Background

Reading Material

Elementary Basics Of

COSTING
 Introductory Concepts
A) Defining Costing

The terms “costing” and “cost accounting” are often used interchangeably. However, there is a subtle
difference between the two in the sense that, “costing” essentially means finding out the cost of
products or services by applying certain methods / techniques whereas “cost accounting” means cost
record maintenance in an appropriate manner (say by applying double entry principles).

The Chartered Institute of Management Accountants (CIMA) which is regarded as the "Mother Body"
in the study of Cost & Management Accounting (COMA) gives a comprehensive definition of costing
in the following manner.

“It is the process of, accounting for costs from the point at which expenditure, is incurred or committed
to the establishment of its ultimate relationship with cost centers and cost units. In its widest usage, it
embraces the preparation of statistical data, the application of cost control methods and
ascertainment of profitability of activities carried out or planned".

B) Cost Accountancy

CIMA defines cost accountancy as “the application of costing and cost accounting principles, and the
science, art and practice of cost control and ascertainment of profitability. It includes the presentation
of information derived there from for the purposes of managerial decision making. Cost Accounting
essentially comprises of costing, cost accounting, cost control and cost audit.”

C) Management Accounting

In layman's language, the term management accounting is applied in respect of providing accounting
information for management activities such as decision-making, planning, controls etc. Thus any form
of accounting which enables a business to be conducted more efficiently can be regarded as
management accounting. It essentially comprises the following sub categories: -

a) Cost Determination
b) Cost Control
c) Performance Evaluation
d) Supplying information for planning & decision making.

The above definition leads us to believe that there are hardly any difference between costing and
management accounting. Probably, this is why Horngreen comments:

“Modern cost accounting is often called management accounting. Why? Because cost
accountants look at their organization through manager’s eyes. Thus managerial aspects of
cost accounting are management accounting and as per the modern outlook these qualities
are inseparable”.

D) Costing vis-à-vis Management Accounting – A Distinction

Basis Costing Management Accounting

Limited to providing cost Much broader in scope since it deals with providing
Scope information for managerial a variety of information (e.g. Both financial
uses. accounting and cost information) for managerial
uses.
Mainly emphasizes on cost Mainly emphasizes on planning, control and
Emphasis ascertainment and cost control decision making parameters for maximization of
ensuring maximization of returns.
profits.
Some of the powerful tools Management Accounting also uses these
Techniques available are: standard costing techniques used in cost accounting but in addition to
& variance analysis, cost profit those it also uses techniques like ratio analysis,
volume analysis, marginal operations research etc. which so ever can aid the
costing for decision making management in its task.
budgetary controls etc.
Evolution of cost accounting is Evaluation of management accounting is due to the
Evolution mainly due to the limitations of limitations of cost accounting. In fact management
financial accounting. accounting is an extension of the managerial
aspects of cost accounting.

E) Limitations of Financial Accounting

Financial Accounting is so limited and inadequate in regard to the information which it can provide to
the management, that, businessmen have been eager to adopt supplementary information through
costing and other management accounting tools. The limitations of financial accounting coupled with
remarks are given below which highlights the importance of study of costing in general.

Limitations Remarks
Financial Accounting provides information about Proper costing system is expected to furnish this
profit, loss, cost etc. of the collective activities of data on a regular basis. Moreover with the
the business as a whole. introduction of AS 17 on segment reporting the
financial accounting information is also expected
to improve substantially.

The information provided is basically historical in The information provided under management
structure. accounting is usually futuristic in nature.

In financial accounting there is no system of Standard costing, budgetary controls and ratio
developing norms and standards to appraise the analysis may be regarded as formidable tools in
deficiency of operations and performance. this regard.

The systems of material and labour controls are Inventory controls and labour control
not in built in the system of financial accounting. mechanisms are integral components of a proper
cost and management accounting system.

In financial Accounting, expenses are not Proper classification and analysis of cost
classified into direct and indirect, fixed and happens to be the starting points in the study of
variable or controllable & uncontrollable which are cost and management accounting.
of prime importance in the management decision-
making process.

Financial Accounting does not fully analyze the These deficiencies are invariably taken care of in
losses and hence the exact causes of such losses the study of cost and management accounting.
are not known.

The financial accounting data fails to provide Cost data is tailor made for providing such
adequate information for price fixation. information.

F) Defining cost center

As per CIMA, cost centers are defined as “a location, person or item or
equipment or a combination of these for which costs may be ascertained and
used for the purpose of control. It may be noted that the main purpose of
ascertaining the costs of cost center is control of such costs. However, usually
in standard commercial parlance cost centers are of the following two types
namely:-

a) Production cost centers and

b) Service cost centers.

G) Methods of Costing
The methods (or types) of costing refers to the techniques and processes
employed in the ascertainment of costs. Several methods have been designed
to suit the requirements of various industries. The method of costing to be
applied in a particular business concern depends on the type and nature of their
operating activities. In this course we shall discuss the following methods of
costing:-
a) Unit costing
b) Process costing
c) Operating costing (Applied in various Service Sector companies)

H) Techniques of costing
In addition to the methods of costing (as explained above), there are certain
techniques of costing which are not alternatives to the above but these are used
for special purposes like planning, reporting, controls and decision making
exercises in a business enterprise irrespective of the method of costing in use.
These techniques include (amongst others),
 a) Cost Volume Profit Analysis Technique
b) Budgetary controls
c) Standard costing

I) Classifications of Costs

Direct Costs
These are costs which are incurred for and conveniently identified
with a particular cost unit, process or department. Raw material cost
and wages to workmen are good examples of direct costs.
Indirect Costs
These are general costs and are incurred for the benefit of a number
of cost units, processes or departments. These costs cannot be
conveniently identified with a particular cost center. Overhead
expenditures are a good example of indirect cost.
Fixed Costs
These costs remain constant in total amount over a wide range of
activity for a specified period of time. These do not increase or
decrease when the volume of production changes. But, it may be
noted that fixed cost per unit decreases when volume of production
increases and vice-versa. Such costs can be controlled mostly by top
management.
Variable Costs
These costs tend to vary in direct proportion to the volume of output.
In other words, when volume of output increases, total variable cost
also increases and vice-versa. But, the variable cost per unit remains
constant. Such costs can mostly be controlled by line managers.
Semi Variable Costs
These costs include both fixed and variable component i.e. these are
partly fixed and partly variable in nature. A semi variable cost has
often got a fixed element below which it will not fall at any level of
output.

Graphical Representations

Behaviour of Fixed Costs

Cost (Rs)
Total Fixed Cost line
Cost

Fixed cost per unit

Volume of Production
Volume of Production

Behaviour of Variable Costs

Cost (Rs)
Cost (Rs)

Total Variable Cost

Variable Cost per unit

Volume of production Volume of Production

Comparative Behaviour of Fixed. Variable and Semi Variable Cost

C
B
Cost (Rs)

A = Fixed cost line

B = Semi variable cost line
 C= Variable cost line

Volume of Production

Product Costs

These are costs, which are necessary for production and which will not be incurred if there is no
production.

Period Cost

These are costs, which are not necessary for production and are incurred even if there is no
production.

Controllable Costs

These are costs, which may be directly regulated at a given level of management authority. Usually
these are in the nature of variable cost but exceptions are possible.

Non-Controllable Costs

These are costs, which cannot be influenced by the action of a specified member of the enterprise.
Usually these are in the nature of fixed costs but exceptions are possible.

(Important: All costs are controllable in the long run and at some appropriate management
level)

Normal Cost and Abnormal Cost

Normal cost may be defined as a cost, which is normally incurred on expected lines at a given level of
output. This cost is a part of cost of production. Abnormal costs are that which is not normally
incurred at a given level of output. Such cost is over and above the normal cost and is not treated as
a component of cost of production. It is charged to The Costing P/L Account. (To be explained later).

J) Essentials of a good costing system

a) The method of costing adopted should be suitable keeping in view the nature and
characteristic features of the industry concerned.

b) The cost accounting system should be flexible and tailor made to suit the specific
requirement.

c) The cost of installing and operating the system should be justified by the results produced.

d) Cost centers should be clearly defined and distinct segregation should be made as regard
to controllable / non-controllable costs in order to promote better controls.

e) The costing system should be properly integrated with the financial accounts.
 f) The costing system should be so designed as to shoot out prompt and accurate reports at
any point of time.

Clarifying Two Important Concepts

The concept of Cost Driver

The cost driver is a factor, such as the level of activity or volume that typically affects costs (over a
given time span). That is, a cause and effect relationship exists between a change in activity level
and a change in the level of total cost of that cost object. The cost driver for the variable costs is the
level of activity whose change causes that cost to change proportionately. For example, in an
automobile industry, the number of vehicles assembled is a cost driver for the cost incurred by the
manufacturer on steering wheels. Costs that are fixed in the short run have no cost driver in the short
run but may have a cost driver in the long run. Consider, for example, the cost of testing personal
computers in Compaq. These costs would comprise Testing Department equipment and staff costs
that are difficult to change and hence, fixed in the short run with respect to changes in volume of
production. Thus, volume of production is not a cost driver for testing costs in the short run. In the
long run, however, Compaq would increase or decrease the Testing Department’s equipment or staff
to the levels needed to support future production volumes. Therefore, volume of production is a cost
driver of testing costs in the long run.

Cost Reduction vis-à-vis Cost Control

Cost Reduction Cost Control

Refers to achieving real and permanent Cost control essentially refers to achieving
reduction in costs in the very true sense of the pre determined costs or targeted costs.
term.

Cost reduction is not exactly concerned with Cost control is concerned with
measuring actual costs with predetermined predetermined or budgeted or standard
costs. In fact, its coverage is far wider as it costs and the exercise of comparing the
would even go to the extent of challenging same with actual costs coupled with
such predetermined costs. appropriate variance analysis and initiating
suitable remedial actions.

Thus, cost reduction is a corrective function Cost control on the other hand is a
because it challenges the predetermined preventive function as it aims to prevent the
targets and seeks to improve performance for costs from exceeding the predetermined
reducing costs. targets.

“Cost reduction” begins where “cost control” For obvious reasons, an exercise of cost
ends. control would precede cost reduction
 exercise.

Elements of Cost

Total Cost

Material Cost Labour Cost Expenses

Direct Indirect Direct Indirect Direct Indirect

Material Material Labour Labour Expense Expense
s s

Prime
Cost

Overhead

Production Administration Selling

Overhead Overhead Distribution
Overhead
 Explaining FIFO, LIFO,
Simple and Weighted Average Methods
METHOD OF PRINCING MATERIAL ISSUES

When materials are issued from stores to production department, a difficulty

arises regarding the price at which materials issued are to be charged. This is
because the same type of material may have been purchased in different lots at
different times at several different prices. This means that actual cost can take
on several different values and some method of pricing the issue of materials
must be selected. This basic problem of pricing the issues of materials is
illustrated in the following Stores Ledger Account (Figure are assumed).
Stores Ledger Account
Date Receipts Issues Balance
1998 Ref Qty. Rate Amt. Ref. Qty. Rate Amt. Qty Rate Amt.
(GRN) Units Rs. Rs (SR) Units Rs Rs. Units Rs Rs.
1 July - - - - - - - - 200 5 1,000

4 July 430 500 6 3,000 - - - - 200 5 1,000

500 6 3,000

200 5 1,000
8 July 310 800 6.50 5,200 - - - - 500 6 3,000
800 6.50 5,200

10 - - - - 115 900 ? ? 600 ? ?

July

How to price the issue of 900 units on 10 July and how to value the stock of 600
units in hand from this data? Various alternative issue prices that could possibly
be charged are Rs. 6 per unit., i.e., the price paid on 4 July on Rs. 6.50 per unit,
i.e., the price paid on 8 July, or Rs. 5 per unit, i.e., the price of opening stock or
an average of these price or some other price altogether. The question is
whether it should be the original purchase price or the current market price on
the date of issue or some other price that should be used for this purpose. The
question is important because the pricing directly affects the amount of profit or
loss reported for the accounting period. If the method chosen puts higher value
to closing stock, it will result in higher profit, and vice-versa, (i.e. lower valuation
of closing stock will result in lower profits).

It should be noted that methods discussed below are methods of pricing the
issue of materials and not the methods of physically issuing materials.

Methods of Pricing

The Most Common Methods of Pricing are,

1. First-in First-out Price (FIFO)
2. Last-in First-out Price (LIFO)
3. Simple Average Price
4. Weighted Average Price
5. Standard Price

First-in First-out (FIFO) Method

This method is based on the assumption that materials which are purchased first are issued
first. It uses the price of the first batch of materials purchased for all issues until all units from
that batch have been issued. After the first batch is fully issued, the price of the next batch
received becomes the issue price. Upon this batch also being fully used, the price of the still
next batch is used for pricing and so on. In other words, the materials are issued at the oldest
cost price listed in the stores ledger account and thus, the materials in stock are valued at the
latest purchase price. Thus, the FIFO features are,

a) Materials issued are priced at the actual cost incurred.

b) Charge to production for material cost is at the oldest prices of materials in stock.
c) Closing stock is valued at the latest price paid.

Illustration From the following transactions, prepare a Stores Ledger Account using FIFO method:

1998 Document Ref

1 July Opening stock 500 units @ Rs 20 each
4 July Purchased GRN 574 400 units @ Rs. 21 each
6 July Issued SR 251 600 units
8 July Purchased GRN 578 800 units @ Rs. 24 each
9 July Issued SR 258 500 units
13 July Issued SR 262 300 units
24 July Purchased GRN 584 500 units @ Rs. 25 each
28 July Issued SR 269 400 units
 GRN = Goods Received Notes, SR – Stores Requisition

(It may please be noted that these transactions pertaining to this illustration have also been used to
explain other methods of pricing given in later section of this booklet).

Solution
FIFO Method
Stores Ledger Account
Date Receipts Issues Balance
1998 Ref. Qty. Rate Amt. Ref. Qty. Rate Amt. Qty. Rate Amt.
GNR Units Rs. Rs. (SR) Units Rs. Rs. Units Rs. Rs.
1 July - - - - - - - - 500 20 10,000

4 July 574 400 21 8,400 - - - - 500 20 10,000

400 21 8,400
600
6 July - - - - 251 500 20 10,000
100 21 2,100 300 21 6,300

8 July 578 800 24 19.200 - - - - 300 21 6,300

800 24 19,200
500
9 July - - - - 258 300 21 6,300
200 24 4,800 600 24 14,400

13 - - - - 262 300 24 7,200 300 24 7,200

July

24 584 500 25 12,500 - - - - 300 24 7,200

July 500 25 12,500

400
28 - - - - 269 300 24 7,200
July 100 25 2,500 400* 25 10,000

* Closing stock is 400 units @ Rs. 25 = Rs. 10,000

It should be noted that the assumption of FIFO is only for accounting purposes i.e., the physical flow
of materials need not necessarily be in the order of the flow of cost, though normally materials would
be expected to move out of stock on approximately a FIFO basis because oldest stocks are unusually
used up first.
Advantages: The following advantages are claimed for FIFO method:

1. It is based on a realistic assumption that materials are issued in the order of their receipts.
2. Materials are issued at actual cost and thus no unrealized profit/loss arises from the operation
of this method.
3. Valuation of closing inventory is at cost as well as at the latest prices paid.
4. This method is easy to understand and simple to operate.
Disadvantages : The main disadvantages of this method are:
 1. As materials are charged to production at the old prices, the cost of production may lag behind
the current economic values.
2. This method does not permit comparison of the costs of similar jobs or cost units because
similar jobs simultaneously started may be charged materials at different prices.
3. When prices are subject to frequent changes, this method involves cumbersome record
maintenance and calculations.

In periods of rising prices, the FIFO method produces higher profits and results in higher tax liability
because lower cost is charged to production. Conversely, in periods of falling prices, the FIFO method
produces lower profits and results in lower taxes because higher costs are charged to the production
activity.
Last-in First-out (LIFO) Method
This method operates in just the reverse order of FIFO method. It is based on the assumption that
the last materials purchased are the first materials issued. Thus the price of the last batch of the
materials purchased is used first for all issues until all units from this batch have been issued, after
which the price of the previous batch of materials purchased is used. It should be noted that physical
flow of materials may not conform to LIFO assumption.
Three points should be noted regarding this method:
a) Material issues are priced at actual cost.
b) Charge to production for material cost is at latest prices paid.
c) Closing stock valuation is at the oldest prices paid and is completely out of line with the current
prices.
Illustration Prepare a Stores Ledger Account, showing pricing of materials on LIFO basis, from the
data given in the previous Illustration.
LIFO Method
Stores Ledger Account
Date Receipts Issues Balance
1998 Ref. Qty. Rate Amt. Ref. Qty. Rate Amt. Qty. Rate Amt.
GRN Units Rs. Rs. (SR) Units Rs. Rs. Units Rs. Rs
1 July - - - - - - - - 500 20 10,000

4 July 574 400 21 8,000 - - - - 500 20 10,000

400 21 8,400

600
6 July - - - - 251 400 21 8,400
200 20 4,000 300 20 6,000

8 July 578 800 24 19,200 - - - - 300 20 6,000

800 24 19,200

9 July - - - - 258 500 24 12,000 300 20 6,000

300 24 7,300

13 July - - - - 262 300 24 7,200 300 20 6,000

24 July 584 500 25 12,500 - - - - 300 20 6,000

500 25 12,500

28 July - - - - 269 400 25 10,000 * 300 20 6,000

100 25 2,500
*Closing stock is 300 units @ Rs. 20 = 6,000 + 100 units @ Rs. 25 = Rs. 2,500. Total 400 units at Rs.
8,500 (i.e. Rs 6000 + Rs 2500)

Advantages The main advantages of this method are:

1. Materials are charged to production at the latest prices paid. In times of rising prices, quotation of
prices for company’s product will be safer and profitable (provided such quotation is based on
costs).
2. This method, like FIFO, does not result in any unrealized profit or loss.
3. This method is also quite simple to operate particularly when prices are fairly steady.
Disadvantages This method suffers from the following disadvantages:
1. This method is not realistic as typically it does not conform to the physical flow of
materials.
2. The closing stock is valued at the old prices and does not represent the current economic
values.
3. Like FIFO method, in this method as well, the material cost of similar jobs may differ
because materials were issued from different lots and thus, at different prices. This might
result into difficulty in comparison.
4. This method is cumbersome when prices are subject to frequent fluctuations. In periods of
rising prices, profit and tax liability under LIFO would be lower than under FIFO method
because cost will be charged at current prices which are at higher level.

Average Cost Methods

These methods are based on the assumption that when materials purchased in different lots is stored
together, their identity is lost, and therefore, issues should be charged at an average price. Basically,
average prices are of two types – simple average and weighted average.

Simple Average Method

Simple average price is calculated by adding all the different prices of materials in stock, from which
the materials to be priced could be drawn, by the number of prices used in that total. This method
does not take into account the quantities of materials in stock while calculating the average.
Suppose, the following three lots of materials are in stock when material is to be issued.
500 units purchased @ Rs. 20
200 units purchased @ Rs. 21
700 units purchased @ Rs. 22

Simple Average Price = = 21

While calculating the simple average, the price of lots of materials which are assumed to
have been completely issued on FIFO basis is not taken into account.

Illustration Prepare Stores Leger Account by Simple Average Method from the transactions
given in the previous Illustration.

Simple Average Price Method

Stores Ledger Account
Date Receipts Issues Balance
1998 Ref. Qty. Rate Amt. Ref. Qty Rate Amt. Qty. Rate Amt.
GRN Units Rs Rs SR Units Rs. Rs. Units Rs. Rs.
1 July - - - - - - - - 500 20 10.000
4 July 547 400 21 8,400 - - - - 900 18.400
6 July - - - - 251 600 20.50 12.300 300 6.100
8 July 578 800 24 19,200 - - - - 1,100 25,300
9 July - - - - 258 500 22.50 11.250 600 14.050
13 July - - - - 262 300 24.00 7.200 300 6.850
24 July 548 500 25 12,500 - - - - 800 19.350
28 July - - - - 269 400 24.50 9.800 400 9.550

Working Note: Various issue prices are computed as follows:

On 6 July = (20 + 21) / 2 = Rs. 20.50

On 9 July = (21 + 24) / 2 = Rs. 22.50
On 13 July = (24 / 1) = Rs. 24.00
On 28 July = (24 + 25) / 2 = Rs. 24.50

Advantages and Disadvantages of Simple Average Method

The only advantage that this method enjoys is its simplicity. No more can be said in favor
this method as it pays no consideration to the relative quantities held at each price. For this
reason, this method is considered unscientific and it usually produces unsatisfactory results.
The value of closing stocks may become negative (under certain situations) which is quite
absurd. For instance, if 100 units at Rs. 10 each and 1000 units at Rs.2 each are held in
stock at a total value of Rs. 3,000, when 600 units are issued at a simple average price of Rs.
6 i.e., (10 + 2) / 2, the closing stock of 500 units will be valued at a negative value of Rs.600,
which is absurd. These figures have been exaggerated to illustrate the point. Another
disadvantage of this method is that this method does not charge materials at actual cost and
thus, may result in unrealized profit or loss.

Weighted Average Method

This method gives due weightage to the quantities held at each price when calculating the
average price. The weighted average price is calculated by dividing the total cost of material
in stock, from which the material to be priced could have been drawn, by the total quantity of
material in that stock. The simple formula is that weighted average price at any time is the
balance value figure divided by the balance units figure.

Illustration From the transactions given in the above Illustration prepare Stores Ledger Account
assuming pricing according to Weighted Average Method.

Solution
Weighted Average Method
Stores Ledger Account
Date Receipts Issues Balance
1998 Ref. Qty. Rate Amt. Ref. Qty Rate Amt. Qty. Rate Amt.
GRN Units Rs Rs SR Units Rs. Rs. Units Rs. Rs.
1 July - - - - - - - - 500 20.000 10,000
4 July 547 400 21 8,400 - - - - 900 20.444 18,400
6 July - - - - 251 600 20.444 12.267 300 20.444 6,133
8 July 578 800 24 19,200 - - - - 1,100 23.030 25.333
9 July - - - - 258 500 22.030 11.515 600 23.030 13.818
13 July - - - - 262 300 23.030 6.909 300 23.030 6.909
24 July 548 500 25 12,500 - - - - 800 24.261 19,409
28 July - - - - 269 400 24.261 9.705 400 24.261 9,704

Note: The issue prices are calculated as follows:

On 4 July Rs.18.400 / 900 units = Rs.20.444

On 8 July Rs. 25,333 / 1,100 units = Rs.23.030
On 24 July Rs. 19,409 / 800 units = Rs. 24.261
The fresh issue rate is determined after each purchase and not at the time of each issue. Thus, as
soon as fresh supply is received, a new price is calculated and all issues are then valued at that price
until the next supply is received when a new issue price would be required to be calculated.

Advantages This method has the following advantages:

1. The method smoothes out the effect of fluctuations in purchase price. It is thus, particularly
advantageous where price variations are wide so that extreme prices are ironed out.

2. The new issue price is calculated at the time of each new purchase and not at the time of each
issue. Since receipts are much less frequent than issues, the work of making calculations is
reduced.

3. No unrealized profit or loss arises by the use of this method.

Disadvantages

1. Issue prices may not be at the current market prices.

2. The method calls for many calculations where purchases are made frequently.

3. To avoid errors, the average price must be calculated to a sufficient number of decimal
points. This makes the operation of the method somewhat tedious.

4. Excessively high or low prices paid in the past are reflected in the average for a considerable
time after the expensive (or inexpensive) material has been consumed.
 Treatment of Overheads
Defining Overheads

CIMA defines overhead costs as an aggregate of indirect materials costs,

indirect labour costs and indirect expenses. Alternatively, overheads may be
defined as all expenses other than direct expenses. As per Blocker and
Weltmer, “overhead costs are the operating costs of a business which cannot
be traced directly to a particular unit of output. In a nutshell, it comprises of
indirect costs, which a cost accountant or the management of an organization
find it difficult to attribute to specific cost units or specific products.

Classification of Overheads

Overheads may essentially be classified into separate buckets on the basis of

their functional or behavioral characteristics. The function-based classification
is provided below for your ready reference.
Indirect expenditure incurred in connection with production
Manufacturing or operations. It is alternatively known as factory overhead, works
Production Overheads overhead or manufacturing overhead. These constitute an invisible
part of the finished product. Factory power and light, depreciation of
factory plant and machinery, factory repairs and maintenance may
be regarded as good examples of the same.

These are the aggregate of all indirect expenses of a business

Office & Administration enterprise, which are not directly related to the production, or selling
Overhead distribution functions of an organization. Salaries paid to general
management staff, printing and stationary, office rent, office lighting
etc, are good examples of the same.

Selling overhead is the cost of creating and stimulating demand or

Sales and Distribution the cost incurred for sourcing orders. Advertising, showroom
Overheads expenses, salary paid to salesmen etc can be regarded as good
examples of the same. Distribution expenses comprise of all
 expenditure incurred from the time the product is completed till it
reaches the customers destination. Hence, packaging costs,
carriage outwards etc. may be regarded as good examples for the
same. Selling overheads and distribution overheads are both
related to the sales function and are normally clubbed into one
category under the head “selling and distribution overheads.”

The overhead classification on behavioral characteristics is provided in the next

page for your ready reference.

These overheads expenses usually remain unaffected

Fixed Overheads irrespective of changes in the volume of operations.
Managerial salaries. Rent, Depreciation of Office Building etc
are good examples of the same.

This component of overhead expenditure usually tends to vary in

Variable Overheads direct proportion to the changes in volume of output. Indirect
material cost salesman’s commission etc., are good examples of
the same.

This component of overhead expenditure is partly fixed and partly

Semi Variable Overheads variable in nature. Depreciation of plant and machinery is a very
good example for the same.

The main purpose of classifying overhead cost into fixed and variable is to help the management in
decision-making and expenditure controls. Hence, the semi variable expenditure may pose certain
problems in the said exercise and thus the cost accountant is expected to split them into fixed and
variable components. The following illustration will explain the concept better.
Illustration Number 1
Kindly segregate the semi variable expenditure into fixed and variable components.

Month Output (Units) Semi Variable Cost (Rs.)

January 80 2200
February 40 1600
March 120 2800
April 160 3400
May 200 4000
June 140 3100

C) Overhead Distribution

Distribution of overhead costs to cost units is one of the most complex problems of cost accounting.
This is because overhead costs cannot be identified with individual cost unit’s and there are no
accounting means for exact distribution. Therefore, such costs are analyzed ad distributed to various
cost centers and cost units in some fair and equitable basis. The cost accountant is constantly
searching for equitable basis to distribute overhead costs to units and divisions of business enterprise
and quite often he needs to exercise his own judgment in this regard. For instance, he may apportion
rent to various departments of the factory on the basis of area occupied by each such department .

Allocation

Certain items of overhead costs can be directly identified with a particular department or cost center
as having been incurred for that cost center. Allotment for such costs to the cost centers is known as
allocation. Thus, allocation may be defined as the “allotment of whole items of cost to cost center or
cost units.” A particular overhead expenditure maybe allocated only if both of the following conditions
are satisfied:

a) The cost center concerned must have caused the overhead to be incurred.
b) The exact amount incurred in that particular cost center must be known.

Apportionment

Certain overhead costs cannot be directly charged to a department or cost center. Such
costs are common to a number of cost centers or departments and it do not originate from
any specific department. Distribution of such overhead costs to various departments is known
as apportionment. Thus apportionment may be defined as “the allotment of proportions of
items of costs to cost centers in some equitable basis.” In other words it is charging to a cost
center a fair share of an overhead expenditure.

Allocation vis-à-vis Apportionment

While allocation deals with whole items of costs, apportionment deals with proportion of items
of costs. Allocation is a direct process while apportionment is an indirect process for which
suitable equitable bases needs to be selected. Overheads should always be allocated as far
as possible. If an overhead cannot be allocated, it is to be apportioned.

Illustration Number 2

The following data were obtained from the books of M.N. Engineering Company for the half
year ended 30th September, 1992. Prepare a Departmental Distribution Summary.

Particulars Production Departments Services Dept.

A B C X Y

Direct Wages Rs 7,000 6,000 5,000 1,000 1,000

Direct Materials Rs. 3,000 2,500 2,000 1,500 1,000
Employees Nos. 200 150 150 50 50
Electricity Kwh. 8,000 6,000 6,000 2,000 3,000
Light points Nos. 10 15 15 5 5
Assets Value Rs. 50,000 30,000 20,000 10,000 10,000
Area occupied Sq.yds 800 600 600 200 200
The overhead expenses for 6 months were as follows:

Stores overhead 400 Depreciation 6,000

Motive power 1,500 Repairs and Maintenance 1,200
Electric lighting 200 General overheads 10,000
Labour welfare 3,000 Rent and Taxes 600

Apportion the expenses of Department X in the ratio of 4:3:3 and that of department Y in
proportion to direct wages, to department A, B and C respectively.

D) Concept of “Machine Hour Rate (MHR)”

Machine hour rate is defined as the overhead cost incurred for running a particular
machine for one hour. This rate is obtained by dividing the amount of factory
overhead apportioned to a machine by the total number of machine hours attributable
to the machine during the period under consideration.

When the direct wages of the machine operators are included in the machine hour
rate, it is known as the “comprehensive machine hour rate”.

Illustration Number 3
A department has three machines. The following figures indicate the departmental expenses.

Rs

Depreciation of machinery 12,000

Depreciation of building 2,880
Repairs to machinery 4,000
Insurance to machinery 800
Indirect wages 6,000
Power 6,000
Lighting 800
Miscellaneous expenditure 4,200

Total 36,680

Particulars Machine I Machine II Machine III

Direct wages (Rs.) 1,200 2,400 2,400

Power units 30,000 10,000 20,000
No. of workers 4 8 8
Light points 8 24 48
Space in square feet 400 800 800
Cost of Machine (Rs.) 3,00,000 1,20,000 1,80,000
Hours worked 200 300 300
From the above information kindly compute:-

a) Simple machine hour rate

b) Comprehensive machine hour rate.

E) Illustration Number 4 (Idle Capacity Cost)

Flakes India Limited manufactures component part “X” at the rate of 2 units per hour. The factory
normally operates 6 days a week on a single eight hour shift basis. During the year, it was closed for
20 working days for holidays. Normal loss of machine time for cleaning, oiling etc is 160 hours per
year. Fixed overhead cost per annum is Rs. 37,128. Normal sales for the component average 2,500
units per year. However, the expected sales for the year under consideration are 2,400 units.
Compute the idle capacity cost when overhead rates are based on practical capacity.
F) Important Note

It must be appreciated that the concepts of computation of machine hour rate, idle capacity
costs, allocation and apportionment of overheads are crucial inputs in form of effective MIS
promoting the management decision making process.

G) Overhead Absorption

Overhead may be absorbed either on the basis of actual rates or pre determined (budgeted) rates.
When a budgeted rate is employed, overheads absorbed may not be equal to actual overheads
incurred. In other words it will amount to under absorption or over absorption of overheads.

Under absorption
When the amount of overheads absorbed is less than the amount of overhead actually incurred, it is
called under absorption or under recovery of overhead. This has the effect of under stating the cost of
production (unless adjusted otherwise) because the overheads incurred are not fully absorbed in the
cost of jobs / processes.

Over absorption
When the amount of overhead absorbed is more than the amount of actual overhead incurred, it is
known as over absorption or over recovery of overheads. It will have the effect of over stating the
cost of production (unless otherwise adjusted).

Adjusting under / over absorption of overheads

Where the amount of under or over absorption of overhead is significant, supplementary overhead
absorption rate is calculated to adjust this amount in the related costs. In the case of under
absorption the overhead is adjusted by a plus rate since the amount is to be added whereas over
absorption is adjusted by a minus rate as the amount is expected to be reduced. However, when the
quantum of under / over absorption is negligible it may not be worthwhile to absorb it with the aid of a
supplementary rate. Such differences may be directly written off / written back in the costing Profit
and Loss Account. If the differences are arising due to some abnormal reasons the same is directly
adjusted in the costing profit and loss account. It may be noted that differences arising due to such
abnormal reasons are never adjusted through supplementary rates.
Illustration Number 5
A company absorbs overheads on pre-determined rates. For the year ended 31.12.1998, factory
overheads absorbed were Rs. 3,66,250 but the actual amount of factory overhead incurred was Rs.
4,26,890. The following figures were extracted from the trial balance. Incidentally, this was the first
year of operation of the said company.

Finished stock = Rs.2, 30,732

Cost of goods sold = Rs.8, 40,588
Work in process = Rs.1, 41,480

Kindly explain how you would dispose of under / over absorption of overheads by applying a
supplementary rate.

Illustration Number 6
During the year ended 31.03.1998, the factory overhead costs of three production departments of an
organization are as under:

X = Rs.48, 950 Y = Rs 89,200 Z = Rs.64, 500

The basis of absorption of overhead is given below:

X = Rs. 5 per machine hour for 10,000 hours.

Y = 75 % of the direct labour cost of Rs 1, 20,000
Z = Rs. 4 per piece for 15000 pieces.

Calculate the department wise under or over absorption of overhead and present the information in a
tabular form.