Fundamentals of Cost and Management Accounting (Study Text)

Fundamentals of Cost and Management Accounting (Study Text)

ALL RIGHTS RESERVED
This book and material including write-up, tables, graphs, figures, etc.,
therein are copyright material and are protected under Copyright Laws
of Pakistan. No part of this publication can be reproduced, stored in a
retrieval system or transmitted in any physical photocopying, recording
or otherwise without prior written permission or the ICMA Pakistan’s
Head Office.
Institute of Cost and Management Accountants of Pakistan

Published by:
Institute of Cost and Management Accountants of Pakistan

Email : education@icmap.com.pk
Website : www.icmap.com.pk
Phone : + 92-21-99243900
Fax : + 92-21-99243342
First Edition 2014

Contents developed by a consortium lead by KAPLAN.
Second Edition 2020
Contents updated by the ICMA Pakistan.
Disclaimer
This document has been developed to serve as a comprehensive study and

reference guide to the faculty members, examiners and students. It is
neither intended to be exhaustive nor does it purport to be a legal document.
In case of any variance between what has been stated and that contained in
the relevant act, rules, regulations, policy statements etc., the latter shall
prevail. While utmost care has been taken in the preparation / updating of
this publication, it should not be relied upon as a substitute of legal advice.
Any deficiency found in the contents of study text can be reported to the
Education Department at education@icmap.com.pk

CONTENTS
1 INTORDUCTION TO MANAGEMENT ACCOUNTING 01
2 SOURCES OF DATA 18
3 COST CLASSIFICATION AND COST BEHAVIOUR 31
4 MATERIALS: ACCOUNTING AND CONTROL 64
5 MATERIALS: NVENTORY CONTROL 87
6 ACCOUNTING FOR LABOUR 106
7 ACCOUNTING FOR OVERHEADS 126

ABSORPTION AND MARGINAL COSTING
8 162
9 JOB AND BATCH COSTING 183
10 SERVICE COSTING 204

428
11 PROCESS COSTING 220
12 STANDARD COSTS: PRINCIPLES AND PREPARATION 262
13 VARIANCE ANALYSIS MATERIALS AND LABOUR 277
14 VARIANCE ANALYSIS:OVERHEADS 301
SALES VARIANCE ANALYSIS

15 AND PROFIT RECONCILIATIONS
321
INDEX
16 343

HOW TO USE THE MATERIAL
The main body of the text is divided into a number of chapters, each of which is
organized on the following pattern:
 Detailed learning outcomes. You should assimilate theses before beginning

detailed work on the chapter, so that you can appreciate where your studies
are leading.
 Step-by-step topic coverage. This is the heart of each chapter, containing

detailed explanatory text supported where appropriate by worked examples
and exercises. You should work carefully through this section, ensuring that
you understand the material being explained and can tackle the examples and
exercises successfully. Remember that in many cases knowledge is
cumulative; if you fail to digest earlier material thoroughly; you may struggle to
understand later chapters.
 Examples. Most chapters are illustrated by more practical elements, such as

relevant practical examples together with comments and questions designed
to stimulate discussion.
 Self-Test question. The test of how well you have learned the material is your
ability to tackle standard questions. Make a serious attempt at producing your
own answers, but at this stage don’t be too concerned about attempting the
questions in exam conditions. In particular, it is more important to absorb the
material thoroughly by completing a full solution than to observe the time
limits that would apply in the actual exam.
 Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an

illusion to think that this provides the same benefits as you would gain from a
serious attempt of your own. However, if you are struggling to get started on a
question you should read the introductory guidance provided at the beginning
of the solution, and then make your own attempt before referring back to the
full solution.

STUDY SKILLS AND REVISION GUIDANCE
Planning
To begin with, formal planning is essential to get the best return from the time
you spend studying. Estimate how much time in total you are going to need
for each subject you are studying for the Managerial Level. Remember that
you need to allow time for revision as well as for initial study of the material.
This book will provide you with proven study techniques. Chapter by chapter it
covers the building blocks of successful learning and examination techniques.
This is the ultimate guide to passing your ICMA Pakistan written by a team of
developers and shows you how to earn all the marks you deserve, and
explains how to avoid the most common pitfalls.
With your study material before you, decide which chapters you are going to
study in each week, and which weeks you will devote revision and final
question practice.
Prepare a written schedule summarizing the above and stick to it.
It is essential to know your syllabus. As your studies progress you will become
more familiar with how long it takes to cover topics in sufficient depth. Your
timetable may need to be adapted to allocate enough time for the whole
syllabus.
Tips for effective studying
(1) Aim to find a quiet and undisturbed location for your study, and plan as
far as possible to use the same period of time each day. Getting into a
routine helps to avoid wasting time. Make sure that you have all the
materials you need before you begin so as to minimize interruptions.
(2) Store all your materials in one place, so that you do not waste time
searching for items around your accommodation. If you have to pack
everything away after each study period, keep them in a box or even a
suitcase, which will not be disturbed until the next time.
(3) Limit distractions. To make the most effective use of your study periods
you should be able to apply total concentration, so turn off all
entertainment equipment, set your phones to message mode and put
up your ‘do not disturb’ sign.

(4) Your timetable will tell you which topic to study. However, before
dividing in and becoming engrossed in the finer points, make sure you
have an overall picture of all the areas that need to be covered by the
end of that session. After an hour, allow yourself a short break and
move away from your study text. With experience. You will learn to
assess the pace you need to work at.
(5) Work carefully through a chapter, note imported points as you go.
When you have covered a suitable amount of material, very the
pattern by attempting a practice question. When you have finished
your attempt, make notes of any mistakes you make, or any areas that
you failed to cover or covered more briefly.

Fundamentals of Cost and Management Accounting (Study Text) 1|Page
Chapter learning objectives
In this chapter you will learn:
 Some cost and accounting concepts

 What is management accounting
 Definitions
 The changing role of management accounting
 ICMA Pakistan and its role in management accounting
 Performance measurement
 Shareholder value and environmental and social concerns

1 Financial, cost and management accounting
Financial accounting
Financial accounting involves recording the financial transactions of an
organisation and summarising them in periodic financial statements for external
users who wish to analyse and interpret the financial position of the organisation.
 The main duties of the financial accountant include: maintaining the book
keeping system of the nominal ledger, payables control account,receivables
control account and so on and to prepare financial statements as required by
law and accounting standards.
 Information produced by the financial accounting system is usually

insufficient for the needs of management.Managers usually want to know
about the costs of individual products and services and the profits made by
individual products and services
 In order to obtain this information, details are needed for each cost, profit,
investment and revenue centre.Such information is provided by cost
accounting and management accounting systems.
Cost accounting
Cost accounting is a system for recording data and producing information about
costs for the products produced by an organisation and/or the services it
provides. It is also used to establish costs for particular activities or
responsibility centres.
 Cost accounting involves a careful evaluation of the resources used within

the enterprise.

 The techniques employed in cost accounting are designed to provide financial
information about the performance of the enterprise and possibly the direction
that future operations should take.
 The terms ‘cost accounting’ and ‘management accounting’ are often used to
mean the same thing.
Management accounting
Management accounting has cost accounting at its essential foundation.
Non-financial information
Information provided by cost accounting systems is financial in nature. Financial

information is important for management because many objectives of an
organisation are financial in nature, such as making profits and avoiding
insolvency. Managers also need information of a non-financial nature.
 At a strategic level, management need to know about developments in their

markets and in the economicsitation. They also need to know about any new
technology that emerges and about the activities of competitors.
 At a tactical level, they might want to know about issues such as product or
service quality, speed of handling customer complaints,customer satisfaction
levels, employee skills levels and employee morale.
 At an operational level, they may want to know about the number of rejects
per machine, the lead time for delivering materials and the number of labour
and machine hours available.
The management accounting systems in many organisations are able to obtain

non-financial as well as financial information for reporting to management. The
importance of non-financial information within the reporting system should not be
forgotten.
Differences between management accounting and financial accounting

The following illustration compares management accounting with financial
accounting.
 capital investment appraisal reports

 standard cost and variance analysis reports
 returns to government departments, e.g. Sales Tax returns.

Management information is generally supplied to management in the form of reports.
Reports may be routine reports prepared on a regular basis (e.g. monthly) or they
may be prepared for a special purpose (e.g. ad hoc report).
Test your understanding 1

The following assertions relate to financial accounting and to cost accounting:
(i) The main purpose of financial information is to provide a true and fair view of
the financial position of an organisation at the end of an accounting period.
(ii) Financial information may be presented in any format deemed suitable by

management.
Which of the following statements are true?
A Assertions (i) and (ii) are both correct.

B Only assertion (i) is correct.
C Only assertion (ii) is correct.

The Management Accountant has communicated a detailed budget to ensure that
cost savings targets are achieved in the forthcoming period.
This is an example of:
A Operational Planning
B Tactical Planning
C Strategic Planning
2 Institute of Cost and Management Accountant of Pakistan (ICMA Pakistan) and

its role:
The Institute of Cost & Management Accountants of Pakistan was established in

1951 and was granted statutory status under the Cost and Management
Accountants Act, 1966 for the regulation of the profession of Cost and
Management Accounting. ICMA Pakistan is the sole provider of cost and
management accounting education, training and professional certification in
Pakistan. The institute has earned reputation both nationally and internationally
for its high standard in imparting education and testing. The Institute has been
meeting an important national human resource need through a steady flow of
professional management accountants to occupy leading positions in the
corporate world.

The Management Accountants produced by the ICMA Pakistan, have met the
requirements of the industry over the years and performed creditably in the
assigned roles. Members occupy top to middle management positions in
industry, financial institutions, consultancy firms etc.
Organisations over the years have turned increasingly complex and the
Management Accountants have enhanced their knowledge and sharpened their
skills to meet the challenge of change, becoming more important players in the
management decision-making. Their training, during this period, has been
modified gradually to cover the best financial and business practices with
information management skills.
In a business, the role of professional Management Accountants is like brain in

the human body. It collects data, analyses it, plans for the future, puts in place
an effective control mechanism and operates an emergency alarm system. This
being so, the economy is greatly indebted to the contribution of professional
Management Accountants.
3 The management accountant
The changing role of the management accountant

The whole of the accountancy profession is changing, and this is especially
true for the management accountant. The traditional management accountant
was largely involved in reporting business results to management, but this is
no longer the case. Management accountants today are seen as value-adding
business partners and are expected to not only forecast the future of the
business, but to assist in delivering this future by identifying opportunities for
enhancing organisational performance.
Management accountants now work alongside business managers as mentors,

advisors and drivers of performance. Management accountants are an integral
part of any business, providing a variety of information to management for the
purposes of planning, control and decision making. Management accountants
often hold senior positions in the organisation.
The work of the Management Accountant (produced by ICMA Pakistan):

Cost and management accountants help organisations establish viable
strategies and convert them into profit (in a commercial context) or into value
for money (in a not-for-profit context). To achieve this they work as an integral
part of multi-skilled management teams in carrying out the:
 Formulation of policy and setting of corporate objectives;

 Formulation of strategic plans derived from corporate objectives;

 Formulation of shorter-term operational plans;
 Acquisition and use of finance;
 Design of systems, recording of events and transactions and management
of information systems;
 Generation, communication and interpretation of financial and operating
information for management and other stakeholders;
 Provision of specific information and analysis on which decisions are
based;
 Monitoring of outcomes against plans and other benchmarks and the
initiation of responsive action for performance improvement;
 Derivation of performance measures and benchmarks, financial and
nonfinancial, quantitative and qualitative, for monitoring and control; and
 Improvement of business systems and processes through risk
management and internal audit review.
Through these forward-looking roles and by application of their expert skills

management accountants help organisations improve their performance,
security, growth and competitiveness in an ever more demanding environment.
We will start to look at some of these functions in the Fundamentals of

Management Accounting syllabus, and others will be studied in later papers. It
can be seen from this that there is no one clear definition of the role of the
management accountant. Their work, experience and responsibilities are
extraordinarily varied and continue to change to reflect the changing needs of
stakeholders.
4 The positioning of management accounting within the organisation
It is clear that the breadth of the work carried out by management accountants,
and their remit continues to grow. Accountants within business can be part of
an internal finance function, or may be part of a business partnering role. When
deciding on their structure, it is therefore important for organisations to
consider where best to position the management accountant within the
organisation. There are several options available:
Dedicated business partners

With this approach, the management accountant is an integral part of the
business area that they support. This brings many benefits to both the
accountants and the management of the area.
The relationship between the management accountant and the managers of
the business area is an important business relationship. To work in the best
interests of the company, they must work as business partners and the
relationship must be based on trust, honesty and respect.

From the accountant’s point of view, they must:
 act professionally at all times – as representatives of the accounting
profession, they are expected to show professional care and attention in
the way they conduct themselves;
 demonstrate technical awareness – can be demonstrated by being a

qualified member of ICMA Pakistan:
 demonstrate business awareness – they must be aware of the nature of

the business and the needs of the managers:
 act with integrity – the work of the management accountant should be

done in the best interests of the company and society and they should
never put themselves in a position where their personal interests conflict
with these interests.
From the manager’s point of view, they must:

 trust the accountant and the information being provided
 respect the accountant’s knowledge, experience and professionalism
 be able to discuss all aspects of work confidentially with the accountant
 be able to state clearly what their requirements are
It is important to remember that both the management accountant and the

managers of the business want the business to succeed and they have to work
together to achieve this.
The management accountant as an adviser

The management accountant plays a range of roles within the organization
from their more traditional scorekeeping role to a full-fledged, value-adding,
business partner. An advisory role falls in between these extremes. As a
technical expert, the management accountant is expected to advise
management on a range of topics, including financial and nonfinancial
analysis, costing, pricing, Business Process Reengineering and performance
management.
As advisers, management accountants no longer simply need financial skills,

but increasingly, communication and presentation skills.
The advantages of this approach are:
 The management accounting function is part of the business it serves.

 Increased knowledge of the business area and its needs.

 Strong relationships can be built up between the accountants and the
business.
The disadvantages are:
 Duplication of effort across the organisation.

 Lack of knowledge: There is no sharing of knowledge which can happen
within a larger, more diverse team.
 The accountants can feel isolated within the business and may develop
their own ways of working which may not constitute best practice.
 The accountant can lose sight of the overall goals of the organisation.
5 Management information
The main purposes of management accounting can be summarised as:
 Planning
 Control
 Decision making
Planning
Planning involves establishing the objectives of an organisation and
formulating relevant strategies that can be used to achieve those objectives.
In order to make plans (budgets), it helps to know what has happened in the
past so that decisions about what is achievable in the future can be made. For
example, if a manager is planning future sales volumes, they need to know
what sales volumes have been in the past.
Planning can be done at different levels in an organisation:
Strategic – long-term planning carried out by the highest level of management

in organization
Managerial – short-to-medium term planning, carried out by middle level

management
Operational – short-term planning for day-to-day operations
Planning is looked at in more detail in the budgeting chapter.

Control
Once planning has been carried out, targets can be set. This allows for
evaluation of performance.
Information relating to the actual results of an organisation must be gathered

and compared to the targets. The differences (variances) can be reported to
management. This type of information facilitates managers to control their
operations.
Many measures can be used to measure performance within an organisation, it

is largely dependent on the type of organisation. Some common performance
measurements are:
 Variances – comparison of actual results against budgeted results.

 Profitability measures – absolute measures such as gross profit or net
profit, or relative measures such as gross margin %
 Return measures – financial ratio measures such as return on capital.
These measures will be covered in more detail in later chapters.
Decision making
Decision making involves considering information that has been provided and
making informed decisions. In most situations, decision making involves
making a choice between two or more alternatives. Managers need reliable
information to compare the different courses of action available and
understand what the consequences might be of choosing each of them.
You can see from the above that managers require information at various
levels and for various purposes. It is the role of the management accountant to
provide that information.
Fundamentals of Cost and Management Accounting (Study Text) 10 | P a g e

Test Your Understanding 3
Activities: Planning Control Decision

making
Preparation of the annual
budget
Revise budgets for next period
Implement decisions based on
information provided
Set organisation’s objectives
for next period
Compare actual and expected
results for a period
Required:
Complete the table shown above, identifying each activity as either a planning,
a decision making or a control function.
Characteristics of good information

The operations of organisations generate a huge quantity of data. Data consist
of raw facts and statistics before they have been processed. Once data have
been processed into a useful form, they are called information.
Managers need good information in order to make good decisions. A useful

way to remember the characteristics of good information is ACCURATE:
A. Accurate: The degree of accuracy depends on the reason the information is

needed. For example, reports may show figures to the nearest Rs 1,000, or
to the nearest Rs 100,000 for a report on the performance of different
divisions. Alternatively, when calculating the cost of a unit of output,
managers may want the cost to be accurate to the nearest dollar or even
cent.
C. Complete: Managers should be given all the information they need, but
information should not be excessive, for example a complete control report
on variances should include all standard and actual costs necessary to
understand the variance calculations.
C. Cost beneficial: The value of information should not exceed the cost of
producing it. Management information is valuable, because it assists
decision making. If a decision backed by information is different from what it
would have been without the information, the value of information equates
the amount of money saved as a result.

U. Understandable: Use of technical language or jargon must be limited.
Accountants must always be careful about the way in which they present
financial information to nonfinancial managers.
R. Relevant: The information contained within a report should be relevant to its

purpose. Redundant parts should be removed.
A. Authoritative: Information should be trusted and provided from reliable

sources so that the users can have confidence in their decision making.
T. Timely: Information should be provided to a manager in time for them make

decisions based on that information.
E. Easy to use: We must always think about the person using the information
we provide and make sure the information meets their needs.
Information for different levels of management

There are three levels of management: Strategic, Managerial and
Operational. Information needs differ at each of these levels.
Strategic level: Management needs to know about developments in the

markets in which they operate and in the general economic situation. They also
need to know about any new technology that emerges, and about the activities
of competitors. Decisions made at this level:
 will have a large impact on the whole organisation

 will be long term
 tend to be unstructured
Managerial level: Management at this level might want to know about issues
such as product or service quality, speed of handling customer complaints,
customer satisfaction levels, employee skills levels and employee morale.
Decisions made at this level:
 will have a medium impact on the whole organisation

 will be medium term
 will act as a bridge between the strategic and operational levels.
Operational level: At this level, management may want to know about the
number of rejects per machine, the lead time for delivering materials and the
number of labour and machine hours available. Decisions made at this level:

 will have a small impact on the whole organisation; they will normally only
affect one business unit or department
 will be short term
 tend to be highly structured
You can see from the above that the information requirements change at the
different levels within the organisation. The nature of the information also
changes:
Information Strategic level Operational level

characteristics
Source Historical and forecasts Historical
Timeliness The timeliness is less Information must be
crucial at this level as available
decisions tend to be taken immediately as
over a period of decisions are taken
weeks or months daily
Accuracy Often highly rounded and Information will be

will contain many objective and
subjective estimates accurate
Breadth Wide variety of information Focused on the

in different forms, covering decision to be
many aspects of the made
organisation’s operations
Detail Highly summarised Detailed
Managerial level – Just as managerial decision making forms a link between

strategic and operational management, the information it requires has some of
the characteristics of each.
Non-financial information
Information provided by management accountants needs to be both financial
and nonfinancial. Financial information is important for management because
many objectives of an organisation are financial in nature, such as making
profits and avoiding insolvency.
Managers also need information of a nonfinancial nature, such as the number

of complaints or the number of orders processed.
The management accounting systems in many organisations are able to obtain

nonfinancial as well as financial information for reporting to management. The

importance of nonfinancial information within the reporting system should not
be forgotten; in fact it is often the information which is most valuable to
managers in their decision making.

Which of the following are characteristics of good information? Mark all that
apply.
 Cost beneficial
 Detailed
 Understandable
 Accurate
 Complete
 Regular
 Timely
 Accountable
6 Information requirements for performance measurement
Financial information is required by a variety of different users, each with

different needs.
Commercial organizations
The main objective of commercial organisations is usually to maximise the
wealth of its shareholders (although it can have many other, sometimes
conflicting objectives). The sort of financial information required by this type of
business would include:
 Costing of departments, functions or products

 Profit measurement
 Calculation of return on capital
Shareholders of these businesses are interested in the growth of their

investment and they will be able to judge the performance of the organisation
by examining the statutory accounts. Other information of interest to the
shareholders will be the level of dividend payments.
A mission statement should describe the overall long term purpose of the
organisation. The different planning levels; Strategic, operational and tactical;
will contain shorter term objectives created in order to achieve the mission of
the business. The shorter term objectives will enable the businesses
progression towards the ultimate long term goal to be monitored and to enable
performance of employees to be measured along the way. Suitable

performance measures therefore need to be set to monitor the achievement of
each objective.
Measures will differ according to the planning level:
Level of Who Part of the Performance

planning business measure
Strategic Senior Business as a Return on investment,
management whole net profit percentage
Tactical Senior and Division or Actual versus budget
middle department of for costs and
management the business revenues,
labour turnover
Operational Potentially all Day to day Quantity of rejects
managers running of the from
business. production, number of
customer complaints
received
Public bodies
The main objective of public bodies is to provide services to the public in line
with government requirements. The information requirement of public bodies
will differ from commercial organisations. There will be no profit measurements
as these are non-profit-making organisations, therefore the focus will be more
on cost management. As these bodies must be run in the public interest, the
level of information must be detailed and accurate and allow assessment of the
efficiency and effectiveness of the organisation to be assessed by central
government and by the public.
Society
Society also has a need for financial information relating to the organisations it
deals with. Members of the public may be shareholders, employees or
customers of these organisations and they will have an interest in how these
organisations are run and are performing. Society will also be interested in the
impact organisations have on the local and wider community. Environmental
reporting, where organisations measure and report on their impact on the
environment, can be of great use to the public.

The objective of non-profit organisations is often "value for money". True or
false?
7 Environmental costing
There is an increasing need for management accountants to provide

information relating to environmental issues.
Environmental costs can be split into two categories:
Internal costs
These are costs that directly impact on the income statement of a company.
There are many different types, for example:
 Improved systems and checks in order to avoid penalties/fines

 Waste disposal costs
 Product take back costs (i.e. in the EU, for example, companies must
provide facilities for customers to return items such as batteries, printer
cartridges etc. for recycling. The seller of such items must bear the cost of
these "take backs")
 Regulatory costs such as taxes (e.g. companies with poor environmental
management policies often have to bear a higher tax burden)
 Upfront costs such as obtaining permits (e.g. for achieving certain levels
of emissions)
 Backend costs such as decommissioning costs on project completion
External costs
These are costs that are imposed on society at large but not borne by the
company that generates the cost in the first instance. For example,
 carbon emissions
 usage of energy and water
 forest degradation
 health care costs
 social welfare costs
However, governments are becoming increasingly aware of these external

costs and are using taxes and regulations to convert them to internal costs.
For example, companies might have to have a tree replacement programme if

they cause forest degradation, or they receive lower tax allowances on

vehicles that cause a high degree of harm to the environment. On top of this,
some companies are voluntarily converting external costs to internal costs
Answers: Test your understandings

A

A
Activity Planning Control Decision

making
Preparation of the annual budget X X
Revise budgets for next period X X
Implement decisions based on X
information provided
Set organisation’s objectives for X X
next period
Compare actual and expected X X
results for a period
Note that all planning and control functions are part of the decision making
process.
Cost beneficial X
Detailed
Understandable X
Accurate X
Complete X
Regular
Timely X
Accountable
True

In this chapter you will learn
 Data and information

 Purpose of management information
 Sources and categories of information
 Types of Data
 Sources of Data
 Secondary Data
 Sampling
 Sampling methods

1 Data and information
Data means facts. Data consists of numbers, letters, symbols, raw facts,
events and transactions which have been recorded but not yet processed into
a form suitable for use. Information is data which has been processed in such
a way that it is meaningful to the person who receives it (for making
decisions).
 The terms data and information are often used interchangeably in

everyday language.
 Make sure that you can distinguish between the two.
 As data is converted into information, some of the detail of the data is
eliminated and replaced bysummaries which are easier to understand.
2 The purpose of management information
The main purposes of management information can be summarised as

follows:
Planning: Establishing the objectives of an organisation and
formulating relevant strategies.
Control: Evaluating the performance and comparing with targets.
Decision making: Making choice between alternatives.
3 Internal and external sources of information
Internal sources of information

Internal information may come from various sources.
(1) Accounting system

The accounts system will collect data from source documents such as
invoices, timesheets and journal entries. The data will be sorted and analysed
by the coding system by type of expense, department, manager and job.

Reports of direct and indirect costs compared to budgets may be produced at
regular intervals to help managers plan and control costs. Ad hoc reports may
be produced to help managers make specific decisions.
(2) Payroll system

The payroll system may provide information concerning detailed labour costs.
Hours paid may be analysed into productive work and non-productive time
such as training, sick, holiday and idle time. Labour turnover by department or
manager may be analysed and may help management to assess the
employment and motivation policies
(3) Strategic planning system

The strategic planning system may provide information relating to the
organisation’s objectives and targets. Assumptions relating to the external
environment may be detailed. Details of the organisation’s capital investment
programme and product launch programme may also be recorded here. Some
of this information will be very commercially sensitive and only accessed by
very senior managers in the organisation.
Benefits of internal sources

 Readily available data
 Data can easily be sorted and analysed
 Reports can easily be produced when required
 Data relates to the organisation concerned
Limitations of internal sources

 Data may need to be further analysed to be of use to management
accountants
External sources of information

Businesses are finding it increasingly difficult to succeed if they ignore the
external environment which will influence their activities. The process known
as environmental scanning or environmental monitoring is becoming a more
important part of the role of the management accountant. These terms are
used to describe the process whereby data is collected from outside, as well
as from inside, the organisation and used in the decision-making process.
The main sources of external information which we shall consider here are:
 government sources
 business contacts – customers and suppliers
 trade associations and trade journals
 the financial and business press and other media.

These are dealt with in more detail below. However, a word of warning first.
Internal information is produced by the company itself so they are aware of
any limitations in its quality or reliability. External information is not under the
control of the organisation – they may not be aware of any limitations in its
quality – this point should always be considered. Even government produced
statistics have been known to contain inaccuracies!
(1) Government sources (secondary data)

There is a wealth of published statistical data covering many aspects of the
nation’s economy: population, manpower, trade, agriculture, price levels,
capital issues and similar matters. Most, but not all of this is produced by
national governments.The primary purpose of this data is to provide
information for economic planning at the national level. The data serves the
secondary purpose of providing industry with useful background information
for deciding on future policies such as raising new finance or recruiting
specialised labour. The data is only published in general terms (e.g. for a
particular industry or geographical area).
(2) Business contacts

Government produced information will be broadly based and general, dealing
with the economy as a whole or particular sectors or industries. An
organisation may be looking for information more focused on its own position.
Its day-to-day business contacts, customers and suppliers, can be a useful
source of this information – and often it is available free.
Customers can provide information on such matters as:

– the product specification which they require
– their quality requirements
– requirements for delivery periods
– preference for packaging and distribution methods
– feedback on the above and on general aspects of customer service.
Suppliers may be able to provide information on:

– quantity discounts and volume rebates which may help the organisation to
decide on order size
– availability of products and services
– alternative products or services which may be available or may become
available
– technical specifications of their product.
(3) Trade associations and trade journals

Most major industries have their own trade association. The role of these
organisations includes:
– representing their member firms in legal and other disputes

– providing quality assurance schemes for customers of member
organisations
– laying down codes of practice to be followed by their member
organisations
– publishing trade journals and other information useful for the management
and
– development of their businesses.
There follows a very brief list of just a small selection of trade associations
operating in the Pakistan
– All Pakistan Textile Mills Association (APTMA)

– Pakistan Sugar Mills Association (PSMA)
– All Pakistan Cement Manufacturers Association (APCMA)
– Leasing Association of Pakistan (LAP)
– Pakistan Leather Garments Manufacturers & Export Association
(PLGMEA)
– Pakistan Cotton Ginners’ Association (PCGA)
Many of these organisations publish their own industry or trade journals which
will contain useful news and other information for organisations operating in
that industry. Trade journals are also published by many publishing
organisations.
(4) The financial press, business press and other media
In Pakistan, Business recoder, Financial daily etc provide statistics and

financial reviews as well as business and economic news and commentary.
These include:
– the KSE 100 Index, the stock market index of the 100 leading shares
– the KSE 30 Index, the stock market index of the 30 leading shares
Such information is now also widely available via electronic media.Digital

television services available on satellite or cable systems carry specialist
business and financial channels and programmes (such as Bloomberg TV)
which give both national and world-wide coverage. There is also the internet
as a widely available source of up-to-date financial information.

Benefits of external sources and Limitations of external sources
 Wide expanse of external sources of information

 Easily accessible especially using the internet
 Data may not be accurate
 Finding relevant information
 Can be time consuming
 More general information available
 Can source specific information needs
4 Sampling techniques
The purpose of sampling is to gain as much information as possible about the
population by observing only a small proportion of that population i.e. by
observing a sample.The term population is used to mean all the items under
consideration in a particular enquiry. A sample is a group of items drawn from
that population. The population may consist of items such as metal bars,
invoices, packets of tea, etc; it need not be people.
For example, in order to ascertain which television programmes are most

popular, a sample of the total viewing public is interviewed and, based on their
replies, the programmes can be listed in order of popularity with all viewers.
There are three main reasons why sampling is necessary:
(1) The whole population may not be known.
(2) Even if the population is known the process of testing every item can
be extremely costly in time and money, for example, gaining
information about the popularity of TV programs by interviewing every
viewer.
(3) The items being tested may be completely destroyed in the process,
for example in order to check the lifetime of an electric light bulb it is
necessary to leave the bulb burning until it breaks and is of no further
use.
The characteristics of a population can be ascertained by investigating only a

sample of that population provided that the following two rules are observed:
(1) The sample must be of a certain size. In general terms the larger the
sample the more reliable will be the results.
(2) The sample must be chosen in such a way that it is representative of

the population. The usual way of achieving this is by using a random

sampling technique – a technique which aims to ensure that each
member of the population has an equal chance of being selected. This
avoids bias in the results achieved from the sampling exercise.
There are several methods of obtaining a sample and these are considered in
turn.
Random Sampling
A simple random sample is defined as a sample taken in such a way that
every member of the population has an equal chance of being selected. The
normal way of achieving this is by numbering each itemm in the population.
If a sample of 20 items is required then 20 numbers from a table of random

numbers are taken and the corresponding items are extracted from the
population to form the sample e.g. in selecting a sample of invoices for an
audit. Since the invoices are already numbered, this method can be applied
with the minimum of difficulty.This method has obvious limitations when either
the population is extremely large or, in fact, not known. The following methods
are more applicable in these cases.
Systematic sampling
If the population is known to contain 50,000 items and a sample of size 500 is
required, then 1 in every 100 items is selected. The first item is determined by
choosing randomly a number between 1 and 100 e.g. 67, then the second
item will be the 167th, the third will be the 267th... up to the 49,967th
item.Strictly speaking, systematic sampling (also called quasi-random) is not
truly random as only the first item is selected randomly. However, it gives a
very close approximation to random sampling and it is very widely used e.g. in
selecting a sample of bags of sugar coming off a conveyor belt.
There is danger of bias if the population has a repetitive structure. For

example, if a street has five types of house arranged in the order, A B C D E A
B C D E... etc, an interviewer visiting every fifth home would only visit one type
of house.
Stratified sampling
If the population under consideration contains several well defined groups
(called strata or layers), e.g. men and women, smokers and non-smokers,
different sizes of metal bars, etc, then a random sample is taken from each
group. This is done in such a way that the number in each sample is
proportional to the size of that group in the population and is known as
sampling with probability proportional to size (pps).

For example, In selecting a sample of people in order to discover their leisure
habits, age could be an important factor. So if 20% of the population are over
60 years of age 65% between 18 and 60 and 15% are under 18, then a
sample of 200 people should contain 40 who are over 60 years old,130
people between 18 and 60 and 30 under 18 years of age, i.e. the subsample
should have sizes in the ratio 20 : 65 : 15.This method ensures that a
representative cross-section of the strata in the population is obtained, which
may not be the case with a simple random sample of the whole
population.The method is often used by auditors to choose a sample to
confirm receivables’ balances. In this case a greater proportion of larger
balances will be selected.
Multi-stage sampling
This method is often applied if the population is particularly large, for example
all TV viewers in the Pakistan.The process involved here would be as follows:
Step 1: The country is divided into areas (counties) and a random sample of
areas is taken.
Step 2: Each area chosen in Step 1 is then subdivided into towns and cities or
boroughs and a random sample of these is taken.
Step 3: Each town or city chosen in Step 2 is further divided into roads and a
random sample of roads is then taken.
Step 4: From each road chosen in Step 3 a random sample of houses is taken
and the occupiers interviewed.
This method is used, for example, in selecting a sample for a national opinion
poll of the type carried out prior to a general election.
Cluster sampling
This method is similar to the previous one in that the country is split intoareas
and a random sample taken. Further sub-divisions can be made until the
required number of small areas have been determined.Then every house in
each area will be visited instead of just a random sample of houses. In many
ways this is a simpler and less costly procedure as no time is wasted finding
particular houses and the amoun of travelling by interviewers is much
reduced.

Quota sampling
With quota sampling the interviewer will be given a list comprising the different
types of people to be questioned and the number or quota of each type e.g.
20 males, aged 20 to 30 years,manual workers; 15 females, 25 to 35, not
working; 10 males, 55 to 60, professional men, etc. The interviewer can use
any method to obtain such people until the various quotas are filled. This is
very similar to stratified sampling, but no attempt is made to select
respondents by a proper random method, consequently thesample may be
very biased.
Sampling methods compared

The objective of a sample is to collect data upon which an opinion can be
formed, and a conclusion drawn in respect of the population of which the
sample is representative.
Ideally the sample would be chosen at random, and would be large enough so
as to be representative of the population. Unfortunately both of these aspects
introduce costs which are often unacceptably high.
Alternatives to the truly random sampling method have been outlined above.
They are all concerned with minimising costs whilst maintaining the
representative nature of the sample compared to the population.
In order to use these alternatives it is often necessary to have some

knowledge of the population. For example, systematic sampling should not be
used if the population follows a repetitive pattern. Quota sampling must be
used with caution. The data collector may introduce bias because they choose
how to fill the quota.

The essence of systematic sampling is that:
A each element of the population has an equal chance of being chosen

B members of various strata are selected by the interviewers up to
predetermined limits
C every nth member of the population is selected
D every element of one definable subsection of the population is selected

A sample is taken by dividing the population into different age bands and then
sampling randomly from the bands, in proportion to their size. What is such a
sample called?

A Simple random
B Stratified random
C Quota
D Cluster

In a survey on the opinions of employees in a large company headquarters,
one of the following is a cluster sample. Which is it?
A. Staff are randomly selected from each department in proportion to

departmental
B. Staff are selected from the list of employees, taking every nth name
C. A sample, which is as representative as possible of the composition of
the staff in terms of gender, age and department, is taken by stopping
appropriate staff in the corridors and canteen
D. One department is selected and all the staff in that department are
surveyed

Associate with each of the following sampling methods (A)–(F) the most
appropriate example from the list, (P)–(U), given below.
A Simple random sample

B Stratified random sample
C Cluster sample
D Systematic sample
E Quota sample
F Multistage sample
Examples
P One city is chosen at random from all cities in the Pakistan, then the
electoral register is used to select a 1-per-1,000 sample.
Q Names picked from a hat.
R Every 10th person is chosen randomly from each ward in a hospital.
S One secondary school in a town is selected at random, then every pupil
in that school is surveyed.
T One person in ten is chosen from an alphabetical list of employees.
U People are stopped in the street according to instructions such as stop
equal numbers of men and women.

7 Chapter summary
Test your understanding answers
Answer C
In systematic sampling, population members are listed and members selected
at regular intervals along the list.
Answer B
In simple random sampling, there is no division of the population into groups.
In cluster sampling, only one group is selected and all its members are
surveyed. Quota sampling and stratified random sampling are both as
described in the question but quota sampling is not random.
Answer D
A is a stratified random sample, B is systematic and C is a quota sample.

The associations are as follows:

A. Most appropriate example is (Q).
B. Most appropriate example is (R).
C. Most appropriate example is (S).
D. Most appropriate example is (T).
E. Most appropriate example is (U).
F. Most appropriate example is (P).

In this chapter you will learn
 The concept of cost

 Cost classification
 Cost classification for control
 Total Product/Service costs
 Direct costs and indirect costs
 Functional costs
 Fixed Costs and Variable Costs
 Production and Non-Production Costs
 Cost Codes
 Cost Units, Cost Objectives and Responsibility Centers
 Cost behaviour and levels of activity
 Cost behaviour patterns
 Determining the fixed and variable elements of semi-variable costs
 Linear Equations and Graphs

1 Introduction
In this chapter, we will look at some of the fundamental concepts of the

framework of cost accounting. You will learn some basic principles which
underpin all of the material in your Cost Accounting syllabus.
Most organisations will have a costing system which is used to gather the cost
information for the organisation together. An organisation’s costing system is
the foundation of the internal financial information system for managers. It
provides the information that management needs to plan and control the
organisation’s activities and to make decisions about the future.
Examples of the type of information provided by a costing system and the

uses to which it might be put include the following:
 Actual unit costs for the latest period; could be used for cost control by
comparing with a predetermined unit cost. Could also be used as the basis
for decisions about pricing and production levels. For example, a manager
cannot make a decision about the price to be charged to a customer
without information which tells the manager how much it costs to produce
and distribute the product to the customer.

 Actual costs of operating a department for the latest period; Could be used
for cost control by comparing with a predetermined budget for the
department. Could also be used as the basis for decisions such as
outsourcing. For example, a manager might be considering the closure of
the packing department and instead outsourcing the packing operations to
another organisation. In order to make this decision the manager needs to
know, amongst other things, the actual cost of operating the packing
department.
 The forecast costs to be incurred at different levels of activity. Could be

used for planning, for decision making and as a part of cost control by
comparing the actual costs with the forecasts. For example, a manager
cannot make a well-informed decision about the appropriate production
level for the forthcoming period unless information is available about the
costs that will be incurred at various possible output levels.
This is by no means an exhaustive list of the information that is provided by a

costing system. However, it should serve to demonstrate that organisations
need costing systems that will provide the basic information that management
requires for planning, control and decision making.
2 What is meant by cost

The word ‘cost’ can be used in two contexts. It can be used as a noun, for
example when we are referring to the cost of an item. Alternatively, it can be
used as a verb, for example we can say that we are attempting to cost an
activity, when we are undertaking the tasks necessary to determine the costs
of carrying out the activity.
The word ‘cost’ can rarely stand alone and should always be qualified as to its
nature and limitations. You will see throughout this text that there are many
different types of cost and that each has its usefulness and limitations in
different circumstances.
Some definitions of cost that you will need to know:
 Historical cost
 Cost unit
 Composite cost unit
 Cost Centre
 Cost object

2.1 Historical cost
The term historical cost is normally used when we consider the purchase of an
asset. This applies to both noncurrent assets, such as buildings or vehicles, or
current assets such as inventory. Historical cost is the original cost paid for the
asset at the time of acquisition.
By their nature, historical costs are out of date and might not reflect the
current value of the asset to the organisation.
The economic value of an asset is the value the organisation derives from
owning and using the asset. This value can be higher or lower than the
historical cost, depending on current circumstances. It can be affected by how
the asset is currently being used, the alternative uses for the asset or the
current inflation rate.
2.2 Cost units
This means that a cost unit can be anything for which it is possible to
ascertain the cost. The cost unit selected in each situation will depend on a
number of factors, including the purpose of the cost ascertainment exercise
and the amount of information available.
Cost units can be developed for all kinds of organisations, whether

manufacturing, commercial or public-service based. Some examples from the
CIMA Terminology are as follows:
Industry sector Cost unit

Brick-making Per 1,000 bricks
Electricity Per Mega-watt-hour (MWH) / KWH
Professional services Per Chargeable hour
Credit control Account maintained
Selling Customer call
The above list is not exhaustive. A cost unit can be anything which is
measurable and useful for cost control purposes. For example, with brick-
making, 1,000 bricks is suggested as a cost unit. It would be possible to
determine the cost per brick but perhaps in this case a larger measure is
considered more useful for control purposes.
Notice that this list of cost units contains both tangible and intangible items.
Tangible items are those which can be seen and touched, for example the
1,000 bricks. Intangible items cannot be seen and touched and do not have

physical substance but they can be measured, for example a chargeable hour
of accounting service.
2.3 Composite cost units

The cost units for services are usually intangible and they are often composite
cost units, that is, they are often made up of two parts. For example, if we
were attempting to monitor and control the costs of a delivery service we
might measure the cost per tonne delivered. However, ‘tonne delivered’ would
not be a particularly useful cost unit because it would not be valid to compare
the cost per tonne delivered from London to Edinburgh with the cost per tonne
delivered from London to Brighton. The former journey is much longer and it
will almost certainly cost more to deliver a tonne over the longer distance.
Composite cost units assist in overcoming this problem. We could perhaps
use a ‘tonne mile’ instead. This means that we would record and monitor the
cost of carrying one tonne for one mile. The cost per tonne-mile would be a
comparable measure whatever the length of journey and this is therefore a
valid and useful cost unit for control purposes.
Other examples of composite cost units might be as follows:
Business Cost unit

Hotel Per Room per night
Bus Company Per Passenger per mile
Hospital Per patient per day
Education Per student per subject
Courier service Per Kg per kilometer
2.4 Cost Centre

A cost centre is a production or service location, a function, an activity or an
item of equipment for which costs are accumulated. (A cost centre is one type
of responsibility centre – will be discussed later in this chapter).
A cost centre is used as a ‘collecting place’ for costs. The cost of operating the
cost centre is determined for the period, and then this total cost is related to
the cost units which have passed through the cost centre. For instance, an
example of a production cost centre could be the machine shop in a factory.
The production cost for the machine shop might be Rs 100,000 for the period.
If 1,000 cost units have passed through this cost centre we might say that the
production cost relating to the machine shop was Rs 100 for each unit.
A cost centre could also be a service location, a function, an activity or an item
of equipment. Examples of these might be as follows but you should try to
think of some others:

Type of cost centre Examples
Service location Stores, canteen
Function Sales representative
Activity Quality control
Item of equipment Packing machine
If you are finding it difficult to see how a sales representative could be used as
a cost centre, then work carefully through the following points:
 What are the costs which might be incurred in ‘operating’ a sales

representative for one period?
Examples might be the representative’s salary cost, the cost of running a

company car, the cost of any samples given away by the representative and
so on. Say this amount to Rs 40,000.
 Once we have determined this cost, the next thing we need to know is the
number of cost units that can be related to the sales representative.
The cost unit selected might be Rs 100 of sales achieved. If the representative
has achieved Rs 400,000 of sales, then we could say that the representative’s
costs amounted to Rs 10 per Rs 100 of sales. The representative has thus
been used as a cost centre or collecting place for the costs, which have then
been related to the cost units.
2.5 Cost objects

A cost object is anything for which costs can be ascertained.
All of the cost units and cost centers we have described earlier in this chapter
are therefore types of cost object. We have seen the quality control activity
being treated as a cost centre, and thus as a cost object.
3 Classification of costs
Total product/service costs can be classified in a number of different ways.
 Element – costs are classified as materials, labour or expenses.

 Function – costs are classified as being production or non-production
costs.
 Nature – costs are classified as being direct costs or indirect costs.
 Behaviour – costs are classified as being fixed costs, variable costs,
semi-variable costs, Stepped variable cost or stepped fixed costs.
 Control – costs are classifed as controllable or non-controllable costs.
 Avoidable or unavoidable costs.

4 Classification by element
The main cost elements that you need to know about are materials, labour
and expenses.
Material costs include the cost of obtaining the materials and receiving them
within the organisation. The cost of ingredients of any product is known as
material’s cost e.g. cost of wood, screws, glue, polish etc. The cost of having
the materials brought to the organisation is known as carriage inwards.
Labour costs are those costs incurred in the form of wages and salaries,
together with related employment costs.
Expense is any cost incurred other than materials and labour costs. These
costs are external costs such as rent, business rates, electricity, gas, postage,
telephones and similar items which will be documented by invoices from
suppliers.
Note: Within these classifications there are a number of subdivisions; for

example, within the materials classification the subdivisions might include the
following:
 Raw materials, that is, the basic raw material used in the manufacturing
process.
 Components, that is, complete parts that are used in the manufacturing
process.
 Consumables, that is, cleaning materials, etc.
 Maintenance materials, that is, spare parts for machines, lubricating oils,
etc.
This list of subdivisions is not exhaustive, and there may even be further
subdivisions of each of these groups. For example, the raw materials may be
further divided according to the type of raw material, for example steel, plastic,
glass, etc.

5 Classification by function - Production and non-production costs
5.1 Production costs

Production costs are the costs which are incurred when raw materials are
converted into finished goods and part finished goods (work in progress).
Examples of production costs
 Direct materials – the direct materials that go into making a product.

For example, cloth in the manufacture of shirts.
 Direct labour – the cost of labour directly engaged in making a product.
For example, the wages of the machinists making the shirts.
 Direct expenses – the cost of expenses directly involved in making a
product. For example, the royalties paid to a designer, or the freight
charges for special materials used to make the shirts.
 Variable production overheads – overheads that vary in direct
proportion to the quantity of product manufactured. For example, code
of fuel used to run machinery.
 Fixed production overheads – overheads that are fixed whatever the
quantity of product manufactured. For example, rent of the factory.
5.2 Non-production costs

Non-production costs are costs that are not directly associated with the
production processes in a manufacturing organisation.

Examples of non-production costs
 Administrative costs – the costs involved in running the general
administration departments of an organisation, for example, the accounts
department.
 Selling costs – costs associated with taking orders from customers who
wish to buy an organisation’s products (sales department costs) and also
marketing costs.
 Distribution costs – the costs involved in distributing an organisation’s
finished products, such as the cost of running the warehouse or delivery
costs.
 Finance costs – the costs that are incurred in order to finance an
organisation, for example, loan interest.
5.3 Distinguishing between production and non-production costs

Once costs have been analysed as being production or non-production costs,
management may wish to collect the costs together on a cost card. A cost card
(or unit cost card) lists out all of the costs involved in making one unit of a
product
COST CARD – statement of the total cost of one unit of a product

Rs
Direct materials X
Direct labour X
Direct expenses X
—
PRIME COST XX
Variable production overheads X
—
MARGINAL PRODUCTION COST XX
Fixed production overheads X
—
TOTAL PRODUCTION COST XX
Non-production overheads:
– Administration X
– Selling X
– Distribution X
—
TOTAL COST XX
Profit X_
Sales price XXX

Understanding a cost card
 The total production cost is the marginal production cost (total direct costs)
plus any fixed production overheads.
 It is important that the total production cost of a product is clearly identified

as being such. Non-production costs must be analysed separately.
 This is because when finished products are transferred to the warehouse

as finished goods, they are transferred at a value that reflects the direct
manufacturing costs that were involved in producing them, i.e. total
production cost.
 When finished goods are transferred to the warehouse, this is where they
remain until they are sold to customers or held as inventory.
 When inventory is sold, it is important that it is given a value that reflects

the ‘cost of sale’ of the product, so that a profit can be calculated and
reported in the statement of comprehensive income .
 Similarly, at the end of an accounting period, inventory is valued and

reported in the statement of financial position of an organisation at its total
production cost.
 It is important, therefore, that the production costs and the non-production

costs are clearly distinguished for the purposes of valuing output and
inventories.

Complete the following table by classifying each expense correctly.
Cost Classification
Overalls for machine workers
Cost of printer cartridges in general office
Salary of factory supervisor
Salary of payroll supervisor
Rent of warehouse for storing goods ready for sale
Loan interest
Salary of factory security guard
Early settlement discounts for customers who pay
early
Salary of the Chairman’s PA
Road tax licence for delivery vehicles
Bank overdraft fee
Salesmen's commissions

Above costs are required to be Classified in following heads.
(1) = Production
(2) = Selling
(3) = Distribution
(4) = Administrative
(5) = Finance
6 Classification by nature - Direct and indirect costs
When costs are classified having regard to their nature, they are grouped
according to the reason for which they have been incurred. The broadest
classification of this type is to divide costs into direct costs and indirect costs.
6.1 Direct costs

A direct cost is one that can be clearly identified with the cost object we are
trying to cost. For example, suppose that a furniture maker is determining the
cost of a wooden table. The manufacture of the table has involved the use of
timber, screws and metal drawer handles. These items are classified as direct
materials. The wages paid to the machine operator, assembler and finisher in
actually making the table would be classified as direct labour.
The designer of the table may be entitled to a royalty payment for each table
made, and this would be classified as a direct expense. The total of direct
costs is known as the prime cost.
6.2 Indirect costs

Other costs incurred would be classified as indirect costs. They cannot be
directly attributed to a particular cost unit, although it is clear that they have
been incurred in the production of the table. These indirect costs are often
referred to as overheads. Examples of indirect production costs are as
follows:
Cost incurred Cost classification

Lubricating oils and cleaning materials Indirect material
Salaries of supervisory labour Indirect labour
Factory rent and power Indirect expense
It is important for you to realize that a particular cost may sometimes be a

direct cost and sometimes an indirect cost. It depends on the cost object we
are trying to cost.
For example, the salary of the machining department supervisor is a direct

cost of that department because it can be specifically identified with the

department. However, it is an indirect cost of each of the cost units processed
in the machining department because it cannot be specifically identified with
any particular cost unit.

Identify whether the following costs are materials, labour or expenses and
whether they are direct or indirect.
Cost Materials, labour or Direct or
expense indirect?
The hire of tools or equipment
Rent of a factory
Packing materials, e.g.
cartons and boxes
Supervisors’ salaries
Oil for lubricating machines
Wages of factory workers
involved in production
Depreciation of equipment

(a) Which of the following would be classed as indirect labour?
A Assembly workers
B A stores assistant in a factory store
C Plasterers in a building company
D An audit clerk in an accountancy firm
(b) Direct costs are:

A costs which can be identified with a cost centre but not a single
cost unit
B costs which can be identified with a single cost unit or cost
centre
C costs which can be attributed to an accounting period
D none of the above.
7 Classification by behaviour - Fixed and variable costs
Cost behaviour means how cost reacts when activity level changes? Costs may be
classified according to the way that they behave. Cost behaviour is the way in which
input costs vary with different levels of activity. Cost behaviour tends to classify costs
as one of the following:

 variable cost
 fixed cost
 semi-variable cost
 stepped fixed cost
 stepped variable cost
7.1 Variable costs
 Variable costs are costs that tend to vary in total with the level of
activity in a direct relation and constant in per unit. As activity levels
increase then total variable costs will also increase.
Variable costs can be shown graphically as follows:
 Note that as total costs increase with activity levels, the cost per unit of
variable costs remains constant.
 Examples of variable costs include direct costs such as raw materials
and direct labour.
7.2 Fixed costs

A fixed cost is a cost which is fixed in total with in a relevant range for all
activity levels. It is incurred for an accounting period, and which, within certain
activity levels remains constant.

Fixed costs can be shown graphically as follows:
 Note that the total cost remains constant over a given level of activity
and the fixed cost per unit falls as the level of activity increases.
 Examples of fixed costs:
 rent
 business rates (taxes on property)
 executive salaries
 Insurance premium
Numerical illustration of graph shapes

 If factory rent is Rs 5,000 per month, this cost will be incurred whether
2 widgets are made, or 200 widgets are made – graph 1 demonstrates
this.
 If 2 widgets are made the fixed cost per unit is Rs 5,000 ÷ 2 , i.e. Rs
2,500 per widget.
 If 200 widgets are made the fixed cost per unit is Rs 5,000 ÷ 200, i.e.
Rs 25 per widget.
 Therefore, the fixed cost per unit falls at a reducing rate but never
reaches zero – graph 2 demonstrates this.
7.3 Stepped fixed costs

This is a type of fixed cost that is only fixed within certain levels of
activity.Once the upper limit of an activity level is reached then a new higher
level of fixed cost becomes relevant.

 Stepped fixed costs can be shown graphically as follows:
Examples of stepped fixed costs:

 warehousing costs (as more space is required, more warehouses
must be purchased or rented)
 supervisors’ wages (as the number of employees increases, more

supervisors are required)
 Postpaid and data packages of cellular companies
Numerical example of stepped costs

 For production of up to 50 widgets, only one supervisor is required but
if production is between 50 and 100 widgets, two supervisors are
required.
 The cost of one supervisor is Rs 18,000 per annum and the cost of two
supervisors is therefore Rs 36,000.
 The fixed costs therefore increase in steps as shown in the stepped

fixed cost graph above.
7.4 Semi variable costs

Semi variable costs are the costs which are partially fixed and partially
variable. It contains both fixed and variable cost elements and are therefore
partly affected by fluctuations in the level of activity.

 Semi variable costs can be shown graphically as follows:
Examples of semi variable costs:

 electricity bills (fixed standing charge plus variable cost per unit of
electricity consumed)
 telephone bills (fixed line rental plus variable cost per call)

Classify the following items of expenditure according to their behaviour i.e. as
fixed, variable, semi-variable or stepped fixed costs.
(1) Monthly Rent (4) Petrol (7) Annual salary
(2) Council tax charge (5) Electricity bill (8) Depreciation of one,two
and three machines
(3) Bank loan interest (6) Telephone bill (9) Raw materials

Study the following graphs, where the vertical axis represents 'Total Costs' or
'Cost per unit. Then answer the questions shown below.

A fixed cost is shown in graph
A variable cost is shown in graph
A semi-variable cost is shown in graph
Fixed cost per unit is shown in graph
Variable cost per unit is shown in graph
A stepped fixed cost is shown in graph
8 Analysis of costs into fixed and variable elements
Cost estimation or cost forecasts

A number of methods exist for analysing semi-variable costs into their fixed
and variable elements. The two main methods are:
 high and low point method
 least squares regression
 Scattered Graphs
8.1 High/low method

 Step 1 – select the highest and lowest activity levels, and their
associated costs. (Note: do not take the highest and lowest costs)
 Step 2 – find the variable cost per unit
Cost at high level of activity

– cost at low level of activity
Variable cost per unit = ––––––––––––––––––––––
High level of activity
– low level of activity
 Step 3 – find the fixed cost by substitution, using either the high or low
activity level.
 Fixed cost = Total cost at activity level – Total variable cost
Making a distinction between fixed and variable costs might be used:
 in product costing
 to analyse profitability of a product or department
 to help managers to make decisions about increasing/decreasing
activity levels
 to estimate future costs (forecasting and budgeting)

 to estimate what costs should have been (for budgetary control and
performance assessment).
Example 1- Analysis of costs into fixed and variable elements

Output (Units) Total cost (Rs)
200 7,000
300 8,000
400 9,000
Required:
(a) Find the variable cost per unit.
(b) Find the total fixed cost.
(c) Estimate the total cost if output is 350 units.
(d) Estimate the total cost if output is 600 units.
Solution
(a) Variable cost per unit = (Rs 9,000 – Rs 7,000)/(400 – 200) = Rs 2,000/200 =
Rs 10 per unit
(b) Total fixed cost by substituting at high activity level:
Total cost = Rs 9,000

Total variable cost = 400 x Rs 10 Rs 4,000
Therefore Fixed cost = Rs 5,000
(c) If output is 350 units:
Variable cost = 350 x Rs 10 = Rs 3,500

Fixed cost = Rs 5,000
(d) If output is 600 units:


The total costs incurred at various output levels in a factory have been
measured as follows:
Output Total
(units) cost
(Rs)
26 6,566
30 6,510
33 6,800
44 6,985
48 7,380
50 7,310
Required:
Using the high/low method, analyse the total cost into fixed and variable
components.
High/low method with stepped fixed costs

Sometimes fixed costs are only fixed within certain levels of activity and
increase in steps as activity increases (i.e. they are stepped fixed costs).
 The high/low method can still be used to estimate fixed and variable
costs.
 Adjustments need to be made for the fixed costs based on the activity
level under consideration.
Example 2 – Analysis of costs into fixed and variable elements

An organisation has the following total costs at three activity levels:
Activity level (units) 4,000 6,000 7,500

Total cost Rs 40,800 Rs 50,000 Rs 54,800
Variable cost per unit is constant within this activity range and there is a step
up of 10% in the total fixed costs when the activity level exceeds 5,500 units.
What is the total cost at an activity level of 5,000 units?

A Rs 44,000
B Rs 44,800
C Rs 45,400
D Rs 46,800

Solution
A
Calculate the variable cost per unit by comparing two output levels where
fixed costs will be the same:
Variable cost per unit = [(54,800 – 50,000) ÷ (7,500 – 6,000)] = Rs 3.20

Total fixed cost above 5,500 units = [54,800 – (7,500 x 3.20)] = Rs 30,800
Total fixed cost below 5,500 units = 30,800/110 × 100 = Rs 28,000
Total cost for 5,000 units = [(5,000 x 3.20) + 28,000] = Rs 44,000
High/low method with changes in the variable cost per unit

Sometimes there may be changes in the variable cost per unit, and the high/low
method can still be used to determine the fixed and variable elements of
semi-variable costs. The variable cost per unit may change because:
 prices may be forecast to increase in future periods
Example 3 – Analysis of costs into fixed and variable elements

The following information relates to the manufacture of Product LL in 20X8:
Output (Units) Total cost (Rs)

200 7,000
300 8,000
400 8,600
For output volumes above 350 units the variable cost per unit falls by 10%.
(Note: this fall applies to all units – not just the excess above 350).
Required:
Estimate the cost of producing 450 units of Product LL in 20X9
Solution
Rs 8,000 – Rs 7,000 Rs 1,000
Variable cost per unit (<350) = ––––––––––––– = –––––– = Rs 10 per unit
300 – 200 100
Total cost at 300 units = Rs 8,000


If output is 450 units in 20X9:
Variable cost = 450 x Rs 9 (W1) Rs 4,050
(W1) Variable cost per unit in 20X9 (when output > 350 units) = Rs 10 x 0.9 =
Rs 9 per unit

The total costs incurred in 20X3 at various output levels in a factory have
been measured as follows:
Output Total cost
(units) (Rs)
26 6,566
30 6,510
33 6,800
44 6,985
48 7,380
50 7,310
When output is 80 units or more, another factory unit must be rented and fixed
costs therefore increase by 100%.
Variable cost per unit is forecast to rise by 10% in 20X4.
Required:
Calculate the estimated total costs of producing 100 units in 20X4.
Advantages and limitations of high/low

The main advantage of the high/low method is that it is easy to understand
and easy to use.
The limitations of the high/low method are as follows:
 it relies on historical cost data and assumes this data can reliably
predict future costs
 it assumes that activity levels are the only factor affecting costs
 it uses only two values (highest and lowest) to predict future costs and
these results may be distorted because of random variations which
may have occurred.
 bulk discounts may be available for purchasing resources in large
quantities.

8.2 Least squares regression analysis
Regression analysis finds the line of best fit computationally rather than by
estimating the line on a scatter diagram. It seeks to minimise the distance
between each point and the regression line.
Example - 4
Following is the data of six months output (number of units) and total cost
incurred by ABC Ltd.
Month Output Total Cost
Rs 000
1 80 730
2 60 610
3 120 880
4 90 750
5 70 650
6 30 430
Calculate the line of best fit using regression analysis.

Solution
Let: output = x
Total cost = y
 the sum of the output (x) column is 450

 the sum of the total cost (y) column is 4,050
 when the two columns are multiplied together and summed (xy) the
total is 326,500
 when the output is squared (x2) and summed, the total is 38,300, and
 when the total cost is squared (y2) and summed, the total is 2,849,300

9 Cost equations
Equation of a straight line

The equation of a straight line is a linear function and is represented by the
following equation:
 y = a + bx
 ‘a’ is the intercept, i.e. the point at which the line y = a + bx cuts the y
axis (the value of y when x = 0).
 ‘b’ is the gradient/slope of the line y = a + bx (the change in y when x
increases by one unit).
 ‘x’ = independent variable.
 ‘y’ = dependent variable (its value depends on the value of ‘x’).
Cost equations or standard cost function

Cost equations are derived from historical cost data. Once a cost equation
has been established, like the high/low method, it can be used to estimate
future costs. Cost equations have the same formula as linear functions:
 ‘a’ is the fixed cost per period (the intercept)
 ‘b’ is the variable cost per unit (the gradient)
 ‘x’ is the activity level (the independent variable)
 ‘y’ is the total cost = fixed cost + variable cost (dependent on the activity
level)
Suppose a cost has a cost equation of y = Rs5,000 + 10x, this can be shown
graphically as follows:

Graph of cost equation y = 5,000 + 10x
Example 5 – Cost equations
If y = 8,000 + 40x
(a) Fixed cost = Rs
(b) Variable cost per unit = Rs
(c) Total cost for 200 units = Rs
Solution
(a) Fixed cost = Rs 8,000
(b) Variable cost per unit = Rs 40
(c) Total cost for 200 units = Rs 16,000
Working
Total cost = fixed cost + variable cost = Rs 8,000 + Rs 8,000 = Rs 16,000

Consider the linear function y = 1,488 + 20x and answer the following
questions.
(a) The line would cross the y axis at the point
(b) The gradient of the line is
(c) The independent variable is
(d) The dependent variable is

If the total cost of a product is given as:
Y = 4,800 + 8x
(a) The fixed cost is Rs
(b) The variable cost per unit is Rs
(c) The total cost of producing 100 units is Rs
10 Responsibility accounting
Responsibility accounting is based on identifying individual parts of a business
which are the responsibility of a single manager.
A responsibility centre is an individual part of a business whose manager has
personal responsibility for its performance.The main responsibility centres are:
 cost centre
 profit centre
 investment centre
 revenue centre.
10.1 Cost centres

A cost centre is a production or service location, function, activity or item of
equipment whose costs are identified and recorded.
 For a paint manufacturer cost centres might be: mixing department;
packaging department; administration; or selling and marketing
departments.
 For an accountancy firm, the cost centres might be: audit; taxation;
accountancy; word processing; administration; canteen. Alternatively,

they might be the various geographical locations, e.g. the London
office, the Cardiff office, the Plymouth office.
 Cost centre managers need to have information about costs that are
incurred and charged to their cost centres.
 The performance of a cost centre manager is judged on the extent to
which cost targets have been achieved.
10.2 Profit centres

A profit centre is a part of the business for which both the costs incurred and
the revenues earned are identified.
 Profit centres are often found in large organisations with a
divisionalised structure, and each division is treated as a profit centre.
 Within each profit centre, there could be several costs centres and
revenue centres.
 The performance of a profit centre manager is measured in terms of
the profit made by the centre.
 The manager must therefore be responsible for both costs and
revenues and in a position to plan and control both.
 Data and information relating to both costs and revenues must be
collected and allocated to the relevant profit centres.
10.3 Investment centres

Managers of investment centres are responsible for investment decisions as
well as decisions affecting costs and revenues.
 Investment centre managers are therefore accountable for the
performance of capital employed as well as profits (costs and
revenues).
 The performance of investment centres is measured in terms
of the profit earned relative to the capital invested (employed). This is
known as the return on capital employed (ROCE)
 ROCE = Profit/Capital employed.
10.4 Revenue centres

A revenue centre is a part of the organisation that earns sales revenue. It is
similar to a cost centre, but only accountable for revenues, and not costs
 Revenue centres are generally associated with selling activities, for

example, a regional sales managers may have responsibility for the
regional sales revenues generated
 Each regional manager would probably have sales targets to reach and
could be held responsible for reaching these targets.

 Sales revenues earned must be able to be traced back to individual
(regional) revenue centres so that the performance of individual
revenue centre managers can be assessed.
11 Cost coding
Cost accountants need to determine the costs that relate to each cost centre.
To make this simpler each expense is classified according to its cost centre
and type of expense. A cost code is then allocated to the expense to
represent this classification.
A code is a system of letters/numbers designed to be applied to a classified
set of item, to give a brief accurate reference, which helps entry to the
records, collation and analysis.
The main purpose of cost codes is to:

 Assist precise information
 Facilitate data processing
 Facilitate logical arrangement of records
 Simplify comparisons of similar expenses
 Incorporate checking for accuracy
There are no set methods for designing a cost code, the organisation will
decide on the most appropriate coding system for their business.
Example
Suppose that the cost coding system for the JJ Ltd the shirt manufacturer is
as follows:
Production cost centre

1 Cutting department
2 Sewing department
3 Pressing department
4 Packaging department
Non Production cost centres

5 Stores department
6 Maintenance department
7 Administration department
8 Selling & Marketing department
Cost code
15 Production labour
16 Production materials
17 Production expenses
18 Non-production labour

19 Non-production materials
20 Non-production expenses
The following invoices would be coded as:
Salesman’s travel expenses 820

Wages of pressing department operatives 315
1000 metres white cotton thread 216
Cleaning of the stores department 518
Salary of the administration supervisor 718
12 Chapter summary

Cost Classification
Overalls for machine workers 1
Cost of printer cartridges in general office 4
Salary of factory supervisor 1
Salary of payroll supervisor 4
Rent of warehouse for storing goods ready for sale 3
Loan interest 5
Salary of factory security guard 1
Early settlement discounts for customers who pay early 2
Salary of the Chairman’s PA 4
Road tax licence for delivery vehicles 3
Bank overdraft fee 5
Salesmen's commissions 2
Cost Materials, Director

labour or indirect?
expense
The hire of tools or equipment Expense Direct
Rent of a factory Expense Indirect
Packing materials, e.g. cartons and Material Direct
boxes
Supervisors’ salaries Labour Indirect
Oil for lubricating machines Material Indirect
Wages of factory workers involved in Labour Direct
production
Depreciation of equipment Expense Indirect
(a) B Store assistants are not directly involved in producing the output
(goods or services) of an organisation.
(b) B This is a basic definition question. Direct costs are costs which can
be identified with a single cost unit, or cost centre.

The items of expenditure would be analysed as follows.
(1) Fixed (4) Variable (7) Fixed
(2) Fixed (5) Semi-variable (8) Stepped Fixed
(3) Fixed (6) Semi-variable (9) Variable
Note that the depreciation charge for the factory machines (8) is as tepped
fixed cost because as activity increases to such a level that a second and
third machine are required, the fixed cost will double and then treble.
A fixed cost is shown in graph 4

A variable cost is shown in graph 1
A semi-variable cost is shown in graph 3
Fixed cost per unit is shown in graph 6
Variable cost per unit is shown in graph 4
A stepped fixed cost is shown in graph 2
Rs 7,310 – Rs 6,566 Rs 744

Variable cost per unit = ––––––––––––– = –––––– = Rs 31 per
unit
50 – 26 24
Substituting at high activity level:

Total variable cost = 50 x Rs 31 = Rs 1,550

Rs 7,310 – Rs 6,566 Rs 744

Variable cost per unit (20X3) = ––––––––––––– = –––––– = Rs 31
per unit
50 – 26 24
Substituting at high activity level:

Therefore Fixed cost (in 20X3) = Rs 5,760
Estimated total costs of producing 100 units in 20X4:

Variable cost = 100 x Rs 31 x 1.1 Rs 3,410
Fixed cost = Rs 5,760 x 2 Rs 11,520
–––––––
(a) The line would cross the y axis at the point 1,488
(b) The gradient of the line is 20
(c) The independent variable is x
(d) The dependent variable is y
4,800
(a) The fixed cost is Rs
(b) The variable cost per unit is Rs 8
(b) The total cost of producing 100 units is Rs 5,600
Working
Variable cost = 100 x Rs 8 = Rs 800
Total cost = fixed cost + variable cost = Rs 4,800 + Rs 800 = Rs 5,600

 Ordering, Receipt and Issue of Raw Materials

 Storage of Raw Materials
 Accounting for Material Costs
 Inventory Valuation
 FIFO (First in First out)
 LIFO (Last in First out)
 AVCO (Cumulative average weighted pricing)

1 Purchasing of materials
1.1 Types of materials

In a manufacturing business, materials purchased fall into three main categories:
(a) raw materials from which the product is made, e.g. sheet steel from which car
body sections are made
(b) consumable stores used in production, e.g. grease, nuts, screws
(c) materials used in operating the business as opposed to making the product, e.g.
machine parts and fuel for power generation.
Categories (b) and (c) are generally treated as indirect materials which form part of
overhead costs, so the remainder of this chapter will concentrate on the costing and
control procedures relating to direct materials.
1.2 Procedures and documentation for purchasing materials

Materials can form the largest single item of cost so it is essential that the material
purchased is the most suitable for the intended purpose from the aspects of utility and
cost. Purchasing a great variety of materials is expensive and ideally the business
should seek to use standard materials wherever possible; classification and coding of
all materials used will help to this end.

1.3 Purchase requisition
It is important to control the placing of orders with suppliers.That functionnormally is

centralised in the purchasing department. Any request for material must therefore be
made on a purchase requisition. The purchasing manager will verify that requisitions
are authorised in accordance with established policy before placing orders.

Specimen purchase requisition
PURCHASE REQUISITION
Date . . . . . . . . . . . 20 . . . . . . Serial No: . . . . . . . . . . .
Purpose*: stock/special production/consumables
capital equipment/ (budget reference)
*Delete as appropriate.
Quantity Description Material Job Delivery Purchase order

And Units code or required
dept. Date Place No. Date
code Supplier
Origination department: . . . . . . . . . . . . . . . . . . Authorisation . . . . . . . . . . . . . .
1.4 Ordering procedure

On receipt of a properly authorised requisition, the purchasing manager will select a
supplier and place an order through purchase order. The selection of supplier will be
based upon a number of factors, including price, delivery promise, quality and past
performance.
Specimen purchase order

A copy of the purchase order is sent to the goods receiving department as
confirmation of expected delivery.If a supplier fails to meet a delivery promise,
sections of the factory may be brought to a standstill and prevent the company from
keeping its delivery promises to its own customers. It is essential that close contact is
maintained with suppliers to obtain advance warning of delayed delivery.

PURCHASE ORDER
To: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Serial No: . . . . . . . . . . . . . . . . . . .
.............................. Date: . . . . . . . . . . . . . . . . . . . . . . .
.............................. Purchase Req. No: . . . . . . . . . . . . .
Please supply, in accordance with the attached conditions
Quantity Description Code Delivery Price Per

date
Your quotation . . . . . . . . . . . . . . . . . . . . . . . . . . .
To be delivered, carriage paid, to . . . . . . . . . . . . . . . . . . . . . Terms
Please quote our Purchase Order number on all correspondence.
For ABC Ltd ...........................
1.5 Goods receiving procedure
When goods are received, the goods receiving department will determine what they
are, in terms of quantity, apparent quality, the supplier and purchase order number to
which they relate check the advice or delivery note accompanying the materials to see
that it agrees with the goods sent and then check the order copy to see that the goods
are as ordered. Full details of the goods are entered on a goods received note (GRN).

Specimen “Goods Received Note”
GOODS RECEIVED NOTE

Supplier: .......................... Serial No: . . . . . . . . . . . . . . . . . . . .
.......................... Date issued: . . . . . . . . . . . . . . . . .
Carrier: .......................... Purchase Order No: . . . . . . . . . . . .
Date of delivery: .......................
Description Code Quantity Packages Gross

weight
INSPECTION REPORT Received by: . . . . . . . . . .

Quantity passed Quantity rejected Remarks .Required by: . . . . . . . .
Accepted: . . . . . . . . . .
Inspector . . . . . . . . . . . . . . . . . . . . . . Date . . . . . . . . . . . . . . . Date: . . . . . . . . . . . . . . . . .
1.6 Purchase invoices

A copy of the GRN will be sent to the purchasing department attached to thecopy
purchase order. When the supplier's invoice is received, the three documents will be
passed to the appropriate individual to approve payment ofthe invoice.
1.7 Computers and inventory control

In reality, of course, in a modern business, this would all be done by electronic means,
either via a specialised messaging system (which would be part of theinventory control
module of an accounting package), or via internal e-mail.
2 Accounting for inventory – the material inventory account

Materials held in store are an asset and are recorded in the balance sheet of a
company.

Accounting transactions relating to materials are recorded in the material inventory
account.
Material inventory account
Opening balance (Note 1)

Payables (Note 2) Work-in-progress (Note 4)
Material returned to stores (Note 3) Material returned to suppliers (Note 5)
Production overheads account(Note 6)
Income statement (Note 7)
Closing balance (Note 8)
Note:
(1) The opening balance of materials held in inventory at the beginning of a period is
shown as a debit in the material inventory account.
(2) Materials purchased on credit are debited to the material inventory account.
(3) Materials returned to stores cause inventory to increase and so are debited to the
material inventory account.
(4) Direct materials used in production are transferred to the work-in-progress

account by crediting the material inventory account.
(5) Materials returned to suppliers cause inventory levels to fall and are therefore
‘credited out’ of the material inventory account.
(6) Indirect materials are not a direct cost of manufacture and are treated as
overheads. They are therefore transferred to the production overhead account by
way of a credit to the material inventory account.
(7) Any material writeoffs are ‘credited out’ of the material inventory account and
transferred to the income statement where they are written off.
(8) The balancing figure on the material inventory account is the closing balance of
material inventory at the end of a period. It is also the opening balance at the
beginning of the next period.

3 Physical inventory and book inventory
3.1 Stores ledger card

Recording for direct materials is carried out in the stores ledger card, which contains a
detailed record for each class of material handled. The ledger may be in the form of a
loose leaf binder, a card index or, more commonly these days, a computer application
(at least a spreadsheet, but more probably a specialised package).This record of
materials is often referred to as a 'perpetual inventory'. Perpetual inventory is the
recording as they occur of receipts, issues, and the resulting balances of individual
items of inventory in either quantity or quantity and value.
3.2 Specimen stores ledger card
STORES LEDGER CARD

Description . . . . . . . . . . Unit . . . . . . . . . . . . . . . . Location . . . . . . . . . . . . Code .
................
Maximum . . . . . . . . . . . Minimum . . . . . . . . . . . Reorder level . . . . . . . .
Reorder quantity . . . . . . .
Receipts Issues On order
Date Ref. Quantity Date Ref. Quantity Physical Date Ref. Quantity
balance
In the above example values have been omitted. Materials are frequently valued at
standard or predetermined prices; this allows value columns to be dispensed with.
3.3 Use of bin cards

A bin card is a record of receipts, issues and balances of the quantity of an item of
inventory handled by a store. he bin card is a duplication of the quantity information
recorded in the storesledger but storekeepers frequently find that such a ready record
is a very usefulaid in carrying out their duties.
3.4 Materials requisition and issues

Materials issued to production departments (and to other departments forinternal use)
are controlled by a materials requisition. This document performs two functions – it
authorises the storekeeper to release the goods and acts as a posting medium to the
stores ledger and bin card.

3.5 Specimen materials requisition
MATERIAL REQUISITION Serial No: . . . . . . . . . . .

Charge Job/
Cost Centre No: . . . . . . . . . . . . . . . . . . . . . . . . . . .
Date: . . . . . . . . .
Co Description Qua Cost office only
de ntity R U R R Stor
No. or a ni s s es
weig t t ledg
ht e er
Authorised by: Storekeeper: Prices entered by:

Received by: Bin card Calculations checked:
entered:
3.6 Other materials movements

When unused materials are returned to store, the transaction will be recorded on a
document of similar format to the materials requisition but printed in a different colour.
This document is called a materials returned note. Similarly, materials which are
transferred from one production order to another (or from one department to another)
should be documented for control and accounting purposes, on a materials transfer
note. Use of the materials returned note and materials transfer note ensures that the
correct cost centre or cost unit is charged with the use of the materials concerned.
4 Costing material issues
4.1 Allocating direct materials cost to production

If materials were purchased exactly as required for production, the cost of a particular
consignment could be immediately attributed to a specific job or production order.
Frequently, however, materials are purchased in large quantities at different prices
and issued to production in smaller lots. In attempting to ascertain unit costs of output,
therefore, the cost accountant is faced with the problem of identifying the material cost
of a particular issue.

4.2 Inventory valuation methods (issue pricing)
Various different methods may be used by the cost accountant in order to solve the
problem of allocating direct materials cost to production. The three that are required
for this syllabus are:
FIFO (first in, first out)

LIFO (last in, first out)
Weighted average cost.
The following example is used to illustrate each of these methods.
Example
In November 1,000 tonnes of 'Grotti' were purchased in three lots:
3 November 400 tonnes at Rs 60 per tonne

During the same period four materials requisitions were completed for 200 tonnes
each, on 5, 14, 22 and 27 November.
There were no inventories of ‘Grotti’ at the beginning of November.
In order to calculate the actual material cost of each requisition the cost countant
would need to identify physically from which consignment(s) each issued batch of 200
was drawn. Such precision is uneconomic as well as impractical, so a conventional
method of pricing materials issues is adopted.
Using the data in the above example, we shall illustrate the three methods listed
above.
Solution 1 – first in first out (FIFO) price

Each issue is valued at the price paid for the material first taken into the inventories
from which the issue could have been drawn.

The stores ledger account (in abbreviated form) would appear as below.
Grotti
Receipts (issues) Balance (quantity)
Date Quantity Price Rs Value Rs @ Rs 60 @ Rs 70 @ Rs 80
3 Nov 400 60 24,000 400
5 Nov (200) 60 (12,000) (200)
11 Nov 300 70 21,000 300
14 Nov (200) 60 (12,000) (200)
21 Nov 300 80 24,000 300
22 Nov (200) 70 (14,000) (200)
27 Nov (200) 75 (15,000) (100) (100)
30 Nov (bal) 200 80 16,000 – – 200
Note that the value of the inventory at 30 November is at the latest price. Note also
that the balance at any time requires analysis by purchase price so that each
consignment is exhausted before charging issues at the next price.

You are given the following information about one line of inventory held by Tolley Ltd:
Units Cost Selling price

Rs Rs
Opening inventory 1 January 50 7
Purchase 1 February 60 8
Sale 1 March 40 10
Purchase 1 April 70 9
Sale 1 May 60 12
Assuming that there are no further transactions in the month of May, what would be
the inventory valuation at that date, using a FIFO valuation method?
Solution 2 – last in first out (LIFO) price

Each issue is valued at the price paid for the material last taken into the inventory from
which the issue could have been drawn.

Date Quantity Price Value @ Rs 60 @ Rs 70 @ Rs 80
Receipts (issues) Balance (quantity)

Rs Rs
3 Nov 400 60 24,000 400
5 Nov (200) 60 (12,000) (200)
11 Nov 300 70 21,000 300
14 Nov (200) 70 (14,000) (200)
21 Nov 300 80 24,000 300
22 Nov (200) 80 (16,000) (200)
27 Nov (200) 75 (15,000) (100) (100)
30 Nov (bal) 200 60 12,000 200 – –
Under LIFO the closing inventory is now valued at Rs 60 per tonne, the earliest
price.The issue on 27 November exhausts the latest receipt (at Rs 80) so that the
previous latest is used to price the remaining 100 tonnes issued
Solution 3 – weighted average price

Each time a consignment is received a weighted average price is calculated as:
Inventory value + Receipt value

Quantity in inventory + Quantity received
The price so calculated is used to value subsequent issues until the next consignment
is received.
Grotti
Receipts (issues)
Date Quantity Price Value Weighted average
price
Rs Rs Rs
3 Nov 400 60 24,000
5 Nov (200) 60 (12,000)
11 Nov 300 70 21,000
Balance 500 33,000 66

14 Nov (200) 66 (13,200)
21 Nov 300 80 24,000
Balance 600 43,800 73

22 Nov (200) 73 (14,600)
27 Nov (200) 73 (14,600)
30 Nov (bal) 200 73 14,600
A fresh calculation is required after each receipt but analysis of the balance is
unnecessary. Alternatively, in a computer system, where data is stored for, say, a
month and then processed all at once, an average price for the month could be
calculated and used to value all issues during the month, irrespective of sequence.
This average can be based on either of the following:
Periodic simple average – Average of all the prices of the period irrespective of
quantity delivered (only used where prices do not fluctuate significantly).
Periodic weighted average - Average of all the prices of the period weighted by
quantity delivered at each price.
For both alternatives, opening inventory is treated as the first delivery of the month.
Periodic simple average tonnes= Rs ( 60 + 70 + 80)= Rs 70 per ton

3
Periodic weighted average= Rs ( 24, 000 + 21, 000 + 24, 000 )= Rs 69 per ton
(400 + 300 + 300)
The closing balance, 200 tonnes at Rs 70 or at Rs 69, would be treated as the

first receipt in the following month to be included in that month's average.

Using the data for Tolley Ltd (Test your understanding 1) recompute the inventory
valuation at 31 May assuming:
(a) a LIFO valuation method

(b) a moving weighted average valuation method.
4.3 Comparison of methods – the effect on profit of the inventory valuation

method selected
The relative advantages and disadvantages of each system are discussed below,
particularly in relation to inflationary situations that are now accepted as being
normality.

FIFO
Advantage:
 produces realistic inventory values.
Disadvantages:
 Produces out of date production costs and therefore potentially overstates profits.
 Complicates inventory records as inventory must be analysed by delivery.
LIFO
Advantage:
 Produces realistic production costs and therefore more realistic/prudent profit figures.
Disadvantages:
 Produces unrealistically low inventory values.
 Complicates inventory records as inventory must be analysed by delivery.
 It is not acceptable under IAS 2 .
Weighted average price
Advantage:
Simple to operate – calculations within the inventory records are minimised.
Disadvantage:
Produces both inventory values and production costs that are far from current values.
Whichever method is adopted it should be applied consistently from period to period

and its limitations should be recognised when material cost informationIs being used.
For example, if FIFO is in use and a business is tendering for a special order, it may
be dangerous to estimate onthe basis of past costs. Such costs probably include the
cost of materials purchased some time ago. Additionally, if selling prices are based on
ascertained costs, the use of FIFO or weighted average price could lead to under-
pricing, since costs may reflect out of date material prices.Note that these are only
methods of costing. In physical terms inventories should and would be used up on a
FIFO basis.

(a) Using the data for Tolley Ltd (Test your understanding 1) and your results from
activities 2 and 3, calculate the gross profit for January to May using each of the
inventory valuation methods
(b) Comment on the results.

5 Checking the level of inventory
5.1 Stocktaking
The process of stocktaking involves checking the physical quantity of inventory held on
a certain date and then checking this balance against the balances on the stores ledger
(record) cards or bin cards. Stocktaking can be carried out on a periodic basis or a
continuous basis.
 Periodic stocktaking involves checking the balance of every item of Inventory on the
same date, usually at the end of an accounting period.
 Continuous stocktaking involves counting and valuing selected items of inventory on a

rotating basis. Specialist teams count and check certain items of inventory on each
day. Each item is checked at least once a year with valuable items being checked
more frequently.
 Any differences (or discrepancies) which arise between ‘book’ inventory and
physical inventory must be investigated.
 In theory any differences, as recorded in the stores ledger or the bin card, must have
arisen through faulty recording.
 Once the discrepancy has been identified, the stores ledger card is adjusted in order
that it reflects the true physical inventory count.
 Any items which are identified as being slow-moving or obsolete should be brought to
the attention of management as soon as possible.
 Management will then decide whether these items should be disposed of and written off
to the income statement.
 Slow-moving items are those inventory items which take a long time to be used up.
 Obsolete items are those items of inventory which have become out of date and are
no longer required.

5.2 Inventory losses and waste
 Inventory losses may be quantified by comparing the physical quantity of an item

held with the balance quantity recorded on the bin card and/or stores ledger card.
 There are two categories of loss: those which occur because of theft, pilferage,
damage or similar means and those which occur because of the breaking of bulk
receipts into smaller quantities.
 It is the second of these which are more commonly referred to as waste.
 Inventory losses must be written off against profits as soon as they occur. If the value to
be written off is significant then an investigation should be made of the cause.
 When waste occurs as a result of breaking up bulk receipts, it is reasonable to expect

that the extent of such wastage could be estimated in advance based upon past
records. Either of two accounting treatments could then be used:
 Issues continue to be made and priced without any adjustment and the difference at the
end of the period is written off.
 Alternatively, the issue price is increased to compensate for the expected waste.
 Suppose that a 100 metre length of copper is bought for Rs 99. The estimated loss
caused by cutting into shorter lengths as required is 1%.
 The issue price could be based on the expected issues of 99 metres, i.e. Rs 1 per
metre rather than pricing the copper at:
Rs 99
Issue price = ––––– = Rs 0.99/metre
100
5.3 Control procedures to minimise discrepancies and losses

The level of investment in inventory and the labour costs of handling and
recording/controlling them is considerable in many organisations. It is for this reason that
organisations must have control procedures in place in order to minimise discrepancies and
losses.

Problem Control procedure
Ordering goods at inflated Use of standard costs for purchases.
prices. Quotation for special items.
Fictitious purchases. Separation of ordering and
purchasing.
Physical controls over materials
receipts, usage and inventory.
Shortages on receipts. Checking in all goods inwards at
gate.
Delivery signatures.
Losses from inventory. Regular stocktaking.
Physical security procedures.
Writing off obsolete or Control of responsible official over
damaged all
inventory which is good. write-offs.
Losses after issue to Records of all issues department.
production . Standard usage allowance
6 Materials classification and coding
6.1 Materials coding system

Where a business uses many types of material there are often at least two ways of
describing any one material and a coding system becomes necessary.A code is a
system of symbols designed to be applied to a classified set of itemsto give a brief,
accurate reference, facilitating entry, collation and analysis.The advantages of using a
materials code are:clerical effort is reduced because the writing out of precise
descriptions becomes unnecessary ambiguity is avoided because everyone knows
what material is being referred to it becomes easier to refer to items and to categorise
them it is normally essential when processing materials data by computer.
6.2 Classifications of materials

Classification is the arrangement of items in logical groups having regard to their
nature (subjective classification) or purpose (objective classification). Here are some
common materials classifications. Raw materials – materials that are converted by
production processesinto a saleable product.
Packing materials – materials that do not form part of the product being sold but are
necessary to nable the product to be distributed to the customer.
Maintenance materials – materials which are not required for production or

distribution but are necessary to keep machines and plant in working order.

Patterns, templates and tools – materials that do not form part of the product but are
necessary in its production.
Other indirect materials – among these would be stationery, protective clothing,

fuels, etc.
6.3 Allocation of codes

The most common coding system is to code the material according to its
characteristics. For instance BOLT.S.075 might be the code for a 75mm steelbolt. This
method avoids duplication, assists storekeeping and can be structured to aid the
memory.
Summary
Materials are likely to be a significant cost of most manufacturing organisations and
therefore it is essential that control is exercised over all aspects of materials from their
purchase through to their issue to production departments. This chapter has looked at
many of those aspects of control and most specifically the important area of valuation
of materials and closing inventory. This valuation and the comparison of the various
methods of valuation tend to be a popular examination topic.
By the time you have finished this chapter you should be able to:
 explain raw material accounting and control procedures

 explain FIFO, LIFO and weighted average inventory valuation methods
 calculate inventory, cost of sales and gross profit under LIFO, FIFO and
weighted average.

Self-test questions
Purchasing of materials
1 What are the three main categories of materials purchases in a manufacturing

business?
Accounting for materials: cost collection
2 Which document is used to record the return of excess materials to the stores?
3 What is a perpetual inventory system? (2.1)
Costing material issues
4 Under the LIFO method of inventory valuation at what price is closing inventory
valued? (3.2)
5 What are the advantages and disadvantages of the weighted average price
method of inventory valuation? (3.3)

Multiple choice questions (MCQs)
1. A firm has a high level of inventory turnover and uses the FIFO (first in first out)
issue pricing system. In a period of rising purchase prices, the closing inventory
valuation is:
A close to current purchase prices

B based on the prices of the first items received
C much lower than current purchase prices
D the average of all goods purchased in the period
2. The purchase and movements of a particular item of material are recorded using
the following documents.Indicate the order in which the documents would be raised by
writing 1, 2, 3, 4 and 5 in the boxes as appropriate.
Goods received
note
Purchase requisition
Materials requisition
Purchase order
Materials returned
note
Answers to MCQs
1) A
2) 3,1,4,2,5

Answers: test your understandings

FIFO results in later purchases remaining in inventory.
Units
Opening inventory 50
Purchases 130
Sales (100)
___
Closing stock 80
___
Rs
Comprising
1 April 70 x Rs 9 = 630
1 Feb 10 X Rs 8 = 80
710

Note: closing inventory is 80 units, as computed in Test your understanding 1.
(a) LIFO results in earlier purchases remaining in inventory. However, care must
be taken as some of the earliest priced inventory may have been used up
before the month end.
The issue of 40 units on 1 March will be valued at Rs 8 (Feb purchase)

The issue of 60 units on 1 May will be valued at Rs 9 (April purchase)
This leaves:
Rs
50 units from opening inventory @ Rs 7 350
20 units from Feb purchase @ Rs 8 160
10 units from April purchase @ Rs 9 90
600

(b) Weighted average
Here we have to work through the averaging process:
Receipts (issues)
Weighted
Date Quantity Price Value average price
Rs Rs Rs
1 Jan 50 7.00 350
1 Feb 60 8.00 480
110 830 7.55
1 Mar (40) 7.55 (302)

1 April 70 9.00 630
140 1,158 8.27
1 May (60) 8.27 (496)

31 May 80 8.27 662

(a) Profit for January to May
FIFO LIFO Weighted
Average
Rs Rs Rs
Cost of purchases 1,110 1,110 1,110
Less closing inventory (710) (600) (662)
(From Test your understanding 2 & 3)
Cost of sales 400 510 448
Sales ((40 × Rs 10) + (60 × Rs 12) 1,120 1,120 1,120
Gross profit 720 610 672
(b) FIFO reports the highest profit because this method charges the older, lower prices to
cost of sales. Conversely, LIFO charges the later prices to cost of sales and thus a
lower profit is reported in times of rising prices. The weighted average method
produces a profit figure which lies between the FIFO and LIFO result.

 What is inventory control?

 Inventory Control Levels

1 The objectives of inventory management
Inventory is a major investment for many companies. Manufacturing

companies can easily be carrying inventory equivalent to between 50% and
100% of the revenue of the business. It is therefore essential to reduce the
levels of inventory held to the necessary minimum.
1.1 Costs of high inventory levels
Keeping inventory levels high is expensive owing to:
 Purchasing cost
 Holding costs / Carrying cost / storage Cost:
– Storage costs
– Stores administration cost
– Risk of theft/damage/obsolescence.
– Interest on funds from which inventory is bought.
– Opportunity cost i.e. earnings that can be earned from the funds if
inventory is not bought.
Carrying inventory involves a major working capital investment and therefore

levels need to be very tightly controlled. The cost is not just that of purchasing
the goods, but also storing, insuring, and managing them once they are in
inventory.
Purchase costs: once goods are purchased, capital is tied up in them and
until sold on (in their current state or converted into a finished product), the
capital earns no return. This lost return is an opportunity cost of holding the
inventory.
Storage and stores administration: in addition, the goods must be stored.

The company must incur the expense of renting out warehouse space, or if
using space they own, there is an opportunity cost associated with the
alternative uses the space could be put to. There may also be additional
requirements such as controlled temperature or light which require extra
funds.
Other risks: once stored, the goods will need to be insured. Specialist
equipment may be needed to transport the inventory to where it is to be used.
Staff will be required to manage the warehouse and protect against theft and if

inventory levels are high, significant investment may be required in
sophisticated inventory control systems.
The longer inventory is held, the greater the risk that it will deteriorate or
become out of date. This is true of perishable goods, fashion items and high
technology products, for example.
1.2 Costs of low inventory levels
If inventory levels are kept too low, the business faces alternative problems:
 Stock outs: Stock out cost is a cost when an entity lost some earnings due
to not having sufficient level of stocks or inventory.
– lost contribution
– production stoppages
– emergency orders
 High reorder/ setup costs

 Lost quantity discounts.
Stock out: If a business runs out of a particular product used in

manufacturing it may cause interruptions to the production process – causing
idle time, stockpiling of work-in-progress (WIP) or possibly missed orders.
Alternatively, running out of goods held for onward sale can result in
dissatisfied customers and perhaps future lost orders if custom is switched to
alternative suppliers. If a stock out looms, the business may attempt to avoid it
by acquiring the goods needed at short notice. This may involve using a more
expensive or poorer quality supplier.
Reorder/ setup costs: each time inventory runs out, new supplies must be
acquired. If the goods are bought in, the costs that arise are associated with
administration – completion of a purchase requisition, authorisation of the
order, placing the order with the supplier, taking and checking the delivery and
final settlement of the invoice. If the goods are to be manufactured, the costs
of setting up the machinery will be incurred each time a new batch is
produced.
Lost quantity discounts: purchasing items in bulk will often attract a discount
from the supplier. If only small amounts are bought at one time in order to
keep inventory levels low, the quantity discounts will not be available.

1.3 The challenge
The objective of good inventory management is therefore to determine:
 the optimum reorder level – how many items are left in inventory when the
next order is placed, and
 the optimum reorder quantity – how many items should be ordered when
the order is placed for all material inventory items.
In practice, this means striking a balance between holding costs on the one
hand and stock out and reorders costs on the other.
The balancing act between liquidity and profitability, which might also be
considered to be a trade-off between holding costs and stock out/reorder
costs, is key to any discussion on inventory management.
1.4 Terminology
Other key terms associated with inventory management include:
 Lead time – the lag between when an order is placed and the item is
delivered
 Buffer inventory – the basic level of inventory kept for emergencies. A

buffer is required because both demand and lead time will fluctuate and
predictions can only be based on best estimates.
Ensure you can distinguish between the various terms used: reorder level,
reorder quantity, lead time and buffer inventory.
2 Practical inventory control systems
2.1 Inventory control systems

It is important that inventory levels are maintained at a high enough level to
service the production facility while at the same time minimising the working
capital tied up in inventory. The following sections look at both the physical
aspects of different control systems and the mathematical techniques
supportingcontrol.
2.2 Two-bin system

Under this system the existence of two bins is assumed, say A and B.
Inventory is taken from A until A is empty. A is then replenished with the order
quantity.During the lead time (the time taken between ordering goods and

receiving them) inventory is used from B. The standard inventory for B is the
expected demand in the lead time, plus any buffer inventory. When the new
order arrives, B is filled up to its standard level and the rest placed in A.
Inventory is then drawn as required from A, and the process repeated.
In considering the costs of inventory control, the actual costs of operating the
system must be recognised. The costs of a continual review as implied by the
two-bin system may be excessive, and it may be more economic to operate a
periodic review system.
2.3 Periodic review system

Under this system the inventory levels are reviewed at fixed intervals, e.g.
every four weeks. The inventory in hand is then made up to a predetermined
level, which takes account of likely demand before the next review and during
the lead time.Thus, a four-weekly review in a system where the lead time was
two weeks would demand that inventory be made up to the likely maximum
demand for the next six weeks. This system is described in some text books
as the constant order cycle system.
Advantages of two-bin system Advantages of periodic review system

inventory can be kept at a lower level The purchasing department's workload
because of the ability to order is more evenly spread and easier to
whenever inventories fall to a low level, plan. For this reason the system is also
rather than having to wait for the next more popular with suppliers.
2.4 ABC inventory analysis
This is a technique that divides inventories into sub-classifications based on

an annual usage value and involves using different control systems for each
classification.
The idea is to gear the quality of inventory control procedures to the value of
the inventory and therefore to help ensure that the inventory control methods
adopted are cost effective.

Example
An example of ABC analysis is the classification of inventory as follows:
No of days' supply
held in inventory
Class A 2 days
Class B 5 days
Class C 10 days
Class D 20 days or more
inventory levels of high value category A items are kept low in order to save
on holding costs.
The priority with category D items is to avoid stockouts, hence much higher
inventories are held. The company could use the 'two bin system' for this
category of items.
3 Re-order level system – control levels
3.1 Re-order level system

This is a more sophisticated version of the two-bin system, which involves the
setting of three control levels,
 Re-order level – a level of inventory at which a replenishment order should

beplaced.
 Minimum inventory level – a inventory level, set for control purposes,

below which stockholding should not fall without being highlighted. (If the
inventories fall below that level the storekeeper will consider the need for
anemergency order.)
 Maximum inventory level – a inventory level, set for control purposes,

which actual stockholding should never exceed. (If the inventory rises
above this level, it is an indication of decline in usage/demand, and the re-
order quantity may need to be reviewed.)
 The following diagram illustrates the re-order level system:

3.2 The minimum level
The minimum level can be described as the buffer inventory Buffer inventory =
Re-order level - (average usage per day x average lead time (days))
Example
ABC Limited uses between 75 and 90 litres of oil per day. Delivery times vary
between 2–3 days. It has set its re-order level at 270 litres, and orders 500
litres each time.
Using simple averages, the minimum level is:
270 - (82.5 x 2.5)

= 63.75 litres

Calculate the minimum inventory level from the following data:
Re-order level 2,400 units

Lead time 2–5 days
Maximum usage 400 units per day
Minimum usage 100 units per day

3.3 The maximum level
The maximum level is the level above which inventory should not normally
rise. It is given by:
= Recorder Level + Reorder quantity – (minimum usage per day x minimum

lead time (days)
Example
In the example of ABC Limited, the maximum level is:
270 + 500 - (75 x 2)

= 620 litres
3.4 The reorder level

The reorder level is the level of inventory at which a replenishment order
should be placed.Reorder level = maximum usage × maximum lead time
Example
In the example of ABC Limited the re-order level can be calculated as: reorder
level = 90 × 3 = 270 litres
3.5 Average inventory level

Although the average inventory level is not a control level as such, an
examination question might require you to apply your knowledge of the control
level system to determine the average inventory. If we assume that a
replenishment order arrives at the point at which inventory reaches the buffer
or safety inventory level, and that thereafter inventory is used evenly until it
reaches the re-order level and an order is placed, the average inventory level
can be calculated as: average inventory = safety inventory + ½ reorder
quantity
Example
In the example of ABC Limited, if we assume that the minimum inventory level
is the safety inventory, then the average inventory will be: average inventory =
63.75 + (0.5 × 500) = 313.75 litres
If we assume that no safety inventory is held, so that a delivery is received just

as inventory falls to zero (an assumption that you will see is made in the
economic order quantity model) then the formula for calculating the average
inventory level becomes: average inventory = ½ reorder quantity

3.6 Free inventory
Free inventory is inventory on hand or on order which has not been scheduled
for use. Free inventory = physical inventory + inventory ordered – inventory
scheduled It will be important for the storekeeper to monitor this inventory
level in an efficient inventory control system. For example at a single point in
time there may be a high level of physical inventory, but if a large proportion of
this inventory has already been requisitioned for use on a particular job then it
may be necessary to place a replenishment order. Monitoring the free
inventory balance against the predetermined control levels helps to avoid the
occurrence of stock-outs.
Example
K Limited has 3,400 units of material Y in stock. Of these units, 2,600 have
been requisitioned by a production cost centre for a job to commence in two
days. An order has been placed with the supplier for 1,500 units. Delivery is
expected in three days.
The free inventory balance is 3,400 + 1,500 – 2,600 = 2,300 units.
If this inventory level is at or below the re-order level then it will be necessary
to place another order with the supplier.
3.7 Reorder level with variable demand or variable lead time

When lead time and demand are known with certainty, ROL = demand during
lead time. Where there is uncertainty, an optimum level of buffer inventory
must be found. This depends on:
 variability of demand
 cost of holding inventory
 cost of stock-outs.
4 Theoretical inventory control – the EOQ
To minimise the total cost of holding and ordering inventory, it is necessary to

balance the relevant costs. These are:
 the variable costs of holding the inventory

 the fixed costs of placing the order

4.1 Holding costs
The model assumes that it costs a certain amount to hold a unit of inventory
for a year (referred to as CH in the formula). Therefore, as the average level of
inventory increases, so too will the total annual holding costs incurred.
Because of the assumption that demand per period is known and is constant
(see below), conclusions can be drawn over the average inventory level in
relationship to the order quantity.
When new batches or items of inventory are purchased or made at periodic

intervals, the inventory levels are assumed to exhibit the following pattern over
time.
If x is the quantity ordered, the annual holding cost would be calculated as:
Holding cost per unit × Average inventory:

X
CH × ––
2

We therefore see an upward sloping, linear relationship between the reorder
quantity and total annual holding costs.
4.2 Ordering costs

The model assumes that a fixed cost is incurred every time an order is placed
(referred to as CO in the formula). Therefore, as the order quantity increases,
there is a fall in the number of orders required, which reduces the total
ordering cost.
If D is the annual expected sales demand, the annual order cost is calculated
as:
Order cost per order × no. of orders per annum.
D
CO × ––
X

However, the fixed nature of the cost results in a downward sloping, curved
relationship.
Because you are trying to balance these two costs (one which increases as
reorder quantity increases and one which falls), total costs will always be
minimised at the point where the total holding costs equals the total ordering
costs. This point will be the economic order quantity.
When the reorder quantity chosen minimises the total cost of holding and
ordering, it is known as the EOQ.

4.3 Assumptions
The following assumptions are made:
 demand and lead time are constant and known

 purchase price is constant
 no buffer inventory held (not needed).
These assumptions are critical and should be discussed when considering the
validity of the model and its conclusions, e.g. in practice, demand and/or lead
time may vary.
4.4 The calculation

The EOQ can be more quickly found using a formula.
EOQ =
Where:
CO = cost per order
D = annual demand
CH = cost of holding one unit for one year.

Calculate the economic order quantity given the following data:
Annual demand 5,000 units

Ordering cost Rs 150 per order
Annual holding cost Rs 2 per unit
4.5 Dealing with quantity discounts

Discounts may be offered for ordering in large quantities. If the EOQ is smaller
than the order size needed for a discount, should the order size be increased
above the EOQ?
To work out the answer you should carry out the following steps:
Step 1: Calculate EOQ, ignoring discounts.
Step 2: If the EOQ is below the quantity qualifying for a discount, calculate the
total annual inventory cost arising from using the EOQ.
Step 3: Recalculate total annual inventory costs using the order size required
to just obtain each discount.
Step 4: Compare the cost of Steps 2 and 3 with the saving from the discount,
and select the minimum cost alternative.

Step 5: Repeat for all discount levels.
Example
D Co. uses component V22 in its construction process. The company has a
demand of 45,000 components pa. They cost Rs 4.50 each. There is no lead
time between order and delivery, and ordering costs amount to Rs 100 per
order. The annual cost of holding one component in inventory is estimated to
be Rs 0.65.
A 0.5% discount is available on orders of at least 3,000 components and a

0.75% discount is available if the order quantity is 6,000 components or
above.
Required: Calculate the optimal order quantity.
Solution
Step 1
CO = Rs 100 per order
D = 45,000 components per annum
CH = Rs 0.65 per component per annum
EOQ =
EOQ =
= 3,721 components
Step 2
Total annual costs for the company will comprise holding costs plus reordering
costs.
= (Average inventory × CH) + (Number of reorders pa × CO)

= (3,721/2 x 0.65) + (45,000/3,721 x 100)
= Rs 2,419 per annum

Step 3
At an order quantity of 6,000 components, total costs are as follows.
(6,000 × Rs 0.65/2) + (45,000 × Rs 100 ÷ 6,000) = Rs 2,700
Rs
Extra costs of ordering in batches of 6,000 (2,700 – 2,419) (281)
Less: Saving on extra discount
(0.75% – 0.5%) × Rs 4.5 × 45,000 506.25
Step 4
Net cost saving 225.25
So a saving can be made on orders of 6,000 components.
Summary
To keep inventory levels under control management will need a regular flow of
information on inventory levels to act upon. For economy the inventory control
system is frequently restricted to the most important items. It has been
estimated that in many businesses, about 20% of the items comprise about
80% of total materials cost.
A inventory control system will contain the following features:
 Prediction of likely usage and delivery period (lead time); expressed as

maximum, minimum and average.
 Calculation of order quantity.
 Establishment of control levels - minimum inventory, reorder level and

maximum level, and monitoring of these levels against the free inventory
balance.
 Regular reports.
As you have seen, a number of formulae are involved in establishing a

inventory control system. You will be provided with the formula for the EOQ in
the examination if you need it. However you must learn all of the other
formulae as they will not be provided in the examination.By the time you have
finished this chapter you should be able to: explain and calculate re-order
quantity, re-order level, maximum inventory minimum inventory, and economic
order quantity.

Self-test questions
Investment in inventory
1 State two benefits and the costs associated with holding inventory. (1.1–1.2)
Practical inventory control systems

2 Explain the meaning of the two-bin system of inventory control. (2.2)
Re-order level system – control levels

3 How is the maximum inventory control level calculated? (3.3)
4 What is the formula for the reorder level? (3.4)
Theoretical inventory control – the EOQ

5 Explain the objective of using the EOQ model. (4.2)

The following information is to be used for questions 1 and 2.

A national chain of tyre fitters inventories a popular tyre for which the following
information is available:
Average usage 140 tyres per day

Minimum usage 90 tyres per day
Maximum usage 175 tyres per day
Lead time 10 to 16 days
Re-order quantity 3,000 tyres
1. Based on the data above, a replenishment order should be issued when the
inventory balance reaches at:
A) 2,500 tyres
B) 2,800 tyres
C) 3,000 tyres
D) 3,200 tyres
2. B
ased on the data above, the maximum inventory level is:
A) 4,500 tyres
B) 4,900 tyres
C) 5,000 tyres
D) 5,200 tyres
3. The objective of the EOQ as part of a inventory control policy is to ensure that
A) the company never runs out of inventory, except in exceptional

circumstances
B) the cost of being out of inventory is minimised
C) the combined cost of ordering and holding inventory is minimised
D) Inventory is purchased from suppliers at the cheapest price

Answers to MCQ
1) B
2) B
3) C
= 2,400 - (250 x 3.5)

= 1,525 units.
= 2 x Rs 150 x 5,000
Rs 2
= 866 units (to nearest unit).

 Measuring labour activity

 Remuneration methods
 Recording labour costs
 Labour turnover
 Accounting for labour costs

1. Measuring labour activity
1.1 Personal history

The personnel department will maintain a history record for each employee.
The record will include such details as:
(a) full name and address

(b) previous employment
(c) clock number issued
(d) date engaged
(e) department, job title and pay rate upon engagement
(f) amendments to (e) above, recorded as and when they occur
(g) on the termination of employment, the date and reason for
leaving.
1.2 Time recording

Time recording is required both for payment purposes and also for
determining costs to be charged to specific jobs. These may be described
diagrammatically:
1.3 Attendance records

Wages cost represents payments for direct and indirect labour. Both types of
workers will be supplied with time cards (gate or clock cards) or other
recordson which to record their time of arrival and departure from the factory.
Such records will provide the basis for wages calculation at time rates. A clock
card is a document on which is recorded the starting and finishing time of an
employee, e.g. by insertion into a time-recording device, for ascertaining total
actual attendance time. The most sophisticated time recorders use plastic
'swipe' cards and are directly linked to a central computer.

1.4 Activity-time records
The precise arrangements for activity-time recording should be adapted to the
nature and organisation of production, and so will vary from one factory
toanother. In some cases a card for each job may accompany that job
through the factory, each worker involved noting or 'clocking' the time spent
on the one card. Alternatively a separate job card or ticket may be issued to
each worker for each job. However, most such records can be categorised as
being either period-related or task-related. However recorded, it will be
essential to reconcile activity time and attendance time to ensure accuracy of
the information
1.5 Period-related activity time records

These may be for daily, weekly, or sometimes longer periods. An example of
a weekly time sheet is given below.
Weekly Time Sheet Dept: ..........................

Employees No Name Wk Edg
To be completed by employee For Office Use
Day Start Finish Job Code Hrs Amounts
Rs
p
Supervisor’s Gross
Signature: Wages
..........................................................................
1.6 Task related activity time records
Known variously as job sheets, operations charts or piece-work tickets. They
are generally more accurate and reliable than time-related activity time records
and are essential for use with incentive schemes. An example is given below.

Time Sheet
Employee name:No:
Start date:
Finish date:
Department: Operation:
Day Start Finish Time Productio Supervisor's
n Singnature
1
2
3
4
5
Total
Time Allowed
Time Saved
Hours Rate Paid
Rs Rs
Time wages
Bonus
Total wages
2. Payroll
2.1 Payroll preparation

Because of the sums of money involved, security control is necessary at all
stages of the task of payroll preparation and payment. One major area of risk
is the introduction of fictitious employees ('dummies' or 'ghosting') in the
payroll.The payroll preparation involves:
 calculating gross wages from time and activity records

 calculating net wages after tax at source and other deductions, and
properly recording the deductions
 preparing a cash analysis of total cash required for payment, if necessary.

3. Remuneration methods
3.1 Introduction
There are two basic approaches to remuneration, time-related or output-
related.The two basic methods are time rate and piece rates.
3.2 Time rates

The most common method of payment is time rate, whereby employees are
paid a basic rate per hour, day, week or month irrespective of production
achieved. Basic time rate provides no incentive to improve productivity and
close supervision is necessary. A variation is known as 'higher time rates',
where rates above the basic level are offered and paid, to attract more
enthusiastic and skilled employees.
3.3 Piece-work
The direct alternative to time rate is piece-work, whereby a fixed amount is
paid per unit of output achieved, irrespective of time spent. Rigid inspection
procedures are required to ensure work is of an adequate standard.
Types of piece-work system

There are two main piecework systems that you need to know about:
Straight piece-work systems: These are almost extinct today as a result of

employment legislation and trade union resistance. Most employees are paid
a guaranteed minimum wage within the piecework system. Piece-workers are
usually required to keep time records for disciplinary and security purposes.
Differential piece rates system: A variation is 'differential piece rates'. This is

almost a penal system, with a low piece rate for the first units of production,
and a high piece rate for subsequent units.
Example
A company operates a differential piece-rate system and the following weekly
rates have been set:
Weekly production Rate of pay per

unit in this band
Rs
1 to 500 units 2.0
501 to 600 units 2.5
601 units and above 5.5
Employees are paid a guaranteed minimum wage of Rs 1,300 per week. How
much would be paid to the following employees for the week?

Employee A – output achieved = 800 units
Employee B – output achieved = 570 units.
Solution
Employee A = (500 units × Rs 2.0) + (100 units × Rs 2.5) + (200 units ×
Rs 5.5) = Rs 2,350
Employee B = (500 units × Rs 2.0) + (70 units × Rs 2.5) = Rs 1175. This
is less than the guaranteed minimum therefore employee B would be paid Rs
1,300.
Example
A company operates a piecework system of remuneration, but also
guarantees its employees 75% of a time-based rate of pay which is based on
Rs 19 per hour for an eight hour working day. Three minutes is the standard
time allowed per unit of output. Piecework is paid at the rate of Rs 18 per
standard hour.
If an employee produces 200 units in eight hours on a particular day, what is

the employee gross pay for that day?
A Rs 114
B Rs 152
C Rs 180
D Rs 190
Solution
C
200 units x standard time of 3 minutes per unit = 600 minutes, or 10 hours.
Employee gross pay = 10 hours x Rs 18 = Rs 180
Guaranteed (Rs 19 x 8 hours) x 75% = Rs 152 x 75% = Rs 114
As gross pay exceeds the guaranteed amount, the answer is Rs 180.
3.4 Incentive schemes

These have developed from the piece rate approach, but attempt to avoid the
crudities of the system described above.

The variety of approaches are described by the diagram below:
 These are all explained in the sections below:

 As a general rule, any incentive scheme should be:
 related closely to effort
 agreed by prior consultation between employer and employees
 understandable and simple to operate
 capable of being beneficial to the average worker.
4. Incentive schemes
4.1 Premium bonus plans

The basic idea of all premium bonus plans is to pay a basic time rate, plus a
portion of the time saved as compared to some agreed allowed time.
Examples of such schemes are Halsey and Rowan.
(a) Halsey – The employee receives 50% of the time saving, i.e.
Bonus =Time allowed - Time taken x Time rate

2

Example
Employee's basic rat = Rs 48 per hour
Allowed time for Job A = 1 hour
Time taken for Job A = 36 minutes
Rs
Bonus = 60 - 36 x Rs 48 9.6
2 60
Basic rate = 36 x 48 28.8

60 38.4
(b) Rowan - The proportion paid to the employee is based on the ratio of time
taken to time allowed, i.e.
Bonus = Time taken x Time rate x Time saved

Time allowed
Example
Using the facts in (a) above
Rs
Bonus = 36 x Rs 48 x 24 11.5
60 60
Basic rate = 36 x 48 28.8

60 40.3

What would be the bonus under each plan if the time taken in the previous
example was 18 minutes?
Premium bonus schemes of the type described are really appropriate only
forskilled craftsmen. In continuous production the output of the individual
workeris largely governed by the speed of the flow line, although such
schemes may be suitable for special jobs, e.g. fitting radios in motorcar
assembly. As with straight piece-work, production under bonus for timesaving
requires strict inspection to prevent poor quality work.Many different schemes
exist in practice for calculating the bonus payable. In an examination you
should follow the instructions carefully to calculate the bonus from the data
supplied

4.2 Measured day work
The concept of this approach is to pay a high time rate, but this rate is based
on an analysis of past performance. Initially, work measurement is used to
calculate the allowed time per unit. This allowed time is compared to the time
actually taken in the past by the employee, and if this is better than the
allowed time an incentive is agreed.
Example
Allowed time – 1 hour.
Average time taken by employee over last three months – 50 minutes.
Normal rate – Rs4.80/hour.
Agreed incentive rate (say) – Rs 5.00/hour.
Note: the incentive rate will be a matter of negotiation. This incentive wage
rate will be reviewed periodically in the light of the employee's actual
performance.
4.3 Share of production plans

In order to understand this plan, it is necessary to introduce the concept of
added value. This is explained below:
Rs
Sales X
Less: Cost of bought in materials and services
(i.e. all costs except payroll and depreciation) X
Value added X
Generally, wages tends to maintain a constant relationship to value added,

usually about 40%. Share of production plans are based on acceptance by
both management and labour representatives of a constant share of value
added for payroll. Thus, any gains in value added – whether by improved
production performance or cost savings – are shared by employees in this
ratio.
Example
Rs
Sales 100,000
Less: bought in materials and services 55,000
Value added 45,000
Agreed wages share 40% value added 18,000

Paid 15,000
Balance paid as bonus 3,000

4.4 Group incentive schemes
All of the schemes discussed above can be operated as group incentive
schemes.This more closely relates to reality, in that improved performance is
the result of group rather than individual effort.
Example
Ten employees work as a group. When production of the group exceeds the
standard – 200 pieces per hour – each employee in the group is paid a bonus
for the excess production in addition to wages at hourly rates. The bonus is
computed thus: the percentage of production in excess of the standard
quantity is found, and one half of the percentage is regarded as the
employees' share. Each employee in the group is paid as a bonus this
percentage of a wage rate of Rs 52 per hour. There is no relationship
between the individual worker's hourly rate and the bonus rate.The following
is one week's record:
Hours
Worked Production
Monday 90 24,500
Tuesday 88 20,600
Wednesday 90 24,200
Thursday 84 20,100
Friday 88 20,400
Saturday 40 10,200
_______ ______
480__ 120,000
You are required:

(a) to compute the rate and amount of bonus for the week
(b) to calculate the total pay of Jamshed, who worked 42 hours and was
paid Rs 30 per hour basic, and that of Salman, who worked 44 hours
and was paid Rs 37.5 per hour basic.
Solution
(a) Standard production for the week = 480 hoursx 200 = 96,000 pieces
Actual production for the week = 120,000 pieces
Bonus rate =
= Rs 6.5 per hour
Total bonus = 480 hour x 6.5 = Rs 3,120

(b)
Jamshed Salman
Rs Rs
Basic 42 x Rs 30 1.260 44 x Rs 37.5 1,650
Bonus 42 x Rs 6.5 273 44 x Rs 6.5 286
Total pay 1,533 1,936
4.5 Incentives to non-production workers

The main incentive schemes are only appropriate where production can be
measured in saleable output. However, the principle of relating reward to
achievement is capable of adaptation to many activities; for example, sales
order staff could be paid a group bonus based on the number of orders
correctly processed in a period. Alternatively, managerial and skilled technical
employees may be given objectives for achievement in the period ahead and,
if they agree that the objectives are attainable, their rewards, in terms of
bonus of increased salary,would be related to success in meeting the
objectives.
5. Labour cost accounting
5.1 Direct and indirect wages

The distinction between direct and indirect costs has previously been
explained. Indirect wages represent:
 the cost of time spent by direct labour on non-productive work, e.g.

cleaning machines or waiting for materials
 the gross wage of factory personnel not actually engaged in
production,e.g. maintenance staff, forklift truck operators, supervisors.
The gross wages total provided from the payroll represents a control figure
forcost analysis and gross wages comprise basic pay, overtime, bonuses and
allowances. For cost ascertainment purposes, direct wages will be charged to
cost units and indirect wages will be charged to cost centres for later allotment
to cost units. Therefore it is important that the system should distinguish
between direct and indirect wages. One further point may require clarification.
The distinction between wages and salaries is meaningless for cost
accounting purposes. What is important is whether the payment can be
regarded as direct or indirect.

5.2 Accounting treatment of overtime premium
The treatment of the overtime premium depends on the reason for the
overtime being worked. If the overtime is worked at the specific request of a
customer the premium should be charged to the customer and therefore to
work in progress control. If the overtime arises as a result of company policy
to increase production generally, then the premium should be charged to
production overhead along with other indirect wage costs and charged to the
product via the overhead recovery rate.
5.3 Accounting entries

Labour costs are an expense and are recorded in an organisation’s income
statement. Accounting transactions relating to labour are recorded in the
labour account.
 The labour account is debited with the labour costs incurred by an

organisation. The total labour costs are then analysed into direct and
indirect labour costs.
 Direct labour costs are credited from the labour account and debited in
the work-in-progress (WIP) account. Remember, direct labour costs are
directly involved in production and are therefore transferred to WIP before
being transferred to finished goods and then cost of sales.
 Indirect labour costs are also credited ‘out of’ the labour account and
debited to the production overheads account. It is important that total
labour costs are analysed into their direct and indirect elements.
Example of labour account
Labour account
Rs 000 Rs 000
Bank (1) 80 WIP (2) 60
Production overheads (3)
Indirect labour 14
Overtime premium 2
Shift premium 2
Sick pay 1
Idle time 1
80 80
(1) Labour costs incurred are paid out of the bank before they are
analysed further in the labour account.

(2) The majority of the labour costs incurred by a manufacturing
organisation are in respect of direct labour costs. Direct labour costs
are directly involved in production and are transferred out of the labour
account via a credit entry to the WIP account as shown above.
(3) Indirect labour costs include indirect labour (costs of indirect labour
workers), overtime premium (unless overtime is worked at the specific
request of a customer), shift premium, sick pay and idle time. All of
these indirect labour costs are collected in the production overheads
account. They are transferred there via a credit entry out of the labour
account and then debited in the production overheads account.

The following information is taken from the payroll records of a company.
Direct Indirect Total

workers workers
Rs Rs Rs
Basic pay for basic hours 43,000 17,000 60,000
Overtime – basic pay 10,000 4,500 14,500
Overtime – premium 5,000 2,250 7,250
Training 2,500 1,250 3,750
Sick pay 750 250 1,000
Idle time 1,200 – 1,200
6. Labour cost control reports
6.1 Productivity
One of the major responsibilities of production management is to improve
productivity. To assist in this, regular reports analysed by process, machine
group or department are required, showing:
 numbers of employees (direct and indirect)

 labour costs (analysed into basic, premium and bonuses)
 production achieved
 hours worked, hours lost and hours spent on non-productive work
 ratios and trends.
Such reports are most effective when a comparison plan is incorporated. A

central feature of such a comparison is the productivity index. This expresses
the actual number of units produced as a percentage of the standard or
budgeted production for the period, e.g. actual production in June was 1,100
units, standard production was 1,000 units. The productivity index is 110%.

Note the difference between production and productivity. Production is output
in terms of units, e.g. 1,000 units per month. Productivity is this output
expressed relative to a vital resource, e.g. 10 cars per man per year, or 12
tons of steel per man per month.
6.2 Idle time

Idle time is a cost that represents waste and warrants close control. To assist
control, time booking procedures should permit analysis of idle time by cause,
and analysis should disclose whether idle time was capable of being avoided
by action within the business.The three main causes of idle time are:
 Production disruption – due to machine breakdown, shortage of

materials, inefficient scheduling, etc.
 Policy decisions – run-down of stocks, changes in product specification,

retraining schemes, seasonal factors, etc.
 Outside influences – sudden fall in demand due to economic changes, a

strike affecting vital supplies etc.
6.3 Labour turnover

A key objective of the personnel department is to retain staff: in other words to
minimise turnover of labour. It is evident that each time an employee is
replaced, the business incurs direct costs of:
 advertising and selection

 administering departure and replacement
training reduced efficiency until the new employee reaches the required
skill.Furthermore, a high rate of turnover tends to lower the performance of
continuing employees, who may become restless and resentful of the extra
burden of training new members and of additional temporary duties imposed
upon them. Labour turnover can be calculated as:
number of employees leaving and replaced × 100

average number of employees in period
To assist control of labour turnover, the personnel department will maintain

records of employees leaving, analysed to show:
(a) personnel details – sex, age groups, etc.
(b) department or section in which employed
(c) length of service
(d) reason for leaving.

Analysis in respect of (d) would be useful to disclose whether a particular
cause is recurring, especially if the cause can be avoided by action within the
business. Such statistics should, however, be regarded with caution, as
employees frequently hide the true reason, or neglect to explain it clearly.
Reasons of Labour Turnover
Avoidable / Controllable Reasons of Labour Turnover:

 poor remuneration
 poor working conditions
 lack of training opportunities
 lack of promotion prospects
 bullying in the workplace.
Unavoidable / Uncontrollable Reasons of Labour Turnover:

 retirement
 illness/death
 family reasons (e.g. pregnancy)
 relocation
Efficient managers will investigate high levels of labour turnover and aim to keep that
turnover rate at a minimum.
Cost of Labour Turnover:

Every time an employee leaves, an organisation will incur costs that are associated
with replacing the employee. These costs are known as replacement costs.
Replacement Costs:
 advertising costs
 cost of selection (time spent interviewing etc.)
 training new employees
 reduced efficiency until the new employee reaches the required skill.
Prevantion Costs:
Preventive costs include the costs associated with escaping the avoidable causes of
labour turnover:
– pay competitive wages and salaries if remuneration is poor
– improve poor working conditions
– offer good training opportunities
– make sure promotion prospects arise as necessary
– stamp out bullying in the workplace
– investigate high labour turnover rates objectively.

Summary
This chapter has considered the remuneration methods available together

with appropriate incentive schemes to improve productivity. The collection of
costs has been explained by reference to the appropriate documentation and
labour cost reporting considered. By the time you have finished this chapter
you should be able to:
 explain labour accounting and control procedures

 discuss and calculate factory incentive schemes for individuals and
groups.

Self-test questions
Labour documentation
1 What is a clock card? (1.3)
2 What is a time sheet? (1.5)
3 What is a job sheet? (1.6)
Payroll
4. What does payroll preparation involve? (2.1)
Remuneration methods
5. What are the two main approaches to calculating the remuneration paid to
employees? (3.1)
Incentive schemes
6. What is measured day work? (4.2)
7. What is value added? (4.3)
8. What is a group incentive scheme? (4.4)
Labour cost accounting

9. How is an overtime premium treated? (5.2)
Labour cost control reports

10. State three possible causes of idle time. (6.2)
11. How is labour turnover calculated? (6.3)

1. A manufacturing firm is very busy and overtime is being worked. The

overtime premium would normally be classed as:
A part of prime cost

B factory overheads
C direct labour costs
D administrative overheads
2. The following graph shows the wages earned by an employee during a single
day.
Which one of the following remuneration systems does the graph

represent?
A Differential piecework
B A flat rate per hour with a premium for overtime working
C Straight piecework
D Piecework with a guaranteed minimum daily wage.

Answers to MCQs:
1) B
2) D
Answer: test your understandings
Halsey
Bonus = 60 – 80 Rs 48 = Rs 16.8
2 60
Rowan
Bonus = 18 x 42 Rs 48 = Rs 10
16 60

Labour account
Bank (1) 87,700 WIP (43,000+10,000) 53,000

Production overheads
Indirect labour 21,500
(17,000+4,500)
Overtime premium 7,250
Training 3,750
Sick pay 1,000
Idle time 1,250
87,700 87,700

Chapter leaning objectives
 Overheads
 Overhead allocation
 Overhead apportionment
 Overhead absorption
 Blanket absorption rates and departmental absorption rates
 Over and under absorption of overheads
 Ledger entries relating to overheads

1 Overheads
Overheads are the sum of Indirect materials, Indirect labour and Indirect expenses
incurred in a manufacturing enviroment.
1.1 Introduction
Direct expenses are expenses that can be directly identified with a specific cost
unit or cost centre.
There are few examples of direct expenses but royalties paid to a designer or fees
paid to a subcontractor for a specific job could be classed as direct expenses.
 Direct expenses are part of the prime cost of a product.
Indirect expenses cannot be directly identified with a specific cost unit or cost
centre. Indirect expenses are part of factory overheads.
 For example, the cost of renting a factory where shirts are manufactured is
classified as an indirect cost because it would be impossible to relate such
costs to shirts only, if other clothes, such as dresses and suits were also made
in the same factory.
Overhead costs may be classified according to the function of the organisation

responsible for incurring the cost. Examples of overhead cost classifications
include production overhead, selling and distribution overhead, and
administration overhead. It is usually possible to classify the majority of overhead
cost in this way, but some overhead costs relate to the organisation generally and
may be referred to as general overhead.
In this chapter we shall focus mainly on production overhead. Production is that

function of the business which converts raw materials into the organisation’s
finished product. The production department is usually divided into a number of
departments or cost centres. Some of these cost centres are directly involved with
the production process. These are called production cost centres and might
include, for example, the cutting department and the finishing department.
Other cost centres in the production department are not directly involved with the
production process but provide support services for the production cost centres.
These are called service cost centres, and examples include the maintenance
department and the stores.
Remember the main objective is to find the cost per unit:

Total cost = Direct costs (prime costs) + Overheads
It is easy to determine the direct costs, but how do we find the cost per unit
including overheads/indirect costs? We can’t ignore these costs (rent, supervisors)
or we won’t get the full cost of the item. These costs need to be 'shared out' among
the cost units as fairly and as accurately as possible.
In this chapter you will learn how this “sharing out” is accomplished for production
overheads, using a costing method known as absorption costing.
1.2 Overhead cost classification and analysis

This topic already has been discussed in detail in chapter 3. Overhead costs are
those costs incurred which cannot be economically attributed to a specific cost unit.
They may be incurred in many different parts of the organisation. Overhead costs
are classified by function, for example production, selling, and administration. As
we'll see, this then enables them to be attributed to individual unit costs, in the case
of production overhead, or dealt with separately in the case of other overheads.
1.3 Production overhead

Production overhead represents indirect materials, indirect wages and indirect
expenses attributable to production, and also the service activities associated
with production.
Indirect production costs are incurred in three main ways:
 Production activities – costs arising in production departments such as

fuel, protective clothing, depreciation and supervision.
 Service activities – the cost of operating non-producing departments or

sections within the factory, e.g. materials handling, production control and
canteen.
 Establishment costs – general production overhead such as

factoryrent/rates, heating and lighting and production management
salaries.
We will now look at the mechanics of attribution of overheads into cost

units.

2 Overview of accounting for overheads
2.1 Introduction
To attribute overhead costs to cost units, a sequence of procedures is
undertaken:
Step 1 Collecting production overhead costs by item.

Step 2 Establishing cost centres.
Step 3 Allocating and apportioning overhead costs to cost centres.
Step 4 Apportioning service cost centre costs to production cost centres.
Step 5 Absorbing production cost centre costs into cost units.
The procedure is illustrated diagrammatically below.
Key:
direct cost allocation
apportionment of service centre costs to production
absorption of production
overhead costs into units of output
2.2 Five steps
Step 1: Collecting costs by item

Indirect materials costs can be obtained by analysing materials requisitions;
indirect wages cost can be derived from an analysis of the payroll. Indirect
expenses are recorded from invoices, petty cash vouchers and journal
entries (e.g. for depreciation).

Step 2: Establishment of cost centres
The cost centres established should ideally combine an identifiable activity
with a specific person responsible. For example, if Department A comprises
three machine groups – I, II and III under the overall supervision of a
departmental supervisor, then it would be helpful for responsibility accounting
to have only one cost centre for Department A. The three machine groups
may, however, perform entirely different production activities, in which case
three separate cost centres may be necessary for costing purposes.Service
cost centres are usually set up to represent individual service departments
such as stores, but in a large factory a department may combine a number
of cost centres related to the responsibility of section heads within the
department: for example each substore would be a separate cost centre.
Step 3: Cost allocation and apportionment

The total cost of production overhead needs to be distributed among specific cost
centres.
 Some items can be allocated immediately, e.g. the salary of a cost centre
supervisor or indirect materials issued to a cost centre.
 Other items need to be apportioned between a number of centres, e.g. factory

rent and rates or the salary of the overall factory manager. The basis for
apportioning a total amount will be selected so that the charge to a specific
centre will reflect, with reasonable accuracy, the benefit obtained by that centre
from the cost incurred.
Step 4: Apportioning service cost centre costs to production cost centres

Part of the total factory overhead will be allotted to cost centres which do not
actually produce the saleable output. In order to reflect the cost of services in unit
costs, service cost centre costs must be re-apportioned to production cost centres,
so that the total cost of the production cost centre can be related to the units that
pass through it. Once again the basis of apportionment should reflect the benefit
derived.
Step 5: Absorption into cost units

Finally, the production cost centres will have been allotted the total amount of
factory overhead, representing:
 allocated costs
 apportioned costs
 share of service department costs.
The overhead to be absorbed by a particular cost unit will be calculated by dividing

the production cost centre overhead for a period by an appropriate measure of the
volume of production in the period. If a cost centre produces dissimilar units the

volume of production must be expressed in a common measurement, e.g. direct
labour hours: if product X takes workers twice as long to make as product Y it is
reasonable that it should bear twice the overhead. When a cost unit passes
through several centres, the overhead absorbed should be calculated separately
for each centre.
2.3 More detail

In the remainder of this chapter we will expand upon these steps by working
through a series of examples.
3 Allocation and apportionment
3.1 Example
The ABC Washing Machine Company produces a standard washing machine in
three production departments (Machining, Assembling and Finishing) and two
service departments (Materials handling and Production control)
Budgeted costs for the next year are as follows:
Materials:
Machining Rs 240,000
Assembly Rs 160,000
Finishing Rs 40,000
Materials handling Rs 3,742
Wages:
Machining Rs 65,000
Assembly Rs 27,500
Finishing Rs 15,000
Production control Rs 11,200
Other costs:
Machining Rs 21,922
Assembly Rs 12,960
Finishing Rs 7,920
Production control Rs 2,400
It is estimated that the benefit derived from the service departments is as

follows:

Machining 60%
Assembly 30%
Finishing 10%
Production control :
Machining 40%
Assembly 30%
Finishing 20%
Materials handling 10%
You are required to prepare a statement showing the overhead allocated and
apportioned to each of the production departments.
Solution
Overhead allocation and apportionment

Materials and wages incurred by the production departments may be assumed to
be direct costs and are therefore excluded from the overhead analysis. We are
only concerned with 'Materials handling', 'Production control' and 'Other costs'.
Allocation
Allocation is simply a matter of extracting the data given in the question and
putting it under (i.e. allocating it to) the appropriate headings. In effect, in this
example, the allocation has already been done: you just need to rearrange the
information.
Machinin Assembl Finishin Material Productio Total

g y g s n control
handling
Rs Rs Rs Rs Rs Rs
Indirect
- - - 3,742 - 3,742
materials
Indirect
- - - 8,000 11,200 19,200
wages
Other 21,922 12,960 7,920 27,998 2,400 73,200
21,922 12,960 7,920 39,740 13,600 96,142
Apportionment
Service department costs (Materials handling and Production control) now have to
be re-apportioned to production departments. The 'portions' are the percentages
shown in the question.
As 10% of the production control overhead is to be charged to materials handling

this must be done first, so we know the total amount of materials handling
overhead to apportion.

The apportionment is shown below. (In practice of course you would simply
continue the table shown above: there is no need to split them.)
Production departments Service departments

Machini Materials Production Total
Assembly Finishing
ng handling control
Allocated
costs as 21,922 12,960 7,920 39,740 13,600 96,142
above
Production
control: Rs
13,600,
5,440 4,080 2,720 1,360 -13,600
apportioned
as
40:30:20:10:0
27,362 17,040 10,640 41,100 0 96,142
Materials
handling: Rs
41,100
24,660 12,330 4,110 -41,100 - _
apportioned
as
60:30:10:0:0
52,022 29,370 14,750 – – 96,142
Now that all the production overhead costs have been attributed to production
cost centres, the total for each cost centre can be related to the cost units worked
on in that cost centre.
3.2 Bases for apportioning costs to cost centres

The guiding principle for apportionment is that each overhead cost should be
apportioned to reflect, with reasonable accuracy, the relative benefit derived by
particular cost centres.
There are no hard and fast rules for which bases of apportionment to use
Except that whichever method is used to apportion overheads, it must be fair.
Possible bases of apportionment include the following:
 floor area – for rent and rates overheads

 net book value (NBV) of fixed assets –for depreciation and insurance of
machinery
 number of employees – for canteen costs.

Example
Suppose that in the previous example instead of being given a department-by-
department allocation of 'other costs' you were told that 'other costs' had been
allocated to two headings – power & rent and rates.
Other costs
Power Rs 24,400
Rent and rates Rs 48,800
Data about power consumption and floor space is also available.
KwH Sq. metres

Machining 83,844 19,870
Assembly 25,920 21,600
Finishing 15,840 13,200
Materials handling 15,996 63,330
Production control 4,800 4,000
Total 146,400 122,000
You are required to apportion 'other costs' to departments on an appropriate

basis.
Solution
Power is most appropriately apportioned on the basis of kilowatt hours (KwH).
The total is 146,400 hours and the proportion used in, for example, Machining is
therefore 83,844/146,400. Applying this fraction to the cost of power Rs 24,400
gives Rs 13,974 as the amount to be apportioned to Machining. Rent and rates is
most appropriately apportioned on the basis of floor space. The total is 122,000
m2 so the proportion used in, for example, the Finishing department is
13,200/122,000. Applying this fraction to the cost of rent and rates gives Rs 5,280
as a fair share for Finishing. The same calculations should be carried out for each
of the other departments giving the following results.

Power Rent and rates Total
Rs Rs Rs
Machining 13,974 7,948 21,922
Assembly 4,320 8,640 12,960
Finishing 2,640 5,280 7,920
Materials
2,666 25,332 27,998
handling
Production
800 1,600 2,400
control
_________ ________ __________
Total 24,400 48,800 73,200
The total column is the same as in the original question, so the overall answer is
unchanged.
In selecting a basis for apportioning an overhead item, the cost of obtaining a high
degree of accuracy must be considered. For example, the charge for heat and
light could be shared on the basis of a complex formula incorporating power
points, light bulbs and wattage but you should be aware that the end result would
still be open to question.

The overhead budget for the month together with data relating to cost centres is
as follows:
Rs
Supervision 7,525
Indirect workers 6,000
Holiday pay and National Insurance 6,200
Tooling cost 9,400
Machine maintenance labour cost 4,500
Power 1,944
Small tools and supplies 1,171
Insurance of machinery 185
Insurance of building 150
Rent and rates 2,500
Depreciation of machinery 9,250
________
48,825__

Machine group
Q R S T Total
Floor Space (sq meter) 1,800 1,500 800 900 5,000
Kilowatt hours 270,000 66,000 85,000 65,000 486,000
Capital cost of machines (Rs.) 30,000 30,000 8,000 16,000 74,000
Indirect workers (persons) 3 3 1 1 8
Total workers (persons) 19 24 12 7 62
Machine maintenance hours 3,000 2,000 3,000 1,000 9,000
Tooling costs (Rs) 3,500 4,300 1,000 600 9,400
Supervision costs (Rs) 2,050 2,200 1,775 1,500 7,525
Small tools and supplies (Rs) 491 441 66 173 1,171
Machine running hours 30,000 36,000 19,000 8,000 93,000
Allocate and apportion each of the costs given to the four groups of machines on
a suitable basis and then calculate a cost per machine running hour (a machine
hour rate) for each of the four groups of machines.
3.3 Cost control

So far we've considered how overheads might be shared out from the point of view of
benefit obtained. Much of the information is only relevant, however, for cost control
purposes, by segregating costs which are controllable by the cost centre manager.
The overhead distribution in Test your understanding 1 could be adapted to achieve
that objective by adding a general cost centre: items which cannot be controlled by
machine group supervisors (such as rent and insurance) would be charged to the
general centre as the responsibility of, say, the factory manager. Cost centres would
then be allotted overhead in two stages:
 allocation of controllable costs
 apportioned costs transferred from the general cost centre.
The sub-total of allocated costs would be suitable for control information and the
grand total would be used, as we'll see later, for absorption purposes.
Example
Speed Manufacturing Co Ltd has three production departments (two machine shops
and one ssembly shop) and three service departments, one of which – the
Engineering Service Department – serves the machine shops only.The annual
budgeted overhead costs for the year are:

Indirect Consumable
wages supplies
Rs Rs
Machine shop A 23,260 6,300
Machine shop B 20,670 9,100
Assembly 8,110 2,100
Stores 4,100 1,400
Engineering service 2,670 2,100
General services 3,760 1,600
62,570 22,600
Rs
Depreciation of machinery 22,000
Insurance of machinery 4,000
Insurance of building 1,800 (Note 1)
Power 3,600
Light and heat 3,000
Rent and rates 7,050 (Note 2)
Notes:
1. Because of special fire risks, Machine shop A is responsible for a special
loading of insurance on the building. This results in a total building
insurance cost for Machine shop A of one-third of the annual premium.
2. The general services department is located in a building owned by the

company. It is valued at Rs 6,000 and a notional rent is charged into costs
at a rate of 8% pa. This cost is additional to the rent and rates shown above.
3. The values of issues of materials to the production departments are in the

same proportions as shown above for consumable supplies. The following
data is also available:

The following data is also available:
Departments Book value
Power Production Capacity
of Area
consumptio Direct labour Machines
machinery (sq. m)
n% hours hours
Rs
Productive:
Machine shop A 60,000 5,000 50 200,000 40,000
Machine shop B
45,000 6,000 33.33 150,000 50,000
Assembly 15,000 8,000 4.16 300,000 –

Service:
Stores 6,000 2,000 –
Engineering
18,000 2,500 12.5
service
General services 6,000 1,500 –
150,000 25,000 100
You are required:

(a) to prepare an overhead analysis sheet showing the bases of any
apportionments of overhead to departments
(b) to show how the service departments' overheads will be reapportioned

to the production departments ignoring the apportionment of service
department costs amongst service departments.
Solution
(a) Overhead analysis sheet
Genera
Machin shop Assem Engineerin
Indirect wages stores l Total
eA B bly g service
Service
Consumable Rs Rs Rs Rs Rs Rs Rs
supplies 23,260 20,670 8,110 4,100 2,670 3,760 62,570
6,300 9,100 2,100 1,400 2,100 1,600 22,600
Depreciation of 8,800 6,600 2,200 880 2,640 880 22,000

Machinery
Insurance of 1,600 1,200 400 160 480 160 4,000
machinery 29,560 29,770 10,210 5,500 4,770 5,360 85,170
Insurance of
600 360 480 120 150 90 1,800
building
1,800 1,200 150 – 450 – 3,600

Power 600 720 960 240 300 180 3,000
Light and heat 1,500 1,800 2,400 600 750 – 7,050
Rent and rates 44,460 41,650 16,800 7,500 9,540 7,150 127,10
Notional rent 0
Bases of apportionment
Depreciation and insurance of Book value of machinery
machinery:
Insurance of building: One-third to machine shop A,
balance apportioned on area
Power: Power consumption
Light and heat: Area
Rent and rates: Area excluding general Service
Notional rent: 8% × Rs 6,000
(b) Production departments

Machine shop Assembly Total
A B
Rs Rs Rs Rs
Total from
overhead analysis sheet 44,460 41,650 16,800 102,910
Apportionment of
service departments:
Stores (W1)
(consumable supplies) 2,700 3,900 900 7,500
Engineering service (W2)
(machine hours) 4,240 5,300 – 9,540
General services (W3)
(direct labour hours) 2,200 1,650 3,300 7,150
53,600 52,500 21,000 127,100
Workings
(W-1) Consumable supplies Consumable supplies Stores cost
apportionment
Rs
Machine shop A 6,300 63/175
Machine shop B 9,100 91/175

Assembly 2,100 21/175
7,500
(W2) Machine hours

Engineering Machine hours
service
apportionment

Assembly - -
90,000
(W3) Direct labour hours
Direct Labour Apportionment General Service

Hours
Assembly 300,000 300/650
______
650,000
3.4 Reciprocal services between service centres

A particular problem arises when service centres provide reciprocal services to
each other, e.g
Maintenance Payroll Section

Department Services
In this situation, a secondary apportionment of costs arises. There are several

methods of dealing with this; your syllabus requires the use of the repeated
distribution method. This involves a continuous process of reapportioning costs
backwards and forwards between cost centres until amounts left in the service
departments areso small that they can be ignored.
Example
A company has three production departments, A, B and C, and two service
departments, maintenance (M) and payroll (P). The following table shows how

costs have been allocated and the relative usage of each service department by
other departments.
Production Service
Department A B C M P
Costs (Rs) 3,000 4,000 2,000 2,500 2,700
Proportion M (%) 20 30 25 – 25
Proportion P (%) 25 25 30 20 –
Required: Re-apportion the service department costs to the production departments

using the repeated distribution method.
Solution
Production Service
A B C M P
Rs Rs Rs Rs Rs
Costs 3,000 4,000 2,000 2,500 2,700
Reapportion M 500 (20%) 750 (30%) 625 (25%) (2,500) 625 (25%)
– 3,325
Reapportion P 831 (25%) 831 (25%) 998 (30%) 665 (20%) (3,325)
665
Reapportion M 133 200 166 (665) 166
166
Reapportion P 41 42 50 33 (166)
33
Reapportion M 7 10 8 (33) 8
Reapportion P* 4,515 5,835 3,850
* These have been rounded to finish off the process.

A company has three production departments: A, B, and C and two production
service departments X and Y. Overhead costs have been attributed to these
departments as follows:
Department Rs '000
A 120
B 80
C 65
X 24
Y 15

An analysis of the services provided by each service department shows the
following percentages of total time spent for the benefit of each department:
Service
Production/Service Departments
department
A B C X Y
X 30% 30% 20% – 20%
Y 50% 10% 30% 10% –
Show the apportionment of production service department costs to production

departments using the repeated distribution method.
4 Absorption
4.1 Introduction
The final stage in the process (Step 5, if you look back at the introduction to this
chapter) is to reflect the cost of overheads in individual cost units. This is done using
a rate per unit, just like materials or labour.
 Absorption costing is a method of costing that, in addition to direct costs,

assigns all, or a proportion of, production overhead costs to cost units by
means of one or a number of overhead absorption rates.
 The overhead absorption rate is a means of attributing overhead (fair share)

to a product or service based for example on direct labour hours, direct
labour cost or machine hours.
The absorption rate may be calculated by the fraction:

Total overhead (Rs)
Total of absorption basis
Where the absorption basis is units, hours or whatever is appropriate for the basis
being used.
4.2 Absorption bases

Overhead can be absorbed into cost units by means of:
 Physical unit produced
 percentage of prime cost (direct labour, direct material and direct expenses)
 percentage of direct wages
 direct labour hours
 machine hours

It is quite likely that different production departments will measure their production
in different ways. The objective is to use a measure which reflects the nature of
the work involved. The physical unit measure is in theory the simplest but it is only
valid if all of the items produced require the same amount of resources. Direct
labour hour rate is logical to used when production is labour intensive and
machine hour rate is more suitable when production is machine intensive.
Example
Returning to the example of the ABC Washing Machine Company we found the
following production overhead costs.
Machining Assembly Finishing Total

Rs Rs Rs Rs
Production overheads 52,022 29,370 14,750 96,142
Let's say it has been decided that a separate absorption rate for each cost centre
is to be calculated as follows:
Cost centre Absorption basis Incurred

Machining Machine hour rate 10,000 machine hours
Assembly Direct labour hour rate 5,000 labour hours
Finishing Percentage of direct wages Rs15,000 direct wages
Solution
Absorption rates:
Machining: Cost centre overhead = Rs 52, 022

Machine hours 10,000
= Rs 5.20 per machine hour
Assembly: Cost centre overhead = Rs 29,370

Direct labour hours 5,000
= Rs 5.87 per labour hour
Finishing: Cost centre overhead x 100 = Rs 14, 750 x 100

Direct wages Rs 15,000
= 98.33% of direct wages
The overhead absorbed by an individual washing machine could then be

accumulated. For example if we are told that a regular washing machine takes 5
hours machining, 2 hours assembly and incurs Rs 7.50 wages cost in the finishing
department, the total overhead absorbed by that machine is as follows.

Rs
Machining 5 hours × Rs 5.20 26.00
Assembly 2 hours × Rs 5.87 9.38
Finishing 98.33% × Rs 7.50 7.38
Overhead absorbed 42.76
The production overhead absorbed is then added to the direct cost of each
washing machine to determine the total production cost per unit. For example if
we are told that a regular washing machine incurs a direct material cost of Rs 220
per unit and a direct labour cost of Rs 55 per unit, the total production cost can be
built up as follows.
Rs
Direct material 220.00
Direct labour 55.00
275.00
Production overhead (as above) 42.76
Total production cost 317.76
4.3 Departmental and blanket overhead absorption rates (OARs)
It is usual for a product to pass through more than one department during the
production process. Each department will normally have a separate departmental
overhead absorptions rate OAR.
 For example, a machining department will probably use a machine-hour OAR.

 Similarly, a labour-intensive department (e.g: assembly department) will
probably use a labour-hour OAR.
 An alternative to a departmental OAR is what is termed a blanket OAR.
 With blanket OARs, only one absorption rate is calculated for the entire factory
regardless of the departments involved in production.
 Blanket OARs are also known as single factory-wide OARs.

Example
Ballard Ltd makes three products A, B and C. Each passes through two
departments: Machining and Assembly.
Labour hours used in each department by each product
Machining Assembly
Product A 1 hr 1 hr
Product B 2 hrs 1/2 hr
Product C None 4 hrs
Production is expected to be as follows:
Product A 1,000 units

Product B 2,000 units
Product C 500 units
Overheads are budgeted as follows:
Machining Assembly
Rs 100,000 Rs 150,000
Required: Calculate overhead absorbed in one unit of “B” by using:
(i) Departmental OAR

(ii) Blanket OAR
Solution
(i) Departmental OAR
Machining Assembly
Budgeted overheads Rs 100,000 Rs 150,000
Budgeted labour hours (1 x 1,000) + (2 x 1 x 1,000) + (1/2 x
2,000) = 5,000 2,000)
+ (4 x 500) = 4,000
OAR Rs 20 Rs 37.50
Machining Assembly
OAR Rs 20 Rs 37.50
One unit of “B” requires 2 hrs 1/2 hr
Overhead absorbed Rs 40 18.75

Total overhead absorbed for one unit of “B” (40+18.75) = Rs 58.75
(ii) Blanket OAR

Company wide
Overheads Rs 250,000
Hours 5,000 + 4,000 = 9,000
OAR Rs 27.78 per hour
Total hours for producing one unit of “B” (2+1/2 hrs) = 2.5 hours
Total overhead absorbed for one unit of “B” (2.5 x 27.78) = Rs 69.45

A business has the following production and fixed overhead budgets for the
coming year.
Production department 1 2
Fixed overhead Rs 240,000 Rs 200,000
Total direct labour cost Rs 2,400,000 Rs 4,000,000
Total direct materials cost Rs 200,000 Rs 400,000
Department 1 labour is paid Rs 5 per hour and department 2 labour Rs 4 per

hour.
The variable production cost of an IC is as follows:
Rs
Direct labour
Department 1 : 3 hours 15
Department 2 : 1 hour 8
Direct materials
Department 1 : 1kg @ Rs 4 per kg 4
Department 2 : 2 kgs @ Rs 5 per kg 10
Variable overheads 7
44
If fixed overheads are absorbed on the basis of direct labour cost, what is the
fixed overhead cost per unit of IC?

5 Under and over absorption
5.1 Introduction
The rates used to absorb overheads into cost units will not, of course, be
calculated with hindsight. They will be predetermined rates, based upon budgeted
figures.
A predetermined rate is used to smooth out seasonal fluctuations in overhead

costs, and to enable unit costs to be calculated quickly throughout the year.
Predetermined absorption rate = Budgeted overhead

Budgeted volume
Budgeted volume' may relate to units, direct labour hours, machine hours, etc.If
either or both of the actual overhead cost or activity volume differ from budget, the
use of this rate is likely to lead to what is known as under absorption or over
absorption of overheads.
Example
In year 9 the budget for the machine shop shows:
Overhead Rs 60,000 Volume of activity 12,000 machine hours.
In January year 9 the machine shop incurred Rs 5,400 of overhead and 1,050
machine hours were worked.
Calculate the pre-determined absorption rate and the overhead under or

overabsorbed in January.
Solution
Absorption rate = Budgeted overhead = Rs 60,000______ = Rs 5.00 per machine
hour Bugdgeted volume 12,000 machine hours
Rs
Actual overhead incurred per question 5,400
Overhead absorbed (1,050 machine hours x Rs 5.00) 5,250

Under-absorbed overhead 150

The under-absorption in this example arises from a combination of two factors:
 actual overhead costs were Rs 400 higher than the budgeted amount of (Rs
60,000 / 12) = Rs 5,000 for the month
 actual volume was 50 hours greater than the budgeted (12,000 hours / 12) =1,000
hours for the month.
Example
Following data relates to STAR manufacturing:
(a) Budgeted production overheads and budgeted hours:
Machining Assembly Finishing

Production overhead costs Rs 40,864 Rs 47,400 Rs 10,100
Number of:
Direct labour hours 32,000 4,000
(b) Actual production overheads and actual hours:

Rs Rs Rs
Actual costs 43,528 49,575 9,240
Actual labour and machine hours recorded against each cost centre were:

Labour hours 31,040 3,925
Required:
Calculate the followings:
(i) Overhead absorption rate and overhead absorbed

(ii) Under/over absorbed overheads.
Solution
(i)
Absorption rates:
Per machine hour Rs 1.277
Per labour hour Rs 1.481 Rs 2.525

The overhead absorption rates (OARs) have been calculated as follows:
Machining – using machine hours:

OAR = Rs 40,864/32,000 = Rs 1.277 per machine hour
Assembly – using labour hours:

OAR = Rs 47,400/32,000 = Rs 1.481 per labour hour
Finishing – using labour hours:

OAR = Rs 10,100/4,000 = Rs 2.525 per labour hour
Overhead absorbed = budgeted OAR × actual hours
Amount absorbed: Machining Assembly Finishing

Rs Rs Rs
32,650 hours × Rs 1.277 41,694
31,040 hours × Rs 1.481 45,970
3,925 hours × Rs 2.525 9,911
(ii)
Rs Rs Rs
Amount absorbed 41,694 45,970 9,911
Actual cost incurred 43,528 49,575 9,240
——— ——— ———
Over/ (Under) absorption (1,834) (3,605) 671
——— ——— ———
If the amount absorbed exceeds the amount incurred, then an over-absorption

arises; The opposite is referred to as an under-absorption. The terms under-
recovery and over-recovery are sometimes used.
Analysis of over/under-absorbed overhead is covered in more detail under the

topic of standard costing and variances, later in this Textbook.

A company budgeted to produce 3,000 units of a single product in a period at a
budgeted cost per unit as follows:
Rs/unit
Direct costs 17
Fixed overhead 9
26

In the period covered by the budget:
(a) Actual production was 3,200 units.

(b) Actual fixed overhead expenditure was 5% above that budgeted – all
other costs were as budgeted. What was the amount, if any, of over or
under absorption of fixed overhead?
other costs were as budgeted.What was the amount, if any, of over or under
absorption of fixed overhead?
5.2 Treatment of under/over absorption
The unit cost of production will include overhead at the predetermined rate and,
generally, overhead under or over-absorbed will be shown as a separate item in
the costing profit and loss account.
Costing profit and loss account

Rs
Sales 100
Cost of sales (units sold - unit cost including absorbed overheads) 70
30
(Under)/over absorption (5)
Operating profit 25
A large balance in the over/under-absorbed account may indicate that unit costs
are inaccurate and management should be made aware that such costs must be
used with care. This situation can be avoided by undertaking regular reviews of
the overhead absorption rate to ensure that it still reflects current operating
conditions.
5.3 Accounting for overhead absorption
The following example will illustrate the cost accounting entries relating to
overhead absorbed.

Example
The following data relates to four departments of a factory.
Actual Absorption rates (based on

overhead predetermined annual
Rs estimates)
Department A 100,000 Rs 10 per machine hour

Department B 400,000 Rs 75 per direct labour hour
Department C 700,000 100% on direct wages
Department D 350,000 Rs 25 per unit
Machine
Hours Direct labour Direct wages Units
worked hours worked Rs Produced
Department A 10,000 11,000 600,000 100,000

Department B 3,000 5,300 600,000 48,900
Department C 6,000 18,000 680,000 52,000
Department D 14,000 30,000 1,000,000 13,800
You are required to:

(a) journalise departmental overheads incurred
(b) journalise departmental overheads absorbed
(c) give the journal entry recording under or over-absorbed overhead expenditure.
Solution
(a)
Dr Cr
Rs Rs
Factory overhead control account 1,550,000
Accounts payable 1,550,000
Overheads incurred
Dr Cr
Rs Rs
Department A overhead account 100,000
Department B overhead account 400,000
Department C overhead account 700,000
Department D overhead account 350,000
Factory overhead control account _ 1,550,000
Transfer of actual departmental overhead for 1,550,000 1,550,000
period

(b)
Dr Cr
Rs Rs
Work-in-progress account (W) 1,522,500
Department A overhead account 100,000
Transfer of absorbed departmental expenses for 1,522,500 1,522,50

period 0
(c)
Dr Cr
Rs Rs
Profit and loss account 27,500
Transfer of under-absorbed departmental 27,500 27,500
expenses for period
Working
Absorbed overhead
Rs
Department A 10,000 machine hours x Rs 100,000
10
Department B 5,300 labour hours x Rs 75 397,500
Department C 100% of Rs 680,000 680,000
Department D 13,800 units x Rs 25 345,000
1,522,500
5.4 Absorption costing v marginal costing

The problem of under/over-absorption of overheads arises because absorption
costing tries to treat a fixed cost as variable. A unit cost based on absorption
costing principles can be misleading – if one extra unit is made then total direct
costs (materials and labour) will increase by the amounts included in the unit cost,
but fixed costs will not. The alternative approach is called marginal costing and we
shall look at that in the next chapter.

Summary
In order for management to take many decisions about their products, such as
stock valuations, pricing decisions and production decisions, they must be given
information on the cost of the items that are being produced. Cost will include not
only the direct costs of production such as direct materials and direct labour but
also indirect costs or overhead. In this chapter much thought has been given to
the process of collecting all of the overhead relevant to a cost centre and cost unit
and then allocating those overheads to the cost centres. The allocation of these
overheads may be done by means of an apportionment of the overhead to a
number of departments on a common sense basis. Service department costs will
need to be reapportioned to production departments using a method based on the
relative benefit derived. If service departments provide reciprocal service between
themselves, the repeated distribution method can be used. Finally the costs
allocated and apportioned to the cost centres must be absorbed into the cost units
in an appropriate manner. The total absorption costing approach is to absorb all
production overheads, fixed and variable, into cost units at a predetermined rate.
This may lead to the necessity for an adjustment for over/under absorption.
 explain absorption costing
 prepare cost statements for allocation and apportionment of overheads
including reciprocal service departments
 calculate and discuss overhead absorption rates
 calculate under/over recovery of overheads.
 calculate product costs under absorption costing.

Self-test questions
Overheads
1 What is overhead? (1.2)
2 What are the three ways in which indirect production costs are incurred? (1.3)
Overview of accounting for overheads

3 What are the five steps in the attribution of indirect costs to cost units? (2.1)
Allocation and apportionment

4 How would the depreciation of machines normally be apportioned to cost centres?
(3.2)
5 What is the problem with apportioning the overheads of reciprocal service
departments? (3.4)
Absorption
6 How is the overhead absorption rate calculated? (4.1)
7 State five possible absorption bases that may be used (4.2)
Under and over absorption

8 Why are predetermined rates used to absorb production overheads into
production costs?
9 How is a predetermined absorption rate calculated? (5.1)
10 How does an over under or absorption of overhead arise? (5.1)
11 How is the overhead actually absorbed calculated? (5.1)
12 What is the usual treatment of an under or over absorption of overhead? (5.2)

1. A company uses the repeated distribution method to reapportion service

department costs. The use of this method suggests:
A the company’s overhead rates are based on estimates of cost and activity
levels,
rather than actual amounts
B there are more service departments than production cost centres
C the company wishes to avoid under or over absorption of overheads in its
production cost centres
D the service departments carry out work for each other.
2. A method of dealing with overheads involves spreading common costs over cost
centres on the basis of benefit received. This is known as:
A overhead absorption
B overhead apportionment
C overhead allocation
D overhead analysis
3. An overhead absorption rate is used to:

A share out common costs over benefiting cost centres
B find the total overheads for a cost centre
C charge overheads to products
D control overheads

Test your understanding - 5
Shown below are next year's budgeted operating costs for Fibrex Ltd, a company
with three production and two service departments.
-Direct materials Production departments Service departments Total

-Direct wages Weaving Proofing Finishing Personnel Equipment
-Indirect dept dept dept dept maintenance
Materials Rs '000 Rs '000 Rs '000 Rs '000 Rs '000 Rs '000

7,000 2,000 1,500 – – 10,500
and wages
6,000 9,900 3,000 – – 18,900
-Power
1,100 900 300 1,500 3,800 7,600
-Rent and rates
5,200 1,000 200 100 800 7,300
-Factory
8,000
administration
10,000
and supervision
2,400
-Machine
Insurance
Additional data extracted from next year's budget is shown below:
Weaving Proofing Finishing Personnel Equipment Total

dept dept dept dept maintenanc
e
-Floor area,
square metres 12,000 27,000 6,000 12,000 3,000 60,000
-Machine 1,600,000 400,000 400,000 – – 2,400,000
hours
-Direct labour 1,200,000 1,800,000 600,000 – – 3,600,000
hours
-Number of 600 1,000 400 100 400 2,500
employees
-Gross book Rs 4.0m Rs 1.0m Rs 1.0m – – Rs 6.0m
value of
equipment
Required:
Calculate the budgeted overhead absorption rates for each production department
using the following methods:
(i) a machine hour rate in the weaving department
(ii) a direct labour hour rate in the proofing department
(iii) another suitable method in the finishing department

Answers to MCQs:
1) D
2) B
3) C

Basis (see below for Machine groups)
Rs Rs Rs Rs Rs
Supervision A 2,050 2,200 1,775 1,500 7,525
Indirect workers 4 2,250 2,250 750 750 6,000
Holiday pay and NI 5 1,900 2,400 1,200 700 6,200
Tooling cost A 3,500 4,300 1,000 600 9,400
Machine
maintenance labour 6 1,500 1,000 1,500 500 4,500
Power 2 1,080 264 340 260 1,944
Small tools, etc. A 491 441 66 173 1,171
Insurance of 3 75 50 20 40 185
machines
Insurance of buildings 1 54 45 24 27 150
Rent and rates 1 900 750 400 450 2,500
Depreciation of
machinery 3 3,750 2,500 1,000 2,000 9,250
17,550 16,200 8,075 7,000 48,82
5
Machine running 30,000 36,000 19,000 8,000
hours
Machine hour rate Rs Rs Rs 0.425 Rs 0.875
0.585 0.450
Bases of apportionment:
1 Floor space 5 Total workers
2 Kilowatt hours 6 Machine maintenance hours
3 Capital cost of machines A Direct – allocated
4 No of indirect workers
Note that depreciation is apportioned on the basis of capital cost. The usage of
machines will be reflected in the machine hour rate.

A B C X Y
Rs Rs Rs Rs Rs
Costs 120.0 80.0 65.0 24.0 15.0
Reapportion X 7.2 7.2 4.8 (24.0) 4.8
Reapportion Y 9.9 2.0 5.9 2.0 (19.8)
Reapportion X 0.6 0.6 0.4 (2.0) 0.4
137.9 89.9 76.2

Department 1 absorption rate = Rs 240,
labour cost
cost
Fixed over head cost per unit of IC:
Rs per unit
Department 1 Rs 15 × 10% 1.50
Department 1 Rs 8 × 5% 0.40
1.90
Over/(under) absorption = Absorbed overheads − Incurred overheads
Budgeted fixed overhead = 3,000 units × Rs 9 = Rs 27,000.
Rs
Fixed overhead absorbed (3,200 units × Rs 9) 28,800
Fixed overhead incurred (27,000 × Rs 1.05) 28,350
Over-absorbed fixed overheads 450
Fibrex Ltd
Note: Overheads are indirect costs so take care to ensure that the direct materials
and wages are not included in the overhead calculations.

(a) The first step is to allocate and apportion total overheads to the cost centres
Basis of Weavin Proofin Finishin Person Maint- Total

apportionmen g g g nel enance
Overhead item t dept dept dept dept
Rs Rs Rs Rs Rs Rs Rs
Indirect materials Given 1,100 900 300 1,500 3,800 7,600

and wages
Given 5,200 1,000 200 100 800 7,300
Power Floor area 1,600 3,600 800 1,600 400 8,000
Rent and rates Number of

2,400 4,000 1,600 400 1,600 10,000
employees
Factory admin & Gross book
1,600 400 400 - 24, 000
Supervision value
11,900 9,900 3,300 3,600 6,600 35,300
Machine insurance
Total
Reapportionments:(s 900 1,500 600 (3,600) 600
ee Tutorial note)
Personnel Number of
mployees -
6:10:4:4
7200
Total
Equipment Gross book
maintenance alue (or 4800 1200 1200 - (7200)
machine
hours) 4:1:1
17,600 12,600 5,100
Total

Overhead Weaving dept Proofing dept Finishing dept
absorbtion Budgeted Budgeted Budgeted
rate Overhead overhead overhead Budgeted
Budgeted Budgeted wage cost
machine hours labour hours x 100
Rs 17 , 600, 000 Rs 12, 600, 000 = Rs 5,100, 000 x 100

1,600,000 1,800,000 3,000,000
Rs 11 perRs 7 per direct 170% of direct

machine hours labour hours wage cost
Tutorial note:
Reapportionment of service cost centres
As personnel provides a service to another service department (equipment
maintenance) it is important to reapportion first the service cost centre which
services other service cost centres, i.e. in this case personnel. Then the total of
the equipment maintenance costs, including a charge from personnel, can be
reapportioned to the production cost centres.

 Absorption Cost
 Marginal Cost and Marginal Costing
 Principle of Marginal Costing
 Marginal Costing and Absorption Costing and the calculation of profit
 Reconciling Profit
 Marginal Costing versus Absorption Costing

1 Marginal costing
The marginal cost of an item is its variable cost. The marginal production cost
of an item is the sum of its direct materials cost, direct labour cost, direct
expenses cost (if any) and variable production overhead cost. So as the
volume of production and sales increases total variable costs rise
proportionately. We can also say that marginal cost is the cost that can be
avoided if activity does not perform.
Fixed costs, in contrast are cost that remain unchanged in a time period,
regardless of the volume of production and sale.
Marginal production cost is the part of the cost of one unit of product or service
which would be avoided if that unit were not produced, or which would increase
if one extra unit were produced.
From this we can develop the following definition of marginal costing as used in
management accounting:
Marginal costing is the accounting system in which variable costs are charged
to cost units and fixed costs of the period are written off in full against the
aggregate contribution.
Note that variable costs are those which change as output changes – these are
treated under marginal costing as costs of the product. Fixed costs, in this
system, are treated as costs of the period.
Marginal costing is also the principal costing technique used in decision

making. The key reason for this is that the marginal costing approach allows
management’s attention to be focussed on the changes which result from the
decision under consideration.
The contribution concept

Contribution is the amount available for recovery of fixed costs, contribution
concept lies at the heart of marginal costing. Contribution can be calculated as
follows.
Contribution = Sales price – All Variable costs

Example
Company A produces a single product with the following budget:
Selling price Rs 10
Direct materials Rs 3 per unit
Direct wages Rs 2 per unit
Variable production overhead Re 1 per unit
Fixed production overhead Rs 10,000 per month.
The fixed overhead absorption rate is based on volume of 5,000 units per
month. Show the operating statement for the month, when 4,800 units were
produced and sold under marginal costing.
Solution
The variable cost of sales is simply Rs 3 + Rs 2 + Re 1 = Rs 6 per week.
Rs
Sales (4,800 x Rs 10) 48,000
Variable cost of sales (4,800 x Rs 6) 28,800
Contribution 19,200
Fixed overhead 10,000
Operating profit 9,200
Based on what we have seen above, the idea of profit is not a particularly
useful one as it depends on how many units are sold. For this reason, the
contribution concept is frequently employed by management accountants.
 Contribution gives an idea of how much ‘money’ there is available to

‘contribute’ towards paying for the overheads of the organisation.
 At varying levels of output and sales, contribution per unit is constant.
 At varying levels of output and sales, profit per unit varies.
 Total contribution = Contribution per unit x Sales volume. (Rs 4 x 4,800 =
19,200)
 Profit = Total contribution – Fixed overheads.
2 Absorption costing
The principles of absorption costing have been discussed in the previous

chapter (Chapter 7: Accounting for overheads).
Absorption costing is a method of building up a full product cost which adds

direct costs and a proportion of production overhead costs by means of one or
a number of overhead absorption rates.

Example
Using the same data as in previous example prepare operating statement
under absorption costing.
Solution
In the absorption costing statement we have to adjust for under-absorbed fixed
production overhead; no such adjustment was necessary in the marginal
costing statement as fixed production overheads are not absorbed in the first
place.
Rs
Sales (4,800 units) 48,000
Cost of sales (4,800 x Rs 8) (W1) 38,400
Operating margin 9,600
Under-absorbed overhead (W2) (400)
Workings
(W1) Unit cost is materials (Rs 3) + wages (Rs 2) + variable overhead (Re 1) +
fixed overhead absorbed Rs 10,000/5,000 = Rs 2 per unit, giving a cost
per unit of Rs 8
(W2) Rs
Fixed overhead incurred 10,000
Fixed overhead absorbed (4,800 units x Rs 2) 9,600
400
2.1 Difference between marginal costing and absorption costing

The fundamental difference between marginal and absorption costing is one of
timing. In marginal costing fixed costs are written off in the period incurred. In
absorption costing fixed production costs are absorbed into units and written
off in the period in which the units are sold.
2.2 Marginal costing and stock valuation

In the above example operating profit is the same under both methods. That
will not be so, however, when production is more or less than sales, i.e. if
stocks increase or decrease.
Stock valuation under marginal costing is based on variable production costs

only. This is in contrast to absorption costing where fixed production overhead
costs are included in stock valuations using the predetermined absorption rate.
The following test your understanding illustrates the effects of the different
stock valuations on profit.

Suppose that in the previous example (Company A) production was in fact
6,000 units, i.e. 4,800 units sold and 1,200 units left in closing stock. Prepare
the profit statement for the month under absorption costing principles.

Now show the profit statement for the month under marginal costing principles.
2.3 Reconciliation of total absorption cost (TAC) profit and marginal

cost (MC) profit
The difference in profit under the two methods in Activities 1 and 2 (Rs 11,600
- Rs 9,200 = Rs 2,400) arises because of the difference in the amount of fixed
production overhead included in stock under the absorption costing system.
The closing stock of 1,200 units includes in its absorption cost valuation Rs 2
per unit of fixed costs. This Rs 2,400 is therefore being carried forward to the
next accounting period rather than being charged in this accounting period,
giving a profit figure in this period Rs 2,400 higher under absorption costing
compare with marginal costing.
This can be summarised as follows:
Rs Rs
Profit under MC 9,200
Stock valuation (TAC) 1,200 x Rs 8 9,600
Stock valuation (MC) 1,200 x Rs 6 7,200
Difference (1,200 x Rs 2) 2,400
Profit under TAC 11,600
3 Marginal costing and decision making

Marginal costing emphasises variable costs per unit and fixed costs in total
whereas absorption costing unitises all production costs. Marginal costing
therefore reflects the behaviour of costs in relation to activity. Since most
decision-making problems involve changes to activity, marginal costing is more
appropriate for short-run decision-making than absorption costing.
It is considered more informative to present comparison statements on a

contribution basis. The term contribution describes the amount which a product
provides or contributes towards a fund out of which fixed overhead may be
paid, the balance being net profit. Where two or more products are
manufactured in a factory and share all production facilities, the fixed overhead
can only be apportioned on an arbitrary basis.

Example
A factory manufactures three components ( X, Y and Z ) and the budgeted
production for the year is 1,000 units, 1,500 units and 2,000 units respectively.
Fixed overhead amounts to Rs 6,750 and has been apportioned on the basis
of budgeted units: Rs 1,500 to X, Rs 2,250 to Y and Rs 3,000 to Z. Sales and
variable costs are as follows:
Component Component Component

X Y Z
Selling price per unit Rs 4 Rs 6 Rs 6
Variable cost per unit Rs 1 Rs 4 Rs 4
Solution
The budgeted profit and loss account based on the above is as follows:
Component Component Component Total

X Y Z
Sales units 1,000 1,500 2,000 4,500
Rs Rs Rs Rs Rs Rs Rs Rs
Sales value 4,000 9,000 10,00 23,00
0 0
Variable cost 1,000 6,000 8,00 15,00
0 0
Fixed 1,500 2,500 2,250 8,250 3,00 11,00 6,750 21,75
overhead 0 0 0
Net 1,500 750 (1,000) 1,250
profit/(loss)
Clearly, there is little value in comparing products in this way. If the fixed overhead is
common to all three products, there is no point in apportioning it.
From the above presentation it seems that component Z is a loss making

product and business should stop its production.
A better presentation is as follows:

Component Component Component Total
X Y Z
Sales units 1,000 1,500 2,000 4,500
Rs Rs Rs Rs
Sales value 4,000 9,000 10,000 23,000
Variable cost 1,000 6,000 8,000 15,000
Contribution 3,000 3,000 2,000 8,000
Fixed 6,750
overhead
1,250
From this presentation under marginal costing provides better information that
all components X, Y and Z are contributing to meet fixed cost and business
should not stop producing any component.
4 Marginal and absorption costing compared
4.1 Introduction
We have identified the following differences between the TAC and MC
approaches to costing units:
 Profit statement layout – TAC deducts fixed production overheads as part
of cost of sales to get to gross profit; MC only includes variable costs in
cost of sales to get to contribution; with fixed overhead costs deducted as a
period cost.
 Over/under absorption adjustment is necessary only for TAC.
 Changes in stock levels will lead to differing reported profits under the wo
approaches. Make sure you understand these points by working this
example and trying the test your understanding that follows.
Example
A company sells a product for Rs 10 per unit, and incurs Rs 4 per unit for
variable costs in its manufacture. The fixed costs are Rs 900 per month and
are absorbed on the basis of the normal production volume of 250 units per
month. The activity levels for the last four months, when no expenditure
variances arose, were as follows:

1st 2nd 3rd month 4th Total
month month units month units
units units units
Opening stock – 200 300 300 –
Production 300 250 200 200 950
___ ___ ___ ___ ___
300 450 500 500 950
Closing stock 200 300 300 200 200
___ ___ ___ ___ ___
Sales 100 150 200 300 750
___ ___ ___ ___ ___
Solution
The profit statement using absorption costing would be as follows:
1st month 2nd month 3rd month 4th month 5th month
Rs Rs Rs Rs Rs
Sales value 1,000 1,500 2,000 3,000 7,500
Rs Rs Rs Rs Rs
Opening
stock – 1,520 2,280 2,280 –
@ Rs 7.60
Variable
costs of
1,200 1,000 800 800 3,800
production
@ Rs 4
Fixed
costs@ Rs.
1080 900 720 720 3420
900/250=
Rs. 3.60
2280 3420 3800 3800 7220
Closing
Stock @ 1520 2280 2280 1520 1520
Rs. 7.60
Cost of
(760) (1140) (1520) (2280) (5700)
Sales
Under/Over
Absorption 180 Nil (180) (180) (180)
(W)
Net Profit 420 360 300 540 1620

Working
Calculation of over/under absorption
(Under) over
Produced Absorbed @
Month Incurred (Rs.) absorbed
(Units) Rs. 3.60 (Rs.)
(Rs.)
1 900 300 1080 180
2 900 250 900 -
3 900 200 720 (180)
4 900 200 720 (180)
If marginal costing had been used instead of absorption, the result would have
been shown as:
1st Month 2nd Month 3rd Month 4th Month Total

Item
Rs. Rs. Rs. Rs. Rs.
Sales 1000 1500 2000 3000 7500
Variable cost
of sales @ 400 600 800 1200 3000
Rs. 4
Contribution 600 900 1200 1800 4500
Fixed Costs 900 900 900 900 3600
Net
(300) - 300 900 900
profit/Less
The total profit for the four months is Rs 720 less under marginal costing
principles. This is because the closing stock at the end of the fourth month is
valued at Rs 800 (Rs 4 × 200 units) compared with Rs 1,520 under absorption
costing. Therefore Rs 720 of the fixed production costs are carried forward in
stock unde absorption costing, to be charged against the sales of a later
month. The profit figures for each month can be reconciled as follows:
Month 1 Month 2 Month3 Month 4

Rs Rs Rs Rs
Profit/(loss) under marginal costing (300) - 300 900
Stock units (decrease)/increase × 720 360 - (360)

Rs. 3.60 per unit
Profit/(loss) under absorption 420 360 300 540
Costing
The profit figures for each month can be reconciled as follows: If marginal
costing is adopted, then stocks of work-in-progress and finished products will
be valued at variable production costs only. Where production and sales
levels are not in sympathy and stock levels are fluctuating, the net profit will be
different from that disclosed by an absorption method of costing.

A company that manufactures one product has calculated its cost on a
quarterly production budget of 10,000 units. The selling price was Rs. 5 per
unit. Sales in the four successive quarters of the last year were:
Quarter 1 10,000 units

The level of stock at the beginning of the year was 1,000 units and the
companymaintained its stock of finished products at the same level at the end
of each of the four quarters. Based on its quarterly production budget, the cost
per unit was:
Rs
Prime cost 3.50
Production overhead 0.75
Selling and administration 0.30
overhead
Total 4.55
Fixed production overhead, which has been taken into account in calculating
the above figures, was Rs 5,000 per quarter. Selling and administration
overhead was treated as fixed, and was charged against sales in the period in
which it was incurred.
You are required to present a tabular statement to bring out the effect on net
profit of the declining volume of sales over the four quarters given, assuming
in respect of fixed production overhead that the company:
(a) absorbs it at the budgeted rate per unit (i.e. absorption costing);
(b) does not absorb it into the product cost, but charges it against sales in
each quarter (i.e.marginal costing).
4.2 Marginal costing – advantages compared with absorption costing

Preparation of routine operating statements using absorption costing is
unconsidered less informative because:
 profit per unit (under absorption costing) is a misleading figure because it is

based on an arbitrary absorption of fixed production overhead.
 build-up or run-down of stocks of finished goods can distort the comparison
of period operating statements and obscure the effect of increasing or
decreasing sales under absorption costing.
 comparison between products can be misleading because of the effect of

arbitrary apportionment of fixed costs.
 There is no need to adjust over and under absorption of overheads as in

absorption costing.
 Fixed cost is ought to incur regardless of any decision about product output
level. So marginal costing is more useful in decision making as it does not
include fixed cost in product cost.
4.3 Defence of absorption costing

Absorption costing is widely used and you must understand both principles.
Defenders of the absorption principle point out that:
 it is necessary to include fixed overhead in stock values for

financialstatements; routine cost accounting using absorption costing
produces stock values which include a share of fixed overhead.
 for a small jobbing business, overhead absorption is the only

practicableway of obtaining job costs for estimating and profit analysis.
 analysis of under/over-absorbed overhead is useful to identify inefficient

utilisation of production resources.
 Absorption costing includes element of fixed cost in inventory valuation

which is according to International accounting standard (i.e.: IAS-2).

Rays Ltd manufactures and sells electric blankets.The selling price is Rs 12
perblanket. Each blanket has the following unit cost:
Rs
Direct material 2
Direct labour 1
Variable production overhead 2
Fixed production overhead 3
8
Administration costs are incurred at the rate of Rs 20,000 per annum. The
company achieved the following production and sales of blankets:

Year 1 2 3
Production (‘000 units) 100 110 90
Sales (‘000 units) 90 110 95
The following information is also relevant:

 The overhead costs of Rs 2 and Rs 3 per unit have been calculated on the
basis of abudgeted production volume of 90,000 units.
 There was no inflation.
 There was no opening stock at the beginning of the year 1.
You are required:

(a) to prepare an operating statement for each year using:
(i) marginal costing
(ii) absorption costing.
(b) to explain why the profit figures reported under the two techniques
disagree.
As Your paper is a computer based exams so for MCQ’s you may use
this formula and most of the MCQ’s are easily calculated with minimum
time.
Absorption costing profit = Marginal costing profit + (Closing stock units

– Opening stock units) X Per unit Fixed OH cost
Sometime in exams MCQ’s are required to calculate the difference in

both costing system profits then this is calculated by using:
Difference in profits = (Closing stock units – Opening stock units) X Per

unit Fixed OH cost

Summary
Under marginal costing principles, only the variable costs are charged against
turnover to give contribution for the period. These variable costs will include
direct materials, labour and expenses as well as variable production overhead
and any variable selling costs. All of the fixed costs of the business, including
fixed production overhead, is then charged against contribution for the period
in order to give net profit. This also means that the closing stocks carried
forward are valued at their variable production cost only. The whole of the
period's fixed costs are charged to the profit and loss account for the period
and none carried forward to later periods. When stock levels change, profits
reported under the TAC and MC approaches will differ as the TAC approach
will carry forward fixed production overheads in its stock value. By the time
you have finished this chapter you should be able to:
 calculate product costs under marginal costing

 compare and contrast absorption and marginal costing
 prepare profit and loss accounts from the same data under absorption and
marginal costing and reconcile and explain the differences in reported
profits.

Self-test questions
Marginal costing
1 What is marginal costing? (1.2)
2 What is the difference between marginal costing and absorption costing? (1.2)
3 What is contribution? (1.2)
4 What is the reason for the difference in operating profit under marginal
and absorption costing? (1.4)
5 What is the best figure to use for comparison product profitability? (1.6)
Marginal and absorption costing compared

6 What are the advantages of marginal costing? (2.2)
7 What are the advantages of absorption costing? (2.3)

Multiple choice questions (MCQs):
1. A company made 17,500 units at a total cost of Rs 16 each. Three

quarters of the costs were variable and one quarter fixed. 15,000 units were
sold at Rs 25 each. There were no opening stocks. By how much will the profit
calculated using, absorption costing principles differ from the profit if marginal
costing principles had been used?
A Absorption costing profit would be Rs 22,500 less

B The absorption costing profit would be Rs 10,000 greater
C The absorption costing profit would be Rs 135,000 greater
D The absorption costing profit would be Rs 10,000 less.
2. When comparing the profits reported under marginal and absorption

costing during a period when the level of stocks increased
A absorption costing profits will be higher and closing stock valuations
lower than those under marginal costing
B absorption costing profits will be higher and closing stock valuations

higher than those under marginal costing
C marginal costing profits will be higher and closing stock valuations

lower than those under absorption costing
D marginal costing profits will be lower and closing stock valuations

higher thanthose under absorption costing.
3. Over-absorbed overheads occur when:

A absorbed overheads exceed actual overheads
B absorbed overheads exceed budgeted overheads
C actual overheads exceed budgeted overheads
D budgeted overheads exceed absorbed overheads
Answers to MCQs:
1) B
2) B
3) A


Rs Rs
Sales 48,000
Cost of sales:
Production (6,000 x Rs 8) 48,000
Closing stock (1,200 x Rs 8) (9,600)
(38,400)
Operating margin 9,600
Over-absorbed fixed overhead ((6,000 units x Rs 2) - Rs 2,000
10,000)

Rs Rs
Sales 48,000
Variable cost of sales:
Production costs (6,000 x Rs 6) 36,000
Closing stock (1,200 x Rs 6) 7,200
28,800
Contribution 19,200
Fixed costs 10,000
Net profit statement (fixedoverhead sorbed)
1st 2nd 3rd 4th

quarter quarter quarter quarter
Sales units 10,000 9,000 7,000 5,500
Rs Rs Rs Rs
Sales value (Rs 5 per unit) 50,000 45,000 35,000 27,500
Cost of sales:
Prime costs (Rs 3.50 per unit) 35,000 31,500 24,500 19,250
Production overhead absorbed 7,500 6,750 5,250 4,125
(Rs 0.75 per unit)
Under-absorbed production – 500 1,500 2,250
overhead (W)
42,500 38,750 31,250 25,625

Gross profit 7,500 6,250 3,750 1,875

Less: Selling and administration 3,000 3,000 3,000 3,000
overhead (10,000 x Rs 0.30)
Net profit/(loss) 4,500 3,250 750 (1,125)
Working
Fixed production overhead absorption rate:
Fixed production overhead = Rs 5,000 = Rs 0.50 per unit

Budgeted production 10,000 units
As finished stock is maintained at 1,000 units, production volume = sales

volume. Therefore fixed overhead under absorbed in each quarter = Rs 5,000
- (Sales units x Rs 0.50).
1st 2nd 3rd quarter 4th

quarter quarter quarter
Sales Unit 10000 9000 7000 5500

Rs. Rs. Rs. Rs.
Sales Value 50000 45000 35000 27500
Less: Variable cost of sales (Rs.
37500 33500 26250 20625
3.75/unit) (W)
Contribution 12500 11250 8750 6875
Less: Fixed production, selling
8000 8000 8000 8000
and administration overhead
Net profit/ (loss) 4500 3250 750 (1125)

Working
Variable cost per unit:
Rs.
Prime cost 3.50
Variable Production overhead
(Rs. 0.75 – Rs. 0.50 fixed) 0.25
3.75
(a) Operating
statement
Year 1 Year 2 Year 3
Rs 000 Rs 000 Rs 000 Rs 000 Rs 000 Rs 000
Marginal costing
Sales 1,080 1,320 1,140
Opening stock @ Nil 50 50
Rs 5
Add: Production 500 550 450
cost @ Rs 5
500 600 500
Less: Closing 50 50 25
stock @ Rs 5
Cost of sales (450) (550) (475)
Year 1 Year 2 Year3

Rs 000 Rs 000 Rs 000 Rs 000 Rs 000 Rs 000
Contribution 630 770 665

Less:
Fixed costs:
Production overhead 270 270 270
Administration 20 20 20
overhead
(290) (290) (290)
Profit 340 480 375
Absorption costing
Sales 1,320 1,140
Opening stock @ Rs8 Nil 80 80
Add: production cost 800 880 720

@ Rs. 8
800 960 800
Less: Closing stock @ 80 80 40
Rs8
Cost of sales (720) (880) (760)
360 440 380

Over absorption
(see working) 30 60 Nil
Administration (20) (20) (20)
overhead
Profit 370 480 360
Working Year 1 Year 2 Year 3

Rs. 000 Rs. 000 Rs. 000
Fixed production overhead
absorbed:
100,000 units × Rs 3 300
110,000 units × Rs 3 330
90,000 units × Rs 3 270
Fixed production overhead
incurred:
90,000 units × Rs 3 270 270 270
Over absorption 30 60 -
b) The difference in profit arises because of the difference in the amount of fixed
production overhead included in stock under the absorption costing system.
When the opening and closing stock includes the same amount of fixed
overheads (i.e. here when the volume of opening and closing stock is the
same, in year 2) profit is the same under both techniques. Where volume of
stock has gone up (year 1) and the amount of fixed production overhead in
stock has increased then profit is higher under absorption costing and vice
versa.

This may be summarised as follows:
Year 1 Year 2 Year 3

Rs 000 Rs 000 Rs 000
Profit per marginal costing 340 480 375
Add:
Increase in fixed overhead
included in stock under
absorption costing:
10,000 units @ Rs 3 30 – –
Less:
Decrease in fixed
overhead included in
stock under absorption
costing:
5,000 units @ Rs 3 – – (15)
Profit per absorption 370 480 360
costing

 Costing Method
 Job Costing
 Batch Costing

1 Product costing methods
1.1 How are products produced?

So far, we have talked rather closely about cost units being generated and costs
being attributed to them to get a cost per unit. Here, we are going to look a little
more closely at how this actually happens. The production operations of most
businesses can be categorised as either being related to specific orders or
continuous operations, and have corresponding costing methods. This covers
process costing and service costing.
1.2 Costing methods

Every organisation will have its own costing system with characteristics which are
unique to that particular system. However, although each system might be
different, the basic costing method used by the organisation is likely to depend on
the type of activity that the organisation is engaged in.
The costing system would have the same basic characteristics as the systems of
other organisations which are engaged in similar activities.
Specific order costing methods are appropriate for organisations which produce
cost units which are separately identifiable from one another. Job costing and
batch costing are types of specific order costing.
Process costing is used by organisations where a number of production

processes are involved and the output of one process is the input to a later
process, this continuing until the final product is completed. Examples of
industries where process costing might be applied are food processing,
chemicals and brewing. The final product is said to be homogeneous (i.e. each
unit is identical and cannot be distinguished from another unit) and is usually
manufactured for inventory from which sales are made to customers.
2 Job costing
2.1 Introduction to job costing

Job costing is a form of specific order costing in which costs are attributed to
individual jobs. A Job can be defined as a special task on request of customer so
this method of costing is adopted when the factory issues an order to produce
one cost unit for a customer. Jobbing firms are engaged in 'one-off' products of a
specialist nature such as tools, machines, replacement parts, etc. The firm ma
meet a demand for products that need to be of a much higher standard than
mass-produced equivalents or where the quantity required is so small that the
planning and setting up involved for other firms would not be worthwhile. Jobbing
firms normally operate with a variety of machines in order to be able to tackle the

majority of operations that will be required in the product. They will handle a wide
range of work and are often used as subcontractors to larger firms which have to
off-load work where they have not the resources required for particular products
or operations. The jobbing firm, therefore, probably has only a small amount of
work of a repetitive nature which means that production plans may be prepared
for just a few weeks or months ahead, and has to be flexible to meet urgent
orders. Note that job costing can also be applied to services. For example a
plumber will use job costing to determine the cost of each individual job.
2.2 Job cost sheet (or card)

The main feature of a job costing system is the use of a job cost sheet or job card
which is a detailed record used to collect the costs of each job. In practice this
would probably be a file in a computerised system but the essential feature is that
each job would be given a specific job number which identifies it from all other
jobs. Costs would be allocated to this number as they are incurred on behalf of
the job. Since the sales value of each job can also be separately identified, it is
then possible to determine the profit or loss on each job.

The job cost sheet would record details of the job as it proceeds. The items
recorded would include:
 Job number;
 Description of the job; Specifications, etc.;
 Customer details;
 Estimated cost, analysed by cost element;
 Selling price, and hence estimated profit;
 Delivery date promised;
 Actual costs to date, analysed by cost element;
 Actual delivery date, once the job is completed;
 Sales details, for example delivery note no., invoice no.

The sheet has a separate section to record the details of each cost element.
There is also a summary section where the actual costs incurred are compared
with the original estimate. This helps managers to control costs and to refine their
estimating process.
Example of a job cost

Jobbers Ltd undertakes jobbing engineering work. Among the requests for
quotations received in December was one from A for a small machine to be
manufactured according to the customer's drawings supplied. Jobbers Ltd
prepared an estimate of the material and labour content based on the drawings,
and amounts were added for overhead and profit. The estimate indicated a price
of Rs 900 and this price was quoted to, and accepted by, A. The work on A's
order was started in January on the authority of Production Order No. 1001
signed by the works manager and was completed in that month. The abstract of
materials requisitions issued in January showed the following against Production
Order No. 1001:
Materials requisition Rs
D57 48
D61 24
D70 26
Total 98
Two operatives paid at Rs 4.20 per hour each had been employed in separate
cost centres on Production Order No. 1001 during January and their time sheets
showed that each had worked for thirty hours on that order. The overhead rates
for the cost centres in which the operatives are employed are in one centre Rs
2.00 per direct labour hour and 100% on direct wages in the other. Administration
and other overhead are recovered at the rate of 30% on production cost.
Required:
Prepare a statement showing the cost and profitability of the order from A

Solution
Statement of cost and profitability – production order number 1001

machine for A per customer's drawing
Rs Rs Rs
Selling price per estimate 900
Direct materials, per stores abstract 98

Direct wages (60 hours x Rs 4.20) 252
Prime cost 350
Production overhead:
30 hours @ Rs 2.00 60
(100% of 30 hours @ Rs 4.20) 126 186
Production cost 536
Administration and other overhead,
30% of production cost 161
Total cost of sales 697

Net profit 203
Note: actual and estimated profit on the order would be compared and any
significant difference reported to management. The estimate should have been
compiled on the same lines as the actual cost in the above statement to assist in
locating the particular costs which were not as estimated.
2.3 Effect of inaccurate overhead absorption rates

The above example shows that selling prices can reflect estimates and that the
major uncertainty in estimating is calculation of an accurate figure for overhead
recovery. Inaccurate estimating can seriously harm the business because:
 if jobs are over-priced, customers will go elsewhere

 if jobs are under-priced, sales revenue will fail to cover costs and/or
provide an adequate return.
2.4 Inaccurate estimate of volume

Predetermined overhead rates are based on a volume estimate. If actual volume
is significantly higher or lower than expected, then estimates, and consequently
selling prices, will be inaccurate.

Example
Company A's budget for the year is as follows:

Rs
Prime costs 50,000
Overhead 30,000
80,000
Profit (40% on cost) 32,000
Sales 112,000
Volume 3,000
labour
hours
If volume were half budget, i.e. 1,500 hours, actual results would show:
Prime costs (half budget) 25,000

Overhead absorbed 15,000 (1,500 hours x Rs
30,000/3,000)
40,000
Profit (40 % on cost) 16,000

Sales 56,000
Actual overhead incurred would not fall to half the budget, however, because of
the fixed element. It may fall to, perhaps, Rs 24,000 but job costs would reflect
overhead at the predetermined rate of Rs 10 per hour, leaving Rs 9,000 under-
absorbed. Actual profit would therefore be Rs(16,000 - 9,000) = Rs 7,000.
2.5 Inaccurate absorption basis

Estimated costs should reflect overhead in relation to the way it is incurred, so
that selling prices are competitive but profitable.
Example
Company B bases its estimates on the following formulae:
Total cost = Prime cost plus 40% for overhead

Selling price = Total cost plus 25% for profit

Estimates for two jobs show:
Item Job X Job Y
Rs Rs
Direct materials 200 100
Direct wages @ Rs 5 per hour 200 300
Prime cost 400 400

Overhead absorbed (40%) 160 160
Total cost 560 560

Profit (25%) 140 140
Selling price 700 700
Thus both jobs will be priced the same even though it would appear from the
direct wages estimate that Job Y takes 50% more time to complete and therefore
uses much more of the factory's resources. Job X may be over-priced in relation
to competitors whereas Job Y is under- priced and the business would lose its
Job X customers and get more orders for Job Y. Consider what would happen if
1,500 hours were available. The factory could produce only 10 of Job Y
compared with 15 of Job X, with the resulting lower total contribution.
2.6 Insufficient analysis by cost centre

A similar effect could arise if overhead rates do not recognise use of more or less
expensive resources.
Example
Company C uses a 'blanket' overhead rate calculated as follows:
Overhead cost Labour

Rs hours
Cost centre Y 40,000 4,000
Cost centre Z 80,000 4,000
120,000 8,000
Absorption rate = Rs 120,000

8,000
= Rs 15 per labour hour
Thus a job that takes one hour in Y will be charged the same amount for
overhead as a job that takes an hour in Z even though the latter centre costs
twice as much per hour to operate. Once again, estimates would not reflect a
realistic charge for the use of resources and over or under-pricing may result.

2.7 Treatment of costs as direct or indirect
Instances may arise when analyses for cost ascertainment can conflict with the
analyses required for control.
Example
Jones is paid Rs 6 per hour for a basic week of 40 hours. In one week he worked
four hours overtime at time and a half and received Rs 32 under a group bonus
scheme. His time sheet for that week shows:
Hours
Job A 20
Job B 10
Job C 8
Training 6
44
Jones' gross wage may be allocated in two ways:
(a) As an average direct wage per hour, i.e.:
Rs
Basic 40 x Rs 6 240
Overtime 4 x Rs 9 36
Bonus 32
308
Hourly rate = Rs 308/44 hours = Rs 7.00 per hour
(b) Basic rate used for costing and overtime premium/bonus treated as
indirect wages. Different allocations would result as follows:
Method (a) Method (b)

Rs Rs
Job A 20 x Rs 7.00 140 20 x Rs 6.00 120
Job B 10 x Rs 7.00 70 10 x Rs 6.00 60
Job C 8 x Rs 8.00 56 8 x Rs 6.00 48
266 228
Overhead:
Training 6 x Rs 7.00 42 6 x Rs 6.00 36
Overtime – 4 x Rs 3.00 12
Bonus – 32
308 308

Method (a) should give more accurate job costs but the total costs of overtime
and bonus will be more difficult to identify for management information purposes.

Discuss how a company manufacturing products on a jobbing basis should deal
with the following cost accounting problems.
(a) It employs a draughtsman from whose drawings templates are produced

which is used in the production process. These drawings are only made
against firm orders. Hitherto the salary and other costs of the draughtsman
have been included in factory overhead and absorbed into the cost of the
job as part of total factory overhead. Discuss whether this method of
dealing with the draughtsman's costs is satisfactory and suggest what
alternative approach might be taken.
(b) The company is at present operating a day and evening shift. It now
proposes a night shift whose average wage rate would involve a premium.
This night shift would concentrate on one particular contract that would
continue over a period of two to three years. Discuss how the company
should deal with the night shift premium in calculating the costs of its
products.
(c) One of the major production cost centres involves a chemical process that
is very complex. The time required to produce any particular quantity of
output depends rather unpredictably on a wide range of factors, some of
which are outside the control of the operator. As a result, a subsidiary
smaller machine to do 'touching up' work as and when products require it
has been installed in that cost centre. Discuss the case for treating the
wages of the operator of the subsidiary machine as an overhead of the cost
centre rather than as direct wages.
2.8 Cost control
When production is related to a specification or to customers' orders, the costing

system will be interlocked with estimating so that the estimate can be used as a
standard to locate excessive usage of materials and time. Control will be assisted
by:
(a) Detailed production orders or job specifications

These should be subject to serial number control. The production order is
the authority to obtain or allocate specific resources in the form of
materials, labour and machines.

(b) Excess material requisitions – Additional requirements for material would be
supplied only on presentation of a properly authorised document that would
show the reason for the request.
(c) Route cards – Each production order or job can be supported by route cards
that specify the sequence of operations and the estimated time for each
operation or stage. Actual time would be recorded and causes of excess time
noted where appropriate.
(c) Regular reports – The above documents will form the basis of a report to
show the incidence of excess usage together with an analysis of main
causes. The aim would be to prevent recurrence, where possible by
appropriate action, e.g.:
 amendment of existing methods of estimating usages

 change of supplier
 increased labour training
 introduction of incentive payment to all grades of works labour
 improved system of preventive plant maintenance
3 Batch costing
3.1 Introduction to batch costing

Batch costing is also a form of specific order costing. It is very similar to job
costing.
 Within each batch are a number of identical units but each batch will be
different.
 Each batch is a separately identifiable cost unit which is given a batch
number in the same way that each job is given a job number.
 Costs can then be identified against each batch number.For example
materials requisitions will be coded to a batch number to ensure that the
cost of materials used is charged to the correct batch.
 When the batch is completed the unit cost of individual items in the
batch is found by dividing the total batch cost by the number of items in
each batch.
Cost per unit in batch = total production cost of batch

number of units in batch

 Batch costing is very common in the engineering component industry,
footwear and clothing manufacturing industries.
 The selling prices of batches are calculated in the same ways as the
selling prices of jobs, i.e. by adding a profit to the cost of the batch.
Summary
This chapter has considered two of the specific order costing methods, job
costing and batch costing. You should ensure you are clear when each would be
used, but note that the costing principles applied to each are very similar.
 compare and contrast job, batch, contract and process costing systems
 prepare ledger accounts for job and batch costing systems.

Self-test questions
Product costing methods

1 In what circumstances will specific order costing be appropriate? (1.2)
Job costing
2 What information will be recorded on a job cost card? (2.2)
3 What are the potential problems arising from inaccurate absorption rates?(2.3)
Batch costing
4 What is batch costing? (3.1)

The following data are to be used for questions 1 and 2 below.
A firm uses job costing and recovers overheads on direct labour. Three jobs
were worked on during a period, the details of which were:
Job 1 Job 2 Job 3

Rs Rs Rs
Opening work-in-progress 8,500 0 46,000
Material in period 17,150 29,025 0
Labour for period 12,500 23,000 4,500
The overheads for the period were exactly as budgeted, Rs 140,000.
1. Jobs 1 and 2 were the only incomplete jobs. The value of closing work-in-
progress was:
A) Rs 180,425
B) Rs 214,425
C) Rs 175,700
D) Rs 205,300
2. Job 3 was completed during the period and consisted of 2,400 identical circuit
boards. The firm adds 50% to total production costs to arrive at a selling
price.The selling price of a circuit board (to the nearest penny) is Rs
A) Rs 41.4
B) Rs 42.5
C) Rs 43.7
D) Rs 40.6
The following data are to be used for questions 3 – 4.
A firm makes special assemblies to customers' orders and uses job costing. The
data for a period are:
Job number Job number Job number

AA10 BB15 CC20
Rs Rs Rs
Opening WIP 26,800 42,790 0
Material added in period 17,2750 0 18,500
Labour for period 14,500 3,500 24,600

The budgeted overheads for the period were Rs 126,000.
3. The overhead to be absorbed by job number CC20 for the period (to the nearest
Rs)mIs:
A) Rs 72,760
B) Rs 74,530
C) Rs 71,220
D) Rs 70,570
3. Job number BB15 was completed and delivered during the period and the firm
wishes to earn 33 1/3 % profit on sales.
The selling price of job number BB15 (to the nearest Rs) is:.
A) Rs 56,640
B) Rs 57,730
C) Rs 54,440
D) Rs 52,520
Job number 123

In order to identify the costs incurred in carrying out a range of work to customer
specification in its factory, a company has a job costing system. This system
identifies costs directly with a job where this is possible and reasonable. In
addition, production overhead costs are absorbed into the cost of jobs at the end
of each month, at an actual rate per direct labour hour for each of the two
production departments. One of the jobs carried out in the factory during the
month just ended was Job No. 123. The following information has been collected
relating specifically to this job:
(1) 400 kilos of Material Y were issued from stores to Department A.
(2) 76 direct labour hours were worked in Department A at a basic wage of Rs 4.50
per hour. 6 of these hours were classified as overtime at a premium of 50%.
(3) 300 kilos of Material Z were issued from stores to Department B. Department B
returned 35 kilos of Material Z to the storeroom being excess to equirements for
the job.
(4) 110 direct labour hours were worked in Department B at a basic wage of Rs 4.00
per hour. 30 of these hours were classified as overtime at a premium of 50%. All

overtime worked in Department B in the month is a result of the request of a
customer for early completion of another job that had been originally scheduled
for completion in the month following.
Overhead costs incurred during the month on all jobs in the two production
departments were as follows:
Dept A Dept B
Rs Rs
Indirect labour, at basic wage rate 2,510 2,960
Overtime premium 450 60
Lubricants and cleaning compounds 520 680
Maintenance 720 510
Other 1,200 2,150
Total labour hours worked during the month were:
Department A 2,000 hours

Department B 2,800 hours
Materials are priced at the end of each month on a weighted average basis.
Relevant information of material stock movements during the month, for materials
Y and Z, is as follows:
Material Y Material Z
Opening stock 1,050 kilos 6,970 kilos
(value Rs 529.75) (value Rs 9,946.50)
Purchases 600 kilos at 16,000 kilos at

Rs 0.50 per kilo Rs 1.46 per kilo
500 kilos at
Rs 0.50 per kilo
400 kilos at
Rs 0.52 per kilo
You are required:
(a) to prepare a list of the costs that should be assigned to Job No. 123.
Provide an explanation of your treatment of each item.
(b) to discuss briefly how information concerning the cost of individual jobs can
be used.

Answers to MCQs:
1. B
2. A
3. A
4. A
Answers: test your understanding

(a) As drawings are only made against firm orders, the cost of producing the
drawings may be considered as a direct cost rather than as a production
overhead. More accurate information, at little expense, could be obtained by
an analysis of time spent by the draughtsman; an hourly rate, including
associated costs, could be developed for charging to jobs. The hourly rate
could incorporate normal idle time or, alternatively, hours not attributable to a
specific order could be charged to drawing office overhead at the rate
developed.
(b) It appears that the night shift will be operated to fulfil the one particular long-
term contract. Consequently, there would be no justification for including
thenight-shift premium in factory overhead as that would unfairly burden jobs
completed during the day and evening shift. In fact it could be appropriate to
separate this particular contract from the normal costing routine and treat it as
a marginal contract by only charging costs directly incurred.
(c) The alternative methods for dealing with the wages of the operator of the
subsidiary machine are:
(i) Charge as direct wages – This method implies that the operator's time
can conveniently be analysed between products. In addition, the machine
operating costs should be charged in conjunction with the operator's
wages, i.e. a composite machine hour rate will be developed.
(ii) Charge as overhead of the production cost centre – Machine operating

costs would be charged similarly. The first method would achieve greater
accuracy of product costs and provide useful information on the cost of the
'touching up' machine but would involve additional clerical work analysing
the operator's time and developing a machine hour rate.

Job number 123

Notes:
1 One point to note is that overhead is absorbed at an actual rate. The normal
approach is to use a predetermined rate.
2 The information is presented in three sections:
 quantities specifically related to Job 123, labelled as items (1) to (4)

 actual overhead costs of Departments A and B
 information concerning Materials Y and Z.
The approach in answering is to go through items (1) to (4) one at a time and
select the relevant information from the other parts of the question as needed.
3 The weighted average used here is a periodic average, i.e. calculated

monthly as opposed to continuously valuing each issue as it occurs during the
month. The latter approach is normally used in problems concerning valuation
of issues.
(a) List of costs that should be assigned to job number 123
(1) Kilos Rs
Material Y:
Opening stock 1,050 529.75
Purchases 600 300.00
500 250.00
400 208.00
2,550 1,287.75
Weighted average price = Rs 1, 287. 75 = Rs 0.505

2,550
Value of material issued to this job: 400 kilos @ Rs 0.505 = Rs 202.00
(2)
Department A labour: 76 hours @ Rs 4.50 = Rs 342.00
It is assumed that the overtime is not worked at the specific request of the
customer for Job 123 and hence the premium has been exclude from direct cost
and therefore included in production overhead.

(3)
Kilos Value
Rs
Material Z 6,970 9,946.50
16,000 23,360.00
22,970 33,306.50
Weighted average price =Rs 33,306.50 = Rs1.45

22,970
Value of material issued to this job: (300 - 35) x Rs 1.45 = 384.25
Rs 384.25
(4)
Department B labour: 110 hours @ Rs 4 = Rs 440.00
The cost of the overtime premium should be charged as a direct cost to the other
customer's jobs.
Carried forward Rs 1,368.25

Brought forward Rs 1,368.25
(5)
Production overhead:
Dept A Dept B
Rs Rs
Amount incurred:
Indirect labour 2,510 2,960

Overtime premium* 450 –
Lubricants and cleaning compounds 520 680
Maintenance 720 510
Other 1,200 2,150
5,400 6,300
* Overtime premium in department B is a direct cost of a specific job.

Overhead recovery rate:
Actual overhead = Rs 5, 400 Rs 6,300
Actual labour hours 2,000 2,800
= Rs 2.70 per = Rs 2.25 per

labour hour abour hour
Production overhead absorbed by Job number 123:

Department A: 76 hours @ Rs 2.70 Rs 205.20
Department B: 110 hours @ Rs 2.25 Rs 247.50
Cost of Job No.123 Rs ,820.95
(b)
The cost of individual jobs may be used in the following ways:
(i) The estimated cost can be calculated in advance in order to provide a basis
for fixing the selling price. In this case it would be necessary to use a
predetermined overhead absorption rate.
(ii) The estimated budgeted cost can be used as a guideline while the work is
being carried out so as to try to ensure that actual costs are kept within the
original estimate.
(iii) The actual cost of jobs can be used for valuing work-in-progress stock if the
job is on hand at the end of the accounting period.
(iv) The actual cost can be compared with the estimated cost in order to identify
variances on individual cost items. This should help to control costs and to
improve the quality of future estimates.
(v) Actual cost can be compared with the selling price of the job in order to
assess profitability of the job.

 Nature of services
 Characteristics of services
 Service Costing
 Understanding of cost units and cost per unit in services

1 The nature of service costing
Service costing is used when an organisation or department provides a service.

There are four main differences between the ‘output’ of service industries and the
products of manufacturing industries. These differences can also be regarded as
characterstics of services businesses.
 Intangibility – output is in the form of ‘performance’ rather than tangible

(‘touchable’) goods.
 Heterogeneity – the nature and standard of the service will be variable due to the
high human input.
 Simultaneous production and consumption – the service that you require cannot
be inspected in advance of receiving it. Or we can say that services are consumed
as they are received by the service provider.
 Perishability – the services that you require cannot be stored.
 No transfer of ownership – In services the customer is not entitled for any

ownership in exchange of services payments e.g. If we travel by air we pay for
travelling and we will not be entitled to any ownership of plane seat or anything
like headphone etc. for the payment made by us. Where as in case of tangible
products we are the owners of those products as we paid for those.
Example 1 – The nature of service and operation costing

Examples of service industries include the following:
 hotel
 college
 hairdressers
 restaurant
We can ask the following questions about, e.g. the hotel industry.
(1) Is output in the form of performance? Yes – the hotel provides a bed and possibly
breakfast. You will judge the service of the hotel on how comfortable the bed was and
how tasty the breakfast was. You cannot really ‘touch’ the performance of the
hotel.
(2) Is the standard of the service variable? Yes – your stay at the hotel may vary
each time you stay there. You may not have such a comfortable bed and your

breakfast may not be very tasty each time you visit. The standard of service is herefore
variable because lots of different staff work at the hotel – the standard of the
service you receive may depend on which staff are on duty.
(3) Can you inspect the services in advance of receiving them? In general, you
cannot sleep in a hotel bed or eat breakfast at the hotel until you have booked in and made
a contract to buy the services of the hotel.
(4) Can the hotel services be stored? No! You cannot take your bed away with
you, nor can you keep your breakfast – it must be eaten during the morning of
your stay.

List as many service industries that you can think of.
2 Suitable unit cost measures for service costing
Unit cost measures for service costing

One of the main difficulties in service costing is the establishment of a suitable cost unit.
In some situations it may be necessary to calculate a composite cost unit.
 A composite cost unit is more appropriate if a service is a function of two

variables.
 Examples of composite cost units are as follows:
– tonne-miles for haulage companies

– patient-days for hospitals
– passenger-miles for public transport companies
– guest-days for hotel services
 Alternatively, service organisations may use several different cost units to

measure the different kinds of service that they are providing.
 The following cost units might be used by a hotel:
Service Cost unit

Restaurant Meals served
Function facilities Hours

Cost per service unit
The total cost of providing a service will include labour, materials, expenses and
overheads (the same as the costs associated with the products produced in
manufacturing industry).
Rs
Direct materials X
Direct labour X
Direct expenses X
Overheads absorbed X
–––
TOTAL COST XX
 In service costing, it is not uncommon for labour to be the only direct cost
involved in providing a service and for overheads to make up most of the
remaining total costs.
 In service costing it is sometimes necessary to classify costs as being fixed,
variable or semi-variable. If costs are semi-variable, it is necessary to separate
them into their fixed and variable constituents using the high/low method.
 The cost per service unit is calculated by establishing the total costs involved in
providing the service and dividing this by the number of service units used in
providing the service.
 The calculation of a cost per service unit is as follows.
Total costs for providing

the service
Cost per service unit = –––––––––––––––––––––––––
Number of service units used
to provide the service
Example 2 – Suitable unit cost measures for service/operation

The canteen of a company records the following income and expenditure
for a month.
Rs Rs
Income 59,010
Food 17,000
Drink 6,000
Bottled water 750
Fuel costs (gas for cooking) 800
Maintenance of machinery 850
Repairs 250
Wages 15,500
Depreciation 1,000
During the month the canteen served 56,200 meals.

Required:
Calculate the average cost per meal served and the average income per meal
served.
Solution
Total canteen expenditure in month = Rs 42,150
Total meals served in the month = 56,200
Rs 42,150
Average cost per meal served = ––––––– = Rs 0.75 per meal
56,200
Rs 59,010
Average income per meal = ––––––– = Rs 1.05 per meal
56,200

Which of the following are characteristics of service costing?
(i) High levels of direct labour costs as a proportion of total cost.

(ii) Use of composite cost units.
(iii) Use of equivalent units.
A (i) only
B (i) and (ii) only
C (ii) only
D (ii) and (iii) only
3 Collection, classification and ascertainment of costs
Costs will be classified under appropriate headings for the particular service. This
will involve the issue of suitable cost codes to be used in the recording and,
therefore, the collection of costs. For a transport undertaking the main cost
classification may be based on the following activities:
(a) operating and running the fleet

(b) repairs and maintenance
(c) fixed charges
(d) administration
Within each of these there would need to be a sub classification of costs, each
with its own code, so that under (c) fixed charges, there might appear the following
breakdown:

 road fund licences
 insurances
 depreciation
 vehicle testing fees
 others
In service costing it is often important to classify costs into their fixed and variable
elements. Many service applications involve high fixed costs and the higher the
number of cost units the lower the fixed costs per unit. The variable cost per unit
will indicate to management the additional cost involved in the provision of one
extra unit of service. In the context of a transport undertaking, fixed and variable
costs are often referred to as standing and running costs respectively.
4 Cost sheets for service industries
At appropriate intervals (usually weekly or monthly) cost sheets will be prepared

by the costing department to provide information about the appropriate service to
management. A typical cost sheet for a service would incorporate the following for
the current period and the cumulative year to date:
(a) Cost information over the appropriate expense or activity headings
(b) Cost units statistics
(c) Cost per unit calculations using the data in and dividing by the data in
(d) Different cost units may be used for different elements of costs and the same
cost or group of costs may be related to different cost unit bases to provide
additional control information to management. In the transport organisation,
for example, the operating and running costs may be expressed in per mile
and per day terms
(e) Analyses based on the physical cost units. On a transport cost sheet, the
following non-cost statistics may be shown:
(i) average miles covered per day

(ii) average miles per gallon of fuel

5 Service cost accounting statements
5.1 Introduction
These reports are derived from the cost sheets and other data collected. Usually
costs are presented as totals for the period, classified often into fixed and variable
costs. The next section illustrates how such statements would be prepared for a
number of difference service organisations.
5.2 Power supply industry

Example 3: cost statement
The following figures were taken from the annual accounts of two electricity supply
boards working on uniform costing methods. Meter reading, billing and collection
costs:
Board A Board B
Rs 000 Rs 000
Salaries and wages of:
 Meter reading 150 240
 Billing and collection 300 480
Transport and travelling 30 40
Collection agency charges – 20
Bad debts 10 10
General charges 100 200
Miscellaneous 10 10
600 1,000
Units sold (millions) 2,880 9,600
Number of consumers 800 1,600
(thousands)
Sales of electricity (millions) Rs18 Rs50
Size of area (square miles) 4,000 4,000
Prepare a comparative cost statement using suitable units of cost. Brief notes
should be added, commenting on likely causes for major differences in unit costs
so disclosed.

Solution
Electricity Boards A and B
Comparative costs – year ending ....
Board A Board B
Rs 000 % of Rs 000 % of total
total
Salaries and wages:
 Meter reading 150 25.0 240 24.0
 Billing and 300 50.0 480 48.0
collection
Transport/travelling 30 5.0 40 4.0
Collection agency – – 20 2.0
Bad debts 10 1.7 10 1.0
General charges 100 16.6 200 20.0
Miscellaneous 10 1.7 10 1.0
600 100.0 1,000 100.0
Rs Rs
Cost per:
Millions units sold 208 105
Thousand consumers 750 625
Rsm of sales 33,333 20,000
Square mile area 150 250
Possible reasons for unit cost differences include:
(a) Area density. B covers the same size of area but has double the number of
consumers, indicating that B is a more urban territory.
(b) Industrialisation. Costs per unit are almost twice as high for A but the
pattern is not continued for costs in relation to sales value. B, therefore,
probably contains a higher proportion of industrial consumers at cheaper
rates.
(c) Territory covered. Comparative costs per square mile deviate from the
pattern shown by the other measurement units, confirming that the bulk of
costs is incurred in relation to consumers and usage.

5.3 Transport operations
Example 4
Remix Ltd makes ready-mixed cement and operates a small fleet of vehicles that
delivers the product to customers within its delivery area.
General data
Maintenance records for the previous five years reveal:
Year Mileage of Maintenance

vehicles cost
Rs
1 170,000 13,500
2 180,000 14,000
3 165,000 13,250
4 160,000 13,000
5 175,000 13,750
Transport statistics reveal:
Vehicle Number of Average tonnage Average

journeys carried to distance To
each day customers customers
Tonnes miles
1 6 4 10
2 4 4 20
3 2 5 40
4 2 6 30
5 1 6 60
There are five vehicles operating a five-day week, for fifty weeks a year. Inflation
can be ignored.Standard cost data include: Drivers' wages are Rs 150 each per
week. Supervisor/relief driver's wage is Rs 200 per week. Depreciation, on a
straight-line basis with no residual value.
Cost Life
Loading equipment Rs 100,000 5 years
Vehicles Rs 30,000 each 5 years
Petrol/oil costs 20 paisa per mile.

Repairs cost 7½ paisa per mile.
Vehicle licences cost Rs 400 pa for each vehicle.
Insurance costs Rs 600 pa for each vehicle.
Tyres cost Rs 3,000 pa in total.
Miscellaneous costs, Rs 2,250 pa in total.
You are required to calculate a standard rate per tonne/mile of operating the
vehicles.
Solution
Calculation of standard rate per tonne/mile:
Running costs
Rs Rs
Maintenance costs (W1) 0.05
Petrol/oil 0.20
Repairs cost 0.075
______
0.325
______
Total per annum: Rs 0.325 x 170,000 (W2) 55,250
Sundry costs
Maintenance fixed costs (W1) 5,000
Drivers' wages: Rs 150 x 52 x 5 39,000
Supervisor/relief driver: Rs 200 x 52 10,400
Depreciation of loading equipment:
Rs 100,000 / 5 20,000
Depreciation of vehicles (Rs 30,000 x 5) / 5 30,000
Vehicle licences Rs 400 x 5 2,000

Insurance: Rs 600 x 5 3,000
Tyres 3,000
Miscellaneous costs 2,250 114,650
169,900
Therefore, standard rate per tonne/mile = Rs 169,900

420,000 (W3)
= Rs 0.4045 per tonne/mile

Workings
(W1) Maintenance cost, separation of fixed and variable element using
high/low method:
Mileage Maintenance
cost
Rs
High 180,000 14,000
Low 160,000 13,000
Variable cost 20,000 1,000
Variable/running cost per mile =Rs 1, 000 = Rs 0.05 per mile

20,000
Total cost = Total fixed cost + (Variable cost per mile x Number of miles)
Rs 14,000 = Total fixed cost + (Rs 0.05 x 180,000)
Total fixed cost = Rs 14,000 – Rs 9,000 = Rs 5,000
(W2) Distance travelled
Vehicle miles
1 6 x 10 x 2 = 120
2 4 x 20 x 2 = 160
3 2 x 40 x 2 = 160
4 2 x 30 x 2 = 120
680 x 5 days x 50 weeks
= 170,000 miles
(W3) Number of tonne/miles

Vehicle Tonne/miles
1 6 x 4 x 10 = 240
2 4 x 4 x 20 = 320
3 2 x 5 x 40 = 400
4 2 x 6 x 30 = 360
1,680 x 5 days x 50 weeks
= 420,000 tonne miles
6 Comparison of manufacturing and service costing
6.1 The nature of a service product
Four key differences can be identified between the products of service industries
and those of a manufacturing business.

 Intangibility – the output is in the form of performance rather than physical
(tangible) goods. As we have seen, this means that it is quite difficult to define
a unique cost unit that will serve for cost control purposes.
 Heterogeneity – the nature and standard of the output will be variable, due to
the high human input. Heterogeneous means 'consisting of elements that are
not of the same kind or nature' e.g. you may get a completely different
standard of service from two different waiters in the same restaurant (or from
the same waiter on different nights). Thus it is difficult to come up with a
standard cost that is meaningful for all the units of service.
 Simultaneous production and consumption – which precludes advance

inspection of the product to ensure it meets a given specification or quality
level. Thus a lot more attention must be paid to the quality of the inputs, i.e.
staff should be properly trained and customers’ requirements should be
properly understood.
 Perishability – stocks of the product cannot be held to cover periods of

unexpectedly high levels of demand; similarly once the opportunity forsale has
passed, it may be lost forever. If a cinema seat for a particularfilm is not sold,
for example, that is revenue that is permanently for gone.
6.2 Differences between manufacturing and service cost statements
Looking back at the cost statement for the power supply industry you can see that
this is very different to the sort of statement we have been used to dealing with in
the manufacturing environment. The main difference between manufacturing and
service cost statements may be identified as:
 The lack of a 'flexed budget' – As it is difficult to define a single cost unit to

which costs would be expected to accrue in any clear relationship, it is very
difficult to predict 'expected costs'. In most cases, the original, fixed budget,
would be used for comparison. Where a predominant activity measure can be
identified, however, a flexed budget approach may well be possible – for
example in an hotel, where room occupancy rate may be used, or in a
restaurant, using meals served as an activity measure.
 The lack of detailed variance analysis – Variances, if shown, will generally

be of a simple expenditure type, comparing actual total cost with a fixed
budget cost. More detailed analysis may be difficult, again due to the lack of
a clear cost unit.

 The lack of stock figures – Due to the perishability of the service product,
no significant stocks will be held. This eliminates the need for stock valuation
policies.
The inclusion of a variety of performance measures – A service industry will

use a variety of cost control indicators, along the lines of cost ratios using various
cost units as a basis. Quality measures, such as customer complaints, new
accounts gained or lost, speed of response to customer needs, etc. will also be of
particular importance to a service based business.
Summary
This chapter has considered the last of the three specific order-costing methods,
contract costing. We considered how costs are attributed to contracts, and how
profit may be recognised in the profit and loss account part way through the
contract period.
We looked at the particular aspects of service costing, where there is rarely one
cost unit that can be used for all planning and control purposes. We contrasted the
nature of a service business with that of manufacturing concern, and looked at
how this affects the way in which cost information is reported. By the time you
have finished this chapter you should be able to prepare and contrast cost
statements for service and manufacturing organisations.

Self-test questions
Service costing methods
1 Give two examples of service industries. (4.1)
2 Explain what is meant by a composite cost unit, giving two examples. (4.2)
Comparison of manufacturing and service costing
3 What are the four main differences between the product of a service
business and that of a manufacturer? (6.1)

Answer: Test your understandings

Here are a few. You may have thought of others. Don’t forget to ask questions 1-4
above if you are unsure whether it is appropriate to classify an industry as being
a service industry:
 hotel
 airline, train and bus companies
 hairdressers
 taxi company
 college/university
 firm of accountants/auditors
 distribution company
 utility company (gas/electricity/telephone)
 banks
 insurance companies
 hospitals

B
Direct labour costs may be a high proportion on the total cost of providing a service
and composite cost units are characteristic features of service costing. (i) and
(ii) are therefore applicable and the correct answer is B.

 The basics of process costing

 Losses in process costing
 Losses with scrap value
 Losses with a disposal cost
 Valuing closing work in progress
 Valuing opening working in process: FIFO method
 Valuing opening working in process: weighted average cost method
 Joint products and by-products
 Dealing with common costs
 Joint products in process accounts
 Accounting for by products

1 Costing systems
Job and batch costing are the costing system used when the work done by an
organisation consists of separately identifiable jobs or batches. (Job & batch
costing already discussed in previous chapter.) Process costing is the costing
method used when goods are produced as a direct result of a sequence of
continuous operations or processes.
2 Process costing
Introduction
As discussed in chapter 9, Process costing is a costing method used when mass
production of many identical products takes place, for example, the production of
bars of chocolate, cans of soup or tins of paint. It is an example of continuous
operation costing. One of the distinguishing features of process costing is that all
the products in a process are identical and indistinguishable from each other. For
this reason, an average cost per unit is calculated for each process.
Average cost per unit = Net costs of inputs

Expected output
Net costs of inputs = Cost incurred for Inputs – scrap value of normal loss +
Disposal value of normal loss
Expected output = Input units – Normal loss units
Expected output is what we expect to get out of the process. Another main feature
of process costing is that the output of one process forms the material input of the
next process.

Also, where there is closing work-in-progress (WIP) at the end of one period his
forms the opening WIP at the beginning of the next period. The details of process
costs and units are recorded in a process account which shows (in very general
terms) the materials, labour and overheads input to the process and the
materials output at the end of the process
Unit Rs Unit Rs
Input transferred 1000 24000
from process 1
Additional raw 5000 Output 1000 ?
materials transferred to
process 3
Direct labour 4000
Departmental 3000
overhead
1,000 36,000 1,000 ?
Example 1 – A process account

Calculate the average cost per unit in Process 2 and complete the Process 2
Account shown above.
Solution
Net costs of input
Average cost per unit = ––––––––––––––
Expected output
Net costs of input= Rs 24,000 + Rs 5,000 + Rs 4,000 + Rs 3,000= Rs 36,000
Expected output = 1,000 units

Rs 36,000
Average cost per unit in Process 2 = ––––––––––– = Rs 36 per unit
1,000
Process 2 Account
Unit Rs Unit Rs
Input transferred 1000 24000
from process 1
Additional raw 5000 Output 1000 36,000
materials transferred to
process 3
Direct labour 4000
Departmental 3000
overhead
1,000 36,000 1,000 36,000
Note that the units completed in Process 1 form the opening WIP in Process 2
and that the units completed in Process 2 form the opening WIP in Process 3.
3 Process costing with losses and gains
Normal losses
Sometimes in a process, the total of the input units may differ from the total of
the output units.
 Losses may occur due to the evaporation or wastage of materials and this
may be an expected part of the process.
 Losses may sometimes be sold and generate revenue which is generally

referred to as scrap proceeds or scrap value.
 Normal loss is the loss that is expected in a process and it is often expressed
as a percentage of the materials input to the process.
Example 2 – Process costing with normal losses

The following data relates to Process 1.
Materials input – 1,000 units costing Rs 10,000

Labour costs – Rs 8,000
Departmental overheads – Rs 6,000
Normal loss is 4% of input.
Calculate the average cost per unit:

Net cost of inputs
Average cost per unit = ——————————
Expected output
Where:
Net cost of inputs = Rs 24,000
Units input = 1,000 units
Normal loss = 4% of 1,000 units = 40 units
Therefore expected output is 1,000 units – 40 units = 960 units
Rs 24,000
Average cost per unit = –––––––––– = Rs 25 per unit
960
Process 1 Account
Unit Rs Unit Rs
Raw materials 1000 10,000 Normal loss 40 0
Direct labour 8,000 Transferred to 960 24,000
finished goods
(W3)
Departmental 6,000
overhead
1,000 24,000 1,000 24,000
Normal loss and scrap value

If normal loss is sold as scrap the revenue is used to reduce the input costs of the
process.
(1) If normal loss is sold as scrap then the formula for calculating the average
cost of the units output does not really change – simply the costs of inputs
are reduced by the revenue received from the scrap that is sold i.e. giving
the net cost.
Net cost of inputs

Average cost per unit = –––––––––––––––
Expected output
Total cost of inputs – Scrap value of normal loss
Average cost per unit = ––––––––––––––––––––––––––––––––––––––
Expected output
(2) If normal loss has a scrap value, it is valued in the process account at this
value.
(3) If normal loss does not have a scrap value, it is valued in the process
account as Rs Nil.

Example 3 – Process costing with normal losses and scrap

Normal loss is 4% of input and is sold as scrap for Rs 12 per unit.
Required:
Calculate the average cost per unit in Process 1 and produce the process account
and the scrap account.
Solution
Average cost per unit in Process 1 (W2) = Rs 24.50
Process 1 Account
Unit Rs Unit Rs
Direct labour 8,000 Transferred to 960 23,520
finished goods
(W3)
Departmental 6,000
overhead
1,000 24,000 1,000 24,000
Scrap Account
Rs. Rs. .
Process 1 (W1) 480 Cash 480
480 480
––––

Workings
(W1)
Normal loss = 4% x 1,000 = 40 units
Scrap value of normal loss = 40 x Rs 12 = Rs 480
This amount is debited to the scrap account and credited to the process account
and used to reduce the cost of inputs to the process.
(W2)
Net costs of input

Expected output
Rs 24,000 – Rs 480 (W1)

Average cost per unit = –––––––––––––
1,000 – 40 (W1)
Rs 23,520
= ––––––– = Rs 24.50 per unit
960
(W3)
Units transferred to finished goods are valued at the average cost per unit, Rs
24.50.
Value of goods transferred = 960 × Rs 24.50 = Rs 23,520
Abnormal losses and gains

Normal loss is the expected loss in a process. Normal gain is the expected gain in
a process. If the loss or the gain in a process is different to what we are expecting
(i.e. differs from the normal loss or gain), then we have an abnormal loss or an
abnormal gain in the process.
 The costs of abnormal losses and gains are not absorbed into the cost of good
output but are shown as losses and gains in the process account.
 Abnormal loss and gain units are valued at the same cost as units of good
output.

Example 4 – Process costing with abnormal losses
Materials input = 1,000 units costing Rs 10,000
Labour costs = Rs 8,000
Departmental overheads = Rs 6,000
Normal loss is 4% of input which cannot be sold.
Actual output = 944 units
Required: Calculate the average cost per unit in Process 1 and produce the
process account and the abnormal gains and losses account.
Solution
Process 1 Account
Unit Rs Unit Rs
Direct labour 8,000 Abnormal loss 16 400
(W1)
Departmental 6,000 Transferred to 944 23,600
overhead finished goods
(W3)
1,000 24,000 1,000 24,000
Abnormal gain and loss Account
Rs. Rs.
Process 1 (W3) 400 Cash 400
400 400

Workings:
(W1)
(W2)
Net costs of input
Expected output
Rs 24,000
Average cost per unit = –––––––––––
1,000 – 40
Rs 24,000
= ––––––– = Rs 25.00 per unit
960
(W3)
Abnormal loss = expected output – actual output = 960 – 944 = 16 units
Abnormal loss is valued at the same cost as good output, i.e. Rs 25.00 per unit.
Abnormal loss value = 16 x Rs 25.00 = Rs 400
(W4)
Value of units transferred to finished goods = 944 x Rs 25.00 = Rs 23,600
Example 5 – Process costing with abnormal losses and scrap

Materials input = 1,000 units costing Rs 10,000

Normal loss is 4% of input and is sold as scrap for Rs 12 per unit.
Required:
Calculate the average cost per unit in Process 1 and produce the process
account, abnormal gains and losses account and the scrap account.

Solution
Process 1 Account
Unit Rs Unit Rs
Raw materials 1000 10,000 Normal loss (W1) 40 480
Direct labour 8,000 Abnormal loss 16 392
(W3)
(W4)
1,000 24,000 1,000 24,000
Rs. Rs.
Process 1 (W3) 392 Scrap (16 × Rs. 12) 192
Income Statement 200
392 392
Scrap Account
Rs. Rs.
Process 1 (W3) 480 Cash (56 × Rs. 12) 672
(Normal Loss)
Abnormal gain and Loss 192
672 672

Workings:
(W1)
(W2)
Net costs of input

Average cost per unit = –––––––––––––––––––––––
Expected output
Rs 24,000 – Rs 480(W1)
Average cost per unit = ––––––––––––––––––
1,000 – 40 (W1)
Rs 23,520
= ––––––– = Rs 24.50 per unit
960
(W3)
Abnormal loss = expected output – actual output = 960 – 944 = 16 units
Abnormal loss is valued at the same cost as good output, i.e. Rs 24.50 per unit
(W4)
Example 6 – Process costing with abnormal gains

Normal loss is 4% of input which cannot be sold.
Required:
account and the abnormal gains and losses account.

Solution
Process 1 Account
Unit Rs Unit Rs
Direct labour 8,000
Abnormal gain 20 5,000 (W1)
1,020 24,500 1,020 24,500
Rs. Rs.
Income Statement 500 Process 1 (W3) 500
500 500
Workings:
(W1)
(W2)
Net costs of input
Average cost per unit = –––––––––––––
Expected output
Rs 24,000
Average cost per unit = –––––––––––
1,000 – 40
Rs 24,000
= ––––––– = Rs 25.00 per unit
960

(W3)
Actual output= 980 units
Abnormal = expected output – actual output = 960 – 980 = 20 gain units

Abnormal gain is valued at the same cost as good output, i.e. Rs 25.00 per unit.
(W4)
Example 7 – Process costing with abnormal gains and scrap
Materials input = 1,000 units costing Rs10,000
Normal loss is 4% of input which can be sold for Rs 12 per unit.
Required:
account, abnormal gains and losses account and the scrap account.
Solution
Process 1 Account
Unit Rs Unit Rs
Direct labour 8,000
Abnormal gain 20 490 (W4)
1,020 24,490 1,020 24,490

Rs. Rs.
Scrap (20 × Rs. 12) 240 Process 1 (W3) 490

Income Statement 250
490 490
Scrap Account
Rs. Rs.
Process 1 (W3) 480 Cash (56 × Rs. 12) 240
(Normal Loss) 240 Abnormal gain and Loss 192
480 480
Workings:
(W1)
(W2)
Net costs of input
Expected output
Rs 24,000 – Rs 480(W1)
Average cost per unit = ––––––––––––––––––
1,000 – 40 (W1)
Rs 23,520
= –––––––– = Rs 24.50 per unit
960
(W3)
Actual output= 944 units
Abnormal gain = expected output – actual output = 960 – 980 = 20 units

Abnormal loss is valued at the same cost as good output, i.e. Rs 24.50 per unit
(W4)
Suggested approach for answering normal loss, abnormal loss/gain
questions
(1) Calculate any normal loss units (forms part of the output units)
(2) Draw the process account and enter the units or produce a flow of units
(Input units = output units). The balancing figure for the units is either
an abnormal loss or gain.
(3) Value the inputs.
(4) Value the normal loss (if any).
(5) Calculate the average cost per unit:
Net costs of input
––––––––––––––––
Expected output
(6) Value the good output and abnormal loss or gain at this average cost per
unit.

W&B Ltd produce a breakfast cereal that involves several processes. At each
stage in the process, ingredients are added, until the final stage of production
when the cereal is boxed up ready to be sold.
In Process 2, W&B Ltd have initiated a quality control inspection. This inspection
takes place BEFORE any new ingredients are added in to Process 2.The
inspection is expected to yield a normal loss of 5% of the input from Process 1.
These losses are sold as animal fodder for Rs. 1 per kg.
The following information is for Process 2 for the period just ended:
Units Rs
Transfer from Process 1 500 kg 750
Material added in Process 2 300 kg 300
Labour 200 hrs 800
Overheads – 500
Actual output 755 kg –
Prepare the process account, abnormal loss and gain account, and scrap

account for Process 2 for the period just ended.
4 Work-in-progress (WIP) and equivalent units (EUs)
WIP
At the end of an accounting period there may be some units that have entered a
production process but the process has not been completed. These units are
called closing work in progress (or WIP) units.
 If we assume that there is no opening WIP, then the output at the end of a
period will consist of the following:
 fully processed units

 Part processed units (closing WIP).
 Closing WIP units become the opening WIP units in the next accounting
period.
 It would not be fair to allocate a full unit cost to part processed units and so
we need to use the concept of equivalent units (EUs) which spreads out the
process costs of a period fairly between the fully- processed and part
processed units.
Concept of EUs
Process costs are allocated to units of production on the basis of EUs.
 The idea behind this concept is that a part processed unit can be
expressed as a proportion of a fully completed unit. We can say that an
equivalent unit is a notional whole unit which is assumed to be completed
in a process in a period.
 For example, if 100 units are exactly half-way through the production
process, they are effectively equal to 50 fully completed units. Therefore
the 100 part processed units can be regarded as being equivalent to 50
fully completed units or 50 EUs.
Example 8 – WIP and EUs

For process 1 in ABC Co the following is relevant for the latest period:
Period costs Rs 4,440

Input 800 units
Output 600 fully worked units and 200 units only 70% complete
There were no process losses.

Required:
Produce the process account
Solution
Statement of EUs
Outp % EUs
Fully worked units ut
600 100% 600
Closing WIP 200 70% 140
Total 800
Costs 740
Rs 4,440
Cost per EU Rs 6
Cost per EU = Rs 4,440/740 units = Rs 6 per unit

The Process 1 account can be completed as follows:
Process 1 Account
Unit Rs Unit Rs
Input 800 4,440 Transferred to 600 3,600
finished goods
(600 x Rs. 6)
WIP (140) 200 840
800 4,440 800 4,440
Different degrees of completion
For most processes the material is input at the start of the process, so it is only
the addition of labour and overheads that will be incomplete at the end of the
period.
 This means that the material cost should be spread over all units, but
conversion costs should be spread over the EUs.
 This can be achieved using an expanded Statement of EUs which separates
out the materials and labour costs.
 Note that the term conversion costs are often used to describe the addition of
labour and overheads together in a process.

Example 9 – WIP and EUs
For Process 1 in LJK Ltd the following is relevant for the latest period:
Material costs 500 units @ Rs 8 per unit

Labour Rs 2,112
Overheads 150% of labour cost
Output: 400 fully worked units, transferred to Process 2. 100 units
Only 40% complete with respect to conversion, but 100% complete with respect to
materials.
Required:
Produce the process account
Solution
The value of fully worked units and WIP are calculated as follows:
Statement of EUs
Output Materials Conversion

% EUs % EUs
Fully worked units 400 100% 400 100% 400
WIP 100 100% 100 40% 40
Total 500 500 440
Costs Rs 4,000 Rs (2,112+ 3,168)
= Rs 5,280
Cost per EU Rs 8 Rs 12
The value of fully worked units is (W1) Rs 8,000
The value of WIP is (W2) Rs 1,280
Workings
(W1) Fully worked units are valued at Rs 20 per unit (Rs 8 + Rs 12).
400 x Rs 20 = Rs 8,000

(W2) WIP is valued as follows:
Materials 100 units x Rs 8 = Rs 800
Conversion 40 units x Rs 12 = Rs 480
Total WIP value = Rs 800 + Rs 480 = Rs 1,280

A firm operates a process costing system. Details of Process 2 for Period 1 are
as follows.
During the period 8,250 units were received from the previous process at a value
of Rs 453,750, labour and overheads were Rs 350,060 and material introduced
was Rs 24,750.
At the end of the period the closing WIP was 1,600 units which were 100%
complete in respect of materials, and 60% complete in respect of labour and
overheads. The balance of units was transferred to Finished goods.
There were no opening WIP or process losses.
Calculate the cost per EU, the value of finished goods and closing WIP.
Statement of EUs
% EUs %EUs
Fully worked
Closing WIP
Total units
Costs:
Total cost
Cost per EU
The value of finished goods is Rs
The value of WIP is Rs

5 Opening work in progress
Until now, we have assumed that there has been no opening WIP. In reality, this
is unlikely to be the case.
 Work remaining in process (WIP) and transfers out of a process (fully

completed units) can be valued on different bases: weighted average method
and the FIFO method.
 These methods are similar to the valuation methods studied when we looked
at materials in an earlier chapter.
5.1 Weighted average costing of production
 In the weighted average method opening inventory values are added to

current costs to provide an overall average cost per unit.
 No distinction is made between units in process at the start of a period and

those added during the period.
Example 10 – Weighted average costing of production
BR Ltd makes a product requiring several successive processes.
Details of the first process for August are as follows:
Opening WIP: 400 units
Degree of completion:
Materials (valued at Rs 19,880) 100 %

Conversion (valued at Rs 3,775) 25 %
Units transferred to Process 2 1,700 units
Closing WIP 300 units

Materials 100 %
Conversion 50 %
Costs incurred in the period:
Material Rs 100,000
Conversion Rs 86,000
Required:
Prepare the process account for August using the weighted average method.
Solution
Process 1 Account
Unit Rs Unit Rs
Opening WIP 400 23,655 Transferred to 1,700 184,394
Materials 1600 100,000 process 2
Conversion 86,000
Closing WIP 300 25,261
2,000 209,655 2,000 209,655
Statement of EUs

% EUs % EUs
Transferred 1,700 100% 1,700 100% 1,700
to Process 2
Closing WIP 300 100% 300 50% 150
Total units 2,000 2,000 1,850
Costs: 19,880 3,775
Opening
WIP
Period 100,000 86,000
Total cost 119,880 89,775
Cost per EU Rs 59.94 Rs 48.527

Valuation of transfers to Process 2:
Materials = (1,700 x Rs 59.94) = Rs 101,898

Conversion = (1,700 x Rs 48.527) = Rs 82,496
Total = Rs 184,394
Valuation of Closing WIP:
Materials = (300 x Rs 59.94) = Rs 17,982

Conversion = (150 x Rs 48.527) = Rs 7,279
Total = Rs 25,261

A business makes one product that passes through a single process. The
business uses weighted average costing. The details of the process for the last
period are as follows:
Materials Rs 98,000
Labour Rs 60,000
Production overheads Rs 39,000
Units added to the process 1,000
There were 200 units of opening WIP which are valued as follows:
Materials Rs 22,000
Labour Rs 6,960
Production overheads Rs 3,000
There were 300 units of closing WIP fully complete as to materials but only 60%
complete for labour and 50% complete for overheads.
Calculate the following:
(a) The value of the completed output for the period.

(b) The value of the closing WIP.

5.2 FIFO costing of production
In the weighted average method opening inventory values are added to current
costs to provide an overall average cost per unit. With FIFO, opening WIP units
are distinguished from those units added in the period.
 With FIFO it is assumed that the opening WIP units are completed first.
 This means that the process costs in the period must be allocated between:
 opening WIP units

 units started and completed in the period (fully worked units)
 closing WIP units.
 This also means that if opening WIP units are 75% complete with respect to
materials and 40% complete with respect to labour, only 25% ‘more work’ will
need to be carried out with respect to materials and 60% with respect to
labour.
 This is a very important point to remember when calculating the EUs of

materials and conversion costs and is demonstrated in the following example.
Example 11 – FIFO costing of production

BR Ltd makes a product requiring several successive processes.
Details of the first process for August are as follows:
Opening WIP: 400 units
Materials (valued at Rs 19,880) 100%
Conversion (valued at Rs 3,775) 25%
Units transferred to Process 2 1,700 units
Closing WIP 300 units

Materials 100%
Conversion 50%
Costs incurred in the period:
Material Rs 100,000
Conversion Rs 86,000
Required:
Prepare the process account for August using the FIFO method.
Solution
Process 1 Account
Unit Rs Unit Rs
Opening WIP 400 23,655 Transferred to 1,700 183,534
Materials 1600 100,000 process 2
Conversion 86,000
Closing WIP 300 26,121
2,000 209,655 2,000 209,655
Statement of EUs
Materials Conversion
Output
% EUs % EUs
Opening WIP 400 0 0 75 300

completed
Fully worked in 1,300 100 1,300 100 1,300
process
Closing WIP 300 100 300 50 150
Total 2,000 1,600 1,750
Costs (Rs) 100,000 86,000
Cost per EU 62.50 49.143

Value of units passed to Process 2:
Opening WIP value from last period = Rs 19,880 + Rs 3,775 = Rs 23,655
Opening WIP completed this period:
Conversion only = 300 x Rs 49.143 = Rs 14,743
Fully worked current period
Materials = 1,300 x Rs 62.50 = Rs 81,250
Conversion = 1,300 x Rs 49.143 = Rs 63,886
Total = Rs 145,136
Total value of units transferred to next process = Rs 183,534
Additional notes for solution to Example
Materials
Units transferred to Process 2 1,700
Closing WIP 300
Opening WIP (400)
–––––
Material units added in period 1,600
–––––
Of the 1,600 units added in the process, 1,300 (units added less closing
WIP) were started and finished in the period.
Opening WIP
Note that the opening WIP is 100% complete with respect to materials and
therefore no further work or costs are involved in completing the opening WIP
units.
Similarly, the opening WIP is 25% complete with respect to conversion costs and
therefore 75% of the conversion work/costs are still outstanding.
Costs to complete opening WIP and fully worked units

Each unit started and finished in the period costs Rs (62.50 + 49.143) = Rs
111.643
1,300 units were fully worked in the process = 1,300 x Rs 111.643 = Rs 145,136
Costs to complete 400 units of opening WIP = 300 units (conversion EUs) x Rs
49.143 = Rs 14,743

Costs to complete units transferred to Process 2
Cost of completing 1,700 units (1,300 fully worked plus 400 opening
WIP) = Rs 145,136 + Rs 14,743 = Rs 159,879
Total cost of units transferred to Process 2 = cost of completing 1,700 units plus
costs already incurred in opening WIP, i.e. Rs (19,880 + 3,775) = Rs 23,655
Therefore, cost of 1,700 units transferred to Process 2 = Rs 159,879 + Rs 23,655

= Rs 83,534
Value of closing WIP

Value of closing WIP = 300 EUs x Rs 62.50 = Rs 18,750 (materials) plus
150 x Rs 49.143 = Rs 7,371.45 = Rs 26,121.45

AXL Ltd operates a process costing system. Details of Process 1 are as follows.
All materials used are added at the beginning of the process. Labour costs and
production overhead costs are incurred evenly as the product goes through the
process. Production overheads are absorbed at a rate of 100% of labour costs.
The following details are relevant to production in the period:
Units Materials Labour and production

overheads
Opening 200 100% complete 75% complete
inventory
Closing 100 100% complete 50% complete
inventory
Opening inventory
Costs associated with these opening units are Rs 1,800 for materials. In addition
Rs 4,000 had been accumulated for labour and overhead costs.
Period costs
Costs incurred during the period were:
Materials Rs 19,000
Labour costs Rs 19,000
During the period, 2,000 units were passed to Process 2. There were no losses.
The company uses a FIFO method for valuing process costs.
Required:
Calculate the total value of the units transferred to Process 2.

6 Losses made part way through production
In the examples we have looked at so far, the losses have occurred at the end of
the process. It is possible that losses (or gains) could be identified part way
through a process. In such a case, EUs must be used to assess the extent to
which costs were incurred at the time at which the loss was identified.
Example 12 – Losses made part way through production

BLT manufactures chemicals and has a normal loss of 15% of material input.
Information for February is as follows:
Material input 200 kg costing Rs 5 per kg
Labour and overheads Rs 4,100
Transfers to finished goods 160 kg
Losses are identified when the process is 40% complete
No opening or closing WIP.
Required:
Prepare the process account for February.
Solution
Normal loss is 15% of input, i.e. 15% x 200 kg = 30 kg
Actual loss is 40 kg. Thus abnormal loss is 10 kg.
(1) Calculate the expected number of EUs of output (where expected output is actual
finished units plus the abnormal loss).
(2) EUs of output EUs

Total Materials Conversion
Finished units 160 160 160
Abnormal loss 10 10 40
Total EUs 170 170 164
(3) Process costs

Rs
Materials: 200 x Rs 5 1,000
Labour and overhead 4,100
–––––
5,100
–––––

(4) Calculate the cost per EU (used to value finished units and abnormal losses).
Rs 1,000
Materials ––––– = Rs 5.88
170
Rs 4,100
Conversion ––––– = Rs25
164
Total cost of completed unit = Rs (5.88 + 25) = Rs 30.88
(5) Write up the process account and normal and abnormal loss accounts.
Process 1 Account
KG Rs KG Rs
Materials 200 1,000 Normal Loss 30 -
Labour and 4,100 Finished goods 160 4,941
overheads (W1)
Abnormal loss 10 159
(W2)
200 5,100 200 5,100
Workings
(W1) 160 x Rs 30.88 = Rs 4,941
(W2) Abnormal loss (10 x Rs 5.88) + (4 x Rs 25) = Rs 159
Normal Loss Account
KG Rs KG Rs
Process 30

Abnormal Loss Account
KG Rs KG Rs
Process account 10 159 Income 159
statement
10 159 - 159
Normal and abnormal losses (or gains) must be recorded and valued. Remember
that abnormal losses (or gains) do not affect the cost per EUs calculation.
7 Joint and by-products
Introduction
The nature of process costing is such that processes often produce more than
one product. These additional products may be described as either joint products
or by-products. Essentially joint products are main products whereas by-products
are incidental to the main products.
Joint products
Joint products are two or more products separated in the course of processing,
each having a sufficiently high saleable value to merit recognition as a main
product. I.e. Joint product is a product which has significant sales value.
 Joint products include products produced as a result of the oil refining

process, for example, petrol and paraffin.
 Petrol and paraffin have similar sales values and are therefore equally
important (joint) products.
By-products
By-products are outputs of some value produced incidentally in manufacturing
something else (main products). We can also say that a by-product is a product
which has insignificant sales value.
 By-products, such as sawdust and bark, are secondary products from the
timber industry (where timber is the main or principal product from the
process).
 Sawdust and bark have a relatively low sales value compared to the timber
which is produced and are therefore classified as by-products.

8 Treatment of joint costs
8.1 Accounting treatment of joint products

The distinction between joint and by-products is important because the accounting
treatment of joint products and by-products differs.
 Joint process costs occur before the split off point. They are sometimes called
pre-separation costs or common costs.
 The joint costs need to be apportioned between the joint products at the split
off point to obtain the cost of each of the products in order to value closing
inventory and cost of sales.
 The basis of apportionment of joint costs to products is usually one of the

following:
 sales value of production (also known as market value)
 production units or Physical output method
 Net realisable value.
Example 13 – Treatment of joint costs

The following information is relevant for a production process for Period 1:
Rs
Direct material cost 10,000
Direct labour cost 5,000
Overheads 3,000
Total cost 18,000
The process produces joint products A and B, which are then sold at the prices
given below. The output figure represents all of the output from the process.

Product A Product B
Units of output 2,000 8,000
Price per unit Rs 5 Rs 2.50
Required:
Calculate the cost of sales, and gross profit for products A and B assuming:
(i) Joint costs are apportioned by market value
(ii) Joint costs are apportioned by production units.
Solution
(a) Market value basis
Product A Product B Total
Sales value Rs 10,000 Rs 20,000 R s 30,000
Joint costs apportioned
(see working) Rs 6,000 Rs 12,000 Rs 18,000
Gross profit Rs 4,000 Rs 8,000 Rs 12,000
Working
Total joint costs = Rs (10,000 + 5,000 = 3,000) =Rs 18,000
10,000
Joint costs allocated to Product A = ––––– × Rs 18,000 = Rs 6,000
30,000
20,000
Joint costs allocated to Product B = ––––– × Rs 18,000 = Rs 12,
30,000
(b) Production units basis

Sales value Rs 10,000 Rs 20,000 Rs 30,000
Joint costs apportioned
(See working) Rs 3,600 Rs 14,400 Rs 18,000
Gross profit Rs 6,400 Rs 5,600 Rs 12,000
Working
Total output units = 2,000 + 8,000 = 10,000
2,000
Joint costs allocated to Product A = ––––– × Rs 18,000 = Rs 3,600
10,000

8,000
Joint costs allocated to Product B = ––––– × Rs 18,000 = Rs 14,400
10,000
8.2 Accounting treatment of by-products

As by-products have an insignificant value the accounting treatment is different.
 The costs incurred in the process are shared between the joint products alone.
The by-products do not pick up a share of the costs, like normal loss.
 The sales value of the by-product at the split off point is treated as a reduction
in costs instead of an income, again just the same as normal loss.
 If the by-product has no known value at the split off point but does have a
value after further processing, the net income of the by-product is used to
reduce the costs of the process
Net income (or net realisable value) = Final sales value – Further processing
costs
Example 14 – Treatment of joint costs

Process M produces two joint products (A and B) and one by-product (C ). Joint
costs are apportioned on the basis of sales units.
The following information is relevant.

Sales units 2,000 8,000 10,000
Apportioned joint cost Rs 3,600 Rs 14,400 Rs 18,000
It is now possible to sell by-product C after further processing for Rs 0.50 per
unit. The further processing costs are Rs 0.20 per unit. 2,000 units of
by-product C are produced.
Required:
How are the joint costs of Rs 18,000 apportioned when by-product C is produced?
Solution
With the production of by-product C, joint costs are reduced by the net
income from the process.
Income from by-product = Rs (0.5 – 0.2) x 2,000 = Rs 600
Joint costs are now Rs 18,000 – Rs 600 = Rs 17,400

Sales unit 2,000 8,000 10,000
Apportioned joint cost Rs 3,480 Rs 13,920 Rs 17,400
Total output units = 2,000 + 8,000 = 10,000
2,000
Joint costs allocated to Product A = –––––– × Rs 17,400 = Rs 3,400
10,000
8,000
Joint costs allocated to Product B = –––––– × Rs 17,400 = Rs 13,920
10,000

A company operates a manufacturing process which produces joint products A
and B, and by-product C.
Manufacturing costs for a period total Rs 272,926, incurred in the manufacture of:
Product A 16,000 kg (selling price Rs 6.10 per kg)
Product B 53,200 kg (selling price Rs 7.50 per kg)
Product C 2,770 kg (selling price Rs 1.20 per kg)
Product B requires further processing after separation from the other two
products. This costs a total of Rs 201,930.
Product C also requires further processing to make it saleable, and this costs Rs
0.40 per kg.
Calculate the total profit earned by Products A and B in the period, using the net
realisable values (net income) to apportion joint costs.
9 Process accounts for joint and by-products
You may be required to deal with joint and by-products when preparing process
accounts. Joint products should be treated as ‘normal’ output from a process. The
treatment of by-products in process accounts is slightly more complicated.
 There is no information value in calculating a cost for a by-product or

measuring its profitability. The accounting treatment of a by-product in process
costing is similar to the treatment of normal loss.

 The by-product income could be treated as additional income in the income
statement. However, it is more usual to deduct the by-product income
from the cost of the process that produces it.
 The by-product income is therefore credited to the process account and

debited to a by-product account.
 To calculate the number of units in a period, by-product units (like normal loss)
reduce the number of units output.
When by-products are produced, the cost per unit is calculated as follows:
Process costs (materials & conversion costs) – Scrap value of

normal loss – Sales value of by-product
––––––––––––––––––––––––––––––––––––––––––––––––
Expected number of units output (Input units – Normal Loss Units –
By-Product units)
OR
Net costs of inputs

–––––––––––––––
Expected output
We can now consolidate what we have learned in this chapter by looking at how
joint and by-products are recorded in a process account.

The following information relates to a company that produces two joint products, X
and Y and one by-product, Z, in a process.
Data for December

Materials input (43,750 units): cost Rs 266,500
Conversion costs Rs 105,000
Abnormal loss: (3,750 units) Rs 37,500
Joint products output:

Joint product X: 18,000 units Rs 180,000
Joint product Y: 15,000 units Rs 150,000
Normal loss is 1,000 units. Units lost have a scrap value of Rs 1 per unit.
6,000 units of by-product Z are produced. Each unit is sold for Rs 0.50 per unit.
Prepare the process account for December.

10 Chapter summary

Process 2 Account
KG Rs KG Rs
Transfer from 500 750 Normal Loss 25 25
process 1 Finished goods 755 2,265
Additional raw 300 30
material
Direct labour 800 Abnormal loss 20 60
Departmental 500
overheads
800 2,350 800 2,350
Normal loss = 5% of transfer from Process 1 = 500 kg x 0.05 = 25 kg
Scrap value of normal loss = 25 kg x Re 1 = Re 25
Cost per unit = (Rs 2,350 – Rs 25) / (800 kg – 25 kg) = Rs 3
Rs. Rs.
Process 1 (W3) 60.00 Scrap (20 × Rs. 1) 20.00

Income Statement 40.00
60.00 60.00
Scrap Account
Rs. Rs.
Process 1 (Normal loss) 25.00 Cash (45 × Rs. 1) 45.00
Abnormal gain and loss 20.00
45.00 45.00


% EUs %
EUs
Fully-worked 6,650 100 6,650 100 6,650
Closing WIP 1,600 100 1,600 60
960
Total units 8,250
Costs: Rs 453,750 Rs 350,060
Rs 24,750
Total cost Rs 478,500 Rs 350,060
The value of finished goods is (W1) Rs 691,600

The value of WIP is (W2) Rs 136,960
Workings
(W1) Value of finished goods:
Materials: 6,650 x Rs 58 = Rs 385,700
Conversion: 6,650 x Rs 46 = Rs 305,900
Total = Rs 691,600
(W2) Value of closing WIP:
Materials: 1,600 x Rs 58 = Rs 92,800
Conversion: 960 x Rs 46 = Rs 44,160
Total = Rs 136,960

Statement of EUs
Materials Labour
Overheads
% EU % EU % EU
Output 100 900 100 900 100 900
Closing WIP 100 300 60 180 50 150
––––– ––––– ––––
Total EUs 1,200 1,080 1,050
––––– ––––– ––––
Rs Rs Rs
Costs – period 98,000 60,000
39,000
Opening WIP 22,000 6,960 3,000
––––––– –––––– ––––––
Total costs 120,000 66,960 42,000
––––––– –––––– ––––––
Cost per unit Rs 100 Rs 62 Rs 40
(Total costs/total EUs)
(a) Value of completed output = 900 x Rs (100 + 62 + 40) = Rs 181,800
(b)
Rs
Materials 300 x Rs 100 30,000
Labour 180 x Rs 62 11,160
Overheads 150 x Rs 40 6,000
–––––––
Value of closing WIP 47,160
–––––––


% EUs % EUs
Opening WIP 200 0 0 25 50

completed
Fully-worked 1,800 100 1,800 100 1,800
in process
Closing WIP 100 100 100 50 50
Total 2,100 1,900 1,900

Costs Rs 19,000 Rs 19,000 +
Rs 19,000*=
Rs 38000
* Overheads are absorbed at 100% of labour cost.
Value of units passed to Process 2:

Opening WIP value from last period = Rs 1,800 + Rs 4,000 = Rs 5,800
Opening WIP completed this period:
Conversion only = 50 x Rs 20 = Rs 1,000

Fully worked current period
Materials = 1,800 x Rs 10 = Rs 18,000
Conversion = 1,800 x Rs 20 = Rs 36,000
Total = Rs 54,000
Total value of units transferred to Process 2 = Rs 60,800

Net revenue from product C = Rs (1.2 – 0.4) = Rs 0.80
Costs to apportion = Joint process costs – net revenue from product C
= Rs 272,926 – (2,770 x Rs 0.80)
= Rs 270,710
A B Total
Rs Rs Rs
Revenue 97,600 399,000 496,600
Further processing costs – – (201,930) (201,930)
––––––– –––––––– –––––
Net realisable values 97,600 197,070 294,670
Joint costs (89,664) (181,046) (270,710)
–––––––– ––––––– ––––––
Total profits 7,936 16,024 23,960
Total net realisable values = Rs (97,600 + 197,070) = Rs 294,670
97,600
Joint costs apportioned to product A = ––––– × Rs 270,710 = Rs 89,664
294,670
197,070
Joint costs apportioned to product B = ––––––– × Rs 270,710 = Rs 181,046
294,670

Process Account
Unit Rs Unit Rs
Direct material 43,750 266,500 Normal loss 1,000 1,000
(W1) 3,750 37,500
Conversion costs 105,500 Abnormal loss 6,000 3,000
by-product Z
(W2)
Joint product X 18,000 180,000
(W3)
Joint product Y 15,000 150,000
(W3)
43,750 371,500 43,750 371,500
Workings:
(W1)
Scrap value of normal loss units = 1,000 x Re 1 = Rs 1,000
(W2)
By-product Z value = 6,000 x Rs 0.50 = Rs 3,000
(W3)
Process costs Rs 371,500 – Scrap value of normal loss
Rs 1,000 – Sales value of by-product Rs 3,000
Cost per EU = –––––––––––––––––––––––––––––––––––––––––––
Input units 43,750 – Normal Loss 1,000 – Byproduct 6,000
Rs 367,500
Cost per EU = ––––––––––––––––––––––
36,750 Equivalent Units
Cost per EU = Rs 10 per unit

 Standard costing
 Preparation of standards
 Uses of standard costing
 Other aspect of standard costing

1 Standard costing
A standard is a predetermined per unit measurable quantity and standard cost

is a carefully pre-determined unit cost which is prepared for each cost unit
based on standard quantity and standard rate. It contains details of the
standard amount and price of each resource that will be utilised in providing
the service or manufacturing of the product.
The standard becomes a target against which performance can be measured.
The actual costs incurred are measured after the event and compared to the
predetermined standards.
The difference between the standard and the actual is known as a variance.
Analysing variances can help managers focus on the areas of the business
requiring the most attention. This is known as management by exception.
1.1 Standard cost card

This shows the standard cost for a single unit of a product.
Standard cost card – cost per unit of product X
Raw materials: 5 kgs P @ Rs 200/kg 10.00

3 kgs Q @ Rs 150/kg 4.50
Labour 4 hrs grade A @ Rs 4/hr 16.00
1 hr grade B @ Rs 5.50/hr 5.50
Variable overheads 5 hurs @ 1.5/hr 7.5
43.50 (MC)
Fixed overheds 5 hurs @ 1.3/hr 6.50
50.00 (TAC)
This standard cost is used as a basis of comparison with actual results.
1.2 The uses of standard costs

The main purposes of standard costs are:
 control: the standard cost can be compared to the actual costs and any
differences investigated.
 performance measurement: any differences between the standard and
the actual cost can be used as a basis for assessing the performance of
cost centre managers.
 to value inventories: an alternative to methods such as LIFO and FIFO.

 to simplify accounting: there is only one cost, the standard.
1.3 Suitability of standard costing

Standard costing is most suited to organisations with:
 mass production of homogenous products

 repetitive assembly work
The large scale repetition of production allows the average usage of resources
to be determined.
Standard costing is less suited to organisations that produce non-homogenous

products or where the level of human intervention is high.
1.4 Standard costing V/S budgetary control

Standard costing is a control technique which compares standard costs and
revenues with actual results to obtain variances that are used to stimulate
improved performance. Historically, standard costing evolved as a parallel
system to budgetary control, representing a different approach to the problem.
Today, standard costing has become a subset of budgetary control, and is
commonly used within an organisation as part of a budgetary control system.
Nevertheless, it is important to identify three factors that differentiate standard
costing from other approaches to budgetary control.
 Under standard costing, for costing purposes all stocks are valued at their
standard costs.
 Standard costs are incorporated in the ledger accounts; budgets are a

memorandum record outside the ledger accounts.
 Standard costs are set as unit costs; budgets tend to be set as total costs.
Thus although standard costing is a subset of budgeting, it has certain distinct

features of its own.
1.5 Use of stnadard costing and budgetary control

The circumstances under which each of the techniques may be used are,
ingeneral terms, as below:
 Standard costing – This may be most effectively utilised where output or

production is routine and regular and can, therefore, be easily and
accurately measured. The principal advantage of standard costing is to
enable a detailed comparison of individual inputs of materials, labour and

other production costs to be made with the standard inputs that should be
used for a given level of output. A superior variance analysis is, therefore,
possible.
 Budgetary control – This can be used for all activities within an

organisation where costs and revenues can be predicted and actual results
compared. Budgetary control is, therefore, of use in the control of overhead
costs and service department costs, and also perhaps in the control of
sales activity. The technique is broader in its application than standard
costing, and budgets may be considered to be a more basic control tool
generally. The use of flexible budgets is suitable for cost centres where
output or volume of activity has an effect on costs and in this situation there
is a closer correlation with standard costing, although a broader measure of
the level of output or activity will be used.
1.6 Marginal or total absorption?

We shall soon be looking at the computations of standard costs in more detail;
however, note that a standard cost may be computed on either a marginal
cost basis, including only variable costs, or on an absorption cost basis. In the
latter case, fixed production overheads will be absorbed into cost units,
possibly using the allocation, apportionment and absorption techniques
studied earlier. In this example, the absorption basis is labour hours, the same
asvariable costs, which is very common in examination questions.
2 Types of standards
2.1 What sort of standards?

There is a whole range of bases upon which standards may be set within a
standard costing system. The choice will be affected by the main purposes fo
which management see such a system operating. In the modern age quality
control and continuous improvement are likely to be the main concerns.The
types of standard that you are most likely to meet are:
 basic standards
 ideal standards
 attainable standards
 current standards.
2.2 Basic standards

A basic standard is: 'a standard established for use over a long period from
which a current standard can be developed'. Such standards do not change
from year to year. Historical trends would be highlighted by a system
incorporating basic standards, but for other management control purposes the
information from the analysis between actual and standard would be limited.

Most businesses operate in a dynamic world of continuously changing
products and production methods. This would necessitate changes to
standards and, therefore, to the base period.
2.3 Ideal standards

Standards may be set 'at ideal levels which make no allowances for [normal
losses, waste and machine downtime], and are only attainable under the most
favourable conditions.'Ideal standards are set on the assumption of maximum
efficiency. So, for example, no allowance for breakdowns, no wastage,
working at full capacity would all be features of such ideal or theoretical
standards. In other words, a perfect and ideal operating environment is
assumed. Such standards would not be achieved and sustained for any
significant period of time, if at all. Large adverse variances are likely to be a
feature of a standard costing system based on ideal standards. They would
reflect a deviation not only from an expected level of activity and performance
but also from the ideal. An important feature of any control system is the
impact that it has on managerial performance. Standard costing is only a
means to an end in that variances and their analysis, as an example of
management by exception, should lead management to appropriate action. A
manager receiving a variance statement that is evolved from a system based
on ideal standards would be unlikely to be motivated to improve performance
and act in the best interests of the whole business. On the contrary, such a
system might operate in the opposite manner and cause the manager to be
demotivated.
2.4 Attainable standards

Standards may also be set at attainable levels which assume efficient levels of
operation, but which include allowances for normal loss, waste and
machinedowntime'.Such standards represent what should be achieved with a
reasonable level of effort under normal efficient operating conditions. This
does not mean that assuch they are 'easy' standards. On the contrary,
behavioural studies tend tosuggest that they should include some element of
'target' in them. Managers at the operating levels in the organisation structure
should be encouraged to set standards at the tightest level acceptable by
themselves – in other words, at a degree of difficulty that they themselves see
as acceptable. In contrast with ideal standards, attainable standards do
include allowances for such occurrences as the normal level of wastage,
machine breakdowns and other non-productive time. If there is any deviation
between actual and standard, it is more likely to be such as to give marginally
adverse variances rather than favourable. However, such variances are likely
to be looked upon by the managers to whose area of responsibility they relate,
as an appropriate measure of performance. Expected or currently attainable
standards are those most commonly found inorganisations operating standard
costing systems because they can be seen to serve a range of advantages in

terms of planning, control and motivation.Variances from systems
incorporating attainable standards are likely to be mostrelevant in terms of
providing appropriate information to management.
2.5 Current standards

Current standards are based on the current levels of efficiency in terms of
allowances for breakdowns, wastage, losses and so on. The major drawback
in the use of current standards is that they provide no incentive to improve on
the current level of performance. A system of basing standards either on last
period's actuals, or on the average of some previous periods, is not
recommended generally. Over time, there could be just a tendency to relax
standards in line with actual results rather than an encouragement to
management to investigate why variances have arisen and to take the
appropriate action. This presupposes adverse variances in the past and a
lowering of standards in the future. Past anomalies or inefficiencies tend to be
built into future standards and treated as normal and any potential
improvement in efficiency, e.g. due to technological change, may be
overlooked. Inefficient use of resources would tend to go unnoticed.
2.6 Conclusions on standards

In the setting of standards, three aspects should be kept in mind:
 their value for control

 their motivational effect
 their usefulness for planning purposes.
The types of standard described above may be evaluated against these types
of criteria:
3 Preparation of standard costs
3.1 The basic computations

In general, a standard cost will be set for each product, comprising:
 Direct materials: standard quantity (kg, litres etc.) x standard price per
unit (kg, litre etc.).
 Direct wages: standard labour hours x standard hourly rate.
 Variable overhead: standard hours (labour or machine) x standard rate

per hour.
 Fixed overhead: budgeted overhead for the period x budgeted standard

hours (labour or machine) for the period. Standard costs are therefore

comprised of two estimates that are multiplied to produce the standard
cost of the output unit. These two estimates are:
 a physical measure of the resources required for each unit of output
 the price expected to be paid for each unit of the resource. It is

assumed that an attainable standard is to be used.
3.2 Physical resources

The first step is to identify the resources required for each output unit. This
includes:
 each type of different raw material or component

 each grade and skill type of labour
 each type of machine.
For each of these an estimate must then be made of the quantity of materials,
number of components, number of hours etc., required for each output unit
(allowing for normal losses, wastage, inefficiency). Sources of information on
which to base such estimates would include
Material usage:
 work study techniques will help to identify normal allowances for wastage,
losses etc
 technical specifications of the material to be used.
Labour times
 technical specifications of the tasks required to manufacture the product or
provide the service.
 work study exercises, from which the standard times to perform required
tasks and grades of labour needed could be determined.
3.3 Resource unit prices

For each resource required, an estimate must then be made of the expected
cost per unit of the resource (i.e. per kg, per unit, per hour). When making
these estimates regard must be given towards the likely level of inflation and
price changes expected in the budget period. Other specific information that
may be used includes:

Material price
 quotes/estimates from potential suppliers
 trend information from past price data
 bulk discounts available
 quality of material to be used
 packaging and carriage inward charges.
Labour rate
 wage rates provided by the personnel department
 forecasts of likely outcomes of any wage rate negotiations/bonus/incentive
scheme in operation.
3.4 Production overhead costs

Earlier, we looked at how predetermined hourly rates were derived for
production overhead. These rates represent the standard hourly rates for
overhead in each cost centre. They can be applied to standard labour hours
or machine hours, etc., for each cost unit.
The overheads will usually be analysed between their fixed and variable
elements, to give separate standard rates for fixed and variable production
overheads.

Lunches Ltd makes sandwiches for sale to offices and over the counter.
Contents of their 'spicy meat special' are as follows:
2 slices bread
88 grams spicy meat mix
44 grams grated cheese
20 grams pickle
It is company policy to guarantee the cooked weight of meat mix to be a

minimum of 88 grams. There is a 20% loss of mix weight during cooking.
Losses due to accidental damage, dropped sandwiches, etc. are estimated to
be 5% of completed sandwiches.
Anticipated prices of raw materials for the coming period are:

Bread Rs 54 per loaf of 18 useable slices
Spicy meat mix (uncooked) Rs 320 per kg
Cheese Rs 300 per kg
Pickle Rs 160 per kg
Prepare the standard ingredients cost of one 'spicy meat special' sandwich.

The fastest time in which a batch of 20 'spicy meat special' sandwiches has
been made was 32 minutes, with no hold-ups. However, work studies have
shown that, on average about 8% of the sandwich makers' time is non-
productive, and that, in addition to this set-up time (getting ingredients
together etc.) is 2 minutes. If the sandwich-makers are paid Rs 45 per hour,
what is the attainable standard labour cost of one sandwich?
3.5 The standard hour

Output is often measured in terms of standard hours, i.e. the amount of work
achievable, at standard efficiency levels, in an hour.
Thus, if 50 articles are estimated to be made in a 'clock' hour, an output of 150

should take three 'clock' hours and would be valued at the standard cost of
those three hours, irrespective of the actual time taken to manufacture them.
Example
A factory in week 1 achieved the following activity level:
Units Standard minutes each

Product F 5,100 6
Product C 2,520 10
Product A 3,150 12
You are required to calculate the number of standard hours produced in

week
Solution
Actual standard hours produced were:
Standard hours
Product F 5,100 × 6/60 = 510

Product C 2,520 ×10/60 = 420
Product A 3,150 x 12/60 = 630
1,560
Standard hours provide managers with a means of measuring and monitoring

output of dissimilar products. For example, suppose that the output for the
same factory in week 2 was as follows:

Units
Product F 1,100
Product C 240
Product A 8,700
Fewer units in total were produced in week 2 than in week 1 (10,040 in week 2
compared with 10,770 in week 1). However we are attempting to add
dissimilar units and the comparison is not valid. If we convert the week 2
output to standard hours we will be able to assess whether productivity in
week 2 was in fact lower than in week 1.
Standard hours produced in week 2:
Standard
hours
Product F 1,100 × 6/60 110

Product C 240 × 10/60 40
Product A 8,700 × 12/60 1,740
1,890
A comparison of the number of standard hours produced reveals that

productivity in week 2 was actually higher than in week 1.

Summary
This chapter has discussed the basic principles of standard costing, and how
standards are set.
Different types of standard may be used – basic, ideal, attainable or current –

of which the attainable standard is generally accepted to be of greatest use in
planning andm control.
Attainable standards will build in allowances for normal levels of loss,

wastage, inefficiency, etc.
 explain the principles of standard costing

 prepare the standard cost for a product/service.

Self-test questions
Standard costing
1 What is standard costing? (1.1)
2 What is a standard cost? (1.1)
Types of standards
3 What is a basic standard? (2.2)
4 What is an ideal standard? (2.3)
5 What is an attainable standard? (2.4)
6 What is a current standard? (2.5)
Preparation of standard costs

7 Give three possible sources of information from which a standard
materials price may be estimated. (3.3)
8 What is a standard hour? (3.5)

1. Performance standards which have remained unchanged over a long period of
time are known as:
A ideal standards
B current standards
C basic standards
D long-term standards.
2. A standard hour is:

A always equivalent to a clock hour
B any hour during which no idle time occurs
C the quantity of work achievable at standard performance in an hour
D an hour throughout which the same units are made.
Budgets and standards

'Budgets and standards are similar but they are not the same.' You are
required to explain and expand on the above statement, mentioning
differences
Answers to MCQs
1. C
2. C

2 slices bread 2/18 x Rs 54 6

Spicy meat mix 88g cooked weight 35.2
88/0.8 uncooked weight @ Rs
320/kg
Grated cheese 44g @ Rs 300/kg 13.2

Pickle 20g @ Rs 160/kg 3.2
Cost per sandwich (95%) 57.6

started
Allowance due to (5%) 3.0
anticipated losses
Standard ingredients (100%) 60.6
cost

Per batch of
20
Ideal time (92%) 32.0 minutes
Non productive time (8%) 2.8 minutes
(100%) 34.8 minutes
Set-up time 2.0 minutes
Total time 36.8 minutes
Total cost @ Rs 45/hr Rs 2.76

Standard labour cost per Rs 1.38
sandwich (/20)
Test your understanding – 3

A budget is a quantitative or financial plan relating to the future. A standard is
a predetermined measurable quantity set in defined conditions.
Similarities
 Both budgets and standards relate to the future.
 Both budgets and standards must be quantified.
 Both are used in planning.
 Both are used in controlling the activities of the business. Actual results
are compared against the budget or standard and if a significant difference

occurs, the reasons behind the difference are investigated and if possible
and desirable,corrective action taken.
 Both may be used as a basis for evaluating performance. Managers and
workers may be judged on their performance compared with the expected
result.
 Neither budgets nor standards should be prepared as just 'cold'
mathematical exercises, the computational/numerate aspects should be
considered in conjunction with motivational effects of budgets and
standards used as targets.
 Both budgets and standards can be designed to show purely the expected
results for a forthcoming period or may be designed to provide a more
difficult target in order to motivate managers/workers.
Differences
 The biggest difference between budgets and standards is that standards
tend to be expressed per unit, whereas budgets are for much bigger
entities such as departments, functions or resources.
 Standards are most often set for materials and labour (but can be set for
variable overheads and fixed overheads). Budgets cover a much greater
variety of costs and entities, such as cash, fixed assets, research and
development, etc.
 Standards are often set up in order to prepare the budget.

 Variances
 Direct material variances
 Direct labour variance

1 Basic cost variance analysis
1.1 Cost variances

A variance is the difference between a planned, budgeted or standard cost
and the actual cost incurred. Cost variances occur when standard costs are
compared to actual costs. There is one important feature of standard costing
that must be remembered: standard costing carries out variance analysis
using the normal, double entry ledger accounts. This is done by recording in
the ledgers:
 actual costs as inputs

 standard costs as outputs
 the difference as the variance.
1.2 Calculating variances

It is essential that you do not simply learn formulae for variances without really
understanding what they mean and the principles behind their calculation. The
examiner may ask you to calculate non-standard variances, which will be
testing your understanding rather than your ability to remember formulae.
Therefore, we have considered each variance from a 'common sense' point of
view, developing its calculation from basic principles. Make sure you work
through this carefully.
2 Direct material cost variances
2.1 Introduction
The purpose of calculating direct material cost variances is to quantify the
effect on profit of actual direct material costs differing from standard direct
material costs. This total effect is then analysed to quantify how much has
been caused by a difference in the price paid for the material and how much
by a difference in the quantity of material used.
2.2 Direct material total cost variance
The materials cost variance is the difference between:
(a) the actual cost of direct material and

(b) the standard material cost of the actual production (flexed budget).
The purpose of this variance is to show the effect on profit for an accounting
period of the actual direct material cost being different from the standard direct
material cost.

Formula:
Material Cost Variance = (Standard quantity x Standard price) – (Actual
quantity x Actual Price)
Example
The following standard costs relate to a single unit of product X: Rs
Direct materials 10
Direct labour 8
Production overhead 5
23
In July, 1,000 units of product X were manufactured, incurring direct material

cost of Rs 12,000.
The total direct materials cost variance is:
Rs
standard direct material cost = 1,000 units × Rs10 10,000
actual direct material cost 12,000
direct materials cost variance - adverse 2,000
The variance is adverse because it causes actual profits to be less than

expected.

The standard direct material cost of product A is Rs 5. During August 600
units of product A were made, and the actual direct material cost was Rs
3,200. Calculate the direct material total cost variance for the period.
2.3 Analysing the direct material total cost variance

When a standard material cost is determined for a unit of a product it is made
up of two parts. These are estimates of:
 the quantity of material to be used

 the price to be paid per unit of material.
If we return to the earlier example concerning product X, the standard direct

material cost per unit was stated to be Rs 10. This was based on using 5 kg of
a particular material to make each unit of product X and paying Rs 2/kg for the
material.

You should remember that the actual direct material cost incurred in making
1,000 units of product X was Rs 12,000. The invoice for these costs shows:
4,800 kg @ Rs 2.50/kg = Rs 12,000.
It should be noted that this form of analysis corresponds to the two estimates
that form the basis of the standard cost. It is this that allows the direct material
total cost variance to be analysed.
2.4 Direct material price variance

The purpose of calculating this variance is to identify the extent to which
profits will differ from those expected by reason of the actual price paid for
direct materials being different from the standard price.
Formula:
Material Price Variance = (Actual quantity x Standard Price) – (Actual quantity
x actual Price)
The standard price per kg of material was stated above to be Rs 2/kg. This
can be used to calculate the expected cost of the actual materials used to
make 1,000 units of product X. On this basis the 4,800 kg of material should
have cost:
4,800 kg x Rs 2/kg = Rs 9,600.
The actual cost of these materials was Rs 12,000 that is Rs 2,400 (Rs 12,000
Rs 9,600) more than expected. Since the actual price was greater than
expected this will cause the profit to be lower than expected. This variance,
known as the direct material price variance, is adverse.

A raw material, used in the manufacture of product F has a standard price of
Rs 1.30 per litre. During May 2,300 litres were bought at a cost of Rs 3,128.
Calculate the direct material price variance for May.
2.5 Direct material usage variance

The purpose of this variance is to quantify the effect on profit of using a
different quantity of raw material from that expected for the actual production
achieved.

Formula:
Material Usage Variance = (Standard quantity used for actual production) –
(Actual quantity used x Standard Price)
Returning to our example concerning product X, it was stated that each unit of
product X had a standard direct material usage of 5 kg. This can be used to
calculate the amount of direct material (in kg) that should be used for the
actual production achieved.
1,000 units of X @ 5 kg of direct material each = 5,000 kg.
You should remember that the analysis of the actual cost showed that 4,800
kg of direct material were actually used.
Thus a saving of 200 kg (5,000 - 4,800) was achieved.
This saving of materials must be valued to show the effect on profit. If the
original standard direct material cost were revised to reflect this saving of
material it would become:
4.8 kg (4,800/1,000) @ Rs 2/kg = Rs 9.60.
This is Rs 0.40 per unit of product X less than the original standard and profit
would therefore increase by this amount for every unit of product X produced.
This has a total value of:
1,000 units x Rs 0.40 = Rs 400.
We achieve the same result by multiplying the saving in quantity by the

standard price:
200 kg x Rs 2/kg = Rs 400.
In this case profits will be higher than expected because less material was
used than expected in the standard. Therefore the variance is said to be
favourable. We can now check that the two sub-variances total to the total
direct material cost variance:
Price variance + usage variance = total material cost variance
Rs 2,400 adverse + Rs 400 favourable = Rs 2,000 adverse

Example
The following information relates to the production of Product “A”.
Extract from the standard cost card of Product “A”
Direct materials (40 square metres x Rs 5.30 per square metre) Rs 212
Actual results for direct materials in the period: 1,000 units were produced and
39,000 square metres of material costing Rs 210,600 (Rs 5.4 per square
metres) in total were used.
Required:
Calculate the materials total, price and usage variances for Product
“A” in the period.
Solution
Material Cost Variance = (Standard quantity x Standard price) – (Actual
quantity x Actual Price)
= (40 x Rs 5.30) – (39 x Rs 5.4) = 1.4 Favourable
Material Price Variance = (Actual quantity x Standard Price) – (Actual quantity

x actual Price)
= (39 x Rs 5.3) – (39 x Rs 5.4) = 3.9 Unfavourable
Material Usage Variance = (Standard quantity used for actual production

x Standard Price) – (Actual quantity used x
Standard Price)
= (40 x Rs 5.3) – (39 x Rs 5.3) = 5.3 Favourable

The standard direct material usage per unit of product K is 0.4 tonnes. The
standard price of the material is Rs 30/tonne.
During April 500 units of K were made using 223 tonnes of material costing Rs
6,913. Calculate the direct material usage variance, and the direct material
price variance.

3 Raw materials stocks
3.1 Introduction
The earlier example has assumed that the quantity of materials purchased
equalled the quantity of materials used by production. Whilst this is possible it
is not always certain to occur. Where this does not occur profit will be affected
by the change in the level of stock. The extent to which this affects the
calculation of direct material variances depends on the methods chosen to
value stock. Stocks may be valued either using:
 the standard price for the material or

 the actual price (as applies from using FIFO, LIFO, etc.).
3.2 Stocks valued at standard price

This is the most common method when using a standard costing system
because it eliminates the need to record value based movements of stock on
stores ledger cards (since all movements, both receipts and issues, will be
valued at the standard price).
The effect of this valuation method is that price variances are calculated
based on the quantity purchased rather than the quantity of materials used.
This is illustrated by the following example.
Example
Product P requires 4 kg of material Z per unit. The standard price of material Z
is Rs 8/kg. During September 16,000 kg of Z were bought for Rs 134,400.
There was no opening stock of material Z but at the end of September 1,400
kg of Z remained in stock. Stocks of Z are valued at standard prices. The price
variance is based on the quantity purchased (i.e. 16,000 kg). The standard
cost of these materials can be calculated:
3.3 Stock account

Continuing the above example the issues of material Z of 14,600 kg (16,000 -
1,400) would be valued at the standard price of Rs 8/kg.
The value of the issues debited to work-in-progress would thus be:
14,600 kg x Rs 8/kg = Rs 116,800.

The stock account would appear thus:
Raw material Z
Rs Rs
Creditor 134,400
Work-in-progress 116,800
Price variance 6,400
c/d 11,200
134,400 134,400
Note that the balance c/d comprises the closing stock of 1,400 kg valued at
the standard price of Rs 8/kg.
1,400 kg x Rs 8/kg = Rs 11,200.
The entry representing the price variance is shown as a credit in the raw
material account because it is an adverse variance. The corresponding entry
is made to a price variance account, the balance of which is transferred to
profit and loss at the end of the year. The price variance account is as follows:
Direct material price variance

Rs Rs
Raw material Z 6,400
3.4 Stocks valued at actual price

If this stock valuation method is used it means that any price variance is
recognised not at the time of purchase but at the time of issue. When using
this method issues are made from stock at actual prices (using FIFO, LIFO,
etc.) with the consequence that detailed stores ledger cards must be kept. The
price variance is calculated based upon the quantity used.

Example
Using the data concerning material Z above, calculations of the value of
closing stock can be made as follows:
Actual cost/kg = Rs 134, 400 = Rs 8.40

16,000
Closing stock value (at actual cost) = 1,400 kg x Rs 8.40

= Rs 11,760.
The direct material price variance based on the issues quantity can be calculated:
Rs
Standard cost of 14,600 kg:
14,600 kg x Rs 8/kg 116,800
Actual cost of 14,600 kg (above) 122,640
Direct material price variance – Adverse 5,840
3.5 Stock account
Raw material Z
Rs Rs
Creditor 134,400
Work-in-progress 116,800
Direct material price 5,840
variance
c/d 11,760
134,400 134,400
Note that the closing balance comprises:

Rs
1,400 kg x standard price of Rs8/kg 11,200
Adverse price variance not yet
recognised:
1,400 kg x (Rs 8.40 - Rs 8.00) 560
11,760

4 Direct labour cost variances
4.1 Introduction
The purpose of calculating direct labour cost variances is to quantify the effect
on profit of actual direct labour costs differing from standard direct labour
costs. This total effect is then analysed to quantify how much has been
caused by a difference in the wage rate paid to employees and how much by
a difference in the number of hours worked.
4.2 Direct labour total cost variance

The labour total variance is the difference between:
(a) the actual cost of direct labour and

(b) the standard direct labour cost of the actual production (flexed
budget).
The purpose of this variance is to show the effect on profit for an accounting
period of the actual direct labour cost being different from the standard direct
labour cost.
Formula:
Labour Cost Variance = (Standard rate x standard hours) – (Actual rate x
actual hours)
Example
Product Q has a standard labour cost of Rs 12 per unit. In August, 800 units
of product Q were manufactured incurring a direct labour cost of Rs 8,000.
The total direct labour cost variance is:

Rs
standard direct labour cost = 800 × Rs 12 9,600
actual direct labour cost 8,000
direct labour cost variance - favourable 1,600
The variance is favourable because it causes actual profits to be more than

expected.

The standard direct labour cost of product H is Rs 7. During January 450 units
of product H were made, and the actual direct labour cost was Rs 3,450.
Calculate the direct labour total cost variance of the period.

4.3 Analysing the direct labour total cost variance
When a standard labour cost is determined for a unit of a product it is made
up of two parts. These are estimates of:
 the number of hours required per unit

 the hourly wage rate.
If we return to the example concerning product Q, the standard direct labour

cost per unit was stated to be Rs 12. This was based on 4 direct labour hours
being required per unit of Q and paying a wage rate of Rs 3/hour.You should
remember that the actual direct labour cost incurred in making 800 units of
product Q was Rs 8,000. An analysis of the payroll records shows:
2,000 hours @ Rs 4/hour = Rs 8,000.
It should be noted that this corresponds to the two estimates that form the
basis of the standard cost. It is this that allows the direct labour total cost
variance to be analysed.
4.4 Direct labour rate variance

The purpose of calculating this variance is to identify the extent to which
profits will differ from those expected by reason of the actual wage rate per
hour being different from the standard.
Formula:
Labour Rate Variance = (Standard rate x actual hours) – (Actual rate x actual
hours)
The standard wage rate per hour was stated to be Rs 3. This can be used to
calculate the expected cost of the actual hours taken to make 800 units of
product Q. On this basis the 2,000 hours should have cost:
2,000 hours x Rs3/hour = Rs 6,000.
The actual labour cost was Rs 8,000 that is Rs 2,000 (Rs 8,000 - Rs 6,000)
more than expected. Since the actual rate was greater than expected, this will
cause the profit to be lower than expected. This variance, known as the direct
labour rate variance, is adverse.
4.5 Direct labour efficiency variance

The purpose of this variance is to quantify the effect on profit of using a
different number of hours than expected for the actual production achieved.

Formula:
Labour Efficiency Variance = (Standard rate x standard hours) – (Standard
rate x actual hours)
Continuing with our example concerning product Q, it was stated that each
unit of product Q would require 4 direct labour hours. This can be used to
calculate the number of direct labour hours that should be required for the
actual production achieved.
800 units of Q x 4 direct labour hours each = 3,200 direct labour hours
You should remember that the analysis of the actual cost showed that only
2,000 hours were used.
Thus a saving of 1,200 direct labour hours (3,200 - 2,000) was achieved.
This saving of labour hours must be valued to show the effect on profit. We do
this by multiplying the difference in hours by the standard hourly rate:
1,200 direct labour hours x Rs 3/hr = Rs 3,600.
In this case profit will be higher than expected because fewer hours were
used. Therefore the variance is favourable.
We can now check that the two sub-variances total to the direct labour total
cost variance:
rate variance + efficiency variance = total labour cost variance

Rs 2,000 adverse + Rs 3,600 favourable = Rs 1,600 favourable
Example
The following information relates to the production of Product X.
Extract from the standard cost card of Product X

Rs
Direct labour
Bonding (24 hrs @ Rs 5 per hour) 120
Finishing (15 hrs @ Rs 4.80 per hour) 72
Actual results for wages:

Production 1,000 units produced
Bonding 23,900 hours costing Rs 131,450 in total
Finishing 15,500 hours costing Rs 69,750 in total

Required:
Calculate the labour total, rate and efficiency variances in each department for
Product X in the period.
Solution
Labour variances in Bonding department

actual hours)
= (Rs 5 x 24 x 1,000) – (131,450) = 11,450 Adverse
hours)
= (Rs 5 x 23,900) – (131,450) = 11,950 Adverse

rate actual hours)
= (Rs 5 x 24 x 1,000) – (Rs 5 x 23,900) = 500 Favourable
Labour variances in Finishing department

actual hours)
= (Rs 4.8 x 15 x 1,000) – (69,750) = 2,250 Favourable
hours)
= (Rs 4.8 x 15,500) – (69,750) = 4,650 Favourable

rate x actual hours)
= (Rs 4.8 x 15 x 1,000) – (Rs 4.8 x 15,500) = 2,400 Adverse

The following data relates to product C
Actual production of C (units) 700

Standard wage rate/hour Rs 4.00
Standard time allowance per unit of C (hours) 1.50

Actual hours worked 1,000
Actual wage cost Rs 4,200
Calculate the direct labour rate and efficiency variances from the above data.
5 Idle time variances
You may come across a situation which involves idle time. Idle time occurs
when labour is available for production but is not engaged in active production
due to, for example:
 shortage of work
 shortage of material
 machine breakdown
During idle time, direct labour wages are being paid but no output is being
produced. The cost of this can be highlighted separately in an idle time
variance, so that it is not ‘hidden’ in an adverse labour efficiency variance. In
this way, management attention can be directed towards the cost of idle time.
Idle time variance can be found by use of this formula;
Idle time variance = (Standard Idle time allowed – Actual idle time) X
Standard Rate per Hour.
Note: Standard idle time allowed means if management feels appropriate that
there is a required wait in manufacturing then it can be accounted while
making standard. If no idle time is allowed in preparation of standard then the
actual idle time will be an adverse idle time variance.
Idle Hours = Hours paid – Hours worked

Note: The idle time variance will always be adverse. If no idle time cushion is
allowed in standard. In Advance level you will learn that idle time could be a
favourable variance as well if actual idle hours are less than standard idle
hours.
Example
You are given the following extract from WQ Ltd.’s operation for April.
Standard cost: Rs per unit

Direct labour (5 hours at Rs 6 per hour) 30
Variable production overhead 10
The variable production overhead is incurred in direct proportion to the direct

labour hours worked. The number of units produced and sold in the month
was 1,750.
Actual results for April: Rs

Direct labour: 8,722 hours 47,971
Variable production overhead 26,166
Of the 8,722 hours of direct labour paid for, only 8,222 were active because of
a shortage of material supplies.
First calculate the direct labour efficiency variance as normal:
Direct labour efficiency variance

Hours
1,750 units produced should take (× 5 hours) 8,750
But did take 8,722
——–
Variance in hours 28 favourable
——–
× Standard labour rate per hour (Rs 6)
Direct labour efficiency variance Rs 168 favourable
An idle time variance could be calculated as follows:
Idle time variance

(Actual hours paid – Active hours) × Standard labour rate per hour
= (8,722 – 8,222) × Rs 6
= Rs 3,000 adverse
This is the standard cost of wages incurred during the idle time.

These idle hours must be eliminated from the calculation of the labour
efficiency variance, so that the efficiency of labour is being measured only
during the hours when they were actually working. This gives a much more
meaningful measure of labour efficiency.
Direct labour efficiency variance

Hours
1,750 units produced should have taken (× 5 hours) 8,750
But did take (active hours) 8,222
———
Variance in hours 528 favourable
———
× standard labour rate per hour (Rs 6)
Direct labour efficiency variance Rs 3,168 favourable
The total of these two variances is the same as the original labour efficiency
variance (Rs 168 favourable).

Summary
This chapter has started your studies of variance analysis, looking at total
variances and labour variances, which can be sub-analysed as follows:
Materials – price variance – usage variance

Labour– rate variance – efficiency variance
 calculate and interpret variances for materials and labour.
Self-test questions
Basic cost variance analysis

1 What is a cost variance? (1.1)
Direct material cost variances

2 What does an adverse materials price variance indicate? (2.4)
3 What would a favourable materials usage variance indicate? (2.5)
Raw material stocks

4 What is the effect on price variance analysis of valuing stocks at standard
price? (3.2)
Direct labour cost variances

5 How can a total labour cost variance be further analysed? (4.4, 4.5)

Exam-type questions
1. Q Ltd uses an integrated standard costing system. In October, when 2,400
units of the finished product were made, the actual material cost details
were:
Material purchased 5,000 units @ Rs 4.50 each

Material used 4,850 units
The standard cost details are that 2 units of the material should be used for
each unit of the completed product, and the standard price of each
material unit is Rs 4.70. The entries made in the variance accounts would
be:
Material price Material

variance a/c usage
variance a/c
A Debit Rs 970 Debit Rs 225

B Debit Rs 1,000 Debit Rs 225
C Credit Rs 970 Debit Rs 235
D Credit Rs 1,000 Debit Rs 235
2. S Ltd has extracted the following details from the standard cost card of one
of its products:
Direct labour4.5 hours @ Rs 6.40 per hour
During March, S Ltd produced 2,300 units of the product and incurred
direct wages costs of Rs 64,150. The actual hours worked were 11,700.
Rate Efficiency
Rs Rs
A 2,090 F 7,402 A
B 2,090 F 8,640 A
C 10,730 F 7,402 A
D 10,730 F 8,640 A
3. The following details have been extracted from a standard cost card of X
plc:
PRODUCT X: Direct labour: 4 hours @ Rs 5.40 per hour

During October, the budgeted production was 5,000 units of product X and
the actual production was 4,650 units of product X. Actual hours worked
were 19,100 and the actual direct labour cost amounted to Rs 98,350.
The labour variances reported were:
Rate Efficiency
Rs Rs
A 9,650 F 4,860 F
B 9,650 F 2,700 A
C 4,790 F 2,575 A
D 4,790 F 2,700 A
4. T plc uses a standard costing system, with its material stock account being
maintained at standard cost. The following details have been extracted
from the standard cost card in respect of direct materials:
8 kg @ Rs 0.80/kg = Rs 6.40 per unit

Budgeted production in April was 850 units.
The following details relate to actual materials purchased and issued to

production during April when actual production was 870 units:
Materials purchased 8,200 kg costing Rs 6,888

Materials issued to production 7,150 kg
Which of the following correctly states the material price and usage
variance to be reported?
Price Usage
A Rs 286 (A) Rs 152 (A)
B Rs 286 (A) Rs 280 (A)
C Rs 286 (A) Rs 294 (A)
D Rs 328 (A) Rs 152 (A)

Company M
The following standard costs apply in Company M that manufactures a
single product:
Standard weight of material to produce one unit 12 kg

Standard price per kg Rs 9
Standard hours to produce one unit 10
Standard rate per hour Rs 4
Actual production and costs for one accounting period were:
Material used 3,770 kg

Material cost Rs 35,815
Hours worked 2,755
Wages paid Rs 11,571
The actual output was 290 units.
You are required to calculate relevant material and labour cost variances,
and present these in a format suitable for presentation to the management
of the company.

Answers to MCQs
1. D
2. D
3. D
4. D

Rs
Standard direct material cost of 600 units:
Rs 5 x 600 3,000
Actual direct material cost 3,200
Direct material total cost variance – Adverse 200

Rs
Standard cost of 2,300 litres:
2,300 litres x Rs 1.30/litre 2,990
Actual cost of 2,300 litres 3,128
Direct material price variance – Adverse 138

Standard usage of 500 units of K:
500 x 0.4 tonnes 200 tonnes
Actual usage 223 tonnes
Excess usage 23 tonnes
Valued at standard price of Rs 30/tonne:
Direct material usage variance is:
23 tonnes x Rs 30/tonne = Rs 690 Adverse

Rs
Standard price of 223 tonnes (× Rs 30) 6,690
Actual price of 223 tonnes 6,913
Direct material price variance – Adverse 223

Standard direct labour cost of 450 units:
Rs 7 x 450 3,150
Actual direct labour cost 3,450
Direct labour total cost variance – Adverse 300

Rs
Expected cost of actual hours worked:
1,000 hours x Rs 4/hr 4,000
Actual wage cost 4,200
Direct labour rate variance – Adverse 200
Expected hours for actual production:
700 units x 1.50 hours/unit 1,050
Actual hours 1,000
A saving (in hours) of 50
These are valued at the standard wage rate/hour.
Direct labour efficiency variance is:
50 hoursx Rs 4/hour = Rs 200 Favourable.
Company M
Tutorial note: The question asks for a 'format suitable for presentation to
management'. It is therefore recommended that the first part of the solution is
a summary of the variances and the detailed workings are shown separately.
Summary of variances for one accounting period

(F = Favourable; A = Adverse)
Rs
Materials:
Price 1,885 (A)
Usage 2,610 (A)
_____
Cost 4,495 (A)
Labour:
Rate: 551 (A)
Efficiency 580 (F)
____
Cost 29 (F)

Workings
Rs Rs
Direct materials
Actual cost 35,815 Price variance 1,885 (A)
Actual quantity purchased/
used at 3,770 x Rs 9 33,930 Usage variance 2,610 (A)
Standard quantity for actual
production at standard price
290 x 12 x Rs 9 31,320 4,495 (A)
Cost variance
Labour
Actual cost 11,571 Rate variance 551 (A)
Actual hours paid/worked at
standard rate 2,755 x Rs 4 11,020
Standard hours for actual production
at standard rate 290 x 10 x Rs 4 11,600 Efficiency variance 580 (F)
Cost vairance 29 (F)
Assumptions
1 Quantity of material purchased = Quantity used.

2 Actual hours paid for = Actual hours worked.

 Variable overhead variances

 Fixed overhead variances

1 Overhead variances
1.1 Introduction
In this chapter you will be learning about the analysis of overhead variances.
Your syllabus requires you to be able to analyse overhead variances in an
absorption costing system and in a marginal costing system.
You need to be able to calculate separate variances for variable overheads

and fixed overheads. It should not surprise you that the analysis of variances
for variable overhead is unaffected by whether we are using an absorption
costing system or a marginal costing system. Both systems apply the same
accounting treatment to variable overheads.
You will be seeing that the analysis of fixed overhead variances does differ
between the two systems. This is because marginal costing treats fixed
overheads as a period cost, whereas absorption costing absorbs fixed
production overhead into unit production costs. This differing accounting
treatment means that different fixed production overhead variances arise in the
two systems.
The analysis of overhead variances requires a sound understanding of the

concept of the standard hour. If you have forgotten what this is, return now and
reread the relevant section of chapter 13.
2 Variable overhead variances
2.1 Introduction
These variances are very similar to those for material and labour because, like
these direct costs, the variable overhead cost also changes when activity
changes.
The most common examination question assumes that variable overhead

costs vary with labour hours worked. This results in the calculation of two
variable overhead variances that are illustrated by the following example.
Example: K Limited has a budgeted variable overhead cost for August of Rs

84,000. Budgeted production is 20,000 units of its finished product and direct
labour hours are expected to be 40,000 hours.
During August the actual production was 20,500 units. Actual hours worked
were 41,600 hours and the variable overhead cost incurred amounted to Rs
86,700.

2.2 Variable overhead total variance
It is normally assumed that variable overheads vary with direct labour hours of
input and the variable overhead total variance will therefore be due to one of the
following:
 the variable overhead cost per hour was different to that expected (an
expenditure variance)
 working more or fewer hours than expected for the actual production (an
efficiency variance)
Formula:
Total variance = (Standard rate x standard hours) – (Actual rate x actual
hours)
In order to calculate the total variance it is necessary to calculate the standard

variable overhead cost for the actual production achieved.The budgeted
variable overhead cost per hour is calculated by:
Budgeted cost = Rs 84,000 = Rs 2.10 per hour

Budgeted hours 40,000
Actual production was 20,500 units that is the equivalent of 41,000 standard
hours. (According to the budget each unit should require 2 hours, i.e. 40,000
hours/20,000 units.)
Rs
The standard cost of 41,000 hours at Rs 2.10 per hour is 86,100
Actual cost 86,700
Variance 600 (A)
The variance is adverse because the actual cost exceeded the standard cost
and therefore profits would be lower than expected.
2.3 Variable overhead expenditure variance

This variance measures the effect on profit of the actual variable overhead cost
per hour differing from the standard hourly cost.
Formula:
Expenditure variance = (Standard rate x actual hours) – (Actual rate x actual
hours)
The actual hours worked were 41,600.

If these had cost Rs 2.10/hour as expected the cost would have been
87,360
(This is the standard cost of actual hours.)
The actual cost was 86,700

Variance 660 (F)
This results in a favourable expenditure variance of Rs 660.F
2.4 Variable overhead efficiency variance

This variance measures the effect on profit of the actual hours worked differing
from the standard hours produced.
Formula:
Efficiency variance = (Standard rate x standard hours) – (Standard rate x
actual hours)
Standard hours produced 41,000

Actual hours worked 41,600
Difference 600
This difference in hours is valued at the standard variable overhead cost/hour:
600 x Rs 2.10 = Rs 1,260 (A).
The variance is adverse because actual hours exceeded standard hours.
2.5 Proof of total variance

Note that the sum of these sub-variances, representing expenditure and
efficiency equals the total variance:
expenditure variance + efficiency variance = total variance Rs 660 favourable

+ Rs 1,260 adverse = Rs 600 adverse

Example
The following information relates to the production of Product X.
Extract from the standard cost card of Product X
Rs
Direct labour:
Bonding (24 hrs @ Rs 5 per hour) 120
Finishing (15 hrs @ Rs 4.80 per hour) 72
Variable overhead:
Bonding (24 hrs @ Rs 1.50 per hour) 36
Finishing (15 hrs @ Rs 1 per hour) 15
Actual results for production and labour hours worked:
Production 1,000 units produced

Bonding 23,900 hours
Finishing 15,500 hours
Actual results for variable overheads:
Bonding Total cost Rs 38,240

Finishing Total cost Rs 14,900
Required:
Calculate the variable overhead total, expenditure and efficiency variances in
each department for Product X for the period.
Solution
Variable overhead variances in Bonding department

Total variance = (Standard rate x standard hours) – (Actual rate x actual hours)
= (Rs 1.5 x 24 x 1,000) – (38,240) = 2,240 Adverse

hours)
= (Rs 1.5 x 23,900) – (38,240) = 2,390 Adverse

actual hours)

= (Rs 1.5 x 24 x 1,000) – (Rs 1.5 x 23,900) = 150 Favourable
Variable overhead variances in Finishing department

Total variance = (Standard rate x standard hours) – (Actual rate x actual hours)
= (Rs 1 x 15 x 1,000) – (14,900) = 100 Favourable

hours)
= (Rs 1 x 15,500) – (14,900) = 600 Favourable

actual hours)
= (Rs 1 x 15 x 1,000) – (Rs 1 x 15,500) = 500 Adverse
3 Fixed overhead variances
3.1 Introduction
These variances show the effect on profit of differences between actual and
expected fixed overhead costs. By definition these costs do not change when
there is a change in the level of activity, consequently many of the variances
are calculated based upon budgets; however, the effect on profit depends
upon whether a marginal or absorption costing system is being used. In the
variance calculations that follow firstly an absorption costing system is
assumed. These are then compared with the variances that would arise if a
marginal costing system were used.
3.2 Fixed overhead total variance

Assuming an absorption costing system, this is the effect on profit of there
beinga difference between the actual cost incurred and the amount absorbed
by the use of the absorption rate based on budgeted costs and activity.
Therefore the fixed overhead total variance is equal to the under or over
absorbed fixed production overhead. This is illustrated by the following
example.
Example
Q Limited has completed its budget for October, the following data have been
extracted:
Budgeted fixed overhead cost Rs 100,000

Budgeted machine hours 25,000

A machine hour absorption rate is used.
The actual fixed overhead cost incurred was Rs 98,500. Actual production was
20,300 units using 25,700 machine hours.
Solution
The absorption rate per machine hour (based upon the budget) is given by:
Budgeted fixed overhead cost

Budgeted machine hours
= Rs 100,000 = Rs 4 per machine hour

25,000
This would be used to determine the fixed overhead cost absorbed (i.e.
attributed to the actual production achieved).
In a standard costing system the actual production achieved is measured in

standard hours, in this case standard machine hours.
According to the budget 20,000 units should require 25,000 machine hours,
this is the equivalent of 1.25 machine hours per unit (25,000/20,000).
Thus the actual production of 20,300 units is equivalent to 20,300 x 1.25 =

25,375 standard machine hours.
The amount absorbed is therefore:
5,375 standard machine hours x Rs 4/machine hour = Rs 101,500
This is the standard cost of the actual production (using absorption costing). It
is compared with the actual cost to find the total variance:
Rs
Standard cost 101,500
Actual cost 98,500
Variance 3,000 (F)
Since the actual cost is less than the standard cost it is a favourable variance.

3.3 Over/under-absorptions and the total variance
The comparison of actual fixed overhead cost incurred and the amount of fixed
overhead cost absorbed is not new, it was used in your earlier studies to
determinethe extent of any under/over-absorption. Often this is done using a
fixed production overhead control account that is shown below based upon the
above figures:
Fixed production overhead control a/c

Rs Rs
Creditors 98,500
P & L (over absorption) 3,000 Work in progress 101,500
101,500 101,500
You should note that the over absorption is equal to the total variance.

P has the following data concerning its fixed production overheads:
Budget cost Rs 44,000

Budget production 8,000 units
Budget labour hours 16,000
Actual cost Rs 47,500
Actual production 8,450 units
Actual labour hours 16,600
Calculate the fixed overhead total variance assuming an absorption system

based upon labour hours.
3.4 Analysing the total variance

The total variance can be analysed into the causes known as expenditure and
volume. The example we used earlier (reproduced below) will be used to show
this.
Example
Q Limited has completed its budget for October, the following data have been
extracted:
Budgeted fixed overhead cost Rs 100,000

Budgeted machine hours 25,000
A machine hour absorption rate is used (calculated in 3.2 at Rs 4 per machine

hour).

The actual fixed overhead cost incurred was Rs 98,500. Actual production was
20,300 (standard hours 25,375) units using 25,700 machine hours.
3.5 Fixed overhead expenditure variance

This variance shows the effect on profit of the actual fixed overhead
expenditure differing from the budgeted value:
R
Rs
Budgeted expenditure 100,000
Actual expenditure 98,500
Expenditure variance 1,500 (F)
The variance is favourable because the actual expenditure is less than that
budgeted.
3.6 Fixed overhead volume variance

This variance measures the difference between the amount actually absorbed
based upon actual production (in standard hours) compared to the amount
expected to be absorbed based upon budgeted production (in standard hours).
Formula:
Volume variance = (Standard hours for actual production x
Overhead absoprtion rate) – Budgeted expenditure
Budgeted production (standard machine hours) 25,000

Actual production (standard machine hours) 25,375
Difference 375
This difference of 375 standard machine hours is valued at the absorption rate
of Rs4/hr:
375 hours x Rs 4/hr = Rs 1,500 (F).
This variance is favourable because the actual output exceeded the expected
output. Since the cost is fixed, the actual cost/unit is lowered by making
greater production and profits will therefore increase or, looking at it another
way, production has been overcharged by Rs 1,500 and this will have to be
credited back by a favourable variance.
Fixed OH volume variance can also be found by this formula depending upon
data given in exam questions.

Fixed OH Volume variance = (Budgeted volume – Actual volume) X OAR
per unit
OAR per unit means standard rate per unit for fixed overheads.
Note: Fixed OH volume variance will arise only in an absorption costing

system because in absorption costing systemen Fixed OH becomes part of
inventory cost therefore they result in volume variance when actual volume
differes from budegted volume.
3.7 The total variance and the sub-variances

Note that the sum of the fixed overhead expenditure and volume variances
equals the fixed overhead total variance:
expenditure variance + volume variance = total variance

Rs 1,500 (F) + Rs 1,500 (F) = Rs 3,000 (F).

Analyse the total variance you calculated in the previous Test your
understanding into the fixed overhead expenditure and volume variances.
3.8 Fixed overhead variances and marginal costing

As was stated earlier, marginal costing does not relate fixed production
overhead costs to cost units. The amount shown in the profit and loss account
is the cost incurred. Therefore there can be no under or over absorption due to
volume changes and the fixed overhead volume variance does not arise in a
marginal costing system.
Since the cost is a fixed cost it is not expected to change when activity
changes thus the expected cost of any level of production is always the
budgeted cost.The purpose of variance analysis is to calculate the effect on
profit of actual performance differing from that expected, consequently, under
marginal costing this will be the difference between the actual and budgeted
expenditure.
Thus under marginal costing the total fixed production overhead variance will
always equal the fixed production overhead expenditure variance which is
calculated in the same way as for absorption costing systems.

Example
The following information is available for a company for Period 4.
Budget
Output Rs 22,960
Unit 6,560
Actual
Fixed production overheads Rs 24,200
Unit 6,460
Required:
Calculate the following:
(a) fixed overhead absorption rate per unit
(b) fixed overhead expenditure variance for marginal costing
(c) fixed overhead expenditure variance for absorption costing
(d) fixed overhead volume variance for marginal costing
(e) fixed overhead volume variance for absorption costing
(f) fixed overhead total variance for marginal costing
(g) fixed overhead total variance for absorption costing.
Solution
(a) FOAR = Rs 22,960/6,560 = Rs 3.50 per unit
(b) Fixed overhead expenditure variance for marginal costing.
Actual expenditure Rs 24,200

Less Budgeted expenditure Rs 22,960
Fixed overhead expenditure variance Rs 1,240 (A)
(c) The fixed overhead expenditure variance for absorption costing is

calculated in exactly the same way as that for marginal costing.
(d) There is no fixed overhead volume variance for marginal costing. This
is because under marginal costing, fixed overheads are not expected to
change when there is a change in volume of activity.
(e) Fixed overhead volume variance for absorption costing
Actual units x FOAR per unit* Rs 22,610

Less Budgeted expenditure Rs 22,960
Fixed overhead volume variance Rs 350 (A)
* (6,460 x Rs 3.50 = Rs 22,610)

The variance is adverse because fewer units were produced than
expected.
(f) The fixed overhead total variance for marginal costing is the same as
the expenditure variance for marginal costing, i.e. Rs 1,240 (A).
(g) The fixed overhead total variance for absorption costing is the total of
the expenditure and volume variances for absorption costing, i.e. Rs
1,240 (A) + Rs 350 (A) = Rs 1,590 (A).
Fixed Overheads volume variance can also be segregated into two variances
namely; Fixed overheads efficiency variance and fixed overheads capacity
variance because efficiency and capacity of workers affects the overall
production volume.
Fixed OH efficiency variance = (Standard Hours for actual output – Actual

Hours worked) X OAR per hour
Fixed OH capacity variance = (Budgeted Hours – Actual Hours) X OAR

per hour
4 Non-production overheads
4.1 Introduction
Since the purpose of variance analysis is to show the effect on profit of actual
results differing from those expected, it is also necessary to compare the costs
of non-production overheads such as selling, marketing and administration.
4.2 Non-production overhead variances

These costs are not related to the cost unit (even in an absorption costing
system) so the calculation of variances for these items is exactly the same as
that for fixed production overheads in a marginal costing system. In other
words the only variance is expenditure that is simply the difference between
actual and budgeted expenditure. It is usual for separate variances to be
calculated for each function (i.e. selling, marketing, administration).

Summary
This chapter has continued your studies of variance analysis, looking at total
variable and fixed production overhead variances, which can be sub-analysed
as follows:
Variable overheads
– expenditure variance
– efficiency variance
Fixed overheads
– expenditure variance
– volume variance (absorption costing only).
Whilst the variable overhead variances are very similar to the other variable
cost variances already studied, the fixed overhead variance is approached
from a different angle, due to its nature.
 calculate and interpret variances for variable overheads and fixed

overheads.

Self-test questions
Variable overhead variances

1 What does an adverse variable overhead total variance indicate? (2.2)
2 What does the variable overhead efficiency variance reflect? (2.4)
Fixed overhead variances

3 What is the difference between absorption and marginal costing, and how
does this affect fixed overhead variance computations? (3.8)
4 How is the fixed overhead volume variance calculated? (3.6)

1. The following details relate to product T, which has a selling price of

Rs 44.00:
Rs /unit
Direct materials 15.00
Direct labour (3 hours) 12.00
Variable overhead 6.00
Fixed overhead 4.00
37.00
During April, the actual production of T was 800 units, which was 100 units
fewer than budgeted. The budget shows an annual production target of
10,800, with fixed costs accruing at a constant rate hroughout the year. Actual
overhead expenditure totalled Rs 8,500 for April.
The overhead variances for April were:
Expenditure Volume
Rs Rs
A 367 A 1,000 A
B 100 A 1,000 A
C 367 A 400 A
D 100 A 400 A
The following data relate to questions 2 and 3 below
H Limited operates a standard costing system for its only product. The
standard cost card includes:
Fixed overhead: 4 hours @ Rs 10 per hour Rs 40.00
Fixed overheads are absorbed on the basis of labour hours. Fixed overhead
costs are budgeted at Rs 240,000 per annum and are expected to be incurred
in equal amounts in each of the twelve accounting periods during the year.
Production is budgeted to be at an equal number of units in each accounting

period.
Actual production during period 6 was 450 units, with actual fixed overhead
costs incurred being Rs 19,600 and actual hours worked being 1,970.

2. The fixed overhead expenditure variance for period 6 was:
A Rs 4,400 (F)
B Rs 400 (F)
C Rs 400 (A)
D Rs 4,400 (A)
3. The fixed overhead volume variance for period 6 was:

A Rs 300 (A)
B Rs 1,200 (A)
C Rs 1,700 (A)
D Rs 2,000 (A)
Department 7
Shown below is the previous month's overhead expenditure and activity, both
budget and actual, for department 7 in a manufacturing company:
Month's Month's
budget actual
Activity:
Standard hours 8,000 8,400
Rs Rs
Fixed overheads:
Salaries 6,750 6,400
Maintenance 3,250 3,315
Variable overheads:
Power 17,600 20,140
Consumable materials 6,000 5,960
Indirect labour 4,400 4,480
Total overheads 38,000 40,295
The budgeted overheads shown above are based upon the anticipated activity
of 8,000 standard hours and it should be assumed that the department's
budgeted overhead expenditure and activity occur evenly throughout the year.
Variable overheads vary with standard hours produced.

You are required:
(a) to calculate the following variances incurred by the department during the
previous month:
(i) fixed overhead volume variance
(ii) fixed overhead expenditure variance
(iii) variable overhead expenditure variance.
(b) to draft a suitable operating statement this will assist management in
controlling the department’s overheads.
Answers to MCQs:
1. D
2. B
3. D


Absorption rate = Budgeted cost = Rs 44,000 = Rs 2.75 per standard labour hr
Budgeted hours 16,000
Actual output in standard hours = 8,450 x 16,000 = 16,900

8,000
Amount absorbed = 16,900 x Rs 2.75 = Rs 46,475
Actual cost = Rs 47,500
Variance Rs 1,025 (A)

Fixed overhead expenditure variance:
Rs
Budget cost 44,000
Actual cost 47,500
3,500 (A)
Fixed overhead volume variance:
Budget production (labour hours) 16,000
Actual production (standard hours) 16,900
900
900 hours x Rs 2.75 = Rs 2,475 (F)
Proof of total:
Rs 3,500 (A) + Rs 2,475 (F) = Rs 1,025 (A)

(a) Calculation of variance
(F = Favourable; A = Adverse)
Fixed overhead volume variance

Budget Actual Variance
8,000 – 8,400 = 400 hours x (Rs 6,750 + Rs 3,250) / 8,000
= 400 x Rs 1.25 = Rs 500 (F)

Fixed overhead expenditure variance
Flexed budget Actual Variance
Rs Rs Rs
6,750 6,400
3,250 3,315
10,000 9,715 Rs 285 (F)
Variable overhead expenditure variance

Original budget Flexed budget Actual Rs Variance
17,600 20,140
6,000 5,960
4,400 4,480
28,000 x 8,400/ 8,000
Rs 29,400 30,580 Rs 1,180 (A)
(b) Operating statement for control of department overheads
Flexed Actual Variance

budget
Rs Rs Rs
Fixed overhead:
Salaries 6,750 6,400 350 (F)
Maintenance 3,250 3,315 65 (A)
Total 10,000 9,715 285 (F)
Variable overhead:
Power Rs 17,600 x 8,400 / 8,000= 18,480 20,140 1,660 (A)
Consumable materials Rs 6,000 x 8,400 / 8,000 6,300 5,960 340 (F)
=
Indirect labour Rs 4,400 x 8,400 / 8,000= 4,620 4,480 140 (F)
Total 29,400 30,580 1,180 (A)
Overall total 39,400 40,295 895 (A)
Strictly an 'operating statement' should include information relating to sales

and to prime costs but information was not provided in the question.

 Sales variances
 Operating statements
 Deriving actual data from standard cost details and Inter-relationship between
variances
 The reason for cost variances

1 Sales variances
1.1 Introduction
There are two causes of sales variances: a difference in the selling price, and a
difference in the sales volume.
1.2 Sales volume variance

The sales volume variance calculates the effect on profit of the actual sales
volume being different from that of budgeted. The effect on profit will differ
depending upon whether a marginal or absorption costing system is being used.
 Under absorption costing any difference in units is valued at the standard

profit per unit.
 Under marginal costing any difference in units is valued at the standard
contribution per unit.
Formula:
Sales volume variance = (Actual Quantity Sold – Budget Quantity sold) x
Standard Margin**
The Standard Margin equals the Contribution per unit (marginal costing), or the
profit per unit (absorption costing).
If the actual quantity sold is greater that the budget this will produce a favourable
variance as it increases profit.
Note: In Exams questions examiner might ask you to calcule sales volume
variance based on standard sales price then we have to multiply by standard
sale price instead of standard profit or standard contribution.
1.3 Sales price variance

The sales price variance shows the effect on profit of selling at a different
price from that expected.
Formula:
Sales price variance = (Actual Price – Budget Price) x Actual Quantity sold
If the actual price is greater that the budget this will produce a favourable
variance as it increases profit.

Example
The following data relates to 20X8.
Actual sales: 1,000 units @ Rs 650 each
Budgeted output and sales for the year: 900 units
Standard selling price: Rs 700 per unit
Budgeted contribution per unit: Rs 245
Budgeted profit per unit: Rs 205
Required:
Calculate the sales volume variance (under absorption and marginal costing)
and the sales price variance.
Solution
Sales volume variance – absorption costing
(1,000 units – 900 units) × Rs 205 = Rs 20,500 Fav
Sales volume variance – marginal costing
(1,000 units – 900 units) × Rs 245 = Rs 24,500 Fav
Sales price variance
(Rs 650 – Rs 700) × 1,000 = Rs 50,000 Adv

Radek Ltd has budgeted sales of 400 units at Rs 2.50 each. The variable costs
are expected to be Rs 1.80 per unit, and there are no fixed costs.
The actual sales were 500 units at Rs 2 each and costs were as expected.
Required:
Calculate the sales price and sales volume variances (using marginal costing).

W Ltd budgeted sales of 6,500 units but actually sold only 6,000 units. Its
standard cost card is as follows:
Rs
Direct materials 25
Direct wages 8
Variable overhead 4
Fixed overhead 18
–––
Total standard cost 55
Standard gross profit 5
–––
Standard selling price 60
–––
The actual selling price for the period was Rs 61.
Required:
Calculate the sales price and sales volume variances for the period (using
absorption costing).
2 Operating statement - Reconciliation of budget and actual results
2.1 Introduction
The purpose of calculating variances is to identify the different effects of each
item of cost/income on profit compared to the expected profit. These
variances are summarised in a reconciliation statement (also called operating
statement).
2.3 The reconciliation statement – absorption costing

The example that follows shows how such a statement reconciles the budget
and actual profit of a period, based on absorption costing.
The statement commences with the budgeted profit that is based upon
budgeted cost and activity levels.
This is then adjusted by all of the variances to arrive at the actual profit.
Format - Absorption costing operating statement

Rs
Budgeted profit X
Sales volume variance (using std profit per X
unit)
Standard profit on actual sales X
Sales price variance X

Cost variances: F A
Rs Rs
Material price
Material usage
Labour rate
Labour efficiency
Variable overhead rate
Variable overhead efficiency
Fixed overhead volume – Production

Fixed overhead expenditure – Production
Fixed overhead expenditure – Non-production
Total X
Actual profit X
(Note that bold highlighted the differences from the marginal costing version)
Example
Chapel Ltd manufactures a chemical protective called Rustnot. The following
standard costs apply for the production of 100 cylinders:
Rs
Materials 500 kgs @ Rs 80 per kg 40,000
Labour 20 hours @ Rs 150 per hour 3,000
Fixed overheads 20 hours @ Rs 100 per hour 2,000
45,000
The monthly production/sales budget is 10,000 cylinders. Selling price = Rs

600 per cylinder.
For the month of November the following actual production and sales
information is available:
Produced/sold 10,600 cylinders

Sales value Rs 6,300,000
Material purchased and used 53,200 kgs Rs 4,250,000
Labour 2,040 hours Rs 310,000
Fixed overheads Rs 220,000
You are required to prepare an operating statement for November detailing all
the variances.

Solution
Operating statement for November
Rs
Budgeted profit (10,000 cylinders) (W(a)) 1,500,000
Total sales margin variance (W(f)) 30,000

Less: Cost variances (W(g) – (i)) Adv. Fav.
Rs Rs
Material price (g) 6,000
Wages rate (h) 4,000
Fixed overhead expenditure (i) 20,000
Material usage (g) 16,000
Labour efficiency (h) 12,000
Fixed overhead volume (i) 12,000
40,000 30,000
10,000
Actual profit (W(b)) 1,520,000
Workings
(a) Budgeted profit R

10,000 cylinders @ Rs 150 1,500,000
(b) Actual profit Rs Rs

Sales 6,300,000
Less: Materials 4,250,000
Labour 310,000
Fixed overheads 220,000 4,780,000
1,520,000
(c) Standard hours
10,600 cylinders x 0.2 hours = 2,120 hours
(d) Budgeted hours

10,000 x 0.2 = 2,000 hours
Variances
(e) Total sales margin variance

Rs
Actual margin earned, based on standard unit costs:
actual sales revenue 6,300,000
standard cost of actual sales volume 4,770,000
Budgeted margin 1,530,000

Total sales margin variance 1,500,000
30,000
favourable
(f) Raw materials
The standard price of the raw material is Rs 80 per kg. If the actual quantity of
53,200 kg had been bought at the standard price this would have been:
53,200 kg x Rs 80/kg = Rs 4,256,000
The actual cost was Rs 4,250,000. This is a price saving, i.e. a favourable
price variance of Rs 6,000.
Each 100 cylinders should use 500 kgs of material. Therefore the 10,600
cylinders produced should use:
10,600 x 500 kg/100 = 53,000 kgs
The actual usage was 53,200 kgs. These additional 200 kgs of material have a
value (using standard prices) of:
200 kgs x Rs 80 = Rs 16,000
This is an adverse material usage variance.
(g) Labour
The standard labour rate is Rs 150 per hour. The actual labour hours were
2,040 hours, so if they had been paid at the standard rate per hour, the wage
cost would have been:
2,040 x Rs 150 = Rs 306,000
The actual wage cost was Rs 310,000. This extra Rs 4,000 is the adverse
wage rate variance.
Each 100 cylinders should take 20 hours to produce.
The actual production was 10,600 cylinders so these should have taken:
10,600 x 20/100 = 2,120 hours.

Actual hours were 2,040 hours, a saving of 80 hours. These hours (valued at
the standard rate) are worth:
80 x Rs 150 = Rs 12,000
This is a favourable labour efficiency.
(h) Fixed overheads

The standard fixed overhead cost is Rs 20 per 100 cylinders. Monthly
production is budgeted at 10,000 cylinders. Therefore the budgeted fixed
overhead cost is:
10,000 x Rs 2000/100 = Rs 200,000
The actual cost was Rs 220,000. The extra cost of Rs 20,000 is an adverse
fixed overhead expenditure variance.
But the actual production was 10,600 cylinders, 600 more than budgeted. This
extra volume of 600 units (valued at the standard absorption rate of Rs20/100
units) is:
600 x Rs 20/100 = Rs 12,000
This is a favourable fixed overhead volume variance.
2.3 Marginal costing reconciliation
Format - Marginal costing operating statement

Rs
Budgeted contribution X
Sales volume variance (using std X
contribution per unit)
Standard contribution on actual sales X
Sales price variance X
Cost variances: F A
Rs Rs
Material price
Material usage
Labour rate

Labour efficiency
Variable overhead rate
Variable overhead efficiency
Actual contribution
Fixed overhead expenditure – Production
Fixed overhead expenditure – Non-production
Total X
Actual profit X
Previous example (Chapel Ltd) on a marginal costing basis would appear as:
Rs
Budgeted contribution (10,000 × Rs (600-430)) 1,700,000
Total sales contribution variance (j) 102,000
1,742,000
Less: Variable cost variances (W(g)–(i)): Adv Fav

Rs Rs
Material price (g) 6,000
Wages rate (h) 4,000
Material usage (g) 16,000
Labour efficiency (h) 12,000
20,000 18,000 2,000

Actual contribution (W(b)) 1,740,000
Fixed overhead: budget 200,000

Expenditure variance 20,000 220,000
Actual profit 1,520,000

Workings
(a) to (i) are as in the previous example.
(j)
Rs
Actual margin earned, based on standard unit variable costs:
actual sales revenue 6,300,000
std variable cost of actual sales volume (10,600 × Rs 4.30) 4,558,000
Budgeted contribution 1,700,000
1,742,000
42,000
favourable
3 Causes of variances
3.1 Introduction
The calculation of variances is only the first stage. Management wants
information to plan and control operations. It is not sufficient to know that a
variance has arisen: we must try to establish why. The figures themselves do
not provide the answers, but they point to some of the questions that should be
asked.
3.2 Possible causes of cost variances

Possible causes of the individual cost variances are now discussed. In addition
to the causes suggested, any of the variances could be due to poor initial
standard setting.
(a) Material price variance

Possible causes:
 different source of supply

 unexpected general price increase
 alteration in quantity discounts
 substitution of a different grade of material
 standard set at mid-year price so one would expect a favourable price
variance in the early months and an adverse variance in the later months of
the year.
(b) Material usage variance

Possible causes:
 higher/lower incidence of scrap

 alteration to product design

 substitution of a different grade of material. A lower grade of material may
be more difficult to work with, so there may be a higher wastage rate and, in
turn, an adverse usage variance may arise.
(c) Labour rate variance

Possible causes:
 unexpected national wage award

 overtime/bonus payments different from plan
(d) Labour efficiency variance

Possible causes:
 improvement in methods or working conditions

 variations in unavoidable idle time
 introduction of incentive scheme
 substitution of a different grade of labour
(e) Variable overhead variance

Possible causes:
 unexpected price changes for overhead items

 labour efficiency variances, (see above).
(f) Variable overhead expenditure variances

Possible causes:
 incorrect budgets being set at the beginning of a period.

 overheads consisting of a number of items, such as: indirect materials,
indirect labour, maintenance costs, power, etc. Consequently, any
meaningful interpretation of the expenditure variance must focus on
individual cost items.
(g) Variable overhead efficiency variances

Possible causes:
 changes in working methods and condition, for example, better supervision

 consequences of the learning effect
 introduction of incentive schemes or staff training
 substitution of one grade of labour for another higher or lower grade
Note that the possible causes of variable overhead efficiency variances are the
same as those for the labour efficiency variance.

(h) Fixed overhead expenditure variance
Possible causes:
 changes in prices relating to fixed overhead items, e.g. rent increase

 seasonal effects, e.g. heat/light in winter. (This arises where the annual
budget is divided into four equal quarters of thirteen equal four-weekly
periods without allowances for seasonal factors. Over a whole year the
seasonal effects would cancel out)
(i) Fixed overhead volume variance

Possible causes:
 change in production volume due to change in demand or alterations to

stockholding policy
 changes in productivity of labour or machinery
 production lost through strikes, etc.
(j) Sales variances
Possible causes:
 unplanned price increases (sales price variance)
 unplanned price reduction, for example, when trying to attract additional
business (sales price variance)
 unexpected fall in demand due to recession (sales volume variance)
 additional demand attracted by reduced price (sales volume variance)
 failure to satisfy demand due to production difficulties (sales volume
variance)
3.3 Inter-relationship between variances

The cause of a particular variance may affect another variance in a
corresponding or opposite way.
 If supplies of a specified material are not available, this may lead to a

favourable price variance (cheaper material used), an adverse usage
variance (cheaper material caused more wastage), an adverse fixed
overhead volume variance (production delayed while material was
unavailable) and an adverse sales margin variance (unable to meet
demand due to production difficulties).
 A new improved machine becomes available which causes an adverse

fixed overhead expenditure variance (because this machine is more

expensive and depreciation is higher) offset by favourable wages efficiency
and fixed overhead volume variances (higher productivity).
 Workers trying to improve productivity (favourable labour efficiency

variance) might become careless and waste more material (adverse
material usage variance).
4 Reporting of variances
In reporting variances, the concept of responsibility accounting would normally
be followed so a variance report to an individual manager should only include
figures relating to his own area of responsibility i.e. within his area of control. If
more figures are given, then they are usually reported in the form of ‘for
information only’ as a help to a manager in seeing the total picture or context in
which his figures arise.
Several questions may be asked before deciding whether or not to investigate
avariance.
These include:
 Is the variance controllable?
 Is the expected benefit from control action likely to exceed the expected
cost?
 Is there a reasonable probability of successfully being able to correct a
variance?
 Is the variance material (significant)?
 Is the variance steadily getting worse?
4.1 Cost versus benefit

For some variances, especially small variances, the cost of investigating its
causes might be more than the likely benefit from any control measures. In such
circumstances, investigation of the variance is not worthwhile.
However, not all significant controllable variances will necessarily lead to control
action. Managers should also consider:
 what it would cost to implement control action

 what would be the benefits from taking control action
Control action is only worthwhile if the expected benefits from the control
measures exceed the cost of implementing them.
The benefits from control action are not the same as the amount of the variance.

4.2 Probability of successful correction
Measures to correct a variance might not be successful. The probability of
control action having the desired effect should therefore be taken into
consideration as well.
4.3 Significance of variances

Variance reports might apply the principle of management by exception.
Variances are differences between actual and standard/budget. Some
differences are inevitable, but it is only large or potentially significant variances
that matter for control purposes. With exception reporting, only large and
potentially significant items are reported to management and drawn to their
attention. Exception reporting means that managers do not have to read through
large amounts of insignificant cost data to find the information that really
matters.
The amount of detail included in reports will vary according to the needs of
management. As a guide, they should be in sufficient detail to motivate the
individual manager to take the most appropriate action in all the circumstances.
If a report lacks the required amount of detail, then an individual manager should
request this from the management accountant.

Summary
This chapter concludes your studies of variance analysis. Our aim is to be able
to reconcile budgeted results to actual results, and present the variances in a
format that is useful to managers. We also considered possible causes of
variances, and the way in which they can be interdependent.
 calculate and interpret variances for sales

 prepare a report reconciling budget gross profit/contribution with actual
profit

Self-test questions
Sales variances
1 How is the sales margin variance calculated in an absorption costing
system? (1.2)
2 How is the sales margin variance calculated under a marginal costing
system? (1.3)
Reconciliation of budget and actual results

3 How is a profit/contribution reconciliation statement laid out? (2.2)
Causes of variances
4 Give two possible causes of a materials price variance. (3.2)
5 Give two possible causes of a labour efficiency variance. (3.2)
6 Give two possible causes of a fixed overhead volume variance. (3.2)

1. J Ltd operates a standard cost accounting system. The following

information has been extracted from its standard cost card and budgets:
Budgeted sales volume 5,000 units

Budgeted selling price Rs 10.00 per unit
Standard variable cost Rs 5.60 per unit
Standard total cost Rs 7.50 per unit
If it used a standard marginal cost accounting system and its actual sales were
4,500 units at a selling price of Rs 12.00, its sales margin (contribution)
variance would be
A) Rs 6,800 favourable
B) Rs 6,800 adverse
C) Rs 800 favourable
D) Rs 800 adverse
2. P Ltd has the following data relating to its budgeted sales for October:
Budgeted sales Rs 100,000.00

Budgeted selling price per unit Rs 8.00
Budgeted contribution per unit Rs 4.00
Budgeted profit per unit Rs 2.50
During October, actual sales were 11,000 units for a sales revenue of Rs
99,000. P Ltd uses an absorption costing system.
The sales margin variance reported for October was Rs.
A) Rs 7,250 adverse
B) Rs 7,250 favourable
C) Rs 12,200 favourable
D) Rs 14,500 adverse

3. The following data are available for Scott's production in September:
Budget
Selling price per unit Rs 120
Variable cost per unit Rs 80
Production and sales 18,000 units
Actual for SeptemberSales 21,000 units
Fixed costs Rs 580,000
Fixed costs expenditure variance Rs 20,000 (F)
Variable cost per unit Rs 60
The budgeted profit for September was:
A) Rs 80,000
B) Rs 100,000
C) Rs 120,000
D) Rs 140,000
Test your understanding – 3

The standard cost per gallon of glow, the only product manufactured by Chand
Ltd,is shown below:
Direct material (4kg @ Rs 3/kg) 12

Direct labour (5 hours @ Rs 4/hour) 20
Variable overhead 5
Fixed overhead 15
Standard cost per gallon 52
The standard selling price of Glow is Rs 60/gallon and the budgeted quantity to
be produced and sold in each period is 10,000 gallons. It may be assumed that
variable overheads vary directly with the number of gallons produced. The
actual results achieved during period 4 were:

Rs Rs
Sales (9,500 gallons) 588,500
Cost of sales:
Direct material (37,000 kg) 120,000
Direct labour (49,000 hours) 200,000
Variable overhead 47,000
Fixed overhead 145,000
512,000
Profit 76,500
There were no stocks of work-in-progress or finished goods at the beginning or

end of the period.
You are required:

(a) to calculate the relevant manufacturing cost variances for period 4
(b) to calculate the sales margin variance for period 4, and prepare a
statement reconciling the budgeted and the actual profit for the period.
Answers to MCQs
1. A
2. B
3. C


Sales price variance = (Rs 2.00 – Rs 2.50) x 500 = Rs 250 (A)
Sales volume variance = (500 – 400) x Rs 0.70* = Rs 70 (F)
––––––
Total sales variance Rs 180 (A)
*Standard contribution per unit = Rs (2.50 – 1.80) = Rs 0.70

Price variance = (Rs 61 – Rs 60) x 6,000 = Rs 6,000 (F)
Volume variance = (6,000 – 6,500) x Rs 5* = Rs 2,500 (A)
Rs 3,500 (F)
* Standard gross profit per unit

(a) Direct material
Rs
Actual quantity at actual price 120,000 Price variance Rs 9,000 (A)
Actual quantity at standard price

37,000 kg @ Rs 3/kg 111,000
Standard quantity at standard price

(9,500 x 4) @ Rs 3/kg 114,000 Usage variance Rs 3,000 (F)
Direct labour
Rs
Actual hours at actual rate 200,000 Rate variance Rs 4,000 (A)
Actual hours at standard rate
49,000 hours @ Rs 4/hour 196,000
Standard hours at standard rate
(9,500 x 5) @ Rs 4/hour 190,000 Efficiency Variance Rs 6,000 (A)
Variable overhead
Rs
Actual hours at actual rate 47,000 Expenditure Variance Rs 2,000 (F)
Actual hours at standard rate
49,000 hours @ Re 1/hour 49,000
Standard hours at standard rate
(9,500 x 5) @ Re 1/hour 47,500 Efficiency Variance Rs 1,500 (A)

Fixed overhead
Rs
Actual cost 145,000 Expenditure Variance Rs 5,000 (F)
Budgeted cost: 10,000 galls. @ Rs 15/gall.

Standard cost (overhead absorbed) 150,000
9,500 galls. @ Rs 15/gall. 142,500 Volume variance Rs 7,500 (A)
(b) Sales margin variance

Rs
Actual margin earned, based on standard unit costs:
Actual sales revenue 588,500
Standard cost of actual sales volume (9,500 × Rs 52) 494,000
94,500
Budgeted margin (10,000 × Rs (60 – 52)) 80,000
Total sales margin variance 14,500 (F)
Profit reconciliation statement Period 4

Rs Rs
Budgeted profit 80,000
Sales margin variance 14,500 (F)
94,500
Cost variances: Materials 6,000 (A)
Labour 10,000 (A)
Variable overhead 500 (F)
Fixed overhead 2,500 (A)
18,000 (A)
Actual profit 76,500

INDEX
Terms Chapter Topics
ABC inventory analysis CHAPTER 5 Inventory control systems
Absorption costing CHAPTER 8 Absorption costing
Accounting system CHAPTER 2 Internal sources of information
Attainable standards CHAPTER 12 Types of standards
Average inventory level CHAPTER 5 Re-order level system
Basic standards CHAPTER 12 Types of standards
Batch costing CHAPTER 9 Batch costing
Buffer inventory CHAPTER 5 Terminology
Business contacts CHAPTER 2 External sources of information
By-products CHAPTER 11 Joint and by-products
Cluster sampling CHAPTER 2 Sampling techniques
Composite cost units CHAPTER 3 What is meant by cost
cost CHAPTER 3 What is meant by cost
Cost accounting CHAPTER 1 Cost accounting
Cost centers CHAPTER 3 What is meant by cost
Cost objects CHAPTER 3 What is meant by cost
Cost units CHAPTER 3 What is meant by cost
Cost variances CHAPTER 13 Cost variances
Current standards CHAPTER 12 Types of standards
Data CHAPTER 2 Data and information
Direct costs CHAPTER 3 Classification by nature
Environmental costing CHAPTER 1 Environmental costing
Financial accounting CHAPTER 1 Financial accounting
Fixed costs CHAPTER 3 Classification by behaviour
Free inventory CHAPTER 5 Re-order level system
Government sources CHAPTER 2 External sources of information
Group incentive CHAPTER 6 Incentive schemes
schemes
High/low method CHAPTER 3 Analysis of costs into fixed and
variable elements
Historical cost CHAPTER 3 What is meant by cost
Ideal standards CHAPTER 12 Types of standards
Idle time CHAPTER 6 Labour cost control reports
Indirect costs CHAPTER 3 Classification by nature
Job costing CHAPTER 9 Job costing
Joint and by-products CHAPTER 11 Joint and by-products
Joint products CHAPTER 11 Joint and by-products
Lead time CHAPTER 5 Terminology
Least squares CHAPTER 3 Analysis of costs into fixed and
regression analysis variable elements
Management CHAPTER 1 Management accounting
accounting
Marginal costing CHAPTER 8 Marginal costing
maximum level CHAPTER 5 Re-order level system
Measured day work CHAPTER 6 Incentive schemes

minimum level CHAPTER 5 Re-order level system
Multi-stage sampling CHAPTER 2 Sampling techniques
Overhead variances CHAPTER 14 Overhead variances
Payroll system CHAPTER 2 Internal sources of information
Periodic review system CHAPTER 5 Inventory control systems
Piece-work CHAPTER 6 Remuneration methods
Premium bonus plans CHAPTER 6 Incentive schemes
Process costing CHAPTER 9 Costing methods
Proof of total variance CHAPTER 14 Overhead variances
Quota sampling CHAPTER 2 Sampling techniques
Random Sampling CHAPTER 2 Sampling techniques
reorder level CHAPTER 5 Re-order level system
Re-order level system CHAPTER 5 Re-order level system
Sales price variance CHAPTER 15 Sales variances
Sales volume variance CHAPTER 15 Sales variances
semi variable cost. CHAPTER 3 Classification by behaviour
Share of production CHAPTER 6 Incentive schemes
plans
Specific order costing CHAPTER 9 Costing methods
Standard cost card CHAPTER 12 Standard cost card
stepped fixed cost CHAPTER 3 Classification by behaviour
Stocktaking CHAPTER 4 Checking the level of inventory
Stores ledger card CHAPTER 4 Physical inventory
Strategic planning CHAPTER 2 Internal sources of information
system
Stratified sampling CHAPTER 2 Sampling techniques
Systematic sampling CHAPTER 2 Sampling techniques
The financial press CHAPTER 2 External sources of information
Time rates CHAPTER 6 Remuneration methods
Trade associations CHAPTER 2 External sources of information
Two-bin system CHAPTER 5 Inventory control systems
Variable costs CHAPTER 3 Classification by behaviour
Variable overhead CHAPTER 14 Overhead variances
efficiency variance
Variable overhead CHAPTER 14 Overhead variances
expenditure variance
Variable overhead total CHAPTER 14 Overhead variances
variance


Fundamentals of Cost and Management Accounting (Study Text)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fundamentals of Cost and Management Accounting (Study Text)

Uploaded by

Copyright:

Available Formats

Fundamentals of Cost and Management Accounting (Study Text)