COSTING

S.No. Chapter Name Page No.

1. INTRODUCTION TO COST AND 1-21

MANAGEMENT ACCOUNTING

2. MATERIAL COST 22-45

3. EMPLOYEE COST 46-59

4. OVERHEADS ABSORPTION 60-80

COSTING METHOD

5. ACTIVITY BASED COSTING 81-95

6. COST SHEET 96-107

7. COST ACCOUNTING SYSTEMS 108-125

8 CONTRACT COSTING 126-132

9. JOINT AND BY PRODUCT 133-142

10. MARGINAL COSTING 143-161

 CHAPTER -1
INTRODUCTION TO COST AND
MANAGEMENT ACCOUNTING

Part A-CONCEPTUAL PART

COST, COSTING AND COST ACCOUNTING

Cost is the amount of resource given up in exchange of some goods

or services. According to CIMA, London, cost means, the amount of
01 Cost expenditure incurred on or attributable to a specified article, product
or activity

02 Costing Costing is defined as “the technique and process of ascertaining costs”.

Cost Accounting is defined as "the process of accounting for cost

Cost which begins with the recording of income and expenditure or the
03 Accounting
bases on which they are calculated and ends with the preparation of
periodical statements and reports for ascertaining and controlling
costs.”

Cost object is anything for which a separate

measurement of cost is required. Cost object may be a
COST OBJECTS product, a service, a project, a customer, a brand
category, an activity, a department or a programme etc.

Examples of cost objects are:

Product Smart phone, Tablet computer, SUV Car, Book etc

An airline flight from Delhi to Mumbai, Concurrent

Service audit assignment, Utility bill payment facility etc.

Project Metro Rail project, Road projects etc.

Activity Quality inspection of materials, Placing of orders etc.

Refinement of crudes in oil refineries, melting of

Process
billets or ingots in rolling mills etc.

Department Production department, Finance & Accounts, Safety etc

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COST CENTRE
A location, person, or item of equipment (or a combination of these) for which costs
can be determined and utilised for cost control.
Cost centres can be separated into two categories in a project:

Production Cost Centres Service Cost Centres

COST UNITS

It is a unit of product, service or time (or combination of these) in relation to

which costs may be ascertained or expressed.
Cost units are usually the units of physical measurement like number,
weight, area, volume, length, time and value.

A few typical examples Some examples from the CIMA

of cost units are as follows: terminology are as follows:

Industry or
Cost Unit Basis Industry or Sector Cost Unit
Product
Automobile Number Brewing Barrel
Cement Ton/ per bag etc. Brick-making 1,000 bricks
Chemicals Litre, gallon, kilogram, ton etc. Coal mining Tonne/ton

Power Kilo-watt hour (kWh) Electricity Kilowatt-hour (kWh)

Steel Ton Engineering Contract, job

Transport Passenger- kilometer Oil Barrel, tonne, litre

Gas Cubic feet Hotel/Catering Room/meal
Professional services Chargeable hour, job,
contract
Education Course, enrolled student,
successful student

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 Activity Cost unit

Credit control Accounts maintained

Selling Customer call, value of sales, orders taken

Materials storage/handling Requisition unit issued/received, material

movement,valueissued/received

Personnel administration Personnel record

RESPONSIBILITY CENTRES
Meaning:
To have a better control over the organisation, management delegates its
responsibility and authority to various departments or persons. These
departments or persons are known as responsibility centres

Types of
responsibility centres

Cost Revenue Profit Investment

Cetres Centres Centres Centres

(I) Cost Centres (II) Revenue Centres

The responsibility centre which is held
accountable for incurrence of costs
which are under its control.
The performance of this responsibility
centre is measured against pre-
determined standards or budgets.
The cost centres are of two types:
(a) Standard Cost Centre and
(b) Discretionary Cost Centre
The responsibility centres which are
accountable for generation of revenue
for the entity. Sales Department for
example, is responsible for
achievement of sales target and
revenue generation.

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 (iii) Profit Centres: (iv) Investment
Centres:

These are the responsibility centres
which have both responsibility of
generation of revenue and incurrence
of expenditures. Examples of profit
centres are decentralised branches of
an organisation.
These are the responsibility centres which
are not only responsible for profitability
but also have the authority to make capital
investment decisions.
The performance of these responsibility
centres are measured on the basis of
Return on Investment (ROI) besides profit.

It means the grouping of costs according to their

CLASSIFICATION common characteristics. The important ways of
OF COSTS classification of costs are:

(I) By Nature or Element (iv) By Controllability

(ii) By Functions (v) By Normality

By Variability or By Costs for Managerial

(iii) (vi)
Behaviour Decision Making

BY NATURE This type of classification is

useful to determine the total cost.
OR ELEMENT
Direct Material
Cost
Material
Cost
Indirect
Material Cost Production
Overheads

Direct Employee Administration

Overheads
(Labour) Cost Overheads
ELEMENT Employee
OF COST (Labour)
Cost Indirect Employee Selling & Distribution
(Labour) Cost Overheads

Direct
Other Expenses
Expenses
Indirect
Expenses

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(I) (I) (I)

Direct Materials Direct Labour Direct Expenses
Materials which are Labour which can be All expenses other
present in the economically than direct material
finished product identified or or direct labour
cost object) or can be attributed wholly to a which are specially
economically cost object is termed incurred for a
identified in the as direct labour. particular cost object
product are termed and can be identified
as direct materials in an economically
feasible way are
termed as Direct
Expenses.

(IV) (V) (VI)

Indirect: Materials Indirect Labour Indirect Expenses
Materials which do not Labour cost which Expenses other than direct
normally form part of the cannot be allocated but expenses are known as
finished product can be pportioned to or indirect expenses. These
(cost object) are known absorbed by cost units or cannot be directly,
as indirect materials. cost centres is known as conveniently and wholly
These are — indirect labour. allocated to cost centres.
- Stores used for Examples of indirect
maintaining machines labour includes salary Factory rent and rates,
and buildings lubricants, paid to foreman and insurance of plant and
cotton waste, bricks etc.) supervisors; machinery, power, light,
- Stores used by service maintenance workers; heating, repairing,
departments like power etc. telephone etc., are some
house, boiler house, examples of indirect
canteen etc. expenses.

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 (VII)
Overheads
The aggregate of
indirect material
costs, indirect labour
costs and indirect
expenses is termed
as Overheads.

Administration
1 Direct Material Cost 5 Overheads
BY FUNCTIONS
Under this classification, Direct Employee
2 Selling Overheads 6
(labour) Cost
costs are divided according
to the function for which they
have been incurred. Direct Expenses Distribution Overheads
3 7
It includes the following:

Production/ Manufacturing Research & Development

Overheads 4 costs etc 8

Based on this classification, costs are classified

By Variability or Behaviour into three groups viz., fixed, variable and semi-variable

(a) Fixed costs

These are the costs which are incurred for a period, and which, within
certain output and turnover limits, tend to be unaffected by fluctuations
in the levels of activity (output or turnover).
They do not tend to increase or decrease with the changes in output.
For example, rent, insurance of factory building etc., remain the same for different levels
of production
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 (b) Variable Costs

These costs tend to vary with the volume of activity. Any increase in the activity results in an
increase in the variable cost and vice-versa.
For example, cost of direct material, cost of direct labour, etc.
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(b) Semi-Variable Costs

These costs contain both fixed and variable components and are thus partly affected by
fluctuations in the level of activity.
Examples of semi variable costs are telephone bills, gas and electricity etc.
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The segregation of semi-variable costs into fixed and variable costs can be carried out by using the
following methods:

High-Low method (b) (c) Analytical method

(a) Graphical method

Comparison by
Least squares
period or level of (d) (e)
method
activity method

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 21100,000
Example 1: 2,000 units
Segregate the SVC into VC and FC
250 pay
Level of activity 10,000 units 12,000 units
mm
SVC Rs. 15,00,000 Rs.16,00,000

VCTOTAL FCTOTAL FCTOTAL VCTOTAL

Example 2: Fame
Segregate the SVC into VC and FC
change
5,000 units
6500
6,000 units
Level of activity

SVC Rs. 14,50,000 Rs.16,00,000

Example 3:
Find out SVC at a output of 6,500 units in the above example.

Example 4: cost
Identify the type of cost, based on behaviour.

Cost Component 10,000 units 15,000 units

A Rs. 10,00,000 Rs.10,00,000

B Rs. 15,00,000 Rs.20,00,000

C Rs. 6,00,000 Rs.8,00,000

Example 5:
Identify the type of cost, based on behaviour.

Cost Component 1,800 units 2,000 units

A Rs. 16,200 Rs.18,000

B Rs. 12,00,000 Rs.12,00,000

C Rs. 2,70,000 Rs.3,00,000

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Example 6:
You have been given cost at 20,000 and 21,000 units. You are required
to find out the total cost at 20,500 units.

Cost Component 20,000 units 21,000 units

Raw Material Rs. 2,00,000 Rs.2,10,000

Labour cost Rs.11,60,000 Rs.11,73,000

Rent Rs.5,00,000 Rs.5,00,000

Example 7:
You have been given cost at 30,000 and 35,000 units. You are required to
s
find out the total cost at 40,000 units. 20,00 000
3 X 40 000
Cost Component 30,000 units 35,000 units

Raw Material

Labour cost
Rs.15,00,000

Rs.20,00,000
Rs.17,50,000

Rs.20,00,000
58t
FCTOTAL
É
900,00
Salary of Salesmen Rs.6,40,000 Rs.6,55,000 VC p u 3
FC 5150,0003

Example 8:
Suppose last month the total semi-variable expenses amounted to `3,000.
The degree of variability is assumed to be 70%. Find out
1) VC and FC.
2) What will be the total SVC, if next year, production increased by 50%.

Example 9:
You have a small business and you sell burgers. For the last 12 months, you have noted down what was
the monthly cost and what was the number of burgers sold in the corresponding month. Now you want
to use a high low method to segregate fixed and variable cost.

Numbers of Total Cost

Month Burger Sold ($)

JANUARY 122 $5,123

FEBRUARY 154 $4,356

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 MARCH 113 $3,670

APRIL 190 $5,800

MAY 98 $4,000

JUNE 90 $3,200

JULY 123 $3,456

AUGUST 111 $2,145

SEPTEMBER 161 $5,468

OCTOBER 78 $3,210

NOVEMBER 118 $4,125

DECEMBER 132 $4,100

Example 10:
Segregate SVC, using Least Square Method.

Capacity % 60% 80%

Volume (Labour hours) or 'x' 150 200

Semi-variable expenses `1,200 `1,275

(maintenance of plant) or 'y'

BY CONTROLLABILITY
Segregate SVC, using Least Square Method.

(a) Controllable Costs: - Cost that can be controlled, typically by a cost, revenue, profit or
investment centre manager is called controllable cost.
Controllable costs incurred in a particular responsibility centre can be influenced by the action of
the manager heading that responsibility centre.
For example, direct costs comprising direct labour, direct material, direct expenses and some of
the overheads are generally controllable by the shop floor supervisor or the factory manager.

(b) Uncontrollable Costs – Costs which cannot be influenced by the action of a specified member
of an undertaking are known as uncontrollable costs.
For example, expenditure incurred by, say, the tool room is controllable by the foreman in-charge
of that section but the share of the tool-room expenditure which is apportioned to a machine shop
is not controlled by the machine shop foreman.

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Distinction between Controllable
Cost and Uncontrollable Cost:

The distinction between controllable and uncontrollable costs is not very prominent and is
sometimes left to individual judgement.

In fact, no cost is uncontrollable; it is only in relation to a particular individual that we may specify a
particular cost to be either controllable or uncontrollable.

BY NORMALITY
According to this basis, cost may be categorised as follows:

(a) Normal Cost (B) Abnormal Cost

It is the cost which is normally It is the cost which is not normally

incurred at a given level of output incurred at a given level of output in the
under the conditions in which that conditions in which that level of output
level of output is normally is normally attained. It is charged to
attained. Costing Profit and loss Account

BY COSTS USED IN MANAGERIAL

DECISION MAKING
According to this basis, cost may be categorised as follows:

(a) Pre-determined Cost (b) Estimated Cost

A cost which is computed in
advance before production or
operations start, on the basis of
specification of all the factors
affecting cost, is known as a pre-
determined cost.
Kohler defines estimated cost as “the expected cost of
manufacture, or acquisition, often in terms of a unit of
product computed on the basis of information
available in advance of actual production or
purchase”. Estimated costs are prospective costs
since they refer to prediction of costs.

(c) Differential Cost (d) Opportunity Cost

(Incremental and decremental
costs). It represents the change
(increase or decrease) in total
cost (variable as well as fixed) due
to change in activity level,
technology, process or method of
production, etc.
This cost refers to the value of sacrifice made or
benefit of opportunity foregone in accepting an
alternative course of action.
For example, a firm financing its expansion plan by
withdrawing money from its bank deposits. In such a
case the loss of interest on the bank deposit is the
opportunity cost for carrying out the expansion plan.

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 (e) Imputed Costs (f) Out-of-pocket Cost

These costs are notional costs which
do not involve any cash outlay.
Interest on capital, the payment for
which is not actually made, is an
example of imputed cost. These costs
are similar to opportunity costs.
It is that portion of total cost, which involves cash
outflow. This cost concept is a short-run concept and
is used in decisions relating to fixation of selling price
in recession, make or buy, etc. Out–of–pocket costs
can be avoided or saved if a particular proposal under
consideration is not accepted.

(g) Explicit Costs (h) Implicit Costs

These costs are also known as out-of- These costs do not involve any immediate cash
pocket costs and refer to costs payment. They are not recorded in the books of
involving immediate payment of Cash. account. They are also known as economic costs.
Salaries, wages, postage and
telegram, printing and stationery,
interest on loan etc. are some
examples of explicit costs involving
immediate cash payment.

(i) Product Costs

These are the costs which are associated with the purchase and sale of goods (in the case of
merchandise inventory).
In the production scenario, such costs are associated with the acquisition and conversion of
materials and all other manufacturing inputs into finished product for sale.
Hence, under marginal costing, variable manufacturing costs and under absorption costing, total
manufacturing costs (variable and fixed) constitute inventoriable or product costs.

(j) Period Costs (k) Shut down Costs

These are the costs, which are not
assigned to the products but are charged
as expenses against the revenue of the
period in which they are incurred.
All non-manufacturing costs such as
general & administrative expenses, selling
and distribution expenses are recognised
as period costs.
Those costs, which continue to be, incurred even
when a plant is temporarily shut-down e.g. rent,
rates, depreciation, etc.
These costs cannot be eliminated with the closure
of the plant. In other words, all fixed costs, which
cannot be avoided during the temporary closure of
a plant, will be known as shut down costs.

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(l) Sunk Costs
Historical costs incurred in the past are
known as sunk costs. They play no role in
decision making in the current period.
For example, in the case of a decision
relating to the replacement of a machine,
the written down value of the existing
machine is a sunk cost and therefore, not
considered.
(n) Discretionary Costs
Such costs are not tied to a clear
cause and effect relationship
between inputs and outputs. They
usually arise from periodic decisions
regarding the maximum outlay to be
incurred.
Examples include advertising, public
relations, executive training etc.
(m) Absolute Cost
These costs refer to the cost of any product, process
or unit in its totality. When costs are presented in a
statement form, various cost components may be
shown in absolute amount or as a percentage of
total cost or as per unit cost or all together. Here the
costs depicted in absolute amount may be called
absolute costs and are base costs on which further
analysis and decisions are made.
(o) Engineered Costs
These are costs that result specifically from a clear
cause and effect relationship between inputs and
outputs. The relationship is usually personally
observable.
Examples of inputs are direct material costs, direct
labour costs etc. Examples of output are cars,
computers etc.
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 Different industries follow different methods of costing
METHODS OF COSTING because of the differences in the nature of their work.
The various methods of costing are as follows:

Methods Description

Singleor Under this method, the cost of a product is ascertained, the product
Output Costing being the only one produced like bricks, coals, etc.

This method is the extension of job costing. A batch may represent a

number of small orders passed through the factory in batch. Each batch
Batch Costing here is treated as a unit of cost and thus separately costed. Here cost per
unit is determined by dividing the cost of the batch by the number of units
produced in the batch.

Under this method of costing, cost of each job is ascertained separately. It

Job Costing is suitable in all cases where work is undertaken on receiving a customer's
order like a printing press, motor workshop, etc.

Under this method, the cost of each contract is ascertained separately. It is

Contract
suitable for firms engaged in the construction of bridges, roads, buildings
Costing
etc.

Under this method, the cost of completing each stage of work is

Process ascertained, like cost of making pulp and cost of making paper from pulp.
Costing In mechanical operations, the cost of each operation may be ascertained
separately; the name given is operation costing.

Operating It is used in the case of concerns rendering services like transport, supply
Costing of water, retail trade etc.

It is a combination of two or more methods of costing outlined above.

Suppose a firm manufactures bicycles including its components; the parts
Multiple
will be costed by the system of job or batch costing but the cost of
Costing
assembling the bicycle will be computed by the Single or output costing
method. The whole system of costing is known as multiple costing.

The following table summarises the various methods of

costing applied in different industries:

Examples of
Nature of Output Method Cost
Industries
Process costing or
A Series of Processes For each process Sugar
Operation Costing
Construction of
Contract Costing For each contract Real estate
building

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Similar units of a Single For the entire activity,
Unit or output or
Product, produced by but averaged for the Cold Drinks
Single Costing
Single Process output

Rendering of Services Operating Costing For all services Hospitals

Customer For each order/

Specifications: Job Costing Advertising
assignment/job
single Unit

Consisting of multiple Combination of

varieties of activities Multiple Costing Car Assembly
any method
and processes

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 Part B-THEORY PART

OBJECTIVES OF COST ACCOUNTING

The main objective of Cost Accounting is accumulation and
Ascertainment
01 of Cost
ascertainment of cost. Costs are accumulated, assigned and
ascertained for each cost object.

Determination
The cost accounting system helps in determination of selling
02 of Selling Price price and thus protability of a cost object.
and Profitability

(a) Determination of pre-determined standard or results

Cost (b) Measurement of actual performance:
03
Control (c) Comparison of actual performance with set standard or target:
(d) Analysis of variance and action:

The three-fold assumptions involved in cost reduction:

(a) There is a saving in unit cost.
Cost
04 (b) Such saving is of permanent nature.
Reduction (c) The utility and quality of the goods and services remain
unaffected, if not improved.

Assisting A robust cost and management accounting system provides

05 management in internal and external information to the industry which will
decision making be relevant for decision making.

DIFFERENCE BETWEEN
COST CONTROL AND COST REDUCTION
Cost Control
Aims at maintaining the costs in
accordance with the established standards
Seeks to attain lowest possible cost under
existing conditions.
Cost Reduction
Concerned with reducing costs. It challenges
all standards and endeavours to improvise
them continuously
Recognises no condition as permanent, since
a change will result in lower cost.

Emphasis is on past and present Emphasis on present and future.

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 A corrective function. It operates even when
Preventive function
an efficient cost control system exists.

Cost control ends when targets are achieved Cost reduction has no visible end and is a
continuous process.

SCOPE OF COST
ACCOUNTING
Costing Cost Accounting
Costing is the technique "the process of accounting for
and process of cost which begins with the
ascertaining costs of recording of income and
products or services. expenditure or the bases on
which they are calculated and
ends with the preparation of
periodical statements and
reports for ascertaining and
controlling costs.”
Cost Analysis
It involves the process of
finding out the factors
responsible for variance in
actual costs from the
budgeted costs and
accordingly fixation of
responsibility for cost
differences.

Cost Comparisons Cost Control Cost Reports

Cost accounting also includes
comparisons of cost involved in
alternative courses of action
such as use of different
technology for production, cost
of making different products
and activities, and cost of same
product/ service over a period
of time.
Each cost is analyzed
to know whether cost
is not exceeding its
budgeted cost and
whether further cost
reduction is possible
or not.
This is the ultimate
function of cost
accounting. These
reports are primarily
prepared for use by
the management at
different levels.

Statutory
Compliances

Maintaining cost
accounting records as
per the rules
prescribed by the
statute.

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 Difference between Cost Accounting and
Management Accounting Basis

Cost Accounting Management Accounting

It records the quantitative It records both qualitative and

Nature aspect only. quantitative aspect.

It records the cost of producing It provides information to management

Objective
a product and providing a service. for planning and co-ordination.
It is wider in scope as it includes
It only deals with cost financial accounting, budgeting,
Area
Ascertainment. taxation, planning etc.

It uses both past and It is focused with the projection

Recording of data
present figures. of figures for future.

Its development is related Its development is related to the

Development
to industrial revolution. need of modern business world.

It follows certain principles and

Rules and It does not follow any specific
procedures for recording costs
Regulation rules and regulations.
of different products.

Difference between Financial Accounting

and Cost Accounting

Basis Financial Accounting Cost Accounting

Objective It provides information about Ascertainment of cost for the
the financial performance purpose of cost control and
of an entity. decision making.

Nature It classifies records, present It classifies, costs records,

and interprets transactions in present, and interprets it in
monetary terms. a significant manner

It makes use of both historical

Recording of data It records Historical data. and pre-determined costs.

Users of The users of financial accounting The cost accounting information

information statements are shareholders, is generally used by internal
creditors, financial analysts and management. But sometimes
government and its agencies, etc. regulatory authorities also.

Analysis of cost It shows profit or loss of the It provides the cost details for each
and profit organization either segment wise cost object i.e. product, process,
or as a whole. job, operation, contracts, etc.

Presentation A set format is used for In general, no set formats for

of information presenting financial information. presenting cost information is
followed.

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USERS OF COST
AND MANAGEMENT Internal users External users
ACCOUNTING • Managers • Regulatory
• Operational Authorities
The users of the information
can be broadly categorised level staffs • Auditors
into internal and external • Employees • Shareholders
to the entity. • Creditors and
Lenders

COST ACCOUNTING WITH THE USE

OF INFORMATION TECHNOLOGY (IT)
Information technology has changed the Cost and Management Accounting functions dramatically with
the introduction of Enterprise Resource Planning (ERP) system. Cost accounting and Management
Information System has become automated and improved.

(I) Integration of Activities (II) Paperless Environment

After the introduction of ERPs, different A move towards paperless environment

functional activities get integrated and as
a consequence, a single entry into the
accounting system provides custom made
reports for every purpose and saves an
organisation from preparing different sets
of documents.
Reconciliation process of results of both
cost and financial accounting systems
becomes simpler and less cumbersome
can be seen where documents like Bill of
Material, Material Requisition Note, Goods
Received Note, labour utilisation report
etc. are no longer required to be prepared
in multiple copies, the related department
can get e-copy from the system.

(III) Accuracy and timely Information (IV) Uniformity

Cost information for a cost centre or cost Uniformity in preparation of report,

object is ascertained with accuracy in
timely manner. Each cost centre a cost
object is codified and all related costs are
assigned to the cost objects or cost
centres using assigned codes.
budgets and standards can be achieved
with the help of IT. ERP software plays an
important role in bringing uniformity
irrespective of location, currency,
language and regulations.

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 (V) (VI)

Cost and revenue variance reports are IT enables an entity to monitor and
generated in real time basis which analyse each process of manufacturing or
enables the management to take control service activity closely to eliminate non
measures immediately. value added activities.

LIMITATIONS OF COST ACCOUNTING

The limitations of cost accounting are as follows:

1. Expensive: It is 2. Requirement of 3. Duplication of work: It

expensive because
analysis, allocation and
absorption of overheads
requires considerable
amount of additional
work, and hence
additional money.
reconciliation: The results
shown by cost accounts
differ from those shown by
financial accounts. Thus
preparation of
reconciliation statements
is necessary to verify their
accuracy.
involves duplication of
work as organization has
to maintain two sets of
accounts i.e. Financial
Accounts and Cost
Accounts.

ESSENTIAL FEATURES OF
A GOOD COST ACCOUNTING SYSTEM
The essential features, which a good cost accounting system should possess, are as follows:

(a) Informative and simple: Cost accounting system should be tailor-made, practical, simple and
capable of meeting the requirements of a business concern.
The system of costing should not sacrifice the utility by introducing inaccurate and unnecessary details.

(b) Accurate and authentic: The data to be used by the cost accounting system should be accurate and
authenticated; otherwise it may distort the output of the system and a wrong decision may be taken.

(c) Uniformity and consistency: There should be uniformity and consistency in classification, treatment
and reporting of cost data and related information.
This is required for benchmarking and comparability of the results of the system for both horizontal
and vertical analysis.

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(d) Integrated and inclusive: The cost accounting system should be integrated with other systems like
financial accounting, taxation, statistics and operational research etc. to have a complete overview and
clarity in results.

(e) Flexible and adaptive: The cost accounting system should be flexible enough to make necessary
amendment and modifications in the system to incorporate changes in technological, reporting,
regulatory and other requirements.

(f) Trust on the system: Management should have trust on the system and its output.

INSTALLATION OF COSTING SYSTEM

A well-established Costing system should provide all relevant information as and when required by
management as well as various stakeholders.

Before setting up a system of cost accounting the factors mentioned below should be studied:

(a) Objective: The objective of setting up the costing system, for example whether it is being
introduced for fixing prices or for establishing a system of cost control.

(b) Nature of Business or Industry: The industry in which the business is operating.

(c) Organisational Hierarchy: Costing system should fulfil the information requirements of different
levels of management. Top management is concerned with the corporate strategy, strategic level
management is concerned with marketing strategy, product diversification, product pricing etc.
Operational level management needs the information on standard quantity to be consumed, report on
idle time etc.

(d) Knowing the product: Nature of the product determines the type of costing system to be
implemented.

(e) Knowing the production process: A good costing system can never be established without the
complete knowledge of the production process.

(f) Information synchronisation: Establishment of a department or a system requires substantial

amount of organisational resources. While drafting a costing system, information needs of various
other departments should be taken into account.

(g) Method of maintenance of cost records: The organization must determine beforehand the manner
in which Cost and Financial accounts could be inter-locked into a single integral accounting system
and how the results of separate sets of accounts i.e. cost and financial, could be reconciled by means
of control accounts.

(h) Statutory compliances and audit: Records are to be maintained to comply with statutory
requirements and applicable cost accounting standards should be followed.

(i) Information Attributes: Information generated from the Costing system should possess all the
attributes of useful information i.e. it should be complete, accurate, timely, relevant. to have an
effective management information system (MIS).

21
 CHAPTER -2
MATERIAL COST

TOPIC MATERIALS PROCUREMENT PROCEDURE

1

TOPIC
1.1 BILL OF MATERIAL

1] Also known as Materials Specification List or Materials List.

2] Meaning: It is a detailed list specifying the standard quantities of each material and components
required for producing a product unit or carrying out a particular job.
3] Preparation: The materials specification list is prepared by the product development team commonly
known as engineering or planning department in a standard form.
4] No. of copies: This is shared with other concerned departments like Purchase, Production, Store, and
Cost/ Accounting department.

Uses of Bill of Material

Purchase Dept. Production Dept. Cost/

Stores Dept. Accounting Dept.

Materials are
Production is planned according
It is used as a It is used to estimate
procured (purchased) reference document cost and profit. Any
to the nature, volume of the
on the basis of while issuing purchase, issue and
materials required to be used.
specifications materials to the usage are compared/
Accordingly, material requisition
mentioned in it. requisitioning verified against this
lists are prepared.
department. document.

TOPIC
1.2 MATERIAL REQUISITION NOTE

1] Also known as “Stores Requisition Note” or “Material Requisition Slip”.

2] Meaning: A document used by the production department to request materials they
need to complete a manufacturing process.
It is a voucher of authority used to get materials issued from store.
3] Preparation: Generally, it's prepared by the Production department.
4] No. of copies: The note is shared with Store and Cost/ Accounting department.

22
Difference between Bill of Materials and
Material Requisition Note:

Bill of Materials Material Requisition Note

1. It is the document prepared by the 1. It is prepared by the production or other

engineering or planning dept. consuming department
2. It is a complete schedule of component 2. It is a document asking Storekeeper to
parts and raw materials required for a issue materials to the consuming
particular job or work order. department.
3. It often serves the purpose of a material
requisition as it shows the complete 3. It cannot replace a bill of materials.
schedule of materials required for a
particular job i.e. it can replace material
requisition.
4. It can be used for the purpose of 4. It is useful in arriving historical cost only.
quotations.
5. It helps in keeping a quantitative control on 5. It shows the material actually drawn
materials drawn through material from stores.
requisition.

TOPIC
1.3 PURCHASE REQUISITION

1] Meaning: A purchase requisition is a form used for making a formal request to the purchasing
department to purchase materials.
2] Preparation: This form is usually filled up by the store-keeper for regular materials and by the
departmental head for special materials (not stocked as regular items).

TOPIC
1.4 PURCHASE ORDERS

It is a written request to the supplier to supply specified materials at specified rates and within a
specified period.

23
 TOPIC
1.5 GOODS RECEIVED NOTE

If everything is in order and the supply is considered suitable for acceptance, the Receiving
department prepares a Receiving Report or Material Inward Note or Goods Received Note.

TOPIC
1.6 MATERIAL RETURNED NOTE

If the material is returned after its entry in the receiving report, a suitable document must be
drawn up in support of the issue so as to exclude from the Stores of Material Account the value of
the materials returned back. This document usually takes the form of a Material Returned Note or
Material outward return note.

TOPIC
2 VALUATION OF MATERIAL RECEIPTS

Ascertainment of cost of material purchased is

called valuation of materials receipts.

COMPONENTS: Cost of material includes cost of purchase net of trade discounts, rebates, duty
draw-back, input credit availed, etc. and other costs incurred in bringing the inventories to their
present location and condition.

Discount & Subsidy

Trade Discount

Quantity Discount
Cash Discount
Subsidy/ Grant/ Incentives
Duties and taxes
Road Tax/ Toll Tax

24
 Integrated Goods and Service Tax (IGST)
State Goods and Service Tax (SGST)
Central Goods and Service Tax (CGST)
Basic Custom Duty
Penalty and Charges
Detention charges/ Fine
Penalty
Other expenditures
Insurance charges
Commission or brokerage paid.
Freight inwards
Cost of containers
Shortage

Illustration - 1
An invoice in respect of a consignment of chemicals
A and B provides the following information:
Chemical A: 10,000 kgs. at `10 per kg. 1,00,000
Chemical B: 8,000 kgs. at `13 per kg. 1,04,000
Basic custom duty @ 10% (Credit is not allowed) 20,400
Railway freight 3,840
Total cost 2,28,240

A shortage of 500 kgs. in chemical A and 320 kgs. in chemical B is noticed due to normal breakages.
You are required to COMPUTE the rate per kg. of each chemical, assuming a provision of 2% for further
deterioration.

Illustration - 2

At WHAT price per unit would Part No. A 32 be entered in the Stores Ledger, if the following invoice
was received from a supplier:

200 units Part No. A 32 @ `5 1,000.00

Less: 20% discount (200.00)
800.00
Add: IGST @ 12% 96.00
896.00
Add: Packing charges (5 non-returnable boxes) 50.00
946.00
(i) A 2 per cent cash discount will be given if payment is made in 30 days.
(ii) Documents substantiating payment of IGST are enclosed for claiming Input credit.

25
 Illustration - 3

SKD Company Ltd., not registered under GST, purchased material P from a company
which is registered under GST. The following information is available for the one lot
of 1,000 units of material purchased:

Listed price of one lot ` 50,000

Trade discount @ 10% on Listed price
CGST and SGST (Credit Not available) 12% (6% CGST + 6% SGST)
Cash discount @ 10%
(Will be given only if payment is made within 30 days.)
Freight and Insurance ` 3,400
Toll Tax paid ` 1,000
Demurrage ` 1,000
Commission and brokerage on purchases ` 2,000
Amount deposited for returnable containers ` 6,000
Amount of refund on returning the container ` 4,000
Other Expenses @ 2% of total cost

• 20% of material shortage is due to normal reasons.

• The payment to the supplier was made within 20 days of the purchases.
• You are required to calculate cost per unit of material purchased to SKD Company Ltd.

TOPIC MATERIAL STORAGE & RECORDS

3

The record of stores may be Bin Stock Store

Cards Control Ledger
maintained in three forms: Cards

TOPIC
3.1 BIN CARDS

1] Meaning: It is a quantitative record of inventory which shows the quantity of inventory available in
a particular bin.

2] Bin & Card: Bin refers to a box/ container/ space where materials are kept. Card is placed with each
of the bin (space) to record the details of material like receipt, issue and return.

3] Maintained: It is maintained by store department.

Separate bin cards are maintained for each item and are placed in shelves or bins.
This card is debited with the quantity of stores received, credited with the quantity of stores issued
and the balance of quantity of store is taken after every receipt or issue.

26
4] Principle: To have an up to date balance of stores, the principle of ‘before touching the
item, bin card should be touched’.

5] Advantages:
(i) There would be fewer chances of mistakes being made as entries are made at the same
time as goods received or issued by the person actually handling the materials.
(ii) Control over stock can be more effective, as comparison of the actual quantity in hand at
any time with the book balance is possible.

6] Disadvantages
(i) Store records are dispersed over a wide area.
(ii) People handling materials are not ordinarily suitable for the clerical work involved in
writing Bin Cards.

TOPIC
3.2 STOCK CONTROL CARDS

1] Meaning: It is also a quantitative record of inventory maintained by stores department for

every item of material. In other words, it is a record which shows the overall inventory
position in store.

2] Recording includes receipt, issue, return, in hand and order given.

TOPIC
3.3 STORES LEDGER

1] Meaning: A Stores Ledger is maintained to record both quantity and cost of materials
received, issued and those in stock.
2] Maintained : It is maintained by the Cost/ Accounts Department.
Usually, records of quantities i.e. Bin cards and Store Control Cards are kept by the store
keeper in store department while record of both quantity and value is maintained by cost
accounting department.

Difference between Bin Card & Stores Ledger

BIN CARD STORES LEDGER

Ÿ It is maintained by the storekeeper in the store. Ÿ It is maintained in cost accounting department.

Ÿ It contains only quantitative details of material
received, issued and returned to stores.
Ÿ Entries are made when transaction takes place.
Ÿ Each transaction is individually posted
Ÿ Inter-department transfers do not appear in Bin
Card.
Ÿ It contains information both in quantity and
value.
Ÿ It is always posted after the transaction
Ÿ Transactions may be summarized and then
posted.
Ÿ Material transfers from one job to another job
are recorded for costing purposes.

27
 TOPIC
4 INVENTORY CONTROL

1] Definition: The Chartered Institute of Management Accountants (CIMA) defines Inventory

Control as “The function of ensuring that sufficient goods are retained in stock to meet all
requirements without carrying unnecessarily large stocks.”
2] Objective: Objective of inventory control is to maintain a trade-off between stock-out and
over-stocking.
3] Methods: The management may employ various methods of inventory control to have a
balance.

Inventory Control

By Setting On the basis of Using

Physical
Quantitative Relative Ratio
Control
Levels Classification Analysis

TOPIC
4.1 INVENTORY CONTROL- BY SETTING QUANTITATIVE LEVELS

Illustration - 4

Two components, A and B are used as follows:

Normal usage 50 per week each
Maximum usage 75 per week each
Minimum usage 25 per week each
Re-order quantity A: 300; B: 500
Re-order period A: 4 to 6 weeks B: 2 to 4 weeks

CALCULATE for each component

(a) Re-ordering level,
(b) Minimum level,
(c) Maximum level,
(d) Average stock level.

Illustration -5

CALCULATE the Economic Order Quantity from the following information. Also state the
number of orders to be placed in a year.

Consumption of materials per annum : 10,000 kg.

Order placing cost per order : ` 50
Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory

28
Illustration - 6

(i) COMPUTE E.O.Q. and the total cost for the following:

Annual Demand = 5,000 units

Unit price = `Rs 20.00
Order cost = ` Rs16.00
Storage rate = 2% per annum
Interest rate = 12% per annum
Obsolescence rate = 6% per annum

(ii) DETERMINE the total cost that would result for the items if a new price of `12.80 is used.

Illustration - 7

Anil & Company buys its annual requirement of 36,000 units in 6 instalments. Each unit costs `1
and the ordering cost is `25. The inventory carrying cost is estimated at 20% of unit value. FIND
the total annual cost of the existing inventory policy. CALCULATE, how much money can be saved
by Economic Order Quantity?

Illustration - 8

G. Ltd. produces a product which has a monthly demand of 4,000 units. The product
requires a component X which is purchased at `20. For every finished product, one unit of
component is required. The ordering cost is `120 per order and the holding cost is 10% p.a.
You are required to CALCULATE:
(I) Economic order quantity.
(ii) If the minimum lot size to be supplied is 4,000 units, what is the extra cost, the
company has to incur?

Illustration - 9

From the details given below, CALCULATE:

(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level

29
 Re-ordering quantity is to be calculated on the
basis of following information:
Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.

Details of lead time :

Average- 10 days,
Maximum- 15 days,
Minimum- 5 days.
For emergency purchases- 4 days.

Rate of consumption :
Average: 15 units per day,
Maximum: 20 units per day.

Illustration - 10

From the details given below, CALCULATE:

(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level

Re-ordering quantity is to be calculated on the basis of following information:

Cost of placing a purchase order is ` 4,000
Number of units to be purchased during the year is 5,00,000
Purchase price per unit, inclusive of transportation cost is ` 50
Annual cost of storage per unit is ` 10.
Details of lead time:
Average- 10 days,
Maximum- 15 days,
Minimum- 5 days,
for emergency purchases- 4 days.
Rate of consumption:
Average: 1,500 units per day,
Maximum: 2,000 units per day.

30
Illustration - 11

A Company manufactures a special product which requires a component 'Alpha'.

The following particulars are collected for the year 2020-21:
(i) Annual demand of Alpha 8,000 units
(ii) Cost of placing an order `200 per order
(iii) Cost per unit of Alpha `400
(iv) Carrying cost p.a.20%

The company has been offered a quantity discount of 4 % on the purchase of

'Alpha' provided the order size is 4,000 components at a time.
Required:
(i) COMPUTE the economic order quantity
(ii) STATE whether the quantity discount offer can be accepted.

Illustration - 12

The complete Gardener is deciding on the economic order quantity for two brands of lawn
fertilizer - Super Grow and Nature's Own. The following information is collected:

Fertilizer
Super grow Nature's Own
Annual demand 2,000 bags 1,280 bags
Relevant ordering cost per purchase order `1,200 `1,400
Annual relevant carrying cost per bag `480 `560

Required:
(I) COMPUTE EOQ for Super Grow and Nature's own.
(ii) For the EOQ, WHAT is the sum of the total annual relevant ordering costs and total annual
relevant carrying costs for Super Grow and Nature's own?
(iii) For the EOQ, COMPUTE the number of deliveries per year for Super Grow and Nature's own.

31
 Illustration - 13

A Company uses three raw materials A, B and C for a particular product for which the following
data apply

Raw Usage per Re-order Price Delivery period Re-order Minimum

Material unit of quantity per (in weeks) level level
Product (Kgs.) (Kgs.) Kg. (Kgs) (Kgs.)
Minimum Average Maximum
A 10 10,000 10 1 2 3 8,000 ?
B 4 5,000 30 3 4 5 4,750 ?
C 6 10,000 15 2 3 4 ? 2,000

Weekly production varies from 175 to 225 units, averaging 200 units of the said product.
COMPUTE the following quantities:
(i) Minimum stock of A,
(ii) Maximum stock of B,
(iii) Re-order level of C,
(iv) Average stock level of A.

Illustration - 14

(a) EXE Limited has received an offer of quantity discounts on its order of materials as under:
Price per ton (`) Ton (Nos.)
1,200 Less than 500
1,180 500 and less than 1,000
1,160 1,000 and less than 2,000
1,140 2,000 and less than 3,000
1,120 3,000 and above.

The annual requirement for the material is 5,000 tons. The ordering cost per order is `R 1,200 and
the stock holding cost is estimated at 20% of per order is `R 1,200 and the stock holding cost is
estimated at 20% of material cost per annum. You are required to COMPUTE the most economical
purchase level.
(b) WHAT will be your answer to the above question if there are no discounts offered and the price
per ton is `1,500?
Inventory Stock- Out
1] Meaning: Stock out is said to be occurred when an inventory item could not be supplied due to
insufficient stock in the store.
2] Loss – Financial or Non Financial: The stock- out situation costs to the entity not only in
financial terms but in non-financial terms also.
Due to stock out an entity not only loses overheads costs and profit but reputation (goodwill)
also due to non-fulfilment of commitment.
3] Trade off: While deciding on the level of inventory, a trade-off between the stock out cost and
carrying cost is made so that overall inventory cost can be minimized.

32
Illustration - 15

IPL Limited uses a small casting in one of its finished products. The castings are purchased from
a foundry. IPL Limited purchases 54,000 castings per year at a cost of `800 per casting.
The castings are used evenly throughout the year in the production process on a 360-days-per-
year basis. The company estimates that it costs `9,000 to place a single purchase order and
about `300 to carry one casting in inventory for a year. The high carrying costs result from the
need to keep the castings in carefully controlled temperature and humidity conditions, and from
the high cost of insurance.
Delivery from the foundry generally takes 6 days, but it can take as much as 10 days. The days of
delivery time and percentage of their occurrence are shown in the following tabulation:

Delivery time (days) : 6 7 8 9 10

Percentage of occurrence : 75 10 5 5 5

Required:
(I) Compute the economic order quantity (EOQ).
(ii) Assume the company is willing to assume a 15% risk of being out of stock. What would be
the safety stock? The re-order point?
(iii) Assume the company is willing to assume a 5% risk of being out of stock. What would be the
safety stock? The re-order point?
(iv) Assume 5% stock-out risk. What would be the total cost of ordering and carrying inventory
for one year?
(v) Refer to the original data. Assume that using process re-engineering the company reduces
its cost of placing a purchase order to only `600. In addition, company estimates that when
the waste and inefficiency caused by inventories are considered, the true cost of carrying a
unit in stock is `720 per year.
(a) Compute the new EOQ.
(b) How frequently would the company be placing an order, as compared to the old purchasing
policy?

Just in Time (JIT) Inventory Management

1] Other Name: It is also known as 'Demand pull' or 'Pull through' system of production.
2] Meaning: JIT is a system of inventory management with an approach to have a zero
inventories in stores. According to this approach material should only be purchased
when it is actually required for production.
3] Process: Production process actually starts after the order for the products is received.
Based on the demand, production process starts and the requirement for raw materials is
sent to the purchase department for purchase.
4] Principles: JIT is based on two principles
(i) Produce goods only when it is required and
(ii) the products should be delivered to customers at the time only when they want.

33
 TOPIC
4.2 Inventory Control- On the basis of Relative Classification

ABC Analysis On the basis of value and frequency of inventory

Fast, Slow and Non Moving (FSN) On the basis of inventory turnover
Vital, Essential and Desirable (VED) On the basis of importance of inventory
High, Medium and Low (HML) On the basis of price of an item of inventory

This system exercises discriminating control over different items of

inventory on the basis of the investment involved.
ABC Analysis: Usually the items are classified into three categories according to their
relative importance, namely, their value and frequency of replenishment
during a period.

(I) 'A' Category

This category of items consists of only a small percentage i.e., about 10% of the total items
handled by the stores but require heavy investment about 70% of inventory value, because of
their high prices or heavy requirement or both.
Items under this category can be controlled effectively by using a regular system which ensures
neither over-stocking nor shortage of materials for production.
Such a system plans its total material requirements by making budgets. The stocks of materials
are controlled by fixing certain levels like maximum level, minimum level and re-order level.

(ii) 'B’ Category

This category of items is relatively less important; they may be 20% of the total items of
material handled by stores. The percentage of investment required is about 20% of the total
investment in inventories.
In the case of these items, as the sum involved is moderate, the same degree of control as
applied in 'A' category of items is not warranted.
The orders for the items, belonging to this category may be placed after reviewing their
situation periodically.

(iii) 'C’ Category

This category of items does not require much investment; it may be about 10% of total inventory
value but they are nearly 70% of the total items handled by store.
For these category of items, there is no need of exercising constant control.

Orders for items in this group may be placed either after six months or once in a year, after
ascertaining consumption requirements. In this case the objective is to economies on ordering and
handling costs.

34
Illustration - 16

A factory uses 4,000 varieties of inventory. In terms of inventory holding and inventory usage, the
following information is compiled:
No. of varieties of inventory % % value of inventory % of inventory usage
holding (average) (in end-product)
3,875 96.875 20 5
110 2.750 30 10
15 0.375 50 85
4,000 100.00 100 100

CLASSIFY the items of inventory as per ABC analysis with reasons.

Illustration - 17

From the following details, DRAW a plan of ABC selective control:

Item Units Unit cost (`)

1 7,000 4.450
2 4,000 19.140
3 1,500 8.900
4 29,000 0.180
5 10,000 8.190
6 40,000 0.450
7 60,000 0.180
8 13,000 0.980
9 10,000 0.205
10 29,000 0.360
11 11,500 6.320
12 4,000 5.220

Fast Moving, Slow Moving and Non Moving (FSN) Inventory:

1] It is also known as FNS (Fast, Normal and Slow moving) classification of inventory analysis.
2] Classification: Under this system, inventories are controlled by classifying them on the basis of
frequency of usage. The classification of items into these three categories depends on the
nature and managerial discretion.
3] Explanation:
(i) Fast Moving- This category of items are placed nearer to store issue point and the stock is
reviewed frequently for making of fresh orders.
(ii) Slow Moving- This category of items are stored little far and stock is reviewed periodically for
any obsolescence. and may be shifted to Non-moving category.
(iii) Non Moving- This category of items are kept for disposal. This category of items is reported
to the management and an appropriate provision for loss may be created.

35
 Shows particulars of FSN analysis

Particulars F-class item S-class item N-class item

Stock High Intermediate Low
Control High Intermediate Low
Check Tight Intermediate No
Safety Stock High Low Rare

Some of the reasons for slow moving and non-moving inventories are stated below:

(i) Failure of (ii) Technological (iii) Lack of periodic

production upgradation in review of
management to terms of new inventories.
communicate the machine requiring
updated requirement new kind of
to the stores material or
management existing material
becoming
obsolete.

Vital, Essential and Desirable (VED):

Under this system of inventory analysis, inventories are classified on the basis of its
criticality for the production function and final product.
Generally, this classification is done for spare parts which are used for production.

(i) Vital- Items are classified as vital when its unavailability can interrupt the production
process and cause a production loss. Items under this category are strictly controlled by
setting re-order level.

(ii) Essential- Items under this category are essential but not vital. The unavailability
may cause sub standardisation and loss of efficiency in production process. Items under
this category are reviewed periodically and get the second priority.

(iii) Desirable- Items under this category are optional in nature, unavailability does not
cause any production or efficiency loss.

High Cost, Medium Cost, Low Cost (HML) Inventory:

Under this system, inventory is classified on the basis of the cost of an individual item,
unlike ABC analysis where inventories are classified on the basis of overall value of
inventory.

A range of cost is used to classify the inventory items into the three categories. High Cost
inventories are given more priority for control, whereas Medium cost and Low cost items
are comparatively given lesser priority.

36
TOPIC
4.3 Using Ratio Analysis
(i) Input- Output Ratio
1] Meaning
The ratio of the quantity of input of
material to production and the
standard material content of the
actual output
(ii) Inventory Turnover Ratio
1] Meaning
The inventory turnover ratio is the
number of times a company has sold
and replenished its inventory over a
specific amount of time.
3] Formula
Inventory Turnover Ratio
Average stock
Average no. of days of Inventory holding
2] Use
This type of ratio analysis enables
comparison of actual consumption
and standard consumption, thus
indicating whether the usage of
material is favourable or adverse.
2] Interpretation
High inventory turnover ratio
indicates that the material in the
question is a fast moving one. A low
turnover ratio indicates over-
investment and locking up of the
working capital in inventories.
= Cost of materials consumed during the period
Cost of average stock held during the period
= 1/2 (opening stock + closing stock)
= 365 days /12 months
Inventory Turnover Ratio
37
 Illustration - 18:

The following data are available in respect of material X for the year ended 31st March, 2021.
(`)
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000

CALCULATE:
(I) Inventory turnover ratio, and
(ii) The number of days for which the average inventory is held.

Illustration - 19:

From the following data for the year ended 31st March, 2021, CALCULATE the inventory turnover
ratio of the two items and put forward your comments on them

Material A (`) Material B (`)

Opening stock 1.04.2020 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.03.2021 6,000 11,000

TOPIC
4.4 Physical Control

Physical Control
1] Two Bin System: Under this system, each bin is divided into two parts –
(I) smaller part to stock the quantity equal to the minimum stock or even the re-ordering level, and
(II) the other part to keep the remaining quantity.

Issues are made out of the larger part; but as soon as it becomes necessary to use quantity out of the
smaller part of the bin, fresh order is placed.

2] Establishment of system of budgets: To control investment in the inventories, it is necessary to know

in advance about the inventories requirement during a specific period (usually a year).

3] Perpetual inventory records and continuous stock verification: CIMA defines “the recording as
they occur of receipts, issues and the resulting balances of individual items of stock in either
quantity or quantity and value”

Perpetual inventory represents a system of records maintained by the stores department. It, in fact,
comprises of: (i) Bin Cards, and (ii) Stores Ledger.

38
A perpetual inventory is usually checked by a program of continuous stock taking.

(iv) Continuous Stock Verification: CIMA defines, “Continuous stock taking is the process of counting and
valuing selected items at different times on a rotating basis”.

The system of continuous stock-taking consists of physical verification of items of inventory.

The stock verification may be done by internal audit department but are independent of the store and
production staff.

Stock verification is done at appropriate interval of time without prior notice. The element of surprise is
essential for effective control of the system.

Annual/ Periodic Stock Taking:

CIMA defines, “a process whereby all stock items are physically counted and then valued”.

Disadvantage: Since all the items have to be covered in a given number of days, either the
production department has to be shut down during those days to enable thorough checking of stock
or else the verification must be of limited character.

Advantages of continuous stock-taking:

1. Closure of normal functioning is not necessary.
2. Stock discrepancies are likely to be brought to the notice and corrected much earlier than under
the annual stock-taking system.
3. The system generally has a sobering influence on the stores staff because of the element of
surprise present therein.

TOPIC
5 MATERIAL ISSUE PROCEDURE

Material Transfer Note:

The surplus material arising on a job or other units of production may sometime be unsuitable for
transfer to store because of its bulk, heavy weight, brittleness or some other reason.
If required, it may be transferred by one production department to the other production department.

Return of Material
Any surplus material left over on the completion of a job should be promptly hand over to the
storekeeper for safe and proper custody.
The surplus material, when it is returned to the storeroom, should be accompanied by a document
known as a Shop Credit Note or alternatively as a Stores Debit Note.

39
 VALUATION OF MATERIAL ISSUES

Illustration - 20:

The following transactions in respect of material Y occurred during the six months ended
30th September, 2021:

Month Purchase (units) Price per unit Issued

(`) Units
April 200 25 Nil
May 300 24 250
June 425 26 300
July 475 23 550
August 500 25 800
September 600 20 400

Required:
(a) The Chief Accountant argues that the value of closing stock remains the same no matter which
method of pricing of material issues is used. Do you agree? Why or why not? EXPLAIN. Detailed
stores ledgers are not required.

(b) STATE when and why would you recommend the LIFO method of pricing material issues?

Illustration - 21:

The following information is provided by Sunrise Industries for the fortnight of April, 2021:
Material Exe:

Stock on 1-4-2021 100 units at `5 per unit.

Purchases
5-4-2021, 300 units at `6
8-4-2021, 500 units at `7
12-4-2021, 600 units at `8
Issues
6-4-2021, 250 units
10-4-2021, 400 units
14-4-2021, 500 units

Required:
(A) CALCULATE using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period
(b) the value of stock of materials on 15-4-2021.

(B) EXPLAIN why the figures in (a) and (b) in part A of this question are different under
the two methods of pricing of material issues used. You need not draw up the Stores
Ledgers.

40
Illustration - 22

The following information is extracted from the Stores Ledger:

Material X
Opening Stock Nil
Purchases:
Jan. 1 100 @ ` 1 per unit
Jan. 20 100 @ ` 2 per unit
Issues:
Jan. 22 60 for Job W 16
Jan. 23 60 for Job W 17

Complete the receipts and issues valuation by adopting the First-In-First-Out, Last-In-First-Out
and the Weighted Average Method. TABULATE the values allocated to Job W 16, Job W 17 and
the closing stock under the methods aforesaid and discuss from different points of view which
method you would prefer.

Illustration - 23

Imbrios India Ltd. is recently incorporated start-up company back in the year 2019. It is engaged
in creating Embedded products and Internet of Things (IoT) solutions for the Industrial market.
It is focused on innovation, design, research and development of products and services. One of
its embedded products is LogMax, a system on module (SoM) Carrier board for industrial use.
It is a small, flexible and embedded computer designed as per industry specifications. In the
beginning of the month of September 2021, company entered into a job agreement of providing
4800 LogMax to NIT, Mandi. Following details w.r.t. issues, receipts, returns of Store Department
handling Micro-controller, a component used in the designated assembling process have been
extracted for the month of September, 2021:

Sep. 1 Opening stock of 6,000 units @ `285 per unit

Sep. 8 Issued 4875 units to mechanical division vide material requisition no. Mech 009/20
Sep. 9 Received 17,500 units @ `276 per unit vide purchase order no. 159/2020
Sep. 10 Issued 12,000 units to technical division vide material requisition no. Tech 012/20
Sep. 12 Returned to stores 2375 units by technical division against material requisition no.
Tech 012/20.
Sep. 15 Received 9,000 units @ `288 per units vide purchase order no. 160/ 2020
Sep. 17 Returned to supplier 700 units out of quantity received vide purchase order no.
160/2020.
Sep. 20 Issued 9,500 units to technical division vide material requisition no. Tech 165/20

On 25th September, 2021, the stock manager of the company expressed his need to leave for his
hometown due to certain contingency and immediately left the job same day. Later, he also
switched his phone off.

41
 As the company has the tendency of stock-taking every end of the month to check and report for
the loss due to rusting of the components, the new stock manager, on 30th September, 2021,
found that 900 units of Micro-controllers were missing which was apparently misappropriated by
the former stock manager. He, further, reported loss of 300 units due to rusting of the
components.

From the above information you are REQUIRED to prepare the Stock Ledger account using
'Weighted Average' method of valuing the issues.

Illustration - 24

'AT' Ltd. furnishes the following store transactions for September, 2021:
1-9-21 Opening balance 25 units value `162.50
4-9- 21 Issues Req. No. 85 8 units
6-9- 21 Receipts from B & Co. GRN No. 26 50 units @ `5.75 per unit
7-9- 21 Issues Req. No. 97 12 units
10-9- 21 Return to B & Co. 10 units
12-9- 21 Issues Req. No. 108 15 units
13-9- 21 Issues Req. No. 110 20 units
15-9- 21 Receipts from M & Co. GRN. No. 33 25 units @ `6.10 per unit
17-9- 21 Issues Req. No. 121 10 units
19-9- 21 Received replacement from B & Co.
GRN No. 38 10 units
20-9- 21 Returned from department, material of
M & Co. MRR No. 4 5 units
22-9- 21 Transfer from Job 182 to Job 187 in the
dept. MTR 6 5 units
26-9- 21 Issues Req. No. 146 10 units
29-9- 21 Transfer from Dept. “A” to
Dept. “B” MTR 10 5 units
30-9- 21 Shortage in stock taking 2 units

PREPARE the priced stores ledger on FIFO method and STATE how would you treat the shortage in
stock taking.

42
TOPIC
6 TREATMENT OF NORMAL AND ABNORMAL LOSS OF MATERIALS

Loss of Material

Waste Scrap Spoilage Defectives Obsolescence

Loss of Treatment of loss

Meaning
material Normal loss Abnormal Loss
The portion of raw material which is Cost of normal The cost of abnormal
lost during storage or production and waste is loss is transferred to
discarded. The waste may or may not absorbed by good Costing Profit and loss
Waste have any value. production units. account.

The materials which are discarded The cost of scrap The scrap account should
and disposed-off without further is borne by good be charged with full cost.
treatment. Generally, scrap has either units and income The credit is given to the
Scrap no value or insignificant value. arises on job or process concerned.
account of The profit or loss in the
realisable value scrap account, on
is deducted from realisation, will be
the cost. transferred to the Costing
Profit and Loss Account.

It is the term used for materials Charging it to the The cost of abnormal
which are badly damaged in production spoilage is charged to the
manufacturing operations, and they overhead so that Costing Profit and Loss
Spoilage cannot be rectified economically and it is spread over Account.
hence taken out of the process to be all the products.
disposed off in some manner without
further processing

It signifies those units or portions of An amount equal The material cost of

production which do not meet the to the cost less abnormal loss is
quality standards. realisable value transferred to costing
The defectives which can be re-made on sale of profit and loss account.
as per the quality standard by using defectives are
additional materials are known as charged to
Defectives reworks. Reworks include repairs, material cost of
reconditioning and refurbishing. good production.
Defectives which cannot be brought
up to the quality standards are known
as rejects. The rejects may either be
disposed- off or re-cycled for
production process.

Loss in the value of an asset due to The loss arising out of obsolete materials is
Obsolescence technological advancements. an abnormal loss and it does not form part of
the cost of manufacture.

43
Difference between Waste and Scrap

Waste Scrap

1. It is connected with raw material or
inputs to the production process.
2. Waste of materials may be visible or
invisible.
3. Generally waste has no recoverable
value.
1. It is the loss connected with the output
2. Scraps are generally identifiable and
has physical substance.
3. Scraps are termed as by-products and
has small recoverable value.

Difference between Scrap and Defectives

Scrap
1. It is the loss connected with the
output
2. Scraps are not intended but cannot
be eliminated due to the nature of
material or process itself.
3. Generally scraps are not used or
rectified.
4. Scraps have insignificant
recoverable value.
Defectives
1. This type of loss is connected with the
output as well as the input .
2. Defectives also are not intended but can
be eliminated through a proper control
system.
3. Defectives can be used after
rectification.
4. Defectives are sold at a lower value
from that of the good one.

Distinction between Spoilage and Defectives:

The difference between spoilage and defectives is that while spoilage cannot be repaired or
reconditioned, defectives can be rectified and transferred, either back to the standard
production or to the seconds.

Illustration - 25

The method of apportionment of spoilage between normal and abnormal is explained below:
Total input 5,000 units
Normal spoilage 5% of input
Total spoiled units 550 units
Total Cost `10,000
Sale value of spoilage `0.50 per unit

Find out cost of normal and abnormal spoilage.

44
Illustration - 26:

2,000 kgs. of Art Board valued at `8,000 were issued for the manufacture of medium sized cartons.
The following details were collected:
(a) 2,400 Nos. medium sized cartons weighing 0.50 kg. each were manufactured.
(b) 480 kg. of offcuts were used for the manufacture of small sized carton. This would have amounted
to `1,000.
(c) 320 medium sized cartons were damaged and rectification costs came up to `160.
(d) 120 kg. of offcuts were sold as scrap for `20.

You are required to calculate the cost of one medium sized carton assuming that there are no opening
or closing stocks.

45
 CHAPTER -3
EMPLOYEE COST

1
ATTENDANCE & PAYROLL PROCEDURES

Time-keeping:
It refers to correct recording of the employees' attendance time.
Methods of Time-keeping

1. Manual Methods

(a) Attendance Register method (b) Metal Disc/ Token method-

2. Mechanical/ Automated Methods

(a) Punch Card Attendance (b) Bio-Metric A endance system

Time-Booking

Time keeping just records the time spent by an employee in the premises for production but it does not
show how much time a person spent on a particular job. Time booking refers to a method wherein each
activity of an employee is recorded.

Difference:

The difference between “time keeping” and “time booking”. The latter refers to break up of time on
various jobs while the former
implies a record of total time spent by the employees in a factory.

2
Payroll Procedure

Component of wages cost or wages for costing purposes

In addition to wages (including allowances, such as D.A.) that are paid to workers, a firm may have to
spend on many other items (such as premium to the ESI or provident fund or bonus).

Further, the worker does not spend all the time for which he is paid on productive work. This is because
he is entitled to weekly holiday and various type of leave. There is also a certain amount of unavoidable
idle time.

46
The question is to what extent such additional payment or cost in respect of Employee can be charged
directly to unit of cost as part of direct Employee cost?

Of course, in the case of indirect Employee, all such payments as also the wages paid to them, must be
treated as part of overheads.

But in the case of direct workers, two alternatives are possible. The additional charges may be treated
as overheads. Alternatively, the wage rates being charged to job may be computed by including such
payments; automatically then, such payments will be charged to the work done along with wages of the
worker. (It should be remembered that such wage rate will be only for costing purposes and not for
payment to workers).

Type of deductions Description

Statutory Deductions
1. Provident fund Employee's contribution to the Provident fund is
deducted from the salary/ wages of the concerned
employee.

2. Employee State Insurance Employee's contribution to the ESI is deducted from the
Scheme (ESI) salary/ wages.

3. Tax Deduction at Source Employer is obliged to deduct tax at source if it will be

(TDS) paying to the employee net salary exceeding maximum
exemption limit, in equal monthly installments to the
income tax department.

4. Professional Tax Professional tax is a state level tax imposed for carrying
on business, profession or service.

Other Deductions

1. Voluntary contribution to If any employee so desires may contribute over and above
Provident fund the contribution payable by the employer.

2. Contribution to any benevolent An employee may contribute to any benevolent

fund. fund voluntarily by putting a request to the payroll
department.

3. Loan deductions Installments of any loan taken by the employee.

4. Other advances and dues Other advances like festival advance and unadjusted
advances taken.

47
 ILLUSTRATION 1:

Inductees
A worker is paid ` 10,000 per month and a dearness allowance of ` 2,000 p.m. Worker contribution
to provident fund is @ 10% and employer also contributes the same amount as the employee. The
Employees State Insurance Corporation premium is 6.5% of wages of which 1.75% is paid by the
employees. It is the firm's practice to pay 2 months' wages as bonus each year.
Basic DA
The number of working days in a year are 300 of 8 hours each. Out of these the worker is entitled to
15 days leave on full pay. CALCULATE the wage rate per hour for costing purposes.

Extra point Normal Idle time 50 Hours

ILLUSTRATION 2:

CALCULATE the Employee hour rate of a worker X from the following data:

Basic pay `10,000 p.m.

D.A. `3,000 p.m.
Fringe benefits `1,000 p.m.

Number of working days in a year 300. 20 days are availed off as holidays on full pay in a year.
Assume a day of 8 hours.

3
Idle Time

1. Meaning: The time during which no production is carried-out because the worker remains idle but
are paid. In other words, it is the difference between the time paid and the time booked.
2. Bifurcation: Idle time can be normal or abnormal.

3. Normal idle time

A] It is the time which cannot
be avoided or reduced in the
normal course of business.
B] Causes
1. The time lost between
factory gate and the place
of work,
2. The interval between one
job and another
3. The setting up time for
the machine,
4. Normal rest time, break
for lunch etc
C] It is treated as a part of
cost of production.
In the case of direct workers
an allowance for normal idle
time is considered setting of
standard hours or standard
rate.
In case of indirect workers,
normal idle time is considered
for the computation of
overhead rate.

49
4. Abnormal Idle time:

Causes Treatment

1. Lack of coordination Abnormal idle time cost is not

2. Power failure, Break down of
machines.
3. Non-availability of raw materials,
strikes, lockouts, poor supervision,
fire, flood etc.
included as a part of production cost
and is shown as a separate item in the
Costing Profit and Loss Account.

ILLUSTRATION 3:

'X' an employee of ABC Co. gets the following emoluments and benefits:

(a) Basic pay `10,000 p.m.

(b) Dearness allowance `2,000 p.m.
(c) Bonus 20% of salary and D.A
(d) Other allowances `2,500 p.m.
(e) Employer's contribution to P.F 10% of salary and D.A
'X' works for 2,400 hours per annum, out of which 400 hours are non-productive and treated as normal
idle time. You are required to COMPUTE the effective hourly cost of employee 'X'..

4 OVERTIME

1] Meaning: Work done beyond normal working hours is known as 'overtime work'.

2] Components: Overtime payment consist of two elements-

(i) Normal wages for overtime work and (ii) Premium payment for overtime work.

3] Overtime premium: The rate for overtime work is higher than the normal time rate; usually it is at
double the normal rates. The extra amount so paid over the normal rate is called overtime premium.

The overtime premium should not be less than the premium calculated as per the statute.
As per the Factories Act 1948 “Where a worker works in a factory for more than nine hours in any day or
for more than fourty eight hours in any week, he shall, in respect of overtime work, be entitled to wages
at the rate of twice his ordinary rate of wages.”

50
 4] Calculation:

Wages paid for Premium (extra)

Over me
= overtime at + payment for
Payment
normal rate overtime work

5] Benefits the company?

Occasional overtime is a healthy sign as it indicates that the firm has the optimum capacity and that the
capacity is being fully utilised. But persistent overtime is rather a bad sign because it may indicate
either (a) that the firm needs larger capacity in men and machines, or (b) that men have got into the
habit of postponing their ordinary work towards the evening so that they can earn extra money in the
form of overtime wages.

6] Treatment

CAUSES TREATMENT
The customer may agree to bear the If overtime is resorted to at the desire
entire charge of overtime because of the customer, then overtime
urgency of work. premium may be charged to the job
directly.

Overtime may be called for to make up If overtime is required to cope with

any shortfall in production due to some
unexpected development.
general production programmes or for
meeting urgent orders, the overtime
premium should be treated as overhead
cost of the particular department or
cost centre which works overtime.

Overtime work may be necessary to If overtime is worked in a department

make up a shortfall in production due to due to the fault of another department,
some fault of management. the overtime premium should be
charged to the latter department.

Overtime work may be resorted to, to Overtime worked on account of

secure an out-turn in excess of the abnormal conditions such as flood,
normal output to take advantage of an earthquake etc., should not be charged
expanding market or of rising demand to cost, but to Costing Profit and Loss
Account.

51
 ILLUSTRATION 4:

CALCULATE the earnings of A and B from the following particulars for a month and allocate the
employee cost to each job X, Y and Z:

A B
(i) Basic wages (rs.) 10,000 16,000
(ii) Dearness Allowance 50% 50%
(iii) Contribution to provident Fund (on basic wages) 8% 8%
(iv) Contribution to Employee's State Insurance (on basic wages) 2% 2%
(v) Overtime (Hours) 10 -

The normal working hours for the month are 200. Overtime is paid at double the total of normal wages
and dearness allowance. Employer's contribution to state Insurance and Provident Fund are at equal
rates with employees' contributions. The two workers were employed on jobs X, Y and Z in the
following proportions:

Jobs X Y Z
Worker A 40% 30% 30%
Worker B 50% 20% 30%

Overtime was done on job Y.

ILLUSTRATION 5:

A
It is seen from the job card for repair of the customer's equipment that a total of 154 labour hours have
been put in as detailed below:
Worker 'A' paid Worker 'B' paid Worker 'C' paid
at Rs.200 per at `100 per day at `300 per day
J
day of 8 hours at of 8 hours of 8 hours

Monday (hours) 10.5 8.0 10.5

Tuesday (hours) 8.0 8.0 8.0

Wednesday (hours) 10.5 8.0 10.5

Thursday (hours) 9.5 8.0 9.5

I
Friday (hours) 10.5 8.0 10.5

Saturday (hours) – 8.0 8.0

Total (hours) 49.0 48.0 57.0

of 5m she
52
 It I s
In terms of an award in employee conciliation, the workers are to be paid dearness allowance on the
basis of cost of living index figures relating to each month which works out @ `968 for the relevant
month. The dearness allowance is payable to all workers irrespective of wages rate if they are present or
are on leave with wages on all working days.

Sunday is a weekly holiday and each worker has to work for 8 hours on all week days and 4 hours on
Saturdays; the workers are however paid full wages for Saturday (8 hours for 4 hours worked).

At D A for more than nine hours in a day or

Overtime is paid twice of ordinary wage rate if a worker works
forty-eight hours in a week. Excluding holidays, the total number of hours works out to 176 in the
relevant month. The company's contribution to Provident Fund and Employees State Insurance In
Premium are absorbed into overheads.

CALCULATE the wages payable to each worker.

ILLUSTRATION 6:

In a factory, the basic wage rate is `100 per hour and overtime rates are as follows:

Before and after normal working hours

Sundays and holidays
175% of basic wage rate
225% of basic wage rate EMI's
During the previous year, the following hours were worked Na Pay for Atf
pontiff Extra pay for OT the
You are required to CALCULATE the
Normal time 1,00,000 hours labour cost chargeable to job 'Z' and
Overtime before and after working hours 20,000 hours overhead in each of the
Overtime on Sundays and holidays 5,000 hours following instances:
Total 1,25,000 hours
(a) Where overtime is worked
regularly throughout the year as
a policy due to the workers'
The following hours have been worked on job 'Z’ shortage.
(b) Where overtime is worked
Normal 1,000 hours irregularly to meet the
Overtime before and after working hrs. 100 hours requirements of production.
Sundays and holidays 25 hours (c) Where overtime is worked at the
request of the customer to
Total 1,125 hours
expedite the job

5 SYSTEMS OF WAGE PAYMENT AND INCENTIVES

5.1 Time based (Time Rate System) Straight Time Rate System:

Under this system, the workers are paid on time basis i.e. hour, day, week, or month.

The amount of wages due to a worker are arrived at by multiplying the time worked (including normal
idle period) by rate for the time.

53
5.2 Output Based (Piece Rate System) Straight Piece Rate System:

Under this system, each operation, job or unit of production is termed a piece.
A rate of payment, known as the piece rate or piece work rate is fixed for each piece. The wages of
the worker depend upon his output and rate of each unit of output; it is in fact independent of the
time taken by him.

The wages paid to a worker are calculated as:

Wages
= Number of units
produced x Rate per unit

5.3 Premium Bonus Method

Under these methods, standard time is established for performing a job. The worker is
guaranteed his daily wages (except in Barth System), if his output is below and upto standard. In
case the task is completed in less than the standard time, the saved time is shared between the
employee and the employer.

(i) Halsey Premium Plan:

Under Halsey premium plan a standard time is fixed for each job or process. If there is no saving on
this standard time allowance, the worker is paid only his day rate. He gets his time rate even if he
exceeds the standard time limit, since his day rate is guaranteed.

If, however, he does the job in less than the standard time, he gets a bonus equal to 50 percent of the
wages of time saved; the employer benefits by the other 50 percent. The scheme also is sometimes
referred to as the Halsey fifty percent plan.

ILLUSTRATION 7:

CALCULATE the earnings of a worker under Halsey System. The relevant data is as below:

Time Rate (per hour) `60

Time allowed 8 hours
Time taken 6 hours
Time saved 2 hours

H AHS X R TSX TOY X R

54
R AHS X R XAMARIN
 (ii) Rowan Premium Plan:

According to this system a standard time allowance is fixed for the performance of a job and bonus
is paid if time is saved.

ILLUSTRATION 8:

Solve illustration no.7 above through Rowan Plan.

Ff DM DW Fact OH
ILLUSTRATION 9: 3490 D 42kt 150

Two workmen, 'A' and 'B', produce the same product using the same material. Their normal wage rate
is also the same. 'A' is paid bonus according to the Rowan system, while 'B' is paid bonus according to
the Halsey system. The time allowed to make the product is 50 hours. 'A' takes 30 hours while 'B' takes
40 hours to complete the product. The factory overhead rate is `5 per man-hour actually worked.
The factory cost for the product for 'A' is `3,490 and for 'B' it is `3,600.

Required:
(a) COMPUTE the normal rate of wages;
(b) COMPUTE the cost of materials cost;
(c) PREPARE a statement comparing the factory cost of the products as made by the two workmen.

ILLUSTRATION 10:

(a) Bonus paid under the Halsey Plan with bonus at 50% for the time saved equals the bonus paid
under the Rowan System. When will this statement hold good? (Your answer should contain the
proof).

(b) The time allowed for a job is 8 hours. The hourly rate is ` 8. PREPARE a statement showing:
i. The bonus earned
ii. The total earnings of employee and
iii. Hourly earnings.
Under the Halsey System with 50% bonus for time saved and Rowan System for each hour saved
progressively.

ILLUSTRATION 11:

A skilled worker in XYZ Ltd. is paid a guaranteed wage rate of `30 per hour. The standard time per unit
for a particular product is 4 hours. Mr. P, a machine man, has been paid wages under the Rowan
Incentive Plan and he had earned an effective hourly rate of `37.50 on the manufacture of that
particular product.

55
STATE what could have been his total earnings and effective hourly rate,
had he been put on Halsey Incentive Scheme (50%)?

ILLUSTRATION 12:

A factory having the latest sophisticated machines wants to introduce an incentive scheme for its
workers, keeping in view the following:

(i) The entire gains of improved production should not go to the workers.
(ii) In the name of speed, quality should not suffer.
(iii) The rate setting department being newly established are liable to commit mistakes.

You are required to PREPARE a suitable incentive scheme and DEMONSTRATE by an illustrative
numerical example how your scheme answers to all the requirements of the management.

ILLUSTRATION 13:

Mr. A. is working by employing 10 skilled workers. He is considering the introduction of some incentive
scheme - either Halsey Scheme (with
mm 50% bonus) or Rowan Scheme - of wage payment for increasing
the Employee productivity to cope with the increased demand for the product by 25%.
He feels that if the proposed incentive scheme could bring about an average 20% increase over the
present earnings of the workers, it could act as sufficient incentive for them to produce more and he
has accordingly given this assurance to the workers.
As a result of the assurance, the increase in productivity has been observed as revealed by the
following figures for the current month:
SH 2500
20003575
Hourly rate of wages (guaranteed)
AH
Average time for producing 1 piece by one worker at the previous performance
408 40
2 hours
480

(This may be taken as time allowed)

No. of working days in the month 25
No. of working hours per day for each worker 8
Actual production during the month 1,250 units

Required:
(i) CALCULATE effective rate of earnings per hour under Halsey Scheme and Rowan Scheme.
(ii) CALCULATE the savings to Mr. A in terms of direct labour cost per piece under the schemes.

ILLUSTRATION 14:

Wage negotiations are going on with the recognised employees' union, and the management wants you
as an executive of the company to formulate an incentive scheme with a view to increase productivity.

56
 s
Edo
The case of three typical workers A, B and C who produce respectively 180, 120 and 100 units of the
company's product in a normal day of 8 hours is taken up for study.
a
Assuming that day wages would be guaranteed at `75 per hour and the piece rate would be based on a
standard hourly output of 10 units, CALCULATE the earnings of each of the three workers and the
employee cost per
on 100 pieces under

(i) Day wages,

(ii) Piece rate,
(iii) Halsey scheme, and
(iv) The Rowan scheme.

Also CALCULATE under the above schemes the average cost of labour for the company to produce 100 pieces.

6
EMPLOYEE (LABOUR) TURNOVER

1] Meaning:

Employee (Labour) Turnover Employee turnover or labour turnover in an organisation is the rate of
change in the composition of employee force during a specified period measured against a suitable
index.

2] Methods:

There are three methods of calculating Employee turnover which are given below:
(I) Replacement Method
(ii) Separation Method
(iii) Flux Method

3] Causes:

The reasons for employee turnover in an organisation can be classified under the following
three heads:
(a) Personal Causes;
(b) Unavoidable Causes; and
(c) Avoidable Causes.

4] Cost of Labour Turnover:

Two types of costs which are associated with employee turnover are:
(a) Preventive Costs: The cost incurred to prevent employee turnover or keep it as lowest as
possible.
(b) Replacement Costs: These are the costs which arise due to employee turnover.

57
 ILLUSTRATION 15:

The Accountant of Y Ltd. has computed employee turnover rates for the quarter ended 31st March,
2021 as 10%, 5% and 3% respectively under 'Flux method', 'Replacement method' and
'Separation method' respectively.
If the number of workers replaced during that quarter is 30,

FIND OUT the number of workers for the quarter

(i) Recruited and joined and
(ii) Left and discharged and
(iii) Equivalent employee turnover rates for the year.

ILLUSTRATION 16:

The management of B.R Ltd. is worried about their increasing employee turnover in the factory and
before analyzing the causes and taking remedial steps; it wants to have an idea of the profit foregone
as a result of employee turnover in the last year.

Last year sales amounted to `83,03,300 and P/V ratio was 20 per cent. The total number of actual
hours worked by the direct employee force was 4.45 lakhs. The actual direct employee hours included
30,000 hours attributable to training new recruits, out of which half of the hours were unproductive.
As a result of the delays by the Personnel Department in filling vacancies due to employee turnover,
1,00,000 potentially productive hours (excluding unproductive training hours) were lost.

The costs incurred consequent on employee turnover revealed, on analysis, the following:

Settlement cost due to leaving `43,820

Recruitment costs `26,740
Selection costs `12,750
Training costs `30,490

Assuming that the potential production lost as a consequence of employee turnover could have
been sold at prevailing prices, FIND the profit foregone last year on account of employee turnover.

58
 ILLUSTRATION 17:

In a factory working six days in a week and eight hours each day, a worker is paid at the rate of `100
per day basic plus D.A. @ 120% of basic. He is allowed to take 30 minutes off during his hours shift for
meals-break and a 10 minutes recess for rest.

During a week, his card showed that his time was chargeable to
:
Job X 15 hrs.
Job Y 12 hrs.
Job Z 13 hrs.

The time not booked was wasted while waiting for a job. In Cost Accounting, STATE how would you
allocate the wages of the workers for the week?

59
 CHAPTER -4
OVERHEADS ABSORPTION
COSTING METHOD
1 CLASSIFICATION OF OVERHEADS
Description
By Function
Factory or Manufacturing overhead is the
Manufacturing indirect cost incurred for
or Production manufacturing or production
Overhead activity in a factory. Manufacturing
overhead includes all expenditures
incurred from the procurement of
materials to the completion of
finished product.
Office and Office and Administrative
Administrative overheads are expenditures
Overheads incurred on all activities relating to
general management and
administration of an organisation.
Selling and (i) Selling overhead: Expenses
Distribution related to sale of products and
Overheads include all indirect expenses in
sales management for the
organisation.
(ii) Distribution overhead: Cost
incurred on making product
available for sale in the market.
60
Example
(I) Stock keeping expenses,
(ii) Repairs and maintenance of
plant,
(iii) Depreciation of factory building,
(iv) Indirect labour,
(v) Cost of primary packing
(vi) Insurance of plant and
machinery etc.
(I) Salary paid to office staffs,
(ii) Repairs and maintenance of
office building,
(iii) Depreciation of office building
(iv) Postage and stationery,
(v) Lease rental in case of
operating lease (in case of
finance lease, lease rental
excluding finance cost)
(vi) Accounts and audit expenses etc.
(i) Salesmen commission,
(ii) Advertisement cost,
(iii) Sales office expenses etc.
(iv) Delivery van expenses,
(v) Transit insurance,
(vi) Warehouse and cold storage
expenses,
(vii) Secondary packing expenses etc.
By Nature
Fixed Overhead These are the costs which are
incurred for a period, and which,
within certain output and turnover
limits, tend to be unaffected by
fluctuations in the levels of activity
(output or turnover). They do not
tend to increase or decrease with
the changes in output.
Variable Overhead These costs tend to vary with the
volume of activity.
Any increase in the activity results
in an increase in the variable cost
and vice-versa.
Semi-Variable These costs contain both fixed and
Overheads variable components and are thus
partly affected by fluctuations in
the level of activity.
By Element
Indirect materials Materials which do not normally
form part of the finished product
(cost object) are known as indirect
materials.
Indirect employee Employee costs which cannot be
cost allocated but can be apportioned to
or absorbed by cost units or cost
centres is known as indirect
employee.
Indirect expenses Expenses other than direct
expenses are known as indirect
expenses, that cannot be directly,
conveniently and wholly allocated
to cost centres.
(i) Salary paid to permanent
employees,
(ii) Depreciation of building and
plant and equipment,
(iii) Interest on capital,
(iv) Insurance.
(i) Indirect materials,
(ii) Power and fuel,
(iii) lubricants,
(iv) tools and spares etc.
(i) Electricity cost,
(ii) water cost,
(iii) telephone and internet
expenses etc.
(i) Stores used for maintaining
machines and buildings
(lubricants, cotton waste, bricks
etc.)
(ii) Stores used by service
departments like power house,
boiler house, canteen etc.
(i) Salary paid to foreman and
supervisor.
(ii) Salary paid to administration
staff etc.
(i) Rates & taxes,
(ii) insurance,
(iii) depreciation,
(iv) advertisement expenses etc.
61
 By Control

Controllable costs These are those costs which can be
controlled by the implementation
of appropriate managerial
influence and proper policies.
(i) Materials cost,
(ii) Wages and salary,
(iii) Power and fuel etc.

Uncontrollable Overhead costs which cannot be (i) Rates and taxes,

costs controlled by the management even (ii) Depreciation,
after the implementation of
(iii) Interest on borrowings.
appropriate managerial influence
and proper polices are known as
uncontrollable costs.

2 STEPS FOR THE DISTRIBUTION OF OVERHEADS

1. Estimation of Overhead

2. Primary Distribution of Overhead

• Allocation of OH
• Apportionment of OH
STEPS
3. Secondary distribution of overhead
(re-apportionment of OH)

4. Absorption of OH

Apportioning overhead expenses over various departments

Overhead Cost Bases of Apportionment

1. (I) Rent and other building expenses Floor area, or volume of

(ii) Lighting and heating (conditioning) department
(iii) Fire precaution service
(iv) Air- conditioning

2. (I) Perquisites Number of workers

(ii) Labour welfare expenses
(iii) Time keeping
(iv) Personnel office
(v) Supervision

62
3. (I) Compensation to workers Direct wages
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Perquisites
Direct labour hour, or Direct wages, or
4. General overhead Machine hours.
5. (I) Depreciation of plant and machinery Capital values
(ii) Repairs and maintenance of plant and
machinery
(iii) Insurance of stock

6. (I) Power/steam consumption Technical estimates

(ii) Internal transport
(iii) Managerial salaries
7. Lighting expenses (light) No. of light points, or Area or Metered
units

8. Electric operation)power(machine Horse power of machines, or Number

9. (I Material handling Stores overhead
of machine hour, or value of machines
or units consumed.
Weight of materials, or volume of
materials, or value of materials or unit
of materials.

Re-apportionment of service department overheads

over production departments

Cost of the Service Departments: Basis

1. Maintenance and Repair shop
2. Planning and progress
3. Tool room
4. Canteen and Welfare
5. Hospital and Dispensary
6. Personnel Department
7. Time-keeping
8. Computer Section
9. Power House (electric lighting cost)
10. Power House (electric power cost)
Direct labour hours, Machine hours, Direct
labour wages, Asset value x Hours worked
No of direct workers
No. of employees etc.
No. of card punched, No. of employees
Computer hours, Specific allocation to
departments
Floor area, Cubic content, No. of electric
Points, Wattage.
Horse power, Kwh, Horse power × Machine

63
 hours, Kwh × Machine hours
11. Stores Department No. of requisitions, Weight or value of
Materials issued.
12. Transport Department Crane hours, Truck hours, Truck mileage,
Truck tonnage, Truck ton- hours, Tonnage
handled. No. of packages of Standard size
13. Fire Protection Capital values
14. Inspection Inspection hours

Methods for Re-apportionment:

The re-apportionment of service department expenses over the production departments

may be carried out by using any one of the following methods:
(i) Direct re-distribution method.
(ii) Step method of secondary distribution or non-reciprocal method.
(iii) Reciprocal Service method.

Secondary
redistribution
of overheads

Direct Step
Reciprocal
redistribution redistribution
step method
of method of method

Repeated Simultaneous
Trail and error
Distribution equation
Method
Method Method

ILLUSTRATION 1

XL Ltd. has three production departments and four service departments. The
expenses for these departments as per Primary Distribution Summary are as follows:

Production Departments: (`) (`)

Dept.-A 30,00,000
Dept.-B 26,00,000
Dept.-C 24,00,000 80,00,000

64
 Service Departments: (`) (`)
Stores 4,00,000
Time-keeping and Accounts 3,00,000
Power 1,60,000
Canteen 1,00,000 9,60,000

The following information is also available in respect of the production

departments:
Dept. A Dept. B Dept. C
Horse power of Machine 300 300 200
Number of workers 20 15 15
Value of stores requisition in (`) 2,50,000 1,50,000 1,00,000

PREPARE a statement apportioning the costs of service departments over the

production departments using direct re-distribution method

ILLUSTRATION 2

Suppose the expenses of two production departments A and B and two service
departments X and Y are as under:

Department Amount (`) Apportionment Basis

Y A B
Dept.-X 2,00,000 25% 40% 35%
Dept.-Y 1,50,000 40% 60%
Dept.-A 3,00,000
Dept.-B 3,20,000

PREPARE a statement apportioning the costs of service departments over the

production departments using step method.

ILLUSTRATION 3

Service departments' expenses

(`)
Boiler house 3,00,000
Pump room 60,000
Total 3,60,000

65
The allocation basis is:

Production Department Service Department

A B Boiler House Pump Room
Boiler House 60% 35% - 5%
Pump Room 10% 40% 50% -

ILLUSTRATION 4

Sanz Ltd. is a manufacturing company having three production departments,

'A', 'B' and 'C' and two service departments 'X' and 'Y'. The following is the
budget for December 2021:

Y A B
Direct material 1,00,000 2,00,000 4,00,000 2,00,000 1,00,000
Direct wages 5,00,000 2,00,000 8,00,000 1,00,000 2,00,000
Factory rent 4,00,000
Power 2,50,000
Depreciation 1,00,000
Other overheads 9,00,000

Additional information:
Area (Sq. ft.) 500 250 500 250 500
Capital value of assets (`lakhs) 20 40 20 10 10
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25

A technical assessment of the apportionment of expenses of service

departments is as under:

A B C X Y
Service Dept. 'X' 45 15 30 – 10
(%)Service Dept. 'Y' (%) 60 35 – 5 –

Required:

1. PREPARE a statement showing distribution of overheads to various

departments.
2. PREPARE a statement showing re-distribution of service departments
expenses to production departments using Trial and error method.

66
 ILLUSTRATION 5

Taking all the information from Illustration 4 above, PREPARE a statement showing re-
distribution of service departments' expenses to production departments using
repeated distribution method. Also CALCULATE machine hour rates of the production
departments 'A', 'B' and 'C'.

ILLUSTRATION 6

The ABC Company has the following account balances and distribution of direct charges
on 31st March.

Total Production Depts. Service Depts.

Machine Packing Gen. Store &
shop Plant Maintenance

Allocated Overheads:
Indirect labour 14,650 4,000 3,000 2,000 5,650
Maintenance material 5,020 1,800 700 1,020 1,500
Misc. supplies 1,750 400 1,000 150 200
Superintendent's salary 4,000 – – 4,000 –
Cost & payroll salary 10,000 – – 10,000 –

Overheads to be apportioned:

Power 8,000
Rent 12,000
Fuel and heat 6,000
Insurance 1,000
Trade License fees 2,000
Depreciation 1,00,000

1,64,420 6, 200 4,700 17,170 7,350

The following data were compiled by means of the factory survey made in the previous year:

Floor Radiator No. of Investment H.P

Space (ft) Sections Employees (`) hours

Machine Shop 2,000 45 20 6,40,000 3,500

Packing 800 90 10 2,00,000 500
400 30 3 10,000 -
General Plant
1,600 60 5 1,50,000 1,000
Store & Maintenance

4,800 225 38 10,00,000 5,000

67
Expenses charged to the stores and maintenance departments are to be distributed to the other
departments by the following percentages:
Machine shop 50%; Packing 20%; General Plant 30%; General Plant overheads is distributed on the
basis of number of employees:
(a) PREPARE an overhead distribution statement with supporting schedules to show
computations and basis of distribution including distribution of the service departments'
expense to production departments.
(b) DETERMINE the service department distribution by the method of continued distribution
(repeated distribution) through 3 cycles. Show all calculations to the nearest rupees.

Absorbing overheads over cost units, products, etc

The whole process of overhead distribution and absorption to units produced is depicted
in the synopsis as

Synopsis of Allocation, Apportionment, Re-apportionment and Absorption

Expenses related to Expenses related to

Department-A All Departments

Allocation Apportionment

Department - A Department - B Department - C Service- Service-

Department -1 Department -2

Allocated Allocated Allocated Allocated Allocated

Overheads Overheads Overheads Overheads Overheads
+ + + + +
Apportioned Apportioned Apportioned Apportioned Apportioned
Overheads Overheads Overheads Overheads Overheads
(and re- (and re-
apportioned) apportioned)
+ +
+ + +
Total Total
Overheads Overheads
Re-Apportionment
Re-Apportioned Re-Apportioned Re-Apportioned
Overheads Overheads Overheads

Total Overheads Total Overheads Total Overheads

Absorption
UNIT UNIT UNIT UNIT UNIT UNIT UNIT UNIT UNIT UNIT UNIT UNIT
1 2 3 4 1 2 3 4 1 2 3 4

68
METHODS OF ABSORBING OVERHEADS
TO VARIOUS PRODUCTS OR JOBS
METHODS OF ABSORPTION OF OVERHEADS

Percentage Percentage Percentage Labour Machine Percentage

of direct of prime of direct hour rate hour rate of prime
materials cost labour cost cost

Example 1

Find out cost per unit if overhead are absorbed on

the basis of % of raw material:
Budgeted Raw Material Cost ` 20,00,000
Budgeted Overhead ` 50,00,000
Raw material per unit ` 100
Direct labour cost per unit ` 150
Direct expenses per unit ` 50

Example 2

Find out cost per unit if overhead are absorbed on

the basis of % of labour cost

Budgeted Labour Cost ` 10,00,000

Budgeted Overhead ` 5,00,000
Raw material per unit ` 100
Direct labour cost per unit ` 300

Example 3

Find out cost per unit if overhead are absorbed

on the basis of % of prime cost

Budgeted Raw Material Cost ` 20,00,000

Budgeted labour cost ` 15,00,000
Budgeted direct expenses ` 10,00,000
Budgeted Overhead ` 1,00,00,000
Raw material per unit ` 200
Direct labour cost per unit ` 150
Direct expenses per unit ` 100

69
Example 4

Find out cost per unit if overhead are absorbed

on the basis of labour hours:
Budgeted labour hours `1,00,000
Budgeted overhead ` 22,00,000
Raw material [5 kgs @ ` 40 per kg.] ` 200 per unit
Labour cost [10 hours @ ` 15 per hour] ` 150 per unit

Example 5

Find out cost per unit if overhead are absorbed

on the basis of machine hours:

Budgeted machine hours `60,000

Budgeted overhead ` 36,00,000
Prime cost per unit `1,000
Machine hours per unit 3 hours

Example 6

Find out overhead per unit :

Budgeted Overhead `30,00,000

Budgeted Units `5,00,000

ILLUSTRATION 7

A machine costing ` 1,00,00,000 is expected to run for 10 years. At the end of this period its scrap
value is likely to be ` 9,00,000. Repairs during the whole life of the machine are expected to be `
18,00,000 and the machine is expected to run 4,380 hours per year on the average. Its electricity
consumption is 15 units per hour, the rate per unit being ` 5. The machine occupies one-fourth of
the area of the department and has two points out of a total of ten for lighting. The foreman has to
devote about one sixth of his time to the machine. The monthly rent of the department is ` 30,000
and the lighting charges amount to ` 8,000 per month. The foreman is paid a monthly salary of
` 19,200. FIND OUT the machine hour rate, assuming insurance is @ 1% p.a. on ` 1,00,00,000 and
the expenses on oil, etc., are ` 900 per month.

70
 ILLUSTRATION 8

A machine shop cost centre contains three machines of equal capacities. To operate
these three machines nine operators are required i.e. three operators on each
machine. Operators are paid ` 20 per hour. The factory works for fourty eight hours in
a week which includes 4 hours set up time. The work is jointly done by operators. The
operators are paid fully for the fourty eight hours. In additions they are paid a bonus of
10 per cent of productive time. Costs are reported for this company on the basis of
thirteen four-weekly period.
The company for the purpose of computing machine hour rate includes the direct
wages of the operator and also recoups the factory overheads allocated to the
machines. The following details of factory overheads applicable to the cost centre are
available:

• Depreciation 10% per annum on original cost of the machine. Original cost of the
each machine is `52,000.
• Maintenance and repairs per week per machine is `60.
• Consumable stores per week per machine are `75.
• Power: 20 units per hour per machine at the rate of 80 paise per unit. No power is
used during the set-up hours.
• Apportionment to the cost centre: Rent per annum `5,400, Heat and Light per
annum `9,720, foreman's salary per annum `12,960 and other miscellaneous
expenditure per annum `18,000.
Required:
CALCULATE the cost of running one machine for a four-week period.

ILLUSTRATION 9

Modern Manufactures Ltd. has three Production Departments P1, P2, P3 and two
Service Departments S1and S2 details pertaining to which are as under:

P1 P2 P3 S1 S2
Direct wages (`) 3,000 2,000 3,000 1,500 195
Working hours 3,070 4,475 2,419 - -
Value of machines (`) 60,000 80,000 1,00,000 5,000 5,000
H.P. of machines 60 30 50 10 -
Light points 10 15 20 10 5
Floor space (sq. ft.) 2,000 2,500 3,000 2,000 500

71
The following figures extracted from the Accounting records are relevant:

(`)
Rent and Rates 5,000
General Lighting 600
Indirect Wages 1,939
Power 1,500
Depreciation on Machines 10,000
Sundries 9,695

The expenses of the service departments are allocated as under:

P1 P2 P3 S1 S2
S1 20% 30% 40% - 10%
S2 40% 20% 30% 10% -

DETERMINE the total cost of product X which is processed for manufacture in

Departments P1, P2 and P3 for 4, 5 and 3 hours respectively, given that its Direct
Material Cost is ` 50 and Direct Labour Cost is ` 30.

ILLUSTRATION 10

Deccan Manufacturing Ltd., have three departments which are regarded as

production departments. Service departments' costs are distributed to these
production departments using the “Step Ladder Method” of distribution.
Estimates of factory overhead costs to be incurred by each department in the
forthcoming year are as follows. Data required for distribution is also shown
against each department

Department Factory Direct No. of Area in

overhead labour employees sq.m.
Production: (`) hours
X 1,93,000 4,000 100 3,000
Y 64,000 3,000 125 1,500
Z 83,000 4,000 85 1,500
Service:
P 45,000 1,000 10 500
Q 75,000 5,000 50 1,500
R 1,05,000 6,000 40 1,000
S 30,000 3,000 50 1,000

72
 The overhead costs of the four service departments are distributed in the same order, viz.,
P, Q, R and S respectively on the following basis.

Department Basis
P Number of employees
Q Direct labour hours
R Area in square metres
S Direct labour hours

You are required to:

(a) PREPARE a schedule showing the distribution of overhead costs of the four service
departments to the three production departments; and
(b) CALCULATE the overhead recovery rate per direct labour hour for each of the three
production departments

ILLUSTRATION 11

Gemini Enterprises undertakes three different jobs A, B and C. All of them require the
use of a special machine and also the use of a computer. The computer is hired and the
hire charges work out to ` 4,20,000 per annum. The expenses regarding the machine are
estimated as follows:

(`)
Rent for a quarter 17,500
Depreciation per annum 2,00,000
Indirect charges per annum 1,50,000

During the first month of operation the following details were taken from the job register:

JOB
A B C
Number of hours the machine was used:
(a) Without the use of the computer 600 900 —
(b) With the use of the computer 400 600 1,000

You are required to COMPUTE the machine hour rate:

(a) For the firm as a whole for the month when the computer was used and when
the computer was not used.
(b) For the individual jobs A, B and C.

73
 ILLUSTRATION 12

A machine shop has 8 identical Drilling machines manned by 6 operators. The machine cannot
be worked without an operator wholly engaged on it. The original cost of all these machines
works out to `8 lakhs. These particulars are furnished for a 6 months period:

Normal available hours per month 208

Absenteeism (without pay) hours 18
Leave (with pay) hours 20
Normal idle time unavoidable-hours 10
Average rate of wages per worker for 8 hours a day. ` 800
Production bonus estimated 15% on wages Value of power
consumed ` 80,500
Supervision and indirect labour ` 33,000
Lighting and electricity ` 12,000
These particulars are for a year
Repairs and maintenance including consumables- 3% of value of machines.
Insurance- ` 40,000
Depreciation- 10% of original cost.
Other sundry works expenses- ` 12,000
General management expenses allocated- ` 54,530.

You are required to COMPUTE a comprehensive machine hour rate for the machine shop.

ILLUSTRATION 13

Job No. 198 was commenced on October 10, 2021 and completed on November 1, 2021.
Materials used were `6,000 and labour charged directly to the job was `4,000. Other
information is as follows:
Machine No. 215 used for 40 hours, the machine hour rate being `35.

Machine No. 160 used for 30 hours, the machine hour rate being `40. Six welders worked on
the job for five days of 8 hours each: the Direct labour hour per welder is `20.

General expenses related to production not included for calculating either the machine hour or
direct labour hour rate totaled 20,000, total direct wages for the period being `2,00,000.

COMPUTE the works costs for job No. 198.

74
 ILLUSTRATION 14

A Ltd., manufactures two products A and B. The manufacturing division consists of two
production departments P1 and P2 and two service departments S1 and S2. Budgeted
overhead rates are used in the production departments to absorb factory overheads to the
products. The rate of Department P1 is based on direct machine hours, while the rate of
Department P2 is based on direct labour hours.

For allocating the service department costs to production departments, the basis adopted is
as follows:
(i) Cost of Department S1 to Department P1 and P2 equally, and
(ii) Cost of Department S2 to Department P1 and P2 in the ratio of 2 : 1 respectively

The following data relating to factory overheads budgeted for the year is available:
Production Departments Service Departments
P1 P2 S1 S2
` 25,50,000 21,75,000 `6,00,000 `4,50,000

Budgeted output in units:

Product A 50,000; B 30,000.
Budgeted time required for production per unit:
Department P1 : Product A : 1.5 machine hours
Product B : 1.0 machine hour
Department P2 : Product A : 2 Direct labour hours
Product B : 2.5 Direct labour hours
You are required to COMPUTE the pre-determined overhead rate for both the production
departments.

3. TREATMENT OF UNDER-ABSORBED AND

OVER–ABSORBED OVERHEADS IN COST ACCOUNTING
Budgeted Figure Actual Figure Absorbed Amount Difference Result
Amount Units Amount Units Under/Over
1 2 3 4 absorption
100 100 110 100
100 100 90 100
100 100 100 90
100 100 100 110
100 100 90 90
100 100 110 110
100 100 110 90
100 100 90 110

75
Treatment of under/ over absorption of overheads in cost accounting:
Treatment of such under/ over absorption of overheads can be understood
with the help of the following flow chart:

Is there any under/over

absorption of overheads?
Yes
Amount of under/over Yes
absorption is small
Costing
No P& L A/c
Amount of under/over Yes
absorption is small
No
Calculate Supplementary Rate and Charge
to Cost of Sales A/c. Finished Goods A/c and W-I-P A/c.

As regards the treatment of such debit or credit balances, the general view is that if the balances are
small they should be transferred to the Costing Profit and Loss Account and the cost of individual
products should not be increased or reduced as these would be representing normal cost.
Where, however the difference is large and due to wrong estimation, it would be desirable to adjust the
cost of products manufactured, as otherwise the cost figures would convey a misleading impression.
Such adjustments usually take the form of supplementary rates.

ILLUSTRATION 15

The total overhead expenses of a factory is ` 4,46,380. Taking into account the normal working of
the factory, overhead was recovered in production at ` 1.25 per hour. The actual hours worked
were 2,93,104. STATE how would you proceed to close the books of accounts, assuming that
besides 7,800 units produced of which 7,000 were sold, there were 200 equivalent units in work-
in-progress?
On investigation, it was found that 50% of the unabsorbed overhead was on account of increase in
the cost of indirect materials and indirect labour and the remaining 50% was due to factory
inefficiency.

ILLUSTRATION 16

In a factory, overheads of a particular department are recovered on the basis of ` 5 per machine
hour. The total expenses incurred and the actual machine hours for the department for the month
of August were ` 80,000 and 10,000 hours respectively. Of the amount of ` 80,000, ` 15,000
became payable due to an award of the Labour Court and ` 5,000 was in respect of expenses of
the previous year booked in the current month (August). Actual production was 40,000 units, of
which 30,000 units were sold. On analysing the reasons, it was found that 60% of the under-
absorbed overhead was due to defective planning and the rest was attributed to normal cost
increase. SHOW the treatment of over/under-absorbed overhead in the cost accounts?

76
 ILLUSTRATION 17

In a manufacturing unit, factory overhead was recovered at a pre-determined rate of ` 25 per

man-day. The total factory overhead expenses incurred and the man-days actually worked were
` 41.50 lakhs and 1.5 lakh man-days respectively. Out of the 40,000 units produced during a
period, 30,000 were sold.
On analysing the reasons, it was found that 60% of the unabsorbed overheads were due to
defective planning and the rest were attributable to increase in overhead costs.
EXPLAIN how would unabsorbed overheads be treated in Cost Accounts?

ILLUSTRATION 18

ABC Ltd. manufactures a single product and absorbs the production overheads at a
pre-determined rate of `10 per machine hour.
At the end of current financial year, it has been found that actual production overheads incurred
were `6,00,000. It included `45,000 on account of ‘written off’ obsolete stores and `30,000 being
the wages paid for the strike period under an award.
The production and sales data for the current year is as under: Production :
Finished goods 20,000 units
Work-in-progress 8,000 units
(50% complete in all respects)
Sales :
Finished goods 18,000 units
The actual machine hours worked during the period were 48,000. It has been found that one-third
of the under-absorption of production overheads was due to lack of production planning and the
rest was attributable to normal increase in costs.
(a) CALCULATE the amount of under-absorption of production overheads during the current
year;and
(b) SHOW the accounting treatment of under-absorption of production overheads.

ILLUSTRATION 19

A light engineering factory fabricates machine parts for customers. The factory commenced
fabrication of 12 nos. machine parts as per customers’ specifications, the expenditure incurred on
the job for the week ending 21st August is as tabulated below:

Direct materials (all items) 780.00

Direct labour (manual) 20 hours @ `15 per hour 300.00
Machine facilities :
Machine No. I : 4 hours @ `45 180.00
Machine No. II : 6 hours @ `65 390.00 570.00
Total 1,650.00
Overheads @ `8 per hour on 20 manual hours 160.00
Total cost 1,810.00

77
The overhead rate of `8 per hour is based on 3,000 man hours per week; similarly, the machine
hour rates are based on the normal working of Machine Nos. I and II for 40 hours out of 45 hours
per week.
After the close of each week, the factory levies a supplementary rate for the recovery of full
overhead expenses on the basis of actual hours worked during the week. During the week ending
21st August, the total labour hours worked was 2,400 and Machine Nos. I and II had worked for
30 hours and 32.5 hours respectively.
PREPARE a Cost Sheet for the job for the fabrication of 12 nos. machine parts duly levying the
supplementary rates.

4. ACCOUNTING AND CONTROL OF

ADMINISTRATIVE OVERHEADS

ILLUSTRATION 20

(Reverse Calculation of Factory Overhead and Administrative overheads)

In an engineering company, the factory overheads are recovered on a fixed percentage basis on
direct wages and the administrative overheads are absorbed on a fixed percentage basis on
factory cost.

The company has furnished the following data relating to two jobs undertaken by it in a period:

Job 101 Job 102

(`) (`)
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Selling price 1,66,650 1,28,250
Profit percentage on Total Cost 10% 20%

Required:
1. COMPUTATION of percentage recovery rates of factory overheads and administrative overheads.
2. CALCULATION of the amount of factory overheads, administrative overheads and profit for each
of the two jobs.
3. Using the above recovery rates DETERMINE the selling price of job 103. The additional data
being:

Direct materials `24,000

Direct wages `20,000
Profit percentage on selling price 12-½%

78
5. ACCOUNTING AND CONTROL OF SELLING
AND DISTRIBUTION OVERHEADS

ILLUSTRATION 21

A company which sells four products, some of these are unprofitable. Company proposes to
discontinue to sale one of these products. The following information is available regarding
income, costs and activity for the year ended 31st March.

Products
A B C D
Sales (`) 30,00,000 50,00,000 25,00,000 45,00,000
Cost of goods sold (`) 20,00,000 45,00,000 21,00,000 22,50,000
Area of storage (Sq.ft.) 50,000 40,000 80,000 30,000
Number of parcels sent 1,00,000 1,50,000 75,000 1,75,000
Number of invoices sent 80,000 1,40,000 60,000 1,20,000

Selling and Distribution overheads and the basis of allocation are

Amount (`) Basis of allocation

to products
Fixed Costs
Rent & Insurance 3,00,000 Area of storage
(Sq.ft.)
Depreciation 1,00,000 No. of Parcels sent
Salesmen’s salaries & expenses 6,00,000 Sales Volume
Administrative wages and salaries 5,00,000 No. of invoices sent
Variable Costs:
Packing wages & materials `2 per parcel
Commission 4% of sales
Stationery `1 per invoice

You are required to PREPARE Costing Profit & Loss Statement,

showing the percentage of profit or loss to sales for each product.

79
6. CONCEPTS RELATED TO CAPACITY
(i) Installed/ Rated capacity:
It refers to the maximum capacity of producing goods or providing services.
Installed capacity is determined either on the basis of technical specification or through a technical
evaluation.
It is also known as theoretical capacity and is could not be achieved in normal operating circumstances.

(ii) Practical capacity:

It is defined as actually utilised capacity of a plant. It is also known as operating capacity.
This capacity takes into account loss of time due to repairs, maintenance, minor breakdown, idle time,
set up time, normal delays, Sundays and holidays, stock taking etc.
Generally, practical capacity is taken between 80 to 90% of the rated capacity.
It is also used as a base for determining overhead rates.
Practical capacity is also called net capacity or available capacity.

(iii) Normal capacity:

Normal capacity is the volume of production or services achieved or achievable on an average over a
period under normal circumstances taking into account the reduction in capacity resulting from
planned maintenance.

(iv) Actual capacity:

It is the capacity actually achieved during a given period. It is presented as a percentage of installed
capacity.

(v) Idle capacity:

It is that part of the capacity of a plant, machine or equipment which cannot be effectively utilised in
production.
(a) Normal Idle Capacity:
It is the difference between Installed capacity and Normal capacity.

(b) Abnormal Idle Capacity:

It is the difference between Normal capacity and Actual capacity utilization where the actual capacity is
lower than the normal capacity.

80
 CHAPTER -5
ACTIVITY BASED
COSTING

ABC is particularly needed by organisations for product costing in the

CLASSIFICATION following situations:
OF OVERHEADS 1. High amount of overhead: When production overheads are high and
form significant costs, ABC is more useful than traditional costing
system.
2. Wide range of products: ABC is most suitable, when, there is diversity in
the product range or there are multiple products.
3. Presence of non-volume related activities: When non-volume related
activities e.g. material handling, inspection set-up, are present
significantly and traditional system cannot be applied, ABC is a superior
and better option.
ABC will identify non-value-adding activities in the production process
that might be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and
there is an urgent requirement to compute cost accurately and to fix the
selling price according to the market situation, ABC is very useful.
ABC can also facilitate in reducing cost by identifying non-value-adding
activities in the production process that might be a suitable focus for
attention or elimination.

MEANING
Activity Based Costing is an accounting methodology that assigns costs to
activities rather than products or services. This enables resources &
overhead costs to be more accurately assigned to products & services that
consume them.
ABC is a technique which involves identification of cost with each cost driving
activity and making it as the basis for apportionment of costs over different
cost objects/ jobs/ products/ customers or services.

MEANING OF TERMS USED IN ABC

(i) Activity – Activity, here, refers to an event that incurs cost.
(ii) Cost Object–It is an item for which cost measurement is required e.g. a product or a customer.
(iii) Cost Driver–It is a factor that causes a change in the cost of an activity. There are two categories
of cost driver.
Resource Cost Driver– It is a measure of the quantity of resources consumed by an activity. It is used to
assign the cost of a resource to an activity or cost pool.
Activity Cost Driver–It is a measure of the frequency and intensity of demand, placed on activities by
cost objects. It is used to assign activity costs to cost objects.
(iv) Cost Pool-It represents a group of various individual cost items. It consists of costs that have same
cause and effect relationship. Example machine set-up.

81
 Examples of Cost Drivers:
Business functions Cost Driver
Research and Development • Number of research projects
• Personnel hours on a project
Design of products, services • Number of products in design
and procedures • Number of parts per product
• Number of engineering hours
Customer Service • Number of service calls
• Number of products serviced
• Hours spent on servicing products
Marketing • Number of advertisements
• Number of sales personnel
• Sales revenue
Distribution • Number of units distributed
• Number of customers

Activity Cost Pools Related Cost Drivers

Ordering and Receiving Materials cost Number of purchase orders
Setting up machines costs Number of set-ups
Machining costs Machine hours
Assembling costs Number of parts
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours

TRADITIONAL ABSORPTION COSTING VS ABC

Direct Cost
Tracing of Product/
Cost Cost Service
Ascertainmenmt
Indirect Cost Cost
Allocation

Traditional Costing Activity based Costing

Based on Machine Based on Cost Driver

hours, labour hours,
Volume etc.

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Activity Based Costing
1. Overheads are related to activities and
grouped into activity cost pools.
2. Costs are related to activities and hence
are more realistic.
3 Activity–wise cost drivers are determined.
4. Activity–wise recovery rates are
determined and there is no concept of a
single overhead recovery rate.
5. Cost are assigned to cost objects, e.g.
customers, products, services,
departments, etc.
6. Essential activities can be simplified and
unnecessary activities can be eliminated. Thus,
the corresponding costs are also reduced/
minimized. Hence ABC aids cost control.
Traditional Absorption Costing
1. Overheads are related to cost centers/
departments.
2 Costs are related to cost centers and
hence not realistic of cost behaviour.
3. Time (Hours) are assumed to be the only
cost driver governing costs in all
departments.
4. Either multiple overhead recovery rates
(for each department) or a single
overhead recovery rate may be
determined for absorbing overheads.
5. Costs are assigned to Cost Units i.e. to
products, or jobs or hours.
6. Cost Centers/ departments cannot be
eliminated. Hence, not suitable for cost
control.

TRADITIONAL ABSORPTION COSTING VS ABC

Level of Activities Meaning Example

1. Unit level These are those activities for
activities which the consumption of
resources can be identified with
the number of units produced.
• The use of indirect
materials/consumables tends to
increase in proportion to the
number of units produced.
• The inspection or testing of
every item produced, if this was
deemed necessary or, perhaps
more likely, every 100th item
produced.

2. Batch level The activities such as setting up of a • Material ordering–where an

activities machine or processing a purchase
order are performed each time a
batch of goods is produced.
The cost of batch related activities
varies with number of batches made,
but is common (or fixed) for all units
within the batch.
order is placed for every batch
of production
• Machine set-up costs–where
machines need resetting
between each different batch of
production.
• Inspection of products where
the first item in every batch is
inspected rather than every
100th item quoted above.

83
 3. Product level These are the activities which are • Designing the product,
activities performed to support different • Producing parts specifications
products in product line • Keeping technical drawings
of products up to date.

4. Facilities level These are the activities which • Maintenance of buildings

activities cannot be directly attributed to • Plant security
individual products.
These activities are necessary to
sustain the manufacturing process
and are common and joint to all
products manufactured

The different stages in ABC calculations are listed below:

STAGES IN
(1) Identify the different activities within the organisation: Usually the number
ACTIVITY BASED of cost centres that a traditional overhead system uses is quite small, say
COSTING (ABC) up to fifteen. In ABC, the number of activities will be much more, say 200;
the exact number will depend on how the management subdivides the
organisation's activities.
The additional number of activities over cost centres means that ABC
should be more accurate than the traditional method regardless of
anything else.

(2) Relate the overheads to the activities, both support and primary, that
caused them. This creates 'cost pools' or 'cost buckets'. This will be done
using resource cost drivers that reflect causality.

(3) Support activities are then spread across the primary activities on some
suitable base, which reflects the use of the support activity. The base is the
cost driver that is the measure of how the support activities are used.

(4) Determine the activity cost drivers that will be used to relate the overheads
collected in the cost pools to the cost objects/products. This is based on the
factor that drives the consumption of the activity.

(5) Calculate activity cost driver rates for each activity, just as an overhead
absorption rate would be calculated in the traditional system.

84
 PART 2
CONCEPT
s

QUESTION [C1] :-

Four students decided to go for "BUFFET" dinner.

Total bill amount is `1,200. How will you share the
bill amount among the friends?

QUESTION [C2] :- RECEIP3T00

Soup 120
One week later, again they decided to go for dinner Mocktail
rse 600
Main cou 180
on Sunday eve. This time they decided to go for Dessert
"A la Carte" dinner. Co-incidentally, the bill amount 1,200
Total
is still ` 1,200 as follows:

Food consumed was as follows:

SOUP
ü ü û ü
MOCKTAIL û ü û û
MAIN
COURSE ü ü ü ü
DESSERT
û ü ü ü
How will you share the bill amount among the friends?

85
QUESTION [C3] :-

Find out cost per car under traditional method of

absorption:
Maruti Ltd. is manufacturing and selling two car
models, namely ALTO and SWIFT. Production and
cost details are as follows:

Overhead
Machining Dept. `15000 lacs
Inspection Dept. ` 6000 lacs
Prime cost per car
ALTO `1,00,000
SWIFT `2,50,000
No. of cars
ALTO 10,000
SWIFT 5,000

QUESTION [C4] :-

Continuing the question no. [C3], find out OH under

logical method :

Hours
Machine 10 lacs
Inspection 2 lacs
Machine Hours per car
ALTO 50
SWIFT 100
Inspection Hours per car
ALTO 6
SWIFT 28

86
 ILLUSTRATION 1

ABC Ltd. is a multiproduct company, manufacturing three products A, B and C.

The budgeted costs and production for the year ending 31st March are as follows:

A B C
Production quantity (Units) 4,000 3,000 1,600
Resources per Unit:
-Direct Materials (Kg.) 4 6 3
-Direct Labour (Minutes) 30 45 60

The budgeted direct labour rate was `10 per hour, and the budgeted material cost was `2 per kg.
Production overheads were budgeted at `99,450 and were absorbed to products using the direct labour
hour rate. ABC Ltd. followed the Absorption Costing System.
ABC Ltd. is now considering to adopt an Activity Based Costing system. The following additional
information is made available for this purpose.

1. Budgeted overheads were analysed into the following:

`
Material handling 29,100
Storage costs 31,200
Electricity 39,150

2. The cost drivers identified were as follows:

Material handling Weight of material handled

Storage costs Number of batches of material
Electricity Number of Machine operations

3. Data on Cost Drivers was as follows:

A B C
For complete production:
Batches of material 10 5 15
Per unit of production:
Number of Machine operations 6 3 2

87
You are requested to:
1. PREPARE a statement for management showing the unit costs and total costs of each product using
the absorption costing method.
2. PREPARE a statement for management showing the product costs of each product using the ABC
approach.
3. STATE what are the reasons for the different product costs under the two approaches?

ILLUSTRATION 2

ABC Ltd. Manufactures two types of machinery equipment Y and Z and applies/absorbs overheads on the
basis of direct-labour hours. The budgeted overheads and direct-labour hours for the month of December
are `12,42,500 and 20,000 hours respectively. The information about Company's products is as follows:

Equipment Equipment
Y Z
Budgeted Production volume 2,500 units 3,125 units
Direct material cost `300 per unit `450 per unit
Direct labour cost
Y : 3 hours @ `150 per hour `450
Z : 4 hours @ `150 per hour `600

ABC Ltd.'s overheads of `12,42,500 can be identified with three major activities:
Order Processing (`2,10,000), machine processing (`8,75,000), and product inspection (`1,57,500).
These activities are driven by number of orders processed, machine hours worked, and inspection
hours, respectively. The data relevant to these activities is as follows:

Orders processed Machine hours worked Inspection hours

Y 350 23,000 4,000
Z 250 27,000 11,000
Total 600 50,000 15,000

Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production, COMPUTE the unit
manufacturing cost of the equipment Y and Z, if the budgeted manufacturing volume is attained.
(ii) Assuming use of activity-based costing, COMPUTE the unit manufacturing costs of the equipment Y
and Z, if the budgeted manufacturing volume is achieved.
(iii) ABC Ltd.'s selling prices are based heavily on cost. By using direct-labour hours as an application
base, CALCULATE the amount of cost distortion (under-costed or over-costed) for each equipment.

88
 ILLUSTRATION 3

'Humara - Apna' bank offers three products, viz., deposits, Loans and Credit Cards. The bank has selected 4
activities for a detailed budgeting exercise, following activity based costing methods.
The bank wants to know the product wise total cost per unit for the selected activities, so that prices may be
fixed accordingly.

The following information is made available to formulate the budget:

Activity Present Cost (`) Estimation for the budget period

ATM Services:
(a) Machine Maintenance
(b) Rents
(c) Currency Replenishment Cost
Computer Processing
Issuing Statements
Computer Inquiries
4,00,000 All fixed, no change. Fully fixed, no change.
2,00,000 fixed, no change.
1,00,000 Expected to double during budget period.
7,00,000 (This activity is driven by no. of ATM
transactions)
5,00,000 Half this amount is fixed and no change is
expected.
The variable portion is expected to increase to
three times the current level.
(This activity is driven by the number of
computer transactions
18,00,000 Presently, 3 lakh statements are made. In the
budget period, 5 lakh statements are expected.
For every increase of one lakh statement, one
lakh rupees is the budgeted increase.
(This activity is driven by the number of statements)
2,00,000 Estimated to increase by 80% during the
budget period.
(This activity is driven by telephone minutes)

The activity drivers and their budgeted quantifies are given below:
Activity Drivers Deposits Loans Credit Cards
No. of ATM Transactions 1,50,000 --- 50,000
No. of Computer Processing Transactions 15,00,000 2,00,000 3,00,000
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000

The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and 14,000 Credit Card
Accounts.
Required:
(i) CALCULATE the budgeted rate for each activity.
(ii) PREPARE the budgeted cost statement activity wise.
(iii) COMPUTE the budgeted product cost per account for each product using (i) and (ii) above.

89
 ILLUSTRATION 4

Woolmark Ltd. manufactures three types of products namely P, Q and R. The data relating to
a period are as under:

Particulars P Q R
Machine hours per unit 10 18 14
Direct Labour hours per unit 4 12 8
Direct Material per unit (`) 90 80 120
Production (units) 3,000 5,000 20,000

Currently the company uses traditional costing method and absorbs all production overheads on
the basis of machine hours. The machine hour rate of overheads is `6 per hour. Direct labour
hour rate is `20 per hour.
The company proposes to use activity based costing system and the activity analysis is as under:

Particulars P Q R
Batch size (units) 150 500 1,000
Number of purchase orders per batch 3 10 8
Number of inspections per batch 5 4 3

The total production overheads are analysed as under:

Machine set up cost 20%
Machine operation cost 30%
Inspection cost 40%
Material procurement related cost 10%

Required
(i) CALCULATE the cost per unit of each product using traditional method of absorbing all production
overheads on the basis of machine hours.
(ii) CALCULATE the cost per unit of each product using activity based costing principles.

90
 ILLUSTRATION 5

RST Limited specializes in the distribution of pharmaceutical products. It buys from the
pharmaceutical companies and resells to each of the three different markets.
(i) General Supermarket Chains
(ii) Drugstore Chains
(iii) Chemist Shops
The following data for the month of April in respect of RST Limited has been reported:

General Supermarket Drugstore Chemist Shops

Chains ` Chains ` `
Average revenue per delivery 84,975 28,875 5,445
Average cost of goods sold per delivery 82,500 27,500 4,950
Number of deliveries 330 825 2,750

In the past, RST Limited has used gross margin percentage to evaluate the relative
profitability of its distribution channels.
The company plans to use activity –based costing for analysing the profitability of its
distribution channels.
The Activity analysis of RST Limited is as under:

Activity Area Cost Driver

Customer purchase order processing
Line-item ordering
Store delivery
Cartons dispatched to stores
Shelf-stocking at customer store
Purchase orders by customers
Line-items per purchase order
Store deliveries
Cartons dispatched to a store per delivery
Hours of shelf-stocking

The April month's operating costs (other than cost of goods sold) of RST Limited are `8,27,970.
These operating costs are assigned to five activity areas. The cost in each area and the quantity
of the cost allocation basis used in that area for the month of April are as follows:

Activity Area Total costs (`) Total Units of Cost Allocation Base
Customer purchase order processing 2,20,000 5,500 orders
Line-item ordering 1,75,560 58,520 line items
Store delivery 1,95,250 3,905 store deliveries
Cartons dispatched to store 2,09,000 2,09,000 cartons
Shelf-stockingat customer store 28,160 1,760 hours

91
Other data for the month of April include the following:

General Supermarket Drugstore Chemist

Chains Chains Shop
Total number of orders 385 990 4,125
Average number of line items per order 14 12 10
Total number of store deliveries 330 825 2,750
Average numberof cartons shipped
per store delivery 300 80 16
Average number of hours of
shelf-stocking per store delivery 3 0.6 0.1

Required:
(i) COMPUTE gross-margin percentage for each of its three distribution channels and compute RST
Limited's operating income.
(ii) COMPUTE the rate per unit of the cost-allocation base for each of the five activity areas.
(iii) COMPUTE the operating income of each distribution channel using the activity-based costing
information. Comment on the results. What new insights are available with the activity-based cost
information?
(iv) DESCRIBE four challenges one would face in assigning the total operating costs of `8,27,970 to five
activity areas.

ILLUSTRATION 6

Family Store wants information about the profitability of individual product lines: Soft drinks,
Fresh produce and Packaged food. Family store provides the following data for the current
year for each product line:

Soft drinks Fresh produce Packaged food

Revenues ` 39,67,500 ` 1,05,03,000 ` 60,49,500
Cost of goods sold ` 30,00,000 ` 75,00,000 ` 45,00,000
Cost of bottles returned ` 60,000 `0 `0
Number of purchase orders placed 360 840 360
Number of deliveries received 300 2,190 660
Hours of shelf-stocking time 540 5,400 2,700
Items sold 1,26,000 11,04,000 3,06,000

92
Family store also provides the following information for the current year:

Activity Description of activity Total Cost Cost-allocation base

Bottles Returns Returning of empty bottles `60,000 Direct tracing to soft drink line
Ordering Placing of orders for `7,80,000 1,560 purchase orders
purchases
Delivery Physical delivery and
receipt of goods `12,60,000 3,150 deliveries
Shelf stocking Stocking of goods on store 8,640 hours of shelf-stocking
shelves and on- going `8,64,000 time
restocking
Customer Support Assistance provided to
customers including `15,36,000 15,36,000 items sold
check-out

Required:
(i) Family store currently allocates support cost (all cost other than cost of goods sold) to product lines on
the basis of cost of goods sold of each product line. CALCULATE the operating income and operating
income as a % of revenues for each product line.
(ii) If Family Store allocates support costs (all costs other than cost of goods sold) to product lines using and
activity-based costing system, CALCULATE the operating income and operating income as a % of
revenues for each product line.

ILLUSTRATION 7

Alpha Limited has decided to analyse the profitability of its five new customers. It buys bottled water at
`90 per case and sells to retail customers at a list price of `108 per case. The data pertaining to five
customers are

Customers
A B C D E
Cases sold 4,680 19,688 1,36,800 71,550 8,775
Listed Selling Price `108 `108 `108 `108 `108
Actual Selling Price `108 06.20 `99 `104.40 `97.20
Number of Purchase orders 15 25 30 25 30
Number of Customer visits 2 3 6 2 3
Number of deliveries 10 30 60 40 20
Kilometers travelled per delivery 20 6 5 10 30
Number of expedited deliveries 0 0 0 0 1

93
Its five activities and their cost drivers are:
Activity Cost Driver Rate
Order taking ` 750 per purchase order
Customer visits ` 600 per customer visit
Deliveries ` 5.75 per delivery Km travelled
Product handling ` 3.75 per case sold
Expedited deliveries ` 2,250 per expedited delivery

Required:
(i) COMPUTE the customer-level operating income of each of five retail customers now being examined
(A, B, C, D and E). Comment on the results.
(ii) STATE what insights are gained by reporting both the list selling price and the actual selling price for
each customer?

ILLUSTRATION 8

BABYSOFT is a global brand created by Bio-organic Ltd. The company manufactures three ranges of beauty
soaps i.e. BABYSOFT- Gold, BABYSOFT- Pearl, and BABYSOFT- Diamond. The budgeted costs and production
for the month of December are as follows:

BABYSOFT- Gold BABYSOFT- Pearl BABYSOFT-Diamond

Production of soaps (Units) 4,000 3,000 2,000
Resources per Unit: Qty Rate Qty Rate Qty Rate
-Essential Oils 60 ml `200 / 100 ml 55 ml `300 / 100 ml 65 ml `300 / 100 ml
-Cocoa Butter 20 g `200 / 100 g 20 g `200 / 100 g 20 g `200 / 100 g
-Filtered Water 30 ml `15 / 100 ml 30 ml ` 5 / 100 ml 30 ml `15 / 100 ml
-Chemicals 10 g `30 / 100 g 12 g `50 / 100 g 15 g `60 / 100 g
-Direct Labour 30 `10 / hour 40 `10 / hour 60 `10 / hour
minutes minutes minutes

Bio-organic Ltd. followed an Absorption Costing System and absorbed its production overheads, to its
products using direct labour hour rate, which were budgeted at `1,98,000.
Now, Bio-organic Ltd. is considering adopting an Activity Based Costing system. For this, additional
information regarding budgeted overheads and their cost drivers is provided below:

Particulars (`) Cost drivers

Forklifting cost 58,000 Weight of material lifted
Supervising cost 60,000 Direct labour hours
Utilities 80,000 Number of Machine operations

94
The number of machine operations per unit of production are 5, 5, and 6 for BABYSOFT- Gold,
BABYSOFT- Pearl, and BABYSOFT- Diamond respectively.
(Consider (i) Mass of 1 litre of Essential Oils and Filtered Water equivalent to 0.8 kg and 1 kg respectively
(ii) Mass of output produced is equivalent to the mass of input materials taken together.)
You are requested to:
(i) PREPARE a statement showing the unit costs and total costs of each product using the absorption
costing method.
(ii) PREPARE a statement showing the product costs of each product using the ABC approach.
(iii) STATE what are the reasons for the different product costs under the two approaches?

ILLUSTRATION 9

MST Limited has collected the following data for its two activities. It calculates activity cost rates based
on cost driver capacity.

Activity Cost Driver Capacity Cost

Power Kilowatt hours 50,000 kilowatt hours `2,00,000
Quality Inspections Number of Inspections 10,000 Inspections `3,00,000

The company makes three products M, S and T. For the year ended March 31st, the following
consumption of cost drivers was reported:

Product Kilowatt hours Quality Inspections

M 10,000 3,500
S 20,000 2,500
T 15,000 3,000

Required:
(i) COMPUTE the costs allocated to each product from each activity.
(ii) CALCULATE the cost of unused capacity for each activity.
(iii) DISCUSS the factors the management considers in choosing a capacity level to compute the
budgeted fixed overhead cost rate.

95
 CHAPTER -6
COST SHEET

Ascertainment of cost includes elementwise collection of

INTRODUCTION costs, accumulation of the costs so collected for a certain
volume or period and then arrange all these accumulated
costs into a sheet to calculate total cost for the cost object.
A Cost Sheet or Cost Statement is “a document which
provides a detailed cost information”.

FUNCTIONAL CLASSIFICATION
OF ELEMENTS OF COST
Under this classification, costs are divided according to the
function for which they have been incurred.
The following are the classification of costs based on functions:
Ÿ Direct Material Cost
Ÿ Direct Employee (labour) Cost
Ÿ Direct Expenses
Ÿ Production/ Manufacturing Overheads
Ÿ Administration Overheads
Ÿ Selling Overheads
Ÿ Distribution Overheads
Ÿ Research and Development costs etc.

COST HEADS IN A COST SHEET

The costs as classified on the basis of functions are
grouped into the following cost heads in a cost sheet:
[1] Prime Cost
[2] Cost of Production
[3] Cost of Goods Sold
[4] Cost of Sales

96
 [1] Prime Cost
Prime cost represents the total of direct materials costs, direct employee (labour) costs and
direct expenses. The total of cost for each element has to be calculated separately.
Direct Material Cost: It is the cost of direct material consumed. The cost of direct material
consumed is calculated as follows:

Opening Stock of Material xxx

Add: Additions/ Purchases xxx
Less: Closing stock of Material (xxx)
Direct materials consumed xxxx

The valuation of materials purchased and issued for production shall be done as per methods
discussed in the ‘Chapter- 2 Material Cost’. Few examples are:
• Cost of material;
• Freight inwards;
• Insurance and other expenditure directly attributable to procurement;
• Trade discounts or rebates (to be deducted);
• Duties & Taxes (if input tax credit is not available/ availed) etc.

Direct Employee (labour) Cost: It is the total of payment made to the employees who are
engaged in the production of goods and provision of services. Employee cost is also known as
labour cost;
It includes the following:
• Wages and salary;
• Allowances and incentives;
• Payment for overtimes;
• Bonus/ ex-gratia;
• Employer’s contribution to welfare funds such as Provident fund and other similar funds;
• Other benefits (medical, leave with pay, free or subsidised food, leave travel concession
and provisions for retirement benefits) etc.

Direct Expenses: Expenses other than direct material cost and direct employee cost, which
are incurred to manufacture a product or for provision of service and can be directly traced in
an economically feasible manner to a cost object.
The following costs are examples for direct expenses:
• Cost of utilities such as power & fuel, steam etc.;
• Royalty paid/ payable for production or provision of service;
• Hire charges paid for hiring specific equipment;
• Fee for technical assistance and know-how;
• Amortised cost of moulds, patterns, patents etc.;
• Cost for product/ service specific design or drawing;
• Cost of product/ service specific software;
• Other expenses which are directly related with the production of goods or provision of
service.

97
[2] Cost of Production
In a conventional cost sheet, this item of cost can be seen. It is the total of prime cost and
factory related costs and overheads.

Prime Cost xxx

Add : Factory Overheads xxx
Gross Works Costs XXX
Add: Opening stock of Work-in-process xxx
Less: Closing stock of Work-in-process (xxx)
Factory or Works Costs xxxx
Add: Quality Control Cost xxx
Add: Research & Development cost (Process related) xxx
Add: Administrative Overheads related with production Xxx
Less: Credit for recoveries (miscellaneous income)
Add: Packing Cost (Primary packing)
Cost of Production

Factory Overheads:
ü It is also known as works/production/manufacturing overheads.
ü It includes the following indirect costs:
• Consumable stores and spares;
• Depreciation of plant and machinery, factory building etc.
• Lease rent of production assets;
• Repair and maintenance of plant and machinery, factory building etc.
• Indirect employees cost related with production activities;
• Drawing and Designing department cost;
• Insurance of plant and machinery, factory building, stock of raw material & WIP etc.
• Amortized cost of jigs, fixtures, tooling etc.
• Service department cost such as Tool Room, Engineering & Maintenance, Pollution Control etc.

Stock of Work-in-process:
ü The cost of opening and closing stock of work-in-process (WIP) is adjusted to arrive at
factory/ works cost.
ü The WIP stock is valued on the basis of percentage of completion in respect of each element
of cost.

Quality Control Cost:

This is the cost of resources consumed towards quality control procedures.

Research & Development cost:

It includes only those research and development related cost which is incurred for the
improvement of process, system, product or services.

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 Administrative Overheads:
It includes only those administration overheads which are related to production. The general
administration overhead is not included in production cost.

Credit for recoveries:

The realised or realisable value of scrap or waste is deducted as it reduces the cost of
production.

Packing Cost (primary):

Packing material which is essential to hold and preserve the product for its use by the customer.

[3] Cost of Goods Sold

Cost of Production xxx

Add: Cost of Opening stock of finished goods xxx
Less: Cost of Closing stock of finished goods (xxx)
Cost of Goods Sold xxxx

[4] Cost of Sales

ü It is the total cost of a product incurred to make the product available to the customer or
consumer.
ü It includes Cost of goods sold, administration and marketing expenses.
ü It is calculated as below:

Cost of Goods Sold xxx

Add: Administrative Overheads (General) xxx
Add: Selling Overheads xxx
Add: Packing Cost (secondary) xxx
Add: Distribution Overheads xxx
Cost of Sales xxxx

Administrative Overheads:
ü It is the cost related with general administration of the entity.
ü It includes the followings:
• Depreciation and maintenance of, building, furniture etc. of corporate or general management.
• Salary of administrative employees, accountants, directors, secretaries etc.
• Rent, rates & taxes, insurance, lighting, office expenses etc.
• Indirect materials- printing and stationery, office supplies etc.
• Legal charges, audit fees, corporate office expenses like directors’ sitting fees, remuneration
and commission, meeting expenses etc.

99
Selling Overheads:
ü It is the cost related with sale of products or services.
ü It includes the following costs:
• Salary and wages related with sales department and employees directly related with selling
of goods.
• Rent, depreciation, maintenance and other cost related with sales department.
• Cost of advertisement, maintenance of website for online sales, market research etc.
Packing cost (secondary): Packing material that enables to store, transport, inform the
customer, promote and otherwise make the product marketable.

Distribution Overheads:
ü It includes the cost related with making the goods available to the customers.
ü The costs are
• Salary and wages of employees engaged in distribution of goods.
• Transportation and insurance costs related with distribution.
• Depreciation, hire charges, maintenance and other operating costs related with distribution
vehicles etc.

COST SHEET/STATEMENT:
Specimen Format of Cost Sheet for a Manufacturing entity

1. Direct Material Consumed Opening Stock of Raw Material xxx

Add: Additions/ Purchases xxx
Less: Closing stock of Raw Material xxx
xxx
2. Direct employee (labour) cost xxx
3. Direct expenses xxx
4. Prime Cost (1+2+3) xxx
5. Add: Works/ Factory Overheads xxx
6. Gross Works Cost (4+5) xxx
7. Add: Opening Work in Process xxx
8. Less: Closing Work in Process (xxx)
9. Works/ Factory Cost (6+7-8) xxx
10. Add: Quality Control Cost xxx
11. Add: Research and Development Cost xxx
12. Add: Administrative Overheads (relating to production activity) xxx
13. Less: Credit for Recoveries/Scrap/By-Products/ misc. income (xxx)
14. Add: Packing cost (primary) xxx
15. Cost of Production (9+10+11+12-13+14) xxx
16. Add: Opening stock of finished goods xxx
17. Less: Closing stock of finished goods (xxx)
18. Cost of Goods Sold (15+16-17) xxx
19. Add: Administrative Overheads (General) xxx
20. Add: Marketing Overheads : Selling Overheads xxx
Distribution Overheads xxx
21. Cost of Sales (18+19+20) xxx

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 Treatment of various items of cost in Cost sheet/statement
Abnormal costs-
Any abnormal cost, where it is material and quantifiable, shall not form part of cost of
production or acquisition or supply of goods or provision of service. Examples of abnormal
costs are:
Ÿ Cost pertaining to or arising out of a pandemic e.g. COVID-19
Ÿ Cost associated with employees due to sudden lockdown.

Subsidy/ Grant/ Incentives- Any such type of payment received/ receivable are reduced from
the cost objects to which such amount pertains.

Penalty, fine, damages, and demurrage - These types of expenses are not form part of cost.

Interest and other finance costs- Interest, including any payment in the nature of interest for
use of non- equity funds and incidental cost that an entity incurs in arranging those funds.
Interest and finance charges are not included in cost of production.

Advantages of Cost sheet or Cost Statements

Abnormal costs-
Ÿ The main advantages of a Cost Sheet are as follows:
Ÿ It provides the total cost figure as well as cost per unit of production.
Ÿ It helps in cost comparison.
Ÿ It facilitates the preparation of cost estimates required for submitting tenders.
Ÿ It provides sufficient help in arriving at the figure of selling price.
Ÿ It facilitates cost control by disclosing operational efficiency.

ILLUSTRATION 1

The following data relates to the manufacture of a standard product during the month of April:

Particulars (Amount)
Raw materials ` 1,80,000
Direct wages ` 90,000
Machine hours worked (hours) 10,000
Machine hour rate (per hour) `8
Administration overheads (general) ` 35,000
Selling overheads (per unit) `5
Units produced 4,000
Units sold 3,600
Selling price per unit ` 125

You are required to PREPARE a cost sheet in respect of the above showing:
Ÿ Cost per unit
Ÿ Profit for the month

101
 ILLUSTRATION 2

The following information has been obtained from the records of

ABC Corporation for the period from June 1 to June 30.

On June 1(`) On June 30 (`)

Cost of raw materials 60,000 50,000
Cost of work-in-process 12,000 15,000
Cost of stock of finished goods 90,000 1,10,000
Purchase of raw materials during June 2020 4,80,000
Wages paid 2,40,000
Factory overheads 1,00,000
Administration overheads (related to production) 50,000
Selling & distribution overheads 25,000
Sales 10,00,000

PREPARE a statement giving the following information:

• Raw materials consumed;
• Prime cost;
• Factory cost;
• Cost of goods sold; and
• Net profit.

ILLUSTRATION 3
Arnav Inspat Udyog Ltd. has the following expenditures for the year ended 31st March, 2021:

Sl. No. Amount (`) Amount (`)

(i) Raw materials purchased 10,00,00,000
(ii) GST paid on the above purchases @18%
(eligible for input tax credit) 1,80,00,000
(iii) Freight inwards 11,20,600
(iv) Wages paid to factory workers 29,20,000
(v) Contribution made towards employees’ PF & ESIS 3,60,000
(vi) Production bonus paid to factory workers 2,90,000
(vii) Royalty paid for production 1,72,600
(viii) Amount paid for power & fuel 4,62,000
(ix) Amount paid for purchase of moulds and
patterns (life is equivalent to two years production) 8,96,000
(x) Job charges paid to job workers 8,12,000
(xi) Stores and spares consumed 1,12,000
(xii) Depreciation on:
Factory building 84,000
Office building 56,000
Plant & Machinery 1,26,000
Delivery vehicles 86,000 3,52,000

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 (xiii) Salary paid to supervisors 1,26,000
(xiv) Repairs & Maintenance paid for:
Plant & Machinery 48,000
Sales office building 18,000
Vehicles used by directors 19,600 85,600
(xv) Insurance premium paid for:
Plant & Machinery 31,200
Factory building 18,100
Stock of raw materials & WIP 36,000 85,300
(xvi) Expenses paid for quality control
check activities 19,600
(xvii) Salary paid to quality control staffs 96,200
(xviii) Research & development cost paid for
improvement in production process 18,200
(xix) Expenses paid for pollution control and
engineering & maintenance 26,600
(xx) Expenses paid for administration of factory work 1,18,600
(xxi) Salary paid to functional mangers:
Production control 9,60,000
Finance & Accounts 9,18,000
Sales & Marketing 10,12,000 28,90,000
(xxii) Salary paid to General Manager 12,56,000
(xxiii) Packing cost paid for:
Primary packing necessary to maintain quality 96,000
For re-distribution of finished goods 1,12,000 2,08,000
(xxiv) Wages of employees engaged in
distribution of goods 7,20,000
(xxv) Fee paid to auditors 1,80,000
(xxvi) Fee paid to legal advisors 1,20,000
(xxvii) Fee paid to independent directors 2,20,000
(xxviii) Performance bonus paid to sales staffs 1,80,000
(xxix) Value of stock as on 1st April, 2020:
Raw materials 18,00,000
Work-in-process 9,20,000
Finished goods 11,00,000 38,20,000
(xxx) Value of stock as on 31st March, 2021:
Raw materials 9,60,000
Work-in-process 8,70,000
Finished goods 18,00,000 36,30,000

Amount realized by selling of scrap and waste generated during manufacturing process – `86,000/-

From the above data you are required to PREPARE Statement of cost for Arnav Ispat Udyog Ltd. for the
year ended 31st March, 2021, showing
(i) Prime cost,
(ii) Factory cost,
(iii) Cost of Production,
(iv) Cost of goods sold and
(v) Cost of sales.

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 SOLUTION
Statement of Cost of Arnav Ispat Udyog Ltd. for the year ended 31st March, 2021:

Sl.No. Particulars Amount(`) Amount(`)

(i) Material Consumed:
Raw materials purchased 10,00,00,000
Freight inwards 11,20,600
Add: Opening stock of raw materials 18,00,000
Less: Closing stock of raw materials (9,60,000) 10,19,60,600
(ii) Direct employee (labour) cost:
Wages paid to factory workers 29,20,000
Contribution made towards employees’ PF & ESIS 3,60,000
Production bonus paid to factory workers 2,90,000 35,70,000
(iii) Direct expenses:
Royalty paid for production 1,72,600
Amount paid for power & fuel 4,62,000
Amortised cost of moulds and patterns 4,48,000
Job charges paid to job workers 8,12,000 18,94,600
Prime Cost 10,74,25,200
(iv) Works/ Factory overheads:
Stores and spares consumed 1,12,000
Depreciation on factory building 84,000
Depreciation on plant & machinery 1,26,000
Repairs & Maintenance paid for plant & machinery 48,000
Insurance premium paid for plant & machinery 31,200
Insurance premium paid for factory building 18,100
Insurance premium paid for stock of raw 36,000
materials & WIP
Salary paid to supervisors 1,26,000
Expenses paid for pollution control and
engineering & maintenance 26,600 6,07,900
Gross factory cost 10,80,33,100
Add: Opening value of W-I-P 9,20,000
Less: Closing value of W-I-P (8,70,000)
Factory Cost 10,80,83,100
(v) Quality control cost:
Expenses paid for quality control check activities 19,600
Salary paid to quality control staffs 96,200 1,15,800
(vi) Research & development cost paid for
improvement in production process 18,200
(vii) Administration cost related with production:
-Expenses paid for administration of factory work 1,18,600
-Salary paid to Production control manager 9,60,000 10,78,600

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 (viii) Less: Realisable value on sale of
scrap and waste (86,000)
(ix) Add: Primary packing cost 96,000
Cost of Production 10,93,05,700
Add: Opening stock of finished goods 11,00,000
Less: Closing stock of finished goods (18,00,000)
Cost of Goods Sold 10,86,05,700
(x) Administrative overheads:
Depreciation on office building 56,000
Repairs & Maintenance paid for
vehicles used by directors 19,600
Salary paid to Manager- Finance & 9,18,000
Accounts
Salary paid to General Manager 12,56,000
Fee paid to auditors 1,80,000
Fee paid to legal advisors 1,20,000
Fee paid to independent directors 2,20,000 27,69,600
(xi) Selling overheads:
Repairs & Maintenance paid for sales
office building 18,000
Salary paid to Manager- Sales & Marketing 10,12,000
Performance bonus paid to sales staffs 1,80,000 12,10,000
(xii) Distribution overheads:
Depreciation on delivery vehicles 86,000
Packing cost paid for re-distribution of
finished goods 1,12,000
Wages of employees engaged in
distribution of goods 7,20,000 9,18,000
Cost of Sales 11,35,03,300

Note:
GST paid on purchase of raw materials would not be part of cost of materials as it is eligible for input

105
 ILLUSTRATION 4
The books of Adarsh Manufacturing Company present the following data for the month of April:

Direct labour cost `17,500 being 175% of works overheads.

Cost of goods sold excluding administrative expenses `56,000.
Inventory accounts showed the following opening and closing balances:

April 1 (`) April 30 (`)

Raw materials 8,000 10,600
Work-in-progress 10,500 14,500
Finished goods 17,600 19,000

Other data are:

(`)
Selling expenses 3,500
General and administration expenses 2,500
Sales for the month 75,000

You are required to:

Ÿ FIND out the value of materials purchased.
Ÿ PREPARE a cost statement showing the various elements of cost and also the profit earned.

ILLUSTRATION 5
From the following particulars, you are required to PREPARE monthly cost sheet of Aditya Industries:

Amount (`)
Opening Inventories:
-Raw materials 12,00,000
-Work-in-process 18,00,000
-Finished goods (10,000 units) 9,60,000
Closing Inventories:
-Raw materials 14,00,000
-Work-in-process 16,04,000
-Finished goods ?
Raw materials purchased 1,44,00,000
GST paid on raw materials purchased (ITC available) 7,20,000
Wages paid to production workers 36,64,000
Expenses paid for utilities 1,45,600
Office and administration expenses paid 26,52,000
Travelling allowance paid to office staffs 1,21,000
Selling expenses 6,46,000

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 Machine hours worked- 21,600 hours
Machine hour rate- ` 8.00 per hour
Units sold- 1,60,000
Units produced- 1,94,000
Desired profit- 15% on sales

ILLUSTRATION 6

A Ltd. Co. has capacity to produce 1,00,000 units of a product every month.
Its works cost at varying levels of production is as under:

Level Works cost per unit (`)

10% 400
20% 390
30% 380
40% 370
50% 360
60% 350
70% 340
80% 330
90% 320
100% 310

Its fixed administration expenses amount to `1,50,000 and fixed marketing expenses amount to
`2,50,000 per month respectively. The variable distribution cost amounts to `30 per unit.

It can sell 100% of its output at `500 per unit provided it incurs the following further expenditure:
(a) it gives gift items costing `30 per unit of sale;

(b) it has lucky draws every month giving the first prize of `50,000; 2nd prize of `25,000, 3rd prize of
`10,000 and three consolation prizes of ` 5,000 each to customers buying the product.

( c) it spends `1,00,000 on refreshments served every month to its customers;

(d) it sponsors a television programme every week at a cost of `20,00,000 per month.

It can market 30% of its output at `550 per unit without incurring any of the expenses referred to in
(a) to (d) above.

PREPARE a cost sheet for the month showing total cost and profit at 30% and 100% capacity level.

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 CHAPTER -7
COST ACCOUNTING SYSTEMS

Cost Accounting System

Non-Integral Accounting System Integral Accounting System

Reconciliation of Profit

Where cost and financial accounting records are integrated,

INTRODUCTION the system so evolved is known as integrated or integral
accounting system. In case cost and financial transactions
are kept separately, the system is called Non- Integrated
Accounting system or Cost Control System.

NON-INTEGRATED
ACCOUNTING SYSTEM

It is a system of accounting under which separate ledgers are maintained for both cost and financial
accounts. This system is also known as cost ledger accounting system.
Under this system the cost accounts restrict itself to recording only those transactions which relate to
the product or service being supplied.
Items of expenses which are related to sales, production or other matters of factory management are
the ones dealt with in such accounts. This leads to the exclusion of certain expenses like interest, bad
debts and revenue/income from 'other than the sale of product or service'.Non-Integrated Accounting
Systems contain fewer accounts as compared to financial accounting system due to the exclusion of
purchases, expenses and also Balance Sheet items like fixed assets, debtors and creditors. Items of
accounts which are excluded are represented by an account known as Cost ledger control account.
The important ledgers to be maintained under non-integrated accounting system in the Cost Accounting
are the followings:
Cost Ledger - This is the principle ledger of the cost department in which impersonal accounts are
recorded. This ledger is made self-balancing by maintaining therein a Control Account for each
subsidiary ledger.
Stores Ledger - It contains an account for each item of stores. The entries in each account maintained
in this ledger are made from the invoice, goods received note, material requisitions, material received
note etc. Accounts in respect of each item of stores show receipt, issue and balance in physical as well
as in monetary terms.

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 Work-in-Process Ledger - This ledger is also known as job ledger, it contains accounts of unfinished
jobs and processes. All material costs, wages and overheads for each job in process are posted to the
respective job accounts in this ledger. The balance in a job account represents total balance of
job/work-in-process, as shown by the job account.
Finished Goods Ledger - It contains an account for each item of finished product manufactured or the
completed job. If the finished product is transferred to stock, a credit entry is made in the work-in-
process ledger and a corresponding debit entry is made in this ledger.

PRINCIPAL ACCOUNTS

The main accounts which are usually prepared when a separate Cost Ledger is maintained are as
follows:
Cost Ledger Control Account - This account is also known as General Ledger Adjustment Account. This
account is made to complete double entry. All items of expenditure are credited to this account. Sales
are debited to this account and net profit/loss from Costing Profit & Loss Account is transferred to this
account. The balance in this account at the end of the particular period represents the net total of all
the balances of the impersonal accounts.
Stores Ledger Control Account – This account is debited for the purchase of material and credited for
issue of materials from the stores. The balance in this account indicates the total balance of all the
individual stores accounts. Abnormal losses or gains if any in this account are transferred to Costing
Profit & Loss Account. Entries are made on the basis of goods received notes and stores requisitions
etc.
Wages Control Account - This account is debited with total wages paid (direct and indirect). Direct
wages are further transferred to Work-in- Process Control Account and indirect wages to Production
Overhead; Administration Overhead or Selling & Distribution Overhead Control Accounts, as the case
may be. Wages paid for abnormal idle time are transferred to Costing Profit & Loss Account either
directly or through Abnormal Loss Account.
Manufacturing/Production/Works/ Factory Overhead Control Account - This account is debited with
indirect costs of production such as indirect material, indirect employee, indirect expenses (carriage
inward etc.). Overhead recovered (absorbed) is credited to this Account. The difference between
overhead incurred and overhead recovered (i.e. Under Absorption or Over Absorption of Overheads) is
transferred to Overheads Adjustment Account.
Work-in-Process Control Account - This account is debited with the total cost of production, which
includes—direct materials, direct employee, direct expenses, production overhead recovered, and is
credited with the amount of finished goods completed and transferred. The balance in this account
represents total balances of jobs/works-in-process, as shown by several job accounts.
Administrative Overhead Control Account - This account is debited with overheads incurred and
credited with overhead recovered. The overhead recovered are debited to Finished Goods Control
Account, if administrative overhead is related with production activities otherwise to Cost of Sales A/c.
The difference between administrative overheads incurred and recovered is transferred to Overhead
Adjustment Account.
Finished Goods Control Accounts - This account is debited with the value of goods transferred from
Work-in-process Control Account and administration costs recovered (if relates to production activities).
This account is credited with Cost of Sales Account. The balance of this account represents the value of
goods unsold at the end of the period.

109
Selling and Distribution Overhead Control Account - This account is debited with selling and
distribution overheads incurred and credited with the selling and distribution overheads recovered. The
difference between overheads incurred and recovered is transferred usually to Overhead Adjustment
Account.
Cost of Sales Account - This account is debited with the cost of finished goods transferred from
Finished Goods Control Account for sale, General Administrative overhead recovered, Selling and
distribution overhead recovered. The balance of this account is ultimately transferred to Sales Account
or Costing Profit & Loss Account.
Costing Profit & Loss Account – This account is debited with cost of sales, under-absorbed overheads
and abnormal losses and is credited with sales value, over-absorbed overhead and abnormal gains. The
net profit or loss in this account is transferred to Cost Ledger Control Account.
Overhead Adjustment Account - This account is to be debited for under- recovery of overhead and
credited with over-recovery of overhead amount. The net balance in this account is transferred to
Costing Profit & Loss Account.
Note: Sometimes, Overhead Adjustment Account is dispensed with and under/over absorbed overheads
is directly transferred to Costing Profit & Loss Account from the respective overhead accounts.

Non-Integrated Accounting System-flowchart

Materials
Control
Wages A/c Production
Control Overhead
A/c Control A/c

Work in
Progress
Control A/c

Finished
Goods
Control A/c

Cost of
Goods Sold
Control A/c

Selling &
Cost of Distribution
Sales Overhead
Control A/c Control A/c

*In the diagram administrative overhead is assumed to be related with production activity. In case of
general administration expenses, it is treated as a part of Cost of Sales.

110
 ILLUSTRATION 1

As on 31st March, the following balances existed in a firm's Cost Ledger:

Dr. Cr.
(`) (`)
Stores Ledger Control A/c 3,01,435
Work-in-Process Control A/c 1,22,365
Finished Stock Ledger Control A/c 2,51,945
Manufacturing Overhead Control A/c 10,525
Cost Ledger Control A/c 6,65,220
6,75,745 6,75,745

During the next three months the following items arose:

(`)
Finished product (at cost) 2,10,835
Manufacturing overhead incurred 91,510
Raw materials purchased 1,23,000
Factory Wages 50,530
Indirect Labour 21,665
Cost of Sales 1,85,890
Material issued to production 1,27,315
Sales returned at Cost 5,380
Material returned to suppliers 2,900
Manufacturing overhead charged to production 77,200

You are required to PASS the Journal Entries; write up the accounts and schedule
the balances, stating what each balance represents.

ILLUSTRATION 2

Acme Manufacturing Co. Ltd. opens the costing records, with the balances as on 1st July as follows:

(`) (`)
Material Control A/c 1,24,000
Work-in-Process Control A/c 62,500
Finished Goods Control A/c 1,24,000
Production Overhead Control A/c 8,400
Administrative Overhead Control A/c 12,000
Selling & Distribution Overhead Control A/c 6,250
Cost Ledger Control A/c 3,13,150
3,25,150 3,25,150

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As on 31st March, the following balances existed in a firm's Cost Ledger:

(`)
Materials purchased 4,80,100
Materials issued to jobs 4,77,400
Materials to works maintenance 41,200
Materials to administrative office 3,400
Materials to sales department 7,200
Wages direct 1,49,300
Wages indirect 65,000
Transportation for indirect materials 8,400
Production overheads incurred 2,42,250
Absorbed production overheads 3,59,100
Administrative overheads incurred 74,000
Administrative overheads allocated to production 52,900
Administrative overheads allocated to sales department 14,800
Selling & Distribution overheads incurred 64,200
Selling & Distribution overheads absorbed 82,000
Finished goods produced 9,58,400
Finished goods sold 9,77,300
Sales 14,43,000

Make up the various accounts as you envisage in the Cost Ledger

and PREPARE a Trial Balance as at 30th September.

INTEGRATED (OR INTEGRAL)

ACCOUNTING SYSTEM

Integrated Accounts is the name given to a system of accounting, whereby cost and financial accounts
are kept in the same set of books. Obviously, then there will be no separate sets of books for Costing
and Financial records.
Integrated accounts provide or meet out fully the information requirement for Costing as well as for
Financial Accounts. For Costing it provides information useful for ascertaining the cost of each product,
job, process and operation of any other identifiable activity and for carrying necessary analysis.
Integrated accounts provide relevant information which is necessary for preparing profit and loss
account and the balance sheet as per the requirement of law and also helps in exercising effective
control over the liabilities and assets of its business.
In non-integrated system, a cost ledger control account or general ledger adjustment account is used in
cost ledger.
But in the integrated accounting system, general ledger adjustment account is eliminated and detailed
accounts for assets and liabilities are maintained. In other words, following accounts are used for
“General Ledger Adjustment Account/ Cost Ledger Control Account” of non- integrated system:

112
 Ÿ Bank account
Ÿ Receivables (Debtors) account
Ÿ Payables (Creditors) account
Ÿ Provision for depreciation account etc.

In integrated system, all accounts necessary for showing classification of cost will be used but the cost
ledger control account of non-integrated accounting is replaced by use of following accounts:
Ÿ Bank account
Ÿ Receivables (Debtors) account
Ÿ Payables (Creditors) account
Ÿ Provision for depreciation account
Ÿ Fixed assets account
Ÿ Share capital account

ILLUSTRATION 3

JOURNALISE the following transactions assuming that cost and financial transactions are integrated:

(`)
Raw materials purchased 2,00,000
Direct materials issued to production 1,50,000
Wages paid (30% indirect) 1,20,000
Wages charged to production 84,000
Manufacturing expenses incurred 84,000
Manufacturing overhead charged to production 92,000
Selling and distribution costs 20,000
Finished products (at cost) 2,00,000
Sales 2,90,000
Closing stock Nil
Receipts from debtors 69,000
Payments to creditors 1,10,000

ILLUSTRATION 4

In the absence of the Chief Accountant, you have been asked to prepare a month's cost accounts for
a company which operates a batch costing system fully integrated with the financial accounts.

113
The following relevant information is provided to you:

(`) (`)
Balances at the beginning of the month:
Stores Ledger Control Account 25,000
Work-in-Process Control Account 20,000
Finished Goods Control Account 35,000
Prepaid Production Overheads brought forward
from previous month 3,000
Transactions during the month:
Materials Purchased 75,000
Materials Issued:
Ÿ To production 30,000
Ÿ To factory maintenance 4,000 34,000
Materials transferred between batches 5,000
Total wages paid:
Ÿ To direct workers 25,000
Ÿ To indirect workers 5,000 30,000
Direct wages charged to batches 20,000
Recorded non-productive time of direct workers 5,000
Selling and Distribution Overheads Incurred 6,000
Other Production Overheads Incurred 12,000
Sales
1,00,000
Cost of Finished Goods Sold 80,000
Cost of Goods completed and transferred
into finished goods during the month 65,000
Physical value of work-in-Process at the
end of the month 40,000

The production overhead absorption rate is 150% of direct wages charged to work- in-Process.

Required:
PREPARE the following accounts for the month:
Ÿ Stores Ledger Control Account.
Ÿ Work-in-Process Control Account.
Ÿ Finished Goods Control Account.
Ÿ Production Overhead Control Account.
Ÿ Costing Profit and Loss Account.

114
 ILLUSTRATION 5

A fire destroyed some accounting records of a company. You have been able to collect the following
from the spoilt papers/records and as a result of consultation with accounting staff for the month of
January:

(I) Incomplete Ledger Entries:

Materials Control A/c

(`) (`)
To Balance b/d 32,000

Work-in-Process Control A/c

(`) (`)
By Finished Goods 1,51,000
To Balance b/d 9,200 Control A/c

Payables (Creditors) A/c

(`) (`)
To Balance b/d 19,200 To Balance b/d 16,400

Manufacturing Overheads Control A/c

(`) (`)
To Bank A/c 29,600
(Amount spent)

Finished Goods Control A/c

(`) (`)
To Balance b/d 24,000 30,000
To Balance c/d

2) Additional Information:
(a) The bank-book showed that `89,200 have been paid to creditors for raw- material.
(b) Ending inventory of work-in-process included materials of `5,000 on which 300 direct labour
hours have been booked against wages and overheads.
(c) The job card showed that workers have worked for 7,000 hours. The wage rate is `10 per labour
hour.
(d) Overhead recovery rate was `4 per direct labour hour.
You are required to COMPLETE the above accounts in the cost ledger of the company.

115
 ILLUSTRATION 6

The following incomplete accounts are furnished to you for the month ended 31st October, 2021.
Stores Ledger Control Account

(`)
1.10.2021 To Balance 9,200

Work in Process Control Account

(`)
1.10.2021 To Balance 6,000

Work in Process Control Account

(`)
1.10.2021 To Balance 75,000

Factory Overheads Control Account

(`)
Total debits for `45,000
October, 2021

Cost of Goods Sold Account

(`)

Creditors for Purchases Account

(`)
1.10. 2021 By Balance `30,000

2) Additional Information:
(a) The factory overheads are applied by using a budgeted rate based on direct labour hours. The budget for
overheads for 2021 is `6,75,000 and the budget of direct labour hours is 4,50,000.
(b) The balance in the account of creditors for purchases on 31.10.2021 is `15,000 and the payments made
to creditors in October, 2021 amount to `1,05,000.
(iii) The finished goods inventory as on 31st October, 2021 is `66,000.
(iv) The cost of goods sold during the month was `1,95,000.
(v) On 31st October, 2021 there was only one unfinished job in the factory. The cost records show that `3,000
(1,200 direct labour hours) of direct labour cost and `6,000 of direct material cost had been charged.
(vi) A total of 28,200 direct labour hours were worked in October, 2021. All factory workers earn same rate of pay.
(vii) All actual factory overheads incurred in October, 2021 have been posted.

116
 You are required to FIND:
ü Materials purchased during October, 2021.
ü Cost of goods completed in October, 2021.
ü Overheads applied to production in October, 2021.
ü Balance of Work-in-process Control A/c on 31st October, 2021.
ü Direct materials consumed during October, 2021.
ü Balance of Stores Ledger Control Account on 31st October, 2021.
ü Over absorbed or under absorbed overheads for October, 2021.

ILLUSTRATION 7
A company operates on historic job cost accounting system, which is not integrated with the
financial accounts. At the beginning of a month, the opening balances in cost ledger were:

(`in lakhs)
Stores Ledger Control Account 80
Work-in-Process Control Account 20
Finished Goods Control Account 430
Building Construction Account 10
Cost Ledger Control Account 540

During the month, the following transactions took place:

(Amounts in lakh)
Materials Purchased 40
Issued to production 50
Issued to factory maintenance 6
Issued to building construction 4
Wages Gross wages paid 150
Indirect wages 40
For building construction 10
Works Overheads Actual amount incurred 160
(excluding items shown above)
Absorbed in building construction 20
Under absorbed 8
Royalty paid (related to production) 5
Selling, distribution and administration overheads 25
Sales 450

At the end of the month, the stock of raw material and work-in-Process was `55 lakhs and `25 lakhs
respectively. The loss arising in the raw material accounts is treated as factory overheads. The
building under construction was completed during the month. Company's gross profit margin is 20%
on sales.

PREPARE the relevant control accounts to record the above transactions in the cost ledger of the
company.

117
 ILLUSTRATION 8

Dutta Enterprises operates an Integral system of accounting. You are required to PASS the Journal
Entries for the following transactions that took place for the year ended 31st March.
(Narrations are not required.)

(`)
Raw materials purchased (50% on Credit) 6,00,000
Materials issued to production 4,00,000
Wages paid (50% Direct) 2,00,000
Wages charged to production 1,00,000
Factory overheads incurred 80,000
Factory overheads charged to production 1,00,000
Selling and distribution overheads incurred 40,000
Finished goods at cost 5,00,000
Sales (50% Credit) 7,50,000
Closing stock Nil
Receipts from debtors 2,00,000
Payments to creditors 2,00,000

The following figures are extracted from the Trial Balance of Go-getter Co. on 31st March:

Dr. Cr.
(`) (`)
Inventories:
Finished Stock 80,000
Raw Materials 1,40,000
Work-in-Process 2,00,000
Office Appliances 17,400
Plant & Machinery 4,60,500
Building 2,00,000
Sales 7,68,000
Sales Return and Rebates 14,000
Materials Purchased 3,20,000
Freight incurred on Materials 16,000
Purchase Returns 4,800
Direct employee cost 1,60,000
Indirect employee cost 18,000
Factory Supervision 10,000
Repairs and factory up-keeping expenses 14,000
Heat, Light and Power 65,000
Rates and Taxes 6,300
Miscellaneous Factory Expenses 18,700

118
 Sales Commission 33,600
Sales Travelling 11,000
Sales Promotion 22,500
Distribution Deptt.—Salaries and Expenses 18,000
Office Salaries and Expenses 8,600
Interest on Borrowed Funds 2,000

Further details are available as follows:

(i) Closing Inventories:

Finished Goods 1,15,000
Raw Materials 1,80,000
Work-in-Process 1,92,000
(ii) Outstanding expenses on:
Direct employee cost 8,000
Indirect employee cost 1,200
Interest on Borrowed Funds 2,000
(iii) Depreciation to be provided on:
Office Appliances 5%
Plant and Machinery 10%
Buildings 4%
(iv) Distribution of the following costs:
Heat, Light and Power to Factory, Office and Distribution in the ratio 8 : 1 : 1.
Rates and Taxes two-thirds to Factory and one-third to Office.
Depreciation on Buildings to Factory, Office and Selling in the ratio 8 : 1 : 1.

With the help of the above information, you are required to PREPARE a condensed
Profit and Loss Statement of Go-getter Co. for the year ended 31st March along with
supporting schedules of:
ü Cost of Sales.
ü Selling and Distribution Expenses.
ü Administration Expenses.

119
 RECONCILIATION OF COST
AND FINANCIAL ACCOUNTS

Causes of differences in Financial and Cost Accounts:

(a) Items included in Financial Accounts only-

ü Purely Financial Expenses:

• Interest on loans or bank mortgages.
• Expenses and discounts on issue of shares, debentures etc.
• Other capital losses i.e., loss by fire not covered by insurance etc.
• Losses on the sales of fixed assets and investments
• Goodwill written off
• Preliminary expenses written off
• Income tax, donations, subscriptions
• Expenses of the company’s share transfer office, if any.

ü Purely Financial Income

• Interest received on bank deposits, loans and investments
• Dividends received
• Profits on the sale of fixed assets and investments
• Transfer fee received.
• Rent receivables

(b) Item included in Cost Accounts only (notional expenses):

• Charges in lieu of rent where premises are owned
• Interest on capital at notional figure though not incurred
• Salary for the proprietor at notional figure though not incurred
• Notional Depreciation on the assets fully depreciated for which book value is nil.

(c ) Items whose treatment is different in the two sets of accounts:

The objective of cost accounting is to provide information to management for decision making and
control purposes while financial accounting conforms to external reporting requirements. Hence there
are chances that certain items are treated differently in the two sets of accounts.
For example, LIFO method is not allowed for inventory valuation in India as per the Accounting Standard
2 issued by the Council of the ICAI. However, this method may be adopted for cost accounts as it is more
suitable for arriving at costs which may be used as a base for deciding selling prices. Similarly cost
accounting may use a different method of depreciation than what is allowed under financial accounting.

(d) Varying basis of valuation: It is another factor which sometimes is responsible for the difference. It
is well known that in financial accounts stock are valued either at cost or market price, whichever is
lower. But in Cost Accounts, stocks are only valued at cost.

Procedure for reconciliation:

There are 3 steps involved in the procedure for reconciliation.
ü Ascertainment of profit as per financial accounts
ü Ascertainment of profit as per cost accounts
ü Reconciliation of both the profits (similar to the bank reconciliation statement)

120
 ILLUSTRATION 9

The following figures are available from the financial records of ABC Manufacturing Co. Ltd. for the
year ended 31st March.

(`)
Sales (20,000 units) 25,00,000
Materials 10,00,000
Wages 5,00,000
Factory Overheads 4,50,000
Administrative Overhead (production related) 2,60,000
Selling and distribution Overheads 1,80,000
Finished goods (1,230 units) 1,50,000

(`) (`)
Work-in-Process:
Materials 30,000
Labour 20,000
Factory overheads 20,000 70,000
Goodwill written off 2,00,000
Interest on loan taken 20,000

In the Costing records, factory overhead is charged at 100% of wages, administrative overhead 10% of
factory cost and selling and distribution overhead at the rate of `10 per unit sold.
PREPARE a statement reconciling the profit as per cost records with the profit as per financial records.

ILLUSTRATION 10

Following are the figures extracted from the Cost Ledger of a manufacturing unit.

(`)
Stores:
Opening balance 15,000
Purchases 80,000
Transfer from WIP 40,000
Issue to WIP 80,000
Issue to repairs and maintenance 10,000
Sold as a special case at cost 5,000
Shortage in the year 3,000
Work-in-Process:
Opening inventory 30,000

121
 Direct labour cost charged 30,000
Overhead cost charged 1,20,000
Closing Balance 20,000
Finished Products:
Entire output is sold at 10% profit on
actual cost from work-in- process.
Others:
Wages for the period 35,000
Overhead Expenses 1,25,000

ASCERTAIN the profit or loss as per financial account and cost accounts and reconcile them.

ILLUSTRATION 11

The following figures have been extracted from the Financial Accounts of a
manufacturing firm for the first year of its operation:

(`)
Direct Material Consumption 50,00,000
Direct Wages 30,00,000
Factory Overheads 16,00,000
General administrative overheads 7,00,000
Selling and Distribution Overheads 9,60,000
Bad debts 80,000
Preliminary expenses written off 40,000
Legal charges 10,000
Dividends received 1,00,000
Interest received on deposits 20,000
Sales (1,20,000 units) 1,20,00,000
Closing stock:
Finished goods (4,000 units) 3,20,000
Work-in-Process 2,40,000

The cost accounts for the same period reveal that the direct material consumption was `56,00,000.
Factory overhead is recovered at 20% on prime cost. Administration overhead is recovered at `6 per
unit of goods sold. Selling and distribution overheads are recovered at `8 per unit sold.
PREPARE the Profit and Loss Accounts both as per financial records and as per cost records.
RECONCILE the profits as per the two records.

122
 SOLUTION

Profit and Loss Account (As per financial records)

(`) (`)
To Direct Material 50,00,000 By Sales (1,20,000 units) 1,20,00,000
To Direct Wages 30,00,000 By Closing Stock
To Factory Overheads 16,00,000 Work-in-process 2,40,000
To Gross Profit c/d 29,60,000 Finished Goods (4,000 units) 3,20,000
1,25,60,000 1,25,60,000
To General Administrative
Overheads 7,00,000 By Gross Profit b/d 29,60,000
To Selling and Dist. OH 9,60,000 By Dividend received 1,00,000
To Bad debts 80,000 By Interest received 20,000
To Preliminary
Expenses written off 40,000
To Legal Charges 10,000
To Net Profit 12,90,000
30,80,000 30,80,000

Statement of Cost and Profit (As per Cost Records)

Total (`)
Direct Material 56,00,000
Direct Wages 30,00,000
Prime Cost 86,00,000
Factory Overhead (20% of `86,00,000) 17,20,000
1,03,20,000
Less: Closing Stock (WIP) (2,40,000)
Works Cost or Cost of production (1,24,000 units) 1,00,80,000
Less: Finished Goods (4,000 units @ `81.29) (3,25,160)
Cost of goods sold (1,20,000 units) 97,54,840
Administrative overhead (1,20,000 units @ ` 6 p.u.) 7,20,000
Selling and Distribution Overhead (1,20,000 @ ` 8 p.u.) 9,60,000
Cost of Sales 1,14,34,840
Net profit (Balancing figure) 5,65,160
Sales Revenue 1,20,00,000

123
Statement of Reconciliation of profit as obtained under Cost and Financial Accounts

(`) Total (`)

Profit as per Cost Records 5,65,160
Add: Excess of Material Consumption 6,00,000
Factory Overhead 1,20,000
Administrative Overhead 20,000
Dividend Received 1,00,000
Interest Received 20,000 8,60,000
14,25,160
Less: Bad debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000
Over-valuation of stock in cost book
(`3,25,160 – `3,20,000) 5,160 (1,35,160)
Profit as per Financial Records 12,90,000

ILLUSTRATION 12

The following information is available from the financial books of a company having a normal production
capacity of 60,000 units for the year ended 31st March:

(i) Sales `10,00,000 (50,000 units).

(ii) There was no opening and closing stock of finished units.
(iii) Direct material and direct wages cost were `5,00,000 and `2,50,000 respectively.
(iv) Actual factory expenses were `1,50,000 of which 60% are fixed.
(v) Actual administrative expenses related with production activities were `45,000 which
are completely fixed.
(vi) Actual selling and distribution expenses were `30,000 of which 40% are fixed.
(vii) Interest and dividends received `15,000.

You are required to:

(a) FIND OUT profit as per financial books for the year ended 31st March;
(b) PREPARE the cost sheet and ascertain the profit as per cost accounts for the year ended 31st
March assuming that the indirect expenses are absorbed on the basis of normal production
capacity; and
(c) PREPARE a statement reconciling profits shown by financial and cost books.

124
 ILLUSTRATION 12

M/s. H.K. Piano Company showed a net loss of `4,16,000 as per their financial accounts for the year
ended 31st March. The cost accounts, however, disclosed a net loss of `3,28,000 for the same period.
The following information was revealed as a result of scrutiny of the figures of both the sets of books:

(`)
(i) Factory overheads under-recovered 6,000
(ii) Administration overheads over-recovered 4,000
(iii) Depreciation charged in financial accounts 1,20,000
(iv) Depreciation recovered in costs 1,30,000
(v) Interest on investment not included in costs 20,000
(vi) Income-tax provided 1,20,000
(vii) Transfer fees (credit in financial books) 2,000
(viii) Stores adjustment (credit in financial books) 2,000

PREPARE a Memorandum reconciliation account.

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CHAPTER -9
CONTRACT COSTING

Contract costing is a form of specific order costing where job

undertaken is relatively large and normally takes period
INTRODUCTION longer than a year to complete.
Contract costing is usually adopted by the contractors
engaged in any type of contracts like
Ÿ Construction of building,
Ÿ Road,
Ÿ Bridge,
Ÿ Erection of tower,
Ÿ Setting up of plant etc.

MEANING OF THE TERMS USED

IN CONTRACT COSTING

(i) Work-in-Progress:
Work-in-progress in contract costing refers to the contract which is not complete at the
reporting date. In Contract Accounts, the value of the work-in-progress consists of the
• Cost of work completed, both certified and uncertified;
• The cost of work not yet completed; and
• The amount of estimated/ notional profit.
In the Balance Sheet (prepared for management), the work-in-progress is usually shown
under two heads, viz., certified and uncertified.
• The cost of work completed and certified and the profit credited will appear under
the head ‘certified’ work-in-progress,
• While the completed work not yet certified, cost of material, employee and other
expenses which has not yet reached the stage of completion are shown under the
head “uncertified” work-in-progress.
(ii) Cost of Work Certified or Value of Work Certified:
A contract is a continuous process and to know the cost or value of the work completed as
on a particular date; assessment of the completion of work is carried out by an expert (it
may be any professional like surveyor, architect, engineer etc.).
The expert, based on his assessment, certifies the work completion in terms of percentage
of total work. The cost or value of certified portion is calculated and is known as Cost of work
certified or Value of work certified respectively.

126
 Mathematically
Value of Work Certified = Value of Contract × Work certified (%)
Cost of Work Uncertified: It represents the cost of the work which has been carried out by
the contractor but has not been certified by the expert. It is always shown at cost price.

The cost of uncertified work may be ascertained as follows:

(`) (`)
Total cost to date xxx
Less: Cost of work certified xxx
Material in hand xxx
Plant at site xxx xxx
Cost of work uncertified xxx

(iii) Progress Payment:

A Contractor gets payments for work done on a contract based on work completion. Since, a
contract takes longer period to complete and requires large investment in working capital to
progress the contract work, hence, it is desirable by the contractor to have periodic
payments from the contractee against the work done to avoid working capital shortage.
For this a contactor enters into an agreement with the contractee and agrees on payment on
some reasonable basis, which generally, includes percentage of work completion as certified
by an expert.

Mathematically
Progress payment = Value of work certified – Retention money – Payment to date

(iv) Retention Money:

In a contract, a contractee generally keeps some amount payable to contractor with himself
as security deposit.
In a contract, a contractor undertakes to completed a job work on the basis of pre- determined
terms and conditions and work specifications. To ensure that the work carried out by the
contractor is as per the plan and specifications, it is monitored periodically by the contractee.
To have a cushion against any defect or undesirable work, the contractee upholds some money
payable to contractor. This security money upheld by the contractee is known as retention
money.
In some contracts the contractor has to deposit some security money before staring of the
contract as a term of contract. This is known as Earnest money. If any deficiency or defect is
noticed in the work, it is to be rectified by the contractor before the release of the retention
money.
Retention money provides a safeguard against the risk of loss due to faulty workmanship.

Mathematically
Retention Money = Value of work certified – Payment actually made/ cash paid

127
 (iv) Cash Received:
It is ascertained by deducting the retention money from the value of work certified i.e.

Cash received = Value of work certified – Retention money

(v) Notional Profit:

It represents the difference between the value of work certified and cost of work certified. It is
determined:

Notional profit = Value of work certified – (Cost of work to date – Cost of work not yet certified)

(vi) Estimated Profit: It is the excess of the contract price over the estimated total cost
of the contract.

COST PLUS CONTRACT

Cost- plus contract is a contract where the value of the contract is determined by adding an
agreed percentage of profit to the total cost. These types of contracts are entered into when it is
not possible to estimate the contract cost with reasonable accuracy due to unstable condition of
factors that affect the cost of material, employees, etc.
Advantages:
Ÿ The Contractor is assured of a fixed percentage of profit. There is no risk of incurring any
loss on the contract.
Ÿ It is useful specially when the work to be done is not definitely fixed at the time of making
the estimate.
Ÿ Contractee can ensure himself about 'the cost of the contract', as he is empowered to
examine the books and documents of the contractor to ascertain the veracity of the cost of
the contract.
Disadvantages
Ÿ The contractor may not have any inducement to avoid wastages and effect economy in
production to reduce cost.

ESCALATION CLAUSE
IN A CONTRACT

Escalation clause in a contract empowers a contractor to revise the price of the contract in case
of increase in the prices of inputs due to some macro- economic or other agreed reasons.
This protect the contractor from adverse financial impacts and empowers the contractor to
recover the increased prices.
As per this clause, the contractor increases the contract price if the cost of materials,
employees and other expenses increase beyond a certain limit. Inclusion of such a clause in a
contract deed is called an “Escalation Clause”.

128
 ILLUSTRATION 1

COMPUTE estimated profit on a contract (which has been 90% complete) from the following particulars:

(`)
Total expenditure to date 22,50,000
Estimated further expenditure to complete the contract
(including contingencies) 2,50,000
Contract price 32,50,000
Work certified 27,50,000
Work uncertified 1,75,000
Cash received 21,25,000

ILLUSTRATION 2

The following expenses were incurred on a contract:

(`)
Materials purchased 6,00,000
Material drawn from stores 1,00,000
Wages 2,25,000
Plant issued 75,000
Chargeable expenses 75,000
Apportioned indirect expenses 25,000

The contract was for `20,00,000 and it commenced on April 1, 2020. The value of the work completed and
certified upto 28th February, 2021 was `13,00,000 of which `10,40,000 was received in cash, the balance
being held back as retention money by the contractee. The value of work completed subsequent to the
architect’s certificate but before 31st March, 2021 was `60,000. There were also lying on the site materials
of the value of `40,000. It was estimated that the value of plant as at 31st March, 2021 was `30,000.
You are required to COMPUTE value of work certified, cost of work not certified and notional profit on the
contract till the year ended 31st March, 2021.

ILLUSTRATION 3

A contractor prepares his accounts for the year ending 31st March each year. He commenced a contract on
1st July, 2020.
The following information relates to the contract as on 31st March, 2021:
(`)
Material issued 2,51,000
Wages 5,65,600
Salary to Foreman 81,300

129
 A machine costing `2,60,000 has been on the site for 146 days, its working life is estimated at 7 years and its
final scrap value at `15,000.
A supervisor, who is paid `8,000 p.m. has devoted one-half of his time to this contract.
All other expenses and administration charges amount to ` 1,36,500. Material in hand at site costs `35,400 on
31st March, 2021.
The contract price is `20,00,000. On 31st March, 2021 two-third of the contract was completed. The architect
issued certificates covering 50% of the contract price, and the contractor had been paid `7,50,000 on account.
PREPARE Contract A/c and show the notional profit or loss as on 31st March, 2021.

ILLUSTRATION 4

M/s. Bansals Construction Company Ltd. took a contract for `60,00,000 expected to be completed in three
years. The following particulars relating to the contract are available:

2018-19 (`) 2019-20 (`) 2020-21 (`)

Materials 6,75,000 10,50,000 9,00,000
Wages 6,20,000 9,00,000 7,50,000
Transportation cost 30,000 90,000 75,000
Other expenses 30,000 75,000 24,000
Cumulative work certified 13,50,000 45,00,000 60,00,000
Cumulative work uncertified 15,000 75,000 —

Plant costing `3,00,000 was bought at the commencement of the contract. Depreciation was to be charged at
25% per annum, on the written down value method. The contractee pays 75% of the value of work certified as
and when certified and makes the final payment on completion of the contract.
You are required to PREPARE a contract account for three years and total estimated profit/ loss from the
contract.

ILLUSTRATION 5

A contractor has entered into a long term contract at an agreed price of `17,50,000 subject to an escalation
clause for materials and wages as spelt out in the contract and corresponding actual are as follows:

Standard Actual
Materials Qty (tons) Rate (`) Qty (tons) Rate (`)
A 5,000 50.00 5,050 48.00
B 3,500 80.00 3,450 79.00
C 2,500 60.00 2,600 66.00
Wages Hours Hourly Rate (`) Hours Hourly Rate (`)
X 2,000 70.00 2,100 72.00
Y 2,500 75.00 2,450 75.00
Z 3,000 65.00 3,100 66.00

130
Reckoning the full actual consumption of material and wages, the company has claimed a final price of
`17,73,600. Give your ANALYSIS of admissible escalation claim and indicate the final price payable.

ILLUSTRATION 6

COMPUTE Notional profit and estimated profit on a contract (which has been 90% complete) from the
following particulars.

(`)
Total expenditure to date 4,50,000
Estimated further expenditure to complete the contract
(including contingencies) 25,000
Contract price 6,12,000
Work certified 5,50,800
Work uncertified 34,000
Cash received 4,40,640

ILLUSTRATION 7

AKP Builders Ltd. commenced a contract on April 1, 2020. The total contract was for `5,00,000. Actual
expenditure for the period April 1, 2020 to March 31, 2021 and estimated expenditure for April 1, 2021 to
December 31, 2021 are given below:

Particulars 2020-21 2021-22

(actual) (9 months) (estimated)
Materials issued 90,000 85,750
Wages: Paid 75,000 87,325
Outstanding at the end 6,250 8,300
Plant 25,000 -
Sundry expenses: Paid 7,250 6,875
Prepaid at the end 625 -
Establishment charges 14,625 -

A part of the material was unsuitable and was sold for `18,125 (cost being `15,000) and a part of plant was
scrapped and disposed- off for `2,875. The value of plant at site on 31 March, 2021 was `7,750 and the
value of material at site was `4,250. Cash received on account to date was `1,75,000, representing 80% of
the work certified. The cost of work uncertified was valued at `27,375.

131
 The contractor estimated further expenditure that would be incurred in completion of the contract:
Ÿ The contract would be completed by 31st December, 2021.
Ÿ A further sum of ` 31,250 would have to be spent on the plant and the residual value of the plant on the
completion of the contract would be `3,750.
Ÿ Establishment charges would cost the same amount per month as in the previous year.
Ÿ 10,800 would be sufficient to provide for contingencies.
Required:
PREPARE a Contract Account for the year ended 31st March, 2021, and CALCULATE estimated total profit on
this contract.

ILLUSTRATION 8

RST Construction Ltd. commenced a contract on April 1, 2020. The total contract was for `49,21,875.
Actual expenditure for the period April 1, 2020 to March 31, 2021 and estimated expenditure for
April 1, 2021 to September 30, 2021 are given below:

April 1, 2020 to April 1, 2021 to

March 31, 2021 Sept. 30, 2021
(Actual)(`) (Estimated) (`)
Materials issued 7,76,250 12,99,375
Wages: Paid 5,17,500 6,18,750
Prepaid 37,500 -
Outstanding 12,500 5,750
Plant purchased 4,00,000 -
Expenses: Paid 2,25,000 3,75,000
Outstanding 25,000 10,000
Prepaid 15,000 -
Plant returns to store (historical cost) 1,00,000 3,00,000
(on September 30, 2020) (on September 30, 2021)
Work certified 22,50,000 Full
Work uncertified 25,000 -
Cash received 18,75,000 -
Materials at site 82,500 42,500

The plant is subject to annual depreciation @ 25% on written down value method. The contract is likely to be
completed on September 30, 2021.
Required:
PREPARE the Contract A/c for the year ended 31st March, 2021 and determine the estimated profit
on the contract.

132
CHAPTER -11
JOINT AND
BY PRODUCT

Meaning of Joint
Products and By-
Products

JOINT
Apportionment
PRODUCTS & BY- of Joint Costs
PRODUCTS
Treatment of By-
Product Cost in
Cost Accounting

MEANING OF JOINT PRODUCTS

AND BY- PRODUCTS

Agricultural product industries, chemical process industries, sugar industries, and

extractive industries are some of the industries where two or more products of equal or
unequal importance are produced either simultaneously or in the course of processing
operation of a main product.
Joint Products
Joint products represent “two or more products separated in the course of the same
processing operation usually requiring further processing, each product being in such
proportion that no single product can be designated as a major product”.
In other words, two or more products of equal importance, produced, simultaneously from
the same process, with each having a significant relative sale value are known as joint
products.
For example, in the oil industry, gasoline, fuel oil, lubricants, paraffin, coal tar, asphalt and
kerosene are all produced from crude petroleum. These are known as joint products.
By-Products
These are defined as “products recovered from material discarded in a main process, or
from the production of some major products, where the material value is to be considered at
the time of severance from the main product.”
Thus by-products emerge as a result of processing operation of another product or they are
produced from the scrap or waste of materials of a process. In short a by-product is a
secondary or subsidiary product which emanates as a result of manufacture of the main
product.
Examples of by-products are molasses in the manufacture of sugar, tar, ammonia and
benzole obtained on carbonisation of coal and glycerin obtained in the manufacture of soap.

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 Distinction between Joint-Product and By-Product
The main points of distinction as apparent from the definitions of Joint Products and By-
Products are:
• Joint products are of equal importance whereas by-products are of small economic
value.
• Joint products are produced simultaneously but the by-products are produced
incidentally in addition to the main products.
Co-Products
Joint products and co-products are used synonymously in common parlance, but strictly
speaking a distinction can be made between two.
Co-products may be defined as two or more products which are contemporary but do not
emerge necessarily from the same material in the same process.
For instance, wheat and gram produced in two separate farms with separate processing of
cultivation are the co-products. Similarly, timber boards made from different trees are co-
products.

APPORTIONMENT OF JOINT COSTS

Joint costs are the expenditures incurred upto the point of separation i.e. split-off point. The
main problem faced in the case of joint products/ by-products is the apportionment of this
joint costs to joint products/ or by products. For costs incurred after the split off point there
is no problem, as these costs can be directly allocated to individual joint products or by-
products.
METHODS OF APPORTIONMENT OF JOINT COST TO JOINT PRODUCTS
Proper apportionment of joint cost over the joint products is of considerable importance, as
this affects
(a) Valuation of closing inventory;
(b) Pricing of products; and
(c) Profit or loss on the sale of different products.
The commonly used methods for apportioning total process costs upto the point of
separation over the joint products are as follows:
Ÿ Physical Units Method
Ÿ Net Realisable Value at split-off point
Ÿ Using Technical Estimates
Ÿ Market value at the point of separation
Ÿ Market value after further processing
Ÿ Average unit cost method
Ÿ Contribution margin method

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 Physical Unit Method:
This method is based on the assumption that the joint products are capable of being
measured in the same units.
Accordingly, joint costs here are apportioned on the basis of some physical base, such as
weight, numbers etc.
Any loss arises during the joint production process is also apportioned over the products on
the same basis.
This method cannot be applied if the physical units of the two joint products are different.
The main defect of this method is that it gives equal importance and value to all the joint
products.

ILLUSTRATION 1

A coke manufacturing company produces the following products by using 5,000 tons of coal
@ `1,100 per ton into a common process.

Coke 3,500 tons

Tar 1,200 tons
Sulphate of ammonia 52 tons
Benzol 48 tons

PREPARE a statement apportioning the joint cost amongst the products on the basis of the
physical unit method.

Net Realisable Value at Split-off Point Method:

In this method of joint cost apportionment the followings are deducted from the sales value
of joint products at final stage i.e. after processing:
Ÿ In this method of joint cost apportionment the followings are deducted from the sales
value of joint products at final stage i.e. after processing:
The resultant figure so obtained is known as net realisable value of joint products. Joint
costs are apportioned in the ratio of net realisable value.
The net realisable value at split-off point method is widely used in the industries. This
method is used when the realisable value of joint products at split-off is not known.

Product- A (`) Product- B (`) Product- C (`)

SalesValue (Units after
processing × Selling Price) xxx xxx xxx
Less: Profit Margin (xxx) (xxx) (xxx)
Less: Selling & Distribution costs (xxx) (xxx) (xxx)
Less: Post split-off cost (xxx) (xxx) (xxx)
Net Realisable Value xxx xxx xxx

135
 Physical Unit Method:
This method is based on the assumption that the joint products are capable of being
measured in the same units.
Accordingly, joint costs here are apportioned on the basis of some physical base, such as
weight, numbers etc.
Any loss arises during the joint production process is also apportioned over the products on
the same basis.
This method cannot be applied if the physical units of the two joint products are different.
The main defect of this method is that it gives equal importance and value to all the joint
products.

EXAMPLE 1

An entity incurs a joint cost of `64,500 in producing two products A (200 units) and B (200
units) and earns a sales revenue of `86,000 by selling @ `170 per unit of product A and
product B @ `260 per unit. Further processing costs for products A and B are `4,000 and
`32,000 respectively.
Apportion the Joint cost.
(iii) Using Technical Estimates:
This method uses technical estimates to apportion the joint costs over the joint products.
This method is used when the result obtained by the above methods does not match with the
resources consumed by joint products or the realisable value of the joint products are not
readily available.
(iv) Other Methods
The followings are the methods which are used by management for taking managerial
decisions:
[1] Market value at the point of separation:
This method is used for the apportionment of joint costs to joint products upto the split off
point. It is difficult to apply this method if the market value of the products at the point of
separation is not available. It is a useful method where further processing costs are incurred
disproportionately.
To determine the apportionment of joint costs over joint products, a factor known as
multiplying factor is determined. This multiplying factor on multiplication with the sales
values of each joint product gives rise to the proportion of joint cost.
Multiply in factor
Joint Cost
x 100
Total Sales Revenue

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 EXAMPLE 2

An entity incurs a joint cost of `64,500 in producing two products A (200 units) and B (200
units) and earns a sales revenue of `86,000 by selling @ ` 170 per unit of product A and
product B @ `260 per unit.
Solution:
The multiplying factor in this case is obtained by dividing the total joint cost by total sales
revenue and finally multiplying the figure so obtained by 100. The multiplying factor based on
the data can be computed as follows:
Multiplying Factor: `64,500 × 100 = 75%
`86,000
Joint cost apportioned over product A = Sales revenue of product A × 75%
= `34,000 × 75%
= `25,500
Joint cost apportioned over product B = Sales revenue of product B × 75%
= ` 52,000 × 75% = `39,000

[2] Market value after further processing:

Here the basis of apportionment of joint cost is the total sales value of finished products and
involves the same principle as discussed above.
The use of this method is unfair where further processing costs after the point of separation
are disproportionate or when all the joint products are not subjected to further processing.
The net realisable value method which is discussed as above overcomes the shortcoming of
this method.

EXAMPLE 3

Suppose that in the example – 2 given above, if sales prices of products A and B after further
processing are `200 and `300 respectively the joint cost apportioned over Products A and B
is as follows:
Solution:
The pre-separation costs of `64,500 will be apportioned in the ratio of (2: 3) as follows:
Market sales value after further processing

(`)
A 200 units × `200 40,000
B 200 units × `300 60,000
1,00,000

Joint cost apportionment:

A = `64,500 × `40,000 `25,800

`1,00,000

B = `64,500 × `60,000 `38,700

`1,00,000

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 Average unit cost = Total process cost (upto the point of separation) ÷ Total units of joint
product produced.[3] Average Unit Cost Method:
Under this method, total process cost (upto the point of separation) is divided by total units
of joint products produced. On division average cost per unit of production is obtained.

Average unit cost = Total process cost (upto the point of separation) ÷ Total
units of joint product produced.

This is a simple method. The effect of application of this method is that all joint products will
have uniform cost per unit. If this method is used as the basis for price fixation, then all the
products may have more or less the same price.
Under this method customers of high quality items are benefitted as they have to pay less
price on their purchase.
[Note: Students may note that the physical unit method also follows the same steps of
calculation as followed under Average unit cost method, ultimately giving the same
outcome.]

ILLUSTRATION 2

FIND OUT the cost of joint products A, B and C using average unit cost method from the
following data:

Pre-separation Joint Cost `60,000

Production data:
Products Units produced
A 500
B 200
C 300
1,000

[4] Contribution Margin Method:

According to this method, joint costs are segregated into two parts - variable and fixed.
The variable costs are apportioned over the joint products on the basis of units produced
(average method) or physical quantities. In case the products are further processed after the
point of separation, then all variable cost incurred be added to the variable costs determined
earlier. In this way total variable cost is arrived which is deducted from their respective sales
values to ascertain their contribution.
The fixed costs are then apportioned over the joint products on the basis of the contribution
ratios.

138
ILLUSTRATION 3

FIND OUT the cost of joint products A and B using contribution margin method from the
following data :
Sales
A 100 kg @ `60 per kg.
B 120 kg @ `30 per kg.
Joint costs
Marginal cost `4,400
Fixed cost `3,900

ILLUSTRATION 4

Inorganic Chemicals purchases salt and processes it into more refined products such as
Caustic Soda, Chlorine and PVC. In the month of July, Inorganic Chemicals purchased Salt
for `40,000. Conversion cost of `60,000 were incurred upto the split off point, at which time
two sealable products were produced. Chlorine can be further processed into PVC.
The July production and sales information is as follows:

Production Sales Quantity Selling price

(in ton) (in ton) per ton (`)
Caustic Soda 1,200 1,200 50
Chlorine 800 — —
PVC 500 500 200

All 800 tons of Chlorine were further processed, at an incremental cost of `20,000 to yield
500 tons of PVC. There was no beginning or ending inventories of Caustic Soda, Chlorine or
PVC in July.
There is active market for Chlorine. Inorganic Chemicals could have sold all its July
production of Chlorine at `75 per ton.
Required :
(a) SHOW how joint cost of `1,00,000 would be apportioned between Caustic Soda and
Chlorine under each of following methods:
Ÿ Sales value at split- off point ;
Ÿ Physical unit method, and
Ÿ Estimated net realisable value.
(b) Lifetime Swimming Pool Products offers to purchase 800 tonnes of Chlorine in August at
`75 per tonne. This sale of Chlorine would mean that no PVC would be produced in August.
EXPLAIN how the acceptance of this offer for the month of August would affect operating
income?

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 TREATMENTOF BY-PRODUCT COST
IN COST-ACCOUNTING

By-product cost can be dealt in cost accounting in the following ways:

(a) When they are of small total value:
When the by-products are of small total value, the amount realised from their sale may be
dealt in any one the following two ways:
• The sales value of the by-products may be credited to the Costing Profit and Loss Account
and no credit be given in the Cost Accounts. The credit to the Costing Profit and Loss
Account here is treated either as miscellaneous income or as additional sales revenue.
• The sale proceeds of the by-product may be treated as deductions from the total costs.
The sale proceeds in fact should be deducted either from the production cost or from the
cost of sales.
(b) When the by-products are of considerable total value:
Where by-products are of considerable total value, they may be regarded as joint products
rather than as by-products.
To determine exact cost of by-products the costs incurred upto the point of separation,
should be apportioned over by-products and joint products by using a logical basis. In this
case, the joint costs may be divided over joint products and by-products by using relative
market values; physical output method (at the point of split off) or ultimate selling prices
(if sold).
(c) Where they require further processing:
In this case, the net realisable value of the by-product at the split-off point may be arrived at
by subtracting the further processing cost from the realisable value of by-products.

ILLUSTRATION 5

Smile company produces two main products and a by-product out of a joint process. The
ratio of output quantities to input quantities of direct material used in the joint process
remains consistent on yearly basis. Company has employed the physical volume method to
allocate joint production costs to the main products. The net realizable value of the by-
product is used to reduce the joint production costs before the joint costs are allocated to the
main products. Details of company's operation are given in the table below. During the
month, company incurred joint production costs of `10,00,000/- The main products are not
marketable at the split off point and thus have to be processed further.

Particulars Product-A Product-B By product

Monthly output in kg. 60,000 1,20,000 50,000
Selling price per kg. ` 50 ` 30 `5
Process costs ` 2,00,000 ` 3,00,000

FIND OUT the amount of joint product cost that Smile company would allocate to the
product-B by using the physical volume method to allocate joint production costs?

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ILLUSTRATION 6

Sun-moon Ltd. produces and sells the following products:

Products Units Selling price at Selling price after

split-off point (`) further processing (`)
A 2,00,000 17 25
B 30,000 13 17
C 25,000 8 12
D 20,000 10 -
E 75,000 14 20

Raw material costs `35,90,000 and other manufacturing expenses cost `5,47,000 in the
manufacturing process which are absorbed on the products on the basis of their ‘Net
realisable value’. The further processing costs of A, B, C and E are `12,50,000; `1,50,000;
`50,000 and `1,50,000 respectively. Fixed costs are `4,73,000.
You are required to PREPARE the following in respect of the coming year:
(a) Statement showing income forecast of the company assuming that none of its
products are to be further processed.
(b) Statement showing income forecast of the company assuming that products A, B, C
and E are to be processed further.
Can you suggest any other production plan whereby the company can maximise its profits?
If yes, then submit a statement showing income forecast arising out of adoption of that plan.

ILLUSTRATION 7

‘Buttery Butter’ is engaged in the production of Buttermilk, Butter and Ghee. It purchases
processed cream and let it through the process of churning until it separates into buttermilk
and butter. For the month of January, ‘Buttery Butter’ purchased 50 Kilolitre processed
cream @ `100 per 1000 ml. Conversion cost of `1,00,000 were incurred up-to the split off
point, where two saleable products were produced i.e. buttermilk and butter. Butter can be
further processed into Ghee.
The January production and sales information is as follows:

Products Production Sales Quantity Selling price

(in Kilolitre/tonne) (in Kilolitre/tonne) per Litre/Kg (`)
Buttermilk 28 28 30
Butter 20 — —
Ghee 16 16 480

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 All 20 tonne of butter were further processed at an incremental cost of `1,20,000 to yield 16
Kilolitre of Ghee. There was no opening or closing inventories of buttermilk, butter or ghee
in the month of January.
Required:
(a) SHOW how joint cost would be apportioned between Buttermilk and Butter under
Estimated Net Realisable Value method.
(b) ‘Healthy Bones’ offers to purchase 20 tonne of butter in February at `360 per kg. In case
‘Buttery Butter’ accepts this offer, no Ghee would be produced in February. SUGGEST
whether ‘Buttery Butter’ shall accept the offer affecting its operating income or further
process butter to make Ghee itself?

ILLUSTRATION 8

NN Manufacturing company uses joint production process that produces three products at
the split off point. Joint productions costs during September were `8,40,000. Product
information for September was as follows:

Particulars Product A Product B Product C

Units produced 1,500 3,000 4,500
Units sold 2,000 6,000 7,500
Sales prices:
At the split-off ` 100
After further processing ` 150 ` 175 ` 50
Costs to process after split-off ` 1,50,000 ` 1,50,000 ` 1,50,000

Assume that product C is treated as a by-product and the company accounts for the by-
product at net realizable value as a reduction of joint cost. Assume also that Product B&C
must be processed further before they can be sold. FIND OUT the total cost of Product A in
September if joint cost allocation is based on net realizable values?

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CHAPTER -14
MARGINAL COSTING

Break-
Meaning of Marginal even
Cost and Marginal Costing Analysis

Characteristics of
Marginal Costing Marginal
Marginal of Safety
Costing
Cost-Volume-Profit
(CVP) Analysis
Angle of
Incidence
Short-term
Decision making

Contribution
Ratio

Marginal Costing is a technique of cost and management

accounting which is used to analyse relationship between
INTRODUCTION cost, volume and profit.
In order to appreciate the concept of marginal costing, it is
necessary to study the definition of marginal costing and
certain other terms associated with this technique. The
important terms have been defined as follows:

Marginal Cost: Marginal cost as understood in economics is the incremental cost of

production which arises due to one-unit increase in the production quantity. As we
understood, variable costs have direct relationship with volume of output and fixed costs
remains constant irrespective of volume of production. Hence, marginal cost is measured by
the total variable cost attributable to one unit.
Marginal Costing: It is a costing system where products or services and inventories are valued
at variable costs only. It does not take consideration of fixed costs. This system of costing is
also known as direct costing as only direct costs forms the part of product and inventory cost.
Direct Costing: Direct costing and Marginal Costing is used synonymously at various places.
But the relation of costs with respect to activity level must be understood. Some costs are
variable at batch level but fixed for unit level whereas others are variable at production line
level but fixed for batches and units.

143
Differential and Incremental Cost: Differential cost is difference between the costs of two different
production levels. It is a relative representation of costs for two different levels that results in the
increase or decrease in cost. Incremental cost, on the other hand, is the increase in the costs due to
change in the volume or process of production activities. Incremental costs are sometime compared
with marginal cost but in reality, there is a thin line difference between the two. Marginal cost is the
change in the total cost due to production of one extra unit while incremental cost can be both for
increase in one unit or in total volume.

CHARACTERISTICS OF MARGINAL COSTING

The technique of marginal costing is based on the distinction between product costs and period costs.
Only the variables costs are treated as the costs of the products while the fixed costs are treated as
period costs which will be incurred during the period regardless of the volume of output.
The main characteristics of marginal costing are as follows:
Ÿ All elements of cost are classified into fixed and variable components. Semi-variable costs are also
analyzed into fixed and variable elements.
Ÿ The marginal or variable costs (as direct material, direct labour and variable factory overheads) are
treated as the cost of product.
Ÿ Under marginal costing, the value of finished goods and work–in–progress is also comprised only
of marginal costs. Variable selling and distribution are excluded for valuing these inventories. Fixed
costs are not considered for valuation of closing stock of finished goods and closing WIP.
Ÿ Fixed costs are treated as period costs and are charged to profit and loss account for the period for
which they are incurred.
Ÿ Prices are determined with reference to marginal costs and contribution margin.
Ÿ Profitability of departments and products is determined with reference to their contribution margin.

COST-VOLUME-PROFIT (CVP) ANALYSIS

It is a managerial tool showing the relationship between various ingredients of profit planning viz., cost,
selling price and volume of activity. As the name suggests, cost volume profit (CVP) analysis is the
analysis of three variables cost, volume and profit. Such an analysis explores the relationship between
costs, revenue, activity levels and the resulting profit. It aims at measuring variations in cost and
volume.

144
 MARGIN OF SAFETY

The margin of safety can be defined as the difference between the expected level of sale and the
breakeven sales. The larger the margin of safety, the higher is the chances of making profits.
The Margin of Safety can also be calculated by identifying the difference between the projected sales
and breakeven sales in units multiplied by the contribution per unit. This is possible because, at the
breakeven point all the fixed costs are recovered and any further contribution goes into the making of
profits.

APPLICATION OF CVP
ANALYSIS IN DECISION MAKING

Framework for Decision Making

Step 1: Step 2: Step 3: Step 4:

Identification Indentification Evaluation Selection of
of Problem of Options of the Options the Option

Step-1: Identification of Problem

Every organisation has its own objectives, and goals are set to achieve these objectives. To reach at the
goal, actions are to be taken.
For example, if an organisation wants to be a cost leader in the industry it operates in, it has to achieve
3Es in its all activities. 3Es means economy in inputs, efficiency in process and operations and
effectiveness in output.

An entity that exists for profit may identify few areas (problem areas) which if worked on can add to the
profit or wealth maximisation.
For example, Arnav Ltd. a manufacturer of Steel products, has identified that it can be leader in the
industry if it can produce steel products at lower cost than its rival. Here the goal should be (problem
area) low cost production.

Step- 2: Identification of Options

After identification of problem(s), the next step is identification of options to achieve the goal (to answer
the problem). Every possible options need to be explored.
In the above example, the Arnav Ltd. may have the following options for low cost production:
· Purchase of inputs from specialised market- Local vs Import
· Make the input in its own factory- Make or Buy
· Bulk purchase to avail discount offer- How much to purchase
· Make in-house- Make vs Outsource
· Bulk processing- How much to produce
· Using efficient machine for manufacturing- Old machine vs New machine
· Optimisation of key resources- Product mix decisions etc.

145
Step- 3: Evaluation of the Options
After identification of options, each option is to be evaluated against the objective criteria. An entity with
objective of making profit may evaluate options on the basis of financial measures like impact of profit
or loss, market share, overall impact on profitability, return on investment etc.
Non-financial factors like customer satisfaction, impact on existing market/ customer, ethics of
decision are also evaluated.
This step is a very important and may be grouped into two tasks
Ÿ Identification of Cost and Benefits of each options
Ÿ Estimation of amount of each options

Step-4: Selection of option:

After evaluation of the options, the best option is selected and implemented.

Principles for Identification of

Cost and Benefits for measurement

The cost and benefit of an option is identified for measurement if it passes the principles of
Controllability and Relevance.
Controllability: Those cost and benefits which arise due to choice of an option. In other words, benefits
received and cost incurred are directly related with the choice of the option. Thus, the costs and
benefits which are controllable are considered for measurement for making decision.

Relevance: The costs which are controllable need to be relevant for decision making. This means all
controllable costs are not relevant for decision making unless it differs under the two options. Thus, a
cost is treated is relevant only if
(a) it is a future cost and (b) it differs under two options under consideration.

For Example, Arnav Ltd. wants to manufacture 1,000 additional units of Product X. It is considering
either to manufacture in its own factory or to outsource to job workers. In this example cost of raw
materials to manufacture additional 1,000 units is controllable as it arises due to management's
decision to make additional units. But it is not relevant for making choice between manufacturing in-
house and outsource to job workers, as under the both options, the raw materials cost would be same.

Hence, for decision making purpose only those cost and benefits are identified for measurement which
are both Controllable and Relevant.

Below is an analysis of few costs for its relevance:

146
Cost Relevance Reason
(i) Historical Cost IrrelevantThe cost has already been incurred
and do not affect the decision. Example: Book
value of machinery etc.
(ii) Sunk Cost Irrelevant The cost which are already paid either for goods or
services availed or to be availed. Example: Raw
material purchased and held in store without having
replacement cost, Cost of drawing, blueprint etc.
(iii) Committed Cost Irrelevant The committed costs are the pre-agreed cost which
cannot be revoked under the normal circumstances.
This is also a sunk cost. Examples: Cost of materials
as per rate agreement, Salary cost to employees etc.
(iv) Opportunity Cost Relevant The opportunity cost is represented by the forgone
potential benefit from the best rejected course of action.
Had the option under consideration not chosen, the
benefit would come to the organisation.
(v) Notional or Imputed Cost RelevantNotional costs are relevant for the decision
making only if company is actually forgoing benefits by
employing its resources to alternative course of action.
For example, notional interest on internally generated
fund is treated as relevant notional cost only if company
could earn interest from it.
(vi) Shut-down Cost Relevant When an organization suspends its manufacturing
operations, certain fixed expenses can be avoided and
certain extra fixed expenses may be incurred depending
upon the nature of the industry. By closing down the
manufacturing, the organization will save variable cost
of production as well as some discretionary fixed costs.
This particular discretionary cost is known as shut-down
cost.

ILLUSTRATION 1

MNP Ltd sold 2,75,000 units of its product at ` 37.50 per unit. Variable costs are ` 17.50 per unit
(manufacturing costs of ` 14 and selling cost ` 3.50 per unit). Fixed costs are incurred uniformly
throughout the year and amounting to ` 35,00,000 (including depreciation of ` 15,00,000). There are
no beginning or ending inventories.

Required:
COMPUTE breakeven sales level quantity and cash breakeven sales level quantity.

147
 ILLUSTRATION 2

You are given the following particulars

(`)
Fixed cost ` 1,50,000
Variable cost ` 15 per unit
Selling price is ` 30 per unit

CALCULATE:
1. Break-even point
2. Sales to earn a profit of ` 20,000
401 601
ILLUSTRATION 3
other

A company has a P/V ratio of 40%. COMPUTE by what percentage must sales be increased to offset:
20% reduction in selling price?

ILLUSTRATION 4

PQR Ltd. has furnished the following data for the two years:

2019-20 2020-21
Sales ` 8,00,000 ?
Profit/Volume Ratio (P/V ratio) 50% 37.5%
Margin of Safety sales as a % of total sales 40% 21.875%

There has been substantial savings in the fixed cost in the year 2020-21 due to the restructuring
process. The company could maintain its sales quantity level of 2019- 20 in 2020-21 by reducing
selling price.
You are required to CALCULATE the following:
1. Sales for 2020-21 in Value,
2. Fixed cost for 2020-21 in Value,
3. Break-even sales for 2020-21 in Value.

148
 ILLUSTRATION 5

You are given the following data for the current financial year of Rio Co. Ltd:

2019-20 2020-21
Variable cost 60,000 60%
Fixed cost 30,000 30%
Net profit 10,000 10%
Sales 1,00,000 100%

not
FIND OUT (a) Break-even point, (b) P/V ratio, and (c) Margin of safety. Also DRAW a break-even chart
showing contribution and profit.

ILLUSTRATION 6

A company earned a profit of ` 30,000 during the year. If the marginal cost and selling price of the
product are ` 8 and ` 10 per unit respectively, FIND OUT the amount of margin of safety.

ILLUSTRATION 7

A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio of 40%. Its fixed
costs amount to ` 5 lakhs.
CALCULATE the following:
1. Break-even sales
2. Total sales
3. Total variable cost
4. Current profit
5. New 'margin of safety' if the sales volume is increased by 7 ½ %.

149
 ILLUSTRATION 8

By noting “P/V will increase or P/V will decrease or P/V will not change”, as the case may be, STATE
how the following independent situations will affect the P/V ratio:
• An increase in the physical sales volume;
• An increase in the fixed cost;
• A decrease in the variable cost per unit;
• A decrease in the contribution margin;
• An increase in selling price per unit;
• A decrease in the fixed cost;
• A 10% increase in both selling price and variable cost per unit;
• A 10% increase in the selling price per unit and 10% decrease in the physical sales volume;
• A 50% increase in the variable cost per unit and 50% decrease in the fixed cost.

ILLUSTRATION 9 VCR 407

PVR Got
If P/V ratio is 60% and the Marginal cost of the product is ` 20. CALCULATE the selling price?

ILLUSTRATION 10

The ratio of variable cost to sales is 70%. The break-even point occurs at 60% of the capacity sales.
Find the capacity sales when fixed costs are ` 90,000. Also COMPUTE profit at 75% of the capacity
sales.

ILLUSTRATION 11

(i) DETERMINE profit, when sales =2,00,000

Fixed Cost =40,000
BEP =1,60,000

(ii) DETERMINE sales, when fixed cost =20,000

Profit =10,000
BEP =40,000

150
 ILLUSTRATION 12

A company has made a profit of ` 50,000 during the year. If the selling price and marginal cost of the
product are `15 and `12 per unit respectively, FIND OUT the amount of margin of safety.

ILLUSTRATION 13

(a) If margin of safety is `2,40,000 (40% of sales) and P/V ratio is 30% of AB Ltd, CALCULATE its (1)
Break even sales, and (2) Amount of profit on sales of `9,00,000.
(b) X Ltd. has earned a contribution of `2,00,000 and net profit of `1,50,000 of sales of `8,00,000.
What is its margin of safety?

ILLUSTRATION 14

A company sells its product at `15 per unit. In a period, if it produces and sells 8,000 units, it incurs a
loss of `5 per unit. If the volume is raised to 20,000 units, it earns a profit of `4 per unit. CALCULATE
break-even point both in terms of Value as well as in units.

ILLUSTRATION 15

You are given the following data:

2019-20 2020-21
Sales Profit
Year 2019-20 ` 1,20,000 8,000
Year 2020-21 ` 1,40,000 13,000

FIND OUT –
1. P/V ratio,
2. B.E. Point,
3. Profit when sales are `1,80,000,
4. Sales required earn a profit of `12,000,
5. Margin of safety in year 2020-21.

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 ILLUSTRATION 16

You are given the following data:

2019-20 2020-21
Sales Profit
Year 2019-20 ` 1,20,000 8,000
Year 2020-21 ` 1,40,000 13,000

FIND OUT –
1. P/V ratio,
2. B.E. Point,
3. Profit when sales are `1,80,000,
4. Sales required earn a profit of `12,000,
5. Margin of safety in year 2020-21.

Products
M N
Units 54,000 18,000
Selling price ` 7.50 ` 15.00
Variable cost ` 6.00 ` 4.50

FIND the break-even points in units, if the company discontinues product 'M' and replace with product
'O'. The quantity of product 'O' is 9,000 units and its selling price and variable costs respectively are `18
and ` 9. Fixed Cost is `15,000.

ILLUSTRATION 17

Mr. X has ` 2,00,000 investments in his business firm. He wants a 15 per cent return on his money.
From an analysis of recent cost figures, he finds that his variable cost of operating is 60 per cent of
sales, his fixed costs are ` 80,000 per year. Show COMPUTATIONS to answer the following questions:
1. What sales volume must be obtained to break even?
2. What sales volume must be obtained to get 15 per cent return on investment?
3. Mr. X estimates that even if he closed the doors of his business, he would incur ` 25,000 as expenses
per year. At what sales would he be better off by locking his business up?

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 ILLUSTRATION 18

A company had incurred fixed expenses of `4,50,000, with sales of `15,00,000 and earned a profit of
`3,00,000 during the first half year. In the second half, it suffered a loss of `1,50,000.
CALCULATE:
1. The profit-volume ratio, break-even point and margin of safety for the first half year.
2. Expected sales volume for the second half year assuming that selling price and fixed expenses
remained unchanged during the second half year.
3. The break-even point and margin of safety for the whole year.

ILLUSTRATION 19

The following information is given by Star Ltd.:

Margin of Safety ` 1,87,500

Total Cost ` 1,93,750
Margin of Safety 3,750 units
Break-even Sales 1,250 units

Required:
CALCULATE Profit, P/V Ratio, BEP Sales (in `) and Fixed Cost.

ILLUSTRATION 20

A single product company sells its product at ` 60 per unit. In 2019-20, the company operated at a
margin of safety of 40%. The fixed costs amounted to ` 3,60,000 and the variable cost ratio to sales was
80%.
In 2020-21, it is estimated that the variable cost will go up by 10% and the fixed cost will increase by
5%.
1. FIND the selling price required to be fixed in 2020-21 to earn the same P/V ratio as in 2019-20.
2. Assuming the same selling price of ` 60 per unit in 2020-21, FIND the number of units required to be
produced and sold to earn the same profit as in 2019-20.

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 ILLUSTRATION 21

a) You are given the following data for the coming year for a factory.
Budgeted output 8,00,000 units
Fixed expenses ` 40,00,000
Variable expenses per unit ` 100
Selling price per unit ` 200
DRAW a break-even chart showing the break-even point.
(b) If price is reduced to ` 180, what will be the new break-even point?

ILLUSTRATION 22

A company has three factories situated in north, east and south with its Head Office in Mumbai. The
management has received the following summary report on the operations of each factory for a period:

Sales Profit
Actual Over/(Under) Actual Over/(Under)
Budget Budget

North 1,100 (400) 135 (180)

East 1,450 150 210 90
South 1,200 (200) 330 (110)

CALCULATE for each factory and for the company as a whole for the period:
(i) the fixed costs. (ii) break-even sales.

ILLUSTRATION 23

Budgeted Output 40,000 Units

` In lakhs ` In lakhs
Net Realisation 2,10,000
Variable Costs:
Materials 79,200
Labour 15,600
Direct expenses 37,200 1,32,000
Specific Fixed Costs 27,000
Allocated Fixed Costs 33,750 60,750
Total Costs 1,92,750
Profit 17,250
Sales 2,10,000

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CALCULATE:
1. Profit with 10 percent increase in selling price with a 10 percent reduction in sales volume.

2. Volume to be achieved to maintain the original profit after a 10 percent rise in material costs, at the originally
budgeted selling price per unit.

ILLUSTRATION 24

An Indian soft drink company is planning to establish a subsidiary company in Bhutan to produce
mineral water. Based on the estimated annual sales of 40,000 bottles of the mineral water, cost studies
produced the following estimates for the Bhutanese subsidiary:

Total annual costs Percent of Total Annual Cost

which is variable
Material 2,10,000 100%
Labour 1,50,000 80%
Factory Overheads 92,000 60%
Administration Expenses 40,000 35%

The Bhutanese production will be sold by manufacturer's representatives who will receive a
commission of 8% of the sale price. No portion of the Indian office expenses is to be allocated to the
Bhutanese subsidiary.
You are required to
1. COMPUTE the sale price per bottle to enable the management to realize an estimated 10% profit on
sale proceeds in Bhutan.
2. CALCULATE the break-even point in rupees sales as also in number of bottles for the Bhutanese
subsidiary on the assumption that the sale price is `14 per bottle.

A B c
Manual (`) Semi-Automatic (`) Fully-Automatic (`)
Monthly fixed costs:
Occupancy 15,000 15,000 15,000
Maintenance contract --- 5,000 10,000
Equipment lease --- 25,000 1,00,000
Unit variable costs
(per report):
Supplies 40 80 20
Labour `200 `60 `20
(5 hrs × `40) (1 hr × `60) (0.25 hr × `80)

Required:
1. CALCULATE cost indifference points. Interpret your results.
2. If the present case load is 600 cases and it is expected to go up to 850 cases in near future, SELECT
most appropriate on cost considerations?

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 ILLUSTRATION 26

XY Ltd. makes two products X and Y, whose respective fixed costs are F1 and F2. You are given that the
unit contribution of Y is one fifth less than the unit contribution of X, that the total of F 1 and F2 is `
1,50,000, that the BEP of X is 1,800 units (for BEP of X, F2 is not considered) and that 3,000 units is the
indifference point between X and Y.(i.e. X and Y make equal profits at 3,000 unit volume, considering
their respective fixed costs). There is no inventory buildup as whatever is produced is sold.

Required
FIND OUT the values F1 and F2 and units contributions of X and Y.

ILLUSTRATION 27

Moon Ltd. produces products 'X', 'Y' and 'Z' and has decided to analyse its production mix in respect of
these three products - 'X', 'Y' and 'Z'.

You have the following information: X YZ

Direct Materials ` (per unit) 160 120 80
Variable Overheads ` (per unit) 8 20 12
Direct labour:

Departments: Rate per Hour (`) Hours per unit Hours per unit Hours per unit
X Y Z
Department-A 4 6 10 5
Department-B 8 6 15 11

From the current budget, further details are as below :

X Y Z
Annual Production at present (in units) 10,000 12,000 20,000
Estimated Selling Price per unit (`) 312 400 240
Sales departments estimate of possible sales
in the coming year (in units) 12,000 16,000 24,000

There is a constraint on supply of labour in Department-A and its manpower cannot be increased
beyond its present level.

Required:
1. IDENTIFY the best possible product mix of Moon Ltd.
2. CALCULATE the total contribution from the best possible product mix.

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 ILLUSTRATION 28

ABC Limited produces and sells two product- X and Y. The product is highly demanded in the market.
Following information relating to both the products are given as under :
Per Unit (`)
X Y
Direct Materials 140 180
Direct Wages 60 100
Variable Overheads (`5 per machine hour) 20 40
Selling price 300 450

The company is facing scarcity of machine hours for working. The availability of machine hours are
limited to 60,000 hrs in a month. At present, the monthly demand of product X and product Y is 8,000
units and 6,000 units respectively. The fixed expenses of the company are ` 2,25,000 per month.
You are required to:
DETERMINE the product mix that generates maximum profit to the company in the given situation and
also CALCULATE the profit of the company.

ILLUSTRATION 29

PQR Ltd. manufactures medals for winners of athletic events and other contests. Its manufacturing
plant has the capacity to produce 10,000 medals each month. The company has current production and
sales level of 7,500 medals per month. The current domestic market price of the medal is ` 150.
The cost data for the month of August 2021 is as under:

(`)
Variable costs:
- Direct materials 2,62,500
- Direct labour cost 3,00,000
- Overhead 75,000
Fixed manufacturing costs 2,75,000
Fixed marketing costs 1,75,000
10,87,500

PQR Ltd. has received a special one-time only order for 2,500 medals at `120 per medal.Required:
1. Should PQR Ltd. accept the special order? Why? EXPLAIN briefly.
2. Suppose the plant capacity was 9,000 medals instead of 10,000 medals each month. The special
order must be taken either in full or rejected totally. ANALYSE whether PQR Ltd. should accept the
special order or not.

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 ILLUSTRATION 30

NN Ltd. manufactures automobiles accessories and parts. The following are the total cost of
processing 2,00,000 units:

Direct materials cost ` 375 per unit

Direct labour cost ` 80 per unit
Variable factory overhead ` 16 per unit
Fixed factory overhead ` 500 lakhs

The purchase price of the component is `485. The fixed overhead would continue to be incurred even
when the component is bought from outside.
REQUIRED:
1. Should the part be made or bought from outside considering that the present facility when released
following a buying decision would remain idle?
2. In case the released capacity can be rented out to another manufacturer for `32,00,000 having good
demand. What should be the decision?

ILLUSTRATION 31

NN Ltd. manufactures automobiles accessories and parts. The following are the total cost of
processing 2,00,000 units:

X Y Z
Selling Price (` / unit) 10 12 12
Variable Costs (` / unit) 6 9 7
Market Demand (unit) 3,000 2,000 1,000
Production Capacity (unit) 2,000 3,000 900
Fixed Costs (`) 30,000

Required
COMPUTE the opportunity costs for each of the products.

ILLUSTRATION 32

M.K. Ltd. manufactures and sells a single product X whose selling price is ` 40 per unit and the
variable cost is `16 per unit.
1. If the Fixed Costs for this year are `4,80,000 and the annual sales are at 60% margin of safety,
CALCULATE the rate of net return on sales, assuming an income tax level of 40
2. For the next year, it is proposed to add another product line Y whose selling price would be `50 per
unit and the variable cost `10 per unit. The total fixed costs are estimated at `6,66,600. The sales mix
values of X : Y would be 7 : 3. DETERMINE at what level of sales next year, would M.K. Ltd. break even?
Give separately for both X and Y the break-even sales in rupee and quantities.

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 ILLUSTRATION 33

X Ltd. supplies spare parts to an air craft company Y Ltd. The production capacity of X Ltd. facilitates
production of any one spare part for a particular period of time. The following are the cost and other
information for the production of the two different spare parts A and B:

Part A Part B
Per unit
Alloy usage 1.6 kgs. 1.6 kgs.
Machine Time: Machine P 0.6 hrs 0.25 hrs.
Machine Time: Machine Q 0.5 hrs. 0.55 hrs.
Target Price (`) 145 115
Total hours available Machine P 4,000 hours
Machine Q 4,500 hours

Alloy available is 13,000 kgs. @ ` 12.50 per kg.

Variable overheads per machine hours
• Machine P : ` 80
• Machine Q : ` 100

Required
1. IDENTIFY the spare part which will optimize contribution at the offered price.
2. If Y Ltd. reduces target price by 10% and offers ` 60 per hour of unutilized machine hour,
CALCULATE the total contribution from the spare part identified above?

ILLUSTRATION 34

The profit for the year of R.J. Ltd. works out to 12.5% of the capital employed and the relevant figures
are as under:

Sales ` 5,00,000
Direct Materials ` 2,50,000
Direct Labour ` 1,00,000
Variable Overheads ` 40,000
Capital Employed ` 4,00,000

The new Sales Manager who has joined the company recently estimates for next year a profit of about
23% on capital employed, provided the volume of sales is increased by 10% and simultaneously there is
an increase in Selling Price of 4% and an overall cost reduction in all the elements of cost by 2%.

Required
FIND OUT by computing in detail the cost and profit for next year, whether the proposal of Sales
Manager can be adopted.

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 ILLUSTRATION 35

Prisha Limited manufactures three different products and the following information has been collected
from the books of accounts:

Prodcuts
A B C
Sales Mix 40% 35% 25%
Selling Price ` 300 ` 400 ` 200
Variable Cost ` 150 ` 200 ` 120
Total Fixed Costs ` 18,00,000
Total Sales ` 60,00,000

The company has currently under discussion, a proposal to discontinue the manufacture of Product C
and replace it with Product E, when the following results are anticipated:

Products
A B E
Sales Mix 45% 30% 25%
Selling Price ` 300 ` 400 ` 300
Variable Cost ` 150 ` 200 ` 150
Total Fixed Costs ` 18,00,000
Total Sales ` 64,00,000

Required:
1. CALCULATE the total contribution to sales ratio and present break-even sales at existing sales mix.
2. CALCULATE the total contribution to sales ratio and present break-even sales at proposed sales mix.
3. STATE whether the proposed sales mix is accepted or not?

ILLUSTRATION 36

A company is considering four alternative proposals for a new toy manufacturing Machine launched in
the market. New machine is expected to produce approximately 25,000 toys every year. The proposals
are as follows:
(a) Purchase and maintain the new toy manufacturing Machine and bear all related costs. These
machines will run on fuel. The average cost of a Machine is `10,00,000. Life of the machine is 4 years
with annual production of 25,000 toys and the Resale value is `2,00,000 at the end of the fourth year.
(b) Hire from Agency-A: It can hire the machine from the Agency-A and pay hire charges at the rate of `
20 per toy and bear no other cost.
(c) Hire from Agency-B: It can hire the machine from the Agency-B and pay hire charges at the rate of `
12 per toy and also bear insurance costs. All other costs will be borne by Agency-B.
(d) Hire from Agency-C: Hire machine from Agency-C at ` 2,50,000 per year. These machines are more

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advanced and run on electricity and therefore, the running cost is considerably low. The company will
have to bear costs of electricity, licensing fees and spare parts. However, Repairs and maintenance and
Insurance cost are borne by Agency-C.
The following further details are available:
The cost of Fuel is `8 per toy, the cost of spare parts is `0.20 per toy and the cost of electricity is `2
per toy. Further, the cost of Repairs and maintenance is `0.25 per toy, the amount of licensing fees to
be paid is `5,000 per machine per annum and the cost of Insurance to be paid is `25,000 per machine
per annum. Consider no taxes.
You are required to:
1. CALCULATE the relative costs of four proposals on cost per toy basis.
2. RANK the proposals on the basis of total cost for 25,000 toys per year.

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