally
involved can be identified and directly allocated to a particular contract. takes more than 1 year
There are few expenses that can be absorbed on the basis of overhead the to complete.
absorption policy of the firm. • Work on contract is carried
The Chartered Institute of Management Accountants (CIMA), UK defines out at the site of contracts.
contract costing as “the aggregated costs relative to a single contract des- • Each contract undertaken
ignated as a cost unit.” It is also “that form of specific order costing which is treated as a cost unit.
applies where the work is undertaken as per the customer’s special require-
ments and each order is of long-term duration (compared with those to which
job costing applies). The work is usually constructional and, in general, the
method is similar to job costing.”

5.4.1 FEATURES OF CONTRACT COSTING

Following are the main features of contract costing:
1. In (contract) job costing, each contract is treated as a separate unit
of cost.
2. Each contract is allotted a specified number and the contract is
generally carried out at the site of customer.
3. Majority of expenses, which are identifiable with a specific contract,
are directly allocated to that contract. A few overheads are allocated on
the basis of the overhead absorption policy of the organization.
4. In contract costing, sub-contracts are assigned for specified jobs like
welding work, electrical work and wood work; therefore, costs are
traceable and directly allocated to the contract.
NOTE
5. A contract work may run for more than one accounting year.
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• Contracts are undertaken to
meet specific requirements of 6. For completion of a contract, required plants and equipment can be
the customer. hired from different sources. Even services of experts and consultants
• Each contract is a cost unit. can be availed of.
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7. A contract may have penalty provisions for non-completion of work in
time or for not carrying out work as per pre-agreed specifications.
8. Another unique feature of contract costing is measurement of profit
on incomplete works. As per the accepted accounting practices, in
contract costing the profit on an incomplete work should be calculated
on accrual basis.
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5.4.2 PROCESS OF CONTRACT COSTING

The process of contract costing passes through the following phases:
1. Material cost: In a contract, all required raw materials are transferred
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from one contract to another. The materials required to complete

a particular contract are debited to the related contract account.
Sometimes some quantity of the materials is returned to the store being
extra material. To account this, a material returned note is prepared
and on the basis of this note the extra materials returned is credited to
the concerned contract account or deducted from the materials issued
on account of that contract. In cases where materials are transferred
from one contract to another, the accounting is done in the similar way
for the materials transfer. If the materials remain in stock at site at the
end of a particular accounting period, they are shown as closing stock
and carried forward to the next period.
2. Labor cost: Wages paid to the workers engaged on a particular contract
should be charged to that contract irrespective of the work performed
by them. If there are common workers on more than one contract and/
or if the workers are transferred from one contract to the other contract,
time sheets must be maintained and wages may be distributed on the
basis of the time spent on each contract. Some workers may be working
in the central office or central stores. Their wages can be apportioned
to a particular contract on a suitable basis like time spent, etc.

3. Expenses: All expenses incurred for a particular contract should be

charged to that contract. In case of any indirect expenses incurred for
the organization as a whole, they should be charged to the contract
on some suitable basis. Direct expenses can be charged directly to the
contract.
4. Plant and machinery: The depreciation on the plant and machinery
used to complete a contract is charged to the contract account as per
the policy of the firm on charging depreciation.
5. Sub-contract: Sometimes due to certain situations, a sub-contractor is
appointed to carry out certain special work for the main contract. This
special work done by the sub-contractor becomes a direct charge to
the main contract and accordingly debited to the contract account. As
payments made to the sub-contractor are charged to the main contract
as direct expenses, no detailed breakup of the same is required. The
material, supplied to the sub-contractor without any charge, is debited
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to the contract account as direct material and machinery, tools, etc.,
supplied to him on rent should be depreciated on an appropriate basis
and debited to the contract account. The rent received for the use of
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such tools and machines should be credited to the contract account or
deducted from the final bill of the sub-contractor.
Let us now understand few cases of measurement of contract costing.
EXAMPLE 5.3
DLF Builders had taken up a contract to construct a building complex for
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Rs. 480 lakh. This work commenced on 1 January, 2012. Initially, the comple-
tion time of the contract was estimated to be 15 months. Work has progressed
as per schedule. The actual costs charged till December, 2012 were as follows:
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Particulars Amount (Rs.) ( 000)

Materials cost 11,220
Labor cost 16,200
Hire charges for equipment and other expenses 3,600
Establishment charges 3,240
The following additional information is available:
Particulars Amount (Rs.) ( 000)

Materials in hand on 31 December, 2012 1,050
Work certified for which Rs. 324 lakh paid as on 40,000
31 December, 2012
Work not certified as on 31 December, 2012 750
According to an estimate, the following expenditure will be further required

to be incurred to complete the work:
1. Materials cost: Rs. 10.50 lakh
2. Labor cost: Rs. 16.00 lakh

3. Sub-contractor: Rs. 20.00 lakh

4. Equipment hiring charges: Rs. 3.00 lakh
5. Establishment charges: Rs. 6.90 lakh
Compute the value of work-in-progress as on 31 December, 2012 taking
into account the margin of profit. Also show appropriate accounts. A provi-
sion for contingencies to the extent of 5% of the total costs is required to be
maintained.
Solution:
Contract A/c
Amount Amount
Particulars (Rs.) Particulars (Rs.)
To materials cost 11,220 By stock of materials 660
To labor cost 16,200 By work-in-progress 40,750
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Work certified/not certified.
40000 + 750
To hire charges 3,600
To establishment charges 3,240
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To profit c/d 7,150
Total 41,410 Total 41,410
To profit & loss A/c* 5,000 By Profit b/d 7,150
To reserve [transfer] 2,150
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Contractee A/c
Particulars Amount (Rs.) Particulars Amount (Rs.)

To contract A/c 40,000 By Bank A/c 32,400
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By Balance c/d 7,600

Computation of profit to be carried to the Profit & Loss A/c:
Amount Amount
Expenditure up to 31 December, 2012 33,600
Rs. 3,42,60,000 [Total of debit side] – Rs. 6,60,000
Add: Estimated expenditure to complete materials: 1,710
Rs. 10,50,000 + Closing stock Rs. 6,60,000
Labor cost 1,600
Sub-contractor 2,000
Equipment hiring charges 300
Establishment charges 690
Total 6,300
Add: 5% on total cost for contingencies, that is, 2,100
Rs. 3,99,00,000 × 5/95

Amount Amount
Total cost (estimated) 42,000
Total profit (estimated) 6,000
Contract price 48,000
*Profit for carrying to the profit and loss A/c = Total estimated profits × Work certified/
Contract Price = Rs. 6000 × Rs. 40000/Rs. 48000 = Rs. 5000
5.4.3 COST PLUS CONTRACT

When it is not possible to estimate the cost of a contract in advance for
various reasons, we use the cost plus contract system to determine the
cost in advance. This system is used when costs fluctuate over the con-
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tract period, as the contract work takes longer time to complete. This
system may also be used when a contract is totally new and cost estima-
tion cannot be done with accuracy. In this contract, the contractor will
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receive a certain percentage of total cost as profit. The customer often
remains suspicious about the cost and needs to monitor the work and cost
both closely. Any higher escalation in the cost will be a reward for the
contractor and additional cost to the customer. The books of accounts of
the contractor need to be properly maintained with all transparency and
kept open for auditing and inspection. The terms and conditions of the
contract will have more clarity on different issues. This system of costing
is applicable and more suitable to special type of work contracts such as
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construction of power house, shipyards, dam, etc.

Following are the advantages and disadvantages of the cost plus contracts
system to contractor and customer:
1. The contractor has no risk of loss. But the customer has to pay more
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if the cost escalates, maybe on account of inefficiency.

2. The contractor is protected from the increased cost of inputs. However,
the customer is not certain about the price of the contract till
the end.
3. If the price of inputs remains favorable, the contractor does not get
benefit. The benefit goes to the customer.
4. It is a simplified way to prepare tenders for contractors.
5.4.4 WORK CERTIFIED

As we understand that construction works usually take a longer period of
time for work completion. The customer needs to make payment from time
to time depending on the extent of work already completed. This amount is
paid on the basis of a certificate issued by an architect or the chartered engi-
neer. This is called work certified. This helps to monitor the work progress
from time to time and also to estimate and monitor the cost.

SELF-ASSESSMENT
7. In contract costing, which of the following provides safeguard against
QUESTIONS
any fluctuation in the prices of material, labour, etc.
a. Pricing clause b. Exclusion clause
c. Arbitration clause d. Escalation clause
8. Which of the following statement is correct in relation to contract
costing?
1. Most of the items of costs are direct in contract costing than in
job costing
2. Foreseeable losses estimated for a contract should be written-off
immediately
3. A debit balance on the contractee account is shown as current
liability in the balance sheet
4. Final contract price to be paid is certain in cost plus contract.
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Choose the answer from the following options:
a. 2 and 4
b. 3 and 4
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d. 1, 2 and 3
9. Which costing is like job costing where contract constitutes a unit of
cost.
a. Process b. Job
c. Batch d. Contract
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10. The Chartered Institute of Management Accountants (CIMA), UK

defines contract costing as “the aggregated costs relative to a single
contract designated as a
a. cost unit
b. performance measurement
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c. monitor result
d. direct material
ACTIVITY 3 Assume (A) that it is common practice that the cash is withheld by the
contractee in a contract when payment of the value of work certified is
being made.
The reason (R) being that retention money is treated as safeguard against
any damage or poor quality of work in the contract. And therefore, it is
released after certain time period.
Choose from the following options the correct answer.
a. Both A and R are true and R is the correct explanation of A.
b. Both A and R are true but R is not the correct explanation of A.
c. A is true, but R is false.
d. A is false, but R is true.

ADDITIONAL SOLVED PROBLEM
PROBLEM 5.1
Compute a conservative estimate of profit on a contract (which has been 80%
complete) from the following particulars. Illustrate at least four methods of
computing the profit.
(Rs.)
Total expenditure to date 85,000
Estimated further expenditure to complete the contract 17,000
(including contingencies)
Contract price 1,53,000
Works certified 1,00,000
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Works not certified 8,500
Cash received 81,600
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Solution:
(Rs.) (Rs.)
Value of works certified 1,00,000
Less: Total expenditure to date 85,000
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Works not certified 8,500
76,500
Notional profit 23,500
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Contract price 1,53,000

Less: Total expenditure to date 85,000
Estimated further expenditure 17,000
1,02,000
Estimated total profit 51,000
Four methods of computing profit are as follows:

2 Cash received
1. × Notional profit ×
3 Value of work certified
2 81, 600
= × 23,500 × = Rs. 12,784
3 1, 00, 000
Value of work certified

2. Notional profit ×
Contract price
1, 00, 000
= 23,500 × = Rs. 15,359
1,53, 000

Value of work certified Cash received

3. Estimated total profit × ×
Contract price Vale of work certified
1, 00, 000 81, 600
= 51, 000 × × = Rs. 27, 200
1,53, 000 1, 00, 000
Cost of work to date Cash received
4. Estimated total profit × ×
Estimate total cost Value of work certified
85, 000 81, 600
= 51, 000 × × = Rs. 34, 680
1,0
02, 000 1, 00, 000
5.5 SUMMARY
A job is a customer-specific order that is accepted and carried out at differ-
ent levels in a workplace in different processes and operations for comple-
tion. Work of each unit/process on a particular job is identifiable and the cost
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associated with it can also be measured. Once a job is completed, the cost
of all activities/units involved in this job is compiled to arrive at the total
cost incurred on carrying out the job. The job orders are comparatively of a
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short duration.
When certain quantities of similar products are produced at one time, this
is known as batch production. The concept of batch costing is applied
when certain quantities of similar and identical products are manufactured
together as one job. Batch production is carried out to meet the requirements
of a specific order of a customer.
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Contract costing is like job costing where contract constitutes a unit of cost.
Therefore, the fundamentals of job costing are also applicable to contract
costing. Practically, we can say that contract costing is an extension of job
costing where a contract is assumed as a completed job. In practice, the con-
tract costing method is used in those projects that require longer time for com-
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pletion such as civil engineering works, ship building industry and construction
industry. Contract costing is used to measure cost and profit of a particular con-
struction assignment. In contract costing, most of the expenses involved can be
identified and directly allocated to a particular contract.
KEY WORDS 1. Job costing: This costing technique is for a particular job.
2. Batch costing: The assessment of cost for a particular batch of
production.
3. Contract costing: The cost allocation methodology of a contract work.
4. Economic batch quantity: The optimal size of a batch from costing
point of view.
5. Set-up cost: The cost involved in changing one set-up of production
process to another set-up.
6. Sub-contract: A part of the contract work is given to another
contractor by the main contractor.
7. Cost plus contract: When a contract is tendered based on certain
profit margin over the cost.

8. Work certified: In a contract, the work is to be certified by the

Engineer from time to time for making payments.
9. Job order sheet: A statement submitted for a particular job.

1. What is job costing and how is it useful in measuring costing for
specific jobs?
2. Describe features, advantages and limitations of job costing.
3. What is batch costing? Explain the concept of economic batch quantity
with suitable examples.
4. How do we measure the cost of work-in-process under batch costing?
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5. What is contract costing? How is it different from job and batch costing?
6. How will you ascertain the cost under the contract costing system for
certified and non-certified works?
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5.7 ANSWER KEY

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Job Order Costing 1. c. Actual factory overheads

2. c. Appliance maker of small size
3. a. Actual overheads
4. d. Applied overhead costs
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Batch Costing 5. c. Batch

6. b. Process costing
Contract Costing 7. d. Escalation clause
8. c. 1 and 2
9. d. Contract
10. a. cost unit

SUGGESTED BOOKS
Mitra, J.K. (2017). Cost and Management Accounting. Oxford University
Press. 600 pp.
Vibrant Publishers (2017). Cost Accounting and Management Essentials
You Always Wanted To Know: 2 (Self Learning Management). 3rd
edition, 130 pp.

E-REFERENCES
Specific Order Costing: https://nscpolteksby.ac.id/ebook/files/Ebook/
Accounting/Fundamentals%20Of%20Management%20Accounting%20
(2009)/8%20-%20Specific%20Order%20Costing.pdf
Cost Accounting vs. Managerial Accounting - AccountingVerse”. account-
ingverse.com. Retrieved 2019-07-16.
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C H A
6 P T E R
INCOME RECOGNITION UNDER MARGINAL

AND ABSORPTION COSTING
6.1 Marginal Costing
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6.1.1 Features of Marginal Costing
6.1.2 Advantages of Marginal Costing
6.1.3 Limitations of Marginal Costing
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Activity
6.2 Absorption Costing
6.2.1 Advantages of Absorption Costing
6.2.2 Limitations of Absorption Costing
6.2.3 Difference Between Marginal Costing and Absorption Costing
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Activity
6.3 Practical Application of Absorption
and Marginal Costing
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Activity
6.4 Summary
6.6 Answer Key

NASHIK WAREHOUSING LTD.
Nashik Warehousing Ltd. is considering the purchase of power trucks

to replace the hand trucks in use now. By such replacement, it is esti-
mated that the effective storage capacity of the water house space can
be increased by 50%. For use of the power trucks, it will require the floor
of the warehouse to be reinforced at an estimated cost of Rs. 1,00,000;
this amount can be written-off over the remaining life of 10 years of
the building. The warehouse building was acquired on January 1, 1974
for Rs. 10,00,000 and depreciation has been provided in the accounts
each year at 2.5% p.a. on straight line basis. The power trucks will cost
Rs. 1,30,000 and will have a service life of 10 years and will have an esti-
mated salvage value of Rs. 20,000. The maintenance cost of these trucks
is estimated at Rs. 20,000 p.a. The land trucks were acquired on July 1,
1991 for Rs. 60,000. Depreciation has been provided in the accounts at
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5% p.a. on straight line basis. These trucks can be sold for Rs. 24,000.
Labor costs vary proportionately to the volume of business. However,
the use of power trucks in place of hand trucks will reduce the labor cost
by 25%. The company has 25,000 preference shares in Mahindra and
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Mahindra Ltd. It is proposed to dispose of 20,000 shares to provide funds
for the cost of purchase of new power trucks. With additional effective
warehousing capacity, the company has two alternatives:
1. Reduce storage racks by 14% and secure an estimated 20% increase
in the volume of the business.
2. To enter into a contract with a company which will use 80% of the
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additional capacity at 50% of present rates. Fire insurance premium

will increase by Rs. 4,000 p.a. Other expenses will remain same, except
where indicated. Following is the condensed statement of profit and
loss of the Nashik Warehousing Ltd. for the year ended June 30, 2004:
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(Rs.) (Rs.)
Income: Warehousing rent 6,00,000 –
Dividend from Mahindra and 25,000 6,25,000
Mahindra Ltd. expenses
Warehousing wages 2,08,200 –
Depreciation: Building 25,000 –
Hand trucks 3,000 –
Maintenance of hand trucks 5,000 –
Insurance 14,000 –
Other expenses 10,91,800 3,66,000
Net profit – 2,59,000
QUESTIONS
1. The company wants your advice whether to replace the hand

trucks and, if so, which of the two alternative opportunities be
availed during the year ending June, 2005. Assume replacement
will be on July 1, 2004.

Income Recognition Under Marginal and Absorption Costing 151
LEARNING OBJECTIVES

>> Concept of absorption and marginal costing.
>> Inventory valuation based on absorption and marginal costing.
>> Preparation of income statement and analysis of differences in
both the methods.
>> Practical application of absorption and marginal costing.
>> Limitations of absorption and marginal costing.
>> Calculation of under/over absorption.
6.1 MARGINAL COSTING
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Before we explain the mechanism of absorption and variable costing, let us
QUICK TIP
understand the concept of marginal cost. Marginal cost can be explained
as a change in the total cost of production of one additional unit of output. Under marginal costing:
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Alternatively, per unit change in the cost of increased output is marginal cost. · Variable costs are treated as
We have already discussed that if a firm produces the next unit of output, product costs
· Fixed
costs are treated as
the cost incurred is only the variable cost, as fixed inputs remain unchanged.
Therefore, it is the variable cost alone which changes with the next unit of period costs
· Fixed
costs are debited to
output. Suppose a firm produces 5,000 units of a product, given the total
Profit & Loss account
capacity of output as 8,000 units. It means that the capacity of the machine
· Contribution
is the decision
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is to produce 8,000 units but, at present, the firm is producing only 5,000
criteria
units. It also indicates that the firm will have the same total fixed cost till · Inventory
is valued at
it produces 8,000 units. Now, the firm intends to produce 5001th unit of the variable cost
product. The firm needs only the variable inputs to produce one additional
unit and that is the variable cost. Further, suppose that the total cost of 5,000
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units was Rs. 60,000 and the total cost of producing 5001 units is Rs. 60,007.
Now, notice that the change in cost on account of producing one additional
unit is Rs. 7 (Rs. 60,007 - Rs. 60,000) and this is the cost of the variable inputs
used to produce one additional unit. This is known as marginal cost.
Marginal costing or variable costing is a concept where all the variable costs
of production are charged to the units produced and the total fixed cost is
charged against the contribution (total sales revenue minus total variable
cost). This is also known as variable costing, as the cost is ascertained only on
the basis of the variable cost. There are following equations which are used
in relation to marginal costing:
Sales = Fixed Cost + Variable cost + Profit
Contribution = (Sales revenue - Variable cost) or (Selling price per
unit - Variable cost per unit)
Contribution = Fixed cost + Profit
Profit = Contribution - Fixed cost
Opening stock = Production + Closing stock - Sales
Closing stock = Opening stock + Production - Sales
Production = Sales - Opening stock + Closing stock
Sales = Opening stock + Production - Closing stock

NOTE Marginal costing may be defined as the technique of presenting cost data
wherein variable costs and fixed costs are shown separately for manage-
Fixed expenses decrease per unit rial decision-making. The Chartered Institute of Management Accountants
with the increases in production (CIMA), London, defines marginal costing as “the ascertainment of the mar-
and increases per unit with the ginal costs and of the effect on the profit of changes in volume or type of
decrease in production. output by differentiating between the fixed costs and the variable costs.”
Only variable costs are charged to cost units (product or inventory), whereas
fixed cost for the period is written off against the profit of the period. Hence,
marginal costing is also known as variable costing technique.
6.1.1 FEATURES OF MARGINAL COSTING

The main features of marginal costing are as follows:
STUDY HINT 1. Cost classification: All costs are classified on the basis of variability,
that is, variable costs and fixed costs. Mixed costs are segregated into
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If sales is less than variable and fixed costs.
production and there is
no opening stock, it suggests 2. Inventory valuation: Under marginal costing, inventory or stock are
there is closing stock. valued at variable cost or marginal cost for profit measurement.
In such a scenario, profit
under marginal costing will
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3. Product and period costs: Under marginal costing, all variable costs
are treated as product cost and fixed costs are treated as period cost.
be less than the one shown
A product cost is charged directly to cost unit, whereas a period cost is
by absorption costing.
written-off against the profit of the period.
4. Contribution: Marginal costing technique makes use of contribution
for marking various decisions. Contribution is the difference between
sales and variable cost. It is on the basis of the contribution of a product
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that production and sales policies are designed by a firm.

5. The price is determined on the basis of the marginal cost and
contribution margin.
6. The contribution margin is the basis for deciding profitability of
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department or product.
7. Fixed costs are treated as period cost and debited to profit and loss
account and, thus, excluded from the production cost.
6.1.2 ADVANTAGES OF MARGINAL COSTING

Following are the advantages of marginal costing:
! IMPORTANT CONCEPT 1. Marginal costing is simple to understand.
Marginal costing is not 2. By not charging fixed overhead to the cost of production, the effect of
suitable where selling price varying charges per unit is avoided.
is determined on the basis of
cost-plus method.
3. It prevents the illogical carry-forward in stock valuation of some
proportion of current year’s fixed overhead.
4. The effects of alternative sales or production policies can be made
readily available and assessed and decisions taken would yield the
maximum returns to the business.
5. It eliminates large balances left in the overhead control accounts,
which indicates the difficulty of ascertaining an accurate overhead
recovery rate.

6. Practical cost control is greatly facilitated. By avoiding arbitrary

allocation of fixed overhead, efforts can be concentrated on maintaining
a uniform and consistent marginal cost. It is useful at various levels of
management.
7. It helps in short-term profit planning by break-even and profitability
analysis, both in terms of quantity and in terms of graphs. Comparative
profitability and performance between two or more products and
divisions can easily be assessed and brought to the notice of the
management for decision making.
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8. It helps in cost–volume–profit analysis.
If the marginal cost is less
9. It is also helpful in budgeting and production planning forecasting. than buying price, additional
10. Profit and loss account is not affected by the level of closing inventory. requirement of the component
should be met by making
11. The performance evaluation becomes more effective in case of rather than buying.
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responsibility accounting system.
6.1.3 LIMITATIONS OF MARGINAL COSTING

Following are the limitations of marginal costing:
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1. At times, it becomes difficult to segregate the fixed cost and the variable
cost.
2. Marginal costing presumes that per unit variable cost will remain the
same at all levels of activity, which is not true.
3. Marginal costing concept is not an accepted accounting procedure for
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external reporting.
(Rs.)
Sales revenue (A) xxxxx
Variable manufacturing costs
Direct material consumed xxxxx
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Direct labor xxxxx

Variable manufacturing overheads (variable cost per unit × no. of units) xxxxx
Cost of goods produced (current variable cost) xxxxx

Add: Opening stock of finished goods xxxxx
(valued at variable cost of previous period)
Less: Closing stock of finished goods (valued at current variable cost) xxxxx
Cost of goods sold (B) xxxxx

Gross contribution (A - B) xxxxx
Add: Non-manufacturing variable overheads
Administrative overheads xxxxx
Selling and distribution overheads xxxxx
Contribution (net) (gross contribution–non production variable cost) xxxxx
Less: Fixed costs
Production costs xxxxx
! IMPORTANT CONCEPT
Admn. costs xxxxx While preparing Marginal cost
Selling and distribution costs xxxxx
Net profit xxxxx and Contribution Statement,
if any factor of production is
key factor then contribution
Figure 6.1 Format of income statement under marginal costing.
should be expressed in terms
of per unit of key factor.

The income statement under marginal costing is prepared in the proper

format so as to arrive at the income/loss figure in a more accurate manner
(Fig. 6.1). This is done in sequence to obtain the figures of cost of production,
contribution etc.
SELF-ASSESSMENT
1. Marginal costs is taken as equal to
QUESTIONS
a. Prime cost plus all variable overheads
b. Prime cost minus all variable overheads
c. Variable overheads
2. If total cost of 100 units is Rs. 5,000 and those of 101 units is Rs. 5,030,
then increase of Rs. 30 in total cost is
a. Marginal cost
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b. Prime cost
c. All variable overheads
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3. Marginal cost is computed as
a. Direct material + Direct labor + Direct Expenses + All variable
overheads
b. Prime cost + All variable overheads
c. Total costs – All fixed overheads
d. All of the above
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4. Which of the following statements are true?
A. Marginal costing is not an independent system of costing.
B. In marginal costing, all elements of cost are divided into fixed
and variable components.
C. In marginal costing, fixed costs are treated as product cost.
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D. Marginal costing is not a technique of cost analysis.

a. A and B b. B and C
c. A and D d. B and D
5. While computation of profit in marginal costing
a. Fixed cost is added contribution
b. Total marginal cost is added to total sales revenues
c. Total marginal cost is deduced from sales revenue
6. Which of the following are the assumptions of marginal costing?
A. All the elements of cost can be divided into fixed and variable
components.
B. Total fixed cost remains constant at all levels of output.
C. Total variable costs varies in proportion to the volume of output.
D. Per unit selling price remain unchanged at all levels of operating
activity.
a. A and B b. B and C
c. A and D d. A, B, C, and D

Ronak Automobiles is engaged in manufacturing of trucks. It sells ACTIVITY 1

one truck at Rs. 75,000. The selling price includes components, such as
Direct Materials Rs. 30,000, Direct Labor Rs. 8,000, Variable Overheads
Rs. 12,000, Fixed Overheads Rs. 6,000, Variable Selling Expenses
Rs. 3,000, Royalty Rs. 4,000, Profit Rs. 7,000. The Firm has sufficient idle
capacity to use. Ronak has another firm called ABC Automotive under
the same management. ABC Automotive requires to purchase four trucks
from Ronak Automobiles under the cost method. Answer the following
questions:
a. What will be the variable cost of producing one truck?
b. What are the other variable costs involved in the process?
c. Which of the costs Ronak should not charge from the ABC?
d. At what price, Ronak should supply one truck to ABC?
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e. Whether royalty should be charged from ABC?
f. Why profit should not be charged from ABC?
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6.2 ABSORPTION COSTING
It is a costing technique in which all manufacturing costs (variable and fixed)
are considered as costs of production. Fixed overhead is treated as a product
cost, not a period cost. All variable manufacturing costs and fixed production
overheads to manufacturing are charged to the product. Other costs, such
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as administrative and selling and distribution overheads, are written-off
against the profit of the period in which they arise. Therefore, full cost of a NOTE
product or stocks comprises the variable (direct) and fixed (indirect) costs
of production. Hence, absorption costing is also known as full costing. The Absorption costing is required for
prescribed format for arriving at the income under the absorption costing is external reporting purpose.
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presented in Figure 6.2.
(Rs.)
Sales revenue (A) xxxxxxx
Production costs:
Direct material consumed xxxxx
Direct labor cost xxxxx
Variable manufacturing overheads (units × variable cost per unit) xxxxx
Fixed manufacturing overheads (units × fixed cost. per unit) xxxxx
Cost of goods produced xxxxx

Add: Opening stock of finished goods xxxxx
(valued at cost of previous period’s production)
Less: Closing stock of finished goods xxxxx
(valued at production cost of current period)
Cost of goods sold (B) xxxxx
Gross margin (A-B) xxxxx
Add (or Less): Under (or over) absorption of fixed
manufacturing overheads
Net margin (gross margin ± adjustments)
Less: Administration costs (fixed + variable) xxxxxxx xxxxx
Selling and distribution costs (fixed + variable) xxxxxxx xxxxxx
Profit xxxxx
Figure 6.2 Format of income statement under absorption costing.

NOTE 6.2.1 ADVANTAGES OF ABSORPTION COSTING

1. It is a recognized and accepted accounting practice for external
Under the Absorption Costing:
reporting.
· If quantity of sale is < than
production, inventory level will 2. It uses the accrual accounting concept of matching costs with revenue
be higher for a particular time period.
· If quantity of sale is > than 3. Fixed cost is absorbed in the production cost and the inventory
production, inventory level will valuation complies accounting standards.
be lower
4. There is a proper adjustment of under or over absorption of fixed costs.
· If quantity of sale is = quantity
of production, there will be no 5. The fixed production overheads are also allocated to different units/
closing inventory divisions.
· All the above situations will 6. It is better for the firms which follow cost plus pricing method.
have impact on net Income
under both the methods
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6.2.2 LIMITATIONS OF ABSORPTION COSTING
1. The advocates of marginal costing are of the view that carrying over
the fixed cost component of the existing year, which has been debited
to profit and loss account to the next year, is not appropriate.
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2. The profit and loss account will be affected to the extent of value of
closing inventory.
3. It is not helpful in taking managerial decisions where management
wants to know the incremental cost on account of increased output.
6.2.3 DIFFERENCE BETWEEN MARGINAL COSTING

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AND ABSORPTION COSTING

We can differentiate marginal costing and absorption costing on the basis of
QUICK TIP
the components provided in Table 6.1.
Absorption costing accounts
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for both variable and fixed TABLE 6.1 DIFFERENCE BETWEEN MARGINAL
non-manufacturing costs. COSTING AND ABSORPTION COSTING
Point of
Difference Marginal Costing Absorption Costing
Separation of Costs are separated into Costs are separated into
costs variable cost and fixed those which can be traced
costs. to the cost center or cost
units and those which
cannot be traced.
Product costs Variable costs are product Both fixed and variable
cost and fixed costs are costs are products cost.
period cost.
Stock Only variable costs are Both fixed and variable
valuation included in stock valuation, costs are included in
whereas fixed costs are stock valuation.
charged to next income
statement for the period.
Profit Computed as contribution Computed as gross profit
and net profit and net profit

TABLE 6.1 DIFFERENCE BETWEEN MARGINAL

COSTING AND ABSORPTION COSTING—CONTINUED
Point of
Difference Marginal Costing Absorption Costing
Decision-making Suitable, more meaningful Unsuitable
Recovery of Only those costs which can All manufacturing costs
costs be traced to the products are recovered
Reporting Used for internal reporting Used for external
to management reporting
SELF-ASSESSMENT
7. Absorption costing is also known as QUESTIONS
a.
Historical costing b. Total costing
c.
Both (a) and (b) d. None of the above
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8. Which of the following statements are true?
a.
In absorption costing, cost is divided into three major parts while
in marginal costing cost is divided into two main parts.
b.
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In absorption costing, period is important and in marginal costing
product is important.
c. Both (a) and (b)
9. Under absorption costing, managerial decisions are based on
a.
Profit b. Contribution
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c.
Profit volume ratio d. None of the above
10. In a competitive market, the price is determined by the
a. Individual concern b. Market forces
c. Both (a) and (b) d. None of the above
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Examine the following situations regarding Inventory holding: ACTIVITY 2

a. Units produced = Units sold
b. Units produced > Units sold
c. Units produced < Units sold
Questions
1. What will be the impact on inventory level under (b) above?
2. What will be the impact on inventory level under (c) above?
3. What will be the impact on inventory level under (a) above?
4. Assess the impact on net Income under Absorption and Variable
costing under (a) above.
costing under (b) above.
costing under (c) above.

NOTE 6.3 PRACTICAL APPLICATION OF ABSORPTION

· Absorption
costing recognizes AND MARGINAL COSTING
costs and revenue on accrual Both the absorption and marginal costing have their own significance. As
basis. we have discussed, absorption costing is accepted technique for recognizing
· Absorption
costing is a full cost income under accounting principles and also applicable under accounting
approach. laws and practices. Absorption costing follows the principle of recognizing
· Marginal
costing is for taking costs and revenues on accrual basis. It is also accepted as full-cost approach
managerial decisions. as both fixed and variable costs are considered in the production cost. It also
helps in taking pricing decisions based on cost plus approach. Moreover, the
· The Net income under both
firms are required to follow this approach as mandatory requirement. It is
costing methods will be
also known as direct cost approach. On the other hand, marginal costing has
different on account of Closing
inventory.
many advantages while taking various managerial decisions. It helps the firm
to assess the income of a product in a more realistic manner. The decisions
· If
actual overheads are more are based on the contribution approach which also facilitates other business
than the applied overheads,
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decisions like standard costing decisions, budgeting, contribution analysis,
this will be called as etc. Therefore, the firms follow both the approaches in practice.
Unabsorbed overheads. IM
ACTIVITY 3 During the first three months of the year, Jackson Company had the
following relationships between units produced and units sold:
a. January: Units produced 12,000 and units sold, 12,000.
b. February: Units produced 15,000 and units sold, 11.000.
c. Units produced: 10,000 and units sold, 13,000.
Questions
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1. In each month, how will net income under variable costing compare
to net income under absorption costing?
2. In each month, will fixed overhead be deferred or released from
inventory?
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PROBLEM 6.1
M/s Rohan Motors assembles and sells motor vehicles. It uses an actual cost-
ing system in which unit costs are calculated on a monthly basis. Data avail-
able for March and April, 2015 is as follows:
March April
Unit data
Beginning inventory 0 150
Production 500 400
Sales 350 520
Variable-cost data
Manufacturing costs per unit produced Rs. 10,000 Rs. 10,000
Distribution costs per unit sold Rs. 3,000 Rs. 3,000

March April
Fixed-cost data
Manufacturing costs Rs. 20,00,000 Rs. 20,00,000
Marketing costs Rs. 6,00,000 Rs. 6,00,000
The selling price per motor vehicle is Rs. 24,000.

1. Present income statements for M/s Rohan Motors in March and April,
2015 under: (a) variable costing and (b) absorption costing.
2. Explain the differences between (a) and (b) for March and April, 2015.
Solution:
(i) Calculation of contribution margin per unit:
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(Amount in Rs.)
Months
Particulars
Selling price (A)
IM March 2015
24,000
April 2015
24,000
Variable cost:
Manufacturing cost 10,000 10,000
Distribution cost 3,000 3,000
Total variable cost (B) 13,000 13,000
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Contribution (A) - (B) 11,000 11,000
(ii) Calculation of closing inventory in units:
(Units)
Months
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Particulars March 2015 April 2015

Beginning inventory 0 150
Add: Production 500 400
Total units available for sale 500 550
Less: Units sold 350 520
Closing inventory 150 30
(iii) Income statement under variable costing:
(Amount in Rs.)
Months
Contribution margin 38,50,000 57,20,000
Less: Total fixed cost (350 units × (520 units ×

Rs. 26,00,000) Rs. 26,00,000)
Opening income 12,50,000 31,20,000

(iv) Preparation of income statement under absorption costing:
(Amount in Rs.)
Months
Sales (A)
March: (350 × 24) 84,00,000
April: (520 × 24) 1,24,80,010
Cost of goods sold:
(a) Opening stock:
March: Nil
April: (150 × 14) 21,00,000
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(b) Cost of production
Variable cost:
March: (500 × 10) 50,00,000
IMApril: (400 × 10) 40,00,000
Fixed cost 20,00,000 20,00,000
(c) Closing stock:
March: (150 × 14) 2,10,00,000
April: (30 × 15) 4,50,000
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Cost of goods sold (a) + (b) - (c) = (B) 49,00,000 76,50,000
(Manufacturing)
Gross profit: (A) - (B) 35,00,000 48,30,000
Less: Variable distribution cost:
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March: (350 × 3) 10,50,000

April: (520 × 3) 15,60,000
Less: Fixed marketing costs 6,00,000 6,00,000
Operating income 18,50,000 26,70,000
PROBLEM 6.2
A firm has a production capacity of 12,500 units and normal capacity utili-
zation is 80%. Opening inventory of finished goods on 01-01-2014 was 1,000
units. During the year ending, that is 31-12-2014, it produced 11,000 units
while it sold only 10,000 units. Standard variable cost per unit is Rs. 6.50 and
standard fixed factory cost per unit is Rs. 1.50. Total fixed selling and admin-
istration overhead amounted to Rs. 10,000. The company sells its product for
Rs. 10,000 at the rate of Rs. 10 per unit.
Prepare income statements under absorption costing and marginal costing.
Explain the reasons for difference in profit, if any.

Solution:
1. Income statement under absorption costing:

Sales (10,000 units × Rs. 10) 1,00,000
Cost of goods sold
Cost of production:
Variable factory cost (11,000 units × Rs. 6.50) 71,500
Fixed factory cost (11,000 units × Rs. 1.50) 16,500 88,000
Add: Opening stock
[1,000 units × (Rs. 6.50 + Rs. 1.50)] 8,000
96,000
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Less: Closing stock
[2,000 units × (Rs. 6.50 + Rs. 1.50)] 16,000
IM 80,000
Less: Over absorption of fixed factory cost
[1,000 units × Rs. 1.5] 1,500*
78,500
Gross profit 21,500
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Less: Fixed selling and administration over- 10,000

heads
Net profit 11,500
*Over absorption of fixed factory cost = Absorbed – Actual
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= Rs. 16,500 – Rs. 15,000 = Rs. 1,500

Actual fixed factory cost has been computed on the basis of normal capacity utilization as follows:
80
12, 500 × × Rs. 1.5 = Rs. 15, 000
100
2. Income statement under marginal costing:

Sales 1,00,000
Cost of goods sold:
Cost of production:
Variable cost (11,000 units × Rs. 6.50) 71,500
Add: Opening stock
(1,000 units × Rs. 6.50) 6,500
78,000


Less: Closing stock
(2,000 units × Rs. 6.50) 13,000 65,000
Gross marginal contribution: 35,000
Less: Fixed factory overheads 15,000
80
12,500 × × 1 .5
100
Fixed selling and administration overheads 10,000 25,000
Net profit 10,000
3. Difference between profit under absorption costing and

marginal costing:
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Rs. 11,500 - Rs. 10,000 = Rs. 1,500
The difference in profit is due to fixed cost. Under absorption costing, the
closing inventory has the component of fixed cost due to which its profit
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increases under it.
[Absorption costing: profit] - [Marginal costing: profit] = [Fixed
manufacturing cost in closing inventory] -
[Fixed manufacturing cost in opening
inventory]
= [2,000 units × Rs. 1.5] - [1,000 units × Rs. 1.50]
= Rs. 3,000 - Rs. 1,500 = Rs. 1,500
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PROBLEM 6.3
A product sells at Rs. 3 per unit. The company uses a first-in-out actual cost-
ing system. A new fixed manufacturing overhead allocation rate is computed
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each year by dividing the actual fixed manufacturing overhead cost by the
actual production. The following data is available for the first two years:
Year 1 Year 2
Sales (units) 1,000 1,200
Production (units) 1,400 1,000
Cost: (Rs.) (Rs.)
Variable manufacturing 700 500
Fixed manufacturing 700 700
Variable marketing and administration 1,000 1,200
Fixed marketing and administration 400 400
Compute:
1. Income statement based on:
(a) Absorption costing.
(b) Variable costing for each year.

2. Explain reasons for the differences in the answer.

Solution:
(Amount in Rs.)
Years
Particulars 1 2
A. Sales at Rs. 3 per unit 3,000 3,600
B. Cost of goods sold
Cost of production:
Variable manufacturing cost 700 500
Fixed manufacturing cost 700 700
Cost of production 1,400 1,200
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Add: Opening stock* – 400
Less: Closing stock* 400 240
Cost of Goods sold 1,000 1,360
C. Gross profit: (A) - (B)
IM 2,000 2,240
D. Marketing and administration cost:
Variable 1,000 1,200
Fixed 400 400
Total 1,400 1,600
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E. Profit: (C) - (D) 600 640
* Working notes:
Total manufacturing cost

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Cost of manufacturing per unit =

Total production
Rs. 1,400
Year 1: = Re. 1
1, 400 units
Rs. 1,200
Year 2: = Rs. 1.20
1, 000 units
Valuation of closing stock:

Year 1: 400 units at Re. 1 per unit = Rs. 400
Year 2: 200 units at Rs. 1.20 per unit = Rs. 240
[Closing stock of Year 1 becomes the opening stock for Year 2]
Fixed manufacturing overhead allocation rate:
Rs. 700
Year 1: = Re. 0.50 per unit
1, 400 units
Rs. 700
Year 2: = Re. 0.70 per unit
1, 000 units

Income statement (marginal costing):
(Amount in Rs.)
Years
Particulars 1 2
Sales (A) 3,000 3,600
Cost of goods sold
Cost of production:
Variable manufacturing cost 700 500
Add: Opening stock – 200
700 700
Less: Closing stock 200 100
Cost of goods sold (B) 500 600
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Gross marginal contribution: (A) – (B) = (C) 2,500 3,000
Less: Fixed manufacturing cost 700 700
Variable marketing and administrative cost 1,000 1,200
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Fixed marketing and administrative cost 400 400
Total (D) 2,100 2,300
Profit: (C) – (D) 400 700
Working notes:
Rs. 1,20,000 (opening stock) + Rs. 25,71,000
=
4, 000 units + 89, 000 units
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= Rate Rs. 28.94 × 5, 000 = Rs. 1,44,677 (approx.)
6.4 SUMMARY
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This chapter describes the concepts and practical application of absorp-

tion and marginal costing approaches. Marginal costing may be defined
as the technique of presenting cost data wherein variable costs and
fixed costs are shown separately for managerial decision-making. CIMA,
London, defines marginal costing as “the ascertainment of marginal
costs and of the effect on profit of changes in volume or type of output
by differentiating between fixed costs and variable costs.” Only variable
costs are charged to cost units (product or inventory), whereas fixed cost
for the period is written-off against the profit of the period. Hence, mar-
ginal costing is also known as variable costing technique.
Absorption costing is a costing technique in which all manufacturing
costs (variable and fixed) are considered as costs of production. Fixed
overhead is treated as a product cost, not a period cost. All variable man-
ufacturing costs and fixed production overheads to manufacturing are
charged to the product. Other costs, such as administrative and sell-
ing and distribution overheads, are written-off against the profit of the
period in which they arise. Therefore, full cost of a product or stocks com-
prises the variable (direct) and fixed (indirect) cost of production. Hence,
absorption costing is also known as full costing.

Both the absorption and marginal costing have their own significance. As
we have discussed, absorption costing is accepted technique for recognizing
income under accounting principles and also applicable under accounting
laws and practices. Absorption costing follows the principle of recognizing
costs and revenues on accrual basis. It is also accepted as full-cost approach
as both fixed and variable costs are considered in the production cost. It also
helps in taking pricing decisions based on cost plus approach. Moreover,
firms are required to follow this approach as mandatory requirement. It is
also known as direct cost approach. On the other hand, marginal costing
has many advantages while taking various managerial decisions. It helps
the firm to assess the income of a product in a more realistic manner. The
decisions are based on contribution approach, which also facilitates other
business decisions like standard costing decisions, budgeting, contribution
analysis, etc. Therefore, firms follow both the approaches in practice.
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1. Marginal cost: Change in the total cost on account of change in one KEY WORDS
additional unit of production.
2. Marginal costing: A concept of recognizing income based on variable
production cost.
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3. Absorption costing: An approach which considers both fixed and
variable costs while considering production cost.
4. Contribution: Sales revenue – Variable cost.
5. Profit: Contribution – Total fixed cost.
6. Fixed overhead absorption rate: Total fixed cost/Normal capacity of
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production.
7. Gross margin: Total sales revenue – Cost of goods sold.
8. Net margin: Gross margin – Adjustment for under/over absorption.
9. Under absorption: When fixed cost in production is adjusted lesser
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than the actual fixed cost.

10. Over absorption: When fixed cost in production is adjusted more
than the actual fixed cost.
11. Closing inventory: The value of finished stock carried over to the
next period in balance sheet.

1. Differentiate between marginal cost and marginal costing with suitable
examples.
2. Explain the concepts of absorption and marginal costing with suitable
example.
3. What are the practical applications of marginal costing in a business firm?
4. Describe the limitations of marginal costing.
5. What are the advantages and limitations of absorption costing?
6. What is the significance of absorption costing from the point of view of
accounting standards?

7. Prepare a statement of income under the marginal and absorption

costing taking an appropriate example.
8. How will you analyze the reasons of difference in income under
absorption and marginal costing approaches?
9. Explain the concept of over absorption and under absorption while
allocating fixed overheads. How will you make the adjustment in gross
margin?
10. Describe the concept of fixed overhead absorption rate. Explain
through a suitable example.
6.6 ANSWER KEY
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Marginal costing 1. a. Prime Cost plus all variable overheads
2. a. Marginal cost
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4. a. A and B
5. c. Total marginal cost is deduced from
sales revenue
6. d. A, B, C, and D
Absorption costing 7. c. Both (a) and (b)
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8. c. Both (a) and (b)

9. a. Profit
10. a. Individual concern
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SUGGESTED BOOKS
Banerjee B. (2015). Fundamentals of Financial Management. PHI
Learning Private Limited; Second edition.
Ramanathan S. (2014). Accounting for Management: A Basic Text in
Financial and Management Accounting. Oxford University Press.
E-REFERENCES
Walther, L.M., Skousen, C.J. (2019). Managerial and Cost Accounting.
https://library.ku.ac.ke/wp-content/downloads/2011/08/Bookboon/
Accounting/managerial-and-cost-accounting.pdf
The Institute of Company Secretaries of India (2019). Cost and Management
Accounting, Module 1, Paper 2. https://www.icsi.edu/media/webmodules/
publications/FULL_BOOK_PP-CMA-2017-JULY_4.pdf

C H A
7 P T E R
PROCESS COSTING AND

JOINT COSTING
CONTENTS
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7.1 Introduction
7.2 Features of Process Costing
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7.3 Difference Between Process
and Job Costing
7.4 Preparation of Process Account
7.5 Process Accounts with Scrap
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7.6 Normal Loss, Abnormal Loss and Abnormal Gain

7.6.1 Normal Loss
7.6.2 Abnormal Loss
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7.6.3 Abnormal Gain

Activity
7.7 Joint Products and By-Products
7.8 Difference Between Joint Product and By-Product
Activity
7.9 Joint Costs
7.10 Methods of Costing of Joint Products
7.10.1 Average Cost Method
7.10.2 Physical Quantity Method
7.10.3 Survey Method
7.10.4 Sales Revenue Method
Activity

7.11 Summary
7.13 Answer Key
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IM
M
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Process Costing and Joint Costing 169
PALOMI SUGAR COMPANY LTD.
This case study discusses a field study of Palomi Sugar Company

Limited. The main motivation for the study was to observe, discuss and
learn about Palomi’s activity-based costing system in order to reflect
upon some fundamental issues regarding costing and pricing.
This case study describes:
1. The physical process of sugar refining.
2. The basic nature and principles of a
ctivity-based costing.
3. The accounting issues raised by Palomi’s operation, including
their application of activity-based costing and transfer pricing
considerations in their operation.
The sugar refining process
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Palomi’s operation is set up in two basic parts. The estate operation is
concerned with cultivating and harvesting the sugar cane and transfer-
ring it to the mill; the mill operation then takes the raw sugar cane and
IM
processes it into brown sugar. (Making white sugar involves further pro-
cessing which the Palomi mill is not equipped to do at this time.)
The estate’s harvesting cycle begins roughly around 1 May each year and
ends roughly in November or December. (The company’s fiscal year also
coincides with its physical operations.) Harvesting the cane involves two
basic steps. First, the standing fields of sugar cane are burned. Burning
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removes the leaves from the standing cane and facilitates the harvesting
process. Without the process of burning the fields, the cane would have to be
harvested with its leaves intact; the leaves would then have to be removed
during the milling process. Further, burning the fields heats up the sucrose
inside the cane, making it easier to work with. In addition, burning the
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fields drives away the native snakes, making it safer for the workers to cut
the cane. Eventually, environmental laws in some countries may prohibit
burning the fields prior to harvest; at that time, Palomi and other sugar pro-
cessing plants will have to revise their harvesting and milling procedures.
After burning the fields, the sugar cane is harvested. Migrant workers
are engaged each year to cut down the cane by hand. Workers are paid
a fixed daily salary with the possibility of earning incentive pay for cut-
ting more than their daily quota. Harvesting the cane is a very labor-
intensive process, making it well suited to the developing economies like
India, where labor resources are plentiful but machinery is not.
The cut cane is transported to Palomi’s mill. On arrival at the mill, the
cut cane is crushed to extract the liquid from its core. (The crushed cane
can then be burned, producing the by-product bagasse, which is used to
fuel the mill’s machinery.) The liquid is heated, causing the sucrose to
fall to the bottom where it can be collected for further processing. At this
point, the sucrose itself is dark and thick, resembling molasses (indeed,
molasses is the other by-product of the process). Chemicals are added to
the sucrose to cause crystallization into the brown sugar that is the mill’s
principal product.

With good soil, sugar cane is a perennial; that is, the cane will grow back
every year without re-planting. However, because the Palomi estates
have poor soil, the cane must be re-planted approximately every five
years. A specially grown seed cane is used to re-plant the fields on a
rotating basis. Palomi produces about one-third of Uttar Pradesh’s total
sugar output annually (Uttar Pradesh’s total annual sugar output is about
4,50,000 tons). Approximately one-third of the state’s total output is used
internally, with the remaining two-thirds being sold on to other states.
Activity-based costing systems
Costs in most manufacturing operations can be divided into three cat-
egories: materials, labor and overhead. Materials, sometimes referred
to as direct materials, are the major raw inputs that go into producing
a product or service for sale. For example, Palomi’s main raw material
is sugar cane. Labor, sometimes referred to as direct labor, represents
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the salaries/wages and related costs of employing the workers directly
involved with physical production. In Palomi’s case, the wages paid to
the workers who harvest the cane is an example of a direct labor cost.
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Through time-and-motion studies and related physical measures of a
firm’s overall operation, it is a relatively simple matter to link direct
materials and direct labor costs to the final product. The third cate-
gory of cost, factory overhead, is more problematic. Factory overhead,
sometimes referred to as factory burden, comprises all the related
costs of producing a product or service. For example, Palomi would
incur the following overhead costs in its operation: equipment depre-
ciation, processing chemicals, water, power for the factory and super-
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visor salaries. Unlike direct materials and direct labor costs, which can
be linked to the product by direct attribution, overhead costs must be
linked through a process of allocation. Naturally, that allocation must
be done in some consistent, rational and logical manner. Activity-
based costing is one way to allocate overhead to a product or service.
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Activity-based costing begins with establishing cost pools. Cost pools

are groups of related costs in a production operation. Some of the cost
pools employed at Palomi include: land preparation, fertilizing, weed
control and irrigating. Costs are assigned to a cost pool on the basis of
a common cost driver.
In activity-based costing, a cost driver is anything which causes
(drives) a cost in the production operation. For example, in a typ-
ical company, purchasing costs might be a cost pool, with number
of purchase orders processed being the cost driver. Once the cost
pools and cost drivers are established, accountants can determine
the amount of cost absorbed by each unit of the cost driver. For exam-
ple, if the total cost of a purchasing department during a period was
Rs. 10,00,000 and the department processed 5,000 purchase orders,
the cost per purchase order would be Rs. 200. To tie purchasing costs
to the product or service, then, accountants (working with production
staff) must determine how many purchase orders were processed to
move a certain group of goods through the factory. If a given lot of
goods required five purchase orders, the accounting system would
allocate Rs. 100 in purchasing costs to that order. A similar process

would be performed for each cost pool, thus building up the overhead
costs associated with a given group of goods.
Accounting issues at Palomi
Palomi’s operation raises at least three accounting issues:
1. Application of activity-based costing.
2. Product pricing and cost control.
3. Transfer pricing.
Activity-based costing
In general, companies establish activity-based costing systems to gain
a more accurate perception of their product’s cost. Knowing a prod-
uct’s cost, naturally, is key to setting its price in the market. However, in
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Palomi’s case, the motivation for establishing an activity-based costing
system was different.
As previously noted, cultivating, harvesting and processing sugar is a
labor-intensive operation. In other words, most of Palomi’s costs are
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labor costs (as opposed to materials or overhead costs). Prior to the
introduction of activity-based costing in the harvesting operation, all
of Palomi’s harvesting labor costs were aggregated in a single general
ledger account. Thus, managers had a difficult time determining which
parts of the cultivating operation were more expensive and which were
relatively less expensive. Palomi introduced activity-based costing to
help managers of the cultivating operation control their costs more effec-
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tively and efficiently. (Note, however, that activity-based costing has only
been applied to cultivating the sugar cane. The harvesting and milling
operations have not adopted activity-based costing, nor have they asked
for it to be introduced.)
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For external accounting purposes, salaries and wages are still reported
as a single-line item on the profit and loss statement. However, for inter-
nal accounting purposes, salary and wage costs from cultivating the
sugar cane are allocated to one of several cost pools: land preparation,
planting, post-harvest management, fertilizing, weed control, pest and
disease control, ripening, irrigating, canal construction, drainage sub-
surface, or drainage maintenance. Those cost pools are reported clearly
on Palomi’s internal profit and loss statements, allowing managers to
see clearly how much cost was incurred in each area. Costs are allocated
to the pools on the basis of labor hours.
Product pricing and cost control
As mentioned earlier, Palomi introduced activity-based costing to give
managers better control over their costs. Cost control is critical in
Palomi’s operation, as they have very little control over product pric-
ing in their markets. Sugar is traded on the world commodity markets,
much like soybeans and pork bellies. The world market, then, deter-
mines the price based on supply and demand factors. Any individual
company, therefore, cannot influence the world price of sugar in any
significant way.

Palomi operates in the western part of the state of Uttar Pradesh in

India. As a developing nation, India receives a special concession when
it sells sugar to external markets. Specifically, Indian sugar is sold on the
world market at three times the established world price for sugar; that
is, if sugar is sold on the world market at $5 per ton, Indian sugar is sold
for $15 per ton.
One of the main factors influencing the world price for sugar is its supply
in the world market. Each sugar producing company in India receives a
quota (allowance) for sugar production each year. For production up to
the quota, Palomi receives a fixed price. For production over the quota,
Palomi receives a price which is always less than the “quota” price. The
two types of revenue are reported separately on Palomi’s internal profit
and loss statement as “unsegregated” (amounts up to the quota) and
“segregated” (amounts over the quota).
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Transfer pricing
Palomi’s operation also raises some interesting transfer pricing
issues. Basically, transfer pricing is concerned with setting prices
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for purely internal transactions where market rules and constraints
do not apply. Transfer pricing was pioneered by the U.S. automobile
manufacturer General Motors when its divisions had to do business
with one another. Normal laws of supply and demand do not apply to
purely internal transactions, and much has been written about the
options for establishing transfer prices and the consequences of the
various options.
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Palomi confronts transfer pricing issues for two of its major inputs:
sugar cane and water. Palomi does not actually own most of the fields
where its sugar cane is grown. Rather, the fields are owned by private
individuals, who agree to sell all their output to Palomi at a fixed price.
In return, Palomi assists the individual farmers with crop maintenance.
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Since the farmers have no option but to sell their output to Palomi, and
since Palomi must buy all the farmers’ output, a transfer price must be
set which satisfies both parties. In this particular case, the transfer pric-
ing problem is somewhat alleviated by Palomi’s participation in the cul-
tivation and harvesting of the grain.
Water is one of the principal indirect materials used in processing
sugar. All of Palomi’s water comes from IRRIGIS, a firm which has
many common shareholders with Palomi. Thus, IRRIGIS has a lot of
control over the price Palomi pays for water. With no external market
forces governing the price, IRRIGIS could potentially raise the price
of water to an exorbitant level, creating severe cost control problems
for Palomi’s overall operation. In this case, however, the strong rela-
tionship between the two firms alleviates the potential problem, and
IRRIGIS basically passes on its direct costs to Palomi in the transfer
price.

QUESTIONS
1. Discuss the accounting and operating issues of Palomi Sugar

Company which arose in the case.
2. Do you agree that the company has confronted and solved
unique issues in product costing and pricing through the
application of activity-based costing and transfer pricing
concepts. Support your answer with relevant details.
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LEARNING OBJECTIVES

>> Concept, importance and uses of process costing system.
>> Difference between process and job costing systems.
>> Concept of equivalent units in process cost and its computation.
>> Preparation of production cost report for process costing system.
>> Concept and treatment of normal loss, abnormal loss and
abnormal gain.
>> Concept of joint costs and its measurement.
>> Difference between joint product and by-product.
>> Basis of joint cost allocation to individual products.
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7.1 INTRODUCTION
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We have already discussed in Chapter 5 about the costing of a particular job
or batch or contract treating them separately as a unit of costing system.
Process costing is another significant costing system to measure, monitor
and control the costs under different processes as in real life the product
passes through different processes before taking a final shape. Each process
has different resources as raw materials, labor and other inputs to give a cer-
tain shape to the product during the particular process. The semi-finished
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product of the process is passed on as raw materials to another process for
further value addition. This process goes on till the product becomes a fin-
ished product. To understand it further, let us assume a product “R,” which
is produced by three different processes – A, B and C. In Process A, certain
inputs in the form of raw materials are introduced to undertake some pro-
cess that may require labor and other overheads. In this process, Product R
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takes some shape that is called semi-finished product. The product in this
form is transferred to the next process called Process B. In this process,
there is further value addition to the product using certain extra raw mate-
rials and labor work. However, Product R is not a final and finished product.
The semi-finished product from Process B is transferred to Process C, and
there is further process to give final shape to the product by using certain
QUICK TIP extra materials and other inputs. Finally, when the product comes out from
In Process Costing: Product C, it is called finished product.
• Final
product is the end result.
• Each process is responsible 7.2 FEATURES OF PROCESS COSTING
to manage cost control.
• Treatment of wastage and Following are the features of process costing:
abnormal loss is accounted 1. The work process is segregated into different processes and each
under the particular process. process becomes the cost center responsible for maintaining the cost
• Semi-finished output of one within the pre-determined standards.
process becomes the input
for the next process. 2. The final product is the result of continuous series of processes.
• The product in the last
3. All the processes are pre-arranged and specific to give a certain shape
process becomes final goods.
to the product.

4. The firm is required to maintain separate account for each process and
all the related costs, direct and indirect, are allocated to that process.
5. The treatment of wastage, abnormal loss/gain, scrap value, etc., are
accounted in the concerned process.
6. The semi-finished output of one process becomes the input for the next
process in sequence.
7. During the process, different products may be produced at one or
multi-stages simultaneously.
8. While output of one process is transferred to the next process, the cost
of the process is also transferred. Thus, output cost of one process
becomes the input cost of the next process.
9. The adjustments of normal loss, abnormal loss and abnormal gain are
done under different processes depending on the nature of loss or gain.
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10. As the work continues under each process, there is always work-in-
progress (WIP) at the end of the process which is carried over to the
next process. The costing is done on the basis of equalization concept.
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7.3 DIFFERENCE BETWEEN PROCESS
AND JOB COSTING
In Chapter 5, we have understood the concepts of job costing in detail, where
we found job as unit costing. The process is a continued running activity in a
firm. We can differentiate between the two as given in Table 7.1.
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TABLE 7.1 DIFFERENCE BETWEEN JOB COSTING

AND PROCESS COSTING
Components/
Basis Job Costing Process Costing
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Production Each job has separate Production is in continuous

process for cost determination. flow and homogenous.
specific jobs
Entity Each job is separate and Costs are compiled for each
independent of others. process and cumulative for
production in a given period
of time.
Per unit costs The cost of a job is There is no product
divided by the number of manufactured on a continuous
units in the job to arrive flow.
at the unit cost.
Measurement Costs are measured when All individual entity costs of
of cost a job is completed. each process are divided by the
total production for the process
to calculate cost per unit.
Cost transfer Cost is not transferred Costs are arrived at the end of
from one job to another. cost period.
(Continued)

TABLE 7.1 DIFFERENCE BETWEEN JOB COSTING

AND PROCESS COSTING—CONTINUED
Components/
Basis Job Costing Process Costing
Work-in- There may or may not Costs are transferred from
progress be WIP at the beginning one process to another as
(WIP) or end of the accounting the product passes from one
period. process to another.
Control Adequate control on There has to be some WIP at
cost is difficult, as each the beginning as well as at the
product unit is different end of the accounting period
and the production is not as the process is ongoing.
continuous.
Focus It is customer-specific. Adequate control is possible, as
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the production is standardized
and it is stable also.
We first compute the cost per unit by aggregating all costs for the entire
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period, usually a month, for each process and then divide accumulated costs
by the number of units produced (tons, pounds, gallons or feet) in that pro-
cess or department. In job costing, the costing is measured for the job as a
whole first. Despite the differences, there are following similarities between
the two.
1. The goal of job and process costing systems is the same, that is, to
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determine the cost of products.
2. The cost flows under both the costing systems are also similar. There
are separate records in production account for raw materials inven
tory, labor and overhead. Thereafter, the costs are transferred to a
work-in-process inventory account.
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3. In both the cases, overheads rates are pre-determined for absorption of

overhead expenditures.
SELF-ASSESSMENT 1. If a firm obtains two salable products from the refining of one ore,
QUESTIONS the refining process should be accounted for as
a. Mixed process b. Joint process
c. Extractive process d. Reduction process
2. Joint costs are allocated to joint products to
a. Obtain a cost per unit for financial statement purposes
b. Provide accurate management information on production costs
of each type of product.
c. Compute variances from expected costs for each joint product
d. Undertake high-low analysis of the firm
3. Joint cost allocation is useful for
a. Decision making b. Product costing
c. Cost control d. Performance evaluation

4. Which of the following components of production can be allocated

as joint costs if a single manufacturing process produces several
products?
a. Direct material and direct labor only
b. Direct material, direct labor, and overhead
c. Overhead and direct material only
d. Direct labor and overhead only
5. Joint costs are most frequently allocated based upon relative
a. Conversion Cost b. Profitability
c. Sales value d. Prime cost
7.4 PREPARATION OF PROCESS ACCOUNT
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The process accounts are prepared in a format so as to ascertain the total
costs including direct and indirect expenses to arrive at the fair cost of each
process and finally the total costs and per unit cost of a product. The gener-
ally accepted format is described as follows:
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Flow of Cost
Dr. Process 1 Account Cr.

A/c Head Rs. A/c Head Rs.
To direct materials XX By normal loss (scrap value) XX
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To direct labor XX By abnormal loss (if any) XX

To direct expenses XX By transfer to next process XX
To factory overheads XX
To abnormal gain (if any)
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XX XX

To carry forward from Process 1 XX By normal loss (scrap value) XX
To direct materials XX By abnormal loss (if any) XX
To direct wages XX By sale of by-product (if any) XX
To direct expenses By transfer to next process
To factory overhead XX
To abnormal gain (if any) XX XX

To transfer from Process 2 XX By normal loss (scrap value) XX
To direct materials XX By abnormal loss (if any) XX
(Continued)


To direct labor XX By transfer to finished stock XX
To direct expenses
To factory overhead XX
To abnormal gain (if any)
XX XX
Let us understand some of the practical situations of process costing

measurement.
7.5 PROCESS ACCOUNTS WITH SCRAP
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As we have already discussed that there is scrap which is a natural element
in each process as the output is often lesser than the inputs. The natural loss
may occur on account of evaporation, leakages, normal wastage in the pro-
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cess, etc. The scrap is sold as wastage and thus revenue is generated for the
firm. This revenue is credited to the process account to assess the fair cost of
the process. Let us have a look at the following example.
EXAMPLE 7.1
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A product of Ranbaxy passes through three distinct processes – 1, 2 and 3.
It is bound that wastage in these processes is 2%, 5% and 10%, respectively.
The percentage of wastage is computed on the basis of the number of units
entering the process. The wastage has a scrap value. The wastage of Pro-
cesses 1 and 2 is sold at Rs. 5 per 100 units and that of Process 3 at Rs. 20
per 100 units. The following information is obtained.
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Process
(Amount in Rs.)
1 2 3
Material consumed 4,000 2,000 1,000
Direct labor 6,000 4,000 3,000
Manufacturing expenses 1,000 1,000 1,500
A total of 20,000 units have been issued to Process 1 at a cost of Rs. 8,000.
The output of Processes 1, 2 and 3 is 19,500, 18,800 and 16,000 units,
respectively. There is no stock or WIP in any process. Prepare the process
account.

Solution:
Process 1 Account
Amount Amount
Particulars Units (Rs.) Particulars Units (Rs.)
To units 20,000 8,000 By normal loss 400 20
introduced
To material 4,000 By abnormal 100 97
consumed loss
To direct labor 6,000
To manufacturing 1,000 By Process C - 19,500 18,883
expenses output t/d
20,000 19,000 20,000 19,000
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Computation of normal cost per unit of normal output:
Total cost - Scrap value of normal loss

Cost per unit =
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Input quantity - Normal loss quantity
19, 000 - 20 18, 980
= =
20, 000 - 400 19, 600
= Re.. 0.968 per unit (approx.)
Process 2 Account
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Amount Amount
To Process 1 - 19,500 18,883 By normal 975 49
output t/d from loss
Process 1
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To material 2,000 By Process 3 - 18,800 26,218

consumed output t/d
To manufacturing 1,000
expenses
To abnormal gain 275 384
19,775 26,267 19,775 26,267
Calculation of normal cost per unit of normal output:
Total cost - Scrap value of normal loss

=
25, 883 - 49 25, 834
= =
19,500 - 975 18,525
= Rs. 1.395 per unit (approx.)

Process 3 Account
Amount Amount
To Process 2 - 18,800 26,218 By normal loss 1,880 376
output t/d from
Process 2
To material 1,000 By abnormal 920 1,704
consumed loss
By finished 16,000 29,638
stock account -
output t/d
To manufacturing 1,500
expenses
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18,800 31,718 18,880 31,718
Calculation of normal cost per unit of normal output:

IM 31,718 - 376 31,342
= =
18, 800 - 1, 880 16, 920
= Rs. 1.85 per unit (approx .)
Remember: Sometimes, it may so happen that the normal loss is lesser than
the standard loss and that is known as abnormal gain. Since the production
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units are increased, it adds to the revenue of the firm. However, the scrap
value should be shown in the process account according to the standard loss.
This is on the assumption that had the process not performed well, the normal
loss could have happened and the process cost could have come down to that
extent. Further, the increased units, because of efficiency in the process, will
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provide additional revenue to the firm. Therefore, the particular process

should get advantage of scrap revenue as if in the normal course.
SELF-ASSESSMENT 6. Total costs incurred in a production process is divided by total

QUESTIONS number of output units if we want to calculate
a. cost of indirect labor b. cost of direct labor
c. cost of direct material d. unit costs
7. If opening WIP equivalent units are 2500 units, work completed
in current period equivalent units are 3800 units and closing WIP
equivalent units are 5000, in that case, complete equivalent units in
current period will be
a. 1800 units b. 1500 units
c. 1300 units d. 1400 units
8. A unit cost calculated in costing system by assigning total costs
incurred to many similar units is categorized as
a. Accounting period costing system
b. Process costing system

c. Job costing system

9. The very objective of process costing system is to
a. summarize flow of output
b. compute output in units
c. arrive at total costs
d. calculate cost for each equivalent unit
10. The last step in process costing system is to
a. allocate separable costs
b. calculate joint costs
c. measurement of gross margin
d. find out total cost of completed units
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7.6 NORMAL LOSS, ABNORMAL LOSS
AND ABNORMAL GAIN
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Let us now understand these terms and their significance in process costing.
NOTE
We have also explained in the following paragraphs the effects of normal loss, In Process Costing:
abnormal loss and abnormal gain on the process cost and their treatment to • Each division is a stage of
the process account. production.
• Production is carried out
7.6.1 NORMAL LOSS continuously.
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Normal loss occurs under normal circumstances, and it is an inbuilt loss. It • The production may result in
cannot be avoided by management decisions. It happens in natural course joint and byproducts.
of production and is also known as a non-controllable loss; for example, • Normal and abnormal losses
loss due to evaporation or shrinkage, etc. This loss is calculated as a certain occurred at different stages are
percentage of the input (on units introduced) in the respective process. accounted for in the unit cost.
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The percentage of the normal loss is determined as per standards fixed in

advance on the basis of past manufacturing process, industry trend and the
kind of raw material used.
Normal loss may have a scrap value. The cost of normal loss after deducting
scrap value, if any, is to be borne by the output of the respective process on
the fundamental that loss of bad units is borne by good units. For this pur-
pose, a separate normal loss account is opened in the cost records. This is to
measure the actual cost of the process. Suppose 1,000 units are introduced in
the process and normal loss is 5%. The 50 units that are scrap will be sold as
wastage and provide revenue to the process. This will bring down the cost of
the process to the extent of scrap value.
7.6.2 ABNORMAL LOSS

The loss that occurs due to abnormal circumstances such as labor strike,
delay tactics of workers, certain breakdown of machinery, power failure and
accidents is abnormal loss. Abnormal loss can be controlled and avoided by
establishing proper precautionary measures. Abnormal loss occurs, in addi-
tion to normal loss, when actual output is lesser than the expected normal
output. It is determined as follows:

Components Units
Input 1000
Less: Normal loss 10%
Expected output 900
Less: Actual output 890
Abnormal loss (if actual output is below the 10
expected normal output)
7.6.3 ABNORMAL GAIN

Abnormal gain occurs when actual output is more than the expected normal
output. For example, if units introduced are 1,000 and expected normal loss
is 5%, the normal output from the inputs should be 950. But actual output is
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970. In this situation, 20 units (actual output – normal output) are abnormal
gain. This happens on account of efficiencies in the process due to a vari-
ety of reasons. Abnormal gain units increase the actual units of production
and thereby provide additional revenue to the firm. Therefore, the value of
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abnormal units is shown as cost to the process and debited to the respective
process account. The value of abnormal gain is calculated as follows:
otal cost of process - Scrap value of normal loss/normal

Abnormal gain = T
output × Number of abnormal gain units
EXAMPLE 7.2
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Product R is obtained after passing through three different processes. The

following data is obtained from the records for the month ending May 30, 2014:
Process (Amount in Rs.)

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Total I II III
Direct material 7,542 2,600 1,980 2,962
Direct wages 9,000 2,000 3,000 4,000
Production overhead 9,000
A total of 1,000 units at Rs. 3 each were introduced to Process I. There was no
stock of materials or WIP at the beginning or end of the period. The output of
each process passes direct to the next process and at the end of Process III to
finished stock value.
Production overhead is recovered on 100% of direct wages. The following
additional data is obtained:
Output During Normal Loss Scrap per

Process the Month to Input (%) Unit (Rs.)
I 950 5 2
II 840 10 4
III 750 15 5

Solution:
Process I Account
Amount Amount
Unit Rate (Rs.) Unit Rate (Rs.)
To units 1,000 3 3,000 By normal 50 2 100
introduced loss 5% of
1,000
To direct 2,600
material
To direct 2,000
wages
To By output 950 10 9,500
production transfer to
overhead Process II
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100% of 2,000
wages
1,000 9,600 1,000 9,600
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Total cost - Value of normal loss
Cost per unit =
9, 600 - 100 9,500
= = = Rs. 10
1, 000 - 50 950
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Process II Account
Amount Amount
To output 950 10 9,500 By 95 4 380
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from normal
Process I loss 10%
introduced of 950
To direct 1,980
material
To direct 3,000
wages
To 3,000 By 15 20 300
production abnormal
overhead loss
(balance
figure)
By output 840 20 16,800
transfer
Process
III
950 17,480 950 17,480

17, 480 - 380 17,100

Cost per unit = = = Rs. 20
940 - 95 855
We can apply this rate to:
Process III Account
Amount Amount
To output 840 20 16,800 By normal 126 5 630
from loss 15% of
Process II 840
To direct 2,962
material
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To direct 4,000
wages
To 4,000 By
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production finished 750 38 28,500
overhead stock
840 27,762
To abnormal 36 38 1,368
gain
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876 29,130 876 29,130
27,762 - 630 27,132

Cost per unit = = = Rs. 38
840 - 126 714
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The value of finished stock and abnormal gain should be calculated at this
rate.
Abnormal Loss Account
Amount Amount
Units Rate (Rs.) Units Rate (Rs.)
To 15 20 300 By cash or 15 4 60
Process II debtors (sale
of scrap)
By costing
profit and
loss a/c
(abnormal
loss)
15 300 15 300

Abnormal Gain Account
Amount Amount
To normal 36 5 180 By Process 36 38 1,368
loss III
To costing 36 1,188
profit and loss
a/c (abnormal
gain)
36 1,368 36 1,368
Normal Loss Account
Amount Amount
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To 50 2 100 By cash
Process I
To 95 4 380
IM Debtors 50 2 100
Process II
To 126 5 630 Debtors 95 4 380
Process III
By abnormal 36 5 180
gain
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By cash/ 90 5 450
debtors
271 1,110 271 1,110
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Suppose 10,000 kg of an input was consigned for storage in the stores of ACTIVITY 1
a manufacturing firm. The material input has features where wastage is
inbuilt. It is expected that normal loss will be 10%. The input was pur-
chased @Rs. 30 per kg and the freight paid was Rs. 60,000. When material
was actually brought to the manufacturing process, it was only 8,800 kg.
Questions
1. Calculate normal loss.
2. What should be the normal inputs for use?
3. What is the quantity of abnormal loss?
4. Calculate per kg cost of abnormal loss.
5. What would be the total value of abnormal loss?
6. If the scrap of normal and abnormal loss is sold at Rs. 1 per kg, what
will be the amount that will be charged to Profit & Loss Account as
Abnormal Loss?
7. What is the amount that will be shown in the credit side of the
process account as Normal loss?

7.7 JOINT PRODUCTS AND BY-PRODUCTS

Two or more products obtained from a single and common process involv-
ing common raw materials, labor and overheads are called joint prod-
ucts. All such products have their own identity and relative sales value.
The examples of joint products may include petrol, diesel, spirit, kero-
sene, fuel oil and lubricant oil. All are produced out of crude petroleum.
Therefore are called joint products. The joint products derived from a
common process essentially differ from each other in their appearance
and physical outlook.
Generally, joint products arise from the same process or at the end of a series
of processes. In that case, they often require further processing. Since all
products have their own identity and significance, no single product can be
treated as a major product.
At the same time, there is another concept of by-product being obtained in a
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firm. A by-product is usually a secondary product obtained during the course
of production process of the main product. This product has very little signif-
icance as compared to the main product. However, this by-product has sale-
able value and can be used for different purposes as raw materials. The term
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“by-product” is generally used for multiple products that have very insig-
nificant sales value as compared to the main product. We can differentiate
between joint and by-products as follows.
7.8 DIFFERENCE BETWEEN JOINT PRODUCT

AND BY-PRODUCT
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The joint product and by-product can be differentiated in the following

manner:
1. Joint products are identified at the end of the process, whereas by-
products are obtained during the process of main product.
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2. Joint products are well designed, whereas by-products are inbuilt in

the process.
3. Joint products have almost same value, whereas by-products have
much lesser value.
4. The cost of by-products is borne by the main product, whereas cost of
joint products is allocated among all products.
5. There is very little scope for further process in case of by-products.
Joint products are further processed.
6. No additional inputs in case of by-products but additional inputs are
required for further processing of joint products.
7. Final products are sold as independent products in case of joint
products, whereas by-products do not have their own identity.
8. By-products if further processed will have economies of scope which is
not the case with joint products.

Identify from the following products as they are Raw Materials, Main ACTIVITY 2
Product, or Byproducts:
1. Coal 2. Coke 3. Crude Tar 4. Steel 5. Iron Ore

6. Carbon 7. Crude Oil 8. Diesel 9. Jet Fuel 10. Sugarcane
Monoxide
7.9 JOINT COSTS

The common costs associated with the combined process of production are
called joint costs. The common costs are incurred up to the split-off point.
A point where the joint products are split-off into individual products is called
split-off point. Obviously, the common costs need to be allocated to individual
products to have a fair assessment of cost to an individual product. However,
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the allocation of joint costs to the individual products is an issue of much con-
cern to individual firms as there is no uniform policy for allocation of such
costs. The individual firms adopt joint cost allocation policy as convenient to
them, depending on their suitability.
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7.10 METHODS OF COSTING OF
JOINT PRODUCTS
The process of joint cost allocation involves assigning proportionate cost to
individual products which is known as common cost and incurred while prod-
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ucts were produced jointly. If this is not done, the concerning issue will be how
to allocate the common costs. Not only this, we cannot determine the reasonable
price of a product. It will have an impact on the valuation of inventory, profit
forecasting and unreasonable costing and pricing of other products. This issue
should be managed in a proper way to overcome such problems. Therefore, the
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prime concern in respect of joint products remains adequate and proper alloca-
tion of the joint costs. In practice, there are different methods followed to allo-
cate the joint costs. We discuss some of them in the following sections.
7.10.1 AVERAGE COST METHOD

In this method the total costs are assessed and distributed in total number units.
This gives an average unit cost with particular net profit for the total operations.
However, this method could be used where processes are common and insepa-
rable for the joint products. Also the products so received can be expressed in a
common unit, say kilograms, numbers etc. Thus all joint products have the same
unit cost. The problem in this case may occur while fixing price based on the cost
of various products where products may be of different variety, grades or quality.
Since the costing system is common, the unit price will be uniform which will
have practical implications. In addition to that if the final products are so that it
cannot be expressed in common units, this method becomes inapplicable.
7.10.2 PHYSICAL QUANTITY METHOD

It is also known as physical unit method. In this method, a physical base,
such as raw material, weight and volume, is applied in allocating common

costs incurred before split-off point to joint products. We can consider an

example of crude oil that has three common products, A, B and C, where
proportion in production is 30%, 40% and 30%, respectively. While allocating
joint costs, we will allocate the total joint costs in the same proportion. After
split-off points, each product may have separate costs.
However in practice, there may be products with different measurements of
units and in that case, it will not be possible to allocate joint costs under this
method. Also, this method assumes that each joint product is equally valu-
able in terms of price and identity. The situation may not be true in all the
cases. Therefore, this has a limitation to an extent.
7.10.3 SURVEY METHOD

This method is based on market survey of relative factors. We consider all
the relative and important factors, like quantity, prevailing selling price,
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technical aspects, marketing process and other factors that affect costing
of a product. This is done through an extensive market survey. We decide
a percentage weight to be given to different products according to their
utility and importance. The common costs are allocated based on those
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pre-decided weights. If a firm feels that a particular product has more
utility in generating its revenue, a higher percentage of weight could be
considered. These weights are arbitrary and may have biasness. The firm
also has the liberty to alter weights to different products depending on
market trends from time to time. We cannot call this method as a ratio-
nal method as it has biasness and the firm may take arbitrary decision,
depending on its convenience.
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7.10.4 SALES REVENUE METHOD

This is one of the simplest methods where joint costs are allocated to differ-
ent products based on the proportion of sales revenue of each product in
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total sales revenue. This is also known as market value method as this is a
convenient approach.
SELF-ASSESSMENT 11. A method to calculate per equivalent unit cost of all production
QUESTIONS related work completed is known as
a. weighted average method
b. net present value method
c. Gross production method
12. If WIP inventory cost is Rs. 3,50,000 and suppose that total equivalent
units completed till date are 3500, what will be the weighted average
cost?
a. Rs. 10 b. Rs. 100
c. Rs. 1,000 d. Rs. 1,200

The net realizable value approach is normally used when the NRV is ACTIVITY 3
expected to be:
Insignificant Significant
(a) Yes Yes
(b) No Yes
(c) Yes No
(d) No No
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PROBLEM 7.1
In manufacturing of a product, there are three processes involved as A, B
and C.
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Process B receives units from Process A. Process B carries out work on the
units and transfers them to process C. The following data is available:
Opening WIP 200 units (25% complete) value at Rs. 5,000

800 units received from processes A valued at Rs. 8,600
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840 units were transferred to Process C closing WIP 160 units (50%
complete). The costs of the period were Rs. 33,160 and no units were
scrapped.
You are required to prepare the process account for Process B. Using the
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average cost method of valuation.

Solution:
Computation of Equivalent Units (Weighted Average Cost Method)
Equivalent Production
Materials Labor Overhead
Units Parti Units Comple Comple Comple
Input culars Output tion % Units tion % Units tion % Units
1,000 Completed 840 100 840 100 840 100 840
units
- Work in 160 50 80 50 80 50 80
progress
1,000 1,000 920 920 920

Process B A/c

To opening 200 5,000 By transfer to Process C 840 42,694
WIP (@ Rs. 50.826)
To Process A 800 8,600
To process - 33,160 By closing WIP 160 4,066
cost (@ Rs. 25.4125)
1,000 46,760 1,000 46,760
Average Cost of Completed Units (Rs.)

Cost of 200 opening WIP units 5,000
Cost of 800 units received from Process A 8,600
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Cost of the period 33,160
Total cost 46,760
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Equivalent units = 920
Average cost per completed units = Rs. 46,760/920 units = Rs. 50.826
PROBLEM 7.2
In a particular month 2,000 units were introduced in Process R. The
normal loss is estimated at 5% of input. At the end of the month, 1,400 units
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were produced and transferred to Process S, 460 were incomplete units

and 140 units were scrapped at the end of the process. The incomplete
units had the following degree of completion: materials 75%, labor 50%,
overheads 50%.
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Additional details of process R are as follows:
(Rs.)
Cost of 2,000 units introduced 58,000
Additional materials consumed 14,400
Direct labor 33,400
Allocated overheads 16,700
The scrapped units were sold at Rs. 10 per unit

Compute:
1. Statement of equivalent production
2. Statement of cost
3. Statement of evaluation
4. Process R account

Solution:
1. Statement of Equivalent Production
Equivalent Production
Labor and
Material Overhead
Degree of Degree of
Input Output Units Completion Units Completion Units
Units Normal loss 100
Introduced (5%)
2,000 Abnormal 40 100% 40 100% 40
loss
Completed 1,400 100% 1,400 100% 1,400
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and trans-
ferred to
Process Y
Closing 460 75% 345 50% 230
work-in-
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progress
2,000 2,000 1,785 1,670
2. Statement of Cost
Production (in Cost per
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Amount Equilibrium Unit
Elements of Cost (Rs.) Units) (Rs.)
Material - Cost of units 58,000
introduced
Additional materials 14,400
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72,400
Less: Scrap value (100 units @ Rs. 10) 1,000
71,400 1,785 40
Labor and overhead: Labor 33,400 1,670 20
Overhead 16,700 1,670 10
70
3. Statement of Evaluation
(Rs.)
Units transferred to Process S (1400 units @ Rs. 70) 98,000
(40 units @ Rs. 70) 2,800
Abnormal loss
Closing WIP
Material (345 units @ Rs. 40) = 13,800
Labor and overhead (230 units @ Rs. 30) = 6,900 20,700

4. Process R A/c
Amount Amount
To units 2,000 58,000 By transfer to 1400 98,000
introduced Process Y
To additional 14,400 By normal loss 100 1,000
materials
To labor 33,400 By abnormal loss 40 2,800
To overheads 16,700 By closing WIP 460 20,700
2,000 1,22,500 2,000 1,22,500
7.11 SUMMARY
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The concept of process costing has been defined in many ways. As per
the Chartered Institute of Management Accountants, process costing is
defined as “the costing method applicable where goods or services result
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from a sequence of continuous or repetitive operations or process.” In the
end, the objective is to arrive at the cumulative cost of a unit or product
during that particular period. This method is more suitable where prod-
ucts pass through different processes, such as units engaged in chemi-
cal work, textiles, paints, steels, glass, refineries, food processing, paper,
dairy products and all other products involving different processes for
finished products. If we look at some of the industries globally, Pepsi-
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Cola makes soft drinks, Exxon Mobil produces oil and Kellogg Company
produces breakfast cereals on a continuous basis over long periods. For
these kinds of products, companies do not have separate jobs. Instead,
production is an ongoing process for them.
When two or more products are obtained from a single and common
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process involving common raw materials, labor and overheads, they

are called joint products. All such products have their own identity and
relative sales value. The examples of joint products may include petrol,
diesel, spirit, kerosene, fuel oil and lubricant oil. All are produced out of
crude petroleum. Therefore, all are called joint products. The joint prod-
ucts derived from a common process essentially differ from each other
in their appearance and physical outlook.
The common costs associated with the combined process of production
are called joint costs. The common costs are incurred up to the split-
off point. A point where the joint products are split-off into individual
products is called split-off point. Obviously, the common costs need to be
allocated to individual products to have a fair assessment of cost to an
individual product. However, the allocation of joint costs to the individ-
ual products is an issue of much concern to individual firms as there is
no uniform policy for allocation of such costs. The individual firms adopt
joint cost allocation policy as convenient to them, depending on their
suitability. However, it is important to understand various joint cost allo-
cation methods and their significance on overall profits of the firm.

1. Process costing: Cost measurement for the particular process. KEY WORDS
2. Normal loss: Wastage occurred in the natural course.
3. Abnormal loss: Wastage occurred due to controllable reasons but
not in normal circumstances.
4. Abnormal gain: When loss of the process is lesser that the expected
loss.
5. Cumulative cost: Aggregate cost of all processes.
6. Scrap value: Revenue received from sale proceeds of wastage
occurred in process.
7. Finished goods: The final output of a product.
8. Joint cost: Common costs of products segregated after a particular
point.
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9. Split-off point: The point at which the products are segregated as
individual products.
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10. By-product: A secondary product being obtained from the main
product.

1. What is process costing? How is it different from job costing?
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2. Describe essential features of process costing.
3. Why is it important to maintain the records of costs under different
processes?
4. Describe the concept of normal loss, abnormal loss and abnormal gain.
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How do we calculate the value of abnormal gain or normal loss?

5. Describe the process of transferring abnormal loss or abnormal gain to
profit and loss account.
6. Explain the concept of equivalent units.
7. What is joint costing? Why do we need to allocate joint cost to individual
products?
8. Describe different methods of allocating joint costs to individual
products.
9. Differentiate between joint product and by-product.
10. Describe net realizable value (NRV) method of joint cost allocation
with a suitable example.

7.13 ANSWER KEY

Features of Process Costing 1. b. Joint process
2. a. Obtain a cost per unit for finan-
cial statement purposes
3. b. Product costing
Difference between Process 4. b. Direct material, direct labor,
and Job Costing and overhead
5. c. Sales value
Process Accounts with Scrap 6. d. unit costs
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7. c. 1300 units
8. b. Process costing system
9. a. summarize flow of output
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units
Methods of Costing of Joint 11. a. weighted average method
Products
12. c. Rs. 1,000
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SUGGESTED BOOKS
Alex, K. (2012). Cost Accounting. Publisher: Pearson India.
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Layne W.A. (1984) Job Costing, Unit Costing, Process Costing and Joint
Product Costing — ‘The Quartet’. In: Cost Accounting. Palgrave, London.
E-REFERENCES
Harris, E. (1996). Process Costing (CIMA Exam Support Books). CIMA
Publishing.
Thukaram Rao, M.E. (2004). Cost and Management Accounting. First
edition. New Age Publishers.

C H A
8 P T E R
STANDARD COSTING AND VARIANCE ANALYSIS
8.1 Standard Costing
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8.1.1 Objectives of Standard Costing
8.2 Need for Fixing Standards
8.3 Process of Standard Costing
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8.4 Factors Determining Standards Under Each Cost Component
Activity
8.5 Uses of Standard Costing
8.6 Benefits of Standard Costing
8.7 Limitations of Standard Costing
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Activity
8.8 Relationship Between Standard Costing and Budgetary Control
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Activity
8.9 Standard Costing and Variance Analysis
8.9.1 Material Cost Variance
8.9.2 Material Price Variance
8.9.3 Material Usage (Quantity) Variance
8.9.4 Material Mix Variance
8.10 Material Yield Variance
Activity
8.11 Labor Cost Variances
8.11.1 Labor Rate Variance
8.11.2 Labor Efficiency Variance
8.12 Idle Time Variance
8.13 Labor Yield Variance
8.14 Labor Mix Variance
8.15 Overhead Variances

8.15.1 Variable Overhead Variance
8.15.2 Fixed Overhead Variance
8.16 Analysis of Variances
8.16.1 Fixed Overhead (FO) Variances
8.16.2 Variable Overhead (VO) Variances
Activity
8.17 Sales Variances
8.17.1 Sales Value Variance
8.17.2 Sales Price Variance
8.17.3 Sales Volume Variance
8.18 Variances Based on Profits
8.18.1 Sales Margin Variance Due to Selling Price
8.18.2 Sales Margin Variance Due to Volume of Sales
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Activity
8.19 Control Ratios
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8.21
Summary
Descriptive Questions
8.22 Answer Key
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Standard Costing and Variance Analysis 197
M/S FILE AND SMILE ASSOCIATES
M/s File and Smile Associates prepare income tax returns for individ-
uals for a fee. Their advice to their clients is to pay the proper tax and
relax. In order to arrive at the proper scale of fees and assess their own
performance, they have a good system. They use the weighted average
method and actual costs for financial reporting purposes. However,
for internal reporting, they use a standard cost system. The standards,
based on equivalent performance, have been established as follows:
Labor per return 5 h @ Rs. 40 per h
Overhead per return 5 h @ Rs. 20 per h
For March 2015 performance, budgeted overhead is Rs. 98,000 for the
standard labor hours allowed. The following additional information per-
tains to the month of March 2015:
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(Numbers)
March 1 Returns in process (25% complete) 200
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Returns started in March 825
March 31 Returns in process (80% complete) 125
Cost data
March 1 Returns in process
(Rs.)
Labor 12,000
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Overheads 5,000
March 1-31 Labor 4,000 h 1,78,000
Overheads 90,000
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QUESTIONS

1. For each cost element, equivalent units of performance and the
actual cost per equivalent unit.
2. Actual cost of returns in process on March 31.
3. The standard cost per return.
4. The total labor, labor rate and labor efficiency variances as
well as total overhead, overhead volume and overhead budget
variances.

LEARNING OBJECTIVES

>> Concept and important uses of standard costing.
>> Need for standard costing and its limitations.
>> Types of standards and its determinants.
>> Measurement of material cost, labor cost and overhead cost variances.
>> Factors affecting variances.
>> Interpretation of variances.
>> Analysis of sales and profit variances.
>> Uses and significance of control ratio in business decisions.
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8.1 STANDARD COSTING
Standard costing is the process where standard of costs of various components
QUICK TIP
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and resources are pre-decided. Therefore, this is a pre-determined expected
cost of a product. This is also known as ideal cost, which is decided by consid-
• S tandard costing, a
ering all the situations as ideal conditions. Standard costs can be defined as
pre-determined expected
the costs for normal production efficiency at a standard level of output.
cost of a product, is also
known as ideal cost. Chartered Institute of Management Accountants defines standard costing as
• It can be defined as the “the pre-determined cost based on technical estimate of material, labor and
costs for normal production overheads for a selected period of time and for the prescribed set of work-
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efficiency at a standard level ing conditions.” The purpose is to measure the variances from standard cost
of output. under various costs and also to find out the reasons for variances so as to take
corrective actions and improve efficiency.
8.1.1 OBJECTIVES OF STANDARD COSTING

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Following are the objectives of standard costing:

1. To exercise control on costs by determining standards in advance.
2. To set standards for quantity and price of various components of cost,
such as raw materials, labor and overheads. The standard so fixed
becomes a goal for future to be achieved.
3. To compare standard costing of one firm with other firms in the industry.
4. To monitor and control the costs by comparing standard costs with
actual costs.
5. To fix the responsibility of the concerned department based on
variance analysis.
6. To take suitable measures to reduce cost and bring efficiency under
different cost components.
7. Once the standards of cost for various cost components are fixed, the
cost control authority is given the responsibility for monitoring and
control of costs at different levels. Thus, control system becomes easy
through standard costing.

8.2 NEED FOR FIXING STANDARDS

It is important to understand why a firm should fix the standards for cost- NOTE
ing under various cost components. The firm has to adhere to a policy of
fixing selling price based on prevailing market prices of its competitors. If standards of cost components
are not fixed in advance,
For this purpose, the firm needs to work backward on optimizing the cost
monitoring and control is not
by fixing standards to each cost component. This way, a firm can achieve
possible.
the desired goals of meeting the cost of the product. In today’s competitive
market, it is necessary for a firm to optimize the cost so as to have a compet-
itive price and gain strategic advantage. Further, if standards of cost compo-
nents are not fixed in advance, monitoring and control is not possible. Things
may go beyond control. Even task managers cannot be held responsible.
Therefore, fixing standards for costing for different cost components is very
much required.
8.3 PROCESS OF STANDARD COSTING
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The process of standard costing in a firm involves the following steps:
1. The standard for per unit cost of different cost components is fixed,
! IMPORTANT CONCEPT
based on the following parameters:
IM Standard Costing aims at:
(a) Firm’s past trends: The firm can decide the standards for various
cost components, such as raw materials, labor and overheads • Cost determination
based on the past trends. Suppose an increase of 5% is observed in • Cost comparison
cost of raw materials every year, the firm may fix standard material • Control on Variances
cost by increasing 5% for the next year. The standards can be fixed • Reporting to Management
under two categories. • Revision of cost if needed
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First,
the firm operates using the best operating processes with an
optimum output and minimum wastage of resources. Second, there
may be certain changes expected in future due to policy decisions. In
that case standard costing can be fixed keeping in view the expected
changes. For example, a firm going for bulk purchases may change
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the raw material procurement policy. Obviously, material cost per

unit will decline in the future. Accordingly, standard material cost
can be adjusted. It can also happen vice versa.
(b) Industry trend: The firm may compare the standard material cost,
labor cost or the overhead cost with the available industry trends
and compare its own standards to fix a reasonable standard cost.
The aim should be to fix a standard cost to reach at par or below the
standard of the industry. We can assure a situation where material
cost per unit for a particular product for the industry is Rs. 6 per
unit. The firm in question may have present standard material
cost of Rs. 6.75 per unit. Therefore, the efforts of the firm should be
to bring down the raw material cost per unit to the industry level
in a phased manner.
(c) Nearest
competitors’ approach: Suppose a firm has achieved the QUICK TIP
industry standards of costs under different cost components, its
efforts should be to achieve the standards of cost components of There is no perfect approach
its nearest competitors for taking strategic advantages. for deciding standard cost of
various cost components of a
(d) Engineering approach: The firm may bring certain technological
product.
changes in the production process, such as shifting to 100%
automation in the process, increasing capacity of production at

a large scale and adopting improved technology. Keeping in view

such changes, the firm may readjust the standard cost of different
cost components and fix the standard cost.
(e) Management perception: Ultimately and practically, standard cost
per unit is adjusted according to the top management perception.
It is the top management who has a final say in the matter, and
the managers act accordingly. If the managing director advices to
bring down the cost per unit by 5%, all standard cost components
will be readjusted accordingly.
There is no perfect approach for deciding standard cost of various cost com-
ponents of a product. A firm may choose one of the approaches discussed
previously or a mixed approach and decide standard cost for each compo-
nent for their own convenience.
8.4 FACTORS DETERMINING STANDARDS
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UNDER EACH COST COMPONENT
Let us now understand in brief various factors responsible for fixing stan-
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dards at operational level.
1. Direct raw material cost: Standard direct material cost involves
separate standards to be fixed for quantity and price of raw material.
For fixing standards of quantity of material, it is always considered as
one unit of production. A firm uses services of production department
to determine such standards. It also considers quality of the product;
quantity and quality of raw material; material consumed per unit;
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wastage of materials and other materials processing factor like input/
output analysis.

Sometimes more than one material is used to process a product. In
that case, a standard mix of different materials is also considered.
Accordingly, standard price of raw materials is determined based on
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present market price and expected inflation. The purchase manager,

cost manager and materials store department are usually involved
in this process. The other considerations are arranging of purchase
and procurement policy, production policy and economic order
quantity.
NOTE 2. Direct labor cost: It involves two important components: time required
to complete a job and wages per hour to be paid. The combination of
Direct labor cost involves
both will decide the standard labor cost per unit. Therefore, we consider
2 important components:
the standard time and standard wages to complete a unit of product.
• T ime required to complete Hence, the product of the standards set for time and wages rate will be
a job. the standard direct labor cost.
• Wages per hour to be paid.
Standard time is determined after analyzing and considering
different aspects of time and motion study, idle time, past experience,
technological changes and future policy considerations.

The standard wage rate is set for different types of workers required to
complete a product. The product completion requires different types
of labor force: skilled, non-skilled and semi-skilled. Standard wages
are decided based on current wage rates, current labor laws, minimum
wages, provisions of the act, availability of workers and future changes.

3. Overhead cost: All other expenses other than materials and labor
are called overheads. Overheads are classified as fixed overhead and
variable overhead.

Fixed overhead remains fixed up to a particular level of production.
The total fixed overhead for the period are decided based on budgeted
production. This has two components: number of units and standard
hours to produce them. On the other hand, variable overhead vary
directly with the level of production. Standard hour (SH) measures the
amount of work that should be performed in an hour under standard
conditions. This is decided based on time and motion study. The
fundamental for decision on allocation of overheads is the output of a
process in each hour.

Standard cost involves different elements of costs, such as material,
labor and overheads, in respect of a product.
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1. ______ is responsible for setting up of materials price standard. SELF-ASSESSMENT
QUESTIONS
a. Production department b. Engineering department
c. Purchase department d. None of the above
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2. ________ reflects a level of attainment based on high level efficiency
which can be achieved.
a. Attainable Standard b. Expected Standard
c. Both (a) and (b) d. None of the above
3. ___________ can be defined as a system which intends to control
the cost of each unit through prior determination of what should be
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the cost and then its comparison with actual cost.
a. Standard costing b. Absorption costing
c. Marginal costing d. None of the above
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Analyze the following situations: ACTIVITY 1

1. A company assigns its variable manufacturing overhead to its
products on the basis of direct labor hours. The actual direct labor
hours exceeded the standard direct labor hours for the products
manufactured during the year. Which variable manufacturing
overhead variance will disclose the amount of this unfavorable
situation?
2. A company applies or assigns its variable manufacturing
overhead costs on the basis of machine hours (MH). The variable
manufacturing overhead spending variance is the difference
between the actual variable manufacturing overhead costs incurred
by the company and _______.
3. The most advantageous time to recognize a variance in the standard
cost of a product’s direct material is at the time the material is put
into which inventories?

8.5 USES OF STANDARD COSTING

The standard costing method has been found quite useful in all industries
and more so in the following industries:
1. Processing units where the process of output and the nature of product
are the same, such as chemical engineering, paper making and metal
processing.
2. In all those works where methods of manufacturing process are repetitive
and products are homogeneous, such as food products and electricity.
3. In service units where operating costing system is implemented, such
as transport and gas.
4. In industries where varieties of products are manufactured, such as
textile and engineering works.
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5. Industries where extraction work is done, such as coal, oil and timber.
6. All other manufacturing and services units where unit cost component
is prevailing.
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7. In construction work, contract work, ship building and erection work.
8.6 BENEFITS OF STANDARD COSTING

Following are the advantages of standard costing:
1. It helps in variance analysis. The actual cost is compared with the
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STUDY HINT standard cost and variance is found. This is required to initiate
Standard costing is an corrective actions and facilitates effective cost monitoring and control
effective tool for management and helps cost reduction.
for taking various business 2. Standard costing helps in determination of selling prices, production
decisions.
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planning, valuation of inventories and transfer of output from one

process to another. It is an effective tool for management for taking
various business decisions.
3. Standard costing also helps in fixing responsibility of the manager
responsible for variations in costing. Once the managers have a sense
of responsibility, they become more cautious towards monitoring the
required standards.
4. It creates a sense of cost consciousness of all the concerned because
NOTE of responsibility and variance analysis. The responsibility is assessed
Standard costing brings in both ways, that is, for favorable or unfavorable performances and
economies in terms of effective reward or punish the concerned accordingly.
utilization of resources.
5. Once the system of standard costing becomes efficient and operational,
the management can focus on other policies and development issues.
6. Standard costing also helps in preparing fairly accurate and meaningful
budget for the future: short-term or long-term. Based on available data
on all the costing aspects, more accurate budget can be proposed.
7. Standard costing brings economies in terms of effective utilization of
resources, such as manpower, machines and materials. This results in
increased productivity and efficiency in cost management.

8. Standard costing also facilitates preparation of financial reports for

analysis and other uses. Thus, the management gets an indication of
trends of business activity and also the likely future trends.
9. It also helps in preparation of flexible budget more conveniently and
easily due to standard costing.
8.7 LIMITATIONS OF STANDARD COSTING

Although there are many advantages of standard costing, it has the following
limitations too:
1. Determination of standard for various cost components requires high
degree of technical skills and fair knowledge. Therefore, small units
may find it difficult to establish standard costing system in view of
limited financial resources.
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2. Practically, fixing up of responsibility in case of wide gaps in variance
analysis becomes difficult as there are many internal and external
factors for such variations. Some are controllable where others are not.
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3. Fixing standards is an arbitrary process. It may be either too stiff or too
liberal. Different firms may have different approaches as convenient
to them.
4. It is only a cost control tool. There is a limited scope for dynamic
approach.
SELF-ASSESSMENT
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4. Standard costing committee is responsible for
QUESTIONS
a. Computation of variances
b. Linking the deviations with responsibilities
c. Setting all types of standards
d. All of the above
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5. The process of standard costing

a. Can be incorporated in accounting routine
b. Helps in reaching variances from the accounting procedure
c. Both (a) and (b)
6. Standard costs are useful in
a. Establishing budgets
b. Supporting cost reduction measures
c. Simplifying cost procedures and expediting cost reports
d. All of the above
7. Standard costing is the preparation of standard costs and their
comparison with _______ and the analysis of ________.
a. Marginal costs, Variances b. Variances, Marginal costs
c. Actual costs, Variances d. Variances, Actual costs

ACTIVITY 2 Identify what each of the following statements signify (among “Use”,
“Benefit” or “Limitation”) of standard costing:
1. Limited scope for dynamic approach.
2. It helps in preparing more realistic budget.
3. It is more relevant for the processing units.
4. The focus is only to control the cost.
5. If the gap is wide under variance analysis, it is difficult to monitor.
6. It is imperatively for the units where products are homogenous.
7. Responsibility for managers could be fixed.
8. The top management can focus on development strategies if
standard costing system is perfect.
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9. It can be implemented in all the units where unit cost is more important.
10. It helps to arrive at the variance.
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8.8 RELATIONSHIP BETWEEN STANDARD
COSTING AND BUDGETARY CONTROL
The standard costing system and budgetary control process are closely asso-
ciated as both aim to control the cost. It is necessary to develop a qualitative
standard costing system along with a sound budgetary control procedure for
having effective control over costs.
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Although the objectives of standard costing and budgetary control system

focus on effective cost control, they differ in the ways as shown in Table 8.1.
TABLE 8.1 DIFFERENCE BETWEEN BUDGETARY CONTROL

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AND STANDARD COSTING

Budgetary Control Standard Costing
Components included in budgetary control Cost components involved in
are related to income and expenditure. It production process alone are
is based on budget of a firm. included.
Different types of budgets are prepared Standard costing is related to
for all the business operations of the firm. production process alone.
It caters to huge activities.
Total expenditure and per unit cost of a Cost of a product is shown per
product are both shown in a budget. unit in standard costing.
Separate budget is prepared for each Based on total production units
activity. in a short period.
There need not be any standard costing Functions only with budgetary
system for budgetary control. control system.
There is no variance analysis in budgetary Variance analysis is an important
control. aspect of standard costing.
Budgetary control analysis is carried out Variance analysis is done for all
only if actual expenses are more than the the cases, irrespective of favorable
budgeted expenses. and unfavorable results.

SELF-ASSESSMENT
8. Which of the following statements are true about standard costing
QUESTIONS
& budgetary control?
a. The budgetary control at finances, production and sales is

almost a necessity for best use of Standard Costing
b.
Standard costing can be applied to each concern whereas
budgetary control is limited to manufacturing concerns
c. Both (a) and (b)
9. Which of the following statements are true about Standard Costs
and Budgetary Control System?
a. Both are the important techniques of management control
b. Under both the techniques targets are decided beforehand
c. Both are based on presumption that cost is controllable
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d. All of the above
Identify the following activities and mark as they represent either s tandard ACTIVITY 3
costing or budgetary control:
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1. Covers all the operations of a business firm
2. Income and expenditure
3. Standard price and actual price
4. Variance analysis
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5. Activity wise estimates

6. Production process
7. Total cost and per unit cost both are relevant
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8.9 STANDARD COSTING AND

VARIANCE ANALYSIS
Having understood the operational aspects of standard costing, let us now
understand the process of variance analysis. The variance can be explained
as a gap (deviation) between actual cost and standard cost. This can also be
called as difference between the two.
If actual cost is lesser than standard cost or the actual outcome is favorable
than the standard one, it is called favorable variance. However, on the other
side, if actual cost exceeds the standard cost or actual outcome is not up to
the required standards, it is called unfavorable or adverse variance.
Remember: The variances may be analyzed with respect to various elements of costs,
sales and profit.
QUICK TIP
1. Material cost variances
Variance can be explained as a
2. Labor cost variances gap (deviation) between actual
3. Overhead variances cost and standard cost.

4. Sales variances
5. Profit variances
The variances in actual and standard costs can happen on account of
following:
1. Variance on account of functions, such as cost function, profit function
and sales function.
2. Variance in relative terms, for example, difference between actual and
standard cost in unit terms or percentage terms. It can be absolute
term when difference in standard cost and actual cost is measured in
money terms.
3. Variance can be favorable or unfavorable as explained earlier.
4. Variance may be controllable when the decision of management can
affect the cost control. It can also be non-controllable variance if it
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cannot be controlled due to external factors.
Now let us understand the measurement of variances in detail.
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8.9.1 MATERIAL COST VARIANCE
! IMPORTANT CONCEPT It is the difference between the standard cost of materials that were planned
to be used and the cost of materials actually used. The standard cost of mate-
Material cost variance is rial can be achieved depending on the standard quantity of materials used
the difference between the for actual production, but it has to be valued at the pre-determined standard
standard cost of materials prices. Suppose, standard quantity required for production of 1,000 units
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that were planned to be used of a product was 10,000 kg of raw material at a standard price of Rs. 10 per kg,
and the cost of materials but actual production was 1,100 units for which standard quantity should
actually used. have been 11,000 kg and standard cost of raw materials considering stan-
dard price could have been Rs. 1,10,000 (11,000 kg × Rs. 10 standard price).
However, the actual price paid to purchase 11,000 kg material would have
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been different, either Rs. 10.50 or Rs. 9.80. Therefore, this will result in vari-
ance between standard cost of raw materials and actual cost of raw materials.
8.9.2 MATERIAL PRICE VARIANCE

As explained earlier, this variance occurs due to the difference between the
standard price already fixed and the actual price paid for the quantity used.
If the actual price is higher than the standard price, it would result in unfa-
vorable price variance and if the actual price is lower than standard price, it
will result in favorable price variance. We may use the following equation for
determining material price variance:
Material price variance = Actual quantity used ×

(Standard price - Actual price)
Material price variance may happen on account of any of the following

reasons:
1. Variations in the market price than the standard price.
2. Change in quantity actually purchased in comparison to standard
quantity required.

3. Purchase of non-standard materials as per the need.

4. Higher or lesser carrying cost than the budgeted one.
5. Inefficient purchase policy of the firm.
6. Difference in actual purchase discounts than expected.
7. Other external reasons, such as inflation and scarcity of raw materials.
8.9.3 MATERIAL USAGE (QUANTITY) VARIANCE

Material usage variance may happen on account of difference between the
standard quantity planned for production initially and actual quantity used STUDY HINT
for production. This is already explained earlier as the quantity planned to Material usage variance
purchase was 10,000 kg, but actual quantity purchased was 11,000 kg. This may happen on account
resulted in material usage variance. We may use the following equation to of difference between the
ascertain the material usage variance: standard quantity planned for
S
Material usage variance = Standard price × production initially and actual
(Standard quantity - Actual quantity) quantity used for production.
Material usage variance may happen on account of any of the following

reasons:
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1. Higher or lower wastage on account of leakages, evaporation, etc., in
storage as compared to expected quantity losses.
2. Difference in the quality of materials actually purchased as compared
to planned quality of materials. It may be either superior quality or
inferior quality.
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3. Higher or lesser wastage on account of scrap, normal wastage, spoilage,

etc., than the standard quantity of wastage.
4. Improper upkeep of materials resulting pilferage of materials.
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5. Theft and leakages of materials due to improper security arrangements

at the storage.
6. The standards set might not be correct.
7. Technological reasons resulting in higher or lesser consumption of
materials.
8. Inefficient handling of materials in the production process.
8.9.4 MATERIAL MIX VARIANCE

Material mix is the phenomenon when a firm uses more than one material
in a product. Suppose three different kinds of materials are used to produce
a final product called “A.” This mix is already decided, which is known as
standard mix. We can presume that three materials required have a standard
mix of 30%, 30% and 40%, respectively. However, when the mix is actually
used in the production process, it is not the same. It might differ to 30%, 35%
and 35%, respectively. This will create variation in the materials cost as all
the materials have different prices. Therefore, when there is a difference in
standard mix and actual mix of quantity of materials used, it results into the

material mix variance. The material mix variance can be ascertained with
the following equation:
Material mix variance = (Standard cost of actual mix at standard rate

of mix) - (Actual cost of actual mixture)
= S
tandard price × (Actual quantity in standard
mix [known as RSQ] - Actual quantity)
8.10 MATERIAL YIELD VARIANCE

Material yield variance is the difference between standard yield (output)
that could have been obtained using actual quantity of materials as per
! IMPORTANT CONCEPT pre-decided standards and actual output obtained. This can be understood
Material yield variance is the through an example. Suppose, if 1,000 kg of raw material is used, the stan-
difference between standard dard output is 950 kg. However, the actual material used is 1,100 kg. In this
case standard output should have been 1,045 kg (1,100 × 95/100). However,
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yield (output) that could have
been obtained using actual the actual output might be different and this causes material yield vari-
quantity of materials as per ance. We can calculate the material yield variance through the following
pre-decided standards and equation:
actual output obtained.
IM
Material yield variance = Standard cost of material per unit of output ´
(Standard output for actual inputs of raw material - Actual output)
Total cost of actual

output at standard price
Standard cost of material per unit of output =
Standard output for
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actuall inputs
Finally, we can summarize the material cost variance as shown in Figure 8.1.
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Material cost variance
Material price variance Material usage variance
Material mix variance Material yield variance
Figure 8.1 Analysis of material cost variance.
Remember: Material cost variance can mainly occur on account of differ-

ences either in standard price and actual price of raw materials or variation
in usage of actual quantity and standard quantity of raw materials. Similarly,
material usage variance can occur only on account of either difference
between standard mix and actual mix of raw materials or variation in stan-
dard and actual output. We can understand it through a simple example as
follows:

EXAMPLE 8.1
The following information is available in respect of a product for January 2015:
Budgeted production = 200 units

Standard consumption of raw materials = 2 kg per unit
Standard price of material = Rs. 6 per kg
Actually, 250 units were produced and the material was purchased at Rs. 8
per kg and consumed at 1.8 kg per unit. Considering the cost information, we
need to compute relevant material cost variances.
Solution:
Actual production = 250 units

Standard quantity for actual = 2 × 250 = 500 kg (standard
S
production quantity [SQ])
Actual quantity for actual = 1.8 × 250 = 450 kg (actual
production quantity [AQ])
Standard price/kg
IM= Rs. 6 (standard price [SP])
Actual price/kg = Rs. 8 (actual price [AP])
1. Total material cost variance = (SP × SQ) - (AP × AQ)
= (6 × 500) - (8 × 450)
= 3,000 - 3,600 = 600 (A)
2. Material price variance = (SP - AP) × AQ
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= (6 - 8) × 450 = 900 (A)

3. Material usage variance = (SQ - AQ) × SP
= (500 - 450) × 6 = 300 (F)
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Remember:
Material cos t var iance = Material price variance +

Material usage variance
600 ( A ) = 900 ( A ) + 300 ( F )
Examine the following situations and analyze the impact on variance: ACTIVITY 4
1. If standard quantity of material inputs required for an output is
40,000 kg at a standard price of Rs. 6 per kg and if actual cost of
material used is Rs. 232000.
2. If actual price paid per kg in the above case (1) is Rs. 5.80, what
would be the material usage variance?
3. What will be the total material cost variance in the above two cases?
4. If the actual mix of material used is higher than the standard mix
and the actual price is lesser than the standard price, what will be
the impact on variance?

5. In a product, a mix of three different materials was used. Materials

K, L and M were used 240 kg, 390 kg and 320 kg, respectively.
The standard price per kg of these materials were Rs. 4, Rs. 11
and Rs. 6, respectively, but the actual price paid for materials was
K = 4.40, L = 12 and M = 5.20. How much is the material price
variance?
8.11 LABOR COST VARIANCES

NOTE Labor cost variance is the difference between the standard direct labor
Labor cost variance is the cost and actual direct labor cost. The labor cost basically has two compo-
difference between the nents, one the wage rate and other the time taken (labor hours) to com-
standard direct labor cost and plete a unit of product. Therefore, labor cost has two major variances:
actual direct labor cost. labor wage rate variance and labor efficiency variance. Let us understand
S
these two terms.
8.11.1 LABOR RATE VARIANCE

When there is a difference between standard wage rate per hour and actual
IM
wage rate per hour, it causes labor rate variance. For example, if the stan-
dard wage rate per hour to a non-skilled labor is Rs. 10 per hour, and the
actual wage rate paid is Rs. 10.75 per hour, it will result in adverse labor
rate variance as the actual labor cost will be more than the standard labor
cost. It may also be vice versa when the actual wage rate paid is lesser than
the standard. Labor rate variance can be calculated through the following
equation.
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Labor rate variance = Actual labor time worked ×

(Standard wage rate - Actual wage rate)
Labor rate variance may occur on account of following reasons:

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1. Change in labor mix than the pre-determined standards, may be on

account of shortage of labor in a particular category, labor sitting idle
for want of materials and other equipment.
2. Rise in wage rates due to inflation or wage rate policy of the government
such as minimum wages act.
3. Hike in wage rate due to overtime work where the wage rate is higher
or working in night shifts. In both the cases, the actual wage rate will be
higher than the standard.
4. Improper allocation of job among the workers.
5. Policy changes in the incentive schemes to be provided to the employees.
6. Increased idle labor time due to external factors, such as power failure
and machine breakdown.
QUICK TIP 8.11.2 LABOR EFFICIENCY VARIANCE

Labor efficiency is measured in Labor efficiency is measured in terms of labor productivity. The workers are
terms of labor productivity. required to produce a product in a pre-determined time known as standard

labor time. However, the actual time to produce a product may be higher or
lower than the standard time. In such a scenario, labor efficiency variance
will occur. The labor efficiency variance may be ascertained through the
following equation:
Labor efficiency variance = Standard wage rate ×

(Standard labor hours - Actual labor hours)
The labor efficiency variance may arise on account of the following reasons:
1. More wastage of time due to lack of proper monitoring and supervision.
2. Inefficiency of labor productivity may be on account of adverse working
conditions.
3. Higher number of labor turnover.
4. Power failure or any other unexpected event such as machine breakdown.
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5. Frequent interruptions in the production process.
6. Lack of trained and skilled workforce.
7. Ineffective co-ordination among different units.
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10. Labor efficiency variance is also known as SELF-ASSESSMENT
QUESTIONS
a. Labor time variance b. Labor quantity variance
c. Labor usage variance d. All of the above
11. If labor time is based on the maximum efficiency, the unit cost
M
will be
a. Higher b. Lower
c. Equal d. None of the above
12. Which of the following statements are true about standard labor
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time?
a. Standard labor time indicates the time in hours needed for a
specified process
b. It is standardized on the basis of past experience with no
adjustments made for time and motion study
c. In fixing standard time due allowance should not be given to
fatigue and tool setting
d. The Production manager does not provide any input in setting
the labor time standards
13. The labor engaged in the making of a product is known as
a. Direct labor b. Indirect labor
c. Temporary labor d. None of the above
8.12 IDLE TIME VARIANCE

The idle time can be defined in terms of time spent by workers without
any productivity or we can say remaining idle without any work. There

are standard norms for idle time as a firm needs to give required time for
tea break, natural calls, etc., to the workers, and this is known as standard
idle time. Obviously, the cost of idle time is included in the production
process itself. However, there may be occasions where workers actually
spend more time without work. This is known abnormal idle time. This
may happen for two reasons: either a deliberate attempt to waste more
time by workers or due to external factors on account of power failure or
machine breakdown. It is the abnormal idle time that needs to be calcu-
lated for variance purpose. This variance is always unfavorable. This can
be calculated as follows:
Idle time variance = Abnormal idle time × Total man hours ×

Standard wage rate per hour
8.13 LABOR YIELD VARIANCE
S
Just like material yield variance, there is also labor yield variance. This
happens on account of difference in standard yield in given number of
work hours and actual yield obtained in actual work hours. Suppose a
product requires 2 hours to produce and in a particular process workers
IM
worked for 1,200 hours. As per the standards, the output in given number
of hours would have been 600 units. However, the actual output may differ.
It may be either higher or lower than the required as per standard. This
difference between actual and standard causes variance, may be favor-
able or unfavorable. This variance can be obtained through the following
equation:
M
Labor yield variance = (Standard yield in units expected from the actual
hours worked - Actual yield) × Standard labor cost per unit
8.14 LABOR MIX VARIANCE

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The different composition of workers comprising skilled, semi-skilled,

NOTE
unskilled, man and woman is known as labor mix. The firm may have
The different composition of pre-determined standards of labor mix among various groups. The actual
workers comprising skilled, mix may differ at the time of production. This causes variation due to change
semi-skilled, unskilled, man and in composition of workers as the wage rate for different groups are dif-
woman is known as labor mix.
ferent and therefore affect the costs. The changes in workers composition
may occur on account of non-availability of required number of workers in
a particular category or change in a firm’s policy to change the composi-
tion in view of cost considerations. This could be ascertained through the
following equation:
Labor mix variance = (Revised standard hours - Actual hours) ×

Standard rate per hour
The revised standard hours can be calculated as follows:
Revised standard hours = Standard hours for the particular composition/

Total standard hours × Total actual hours
Remember: The labor cost variance is sum of labor rate variance and labor
efficiency variance. Then labor efficiency variance occurs on account of labor

yield, variance, idle time variance and labor mix variance (Fig. 8.2). Following
are the equations for labor cost variance:
Labor cost variance = Labor rate variance + Labor efficiency variance

Labor efficiency variance = Idle time variance + Yield variance +
Labor mix variance
Labor cost variance
Labor rate variance Labor efficiency variance
S
Labor idle time variance Labor yield variance Labor mix variance
Figure 8.2 Analysis of labor cost variance.

IM
On the basis of these equations, we can self-check the accuracy of the vari-
ance analysis.
This could be further understood through the following example.
EXAMPLE 8.2
M
The following information is available about a product for the month of
December 2014.
Material purchased 24,000 kg (Rs. 1,05,600)

Material consumed 22,800 kg
N
Actual wages paid for 5,940 hours Rs. 29,700

Units produced 2,160
Standard rates and prices are as follows:
Direct material rate Rs. 4.00 per unit

Direct labor rate Rs. 4.00 per hour
Standard input 10 kg for one unit
Based on the data and information, calculate relevant material and labor cost
variances.
Solution:
Material Variances
(i) Material cost variance = (SQ × SP) - (AQ × AP)

= (2,160 × 4 × 10) - (22,800 × 4.40)
= Rs. 86,400 - Rs. 1,00,320 = 13,920 (A)

(ii) Material price variance = AQ (SP - AP)

= 22,800 kg (4 - 4.40) = 9,120 (A)
(iii) Material usage variance = SP (SQ - AQ)
= 4 (21,600 - 22,800) = 4,800 (A)
Labor Variances
(i) Labor cost variance = (SH × SR) - (AH × AR)

= (2,160 × 2.50 × 4) - (29,700)
= 21,600 - 29,700 = 8,100 (A)
(ii) Labor rate variance = AH (SR - AR)
= 5,940 (4 - 5) = 5,940 (A)
(iii) Labor efficiency variance = SR (SH - AH)
S
= 4 (5,400 - 5,940) = 2,160 (A)
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8.15 OVERHEAD VARIANCES
As we have already discussed, overheads are indirect costs associated
QUICK TIP with a product, which are absorbed based on certain criteria. A firm has
standard overhead rate that is fixed for a particular product. The stan-
Overheads are indirect costs
dard overheads are compared with the actual overheads. The overheads
associated with a product.
are further categorized into two categories: fixed and variable overheads.
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The fixed overheads may be pre-determined depending on capacity of
production. The variable overheads can be fixed on per unit basis. We
can observe variance in overheads also as actual overheads may be dif-
ferent from the standard overheads. It may happen on account of lesser
or higher output than budgeted. Since overheads are variable and fixed
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in nature, overhead variance can be calculated separately for fixed and

variable overheads.
The overhead variance occurs on account of fixed and variable overhead
variances. Both variances are influenced by expenditure and volume vari-
ances. This has been shown in Figure 8.3.
Total overhead variance
Variable overhead variance Fixed overhead variance
Expenditure variance Volume variance
Efficiency Capacity Calendar

variance variance variance
Figure 8.3 Analysis of overhead variance.

8.15.1 VARIABLE OVERHEAD VARIANCE

This variance could be obtained on account of difference between the stan-
dard variable overheads and absorbed variable overheads. This can be a STUDY HINT
favorable or unfavorable variance depending on variable overhead absorbed
Overhead variance is the
to actual output is more or less than the pre-determined standards. Overhead
difference between the
variance is the difference between the amount calculated at standard rate of amount calculated at
variable overhead and the amount calculated at actual rate of variable over- standard rate of variable
head on the actual output. We can ascertain overhead variance through the overhead and the amount
following equation: calculated at actual rate of
variable overhead on the
Overhead variance = AO (SR - AR) actual output.
= (AO × SR) - (AO × AR)

= SVO - AVO

where AO = actual output, SR = standard rate, AR = actual rate, SVO = stan-
S
dard variable overhead and AVO = actual variable overhead.
Variable overhead variance indicates the difference between the variable
overhead expenses actually recovered for actual output as per the standard
IM
rate and the actual variable overhead expenses incurred in the production
process.
We can also explain variable overhead variance as follows:
Variable overhead variance = (Standard variable cost per unit × Actual

output) - Actual output
M
= (Standard hours × Standard variable
overhead rate per hour) - (Actual hours ×
Actual variable overhead rate per hour)
The variable overheads can be further categorized as explained in the follow-

ing sections.
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VARIABLE OVERHEAD SPENDING (EXPENDITURE) VARIANCE

This will vary with direct labor hours of input that is budgeted and actual
labor hours. The actual variable overhead spending may be different from
the budgeted variable overhead spending. This will cause variance either
favorable or unfavorable. This can be calculated as follows:
Variable overhead spending variance = (Actual hours ×

Standard variable overhead rate per hour) - (Actual hours ×
Actual variable overhead rate per hour)
VARIABLE OVERHEAD EFFICIENCY VARIANCE (VOEV)

As the name suggests, efficiency variance measures the efficiency of labor
hours working with the standard output. Therefore, the variation between NOTE
the actual hours used to complete the work and the standard hours required Efficiency variance measures
to complete the work may vary. This certainly indicates the efficiency or ineffi the efficiency of labor hours
ciency. The efficiency can be measured in terms of cost savings or excess cost working with the standard
incurred. We can calculate the variance as follows: output.

Variable overhead efficiency variance = (Standard hours allowed for actual

output - Actual hours used for actual output) × Standard variable overhead
rate per hour = (Actual output hours × Standard per unit) -
(Actual hours × Standard variable overhead recovery rate)
The variable overhead efficiency variance can occur on account of labor

efficiency or inefficiency due to various factors, such as workers grievances,
inappropriate incentive plans, faulty work process, frequent machine faults
and inferior materials quantity.
8.15.2 FIXED OVERHEAD VARIANCE

Fixed overhead variance is caused due to over-absorption or under-
absorption of fixed overheads. The fixed overheads are not affected by the
STUDY HINT
volume of output as it remains the same. Fixed overhead variance occurs
Fixed overhead variance on account of difference between standard fixed overhead and actual fixed
S
occurs on account of overhead on the actual output. We can calculate this variance through the
difference between standard following equation:
fixed overhead and actual
fixed overhead on the actual Fixed overhead variance = TSC - TAC
output.
IM or [AO × SFO] - [AO × AFO]
or TSO - TAO
where TSC = total standard cost for actual output, TAC = total actual cost,
AO = actual output, SFO = standard fixed overhead, AFO = actual fixed over-
head, TSO = total standard overhead and TAO = total actual overhead.
M
The fixed overhead variance may be further sub-divided into expenditure

variance and volume variance.
1. Expenditure or spending variance: There are fixed overheads charged
as an expense for a particular time period. These remain unchanged
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during a short span of time. Fixed overhead expenditure variance

explains the difference between the amount actually spent during
a certain period as fixed overhead and the amount of fixed overhead
budgeted for the period. Through the fixed overhead cost variance
analysis, we can analyze if the actual amount of fixed overhead is lesser
or higher than the amount already budgeted. We can calculate the
variance through the following equation:
Expenditure variance = Budgeted fixed overhead -
Actual fixed overhead
2. Volume variance: Volume relates to measurement of output. This
variance may be caused mainly due to the difference between
budgeted output and actual output. To arrive at this variance, we
may find out the difference in budgeted output and actual output and
then multiply it by the standard fixed overhead absorption rate. This
variance indicates the over- absorbed overhead or under-absorbed
overheads may be on account of the difference in budgeted level
of output and actual level of output. We can calculate this variance
through the following equation:
Volume variance = SC (AQ - BQ)

where SC = standard cost per unit of fixed overheads, AQ = actual

output in actual hours worked and BQ = budgeted standard output
planned in budgeted standard hours.
The volume variance may occur on account of labor efficiency or inefficiency
resulting in higher or lower output than the budgeted. Also, the number of
hours available for working may be lesser or higher than the planned hours
in the budget.
EXAMPLE 8.3
The following information in respect of a production process is available for
the month of January 2014.
Budgeted Actual
S
Output (units) 30,000 32,500
Hours 30,000 33,000
Fixed overheads 45,000 50,000
Variable overheads
IM60,000 68,000
Working days 25 26
Compute relevant overhead variances.

Solution:
Measurement of per Hour Overheads

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Budgeted hours 30, 000

Standard hours per unit = = =1 h
Budgeted units 30, 000
Standard hours for actual = 32,500 units × 1 h = 32,500
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output
Budgeted overheads
Standard overhead rate per =
hour Budgeted hours
45, 000
For fixed overheads = = Rs. 1.50 per h
30, 000
For variable overheads = 60,000 = Rs. 2.00 per h
Rs. 45,000
Standard fixed overheads = = Rs. 1,800
rate per day 25 days
Standard hours for actual output ×
Recovered overheads =
Standard rate
For fixed overheads = 32,500 h × Rs. 1.50 = Rs. 48,750
For variable overheads = 32,500 h × Rs. 2 = Rs. 65,000
Standard overheads = Actual hours × Standard rate
For fixed overheads = 33,000 × 2 = Rs. 66,000

Budgeted hours
Revised budgeted hours = ´Actual days
Budgeted days
30, 000
= ´ 26 = 31, 200 h
25
Revised budgeted over- = 31,200 × 1.50 = Rs. 46,800

heads (for fixed overheads)
8.16 ANALYSIS OF VARIANCES
8.16.1 FIXED OVERHEAD (FO) VARIANCES

1. FO cost variance = Recovered overheads - Actual overheads
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= 48,750 - 50,000 = Rs. 1,250 (A)
2. FO expenditure variance = Budgeted overheads - Actual overheads
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= 45,000 - 50,000 = Rs. 5,000 (A)

3. FO volume variance = Recovered overheads - Budgeted overheads
= 48,750 - 45,000 = Rs. 3,750 (F)
4. FO efficiency variance = Recovered overheads - Standard overheads
= 48,750 - 49,500 = Rs. 750 (A)
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5. FO capacity variance = Standards overheads - Revised budgeted

overheads
= 49,500 - 46,800 = Rs. 2,700 (F)
6. Calendar variance = (Actual days - Budgeted days) × Standard rate per
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day
= (26 - 25) × 1,800 = Rs. 1,800 (F)
8.16.2 VARIABLE OVERHEAD (VO) VARIANCES

1. VO cost variance = Recovered overheads - Actual overheads
= 65,000 - 68,000 = Rs. 3,000 (A)
2. VO expenditure variance = Standard overheads - Actual overheads
= 66,000 - 68,000 = Rs. 2,000 (A)
3. VO efficiency variance = Recovered overheads - Standard overheads
= 65,000 - 66,000 = Rs. 1,000 (A)
We may check the analysis as follows:
FO cost variance = Expenditure variance + Efficiency variance +
Capacity variance + Calendar variance
1,250 (A) = 5,000 (A) + 750 (A) + 2,700 (F) + 1,800 (F)

FO volume variance = Efficiency variance + Capacity variance +

Calendar variance
or
Standard overhead rate per day = Standard hours per day ×
Standard rate per hour = 500 h × Rs. 5 = Rs. 2,500
Calendar variance = (Actual working days - Standard working days) ×
Standard rate per day = (22 - 25) × 2,500 = Rs. 7,500 (A)
The budgeted fixed production overheads are Rs. 10,000 and budgeted ACTIVITY 5
output is 1000 units. Assume that actual activity is more than the budgeted
activity by 200 units. The actual overheads are Rs. 10,000.
Questions
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1. Calculate fixed overhead absorption rate.
2. What is the actual output?
3. How much are the overheads actually absorbed?
4. Explain if it is under/over absorption.
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5. How much is the under/above absorption?
6. Is it favorable or adverse?
8.17 SALES VARIANCES

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So far we have done analysis of different cost variances to ascertain the

difference and take needed measure to control the costs within the pre-
determined standards. Now, we will understand sales and profit variances.
The sales variance occurs on account of selling price, and the selling price
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depends on the cost of product per unit. Therefore, a firm may understand
the consequences and implications of cost variances on the selling price and
sales volume. Further, sales and volume of profit are also interlinked; there-
fore, to have a better understanding, an analysis of variances between the
actual profit and the standard profit is also necessary. On the other hand, it
is equally important to make an analysis of sales variances to measure the
profit variance as we know that the profit is the difference between sales and
cost. Therefore, this analysis becomes more significant.
The sales volume variance takes place on account of changes in selling price
and sales volume as against the standards. The actual sales and price can
either be on the lower or higher side which causes variations. The sales
volume variance again may occur on account of changes in actual sales mix
and sales sub-volume as compared to standards. This has been explained in
Figure 8.4.
Remember: Sales value variance measures the difference between actual QUICK TIP
sales value and planned sales value. This difference again may occur on
account of two factors, one there may be difference in actual selling price Sales value variance measures
and standard selling price and two there may be a variation in planned sales the difference between actual
sales value and planned sales
volume and actual sales volume. Further, the sales volume may be affected
value.

Sales value variance
Sales price variance Sales volume variance
Sales mix variance Sales sub-volume variance
Figure 8.4 Analysis of sales variance.
by another two factors, one there may be difference in actual sales mix and
standard sales mix and two there may be difference between actual sales
sub-volume and planned sales sub-volume. We will now understand all these
factors in detail.
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8.17.1 SALES VALUE VARIANCE
As already explained, sales value variance is the difference between the
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planned value of sales and actual value of sales in a given time period. A
firm should make all efforts to measure this gap and further analyze the rea-
sons for the variations. We can calculate the sales value variance through the
following equation:
Sales value variance = Actual value of sales - Standard value of sales
Sales value variance can be favorable or unfavorable, and this may arise on
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account of following reasons:

1. There may be a difference in standard selling price and actual selling
price which may be higher or lower than the pre-determined standard
price. Obviously, this will cause variation in sales total sales value.
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2. Further, the actual quantity of goods sold may also vary than the planned
one which could be higher or lesser. This will also cause variance in
sales value.
3. As already mentioned, there may be a difference in actual sales mix
and the standard sales mix. The sales mix can be explained in terms of
combination of different products/varieties produced by a firm.
8.17.2 SALES PRICE VARIANCE

Sales price variance can be explained in terms of difference in actual sales
price and budgeted sales price. This will cause difference in actual sales value
as compared to planned sales value. We can calculate the sales price variance
Sales price variance = Actual quantity sold ×

(Actual price - Standard price)
It will be favorable if actual selling price is higher than the standard selling
price and vice versa. The actual selling price depends on market conditions
and other external factors. Therefore, this variance is common.

8.17.3 SALES VOLUME VARIANCE

Sales volume variance can be explained in terms of difference in actual
quantity of sales and budgeted quantity of sales. This will cause difference in STUDY HINT
actual sales value as compared to planned sales value. We can calculate the Sales volume variance can
sales volume variance through the following equation: be explained in terms of
difference in actual quantity
Sales volume variance = Standard price × (Actual quantity of sales -
of sales and budgeted
Standard quantity of sales)
quantity of sales.
It is easy to understand that the quantity of sales directly affect the sales
value. If the quantity sold is higher than the budgeted, it will be favorable
variance and if quantity sold is lesser, it will be unfavorable. We must also
understand that the difference in sales quantity is multiplied by the standard
selling price. This is on account of comparison with the standard.
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SALES MIX VARIANCE
Sales mix variance can be explained in terms of difference in actual quantity
of sales mix and budgeted quantity of sales mix. This will cause difference in
actual sales volume as compared to planned sales volume as all the variet-
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ies or products have different selling price. We have already discussed that
sales mix is the combination of various products produced by a firm and
sold during a given period of time. We can calculate the sales mix variance
Sales mix variance = Standard value of actual mix -

Standard value of revised standard mix
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SALES SUB-VOLUME VARIANCE

This is explained in terms of difference between the budgeted sales and
revised standard sales. The sub-variance is calculated to understand the
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effect of RSQ as compared to budgeted sales quantity. This is also known

as sales quantity variance. We can calculate the sales sub-volume variance
Sales quantity variance = (Revised standard sales quantity ×

Standard selling price) - (Standard sales quantity × Standard selling price)
8.18 VARIANCES BASED ON PROFITS

Total sales margin variance: We can also calculate variances based on bud-
geted profit and actual profit. This is a composite variance that is arrived
based on other sub-variances. Basically, it represents the difference between
the standard margin of profit in relation to budgeted quantity of sales during
a particular time period and the margin between the standard cost and the
actual selling price. We can calculate the sales margin variance through the
following equation:
Total sales margin variance = Standard or budgeted margin -

Actual margin
Remember: The total sales margin variance may occur on account of vari-
ance in selling price or quantity of goods sold. Let us understand both.

8.18.1 SALES MARGIN VARIANCE DUE TO SELLING PRICE

Sales margin variance may occur on account of the difference between the
standard price of the quantity of sales offered during the period and the
actual price. This can be calculated as follows:
Sales price variance = (Actual quantity of sales × Standard price) -
(Actual quantity of sales × Actual price)
We can also calculate sales margin variance on account of difference in sell-
ing price as follows:
Sales price variance = Budgeted profit on actual sales at standard
price and standard cost - Actual profit
8.18.2 SALES MARGIN VARIANCE DUE TO VOLUME OF SALES
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The volume represents the quantity. The sales margin variance on account
of quantity of sales may occur due to the difference between the budgeted
quantity of sales and the actual quantity of sales. For further analysis, we can
calculate two more sub-variances on account of change in the ratio of quan-
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tities of sales of different products known as mix variance. This may occur
on account of actual mix of quantities that may be more or lesser than the
budgeted sales mix of different quantities. This can be calculated as follows:
Sales volume variance = Budgeted profit on standard quantity of sales -
Standard profit on actual quantity of sales
or
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Sales volume variance = Budgeted profit - Profit on actual sales
at standard price and standard costs
EXAMPLE 8.4
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The budgeted and actual sales of a manufacturing unit for December 2014 are
as follows:
Budgeted Actual
A 1,100 units @ Rs. 50 per unit 1,300 units @ Rs. 55 per unit
B 950 units @ Rs. 100 per unit 1,000 units @ Rs. 95 per unit
C 1,200 units @ Rs. 80 per unit 1,200 units @ Rs. 78 per unit
The cost per unit of A, B and C was Rs. 45, Rs. 85 and Rs. 70, respectively. Com-
pute the different variances to explain the difference between the budgeted
and actual profit.
Solution:
1. Standard and actual profit per unit:
Standard (Rs.) Actual (Rs.)

SP Cost Profit SP Cost Profit
A 50 45 5 55 45 10
B 100 85 15 95 85 10
C 80 70 10 78 70 8

2. Budgeted and actual total profit:
Budgeted Actual
Profit Total Profit Total
Sales per Unit Profit Sales per Unit Profit
Quantity (Rs.) (Rs.) Quantity (Rs.) (Rs.)
A 1,100 5 5,500 1,300 10 13,000
B 950 5 14,250 1,000 10 10,000
C 1,250 10 12,500 1,200 8 9,600
Total 32,250 32,600
Calculation of Variances
Total profit variance = Actual profit - Budgeted profit
= Rs. 32,600 - Rs. 32,250 = Rs. 350 (F)
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Profit variance on account of selling price = Actual quantity (Actual selling
price - Standard selling price)
A = 1,300 (55 - 50) = Rs. 6,500 (F)
B = 1,000 (95 - 100) = Rs. 5,000 (F)
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C = 1,200 (78 - 80) = Rs. 2,400 (F) = Rs. 900 (A)
Profit variance on account of sales volume = Standard profit (Actual quantity -
Budgeted quantity)
A = 5 (1,300 - 1,100) = Rs. 1,000 (F)
B = 15 (1,000 - 950) = Rs. 750 (F)
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C = 10 (1,200 - 1,250) = Rs. 500 (A) = Rs. 1,250 (F)

Profit variance due to sales volume can be further analyzed into:
Profit variance on account of sales mix = Standard profit (Actual quantity -
Standard proportion for actual sales)
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A = 5 (1,300 - 1,167) = Rs. 665 (F)

B = 15 (1,000 - 1,008) = Rs. 120 (A)
C = 10 (1,200 - 1,325) = Rs. 1,250 (A) = Rs. 705 (A)
Calculation of revised standard sales based on actual sales
A = (3,500 ÷ 3,300) × 1,100 = 1,167 units
B = (3,500 ÷ 3,300) × 950 = 1,008 units
C = (3,500 ÷ 3,300) × 1,250 = 1,325 units
Total = 3,500 units
Profit variance on account of quantity of sales
A = 5 (1,167 - 1,100) = Rs. 335 (F)
B = 15 (1,008 - 950) = Rs. 870 (F)
C = 10 (1,325 - 1,250) = Rs. 750 (F)
Total = Rs. 1,995 (F)
Remember:
Sales volume variance = Sales mix variance + Sales quantity variance
Rs. 1,250 (F) = Rs. 705 (A) = 1,955 (F)

Analysis of Variances
Particulars A B C
Budgeted sales Rs. 55,000 Rs. 95,000 Rs. 1,00,000
Less: budgeted cost 49,500 80,750 87,500
Budgeted profit 5,500 14,250 12,500
Variances
Profit variance due to selling 6,500 (F) 5,000 (A) 2,400 (A)
price
Profit variance due to sales 665 (F) 120 (A) 1,250 (A)
mix
Profit variance due to sales 335 (F) 870 (F) 750 (F)
quantity
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Actual profit 13,000 10,000 9,600
SELF-ASSESSMENT
QUESTIONS
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14. When actual price is higher or lower than the standard price, then
it is
a. Sales price variance b. Sales volume variance
c. Sales mix variance d. Sales quantity variance
15. Sales margin variance due to sales quantities is measured as
a. Standard profit – Revised standard profit
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b. Revised standard profit – Budgeted profit
c. Standard profit + Revised standard profit
d. Revised standard profit + Budgeted profit
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ACTIVITY 6 Indicate which of the sales variance will be impacted in the following
statements?
1. Change in standard price and actual price.
2. Difference between actual quantity and standard quantity of sale.
3. Change in different components of sale.
4. Budgeted profit minus profit on actual sales at standard price and
cost.
5. Variance in selling price or quantity sold?
6. If actual units sold are 1300 against the budgeted units of 1100 at
selling price of Rs. 55 against the standard price of Rs. 50 per unit,
what would be the profit variance?
7. If standard selling price is Rs. 50 and standard cost is Rs. 45 and if
1200 units of a product are actually sold as against budgeted sale of
1120 units, what is the profit variance?

8.19 CONTROL RATIOS

NOTE
A firm needs to monitor the performance from time to time to evaluate and
The control ratios measure
assess actual performance as against the budgeted and planned performance.
the extent of variation
To achieve this goal, control ratios are very important. The control ratios
from the standards as
measure the extent of variation from the standards as compared to actual
compared to actual
performance. We can also understand whether the variation between the
performance.
actual and the budgeted is favorable or unfavorable. This can be explained
through an example. Suppose, budgeted labor hours to complete a job is 200
but actually the work is completed in 180 hours. Therefore, in this case the
difference of 20 hours is favorable since the actual time taken to complete the
work is lesser than the budgeted time.
1. Standard hour: Standard hour (SH) denotes the ideal time to complete
a job within normal circumstances. This is the basic concept to ! IMPORTANT CONCEPT
understand and to further evaluate control ratios. SH is a measurement Standard hour (SH) denotes
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tool to measure the output. Sometimes, a firm may be engaged in the ideal time to complete
manufacturing of different types of products or varieties of products a job within normal
that may differ in size, shape, value and utility, in that case it becomes circumstances.
difficult to measure the output of different products. Therefore, the
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concept of SH becomes more significant to identify the total output. We
can further understand this concept through the following example.

Suppose the standard monthly output of a firm in a particular
production process is 6,000 units of A and 4,000 units of product B.
Further, we assume that it takes 10 hours to produce 1 unit of A and 8
hours to produce 1 unit of product B. In this case, the budgeted output
measurement in terms of SH will be:
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6, 000 4, 000
Budgeted output in SH = + = 600 + 500 = 1,100 SH
10 8

Now, suppose in any particular month, the firm has produced 6,200
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units of A and 4,400 units of product B, the actual output in terms of SH

can be measured as follows:
6, 200 4, 400
Actual output in SH = + = 620 + 550 = 1,170 SH
10 8

Therefore, the actual output (1,170 SH) is more than the budgeted
output (1,100 SH), and in that case the firm has performed more
efficiently as compared to the budgeted level.
Remember: We may calculate different control ratios based on SH
concept. We explain some of them here.
2. Activity ratio: Through this ratio, we can measure actual level of
production as compared to the budgeted level of production and find
out the variance. It aims to measure whether actual level is higher or
lesser than the performance level. This ratio is also known as production
volume ratio. We can measure the level of activity to be achieved over a
given time period. Following is the equation of activity ratio:
Actual output in SH
Actual ratio = ´100
Budgeted output in SH


Suppose actual output and budgeted output for a particular month are
600 SH and 560 SH, respectively. In that case, the activity ratio will
be 107.15% (600/560). Therefore, we can say that in activity ratio, the
actual SH is represented as percentage of budgeted SH.
3. Capacity ratio: Through this ratio, we can establish the relationship
NOTE
between the actual hours worked and the budgeted hours pre-planned
Through capacity ratio, the for completion of a job in a particular time period. Therefore, this
relationship between the ratio measures as to what extent the actual hours worked are different
actual hours worked and the
from the budgeted hours for a particular time period. It assesses the
budgeted hours pre-planned
difference between “how many hours should have been worked as
for completion of a job in a
per standards” and “how many hours actually have been worked to
particular time period can be
complete a job.” The capacity ratio can be calculated as follows:
established.
Actual hours worked
Capacity ratio = ´ 100
Budgeted hours
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4. Efficiency ratio: This ratio establishes the relationship between the
actual output in terms of SH and the actual hours worked for actual
production. This ratio can be calculated as follows:
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Efficiency ratio = ´ 100
Actual hours for actual output
5. Calendar ratio: This ratio indicates the relationship between actual

number of days worked during the budget period and the budgeted
working days planned during the budget period. It can be calculated as
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follows:
Actual no. of days in budget period

Calendar ratio = ´ 100
No. of budgeted days in budget period
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8.20 SUMMARY
Standard costing is the process where standard of costs of various
components and resources are pre-decided. Therefore, this is a pre-
determined expected cost of a product. It is also known as ideal cost,
which is decided by considering all the situations as ideal conditions.
Standard costs can be defined as the costs for normal production effi-
ciency at standard level of output. The firm has to adhere to a policy of
fixing selling price based on prevailing market prices of its competitors.
For this purpose, the firm needs to work backward on optimizing the
cost by fixing standards to each cost component. This way, a firm can
achieve the desired goals of meeting the cost of the product. In today’s
competitive market, it is necessary for a firm to optimize the cost so as to
have a competitive price and gain strategic advantage.
Material cost variance is the difference between the standard cost of
materials, which was planned to be used, and the costs of materials actu-
ally used. The standard cost of material can be achieved based on the
standard quantity of materials used for actual production, but it has to
be valued at the pre-determined standard prices. We should also under-
stand that material cost variance may happen on account of two factors,

one the difference in standard price and two the difference in standard
quantity and actual quantity used. Therefore, material cost variance may
be further divided into material price variance and material usage (quan-
tity) variance.
Labor cost variance is the difference between the standard direct labor
cost and the actual direct labor cost. The labor cost basically has two
components, one the wage rate and other the time taken (labor hours)
to complete a unit of product. Therefore, labor cost has two major vari-
ances: labor wage rate variance and labor efficiency variance.
Under overhead variance, indirect costs associated with a product are
absorbed based on certain criteria. A firm has standard overhead rate
fixed for a particular product. The standard overheads are compared
with the actual overheads. The overheads are further categorized into
two categories: fixed and variable overheads. The fixed overheads may
be pre-determined depending on capacity of production. The vari-
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able overheads can be fixed on per unit basis. We can observe variance
in overheads also as actual overheads may be different from the standard
overheads. It may happen on account of lesser or higher output than
budgeted. Since overheads are variable and fixed in nature, overhead
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variance can be calculated separately for fixed and variable overheads.
The sales variance occurs on account of selling price, and selling price
depends on the cost of product per unit. Therefore, a firm may under-
stand the consequences and implications of cost variances on selling price
and sales volume. Furthermore, sales and volume of profit are also inter-
linked; therefore, to have a better understanding, an analysis of variances
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between the actual profit and the standard profit is also necessary. On the
other hand, it is equally important to make an analysis of sales variances
to measure the profit variance as we know that the profit is the difference
between sales and cost. Therefore, this analysis becomes more significant.
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1. Standard cost: A pre-determined cost for various cost components KEY WORDS
to set standards to follow.
2. Actual cost: Costs actually incurred on different cost components.
3. Variance: The difference between the standard cost and the actual cost.
4. Material cost variance: The difference between standard cost
of raw materials and actual cost of raw materials.
5. Labor cost variance: The difference between standard labor cost of
a product and actual labor cost of that product.
6. Overhead variance: The difference in standard and budgeted
overheads of a production process and actual overheads.
7. Sales variance: The difference between budgeted value of sale and
actual value of sale.
8. Profit margin: The difference between budgeted profit per unit and
actual profit per unit.
9. Yield variance: The difference between standard output expected
from actual inputs and actual outputs obtained.


1. What is standard costing and why a firm should set standards for
costing?
2. Why does a firm introduce system of variance analysis?
3. Differentiate between budgetary control and standard costing.
4. Describe the factors responsible for material cost variance.
5. Explain material mix variance. How will you calculate revised standard
mix?
6. How will you verify that the variances measured are correct?
7. What are the different factors responsible for labor cost variances?
8. What is labor idle time variance? Explain with suitable examples.
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9. Why does a firm assess overhead variances?
10. Explain the difference between fixed and variable overheads.
11. How does volume of sales affect the profit margin? Explain with
IMsuitable examples.
12. What are the sub-variances of profit variance? Explain with suitable
examples.
13. Explain the significance of control ratios in business operations of a
firm.
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14. Explain with example the capacity ratio and activity ratio.
15. What is efficiency ratio? Explain its significance.
8.22 ANSWER KEY

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Factors Determining Standards 1. c. Purchase department
under Each Cost Component
2. c. Both (a) and (b)
3. a. Standard costing
Limitations of Standard Costing 4. d. All of the above
5. a. Can be incorporated in
accounting routine
7. c. Actual costs, Variances
Relationship between Standard 8. a. The budgetary control at
Costing and Budgetary Control finances, production and
sales is almost a necessity for
best use of Standard Costing


Labor Cost Variances 10. d. All of the above
11. c. Equal
12. a. Standard labor time indi-
cates the time in hours need-
ed for a specified process
13. a. Direct labor
Variances Based on Profits 14. a. Sales price variance
15. b. Revised standard profit –
Budgeted profit
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SUGGESTED BOOKS
Berger, A. (2011). Standard Costing, Variance Analysis and Decision-
Making. Grin Verlag.
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Rajasekaran, V., Lalitha, R. (2010). Cost Accounting. Pearson India.
E-REFERENCES
Drury C. (1992) Standard costing and variance analyses: 1. In: Management
and Cost Accounting. Springer, Boston, MA.
Gazely, A., and Lambert, M. (2006). Management Accounting, Sage
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publications.
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C H A
9 P T E R
MANAGEMENT ACCOUNTING IN GLOBAL PERSPECTIVE
CONTENTS
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9.1 Introduction
9.2 Activity as a Focus
9.3
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Change in Focus
Activity
9.4 Management Accounting in a Competitive World
9.5 Management Accounting and Global Environment
9.6 Global Management Accounting Principles
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Activity
9.7 Management Accounting and Developed Costing Systems
9.7.1 e-Business
9.7.2 Increased Role of Service Sector
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9.7.3 Increased Global Competition

9.7.4 Stress on Cross-Functional Groups
9.7.5 Product Life Cycles and Diversity
9.7.6 Focus on Inventory Management
9.7.7 Total Quality Management Concept
9.8 Modern Cost Management Systems
Activity
9.9 Summary
9.11 Answer Key
9.12 Suggested Books and e-References

MANAGERIAL DECISIONS IN GLOBAL PERSPECTIVE
A global company has 3 business groups, net sales of 8.5 billion USD,
and over 35,000 employees, having its presence in 45 countries. This
business group develops and manufactures infrastructure equipment
and systems, and it commands a global leadership in its technology. Net
sales of the target business group was about 2 billion USD and person-
nel was over 15,000, while operating profit was over 0.5 billion USD, with
40 to 60% expected annual growth. According to the market reports, the
targeted business group is the most profitable and fastest-growing part
of a very profitable and fast-growing company, and it competes in global,
rapidly growing and changing markets. The business group is organized
as a matrix structure, and it includes two customer segment-based and
production-oriented divisions, which have been divided into nine stra-
tegic business units, five of them in the first division and four in the
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second. There are also divisions of systems platforms and a customer
service and worldwide area organization. Area organization sells the
company’s systems, and customer service arranges the installation.
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There are four major issues, which require attention to establish rela-
tionship between strategic management and management accounting,
environment, strategy and strategic management itself, culture with
managerial philosophies, and finally organizational structure. The group
made management strategies in order to interpret the rational and irra-
tional relationships and interplay between environmental, strategic,
cultural and organizational characteristics as well as employed modern
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managerial technologies behind the strategic management accounting
practice. These factors have significant impact on strategic and other
management accounting practices. The global company analyzed all
the aspects needed for takeover of the target company. After analyzing,
the global company found the target company much beneficial and its
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management felt that by adopting suitable strategies, this could be a

successful takeover. This shows the significance of managerial decisions
in global perspective.
QUESTIONS
1. What were the reasons for considering the takeover proposal

of the target company by the global firm?
2. How do global management accounting practices help in cross-
border mergers and acquisitions?

Management Accounting in Global Perspective 233
LEARNING OBJECTIVES

>> Global practices of management accounting.
>> Technicalities of global business.
>> Survival and growth factors of global business.
>> Management accounting in competitive world.
>> Global environment and changed management accounting
practices.
>> Global management accounting principles.
>> Recent developments in costing techniques across the globe.
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9.1 INTRODUCTION
The organizations across the globe have common goals in terms of profit-
ability, quality of products and customer service. The focus is on cost opti-
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mization. All this require proper managerial information system focusing
on costing and revenue data to take appropriate decision and initiating
required strategies to achieve the goals. The present business environment
has changed rapidly in terms of global competition, advanced technology
and a faster pace of communication. The strategies change overnight and the
firms keep on innovating newer areas and continue changing the decision-
making process and strategies. The important challenges before the man-
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agers involved in management accounting are assessment of their own firm

with competitors, changing strategies by adopting new techniques of man-
agerial decisions, learning and continuously improving operations, etc. We
can observe the branded multi-national corporations, who with their differ-
ent strategies and unique approach in their managerial decisions become the
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market leaders.
The market features have changed drastically due to faster pace of global-
ization. It is a global market with much faster accessibility through internet,
a 24×7 market where one can have trade and transactions round the clock.
The transactions, transfer of goods, settlement, etc., have no boundary lines.
The development and effective functioning of international organizations,
such as World Trade Organization (WTO), European Union (EU), Association
of South East Asian Nations (ASEAN), South Asian Association for Regional
Cooperation (SAARC), BRICS, etc., have changed the way of international
business. Even accounting policies and external reporting systems are being
integrated to increase the business and trade across the globe. In view of the
efficient system of exchange rate, the payment and settlement systems, in all
these crucial developments and faster pace of growth, the cost effectiveness
with difference in quality of product has received top priority. Therefore, we
have explained all the relevant issues in this chapter.
The purpose of this chapter is to make an analysis between the current man-
agement accounting systems and the new activity-management philosophy
as being practiced by the new business community. The experts believe that
traditional management accounting practices no longer work effectively in

modern businesses. One of the major contributing factors to the gap between
current management practices and traditional management practices is on
account of tremendous changes in the IT and communication system. It
would be most beneficial for management accounting practitioners to solicit
views from management accountants in business about current problems
and how effectively they are handled. There is also a need to develop a better
coordination between the industry and academic institutes to seek advice
from each other. The business schools have to understand the current busi-
ness practices and give viable and practical solutions keeping in view the
global perspectives and changed practices. The management accounting
problems are no longer simple, but they have become more complex. The
differences have emerged in terms of the following factors:
1. The new and much developed information and communication
technology enabled customers to find and get access to what they
wanted wherever it was available. This has resulted in greater supplier
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competition. The global market is no longer across the globe, but a
small market on customers table.
2. The advanced production techniques and much faster production
IMoperation system allowed suppliers to profitably sell their goods
of distinct not only at low but also at competitive prices. The new
techniques and continued product innovations have mainly focused on
satisfying customer demands.
3. Both the above developments have successfully created competitive
environment at a faster pace. The traditional management accounting
systems are no longer relevant and they cannot cope up with the new
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challenges as the spirit of competitiveness has been defined as
defeating your competitors not only on costs but also on the quality.
4. This kind of philosophy greatly emphasizes that the firm needs to
control unit costs and achieve profitability by producing all it can sell
at a price that exceeds variable costs, or in other words the positive
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contribution.
QUICK TIP 5. The new business environment calls for two major steps to come over
Global management the competitiveness, which traditional management accounting system
accounting focuses on: did not even feel. The present mantra for a business success depends on
two crucial factors: first, listen to the customer needs and preferences
• Identify global competitive
and second, more focus on eliminating the waste.
firms for possible business
collaborations 6. The whole management accounting strategies have undergone sea
• Focus on value adding changes. The new concepts of inventory management, classification of
activities to bring cost, new cost allocation strategies, workers participation for continuous
competitiveness product improvements, etc., have brought significant changes in the
• Optimizing the cost keeping planning, practices and strategies of modern managerial accounting
international perspective practitioners.
• Global competitiveness to
expand business lines
• Establishing relationship 9.2 ACTIVITY AS A FOCUS
among business
The modern business firms have realized that success of the firm directly
environment, strategies and
depends on factors like what will satisfy customer, plan and chalk out strate-
management accounting
gies and course of action required to provide the required customer satisfac-
practices
tion and preference. The key to achieve the desired goals is to manage the

activities and not the costs, as it used to happen with traditional managerial
accounting practices. In this direction, the process of activity audit has been
much instrumental to some of the firms in United States (US). Some of these
firms have experienced that 50%–90% of the work they do adds no value to the
customers. Therefore, the focus of globally competitive firms is to identify non-
value-added activities and eliminate to avoid wastage and, on the other hand,
focus on the continuous flow of value-adding activities to a greater extent. In
essence, this aims producing only what customer demands, keeping in view
the time factor also. Activity audit is also helpful to a firm as it can stop exist-
ing production, if required, and further correct mistakes by taking required
steps. To further strengthen the activity audit, the following approaches have
been found useful in an efficient activity management practices:
1. Activity management: An efficient activity management system is a
process to identify all the activities, measure its relevance and utility
to the product, extent of particular activity in value addition to the
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product, etc. In fact, it is the exercise to eliminate the non-financial
outcomes of activities. The major focus of this approach is practically
to ignore the costs and pay more attention to eliminate the waste since
waste causes the increased costs.
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2. Activity cost accounting: Another concept is activity cost accounting
which measures the costs of activities and focuses on eliminating waste.
In practice, it is observed that many activities are inherently wasteful.
This aspect requires prompt attention of the management to identify
different cost drivers.
3. Activity-based product costing: The activity-based product costing
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mainly stresses on activities to put them at logical place and assign
them appropriate costs. Identifying appropriate cost driver is also an
important exercise in this area as it relates to product cost.
Remember, activity cost accounting and activity-based product costing are not
the full-fledged approaches to indicate that the firm is able to meet the global
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competitiveness automatically. This is because of the fact that the traditional

managerial accounting philosophy does not change and underlying traditional
cost variance control systems do exist. Therefore, the stress should be on pro-
ducing as much output as possible, which facilitates to achieve economies of
scale for being a successful firm. Despite the fact that the focus of activity cost
accounting is on eliminating non-value adding activities in the production pro-
cess, the important challenge before the firms remain to analyze and understand
to organize operations in such a way that non-value activities become irrelevant.
9.3 CHANGE IN FOCUS

The management accounting practitioners have to redefine the management
phenomena focusing on the firm and the individual. The first challenge is
that there is a feeling that current managed firms achieve results through
group or team behavior. The other one is to encourage managers to control a
firm’s operational activities with accounting information that is designed ini-
tially to plan and coordinate financial strategies. This problem is basically on
account of top management approach of rolling down budgets and a ssigning
performance targets for workers and supervisors at different levels. The
management believes that firm maximizes wealth by managing financial

numbers, meaning that firm should maximize its production. However, the
costing approach is slightly different and it pays more attention, particu-
larly to cost control information such as standard cost variances. The two
approaches at times become contradictory. Therefore, there has to be more
emphasis on information about activity outcomes to help workers and find
the sources of waste and value. There may be many areas of improvements,
such as space utilization, distance factor, time required to actually execute
things, rejection rates, customer responses, total costs, which are more rele-
vant in bringing continuous improvements in the overall production process
and cost optimization.
In view of the above, the areas of concern in the present context of managerial
practices are to evaluate and change the strategies as regards to emphasis on
integrating financial planning with control information and the principle of
constrained optimization. These concepts may have an adverse impact on
continuous improvement. Extra focus on variances from budgets certainly
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limits managers’ focus and they are more attentive to achieve targets that are
static and merely financial. Therefore, extra focus on determining optimum
outcomes based on static constraints (budgets) causes managers to focus on
minimizing unit costs. It is an obstacle to think beyond, that is, to produce
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what is needed and when it is needed. Therefore, the whole focus to achieve
global competitiveness should be to overcome the constraints and not merely
to optimize costs within constraints. Following are the areas which need
focus as per the modern management practitioners:
1. The modern managerial accounting system needs to be developed
which pays more attention to eliminate most of the material on financial
control systems, especially the use of variances from standard cost
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budgets to measure the performance of operating managers. The budgets

are needed for planning, but should not be strictly used for cost control.
2. The modern managerial practitioners are also of the view that there is
a need to eliminate breakeven analysis and cost behavior. There is not
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much significance for separating the costs on traditional basis, such as

fixed and variable costs.
3. According to the modern managerial accounting practitioners, the
concept of constrained optimization should also be eliminated. This
has been discussed above.
SELF-ASSESSMENT 1. The global competitiveness has increased the role of

QUESTIONS
a. management accounting
b. cost accounting
c. both (a) and (b)
2. In the competitive environment activity assumes more significance
rather than
a. values
b. cost
c. customers
d. organization

3. Value-adding activities receive more focus in

a. local context
b. international level
c. both (a) and (b)
d. global context
4. Proper cost drivers help in eliminating
a. economies of scale
b. global competitiveness
c. non-value activities
Indicate the focus in the management accounting in global perspective ACTIVITY 1
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in the following statements:
1. Customers needs and types of product requirements.
2. Achieving profitability by producing and selling all products.
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3. Focus of a global competitive Firm.
4. To measure cost of activities to eliminate wastage.
5. For putting activities at logical place to assign appropriate cost.
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9.4 MANAGEMENT ACCOUNTING IN

A COMPETITIVE WORLD
Management accounting needs an extra focus and more discipline in a
competitive world. There is feeling in US that the effects of global accounting
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standards convergence are quite significant, they are certainly not the only
effects of globalization on US accountants. The pace of globalization is also
changing the balance among the multiple disciplines within the accounting
profession across the world and, more particularly, in America. Traditionally,
the accounting profession in US was focused on the preparation and auditing
of financial accounting statements, which was thought to be the assignment of
financial accounting. The focus is now getting shifted to America and across
the world and the discipline of management accounting has been well recog-
nized as an important segment of the accounting profession. There is now
a clear demarcation between the responsibilities of financial accountant and
management accountants. Following are the areas which differentiate their role:
1. The management accounting deals with both financial and non-
financial data to support a wide range of managerial decisions, whereas
financial accounting focuses only on financial data to support investors’
and creditors’ capital allocation decisions. However, it is observed that
real value-add is the integration of financial reporting with operational
information.
2. Management accounting looks forward as well as backward, whereas
financial accounting is oriented solely toward history. Management
accounting involves future forecasting and anticipations as what will,

could or should happen, as well as indicating the past happenings

and results.
3. The important tools and techniques for management accounting for
managerial decisions involve forecasting, planning and budgeting.
Financial accounting focuses on financial statements, financial ratios
and financial reporting, and important instruments are the balance
sheet and the annual reports.
4. In practice, management accounting looks outward as well as inward,
whereas financial accounting is solely focused on what happens
internally within an enterprise.
5. Management accounting involves proactively seeking and identifying
opportunities and threats that an enterprise faces from customers,
competitors, suppliers, regulatory agencies and other external parties.
However, financial accounting has hardly any role in this.
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6. Management accounting is focused on enhancing business perfor
mance in a competitive environment, not simply on ensuring
compliance with standards and regulations.
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7. Management accountants contribute directly to the creation of value, not
merely to protect and preserve it. The role of management accountants
has increased considerably in the present global competitive
environment as their managerial decisions have direct impact on cost
optimization and revenue increase, thereby contributing more to the
profit growth of a firm.
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9.5 MANAGEMENT ACCOUNTING AND

STUDY HINT GLOBAL ENVIRONMENT
The global competitive Over the decades, the economics and fundamentals of doing the business
environment focuses on: have changed considerably across the globe. The things have changed in
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terms of how individuals and business managers interact with each other,
• Rationalizing International how businesses interact with other businesses and how the interactions take
Accounting standards. place across the government, etc. In addition, there is an ethical change in
• Analyzing business business climate. In all these changes, management accounting role has
environment and is emerged as more crucial. Following are the increased roles of a managerial
implications on overall professional:
strategies of business
growth. 1. The major responsibility is to design internal accounting systems
• Competitive prices of the to achieve the goals of the firm and at the same time have perfect
product. monitoring of the operations.
• Understanding the
2. There is a need to redefine the parameters of performance evaluation
preferences for the products
and services.
which are basically based on budgets and variance analysis.
• Setting up business ethics 3. Understand the implications of conducting business across the globe.
based on the global In this case, interactions with individuals, firms and others assume
environment. significance. Therefore, a managerial professional have to acquire a global
vision to analyze and understand business intricacies across the globe.
4. Management accountants need to thoroughly understand the appli
cations of new costing techniques to effectively use them. An in-depth
analysis is required to assess the impact of these strategies on costing
and pricing of a product in comparison to global prices.

5. They also need to understand the various ethical issues of business

which affect the very brand of the product and firm both. The overall
impact of business ethics should be evaluated and a communication
passed across the work force to make them more cautious toward this
important issue.
6. Of course, the prime responsibility is to establish a perfect management
costing system where more focus is required on activity management
in the changing context.
7. Identification of proper cost drivers has been quite useful in eliminating
the non-value activities and thereby reducing the costs. This exercise
has been found quite useful and advantageous. This should be made
for systematic approach.
8. Management accounting professionals have a key role in optimizing
the performance of the firm. They have a close track not only on costing
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and revenue aspects but also on other important factors related to
the decision-making process. The important factors among them are
optimizing operations of the firm, boosting morals of the work force
through different motivations and incentives, ensuring proper training
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for updating technical skills of the workers, establishing proper
relationship between government and business, keeping close track on
business policies and business environment across the globe, etc.
9.6 GLOBAL MANAGEMENT ACCOUNTING

PRINCIPLES
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The management accounting professionals and practitioners require a thor-

ough understanding of the business and various business models. They
also need to analyze the operating environment so that organizational risks
and opportunities are reasonably evaluated. The timely management and
taking appropriate strategies to manage various risks will enable the firm to
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exploit opportunities and generate value for the stakeholders. Management

accounting is a key between finance and management. It provides structured
solutions to complex problems by translating them into simple strategies.
This can also play a vice versa role. It joins together both the financial and
the non-financial considerations. Management accounting is an area which
can be better used to run the firms’ operations. The firms’ goals are achieved
through better control and performance measurement.
The business model is a practical guide and an important means which
helps a firm in value addition. The management accounting professionals
require a thorough understanding of the business model, firm’s strategies,
market and macro-economic environment; therefore, they contribute their
skills for achieving goals and success on sustainable basis. The information
system plays a greater role in d
ecision-making process. Most of the decisions
are evidenced based on the recent experience.
The role of a management accounting professional lies in extracting more
value from the available information for taking better decisions in the over-
all interest of the firm. Therefore, major global management accounting
principles flow from this essence of managerial accounting. The global man-
agement accounting principles describe the fundamental values, qualities,

norms and features to motivate and inspire the management accounting

professionals. The major factors which facilitate in achieving this are as
QUICK TIP follows:
A strategy can be defined as 1. An effective communication system which provides insight that is
an integrated broad set of influential helps in strategy development and execution. It also helps in
action plans cutting across all better conversation among the groups. The communication is tailored
business functions. to facilitate better decisions.
2. Availability of information which is relevant, reliable and easily
accessible.
3. The further requirement is to analyze impact of communication and
information on value of the firm. This analysis also provides insight into
various alternatives and options to prioritize actions by their impact on
different outcomes.
4. Then the next important pillar of the management accounting principle
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is stewardship, which builds trust and suggests accountability and
credibility for long-term sustainability.
5. Integrity and ethics are also more important for an effective manage
IMment accounting system. This, of course, is developed among the skilled
and competent people who are closely associated in implementing
the management accounting principles. They need to maintain and
improve the firm’s performance by practicing. Therefore, all the above
principles apply to the discipline of management accounting system.
“Stewardship builds trust” applies to the individual behavior of
management accounting professionals.
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In addition to the above principles, quantitative and qualitative skills are

also needed in management accounting professionals to inform decision
making on the basis of past and present data and predictive insights. For
example, management accounting, based on various analyses, can provide
hindsight to decide about the performance and the kind of reward that can
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be awarded. It can provide insight from real-time information. They can also
monitor the execution of strategies and plans and bring them in line with
pre-determined targets; there are various tools to do this, such as, scenario
planning, forecasting and other predictive tools.
The practical aspects of the management accounting function can be sum-
marized in the changing global management practices perspective as follows:
1. Cost transformation and management: The exercise of reducing
waste but at the same time preserving or enhancing value. It involves
the continuous exercise to identify activities and eliminate waste across
all the operations of the firm. The resources saved through this exercise
can be invested in customer focused innovations.
2. External reporting: The management accounting professionals are
also required to integrate a comprehensive assessment of financial and
non-financial performance, business model per se, risks associated and
strategies for effective assessment of future performance.
3. Financial strategy: This requires identification of the future strategies
which will be helpful for maximizing the firm’s net present value.
This also involves appropriate allocation of available capital resources

among the competing opportunities, and an effective implementation

and monitoring system to evaluate the selected strategies to achieve
pre-decided goals and objectives of the firm.
4. Internal control: The strengthening of internal control systems and
procedures is also a prime responsibility of management accounting
professionals. They need to prepare a framework of policies, systems,
processes and procedures for effective management of risks. There
has to be a well-defined system to ensure efficient and effective
implementation of the framework.
5. Investment appraisal: A decision to evaluate an investment proposal,
keeping in view the financial viability and technical feasibility, is an
important decision area where management accounting professional
can play a crucial role. They can prioritize the investment options
based on affordability and expected returns and different kinds of risks
associated with the investments.
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6. Management and budgetary control: This is of course a traditional role
of managerial accounting professionals to control performance against
budgeted targets. The controlling areas may include projects, people,
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activities, processes, sales volumes and revenues, resource quantities,
operating costs and expenses, assets, liabilities and cash flows, etc.
7. Price, discount and product decisions: The most crucial decision in a
firm’s operations to decide what to produce, how much to produce and
at what selling price and discount the product is to be sold.
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SELF-ASSESSMENT
5. The business models in global perspective should specify the
QUESTIONS
a. profits
b. risks
c. contracts
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6. The most crucial decision in a firm’s operations include
a. Pricing
b. Discount
c. Product decisions
d. All of the above
7. Financial strategy also involves which resources at competitive costs?
a. capital
b. human power
c. machinery
The focus of financial accounting is indicated in the following sentences. ACTIVITY 2

Based on this, identify the focus of management accounting:
1. Financial accounting focuses only on financial data.
2. Financial accounting focuses on financial rations and reporting.

3. Financial accounting is for compliance of regulations.

4. Financial accounting is for external use for all stake holders.
5. Financial accounting presents historical performance.
9.7 MANAGEMENT ACCOUNTING AND

DEVELOPED COSTING SYSTEMS
The following sections describe the unique developments which have
changed the very way of functioning and role of management accounting
professionals.
9.7.1 E-BUSINESS
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NOTE The rapid growth of e-commerce and e-business witnessed the rapid
Modern management electronic transformation of the business environment. The depth of the
accounting practices focus on: e-commerce had an impact throughout the spectrum of the business environ-
ment. One can order anything online in consumer-to-business e-commerce
• E-commerce and E-business.
• E-budgeting.
IM
channels; businesses can order raw materials and supplies using business-
to-business networks. Further, supply chain management, a tool for coordi-
• Lowering down the cost nation of order generation, order taking, order fulfillment and distribution of
through online delivery
products and services, has increased online transactions to a larger volume
system.
across the globe. e-Commerce may be defined as buying and selling over
• Effective logistics and supply
digital media, and e-business is a broader concept.
chain management.
Managerial professionals have moved fast toward e-accounting by harness-
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ing the power of online communications to streamline the procedures of

managerial accounting. For example, e-budgeting is now used by hundreds
of companies to quickly and effectively transmit the information needed to
construct a budget from far-flung business units around the globe.
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e-Business is here to stay and it will affect our lives and our jobs in ways we
cannot even imagine today.
THE INTERNET: A REVOLUTIONARY CHANGE IN GLOBAL BUSINESS

In today’s business environment, the wider use of internet has converted the
large globe into a small room. It is in fact a lifeline for the business. The firms
look internet as a cost-cutting tool and a new stream for generating revenues.
The internet is also viewed as an effective tool for serving the customers,
besides an efficient payment and settlement mechanism. We reproduce here
some of the examples as how firms are using the web to their advantages:
1. On a single day, Alibaba was able to generate double digit sales clocking
an impressive $9 billion (Rs. 55,000 crores) and beating its own record
of $5.9 billion last year.
2. A report on e-commerce states that a broking firm, Motilal Oswal, says
that this is just the start of a multi-year growth for the e-commerce
sector in India. Indian retailers, therefore, do not have to be too

concerned as despite strong growth in US and China, e-tailing is still
only 5%–6% of the total retail sales there.

3. India is almost 10 years behind China in the e-commerce space. China’s

inflection point was reached in 2005 when its size was similar to India’s
current market size. Thankfully, for India, the dynamics currently
are similar to what existed in China then – growing broadband
penetration, acceptance of online marketplaces and lack of physical
retail infrastructure in many places.
4. Forget the Flipkarts, Snapdeals and Amazons, travel is where the real
money in India’s e -commerce is. Online travel accounts for nearly
71% of e-commerce business in India. This business has grown at a ! IMPORTANT CONCEPT
compounded annual growth rate (CAGR) of 32% over 2009–2013. • Impact of E Business and
5. Alibaba is an outlier when it comes to margins and making money in the E commerce on Management
e-commerce ecosystem. The Chinese company makes an operating profit Accounting practices.
of 40% compared to industry standard (US and China) of 8%–10%. Travel • Understand the online
sites typically make 2.3%. Amazon, the industry pioneer, is yet to achieve business practices and its
effect on operational costs.
healthy profitability even after two decades of dominance. Indian players,
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• Implications of cross-
the report points out, are not even thinking of profitability yet. It’s a game
functional groups on
of market share and market penetration, causing all serious players to
managerial decisions.
have a war chest ready for, when the industry scales multiple times. • Impact of shorter product
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6. For every Rs. 100 spent on e-tailing, Rs. 35 is spent on supporting
services like warehousing, payment gateways and logistics, among
life cycle on business
decisions.
others. Delivery costs a platform owner 8%–10% implying significant • The process of total quality
burn. Though 50%–60% of delivery logistics today are handled by large management in bringing
e-tailers themselves, this proportion may reduce going forward as the cost effectiveness.
participation of lower tier cities picks up. Presently, aggressive pricing
in India is leading to e-tailers making losses on every segment. For
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every Rs. 100 sale of a book, the e-retailer incurs a loss of Rs. 24, a loss
of Rs. 13 on mobiles and Rs. 8 on apparels.
Demand in India exists across 4,000–5,000 towns and cities, but there is no
significant presence of physical retail in almost 95% of these. High real estate
cost is one of the main reasons why organized retail is unable to expand at
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speeds expected earlier.
9.7.2 INCREASED ROLE OF SERVICE SECTOR

The market share of service sector has been growing across the globe. Several
governments have made engagements and provided incentives to boost this
sector. The telecommunications, financial services and airline industries
are among them. As more and more firms provide financial, medical, com-
munication, transportation, consulting and hospitality services, managerial
accounting techniques must be adapted to meet the needs of managers in
those industries. As we are aware that the main difference between service
and manufacturing firms is that most services are consumed as they are pro-
duced, the services cannot be inventoried like manufactured goods. It has
been observed that many of the techniques developed for measuring costs
and performance in manufacturing firms have been adapted successfully to
service industry firms.
9.7.3 INCREASED GLOBAL COMPETITION

Today the market place is in real sense a global one. A firm in London is
just as likely to be in competition with a firm from US, Germany or France.

The extensive global competition is forcing firms to strive for excellence in

product quality and service, which was not the case earlier.
Multi-national firms face several challenges that do not confront domestic
firms. Political systems, accounting rules for external reporting, legal systems
and cultural norms vary widely among countries. Therefore, management
professionals must be aware of various policies and practices to successfully
carry out operations across the countries.
9.7.4 STRESS ON CROSS-FUNCTIONAL GROUPS

In past, managers used to stick to their own work area. Production man-
agers focused on how best to manufacture a product or produce a service.
Marketing managers concentrated on selling the product or service. Design
engineers often emphasized engineering elegance rather than designing a
product for manufacturability. Managerial accountants provided informa-
S
tion for decision making, planning, control and performance evaluation.
Today, the things have changed drastically. The cross-functional approach
has replaced this narrow managerial perspective. The functional groups
bring together production and operations managers, marketing managers,
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purchasing and material handling experts, design engineers, quality man-
agement personnel and managerial accountants to focus their varied exper-
tise and experience on virtually all management issues. The managerial
accounting professionals develop information system and provide data rang-
ing across all aspects of the organizations internal operations and external
environment. They also work as an integral member of the cross-functional
team, interpreting information and analyzing the implications of decision
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alternatives. The cross-functional groups create value for the firm by under-
standing customer’s needs in the most effective manner possible.
9.7.5 PRODUCT LIFE CYCLES AND DIVERSITY

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In view of changes in technology at faster pace, the lifespan of most products

is becoming shorter. In the computer industry, for example, product models
are used only a few years before they are replaced by more powerful versions.
To be competitive, manufacturers must keep up with the rapidly changing
market place. The challenge before management accounting professionals
is to have timely information about production costs and other product fea-
tures in order to meet effectively to the competition.
9.7.6 FOCUS ON INVENTORY MANAGEMENT

We are aware that in traditional manufacturing system, inventories of raw
materials and parts, Work In Process (WIP) and finished goods were kept as
a buffer against the possibility of running out of a needed item. Also, large
buffer inventories consume valuable resources and cost heavily to a firm.
Therefore, many manufacturers have completely changed their approach to
production and inventory management. These manufacturers have adopted
a strategy for controlling the flow of manufacturing in a multi-stage produc-
tion process. In a just-in-time (JIT) production system, raw materials and
parts are purchased or produced just in time to be used at each stage of the
production process.

9.7.7 TOTAL QUALITY MANAGEMENT CONCEPT

The concept of total quality management (TQM) has emerged very strongly
in the recent past. If a component is to be produced just in time for the next
production stage, it must be “just right” for its intended purpose. A slight
delay in the inventory process may shut down the entire production line,
entailing considerable cost. Therefore, managerial accountants have become
involved increasingly in monitoring product quality and measuring the
costs of maintaining quality. This information helps companies maintain
programs of TQM.
9.8 MODERN COST MANAGEMENT SYSTEMS

The modern cost management and managerial accounting system are
required to focus on the following:
1. Assessment of cost of the resources consumed in performing significant
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activities.
2. Continued focus to identify and eliminate non-value-added costs. The
costs incurred on activities which do not increase the value of a product
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can be eliminated with no deterioration of product quality, performance
or perceived value.
3. More stress on measuring efficiency and effectiveness of all major
activities performed in the firm.
4. Ongoing efforts to identify and evaluate new activities that can
improve the future performance of the firm.
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SELF-ASSESSMENT
8. Because of online transactions, management accounting now
QUESTIONS
focuses on:
a. e-accounting
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b. online payments
c. both (a) and (b)
9. E commerce signifies business transactions over
a. social media
b. print media
c. digital media
10. Management accounting should now focus on which sector due to
its increased role?
a. Agrobusiness
b. Service
c. Automobile

ACTIVITY 3 Identify the focus under the following activities:

1. Larger volume of online transactions.
2. Growth of telecom and financial services.
3. Excellence in product services and quality.
4. Coordination among production, operation and marketing
managers.
5. Shortening span of product models.
6. Just-in-time.
7. Focus on just right product.
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9.9 SUMMARY
The market features have changed drastically due to faster pace of
lobalization. It is a global market with much faster accessibility through
g
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internet, a 24×7 market where one can have trade and transactions
round the clock. The transactions, transfer of goods, settlement, etc.,
have no boundary lines. The development and effective functioning of
international organizations, such as WTO, EU, ASEAN, SAARC, BRICS,
etc., have changed the way of international business. Even accounting
policies and external reporting system are being integrated to increase
the business and trade across the globe. In view of the efficient system
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of exchange rate, the payment and settlement systems, in all these cru-
cial developments and faster pace of growth, the cost effectiveness with
difference in quality of product has received top priority.
The modern business firms have realized that success of the firm directly
depends on factors like what will satisfy customer, plan and chalk out
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strategies and course of action required to provide the required customer

satisfaction and preference. The key to achieve the desired goals is to
manage the activities and not the costs, as it used to happen with tradi-
tional managerial accounting practices. In this direction, the process of
activity audit has been much instrumental to some of the firms in US.
Some of these firms have experienced that 50%–90% of the work they
do adds no value to the customers. Therefore, the focus of globally com-
petitive firms is to identify non-value-added activities and eliminate to
avoid wastage and, on the other hand, focus on the continuous flow of
value-adding activities to a greater extent. In essence, this aims produc-
ing only what customer demands, keeping in view the time factor also.
Activity audit is also helpful to a firm as it can stop existing production if
required and further correct mistakes by taking required steps. To fur-
ther strengthen the activity audit, the following approaches have been
found useful in an efficient activity management practices.
The management accounting professionals and practitioners require
a thorough understanding of the business and various business
models. They also need to analyze the operating environment so that
organizational risks and opportunities are reasonably evaluated. The
timely management and taking appropriate strategies to manage various

risks will enable the firm to exploit opportunities and generate value
for s takeholders. Management accounting is a key between finance and
management. It provides structured solutions to complex problems by
translating them into the simple strategies. This can also play a vice versa
role. It joins together both the financial and the non-financial consider-
ations. The management accounting is an area which can be better used
to run the firm’s operations. The firm’s goals are achieved through better
control and performance measurement.
1. Global business: The business transactions across the globe. KEY WORDS
2. WTO: World Trade Organization.
3. Global competitive firm: A firm having competitive advantage in
global business.
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4. Activity management: The focus of a firm to manage relevant and
value-added activities rather than cost.
5. Activity cost accounting: Measurement of cost based on cost drivers.
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6. Management ethics: Managerial practices with value and ethics.
7. Cost optimization: Optimum utilization of resources at a minimum
cost.
8. External reporting: Financial reports meant for external
stakeholders.
9. Investment appraisal: Assessment of viability of a new investment
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opportunity.
10. e-Business: Business transactions through internet.
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1. What are the differences in management accounting practices being
followed at domestic level and global level?
2. Why global management accounting system has emerged so fast?
3. Why should a firm pay more attention to manage the activities rather
than costs?
4. Describe the changes being brought out in US and other developing
countries in the area of global management accounting practices.
5. What are the universally accepted management accounting principles?
Describe them with suitable examples.
6. Describe important areas which have received the attention of
management accounting practitioners.
7. Describe the recently developed cost accounting techniques used by
the firms for efficient cost management practices.
8. Explain the business transaction through e-commerce. How e-business
strategies have changed the very way of conducting business across
the globe?

9.11 ANSWER KEY

Activity as a Focus 1. a. management accounting
2. b. cost
3. d. global context
4. c. non-value activities
Global Management Accounting 5. b. risks
Principles
7. a. capital
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Management Accounting and 8. a. e-accounting
Developed Costing Systems
9. c. digital media
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SUGGESTED BOOKS
Kanhaiya S. (2015). Management Accounting: Concepts and Strategic
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Costing Decision. Wiley.
Khatri, P. V. and Verma, S. (2015). Management Accounting: Concepts
and Applications. 2nd edition, Global Vision Publishing House.
E-REFERENCES
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Chapman, C., Hopwood, A.G., Shields, M.D. (2006). Handbook of

Management Accounting Research, Volume 2, 1st Edition, Elsevier.
Shields, G. (2018). Management Accounting: The Ultimate Guide to
Managerial Accounting for Beginners Including Management Accounting
Principles. CreateSpace Independent Publishing Platform.

C H
10 A P T E R
CASE STUDIES
CONTENTS
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Case Study 1 Relevance of Management Accounting in Business Decisions
Case Study 2 Allied Electro Plast Ltd.
Case Study 3A
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Case Study 3B HHE Ltd.
Case Study 4 Hindustan Petroleum Corporation Limited
Case Study 5A Cost Analysis
Case Study 5B XYZ Business Firm
Case Study 6 Apollo India Ltd.
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Case Study 7A The Household Products Company

Case Study 7B Segregating Costs
Case Study 8 Harden Company
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Case Study 9A Management Accounting Practices in Global Perspective

Case Study 9B Management Accounting Information and Practices

CASE STUDY 1
N O T E S
RELEVANCE OF MANAGEMENT ACCOUNTING

IN BUSINESS DECISIONS
Management Accounting deals with providing information for inter-

nal users, mainly the managers. Since they are the section of people
who direct and control the operations of the firm, the information that
Management Accounting provides is very useful. Some of the basic
management activities are:
Planning: Considering various alternatives and choosing the best among
them.
Control: Ensure that the chosen plan is being followed and whether
those are in line with the objectives of the firm.
Directing and motivating: Activities need to be monitored and employ-
ees need to be motivated and encouraged to ensure smooth and effective
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functioning of the organization.
The concept of Management Accounting evolved during the Industrial
revolution of the 19th century. During that period, most of the companies
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were controlled and owned by a few managers. Elaborate financial reports
were not demanded as there were no external shareholders. The 20th
century saw a lot of changes in the economy; companies were required to
submit detailed financial reports in order to satisfy the capital markets,
taxation purposes and creditors. Earlier, production technology was
simple, with products passing through a series of distinct phases of pro-
duction. So, it was easier to identify the associated material and labour
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costs, thus direct labour was used as the basis for assigning indirect costs
to products.
The Modern Management Accounting
Organizations are under pressure not only to make decisions on a day-to-
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day basis, but also to chalk out a plan that will help them to survive and
grow in the ever-changing market place, considering the fact that they
will be faced with uncertain circumstances. The main role of modern
management accounting is to provide the various levels of management
with information that is relevant to make sound decisions and to add
value to the company. It is slightly different from traditional accounting,
because they provide managers with essential information in time to set
targets, minimize the cost, develop standards, monitor performances and
compute variances, thereby improving the quality of the products with
reduced wastage. Apart from these, Management Accounting aids in
improving the flexibility and innovative capacity of the organization, thus
making continuous changes to improve its financial and non-financial
performance to stay on track with the rapidly changing economy.
Shaping an Organization
Management Accounting can help shape an organization in the follow-
ing ways:
1. Provides accurate and timely information to help cut costs,
measure and improve productivity.

CASE STUDIES 251
CASE STUDY 1
N O T E S
(a) Information on product costs helps in the introduction of new

products in the market, pricing decisions and, if required,
abandonment of obsolete products.
(b) For large and decentralized organizations, it is essential
to motivate employees using appropriate incentives and
benefits. This decision is based on the results provided by the
management accounting system.
(c) Acts as a communication tool which the upper management
uses to communicate with the middle and lower management
and vice versa. Information about the organizational goals and
strategy is passed on to the operational divisions and feedback
is communicated back to the upper management.
2. Binds the operational and strategic goals together in order to
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ensure that the performances of the operational divisions are
aligned with the organizational goals.
Management Accounting Shaped by Organization
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An organization can also have an impact on this accounting system in
the following ways:
1. In order to successfully grow in the rapidly advancing market,
customer satisfaction has become the prime focus. This affects the
kind of information required by the organization and demands
sophisticated form of management accounting system.
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2. Since organizations are divided into sub units, the interdependence
among them would be very high. As a result the dynamics of the
information needed has changed.
3. Due to increased coordination among organizations, the gap
between suppliers and employees are getting narrow. This has
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led to changes in the way that organizations collect and use

management accounting information.
(a) A major computer revolution has brought about a significant
reduction in the information collection and processing costs
and has eased the work of accountants.
QUESTIONS
1. Explain three basic objectives of Management Accounting with

suitable examples. Can all these three objectives be integrated?
Justify.
2. Based on the above contents, how would you differentiate
the modern management accounting from the traditional
accounting?
3. Describe the concept of “Management Accounting shaping an
organization” giving an example of an organization.
4. How do you justify the statement that “Management accounting
shaped by organization”?

CASE STUDY 2
N O T E S
ALLIED ELECTRO PLAST LTD.
This case study has been carried out in company known as Allied Electro
Plast Ltd. This company was established in the year 2008. The company
is engaged in manufacturing and supply of different types of blowers.
The company has supplied its products to many customers in India. The
production unit is situated in Amrawati. The company has office in Pune,
Maharashtra, that basically looks after marketing arrangements. Raw
material required for manufacturing blowers are H.R. Sheet, Motors of
different H.P. C-channel, L-angle, nut bolt and paint. The main issue of
this industry is inventory control for ordering raw material and supply
of blowers to customers. The top management has been experiencing
that materials procurement cost is on higher side as compared to their
competitors. The management has consulted with different professionals
where one of the cost accountants understood the reason of high mate-
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rial cost and advised to follow the system of Efficiency Order Quantity
(EOQ). Therefore, to manage inventory of raw materials, a case study is
carried out using EOQ method of inventory management.
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To carry out the case study on inventory management, the professional
management accountant approached the company and asked for detailed
information. During the interactions, it was observed that the ongoing
forecasting method used by this firm had brought some problem due to
inaccurate forecasting. Forecasting method used is the simple average
based on the average historical demand, but this had led to inaccurate
prediction. The top management wanted the professional accountant to
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recommend alternative options to help the company to reduce the stock
and cost by using more effective prediction EOQ and ROP. For this pur-
pose, analysis of a product of the company is done, using data of the last
one year. Finally cost is estimated to see the importance and the differ-
ence is compared with the current and proposed model.
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Determination of EOQ: To calculate EOQ, the annual demand of the

firm, cost of ordering and holding cost was obtained. The professional
manager observed that calculation of EOQ of H.R. Sheet is somewhat
typical. Therefore, the manager calculated total cost of ordering, holding
cost, etc., in his own way. The following are the basic calculations.
Annual Demand: The annual demand for lug is calculated based on
average monthly turnover of the firm. According to the data available,
the demand for H.R. Sheet is 3000 kg per month. Therefore, total annual
demand = 3000 kg per month × 12 = 36,000 kg.
Unit Cost: Cost of one unit is Rs. 60 per kg. Accordingly, C = Rs. 60 per kg
Ordering Cost: According to the company’s current forecasting model,
the company makes order once in a month and the total charge is
Rs. 200,000. Therefore, according to the company’s data sheet, ordering
is 10% of Rs. 200,000/-. So, ordering cost per order = Rs. 20,000. Therefore,
cost of H.R. Sheet = Rs. 200,000 – Rs. 20,000 = Rs, 180,000.

CASE STUDIES 253
CASE STUDY 2
N O T E S
QUESTIONS
Based on the information as given in the case study, you are required to:
1. Calculate order cost per kg.
2. What is the EOQ of HR Sheet?
3. What is the holding and ordering cost?
4. Prepare a table to show the difference in cost between the EOQ
method of inventory system and traditional technique being
adopted by the company.
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CASE STUDY 3A
N O T E S
RALLIS INDIA
A company Rallis India is engaged in manufacturing of an electronic

equipment. The product passes through different processes. The com-
pany has employed different types of workers in the production process,
such as, full-time workers and workers paid on hourly base. The cost
accountant prepared a report and placed before the General Manager
of the department. Looking to the report, the General Manager felt that
the labour cost is too high considering the number of workers employed
and wages paid to them. He also felt that the proportion of labour cost is
also high in the total factory cost. He advised the Manager to prepare a
detailed report and submit for review. The manger asked the cost accoun-
tant to collect all the details of the labour cost being incurred by the com-
pany for the last 1 year. The accountant collected the following data.
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The company has 255 full-time employees and 95 part-time employees.
The full-time workers are paid at a higher wage rate, while part time
workers are paid on hourly basis. As per the calculations, the average
wage rate per hour is Rs. 350 per worker. The following is the additional
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information available relating to the labour cost.
1. Each worker works for 40 hours in a week and the company
operates for 52 weeks in a year.
2. Form the records, the company found that workers remain absent
particularly those who have been engaged on part-time basis. It is
observed that on an average a worker remains absent for 10 hours
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among those who work on part time. This reduces the net working
hours of the part-time workers and accordingly the wages.
3. Other expenses incurred on the workers are as follows:
Insurance Rs. 500

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Taxes Rs. 500

Overtime Rs. 1,000
Benefits Rs. 1,500
Supplies Rs. 500
The above expenses are incurred per worker.
4. The cost accountant also observed that each worker remains idle
for 2 hours in a week and these 2 hours are permitted as idle time
for the necessities.
The manager made the detailed analysis of all the available informa-
tion and data and prepared a detailed report. The effective labour cost
was arrived at considering all the direct and indirect costs. The actual
cost was higher than the cost as perceived by the General Manager. The
detailed report was put up before the General Manager and he was con-
vinced about the actual labour cost being incurred on workers.
Suppose, you are the General Manager and the cost accountant pro-
vided all the above information and data. How would you attempt to the
following?

CASE STUDIES 255
CASE STUDY 3A
N O T E S
QUESTIONS
1. What will be the gross pay payable to all the workers consid
ering the number of workers and wage rate?
2. How many hours the workers effectively work in a year
considering the absentees?
3. What is the total indirect labour cost the company incurs on its
workers during a year?
4. Calculate annual payroll labour cost.
5. Calculate actual hourly labour cost that company incurs per
worker.
6. Prepare a report to the General Manager justifying the labour
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cost being incurred by the company.
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CASE STUDY 3B
N O T E S
HHE LTD.
The HHE Ltd., a manufacturing unit, requires 4000 units of a particular

raw material per year. At the beginning of the current year, the purchase
department estimated the purchase price @ Rs. 90 per unit, while the
accounting department estimated the incremented cost processing an
order is Rs. 135 and the cost of storage is estimated to be Rs. 12 per
unit. But the costing department is against the incremental processing
cost of Rs. 135 per unit. Rather, according to it, this should have been
Rs. 80. At the commencement, the supplier offers 4000 units @ Rs. 86
per unit. The material will be delivered immediately and placed in the
stores. One of the directors of the company saw that ‘due to present com-
munication system the incremental cost of placing an order is zero, but
the accounting department’s original estimate of Rs. 135 for placing an
order for economic batch is correct. After a series of discussions of the
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departmental heads company reached to decision not to buy 4000 units
at a time.
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1. Comment on the company’s decision.

2. Calculate the total cost, when incremental cost process on order
is Rs. 135 per unit.
3. What would be the total cost, if incremental cost processing an
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order is Rs. 86?
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CASE STUDIES 257
CASE STUDY 4
N O T E S
HINDUSTAN PETROLEUM CORPORATION LIMITED
The following is the cost sheet of Hindustan Petroleum Corporation

where required cost details and other relevant information is provided.
COSTING OF HINDUSTAN PETROLEUM Hindustan Petroleum
Corporation Limited (HPCL) is the result of a successful convergence
of four established companies. Today the second-largest integrated oil
refining and marketing company in India, HPCL born of the merger of
ESSO, Lube India Ltd., Caltex Oil Refining India Ltd. and Kosan Gas
Company Ltd.
The Company was first incorporated as Standard Vacuum Refining
Company of India Limited, on July 5, 1952, and later named ESSO India
Limited on March 31, 1962. On July 12, 1974, when Esso and Lube India
were nationalised, the company was renamed Hindustan Petroleum
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Corporation Limited with effect from July 15, 1974. The undertakings
after nationalisation were then vested in HPCL. The Government of
India also nationalised the Caltex undertakings in the year 1976, which
were subsequently merged with HPCL in 1978. In the following year, the
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undertakings of Kosan Gas Company Ltd., the concessionaires of HPCL
in the domestic LPG market, were merged with HPCL. Thus, the vari-
ous amalgamations, at different points in time, have given rise to HPCL
that has ever since been growing from strength to strength.
HPCL had a humble beginning in 1974 with one refinery at Mumbai
that had a refining capacity of 3.5 million metric tonnes per annum
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(MMTPA). The lube oil refinery at Mumbai stood around 165,000 tonnes
per annum. The sales turnover in that year was only Rs. 3.67 billion, and
the net profit was Rs. 58 million. But over the years, the Corporation
has made judicious use of its assets to achieve tremendous growth.
Dedicated and well-experienced manpower, strategically located refin-
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eries at Mumbai and Visakh and a widespread marketing network have

enabled the company to carve a niche in the Indian oil industry today.
COST SHEET
Cost Sheet for Hindustan Petroleum Corporation Ltd for the year
2003–2004
Rs./ Crores
R.M Consumed 15,017.04
Direct Labour (See Assumption 1) 280.055
Direct Expense
-Excise Duties 5993.47
Prime Cost 21290.565
Factory Overheads
Packages Consumed 79.15
Transshipping Expenses 1228.97

CASE STUDY 4
N O T E S
Duties Applicable to Products 317.61

Repairs and maintenance to Plant 165.68
Rent (See Assumption 3) 28.65
Repair and maintenance to other assets 1.633
(See Assumption 2)
Electricity and Water 94.93
Power and Fuel 9.17
Rates and Taxes 21.2
Equipment Hire Charges 0.3
Consumption of stores, spares and 71.08
chemicals
Depreciation:
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-Transport Equipment (See Assumption 4) 2.335
-Roads and Culverts 7.16
-Leasehold Property 2.45
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-Railway siding and Rolling stock 12.42
-Plant and Machinery 536.24 560.605 2578.978
Work Cost (Gross) 23869.543

Opening WIP 212.67
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Less: Closing WIP 197.68 14.99

Works Cost (Net) 23884.533

Administrative Overheads
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Security Charges 16.67

Depreciation
- Building 17.25
-Furniture, fixtures and equipments 26.39 43.68
Office appliances--- Printing & Stationary 7.69
Rent (See Assumption 3) 28.65
Repair and maintenance to building 11.7
(See Assumption 2)
Insurance 40.08
Consultancy and Technical charges 37.26
Sundry Expenses and Charges 163.04
Office Salaries (See Assumption 1) 280.055 630.459
Total Cost 24514.989

CASE STUDIES 259
CASE STUDY 4
N O T E S
Add: Opening Finished Goods 3777.2

Add: Purchase of Finished Goods 30583.9 34361.1
Less: Finished Goods –4149.69

Cost of production of Saleable units 54726.399
Selling and Distribution Expenses

Traveling and Conveyance 55.97
(See Assumption 2)
Depreciation on transport equipment (See 2.335
Assumption 4)
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Advertising & Publicity 81.45 141.388
Cost of Sales 54867.787

Profit
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Sales 57511.13
Assumptions
1. A bifurcation between factory wages and office salaries has not
been given. However, the annual report says that HPCL has 11,088
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employees of which 3594 are management employees and 7494
are non-management employees. Let us assume this to be the
distribution of office and factory staff. However, the management
employees have higher salaries. Thus, Wages, Salaries and
Bonus have been divided equally between Direct Labour and
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Administrative overheads.
2. Repairs and Maintenance to other assets has been equally divided
between Factory overheads, Administrative overheads and
Selling and Distribution overheads, since the assets have not been
mentioned.
3. Rent is equally distributed as Factory rent and Office rent.
4. We assume that Transport equipment is used for both Factory
and Selling and Distribution purposes. Thus, depreciation
on transport equipment is equally divided between Factory
overheads and Selling and Distribution overheads.

CASE STUDY 4
N O T E S
QUESTIONS
1. Analyse and comment on Prime cost, Factory overheads, Work

cost and Administrative overheads. Calculate the proportion of
these costs in total cost of sale.
2. What is the percentage of profit in total sales?
3. Explain justification of each of the assumptions provided in the
cost sheet.
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CASE STUDIES 261
CASE STUDY 5A
N O T E S
COST ANALYSIS
A company is engaged in different kinds of jobs related to printing work.

It has a very old existence and therefore receives good number of orders.
The company received many job orders in the recent few months. The
company is not able to reconcile the cost details and other inventory
details. The company is looking for a professional to prepare a statement
to present a clear picture so that the company can know the details.
The following are incomplete account of a printing plant up to 31
January, 2019.
Also consider the data that appear The Accounts Materials Costs
December 31, 2018 Balance 30,000 Wages Liability 31/12/2018 Balance
6000 Work in progress control Factory Department overhead control
Total January Charges 1,14,000 Factory overheads Applied Cost’ of
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Goods Sold Finished Goods Control 31/12/2018 Balance 40,000 Cost of
Goods Sold.
The following is the additional information available from the cost
records:
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1. The overhead is applied using a budgeted rate that is set every
December by forecasting the following years’ overheads and
relating it to forecast direct labour cost. The budget for 2019 called
for Rs. 8,00,000 of Direct Labour and Rs. 12,00,000 of Factory
overhead.
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2. The only Job unfurnished on 31st January 2019 was Job number
819, where total direct Labour costs were Rs. 4000 (125 direct
labour hours) and total direct material costs were Rs. 16,000.
3. Total material placed into production during January were
Rs. 1,80,000.
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4. Cost of goods completed during January were Rs. 3,60,000.

5. Material in stock of January 31 was Rs. 40,000.
6. Finished goods inventory as of January 31 was Rs. 30,000.
7. All factory workers earn the same rate of pay. Direct labour hours
for January total 5,000; other labour and supervision totalled
Rs. 20,000.
8. Gross factory wages on January paydays amounted to Rs. 1,04,000
ignoring holidays.
9. All “actual” Factory overheads incurred during January has
already been posted.

CASE STUDY 5A
N O T E S
QUESTIONS
1. Calculate the materials purchased in January.

2. Calculate the cost goods sold during January.
3. Calculate the direct labour costs incurred during January.
4. Calculate the overhead applied during January.
5. Balance, Wages Liability, 31 December 2018.
6. Balance of Work-in Progress control, 31 December 2018.
7. Work-in Progress control, 31st December 2019.
8. Overhead applied or unapplied overhead for January.
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CASE STUDIES 263
CASE STUDY 5B
N O T E S
XYZ BUSINESS FIRM
XYZ is a business firm engaged in manufacturing of different sizes of

shoes. For convenience in the process, the firm uses batch costing con-
cept in the manufacturing of its products. The top management is keen
to know if the batch costing concept used by the firm reflects the true
cost of the product. For this purpose, a cost accountant has been assigned
this task to find out the details and submit a report to the management
justifying the batch costing approach. The cost accountant collects the
required information and data from different departments. The follow-
ing data is obtained by the cost accountant.
For a batch of 80 units, the following costing information is available:
Summary Costing Information
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Direct labour hours 30
Direct labour 450
Direct material 340
Direct expenses 50
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Production overhead 1200
The following is the additional information:
1. Production overhead is absorbed into the batch costs at the rate of
12.00 per direct labour hour.
2. Selling, general and administrative overhead is absorbed into
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batch costs at a rate of 20% of the total production cost.

3. The selling price of a unit is assumed at Rs. 40.00. Calculate the
unit and batch profit.
The following are the Selling, General and Administrative Overhead:
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The business allocates selling, general and administrative (SG&A) over-

head at the rate of 20% of the total production cost. The selling, general
and administrative overhead applied to this batch based on production
cost and overhead rate.
The cost accountant makes all the required calculations and presented
a summary to the management, recommending that the batch cost con-
cept followed by the firm is appropriate. He also explained the Batch
Quantity concept to the management.
Suppose you are assigned this task and asked to prepare a report. What
would you recommend keeping the following questions in mind?

CASE STUDY 5B
N O T E S
QUESTIONS
1. How would you arrive at unit and batch profit?

2. How will you arrive at the selling and administration overheads?
3. What will be the batch profit?
Prepare summary for the top management justifying the Batch

Costing approach adopted by the management and also appraise about
Economic Batch quantity.
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CASE STUDIES 265
CASE STUDY 6
N O T E S
APOLLO INDIA LTD.
Apollo India Ltd. is engaged in the production of aluminium parts that

are used for different purposes. The company was established in 1975
when traditional costing system was being followed by majority of busi-
ness firms. The top management is also not very much equipped with
the modern accounting concepts. One day, the manager and in charge of
accounts department presented a report and analysis showing the prof-
its. Simultaneously, the cost accountant also reported to the top manage-
ment about the income. The cost accountant prepared two statements
where two different incomes were shown. The General Manager was not
convinced about the two different incomes shown under the two state-
ments. The cost accountant explained that the income will be different
if we prepare two different income statements. The General Manager
advised him to prepare the detailed report justifying the reason for dif-
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ferences under both the methods.
The cost accountant collected all the information and data on produc-
tion, costs, sales and inventory and prepared two different statements of
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income, one under the Marginal Costing approach and another follow-
ing the Absorption Costing Approach. He also prepared an explanatory
note justifying the difference in income under both the methods.
The following are the details of cost as obtained by the cost accountant:
Production capacity of 2,00,000 units per year.
Normal capacity utilization is reckoned as 90%.
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Standard variable production costs are Rs. 11 per unit. The fixed fac-
tory costs are Rs. 3,60,000 per year. Variable selling costs are Rs. 3 per
unit and fixed selling costs are Rs. 2,70,000 per year. The fixed selling
expenses include storage cost and publicity costs.
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The unit selling price is Rs. 20. In the year just ended on 30th June, 2018,
the production was 1,60,000 units and sales were 1,50,000 units. The clos-
ing inventory as of June 30, 2018, was 20,000 units. The actual variable
production costs for the year were Rs. 35,000 higher than the standard.
Assume that you are the cost accountant. How would you attempt the
following?
QUESTIONS
1. Calculate the profit for the year under:

(a) By the absorption costing method and

(b) By the marginal costing method.
2. Prepare a report to be submitted to the General Manager,
justifying the differences in the profits under both the
approaches.

CASE STUDY 7A
N O T E S
THE HOUSEHOLD PRODUCTS COMPANY
The Household Products Company assembles clip clothespins in three

sections, and uses process costing. Under normal operating conditions,
each section has a spoilage rate of 4, 3, and 1%, respectively. However,
spoilage can go as high as 7% in the first stage, 3% in the second stage
and 2% in the first stage and is usually discovered when a faulty pin
enters process or on final completion by a section.
The spring mechanism is the only material which can be saved from a
spoiled unit. The production supervisor assigns a worker once or twice
a week to remove the springs from spoiled units. The salvaged springs
are placed in bins at the assembly tables in section No. 1 to be used
again. No accounting entry is made of this salvage operation.
In the past, the controller had made no attempt to account for spoilage
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separately. Lost unit costs have been absorbed by the units transferred
out of the section and those remaining in the process. However, because
spoilage is increasing, a different method is needed.
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QUESTIONS
1. Write an explanatory note on the concept of spoilage in a

manufacturing unit.
2. Describe the method that can be used for accounting for
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spoiled units.
3. Why it is important to account for abnormal wastage?
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CASE STUDIES 267
CASE STUDY 7B
N O T E S
SEGREGATING COSTS
The University of California has four different colleges with the fol-
lowing characteristics. There are different types of revenues being
generated from various activities as well as the costs incurred. The
university management finds difficulty in segregating the costs from
different perspectives.
Business Engineering Science Human

Number of 10,000 9,000 9,600 2,400
majors
Number of 2,000 1000 4,800 7,200
non-majors
taking classes
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Revenue from $1,200,000 $1,000,000 $1,440,000 $960,000
student fees
Revenue from $400,000 $3,000,000 $1,600,000 $240,000
external grants
Variable cost per $35.00
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student
Fixed cost per $35.00 $65.00 $25.00 $10.00
student (based
on total students)
The university hires a cost accountant to explain this and advise for
M
appropriate allocation of costs. Suppose you are the cost accountant;
how would you attend the following questions?
QUESTIONS
N
1. List three items that would likely be included in the category of

variable costs per student from the perspective of each college.
2. List two items that would likely be included as fixed costs per
student from the perspective of each college.
3. Calculate the contribution margin per student from the
perspective of each college and then from the perspective of the
university as a whole.
4. Calculate the total profit from the perspective of each college
and then for the university as a whole.
5. Based on financial considerations alone, identify the college
that would be most likely to be dropped from the university
during a budget crisis. Then identify the candidate that would
least likely be dropped.

CASE STUDY 8
N O T E S
HARDEN COMPANY
Harden Company has experienced increased production costs. The

primary area of concern identified by management is direct labour.
The company is considering adopting a standard cost system to help
control labour and other costs. Useful historical data are not available
because detailed production records have not been maintained.
To establish labour standards, Harden Company has retained an engi-
neering consulting firm. After a complete study of the work process,
the consultants recommended a labour standard of 1 unit of production
every 30 minutes, or 16 units per day for each worker. The consultants
further advised that Harden’s wage rates were below the prevailing rate
of $ per hour.
Harden’s production vice president thought that this labour standard
S
was too tight, and from experience with the labour force believed that
a labour standard of 40 minutes per unit or 12 units per day for each
worker would be more reasonable.
IM
The president of Harden Company believed the standard should be set
at a high level to motivate the workers and to provide adequate informa-
tion for control and reasonable cost comparison. After much discussion,
the management decided to use a dual standard. The labour standard
of 1 unit every 30 minutes, recommended by the consulting firm, would
be employed in the plant as a motivation device, while a cost standard of
40 minutes per unit would be used in reporting. The management also
M
concluded that the workers would not be informed of the cost standard
used for reporting purposes. The production vice president conducted
several sessions prior to implementation in the plant, informing the
workers of the new standard cost system and answering questions. The
new standards were not related to incentive pay but were introduced
N
when wages were increased to $7 per hour.

The standard cost system was implemented on January 1, 1917. At the
end of 6 months of operation, these statistics on labour performance
were presented to executive management:
January February March April May June

Production 5,100 5,000 4,700 4,500 4,300 4,400
(units)
Direct labour 3,000 2,900 2,900 3,000 3,000 3,100
hours

CASE STUDIES 269
CASE STUDY 8
N O T E S
Quantity Variances:
Variance $3150 U* $2,800 U $3,850 U $5,250 U $5,950 U $6,300 U
based on
labour
standard
(one unit
each 30
minutes)
Variance $2,800 F $3,033 F $1,633 F -0- $933 U $1,167 U
based
on cost
standard
(one unit
each 40
S
minutes)
*U = Unfavourable; F = Favourable
Materials quality, labour mix, and plant facilities and conditions have
IM
not changed to any great extent during the six month period.
QUESTIONS
1. Discuss on the impact of different types of standards on

motivations and specifically the likely effect on motivation
M
of adopting the labour standard recommended for Harden

Company by the engineering firm.
2. Evaluate Harden Company’s decision to employ dual standards
in its standard cost system.
N

CASE STUDY 9A
N O T E S
MANAGEMENT ACCOUNTING PRACTICES

IN GLOBAL PERSPECTIVE
The increased need for non-financial information and the continued

emergence of integrated reporting models were the main drivers cited
by European (excluding United Kingdom) and Middle Eastern respon-
dents. They were also the most concerned with the move towards
greater harmonisation of global accounting and business standards. On
the other hand, US-based respondents placed more emphasis on the
shift in demographics, the changing balance in the workforce and the
increasing welfare needs of an older society, these being their main driv-
ers in the medium term.
The second critical global driver, the closer focus on the accountant’s
role as business partner, topped the list for UK and Asia-Pacific respon-
dents. The increasing importance of and pressures from BRIC econ-
S
omies (Brazil, Russia, India and China), as they become significant
markets and sources of future competition, was cited as the second-most
important driver for respondents based in the United Kingdom and
Asia-Pacific region. Irrespective of their size, organisations reported the
IM
same three drivers as the most important in the medium term.
Medium and large organisations regarded the increasing role of non-
financial information and the evolution of integrated reporting models
as their main drivers of change. This was followed by the changing role
of accountants and their expanding remit, which will encompass a new
range of evolving demands and services. The new demands on accoun-
M
tants might involve greater input into corporate strategy, mergers and
acquisition deals, and interaction with the media and policymakers. In
addition to this, accountants may be expected to display greater respon-
sibility in risk management and ensuring that strategic decisions bring
about sustainable value.
N
In general, SMEs, irrespective of the sector in which they operate,

reported “greater harmonisation of global accounting and business
standards” as the main driver that will have the greatest impact in the
medium term. The increased focus on the accountant’s role as a busi-
ness partner and the broader skill sets required were identified as the
third critical driver.
QUESTIONS
1. How do you perceive the changes in management accounting

practices in global perspective? Analyse keeping in view the
above cases.
2. How do global management accounting practices help in the
growth of medium and large organizations?

CASE STUDIES 271
CASE STUDY 9B
N O T E S
MANAGEMENT ACCOUNTING INFORMATION

AND PRACTICES
As the development of the global accounting standards, the International

Financial Reporting Standards is widely recognized over 100 countries.
It is very important for an international firm to use the global finan-
cial standards to presenting its accounting information for its investors.
So, more and more companies present their financial information in
the International Financial Reporting Standards to their internal and
external users. As one of the largest retailers in the world, Tesco has
its business over 14 countries and employed almost 520,000 peoples. It
is very interesting to see how its accounting information supports its
operations.
To show how the business is running, the accounting information are
provided to all users as managers, customers, suppliers, associations
S
and government. Tesco plc. is not an exception. As a retailer, it is very
important for Tesco plc. to provide a positive financial statement to its
accounting information users. The case focuses on three internal users
of Tesco’s accounting information to identify their needs, requirements
IM
and how these financial information affect their decision making.
Internal Users: In general, the internal users of accounting informa-
tion include management, employees, trade unions, shareholders and
internal auditors. In this case, it will discuss management at all levels,
employees and shareholders related to Tesco plc.
The financial informational of Tesco plc. is the basis for the management
M
team in the company. First of all, the managers need these accounting
information to examine the process of their previous decision in Tesco
plc., such as, what is the position of the decision, does it increase the
profit in Tesco plc., etc. If the management team get some evidence
from the financial information that shows any negative effects of pre-
N
vious decision, the management team will raise another policy to fix it.
Besides that, Tesco plc., which is a global retailer, the management team
can get the overall and specific financial information of its global busi-
ness. So they can easily get the position of its branch business activi-
ties all over the world. For example, the financial information shows a
drastically increase in profit in the Chinese market. So for the manage-
ment team, they may plan for an increasing investment in the Chinese
market. Finally, the management team also uses financial information
to determine the appropriate financial structure and maintain the finan-
cial stability to its shareholders. The management team of Tesco plc.
will decide how much to pay to the shareholder according to its finan-
cial statements. In a word, the management team in Tesco plc. need the
accounting information to plan, control and improve the business activ-
ities and then help the company to make more profits.
The employees of Tesco plc. are the users of the accounting informa-
tion as well, because the employees should make sure the stability of
their employment and the salary level. A positive growth in the finan-
cial statement of Tesco plc. should give the employees the confidence

CASE STUDY 9B
N O T E S
of their employment and job security, and also give them the chance to
get more motivation from the job in Tesco plc. So the accounting infor-
mation gives the opportunity for the employees to know more about the
business and activities in Tesco plc. and then have a negotiation to the
company about their motivations and future opportunities.
The next internal user of accounting information is the shareholder of
Tesco plc. The accounting information showed the annual financial per-
formance of Tesco plc., which provide the information for shareholders
about their investment activities. With these financial information, the
shareholders can measure the risk and return of investment in Tesco
plc. and make a further investment decision, buy more shares or sell the
existing shares. For example, if Tesco plc. increased its profit and earn-
ings per share from year 2011 to 2012, the shareholders may invest more
on Tesco plc. in the following year.
S
QUESTIONS
IM
1. Describe the relevance of management accounting information
to employees in an organization based on the analysis of the
above case.
2. In what way management accounting practices in global
perspective are relevant to shareholders?
M
N

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COST AND MANAGEMENT ACCOUNTING

00_TOC.indd 1 31-10-2019 3:47:05 PM

Chief Academic Officer

Author: Kanhaiya Singh

NMIMS Global Access - School for Continuing Education

00_TOC.indd 2 31-10-2019 3:47:05 PM

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Management Accounting Fundamentals 1

2 Materials Cost Control 23

3 Labor Cost and Overhead Cost Control 51

5 Cost Analysis: Job Order, Batch and Contract Costing 129

7 Process Costing and Joint Costing 167

8 Standard Costing and Variance Analysis 195

9 Management Accounting in Global Perspective 231

10 Case Studies 249

NMIMS Global Access - School for Continuing Education

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