SESSION 3

ELEMENTS OF COST: DIRECT MATERIAL &

DIRECT LABOR

ALOK DIXIT
IIM, LUCKNOW
 ELEMENTS OF COST
Conversion Costs=
Direct Manufacturing Labour
TOTAL Costs + Direct Expenses +
COST Manufacturing Overheads

A. B. C.
MATERIAL LABOUR EXPENSES

Direct Indirect Direct Indirect Direct Indirect

Material Material Labour Labour Expenses Expenses

Prime Costs= Direct Material

+ Direct Manufacturing Labour
+ Direct Expenses
COST ELEMENTS: DIRECT
MATERIAL
 PURCHASE OF MATERIAL

RESPONSIBILITY OF PURCHASE DEPARTMENT

The purchasing department is responsible for acquiring materials

of the proper quality, in the proper quantity, at an acceptable
price, and in a timely manner.

THREE FROMS USED

• Purchase Requisition/ Material Requisition Form (MRF)

• Purchase Order (PO)

• Receiving report/ Goods Received Note (GRN)

 MATERIAL COSTING

Material Cost =Unit cost*Quantity purchased

 MATERIAL COST
As per Cost Accounting Standard (CAS 6), issued by the Institute
of Cost & Management Accountants of India
The material receipt should be valued at:
purchase price including duties and taxes, freight
inwards, insurance, and other expenditure directly
attributable to procurement (net of trade discounts,
rebates, taxes and duties refundable or to be credited by
the taxation authorities) that can be quantified with
reasonable accuracy at the time of acquisition.
Example of taxes and duties to be deducted from cost is the GST Input Tax
Credit(ITC). For example, credit against the GST paid on input goods, input
service and capital goods, and credit for IGST. In the case of imported
inputs, the input tax credit is generally availed against the IGST component.
The Additional Duty of Customs - Countervailing Duty (CVD) and Special
Additional Duties (SAD), has been subsumed in IGST.
 SELECT ASPECTS OF MATERIAL
COSTING

 Treatment of taxes, insurance, freight, packaging & handling

charges;

 Treatment of discounts;

 Treatment of Normal/ Abnormal losses;

GST AND ITC (TAX TO BE CLAIMED/ REFUNDED)
• Assume that you have purchased inputs worth Rs. 224,000.
The input goods include a GST of 12% (6% each for SGST
and CGST).
• Assume that these inputs are converted into saleable output
worth Rs. 500,000 [conversion cost: 176,000, profit:
100,000], before GST. The applicable GST on the output is
18% (9% each for CSGT and SGST).
 MATERIAL COST
&
TREATMENT OF TAXES, INSURANCE, FREIGHT,
PACKAGING & HANDLING CHARGES
 TREATMENT OF TAXES, INSURANCE, FREIGHT,
PACKAGING & HANDLING CHARGES
 Indirect taxes
 GST and IGST
 Custom duty (should be included in the material cost)
Note: In case the material used is covered under the ‘GST Input Tax Credit
scheme’, GST paid on it should be deducted from the invoiced price (in case
invoiced price includes it) to determine the cost of material.

 Treatment of transfer & delivery charges

Whether payment of freight is made by vendor or buyer depends on
INCOTERMS

 The invoice price of material may be F.O.B. (vendor’s/ supplier’s

plant or buyer’s plant) or CIF or EXW (Ex works)/ Ex Factory, etc.
 Freight and Insurance is a direct material cost. It should be included in
the material cost (invoice includes it under C.I.F. scheme); If not, it
should be included while computing the direct material cost.

FOB : Free on Board; CIF: Cost, Insurance & Freight

PACKING & CONTAINER CHARGES
MATERIAL COSTING: PACKING & CONTAINER CHARGES
CHARGES OF PACKING & NON-RETURNABLE CONTAINER

 Containers, if not charged separately, are inbuilt in the invoiced price, and hence need no
adjustment.

 If supplier charges for containers separately, treatment varies as per the situation.

NON-RETURNABLE CONTAINERS
 Cost of non-returnable container is added to purchase price of material (in case not already
included in the invoice)

 Amount realized on sale of such containers is treated as other income. Reduces factory
overheads to that extent.

RETURNABLE CONTAINERS

 Cost of returnable containers should not be included in the material cost; rather, the difference
between the ‘charge for returnable containers and the amount refunded when containers are
returned’ should be added to arrive at the material cost.

Rs 20 charged for container

Rs 15 refundable on return of container
Rs 5 should be added to arrive at material
MATERIAL COSTING: TREATMENT
OF JOINT PURCHASE COST
 MATERIAL COSTING:
TREATMENT OF JOINT PURCHASE COST
 Material with different specifications to be issued individually and
shown as a lot in the invoice & a single amount is shown against the
lot as price.
 Current market price for each type of Material need to be
ascertained.
 Joint price are apportioned to ‘the various types of Materials’ in
the ratio of their market price.

 In case market price is not available, joint price apportioned on

basis of some technical estimate.

Some examples of Joint costs: Transport & storage charges on basis

of weight or volume of each consignment
Transit insurance on basis of value of each consignment.
 MATERIAL COSTING

 MATERIAL HANDLING CHARGES (cost of receiving & handling

materials)

 Should be recovered as cost in addition to cost of all materials by

 Recovered on tonnage basis

 Recovered on value basis

 If it can be assigned to a particular item of material, it will form part of

direct material cost

 If not, it will be treated as overheads which is subsequently distributed to

different types of materials on some rational basis.
 MATERIAL COST
&
TREATMENT OF DISCOUNTS
 MATERIAL COSTING

 QUANTITY DISCOUNT (by seller to encourage bulk purchase)

• Discount varies according to size of the order.
• Deducted from the cost of direct material if not adjusted in
the invoice price.

 TRADE DISCOUNT (By supplier to retailers/ consumers who

resell/consume the product/ material)
• Deducted from the material cost if not adjusted in the
invoice.

 CASH DISCOUNT (offered by supplier for early payment)

• Should not be not be deducted from the material cost.
 EXAMPLE 1: MATERIAL COST

CGST and SGST, each payable @ 5% on raw materials. No Tax on returnable containers.

net of discount on returned

containers.

Note: F.O.B. supplier’s factory, or Ex Works (EXW), or Ex Factory indicates the same invoicing terms.
CGST and SGST, each payable @ 5% on raw materials. No Tax on returnable containers.

net of discount on returned

containers.
 SOLUTION:
CASE 1: RM QUALIFIES FOR THE INPUT TAX CREDIT (ITC)
Total Cost
PARTICULARS
(in Rupees)
RAW MATERIAL 1200 KG @ Rs 20 24,000.00
Less: TRADE DISCOUNT @ 20% -4,800.00
NET RAW MATERIALS COST
19,200.00
GST: A. CGST @ 5% ON RAW MATRL COST (19,200)

B. SGST @ 5% ON RAW MATRL COST (19,200) 1920

CHARGE FOR CONTAINERS (48 DRUMS @ RS 10) 480
NET INVOICE VALUE 21,600
TOTAL FREIGHT PAID 240
INSURANCE (2.5% ON NET INVOICE VALUE )
540
CREDIT ALLOWED ON RETURNABLE CONTAINERS (@ RS. 8 PER DRUM)
(384)
TOTAL PURCHASE PRICE
21996
—STORES OVERHEADS (5% ON TOTAL PURCHSE COST 21,996) 1100
INPUT TAX CREDIT (ITC) ALLOWED (1920)
TOTAL COST OF MATERIAL PURCHASED
21,176
 SOLUTION:
CASE 2: RM DOES NOT QUALIFY FOR ITC
Total Cost
PARTICULARS
(in Rupees)
RAW MATERIAL 1200 KG @ Rs 20 24,000.00
Less: TRADE DISCOUNT @ 20% -4,800.00
NET RAW MATERIALS COST
19,200.00
GST: A. CGST @ 5% ON RAW MATRL COST (19,200)
B. SGST @ 5% ON RAW MATRL COST (19,200) 1920
CHARGE FOR CONTAINERS (48 DRUMS @ RS 10) 480
NET INVOICE VALUE
21,600
TOTAL FREIGHT PAID
240
INSURANCE (2.5% ON NET INVOICE VALUE )
540
CREDIT ALLOWED ON RETURNABLE CONTAINERS (@ RS. 8 PER DRUM)
(384)
TOTAL PURCHASE PRICE
21996
—STORES OVERHEADS (5% ON TOTAL PURCHSE COST 21,996) 1100
TOTAL COST OF MATERIAL PURCHASED
23096
 MATERIAL COST
&
TREATMENT OF NORMAL/ ABNORMAL
LOSSES
 MATERIAL COST AND NORMAL LOSS

WASTE
The discarded substance has no sale
value.

NORMAL /
ABNORMAL
SCRAP
LOSS
The discarded substance has some sale
value.

IMPORTANT:
Normal loss needs to be borne by the remaining units which are in good condition.
 CAS 6 ON TREATMENT OF NORMAL
LOSS

 Normal loss or spoilage of material prior to reaching the

factory or at places where the services are provided shall be

absorbed in the cost of balance materials, net of amounts

recoverable from suppliers, insurers, carriers or recoveries

from disposal.
 STORAGE & ISSUING LOSSES
Waste, scrap, spoilage & defective work
Waste (normal)
 Waste is a discarded substance, having no value.
 Loss on normal wastage (expected, unavoidable)
 Normally arises in storage or during process.
 Part of production cost & affects Cost of Production (COP).
 Natural losses: loss during electricity transmission; evaporation of oil, paints, etc;

shrinkage, natural deterioration through dust & rust, losses inherent in breaking
the bulk as in the case of coal, absorption of moisture as in the case of lime.

 Cost of normal waste units is borne by the remaining good units

 Charged to COP by inflating the unit price of material in such a way that
total cost is recovered.

Example: 1000 KG OF MATERIAL @ Rs 9 per kg; normal loss 10%.

Material cost per unit
Rs 9 x 1,000 kg = Rs 10 per Kg
(1,000 - 10% of 1000) kg
 STORAGE & ISSUING LOSSES
WASTE (ABNORMAL)

LOSS ON ABNORMAL WASTAGE (AVOIDABLE)

Examples: Pilferage, defective storage, careless handling, defective
workmanship, obsolescence due to irregular issues

 Not included in the COP

 Considered as nonmanufacturing loss

 Directly transferred to Costing P&L A/c

 STORAGE & ISSUING LOSSES

SCRAP
Discarded material having some value
 Results from processing of materials, defective & broken parts,
obsolete parts, etc.

Treatment of scrap in Material Costing:

 IF ITS VALUE IS SIGNIFICANT & IDENTIFIABLE WITH JOB (Preferred

Treatment)

 Its sale value transferred to scrap a/c, i.e., the cost of job/
MATERIAL will be reduced by sale value of scrap.
 STORAGE & ISSUING LOSSES
SCRAP
If its value is significant but not identifiable with job

 Sales value of scrap is credited to Manufacturing Overheads a/c;

 This reduces cost of material or factory overhead to the extent of sale

proceeds of scrap;
 EXAMPLE 2: MATERIAL COST AND NORMAL
LOSS

In Example 1 (Case 1, ITC allowed), assume that, on inspection, 100 Kg. of

Raw Material was damaged in transit. Based on prior experience, the company
expects a normal loss of 5% for such raw materials. The company will not
receive any compensation for the spoilt material.

Required: Determine the raw material cost per Kg.

 EXAMPLE 3: NORMAL & ABNORMAL LOSS

Following information relates to the import of sealing rings by ABC Ltd.

Sealing rings: 1000 pieces @ $ 2 per piece (CIF price); converted into INR @ Rs.
82 per USD (USDINR rate). 1% Handing charges are payable on the CIF value.
Basic Custom Duty is paid @ 100% on the assessable value (CIF+ handling
charges). In addition, IGST @ 18% is applicable. The IGST is payable on the
invoiced value (CIF) + custom duty and other import duties (handling charges).
Freight charges of Rs. 11820 are paid for transporting goods from Bombay port to
the factory premises.
 On inspection, it was found that 100 pieces of above material were broken. The broken parts
have no value (Waste). Furthermore, no refund for broken material was documented in the
contract.
 Based on the prior experience, the management expects 6% loss in the case of Sealing rings
as Normal Loss.
 The entire quantity of 900 pieces was issued for production.

Required
 Total cost of material ?
 Unit cost of material issued to production department?
 How would the rejected pieces in inspection be treated in cost accounts?
Following information relates to the import of sealing rings by ABC Ltd.
Sealing rings: 1000 pieces @ $ 2 per piece (CIF price); converted into INR @ Rs. 82
per USD (USDINR rate). 1% Handing charges are payable on the CIF value. Basic
Custom Duty is paid @ 100% on the assessable value (CIF+ handling charges). In
addition, IGST @ 18% is applicable. The IGST is payable on the invoiced value
(CIF) + custom duty and other import duties (handling charges). Freight charges of
Rs. 11820 are paid for transporting goods from Bombay port to the factory premises.
 On inspection, it was found that 100 pieces of above material were broken. The broken parts
have no value (Waste). Furthermore, no refund for broken material was documented in the
contract.
 Based on the prior experience, the management expects 6% loss in the case of Sealing rings as
Normal Loss.
 The entire quantity of 900 pieces was issued for production.
 SOLUTION
Total Purchasing Cost/ Total Cost of Material
Total cost
(in Rupees)
Sealing ring 1000 no. @ $2/ unit (exchange rate Rs. 82/ $) 164000

Add: Handling charges (1% of CIF)

1640
Add: Basic Customs Duty (100% of CIF + Handling Charges) 165640
Add: IGST (18% of CIF+HC+BCD) 59630.4
 Add:cost
Unit Freight charges – issued
of material port to factory
to production 11820 402,730.4
Less: Input Tax
Material Credit
needs tofor
be IGST*
issued at inflated cost to cover normal losses 59630.4
Total Purchasing Cost 343,100
Hence, unit cost of material
Total Material Cost

(Total No. of Units Purchased  Normal Loss )

 =343100/(1000 – 60) = Rs. 365 per unit

 Abnormal loss on 40 units = 365 x 40 = Rs. 14,600 will be debited to Costing P&L a/c.
 Cross checking ( reconciliation)

* assuming that sealing rings are covered under GST Input Tax Credit scheme.
 EXAMPLE: NORMAL & ABNORMAL LOSS
In addition to the information provided in Ex. 3, assume the following:
 Case 2: The broken sealing rings can be sold at Rs. 47 per unit.

 Case 3: Further, suppose that the actual loss is 25 sealing rings instead of
100. The broken sealing rings can be sold at Rs. 47 per unit.
 ADDITIONAL PROBLEMS

 Material Costing: Problems on material costing

LABOUR/ EMPLOYEE COSTING & CONTROL
 ELEMENTS OF LABOUR COST

Cost Elements

Material Labor Expense (s)

Direct Labor

Indirect Material Indirect Labour Indirect Expense

OVERHEADS
 EMPLOYEE/ LABOR COSTS
 Labor is the physical or mental efforts expended/ utilized in the
production (rendering) of a product (service).

 This includes wages & salary paid to everyone from temporary

helper to the CEO of the company. (WAGES AND
SALARIES)

 Forms substantial part of COP/ Operating cost in a labor-intensive/ service

industries (e.g., in IT industry, Labour cost accounts for nearly 50 % of total
cost).

“Rich labor resources and mounting employment pressures will make it a

must for India to continue to develop labor-intensive manufacturing
industries … (e.g., Toy, Apparel, Footwear industry, BPOs, KPOs etc.)”

 Labor costs can be divided into direct and indirect costs. This
classification is usually based on the employee’s relationship to the
finished product.
SELECT ASPECTS OF LABOUR COSTS
 SELECT ASPECTS OF LABOUR COSTS REQUIRING SPECIAL
TREATMENT
 IDLE TIME
Difference between the labour hours purchased (paid for) and the actual
productive labour hours.
for example, Employees ‘on the bench’ in an IT firm.
It can be traced to the normal tea/ lunch breaks, lack of orders, machine
breakdowns, material shortages, poor scheduling, etc.

 OVER TIME & SHIFT PREMIUM

When an employee (direct or indirect) is required to work beyond normal
working hours, the rate at which they are paid for such hours is termed as
over-time rate. When employees work on odd shifts, they are paid at a
higher rate. The difference is referred to as the ‘Overtime Premium’.
NOTE: Unless, otherwise specified, the cost of idle time & overtime is
generally considered as overheads (indirect costs). In case overtime is
caused by a rush order, it becomes a direct cost for that order.
IDLE TIME
 SELECT ASPECTS OF LABOUR COSTS REQUIRING SPECIAL
TREATMENT

IDLE TIME
 NORMAL IDLE TIME (inevitable loss of labour hours)
 Tea & lunch break

 Machine or job setting time

 Travelling time from one dept. to another

 Elapse of time between finishing one job & starting other (normal fatigue)

 ABNORMAL IDLE TIME

 Strikes

 Lockouts

 Fire, flood

 Power failure

 Breakdown of machine

 Bottlenecks in production due to shortage of material, poor scheduling,

etc.
 SELECT ASPECTS OF LABOUR COSTS REQUIRING SPECIAL
TREATMENT

IDLE TIME
 Normal Idle Time

 In case of direct labour, revise the labour rate.

 In case of indirect labour, revise the overheads rate.

 Abnormal Idle Time (Controllable or Uncontrollable?)

 Its payment is not recorded as cost of production
 Charged directly to Costing P&L a/c
EXAMPLE 4.1
 EXAMPLE 4.2
A direct worker is paid Rs. 6,000 p.m. as basic pay, and the
dearness allowance (DA) @ 100% of the basic pay per month. The
employee and employer contribute 10% and 15% of the ‘Basic+DA’
towards the provident fund, and 1.75% and 5% of the wages paid
(Basic+DA) towards ESI. The non-monetary benefits cost the
employer Rs. 2,400 p.m. Actual number of working days are 250
per year (8 Hours per day), after adjustment for weekly offs,
holidays, and leave entitlement. Normal idle time is 10%. Also,
every year, the top 10% employees of the company (from every
category) get a bonus of 25% of ‘Basic+DA’.

 Required: Determine wage rate per hour for costing

purpose.
A direct worker is paid Rs. 6,000 p.m. as basic pay, and the dearness
allowance (DA) @ 100% of the basic pay per month. The employee and
employer contribute 10% and 15% of the ‘Basic+DA’ towards the
provident fund, and 1.75% and 5% of the wages paid (Basic+DA) towards
ESI. The non-monetary benefits cost the employer Rs. 2,400 p.m. Actual
number of working days are 250 per year (8 Hours per day), after
adjustment for weekly offs, holidays, and leave entitlement. Normal idle
time is 10%. Also, every year, the top 10% employees of the company
(from every category) get a bonus of 25% of ‘Basic+DA’.
 Solution
Particulars Amount (₹)
Basic pay 6,000
Add: Dearness Allowance @ 100% 6,000
Add: Contribution to PF @ 15% of Basic pay + DA 1,800

Add: Employer's E.S.I. contribution @ 5% of Basic pay + DA 600

Add: Non-monetary benefits 2,400
Gross Salalry/ Total cost to company per month 16,800
Annual Salary 201,600
Annual Bonus (12000*12*.25*.1) 3600
Total no. of Hours paid for (8*250) 2,000
Less: Normal Idle Time @ 10% 200
Total Hours expected to work for 1,800
Labour rate per hour [(Rs. 201,600+3600)/1,800] 114
SELECT ASPECTS OF LABOUR COSTS: OVERTIME
SELECT ASPECTS OF LABOUR COSTS REQUIRING SPECIAL
TREATMENT

Overtime
Work done beyond normal hours

Workers are paid at a higher rate than the regular rate.

The difference between the regular and overtime rates is

termed as ‘Overtime Premium’. In the case of Shifts, odd-
shifts attract higher wages, and the difference is termed as
‘Shift Premium’.
 EXAMPLE 5: OVERTIME AND EMPLOYEE COST
Assume that in Example 4.2, the company estimates that this class of
employees will work for additional four hours per day (beyond normal
working hours - 8 hours a day) for three months in a year to cope with
the general increase in production during festive seasons. The company
is liable to pay 100% (Basic+DA) overtime premium (over and above
the regular salary and benefits) if an employee works for more than 9
hours. For 9th hour only single rate will be paid.

Required: Determine the labour rate per hour.

 SELECT ASPECTS OF LABOUR COSTS REQUIRING SPECIAL
TREATMENT

Causes of Overtime
 Scheduling more production (Examples: Seasonal Production, More
work on week-ends, among others)
 The shift premium needs to be borne by all the unit produced
during the whole day and should not be confined to those
produced in odd shifts.
 Charged to production overheads. Distributed to all orders
during that particular period.

 Rush orders (Example: bulk orders placed on Saturday afternoon to be

delivered on Monday.)
OT necessitated with one particular order. That order should be
logically charged with full labour cost.
No other order receives benefit of OT working. Thus, no part of
OT is charged to any other job.
 SELECT ASPECTS OF LABOUR COSTS REQUIRING SPECIAL
TREATMENT

Treatment of Overtime (Based on causes)

Normal/ Expected
 AS PART OF DIRECT LABOUR COST (Rush Order)
• When exclusively associated with a particular product/ Job.

 AS PART OF FACTORY OVERHEADS

(when caused by increase in production volume, e.g., seasonal
manufacturing firms like Sugar Industry)
 OT prorated equally for all works done during given period
 In case the Overtime premium is being paid due to inefficiency of some other
department, it should be transferred to Overheads of that Department.

Abnormal: Debited to Costing P/L A/C

 In case OT is attributed to some abnormal factors (say, machine breakdown), it should be
debited to Costing P & L a/c.