BBA – III yr

Cost Accounting
Unit – 1 & 2
COSTING
INTRODUCTION
Cost accounting is the process of ascertaining cost from the point at which
expenditure is incurred or committed to the establishment of its ultimate relationship
with cost centres and cost units.
A modern business enterprise is dynamic in nature. It has to operate in an
environment of competition and risk. Further, the economic and political situation and
the extent of development of technology and social obligations, influence and alter the
destinies of a business enterprise. No need to mention about the internal factors or
forces influencing its functioning. The ever changing nature of modern business and
the changes that are taking place in the realm of business and industry placed
increasing emphasis on accounting information. Decision-making,planning and
controlling functions necessitated a resort to accounting information.In the olden days
ownership, managership and workmanship were rolled in one and one person
performed all these functions. Infact, the owner himself was the consumer. There was
no problem pertaining to recalling of past events or information as the business was
very small in size and the owner was able to recollect all the things. The whole
information was on his finger tips. But the increase in the size of business necessitated
him to focus attention on policy matters and assign much of his authority to his sub-
ordinates. Such assignment required as exercise of control by him to see that the
subordinates functions efficiently within the policy framed by him. Hence, it became
necessary for him to resort to accounting information.
In the initial stages accounting system was developed to serve the requirements
of owners and creditors. So, income and position statements were prepared by
systematically classifying, recording and analyzing financial information. After wards to
meet the legal requirements preparation of financial statements became a cessity.
Thus, mainly for external reporting purpose financial accounting system
as developed. This does not mean that management was not benefited by the financial
accounting information. Financial accounting system provided useful information for
controlling the major functions of business. However, the formation provided was
historical in nature. Planning, decision-making and controlling of the activities of an
enterprise required further information not revealed by financial accounting. Here the
focus is on what an operation ought to have cost rather than what it had cost.
Therefore, accountants have started to focus attention on a supplementary system of
accounting.
Costing was thus developed primarily to serve the needs of management. In
Other words, it focuses attention on internal reporting of cost data for the
ascertainment of cost, cost control, planning and decision-making. So costing is a
recent development which has been born in response it to the needs of managers for
information in detail about the cost of production per unit of product or service.
Costing is becoming popular day by day due to limitations of financial accounts. In
fact, costing is a fascinating subject. It has assumed a lot of importance today. If a
concern is not having an efficient system of costing its very survival may become
doubtful.
Costing – Cost Accounting – Cost Accountancy
The terms ‘Costing’, ‘Cost Accounting’ and ‘Cost Accountancy’ have been often
used interchangeably to describe all or some of the aspects of the same subject. The
Institute of Cost and Management Accountants, London, has defined these terms
assigning a specific meaning to each one of them, with a view to avoid confusion and
bring about uniformity in their usage.
Costing Meaning
According to the terminology published by the Institute, “Costing is the
technique and process of ascertaining costs”. As a technique, costing refers to the body
of rules and principles to be followed for the ascertainment of cost. As a process, it
refers to the procedure to be followed for ascertainment of cost. The technique and
method to be used for ascertainment of cost vary from unit to unit depending upon the
nature of the industry, type of product, method of production and the meaning or the
sense in which the term ‘cost’ is used. By nature, industries may be classified into two
basic types i.e. (i) jobbing industries where production is intermitant and products are
different and (ii) process industries where production is continuous and products are
indentical. Different types of industries requires different methods of costing like job
costing, process costing, unit costing etc. The technique of costing to be adopted varies
depending upon the nature of cost, which the management wants to ascertain. Cost
may mean historical cost or marginal cost or standard cost or total cost. Different
techniques have to be adopted to ascertain different types of cost. These include
historical costing, marginal costing, standard costing, absorption or total costing etc.
The procedure to be adopted for ascertainment of cost can be split up into distinct
steps or stages. These are in the order of sequence (i) analysis and classification, (ii)
allocation (iii) apportionment and (iv) absorption.
Cost Accounting
This is defined as “the process of accounting for cost from the point at which
expenditure is incurred or committed to the establishment of its relationship with cost
centres and cost units”. Thus cost accounting refers to the accounting rocedures
formulated for recording incomes and expenses and for the preparation of periodical
statements and reports. In short, it is the formal mechanism set up for ascertainment
of cost. It provides all the information required for ascertainment of cost. On the basis
of information supplied, costing can be carried out by the process of arithmetic or by
means of memoranda or statements.
Cost Accountancy
This is defined as “the application of costing and cost accounting principles,
methods and techniques to the science, art and practice of cost control and the
ascertainment of profitability. It includes the presentation of information derived
there from for the purpose of managerial decision-making”. According to this definition,
cost accountancy embraces both costing and cost accounting. The purpose of cost
accountancy is to assist management in decision-making and cost control.
Differences between cost accounting and financial accounting
Cost accounting is an extension or phase of financial accounting.
It has been developed as a supplementary aid to management to overcome the
limitations or deficiencies of financial accounting. Financial accounting is concerned
with systematic recording, classifying, summarizing and reporting of information,
which is essentially financial in character, to interested parties like owners, creditors,
Government, prospective investors and others outside the management. Cost
Accounting, on the other hand, is concerned with classifying, recording and informing
the management of the cost of materials, labour and other expenses incurred to
manufacture and sell each product. In fact, the two systems are the two faces of the
same coin, having some common features but differing from one another in many
aspects. Both are concerned with systematic recording and presentation of financial
data. As such they form part of the management information system. Both draw their
information from the same source. Both are maintained on double entry system. Both
record, interpret and report events and transactions in terms of money. However, they
differ from one another in the following respects.
Objectives
The primary objective of financial accounting is to protect the interests of the
business, its proprietors, creditors and others related to it. This is ensured by
supplying suitable information to them. But costing provides information to meet the
requirements of the management for planning, decision-making and control. For
instance, financial accounts reveal whether money has been paid to the suppliers of
raw material and accounted properly or not. But costing reveals whether the material
purchased has been proper or not both in terms of quality and quantity, whether the
purchase was necessary or not, whether the quantity used was reasonable or not.
Similarly, regarding the utilization of labour and capital resources information needs
are fulfilled differently in the two system of accounting.
Type or mode of Presentation
To meet the requirements of the Companies Act, Income-tax law, Exercise and
other enactments, financial accounts are prepared. For this purpose some accepted
accounting concepts and conventions are considered. But preparation of costing
records is purely voluntary and there are no statutory forms for their presentation.
However as per Section 209 (d) inserted by Section 20 of the Companies (Amendment)
Act, 1965 the Central Government has got power to require by notification any
company engaged in production, manufacturing or mining activities to maintain proper
cost records.
Recording
The focus in financial accounts is on finding out whether profits are made or
losses are incurred. For this purpose the transactions are recorded, classified and
analyzed in financial accounts in a subjective manner according to the nature of the
expenditure. But in costing transactions are recorded in an objective manner i.e.,
according to the purpose for which the costs are incurred. For instance, if Rs.4,000
and Rs.6,000 are paid as wages for products P, Q and R, financial accounts will record
the total wages paid whilst, the cost accounts record wages product-wise. In addition to
this, in costing a difference is shown between direct and indirect wages.
Profit Analysis
Financial accounts reveal profit as a whole where as cost records show profits
product wise, operations or process-wise. This facilitates the management to give up
less profitable products or jobs and maximize the profits by concentrating on more
profitable ones.
Reporting Period
In financial accounts the accounting period convention is followed. This is
usually a year. The final accounts – Profit and loss account and Balance sheet are
prepared at the end of the accounting year and presented before the members at the
end of the accounting period. But costing is primarily concerned with the people within
the organization. So costing reports are prepared and presented to the management as
and when required some of these are prepared and submitted every week.
Functions of Cost Accounting
The functions of cost accounting are as follows:
Cost Control
The primary function of cost accounting is to assist the management in cost
control and cost reduction. The emphasis has now shifted from the traditional function
of cost ascertainment to cost control and managerial decision-making. Control is
exercised over costs through the techniques of standard costing and budgetary control.
The technique of marginal costing helps management in decision-making.
Cost Consciousness
One of the important functions of cost accounting is to stimulate cost
consciousness among the employees of the enterprise. The cost accountant should
create an awareness in the employees about the importance of cost to the well being
of the concern. The employees should be motivated to assess the effect of their
individual and collective actions on cost of production and the profits of the concern.
They should be made to realize the need to reduce cost not only in the interest of the
company but also in their own self interest.
Cost Ascertainment
The ascertainment of unit product cost is now considered to be a function of
secondary importance. Cost ascertainment should not be the sole aim of cost
accounting. It should be subordinated to the needs of cost control, planning and
decision-making. Though a function of secondary importance, cost finding is an
important function as ascertained costs form the basis for price fixation and
submission of tenders and quotations. Cost ascertainment is also necessary to identify
profitable lines of activity and to locate the sources of waste.
Fixation of Selling Price
This is a function ancillary to cost ascertainment. Cost accounting should
provide detailed cost figures making a distinction between variable costs and fixed
costs, so that the management can quote prices even below cost in times of depression
or severe competition. Price is a matter of policy. In fixing the price, management has to
take into consideration a number of factors besides cost. Thus ascertained costs serve
only as a guide in the determination of selling price. It should be realized that in the
long run price must cover both fixed and variable costs.
Assessment of Operating Efficiency
One of the major functions of cost accounting is to assess the operating efficiency of
different departments, workers and machines. Operating efficiency is judged by inter-
firm and intra-firm comparison of costs analyzed and gathered by departments,
products, men and machines.
Inventory Valuation and Profit Determination
The accuracy of profit depends, among other things, on the accuracy of
inventory valuation. One of the principal functions of cost accounting is the
provision of reliable cost data for the purpose of inventory valuation. Correct valuation
of inventories is possible only when data relating to prices of inputs and outputs is
made available making a distinction between product costs and period costs.
Special Studies
Cost accounting should also help the management in undertaking special
studies and investigations of a non-routine nature like expansion programmes, pricing
of new products, changes in the channels of distribution etc.
Decision-making
Planning and decision-making are the basic twin functions of management.
Decision-making involves choice among alternative courses of action. Cost accounting
should help the management in taking the right decision by disclosing the merits and
demerits of alternative courses of actions.
Solving Problems
The scope of modern cost accounting has extended beyond the traditional
functions of cost ascertainment and cost control. Cost accounting has now grown to
the status of a managerial partner. It is a service to management. It can identify and
solve problems of all kinds, if properly used.
Advantages of Costing
Costing is a powerful managerial tool fabricated to aid managerial functions.
But the benefits from cost accounts are not confined to0 management alone. They
extend to all the parties who are interested in the enterprises either directly or
indirectly and to the society at large.
ADVANTAGES TO MANAGEMENT
1. Measure of Economic Performance
It serves as a measure of economic performance. It discloses profitable and
unprofitable activities. Hence, steps can be taken to reduce or eliminate unprofitable
activities or make such activities profitable.
2. Guide to Pricing
It provides cost data which serves as a guide in price fixing and in formulating
price policy of the business. While price must cover all costs in the long run, in the
short term marginal cost provides the lower limit for price fixation.
3. Basis of Estimates and Tenders
It provides information on the basis of which tenders and estimates can be
submitted with reasonable degree of accuracy. Thus the danger of losing orders by
quoting prices which are too high or incurring loss by quoting prices which are too
can be avoided. In submitting tenders and estimates, past cost data has to be updated
in the light of current conditions.
4. Aid to Decision-making
It reveals the merits and demerits of alternative courses of action and thereby
enables management to select the most advantageous alternative. For example, the
decision whether to make or buy, lease or buy, add or drop, etc., can be made only on
the basis of data provided by cost accounts.
5. Cost Control:
It provides an effective control over materials labour and overhead costs.
Control is exercised over materials through such techniques as ABC analysis, perpetual
inventory etc. Standards are set to measure efficiency of labourers, so that schemes
can be assigned work for which they are best fitted. Overheads are classified into
controllable and uncontrollable items of cost, so that management can concentrate
attention on controllable items of cost.
6. Measurement of Efficiency
It provides a yardstick to measure efficiency of performance. It reveals not only
what actually the cost of production is but also what it ought to be. It lays down
standards both in terms of quantity and cost for materials, labour and expenses. An
analysis of the variances between actual costs and standard costs reveals causes
responsible for inefficiency.
7. Profit Planning
It helps management in forward planning for profit. Through budgeting, it is
possible to forecast each element of cost and profits for the coming year or years.
8. Check on Financial Account
Cost account provide an independent check on financial accounts.
9. Special Factors
Cost accounts keep the management informed of special factors like cost of idle
time, idle capacity, seasonal fluctuations in cost, optimum level of profitability, relative
efficiencies of different machines, etc.
10. Special Studies and Investigations
It enables management to undertake special studies and investigations for some
non-routine plans like expansion or contraction programmes, changes in the
channel of distribution, etc.
11. Managerial Partner
cost accounts have now grown to the status of a managerial partner with the
support of modern management aids like electronic data processing, linear
programming, operational research, etc. It can be used to identify and solve problems
of all kinds.
12.2.4.12. Advantages to Workers
An efficient system of costing promotes prosperity of the business through cost
reduction and profit maximization and thereby ensures security of service and
adequate reward to workers.
13. Advantages to Creditors
Cost accounts reveal not only the present position of the business but also its
future prospects. It enables the creditors, banks and other financial agencies to judge
the financial position and credit worthiness of the business.
14. Advantages to the Government
Cost records facilitate the assessment of excise duty and income-tax. They are
also useful to the Government in formulating policies and planning for economic
development.
15. Advantage to Nationalised undertakings pr Public Enterprises
Public enterprises lack the personal initiative of the private enterprise. They
tend to be wasteful and uneconomic. They require efficient management and effective
supervision. A good system of costing ensures effective control through a proper
analysis of their working. It helps the management in fixing reasonable prices for the
goods manufactured or services rendered.
16. Advantages to the General Public
A good system of costing should ultimately result in cost reduction and profit
maximization. A part of the benefit resulting from cost reduction is usually passed
on to the consumers in the form of lower prices. Besides the installation of a costing
system will infuse confidence in the minds of the public about the fairness of the
prices charged.
Objections against the introduction of costing
Inspite of its many sided advantages, a number of objections are generally
raised against the introduction of costing on various grounds. The foll9iwng are some of
the important objections.
1. Want of Necessity
It has been argued that costing in of recent origin and that industries prospered
in the past and are still prospering even without the aid of costing and therefore the
expenditure incurred in installing a costing system would be an unnecessary
expenditure. This argument overlooks the fact that modern industries are conducted in
highly competitive conditions and that every manufacturer should know the actual cost
of production to decide how far he can reduce the selling price. Many industrial failures
in the past may be attributed to the lack of knowledge on the part of manufactures of
the actual cost of production and therefore selling products below cost.
2. Inapplicability
It is argued that modern methods of costing are inapplicable to many types of
industries. It is true that costing cannot be applied with advantage to trading concerns
and concerns of small size. But in many cases, some method of costing can always be
devised to suit the requirements of the business. It should be clearly understood that
there is no stereo-typed system of costing which can be applied to all types of
industries. The system of costing should be so devised, as to suit the business but not
the business to suit the system.
3. Failure in Many Cases
It is argued that the adoption of costing system failed to produce the desired
results in many cases and therefore the system is defective. The failure of a system may
be due to several causes, such as apathy or indifference of the management, lack of
adequate facilities and non-operation or opposition form the employees. So, it is hasty
to find fault with the system, if it fails to produce the desired results in a few cases.
4. Mere Matter of Forms and Rulings
It is argued that after sometimes, a costing system degenerates into a matter of
forms and rulings. This is not that fault of the system. It is the fault of the way in
which the system is maintained. Forms and rulings are essential for a costing system,
but they must be revised and brought upto date in the light of altered conditions. If this
is not done, the system is bound to degenerate into a mere matter of forms and rulings.
5. Expensive
It is said that the cost involved in installing and working a costing system is out
of all proportion to the benefit derived therefrom. This is not correct. If care is taken
to device a costing system to suit the requirement of the industry and avoid
unnecessary elaboration, expenditure incurred in installing and operating the system,
will be profitable investment and will bring adequate return.
Methods of costing
The main object of costing is to ascertain the cost per unit of production. To
achieve this object, a suitable method of costing should be adopted depending upon
the nature of the business.
Basically, there are two methods of costing vis., (1) Job casting and (2) Process
or Unit costing. Job costing ins suitable for industries manufacturing different
products or executing different jobs for different customers according to different
specifications. Process or unit costing is suitable for industries where production is
continuous and units are identical.
All the other methods of costing are improvements, extensions or combinations
of the above two basic methods.
1. Job Costing
This is suitable for industries where jobs of contracts are kept separate during
manufacture or construction. A separate account is maintained for each job, to which
all the expenditure incurred thereon is debited. The method is suitable for printers,
garages, foundries, machine tools, etc.
2. Contract Costing
This is an extension of job costing. This is also called as Terminal costing. A
big job is normally referred to as contract. Costs are accumulated separately for each
contract. This method is applied in constructional industries engaged in shipbuilding
dams, roads, bridges, building, etc.
3. Batch Costing
This is an extension of job costing. A batch may represent a number of small
orders passed through the factory in a batch. Each batch is treated as a unit of cost
and separately costed. The cost per units is arrived at by dividing the cost of the
batch by the number of units produced in the batch. This is suitable for biscuit
factories, bakeries, hosiery and ready-made garment manufacturing industries, etc.
4. Unit Costing
This is also known as output or single costing. This is suitable for industries
where manufacture is continuous and units are identical or may be so regarded by the
use of suitable rations. The method is suitable for collieries, breweries, cement works,
brick works, etc. In all these industries there is standard or natural unit of cost. Ex. A
barrel of beer in breweries, a ton of coal in collieries, one thousand bricks in brick
works, etc. The object of unit costing is to ascertain the cost per unit is determined by
dividing the total expenditure incurred during a given period by the number of units
produced during that period.
5. Operating Costing
This is suitable for industries which render services as distinct from those which
produce goods. So, the method is used to ascertain the cost of services rendered. The
selection of a suitable unit of cost involves some difficulty. In certain industries, it may
be necessary to select more than one unit of cost. For instance, in Railways, cost is
ascertained per passenger mile and ton mile. The unit of cost is kilowatt hour in the
case of electricity undertakings.
6. Process Costing
This is suitable for industries having the following features:
(a) Production is continuous.
(b) Manufacture is carried on by distinct and well-defined processes.
(c) The finished product of one process becomes the raw material of the subsequent
process.
(d) Different product with or without by-products are produced simultaneously at the
same process.
(e) Products produced during a particular process are exactly identical.
As finished products are obtained at the end of each process, it will be necessary to
ascertain not only the cost of each process but also cost per unit at each process. A
separate account is opened for each process to which all the expenditure incurred
thereon charged. The cost per unit is obtained by averaging the expenditure incurred
as average costing. This method is also known as continuous costing as products are
manufactured in a continuous process. This and drugs, paints and varnishes, oil
refineries, vegetable ghee, etc.
7. Operation Costing
This is a refinement of process costing. A process may consist of several
operations. Under this methods, each operation is treated as a cost centre and costs
are accumulated for each operation instead of each process. This method is applied in
industries producing standard products which pass through several operation in
sequence.
8. Multiple Costing
It represents the application of more than one method of costing in respect of
the same product. This is suitable for industries where a number of component parts
are separately produced and subsequently assembled into a final product. In such
industries, each component different from others as to price, materials used and
process of manufacture undergone. So, it will be necessary to ascertain the cost
of each component. For this purpose, process costing may be applied. To ascertain
the cost of the final product, batch costing may be applied. This method is used in
factories manufacturing engines, radios, cycles and automobiles, typewriters,
aeroplanes and other complex products.
9. Departmental Costing
This is adopted where different department produce different types of products
and it is desired to ascertain the cost of output of each department. Examples are:
manufacturing of rubber products, cosmetics, etc. Frequently, this method is also used
to ascertain the cost of operating a service department or cost centre.
Techniques of Costing
Techniques of costing should not be confused with methods of costing.
Techniques of costing to be used depend upon the nature and purpose of the
information required by management. Management may require different types of cost
information for the purposes of control, decision making, price determination and
forward planning for profit. Thus the desired technique of costing is used in
conjunction with an appropriate method of costing. For example for decisionmaking
marginal costing may be used along with a suitable method of costing. The following
are the techniques of costing associated with planning, control and decision-making
processes of the management.
1. Total or Absorption Costing
Under this technique, the entire cost is absorbed into individual units. In other
words, both fixed and variable costs are charged to production. This technique is also
called ‘full costing’.
2. Marginal Costing
This is a type of partial costing. It takes into account only the variable costs.
Fixed costs are written against profits in the period in which they arises. Marginal
cost represents the change in the aggregate cost resulting from variation in volume
of output by one unit. Marginal costing is an important managerial tool for
decisionmaking.
This is called direct costing, as it takes to production.
3. Standard Costing
This is a technique of cost control. Under this technique, costs are
predetermined on the basis of management’s standard of efficient operation. These
predetermined costs are called standard costs. Actual costs are compared with
standard cost and remedial action is taken in case the former exceed the latter.
Standard costs not only serve as a yardstick to measure efficiency but also provide a
basis for price fixation.
4. Budgetary Control
This a important managerial tool for planning and control. A budget is an
“overall financial plan for future activities. It seeks to co-ordinate and control the
use of resources for a specified period. Budgetary control involves establishment to
the requirements of budgets relating to responsibilities of executives to the
requirements of a policy, comparison of actual performance with budgeted
performance and prompt remedial action when the former falls short of the latter.
Budgetary control may be described as “forward costing” as it seeks to control the
future activities of the concern through establishment of budgets. The methods and
techniques of costing are tools for cost ascertainment and cost control. The cost
accountant should select an appropriate method and technique depending upon the
nature of the industry ad the purpose for which cost information is required by the
management. As a general rule, it can stated that one method of costing should be
supplemented by at least one technique of costing.
ELEMENTS OF COST
Cost means the actual cost of an article manufactures, job executed or service
rendered. It represents the cost of material, labour and expense that have gone into
the production of the article, job or service. The actual cost may be ascertained after
the work is over or as and when the expenditure is incurred. Cost is a fact in the
sense that it represents the true cost of producing a particular unit of production.
The ascertained cost provides a measure for estimate and a guide to policy.
Cost is composed of three elements viz., cost of materials, wages and expenses.
These elements are also called as called as Primary costs. The expenditure incurred
under each element may be direct or indirect. Direct expenditure includes the elements
of direct material, direct wages and direct expenses.
1. Direct material
Direct material is the material which enters into and forms part of the product.
It is the material which can be identified wholly with a particular cost centre or cost
unit. It can be conveniently measured and directly charged to the product. Flour in
bread, clay in bricks, leather in shoes are examples of direct materials. Direct material
cost is defined as “material cost which can be allocated to cost centres or cost units”.
Material cost does not mean only its invoice price. It also includes all direct expenses
incurred in connection with the purchase of materials such as freight, duty, clearing
charges, cartage, etc. The following groups of material fall within this definition.
(i) All raw materials forming pat of the product like cotton in yarn, timber in furniture
etc.,
(ii) All materials specially purchased for a particular job, order or process,
(iii) All materials requisitioned from stores for a particular job, order or process,
(iv) Components purchased or produced for assembly into finished product,
(v) Partly processed raw materials passing from one process to another.
(vi) Primary packing materials such as cartons, wrappings, etc.
2. Direct Labour
Direct labour is labour expended in converting raw materials into finished
products or in altering the construction, composition, conformation or condition of the
product. It is labour which can be conveniently and wholly identified with a particular
job, product or process. It is defined as “wages which can be allocated to cost centres or
cost units”.
Direct labour includes payments made to the following groups of labour.
i) Workers engaged in actual production or in carrying out of an operation or process,
and
ii) Inspectors, analysis, specially required for a particular job, operation or process.
Wages paid to foremen, inspectors, supervisors, etc., are generally treated as indirect
labour, because they expend their time on different jobs. If they expend their time
exclusively on a particular job, order or process, the wages paid to them should be
treated as direct labour.
3. Direct or Chargeable Expenses
Direct expense is any expenditure other than direct material or direct labour,
directly incurred on a specific product, order or process. Such special expenses is
charged direct to the product, order or process on which it is incurred. Direct expense
is defined as an “expense which can be allocated to cost centres or cost units”. It is also
called as chargeable expenses. The following are examples of direct expenses.
(i) Hire of special tools or equipment for a particular production order.
(ii) Cost of special patterns and designs.
(iii) Maintenance cost of special equipment.
(iv) Architect’s fee paid for the design of a building.
(v) Travelling expenses incurred for a particular job.
(vi) Experimental costs of any particular production order.
(vii) Cost of defective work in connection with trial production.
4. Factory Overheads:
These comprise all expenses incurred for running the factory and
manufacturing the product. It is referred to as ‘Production Cost’ in the Terminology
of Cost Accountancy. It is defined as the cost of the process which begins with the
supply of materials, labour and services and ends with primary packing of the product.
In other words it is the expenditure incurred in the process of concerting raw materials
into finished products excluding the cost of direct material, indirect labour and indirect
expenses. The items that come under this overheads can be grouped under three head
viz., indirect materials, indirect labour and indirect expenses.
5. Indirect Materials
These are materials, which cannot be identified wholly with a particular product. They
are used for operating and maintaining the plant and equipment.
These include the following.
(i) Consumable stores like cotton waste, grease, oil, lubricants, works stationery, sand
paper used for polishing, soaps used for cleaning, etc.
(ii) Hand tools used for setting the machines and minor items of materials like nuts.
(iii) Direct materials treated as indirect materials for reasons of convenience like thread
in garment manufacturing, glue and nails in shoe manufacturing etc.
6. Indirect Labour
This includes wages of salaries paid to employees, which cannot be identified wholly
with a particular product, job or work order. The following items fall under this head:
(i) Technical Directors’ salaries and fees.
(ii) Works Manager’s salary.
(iii) Wages of foremen, supervisors, inspectors, etc.
(iv) Salaries of clerical staff in the factory.
(v) Salaries to staff engaged in testing, gauging and examining.
(vi) Welfare expenses such as canteen, recreation, first aid, entertainment, etc.
(vii) Normal idle time of workers and holiday wages.
7. Indirect Expense
These include all general factory expenses or payments made for services made
available in aid of production. The following items fall under this head;
(i) Rent, rates and insurance chargeable against works.
(ii) Power such as gas, steam, electricity, hydraulic pressure, compressed air etc.
(iii) Depreciation, maintenance and repairs of factory buildings, plant and machinery
and tools.
(iv) Factory insurance (fixed assets and stock of finished goods).
(v) Factory lighting, heating, etc.
(vi) Internal transport.
(vii) Factory management and administrative expenses.
(viii) Research and experiment expenses.
(ix) Normal wastage of materials.
(x) Drawing office expenses.
(xi) Factory cleaning.
ADMINISTRATIVE OVERHEADS
These comprise all expenses incurred in formulating the policy, directing the
organisation and controlling the operations of an undertaking, which is not related
directly to research, development, production or distribution. The following items
fall under this head.
(i) Salaries of executives and clerks on the administrative staff such as
secretary, accountants, general manager, directors, etc.
(ii) Rent, rates, lighting, heating and insurance of office buildings.
(iii) Telephone and postage.
(iv) Printing and stationery.
(v) Legal expenses
(vi) Maintenance and repairs of accounting machines.
(vii) Depreciation of office furniture and buildings.
(viii) Audit fees.
SELLING OVERHEADS
These comprise all expenses incurred in promoting sales and retaining
customers. It consists of expenditure incurred for creating demand, securing orders,
handling orders, and administering the sales staff. The following items fall under this
head:
(i) Salaries and commission to Sales Managers, Travelling Salesmen and Agents.
(ii) Advertising.
(iii) Sales department’s expenses (postage, stationery, invoicing, credit control etc.)
(iv) Samples, catalogues and other free gifts.
(v) Showroom rent and rates.
(vi) Bad debts.
(vii) Debt collection charges.
(viii) Cost of preparing tenders and estimates.
(ix) Travelling expenses of Salesmen.
(x) Consumer’s service and services after sales.
DISTRIBUTION OVERHEADS
These comprise all expenses incurred from the time the product is completed till
it reaches its destination. It is defined as the cost of the process, which begins with
making the packed pro0ducts available for dispatch and ends with making the
reconditioned returned empty packages available for re-use. Under this head the
following expenses are considered.
(i) Warehouse or godown expenses.
(ii) Packing charges and materials.
(iii) Loading expenses and transport.
(iv) Depreciation and maintenance of delivery van.
(v) Insurance in transit.
(vi) Expenses of reconditioning returned empties.
By grouping the above elements of costs, the following dividisons of cost are obtained:
DIVISION OF COST
1. Prime Cost
This is the aggregate of direct material cost, direct wages and direct expenses.
2.Works or Factory Cost
This is made up of Prime Cost plus factory overheads.
3. Cost of Production
This is made up of Works Cost plus administrative overheads.
4. Total Cost or Selling Cost
This is made up of the cost of production plus selling and distribution
overheads.
Total cost plus profit or minus loss is the selling price.
The various divisions of cost may be tabulated as follows:
7. COST UNIT
One of the important functions of costing is cost ascertainment. To ascertain
cost, it is necessary to select a unit in terms of which cost may be computed and
expressed. The unit so selected is known as the cost unit. Cost unit is defined as “a
unit of quantity of product, service or time in relation to which costs may be
ascertained. “In short, cost unit is the unit of measurement with which expenditure
may be identified. The product manufactured or service rendered may be measured or
expressed quantitatively in terms of number, length, weight, volume, time or value. In
jobbing industries, job itself is the cost unit. In industries producing identical products
in bulk, cost unit corresponds to unit of measurement such as a litre, a tonne, a metre,
a cubic foot, etc. Industries rendering services like railways etc., select a composite unit
of cost like tonne – kilometre, passenger kilometre etc. It is essential that cost unit
selected must be one which is most natural to the business and which is readily
understood and accepted by all concerned.
The following are the units of cost to certain industries.
INDUSTRY COST UNIT
Steels works Per ton of steel
Flour mills Per sack of flour or ton
Collieries Per tone of coal
Breweries Per dozen bottles or
per gallon of draught brew
Cement Per ton of 50kg bag
Textile Per metre
Biscuits Per CWT
Water works Per thousand gallons
Gas works per thousand cubic feet
Electricity Per kilowatt hour
Hospitals Per bed occupied
8. COST CENTRE
In some industries cost unit and cost centre are one and the same. For example
in jobbing industries, job itself is both the cost unit and cost centre. In other words
expenditure is charged directly to the job. In some industries expenditure is charged to
an intermediate point for later distribution over the cost units. The intermediate point
to which expenditure is charged is called cost centre. According to Costing
Terminology, a cost centre is “a location, person or item of equipment (or group of
these) for which costs may be ascertained and used for the purpose of cost control”.
Thus a cost centre can be (i) a location i.e., an area such as department, storeyard or
sales area, (ii) an item of equipment i.e., lathe, machine, delivery van or (iii) a person
i.e., salesman, foreman. For effective control and administration, a factory is generally
is generally divided into a number of departments. Some of these departments may be
engaged in actual production, while others may be rendering services in aid of
‘production’. Each of the production and service departments may be considered as a
separate cost centre. For more effective control, each of the production and service
departments may be further sub-divided into a number of cost centres on the basis of
location, equipment or person in charge of a particular function, area or equipment.
The size and number of cost centres vary from concern to concern depending upon the
expenditure involved and the degree of control desired over costs. In determining
suitable cost centres, consideration must be given to such factors as layout and
organisation of factory, availability of information and management policy regarding
cost centres. The determination of cost centres is very important from the view point of
cost control and cost ascertainment. It fixes responsibility on individuals for control of
cost. A person placed in charge of a cost centre is held responsible for cost control of
that centre. Further, the division of the organisation into distinct cost centres,
facilitates collection of cost data and their recovery by means of a common base.
SPECIMEN OF COST SHEET
A specimen of cost sheet is given below.
Specimen of Cost Sheet
Const Sheet for the Period …………………..
Production ……………Units
Particulars Total Cost per
Cost Unit
Rs. Rs.
DIRECT MATERIALS
Opening Stock:
Add: Purchases
Carriage inwards
Less: Closing Stock
Direct Material Consumed
Direct Wages
Direct Expenses
PRIME COST
Add: Works or Factory Overheads:
Indirect wages
Rent & Rates
Lighting & Heating
Power & Fuel
Repairs & Maintenance
Cleaning
Drawing office expenses
Cost of Research & Experiments
Depreciation of factory plant
Works stationery
Indirect materials
State insurance
Welfare service expenses
Insurance – Fixed assets etc.
- Stock and Finished goods
Loose tools – very small
Works manager’s salaries etc.
WORKS OR FACTORY COST
Add: Office and Administration Overheads:
Rent and Rates
Salaries
Lighting & heating
Insurance
Cleaning
Telephones & Postages
Printing & Stationery
Depreciation of furniture and
office equipments & building
Legal expenses
Audit fees
Bank charges
COST OF PRODUCTION
Add: Selling and Distribution Overheads:
Showroom rent and rates
Lighting & heating
Salesmen’s salaries
Commission
Travelling expenses of salesmen
Printing & stationery
Advertising
Bad debts
Salaries of Director
Postage
Depreciation and running expenses
of delivery van
Debt collection charges
Carriage outwards
Sample and other free gifts
COST OF SALES
ADD OR DEDUCT NET PROFIT OR LOSS
SALES
Note:
Items of expenses which are an apportionment of profit should not form a part
of the costs. Examples of such expenses are:
i) Income – tax
ii) Dividends to shareholders
iii) Commission of managing directors or partners
iv) Capital loss, i.e., loss arising out of sale of assets
v) Interest on loan
vi) Donations
vii) Capital expenditure
viii) Discount on shares and debentures
ix) Underwriting commission and
x) Writing off goodwill.
MATERIALS – PURCHASE CONTROL
The main objective of costing is cost control. This is ensured by providing
effective control over every element of cost. Among the three elements of costmaterials,
labour and overheads-materials constitute the greatest proportion of the total cost of a
product. Thus, the managerial function of cost control loses its significance if special
attention is not paid to material control. Material control implies “the regulation of the
functions of an organisation relating to the procurement, storage and usage of
materials in such a way as to maintain an ever flow of production without excessive
investment in material stock”. Material control has been defined as “providing the right
quantity of material of the right quality at the right time and place at the minimum
cost”. These definitions clearly reveals that material control implies the control of the
three importants functions – Procurement or purchase control, storage or stock or
inventory control and issue or usage or consumption contro0l of materials.
1. Objectives of Material Control
The objectives of material control are:
(a) To ensure continuous supply of materials so as to avoid work stoppages due to non-
availability of materials.
(b) To make purchase of materials of right quality so as to maintain the standard fixed
for the product.
(c) To procure materials on most favourable terms.
(d) To prevent the locking up of the working capital in the form of inventories due to
over stocking of materials.
(e) To minimize the losses or wastage of materials in their handling.
(f) To provide the necessary information to the management regarding material cost
and availability of stocks.
These objective can be fulfilled by taking proper care with respect to the three
managerial functions – purchase control, storage control and issue control.
Purchase Control: This function starts with the initiation of purchase requisitions and
ends with the receipt of material in the stores and the payment of bills for purchases.
However, the details of the procedure may vary with individual concerns. The stages of
purchase control as follows:
1. Initiation or purchase requisitions
For exercising the purchase control function in an appropriate manner, there
should be proper co-ordination between the Purchase Department, Receiving
Department, Inspection Department, Stores Department and Production Department.
The purchase manager arranges for the purchase of materials only on the basis of the
requisitions received from the departments initiating them. In large concerns usually
the stores manager or store keeper prepares the purchase requisition or indent
whenever there is a necessity of replenishing the stocks of a particular item of store.
Sometimes other department may also prepare and send the purchase requisition to
the purchase manager. Normally for regular items of store the purchase requisitions
are prepared by the stores department and for special material required for a particular
job the requisition may come from the production department. For maintenance
equipment and items of capital expenditure the requisition may come from the
maintenance department and for office equipment the requisition may be prepared by
the department which requires it. But there is no hard and fast rule regarding the
initiation of purchase requisition. It is only a matter of convenience. For instance, in
job order concerns the estimates department prepares an estimate of cost for each job,
and sends a copy of it to the stores department along with the work order. The store-
keeper then verifies stocks and if necessary prepares and sends the purchase
requisition to the purchasing department.
PURCHASE REQUISITION OR INDENT
Form No.1 Date Required:
Date: Dept. or Work Order No.
Req. No. Purchase Order No.
S.No. Code No. Description Quantity Grade Remarks
Requisitioned by ……………………….. Checked by ..…………………Approved by ………
Purchasing: For proper execution of th9is function it is better to entrust the work of
purchasing to a separate department, known as the purchase department, headed by
the Purchase Manager. The Purchase manager is also called as the Chief Buyer.
Sometimes it may not be possible and useful to entrust the whole work of purchasing
to one person holding the purchase department. It is here we have to make a
distinction between centralised purchasing and decentralised purchasing.
When purchasing function is performed by one person on behalf of the whole concern it
is called as the centralised purchasing On the other, if the purchase function is also
performed by others in addition to the purchase manger such organisation may be
referred as decentralised. There are several factors which may be taken into
consideration in deviding whether the purchase function is going to be centralised or
decentralised. Besides, the respective merits and demerits of the two, nature of the
product produced, the basic raw material required, the distance between various
divisions the cost of transport, the time factor, etc., are also considered in deciding the
purchase function. The merits and demerits of the above two are as follows.
Merits of Centralised purchasing/buying or demerits of decentralised
purchasing
1. If one person performs the purchase function he may become specialized in that area
and inturn ensures economical purchases.
2. It prevents duplicate and haphazard buying as there is only one person who
discharged the purchase function.
3. It relieves the other departmental heads from the purchase function and on account
of this they can concentrate in their areas of operation.
4. It facilitates standardization of materials and parts in purchases. If a number of
persons purchase material ensuring of standardization may become a difficult task.
5. Co-ordination of the purchase department and the finance department is ensured as
a result of centralised purchasing. The finance department will honour the
commitments made by the purchase department with least difficulty. The above
advantages are not possible if the purchase function is decentralised. Hence, the above
advantages are the demerits or disadvantages of decentralised purchasing.
Demerits of centralised purchasing or merits of decentralised purchasing
The draw backs of the centralised purchasing are the merits of the decentralised
purchasing function.
1. bulk purchasing is a important feature of the centralised purchasing. This involves
unnecessary locking up of working capital in the form of inventories.
2. Since a stereotyped procedure of purchasing is followed by the organisation, it may
result in abnormal delay in procuring materials.
3. When an organisation has got a number of manufacturing units at different places
local purchases may be advantageous. But centralised purchase organisation does not
ensure the benefits of local purchases.
4. Finally, purchasing materials at one place and transporting the same to different
manufacturing units at different places. for consumption would increase the
transportation costs.
Thus, centralised purchasing is suitable to a concern having one manufacturing
unit. On the other, if the concern has got a number of manufacturing units at different
places decentralised purchasing is suitable. Further, the reason for the setting up of
manufacturing units at different places may be nearness to the sources of supply of
raw materials. If that is the reason, centralised purchasing is not only advantageous
but also necessary. In fact, a via media is always desirable. For items which are
common for all plants and which can be procured quickly centralised purchasing is
desirable. For locally available raw materials, in case of different plants at different
places, decentralised purchasing is advisable.
Purchase manager
The qualifications required
The purchase manager plays an important role in a large manufacturing
concern. Since materials and money mean something to the business he has to ensure
economical and efficient purchases. Though the purchase manager looks
after only one function viz. purchases, it is a multiface problem, the purchase function
demands skill and ability on the part of the purchase manager since prior to placing an
order, he has to decide (a0 what to purchase (b) when to purchase (c) from whom to
purchase (d) how much to purchase and (e) at what price to purchase. For discharging
his functions properly, the purchases manager should posses thorough technical
knowledge of the industry in general and his concern in particular. If he is aware of the
technics of manufacture he can ensure the purchase of right type of material. He
should have a knowledge of different sources of supply of the some. Further, he has to
maintain a record regarding different suppliers and their terms of supply, In case
materials are available seasonally, he has to procure them in advance. Otherwise,
Production hold ups may take place due to non availability of stocks. Further, in case
of a necessity he has to obtain the permission of the Government for the import of raw
materials. If he is going to make C.I.F. (Cost Insurance and Freight) Contracts for the
knowledge of different means of transport and the impact of the transport cost on
materials. Besides, he should have a working knowledge of law and the principles of
the law of contracts. Otherwise, he is likely to involve his concern in litigation due to
legal errors in the process of negotiations.
Duties of the Purchase Manager
On the basis of the above the duties of the purchases manager may be listed out. He
should:
(a) Prepare the purchase budget.
(b) Receive purchase requisitions and find out on their basis the requirements of
materials.
(c) Findout the possible sources of supply of materials,
(d) Call for tenders from the approved suppliers.
(e) Select the supplier who offers best terms and conditions.
(f) Send the purchase order to be supplier selected.
(g) Get an acknowledgement of the purchase order.
(h) Follow up the purchase order for avoiding delay in delivery of materials.
(i) Receive the Goods received Note and the Inspection Report to see whether
the materials conform to the purchase order.
(j) Return materials which are not according to the specifications and get an
adjustment with the supplier on claims for differences between ordered material and
materials received.
(k) Verify the invoice and pass it for payment.
(l) Send the invoice to the accounting department.
(m) Have a research wing for finding out improved and cheaper substitutes for
materials.
(n) Six standards for materials and help the engineering department to codify
them for sy identification.
Coming back to stage two of the purchasing procedure, after receiving the
purchase requisitions the purchase manager has to call for quotations from approved
suppliers and prepare a statement of quotations with all details. The particulars of this
statement has to be verified with price lists or cataloguers previously collected, while
taking a decision regarding the selection of the supplier the purchase manager has to
give proper consideration to aspects such as, price, quality, changes, time of delivery,
reliability of the suppliers, credit facility and discounts.
After selecting the supplier the purchase manager has to send purchase order
which contains particulars such as the date, serial number, name and address of the
supplier, the description of the material, the quantity ordered, the date and place of
delivery, the price, terms of payment, discount, packing and shipping instructions,
transport expenses, the number of invoice copies required, the signature of the
purchase manager, and the name and address of the buyer. The purchase order is an
important document both from legal and accounting points of view. it indicates the
contract between the purchasing manager and the supplier and it commits the firms to
a particular amount of expenditure. Further, this document is the basis for payment of
bills and making entries in the accounting records. A model purchase order is as
follows:
PURCHASE ORDER
No. Dated: purchase requisition No:
Name and address of the supplier:
Ref: Your quotation number ………….. dt ……………………………
Please supply the following items in accordance with the terms and conditions
listed on the reserve.
S. No. Description Quantity Rate Total Cost
Delivery
Date
Remarks
Purchase Manager
In large concerns the purchase order is prepared in five copies. Out of these,
one is sent to the supplier, one copy is sent to the receiving department, one is sent
to the department which sent the purchase requisition, one is sent to the accounting
department and the last copy is retained by the purchase department for future
reference.
Follow Up
The purchase manager has to follow up the purchase orders regularly so that
the materials may be received in time. For this purpose he has to make enquiries in
advance. In case of any difficulty, he has to tap alternative sources of supply so that
material is received in time. Follow up is necessary for ensuring regular supply of
materials to production department.
Receiving and Inspecting Materials
In big concerns, normally, separate receiving and inspection department are set
up. But in small concerns these functions (receiving and inspection) are performed
by the store keeper. The receiving department looks after receiving, unloading and
unpacking of the material delivered by the suppliers. Since one copy of the purchase
order is sent to the receiving department, the departmental manager knows the date of
receipt and as a result makes adequate arrangements for taking the delivery of the
materials. Sometimes, the quantities are omitted in the copy of the purchase order sent
to the receiving department. This is done with a view to avoid mechanical verification of
the received materials. The purchase order also serves as an authorization to received
the packages. After receiving the packages the receiving open them and make a detailed
physical verification of the contents and acknowledges the receipt of the material by
filling up a goods received note in four copies. The goods received report. A model
goods received note is given below:
GOODS RECEIVED NOTE
Form No: Date:
Purchase order No:
Receive from:
Item No. Quantity
received
Description Grade Condition of
Goods
Verified by: Counted or measured by: Approved by:
One of the note is sent to the purchasing department, the second copy is sent
to the stores department through the inspection department along with the
materials, the third copy is sent to the accounts department and the last copy is
retained by the receiving department.
On receiving the goods received note along with the materials, the inspection
department staff inspect and test the quality of the material received. On the basis of
inspection and testing, the inspection department prepares a report in detail. This
report is called as the ‘Inspection and Testing Report’ and this is prepared in three
copies. One copy is sent to the purchasing department, another copy to the stores
department. This report may be either a clear report or a qualified report. The report is
called clean when the materials received conform to the quality and specifications
mentioned in the purchase order. Otherwise, the report is called as a qualified report.
In case of a clean report materials are sent to the stores along with the report whereas
in case of a qualified report the purchasing department orders the inspection
department not to forward the material to the stores department. It instructs the
inspection department to retain the materials until the return shipping order is
prepared. In certain cases the purchase department may notice an excess or shortage
in the material received when the material (mentioned in the goods received note) are
verified with the quantities mentioned in the purchase order. Under such
circumstances the purchase department makes a bargain with the supplier for making
suitable alterations in the invoice. At the same time it sends the material to the store-
keeper for inclusion of the same in stocks. Some times, even when the quality of the
material received does not conform to the purchase order, the material may not be
returned to the supplier. Instead a negotiation may take place for price adjustments.
Passing The Bill for Payment
The accounting department verifies the invoice sent by the supplier and
compares it with the purchase order, the goods received note and the inspection report.
After verifying the invoice in all respects the accounting department certifies it and
passes it for payment. On this basis the cashier makes the payment.
STORES CONTROL
The stores control functions performed by the store-keeper. He heads the stores
department. The stores department is a service department which renders services not
only to the manufacturing department but also other departments. Especially the
stores department but also other departments. Especially the stores department
provides useful information to the accounting department and on this basis the
accounting department prepares interim financial statements.
1. Functions of The Store-Keeper
The store-keeper plays an important role in the organisation. His position is
equivalent to that of the purchase manager in the organizational hierarchy. Hence, his
functions are similar to those of the purchase manger. The store-keeper’s functions
commence after he acknowledges the receipt of materials into the stores.
The functions of the store-keeper are as follows: he should
(a) Place the materials in their respective places on their receipt.
(b) Issue materials on the basis of authorized material requisitions.
(c) Maintain a record pertaining to the receipts, issues, and balances.
(d) Do verification of stocks of materials at periodical intervals.
(e) Preserve the materials in proper condition.
(f) Maintain the stores department neat and tidy.
(g) Indicate the stock levels with respect each item of stores.
(h) Prepare the purchase requisition for the replenishment of stocks.
(i) See that stores handling charges are at the minimum.
(j) Provide detailed information regarding every item of stores whenever asked
for.
2. Types of stores
The size of the concern, type of the industry, policy of management, etc., will have an
influence on the selection of the stores organisation, In general stores may be of three
types:
1. Centralised
2. Decentralised
3. A combination of (1) and (2), i.e., Centralised store with sub-stores.
Centralised stores refers to a system where store are received by, and issued
from, one stores department. Under decentralised stores system independent stores
are maintained in various departments. Purchasing and handling of stores are
looked after by the buyer and the store-keeper in each department. The advantages
and disadvantage of the centralised stores are as follows:
1. Advantages
1. Better layout of stores and equipment.
2. Proper supervision.
3. Less storage space as stocks are maintained at the minimum.
4. Facilitates stock-taking.
5. Economy in costs, eg., clerical costs, stationery, etc.
6. Experts are available in the department and on account of this there will be
encouragement for the development of high technical skill.
7. Better planning of the requirements.
8. Reduces capital investment.
9. Better records for comparing prices and source of supply.
10. Better security arrangements.
2. Disadvantages
1. High transportation cost: When the production department are located at different
places there will be enormous expenditure in transporting materials from the central
stores to the production departments.
2. Delay and inconvenience: When the production departments are located at different
places there may be a delay in receiving the materials by them from the control stores.
Further, delay causes a lot of inconvenience and as a result production stoppages may
take place.
3. There will be a greater risk of loss by fire.
4. If the head of the stores department is inefficient it will result in several losses to the
concern.
The above disadvantages are the advantages of the Decentralised stores.
For ensuring maximum possible efficiency, the location of the stores should be properly
planned out. There should be easy access to the production departments.
The store-keeper should be a person of high integrity and character as he is placed in
charge of materials of enormous value. An unscrupulous of dishonest store-keeper is a
source of fraud and manipulation and a permanent drain on the revenues of the
concern.
The store-keeper should have a thorough knowledge of the various materials
handled in the stores. He should know not only the characteristics of different
materials but also the technique of their orderly arrangement, preservation and
handling. He should be able to arrange the stores in such a way that any item can
be easily traced and identified. He should be able to maintain various records relating
to stores and to make the best use of them to exercise proper control over inventories.
He should know when to supply and in what quantity, so that there should be no
shortage of materials.
3. Bin Card
Bin card is a card or tag attached to each bin, rack, shelf of other container for
stores. It contains a record of the materials entering and leaving the bin and also
the balance on hand after every transaction. Only quantities are indicated in the bin
card. In writing on the bin cards, the principle to the observed is “tough the bin card
before you touch the item”. This implies that an entry should be first made in the bin
card before the materials and physically put inside or removed from the bin.When
materials are received, an entry is made in the receipt column and simultaneously the
balance is arrived at and entered in the receipt column. Similarly, when materials are
issued, an entry is made in the issue column and simultaneously, the balance is
entered in the balance column. In job costing industries, it may be useful to provide
two more additional columns in the bin card; one for ‘Ordered’ or ‘Dues’ and the other
for ‘Reserved’ or ‘Liabilities,. The ‘Dues’ column is used to record quantities of goods
ordered, but not yet received. The ‘Reserved’ column is meant to record quantities
already reserved or allocated to specific jobs. When these additional columns are
provided, a distinction should be drawn between stock-on-hand and available stock.
Available stock means the stock available for general issue. This can be arrived at by
deducting ‘Liabilities’ from stock-on-hand plus ‘Dues’. The bin card contains
information regarding maximum and minimum quantities as well as re-ordering level.
These will enable the storekeeper to maintain the stocks within the prescribed limits
and initiate purchase requisition for the replenishment of stocks at the appropriate
time. The normal quantity to the ordered is also stated on the card. This quantity
indicates the customary market unit for which orders are to be placed. This facilitates
ordering of further supplies and avoids the possibility of placing orders for irregular
quantities.
A specimen copy of the Bin Card is given below.
Name of the material ……………………… No ..……………………………………….
Bin No ………………………………………… Maximum Quantity …………………..
Unit …………………………………………… Minimum Quantity …………………..
Storage Ledger Folio ………………………. Re-ordering Level ……………………..
Ordering Quantity …………………….
Date
Receipts Issues Balance
G.R.No. Quantity M.R.No. Quantity Quantity Checked
by
G.R.No.: Goods Received Note
M.R.No.: Material Requisition
Advantages of Bin Cards
1. Entries are made in the bin cards simultaneously as and when the materials are
received or issued by the persons actually handling the materials. Hence, the chances
for mistakes being made in writing up the bin card will be less. The entries in the bin
card will be more accurate and reliable.
2. A more effective control can be exercised over stocks,since it is possible to compare
at any time, the actual quantity in hand with the balance as shown by the bin card.
3. Bin cards are useful in identifying different types of materials.
4. They provide an independent check on the Stores Ledger (usually maintained by the
cost office and this provides for noting materials both in terms of quantity and value) as
the balances on the bin cards can be compared with their corresponding balances in
the Stores Ledger.
5. They Provide the management with a second perpetual inventory.
Disadvantages of Bin cards
1. Stores records are dispersed over a wide area and so it is difficult to get an overall
idea of the stock position without going round the stores.
2. The cards may become dirty because of nearness to materials. Sometimes, they may
be lost or damaged in the course of handling the materials.
3. People handling the materials are not ordinarily suitable for the clerical work
involved in writing up the bin cards. So the entries in the bin cards may not be
accurate.
Classification and Codification
Appropriate system of classification and codification is essential to avoid mixing
of one type of materials with the other. This increases the efficiency in the functioning
of the factory since there is a continual supply of the required materials for production
purposes due to ease in location and identification of materials kept in stores.
Depending upon the nature materials should be classified into appropriate categories.
For instance, materials of an engineering firm may be classified into categories such as
mild steel, bronze steel, tool sheet copper, etc., and again each of these may be further
classified into suitable categories. For ease in identification, description of materials
and saving time in handling materials and preparing documents, it will be proper if
each store item is allotted as code number. There are two important methods of
codification of materials. They are as follows:
1. Alphabetical
Under this method alphabets or letters are used of codification of each category
of materials. For example, copper wire may be code as CW or mild steel may be
coded as MS, etc.
2. Numerical Method
This system will be used where material accounting is to be mechanized by
using punched cards. Under this method first a list of various departments is prepared
and each of these is allotted a code number. Further, a list of materials is prepared and
each type of material is given a number. The first two degists may indicate the
department for which the materials are intended and the other two degists may reveal
the name of materials mentioned in the standard list. For instance, if the code is 1432
it implies material No.32 (say tool steel) used in department 14.
Some concern use a combination of the above two methods for coding. This
method given much more clear-cut information than any one of the above two methods
of codification.
Codification serves two important purposes:
i) If there is not codification, the name of an account may have to be written
many times. Due to this there will be unnecessary clerical work.
ii) Secrecy can be maintained regarding the exact nature of the transaction
from the general office employees. Since the stores department comprises a number of
materials the entire department may be divided into a number of sections, each
intended for one specific type of material. Further each section will have adequate
number of containers for keeping divergent varieties of that particular material. The
containers which contain materials are termed as bins or racks (as stated earlier). Each
bin should be given a number for ease in identification. For instance there may be a
bolts section in the stores and this may consist of several bins containing bolts of
different sizes. Normally, for ease in identification, the stores department plan is
exhibited at the entrance so that each section can be located and material can be
handled easily.
5. Levels of stocking of materials
The losses arising out of over-stocking or under – stocking can be avoided or
minimized by fixing maximum and minimum stock levels for each stores item.
Besides, the fixation of certain other stock levels such as re-order level, danger level
and re-ordering quantity will facilitate a concern to see that inventory costs are kept at
the minimum. Different levels of stocking of materials are explained below.
1. Re-order Level
At this level arrangements should be made for getting fresh supplies of
materials. It is so decided that the ordered materials are received just before the stock
on hand is about to be exhausted or reach the safety stock or minimum stock level.
Under conditions of certainty, i.e., when the lead time and the rate of consumption of
materials are constant, there will be no need to maintain safety stock and therefore the
re-order level can be so fixed that the ordered materials should be arriving before stock
on hand is about to be exhausted. Under such conditions, re-order level will be equal to
the consumption during the lead time. This can be expressed by means of the following
equation.
Re-order level = lead time x Rate of Consumption
But under conditions of uncertainty, i.e., when the lead time and the rate of
consumption of materials are not fixed, re–ordering level must be so fixed that
despite delay in the supply of materials and consumption at the maximum rate
during the extended lead time, the ordered materials are received just before the
stock on hand is exhausted. In other words re-ordering level must be fixed taking
into account maximum lead time and maximum rate of consumption in maximum
lead time at the maximum rate. This can be expressed by means of the following
equations.
Re-order level = Maximum lead time x Maximum rate of consumption
2. Minimum Level
This is the level below which stock on hand should not be allowed to fall in the
normal course. It is useful for serving as a cushion or buffer to meet two
contingencies, viz.,
a) There may be unexpected delay in the receipt of materials ordered.
b) The rate of consumption of materials may increase after the order is placed.
In the absence of reserve stock, production would have to be stopped on
account of shortage of materials in case any one or both the contingencies arise.
Under conditions certainty, i.e., where the lead time and the rate of consumption of
materials are constant, there will be no need to maintain a reserve stock. Materials
can be ordered sufficiently in advance so that they are received just before the stock
on hand is about to be exhausted. Normally minimum stock level is fixed taking
into account the following factors:
a) Nature of the item
b) Re-order level
c) Lead time
d) Average rate of consumption
Holding of minimum stocks at all times costs money. They cost of carrying the
minimum stock is an insurance against loss on account of probable shut down for
want of materials. What comprises minimum stock is again a matter of judgement.
It is based on the degree of risk the management can afford to bear. The less the
risk, the less will be the quantity of minimum stock. There are practices in use
regarding the fixation of minimum stock. Some of them are as follows:
a) Two or three months’ consumption
b) Consumption at average rate during normal lead time
c) Consumption at maximum rate during minimum lead time
d) Re-order level – (Average lead time x Average rate of consumption)
Minimum stock does not mean the level of stock below which the stock on hand
should not be allowed to fall under any circumstances. It is provided to meet certain
contingencies and is therefore used when such contingencies emerge. The reason
for minimum stock level is to draw the attention of the management to an
extraordinary situation. It requires urgent action, when it reached. Every care must
be taken to see that stock on hand does not touch or fall below the minimum. But
when material reaches this level urgent action must be taken for replenishment of
stock.
3. Maximum Level
This refers to the maximum quantity of an item of store which can be held in
stock at any time. Stock on hand will not be allowed to exceed this level in the normal
course. Maximum level of stock is fixed to see that capital is not unnecessarily locked
up in excessive stocks. Fixation of maximum is also a matter of judgement. It is fixed
taking into account the following factors.
a) Financial Resources: If the has sufficient financial resources maximum can
be fixed at a higher level. On the other, if the funds are not sufficient the maximum is
fixed at a lower level so that least amount of capital is locked up in inventories.
b) Storage Space: Larger the storage space greater the maximum and vice versa.
c) Storage Cost: Higher the storage cost lower the maximum level and vice versa.
d) Nature of Material: For perishable, combustible and volatile materials, Maximum
should be fixed at a lower level.
e) Stability of Price: In case the material prices are likely to increase the maximum level
may be fixed at a higher level and vice versa.
f) Seasonal Availability: In case the material are available only during a particular season,
they have to be produced in adequate quantity in advance.
g) Government Policies: If import restrictions are there and higher duties are anticipated
maximum level may be increased.
h) Changes in Fashions and Demand: In case of fashionable goods materials maximum is
fixed at lower levels.
i) Government Restrictions: In case of explosive, controlled materials
Government may prescribe maximum quantity.
j) Economic Ordering Quantity: Please refer the next pages.
Maximum level is so fixed that it is not exceeded on the receipt of ordered materials.
Ordering level is so fixed that ordered materials are received just before the stock on
hand is about to reach the minimum level. Hence maximum level will be equal to
minimum level plus ordering quantity. Under conditions of uncertainty, i.e., when lead
time and usage have maximum and minimum values, maximum levels is fixed taking
into account minimum values.
Maximum level = Minimum level + Ordering Quantity or
Maximum level = Ordering level – (Minimum Lead time x Minimum Usage)+ Ordering
Quantity
4. Danger Level
At this level urgent steps should be taken for replenishment of stock. It serves
as a warning point to the management and indicates that unless steps are taken to
replenish the materials, production would have to be stopped due to shortage of
materials. Normally it is fixed below the minimum level.
6. Economic Order Quantity or Re-order Quantity
The re-ordering quantity or the Economic Order Quantity (EOQ) is the optimum
or the most favourable quantity which should be purchased each time when the
purchases are to be made. For the EOQ the costs of carrying inventory is equal or
almost equal to the cost of not carrying inventory. It is also called as optimum or
standard ordering quantity. It is fixed taking into account the following costs:
1. ORDERING COST
It is the cost of placing an order and getting supplies. It differs from time to time
based upon the number of orders placed and the number of items ordered. If more
frequently orders are placed and small quantities are purchased on each order, the
greater will be the ordering cost and vice versa.
2. Inadequate Inventory Cost
Finding out precisely such cost is virtually impossible. It consists the cost of
expediting purchases, obtaining rush deliveries, keeping track of back orders etc., all
associated with carrying too little inventory. In addition to the loss of sales, customers,
goodwill etc., arising from non-fulfillment of delivery promises are also covered by this
category.
3. Inventory Carrying Cost
This is the cost of keeping materials in stock. It includes interest on investment,
obsolescence losses, store keeping cost, insurance premium etc. the larger the quantity
of inventory, the higher will be the inventory carrying cost and vice versa.
The first tow costs can be referred to as the ‘Cost of Acquiring’ or ‘the Cost of Not
Carrying’ while the last as ‘Cost of Holding’ or ‘Cost of Carrying’ inventory. We can
summaries both these costs as below:
Costs of Carrying Costs of not carrying Enough
1. Interest on capital invested
2. Space for storage
3. Risk of obsolescence
4. Wastage and loss of materials
5. handling and transfer
6. Insurance, rent and warehousing
7. Clerical costs
1. Disurption of production
2. Higher prices for off-season goods
3. Foregone discounts
4. Extra cost of uneconomic production runs, over-time wages etc.
5. Loss of sales and customer goodwill
6. Extra purchasing and transportation costs-
7. Cost of placing orders
The cost of acquiring decreases while the cost of holding increases with every
increase in the quantity of purchase lot. A balance is struck between these two
factors and the EOQ is fixed at a level for which the aggregate of the two costs is the
minimum.
The EOQ can be calculated with the help of the following formula:
7. Techniques of Inventory Control
The term ‘Inventory control’ is used to refer to the various techniques applied to
achieve maximum efficiency in production and sales with least investment in
inventory. The following techniques are commonly applied of inventory control.
1. A. B. C. Analysis
2. Two – Bin system
3. Fixation of stock levels
4. Fixation of EOQ
5. Codification
6. Standardisation and Simplification
7. Perpetual Inventory system
8. Control Ratios
9. Modern aids to management like Electronic
Data Processing, Operational Research, etc.
1. A. B. C. Analysis
This is a selective approach to the problem of inventory management. Also
known as ‘Always Better Control Method’ or ‘Proportional parts Value Analysis’ it
analyses items of inventories into three classes namely high value, medium value and
low value. These three classes are named as A, B and C respectively. The classification
may be made on the basis of total inventory value or value of consumption during a
specific period. It has been found from an analysis of stores records of a number of
concerns that only a few inventory items account for a significant proportion of relative
importance of the three classes. Class or Group Percentage of items Percentage of cost
A (High Value) 8% 75%
B (Medium Value) 25% 29%
C (Low Value) 67% 5%
It can be seen from the above table3 that nearly two thirds of the inventory
items are relatively unimportant and that they acco8unt for nearly 5% of the total
cost of material consumed. These items which fall under class C do not require much
attention. Strict control procedures are not necessary for these items. There is no need
to fix maximum, minimum and reorder levels for these items. Even if such levels are
fixed, they may not be adhered to strictly. These items are generally controlled by
setting up norms for consumption and the use of two-bin system for replenishment of
stock. The time money and effo0rt save on these items is utilized on A and B group
items. Group A items are subjected to the closest attention. Maximum, minimum and
reorder levels are fixed for each items along with economic ordering quantity. Every
care is taken to see that the stocks are within the prescribed limits. The system of
perpetual inventory is strictly enforced in respect of these items. On account of their
high value, they are purchased in smaller quantities and more often than other items.
Group B items are paid as much attention as group A item. But the frequency of their
purchases is reduced to the minimum. These items are generally controlled by the
system of periodic inventory along with budgetary control. The following are the
advantages of ABC Method of inventory control:
a) It minimizes the cost of holding inventories.
b) It minimizes the chances of over-stocking and under-stocking.
c) It reduces clerical work and record keeping. The time and effort saved can be devoted
for other important work.
d) It makes follow-up action after purchases easy and effective attention is
concentrated on fewer items.
e) It reduces investment in inventories to the minimum.
2. Two-bin System
This is the method generally followed for controlling group C items. Under this
method, the stock of each item order is placed for replenishment and in the meanwhile
the stock of the second bin is made use of. On receipt of the ordered materials, the
used stock of he second bin is replaced and the remaining quantity is placed in the first
bin.
3. Fixation of EOQ
(Please refer our earlier discussion)
4. Codification
(Please refer our earlier discussion)
5. Standardisation and Simplification
Standardisation is the process of establishing norms for bringing about
uniformity. Mass production of goods is possible only when materials and components
are standardized. Standardisation ensures production of goods of uniform quality. It
facilitates procurement and inspection of materials and components. Simplification
means reduction of superfluous varieties. Satandardisation eliminates the need to
maintain a variety of inventories of materials and components.
6. Perpetual Inventory System
Stock-taking or verification of physical inventory is an essential feature of every
system of material control. Stock-taking may be periodical or continuous. Under
periodical or annual stock-taking stocks are verified at the end of the financial years.
Under continuous stock-taking, certain number of stock items are verified every day
or at frequent intervals throughout the year. Annual stock-taking has the following
demerits.
i) Production departments have to be shut down during the period of annual stock-
taking. This is not only results in loss of revenue but causes inconvenience to
customers.
ii) It is different to secure adequate trained staff to conduct annual stocktaking. The
staff which is usually drawn from different departments for this purpose, is not well
trained in stock taking. Hence verification cannot be satisfactory.
iii) The element of surprise, which is so essential for effective control is completely
absent under this system.
iv) Stock discrepancies are not detected till the end of the period Hence reasons for
discrepancies cannot be investigated because of lapse of time. The system of
continuous stock-taking is intended to overcome the above drawbacks. The term
‘perpetual inventory’ has a wider meaning than ‘continuous stock-taking’. It includes
continuous stock-taking and maintenance of stock records with a view to facilitate
continuous stock-taking. Wheldon defines perpetual inventory as “a method of
recording stores balances after every receipt and issue to facilitate regular checking
with quantities actually in store and thereby obviate closing down for stock-taking”.
I.C.M.A. of England defines it as “a system of records maintained by the controlling
department., which reflects the physical movement of stock and their current balance”.
Thus perpetual inventory is a system of ascertaining current balances after recording
every receipt and issue of materials through stock records. It is meant to facilitate
continuous stock-taking and thereby avoid closing down for annual stock-taking.
Perpetual inventory includes the following measures:
(i) Maintenance of up-to-date stock records i.e. Bin Cards and Stores Ledger.
(ii) Investigation into the causes for discrepancies between ground balances and book
figures.
(iii) Investigation into the causes for discrepancies between ground balances and book
figures.
(iv) Prompt rededial action to eliminate the causes for discrepancies.
Procedure of Perpetual Inventory
Under this system, a small number of stock verifies is permanently employed.
They are absolutely independent of the stores. They visit the stores daily or at other
frequent intervals and check a fixed number of items of their choice. The items are
so selected for verification, that every item is checked at least once in a year.
Perishable and valuables should be checked more frequently than others. Similarly
fast moving items should be checked more often than slow moving items. If the
verification is to be effective. The stores staff should not have any advance
intimation about the items to be checked on a particular day. The staff investigates into
the discrepancies that come to light during the course of checking. In most cases, the
discrepancies may be due to clerical errors. Such discrepancies are adjusted by making
the necessary corrections. Where the stock is incorrect, an enquiry is made, after which
the actual stock is entered in the bin card, preferably in red ink. The results of stock
verification are also entered in stock verification sheets, which are prepared in
triplicate. Of the three copies, one is given to the store-keeper, the second is sent to the
stores accountant and the third is retained as office copy by the verification staff. The
stores accountant makes necessary adjustments in the stores ledger based on the copy
sent to him.
Advantages
(i) There is no necessity of stopping production as in the case of annual stock-taking.
(ii) Stock discrepancies are noticed earlier and so steps can be taken to prevent the
recurrence of the discrepancies in future.
(iii) A detailed and reliable check is continuously exercised on the stores.
(iv) The element of surprise in the system of perpetual inventory 9imposes an excellent
moral check on the stores staff.
(v) Stores records are kept upto date as stock-taking is carried out throughout the year.
(vi) The value of materials on hand, can be obtained quickly for the preparation of final
accounts.
(vii) Perpetual inventory covers the comparison of the actual stock with the authorized
maximum and minimum levels. The ensures that adequate stocks are maintained
within the prescribed limits. So, the working capital locked up in stores and material,
cannot exceed the amount arranged for and production will not be affected for want of
materials.
(viii) The disadvantages of excessive stocks are avoided, i.e., loss of interest on
capital locked up in stock, deterioration, loss due to fall in market value,
risk of obsolescence, etc.
Control Rations of Accounting Ratios
Control can be exercised over inventories though the use of management ratios.
The inventory turnover ratio indicates the degree of efficiency or inefficiency with which
inventories are maintained. It also reveals the weak areas of material the adequacy or
otherwise of the inventories to meet the requirements of the business.
Modern aids to Management
In recent years modern aids to management like Electronic Data Processing,
Operational Research etc. are being used for inventory management.
(1) Define function of the store-keeper
(2) Explain the advantages and disadvantage of centralised stores.
(3) Discuss the advantages of Bin cards
(4) classification and codification – Discuss
(5) Explain – (a) Re-order level (b) minimum stock level (c) maximum stock level
(d) Danger level (e) Re-order Quantity.
(6) Indicate the comparative advantages to a manufacturing concern of maintaining its
stock in (a) Central Stores (b) Sub-stores.
(7) Discuss the importance of good store-keeping in an organisation. What are the
duties of a store-keeper?
(8) What is inventory control? Explain different techniques of exercising control over
inventories.
(9) Explain the procedure of continuous-taking and its advantages over annual stock-
taking. What do you understand by the term ‘perpetual Inventory’?
ISSUE CONTROL
INTRODUCTION
Material control also includes control open issues of materials. Infact,
materials and other items are procured by the store-keeper with a view to issue
them for production purposes.
Material control also includes control over issues of material. Infact, materials
and other items are producer by the store-keeper with a view to issue them for
production purposes. Hence, it is the responsibility of the store-keeper not only to
receive the items into the stores, safeguard them, but also to issue them for production
purposes. He has to take utmost care with respect to each item of store and
transaction; he has to issue materials only on the basis of proper authorization.
The management has to decide the procedure for the issue of materials.
The main document on the basis of which material issues are made, is the material or
stores requisition. If the concern has got a planning department, then it will prepare
the requisition. Otherwise, any other department head who requires the material
prepares the requisition. Normally the stores requisition is prepare in triplicate. Two
copies are sent to the stores department and the remaining is retained by the
department or person preparing it. A specimen material requisition form is given below:
MATERIAL REQUISITION
Form No: Requisition No:
Department or Job No: Date:
Standing order No:
S.No. Code No. Quantity Description Rate Amount Remarks
Requisitioned by: Issued by: Bin No:
Authorised by: Received by: Bill card No: Priced by:
The store-keeper on receipt of two copies of the requisition, issues the materials
and gets the signature of the person receiving them. One copy is used by the
storekeeper
for making entries in the oil card and the other is sent to the material control
Department or cost Office. In case the copy is sent to the material control
Department, the stores ledger clerk will price the issue and fill up the rate and
amount columns and after wards forward it to the cost office for facilitating it to
made a charge to the job concerned or the overhead control account based upon
whether the material issues are direct or indirect.
1. Bill of Materials
Bill of material is also referred to as standard materials estimate or the
specification of materials. It is a list of all materials and other items required for
completing a job or work order. For standard works or respective nature the estimates
department prepares the bill of materials indicating in detail the material and parts
required along with required drawings and instructions. In other words, it is a special
form of material requisition. It serves the same purpose as material requisition. Instead
of sending several departments which have to be cooperated in the execution of the
work order or job. Thus, it saves time and energy. Further, it helps the store-keeper as
an advance intimation regarding material requirements. If at all necessary on this basis
the store-keeper may initiate purchase requisition. The material requisition helps the
accounting department in binding out the material cost of the job within a very short
duration of time.
A specimen of the bill of materials is given below:
Form No: Bill of materials
Job or work order No: No. and rate:
S. No. Name Code No: Description Quantity Rate Amount Remarks
2. Material Returned Note
Sometimes the materials issued for a specific job may be in excess of the actual
requirements, or defective. In such case the department which received the material
returns the excess or the defective materials to the store-keeper along with a document,
i.e. material returned note or contra requisition slip. This note is similar to the
requisition note but printed in a different colour. The note is prepared in duplicate and
sent to the store-keeper. The store-keeper retains one copy in the stores for making
adjustments in the bin card and sends the other copy to the accounting department.
The accounting department will give the needed credit to the job concerned. In certain
cases the material requisition slip may be used for returns also. Then a note, ie.
“Contra” is written on the slip and such slip is called contra requisition slips.
3. Material Transfer Note
Sometimes material issued for a specific job may be transferred to another job.
Under normal conditions such transfers are avoided, otherwise calculation of the cost
of each job becomes difficult. But in times of contingency transfer of materials from one
job to the other is allowed ie., when urgent orders are to be executed on time this
method may be followed. This will avid unnecessary movement of materials from the
production department to the stores and again to the production department for
another job. This also saves a lot of time and energy.
A specimen material transfer note is given below:
Form No: Material transfer Note:
Issuing Department No. or Name: No. and rate:
Receiving Department No. or Name:
S. No. Name Description Quantity Code No: Rate Amount Remarks
Authorised by: Received by:
From Job No: To Job No:
Costed by:
Normally the material transfer note is prepared in triplicate. The three copies
are sent to the receiving department along with the materials and then the receiving
department official acknowledges the receipt on the three copies and sends one copy
back to the transfer department. He also sends and second copy to the store-keeper
and the third is retained by the transfer department. The store-keeper makes the
necessary entries in the bin card on the basis of the material transfer note and
afterwards forwards it with his signature to the accounts department for pricing the
transfer and debiting he job with quality of materials issued. Under any
circumstances surplus materials should not be left lying in the production
department.
4. The Stores Ledger
Sometimes the stores department maintains not only bin cards but also the
stores ledger. Bin cards are attached to the respective bins while the stores ledger is
maintained separately by the store-keeper. Both are helpful for finding out stocks.
While the bin card indicates the physical quantities of materials held in stock the
stores ledger indicates not only the physical quantities of stock but also their values,.
Perpetual inventory system involves the use of the two sets of records. So0me people
argue that the stores ledger is adequate and the additional record i.e., bin cards are
useless. But when the two records are maintained by different departments they will be
useful for cross checking purpose. Hence, normally the stores ledger is maintained by
the accounting department. The accounting department also maintains a stores ledger
control account. At the end of a specific period, say a month, the total of the columns
such as the opening balances, purchases and issues and closing balances as revealed
by the store ledger are recorded in the stores ledger control account. In some concerns
instead of entering each transaction of the issues in the stores ledger, the issues are
first recorded in the material issue Abstract or the Analysis sheet and afterwards the
total are entered in the issue column of the stores ledger.
A specimen stores ledger card is given below:
5. Pricing of material issues
 Normally the prices of purchases of raw materials vary from time to time.
Materials are purchases with a view to utilise them for purposes of production. The
materials held in stock represent various lots purchased at different levels of prices.
Hence, determination of the rate of each issue becomes a major problem in cost
accounting.
There are several methods of pricing material issues. Each method has got its
own advantages and disadvantages. There is no universally accepted method of pricing
material issues. What is suitable for a concern may not be suitable for another.
Further, from industry to industry there may be a variance with regard to the method
of pricing material issues. But while deciding the method of pricing material issues the
following factors have to be given proper consideration:
a) Nature of the business and the type of production.
b) The frequency of purchases.
c) Price fluctuations.
d) The quantity of material involves.
e) The clerical work involved.
f) The accuracy with which issues can be completed.
g) The duration of inventory turnover.
h) The procedure of costing.
i) Nature of the material.
j) The ratio of material cost to total cost
k) Need for uniformity within industry.
l) The purpose of production, i.e., whether short term or long term.
m) The opinion the management and the cost accountant.
Different methods of pricing material issues can be summarized in the following
main categories:
I. Cost Price Methods
1. Specific price or Actual Price
2. First – in First – out (FIFO) Price
3. Last – in First – out (LIFO) Price
4. Base Stock Price
5. Highest-in First-out (HIFO) Price
6. First – in Last – Out (FILO) Price
II. Average Cost Price Methods
1. Simple Average Price
2. Weighted Simple Average Price
3. Periodic Simple Average Price
4. Periodic Weighted Average Price
5. Moving Simple Average Price
6. Moving Weighted Average Price
II. National price Methods
1. Standard Price
2. Inflated Price
3. Replacement Price
Among the above, the following important methods are explained. Suitable
illustrations are given in the illustrations part of the lesson.
1. Specific Price Method
When it is possible to keep material purchased for specific jobs and its cost records as
separate this method is followed. The material is kept at a special place and its records
are also maintained separately. The there will be cease in identification of the material
and its cost records. This method is suitable for concerns which undertaken individual
jobs or contracts against specific orders.
ADVANTAGES
(a) Under this method materials are issued at their purchase price. Hence, it will not
result in either profit or loss.
(b) It is useful for costly and special type of materials.
DISADVANTAGES
(a) As independent records have to be maintained this method involves a lot of clerical
work.
(b) When purchases are made frequently it is very difficult to maintain separately the
materials and their cost records.
(c) It is not possible to price material issues until invoice is received.
First - in, First - out method
This method is popularly known as FIFO. Under this method materials are
issued in the order in which they are received. In otherwords first lot will be issued
first, the second lot next and so on. Though this is the assumption different lots get
mixed up and while issuing materials the chronological order pertaining to the prices is
followed:
ADVANTAGES
a) This method is very simple and adoptable.
b) Since materials are issued at their cost prices the manufacturing price reflects the
market price.
c) This method is useful when prices are falling in the market.
d) The closing stock will be nearer to its market price.
e) When items to be issued are less with stable prices but high unit cost, this method is
useful.
DISADVANTAGES
a) When purchases and issues are numerous this method results in enormous clerical
work and there may be clerical errors.
b) In certain cases price of one requisition involves more than one price.
c) In times of increasing prices this method results in less production cost while the
cost of replacing material will be high.
d) As issue prices vary from one lot to another, maintenance of uniformity in cost price
is difficult. Further, comparison between similar jobs becomes a difficult task.
e) In times of increasing prices the issue price may not represent the current market
price.
Last – in – First – Out
This method is popularly known as LIFO. This is based on the assumption that
last purchased materials are to be issued first. They are issued at their purchase price.
Hence, closing stocks represent the more historic prices and while valuing the closing
stock the oldest prices are considered. In other words, the inventory is priced at the
oldest price.
ADVANTAGES
a) This is very simple and is useful for the issue of bulkly materials with high price.
b) Material issue price reflects the near market price.
c) In times of rising prices this method gives the benefit of accounting for inflation.
d) When the market is falling for purchases profits are likely to rise as the cost of
production reflects the lower material prices.
e) Undue profits or losses are not made under this method.
DISADVANTAGES
a) Sometimes calculation get complicated and there will be more chances for clerical
errors.
b) Comparision of similar jobs in terms of material costs becomes very difficult.
c) In times of falling prices issues are price at lower rates and materials held in stock
represent higher prices.
d) As in the case of FIFO, more than one price is to be adopted for the same issue lot of
material.
Base Stock Price Method
Generally, every concern maintains a minimum quantity of materials in stock
at all times. This quantity is also called as base stock. For issue purposes, materials
beyond this quantity are used. Only in times of emergencies issues are made from the
base stock. The base stock will be representing its purchase price and for issue
purpose the base stock method is implemented in conjunction with FIFO, LIFO or some
average method. When the processing period is long and where the cost of finished
product is largely made up of basic raw material like crude oil this method is largely
made up of basic raw material like crude oil this method is used. Thus, this method is
not an independent method of pricing material issues, further, fixation of base stock
becomes difficult. Since the method works in conjunction with LIFO or other average
methods of pricing material issues, if suffer from all the disadvantages of the respective
methods.
Highest – In – First - out
This method is also called as HIFO. It is based on the assumption that
materials held in stock should represent lowest possible prices. For instance, the
receipts side of stock ledger and their prices are: April 1st Balance 200 unit @
Rs.20.00 per unit. April 7th 10,400 units @ Rs.22.00 and April 10th 20,600 units @
Rs.23.00 per unit. On April 16th, a requisition for 400 units is received. The issue
price, on the basis of HIFO would be the highest purchase price between April 1st to
April 10th. The highest price per unit is Rs.23.00. Hence 200 units would be issued
at Rs.23.00 per unit being the highest price of inventory in the stores.
This is a useful method of pricing material issues as under-valuation of stocks
results in creation of a secret reserve. But in practice this method is very difficult
for implementation. On account of this reason this method has not become very
popular.
AVERAGE PRICE
The above methods of pricing materials issues are based on the assumption that
materials are to be price either actual cost or exact cost. But the average pricing
methods are different. They are based on two assumptions.
a) When different materials are kept in stores their identity is usually lost as
distinct lots.
b) The Fluctuations in prices have to be smoothened and the change in the issue price
should be gradual.
The average methods of pricing material issues are given below:
1. Simple Average Price
Simple average price is a price arrived at by dividing the total of the price of the
materials in stock from which the material to be priced could be drawn by the
number of prices used in that total. Hence, the prices of the receipt lots are used for
finding out the average irrespective of the quantity in each lot. For example three
lots have been received as follows:
Jan. 1st 1000 units are purchased @ Rs.6/- per unit.
Jan. 6th 2000 units are purchased @ Rs.6.50/- per unit.
Jan. 8th 4000 units are purchased @ Rs.6.10/- per unit.
If the material is to be issued on 9th issue price will be worked out as indicated
blow:
6+6.50+6.10 = 18.60/3 = 6.30
Whenever there is uniformity in lots purchased and price fluctuations are very
minor this method of pricing material issues is useful.
Periodic Simple Average
Under this method, instead of calculating the issue price after every receipt, the
price is determined periodically, say a month. But this method involves several
calculations and needs a lot of clerical work. The issue price is calculated for the next
month rather than the current month.
Moving Simple Average
This is the average of the average method. In other words, the average of a given
number of periods is worked out. While calculating the price for the next period the
first period’s average is omitted and the average of the next period for which issue rate
is to be worked out is added. For example, the period may be 4 months. While
calculating the issue price for the 5th month the first month’s average is omitted and
the average of the 5th month the first month’s average is omitted and the average of the
5th month is added. The advantages and disadvantages of the other average methods
of pricing material issues will be experiences under this method.
4. Weighted average price
Weighted average price is the “price calculated by deviding the total cost of
materials in the stock from which the material to be priced could be drawn by the total
quantity of materials in the stock. In other words, the weighted average method take
into account both quantity and price of material in the stores for fixing the issue price.
Under this method the issue is worked out on receipt of materials and not on issue of
materials.
Periodic weighted average price
The weighted average struck at the end of the period, of all the purchased made
during that period including the opening stock is called the periodic weighted average
price.
The disadvantage of this method is that the pricing of issue is delayed involving
heavy clerical work at the end of the month.
Moving Weighted Average
This is the average of the periodic weighted averages of a specific number of
months. It is obtained by dividing the total of periodic weighted average of a specific
number of months by the number of months. It is calculated for a specific numbers
of months, say 3, 5, 7, etc. For instance, if a three monthly average is being used,
the issues in April will be priced at the average of the weighted periodic averages
prices of January, February and March. For pricing issues in May, January is dropped
and a fresh average is calculated of the weighted periodic average prices of February,
March and April.
ADVANTAGES
1. This method is useful when prices of materials and quantities of different lots
fluctuate frequently.
2. Issue price is calculated as and when a fresh receipt is made there is no need to
calculate the issue price before every issue. Closing stock represents for value and it
can be used for financial statements.
3. Closing stock represents fair value and it can be used for financial statements.
4. In times of market fluctuations this method ensures uniformity in price.
5. This method is suitable to manufacturing concerns in which several processes take
place.
DISADVANTAGES
1. Calculations get complicate when prices fluctuate frequently and receipts are
numerous.
2. There is a need to calculate the issue price after every receipt. But there may not be
issues for some durations of time.
3. The impact of high prices or low prices of the past will fall on the issues for a
considerable time.
1. Standard Price
Taking into consideration quantity of purchase, quantity discount, anticipated
price fluctuations and transportation costs the standard price is determined. Normally
standard costing concerns consider this method of pricing material issues. By making a
forecast of all issues during a specific period the standard price is fixed at the
commencement of the accounting period. if there is any variance between the standard
price and the actual price of materials the difference is called variance and it is
transferred to various accounts. Thus, standard price is a predetermined price or
national price and it is not based on actual purchase cost. It is also to be noted that the
standard price is fixed for a specific period after which it is reviewed in the light of
altered conditions and revised if necessary.
ADVANTAGES
1. As all issues are prices at the same rate, clerical work is considerably reduced.
2. The efficiency or otherwise of the purchase department is judged under this method.
When the actual price is greater than the standard price, the stores ledger account
discloses a debit balance which indicates loss. This is called as negative variance. On
the other, if the actual price paid is less than the standard price, the stores ledger
account reveals a credit balance which indicates profit. This is referred to as positive
variance.
DISADVANTAGES
1. Under this method issues do not reflect current market conditions.
2. The differences that take place in the stores ledger accounts have to be
adjusted by transferring them to price variance account.
3. Fixation of standard price for each material is difficult. Different people may fix
different prices for the same material because of difference of opinion. Further, when
prices fluctuate frequency, it will not be practicable to fix standard price on a long term
basis. Under such circumstances, standard price can be fixed only for a short period.
2. The Market Price Method
Under this method materials are issued at their replacement price, i.e, the
market rate prevailing on the date of material issue. This method is based on the
assumption that material issues should represent current market prices. When
materials are purchased in bulk and their market prices deteriorate and stores are
lying idle or obsolete for a long term in the store the market price method is
advantageous. Realisable price under such circumstance is suitable. But it suffers
from several draw backs.
It is very difficult to find out at the time of each issue the current price of each
item of material held in stores. If the material issue prices do not coincide with the
purchase price, at the end of he accounting period adjustments have to be made in
the stores records. The reason is that the stores records are not cleared of the full
value of materials purchased. Further, unearned profits or losses are reflected in
issues and stores values. Lastly, this method is not useful and cannot be applied for
materials purchased for daily production purposes.
3. Inflated Price
In certain cases materials are issued at an inflated rate. The rate is fixed above
the purchase price to include not only the cost of purchases but also contingencies
and other related costs. Evaporation, leakagers and loss due to loading and
unloading are some of the contingencies for which a provision should be made while
fixing the issue price. Under all these cases the price of the material is adequately
pushed up to get the full cost of the concerned material.
4. Pricing of Material Returns
Sometimes materials issued to production department may be returned to the
stores on a material Return Note. The returned materials may be of the following
categories:
i) Unused portion of material in the original form.
ii) Material issued for a specific job order which has been cancelled subsequently.
iii) Residual, scraps, waste, etc. The returned materials are recorded in the respective
bin cards and in the stores ledger as receipts or as minus issue. Valuing of the
materials returned is done by one of the following methods:
i) At the Same Price at which Issued: Under this method the material returns are priced at
their issue prices. The relevant requisition slips are used as reference for pricing
purposes.
ii) At the Current Price of Issue: The price of issue of materials on the date of
return and issue may be different. Under such cases material is to be
price on the issue rate preceding the date of return of materials.
But residual materials, scrap, waste and spoiled materials are priced depending
upon the condition of the materials returned. Such returns are recorded separately
and priced accordingly.
5. Material Losses
Material losses occur in all types of manufacturing organizations. These may
be in the form of waste, spoilage, or defective work. Waste represents material cost
in the manufacturing process which has no recoverable value, e.g., dust, smoke
unsaleable residues, losses on account of evaporations, shrinkage, etc. Certain
standards should be fixed up for each type of waste. Further, the actual waste
should be compared with the standard from time to time. Waste reports have to be
prepared regularly. Special care should be taken to check abnormal waste. For this
purpose it is better to hold regular meeting meetings with the foreman and his staff.
The accounting treatment for waste or wastage is as follows:
a) Normal Wastage: This takes place due to normal conditions or reasons. If
the waste is in normal limits it should be distributed over good output. In other words,
per unit cost should be increased for recovering such wastage. The reason for this is
that normal wastage take place on account of the inferent nature of the material and it
cannot be avoided. For instance, kerosene, petrol and agricultural commodities lose
weight or volume during storage due to evaporations, shrinkage etc. Some materials
deteroriorate in Quality with the passage of time. Further, it is not possible to cut some
materials to the needed size of length, without incurring some loss or other.
b) Abnormal Wastage: Any wastage in excess of the margin allowed for normal wastage
which results in due to causes outside the ordinary course of business is called as
abnormal wastage. Such loss should not be charged to production. It should be
transferred to costing profit and loss account so as to avoid any fluctuations in the cost
of production.
4. Scrap and its accounting Treatment
Scrap is the incidental material residue coming out of certain types of
manufacturing process. This is usually of small amount and low value, recoverable
without further processing. It should be remembered that scrap is always physically
available whereas waste may or may not be present in the form of residue. Control
should be exercised over scrap by setting up standards for scrap, determining
responsibility for scrap and maintaining proper records of scrap (scrap reports). The
accounting treatment of scrap may be given by one of the following methods.
a) If the sale value of scrap is almost negligible, it is credited to the costing profit and
loss account.
b) The sale proceeds of scrap are deducted from the cost of material or factory
overheads. Thus, under this method, overall or factory over heads. Thus, under this
method, overall cost of materials or overheads is reduced by this method.
c) The value realized from the sale of scrap is credited to the particulars job, process of
operation. This has got an advantage of identifying scrap with each job, process or
operation.
5. SPOILAGE AND ITS ACCOUNTING TREATMENT
Spoilage refers to good units damaged beyond rectifications and these are to be
sold without further processing. Spoilage is different from scrap. Scrap always
takes place due to the processing of materials while spoilage arises on account of
some defect in materials or in operation and this may or may not be inherent in
manufacturing process or operation. Further, scrap involves loss of materials, loss
of labour and manufacturing overheads.
The spoilage which is the inherent result of the process and uncontrollable in
the short run, i.e., normal spoilage, will be borne by good units.
On the other, avoidable and controllable spoilage even in the short run, which
is called as abnormal spoilage, should be charged to costing profit and loss account.
Defectives represent that portion of production which can be rectified and turned into
good units by putting in extra material, labour and overheads. The main difference
between spoilage and defectives is that in majority of cases spoilage cannot be rectified
and sold as ‘seconds’ ‘thirds’ where as defective can be rectified by working again, and
sold as ‘first’ or ‘seconds’. Proper control should be taken to see that defectives are
within the standard units.
In case of normal defectives which take place due to inherent nature of the
manufacturing process, cost of rectification of such defectives should be charged to
specific jobs or process when identification is possible and otherwise to the works
overheads. Abnormal defectives which arise due to abnormal causes should be
taken to costing profit and loss account.