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Intermediate Course
Study Material
(Modules 1 to 2)

Paper 3

Cost and Management

Accounting
Module - 1

BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

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ii

This Study Material has been prepared by the faculty of the Board of Studies. The
objective of the Study Material is to provide teaching material to the students to enable
them to obtain knowledge in the subject. In case students need any clarification or
have any suggestion for further improvement of the material contained herein, they
may write to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner useful
for the students. However, the Study Material has not been specifically discussed by the
Council of the Institute or any of its Committees and the views expressed herein may
not be taken to necessarily represent the views of the Council or any of its Committees.
Permission of the Institute is essential for reproduction of any portion of this material.

© The Institute of Chartered Accountants of India

All rights reserved. No part of this book may be reproduced, stored in a retrieval system,
or transmitted, in any form, or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without prior permission, in writing, from the publisher.

Edition : July, 2017

Website : www.icai.org

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Committee/ : Board of Studies

Department

ISBN No. : 978-81-8441-881-1

Price : 300/- (For All Modules)

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Chartered Accountants of India, ICAI Bhawan, Post Box No.
7100, Indraprastha Marg, New Delhi 110 002, India.

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July/2017/P2117 (New)

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BEFORE WE BEGIN….

The traditional role of a Chartered Accountant restricted to accounting and auditing,

has now changed substantially and there has been a marked shift towards strategic
decision making and entrepreneurial roles that add value beyond traditional financial
reporting. The primary factors responsible for the change are the increasing business
complexities on account of plethora of laws, borderless economies consequent to gi-
ant leap in e-commerce, emergence of new financial instruments, emphasis on corpo-
rate social responsibility, significant developments in information technology, to name
a few. These factors necessitate an increase in the competence of Chartered Account-
ants to take up the role of not merely an accountant or auditor, but a global solution
provider. Towards this end, the scheme of education and training is being continuously
reviewed so that it is in sync with the requisites of the dynamic global business envi-
ronment; the competence requirements are being continuously reviewed to enable
aspiring chartered accountants to acquire the requisite professional competence to
take on new roles.
Under the Revised Scheme of Education and Training, at the Intermediate Level, you
are expected to not only acquire professional knowledge but also the ability to apply
such knowledge in problem solving. The process of learning should also help you
inculcate the requisite professional skills, i.e., the intellectual skills and communication
skills, necessary for achieving the desired professional competence.
The entire syllabus has been divided into fifteen chapters. The chapters have been
grouped into two modules
• Module- 1 Consisting of seven chapters namely :
Chapter- 1 : Introduction to Cost and Management Accounting
Chapter- 2 : Material Cost
Chapter- 3 : Employee Cost and Direct Expenses
Chapter- 4 : Overheads: Absorption Costing method
Chapter -5 : Activity Based Costing (ABC)
Chapter- 6 : Cost Sheet
Chapter- 7 : Cost Accounting Systems

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• Module- 2 Consisting of eight chapters namely :

Chapter- 8 : Unit & Batch Costing
Chapter- 9 : Job and Contract Costing
Chapter- 10 : Process & Operation Costing
Chapter- 11 : Joint Products & By Products
Chapter- 12 : Service Costing
Chapter- 13 : Standard Costing
Chapter -14 : Marginal Costing
Chapter -15 : Budget and Budgetary Control
The content for each chapter at the Intermediate level has been structured in the fol-
lowing manner –
1. Learning Outcomes – Learning outcomes which you need to demonstrate after
learning each topic have been detailed in the first page of each chapter. Demonstra-
tion of these learning outcomes would help you to achieve the desired level of techni-
cal competence.
2. Chapter Overview - As the name suggests, this chart/table would give a broad
framework of the contents covered in the chapter.
3. Introduction – A brief introduction is given at the beginning of each chapter, which
would help you get a feel of the topic.
4. Content - In each chapter, the topics have been covered following ‘step by step’
approach. The concepts are explained in student-friendly manner with the aid of Ex-
amples/illustrations/diagrams/flow charts as per requirement. These value additions
would help you develop conceptual clarity and to get a good grasp of the topic. Dia-
grams and Flow charts would help you understand the concepts in a better manner.
Illustrations would help you understand the application of concepts/provisions.
5. Illustration with answers – Illustrations and examples have been included in the
Study Material systematically, after discussion on each topic, so that application of
the concept can be understood very clearly. This would also enable you to learn and
sharpen your application skills and test your understanding.
6. Let us recapitulate – A summary of the chapter is given at the end to help you re-
vise what you have learnt. It would especially help you to revise the chapter(s) quickly
the day before the examination.

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7. Test your Knowledge - This comprises of Multiple Choice Questions, Theoretical

Questions and Practical Problems with solutions which test the breadth and depth of
your understanding of the topic.
In this Study Material, formats of Financial Statements (i.e. Balance Sheet, Income
Statements etc) and financial terms used are for illustrative purpose only. For appro-
priate format and applicability of various Standards, students are advised to refer the
study material of appropriate subject (s).
Every effort has been made to make the Study Material error free, however if inadvert-
ently any error is present and found by readers they may send it to us immediately, so
that it can be rectified at our end.
In case you need any further clarification/ guidance, you may send your queries at
[email protected]; and [email protected].

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SYLLABUS
PAPER – 3 : COST AND MANAGEMENT ACCOUNTING
(One paper – Three hours – 100 Marks)

Objectives :
(a) To develop an understanding of the basic concepts and applications to es-
tablish the cost associated with the production of products and provision
of services and apply the same to determine prices.
(b) To develop an understanding of cost accounting statements.
(c) To acquire the ability to apply information for cost ascertainment, planning,
control and decision making.
Contents :
1. Overview of Cost and Management Accounting
(i) Introduction to Cost and Management Accounting
(a) Objectives and Scope of Cost and Management Accounting,
(b) The users of Cost and Management accounting information, Func-
tions of management accounting.
(c) Role of cost accounting department in an organisation and its rela-
tion with other departments.
(d) Installation of Costing System
(e) Relationship of Cost Accounting, Financial Accounting, Manage-
ment Accounting and Financial Management.
(f) Cost terms and Concepts
(g) Cost Reduction and Cost Control
(h) Elements of Costs
(i) Cost behavior pattern, Separating the components of fixed, vari-
able, semi-variable and step costs.
( j) Methods of Costing, Techniques of Costing.
(k) Cost Accounting with use of Information Technology.

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(ii) Elements of Cost and preparation of Cost Sheets

(a) Functional classification and ascertainment of cost
(b) Preparation of Cost Sheets for Manufacturing sector and for Ser-
vice sector
2. Ascertainment of Cost and Cost Accounting System
(i) Material Cost
(a) Procurement procedures-Store procedures and documentation in
respect of receipts and issue of stock, Stock verification,
(b) Valuation of material receipts,
(c) Inventory control-
- Techniques of fixing level of stocks- minimum, maximum, re-or-
der point, safety stock, determination of optimum stock level,
- Determination of Optimum Order quantity- Economic Order
Quantity (EOQ),
- Techniques of Inventory control- ABC Analysis, Fast, Slow mov-
ing and Non moving (FSN), High, Medium, Low (HML), Vital, Es-
sential, Desirable (VED), Just-in-Time (JIT)- Stock taking and per-
petual inventory system, use of control ratios,
(d) Inventory Accounting
(e) Consumption- Identification with products of cost centres, Basis for
consumption entries in financial accounting, monitoring consump-
tion.
(ii) Employee Cost
(a) Attendance and Payroll procedures-
- Elements of wages- Basic pay, Dearness Allowance, Overtime,
Bonus, Holiday and leave wages, Allowances and perquisites.
(b) Employee Cost Control
(c) Employee Turnover- Methods of calculating employee turnover,
causes of employee turnover, effects of employee turnover.
(d) Utilisation of Human Resource, Direct and indirect employee Cost,
charging of employee cost, Identifying employee hours with work
orders or batches or capital jobs.

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(e) Remuneration systems and incentive schemes-

- Time Rate System, Piece Rate System, Differential piece rate sys-
tem, Calculation of wages, Effective Wages.
(iii) Direct Expenses
(a) Direct expenses
(b) Nature of Direct or Chargeable expenses.
(c) Sub-contracting- Control on material movements, Identification
with the main product or service.
(iv) Overheads
(a) Functional analysis- Factory, Administration, Selling, Distribution,
Research and Development.
(b) Behavioral analysis- Fixed, Variable and Semi- Variable.
(c) Allocation and Apportionment of overheads using Absorption
Costing Method.
(d) Factory Overheads- Primary and secondary distribution,
(e) Administration Overheads- Method of allocation to cost centres or
products,
(f) Selling & Distribution Overheads- Analysis and absorption of the
expenses in products/ customers, impact of marketing strategies,
cost effectiveness of various methods of sales promotion.
(g) Treatment of Research and development cost in cost accounting.
(v) Concepts of Activity Based Costing (ABC)
(vi) Recording and Accounting of Costs
(a) Non-integrated Cost Accounting system- Ledger under non-inte-
gral system
(b) Integrated (Cost and Financial) Accounting system- Ledgers under
integral system.
(c) Difference between the Non- integrated and Integrated Account-
ing system.
(d) Reconciliation of profit as per Cost and Financial Accounts (under
Non-Integrated Accounting System).

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3. Methods of Costing
(i) Single Output/ Unit Costing
(ii) Job Costing : Job cost cards and databases, collecting direct costs of
each job, attributing overheads to jobs, Application of job costing.
(iii) Batch Costing : Determination of optimum batch quantity, Ascertain-
ment of cost for a batch, Preparation of batch cost sheet, Treatment of
spoiled and defective work.
(iv) Contract Costing
(a) Ascertainment of cost of a contract, Progress payment, Retention
money, Escalation clause, Cost plus contract, Value of work certi-
fied, Cost of Work not certified.
b) Determination Value of work certified, Cost of work not certified,
Notional or Estimated profit from a contact.
(v) Process/ Operation Costing
(a) Process cost recording, Process loss, Abnormal gains and losses,
Equivalent units of production, Inter-process profit, Valuation of
work in process.
(b) Joint Products- Apportionment of joint costs, Methods of appor-
tioning joint cost over joint products,
(c) By-Products- Methods of apportioning joint costs over by-prod-
ucts, treatment of By-product cost.
(vi) Costing of Service Sectors
a) Determination of Costs and Prices of services of following sectors/
Industries:
- Transport, Toll roads, Hospitals, Canteen/ Restaurants, Hotels/
Lodges, Educational Institutions, Financial Institutions/ Banks,
Insurance, IT sector and other services.
4. Cost Control and Analysis
(i) Standard Costing
(a) Setting up of Standards, Types of Standards, Standard Costing as
method of performance measurement.

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(b) Calculation and Reconciliation of Cost Variances-

- Material Cost Variance, employee Cost Variance, Variable Over-
heads Variance and Fixed Overhead Variance.
(ii) Marginal Costing
(a) Basic concepts of marginal costing, Contribution margin, Break-
even analysis, Break –even and profit volume charts, Contribution
to sales ratio, Margin of Safety, Angle of Incidence, Cost-Volume-
Profit Analysis (CVP), Multi- product break- even analysis, Consid-
eration of Limiting factor (key factor),
(b) Determination of Cost of a product/ service under marginal costing
method, determination of cost of finished goods, work-in-progress,
(c) Comparison of Marginal costing with absorption costing method-
Reconciliation of profit under the both methods,
(d) Short term decision making using the above concepts (basic / fun-
damental level).
(iii) Budget and Budgetary Control
(a) Meaning of Budget, Essentials of Budget, Budget Manual, Budg-
et setting process, Preparation of Budget and monitoring proce-
dures.
(b) The use of budget in planning and control
(c) Flexible budget, Preparation of Functional budget for operating
and non- operating functions, Cash budget, Master budget,
(d) Introduction to Principal/ Key budget factor, Zero Based Budgeting
(ZBB), Performance budget, Control ratios and Budget variances.

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CONTENTS
MODULE – 1
Chapter 1 – Introduction to Cost and Management Accounting
Chapter 2 – Material Cost
Chapter 3 – Employee Cost and Direct Expenses
Chapter 4 – Overheads: Absorption Costing Method
Chapter 5 – Activity Based Costing
Chapter 6 – Cost Sheet
Chapter 7 – Cost Accounting System

MODULE – 2
Chapter 8 – Unit & Batch Costing
Chapter 9 – Job Costing and Contract Costing
Chapter 10 – Process & Operation Costing
Chapter 11 – Joint Products & By Products
Chapter 12 – Service Costing
Chapter 13 – Standard Costing
Chapter 14 – Marginal Costing
Chapter 15 – Budget and Budgetary Control

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DETAILED CONTENTS : MODULE-1

Pages
CHAPTER 1 – INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING
1.1 Introduction ....................................................................................................................... 1.2
1.2 Objectives of Cost Accounting ................................................................................... 1.3
1.3 Scope of Cost Accounting ............................................................................................. 1.5
1.4 Relationship of Cost and Management Accounting with other related
disciplines............................................................................................................................. 1.6
1.5 Role & Functions of Cost and Management Accounting.................................. 1.8
1.6 Users of Cost and Management Accounting ......................................................... 1.9
1.7 Essentials of a Good Cost Accounting System ...................................................... 1.10
1.8 Installation of Costing System...................................................................................... 1.11
1.9 Cost Accounting with the use of Information Technology (IT)........................ 1.12
1.10 Cost Objects ........................................................................................................................ 1.13
1.11 Responsibility Centres ..................................................................................................... 1.15
1.12 Limitations of Cost Accounting ................................................................................... 1.16
1.13 Classification of Costs...................................................................................................... 1.17
1.14 Methods of Costing ......................................................................................................... 1.27
1.15 Techniques of Costing ..................................................................................................... 1.28
Summary .............................................................................................................................. 1.29
Test Your Knowledge ....................................................................................................... 1.31
Answers/ Solutions ........................................................................................................... 1.33

CHAPTER 2 – MATERIAL COST

2.1 Introduction......................................................................................................................... 2.2
2.2 Material control ................................................................................................................ 2.3
2.3 Materials Procurement Procedure ............................................................................. 2.5
2.4 Valuation of Material Receipts ..................................................................................... 2.10
2.5 Material Storage & Records .......................................................................................... 2.14
2.6 Inventory Control .............................................................................................................. 2.17
2.7 Material Issue Procedure................................................................................................ 2.38
2.8 Valuation of Material Issues .......................................................................................... 2.40

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2.9 Valuation of Returns & Shortages .............................................................................. 2.50

2.10 Treatment of normal and abnormal loss of materials......................................... 2.50
2.11 Consumption of Materials ............................................................................................. 2.53
Summary .............................................................................................................................. 2.56
Test Your Knowledge ....................................................................................................... 2.58
Answers/ Solutions ........................................................................................................... 2.64

CHAPTER 3 –EMPLOYEE COST AND DIRECT EXPENSES

3.1 Introduction......................................................................................................................... 3.2
3.2 Employee (Labour) Cost ................................................................................................. 3.3
3.3 Employee (Labour) Cost Control ................................................................................ 3.4
3.4 Attendance & Payroll Procedures ............................................................................... 3.5
3.5 Idle Time ............................................................................................................................... 3.11
3.6 Overtime ............................................................................................................................... 3.13
3.7 LabourUtilisation ............................................................................................................... 3.20
3.8 Systems of Wage Payment and Incentives .............................................................. 3.21
3.9 Absorption of Wages ....................................................................................................... 3.42
3.10 Efficiency Rating Procedures ........................................................................................ 3.45
3.11 Employee (Labour) Turnover......................................................................................... 3.47
3.12 Direct Expenses .................................................................................................................. 3.53
Summary .............................................................................................................................. 3.54
Test Your Knowledge ....................................................................................................... 3.56
Answers/ Solutions ........................................................................................................... 3.61

CHAPTER 4 – OVERHEADS: ABSORPTION COSTING METHOD

4.1 Introduction......................................................................................................................... 4.2
4.2 Classification of Overheads ........................................................................................... 4.2
4.3 Accounting and Control of Manufacturing Overheads .................................... 4.6
4.4 Steps for the Distribution of Overheads .................................................................. 4.9
4.5 Methods of Absorbing Overheads to Various Products or Jobs ................... 4.22
4.6 Types of Overhead Rates................................................................................................ 4.28
4.7 Treatment of Under-Absorbed and Over-Absorbed Overheads in
Cost Accounting ................................................................................................................ 4.35

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4.8 Accounting and Control of Administrative Overheads ..................................... 4.39

4.9 Accounting and Control of Selling and Distribution Overheads .................... 4.43
4.10 Concepts Related to Capacity ..................................................................................... 4.47
4.11 Treatment of Certain Items in Costing ..................................................................... 4.48
Summary .............................................................................................................................. 4.51
Test Your Knowledge ....................................................................................................... 4.52
Answers/ Solutions ........................................................................................................... 4.60

CHAPTER 5 – ACTIVITY BASED COSTING

5.1 Introduction to Activity Based Costing ..................................................................... 5.2
5.2 Meaning and Definition.................................................................................................. 5.3
5.3 Meaning of Terms used in ABC ................................................................................... 5.3
5.4 Cost Allocation under ABC ............................................................................................ 5.4
5.5 Traditional Absorption Costing vs ABC .................................................................... 5.5
5.6 Level of Activities under ABC Methodology/ Cost Hierarchy .......................... 5.6
5.7 Stages in Activity Based Costing (ABC) .................................................................... 5.7
5.8 Advantages of Activity Based Costing ...................................................................... 5.13
5.9 Limitations of Activity Based Costing ........................................................................ 5.13
5.10 Requirements in ABC Implementation ..................................................................... 5.14
5.11 Practical Applications of Activity Based Costing ................................................... 5.14
Summary .............................................................................................................................. 5.21
Test Your Knowledge ....................................................................................................... 5.21
Answers/ Solutions ........................................................................................................... 5.26

CHAPTER 6 – COST SHEET

6.1 Introduction......................................................................................................................... 6.1
6.2 Functional Classification of Elements of Cost ........................................................ 6.2
6.3 Cost Heads in a Cost Sheet ........................................................................................... 6.3
6.4 Cost Sheet/ Statement .................................................................................................... 6.6
Summary .............................................................................................................................. 6.9
Test Your Knowledge ....................................................................................................... 6.10
Answers/ Solutions ........................................................................................................... 6.13

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CHAPTER 7 – COST ACCOUNTING SYSTEM

7.1 Introduction......................................................................................................................... 7.2
7.2 Non-Integrated Accounting System .......................................................................... 7.2
7.3 Integrated (Integral) Accounting System ................................................................. 7.24
7.4 Reconciliation of Cost and Financial Accounts ...................................................... 7.34
7.5 Accounting for Management Information and Cost Control. ......................... 7.44
Summary .............................................................................................................................. 7.46
Test Your Knowledge ....................................................................................................... 7.47
Answers/ Solutions ........................................................................................................... 7.53

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CHAPTER 1
INTRODUCTION TO COST
AND MANAGEMENT
ACCOUNTING
LEARNING OUTCOMES
r State the meaning, objective and importance of cost and
management accounting.
r Discuss the functions and role of cost accounting department
in an organization.
r Discuss the essentials of cost and management accounting
and to know how a system of cost accounting is installed.
r Differentiate between cost accounting with financial
accounting and management accounting.
r List the various elements of cost and the way these are
classified.
r Explain the methods of segregating semi-variable costs into
fixed and variable cost.
r Discuss the concept of cost reduction and cost control.
r Discuss the methods and techniques of costing.
r Discuss cost accounting with the use of information technology.

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1.2 COST AND MANAGEMENT ACCOUNTING

CHAPTER OVERVIEW

Objectives of Cost Cost Accounting

Accounting Cost Objects
using IT

Users of Cost and

Scope of Cost Responsibility
Management
Accounting Accounting Centres

Relationship of Cost Role & Functions of

and Management Cost and
Accounting with Cost Classification
Management
other related Accounting
desciplines

1.1 INTRODUCTION
Michael E. Porter in his theory of Generic Competitive Strategies has described ‘Cost
Leadership’ as one of the three strategic dimensions (others are ‘Product differentiation’
and ‘Focus or Niche’) to achieve competitive advantage in industry. Cost Leadership
implies producing goods or provision of services at lowest cost while maintaining
quality to have better competitive price. In a business environment where each entity
is thriving to achieve apex position not only in domestic but global competitive market,
it is essential for the entity to fit into any of the three competitive strategic dimensions.
Cost Leadership, also in line with the subject Cost and Management Accounting, can
be achieved if an entity has a robust cost and management accounting system in place.
In this chapter, we will learn various aspects of cost and management accounting and
its application in different manufacturing and service environment.
1.1.1 Meaning and Definition
(i) Cost-As a noun-The amount of expenditure (actual or notional) incurred on or
attributable to a specified article, product or activity.
As a verb- To ascertain the cost of a specified thing or activity.
(ii) Costing- Costing is defined as “the technique and process of ascertaining costs”.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.3

According to CIMA “an organisation’s costing system is the foundation of the internal
financial information system for managers. It provides the information that management
needs to plan and control the organisation’s activities and to make decisions about the
future.”
(iii) Cost Accounting-Cost Accounting is defined as “the process of accounting for
cost which begins with the recording of income and expenditure or the bases on which
they are calculated and ends with the preparation of periodical statements and reports
for ascertaining and controlling costs.”
(iv) Cost Accountancy-Cost Accountancy has been defined as “the application of
costing and cost accounting principles, methods and techniques to the science, art
and practice of cost control and the ascertainment of profitability. It includes the
presentation of information derived there from for the purpose of managerial decision
making.”
(v) Management Accounting-As per CIMA Official Terminology “Management
accounting is the application of the principles of accounting and financial management
to create, protect, preserve and increase value for the stakeholders of for-profit and
not-for-profit enterprises in the public and private sectors.”
Management accounting is an integral part of management. It assists management
by provision of relevant information for planning, organising, controlling, decision
making etc.
(vi) Cost Management- It is an application of management accounting concepts,
methods of collections, analysis and presentation of data to provide the information
needed to plan, monitor and control costs.

1.2 OBJECTIVES OF COST ACCOUNTING

The main objectives of cost accounting are explained as below:
(i) Ascertainment of Cost: The main objective of cost accounting is accumulation
and ascertainment of cost. Costs are accumulated, assigned and ascertained for
each cost object.
(ii) Determination of Selling Price and Profitability: The cost accounting system
helps in determination of selling price and thus profitability of a cost object.
Though in a competitive business environment, selling prices are determined by
external factors but cost accounting system provides a basis for price fixation and
rate negotiation.
(iii) Cost Control: Maintaining discipline in expenditure is one of the main objective
of a good cost accounting system. It ensures that expenditures are in consonance
with predetermined set standard and any variation from these set standards is
noted and reported on continuous basis. To exercise control over cost, following
steps are followed:
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1.4 COST AND MANAGEMENT ACCOUNTING

(a) Determination of pre-determined standard or results: Standard cost or

performance targets for a cost object or a cost centre is set before initiation
of production or service activity. These are desired cost or result that need to
be achieved.
(b) Measurement of actual performance: Actual cost or result of the cost object
or cost centre is measured. Performance should be measured in the same
manner in which the targets are set i.e. if the targets are set operation-wise,
and then the actual costs should also be collected and measured operation-
wise to have a common basis for comparison.
(c) Comparison of actual performance with set standard or target: The actual
performance so measured is compared against the set standard and desired
target. Any deviation (variance) between the two is noted and reported to the
appropriate person or authority.
(d) Analysis of variance and action: The variance in results so noted are further
analysed to know the reasons for variance and appropriate action is taken to
ensure compliance in future. If necessary, the standards are further amended
to take developments into account.
(iv) Cost Reduction: It may be defined “as the achievement of real and permanent
reduction in the unit cost of goods manufactured or services rendered without
impairing their suitability for the use intended or diminution in the quality of the
product.”
Cost reduction is an approach of management where cost of an object is believed
to be further reducible. No cost is termed as lowest and every possibility of cost
reduction is explored. To do cost reduction, the following action is taken:
(a) Each activity within an entity is segmented to analyse and identify value added
and non- value added activities. All non-value added activities are eliminated
without affecting the essential characteristics of the product or process. Value
chain Analysis, a strategic tool, developed by Michael Porter, is one of the
method to do value analysis.
(b) Conducting continuous research and study to know better way to do anything.
The three-fold assumptions involved in the definition of cost reduction may be
summarised as under:
(a) There is a saving in unit cost.
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if not
improved.
(v) Assisting management in decision making: Cost and Management accounting
by providing relevant information, assists management in planning, implementing,
measuring, controlling and evaluation of various activities. A robust cost and
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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.5

management accounting system not only provides information internal to industry

but external also.
1.2.1 Difference between Cost Control and Cost Reduction
Cost Control Cost Reduction
1. Cost control aims at maintaining 1. Cost reduction is concerned with
the costs in accordance with the reducing costs. It challenges all
established standards. standards and endeavours to better
them continuously
2. Cost control seeks to attain lowest 2. Cost reduction recognises no
possible cost under existing condition as permanent, since a
conditions. change will result in lower cost.
3. In case of cost control, emphasis is on 3. In case of cost reduction, it is on
past and present present and future.
4. Cost control is a preventive function 4. Cost reduction is a corrective function.
It operates even when an efficient
cost control system exists.
5. Cost control ends when targets are 5. Cost reduction has no visible end.
achieved.

1.3 SCOPE OF COST ACCOUNTING

Scope of cost accounting consists of the following functions:
(i) Costing: Costing is the technique and process of ascertaining costs of products or
services. The cost ascertainment procedure is governed by some cost accounting
principles and rules. Generally, cost is ascertained using some arithmetical process.
(ii) Cost Accounting: This is a process of accounting for cost which begins with the
recording of expenditure and ends with the preparation of periodical statement
and reports for ascertaining and controlling cost. Cost Accounting is a formal
mechanism of cost ascertainment.
(iii) 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. This also helps in better cost management and
strategic decisions.
(iv) Cost Comparisons: Cost accounting also includes comparisons of cost from
alternative courses of actions 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.
(v) Cost Control: It involves a detailed examination of each cost in the light of
advantage received from the incurrence of the cost. Thus, we can state that cost

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1.6 COST AND MANAGEMENT ACCOUNTING

is analyzed to know whether cost is exceeding its budgeted cost and whether
further cost reduction is possible.
(vi) Cost Reports: This is the ultimate function of cost accounting. These reports are
primarily prepared for the use by the management at different levels. Cost Reports
helps in planning and control, performance appraisal and managerial decision
making.
(vii) Statutory Compliances: Maintaining cost accounting records as per the rules
prescribed by the statute to maintain cost records relating to utilization of
materials, labour and other items of cost as applicable to the production of goods
or provision of services as provided in the Act and these rules.

1.4 RELATIONSHIP OF COST AND MANAGEMENT

ACCOUNTING WITH OTHER RELATED DISCIPLINES
Cost and Management Accounting as a discipline is interrelated and dependent of
other disciplines of accounting.
1.4.1 Cost Accounting with Management Accounting
As we already studied that though Cost Accounting and Management Accounting is
used synonymously but there are few differences. Management Accounting is an open
ended discipline which enables managers to take informed decision. Management
Accounting takes inputs from cost accounts, financial accounts, statistical and operation
management tools etc.
Difference between Cost Accounting and Management Accounting
Basis Cost Accounting Management Accounting
(i) Nature It records the quantitative It records both qualitative
aspect only. and quantitative aspect.
(ii) Objective It records the cost of It Provides information to
producing a product and management for planning
providing a service. and co-ordination.
(iii) Area It only deals with cost It is wider in scope as it
Ascertainment. includes financial accounting,
budgeting, taxation, planning
etc.
(iv) Recording of It uses both past and present It is focused with the
data figures. projection of figures for
future.
(v) Development Its development is related to It develops in accordance to
industrial revolution. the need of modern business
world.
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(vi) Rules and It follows certain principles It does not follow any specific
Regulation and procedures for recording rules and regulations.
costs of different products.
1.4.2 Cost Accounting with Financial Accounting
Cost accounting accumulates and ascertain costs for goods sold and for inventories. It
provides inputs to record costs in financial accounting system.
Difference between Financial Accounting and Cost Accounting
Basis Financial Accounting Cost Accounting
(i) Objective Providing information about Ascertainment of cost for the
the financial performance of purpose of cost control and
an entity. decision making.

(ii) Nature It classifies records, present It classifies costs, records,

and interprets transactions in present, and interprets it in a
monetary terms. significant manner.
(iii) Recording of It records Historical data. It makes use of both historical
data and pre-determined costs.
(iv) Users of The users of financial The cost accounting
information accounting statements are information is generally used
shareholders, creditors, by internal management.
financial analysts and But some time regulatory
government and its agencies, authorities also.
etc.
(v) Analysis of It shows profit or loss of the It provides the cost details for
cost and organization either segment each cost object i.e. product,
profit wise or as a whole. process, job, contracts, etc.
(vi) Time period Financial Statements are Reports and statements
prepared usually for a year. are prepared as and when
required.
(vii) Presentation A set format is used In general, no set formats for
of information for presenting financial presenting cost information is
information. followed.

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1.8 COST AND MANAGEMENT ACCOUNTING

1.4.3 Cost and Management Accounting with Financial Management

Cost and Management Accounting is an application of financial management. The
techniques of financial management are used for decision making.
The relationship among Cost Accounting, Management Accounting, Financial
Accounting and Financial Management can be understood with the help of the
following diagram.

Financial Management
Accounting Accounting

Cost
Accounting

Financial Management

1.5 ROLE & FUNCTIONS OF COST AND MANAGEMENT

ACCOUNTING
The role of a cost and management accounting system is to:
• Provide relevant information to management for decision making,
• Assist management for planning, measurement, evaluation and controlling of
business activities,
• Help in allocation of cost to products and inventories for both external and internal
users.
Though the term cost accounting and management accounting is used by various
authors synonymously but in actual, cost accounting is concerned with accumulation
and allocation of costs to different cost objects. Whereas, management accounting
concerned with provision of information to internal users for decision making.
The functions of cost and management accounting includes:
(i) Collection and accumulation of cost for each element of cost.
(ii) Assigning costs to cost objects to ascertain cost.
(iii) Cost and management accounting department (whatever nomenclature may be
used to denote the department) sets budget and standards for a particular period or
activity beforehand and these are compared with the assigned and ascertained cost.
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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.9

Any deviation with the set standards are analysed and reported. All these mechanism
is done to control costs.
(iv) The main function of cost and management accounting is provision of relevant
information to the management for decision making. An Information system
environment is set up which is popularly known as management information system
(MIS). The MIS provides relevant and timely information related to both internal and
external to the organisation to enable management at all levels to take decisions.
Decisions include cost optimisation, price fixation, implementation of any plan related
with product, process, marketing etc.
(v) The performance of a responsibility centre is measured and evaluated against the
set standards. The function of cost and management accounting is to gather data like
time taken, wastages, process idleness etc., analyse the data, prepare reports and take
necessary actions.

1.6 USERS OF COST AND MANAGEMENT ACCOUN-

TING
Cost and management accounting information which are generated or collected are
used by different stakeholders. The users of the information can be broadly categorised
into internal and external to the entity.
Internal Users
Internal users, which use the cost and management accounting information may
include the followings:
(a) Managers- The managers use the information
(i) to know the cost of a cost object and a cost centre
(ii) to price for the product or service
(iii) to measure and evaluate performance of responsibility centres
(iv) to know the profitability- product-wise, department-wise, customer-wise etc.
(v) to evaluate the strategic options and to make decisions
(b) Operational level staffs- The operational level staffs like supervisors, foreman,
team leaders are requiring information
(i) to know the objectives and performance goals for them
(ii) to know product and service specifications like volume, quality and process etc.
(ii) to know the performance parameters against which their performance is measured
and evaluated.
(iii) to know divisional (responsibility centre) profitability etc.
(c) Employees- Employees are concerned with the information related with time and
attendance, incentives for work, performance standards etc.

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1.10 COST AND MANAGEMENT ACCOUNTING

External Users
External users, which use the cost and management accounting information may
include the followings:
(a) Regulatory Authorities- Regulatory Authorities are concerned with cost accounting
data and information for different purpose which includes tariff determination, providing
subsidies, rate fixation etc. To do this the regulatory bodies require information on the
basis of some standards and format in this regard.
(b) Auditors- The auditors while conducting audit of financial accounts or for some
other special purpose audit like cost audit etc., requires information related with
costing and reports reviewed by management etc.
(c) Shareholders- Shareholders are concerned with information that effect their
investment in the entity. Management communicate the shareholders through periodic
communique, annual reports etc. regarding new orders received, product expansion,
market share for products etc.
(d) Creditors and Lenders- Creditor and lenders are concerned with data and
information which affects an entity’s ability to serve lenders or creditors. For example,
any financial institutions which provides loan to an entity against book debts and stocks
are more concerned with regular reporting on net debt position and stock balances.

1.7 ESSENTIALS 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 meticulous 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.
(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.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.11

(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.
For this, an active role of management is required for the development of such a
system that reflect a strong conviction in using information for decision making.

1.8 INSTALLATION OF COSTING SYSTEM

As in the case of every other form of activity, it should be considered whether it would
be profitable to have a cost accounting system. Management of an organisation needs
complete and accurate information to make decisions. 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 under mentioned factors should be
studied:
(a) Objective: The objective of costing system, for example whether it is being
introduced for fixing prices or for insisting a system of cost control.
(b) Nature of Business or Industry: The Industry in which business is operating. Every
business industry has its own peculiarity and objectives. According to its cost
information requirement cost accounting methods are followed. For example,an
oil refinery maintains process wise cost accounts to find out cost incurred on a
particular process say in crude refinement process etc.
(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 product determines the type of costing system
to be implemented. The product which has by-products requires costing system
which accounts for by-products as well. In case of perishable or short self- life
products, marginal costing is appropriate to know the contribution and minimum
price at which products could be sold.
(e) Knowing the production process: A good costing system can never be established
without the complete knowledge of the production process. Cost apportionment
can be done on the most appropriate and scientific basis if a cost accountant can
identify degree of effort or resources consumed in a particular process. This also
includes some basic technical know-how and process peculiarity.

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1.12 COST AND MANAGEMENT ACCOUNTING

(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. For
example, in a typical business organisation accounts department needs to submit
monthly stock statement to its lender bank, quantity wise stock details at the time
of filing returns to tax authorities etc.
(g) Method of maintenance of cost records: 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 to be followed.
(i) Information Attributes: Information generated from the Costing system should
possess all the attributes of information i.e. complete, accurate, timeliness, relevant
etc. to have an effective management information system (MIS).

1.9 COST ACCOUNTING WITH THE USE OF INFORMA-

TION TECHNOLOGY (IT)
The information technology in a business organisation has become essential for
today’s business environment. With the expansion of e-commerce and increasing
competitive business environment, information technology is becoming an integral
part of each activity in an organisation including cost and management accounting.
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 got automated and improved. The
new industrial revolution in the form of digital innovation which is popularly known as
Industry 4.0, has more emphasis on digitisation and automation of business process to
have a better control over cost to maintain market competitiveness. Cost Accounting
system has seen lots of savings in terms of time, money and efforts. The impact of IT
in cost accounting may include the followings:
(i) After the introduction of ERPs, different 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 become simpler and less sophisticated.
(ii) A move towards paperless environment 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-copies from the system.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.13

(iii) Information Technology with the help of internet (including intranet and extranet)
helping in resource procurement and mobilisation. For example, production
department can get materials from the stores without issuing material requisition
note physically. Similarly, purchase orders can be initiated to the suppliers with the
help of extranet. This enables an entity to shift towards Just-in-Time (JIT) approach of
inventory management and production.
(iv) Cost information for a cost centre or cost object is ascertained with accuracy in
timely manner. Each cost centre and cost object is codified and all related costs are
assigned to the cost objects or cost centres using assigned codes. This automates the
cost accumulation and ascertainment process. The cost information can be customised
as per the requirement. For example, when an entity manufacture or provide services,
are able to know information job-wise, batch-wise, process-wise, cost centre wise etc.
(v) Uniformity in preparation of report, 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.
(vi) Cost and revenue variance reports are generated in real time basis which enables
the management to take control measures immediately.
(vii) IT enables an entity to monitor and analyse each process of manufacturing or
service activity closely to eliminate non value added activities.
The above are the examples of few areas where Cost Accounting is done with the help
of IT.

1.10 COST OBJECTS

Cost object is anything for which a separate measurement of cost is required. Cost
object may be a product, a service, a project, a customer, a brand category, an activity,
a department or a programme etc.
Examples of cost object are:
Product Smart phone, Tablet computer, SUV Car, Book etc.
Service An airline flight from Delhi to Mumbai, Concurrent audit assignment,
Utility bill payment facility etc.
Project Metro Rail project, Road projects etc.
Activity Quality inspection of materials, Placing of orders etc.
Process Refinement of crudes in oil refineries, melting of billets or ingots in
rolling mills etc.
Department Production department, Finance & Accounts, Safety etc.

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1.14 COST AND MANAGEMENT ACCOUNTING

1.10.1 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.
We may for instance, determine the cost per ton of steel, per ton-kilometre of a transport
service or cost per machine hour. Sometime, a single order or a contract constitutes a
cost unit. A batch which consists of a group of identical items and maintains its identity
through one or more stages of production may also be considered as a cost unit.
Cost units are usually the units of physical measurement like number, weight, area,
volume, length, time and value.
A few typical examples of cost units are given below:
Industry or Product Cost Unit Basis
Automobile Number
Cement Ton/ per bag etc.
Chemicals Litre, gallon, kilogram, ton etc.
Power Kilo-watt hour (kWh)
Steel Ton
Transport Passenger- kilometer
Gas Cubic feet
Some examples from the CIMA terminology are as follows:
Industry Sector Cost unit
Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)
Engineering Contract, job
Oil Barrel, tonne, litre
Hotel/Catering Room/meal
Professional services Chargeable hour, job, contract
Education Course, enrolled student, successful
student
Hospitals Patient day

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.15

Activity Cost unit

Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials storage/handling Requisition unit issued/received, material
movement, value issued/received
Personnel administration Personnel record
1.10.2 Cost Driver
A Cost driver is a factor or variable which effect level of cost. Generally, it is an activity
which is responsible for cost incurrence. Level of activity or volume of production is the
example of a cost driver. An activity may be an event, task, or unit of work etc.
CIMA Official terminology defines cost driver as“Factor influencing the level of cost.
Often used in the context of ABC to denote the factor which links activity resource
consumption to product outputs, for example the number of purchase orders would
be a cost driver for procurement cost.”
Examples of cost drivers are number of machines setting ups, number of purchase
orders, hours spent on product inspection, number of tests performed etc.

1.11 RESPONSIBILITY CENTRES

With the growth of an organisation, its functions, organisational structure and other
related functions also grows in terms of volume and complexity. 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 and are held responsible for performance in terms of expenditure,
revenue, profitability and return on investment. Performance of these responsibility
centres are measured against some set standards (input-output ratio, budgets etc.)
and evaluated against organisational goal and performance targets. There are four
types of responsibility centres:
(i) Cost Centres
(ii) Revenue Centres
(iii) Profit Centres
(iv) Investment Centres
(i) Cost 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

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1.16 COST AND MANAGEMENT ACCOUNTING

(a) Standards Cost Centres: Cost Centre where output is measurable and input
required for the output can be specified. Based on a well-established study, an estimate
of standard units of input to produce a unit of output is set. The actual cost for inputs
is compared with the standard cost. Any deviation (variance) in cost is measured and
analysed into controllable and uncontrollable cost. The manager of the cost centre is
supposed to comply with the standard and held responsible for adverse cost variances.
The input-output ratio for a standard cost centre is clearly identifiable.
(b) Discretionary Cost Centre: The cost centre whose output cannot be measured
in financial terms, thus input-output ratio cannot be defined. The cost of input is
compared with allocated budget for the activity. Example of discretionary cost centres
are Research & Development department, Advertisement department where output of
these department cannot be measured with certainty and co-related with cost incurred
on inputs.
(ii) Revenue Centres:
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. Though, revenue centres does not have control on expenditures
it incurs but some time expenditures related with selling activities like commission to
sales person etc. are incurred by revenue centres.
(iii) Profit Centres:
These are the responsibility centres which have both responsibility of generation
of revenue and incurrence of expenditures. Since, managers of profit centres are
accountable for both costs as well as revenue,profitability is the basis for measurement
of performance of these responsibility centres. Examples of profit centres are
decentralised branches of an organisation.
(iv) Investment Centres:
These are the responsibility centres which are not only responsible for profitability
but also has 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. Examples of investment centres are Maharatna, Navratna and Miniratna
companies of Public Sector Undertakings of Central Government.

1.12 LIMITATIONS OF COST ACCOUNTING

Like other branches of accounting, cost accounting is also having certain limitations.
The limitations of cost accounting are as follows:
1. Expensive: It is expensive because analysis, allocation and absorption of overheads
require considerable amount of additional work, and hence additional money.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.17

2. Requirement of 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.
3. Duplication of Work: It involves duplication of work as organization has to
maintain two sets of accounts i.e. Financial Account and Cost Account.
4. Inefficiency: Costing system itself does not control costs but its usage does.

1.13 CLASSIFICATION OF COSTS

It means the grouping of costs according to their common charac¬teristics. The
important ways of classification of costs are:
(i) By Nature or Element
(ii) By Functions
(iii) By Variability or Behaviour
(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making
1.13.1 By Nature or Element
This type of classification is useful to determine the total cost.
A diagram as given below shows the elements of cost described as under:
ELEMENT OF COST

Materials Cost Employee (Labour) Cost Other Expenses

Direct Indirect Direct Indirect Direct Indirect

Materials Cost Materials Cost Employee Employee Expenses Expenses
(Labour) (Labour) Cost
Cost

Overheads

Selling and
Production Administration
Distribution
Overheads Overheads
Overheads

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1.18 COST AND MANAGEMENT ACCOUNTING

(i) Direct Materials: Materials which are present in the finished product(cost object)
or can be economically identified in the product are called direct materials. For
example, cloth in dress making; materials purchased for a specific job etc. However,
in some cases a material may be direct but it is treated as indirect, because it is
used in small quantities, it is not economically feasible to identify that quantity
and those materials which are used for purposes ancillary to the business.
(ii) Direct Employee (Labour): Labour which can be economically identified or
attributed wholly to a cost object is called direct labour. For example, employee
engaged on the actual production of the product or in carrying out the necessary
operations for converting the raw materials into finished product.
(iii) Direct Expenses: It includes all expenses other than direct material or direct labour
which are specially incurred for a particular cost object and can be identified in an
economically feasible way. For example, hire charges for some special machinery,
cost of defective work.
(iv) Indirect Materials: Materials which do not normally form part of the finished
product (cost object) are known as indirect materials. These are —
• Stores used for maintaining machines and buildings (lubricants, cotton waste,
bricks etc.)
• Stores used by service departments like power house, boiler house, canteen
etc.
(v) Indirect Labour: Labour costs which cannot be allocated but can be apportioned
to or absorbed by cost units or cost centres is known as indirect labour. Examples
of indirect employees include foreman and supervisors; maintenance workers; etc.
(vi) Indirect Expenses: Expenses other than direct expenses are known as indirect
expenses, that cannot be directly, conveniently and wholly allocated to cost
centres. Factory rent and rates, insurance of plant and machinery, power, light,
heating, repairing, telephone etc., are some examples of indirect expenses.
(vii) Overheads: It is the aggregate of indirect material costs, indirect labour costs and
indirect expenses. The main groups into which overheads may be subdivided are
the following:
• Production or Works Overheads: Indirect expenses which are incurred in the
factory and for the running of the factory. E.g.: rent, power etc.
• Administration Overheads:Indirect expenses related to management and
administration of business. E.g.: office rent, lighting, telephone etc.
• Selling Overheads: Indirect expense incurred for marketing of a commodity.
E.g.: Advertisement expenses, commission to sales persons etc.
• Distribution Overheads: Indirect expense incurred to despatch of the goods
E.g.: warehouse charges, packing and loading charges.

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1.13.2 By Functions
Under this classification, costs are divided according to the function for which they
have been in-curred. It includes the following:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.
Direct Materials 
Direct Employees 
 Prime Cost
(Labours) 

Direct Expenses 
Factory Overheads
Indirect Material  Factory Cost or Works Cost


Indirect Labour  Cost of Goods Sold
 Administration Overheads

Indirect Expenses  Selling and Distribution
 Overheads


Cost of Sales
1.13.3 By Variability or Behaviour
According to this classification costs are classified into three group 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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1.20 COST AND MANAGEMENT ACCOUNTING

Fixed Cost

40000
35000
30000
25000
Cost ( `)

20000
15000
Fixed Cost
10000
5000
0
0 100 200 300 400 500 600
Output (in units)

(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 labour, etc.

Variable Cost
60000

50000

40000
Cost ( `)

30000

20000

10000

0
0 100 200 300 400 500 600

Output (in units)

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.21

(c) 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. Such costs are
depicted graphically as follows:

Semi- Variable Cost

90000
80000
70000
60000
Cost ( `)

50000
40000
30000
20000
10000
0
0 100 200 300 400 500 600
Output (in units)

1.13.3.1 Methods of segregating Semi-variable costs into fixed and variable costs
The segregation of semi-variable costs into fixed and variable costs can be carried out
by using the following methods:
(a) Graphical method
(b) High points and low points method
(c) Analytical method
(d) Comparison by period or level of activity method
(e) Least squares method
(a) Graphical Method: Under this method, the following steps are followed:
i. A large number of observations regarding the total costs at different
levels of output are plotted on a graph with the output on the X-axis
ii. The total cost is plotted on the Y-axis.
iii. Then, by judgment, a line of “best-fit”, which passes through all or most
of the points, is drawn.
iv. The point at which this line cuts the Y-axis indicates the total fixed cost
component in the total cost.

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1.22 COST AND MANAGEMENT ACCOUNTING

v. If a line is drawn at this point parallel to the X-axis, this indicates the fixed
cost.
vi The variable cost, at any level of output, is derived by deduct¬ing this
fixed cost element from the total cost.
The following graph illustrates this:

(b) High points and Low Points Method: Under this method difference between
the total cost at highest and lowest volume is divided by the difference
between the sales value at the highest and lowest volume. The quotient thus
obtained gives us the rate of variable cost in relation to sales value.
ILLUSTRATION 1: (Segregation of fixed cost and variable cost)

Sales value Total cost
(`) (`)
At the Highest volume 1,40,000 72,000
At the Lowest volume 80,000 60,000
60,000 12,000
Thus, Variable Cost (` 12,000/`60,000)
= 1/5 or 20% of sales value = ` 28,000 (at highest volume)
Fixed Cost ` 72,000 – ` 28,000 i.e., (20% of ` 1,40,000) = ` 44,000.
Alternatively,
` 60,000 – ` 16,000 (20% of ` 80,000) = ` 44,000.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.23

(c) Analytical Method: Under this method, an experienced cost accountant

tries to judge empirically what proportion of the semi-variable cost would
be variable and what would be fixed. The degree of variability is ascertained
for each item of semi-variable expenses. For example, some semi-variable
expenses may vary to the extent of 20% while others may vary to the extent
of 80%. Although it is very difficult to estimate the extent of variability of an
expense, the method is easy to apply. (Go through the following illustration
for clarity).
ILLUSTRATION 2: (Segregation of fixed cost and variable cost)
Suppose, last month the total semi-variable expenses amounted to ` 3,000.
If the degree of variability is assumed to be 70%, then variable cost = 70%
of ` 3,000 = ` 2,100. Fixed cost = ` 3,000 – ` 2,100 = ` 900.Now in the future
months, the fixed cost will remain constant, but the variable cost will vary
according to the change in pro-duction volume. Thus, if in thenext month
production increases by 50%, the total semi-variable expenses will be:Fixed
cost of ` 900, plus variable cost viz.,` 3,150 i.e., (` 2,100(V.C.) plus 50% increase
of V.C. i.e.,` 1,050) i.e., ` 4,050.
(d) Comparison by period or level of activity method: Under this method, the
variable overhead may be determined by comparing two levels of output
with the amount of expenses at those levels. Since the fixed element does
not change, the variable element may be ascertained with the help of the
following formula.
Change in the amount of expense
Change in the quantity of ou
utput

Suppose the following information is available:

Production Units Semi-variable expenses
(`)
January 100 260
February 140 300
Difference 40 40
The variable cost:
Change in Semi - variable expenses ` 40
= = ` 1/unit
Change in production vo olume 40 units

Thus, in January, the variable cost will be 100 × ` 1 = ` 100 and the fixed cost
element will be (` 260 – ` 100) or ` 160. In February, the variable cost will be
140 × ` 1 = ` 140 whereas the fixed cost element will remain the same, i.e., `
160.
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1.24 COST AND MANAGEMENT ACCOUNTING

(e) Least Square Method: This is the best method to segregate semi-variable
costs into its fixed and variable components. This is a statistical method and
is based on finding out a line of best fit for a number of observations.
The method uses the linear equation y = mx + c, where
‘m’ represents the variable element of cost per unit, ‘c’ represents the total
fixed cost, ‘y’ represents the total cost, ‘x’ represents the volume of output.
The total cost is thus split into its fixed and variable elements by solving this
equation.
ILLUSTRATION 3: (Segregation of fixed cost and variable cost)
Level of activity
Capacity % 60% 80%
Volume (Labour hours) or ‘x’ 150 200
Semi-variable expenses (maintenance of plant) or ‘y’ ` 1,200 ` 1,275
Substituting the values of ‘x’ and ‘y’ in the equation, y = mx + c, at both the
levels of activity, we get
1,200 = 150 m + c
1,275 = 200 m + c
On solving the above equations, we get the value of ‘c’
Fixed cost or ‘c’ = ` 975 and Variable cost or ‘m’ = ` 1.50 per labour hour.
1.13.4 By Controllability
Costs here may be classified into controllable and uncontrollable costs.
(a) Controllable Costs: - Cost that can be controlled, typically by a cost, profit
orinvestment centre manager is called controllable cost. Controllable costs
incurred in a particular responsibility centre can be influenced by the action of the
executive 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 level management.
(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 to be controlled by the machine
shop foreman.
Distinction between Controllable Cost and Uncontrollable Cost: The distinction
between controllable and uncontrollable costs is not very sharp 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.
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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.25

1.13.5 By Normality
According to this basis cost may be categorised as follows:
(a) Normal Cost - It is the cost which is normally incurred at a given level of output
under the conditions in which that level of output is normally attained.
(b) Abnormal Cost - It is the cost which is not normally incurred at a given level of
output in the conditions in which that level of output is normally attained. It is
charged to Costing Profit and loss Account.
1.13.6 By Costs for Managerial Decision Making
According to this basis cost may be categorised as follows:
(a) Pre-determined 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.
(b) Standard Cost - A pre-determined cost, which is calculated from managements
‘expected standard of efficient operation’ and the relevant necessary expenditure.
It may be used as a basis for price fixation and for cost control through variance
analysis.
(c) Marginal Cost -The amount at any given volume of output by which aggregate
costs are changed if the volume of output is increased or decreased by one unit.
(d) Estimated 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.
(e) Differential 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. For example, if any
change is proposed in the existing level or in the existing method of production,
the increase or decrease in total cost or in specific elements of cost as a result of
this decision will be known as incremental cost or decremental cost.
(f) Imputed Costs - 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.
(g) Capitalised Costs -These are costs which are initially recorded as assets and
subsequently treated as expenses.
(h) 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.
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1.26 COST AND MANAGEMENT ACCOUNTING

(i) Opportunity Cost - This cost refers to the value of sacrifice made or benefit of
opportunity foregone in accepting an alterna¬tive 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.
(j) Out-of-pocket Cost - 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.
(k) Shut down Costs - Those costs, which continue to be, incurred even when a plant
is temporarily shut-downe.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.
(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.
(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
based.
(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.
(o) Period 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.
(p) 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.
(q) Explicit Costs - These costs are also known as out of pocket costs and refer to
costs involving immediate payment of cash.Salaries, wages, postage and telegram,
printing and stationery, interest on loan etc. are some examples of explicit costs
involving immediate cash payment.
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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.27

(r) Implicit Costs - These costs do not involve any immediate cash payment. They are
not recorded in the books of account. They are also known as economic costs.

1.14 METHODS OF COSTING

Different industries follow different methods of costing because of the differences in
the nature of their work. The various methods of costing are as follows:
Methods Description
Single or Output Costing Here the cost of a product is ascertained, the product
being the only one produce like bricks, coals, etc.
Batch Costing It is the extension of job costing. A batch may represent
a number of small orders passed through the factory in
batch. Each batch 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.
Job Costing In this method of costing, cost of each job is ascertained
separately. It is suitable in all cases where work is
undertaken on receiving a customer’s order like a
printing press, motor workshop, etc.
Contract Costing Here the cost of each contract is ascertained separately.
It is suitable for firms engaged in the construction of
bridges, roads, buildings etc.
Process Costing Here the cost of completing each stage of work is
ascertained, like cost of making pulp and cost of making
paper from pulp. In mechanical operations, the cost
of each operation may be ascertained separately; the
name given is operation costing.
Operating Costing It is used in the case of concerns rendering services like
transport, supply of water, retail trade etc.
Multiple Costing It is a combination of two or more methods of costing
outlined above. Suppose a firm manufactures bicycles
including its components; the parts will be costed
by the system of job or batch costing but the cost of
assembling the bicycle will be computed by the Single
or output costing method. The whole system of costing
is known as multiple costing.

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1.28 COST AND MANAGEMENT ACCOUNTING

The following table summarises the various methods of costing applied in different
industries:
Nature of Output Method Cost Examples of
Industries
A Series of Processes Process costing or For each process Sugar
Operation Costing
Construction of Contract Costing For each contract Real estate
building
Similar units of a Single Unit or output or For the entire Cold Drinks
Product, produced by Single Costing activity, but
Single Process averaged for the
output
Rendering of Services Operating Costing For all services Hospitals
Customer Job Costing For each order/ Advertising
Specifications: single assignment/job
Unit
Consisting of multiple Multiple Costing Combination of any Car Assembly
varieties of activities method
and processes

1.15 TECHNIQUES OF COSTING

For ascertaining cost, following types of costing are usually used.
Techniques Description
Uniform Costing When a number of firms in an industry agree among
themselves to follow the same system of costing in detail,
adopting common terminology for various items and
processes they are said to follow a system of uniform costing.
Advantages of such a system are that
i. A comparison of the performance of each of the firms
can be made with that of another, or with the average
performance in the industry.
ii. Under such a system it is also possible to determine
the cost of production of goods which is true for the
industry as a whole. It is found useful when tax-relief or
protection is sought from the Government.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.29

Marginal Costing It is defined as the ascertainment of marginal cost by

differentiating between fixed and variable costs. It is used to
ascertain effect of changes in volume or type of output on
profit.
Standard Costing It is the name given to the technique whereby standard
and Variance costs are pre-determined and subsequently compared with
Analysis the recorded actual costs. It is thus a technique of cost
ascertainment and cost control. This technique may be used
in conjunction with any method of costing. However, it is
especially suitable where the manufacturing method involves
production of standardised goods of repetitive nature.
Historical Costing It is the ascertainment of costs after they have been incurred.
This type of costing has limited utility.
• Post Costing: It means ascertainment of cost after
production is completed.
• Continuous costing: Cost is ascertained as soon as the
job is completed or even when the job is in progress.
Absorption Costing It is the practice of charging all costs, both variable and
fixed to operations, processes or products. This differs from
marginal costing where fixed costs are excluded.

SUMMARY
• Cost: The amount of expenditure (actual or notional) incurred on or attributable
to a specified article, product or activity. (as a noun)
• To ascertain the cost of a specified thing or activity. (as a verb)
• Costing: Costing is the technique and process of ascertaining costs.
• Cost Accounting: The process of accounting for cost which begins with the
recording of income and 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 Accountancy: Cost Accountancyhas been defined as “the application of
costing and cost accounting principles, methods and techniques to the science,
art and practice of cost control and the ascertainment of profitability. It includes
the presentation of information derived there from for the purpose of managerial
decision making.”
• Management Accounting: As per CIMA Official Terminology “Management
accounting is the application of the principles of accounting and financial
management to create, protect, preserve and increase value for the stakeholders
of for-profit and not-for-profit enterprises in the public and private sectors.”
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1.30 COST AND MANAGEMENT ACCOUNTING

• Cost Management: It is an application ofmanagement accounting concepts,

methods of collections, analysis and presentation of data to provide the information
needed to plan, monitor and control costs.
• Cost Control: Maintainingdiscipline in expenditure is one of the main objective
of a good cost and management accounting system. It ensures that expenditures
are in consonance with predetermined set standard and any variation from these
set standards is noted and reported on continuous basis.
• Cost Reduction: It may be defined “as the achievement of real and permanent
reduction in the unit cost of goods manufactured or services rendered without
impairing their suitability for the use intended or diminution in the quality of the
product.”
• Cost Objects: Cost object is anything for which a separate measurement of cost
is required. Cost object may be a product, a service, a project, a customer, a brand
category, an activity, a department or a programme etc.
• 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 Drivers: A Cost driver is a factor or variable which effect level of cost.
Generally, it is an activity which is responsible for cost incurrence. Level of activity
or volume of production is the example of a cost driver. An activity may be an
event, task, or unit of work etc.
• Responsibility Centres: 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 and
are held responsible for performance in terms of expenditure, revenue, profitability
and return on investment.
• Cost 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.
• Revenue Centres: The responsibility centres which are accountable for generation
of revenue for the entity.
• Profit Centres: These are the responsibility centres which have both responsibility
of generation of revenue and incurrence of expenditures. Since, managers of profit
centres are accountable for both costs as well as revenue, profitability is the basis
for measurement of performance of these responsibility centres.
• Investment Centres: These are the responsibility centres which are not only
responsible for profitability but also has 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.

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.31

TEST YOUR KNOWLEDGE

MCQs based Questions
1. ___________is anything for which a separate measurement is required.
(a) Cost unit
(b) Cost object
(c) Cost driver
(d) Cost centre
2. Which of the following is true about Cost control:
(a) It is a corrective function
(b) It challenges the set standards
(c) It ends when targets achieved
(d) It is concerned with future
3. Cost units used in power sector is:
(a) Kilo meter (K.M)
(b) Kilowatt-hour (kWh)
(c) Number of electric points
(d) Number of hours
4. Processes Costing method is suitable for
(a) Transport sector
(b) Chemical industries
(c) Dam construction
(d) Furniture making
5. Distinction between direct cost and indirect cost is an example of ______classification
(a) By Element
(b) By Function
(c) By Controllability
(d) By Variability
6. The advantage of using IT in Cost Accounting does not include:
(a) Integration of various functions
(b) Stock needs to be reconciled with Goods Received Note
(c) Reduction in multicity of documents
(d) Customised reports can be prepared.

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1.32 COST AND MANAGEMENT ACCOUNTING

7. A taxi provider charges minimum `80 thereafter `12 per kilometer of distance
travelled, the behaviour of conveyance cost is:
(a) Fixed Cost
(b) Semi-variable Cost
(c) Variable Cost
(d) Administrative cost.
8. A Ltd. has three production department and each department has two machines,
which of the following cannot be treated as cost centre for cost allocation:
(a) Machines under the production department
(b) Production departments
(c) Both Production department and machines
(d) A Ltd.
9. Which of the following is an example of functional classification of cost:
(a) Direct Material Cost
(b) Fixed Cost
(c) Administrative Overheads
(d) Indirect Overheads.
10. Ticket counter in a Railway Station is an example of
(a) Cost Centre
(b) Revenue Centre
(c) Profit Centre
(d) Investment Centre
Theoretical Questions
1. Enumerate the main objectives of introduction of a Cost and Management
Accounting System in a manufacturing organization
2. What is meant by cost centre?
3. Discuss cost classification based on variability and controllability.
4. Discuss the essential features of a good cost accounting system?
5. Enumerate the factors which are to be considered before installing a system of
cost accounting.
6. Discuss the four different methods of costing alongwith their applicability to
concerned industry?

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INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING 1.33

7. State the method of costing and the suggestive unit of cost for the following
industries:
(a) Transport (b) Power
(c) Hotel (d) Hospital
(e) Steel (f) Coal
(g) Bicycles (h) Bridge Construction
(i) Interior Decoration (j) Advertising
(k) Furniture (l) Brick-works
ANSWERS/ SOLUTIONS
Answers to the MCQs based Questions
1. (b) 2. (c) 3. (b) 4. (b) 5. (a) 6. (b)
7. (b) 8. (d) 9. (c) 10. (b)
Answers to the Theoretical Questions
1. Please refer paragraph 1.2
2. Please refer paragraph 1.11
3. Please refer paragraph 1.13
4. Please refer paragraph 1.7
5. Please refer paragraph 1.8
6. Please refer paragraph 1.14
7. Please refer paragraph 1.14 & 1.10

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CHAPTER 2

MATERIAL COST
LEARNING OUTCOMES
r State the meaning, need and importance of materials.
r Discuss the procedures and documentations involved in
procuring, storing and issuing material.
r Discuss the various inventory control techniques and
determination of various stock levels.
r Compute Economic Order Quantity (EOQ) and apply the EOQ
to determine the optimum order quantity.
r Discuss the various methods of inventory accounting and
Prepare stock ledger/ account.
r Identify and explain normal and abnormal loss and its
accounting treatment.

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2.2 COST AND MANAGEMENT ACCOUNTING

CHAPTER OVERVIEW

2.1 INTRODUCTION
We have acquired a basic knowledge about the concepts, objectives, advantages,
methods and elements of cost. We shall now study each element of cost separately
begining with material cost. The general meaning of material is all commodities/
physical objects used to make the final product. It may be direct or indirect.
(i) Direct Materials: Materials, cost of which can be directly attributable to the end
product for which it is being used, in an economically feasible way.
(ii) Indirect Materials: The materials which are not directly attributable to a particular
final product.
Direct Materials constitute a significant part for manufacturing and production of a
goods. Being an input and a significant cost element, it requires adequate management
attention. Cost control starts from here, and for this purpose it is necessary that the
principles of 3Es (Economy, Efficiency and Effectiveness) i.e. economy in procurement,
efficiency in handling and processing the material and effectiveness in producing the

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MATERIAL COST 2.3

desired output as per the standard, is also applied for this cost element. Importance of
proper recording and control of material are as follows:
(a) Quality of final product : The quality of output depends on the quality of inputs.
(b) Price of the final product : Material constitute a significant part of any product
and the cost of final product is directly related with cost of materials used to produce
the product.
(c) Production continuity : The production process should run smoothly and should
not be paused for the want of materials. To avoid production interruptions, an adequate
level of stock of materials should be maintained.
(d) Cost of Stock holding and stock-out : An entity has to incur stock holding costs
in the form of interest and/or opportunity cost for the fund used, stock handling losses
like evaporation, obsolescence etc. Under-stocking causes in loss of revenue due to
stock-out and breach of commitment.
(e) Wastage and other losses : While handling and processing of materials, some
wastage and loss arise. Based on the nature of material and process, these are classified
as normal and abnormal for efficient utilisation and control.
(f) Regular information about resources : A regular and updated information
on availability and utilisation of materials are necessary for the entity for timely and
informed decision making.

2.2 MATERIAL CONTROL

In previous chapter, we have discussed the term Cost Control, which means all activities
and control mechanism which are necessary to keep the cost in adherence to the set
standards. Material, being the one of the total cost elements, are also required to be
controlled so that the overall cost control objective can be fulfilled.
2.2.1 Objectives of system of material control
The objectives of a system of material control are the following:
(i) Minimising interruption in production process : Ensuring that no activity,
particularly production, suffers from interruption for want of materials and stores.
It should be noted that this requires constant availability of every item that may be
needed howsoever small its cost may be.
(ii) Optimisation of Material Cost : Seeing to it that all the materials and stores
are acquired at the lowest possible price considering the quality that is required and
considering other relevant factors like reliability in respect of delivery, etc. Holding cost
should also required to be minimized.
(iii) Reduction in Wastages : Avoidance of unnecessary losses and wastages that
may arise from deterioration in quality due to defective or long storage or from
obsolescence. It may be noted that losses and wastages in the process of manufacture,
concern the production department.
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2.4 COST AND MANAGEMENT ACCOUNTING

(iv) Adequate Information : Maintenance of proper records to ensure that reliable

information is available for all items of materials and stores that not only helps in
detecting losses and pilferages but also facilitates proper production planning.
(v) Completion of order in time : Proper material management is very necessary for
fulfilling orders of the firm. This adds to the goodwill of the firm.
2.2.2 Requirements of material control
Material control requirements can be summarised as follows :
1. Proper co-ordination of all departments involved viz., finance, purchasing,
receiving, inspection, storage, accounting and payment.
2. Determining purchase procedure to see that purchases are made, after making
suitable enquiries, at the most favourable terms to the firm.
3. Use of standard forms for placing the order, noting receipt of goods, authorising
issue of the materials etc.
4. Preparation of budgets concerning materials, supplies and equipment to ensure
economy in purchasing and use of materials.
5. Operation of a system of internal check so that all transactions involving materials,
supplies and equipment purchases are properly approved and automatically
checked.
6. Storage of all materials and supplies in a well designated location with proper
safeguards.
7. Operation of a system of perpetual inventory together with continuous stock
checking so that it is possible to determine at any time the amount and value of
each kind of material in stock.
8. Operation of a system of stores control and issue so that there will be delivery of
materials upon requisition to departments in the right amount at the time they
are needed.
9. Development of system of controlling accounts and subsidiary records which
exhibit summary and detailed material costs at the stage of material receipt and
consumption.
10. Regular reports of materials purchased, issue from stock, inventory balances,
obsolete stock, goods returned to vendors, and spoiled or defective units.
2.2.3 Elements of Material Control
Material control is a systematic control over the procurement, storage and usage of
material so as to maintain an even flow of material.

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MATERIAL COST 2.5

Material control involves efficient functioning of the following operations:

• Purchasing of materials
• Receiving of materials
• Inspection of materials
• Storage of materials
• Issuing materials
• Maintenance of inventory records
• Stock audit

2.3 MATERIALS PROCUREMENT PROCEDURE

Material procurement procedure can be understood with help of the following
diagram. Documents required and the departments who initiate these documents are
shown sequentially.

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2.6 COST AND MANAGEMENT ACCOUNTING

Engineering/Planning
Department

Production Department/
Workshop

Diagram: Material Procurement Procedure

[The name of the departments and documents shown in the diagram are for illustrative purpose
only]
2.3.1 Bill of Materials
It is also known as Materials Specification List or Materials List. It is a detailed list
specifying the standard quantities and qualities of materials and components required
for producing a product or carrying out of any job. The materials specification list
is prepared by the product development team commonly known as engineering
or planning department in a standard form. This is shared with other concerned
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MATERIAL COST 2.7

departments like Marketing, Production,Store, and Cost/ Accounting department.

Format and content of a Bill of Materialsvary on the basis of industrial
peculiarities,management information system (MIS) and accounting system in place.
Uses of Bill of Material
Marketing Production Dept. Stores Dept. Cost/ Accounting
(Purchase) Dept.
Dept.
Materials Production is planned It is used as It is used to estimate
are procured according to the a reference cost and profit. Any
(purchased) nature, volume of the document purchase, issue and
on the basis of materials required while issuing usage is compared
specifications to be used and materials to the against this
mentioned in it. accordingly Material requisitioning document.
requisition lists are department.
prepared.
2.3.2 Material Requisition Note
It is also known as material requisition slip, It is a voucher of authority used to get
materials issued from store.Generally, it is prepared by the production department
and materials are withdrawn on the basis of material requisition list or bill of materials.
If no material list has been prepared, it is desirable that the task of the preparation of
material requisition notes be left to the planning department or by the department
requires the materials.The note is shared with Store and Cost/Accounting department.
Format of a Material requisition note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.
Difference between Bill of Materials and Material Requisition Note :

Bill of Materials Material Requisition Note

1. It is the document prepared by 1. It is prepared by the production or other
the engineering or planning dept.. consuming department.
2. It is a complete schedule of 2. It is a document authorizing Store-keeper
component parts and raw to issue materials to the consuming
materials required for a particular department.
job or work order.
3. It often serves the purpose of a 3. It cannot replace a bill of materials.
material requisition as it shows the
complete schedule of materials
required for a particular job i.e. it
can replace material requisition.

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2.8 COST AND MANAGEMENT ACCOUNTING

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 5. It shows the material actually drawn
control on materials drawn from stores.
through material requisition.
2.3.3 Purchase Requisition
This is a document which authorises the purchase department to order for the materials
specified in the note.Since the materials purchased will be used by the production
departments, there should be constant co-ordination between the purchase and
production departments.A purchase requisition is a form used for making a formal
request to the purchasing department to purchase materials. 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).
At the beginning a complete list of materials and stores required should be drawn
up, which should be reviewed periodically for any addition or deletion. On the basis
of standing order, once an item is included in the standard list, it becomes the duty
of the purchase department to arrange for fresh supplies before existing stocks are
exhausted. Any change in the consumption pattern should be informed to the purchase
department for necessary action from their end.
For control over buying of regular store materials, Inventory control system is to
determine stock levels to be maintained and the number of quantities to be ordered.
In respect of special materials, required for a special order or purpose, it is desirable
that the concerned technical department should prepare materials specifications list
specifying the quantity, size and order for the materials.
Purchase requisition note may either be originated bythe stores department in
connection with regular materials or by the production planning or other technical
departments in respect of special materials.
Format of a purchase requisition note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.
2.3.4 Inviting Quotation/ Request for proposal (RFP)
After receipt of duly authorised purchase requisition from the store department or
other departments, role of purchase department comes into play. If a concern can
afford or the size of the concern is big enough, there should be a separate purchase
department for all purchases to be made on behalf of all other departments. Such a
department is bound to become expert in the various matters to be attended to, for
examples— units of materials to be purchased and licences to be obtained, transport,
sources of supply, probable price etc.
Materials purchase department in a business house is confronted with the following
issues:
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MATERIAL COST 2.9

(i) What to purchase?

(ii) When to purchase?
(iii) How much to purchase?
(iv) From where to purchase.
(v) At what price to purchase.
To overcome these questions, purchase department make an enquiry into the market
for the required material. The process of gathering information about the rate, quantity,
technology, services and support etc., purchase department sent RFP to selected
vendors in case if purchase policy allows this practice. Some organizations follow
the open and transparent purchase policy and invite quotations from the interested
vendors. This process is called Tender Notification or Invitation of Tender.
2.3.5 Selection of Quotation/ Proposal
After invitation of tender from the vendors, interested vendors who are fulfilling all
the criteria mentioned in the tender notice send their price quotations/proposals to
the purchase department. On the receipt of quotations, a comparative statement is
prepared. For selecting material suppliers, the factors which the purchase department
keeps in its mind are—price, quantity, quality offered, time of delivery, mode of
transportation, terms of payment, reputation of supplier etc. In addition to the above
listed factors purchase manager obtains other necessary information for finalselection
of material suppliers.
2.3.6 Preparation and execution of Purchase Orders
Having decided on the best quotation that should be accepted, the purchase manager
or concerned officer proceeds to issue the formal purchase order. It is a written request
to the supplier to supplyspecified materials at specified rates and within a specified
period.Generally,copies of purchase order are given to Store or order indenting
department, receiving department and cost accounting department. A copy of the
purchase order with relevant purchase requisitions, is held in the file of the department
to facilitate the follow-up of the delivery and also for approval of the invoice for
payment.
2.3.7 Receipt and inspection of materials
After execution of purchase order and advance payment (if terms of quotation so
specify), necessary arrangement is made to receive the delivery of materials After receipt
of materials along with relevant documents or/ and invoice, receiving department
(store dept.) arrange to inspect the materials for its conformity with purchase order.
After satisfactory inspection materials are received and Goods Received Note is issued.
If some materials are not found in good condition or are not in conformity with the
purchase order are returned back to the vendor alongwith a Material Returned Note.

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2.10 COST AND MANAGEMENT ACCOUNTING

2.3.7.1 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. Generally, it is prepared in quadruplicate, the copies being distributed
to purchase department, store or order indenting department, receiving depart and
accounting department.
2.3.7.2 Material Returned Note
Sometimes materials have to be returned to suppliers after these have been received
in the factory. Such returns may occur before or after the preparation of the receiving
report. If the return takes place before the preparation of the receiving report, such
material obviously would not be included in the report and hence not shown in the
stores ledgers. In that case, no adjustment in the account books would be necessary.
But 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.
2.3.8 Checking and passing of bills for payment
The invoice received from the supplier is sent to the accounts section to check
authenticity and mathematical accuracy. The quantity and price are also checked with
reference to goods received note and the purchase order respectively. The accounts
section after checking its accuracy finally certifies and passes the invoice for payment.

2.4 VALUATION OF MATERIAL RECEIPTS

After the procurement of materials from the supplier actual material cost is calculated.
Ascertainment of cost of material purchased is called valuation of materials of material
receipts. 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. Invoice of material purchased from
the market sometime contain items such as trade discount, quantity discount, freight,
duty, insurance, cost of containers, taxes, cash discount etc.
Treatment of items associated with purchase of materials is tabulated as below
Sl No. Items Treatment
Discounts and Subsidy
(i) Trade Discount Trade discount is deducted from the purchase
price if it is not shown as deduction in the invoice.

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MATERIAL COST 2.11

(ii) Quantity Discount Like trade discount quantity discount is also shown
as deduction from the invoice. It is deducted from
the purchase price if not shown as deduction.
(iii) Cash Discount Cash discount is not deducted from the purchase
price. It is treated as interest and finance charges.
It is ignored.
(iv) Subsidy/ Grant/ Any subsidy/ grant/ incentive received from the
Incentives Government or from other sources deducted from
the cost of purchase.Duties and Taxes
Duties and Taxes
(v) Road Tax/ Toll Tax Road tax/ Toll tax if paid by the buyer then it is
included with the cost of purchase.
(vi) Integrated Goods and Integrated Goods and Service Tax (IGST) is paid
Service Tax (IGST) on inter-state supply of goods and provision
of services and collected from the buyers. It is
excluded from the cost of purchase if credit for the
same is available. Unless mentioned specifically it
should not form part of cost of purchase.
(vii) State Goods and State Goods and Service Tax (SGST) is paid on
Service Tax (SGST) intra-state supply and collected from the buyers. It
is excluded from the cost of purchase if credit for
the same is available. Unless mentioned specifically
it should not form part of cost of purchase.
(viii) Central Goods and Central Goods and Service Tax (CGST) is paid on
Service Tax (CGST) manufacture and supply of goods and collected
from the buyer. It is excluded from the cost of
purchase if the input creditis available for the same.
Unless mentioned specifically CGST is not added
with the cost of purchase.
(ix) Basic Custom Duty Basic Custom duty is paid on import of goods from
outside India. It is added with the purchase cost.
Penalty and Charges
(x) Demurrage Demurrage is a penalty imposed by the transporter
for delay in uploading or offloading of materials. It
is an abnormal cost and not included with cost of
purchase

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2.12 COST AND MANAGEMENT ACCOUNTING

(xi) Detention charges/ Detention charges/ finesare imposed for non-

Fine compliance of rule or law by any statutory authority.
It is an abnormal cost and not included with cost
of purchase
(xii) Penalty Penalty of any type is not included with the cost
of purchase.
Other expenditures
(xiii) Insurance charges Insurance charges are paid for protecting goods
during transit. It is added with the cost of purchase.
(xiv) Commission or Commission or brokerage paid is added with the
brokerage paid. cost of purchase.
(xv) Freight inwards It is added with the cost of purchase as it is directly
attributable to procurement of material.
(xvi) Cost of containers Treatment of cost of containers are as follows :
• Non-returnable containers : The cost of containers
is added with the cost of purchase of materials.
• Returnable Containers : If on return of containers
cost of containers is returned back then in this
case cost of containers is not added with the cost
of purchase.
• If the amount of refund on returning the container
is less than the amount paid then only short fall is
added with the cost of purchase.
(xvii) Shortage Shortage in materials are treated as follows :
Shortage due to normal reasons : Good units
absorb the cost of shortage due to normal reasons.
Losses due to breaking of bulk, evaporation, due
to unavoidable conditions etc. are the reasons of
normal loss.
Shortage due to abnormal reasons : shortage
arises due to abnormal reasons such as material
mishandling, pilferage, due to avoidable reasons
are not absorbed by the good units. Losses due to
abnormal reasons are debited to costing profit and
loss account.

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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 determine the rate per kg. of each chemical, assuming a
provision of 2% for further deterioration.
SOLUTION
Working :
Computation of effective quantity of each chemical available for use
Chemical A (kg.) Chemical B (kg.)
Quantity purchased 10,000 8,000
Less: Shortage due to normal breakages 500 320
9,500 7,680
Less: Provision for deterioration 2% 190 153.6
Quantity available 9,310 7,526.4
Statement showing the computation of rate per kg. of each chemical
Chemical A (`) Chemical B (`)
Purchase price 1,00,000 1,04,000
Add : Basic Custom Duty @10% 10,000 10,400
Add : Railway freight 2,133 1,707
(in the ratio of quantity purchased i.e., 5:4)
Total cost (A) 1,12,133 1,16,107
Effective Quantity (see working) (B) 9,310 kg. 7,526.4 kg.
Rate per kg. (A ÷ B) 12.04 15.43
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 :

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2.14 COST AND MANAGEMENT ACCOUNTING

Invoice (`)
200 units Part No. A 32 @ ` 5 1,000.00
Less : 20% discount (200.00)
800.00
Add : SGST @ 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 SGST is enclosed for claiming Input credit.
SOLUTION
Computation of cost per unit
(`)
Net purchase Price 800.00
Add: Packing charges (5 non-returnable boxes) 50.00
850.00
No. of units purchased 200 units
Cost per unit 4.25
Note : (i) Cash discount is treated as interest and finance charges hence, it is not
considered for valuation of material.
(ii) Input credit is available for SGSTpaid; hence it will not be added to purchase cost.

2.5 MATERIAL STORAGE & RECORDS

Proper storing of materials is of primary importance. It is not enough only to purchase
material of the required quality. If the purchased material subsequently deteriorates
in quality because of bad storage, the loss is even more than what might arise from
purchase of bad quality of materials. Apart from preservation of quality, the store-
keeper also ensure safe custody of the material. It should be the function of store-
keeper that the right quantity of materials always should be available in stock.
2.5.1 Duties of store keeper
These can be briefly set out as follows:
(i) General control over store : Store keeper should keep control over all activities
in Stores department. He should check the quantities as mentioned in Goods received
note and with the purchased materials forwarded by the receiving department and to
arrange for the storage in appropriate places.

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MATERIAL COST 2.15

(ii) Safe custody of materials : Store keeper should ensure that all the materials are
stored in a safe condition and environment required to preserve the quality of the
materials.
(iii) Maintaining records : Store keeper should maintain proper record of quantity
received, issued, balance in hand and transferred to/ from other stores.
(iv) Initiate purchase requisition : Store keeper should initiate purchase requisitions
for the replacement of stock of all regular stores items whenever the stock level of any
item of store approaches the re-order level fixed.
(v) Maintaining adequate level of stock : Store keeper should maintain adequate
level of stock at all time. He/ she should take all necessary action so that production
could not be interrupted due to lack of stock. Further he/ she should take immediate
action for stoppage of further purchasing when the stock level approaches the
maximum limit. To reserve a particular material for a specific job when so required.
(vi) Issue of materials : Store keeper should issue materials only against the material
requisition slip approved by the appropriate authority. He/ she should also refer to bill
of materials while issuing materials to requisitioning department.
(vii) Stock verification and reconciliation : Store keeper should verify the book
balances with the actual physical stock at frequent intervals by way of internal control
and check the any irregular or abnormal issues, pilferage, etc.
2.5.2 Store Records
The record of stores may be maintained in three forms :
Ü Bin Cards
Ü Stock Control Cards
Ü Store Ledger
Bin Cards : It is a quantitative record of inventory which shows the quantity of inventory
available in a particular bin. 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. It is maintained by store department.
Stock Control Cards : It is also a quantitative record of inventorymaintained by stores
department for every item of material. In other words, it is a record which shows the
overall inventory position in store. Recording includes receipt, issue, return, in hand
and order given.
Advantages and Disadvantages of Bin Cards
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, in as much as comparison of the actual
quantity in hand at any time with the book balance is possible.

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2.16 COST AND MANAGEMENT ACCOUNTING

(iii) Identification of the different items of materials is facilitated by reference to the

Bin Card the bin or storage receptacle.
Disadvantages :
(i) Store records are dispersed over a wide area.
(ii)The cards are liable to be smeared with dirt and grease because of proximity to
material and also because of handling materials.
(iii) People handling materials are not ordinarily suitable for the clerical work involved
in writing Bin Cards.
Advantages and disadvantages of Stock Control Cards
Advantages :
(i) Records are kept in a more compact manner so that reference to them is facilitated.
(ii) Records can be kept in a neat and clean way by men solely engaged in clerical work
so that a division of workers between record keeping and actual material handling is
possible.
(iii) As the records are at one place, it is possible to get an overall idea of the stock
position without the necessity of going round the stores.
Disadvantages :
(i) On the spot comparison of the physical stock of an item with its book balance is
not facilitated.
(ii) Physical identification of materials in stock may not be as easy as in the case of bin
cards, as the Stock Control Cards are housed in cabinets or trays.
Stores Ledger : A Stores Ledger is maintainedto record of both quantity and cost of
materials received, issued and those in stock. Its being a subsidiary ledger to the main
cost ledger, it is maintained by the Cost/ Accounts Department. The source documents
for posting the ledger are Goods received notes, Materials requisition notes etc.
The first two forms are records of quantities re¬ceived, issued and those in balance,
but in the third record i.e. store ledger, value of receipts, issues and closing balance is
also maintained. 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
It is maintained by the storekeeper in the It is maintained in cost accounting
store. department.
It contains only quantitative details of It contains information both in quantity
material received, issued and returned to and value.
stores.

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MATERIAL COST 2.17

Entries are made when transaction takes It is always posted after the transaction.
place.
Each transaction is individually posted. Transactions may be summarized and
then posted.
Inter-department transfers do not appear Material transfers from one job to another
in Bin Card. job are recorded for costing purposes.

2.6 INVENTORY CONTROL

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.”
The objective of inventory control is to make a balance between sufficient stock
and over-stock. The stock maintained should be sufficient to meet the production
requirements so that uninterrupted production flow can be maintained. Insufficient
stock not only pause the production but also cause a loss of revenue and goodwill.
On the other hand, Inventory requires some funds for purchase, storage, maintenance
of materials with a risk of obsolescence, pilferage etc. A trade-off between Stock-out
and Over-stocking is required. The management may employ various methods of
Inventory control to have a balance. Management may adopt the following basis for
Inventory control :

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2.18 COST AND MANAGEMENT ACCOUNTING

2.6.1 Inventory Control- By Setting Quantitative Levels

(i) Re-order Stock Level (ROL) : This level lies between minimum and the maximum
levels in such a way that before the material ordered is received into the stores, there is
sufficient quantity on hand to cover both normal and abnormal consumption situations.
In other words, it is the level at which fresh order should be placed for replenishment
of stock.
It is calculated as :
ROL = Maximum Consumption × Maximum Re-order Period

Maximum Consumption = The maximum rate of material consumption in

production activity
Maximum Re-order period = The maximum time to get order from supplier to the
stores
This can also be calculated alternatively as below:
ROL = Minimum Stock Level + (Average Rate of Consumption × Average
Re-order period)

Minimum Stock Level = Minimum Stock level that must be maintained all
the time.
Average Rate of Consumption = Average rate of material consumption in
production activity. It is also known as normal
consumption/ usage

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MATERIAL COST 2.19

Average Re-order period = Average time to get an order from supplier to the
stores. It is also known as normal period.
(Re-order period is also known as Lead time)
(ii) Re-Order Quantity : Re-order quantity is the quantity of materials for which
purchase requisition is made by the store department. While setting the quantity to
be re-ordered, consideration is given to the maintenance of minimum level of stock,
re-order level, minimum delivery time and the most important the cost. Hence, the
quantity should be where, the total of carrying cost and ordering cost be at minimum.
For this purpose, an economic order quantity should be calculated.
Economic Order Quantity (EOQ) : The size of an order for which total of ordering and
carrying cost are at minimum.
Ordering Cost : The costs which are associated with the purchase or order of
materials. It includes cost to invite quotations, documentation works like preparation
of purchase orders, employee cost directly attributable to the procurement of material,
transportation and inspection cost etc.
Carrying Cost : The costs for holding/ carrying of inventories in store. It includes the
cost of fund invested in inventories, cost of storage, insurance cost, obsolescence etc.
The Economic Order Quantity (EOQ) is calculated as below :

2×Annual Requirement(A)×Costper order (O)

EOQ =
Carrying Costperunitper annum (C)

Annual Requirement (A)- It represents demand for Raw material or Input for a year.
Cost per Order (O) - It represents cost of placing an order for purchase.
Carrying Cost (C) – It represents cost of carrying average inventory on annual basis.
Assumptions underlying E.O.Q. : The calculation of economic order of material to be
purchased is subject to the following assumptions :
(i) Ordering cost per order and carrying cost per unit per annum are known and
they are fixed.
(ii) Anticipated usage of material in units is known.
(iii) Cost per unit of the material is constant and is known as well.
(iv) The quantity of material ordered is received immediately i.e. the lead time is zero.

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2.20 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 3
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
SOLUTION

EOQ = 2×A×O
C
A = Units consumed during year
O = Ordering cost per order
C = Inventory carrying cost per unit per annum.

2×10,000×50 2×10,000×50×25
EOQ = =
2×8 4
100

= 2,500 kg.
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MATERIAL COST 2.21

No. of orders to be placed in a year

Total consumption of materials per annum
=
EOQ
10,000 kg.
= = 4 Orders per year
2,500 kg.

ILLUSTRATION 4
(i) Compute E.O.Q. and the total variable cost for the following:
Annual Demand = 5,000 units
Unit price = ` 20.00
Order cost = ` 16.00
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 an incorrect price of
` 12.80 is used.
SOLUTION
(i) Carrying cost (C) = Storage rate = 2%
Interest Rate = 12%
Obsolescence Rate = 6%
Total 20% per annum
C = 20% of ` 20 = ` 4 per unit per annum.
2AO 2×5000×16
E.O.Q = = = 40,000 =200 units
C 4
Total cost :
Purchase price of 5,000 units @ ` 20.00 per unit = ` 1,00,000
5000
Ordering cost = = 25 orders @ ` 16 = ` 400
200

200
Carrying cost of average Inventory = = 100 units @ ` 4 = ` 400
2
Total cost ` 1,00,800
(ii) If an incorrect price of ` 12.80 is used :
C = 20% of 12.80 = ` 2.56 per unit per annum.
2×5,000×16
E.O.Q. = = 250 units
2.56

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2.22 COST AND MANAGEMENT ACCOUNTING

Total cost:
Purchase price of 5,000 units @ ` 12.80 per unit = ` 64,000
5,000
Ordering cost = = 20 orders @ ` 16 = ` 320
250
250
Carrying cost (of average inventory) = =125 units @ ` 2.56 = ` 320
2
Total variable cost ` 64,640
(iii) Minimum Stock Level : It is lowest level of material stock, which must be
maintained in hand at all times, so that there is no stoppage of production due to
non-availability of inventory.
It is calculated as below :

(iv) Maximum Stock Level : It is the highest level of quantity for any material which
can be held in stock at any time. Any quantity beyond this level cause extra amount of
expenditure due to engagement of fund, cost of storage, obsolescence etc.
It can be calculated as below :

Here, Re-order Quantity may be EOQ

(v) Average Inventory Level : This is the quantity of material that is normally held in
stock over a period.It is also known as normal stock level.
It can be calculated as below :
Average Stock Level = Minimum Stock Level + 1/2 Re-order Quantity

Alternatively, it can be calculated as below :

Maximum Stock Level + Minimum StockLevel
Average Stock Level=
2

(vi) Danger level : It is the level at which normal issues of the raw material inventory
are stopped and emergency issues are only made.
It can be calculated as below :
Danger Level = Average Consumption* × Lead time for emergency purchase

*Some time minimum consumption is also used.

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MATERIAL COST 2.23

(vii) Buffer Stock : Some quantity of stock may be kept for contingency to be used in
case of sudden order, such stock is known as buffer stock.
All the above stock levels can be understood with the help of the following diagram :

Order
Quantity

ILLUSTRATION 5
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.
SOLUTION
(a) Re-ordering level :
Maximum usage per week × Maximum delivery period.
Re-ordering level for component A =75 units× 6 weeks = 450 units
Re-ordering level for component B =75 units× 4weeks = 300 units

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2.24 COST AND MANAGEMENT ACCOUNTING

(b) Minimum level :

Re-order level – (Normal usage × Average period)
Minimum level for component A = 450 units – (50 units × 5 weeks)
= 200 units
Minimum level for component B = 300 units – (50 units × 3 weeks)
= 150 units
(c) Maximum level :
Re-order level + Re-order quantity – (Min. usage × Minimum period)
Maximum level for component A = (450 units + 300 units) – (25 units × 4
weeks) = 650 units
Maximum level for component B = (300 units + 500 units) – (25 units × 2
weeks) = 750 units
(d) Average stock level :
½ (Minimum + Maximum) stock level
Average stock level for component A = ½ (200 units + 650 units) = 425 units.
Average stock level for component B = ½ (150 units + 750 units) = 450 units.
ILLUSTRATION 6
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 ` 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.
SOLUTION
Basic Data :
A (Number of units to be purchased annually) = 5,000 units
O (Ordering cost per order) = ` 20
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MATERIAL COST 2.25

C (Annual cost of storage per unit) =`5

Purchase price per unit inclusive of transportation cost = ` 50.
Computations :
(i) Re-ordering level = Maximum usage per period × Maximum lead time
(ROL) = 20 units per day × 15 days = 300 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consumption × Min.
(Refer to working notes1 and 2) lead time]
= 300 units + 200 units – [10 units per day × 5 days]
= 450 units
(iii) Minimum level = ROL – Average rate of consumption × Average re-
order-period
= 300 units – (15 units per day × 10 days) =150 units
(iv) Danger level = Average consumption × Lead time for emergency
purchases
= 15 units per day × 4 days=60 units
Working Notes :
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2
X unit/day + 20 units per day
15 units per day = or X =10 units per day.
2
2. Re-order Quantity (ROQ)

= 2×5,000 units×` 20
= 200 units
5
2.6.2 Inventory Stock-Out
Stock out said to be occurred when an inventory item could not be supplied due to
insufficient stock in the store. 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. Though it may not be a monetary loss in short term but in long term
it could be a reason for financial loss.
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.

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ILLUSTRATION 7
M/s Tyrotubes trades in four wheeler tyres and tubes. It stocks sufficient quantity of tyres
of almost every vehicle. In year end 20X1-X2, the report of sales manager revealed that
M/s Tyrotubes experienced stock-out of tyres.
The stock-out data is as follows :
Stock-out of Tyres No. of times
100 2
80 5
50 10
20 20
10 30
0 33
M/s Tyrotubes loses ` 150 per unit due to stock-out and spends ` 50 per unit on carrying
of inventory.
Determineoptimum safest stock level.
SOLUTION
Computation of Stock-out and Inventory carrying cost
Safety Stock- Probability Stock-out Inventory Total cost
Stock out (3) cost (`) Expected carrying (`) (7) (5)
Level (units) (4)=(2) x stock-out cost (`) + (6)
(units) (2) `150 cost(`) (6)=(1)x
(5)=(3)x(4)
(1) `50
100 0 0.00 0 0 5,000 5,000

80 20 0.02 3,000 60 4,000 4,060

50 50 0.02 7,500 150
30 0.05 4,500 225
12,000 375 2,500 2,875
20 80 0.02 12,000 240
60 0.05 9,000 450
30 0.10 4,500 450
25,500 1,140 1,000 2,140
10 90 0.02 13,500 270
70 0.05 10,500 525

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MATERIAL COST 2.27

40 0.10 6,000 600

10 0.20 1,500 300
31,500 1,695 500 2,195
0 10 0.02 15,000 300 2,700
80 0.05 12,000 600
50 0.10 7,500 750
20 0.20 3,000 600
10 0.30 1,500 450
39,000 2,700 0 2,700

At safety stock level of 20 units, total cost is least i.e. ` 2,140.

Working Note :
Computation of Probability of Stock-out
Stock-out (units) 100 80 50 20 10 0 Total
Nos. of times 2 5 10 20 30 33 100
Probability 0.02 0.05 0.10 0.20 0.30 0.33 1.00

Explanation :
Stock-out means the demand of an item that could not be fulfilled because of
insufficient stock level.
Safety stock is the level of stock of any item which is maintained in excess of lead time
consumption. It is kept as cushion against any unexpected demand for that item.

Safety stock level Impact

100 units Any unexpected demand upto 100 units can be met.
80 units Stock out will only arise if unexpected demand will be for 100
units. In this case 20 units will remain unsatisfied. The probability
of any unexpected demand for 100 units is 0.02.

50 units Any unexpected demand beyond 50 units will be remain

unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02) 50 units will be unsatisfied. Similarly, if
unexpected demand for 80 units arises (probability is 0.05), 30
units will be unsatisfied.

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2.28 COST AND MANAGEMENT ACCOUNTING

20 units Any unexpected demand beyond 20 units will be remain

unsatisfied. If unexpected demand for 100 units arises (probability
is 0.02), 80 units will remain unsatisfied. If unexpected demand
for 80 units arises (probability is 0.05), 60 units will remain
unsatisfied. Similarly, when unexpected demand for 50 units
arises (probability is 0.10), 30 units will remain unsatisfied.
10 units Any unexpected demand beyond 10 units will be remain
unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02), 90 units will remain unsatisfied. If unexpected
demand for 80 units arises (probability is 0.05), 70 units will
remain unsatisfied. If unexpected demand for 50 units arises
(probability is 0.10), 40 units will remain unsatisfied. Similarly,
when unexpected demand for 20 units arises (probability is
0.20), 10 units will remain unsatisfied.
0 unit When no safety stock level is maintained, any unexpected
demand cannot be satisfied. If unexpected demand for 100
units arises (probability is 0.02), 100 units will remain unsatisfied.
If unexpected demand for 80 units arises (probability is 0.05),
80 units will remain unsatisfied. If unexpected demand for 50
units arises (probability is 0.10), 50 units will remain unsatisfied.
If unexpected demand for 20 units arises (probability is 0.20),
20 units will remain unsatisfied. Similarly, unexpected demand
for 10 units (probability is 0.30), 10 units will remain unsatisfied.

2.6.3 Just in Time (JIT) Inventory Management

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.
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.
It is also known as ‘Demand pull’ or ‘Pull through’ system of production. In this system,
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. This can be understood with the help of the
following diagram :

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MATERIAL COST 2.29

Production Material Order for

Supplier
Demand starts to Requirement raw
sent the
for final process the is sent to materials
material for
product demad for Purchase sent to
production
product department supplier

2.6.4 Inventory Control-On the basis of Relative Classification

(1) ABC Analysis : This system exercises discriminating control over different items
of inventory on the basis of the investment involved. 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 : Thiscategory 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 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,

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2.30 COST AND MANAGEMENT ACCOUNTING

after ascertaining consumption requirements. In this case the objective is to economies

on ordering and handling costs.
Cost

ILLUSTRATION 8
From the following details, draw a plan of ABC selective control:
Item Units Unit cost (`)
1 7,000 5.00
2 24,000 3.00
3 1,500 10.00
4 600 22.00
5 38,000 1.50
6 40,000 0.50
7 60,000 0.20
8 3,000 3.50
9 300 8.00
10 29,000 0.40
11 11,500 7.10
12 4,100 6.20

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SOLUTION
Statement of Total Cost and Ranking
Item Units %of Total Unit cost Total cost % of Total Ranking
units (`) (`) cost
1 7,000 3.1963 5.00 35,000 9.8378 4
2 24,000 10.9589 3.00 72,000 20.2378 2
3 1,500 0.6849 10.00 15,000 4.2162 7
4 600 0.2740 22.00 13,200 3.7103 8
5 38,000 17.3516 1.50 57,000 16.0216 3
6 40,000 18.2648 0.50 20,000 5.6216 6
7 60,000 27.3973 0.20 12,000 3.3730 9
8 3,000 1.3699 3.50 10,500 2.9513 11
9 300 0.1370 8.00 2,400 0.6746 12
10 29,000 13.2420 0.40 11,600 3.2605 10
11 11,500 5.2512 7.10 81,650 22.9502 1
12 4,100 1.8721 6.20 25,420 7.1451 5
2,19,000 100 3,55,770 100
Basis for selective control (Assumed)
` 50,000 & above -- ‘A’ items
` 15,000 to 50000 -- ‘B’ items
Below ` 15,000 -- ‘C’ items
On this basis, a plan of A B C selective control is given below:
Ranking Item Nos. % of Total Cost (`) % of Total Cost Category
units
1 11 5.2512 81,650 22.9502
2 2 10.9589 72,000 20.2378
3 5 17.3516 57,000 16.0216
Total 3 33.5617 2,10,650 59.2096 A
4 1 3.1963 35,000 9.8378
5 12 1.8721 25,420 7.1451
6 6 18.2648 20,000 5.6216
7 3 0.6849 15,000 4.2162
Total 4 24.0181 95,420 26.8207 B

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2.32 COST AND MANAGEMENT ACCOUNTING

8 4 0.2740 13,200 3.7103

9 7 27.3973 12,000 3.3730
10 10 13.2420 11,600 3.2605
11 8 1.3699 10,500 2.9513
12 9 0.1370 2,400 0.6746
Total 5 42.4202 49,700 13.9697 C
Grand Total 12 100 3,55,770 100
(1) Advantages of ABC analysis : The advantages of ABC analysis are the following:
(i) Continuity in production : It ensures that, without there being any danger
of interruption of production for want of materials or stores, minimum
investment will be made in inventories of stocks of materials or stocks to
be carried.
(ii) Lower cost : The cost of placing orders, receiving goods and main-taining
stocks is minimised specially if the system is coupled with the determination
of proper economic order quantities.
(iii) Less attention required : Management time is saved since attention need
be paid only to some of the items rather than all the items as would be the
case if the ABC system was not in operation.
(iv) Systematic working : With the introduction of the ABC system, much of the
work connected with purchases can be systematized on a routine basis to
be handled by subordinate staff.
ILLUSTRATION 9
A factory uses 4,000 varieties of inventory. In terms of inventory holding and inventory
usage, the following information is compiled:
No. of varieties % % value of inventory % of inventory usage(in
of inventory holding (average) 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.

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SOLUTION
Classification of the items of inventory as per ABC analysis
1. 15 number of varieties of inventory items should be classi¬fied as ‘A’ category
items because of the following reasons:
(i) Constitute 0.375% of total number of varieties of inventory handled by
stores of factory, which is minimum as per given classification in the table.
(ii) 50% of total use value of inventory holding (average) which is maximum
according to the given table.
(iii) Highest in consumption about 85% of inventory usage (in end-product).
2. 110 number of varieties of inventory items should be classified as ‘B’ category
items because of the following reasons:
(i) Constitute 2.750% of total number of varieties of inventory items handled
by stores of factory.
(ii) Requires moderate investment of about 30% of total use value of inventory
holding (average).
(iii) Moderate in consumption about 10% of inventory usage (in end–product).
3. 3,875 number of varieties of inventory items should be classified as ‘C’ category
items because of the following reasons:
(i) Constitute 96.875% of total varieties of inventory items handled by stores
of factory.
(ii) Requires about 20% of total use value of inventory holding (average).
(iii) Minimum inventory consumption i.e. about 5% of inventory usage (in end-
product).
(2) Fast Moving, Slow Moving and Non Moving (FSN) Inventory : It is also known
as FNS (Fast, Normal and Slow moving) classification of inventory Analysis. 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. A threshold range on the basis of inventory turnover is
decided and classified accordingly.
(i) Fast Moving : This category of items are placed nearer to store issue point and the
stock is reviewed frequently for making of fresh order.
(ii) Slow Moving : This category of items are given 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.

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(3) 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 gets the second priority.
(iii) Desirable : Items under this category are optional in nature, unavailability does
not cause any production or efficiency loss.
(4) 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.
2.6.5 Using Ratio Analysis
(i) Input Output Ratio : Inventory control can also be exercised by the use of input
output ratio analysis. Input-output ratio is the ratio of the quantity of input of material
to production and the standard material content of the actual output.
This type of ratio analysis enables comparison of actual consumption and standard
consumption, thus indicating whether the usage of material is favourable or adverse.
(ii) Inventory Turnover Ratio : Computation of inventory turnover ratios for different
items of material and comparison of the turnover rates provides a useful guidance for
measuring inventory performance. 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. Inventory turnover
ratio may be calculated by using the following formulae :
Cost of materials consumed during the period
Inventory Turnover Ratio =
Cost of average stock held during the period
Average stock = 1/2 (opening stock + closing stock)
360 days/12 months
Average no. of days of Inventory holding =
Inventory Turnover Ratio

By comparing the number of days in the case of two different materials, it is possible
to know which is fast moving and which is slow moving. On this basis, attempt should

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MATERIAL COST 2.35

be made to reduce the amount of capital locked up, and prevent over-stocking of the
slow moving items.
ILLUSTRATION 10
The following data are available in respect of material X for the year ended 31st March,
20X1.
(`)
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.
SOLUTION
Inventory turnover ratio
Cost of stock of raw material consumed
(Refer to working note) =
Average stock of raw material

` 2,50,000
= = 2.5
` 1,00,000

Average number of days for which

365
the average inventory is held = = 146 days
Inventory turnover ratio

Working Note :

(`)
Opening stock of raw material 90,000
Add: Material purchases during the year 2,70,000
Less: Closing stock of raw material 1,10,000
Cost of stock of raw material consumed 2,50,000
ILLUSTRATION 11
From the following data for the year ended 31st December, 20X1, calculate the inventory
turnover ratio of the two items and put forward your comments on them.

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2.36 COST AND MANAGEMENT ACCOUNTING

Material A (`) Material B (`)

Opening stock 1.1.20X1 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.12.20X1 6,000 11,000
SOLUTION
First of all it is necessary to find out the material consumed :
Cost of materials consumed Material A Material B
(`) (`)
Opening stock 10,000 9,000
Add : Purchases 52,000 27,000
62,000 36,000
Less : Closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory : (Opening Stock + Closing Stock) ÷ 2 8,000 10,000
Inventory Turnover ratio : (Consumption ÷ Average 7 times 2.5 times
inventory)
Inventory Turnover (Number of Days in a year/IT ratio) 52 days 146 days
Comments : Material A is moving faster than Material B.
2.6.6 Physical Control
(i) Two Bin System
Under this system each bin is divided into two parts - one, smaller part, should stock
the quantity equal to the minimum stock or even the re-ordering level, and the other
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. “Two Bin System” is supplemental to the record of respective quantities on the
bin card and the stores ledger card.
(ii) 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. The exact quantity
of various types of inventories and the time when they would be required can be
known by studying carefully production plans and production schedules. Based on
this, inventories requirement budget can be prepared. Such a budget will discourage
the unnecessary investment in inventories.

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(iii) Perpetual inventory records and continuous stock verification

Perpetual inventory represents a system of records maintained by the stores department.
It in fact comprises: (i) Bin Cards, and (ii) Stores Ledger.
The success of perpetual inventory depends upon the following:
(a) The Stores Ledger-(showing quantities and amount of each item).
(b) Stock Control cards (or Bin Cards).
(c) Reconciling the quantity balances shown by (a) & (b) above.
(d) Checking the physical balances of a number of items every day systematically
and by rotation.
(e) Explaining promptly the causes of discrepancies, if any, between physical balances
and book figures.
(f) Making corrective entries where called for after step (e) and
(g) Removing the causes of the discrepancies referred to in step (e)
Advantages of perpetual inventory:The main advantages of perpetual inventory are
as follows :
(1) Physical stocks can be counted and book balances adjusted as and when desired
without waiting for the entire stock-taking to be done.
(2) Quick compilation of Profit and Loss Account (for interim period) due to prompt
availability of stock figures.
(3) Discrepancies are easily located and thus corrective action can be promptly taken
to avoid their recurrence.
(4) A systematic review of the perpetual inventory reveals the existence of surplus,
dormant, obsolete and slow-moving materials, so that remedial measures may
be taken in time.
(5) Fixation of the various stock levels and checking of actual balances in hand with
these levels assist the Store keeper in maintaining stocks within limits and in
initiating purchase requisitions for correct quantity at the proper time.
(iv) Continuous Stock Verification
The checking of physical inventory is an essential feature of every sound system of
material control. 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 are done
at appropriate interval of time without prior notice. The element of surprise, that is
essential for effective control of the system.
Advantages of continuous stock-taking: The advantages of continuous stock-taking
are:
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.
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2.38 COST AND MANAGEMENT ACCOUNTING

3. The system generally has a sobering influence on the stores staff because of the
element of surprise present therein.
4. The movement of stores items can be watched more closely by the stores auditor
so that chances of obsolescence buying are reduced.
5. Final Accounts can be ready quickly. Interim accounts are possible quite
conveniently.
Disadvantages: Annual stock-taking, however, has certain inherent shortcomings
which tend to detract from the usefulness of such physical verification. For instance,
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.

2.7 MATERIAL ISSUE PROCEDURE

Issue of material must not be made except under properly authorised requisition slip;
usually it is the foreman of a department who has the authority to draw materials from
the store. Issue of material must be made on the basis of first in first out, that is, out of
the earliest lot on hand. If care is not exercised in this regard, quality of earliest lot of
material may deteriorate for having been kept for a long period.
(i) Issue against Material Requisition Note: It is the voucher of the authority as
regards issue of materials for use in the factory or in any of its departments. After
receipt of material requisition slip, store keeper ensures that requisition is properly
authorized and requisitioned quantity is within the quantity specified in bill of materials.
After satisfied with the documents, store keeper issue materials and keep one copy of
based materials and record the transaction in the records maintained by the stores
department.
(ii) Transfer of Material: 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 such reason. It may, however, be possible to find
some alternative use for such materials by transferring it to some other job instead of
returning it to the store.
It must be stressed that generally transfer of material from one job to another is
irregular, if not improper, in so far it is not conducive to correct allocation and control
of material cost of jobs or other units of production. It is only in the circumstances
envisaged above that such direct transfer should be made, at the time of material
transfer a material transfer note should be made in duplicate, the disposition of the
copies of this note being are as follows:

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MATERIAL COST 2.39

Cost Accounting Department

Material Transfer Note

Department Making Transfer

No copy is required for the Store as no entry in the stores records would be called for.
The Cost Accounting Department would use its copy for the purpose of making the
necessary entries in the cost ledger accounts for the jobs affected.
Format of a material requisition note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.
(iii) Return of Material: Sometimes, it is not possible before hand to make any precise
estimate of the material requirements or units of production. Besides, at times due to
some technical or other difficulty, it is not practicable to measure exactly the quantity of
material required by a department. In either case, material may have to be issued from
stores in bulk, often in excess of the actual quantity required. Where such a condition
exists, it is of the utmost importance from the point of view of materials control that
any surplus material left over on the completion of a job should be promptly hand over
to the storekeeper for safe and proper custody.
Unless this is done, the surplus material may be misappropriated or misap¬plied to
some purpose, other than that for which it was intended. The material cost of the
job against which the excess material was originally drawn in that case, would be
overstated unless the job is given credit for the surplus arising thereon.
The surplus material, when it is returned to the storeroom, should be accompanied by
a document known either as a Shop Credit Note or alternatively as a Stores Debit Note.
This document should be made out, by the department returning the surplus material
and it should be in triplicate to be used as follows:
Store Room

Shop Credit Note Cost Accounting Department

Department Returning it

Format of a shop credit note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.

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2.40 COST AND MANAGEMENT ACCOUNTING

2.8 VALUATION OF MATERIAL ISSUES

Materials issued from stores should be priced at the value at which they are carried
in stock. But there can be a situation where the material may have been purchased at
different times and at different prices with varying discounts, taxes etc. Because of this
the problem arises as to how the material issues to production are to be valued. There
are several methods for tackling this situation. The cost accountant should select the
proper method based on following factors:
1. The frequency of purchases, price fluctuations and its range.
2. The frequency of issue of materials, relative quantity etc.
3. Nature of cost accounting system.
4. The nature of business and type of production process.
5. Management policy relating to valuation of closing stock.
Several methods of pricing material issues have been evolved in an attempt to
satisfactorily answer the problem. These methods may be grouped and explained as
follows:
2.8.1 Cost Price Methods
(i) Specific Price Method : This method is useful, specially when materials are
purchased for a specific job or work order, and as such these materials are issued
subsequently to that specific job or work order at the price at which they were
purchased.
To use this method, it is necessary to store each lot of material separately and maintain
its separate account.
Advantages and Disadvantages
Advantages Disadvantages
• The cost of materials issued for • This method is difficult to operate,
production purposes to specific specially when purchases and issues are
jobs represent actual and correct numerous.
costs.
• This method is best suited for non-
standard and specific products.
(ii) First-in First-out (FIFO)method : It is a method of pricing the issues of materials,
in the order in which they are purchased. In other words, the materials are issued in
the order in which they arrive in the store or the items longest in stock are issued first.
Thus each issue of material only recovers the purchase price which does not reflect the
current market price.
This method is considered suitable in times of falling price because the material cost
charged to production will be high while the replacement cost of materials will be low.
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MATERIAL COST 2.41

But, in the case of rising prices, if this method is adopted, the charge to production will
be low as compared to the replacement cost of materials. Consequently, it would be
difficult to purchase the same volume of material (as in the current period) in future
without having additional capital resources.
Advantages and disadvantages
Advantages Disadvantages
• It is simple to understand and easy • If the prices fluctuate frequently, this
to operate. method may lead to clerical error.
• Material cost charged to production • Since each issue of material to production
represents actual cost with which is related to a specific purchase price, the
the cost of production should have costs charged to the same job are likely
been charged. to show a variation from period to period.
• In the case of falling prices, the use • In the case of rising prices, the real profits
of this method gives better results. of the concern being low, may not be
adequate to meet the materialspurchase
demand at the current market price.

• Closing stock of material will be

represented very closely at current
market price.
The application of FIFO method is illustrated below:
Material Received and Issued
Lot Date Quantity Kg. Lot No. Rate (`) Amount
No. (`)
1. July 3 600 1.00 600.00
2. July 13 800 1.20 960.00
3. July 23 600 0.90 540.00
4. August 5 400 1.10 440.00
5. August 6 1200 0.80 960.00
July 8 400 Kgs. out of (1) 1.00 400.00
July 12 200 Kgs. out of (1) 1.00 200.00
July 22 600 Kgs. out of (2) 1.20 720.00
July 25 200 Kgs. out of (2) 1.20 240.00
200 Kgs. out of (3) 0.90 180.00
August 8 400 Kgs. out of (3) 0.90 360.00
400 Kgs. out of (4) 1.10 440.00
200 Kgs. out of (5) 0.80 160.00

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The stock in hand after 8th August will be 1,000 Kgs. This will be out of lot number (5)
and its value will be ` 800, i.e., @ ` 0.80 per Kg.
(iii) Last-in-First-out (LIFO) method : It is a method of pricing the issues of materials.
This method is based on the assumption that the items of the last batch (lot) purchased
are the first to be issued. Therefore, under this method the prices of the last batch (lot)
are used for pricing the issues, until it is exhausted, and so on. If however, the quantity
of issue is more than the quantity of the latest lot than earlier (lot) and its price will also
be taken into consideration.
During inflationary period or period of rising prices, the use of LIFO would help to
ensure that the cost of production determined on the above basis is approximately the
current one. This method is also useful specially when there is a feeling that due to the
use of FIFO or average methods, the profits shown and tax paid are too high.
Advantages and Disadvantages
Advantages Disadvantage
• The cost of materials issued will be • Calculation under LIFO system becomes
either nearer to and or will reflect the complicated and cumbersome when
current market price. Thus, the cost frequent purchases are made at highly
of goods produced will be related fluctuating rates.
to the trend of the market price of
materials. Such a trend in price of
materials enables the matching of
cost of production with current sales
revenues.
• The use of the method during the • Costs of different similar batches of
period of rising prices does not reflect production car¬ried on at the same
undue high profit in the income time may differ a great deal.
statement as it was under the first-in-
first-out or average method. In fact,
the profit shown here is relatively
lower because the cost of production
takes into account the rising trend of
material prices.
• In the case of falling prices profit tends • In time of falling prices, there will
to rise due to lower material cost, yet be need for writing off stock value
the finished products appear to be considerably to stick to the principle
more competitive and are at market of stock valuation, i.e., the cost or the
price. market price whichever is lower.
• Over a period, the use of LIFO helps to • This method of valuation of material
iron out the fluctuations in profits. is not acceptable to the income tax
authorities.
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MATERIAL COST 2.43

• In the period of inflation LIFO will tend

to show the correct profit and thus
avoid paying undue taxes to some
extent.

It may be noted that Last in First out (LIFO) is not permitted under Accounting
Standard (AS)-2: Valuation of Inventories and Ind AS- 2: Inventories. However, for the
purpose of academic knowledge LIFO method is included in this Study Material
ILLUSTRATION 12
The following transactions in respect of material Y occurred during the six months ended
30th June, 20X1:
Month Purchase (units) Price per unit (`) Issued units
January 200 25 Nil
February 300 24 250
March 425 26 300
April 475 23 550
May 500 25 800
June 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? Detailed stores ledgers are not required.
(b) When and why would you recommend the LIFO method of pricing material issues?
SOLUTION
(a) The Closing Stock at the end of six months’ period i.e., on 30th June, 20X1 will be
200 units, whereas up to the end of May 20X1, total purchases coincide with the total
issues i.e., 1,900 units. It means that at the end of May 20X1, there was no closing stock.
In the month of June 20X1, 600 units were purchased out of which 400 units were
issued. Since there was only one purchase and one issue in the month of June, 20X1
and there was no opening stock on 1st June 20X1, the Closing Stock of 200 units is to
be valued at ` 20 per unit.
In view of this, the argument of the Chief Accountant appears to be correct. Where
there is only one purchase and one issue in a month with no opening stock, the
method of pricing of material issues becomes irrelevant. Therefore, in the given case
one should agree with the argument of the Chief Accountant that the value of Closing
Stock remains the same no matter which method of pricing the issue is used.

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It may, however, be noted that the argument of Chief Accountant would not stand if
one finds the value of the Closing Stock at the end of each month.
(b) LIFO method has an edge over FIFO or any other method of pricing material issues
due to the following advantages:
(i) The cost of the materials issued will be either nearer or will reflect the current
market price. Thus, the cost of goods produced will be related to the trend of
the market price of materials. Such a trend in price of materials enables the
match¬ing of cost of production with current sales revenues.
(ii) The use of the method during the period of rising prices does not reflect undue
high profit in the income statement, as it was under the first-in-first-out or
average method. In fact, the profit shown here is relatively lower because the
cost of production takes into account the rising trend of material prices.
(iii) In the case of falling prices, profit tends to rise due to lower material cost, yet the
finished products appear to be more competitive and are at market price.
(iv) During the period of inflation, LIFO will tend to show the correct profit and thus,
avoid paying undue taxes to some extent.
ILLUSTRATION 13
The following information is provided by Sunrise Industries for the fortnight of April,
20X1:
Material Exe:
Stock on 1-4-20X1 100 units at ` 5 per unit.
Purchases
5-4-20X1, 300 unitsat ` 6
8-4-20X1, 500 unitsat ` 7
12-4-20X1, 600unitsat ` 8
Issues
6-4-20X1, 250 units
10-4-20X1, 400units
14-4-20X1, 500units
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 15-4-20X1.
(B) Explain why the figures in (a) and (b) in part A of this question are different under
the two methods of pricing of mate¬rial issues used. You need not draw up the Stores
Ledgers.

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MATERIAL COST 2.45

SOLUTION
(A) (a) Value of Material Exe consumed during the period
1-4-20X1 to 15-4-20X1 by using FIFO method.
Date Description Units Qty. Rate(`) Amount(`)
(Units)
1-4-20X1 Opening balance 100 5 500
5-4-20X1 Purchased 300 6 1,800
6-4-20X1 Issued 100 5 
150 6  1,400

8-4-20X1 Purchased 500 7 3,500
10-4-20X1 Issued 150 6 

250 7  2,650
12-4-20X1 Purchased 600 8 4,800
14-4-20X1 Issued 250 7 

250 8  3,750
15-4-20X1 Balance 350 8 2,800
Total value of material Exe consumed during the period under FIFO method
comes to (` 1,400 + ` 2,650 + ` 3,750) ` 7,800 and balance on 15-4-20X1 is of
` 2,800.
Value of material Exe consumed during the period 01-4-20X1 to 15-4-
20X1 by using LIFO method
Date Description Qty. (Units) Rate (`) Amount (`)
1-4-20X1 Opening balance 100 5 500
5-4-20X1 Purchased 300 6 1,800
6-4-20X1 Issued 250 6 1,500
8-4-20X1 Purchased 500 7 3,500
10-4-20X1 Issued 400 7 2,800
12-4-20X1 Purchased 600 8 4,800
14-4-20X1 Issued 500 8 4,000
15-4-20X1 Balance 350 — 2,300*
Total value of material Exe issued under LIFO method comes to (` 1,500 + `
2,800 + ` 4,000) ` 8,300.

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2.46 COST AND MANAGEMENT ACCOUNTING

*The balance 350 units on 15-4-20X1 of ` 2,300, relates to opening balance

on 1-4-20X1 and purchases made on 5-4-20X1, 8-4-20X1 and 12-4-20X1. (100
units @ ` 5, 50 units @ ` 6, 100 units @ ` 7 and 100 units @ ` 8).
(b) As shown in (a) above, the value of stock of materials on 15-4-20X1:
Under FIFO method ` 2,800
Under LIFO method ` 2,300
(B) Total value of material Exe issued to production under FIFO and LIFO methods
comes to ` 7,800 and ` 8,300 respectively. The value of closing stock of material
Exe on 15-4-20X1 under FIFO and LIFO methods comes to ` 2,800 and ` 2,300
respectively.
The reasons for the difference of ` 500 (` 8,300 – ` 7,800) as shown by the following
table in the value of material Exe, issued to production under FIFO and LIFO are as
follows:
Date Quantity Value Total Value Total
Issued FIFO LIFO
(Units) (`) (`) (`) (`)
6-4-20X1 250 1,400 1,500
10-4-20X1 400 2,650 2,800
14-4-20X1 500 3,750 7,800 4,000 8,300
1. On 6-4-20X1, 250 units were issued to production. Under FIFO their value
comes to `1,400 (100 units × ` 5 + 150 units × ` 6) and under LIFO ` 1,500
(250 × ` 6). Hence, ` 100 was more charged to production under LIFO.
2. On 10-4-20X1, 400 units were issued to production. Under FIFO their value
comes to ` 2,650 (150 × ` 6 + 250 × ` 7) and under LIFO ` 2,800 (400 × ` 7).
Hence, ` 150 was more charged to production under LIFO.
3. On 14-4-20X1, 500 units were issued to production. Under FIFO their value
comes to ` 3,750 (250 × ` 7 + 250 × ` 8) and under LIFO ` 4,000 (500 × ` 8).
Hence, ` 250 was more charged to production under LIFO.
Thus the total excess amount charged to production under LIFO comes to ` 500.
The reasons for the difference of ` 500 (` 2,800 – ` 2,300) in the value of 350 units
of Closing Stock of material Exe under FIFO and LIFO are as follows:
1. In the case of FIFO, all the 350 units of the closing stock belongs to the purchase
of material made on 12-4-20X1, whereas under LIFO these units were from
opening balance and purchases made on 5-4-20X1, 8-4-20X1 and 12-4-20X1.
2. Due to different purchase price paid by the concern on differ¬ent days of
purchase, the value of closing stock differed under FIFO and LIFO. Under FIFO
350 units of closing stock were valued @ ` 8 p.u. Whereas under LIFO first 100

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MATERIAL COST 2.47

units were valued @ ` 5 p.u., next 50 units @ ` 6 p.u., next 100 units @ ` 7 p.u.
and last 100 units @ ` 8 p.u.
Thus under FIFO, the value of closing stock increased by ` 500.
(iv) Base Stock Method : Minimum quantity of stock under this method is always held
at a fixed price as reserve in the stock, to meet a state of emergency, if it arises. This
minimum stock is known as base stock and is valued at a price at which the first lot of
materials is received and remains unaffected by subsequent price fluctuations.
This method of valuing inventory is different from other methods of valuing issues,
as the base stock of materials are valued at the original cost, whereas,materials other
than the base are valued using other methods like FIFO, LIFO etc. This method is not
an independent method as it uses FIFO or LIFO.
Advantages and disadvantages of this method depend upon the use of the other
method viz., FIFO or LIFO.
2.8.2 Average Price Methods
(i) Simple Average Price Method:Under this method, materials issued are valued at
average price, which is calculated by dividing the total of rates at which different lot of
materials are purchased by total number of lots. In this method quantity purchased in
each lot is ignored.
Example: During the month of April, a company has made five purchases as follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ `11 each.
The issue price under Simple Average Price Method would be calculated as below:
` 10+ ` 12+ ` 12+ ` 15+ ` 11
= `12 each
5 lots
This method is suitable when the materials are received in uniform lots of similar
quantity, and prices do not fluctuate considerably.
Advantages and Disadvantages:
Advantages Disadvantages
• This method is simple to use for an • This method does not provide right
entity which orders materials in a lot stock valuation when standard
of standard quantity, as only price per quantity for purchase in a lot is not
lot is taken to calculate average price specified.

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2.48 COST AND MANAGEMENT ACCOUNTING

• In a stable price environment, • When price of materials fluctuates

this method gives a price which and the entity choses to customise
approximates to the current market the order quantity, in this situation
price. price under this method may differs
substantially from current market
price.
(ii) Weighted Average Price Method : Unlike Simple Average Price method, this
method gives due weightage to quantities also. Under this method, issue price is
calculated dividing sum of products of price and quantity by total number quantities.
Example: During the month of April, a company has made five purchases as follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
14th April, 210 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ `11 each.
The issue price under Weightage Average Price Method would be calculated as below:
{( ` 10×200units)+( ` 12×150units)+( ` 12×210units)+( ` 15×50units)+( ` 11×140units)}
(200+150+210+50+140)units
` 8,610
= `11.48 each
750units

This method is useful in case when quantity purchased under each lot is different and
price fluctuates frequently.
Advantages and Disadvantages:
Advantages Disadvantages
• It smoothens the price fluctuations • Material cost does not represent actual
if at all it is there due to material cost price and therefore, a profit or loss
purchases. will arise out of such a pricing method.
• Issue prices need not be calculated • It may be difficult to compute since
for each issue unless new lot of every time lot received would require re-
materials is received. computation of issue prices.
2.8.3 Market Price Methods
(i) Replacement Price Method : Replacement price is defined as the price at which
it is possible to purchase an item, identical to that which is being replaced or revalued.
Under this method, materials issued are valued at the replacement cost of the items.
This method pre-supposes the determination of the replacement cost of materials
at the time of each issue; viz., the cost at which identical materials could be currently

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MATERIAL COST 2.49

purchased. The product cost under this method is at current market price, which is the
main objective of the replacement price method.
This method is useful to determine true cost of production and to value material issues
in periods of rising prices, because the cost of material considered in cost of production
would be able to replace the materials at the increased price.
(ii) Realisable Price Method : Realisable price means a price at which the material
to be issued can be sold in the market. This price may be more or may be less than
the cost price at which it was originally purchased. Like replacement price method, the
stores ledger would show profit or loss in this method too.
2.8.4 Notional Price Methods
(i) Standard Price Method : Under this method, materials are priced at some
predetermined rate or standard price irrespective of the actual purchase cost of the
materials. Standard cost is usually fixed after taking into consideration the following
factors:
(i) Current prices,
(ii) Anticipated market trends, and
(iii) Discount available and transport charges etc.
Standard prices are fixed for each material and the requisitions are priced at the
standard price. This method is useful for controlling material cost and determining the
efficiency of purchase department. In the case of highly fluctuating prices of materials,
it is difficult to fix their standard cost on long-term basis.
Advantages Disadvantages
• The use of the standard price method • The use of standard price does not
simplifies the task of valuing issues of reflect the market price and thus results
materials. in a profit or loss.
• It facilitates the control of material • The fixation of standard price becomes
cost and the task of judging the difficult when prices fluctuate frequently
efficiency of purchase department.
• It reduces the clerical work.
(ii) Inflated Price Method : In case material suffers loss in weight due to natural or
climatic factors, e.g., evaporation, the issue price of the material is inflated to cover up
the losses.
(iii) Re-use Price Method : When materials are rejected and returned to the stores
or a processed material is put to some other use, then for the purpose it is meant,
then such materials are priced at a rate quite different from the price paid for them
originally. There is no final procedure for valuing use of material.

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2.50 COST AND MANAGEMENT ACCOUNTING

2.9 VALUATION OF RETURNS & SHORTAGES

2.9.1 Valuation of Materials Returned to the Vendor
Materials which do not meet quality and other specifications and are considered to
be unfit for production and are usually returned to the vendor. These materials can
be returned to the vendor before they are sent to the stores. In case materials reach
store and then are noticed of a sub-standard quality, then also they can be returned
to vendor.
The price of the materials to be returned to vendor should include its invoice price plus
freight, receiving and handling charges etc. Strictly speaking, the materials returned to
vendor should be returned at the stores ledger price and not at invoice price. But in
practice invoice price is only considered, the gap between the invoice price and stores
ledger price is charged as overhead.In Stores ledger the defective or sub-standard
materials are shown in the issue column at the rate shown in the ledger, and the
difference between issue price and invoice cost is debited to an inventory adjustment
account.
2.9.2 Valuationof Materials Returned to Stores
When materials requisitioned for a specific job or work-in progress are found to be in
excess of the requirement or are unsuitable for the purpose, they are returned to the
stores. There are two ways of treating such returns.
(1) Such returns are entered in the receipt column at the price at which they were
originally issued, and the materials are kept in suspense, to be issued at the same
price against the next requisition.
(2) Include the materials in stock as if they were fresh purchases at the original issue
price.
2.9.3 Valuation of Shortages during Physical Verification
Materials found short during physical verification should be entered in the issue column
and valued at the rate as per the method adopted, i.e., FIFO or any other.

2.10 TREATMENT OF NORMAL AND ABNORMAL

LOSS OF MATERIALS
Loss of materials during handling, storage, process may occur any of the following
forms:

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MATERIAL COST 2.51

(i) Waste : The portion of raw material which is lost during storage or production and
discarded. The waste may or may not have any value.
Treatment of Waste
Normal- Cost of normal waste is absorbed by good production units.
Abnormal- The cost of abnormal loss is transferred to Costing Profit and loss account.
(ii) Scrap : The materials which are discarded and disposed-off without further
treatment. Generally, scrap has either no value of insignificant value. Some time it may
reintroduced into the process as raw material.
Treatment of Scrap
Normal- The cost of scrap is borne by good units and income arises on account
realisable value is deducted from the cost.
Abnormal- The scrap account should be charged with full cost. The credit is given to
the job or process concerned. The profit or loss in the scrap account, on realisation, will
be transferred to the Costing Profit and Loss Account.
(iii) Spoilage : It is the term used for materials which are badly damaged in
manufacturing operations, and they cannot be rectified economically and hence taken
out of process to be disposed of in some manner without further processing.
Treatment of Spoilage
Normal- Normal spoilage (i.e., which is inherent in the operation) costs are included in
costs either charging the loss due to spoilage to the production order or by charging
it to production overhead so that it is spread over all products.
Any value realised from spoilage is credited to production order or production
overhead account, as the case may be.
Abnormal-The cost of abnormal spoilage (i.e., arising out of causes not inherent in
manufacturing process) is charged to the Costing Profit and Loss Account. When
spoiled work is the result of rigid specification, the cost of spoiled work is absorbed by
good production while the cost of disposal is charged to production overhead.
(iv)Defectives : It signifies those units or portions of production which do not meet
the quality standards. Defectives arise due to sub-standard materials, bad-supervision,
bad-planning, poor workmanship, inadequate-equipment and careless inspection.

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2.52 COST AND MANAGEMENT ACCOUNTING

Defectives which can be re-made as per the quality standard by using additional
materials are known as reworks. Reworks includes repairs, reconditioning and
refurbishing.
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.
Treatment of Defectives
Normal- The cost less realisable value on sale of defectives are charged to material
cost of good production.
Abnormal-Material Cost of abnormal defectives are notincluded in material cost but
treated as loss after giving credit to the realisable value of such defectives. The material
cost of abnormal loss is transferred to costing profit and loss account.
Reclamation of loss from defective units
In the case of articles that have been spoiled, it is necessary to take steps to reclaim as
much of the loss as possible. For this purpose:
(i) All defective units should be sent to a place fixed for the purpose;
(ii) These should be dismantled;
(iii) Goods and serviceable parts should be separated and taken into stock;
(iv) Parts which can be made serviceable by further work should be separated and
sent to the workshop for the purpose and taken into stock after the defects have
been removed; and
(v) Parts which cannot be made serviceable should be collected in one place for
being melted or sold.
Printed forms should be used to record quantities for all purposes aforementioned.
Difference between Waste and Scrap
Waste Scrap
1. It is connected with raw material or 1. It is connected with output
inputs to the production process.
2.Waste of materials may be visible or 2. Scraps are generally identifiable and
invisible. has physical substance.
3.Generally waste has no recoverable 3. Scraps are termed as by-products and
value. has small recoverable value.
Difference between Scrap and Defectives
Scrap Defectives
1. It is loss connected with output 1. This type of loss connected with the
output but it can be in the input as well.

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MATERIAL COST 2.53

2. Scraps are not intended but cannot be 2. Defectives also are not intended but can
eliminated due to nature of material or be eliminated through proper control.
process itself.
3. Generally scraps are not used or 3. Defectives can be used after rectification.
rectified.
4. Scraps have insignificant recoverable 4. Defectives are sold at lower value from
value. that of 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 standard production or to seconds.
The problem of accounting for defective work is the problem of accounting of the
costs of rectification or rework.
(v) Obsolescence: Obsolescence is defined as “the loss in the intrinsic value of an
asset due to its supersession”.
Treatment: Materials may become obsolete under any of the following circumstances:
(i) where it is a spare part or a component of a machinery used in manufacture and
that machinery becomes obsolete;
(ii) where it is used in the manufacture of a product which has become obsolete;
(iii) where the material itself is replaced by another material due to either improved
quality or fall in price.
In all three cases, the value of the obsolete material held in stock is a total loss and
immediate steps should be taken to dispose it off at the best available price. The loss
arising out of obsolete materials on abnormal loss does not form part of the cost of
manufacture.

2.11 CONSUMPTION OF MATERIALS

Any product that is manufactured in a firm entails consumption of resources like
material, labour etc. The management for planning and control must know the cost of
using these resources in manufacturing. The consumption of materials takes place say
when the material is used in the manufacture of the product.
It is important to note that the amount of materials consumed in a period by a cost object
need not be equal to the amount of material available with the concern. For example,
during any period the total of raw material stock available for use in production may
not be equal to the amount of materials actually consumed and assigned to the cost
object of the production. The difference between the material available and material
consumed represents the stock of material at the end of the period.

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2.54 COST AND MANAGEMENT ACCOUNTING

2.11.1 Identification of Materials

For the identification of consumption of materials with products of cost centres the
followings points should be noted:
1. It is required that the concern should follow coding system for all materials so
that each material is identified by unique code number.
2. It is required that each product of a cost centre should be given a unique code
number so that the direct material issued for production of particular product of
a cost centre can be collected against the code number of that product.
However, it may not be possible to allocate all materials directly to individual
product of a cost centre e.g. maintenance materials, inspection and testing
materials etc. The consumption of these materials are collected for cost
centre and then charged to individual product by adopting suitable overhead
absorption rate of cost centre.

Cost for cost centre

Overhead absorption rate of cost centre =
Base relating to cost centre
(e.g.labou r hrs. or machine hrs.)
3. Each issue of materials should be recorded. One way of doing this is to use a
material requisition note. This note shows the details of materials issued for
product of cost centre and the cost centre which is to be charged with cost of
materials.
4. A material return note is required for recording the excess materials returned to
the store. This note is required to ensure that original product of cost centre is
credited with the cost of material which was not used and that the stock records
are updated.
5. A material transfer note is required for recording the transfer of materials from
one product of cost centre to other or from one cost centre to other cost centre.
6. The cost of materials issued would be determined according to stock valuation
method used.

2.11.2 Monitoring Consumption of Materials

For monitoring consumption of materials, a storekeeper should periodically analyse the
various material requisitions, material return notes and material transfer notes. Based
on this analysis, a material abstracts or material issue analysis sheet is prepared, which
shows at a glance the value of material consumed in manufacturing each product. This
statement is also useful for ascertaining the cost of material issued for each product.

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MATERIAL COST 2.55

Format of Material Abstract

Week Ending ............
Material Amount Product Nos. Total Overheads
requisition (`) for (Indirect
or Transfer 101 102 103 104 105 106 Product Material
Note or charged)
Returned
Note No.
(`) (`) (`) (`) (`) (`) (`)

— — — — — — — — —

Total

The material abstract statement serves a useful purpose. It in fact shows the amount
of material to be debited to various products & overheads. The total amount of stores
debited to various products & overheads should be the same as the total value of
stores issued in any period.
2.11.3. Basis for consumption entries in Financial Accounts
Every manufacturing organisation assigns material costs to products for two purposes.
Firstly, for external financial accounting requirements, in order to allocate the material
costs incurred during the period between cost of goods produced and inventories;
secondly to provide useful information for managerial decision making requirements.
In order to meet external financial accounting requirements, it may not be necessary
to accurately trace material costs to individual products.
Some products costs may be overstated and others may be understated but this may
not matter for financial accounting purposes as long as total of individual materials
costs transactions are recorded i.e., transactions between cost centre within the firm
are recorded in a manner that facilitates analysis of costs for assigning them to cost
units.
The consumption entries in financial accounts are made on the basis of total cost of
purchases of materials after adjustment for opening and closing stock of materials.
The stock of materials is taken at cost or net realisable value whichever is less.

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2.56 COST AND MANAGEMENT ACCOUNTING

SUMMARY
• Material Control : It is the systematic control over the procurement, storage and
usage of materials to maintain even flow of materials and avoiding at the same
time excessive investment in inventories.
• Material Requisition Note : Document used to authorize and record the issue
of materials from store.
• Purchase Requisition Note : Document is prepared by the storekeeper to initiate
the process of purchases.
• Purchase Order: It is a written request to the supplier to supply certain specified
materials at specified rates and within a specified period.
• Goods Received Note : This document is prepared by receiving department
which unpacks the goods received and verify the quantities and other details.
• Material Transfer Note : This document is prepared when the material is
transferred from one department to another.
• Material Return Note : It is a document given with the goods being returned
from Factory back to the stores.
• Bin Card : A prime entry record of the quantity of stocks, kept on in/out/balance,
held in designated storage areas.
• Stores Ledger : A ledger containing a separate account for each item of material
and component stocked in store giving details of the receipts, issues and balance
both in terms of quantity and value.
• Minimum Level : It is the minimum quantity, which must be retained in stock
ROL- (Avg. consumption × Avg. Lead time)
• Maximum Level : It is the maximum limit upon which stock can be stored at any
time
ROL + ROQ – (Min consumption × Min Lead Time)
• Re order Level : It is the level, when reached the order needs to be placed
Maximum lead time × Maximum Usage
Or
Minimum level + (Average rate of consumption × Average time to obtain fresh
supplies).
• Average Inventory Level =Minimum level + 1/2 Re-order quantity
Or
Maximum level + Minimum level
=
2

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MATERIAL COST 2.57

• Danger Level : level where normal issue of materials is stopped, and only
emergency materials are issued.
Danger level = Average consumption Lead time for emergency purchases.
• Stock-out = Stock out said to be occurred when an inventory item could not be
supplied due to insufficient stock in the store.
• Just-in-time (JIT) Inventory management = 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.
• ABC analysis : Items are classified into the following categories:
A Category : Quantity less than 10 % but value more than 70 %
B Category ; Quantity less than 20 % but value about 20 %
C Category : Quantity about 70 % but value less than 10%
• Fast Moving, Slow Moving and Non Moving (FSN) Inventory : Under this
system, inventories are controlled by classifying them on the basis of frequency
of usage.
• 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.
• 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.
• Two bin system : If one bin items exhausts, new order is placed and till the mean
time quantity from the other bin is purchased.
• First-in First-out method : The materials received first are to be issued first
when material requisition is received. Materials left as closing stock will be at the
price of latest purchases.
• Last-in First-out method : The materials purchased last are to be issued first
when material requisition is received. Closing stock is valued at the oldest stock
price.
• Simple Average Method : Material Issue Price
Total of unit price of each purchase
=
Total Nos of Purchases
• Weighted Average Price Method : This method gives due weightage to
quantities purchased and the purchase price to determine the issue price.
Total costof materialsin stock
Weighted Average Price =
Total quantity of materials
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2.58 COST AND MANAGEMENT ACCOUNTING

• Various Material Losses

(a) Wastage: Portion of basic raw material lost in processing having no recoverable
value
(b) Scrap: The incidental material residue coming out of certain manufacturing
operations having low recoverable value.
(c) Spoilage: Goods damaged beyond rectification to be sold without further
processing.
• Defectives: Goods which can be rectified and turned out as good units by the
application of additional labour or other services.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Direct material can be classified as
(a) Fixed cost
(b) Variable cost
(c) Semi-variable cost.
(d) Prime Cost
2. In most of the industries, the most important element of cost is
(a) Material
(b) Labour
(c) Overheads
(d) Administration Cost
3. Which of the following is considered to be the normal loss of materials?
(a) Loss due to accidents
(b) Pilferage
(c) Loss due to breaking the bulk
(d) Loss due to careless handling of materials.
4. In which of following methods of pricing, costs lag behind the current economic
values?
(a) Last-in-first out price
(b) First-in-first out price
(c) Replacement price
(d) Weighted average price

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MATERIAL COST 2.59

5. Continuous stock taking is a part of

(a) Annual stock taking
(b) Perpetual inventory
(c) ABC analysis.
(d) Bin Cards
6. In which of the following methods, issues of materials are priced at pre-determined
rate ?
(a) Inflated price method
(b) Standard price method
(c) Replacement price method
(d) Specific price method.
7. When material prices fluctuate widely, the method of pricing that gives absurd
results is
(a) Simple average price
(b) Weighted average price
(c) Moving average price
(d) Inflated price.
8. When prices fluctuate widely, the method that will smooth out the effect of
fluctuations is
(a) Simple average
(b) Weighted average
(c) FIFO
(d) LIFO
9. Under the FSN system of inventory control, inventory is classified on the basis of:
(a) Volume of material consumption
(d) Frequency of usage of items of inventory
(c) Criticality of the item of inventory for production
(d) Value of items of inventory
10. Materials are issued from one process to another, on the basis of:
(a) Material Transfer Note
(b) Material Requisition Note
(c) Bill of Materials
(d) Purchase Requisition Note

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2.60 COST AND MANAGEMENT ACCOUNTING

Theoretical Questions
1. How normal and abnormal loss of material arising during storage are treated in
Cost Accounts?
2. Distinguish clearly between Bin cards and Stores Ledger.
3. Discuss the accounting treatment of defectives in Cost Accounts.
4. Explain the concept of “ABC Analysis” as a technique of inventory control.
5. Distinguish between Re-order level and Re-order quantity.
6. How is slow moving and non-moving item of stores detected and what steps are
necessary to reduce such stocks?
7. Write short notes on any three of the following:
(i) Re-order quantity
(ii) Re-order level
(iii) Maximum stock level
(iv) Minimum stock level
Practical Problems
1. 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.
How much money can be saved by Economic Order Quantity.
2. A Company manufactures a special product which requires a component ‘Alpha’.
The following particulars are collected for the year 20X1:
(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) Advise whether the quantity discount offer can be accepted.
3. 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:

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MATERIAL COST 2.61

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.
4. 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- Minimum
Material unit of quantity per (In weeks) order level
Product (Kgs.) Kg. level
(Kgs.) (Kgs)
Mini- Aver- Maxi-
mum age mum
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. What would be 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.
5. (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.
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2.62 COST AND MANAGEMENT ACCOUNTING

The annual requirement for the material is 5,000 tons. The ordering cost per
order is ` 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?
6. 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 ` 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.
7. 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?
(iii) What is the minimum carrying cost, the company has to incur?
8. From the following data for the year ended 31st December, 20X1, calculate the
inventory turnover ratio of the two items and put forward your comments on them.
Material A(`) Material B (`)
Opening stock 1.1.20X1 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.12.20X1 6,000 11,000

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MATERIAL COST 2.63

9. ‘AT’ Ltd. furnishes the following store transactions for Septem¬ber, 20X1:
1-9-X1 Opening balance 25 units value ` 162.50
4-9-X1 Issues Req. No. 85 8 units
6-9-X1 Receipts from B & Co. GRN No. 26 50 units @ ` 5.75 per unit
7-9-X1 Issues Req. No. 97 12 units
10-9-X1 Return to B & Co. 10 units
12-9-X1 Issues Req. No. 108 15 units
13-9-X1 Issues Req. No. 110 20 units
15-9-X1 Receipts from M & Co. GRN. No. 33 25 units @ ` 6.10 per unit
17-9-X1 Issues Req. No. 121 10 units
19-9-X1 Received replacement from B & Co.
GRN No. 38 10 units
20-9-X1 Returned from department, material of
M & Co. MRR No. 4 5 units
22-9-X1 Transfer from Job 182 to Job 187 in the
dept. MTR 6 5 units
26-9-X1 Issues Req. No. 146 10 units
29-9-X1 Transfer from Dept. “A” to Dept. “B” MTR 10 5 units
30-9-X1 Shortage in stock taking 2 units
Write up the priced stores ledger on FIFO method and discuss how would you treat
the shortage in stock taking.
10. 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.

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2.64 COST AND MANAGEMENT ACCOUNTING

ANSWERS/SOLUTIONS
Answers to the MCQs based Questions
1. (b) 2. (a) 3. (c) 4. (b) 5. (b) 6. (b)
7. (a) 8. (b) 9. (b) 10. (a)
Answers to the Theoretical Questions
1. Please refer paragraph 2.10
2. Please refer paragraph 2.5
3. Please refer paragraph 2.10
4. Please refer paragraph 2.6.4
5. Please refer paragraph 2.6.1
6. Please refer paragraph 2.6.4
7. Please refer paragraph 2.6.1
Answers to the Practical Problems
1. (a) Total Annual Cost in Existing Inventory Policy
(`)
Ordering cost (6 orders @ ` 25) 150
Carrying cost of average inventory (36,000 ÷ 6) = 6,000 units per order
Average inventory = 3,000 units
Carrying cost = 20% of ` 1 ÷ 3,000 = 3,000 ÷ 0.20 600
Total cost A 750
(b) Total Annual Cost in E.O.Q
2×36,000×25
EOQ = = 3000 units
` 1×20%

(`)
No. of orders = 36,000 ÷3,000 units = 12 orders
Ordering cost (12 ÷ ` 25) =
300
Carrying cost of average inventory (3,000 ÷ 0.20) ÷ 2 = 300
Total Cost B 600
Savings due to E.O.Q ` (750 – 600) (A – B ) 150
Note : As the units purchase cost of `1 does not change in both the computation,
the same has not been considered to arrive at total cost of inventory for the
purpose of savings.

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MATERIAL COST 2.65

2. (i) Calculation of Economic Order Quantity

2AO 2×8,000 units×` 200
EOQ = = = 200 units
C ` 400×20/100

(ii) Evaluation of Profitability of Different Options of Order Quantity

(a) When EOQ is ordered
(`)
Purchase Cost (8,000 units × `400) 32,00,000
Ordering Cost [(8,000 units/200 units) × ` 200] 8,000
Carrying Cost (200 units `400 ½ × 20/100) 8,000
Total Cost 32,16,000
(b) When Quantity Discount is accepted
(`)
Purchase Cost (8,000 units × `384) 30,72,000
Ordering Cost [(8,000 units/4000 units) × `200] 400
Carrying Cost (4000 units × `384 × ½ × 20/100) 1,53,600
Total Cost 32,26,000
Advise – The total cost of inventory is lower if EOQ is adopted. Hence, the company
is advised not to accept the quantity discount.
2AO
3. EOQ =
C
Where,
A = Annual Demand
O = Ordering cost per order
C = Inventory carrying cost per unit per annum
(i) Calculation of EOQ
Super Grow Nature’s Own

2× 2,000 ×1,200 2× 1,280 ×1, 400

EOQ = EOQ =
480 560

= 10,000 or 100 bags = 6, 400 or or 80 bags

(ii) Total annual relevant cost = Total annual relevant ordering costs + Total
annual relevant carrying cost

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2.66 COST AND MANAGEMENT ACCOUNTING

Super Grow Nature’s Own

= (2,000/100 × `1,200) + (½ × 100 = (1,280/80 × `1,400) + (½ × 80
bags × `480) bags × ` 560)
= ` 24,000 + ` 24,000 = ` 48,000 = ` 22,400 + ` 22,400 = ` 44,800

(iii) Number of deliveries for Super Grow and Nature’s own fertilizer per year
Annual demand for fertilizer bags
=
EOQ

Super Grow Nature’s Own

2,000 bags 1,280 bags
= = 20 orders = = 16 orders.
100 bags 80 bags

4. (i) Minimum stock of A

Re-order level – (Average rate of consumption × Average time required to
obtain fresh delivery)
= 8,000 – (200 × 10 × 2) = 4,000 kgs.
(ii) Maximum stock of B
Re-order level + Re-order quantity – (Minimum consumption × Minimum
delivery period)
= 4,750 + 5,000 – (175 × 4 × 3)
= 9,750 – 2,100 = 7,650 kgs.
(iii) Re-order level of C
Maximum delivery period × Maximum usage
= 4 × 225 × 6 = 5,400 kgs.
OR
Re-order level of C
= Minimum stock of C + [Average rate of consumption × Average time
required to obtain fresh delivery]
= 2,000 + [(200 × 6) × 3] kgs.
= 5,600 kgs.
(iv) Average stock level of A
= Minimum stock level of A + ½ Re-order quantity of A
= 4,000 + ½ × 10,000 = 4,000 + 5,000 = 9,000 kgs.

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MATERIAL COST 2.67

OR
Average Stock level of A
Minimum stock level of A + Maximum stock level of A
(Refer to working note)
2

4,000 +16,250
= 10,125 kgs.
2
Working note:
Maximum stock of A = ROL+ ROQ – (Minimum consumption × Minimum
re-order period)
= 8,000 + 10,000 – [(175 × 10) × 1]
= 16,250 kgs.
5. (a)
Total Order No. of Cost of inventory Ordering Carrying cost Total
annual size orders A × Per ton cost cost A/q p.t.p.a 1/2 × q Cost
A/q (`) × `1200 × 20% of cost
require- (Ton) (4+5+6)
(`) p.t. (`)
ment (q) (`)

(A)
1 2 3 4 5 6 7
5,000 400 12.5 60,00,000 15,000 48,000 60,63,000
ton (5,000 × `1200) (200 × ` 240)
500 10 59,00,000 12,000 59,000 59,71000
(5,000 ×` 1180) (250 × ` 236)
1,000 5 58,00,000 6,000 1,16,000 59,22,000
(5,000 × ` 1160) (500 × ` 232)
2,000 2.5 57,00,000 3,000 2,28,000 59,31,000
(5,000 × ` 1140) (1,000 × `228)
3,000 1.666 56,00,000 2,000 3,36,000 59,38,000
(5,000×` 1120) (1,500 × `224)
The above table shows that the total cost of 5,000 units including ordering
and carrying cost is minimum (` 59,22,000) when the order size is 1,000 units.
Hence the most economical purchase level is 1,000 units.
(b) If there will are no discount offer then the purchase quantity should be equal
to EOQ. The EOQ is as follows:
2AO
EOQ =
C

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2.68 COST AND MANAGEMENT ACCOUNTING

where A is the annual inventory requirement,

O is the ordering cost per order and
C is the carrying cost per unit per annum.
2×5,000units × ` 1,200
= = 200 units
20% × ` 1,500
6. Basic Data:
A (Number of units to be purchased annually) = 5,000 units
O (Ordering cost per order) = ` 20
C (Annual cost of storage per unit) = `5
Purchase price per unit inclusive of transportation cost = ` 50.
Computations :
(i) Re-ordering level = Maximum usage per period × Maximum lead time
(ROL) = 20 units per day × 15 days = 300 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consump¬tion × Min.
lead time]
(Refer to working notes1 and 2)
= 300 units+200units–[10 units per day×5 days] = 450
units
(iii) Minimum level = ROL – Average rate of consump¬tion×Average re-
order-period
= 300 units – (15 units per day × 10 days) =150 units
(iv) Danger level = Average consumption × Lead time for emergency
purchases
= 15 units per day × 4 days = 60 units
Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2

15 units per day = X units/day + 20 units per day or X = 10 units per day.
2
2. Re-order Quantity (ROQ)
2×5,000 units×` 20
= = 200 units
5
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MATERIAL COST 2.69

7. (a) (i) Economic order quantity:

A (Annual requirement or = 4,000 units per month × 12 months
Component ‘X’) = 48,000 units
C (Purchase cost p.u.) = ` 20
O (Ordering cost per order) = ` 120
i (Holding cost) = 10% per annum
2AO 2×48,000units× ` 120
E.O.Q. = = = 2,400 units
C 10%of ` 20
i

(ii) Extra cost incurred by the company:

A. Total cost when order size is equal 4,000 units:

Total cost = Total ordering cost + Total carrying cost

A 1
= × Q+ Q (Ci )
Q 2

48,000 units 1
=( × ` 120) + ( × 4,000 units × 10% × ` 20)
4,000 units 2
= ` 1,440 + ` 4,000 = ` 5,440
B. Total cost when order size is equal EOQ i.e. 2,400 units:
48,000 units 1
Total cost = ( × ` 120) + ( × 2,400 units × 10% × ` 20)
2, 400 units 2
= ` 2,400 + ` 2,400 = ` 4,800
Extra cost that the company has to incur = (A) – (B) = ` 5,440 – ` 4,800 =
` 640
(iii) Minimum carrying cost: Carrying cost depends upon the size of the
order. It will be minimum on the least order size. (In this part of the
question the two order sizes are 2,400 units and 4,000 units. Here 2,400
units is the least of the two order sizes. At this order size carrying cost will
be minimum.)
The minimum carrying cost in this case can be computed as under:
1
Minimum carrying cost = × 2,400 units × 10% × ` 20 = ` 2,400.
2

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2.70 COST AND MANAGEMENT ACCOUNTING

8. First,it is necessary to find out the material consumed:

Cost of materials consumed Material A Material B
(`) (`)
Opening stock 10,000 9,000
Add: Purchases 52,000 27,000
62,000 36,000
Less: Closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory : (Opening Stock + Closing Stock) 8,000 10,000
÷2
Inventory Turnover ratio: (Consumption ÷ Average 7 times 2.5 times
inventory)
Inventory Turnover (Number of Days in a year/IT ratio) 52 days 146 days
Comments: Material A is moving faster than Material B.
9. Working Notes:
1. The material received as replacement from vendor is treated as fresh supply.
2. In the absence of information the price of the material received from within
on 20-9-X1 has been taken as the price of the earlier issue made on 17-9-
X1. In FIFO method physical flow of the material is irrelevant for pricing the
issues.
3. The issue of material on 26-9-X1 is made out of the material received from
within.
4. The entries for transfer of material from one job and depart¬ment to other on
22-9-X1 and 29-9-X1 are book entries for adjust¬ing the cost of respective
jobs and as such they have not been shown in the stores ledger account.
5. The material found short as a result of stock taking has been written off.

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 Stores Ledger of AT Ltd. for the month of September, 20X1 (FIFO Method)
RECEIPT ISSUE BALANCE

Date GRN No. Qty. Rate Amount Requisi- Qty. Rate Amount Qty. Rate Amount
MRR No. Units (`) (`) tion No. Units (`) (`) Units (`) (`)
1 2 3 4 5 6 7 8 9 10 11 12
1-9-X1 — — — — — — — — 25 6.50 162.50
4-9-X1 — — — — 85 8 6.50 52 17 6.50 110.50
6-9-X1 26 50 5.75 287.50 — — — — 17  6.50 
  398.00
50  5.75 
7-9-X1 — — — — 97 12 6.50 78 5  6.50 

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  320.00
50  5.75 
10-9-X1 — — — — Nil 10 5.75 57.50 5  6.50 
  262.00
40  5.75 
12-9-X1 — — — — 108 5  6.50 
 
MATERIAL COST

10  5.75  90 30 5.75 172.50

13-9-X1 — — — — 110 20 5.75 115 10 5.75 57.50
15-9-X1 33 25 6.10 152.50 — — — — 10  5.75 
  210.00
25  6.10 
2.71
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 17-9-X1 — — — — 121 10 5.75 57.50 25 6.10 152.50
19-9-X1 38 10 5.75 57.50 — — — — 25  6.10 
2.72

  210.00
10  5.75 

5  5.75 

20-9-X1 4 5 5.75 28.75 — — — — 25 6.10 
 258.75
10 7.75 
26-9-X1 — — — — 146 5  5.75  20  6.10 
  
5  6.10  59.25 10  5.75  179.50
30-9-X1 — — — — Shortage 2 6.10 12.20 18  6.10 
  167.30
10  5.75 

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COST AND MANAGEMENT ACCOUNTING
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MATERIAL COST 2.73

9. From the point of view of cost of material charged to each job, it is minimum under
FIFO and maximum under LIFO (Refer to Tables). During the period of rising prices,
the use of FIFO give rise to high profits and that of LIFO low profits. In the case of
weighted average there is no significant adverse or favourable effect on the cost of
material as well as on profits.
From the point of view of valuation of closing stock it is apparent from the above
statement that it is maximum under FIFO, moderate under weighted average and
minimum under LIFO.
It is clear from the Tables that the use of weighted average evens out the fluctuations
in the prices. Under this method, the cost of materials issued to the jobs and the
cost of material in hands reflects greater uniformity than under FIFO and LIFO. Thus
from different points of view, weighted average method is preferred over LIFO and
FIFO.

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 Statement of receipts and issues by adopting First-in-First-Out Method
Receipts Issues Balance
2.74

Date Particulars Units Rate Value Units Rate Value Units Rate Value
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
Jan. 20 Purchase 100 2 200 — — — 100  1  100 
  
100  2  200 
Jan. 22 Issue to Job W 16 — — — 60 1 60 40  1  40 
  
100  2  200 
Jan. 23 Issue to Job W 17 — — — 40 1  40 
 
20 2  80  80 2 160

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Statement of receipts and issues by adopting Fast-in-First-Out Method
Receipts Issues Balance
Date Particulars Units Rate Value Units Rate Value Units Rate Value
No.
COST AND MANAGEMENT ACCOUNTING

(`) (`) No. (`) (`) No. (`) (`)

Jan. 1 Purchase 100 1 100 — — — 100 1 100
Jan. 20 Purchase 100 2 200 — — — 100  1  100 
 
100  2  200 
Jan. 22 Issue to Job W 16 — — — 60 2 120 100  1  100 
 
40  2  80 
Jan. 23 Issue to Job W 17 — — — 40  2  80  80 1 80
  
20  1  20 
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 Statement of Receipts and Issues by adopting Weighted Average method
Receipts Issues Balance
Date Particulars Units Rate Value Units Rate Value Units Rate Value
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
Jan. 20 Purchase 100 2 200 — — — 200 1.50 300
Jan. 22 Issue to Job W 16 — — — 60 1.50 90 140 1.50 210
Jan. 23 Issue to Job W 17 — — — 60 1.50 90 80 1.50 120
Statement of Material Values allocated to Job W 16, Job 17 and Closing Stock, under aforesaid methods

FIFO LIFO Weighted Average

(`) (`) (`)

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Material for Job W 16 60 120 90
Material for Job W 17 80 100 90
Closing Stock 160 80 120
300 300 300
MATERIAL COST
2.75
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CHAPTER 3
EMPLOYEE COST AND
DIRECT EXPENSES
LEARNING OUTCOMES
r State the meaning and importance of employee (labour) cost in
an organisation.
r Discuss the attendance and payroll procedures.
r State the meaning and treatment of idle time and overtime cost.
r Compute employee (labour) turnover, discuss its meaning,
reasons, methods of measurement and cost impacts.
r Discuss and apply the various methods of remuneration and
incentive system in calculation of wages, bonus etc.
r Discuss the efficiency rating procedures.

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3.2 COST AND MANAGEMENT ACCOUNTING

CHAPTER OVERVIEW

3.1 INTRODUCTION
To manufacture a product or to make provision for service, the role of human exertion
is inevitable. The term used for human resources may include workers, employees,
labourers, staffs etc. Whatsoever nomenclature may be used to denote them; they
are required to be compensated for their exertions. The compensation so paid, either
in monetary terms or in kind and facility is known as wages. Cost of paying wages to
workers is popularly known as labour cost as it relates to labour (exertion) they put
for manufacturing of product or provision of services; hence, employee cost is also
interchangeably known as labour cost. In a nutshell, employee cost is wider term which
includes wages, salary, bonus, incentives etc. paid to an employee and charged to a
cost object as labour cost.
Unlike other costs, employee costs are influenced by human behavior. Due to this
peculiarity, divergence in employee compensation is observed across the different
industries. Wages are determined on both quantitative and qualitative factors like
volume of work, skills required etc. Hence, it is necessary that employees should be
monitored, measured, and compensated appropriately to achieve economy in cost,
efficiency in performance and effectiveness in desired output.

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EMPLOYEE COST AND DIRECT EXPENSES 3.3

3.2 EMPLOYEE (LABOUR) COST

Employee (Labour) cost : Benefits paid or payable to the employees of an entity,
whether permanent, or temporary for the services rendered by them. Employee cost
includes payments made in cash or kind. Employee cost includes the following:
(i) Wages and salary;
(ii) Allowances and incentives;
(iii) Payment for overtimes;
(iv) Employer’s contribution to Provident fund and other welfare funds;
(v) Other benefits (leave with pay, free or subsidised food, leave travel concession
etc.) etc.
Classification of Employee (Labour) cost : Employee cost are broadly classified as
direct and indirect employee cost.
(i) Direct Employee (Labour) Cost
Benefits paid or payable to the employees which can be attributed to a cost object
in an economically feasible manner. This can be easily identified and allocated to an
activity, contract, cost centre, customer, process, product etc.
(ii) Indirect Employee (Labour) Cost
Benefits paid or payable to the employees, which cannot be directly attributable to a
particular cost object in an economically feasible manner.
Distinction between Direct and Indirect Employee Cost:

Direct employee cost Indirect employee cost

1. It is the cost incurred in payment 1. Cost incurred for payment of employee
of employees who are directly who are not directly engaged in the
engaged in the production production process.
process.
2. Direct employee cost can be 2. Indirect employee cost is apportioned
easily identified and allocated to on some appropriate basis.
cost unit.
3. Direct employee cost varies with 3. Indirect employee cost may not vary
the volume of production and with the volume of production.
has positive relationship with the
volume.

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3.4 COST AND MANAGEMENT ACCOUNTING

3.3 EMPLOYEE (LABOUR) COST CONTROL

Employee costs are associated with human beings. To control employee costs one has
to understand human behavior. Employee cost control means control over the cost
incurred on employees. Control over employee costs does not imply control over the
size of the wage bill; it also does not imply that wages of each employee should be
kept as low as possible.
The aim should be to keep the wages per unit of output as low as possible. This can only
be achieved by giving employees appropriate compensation to encourage efficiency
so that optimum output can be achieved in effective manner.
A well-motivated team of employees can bring about wonders. Each concern should,
therefore, constantly strive to raise the productivity of employee. The efforts for the
control of employee costs should begin from the very beginning. There has to be a
concerted effort by all the concerned departments.
Department Functions
1. Personnel Department i) On receipt of employee requisition from the various
departments it searches for the required skills
and qualification.
ii) It ensures that the persons recruited possess the
requisite qualification and skills required for the
job
iii) Arranges proper training for the newly recruited
employees and workshops for existing
employees.
iv) Maintains all personal and job related records of
the employees.
v) Evaluation of performance from time to time
2. Engineering and Work i) Prepares plans and specifications for each job.
Study Department
ii) Providing training and guidance to the employees.
iii) Supervises production activities.
iv) Conducts time and motion studies.
v) Undertakes job analysis.
vi) Conducts job evaluation.
3. Time-keeping i) Concerned with the maintenance of attendance
Department records i.e. time keeping and

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EMPLOYEE COST AND DIRECT EXPENSES 3.5

ii) Time spent by an employee on various jobs i.e.

time booking etc.
4. Payroll Department i) The preparation of payroll of the employees.
ii) It disburses salary and wage payments.
5. Cost Accounting i) Accumulation and classification employee costs.
Department
ii) Analysis and allocation of costs to various cost
centres or cost objects
3.3.1 Important Factors for the Control of Employee Cost
To exercise an effective control over the employee costs, the essential requisite
is efficient utilisation of employee and allied factors. The main points which need
consideration for controlling employee costs are the following:
(i) Assessment of manpower requirements.
(ii) Control over time-keeping and time-booking.
(iii) Time & Motion Study.
(iv) Control over idle time and overtime.
(v) Control over employee turnover.
(vi) Wage and Incentive systems.
(vii) Job Evaluation and Merit Rating.
(viii) Employee productivity.
3.3.2 Collection of Employee Costs
The task of collecting employee costs is performed by the Cost Accounting Department
which record separately wages paid to direct and indirect employee. It is the duty of
this department to ascertain the effective wages per hour in each department and to
analyse the total payment of wages of each department into:
(i) the amount included in the direct cost of goods produced or jobs completed;
(ii) the amount treated as indirect employee and thus included in overheads; and
(iii) the amount treated as the cost of idle time and hence loss.
(iv) the amount treated as abnormal loss/ gain and to be transferred to profit and
loss account.
Through this process costs of various jobs are ascertained. Naturally, in this the proper
recording of time spent by the employees is essential.

3.4 ATTENDANCE & PAYROLL PROCEDURES

3.4.1 Attendance Procedure / Time-keeping
It refers to correct recording of the employees’ attendance time. Students may note
the difference between “time keeping” and “time booking”. The latter refers to break

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3.6 COST AND MANAGEMENT ACCOUNTING

up of time on various jobs while the former implies a record of total time spent by the
employees in a factory.
Objectives of Time-keeping : Correct recording of employees’ attendance time is of
utmost importance where payment is made on the basis of time worked.
Where payment is made by results viz; straight piece work, it would still be necessary
to correctly record attendance for the purpose of ensuring that proper discipline and
adequate rate of production are maintained. The objectives of time-keeping are as
follows:
(i) For the preparation of payrolls.
(ii) For calculating overtime.
(iii) For ascertaining and controlling employee cost.
(iv) For ascertaining idle time.
(v) For disciplinary purposes.
(vi) For overhead distribution.
Methods of Time-keeping : There are various methods of time-keeping, which may be
categorized into manual and mechanical methods. The choice of a particular method
depends upon the requirements and policy of an entity; but whichever method is
followed, it should make a correct record of the time by incurring minimum possible
expenditure and it should minimise the risk of fraudulent payments of wages. The
examples of time keeping methods are follows:
1. Manual Methods
(a) Attendance Register method- Under this method, an attendance register is kept
to record
the arrival and departure time of an employee. This method is simple and expensive
and is suitable for small organisations. However, this method may lead to dishonest
practice of time manipulation by way of recording wrong time and back date entry in
collusion with time keeper.
(b) Metal Disc/ Token method : This method of time recording is very old and is
almost obsolete in practice. Under this method, each employee is allotted a metal disc
or a token with a hole bearing his identification number. The token is kept or handed
to the time keeper who record the token number in his register. Like attendance
register method, this method also has some disadvantages like error in recording,
proxy attendance etc.
2. Mechanical/ Automated Methods
(a) Punch Card Attendance-Under this method, each employee is provided a card for
marking attendance. A punch card contains data related with the employee in digital
form. In punch card attendance system, an employee needs to either insert or wave his

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EMPLOYEE COST AND DIRECT EXPENSES 3.7

card to a card reader which then ensures whether the correct person is logging in and/
or out. This system does not require to employ any time keeper and minimises the risk
of recording error and time manipulation.
(b) Bio- Metric Attendance system-Under bio-metric attendance system attendance
is marked by recognizing an employee on the basis of physical and behavioral traits.
An employee’s unique identity like finger print, face and retina image etc. are kept
in a database which is matched at the time of marking of attendance before the
attendance device for this purpose. Bio-metric attendance system includes fingerprint
recognition system, face recognition system, Time and attendance tracking technology
etc.This system reduces the risk of time manipulation and proxy attendance. However,
it may not be suitable for small organisations due to cost associated with set-up and
maintenance.
Requisites of a Good Time-keeping System : A good time-keeping system should
have following requisites:
1. System of time-keeping should be such which should not allow proxy for another
employee under any circumstances.
2. There should also be a provision of recording of time of piece employees so
that regular attendance and discipline may be maintained. This is necessary to
maintain uniformity of flow of production.
3. Time of arrival as well as time of departure of employees should be recorded
so that total time of employees may be recorded and wages may be calculated
accordingly.
4. As far as possible, method of recording of time should be mechanical so that
chances of disputes regarding time may not arise between employees and the
time-keeper.
5. Late-comers should record late arrivals. Any relaxation by the time-keeper in this
regard will encourage indiscipline.
6. The system should be simple, smooth and quick. Unnecessary queuing for
marking attendance should be avoided.
7. The system should be reviewed and maintained periodically to prevent any error.
3.4.2 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.
This data recorded is further used for measure the time spent on a particular job for
costing, measurement of efficiency, fixation of responsibility etc.
Time booking for costing : The time spent on a particular job or activity is used to
compute the cost of the job or activity.

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3.8 COST AND MANAGEMENT ACCOUNTING

Time booking to measure efficiency : The efficiency of the employees is measures by

comparing the actual time taken by an employee with the standard time that should
have been taken.
Time booking for fixation of responsibility : The time booked data is used to analyse
the variance in time taken by an employee on a particular job or process with respect
to standard time to see the reasons for the variance. The reasons for variance is further
classified as controllable and uncontrollable. The controllable reasons are those which
can be avoided by due care and efficiency. On the other hand, uncontrollable reasons
cannot be avoided under the normal circumstances. Employees or any other concerned
person or departments are made accountable for variance under controllable reasons.
For the collection of all such data, a separate record, generally known as Time (or Job)
card, is kept.
The time (or job) card can be of two types—
• One containing analysis of time with reference to each job : A separate job
card is employed in respect of a job undertaken; where a job involves several
operations, a separate entry is made in respect of each operation.
Thus the job card would record the total time spent on a particular job or
operation. If a number of people are engaged on the same job or operation, the
time of all those employees would be booked on the same card.
One advantage of this method is that it provides complete data on the employee
content of job or operation collectively so that the computation of employee
cost is greatly facilitated.
But this method has drawbacks as well. Since anemployee’s job timing is scattered
over a number of job cards the time spent on all these jobs and idle time must be
abstracted periodically for finding each employee’s total time spent on different
jobs and the time for which he remained idle during the period. The total of
these two times (job and idle) must obviously equal his total attendance time, as
shown by his attendance record.
• The other with reference to each employee : In this case, it would greatly
facilitate reconciliation of the employee’s job time with his attendance time
recorded.
Under this system, a separate card would be used for each employee for each
day or for each week and the time which he spends on different jobs (and also
any idle time) would be recorded in the same card so that the card would have a
complete history on it as to how his time had been spent during the period.
The format of job or time may vary industry to industry and according to the
accounting system into used.

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EMPLOYEE COST AND DIRECT EXPENSES 3.9

3.4.3 Payroll Procedure

Steps included in this process are as under:

1. Attendance and Time details : A detailed sheet of number of days or hours

worked by each employee (in case of time based payment) and units or
percentage of work (in case of piece rate) as reflected by the time keeping
methods are sent to the payroll department by the time keeping department.
Further, payroll department with the help of time booking records calculate any
further incentives such as overtime payment, bonus to be paid to the employees.
2. List of employees and other details : A list of employees on roll and the rate
at which they will be paid is sent by the personnel/ HR department. Payroll
department should ensure that no unauthorised or bogus employee is paid.
3. Computation of wages and other incentives : Payroll department based on
the details provided by the time keeping department and personnel department
calculate wages/ salary to be paid to the employees. Payroll department
prepares pay slip for all employees authorized by the personnel department and
forward the same to the cost/ accounting department for further deductions and
payment.

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3.10 COST AND MANAGEMENT ACCOUNTING

4. Payment to the employees : Cost/ accounting department deduct all statutory

deduction such as employee’s contribution to provident fund and employee state
insurance (ESI) scheme, TDS on salary etc. After all deductions wages/ salary is
paid to the employees.
5. Deposit of all statutory liabilities : All statutory deduction made from wages/
salary of the employees alongwith employer’s contributions such as provident
fund and employee state insurancescheme are paid to the respective statutory
bodies.
The followings are generally deducted from the payroll
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
Scheme (ESI) the 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
Provident fund above the contribution payable by the employer.
2. Contribution to any An employee may contribute to any benevolent
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.

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EMPLOYEE COST AND DIRECT EXPENSES 3.11

3.5 IDLE TIME

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. Idle time can be normal or abnormal. The time for which employees are paid
includes holidays, paid leaves, allowable rest or off time etc.
Normal idle time : It is the time which cannot be avoided or reduced in the normal
course of business.

Causes Treatment
1. The time lost between factory gate It is treated as a part of cost of production.
and the place of work, Thus, in the case of direct workers an
allowance for normal idle time is considered
setting of standard hours or standard rate.
2. The interval between one job and In case of indirect workers, normal idle
another, time is considered for the computation of
overhead rate.
3. The setting up time for the
machine,
4. Normal rest time, break for lunch
etc.
Abnormal idle time : Apart from normal idle time, there may be factors which give
rise to abnormal idle time.
Causes Treatment

1. Idle time may also arise due to Abnormal idle time cost is not included as
abnormal factors like lack of a part of production cost and is shown as a
coordination separate item in the Costing Profit and Loss
2. Power failure, Breakdown of Account.
machines The cost of abnormal idle time should be
3. Non-availability of raw materials, further categorised into controllable and
strikes, lockouts, poor supervision, uncontrollable. For each category, the
fire, flood etc. break-up of cost due to various factors
should be separately shown. This would help
4. The causes for abnormal idle time
the management in fixing responsibility for
should be further analysed into
controlling idle time.
controllable and uncontrollable.

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3.12 COST AND MANAGEMENT ACCOUNTING

i) Controllable abnormal idle time Management should aim at eliminating

refers to that time which could controllable idle time and on a long-term
have been put to productive use basis reducing even the normal idle time.
had the management been more This would require a detailed analysis of the
alert and efficient. All such time causes leading to such idle time.
which could have been avoided is
controllable idle time.
ii) Uncontrollable abnormal idle time
refers to time lost due to abnormal
causes, over which management
does not have any control e.g.,
breakdown of machines, flood
etc. may be cha-racterised as
uncontrollable idle time

ILLUSTRATION 1
‘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’.
SOLUTION
Statement showing computation of effective hourly cost of employee ‘X’
Per month (`) Per annum (`)
(A) Earning of Employee ‘X’:
Basic pay 10,000 1,20,000
Dearness Allowance 2,000 24,000
Bonus 2,400 28,800
Employer’s contribution to provident fund 1,200 14,400
Other allowances 2,500 30,000
18,100 2,17,200
(B) Effective working hours (refer workings) 2,000 hours
(C) Effective hourly cost {(A) ÷ (B)} `108.60
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EMPLOYEE COST AND DIRECT EXPENSES 3.13

Workings:
Calculation of effective working hours :
Annual working hoursless Normal idle time = 2,400 hours – 400 hours = 2,000 hours.
ILLUSTRATION 2
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, how would
you allocate the wages of the workers for the week?
SOLUTION
Working notes :
(i) Total effective hours in a week:
[(8 hrs. – (30 mts. + 10 mts.)] × 6 days= 44 hours
(ii) Total wages for a week:
(`100 + 120% of `100) × 6 days= `1,320
(iii) Wage rate per hour = `30
(iv) Time wasted waiting for job (Abnormal idle time):
= 44 hrs. – (15 hrs. + 12 hrs. + 13 hrs.)= 4 hrs.
Allocation of wages in Cost Accounting
(`)
Allocated to Job X : 15 hours × `30 450
Allocated to Job Y : 12 hours × `30 360
Allocated to Job Z : 13 hours × `30 390
Charged to Costing Profit & Loss A/c : 4 hours × `30 120
Total 1,320

3.6 OVERTIME
Work done beyond normal working hours is known as ‘overtime work’.Overtime
payment is the amount of wages paid for working beyond normal working hours.
Overtime payment consist of two elements- (i) Normal wages for overtime work and
(ii) Premium payment for overtime work.

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3.14 COST AND MANAGEMENT ACCOUNTING

Overtime Payment = Wages paid for overtime at normal rate + Premium (extra)
payment for overtime work

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.
Rate and conditions for overtime premium may either be fixed by an entity itself or it
may be required by any statute in force. 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 fourtyeight 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.”
Where any workers in a factory are paid on a piece-rate basis, the time rate shall be
deemed to be equivalent to the daily average of their full-time earnings for the days on
which they actually worked on the same or identical job during the month immediately
preceding the calendar month during which the overtime work was done, and such
time rates shall be deemed to be the ordinaryrates of wages of those workers
Ordinary rate of wages means the basic wages plus such allowances, including the
cash equivalent of the advantage accruing through the concessional sale to workers of
food grains and other articles, as the worker is for the time being entitled to, but does
not include a bonus and wages for overtime work.
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.
Causes of Overtime and Treatment of Overtime premium in cost accounting
Causes Treatment
(1) The customer may agree to bear the (1) 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.

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EMPLOYEE COST AND DIRECT EXPENSES 3.15

(2) Overtime may be called for to make (2) If overtime is required to cope with
up any shortfall in production due general production programmes
to some unexpected development. or for meeting urgent orders, the
overtime premium should be treated
as overhead cost of the particular
department or cost centre which
works overtime.
(3) Overtime work may be necessary to (3) If overtime is worked in a
make up a shortfall in production department due to the fault of
due to some fault of management. another department, the overtime
premium should be charged to the
latter department.
(4) Overtime work may be resorted to, (4) Overtime worked on account of
to secure an out-turn in excess of the abnormal conditions such as flood,
normal output to take advantage of earthquake etc., should not be
an expanding market or of rising charged to cost, but to Costing Profit
demand and Loss Account.
ILLUSTRATION 3
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 (`) 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.

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3.16 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Statement showing Earnings of Workers A and B
A (`) B (`)
Basic wages 10,000 16,000
Dearness Allowance (50% of Basic Wages) 5,000 8,000
Overtime wages (Refer to Working Note 1) 1,500 --
Gross wages earned 16,500 24,000
Less: Contribution to Provident fund (800) (1,280)
Less: Contribution to ESI (200) (320)
Net wages earned 15,500 22,400
Statement of Employee Cost
A (`) B (`)
Gross Wages (excluding overtime) 15,000 24,000
Add: Employer’s contribution to PF 800 1,280
Add: Employer’s contribution to ESI 200 320
Gross wages earned 16,000 25,600
Normal working hours 200 200
Ordinary wages arte per hour 80 128
Statement Showing Allocation of Wages to Jobs
Total Jobs
Wages (`)
X(`) Y(`) Z(`)
Worker A:
- Ordinary Wages (4: 3 : 3) 16,000 6,400 4,800 4,800
- Overtime 1,500 -- 1,500 --
Worker B:
- Ordinary Wages(5:2:3) 25,600 12,800 5,120 7,680
43,100 19,200 11,420 12,480
Working Notes
1. Normal Wages are considered as basic wages
2×(Basic wages + DA)× 10 hours
Over time =
200
 `15, 000 
= 2×
 200  × 10 hours= `150 × 10 hours = `1,500
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EMPLOYEE COST AND DIRECT EXPENSES 3.17

ILLUSTRATION 4
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 at Worker ‘B’ paid Worker ‘C’ paid
` 200 per day of 8 at ` 100 per day at ` 300 per
hours of 8 hours day 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
Friday (hours) 10.5 8.0 10.5
Saturday (hours) -- 8.0 8.0
Total (hours) 49.0 48.0 57.0
In terms of an award in anemployee 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).
Workers are paid overtime according to the Factories Act, 1948. Excluding holidays,the
total numberof hours worksout to 176 in the relevant month. The company’s contribution
to Provident Fund and Employees State Insurance Premium are absorbed into overheads.
Work out the wages payable to each worker.
SOLUTION
(1) Calculation of hours to be paid for worker A :
Normal Extra Overtime Equivalent normal Total normal
hours hours hours hours for overtime hours
worked
Monday 8 1 1½ 3 12
Tuesday 8 -- -- -- 8
Wednesday 8 1 1½ 3 12
Thursday 8 1 ½ 1 10
Friday 8 1 1½ 3 12
Saturday -- -- -- -- --
Total 40 4 5 10 54
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3.18 COST AND MANAGEMENT ACCOUNTING

Calculation of hours to be paid for worker B :

Normal Extra Overtime Equivalent normal Total
hours hours hours hours for overtime normal
worked hours
Monday 8 --- --- --- 8
Tuesday 8 --- --- --- 8
Wednesday 8 --- --- --- 8
Thursday 8 --- --- --- 8
Friday 8 --- --- --- 8
Saturday 4 4* --- --- 8
Total 44 4 --- --- 48
(*Worker-B has neither worked more than 9 hours in any day nor more than 48
hours in the week)
Calculation of hours to be paid for worker C :
Normal Extra Overtime Equivalent normal Total
hours hours hours hours for overtime normal
worked hours
Monday 8 1 1½ 3 12
Tuesday 8 --- --- --- 8
Wednesday 8 1 1½ 3 12
Thursday 8 1 ½ 1 10
Friday 8 1 1½ 3 12
Saturday 4 --- 4* 8 12
Total 44 4 9 18 66
(*Worker-C has worked more than 48 hours in the week)
Wages payable :
A B C
Basic Wages per hour (`) 25.00 12.50 37.50
Dearness allowance per hour (`) 5.50 5.50 5.50
Hourly rate (`) 30.50 18.00 43.00
Total normal hours 54.00 48.00 66.00
Total Wages payable (`) 1,647.00 864.00 2,838.00

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EMPLOYEE COST AND DIRECT EXPENSES 3.19

ILLUSTRATION 5
In a factory, the basic wage rate is `100 per hour and overtime rates are as follows:
Before and after normal working hours 175% of basic wage rate
Sundays and holidays 225% of basic wage rate
During the previous year, the following hours were worked
- Normal time 1,00,000 hours
- Overtime before and after working hours 20,000 hours
Overtime on Sundays and holidays 5,000 hours
Total 1,25,000 hours
The following hours have been worked on job ‘Z’
Normal 1,000 hours
Overtime before and after working hrs. 100 hours.
Sundays and holidays 25 hours.
Total 1,125 hours
You are required to calculate the labour cost chargeable to job ‘Z’ and overhead in
each of the following instances:
(a) Where overtime is worked regularly throughout the year as a policy due to the
workers’ shortage.
(b) Where overtime is worked irregularly to meet the requirements of production.
(c) Where overtime is worked at the request of the customer to expedite the job.
SOLUTION
Workings
Basic wage rate : `100 per hour
Overtime wage rate before and after working hours : `100 × 175% = `175 per hour
Overtime wage rate for Sundays and holidays : `100 × 225% =`225 per hour
Computation of average inflated wage rate (including overtime premium):
Particulars Amount (`)
Annual wages for the previous year for normal time
(1,00,000 hrs. × `100) 1,00,00,000
Wages for overtime before andafter working hours
(20,000 hrs. × `175) 35,00,000
Wages for overtime on Sundays and holidays
(5,000 hrs. × `225) 11,25,000
Total wages for 1,25,000 hrs. 1,46,25,000

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3.20 COST AND MANAGEMENT ACCOUNTING

` 1, 46,25,000
Average inflated wage rate = =`117
1,25,000hours
(a) Where overtime is worked regularly as a policy due to workers’ shortage :
The overtime premium is treated as a part of employee cost and job is charged at
an inflated wage rate.Hence, employee cost chargeable to job Z
= Total hours × Inflated wage rate = 1,125 hrs. × `117 = `1,31,625
(b) Where overtime is worked irregularly to meet the requirements of production:
Basic wage rate is charged to the job and overtime premium is charged to factory
overheads as under:
Employee cost chargeable toJob Z:1,125 hours @ `100 per hour=`1,12,500
Factory overhead:{100 hrs. × `(175 – 100)} + {25 hrs. × ` (225 – 100)} = {`7,500 +
`3,125} = `10,625
(c) Where overtime is worked at the request of the customer, overtime premium
is also charged to the job as under :
(`)
Job Z Employee cost 1,125 hrs. @ `100 = 1,12,500
Overtime premium 100 hrs. @ `(175 – 100) = 7,500
25 hrs. @ `(225 – 100) = 3,125
Total 1,23,125

3.7 LABOUR UTILISATION

For identifying utilisation of labour a statement is prepared (generally weekly) for each
department / cost centre. This statement should show the actual time paid for, the
standard time (including normal idle time) allowed for production and the abnormal
idle time analysed for causes thereof.
3.7.1 Identification of Utilisation of labours with Cost Centres:
For the identification of utilisation of labour with the cost centre, a wage analysis sheet
is prepared. Wage analysis sheet is a statement in which total wages paid are analysed
according to cost centre, jobs, work orders etc. The data for analysis is provided by
wage sheet, time card, piece work cards and job cards.
The preparation of such sheet serves the following purposes:
(i) It analyse the labour time into direct and indirect labour by cost centres, jobs,
work orders.
(ii) It provides details of direct labour cost comprises of wages, overtime to be
charged as production cost of cost centre, jobs or work orders.
(iii) It provides information for treatment of indirect labour cost as overhead
expenses.
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EMPLOYEE COST AND DIRECT EXPENSES 3.21

3.7.2 Identification of lanour hours with work order or batches or capital job:
For identification of labour hours with work order or batches or capital jobs or overhead
work orders the following points are to be noted:
(i) The direct labour hours can be identified with the particular work order or batches
or capital job or overhead work orders on the basis of details recorded on source
document such as time sheet or job cards.
(ii) The indirect labour hours cannot be directly identified with the particular work
order or batches or capital jobs or overhead work orders. Therefore, they are
traced to cost centre and then assigned to work order or batches or capital jobs
or overhead work orders by using overhead absorption rate.
3.8 SYSTEMS OF WAGE PAYMENT AND INCENTIVES
There exist several systems of employee wage payment and incentives, which can be
classified under the following heads:

3.8.1 Time based (Time Rate System)

(i) 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.
Time based wages payment is suitable for the employees (i) whose services cannot be
directly or tangibly measured, e.g., general helpers, supervisory and clerical staff etc.
(ii) engaged in highly skilled jobs, (iii) where the pace of output is independent of the
operator, e.g., automatic chemical plants.
Wages under time rate system is calculated as under:

Wages = Time Worked (Hours/ Days/ Months) × Rate for the time

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3.22 COST AND MANAGEMENT ACCOUNTING

(ii) Differential Time Rate System

According to this method, different hourly rates are fixed for different levels of
efficiency. Up to a certain level of efficiency the normal time or day rate is paid. Based
on efficiency level the hourly rate increases gradu¬ally. The following is an example of
differential time ratesystem:
Up to, say 75% efficiency Normal (say `N per hr.)
From 76% to 80% efficiency 1.10 × N
From 81% to 90% efficiency 1.20 × N
From 91% to 100% efficiency 1.30 × N
From 101% to 120% efficiency 1.40 × N
As this method is linked with the output and efficiency of work¬ers, therefore, it cannot
be strictly called as a time rate method of wage payment. This method in fact is similar
to differential piece work system.
Merits and Demerits of Time rate system
Merits :
(i) Simple to understand and to calculate wages.
(ii) Reduces temptation on the part of workers to increase the output at the cost of
quality.
(iii) Unity in employee, no distinction between efficient and inefficient employee due
to quality of production.
(iv) Stability in wages
Demerits :
(i) No monetary incentive to raise the level of production.
(ii) No distinction between the slow and the efficient worker.
(iii) The tendency is for the fall in output; this raises the cost per unit (because both
employee and fixed expenses will be spread over a smaller number of units).
(iv) A firm cannot be sure of employee costs per unit under this method and, hence,
may suffer a loss on quotations if already submitted.
3.8.2 Output Based (Piece Rate System)
(i) 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 × Rate per unit

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EMPLOYEE COST AND DIRECT EXPENSES 3.23

(ii) Differential Piece Rate System

Under this system, the rate of wages is linked to efficiency of the workers for producing
a unit. Efficiency is measured against a set standard. Different rate is given for different
efficiency level. The main feature of all differential piece-work systems is that several
piece rates on a slab scale are fixed for a job or operation. For different levels of output
below and above the standard, different piece rates are applicable.
The two important differential piece rate systems to be discussed here are (a) Taylor’s
Differential Piece Rate System and (b) Merrick’s Differential Piece Rate System.
(a) Taylor’s Differential Piece Rate System : This system of wages payment aims
at rewarding efficient workers by providing increased piece rate beyond certain level
of output.
Under this system two widely differing piece-rates are prescribed for each job. The
lower rate is 83%* of the normal piece rate and the higher rate is 125%* of the normal
piece rate. In other words, the higher rate is 150% of the lower rate. The lower rate is
given to a worker when his efficiency level is less than 100%. The higher rate is offered
for efficiency level of 100% or more.
*Some authors also use 80% and 120% of the piece rates in place of 83% and 125% respectively.
ILLUSTRATION 6
Using Taylor’s differential piece rate system, find the earnings of ‘A’ from the following
particulars:
Standard time per piece 12 minutes
Normal rate per hour (in an 8 hour- day) `20
A produced 37 units
Solution
Actual output = 37 units
8hrs. × 60 minutes
Standard output = = 40 units
12 minutes per piece

37 units
Efficiency = × 100 = 92.5%
40 units
Under Taylor’s differential piece rate system, a worker is paid lower piece rate of 83%,
since his efficiency is less than 100%.
Standard production per hour = 60 minutes/12 minutes = 5 units
Normal Rate per hour = `20
Normal piece rate per unit = `20/5 units = `4
Lower piece rate per unit = `4 × 83/100 = `3.32
Total earnings = 37 units × `3.32 = `122.84
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3.24 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 7
Using Taylor’s differential piece rate system, compute the earnings of the Amar, Akbar
and Ali from the following particulars:
Standard time per piece 20 minutes
Normal rate per hour (in an 8 hour- day) `90.00
Amar produced 23 units
Akbar produced 24 units
Ali produced 30 units
Solution
Computation of earnings under Taylor’s differential piece rate system
Particulars Amar Akbar Ali
A. Standard output per day 24 24 24
(units) {(8 hours × 60
minutes)/ 20 minutes}
B. Actual output per day (units) 23 24 30
C. Efficiency (%) 95.83% 100% 125%
 Actual output   23 units   24 units   30 units 
 Standarad output ×100  24 units ×100  24 units ×100  24 units ×100
 
D. Percentage of piece rate 83% 125% 125%
E. Rate per unit (`) 24.90 37.50 37.50
(83% of `30*) (125% of `30*) (125% of `30*)
F. Earnings (`) (B × E) 572.7 900.00 1,125.00
 ` 90.00 
* Normal rate per unit =  
 Standard production per hour 
` 90.00
= = `30
3 units
(b) Merrick Differential Piece Rate System : Under this system three piece rates for
a job are fixed. None of the fixed rates is below the normal. These three piece rates are
as below :
Efficiency Piece rate applicable
Upto 83% Normal piece rate
Above 83% but upto 100% 10% above the normal rate
Above 100% 20% or 30% of normal rate
This system is an improvement over Taylor’s Differential Piece Rate System.
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EMPLOYEE COST AND DIRECT EXPENSES 3.25

ILLUSTRATION 8
Refer the Illustration-7 and compute the earnings of workers under Merrick’s Differential
Piece Rate System
SOLUTION
Computation of earnings under Merrick’s differential piece rate system
Particulars Amar Akbar Ali
A. Standard output per day 24 24 24
(units)
{(8 hours × 60 minutes)/
20 minutes}
B. Actual output per day 23 24 30
(units)
C. Efficiency (%) 95.83% 100% 125%
 Actual output   23 unit   24 unit   30 unit 
 Standard output ×100  24 unit ×100  24 unit ×100  24 unit ×100
 
D. Percentage of piece rate 110% of 110% of 120% of
Piece rate Piece rate Piece rate
Or
130% of
Piece rate
E. Rate per unit (`) 33.00 33.00 36.00 or
39.00
(110% of `30*) (110% of `30*) (120% of `30*)
or
(130% of `30)
F. Earnings (`) (B × E) 759.00 792.00 1,080 or
1,170
 ` 90.00  ` 90.00
* Normal rate per unit =   = = `30
 Standard production per hour  3 units

ILLUSTRATION 9
Calculate the earnings of workers A, B and C under Straight Piece Rate System and
Merrick’s Piece Rate System from the following particulars:
Normal Rate per Hour `54
Standard Time per Unit 1 Minute

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3.26 COST AND MANAGEMENT ACCOUNTING

Output per day is as follows :

Worker A – 390 Units; Worker B – 450 Units; Worker C – 600 Units
Working hours per day are 8.
SOLUTION
(i) Calculation of earnings under Straight Piece Rate System:
Worker A = 390 units `0.09 = `35.10
Worker B = 450 units `0.09 = `40.50
Worker C = 600 units `0.09 = `54.00
(ii) Calculation of earnings under Merrick’s Multiple Piece Rate System
Particulars Worker- A Worker- B Worker- C
A. Standard output per 480 480 480
day (units)
B. Actual output per day 390 450 600
(units)
C. Efficiency (%) 81.25% 93.75% 125%
 Actual output   390 unit   450 unit   600 unit 
 Standard output ×100  480 unit ×100  480 unit ×100  480 unit ×100
 
D. Percentage of piece Piece rate 110% of Piece 120% of Piece rate
rate rate or
130% of Piece rate
E. Rate per unit (`) 0.9 0.99 1.08 or 1.17
(100% of `0.9*) (110% of `0.9*) (120% of `0.9*)
or
(130% of `0.9*)
F. Earnings (`) (B × E) 351.00 445.50 648 or 702
*Normal wage rate per unit = Normal Rate per Hour ÷ Standard output per hour
= ` 54 ÷ 60 units = ` 0.9
3.8.3 Combination of Time and Output based System
(i) Gantt Task and Bonus system : This system is a combination of time and piece
work system. According to this system a high standard or task is set and payment is
made at time rate to a worker for production below the set standard.
If the standards are achieved or exceeded, the payment to the concerned worker
is made at a higher piece rate. The piece rate fixed under this system also includes
an element of bonus to the extent of 20%. The figure of bonus to such workers is
calculated over the time rate of the workers.

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EMPLOYEE COST AND DIRECT EXPENSES 3.27

Thus in its essence, the system consists of paying a worker on time basis if he does not
attain the standard and on piece basis if he does. Wages payable to workers under this
plan are calculated as under:
Output Payment
(i) When output is below the standard output Guaranteed time rate is paid
(ii) When output is at par with standard output Time rate plus bonus of 20% of time
rate.
(iii) When output is above the standard output High piece rate or Piece rate plus
20% of piece rate.
ILLUSTRATION 10
In a factory the standard time allowed for completing a given task (50 units), is 8 hours.
The guaranteed time wages are `20 per hour. If a task is completed in less than the
standard time, the high rate of `4 per unit is payable. Calculate the wages of a worker,
under the Gantt system, if he completes the task in
(i) 10 hours; (ii) 8 hours, and (iii) in 6 hours. Also ascertain the comparative rate of
earnings per hour under the three situations.
SOLUTION
(i) When the worker performs the task in 10 hours, his earnings will be at the time
wage rate i.e. 10 hours × `20 per hour = `200.
(ii) When the worker performs the task is standard time i.e. in 8 hours, his earning
will be:
8 hours × `20 = `160
Bonus @ 20% of time wages = ` 32
Total earnings `192
(iii) When the worker performs the task in less than the standard time his earning will
be at piece rate i.e.
50 units × `4 per unit = `200
The comparative rate of earnings per hour under the above three situations is:
(i) `200/10 hrs. = `20 per hour
(ii) `192/8 hrs. = `24 per hour
(iii) `200/6 hrs. = `33.33 per hour
(ii) Emerson’s Efficiency System : Under this system minimum time wages are
guaranteed. But beyond a certain efficiency level, bonus in addition to minimum day
wages is given.
A worker who is able to attain efficiency, measured by his output equal to 2/3rd
of the standard efficiency, or above, is deemed to be an efficient worker deserving

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3.28 COST AND MANAGEMENT ACCOUNTING

encouragement. The scheme thus provides for payment of bonus at a rising scale at
various levels of efficiency, ranging from 66.67% to 150%.
The levels are as mentioned below:
(i) For a performance below 66.67% only time rate wages without any bonus are
paid.
(ii) 662/3%to 100% efficiency, bonus varies between 0.01% and 20%.
(iii) Above 100% efficiency bonus of 20% of basic wages plus 1% for each 1% increase
in efficiency is admissible.
This system is superior to one to the differential piece rate in so far as it encourages
the slow worker to do a little better than before. Also it does not pre-suppose a high
degree of average performance. Wages on time basis are guaranteed.
ILLUSTRATION 11
From the following information you are required to calculate the bonus and earnings
under Emerson Efficiency System. The relevant information is as under:
Standard working hours : 8 hours a day
Standard output per hour in units : 5
Daily wage rate : `500
Actual output in units
Worker A 25 units
Worker B 40 units
Worker C 45 units
Solution
Calculation of bonus and total earnings under Emerson Efficiency System
Particulars Worker- A Worker- B Worker- C
A. Standard output (units) 40 40 40
B. Actual output (units) 25 40 45
C. Efficiency (%) 62.5% 100% 112.5%
 Actual output   25 unit   40 unit   45 unit 
 Standarad output ×100   40 unit ×100   40 unit ×100   40 unit ×100 
 
D. Time wages per day (`) 500 500 500
E. Rate of bonus No bonus 20% of time 32.5% of time
rate rate (20% +
12.5%)

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EMPLOYEE COST AND DIRECT EXPENSES 3.29

F. Bonus earnings (`) 0 100 162.50

(20% of ` 500*) (32.5% of `500*)
G. Total Earnings (`) (D + F) 500.00 600.00 662.50
(iii) Points Scheme- Bedaux System : Under this scheme, firstly the quantum of work
that a worker can perform is expressed in Bedaux points or B’s. These points represent
the standard time in terms of minutes required to perform a job. The standard numbers
of points in terms of minutes are ascertained after a careful and detailed analysis of
each operation or job. Each such minute consists of the time required to complete a
fraction of the operation or the job, and also an allowance for rest due to fatigue.
Workers who are not able to complete tasks allotted to them within the standard time
are paid at the normal daily rate.
Those who are able to improve upon the efficiency rate are paid a bonus, equal to the
wages for time saved as indicated by excess of B’s earned (standard minutes for work
done) over actual time. Workers are paid 75% of the time saved.
ILLUSTRATION 12
Calculatethe earnings of worker from the following information under Bedauxsystem:
Standard time for a product A-30 seconds plus relaxation allowance of 50%.
Standard time for a product B-20 second plus relaxation allowance of 50%.
During 8 hour- day for
Actual output of product A- 500 units.
Actual output of product B- 300 units
Wage rate- `100 per hour
Solution
Workings :
(i) Bedaux point per unit of product A:
30 sec onds + 50% of 30 sec conds 45
= = 0.75 B’s
60 sec onds 60

(ii) Bedaux point per unit of product B:

20 sec onds + 50% of 20 sec onds 30
= = = 0.50 B’s
60 sec onds 60

(iii) Total production in terms of B’s:

500 units × 0.75 + 300 units × 0.50 = 525 B’s
Standard B’s (8 hours × 60) = 480 B’s
No. of B’s saved (525 B’s – 480 B’s) = 45 B’s

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3.30 COST AND MANAGEMENT ACCOUNTING

Calculation of earnings under Bedaux system

45
= Hrs. worked × Rate per hour + 75/100 × × `100
60
45
= 8 hours ×`100 + 75/100 × × `100
60

= `800 + `56.30 = `856.30

3.8.4 Premium Bonus Method
Under these methods, standard time is established for performing a job. The worker is
guaran-teed 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. Earnings under
Halsey Premium plan is calculated as under:
Wages = Time taken × Time rate + 50% of time saved × Time rate

Advantages and Disadvantages of Halsey Premium Plan

Advantages Disadvantages
1. Time rate is guaranteed while 1. Incentive is not so strong as with piece
there is opportunity for increasing rate system. In fact the harder the worker
earnings by increasing production. works, the lesser he gets per piece.
2. The system is equitable in as 2. The sharing principle may not be liked by
much as the employer gets a employees.
direct return for his efforts in
improving production methods
and providing better equipment.
ILLUSTRATION 13
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

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EMPLOYEE COST AND DIRECT EXPENSES 3.31

SOLUTION
Calculation of total earnings :
= Time taken × Time rate + 50% (Time Allowed – Time Taken) × Time rate
= 6 hrs. × `60 + 1/2 × (2 hrs. × `60) or `360 + `60 = `420
Of his total earnings, `360 is on account of the time worked and `60 is on account of
his share of the premium bonus.
(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.
Under Rowan System the bonus is that proportion of the time wages as time saved
bears to the standard time.
Time Saved
Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed

Advantages and Disadvantages of Rowan Premium Plan

Advantages Disadvantages
1. It is claimed to be a fool-proof system 1. The system is a bit complicated.
in as much as a worker can never
double his earnings even if there is
bad rate setting.
2. It is admirably suitable for 2. The incentive is weak at a high
encouraging moderately efficient production level where the time
workers as it provides a better return saved is more than 50% of the time
for moderate efficiency than under allowed.
the Halsey Plan.
3. The sharing principle appeals to the 3. The sharing principle is not generally
employer as being equitable. welcomed by employees.

ILLUSTRATION 14
Calculate the earnings of a worker under Rowan System. The relevant data is given as
below:
Time rate (per Hour) `60
Time allowed 8 hours.
Time taken 6 hours.
Time saved 2 hours.

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3.32 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Calculation of total earnings :
Time Saved
= Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed
2 hours
= 6 hours × `60 + × 6 hours × `60 = `360 + `90 = `450
8 hours

ILLUSTRATION 15
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.
SOLUTION
Step 1 : Let X be the cost of material and Y be the normal rate of wages per hour.
Step 2 : Factory Cost of Workman ‘A’
(`)
A. Material Cost X
B. Wages 30 Y

30 12 Y
C. Bonus = × (50 - 30) × Y
50

D. Overheads (30 `5) 150

E. Factory Cost 3,490
Or,, X + 42 Y = `3,490 (Given) – `150 = `3,340 .......................………………….. equation (i)

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EMPLOYEE COST AND DIRECT EXPENSES 3.33

Step 3 : Factory Cost of Workman ‘B’

(`)
A. Material Cost X
B. Wages 40 Y
C. Bonus = 50% of (SH - AH) × R 5Y
= 50% of (50 - 40) ×R
D. Overheads (40 × `5) 200

E. Factory Cost 3,600

Or, X + 45 Y = `3,600 (Given) – `200 = `3,400…………………...................…….equation (ii)
Step 4 : Subtracting equation (i) from equation (ii)
3Y = `60
Y = `60/3 = `20 per hour.
(a) The normal rate of wages:`20 per hour
(b) The cost of material: X + 45 × `20 = `3,400 or, X= `3,400 – `900 = `2,500
(c) Comparative Statement of the Factory Cost of the product made by the two
workmen.
‘A’(`) ‘B’(`)
Material cost 2,500 2,500
Direct Wages 600 800
(30 × `20) (40 × ` 20 )
Bonus 240 100
(12 × ` 20) (5 × ` 20)
Factory Overhead 150 200
Factory Cost 3,490 3,600
ILLUSTRATION 16
(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 statementshowing:
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.

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3.34 COST AND MANAGEMENT ACCOUNTING

SOLUTION
50
(a) Bonus under Halsey Plan = × (SH - AH) × R (i)
100

AH
Bonus under Rowan Plan = × (SH - AH) × R (ii)
SH

Bonus under Halsey Plan will be equal to the bonus under Rowan Plan when the
following condition holds good:
50 AH
× (SH - AH) × R = × (SH - AH) × R
100 SH

50 AH
=
100 SH

Hence, when the actual time taken (AH) is 50% of the time allowed (SH), the bonus
under Halsey and Rowan Plans is equal.
(b) Statement of Bonus, total earnings of Employee and hourly earnings under Halsey
and Rowan Systems.
SH AH Time Basic Bonus Bonus Total Total Hourly Hourly
saved wages under under Earnings Earnings Earnings Earnings
(AH × Halsey Rowan under under under under
`8) (B System system Halsey Rowan Halsey Rowan
× `8) System System System System
 50 ×C×8  B ×C×8 D+E D+F G/B H/B
 100   A 

A B C = (A D (`) E (`) F (`) G (`) H (`) I (`) J (`)

hours hours - B)
hours
8 8 - 64 - - 64 64 8.00 8.00
8 7 1 56 4 7 60 63 8.57 9.00
8 6 2 48 8 12 56 60 9.33 10.00
8 5 3 40 12 15 52 55 10.40 11.00
8 4 4 32 16 16 48 48 12.00 12.00
8 3 5 24 20 15 44 39 14.67 13.00
8 2 6 16 24 12 40 28 20.00 14.00
8 1 7 8 28 7 36 15 36.00 15.00

ILLUSTRATION 17
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

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EMPLOYEE COST AND DIRECT EXPENSES 3.35

`37.50 on the manufacture of that particular product.

What could have been his total earnings and effective hourly rate, had he been put on
Halsey Incentive Scheme (50%)?
SOLUTION
Total earnings (under 50% Halsey Scheme) = Hours worked × Rate per hour + ½ ×
time saved × Rate per hour
= 3 hours × `30 + ½ × 1 hour × `30 = `105
Total earnings ` 105
Effective hourly rate = = = ` 35
Hours taken 3 hours
Working Note:
Let T hours be the total time worked in hours by the skilled workers (machine man P),
`30 is the rate per hour; standard time is 4 hours per unit and effective hourly earnings
rate is `37.50 then
Time saved
Earning (under Rowan plan) = Hours worked × Rate per hr + ×
Time allowed
Time taken × Rate per hr
(4 – 1)
`37.5 T = T × `30 + × T × `30
4
`37.5 = `30 + (4 – T) × `7.5
or, `7.5 T = `22.5
or, T = 3 hours.
ILLUSTRATION 18
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 devise a suitable incentive scheme and demon¬strate by an
illustrative numerical example how your scheme answers to all the requirements of the
management.
SOLUTION
Rowan Scheme of premium bonus (variable sharing plan) is a suit¬able incentive
scheme for the workers of the factory. If this scheme is adopted, the entire gains due
to time saved by a worker will not pass to him.
Another feature of this scheme is that a worker cannot increase his earnings or bonus
by merely increasing its work speed. The reason for this is that the bonus under Rowan
Scheme is maximum when the time taken by a worker on a job is half of the time
allowed. As this fact is known to the workers, therefore, they work at such a speed
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3.36 COST AND MANAGEMENT ACCOUNTING

which helps them to maintain the quality of output too.

Lastly, Rowan System provides a safeguard in the case of any loose fixation of the
standards by the rate-setting department. It may be observed from the following
illustration that in the Rowan Scheme the bonus paid will be low due to any loose
fixation of standards. Workers cannot take undue advantage of such a situation. The
above three features of Rowan Plan can be discussed with the help of the following
illustration:
(i) Time allowed = 4 hours
Time taken = 3 hours
Time saved = 1 hour
Rate = `5 per hour
Time taken
Bonus = × Time saved × Rate
Time allowed
3 hours
= 4 hours × 1 hour × `5 = `3.75

In the above illustration time saved is 1 hour and, therefore, total gain is `5. Out
of `5 according to Rowan Plan only `3.75 is given to the worker in the form of
bonus and the remaining `1.25 remains with the management. In other words, a
worker is entitled for 75 percent of the time saved in the form of bonus.
(ii) The figures of bonus in the above illustration when the time taken is 2 hours and
1 hour respectively are as below:
Time taken
Bonus = Time allowed × Time saved × Rate

2 hours
= × 2 hours × `5 = `5
4 hours
1hour
= 10 hours × 3 hours × `5 = `3.75
The above figures of bonus clearly show that when time taken is half of the time
allowed, the bonus is maximum. When the time taken is reduced from 2 to 1
hour, the bonus figure fell by `1.25. Hence, it is quite apparent to workers that it
is of no use to increase speed of work. This feature of Rowan Plan thus protects
the quality of output.
(iii) If the rate-setting department erroneously sets the time allowed as 10 hours
instead of 4 hours, in the above illustration; then the bonus paid will be as follows:
3 hours
Bonus = × 7 hours × `5 = `10.50
10 hours

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EMPLOYEE COST AND DIRECT EXPENSES 3.37

The bonus paid for saving 7 hours thus is `10.50 which is approximately equal
to the wages of 2 hours. In other words, the bonus paid to the workers is low.
Hence workers cannot take undue advantage of any mistake committed by the
time setting department of the concern.

(iii) Barth System : The system is particularly suitable for trainees and beginners and
also for unskilled workers. The reason is that for low production efficiency, the earnings
are higher than in the piece-work system but as the efficiency increases, the rate of
increase in the earnings falls.
This system is not suitable for workers having more than 100% efficiency as it does not
provide incentive on working at more than 100% efficiency.
The formula used for calculating the remuneration under this system is as follows:

Earnings = Hourly rate × Standard hours × Hours worked

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3.38 COST AND MANAGEMENT ACCOUNTING

3.8.5 Group Bonus Scheme

Certain jobs or operations are required to be performed collectively by a number of
workers. Under such cases each man’s work depends on the work performed by one or
more of his colleagues and as such it is not possible to measure separately the output
of each worker.
The workers constituting a group or a team here are considered as a composite
unit and the combined output of such a unit is measured for the purpose of wage
calculation. Bonus is paid for the collective efforts made by the group of workers. The
amount of bonus is distributed among the individual members of the group on some
agreed basis.
There following are few schemes of group bonus:
(i) Priestman’s Production Bonus : According to this method when the actual
production in units or points exceeds the standard units or points, a bonus is
paid to the workers as additional wages equivalent to the percentage of actual
output over the standard output.
(ii) Cost Efficiency Bonus: Under this scheme, bonus is paid when the actual cost is
reduced to below the normal established targets. Targets for each cost elements
(material, employee and overheads) are set. If the measurement of actual
performance shows a saving in the cost either in total or for cost element (as the
case may be), a fair percentage of the saving is distributed among the staff.
Three popular schemes usually used for calculating the amount to be distributed
to workers as bonus are as below:
(a) Nunn-Bush Plan : According to this plan a norm for direct employee
cost is fixed and expressed as a percentage of the sales value.The amount
calculated at this percentage is credited to a fund. The actual employee
cost is debited to this fund and the balance remaining to the credit of this
fund is distributed as bonus to all the workers and employees.
(b) Scanlon Plan : Here also a fund is created for the normal cost of wages
and salaries. This fund is debited with the actual employee cost. Two-thirds
to three-fourths of the credit balance, if any, is distributed as bonus, the
balance is kept as reserve for future set-backs.
(c) Rucker Plan : This plan is quite similar to Nunn-Bush Plan except that the
percentage for crediting the fund is based on the total value added by
manufacturer (i.e. the total cost less the value of the material) and not on
total sales value.
Many times group bonus schemes do not enjoy the approval of workers. Some workers
tend to feel that their personal incentives are low merely because some members
of the group are lazy or inefficient. Such workers believe that it is better to provide
incentives on individual basis, if it is possible.

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EMPLOYEE COST AND DIRECT EXPENSES 3.39

3.8.6 Incentives for Indirect Employees

Since the setting of work standards and measurement of output in the case of indirect
workers is not an easy task in respect of maintenance, internal transport, inspection,
packing and cleaning, therefore the introduction of a system of payment by results for
indirect workers is difficult. In spite of the aforesaid difficulty, it has been felt necessary
to provide for incentives to indirect workers, due to the following reasons:
1. Dissatisfaction : Payment of incentive bonus to direct workers and time rate to
indirect workers leads to dissatisfaction and employee unrest.
2. Entitlement : Indirect workers are as much entitled to bonus as direct workers.
3. Team Spirit : Bonus payment to indirect workers creates team spirit.
4. Increase in efficiency : An incentive system for indirect workers assists in
maintaining the efficiency of services such as plant repairs, stores maintenance,
material handling etc.
5. Dependence on indirect employee : The efficiency of direct workers is reduced
where their work is dependent upon the service rendered by the indirect workers.
ILLUSTRATION 19
A, B and C were engaged on a group task for which a payment of `72,500 was to be
made. A’s time basis wages are `800 per day, B’s `600 per day and C’s `500 per day. A
worked for 25 days; B worked for 30 days; and C for 40 days. Calculatethe share of bonus
to be distributed among the workers and total earnings thereof.
SOLUTION
Working:
Total wages on time basis:
Worker (`)
A(25 days × ` 800) 20,000
B (30 days × `600) 18,000
C (40 days × `500) 20,000
58,000
Bonus (balancing figure) 14,500
Payment received for the task 72,500
The group bonus of `14,500 is 25% (`14,500/`58,000 ×100) of total time wages, the
bonus is to be distributed among the workers at the rate of 25% of their respective
time wages.

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3.40 COST AND MANAGEMENT ACCOUNTING

Calculation of share of bonus and total earnings of each worker

Worker Basic Wages (`) Share of bonus @25% (`) Total earnings (`)
A 20,000 5,000 (25% of `20,000) 25,000

B 18,000 4,500 (25% of `18,000) 22,500

C 20,000 5,000 (25% of `20,000) 25,000

Total 58,000 14,500 72,500

ILLUSTRATION 20
Both direct and indirect employees of a department in a factory are entitled to production
bonus in accordance with a group incentive scheme, the outline of which is as follows:
(a) For any production in excess of the standard rate fixed at 16,800 tons per month
(of 28 days) a general incentive of `1,500 per ton is paid in aggregate. The total
amount payable to each separate group is determined on the basis of an assumed
percentage of such excess production being contributed by it, namely @ 65% by
direct employee, @ 15% by inspection staff, @ 12% by maintenance staff and @
8% by supervisory staff.
(b) Moreover, if the excess production is more than 20% above the standard, direct
employees also get a special bonus @ `500 per ton for all production in excess of
120% of standard.
(c) Inspection staff are penalized @ `2,000 per ton for rejection by customer in excess
of 2% of production.
(d) Maintenance staff are also penalized @ `2,000 per hour for breakdown.
From the following particulars for a month, compute production bonus earned by each
group:
(a) Actual working days : 25
(b) Production : 21,000 tons
(c) Rejection by customer : 500 tons
(d) Machine breakdown : 40 hours

SOLUTION
Standard output per month
1. Standard output per day =
Budgeted number of days in a month

16,800 tons
= = 600 tons
28 days

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EMPLOYEE COST AND DIRECT EXPENSES 3.41

2. Standard output for 25 days = 600 tons × 25 days = 15,000 tons

(a) General Incentive
(i) Standard output : 15,000 tons
(ii) Actual output : 21,000 tons
(iii) Excess output over standard : 21,000 – 15,000 = 6,000 tons
(iv) Percentage of excess : 40%
6,000 tons
production to standard output : × 100
15,000 tons
(v) Aggregate general incentive : = Excess output × `1,500
: = 6,000 tons × `1,500 = `90,00,000
(vi) Allocation of general incentive
Direct Employee : 65% of `90,00,000 = `58,50,000
Inspection staff : 15% of `90,00,000 = `13,50,000
Maintenance staff : 12% of `90,00,000 = `10,80,000
Supervisory staff : 8% of `90,00,000 = ` 7,20,000
Total ` 90,00,000
(b) Special bonus to direct workers
(i) 20% is the excess output over 120% of standard output
or 3,000 tons (15,000 tons × 20%)
(ii) Special incentive = 3,000 tons × `500 = `15,00,000
(c) Penalty imposed on inspection staff
(i) Normal rejection = 2% of production = 2% of 21,000 tons
= 420 tons
(ii) Actual rejection = 500 tons
(iii) Excess rejection over normal rejection = 500 – 420 = 80 tons
(iv) Penalty = 80 tons × `2,000 per ton = `1,60,000
(d) Penalty imposed on maintenance staff
(i) Breakdown hours = 40 hours
(ii) Penalty = 40 hours × `2,000 per hour = `80,000

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3.42 COST AND MANAGEMENT ACCOUNTING

Statement of production bonus earned by each group

Particulars Direct Inspection Maintenance Supervisory Total (`)
Employee staff (`) staff (`) staff (`)
(`)
Aggregate 58,50,000 13,50,000 10,80,000 7,20,000 90,00,000
general
incentive
Special 15,00,000 - - - 15,00,000
bonus
Penalty - (1,60,000) (80,000) - (2,40,000)
Production 73,50,000 11,90,000 10,00,000 7,20,000 1,02,60,000
bonus

3.9 ABSORPTION OF WAGES

3.9.1 Elements of wages
In common parlance, the term ‘wages’ represents monetary payment which an
employee receives at regular intervals for the services rendered. Strictly speaking,
however, from the point of view of the employer and the cost to the industry, wages
should be taken to include also non-monetary benefits which an employee receives by
virtue of employment. Such non-monetary benefits may include:
(i) Medical facilities;
(ii) Educational and training facilities;
(iii) Recreational and sports facilities;
(iv) Housing and social welfare; and
(v) Cost of subsidised canteen and co-operative societies.
Such benefits are generally given in an industrial establishment. In some cases, the
provision of benefits is compulsory. Therefore, while computing the wage cost per
worker, the monetary value of such non-monetary benefits should also be taken into
account.
The monetary part of a worker’s remuneration includes the basic wages, dearness
allowance, overtime wages, other special allowance, if any, production bonus,
employer’s contribution to the provident fund, Employees State Insurance scheme
premium, contribution to pension fund, leave pay, etc.
The basic wage is the payment for work done, measured in terms of hours attended
or the units produced, as the case may be. The basic wage rate is not normally altered
unless there is a fundamental change in the working conditions or methods of
manufacture.

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EMPLOYEE COST AND DIRECT EXPENSES 3.43

Dearness allowance is an allowance provided to cover the increase in cost of living

from one period to another. This allowance is calculated either as percentage of the
basic wage or as a fixed amount for the days worked. In either case, the percentage or
the fixed amount is subject to revision whenever the cost of living index or consumer
price Index rises or falls by a certain figure as agreed to by the employer with the
Employee union. When permanent rise in the cost of living index occurs, a part of the
dearness allowance is often absorbed in the basic wage.
Overtime allowance is an allowance paid for the extra hours worked at the rates laid
down in the Factories Act. In certain industries, where special allowance for the working
conditions, tool maintenance, etc., are paid they are also considered as part of wages.
Production Bonus is an incentive payment made to workers for efficiency that results in
production above the standard. There are different methods of computing incentives.
Under the Payment of Bonus Act, a worker is entitled to compulsory bonus of 8.33%
wages earned in the relevant year or `100 (whichever is greater). The bonus may be
upto 20% of wages depending upon the quan-tum of profits calculated as per the Act.
3.9.2 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. 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 alongwith wages of the worker. (It should be remembered
that such wage rate will be only for costing purposes and not for payment to workers).
The total of wages and additional payment should be divided by effective hours of
work to get such wage rates for costing purposes.
ILLUSTRATION 21
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.

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3.44 COST AND MANAGEMENT ACCOUNTING

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.
SOLUTION
(`)
Wages paid to worker during the year{(` 10,000 +2,000) × 12} 1,44,000
Add: Employer Contribution to:
-Provident Fund @ 10% 14,400
-E.S.I. Premium @ 4.75% (6.5 – 1.75) 6,840
Bonus at 2 months’ wages (Basic + DA) 24,000
Total 1,89,240
Effective hours per year: 285 days × 8 hours = 2,280 hours
Wage rate per hour (for costing purpose): `1,89,240/2,280 hours = `83
3.9.3 Holiday and leave wages
One alternative to account for wages paid on account of paid holiday and leave can
be to include them as departmental overheads. In such a case, it is necessary to record
such wages separately from “worked for wages”. Such a segregation can be made
possible by providing a separate column in the payroll for holiday and leave wages in
the same way as there are columns for dearness allowance, provident fund deductions,
etc. If, however, a separate or additional column cannot be provided for this purpose
it would be necessary to analyse the payroll periodically to ascertain how much of the
total payment pertains to “worked for wages” and how much is attributed to leave and
holiday wages.
Another way could be to inflate the wage rate for costing purposes to include holiday
and leave wages. This can be done only in the case of direct workers.
ILLUSTRATION 22
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.
SOLUTION
(a) (i) Effective working days in a year 300
Less: Leave days on full pay 20
Effective working days 280 days
Total effective working hours (280 days × 8 hours) 2,240
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EMPLOYEE COST AND DIRECT EXPENSES 3.45

(ii) Total wages paid in a year (`)

Basic pay 1,20,000
D.A. 36,000
Fringe benefits 12,000
1,68,000
(iii) Hourly rate :`1,68,000/2,240 hours `75.00
3.9.4 Night shift allowance
In some cases, workers get extra payment if they work at night. Since the extra payment
is not for any particular job, therefore such a payment should be treated as part of
overheads.
3.9.5 Absorption rates of Employee cost
Employee cost as stated above include monetary compensation and non-monetary
benefits to workers.
Monetary benefits include, basic wages, D.A., overtime pay, incentive or production
bonus contribution to employee provident fund, House Rent Allowance, Holiday and
vacation pay etc.
The non-monetary benefits include medical facilities, subsidized canteen services,
subsidized housing, education and training facilities.
Accounting of monetary and non-monetary benefits to indirect workers does not pose
any problems because the total of monetary and non-monetary benefits are treated
as overheadand absorbed on the basis of rate per direct employee hour, if overheads
are predominantly employee oriented.
For direct workers, the ideal method is to charge jobs or units produced by supplying
per hour rate calculated as below:

Total estimated monetary benefits and cost of nonmonetary benefits

Rate per hour =
Budgeted direct employee hour-Normal idle time

Another alternative method isto treat the monetary benefits other than basic wages
and dearness allowance as well as cost of non-monetary benefits as overheads.

3.10 EFFICIENCY RATING PROCEDURES

Efficiency is usually related with performance and may be computed by comparing the
time taken with the standard time allotted to perform the given job/task.
If the time taken by a worker on a job equals or less than the standard time, then he
is rated efficient.

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3.46 COST AND MANAGEMENT ACCOUNTING

In case he takes more time than the standard time he is rated as inefficient.

Time allowed as per standard

Efficiency in % = ×100
Time Taken

For efficiency rating of employees the following procedures may be followed:

1. Determining standard time/performance standards : The first step is to
determine the standard time taken by a worker for performing a particular job/
task. The standard time can be determined by using Time & Motion study or
Work study techniques. While determining the standard time for a job/task a
heterogeneous group of workers is taken and contingency allowances are added
for determining standard time.
2. Measuring Actual Performance of workers : For computing efficiency rating
it is necessary to develop a procedure for recording the actual performance of
workers. The system developed should record the output of each worker along
with the time taken by him.
3. Computation of efficiency rating : The efficiency rating of each worker can be
computed by using the above mentioned Formula.
3.10.1 Need for efficiency rating
1. As discussed earlier when a firm follows a system of payment by results, the
payment has a direct relationship with the output given by a worker. The firm
for making payment to worker is required to ascertain his efficiency level. For
instance, under Taylor’s differential piece work system the lower rate i.e. 83% of
piece rate is given to a worker when his efficiency rating is less than 100% and
higher rate viz., 125% of piece rate is offered at efficiency level of either 100% or
more. Similarly, under Emersion efficiency plans bonus is paid at rising scale at
various level of efficiency, ranging from 66.67% to 150%.
2. The efficiency rating also helps the management in preparing employee
requirement budget or for preparing manpower requirements.
Example : P Ltd. manufactures two products by using one grade of employees.
The following estimates are available:
Product- A Product- B
Budgeted production (units) 3,480 4,000
Standard hours allowed per product 5 4
It is further worked out that the efficiency rating (efficiency ratio) for productive
hours worked by direct workers in actually manufacturing the production is 80%
then the exact standard employee-hours requirement can be worked out as
follows:

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EMPLOYEE COST AND DIRECT EXPENSES 3.47

Product- A Product- B Total

Budgeted production 3,480 4,000
(units)
Standard hours 17,400 16,000 33,400
allowed for budgeted (3,480 units × 5 hours) (4,000 units × 4 hours)
production
Since efficiency ratio is given as 80% therefore standard employee hours required
 100 
for 100% efficiency level is  33,400 hours ×  = 41,750 hours.
 80 

Employee Productivity : Productivity is generally determined by the input/output

ratio. In case of employees, it is calculated as below :

Standard time for doing actual work

Actual time taken

Employee productivity is used for measuring the efficiency of individual workers. It is

an index of efficiency in the utilisation of human resources, materials, capital, power
and all kinds of services and facilities.
It is measured by the output in relation to input. Productivity can be improved by
reducing the input for a certain quantity or value of output or by increasing the output
from the same given quantity or value of input.
Factors for increasing Employee productivity : The important factors which must be
taken into consideration for increasing employee productivity are as follows:
1. Employing only those workers who possess the right type of skill.
2. Placing a right type of person to a right job.
3. Training young and old workers by providing them the right types of opportunities.
4. Taking appropriate measures to avoid the situation of excess or shortage of
employees.
5. Carrying out work study for fixation of wages and for the simplification and
standardisation of work.

3.11 EMPLOYEE (LABOUR) TURNOVER

3.11.1 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.

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The standard of usual employee turnover in the industry or locality or the employee
turnover rate for a past period may be taken as the index or norm against which actual
turnover rate is compared.
There are three methods of calculating Employee turnover which are given below:
(i) Replacement Method : This method takes into consideration actual replacement
of employees irrespective of number of persons leaving the organisation. Employee
Turnover under this method is calculated as under:

Number of employees Replaced during the period

×100
Average number of employees during the period on roll

New employees appointed on account of expansion plan of the organisation are

not included in number of replacements.
(ii) Separation Method : In this method employee turnover is measured by dividing
the total number of employees separated during the period by the average total
number of employees on payroll during the same period. Employee Turnover
under this method is calculated as under:

Number of employees Separated during the period

×100
Average number of employees during the period on roll

(iii) Flux Method : This method takes both the number of replacements as well as the
number of separations during the period into account for calculation of employee
turnover. Employee Turnover under this method is calculated as under:

Number of employees Separated +

Number of employees Replaced during the period
×100
Average number of employees during the period on roll

Employee turnover due to new recruitment : Generally, employees recruited on

account of expansion of an organisation, are not considered for calculation of employee
turnover. But it is considered that the newly recruited employees are also responsible
for changes in the composition or work force. Due to this feature, some management
accountants feel to take new recruitment for calculating employee turnover.
The total number of workers joining, including replacements, is called accessions.
When number of accessions are considered for measuring employee turnover, the
employee turnover rate by Flux method may be computed by using any one of the
following expressions:

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EMPLOYEE COST AND DIRECT EXPENSES 3.49

No.of Separation+No.ofReplacements+No.of new Joinings

×100
Averageno.of employeesduring the periodonroll

Or
No.of Separations+No.of Accessions
×100
Averageno.of employees during the periodonroll

Average number of employees during the period is calculated as follows:

No.of employeesatbegining +No.of employeesatendof theperiod
=
2

Equivalent Employee (Labour) Turnover rate :

If in the above computations, the data given is for a period other than a year, the
employee turnover rate so computed may be converted into equivalent annual
employee turnover rate by using the following formula:

Employee Turnoverratefor theperiod

×365
Number of days in the period

ILLUSTRATION 23
The Accountant of Y Ltd. has computed employee turnover rates for the quarter ended
31st March, 20X1 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 outthe number of workers for the quarter
(i) recruited and joined and (ii) left and discharged and (iii) Equivalent employee turnover
rates for the year.
SOLUTION
Working Note :
Average number of workers on roll (for the quarter):
Employee Turnover rate using Replacement method
No. of replacements
= ×100
Average number of workers on roll

5 30
Or, =
100 Average number of workers on roll

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3.50 COST AND MANAGEMENT ACCOUNTING

30×100
Or, Average number of workers on roll = = 600
5
(i) Number of workers recruited and joined :
Employee turnover rate (Flux method)
No. of Separations * (S)+No. of Accessions(A)
=
Average number of workers on roll
10 18 *+A  6000 
Or, = Or, A =  – 18 = 42
100 600  100 
No. of workers recruited and joined 42.
(ii) Number of workers left and discharged:
Employee turnover rate (Separation method)

No. of Separations(S) 3 S
= × 100 = = Or, S* =18
Average number of workers on roll 10 600

Hence, number of workers left and discharged comes to 18

(iii) Calculation of Equivalent employee turnover rates:
Employee Turnover rate for the quater (s)
= × 4 quarters
Number of quarter (s)
10%
Using Flux method = × 4 = 40%
1

5%
Using Replacement method = × 4 = 20%
1
3%
Using Separation method = × 4 = 12%
1
3.11.2 Causes of Employee (Labour) Turnover
The reasons for employee turnover in an organisationcan be classified under the
following three heads:
(a) Personal Causes;
(b) Unavoidable Causes; and
(c) Avoidable Causes.
(a) Personal causes : All the personal reasons which induce or compel an employee to
leave his job; such causes include the following:
(i) Change of jobs for betterment.
(ii) Premature retirement due to ill health or old age.
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EMPLOYEE COST AND DIRECT EXPENSES 3.51

(iii) Domestic problems and family responsibilities.

(iv) Discontent over the jobs and working environment.
In all the above cases the employee leaves the organisation at his will and, therefore, it
is difficult to suggest any possible remedy in the first three cases.
But the last one can be overcome by creating conditions leading to a healthy working
environment. For this, officers should play a positive role and make sure that their
subordinates work under healthy working conditions.
(b) Unavoidable Causes : Unavoidablecauses are those under which it becomes
obligatory on the part of management to ask one or more of their employees to leave
the organisation; such causes are summed up as listed below:
(i) Seasonal nature of the business;
(ii) Shortage of raw material, power, slack market for the product etc.;
(iii) Change in the plant location;
(iv) Disability, making a worker unfit for work;
(v) Disciplinary measures;
(vi) Marriage (generally in the case of women).
(c) Avoidable Causes : Avoidablecauses are those which require the attention of
management on a continuous basis so as to keep employee turnover ratio as low as
possible. The main causes under this case are indicated below:
(1) Dissatisfaction with job, remuneration, hours of work, working conditions, etc.,
(2) Strained relationship with management, supervisors or fellow workers;
(3) Lack of training facilities and promotional avenues;
(4) Lack of recreational and medical facilities;
(5) Low wages and allowances.
Proper and timely management action can reduce the employee turn¬over appreciably
so far as avoidable causes are concerned.
3.11.3 Effects of Employee (Labour) Turnover
High employee turnover increases the cost of production in the following ways:
(i) Even flow of production is disturbed;
(ii) Efficiency of new workers is low; productivity of new but experienced workers is
low in the beginning;
(iii) There is increased cost of training and induction;
(iv) New workers cause increased breakage of tools, wastage of materials, etc.
(v) Cost of recruitment and training increases.

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3.52 COST AND MANAGEMENT ACCOUNTING

Cost of Employees (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. Cost incurred for prevention of employee turnover includes the
following:
(i) Cost of medical benefit provided to the employees;
(ii) Cost incurred on employees’ welfare like pension etc.
(iii) Cost on other benefits with an objective to retain employees.
(b) Replacement Costs : These are the costs which arise due toemployee turnover. If
employees leave soon after they acquire the necessary training and experience of good
work, additional costs will have to be incurred on new workers,i.e., cost of recruitment,
training and induction, abnormal breakage and scrap and extra wages and overheads
due to the inefficiency of new workers.
It is obvious that a company will incur very high replacement costs if the rate of employee
turnover is high. Similarly, only adequate preventive costs can keep Employee turnover
at a low level. Each company must, therefore, work out the optimum level of Employee
turnover keeping in view its personnel policies and the behaviour of replacement cost
and preventive costs at various levels of Employee turnover rates.
ILLUSTRATION 24
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. As a result of the
delays by the Personnel Department in filling vacancies due to employee turnover,
1,00,000 potentially productive hours were lost. The actual direct employee hours
included 30,000 hours attributable to train¬ing new recruits, out of which half of the
hours were unproductive.
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.

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EMPLOYEE COST AND DIRECT EXPENSES 3.53

SOLUTION
Workings :
Computation of productive hours and contribution foregone
Actual hours worked (given) 4,45,000
Less: Unproductive training hours 15,000
Actual productive hours 4,30,000
The potentially productive hours lost are 1,00,000

` 83, 03,300
Sales lost for 1,00,000 hours= 4,30,000 hours × 1,00,000 hours = `19,31,000

` 19, 31,000
Contribution lost for 1,00,000 hours = × 20 = `3,86,200
100
Computation of profit forgone on account of employee turnover
(`)
Contribution foregone (as calculated above) 3,86,200
Settlement cost due to leaving 43,820
Recruitment cost 26,740
Selection cost 12,750
Training costs 30,490
Profit foregone 5,00,000

3.12 DIRECT EXPENSES

3.12.1 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:
(i) Royalty paid/ payable for production or provision of service;
(ii) Hire charges paid for hiring specific equipment;
(iii) Cost for product/ service specific design or drawing;
(iv) Cost of product/ service specific software;
(v) Other expenses which are directly related with the production of goods or
provision of service.
The above list of expenses is not exhaustive, any other expenses which are directly
attributable to the production or service are also included as direct expenses.
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3.54 COST AND MANAGEMENT ACCOUNTING

3.12.2 Measurement of Direct Expenses

The direct expenses are measured at invoice or agreed price net of rebate or discount
but includes duties and taxes (for which input credit not available), commission and
other directly attributable costs.
In case of sub-contracting, where goods are get manufactured by job workers
independent of the principal entity, are measured at agreed price. Where the principal
supplies some materials to the job workers, the value of such materials and other
incidental expenses are added with the job charges paid to the job workers.
3.12.3 Treatment of Direct Expenses
Direct Expenses forms part the prime cost for the product or service to which it can be
directly traceable and attributable. In case of lump-sum payment or one-time payment,
the cost is amortisedover the estimated production volume or benefit derived.
If the expenses incurred are of insignificant amount i.e. not material, it can be treated
as part of overheads.

SUMMARY
Employee Cost : Benefits paid or payable to the employees of an entity, whether
permanent or temporary for the services rendered by them. Employee cost includes
payments made in cash or kind.
Direct Employee (Labour) Cost : Benefits paid or payable to the employees which can
be attributed to a cost object in an economically feasible manner.
Indirect Employee (Labour) Cost : Benefits paid or payable to the employees, which
cannot be directly attributable to a particular cost object in an economically feasible
manner.
Idle Time : The time for which the employer pays but obtains no direct benefit or for
no productive purpose.
Normal Idle Time : Time which cannot be avoided or reduced in the normal course
of business. The cost of normal idle time should be charged to the cost of production.
Abnormal Idle Time : It arises on account of abnormal causes and should be charged
to Costing Profit and Loss account.
Time Keeping : It refers to recording and keeping of the employees’ attendance time.
Time Booking : It is basically recording the details of work done and the time spent
by an employee on each job or process.
Overtime : Payment to employees, when an employee works beyond the normal
working hours. Usually overtime has to be paid at double the rate of normal hours.
Overtime Premium : It’s the amount of extra payment paid to an employee for extra
work.
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EMPLOYEE COST AND DIRECT EXPENSES 3.55

Employee (Labour) Turnover: It is the rate of change in employee force during a

specified period due to resignation, retirement and retrenchment. If the employee
turnover is high, it’s a sign of instability and may affect the profitability of the firm.
Employee (Labour) turnover can be measured through the following methods :
(i) Replacement Method :
Number of employees replaced
×100
Average number of employees on roll

(ii) Separation Method:

Number of employees separated during the year
×100
Average number of employees on rolls during the period
(iii) Flux Method:
Number of employees separated + number of employees replaced
×100
Average number of employees on rolls during the period
(iv) Employee turnover due to new recruitment :
No. of new employees joining in a period (excluding replacements)
× 100
Average number of employees on the roll in a period
(v) Employee turnover including accessions :
No. of new employees joining in a period (excluding replacements)
× 100
Average number of employees on the roll in a period
OR
No. of separations + No. of accessions
× 100
Average number of employees

Time Rate System : The system of wage payment where wages to an employee is paid
on the basis of time irrespective of production volume.
Differential Time Rate : Under this system of wage payment different hourly rates are
fixed for different levels of efficiency. Upto a certain level a fixed rate is paid and based
on the efficiency level the hourly rate increases gradually.
Straight Piece Work : The system of wage payment where wages is paid on the basis
of number of units produced irrespective of time spent for production. Calculation
takes number of units produced by the employee multiplied by rate per unit.
Differential Piece Rate : For different level of output below and above the standard,
different piece rates are applicable.

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3.56 COST AND MANAGEMENT ACCOUNTING

(i) Taylor’s Differentials Piece Work system :

Output/ Efficiency Rate
< 100% 83% of normal rate
100% 125% of normal rate or 150% of lower rate
(ii) Merrick Differential Piece Work System:
Efficiency Piece rate applicable
Upto 83% Normal rate,
Above 83% and upto 100% 10% above normal rate.
Above 100% 20% or 30% above normal rate.
Gantt Task and bonus system
Output Payment
Output below standard guaranteed time rate.
Output at standard Time rate plus bonus of 20% (usually) of time
rate.
Output above standard High piece rate on employee’s whole output.
It is so fixed, so as to include a bonus of 20% of the time rate
Emerson’s Efficiency system :
Efficiency Payment
<66.67% Hourly Rate
66.67%-100% Bonus varies from 1% to 20%
100% Bonus of 20% of basic + 1% of every 1% increase
in efficiency.
Halsey System : Time taken × Time rate + 50% of time saved × Time rate.
Time Saved
Rowan System : Time taken × Rate per hour + × Time taken × Rate
per hour Time allowed

Barth System : Earnings = Hourly rate × Stadndard hours × Hours worked

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Idle time is the time under which
(a) Full wages are paid to workers
(b) No productivity is given by the workers
(c) Both (a) and (b)
(d) None of the above
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EMPLOYEE COST AND DIRECT EXPENSES 3.57

2. Cost of idle time due to non- availability of raw material is

(a) Charged to overhead costs
(b) Charged to respective jobs
(c) Charged to costing profit and loss account
(d) None of the above
3. Time and motion study is conducted by
(a) Time keeping department
(b) Personal department
(c) Payroll department
(d) Engineering department
4. Identify, which one of the following, does not account for increasing labour
productivity
(a) Job satisfaction
(b) Motivating workers
(c) High labour turnover
(d) Proper supervision and control
5. Labour turnover is measured by
(a) Number of persons replaced/ average number of workers
(b) Numbers of persons separated / number of workers at the beginning of the
year
(c) (Number of persons replaced + number of persons separated)/(number of
persons at the beginning +the number of persons at the end of the year)
(d) None of the above
6. Labour productivity is measured by comparing
(a) Actual time and standard time
(b) Total out put with total man-hours
(c) Added value for the product with total wage cost
(d) All of the above
7. Under Taylor’s differential piece rate scheme, if a worker failed to complete the
task within the standard time, then he was paid
(a) 67% of the piece work rate
(b) 125% of the piece work rate
(c) 83% of the piece work rate
(d) 175% of the piece work rate
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3.58 COST AND MANAGEMENT ACCOUNTING

8. If the time saved is less than 50% of the standard time, then the wages under
Rowan and Halsey premium plan on comparison gives
(a) More wages to workers under Rowan plan than Halsey plan
(b) More wages to workers under Halsey plan than Rowan plan
(c) Equal wages under two plans
(d) None of the above
9. Standard time of a job is 60 hours and guaranteed time rate is `0.30 per hour.
What is the amount of wages under Rowan plan if job is completed in 48 hours?
(a) ` 16.20
(b) ` 17.28
(c) ` 18.00
(d) ` 14.40
10. Under Merrick multiple piece rate scheme, if the efficiency of a worker is more
than 83% but up to 100%, then the applicable piece rate is
(a) Ordinary piece rate
(b) 105% of ordinary piece rate
(c) 110% of Ordinary piece rate
(d) 120% of Ordinary piece rate
Theoretical Questions
1. Discuss the Gantt task and bonus system as a system of wage payment and
incentives.
2. Discuss the accounting treatment of Idle time and overtime wages.
3. Discuss the effect of overtime payment on productivity.
4. State the circumstances in which time rate system of wage payment can be
preferred in a factory.
5. Discuss the objectives of time keeping & time booking.
6. Discuss the two types of cost associated with labour turnover.
7. Describe briefly, how wages may be calculated under the following systems:
(i) Gantt task and bonus system
(ii) Emerson’s efficiency system
(iii) Rowan system
(iv) Halsey system
(v) Barth system

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EMPLOYEE COST AND DIRECT EXPENSES 3.59

Practical Questions
1. Mr. A. is working by employing 10 skilled workers. He is consider¬ing the
introduction of some incentive scheme - either Halsey Scheme (with 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:
Hourly rate of wages (guaranteed) `40
Average time for producing 1 piece by one worker at the
previous performance (This may be taken as time allowed) 2 hours
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.
2. Wage negotiations are going on with the recognised employees’ union, and the
management wants you as the as an executive of the company to formulate an
incentive scheme with a view to increase productivity.
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.
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 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.
3. During audit of account of the G Ltd., your assistant found errors in the calculation
of the wages of factory workers and he wants you to verify his work.
He has extracted the following information:

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3.60 COST AND MANAGEMENT ACCOUNTING

(i) The contract provides that the minimum wage for a worker is his base rate.
It is also paid for downtimes i.e.; the machine is under repair or the worker is
without work. The standard work week is 40 hours. For overtime production,
workers are paid 150 percent of base rates.
(ii) Straight Piece Work – The worker is paid at the rate of `20 per piece.
(iii) Percentage Bonus Plan – Standard quantities of production per hour are
established by the engineering department. The workers’ average hourly
production, determined from his total hours worked and his production, is
divided by the standard quantity of production to determine his efficiency
ratio. The efficiency ratio is then applied to his base rate to determine his
hourly earnings for the period.
(iv) Emerson Efficiency Plan – A minimum wages is paid for production upto 66-
2/3% of standard output or efficiency. When the workers production exceeds
66-2/3% of the standard output, he is paid bonus as per the following table:
Efficiency Level Bonus
Upto 662/3 % Nil
662/3 % to 79 % 10%
80% – 99% 20%
100% – 125% 45%
Your assistant has produced the following schedule pertaining to certain workers
of a weekly pay roll:
Worker Wages Total Down- Units Standard Base Gross
incentive hours time produced units rate wages
plan hours as per
book
Rajesh Straight 40 5 400 - 180 8,500
piece work
Mohan* S t r a i g h t 46 - 455 - 180 9,500
piece work
John Straight 44 - 425 - 180 8,500
piece work
Harish Percentage 40 4 250 200 220 12,000
bonus plan
Mahesh Emerson’s 40 - 240 300 210 9,300
Anil Emerson’s 40 - 600 500 200 12,600
* Total hours of Mohan include 6 overtime hours.
Prepare a schedule showing whether the above computation of workers’ wages is
correct or not. Give details.
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EMPLOYEE COST AND DIRECT EXPENSES 3.61

ANSWERS/ SOLUTIONS
Answers to the MCQs based Questions
1. (c) 2. (b) 3. (d) 4. (c) 5. (d) 6. (d)
7. (c) 8. (a) 9. (b) 10. (c)
Answers to Theoretical Questions
1. Please refer paragraph 3.8.3
2. Please refer paragraph 3.5 & 3.6
3. Please refer paragraph 3.6
4. Please refer paragraph 3.8.1
5. Please refer paragraph 3.4
6. Please refer paragraph 3.11
7. Please refer paragraph 3.8
Answers to the Practical Questions
1. Working Notes :
1. Total time wages of 10 workers per month:
= No. of working days in the month × No. of working hours per day of each
worker × Hourly rate of wages × No. of workers
= 25 days × 8 hrs. × `40 × 10 workers = `80,000
2. Time saved per month:
Time allowed per piece to a worker 2 hours
No. of units produced during the month by 10 workers 1,250 pieces
Total time allowed to produce 1,250 pieces (1,250 × 2 hours) 2,500 hours
Actual time taken to produce 1,250 pieces 2,000 hours
Time saved (2,500 hours – 2,000 hours) 500 hours
3. Bonus under Halsey scheme to be paid to 10 workers:
Bonus = (50% of time saved) × hourly rate of wages
= 50/100 × 500 hours × `40 = `10,000
Total wages to be paid to 10 workers are (`80,000 + `10,000) `90,000, if Mr.
A considers the introduction of Halsey Incentive Scheme to increase the
employee productivity.
4. Bonus under Rowan Scheme to be paid to 10 workers:
Time taken
Bonus = × Time saved × hourly rate
Time allowed

2,000 hours
= × 500 hours × ` 40= `16,000
2,500 hours
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3.62 COST AND MANAGEMENT ACCOUNTING

Total wages to be paid to 10 workers are (`80,000 + `16,000) `96,000, if Mr.

A considers the introduction of Rowan Incentive Scheme to increase the
Employee productivity.
(i). (a) Effective hourly rate of earnings under Halsey scheme :
(Refer to Working Notes 1, 2 and 3)
= Total time wages of 10 workers + Total bonus under Halsey scheme
Total hours worked
` 80,000 + ` 10,000
= = `45
2,000 hours

(b) Effective hourly rate of earnings under Rowan scheme:

(Refer to Working Notes 1, 2 and 4)
Total time wages of 10 workers + Total bonus under Rowan scheme
=
Total hours worked

` 80,000 + ` 16,000
= = `48
2,000 hours

(ii). (a) Saving in terms of direct Employee cost per piece under Halsey
scheme:
(Refer to Working Note 3)
Employee cost per piece (under time wage scheme) = 2 hours × `40 = `80.
Employee cost per piece (under Halsey scheme)
Total wages paid under the scheme ` 90,000
= = = `72
Total number of units produced 1,250

Saving per piece: (`80 – `72) = `8

(b) Saving in terms of direct Employee cost per piece under Rowan
Scheme:
(Refer to Working Note 4)
Employee cost per piece under Rowan scheme = `96,000/1,250 units =
`76.80
Saving per piece = `80 – `76.80 = `3.20

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EMPLOYEE COST AND DIRECT EXPENSES 3.63

2. Calculation of earningsunder different wage schemes:

(i) Day wages
Worker Day wages (`) Actual Output Labour cost
(Units) per 100 pieces
(`)
A 600 180 333.33
B 600 120 500.00
C 600 100 600.00
Total 1,800 400
Average labour cost to produce 100 pieces:
Total wages paid ` 1,800
= × 100 = = `450
Total output 400 units
(ii) Piece rate
Worker Actual Output Piece rate Wages Labour cost per
(Units) (`) earned (`) 100 pieces (`)
A 180 7.50 1,350 750.00
B 120 7.50 900 750.00
C 100 7.50 750 750.00
Total 400 3,000
Average cost of labour for the company to produce 100 pieces:
` 3,000
= = `750
400 units

(iv) Halsey Scheme

Worker Actual Std. Actual Time Bonus Rate Total Labour
Output time time saved hours per wages cost
(Units) (Hrs.) (Hrs.) (Hrs.) (50% hour (`) per 100
of (`) pieces
time (`)
saved)
A B C D= E F G = F H = G/A*
B-C × (C + 100
D)
A 180 18 8 10 5 75 975 541.67
B 120 12 8 4 2 75 750 625.00
C 100 10 8 2 1 75 675 675.00
Total 400 2,400
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3.64 COST AND MANAGEMENT ACCOUNTING

` 2, 400
Average cost of labour for the company to produce 100 pieces = × 100
= `600 400 units
(v) Rowan Scheme :
Worker Actual Std. Actual Time Bonus Rate Total Labour
Output time time saved hours* per wages cost
(Units) (Hrs.) (Hrs.) (Hrs.) hour including per 100
(`) bonus (`) pieces (`)

A B C D= E F G=F× H=G/
B-C (C + D) A* 100
A 180 18 8 10 4.44 75 933 518.33
B 120 12 8 4 2.67 75 800 666.67
C 100 10 8 2 1.60 75 720 720.00
Total 400 2,453
Time Saved
* Bonus hours = Std. Time ×Actual time
` 2, 453
Average cost of labour for the company to produce 100 pieces = × 100
= `613.25 400 units

3.
Schedule showing the correct figure of
minimum wages, gross wages and wages to be paid
Worker Wages Working Minimum Gross Gross Wages to
incentive note wages (`) wages wages as be paid.
plan as per book (`) (`)
plan (`)
A B C D = min.
of B & C
Rajesh Straight piece 1 7,200 8,000 8,500 8,000
work
Mohan* Straight piece 2 8,820 9,100 9,500 9,100
work
John Straight piece 3 8,280 8,500 8,500 8,500
work
Harish Pe r c e n t a g e 4 8,800 12,200 12,000 12,200
bonus plan
Mahesh Emerson’s 5 8,400 10,080 9,300 10,080
Anil Emerson’s 6 8,000 11,600 12,600 11,600
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EMPLOYEE COST AND DIRECT EXPENSES 3.65

Working notes :
1. Minimum wages = Total normal hours × rate per hour
= 40 hours × `180 = `7,200
Gross wages (computed) = No. of units × rate per unit
as per incentive plan = 400 units × `20 = `8,000
2. Minimum wages = Total normal hours × Rate per hour + Overtime
hours × Overtime rate per hour
= 40 hours × `180 + 6 hours × `270
= `7,200 + `1,620 = `8,820
Gross wages (computed) = 455 units × `20 = `9,100
as per incentive plan
3. Minimum wages = 40 hours × `180 + 4 hours × `270
= `7,200 + `1,080 = `8,280
Gross wages (computed) = 425 units × `20 = `8,500
as per incentive plan
4. Minimum wages = 40 hours × ` 220 = `8,800
Actual production per hour
Efficiency of worker = × 100
Standard production per hour

(250 units/36 hours)

= × 100 = 138.89%
(200 units/40 hours)

Hourly rate = Rate per hour × Efficiency of worker

= `220 × 138.89% = `305
Gross wages (computed)
as percentage of bonus plan = 40 hours × `305 = `12,200
5. Minimum wages = 40 hours × `210 = `8,400
(240 units/40 hours)
Efficiency of worker = × 100 = 80%
(300 units/40 hours)

Bonus (as per Emerson’s plan) = Total minimum wages × Bonus percentage
= `8,400 × 20% = `1,680
Gross wages (computed) as per
Emerson’s Efficiency plan = Minimum wages + Bonus
= `8,400 + `1,680 = `10,080

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3.66 COST AND MANAGEMENT ACCOUNTING

6. Minimum wages = 40 hours × `200 = `8,000

600
Efficiency of worker = × 100 = 120%
500

Bonus (as per Emerson’s plan) = `8,000 × 45% = `3,600

Gross wages (computed) as per
Emerson’s Efficiency plan = `8,000 + `3,600 = `11,600

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CHAPTER 4
OVERHEADS-ABSORPTION
COSTING METHOD

LEARNING OUTCOMES
r Discuss the meaning of Overheads- Production, Administrative
and Selling & Distribution.
r Discuss the meaning and methods of allocation, apportionment
and absorption of overheads.
r Discuss the meaning and treatment of under-absorption and
over-absorption of overheads and apply the same in cost
computation.
r State the accounting and control of administrative, selling
and distribution overheads.
r Discuss and apply the various methods to calculate overhead
rate.

CHAPTER OVERVIEW

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4.2 COST AND MANAGEMENT ACCOUNTING

4.1 INTRODUCTION
Overheads are the expenditure which cannot be conveniently traced to or identified
with any particular cost unit. Such expenses are incurred for output generally and not
for a particular work order e.g., wages paid to watch and ward staff, heating and lighting
expenses of factory etc. Overheads are also very important cost element alongwith
direct materials and direct employees. Often in a manufacturing concern, overheads
exceed direct wages or direct materials and at times even both put together. On this
account, it would be a grave mistake to ignore overheads either for the purpose of
arriving at the cost of a job or a product or for controlling total expenditure.
Overheads also represent expenses that have been incurred in providing certain
ancillary facilities or services which facilitate or make possible the carrying out of the
production process; by themselves these services are not of any use. For instance, a
boiler house produces steam so that machines may run and, without the generation
of steam, production would be seriously hampered. But if machines do not run or do
not require steam, the boiler house would be useless and the expenses incurred would
be a waste.
Overheads are incurred not only in the factory of production but also on administration,
selling and distribution.

4.2 CLASSIFICATION OF OVERHEADS

Description Example
By Function
Factory or Manufactur- Manufacturing overhead is (i) Stock keeping
ing or Production Over- the indirect cost incurred expenses, (ii) Repairs and
head for manufacturing or maintenance of plant, (iii)
production activity in a Depreciation of factory
factory. Manufacturing building, (iv) Indirect
overhead includes all labour, (v) cost of primary
expenditures incurred packing (vi) Insurance
from the procurement of of plant and machinery
materials to the completion etc. Production overhead
of finished product. include administration
costs relating to
production, factory, works
or manufacturing.

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OVERHEADS-ABSORPTION COSTING METHOD 4.3

Office and Administrative Office and Administrative (i) Salary paid to office
Overheads overheads are staffs, (ii) Repairs and
expenditures incurred maintenance of office
on all activities relating building, (iii) Depreciation
to general management of office building (iv)
and administration postage and stationery,
of an organisation. It (v) Lease rental in case of
includes formulating operating lease (in case of
the policy, directing finance lease lease rental
the organisation and excluding finance cost)
controlling the operations (vi) accounts and audit
of an undertaking which expenses etc.
is not related directly
to production, selling,
distribution, research or
development activity or
function.
Selling and Distribution (i) Selling overhead: (i) Salesmen commission,
Overheads expenses related to sale (ii) Advertisement cost, (iii)
of products and include Sales office expenses etc.
all indirect expenses in
sales management for the
organisation. (i) Delivery van expenses,
(ii) Distribution overhead: (ii) Transit insurance,
cost incurred on making (iii) warehouse and
product available for sale cold storage expenses,
in the market. (iv) secondary packing
expenses etc.
By Nature
Fixed Overhead These are the costs which (i) Salary paid to permanent
are incurred for a period, employees,
and which, within certain
(ii) Depreciation of building
output and turnover limits,
and plant and equipment,
tend to be unaffected
(iii) Interest on capital, (iv)
by fluctuations in the
Insurance
levels of activity (output
or turnover). They do
not tend to increase or
decrease with the changes
in output.

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4.4 COST AND MANAGEMENT ACCOUNTING

Variable Overhead These costs tend to vary (i) Indirect materials,

with the volume of activity. (ii) Power and fuel, (iii)
Any increase in the activity lubricants, (iv) tools and
results in an increase in spares etc.
the variable cost and vice-
versa.
Semi-Variable Overheads These costs contain (i) Electricity cost, (ii) water
both fixed and variable cost, (iii) telephone and
components and are internet expenses etc.
thus partly affected by
fluctuations in the level of
activity.
By Element
Indirect materials Materials which do not (i)Stores used for
normally form part of the maintaining machines
finished product (cost and buildings (lubricants,
object) are known as cotton waste, bricks etc.)
indirect materials.
(ii) Stores used by service
departments like power
house, boiler house,
canteen etc.
Indirect employee cost Employee costs which (i) Salary paid to foreman
cannot be allocated but and supervisor
can be apportioned to or
(ii) Salary paid to
absorbed by cost units or
administration staff etc.
cost centres is known as
indirect employee.
Indirect expenses Expenses other than (i) Rates & taxes, (ii)
direct expenses are known insurance, (iii) depreciation,
as indirect expenses, (iv) advertisement
that cannot be directly, expenses etc.
conveniently and wholly
allocated to cost centres.
By Control
Controllable costs These are those costs (i) Materials cost, (ii) wages
which can be controlled and salary, (iii) power and
by the implementation of fuel etc.
appropriate managerial
influence and proper
policies.
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OVERHEADS-ABSORPTION COSTING METHOD 4.5

Uncontrollable costs Overhead costs which (i) Rates and taxes, (ii)
cannot be controlled by Depreciation, (iii) Interest
the management even on borrowings
after the implementation
of appropriate managerial
influence and proper
polices are known as
uncontrollable costs.
4.2.1 Advantages of Classification of Overheads into Fixed and Variable
The primary objective of segregating semi-variable expenses into fixed and variable is
to ascertain marginal costs. Besides this, it has the following advantages also.
(a) Controlling Expenses : The classification of expenses into fixed and variable
components helps in controlling expenses. Fixed costs are generally policy costs,
which cannot be easily reduced. They are incurred irrespective of the output and
hence are more or less non controllable. Variable expenses vary with the volume
of activity and the responsibility for incurring such expenditure is determined in
relation to the output. The management can control these costs by giving proper
allowances in accordance with the output achieved.
(b) Preparation of Budget Estimates : The segregation of overheads into fixed and
variable part helps in the preparation of flexible budget. It enables a firm to es-
timate costs at different levels of activity and make comparison with the actual
expenses incurred.
Suppose in October, 20X1 the output of a factory was 1,000 units and the expens-
es were:
(`)
Fixed 5,00,000
Variable 4,00,000
Semi-variable (40% fixed) 6,00,000
15,00,000
In November, 20X1 the output was likely to increase to 1,200 units. In that case the
budget or estimate of expenses will be:
(`)
Fixed 5,00,000
æ ` 4,00,000× 1,200 unitsö÷
Variable ççç ÷ 4,80,000
è 1,000 units ø÷
Semi-variable
Fixed, 40% of ` 6,00,000 2,40,000

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4.6 COST AND MANAGEMENT ACCOUNTING

 `3,60,000 × 1,200 units 

Variable :   4,32,000
 1,000 units 
16,52,000
It would be a mistake to think that with the output going up from 1,000 units to
1,200 units the expenses would increase proportionately to `18,00,000. This would
be wrong budgeting.
(c) Decision Making : The segregation of semi variable cost between fixed and var-
iable overhead also helps the management to take many important decisions.
For example, decisions regarding the price to be charged during depression or
recession or for export market. Likewise, decisions on make or buy, shut down or
continue, etc., are also taken after separating fixed costs from variable costs.
In fact, when any change is contemplated, say, increase or decrease in production,
change in the process of manufacture or distribution, it is necessary to know the total
effect on cost (or revenue) and that would be impossible without a correct segregation
of fixed and variable costs. The technique of marginal costing, cost volume profit
relationship and break-even analysis are all based on such segregation.

4.3 ACCOUNTING AND CONTROL OF MANUFAC-

TURING OVERHEADS
We have already seen that overheads are by nature those costs which cannot be directly
related to a product or to any other cost unit. Yet for working out the total cost of a
product or a unit of service, the overheads must be included. Thus we have to find out
a way by which the overheads can be distributed over the various units of production.
One method of working out the distribution of overheads over the various products
could be to ascertain the amount of actual overheads and distribute them over the
products. This however, creates a problem since the actual amount of overheads can
be known only after the financial accounts are closed. If we wait that long, the cost
sheets lose their main advantages and utility to the management. All the decisions for
which cost sheets are prepared are immediate decisions and cannot be postponed till
the actual overheads are known. Therefore, some method has to be found by which
overheads can be included in the cost of the products, as soon as prime cost, the cost
of raw materials, direct employees and other direct expenses, is ascertained.
One method is to work out pre-determined rates for absorbing overheads. These
rates are worked out before an accounting period begins by estimating the amount of
overheads and the level of activity in the ensuing period. Thus, as soon as the prime
cost of a product or a job is available, the various overheads are charged by these
rates. Of course, this implies that the over-heads are charged on an estimated basis.
Later, when the actual overheads are known, the difference between the overheads
charged to the products and actual overheads is worked out and adjusted.

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OVERHEADS-ABSORPTION COSTING METHOD 4.7

Manufacturing Overheads: Generally manufacturing overheads form a substantial

portion of the total overheads. It is important, that such overheads should be properly
absorbed over the cost of production. The following procedure may be adopted in this
regard. The steps given below shows how factory overhead rates are estimated and
overheads absorbed on that basis and the last one shows how actual are compared
with the absorbed amount.
(Students should carefully note the distinction between the various terms used).
1. Estimation and collection of manufacturing overheads : The first stage is to es-
timate the amount of overheads, keeping in view the past figures and adjusting them
for known future changes. The sources available for the collection of factory overheads
may include(a) Invoices, (b) Stores requisition, (c) Wage analysis book (d) Journal en-
tries. etc.
2. Assignment of Manufacturing Overheads : The guiding principle for assign-
ment of manufacturing overheads to a cost object is the traceability of the overheads
in an economically feasible manner.
Assignment of the manufacturing overhead is done on the basis of either of
the following two principles :
(i) Cause and Effect : Cause is the process or operation or activity and effect is
the incurrence of cost.
(ii) Benefit received : Manufacturing overheads are to be apportioned to
various cost objects in proportion to the benefits received by them.
(a) Cost Allocation : The term ‘allocation’ refers to the direct assignment of cost
to a cost object which can be traced directly. It implies relating overheads directly to
the various departments. The estimated amount of various items of manufacturing
overheads should be allocated to various cost centres or departments.For example- if
a separate power meter has been installed for a department, the entire power cost
ascertained from the meter is allocated to that department. The salary of the works
manager cannot be directly allocated to any one department since he looks after the
whole factory. It is, therefore, obvious that many overhead items will remain unallocat-
ed after this step.
(b) Cost Apportionment : There are some items of estimated overheads (like the
salary of the works manager) which cannot be directly allocated to the various depart-
ments and cost centres.Such unallocable expenses are to be spread over the various
departments or cost centres on the basis of two principles. This is called apportion-
ment. Thus apportionment implies “the allotment of proportions of items of cost to
cost centres or departments”. After this stage, all the overhead costs would have been
either allocated to or apportioned over the various departments.
(c) Re-apportionment : Upto the last stage all overheads are allocated and appor-
tioned to all the departments- both production and service departments. Service de-
partments are those departments which do not directly take part in the production of
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4.8 COST AND MANAGEMENT ACCOUNTING

goods or providing services. Such departments provide auxiliary services across the
entity and renders services to other cost centres and in some cases to outside parties.
Examples of such departments are engineering, quality control and assurance, labora-
tory, canteen, stores, time office, dispensary etc. The overheads of these departments
are to be sharedby the production departments since service departments operate
primarily for the purpose of providing services to production departments. The pro-
cess of assigning service department overheads to production departments is called
reassignment or re-apportionment. At this stage, all the factory overheads are collect-
ed under production departments.
3. Absorption : After completing the distribution as stated above the overheads
charged to department are to be recovered from the output produced in respective
departments. This process of recovering overheads of a department or any other cost
center from its output is called recovery or absorption.
Absorption of manufacturing overheads shall be as follows :
(i) Variable Manufacturing overheads : The variable manufacturing overheads
shall be absorbed on the basis of actual production.
(ii) Fixed Manufacturing overheads : The fixed manufacturing overhead shall
be absorbed on the basis of normal capacity.
The overhead expenses can be absorbed by estimating the overhead (as assigned
above) and then working out an absorption rate. When overheads are estimated, their
absorption is carried out by adopting a pre-determined overhead absorption rate. This
rate can be calculated by using any one method as discussed in this chapter at the end.
As the actual accounting period begins, each unit of production automatically absorbs
a certain amount of factory overheads through pre-determined rates. During the year
a certain amount will be absorbed over the various products. This is known as the total
amount of absorbed overheads.
4. Treatment of over and under absorption of overheads : After the year end
the total amount of actual factory overheads is known. There is bound to be some
difference between the actual amount of overheads and the absorbed amount of
overheads. So the overheads are generally either under-absorbed or over-absorbed.
The difference has to be adjusted keeping in view of such differences and the reasons
therefore.
Students will thus see that the whole discussion as above is meant to serve the following
two purposes :
(a) to charge various products and services with an equita¬ble portion of the total
amount of factory overheads; and
(b) to charge factory overheads immediately as the product or the job is completed
without waiting for the figures of actual factory overheads.

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OVERHEADS-ABSORPTION COSTING METHOD 4.9

4.4 STEPS FOR THE DISTRIBUTION OF

OVERHEADS
The various steps for the distribution of overheads have been discussed in detail as
below:
4.4.1 Estimation and Collection of Manufacturing Overheads
The amount of factory overheads is required to be estimated. The estimation is usually
done with reference to past data adjusted for known future changes. The overhead
expenses are usually collected through a system of standing orders.
Standing Orders : In every manufacturing business, expenses are incurred on direct
materials and direct labour in respect of several jobs or other units of production,
manufacture of which is undertaken. The incurring of these expenses is authorised by
production orders or work orders. The work order numbers are not ordinarily fixed
or permanent. They are generally allotted in a serial order according to the number
of manufacturing jobs undertaken by the business. In addition, indirect expenses are
incurred in connection with the rendering of services to the production departments,
or to the manufacturing process. The term “Standing Order” denotes sanction for
indirect expenses under various heads of expenditure.
In large factories, usually the classification of indirect expenditures is combined with
a system of Standing Orders (sometimes also referred as Service “Orders”). It is a
system under which a number is allotted to each item of expense for the purpose of
identification, and the same is continued from year to year. All the indirect expenditure
in such a case, is charged to one or the other of the Standing Orders and periodical
summaries, giving total of each Standing Order, are prepared for comparison with
budgets, as well as for apportioning them among the various departments. The extent
of such analysis and the nomenclature adopted are settled by the management
according to the needs of the industry.
4.4.2 Allocation of Overheads over various Departments or
Departmentalisation of Overheads
Most of the manufacturing processes functionally are different and are performed
by different departments in the factory. Where such a division of functions had been
made, some of the departments should be engaged in actual production of goods,
and others in providing services ancillary thereto. At this stage, the factory overheads
which can be directly related to the various production or service departments are
allocated in this manner.
It may, sometime, become necessary to sub-divide a manufacturing organisation into
several cost centres, so that a closer distribution of expenses and a more detailed
control is practicable.
It is thus obvious that the principal object of setting up cost centres is to collect data, in
respect of similar activities more conveniently. This avoids a great deal of cost analysis.
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4.10 COST AND MANAGEMENT ACCOUNTING

When costs are collected by setting up cost centres, several items can be ascertained
definitely and the element of estimation is re-duced considerably. For instance,
theallowance of the normal idle time or the amount to be spent on consumable stores,
etc. There are two main types of cost centres - machine or personal - depending on
whether the process of manufacture is carried on at a centre by man or machine. For
the convenience of recording of expenditure, cost centres are sometimes allotted a
code number.
Advantages of Departmentalisation : The collection of overheads department wise
gives rise to the following advantages:
(a) Better Estimation of Expenses: Some expenses which relate to the departments will
be estimated almost on an exact basis and, to that extent, the accuracy of estima-
tion of overheads will be higher.
(b) Better Control: For the purpose of controlling expenses in a department, it is ob-
viously necessary that the figures in relation to each department should be sepa-
rately available. It is one of the main principles of control that one should know for
each activity how much should have been spent and how much is actually spent.
If information about expenses is available only for factory as a whole, it will not be
possible to know which department has been over spending.
(c) Ascertainment of Cost for each department: From the point of view of ascertaining
the cost of each job, the expenses incurred in the departments through which
the job or the product has passed should be known. It is only then that the cost
of the job or the product can be charged with the appropriate share of indirect
expenses. It is not necessary that a job must pass through all the departments or
that the work required in each department should be the same for all jobs. It is,
therefore, necessary that only appropriate charge in respect of the work done in
the department is made. This can be done only if overheads for each department
are known separately.
(d) Suitable Method of Costing: A suitable method of costing can be followed differently
for each department e.g., batch costing when a part is manufactured, but single or
output costing when the product is assembled.
4.4.3 Apportioning overhead expenses over various departments
After the allocable overheads are related to the departments, expenses incurred for
several departments have to be apportioned over each department, e.g. rent, power,
lighting, insurance and depreciation. For distributing these overheads over different
departments benefiting thereby, it is necessary at first to determine the proportion
of benefit received by each department and then distribute the total expenditure
proportionately on that basis. But the same basis of apportionment cannot be followed
for different items of overheads since the benefit of service to a department in each
case has to be measured differently. Some of the bases that may be adopted for the
apportionment of expenses are stated below:
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OVERHEADS-ABSORPTION COSTING METHOD 4.11

Overhead Cost Overhead Cost Bases of Apportionment

1. (i) Rent and other building ex- Floor area, or volume of department
penses
(ii) Lighting and heating (condi
tioning)
(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
3. (i) Compensation to workers Direct wages
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Perquisites
4. General overhead Direct labour hour, or Direct wages, or
Machine hours.
5. (i) Depreciation of plant and Capital values
machinery
(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 power (machine operation) Horse power of machines, or Number of
machine hour, or value of machines or
units consumed.
9. (i) Material handling Weight of materials, or volume of
(ii) Stores overhead materials, or value of materials or unit of
materials.

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4.12 COST AND MANAGEMENT ACCOUNTING

Some other basis of apportioning overhead costs : We have considered already that
the benefit received by the department generally is the principal criterion on which the
costs of service departments or common expenses are apportioned. But other bases
of apportionments which may be used are mentioned below:
(a) Analysis or survey of existing conditions.
(b) Ability to pay.
(c) Efficiency or incentive.
A single concern may have only one criterion under consideration predominantly or
may use all (including the service or benefit criterion) for different phases of its activity.
Analysis or Survey of existing conditions : At times it may not be possible to
determine the advantage of an item of expenses without undertaking an analysis of
expenditure. For example, lighting expenses can be distributed over departments only
on the basis of the number of light points fixed in each department.
Ability to pay : It is a principle of taxation which has been applied in cost accounting as
well for distributing the expenditure on the basis of income of the paying department,
on a proportionate basis. For example, if a company is selling three different products
in a territory, it may decide to distribute the expenses of the sales organisation to the
amount of sales of different articles in these territories. This basis, though simple to
apply, may be inequitable since the expenditure charged to an article may have no
relation to the actual effort involved in selling it. Easy selling lines thus may have to
bear the largest proportion of expenses while, on the other hand, these should bear
the lowest charge.
Efficiency or Incentives : Under this method, the distribution of overheads is made
on the basis of pre-determined levels of production or sales. When distribution of
overhead cost is made on this basis and if the level of production exceeds the pre-
determined level of production the incidence of overhead cost gets reduced and the
total cost per unit of production or of sales, lowered. The opposite is the effect if the
assumed levels are not reached.
Thus the department whose sales are increasing is able to show a greater profit and
thereby is able to earn greater goodwill and appreciation of the management than it
would have if the distribution of overheads was made otherwise.
Difference between Allocation and Apportionment
The difference between the allocation and apportionment is important to understand
because the purpose of these two methods is the identification of the items of cost
to cost units or centers. However, the main difference between the above methods is
given below.
(1) Allocation deals with the whole items of cost, which are identifiable with any one
department. For example, indirect wages of three departments are separately

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OVERHEADS-ABSORPTION COSTING METHOD 4.13

obtained and hence each department will be charged by the respective amount of
wages individually.
On the other hand, apportionment deals with the proportions of an item of cost for
example; the cost of the benefit of a service department will be divided between
those departments which has availed those benefits.
(2) Allocation is a direct process of charging expenses to different cost centres whereas
apportionment is an indirect process because there is a need for the identification
of the appropriate portion of an expense to be borne by the different departments
benefited.
(3) The allocation or apportionment of an expense is not dependent on its nature, but
the relationship between the expense and the cost centre decides that whether it
is to be allocated or apportioned.
(4) Allocation is a much wider term than apportionment.
4.4.4 Re-apportioning service department overheads over production
department
The re-apportionment of the service department cost to the production department
is known as secondary distribution. The suggestive bases that may be adopted for re-
apportionment are given below:
Cost of the Service Departments: Basis
1. Maintenance and Repair shop  Direct labour hours, Machine hours,
2. Planning and progress  Direct labour wages, Asset value

3. Tool room  × Hours worked.

4. Canteen and Welfare  No. of direct workers

5. Hospital and Dispensary  No. of employees etc.
6. Personnel Department 

7. Time-keeping No. of card punched, No. of employees
8. Computer Section Computer hours, Specific allocation to
departments
9. Power House (electric lighting cost) Floor area, Cubic content, No. of electric
Points, Wattage.
10. Power House (electric power cost) Horse power, kWh, Horse power ×
Machine hours, kWh × Machine hours
11. Stores Department No. of requisitions, Weight or value
ofMaterials issued.

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4.14 COST AND MANAGEMENT ACCOUNTING

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
Notes :
(1) Repairs included in repairs shop cost, building maintenance cost included in
maintenance shop cost etc. should be apportioned on the basis of capital values.
(2) Economy, practicability, equitability and reliability are the matters of consideration
for selection of the base.
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.

(i) Direct Re-Distribution Method :

Service department costs under this method are apportioned over the production
departments only, ignoring the services rendered by one service department to the
other. To understand the applications of this method, go through the illustration which
follows.
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:

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OVERHEADS-ABSORPTION COSTING METHOD 4.15

Production Departments: (`) (`)

A 30,00,000
B 26,00,000
C 24,00,000 80,00,000
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
Apportion the costs of service departments over the production departments.
SOLUTION
Secondary Overhead Distribution Statement
Items of cost Basis of Total Production Departments
(as per primary apporionment (`) A (`) B (`) C (`)
distribution summary)
Cost as per 80,00,000 30,00,000 26,00,000 24,00,000
primary distribution
summary
Stores(5:3:2) Value of Store 4,00,000 2,00,000 1,20,000 80,000
requisition
Time-keeping and No. of workers 3,00,000 1,20,000 90,000 90,000
Accounts (4:3:3)
Power (3:3:2) H.P. of Machine 1,60,000 60,000 60,000 40,000
Canteen (4:3:3) No. of workers 1,00,000 40,000 30,000 30,000
89,60,000 34,20,000 29,00,000 26,40,000
(ii) Step Method or Non-reciprocal method :
This method gives cognizance to the services rendered by service department to
another service department. Therefore, as compared to previous method, this method is
more complicated because a sequence of apportionments has to be selected here. The

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4.16 COST AND MANAGEMENT ACCOUNTING

sequence here begins with the department that renders maximum number of services
to theother service department(s). In other words, the cost of the service department
that serves the largest number of services to the other service department(s) and
production department(s) is distributed first. After this, the cost of service department
serving the next largest number of departments is apportioned.
This process continues till the cost of last service department is apportioned. The cost
of last service department is apportioned among production departments only.
Some authors are of the view that the cost of service department with largest amount
of cost should be distributed first.
ILLUSTRATION 2
Suppose the expenses of two production departments A and B and two service departments
X and Y are as under:
Amount Apportionment Basis
(`) Y A B
X 2,00,000 25% 40% 35%
Y 1,50,000 — 40% 60%
A 3,00,000
B 3,20,000
SOLUTION
Summary of Overhead Distribution
Departments X (`) Y (`) A (`) B (`)
Amount as given above 2,00,000 1,50,000 3,00,000 3,20,000
Expenses of X Dept. (2,00,000) 50,000 80,000 70,000
apportioned over Y, A
andB Dept. in the ratio
(5:8:7)
2,00,000 3,80,000 3,90,000
Expenses of Y Dept. - (2,00,000) 80,000 1,20,000
apportioned over A
andB Dept. in the ratio
(2:3)
Total Nil Nil 4,60,000 5,10,000
(iii) Reciprocal Service Method :
This method recognises the fact that where there are two or more service departments
they may render services to each other and, therefore, these inter-departmental
services are to be given due weight while re-distributing the expenses of the service
departments.

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OVERHEADS-ABSORPTION COSTING METHOD 4.17

The methods available for dealing with reciprocal services are:

(a) Simultaneous equation method;
(b) Trial and error method;
(c) Repeated distribution method.
(a) Simultaneous Equation Method :
According to this method firstly, the costs of service departments are ascertained.
These costs are then re-distributed to production departments on the basis of given
percentages. (Refer to the following illustration to understand the method)
ILLUSTRATION 3
Service departments’ expenses
(`)
Boiler House 3,00,000
Pump Room 60,000
3,60,000
The allocation is :
Production Departments Boiler House Pump Room
A B
Boiler House 60% 35% – 5%
Pump Room 10% 40% 50% –
SOLUTION
The total expenses of the two service departments will be determined as follows:
Let B stand for Boiler House expenses and P for Pump Room expenses.
Then
B = 3,00,000 + 1/2 P
P = 60,000 + 1/20 B
Substituting the value of B,
P = 60,000 + 1/20 (3,00,000 + 1/2 P)
= 60,000 + 15,000 + 1/40 P
= 75,000 + 1/40 P
40 P = 30,00,000 + P
39 P = 30,00,000
P = ` 76,923
The total of expenses of the Pump Room are ` 76,923 and that of the Boiler House is
` 3,38,462 i.e., ` 3,00,000 + 1/2 × ` 76,923.

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4.18 COST AND MANAGEMENT ACCOUNTING

The expenses will be allocated to the production departments as under:

Production departments: A B
(`) (`)
Boiler House (60% and 35% of ` 3,38,462) 2,03,077 1,18,462
Pump Room (10% and 40% of ` 76,923) 7,692 30,769
Total 2,10,769 1,49,231
The total of expenses apportioned to A and B is `3,60,000.
(b) Trial and Error Method :
According to this method the cost of one service cost centre is apportioned to another
service cost centre. The cost of another service centre plus the share received from the
first cost centre is again apportioned to the first cost centre. This process is repeated till
the amount to be apportioned becomes negligible, that means repeated distribution
method is followed to the extent of service departments only. All apportioned amounts
for each service cost centre are added to get the total apportioned cost. These total
service cost centre costs are redistributed to the production departments. Trial and
error method and Simultaneous equation method gives the same result. (Refer to the
following illustration to understand this method.)
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
20X3 :
Total(`) A(`) B(`) C(`) X(`) Y(`)
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 20 40 20 10 10
assets (` lakhs)
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of 50 40 20 15 25
machines

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OVERHEADS-ABSORPTION COSTING METHOD 4.19

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 :
(i) A statement showing distribution of overheads to various departments.
(ii) A statement showing re-distribution of service departments expenses to production
departments using Trial and error method.
SOLUTION
(i) Overhead Distribution Summary
Basis Total (`) A (`) B (`) C (`) X (`) Y (`)
Direct Direct – – – – 2,00,000 1,00,000
materials
Direct Direct – – – – 1,00,000 2,00,000
wages
Factory rent Area 4,00,000 1,00,000 50,000 1,00,000 50,000 1,00,000
Power H.P. × 2,50,000 50,000 80,000 80,000 15,000 25,000
Machine
Hrs.
D e p r e c i a - Capital 1,00,000 20,000 40,000 20,000 10,000 10,000
tion value
Other Machine 9,00,000 1,00,000 2,00,000 4,00,000 1,00,000 1,00,000
overheads hrs.
16,50,000 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
(ii) Redistribution of Service Department’s expenses :
Service Departments
X (`) Y (`)
Overheads as per primary distribution 4,75,000 5,35,000
(i) Apportionment of Dept-X expenses to Dept-Y --- 47,500
(10% of ` 4,75,000)
--- 5,82,500
(ii) Apportionment of Dept-Y expenses to Dept-X
[5% of (` 5,35,000 + ` 47,500)] 29,125 ---
(i) Apportionment of Dept-X expenses to Dept-Y
(10% of ` 29,125) --- 2,913

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4.20 COST AND MANAGEMENT ACCOUNTING

(ii) Apportionment of Dept-Y expenses to Dept-X

(5% of ` 2,913) 146 ---
Total 5,04,271 5,85,413
Distribution of Service departments’ overheads to Production departments
Production Departments
A (`) B (`) C (`)
Overhead as per primary distribution 2,70,000 3,70,000 6,00,000
Dept- X (90% of ` 5,04,300) 2,26,900 75,600 1,51,300
Dept- Y (95% of ` 5,85,400) 3,51,300 2,04,900 ---
8,48,200 6,50,500 7,51,300
(c) Repeated Distribution Method :
Under this method, service departments’ costs are distributed to other service and
production departments on agreed percentages and this process continues to be
repeated, till the figures of service departments are either exhausted or reduced to too
small a figure. (Refer to the following illustration to understand this method)
ILLUSTRATION 5
PH 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 20X1:
Total(`) A(`) B(`) C(`) X(`) Y(`)
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

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OVERHEADS-ABSORPTION COSTING METHOD 4.21

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 :
(i) A statement showing distribution of overheads to various departments.
(ii) A statement showing re-distribution of service departments expenses to production
departments.
(iii) Machine hour rates of the production departments ‘A’, ‘B’ and ‘C’.
SOLUTION
(i) Overhead Distribution Summary
Basis Total (`) A (`) B (`) C (`) X (`) Y (`)
Direct Direct – – – – 2,00,000 1,00,000
materials
Direct wages Direct – – – – 1,00,000 2,00,000
Factory rent Area 4,00,000 1,00,000 50,000 1,00,000 50,000 1,00,000
Power H.P. × 2,50,000 50,000 80,000 80,000 15,000 25,000
Machine
Hrs.
Depreciation Capital 1,00,000 20,000 40,000 20,000 10,000 10,000
value
Other Machine 9,00,000 1,00,000 2,00,000 4,00,000 1,00,000 1,00,000
overheads hrs.
16,50,000 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
(ii) Redistribution of Service Department’s expenses
A (`) B (`) C (`) X (`) Y (`)
Total overheads 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
Dept. X overhead apportionedin 2,13,750 71,250 1,42,500 (4,75,000) 47,500
the ratio (45:15:30: —:10)
Dept. Y overhead apportioned in 3,49,500 2,03,875 – 29,125 (5,82,500)
the ratio (60:35: —:5: —)
Dept. X overhead apportionedin 13,106 4,369 8,738 (29,125) 2,912
the ratio (45:15:30: —:10)

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4.22 COST AND MANAGEMENT ACCOUNTING

Dept. Y overhead apportionedin 1,747 1,019 – 146 (2,912)

the ratio (60:35: —:5: —)
Dept. X overhead apportionedin 65 22 44 (146) 15
the ratio (45:15:30: —:10)
Dept. Y overhead apportionedin 9 6 - - (15)
the ratio (60:35: —:5: —)
8,48,177 6,50,541 7,51,282 – –

(iii) Machine hour rate :

A B C
A Total overheads (`) 8,48,177 6,50,541 7,51,282
B Machine hours 1,000 2,000 4,000
C Machine hour rate (`) [A ÷ B] 848.18 325.27 187.82
4.4.5 Absorbing overheads over cost units, products, etc.
Collection of the figure of overheads for the factory as a whole or for various departments
is not enough. It is clearly necessary to ascertain how much of the overheads is to be
debited to the cost of the various jobs, products etc. This process is called absorbing
the overhead to cost units. We take up below the various implications of this process.
However, if only one uniform type of work is done, the task is easy and under such
a situation the overhead expenses to be absorbed may be calculated by dividing
actual overheads by the number of units of work done or estimated overheads by the
estimated output.
4.5 METHODS OF ABSORBING OVERHEADS TO
VARIOUS PRODUCTS OR JOBS
The method selected for charging overheads to products or jobs should be such as
will ensure:
(i) that the total amount charged (or recovered) in a period does not differ materially
from the actual expenses incurred in the period. and
(ii) that the amount charged to individual jobs or products is equitable. In case of
factory overhead, this means:
(a) that the time spent on completion of each job should be taken into consideration;
(b) that a distinction should be made between jobs done by skilled workers and those
done by unskilled workers. and
(c) that jobs done by manual labour and those done by machines should be
distinguished.
In addition, the methods shouldbe capable of being used conveniently; and yield
uniform result from period to period as far as possible; any change that is apparent
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OVERHEADS-ABSORPTION COSTING METHOD 4.23

should reflect a change in the underlying situation such as substitution of human

labour by machines.
Several methods are commonly employed either individually or jointly for computing
the appropriate overhead rate. The more common of these are:
(1) Percentage of direct materials,
(2) Percentage of prime cost,
(3) Percentage of direct labour cost,
(4) Labour hour rate,
(5) Machine hour rate and
(6) Rate per unit of Output
4.5.1 Percentage of Direct material cost
Under this method, the cost of direct material consumed is the base for calculating
the amount of overhead absorbed. This overhead rate is computed by the following
formula :

Total Production Overheads of a Department

Overhead rate =
Budgeted Direct Material cost of all Products
4.5.2 Percentage of Prime cost method
This method is based on the fact that both materials as well as labour contribute
in raising factory overheads. Hence, the total of the two i.e. Prime cost should be
taken as base for absorbing the factory overhead. The overhead rate in this method is
computed by the following formals :

Total Production Overheads of a Department

Overhead rate = ×100
Prime Cost

Example for the above two methods :

Suppose for a given period, actual figures are estimated as follows:
`
Direct materials 2,00,000
Direct labour 1,00,000
Factory overheads 90,000
The percentage of factory overheads to direct materials will be 45%, to prime cost
30% . If, on a job, material cost is ` 10,000 and direct labour is `7,000 the cost, after
absorbing factory overhead, will be as follows :
(i) ` 17,000 + 45% ` 10,000 or ` 21,500,
(ii) ` 17,000 + 30% ` 17,000 or ` 22,100, and
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4.24 COST AND MANAGEMENT ACCOUNTING

One can see how, with a different method, the works cost comes out to be different.
Of these methods, the first and second are generally considered to be unsuitable on
account of the following reasons:
(i) Manufacturing overhead expenses are mostly a function of time i.e., time is the
determining factor for the incurrence and application of manufacturing overhead
expenses. That they are so would be clear if we recall that overhead expenses,
specially manufacturing expenses, can in the ultimate analysis be regarded as
expenditure incurred in providing the necessary facilities and service to workers
employed in the productive process. The question of facilities and service made
available to workers naturally is dependent on the length of time during which
workers make use of the facilities. It may, therefore, be said that the job or product
on which more time has been spent would entail larger manufacturing expenses
than the job requiring less time. The factor is ignored altogether by the first
method and largely by the second method.
(ii) Overheads are neither related to the prime cost nor to direct material cost except
to a very small extent. Thus, if the percentage of material cost is used when there
are two jobs requiring the same operational time but using material having varying
prices, their manufacturing overhead cost would be different whereas this should
not normally be so.
The method of absorbing overhead costs on the basis of prime cost also does not
take into consideration the time factor. The fact that the amount includes labour
cost in addition to material cost does not render the prime cost to be more suitable;
infact, the results are liable to be more misleading because of the cumulative error
of using both the labour and material cost as the basis of allocation of overhead
expenses, on neither of which they are already dependent.
(iii) Since material prices are prone to frequent and wide fluctuations, the manufacturing
overheads, if based on material cost or prime cost, also would fluctuate violently
from period to period.
(iv) The skill of the workers involved and whether machines were used or not, are
ignored when these methods are used.
Percentage of materials cost may, however, be used for the limited purpose of
absorbing material handling and store overheads.
4.5.3 Percentage of direct labour cost
Formula to be used under this method is-

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OVERHEADS-ABSORPTION COSTING METHOD 4.25

Direct Labour CostPercentage Rate

Total Production Overheads of a Department

Overhead rate = ×100
Direct Labour Cost

Advantages Disadvantages
(i) The method is simple and (i) It gives rise to certain inaccuracies
economical to apply. due to the time factor not being given
full importance.
(ii) The time factor is given recognition (ii) Where machinery is used to some
extent in the process of manufacture,
even if indirectly.
an allowance for such a factor is not
made.
(iii) Total expenses recovered will not (iii) It does not provide for varying skills
differ much from the estimated of workers
figure since total wages paid are
not likely to fluctuate much.

4.5.4 Labour hour rate

This method is an improvement on the percentage of direct wage basis, as it fully
recognises the significance of the element of time in the incurring and absorption
of manufacturing overhead expenses. This method is admirably suited to operations
which do not involve any large use of machinery. To calculate labour hour rate, the
amount of factory overheads is divided by the total number of direct labour hours.
Suppose factory overheads are estimated at `90,000 and labour hours at 1,50,000. The
overhead absorption rate will be `0.60. If 795 direct labour hours are spent on a job,
`477 will be absorbed as overhead. It can be calculated for each category of workers.
Formula to be used under this method is-
Total Production Overheads of a Department
Direct Labour Hour Rate =
Direct labour Hours

4.5.5 Machine hour rate

Machine hour rate implies, cost of running a machine for an hour to produce goods.
There are two methods of computing machine hour rates:
(i) Direct Machine hour rate: According to the first method, only the expenses
directly or immediately connected with the operation of the machine are taken
into account e.g., power, depreciation, repairs and maintenance, insurance, etc.
The rate is calculated by dividing the estimated total of these expenses for a
period by the estimated number of operational hours of the machines during the
period.
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4.26 COST AND MANAGEMENT ACCOUNTING

(ii) Comprehensive Machine hour rate: It will be obvious, however, that in addition
to the expenses stated above there may still be other manufacturing expenses such
as supervision charges, shop cleaning and lighting, consumable stores and shop
supplies, shop general labour, rent and rates, etc. incurred for the department as
a whole and, hence, not charged to any particular machine or group of machines.
In order to see that such expenses are not left out of production costs, one
should include a portion of such expenses to compute the machine hour rate.
Alternatively, the overheads not directly related to machines may be absorbed on
the basis of Productive Labour Hour Rate Method or any other suitable method.
Note : Some people even prefer to add the wages paid to the machine operator in
order to get a comprehensive rate of working a machine for one hour.
By the machine hour rate method, manufacturing overhead expenses are charged to
production on the basis of number of hour machines are used on jobs or work orders.
Here each machine or group of machines are treated as a cost centre. Overheads
apportioned to a production department is further apportioned to machines or group
of machines. These apportioned costs are divided by the estimated productive machine
hour to get machine hour rate.
The steps involved in determining of Machine hour rate is as follows :

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OVERHEADS-ABSORPTION COSTING METHOD 4.27

The above costs are further divided into fixed cost or standing charges and variable
cost. Costs which remain constant irrespective of operation machine are treated as
fixed cost or standing charges. Examples of fixed cost include insurance premium for
machine, rent for premises, supervisor’s salary, depreciation (if relates to effluxion of
time) etc.
Costs which vary with the operation of the machine are treated as variable cost.
Examples of variable cost include cost for power, cost for consumables (lubricants, oils
etc.), repairs and maintenance, depreciation (if it relates to activity) etc.

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4.28 COST AND MANAGEMENT ACCOUNTING

Advantages and disadvantages of Machine hour rate :

Advantages Disadvantages
(1) Where machines are the main (1) Additional data concerning the
factor of production, it is usually the operation time of machines, not
best method of charging machine otherwise necessary, must be
operating expenses to production. recorded and maintained.
(2) The under-absorption of machine (2) As general department rates for
overheads would indicate the extent all the machines in a depart¬ment
to which the machines have been may be suitable, the computation
idle. of a separate machine hour rate for
(3) It is particularly advantageous where each machine or group of machines
one operator attends to several would mean further additional work.
machines (e.g. automatic screw
manufacturing machine), or where
several operators are engaged on
the machine e.g. the belt press used
in making conveyer belts.
4.5.6 Rate per unit of output method
This is the simplest of all the methods. In this method overhead rate is determined by
the following formula:

Amount of overhead
Overheads rate =
No. of Units

4.6 TYPES OF OVERHEAD RATES

The overhead rates may be of the following types:
1. Normal Rate : This rate is calculated by dividing the actual overheads by actual
base. It is also known as actual rate.
It is calculated by the following formula:

Actual amount of overheads

Normal overhead rate =
Actual base

2. Pre-determined Overhead Rate: This rate is determined in advance by estimating

the amount of the overhead for the period in which it is to be used. It is computed by
the following formula:

Budgeted amount of overhead

Pre-determined rate =
Budgeted base

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OVERHEADS-ABSORPTION COSTING METHOD 4.29

The amount of overhead rate of expenses for absorbing them to production may be
estimated on the following three basis.
(1) The figure of the previous year or period may be adopted as the overhead rate to
be charged to production in the current year. The assumption is that the value of
production as well as overheads will remain constant or that the two will change,
proportionately.
(2) The overhead rate for the year may be determined on the basis of estimated
expenses and anticipated volume of production activity.
For instance, if expenses are estimated at `10,000 and output at 4,000 units, the
overhead rate will be `2.50 per unit.
(3) The overhead rate for a year may be fixed on the basis of the normal volume of
the business.
3. Blanket Overhead Rate : Blanket overhead rate refers to the computation of
one single overhead rate for the whole factory. It is to be distinguished from the
departmental overhead rate which refers to a separate rate for each individual cost
centre or department. The use of blanket rate may be proper in certain factories
producing only one major product in a continuous process or where the work
performed in every department is fairly uniform or standardised.
This overhead rate is computed as follows :

Total overheads for the factory

Blanket rate = Total number of units of base for the factory

A blanket rate should be applied in the following cases:

(1) Where only one major product is being produced.
(2) Where several products are produced, but
(a) All products pass through all departments; and
(b) All products are processed for the same length of time in each department.
Where these conditions do not exist, departmental rates should be used.
4. Departmental Overhead Rate : It refers to the computation of one single
overhead rate for a particular production unit or department. Where the product lines
are varied or machinery is used to a varying degree in the different departments, that
is, where conditions throughout the factory are not uniform, the use of departmental
rates is to be preferred.
This overhead rate is determined by the following formula:

Overhead of department or cost centre

Departmental overhead rate =
Corresponding base

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4.30 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 6
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. In applying overheads,
the pre-determined rates are multiplied by actual 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 budgeted and actual data are available:
Annual profit plan data:
Factory overheads budgeted for the year:
Departments P1 25,50,000 S1 6,00,000
P2 21,75,000 S2 4,50,000
Budgeted output in units:
Product A 50,000; B 30,000.
Budgeted raw-material cost per unit :
Product A ` 120; Product B ` 150.
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
Average wage rates budgeted in Department P2 are:
Product A - ` 72 per hour and Product B – ` 75 per hour.
All materials are used in Department P1 only.
Actual data: (for the month of July, 20X1)
Units actually produced : Product A : 4,000 units
Product B : 3,000 units
Actual direct machine hours worked in Department P1:
On product A 6,100 hours, Product B 4,150 hours.
Actual direct labour hours worked in Department P2:
on product A 8,200 hours, Product B 7,400 hours.
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OVERHEADS-ABSORPTION COSTING METHOD 4.31

Costs actually incurred :

Product A Product B
` `
Raw materials 4,89,000 4,56,000
Wages 5,91,900 5,52,000
` `
Overheads : Department P1 2,31,000 S1 60,000
P2 2,04,000 S2 48,000
You are required to :
(i) Compute the pre-determined overhead rate for each production department.
(ii) Prepare a performance report for July, 20X1 that will reflect the budgeted costs and
actual costs.
SOLUTION
(i) Computation of predetermined overhead rate for each
production department from budgeted data
Production Department Service Department
P1 P2 S1 S2
Budgeted factory overheads 25,50,000 21,75,000 6,00,000 4,50,000
for the year in (`)
Allocation of service 3,00,000 3,00,000 (6,00,000) --
department S1’s costs to
production departments P1
and P2 equally in (`)
Allocation of service 3,00,000 1,50,000 – (4,50,000)
departmentS2’s costs to
production departments P1
and P2 in the ratio of 2:1 in (`)
Total 31,50,000 26,25,000 -- --
Budgeted machine hours in 1,05,000 --
department P1(working note-1)
Budgeted labour hours in -- 1,75,000
department P2(working note-1)
Budgeted machine/ labour 30.00 15.00
hour rate (`)

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4.32 COST AND MANAGEMENT ACCOUNTING

(ii) Performance report for July, 20X1

Budgeted (`) Actual (`)

Raw materials used in Dept. P1:
A : 4,000 units × ` 120 4,80,000 4,89,000
B : 3,000 units × ` 150 4,50,000 4,56,000
Direct labour cost
(on the basis of labour hours worked in department P2)
A : 4,000 units × 2 hrs. × ` 72 5,76,000 5,91,900
B : 3,000 units × 2.5 hrs. × ` 75 5,62,500 5,52,000
Overhead absorbed on machine hour basis in Dept. P1:
A : 4,000 units × 1.5 hrs. × ` 30 1,80,000 1,74,400*
B : 3,000 units × 1 hr. × ` 30 90,000 1,18,649
Overhead absorbed on labour hour basis in Dept. P2:

A : 4,000 units × 2 hrs. × ` 15 1,20,000 1,31,364

B : 3,000 units × 2.5 hrs. × ` 15 1,12,500 1,18,548

25,71,000 26,31,861
* (Refer to working note 4)** (Refer to working note 5)
Working notes :
1.
Product A Product B Total
Budgeted output(in units) 50,000 30,000
Budgeted machine hoursin 75,000 30,000 1,05,000
Dept. P1 (50,000×1.5 hrs.) (30,000×1 hr.)

Budgeted labour hoursin Dept. 1,00,000 75,000 1,75,000

P2 (50,000 × 2 hrs.) (30,000×2.5 hrs.)

2.
Product A Product B Total
Actual output(in units) 4,000 3,000
Actual machine hours utilized in Dept. P1 6,100 4,150 10,250
Actual labour hours utilised in Dept. P2 8,200 7,400 15,600

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OVERHEADS-ABSORPTION COSTING METHOD 4.33

3. Computation of actual overhead rates for each production department from

actual data
Production Department Service Department
P1 P2 S1 S2
Actual factory overheads for the 2,31,000 2,04,000 60,000 48,000
month of July, 20X1 in (`)
Allocation of service Dept. S1’s 30,000 30,000 (60,000) –
costs to production Dept. P1 and
P2 equally in (`)
Allocation of service Dept. S2’s 32,000 16,000 – (48,000)
costs to production Dept. P1 and
P2 in the ratio of 2:1 in (`)
Total 2,93,000 2,50,000 – –
Actual machine hours in Dept. P1 10,250 –
(working note-2)
Actual labour hours in Dept. P2 – 15,600
(working note-2)
Actual machine/ labour hour rate 28.59 16.02
(`)
4. Actual overheads absorbed (based on machine hours)
A : 6,100 hrs × ` 28.59 = ` 1,74,400
B : 4,150 hrs × ` 28.59 = ` 1,18,649
5. Actual overheads absorbed (based on labour hours)
A : 8,200 hrs × ` 16.02 = ` 1,31,364
B : 7,400 hrs × ` 16.02 = ` 1,18,548
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. and the expenses on oil, etc.,
are `900 per month.

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4.34 COST AND MANAGEMENT ACCOUNTING

SOLUTION
Total number of hours per annum- 4,380
Total number of hours per month- 365
Computation of Machine Hour Rate
Per month(`) Per hour (`)
Fixed costs (Standing Charges)
Depreciation (Refer working note-1) 75,833
Rent (`30,000 × ¼ ) 7,500
Lighting charges {(`8,000 × 2 points) ÷ 10 points} 1,600
Foreman’s salary (`19,200 × 1/6) 3,200
Sundry expenses (oil etc.) 900
Insurance {(1% of `9,10,000) ÷ 12 months} 758
89,791 246.00
Variable costs :
Repairs (Refer working note -2) 41.10
Electricity (15 units × `5) 75.00
Machine Hour rate 362.10
Working Notes :
Cost of Machine – Scrap value
(1) Depreciation per month =
Life of the machine
`1,00,00,000– `9,00,000
= = ` 75,833
(10 years × 12 months)*

*In the question the life of the machine is given as 10 years and it is also mentioned
the machine will run for 4,380 hours per annum. The depreciation can be calculated
either on the basis of time i.e. 10 years or on the basis of activity of 43,800 hours (4,380
hours p.a.)

(2) Repairs for the whole life is `18,00,000, which can be linked to activity level of
` 18,00,000
43,800 hours. Thus, Repairs cost per hour = = `41.10
43,800 hours

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OVERHEADS-ABSORPTION COSTING METHOD 4.35

4.7 TREATMENT OF UNDER-ABSORBED AND OVER-

ABSORBED OVERHEADS IN COST ACCOUNTING
Overhead expenses are usually applied to production on the basis of pre-determined
rates. Production overheads are to be determined in advance as follows for fixing
selling price, quote tender price and to formulate budgets etc.
Estimated/Normal overheads for the period
Pre-determined overhead rate =
Budgeted Number of units during the period

The actual overhead rate will rarely coincide with the pre-determined overhead rate,
due to variation in pre-determined overhead rate and actual overhead rate. Such a
variation may arise due to any one of the following situations:
(i) Estimated overheads for the period under consideration may remain the same or
they coincide with actual overheads but the number of units produced during the
period is either more or less in comparison with budgeted figure. In the former
case actual overhead rate will be less and in the latter case, actual overhead rate
will be more than the pre-determined overhead rate, hence over-absorption and
under-absorption will occur respectively.
(ii) Similarly, if the number of units actually produced during the period remains the
same as budgeted figure but the actual overheads incurred are more or less than
the estimated overheads for the period, then a situation of under-absorption or
over-absorption will arise respectively.
(iii) If changes occur in different proportion both in the actual overheads and in the
number of units produced during the period, then a situation of under or over-
absorption (depending upon the situation) will arise.
(iv) If the changes in the numerator (i.e. in actual overheads) and denominator (i.e.
in number of units produced) occur uniformly (without changing the proportion
between the two) then a situation of neither under nor of over-absorption will
arise.
Such over or under-absorption as arrived at under different situations may also be
termed as overhead variance. The amount of over-absorption being represented by a
credit balance in the account and conversely, the amount of under-absorption being
a debit balance.
Treatment of such under/ over absorption of overheads can be understood with the
help of the following flow chart:

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4.36 COST AND MANAGEMENT ACCOUNTING

Treatment of Under-absorbed and Over-absorbed of overheads in Cost Accounting

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 where there is a debit balance in the overhead account and a
credit in the other case.

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OVERHEADS-ABSORPTION COSTING METHOD 4.37

Now, the production of any period can be identified in three forms, goods finished and
sold, goods finished but held in stock (not yet sold) and semi-finished goods (work
in progress). So far as the first category of goods is concerned, it is arguable that the
post-mortem of the costs of individual products long after they have been sold may
have some academic utility but it is frequently devoid of any practical significance.
Therefore, it is suggested that the total variance concerning goods finished and sold
should be adjusted by transferring the amount to the Cost of Sale Account, the costs
of the individual items of such goods not being affected.
As regards the variance pertaining to goods finished and held in stock (i.e. not yet
sold), it would be necessary to adjust the value of the stock; similarly, the value of
work-in-progress should be adjusted.
However, over or under recovery of overheads due to abnormal reasons (such as
abnormal over or under capacity utilisation) should be transferred to the Costing Profit
and Loss Account.
ILLUSTRATION 8
A light engineering factory fabricates machine parts to customers. The factory commenced
fabrication of 12 Nos. machine parts to customers’ specifications and the expenditure
incurred on the job for the week ending 21st August, 20X1 is given 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

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, 20X1, the total labour hours worked was 2,400 and Machine
Nos. I and II had worked for 30 hours and 32.5 hours respectively.

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4.38 COST AND MANAGEMENT ACCOUNTING

Prepare a Cost Sheet for the job for the fabrication of 12 Nos. machine parts duly levying
the supplementary rates.
SOLUTION
Fabrication of 12 Nos. machine parts (job No......) Date of commencement: 16 August,
20X1 Date of Completion. Cost sheet for the week ending, August 21, 20X1 :
(`) (`)
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
Supplementary Rates
Overheads 20 hours @ `2 per hour 40.00
Machine facilities:
Machine No. I - 4 hours @ `15 60.00
Machine No. II - 6 hours @ `15 90.00 190.00
Cost 2,000.00
Working notes :
Overheads budgeted: 3,000 hours ×`8 =`24,000
Actual hours: 2,400
Actual rate per hour `24,000 ÷ 2,400 hours = `10
Supplementary charge `2 (`10 – ` 8) per hour
Machine facilities :
Machine No. I Machine No. II
Budgeted `1,800 `2,600
(40 × `45) (40 × `65)
Actual number of hours 30 32.5
Actual rate per hour `60.00 `80.00
Supplementary rate per hour ` 15.00 ` 15.00
(`60.00 – `45.00) (`80.00 – `65.00)

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OVERHEADS-ABSORPTION COSTING METHOD 4.39

4.8 ACCOUNTING AND CONTROL OF ADMINIS-

TRATIVE OVERHEADS
Definition - According to CIMA Terminology, Administrative overhead is defined as
“The sum of those costs of general management and of secretarial accounting and
administrative services, which cannot be directly related to the production, marketing,
research or development functions of the enterprise.” According to this definition,
administrative overhead constitutes the expenses incurred in connection with the
formulation of policy directing the organisation and controlling the operations of an
undertaking. These overheads are also collected and classified in the same way as the
factory overheads.
4.8.1 Accounting of Administrative Overheads
There are three distinct methods of accounting of administrative overheads, which are
briefly discussed below:
(a) Apportioning Administrative Overheads between Production and Sales
Departments : According to this method administrative overheads are apportioned
over production and sales departments. The reason for the apportionment of overhead
expenses over these departments, recognises the fact that administrative overheads
are incurred for the benefit of both of these departments. Therefore, each department
should be charged with the proportionate share of the same. When this method is
adopted, administrative overheads lose their identity and get merged with production
and selling and distribution overheads.
Disadvantages:
(1) It is difficult to find suitable bases of administrative overhead apportionment over
production and sales departments.
(2) Lot of clerical work is involved in apportioning overheads.
(3) It is not justified to apportion total administrative overheads only over production
and sales departments when other equally important department like finance is
also there.
(b) Charging to Profit and Loss Account : According to this method administrative
overheads are charged to Costing Profit & Loss Account. The reason for charging to
Costing Profit & Loss are firstly, the administrative overheads are concerned with the
formulation of policies and thus are not directly concerned with either the production
or the selling and distribution functions. Secondly, it is difficult to determine a
suitable basis for apportioning administrative overheads over production and sales
departments. Lastly, these overheads are the fixed costs. In view of these arguments,
administrative overheads should be charged to Profit and Loss Account.

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4.40 COST AND MANAGEMENT ACCOUNTING

Disadvantages :
(1) Cost of products is understated as administrative overheads are not charged to
costs.
(2) The exclusion of administrative overheads from cost of products is against sound
accounting principle.
(c) Treating Administrative Overheads as a separate addition to Cost of
Production/ Sales : This method considers administration as a separate function like
production and sales and, as such costs relating to formulating the policy, directing the
organisation and controlling the operations are taken as a separate charge to the cost
of the jobs or a product, sold along with the cost of other functions. The basis which
are generally used for apportionment are:
(i) Works cost
(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced
(v) Conversion cost, etc.
4.8.2 Control of Administrative Overheads
Mostly administrative overheads are of fixed nature, and they arise as a result of
management policies. These fixed overheads are generally non-controllable. But at
the same time these overheads should not be allowed to grow disproportionately.
Some degree of control has to be exercised over them. The methods usually adopted
for controlling administrative overheads are as follows:
(i) Classification and analysis of overheads by administrative departments according to
their functions, and a comparison with the accomplished results: According to this
method the expenses incurred by each administrative department are collected
under standing order numbers for each class of expenditure. These are compared
with similar figures of the previous period in relation to accomplishment. Such a
comparison will reveal efficiency or inefficiency of the concerned department.
However, this method provides only a limited degree of control and comparison
does not give useful results if the level of activity is not constant during the periods
under comparison. To overcome this difficulty, overhead absorption rates may
also be compared from period to period; the extent of over or under absorption
will reveal the efficiency or otherwise of the department. It may be possible to
compare the cost of a service department with that of similar services obtainable
from outside and a decision may be taken whether it is economical to continue
the department or entrust the work to outsiders.
(ii) Control through Budgets - According to this method, administration budgets
(monthly or annually) are prepared for each department. The budgeted figures are

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OVERHEADS-ABSORPTION COSTING METHOD 4.41

compared with actual ones to determine variances. The variances are analysed and
responsibility assigned to the concerned department to control these variances.
(iii) Control through Standard - Under this method, standards of performance are fixed
for each administrative activity, and the actual performance is compared with the
standards set. In this way, standards serve not only as yardstick of performance
but also facilitate control of costs.
ILLUSTRATION 9 : (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 :
(i) Computation of percentage recovery rates of factory overheads and administrative
overheads.
(ii) Calculation of the amount of factory overheads, administrative overheads and profit
for each of the two jobs.
(iii) Using the above recovery rates fix 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%
SOLUTION
(i) Let factory overhead recovery rate, as percentage of direct wages be F and
administrative overheads recovery rate, as percentage of factory cost be A.
Factory Cost of Jobs :
Job 101=`96,000 + `42,000F
Job 102=`67,500 + `30,000F

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4.42 COST AND MANAGEMENT ACCOUNTING

Total Cost of Jobs:

Job 101 = (`96,000 + `42,000F) + (`96,000+ `42,000F)A = ` 1,51,500
Job-102 = (`67,500 + ` 30,000F) + (`67,500+ `30,000F)A = ` 1,06,875
(Refer to working note)
On solving above relations:F = 0.60 and A = 0.25
Hence, percentage recovery rates of factory overheads and administrative overheads
are 60% and 25% respectively.
Working note :
Job 101 Job 102
Total cost (`) 1,51,500 1,06,875
Selling price
(` 1,66,650/110%) (` 1,28,250/120%)
(100% + Percentage of profit)

(ii) Statement of jobs, showing amount of factory overheads, administrative

overheads and profit
Job 101 Job 102
(`) (`)
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Prime cost 96,000 67,500
Factory overheads
60% of direct wages 25,200 18,000
Factory cost 1,21,200 85,500
Administrative overheads
25% of factory cost 30,300 21,375
Total cost 1,51,500 1,06,875
Profit 15,150 21,375
Selling price 1,66,650 1,28,250
(iii) Selling price of Job 103
(`)
Direct materials 24,000
Direct wages 20,000
Prime cost 44,000
Factory overheads (60% of Direct Wages) 12,000

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OVERHEADS-ABSORPTION COSTING METHOD 4.43

Factory cost 56,000

Administrative overheads 14,000
(25% of factory cost)
Total cost 70,000
Profit margin (balancing figure) 10,000
é Total Cost ù
Selling price ê ú 80,000
êë 87.5% úû

4.9 ACCOUNTING AND CONTROL OF SELLING AND

DISTRIBUTION OVERHEADS
Selling cost or overhead expenses are the expenses incurred for the purpose of
promoting the marketing and sales of different products. Distribution expenses, on
the other hand, are expenses relating to delivery and dispatch of goods sold. Examples
of selling and distribution expenses have been considered earlier in this booklet. From
the definitions it is clear that the two type of expenses represent two distinct type of
functions. Some concerns group together these two type of overhead expenses into
one composite class, namely, selling and distribution overhead, for the purpose of
Cost Accounting.
4.9.1 Accounting of selling and distribution overheads
The collection and accumulation of each expense is made by means of appropriate
standing order numbers in the usual way. Where it is decided to apportion a part of
the administrative overhead to the selling division the same should also be collected
through appropriate standing order numbers.
As in the case of administrative overheads, it is not easy to determine an entirely
satisfactory basis for computing the over¬head rate for absorbing selling overheads.
The bases usually adopted are:
(a) Sales value of goods;
(b) Cost of goods sold;
(c) Gross Profit on sales; and
(d) Number of orders or units sold.
It is considered that the sale value is ordinarily the most logical basis, there being some
connection between the amount of sales and the amount of expenses incurred to
achieve them. The cost of production, however, is not as satisfactory on basis as it may
not have any direct relationship with the selling and distribution cost.
The basis of gross profit on sales results in a larger share of the selling overhead being
applied to goods yielding a large margin of profit and vice versa. The basis therefore
follows the principle of ‘ability to pay, it may not reflect costs or incurred efforts.
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4.44 COST AND MANAGEMENT ACCOUNTING

An estimated amount per unit - The best method for absorbing selling and distributing
expenses over various products is to separate fixed expenses from variable expenses.
Apportion the fixed expenses according to the benefit derived by each product and
thus ascertaining the fixed expenses per unit. We give below some of the fixed expenses
and thebasis of apportionment:

Expenses Basis
Salaries in the Sales Department and of Estimated time devoted to the sale of
the sales men. variousproducts.
Advertisement Actual amount incurred for each product
since these days it is usual to advertise
each product separately; common
expenses, such as in an exhibition,
should be apportioned on the basis
of advertisement expenditure on each
product.
Show Room expenses Average space occupied by each product.
Rent of finished goods godowns and Average quantities delivered during a
Expenses on own delivery vans period.
If a suitable basis for apportioning expenses does not exist it may be apportioned in
the proportion of sales of various products.
The total of fixed expenses apportioned in this manner, divided by the number of units
sold or likely to be sold, will give the fixed expenses per unit. To this should be added
the variable expenses which will be different for each product. These expenses are,
packaging, freight outwards, insurance in transit, commission payable to salesmen,
rebate allowed to customers, etc. All these items will be worked out per unit for each
product separately. These items added to fixed expenses per unit will give an estimated
amount of the selling and distribution expenses per unit.
4.9.2 Control of Selling & Distribution Overheads
Control of selling and distribution expenses is a difficult task. The reasons for this are
as follows :
1. The incidence of selling and distribution overheads depends mainly on external
factors, such as distance of market, extent and nature of competition, terms of sales,
etc. which are beyond the control of management.
2. These overheads are dependent upon the customers, behaviour, their liking and
disliking, tastes etc. Therefore, as such control over the overheads may result in loss of
customers.
3. These expenses being of the nature of policy costs, are not amenable to control.
In spite of the above difficulties, the following methods may be used for controlling
them.
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OVERHEADS-ABSORPTION COSTING METHOD 4.45

(a) Comparison with past performance - According to this method, selling and
distribution overheads are compared with the figures of the previous period.
Alternatively, the expenses may be expressed as a percentage of sales, and the
percentages may be compared with those of the past period. This method is
suitable for small concerns.
(b) Budgetary Control - A budget is set up for selling and distribution expenses. The
expenses are classified into fixed and variable. If necessary, a flexible budget
may be prepared indicating the expenses at different levels of sales. The actual
expenses are compared with the budgeted figures and in the case of variances
suitable actions are taken.
(c) Standard Costing - Under this method standards are set up in relation to the
standard sales volume. Standards may be set up for salesmen, territories, products
etc. Once the standards are set up, comparison is made between the actuals and
standards : variances are enquired into and suitable action taken.
ILLUSTRATION 10
A company which sells four products, some of them unprofitable, proposes discontinuing
the sale of one of them. The following information is available regarding income, costs
and activity for the year ended 31st March, 20X2.
Products

A B C D

Sales (` ) 30,00,000 50,00,000 25,00,000 45,00,000

Cost of sales (` ) 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 :

(`) Basis of allocation
to products
Fixed Costs
Rent & Insurance 3,00,000 Square feet
Depreciation 1,00,000 Parcel
Salesmen’s salaries & expenses 6,00,000 Sales Volume

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4.46 COST AND MANAGEMENT ACCOUNTING

Administrative wages and salaries 5,00,000 No. of invoices

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.
SOLUTION
Statement of Profit or Loss on Various Products during the year ended March 31,
20X2.
Total(`) Products
A(`) B(`) C(`) D(`)
Sales 1,50,00,000 30,00,000 50,00,000 25,00,000 45,00,000
Variable costs:
Cost of sales 1,08,50,000 20,00,000 45,00,000 21,00,000 22,50,000
Commissions 4% of sales 6,00,000 1,20,000 2,00,000 1,00,000 1,80,000
Packing wages 10,00,000 2,00,000 3,00,000 1,50,000 3,50,000
&materials@ `2per
parcel

Stationery @ `1 per 4,00,000 80,000 1,40,000 60,000 1,20,000

invoice
Total variable costs 1,28,50,000 24,00,000 51,40,000 24,10,000 29,00,000
Contribution
(Sales –variable cost) 21,50,000 6,00,000 (1,40,000) 90,000 16,00,000
Fixed Costs:
Rent & Insurance 3,00,000 75,000 60,000 1,20,000 45,000
(5:4:8:3)
Depreciation (4:6:3:7) 1,00,000 20,000 30,000 15,000 35,000
Salesmen’s salaries & 6,00,000 1,20,000 2,00,000 1,00,000 1,80,000
expenses (6:10:5:9)
Administrative wages & 5,00,000 1,00,000 1,75,000 75,000 1,50,000
salaries (4:7:3:6)
Total Fixed costs 15,00,000 3,15,000 4,65,000 3,10,000 4,10,000

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OVERHEADS-ABSORPTION COSTING METHOD 4.47

Profit or 6,50,000 2,85,000 (6,05,000) (2,20,000) 11,90,000

Loss(Contribution–fixed
Costs)
Percentage of profitor 4.33 9.50 (12.10) (8.80) 26.4
Loss on sales (%)

4.10 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.
Normal capacity is determined as under :
Installed capacity xxx
Adjustments for :
(i) Time lost due to scheduled preventive or planned
maintenance xxx
(ii) Number of shifts or machine hours or man hours
(iii) Holidays, normal shut down days, normal idle time xxx
(iv) Normal time lost in batch change over xxx xxx
Normal Capacity xxx
(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.

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4.48 COST AND MANAGEMENT ACCOUNTING

(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.
The idle capacity may arise due to lack of product demand, non-availability of raw
material, shortage of skilled labour, absenteeism, shortage of power fuel or supplies,
seasonal nature of product etc.
Installed Capacity 

 Normal Idle Capacity

Normal Capacity 

 Abnormal Idle Capacity

Actual Capacity 

Treatment of Idle capacity costs: Idle capacity costs can be treated in product costing,
in the following ways:
(a) If the idle capacity cost is due to unavoidable reasons such as repairs, maintenance,
changeover of job etc. a supple¬mentary overhead rate may be used to recover
the idle capacity cost. In this case, the costs are charged to the production capacity
utilised.
(b) If the idle capacity cost is due to avoidable reasons such as faulty planning, power
failure etc.; the cost should be charged to costing profit and loss account.
(c) If the idle capacity cost is due to seasonal factors, then, the cost should be charged
to the cost of production by inflating overhead rates.

4.11 TREATMENT OF CERTAIN ITEMS IN COSTING

(i) Interest and financing charges : It includes any payment in nature of interest
for use of non-equity funds and incidental cost that an entity incurs in arranging
those funds. Example of interest and financing charges are interest on borrowings,
financing charges in respect of finance leases, cash discount allowed to customers.
The term interest and financing charges, finance costs and borrowing costs are used
interchangeably. It does not include imputed costs.
Interest and financing charges shall be presented in the cost statement as a separate
item of cost of sales.
(ii) Depreciation : Depreciation “is the diminution in the intrinsic value of an asset due
to use and/or the lapse of time.” Depreciation is thus the result of two factors viz., the
use, and the lapse of time. We know that each fixed asset loses its intrinsic value due
to their continuous use and as such the greater the use the higher is the amount of
depreciation. The loss in the intrinsic value may also arise even if the asset in question
is not in service.

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OVERHEADS-ABSORPTION COSTING METHOD 4.49

Assignment of Depreciation :
It shall be traced to the cost object to the extent economically feasible. Where it is not
directly traceable it should be assigned using either or two principles i.e. (i) Cause and
Effect and (ii) Benefit received.
(iii) Packing expenses : Cost of primary packing necessary for protecting the product
or for convenient handling, should become a part of the production cost. The cost of
packing to facilitate the transportation of the product from the factory to the customer
should become a part of the distribution cost. If the cost of special packing is at the
request of the customer, the same should be charged to the specific work order or
the job. The cost of fancy packing necessary to attract customers is an advertising
expenditure. Hence, it is to be treated as a selling overhead.
(iv) Fringe benefits : These are the additional payments or facilities provided to the
workers apart from their salary and direct cost-allowances like house rent, dearness
and city compensatory allowances. These benefits are given in the form of overtime,
extra shift duty allowance, holiday pay, pension facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability ofemployees
towards the organisation. If the amount of fringe benefit is considerably large, it may
be recovered as direct charge by means of a supplementary wage or labour rate;
otherwise these may be collected as part of production overheads.
(v) Expenses on removal and re-erection of machines : Expenses are sometime
incurred on removal and re-erection of machinery in factories. Such expenses may
be incurred due to factors like change in the method of production; an addition
or alteration in the factory building, change in the flow of production, etc. All such
expenses are treated as production overheads. When amount of such expenses is
large, it may be spread over a period of time.
If such expenses are incurred due to faulty planning or some other abnormal factor,
then they may be charged to costing Profit and Loss Account.
(vi) Bad debts : There is no unanimity among different authors of Cost Accounting
about the treatment of bad debts. One view is that ‘bad debts’ should be excluded
from cost. According to this view bad debts are financial losses and therefore, they
should not be included in the cost of a particular job or product.
According to another view it should form part of selling and distribution overheads,
especially when they arise in the normal course of trading. Therefore bad debts should
be treated in cost accounting in the same way as any other selling and distribution
cost. However extra ordinarily large bad debts should not be included in cost accounts
(vii) Training expenses : Training is an essential input for industrial workers. Training
expenses in fact includes wages of workers, costs incurred in running training
department, loss arising from the initial lower production, extra spoilage etc. Training
expenses of factory workers are treated as part of the cost of production. The training

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4.50 COST AND MANAGEMENT ACCOUNTING

expenses of office; sales or distribution workers should be treated as office; sales or

distribution overhead as the case may be. These expenses can be spread over various
departments of the concern on the basis of the number of workers on roll.
Training expenses would be abnormally high in the case of high labour turnover such
expenses should be excluded from costs and charged to the costing profit and loss
account.
(viii) Canteen expenses : The subsidy provided or expenses borne by the firm in
running the canteen should be regarded as a production overhead. If the canteen is
meant only for factory workers therefore this expenses should be apportioned on the
basis of the number of workers employed in each department. If office workers also
take advantage of the canteen facility, a suitable share of the expenses should be
treated as office overhead.
(ix) Carriage and cartage expenses : It includes the expenses incurred on the
movement (inward and outwards) and transportation of materials and goods.
Transportation expenses related to direct material may be included in the cost of
direct material and those relating to indirect material (stores) may be treated as factory
overheads. Expenses related to the transportation of finished goods may be treated as
distribution overhead.
(x) Expenses for welfare activities : All expenses incurred on the welfare activities
of employees in a company are part of general overheads. Such expenses should be
apportioned between factory, office, selling and distribution overheads on the basis of
number of persons involved.
(xi) Night shift allowance : Workers in the factories, which operate during night time
are paid some extra amount known as ‘night shift allowance’. This extra amount is
generally incurred due to the general pressure of work beyond normal capacity level
and is treated as production overhead and recovered as such.
If this allowance is treated as part of direct wages, the jobs/production carried at night
will be costlier than jobs/production performed during the day. However, if additional
expenditure on night shift is incurred to meet some specific customer order, such
expenditure may be charged directly to the order concerned. If night shifts are run
due to abnormal circumstances, the additional expenditure should be charged to the
costing profit and loss account.
(xii) Research and Development Expenses : The Terminology defines research
expenses as “the expenses of searching for new or improved products, new application
of materials, or new or improved methods.” Similarly, development expenses are
defined as “the expenses of the process which begins with the implementation of the
decision to produce a new or improved product.”

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OVERHEADS-ABSORPTION COSTING METHOD 4.51

If research is conducted in the methods of production, the research expenses should

be charged to the production overhead; while the expenditure becomes a part of
the administration overhead if research relates to administration. Similarly, market
research expenses are charged to the selling and distribution overhead.
Development costs incurred in connection with a particular product should be charged
directly to that product. Such expenses are usually treated as “deferred revenue
expenses,” and recovered as a cost per unit of the product when production is fully
established.
General research expenses of a routine nature incurred on new or improved methods
of manufacture or the improvement of the existing products should be charged to the
general overhead.
Even in this case, if the amount involved is substantial it may be treated as a deferred
revenue expenditure, and spread over the period during which the benefit would
accrue. Expenses on fundamental research, not relating to any specific product, are
treated as a part of the administration overhead. Where research proves a failure, the
cost associated with it should be excluded from costs and charged to the costing Profit
and Loss Account.

SUMMARY
• Overheads : Overheads represent expenses that have been incurred in providing
certain ancillary facilities or services which facilitate or make possible the carrying
out of the production process; by themselves these services are not of any use.
• Cost allocation : The term ‘allocation’ refers to assignment or allotment of an
entire item of cost to a particular cost center or cost unit.
• Cost apportionment : Apportionment implies the allotment of proportions of
items of cost to cost centres or departments.
• Re-apportionment : The process of assigning service department overheads to
production departments is called reassignment or re-apportionment.
• Absorption : The process of recovering overheads of a department or any other
cost center from its output is called recovery or absorption.
• Direct re-distribution method : Under this method service department costs
are apportioned over the production departments only, ignoring the services
rendered by one service department to the other.
• Step Method or Non-reciprocal method : This method gives cognizance to
the service rendered by service department to another service department. The
sequence here begins with the department that renders service to the maximum
number of other service departments.
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4.52 COST AND MANAGEMENT ACCOUNTING

• Reciprocal Service Method : These methods are used when different service
departments render services to each other, in addition to rendering services to
production departments. In such cases various service departments have to share
overheads of each other. The methodsavailable for dealing with reciprocal services
are
(a) Simultaneous equation method;
(b) Repeated distribution method;
(c) Trial and error method.
• Blanket overhead rates : Blanket overhead rate refers to the computation of
one single overhead rate for the whole factory. It is to be distinguished from the
departmental overhead rate which refers to a separate rate for each individual
cost centre or department.
Overhead costs for the whole factory
Blanket Overhead rate = × 100
Total units of the selected base

TEST YOUR KNOWLEDGE

MCQs based Questions
1. “Fixed overhead costs are not affected in monetary terms during a given period by
a change in output”. But this statement holds good provided
(a) Increase in output is not substantial
(b) Increase in output is substantial
(c) Both (a) and (b)
(d) None of the above
2. The concept of ‘idle capacity of plant’ as used in cost accounting is its
(a) Best capacity for normal production
(b) Capacity used for standard setting
(c) Theoretical maximum capacity
(d) Capacity below which production should not fall
3. The allotment of whole items of cost to cost centres or cost units is called
(a) Overhead absorption
(b) Cost apportionment
(c) Cost allocation
(d) None of the above
4. Primary packing cost is a part of
(a) Direct material cost
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OVERHEADS-ABSORPTION COSTING METHOD 4.53

(b) Production cost

(c) Selling overheads
(d) Distribution overheads
5. Director’s remuneration and expenses form part of
(a) Production overhead
(b) Administration overhead
(c) Selling overhead
(d) Distribution overhead
6. In case, the output of a factory is doubled, the depreciation should be treated as
(a) Fixed cost
(b) Variable cost
(c) Semi- variable cost
(d) None of the above
7. Bad debt is an example of
(a) Distribution overhead
(b) Production overhead
(c) Selling overhead
(d) Administration overhead
8. Normal capacity of a plant refers to the difference between
(a) Maximum capacity and practical capacity
(b) Practical capacity and normal capacity
(c) Practical capacity and estimated idle capacity as revealed by long term sales
trend.
(d) Maximum capacity and actual capacity
9. The difference between actual factory overhead and absorbed factory overhead
will be usually at the minimum level, provided pre- determined overhead rate is
based on
(a) Maximum capacity
(b) Direct labour hours
(c) Machine hours
(d) Normal capacity
10. Identify among the following a scientific and accurate method of factory overhead
absorption
(a) Percentage of direct material cost method
(b) Percentage of direct labour cost method

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4.54 COST AND MANAGEMENT ACCOUNTING

(c) Percentage of prime cost method

(d) Machine hour rate method
Theoretical Questions
1. What is blanket overhead rate? In which situations, blanket rate is to be used and
why?
2. Discuss the step method and reciprocal service method of secondary distribution
of overheads.
3. Discuss the problems of controlling the selling and distribution overheads.
4. Distinguish between cost allocation and cost absorption.
5. Explain Single and Multiple Overhead Rates.
6. How would you treat the idle capacity costs in Cost Accounts?
7. Discuss the difference between allocation and apportionment of overhead.
8. What are the methods of re-apportionment of service department expenses over
the production departments? Discuss.
Practical Questions
1. The ABC Company has the following account balances and distribution of direct
charges on 31st March, 20X1.
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
Taxes 2,000
Depreciation 1,00,000
1,64,420 6,200 4,700 17,170 7,350
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OVERHEADS-ABSORPTION COSTING METHOD 4.55

The following data were compiled by means of the factory survey made in the
previous year:
Floor Radiator No. of Investment H.P
Space Sections Employees ` hours
Machine Shop 2,000 Sq. ft. 45 20 640,000 3,500
Packing 800 ”” 90 10 200,000 500
General Plant 400 ”” 30 3 10,000 –
Store & Maint. 1,600 ”” 60 5 150,000 1,000
4,800 ”” 225 38 1,000,000 5,000
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 department expenses to producing department.
(b) Determine the service department distribution by the method of continued
distribution. Carry through 3 cycles. Show all calculations to the nearest
rupees.
2. Modern Manufactures Ltd. has three Production Departments P1, P2, P3 and two
Service Departments S1 and 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
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
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4.56 COST AND MANAGEMENT ACCOUNTING

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% -
Find out 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.
3. 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 overhead Direct labour No. of Area in
(`) hours employees sq.m.
Production :
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
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.
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OVERHEADS-ABSORPTION COSTING METHOD 4.57

4. 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 regard¬ing
the machine are estimated as follows:
(`)
Rent for the 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.
5. 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. ` 20
Production bonus estimated 15% on wages
Value of power consumed ` 8,050
Supervision and indirect labour ` 3,300
Lighting and electricity ` 1,200
These particulars are for a year
Repairs and maintenance including consumables 3% of value of machines.
Insurance `40,000

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4.58 COST AND MANAGEMENT ACCOUNTING

Depreciation 10% of original cost.

Other sundry works expenses `12,000
General management expenses allocated `54,530.
You are required to work out a comprehensive machine hour rate for the machine
shop.
6. Job No. 198 was commenced on October 10, 20X1 and completed on November
1, 20X1. Materials used were ` 600 and labour charged directly to the job was `
400. Other information is as follows:
Machine No. 215 used for 40 hours, the machine hour rate being ` 3.50.
Machine No. 160 used for 30 hours, the machine hour rate being ` 4.00. 6 welders
worked on the job for five days of 8 hours each : the Direct labour hour per welder
is ` 0.20.
Expenses not included for calculating the machine hour or direct labour hour rate
total led ` 2,000,total direct wages for the period being ` 20,000. Ascertain the
works costs of job No. 198.
7. 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. How would you treat the under-absorbed
overhead in the cost accounts?
8. 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.
How would unabsorbed overheads be treated in Cost Accounts ?
9. A factory has three production departments. The policy of the factory is to recover
the production overheads of the entire factory by adopting a single blanket rate
based on the percentage of total factory overheads to total factory wages. The
relevant data for a month are given below:

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OVERHEADS-ABSORPTION COSTING METHOD 4.59

Department Direct Direct Factory Direct Machine

Materials Wages Over- Labour hours
heads hours
(`) (`) (`)
Budget :
Machining 6,50,000 80,000 3,60,000 20,000 80,000
Assembly 1,70,000 3,50,000 1,40,000 1,00,000 10,000
Packing 1,00,000 70,000 1,25,000 50,000 –
Actual :
Machining 7,80,000 96,000 3,90,000 24,000 96,000
Assembly 1,36,000 2,70,000 84,000 90,000 11,000
Packing 1,20,000 90,000 1,35,000 60,000 –
The details of one of the representative jobs produced during the month are as
under :
Job No. CW 7083 :
Department Direct Direct Direct Machine
Materials Wages Labour hours hours
(`) (`)
Machining 1,200 240 60 180
Assembly 600 360 120 30
Packing 300 60 40 –
The factory adds 30% on the factory cost to cover administration and selling
overheads and profit.
Required :
(i) Calculate the overhead absorption rate as per the current policy of the
company and determine the selling price of the Job No. CW 7083.
(ii) Suggest any suitable alternative method(s) of absorption of the factory
overheads and calculate the overhead recovery rates based on the method(s)
so recommended by you.
(iii) Determine the selling price of Job CW 7083 based on the overhead application
rates calculated in (ii) above.
(iv) Calculate the department-wise and total under or over recovery of overheads
based on the company’s current policy and the method(s) recommended by
you.

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4.60 COST AND MANAGEMENT ACCOUNTING

10. The total overhead expenses of a factory are ` 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. 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. Also give the profit implication of
the method suggested.
11. 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 financial year 20X1-X2, 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 year 20X1-X2 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.
(i) Calculate the amount of under-absorption of production overheads during
the year 20X1-X2; and
(ii) Show the accounting treatment of under-absorption of production overheads.
ANSWERS/ SOLUTIONS
Answers to the MCQs
1. (a) 2. (c) 3. (c) 4. (b) 5. (b) 6. (c)
7. (c) 8. (c) 9. (d) 10. (d)
Answers to the Theoretical Questions
1. Please refer paragraph 4.6
2. Please refer paragraph 4.4.4
3. Please refer paragraph 4.9
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OVERHEADS-ABSORPTION COSTING METHOD 4.61

4. Please refer paragraph 4.3

5. Please refer paragraph 4.6
6. Please refer paragraph 4.10
7. Please refer paragraph 4.4.3
8. Please refer paragraph 4.4.4
Answers to the Practical Problems
1. (a) Overhead Distribution Statement
Production Departments Service Departments
Machine Packing General Stores &
Allocated Expenses : Shop Plant Maintenance
Indirect labour 4,000 3,000 2,000 5,650
Maintenance material 1,800 700 1,020 1,500
Superintendent’s salary – – 4,000 –
Misc. supplies 400 1,000 150 200
Cost & payroll salaries – – 10,000 –
Total 6,200 4,700 17,170 7,350
Apportioned expenses
(See schedule below) 77,720 25,800 2,830 22,650
Total 83,920 30,500 20,000 30,000
Schedule of Apportioned Expenses
Item Basis Machine Packing General Stores &
Shop Plant Maintenance
(`) (`) (`) (`)
Power Horse Power Hrs. 5,600 800 – 1,600
Rent Floor Space 5,000 2,000 1,000 4,000
Fuel & Heat Radiator Secs. 1,200 2,400 800 1,600
Insurance Investment 640 200 10 150
Taxes Investment 1,280 400 20 300
Depreciation Investment 64,000 20,000 1,000 15,000
Total 77,720 25,800 2,830 22,650

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4.62 COST AND MANAGEMENT ACCOUNTING

(b) Distribution of Service Department Expenses

Production Departments Service Departments
Machine Packing General Stores &
Plant Maintenance
(`) (`) (`) (`)
Total Expense [as per (a)] 83,920 30,500 20,000 30,000
Transfer from Stores &
Maintenance 15,000 6,000 9,000 –30,000
Transfer from General Plant 16,571 8,286 –29,000 4,143
Transfer from Stores &
Maintenance 2,072 829 1,242 –4,143
Transfer from General Plant 710 355 –1,242 177
Transfer from Stores &
Maintenance 88 36 53 –177
Transfer from General Plant 35 18 –53 —
Total 1,18,396 46,024 — —
2. Statement Showing Distribution of Overheads of Modern Manufactures Ltd.

Production Service
Departments Departments
Particulars Basis Total P1 P2 P3 S1 S2
(`) (`) (`) (`) (`) (`)
Direct wages Actual 1,695 - - - 1,500 195
Rent & rates Area 5,000 1,000 1,250 1,500 1,000 250
General lighting Light points 600 100 150 200 100 50
Indirect wages Direct wages 1,939 600 400 600 300 39
Power H.P. 1,500 600 300 500 100 –
Depreciation Value
of machines of machines 10,000 2,400 3,200 4,000 200 200
Sundries Direct wages 9,695 3,000 2,000 3,000 1,500 195
30,429 7,700 7,300 9,800 4,700 929

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OVERHEADS-ABSORPTION COSTING METHOD 4.63

Redistribution of Service Department’s Expenses over Production Departments

Total P1 P2 P3 S1 S2
(`) (`) (`) (`) (`) (`)
Total Overheads 30,429.00 7,700 7,300 9,800 4,700 929
Dept. S1 Overheads 4,700.00 940 1,410 1,880 –4,700 470
apportioned in the ratio :
(20 : 30 : 40 : — : 10)
Dept. S2 overheads 1,399.00 559.60 279.80 419.70 139.90 –1,399.00
apportioned in the ratio :
(40 : 20 : 30 : 10 : —)
Dept. S1 overheads 139.90 27.98 41.97 55.96 –139.90 13.99
apportioned in the ratio
(20 : 30 : 40 : — : 10)
Dept. S2 overheads 13.99 5.60 2.80 4.20 1.39 –13.99
apportioned in the ratio
(40 : 20 : 30 : 10 : —)
Dept. S1 overheads 1.39 0.28 0.42 0.56 –1.39 0.13
apportioned in the ratio
(20 : 30 : 40 : — : 10)
Dept. S2 overheads 0.13 0.06 0.03 0.04 –0.13
apportioned in the ratio
(40 : 20 : 30 : 10 : —)
Total 9,233.52 9,035.02 12,160.46
Working hours 3,070.00 4,475.00 2,419.00
Working rate per hour 3.00 2.02 5.03
Cost of the Product ‘X’
(`)
Direct material cost 50.00
Direct labour cost 30.00
Overhead cost (See working note) 37.19
117.19
Working Note :
Overhead cost :
(` 3 × 4 hrs.) + (` 2.02 × 5 hrs.) + (` 5.03 × 3 hrs.)
= ` 12 + ` 10.10 + ` 15.09 = ` 37.19

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4.64 COST AND MANAGEMENT ACCOUNTING

3. (a) Deccan Manufacturing Limited

Schedule Showing the Distribution of Overhead Costs among Departments

Service Production
P Q R S X Y Z
(`) (`) (`) (`) (`) (`) (`)
Overhead costs 45,000 75,000 1,05,000 30,000 1,93,000 64,000 83,000
Distribution of over-
head cost of Dept. ‘P’ (45,000) 5,000 4,000 5,000 10,000 12,500 8,500
Distribution of over-
head costs of Dept. ‘Q’ (80,000) 24,000 12,000 16,000 12,000 16,000
Distribution of over-
head cost of Dept. ‘R’ - (1,33,000) 19,000 57,000 28,500 28,500
Distribution of over-
head costs of Dept. ‘S’ - - (66,000) 24,000 18,000 24,000
Total (A) 3,00,000 1,35,000 1,60,000
(b) Direct labour hours (B) 4,000 3,000 4,000
(A)
Overhead recovery rate per hour ` 75 ` 45 ` 40
(B)
4. Working notes :
(`)
(i) Total machine hours used 3,500
(600 + 900 + 400 + 600 + 1,000)
(ii) Total machine hours without the use of computers 1,500
(600 + 900)
(iii) Total machine hours with the use of computer 2,000
(400 + 600 + 1,000)
(iv) Total overheads of the machine per month
Rent (` 17,500 ÷ 3 months) 5,833.33
Depreciation (` 2,00,000 ÷ 12 months) 16,666.67
Indirect Charges (` 1,50,000 ÷ 12 months) 12,500.00
Total 35,000.00
(v) Computer hire charges for a month = ` 35,000
(` 4,20,000 ÷ 12 months)

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OVERHEADS-ABSORPTION COSTING METHOD 4.65

(vi) Overheads for using machines without computer

` 35,000
= × 1,500 hrs. = ` 15,000
3,500 hrs.
(vii) Overheads for using machines with computer
` 35,000
= 2,000 hrs. + ` 35,000 = ` 55,000
3,500 hrs.
(a) Machine hour rate of Gemini Enterprises for the firm as a whole for a
month.
` 55,000
(1) When the Computer was used : = ` 27.50 per hour
2,000 hours
` 15,000
(2) When the computer was not used : = ` 10 per hour
1,500 hrs.
(b) Machine hour rate for individual job
Rate per hr. Job
A B C
(`) Hrs. (`) Hrs. (`) Hrs. (`)
Overheads
Without Computer 10.00 600 6,000 900 9,000 – –
With computer 27.50 400 11,000 600 16,500 1,000 27,500
1,000 17,000 1,500 25,500 1,000 27,500
Machine hour rate ` 17 ` 17 ` 27.50
5. Computation of comprehensive machine hour rate of machine shop
(`)
Operator’s wages 17,100
(Refer to working note 2)
Production bonus 2,565
(15% on wages)
Power consumed 8,050
Supervision and indirect labour 3,300
Lighting and electricity 1,200
Repairs and maintenance 12,000
Insurance 20,000
Depreciation 40,000
Sundry works expenses 6,000
General management expenses 27,265
1,37,480

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4.66 COST AND MANAGEMENT ACCOUNTING

Total overheads of machine shop

Machine hour rate =
Hours of machines operation
` 1,37,480
= (Refer to working note 1)= ` 23.87
5,760 hours
Working notes
1. Computation of hours, for which 6 operators are available for 6 months.
Normal available hours p.m. 208
per operator.
Less: Absenteeism hours 18
Less: Leave hours 20
Less: Idle time hours 10
48
Utilisable hours p.m. per operator 160
Total utilisable hours for 6 operators and for 6 months are = 160 × 6× 6
= 5,760
As machines cannot be worked without an operator wholly engaged on them
therefore, hours for which 6 operators are available for 6 months are the hours
for which machines can be used. Hence 5,760 hours represent total machine
hours.
2. Computation of operator’s wages
` 20
Average rate of wages : = ` 2.50 per hour
8
Hours per month for which wages are paid to a worker (208 hours – 18 hours)
= 190 hours.
Total wages paid to 6 operators for 6 months
= 190 hours × 6 × 6 × ` 2.50 = ` 17,100
6. (`)
Materials 600.00
Direct labour 400.00
1,000.00
Factory overheads : (`)
Machine No. 215 : 40 hours @ ` 3.50 140.00
Machine No. 160 : 30 hours @ ` 4.00 120.00
2401 hours of welders @ ` 0.20 per hr. 48.00
General2 10% of wages 40.00 348.00
Works cost 1,348.00
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OVERHEADS-ABSORPTION COSTING METHOD 4.67

1. 6 welders × 5 days × 8 hours = 240 hours

2. Un apportioned expenses ` 2,000 which works out at 10% of direct wages.
7. Under-absorbed overhead expenses during the month of August
(`) (`)
Total expenses incurred in the month of August: 80,000
Less: The amount paid according to labour
court award (Assumed to be non-recurring) 15,000
Expenses of previous year 5,000 20,000
Net overhead expenses incurred for the month 60,000
Overhead recovered for 10,000 hours @ ` 5 per hour 50,000
Under-absorbed overheads 10,000
`4,000 may be distributed over Finished Goods and Cost of Sales as follows:
Finished Goods *`1,000
Cost of Sales *`3,000
*Working notes
Under-absorbed overhead : `4,000
Units produced : 40,000
Rate of under-absorbed overhead recover `0.10 per unit
Amount of under-absorbed overheads
charged to finished goods (10,000 × `0.10) ` 1,000
Amount of under-absorbed overheads
charged to cost of sales : (30,000 × `0.10) ` 3,000
8. Computation of unabsorbed overheads
Man-days worked 1,50,000
(`)
Overhead actually incurred 41,50,000
Less: Overhead absorbed @ ` 25 per man-day 37,50,000
(` 25 × 1,50,000) __________
Unabsorbed overheads 4,00,000
Unabsorbed overheads due to defective
planning (i.e. 60% of ` 4,00,000) 2,40,000
Balance of unabsorbed overhead 1,60,000

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4.68 COST AND MANAGEMENT ACCOUNTING

Treatment of unabsorbed overheads in Cost Accounts

(i) The unabsorbed overheads of ` 2,40,000 due to defective planning to be
treated as abnormal and therefore be charged to Costing Profit and Loss
Account.
(ii) The balance unabsorbed overheads of ` 1,60,000 be charged to production
i.e., 40,000 units at the supplementary overhead absorption rate i.e.,` 4 per
unit (Refer to Working Note)
(`)
Charge to Costing Profit and Loss Account as part of the cost of unit sold 1,20,000
(30,000 units @ ` 4 p.u.)
Add : To closing stock of finished goods 40,000
(10,000 units @ ` 4 p.u.) _________
Total 1,60,000
Working Note :
` 1,60,000
Supplementary overhead absorption rate = = ` 4 p.u.
40,000 units
9.
(i) Computation of overhead absorption rate
(as per the current policy of the company)
Department Budgeted factory Budgeted direct
overheads wages
(`) (`)
Machinery 3,60,000 80,000
Assembly 1,40,000 3,50,000
Packing 1,25,000 70,000
Total 6,25,000 5,00,000
Budgeted factory overheads
Overhead absorption rate = × 100
Budgeted direct wages
` 6,25,000
= × 100 = 125% of Direct wages
5,00,000
Selling Price of the Job No. CW-7083
(`)
Direct materials (` 1,200 + ` 600 + ` 300) 2,100.00
Direct wages (` 240 + ` 360 + ` 60) 660.00

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OVERHEADS-ABSORPTION COSTING METHOD 4.69

Overheads (125% × ` 660) 825.00

Total factory cost 3,585.00
Add: Mark-up (30% × ` 3,585) 1,075.50
Selling price 4,660.50
(ii) Methods available for absorbing factory overheads and their overhead
recovery rates in different departments
1. Machining Department
In the machining department, the use of machine time is the predominant
factor of production. Hence machine hour rate should be used to recover
overheads in this department. The overhead recovery rate based on machine
hours has been calculated as under:
Budgeted factory overheads
Machine hour rate = Budgeted machine hours

` 3,60,000
= = ` 4.50 per hour
80.,000 hours
2. Assembly Department
In this department direct labour hours is the main factor of production. Hence
direct labour hour rate method should be used to recover overheads in this
department. The overheads recovery rate in this case is:
Budgeted factory overheads
Direct labour hour rate =
Budgeted direct labour hours
` 1, 40,000
= = ` 1.40 per hour
1,00,000 hours
3. Packing Department
Labour is the most important factor of production in this depart-ment. Hence
direct labour hour rate method should be used to recover overheads in this
department.
The overhead recovery rate in this case comes to:
Budgeted factory overhead
Budgeted factory overheads
Direct labour hour rate =
Direct labour hours
` 1,25,000
= = ` 2.50 per hour
50,000 hours

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4.70 COST AND MANAGEMENT ACCOUNTING

(iii) Selling Price of Job CW-7083 [based on the overhead application rates
calculated in (ii) above]
(` )
Direct materials 2,100.00
Direct wages 660.00
Overheads (Refer to Working note) 1,078.00
Factory cost 3,838.00
Add: Mark up (30% of ` 3,838) 1,151.40
Selling price 4,989.40
Working note :
Overhead Summary Statement
Dept. Basis Hours Rate Overheads
(`) (`)
Machining Machine hour 180 4.50 810
Assembly Direct labour hour 120 1.40 168
Packing Direct labour hour 40 2.50 100
Total 1,078
(iv) Department-wise statement of total under or over recovery of overheads
(a) Under current policy
Departments
Machining Assembly Packing Total
(`) (`) (`) (`)
Direct wages (Actual) 96,000 2,70,000 90,000
Overheads recovered @
125% of Direct wages: (A) 1,20,000 3,37,500 1,12,500 5,70,000
Actual overheads: (B) 3,90,000 84,000 1,35,000 6,09,000
(Under)/Over recovery of
overheads : (A—B) (2,70,000) 2,53,500 (22,500) (39,000)
(b) As per methods suggested

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OVERHEADS-ABSORPTION COSTING METHOD 4.71

Basis of overhead recovery

Machine Direct Direct Total
hours labour labour (`)
hours hours
Hours worked 96,000 90,000 60,000
Rate/hour (`) 4.50 1.40 2.50
Overhead recovered (`): (A) 4,32,000 1,26,000 1,50,000 7,08,000
Actual overheads (`) : (B) 3,90,000 84,000 1,35,000 6,09,000
(Under)/Over recovery: 42,000 42,000 15,000 99,000
(A—B)
10. (`)
Actual factory overhead expenses incurred 4,46,380
Less : Overheads recovered from production 3,66,380
(2,93,104 hours × ` 1.25)
Unabsorbed overheads 80,000
Reasons for unabsorbed overheads
(i) 50% of the unabsorbed overhead was on account of 40,000
increased in the cost of indirect materials and indirect labour
(ii) 50% of the unabsorbed overhead was due to factory inefficiency. 40,000
Treatment of unabsorbed overheads in Cost Accounting
1. Unabsorbed overhead amounting to ` 40,000, which were due to increase in
the cost of indirect material and labour should be charged to units produced
by using a supplementary rate.
` 40,000
Supplementary rate = = ` 5 per unit
(7,800 + 200) units
The sum of ` 40,000 (unabsorbed overhead) should be distributed by using a
supplementary rate among cost of sales, finished goods and work-in progress
as below:
(`)
Cost of sales 35,000
(7,000 units × ` 5)
Finished goods 4,000
(800 units × `5)
Work-in progress 1,000
(200 units × ` 5)
40,000

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4.72 COST AND MANAGEMENT ACCOUNTING

The use of cost of sales figure, would reduce the profit for the period by `
35,000 and will increase the value of stock of finished goods and work-in-
progress by ` 4,000 and ` 1,000 respectively.
2. The balance amount of unabsorbed overheads viz. of ` 40,000 due to factory
inefficiency should be charged to Costing Profit & Loss Account, as this is an
abnormal loss.
11. (i) Amount of under-absorption of production overheads during the year
20X1-12
(`)
Total production overheads actually incurred 6,00,000
during the year 20X1-X2
Less : ‘Written off’ obsolete stores ` 45,000
Wages paid for strike period ` 30,000 75,000
Net production overheads actually incurred : (A) 5,25,000
Production overheads absorbed by 48,000 machine
hours @ ` 10 per hour : (B) 4,80,000
Amount of under – absorption of production overheads : [(A) – (B)] 45,000
(ii) Accounting treatment of under absorption of production overheads
It is given in the statement of the question that 20,000 units were completely
finished and 8,000 units were 50% complete, one third of the under-absorbed
overheads were due to lack of production planning and the rest were
attributable to normal increase in costs.
(`)
1. (33 – 1/3% of ` 45,000) i.e., ` 15,000 of under-absorbed
overheads were due to lack of production planning. This
being abnormal, should be debited to the Costing Profit
and Loss A/c. 15,000
2. Balance (66–2/3% of ` 45,000) i.e., ` 30,000 of under-absorbed
overheads should be distributed over work-in-progress, finished
goods and cost of sales by using supplementary rate. 30,000
Total under-absorbed overheads 45,000

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OVERHEADS-ABSORPTION COSTING METHOD 4.73

Apportionment of unabsorbed overheads of ` 30,000 over, work-in

progress, finished goods and cost of sales
Equivalent (`)
Completed Units
Work-in-Progress (4,000 units × ` 1.25) 4,000 5,000
(Refer to working note)
Finished goods (2,000 units × ` 1.25) 2,000 2,500
Cost of sales (18,000 units × ` 1.25) 18,000 22,500
_______ _______
24,000 30,000
Working Note :
` 30,000
Supplementary rate per unit = = ` 1.25
24,000

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CHAPTER 5
ACTIVITY BASED
COSTING

LEARNING OUTCOMES
r Discuss problem of traditional costing system.
r Discuss usefulness of Activity Based Costing(ABC).
r Discuss Cost Allocation under ABC.
r Discuss Different level of activities under ABC.
r Understand stages, advantages, and limitations of ABC.
r Discuss various requirements in ABC implementation.
r Explain the concept of Activity Based Management(ABM).
r Explain the concept of Activity Based Budgeting(ABB).

CHAPTER OVERVIEW

Activity Based
Costing

Concept Usefullness Cost Hierarchy Steps

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5.2 COST AND MANAGEMENT ACCOUNTING

5.1 INTRODUCTION
As discussed in chapter 4 i.e. Overhead, in traditional costing system, overhead costs
are grouped together under cost center and then absorbed into product costs on one
of the basis such as direct labour hours, machine hours, volume etc. In certain cases
this traditional costing system gives inaccurate cost information. Though, It should not
be assumed that all traditional absorption costing systems are not accurate enough to
give adequate information for pricing purposes or other long-run management deci-
sion purposes. Some traditional systems treat overheads in a detailed way and relate
them to service cost centres as well as production cost centres. The service centre
overheads are then spread over the production cost centres before absorption rates
are calculated. The main cause of inaccuracy is in the calculation of the overhead rate
itself, which is usually based on direct labour hours or machine hours. These rates as-
sume that products that take longer to make, generate more overheads and so on.
Organisations, who do not wish to know how much it costs to make a product with
precise accuracy, may be happy with traditional costing system. Others however fix
their price on cost and need to be able to determine it with reasonable accuracy. The
latter organisations have been greatly benefitted from the development of activity
based costing (ABC), which is more a modern absorption costing method, and was
evolved to give more accurate product costs.
5.1.1 Factors prompting the development of ABC
Various factors lead to the development of ABC include:
1. Growing overhead costs because of increasingly automated production
2. Increasing market competition which necessitated more accurate product costs.
3. Increasing product diversity to secure economies of scope & increased market
share.
4. Decreasing costs of information processing because of continual improve-
ments and increasing application of information technology.
5.1.2 Usefulness/Suitability of ABC
ABC is particularly needed by organisations for product costing in the following situ-
ation:
1. High amount of Overhead : When Production overheads are high and signifi-
cant cost, ABC will be very much useful instead of traditional costing system.
2. Wide range of products : ABC is most suitable, when, there is a diversity in the
product range or there are multiple products.
3. Presence of Non-volume related activities : When non-volume related ac-
tivities e.g. material handling, inspection set-up, are present significantly and
traditional system cannot be applied, ABC is a superior and better option. ABC

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ACTIVITY BASED COSTING 5.3

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 also can facilitate in
reducing cost by identifying non-value-adding activities in the production pro-
cess that might be a suitable focus for attention or elimination.

5.2 MEANING AND DEFINITION

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/ custom-
ers or services.
ABC assigns cost to activities based on their use of resources. It then assigns cost to
cost objects, such as products or customers, based on their use of activities. ABC can
track the flow of activities in organization by creating a link between the activity (re-
source consumption) and the cost object.
CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring
of activities which involves tracing resource consumption and costing final outputs.
Resources are assigned to activities, and activities to cost objects based on consump-
tion estimates. The latter utilise cost drivers to attach activity costs to outputs.”

5.3 MEANING OF TERMS USED IN ABC

(i) Activity – Activity, here, refers to an event that incurs cost.
(ii) A Cost Object–It is an item for which cost measurement is required e.g. a product
or a customer.
(iii) A Cost Driver–It is a factor that causes a change in the cost of an activity. There
are two categories of cost driver. Example Production runs
• A 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.
• An 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 ob-
jects.
(iv) Cost Pool-It represents a group of various individual cost items. It consists of costs
that have same cause effect relationship. Example Machine set-up.

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5.4 COST AND MANAGEMENT ACCOUNTING

Examples of Cost Drivers:

Business functions Cost Driver

Research and Development • Number of research projects

• Personnel hours on a project

Design of products, services and proce- • Number of products in design

dures • 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

5.4 COST ALLOCATION UNDER ABC

Under activity based cost allocation overheads are attributed to products on an activity
base. Traditionally, overhead costs are grouped together under cost centre and then
absorbed into product costs on some basis such as direct labour hours. Activity based
costing identifies the activities which cause cost to be incurred and searches for fun-
damental cost drivers of these activities. Once the activities and there cost drivers have
been identified this information can be used to assign overheads to cost objects (e.g.
products) which have actually caused cost to be incurred.

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ACTIVITY BASED COSTING 5.5

5.5 TRADITIONAL ABSORPTION COSTING VS

ABC

Direct Cost Product/

Tracing of Service
Cost Ascertainment Cost
Indirect Cost
Cost
Allocation

Traditional Costing Activity based Costing

Based on Machine
Based on Cost
hours, labour Hours,
Driver
Volume etc,.

Cost Allocation under Traditional and Activity Based Costing system

Cost Allocation under Traditional and Activity Based Costing system
In traditional absorption costing overheads are first related to cost centres (Production
& Service Centres) and then to cost objects, i.e., products. In ABC overheads are related
to activities or grouped into cost pools. Then they are related to the cost objects, e.g.,
products. The two processes are, therefore, very similar, but the first stage is different
as ABC uses activities instead of functional departments (cost centres). The problem
with functional departments is that they tend to include a series of different activities,
which incur a number of different costs that behave in different ways. Activities also
tend to run across functions; for instance, procurement of materials often includes
raising a requisition note in a manufacturing department or stores. It is not raised
in the purchasing department where most procurement costs are incurred. Activity
costs tend to behave in a similar way to each other i.e., they have the same cost driver.
Therefore, ABC gives a more realistic picture of the way in which costs behave.
Activity Based Costing Traditional Absorption Costing
1. Overheads are related to activi- 1. Overheads are related to cost cen-
ties and grouped into activity cost ters/departments.
pools.
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5.6 COST AND MANAGEMENT ACCOUNTING

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

5.6 LEVEL OF ACTIVITIES UNDER ABC METHO -

DOLOGY/COST HIERARCHY
These categories are generally accepted today but were first identified by Cooper
(1990). The categories of activities help to determine the type of activity cost driver
required.
The categories of activities are:
Level of Meaning Example
Activities
1.Unit level activi- These are those activities for • The use of indirect materi-
ties which the consumption of re- als/consumables tends to
sources can be identified with increase in proportion to
the number of units produced. the number of units pro-
duced.
• The inspection or testing
of every item produced, if
this was deemed necessary
or, perhaps more likely, ev-
ery 100th item produced.

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ACTIVITY BASED COSTING 5.7

2.Batch level ac- The activities such as setting up • Material ordering–where

tivities of a machine or processing a an order is placed for
purchase order are performed every batch of produc-
each time a batch of goods is tion
produced. The cost of batch • Machine set-up costs–
related activities varies with where machines need
number of batches made, but is resetting between each
common (or fixed) for all units different batch of pro-
within the batch. duction.
• Inspection of products
where the first item in
every batch is inspected
rather than every 100th
item quoted above.
3. Product level These are the activities which • Designing the product,
activities are performed to support dif- • Producing parts specifi-
ferent products in product line cations
• keeping technical draw-
ings of products up to
date.
4.Facilities level These are the activities which • Maintenance of build-
activities cannot be directly attributed ings
to individual products. These • Plant security
activities are necessary to sus-
tain the manufacturing process
and are common and joint to all
products manufactured

5.7 STAGES IN ACTIVITY BASED COSTING ( ABC )

The different stages in ABC calculations are listed below:
(1) Identify the different activities within the organisation : Usually the number
of cost centres that a traditional overhead system uses are quite small, say 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 ac-
tivities. It is possible to break the organisation down into many very small activi-
ties. But if ABC is to be acceptable as practical system it is necessary to use larger
groupings, so that, say, 40 activities may be used in practice. The additional num-
ber of activities over cost centres means that ABC should be more accurate than

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5.8 COST AND MANAGEMENT ACCOUNTING

the traditional method regardless of anything else. Some activities may be listed
as follows:-
• Production schedule changes
• Customer liaison
• Purchasing
• Production process set up
• Quality control
• Material handling
• Maintenance
(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. The question to ask is – what
causes the activity to incur costs? In production scheduling, for example, the
driver will probably be the number of batches ordered.
(5) Calculate activity cost driver rates for each activity, just as an overhead ab-
sorption rate would be calculated in the traditional system.
Total cost of activity
Activity cost driver rate =
Activity driver

The activity driver rate can be used to cost products, as in traditional absorption
costing, but it can also cost other cost objects such as customers/customer seg-
ments and distribution channels. The possibility of costing objects other than prod-
ucts is part of the benefit of ABC. The activity cost driver rates will be multiplied
by the different amounts of each activity that each product/other cost object con-
sumes.

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ACTIVITY BASED COSTING 5.9

Let us take a small example to understand the steps stated above:

Assume that a company makes widgets and the management decides to install an
ABC system. The management decides that all overhead costs will have only three cost
drivers viz. Direct labour hours, Machine hours and number of purchase orders and the
general ledger of the company shows the following overhead costs –
General Ledger Amount (`)
Payroll taxes 1,000
Machine maintenance 500
Purchasing Dept. labour 4,000
Fringe benefits 2,000
Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
Total 11,250
So, which overheads do you think are driven by direct labour hours?
The answer is
Payroll taxes ` 1,000
Fringe benefits ` 2,000
Unemployment insurance ` 1,500
Total ` 4,500
Similarly, overheads driven by machine hours include Machine maintenance, depreci-
ation and Electricity totaling ` 2,500 and finally overheads driven by number of pur-
chase orders include purchasing department labour and purchasing department sup-
plies totaling ` 4,250.
Now, overhead rate is calculated by the formula total cost in the activity pool / Base,
base being the total number of labour hours, machine hours and total number of pur-
chase orders in the given case.
Assume that the total number of labour hours be 1,000 hours, machine hours be 250
hours and total purchase orders be 100 orders.
So, Cost driver rate would be
Cost Driver Rate (`)
` 4,500/ 1,000 ` 4.50 per labour hour
` 2,500/ 250 ` 10 per machine hour
` 4,250/ 100 ` 42.50 per purchase order

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5.10 COST AND MANAGEMENT ACCOUNTING

Now, let’s allocate the overheads between two widgets A and B the details of which
are given below
Particulars Widget A Widget B
Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50
So, total overhead costs applied to widget A = (400 ×4.50) + (100×10) + (50×42.50) =
` 4,925
And total overheads applied to widget B = (600×4.50) + (150×10) + (50×42.50) = `
6,325
So total overheads = ` 4,925 + ` 6,325 = ` 11,250.
Generally, in the traditional costing method, overheads are applied on the basis of
direct labour hours (total 1,000 labour hours in the given case). So, in that case the
overhead absorption rate would be – ` 11,250/ 1000 = ` 11.25 per hour and the total
overheads applied to Widget A would have been = 400 × 11.25 = ` 4,500 and to Wid-
get B = 600 ×11.25 = ` 6,750.
Hence Widget A would have been undervalued and Widget B overvalued by ` 425.
Example of cost drivers for different activity pools in a production department can be
explained below:
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

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, 20X8 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

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ACTIVITY BASED COSTING 5.11

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 prod-
ucts using the direct labour hour rate. ABC Ltd. followed an 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 operators 6 3 2
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. What are the reasons for the different product costs under the two approaches?
SOLUTION
1. Traditional Absorption Costing
A B C Total
(a) Quantity (units) 3,000 1,600 - -
(b) Direct labour (minutes) 30 45 60 -
(c) Direct labour hours (a × b) 2,000 2,250 1,600 5,850

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5.12 COST AND MANAGEMENT ACCOUNTING

Overhead rate per direct labour hour:

= Budgeted overheads ÷ Budgeted labour hours
= ` 99,450 ÷ 5,850 hours
= ` 17 per direct labour hour
Unit Costs:
A (`) B (`) C (`)
Direct Costs:
- Direct Labour 5.00 7.50 10.00
- Direct Material 8.00 12.00 6.00
- Production Overhead: 8.50 12.75 17.00
 17 × 30   17 × 45   17 × 60 
     
60  60  60 

Total unit costs 21.50 32.25 33.00

Number of units 4,000 3,000 1,600
Total costs 86,000 96,750 52,800
2. Activity Based Costing
A B C Total
Quantity (units) 4,000 3,000 1,600 -
Weight per unit (Kg.) 4 6 3 -
Total weight 16,000 18,000 4,800 38,000
Machine operations per 6 3 2 -
unit
Total operations 24,000 9,000 3,200 36,200
Total batches of Material 10 5 15 30

Material handling rate per kg. = ` 29,000 ÷ 38,800 kg. = ` 0.75 per kg.
Electricity rate per machine operations = ` 39,150 ÷ 36,200
= ` 1,082 per machine operations
Storage rate per batch = ` 31,200 ÷ 30 batches
= ` 1,040 per batch

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ACTIVITY BASED COSTING 5.13

Unit Costs:
A (`) B (`) C (`)
Direct Costs:
Direct Labour 5.00 7.50 10.00
Direct material 8.00 12.00 6.00
Production Overheads:
Material Handling 3.00 4.50 2.25
(`0.75 × 4) (`0.75 × 6) (`0.75 × 3)
Electricity 6.49 3.25 2.16
(`1.082 × 6) (`1.082 × 3) (`1.082 × 2)
Storage 2.60 1.73 9.75

 `1,040   `1,040   `1,040 

 `10 ×   `5 × 3,000   `15 × 1,600 
 4,000     
Total unit costs 25.09 28.98 30.16
Number of units 4,000 3,000 1,600
Total costs ` 1,00,360 ` 86,940 ` 48,256
3. Comments: The difference in the total costs under the two systems is due to the
differences in the overheads borne by each of the products. The Activity Based Costs
appear to be more precise.

5.8 ADVANTAGES OF ACTIVITY BASED COSTING

The main advantages of using Activity Based Costing are:
(i) More accurate costing of products/services.
(ii) Overhead allocation is done on logical basis.
(iii) It enables better pricing policies by supplying accurate cost information.
(iv) Utilizes unit cost rather than just total cost
(v) Help to identify non-value added activities which facilitates cost reduction.
(vi) It is very much helpful to organization with multiple product.
(v) It highlights problem areas which require attention of the management.

5.9 LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
(i) It is more expensive particularly in comparison with Traditional costing system.
(ii) It is not helpful to small Organization.

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5.14 COST AND MANAGEMENT ACCOUNTING

(iii) It may not be applied to organization with very limited products.

(iv) Selection of most suitable cost driver may not be useful.

5.10 REQUIREMENTS IN ABC IMPLEMENTATION

A number of distinct practical stages are required in the ABC implementation which
are given as below:
(1) Staff Training : The co-operation of the workforce is critical to the successful
implementation of ABC. Staff training should be done to create an awareness of the
purpose of ABC.
(2) Process Specification : Informal, but structured, interviews with key members of
personnel will identify the different stages of the production process, the commitment
of resources to each, processing times and bottlenecks.
(3) Activity Definition : Early activity should be clearly defined the problem must be
kept manageable at this stage, despite the possibility of information overload from
new data, much of which is in need of codification.
(4) Activity Driver Selection : Cost driver for each activity shall be selected.
(5) Assigning Cost : A single representative activity driver can be used to assign costs
from the activity pools to the cost objects.

5.11 PRACTICAL APPLICATIONS OF ACTIVITY

BASED COSTING
5.11.1 As a Decision-Making Tool
ABC can act as a decision making tools in the following ways:
(i) ABC along with some other Cost Management technique can be utilized to improve
performance and profitability of an organization.
(ii) Wholesale distributors can gain significant advantage in the decision-making pro-
cess through implementation of ABC concepts by correlating costs to various activity.
Introduction of new product or vendor can be better decided through ABC.
(iii) ABC can assist in decisions related to facility and resource expansion. Often the ba-
sis for relocation or opening of a new distribution center is based on cost associations.
Reduction in freight or other logistic costs can offset the expense of the new facility,
staff or equipment. The ABC model can identify the specific cost elements being tar-
geted, providing a much clearer picture from which management can act.
(iv) Decision support for human resources can be augmented by ABC. Where activity,
and therefore cost, can be associated to an individual, new levels of financial perfor-
mance can be determined. This might be appropriate in cases of branch management
or sales.
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ACTIVITY BASED COSTING 5.15

(v) Companies who wish to determine price based on cost plus markup basis find ABC
method of costing very relevant and are able to determine competitive prices for their
products.
5.11.2 As Activity Based Management
Meaning of Activity Based Management
The term Activity based management (ABM) is used to describe the cost management
application of ABC. The use of ABC as a costing tool to manage costs at activity level
is known as Activity Based Cost Management (ABM). ABM is a discipline that focuses
on the efficient and effective management of activities as the route to continuously
improving the value received by customers. ABM utilizes cost information gathered
through ABC.
Various analysis in Activity Based Management
The various types of analysis involved in ABM are as follows:
(1) Cost Driver Analysis : The factors that cause activities to be performed need to be
identified in order to manage activity costs. Cost driver analysis identifies these causal
factors.
(2) Activity Analysis.
(a) Value-Added Activities (VA) : The value-added activities are those activ-
ities which are indispensable in order to complete the process. The cus-
tomers are usually willing to pay (in some way) for these services. For ex-
ample, polishing furniture by a manufacturer dealing in furniture is a value
added activity.
(b) Non-Value-Added Activities (NVA) : The NVA activity represents work
that is not valued by the external or internal customer. NVA activities do
not improve the quality or function of a product or service, but they can
adversely affect costs and prices. Moving materials and machine set up for
a production run are examples of NVA activities.
(3) Performance Analysis : Performance analysis involves the identification of appro-
priate measures to report the performance of activity centres or other organisational
units, consistent with each unit’s goals and objectives.
Activity Based Management in Business
Activity based management can be used in the following ways
(i) Cost Reduction : ABM helps the organisation to identify costs against activities and
to find opportunities to streamline or reduce the costs or eliminate the entire activity,
especially if there is no value added.
(ii) Business Process Re-engineering : Business process re-engineering involves ex-
amining business processes and making substantial changes to how organisation cur-
rently operates. ABM is a powerful tool for measuring business performance, deter-

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5.16 COST AND MANAGEMENT ACCOUNTING

mining the cost of business output and is used as a means of identifying opportunities
to improve process efficiency and effectiveness.
(iii) Benchmarking : Benchmarking is a process of comparing of ABC-derived activity
costs of one segment of company with those of other segments. It requires uniformity
in the definition of activities and measurement of their costs.
(iv) Performance Measurement : Many organisations are now focusing on activity
performance as a means of facing competitors and managing costs by monitoring the
efficiency and effectiveness of activities.
Area Measure
Quality of purchased component Zero defects
Quality of output % yield
Customer awareness Orders; number of complaints
5.11.3 Facilitate Activity Based Budgeting
Meaning of Activity Based Budgeting(ABB)
Activity based budgeting analyse the resource input or cost for each activity. It pro-
vides a framework for estimating the amount of resources required in accordance with
the budgeted level of activity. Actual results can be compared with budgeted results
to highlight both in financial and non-financial terms those activities with major dis-
crepancies from budget for potential reduction in supply of resources. It is a planning
and control system which seeks to support the objectives of continuous improvement.
It means planning and controlling the expected activities of the organization to derive
a cost-effective budget that meet forecast workload and agreed strategic goals. ABB is
the reversing of the ABC process to produce financial plans and budgets.
Key Elements of ABB
The three key elements of activity based budgeting are as follows:-
• Type of work to be done
• Quantity of work to be done
• Cost of work to be done
Benefits of ABB
Few benefits of activity based budgeting are as follows:-
1. Activity Based Budgeting (ABB) can enhance accuracy of financial forecasts and
increasing management understanding.
2. When automated, ABB can rapidly and accurately produce financial plans and
models based on varying levels of volume assumptions.
3. ABB eliminates much of the needless rework created by traditional budgeting
techniques.

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ACTIVITY BASED COSTING 5.17

ILLUSTRATION 2
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 31, 20X4, 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.
SOLUTION
(i) Statement of cost allocation to each product from each activity
Product

M (`) S (`) T (`) Total (`)

Power (Refer to 40,000 80,000 60,000 1,80,000

working note) (10,000 kWh (20,000 kWh (15,000 kWh
× `4) × `4) × `4)

Quality Inspec- 1,05,000 75,000 90,000 2,70,000

tions (3,500 inspec- (2,500 inspec- (3,000 inspec-
(Refer to working tions × `30) tions × ` 30) tions × ` 30)
note)

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5.18 COST AND MANAGEMENT ACCOUNTING

Working note :
Rate per unit of cost driver:
Power (` 2,00,000 / 50,000 kWh) ` 4/kWh
Quality Inspection (` 3,00,000 / 10,000 inspections) ` 30 per inspection
(ii) Computation of cost of unused capacity for each activity:
(`)
Power 20,000
(`2,00,000 – ` 1,80,000)
Quality Inspections 30,000
(`. 3,00,000 – ` 2,70,000)
Total cost of unused capacity 50,000
(iii) Factors management consider in choosing a capacity level to compute the
budgeted fixed overhead cost rate:
- Effect on product costing & capacity management
- Effect on pricing decisions.
- Effect on performance evaluation
- Effect on financial statements
- Regulatory requirements.
- Difficulties in forecasting chosen capacity level concepts.
ILLUSTRATION 3
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-la-
bour hours for the month of December, 20X6 are ` 12,42,500 and 20,000 hours respec-
tively. 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
X : 4 hours @ ` 150 per hour ` 450 ` 600

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ACTIVITY BASED COSTING 5.19

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 Inspection
worked 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.
SOLUTION
(i) Overheads application base: Direct labour hours
Equipment Equipment

Y (`) Z (`)

Direct material cost 300 450

Direct labour cost 450 600
Overheads* 186.38 248.50

936.38 1,298.50

Budgeted overheads ` 12,42,500

*Pre-determined rate = = = `62.125
Budgeted direct labour hours 20,000 hours

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5.20 COST AND MANAGEMENT ACCOUNTING

(ii) Estimation of Cost-Driver rate

Activity Overhead cost Cost-driver level Cost driver rate
(`) (`)
Order processing 2,10,000 600 350
Orders processed
Machine processing 8,75,000 50,000 17.50
Machine hours
Inspection 1,57,500 15,000 10.50
Inspection hours

Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Prime Cost 750 1,050
Overhead Cost
Order processing 350 : 250 1,22,500 87,500
Machine processing 23,000 : 27,000 4,02,500 4,72,500
Inspection 4,000 : 11,000 42,000 1,15,500
Total overhead cost 5,67,000 6,75,500

Per unit cost ` `

5,67,000 /2,500 226.80 `. 216.16
6,75,500/ 3,125
Unit manufacturing cost 976.80 1,266.16
(iii)
Equipment Equipment
Y (`) Z (`)
Unit manufacturing cost–using direct labour
hours as an application base 936.38 1,298.50
Unit manufacturing cost–using activity 976.80 1,266.16
based costing
Cost distortion (–) 40.42 + 32.34
Low volume product Y is under-costed and high volume product Z is over costed
using direct labour hours for overhead absorption

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ACTIVITY BASED COSTING 5.21

SUMMARY
• Activity based costing is an accounting methodology that assigns costs to activ-
ities rather than products or services. This enables resources & overhead costs
to be more accurately assigned to products & services that consume them
• Unit level activities, batch level activities, product level activities and facility level
activities are the categories of activities helps to determine the type of activity
cost driver required
• ABC is very much useful to the organization with multiple product
• One of the few weakness of ABC is, it is very costly and cannot be applied to all
companies
• The use of ABC as a costing tool to manage costs at activity level is known as
activity based cost management (ABM). ABM is a discipline that focuses on the
efficient and effective management of activities as the route to continuously
improving the value received by customers. ABM utilizes cost information gath-
ered through ABC.
• The value-added activities are those activities which are indispensable in order
to complete the process.
• NVA activity represents work that is not valued by the external or internal cus-
tomer. NVA activities do not improve the quality or function of a product or
service, but they can adversely affect costs and prices.
• Activity-based budgeting is a process of planning and controlling the expected
activities for the organisation to derive a cost-effective budget that meets fore-
cast workload and agreed strategic goals.
• Key elements of ABB are type of work/activity to be performed, quantity of
work/activity to be performed and cost of work/activity to be performed.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. A cost driver is:
(a) An item of production overheads
(b) A common cost which is shared over cost centres
(c) Any cost relating to transport
(d) An activity which generates costs
2. In activity based costing, costs are accumulated by activity using:
(a) Cost drivers
(b) Cost objects

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5.22 COST AND MANAGEMENT ACCOUNTING

(c) Cost pools

(d) Cost benefit analysis
3. A cost driver:
(a) Is a force behind the overhead cost
(b) Is an allocation base
(c) Is a transaction that is a significant determinant of cost
(d) All of the above
4. Which of the following is not a correct match:
Activity Cost Driver
a) Production Scheduling Number of Production runs
b) Despatching Number of dispatch orders
c) Goods receiving Goods received orders
d) Inspection Machine hours
5. Transactions undertaken by support department personnel are the appropriate
cost drivers. They are:
(a) The number of purchase, supplies and customers’ orders drives the cost as-
sociated with new material inventory, work-in-progress and finished goods
inventory
(b) The number of production runs undertaken drives production scheduling,
inspection and material handling
(c) The quality of raw material issued drives the cost of receiving department
costs
(d) The number of packing orders drives the packing costs
6. Steps in ABC include:
(a) Identification of activities and their respective costs
(b) Identification of cost driver of each activity and computation of an allocation
rate per activity
(c) Allocation of overhead cost to products/ services based on the activities in-
volved
(d) All of the above
7. Which of the following is not a benefit of ABC?
(a) Accurate cost allocation
(b) Improved decision making
(c) Better control on activity and costs
(d) Reduction of prime cost

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ACTIVITY BASED COSTING 5.23

8. The steps involved for installation of ABC in a manufacturing company include the
following except:
(a) Borrowing fund
(b) Feasibility study
(c) Building up necessary IT infrastructure and training of line employees
(d) Strategy and value chain analysis
9. Which of the following statements are true: (1) Activity based Management in-
volves activity analysis and performance measurement. (2) Activity based costing
serves as a major source of information in ABM.
(a) (1) True; (2) False
(b) (1) True; (2) True
(c) (1) False; (2) True
(c) (1) False; (2) False
10. The key elements of activity based budgeting are:
(a) Type of activity to be performed
(b) Quantity of activity to be performed
(c) Cost of activity to be performed
(d) All of the above
Theoretical Questions:
1. Define the following terms:
(i) Cost driver
(ii) Activity cost pool
2. Explain in brief the problems of traditional costing where overhead costs are allo-
cated based on volume
3. What is Activity based costing? How product costs determined in ABC?
4. A manufacturing company in India wants to replace its traditional costing system
by ABC. It produces a number of products, each having complex production pro-
cess of different degree. Suggest various requirements for installing activity based
costing.
5. Describe various level of activities under ABC.
6. What are the benefits of ABC?
7. What are the limitations of ABC?
8. What are the practical application of ABC?
9. What is Activity based Management? How does ABC help ABM?
10. Define Activity based Budgeting. What are its key elements?

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5.24 COST AND MANAGEMENT ACCOUNTING

Practical Problems
1. 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, 20X7 in respect of RST Limited has been
reported:
General Drugstore Chains Chemist Shops
Supermarket Chains (`)
(`) (`)
Average revenue per 84,975 28,875 5,445
delivery
Average cost of 82,500 27,500 4,950
goods sold per de-
livery
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 Purchase orders by customers
Line-item ordering Line-items per purchase order
Store delivery Store deliveries
Cartons dispatched to stores Cartons dispatched to a store per delivery
Shelf-stocking at customer store Hours of shelf-stocking
The April, 20X7 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 April, 20X7 are
as follows:

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ACTIVITY BASED COSTING 5.25

Activity Area Total costs in Total Units of Cost

April, 20X7 (`) Allocation Base used in
April, 20X7
Customer purchase order pro- 2,20,000 5,500 orders
cessing
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-stocking at customer store 28,160 1,760 hours
Other data for April, 20X7 include the following:
General Drugstore Chemist
Supermarket Chains Shops
Chains
Total number of orders 385 990 4,125
Average number of line items per 14 12 10
order
Total number of store deliveries 330 825 2,750
Average number of cartons shipped 300 80 16
per store delivery
Average number of hours of shelf- 3 0.6 0.1
stocking per store delivery
Required:
(i) Compute for April, 20X7 gross-margin percentage for each of its three distribution
channels and compute RST Limited’s operating income.
(ii) Compute the April, 20X7 rate per unit of the cost-allocation base for each of the
five activity areas.
(iii) Compute the operating income of each distribution channel in April, 20X7 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 April, 20X7 operating
costs of ` 8,27,970 to five activity areas.
2. 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:

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5.26 COST AND MANAGEMENT ACCOUNTING

Customers
A B C D E
Cases sold 4,680 19,688 1,36,800 71,550 8,775
List Selling Price ` 108 ` 108 `. 108 ` 108 ` 108
Actual Selling Price ` 108 ` 106.20 ` 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
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) What insights are gained by reporting both the list selling price and the actual
selling price for each customer?
ANSWERS/SOLUTIONS
Answers to the MCQs based Questions
1. (d) 2. (c) 3. (d) 4. (d) 5. (c) 6. (d)
7. (d) 8. (a) 9. (c) 10. (d)
Answers to the Theoretical Questions
1. Please refer paragraph 5.3
2. Please refer paragraph 5.1
3. Please refer paragraph 5.2 and 5.5
4. Please refer paragraph 5.10
5. Please refer paragraph 5.6
6. Please refer paragraph 5.8
7. Please refer paragraph 5.9

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ACTIVITY BASED COSTING 5.27

8. Please refer paragraph 5.11

9. Please refer paragraph 5.11.2
10. Please refer paragraph 5.11.3
Answers to the Practical Questions
1.
(i) RST Limited’s
Statement of operating income and gross margin percentage for each of its
three distribution channel
General Super Drugstore Chemist Total
Market Chains Chains Shops
Revenues: (`) 2,80,41,750 2,38,21,875 1,49,73,750 6,68,37,375
(330 × ` (825 × ` 28,875) (2,750 × `
84,975) 5,445)
Less: Cost of 2,72,25,000 2,26,87,500 1,36,12,500 635,25,000
goods sold: (`) (330 × ` (825 × ` (2,750 × `
82,500) 27,500) 4,950)
Gross Margin: 8,16,750 11,34,375 13,61,250 33,12,375
(`.)
Less: Other
operating costs:
(`) 8,27,970
Operating in- 24,84,405
come: (`.)
Gross Margin 2.91% 4.76 % 9.09% 4.96%
Operating in- 3.72
come %
(ii) Computation of rate per unit of the cost allocation base for
each of the five activity areas for April 20X7
(`)
Customer purchase order processing 40 order
(`. 2,20,000/ 5,500 orders)
Line item ordering 3 line item order
(`. 1,75,560/ 58,520 line items)

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5.28 COST AND MANAGEMENT ACCOUNTING

Store delivery 50 delivery

(` 1,95,250/ 3,905 store deliveries)
Cartons dispatched 1 dispatch
(` 2,09,000/ 2,09,000 dispatches)
Shelf-stocking at customer store (`) 16 hour
(` 28,160/ 1,760 hours)
(i) Operating Income Statement of each distribution channel
in April-20X7 (Using the Activity based Costing information)
General Super Drugstore Chemist
Market Chains Chains Shops
Gross margin (`.) : (A) 8,16,750 11,34,375 13,61,260
(Refer to (i) part of the answer)
Operating cost (`.) : (B) 1,62,910 1,90,410 4,74,650
(Refer to working note)
Operating income (`.) : (A–B) 6,53,840 9,43,965 8,86,600
Operating income (in %) 2.33 3.96 5.96
(Operating income/ Revenue) ×
100
Comments and new insights : The activity-based cost information highlights, how
the ‘Chemist Shops’ uses a larger amount of RST Ltd’s resources per revenue than do
the other two distribution channels. Ratio of operating costs to revenues, across these
markets is:
General supermarket chains 0.58%
(` 1,62,910/ `. 2,80,00,750) × 100

Drug store chains 0.80%

(` 1,90,410/ ` 2,38,21,875) × 100

Chemist shops 3.17%

(` 4,74,650/ ` 1,49,73,750) ×100

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ACTIVITY BASED COSTING 5.29

Working note:
Computation of operating cost of each distribution channel:
General Super Drugstore Chains Chemist Shops (`)
Market Chains (`) (`)
Customer purchase 15,400 39,600 1,65,000
order processing (`. 40 × 385 or- (` 40 × 990 orders) (` 40 ×4125 orders)
ders)
Line item ordering 16,170 35,640 1,23,750
(` 3 × 14 x 385) (` 3 × 12 x 990) (` 3 × 10 × 4125)
Store delivery 16,500 41,250 1,37,500
(` 50 × 330 deliv- (` 50 × 825 deliv- (` 50 × 2750
eries) eries) deliveries)
Cartons dispatched 99,000 66,000 44,000
(` 1 × 300 cartons (` 1 × 80 cartons × (`1 × 16 cartons ×
× 300 deliveries) 825 deliveries) 2,750 deliveries)
Shelf stocking 15,840 7,920 4,400
(` 16 × 330 deliv- (` 16 × 825 deliv- (` 16 × 2,750 deliv-
eries × 3 Av. hrs.) eries × 0.6 Av. hrs) eries × 0.1 Av. hrs)
Operating cost 1,62,910 1,90,410 4,74,650
(iv) Challenges faced in assigning total operating cost of ` 8,27,970 :
- Choosing an appropriate cost driver for activity area.
- Developing a reliable data base for the chosen cost driver.
- Deciding, how to handle costs that may be common across several activities.
- Choice of the time period to compute cost rates per cost driver.
- Behavioural factors.
2
Working note:
Computation of revenues (at listed price), discount, cost of goods sold
and customer level operating activities costs:
Customers
A B C D E
Cases sold: (a) 4,680 19,688 1,36,800 71,550 8,775
Revenues (at listed 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
price) (`.): (b)
{(a) × ` 108)}
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5.30 COST AND MANAGEMENT ACCOUNTING

Discount (`): (c) - 35,438 12,31,200 2,57,580 94,770

{(a) × Discount per (19,688 (1,36,800 (71,550 (8,775 cases
case} cases × ` cases × cases × ` × `. 10.80)
1.80) ` 9) 3.60)
Cost of goods sold 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
(`) : (d)
{(a) × ` 90}
Customer level operating activities costs
Order taking costs 11,250 18,750 22,500 18,750 22,500
(`):
(No. of purchase ×
`750)
Customer visits 1,200 1,800 3,600 1,200 1,800
costs (`)
(No. of customer
visits × ` 600)
Delivery vehicles 1,150 1,035 1,725 2,300 3,450
travel costs (`)
(` 5.75 per km)
(Kms travelled by
delivery vehicles ×
`. 5.75 per km.)
Product handling 17,550 73,830 5,13,000 2,68,313 32,906
costs (`)
{(a) × `. 3.75}
Cost of expediting - - - - 2,250
deliveries (`)
{No. of expedited
deliveries × `
2,250}
Total cost of cus- 31,150 95,415 5,40,825 2,90,563 62,906
tomer level operat-
ing activities (`)

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ACTIVITY BASED COSTING 5.31

(i) Computation of Customer level operating income

Customers
A (`) B (`) C (`) D (`) E (`)
Revenues 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
(At list price)
(Refer to working note)
Less: Discount - 35,438 12,31,200 2,57,580 94,770
(Refer to working note)
Revenue 5,05,440 20,90,866 1,35,43,200 74,69,820 8,52,930
(At actual price)
Less: Cost of goods 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
sold (Refer to working
note)

Gross margin 84,240 3,18,946 12,31,200 10,30,320 63,180

Less: Customer level 31,150 95,415 5,40,825 2,90,563 62,906
operating activities
costs (Refer to working
note)

Customer level operat- 53,090 2,23,531 6,90,375 7,39,757 274

ing income
Comment on the results:
Customer D is the most profitable customer, despite having only 52.30% of the unit
volume of customer C. The main reason is that C receives a ` 9 per case discount while
customer D receives only a ` 3.60 discount per case.
Customer E is less profitable, in comparison with the small customer A being profita-
ble. Customer E received a discount of ` 10.80 per case, makes more frequent orders,
requires more customer visits and requires more delivery kms. in comparison with
customer A.
(ii) Insight gained by reporting both the list selling price and the actual sell-
ing price for each customer:
Separate reporting of both-the listed and actual selling prices enables Alpha Ltd. to
examine which customer has received what discount per case, whether the discount
received has any relationship with the sales volume. The data given below provides us
with the following information;

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5.32 COST AND MANAGEMENT ACCOUNTING

Sales volume Discount per case (`)

C (1,36,800 cases) 9.00
D (71,550 cases) 3.60
B (19,688 cases) 1.80
E (8,775 cases) 10.80
A (4,680 cases) 0
The above data clearly shows that the discount given to customers per case has a di-
rect relationship with sales volume, except in the case of customer E. The reasons for
10.80 discount per case for customer E should be explored.

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CHAPTER 6
COST SHEET
LEARNING OUTCOMES
r Classify and ascertain cost on the basis of function.
r Prepare cost sheet/ statement for production of goods and
providing services.

CHAPTER OVERVIEW

6.1 INTRODUCTION
One of the objectives of cost accounting system is ascertainment of cost for
a cost object. The cost objects may be a product, service or any cost centre.
Ascertainment of cost includes elementwise collection of 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. In this chapter, a product or a service will be the cost object for cost
calculation and cost ascertainment. A Cost Sheet or Cost Statement is “a
document which provides a detailed cost information. In a typical cost sheet,
cost information are presented on the basis of functional classification.
However, other classification may also be adopted as per the requirements of
users of the information.

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6.2 COST AND MANAGEMENT ACCOUNTING

6.2 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:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.

6.3 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:
(i) Prime Cost
(ii) Cost of Production
(iii) Cost of Goods Sold
(iv) Cost of Sales
6.3.1 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 xxx
Direct Employees (labour) Cost xxx
Direct Expenses xxx
Prime Cost: xxxx
(i) 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
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COST SHEET 6.3

The valuation of materials purchased and issued for production shall be done as
per methods discussed in the ‘Chapter- 2 Material Cost’.
(ii) 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:
(a) Wages and salary;
(b) Allowances and incentives;
(c) Payment for overtimes;
(d) Employer’s contribution to Provident fund and other welfare funds;
(e) Other benefits (leave with pay, free or subsidised food, leave travel concession
etc.).
(iii) 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:
(a) Royalty paid/ payable for production or provision of service;
(b) Hire charges paid for hiring specific equipment;
(c) Cost for product/ service specific design or drawing;
(d) Cost of product/ service specific software;
(e) Other expenses which are directly related with the production of goods or
provision of service.
6.3.2 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 xxxx
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 xxx
related)
Add: Administrative Overheads related with xxx
production

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6.4 COST AND MANAGEMENT ACCOUNTING

Less: Credit for recoveries (miscellaneous income) (xxx)

Add: Packing Cost (Primary packing) xxx
Cost of Production xxxx
(i) Factory Overheads : It is also known as works/ production/ manufacturing
overheads. It includes the following indirect costs:
(a) Consumable stores and spares.
(b) Depreciation of plant and machinery, factory building etc.
(c) Lease rent of production assets.
(d) Repair and maintenance of plant and machinery, factory building etc.
(e) Indirect employees cost connected with production activities.
(f) Drawing and Designing department cost.
(g) Insurance of plant and machinery, factory building, stock of raw material &
WIP etc.
(h) Amortized cost of jigs, fixtures, tooling etc.
(i) Service department cost such as Tool Room, Engineering & Maintenance,
Pollution Control etc.
(ii) Stock of Work-in-process : The cost of opening and closing stock of work-in-
process is adjusted to arrive at factory/ works cost. The WIP stock is valued on the
basis of percentage of completion in respect of each elements of cost. Students
may refer the ‘Chapter- Process & Operation Costing’ to know the WIP valuation
methods.
(iii) Quality Control Cost : This is the cost of resources consumed towards quality
control procedures.
(iv) Research & Development cost : It includes only those research and
development related cost which with is incurred to improvement of process,
system, product or services.
(v) Administrative Overheads : It includes the cost of production administration
only. The general administration overhead is not included in production cost.
(vi) Credit for recoveries : The realised or realisable value of scrap or waste is
deducted.
(vii) Packing Cost (primary) : Packing material which is essential to hold and
preserve the product for its use by the customer.
6.3.3 Cost of Goods Sold
It is the cost of production for goods sold. It is calculated after adjusting the
values of opening and closing stocks of finished goods. It can be calculated as
below:

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COST SHEET 6.5

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
6.3.4 Cost of Sales
It is the total cost of a product incurred to make the product available to the
customer or consumer. It includes Cost of goods sold, administration and
marketing expenses. 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
(i) Administrative Overheads : It is the cost related with general administration of
the entity. It includes the followings:
(a) Depreciation and maintenance of machines, building, furniture etc. of
corporate or general management.
(b) Salary of administrative employees, accountants, directors, secretaries
etc.
(c) Rent, insurance, lighting, office expenses etc.
(ii) Selling Overheads : It is the cost related with sale of products or services. It
includes the following costs:
(a) Salary and wages related with sales department and employees directly
related with selling of goods.
(b) Rent, depreciation, maintenance and other cost related with sales
department.
(c) Cost of advertisement, maintenance of website for online sales, market
research etc.
(iii) Packing cost (secondary) : Packing material that enables to store, transport,
inform the customer, promote and otherwise make the product marketable.
(iv) Distribution Overheads : It includes the cost related with making the goods
available to the customers. The costs are
(a) Salary and wages of employees engaged in distribution of goods.
(b) Transportation and insurance costs related with distribution.
(c) Depreciation, hire charges, maintenance and other operating costs
related with distribution vehicles etc.
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6.6 COST AND MANAGEMENT ACCOUNTING

6.4 COST SHEET/STATEMENT

6.4.1 Presentation of cost information
The cost items in the cost statement shall be presented on ‘basis of relevant classification’.
Specimen Format of Cost Sheet for a Manufacturing entity
Particulars Total Cost per
Cost (`) unit (`)
1. Direct materials 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. 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. Quality Control Cost xxx
11. Research and Development Cost xxx
12. Administrative Overheads (relating to production xxx
activity)
13. Less: Credit for Recoveries/Scrap/By-Products / (xxx)
misc. income
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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COST SHEET 6.7

6.4.2 Advantages of Cost sheet or Cost Statements

The main advantages of a Cost Sheet are as follows:
(i) It provides the total cost figure as well as cost per unit of production.
(ii) It helps in cost comparison.
(iii) It facilitates the preparation of cost estimates required for submitting tenders.
(iv) It provides sufficient help in arriving at the figure of selling price.
(v) 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, 20X8:

Raw materials ` 1,80,000

Direct wages ` 90,000
Machine hours worked (hours) 10,000
Machine hour rate (per hour) `8
Administration overheads ` 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:
(i) Cost per unit
(ii) Profit for the month
SOLUTION
(i) Cost Sheet Output: 4,000 units
Total Cost (`) Cost per (unit)
(`)
Raw materials 1,80,000 45.00
Direct wages 90,000 22.50
Prime cost 2,70,000 67.50
Add: Factory overheads (10,000 hrs × ` 8 per 80,000 20.00
hour)
Cost of Production 3,50,000 87.50
Less: Closing Stock of finished goods (4,000 – (35,000) --
3,600 units)

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6.8 COST AND MANAGEMENT ACCOUNTING

Cost of Goods Sold 3,15,000 87.50

Add: Administration overheads 35,000 8.75
Add: Selling Overheads (3,600 units × ` 5 unit) 18,000 5.00
Cost of sales (total Cost) 3,68,000 101.25
(ii) Statement of Profit
Total Cost (`)
Sales revenue (3,600 units @ ` 125) 4,50,000
Less: Cost of sales 3,68,000
Profit 82,000
ILLUSTRATION 2
The following information has been obtained from the records of ABC Corporation
for the period from June 1 to June 30, 20X8.
On June 1, On June 30,
20X8 (`) 20X8 (`)
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’ 20X8 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:
(a) Raw materials consumed;
(b) Prime cost;
(c) Factory cost;
(d) Cost of goods sold; and
(e) Net profit.

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COST SHEET 6.9

SOLUTION
Statement of Cost & Profit
(for the month of June 20X8)
Amount (`)
Opening stock of raw materials 60,000
Add: Purchase of raw materials during June’ 20X8 4,80,000
Less: Closing stock of raw materials (50,000)
(a) Raw materials consumed 4,90,000
Add: Direct wages 2,40,000
(b) Prime cost 7,30,000
Add: Factory overheads 1,00,000
Works cost 8,30,000
Add: Opening work-in-process 12,000
Less: Closing work-in-process (15,000)
(c) Factory cost 8,27,000
Add: Administration overheads 50,000
Cost of production 8,77,000
Add: Opening stock of finished goods 90,000
Less: Closing stock of finished goods (1,10,000)
(d) Cost of goods sold 8,57,000
Add: Selling & distribution overheads 25,000
Cost of sales 8,82,000
(e) Net Profit 1,18,000
Sales 10,00,000

SUMMARY
w Cost Sheet : A Cost Sheet or Cost Statement is “a document which provides a
detailed cost information. In a typical cost sheet, cost information are presented
on the basis of functional classification. However, other classification may also be
adopted as per the requirements of users of the information.
w Prime Cost : Prime cost represents the total of direct materials costs, direct
employee (labour) costs and direct expenses.
w 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.
w Cost of Sales : It is the total cost of a product incurred to make the product
available to the customer or consumer.
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6.10 COST AND MANAGEMENT ACCOUNTING

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Generally, for the purpose of cost sheet preparation, costs are classified on
the basis of:
(a) Functions
(b) Variability
(c) Relevance
(d) Nature
2. Which of the following does not form part of prime cost:
(a) Cost of packing
(b) Cost of transportation paid to bring materials to factory
(c) GST paid on raw materials (input credit can be claimed)
(d) Overtime premium paid to workers.
3. A Ltd. received an order, for which it purchased a special frame for
manufacturing, it is a part of:
(a) Direct Materials
(b) Direct expenses
(c) Factory Overheads
(d) Administration Overheads
4. Salary paid to plant supervisor is a part of
(a) Direct expenses
(b) Factory overheads
(c) Quality control cost
(d) Administration cost
5. Depreciation of director’s laptop is treated as a part of:
(a) Administration Overheads
(b) Factory Overheads
(c) Direct Expenses
(d) Research & Development cost.
6. A manufacturer has set-up a lab for testing of products for compliance with
standards, salary of this lab staffs are part of:
(a) Works overheads
(b) Quality Control Cost
(c) Direct Expenses
(d) Research & Development Cost.
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COST SHEET 6.11

7. Audit fees paid to auditors is part of:

(a) Administration Cost
(b) Production cost
(c) Selling & Distribution cost
(d) Not shown in cost sheet.
8. Salary paid to factory store staff is part of:
(a) Factory overheads
(b) Production Cost
(c) Direct Employee cost
(d) Direct Material Cost.
9. Canteen expenses for factory workers are part of:
(a) Factory overhead
(b) Administration Cost
(c) Marketing cost
(d) None of the above.
10. A company pays royalty to State Government on the basis of production, it
is treated as:
(a) Direct Material Cost
(b) Factory Overheads
(c) Direct Expenses
(d) Administration cost.
Theoretical Questions
1. Describe how costs are classified on the basis of function?
2. Explain the treatment of administration overheads.
3. State the advantages of cost sheets.
Practical Questions
1. The books of Adarsh Manufacturing Company present the following data for
the month of April, 20X9:
Direct labour cost ` 17,500 being 175% of works overheads.
Cost of goods sold excluding administrative expenses ` 56,000.

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6.12 COST AND MANAGEMENT ACCOUNTING

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:
(i) Compute the value of materials purchased.
(ii) Prepare a cost statement showing the various elements of cost and also the
profit earned.
2. 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.
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COST SHEET 6.13

(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.
ANSWERS/ SOLUTIONS
Answers to the MCQs based Questions
1. (a) 2. (a) 3. (b) 4. (b) 5. (a) 6. (b)
7. (a) 8. (a) 9. (a) 10. (c)
Answers to the Theoretical Questions
1. Please refer paragraph 6.1
2. Please refer paragraph 6.3
3. Please refer paragraph 6.4
Answers to the Practical Questions
1. (i) Computation of the value of materials purchased
(`)
Cost of goods sold 56,000
Add: Closing stock of finished goods 19,000
Less: Opening stock of finished goods (17,600)
Cost of goods manufactured 57,400
Add: Closing stock of work-in-progress 14,500
Less: Opening stock of work-in-progress (10,500)
Works cost 61,400
 100  (10,000)
Less: Factory overheads:  of Direct labour cost 
 175 
Prime cost 51,400
Less: Direct labour (17,500)
Raw material consumed 33,900
Add: Closing stock of raw materials 10,600
Raw materials available 44,500
Less: Opening stock of raw materials (8,000)
Value of materials purchased 36,500

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6.14 COST AND MANAGEMENT ACCOUNTING

(ii) Cost statement

(`)
Raw material consumed [Refer to statement (i) above] 33,900
Add: Direct labour cost 17,500
Prime cost 51,400
Add: Factory overheads 10,000
Works cost 61,400
Add: Opening work-in-progress 10,500
Less: Closing work-in-progress (14,500)
Cost of goods manufactured 57,400
Add: Opening stock of finished goods 17,600
Less: Closing stock of finished goods (19,000)
Cost of goods sold 56,000
Add: General and administration expenses 2,500
Add: Selling expenses 3,500
Cost of sales 62,000
Profit (Balance figure ` 75,000 – ` 62,000) 13,000
Sales 75,000
2. (a) Cost Sheet (For the month)
Level of Capacity 30% 100%
30,000 units 1,00,000 units
Per unit (`) Total (`) Per unit (`) Total (`)
Works Cost 380.00 1,14,00,000 310.00 3,10,00,000
Add: Fixed administration 5.00 1,50,000 1.50 1,50,000
expenses
Add: Fixed marketing 8.33 2,50,000 2.50 2,50,000
expenses
Add: Variable distribution cost 30.00 9,00,000 30.00 30,00,000
Add: Special Costs
- Gift items costs - - 30.00 30,00,000
- Customers’ prizes* - - 1.00 1,00,000
- Refreshments - - 1.00 1,00,000
- Television programme - - 20.00 20,00,000
sponsorship cost

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COST SHEET 6.15

Cost of sales 423.33 1,27,00,000 396.00 3,96,00,000

Profit (Balancing figure) 126.67 38,00,000 104.00 1,04,00,000
Sales revenue 550.00 1,65,00,000 500.00 5,00,00,000
*Customers’ prize cost:
Amount (`)
1 Prize
st
50,000
2nd Prize 25,000
3rd Prize 10,000
Consolation Prizes (3 × `5,000) 15,000
Total 1,00,000

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CHAPTER 7
COST ACCOUNTING
SYSTEM
LEARNING OUTCOMES
r Discuss the Cost Accounting System.
r Differentiate between Integral and Non- Integral system of
accounting.
r Identify the ledgers maintained under Integral and Non-
Integral accounting system.
r Analyse the reasons for differences in profit under financial
and cost accounts.
r Prepare reconciliation statement for profit under financial
and cost accounts.
r Discuss the accounting for management information and
cost control.

CHAPTER OVERVIEW

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7.2 COST AND MANAGEMENT ACCOUNTING

7.1 INTRODUCTION
To operate business operations efficiently and successfully, it is necessary to make
use of an appropriate accounting system. Such a system should state in clear terms
whether cost and financial transactions should be integrated or kept separately (Non-
integrated). Where cost and financial accounting records are integrated, the system
so evolved is known as integrated or integral accounting. In case cost and financial
transactions are kept separately, the system is called Non-Integrated Accounting or Cost
Control System. While non-integrated system of accounting necessitates reconciliation
between financial and cost accounts, no reconciliation between two sets of accounts is
required under integrated accounting.

7.2 NON - INTEGRATED ACCOUNTING SYSTEM

It is a system of accounting under which separate ledgers are maintained for cost
and financial accounts by Accountants. This system is also referred to as cost ledger
accounting system. Under such a system the cost accounts restrict itself to recording
only those transactions which relate to the product or service being provided. Hence
items of expenses which have a bearing with sales or, production or for that matter any
other items which are under the 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’.
A special feature of the non-integrated system of accounts is its ability to deal with
notional expenses like rent or interest on capital tied up in the stock. The accounting
of notional rent facilitates c omparisons amongst factories (some owned and some
rented).
Non-Integrated Accounting Systems contain fewer accounts when compared with
financial accounting because of 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 department are the following:
(a) 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.
(b) 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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COST ACCOUNTING SYSTEMS 7.3

(c) 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 account in this ledger. The balance
in a job account represents total balance of job/work-in-process, as shown by the job
account.
(d) 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 stores, a
credit entry is made in the work-in-process ledger and a corresponding debit entry is
made in this ledger.
7.2.1 Principal Accounts
The main accounts which are usually prepared when a separate Cost Ledger is
maintained are as follows:
(1) 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 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
account
(2) Stores Ledger Control Account –This account is debited for the purchase of
material and credited for issue of materials from 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.
(3) 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.
(4) 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 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.

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7.4 COST AND MANAGEMENT ACCOUNTING

(5) 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.
(6) Administrative Overhead Control Account - This account is debited with
overhead 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.
(7) Finished Goods Control Accounts - This account is debited with the value of
goods transferred from Work-in-process Control Account, 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 lying at
hand.
(8) 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.
(9) Cost of Sales Account - This account is debited with the cost of finished goods
transferred from Finished Goods Control Accou nt for sale, Administrative
overhead recovered, Selling and distribution overhead recovered. The balance of
this account is ultimately transferred to Sales Account or Costing Profit & Loss
Account.
(10) Costing Profit & Loss Account – This account is debited with cost of goods
sold, 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.
(11) 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.
7.2.2 Scheme of Entries
The manner in which the Cost Ledger, when maintained on a double entry basis,
would operate is illustrated by the following statements of various journal entries
as would appear in the cost books.
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COST ACCOUNTING SYSTEMS 7.5

Material:
(a) Purchase—` 5,000 (credit or cash) (`) (`)
(i) Material Control A/c …………………………….. Dr. 5,000
To Cost Ledger Control A/c 5,000
(ii) Stores Ledger Control A/c ……………………… Dr. 5,000
To Material Control A/c 5,000
Note: Sometimes Material Control Account is dispensed with and entries are directly
made into Stores Ledger Control A/c, giving a credit to Cost Ledger Control A/c.
(b) Purchases worth ` 500 for special job
Work-in-Process Ledger Control A/c…………………. Dr. 500
To Cost Ledger Control A/c 500
(c) Material returned to vendor—` 500
Cost Ledger Control A/c …………………………………. Dr. 500
To Store Ledger Control A/c 500
(d) (i) Material (Direct) issued to production—` 1,000
Work-in-Process Control A/c……………………. Dr. 1,000
To Store Ledger Control A/c 1,000
(ii) Material (Indirect) issued to production—` 200
Production Overhead Control A/c…………………. Dr. 200
To Store Ledger Control A/c 200
(e) (i) Material worth ` 200 returned from shop to stores
Stores Ledger Control A/c…………………. Dr. 200
To Work-in-Process Control A/c 200
(ii) Material worth ` 100 is transferred from Job-1 to Job- 2
Job- 2 A/c………………………………………… Dr. 100
To Job- 1 A/c 100
(f) Material worth ` 100 is issued from stores for re¬pairs
Production Overhead Control A/c………………………. Dr. 100
To Stores Ledger Control A/c 100
Labour:
(g) Direct wages paid to workers— ` 1,000
Wages Control A/c………………………………………… Dr. 1,000
To Cost Ledger Control A/c 1,000

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7.6 COST AND MANAGEMENT ACCOUNTING

(h) Indirect wages paid to workers in the production— ` 700

(i) Wages Control A/c……………………………………… Dr. 700
To Cost Ledger Control A/c 700
(ii) Production Overhead Control A/c…………………… Dr. 700
To Wages Control A/c 700
(i) Indirect wages paid to workers in administration— ` 500
(i) Wages Control A/c……………………………………… Dr. 500
To Cost Ledger Control A/c 500
(ii) Administration Overhead A/c………………………… Dr. 500
To Wages Control A/c 500
(j) Indirect wages paid to workers in Selling & Dist. department— ` 300
(i) Wages Control A/c……………………………………… Dr. 300
To Cost Ledger Control A/c 300
(ii) Selling & Dist. Overhead A/c…………………………. Dr. 300
To Wages Control A/c 300
Direct Expenses:
(k) Direct expenses incurred ` 500 for Job No. 12
Job No. 12 A/c (WIP Control A/c)………………………. Dr. 500
To Cost Ledger Control A/c 500
Overheads:
(l) Overhead expenses incurred ` 500 (Production ` 150;
Administrative ` 150; Selling and Distribution ` 200)
Production Overhead Control A/c……………………….. Dr. 150
Administrative Overhead Control A/c…………………… Dr 150
Selling & Dist. Overhead Control A/c…………………… Dr 200
To Cost Ledger Control A/c 500
(m) Carriage Inward (Direct to Factory)—` 100
Production Overhead Control A/c……………………….. Dr. 100
To Cost Ledger Control A/c 100
(n) Production overhead recovered—` 1,000
Work-in-Process Ledger Control A/c…………………... Dr. 1,000
To Production Overhead Control A/c 1,000

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COST ACCOUNTING SYSTEMS 7.7

(o) Administrative Overhead recovered ` 500 from finished goods

Finished Goods Ledger Control A/c…………………….. Dr. 500
To Administrative Overhead Control A/c 500
(p) Selling and Distribution Overhead ` 100 recovered from sales
Cost of Sales A/c………………………………………….. Dr. 100
To Selling & Dist. Overhead Control A/c 100
(q) Under recovery of overheads
Costing Profit & Loss A/c…………………………………. Dr. xxx
To Administrative Overhead Control A/c xxx
(r) Over recovery of overheads
Production Overheads Control A/c…………………….. Dr. xxx
To Costing Profit & Loss A/c xxx
Sales :
(s) Cost Ledger Control A/c………………………………….. Dr. xxx
To Costing Profit & Loss A/c xxx
Profit/ Loss:
(t) In case of Profit
(i) Costing Profit & Loss A/c…………………………… Dr. xxx
To Cost Ledger Control A/c xxx
(u) In case of Loss
(ii) Cost Ledger Control A/c…………………………… Dr. xxx
To Costing Profit & Loss A/c xxx

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7.8 COST AND MANAGEMENT ACCOUNTING

Non-Integrated Accounting System-flowchart

* Administrative overhead is assumed to be related with production.

ILLUSTRATION 1
As on 31st March, 20X3, 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

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COST ACCOUNTING SYSTEMS 7.9

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.
SOLUTION
Journal entries are as follows:

Dr. Cr.

(`) (`)

1. Finished stock ledger Control A/c..................................... Dr. 2,10,835

To Work-in-Process Control A/c 2,10,835

2. Manufacturing Overhead Control A/c............................. Dr. 91,510

To Cost Ledger Control A/c 91,510

3. Stores Ledger Control A/c.................................................... Dr. 1,23,000

To Cost Ledger Control A/c 1,23,000

4. (i) Wages Control A/c.......................................................... Dr. 72,195

To Cost Ledger Control A/c 72,195

(ii) Work-in-Process Control A/c...................................... Dr. 50,530

To Wages Control A/c 50,530

(iii) Manufacturing Overhead Control A/c..................... Dr. 21,665

To Wages Control A/c 21,665

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7.10 COST AND MANAGEMENT ACCOUNTING

5. Cost of Sales A/c.......................................................................Dr. 1,85,890

To Finished Stock Ledger A/c 1,85,890

6. Work-in-Process Control A/c................................................Dr. 1,27,315

To Stores Ledger Control A/c 1,27,315

7. Finished Stock Ledger Control A/c.................................... Dr. 5,380

To Cost of Sales A/c 5,380

8. Cost Ledger Control A/c........................................................ Dr. 2,900

To Stores Ledger Control A/c 2,900

9. Work-in-Process Control A/c............................................... Dr. 77,200

To Manufacturing Overhead Control A/c 77,200

COST LEDGERS
Cost Ledger Control Account
(`) (`)
To Stores Ledger Control A/c 2,900 By Balance b/d 6,65,220
(return) ” Manufacturing OH Control 91,510
A/c
” Balance c/d 9,49,025 ” Stores Ledger Control A/c 1,23,000
” Wages Control A/c 72,195
9,51,925 9,51,925

Stores Ledger Control Account

(`) (`)

To Balance b/d 3,01,435 By Work in Process Control 1,27,315

A/c
” Cost Ledger Control A/c 1,23,000 ” Cost Ledger Control A/c 2,900

” Balance c/d 2,94,220

4,24,435 4,24,435

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COST ACCOUNTING SYSTEMS 7.11

Work-in-Process Control Account

(`) (`)

To Balance b/d 1,22,365 By Finished Stock Ledger 2,10,835

Control A/c

” Wages Control A/c 50,530 ” Balance c/d 1,66,575

” Stores Ledger Control A/c 1,27,315

” Manufacturing OH Control A/c 77,200

3,77,410 3,77,410

Finished Stock Ledger Control Account

(`) (`)
To Balance b/d 2,51,945 By Cost of Sales Control A/c 1,85,890
” Work in Process Control A/c 2,10,835 ” Balance c/d 2,82,270
” Cost of Sales Control A/c 5,380
(Return at cost)
4,68,160 4,68,160
Manufacturing Overhead Control Account
(`) (`)
To Cost Ledger Control A/c 91,510 By Balance b/d 10,525
” Wages Control A/c 21,665 ” Work in Process Control 77,200
A/c
” Balance c/d 25,450
1,13,175 1,13,175

Wages Control Account

(`) (`)
To Cost Ledger Control A/c 72,195By Work in Process Control 50,530
A/c
” Manufacturing OH Control 21,665
A/c
72,195 72,195

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7.12 COST AND MANAGEMENT ACCOUNTING

Cost of Sales Account

(`) (`)
To Finished Stock Ledger 1,85,890 By Finished Stock Ledger 5,380
Control Control (Return)
” Balance c/d 1,80,510

1,85,890 1,85,890

Trial Balance
Dr. Cr.
(`) (`)
Stores Ledger Control A/c 2,94,220
Work-in-Process Control A/c 1,66,575
Finished Stock Ledger Control A/c 2,82,270
Manufacturing Overhead Control A/c 25,450
Cost of Sales A/c 1,80,510
Cost Ledger Control A/c 9,49,025
9,49,025 9,49,025

ILLUSTRATION 2
From the following details show the necessary accounts in the Cost Ledger
Materials (`) Work-in-Process (`) Finished Stock (`)

Opening balance 8,000 5,000 10,000

Closing balance 11,000 9,000 12,000

Transactions during the period: (`)

Materials purchased 25,000
Wages paid (including ` 2,000 indirect) 10,000
Overheads incurred 8,000
Overheads absorbed 9,000
Sales 50,000

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COST ACCOUNTING SYSTEMS 7.13

SOLUTION
Cost Ledgers
Cost Ledger Control Account
(`) (`)
To Cost of Sales A/c 50,000 By Balance b/d
(8,000 + 5,000 + 10,000) 23,000
” Stores Ledger Control A/c 25,000
” Wages Control A/c 10,000
” Overheads Control A/c 8,000
” Balance c/d 32,000 ” Costing P&L A/c (profit) 16,000
(11,000 + 9,000 + 12,000)
82,000 82,000
Stores Ledger Control Account
(`) (`)
To Balance b/d 8,000 By Work-in-process A/c 22,000
(balancing figure)
” Cost Ledger Control A/c 25,000 ” Balance c/d 11,000
33,000 33,000
Work-in-process Control A/c
(`) (`)
To Balance b/d 5,000 By Finished stock 35,000
(balancing figure)
” Store Ledger Control A/c 22,000 ” Balance c/d 9,000
” Wages Control A/c 8,000
” Overheads Control A/c 9,000
44,000 44,000
Finished Stock Account
(`) (`)
To Balance b/d 10,000 By Cost of Sales A/c 33,000
(balancing figure)
” Work-in-Process Control A/c 35,000 ” Balance c/d 12,000
45,000 45,000

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7.14 COST AND MANAGEMENT ACCOUNTING

Wages Control Account

(`) (`)
To Cost Ledger Control A/c 10,000 By Work-in-process Control A/c 8,000
” Overheads A/c 2,000
10,000 10,000
Overheads Control Account
(`) (`)
To Cost Ledger Control A/c 8,000 By Work-in-process Control A/c 9,000
” Wages Control A/c 2,000 ” Costing P&L A/c* 1,000
10,000 10,000
* [(Overhead incurred + Indirect wages) – Overheads absorbed]
[(` 8,000 + ` 2,000) - ` 9,000] = ` 1,000 (under-absorption)
Cost of Sales Account
(`) (`)
To Finished Stock A/c 33,000 By Costing P&L A/c 33,000
33,000 33,000
Costing P & L Account
(`) (`)
To Cost of Sales A/c 33,000 By Cost Ledger Control A/c 50,000
(Sales A/c)
” Overheads Control (under- 1,000
absorbed)
” Cost Ledger Control A/c 16,000
(Profit) (balancing figure)
50,000 50,000
ILLUSTRATION 3
On 31st March, 20X3 the following balances were extracted from the books of the
Supreme Manufacturing Company:
Dr. (`) Cr. (`)
Stores Ledger Control A/c 35,000
Work-in-Process Control A/c 38,000
Finished Goods Control A/c 25,000
Cost Ledger Control A/c 98,000
98,000 98,000

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COST ACCOUNTING SYSTEMS 7.15

The following transactions took place in April 20X3:

(`)
Raw Materials:
-Purchased 95,000
-Returned to suppliers 3,000
-Issued to production 98,000
-Returned to stores 3,000
Productive wages 40,000
Indirect wages 25,000
Factory overhead expenses incurred 50,000
Selling and Administrative expenses 40,000
Cost of finished goods transferred to warehouse 2,13,000
Cost of Goods sold 2,10,000
Sales 3,00,000
Factory overheads are applied to production at 150% of direct wages, any under/over
absorbed overhead being carried forward for adjustment in the subsequent months. All
administrative and selling expenses are treated as period costs and charged off to the
Profit and Loss Account of the month in which they are incurred.
Show the following Accounts:
(a) Cost Ledger Control A/c
(b) Stores Ledger Control A/c
(c) Work-in-Process Control A/c
(d) Finished Goods Stock Control A/c
(e) Factory Overhead Control A/c
(f) Costing Profit and Loss A/c
(g) Trial Balance as at 30th April, 20X3.
SOLUTION
(a) Cost Ledger Control A/c
(`) (`)
To Costing P&L A/c (sales) 3,00,000 By Balance b/d 98,000
” Stores Ledger Control A/c 3,000 “ Stores Ledger Control A/c 9,5000
“ Wages Control A/c 65,000
(Productive + Indirect wages)

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7.16 COST AND MANAGEMENT ACCOUNTING

“ Factory OH Control A/c 50,000

“ Selling & Admn. OH A/c 40,000
” Balance c/d 95,000 “ Costing P&L A/c (profit) 50,000
3,98,000 3,98,000
(b) Stores Ledger Control A/c
(`) (`)
To Balance b/d 35,000 By Cost Ledger Control A/c 3,000
” Cost Ledger Control A/c 95,000 “ Work-in-process Control A/c 98,000
“ Work-in-process Control 3,000 “ Balance c/d 32,000
A/C
1,33,000 1,33,000
(c) Work-in-Process Control A/c
(`) (`)
To Balance b/d 38,000 By Stores Ledger Control A/c 3,000
” Strore Ledger Control A/c 98,000 “ Finished Goodes Control A/C 2,13,000
“ Wages Control A/c 40,000
“ Factory OH Control A/c 60,000 “ Balance c/d 20,000
2,36,000 2,36,000
(d) Finished Goods Control A/c
(`) (`)

To Balance b/d 25,000 By Cost of goods sold A/c 2,10,000

” Work-in-Process 2,13,000 ” Balance c/d 28,000

ControlA/c
2,38,000 2,38,000

(e) Factory Overhead Control A/c

(`) (`)
To Wages Control A/c (Indirect 25,000 By Work-in-process A/c 60,000
wages) (150% of `40,000)
” Cost Ledger Control A/c 50,000 ” Balance c/d 15,000
75,000 75,000

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COST ACCOUNTING SYSTEMS 7.17

(f) Costing Profit and Loss A/c

(`) (`)
To Cost of Goods Sold A/c 2,10,000 By Cost Ledger Control A/c 3,00,000
(Sales)
” Selling and Admn. 40,000
OH Control A/c
“ Cost Ledger Control A/c 50,000
(Profit) (balancing figure)
3,00,000 3,00,000
(g) Trial Balance (as at 30th April, 20X3)
Dr. (`) Cr. (`)
Stores Ledger Control A/c 32,000
Work-in-Process Control A/c 20,000
Finished Goods Control A/c 28,000
Factory Overhead Control A/c 15,000
Cost Ledger Control A/c 95,000
95,000 95,000
Working Notes:
(1) Wages Control A/c
(`) (`)
To Cost Ledger Control A/c 65,000 By Work-in-process Control A/c 40,000
” Factory OH Control A/c 25,000
65,000 65,000
(2) Cost of Goods Sold A/c
(`) (`)
To Finished Goods Control A/c 2,10,000 By Costing P&L A/c 2,10,000
2,10,000 2,10,000

(3) Selling & Administrative Expenses A/c

(`) (`)
To Cost Ledger Control A/c 40,000 By Costing P&L A/c 40,000
40,000 40,000

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7.18 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 4
Acme Manufacturing Co. Ltd. opens the costing records, with the balances as on 1st July,
20X2 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
The following are the transactions for the quarter ended 30th September 20X2:
(`)
Materials purchased 4,80,100
Materials issued to jobs 4,77,400
Materials to works maintenance 41,200
Materials to administration office 3,400
Materials to selling department 7,200
Wages direct 1,49,300
Wages indirect 65,000
Transportation for indirect materials 8,400
Production overheads 2,42,250
Absorbed production overheads 3,59,100
Administration overheads 74,000
Administration allocation to production 52,900
Administration allocation to sales 14,800
Sales overheads 64,200
Sales overheads absorbed 82,000
Finished goods produced 9,58,400
Finished goods sold 9,77,300
Sales realisation 14,43,000
Make up the various accounts as you envisage in the Cost Ledger and prepare a Trial
Balance as at 30th September, 20X2.

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SOLUTION
Cost Ledgers
Material Control A/c*
(`) (`)
To Balance b/d 1,24,000 By Work-in-process Control A/c 4,77,400
” Cost Ledger Control A/c 4,80,100 “ Production OH Control A/c 41,200
(purchase)
“ Admn. OH Control A/c 3,400
“ S&D OH Control A/c 7,200
“ Balance c/d 74,900
6,04,100 6,04,100
*Material Control A/c may also be written as Stores Ledger Control A/c
Wages Control A/c
(`) (`)
To Cost Ledger Control A/c 2,14,300 By Work-in-process Control A/c 1,49,300
” Production OH Control A/c 65,000
2,14,300 2,14,300
Work-in-Process Control A/c
(`) (`)
To Balance b/d 62,500 By Finished goods Control A/c 9,58,400
“ Material Control A/c 4,77,4000
Wages Control A/c 1,49,300
Production OH Control A/c 3,59,100
Admn. OH Control A/c 52,900 ” Balance c/d 1,42,800
11,01,200 11,01,200
Production Overhead Control A/c
(`) (`)
To Balance b/d 8,400 By Work-in-process Control A/c 3,59,100
” Cost Ledger Control A/c:
” -Transportation 8,400
” -Production OH 2,42,250
” Wages Control A/c 65,000
” Material Control A/c 41,200 ” Balance c/d 6,150
3,65,250 3,65,250

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7.20 COST AND MANAGEMENT ACCOUNTING

Administration Overhead Control A/c

(`) (`)
To Cost Ledger Control A/c: 74,000 By Balance b/d 12,000
” Material Control A/c 3,400 “ Work-in-process Control 52,000
A/c
” Balance c/d 2,300 “ Cost of sales A/c 14,800
79,700 79,700
Selling and Distribution Overhead Control A/c
(`) (`)
To Balance b/d 6,250 By Cost of Sales A/c 82,000
” Cost Ledger Control A/c: 64,200
” Material Control A/c 7,200
” Balance c/d 4,350
82,000 82,000
Finished Goods Control A/c
(`) (`)
To Balance b/d 1,24,000 By Cost of Sales A/c 9,77,300
” Work-in-process Control 9,58,400 “ Balance c/d 1,05,100
A/c
10,82,400 10,82,400
Cost of Sales A/c
(`) (`)
To Finished Goods Control 9,77,300 By Costing P&L A/c 10,74,100
A/c
“ Admn. OH Control A/c 14,800
“ S&D OH Control A/c 82,000
10,74,100 10,74,100
Cost Ledger Control A/c
(`) (`)
To Costing P&L A/c (Sales) 14,43,000 By By Balance b/d 3,13,150
” Material Control A/c 4,80,100
” Wages Control A/c 2,14,300

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COST ACCOUNTING SYSTEMS 7.21

” Production OH Control 2,50,650

A/c
” Administrative OH A/c 74,000
” S&D OH Control A/c 64,200
” Balance c/d 3,22,300 ” Costing P&L A/c 3,68,900
17,65,300 17,65,300
Costing Profit & Loss A/c
(`) (`)
To Cost of sales A/c 10,74,100 By Cost Ledger Control A/c 14,43,000
(sales)
” Cost Ledger Control A/c 3,68,900
(profit) (balancing figure)
2,14,300 2,14,300
Trial Balance as at 30th September, 20X2
Dr. (`) Cr. (`)
Material Control A/c 74,900
Production OH Control A/c 6,150
Administrative OH Control A/c 2,300
Selling & Distribution OH Control A/c 4,350
Work-in-process Control A/c 1,42,800
Finished Goods Control A/c 1,05,100
Cost Ledger Control A/c 3,22,300
3,28,950 3,28,950

ILLUSTRATION 5
(a) 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 in respect of January, 20X3:
(i) Incomplete Ledger Entries:
Materials Control A/c
(`) (`)
To Balance b/d 32,000

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7.22 COST AND MANAGEMENT ACCOUNTING

Work-in-Process Control A/c

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

Payables (Creditors) A/c

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

Manufacturing Overheads Control A/c

(`) (`)
To Cost Ledger Control A/c 29,600
(Amount spent)

Finished Goods Control A/c

(`) (`)
To Balance b/d 24,000
By Balance b/d
30,000
(ii) Additional Information:
(1) The cash-book showed that ` 89,200 have been paid to creditors for raw-
material.
(2) Ending inventory of work-in-process included material ` 5,000 on which 300
direct labour hours have been booked against wages and overheads.
(3) The job card showed that workers have worked for 7,000 hours. The wage rate
is ` 10 per labour hour.
(4) Overhead recovery rate was ` 4 per direct labour hour.
You are required to complete the above accounts in the cost ledger of the company:

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COST ACCOUNTING SYSTEMS 7.23

SOLUTION
Materials Control A/c
(`) (`)
To Balance b/d 32,000 By Work-in-process control A/c 53,000
Cost Ledger Control A/c 92,000 By Balance b/d 71,000
(Purchases) (refer
working note)
1,24,000 1,24,000
Work-in-Process Control A/c
(`) (`)
To Balance b/d 9,200 By Finished Goods Control A/c 1,51,000
To Materials Control A/c 53,000 By Balance c/d:
(Bal. fig.)
To Wages Control A/c 70,000 Material 5,000
(` 10 × 7,000 hours)
Wages (` 10 × 300 3,000
hours)
To Overheads Control A/c 28,000 Overheads (` 4 × 1,200 9,200
(` 4 × 7,000 hours) 300 hours)
1,60,200 1,60,200
Finished Goods Control A/c
(`) (`)
To Balance b/d 24,000 By Cost of sales A/c (Bal. fig.) 1,45,000
To Work-in-process Control 1,51,000 By Balance b/d 30,000
A/c (as above)
1,75,000 1,75,000
Manufacturing Overheads A/c
(`) (`)
To Cost Ledger Control A/c 29,600 By Work-in-process control A/c 28,000
(` 4 × 7,000 hours)
By Costing P/L A/c (Under- 1,600
absorbed OH)
29,600 29,600

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7.24 COST AND MANAGEMENT ACCOUNTING

Working Note:
Payables (Creditors) A/c
(`) (`)
To Cash or Bank 89,200 By Balance b/d 16,400
To Balance c/d 19,200 By Purchases (Balancing fig.) 92,000
1,08,400 1,08,400

7.3 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, 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 sheets as per the
requirement of law and also helps in exercising effective control over the liabilities and
assets of its business.
7.3.1 Advantages
The main advantages of Integrated Accounts are as follows:
(a) No need for Reconciliation- The question of reconciling costing profit and finan-
cial profit does not arise, as there is only one figure of profit.
(b) Less efforts- Due to use of one set of books, there is a significant saving in efforts
made.
(c) Less time consuming- No delay is caused in obtaining information as it is provided
from books of original entry.
(d) Economical process- It is economical also as it is based on the concept of “Cen-
tralisation of Accounting function”.
7.3.2 Essential pre-requisites for Integrated Accounts
The essential pre-requisites for integrated accounts include the following steps:
1. The management’s decision about the extent of integration of the two sets of
books. Some concerns find it useful to integrate up to the stage of primary cost or
factory cost while other prefer full integration of the entire accounting records.

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COST ACCOUNTING SYSTEMS 7.25

2. A suitable coding system must be made available so as to serve the accounting

purposes of financial and cost accounts.
3. An agreed routine, with regard to the treatment of provision for accruals, prepaid
expenses, other adjustment necessary for preparation of interim accounts.
4. Perfect coordination should exist between the staff responsible for the financial
and cost aspects of the accounts and an efficient processing of accounting docu-
ments should be ensured.
Under this system there is no need for a separate cost ledger. Of course, there will be
a number of subsidiary ledgers; in addition to the useful Customers’ Ledger and the
Bought Ledger, there will be: (a) Stores Ledger; (b) Stock Ledger and (c) Job Ledger.
7.3.3 Features of Integrated Accounting System
Following are the main points of integrated accounting:
(a) Complete analysis of cost and sales are kept.
(b) Complete details of all payments in cash are kept
(c) Complete details of all assets and liabilities are kept and this system does not use
a notional account to represent all impersonal accounts
In non-integrated system, a cost ledger control account or general ledger adjustment
account is used in cost ledger. In this 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:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) 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:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) Provision for depreciation account
(e) Fixed assets account
(f) Share capital account
If the illustration given below is to be worked out on integrated account basis, the
journal entries would be as follows:

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7.26 COST AND MANAGEMENT ACCOUNTING

ILLUSTRATION 6
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
SOLUTION
Journal entries are as follows:
DR. (`) CR. (`)
Stores Ledger Control A/c………………………………................. Dr. 2,00,000
To Payables (Creditors) A/c 2,00,000
(Materials purchased)
Work-in-Process Control A/c……………………………................. Dr. 1,50,000
To Stores Ledger Control A/c 1,50,000
(Materials issued to production)
Wages Control A/c………………………………………..................... Dr. 1,20,000
To Bank A/c 1,20,000
(Wages paid)
Factory Overhead Control A/c…………………………................. Dr. 36,000
To Wages Control A/c 36,000
(30% of wages paid being indirect charged to overhead)
Work-in-Process Control A/c……………………………................ Dr. 84,000
To Wages Control A/c 84,000
(Direct wages charged to production)

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COST ACCOUNTING SYSTEMS 7.27

Factory Overhead Control A/c…………………………................ Dr. 84,000

To Bank A/c 84,000
(Manufacturing overhead incurred)
Work-in-Process Control A/c……………………………................ Dr. 92,000
To Factory Overhead Control A/c 92,000
(Manufacturing overhead charged to production)
Selling and Distribution Overhead Control A/c………....... Dr. 20,000
To Bank A/c 20,000
(Selling and distribution costs incurred)
Finished Goods Control A/c……………………………................. Dr. 2,00,000
To Work-in-Process Control A/c 2,00,000
(Cost of finished goods)
Cost of Sales A/c…………………………………………...................... Dr. 2,20,000
To Finished Goods Control A/c 2,00,000
To Selling and Distribution Control A/c 20,000
(Costs of goods sold)
Receivables (Debtors) A/c……………………………….................. Dr. 2,90,000
To Sales A/c 2,90,000
(Finished stock sold)
Bank A/c…………………………………………………........................... Dr. 69,000
To Receivables (Debtors) A/c 69,000
(Receipts from receivables)
Payables (Creditors) A/c………………………………..................... Dr. 1,10,000
To Bank A/c 1,10,000
(Payment made to payables)
ILLUSTRATION 7
Bangalore Petrochemicals Co. keeps books on integrated accounting system. The
following balances appear in the books as on 1st January, 20X2.
DR. (`) CR. (`)
Stores Ledger control A/c 18,000
Work-in-Process Control A/c 17,000
Finished Goods Control A/c 13,000
Bank A/c 10,000
Creditors A/c 8,000

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7.28 COST AND MANAGEMENT ACCOUNTING

Fixed assets A/c 55,000

Debtors A/c 12,000
Share capital A/c 80,000
Provision for depreciation A/c 5,000
Profit and loss A/c ________ 32,000
1,25,000 1,25,000
Transaction for the year ended 31st Dec., 20X2 were as given below:
(`) (`)
Wages-direct 87,000
Wages-indirect 5,000 92,000
Purchase of materials (on credit) 1,00,000
Materials issued to production 1,10,000
Materials for repairs 2,000
Goods finished during the year (at cost) 2,15,000
Sales (credit) 3,00,000
Cost of goods sold 2,20,000
Production overhead absorbed 48,000
Production overhead incurred 40,000
Administration overhead incurred (production) 12,000
Selling overhead incurred 14,000
Payments of creditors 1,01,000
Payments of debtors 2,90,000
Depreciation on machinery 1,300
Prepaid rent (included in factory overheads) 300
Write up accounts in the integrated ledger.
SOLUTION
Stores Ledger Control Account
(`) (`)
To Balance b/d 18,000 By Work-in-process Control 1,10,000
A/c
To Payables (Creditors) A/c 1,00,000 By Production OH Control 2,000
A/c
By Balance c/d 6,000
1,18,000 1,18,000

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COST ACCOUNTING SYSTEMS 7.29

Wages Control Account

(`) (`)
To Bank A/c 92,000 By Work-in-process A/c 87,000
By Production OH A/c 5,000
92,000 92,000
Work-in-Process Control A/c

(`) (`)
To Balance b/d 17,000 By Finished Goods Control 2,15,000
A/c
To Stores Ledger Control A/c 1,10,000 By Balance c/d 47,000
To Wages Control A/c 87,000
To Production OH A/c 48,000
2,62,000 2,62,000
Production Overhead Control A/c
(`) (`)
To Wages Control A/c 5,000 By Work-in-process Control 48,000
A/c
To Stores Ledger Control A/c 2,000 By Prepaid Rent A/c 300
To Bank A/c 40,000
To Prov. for Depreciation 1,300
48,300 48,300
Finished Goods Control A/c

(`) (`)
To Balance b/d 13,000 By Cost of Sales A/c 2,20,000
(Cost of goods sold)
To Work-in-process Control 2,15,000 By Balance c/d 20,000
A/c
To Administrative OH Control 12,000
A/c
2,40,000 2,40,000
Administration Overheads Control A/c
(`) (`)
To Bank A/c 12,000 By Finished Goods Control 12,000
A/c
12,000 12,000
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7.30 COST AND MANAGEMENT ACCOUNTING

Cost of Sales A/c

(`) (`)
To Finished Goods Control 2,20,000 By Sales A/c 2,34,000
A/c
To Selling & Dist. OH A/c 14,000
2,34,000 2,34,000
Selling and Distribution Overheads A/c
(`) (`)
To Bank A/c 14,000 By Cost of Sales A/c 14,000
14,000 14,000
Sales A/c
(`) (`)
To Cost of Sales A/c 2,34,000 By Receivables A/c 3,00,000
To Costing P&L A/c 66,000
3,00,000 3,00,000
Prepaid Rent A/c
(`) (`)
To Production OH Control A/c 300 By Balance c/d 300
300 300
Provision for Depreciation A/c
(`) (`)
To Balance c/d 6,300 By Balance b/d 5,000
By Production OH Control 1,300
A/c
6,300 6,300
Profit and Loss A/c
(`) (`)
By Balance b/d 32,000
To Balance c/d 98,000 By Sales A/c 66,000
98,000 98,000
Receivables (Debtors) A/c
(`) (`)
To Balance b/d 12,000 By Bank A/c 2,90,000
To Sales 3,00,000 By Balance c/d 22,000
3,12,000 3,12,000
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COST ACCOUNTING SYSTEMS 7.31

Payables (Creditors) A/c

(`) (`)
To Bank A/c 1,01,000 By Balance b/d 8,000
To Balance c/d 7,000 By Stores Ledger 1,00,000
Control A/c
1,08,000 1,08,000
Bank A/c
(`) (`)
To Balance b/d 10,000 By Payables (Creditors) 1,01,000
A/c
To Receivables (Debtors) A/c 2,90,000 By Wages Control A/c 92,000
By Production OH A/c 40,000
By Administration OH 12,000
A/c
By Selling & Dist. OH 14,000
A/c
By Balance c/d 41,000
3,00,000 3,00,000
Fixed Assets A/c
(`) (`)
To Balance b/d 55,000 By Balance c/d 55,000
55,000 55,000
Share Capital A/c
(`) (`)
To Balance c/d 80,000 By Balance b/d 80,000
80,000 80,000

ILLUSTRATION 8
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. The following relevant information is provided to you:

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7.32 COST AND MANAGEMENT ACCOUNTING

(`) (`)
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 3,000
previous month
Transactions during the month:
Materials Purchased 75,000
Materials Issued:
To production 30,000
To factory maintenance 4,000 34,000
Materials transferred between batches 5,000
Total wages paid:
To direct workers 25,000
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 65,000
during the month
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:
(a) Stores Ledger Control Account.
(b) Work-in-Process Control Account.
(c) Finished Goods Control Account.
(d) Production Overhead Control Account.
(e) Costing Profit and Loss Account.

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COST ACCOUNTING SYSTEMS 7.33

SOLUTION
(a) Stores Ledger Control Account
(`) (`)
To Balance b/d 25,000 By Work in Process Control 30,000
A/c
” Creditors/ Bank A/c 75,000 ” Production OH Control 4,000
A/c
” Balance c/d 66,000
1,00,000 1,00,000
(b) Work-in-Process Control Account
(`) (`)
To Balance b/d 20,000 By Finished Goods Control 65,000
A/c
” Store Ledger Control 30,000 ” Balance c/d (Physical 40,000
A/c value)
” Wages Control A/c 20,000
” Production OH Control 30,000
A/c (150% of direct
wages)
” Costing P&L A/c
(Stock Gains) 5,000
1,05,000 1,05,000
(c) Finished Goods Control Account
(`) (`)
To Balance b/d 35,000 By Cost of Goods Sold* A/c 80,000
” Work-in-Process Control 65,000 ” Balance c/d 20,000
A/c
1,00,000 1,00,000
* Alternatively, Costing Profit & Loss Account
(d) Production Overhead Control Account
(`) (`)
To Balance b/d 3,000 By Work-in-Process Control 30,000
(Prepaid amount) A/c (150% of direct
wages)

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7.34 COST AND MANAGEMENT ACCOUNTING

” Stores Ledger Control A/c 4,000

” Wages Control A/c
(`5,000 + `5,000) 10,000
” Bank A/c 12,000
” Costing P&L A/c*
(Over-absorption, 1,000
balancing figure)
30,000 30,000
* Alternatively the over absorbed overhead may be carried forward.
(e) Costing Profit & Loss Account

(`) (`)
To Finished goods control A/c 80,000 By Sales A/c 1,00,000
or Cost of Goods Sold A/c
” Selling & distribution OH 6,000 ” Production OH Control 1,000
A/c A/c
” Balance c/d 20,000 ” Work-in-Process 5,000
Control A/c (Stock gain)
1,06,000 1,06,000
Notes:
(1) Materials transferred between batches will not affect the Control Accounts.
(2) Non-production time of direct workers is a production overhead and therefore
will not be charged to work-in-Process control A/c.
(3) Production overheads absorbed in work-in-Process Control A/c will then
equal ` 30,000 (150% of ` 20,000).
(4) In the work-in-Process Control A/c the excess physical value of stock is taken
resulting in stock gain. Stock gain is transferred to Profit & Loss A/c.

7.4 RECONCILIATION OF COST AND FINANCIAL

ACCOUNTS
When the cost and financial accounts are kept separately, it is imperative that those
should be reconciled, otherwise the cost accounts would not be reliable. In this
connection, it is necessary to remember that a reconciliation of the two sets of accounts
only can be made if both the sets contain sufficient details as would enable the causes
of differences to be located. It is, therefore, important that in the financial accounts,
the expenses should be analysed in the same way as in the cost accounts.
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COST ACCOUNTING SYSTEMS 7.35

In the text book, there appears a General Ledger Adjustment Account as would appear
in the Cost Ledger, students should study the entries therein as well as a discussion
that follows to explain the manner in which the details of items included therein
could be reconciled with the corresponding items appearing in the financial accounts.
They would thus realise that the reconciliation of the balances generally, is possible
preparing a Memorandum Reconciliation Account. In this account, the items charged
in one set of accounts but not in the other or those charged in excess as compared
to that in the other are collected and by adding or subtracting them from the balance
of the amount of profit shown by one of the accounts, shown by the other can be
reached. The procedure is similar to the one followed for reconciling the balance with
a bank that shown by the cash book or the ledger.
It is important, however, to know the causes which, generally, give rise to differences
in the Cost and Financial Accounts. These are briefly summarised below:
7.4.1 Items included in the financial accounts but not in cost accounts
1. Items included in Financial Accounts only-
(a) Purely Financial Expenses:
(i) Interest on loans or bank mortgages.
(ii) Expenses and discounts on issue of shares, debentures etc.
(iii) Other capital losses i.e., loss by fire not covered by insurance etc.
(iv) Losses on the sales of fixed assets and investments
(v) Goodwill written off
(vi) Preliminary expenses written off
(vii) Income tax, donations, subscriptions
(viii) Expenses of the company’s share transfer office, if any.
(b) Purely Financial Income
(i) Interest received on bank deposits, loans and investments
(ii) Dividends received
(iii) Profits on the sale of fixed assets and investments
(iv) Transfer fee received.
(v) Rent receivables
2. Item included in Cost Accounts only (notional expenses):
(i) Charges in lieu of rent where premises are owned
(ii) Interest on capital at notional figure though not incurred
(iii) Salary for the proprietor at notional figure though not incurred
(iv) Notional Depreciation on the assets fully depreciated for which book value is
nil.

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7.36 COST AND MANAGEMENT ACCOUNTING

(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 shall 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.
7.4.2 Procedure for reconciliation
There are 3 steps involved in the procedure for reconciliation.
1. Ascertainment of profit as per financial accounts
2. Ascertainment of profit as per cost accounts
3. Reconciliation of both the profits (similar to the bank reconciliation statement)
Circumstances where reconciliation statement can be avoided : When the Cost and
Financial Accounts are integrated - there is no need to have a separate reconciliation
statement between the two sets of accounts. Integration means that the same set of
accounts fulfil the requirement of both i.e., Cost and Financial Accounts.
ILLUSTRATION 9
The following figures are available from the financial records of ABC Manufacturing Co.
Ltd. for the year ended 31-3-20X3.
(`)
Sales (20,000 units) 25,00,000
Materials 10,00,000
Wages 5,00,000
Factory Overheads 4,50,000
Office and administrative Overhead (production related) 2,60,000
Selling and distribution Overheads 1,80,000
Finished goods (1,230 units) 1,50,000

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COST ACCOUNTING SYSTEMS 7.37

(`) (`)
Work-in-Process:
Materials 30,000
Labour 20,000
Factory overheads 20,000 70,000
Goodwill written off 2,00,000
Interest on capital 20,000
In the Costing records, factory overhead is charged at 100% of wages, administration
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.
SOLUTION
Profit & Loss Account of ABC Manufacturing Co. Ltd.
(for the year ended 31-3-20X3)
(`) (`)
To Opening Stock Nil By Sales (20,000 units) 25,00,000
To Materials 10,00,000 By Closing Stock:
To Wages 5,00,000 Finished goods (1,230 1,50,000
units)
To Factory Overheads 4,50,000 Work-in-Process 70,000
To Office & Admn. Overheads 2,60,000
To Selling & Dist. Overheads 1,80,000
To Goodwill written off 2,00,000
To Interest on Capital 20,000
To Profit 1,10,000
27,20,000 27,20,000
Cost Sheet
(`)
Materials 10,00,000
Wages 5,00,000
Direct Expenses Nil
Prime Cost 15,00,000

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7.38 COST AND MANAGEMENT ACCOUNTING

Add : Factory overhead at 100% wages 5,00,000

20,00,000
Less : Closing WIP (70,000)
Factory Cost of (20,000 + 1,230) units 19,30,000
Office & Admn. Overhead 10% of Factory cost 1,93,000
21,23,000
Less : Closing Stock of finished goods (1,230 units) (1,23,000)*
Production Cost of 20,000 units 20,00,000
Selling & Dist. Overhead @ ` 10 per unit 2,00,000
Cost of sales of 20,000 units 22,00,000
Sales of 20,000 units 25,00,000
Profit 3,00,000
* (` 21,23,000 x 1,230 units/ 21,230 units)
Reconciliation Statement
(`) (`)
Profit as per Cost Accounts 3,00,000
Add : Factory overheads over-absorbed 50,000
(` 5,00,000 – ` 4,50,000)
Selling & Dist. Overhead over-absorbed 20,000
(` 2,00,000 – ` 1,80,000)
Difference in the valuation of closing stock of finished 27,000 97,000
goods (` 1,50,000 – ` 1,23,000)
3,97,000
Less : Office & Admn. overhead under-absorbed 67,000
(` 2,60,000 – ` 1,93,000)
Goodwill written off taken in financial accounts 2,00,000
Interest on capital 20,000 2,87,000
Profit as per financial accounts 1,10,000

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COST ACCOUNTING SYSTEMS 7.39

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

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.
SOLUTION
Stores Ledger Control A/c
(`) (`)
To Balance b/d 15,000 By Work-in-process Control 80,000
A/c (Issued to WIP)

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7.40 COST AND MANAGEMENT ACCOUNTING

To Cost Ledger Control A/c 80,000 By Overhead Control A/c 10,000

(Purchases) (Issued for repairs)
To Work-in-process Control 40,000 By Cost Ledger Control A/c 5,000
A/c (Return from WIP) (Sold at cost)
By Overheads Control A/c* 3,000
(Shortages)
By Balance c/d 37,000
1,35,000 1,35,000
* Assumed normal
Wages Control A/c
(`) (`)
To Cost Ledger Control A/c 35,000 By Work-in-process Control A/c 30,000
By Overhead Control A/c 5,000
35,000 35,000
Overhead Control A/c
(`) (`)
To Stores Ledger Control A/c 10,000 By Work-in-process Control A/c 1,20,000
To Stores Ledger Control A/c 3,000
To Cost Ledger Control A/c 1,25,000
To Wages Control A/c 5,000 By Balance c/d 23,000
1,43,000 1,43,000
WIP Control A/c
(`) (`)
To Balance b/d 30,000 By Stores Ledger Control A/c 40,000
To Stores Ledger Control A/c 80,000 By Finished goods Control A/c 2,00,000*
To Wages Control A/c 30,000
To Overheads Control A/c 1,20,000 By Balance c/d 20,000
2,60,000 2,60,000
* Finished output at cost 2,00,000
Profit at 10% on actual cost from WIP Sales 20,000
2,20,000

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COST ACCOUNTING SYSTEMS 7.41

Statement of Profit as per Costing Records

(`)
Direct material Cost 40,000
Direct wages 30,000
Prime Cost 70,000
Production Overheads 1,20,000
Works Cost 1,90,000
Add : Opening WIP 30,000
2,20,000
Less : Closing WIP (20,000)
Cost of finished goods 2,00,000
Profit (10% of cost) 20,000
Sales 2,20,000
Profit & Loss A/c
(`) (`)
To Material (Op. bal. + Purchases 90,000 By Sales A/c 2,20,000
- Sale)
To Work-in-process Control A/c 30,000 By Closing Work-in-process 20,000
To Wages Control A/c 35,000 By Closing Finished goods 37,000
To Overheads Control A/c 1,25,000 By Net loss 3,000
2,80,000 2,80,000
Reconciliation Statement
(`)
Profit (loss) as per Financial Accounts (3,000)
Add : Overheads over absorbed in Cost A/c 23,000
Net Profit as per Accounts 20,000
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 Overhead 16,00,000
Administration Overheads (production related) 7,00,000

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7.42 COST AND MANAGEMENT ACCOUNTING

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 production. 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.
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 3,20,000
(4,000 units)
1,25,60,000 1,25,60,000
To Administration Overheads 7,00,000 By Gross Profit b/d 29,60,000
To Selling and Dist. OH 9,60,000 By Dividend 1,00,000
To Bad Debts 80,000 By Interest 20,000
To Preliminary Expenses 40,000
written off
To Legal Charges 10,000
To Net Profit 12,90,000
30,80,000 30,80,000

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COST ACCOUNTING SYSTEMS 7.43

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 (1,24,000 units) 1,00,80,000
Administration overhead (1,24,000 units @ ` 6 p.u.) 7,44,000
Cost of production of (1,24,000 units) 1,08,24,000
Less : Finished Goods (4,000 units @ ` 87.29) (3,49,160)
Cost of goods sold (1,20,000 units) 1,04,74,840
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
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
Administration Overhead 44,000
Dividend Received 1,00,000
Interest Received 20,000 8,84,000
14,49,160
Less : Bad debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000
Over-valuation of stock in cost book 29,160
(` 3,49,160 – ` 3,20,000) (1,59,160)
Profit as per Financial Records 12,90,000

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7.44 COST AND MANAGEMENT ACCOUNTING

7.5 ACCOUNTING FOR MANAGEMENT INFORMA-

TION AND COST CONTROL
With a view to control costs, standard cost for each element of cost is set. The standard
costs so set are used to measure and compare the actual costs. This enable the
management to trace cost variances from the standard cost. The variances so obtained
are analysed and necessary actions are taken. This ensures that standard costs are
adhered.
For cost control purpose, the management needs specific accounting system which
fulfils the management objective of controlling costs. On the basis of timing of variance
analysis, two main types of management accounting systems are followed:
(I) SINGLE PLAN :
Under this system of management accounting, the variances in costs from the set
standards are reported at its happenings without waiting for books closing. Timely
analysis is done so that much time is not lost in taking corrective action wherever
needed.
The single plan system envisages the posting of all items in the debit side of the
work-in-progress account at the standard cost leaving the credit side to represent the
standard cost of finished production and work-in-progress.
This system enables the ascertainment of variances as and when the transaction is
posted to work-in-progress account. In other words, the analysis of variances is done
from the original documents like invoices, labour sheets, etc., and this method of
analysis is known as analysis at source.
Since, the single plan system contemplates the analysis of variances at source, the
installation of this system requires more planning so that effective documentation at
each stage is introduced for proper recording and analysis of variance.
Thus for example, the issue of bill of materials to the stores enables the storekeeper to
calculate the standard value of materials. If any material is requisitioned beyond the
standard, he can mark the same for material usage variance account. In the production
department, as and when the finished output is recorded, the standard waste and actual
waste can be compared and necessary entries can be made by the shop supervisors for
posting the excessive usage to appropriate variance accounts.
Scheme of entries : So far as materials are concerned, material price variances are
recorded at the time of receipt of the material and the material quantity variances
are recorded as far as possible when excess materials are used. The entries will be as
illustrated below:

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COST ACCOUNTING SYSTEMS 7.45

1. Material Control A/c ……………………………. Dr.

Material Price Variance A/c ……………….……Dr.
(Actual Cost > Standard Cost)
To Creditors/ Cost Ledger Control A/c.
To Material Price Variance A/c
(Actual Cost < Standard Cost)
This entry enables the firm to debit the material control account with the actual
purchases at standard cost and credit the creditor’s account at the actual cost of actual
prices thereby transferring the variances to price variance account.
2. Work-in-progress Control A/c ………………. Dr.
Material Usage Variances A/c………………. Dr.
(Actual usage > Standard usage)
To Material Control A/c
To Material Usage Variances A/c
(Actual usage < Standard usage)
This entry charges the work-in-progress control account with the standard cost of
standard quantity and credit the material control account at the standard cost of actual
issue, the variance being transferred to usage variance account.
3. Wages Control A/c ……………………….……. Dr.
Labour Rate Variances A/c ………….….……. Dr.
(Actual wage rate > Standard wage rate)
To Cash/ Cost Ledger Control A/c
To Labour Rate Variances A/c
(Actual wage rate < Standard wage rate)
This entry is passed to record the wages at standard rate thereby transferring rate
variances to the appropriate account.
4. Work-in-progress Control A/c …………….…. Dr.
Overhead Expense Variances A/c ……..…….Dr.
(Actual OH > Standard OH)
To Overhead Expense Control A/c.
To Overhead Expense Variances A/c
(Actual OH < Standard OH)
(II) PARTIAL PLAN :
In the partial plan, variances are analysed at the end of period. Under this method the
work-in-progress account is charged at the actual cost of production for the period and
is credited with the standard cost of the period’s production of finished product.

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7.46 COST AND MANAGEMENT ACCOUNTING

The closing balance of work-in-progress is also shown at standard cost. The balance
after making the credit entries represent the variance from standard for the period.
The analysis of the variance is done after the end of the period. This method is simple
in operation because variances are analysed after the end of period but may present
difficulties if the firm makes a variety of products.
Recapitulation:
(1) Current standards are used in both the systems.
(2) Under the partial plan, material stocks are carried at actual cost whereas the same
are carried out at standard cost under the single plan.
(3) The work-in-progress and finished goods are valued at standard cost under both
the methods.
(4) Computation of variances :
(a) In partial plan, material price variance is computed on material used in finished
goods and work-in-progress whereas in single plan it is computed on the
material quantity purchased.
(b) The partial plan is suitable where simple analysis of variance is sufficient at
the end of the period whereas the single plan is preferred if frequent detailed
analysis of variance is desired, as (a) the comparison of actual with standard
cost of each operation or operator or (b) the daily reporting of standard cost of
excess material used.
SUMMARY
• Cost Control Accounts : These are accounts maintained for the purpose of
exercising control over the costing ledgers and also to complete the double entry
in cost accounts.
• Integral System of Accounting : A system of accounting where both costing and
financial transactions are recorded in the same set of books.
• Non- Integral System of Accounting : A system of accounting where two sets of
books are maintained- (i) for costing transactions; and (ii) for financial transactions.
• Reconciliation : In the Non-Integral System of Accounting, since the cost and
financial accounts are kept separately, it is imperative that those should be
reconciled, otherwise the cost accounts would not be reliable. The reason for
differences in the cost & financial accounts can be of purely financial nature
(Income and expenses) and notional nature.
• On the basis of timing of variance analysis:
o Single Plan- Under this system of management accounting, the variances in
costs from the set standards are reported at its happenings without waiting
for books closing.
o Partial Plan- In this pan, variances are analysed at the end of period.
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COST ACCOUNTING SYSTEMS 7.47

TEST YOUR KNOWLEDGE

MCQs based Questions
1. Under non-integrated accounting system
(a) Same ledger is maintained for cost and financial accounts by accountants
(b) Separate ledgers are maintained for cost and financial accounts
(c) (a) and (b) both
(d) None of the above
2. Notional costs
(a) May be included in integrated accounts
(b) May be included in non- integrated accounts
(c) Cannot be included in non-integrated accounts
(d) None of the above
3. Under non-integrated accounting system, the account made to complete double
entry is
(a) Stores ledger control account
(b) Work in progress control account
(c) Finished goods control account
(d) General ledger adjustment account
4. Integrated systems of accounts are maintained
(a) In separate books of accounts for costing and financial accounting purposes
(b) In same books of accounts
(c) Both (a) & (b)
(d) None of the above
5. Under non-integrated system of accounting, purchase of raw material is debited
to which account
(a) Material control account / stores ledger control account
(b) General ledger adjustment account
(c) Purchase account
(d) None of the above
6. Under control accounts, if material worth ` 1500 is purchased for a special job,
then which account will be debited
(a) Special job account / work in progress account
(b) Material control account

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7.48 COST AND MANAGEMENT ACCOUNTING

(c) Cost control account

(d) None of the above
7. Which account is to be debited if material worth ` 500 is returned to vendor under
control accounts
(a) Cost ledger control account
(b) Stores ledger control account
(c) WIP control account
(d) None of the above
8. Which of the following items is included in cost accounts?
(a) Notional rent
(b) Donations
(c.) Transfer to general reserve
(d) Rent receivable
9. When costing loss is ` 5,600, administrative overhead under-absorbed being `
600, the loss as per financial accounts should be
(a) ` 5,600
(b) ` 6,200
(c) ` 5,000
(d) None of the above
10. Which of the following items should be added to costing profit to arrive at financial
profit?
(a) Over-absorption of works overhead
(b) Interest paid on debentures
(c) Income tax paid
(d) All of the above
Theoretical Questions
1. What are the essential pre-requisites of integrated accounting system?
2. What are the advantages of integrated accounting?
3. Why is it necessary to reconcile the Profits between the Cost Accounts and Financial
Accounts?
4. What are the reasons for disagreement of profits as per cost accounts and financial
accounts? Discuss.
5. List the Financial expenses which are not included in cost.
6. When is the reconciliation statement of Cost and Financial accounts not required?

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COST ACCOUNTING SYSTEMS 7.49

Practical Problems
1. The following incomplete accounts are furnished to you for the month ended 31st
October, 20X2.
Stores Ledger Control Account
1.10.20X2 To Balance ` 54,000
Work in Process Control Account
1.10. 20X2 To Balance ` 6,000
Finished Goods Control Account
1.10. 20X2 To Balance ` 75,000
Factory Overheads Control Account
Total debits for October, 20X2 ` 45,000
Factory Overheads Applied Account

Cost of Goods Sold Account

Creditors for Purchases Account

1.10. 20X2 By Balance ` 30,000
Additional information:
(i) The factory overheads are applied by using a budgeted rate based on direct
labour hours. The budget for overheads for 20X2 is ` 6,75,000 and the budget
of direct labour hours is 4,50,000.
(ii) The balance in the account of creditors for purchases on 31.10.20X2 is
` 15,000 and the payments made to creditors in October, 20X2 amount to
` 1,05,000.
(iii) The finished goods inventory as on 31st October, 20X2 is ` 66,000.
(iv) The cost of goods sold during the month was ` 1,95,000.
(v) On 31st October, 20X2 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, 20X2. All factory
workers earn same rate of pay.
(vii) All actual factory overheads incurred in October, 20X2 have been posted.
You are required to find:
(a) Materials purchased during October, 20X2.
(b) Cost of goods completed in October, 20X2.

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7.50 COST AND MANAGEMENT ACCOUNTING

(c) Overheads applied to production in October, 20X2.

(d) Balance of Work-in-process Control A/c on 31st October, 20X2.
(e) Direct materials consumed during October, 20X2.
(f) Balance of Stores Ledger Control Account on 31st October, 20X2.
(g) Over absorbed or under absorbed overheads for October, 20X2.
2. 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 transaction took place:
Materials – Purchased 40
Issued to production 50
Issued to factory maintenance 6
Issued to building 4
construction
Wages – Gross wages paid 150
Indirect wages 40
For building construction 10
Works Overheads – Actual amount incurred 160
(excluding items shown 20
above) 8
Absorbed in building 5
construction
Under absorbed
Royalty paid (related to production)
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.
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COST ACCOUNTING SYSTEMS 7.51

Prepare the relevant control accounts to record the above transactions in the cost
ledger of the company.
3. Dutta Enterprises operates an integral system of accounting. You are required to
pass the Journal Entries for the following trans¬actions that took place for the
year ended 30th June, 20X2.
(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
4. The following figures are extracted from the Trial Balance of Go-getter Co. on 30th
September, 20X2:
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
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7.52 COST AND MANAGEMENT ACCOUNTING

Indirect employee cost 18,000

Factory Supervision 10,000
Repairs and Upkeep Factory 14,000
Heat, Light and Power 65,000
Rates and Taxes 6,300
Miscellaneous Factory Expenses 18,700
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) Accrued 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 30th September,
20X2 along with supporting schedules of:
(i) Cost of Sales.
(ii) Selling and Distribution Expenses.
(iii) Administration Expenses.
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COST ACCOUNTING SYSTEMS 7.53

5. 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, 20X3:
(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,20X3;
(b) Prepare the cost sheet and ascertain the profit as per cost accounts for the year
ended 31st March, 20X3 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.
6. 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, 20X3. 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.
ANSWERS/ SOLUTIONS
Answers to the MCQs
1. (b) 2. (c) 3. (d) 4. (b) 5. (a) 6. (a)
7. (a) 8. (a) 9. (b) 10. (a)

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7.54 COST AND MANAGEMENT ACCOUNTING

Answers to the Theoretical Questions

1. Please refer paragraph 7.3
2. Please refer paragraph 7.3
3. Please refer paragraph 7.4
4. Please refer paragraph 7.4
5. Please refer paragraph 7.4
6. Please refer paragraph 7.4
Answers to the Practical Problems
1.
Working Notes:
(i) Overhead recovery rate per direct labour hour:
Budgeted factory overheads : ` 6,75,000
Budgeted direct labour hours : 4,50,000
Budgeted factory overheads
Overhead recovery rate =
Budgeted direct labour hours
` 6,75,000
=
4,50,000 hours
= ` 1.50 per direct labour
(ii) Direct wage rate per hour:
Direct labour cost of WIP : ` 3,000
(on 31st October 20X2)
Direct labour hours of WIP : 1,200 hours
Direct labour cost on WIP
Direct wage rate per hour =
Direct labour hours on WIP
` 3,00
=
1,200 hours = `2.50
(iii) Total direct wages charged to production:
Total direct labour hours spent on production × Direct wage rate per hour
= 28,200 hours × ` 2.50 = ` 70,500

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COST ACCOUNTING SYSTEMS 7.55

(a) Material purchased during October, 20X2

(`)
Payment made to creditors 1,05,000
Add: Closing balance in the account of creditors for purchase 15,000
Less: Opening balance (30,000)
Material Purchased 90,000
(b) Cost of goods completed in October, 20X2
(`)
Cost of goods sold during the month 1,95,000
Add: Closing finished goods inventory 66,000
Less: Opening finished goods inventory (75,000)
Cost of goods completed during the month 1,86,000
(c) Overhead applied to production in October, 20X2
= 28,200 hours × ` 1.50 = ` 42,300
(d) Balance of Work-in-Process on 31st October, 20X2
(`)
Direct material cost 6,000
Direct labour cost 3,000
Overheads (` 1.50 × 1,200 hours) 1,800
10,800
(e) Direct material consumed during October, 20X2 ` 78,000
(Refer to following Account)
Work in Process Control A/c
(`) (`)
To Balance b/d 6,000 By Finished goods stock 1,86,000
To Wages Control A/c [Refer 70,500 By Balance c/d 10,800
working note (iii)] [Refer (d) above]
To Factory OH Control A/c 42,300
[Refer (c) above]
To Material consumed (Bala- 78,000
ncing fig.)
1,96,800 1,96,800

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7.56 COST AND MANAGEMENT ACCOUNTING

(f) Balance of Stores Control Account on 31st October, 20X2 ` 66,000

(Refer to following Account)
Stores Ledger Control Account
(`) (`)
To Balance b/d 54,000 By Work-in-process Control A/c 78,000
[Refer (a) above}
To Cost Ledger Control A/c 90,000 By Balance c/d (Balancing fig.) 66,000
[Refer (e) above]
1,44,000 1,44,000
(g) Over-absorbed or under-absorbed overheads for October, 20X2 : Balance in
Factory Overhead Account below showing that ` 2,700 is under-absorbed.
Factory Overhead Account
(`) (`)
To Cost Ledger Control A/c 45,000 By Work-in-process Control A/c 42,300
(Factory OH applied)
By Costing P/L A/c 2,700
(Under-absorbed)
45,000 45,000
2.
Amount (in lakhs)
Cost Ledger Control A/c
(`) (`)
To Costing P&L A/c 450 By Balance b/d 540
To Building Construction A/c 44 By Stores Ledger Control A/c 40
To Balance c/d 483 By Wages Control A/c 150
By Works OH Control A/c 160
By Royalty A/c 5
By Admn. OH and S&D OH A/c 25
By Costing P&L A/c 57
977 977

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COST ACCOUNTING SYSTEMS 7.57

Stores Ledger Control A/c

(`) (`)
To Balance b/d 80 By Work-in-process A/c 50
To Cost Ledger Control A/c 40 By Works OH Control A/c 6
By Building Const. A/c 4
By Works OH Control A/c 5
(Bal. fig.) (loss)
By Balance c/d 55
120 120

Work-in-Process Control A/c

(`) (`)
To Balance b/d 20 By Finished Goods Control A/c 333
(Balancing figure)
To Stores Ledger Control A/c 50
To Wages Control A/c 100
To Works OH Control A/c 183
To Royalty A/c 5 By Balance c/d 25
358 358

Works Overhead Control A/c

(`) (`)
To Stores Ledger Control A/c 6 By Building Const. A/c 20
To Wages Control A/c 40 By Work-in-process Control A/c 183
(Balancing figure)

To Cost Ledger Control A/c 160 By Costing P&L A/c (under- 8

absorption)
To Store Ledger Control A/c 5
(loss)
211 211

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7.58 COST AND MANAGEMENT ACCOUNTING

Wages Control A/c

(`) (`)
To Cost Ledger Control A/c 150 By Works OH Control A/c 40
By Building Const. A/c 10
By Work-in-process Control A/c 100
(Balancing figure)

150 150
Royalty A/c
(`) (`)
To Cost Ledger Control A/c 5 Work-in-process Control A/c 5
5 5
Finished Goods Control A/c
(`) (`)
To Balance b/d 430 By Cost Ledger Control A/c 360
(80% of ` 450)
Work-in-process Control 333 By Balance b/d 403
A/c
763 763
Cost of Goods Sold A/c
(`) (`)
To Finished Goods Control 360 By Cost of sales A/c 360
A/c
360 360
Selling, Distribution and Administration Overhead A/c
(`) (`)
To Cost Ledger Control A/c 25 By Cost of sales A/c 25
25 25
Cost of Sales A/c
(`) (`)
To Cost of Goods Sold 360 By Costing P&L A/c 385
To Admn. OH and S&D OH 25
A/c
385 385
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COST ACCOUNTING SYSTEMS 7.59

Costing P & L A/c

(`) (`)
To Cost of Sales A/c 385 By Cost Ledger Control A/c 450
(Sales)
To Works Overhead Control 8
A/c
To Cost Ledger Control A/c 57
(Profit) (Balancing figure)
450 450
Building Construction A/c
(`) (`)
To Balance b/d 10 By Cost Ledger Control A/c 44
To Stores Ledger Control A/c 4
To Wages Control A/c 10
To Works OH Control A/c 20
44 44
Trial Balance (` in lakhs)
DR. (`) CR. (`)
Stores control A/c 55
Work-in-Process A/c 25
Finished goods A/c 403
Cost Ledger Adjustment A/c 483
483 483
3.
Journal entries are as follows:
DR. (`) CR. (`)
Stores Ledger Control A/c………………………………................ Dr. 6,00,000
To Payables (Creditors) A/c 3,00,000
To Cash or Bank 3,00,000
Work-in-Process Control A/c……………………………............... Dr. 4,00,000
To Stores Ledger Control A/c 4,00,000
Wages Control A/c……………………………………...................…. Dr. 2,00,000
To Bank A/c 2,00,000

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7.60 COST AND MANAGEMENT ACCOUNTING

Factory Overhead Control A/c………………………...............…. Dr. 1,00,000

To Wages Control A/c 1,00,000
Work-in-Process Control A/c……………………………............... Dr. 1,00,000
To Wages Control A/c 1,00,000
Factory Overhead Control A/c…………………………................ Dr. 80,000
To Bank A/c 80,000
Work-in-Process Control A/c……………………………............... Dr. 1,00,000
To Factory Overhead Control A/c 1,00,000
Selling and Distribution Overhead Control A/c………...... Dr. 40,000
To Bank A/c 40,000
Finished Goods Control A/c…………………….......................... Dr. 5,00,000
To Work-in-Process Control A/c 5,00,000
Cost of Sales A/c…………………………………………..................... Dr. 5,40,000
To Finished Goods Control A/c 5,00,000
To Selling and Distribution Control A/c 40,000
Receivables (Debtors) A/c………………………………................ Dr. 3,75,000
Bank or Cash A/c………………………………………….......... Dr. 3,75,000
To Sales A/c 7,50,000
Bank A/c………………………………………………….......................... Dr. 2,00,000
To Receivables (Debtors) A/c 2,00,000
Payables (Creditors) A/c……………………………….................... Dr. 2,00,000
To Bank A/c 2,00,000
4.
Profit and Loss Statement of Go-getter Company
for the year ended 30th September, 20X2

(`) (`)
Gross Sales 7,68,000
Less: Returns (14,000) 7,54,000
Less: Cost of Sales [Refer to Schedule (i)] (7,14,020)
Net Operating Profit 39,980
Less: Interest on borrowed funds (4,000)
Net Profit 35,980

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COST ACCOUNTING SYSTEMS 7.61

(i) Schedule of Cost of Sales

(`) (`)
Raw Material (Inventory opening balance) 1,40,000
Add: Material Purchased 3,20,000
Add: Freight on Material 16,000
Less: Purchase Returns (4,800) 3,31,200
4,71,200
Less: Closing Raw Material Inventory (1,80,000)
Materials consumed in Production 2,91,200
Direct employee cost (` 1,60,000 + ` 8,000) 1,68,000
Prime Cost 4,59,200
Factory Overheads:
Indirect employee cost (` 18,000 + ` 1,200) 19,200
Factory Supervision 10,000
Repairs and Factory Upkeep 14,000
Heat, Light and Power (` 65,000 × 8/10) 52,000
Rates and Taxes (` 6,300 × 2/3rd) 4,200
Miscellaneous Factory Expenses 18,700
Depreciation of Plant (10% of ` 4,60,500) 46,050
Depreciation of Buildings (4% of ` 2,00,000 × 8/10) 6,400 1,70,550
6,29,750
Add: Opening Work-in-Process inventory 2,00,000
Less: Closing Work-in-Process inventory (1,92,000)
Cost of Producction 6,37,750
Add: Opening Finished Goods inventory 80,000
Less: Closing Finished Goods inventory (1,15,000)
Cost of Goods Sold 6,02,750
Add: Administration Expenses [See Schedule (iii)] 18,870
Add: Selling and Distribution Expenses [See Schedule (ii)] 92,400
Cost of Sales 7,14,020

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7.62 COST AND MANAGEMENT ACCOUNTING

(ii) Schedule of Selling and Distribution Expenses

(`)
Sales Commission 33,600
Sales Travelling 11,000
Sales Promotion 22,500
Distribution Deptt.—Salaries and Expenses 18,000
Heat, Light and Power 6,500
Depreciation of Buildings 800
92,400
(iii) Schedule of Administration Expenses
(`)
Office Salaries and Expenses 8,600
Depreciation of Office Appliances 870
Depreciation of Buildings 800
Heat, Light and Power 6,500
Rates and Taxes 2,100
18,870
5.
Working Note:
Profit & Loss Account
(for the year ended 31st March, 20X3)
(`) (`)
To Direct Material 5,00,000 By Sales (50,000 units) 10,00,000
To Direct Wages 2,50,000 By Interest and dividends 15,000
To Factory expenses 1,50,000
To Administrative expenses 45,000
To Selling & Dist. Expenses 30,000
To Net Profit 40,000
10,15,000 10,15,000
(a) Profit as per financial books for the year ended 31st March, 20X3 is ` 40,000 (Refer
to above Working note).

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COST ACCOUNTING SYSTEMS 7.63

(b) Cost Sheet

(for the year ended 31st March, 20X3)
(`) (`)
Direct material 5,00,000
Direct wages 2,50,000
Prime cost 7,50,000
Factory expenses:
Variable (40% of ` 1,50,000) 60,000
Fixed (` 90,000 × 50,000/60,000) 75,000 1,35,000
Works cost 8,85,000
Administrative expenses: (` 45,000 × 50,000/60,000) 37,500
Cost of production 9,22,500
Selling & distribution expenses:
Variable (60% of ` 30,000) 18,000
Fixed* (` 12,000 × 50,000/60,000) 10,000 28,000
Cost of Sales 9,50,500
Profit (Balancing figure) 49,500
Sales revenue 10,00,000
*It is assumed that the company sells what it generally produces i.e. normal production.
(c) Statement of Reconciliation
(Reconciling profit shown by Financial and Cost Accounts)
(`) (`)
Profit as per Cost Account 49,500
Add : Income from interest and dividends 15,000
64,500
Less : Factory expenses under-charged in Cost
Accounts (` 1,50,000 – ` 1,35,000) 15,000
Administrative expenses under-charged in Cost
Accounts (` 45,000 – ` 37,500) 7,500
Selling & distribution expenses under—charged in Cost 24,500
Accounts (` 30,000 – ` 28,000) 2,000
Profit as per Financial Accounts 40,000

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7.64 COST AND MANAGEMENT ACCOUNTING

6.
Memorandum Reconciliation Account
(`) (`)
To Net loss as per costing books 3,28,000 By Administration overhead 4,000
over-recovered in costs
To Factory overheads under- 6,000 By Depreciation overcharged 10,000
recoveredin costs in costs
To Income-tax not provided in 1,20,000 By Interest on investments 20,000
costs not included in costs
By Transfer fees in financial 2,000
books
By Stores adjustment 2,000
By Net loss as per financial 4,16,000
books
4,54,000 4,54,000

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