CHAPTER 1

INVENTORY VALUATION

AT A GLANCE
IN THIS CHAPTER
Inventory is one of the major components of manufacturing and
AT A GLANCE trading organizations and, in most cases, the higher proportion
of cost. Therefore, it is important to put proper controls over

AT A GLANCE
SPOTLIGHT inventory’s cost and its usage cycle.
Inventory which is consumed during the production is treated
1. Material: Procedures & as expense whereas the unused inventory at the end of
Documentation reporting period is treated as an asset in the financial
statements.
2. Inventories and their Valuation
Cost of inventories includes purchase cost and any cost
incurred to bring the inventory into saleable condition. In
3. Comprehensive Examples
manufacturing entities, inventory includes raw material, work
in progress and finished goods.
STICKY NOTES
Net realizable value(NRV) is the estimated selling price in the
ordinary course of business less the estimated cost of

SPOTLIGHT
completion and estimated cost necessary to make the sale.
Inventory should be valued at lower of cost or NRV in the
financial statements.
The inventories that are purchased in bulk quantities with
different prices during a period are allocated cost on the basis
of First-In-First-Out (FIFO) or Weighted Average Cost (AVCO).

STICKY NOTES

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 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

1. MATERIALS: PROCEDURES AND DOCUMENTATIONS

1.1 Material handling procedure and related documentations:
Materials are the basic components of manufacturing and production process in a goods manufacturing entity.
Materials are also called raw materials which are used in the production of a finished products (such as Crude
Oil is a raw material for Petrol, Milk is a raw material for Yogurt, Yarn is a raw material for Garment whereas
Petrol, Yogurt and Garment are the finished products).
In some manufacturing processes, raw material cost is major part of its total production cost and any loss of
control over material may cause significant increase in production cost. It is, therefore, important for any entity
to control the material activities from purchase till its use.
An entity that purchases materials to be used in its production or further sale, must ensure that proper
AT A GLANCE

procedures are in place to enable the controls over their costs, purchase quantity, quality as well as usage
quantity.
In order to make the controls effective, their documentation is necessary so that verifiable records can be
maintained.
The following example shall illustrate the procedure of purchasing, storing and issuing the raw materials to the
production department.
 Example 01:
A Limited is engaged in the manufacturing of Cotton Garment. It uses yarn as its raw material. It
requires 10 tons of yarn for the next production.
The Production Department raises the Material Requisition (M.R) to the Store / Warehouse of
SPOTLIGHT

the company depicting the quantity and time at which the stock is needed. The Store / Warehouse
of the company raises a Purchase Requisition (P.R) to the Purchase / Procurement Department.
The Purchase / Procurement Department raises a request for quotation to the yarn suppliers and
on the basis of accepted quotation, raises a Purchase Order (P.O) which is delivered to the
supplier. The supplier on the basis of P.O (which includes quantity, rate and time of delivery)
delivers the yarn at the store / warehouse of A Limited and issues a Goods Dispatch / Delivery
Note (GDN) to the Store and Purchase/ Procurement Departments of “A Limited”. The
storekeeper / warehouse in-charge of “A Limited” issues a Goods Received Note (GRN) the copy
of which is given to the supplier and Purchase / Procurement Department after inspecting the
goods along with the invoice.
The Storekeeper / Warehouse in-charge arranges the goods on the First in First Out (FIFO) basis
STICKY NOTES

or Weighted Average (AVCO) basis depending upon the company’s policy (usually perishable
products are carried at FIFO basis).
The Store then issues the raw materials to the Production Department and prepares a Goods
Issue Note (GIN).
The following table summarizes the above procedures and documents.

Process Documents
Production Department raise material requisition to Store / Material Requisition
Warehouse
Store / Warehouse issues purchase requisition to Procurement Purchase Requisition
/ Purchase Department
Procurement Department raises Purchase Order to the Purchase Order
approved supplier

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Process Documents
Supplier delivers goods at company’s warehouse Goods Dispatch / Delivery
Note and Invoice / Bill
The warehouse in-charge receives the goods and inspect Goods Received Note
The warehouse issues raw materials to the production Goods Issue Note
department

Documentation of purchase process is therefore needed:

• to ensure that the procedures for ordering, receiving and paying for materials has been
conducted properly, and there is no error or fraud

AT A GLANCE
• to provide a record of materials purchases for the financial accounts
• to provide a record of materials costs for the cost and management accounts.
• to ensure physical controls over the materials and to ensure its proper usage
• to ensure that each document is authorized by line manager
The detailed procedures for purchasing materials and the documents used might differ according
to the size, complexity and nature of the business. However, the basic requirements are same for
all types of business where material purchases are made.

1.2 Functions of storekeeper:

Storekeeper has to perform four basic functions including receiving of goods, storing of goods, issuing of goods

SPOTLIGHT
and recording the inventory movements.
Whenever purchase department issues purchase order, the supplier/s deliver goods to store department of
entity. It is the basic responsibility of storekeeper to check that goods are intact, means that these goods are not
damaged and are in accordance with the specification provided in the purchase order.
Storing looks more simple, but it’s one of the most important functions as negligence in proper storing may cause
damage or expiry of goods/ raw material. These goods must be stored in proper storage in such a way that
existing stock of goods/ raw material should be issued first. Similarly, few raw materials in industries require
specific storage like some chemicals should be stored in cold storage, otherwise, these could be damaged.
Another important function of storekeeper is to issue the goods/ raw materials to relevant department against
purchase requisition. Storekeeper must ensure that the document is properly authorized by line manager

STICKY NOTES
(authorized person) of that department.
All the transactions of receiving and issuing must be recorded by storekeeper; normally bin card is maintained
for each raw material item. Bin card includes quantities received and issued; running balance is maintained in it.
It helps the storekeeper to ensure that items of raw materials are not falling to re-order level, otherwise, new
purchase is required.

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2. INVENTORIES AND ITS VALUATION

2

2.1 Types of inventories:

In manufacturing entities, inventory comprises raw materials, work-in-process, stores, spares and tools and
finished goods.
Raw materials are purchased by manufacturing entities for consumption in the production during a period.
They are treated as expense when these are issued to production whereas those raw materials that still exist, at
the end of the reporting period are treated as current assets and are termed as inventories.
Work-in-process is the inventory on which partial costs have been incurred till period end but it is not yet
finished or completed and further cost is required to complete it. For instance, for manufacturing a liter of mango
juice, 100% of mango pulp (raw material) has been put into process whereas the labour has worked only 50%
AT A GLANCE

up to the end of the reporting period. Due to this, the product is neither considered completed nor it is raw
material any more. This kind of inventory is called work-in-process and is treated as current asset.
Finished goods are the final products which have been completed and stored in a warehouse known as “Finished
Goods Store”. The goods that have been sold to the customers are treated as cost of sales in the financial
statements whereas, the goods that have not been sold till the end of the reporting period are considered as
inventories.
Stores, spares and loose tools are used in the equipment and machinery and are kept in inventory so that in
case of any damage to the machinery or equipment, the production should not stop and necessary tools are
available in stock to resume the production at earliest. The unused stores, spares and loose tools at period end
is treated as inventory while used stores, spares and loose tools is charged as expense in financial statements.
SPOTLIGHT

2.2 Cost of inventories:

The following table explains the cost of each type of inventory:
Inventory Cost
Raw Material Purchase price including import duties & taxes (other than those subsequently
recoverable by the entity), transport, handling and other cost directly attributable
to the purchase of goods. Trade discounts, rebates and other similar items are
deducted in determining the cost. (IAS 2)
Work-in-process Cost of raw material as determined above, plus direct labour cost and production
overhead costs to the extent of work done.
Stores, spares and tools Same as Raw Material
STICKY NOTES

Finished Goods Cost of raw material as determined above, plus direct labour cost and production
overheads.
Sometimes, the inventories are damaged or become wholly or partly obsolete. In such a case, the company
• Either have to incur more cost to bring them into saleable condition due to which the cost may exceed
the selling price
• Or sell them in the damaged / obsoleted form for which the selling price would probably be lower than
actual cost as demand of such obsoleted product may have come down
In such cases, the company needs to bring the inventories at their net realizable value.

2.3 Net Realizable Value:

Net realizable value is the estimated selling price in the ordinary course of business less the estimated cost of
completion and estimated cost necessary to make the sale (IAS 2).
It refers to the net amount that an entity expects to realize from the sale of the inventory in the ordinary course
of business (IAS 2).

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 Example 02:
Jawa Enterprises received consignment on January 15, 2019, consisting of 4 different types of
material items, A, B, C and D. The relevant data is given as under:

Description A B C D
Invoice price Rs. 500,000 400,000 300,000 200,000
Relative weight Kg 1,500 2,500 2,000 1,000

Total freight paid on consignment Rs. 350,000; of which 20% shall be refundable.
a) Calculation of cost per kg of each material, if the freight is apportioned on the basis of
invoice price.

AT A GLANCE
Freight cost of Rs. 280,000 shall be added in cost of inventories of each material while
Rs. 70,000 (20% of freight) shall not be included as it is refundable.
Freight is apportioned in the ratio of invoice price as 5:4:3:2.
Description A B C D
Invoice price Rs. 500,000 400,000 300,000 200,000
Freight Rs. 100,000 80,000 60,000 40,000
Cost of inventory Rs. 600,000 480,000 360,000 240,000
Cost per kg 400.00 192.00 180.00 240.00
b) Calculation of cost per kg of each material, if the freight is apportioned on the basis of
relative weight.

SPOTLIGHT
Freight is apportioned in the ratio of relative weight as 3:5:4:2.
Description A B C D
Invoice price Rs. 500,000 400,000 300,000 200,000
Freight Rs. 60,000 100,000 80,000 40,000
Cost of inventory Rs. 560,000 500,000 380,000 240,000
Cost per kg 373.33 200.00 190.00 240.00

2.4 Valuation of Inventory:

STICKY NOTES
An entity is required to evaluate, at the end of each reporting period, the net realizable value of its inventories
and value the inventories at lower of:
• Cost or
• Net realizable value
The cost of the inventories is ordinarily lower than the net realizable value. Therefore, the inventories are carried
at their costs. However, the cost may exceed the net realizable value in the following cases:
• The inventories are damaged,
• The inventories have become wholly or partially obsolete,
• The selling price of the inventories have declined, or
• The estimated cost of completion or estimated cost to be incurred to make the sale have increased (IAS
2).

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 Example 03:
A business has three items of inventory currently carried at their cost. The market prices of the
inventories have fallen down due to sudden decrease in demand. Their estimated selling prices,
cost of completion and selling costs are as under:

Cost Sales price Cost of completion Selling costs

Rs. Rs. Rs. Rs.
Finished Product A1 8,000 7,800 - 500
Finished Product A2 14,000 12,000 - 200
Work-in-process B1 16,000 14,000 1,500 200

Calculation of the NRV of each inventory item is given below:

AT A GLANCE

Est. Selling price – Est. Cost of completion - Est. Selling Cost: Rs.
Finished Product A1 7,800 – 500 7,300
Finished Product A2 12,000 – 200 11,800
Work-in-process B1 14,000 – 1,500- 200 12,300

It is to be noted that for finished goods no further processing cost is needed and therefore, the
formula for NRV does not include cost to complete.
 Example 04:
A business has following items of inventories with their costs and NRV. You are required to
SPOTLIGHT

calculate the value at which the inventories should be carried.

Cost of Cost to Selling

Inventories Cost
Completion Sell Price
---------------Rs.----------------
Raw Materials 150,000 500,000 50,000 850,000
Work-in-process 450,000 250,000 50,000 850,000
Finished Goods – in good condition 700,000 - 50,000 850,000
Finished Goods – damaged during 700,000 300,000 50,000 850,000
transport
STICKY NOTES

Calculating the value of inventories:

NRV (Est. Selling Value at

Price-Est. Cost to lower of
Inventories Cost
complete-Est. Cost cost or
to Sell) NRV
---------------Rs.----------------
Raw Materials 150,000 300,000 150,000
Work-in-process 450,000 550,000 450,000
Finished Goods – in good condition 700,000 800,000 700,000
Finished Goods – damaged during transport 700,000 500,000 500,000
It is to be noted here that the finished goods that were damaged during transport need to be
worked on further before sale, therefore, the formula of NRV shall now include cost to complete
the goods.

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2.5 Cost Formula

For all inventory items, particularly large and expensive items, it might be possible to recognize the actual cost
of each item.
In practice, however, this is unusual because the task of identifying the actual cost for all inventory items is
impossible because of the large numbers of such items and when the prices of those items differ in different
periods. The following example explains the situation well.
 Example 05:
On 1 January a company had an opening inventory of 100 units which cost Rs.50 each.
During the year it made the following purchases:
• 5 April: 300 units at Rs. 60 each

AT A GLANCE
• 14 July: 500 units at Rs. 70 each
• 22 October: 200 units at Rs. 80 each.
During the period it sold 800 units as follows:
• 9 May: 200 units
• 25 July: 200 units
• 23 November: 200 units
• 12 December: 200 units
This means that it has 300 units left at the end of the year (100 + 300 + 500 + 200 – (200 + 200
+ 200 + 200 + 200))

SPOTLIGHT
But since the units were purchased at different prices so what price should the remaining units
be allocated?
Should the units be allocated cost of units that were purchased last (that is Rs. 80)? But in that
case the inventory shall be overstated as only 200 out of 300 units were purchased at Rs. 80.
Should the cost of oldest purchased units be used? But in this case inventory will be understated.
Should the units be given the weighted average cost?
A system is therefore needed for measuring the cost of inventory.
The historical cost of inventory is usually measured by one of the following methods:

STICKY NOTES
• First in, first out (FIFO)
• Weighted average cost (AVCO)
The FIFO and weighted average cost (AVCO) methods of inventory valuation are used within perpetual inventory
systems. They can also be used to establish a cost for closing inventory with the period-end inventory system.

First-in, first-out method of valuation (FIFO)

With the first-in, first-out method of inventory valuation, cost of inventory consumed is strictly based in the order
of purchase means first purchase is issued first and so on. In simple words, the first items that are received into
inventory are the first items that go out.
To establish the cost of inventory using FIFO, it is necessary to keep a record of:
• the date that units of inventory are received into inventory, the number of units received and their
purchase price (or manufacturing cost)
• the date that units are issued from inventory and the number of units issued.

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With this information, it is possible to put a cost to the inventory that is issued (sold or used) and to identify the
cost of the items still remaining in inventory.
Since it is assumed that the first items received into inventory are the first units that are used, it follows that the
value of inventory at any time should be the cost of the most recently-acquired units of inventory.
 Example 06:
Taking the data from example 04 above, we are preparing the cost ledger as per FIFO method:
Receipts Issues Balance
Date Qty @ Rs. Qty @ Rs. Qty @ Rs.
1 Jan b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
AT A GLANCE

400 50/60 23,000

9 May 100 50 5,000 100 50 5,000
100 60 6,000 100 60 6,000
200 50/60 11,000 (200) 50/60 (11,000)
200 60 12,000
14 Jul 500 70 35,000 500 70 35,000
700 60/70 47,000
25 Jul 200 60 12,000 (200) 60 12,000
500 70 35,000
SPOTLIGHT

22 Oct 200 80 16,000 200 80 16,000

700 70/80 51,000
23 Nov 200 70 14,000 (200) 70 (14,000)
500 70/80 37,000
12 Dec 200 70 14,000 (200) 70 (14,000)
1,100 74,000 800 51,000 300 70/80 23,000
Note: 1,100 minus 800 equals 300
74,000 minus 51,000 equals 23,000

Weighted average cost (AVCO) method

STICKY NOTES

With the weighted average cost (AVCO) method of inventory valuation it is assumed that all units are issued at
the current weighted average cost per unit.
The normal method of measuring average cost is the perpetual basis method. With the perpetual basis AVCO
method, a new average cost is calculated whenever more items are purchased and received into store. It is also
termed as running weighted average method, as at new purchase with different price will change the average
cost of inventory. The weighted average cost is calculated by using the following formula:
 Formula:

Cost of inventory currently in store + Cost of new items received

Average cost:
Number of units currently in store + Number of new units received

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 Example 07:
Taking the data from example 04 above, we are preparing the cost ledger as per AVCO method:
Receipts Issues Balance
Date Qty. @ Rs. Qty. @ Rs. Qty. @ Rs.
1 Jan b/f 100 50 5,000 100 50 5,000
5 Apr 300 60 18,000 300 60 18,000
400 57.5000 23,000
9 May 200 57.5000 11,500 (200) 57.5000 (11,500)
200 57.5000 11,500
14 Jul 500 70 35,000 500 70 35,000

AT A GLANCE
700 66.4286 46,500
25 Jul 200 66.4286 13,286 (200) 66.4286 (13,286)
500 66.4286 33,214
22 Oct 200 80 16,000 200 80 16,000
700 70.3057 49,214

23 Nov 200 70.3057 14,061

(200) 70.3057 (14,061)
500 70.3057 35,153
12 Dec 200 70.3057 14,061 (200) 70.3057 (14,061)
1,100 74,000 800 52,912 300 70.3057 21,092
Note: 1,100 minus 800 Equals 300

SPOTLIGHT
74,000 Minus 52,912 equals 21,092
 Example 08:
XYZ Limited manufactures four products. The related data for the year ended December 31, 20X3
is given below:

A B C D
Opening inventory
- Units 10,000 15,000 20,000 25,000
- Cost (Rs.) 70,000 120,000 180,000 310,000

STICKY NOTES
- NRV (Rs.) 75,000 110,000 180,000 300,000
Production in units 50,000 60,000 75,000 100,000
Costs of goods produced (Rs.) 400,000 600,000 825,000 1,200,000
Variable selling costs (Rs.) 60,000 80,000 90,000 100,000
Closing inventory (units) 5,000 10,000 15,000 24,000
Damaged units included in
closing inventory 300 600 800 1,500

Weighted Weighted
Inventory valuation method in use FIFO FIFO
Average Average
Unit cost of purchase from market (Rs.) 10.50 11.00 11.50 13.00
Selling price per unit (Rs.) 10.00 12.00 12.00 12.50
Unit cost to repair damaged units (Rs.) 3.00 2.00 2.50 3.50

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The company estimates that selling expenses will increase by 10% in January 20X4.
In computing the amount of closing inventory that should be reported in the statement of
financial position as on December 31, 20X3, following are the considerations.
To calculate the cost of closing stock, we have to first calculate the cost of goods available for sale
to determine the weighted average cost per unit for the purpose of AVCO method.

Formula A B C D
Step 1: Calculating Units Sold during the
Units
period
Opening stock Given 10,000 15,000 20,000 25,000
Production during Given 50,000 60,000 75,000 100,000
AT A GLANCE

the period
Goods available Op. stock + production 60,000 75,000 95,000 125,000
for sale during the period
Closing Stock Given (5,000) (10,000) (15,000) (24,000)
Units Sold Goods available for 55,000 65,000 80,000 101,000
sale – Closing Stock
*Units sold are calculated only to determine the mix of units for the purpose of costing of
closing stock as per FIFO.
Step 2: Calculating Cost of goods available for sale
SPOTLIGHT

-----------------Rs.--------------
Opening stock From the given data 70,000 110,000 180,000 300,000
valuation (at
lower of cost and
NRV)
Cost of Given 400,000 600,000 825,000 1,200,000
production for the
period
Cost of goods Op. stock + production 470,000 710,000 1,005,000 1,500,000
available for sale during the period
STICKY NOTES

Step 3: Calculating cost of closing stock

A & B (W/Avg.): (Cost of goods available 39,167 94,667
for sale /Goods
available for sale) x
Closing Stock
C & D (FIFO): (Cost of goods 165,000 288,000
produced during the
period/Goods
produced during the
period) x Closing
Stock

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Formula A B C D
Step 4: Calculating NRV
Sales price - per Given 10.0 12.0 12.0 12.5
unit
Total sales price (Closing Stock x Sales 50,000 120,000 180,000 300,000
of closing stock Price per unit)
Selling costs (Selling (6,000) (13,538) (18,563) (26,139)
Cost/Production
Units) x Closing Stock

AT A GLANCE
Repair cost of Damaged units x (900) (1,200) (2,000) (5,250)
damaged units repair cost per unit
NRV of Closing Selling price – cost to 43,100 105,262 159,438 268,611
stock sell – cost to complete
Value of closing Lower of cost and NRV 39,167 94,667 159,438 268,611
stock to be
reported in the
SFP

2.5 Comparison of Methods

SPOTLIGHT
The different methods of inventory valuation will give significantly different valuations for the cost of sales and
the value of closing inventory during a period of high inflation (when prices are increasing)
• With FIFO during a period of high inflation, the cost of sales will be lower than the current replacement
cost of materials used. The closing inventory value should be close to current value since they will be the
units bought most recently.
• With AVCO during a period of high inflation, the cost of sales will be higher and the value of closing
inventory lower than with FIFO valuation.
In the example used above to illustrate FIFO and AVCO, prices were rising and the valuations of the cost of goods
issued and closing inventory were as follows
Valuation method Cost of goods issued Closing inventory

STICKY NOTES
Rs. Rs.
FIFO 51,000 23,000
AVCO 52,912 21,092
The valuation of closing inventory is higher and the cost of goods issued is lower using FIFO. This is typical during
a period when prices are rising steadily.
The opposite is true when prices are falling. The valuation of closing inventory is lower and the cost of goods
issued is higher using FIFO.

Advantages & Disadvantages of FIFO

Advantages
• This method is realistic and in line with the physical movement of goods normally.
• Easy to understand and explain to managers
• Gives a value near to replacement cost

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Disadvantages
• Can be cumbersome to operate especially when frequent purchase is made and prices are fluctuating on
regular basis
• Managers may find it difficult to compare costs and make decisions when they are charged with varying
prices for the same materials
• In a period of high inflation, inventory issue prices will lag behind current market value

Advantages & Disadvantages of AVCO

Advantages
• Smoothens out price fluctuations as different prices are converted into average prices.
• Easier to administer than FIFO
AT A GLANCE

Disadvantages
• Issue price is rarely what has been paid
• Prices tend to lag a little behind current market values when there is gradual inflation

2.6 Journal Entries

Following journal entries are related to movement of raw material inventory under perpetual inventory system.

Description Journal Entry

When raw material is purchased Material Inventory Dr.

SPOTLIGHT

Accounts Payable Cr.

When raw material is issued to production Work in process Dr. (Direct material)
Factory overhead control Dr. (Indirect material)
Material Inventory Cr.

When raw material is returned to vendor Accounts Payable Dr.

Material Inventory Cr.

When raw material is returned from Material Inventory Dr.

STICKY NOTES

production to store
Work in process Cr. (Direct material)
Factory overhead control Cr. (Indirect material)

Recording of loss of raw material inventory Factory overhead control Dr.

(Shortage)
Material Inventory Cr.

Recording of inventory at NRV if cost Factory overhead control Dr.

exceeds NRV at period end
Material Inventory Cr.
(With difference of cost and NRV)

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 Example 09:
Taking the data from example 04 above, Journal Entries on basis of AVCO method of costing are
given below:
Debit Credit
Journal entries:
Rupees
5 April Raw material 18,000
Account payable 18,000
(Cost of material purchased)
9 May Work in process 11,500
Raw material 11,500
(Issue of raw material to production)

AT A GLANCE
14 July Raw material 35,000
Account payable 35,000
(Cost of material purchased)
25 July Work in process 13,286
Raw material 13,286
(Issue of raw material to production)
22 October Raw material 16,000
Account payable 16,000
(Cost of material purchased)
23 November Work in process 14,061
Raw material 14,061
(Issue of raw material to production)

SPOTLIGHT
22 December Work in process 14,061
Raw material 14,061
(Issue of raw material to production)

STICKY NOTES

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2 COMPREHENSIVE EXAMPLES
 Example 01:
Mehanti Limited(ML) produces and markets a single product Wee. Two chemicals Bee and Gee
are used in the ratio of 60:40 for producing 1 liter of Wee. ML follows perpetual inventory system
and uses weighted average method for inventory valuation. The purchase and issue of Bee and
Gee for May 20X3, are as follows:
Bee Gee
Date Receipt Issue Receipt Issue
Liter Rate Liter Liter Rate Liter
02-05-20X3 - - 450 110 -
AT A GLANCE

05-05-20X3 - - 560 - - 650

09-05-20X3 - - 300 - - 300
12-05-20X3 420 52 - 700 115 -
18-05-20X3 - - 250 - - 150
24-05-20X3 500 55 - 250 124 -
31-05-20X3 - - 500 - - 450
Following further information is also available:
i. Opening inventory of Bee and Gee was 1,000 liters at the rate of Rs.50 per liter and 500
liters at the rate of Rs. 115 per liter respectively.
ii. The physical inventories of Bee and Gee were 535 liters and 140 liters respectively. The
stock check was conducted on 01 June and 31 May 20X3 for Bee and Gee respectively.
SPOTLIGHT

iii. Due to contamination, 95 liters of Bee and 105 liters of Gee were excluded from the stock
check. Their net realizable values were Rs20 and Rs.50 per liter respectively.
iv. 250 liters of Bee which was received on 01 June 20X3 and 95 liters of Gee which was
issued on 31 May 20X3 after the physical count were included in the physical inventory.
v. 150 liters of chemical Bee was held by ML on behalf of a customer, whereas 100 liters of
chemical Gee was held by one of the suppliers on ML’s behalf.
vi. 100 liters of Bee and 200 liters of Gee were returned from the production process on
31May and 01 June 20X3 respectively.
vii. 240 liters of chemical Bee purchased on 12th May and 150 liters of chemical Gee
purchased on 24th May 20X3 were in advertently recorded as 420 liters and 250 liters
STICKY NOTES

respectively.
a) Reconcile the physical inventory balances with the balances as per book.
Reconciliation (Bee) Liters
Bal. as per physical count (1st June) 535
Add: Contaminated Stock 95
Less: Receipt of June, 1 (250)
Third party stock (150)
Balance as per books (W-1) 230
Reconciliation (Gee) Liters
Balance as per physical count (31st May) 140
Less: Issued after Count (95)
Actual Physical as on 31.5.20X3 45
Add: Contaminated stock 105
Stock with 3rd party 100
Stock as per books (W-2) 250

14 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

(W-1) (Bee)
Receipts Issues Balance
Date
Units PUC TC Units PUC TC Units PUC TC
1-5-X3 1,000 50 50,000
5-5- X3 560 50 28,000 440 50 22,000
9-5- X3 300 50 15,000 140 50 7,000
12-5- X3 420 52 21,840 560 51.5 28,840
18-5- X3 250 51.5 12,875 310 51.5 15,965
24-5- X3 500 55 27,500 810 53.66 43,465
31-5- X3 500 53.66 26,830 310 53.66 16,635
31-5- X3 (100) (53.66) 5366 410 53.66 22,001
31-5- X3 (180)* (52) (9,360) 230 54.96 12,641
(Adj)

AT A GLANCE
*Purchases of 240 liters erroneously recorded as 420 liters now corrected. It is assumed
that the error was highlighted on 31st May or later.
(W-2) (Gee)
Receipts Issues Balance
Date
Units PUC TC Units PUC TC Units PUC TC
1-5- X3 500 115 57,500
2-5- X3 450 110 49,500 950 112.63 107,000
5-5- X3 650 112.63 73,210 300 112.63 33,790
9-5- X3 300 112.63 33,789 - - -
12-5-X3 700 115 80,500 700 115 80,500
18-5- X3 150 115 17,250 550 115 63,250

SPOTLIGHT
24-5- X3 250 124 31,000 800 117.81 94,250
31-5- X3 450 117.81 53,015 350 117.81 41,235
31-5- X3 *(100) 124 12,400 250 115.34 28,835
*Purchases of 150 liters were erroneously recorded as 250 liters. It is assumed that error
is highlighted on 31st May 20X3.
b) Determine the cost of closing inventory of chemical Bee and Gee. Also compute the
cost of contaminated materials as on 31 May 20X3.
Valuation of Bee
As on 31 May 20X3
Units PUC TC

STICKY NOTES
Balance as per books 230 54.96 12,641
Less: contaminated stock (BV) (95) (54.96) (5,221)
Add: contaminated stock (NRV) 95 20 1,900
Balance as per books as on 31 May 20X3 230 40.52 9,320
Above calculated stock include 95 liters of contaminated stock @ 20/ liter i.e. its NRV
Thus the cost of closing inventory of Bee is Rs. 9,320 and cost of contaminated material
would be Rs. 1,900 included above.
Valuation of Gee
As on 31 May 20X3
Units PUC TC
Stock as per books 250 115.34 28,835
Less: Contaminated stock (BV) (105) (115.34) (12,110.70)
Add: Contaminated stock (NRV) 105 50 5,250
Value of stock as on 31 May 20X3 250 87.90 21,974.30

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 15

 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

Thus the cost of closing inventory of Gee is Rs. 21,974.30 including the cost of contaminated
material Rs. 5,250.
Above calculated stock include 105 liters of contaminated material at its NRV i.e. Rs. 50/ liter.
 Example 02:
Quality Limited (QL) is a manufacturer of washing machines. The company uses perpetual
method for recording and weighted average method for valuation of inventory.
The following information pertains to a raw material (SRM), for the month of June 20X3.
i. Opening inventory of SRM was 100,000 units having a value of Rs. 80 per unit.
ii. 150,000 units were purchased on June 5, at Rs. 85 per unit
iii. 150,000 units were issued from stores on June 6.
iv. 5,000 defective units were returned from the production to the store on June 12.
AT A GLANCE

v. 150,000 units were purchased on June 15 at Rs. 88.10 per unit.

vi. On June 17, 50% of the defective units were disposed of as scrap, for Rs. 20 per unit,
because these had been damaged on account of improper handling at QL.
vii. On June 18, the remaining defective units were returned to the supplier for replacement
under warranty.
viii. On June 19, 5,000 units were issued to production in replacement of the defective
units which were returned to store.
ix. On June 20, the supplier delivered 2,500 units in replacement of the defective units
which had been returned by QL.
x. 150,000 units were issued from stores on June 21.
xi. During physical stock count carried out on June 30, 2010 it was noted that closing
SPOTLIGHT

inventory of SRM included 500 obsolete units having net realizable value of Rs. 30 per
unit. 4,000 units were found short.
Necessary journal entries to record the above transactions would be prepared as follows
Debit Credit
Journal entries:
Rupees
5-Jun-20X3 Raw material 12,750,000
Account payable (150,000 x 85) 12,750,000
(Cost of material purchased)
6-Jun-20X3 Work in process 12,450,000
Raw material 12,450,000
STICKY NOTES

(Issue of raw material to production)

12-Jun-20X3 Raw material 415,000
Work in process 415,000
(Defective material returned from the
production)
15-Jun-20X3 Raw material 13,215,000
Account payable (150,000 x 88.1) 13,215,000
(Cost of material purchased)
17-Jun-20X3 Cash (2,500 x 20) 50,000
Factory overheads 165,000
Raw material 215,000
(Defective units sold as scrapped)
18-Jun-20X3 Account payable 212,500
Raw material 212,500
(Defective material returned to the
supplier)

16 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

Debit Credit
Rupees
19-Jun-20X3 Work in process 430,050
Raw material 430,050
(Replacement of defective material to
production by the store)
20-Jun-20X3 Raw material 212,500
Account payable (2,500 x 85) 212,500
(Goods returned were replaced by the
supplier)
21-Jun-20X3 Work in process 12,900,000
Raw material 12,900,000

AT A GLANCE
(Issue of raw material to production)
Factory overheads -
30-Jun-20X3 {500 x (86-30)} (obsolete items) 28,000
Factory overheads -
(4,000 x 86) (shortages) 344,000
Raw material 372,000
(Cost of obsolete and shortages charged to
factory overheads)

Receipts /(Issues)
Date Particulars
Quantity Rate Rupees

SPOTLIGHT
01-Jun-20X3 Balance 100,000 80.00 8,000,000
05-Jun-20X3 Purchases 150,000 85.00 12,750,000
Balance 250,000 83.00 20,750,000
06-Jun-20X3 Issues (150,000) 83.00 (12,450,000)
12-Jun-20X3 Returned from production 5,000 83.00 415,000
15-Jun-20X3 Purchases 150,000 88.10 13,215,000
Balance 255,000 86.00 21,930,000
17-Jun-20X3 Defective goods sold (2,500) 86.00 (215,000)
18-Jun-20X3 Returned to supplier (2,500) 85.00 (212,500)

STICKY NOTES
Balance 250,000 86.01 21,502,500
19-Jun-20X3 Replacement to production (5,000) 86.01 (430,050)
20-Jun-20X3 Replacement by supplier 2,500 85.00 212,500
Balance 247,500 86.00 21,284,950
21-Jun-20X3 Issues (150,000) 86.00 (12,900,000)
Balance 97,500 86.00 8,384,950
30-Jun-20X3 Shortage (4,000) 86.00 (344,000)
Balance 93,500 86.00 8,040,950

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 17

 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

 Example 03:
Standard Limited (SL) is in the business of buying and selling electric ovens. It follows perpetual
inventory system and uses weighted average method for valuation of inventory. Following
information is extracted from SL’s records for the month of February 2021:
i. Opening inventory consisted of 220,000 units having average cost of Rs. 7,000 per unit.
ii. 280,000 units were purchased on 5 February 2021, at Rs. 7,200 per unit.
iii. 180,000 units were sold to Khurram Limited (KL) on 10 February 2021.
iv. 5,000 defective units were returned by KL on 12 February 2021.
v. 30% of the defective units returned to SL, had a manufacturing fault and were returned
to the supplier on 15 February 2021. Remaining defective units were damaged due to
AT A GLANCE

mishandling at the warehouse. These units were disposed of as scrap on 20 February

2021 for Rs. 2,000 per unit.
vi. 5,000 units were sent to KL on 22 February 2021 in replacement of the defective units
returned.
vii. 150,000 units were sold on 25 February 2021. On 28 February 2021, a physical stock
count was carried out and the following was discovered:
• 4,500 units were identified as obsolete having net realizable value of Rs. 6,000 per
unit.
• 500 units were found missing.
Necessary journal entries to record the above transactions relating to inventory are as
SPOTLIGHT

follows:
Debit Credit
Journal entries:
Rupees in ‘000
1-Feb-21 Inventory 2,016,000
Account payable 2,016,000
(Inventory purchased)
10-Feb-21 Cost of goods sold 1,280,160
Inventory 1,280,160
(Sales made to KL)
STICKY NOTES

12-Feb-21 Inventory 35,560

Cost of goods sold 35,560
(Defective units returned by KL)
15-Feb-21 Accounts Payable 10,800
Inventory 10,800
(Defective units returned by KL)
20-Feb-21 Cash (3,500 x 2,000) 7,000
Profit & Loss account (Bal) 17,891
Inventory 24,891
(Defective units sold as scrap)
22-Feb-21 Cost of goods sold 35,558
Inventory 35,558
(Replacement of defective units to KL)

18 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 1: INVENTORY VALUATION

Debit Credit
Rupees in ‘000
25-Feb-21 Cost of goods sold 1,066,739
Inventory 1,066,739
(Sales made)
Profit & Loss account-NRV Adjustment [4,500
28-Feb-21 x (7,111.59-6,000.00)] 5,002
Profit & Loss account- Shortage 3,556
Inventory 8,558
(Cost of obsolete and shortages charged to
factory overheads)

AT A GLANCE
In order to prepare journal entries of above transactions, it is important to prepare stock ledger
card of electric ovens. It will help to identify cost assigned to each transaction.

Receipts /(Issues)
Date Particulars
Quantity Rate Rs. In ‘000
01-Feb-21 Balance 220,000 7,000.00 1,540,000
05-Feb-21 Purchases 280,000 7,200.00 2,016,000
Balance 500,000 7,112.00 3,556,000
10-Feb-21 Sales to KL (180,000) 7,112.00 (1,280,160)

SPOTLIGHT
12-Feb-21 Returned by KL 5,000 7,112.00 35,560
15-Feb-21 Returned to supplier-defective (1,500) 7,200.00 (10,800)
Balance 323,500 7,111.59 2,300,600
20-Feb-21 Defective goods scrapped (3,500) 7,111.59 (24,891)
22-Feb-21 Replacement of defective to KL (5,000) 7,111.59 (35,558)
25-Feb-21 Sales (150,000) 7,111.59 (1,066,739)
28-Feb-21 Short inventory found in physical count (500) 7,111.59 (3,556)
Balance 164,500 7,111.59 1,169,856

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 19

 CHAPTER 1: INVENTORY VALUATION CAF 8: CMA

STICKY NOTES

Inventory is valued at lower of cost or NRV

Net Realizable value is the estimated selling price in the ordinary course of
business
AT A GLANCE

The costs of large volume inventories are calculated using FIFO or AVCO
method

FIFO & AVCO methods provide different results of cost of sales and closing
value of inventories if the prices are moving frequently
SPOTLIGHT
STICKY NOTES

20 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 2

INVENTORY MANAGEMENT

AT A GLANCE
IN THIS CHAPTER
Inventory management refers to the process of ordering,
storing and using a company’s inventories. Managers of
AT A GLANCE
inventory-intensive industries have to be very vigilant to

AT A GLANCE
manage the inventories in such a way so as to make adequate
SPOTLIGHT
stock available to meet expected demands at minimum costs,
while keeping it safe from obsolescence and damage.
1. What is Inventory Management?
They have to determine:
2. Economic Order Quantity
• order quantity at which the relevant cost is lowest and
level of stock at which the order must be placed.
3. Inventory Levels and Buffer
Stock • quantity in addition to the normal usage to meet
unexpected demand in order to avoid loss of profit whereas
4. Comprehensive Examples keeping the holding cost lowest.
Costs associated with inventories include: cost of purchasing,
STICKY NOTES

SPOTLIGHT
ordering and holding the inventory. Relevant costs are the costs
that occur on the occurrence of an activity.
EOQ model is used to determine the order quantity at which the
cost is minimum. EOQ can be determined using: Tabular
Method, Graphical Method and EOQ Formula.
A business entity shall always maintain certain levels of
inventories. These levels are: Re-order Level, Safety Stock /
Buffer Stock, Maximum and Minimum Inventory Levels.
Probabilities are used to make the comparison of holding cost
with stock-out cost to achieve cost efficiencies.

STICKY NOTES

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 21

 CHAPTER 2: INVENTORY MANAGEMENT CAF 8: CMA

1. WHAT IS INVENTORY MANAGEMENT?

Inventory management refers to the process of ordering, storing and using a company’s inventories. This
includes management of raw materials, components and finished products as well as warehousing and
processing such items.
Since the inventory is the most important component of any inventory-intensive sectors, special efforts are put
to ensure that:
• There is sufficient inventory of raw materials available to produce the quantity of finished goods to meet the
sale forecast,
• There is sufficient inventory of finished goods available to meet the immediate sales requirement (both
expected and unexpected) to avoid stock out situations,
AT A GLANCE

• The quantity so available is not in excess of the market needs to avoid any obsolescence, damage or blockage
of finance and
• The costs associated with inventory are minimized.

1.1. Why do companies hold stocks?

There are three general reasons:
1. Transaction motive
2. Precautionary motive and
3. Speculative motive.
The transaction motive occurs when there is a need to hold stocks to meet production and sales requirements
SPOTLIGHT

instantaneously. The stock is maintained in order to operate the production smoothly without stoppage of work
due to mishandling of material.
The firm might also decide to hold additional amounts of stocks to cover the possibility that it may have
underestimated its future production and sales requirements or the supply of raw materials may be unreliable
because of uncertain events affecting the supply of materials. This represents precautionary motive which
applies only when future demand is uncertain and fluctuating .
When it is expected that future input prices may change, a firm might maintain higher or lower stock levels to
speculate on the expected increase or decrease in future prices. This is called speculative motive.

1.2. Costs Associated with Inventories:

Inventory management is quite critical for the companies as it includes substantial costs, especially in material-
STICKY NOTES

intensive manufacturing concerns. Following are the costs that are associated with inventories:
1. Cost of purchasing the inventory – the price that is settled with the supplier, after deducting the trade
discounts and rebates.
2. Cost of ordering the inventory – such as clerical costs of preparing the material requisition, purchase
order, receiving and handling shipments and preparing receiving report, communicating in case of
quantity/ quality errors or delay in receipt of shipment, and accounting for the shipment and the
payment.
3. Cost of holding the inventory – such as interest cost on borrowings for purchase of inventory,
insurance cost, warehouse and storage cost, handling cost and cost of obsolescence, deterioration of
inventory and opportunity cost of holding the stocks.
All these costs are financed either through company’s own funding or borrowings from banks.
a) If inventories are financed using company’s own funds, the company would have to bear the opportunity
cost in a way had these funds were not invested in the inventories could be used in investing in any other
avenues to earn a fixed return. The gain so forgone shall be treated as the opportunity cost.

22 INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

b) Similarly, if the inventories are funded by obtaining bank loan, the interest on such loan shall make the
part of cost of inventories.
Now if the investment on which a fixed return could be attained or the loan was obtained, for three months, the
company would have to complete its cycle of purchasing, manufacturing, selling and realizing cash in three
months to:
• adjust the opportunity cost with gain from sale of inventories or
• pay off the borrowings and interest
which if not materialize in the given time would make the company to bear more cost (more interest, more
storage and insurance costs etc.). Therefore, to avoid such a situation the companies put substantial efforts to
determine the expected market demand on the basis of which purchasing and manufacturing plans are made in
order to achieve a point of inventory at which the cost is minimized.

AT A GLANCE
The mathematicians have therefore derived quantitative models to determine the level of stock to be maintained
at which the price is minimal (known as optimum stock level).
Such quantitative models undertake only relevant costs in calculation.

1.3. Relevant and Irrelevant Cost:

Relevant costs are the costs that occur on the occurrence of given relevant activity.
Irrelevant costs are those that occur whether or not any activity is carried, means not related to specific activity.
 Example 01:
A company is planning to shut down its operations for two months. The operations run on a
factory for which company pay rent of Rs. 50,000 per month. The company uses raw material of

SPOTLIGHT
Rs. 75,000 for monthly production and incurs Rs. 60,000 towards labour cost. Due to it shut
down, the company would not purchase raw material for the two months and pay half to the
labours as per labour unions agreement. However, it would be required to pay full amount of
rent for the factory.
In this case the cost of raw materials and half cost of labour is relevant cost as the same occur
when the factory runs. Whereas, the rent of the factory and half cost of labours shall occur
irrespective the operations run or not and is irrelevant cost .
This concept shall be discussed in detail in chapter ‘Decision Making’ and here we will look at areas that are
relevant for decisions relating to inventories.
The relevant cost that should be considered when determining optimum stock levels are holding cost and

STICKY NOTES
ordering cost.
Relevant Holding Cost to be used in quantitative models should include only those items that will vary with the
levels of stock. For example, in the case of storage and warehouse only those costs should be included that will
vary with changes in number of units ordered. Such costs are called variable costs. However, fixed cost is not
included in holding cost because it will not change as a result of holding higher or lower inventory levels.
 Example 02:
Fixed and variable holding costs
Salaries of storekeepers, depreciation of equipment and fixed rental of equipment and buildings
are often irrelevant because they are unaffected by changes in stock levels.
On the other hand, if storage space is owned and can be used for other productive purposes, such
as to obtain rental income, then the opportunity cost must be included in the analysis.
Similarly, the insurance cost of stock must be undertaken when the premium is paid at the
fluctuating value of stocks and not the fixed insurance cost per annum.

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 19

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

To the extent that funds are invested in stocks, the analysis must include opportunity cost (as
explain in cost associated with inventories). The opportunity cost is reflected by the required
return that is lost from investing in stocks.
The relevant holding costs for other items such as material handling, obsolescence and
deterioration are difficult to estimate and these costs are not very critical to the investment
decision.
Normally, the holding costs are expressed as a percentage rate per rupee of average investment.
Same as holding costs, the ordering costs that are common to all inventory decisions are
irrelevant and only the incremental costs of placing an order are useful for this purpose.
Note: the cost of purchasing or manufacturing the inventories are irrelevant for the purpose
of determining optimum stock level since it remains unchanged irrespective of the order size
or stock levels unless quantity discounts are available.

AT A GLANCE
 Example 03:
Ore Limited (OL) is a manufacturer of sports bicycles. The company buys tyres from a local
vendor.
Following data, relating to a pair of tyres, has been extracted from OL’s records:
Cost (per unit) Rs.
Storage cost based on average inventory 80
Insurance cost based on average inventory 60
Store keeper’s salary (included in absorbed overheads) 8
Cost incurred on final quality check at the time of delivery 10

SPOTLIGHT
Other relevant details are as follows:
i. The purchase price is Rs. 900 per pair.
ii. The annual demand for tyres is 200,000 pairs.
iii. The ordering cost per order is Rs. 8,000.
iv. The delivery cost per order is Rs. 3,000.
v. OL’s rate of return on investment in inventory is 15%.
vi. Recently the vendor has offered a quantity discount of 3% on orders of a minimum of
5,000 pairs.
a) Annual Ordering Cost, can be calculated as follows:
Annual Ordering Cost = Number of orders per annum x cost per order

STICKY NOTES
Number of orders = Annual demand / order size = 200,000/5000 = 40 orders per annum
Cost per Order = Ordering Cost + Delivery Cost = Rs. 8,000 + Rs. 3,000 = 11,000
Therefore, the annual ordering cost = 40 x 11,000 = Rs. 440,000
b) To calculate Average inventory, following calculations would be required:
Average Inventory = (Opening quantity of stock + Closing quantity of stock) / 2
(0+5000)/2 = 2,500 pairs
c) Annual Holding cost, to be calculated as follows:
Annual Holding Cost = Holding Cost per unit x Average Inventory
Holding cost per unit:
Storage cost based on average inventory = 80
Insurance cost based on average inventory = 60
Opportunity Cost = Rs. 900 x 97% x 15% = 130.95
Total (relevant) holding cost per unit = 270.95
Annual Holding Cost = 270.95 x 2,500 = 677,375

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 20

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

d) Lastly, Total Cost of Inventory would be

Total Cost of Inventory:
Purchase cost (net of discount) = 900 x 200,000 x 97% = 174,600,000
Annual Ordering Cost = (a) = 440,000
Annual Holding Cost = (c) = 677,375
Total Cost of Inventory per annum = 175,717,375
Note: for the purpose of average stock it is assumed that there is no inventory available when the
order is received and the inventory is consumed at a constant rate throughout the period,
therefore, opening stock is zero and closing stock is the order size.
Alternatively, it can be assumed that the stock level is at the quantity of order received (5,000 in

AT A GLANCE
this case) which is consumed at a constant rate and becomes zero before the new order is
received. This way opening shall become 5,000 and closing will be zero. However, in both cases
the answer will be same.
Therefore, the average inventory is quantity reordered divided by 2.

SPOTLIGHT
STICKY NOTES

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 21

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

2. ECONOMIC ORDER QUANTITY

There are models which incorporate transaction motive for holding optimum level of stocks. This is possible
where a company is able to predict the demand for its inputs and outputs with perfect certainty and where it
knows with certainty that prices of inputs, will remain constant for some reasonable length of time.
In such a situation, the optimum order will be determined by those costs that are affected by either:
• the quantity of stocks held or
• the number of orders placed.
If more units are ordered at one time, fewer orders will be required per year. This will result in reduction in
ordering costs.
As seen in above example, if order size is 10,000 units, the number of orders will be 200,000 / 10,000 = 20 orders

AT A GLANCE
which will reduce the ordering cost to Rs. 220,000
However, when fewer orders are placed, larger average stocks must be maintained which leads to increase in
holding costs that is (10,000 / 2) x 270.95 = 1,354,750. Hence the total relevant cost (ordering cost + holding
cost) shall become Rs. 1,574,750 that is Rs. 457,375 higher than the one calculated at 5,000 units (i.e.
440,000+677,375=1,117,375).
Therefore, an optimum level must be determined at which the total relevant cost is minimized. This optimum
level is called Economic Order Quantity (EOQ).
The EOQ can be determined by using the following methods:
1. Tabular Method
2. Graphical Method

SPOTLIGHT
3. Formula Method
We shall look into these methods using the following example.
 Example 04:
Stock items 6786:
A company uses 40,000 units of stock item 6786 each year. The item has a purchase cost of Rs.10
per unit. The cost of placing an order for re-supply is Rs.2. The annual holding cost of one unit of
the item is 10% of its purchase cost.
if it would be required to calculate the economic order quantity for item 6786, to the nearest unit
using:

STICKY NOTES
a) Tabular method
b) Graphical method
c) Formula Method
a) Tabular Method:
Order Quantity (Q) 100 200 300 400 500 600 800 10,000
Average Inventory (Q/2) 50 100 150 200 250 300 400 5000
Number of Purchase Orders 400 200 133 100 80 67 50 4
(Annual Demand (A) / Q)
Annual Holding Cost (10% x 10 x 50 100 150 200 250 300 400 5000
Average Inventory)
Annual Ordering Cost (2 x No. of 800 400 266 200 160 134 100 8
Orders)
Total Relevant Cost 850 500 416 400 410 434 500 5,008
So the relevant cost is minimum at 400 units per order where annual OC and HC are equal.
This is the optimum point or EOQ.

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 22

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

b) Graphical Presentation Method:

We have taken total relevant cost (ordering cost + holding cost) on the vertical axis and order
quantity and average inventory on the horizontal axis.
We can see that as the average inventory and order size increases, the holding cost also increases
whereas the order cost decreases.
It also to be noted here that the total relevant cost line is lowest at a point where ordering cost
line and holding cost line are intersecting. This intersecting point determines our EOQ.

EOQ
900
800

AT A GLANCE
700
Total Relevant Cost

600
500
400
300
200
100
0
50 100 150 200 250 300 400

SPOTLIGHT
100 200 300 400 500 600 800

Order Quantity

Relevant Annual Cost Holding Cost Ordering Cost

c) Formula method:
The economic order quantity formula is based on mathematical model that incorporates the
basic relationships between ordering and holding costs.
These relationships can be stated as follows:

STICKY NOTES
Annual Demand = A
Quantity per Order / Order size = Q
Cost per Order = Oc
Holding cost per unit = Hc
Average Inventory = Q / 2
Annual Ordering Cost (AOc) shall be calculated as (A / Q) x Oc
Annual Holding (AHc) shall be calculated as (Q / 2) x Hc
𝐴𝐴 𝑄𝑄
TRC =
𝑄𝑄
× 𝑂𝑂𝑂𝑂 + 2 × 𝐻𝐻𝐻𝐻
Total Relevant Cost (TRC) = Annual Holding Cost (AHc) + Annual Ordering Cost (AOc)

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 23

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

When differentiating the above equation with respect to Q and setting the derivative equal to
zero, we get the economic order quantity ‘Q’:

2𝐴𝐴𝐴𝐴𝐴𝐴
𝑄𝑄 = �
𝐻𝐻𝐻𝐻

Applying this formula to the example 2 above:

(2 x 40,000 x 2)
𝑄𝑄 = �
1

= 400 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢

AT A GLANCE
Assumptions of EOQ:
EOQ model is valid only as per the following assumptions:
1. The holding cost per unit will be constant.
2. The average inventory is equal to one half of the order quantity as the stock is consumed at a constant
rate throughout the period. (discussed in above sections)
3. The cost per order is constant.
4. There are no quantity discounts available.
5. The demand for its inputs and outputs can be predicted with perfect certainty.
 Example 05:
Taking the data from example 04, determine the effect of an increase in annual holding cost per

SPOTLIGHT
unit on:
a) EOQ
b) Total annual ordering cost
In order to fulfil the requirement, assume that HC has increased to 15%, the revised HC will be =
15% x 10 = 1.5

(2×40,000×2)
The revised EOQ would be � = 326.6 ≈ 327
1.5

Effect: the order size shall decrease due to increase in holding cost.

STICKY NOTES
The Annual Ordering Cost shall increase due to reduction in order size.
40,000
𝐴𝐴𝐴𝐴𝐴𝐴 = × 2 = 𝑅𝑅𝑅𝑅. 244.6
326.6
The AOC has increased by Rs. 44.6
 Example 06:
Rana Manufacturers require 1,500 units of an item per month. The cost of each unit is Rs. 27. The
cost per order is Rs. 150 and material carrying charge works out to 20% of the average material.
(a) Calculation of EOQ by using formula, is given below:
Here, A = 18,000 (1,500 x 12)
Oc= Rs. 150
Hc= Rs.5.40 (27 x 20%)

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We use the economic order quantity formula ‘Q’ as:

2 𝐴𝐴𝐴𝐴𝐴𝐴
𝑄𝑄 = �
𝐻𝐻𝐻𝐻

By putting values in formula

(2×18,000×150)
EOQ would be � = 1,000 units
5.40

(b) Calculation of Annual ordering and holding cost, is given below:

Annual cost Rupees

AT A GLANCE
Ordering cost (18,000/ 1,000 x 150) 2,700
Holding cost (1,000 / 2 x 5.40) 2,700
5,400

2.1 Quantity Discounts affecting the decision of order size:

As per above assumptions, it is assumed that no quantity discounts exist. However, sometimes the suppliers offer
discounts on bulk purchases. In such a case, the EOQ model can only be used when the total cost including
purchase price after taking into account the discounts is more than the cost at EOQ. This means, the entity shall
evaluate both the options and determine which option gives the lesser cost.
Following steps should be followed in order to calculate EOQ in case of bulk discounts.

SPOTLIGHT
i. Calculate EOQ (Ignoring discounts)
ii. Calculate Annual Inventory Cost including purchase cost at above EOQ level.
iii. Calculate Annual Inventory Cost at each discount level including purchase cost.
iv. Compare annual inventory costs calculated in above II and III, and determine EOQ level at a point where
total inventory cost is minimum.
 Example 07:
Entity G uses 105 units of an item of inventory every week. These cost Rs.150 per unit. They are
stored in special storage units and the variable costs of holding the item is Rs.4 per unit each year
plus 2% of the inventory’s cost.

STICKY NOTES
a) If placing an order for this item of material costs Rs.390 for each order, the optimum order
quantity to minimize annual costs would be calculated as follows. It is assumed that there
are 52 weeks in each year.
The annual holding cost per unit of inventory = Rs.4 + (2% × Rs.150) = Rs.7.
Annual demand = 52 weeks × 105 units = 5,460 units.

2 × 390 × 5,460 = 780 Units

EOQ =
7
b) Now suppose that the supplier offers a discount of 1% on the purchase price for order sizes
of 2,000 units or more. The order size to minimize total annual costs would require following
calculations
A discount on the price is available for order sizes of 2,000 units or more, which is above the EOQ.
The order size that minimizes cost is therefore either the EOQ or the minimum order size to
obtain the discount, which is 2,000 units.

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Order size Order size

Annual costs
780 units 2,000 units
Rs. Rs.
Purchases
(5,460 × Rs.150): ((5,460 × Rs.150 × 99%) 819,000 810,810
Holding costs 2,730 6,970
(Rs.7 × 780/2): (Rs.6.97 × 2,000/2)
Ordering costs 2,730 1,065
(Rs.390 × 5,460/780): (Rs.390 × 5,460/2,000)
Total costs 824,460 818,875
Conclusion: The order size that will minimize total annual costs is 2,000 units

AT A GLANCE
 Example 08:
W Co. is retailer of barrels. The company has an annual demand of 30,000 barrels. The barrel cost
Rs. 12 each. Fresh supplies can be obtained immediately, with ordering and transport costs
amounting to Rs. 200 per order. The annual cost of holding one barrel in stock is estimated to be
Rs. 1.20 per year.
A 2% discount is available on orders of at least 5,000 barrels and 2.5% discount is available if the
order quantity is 7,500 barrel or above.
Step-I Calculation of EOQs (Ignoring discounts)
Holding cost per barrel per year = Rs. 1.20

SPOTLIGHT
Cost per order = Rs. 200
Annual demand = 30,000 barrels

2 × 200 × 30,000 = 3,162 barrels

EOQ =
1.20
Step II Calculation of annual inventory cost at Q= 3,162
Order size
Annual costs
3,162 barrels
Rs.
Purchases (30,000 x 12) 360,000

STICKY NOTES
Ordering cost (30,000/3,162 x 200) 1,898
Holding cost (3,162/2 x 1.20) 1,897
Total Inventory Cost 363,795
Step III Calculation of annual inventory cost at each discount level
Order size Order size
Annual costs 5,000 7,500
barrels barrels
Rs. Rs.
Purchases (30,000 x 12 x 98%) / (30,000 x 12 x 97.5%) 352,800 351,000
Ordering cost (30,000/5,000 x 200) / (30,000/7,500 x 200) 1,200 800
Holding costs (5,000/2 x 1.20) / (7,500/2 x 1.20) 3,000 4,500
Total Inventory cost 357,000 356,300

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Step IV Determine EOQ

The optimal order size should be 7,500 barrels as at this level, annual inventory cost is
minimum.
Sometimes, the holding cost is based on percentage of purchase price (opportunity cost or interest cost) which
will be changed in case of discounts in purchase cost. The annual holding cost shall also change as result of
discounts. It can be explained with the help of following example.
 Example 09:
Raveen Shah Enterprises produces Product Y and its monthly demand is 2,000 units. 2.5 kg of
material K is required to produce one unit of Product Y. Cost of placing an order is Rs. 150 and
purchase price of Material K is Rs. 80 per Kg. Average holding cost is 8% of purchase price.
Recently, vendor offers discount of 2% at minimum purchase quantity of 5,000 kg and 3% at

AT A GLANCE
minimum purchase quantity of 10,000 kg.
In order to calculate EOQ following steps are used:
Step-I Calculation of EOQs (Ignoring discounts)
Holding cost per unit per year = Rs. 6.40 (80 x 8%)
Cost per order = Rs. 150
Annual demand = 60,000 kg (2,000 x 12 x 2.5)

2 × 150 × 60,000 = 1,677 kg

EOQ =
6.40
Step II Calculation of annual inventory cost at Q= 1,677

SPOTLIGHT
Order size
Annual costs
1,677 Kg
Rs.
Purchases (60,000 x 80) 4,800,000
Ordering cost (60,000/1,677 x 150) 5,367
Holding cost (1,677/2 x 6.40) 5,366
Total Inventory Cost 4,810,733

STICKY NOTES
Step III Calculation of annual inventory cost at each discount level

Order size Order size

Annual costs
5,000 Kg 10,000 Kg
Rs. Rs.
Purchases (60,000 x 80 x 98%) / (60,000 x 80 x 97%) 4,704,000 4,656,000
Ordering cost (60,000/5,000 x 150) / (60,000/10,000 x 150) 1,800 900
Holding costs (5,000/2 x 80 x 8% x 98%) / (10,000/2 x 80 x 15,680 31,040
8% x 97%)
Total Inventory cost 4,721,480 4,687,940

Step IV Determine EOQ

The optimal order size should be 10,000 kg as at this level, annual inventory cost is minimum.

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2.2 Limitations of Economic Order Quantity Model:

a) It is assumed that annual demand of material is known and constant, which in fact not. The demand will
be based on sales which may vary.
b) It is also assumed that per order cost and holding cost per unit shall not change. In practice, it is not
possible as some of these costs are not controllable. For example, increase in prices of petrol by
Government will enhance transportation cost.
c) Another limitation of EOQ model is its assumption in connection to non-availability of discounts which
is not possible in practice.
d) In seasonal variation situation, the demand will be higher during season while it will be declined in off
season. Therefore, it will not justify the assumption that demand can be predicted with perfect certainty.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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3. INVENTORY LEVELS AND BUFFER STOCK

A business entity shall always maintain certain levels of inventories. These levels are:
a) Re-order Level
b) Safety Stock / Buffer Stock
c) Maximum Inventory Level
d) Minimum Inventory Level
So far, it has been assumed that when an item of materials is purchased from a supplier, the delivery from the
supplier will happen immediately. In practice, however, there is likely to be some uncertainty about when to
make a new order for inventory in order to avoid the risk of running out of inventory before the new order arrives
from the supplier. The period of time between placing a new order with a supplier and receiving the delivery of
the same is called “Lead Time”. This lead time could be in days, weeks or months.

AT A GLANCE
On the basis of this lead time, the companies determine the level of stock at which new order should be placed
to avoid stock-out situation. The level at which a new order is placed is called “Re-order Level”. It depends upon
two factors, one is lead time and other is usage. If any of these factors is higher, then re-order level should be
higher to avoid any stock out.
Such re-order level is determined using the average consumption during lead time. However, sometimes the
demand during lead time exceeds the expectations, in such case, if the demand is not fulfilled, the customers may
move to competitors and result in loss of profit and good will. Also, the delivery may delay the expected time due
to which the company may fail to produce the expected demand which again result in loss of profits. To avoid
such risk, the company also maintains a level of stock which is called “Safety Stock or Buffer Stock”

The re-order level is determined by two ways:

SPOTLIGHT
- Under certain circumstances = Average consumption during lead time =Average Lead Time (days /
week / month) x Average Consumption per day / week / month. This is also called Minimum Inventory
Level
- Under uncertain circumstances = maximum lead time (days / weeks / month) x maximum demand per
day / week / month

The Safety Stock is determined as:

Re-order level at uncertain circumstances – Re-order level at certain circumstances
(Maximum Demand x Maximum Lead Time) – (Average consumption x Average Lead Time)

STICKY NOTES
Due to safety stock, the average inventory shall become:
𝑄𝑄
+ 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
2

This way, the entity carries safety stock on the basis of maximum demand as well as maximum delivery time.
However, the probability of both the events occurring at the same time is very low. Thereby, the management is
incurring excessive holding cost on safety stocks.
If the cost of holding safety stocks is greater than the cost of stock-out, the business would be incurring more
loss. Therefore, a level should be set where the cost of stock-out plus the cost of holding the safety stock is
minimized.

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Stock-out Cost are the opportunity cost of running out of stock. As the stock-out occurs when there is demand
but no stock available, therefore, the loss of profit, which could be earned had the stock available. It also leads
to loss of customers’ goodwill as the customers may move to the products of competitors. If the customer is
permanently lost, the stock-out cost is determined using the loss of future profits as well.

Once the stock-out cost has been estimated, the cost of holding safety stocks should be compared for various
demand levels. This can be done using probability theory by attaching probabilities to different potential demand
levels.
 Example 10:
XY Enterprises produces product that requires two components X and Y and relevant data for
each type of components are given as below:

AT A GLANCE
Description
Normal usage in kg for each component per week 500
Minimum usage in kg for each component per week 250
Maximum usage in kg for each component per week 750
Re order quantity X: 4,000 kg
Y: 6,000 kg
Re order period X: 4-6 weeks
Y: 2-3 weeks

SPOTLIGHT
Required. Compute re order level, safety stock level and average stock level for each component
of material.
 Solution
For each component of material, re order level, safety stock level and average stock level is
calculated as under:
Re-order level = Average usage per week x Average lead time per week

Component Kg
Component X (500 x 5) 2,500
Component Y (500 x 2.5) 1,250

STICKY NOTES
Safety stock level = (Maximum usage x Maximum lead time) - (Average usage x Average lead
time)

Component Kg
Component X [(750 x 6) - (500 x 5)] 2,000
Component Y [(750 x 3) - (500 x 2.5)] 1,000

Average stock level = EOQ/2 + Safety stock level

Component Kg
Component X (4,000/2) + 2,000 4,000
Component Y (6,000/2) + 1,000 4,000

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3.1 Probability Theory to determine the Safety Stocks:

A probability table can be prepared. For each possible reorder level under consideration, we can calculate:
• the probable demand in the lead time between order and delivery;
• the risk of having excess inventory (buffer stock) and its cost;
• the risk of stock-outs, and their cost.
The reorder level selected might be the reorder level at which the expected value (EV) of cost is minimized.
 Example 11:
Entity X uses item Z in its production process. It purchases item Z from an external supplier, in
batches.

AT A GLANCE
For item Z, the following information is relevant:

Holding cost Rs.15 per unit per year

Stock out cost Rs.5 for each stock-out
Lead-time 1 week
EOQ 270 units

Entity X operates for 48 weeks each year. Weekly demand for unit Z for production is variable,
as follows:

Units demanded during the lead time Probability

SPOTLIGHT
70 10%
80 20%
90 30%
100 40%

Required
Suggest whether a reorder level of 90 units or 100 units would be more appropriate.
 Solution
The probabilities in the above example allow us to identify the possible stock-outs associated
with different reorder levels.

STICKY NOTES
Demand is always greater than 60 units in the lead time. Therefore, if the company allowed
inventory to fall to 60 units before placing an order, it would face a stock shortage in every lead
time. There is a 10% chance that demand would be 70 leading to a shortage of 10 units, a 20%
chance that demand would be 80 leading to a shortage of 20 units, a 30% chance that demand
would be 90 leading to a shortage of 30 units and a 10% chance that demand would be 100
leading to a shortage of 40 units. This can be used to work out the expected value of the stock out
and its associated cost.
Setting a higher reorder level reduces the chance of a stock out but the company would then have
more inventory on hand on average and this would increase holding cost. For example, if the
company set the reorder level to 80 units it would only face stock-out if demand were greater
than 80 in the lead time. The above information shows that there is a 30% chance that demand
would be 90 leading to a shortage of 10 units and a 10% chance that demand would be 100
leading to a shortage of 20 units. Thus, the stock-out cost would be reduced. However, the
company would hold an extra 20 units on average compared to a reorder level of 60 units.

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Following steps are suggested:

Step 1: Calculate the average demand in the lead time
The average demand in the lead-time is:
(70 × 10%) + (80 × 20%) + (90 × 30%) + (100 × 40%) = 90 units
Average annual demand is 48 weeks × 90 units = 4,320 units.
4,320
Since the EOQ is 270 units, entity X will expect to place orders = 16 orders each year.
270
Therefore, there will be 16 lead times each year.
Step 2: Set up a probability table
(Starting with a reorder level set to the average demand in the lead time and then looking at higher

AT A GLANCE
reorder levels).

Reorder level of 90 (the company will be out of stock if demand is greater than 90)
Demand = 100
Stock outs if demand is 100 10 units
Probability of demand of 100 × 0.4
Cost per stock out × Rs. 5
Number of orders per year × 16
Annual stock out cost 320
Buffer stock (reorder level − average demand in lead time) nil
320

SPOTLIGHT
Reorder level of 100 (the company will never be out of stock)
Stock out cost nil
Buffer stock (reorder level − average demand in lead time) 10 units
Holding cost per unit per annum × Rs. 15
Rs. 150
The reorder level should be set at 100 units. The extra cost of the buffer stock (Rs. 150) achieves
savings by reducing the stock out cost (Rs. 320).

3.2 Maximum inventory level:

STICKY NOTES
A company will set a maximum level for inventory. Inventory held above this would incur extra holding cost
without adding any benefit to the company.
The inventory level should never exceed a maximum level. If it does, something unusual has happened to either
the supply lead time or demand during the supply lead time. The company would investigate this and take action
perhaps adjusting purchasing behavior.
When demand during the supply lead time is uncertain and the supply lead time is also uncertain, the maximum
inventory level is found as follows.

Maximum inventory level:

Re-order level X
Add: Re-order quantity / EOQ X
XX
Less: Minimum Demand x Minimum Lead Time (X)
X

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3.3 Minimum inventory level:

The inventory level could be dangerously low if it falls below a minimum warning level. When inventory falls
below this amount, management should check that a new supply will be delivered before all the inventory is used
up, so that there will be no stock-out.
When demand during the supply lead time is uncertain and the supply lead time is also uncertain, the minimum
(warning) level for inventory is set as follows.

Minimum inventory level:

Re-order level X
Less: Average Demand x Average Lead Time (X)
X

AT A GLANCE
 Example 12:
Stock Item 6787:
Data relating to stores item 6787 are as follows.
Daily use: 300 units
Lead time for re-supply: 5 – 20 days
Reorder quantity: 10,000 units

Required
Identify the reorder level for this stock item, to avoid the possibility of inventory-outs.

SPOTLIGHT
 Solution
In order to identify the reorder level for this stock item, to avoid the possibility of inventory-outs,
following calculations would be required:
Reorder level to avoid inventory-outs
= Daily demand × Maximum lead time
= 300 units × 20 days
= 6,000 units.
 Example 13:

STICKY NOTES
Robin Limited (RL) imports a high value component for its manufacturing process. Following
data, relating to the component, has been extracted from RL’s records for the last twelve months:

Maximum usage in a month 300 units

Minimum usage in a month 200 units
Average usage in a month 225 units
Maximum lead time 6 months
Minimum lead time 2 months
Re-order quantity 750 units
Required
Calculate the average stock level for the component.

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 Solution
The average stock level for the component would be calculated as follows:
Average stock level:
Average stock level = minimum level + ½ (reorder quantity)
As minimum level is not given it will be computed as follows:
Re-order level = maximum usage × maximum lead time
Re-order level = 300 × 6 = 1,800 units.
Minimum level = Re-order level – (average usage × average lead time)
Minimum level = 1,800 –[(225 × (6+2/2) = 900 units.
Therefore, Average stock level = 900 + (½ 750) = 1,275 units.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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4. COMPREHENSIVE EXAMPLES
 Example 01:
Orchid Limited (OL) is a trading concern. It is planning to implement Economic Order Quantity
model (EOQ) from 1 April 2019. OL deals in four products each of which is purchased from a
different supplier. To compute EOQ for one of its products Beta, the following data has been
gathered:
i. Actual data for the last year relating to Beta:
Annual Sales Units 72,000
Safety Stocks Units 2,000
Transit Losses as % of purchases 10%
Average Holding Cost per Month Rs. 500,000

AT A GLANCE
Average Holding Cost per Month per Unit Rs. 80
Number of Purchase Order issued for Beta 40
ii. Total cost of purchase department for the last year amounted to Rs. 4,500,000 which
included fixed cost of Rs. 1,350,000. A total of 100 purchase orders were issued during
the last year.
iii. Projections for the next year:
Increase in Sales Volume 25%
Safety Stock Units 2,500
Transit Losses as % of Purchase 6%
Impact of inflation on all costs 10%

SPOTLIGHT
iv. Closing inventory (excluding safety stock) varies in line with the sale volume.

Required
Calculate EOQ for Beta.
 Solution
EOQ for Beta can be calculated as follows:
Annual demand (Purchases): Units
Projected sales 72,000×1.25 90,000
Opening stock - including safety stock (500,000÷80) (6,250)

STICKY NOTES
Closing stock - including safety stock [(6,250–2,000)×1.25]+2,500 7,813
Purchases - net of transit losses 91,563
Purchases including transit losses of 6% 91,563÷0.94 97,407

Ordering cost per order: Rupees

Variable cost (4,500,000–1,350,000)×(1.1÷100) 34,650
Holding cost per unit per annum 80×1.1×12 1,056

Economic Order Quantity (EOQ): Units

SQRT[(2×Annual demand × Ordering cost per order)÷Carrying cost per unit]
SQRT[(2×97,407×34,650)÷1,056] 2,528

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 Example 02:
ABC has recently established a new unit in Multan. Its planning for the first year of operation
depicts the following:
i. Cash sales 600,000 units
ii. Credit sales 1,200,000 units
iii. Ending inventory Equivalent to 15 days sales
iv. Number of working days in the year 300
v. Expected purchase price Rs. 450 per unit
Manufacturer offers 2% discount on purchase of 500 units or more as bulk quantity discount.
The company intends to avail this discount.
vi. Carrying costs include:

AT A GLANCE
- Financial cost of investment in inventory @ 16% per annum.
- Godown rent of Rs. 10,000 per month.
vii. Ordering costs are Rs. 300 per order.

Required
Compute Economic Order Quantity (EOQ), the estimated carrying costs and ordering costs for
the first year of operation.
 Solution
Computation of the Economic Order Quantity (EOQ) and the estimated carrying costs and
ordering costs for the first year of operation would be as follows:

SPOTLIGHT
Computation of annual requirement
Units sold on cash basis 600,000
Units sold on credit basis 1,200,000
Ending Inventory (1.8 million x 15/300) 90,000
Annual purchases 1,890,000
Computation of Carrying Cost per unit
Carrying cost per unit (Rs. 450 × 98% × 16%) (Bulk quantity discount availed) Rs. 70.56
Computation of EOQ
EOQ = 2 × 1,890,000 × 300

STICKY NOTES
70.56
= 4,009 units
Estimated carrying cost = (EOQ/2) × carrying cost per unit
= 4,009/2 × 70.56
= Rs. 141,438
Add: Godown rent p.a. = Rs. 120,000
Total carrying cost = Rs. 261,438
Estimated ordering cost = (annual requirement / EOQ) × cost per order
= (1,890,000 / 4,009) × 300
= Rs.141,432

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 Example 03:
Karachi Limited is a large retailer of sports goods. The company buys footballs from a supplier in
Sialkot. Karachi Limited uses its own truck to pick the footballs from Sialkot. The truck
capacity is 2,000 footballs per trip and the company has been getting a full load of footballs
at each trip, making 12 trips each year.
Recently the supplier revised its prices and offered quantity discount as under:
Quantity Unit price (Rs.)
2,000 400
3,000 390
4,000 380
6,000 370
8,000 360

AT A GLANCE
Other related data is given below:
• All the purchases are required to be made in lots of 1,000 footballs.
• The cost of making one trip is Rs. 15,000.
• The company has the option to hire a third party for transportation which would charge
Rs. 9 per football. The cost of placing an order is Rs. 2,000.
• The carrying cost of one football for one year is Rs. 80.
Required
a) Work out the most economical option.
b) Compute the annual savings in case the company revises its policy in accordance with

SPOTLIGHT
the computation in (i) above
 Solution
a) When required to work out the most economical option, below are the computations
involved:
Karachi Limited
Price per football A 400 390 380 370 360
Annual purchases B 24,000 24,000 24,000 24,000 24,000
(nos.)
Purchase cost A×B 9,600,000 9,360,000 9,120,000 8,880,000 8,640,000
Minimum order size C 2,000 3,000 4,000 6,000 8,000

STICKY NOTES
No. of orders (B÷C) D 12.00 8.00 6.00 4.00 3.00
Ordering cost D × 2,000 24,000 16,000 12,000 8,000 6,000
Trips per order E 1.00 1.00 2.00 3.00 4.00
(C÷2,000) (hired
transport)
Total no. of trips F 12.00 8.00 12.00 12.00 12.00
(D×E)
Transportation cost F× 180,000 120,000 180,000 180,000 180,000
15,000
Hired transport cost 8,000 72,000
units×9
Average inventory G 1,000 1,500 2,000 3,000 4,000
(C÷2)
Inventory G × 80 80,000 120,000 160,000 240,000 320,000
carrying cost
Total cost (Rs.) 9,884,000 9,688,000 9,472,000 9,308,000 9,146,000

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b) Computation of the annual savings in case the company revises its policy in accordance
with the computation in (i) above, will be as follows:
The most economical option is to purchase 3 lots of 8,000 footballs each against the
existing purchases of 12 lots of 2,000 footballs. The saving will be as under:
Cost for 12 lots of 2,000 footballs each. 9,884,000
Cost for 03 lots of 8,000 footballs each. 9,146,000
Cost saving Rs. 738,000

 Example 04:
Modern Distributors Limited (MDL) is a distributor of CALTIN which is used in various
industries and its demand is evenly distributed throughout the year.

AT A GLANCE
The related information is as follows:
• Annual demand in the country is 240,000 tons whereas MDL’s share is 32.5% thereof.
• The average sale price is Rs. 22,125 per ton whereas the profit margin is 25% of cost.
• The annual variable costs associated with purchasing department are expected to
be Rs. 4,224,000 during the current year. It has been estimated that 10% of the
variable costs relate to purchasing of CALTIN.
• Presently, MDL follows the policy of purchasing 6,500 tons at a time.
• Carrying cost is estimated at 1% of cost of material.
• MDL maintains a buffer stock of 2,000 tons.
Required

SPOTLIGHT
Compute the amount of savings that can be achieved if MDL adopts the policy of placing orders
based on Economic Order Quantity.
 Solution
Computation of the amount of savings that can be achieved if MDL adopts the policy of placing
orders based on Economic Order Quantity would be as follows:
Purchase department’s variable cost: Rs. 4,224,000
Costs applicable to product CALTIN - 10% of above Rs. 422,400
Ordering costs per purchase order
Annual purchases of CALTIN (tons) [240,000 x 32.5%) Tons 78,000
Existing size of purchase order (tons) Tons 6,500

STICKY NOTES
No. of orders (78,000 / 6,500) Orders 12
Ordering cost per order (422,400/12) Rs. 35,200
Carrying costs per ton (22,125 / 1.25 x 1%) Rs. Per Ton 177
Computation of EOQ 2 × 78,000 tons x 35,200 tons
= 5,570
177
EOQ Existing
Demand of CALTIN Tons 78,000 78,000
Order quantity Tons 5,570 6,500
No. of orders 14 12
Average inventory excluding buffer stock (Q / 2) Tons 2,785 3,250
Cost of placing orders (Rs 35,200 per order) Rupees 492,800 422,400
Carrying cost ([Avg. Inventory x Rs. 177) Rupees 492,945 575,250
Total costs Rupees 985,745 997,650
Savings on adoption of EOQ Rupees 11,905

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CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

 Example 05:
Aroma Herbs (AH) deals in a herbal tea. The tea is imported on a six monthly basis. The
management is considering to adopt a stock management system based on Economic Order
Quantity (EOQ) model. In this respect, the following information has been gathered:
i. Annual sale of the tea is estimated at 60,000 kg at Rs. 1,260 per kg. Sales are evenly
distributed throughout the year.
ii. C&F value of the tea after 10% discount is Rs. 900 per kg. Custom duty and sales tax are
paid at the rates of 20% and 15% respectively. Sales tax paid at import stage is
refundable in the same month.
iii. Use of EOQ model would reduce the quantity per order. As a result, bulk purchase
discount would be reduced from 10% to 8%.
iv. Cost of financing the stock is 1% per month.

AT A GLANCE
v. Annual storage cost is estimated at Rs. 320 per kg.
vi. Administrative cost of processing an order is Rs. 90,000. Increase in number of purchase
orders would reduce this cost by 10%.
vii. AH maintains a buffer stock equal to fifteen days' sales.
Required
a) Compute EOQ.
b) Determine the amount of savings (if any) which can be achieved by AH by adopting the
stock management system based on EOQ model.
 Solution

SPOTLIGHT
a) Economic order quantity can be computed as follows (EOQ):
Annual demand of herbal tea (A) kg 60,000.00

Rupees
Purchase cost per kg (C&F + Import duty) [(900÷0.9)*0.92 ×1.2] B 1,104.00
Ordering cost per purchase order 90,000×90% C 81,000.00
Annual holding cost per kg
- Finance cost B×1%×12 132.48
- Storage cost 320.00
(D) 452.48

STICKY NOTES
EOQ =
SQRT [(2×annual demand × ordering cost) ÷ Holding cost per kg)]
SQRT [(2×60,000×81,000)÷452.48)] (E) kg 4,635.00
b) Determination of the amount of savings (if any) which can be achieved by AH by
adopting the stock management system based on EOQ model would be as follows
Savings on adopting EOQ:
No. of purchase orders (A÷E) (F) 13 2
Holding of inventory:
- Average inventory (E÷2); (A÷F ÷2) 2,318 15,000
- Buffer stock 2,500 2,500
(G) 4,818 17,500

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 39

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

-------- Rupees --------

Ordering costs (C×F); (90,000×F) 1,053,000 180,000
Holding costs of inventory (G×D); (G×*449.6) 2,180,049 7,868,000
Purchasing cost of tea (A×B); (60,000×900×1.2) 66,240,00 0 64,800,000
Cost of 60,000 kg of tea 69,473,04 9 72,848,000
Savings on using EOQ model (72,848,000 – 69,473,049) 3,374,951
*Existing holding cost per unit (900×1.2×0.12)+320=449.6
 Example 06:
Chocó-king Limited (CL) produces and markets various brands of chocolates having annual
demand of 80,000 kg. The following information is available in respect of coco powder which is
the main component of the chocolate and represents 90% of the total ingredients.

AT A GLANCE
i. Cost per kg is Rs. 600.
ii. Process losses are 4% of the input.
iii. Purchase and storage costs are as follows:
• Annual variable cost of the procurement office is Rs. 6 million. The total number of
orders (of all products) is estimated at 120.
• Storage and handling cost is Rs. 20 per kg per month.
• Other carrying cost is estimated at Rs. 5 per kg per month.
iv. CL maintains a buffer stock of 2,000 kg.
Required:
(a) Calculate economic order quantity.

SPOTLIGHT
(b) A vendor has offered to CL a quantity discount of 2% on all orders of minimum of 7,500 kg.
Advise CL, whether the offer of the vendor may be accepted.
 Solution
a) Economic order quantity (EOQ) can be calculated as follows:
Annual requirement of the coco powder 80,000÷0.96×90% kg 75,000
Ordering cost per order (6,000,000÷120) Rs. 50,000
Storage and handling 20×12 240
Other carrying cost 5×12 60
Carrying cost per kg Rs. 300

STICKY NOTES
Economic order quantity (EOQ)
SQRT[(2 × Annual demand × Ordering cost per order) ÷ Carrying cost per kg]
SQRT[(2×75,000×50,000)÷300] = �25,000,000 = 5,000
A vendor has offered to CL a quantity discount of 2% on all orders of minimum of 7,500 kg.
Advise CL, whether the offer of the vendor may be accepted. This would require computation
as below:
b) Analysis of purchases using EOQ / minimum quantity as offered by the vendor:
EOQ Vendor's offer
No. of orders (75,000÷5,000), (75,000÷7,500) A 15.00 10.00
Average inventory including buffer stock
(Order quantity÷2)+2,000 B 4,500 5,750

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CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

Rs. Rs.
Annual cost of placing orders (A×50,000) 750,000 500,000
Carrying cost (B×300) 1,350,000 1,725,000
Discount on placing order of 7,500 kg each
(75,000×600×2%) - (900,000)
Net cost 2,100,000 1,325,000
Annual saving on acceptance of vendor's offer 775,000

 Example 07:
Hockey Pakistan Limited (HPL) is engaged in the manufacturing of a single product ‘H-2’ which
requires a chemical ‘AT’. Presently, HPL follows a policy of placing bulk order of 60,000 kg of AT.

AT A GLANCE
However, HPL’s management is presently considering to adopt economic order quantity model
(EOQ) for determining the size of purchase order of AT.
Following information is available in this regard:
i. Average annual production of H-2 is 45,600 units. Production is evenly distributed
throughout the year.
ii. Each unit of H-2 requires 10 kg of AT. Cost of AT is Rs. 200 per kg. 5% of the quantity
purchased is lost during storage.
iii. Annual cost of procurement department is Rs. 2,688,000. 65% of the cost is variable.
iv. AT is stored in a third party warehouse at a cost of Rs. 6.25 per kg per month.
v. HPL’s cost of financing is 8% per annum.
Required:

SPOTLIGHT
a) Calculate economic order quantity.
b) Supplier of AT has offered a discount of 5% quantity per order is increased to 120,000
kg. Advise whether HPL should accept the offer.
c) Discuss any three practical limitations of using the EOQ model.
 Solution
a) Computation of Economic Order Quantity (Units to order) would be as follows
SQRT [(2×annual demand × ordering cost) ÷ Holding cost per kg)]
SQRT [(2×480,000 (W-4) × 218,400 (W-1) ÷ 91(W.5)] 48,000

STICKY NOTES
W-1: Ordering cost per order (Rs.) (1,747,200( W-2)÷8 (W-3) 218,400
W-2: Purchase department cost -Variable cost (Rs.) 2,688,000×65% 1,747,200
W-3: Number of orders 480,000 (W-4)÷60,000 8
W-4: Annual Requirement of AT (kg) 45,600×10/95% 480,000
W-5: Holding cost (Rs. per unit) Rs. per unit
Storage cost (6.25 per kg per month×12) 75
Finance cost 200×8% 16
Total holding cost (Rs. per unit) 91

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CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

b) Supplier of AT has offered a discount of 5% quantity per order is increased to 120,000

kg. Whether HPL should accept the offer or not, the evaluation would involve following:
Evaluation of discount offer from supplier of AT
Comparison of cost EOQ As per offer
Annual Requirement of AT (kg) A (W-4) 480,000 480,000
Order quantity (kg) B (EOQ, Given) 48,000 120,000
Number of orders C=A/B 10 4
Average inventory (kg) D=B/2 24,000 60,000
--------- Rupees ---------
Ordering cost C×218,400 (W-1) 2,184,000 873,600
Holding cost

AT A GLANCE
D×91(W-5);[D×{75(W-5)+(16(W-5)×95%)}] 2,184,000 5,412,000
Purchase cost

(200×480,000); (200×480,000×95%) 96,000,000 91,200,000

Total cost 100,368,000 97,485,600
Opinion: Offer from AT's supplier should be accepted as it would reduce the purchase
cost.
c) The practical limitations/assumptions of EOQ are as follows
i. The formula assumes that demand/usage is constant throughout the period. In
practice, actual demand/usage may be uncertain and subject to seasonal
variations.

SPOTLIGHT
ii. Holding cost per unit are assumed to be constant. Further, many holding costs are
fixed throughout the period and not relevant to the model whereas some costs (e.g.
store keepers' salaries) are fixed but change in steps.
iii. Purchasing cost per unit is assumed to be constant for all purchase quantities and
is ignored while calculating order size in EOQ. In practice, quantity discounts can
be available in case of bulk purchasing.
iv. The ordering costs are assumed to be constant per order placed. In practice, most
of the ordering costs are fixed or subject to stepwise variation. It is therefore,
difficult to estimate the incremental cost per order.
 Example 08:
Alpha Motors (Pvt.) Ltd. uses a special gasket for its automobiles which is purchased from a local

STICKY NOTES
manufacturer. The following information has been made available by the procurement
department:
Annual requirement (no. of gaskets) 162,000
Cost per gasket (Rs.) 1,000
Ordering cost per order (Rs.) 27,000
Carrying cost per gasket (Rs.) 300
The gaskets are used evenly throughout the year. The lead time for an order is normally 11 days
but it can take as much as 15 days. The delivery time and the probability of their occurrence are
given below:
Delivery time (in days) Probability of occurrence
11 68%
12 12%
13 10%
14 6%
15 4%

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 42

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

Required
a) Compute the Economic Order Quantity (EOQ) and the total Ordering Costs based on
EOQ.
b) What would be the safety stock and re-order level if the company is willing to take:
i. a 20% risk of being out of stock?
ii. a 10% risk of being out of stock?
Note: Assume a 360 day year.
 Solution
a) Computation of EOQ and Ordering Costs:

AT A GLANCE
2 x 162,000 x 27,000
EOQ = 300
EOQ = 5,400 gaskets
Number of orders = 162,000 / 5,400 = 30 Orders
Ordering costs = 30 x Rs. 27,000 = Rs. 810,000
b) Computation of the safety stock and re-order level if the company is willing to take
(Assuming a 360 day year):
• 20% risk of being out of stock?
• 10% risk of being out of stock?
Safety stock required to be maintained at 20% and 10% risk level

SPOTLIGHT
Risk level
20% 10%
Number of days required to be maintained 1 2
Safety Stock
1 x 450 (W-1) 450
2 x 450 (W-2) 900
W-1
Average Stock requirements per day = Annual Demand ÷ 360 days
= 162,000 ÷ 360 = 450

STICKY NOTES
Re-Order Level at 20% and 10% risk level
Re-order level = (Average Consumption x Average Lead Time) + Safety Stock
Re-order level at 20% = (450 x 11) + 450 = 5,400 gaskets
Re-order level at 10% = (450 x 11) + 900 = 5,850 gaskets
Notice the trade off, in the above example, between the cost of stock out and the holding costs at
different reorder levels. A higher reorder level reduces the chance of a stock out but incurs higher
holding costs.
Practically the risks associated with a stock out are so great that the company always tries to
avoid it even if it leads to extra holding cost.
 Example 09:
a) List any four situations in which EOQ model for determining optimum level of stocks
becomes invalid.
The EOQ model becomes invalid in the following situations:
• The holding cost per unit is not constant.

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CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

• The stock is not consumed at a constant rate throughout the period due to which
average inventory is not equal to one half of the order quantity.
• The cost per order is not constant.
• There are quantity discounts available.
b) Jamal Limited (JL) purchases raw material T3 for its product DBO on a quarterly basis as
per the requirement of the production department. The management is considering to
revise the existing policy of placing orders for T3. Following information is available in
this regard:
i. Annual production of DBO is 19,000 units.
ii. Each unit of DBO requires 1 kg of T3 which is the resultant quantity after normal
loss of 5%.

AT A GLANCE
iii. Minimum order quantity set by the supplier for purchase of T3 is 3,500 kg. However,
the supplier offers following prices at different order quantities:
Order Quantity Kg Price per kg (Rs.)
3,500 305
4,000 299
5,000 296
iv. JL maintains T3’s safety stock of 320 kg.
v. The cost of placing each order is Rs. 4,200 out of which Rs. 1,780 pertains to salaries
of staff of purchase department.
vi. Holding cost per kg of average stock is Rs. 260 which includes rent of Rs. 180 for the

SPOTLIGHT
floor space occupied by each kg. Variation in the stock held has no effect on the
remaining holding cost.
Required:
Determine the purchase order quantity of T3 offered by the supplier at which JL’s cost
would be minimized.
Holding
Purchase cost at
Order Cost Number of Order Total
of cost of Rs. 180
Quantity per kg orders cost cost
20,000 kg per unit
Note 1

STICKY NOTES
A B C=20,000xB D=20,000+A E=2,420
[4,200-
1,780]xD
3,500 305 6,100,000 6.00 14,520 372,600 6,487,120
4,000 299 5,980,000 5.00 12,100 417,600 6,409,700
4,500 296 5,920,000 4.00 9,680 507,600 6,437,280
Annual usage = [(19,000 x 1)/95%] = 20,000
Note 1:
Holding cost = (*average stock + safety stock) × holding cost per unit
*Average stock = Order quantity ÷ 2

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CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

 Example 10:
QZ Ltd., deals in domestic appliances and supplies special toasters to various outlets in south
zone of the country. Special toaster is a popular product of QZ Ltd., which is distributed in large
quantities throughout the year. The company’s Chief Executive Officer, Mr. Kamal came to know
the fact that company is holding excessive stocks which causes increase in monthly cost.
Mr. Kamal is of the opinion that application of Economic Order Quantity (EOQ) model will help
in reducing cost. Being a Management Accountant, you are asked to guide Mr. Kamal regarding
EOQ application.
Information regarding stocks for the month of January 2015 is given below:
Toasters demand from outlets (Units) 40,000
Carrying cost per lot (Rs. 0.20 per toaster) (Rs.) 200

AT A GLANCE
Ordering cost (Rs.) 60
Special toasters are ordered from outlets in lot sizes of 1,000 units.
i. Calculation of optimal order quantity in lots and number of orders that should be placed
by the company are given below:
Annual demand (40,000 x 12) = 480,000 units
Carrying cost per unit (0.20 x 12) = Rs. 2.40 per toaster
Order cost = Rs. 60 per order
Hence, EOQ shall be:

2 x 480,000 x 60

SPOTLIGHT
EOQ =
2.40
EOQ = 4,899 units or 5 lots
Number of orders = 40 lots / 5 lots = 8 Orders
ii. Impact on EOQ and number of orders if carrying cost per month is reduced to Rs. 0.10:
Carrying cost per unit (0.10 x 12) = Rs. 1.20
Hence, EOQ shall be:

EOQ =
2 x 480,000 x 60
1.20

STICKY NOTES
EOQ = 6,928 units or 7 lots
Number of orders = 40 lots / 7 lots = 6 Orders
iii. Impact on EOQ and number of orders if order cost is reduced to Rs. 20:
Order cost = Rs. 20 per order
Hence, EOQ shall be:

EOQ =
2 x 480,000 x 20
2.40
EOQ = 2,828 units or 3 lots
Number of orders = 40 lots / 3 lots = 13 Orders
The EQO will decrease to 3 lots per order but orders will increase to 13 orders per year,
in case per order cost will reduce to Rs. 20.

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CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

iv. Impact on EOQ and number of orders if order cost is reduced to Rs. 20 and carrying cost
is declined to Rs. 0.10 per month:
Carrying cost per unit (0.10 x 12) = Rs. 1.20
Order cost = Rs. 20 per order
Hence, EOQ shall be:

EOQ =
2 x 480,000 x 20
1.20
EOQ = 4,000 units or 4 lots
Number of orders = 40 lots / 4 lots = 10 Orders

AT A GLANCE
The EQO will decrease to 4 lots per order but orders will increase to 10 orders per year,
in case per order cost will reduce to Rs. 20 and carrying cost per month will decline to Rs.
0.10.
 Example 11:
Two-way Engineering Limited has been experiencing stock-outs on one of its important product
RD-11. Using the EOQ formula, the company places orders of 1,250 units whenever the stock
level reduces to 1,500 units. The records of the company show the following data relating to the
usage of Product RD-11 during lead times:
Usage (Units) 1,800 1,600 1,400 1,200 1,000
Usage Probability (%) 4% 6% 10% 20% 60%
The company sells RD-11 at a price of Rs. 500 per unit. The annual carrying cost of one unit is Rs.

SPOTLIGHT
30. The company estimates that the cost of being out of stock is Rs. 125 for each unit.
The optimal safety stock level is calculated as under:
Safety Stock Total of Stock out
Stock out Holding Cost
Stock out Probability and Holding cost
cost (Rs.) (Rs.)
(Units) (Units) (Rs.)
A B C D=B x 125 x E=A x 30 D+E
C
0 300 4% 1,500 0
100 6% 750 2,250

STICKY NOTES
100 200 4% 1,000 3,000 4,000
200 100 4% 500 6,000 6,500
300 0 - 0 9,000 9,000
The optimal level of safety stock is zero units, as at this level, annual stock out and holding cost
is minimum i.e. Rs. 2,250.

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 46

CAF 8: CMA CHAPTER 2: INVENTORY MANAGEMENT

STICKY NOTES

Inventory management refers to the process of ordering, storing and using a

company’s inventories

Relevant costs are the cost that occur on the occurrence of an activity.

AT A GLANCE
Economic order quantity is used to determine the order quantity at which
cost is minimum.

The EOQ can be determined using tabular method, graphical method and EOQ
formula

Inventory management includes determining re-order level, safety stock,

SPOTLIGHT
minimum and maximum inventory levels.

STICKY NOTES

INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 47

 CHAPTER 3

OVERHEADS

AT A GLANCE
IN THIS CHAPTER
Overheads are the indirect costs those that incur in the course
of making a product, providing of service or running
AT A GLANCE
department but which cannot be traced directly and fully to the

AT A GLANCE
product, service or department.
SPOTLIGHT
Overheads are charged to departments, cost center, cost pools
1. Manufacturing Expenses and products using a predetermined rate.
Predetermined rate is determined using estimated figures of
2. Costing of Production Overheads
the overhead cost and the activity level.
3. Basis of apportionment of Shared costs of service departments are distributed among
Service Centre Costs to departments first and then total overheads are calculated for
Production Departments the production departments to be further allocated to products.
At the end of the period, the applied overhead is compared with
4. Over or Under Applied /
actual overhead to determine over or under absorption of
Absorbed Overhead

SPOTLIGHT
overheads.
5. Comprehensive Examples

SITCKY NOTES

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 39

 CHAPTER 3: OVERHEADS CAF 8: CMA

1. MANUFACTURING EXPENSES
Manufacturing expenses are of two types:
1. Direct expenses – expenses that are fully traceable to the product, service or department that is being
costed or in other words, the expenses which can be attributable directly to specific cost object.
 Examples:
• Raw Materials that are specifically used for the product in consideration. For example, milk is
raw material used in production of butter or cheese.
• Labour which is directly involved in converting the raw material. For example, labour cost in
connection with production of sugar.
• Other expenses that are specifically incurred for the product. For example, hiring cost of machine
in order to manufacture specific product.
AT A GLANCE

2. Indirect expenses (Production overheads) –are those expenses that incur in the course of making a
product, providing of service or running department but which cannot be traced directly and fully to the
product, service or department.
 Examples:
• Labour which is not directly involved in the conversion of raw material but indirectly involved
in making of the product. Such as supervisor who is responsible to supervise the production
process is not directly involved and therefore treated as indirect cost,
• Tools, spares and materials that are used in the machinery or equipment used in the production,
• Factory rent if the factory premises are hired,
• Depreciation of machinery and equipment.
SPOTLIGHT

• Electricity and other utility expenses incurred for the production facilities
The manufacturing expenses generally comprise:
a) Direct materials,
b) Direct labours and
c) Production / manufacturing / factory overheads.

Note:
Material cost + Labour cost are called ‘Prime Costs’
Labour cost + Overhead cost are called ‘Conversion Costs’
STICKY NOTES

1.1 Cost Behaviors:

Cost behaviors refer to how a cost reacts to changes in the level of activity. As the activity level rises or falls,
a particular cost may rise or fall as well or it may remain constant. To help make such distinctions, the costs
are often categorized as ‘variable cost’ or ‘fixed cost’.
Variable costs are those that tend to change with level of activity in direct ratio with equal proportion. For
example, 100 units of raw materials are used to produce 100 units of the final product. It means for one unit
of final product one unit of raw material will be required. Where the cost of one unit of material is Rs.10, the
cost of 100 units will be (10x100) Rs. 1,000. Similarly, labour takes two hours to produce 1 unit of final
product and so 400 hours will be used to produce 200 units. The labour charges Rs. 5 per hour and so their
cost at 200 units, using 400 hours, will be Rs. 2,000. Since these costs vary with the variations in the output,
therefore, these are called variable costs.
The variable expenses are fixed per unit of output while they vary in total.

40 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

Note: there are few expenses that are called ‘Semi-variable’ because they carry some fixed part of cost
and some variable. For example, electricity bill comprises of fixed charges as line rent / fixed connection
charges as well as variable charges based on units of power consumed.

Fixed costs are those that remained constant, irrespective of the level of output. For example, the rent of the
factory shall be charged on monthly basis whether or not the production is carried. The rent is charged for
the occupation of the premises and therefore, do not vary with the production.
Fixed expenses vary per unit of output while they are fixed in total.
For example, factory rent is Rs. 10,000 per month. During month 1, the company produced 100 units and
during month 2 it produced 150 units. The rent per unit for month 1 and 2 would be Rs. 100 (10,000/100)
and Rs. 66.67 (10,000/150) however, the actual cost paid is Rs. 10,000 each month.

Note: Few fixed costs are called ‘Step fixed costs’ which remains same at certain activity level and

AT A GLANCE
changes when the activity level changes. For example, a company uses one supervisor to supervise for up
to 25 labour hours to produce 100,000 units a month. The cost of supervisor is Rs. 15,000. Next month,
the company intends to produce 125,000 units using 6 more labour hours. Now a new supervisor would
be required to supervise for additional 6 labour hours and 25,000 units. The cost is now increased to Rs.
30,000 when the activity level increased.

1.2 Production overheads and non-production overheads:

Production Overheads:
Overheads that incur in relation to the production processes are called production overheads (also called
manufacturing overheads / factory overheads). For example, salary of factory supervisor, depreciation of
production machine, electricity cost of factory, rent of factory premises etc. Production overheads can be

SPOTLIGHT
fixed or variable. Any production overheads related to period are fixed production overheads like rent of
factory premises or plant. However, some production overheads that tend to change with level of activity
are known as variable production overheads like electricity consumption.
Non-Production Overheads:
Overheads that incur to support the overall objectives of the business are called non-production overheads.
For example, salaries of sales team, salaries of finance, HR and IT teams, rent of the building occupied by
finance, IT, sales and HR departments (other than production department), Depreciation of computers being
used in these departments etc. These are classified as ‘Administrative Expenses, Marketing, Selling and
Distribution Expenses’ in the Statement of Comprehensive Income.
Administrative Expenses:

STICKY NOTES
The term administration generally relates to the functions necessary for the overall running of the business.
Administrative costs include all costs associated with the general management of the organization rather
than with manufacturing or selling. Examples of administrative activities include implementing and ensuring
the effectiveness of fire extinguishing system for the safety of employees and overall business, ensuring the
overall security of the business premises, the accounting and finance, human resource and information
technology functions of the business are classified under administration and the cost incurred to run these
functions are called administrative expenses.
These are mostly fixed expenses and charged to profit and loss account in the period in which they occur.
Marketing, Selling and Distribution Expenses:
These expenses are related to the process of selling inventory to customers. These costs include all costs that
are incurred to secure customer orders and get the finished product to the customer. Examples of marketing,
selling and distribution activities are advertising the company’s products / services on electronic and print
media, devising and implementing marketing strategies to enter new markets, obtaining information about
customers and competitors, distributing products to the markets for the customers, obtaining feedbacks
from customers after sales and providing after sales services. The costs so incurred in performing such
activities are classified as marketing, selling and distribution expenses.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 41

 CHAPTER 3: OVERHEADS CAF 8: CMA

These are both fixed and variable. Salaries of marketing staff, cost of advertisement, depreciation of
equipment used in the marketing and distribution department etc. are fixed expenses. Commission of sales
staff which depends on the number of units sold, delivery charges per weight of the unit or area of the carrier
occupied by the unit are considered as variable expenses.
The administrative and marketing, selling and distribution expenses are never made part of the cost of the
product. However, for internal reporting purposes (marginal costing) the variable marketing and selling
costs are charged to cost of goods sold in determining the contribution margin. (This concept is discussed in
Chapter 5)
These multiple bifurcations of expenses are elaborated as under:

Manufacturing
Expenses
AT A GLANCE

Direct Expenses Indirect Expenses

(Production Overeads)

Variable Expenses Fixed Expenses Variable Expenses Fixed Expenses

Overheads
SPOTLIGHT

Production Overheads Non-Production Overheads

Variable
Variable Fixed admin and marketing
Fixed Overheads
Overheads marketing overheads overheads

In addition to classifying costs as manufacturing and non-manufacturing, they can also be classified as period
cost and product cost. To understand the difference between product costs and period costs, we must first recall
STICKY NOTES

the matching principle from financial accounting.

The matching principle is based on the accrual concept that costs incurred to generate a particular revenue
should be recognized as expenses in the same period that the revenue is recognized. This means that if a cost is
incurred to acquire or make something that will eventually be sold, then the cost should be recognized as an
expense only when the sale takes place—that is, when the benefit occurs. Such costs are called product costs.
Period costs are all costs that are not product costs. Period costs are not included as part of the cost of either
purchased or manufactured goods instead, period costs are expensed in the period in which they are incurred.
Identifying manufacturing overheads:
Overhead Classification
Depreciation of factory machinery Manufacturing overhead
Factory insurance Manufacturing overhead
Salary of the Finance Director Administration overhead
Depreciation of the accounts clerk’s computer Administration overhead
Petrol used in delivery vehicles Selling overhead
Cost of an advertising campaign Selling overhead

42 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

2. COSTING OF PRODUCTION OVERHEADS

When more than one product is being produced using the same facilities, then they are allocated cost on
individual basis. The costs that are directly attributable to the product can be easily allocated to that product.
However, costs that are incurred in accumulation for all the products, need to be allocated on systematic basis.
These are known as absorption of indirect cost and explained in detail in section 2.1.

2.1 How to absorb indirect production cost to product cost:

In order to absorb indirect production related cost to product cost, following steps should be followed:
1. Allocation: It is the process of allocating the individual cost element to specific cost center. For example,
Mr. Jamal is supervisor in Finishing Department, therefore, his salary and related expenses are allocated to
Finishing Department.

AT A GLANCE
2. Apportionment: It is the process of allocating the common cost to more than one cost centers on fair
basis. For example, rent of factory is to be apportioned between all production and service departments on
the basis of area occupied by each department.
3. Re-apportionment: It is the process of apportioning the service department costs to production
departments based on service provided by service cost centers to production cost centers. There are three
different methods in dealing re-apportionment.
(a) When service departments only provided services to production departments, then direct allocation
method is used. In this method, no service department cost is transferred to other service
department/s, rather it is apportioned to production departments only.
(b) When one service department provides services to production departments along with other service
department but with no reciprocity, then step down method is used. In this method, one service

SPOTLIGHT
department cost is transferred to other service department/s along with production department, but
with no reciprocity.
(c) Sometimes, each service department provides services to each other including production
departments, then we use the reciprocal method. For example, there are two service departments X
and Y. Department X provides services to department Y which provides services to department X
including production departments. It can be solved through further two methods, first is repeated
distribution method and second is algebraic method. Both methods are discussed in detail with
examples in following sections.
4. Absorption Rate: Next step is to calculate rate which is used to absorb production overheads to product or
service cost. The rate can be single which is termed as composite rate or blanket rate and it can be separate
rate for each department and is termed as departmental rates. The absorption rate/s can be calculated by

STICKY NOTES
using the following formula:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑡𝑡𝑡𝑡 𝑏𝑏𝑏𝑏 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈
Note: If the base is in cost, it is recommended to calculate the rate in percentage and in this situation,
multiply the above formula with 100.
Estimated factory overhead:
The estimated factory overhead is the amount of overheads that management expects to incur in the coming
periods. The amount of estimated factory overhead can be calculated by applying first three steps as mentioned
above.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 43

 CHAPTER 3: OVERHEADS CAF 8: CMA

Base to be used:
The following bases can be used for this purpose:
1. Physical output
2. Direct material cost
3. Direct labour cost
4. Prime cost
5. Direct labour hours
6. Machine hours
The selection of the base depends upon the nature or the function of the factory overhead. For example, if the
factory overhead cost comprises indirect labour predominantly, the direct labour cost or hour can be used as
AT A GLANCE

base. If it relates to machine expenditures such as maintenance, depreciation and normal wear tear, then the
base could be machine hours.
The base selection also depends on the nature of business and it may vary from company to company,
department to department and one cost center to the other.
 Example 01: (Allocation and apportionment)
The AJFA & Co is preparing its production overhead budgets and therefore need to determine the
apportionment of these overheads to products. Cost center expenses and related information have been
budgeted as below:

Production department Service departments

Total Machine Machine Assembly Canteen Maintenance
SPOTLIGHT

Shop A Shop B
Direct wages (Rs.) 518,920 128,480 99,640 290,800
Indirect wages (Rs.) 313,820 34,344 36,760 62,696 118,600 61,420
Consumable 67,600 25,600 34,800 4,800 2,400
materials (incl.
maintenance)
Rent & rates (Rs.) 66,800
Building insurance 9,600
(Rs.)
STICKY NOTES

Heat & light (Rs.) 13,600

Power (Rs.) 34,400
Depreciation of 160,800
machine (Rs.)
Area (Sq ft) 90,000 20,000 24,000 30,000 12,000 4,000
Value of machines 1,608,000 760,000 716,000 88,000 12,000 32,000
(Rs.)
Power usage (%) 100 54 40 3 1 2
Direct labour hours 72,020 16,020 21,410 43,590
Machine usage 54,422 14,730 37,632 2,060
hours

44 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

Allocation and apportionment sheet of AJFA & Co is given below:

All amounts are given in Rupees.

Base Production department Service departments

Total Machine Machine Assembly Canteen Maintenance
Shop A Shop B
Indirect Allocated
wages 313,820 34,344 36,760 62,696 118,600 61,420
Consumable
materials Allocated
(incl. 67,600 25,600 34,800 4,800 2,400
maintenance)

AT A GLANCE
Rent & Rates Area sqft 66,800 14,844 17,813 22,267 8,907 2,969
Building
insurance Area sqft 9,600 2,133 2,560 3,200 1,280 427
Heat & Light Area sqft 13,600 3,022 3,627 4,534 1,813 604
Power Power
usage % 34,400 18,576 13,760 1,032 344 688
Depreciation Value of
of machine machine 160,800 76,000 71,600 8,800 1,200 3,200
Allocated &
Apportion

SPOTLIGHT
666,620 174,519 180,920 107,329 134,544 69,308
cost

 Example 02: (Re-apportionment – Direct allocation method)

The RS company has provided you following data for its overheads. The allocated and
apportioned cost of each department is given below:

Production Departments Service Departments

A B C Canteen Maintenance
Allocated and apportioned cost 150,000 100,000 60,000 30,000 40,000
Number of employees 80 60 10

STICKY NOTES
Machine hours 3,000 4,500 2,500

Cost of service departments: canteen and maintenance is apportioned to production

departments only.
The reapportionment sheet of overheads under direct allocation method is given below:

Base Production Departments Service Departments

A B C Canteen Maintenance
Allocated and 150,000 100,000 60,000 30,000 40,000
apportioned cost
Canteen cost Employees 16,000 12,000 2,000 (30,000) -
Maintenance cost Machine H 12,000 18,000 10,000 - (40,000)
178,000 130,000 72,000 - -

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 45

 CHAPTER 3: OVERHEADS CAF 8: CMA

 Example 03: (Re-apportionment – Step down method)

The RS company has provided you following data for its overheads. The allocated and
apportioned cost of each department is given below.

Production Departments Service Departments

A B C Canteen Maintenance
Allocated and apportioned cost 150,000 100,000 60,000 34,000 40,000
Number of employees 80 60 10 20
Machine hours 3,000 4,500 2,500

Cost of service department canteen is transferred to maintenance department but maintenance

department cost is only transferred to production departments.
AT A GLANCE

The reapportionment sheet of overheads under step down method is given below.

Base Production Departments Service Departments

A B C Canteen Maintenance
Allocated and 150,000 100,000 60,000 34,000 40,000
apportioned cost
Canteen cost Employees 16,000 12,000 2,000 (34,000) 4,000
Maintenance cost Machine H 13,200 19,800 11,000 - (44,000)
179,200 131,800 73,000 - -

 Example 04: (Re-apportionment – Repeated Distribution method and Simultaneous method)

SPOTLIGHT

In a factory with four production departments and two service departments, the operating costs
for the month of October were as shown below.
Rs.
Production Department 1 700,000
Production Department 2 300,000
Production Department 3 400,000
Service departments
Canteen 78,000
Boiler house 100,000
STICKY NOTES

1,578,000
The costs of running the canteen are apportioned to each department on the basis of the
estimated use of the canteen by employees in each department.
The costs of the boiler house are apportioned on the basis of the estimated consumption of power
by each department.
The service departments’ costs are therefore apportioned as follows:
Canteen Boiler house
% %
Production Department 1 40 30
Production Department 2 20 30
Production Department 3 30 20
Service departments
Canteen - 20
Boiler house 10 -

46 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

(a) Preparation of a statement showing the allocation of costs to the production departments
using the repeated distribution method would be as follows:
C = Canteen
BH = Boiler house
Dept 1 Dept 2 Dept 3 C BH
Rs. Rs. Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000 78,000 100,000
Apportion:
BH (30:30:20:20) 30,000 30,000 20,000 20,000 (100,000)
98,000

AT A GLANCE
C (40:20:30:10) 39,200 19,600 29,400 (98,000) 9,800
BH (30:30:20:20) 2,940 2,940 1,960 1,960 (9,800)
C (40:20:30:10) 784 392 588 (1,960) 196
BH (30:30:20:20) 59 59 39 39 (196)
C (40:20:30:10) 15 8 12 (39) 4
BH (30:30:20:20) 1 1 1 1 (4)
C (40:20:30:10) 1 0 0 (1) 0
Total overhead 773,000 353,000 452,000

(b) the simultaneous equations method.

SPOTLIGHT
Let X = the total overheads apportioned from the Canteen
and Y = the total overheads apportioned from the Boiler House
This gives us the simultaneous equations:
X = 78,000 + 0.2 Y … (1)
Y = 100,000 + 0.1 X … (2)
Re-arrange:
78,000 = X – 0.2 Y … (1)
100,000 = – 0.1 X + Y … (2)
Multiply (2) by 10

STICKY NOTES
1,000,000 = – X + 10Y … (3)
Add (1) and (3)
1,078,000 = 9.8Y
Y = 110,000
Therefore, from (1) and substituting Y = 110,000:
X = 78,000 + 0.2 (110,000) = 100,000.
Dept 1 Dept 2 Dept 3
Rs. Rs. Rs.
Initial overheads 700,000 300,000 400,000
Apportion:
BH (30%, 30% and 20% of 110,000) 33,000 33,000 22,000
C (40%, 20% and 30% of 100,000) 40,000 20,000 30,000
Total overhead apportionment 773,000 353,000 452,000

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 47

 CHAPTER 3: OVERHEADS CAF 8: CMA

 Example 05: (Overhead absorption rate- Composite on different basis)

Ahsan Enterprises (AE) produces three products Alpha, Beta and Gamma. The management has
some reservations on the method of costing. Consequently, the cost accountant has reviewed the
records and gathered the following information:
i. The costs incurred during the latest quarter were as follows:
Rupees
Direct material 240,000
Direct labour 1,680,000
Indirect wages – machine maintenance 600,000
– stores 360,000
– quality control 468,000
AT A GLANCE

– cleaning and related services 400,000

Fuel and power 2,800,000
Depreciation on plant, machinery and building 1,560,000
Insurance on plant and machinery 240,000
Insurance on building 60,000
Stores, spares and supplies consumed 1,800,000
Rent, rates and taxes 1,200,000
ii. The production report for the previous quarter depicted the following information:
Production Direct labour Machine hours Inspection hours
SPOTLIGHT

(units) hours per unit per unit per unit

Alpha 12,000 20.00 6.00 2.00
Beta 20,000 5.00 8.00 3.00
Gamma 45,000 4.00 10.00 4.00

The rate of depreciation for plant and machinery is 10% per annum.

a) Calculations that would be required to determine the factory overhead rate on various
basis are as follows:

a) Physical Output Bases:

STICKY NOTES

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
9,488,000
77,000 (𝑤𝑤 − 1)
Factory Overhead Rate = Rs. 123.221 per unit

b) Direct Labour Cost Bases:

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
× 100
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
9,488,000
= × 100
1,680,000 (𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔)
Factory Overhead Rate = 564.76%

48 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

c) Direct Labour Hour Bases:

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻
9,488,000
520,000 (𝑤𝑤 − 1)
Factory Overhead Rate = Rs. 18.246 per direct labour hour

d) Machine Hour Bases:

𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑖𝑖𝑖𝑖𝑖𝑖 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻
9,488,000

AT A GLANCE
682,000 (𝑤𝑤 − 1)
Factory Overhead Rate = Rs. 13.912 per machine hour
W-1 Alpha Beta Gamma Total
Physical Output 12,000 20,000 45,000 77,000
Direct Labour Hours per unit 20.00 5.00 4.00
Total Hours (12,000 x 20) (20,000 x 5) (45,000 x 4) 520,000
= 240,000 = 100,000 =180,000
Machine Hours per unit 6.00 8.00 10.00
Total Hours (12,000 x 6) (20,000 x 8) (45,000 x 10) 682,000

SPOTLIGHT
72,000 160,000 450,000

Absorption of overheads to cost objects

Once absorption rate is calculated, then this rate is used to absorb overheads to cost object. If
cost object is product, then actual base is determined and overhead absorption rate is applied to
absorb overheads to each product as “Actual base x OAR/base”. For example, if OAR is Rs. 50 per
labour hour and 500 actual labour hours are incurred in production of specific product, then
overhead cost of Rs. 25,000 (500 x 50) is included in cost of this product.
The concept is further elaborated in above example, and given below in part b.
b) Factory overhead cost allocable to each product can be determined as follows:

STICKY NOTES
Alpha Beta Gamma Total
Allocation based on physical units:
Physical Units 12,000 20,000 45,000 77,000
Factory Overhead Rate 123.221 123.221 123.221
based on physical output
Cost allocated to the (12,000* (20,000* (45,000* 9,488,000
products 123.221) 123.221) 123.221)
= 1,478,652 = 2,464,420 = 5,544,945
Allocation based on direct labour cost:
Direct Labour cost per unit (1,680,000 (1,680,000 (1,680,000
/77,000) /77,000) /77,000)
= 21.818 = 21.818 = 21.818
Labour Cost for total units (12,000* (20,000* (45,000* 1,680,000
21.818) 21.818) 21.818)
= 261,818.182 = 436,363.636 = 981,818.182

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 49

 CHAPTER 3: OVERHEADS CAF 8: CMA

Alpha Beta Gamma Total

Factory Overhead rate 564.76% 564.76% 564.76%
Cost allocated to the (564.76%* (564.76% * (564.76% * 9,488,000
products 261,818.182) 436,363.636) 981,818.182)
= 1,478,649.340 = 2,464,415.605 = 5,544,935.168
Allocation based on direct labour hours:
Direct Labour Hours (w-1) 240,000 100,000 180,000 520,000
Factory overhead rate 18.246 18.246 18.246
Cost allocated to the (240,000x (100,000x (180,000x 9,488,000
products 18.246) = 18.246) = 18.246) =
4,379,076.923 1,824,615.385 3,284,307.692
AT A GLANCE

Allocation based on machine hours:

Machine Hours 72,000 160,000 450,000 682,000
(w-1)
Factory overhead rate 13.912 13.912 13.912
Cost allocated to the (72,000x (160,000x (450,000* 9,488,000
products 13.912) = 13.912) = 13.912) =
1,001,665.689 2,225,923.754 6,260,410.557
We must also note that factory overhead cost allocated to products in each case is different. This
is why selection of base is very crucial and management must determine with vigilance the
appropriate base to be used.
SPOTLIGHT

2.2 Factors affecting the predetermined overhead rate:

In addition to the selection of bases, the following more factors are also considered:
1. Activity level selection
2. Inclusion or exclusion of fixed overheads
3. Single rate or several rates

2.2.1. Activity Level Selection:

Activity level can be described as the level at which the business performs its production activities. For example,
a company has the capacity to produce 100,000 units every month using 7,000 labour hours and 5,000 machine
hours. However, in past months the company has only produced 80,000 units due to the market demand. This
STICKY NOTES

shows that company’s activity level is 80% (80,000/100,000) of its maximum capacity.
If, the company expects that there is no change in the demand and therefore, the same number of units shall be
produced. This is called Normal Capacity and overhead rate should be based on this capacity.
If the company expects that the demand will increase or decrease and estimates a level at 90% or 70%, this is
called Expected Actual Capacity and overhead rate should be based on this capacity.
In normal capacity, the overhead rate is calculated using average utilization of plant and expenditures over a
period long enough to level out the highs and lows that occur in every business venture. A rate based on normal
capacity should not change periodically because of change in actual production. The rate will be changed when
the prices of certain expense items change or when fixed costs increase or decrease.
In expected actual capacity, the overhead rate is determined using the expected cost and production at expected
actual output for the next production period. This method usually results in different predetermined rates for
each period. When the company is unable to judge its current performance on a long range (normal capacity)
then this activity level is used.

50 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

2.2.2. Inclusion and Exclusion of Fixed Overheads:

In cost accounting there are two methods of assigning costs to the product:
a) Absorption costing / conventional costing or full costing
b) Marginal Costing or Direct Costing
In Absorption costing, both fixed and variable manufacturing expenses are included in product cost. However,
in Marginal costing, fixed expenses are considered as period cost and not the product cost and therefore, are not
included in the cost of the product.
Similarly, when predetermined overhead rate is determined, both fixed and variable overhead expenses are taken
into account when using absorption costing, whereas, only variable overhead costs are taken into account in
marginal cost system. This way, the fixed expenses shall be charged off in the profit and loss account in full unlike
absorption costing where the portion of fixed cost is absorbed in the actual production.

AT A GLANCE
2.2.3. Single Overhead Rate or Several Rates:
Overhead rates can be classified as:
a) Blanket rate or Plant-wide rate or composite rate,
b) Departmental rates or Cost centers or cost pool rates.
A plant-wide or blanket overhead rate or composite rate is used to describe a single overhead rate that is
established for the organization as a whole.
If a business produces single product using one or more production departments, a single overhead rate can be
used. However, if more than one products are produced using more than one departments, and each of them
consuming different amount of overheads in each department, then using a blanket rate would not allocate the

SPOTLIGHT
justified cost to products. Therefore, a separate rate is determined for each independent department and are
called departmental rates. Departments are also called cost centers. However, cost centers may be a small
segment within a department.
 Example 06: (Blanket rate and departmental rates)
A company makes two products, Product X and Product Y. Each product is processed through
two cost centers, CC1 and CC2. The following budgeted data is available.

CC1 CC2
Allocated and apportioned overheads Rs. 126,000 Rs. 180,000
(All overheads are fixed costs.)

STICKY NOTES
Direct labour hours per unit
Product X 1.5 2.0
Product Y 1.2 2.6

The budgeted production is 12,000 units of Product X and 10,000 units of Product Y. Fixed
overheads are absorbed into costs on a direct labour hour basis.
The budgeted total fixed overhead cost per unit for Product X and for Product Y can be calculated
using:
a) Blanket rate
In blanket rate, the overhead costs and labour hours of both departments / cost centers shall
be summed and evenly distributed between both the products irrespective of their usage of
the labour hours. Thereafter, using the blanket overhead rate, the overhead cost shall be
allocated to each product using number of hours used by each product. Then the total
allocated cost is divided by total units to arrive at the cost per unit.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 51

 CHAPTER 3: OVERHEADS CAF 8: CMA

Factory Overhead rate = (𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂ℎ𝑒𝑒𝑒𝑒𝑒𝑒)/(𝐷𝐷𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻𝐻)

FOH rate = 306,000/((1.5 + 2.0) × 12,000 + (1.2 + 2.6) × 10,000)
FOH rate = 306,000 / 80,000
Blanket rate of overhead = Rs. 3.825 per direct labour hour
b) Cost center rates:
In cost center rates, the total hours of each center shall be calculated first. The overhead cost
of each department shall be divided by the total hours of that department to arrive at the
absorption rate for each department / cost center. Thereafter, the overhead cost shall be
charged to products on the basis of hours used by each unit of products.

CC1 CC2
AT A GLANCE

Total hours Total hours

Product X 12,000 × 1.5 18,000 12,000 × 2.0 24,000
Product Y 10,000 × 1.2 12,000 10,000 × 2.6 26,000
30,000 50,000

Total overheads Rs.126,000 Rs.180,000

Absorption rate per hour Rs.4.20 Rs.3.60
c) Absorption of fixed overheads under both methods.
SPOTLIGHT

If blanket rate of overheads is used.

Product X Product Y
Fixed overhead cost/unit
Rs. Rs.
Product X (1.5+2.0) x 3.825 13.39
Product Y (1.2+2.6) x 3.825 14.54
If separate rates are used for each department, then absorption of fixed overheads are:
Product X Product Y
Fixed overhead cost/unit
Rs. Rs.
STICKY NOTES

CC1 1.5 × Rs.4.20 6.30 1.2 × Rs.4.20 5.04

CC2 2.0 × Rs.3.60 7.20 2.6 × Rs.3.60 9.36
Total 13.50 14.40

In some situations, it is possible to go a stage further and establish separate overhead rates for
small segments within a department (such as group of similar machines in a department). These
small segments are called cost centers. A department can be reciprocated as cost center.
However, a cost center describes a location to which overhead costs are initially assigned. The
total cost accumulated in each cost center are then assigned to cost objects using a separate
allocation base for each cost center. Therefore, it can be a department but it can also be a smaller
segment.
When a departmental overhead rate is determined for the entire department, it may result in
inaccurate allocation of overheads when a department consists of a number of different
production centers with products passing through the departments consume overheads of each
production center in different proportions. Therefore, determining overhead rates for each
production centers / cost pools would help achieving the more accurate results.

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 Example 07:
Using the data in Example 07, when required to calculate the factory overhead cost per unit, for
each product, by allocating individual expenses on the basis of specific utilization of related
facilities, please see below:

Allocation
Alpha Beta Gamma Total
basis
Production (no. of units) A 12,000 20,000 45,000 77,000
Machine hours per unit 6 8 10
Total machine hours Units x 72,000 160,000 450,000 682,000
Machine hours

AT A GLANCE
per unit
Units inspected 600 400 1,350 2,350
Per unit inspection hours 2 3 4
Total no. of hours for units Units inspected 1,200 1,200 5,400 7,800
inspected x hours per
unit
Overhead allocation:
Indirect wages:
Machine maintenance Machine hours 63,343 140,763 395,894 600,000
Stores Store 144,000 54,000 162,000 360,000

SPOTLIGHT
consumption
Quality control Inspected 72,000 72,000 324,000 468,000
hours
Cleaning and related Factory space 160,000 140,000 100,000 400,000
services utilization
Fuel and power Machine hours 295,601 656,892 1,847,507 2,800,000
Depreciation on plant and 600,000 400,000 300,000 1,300,000
machinery Machinery cost
Depreciation on building Factory space 104,000 91,000 65,000 260,000

STICKY NOTES
(1,560,000-1,300,000) utilization
Insurance on plant and Cost of 110,769 73,846 55,385 240,000
machinery Machinery
Insurance on building Factory space 24,000 21,000 15,000 60,000
utilization
Stores, spares and 720,000 270,000 810,000 1,800,000
supplies consumed Actual
Rent, rates and taxes Factory space 480,000 420,000 300,000 1,200,000
utilization
Total overheads B Rs. 2,773,714 2,339,500 4,374,786 9,488,000
Cost per unit (B/A) Rs. 231.14 116.98 97.22

In this example we could see that rate is calculated for each expense using its related activity and
then allocation is based on the proportion utilized by the products of such activities.

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 Example 08:
A production center has three production departments, A, B and C.
Budgeted production overhead costs for the next period are as follows:

Rs.

Factory rent 60,000

Equipment depreciation 80,000

Insurance 20,000

Heating and lighting 18,000

AT A GLANCE

Indirect materials:

Department A 7,000

Department B 6,600

Department C 9,400

Indirect labour:

Department A 40,000

Department B 27,000
SPOTLIGHT

Department C 20,000

Insurance costs relate mainly to health and safety insurance, and will be apportioned on the basis
of the number of employees in each department. Heating and lighting costs will be apportioned
on the basis of volume.
Other relevant information is as follows:

Total Department A Department B Department C

Direct labour hours 18,000 8,000 6,000 4,000

STICKY NOTES

Number of employees 50 20 16 14

Floor area (square 1,200 300 400 500

metres)

Cost of equipment 1,000 200 600 200

(Rs.000s)

Volume (cubic metres) 18,000 8,000 6,000 4,000

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a) Calculation for the overhead costs and overhead absorption rate for the period for each
production department, assuming that a separate direct labour hour absorption rate is
used for each department, would be as follows.

Basis of Total A B C
apportionment
--------------------Rs.-----------------
Indirect materials Given 23,000 7,000 6,600 9,400
Indirect labour Given 87,000 40,000 27,000 20,000
Factory Rent Floor area 60,000 15,000 20,000 25,000
Depreciation Equipment cost 80,000 16,000 48,000 16,000

AT A GLANCE
Insurance Employee 20,000 8,000 6,400 5,600
numbers
Heating, lighting Volume 18,000 8,000 6,000 4,000
Total 288,000 94,000 114,000 80,000
Direct labour hours 8,000 6,000 4,000
Absorption rate (per direct labour hour) Rs. 11.75 Rs.19.00 Rs.20.00

b) Then, overhead absorption rate for the period, assuming that a single factory-wide direct
labour hour absorption rate is use, would be calculated as below:
If a single factory-wide absorption rate is used instead of separate absorption rates for

SPOTLIGHT
each department, the absorption rate would be Rs.16 per direct labour hour
(Rs.288,000/18,000 hours).
 Example 09:
On December 1, 20X3 Zia Textile Mills Limited purchased a new cutting machine for Rs.
1,300,000 to augment the capacity of five existing machines in the Cutting Department. The new
machine has an estimated life of 10 years after which its scrap value is estimated at Rs. 100,000.
It is the policy of the company to charge depreciation on straight line basis.
The new machine will be available to Cutting Department with effect from February 1, 20X4. It is
budgeted that the machine will work for 2,600 hours in 20X4. The budgeted hours include:
- 80 hours for setting up the machine; and

STICKY NOTES
- 120 hours for maintenance.
The related expenses, for the year 20X4 have been estimated as under:
i. Electricity used by the machine during the production will be 10 units per hour @ Rs.
8.50 per unit.
ii. Cost of maintenance will be Rs. 25,000 per month.
iii. The machine requires replacement of a part at the end of every month which will cost
Rs. 10,000 on each replacement.
iv. A machine operator will be employed at Rs. 9,000 per month.
v. It is estimated that on installation of the machine, other departmental overheads will
increase by Rs. 5,000 per month.
Cutting Department uses a single rate for the recovery of running costs of the machines. It has
been budgeted that other five machines will work for 12,500 hours during the year 20X4,
including 900 hours for maintenance. Presently, the Cutting Department is charging Rs. 390 per
productive hour for recovery of running cost of the existing machines.

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 55

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Required
Compute the revised machine hour rate which the Cutting Department should use during the
year 20X4.
 Solution
Calculation of Annual Charges of New Machine

Rupees
Total budgeted costs of existing five machines (Rs. 390 x (12,500 - 900)) 4,524,000
Add: Costs of new machines
i. Depreciation (1,300,000 – 100,000)/10 x 11/12 110,000
AT A GLANCE

ii. Electricity (2,400 x 10 x Rs. 8.50) 204,000

iii. Cost of maintenance (Rs. 25,000 x 11) 275,000
iv. Part replacement (Rs. 10,000 x 11) 110,000
v. Operator Wages (Rs. 9,000 x 11) 99,000
vi. Departmental expenses (Rs. 5,000 x 11) 55,000
Total Cost 5,377,000

Productive Budgeted hours (12,500 + 2,600 - 900 - 120 - 80) 14,000

SPOTLIGHT

Adjusted machine hours rate 384.07

STICKY NOTES

56 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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3. BASIS OF APPORTIONMENT OF SERVICE CENTRE COSTS TO PRODUCTION

DEPARTMENTS
Case 1
The costs of service centers usually are apportioned among the production departments on the basis of their
usage of services. For example, Service department X provides electricity to three production departments A, B
and C in the ratio of 3:2:1 therefore, the cost of department X must be allocated to production departments in the
same ratio.
 Example 10:
Ternary Engineering Limited produces front and rear fenders for a motorcycle manufacturer.
It has three production departments and two service departments. Overheads are allocated on

AT A GLANCE
the basis of direct labour hours. The management is considering changing the basis of overhead
allocation from a single overhead absorption rate to departmental overhead rate. The estimated
annual overheads for the five departments are as under:

Production Departments Service

Fabrication Phosphate Painting Inspection Maintenance
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
Direct materials 6,750 300 750
Direct labour 1,200 385 480
Indirect material 30 75

SPOTLIGHT
Other variable overheads 200 70 100 30 15
Fixed overheads 480 65 115 150 210
Total departmental expenses 8,630 820 1,445 210 300
Maximum production
capacity (Units) 20,000 25,000 30,000
Direct labour hours 24,000 9,600 12,000
Machine hours 9,000 1,000 1,200

STICKY NOTES
Use of service departments:
Maintenance - Labour hours 630 273 147
Inspection - Inspection hours 1,000 500 1,500

a) Computation of the single overhead absorption rate for the next year, would be as follows

Production departments Rs. (000)

Variable overhead 370
Fixed overhead 660
Service department
Inspection 210
Maintenance 300
1,540

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 57

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Production departments Rs. (000)

Estimated direct labour hours (DLH)
Fabrication 24,000
Phosphate 9,600
Painting 12,000
Total estimated direct labour hours 45,600
Estimated Total Overheads
Single overhead absorption rate =
Estimated Direct Labour Hours
AT A GLANCE

Rs. 1,540,000 = Rs. 33.77 per

=
45,600 hours direct labour hour

b) Computation of the departmental overhead absorption rates in accordance with the below
circumstances would be as follows:
• The Maintenance Department costs are allocated to the production department on
the basis of labour hours.
• The Inspection Department costs are allocated on the basis of inspection hours.
• The Fabrication Department overhead absorption rate is based on machine hours
whereas the overhead rates for Phosphate and Painting Departments is based on
direct labour hours.
SPOTLIGHT

Production Service
Fabrication Phosphate Painting Inspection Maintenance
Rupees in thousand
Variable Overhead 200 70 100 60 90
Fixed Overhead 480 65 115 150 210
Allocation of Maintenance Department Costs on the basis of labour hours
630 ÷ 1,050 x 300 180 (180)
STICKY NOTES

273 ÷ 1,050 x 300 78 (78)

147 ÷ 1,050 x 300 42 (42)
Allocation of Inspection Department Costs on the basis of Inspection hours
1,000 ÷ 3,000 x 210 70 (70)
500 ÷ 3,000 x 210 35 (35)
1,500 ÷ 3,000 x 210 105 (105)
930 248 362 - -

Base Machine hours Direct labour hours

number of hours 9,000 9,600 12,000
Departmental Overhead Rate (Rs.) 103.33 25.83 30.17

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 Example 11:
Sparrow (Pvt) Limited (SPL) is engaged in the manufacture of two products A and B. These
products are manufactured on two machines M1 and M2 and are passed through two service
departments, Inspection and Packing, before being delivered to the warehouse for final
distribution. SPL’s overhead expenses for the month of August 2011 were as follows:

Rupees
Electricity 2,238,000
Rent 1,492,000
Operational expenses of machine M1 5,500,000

AT A GLANCE
Operational expenses of machine M2 3,200,000

Following information relates to production of the two products during the month:

A B
Units produced 5,600 7,500
Labour time per unit – Inspection department 15 minutes 12 minutes
Labour time per unit – Packing department 12 minutes 10 minutes

The area occupied by the two machines M1 and M2 and the two service departments is as follows:

SPOTLIGHT
Square feet
Machine M1 5,500
Machine M2 4,800
Inspection department 12,000
Packing department 15,000

Machine M1 has produced 50% units of product A and 65% units of product B whereas machine
M2 has produced 50% units of product A and 35% units of product B.
For Allocating overhead expenses to both the products A and B., the following calculation shall

STICKY NOTES
be made:

Allocation of costs
Basis Machine M1 Machine M2 Inspection Packing Total
to cost centers
Area Occupied 5,500 4,800 12,000 15,000 37,300
Allocation of Area 330,000 288,000 720,000 900,000 2,238,000
Electricity
Allocation of rent Area 220,000 192,000 480,000 600,000 1,492,000
Operational cost 5,500,000 3,200,000 - - 8,700,000
6,050,000 3,680,000 1,200,000 1,500,000 12,430,000

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ALLOCATION OF COST TO PRODUCTS

Basis of Cost Allocation A B TOTAL
Units produced 5,600 7,500
Inspection time (hours) 1,400 1,500 2,900
(5,600 x 15 min /60) & (7,500 x 12 min /60)
Packing time (hours) 1,120 1,250 2,370
(5,600 x 12 min /60) & (7,500 x 10 min /60)
Units produced on Machine M1 2,800 4,875 7,675
(50% A and 65% B)
AT A GLANCE

Units produced on Machine M2 2,800 2,625 5,425

(50% A and 35% B)
Cost Allocated
Machine M1 cost (based on units produced on M1) 2,207,166 3,842,834 6,050,000
Machine M2 cost (based on units produced on M2) 1,899,355 1,780,645 3,680,000
Inspection department cost (based on inspection hours) 579,310 620,690 1,200,000
Packing department cost (based on packing hours) 708,861 791,139 1,500,000
5,394,692 7,035,308 12,430,000
SPOTLIGHT

Case 2
However, in some cases, one or more service departments use other service department. In such a case, the cost
of that service department shall be distributed first which provides services to other service departments too
and the cost shall be distributed to all the departments (that is production and service departments which receive
its services). Thereafter, the cost of remaining service departments is distributed to production departments.
This case can be understood with the help of following examples.
 Example 12:
The Torrence manufacturing company has four production departments and three service
departments: Maintenance, Toolroom and Storeroom. The estimated annual production
overheads for these seven departments is given below:
STICKY NOTES

Departments
Producing Service
01 02 03 04 Maintenance Tool-room Store-room
Estimated overheads Amount in Rupees

Fixed production
overheads 360,000 480,000 450,000 300,000 150,000 105,000 120,000

Variable production
overheads 240,000 220,000 200,000 200,000 108,000 105,000 30,000
Total 600,000 700,000 650,000 500,000 258,000 210,000 150,000

The management decided to distribute the service departments costs on a dual basis: (a) fixed
production overheads on standby or ready to serve basis and (b) variable production overheads
on a billing or charging rate basis. The fixed production overheads of the three service
departments are to be distributed as shown in below table.

60 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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Allocation of fixed production overheads of

Total 01 02 03 04
service departments
Amount in Rupees
Maintenance 150,000 50,000 40,000 30,000 30,000
Toolroom 105,000 35,000 25,000 25,000 20,000
Storeroom 120,000 60,000 30,000 20,000 10,000

The variable production overheads of the service departments are distributed on the basis of
charging rate based on the following plant survey and other pertinent data:
Storeroom
Maintenance Toolroom
Departments (Number of Material
(Area in sqft) (Number of employees)

AT A GLANCE
requisitions)
01 12,000 40 30,000
02 10,000 30 30,000
03 9,000 20 28,000
04 5,000 10 12,000
Maintenance 5,000 5
Tool-room 3,000 3
Storeroom 1,000 2

Maintenance department cost is apportioned to other service departments along with

production departments but costs of tool-room and storeroom is transferred to production

SPOTLIGHT
departments only.
Production overhead apportionment sheet on the basis of above data and analysis, is given
below.
Departments
Producing Service
01 02 03 04 Maintenance Tool-room Store-room
Estimated overheads Amount in Rupees
Fixed production
overheads 360,000 480,000 450,000 300,000 150,000 105,000 120,000
Maintenance 50,000 40,000 30,000 30,000 (150,000)

STICKY NOTES
Tool-room 35,000 25,000 25,000 20,000 (105,000)
Storeroom 60,000 30,000 20,000 10,000 (120,000)
Apportioned fixed
production
overheads (A) 505,000 575,000 525,000 360,000
Variable production
overheads 240,000 220,000 200,000 200,000 108,000 105,000 30,000
Maintenance (sqft) 32,400 27,000 24,300 13,500 (108,000) 8,100 2,700
Tool-room 45,240 33,930 22,620 11,310 (113,100)
Storeroom 9,810 9,810 9,156 3,924 (32,700)
Apportioned
variable production
overheads (B) 327,450 290,740 256,076 228,734
Apportioned total
production
overheads (A+B) 832,450 865,740 781,076 588,734

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 61

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Case 3
In some cases, the structure becomes complex when service departments share services with each other. For
example, Department X and Y provides services to each other as well as to production departments. In such a
case, reciprocal apportionment of cost is carried. The following methods are used for such apportionment:
a) Repeated distribution method
b) Simultaneous equation method

Repeated Distribution Method:

In this method, cost of one service department is apportioned to all the departments according to the determined
proportion. This way, the cost of that department becomes zero. Thereafter, the cost of other service department
is distributed to all the departments in the given proportion. Now since the departments share services, the
AT A GLANCE

department whose cost is distributed first has receive the portion of cost from the departments whose costs are
subsequently apportioned. This will happen with all the service departments. Therefore, the process of
distribution should be repeated till all the costs including the ones after repeated distribution have become zero.

Simultaneous Equation Method:

In this method, simultaneous equations are made to solve the problem in shortest way.
These methods can be best understood through examples.
 Example 13:
The expenses of the production and service departments of a company for a year are as follows:
Expenses before distribution Service provided (%age)
SPOTLIGHT

Department of service department cost Dept. X Dept. Y

Rs. ‘000
Production department - A 500 50 40
-B 400 30 50
Service department – X 100 - 10
-Y 60 20 -
For allocating the service departments expenses to production departments by:
a) Repeated distribution method
Production Service
Department Department
STICKY NOTES

A B X Y
Total expenses as given 500 400 100 60
Allocation of X department cost 50 30 (100) 20
Allocation of Y department cost 32 40 8 (80)
Allocation of X department cost 4 2 (8) 2
Allocation of Y department cost 1 1 - (2)
587 473 - -
b) Simultaneous equation method
Let total expenses of department X inclusive of expenses allocated from department
Y=x
Let total expenses of department Y inclusive of expenses allocated from department
X=y
Then according to question

62 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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x = 100 + 0.1 y ------------ eq. (1)

y = 60 + 0.2 x -------------- eq. (2)
Putting the value of y from eq. (1) in eq. (2)
x = 100 + 0.1 (60 + 0.2x)
x = 100 + 6 + 0.02 x
x – 0.02 x = 106
x = 108
y = 60 + 0.2 (108)
y= 60 + 22 = 82

AT A GLANCE
ALLOCATIONS
Production
Description Department
A B
Product department costs 500 400
Distribution of X department cost
(108 × 50%) & (108 × 30% ) 54 32
Distribution of Y department cost
(82 × 40%) & (82 × 50% ) 33 41

SPOTLIGHT
587 473

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 63

 CHAPTER 3: OVERHEADS CAF 8: CMA

4. OVER OR UNDER APPLIED / ABSORBED OVERHEAD

Once the factory overhead rate is determined using the estimated amount of factory overhead and estimated
base, it is used to charge overhead cost to the jobs, products or work performed. The overhead absorbed is based
on actual activity on which the rate is calculated. Multiply this rate with actual capacity resulted in absorbed
overheads.
Since, some of the expenses are not related to product and cannot be identified when production is taken place
because these are related to period. For example, electricity bill and rent is paid on monthly basis, while
production is taken place on daily and continuous basis. In order to include the indirect cost, we have to calculate
overhead absorption rate, as discussed in section 3.
Due to this, at each period end, the management calculates and compares the actual overhead cost with the
applied overhead cost and determine the over or under applied overheads.
AT A GLANCE

The over or under absorbed overhead is calculated as follows:

Actual Factory Overhead xxx

Applied / Absorbed Factory Overhead
(Budgeted overhead rate x actual activity level of the selected base) (xxx)
Over or Under Applied / Absorbed Overhead xxx

• Over applied / absorbed means the actual overhead cost is lesser than the cost applied to the production
• Under applied / absorbed means the actual overhead cost is greater than the cost applied to the production

Treatment of Over or Under Applied / Absorbed Overhead:

SPOTLIGHT

The over or under applied overhead so calculated is treated either as:

a) Period cost – charged to cost of goods sold, or
b) Product cost – charged to production (including closing inventory)
For financial reporting purposes, it is often closed to cost of goods sold as period cost.
 Example 14:
Amber Limited (AL) manufactures a single product. Following information pertaining to the year
20X4 has been extracted from the records of the company’s three production departments.

Material Labour Machine

Department
STICKY NOTES

Rs. in million Hours

A 80 200,000 400,000
Budgeted B 150 500,000 125,000
C 120 250,000 350,000
A 80 220,000 340,000
Actual B 150 530,000 120,000
C 120 240,000 320,000

AL produced 3.57 million units during the period. The budgeted labour rate per hour is Rs. 120.
The overheads for Department-A is budgeted at Rs. 5.0 million, for Department-B at 15% of
labour cost and for department-C at 5% of prime cost of the respective departments. Actual
overheads for department A, B and C are Rs. 5.35 million, Rs. 8.90 million and Rs. 7.45 million
respectively.

64 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

Overheads are allocated on the following basis:

Department-A Machine hours
Department-B Labour hours
Department-C Percentage of Prime cost
There was no beginning or ending inventory in any of the production departments.
a) For calculating budgeted overhead application rate for each department, the following
working shall be made

Budgeted overhead rate for department-A Rs.

Budgeted Overhead rate per machine hour (OHD/MH Rs.5m/400,000) Rs. 12.5
Budgeted overhead rate for department-B

AT A GLANCE
Budgeted labour cost (Rs. 120 × 500,000) Rs. 60 million
Budgeted overhead (Rs. 60 m × 15%) Rs. 9 million
Budgeted overhead rate per labour hour (Rs. 9 m/0.5 m) Rs. 18
Budgeted overhead rate for department-C
Budgeted overhead as a % of Prime Cost (Rs.7.5 m /150 m) 5%

b) For calculation of the total and departmental actual cost for each unit of product, the
following working shall be made

Departments

SPOTLIGHT
Rupees in million
A B C
Material cost 80.00 150.00 120.00
Labour cost
(0.22 m × Rs. 120) 26.40
(0.53 m × Rs. 120) 63.60
(0.24 m × Rs. 120) 28.80
Actual overhead cost 5.35 8.90 7.45

STICKY NOTES
Total Cost 111.75 222.50 156.25

Unit cost (Cost/3.57 m. units) (Rs.) 31.30 62.32 43.77

Total Actual Cost per unit (Rs.) 137.39

c) For calculation of over or under applied overhead for each department, the following
working shall be made.

(0.34 m × 12.5) 4.25

(0.53 m × Rs. 18) 9.54
(Rs. 148.8 m × 5%) 7.44
Actual Overhead Cost 5.35 8.90 7.45
Under applied / (over) applied 1.10 (0.64) 0.01

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5. COMPREHENSIVE EXAMPLES
 Example 01:
Salman Limited (SL) has two production departments, PD-A and PD-B, and two service
departments, SD-1 and SD-2. A summary of budgeted costs for the year ending June 2015 is as
follows:

PD-A PD-B SD-1 SD-2 Total

----------------------- Rs. in ‘000 -----------------------

Direct labour 5,400 3,648 - - 9,048

AT A GLANCE

Direct material 13,500 9,120 - - 22,620

Indirect labour 1,900 600 50 20 2,570

Indirect materials 900 1,100 150 55 2,205

Factory rent - - - - 1,340

Power cost - - - - 1,515

Depreciation - - - - 3,500

Other related data is as follows:

SPOTLIGHT

PD-A PD-B SD-1 SD-2

Production (units) 2,250 800 - -

Direct labour hours (per unit) 20 38 - -

Machine hours 19,250 12,250 2,800 700

Kilowatt hours (000) 800 600 50 150

Floor area (square feet) 5,000 4,000 500 500

STICKY NOTES

Machine hours Direct labour

Basis of overhead application
hours - -

SL allocates the costs of service departments applying repeated distribution method. Details of
services provided by SD-1 and SD-2 to the other departments are as follows:

Service Departments PD-A PD-B SD-1 SD-2

SD-1 30% 65% - 5%

SD-2 55% 35% 10% -

Required
Compute the departmental overhead absorption rat.

66 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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 Solution
The departmental overhead absorption rate can be calculated as follows:
Allocation of overheads and overheads absorption rate

Allocation Total PD-A PD-B SD-1 SD-2

basis Rs. in 000
Direct labour - - - - -
Direct material - - - - -
Indirect labour - 1,900 600 50 20
Indirect materials - 900 1,100 150 55

AT A GLANCE
Factory rent Floor area 1,340 670 536 67 67
Kilowatt
Power hrs. 1,515 758 568 47 142
Machine
Depreciation hrs. 3,500 1,925 1,225 280 70
6,153 4,029 594 354
Allocation of service departments cost:
SD-1 30:65:5 178 386 (594) 30
SD-2 55:35:10 211 134 39 (384)

SPOTLIGHT
SD-1 30:65:5 12 25 (39) 2
SD-2 55:35:10 1 1 0 (2)
6,555 4,576 - -

D.
Machine
Allocation basis labour
hrs.
hrs.
Machine/D. labour hours 19,250 30,400 800×38
Overhead absorption rate per hour Rs. 340.52 150.53

STICKY NOTES
 Example 02:
Opal Industries Limited (OIL) produces various products which pass through Processing and
Finishing departments. Logistics and Maintenance departments provide necessary support for
the production. Following information is available from OIL’s records for the month of June 20X1:
(i) Overhead costs Direct labour hours
*Budgeted Actual Budgeted Actual
Departments
-------- Rupees -------- -------- Rupees --------
Processing 560,000 536,000 14,000 14,350
Finishing 320,000 258,000 10,000 9,800
Logistics - 56,700 - -
Maintenance - 45,000 - -

*including apportionment of overhead costs of support departments

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(ii) Costs of support departments are apportioned as under:

Processing Finishing Logistics Maintenance
Logistics 50% 40% - 10%
Maintenance 35% 45% 20% -

Required:
a) Allocate actual overhead costs of support departments to production departments using
repeated distribution method.
b) Compute under/over applied overheads for the month of June 20X1
 Solution
AT A GLANCE

a) Allocate actual overhead costs of support departments to production departments using

repeated distribution method.
Allocation of support departments' actual overheads:
Production departments Support departments
Processing Finishing Logistics Maintenance
Rupees
Cost incurred 536,000 258,000 56,700 45,000
Allocation of support departments' costs:
Logistics
50%:40%:0%:10% 28,350 22,680 (56,700) 5,670
SPOTLIGHT

Maintenance
35%:45%:20%:0% 17,734 22,802 10,134 (50,670)
Logistics 5,067 4,054 (10,134) 1,013
Maintenance 354 456 203 (1,013)
Logistics (Being immaterial
amount, allocated to
production dept. only) 50:40 113 90 (203) -
Total - Actual overhead costs
A 587,618 308,082 - -

b) Compute under/over applied overheads for the month of June 20X1.

STICKY NOTES

Under/over applied overheads:

Predetermined overhead rate:
Budgeted direct labour hours B 14,000 10,000
Budgeted overhead costs C 560,000 320,000
Budgeted overhead rate (C÷B) D 40.00 32.00
Overheads applied:
Actual direct labour hours E 14,350 9,800
Overheads applied (D×E) F 574,000 313,600
Overheads under/(over) applied
(A-F) 13,618 (5,518)

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 Example 03:
Following information has been extracted from the records of RT Limited for August 20X3:

Departments
Production Service
P-1 P-2 P-3 S-1 S-2
Budgeted machine hours 60,000 100,000 120,000
Actual machine hours 60,500 110,000 100,000
Budgeted labour hours 50,000 200,000 75,000
Actual labour hours 55,000 190,000 75,000

AT A GLANCE
Budgeted material cost (Rs. ‘000) 50,000 40,000 3,000
Actual material cost (Rs. ‘000) 50,000 42,000 3,200
Budgeted overheads (Rs. ‘000) 1,200 2,000 2,250 600 700
Actual overheads (Rs. ‘000) 1,250 2,000 1,800 500 750
Services provided by S-1 20% 30% 40% - 10%
Services provided by S-2 30% 40% 20% 10% -
Basis of overhead application Machine Labour 75% of
hours hours Material cost

SPOTLIGHT
Required
a) Allocate costs of service departments using repeated distribution method.
b) Compute department wise over / under applied overheads.
 Solution
a) Allocation of Service dept. cost to production dept. - Repeated distribution method:
Production Dept. Service Dept.
P1 P2 P3 S1 S2
Rupees in thousand

STICKY NOTES
S1 overheads allocation % 20% 30% 40% 10%
S2 overheads allocation % 30% 40% 20% 10%
Actual overheads as given 1,250 2,000 1,800 500 750
Allocation of S2 cost
30:40:20:10 225 300 150 75 (750)
Allocation of S1 cost
20:30:40:10 115 172 230 (575) 58
Allocation of S2 cost
30:40:20:10 17 23 11 6 (58)
Allocation of S1 cost
20:30:40:10 1 2 3 (6)
Allocation from service dept. 358 497 394
Total 1,608 2,497 2,194 − −

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b) Compute department wise over / under applied overheads.

Department wise over / under applied overheads:

P1 P2 P3
Budgeted OH’s 1,200,000 2,000,000 2,250,000
Re-distributed OH’s of service 365,657 510,101 424,242
departments (W-2)
Total budgeted OH’s (I) 1,565,657 2,510,101 2,674,242

Budgeted Base Machine Hours Labour Hours Material Cost

AT A GLANCE

60,000 200,000 -
Budget OAR (II) Rs. 26.0943 Rs. 12.5505 75% of DMC
Per M.H Per L.H Given
Actual data of Base (III) 60,500 190,000 Rs. 3,200,000
Applied FOH (III x II) Rs. 1,578,705 2,384,595 2,400,000
Actual FOH (W-1) 1,608,586 2,497,475 2,193,939
(Under)/Over FOH Applied (29,881) (112,880) 206,061

(W-1)
SPOTLIGHT

P-1 P-2 P-3

Actual FOH
Direct Incurred 1,250,000 2,000,000 1,800,000
Share of service dept’s (part a) 358,586 497,475 393,939
1,608,586 2,497,475 2,193,939

(W-2) Allocation of Service departments using Repeated Distribution Method.

R.T Limited FOH Distribution Sheet
For the month of August, 2009 (Based on Budgeted Cost for Computation of Budgeted OAR)
STICKY NOTES

Date Particulars Head Amount Basis Production Department Service Department

of P1 P2 P3 S1 S2
A/c
Budgeted 1,300,000 600,000 700,000
Overheads
Redistribution
S–1 20:30:40:10 120,000 180,000 240,000 (600,000) 60,000
760,000
S–2 30:40:20:10 228,000 304,000 152,000 76,000 (760,000)
S–1 20:30:40:10 15,200 22,800 30,400 (76,000) 7,600
S–2 30:40:20:10 2,280 3,040 1,520 760 (7,600)
S–1 20:30:40:10 152 228 304 (760) 76
S–2 30:40:20:10 23 30 15 8 (76)
S–1 20:30:40:10 2 3 3 (8) -
1,300,000 365,657 510,101 424,242 0 0

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 Example 04:
Hi-way Engineering Limited uses budgeted overhead rate for applying overhead to production
orders on a direct labour cost basis for department A and on a machine hour basis in department
B.
The company made the following forecasts for August 2006:
Dept A Dept B
Budgeted factory overhead (Rs.) 216,000 225,000
Budgeted direct labour cost (Rs.) 192,000 52,500
Budgeted machine hours 500 10,000
During the month, 50 units were produced in Job no. CNG-011. The job cost sheet for the month
depicts the following information:

AT A GLANCE
Dept A Dept B
Material issued (Rs.) 1,500 2,250
Direct labour cost (Rs.) 1,800 1,250
Machine hours 60 150
Actual data for the month were as follows:
Dept A Dept B
Factory overhead (Rs.) 240,000 207,000
Direct labour cost (Rs.) 222,000 50,000
Machine hours 400 9,000

SPOTLIGHT
Required
a) Compute predetermined overhead rates for each department.
b) Compute total costs and unit cost of Job no. CNG-011.
 Solution
a) Predetermined overhead rates for each department would be computed as follows:
Dep A Dep B
Budgeted factory overhead (Rs.) 216,000 225,000
Pre determined Overhead rate 216,000/192,000*100= 225,000/10,000=

STICKY NOTES
125% of labour cost 22.5 per machine hours
(activity= labour cost) (activity=machine hour)
b) The total costs and unit cost of Job no. CNG-011, would be as follows
Dep A Dep B Total
cost
Material issued (Rs.) 1500 2250 3750
Direct labour cost (Rs.) 1800 1250 3050
Factory overheads (actual activity*predetermined 2250 3375 5625
overhead rate)
Total cost 5550 6875 12425
Number of units 50 50 50
Per unit cost (total cost/number of units) 111 137.5 248.5

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c) The over / under applied overhead for each department would be as follows:
Dep A Dep B
Actual factory overheads 240,000 207,000
Applied factory overheads (actual activity*predetermined 277,500 202,500
overhead rate)
(over) under applied factory overheads (37,500) 4500
 Example 05:
Bright Limited (BL) is engaged in the manufacturing of two products, Shine and Glow. Both these
products are processed through two production departments, A and B, while department X and
Y provide services to both the production departments. Below is a summary of the indirect costs
incurred by BL for manufacture of 100,000 units of Shine and 60,000 units of Glow during the
AT A GLANCE

year ended 31 December 2020:

Rs. 000
Salaries and wages 115,000
Depreciation of machinery 80,000
Building insurance 25,000
Electricity 60,000
280,000

Other information related to the four departments is given below:

SPOTLIGHT

Department Department Department Department Total

A B X Y
Cost of
machinery (Rs. 250,000 150,000 400,000
000)
Floor area
(square feet) 15,000 6,000 6,000 3,000 30,000
No. of employees 150 50 25 25 250
STICKY NOTES

Services
provided by
- Department X 80% 20%
- Department Y 75% 15% 10%

The overhead absorption rates used by BL for allocation to Shine and Glow are Rs. 1,800 and Rs.
1,700 per unit respectively. Any under/over absorbed overheads are adjusted to cost of sales.
Required
a) Compute product wise actual overheads for shine and glow.
b) Compute under / over absorbed overheads.

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 Solution
a) Computation of product wise actual overheads for shine and glow is given below:
Cost allocation to production departments

Items Allocation Total Production Service

basis departments departments
A B X Y
Amount in Rs. 000
Salaries & wages No. of 115,000 69,000 23,000 11,500 11,500
employees

AT A GLANCE
Depreciation Cost of 80,000 50,000 30,000
machine
Building Floor area 25,000 12,500 5,000 5,000 2,500
insurance
Electricity Floor area 60,000 30,000 12,000 12,000 6,000
28,500 20,000
Service departments:
Department Y 75:15:10 15,000 3,000 2,000 (20,000)
Department X 80:20 24,400 6,100 (30,500)

SPOTLIGHT
200,900 79,100

Cost allocation to Shine and Glow

Shine Glow Total

Actual units produced 100,000 60,000 160,000
Overheads allocation on the basis of units
Rs. In 000
- Department A 125,563 75,337 200,900

STICKY NOTES
- Department B 49,437 29,663 79,100
175,000 105,000 280,000

b) Computation of Under / Over absorbed overheads is given below.

Absorbed Actual Under/(Over)

overheads overheads absorbed
Rs. In 000
Shine @ Rs. 1,800 per unit 180,000 175,000 (5,000)
Glow @ Rs. 1,700 per unit 102,000 105,000 3000
282,000 280,000 (2,000)

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 Example 06:
Omega Industries Limited (OIL) produces two products Alpha and Beta. These products are
processed through Fabrication and Finishing departments. Quality control and Logistics
departments provide all the necessary support for the production.
OIL allocates production overheads to Alpha and Beta at a pre-determined rate of Rs. 1,300 and
Rs. 500 per unit respectively. Any under/over absorbed overheads are adjusted to cost of sales.
Following actual data has been extracted from the cost records of OIL for the month of December
2015:
Fabrication Finishing Quality control Logistics Total
Indirect labour Rs. in 1,500 1,200 500 400 3,600
000
AT A GLANCE

Factory rent Rs. In 000 2,000

Power Rs. In 000 1,200
Depreciation-plant Rs. 9,000
In 000
Other information:
Cost of plant Rs. In 000 32,000 20,000 2,000 6,000 60,000
Floor area Square feet 10,000 5,000 3,000 2,000 20,000
Power KWH 50,000 40,000 4,000 6,000 100,000
Hours worked for Alpha 70% 60%
Hours worked for Beta 30% 40%
Services provided by:
- Quality Control 40% 60% 100%
SPOTLIGHT

- Logistics 60% 35% 5% 100%

8,000 units of Alpha and 10,000 units of Beta were produced during the month of December
2015.
Required
a) Calculate product wise actual overheads for Alpha and Beta.
b) Make journal entries to record:
i. applied production overhead
ii. under/ over absorbed production overheads
 Solution
a) Product wise actual overheads for Alpha and Beta are calculated below.
STICKY NOTES

Items Allocation Total Production departments Service

basis departments
Fabrication Finishing Quality Logistics
control
Amount in Rs. 000
Indirect Given 3,600 1,500 1,200 500 400
labour
Factory rent Floor area 2,000 1,000 500 300 200
Power KWH 1,200 600 480 48 72
Depreciation Plant cost 9,000 4,800 3,000 300 900
1,148 1,572
Service departments:
Logistics 60:35:5 1,572 943 550 79 (1,572)
Quality 40:60 1,227 491 736 (1,227)
control
9,334 6,466

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CAF 8: CMA CHAPTER 3: OVERHEADS

Cost allocation to Alpha and Beta

Alpha Beta Total
Actual units produced 8,000 10,000 18,000
Overheads allocation on the basis of hours worked
Rs. In 000
- Fabricating in the ratio of 70:30 6,534 2,800 9,334
- Finishing in the ratio of 60:40 3,880 2,586 6,466
10,414 5,386 15,800
b) Journal entries to record (i) applied production overhead and (ii) Under/ over absorbed
production overheads are given as under.

AT A GLANCE
Debit Credit
Rs. In 000
Work in process (8,000 x 1,300) + (10,000 x 500) 15,400
Factory overheads control account 15,400
(Overheads charged to production at pre-determined
rate)
Cost of sales (15,800 – 15,400) 400
Factory overheads control account 400
(Under applied overheads charged to cost of sales)
 Example 07:
Alpha Limited is preparing its departmental budgets and product cost estimates for the next year.

SPOTLIGHT
The costs and related data for the year ending 31 December 2014 have been estimated as follows:
Machining Assembly Finishing Maintenance Total
Rs. In 000
Direct wages 274 146 328 748
Indirect wages 46 27 36 137 246
Direct materials 365 46 18 429
Indirect materials 68 18 36 91 213
Power 465
Light and heat 46

STICKY NOTES
Depreciation 108
Rent and rates 114
Warehousing cost 98
Other data:
Direct labour hours 12,000 8,000 16,000 6,000 42,000
Machine hours 40,000 2,000 3,000 45,000
No. of employees 6 4 8 3 21
Floor area (sqm) 1,000 400 300 300 2,000
Net book value of fixed
assets (Rs. 000) 20,000 8,000 3,000 4,000 35,000
80% of the maintenance department’s time is used in the maintenance of machines whereas the
remaining time is consumed in cleaning and maintenance of factory buildings.
Required.
Compute appropriate absorption rates for machining, assembly and finishing departments.

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 CHAPTER 3: OVERHEADS CAF 8: CMA

 Solution
Overhead analysis sheet for Alpha Limited for the year ending 31 December 2014:

Base Machining Assembly Finishing Maintenance Total

Rs. In 000
Indirect wages Actual 46 27 36 137 246
Indirect Actual 68 18 36 91 213
materials
Power Machine 465
hours 413 21 31
Light and heat Floor area 23 9 7 7 46
AT A GLANCE

Depreciation NBV 62 25 9 12 108

Rent and rates Floor area 57 23 17 17 114
Warehousing Direct
cost materials 83 11 4 98
752 134 140 264 1,290
80% based
on
Reallocation of machine 188 9 14 (211)
Maintenance hours
costs 20% based
SPOTLIGHT

on floor 31 13 9 (53)
area
971 156 163 - 1,290

Overhead absorption rates of each department

Machining Assembly Finishing

Overheads (Rs. 000) 971 156 163
Base 40,000 8,000 16,000
Machine hours Direct labour Direct labour
STICKY NOTES

hours hours
Overhead absorption rate (Rs.) 24.28 19.50 10.19

 Example 08:
Zaiqa Limited (ZL) is engaged in the business of manufacturing fruit jam. It has three production
and two service departments. Following information is available from ZL’s records for the month
of August 2013:
Rupees
Rent and rates 85,000
Indirect wages 60,000
General lighting 75,000
Power 150,000
Depreciation machinery 50,000

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Following further information relating to the departments is also available:

Service
Production Departments
Departments
Jam Distribut
Selection Bottling Storage
making ion
Direct wages (Rs.) 60,000 80,000 32,000 8,000 20,000
Power consumed (KWH) 1,000 6,000 2,000 1,000 -
Floor area (Sq. ft.) 1,500 2,000 1,250 1,000 500
Light points (Nos.) 10 20 15 5 10
Production hours 1,533 3,577 1,815 - -

AT A GLANCE
Labour hours per bottle 0.10 0.25 0.15 - -
Cost of machinery (Rs.) 600,000 1,200,000 900,000 300,000 -
After production, the jam bottles are finally packed in a carton consisting of 12 bottles. The
service departments costs are apportioned as follows:
Service
Production Departments
Departments
Jam Distribut
Selection Bottling Storage
making ion
Storage 10% 30% 40% - 20%
Distribution 20% 50% 30% - -

SPOTLIGHT
Raw and packing material costs of Rs. 36 and labour cost of Rs. 25 is incurred on each bottle.
Required
Compute cost of each carton.
 Solution
Cost of each carton is calculated as under:
Primary Distribution of overheads
Service
Production Departments
Basis of Total Departments
Apportio overheads Distribu

STICKY NOTES
Selection Jam making Bottling Storage
nment tion
Direct wages Given 28,000
8,000 20,000
(Rs.)
Floor
Rent and rates
area 85,000 20,400 27,200 17,000 13,600 6,800
General Light
lighting points 75,000 12,500 25,000 18,750 6,250 12,500
Direct
Indirect wages
wages 60,000 18,000 24,000 9,600 2,400 6,000
KWH
Power
cons. 150,000 15,000 90,000 30,000 15,000 -
Cost of
Depreciation
mach. 50,000 10,000 20,000 15,000 5,000 -
Total departmental 448,000 75,900 186,200 90,350 50,250 45,300
overheads

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Secondary Distribution of overheads

Production Departments Service Departments
Total Selection Jam making Bottling Storage Distribution
overheads
Total overheads 448,000 75,900 186,200 90,350 50,250 45,300
Storage (1:3:4:2) 5.025 15,075 20,100 (50,250) 10,050
Distribution 11,070 27,675 16,605 - (55,350)
(2:5:3)
Total 448,000 91,995 228,950 127,055
Production hours 1,533 3,577 1,815
Rate per hour 60.0 64.0 70.0
AT A GLANCE

(Rs.)

Cost of one carton

Rupees Rupees
Packing and raw materials (36 x 12) 432
Direct labour (25 x 12) 300
Overheads:
Selection (0.1 x 12 x 60) 72
Jam making (0.25 x 12 x 64) 192
Bottling (0.15 x 12 x 70) 126 390
Total 1,122
SPOTLIGHT
STICKY NOTES

78 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

CAF 8: CMA CHAPTER 3: OVERHEADS

STICKY NOTES

Manufacturing expenses are of two types: Direct expenses and Indirect

Expenses.
Direct expenses are fully traceable to the product/service/department being
costed. e.g. Direct material, Direct Labour and direct expenses. Indirect
expenses (Production overheads) –incur in the course of making a
product/providing service/ running department but cannot be traced directly
and fully to the product, service or department

AT A GLANCE
Costs are often categorized as variable cost that vary with the level of output
and fixed cost that remained constant irrespective of the level of output.

Production Overheads incur in relation to the production processes (also

called manufacturing overheads / factory overheads). Non-Production
Overheads incur to support the overall objectives of the business. (classified
as ‘Administrative Expenses, Marketing, Selling and Distribution Expenses’ in
the Statement of Comprehensive Income.)

SPOTLIGHT
Estimated factory overheads can be calculated using physical output, direct
material cost, direct labour cost, prime cost, direct labour hours, machine
hours.

In addition to the selection of bases, the following factors are also considered
to estimate factory overheads:
1. Activity level: at which the business performs its production activities

STICKY NOTES
2. Inclusion or exclusion of fixed overheads: Absorption costing /
conventional costing/full costing or Marginal Costing/Direct Costing
3. Single rate or several rates Blanket rate/Plant-wide rate, Departmental
rates or Cost centers/cost pool rates.

The overhead costs of servicing departments are transferred to production

departments and service departments in the proportion of the facilities used

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 CHAPTER 3: OVERHEADS CAF 8: CMA

When service departments share services with each other, reciprocal

apportionment of cost is carried with one of the following methods:
a) Repeated distribution method
b) Simultaneous equation method

All the production related overhead costs are to be accumulated at the

smallest segment of the production process
AT A GLANCE

Budgeted overhead rate is calculated to allocate cost to the products

At the period end, actual overhead is compared with applied
Overhead rate to calculate the over or under absorption
SPOTLIGHT
STICKY NOTES

80 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 4

LABOUR COSTING

AT A GLANCE
IN THIS CHAPTER
Labour is an important element in a production cost, as most of
the industries are labour intensive and labour constitutes major
AT A GLANCE
cost of total cost of production

AT A GLANCE
SPOTLIGHT Industries that are dependent on human workforce have to
adopt strategies that benefit them in terms of human resource
1. Introduction to Labour costing retention as well as keeping their labour cost low.
and Cost Control
Various wage systems are designed to achieve these objectives,
termed as incentive wage plans.
2. Management of Productivity and
Efficiency Management must have to monitor labour performance in
terms of productivity (efficiency) and effectiveness (cost).
3. Wage Incentive Plans A quantitative method called ‘Learning Curve’ is used to
calculate in advance the expected time to be taken by the labour
4. Learning Curve Theory when they become fully conversant with the work.

SPOTLIGHT
5. Recording and Accounting for
Labour Cost

6. Comprehensive Examples

STICKY NOTES

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 69

 CHAPTER 4: LABOUR COSTING CAF 8: CMA

1. INTRODUCTION TO LABOUR COSTING AND LABOUR COST CONTROL

Labour cost is the second important element of the cost of production after material cost. Labour costs constitute
a major portion of the total cost of a product or service that may take the form of wages, salaries and/or other
incentives of employee remunerations. The profitability and growth of the entity depends greatly upon the
proper utilization of the human resources that in turn needs to be properly recoded and controlled.
Most of the industries produce goods and services, requiring higher amount of labour cost and these are known
as labour intensive industries. The share of labour cost in these industries is significant and therefore, labour
cost control become more important. Main labour intensive industries are agriculture, mining, hospitality and
food service etc.

1.1. Types of labour cost:

AT A GLANCE

The labour cost has two types:

a) Direct Labour Cost: Direct labour cost is any cost that is specifically incurred for or can be readily charged
to or recognized with any specific contract, job or work order. In cost accounting it is classified as direct
labour cost which becomes part of prime cost. For example: In a watch manufacturing factory, a worker
operating a molding machine to produce a part of wrist watch.
b) Indirect Labour Cost: Where the direct labour can be recognized with and charged to the job, the indirect
labour cannot be so charged and hence is treated as part of the factory overheads. For example: Wages paid
to supervisor of a factory or salary paid to driver of delivery van used for distribution of the product.
Wage payments are generally based on the productivity, time and skill or their combination. Proper control and
accounting for this cost factor and motivation of worker is important in bringing efficiency to an enterprise.
 For example:
SPOTLIGHT

Wage payment based on productivity: Wages paid on the basis of number of units produced,
like stitching 2000 pieces of shirts at Rs. 75 per piece. The wage payment based on productivity
are termed as piece wage system.
Wage payment based on time: Wages paid on the basis of number of hours a worker performed
his in a production line, like 160 hours paid at Rs. 175 per hour. Its normal to pay per hour and
known as time-based wages.
Wage payment based on skill: A wage differentiation due to varied skills, like skilled workers
are paid higher than apprentice for the same job.

1.2. Measuring labour activity:

STICKY NOTES

It is important to differentiate between “production” and “productivity” while measuring labour activity.
• Production: Production refers to the quantity or volume of the output produced i.e. the total number of
units produced. Production therefore is a measure of quantity of work.
• Productivity: Productivity unlike production is a measure of efficiency with which the units have been
produced.
 Example 01:
Mr. X is supposed to produce six units in every hour at work. The standard productivity rate is
six units per hour for every employee. During the week he made 252 units in 38 hours of work.
Required:
Calculate the productivity ratio?

70 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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 Solution:
The productivity ratio is worked out as:
The total production in the week is 252 units.
Productivity is a relative measure of the hours actually taken and the hours that should have been
taken to make the output. It might be determined in either of the following two methods
Method 1:
252 units should take (252/6) 42 hours
But it took 38 hours
Productivity ratio = 42/38 x 100 110.5%
Method 2:
In 38 hours Mr. X should make (38 x 6) 228 units

AT A GLANCE
But made 252 units
Productivity ratio = 252/228 x 100 110.5%
Comment: A productivity ratio greater than 100% indicates that the actual performance is better
than the standard or expected level of efficiency.

1.3. Labour payment methods:

The choice of appropriate labour payment method is very important for any organization as it:
• may affect the cost of the finished products specially when it is a labour intensive organization,
• casts a major impact on the morale and efficiency of the employees and serious consideration should
therefore be given to the possible motivational impact of the remuneration method being adopted.

SPOTLIGHT
The two widely known basic labour payment methods are time rate and piece work. These are discussed in detail
below:

Time rate
Time rate/ time work or basic pay is where the employee gets paid on the basis of his time spent at work. The
most common form of this type is a day-rate system.

The formula used for calculating wages under this method is:
Wages = Hours worked x Per hour pay rate
• If an employee works for more hours than the basic daily requirement or on days which do not constitute a

STICKY NOTES
part of the working week (e.g. Saturdays and Sundays), then he may be entitled to an overtime payment.
The overtime hours are usually paid at a premium rate such as “time and a quarter”, “time and a half” or
“double-time”.
Time and a quarter for example, means that 1.25 times the basic hourly rate is paid for hours worked in
excess of the basic requirement. The overtime premium is the extra rate paid over and above the basic rate.
If employees work unsocial hours, e.g. overnight, then they are entitled to a shift premium which is quite
similar to an overtime premium and means that the employees are paid at an increased hourly rate.
 Example 02:
If the basic rate of pay per hour is Rs. 6 and overtime rate is time and a half, then calculating the
overtime premium for 12 hours worked in excess of the basic requirement of 8 hours per day
would involve below working:
Rs.
Basic Pay (12 x Rs. 6) 72
Overtime premium (4 x Rs. 3) 12
Total (8 x 6) + (4 x 9) 84

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Piece rate system:

Under this method the employee is paid an agreed amount for each unit of output completed or for each task
carried out. Output units per hour may also be an agreed upon number that is referred to as “standard hour
produced”. It is also normal under piecework scheme that the employees get a guaranteed minimum wage
regardless of the number of units produced. This safeguards them from loss of earnings when the production is
low and is not on account of their own fault.

The wages under the piecework system can be calculated as:

Wages = Units produced x Per unit pay rate

 Example 03:
Straight piecework with guaranteed minimum wage
AT A GLANCE

Sara is paid Rs. 20 for each unit produced with a guaranteed wage of Rs. 2,000 for a 40-hour
week. For a series of 4 weeks of the month she produced 140, 160, 180 and 200 units.
Required.
Calculate total wages for the month.
Solution
In order to calculate total amount for the month, please see below:

Rs.
Week 1 [(140 units x Rs. 20) + Rs. 2000] 4,800
SPOTLIGHT

Week 2 [(160 units x Rs. 20) + Rs. 2000] 5,200

Week 3 [(180 units x Rs. 20) + Rs. 2000] 5,600
Week 4 [(200 units x Rs. 20) + Rs. 2000] 6,000
Total for the month 21,600

1.4. Basis of labour cost control:

Labour cost control requires analysis of labour cost with different angles and perspectives, such as, cost per hour,
cost by departments, by product lines, by direct and indirect cost perspective , by rates, by jobs or processes.
Labour cost controls aim to achieve maximum efficiency without compromising the quality and effectiveness of
STICKY NOTES

the operations. Cost analysis and wage system help in achieving this objective.
 Example 04:
ABC Publishers Limited pays wages to workers working on book binding machine at the rate of
Rs. 17 per book. Workers are not paid for the misaligned binding and such book is scraped for
Rs. 15 per kg. The policy motivates the workers to work hard and maximize productivity.
However, the rate of wastage in ABC is 3% as against industry average of 1%.
ABC re-visited the wage policy and felt that it is likely that workers tend to compromise the
quality because of insignificant loss they suffer due to bad quality. It intends to bring a policy
whereby a deduction of Rs. 70 will be made from the wages for each misaligned binding beyond
1% industry average. However, it is estimated that such policy will reduce the efficiency of
workers because they would reduce the speed to achieve desired quality benchmark and avoid
deduction.
The cost controller of ABC is supposed to work out the differential cost and revenue to evaluate
the policy before implementation. For this purpose, cost controller needs precise data with
reasonable accuracy about the machine capacity, labour related wastage, impact of slow speed
and contribution margin per unit.

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Effective labour cost control is achieved through different tools including;

• analyzing the targeted production,
• preparing labour budget and standardizing labour cost per unit,
• monitoring output, quality, wastage ratios, rework cost due to bad workmanship
• wage incentive systems.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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2. MANAGEMENT OF PRODUCTIVITY AND EFFICIENCY

2.1. Labour Productivity:
Labour productivity can be described as a ratio between labour hours and units produced. Productivity may be
defined as the measurement of production performance using the expenditure of human effort as a yardstick.
Greater productivity can be achieved by better processes, improved or modern equipment and other factor that
improves the utilization of manpower. Productivity can be measured by following formula.
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = 𝑥𝑥 100
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃

2.2. Labour Efficiency:

AT A GLANCE

Labour efficiency measures how efficiently workers produce a given quantity of units. It can be calculated by
creating the ratio between standard hours and actual hours. Efficiency can be calculated with the help of
following formula.
𝑆𝑆𝑆𝑆𝑆𝑆𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 = 𝑥𝑥 100
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜
Productivity can be stated in one figure, such as; in Engine Installation Department of Motor company, 3 units
per 8 labour hours is the productivity of the department. In assessing efficiency, a single figure would not suffice.
There should be any comparable figure, like own historical data, industry average or budgeted productivity.
If Motor company achieved 3 units per 8 labour hours’ productivity in 2018 in Engine Installation Department
as against 2.8 units per 8 labour hours in 2017. The department efficiently utilized its human resources in the
year 2018 as compared to 2017.
SPOTLIGHT

Efficiency is achieved through high motivation and skills of workers and by better processes and quality of
machines and tools. Improved productivity positively impacts the business profits and the earnings of workers.
It may be noted that productivity and efficiency measures generally indicate number of output as against the
labour input and do not usually refer to the quality and level of bad workmanship. The quality aspect is also
important to achieve the objectives of cost controls.

2.3. The importance of measuring productivity and efficiency:

In a competitive business environment where the price of a product is difficult to be controlled by the producers,
the efficient utilization of resources is one of the key factors. Labour cost in many industries is so significant that
its efficiency can make the difference. A producer should be able to set standards of performance in terms of
hours and cost per hour or cost per unit of production.
STICKY NOTES

The performance standards measure the performance in unit and rupee term and variances help the managers
to focus around the problem areas.
► Example 05:
In a production department the performance standards for a production of 3,000 units are set as
2,000 hours at Rs. 90 per hour. If 2,200 hours are used at standard rate of Rs. 90 per hour to
produce 3,000 units then there is an unfavorable labour efficiency ratio of 90.91% (2,000
/2,200). In rupee term the unfavorable variance is Rs. 18,000 computed as (100%-90.91%) x
2,200 x 90
There can be a variance as against the performance standards, which arises due to difference in wage rates.
Therefore, a total variance between the performance standards and actual results is analyzed in a way that we
arrive at the break up of both variances, namely, labour efficiency variance and labour rate variance. These
variances will be discussed in detail in chapter “Variance Analysis”.

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3. WAGE INCENTIVE PLANS

3.

In the modern industrial enterprise of mass production and many employees, a worker’s wage is based on
various factors which includes negotiated labour contracts with union, productivity analysis, job evaluation
process, profit sharing schemes and most important wage incentive plans. Initially, bonus/incentive schemes
had been introduced for workers who had been working under a time-based system, in order to compensate
them for their inability to increase their earnings. Wage incentive plans refer to performance linked
compensation paid to improve motivation and productivity. Incentive schemes may either be short-term or long-
term schemes.

3.1. Bonus Systems:

Bonus systems base workers’ earnings on a combination of extra time served and work done. The indirect labour
is usually paid on a weekly or monthly basis, such wages and salaries may also be increased by bonus payments.

AT A GLANCE
SPOTLIGHT
Characteristics of bonus systems:
• A target is set and the performance is matched against that target.
• Employees feel trusted and motivated, the productivity increase and they are paid more for their increased
efficiency.
• Despite of the organization’s labour cost being increased in terms of bonus payments, the total unit cost of
the output stands reduced and the profit per unit of sale is increased.

STICKY NOTES
Note: Only those schemes should be applied, which provides benefits to both employer or employee. The
employer benefit can be judged from decrease in unit labour cost whereas employee’s benefit can be highlighted
by higher earnings in per hour rate.
The widely known bonus/ incentive schemes are discussed in the following paragraphs.

3.2. High day-rate system:

Under a high day-rate system employees get paid at a higher than average hourly rate provided they agree to
produce a given amount of product at a given quality. A target is given to employee and if employee attains target,
then higher rate per hour is applied, otherwise, normal rate is applicable.
 Example 06:
Shahid makes 200 units in a 40-hour week if he was paid Rs. 4 per hour, but 240 units if he was
paid Rs. 5 per hour.

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Required
(a) Calculate the amount to be paid to Shahid in both the cases.
(b) Calculate labour cost per unit.
(c) Calculate cost per unit of output if the production overhead is recorded at the rate of Rs. 4
per direct labour hour.
(d) Write advantages and disadvantages of high day-rate system.
 Solution:
a) The amount to be paid to Shahid in both the cases, would be calculated as:

Rs.
AT A GLANCE

i. Amount to be paid to Shahid

a. Under low day-rate scheme 40 hours x Rs. 4 160
b. Under high day-rate scheme 40 hours x Rs. 5 200

b) In order to calculate labour cost per unit, amount paid would be:
ii. Labour cost per unit
a. Under low day-rate scheme (40 x 4) 0.80/unit
200
b. Under high day-rate scheme (40 x 5) 0.833/unit
240
c) cost per unit of output if the production overhead is recorded at the rate of Rs. 4 per direct
SPOTLIGHT

labour hour, would be as follows:

Cost per unit
a. Under low day-rate scheme (40 x 8) 1.60/unit
200
b. Under high day-rate scheme (40 x 9) 1.50/unit
240
Comment:
Though in the given example the labour cost per unit is lower under the low day-rate scheme but
the total unit cost is lower under the high day-rate scheme. Therefore, we see that the high day-
STICKY NOTES

rate scheme in the given scenario would reward both i.e. the employer (a lower unit cost by 10p)
and employee (an extra Rs.1 earned per hour).
d) The advantages and disadvantages of high day-rate system are as follows:
Advantages
• It is easier to calculate and understand.
• It assures the employee a consistently high wage.
Disadvantages
• Employees cannot go beyond the fixed hourly rate for the extra effort they put in. In the
example given above if the employee makes 280 units instead of 240 units in a 40 hours
week, the cost per unit would decrease even further but all the savings would go to the
benefit of the employer and none would go to the employee.
• The high wages might become the accepted wage level for normal working. Management
might need to keep checks on the productivity and efficiency levels of the employees.

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3.3. Individual bonus schemes:

An individual bonus scheme sets out performance objectives/targets and usually forms part of the performance
appraisal systems of organizations. Every individual’s bonus is calculated separately and is unique to every
employee. More efficient employee gets more amount of bonus while less efficient employee might get lesser
amount of bonus or even no bonus, if standard is not attained.
 Example 07:
Rs.100 per unit bonus is paid to an employee if he produced at least 500 units per month. If an
employee achieves that performance standard, then he will be entitled to get a bonus on all units
produced.
 Example 08:
Standard production of an employee in the Assembly department is 20 units per hour in an 8-hour

AT A GLANCE
day. The hourly rate is Rs. 30.
The first day of week, employee produced 150 units and on second day of week, he produced 180
units. On both days he worked for 8-hours.
Required
Calculate the earnings of employee, effective rate per hour and labour cost per unit:
(a) if bonus of 50% of time saved is applied.
(b) If bonus of 100% of time saved is paid to employee.
 Solution
(a) If bonus of 50% of time saved is applied, the earnings of employee, effective rate per hour and

SPOTLIGHT
labour cost per unit is computed as under:

Day Actual Standard Extra Bonus Basic Bonus Total

units units units hours pay
A A/ 20x --------------Rupees-----------
50%
1 150 160 - - 240 - 240
2 180 160 20 0.50 240 15 255

STICKY NOTES
Calculation of effective rate and cost per unit on each day Rs.
Day-1
Effective earnings by employee per hour (240/ 8) 30.00
Cost per labour hour for employer point of view (240 / 150) 1.60
Day-2
Effective earnings by employee per hour (255/ 8) 31.88
Cost per labour hour for employer point of view (255 / 180) 1.42

The above incentive plan is beneficial as it increases benefits to both employee and employer.
From employee point of view, the effective earning rate per hour is increased from Rs. 30.00
per hour to Rs. 31.88 and from employer point of view, cost per labour hour was reduced from
Rs. 1.60 per unit to Rs. 1.42 per unit.

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(b) If bonus of 100% of time saved is paid to employee; the earnings of employee, effective rate per
hour and labour cost per unit is computed as under.

Day Actual Standard Extra Bonus Basic Bonus Total

units units units hours pay
A A/ 20 --------------Rupees-----------
1 150 160 - - 240 - 240
2 180 160 20 1 240 30 270

Calculation of effective rate and cost per unit on each day Rs.
Day-1
AT A GLANCE

Effective earnings by employee per hour (240/ 8) 30.00

Cost per labour hour for employer point of view (240 / 150) 1.60
Day-2
Effective earnings by employee per hour (270/ 8) 33.75
Cost per labour hour for employer point of view (270 / 180) 1.50

If bonus of time save is increased to 100%, then again the plan is beneficial as the effective
earning rate per hour is increased from Rs. 30.00 per hour to Rs. 33.75 and from employer point
of view, cost per labour hour was reduced from Rs. 1.60 per unit to Rs. 1.50 per unit.
SPOTLIGHT

3.4. Group bonus schemes:

In cases where individual efforts cannot be exactly measured and employees work as a team, individual incentive
schemes become impracticable. In such scenarios, group incentive schemes are found to be more relevant and
feasible. Even in cases where an individual alone cannot complete his job without the cooperation of his fellow
workers, there too, group incentive schemes are given preference over the individual bonus schemes.
Group bonus plans reward all team members equally based on overall performance of the team members. It
usually comes into play when individual output cannot be measured with accuracy. Therefore, team performance
is evaluated on the basis of time taken to complete the job rather than output produced. Usually, the bonus earned
by the group is divided among the group members in accordance with their respective base rates.
Advantages
STICKY NOTES

• Group schemes reduce the clerical efforts to be put in for the calculations of individual incentive schemes.
• They are easy to be administered.
• Group schemes improve the team cohesion.

Disadvantages
• Employees might demand for minimum targets for accepting the scheme.
• Employees doing the best and the worst might fall victim to team’s politics.

3.5. Profit sharing schemes:

A profit sharing scheme offers the employees a certain proportion of the organization’s profits. In these schemes,
there might be few conditions, and bonus is payable to employees who vests the conditions mentioned in this
scheme. For example, condition is imposed by entity that only those employees are eligible for profit sharing
scheme, who have completed at least one year of service with the company.

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Advantages
• The biggest advantage is that the organization will pay only what it can afford to pay out of the actual
profits earned. In case of low profit, low proportion of bonus is declared and paid.
• Such schemes can be offered to indirect labour and other administrative staff.

Disadvantages
• Employees may be putting in best of their efforts yet the organization might still incur losses on account of
issues beyond the control of the employees.
• It is a long term commitment that the organization is asking for. The employees have to wait for the bonus
until the year ends. The reward is not an immediate one.

3.6. Share incentive schemes:

AT A GLANCE
A share incentive scheme is where the employees of the company are given an option to acquire the shares as an
incentive. In this way the employees’ morale rises so does their loyalty due to the feeling that they now have a
stake in the company they work for.

SPOTLIGHT
STICKY NOTES

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4. LEARNING CURVE THEORY

4.1. Learning Effect:
Learning is the process by which an individual acquires skill, knowledge and ability. When a new product or
process is started, the performance of the worker is relatively low since the job has just recently started but if it
is fairly repetitive in nature then the learning phenomenon takes place. When the experience is gained, the
worker is likely to become more confident and knowledgeable about the task thus the performance improves,
which in turn reduces the time taken per unit and increases the productivity.
The effect that learning casts on employees, can be represented by a line called a learning curve. It displays the
relationship between the production time per unit and the cumulative number of units produced. Learning curve
has a direct impact on direct labour wages.
AT A GLANCE

Eventually when the worker has had enough experience and nothing more is left for him to learn, then the
learning process stops i.e. the learning would stop after a certain time limit and beyond specific number of units
produced.
Assumptions
• The amount of time required to complete a unit of a product or a given task will decrease every time the
task is undertaken.
• The unit time will decrease at a decreasing rate, and
• The time reductions will have a predictable pattern.

4.2. Learning curve theory:

The learning curve theory refers to the phenomenon that the cumulative average time required per unit will
SPOTLIGHT

decrease by a constant percentage every time total output of the product doubles. Doubling of output is an
important part of the measurements determining the learning effect. In other words, learning effect is based on
Geometric progression such as 1 unit, then 2 units, then 4 units and so on.
For example, if we take 80% learning effect, the cumulative average time required per unit is reduced to 80% of
the previous cumulative average time when the output is doubled. Note that the cumulative average time is the
average time per unit for all units produced till now, inclusive of the first unit made.

4.3. Importance of Learning curve effect:

Learning curve theory helps users to predict how much time is required to complete the future tasks. It is helpful
in determination of realistic cost of labour and is also useful in planning, control and decision-making. In pricing
decisions, it is extremely important to know the average time incorporating the learning effect, otherwise, cost
STICKY NOTES

will be higher if it is based on first unit which requires maximum time. In planning and control, learning curve is
also important because in standard costing, cost of one unit is calculated. If the learning effect is ignored, then
standard cost will be overstated, resulting unrealistic variances at period end.

4.4. Methods of learning curve:

The learning effect can be calculated with the help of two methods:
1. Tabular Method
2. Mathematical Method
 Example 09:
If the first unit of output requires 100 hours and a 70% learning effect occurs, then determine
the production times for:
• Total production
• Incremental total hours
• Incremental hours per unit

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Cumulative Cumulative
Total
no. of units avg. Incremental time
Time
produced time/unit
Total Time per
time unit
Hours Hours Hours Hours
1 100.0 (x1) 100
2 (70%) 70.0 (x2) 140 40 ÷1 40
4 (70%) 49.0 (x4) 196 56 ÷2 28
8 (70%) 34.3 (x8) 274.4 78.4 ÷4 19.6

AT A GLANCE
 Formula:

Y = axb
Where
Y = cumulative average time per unit to produce x units
a = the time taken for the first unit of output
x = the cumulative number of units produced (output)
b = the learning curve factor (i-e. log LR/log2)
LR = the learning rate as a decimal

 Example 10:

SPOTLIGHT
Find the value of b when a 90% learning curve effect takes place.
 Solution
b = log 0.9/log 2
= -0.0458/0.3010
= -0.152
 Example 11:
Calculate labour time to produce 50 units assuming learning rate of 80% will continue till first
30 units. Time taken to produce first unit is 10 hours.
 Solution

STICKY NOTES
First calculate total time required to produce first 30 units.
𝑌𝑌 = 𝑎𝑎𝑋𝑋 𝑏𝑏
Whereas b = log 0.80/log 2
= -0.3219
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 30 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 = 10 𝑥𝑥 30−0.3219 𝑥𝑥 30
= 100.38 hours
The next 20 units will take equal time per unit and will be equal to time taken by 30th unit.
The calculation of time taken by 30th unit is calculated by difference between total time for 30 units
(as calculated above) and total time for 29 units.
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 29 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 = 10 𝑥𝑥 29−0.3219 𝑥𝑥 29
= 98.10 hours
Hence, time taken to produce 29th unit is 2.28 hours (100.38-98.10).
Total time required to produce next 20 units (2.28 x 20) = 45.60 hours
Labour time to produce 50 units (100.38+45.60) = 145.98 hours

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5. RECORDING AND ACCOUNTING FOR LABOUR COST

5.1 Recording labour costs
There are various departments within an organization that are involved in collecting, recording and costing of
labour. The procedures involve production planning, time and motion study, timekeeping, labour budgeting, etc.
A brief detail of the departments involved and procedures performed by them in the due process is discussed
below.

Human Resource department

The HR department is primarily responsible for the hiring of employees, engaging them, their transfer, departure
and termination etc. This department maintains employees’ records and issues the reports for the management
to facilitate the decision making process of HR related issues.
AT A GLANCE

Production Planning department

The Production Planning department schedules work, issues the job orders to production departments and
chases up jobs in the factory when they run late.

Time keeping department

The timekeeping department keeps track of the time spent in the factory by each worker and the time spent by
each worker on each job. The time keeping activity might be carried out using any of the following tools with
reference to the relevance and importance to the nature of activity.

• Daily time sheets: The daily time sheet is filled in by the employee on everyday basis. It will record how
SPOTLIGHT

his/ her time in the factory has been spent. The total time on the sheet should however correspond to the
record on the attendance form.

• Weekly time sheets: They are similar to the daily time sheets but are sent to the cost office towards the end
of every week.

• Job cards: Job cards are job specific and are prepared for every job or batch separately. In a time sheet the
worker if engaged with many jobs will have several entries related to the respective jobs wherein in case of
job cards, each job card will contain the detail of activities carried out by the employee in respect to that
specific job only.

• Piecework or operation card: A Piecework ticket contains the record of total number of items produces by
the employee and the total number of the units rejected. Payment would be made for only the items that are
STICKY NOTES

as per the required standards.

Cost accounting department

The cost accounting department accumulates and classifies all the data related to the labour costs. The
information is then shared with the management to help determine the control measures if required.

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5.2 Journal entries for recording labour costs

The primary journal entry for payroll is the summary-level entry that is compiled from the payroll register and
which is recorded in either the payroll journal or the general ledger. This entry usually includes debits for the
direct labour expense, salaries and the company's portion of payroll taxes. There will also be credits to the
liability for payroll taxes that have not been paid, as well as for the amount of cash already paid to employees for
their net pay. The basic entry (assuming no further breakdown of debits by individual department) is:

(i) to record the total wages earned

Debit Credit
Payroll xxx
Accrued Payroll tax xxx

AT A GLANCE
Payroll advances xxx
Payroll deductions xxx
Accrued Payroll xxx
(ii) to record payment of the payroll
Debit Credit
Accrued Payroll xxx
Cash/Bank xxx
(iii) To record the closure of the Payroll account

SPOTLIGHT
Debit Credit
W-I-P – Direct Labour xxx
FOH – Indirect Labour xxx
Selling Expenses Control a/c – Sales Salaries xxx
Administrative Expenses – Office Salaries xxx
Payroll xxx

STICKY NOTES

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6. COMPREHENSIVE EXAMPLES
 Example 01:
Quality Plastics Limited (QPL) produces plastic bodies of various appliances according to the
customers’ specifications. It has received an order for supply of 10,000 plastic bodies of a
washing machine. The supply is to be made within 30 days.
The following information is available:
i. QPL carries out production process in batches of 100 units each. Cost of the first batch
is estimated as under:

Rupees
Direct material (inclusive of 10% input losses) - 1,100 kg 66,000
AT A GLANCE

Direct labour cost at normal rate - 200 hours 44,000

Overheads at normal rate 200 hours 30,000

ii. It is estimated that due to learning curve effect, completion of the first, second, third and
fourth batch would require 200, 160, 148 and 140 hours respectively.
This learning effect would continue till completion of 64 batches only.
Learning effect at various learning levels is as under:

80% 85% 90%

–0.322 –0.235 –0.152
SPOTLIGHT

iii. It is estimated that after completion of the first 16 batches, material input losses would
be reduced from 10% to 6%.
iv. QPL works a single shift of 8 hours per day. For the above order, QPL can spare 8,000
direct labour hours. Overtime hours can be worked at 1.5 times the normal rate. During
the overtime hours, overheads would be 1.25 times the normal rate.
Required
Calculate the price that QPL should quote in order to earn a margin of 25% of the selling price.
 Solution
The price that QPL should quote in order to earn a margin of 25% of the selling price would be
STICKY NOTES

computed as follows:
Material Rs.
First 16 batches (16 x 66,000) 1,056,000
Next 84 batches 84 x (66,000 x 0.90/0.94) 5,308,085
Direct labour cost
Normal hours (8.000 x 220) 1,760,000
Overtime hours (2,079 W-1 x 220 x 1.50) 686,070
Overheads
Normal hours (8,000 x 150) 1,200,000
Overtime hours (2,079 W-1 x 150 x 1.25) 389,813
Total costs 10,399,968
Order price at a margin of 25% of the selling price 13,866,624

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W.1: Learning curve %:

Average hours per Learning

Batch No. Cumulative hours
batch curve %
1 200.00 200.00
2 (200+160) 360.00 180.00 (180/200) 90%
4 (360+148+140) 648.00 162.00 (162/180) 90%
Hours for first 64 batches 64*200*(64)-0.152 6,803
Hours for first 63 batches 63*200*(63) -0.152 ( 6,712)

AT A GLANCE
Hours per batch after 63rd batch 91
Hours required:
First 64 batches 6,803
Last 36 batches (91×36) 3,276
Total hours 10,079
Overtime hours (10,079 – 8,000) 2,079

 Example 02:
Smart Processing Limited (SPL) is considering to sign a contract for manufacturing 10,000 auto

SPOTLIGHT
parts for a large automobile assembler. The parts would be produced in batches of 500 units
each. The estimated cost of the first batch is as under:

Rupees
Direct material ( kg) 135,000
Direct labour (1,500 hours) 225,000
Variable overheads (Rs. 120 per direct labour hour) 180,000
Set-up cost per batch 40,000
Fixed costs:

STICKY NOTES
- Depreciation of equipment purchased for the project 45,000
- Allocation of existing overheads @ Rs. 16 per hour 24,000
Cost of first batch 649,000

Additional information:
i. The set-up cost per batch would be reduced by 5% for each subsequent batch. However,
there would be no further reduction in the set-up cost from the 5th batch onward.
ii. Learning curve effect is estimated at 90% but would remain effective for the first eight
batches only.
iii. The index of 90% learning curve is -0.152.
Required
Compute the contract price that would enable SPL to earn an incremental profit of 30% of the
contract price.

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 Solution
The contract price that would enable SPL to earn an incremental profit of 30% of the contract
price would be computed as follows:

Computation of contract price Rupees

Cost of material 135,000×20 2,700,000

Direct labour cost:

- For the first 8 batches (W-1) 8,748

- For the last 12 batches (W-1) 937×12 11,244

AT A GLANCE

19,992 ×150 2,998,800

Variable overheads 19,992 ×120 2,399,040

Batch set-up cost:

- For the first 4 batches 40,000+[40,000×(0.95)1]+[40,000×(0.95)2]+[40, 148,395

000×(0.95)3]

- For the last 16 batches [(40,000×(0.95)3)]×16 548,720

Fixed costs:

- Depreciation on equipment purchased 45,000×20 900,000

for the project
SPOTLIGHT

- Allocation of existing fixed overheads Irrelevant cost -

Total incremental cost of the contract A 9,694,955

Contract price (A÷70%) 13,849,936

W-1: Direct labour hours per batch for batch 9 onward: Hours

Direct labour hours for the first 8 batches 8×1,500×(8)–0.152 8,748

STICKY NOTES

Direct labour hours for the first 7 batches 7×1,500×(7)–0.152 (7,811)

Hours per batch for 8th and onward batches 937

 Example 03:
Toy Limited is engaged in the production of a single product. On the basis of past history, the
management has estimated the cost of production per unit, as follows:
Rupees

Raw material – 5 kg @ Rs. 40 per kg 200

Labour – 10 hours @ Rs. 25 per hour 250

Variable overheads – 60% of direct labour 150

Total 600
The annual production requirement is 100,000 units.

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The management has been deeply concerned with the performance of its labour as it has been
witnessing various inefficiencies. The industrial relations department has recently carried out a
study under the guidance of a consultant. It has put forward a plan whereby the company’s wage
policy is to be revised as under:
• Rate of wages would be increased by 12%.
• Workers who perform their tasks in less than the estimated time of 10 hours per unit
would be given a premium of Rs. 18 per hour saved.
The consultant is of the view that the following efficiencies can be brought about by introducing
the above change:
(i) Raw material input per unit includes wastage of 7%. It would reduce to 3%.
(ii) 70% of the workers would work more efficiently and improve their efficiency by 20%.
(iii) Overheads will be reduced to 55% of the revised cost of direct labour (including

AT A GLANCE
premium).
(iv) The quality of production will improve and the rate of rejection will be reduced from 4%
to 3%. Rejected units are sold for Rs. 150 each.
Required
Determine that the wage plan recommended by the industrial relations department would be
beneficial for the company or not.
 Solution
Determination of wage plan recommended by the industrial relations department whether it
would be beneficial for the company or not, would be calculated as under:
Net benefit from proposed plan

SPOTLIGHT
Rupees
Savings in raw material consumption W-1 824,000
Increase in labour cost W-2 (1,600,000)
Savings in overheads W-3 370,000
Decrease in rejections W-4 470,742
Net Savings 64,742
W-1 Raw material consumption
Rupees

STICKY NOTES
Raw materials consumption per unit – current- 5.000
Present wastage (5 x 7/100) (0.350)
Raw materials forming part of finished goods 4.650
Raw materials consumption per unit as revised (4.650/0.97) 4.794
Savings in raw material consumption (5.000-4.794) x 100,000 x 40 824,000
W-2 Labour cost
Rupees
Labour hours – current 10.00
Saving in labour hours due to efficiency (10 x 70% x 20%) (1.40)
Labour hours – revised 8.60
Labour cost: Revised wages (8.60 x 25 x 1.12) 240.80
Premium on hours saved (1.40 x 18) 25.20
Revised labour cost per unit 266.00
Increase in labour cost (Rs. 266-250) x100,000 1,600,000

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W-3 Overheads
Rupees

Current overheads per unit 150.00

Revised overheads per unit (266 x 0.55) 146.30

Saving in overheads (150-146.30) x 100,000 370,000

W-4 Rejections
Rupees

Present rejections {(100,000/0.96)-100,000} 4,167

AT A GLANCE

Rejections in the new situation {(100,000/0.97)-100,000} 3,093

Present cost of rejections of 4,167 units @ Rs. 450 (600-150) 1,875,150

Revised cost of rejection for 3,093 units:

{(4.794 x 40)+266+146.30-150} x 3,093 1,404,408

Decrease in rejection (1,875,150-1,404,408) 470,742

 Example 04:
Pakair Limited manufactures special tools. Information pertaining to payroll costs for the month
of April 2010 is as under:
SPOTLIGHT

Department Gross salaries Overtime Income tax

excluding overtime deductions

Rupees in thousands

Machining 1,000 75 25

Assembly 400 40 15

Tool-room 25 5 -

Warehouse 75 15 -
STICKY NOTES

Details of other benefits are as under:

(i) 35 paid leaves are allowed per year including annual, casual and sick leaves.
(ii) Annual bonus equal to one month salary is paid in June.
(iii) The company maintains a contributory Provident Fund in which 8.33% of the monthly
salary is contributed by the employer as well as the employees.
(iv) During April 2010, the employees availed leaves that cost Rs. 85,000.
(v) Advances paid and recovered during the month amounted to Rs. 17,000 and Rs. 28,000
respectively.
(vi) The company follows a policy of accruing bonus and paid leaves on a monthly basis.
Required.
Make Journal entries to record pay roll and its disbursement.

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 Solution
The journal entries to record pay roll and its disbursement are given below:

Journal Entries Debit Credit

Rupees in ‘000
Payroll expense (W-1) 2,030.83
Provision for vacations pay (vacations availed during the 85.00
month)
Payroll payable (1,635-193+85) 1,527.00
Contribution to provident fund payable (Co. & 250.00
employees)

AT A GLANCE
Provision for bonus 125.00
Provision for vacation pay 145.83
Employees’ income tax payable 40.00
Advance against salary 28.00
(To record payroll cost, liability and provisions)
Work in process (1,338.88+545.56) 1,884.44
Factory overheads (36.60+109.79) 146.39
Payroll expenses 2,030.83
(To allocate payroll cost to WIP and factory overheads)

SPOTLIGHT
Advance against salary 17.00
Payroll payable 1,527.00
Contribution to provident fund payable (Co. & employees) 250.00
Employees’ income tax payable 40.00
Bank 1,834
(To record disbursement of payroll and payment of
liabilities)
W-1 Calculation of payroll
Cost Machining Assembly Tool Stores Total

STICKY NOTES
room
WIP Overheads
Rupees in ‘000
Payroll cost (A) 1,000.00 400.00 25.00 75.00 1,500.00
Overtime 75.00 40.00 5.00 15.00 135.00
1,075.00 440.00 30.00 90.00 1,635
Employer’s contribution to PF
(A x 0.833) 83.33 33.34 2.09 6.25 125.00
Provision for year-end bonus
(A/12) 83.33 33.34 2.09 6.25 125.00
Provision for paid vacation
(A x 35/360) 97.22 38.89 2.43 7.29 145.83
1,338.88 545.56 36.60 109.79 2,030.83

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Cost Machining Assembly Tool Stores Total

room
Deductions from
employees:
Employee income tax 25.00 15.00 - - 40.00
Employees’ contribution to PF
(A x 0.833) 83.33 33.33 2.08 6.25 125.00
Salary advance recoveries 28.00
108.33 48.33 2.08 6.25 193.00

 Example 05:
AT A GLANCE

Zircon Limited (ZL) manufactures and supplies footballs for both domestic and international
markets. Following information is available from the company’s records.

Number of skilled workers 250

Standard working hours per month 200
Actual hours per unit of product 1.5
Standard labour rate per hour (Rupees) 42
Variable overhead rate per labour hour (Rupees) 75

The company manufactures 40,000 footballs per month. Overtime is paid to the workers at the
SPOTLIGHT

rate of 75% over and above the standard wage rate.

In order to increase the production efficiency and reduce the cost of conversion, the management
is currently evaluating various wage incentive plans. The production manager has suggested the
following options to the management.
Option 1: Introduce a piece wage system at the rate of Rs. 72 per unit. It is expected to improve
the current production efficiency from 65% to 78%.
Option 2: Introduce a monthly group bonus plan with a guaranteed wage of Rs. 48 per hour based
on a standard 1.4 hours per unit of product. This plan is expected to reduce the overtime by 60%.
Required
STICKY NOTES

Evaluate the above options in contrast with the existing schemes and advise management about
most economical option.
 Solution
The evaluation of above options in contrast with the existing schemes along with advise to
management about the most economical option is given below:
Conversion cost under existing scheme
Conversion cost Rupees
Normal hours (50,000 × Rs. 42) 2,100,000
Overtime hours (10,000 W-1 × Rs. 73.50) 735,000
Total labour cost 2,835,000
Variable overhead (60,000 × Rs. 75) 4,500,000
Total conversion cost 7,335,000

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Conversion cost under option 1

Conversion cost
No. of hours required per unit (1.5 × 0.65/ 0.78) 1.25
Total no. of hours required (40,000 × 1.25) 50,000
Rupees
Piece wages (40,000 × 72) 2,880,000
Variable overhead ( 50,000 × 75) 3,750,000
Total conversion cost 6,630,000
Conversion cost under option 2
Conversion cost Hours

AT A GLANCE
Labour hours available (250 × 200) 50,000
Overtime hours (10,000 × 40%) 4,000
Total labour hours 54,000
Standard hours allowed for the bonus plan (40,000 × 1.4) 56,000
Rupees
Guaranteed wages (56,000 × 48) 2,688,000
Variable overhead (54,000 × 75) 4,050,000
Total conversion cost 6,738,000
Recommendation: By implementing option 1 the conversion cost would be reduced to Rs

SPOTLIGHT
165.75 per unit from the existing Rs. 183.38 per unit. The workers would be paid Rs. 2.880
million which is better than option 2. The workers would certainly try to earn this amount in the
least possible time.
Therefore, option 1 would be the most economical choice for both the workers and the
management.
W-1 Overtime hours
Hours
No. of labour hours required (40,000 × 1.5) 60,000
Labour hours available at standard rate (250 × 200) 50,000

STICKY NOTES
Overtime hours 10,000

 Example 06:
a) The following information relates to a week’s work for three employees:

Employee A Employee B Employee C

Output (units) 160 276 68
Time allowed (hours per unit) 0.5 0.25 0.75
Basic hourly wage rate (Rupees) 80 100 70
Hours worked as direct labour 48 54 30
Hours worked as indirect labour - - 12

The normal working week is 42 hours. For the first six hours, overtime is paid at 50% above
the normal rate. Any further overtime is paid at double the normal rate. Bonus is paid at
three-fifth of the normal rate for the hours saved.

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Required:
a) Calculate total wages of each employee.
b) Make a summary of payroll of LMN Factory Limited for the month of February 2014.
c) Make journal entries to record payroll cost for the month of February 2014.
 Solution
a) Total wages of each employee is calculated below:

Particulars Employee A Employee B Employee C

Hours worked 48 54 42
Normal hours per week 42 42 42
AT A GLANCE

Overtime hours 6 12 -

Normal wages (48×80), (54×100), 3,840 5,400 2,940

(42×70)
First six overtime hours 240 300 -
(6×80×50%), (6×100×50%)
Overtime hours > 6 hours (6×100) - 600 -
Total wages in Rs. (A) 4,080 6,300 2,940
Bonus amount
Hours allowed (160×0.5), 80 69 51
SPOTLIGHT

(276×0.25), (68×0.75)
Direct hours worked 48 54 30
Bonus hours earned/Time saved 32 15 21
Hourly bonus rate - at three fifth of (80×3/5)=48 (100×3/5)=60 (70×3/5)=42
the normal rate
Bonus in Rs. (B) 1,536 900 882
Total wages in Rs. (A + B) 5,616 7,200 3,822

b) The following is a summary of payroll of LMN Factory Limited for the month of February
2014:
STICKY NOTES

Rupees
Basic salary 420,000
Allowances 147,000
Gross salary 567,000
Deductions :
Loans to staff (13,000)
Income tax (15,500)
Employees' provident fund contribution (35,000)
Net salary 503,500

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The company is also required to pay the following:

• Company’s contribution to the provident fund which is equal to employees’
contribution
• 5% of the basic salary to a government organisation.
c) Journal Entries to record payroll cost for the month of February 2014 are given below:

Journal Entries Debit Credit

Rupees
Salaries 420,000
Allowances 147,000

AT A GLANCE
Loans to staff 13,000
Staff income tax payable 15,500
Trustees- provident fund payable 35,000
Salary payable/bank 503,500
(Payroll for the month of February 2014)
Co’s contribution to provident fund 35,000
Trustees- provident fund payable 35,000
(Being Co. contribution to PF for February 2014

SPOTLIGHT
Contribution to the Government organization 21,000
Account payable - Government organization 21,000
(Amount payable to a government organisation at 5%
of basic salary for February 2014)

STICKY NOTES

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STICKY NOTEs

Labour cost is measured with respect to ‘Production’ and ‘Productivity’

Labour intensive industries tend to develop labour and production

designated wage policies
AT A GLANCE

Labour performances are worked out at each period end to analyze the cost
and productivity outcome

Learning curve is used to quantify the expected output in the expected time

Payroll account generally includes debit for direct labour expense, salaries
SPOTLIGHT

and the company’s portion of payroll taxes. Credit would be liability or

amount of cash paid to the employees.
STICKY NOTES

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 CHAPTER 5

COST FLOW IN PRODUCTION

AT A GLANCE
IN THIS CHAPTER
Accounting is a systematic process of identifying, recording,
AT A GLANCE measuring, classifying, verifying, summarizing, interpreting
and communicating financial information

AT A GLANCE
SPOTLIGHT Cost accounting is primarily about costing of the product and
Management accounting is all about Planning, Control and
1. Accounting for Inventory Decision Making.

2. Cost bookkeeping Systems Accounting for the production of inventory mirrors the cost
flow from Raw Material accounts, wages control account,
3. Comprehensive Examples Production overhead control account to WIP account and then
to finished goods and P&L account.
STICKY NOTES Integrated accounts combine both financial and cost accounts
in one system of ledger accounts. Interlocking systems contain
separate cost accounting and financial accounting ledgers.

SPOTLIGHT
STICKY NOTES

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1. ACCOUNTING FOR INVENTORY

There are two main methods of recording inventory.
• Periodic inventory method (period end system)
• Perpetual inventory system
Each method uses a ledger account for inventory but these have different roles.

Periodic inventory method

In periodic inventory method, inventory is measured at period-end on the basis of physical count and no record
is maintained in the form of stock ledger card. At year-end, closing inventory is valued and recorded in books. In
this system, opening inventory in the trial balance (a debit balance) and purchases (a debit balance) are both
AT A GLANCE

transferred to cost of sales thus clearing both accounts.

Closing inventory is recognized in the inventory account as an asset (a debit balance) and the other side of the
entry is a credit to cost of sales. Cost of sales comprises purchase in the period adjusted for movements in
inventory level from the start to the end of the period.
Cost of sales = Opening inventory + Purchases (net) – Closing inventory.

Perpetual inventory method

In perpetual inventory method, stock ledger is maintained showing movements of inventory at the time of
occurrence. Inventory account is maintained and all movements in inventory is recorded in it.. The inventory
account is used to show the current cost of inventory in hand. In this type of accounting, a separate account for
purchases is not maintained as part of double entry records. The account is also used to record all issues out of
inventory. These issues constitute the cost of sales.
SPOTLIGHT

When the perpetual inventory method is used, when inventory is bought, it is debited to inventory account but
when it is sold, inventory is credited and cost of sales is debited.
Each issue of inventory is assigned a cost, and the cost of the items issued is either the actual cost of the inventory
(if it is practicable to establish the actual cost i.e. the inventory is individually identifiable) or a cost obtained
using a valuation method.
Each receipt and issue of inventory is recorded in the inventory account. This means that a purchases account
becomes unnecessary, because all purchases are recorded in the inventory account. Though a separate detail of
purchases may be maintained for vendor documentation purposes.
All transactions involving the receipt or issue of inventory must be recorded, and at any time, the balance on the
STICKY NOTES

inventory account should be the value of inventory currently held. Though there is no need for inventory count
but one at the end of each period is conducted to maintain control over the integrity of records.

1.1 Accounting for the production of inventory

Cost Flow
Cost flow represents movement of cost and inventories through various ledgers until cost are sold and closed to
cost of sales. In this chapter, we will discuss how three elements of cost (Material, Labour and Production
overheads) combine to compute cost of sales.
As a simple starting point:
• For a retail company, the cost of goods sold is simply the purchase price of the goods.
• For a manufacturing company, the cost of goods sold is the total production cost including direct materials,
direct labour and production overheads. The accounting systems must identify these costs and then transfer
them into finished goods (usually via work-in-progress) and thus into cost of sales.

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 Illustration: Cost flow

AT A GLANCE
This diagram implies that cost accounting can be studied as a series of steps:
Step No. Stage of inventory Accounting treatment
1. The inventory is purchased Recognize costs in appropriate cost accounts
2. The inventory is issued to the Transfer costs from the cost accounts into
production process work-in- progress
3. Finished products are Transfer costs from work-in-progress into
obtained at the end of finished goods

SPOTLIGHT
manufacturing process
4. Finished goods are sold Transfer costs from the finished goods account
into the statement of profit or loss (income
statement) to become part of cost of sales

1.2 Explanation of Inventory ledgers

Raw materials
Raw materials ledger is inventory account and it shows the inventory movement. When raw material is
purchased it is debited and when material is issued, it is credited and transferred to work in progress account.
The balance at year end represents raw material inventory on hand and is shown in statement of financial

STICKY NOTES
position.

Work in progress
Work in progress is another inventory account in manufacturing concern and it shows that goods are in progress.
It includes direct labour cost and absorbed production overheads, in addition to direct materials transferred
from raw material ledger. The work completed during the year is credited to work in progress and transferred
to Finished goods. The year-end balance of work in progress is production cost which is not yet completed and
shown as inventory in statement of financial position.

Finished goods
Finished goods is third inventory account which is maintained by manufacturing concern. This account is debited
by amount transferred from work in progress and represents completed goods. When the goods are sold, finished
goods account is credited and ultimately transferred to cost of sales, to complete the cost flow. The year-end
balance represents unsold goods and treated as inventory which is shown in statement of financial position.

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 Illustration: Cost flows showing reclassification of non-production wages

AT A GLANCE

Over (under) absorption of fixed production overhead

The fixed production overheads account is debited with the actual fixed production overhead incurred in the
period. Fixed production overheads are transferred into WIP using a pre-determined absorption rate (as
discussed in chapter 3 earlier). The difference between the absorbed overhead and the actual overhead is over
SPOTLIGHT

(under) absorption. This must be adjusted in the statement of profit or loss.

 Illustration:
STICKY NOTES

 Example 01
A company manufactures and sells a range of products in a single factory. Its budgeted
production overheads for Year 6 were Rs.150,000, and budgeted direct labour hours were 50,000
hours.
Actual results in Year 6 were as follows:

Rs.
Direct materials costs 130,000
Direct labour costs 160,000
Fixed production overhead 140,000 (40,000 hours)

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There was no opening or closing inventory at the beginning or end of Year 6.

The company uses an absorption costing system, and production overhead is absorbed using a
direct labour hour rate.
The information would be accounted for as follows.

Recognition of costs
Debit Credit
Materials control 130,000
Salaries & Wages control 160,000
Production overhead control 140,000

AT A GLANCE
Cash/payables 430,000

Transfer of costs into work-in-progress

Debit Credit
WIP 130,000
Materials control 130,000
WIP 160,000
Salaries & wages control 160,000
WIP (see working below) 120,000

SPOTLIGHT
Production overhead control 120,000

Working
The predetermined absorption rate is Rs.150,000/50,000 hours = Rs.3 per direct labour hour.
Therefore, the amount transferred = Rs. 120,000 (40,000 hours × Rs. 3)
Transfer of costs from work-in-progress into finished goods

Debit Credit
Finished goods 410,000
WIP 410,000

STICKY NOTES
Accounting for under-absorption of fixed production overhead

Debit Credit
Statement of profit or loss (see working below) 20,000
Production overhead control 20,000

Working: Under absorption

Rs.

Overhead absorbed (40,000 hours @ RS. 3 per hour) 120,000

Overhead incurred (actual cost) (140,000)

Under absorption of overheads (20,000)

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This can be represented (in part) by the following diagram (figures in Rs. 000)
AT A GLANCE

1.3 Accounting entries in the cost accounting system

The following suite of journals describes the typical accounting entries that might be posted within a cost
accounting system that uses perpetual inventory system.
SPOTLIGHT

Journals to recognize expenses as incurred

Entries related to raw materials

Debit Credit

Purchase of raw materials

Inventory control (raw materials) X

Payables (or cash) X

Issue of raw materials to production

STICKY NOTES

Work in progress control (Direct materials) X

Production overhead control (Indirect materials) X

Inventory control (raw materials) X

Return of raw materials from production to store

Inventory control (raw materials) X

Work in progress control (Direct materials) X

Production overhead control (Indirect materials) X

Raw materials returned to vendor

Payables (or cash) X

Inventory control (raw materials)

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Entries related to labour

Debit Credit
Preparation of payroll
Salaries & wages control X
Deductions X
Accrued salaries & wages control X
Payment of payroll
Accrued salaries & wages control X

AT A GLANCE
Cash X
Transfer of salaries & wages to proper head of accounts
Work in progress control (direct labour) X
Production overhead control (indirect labour) X
Administrative cost X
Selling & marketing cost X
Salaries & wages control X
Recording of employer’s contribution

SPOTLIGHT
Production overhead control X
Administrative cost X
Selling & marketing cost X
Contribution payable X
Entries related to Production overheads
Debit Credit
Recording of actual production overheads

STICKY NOTES
Production overheads control X
Payables or cash or accumulated depreciation X
Absorbed production overheads to product cost
Work in progress control X
Production overheads control X
Close under or over absorbed overheads
In case of under absorbed overheads
Cost of sales (Income statement) X
Production overheads control X

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Transfer of completed goods to finished goods

Debit Credit
Transfer of costs on completion of production
Finished goods inventory X
Work in progress control X

Entries when goods are sold

Debit Credit
Recording of sales
AT A GLANCE

Accounts receivables (or cash) X

Sales X

Recording of cost of sales

Cost of sales X
Finished goods inventory X
Closing entries
Debit Credit
SPOTLIGHT

Close Cost of sales

Income statement X
Cost of sales X

Close sales account

Sales X
Cost of sales X
STICKY NOTES

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2. COST BOOKKEEPING SYSTEMS

Cost book-keeping systems can be categorized into two types in terms of how the cost accounts relate to other
ledger accounts. These two systems are called:
• integrated accounts;
• interlocking accounts.
2.1 Integrated accounts
Integrated accounts can be defined as
• A single set of accounting records that provide financial and cost accounts using a common input of data.
• A system where all information (both financial and costing) is kept in a single set of books.

AT A GLANCE
As the name suggests, the cost accounts are integrated into the entity’s bookkeeping system. There is a single
general ledger which includes the cost accounts.
Double entry is simply the normal double entry associated with maintaining a set of accounts including the
entries described above.
In practice most companies and ERP solutions available in the market use integrated accounting system.
Advantages of integrated accounts
• This system avoids duplication of effort between cost and financial accounting systems, by eliminating
unnecessary duplicate record.
• There is no need to reconcile the profits of cost and financial accounting, as single set of accounts calculates
profits for both.

SPOTLIGHT
• This system helps to reduce the cost of keeping two separate set of accounts.
Disadvantages of integrated accounts
• Using a single system for external reporting and the provision of management information reduces
flexibility. For example, inventory must be valued at full absorption cost for external reporting purposes (in
accordance with IAS 2: Inventories) but management might require marginal cost information for decision
making.
• The system causes delay in providing information to management. Since this system is developed to provide
information to both financial and cost accounting, it might get complicated.
• This system creates difficulty for large entities which require detailed cost and financial information on on-

STICKY NOTES
going basis.

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 Illustration:
This diagram shows the various ledger accounts and accounting entries used within integrated
accounts.
Chart of accounting flow in an integrated accounts system
AT A GLANCE

The direct materials account above might be named differently, for example, raw materials a/c,
inventory (raw materials) a/c, stores etc. Similarly, the WIP account might be described as
inventory (WIP) a/c and the finished goods account as inventory (finished goods) a/c.
The above diagram does not show it but there may well be a need for an entry to account for Over
(under) absorption of fixed production overhead as explained earlier in this chapter (section
SPOTLIGHT

1.5).
Profit or loss is calculated in the usual way as the balance on the P&L account. The balance would be transferred
to the accumulated profit account (retained earnings account).

2.2 Integrated accounts: Comprehensive illustration

The following illustration applies the accounting entries to ledger accounts for a comprehensive example.
The following balances and transactions relate to a manufacturing company.

Opening inventories raw materials 10,000kg Rs.25,000

work in progress nil
STICKY NOTES

finished goods 1,000 units Rs.100,000

Materials Purchases 28,000 kg Rs.77,000
issues to production 30,000kg FIFO
Labour Paid 16,000 hours Rs.96,000
Direct labour 15,000 hours
Production overhead Rs.250,000
Standard overhead rate per hour Rs.20
Completed production 4,000 units
Closing inventories raw materials see above
work in progress nil
finished goods 500 units FIFO
Sales revenue see above Rs. 540,000

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The Journal entries of above transactions are given below:

Entries related to materials Debit Credit

Materials Control 77,000
Payables 77,000
(Purchases of raw materials)
Work in progress control W-1 80,000
Materials Control 80,000
(Direct materials issued to production)
W-1 Material issues on FIFO basis Rupees

AT A GLANCE
From opening inventory-10,000 kg 25,000
From current purchase- 20,000 kg (77,000 x 20,000/28,000) 55,000
80,000

Entries related to labour Debit Credit

Salaries & Wages control 96,000
Cash 96,000
(Payment of wages made)
Work in progress control 90,000
Production overheads control W-2 6,000

SPOTLIGHT
Salaries & Wages control 96,000
(Transfer of wages to proper head of accounts)
W-2
Number of hours: 16,000 − 15,000 1,000
Hourly rate: Rs. 96,000/16,000 hours Rs.6
Transfer (Rs.) 6,000

Entries related to production overheads Debit Credit

STICKY NOTES
Production overheads control 250,000
Payables 250,000
(Actual production overheads recorded)
Work in progress control (15,000 x 20) 300,000
Production overheads control 300,000
(Production overheads were absorbed)

Transfer of costs from WIP into finished goods Debit Credit

Finished goods inventory 470,000
Work in progress control W-3 470,000

W-3: Balance in WIP before transfer Rs.

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Opening WIP −
Raw materials 80,000
Direct labour 90,000
Overhead absorbed 300,000
470,000
Less: Closing WIP −
Balance transferred to finished goods 470,000

Note:
Cost per unit = Rs. 470,000 /4,000 units Rs. 117.50
AT A GLANCE

Transfer of finished goods to cost of sales Debit Credit

Cost of sales W-4 511,250
Finished goods inventory 511,250

W-4 Units Rs.

Opening inventory of finished goods 1,000 100,000
Production 4,000 470,000
5,000 570,000
SPOTLIGHT

Closing inventory of finished goods (@ Rs. 117.50) (500) (58,750)

4,500 511,250
Over-absorption of overhead
Production overhead control W-5 44,000
Cost of sales 44,000
W-5: Rs.
Overhead incurred 250,000
Transfer from wages control a/c 6,000
Actual overheads 256,000
STICKY NOTES

Overhead absorbed 300,000

Over absorption 44,000

Recognition of sales Debit Credit

Receivables 540,000
Sales 540,000
Sales 540,000
P&L control a/c 540,000
Closing of cost of sales Debit Credit
P&L control a/c 511,250
Cost of sales 511,250

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Transfer of profit to accumulated profit Debit Credit

P&L control a/c W-6 72,750
Accumulated profit 72,750

W-6: Profit for the period Rs.

Sales 540,000
Cost of sales
Opening inventory -
Raw materials 25,000

AT A GLANCE
Finished goods 100,000
125,000
Production costs
Raw materials 77,000
Wages 96,000
Overheads 250,000
423,000
Closing inventory

SPOTLIGHT
Raw materials 22,000
Finished goods 58,750
(80,750)
(467,250)
Profit 72,750

The general ledger T accounts after the double entries are as follows:
Raw materials

STICKY NOTES
Rupees Rupees
Balance b/f 25,000
Payables 77,000 Work in progress control 80,000
Balance c/f 22,000
102,000 102,000

Salaries & Wages control

Rupees Rupees
Cash 96,000 Overhead control 6,000
Work in progress control 90,000
96,000 96,000

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Production Overhead control

Rupees Rupees
Payables 250,000 Work in progress control 300,000
Salaries & Wages control 6,000
Cost of sales 44,000
300,000 300,000

Work in progress control

Rupees Rupees
AT A GLANCE

Materials control 80,000 Finished goods 470,000

Salaries & Wages control 90,000
Production Overhead control 300,000
470,000 470,000

Finished goods
Rupees Rupees
Balance b/f 100,000 Cost of sales 511,250
Work in progress control 470,000 Balance c/f 58,750
570,000 570,000
SPOTLIGHT

Sales
Rupees Rupees
P&L control a/c 540,000
Receivables 540,000
540,000 540,000

Cost of sales
STICKY NOTES

Rupees Rupees
Finished goods 511,250 Production overheads control 44,000
Profit & Loss a/c 467,250
511,250 511,250

P&L control a/c

Rupees Rupees
Cost of sales 467,250 Sales 540,000
Profit for the period 72,750
540,000 540,000

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2.3 Interlocking accounts

Interlocking accounts involve using separate ledgers for costing and for financial reporting purposes. Each of
these ledgers includes an account (or accounts) to reflect the relationship with the other ledger (thus they are
said to interlock). Interlocking systems can vary in the range of transactions reflected in the cost ledger.

• In some systems the cost ledger includes only costing information.

• In other systems the cost ledger recognizes sales and the subsequent calculation of profit. For ease of
description we will describe this system as being fully interlocking.

There are separate records but these are kept in agreement or are readily reconcilable.
It is convenient to think of a business split into two entities (but remember that this is not necessarily the case):

AT A GLANCE
• The head office maintains the general ledger which is used to generate external reports; and
• A factory maintains the cost ledger (or factory ledger) which is used to record manufacturing.
Each ledger contains an account which reflects each entity’s relationship with the other entity. Thus:
• The general ledger contains a Factory Ledger Control Account (FLC a/c). This is a receivable and shows
the assets that the head office owns that are held by the factory.
• The factory ledger contains a General Ledger Control Account (GLC a/c). This is a payable that shows the
assets that the factory is holding on behalf of the head office. At each period end this would be the sum of
raw materials, WIP and finished goods not yet sold.
The balances on these accounts are a mirror image of each other and should agree.

Advantages of interlocking accounts

SPOTLIGHT
• Allows greater flexibility

Disadvantages of interlocking accounts

• Duplication of effort as entries need processing in both sets of ledgers
• Different profit figures may emerge
• Inventory valuations will be different between the two systems
• Reconciliation may be necessary (which takes time and effort)
The general ledger reflects this with the following double entries.

STICKY NOTES
Illustration: Expenses incurred by the head office for the factory

General ledger Debit Credit

Purchase of direct materials
Factory ledger control a/c X
Payables X
Payment for direct labour
Factory ledger control a/c X
Cash X
Production overhead incurred
Factory ledger control a/c X
Cash/payables X

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The result of the above is that the factory ledger control account in the general ledger shows that the factory
“owes” these amounts to the head office. They are amounts the head office has invested in the factory.
The amounts are entered in the factory ledger as follows.

Illustration: Expenses incurred by the head office for the factory

Factory ledger Debit Credit
Purchase of direct materials
Materials control X
General ledger control a/c X
Payment for direct labour
AT A GLANCE

Work in progress control X

General ledger control a/c X
Production overhead incurred
Production overheads control X
General ledger control a/c X

In the factory ledger, costs are transferred from the cost accounts into WIP and hence on to finished goods as
previously described. The finished goods are the output the head office receives from the factory for onwards
sale. The following entries are then made to reflect the completion and transfer of production. The goods may
not be physically moved from factory to head office but become available for sale.
SPOTLIGHT

Illustration: Completion of production Debit Credit

Completion of production: Factory ledger
General ledger control a/c X
Finished goods inventory X
Completion of production: General ledger
Cost of sales X
Factory ledger control a/c X
STICKY NOTES

 Illustration:
The following diagram provides an overview of the various ledger accounts and the flow of
information represented by the accounting entries used within interlocking accounts.

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General ledger control account

AT A GLANCE
FLC a/c = Factory ledger control account

2.4 Interlocking accounts: Comprehensive illustration

Continuing the same example given in section 2.3; the following pages will show how the balances and
transactions would be recorded in the cost ledger and the financial ledger.
Factory ledger

Entries related to materials Debit Credit

Materials control 77,000

SPOTLIGHT
General ledger control a/c 77,000
(Materials purchased)
Work in progress control 80,000
Materials control 80,000
(Materials issued to production)

Entries related to labour Debit Credit

Work in progress control 90,000

STICKY NOTES
Production overheads control 6,000
General ledger control a/c 96,000
(Transfer of salaries & wages to proper head of accounts)

Entries related to production overheads Debit Credit

Production overheads control a/c 250,000
General ledger control a/c 250,000
(Payment of production overheads by head office)
Work in progress control 300,000
Production overheads control a/c 300,000
(Overheads absorbed in production)

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Goods transferred to finished goods Debit Credit

Finished goods inventory 470,000
Work in progress control 470,000
(Goods completed and transferred to finished goods)
Record cost of goods sold Debit Credit

General ledger control a/c 511,250

Finished goods inventory 511,250

Close Over-absorption of overhead Debit Credit

AT A GLANCE

Production Overhead control a/c 44,000

General ledger control a/c 44,000

The Factory Ledger T accounts after the double entries are as follows:

Raw materials Control

Rupees Rupees
Balance b/f 25,000
General ledger control a/c 77,000 Work in progress control 80,000
SPOTLIGHT

Balance c/f 22,000

102,000 102,000

Production Overhead control

Rupees Rupees
General ledger control a/c 250,000 Work in progress control 300,000
General ledger control a/c 6,000
STICKY NOTES

General ledger control a/c 44,000

256,000 256,000

Work in progress control

Rupees Rupees
Materials control 80,000 Finished goods 470,000
General ledger control a/c 90,000
Production Overhead control 300,000

470,000 470,000

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Finished goods

Rupees Rupees
Balance b/d 100,000 General ledger control a/c 511,250
Work in progress control 470,000 Balance c/f 58,750

570,000 570,000

General Ledger Control Account

Rupees Rupees
Balance b/f 125,000

AT A GLANCE
Materials control 77,000
Finished goods 511,250 Work in progress control 90,000
Production overheads control 6,000
Production overheads control 250,000
Balance c/f 80,750 Production overheads control 44,000
592,000 592,000

General ledger

Entries related to materials, labour and production overheads Debit Credit

SPOTLIGHT
Factory ledger control a/c 77,000
Payables 77,000
(Purchases of raw materials by factory)
Salaries & Wages control 96,000
Cash 96,000
(Payment of wages by head office)
Factory ledger control a/c 96,000
Salaries & wages control 96,000
(Transfer of factory wages to factory ledger)

STICKY NOTES
Factory ledger control a/c 250,000
Payables 250,000
(Recording of liability against production overheads)

Recognition of sales and cost of sales Debit Credit

Receivables 540,000
Sales 540,000
(Recording of goods sold)
Cost of sales 511,250
Factory ledger control a/c 511,250
(Recording cost of goods sold)

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Closing of over absorbed to cost of sales Debit Credit

Factory ledger control a/c 44,000

Cost of sales 44,000
(Recording of goods sold)

Closing of cost of sales Debit Credit

P&L control a/c 467,250

AT A GLANCE

Cost of sales 467,250

Closing of sales Debit Credit

Sales 540,000
P & L control a/c 540,000

Transfer of profit to accumulated profit Debit Credit

P&L control a/c 72,750
SPOTLIGHT

Accumulated profit 72,750

Note: Workings are shown in comprehensive example in section 2.3.

The general ledger T accounts after the double entries are as follows:

Payables
Rupees Rupees
Factory ledger control 77,000
Balance c/f 327,000 Factory ledger control 250,000
327,000 327,000
STICKY NOTES

Cash
Rupees Rupees
Balance b/f X Salaries & Wages control 96,000
Balance c/f X
X X

Salaries & Wages control

Rupees Rupees
Cash 96,000 Factory ledger control 96,000
96,000 96,000

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Sales
Rupees Rupees
P&L control a/c 540,000 Receivables 540,000
540,000 540,000

Profit & Loss Control Account

Rupees Rupees
Cost of sales 467,250 Sales 540,000

AT A GLANCE
Profit for the year 72,750
540,000 540,000

Factory Ledger Control Account (FLC a/c)

Rupees Rupees
Balance b/f 125,000
Payables 77,000 Cost of sales 511,250
Salaries & Wages 96,000
Payables 250,000

SPOTLIGHT
Cost of sales 44,000 Balance c/f 80,750
592,000 592,000
Cost of Sales
Rupees Rupees
Factory ledger control a/c 511,250 Factory ledger control a/c 44,000
Profit & loss control a/c 467,250
540,000 540,000

Cost ledger control account (CLC)

STICKY NOTES
This account is used for ‘the other side’ of cost accounting double entries within interlocking accounts to replace
accounts that are not included (as being of no interest for costing purposes). This account is sometimes called
‘the dustbin account’.
Examples of such accounts include:
• Cash
• Bank
• Trade receivables
• Trade payables

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 Illustration:
The following diagram provides an overview of the various ledger accounts and the flow of
information represented by the accounting entries used within fully interlocking accounts.
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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3. COMPREHENSIVE EXAMPLES
 Example 01:
At 1 July a manufacturing company had the following balances in the general ledger adjustment
account in its cost ledger:

Rs.
Balance brought forward (credit) 5,625
Stores ledger control account 2,125
Finished goods stock control account 1,500
Work in progress control account 2,000

AT A GLANCE
Required
(a) Open ledger accounts for the above items in the cost ledger,
(b) Post the following items which occurred in the four-month period up to 31 October
(c) Open up other accounts as considered necessary, including a costing profit and loss account.

Stock material purchased 12,000

Stock materials issued to production 12,500
Stock materials issued to maintenance department 1,000
Wages – direct 10,830

SPOTLIGHT
Included in direct wages is indirect work 600
Factory overheads incurred 4,200
Factory overheads absorbed into production 5,800
Work transferred to finished stock, at cost 24,000
Factory cost of sales 22,500
Sales at selling price 28,750
Administrative and selling costs (to be written off against profits) 4,250

STICKY NOTES
General ledger control a/c
Rs. Rs.
Balance b/d 5,625
Sales account 28,750 Stores 12,000
Wages 10,830
Production overhead 4,200
Administration and selling expenses 4,250
Balance c/d 10,155 Profit and loss a/c 2,000
38,905 38,905
Balance b/d 10,155

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Stores ledger control a/c

Rs. Rs.
Balance b/d 2,125 Work in progress 12,500
General ledger control 12,000 Production overhead 1,000
Balance c/d 625
14,125 14,125
Balance b/d 625
Wages control a/c
Rs. Rs.
AT A GLANCE

General ledger control 10,830 Production overhead 600

Work in progress 10,230
10,830 10,830

Production overhead control a/c

Rs. Rs.
Stores ledger control 1,000 Work in progress 5,800
Wages control 600
SPOTLIGHT

General ledger control 4,200

5,800 5,800

Administration and selling expenses control a/c

Rs. Rs.
General ledger control 4,250 Profit and loss a/c 4,250
4,250 4,250

Sales a/c
STICKY NOTES

Rs. Rs.
Profit and loss a/c 28,750 General ledger control 28,750
28,750 28,750

Work in progress control a/c

Rs. Rs.
Balance b/d 2,000 Finished goods control 24,000
Stores 12,500
Wages 10,230
Production overhead 5,800 Balance c/d 6,530
30,530 30,530
Balance b/d 6,530

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Finished goods control a/c

Rs. Rs.
Balance b/d 1,500 Cost of sales 22,500
Work in progress 24,000
Balance c/d 3,000
25,500 25,500
Balance b/d 3,000

Cost of goods sold

AT A GLANCE
Rs. Rs.
Finished goods stock 22,500 Profit and loss a/c 22,500
22,500 22,500

Profit and loss a/c

Rs. Rs.
Cost of goods sold 22,500 Sales 28,750
Administration and selling 4,250
expenses

SPOTLIGHT
Profit (to general ledger 2,000
control)

28,750 28,750

 Example 02:
Kaat Ltd operates separate cost accounting and financial accounting systems. The following
manufacturing and trading statement has been prepared from the financial accounts for the
quarter ended 31 March.

STICKY NOTES
Rs. Rs.
Raw materials
Opening stock 48,000
Purchases 108,800
156,800
Closing stock (52,000)
Raw materials consumed 104,800
Direct wages 40,200
Production overhead 60,900
Production cost incurred 205,900
Work in progress
Opening stock 64,000
Closing stock (58,000) 6,000
Cost of goods produced carried down 211,900

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Rs. Rs.
Sales 440,000
Cost of goods sold
Finished goods opening stock 120,000
Cost of goods produced brought down 211,900
331,900
Finished goods closing stock (121,900) (210,000)
Gross profit 230,000
The following information has been extracted from the cost accounts:
Control account balances at 1 January
AT A GLANCE

Rs.
Raw material stores 49,500
Work in progress 60,100
Finished goods 115,400
Transactions for the quarter

Rs.
Raw materials issued 104,800
Cost of goods produced 222,500
Cost of goods sold 212,100
SPOTLIGHT

Loss of materials damaged by flood (insurance claim pending) 2,400

A notional rent of Rs.4,000 per month has been charged in the cost accounts. Production
overhead was absorbed at the rate of 185% of direct wages. Profit at the end of the period is
shown as Rs.238,970.
Required
(a) Prepare the following control accounts in the cost ledger:
(i) Raw materials stores
(ii) Work in progress
STICKY NOTES

(iii) Finished goods

(iv) Production overhead.
(b) Prepare a statement reconciling the gross profit as per the cost accounts and the financial
accounts.
 Solution
a) Preparation of the relevant control accounts in the cost ledger, would be as follows:
Raw materials stores a/c
Rs. Rs.
Balance b/f 49,500 Work in progress 104,800
Purchases 108,800 Loss due to flood 2,400
Balance c/f 51,100
158,300 158,300
Balance b/f 51,100

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Work in progress control a/c

Rs. Rs.
Balance b/f 60,100 Finished goods 222,500
Raw materials 104,800 Balance c/f 56,970
Direct wages 40,200
Production overhead 74,370
279,470 279,470
Balance b/f 56,970

Finished goods control a/c

AT A GLANCE
Rs. Rs.
Balance b/f 115,400 Cost of sales 212,100
Work in progress 222,500 Balance c/f 125,800
337,900 337,900
Balance b/f 125,800

Production overhead
Rs. Rs.
General ledger control 60,900 Work in progress 74,370
Notional rent 12,000

SPOTLIGHT
Overhead overabsorbed 1,470
74,370 74,370

b) Reconciliation statement

Rs. Rs. Rs.

Profit as per financial accounts 230,000
Difference in stock values
Work in progress opening stock 3,900
Finished goods opening stock 4,600

STICKY NOTES
Finished goods closing stock 3,900
-------------- 12,400

Raw materials opening stock 1,500

Raw materials closing stock 900
Work in progress closing stock 1,030
(3,430)
8,970
Profit as per cost accounts 238,970

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Cost accounting profit and loss Rs. Rs. Rs.

Sales 440,000
Cost of sales 212,100
Loss of stores 2,400
214,500
Overhead over-absorbed 1,470
Notional rent 12,000
(13,470)
(201,030)
238,970
AT A GLANCE

 Example 03:
Mirza Limited is engaged in the manufacturing of spare parts for automobile industry. The
company records the purchase and issue of materials in a store ledger which is not integrated
with the financial ledger. It is the policy of the company to value inventories on weighted average
basis. The valuation is carried out by the Finance Department using stores memorandum record.
A physical stock count is carried out after every six months. Any shortage/excess is then adjusted
in the financial as well as stores ledger.
On December 31, 20X3, physical stock count was conducted by the Internal Auditor of the
company. He submitted the following statement to the Finance Department:

Balance (in units) Cost per unit (Rs.)

SPOTLIGHT

Item Code Store Financial

Physical Average Current
Ledger Records
010-09 20,500 20,500 20,000 2.00 2.25
013-25 10,000 10,000 10,000 4.00 1.50
017-10 5,500 5,500 5,000 1.00 1.10
022-05 4,000 4,500 5,500 2.00 2.00
028-35 1,200 1,200 1,000 2.75 2.50
035-15 640 600 600 3.00 3.50
STICKY NOTES

On scrutinizing the details, Finance Department was able to ascertain the following reasons:

Item Code Reasons

010-09 500 units were defective and therefore the Internal Auditor
excluded them while taking the physical count.
013-25 This item is not in use and is considered obsolete. The net realizable value is
Rs. 0.60 per unit.
017-10 Shortage is due to theft.
022-05 A receipt of 1,000 units was not recorded. The remaining difference is
due to errors in recording the quantity issued.
028-35 200 units returned to a supplier were not recorded. The invoiced cost was
Rs. 3 per unit.
035-15 Discrepancy is due to incorrect recording of a Goods Receipt Note.

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Required
a) Prepare necessary Journal entries to record the adjustments in the financial ledger.
b) State how would you make the necessary adjustments in the stores ledger.
 Solution
a)
Journal Entries in Financial Ledger

Dr. Cr.
Rupees Rupees
(i) Cost of sales/ FOH/ Abnormal loss 1,000

AT A GLANCE
Stores Ledger A/c 1,000
(Record the normal loss of item # 010-09)
(ii) Cost of sales/ FOH 34,000
Provision for obsolescence 34,000
(Record the provision for obsolescence against item # 013-25)
(iii) Cost of sales/ FOH/ Abnormal loss 500
Stores Ledger A/c 500
(Record the theft of item # 017-10)

SPOTLIGHT
(iv) (a) Stores Ledger A/c 2,000
Creditors / Cash 2,000
(Record the purchase of items # 022-05 )
(b) No adjustment
(v) Creditors/ Cash 600
Stores Ledger A/c 600
(Record the return of item # 028-35)

STICKY NOTES
(vi) No adjustment

b) Recording in Stores Ledger

i. The quantity should be shown as issued in the stores ledger.
ii. No adjustment.
iii. 500 units should be shown in the issue column and adjust the balance accordingly.
iv. a) 1,000 units should be recorded on the receipt side of individual stores ledger
account.
b) The issue column of the individual stores ledger account should be reduced by
500 units.
v. 200 units should be reduced from the receipt and accordingly adjust the balance
columns of the individual stores ledger account.
vi. The postings of incorrectly recorded Goods Receipt Note should be corrected.

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 Example 04
Sapphire limited (SL) fabricates parts for auto manufacturers and follows job order costing. The
company’s head office is situated in Lahore but the factory is in Karachi. A separate set of
records is kept at the head office and at the factory. Following details were extracted from SL’s
records for the month of February 20X4.

Jobs
A B C
Materials issued to production (units)
• Material X 40,000 - 10,000
• Material Y - 75,000 25,000
AT A GLANCE

Direct labour hours worked (hours) 6,000 9,000 15,000

Labour rate per hour (Rs.) 75 60 65

The other related information is as follows:

i. Materials purchased on account:
• 100,000 units of material X at Rs. 25 per unit
• 150,000 units of material Y at Rs. 35 per unit
ii. The head office prepared the payroll and deducted 8% for payroll taxes. The payroll
amounted to Rs. 3.0 million out of which Rs. 1.0 million pertained to selling and
administrative staff salaries. After charging direct labour cost to each job the balance
amount of payroll cost was attributed to general factory overhead.
SPOTLIGHT

iii. Factory overhead was applied to the jobs at Rs. 25 per direct labour hour.
iv. Actual factory overheads amounted to Rs. 700,000 including depreciation on machinery
amounting to Rs. 400,000. All payments were made by head office.
v. Over or under-applied factory overheads are closed to cost of goods sold account.
vi. Jobs A and B were completed during the month. Job A was sold for Rs. 2.0 million to one
of the auto manufacturer on credit. The customer however, agreed to settle the
transaction at 2% cash discount.
vii. Selling and administrative expenses, other than salaries paid during the month were Rs.
500,000.
STICKY NOTES

Required
Record journal entries to record all the above transactions in SL’s factory ledger and general
ledger for the month of February 20X4.
 Solution
Journal entries to record all the above transactions in SL’s factory ledger and general ledger for
the month of February 20X4, would be prepared as follows:

General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
Material X 2,500,000 Factory Ledger 7,750,000
Material Y 5,250,000 Trade Creditors 7,750,000
General Ledger 7,750,000

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General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
(Purchase of material)
Payroll 2,000,000 Factory Ledger 2,000,000
General Ledger 2,000,000 Selling and 1,000,000
administrative
expenses
Accrued Payroll 2,760,000
(Payroll accrual) Payroll taxes 240,000

AT A GLANCE
No Entry Accrued payroll 2,760,000
Payroll Taxes 240,000
Bank 3,000,000
(Payment of
payroll & taxes)
Work in process A 1,000,000
Work in process B 2,625,000
Work in process C 1,125,000 No Entry
Material X 1,250,000
Material Y 3,500,000

SPOTLIGHT
General Journal entries
Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
(Issuance of raw material to WIP)
Work in process A 450,000
Work in process B 540,000

STICKY NOTES
Work in process C 975,000 No Entry
Factory overheads 35,000
Payroll 2,000,000
(Direct labour cost allocated to WIP)
Work in process A 150,000
Work in process B 225,000
Work in process C 375,000 No Entry
Factory overheads - applied 750,000
(Factory overheads applied to WIP)
Factory overheads 700,000 Factory Ledger 700,000
General Ledger 700,000 Bank 300,000

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General Journal entries

Factory Ledger General Ledger
Particulars Particulars
Debit Credit Debit Credit
Accumulated 400,000
Depreciation
(Actual factory
overheads transferred)
Factory overheads - 15,000 Factory Ledger 15,000
applied
General Ledger 15,000 Cost of goods sold 15,000
AT A GLANCE

(Over applied overheads transferred to cost of goods sold)

Finished goods A 1,600,000
Finished goods B 3,390,000 No Entry
Work in process A 1,600,000
Work in process B 3,390,000
(Jobs A and B completed and transferred to finished goods)
General Ledger 1,600,000 Cost of goods sold 1,600,000
Finished goods A 1,600,000 Factory Ledger 1,600,000
SPOTLIGHT

(Job A delivered and transferred to cost of goods sold)

No Entry Trade Debtors 2,000,000
Sales 2,000,000
(Job A sold to
customer)
No Entry Bank 1,960,000
Cash discount 40,000
Trade debtors 2,000,000
STICKY NOTES

(Amount realized
from customer)
No Entry Selling and 500,000
administrative
expenses
Bank 500,000
(Payment of
Selling and admin.
Expenses)

 Example 05:
The following information is available for the month of December 2000 of Khalid Enterprises:

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Rs.
Accounts payable December 01 6,000
Work in process December 01 30,000
Finished goods December 01 50,000

Materials December 31 15,000

Accounts payable December 31 10,000

Finished goods December 31 60,000

Actual factory overheads 150,000

AT A GLANCE
Cost of sales 300,000

Payment of accounts payable used only for material purchases 35,000

Factory overhead is applied at 200% of direct labour cost. Jobs still in process on December 31, have been
charged Rs. 6,000 for material and Rs. 12,000 for direct labour hours (1,200 hours). Actual direct labour
hours 10,000 @ Rs. 8.00 per hour.

Required
Calculate material purchases, cost of goods manufactured, applied factory overheads, Work in process
December 31, Material used, Materials as on December 01 and under or over applied factory overhead,

SPOTLIGHT
Solution
Calculation of material purchases, cost of goods manufactured, applied factory overheads, Work in process
December 31, Material used, Materials as on December 01 and under or over applied factory overhead, along
with relevant ledgers, are given below:

Materials Inventory
Rs. Rs.
Balance b/f (Bal. Fig.) 58,000 Work in progress 82,000

STICKY NOTES
Purchases 39,000 Balance c/f 15,000
97,000 97,000

Accounts payable
Rs. Rs.
Cash 35,000 Balance b/f 6,000
Balance c/f 10,000 Purchases (Balancing figure) 39,000
45,000 45,000

Work in process
Rs. Rs.
Balance b/f 30,000
Materials (Bal. Fig.) 82,000 Finished goods 310,000

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Payroll 80,000
Production overheads W-1 160,000 Balance c/f W-2 42,000
352,000 352,000

Finished goods
Rs. Rs.
AT A GLANCE

Balance b/f 50,000 Cost of sales 300,000

Work in process (Bal. Fig.) 310,000 Balance c/f 60,000
360,000 360,000

Production overheads
Rs. Rs.
Cash 150,000 Work in process 160,000
Cost of sales 10,000
SPOTLIGHT

160,000 160,000
Cost of sales
Rs. Rs.
Finished goods 300,000 Production overheads 10,000
Profit & Loss 290,000
290,000 290,000
STICKY NOTES

W-1 Factory overhead applied and over absorbed Rs.

overheads
Factory overhead applied (80,000 x 200%) 160,000
Actual factory overheads 150,000
Over absorbed overheads 10,000

W-2 Closing inventory of work in process Rs.

Materials 6,000
Labour 12,000
Factory overhead applied (12,000 x 200%) 24,000
42,000

 Example 06:
The incomplete cost accounts for a period of Company A are given below:

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Store ledger control account

Rs. 000 Rs. 000
Opening balance 2,640
Financial ledger control 3,363

Production wages control account

Rs. 000 Rs. 000
Financial ledger control 2,940

Production overhead control account

AT A GLANCE
Rs. 000 Rs. 000
Financial ledger control 1,790

Work in process control account

Rs. 000 Rs. 000
Opening balance 1,724

The balances at the end of the period in Rs. 000 were:

Store ledger Rs. 2,543

SPOTLIGHT
WIP ledger Rs. 2,295

During the period 65,000 kilos of direct material were issued from stores at a weighted average price of Rs.
48 per kilo. The balance of materials issued from stores represented indirect materials.

Two thirds of the production wages are classified as ‘direct’. Average gross wage of direct workers was Rs.
20 per hour. Production overheads are absorbed at a predetermined rate of Rs. 30 per direct labour hour.
Goods were delivered immediately after completion, as no finished goods store is maintained.

Required
Complete cost accounts for the period.

STICKY NOTES
Solution

Completion of cost accounts for the period, are given below:

Store ledger control account
Rs. 000 Rs. 000
Opening balance 2,640 Work in process control
(65,000x48) 3,120
Financial ledger control 3,363 Production overheads (Bal) 340
Closing balance 2,543
Production wages control account
6,003 6,003
Rs. 000 Rs. 000
Financial ledger control 2,940 Work in process control
(2,940,000 x 2/3) 1,960

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Production overheads (Bal) 980

2,940 2,940

Production overhead control account

Rs. 000 Rs. 000
AT A GLANCE

Financial ledger control 1,790 Work in process control

(1,960,000 x 30/20) 2,940
Store ledger control 340
Production wages control 980 Cost of sales (Under absorbed) 170
3,110 3,110

Work in process control account

Rs. 000 Rs. 000
Opening balance 1,724 Cost of sales 7,449
Store ledger control 3,120
SPOTLIGHT

Production wages control 1,960 Closing balance 2,295

Production overhead
control 2,940
9,744 9,744

 Example 07:
Mr. Azad had provided you the following information from his factory ledger for the quarter ended 31
December 2005.
STICKY NOTES

Rs.
Control account balances as on October 1, 2005
Materials 49,500
Work in process 60,100
Finished goods 115,400
Transaction for quarter ended 31 December 2005
Material purchased 108,000
Direct wages 50,200
Payments for factory overheads 30,900
Depreciation of factory building and machine 42,000

Other related information is as under:

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− Closing stock of raw materials and finished goods at December 31, 2005 amounted to Rs. 50,300
and Rs. 125,800 respectively.
− Cost of goods produced is Rs. 222,500.
− Factory overheads are absorbed in production @ 160% of direct wages.
− Diesel costing Rs. 2,000 included in the factory overheads was transferred to head office for use in
generator.
− A bill for repairs amounting to Rs. 12,000 undertaken at the factory remained unpaid at the end of
the quarter.
− Material costing Rs. 2,400 was destroyed by rain.

Required
Prepare Materials, Work in process, Finished goods, Factory overheads and Cost of sales ledgers.

AT A GLANCE
Solution

Preparation of Materials, Work in process, finished goods, Factory overheads and Cost of sales
ledgers are given below.
Materials
Rupees Rupees
Balance b/f 49,500 Profit & Loss 2,400
Purchase 108,000 Work in process (Bal) 104,800
Balance c/f 50,300
157,500 157,500

SPOTLIGHT
Work in process
Rupees Rupees
Balance b/f 60,100 Finished goods 222,500
Wages 50,200
Factory overhead 80,320
Materials 104,800 Balance c/f 72,920
295,420 295,420

STICKY NOTES
Finished Goods
Rupees Rupees
Balance b/f 115,400 Cost of sales 212,100
Work in process 222,500 Balance c/f 125,800
337,900 337,900

Factory overheads
Rupees Rupees
Cash 30,900 Work in process 80,320
Accumulated depreciation 42,000 General ledger 2,000
Payables 12,000 Cost of sales 2,580
84,900 84,900

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Cost of sales
Rupees Rupees
Finished goods 212,100 Profit and loss 214,680
Factory overheads 2,580
214,680 214,680
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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STICKY NOTES

The objective of accounting for production of inventory is to record and mirror

the cost throughout the production process.

The cost flows from:

• material account, wages control account,
AT A GLANCE

production overhead account to WIP account;

• then to finished goods accounts; and
• ultimately to Profit and loss account.

Cost book-keeping systems can be categorized into two types in terms of how
the cost accounts relate to other ledger accounts:
• integrated accounts;
• interlocking accounts.
SPOTLIGHT

Integrated accounts combine both financial and cost accounts in one system of
ledger accounts. A reconciliation between cost and financial profits is not
necessary with an integrated system.

Interlocking accounts are recorded in factory ledger for cost accounts and
general ledger for other accounts, which are readily reconcilable.
STICKY NOTES

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 CHAPTER 6

JOB AND SERVICE COSTING

AT A GLANCE

IN THIS CHAPTER A costing method is one which is designed to suit the way goods
are processed or manufactured or the way that services are
provided.

AT A GLANCE
AT A GLANCE
A job is a cost unit which consists of a single order or contract.
SPOTLIGHT Job costing is a basic cost accounting method applicable where
work consists of separate contracts, jobs or batches.
1. Job costing
The cost of a job consists of direct material cost, direct labour
cost, direct expenses, production overheads and administrative,
2. Service costing
selling and distribution overheads.
3. Comprehensive examples Service organizations do not make or sell tangible goods. Service
costing differs from other costing methods. With many services
STICKY NOTES the cost of direct materials consumed will be relatively small
compared to labour, direct expenses and overheads cost.

SPOTLIGHT
The output of most service organizations is often intangible and
difficult to define. A unit cost is therefore difficult to calculate.
Specific characteristics of services are intangibility,
simultaneity, perishability and heterogeneity.

STICKY NOTES

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1. JOB COSTING
1.1 The nature of job costing
Job costing is used when a business entity carries out tasks or jobs to meet specific customer orders. Although
each job might involve similar work, they are all different and are carried out to the customer’s specific
instructions or requirements. In order words, job order costing is used in situations where many different
products are manufactured each period on request of customer.
Examples of ‘jobs’ include work done for customers by builders or electricians, audit work done for clients by a
firm of auditors, and repair work on motor vehicles by a repair firm. Another example is printing work, where
printing job is done on the specification of customers, not readily available for sales.
It is simplest method of costing, where each job is assigned a unique job number and all direct cost is allocated
to respective jobs as they are incurred. However, indirect cost is assigned to job costing mostly on absorption
AT A GLANCE

costing principle, however, marginal costing may be used depending upon policy of company.

1.2 The cost of a job

As discussed in above paragraph, each job is given unique number for the purpose of measuring profit of each
job, after allocating the costs to each job.
Job costing differs from most other types of costing system because every job is a cost unit which consists of a
single order or contract and the costing is being done for every job separately. The expected cost of a job has to
be estimated so that a price for the job can be quoted to a customer.
The features of Job costing are as follows:
• Work is undertaken to customer’s special attention, thus, creating flexibility in creating customer demands.
For example, specific design of furniture on request of customer is manufactured.
SPOTLIGHT

• Normally, each job takes short period of time, but still there might be chance of getting large order.
• Jobs move through processes and operations as a continuously identifiable unit.
• Each job usually differs in one or more respects from every other job and therefore a separate record must
be maintained to show the details of a particular job.
• Job costs are allocated on a job cost sheet or job cost card.
• Rectification work is the cost of rectifying substandard work. it is to be charged as direct cost of the job
concerned if not a frequent occurrence and can be directly attributable to a job. It is to be treated as
production overhead if regarded as normal part of the work and it is of recurring nature.
A job costing system is usually based on absorption costing principles, and in addition a cost is included for non-
STICKY NOTES

production overheads, as follows.

Illustration: Job cost Rs.

Direct materials 500
Direct labour 300
Direct expenses 200
Prime cost 1,000
Production overhead absorbed 750
Production cost of the job 1,750
Non-production overheads 400
Total job cost 2,150
In many cases, job costs include not just direct materials costs and direct labour costs, but also direct expenses,
such as:
• the rental cost of equipment hired for the job

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• the cost of work done for the job by sub-contractors

• the depreciation cost of equipment used exclusively on the job.
Production overheads might be absorbed on any suitable base as discussed in Chapter 3.
Non-production overheads might be added to the cost of the job:
• as a percentage of the prime cost of the job, or
• as a percentage of the production cost of the job.

1.3. Job cost card or sheet

A job order cost sheet or card is a form prepared for a job that record all manufacturing costs both direct and
indirect and also non-manufacturing costs absorbed to specific job. It includes details of materials issued along
with quantities; direct labour including time consumed on each job and other direct expenses incurred in

AT A GLANCE
connection with specific job. Indirect manufacturing cost and non-manufacturing costs are absorbed into
product or service cost on the basis of absorption rate as discussed in section 1.2. above.
Following examples reflect process of recording the costs into job order cost sheet or card.
 Example 01:
The following cost information has been gathered about Job number 453.
The direct materials cost is Rs.10,000, the direct labour cost is Rs.6,000 and direct expenses are
Rs.4,000. Direct labour costs Rs.20 per hour. Production overheads are charged at the rate of
Rs.30 per direct labour hour and non-production overheads are charged at the rate of 40% of
prime cost. Total production of job number 453 is 5,000 units.
The job cost and unit cost for Job 453 is calculated as follows:

SPOTLIGHT
Job cost: Job 453 Rs.
Direct materials 10,000
Direct labour 6,000
Direct expenses 4,000
Prime cost 20,000
Production overhead (6,000 x 30/20) 9,000
Production cost of the job 29,000

STICKY NOTES
Non-production overheads (40% of prime cost i.e. Rs. 20,000) 8,000
Total job cost 37,000
Unit cost of job (37,000 / 5,000) 7.40

 Example 02:
A company operates a job costing system. Job number 6789 will require Rs.3,450 of direct
materials and Rs.2,100 of direct labour, which is paid Rs.14 per hour. Production overheads are
absorbed at the rate of Rs.30 per direct labour hour and non-production overheads are absorbed
at the rate of 30% of production cost.
Expected sales price of the job, assuming above order contains 1,000 units and company expects
20% markup.

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Rs.
Direct materials 3,450
Direct labour 2,100
Prime cost 5,550
Production overheads (2,100 × Rs.30/ Rs. 14) 4,500
Full production cost 10,050
Non-production overheads (30% × Rs.10,050) 3,015
Full cost of sale for the job 13,065
Add: Markup at 20% 2,612
AT A GLANCE

Sales value of job 15,678

Unit sales price (15,678/ 1,000) 15.68

1.4 Cost records and accounts for job costing

In order to establish the cost of each individual job in a costing system, it is necessary to have procedures for
recording direct costs in such a way that they can be allocated to specific jobs. Production overheads and non-
production overheads can be charged using overhead absorption rates within a system of absorption costing.
The procedure with accounting entry of each cost charged to job is given in following paragraphs.
Accounting for Materials
SPOTLIGHT

Debit Credit
Purchases of materials
Materials control X
Accounts payable X

Purchase returns of materials

Accounts payable X
Materials control X

Issuance of direct materials to job

STICKY NOTES

Work in progress- Job No. 123 X

Materials control X

Return of excess direct materials from job

Materials control X
Work in progress- Job No. 123 X

Issuance of indirect materials to job

Production overhead control X
Materials control X

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Accounting for Labour

Debit Credit
Recording of payroll
Salaries & Wages control X
Accrued payroll (Assuming no deductions) X
Recording of direct and indirect labour
Work in progress- Job No. 123 X
Production overhead control X
Salaries & wages control X
Accounting for Production overheads

AT A GLANCE
Debit Credit
Recording of actual production overheads
Production overhead control X
Payable or cash or other credits X

Absorption of production overheads to jobs

Work in progress- Job No. 123 X
Production overhead control X
Accounting for completion and sales of job
Debit Credit

SPOTLIGHT
Completion of job and delivering it to
customer without storing in finished goods
Cost of sales X
Work in progress-Job No. 123 X

Sales of job
Accounts receivables X
Sales X

STICKY NOTES
Illustration: Job cost account
Work in process account: Job 123
Rs. Rs.
Materials control 1,800 Cost of sales 7,800
Salaries & wages control 3,000
Production overhead control 3,000
7,800 7,800
When the job is finished, the total cost of the job is transferred to the cost of sales.

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 Example 03:
The following information relates to job activity in the month of June.
Job 0503 Job 0402 Job 0607
Contract price Rs. 500,000 Rs. 980,000 Rs. 600,000
Commenced 3 May 2 April 7 June
Completed 25 June Not completed 19 June
Opening WIP comprised: Nil
Direct materials (all material X) Rs. 5,000 Rs. 10,000
Direct labour (all grade A) Rs. 10,000 Rs. 18,000
Variable production o’head Rs. 12,000 Rs. 21,600
AT A GLANCE

Fixed production overhead Rs. 12,800 Rs. 23,040

Rs. 39,800 Rs. 72,640
Material issues from stores:
Material X 200 kgs 800 kgs 900 kgs
Material Y 400 kgs 600 kgs
Labour
Grade A 60 hours 120 hours 150 hours
Grade B 25 hours 100 hours 20 hours
Costs:
Material X Rs. 220 per kg
Material Y Rs. 500 per kg
SPOTLIGHT

Grade A Rs. 250 per hour

Grade B Rs. 400 per hour
Variable overhead recovery rate Rs. 300 per hour
Fixed production overhead is absorbed using direct labour hours
Budgeted fixed production overhead Rs. 160,000
Budgeted labour hours 500 hours
Actual fixed production overhead expenditure in the Rs. 161,000
period
The company needed to hire a special machine for job 0402 at a cost of Rs. 5,000 in the current
STICKY NOTES

month.
20 kgs of raw material were returned to stores on completion of job 0607.
For internal profit reporting purposes administration and marketing expenses are added to cost
of sales at 20% of full product cost at the time of completion of the job. Actual administration and
marketing expense in the period was Rs. 130,000.
(Note: The system suggested is similar to that for the receivables control account backed up by
the receivables ledger. In this case there is a WIP control account backed up by the job costing
ledger).

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Task 1 – Schedule of resources used in month

Material X Kgs Cost per kg Rs.
Job 0503: 200 220 44,000
Job 0402 800 220 176,000
Job 0607 900 220 198,000
Less returns (20) 220 (4,400)
880 220 193,600
1,880 220 413,600

Material Y Kgs Cost per kg Rs.

Job 0503: 400 500 200,000

AT A GLANCE
Job 0402 600 500 300,000
1,000 500 500,000

Labour grade A Hours Cost per hour Rs.

Job 0503: 60 250 15,000
Job 0402: 120 250 30,000
Job 0607: 150 250 37,500
330 250 82,500

Labour grade B Hours Cost per hour Rs.

Job 0503: 25 400 10,000

SPOTLIGHT
Job 0402: 100 400 40,000
Job 0607: 20 400 8,000
145 400 58,000
Variable overhead Hours Cost per hour Rs.
Job 0503: 60 + 25 = 85 300 25,500
Job 0402: 120 + 100 = 220 300 66,000
Job 0607: 150 + 20 = 170 300 51,000
475 300 142,500

Fixed overhead Hours Cost per hour Rs.

STICKY NOTES
Job 0503: 85 320 27,200
Job 0402: 220 320 70,400
Job 0607 170 320 54,400
475 320 152,000
Task 2 – Journal entries to record costs in the job accounts

Debit Credit
Issues of Material X
Job 0503 account 44,000
Job 0402 account 176,000
Job 0607 account 198,000
Material X inventory account 418,000
Returns of Material X

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Debit Credit
Material X inventory account 4,400
Job 0607 account 4,400
Issues of Material Y
Job 0503 account 200,000
Job 0402 account 300,000
Material Y inventory account 500,000
Grade A labour
Job 0503 account 15,000
AT A GLANCE

Job 0402 account 30,000

Job 0607 account 37,500
Salaries & Wages control account 82,500
Grade B labour
Job 0503 account 10,000
Job 0402 account 40,000
Job 0607 account 8,000
Salaries & Wages control account 58,000
Variable overhead
SPOTLIGHT

Job 0503 account 25,500

Job 0402 account 66,000
Job 0607 account 51,000
Production overhead control account 142,500
Fixed overhead
Job 0503 account 27,200
Job 0402 account 70,400
Job 0607 account 54,400
STICKY NOTES

Production overhead control account 152,000

Hire cost
Job 0402 account 5,000
Cash 5,000
Task 3 – Job cost accounts

Job 0503
Rs. Rs.
Balance b/d 39,800
Issues from stores:
Material X 44,000
Material Y 200,000

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Labour:
Grade A 15,000
Grade B 10,000
Variable overhead 25,500
Fixed overhead 27,200 Cost of sales 361,500
361,500 361,500

Job 0402
Rs. Rs.

AT A GLANCE
Balance b/d 72,640
Issues from stores:
Material X 176,000
Material Y 300,000
Labour:
Grade A 30,000
Grade B 40,000
Variable overhead 66,000
Fixed overhead 70,400

SPOTLIGHT
Machine hire 5,000 Balance c/d 760,040
760,040 760,040
Job 0607
Rs. Rs.
Issues from stores: Returns to stores
Material X 198,000 Material X 4,400
Labour:

STICKY NOTES
Grade A 37,500
Grade B 8,000
Variable overhead 51,000
Fixed overhead 54,400 Cost of sales 344,500
348,900 348,900

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Task 4–Job cost cards (showing the resources allocated to the jobs and the allocation of
administration and marketing expenses for the jobs completed in the period. Also
incorporate the revenue for the period and show the profit or loss on those jobs
completed)

Job 0503 Job 0402 Job 0607

Material X
In opening WIP 5,000 10,000 -
In period 44,000 176,000 193,600
49,000 186,000 193,600
Material Y (in period) 200,000 300,000
AT A GLANCE

Grade A labour
In opening WIP 10,000 18,000 -
In period 15,000 30,000 37,500
25,000 48,000 37,500
Grade B labour 10,000 40,000 8,000
Variable overhead
In opening WIP 12,000 21,600
In period 25,500 66,000 51,000
37,500 87,600 51,000
SPOTLIGHT

Fixed overhead
In opening WIP 12,800 23,040
In period 27,200 70,400 54,400
40,000 93,440 54,400
Machine hire 5,000
Factory cost 361,500 760,040 344,500
Administration and 72,300 68,900
marketing @ 20%
Cost of sale 433,800 413,400
STICKY NOTES

Contract price 500,000 600,000

Profit 66,200 186,600

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Task 5– Journal entries to record costs in the general ledger (Assuming that the company
operates a system using a control account in its general ledger for jobs show the double
entry (as T-accounts) to account for job activity in the period)
The following journals were not asked for but they are included to help you to understand the
double entry in the general ledger.

Debit Credit
a Issues of Material X
WIP control account 418,000
Inventory control account 418,000
b Returns of Material X

AT A GLANCE
Inventory control account 4,400
WIP control account 4,400
c Issues of Material Y
WIP control account 500,000
Inventory control account 500,000
d Grade A labour
WIP control account 82,500
Payroll control account 82,500

SPOTLIGHT
e Grade B labour
WIP control account 58,000
Payroll control account 58,000
f Variable overhead
WIP control account 142,500
Variable overhead account 142,500
g Fixed overhead

STICKY NOTES
WIP control account 152,000
Fixed production overhead account 152,000
h Hire cost
WIP control account 5,000
Cash 5,000
i Transfer of costs on completed sales
Cost of sales account
Job 0503 361,500
Job 0607 344,500
706,000
WIP control account 706,000

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WIP control
Rs. Rs.
Balance b/d
Job 0503 39,800
Job 0402 72,640
112,440
a) Inventory control 418,000 b) Inventory control 4,400
c) Inventory control 500,000
d) Payroll control 82,500
e) Payroll control 58,000
AT A GLANCE

f) Var. overhead 142,500

g) Fixed overhead 152,000
h) Hire cost 5,000 i) Cost of sales 706,000
Balance c/d 760,040
1,470,440 1,470,440
Balance b/d 760,040

Cost of sales
Rs. Rs.
SPOTLIGHT

i) WIP control a/c 706,000

Fixed production overhead

Rs. Rs.
Balance b/d 161,000 g) WIP control a/c 152,000
(Actual spend)

We now need to recognize the following entries. Once again journals are provided for your
convenience.

Debit Credit
STICKY NOTES

j Administration and marketing mark-up (20% of

cost of sales figure)
Profit & Loss (20% of 706,000) 141,200
Administration and marketing control a/c 141,200
Note that this is the same sum of the two figures shown
on the job cost card in task 4 (72,300 + 68,900)
k Transfer of balance on cost of sales to the income
statement
Income statement 706,200
Cost of sales account 706,200
l Under recovery of fixed production overhead
Income statement (161,000 – 152,000) 9,000
Fixed production overhead account 9,000

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Debit Credit
m Over recovery of administration and marketing
overhead
Administration and marketing control a/c 11,200
Income statement (141,200 – 130,000) 11,200
n Recognition of revenue on finished jobs
Receivables (500,000 + 600,000) 1,100,000
Income statement 1,100,000
 Example-04:
Ahmer and Company is engaged in production of engineering parts. It receives bulk orders from

AT A GLANCE
bicycle manufacturers and follows job order costing. On July 1, 20X3 two jobs were in progress
whereas two jobs were opened during the year. The details are as follows:

JOBS
A B C D
Work in process – opening (Rs.) 1,400,000 2,500,000 - -
Raw material issued from stores (Rs.) 800,000 1,200,000 1,500,000 600,000
Direct labour hours worked (Hours) 20,000 30,000 15,000 18,000
Rate of direct labour per hour (Rs.) 20 18 16 15
Other related information is as follows:
i. Factory overhead is applied to the jobs at Rs. 10 per labour hour.

SPOTLIGHT
ii. Actual factory overheads for the year amounted to Rs. 900,000.
iii. Under/over applied factory overheads are charged to profit and loss account.
iv. Job A was completed during the year. All the goods were shipped to the customers.
v. Job B was also completed during the year. However, about 10% of the goods were
rejected during inspection. These were transferred to Job C where they will be used
after necessary adjustments.
Journal entries to record all the above transactions can be prepared as follows:

General Journal entries

STICKY NOTES
Date Particulars Ledger Debit Credit
folio
1 Work in process –Job A 800,000
Work in process –Job B 1,200,000
Work in process –Job C 1,500,000
Work in process –Job D 600,000
Materials control 4,100,000
(Issuance of raw material to WIP)
2 Work in process –Job A (20,000 x 20) 400,000
Work in process –Job B (30,000 x 18) 540,000
Work in process –Job C (15,000 x 16) 240,000

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General Journal entries

Date Particulars Ledger Debit Credit
folio
Work in process –Job D (18,000 x 15) 270,000
Salaries & Wages control 1,450,000
(Direct labour cost allocated to WIP)
3 Work in process –Job A (20,000 x 10) 200,000
Work in process –Job B (30,000 x 10) 300,000
Work in process –Job C (15,000 x 10) 150,000
AT A GLANCE

Work in process –Job D (18,000 x 10) 180,000

Production overhead control 830,000
(Factory overheads applied to WIP @ Rs. 10
per direct labour hours)
4 Profit and loss account (900,000-830,000) 70,000
Factory overheads Control 70,000
(Factory overheads applied transferred to
overheads control a/c and under applied
overheads charged to P&L account)
SPOTLIGHT

5 Finished goods A 2,800,000

(1,400,000+800,000+400,000+200,000)
Work in process –Job A 2,800,000
(Job A completed and transferred to
finished goods)
6 Finished goods B 4,086,000
90% of
(2,500,000+1,200,000+540,000+300,000)
STICKY NOTES

Work in process –Job C 454,000

10% of
(2,500,000+1,200,000+540,000+300,000)
Work in process –Job B 4,540,000
(Job B completed and transferred to
finished goods, 10% rejected items
transferred to Job C)
7 Cost of goods sold 6,886,000
Finished goods A 2,800,000
Finished goods B 4,086,000
(Jobs A and B delivered and transferred to
cost of goods sold.)

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2. SERVICE COSTING
2.1 The nature of services and operations
It is usual to explain costing in terms of how to calculate and record the costs of manufactured products. However,
many business entities do not make and sell products; they provide services.
Service organization do not make or sell tangible goods. Services are any activity carried out by a party to the
benefit of another that is essentially intangible and does not result in the ownership of anything.
Examples include hotel services, consultancy services, legal and accounting services, providers of telephone
services (telecommunications companies), providers of television and radio channels, entertainment services,
postal services, medical services, and so on.

AT A GLANCE
Characteristics of services
These are major characteristics of services:
• Intangibility: They do not have a physical substance unlike goods. They have no physical existence.
• Inseparability: Consumption and creation of a service cannot be separated. Services are consumed as they
are created. A service does not exist until it is consumed by the person being served.
• Variability: Services face the problem of maintaining consistency in the standard of output. Goods can
usually be supplied to a standard specification. This is more difficult to achieve for services, because each
service is distinct from other service(s).
• Perishability: Services cannot be stored. They do not have a shelf life.
• Lack of ownership: Services do not result in the transfer of property in anything. The purchase of a service

SPOTLIGHT
only confers on the customer a temporary benefit.
• Heterogeneous: a haircut is heterogeneous and so the exact service received will vary each time, not only
will two hairdressers cut hair differently, but a hairdresser will not consistently deliver the same standard
of haircut.

Operations
Operations are activities. Like services, they do not result in a finished product to sell to customers. Examples of
operations include a customer service center taking telephone calls and e-mails from customers, and the staff
canteen providing meals to employees.

STICKY NOTES
2.2 Service costing, product costing and job costing compared
Costs can be established for services, such as hotel accommodation, telephone calls, auditing work, holidays and
travel, and so on. The costs of a service are the sum of direct materials, direct labour, direct expenses (if any) and
a share of operational overheads.
Costs can also be established for operations, in a similar way.
Service costing differs from costing in manufacturing industries in several ways.
• There is no production system; therefore, there are no production overheads.
• Direct materials costs are often a fairly small proportion of total costs (for example, the direct materials costs
to a telecommunications company of providing telephone services are very small).
• In some service industries, direct labour costs are high (for example, in the film-making industry,
accountancy and investment banking).
• General overhead costs can be a very high proportion of total costs.
• Inventory is usually very small; therefore, absorption costing is usually of little or no value for management
information purposes.

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Not all entities that provide services will use service costing. The purpose of service costing is to provide
information to management about the costs of different services that the entity provides, and the profitability of
each of the different services. Each service should be fairly standard. If they are not standard services, it is more
sensible to use job costing to calculate the cost of each ‘job’ of service. For example:
• Service costing might be used by a hospital to record or calculate the cost of each of the different services
provided by the hospital, such as the cost of treating a patient for a particular condition such as cardiac
arrests etc.
• Job costing might be used by a professional firm such as a firm of accountants or solicitors, where the cost of
each job depends largely on the amount of time spent on each job by the professional staff.

2.3 Cost units in service costing: composite cost units

One of the main problems with service costing is that it can be difficult to identify a suitable cost unit for the
AT A GLANCE

service. It is often appropriate to use a composite cost unit in service costing. It is known as composite cost unit
like in railway industry where cost is calculated on the basis of passenger/km. This is a cost that is made up from
two variables, such as a cost per man per day (a cost per ‘man/day’). Here, the two variables are ‘men’ (the
number of employees) and ‘days’.
Examples of composite cost units used in service costing are as follows:
• The cost per room per night. This is a useful unit cost in the hotel services industry.
• The cost per passenger mile or the cost per passenger kilometer (the average cost of transporting a
passenger for one mile or one kilometer). This unit measure of cost is used by transport companies that
provide bus or train services.
• The cost per ton mile delivered (the average cost of transporting one ton of goods for one mile). This unit
cost is commonly used for costing freight services and delivery operations.
SPOTLIGHT

• The cost per patient/day (the average cost of treating one patient for one day) or the cost per hospital
bed/day (the cost of maintaining one hospital bed in a hospital for one day). These costs are used by health
service providers.
• The cost per man day. This unit cost is widely used in professional services, such as auditing, legal services
and consultancy services.
Composite cost units can be used in addition to a ‘job costing’ type of service costing system. For example, a firm
of accountants might calculate the cost of each job performed for a client. In addition, it might calculate the
average cost per man day for the professional services such as taxation, auditing, consultancy etc. that it provides.
• The cost of each service ‘job’ enables management to monitor costs and profits on individual jobs for a
customer.
STICKY NOTES

• The composite cost, which is an average cost for all ‘jobs’ allows management to monitor the general level
of costs.

2.4 Calculating the cost per unit of service (or operation)

The cost of a service unit (or composite cost unit) is calculated as follows.
 Formula

Total costs of the service

Cost per unit of service
Number of units of service

In case of absorption cost, total costs include direct material, direct labour and production overheads whereas
in marginal cost, total costs include direct material, direct labour and variable production overheads.

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The total number of service units might be a bit more difficult to calculate. Here are a few examples.
 Example 05:
A hotel has 80 standard twin-bedded rooms. The hotel is fully-occupied for each of the 350 days
in each year that it is open. The total costs of running the hotel each year are Rs. 3,360,000.
What would be a useful measure of the cost of providing the hotel services?
A useful unit cost is the cost per room/day. This is the average cost of maintaining one room in
the hotel for one day.
Room available in a year = 80 rooms × 350 days = 28,000
Cost per room/day = Rs. 3,360,000/28,000 = Rs 120.
 Example 06:

AT A GLANCE
A train company operates a service between two cities, Southtown and Northtown. The distance
between the cities is 400 miles. During the previous year, the company transported 200,000
passengers from Southtown to Northtown and 175,000 passengers from Northtown to
Southtown. The total costs of operating the service were Rs.60 million.
What would be a useful measure of the cost of providing the train service between the two cities?
A useful unit cost is the cost per passenger/mile. This is the average cost of transporting one
passenger for one mile.
Passenger/miles per year = (200,000 × 400) + (175,000 × 400) = 150 million.
Mile = Rs. 60,000,000/150,000,000 = Rs.0.40.

SPOTLIGHT
STICKY NOTES

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3. COMPREHENSIVE EXAMPLES
 Example 01:
RI Limited (RIL) is engaged in the manufacturing of spare parts for industrial machines. RIL
receives bulk orders from its customers and follows job order costing. Following data pertains to
two of the jobs which were started in the month of February 2018:

Job F01 Job F02

Size of job order (Units) 5,400 3,600
Labour hours used 27,500 21,600
Labour rate per hour Rs. 360 Rs. 400
AT A GLANCE

i. Each unit of both jobs require 24 kg of raw material S40. Purchase price of S40 was Rs.
30 per kg.
ii. The inventory of S40 at beginning and end of the month was Rs. 2,940,000 and Rs.
1,740,000 respectively.
iii. Wages were paid on 28 February 2018. Income tax withheld from the wages amounted
to Rs. 500,000 which would be deposited in government treasury in the following
month.
iv. Job F01 was in process at month-end. However, Job F02 was completed during the
month of February and finished goods were sent to warehouse. During the delivery to
the customer, 500 units were damaged badly and their realizable value is 50% of the
cost.
SPOTLIGHT

Total labour hours utilized during the month were 100,000. Factory overheads are applied at Rs.
120 per direct labour hour. Under/over applied factory overheads are charged to cost of sales at
month-end. Total actual factory overheads amounted to Rs. 11,000,000, out of which 40% were
fixed.
Required: Prepare journal entries to record the transactions for the month of February 2018.
Solution
Journal entries to record the transactions for the month of February 2018 can be prepared as
follows:
Journal entries
STICKY NOTES

Debit Credit
Date Particulars
----- Rs. in '000 -----
1 Materials control (W-1) 5,280
Supplier/cash 5,280
(Purchased raw material)
2 Work in process -JobF01 (W-1) 3,888
Work in process -JobF02 (W-1) 2,592
Materials control 6,480
(Allocated raw material consumed to the jobs)
3 Work in process -JobF01 (27,500×360) 9,900
Work in process -JobF02 (21,600×400) 8,640
Payroll 18,540

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Debit Credit
Date Particulars
----- Rs. in '000 -----
(Allocated direct labour to the jobs)
4 Payroll 18,540
Accrued payroll tax 500
Bank/Cash 18,040
(Paid of payroll)
5 Work in process -JobF01 (27,500×120) 3,300
Work in process -JobF02 (21,600×120) 2,592
Factory overheads applied 5,892

AT A GLANCE
(Applied factory overheads to the jobs @ Rs. 120 per
direct labour hour)
6 Finished goods (2,592+8,640+2,592) 13,824
Work in process -JobF02 13,824
(Transferred WIP of job F02 to finished goods)
7 Damaged goods inventory (at NRV) 960
(13,824/3,600×500×50%)
Abnormal loss - P&L (13,824/3,600×500×50%) 960
Finished goods 1,920

SPOTLIGHT
(Recorded 500 damaged units)
8 Cost of sales (13,824–1,920) 11,904
Finished goods 11,904
(Transferred total finished goods to cost of sales)
9 Factory overheads applied (100,000×120) 12,000
Cost of sales (overhead over applied) 1,000
Factory overheads control 11,000
(Transferred applied factory overheads to control
a/c and charged under applied overheads to cost of

STICKY NOTES
sales)
10 Factory overheads control 11,000
Cash/suppliers 11,000
(Recorded actual factory overheads incurred)

W-1: Purchase of raw materials Rs. In 000

Material consumption - F01 (5,400×24×30) 3.888.00
Material consumption - F02 (3,600×24×30) 2,592.00
Add: Closing stock of raw material Given 1,740.00
Less: Opening stock of raw material Given (2,940.00)
Purchases - Raw material 5,280.00

 Example 02:

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Modern Engineering Workshop (MEW) is engaged in production of customized spare parts of

textile machinery. The following information pertains to the jobs worked by MEW during the
month of June 2014:

Job 101 Job 202

Size of job order 4,000 units 5,000 units

------------ Rs. in ‘000 ------------
Opening work in process 15,000 -
Raw material consumed 10,000 31,000
Direct labour used (Rs. 100 per hour) 5,000 8,000
AT A GLANCE

i. Overheads are applied to jobs at Rs. 25 per direct labour hour. Under/over applied
overheads are transferred to cost of sales.
ii. Job 101 was completed during the month and the goods were sent to the warehouse for
delivery to the customer. During the transfer to the warehouse, 160 units were damaged.
Net realizable value of the damaged units was Rs. 500,000. Remaining units were
transferred to the customer.
iii. Job 202 is in process; however, 2,000 units are fully complete and were transferred to
the warehouse during the month while 3,000 units are 70% complete as at 30 June 2014.
iv. Actual overheads for the month of June 2014 amounted to Rs. 4,000,000.
Required: Prepare journal entries to record the above transactions.
SPOTLIGHT

Solution
In order to prepare journal entries to record the above transactions, please see below:

Journal entries
Debit Credit
Date Particulars
Rs. in '000
1 Work in process Job # 101 10,000
Work in process Job # 202 31,000
STICKY NOTES

Materials control 41,000

(Raw material consumed for jobs)
2 Work in process Job # 101 5,000
Work in process Job # 202 8,000
Payroll 13,000
(Direct labour cost allocated to jobs)
3 Work in process Job # 101 1,250
5,000/100*25
Work in process Job # 202 2,000
8,000/100*25
Factory overheads applied 3,250

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Journal entries
Debit Credit
Date Particulars
Rs. in '000
(Overheads applied to the jobs @ Rs. 25 per direct
labour hour)
4 Factory overheads applied 3,250
Cost of sales – overhead under applied 750
(4,000–3,250)
Factory overheads control 4,000

AT A GLANCE
(Transfer of applied factory overheads to control
a/c and under applied overheads charged to cost
of sales)
5 Finished goods (Job # 101) 30,000
(15,000+10,000+5,000+1,250)*3,840/4,000
Damaged goods (at NRV) 500
Profit and loss account (damaged goods cost 750
exceeding NRV) (31,250×160/4,000)-500
Work in process Job # 101 31,250
(WIP of Job order # 101 transferred to finished

SPOTLIGHT
goods)
6 Cost of sales 30,000
Finished goods 30,000
(Finished goods of Jobs # 101 transferred to cost
of sales)
7 Finished goods 20,000
(31,000+8,000+2,000)/(2,000+3,000*0.7)*2,000
Work in process Job # 202 20,000

STICKY NOTES
(Units fully completed for Job # 202 transferred
to finished goods)

 Example 03:
The Composite Manufacturing Company uses job order costing. At the beginning of May, two jobs were
in process:

Job 469 Job 475

-------------Rs. In ‘000---------------

Materials 9,000 7,500

Direct labour 4,200 3,300

Applied production overhead 6,300 4,950

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There was no inventory of finished goods on May 1. During the month Job 476 to 481 were started.
Materials requisitions for May totaled Rs. 55,300; direct labour cost Rs. 48,600 and actual production
overheads Rs. 75,000. Production overhead is absorbed at the rate of 150% of direct labour cost.
The only job still in process at the end of May is Job 481, with costs of Rs. 5,900 for materials and Rs.
4,200 for direct labour.
Job 479, the only finished job on hand at the end of May, has a total cost of Rs. 9,500.
Required

Prepare:
(a) T accounts for work in process, finished goods, cost of goods sold and factory overhead control.
AT A GLANCE

(b) General entries to record the cost of goods manufactured, cost of goods sold and closing of over or
under absorbed production overheads to cost of goods sold,
Solution
(a)

Work in process control

Rs. In ‘000 Rs. In ‘000
Balance b/d W-1 35,250 Finished goods (Bal. Fig.) 195,650
Materials control 55,300
SPOTLIGHT

Salaries & wages control 48,600

Production overhead control
(48,600 x 150%) 72,900 Balance c/d W-2 16,400
212,050 212,050
Finished goods
Rs. In ‘000 Rs. In ‘000
Work in process control 195,650 Cost of sales (Bal. Fig.) 186,150
Balance c/d 9,500
195,650 195,650
STICKY NOTES

Cost of goods sold

Rs. In ‘000 Rs. In ‘000
Finished goods 186,150
Production overheads control 2,100 Profit & Loss account 188,250
188,250 188,250
Production overheads control
Rs. In ‘000 Rs. In ‘000
Cash or payables (Actual) 75,000 Work in process control 72,900
Cost of sales 2,100
75,000 75,000

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W-1 Opening Inventory of WIP Job 469 Job 472 Total

---------Rs. In ‘000------------
Materials 9,000 7,500 16.500
Direct labour 4,200 3,300 7,500
Applied production overhead 6,300 4,950 10,250
Total 19,500 15,750 35,250

W-2 Closing Inventory of WIP-Job 481 Rs. In ‘000

AT A GLANCE
Materials 5,900
Direct labour 4,200
Applied production overhead (4,200 x 150%) 6,300
Total 16,400

(b) Journal entries

Debit Credit
Date Particulars

SPOTLIGHT
Rs. in '000
Finished goods 195,650
Work in process control 195,650
(Recording of cost of goods manufactured)
Cost of goods sold 186,150
Finished goods 186,150
(Recording of cost of goods sold)
Cost of goods sold 2,100

STICKY NOTES
Production overhead control 2,100
(Closing of under absorbed production
overheads)

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 Example 04:
Best Products Limited, provided the following data for January 2021.

Rs. In 000

Materials:
Inventory, January 1, 2021 12,000
Purchases on account 36,000
Labour:
Accrued, January 1, 2021 3,600
Paid during January 30,000
AT A GLANCE

Factory overhead costs:

Supplies (issued from materials) 1,800
Indirect labour 4,200
Depreciation 1,200
Other production overheads (all from outside suppliers on account) 17,400

Job A Job B Job C

Work in process:
Rs. In ‘000
Work in process January 1, 2021 1,200 - -
Jobs costs during January, 2021:
SPOTLIGHT

Direct materials 4,800 7,200 6,000

Direct labour 6,000 9,600 8,400
Absorbed production overheads 6,000 9,600 8,400

Job A: Started in December, 2020, finished during January and sold to customer for Rs. 25,200,000.
Job B: Started in January, 2021, not yet finished.
Job C: Started in January 2021, finished during January 2021 and now in the finished goods warehouse
awaiting customer’s disposition. There was no finished goods inventory at start of January, 2021.
Required
STICKY NOTES

Prepare relevant ledger accounts for the month of January, 2021.

 Solution

Materials control
Rs. In ‘000 Rs. In ‘000
Balance b/d 12,000 Production overheads control 1,800
Accounts payable 36,000 Work in process –Job A 4,800
Work in process –Job B 7,200
Work in process –Job C 6,000
Balance c/d 28,200
48,000 48,000

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Work in process –Job A

Rs. In ‘000 Rs. In ‘000
Balance b/d 1,200
Materials control 4,800
Payroll 6,000
Production overhead control 6,000 Finished goods 18,000
18,000 18,000
Work in process –Job B
Rs. In ‘000 Rs. In ‘000
Materials control 7,200

AT A GLANCE
Payroll 9,600
Production overhead control 9,600 Balance c/d 26,400
26,400 26,400
Work in process –Job C
Rs. In ‘000 Rs. In ‘000
Materials control 6,000
Payroll 8,400
Production overhead control 8,400 Finished goods 22,800
22,800 22,800

SPOTLIGHT
Finished Goods
Rs. In ‘000 Rs. In ‘000
Work in process- Job A 18,000 Cost of sales 18,000
Work in process- Job B 22,800 Balance c/d 22,800
40,800 40,800
Production overheads control
Rs. In ‘000 Rs. In ‘000
Materials control 1,800 Work in process –Job A 6,000

STICKY NOTES
Payroll 4,200 Work in process –Job B 9,600
Accumulated depreciation 1,200 Work in process –Job C 8,400
Accounts payable 17,400 Cost of sales 600
24,600 24,600
Payroll
Rs. In ‘000 Rs. In ‘000
Accrued payroll 28,200 Work in process –Job A 6,000
Work in process –Job B 9,600
Work in process –Job C 8,400
Production overheads 4,200
28,200 28,200

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Accrued Payroll
Rs. In ‘000 Rs. In ‘000
Cash 30,000 Balance b/d 3,600
Balance c/d 1,800 Payroll 28,200
31,800 31,800
Cost of sales
Rs. In ‘000 Rs. In ‘000
Finished goods 18,000
Production overheads control 600 Profit and Loss 18,600
18,600 18,600
AT A GLANCE

Sales
Rs. In ‘000 Rs. In ‘000
Profit and Loss 25,200 Accounts receivables 25,200
25,200 25,200
SPOTLIGHT
STICKY NOTES

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STICKY NOTES

Job costing is a costing method used where each cost unit is separately
identifiable. The work is undertaken to customer’s specific requirements and
the job is of short duration. The main focus of Job costing is to calculate cost of
a specific job or batch.

Costs for each job are collected on a job cost card. Costs includes Material,
labour and overheads. Overheads are absorbed in to the cost of jobs using
AT A GLANCE

pre-determined overhead absorption rates.

Service costing can be used by companies operating in a service industry

often by companies wishing to establish the cost of services carried out by
some of their departments

Service costing differs from the other costing methods. With many services
the cost of direct materials consumed will be relatively small compared to the
SPOTLIGHT

labour, direct expenses and overheads cost.

STICKY NOTES

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 CHAPTER 7

PROCESS COSTING

AT A GLANCE
IN THIS CHAPTER Process Costing is used where production is a continuous
process and it is not possible to identify separate units of
AT A GLANCE Production.

AT A GLANCE
SPOTLIGHT The output of one process is the input to a subsequent
process until product is transferred to Finished Goods.
1. Introduction to Process costing, There is often a loss in process which is called normal loss
2. Normal and Abnorml Losses due to spoilage, wastage, evaporation etc.
3. Abnormal Gain If actual loss is greater than normal loss the difference is
called abnormal loss and if actual loss is less than normal
4. Process Costing With Closing Work In loss, we treat the difference as abnormal gain.
Progress
Losses and Gain can occur at different stages in the
5. Opening Work In Progress process
6. Work in Progress and losses Loss or spoilage may have a scrap value; the scrap value

SPOTLIGHT
7. Losses and Gain at differenet stages of normal loss will probably be deducted from the cost of
in the process material in the process.
8. Cost of Rework The scrap value of abnormal loss (or abnormal Gain) will
probably be set off against its cost, in an abnormal loss and
9. Comprehensive Examples abnormal gain account, and only the balance on the
account will be written to the P & L account at the end of
STICKY NOTES the period.
Process account may have closing and opening WIP, there
are two methods to deal with opening WIP – FIFO and
Weighted Average.

STICKY NOTES

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1. INTRODUCTION TO PROCESS COSTING

1.1 Process costing
A process costing system is used in those industries where masses of similar products or services are produced.
Products are produced in the same manner and consume the same amount of direct costs and overheads. It is,
however, difficult to assign costs to individual units of output. The completed product may take several process
and in this case, the output of one process is the input to a subsequent process until a completed product is
produced.
Examples, of manufacturing industries where process costing is widely used, are:
• chemicals manufacturing;
• petroleum refining

AT A GLANCE
• the manufacture of liquids;
• brewing industry and
• the continuous processing of high volumes of low-cost food items such as tins of peas or beans, or bottles of
tomato ketchup.
In these types of production process, losses in process might occur and there are often problems in measuring
exactly the amount of unfinished work-in-process at the end of a period. The losses and their accounting
treatment are discussed in later section of this chapter.
The basic principle of costing is the same as for other types of costing. The cost of a unit of output from a process
is measured as the total cost of resources consumed by the process divided by the total units produced.

1.2 Features of Process Costing

SPOTLIGHT
Process costing provides a system of costing where any or all of these characteristics occur.
• The output of one process is the input to a subsequent process until conversion into finished product.
• Output is normally measured in total quantities, such as tones or liters produced, or in very large quantities
of small units (such as the number of cans or tins).
• Materials might be added in full at the start of a process or sometimes during specific percentage of
completion or might be added gradually throughout the process. The materials are processed to produce the
final output. In a process costing system, it is usual to distinguish between:
o direct materials; and
o conversion costs, which are direct labour costs and production overheads.

STICKY NOTES
• There might be losses in the process (due to evaporation, spoilage, wastage or chemical reaction) so the
quantity of output might therefore be less than the quantity of materials input. Process costing provides a
system of costing that allows for expected losses in the manufacturing process.
• When there is a continuous production process there will usually be closing work in process and it is difficult
to measure the quantity of work-in-process (incomplete production) at the end of a financial period. Process
costing provides a method of measuring and costing incomplete WIP.
• Output from production might be a single product, but there may be joint products and by products.
• In some process manufacturing systems, there is a series of sequential processes. For example, a
manufacturing system might consist of three consecutive processes: raw materials are input to Process 1,
then the output from Process 1 goes onto the next process (Process 2) and the output from Process 2 then
goes into a final process, Process 3. The output from Process 3 is the final product. Each process is different
and all these characteristics do not occur in all processes.

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1.3 Flow of cost in process costing and comparison with Job order costing
The major differences between process costing and job order costing is that in process costing production moves
from one process to subsequent process, until final completion occurs. Final product is then transferred to
finished goods after accumulation cost process. Whereas in job order costing, cost to each job is assigned
separately and transferred to finished goods after completion of independent job.
The cost accumulation procedure follows this production flow and control accounts are established for each
department or process and all direct and indirect costs are assigned to each process. The cost of first process is
transferred to second process and accumulates with cost of second process. This cost accumulation procedure
continues, until goods are completed and transferred to finished goods.

1.4 The basics of Process Costing

Where a series of separate processes is required to manufacture the finished product the output of one process

AT A GLANCE
becomes the input to the next until the final output is made in the final process. For example, if two processes
are required the accounts would be like this.
 Illustration:
Simple process account

Process 1 Account
Units Rs. Units Rs.
Materials 100 1,000
Transfer to
Conversion cost 500 Process 2 100 1,500

SPOTLIGHT
100 1,500 100 1,500

Process 2 Account
Units Rs. Units Rs.
Material from process 1 100 1,500

Added materials 50 500

Direct labour 700
Output to

STICKY NOTES
Production overhead 400 Finished Goods 150 3,100
150 3,100 150 3,100

Note that direct labour and production overhead may be treated together as conversion cost.
Added material, labour and production overheads in process 2 are added gradually throughout
the process. Cost transfer from process 1 to process 2 is treated ‘materials from process 1’ for
Process 2.

1.5 Addition of Materials in Subsequent Process

Many industries that utilize process costing have more than one processes through which the units pass through
before being turned into finished goods e.g. In oil refining the crude oil passes through distillation, reforming,
isomerization etc. before turning into a final finished product.
As the production passes through different products, the finished goods output of one process becomes the raw
materials input of the next process, in addition to the units from the previous process, new materials may also

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be added in the next process. In order to separately distinguish the costs incurred in different processes or
department the cost from the previous process are labelled as “Direct Materials – Process 1”.
 Example 01
ABC company manufactures product A101 which is produced in two processes and following data
represents 500 units produced during the month of March 2019.

Units Rs.
Material input – Process I 500 35,000
Added material – Process II 5,200
Conversion cost – Process I 12,750
Conversion cost – Process II 17,450
AT A GLANCE

There is no losses and work in progress in both processes and all input units are converted into
finished product.
Process I and II accounts for the month of March 2019 are given below:

Process I Account
Units Rs. Units Rs.
Materials 500 35,000
Conversion cost 12,750 Process II 500 47,750
47,750 47,750
SPOTLIGHT

Process II Account
Units Rs. Units Rs.
Materials-Process I 500 47,750
Added material 5,200
Conversion cost 17,450 Finished goods 500 70,400
70,400 70,400
STICKY NOTES

Cost per unit of Product A101 is Rs. 140.80 (70,400/ 500)

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2. LOSSES
2.1. Normal loss
A feature of process manufacturing is that there is often some loss or wastage in production and output quantities
are less than input quantities of materials.
Normal loss is the expected loss in the process due to evaporation of liquids, wastage or rejected units.
 Formula: Normal loss

Normal loss = Quantity of material input − Expected output OR

Quantity of material input = Normal loss + Expected output OR
Expected output = Quantity of material input − Normal loss

AT A GLANCE
Normal loss is usually expressed as a percentage of the input units of materials.
 Example 02:
Normal loss of a process is 10%.
A company puts 5,000 liters into the process.
Normal loss is 10% of 5,000 = 500.
Expected output from the process would be 90% of 5,000 liters = 4,500 liters
Normal loss is unavoidable in the normal course of events. It is inherent in the physical and chemical reactions
that take place in a process.

SPOTLIGHT
2.1.1. Normal loss with no recovery value
The normal losses are inherent to production process and cannot be avoided. Therefore, in process account, if
it has no scrap value (like in case of evaporation), then no cost is assigned (credited) to normal loss in process
account. As consequence, the cost per unit of finished product will increase.
 Example 03:
A person buys one liter tin of soup for Rs. 500.
Normal evaporation during cooking is 10%.
When the soup is ready to eat there is 0.9 liters left.

STICKY NOTES
The person has paid Rs. 500 for 0.9 liters and this is unavoidable.
The implication of this simple example is as follows.
The normal loss is something that is unavoidable in order to get the good output. The cost of the lost units is part
of the cost of obtaining the good output.
All of the cost should be assigned to the good output and none to the normal loss.
The cost of input per liter is Rs. 500 whereas cost of output per liter is Rs. 555.55 as the cost of normal loss is
assigned to good units.
 Formula: Unit cost of good output

Total process costs

Per unit Cost of good output =
Expected units of output

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 Example 04:
The following information relates to a production process:

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,800 liters
Direct materials cost Rs. 3,600
Direct labour cost Rs. 300
Production overhead absorbed Rs. 600
AT A GLANCE

The cost per unit produced can be calculated as follows:

Rs.
Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs.2.50
SPOTLIGHT

 Example 05:

Descriptions Process X Process Y

Materials Added (KGs) 10,000 2,000
Materials (Rs.) 30,000 3,000
Direct Wages (Rs.) 16,000 40,000
Production OH as % of Direct Wages 25% 30%
Normal Loss% 5% 5%
STICKY NOTES

There is no work in process and abnormal losses in both processes. The losses have no scrap
value.
The process X and Process Y accounts are prepared, as follows.

Process X A/c
KGs Rs. KGs Rs.
Direct Materials 10,000 30,000 Normal Loss 500 -
Direct Wages 16,000 Process Y 9,500 50,000
Production OH 4,000
10,000 50,000 10,000 50,000

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Process Y A/c
KGs Rs. KGs Rs.

Process X 9,500 50,000 Normal Loss 575 -

Direct Materials 2,000 3,000 Output 10,925 105,000
Direct Wages 40,000
Production OH 12,000
11,500 105,000 11,500 105,000

Process account in the cost ledger

AT A GLANCE
The process cost account (shown above) is a work-in-progress account for the process. The debit side of the
account records input as direct materials, direct labour costs and production overheads absorbed. The credit
side of the WIP account records the cost of the finished output.
The account also includes memorandum columns for the quantities of direct materials input and the quantities
of output and loss. Normal loss is shown so that the quantities columns add up to the same amount on the debit
or credit sides, but the normal loss has no cost (as it’s cost is built into the cost of output).
Note that it is always useful to draft a process account at the start of an answer as it focuses the mind on
what needs to be done.

2.1.2. Normal loss with recovery value

In some cases, loss units in a process are in physical form and have a scrap value. The normal loss quantity might

SPOTLIGHT
not be physically lost but is changed in some way, so that it is not the same as good output. For example, there
might be some kind of chemical separation with a substance scraped off the top of the liquid in the process and
whatever is scraped off might have a scrap value.
If normal loss has a scrap value, the company is able to recover some of the input costs to the process. The scrap
value reduces the cost of the process.
To reflect this in the process account the normal loss is credited at its scrap value and the calculation of the cost
of good output can be calculated with the help of following formula.
 Formula:
Total process costs − Scrap value of the normal loss
Per unit Cost of good output =

STICKY NOTES
Expected units of output
The concept can be easily understood with the help of following example.
 Example 06:
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,800 liters
Scrap value of normal loss Rs. 0.9 per liter
Direct materials cost Rs. 3,600
Direct labour cost Rs. 300
Production overhead absorbed Rs. 600

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The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Less scrap value of normal loss (200 litres × 0,9) (180)
4,320
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs.2.40
AT A GLANCE

The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Output (actual)
Materials 2,000 3,600 at Rs. 2.4 each 1,800 4,320
Direct labour 300
Prod. O’hd 600 Normal loss 200 180
2,000 4,500 2,000 4,500
SPOTLIGHT

2.1.3. Normal loss with cost of disposal

In other cases, a company might have to pay to dispose-off losses in a process and additional cost might be
incurred to its disposal. The substance scraped off the top of the liquid in the process might be toxic and has to
be disposed-off safely.
The cost of disposal represents an additional cost to the process.
To reflect this in the process account the normal loss is measured at zero but the expected costs of disposal are
debited to the process account.
 Formula:

Total process costs + Disposal costs of the normal loss

STICKY NOTES

Per unit Cost of good output =

Expected units of output

 Example 07:
The following information relates to a production process X

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,800 liters
Disposal cost of normal loss Rs. 1 per liter

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The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Disposal costs of normal loss (200 litres × 1) 200
4,700
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.6111

AT A GLANCE
The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Output (actual) at
Materials 2,000 3,600 Rs. 2.6111 each 1,800 4,700
Direct labour 300
Prod. overhead 600
Disposal cost of

SPOTLIGHT
normal loss 200 Normal loss 200 −
2,000 4,700 2,000 4,700

STICKY NOTES

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2.2. Abnormal Loss

As discussed above, normal loss is the expected amount of loss in a process. However, actual loss might be
more than the expected or normal loss. When actual loss exceeds normal loss, there is abnormal loss. The
difference between total actual loss and normal loss is abnormal loss.
 Formula:
Abnormal loss = Actual loss – Expected (normal) loss
From earlier:
Quantity of material input = Normal loss + Expected output
But:
Expected output = Actual output + Abnormal loss
Therefore:
AT A GLANCE

Quantity of material input = Normal loss + Actual output + Abnormal loss

Total loss = Normal loss + Abnormal loss.
Abnormal loss is not expected and might occur due to negligence, carelessness or natural disaster. It is, therefore,
important to assign it cost. By giving a cost to abnormal loss, management information about the loss can be
provided, and management can be made aware of the extent of any problem that might exist with excessive losses
in process.
2.2.1. Accounting for abnormal loss
If it is assumed that all losses in process occur at the end of the process, units of abnormal loss are cost in exactly
the same way in the as units of finished output. This might seem a little strange but the idea is to highlight the
impact of the loss.
SPOTLIGHT

The cost per unit of abnormal loss is therefore the same as the cost of units of good output. This is exactly the
same as before.
 Formula:
Total process costs − Scrap value of the normal loss
Per unit Cost of good output =
Expected units of output
The cost of units of abnormal loss is treated as an expense for the period, and charged as an expense in the
income statement for the period.
 Example 08:
The following information relates to a production process X.
STICKY NOTES

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,700 liters
Therefore abnormal loss 100 liters

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
Production overheads 600
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.5

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Costing:
Cost of finished output = 1,700 units × Rs.2.50 = Rs.4,250.
Cost of abnormal loss = 100 units × Rs.2.50 = Rs.250.
The process account can be completed as follows
Process X
Liters Rs. Liters Rs.
Output (actual) at
Materials 2,000 3,600 Rs. 2.5 each 1,700 4,250
Direct labour 300 Abnormal loss 100 250

AT A GLANCE
Production overheads 600
Normal loss 200 −
2,000 4,500 2,000 4,500

Abnormal loss can be prepared as follows, assuming that it has no scrap value.
Abnormal Loss Account
Liters Rs. Liters Rs.
Process X 100 250 Profit & Loss A/C 100 250
250 250

SPOTLIGHT
The appropriate abnormal loss double entry in the cost ledger is:

Debit Credit
Abnormal loss account X
Process accounts X

The entry to close the abnormal loss account at period end is:

Debit Credit
Profit and Loss Account X

STICKY NOTES
Abnormal Loss Account X

At the end of the financial period, the balance on the abnormal loss account is written off as a cost in the
costing income statement. Unlike normal loss the cost of abnormal loss is not built into inventory, however,
the cost of abnormal loss is treated as a period cost rather than a product cost.

2.2.2. Abnormal loss with recovery value

When loss has a scrap value, the scrap value of normal loss is deducted from the process cost, as explained
earlier.
Abnormal loss will also have a scrap value but this is treated differently to the scrap value of normal loss.
• The cost of expected units of output is calculated in the usual way and scrap value of abnormal loss will not
affect cost per unit of output.
• The scrap value of normal loss is normal loss units × scrap value per unit (as usual).
• In the process account the cost of abnormal loss is measured at the cost of expected units (just as before).

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• Periodically the units in the normal loss account are transferred to a scrap account at scrap value.
• The balance on the abnormal loss account is an expense for the period (measured at the cost of the units
less the scrap value of abnormal loss).
• This means that scrap value of abnormal loss is set off against the cost of abnormal loss in the abnormal
loss account, not in process account.
 Example: 09:
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
AT A GLANCE

Actual output 1,700 liters

Therefore abnormal loss 100 liters
Scrap value of losses Rs. 0.9 per liter

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Direct labour 300
SPOTLIGHT

Production overheads 600

Scrap value of normal loss (200 × Rs.0.90) (180)
Total production cost 4,320
Expected output (90% of 2,000) ÷1,800 liters
Cost per litre Rs. 2.4

Costing:
Cost of finished output = 1,700 units × Rs. 2.40 = Rs. 4,080.
Cost of abnormal loss = 100 units × Rs. 2.40 = Rs. 240.
STICKY NOTES

Normal loss = 200 units × Rs. 0.9 = Rs. 180

The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Materials 2,000 3,600 Output 1,700 4,080
Direct labour 300 Abnormal loss 100 240
Prod. Overhead 600 Normal loss 200 180
2,000 4,500 2,000 4,500

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Abnormal loss account with scrap value is prepared as follows.

Abnormal loss account

Liters Rs. Liters Rs.
Process X account 100 240 Scrap account 100 90
Income statement 150
100 240 100 240

Scrap account
Liters Rs. Liters Rs.

AT A GLANCE
Process X account
(normal loss) 200 180 Cash 300 270
Abnormal loss
account 100 90
300 270 300 270

The appropriate abnormal loss double entry in the cost ledger is:

Debit Credit

SPOTLIGHT
Abnormal loss account X
Process accounts X

The entry to close the abnormal loss account at period end is:

Debit Credit
Profit and Loss Account X
Scrap account X
Abnormal Loss Account X

STICKY NOTES

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3. ABNORMAL GAIN
Abnormal loss occurs when actual loss is more than the expected (normal) loss. Abnormal gain occurs when the
actual loss is less than normal loss. Abnormal gain is the difference between the expected normal loss and the
actual loss. It might be due to enhanced efficiency of the manufacturing process, if the gain is expected to be
permanent then the expected loss ratio should be revised.
 Formula: Abnormal gain

Abnormal gain = Expected (normal) loss – Actual loss

From earlier:
Expected output = Actual output + Abnormal loss
AT A GLANCE

Gain is opposite in sign so goes to the other side of the expression:

Expected output + Abnormal gain = Actual output

Actual loss = Normal loss – Abnormal gain

3.1. Accounting for abnormal gain: no scrap value for loss

The method of costing for abnormal gain is the same in principle as for abnormal loss. If it is assumed that all
losses occur at the end of the process, the cost per unit of finished output and the value/cost of abnormal gain
are calculated as the cost per expected unit of output. (i.e. the cost of good output)
The unit cost credited to abnormal gain is therefore the same as the cost of units of good output. This is exactly
the same as before.
SPOTLIGHT

 Formula: Cost of good output

Total process costs − Scrap value of the normal loss

Per unit Cost of good output =
Expected units of output

The differences between costing for abnormal loss and costing for abnormal gain are that:
• Abnormal gain is a benefit rather than an expense. Whereas abnormal loss is written off as a cost at the end
of the financial period, abnormal gain is an adjustment that increases the profit for the period.
• Abnormal gain account has credit balance and is recorded as a debit entry in the process account, because
STICKY NOTES

it is a benefit.
• The other side of the double entry is recorded in an abnormal gain account. At the end of the period, the
balance on the abnormal gain account is then transferred to the income statement as a benefit for the
period, adding to profit.
 Example 10:
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
Actual output 1,850 liters
Therefore abnormal gain 50 liters

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The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
Conversion costs (direct labour + production overheads) 900
Total production cost 4,500
Expected output (90% of 2,000) ÷1,800 litres
Cost per litre Rs. 2.5

Costing:
Cost of finished output = 1,850 units × Rs. 2.50 = Rs. 4,625.

AT A GLANCE
Cost of abnormal gain = 50 units × Rs. 2.50 = Rs. 125.
Normal loss = zero (as there is no scrap value).
The process account can be completed as follows
Process X
Liters Rs. Liters Rs.
Materials 2,000 3,600 Output 1,850 4,625
Conversion cost 900
Abnormal gain 50 125 Normal loss 200 nil
2,050 4,625 2,050 4,625

SPOTLIGHT
Abnormal gain account
Liters Rs. Liters Rs.
Income statement 50 125 Process X 50 125
50 125 50 125

The balance on this account is taken to the costing income statement at the end of the period,

STICKY NOTES
and added to the reported profit.
The appropriate double entry in the cost ledger is:

Debit Credit
Process account X
Abnormal gain account X

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3.2. Abnormal gain where loss has a scrap value

When loss has a scrap value, the value of abnormal gain is actually less than the amount shown in the process
account. The process has been more efficient and produced more good output than expected but there are less
normal loss units so the revenue from scrap is less than expected.
Accounting for the scrap value of abnormal gain is similar to accounting for the scrap value of abnormal loss.
• In the process account (WIP), abnormal gain is valued at the cost per expected unit of output.
• The scrap value of normal loss is normal loss units × scrap value per unit (as usual).
• The scrap value of abnormal gain is recorded as a debit entry in the abnormal gain account (in a similar way
to recording the scrap value of abnormal loss as a credit entry in the abnormal loss account).
• The scrap value of the abnormal gain is set off against the value of the abnormal gain in the abnormal gain
account, not in process account.
AT A GLANCE

• The balance on the abnormal gain account is the net value of abnormal gain (value of abnormal gain minus
the scrap value not earned from the normal loss). This balance is transferred as a net benefit to the cost
accounting income statement at the end of the accounting period.
 Example 11:
Abnormal gain where loss has scrap value.
The following information relates to a production process X.

Input quantities 2,000 liters

Normal loss 10%
Therefore expected output 1,800 liters
SPOTLIGHT

Actual output 1,850 liters

Therefore abnormal gain 50 liters

Scrap value of losses Rs. 0.9 per liter

The cost per unit produced can be calculated as follows: Rs.

Direct materials 3,600
STICKY NOTES

Direct labour 300

Production overheads 600
Scrap value of normal loss (200 × Rs.0.90) (180)
Total production cost 4,320
Expected output (90% of 2,000) ÷1,800 liters
Cost per litre Rs. 2.4

Costing:
Cost of finished output = 1,850 units × Rs. 2.40 = Rs. 4,440.
Cost of abnormal gain = 50 units × Rs. 2.40 = Rs. 120.
Normal loss = 200 units × Rs. 0.90 = Rs. 180.

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The process account can be completed as follows

Process X
Liters Rs. Liters Rs.
Materials 2,000 3,600 Output 1,850 4,440
Conversion cost 900
Abnormal gain 50 120 Normal loss 200 180
2,050 4,620 2,050 4,620

Accounting for the abnormal gain and the normal loss

The double entry to account for the losses can be completed as follows

AT A GLANCE
Abnormal gain account
Liters Rs. Liters Rs.
Process X
Scrap account 50 45 account 50 120
Income statement 75
50 120 50 120

The balance on this account is Rs.75. This is treated as an addition to profit in the cost
accounting income statement for the period.

SPOTLIGHT
Scrap account
Liters Rs. Liters Rs.
Process X a/c (normal 200 180 Abnormal gain 50 45
loss) account
Cash 150 135
200 270 200 180

The company expected to be able to sell 200 liters of scrap product. The abnormal gain means
that they only have 150 liters to sell. The scrap value of 50 liters is adjusted against abnormal
gain account.

STICKY NOTES
 Example 12:
AK chemicals process high quality plastic sheeting in a continuous manufacturing operation. All
materials are input at the beginning of the process. Conversion costs are incurred evenly
throughout the process. The cost in process is given in the following table.

Process
Rs.
Materials cost 90,000
Conversion costs 72,650

40,000 units were put into process and 36,000 units were transferred to finished goods. There is
no opening or closing work in progress. Past experience indicates that approximately 7.5% of the
units started are found to be defective on inspection by quality control. The scrap value of loss is
Rs. 1.80 per unit.

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Process account and abnormal loss account is prepared as below.

Process Account
Units Rs. Units Rs.
Materials 40,000 90,000 Normal loss 3,000 5,400
Conversion cost 72,650 Abnormal loss 1,000 4,250
Finished goods 36,000 153,000
40,000 162,650 40,000 162,650

Calculation of cost per unit = (162,650 – 5,400) / 37,000 = Rs. 4.25

Cost assigned to output (Finished goods) = 36,000 x 4.25 = Rs. 153,000
AT A GLANCE

Cost assigned to Abnormal Loss = 1,000 x 4.25 = Rs. 4,250

Abnormal loss account
Units Rs. Units Rs.
Process account 1,000 4,250 Scrap account 1,000 1,800
Income statement 2,450
1,000 4,250 1,000 4,250
 Example 13:
HL Limited manufactures product B201 which was produced in two processes i.e. Process A
and Process B.
SPOTLIGHT

Relevant data for the month of April 2020 is given below.

Process A Process B
Units started/ received from process A 60,000 55,000
Units lost in process 5,000 2,500
Units transferred to Process B/ Finished goods 55,000 52,500
Normal Loss in % 5% 5%
Cost data: Rupees Rupees
Materials 65,200 -
Conversion cost 102,500 35,600
STICKY NOTES

There shall be no work in progress in both process. Scrap value of losses in process A is Rs. 0.80
per unit whereas in process B Rs. 1.20 per unit. Assuming all losses were occurred at end of
both process.
Process A, Process B and Abnormal loss/ gain accounts for the month of April 2020 are
prepared, as under.

Process I Account
Units Rs. Units Rs.
Materials 60,000 65,200 Normal loss 3,000 2,400
Conversion cost 102,500 Abnormal loss 2,000 5,800
Finished goods 55,000 159,500
60,000 167,700 60,000 167,700

Calculation of cost per unit = (167,700 – 2,400) / 57,000 = Rs. 2.90

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Cost assigned to normal loss = 3,000 x 0.80 = Rs. 2,400

Cost assigned to output (Finished goods) = 55,000 x 2.90 = Rs. 159,500
Cost assigned to Abnormal Loss = 2,000 x 2.90 = Rs. 5,800

Process II Account
Units Rs. Units Rs.
Process I- Materials 55,000 159,500 Normal loss 2,750 3,300
Conversion cost 42,350
Abnormal gain 250 950 Finished goods 52,500 199,500
55,250 202,800 55,250 202,800

AT A GLANCE
Calculation of cost per unit = (201,850 – 3,300) / 52,250 = Rs. 3.80
Cost assigned to normal loss = 2,750 x 1.20 = Rs. 3,300
Cost assigned to output (Finished goods) = 52,500 x 3.80 = Rs. 199,500
Cost credited to Abnormal Gain = 250 x 3.80 = Rs. 950

SPOTLIGHT
STICKY NOTES

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4. PROCESS COSTING WITH CLOSING WORK IN PROGRESS

4.1. Sharing out process costs between finished units and unfinished inventory
When manufacturing is a continuous process, there may be unfinished work-in-progress (WIP) at the start and
end of a period. This section looks at closing WIP, whereas opening WIP will be dealt later in this chapter. In all
the examples in this section it is assumed that there is no opening WIP.
It stands to reason that the cost or value of an unfinished unit is less than the cost of a completed unit. The costs
of the process must be shared between finished output and unfinished work-in-process on a fair basis.
Previous sections have explained that costs are allocated to output by calculating a cost per unit. This involves
dividing a cost figure by the number of units of expected output.
We normally assume that all costs occur evenly throughout the process unless stated otherwise. For instance, if
AT A GLANCE

it is written that material was added at start of process, then it is treated as 100% at start of process. But in
normal circumstances, 70% completion means that costs should be allocated to 70% to respective units.
In order to allocate the cost to closing work in progress, it is important to know about equivalent production unit
concept, normally termed as ‘equivalent units’.

4.2. Equivalent units

Equivalent units represent the production in terms of completed units. At the end of any given period there are
likely to be partly completed units (work in process). It is evident that some of the costs pertaining to this period
are attributable to partially completed units. A number of partially complete units is the equivalent of a number
of complete units depending on their degree of completion. It is assumed that the costs are added uniformly
throughout the process, unless otherwise mentioned.
SPOTLIGHT

 Illustration:
200 units that are 50% complete are equivalent to 100 (50% × 200) complete units
The above indicates that cost incurred on partially completed 200 units is equal to 100 completed units. The
easiest way of calculation is multiplying the WIP units with percentage of completion, assuming that cost occur
evenly throughout the process.

Complication
In all of the previous examples a cost per unit was calculated by dividing the total process costs (perhaps
adjusting for expected normal loss or cost of disposal) by the expected number of units.
STICKY NOTES

The existence of work in progress complicates this because the work in progress might be complete to different
degrees in respect of different cost inputs. For example, a unit in the closing work in progress might be 80%
complete with respect to material but only 50% complete with respect to labour.
In this case, the number of equivalent units of direct materials cost in a period will therefore differ from the
number of equivalent units of labour.
A cost per unit is calculated for each type of cost using the equivalent units for that cost. The cost of output is
then based on these individual costs.
Costs for finished output and closing inventory can be calculated from the number of equivalent units and the
cost per equivalent unit.

4.3. A three-stage calculation

We recommend a three-stage calculation:
• Prepare a statement of equivalent units to calculate the equivalent units for each type of cost in the output
from the process and for closing WIP

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• Next, prepare a statement of cost per equivalent unit for each type of cost and it is known as per unit cost
of each cost element.
• Third, prepare a statement to calculate the cost of finished output and closing WIP from the statement of
equivalent units and statement of cost per equivalent unit.

4.4 Example related to closing WIP without losses (single process)

 Example 14:
The following information relates to a production process X.

Input quantities 4,000 units

Completed output 3,500 units

AT A GLANCE
Closing WIP 500 units

All the direct materials are added to production at the beginning of the process.
Closing inventory of 500 units is therefore 100% complete for materials but is only 40%
complete for conversion

The costs incurred in the period were: Rs.

Direct materials 24,000
Converison costs: 7,400

Statement of equivalent units would require be as follows:

Equivalent units

SPOTLIGHT
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 3,500 100% 3,500 3,500
Closing WIP:
Materials 500 100% 500
Conversion 40% 200
4,000 4,000 3,700
Statement of cost per equivalent unit

STICKY NOTES
Direct materials Conversion costs
Total costs Rs.24,000 Rs.7,400
Equivalent units ÷ 4,000 ÷ 3,700
Cost per equivalent unit Rs.6 Rs.2
Statement of evaluation
Rs.
Cost of finished goods (3,500 × (Rs. 6 + Rs. 2)) 28,000
Cost of closing WIP
Materials (500 units × Rs. 6) 3,000
Conversion (200 units × Rs. 2) 400
3,400

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These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Direct materials 4,000 24,000 Finished goods 3,500 28,000
Conversion costs - 7,400 Closing WIP 500 3,400
4,000 31,400 4,000 31,400

4.5 Example related to closing WIP without losses (two processes)

 Example 15:
A manufacturing company operates two processes. Output from Process 1 is transferred as input
AT A GLANCE

to Process 2. Output from Process 2 is the finished product.

Data for the two processes in January are as follows:

Process 1
Opening work in process Nil
Units put into the process 14,000
Units completed and transferred to the next process (Process 2) 10,000
Closing work-in-progress 4,000
Material cost added during the period Rs.70,000
Conversion cost added during the period Rs.48,000
SPOTLIGHT

Materials are input into Process 1 at the start of the process and conversion costs are incurred at
a constant rate throughout processing. The closing work-in-progress in Process 1 at the end of
January is estimated to be 50% complete for the conversion work.

Process 2
Opening work-in-process Nil
Units transferred into the process from Process 1 10,000
Closing work-in-progress 1,000
Units completed and transferred to finished goods inventory 9,000
Costs for the period:
STICKY NOTES

Conversion cost added during the period Rs.57,000

Added materials during Process 2 Rs.36,000
The materials from Process 1 are introduced at the start of processing in Process 2, but the added
materials are introduced at the end of the process 2. Conversion costs are incurred at a constant
rate throughout processing. The closing work-in-progress in Process 2 at the end of January is
estimated to be 50% complete.
It is required to:
a) Calculate the cost of completed output from Process 1 and Process 2
b) Calculate the cost of the closing work-in-process in each process at the end of January.
c) Prepare the Process 1 account and the Process 2 account for January.

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 Solution
There is no opening inventory in either process; therefore, there is no difference between the
weighted average cost and FIFO valuation methods.
Process 1
Equivalent units Total Direct materials Conversion costs
Total units Equivalent units Equivalent units
Completed units 10,000 10,000 10,000
Closing inventory 4,000 4,000 (4,000 × 50%) 2,000
Total equivalent units 14,000 14,000 12,000
Cost Rs.70,000 Rs.48,000

AT A GLANCE
Cost per equivalent unit Rs.5 Rs.4

Cost assigned to units transferred to Process 2 Rs.

Cost of finished goods (10,000 × (Rs. 5 + Rs. 4)) 90,000

Cost assigned to closing WIP inventory Rs.

Materials (4,000 x 5) 20,000
Conversion cost (4,000 x 50% x 4) 8,000
28,000

SPOTLIGHT
The process account is prepared as follows:
Process 1 account
units Rs. units Rs.
Direct 14,000 70,000 Process 2 10,000 90,000
materials account
Conversion 48,000 Closing 4,000 28,000
costs inventory c/f
14,000 118,000 14,000 118,000

STICKY NOTES
Process 2
Materials from Conversion Added
Equivalent units Total
Process 1 costs materials
Equivalent Equivalent Equivalent
Total units
units units units
Completed units 9,000 9,000 9,000 9,000
Closing inventory 1,000 1,000 500 0
Total equivalent units 10,000 10,000 9,500 9,000
Cost Rs.90,000 Rs.57,000 Rs.36,000
Rs.9 Rs.6 Rs.4
Note: The added materials are added at the end of the process, which means that there are no
added materials in the (unfinished) closing inventory.

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Cost assigned to units transferred to Finished goods Rs.

Cost of finished goods (9,000 × (Rs. 9 + Rs. 6 + Rs. 4)) 171,000

Cost assigned to closing WIP inventory Rs.

Cost of process I (1,000 x 9) 9,000
Conversion cost (1,000 x 50% x 6) 3,000
12,000

The process account is prepared as follows:

Process 2 account
AT A GLANCE

units Rs. units Rs.

Materials from 10,000 90,000 Finished goods 9,000 171,000
Process 1
Conversion costs 57,000
Added materials 36,000 Closing inventory c/f 1,000 12,000
10,000 183,000 10,000 183,000
SPOTLIGHT
STICKY NOTES

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5 OPENING WORK IN PROGRESS

5.1. Introduction to opening work in progress
Closing work in progress in one period is treated as opening work in progress in next period of same process.
Opening work in progress adds another level of complexity.
When there is opening work in progress there are two types of cost on the debit side of the account. These are
the costs that were incurred last period and brought forward as work in progress and the costs that were
incurred in the current period. The issue is whether they should be treated together or separately. It depends
upon selection of inventory method by management for WIP. Following are two methods of valuation of WIP.
• weighted average cost method treats all costs on the debit side of the account in the same way.
• first-in, first-out (FIFO) method allocates the costs in opening WIP to the finished goods and then spreads

AT A GLANCE
the remaining costs elsewhere.

5.2. Opening Work In Progress: Weighted Average Cost Method

5.2.1. The underlying principle

When the weighted average cost method is used, the assumption is that all units produced during the period and
all units of closing inventory should be valued at the same cost per equivalent unit for materials and the same
cost per equivalent unit for conversion costs.
An average cost per equivalent unit is calculated for all units of output and closing inventory. This includes the
units that were partly-completed at the beginning of the period (and which were therefore valued as closing WIP
at the end of the previous period).
The calculation of equivalent units is based on the number of units finished in the period (it does not matter

SPOTLIGHT
when they were started) and the number of units in closing WIP.

5.2.2. The three-stage calculation

The costs are worked out in a similar way to the previous example (where there was no opening WIP).
• Statement of equivalent units. Prepare a statement of equivalent units for finished output and for closing
WIP. It is similar to equivalent units calculated in above examples.
• Statement of cost per equivalent unit. Calculate the cost per equivalent unit for direct materials and the
cost per equivalent unit for conversion costs. However, remember to include the cost of the opening WIP.
The materials cost of the opening WIP should be included in the total direct materials cost, and the
conversion costs in the opening WIP should be added to the conversion costs for the current period.

STICKY NOTES
You will normally have to calculate a separate cost per equivalent units for materials and for conversion
costs. This is because the equivalent units of closing inventory will be different for materials and
conversion costs.
• Statement of evaluation. Having calculated the equivalent units and a cost per equivalent unit, prepare a
statement of evaluation in which cost is assigned to all units accordingly.
 Example 16:
The following information relates to a production process X.
Opening inventory 3,000 units
Material cost in opening WIP (100% complete) Rs. 12,600
Conversion costs in opening WIP (30% complete) Rs. 970
During the month
Input quantities 7,000 units
Completed output 8,000 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

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All the direct materials are added to production at the beginning of the process.
Closing inventory of 2,000 units is therefore 100% complete for materials but is only 60%
complete for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000
Converison costs: 17,430

Statement of equivalent units

Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
AT A GLANCE

Finished output 8,000 100% 8,000 8,000

Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 10,000 9,200
And the Statement of cost per equivalent unit, would be as follows

Direct materials Conversion costs

Total costs
Costs in opening WIP Rs. 12,600 Rs. 970
SPOTLIGHT

Costs in the period Rs. 28,000 Rs.17,430

Rs. 40,600 Rs.18,400
Equivalent units ÷ 10,000 ÷ 9,200
Cost per equivalent unit Rs. 4.06 Rs. 2.00
Statement of evaluation

Rs.
Cost of finished goods (8,000 × (Rs. 4.06 + Rs. 2.00)) 48,480
Cost of closing WIP
STICKY NOTES

Materials (2,000 units × Rs. 4.06) 8,120

Conversion (1,200 units × Rs. 2.00) 2,400
10,520

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 8,000 48,480
Conversion costs - 17,430 Closing WIP 2,000 10,520
10,000 59,000 10,000 59,000

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5.2.3. Weighted average cost method: summary

The weighted average cost method for process costing with opening WIP can be summarized as follows:
• All output and closing inventory is valued at the same cost per equivalent unit
• Cost of opening inventory + Costs in the period = Total costs
• Units of closing inventory + Units of output in the period = Total equivalent units
• Cost per equivalent unit = Total costs/Total equivalent units
Illustration for the summary of weighted average calculation of cost per unit, is below
Direct Conversion
materials costs
Cost of opening inventory X X

AT A GLANCE
Costs incurred in the period X X
Total costs Xm Xcc

Number of units output Y Y

Equivalent units of closing inventory Y Y
Total equivalent units Ym Ycc
Cost per equivalent unit (Xm/Ym) (Xcc/Ycc)

5.3. Opening Work In Progress: FIFO Method

SPOTLIGHT
5.3.1. FIFO method in process costing
The first-in, first-out (FIFO) method of process costing is based on the assumption that the opening units of work-
in-process at the beginning of the month will be the first units completed. The cost of these units is their value at
the beginning of the period plus the cost to complete them in the current period. Therefore, cost of opening WIP
is not merged with cost of current production units, rather, it is separately allocated to units transferred on first-
om-first-out basis.
It is necessary to calculate the number of equivalent units of work done in the period. This consists of:
• The equivalent units of direct materials and conversion costs required to complete the opening WIP. These
are the first units completed in the period.

STICKY NOTES
• The equivalent units of finished output in the period that was started as well as finished in the period. These
have one equivalent unit of direct materials and one equivalent unit of conversion costs. The total number
of these units is:
o the total finished output in the period
o minus the quantity of opening WIP (which are completed first)
• The equivalent units of closing WIP (calculated in the normal way).

5.3.2. The three-stage calculation

The three-stage calculation with the FIFO method is similar to the calculation method previously described, with
the exception that in the statement of evaluation, the cost of finished output consists of:
• The finished cost of opening WIP which is the sum of:
o the costs in the opening WIP value at the start of the period; plus
o the costs in the current period to complete these units; plus
• the cost of finished output started as well as finished in the period.

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Study the following example carefully.

 Example 17:
The following information relates to a production process X.
Opening inventory 3,000 units
Material cost in opening WIP (100% complete – therefore 0% is needed in
this period) Rs. 12,600
Conversion costs in opening WIP (30% complete – therefore 70% is
needed in this period) Rs. 970
Rs. 13,570
AT A GLANCE

During the month

Input quantities 7,000 units
Completed output 8,000 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

All the direct materials are added to production at the beginning of the process.
Closing inventory of 2,000 units is therefore 100% complete for materials but is only 60%
complete for conversion.

The costs incurred in the period were: Rs.

SPOTLIGHT

Direct materials 28,000

Converison costs: 17,430

In solving for Statement of equivalent units, please see below:

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Started last period
Opening WIP 3,000
STICKY NOTES

Materials 0% nil
Conversion 70% 2,100
Started and finished in the period 5,000 100% 5,000 5,000
Finished in period 8,000 5,000 7,100
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
10,000 7,000 8,300

Statement of cost per equivalent unit

Total costs in current period Rs. 28,000 Rs.17,430

Equivalent units ÷ 7,000 ÷ 8,300
Cost per equivalent unit Rs. 4.00 Rs. 2.10

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Statement of evaluation

Rs.
Cost of goods finished in the period (8,000 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100 × Rs. 2.10) 4,410
17,980
Started and finished in this period [5,000 × (Rs. 4.00 + Rs. 2.10)] 30,500
48,480

AT A GLANCE
Cost of closing WIP
Materials (2,000 units × Rs. 4.00) 8,000
Conversion (1,200 units × Rs. 2.10) 2,520
10,520

These costs would be recorded in the process account as follows

Process (WIP) account
units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 8,000 48,480

SPOTLIGHT
Conversion costs - 17,430 Closing WIP 2,000 10,520
10,000 59,000 10,000 59,000

(Tutorial note: If you compare this example using FIFO with the previous example using the
weighted average cost method, you will see that the cost of finished output and value of closing
WIP is the same in each case. This is a coincidence. Normally, the two methods provide different
costs for finished output and different closing WIP valuations.)

5.3.3. FIFO method: summary

The first-in, first-out method for process costing with opening WIP can be summarized as follows.

STICKY NOTES
• The cost of the opening units completed in the current period is calculated separately from the cost of the
units that are started and finished in the current period.
• A cost per equivalent unit is calculated for the current period, as follows:
 Illustration for the summary of weighted average calculation of cost per unit, is given below
Direct Conversion
materials costs
Costs incurred in the current period TCm TCc
Equivalent units of work in the current period:
to complete opening WIP X Y
to start and finish units X Y
to make closing WIP X Y
Total equivalent units of work in this period Xm Ycc
Cost per equivalent unit in the current period TCm / Xm TCc / Ycc

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• These costs are used to apportion the process costs in the current period between:
o the cost of completing the opening WIP
o the cost of units started and finished in the current period
o the value of closing inventory.
• Having calculated costs for the current period, the valuation of output from the process
is calculated as follows:
and illustration for the summary of evaluation of outputs under the FIFO method, is given
below:

Rs.
AT A GLANCE

Cost of Items started in the previous period and finished in this period
Opening WIP X
Cost of finishing the opening WIP
To complete material X
To complete other costs X
X
Cost of items started and finished in this period X
Cost of items finished in the period X
SPOTLIGHT

Cost of items started in this period

Material X
Other costs X
X
Total process costs X
STICKY NOTES

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6 WORK IN PROGRESS AND LOSSES

6.1. Introduction
Earlier in the chapter, we explained that normal loss is not assigned any cost, unless it has scrap value and in this
case, normal loss shall be assigned, equal to its scrap value. This recognized that the scrap recovery reduces the
overall cost of the process.
We saw that abnormal loss is measured in the same way as good production, because we assume that losses were
occurred at end of process. The number of abnormal loss units are included in the expected good output used in
the cost per unit calculation.
The same principles are followed when a question requires the calculation of cost per unit by component through
the calculation of equivalent units. The number of equivalent units taken to build the abnormal loss must be
included in the total number of equivalent units.

AT A GLANCE
The following examples help to understand the treatment of normal and abnormal losses along with closing work
in progress.
 Example 18:
Following data is related to process I of ABC Limited for the month of May, 2020.
Process 1
Opening work in process Nil
Units started 20,000
Units transferred to process 2 15,000
Units in process (80% completed) 3,000
Normal loss 10%

SPOTLIGHT
Cost data:
Direct materials Rs. 78,000
Conversion cost Rs. 121,800
Normal loss has scrap value of Rs. 3 per unit. Material was added at start of the process 1 and
conversion cost was spread evenly throughout the process.
Process 1 account for the month of May, 2020 and its relevant calculation is given below:
Calculation of equivalent units:
Equivalent units Total Direct materials Conversion costs
Total units Equivalent units Equivalent units

STICKY NOTES
Completed units 15,000 15,000 15,000
Closing inventory 3,000 3,000 (3,000 × 80%) 2,400
Total equivalent units 18,000 18,000 17,400

Calculation of Unit cost

Cost Equivalent Unit Cost
Rs. Unit Rs.
Direct materials 78,000
Less: scrap value of normal loss (6,000)
(2,000 x 3)
72,000 18,000 4.00
Conversion cost 121,800 17,400 7.00
Total unit cost 11.00

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Cost assigned to units transferred to Finished goods Rs.

Cost of finished goods (15,000 × 11) 165,000

Cost assigned to closing WIP Inventory Rs.

Direct materials (3,000 x 4) 12,000
Conversion cost (3,000 x 80% x 7) 16,800
28,800

Process I Account is given as under:

Process 1 account
AT A GLANCE

units Rs. units Rs.

Direct materials 20,000 78,000 Normal loss 2,000 6,000
Conversion costs 121,800 Process 2 15,000 165,000
Closing inventory 3,000 28,800
14,000 199,800 14,000 199,800

 Example 19:
Following data is related to process I of ABC Limited for the month of May, 2020.

Process 1
Opening work in process Nil
SPOTLIGHT

Units started 20,000

Units transferred to process 2 15,000
Units in process (80% completed) 3,000
Normal loss 8%
Cost data:
Direct materials Rs. 95,200
Conversion cost Rs. 106,800

Normal loss has scrap value of Rs. 2 per unit. Material was added at start of the process 1 and
conversion cost was spread evenly throughout the process.
STICKY NOTES

Process 1 account for the month of May, 2020 and its relevant calculation is given below:
Calculation of equivalent units:
Equivalent units Total Direct materials Conversion costs
Total units Equivalent units Equivalent units
Completed units 15,000 15,000 15,000
Closing inventory 3,000 3,000 (3,000 × 80%) 2,400
Abnormal loss 400 400 400
Total equivalent units 18,400 18,400 17,800

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Calculation of Unit cost

Cost Equivalent Unit Cost

Rs. Unit Rs.
Direct materials 95,200
Less: scrap value of normal loss (3,200)
(1,600 x 2)
92,000 18,400 5.00
Conversion cost 106,800 17,800 6.00
Total unit cost 11.00

AT A GLANCE
Cost assigned to units transferred to Finished goods Rs.
Cost of finished goods (15,000 × 11) 165,000

Cost assigned to closing WIP Inventory Rs.

Direct materials (3,000 x 5) 15,000
Conversion cost (3,000 x 80% x 6) 14,400
29,400

Cost assigned to units transferred to Abnormal loss Rs.

SPOTLIGHT
Cost of finished goods (400 × 11) 4,400

Process I Account is given as under:

Process 1 account
units Rs. units Rs.
Direct materials 20,000 95,200 Normal loss 1,600 3,200
Conversion costs 106,800 Process 2 15,000 165,000
Abnormal Loss 400 4,400
Closing inventory 3,000 29,400
14,000 202,000 14,000 202,000

STICKY NOTES
 Example 20:
The following information relates to a production process X

Input quantities 4,000 units

Normal loss (all units having a scrap recovery of Rs. 1) 10% of input
Completed output 3,000 units
Closing WIP 500 units
All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to
conversion as they are 100% complete for material).
Closing inventory of 500 units is therefore 100% complete for materials but is 60% complete
for conversion.

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The costs incurred in the period were: Rs.

Direct materials 24,016
Converison costs: 7,370
It is useful to construct an extra working with these questions to show the physical number of
units.
Closing work in progress and losses – (Preliminary working)
Units
Opening WIP 0
Input 4,000
AT A GLANCE

Total possible units 4,000

Normal loss (10% of input) (400)
Expected good output 3,600
Actual good output (3,000)
Closing WIP (500)
Abnormal loss 100

Closing work in progress and losses

Statement of equivalent units
SPOTLIGHT

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 3,000 100% 3,000 3,000
Closing WIP:
Materials 500 100% 500
Conversion 60% 300
Abnormal loss
Materials 100 100% 100
Conversion 50% 50
STICKY NOTES

3,600 3,600 3,350

Statement of cost per equivalent unit

Total costs Rs.24,016 Rs.7,370

Expected scrap recovery of normal loss (10% × 4,000 units × Rs. 1) Rs. (400)
Rs.23,616 Rs.7,370
Equivalent units ÷ 3,600 ÷ 3,350
Cost per equivalent unit Rs.6.56 Rs.2.20

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Statement of evaluation

Rs.
Cost of finished goods (3,000 × (Rs. 6.56 + Rs. 2.20)) 26,280
Cost of closing WIP
Materials (500 units × Rs. 6.56) 3,280
Conversion (300 units × Rs. 2.20) 660
3,940
Cost of closing abnormal loss
Materials (100 units × Rs. 6.56) 656
Conversion (50 units × Rs. 2.20) 110

AT A GLANCE
766
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Direct materials 4,000 24,016 Finished goods 3,000 26,280
Normal loss 400 400
Conversion costs - 7,370 Abnormal loss 100 766
Closing WIP 500 3,940
4,000 31,386 4,000 31,386

SPOTLIGHT
6.2. Opening WIP and losses (Weighted average)
 Example 21:
The following information relates to a production process X
Opening inventory 3,000 units
Material cost in opening WIP (100% complete) Rs. 12,600
Conversion costs in opening WIP (30% complete) Rs. 970
During the month
Input quantities 7,000 units

STICKY NOTES
Normal loss (all units having a scrap recovery of Rs. 1) 5% of Current input
Completed output 7,500 units
Closing WIP (100% complete for direct materials and 60% 2,000 units
complete for conversion costs).
All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to
conversion as they are 100% complete for material).
Closing inventory of 2,000 units is therefore 100% complete for materials but is 60% complete
for conversion.
The costs incurred in the period were: Rs.
Direct materials 28,000
Converison costs: 17,430

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Calculation of abnormal loss:

Units
Opening WIP 3,000
Input 7,000
Total possible units 10,000
Normal loss (5% of input) (350)
Expected good output 9,650
Actual good output (7,500)
Closing WIP (2,000)
Abnormal loss 150
AT A GLANCE

Statement of equivalent units

Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
Finished output 7,500 100% 7,500 7,500
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
Abnormal loss
Materials 150 100% 150
Conversion 50% 75
SPOTLIGHT

9,650 9,650 8,775

Statement of cost per equivalent unit

Direct materials Conversion costs

Total costs Rs. Rs.
Costs in opening WIP 12,600 970
Costs in the period 28,000 17,430
Expected scrap recovery of normal loss (350)
(5% × 7,000 units × Rs. 1)
STICKY NOTES

40,250 18,400
Equivalent units ÷ 9,650 ÷ 8,775
Cost per equivalent unit 4.17098 2.09687

Statement of evaluation
In order to avoid difference due to rounding off, it is important to take values of unit cost up to 5
decimal places.

Rs.
Cost of finished goods (7,500 × (Rs. 4.17098 + Rs. 2.09687)) 47,009
Cost of closing WIP
Materials (2,000 units × Rs. 4.17098) 8,342
Conversion (1,200 units × Rs. 2.09687 2,516
10,858

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Abnormal loss
Materials (150 units × Rs. 4.17098) 626
Conversion (75 units × Rs. 2.09687) 157
783

These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Opening WIP 3,000 13,570 Finished goods 7,500 47,009
Direct materials 7,000 28,000 Normal loss 350 350

AT A GLANCE
Conversion costs - 17,430 Abnormal loss 150 783
Closing WIP 2,000 10,858
10,000 59,000 10,000 59,000

8.3 Opening WIP and losses (FIFO)

 Example 22:
The following information relates to a production process X.

Opening inventory 3,000 units

Material cost in opening WIP (100% complete Rs. 12,600

SPOTLIGHT
Conversion costs in opening WIP (30% complete) Rs. 970
Rs. 13,570
During the month
Input quantities 7,000 units
Normal loss (all units having a scrap recovery of Rs. 1) 5% of current
input
Completed output 7,500 units
Closing WIP (100% complete for direct materials and 60% complete for 2,000 units
conversion costs).

STICKY NOTES
All the direct materials are added to production at the beginning of the process.
Inspection of the units occurs when they are 50% complete. (Note that this must relate to
conversion as they are 100% complete for material).
Closing inventory of 2,000 units is therefore 100% complete for materials but is 60% complete
for conversion.

The costs incurred in the period were: Rs.

Direct materials 28,000
Converison costs: 17,430

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Calculation of abnormal loss (units)

Units
Opening WIP 3,000
Input 7,000
Total possible units 10,000
Normal loss (5% of input) (350)
Expected good output 9,650
Actual good output:
Started in the previous period but finished in this period (3,000)
AT A GLANCE

Started and finished in this period (4,500)

Output in this period (7,500)
Closing WIP (2,000)
Abnormal loss 150

Statement of equivalent units

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Started last period
SPOTLIGHT

Opening WIP 3,000

Materials 0% nil
Conversion 70% 2,100
Started and finished in the period 4,500 100% 4,500 4,500
Finished in period 7,500 4,500 6,600
Closing WIP:
Materials 2,000 100% 2,000
Conversion 60% 1,200
Abnormal loss
STICKY NOTES

Materials 150 100% 150

Conversion 50% 75
9,650 6,650 7,875

Statement of cost per equivalent unit

Direct Conversion
materials costs
Total costs in current period 28,000 17,430
Expected scrap recovery of normal loss (350)
(5% × 3,500 units × Rs. 1)
27,650 17,430
Equivalent units ÷ 6,650 ÷ 7,875
Cost per equivalent unit Rs. 4.15789 Rs. 2.21333

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Statement of evaluation
In order to avoid difference due to rounding off, it is important to take values of unit cost up to 5
decimal places.

Rs.
Cost of goods finished in the period (7,500 units)
Started in previous period but finished in this period
Opening WIP (3,000 units) 13,570
Conversion cost to finish opening WIP (2,100 × Rs. 2.21333) 4,648
18,218
Started and finished in this period (4,500 × (Rs. 4.15789 + Rs. 2.21333)) 28,670

AT A GLANCE
46,888

Cost of closing WIP Rs.

Materials (2,000 units × Rs. 4.15789) 8,316
Conversion (1,200 units × Rs. 2.21333) 2,656
10,972
Cost of abnormal loss
Materials (150 units × Rs. 4.15789) 624
Conversion (75 units × Rs. 2.21333) 166

SPOTLIGHT
790

These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Opening WIP 3,000 13,570
Direct materials 7,000 28,000 Finished goods 7,500 46,888
Conversion costs - 17,430 Normal loss 350 350
Abnormal loss 150 790

STICKY NOTES
Closing WIP 2,000 10,972
10,000 59,000 10,000 59,000

Tutorial note: FIFO stock valuation is more common than the weighted average method, and
should be used unless an indication in given to the contrary. You may be presented with limited
information about the opening stock which forces you to use either the FIFO or the weighted
average method. The rules are as follows:
1. If you are given with degree of completion of each element of opening stock but not the
value of each element, then you must use FIFO method.
2. If you are not given the degree of completion of each element in opening stock but you
are given with value, then you must use weighted average method.

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7 LOSSES AND GAINS AT DIFFERENT STAGES IN THE PROCESS

7.1 Assumptions about when loss occurs
In the earlier explanation of accounting for abnormal loss and abnormal gain, it was assumed that losses occur
at the end of the production process. This assumption is not relevant for normal loss, but it is relevant for
abnormal loss and abnormal gain, because these are given a value.
If it is assumed that losses occur at the end of a process, units of abnormal loss or gain are given a cost or value
as if they are fully completed units – and so one equivalent unit each.
If losses occur at a different stage in the process, this assumption should not be applied. Instead, the concept of
equivalent units should be used to decide the cost of the abnormal loss or the value of the abnormal gain.
Equivalent units can be used provided that an estimate is made of the degree of completion of units at the time
AT A GLANCE

that loss occurs in the process. Differing degrees of completion might be used for direct materials and conversion
costs.

7.2 Equivalent units and abnormal loss part-way through the process
When loss occurs part-way through a process, the cost of any abnormal loss should be calculated by:
• establishing the equivalent units of direct materials and conversion costs for the loss
• calculating a cost per equivalent units
• using the calculations of equivalent units and cost per equivalent unit to obtain a cost for finished output and
abnormal loss in the period.
 Example 23:
SPOTLIGHT

Abnormal loss and loss part-way through a process

The following information relates to a production process X.

Input quantities 10,000 units

Normal loss 10%
Therefore expected output 9,000 units
Actual output 8,500 units
Therefore abnormal loss 500 units
Direct materials are added in full at the beginning of the process, and loss occurs 60% of the way
through the process.
STICKY NOTES

The costs incurred in the period were: Rs.

Direct materials 27,000
Converison costs: 13,200
Statement of equivalent units
Equivalent units
Output Total units Percentage Direct Conversion
complete materials costs
Finished output 8,500 100% 8,500 8,500
Abnormal loss
Materials 500 100% 500
Conversion 60% 300
Expected output 9,000 9,000 8,800

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Statement of cost per equivalent unit

Direct materials Conversion costs

Rs. 27,000 Rs.13,200
Equivalent units ÷ 9,000 ÷ 8,800
Cost per equivalent unit Rs. 3.00 Rs. 1.50

Statement of evaluation

Rs.
Cost of finished goods (8,500 × (Rs. 3.00 + Rs. 1.50)) 38,250

AT A GLANCE
Abnormal loss
Materials (500 units × Rs. 3.00) 1,500
Conversion (300 units × Rs. 1.50) 450
1,950

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Direct materials 10,000 27,000 Finished goods 8,500 38,250

SPOTLIGHT
Abnormal loss 500 1,950
Conversion costs - 13,200 Normal loss 1,000 nil
10,000 40,200 10,000 40,200

7.3 Equivalent units and abnormal gain part-way through the process
The same principles apply to the valuation of abnormal gain where the loss/gain occurs part-way through the
process. However, there is one important difference. Equivalent units of abnormal gain are given a negative value
and are subtracted from the total equivalent units of output in the period.
Perhaps the easiest way to think of the reason for this is that abnormal gain is on the opposite side of the process

STICKY NOTES
account (the debit side) from actual finished output (credit side) and abnormal gain equivalent units are
subtracted because they offset the cost of the finished output.
 Example 24:
Abnormal gain part-way through a process
The following information relates to a production process X.

Input quantities 6,000 units

Normal loss 10%
Therefore expected output 5,400 units
Actual output 5,600 units
Therefore abnormal gain 200 units

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Direct materials are added in full at the beginning of the process, and loss occurs 40% of the
way through the process.

The costs incurred in the period were: Rs.

Direct materials 27,000
Converison costs 11,040

Statement of equivalent units

Equivalent units
Output Total Percentage Direct Conversion
units complete materials costs
Finished output 5,600 100% 5,600 5,600
AT A GLANCE

Abnormal gain (200)

Materials 100% (200)
Conversion 40% (80)
Expected output 5,400 5,400 5,520

Statement of cost per equivalent unit

Direct materials Conversion costs

Rs. 27,000 Rs.11,040
Equivalent units ÷ 5,400 ÷ 5,520
SPOTLIGHT

Cost per equivalent unit Rs. 5 Rs. 2

Statement of evaluation

Cost of finished goods (5,600 × (Rs. 5 + Rs. 2)) 39,200

Cost of abnormal gain
Materials (200 units × Rs. 5) 1,000
Conversion (80 units × Rs. 2) 160
1,160
STICKY NOTES

These costs would be recorded in the process account as follows.

Process (WIP) account

units Rs. units Rs.
Direct materials 6,000 27,000 Finished goods 5,600 39,200
Conversion costs - 11,040
Abnormal gain 200 1,160 Normal loss 600 nil
6,200 39,200 6,200 39,200

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8 COST OF REWORK
Sometimes the loss incurred in processing is not scrapped but is subject to a further rectification process, this
extra processing cost is referred to as rework. Rework might occur when benefit generated from rework
exceeds the scrap value of losses.
Rework might be performed on units that are either classified as normal or abnormal loss:

8.1. Normal Rework

The rework cost is charged to the normal processing cost. Rework may involve some material use, labour use
etc. Hence the entry is:

Debit Credit

AT A GLANCE
Process account X
Materials Account X
Payroll Account X

8.2. Abnormal Rework

Abnormal rework is not charged to process account, rather it shall be charged to abnormal loss account and it
then be closed to profit and loss account:

Debit Credit
Abnormal loss account X
Materials account X

SPOTLIGHT
Payroll Account X

STICKY NOTES

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9 COMPREHENSIVE EXAMPLES
 Example 01:
XYZ operates several process production systems.
a) For Process 5, the FIFO method of valuing opening work-in-progress is used, and the
following details relate to September Year 5.
Opening work-in-process was 600 units, each 80% processed as to materials and 60%
processed as to conversion costs.
Finished output was 14,500 units. There were no abnormal losses or gains.
Closing work-in-process was 800 units, each 70% processed as to materials and 40%
processed as to conversion costs.
AT A GLANCE

Costs of processing during the current period were:

Materials: Rs. 36,450
Conversion costs: Rs. 17,352.
Calculation for the cost per equivalent unit of output produced during September (one
unit started and completed during the month), would be as follows.
FIFO method

Equivalent units Total Direct materials Conversion costs

Units Equivalent units Equivalent units
Completion of opening WIP 600 (20%) 120 (40%) 240
SPOTLIGHT

Other completed units 13,900 13,900 13,900

14,500 14,020 14,140
Closing inventory 800 (70%) 560 (40%) 320
Total equivalent units (A) 15,300 14,580 14,460
Costs in the current period (B) Rs.36,450 Rs.17,352
Cost per equivalent unit (B/A) Rs.2.50 Rs.1.20

Cost per equivalent unit of fully completed units in the current period = Rs.2.50 + Rs.1.20 =
Rs.3.70.
STICKY NOTES

b) The following details relate to Process 16 in September Year 5:

Opening work-in-progress 2,000 litres, fully complete as to materials and 40%

complete as to conversion. The cost of materials in the
opening WIP was Rs.9,860 and conversion costs in the
opening WIP were Rs.4,700.
Material input 24,000 litres, cost Rs.130,540
Conversion costs in the month Rs.82,960
Output to process 2 23,000 litres
Closing work-in-progress 3,000 litres, fully complete as to materials and 45%
complete as to conversion.

The weighted average cost system is used for inventory valuation in Process 16.

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Calculation of the cost per unit of output from this process during September, would be as
follows:
Weighted average cost

Equivalent units Total Direct materials Conversion costs

Total units Equivalent units Equivalent units
Completed units 23,000 23,000 23,000
Closing inventory 3,000 (100%) 3,000 (45%) 1,350
Total equivalent units (A) 26,000 26,000 24,350
Costs: Rs. Rs.

AT A GLANCE
Opening WIP 9,860 4,700
Current period costs 130,540 82,960
Total costs (B) 140,400 87,660
Cost per equivalent unit Rs.5.40 Rs.3.60

Cost per equivalent unit of fully completed units in the current period = Rs.5.40 + Rs.3.60 =
Rs.9.00.
 Example 02:
Yahya Limited produces a single product that passes through three departments, A, B and C.

SPOTLIGHT
The company uses FIFO method for process costing. A review of department A’s cost records
for the month of January 20X4 shows the following details:

Units Material Labour

Rs. Rs.
Work in process inventory as at January 1, 20X4 16,000 64,000 28,000
(75% complete as to conversion costs)
Additional units started in January 20X4 110,000 - -
Material costs incurred - 430,500 -
Labour costs incurred - - 230,000

STICKY NOTES
Work in process inventory as at January 31, 20X4 18,000 - -
(50% complete as to conversion costs)
Units completed and transferred in January 20X4 100,000 - -

Overhead is applied at the rate of 120% of direct labour. Normal spoilage is 5% of output. The
spoiled units are sold in the market at Rs. 6 per unit.
Required
Compute the following for the month of January:
(a) Equivalent production units.
(b) Costs per unit for material, labour and factory overhead.
(c) Cost of abnormal loss (or gain), closing work in process and the units transferred to the next
process.

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 Solution
a) Equivalent production units.

Material FOH/ Labour

Units Units
Units completed and transferred out 100,000 100,000
Less: Beginning inventory (all units) 16,000 16,000
Started and completed in January 84,000 84,000
Beginning inventory (completed in January)
Labour and FOH (25%) 4,000
Closing inventory (completed in January)
AT A GLANCE

Material (100%) 18,000

Labour and FOH (50%) - 9,000
Abnormal loss 3,000 3,000
105,000 100,000

b) Costs per unit for material, labour and factory overhead.

Cost in Rs. Eq. Units Cost per unit

Materials 430,500
Less: Scrap value of normal loss
SPOTLIGHT

(5,000 x 6) (30,000)
400,500 105,000 3.81429
Labour 230,000 100,000 2.30000
Factory overheads (120% of DL) 276,000 100,000 2.76000
Total 8.87429

c) Cost of abnormal loss (or gain), closing work in process and the units transferred
to the next process.

Rupees
STICKY NOTES

Cost of abnormal loss

3,000 units @ Rs.8.87429 26,622
Closing work in process
Material (18,000 x Rs. 3.81429) 68,657
Labour (18,000 x Rs. 2.30 x 50%) 20,700
FOH (18,000 x Rs. 2.76 x 50%) 24,840
114,197
Cost of units transferred to next process
From beginning inventory
Beginning Inventory-Already incurred costs
Materials 64,000
Labour 28,000
Factory Overhead (Rs. 28,000 x 120%) 33,600

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Rupees
Beginning Inventory-Costs incurred in January
Labour (16,000 x Rs. 2.30 x 25%) 9,200
FOH (16,000 x Rs. 2.76 x 25%) 11,040
Units fully produced during the current month (84,000 x Rs. 8.87429) 745,441
891,281

 Example 03:
Smart Processing Limited produces lubricants for industrial machines. Material COX is
introduced at the start of the process in department A and subsequently transferred to
department B. Normal loss in department A is 5% of the units transferred.

AT A GLANCE
In department B, material COY is added just after inspection which takes place when the
production is 60% complete. 10% of the units processed are evaporated before the inspection
stage. However, no evaporation takes place after adding material COY. During the year, actual
evaporation in department B was 10% higher than the estimated normal losses because of high
level of Sulphur contents in natural gas used for processing.
Other details for the year ended December 31, 20X3 are as under:
Department A Department B
Rupees
Opening work in process 2,184,000 2,080,000
Material input - 600,000 Liters 17,085,000

SPOTLIGHT
- 500,000 Liters 9,693,000
Labour 8,821,000 6,389,000
Overheads 2,940,000 3,727,000

Department A Department B
Completion % Completion %
Liters Conversion Liters Conversion
Material Material
costs costs
Opening WIP 64,500 100 60 40,000 100 60
Closing WIP 24,000 100 70 50,000 100 80

STICKY NOTES
Conversion costs are incurred evenly throughout the process in both departments. The
company uses FIFO method for inventory valuation.
Required
(a) Equivalent production units
(b) Cost of abnormal loss and closing WIP
(c) Cost of finished goods produced

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 Solution
a) Calculations for the equivalent production units, would be:

Quantity Schedule (in liters) Dept. A Dept. B

WIP opening 64,500 40,000
Started in process / material added 600,000 500,000
Received from preceding department - 610,000
664,500 1,150,000
Transferred out to B (664,500-24,000)x100/105 610,000 -
Transferred to finished goods (1,150,000-50,000-61,000-6,100) - 1,032,900
AT A GLANCE

WIP closing 24,000 50,000

Normal loss – A (664,500-24,000)x5/105) 30,500 -
Normal loss – B (10% x 610,000) - 61,000
Abnormal loss – B (10% x 61,000) - 6,100
664,500 1,150,000

Equivalent production unit (in liters)

Department A Department B
Material Conversion Material Conversion
Units completed and transferred out 610,000 610,000 1,032,900 1,032,900
SPOTLIGHT

Opening Inventory (60% completed) (64,500) (38,700) (40,000) (24,000)

Abnormal loss (B: 6,100 x 60%) - - - 3,660
Closing inventory (A: 70%, B: 80%) 24,000 16,800 50,000 40,000
569,500 588,100 1,042,900 1,052,560

b) The cost of abnormal loss and closing WIP, would be calculated as:

Department A Department B
Cost of abnormal loss
Quantity Rate Amount Quantity Rate Amount
(Department B)
Units Rs. Rs. Units Rs. Rs.
STICKY NOTES

From department A 6,100 (W-2) 333,044

(610,000 x 10% x 10%) 54.60
Labour (60%) 3,660 6.07 22,216
Overheads (60%) 3,660 3.54 12,956
- 368,216
WIP-closing costs
From department A - - - 50,000 (W-2) 1,421,000
28.42
Material 24,000 30.00 720,000 50,000 9.29 464,500
Labour (70%, 80%) 16,800 15.00 252,000 40,000 6.07 242,800
Overheads (70%, 80%) 16,800 5.00 84,000 40,000 3.54 141,600
1,056,000 2,269,900

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c) For the cost of finished goods produced, calculations would be as follows:

Rupees
Total costs charged to department (W-1) 51,863,000
Less: WIP closing costs (Computed above) (2,269,900)
Less: Cost of abnormal loss (Computed above) (368,216)
Costs transferred to finished goods 49,224,884

W-1: Cost charged to department:

Department A Department B

AT A GLANCE
Equivalent Cost Unit cost Equivalent Cost Unit cost
Units (Rs.) (Rs.) Units (Rs.) (Rs.)
WIP - opening 2,184,000 2,080,000
inventory
Cost from 29,974,000
department A
Material 569,500 17,085,000 30.00 1,042,900 9,693,000 9.29
Labour 588,100 8,821,000 15.00 1,052,560 6,389,000 6.07
Overheads 588,100 2,940,000 5.00 1,052,560 3,727,000 3.54

SPOTLIGHT
Total cost to 31,030,000 50.00 51,863,000 18.90
be accounted
for

W-2: Allocation of cost received from department A:

Quantity Amount (Rs.) Unit cost (Rs.)
Units received from A 610,000
Normal loss at 10% (61,000)

STICKY NOTES
549,000 *29,974,000 54.60
Abnormal loss at 1% (6,100) (333,044) 54.60
Units after inspection 542,900 29,640,956 54.60
Addition of material COY 500,000
1,042,900 29,640,956 28.42
*Rs. 31,030,000 (Total cost) – Rs. 1,056,000 (Closing WIP) = Rs. 29,974,000

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 Example 04:
Hornbill Limited (HL) produces certain chemicals for textile industry. The company has three
production departments. All materials are introduced at the beginning of the process in
Department-A and subsequently transferred to Department-B. Any loss in Department-B is
considered as a normal loss.
The following information has been extracted from the records of HL for Department-B for the
month of August 20X3:

Department B
Opening work in process (Liters) Nil
Closing work in process (Liters) 10,500
AT A GLANCE

Units transferred from Department-A (Liters) 55,000

Units transferred to Department-C (Liters) 39,500
Labour (Rupees) 27,520
Factory overhead (Rupees) 15,480
Materials from Department-A were transferred at the cost of Rs. 1.80 per liter.
The degree of completion of work in process in terms of costs originating in Department-B was
as follows:
WIP Completion %
50% units 40%
20% units 30%
SPOTLIGHT

30% units 24.5%

Required
Prepare the following for department B for the month:
a) A statement of equivalent units.
b) A statement showing cost per equivalent unit.
c) A statement showing the evaluation of output.
d) A process account
(Tip: Treat the costs transferred from department A in the same way as material costs introduced
STICKY NOTES

at the start of the department B process and treat department B costs in the same way as conversion
costs).

Preliminary working: Units

Opening WIP 0
Received from Process A 55,000
Total possible units 55,000
Actual good output (39,500)
Closing WIP (10,500)
Normal loss (as specified in the question) 5,000

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a) For the given examples, Statement of equivalent units would be:

Statement of equivalent units

Equivalent units
Output Total Percentage Materials Department
units complete (input from B costs
Dept. A)
Finished output 39,500 100% 39,500 39,500
Closing WIP:
Materials 10,500 100% 10,500
Dept. B costs 50% × 40% 2,100

AT A GLANCE
Dept. B costs 20% × 30% 630
Dept. B costs 30% × 24.5% 770
3,500
55,000 50,000 43,000

b) Statement of Statement of cost per equivalent unit

Materials
Department
(input from
B costs
Dept. A)

SPOTLIGHT
Total costs:
Input from department A (55,000 units × Rs. 1.80) Rs.99,000
Department B costs (27,520 + 15,480) Rs. 43,000
Equivalent units (÷) 50,000 4,300
Cost per equivalent unit Rs.1.98 Rs.1.00

c) Statement of evaluation of units would be

Rs.
Cost of finished goods (39,500 × (Rs. 1.98 + Rs. 1.00)) 117,710

STICKY NOTES
Cost of closing WIP
Materials (10,500 units × Rs. 1.98) 20,790
Conversion (3,500 units × Rs. 1.00) 3,500
24,290

d) Process WIP would be accounted for as follows:

Process (WIP) account
units Rs. units Rs.
Transfers 55,000 99,000 Finished goods 39,500 117,710
from A (transfer to C)
Labour 27,520 Normal loss 5,000 −
Overhead 15,480 Closing WIP 10,500 24,290
55,000 142,000 55,000 142,000

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 Example 05:
Ababeel Foods produces and sells chicken nuggets. Boneless chicken is minced, spiced up, cut to
standard size and semi-cooked in the cooking department. Semi-cooked pieces are then frozen
and packed for shipping in the finishing department.
Inspection is carried out when the process in the cooking department is 80% complete. Normal
loss is 5% of input and comprises of:
2% weight loss due to cooking; and
3% rejection of nuggets. The rejected nuggets are sold at Rs. 60 per kg.
Overheads are applied at the rate of 120% of direct labour cost. Inventory is valued using
weighted average cost. Following information pertains to cooking department for the month of
AT A GLANCE

June 2014:
Kg. Material Labour
----- Rs. in ‘000 -----
Opening work in progress (100% complete to 30,000 6,260 1,288
material and 50% complete to conversion)
Costs for the month 420,000 50,000 20,000
Weight after cooking 440,000 - -
Transferred to finishing department 362,000 - -
Closing work in progress (100% complete to material 65,000 - -
and 65% complete to conversion)
Required:
SPOTLIGHT

Prepare process account for cooking department for the month of June 2014.
 Solution

Ababeel Foods
Cooking department production and cost for June 2014
Process Account - Cooking department
Kg. Rs. in '000' Kg. Rs. in '000'
Opening WIP 30,000 (W-2)9,094 Normal loss:
Material 420,000 50,000  weight loss (W.1) 7,700 -
STICKY NOTES

Labour 20,000  rejection (W.1) 11,550 693

Overheads 24,000 Abnormal loss:
(20,000*1.2)
 weight loss (W.1) 2,300
 rejection (W.1) 1,450
(W.2) 3,750 829
Transferred out (W.2) 362,000 88,328
Closing WIP (W.2) 65,000 13,244
450,000 103,094 450,000 103,094

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W-1: Normal and abnormal Total loss Normal loss (Cooking Abnormal
losses: loss at 2% & rejection loss
loss at 3% of input) (Balancing)
Kg.
Weight loss:
Opening WIP 30,000
Input for the month 420,000
450,000
Transferred to finishing
department (362,000)

AT A GLANCE
Closing WIP
(65,000)
Total loss 23,000
Weight loss (450,000-440,000) 10,000 (450,000- 7,700 2,300
65,000)×2%
Rejection loss (balancing) 13,000 (450,000- 11,550 1,450
65,000)×3%
23,000 19,250 3,750

SPOTLIGHT
W-2: Cost and equivalent Material Conv. Total cost
quantity: cost cost
Rs. in '000'
Opening WIP 1,288 x 2.20 6,260 2,834 9,094
Cost added 20,000 x2.20 50,000 44,000 94,000
Normal rejection valued @ Rs. 60 11,550x60 (693) - (693)
per kg
Total cost (A) 55,567 46,834 102,401

STICKY NOTES
Rupees
Cost per kg. (A×1,000)÷(B) 129.0 115.0 244.0

Equivalent kg. Total cost

Material Conv. (Rs. in ‘000)
Finished goods 362,000 362,000 88,328
Closing WIP (100% to material and 65% to conv.) 65,000 42,250 13,244
Total abnormal loss 3,750 3,000 829
(100% to material and 80% to conv.)
Total equivalent quantity and cost (B) 430,750 407,250 102,401

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 Example 06:
Bela Enterprises (BE) produces a chemical that requires two separate processes for its
completion. Following information pertains to process II for the month of August 2016:
kg Rs. in '000
Opening work in process (85% to conversion) 5,000 2,000
Costs for the month:
Received from process I 30,000 18,000
Material added in process II 15,000 10,000
Conversion cost incurred in process II - 11,000
Finished goods transferred to warehouse 40,000 -
Closing work in process (60% to conversion) 4,000 -
AT A GLANCE

In process II, material is added at start of the process and conversion costs are incurred evenly
throughout the process. Process losses are determined on inspection which is carried out on 80%
completion of the process. Process loss is estimated at 10% of the inspected quantity and is sold
for Rs. 100 per kg.
BE uses FIFO method for inventory valuation.
a) A statement of equivalent production units, would be prepared as follows:

Equivalent units Quantity

schedule
Statement of equivalent units: Material Conversion
------------------- kg -------------------
SPOTLIGHT

Opening WIP (85% to conversion) (5,000) (4,250) 5,000

Received from process I 30,000
Material added in process II 15,000
50,000
Transferred to finished goods 40,000 40,000 40,000
Goods started and completed during the A 35,000 35,750
month
Closing WIP (60% to conversion) B 4,000 2,400 4,000
STICKY NOTES

Normal loss at 10% 4,100

(50,000−5,000−4,000)×10%
Abnormal loss (80% conversion) C 1,900 1,520 1,900
(Balancing)
D 40,900 39,670 50,000

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b) Computation of costs would be as follows

Material Conversion Total

Cost per unit ---------- Rs. in ‘000 ----------
Opening WIP - - 2,000
Cost for the month: Process I 18,000 - 18,000
Process II 10,000 11,000 21,000
Normal loss quantity at sale price (4,100×100) (410) - (410)
Total cost E 27,590 11,000 40,590
----------------- Rupees -----------------

AT A GLANCE
Cost per unit F=(E÷D) 674.57 277.29

(i) Cost of finished goods: --------------- Rs. in ‘000 -------------

Opening WIP 2,000
Cost for the month A×F 23,610 9,913 33,523
35,523
(ii) Cost of closing WIP B×F 2,698 666 3,364
(iii) Cost of abnormal loss C×F 1,282 421 1,703

SPOTLIGHT
c) Accounting entries to account for production losses for the month would be as follows

Accounting entries to account for production losses:

Debit Credit
Date Description
--- Rs. in '000 ---
1 Scrap inventory (normal loss quantity) 4,100×100 410
WIP – II 410
(Normal loss quantity credited to WIP at sales value)
2 Scrap inventory (abnormal loss quantity) 1,900×100 190

STICKY NOTES
Profit and loss account (Balancing) 1,513
WIP – II As (iii) above 1,703
(Loss on abnormal loss quantity debited to profit and
loss account)

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 Example 07:
KS Limited operates two production departments A and B to produce a product XP-29.
Following information pertains to Department A for the month of December 2014.
Liters Rs. in '000
Opening work in process (Material 100%, conversion 80%) 15,000
• Material 5,000
• Direct labour and overheads 2,125
Actual cost for the month:
• Material 120,000 36,240
• Overheads 14,224
AT A GLANCE

• Direct labour 11,500

Expected losses 5%
Closing work in process (Material 100%, conversion 80%) 17,000
Units transferred to Department B 110,000

KS uses FIFO method for inventory valuation. Direct materials are added at the beginning of the
process. Expected losses are identified at the time of inspection which takes place at the end of
the process. Overheads are applied at the rate of 80% of direct labour cost.
a) Equivalent production units

KS Limited
SPOTLIGHT

Equivalent production: Material Conversion

------------ Liters ------------
Units completed and transferred out 110,000 110,000
Closing WIP (100% material and 80% 17,000 13,600
conversion)
Opening WIP (100% material and 80% (15,000) (12,000)
conversion)
Abnormal loss W.1 2,100 2,100
Equivalent production (A) 114,100 113,700
STICKY NOTES

Cost per liter: ---------- Rupees ----------

Cost incurred in December 2014 (B) 36,240,000 25,603,200
(14,224,000×1.8)
Cost per liter (B÷A) 317.62 225.18
b) Cost of goods transferred to Department B
Rs. in '000
From opening WIP:
- Cost incurred prior to 1 Dec. 2014 5,000+2,125 7,125
- Conversion cost incurred in Dec. 2014 15,000×20%×225.18 676
7,801
From units started and completed in Dec. 2014 51,566
[(110,000-15,000)×(317.62+225.18)]
59,367

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W.1: Abnormal loss Liters

Opening WIP 15,000
Units started in December 2014 120,000
Closing WIP (17,000)
Units completed in December 2014 118,000
Transferred to department B (110,000)
Normal loss 118,000 × 5% (5,900)
Abnormal loss 2,100
c) Accounting entries for the month of December 2014 are as follows

Date Description Debit Credit

AT A GLANCE
Rs. in '000
31-Dec-14 WIP - Department A 61,843
Raw material 36,240
Payroll 14,224
Applied overheads 14,224×80% 11,379
(Cost charged / overheads applied to department
A)
31-Dec-14 Applied overheads 11,379
Cost of sale (under applied overheads) 121
Overhead control account 11,500

SPOTLIGHT
(Under-absorbed overheads charged to P&L
account)
31-Dec-14 WIP - Department B 59,367
P&L account (abnormal loss) 1,140
[2,100×(317.62+225.18)]
WIP - Department A 60,507
(Units transferred to B and abnormal loss charged
to department B and P&L account respectively)
 Example 08:

STICKY NOTES
Quality Chemicals (QC) produces one of its products through two processes A and B. Following
information has been extracted from the records of process A for the month of January 2016.

Quantity Material Conversion

Units --------Rs. In ‘000’-------
Opening work in process 5,000 2,713 1,499
Input during the month 20,000 10,000 5,760
Transferred to process B 18,000 - -
Closing work in process 6,000 - -

Additional information:
i. Materials are introduced at the beginning of the process. In respect of conversion,
opening and closing work in process inventories were 40% and 60% complete,
respectively.

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ii. Inspection is performed when the units are 50% complete. Expected rejection is
estimated at 5% of the inspected units. The rejected units are not processed further and
sold at Rs. 100 per unit.
iii. QC uses 'weighted average method' for inventory valuation.
a) Computation of equivalent production units and cost per unit, would require

Process A - production and cost for the Equivalent

month of January 2016 Quantity units
Equivalent units under weighted average schedule Material Conv.
method:
-------------- No. of units --------------
AT A GLANCE

Opening WIP (40% to conversion) 5,000

Input for the month 20,000
A 25,000
Transferred to process B 18,000 18,000 18,000
Closing WIP (60% to conversion) 6,000 6,000 3,600
Normal loss-5% of the inspected units 1,250 - -
(A×5%)
Abnormal gain (50% to conv.) (Bal.) (250) (250) (125)
Normal equivalent units B 25,000 23,750 21,475
SPOTLIGHT

Cost per unit: ------ Rs. in '000 ------

Opening WIP 2,713 1,499
Cost for the month 10,000 5,760
Scrapped units at sale price 1,250×100 (125) -
C 12,588 7,259
Cost per unit C÷B 530 338

b) Journal entries to record the above transactions would be as follows

Accounting entries
STICKY NOTES

Date Description Debit Credit

--- Rs. in '000 ---
1 WIP - Process A 15,760
Raw material 10,000
Labour and overheads 5,760
(Material, labour and overheads charged to
Process A)
2 WIP - Process A (250×530)+(125×338) 175
OR (250×530)+(250×169)
Abnormal gain 175
(To record abnormal gain)
3 Scrapped units 1,250×100 125
WIP - Process A 125

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Accounting entries
Date Description Debit Credit
--- Rs. in '000 ---
(Sales value of rejected units credited to WIP)
4 WIP - Process B 15,624
18,000×(530+338)
WIP - Process A 15,624
(Goods completed transferred to Process B)
5 Abnormal gain 175
(250×530)+(125×338)
Scrapped units 250×100 25

AT A GLANCE
Profit or loss account 150
(Abnormal gain adjusted to profit or loss account)

SPOTLIGHT
STICKY NOTES

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 Example 09:
Ravi Limited (RL) is engaged in production of industrial goods. It receives orders from steel
manufactures and follows job order costing. The following information pertains to an order
received on 1 December 2016 for 6,000 units of a product:
Production details for the month of December 2016:

Units
Produced and transferred to finished goods 3,200
Delivered to the buyer from the finished goods 3,000
Units rejected during inspection 120
Closing work in process (100% material and 80% conversion) 680
AT A GLANCE

Actual expenses for the month of December 2016:

Rupees
Direct material 1,140,000
Direct labour (6,320 hours) 948,000
Factory overheads 800,000

Additional information:
• Factory overheads are applied at Rs. 120 per hour. Under/over applied factory
overheads are charged to profit and loss account.
SPOTLIGHT

• Units completed are inspected and transferred to finished goods. Normal rejection is
estimated at 10% of the units transferred to finished goods. The rejected units are sold
as scrap at Rs. 150 per unit.
• RL uses weighted average method for inventory valuation.
a) Work in process for the month of December 2016 would be

WIP
Description Units Rupees Description Units Rupees
Raw material W.1 4,000 1,140,000 Finished goods 3,200 2,490,336
(A) [3,200×778.23 (W-2)]
STICKY NOTES

Direct labour 948,000 Norm al loss 320 48,000

(320×150)
Applied overheads 758,400 Closing WIP *(Bal.) 680 463,710
(6,320×120)
Abnormal gain 200 155,646
[200×(778.23)]
4,200 3,002,046 4,200 3,002,046
*(680×296.74)+(544×481.49)

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Equivalent units
W-1: Equivalent units and costs applied to Quantity Material Conversion
the job schedule
Transferred to finished goods 3,200 3,200 3,200
Closing WIP 680×80% 680 680 544
Normal loss at 10% of the units completed 320
3,200×10%
4,200
Abnormal gain 120–320 (200) (200) (200)

AT A GLANCE
Normal production A 4,000 3,680 3,544

W-2: Cost per unit ----------- Rupees -----------

Raw material 1,140,000
Direct labour - 948,000
Applied overheads 6,320×120 - 758,400
Normal loss - sales price 320×150 (48,000)
B 1,092,000 1,706,400
(B÷A) 296.74 481.49
778.23

SPOTLIGHT
b) Accounting entries to record over/under applied overheads and production loss/gains

Date Description Debit Credit -

--------- Rupee ---------
31-Dec 2016 Factory overhead applied (6,320×120) 758,400
P& L account–overheads under applied 41,600
Factory overheads control 800,000
(Transfer of applied factory overheads to
control a/c and under applied overheads

STICKY NOTES
charged to P&L account)
31-Dec 2016 WIP (200×778.23) 155,64 6
Abnormal gain 155,646
(To record abnormal gain)
31-Dec2016 Scrap inventory (320×150) 48,000
WIP 48,000
(Sales value of rejected units credited to
WIP)
31-Dec2016 Abnormal gain (200×778.23) 155,646
Scrap inventory (320- 120)×150 30,000
P&L account 125,646
(Abnormal gain adjusted to P&L account)

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 Example 10:
Tulip Enterprises (TE) manufactures a product Alpha that requires two separate processes, A
and B. Following information has been extracted from the cost records of Process B for the month
of February 2019:
Quantity Process A Process B cost
cost
Material Conversion
Liters ------------------Rs. In ‘000’----------------
Opening work-in-process – Process B 10,000 1,500 600 400
(80% complete as to conversion)
Cost for the month:
AT A GLANCE

- Received from process A 90,000 14,000 - -

- Added during process B 12,000 - 7,000 5,600
Closing work-in-process – Process B 9,500 - - -
(70% complete as to conversion)

Additional information:
i. Materials are added at start of the process.
ii. Normal loss is estimated at 5% of the input. Loss is determined at completion of the
process. Loss of each liter results in a solid waste of 0.75 kg. During the month of
February 2019, solid waste produced was 6,000 kg.
iii. Solid waste is sold for Rs. 170 per kg after incurring further cost of Rs. 20 per kg.
SPOTLIGHT

iv. TE uses weighted average method for valuation of inventory.

Accounting entries to record the transactions of process B are as follows (Narrations to
accounting entries are not required)
Accounting entries for Process B
Date Description Debit Credit
------ Rs. in '000 ------
1 WIP - Process B 26,600
WIP - Process A 14,000
Raw material 7,000
STICKY NOTES

Labour and overheads 5,600

2 Scrapped inventory (Normal loss) [C×0.75×170] 653
Bank [C×0.75×20] 77
WIP - Process B (Normal loss) (W-1) 576
3 Scrapped inventory (Abnormal loss) 367
[D×0.75×170]
Profit or loss account 448
Balancing
Bank [D×0.75×20] 43
WIP - Process B (Abnormal loss) (D×H) 772
4 Finished goods (E×H) 25,366
WIP - Process B 25,366

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W-1: Equivalent production and cost per liter - Weighted average method
Quantity Equivalent units
Schedule
Material Conversion
------------------ Liters ------------------
Opening WIP (80% complete as to 10,000
conversion)
Input for the Process A 90,000
month -
Process B 12,000
Total input A 112,000

AT A GLANCE
Closing WIP (70% complete B 9,500 9,500 6,650
as to conversion)
Normal loss (A–B)×5% C 5,125 - -
Abnormal loss D 2,875 2,875 2,875
[(6,000÷0.75)–C]
Transferred to finished E 94,500 94,500 94,500
goods Balancing
F 112,000 106,875 104,025

Process A & Process B

SPOTLIGHT
material conversion
costs costs
------ Rs. in '000 ------
Opening WIP Process A 1,500
Process B 600 400
Cost for the Process A 14,000
month
Process B 7,000 5,600
Scrapped inventory (Recovery from normal scrapped (576)
units) (C×0.75)×(170–20)
Total cost G 22,524 6,000

STICKY NOTES
Rupees
G÷F×1,000 210.74 57.68
Total - Cost per liter H
268.42
 Example 11:
Mehnat Limited (ML) manufactures a product KLM which goes through two processes, Process A
and Process B. Following information pertains to process A for the month of February 2021:

Kg Rs. In 000
Opening work in process (80% complete) 2,000 5,000
Materials added during the month 18,000 36,000
Conversion costs 12,000
Transferred to Process B 16,000 -
Closing work in process (60% complete) 3,000 -

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Additional information relating to Process A:

(i) Costs of opening work in process consisted of Rs. 3,600,000 as to material and Rs.
1,400,000 as to conversion costs.
(ii) Materials are added at the start of the process and conversion costs are incurred evenly
throughout the process.
(iii) Process loss is determined on inspection which is carried out at 75% of completion.
(iv) Process loss is estimated at 12% of the input which is sold as scrap at Rs. 400 per kg.
(v) Inventory is valued using weighted average method.
(a) Statement of equivalent production units is prepared as under.

Equivalent units
AT A GLANCE

Process A Quantity Material Conversion

schedule Kg Kg
Opening WIP 2,000 - -
Material 18,000 - -
20,000
Goods transferred during the month 16,000 16,000 16,000
Closing WIP (60% converted) 3,000 3,000 1,800
Normal loss (18,000-3,000) x 12% 1,800 - -
Abnormal gain (75% converted) (800) (800) (600)
SPOTLIGHT

(A) 20,000 18,200 17,200

(b) Computation of costs of finished goods, closing work in process and production gain/loss, are
calculated below.

Computation of costs Material Conversion

--------Rs. In ‘000’-------
Opening WIP 3,600 1,400
Costs for the month 36,000 12,000
Normal loss (1,800 x 400) (720) -
STICKY NOTES

(B) 38,880 13,400

--------Rupees-------
Material Conversion Total
Cost per unit (B/A) 2,136 779 2,915
--------Rs. In ‘000’-------
Finished goods 34,176 12,464 46,640
Closing WIP 6,408 1,402 7,810
Abnormal gain 1,709 467 2,176

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(c) Accounting entries for production losses are given below.

Accounting entries for Production losses

Description Debit Credit
------ Rs. in '000 ------
Scrap inventory 720
WIP - Process A 720
WIP – Process A 2,176
Scrap inventory (800 x 400) 320

AT A GLANCE
Profit and Loss account (Balancing) 1,856

 Example 12:
A manufacturing company makes a product by two processes and the data below relates to the
second process for the month of June 2002.
Work in process as on June 01, 2002 was 1,200 units represented by the following costs:

Rupees
Direct materials (100%) 54,000
Direct wages (60%) 34,200
Overheads (60%) 36,000

SPOTLIGHT
During June 4,000 units were transferred from first process @ Rs.37.50 per unit. This cost is
treated as material cost of second process.
Other costs were as follow:

Rupees
Additional materials 24,150
Direct wages 164,825
Overhead 177,690

STICKY NOTES
Quantitative data shows the following:

Units
Finished goods transferred to warehouse 3,200
Finished goods in hand 500
Normal loss 520
Work in process (100% materials and
50% wages and overheads) 980

Average pricing method is used.

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(a) Equivalent production unit statement for June 2002, is prepared as under.
Equivalent production: Material Conversion
------------ Units ------------
Units completed and transferred out 3,200 3,200
Units completed but still on hand 500 500
Units in process (Materials 100%; Conversion 50%) 980 490
4,680 4,190

(b) Process account for the month of June 2002 is given as under:
Process Account
AT A GLANCE

Description Units Rupees Description Units Rupees

Opening WIP 1,200 124,200 Normal loss 520 -
Process I-Material 4,000 150,000 Finished goods 3,200 471,200
Additional material 24,150 WIP 1,480 169,665
Direct wages 164,825
Overheads 177,690
5,200 640,865 5,200 640,865

W-1 Computation of costs Material Labour Overheads

SPOTLIGHT

--------Rupees-------
Opening WIP 54,000 34,200 36,000
Process I 150,000 - -
Cost added 24,150 164,825 177,690
(A) 228,150 199,025 213,690
Equivalent units (B) 4,680 4,190 4,190
Unit cost 48.75 47.50 51.00
STICKY NOTES

W-2 Cost assigned to units transferred Rupees

Cost- Finished goods transfer [3,200 x (48.75+47.50+51.00) 471,200

W-3 Cost assigned to WIP Rupees

Cost- Finished goods on hand [500 x (48.75+47.50+51.00) 73,625
Cost assigned to partially completed units- 980 units
Materials (980 x 48.75 x 100%) 47,775
Labour (980 x 47.50 x 50%) 23,275
Overheads (980 x 51.00 x 50%) 24,990
169,665

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 Example 13:
Tata Cools manufactures a range of products including Air conditioners which pass through
three processes before transfer to finished goods store. Production department for the current
month has given the following production data.

PROCESS
1 2 3 Total
Basic raw material (10,000 kg) Rs. 6,000 6,000
Raw material addition Rs. 8,500 9,500 5,500 23,500
Direct wages Rs. 4,000 6,000 12,000 22,000
Production overheads (to be

AT A GLANCE
allocated on direct wages base) Rs. 16,500
Output Units 9,200 8,700 7,900
Normal loss in process of input % 10 5 10
Scrap value of each lost unit Rs. 0.20 0.50 1.00

There was no stock at start or at the end in any process.

(a) Process 1 account for the current month, is given below.
Calculation of Abnormal loss/ gain
PROCESS
1 2 3

SPOTLIGHT
Units started/Received from
preceding process 10,000 9,200 8,700
Transferred out (9,200) (8,700) (7,900)
Normal loss (1,000) (460) (870)
Abnormal loss (gain) (200) 40 (70)

Process 1 Account
Description Units Rupees Description Units Rupees
Materials 10,000 6,000 Normal loss 1,000 200

STICKY NOTES
Added material 8,500
Direct wages 4,000 Process 2 Account 9,200 21,773
Overheads W-1 3,000
Abnormal gain 200 473
10,000 21,973 10,000 21,973
(b) Process 2 account for the current month is given below.

Process 2 Account
Description Units Rupees Description Units Rupees
Process 1-Material 9,200 21,773 Normal loss 460 230
Added material 9,500 Abnormal loss 40 190
Direct wages 6,000 Process 3 Account 8,700 41,353
Overheads W-1 4,500

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9,200 41,773 9,200 41,773

(c) Process 3 account for the current month is given below.

Process 3 Account
Description Units Rupees Description Units Rupees
Process 2 Material 8,700 41,353 Normal loss 870 870
Added material 5,500
AT A GLANCE

Direct wages 12,000 Process 2 Account 7,900 67,582

Overheads W-1 9,000
Abnormal gain 70 599
8,770 68,452 8,770 68,452
W-1 Allocation of overheads to process accounts Rupees
Process 1 (16,500 x 4,000/22,000) 3,000
Process 2 (16,500 x 6,000/22,000) 4,500
Process 3 (16,500 x 12,000/22,000) 9,000
SPOTLIGHT

W-2 Unit cost Calculation Rupees

Process 1 (21,500 – 200)/9,000) 2.36667
Process 2 (41,773 - 230/8,740) 4.75320
Process 3 (67,853 - 870/7,830) 8.55466

W-3 Evaluation of cost Rupees

Transferred to process 2 (9,200 x 2.36667) 21,773
STICKY NOTES

Abnormal gain in process 1 (200 x 2.36667) 473

Transferred to process 3 (8,700 x 4.75320) 41,353
Abnormal loss in process 2 (40 x 4.75320) 190
Transferred to finished goods (7,900 x 8.55466) 67,581
Abnormal gain in process 3 (70 x 8.55466) 599

(d) Abnormal Loss and Abnormal Gain accounts are given below.

Abnormal loss account

Liters Rs. Liters Rs.
Process 2 account 40 190 Scrap account 40 80
Income statement 150
100 240 100 240

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Abnormal gain account

Liters Rs. Liters Rs.
Scrap account 200 100 Process 1 200 473
Scrap account 70 70 Process 2 70 599
Income statement 902
270 1,072 270 1,072
 Example 14:
Following is the data of Department B of EFG Company for December, 2003:

AT A GLANCE
Units Rupees
Work in process (opening); completed as to material
20% and conversion cost 25% 8,500 43,860
Work in process (ending); completed as to material
50% and conversion cost 25% 11,540
Current period transactions are:
Transferred from Department A 12,000 45,600
Units mishandled and lost before start of any process 460
Material consumed 27,654
Conversion cost incurred 47,689

SPOTLIGHT
Units transferred out 7,500
Normal spoilage is 6% of units transferred and inspection is done at the end of the process. Company
uses FIFO method for inventory valuation.

Preparation of Process B account including all relevant workings are given as under.

Equivalent units
Process B Material Conversion
Units Units
Units transferred from opening WIP- 7,500 units

STICKY NOTES
Material 80%; Conversion cost 75% 6,000 5,625
Units converted into closing WIP from opening WIP-
1,000 units; Material 30%; Conversion cost 0% 300 -
Normal loss 450 450
Abnormal loss 550 550
Closing WIP from current production- 10,540 units
Materials 50%; Conversion cost 25% 5,270 2,635
12,570 9,260

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W-1 Unit cost Calculation Rupees

Department A (45,600/12,000) 3.80
Material (27,654/12,570) 2.20
Conversion cost (47,689/9,260) 5.15
Total 11.15

W-2 Evaluation of cost Rupees

Abnormal Loss:
Units lost at start of process (460 x 3.80) 1,748
AT A GLANCE

Units lost at end of process (550 x 11.15) 6,132

7,880
Cost of goods transferred out:
From opening WIP (43,860 x 7,500/8,500) 38,700
Material added (7,500 x 2.20 x 80%) 13,200
Conversion cost added (7,500 x 5.15 x 75%) 28,969
Normal loss cost added (450 x 11.15) 5,018
85,887
Value of closing WIP:
SPOTLIGHT

From opening WIP (43,860 x 1,000/8,500) 5,160

Material cost added (1,000 x 2.20 x 30%) 660
5,820
From current production
Cost of department A (10,540 x 3.80) 40,052
Material added (10,540 x 2.20 x 50%) 11,594
Conversion cost added (10,540 x 5.15 x 25%) 13,570
65,216
71,036
STICKY NOTES

Note: It is assumed that all losses were occurred at end of process and from current production only.

Department B Account
Description Units Rupees Description Units Rupees
Opening WIP 8,500 43,860 Normal Loss 450 -
Department-A 12,000 45,600 Abnormal loss W-2 1,010 7,880
Materials 27,654 Transferred out W-2 7,500 85,887
Conversion cost 47,689 Closing WIP W-2 11,540 71,036
20,500 164,803 20,500 164,803

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Process costing is used where production is a continuous process, the output

of one process will be input to the next until a finished product is being
produced

Losses may occur in process. If a certain level of loss is expected this is called
normal loss. If losses are greater than expected the difference is abnormal
loss and if losses are less than normal the difference is known as abnormal
gain

AT A GLANCE
Scrap value of normal loss to be deducted from the cost of materials before
cost per equivalent unit is calculated. Units of normal loss are valued at their
scrap vale in the process account

Abnormal loss and gains have no concern with the cost of goods units of
production. The scrap value of the abnormal losses is not credited to the
process account, and abnormal loss and gain units carry the same full cost as
a good unit of production

SPOTLIGHT
When units are partly completed at the end of a period (closing WIP) it is
necessary to calculate the equivalent units of production in order to
determine the cost of a completed unit

There are two methods to deal with opening work in progress i.e. FIFO and
weighted average cost method.

STICKY NOTES
In the weighted average method, no distinction is made between units of
opening stock and new units introduced to the process during the period. The
cost of opening stock is added to costs incurred during the period and units of
opening stock are each given a value of one full equivalent unit off production

If there is opening and closing WIP, losses during the process and the loss has
no scrap value the following rules should be followed.
• Costs should be divided between finished output, closing stock and
abnormal loss/gain using equivalent units as a basis of apportionment
• Units of abnormal loss / gain are often taken to be one full equivalent unit
each, and are valued on this basis
• Abnormal loss units are an addition to the total equivalent units produced
but abnormal gain units are subtracted in arriving at the total number of
equivalent units produced

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When loss has a scrap value and the equivalent units are a different
percentage of the total units for materials, labour and overheads, it is
conventional that the scrap value of normal loss is deducted from the cost of
materials before a cost per equivalent unit is calculated

If units are rejected as scrap or loss at an inspection stage before the

completion of processing, units of abnormal loss should count as a proportion
of an equivalent unit, according to the volume of work done and materials
added up to the point of inspection
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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 CHAPTER 8

JOINT AND BY-PRODUCT COSTING

AT A GLANCE
IN THIS CHAPTER By-product is generally referred to one or more products
with relatively less in value but produced in common
AT A GLANCE process in joint products production.

AT A GLANCE
SPOTLIGHT By-product is treated similar to normal loss as its scrap
value is deducted from joint cost.
1. By-Products The products manufactured simultaneously by common
2. Joint Products process or processes and each product has significance
and controlled by management.
3. Distinguishing between Joint
products and by-products In volume method of joint product, equal cost per unit is
allocated to each product with assumption that all
4. Methods of allocating joint cost products receive same benefits from joint cost.
5. Comprehensive Examples Sales value at split-off method is used to allocate the joint
cost on the basis of sales value. This method is used where
STICKY NOTES

SPOTLIGHT
joint products have sales value at split off point.
Net realizable value method is used on products which
require further processing, before these are sold. These
joint products have no sales value at split off point and
joint cost is allocated on the basis of net realizable value of
each joint product.

STICKY NOTES

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1. BY-PRODUCTS
1.1 Concept and definition of By-products
The products manufactured from common production process for joint products and relatively insignificant in
value are known as by-products. While producing joint products from common process, there might be another
product or products which have insignificant value as compared to joint products. In simple words, it is treated
as wastage from common process which can be sold as scrap. In pursuance to produce main products, by-
products are produced as unavoidable result and has negligible sales value.

1.2 Examples of by-product

Examples of by-products in different manufacturing entities are given below.
AT A GLANCE

• During the process of sugar refining, a by-product “Sugar beet molasses” are produced. This by-product can
be used as fodder for animals or is used in some foods for flavouring and colouring.
• While processing fruit juice and other related beverages, few by-products are also produced. These are fruit
pulp, seeds and peels, and these can be used in cosmetic industry for their medicine properties.
• Ethylene is another example of by-product, which is related with petroleum refinery. This by-product is
essential in polythene based products like plastic products.

1.3 Accounting treatment of by-products

Normal accounting treatment of by-products is simple and similar to treatment of normal loss as discussed in
chapter 7 earlier. The scrap value of by-product is deducted from joint cost, before allocating to joint products.
Joint cost is not allocated to by-products, but it is reduced by sales value of by-products. However, it can be
recognized as other income but in this case, joint cost is not allocated to by-products.
SPOTLIGHT

Treatment of proceeds of sale Measurement of by-product in joint process

account
As other income No cost is allocated to the by product.
As a deduction from joint process costs (this is the By-product is measured at scrap value (the accounting
most commonly used method). treatment is very similar to that used for normal loss).
 Example 01:
AB Limited produces two joint products viz. Product A and Product B from common process. As consequence of
production of two main products, one by-product X is produced which can be sold at Rs. 8 per unit.
STICKY NOTES

During the month of December, 2020 total joint cost of Rs. 600,000 is incurred including direct and indirect cost.
6,000 units were produced in joint process.
The treatment of by-product is enumerated as under.
1. The sales value of Rs. 48,000 (6,000 x 8) of by-product X is recognized as other income and joint cost of Rs.
600,000 is allocated to joint products A and B.
2. The sales value of Rs. 48,000 (6,000 x 8) of by-product X is deducted from joint cost and remaining joint cost
of Rs. 552,000 (600,000 – 48,000) is allocated to joint products A and B.
 Example 02:
RS manufacturing company is engaged in production of chemicals in common process. At end of process,
Chemical K was resulted as by-product. RS manufacturing company deducts the sales value of by-product from
cost of main products.
In the month of November 2020, 5,000 liters of by-product Chemical A was produced. The liquid is converted
into solid waste and 10 liters is converted into 7 kg, which can be sold at Rs. 25 per kg.

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The scrap value of Chemical A (solid waste) of Rs. 87,500 (5,000 x 7/10 x 25) is deducted from joint cost, before
allocation it to joint products.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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2. JOINT PRODUCTS
1.1. Definition of joint products
In some manufacturing processes, two or more different products are produced and both are main products,
termed as joint products. Joint product costs can be defined as:
• Joint products are two or more products generated simultaneously, by a single manufacturing process or
series of processes using common input, and being substantially equal in value
Until the joint products are produced in the manufacturing process, they cannot be distinguished from each
other. The same input materials and processing operation produces all the joint products together.
Each joint product has a substantial sale value relative to each other joint product. An increase in one product’s
output will bring about an increase in other products quantity, not necessarily in the same proportion.
AT A GLANCE

1.2. Examples of joint products

The examples of joint products manufactured from common process are given below.
Oil industry produces gasoline, fuel oil, lubricants, paraffin, coal tar, asphalt and kerosene oil as joint products
from common process with crude oil.
Production of butter, cream and cheese from Milk.

1.
SPOTLIGHT
STICKY NOTES

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3. JOINT PRODUCTS AND BY-PRODUCTS DISTINGUISHED

The main points of distinction between joint products and by-products are apparent from the following.
• Joint products are of equal values and importance while by-products are relatively small in economic
value.
• Joint products are produced simultaneously while by-products are produced incidentally in the
manufacturing of main products.
• Joint products are crucial to the commercial viability of an organization, whereas by-products are not.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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4. METHODS OF ALLOCATING JOINT COST

The costs of the common process that produces the joint products are common costs. In order to calculate a cost
for each joint product, these common costs must be shared (apportioned) between the joint products. The
common costs of the process must be apportioned between the joint products on a fair basis, in much the same
way that overhead costs are apportioned between cost centers.
One of the following three methods of apportionment is normally used:
• Physical Measures Method: Common costs are apportioned on the basis of the total number of units
produced. The cost per unit is the same for all the joint products. (This is also described as the physical
quantities basis).
• Sales value at the split-off point basis: Common costs are apportioned on the basis of the sales value of the
joint products produced, at the point where they are separated in the process (the ‘split off point’).
AT A GLANCE

• Net realizable value (sales value less further processing costs basis): Common costs are apportioned on
the basis of their eventual sales value after they have gone through further processing to get them ready for
sale.
 Example 03:
During the month of July, the NV Company processes a basic raw material through a
manufacturing process that yields three products – products X, Y and Z. There were no opening
inventories and the products are sold at the split-off point without further processing. Company
uses physical measurement method for allocating the joint costs.
In the month of July, joint costs of Rs. 600,000 was incurred and 40,000 units, 20,000 units and
60,000 units of product X, Y and Z were produced.
SPOTLIGHT

The joint costs allocated to each product is computed as under.

Calculation of per unit cost of each product

Joint cost (A) 600,000
Production Units
Product X 40,000
Product Y 20,000
Product Z 60,000
Total units produced (B) 120,000
STICKY NOTES

Unit cost (A/B) 5.00

Joint costs allocated to each product Rupees

Product X (40,000 x 5) 200,000
Product Y (20,000 x 5) 100,000
Product Z (60,000 x 5) 300,000

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 Example 04:
The Tracy Company manufacturers joint products X and Y as well as by-product Z. Cumulative cost
data for the period show Rs. 204,000 incurred in refining department. Costs are assigned to X and Y
by volume method. Additional data is given below.
Products Units Rs.
Product X 8,000
Product Y 10,000
Product Z (Sales price of Rs. 4.80 per unit) 2,000 9,600

Joint cost allocated to all joint and by-products is given below.

AT A GLANCE
Calculation of per unit cost of each product Rupees
Joint cost 204,000
Cost assigned to by-product Z (2,000 x 4.80) (9,600)
Joint cost to be allocated to main products (A) 194,400
Production Units
Product X 8,000
Product Y 10,000
Total units produced (B) 18,000

SPOTLIGHT
Unit cost (A/B) 10.80

Joint costs allocated to each product Rupees

Product X (8,000 x 10.80) 86,400
Product Y (10,000 x 10.80) 108,000
Product Z 9,600
Total Joint cost allocated 204,000

STICKY NOTES
 Example 05:
The Buildon Company produces three joint products, Buildon, Buildeze and Buildrite. Total joint production
cost for November 2020 was Rs. 216,000.
The units produced and unit sales prices at the split off point were.
Products Units Unit sales
price Rs.
Buildon 6,000 22.00
Buileze 8,000 12.50
Buildrite 10,000 12.80
Company is using “sales value at split off method” for allocating the joint cost to all joint products.

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Allocation of the joint production cost, using sales value at split off, is given below.
Products Units Unit sales Total Sales % of sales Joint cost
Produced price Rs. value Rs. value to allocated
total Rs.
Buildon 6,000 22.00 132,000 36.66667% 79,200
Buileze 8,000 12.50 100,000 27.77778% 60,000
Buildrite 10,000 12.80 128,000 35.55556% 76,800
360,000 216,000
 Example 06:
The Star Company manufactures three joint products from a single raw material. A summary of
AT A GLANCE

production costs shows:

Products
S K A Total
Output in kilograms 80,000 200,000 160,000 440,000
Selling price per kilogram Rs. 0.75 1.00 1.50

Products
S K A Total
Production costs:
SPOTLIGHT

Materials - - - 90,000
Direct labour Rs. 3,000 20,000 30,000 80,000
Variable production overheads Rs. 2,000 10,000 16,000 45,000
Fixed productin overheads Rs. 15,000 34,000 30,000 115,000
All separable costs have been assigned to products but the joint cost has not been allocated. All of
the year’s output was sold.
Gross profit for each product, after allocating the joint cost by sales value method, is calculated as
under.
Products
STICKY NOTES

S K A Total
-------------------Rupees------------------
Sales 60,000 200,000 240,000 500,000
(80,000x0.75/200,000x1/160,000x1.50)
Less: Cost of sales:
Direct labour (3,000) (20,000) (30,000) (53,000)
Variable production overheads (2,000) (10,000) (16,000) (28,000)
Fixed production overheads (15,000) (34,000) (30,000) (79,000)
Joint cost allocated W-1 (20,400) (68,000) (81,600) (170,000)
(40,400) (132,000) (157,600) (330,000)
Gross profit 19,600 68,000 82,400

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W-1 Allocation of Joint cost

Products Units Unit sales Total Sales % of sales Joint cost
Produced price Rs. value Rs. value to allocated
total Rs. W-2
S 80,000 0.75 60,000 12% 20,400
K 200,000 1.00 200,000 40% 68,000
A 160,000 1.50 240,000 48% 81,600
500,000 170,000
W-2 Calculation of Joint Cost

AT A GLANCE
Description Rupees
Materials 90,000
Direct labour (80,000 – 3,000- 20,000 – 30,000) 27,000
Variable production overheads (45,000- 2,000- 10,000- 16,000) 17,000
Fixed production overheads (115,000- 15,000- 34,000- 30,000) 36,000
Total joint cost to be allocated 170,000

 Example 07:
Two joint products JP1 and JP2, are produced from a common process.

SPOTLIGHT
During March, 8,000 units of materials were input to the process. Total costs of processing (direct
materials and conversion costs) were Rs. 135,880.
Output was 5,000 units of JP1 and 3,000 units of JP2.
JP1 has a sales value of Rs. 40 per unit when it is output from the process and can be sold for
Rs.120 per unit after further processing costs of Rs.25 per unit.
JP2 has a sales value of Rs. 55 per unit when it is output from the process and can be sold for
Rs.80 per unit after further processing costs of Rs.15 per unit.
Joint costs allocation under all of the above mentioned methods, is calculated as under.
Volume/ Physical measurement method

STICKY NOTES
Output Units
JP1 5,000
JP2 3,000
8,000

Costs: Rs.
JP1: 5,000 units/8,000 units × Rs.135,880. 84,925
JP2: 3,000 units/8,000 units × Rs.135,880. 50,955
135,880

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These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 84,925
JP2 3,000 50,955
8,000 135,880 8,000 135,880
Sales value at point of split off, assuming no further processing is required and products
are sold at split off point.
Sales value Rs.
JP1 (5,000 units × Rs. 40) 200,000
AT A GLANCE

JP2 (3,000 units × Rs. 55) 165,000

365,000
Costs: Rs.
JP1: Rs. 200,000/ Rs. 365,000 × Rs.135,880. 74,455
JP2: Rs. 165,000/ Rs. 365,000 × Rs.135,880. 61,425
135,880
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
SPOTLIGHT

Processing cost 8,000 135,880 JP1 5,000 74,455

JP2 3,000 61,425
8,000 135,880 8,000 135,880
Net realizable value at the point of split off

NRV value Rs.

JP1 (5,000 units × Rs. 120 − Rs. 25) 475,000
JP2 (3,000 units × Rs. 80 − Rs. 15) 195,000
670,000
STICKY NOTES

Costs: Rs.
JP1: Rs. 475,000/Rs. 670,000 × Rs.135,880. 96,333
JP2: Rs. 195,000/Rs. 670,000 × Rs.135,880. 39,547
135,880
These costs would be recorded in the process account as follows.
Process account
units Rs. units Rs.
Processing cost 8,000 135,880 JP1 5,000 96,333
JP2 3,000 39,547
8,000 135,880 8,000 135,880

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 Example 08:
Physical unit basis
In a joint process, two joint products are made, Product A and Product B. There is no inventory
of work-in-process. Information relating to last month’s production is set out in the table below.

Joint product Opening inventory Closing inventory Sales

Units units units
A 800 1,200 8,000
B 700 300 10,000

The costs of the joint process in the month were Rs. 144,000. These are apportioned between
the joint products on the basis of units produced.

AT A GLANCE
The joint processing costs for the month that are charged to each product can be calculated as
follows

Production
units
Joint product A: (1,200 + 8,000 – 800) 8,400
Joint product B: (300 + 10,000 – 700) 9,600
Total production 18,000

Joint processing costs Rs.144,000

SPOTLIGHT
Joint processing costs per unit Rs.8

Apportionment of joint costs Rs.

To Joint product A: (8,400 × Rs.8) 67,200
To Joint product B: (9,600 × Rs.8) 76,800
144,000

 Example 09:
Two joint products JP1 and JP2, are produced from a common process.

STICKY NOTES
During March, 9,000 units of materials were input to the process. Total costs of processing (direct
materials and conversion costs) were Rs. 135,880.
Output was 5,000 units of JP1 and 3,000 units of JP2 and 1,000 units of by-product BP3.
JP1 has a sales value of Rs. 40 per unit when it is output from the process and can be sold for
Rs.120 per unit after further processing costs of Rs.25 per unit.
JP2 has a sales value of Rs. 55 per unit when it is output from the process and can be sold for
Rs.80 per unit after further processing costs of Rs.15 per unit.
BP3 has a sales value of Rs.1.58 per unit.
The company’s policy is to treat the proceeds of sale of a by-product as a reduction of joint
process costs
Apportionment of the process costs between the joint products on the basis of net realizable sales
value at the split off point, would be as follows.

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Net realizable value at the point of split off

Common process costs Rs.
Total process costs 135,880
Deduct: Sales value of by-product (1,000 × Rs.1.58) (1,580)
134,300

NRV value Rs.

JP1 (5,000 units × Rs. 120 − Rs. 25) 475,000
JP2 (3,000 units × Rs. 80 − Rs. 15) 195,000
AT A GLANCE

670,000

Costs: Rs.
JP1: Rs. 475,000/Rs. 670,000 × Rs. 134,300. 95,213
JP2: Rs. 195,000/Rs. 670,000 × Rs. 134,300. 39,087
134,300

These costs would be recorded in the process account as follows.

Process account
units Rs. units Rs.
SPOTLIGHT

Processing cost 9,000 135,880 JP1 5,000 95,213

JP2 3,000 39,087
By product 1,000 1,580
9,000 135,880 9,000 135,880

 Example 10:
Two joint products XX and YY, are produced from a common process.
During July, 11,000 units of materials were input to the process. Total costs of processing (direct
materials and conversion costs) were Rs. 100,000.
STICKY NOTES

Output was 6,000 units of XX and 4,000 units of YY and 1,000 units of by-product Q.
XX has a sales value of Rs. 24 per unit when it is output from the process.
YY has a sales value of Rs. 12 per unit when it is output from the process.
Q has a sales value of Rs.1 per unit
The company’s policy is to apportion joint costs based on sales value at the point of split off.
80% of the output of both XX and YY was sold by the month end.
The proceeds of sale of the by-product could be treated in one of the following ways.
Sales value at point of split off deducting proceeds of sale of the by-product from the joint process
cost (as before)
Sales value Rs.
XX (6,000 units × Rs. 24) 144,000
YY (4,000 units × Rs. 12) 48,000
192,000

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By-product deducted from costs Rs.

XX: Rs. 144,000/ Rs. 192,000 × (Rs.100,000 − Rs. 1,000) 74,250
YY: Rs. 48,000/ Rs. 192,000 × (Rs.100,000 − Rs. 1,000). 24,750
99,000
These costs would be recorded in the process account as follows.
Process (WIP) account
units Rs. units Rs.
Processing cost 11,000 100,000 XX 6,000 74,250
YY 4,000 24,750

AT A GLANCE
Q 1,000 1,000
11,000 100,000 11,000 100,000
The income statement would show the following:

Rs.
Revenue:
Sales of XX (80% × 6,000 units × Rs. 24) 115,200
Sales of YY (80% × 4,000 units × Rs. 12) 38,400
153,600

SPOTLIGHT
Cost of sales:
Production costs (99,000)
Less: Closing inventory (20% × 99,000) 19,800
(79,200)
Profit 74,400

Sales value at point of split off treating proceeds of sale of the by-product as other income

Sales value Rs.

XX (6,000 units × Rs. 24) 144,000

STICKY NOTES
YY (4,000 units × Rs. 12) 48,000
192,000

By-product deducted from costs Rs.

XX: Rs. 144,000/ Rs. 192,000 × Rs.100,000 75,000
YY: Rs. 48,000/ Rs. 192,000 × Rs.100,000 25,000
100,000

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These costs would be recorded in the process account as follows.

Process (WIP) account
units Rs. units Rs.
Processing cost 11,000 100,000 XX 6,000 75,000
YY 4,000 25,000
Q 1,000 nil
11,000 100,000 11,000 100,000

The income statement would show the following:

Revenue:
AT A GLANCE

Sales of XX (80% × 6,000 units × Rs. 24) 115,200

Sales of YY (80% × 4,000 units × Rs. 12) 38,400
153,600

Cost of sales:
Production costs (100,000)
Less: Closing inventory (20% × 100,000) 20,000
(80,000)
Gross profit 73,600
SPOTLIGHT

Other income 1,000

Profit 74,600

The profit in the above example is higher than the profit in the previous example by Rs. 200.
This is because the whole sales proceeds from the sale of the by-product has been recognized as
other income.
When the sales proceeds from the sale of the by-product are deducted from the joint process cost
part of that deduction is carried forward to the next period in the valuation of closing inventory.
The deduction in joint process costs was Rs. 1,000 and 80% of the inventory to which it relates
has been sold leaving 20% (Rs. 200) to be carried forward to the next period.
STICKY NOTES

 Example 11:
PQR Limited produces two joint products – P and Q- together with a by-product R, from a single
main process (process 1). Product P is sold at the point of separation for Rs. 5 per kg, whereas
product Q is sold for Rs. 7 per kg after further processing into product Q2 in process 2. By-product
R is sold without further processing for Rs. 1.75 per kg.
Process 1 is closely monitored by a team of chemists, who planned the output per 1,000kg of input
materials to be as follows:

Products Kg
P 500
Q 350
R 100
Toxic waste 50

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The toxic waste is disposed of at a cost of Rs. 1.50 per kg, and arises at the end of processing.
Process 2, which is used for further processing of product Q into Q2, has the following cost
structure.

Rs.
Fixed costs per week 3,450
Variable cost per kg processed 2.00

The following actual data relate to the first week of accounting period 10:

Process 1 Rs.
Opening work in process Nil

AT A GLANCE
Materials 10,000 kg input 15,000
Direct labour 10,000
Variable production overhead 4,000
Fixed production overhead 4,000
Output: Kg
Product P 4,800
Product Q 3,600
Product P 1,000
Toxic waste 600

SPOTLIGHT
Closing work in process Nil
Process 2 Kg
Opening work in process Nil
Input of product Q 3,600
Output of product Q2 3,300
Closing work in process (50% coverted) 300

Conversion costs were incurred evenly throughout the process.

(a) Preparation of process 1 account, is given below.

STICKY NOTES
Process 1 Account
Kg Rs. Kg Rs.
Materials 10,000 15,000 Normal loss 500 -
Abnormal loss
Direct labour 10,000 W-1 100 400
Product R
Variable overheads 4,000 (1,000 x 1.75) 1,000 1,750
Fixed overheads 6,000 Product P W-4 4,800 21,000
Disposal cost (600x
x1.50) 750 Product Q W-4 3,600 12,600
10,000 35,750 10,000 35,750

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W-1 Abnormal loss in units and Rs.

Kg
Input 10,000
Product P (4,800)
Product Q (3,600)
Product R (1,000)
Normal loss (50/1,000 x 10,000) (500)
Abnormal loss in units 100
x Unit cost W-2 4.00
Cost assigned to abnormal loss 400
AT A GLANCE

W-2 Unit cost

Rs.
Input cost 35,000
Disposal cost of toxic waste 750
35,750
Sales value of by-product (1,750)
Total cost 34,000
Expected output (10,000-1,000-500) 8,500
SPOTLIGHT

Unit cost (34,000/8,500) 4.00

W-3 Joint cost to be allocated

Rs.
Total input cost plus disposal cost W-1 34,000
Cost assigned to abnormal loss W-2 (400)
33,600

W-4 Allocation of Joint cost

Product Prod. Final Sales Further NRV per % of Joint cost

STICKY NOTES

Units price Rs. cost per unit Rs. sales allocated

unit Rs. value to Rs. W-2
W-5 total
P 4,800 5.00 - 24,000 62.5% 21,000
Q 3,600 7.00 (3.00) 14,400 37.5% 12,600
38,400 33,600

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W-5 Further processing cost of Product Q per unit

Rs.
Fixed cost 3,450
Variable cost (3,300 x 2)+ (300 x 2 x 50%) 6,900
Total further processing cost (A) 10,350
Equivalent units: Units
Units completed and transferred 3,300
Units in process (300 x 50%) 150
Equivalent Unit (B) 3,450
Unit cost of further processing (A/B) 3.00

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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5. COMPREHENSIVE EXAMPLES
 Example 01:
A chemical is manufactured by passing through two processes X and Y using two types of direct
material, A and B. In process Y, a by-product is also produced which is then transferred to process
Z where it is completed. For the first week of a month, the actual data has been as follows:

Process
X Y Z
Output of main product (kgs) 9,400 8,000
Output of by-product (kgs) 1,400 1,250
Direct material (Rs.) 123,500
AT A GLANCE

- A (9,500 units)
Direct material (kgs) 500 300 20
- B added in process
Direct material (Rs.) 19,500 48,100 1,651
- B added in process
Direct wages (Rs.) 15,000 10,000 500
Scrap value (Rs. per unit) 5 10 6
Normal loss of units in process (%) 4 5 5
The factory overheads are budgeted @ 240% of direct wages and are absorbed on the basis of
SPOTLIGHT

direct wages. Actual factory overheads for the week amounted to Rs. 65,000. Estimated sales
value of the by-product at the time of transfer to process Z was Rs. 22 per unit.
Preparation the required accounts for the given example are as follows
a) Process accounts for X, Y and Z.
Process X A/c
Kgs Rs. Kgs Rs.
Direct materials – A 9,500 123,500 Normal loss 400 2,000
A/c
Direct material – B 500 19,500 Abnormal loss 200 4,000
A/c
STICKY NOTES

Transfer to
Direct wages 15,000 process Y 9,400 188,000
Production overheads @ 240%
of direct wages 36,000
10,000 194,000 10,000 194,000

Working:
Cost per unit of good units and abnormal loss units Rupees
Total cost less scrap
(194,000 – 2,000) 192,000
No. of units including abnormal losses
(9,400 + 200) 9,600
Cost per unit (Rs.) 20

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Process Y A/c
Kgs Rs. Kgs Rs.
Transfer from process X 9,400 188,000 Normal loss A/c 485 4,850
Direct materials – B 300 48,100 Finished goods 8,000 240,000
Direct wages 10,000 Byproduct 1,400 30,800
Production overheads @
240% of direct wages 24,000
9,700 270,100
Abnormal gain A/c 185 5,550

AT A GLANCE
9,885 275,650 9,885 275,650

Working:
Cost per unit of good units and abnormal loss units Rupees
Total cost less scrap and by-product cost (270,100 – 4,850 – 30,800) 234,450
Less: Total No. of units less normal losses and by-product
(9700-485-1400) 7,815
Cost per unit (Rs.) 30

Process Z A/c

SPOTLIGHT
Kgs Rs. Kgs Rs.
Input 1,400 30,800 Normal loss A/c 71 426
Abnormal loss
Direct materials – B 20 1,651 A/c 99 2,475
Direct wages 500 Finished goods 1,250 31,250
Production overheads
@ 240% of direct
wages 1,200
1,420 34,151 1,420 34,151

STICKY NOTES
Working: Cost per unit of good and abnormal loss units Rupees
Total cost less scrap (34,151 – 426) 33,725
No. of units including abnormal losses (1,420 – 71) 1,349
Cost per unit (Rs.) 25

b) Abnormal loss and abnormal gain accounts.

Abnormal Loss A/c
Units Rs. Units Rs.
Process X 200 4,000 Bank Account 200 1,000
Process Z 99 2,475 Bank account 99 594
Costing P & L A/c 4,881
299 6,475 299 6,475

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Abnormal Gain A/c

Units Rs. Units Rs.
Bank A/c / normal loss A/c 185 1,850 Process Y 185 5,550
Costing P & L A/c 3,700
185 5,550 185 5,550

c) Factory overhead account.

Factory overheads A/c
Rs. Rs.
Cash/bank/payables (actual
AT A GLANCE

overheads) 65,000 Charged to process accounts:

Process X 36,000
Process Y 24,000
Process Z 1,200
Cost of goods sold accounts:
Overheads under absorbed 3,800
65,000 65,000

 Example 02:
Platinum Limited (PL) manufactures two joint products Alpha and Beta and a by-product Zeta
from a single production process. Following information is available from PL’s records for the
SPOTLIGHT

month of February 20X4:

Direct material 25,000 kg. @ Rs. 25 per kg.

Direct labour @ Rs. 15 per hour Rs. 432,000
Normal process loss 20% of the material consumed
Overheads are allocated to the products at the rate of Rs. 10 per direct labour hour. The normal
loss is sold as scrap at the rate of Rs. 8 per kg.
Following data relates to the output from the process:

Product Output ratio Selling price per kg. (Rs.)

STICKY NOTES

Alpha 75% 95.0

Beta 15% 175.0
Zeta 10% 52.5

Alpha is further processed at a cost of Rs. 30 per unit, before being sold in the market. Joint
costs are allocated on the basis of net realizable value.
a) Computation of the total manufacturing costs for February 20X4 would be as follows.
Total cost of output: Kg. Rupees
Direct material [25,000 x Rs. 25] 25,000 625,000
Direct Labour 432,000
Overheads [ 432,000 / Rs. 15 x Rs. 10] 288,000
1,345,000
Less: Sale of scrap [ 25,000 x 20% x Rs. 8] (5,000) (40,000)
Total cost of products 20,000 1,305,000

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b) And the calculation for the profit per kg for Alpha, Beta would be as follows:

Profit per kg of Alpha and Beta: Rupees

Joint costs of products 1,305,000
Less: Sale of Zeta [20,000 x 10% x Rs. 52.5] (105,000)
1,200,000

NRV at % of NRV to Joint cost Total Profit

Product Kg. Total NRV total
split-off allocation profit per Kg.
Alpha 15,000 95-30=65 975,000 65% 780,000 195,000 13

AT A GLANCE
Beta 3,000 175 525,000 35% 420,000 105,000 35
18,000 1,500,000 1,200,000

 Example 03:
Oceanic Chemicals manufactures two joint products Sigma and Beta in a single process at its
production department. Incidental to the production of these products, it produces a by-product
known as ZEE. Sigma and ZEE are sold upon completion of processing in production department
whereas Beta goes to refining department where it is converted into Theta.
Joint costs are allocated to Sigma and Beta on the basis of their net realizable values. Proceeds
from sale of by-product are treated as reduction in joint costs. In both the departments, losses up
to 5% of the input are considered as a normal loss.

SPOTLIGHT
Actual data for the month of June 2015:

Department
Production Refining
Cost ------ Rs. in '000 ------
Material input at Rs. 50 per kg 3,000 -
Direct labour at Rs. 100 per hour 2,500 350
Production overheads 1,850 890

STICKY NOTES
Output ---------- Liters----------
Sigma 34,800 -
Beta 16,055 -
ZEE (by-product) 5,845 -
Theta - 15,200

Sigma, Theta and by-product ZEE were sold at Rs. 300, Rs. 500 and Rs. 40 per liter respectively.
There was no work in process at the beginning and the end of the month.

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The cost per liter of Sigma and Theta, for the month of June 2015 would require following
calculations:

Oceanic Chemicals Sigma Theta

Product-wise cost of Sigma and Theta ----------- Rs. in '000’ -----------
Joint costs of production W.2 4,303.49 2770.98
Cost of refining (350+890) - 1,240.00
(A) 4,303.49 4,010.98
No. of units produced Liter. (B) 34,800 15,252
Cost per Liter Rs. (A÷B) 123.66 262.98
AT A GLANCE

W.1: Joint cost of production Rs. in '000’

Joint cost of production (3,000+2,500+1,850) 7,350.00
Sale proceeds from by-product ZEE (5,845×40) (233.80)
7116.20
Cost of abnormal loss of production [7,116.20÷(34,800+16,055+300)×300] (41.73)
7,074.47

NRV at Units Total Joint cost

W.2: Allocation of joint costs split-off produced NRV allocation
SPOTLIGHT

Rs. Liters -------- Rs. in '000 --------

Sigma 300.00 34,800 10,440.00 4,303.49
Beta 500-[(350+890)÷15,252)] 418.70 16,055 6,722.23 2,770.98
17,162.23 7,074.47

Production Refining
W.3: Abnormal loss quantity
---------- Liters ----------
Input quantity 3,000,000÷50 60,000 16,055
STICKY NOTES

Output quantity (34,800+16,055+5,845) (56,700) (15,200)

Production losses 3,300 855
Normal losses up to 5% of input (60,000×5%), (16,055×5%) 3,000 803
Abnormal loss 300 52

 Example 04:
Cricket Chemicals Limited (CCL) is a manufacturing concern and has two production processes.
Process I produces two joint products i.e. X-1 and X-2. Incidental to the production of joint
products, it produces a by-product known as Zee. X-1 is further processed in process II and
converted into ‘X1-Plus’.

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Following information has been extracted from the budget for the year ending 31 August 2019:
i. Process wise budgeted cost:
Process I Process II
-------------- Rupees ------------
Direct material (500,000 liters) 98,750,000 -
Conversion cost 72,610,000 19,100,000
ii. Expected output ratio from process I and budgeted selling prices:
Products Output ratio in process I Selling price (Rs. per liter)
Joint product – X-1 55% -

AT A GLANCE
Joint product – X-2 40% 532
By-product – Zee 5% 120
X1-Plus - 768

Additional information:
i. Material is added at the beginning of the process and CCL uses 'weighted average
method' for inventory valuation.
ii. Joint costs are allocated on the basis of net realizable value of the joint products at the
split-off point. Proceeds from the sale of by-product are treated as reduction in joint
costs.
iii. Joint product X-2 is sold after incurring packing cost of Rs. 75 per liter.

SPOTLIGHT
iv. Normal production loss in process I is estimated at 5% of the input which occurs at
beginning of the process. Loss of each liter results in a solid waste of 0.7 kg which is sold
for Rs. 10 per kg. No loss occurs during process II.
v. Budgeted conversion cost of process I and process II include fixed factory overheads
amounting to Rs. 7,261,000 and Rs. 3,820,000 respectively.
a) Preparation of product wise budgeted income statement for the year ending 31 August 2019,
under marginal costing is given below

Cricket Chemicals Limited

Product wise budgeted income statement X1 - Plus X2

STICKY NOTES
- (Marginal costing) ---- Rs. in million ----
Sales [768×261,250 (W-4)], [532×190,000(W-4)] 200.64 101.08
Variable production cost:
Joint cost (W-1) (108.96) (52.11)
Process II Conversion cost (19.10m–3.82m) (15.28) -
Packing cost (75×190,000) - (14.25)
Budgeted contribution margin 76.40 34.72
Fixed cost:
Joint cost (W-1) (4.91) (2.35)
Process II conversion cost (3.82) -
Budgeted profit 67.67 32.37
Total budgeted profit 100.04

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W-1: Allocation of joint cost on the basis of NRV

Joint NRV at Production Total NRV Joint cost Fixed Variable
products split-off point (Units) (A×B) allocation on NRV cost (D) joint cost
(Rs. per unit) (B) basis (C) (C–D)
(A) ---------------------- Rs. in million ----------------------
X1 694.89 261,250 181.54 113.87 4.91 108.96
768–73.11 (W-4) (168.33×181.5/ (7.26×181.54/
(W-3) 268.37) 268.37)
X2 457.00 190,000 86.83 54.46 2.35 52.11
(532–75) (W-4) (168.3×86.83/ (7.26×86.83/
AT A GLANCE

268.37) 268.37) (W-1)

268.37 (W-2)168.33 7.26 161.07

W-2: Joint cost - Process I Rs. in million

Direct material 98.75
Conversion cost 72.61
Proceeds from By product - Zee (23,750 (W-4)×120) (2.85)
Proceeds from sale of normal loss (25,000(W-4)×0.7kg×10) (0.18)
Total joint cost 168.33
W-3: Conversion cost -
SPOTLIGHT

Process II (Rs. per unit) [19,100,000 / 261,250 (W-4)] 73.11

Process I
W-4: Quantity schedule
--- Liters ---
Input quantity 500,000
Joint product - X-1 (500,000–25,000)×55% (261,250)
Joint product - X-2 (500,000–25,000)×40% (190,000)
By product – Zee (500,000–25,000)×5% (23,750)
Normal loss (500,000×5%) (25,000)
STICKY NOTES

b) CCL has recently received an offer from Football Industries Limited (FIL) to purchase the
entire expected output of X-1 during the year ending 31 August 2019 at Rs. 670 per litter. It
is estimated that if process II is not carried out, fixed costs associated with it would reduce
by Rs. 2,500,000. Advise whether FIL’s offer may be accepted.
Evaluation of offer from FIL Rs. in million
Loss of revenue if offer is accepted {261,250 (W-4) ×(768–670)} (25.60)
Variable cost saved in process-II (19.10m – 3.82m) 15.28
Fixed cost saved 2.50
(Decrease)/Increase in budgeted profits (7.82)
Conclusion: Offer should not be accepted

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 Example 05:
Production at Platinum Chemicals (PC) involves two processes I and II. Following information
pertains to the month of August 2017:
i. Actual cost:
Process I Process II
--------- Rupees ---------
Direct material (12,000 liters) 5,748,000 -
Conversion 2,610,000 1,542,000
ii. Production and sales
Process I Process II

AT A GLANCE
Description Remarks
------ Liters ------
Products:
Joint product – J101 5,000 - Sold for Rs. 1,200 per liter after
incurring packing cost of Rs. 120 per
liter
Joint product – J202 4,500 - Transferred to process II for
conversion into a new product J-plus
By-product – BP01 1,000 - Sold at the split-off point for Rs. 500
per liter
J-plus - 3,400 Sold for Rs. 1,400 per liter
Work-in-process:

SPOTLIGHT
Opening - -
Closing - 650 70% complete as to conversion
iii. Materials are introduced at the beginning of process I and PC uses 'weighted average
method' for inventory valuation.
iv. Proceeds from sale of by-product are treated as reduction in joint costs. Joint costs are
allocated on the basis of net realizable values of the joint products at split-off point.
v. Normal production losses in both processes are estimated at 10% of the input and are
incurred at beginning of the process. Loss of each liter in process I results in a solid waste
of 0.8 kg which is sold for Rs. 100 per kg. Loss of process II has no sale value.

STICKY NOTES
a) The cost of sales of J101 and J-plus for the month of August 2017, would be
calculated as follow:

Platinum Chemicals
Cost of sales for the month of August 2017 - J101 J-plus
Product J101 and J-plus
Quantity sold Liters. 5,000 3,400
-------------- Rupees --------------
Allocated joint costs from process I (W-1) 4,147,792 -
3,456,494(W-1)÷(3,400+650)×3,400 - 2,901,748
Process II – Conversion cost (3,400×400) - 1,360,000
Packing cost (5,000×120) 600,000 -
4,747,792 4,261,748

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W-1: Allocation of joint cost - Process I (on the basis of NRV)

Joint product NRV per unit at Units Total NRV Joint cost
split-off produced allocation
------- Rs. ------- Liters ------- Rupees -------
J101 (1,200-120) 1,080 5,000 4,147,792
5,400,000
J202 [1,400- 1,000 4,500 4,500,000 3,456,494
400(W-3)]
(W-2)
9,900,000 7,604,286
AT A GLANCE

W-2: Joint costs - Process I Rupees

Direct material 5,748,000
Proceeds from sale of solid waste - normal loss 1,200 (W-4)×80%×100 (96,000)
Proceeds from sale of by-product BP01 1,000(W-4)×500 (500,000)
5,152,000
Cost of abnormal loss 5,152,000×300÷9,800 (157,714)
Conversion cost 2,610,000
Cost allocation between joint products J101 and J202 7,604,286
W-3: Conversion cost per unit - Process II Rupees
SPOTLIGHT

Conversion cost of process II A 1,542,000

Equivalent units 3,400(W-4)+(650×0.7) B 3,855
Cost per unit (A÷B) C 400
Process I Process II
W-4: Normal and abnormal losses quantity
--------- Liters ---------
Input quantity 12,000 4,500
Less: J101 (5,000) -
J202 – Transfer to process II (4,500)
By-product BP01 (1,000) -
STICKY NOTES

J-plus - (3,400)
Closing work in process (70% conversion) - (650)
Normal loss - 10% of input (12,000×10%); (1,200) (450)
(4,500×10%)
Abnormal loss 300 -

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b) For the given example, accounting entries to record production gains/losses and
their ultimate disposal, are as follows.

Journal entries to record production and disposal of solid waste

Debit Credit
Date Description
-------- Rupees --------
30-Aug-2017 Solid waste inventory (normal loss at sale 96,000
price) (W-2)
Solid waste inventory (abnormal loss at cost) 157,714
(W-2)
WIP - Process I 253,714

AT A GLANCE
(Normal losses at sale price and abnormal
losses at cost credited to WIP)
30-Aug-2017 Bank (1,200+300)×0.8×100 120,000
Profit and loss account Balancing 133,714
Solid waste inventory 253,714
(Sale of normal and abnormal solid waste)

 Example 06:
Scents Limited produces three joint products P, Q and R. Raw material is added at the beginning of
process I. On completion of process I, these three products are split in the ratio of 50:30:20
respectively. Joint costs incurred in process I are apportioned on the basis of net realizable value

SPOTLIGHT
of the three products at split-off point. Products P and Q are sold in the same state whereas
product R is further processed in process II before being sold in the market. A by-product TS is
also produced in process II.
Following information relating to the two processes is available for the month of February 2020:
Process I Process II
Raw materials at Rs. 411 per kg 744,000 kg
Direct labour at Rs. 200 per hour 611,568 hours 55,450 hours
Production overheads RS. 91,456,000 RS. 7,230,000
Additional information:

STICKY NOTES
(i) Loss of 7% is considered normal in process I.
(ii) Details of opening and closing stocks, estimated cost to sell and selling price are given as
under:
Selling price Cost to sell Opening stock Closing stock
per kg (Rs.) per kg (Rs.) Kg Kg
Product P 1.045 15 - 20,200
Product Q 960 10 - 15,140
Product R 1,021 12 7,800 48,134
(iii) Values of opening and closing stocks of product R comprised of cost of both processes.
Value of opening stock of product R is Rs. 5,850,000.
(iv) In process II, 7450 kg of TS was produced and sold at Rs. 175 per kg. Proceeds from sale of
TS are adjusted against cost of process II
(v) Selling and administration costs are charged to P, Q and R at 12% of sales.

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 CHAPTER 8: PROCESS COSTING CAF 8: CMA

FIFO method is used for inventory valuation.

Product wise income statement for the month of February 2020 is given below.
P Q R
--------------Rupees-----------
Sales (quantity sold × selling price) 340,419,200 184,738,560 92,502,600
Cost of sales
Opening stock - - 5,850,000
(W-1) (W-1) (W-5)
Production cost 273,813,041 151,527,605 110,622,450
Less: Closing stock [Cost per kg (W-
1)&(W-5)×quantity(W-1) (16,010,318) (11,067,794) (40,666,973)
AT A GLANCE

Cost of sales (257,802,723) (140,459,811) (75,805,477)

Gross profit 82,616,477 44,278,749 16,697,123
Selling and administration costs @12% of
revenue (40,850,304) (22,168,627) (11,100,312)
Net profit 41,766,173 22,110,122 5,596,811
W-1 Quantity schedule
Process I Qty Prod. Closing Qty NRV of Total cost (as perCost per kg
[Total Qty stock transferred products W-3 NRV ratio)
W-2 x split / sold
ratio]
SPOTLIGHT

A B C= B/A
Product P-50% 345,960 20,200 325,760 356,338,800 274,203,639 792.59
Product Q-30% 207,576 15,140 192,436 197,197,200 151,743,761 731.03
Product R-20% 138,384 - 138,384 121,645,071 93,606,200
691,920 35,340 656,580 675,181,071 519,553,600
W-4

Process II Product R
Kgs
STICKY NOTES

Opening stock 7,800

Quantity produced (138,384- 7,450) 130,934
Closing stock (48,134)
Quantity sold 90,600
W-2
Kgs
Input material 744,000
Normal loss @ 7% (52,080)
Total quantity produced 691,920

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W-3
P Q R
--------------Rupees-----------
Selling price per kg 1,045 960 1,021
Less: Estimated cost to sell per kg 15 10 12
1,030 950 1,009
Less: Estimated further processing cost
per kg (Process II)
- Labour cost (11,090,000(W-5)/130,934) - - 84.70
- Production overheads
(7,230,000/130,934) - - 55.22

AT A GLANCE
- Sales of by-product TS
[(175×7,450)/130,934] - - (9.96)
- - 129.96
Net realizable value per kg 1,030 950 879.04
Net realizable value [NRV per kg ×
quantity produced(W-1)] 356,338,800 197,197,200 121,645,071
W-4 Process I
Rupees
Material cost (744,000×411) 305,784,000
Labour (611,568×200) 122,313,600

SPOTLIGHT
Production overheads 91,456,000
Total cost of process I 519,553,600
W-5 Process II
Rupees
Cost transferred from PI (W-1) 93,606,200
Labour cost (55,450×200) 11,090,000
Production overheads 7,230,000
111,926,200
Less: Sales of by-product TS (175×7,450) (1,303,750

STICKY NOTES
Total cost of process II 110,622,450
Cost/kg of final product R[110,622,450÷130,934(W-1)] 844.87
 Example 07:
Colon Limited (CL) manufactures two joint products Pollen and Stigma in the ratio of 65:35. The
company has two production departments A and B. Pollen can either be sold at split off point or
can further be processed at department-B and sold as a new product Seeds. Stigma is sold without
further processing. Following information relating to the three products is available from CL’s
records:
Pollen Stigma Seeds
-----------------Rupees---------------
Sales price per kg 90 300 125
Total selling expenses 135,000 306,000 180,000

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Following further information relating to the two departments is available:

Department A Department B
Material X 75,000 kg at Rs. 60 per kg -
Material Y - 12,000 kg at Rs. 25 per kg
Labour @ Rs. 150 per hour 12,000 hours 3,600 hours
Variable overheads Rs. 125 per labour hour Rs. 65 per labour hour
Fixed overheads Rs. 100 per labour hour Rs. 50 per labour hour
Material input output ratio 100:88 100:96
Material is added at the beginning of the process. Joint costs are allocated on the basis of net
AT A GLANCE

realisable value at split off point.

(a) Calculation of joint cost and its apportionment to two products, are given below.
Calculation of joint cost
Department A Rupees in 000
Material X [75,000 × Rs. 60] 4,500
Labour [12,000 × Rs. 150] 1,800
Variable overheads [12,000 × Rs. 125] 1,500
Fixed overheads [12,000 × Rs. 100] 1,200
9,000
Apportionment of Joint cost
SPOTLIGHT

Input of material X in dept. A 75,000 kg

Yield (88% of input material X) 66,000 kg
Ratio of output for Pollen and Stigma 65:35
Quantity of Pollen produced at split off point (66,000 × 65/100) 42,900 kg
Quantity of Stigma produced at split off point (66,000 × 35/100) 23,100 kg

Statement showing apportionment of joint costs: Pollen Stigma

Rupees in 000
STICKY NOTES

Sales [42,900 × 90] and [23,100 × 300] 3,861 6,930

Less: Selling expenses (135) (306)
Net realisable value 3,726 6,624
Ratio 36% 64%
Allocation of joint costs [9,000 × 36%] and [ 9,000 × 64%] 3,240 5,760
(b) Advise to CL whether it should produce Seeds or sell Pollen without further processing, is
based on following calculations:
Computation of output of seeds Kg
Transfer of Pollen to dept. B for further processing 42,900
Input of material Y in dept. B 12,000
Total material in dept. B 54,900
Yield (96% of input material) [54,900 × 96%] 52,704

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Statement showing profit earned from Seeds Seed

Rs. In 000
Sales [52,704 × 125] 6,588
Less: Expenses
Joint costs (3,240)
Cost incurred in dept. B W-1 (1,254)
Selling expenses (180)
Profit from Seeds 1,914
If Pollen is sold without further processing, then the profitability would be as under:
Rs. In 000

AT A GLANCE
Net realisable value at split off point [(42,900 × 90) – 135,000 ] 3,726
Less: Joint costs (3,240)
Profit from Pollen 486
Advise: The company’s profit has increased by Rs. 1,428,000 (i.e. Rs. 1,914,000 – Rs. 486,000)
on further processing of Pollen into Seeds. Therefore, it is advisable to CL to further process
Pollen into Seeds.
W-1 Cost incurred in Department B
Department B
Rs. 000
Material Y [12,000 × Rs. 25] 300

SPOTLIGHT
Labour [3,600 × Rs. 150] 540
Variable overheads [3,600 × Rs. 65] 234
Fixed overheads [3,600 × Rs. 50] 180
Total cost 1,254
 Example 08:
Binary Limited manufactures three joint products viz. Aay, Bee and Cee in one common process.
Following this process, product Aay and Bee are sold immediately while product Cee is subjected
to further processing. Following information is available for the period ended June 30, 2007:
(i)

STICKY NOTES
Aye Bee Cee
Opening stock in kg Nil Nil Nil
Production in kg 335,000 295,000 134,000
Sales in kg 285,000 212,000 -
Sales price per kg (Rs.) 30.85 40.38
(ii) Total costs of production were Rs 17,915,800.
(iii) 128,000 kg of Cee were further processed during the period and converted into 96,000 kg
of Zee. The additional cost of further processing was as follows:
Rupees
Direct labour 558,500
Production overheads 244,700

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 CHAPTER 8: PROCESS COSTING CAF 8: CMA

(iv) 94,000 kg of Zee was sold during the period, with total revenue of Rs. 3,003,300. Opening
stock of Zee was 8,000 kg, valued at Rs 172,800. FIFO method is used for pricing transfers
of Zee to cost of sales.
(v) 8,000 kg of a bye-product Vee was also produced during further processing and sold @ Rs.
10 per kg. Sales proceeds of bye-product are adjusted against production cost of product
Zee.
(vi) The cost of production is apportioned among Aay, Bee and Cee on the basis of weight of
output.
(vii) Selling and administration costs of Rs. 2,500,000 were incurred during the period. These
are allocated to all the main products based on sales value.
Preparation of profit and loss account for the period, identifying separately the profitability of
AT A GLANCE

each of the three main products, is given below.

Binary Limited
Profit and Loss Statement
For the year ended 30 June 2007
Aye Bee Zee Total
------------Rupees-------------
Sales W-1 8,792,250 8,560,560 3,003,300 20,356,110
Cost of sales:
Joint product cost W-2 (7,855,750) (6,917,750) (3,142,300) (17,915,800)|
Less: closing stock W-3 1,172,500 1,946,350 140,700 3,259,550
SPOTLIGHT

(6,683,250 (4,971,400) (3,001,600) (14,656,250)

Further processing cost W-4 - - (723,200) (723,200)
Less: closing stock of Zee W-5 - - 77,600 77,600
(6,683,500) (4,971,400) (3,647,200) (15,301,850)
Gross profit (loss) 2,109,000 3,589,160 (643,900) 5,054,260
Selling & Administration cost W-6 (1,079,805) (1,051,350) (368,845) (2,500,000)
Net profit 1,029,195 2,537,810 (1,012,745) 2,554,260
W-1 Sales
Rupees
STICKY NOTES

Aye (285,000 x 30.85) 8,792,250

Bee (212,000 x 40.38) 8,560,560
W-2 Joint cost allocation
Kg
Total volume in Kg (335,000+ 295,000+ 134,000) 764,000
Rupees
Joint cost 17,915,800
Joint cost per kg (17,915,800/ 764,000) 23.45
Cost apportion to joint products Rupees
Aay (335,000 x 23.45) 7,855,750
Bee (295,000 x 23.45) 6,917,750
Cee (134,000 x 23.45) 3,142,300

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W-3 Closing stock

Aye Bee Cee
Production in kg 335,000 295,000 134,000
Sold in kg (285,000) (212,000) -
Converted in Zee - - (128,000)
Closing stock in kg 50,000 83,000 6,000
x cost per kg 23.45 23.45 23.45
Closing stock in Rs. 1,172,500 1,946,350 140,700

W-4 Further processing cost

AT A GLANCE
Rupees
Direct labour 558,500
Production overheads 244,700
803,200
Less: scrap of Vee (8,000 x 10) (80,000)
723,000
W-5 Closing stock of Zee

Rupees
Cost of production converted from Cee 3,001,600
Further processing cost 723,200

SPOTLIGHT
Total cost of Zee 3,724,800
Unit cost per kg (3,724,800/ 96,000) 38.80
Closing stock of Zee (2,000 x 38.80) 77,600
W-6 Selling and administration cost

Rupees
Aye (2,500,000 x 8,792,250/ 20,356,110) 1,079,805
Bee (2,500,000 x 8,560,560/ 20,356,110) 1,051,350
Zee (2,500,000 x 3,003,300/ 20,356,110) 368,845

STICKY NOTES

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STICKY NOTES

By-product is generally referred to one or more products with relatively less

in value but produced in common process in joint products production.

By-product is treated similar to normal loss as its scrap value is deducted

from joint cost.

AT A GLANCE
Joint products are two or more products generated simultaneously, by a
single manufacturing process or series of processes using common input, and
being substantially equal in value

In volume method of joint product, equal cost per unit is allocated to each
product with assumption that all products receive same benefits from joint
cost.

Sales value at split-off method is used to allocate the joint cost on the basis of

SPOTLIGHT
sales value. This method is used where joint products have sales value at split
off point.

Net realizable value method is used on products which require further

processing, before these are sold. These joint products have no sales value at
split off point and joint cost is allocated on the basis of net realizable value of
each joint product.

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 208

 CHAPTER 9

MARGINAL COSTING AND

ABSORPTION COSTING

AT A GLANCE
IN THIS CHAPTER

AT A GLANCE
In marginal costing only variable production costs (marginal
AT A GLANCE costs) are charged to the cost of inventory and variable selling
cost is deducted to calculate contribution margin. Fixed costs
SPOTLIGHT are treated as period costs and are deducted from profit. They
are charged in full against the profit of the period in which they
1. Marginal Cost and Marginal are incurred.
Costing In absorption costing variable production costs as well as fixed
production costs are charged to the cost of making the product
2. Reporting Profit with Marginal or service. Fixed production cost are absorbed using a
Costing predetermined absorption rate.

3. Reporting Profit with In marginal costing the closing stocks are valued at marginal
Absorption Costing (variable) production cost where as in absorption costing stocks

SPOTLIGHT
are valued at their full production cost which includes absorbed
4. Marginal and Absorption fixed production overhead.
Costing Compared If the opening and closing stock levels differ the profit for the
accounting period under the two methods of cost accumulation
5. Advantages and Disadvantages will be different because the two systems value stock differently.
of Absorption and Marginal
Costing Increase in stock level resulted higher profits in absorption
costing and decrease in stock level resulted higher profits in
6. Comprehensive Examples marginal costing.

STICKY NOTES

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 85

 CHAPTER 5: MARGINAL COSTING AND ABSORPTION COSTING CAF 8: CMA

1. MARGINAL COST AND MARGINAL COSTING

1.1 Marginal cost
The marginal cost of an item is its variable cost.
• Marginal production cost includes direct materials, direct labour and variable production overheads.
• Marginal cost of sale for a product includes variable selling and administrative cost in marginal
production cost.
• Marginal cost of sale for a service includes similar cost as mentioned in marginal production cost, only
difference is that here marginal cost of service is included.
It is usually assumed that direct labour costs are variable (marginal) costs, but often direct labour costs might
AT A GLANCE

be fixed costs, and so would not be included in marginal cost. E.g. If the workers are not being paid on piece rate
basis but rather on fixed salary.
Variable overhead costs might be difficult to identify. In practice, variable overheads might be measured using
a technique such as high/low analysis or linear regression analysis, to separate total overhead costs into fixed
costs and a variable cost per unit of activity.
• For variable production overheads, the unit of activity is often either direct labour hours or machine
hours, although other suitable measures of activity might be used.
• For variable selling and distribution costs, the unit of activity might be sales volume or sales revenue.
• Administration overheads are usually considered to be fixed costs, and it is very unusual to come across
variable administration overheads.
Marginal costing is also known as direct costing or variable costing, as in marginal costing, inventory is measured
SPOTLIGHT

at variable product cost.

1.2 Marginal costing and its uses

Marginal costing is a method of costing in which inventories are measured with variable cost of production. It is
an alternative to absorption costing as a method of costing. In marginal costing, fixed production overheads are
treated as period cost and charged as expense in the year of occurrence.
There are arguments in support of using marginal costing:
• Marginal costing provides more useful information for decision-making. The separation of fixed and
variable costs helps to provide relevant information for better decision-making. In addition, the
estimation of costs at various level helps to judge appropriate level for decision-making as well.
STICKY NOTES

• Another argument for using variable costing for internal reporting is that the internal profit statements
may be used as a basis for measuring the managerial performance. In absorption costing, there might
be chances of manipulating performance by enhancing closing inventory, where fixed cost is included
in cost of closing inventory. Whereas in marginal costing, it is not possible for managers to manipulate
profits, because fixed cost is not a part of inventory.
• The situation where market demand of product declines, the stock can be end up with surplus stock. In
absorption costing, fixed cost proportion is included in the surplus stock. If this surplus stock cannot
be sold, then profit calculation for the current period will be misleading. Marginal costing, in this
situation, provides true picture of profits, as fixed cost is treated as period cost, not product cost.
(Drury, 6th Edition, p. 238)

1.3 Marginal costing characteristics

• All elements of costs are segregated into fixed and variable, whether it is production or non-production
cost.
• Variable cost per unit remains constant irrespective of level of production. However, total variable cost
change in accordance with change in volume.

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• Fixed cost is treated as period cost, and is charged to profit & loss in the period of occurrence.
• The inventories in marginal costing includes only variable production cost. All fixed costs and variable
non-production costs are not part of inventory.
• Marginal costing technique helps to management in decision-making process. For example, large order
from customer at discounted price can be judged from marginal costing technique. (Ashok, 2020)

1.4 Assumptions in marginal costing

For the purpose of marginal costing, the following assumptions are normally made:
• Every additional unit of output or sale, or every additional unit of activity, has the same variable cost as
every other unit. In other words, the variable cost per unit is a constant value.
• Fixed costs are costs that remain the same in total in each period, regardless of how many units are

AT A GLANCE
produced and sold.
• Costs are either fixed or variable, or a mixture of fixed and variable costs. Mixed costs can be separated
into a variable cost per unit and a fixed cost per period.
• The marginal cost of an item is therefore the extra cost that would be incurred by making and selling
one extra unit of the item. Therefore, marginal costing is particularly important for decision making as
it focuses on what changes as a result of a decision.

1.5 Contribution margin

Contribution is a key concept in marginal costing. Gross contribution margin is calculated by deducting the
variable production cost from its revenue whereas net contribution margin, mostly known as contribution
margin, is derived by deducting total variable costs from its revenue.

SPOTLIGHT
Gross Contribution margin = Sales – Variable Production costs
Contribution margin = Sales – Variable costs (Both production and non-production)
Fixed costs are a constant total amount in each period. To make a profit, an entity must first make enough
contribution to cover its fixed costs. Contribution therefore means: ‘contribution towards covering fixed costs
and making a profit’.
Total contribution margin – Fixed costs = Profit
In simple words…
Contribution margin is sales minus all Variable costs

STICKY NOTES

THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN 87

 CHAPTER 9: MARGINAL COSTING AND ABSORPTION COSTING CAF 8: CMA

2. REPORTING PROFIT WITH MARGINAL COSTING

2.1 Total contribution minus fixed costs
Profit is measured by comparing revenue to the cost of goods sold in the period and then deducting other
expenses.
The cost of goods sold is the total cost of all production costs in the period adjusted for the inventory movement.
In a marginal costing system, the opening and closing inventory is measured at its marginal product cost. The
cost per unit only includes the variable costs of production (direct materials + direct labour + direct expenses +
variable production overhead).
Format of marginal costing statement of profit is given below.
AT A GLANCE

Format of marginal costing profit statement Rs. Rs.

Sales X
Opening inventory X
Add: variable production cost:
Direct materials cost (A) X
Direct labour cost (B) X
Variable production overheads (C) X
Less closing inventory (A+B+C)/units produced x closing inventory units (X) (X)
Gross contribution X
Less: variable selling and administrative cost (X)
SPOTLIGHT

Net contribution margin X

Less: Fixed cost:
Production X
Non-production X (X)
Net profit X
Total contribution and contribution per unit
In marginal costing, it is assumed that the variable cost per unit of product (or per unit of service) is constant. If
the selling price per unit is also constant, this means that the contribution earned from selling each unit of
product is the same.
STICKY NOTES

Total contribution can therefore be calculated as: Units of sale × Contribution per unit.
 Example 01:
A company manufactures and sells two products, A and B.
Product A has a variable cost of Rs.6 and sells for Rs.10, and product B has a variable cost of Rs.8
and sells for Rs.15.
During the period, 20,000 units of Product A and 30,000 units of Product B were sold.
Fixed costs were Rs.260,000. What was the profit or loss for the period?
Contribution per unit:
Product A: Rs.10 – Rs.6 = Rs.4
Product B: Rs.15 – Rs.8 = Rs.7

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Rs.
Contribution from Product A: (20,000 × Rs.4) 80,000
Contribution from Product B: (30,000 × Rs.7) 210,000
Total contribution for the period 290,000
Fixed costs for the period (260,000)
Profit for the period 30,000

2.2 A marginal costing income statement with opening and closing inventory
 Example 02:

AT A GLANCE
NT Enterprises provides the following data for month of March 2021, for calculation of profit
under marginal costing principle.
Units
Opening inventoy 3,000
Closing inventory 5,000
Units produced 25,000
Units sold 23,000
Other data: Rupees

SPOTLIGHT
Direct material cost per unit 6.00
Direct labour cost per unit 3.50
Variable production overheads per unit 2.50
Sales price 22.00
Variable selling & administration cost 10% of sales
Fixed production overheads 50,000
Fixed selling & administration cost 28,000

If an income statement is prepared using marginal costing, the opening and closing inventory might be shown,

STICKY NOTES
as follows:

Marginal costing income statement for the period Rs. Rs.

Sales (23,000 x 22) 506,000
Opening inventory (3,000 x [6.00+3.50+2.50]) 36,000
Variable production costs
Direct materials (25,000 x 6.00) 150,000
Direct labour (25,000 x 3.50) 87,500
Variable production overheads (25,000 x 2.50) 62,500
336,000
Less: Closing inventory (5,000 x [6.00+3.50+2.50]) (60,000) (276,000)
Gross contribution 230,000

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Variable selling and distribution costs (10% of sales) (50,600)

Contribution margin 179,400
Fixed costs:
Production fixed costs 50,000
Selling and administration costs 28,000 (78,000)
Profit 101,400

 Example 03:
Mingora Manufacturing makes and sells a single product:
AT A GLANCE

Rs.

Selling price per unit 150

Variable costs:

Direct material per unit 35

Direct labour per unit 25

Variable production overhead per unit 10

SPOTLIGHT

Marginal cost per unit 70

Budgeted fixed production overhead Rs. 110,000 per month

The following actual data relates to July and August:

July August

Fixed production costs Rs. 110,000 Rs. 110,000

STICKY NOTES

Production 2,000 units 2,500 units

Sales 1,500 units 3,000 units

There was no opening inventory in July.

This means that there is no closing inventory at the end of August as production in the two
months (2,000 + 2,500 units = 4,500 units) is the same as the sales (1,500 + 3,000 units = 4,500
units)

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The profit statements for each month are shown below. Work through these carefully one month
at a time.

July August
Sales:
1,500 units × Rs. 150 225,000
3,000 units × Rs. 150 450,000

Opening inventory nil 35,000

AT A GLANCE
Variable production costs
Direct material: 2,000 units × Rs. 35 70,000
Direct labour: 2,000 units × Rs. 25 50,000
Variable overhead 2,000 units × Rs. 10 20,000

Direct material: 2,500 units × Rs. 35 87,500

Direct labour: 2,500 units × Rs. 25 62,500
Variable overhead 2,500 units × Rs. 10 25,000

SPOTLIGHT
Closing inventory
500 units @ Rs. 70 (35 + 25 + 10) (35,000)
Closing inventory nil
Cost of sale (105,000) (210,000)
Contribution margin 120,000 240,000
Fixed production costs (expensed) (110,000) (110,000)
Profit for the period 10,000 130,000

In simple words…

STICKY NOTES
To calculate profit, we have to deduct all Fixed Cost from Contribution Margin.

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3. ABSORPTION COSTING
3.1 Absorption costing
In Chapter 3, we have discussed the use of factory overhead rate for product costing. When this is established,
the production capacity volume must be selected, so that all costs and expenses can be expected to be
recovered over a certain period of time. This concept of costing is known as “Absorption costing” and it is,
sometimes, termed as “Full costing” or “Conventional costing”. It includes direct materials, direct labour,
direct expenses, variable production overheads and fixed production overheads. In absorption costing, fixed
production cost is product cost, and inventory is valued at full production cost. Still, fixed non-production
overheads are period cost and charged to profit or loss for the year.

At end of each period, differences between absorbed and fixed production overheads are closed to cost of
AT A GLANCE

sales. The under or over absorption of production overheads arise because of actual production level was
less or more than budgeted or normal activity level.

3.2 Arguments in favour of absorption costing

• Absorption costing does not understate the importance of fixed production overheads. Inventory in
this method is calculated on realistic cost of production because of inclusion of fixed production
overheads.
• Absorption costing avoids fictitious losses being reported as in seasonal sales situation, it provides
realistic profit or loss for the period. Unlike in marginal costing, where in low sales season, fixed cost
in total is deducted from contribution margin, resulting losses.
• Another arguments towards absorption costing is that the production of goods is not possible
SPOTLIGHT

without incurring fixed manufacturing cost. As a result, we add fixed production overhead in
inventory valuation.
• Most important argument is that absorption costing is in consistent with external reporting.
STICKY NOTES

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4 REPORTING PROFIT WITH ABSORPTION COSTING

4.1 Reporting profit with absorption costing
Absorption costing is the ‘traditional’ way of measuring profit in a manufacturing company. Inventory is valued
at the full cost of production, which consists of direct materials and direct labour cost plus absorbed production
overheads (fixed and variable production overheads).
Fixed production overhead may be under- or over- absorbed because the absorption rate is a predetermined rate
and calculated at specified level of activity. This was covered in chapter 3.
Over and under absorption is the difference between absorbed and actual overheads. If absorbed are greater
than actual overheads, it is over absorption and vice versa.
Format of marginal costing statement of profit is given below.

AT A GLANCE
Format of absorption costing profit statement Rs. Rs.
Sales X
Opening inventory at full product cost of last period X
Add: production cost:
Direct materials cost (A) X
Direct labour cost (B) X
Variable production overheads (C) X
Fixed production overheads absorbed (D)
Less closing inventory (A+B+C+D)/units produced x closing inventory units (X)

SPOTLIGHT
X
Add: Under absorbed or Less: Over absorbed fixed production overheads X (X) (X)
Gross profit
Less: Non-production overheads:
Selling & distribution costs X
Administration costs X (X)
Net profit X

4.2 Calculation of total absorption costing profit

STICKY NOTES
The following example uses the same base scenario as that used to illustrate absorption costing, assuming no
opening and closing inventories.
 Example 04:
Rashid Manufacturing Company manufactures single product X11. Following data is relevant
for the preparation of income statement under absorption costing.

Rs.
Selling price per unit 100
Variable costs:
Direct material per unit 25
Direct labour per unit 20
Variable production overhead per unit 15
60

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Fixed overhead per unit (see below) 20

Total absorption cost per unit 80

Normal production 2,100 units per month

Budgeted fixed production overhead Rs. 42,000 per month

Fixed overhead absorption rate Rs. 42,000/2,100 units= Rs. 20 per unit

The following data relates to July 2020:

AT A GLANCE

July, 2020

Fixed production costs Rs. 110,000

Production and Sales (Actual) 2,000 units

Total absorption cost profit statement for the month of July, 2020, is given below.

Rupees
Sales (2,000 x 100) 200,000
Less: Cost of sales:
SPOTLIGHT

Opening inventory Nil

Production costs
Direct material: 2,000 units × Rs. 25 (50,000)
Direct labour: 2,000 units × Rs. 20 (40,000)
Variable overhead 2,000 units × Rs. 15 (30,000)
Fixed production costs (absorbed) 2,000 x Rs. 20 (40,000)
(160,000)
Less: Closing inventory -
(160,000)
STICKY NOTES

Under absorbed fixed production overhead (2,100-2,000) x Rs. 20 (2,000)

Cost of sale (162,000)
Profit 38,000

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4.3 A marginal costing income statement with opening and closing inventory
 Example 05:
NT Enterprises provides the following data for month of March 2021, for calculation of profit
under absorption costing principle.
Units
Opening inventoy 3,000
Closing inventory 5,000
Units produced 25,000
Units sold 23,000

AT A GLANCE
Budgeted level per month 20,000
Other data: Rupees
Direct material cost per unit 6.00
Direct labour cost per unit 3.50
Variable production overheads per unit 2.50
Sales price 22.00
Variable selling & administration cost 10% of sales
Fixed production overheads 50,000

SPOTLIGHT
Fixed selling & administration cost 28,000

If an income statement is prepared using absorption costing, the opening and closing inventory
might be shown, as follows:

Absorption costing income statement for the period Rs. Rs.

Sales (23,000 x 22) 506,000
Opening inventory (3,000 x [6.00+3.50+2.50+2.50 W-1]) 43,500
Variable production costs
Direct materials (25,000 x 6.00) 150,000

STICKY NOTES
Direct labour (25,000 x 3.50) 87,500
Variable production overheads (25,000 x 2.50) 62,500
Absorbed fixed production overheads (25,000 x 2.50 W-1) 62,500
406,000
Less: Closing inventory (5,000 x [6.00+3.50+2.50+2.50 W- (72,500)
1])
333,500
Less: Over absorbed fixed production overheads [(25,000- (12,500) (321,000)
20,000) x 2.50]
Contribution profit 185,000
Non-production overheads:
Variable selling and administration cost (10% of 506,000) 50,600

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Fixed Selling and administration costs 28,000 (78,600)

Profit 106,400

W-1 Fixed production overhead rate

Fixed production overheads (Rs.) 50,000
Budgeted level in units 20,000
Fixed overhead absorption rate (Rs.)- [50,000/ 20,000] 2.50

 Example 06:
AT A GLANCE

Silver Limited (SL) produces and markets a single product. Following budgeted information is
available from SL’s records for the month of March 2020:

Volumes
Sales 100,000 units
Production 120,000 units
Standard costs:
Direct materials per unit 0.8 kg at Rs. 60 per kg
Labour per unit 27 minutes at Rs. 80 per hour
Variable production overheads Rs. 40 per labour hour
SPOTLIGHT

Variable selling expenses Rs. 15 per unit

Fixed selling expenses Rs. 800,000

Fixed production overheads, at a normal output level of 105,000 units per month, are estimated
at Rs. 2,100,000. The estimated selling price is Rs. 180 per unit.
Assuming there are no opening stocks, preparation SL’s budgeted profit and loss statement for
the month of March 2020 using absorption costing would be as follows:

Absorption costing: Rupees

Sales [100,000 x Rs. 180] 18,000,000
Less: Cost of sales:
STICKY NOTES

Opening stock -
Add: Direct materials [ 0.8 x 120,000 x 60] (5,760,000)
Direct labour [27/60 x 120,000 x 80] (4,320,000)
Variable overheads [ 27/60 x 120,000 x 40] (2,160,000)
Fixed overheads
[ 2,100,000 / 105,000 x 120,000] (2,400,000)
(14,640,000)
Less: Closing stock
[14,640,000 / 120,000 x 20,000] 2,440,000
Cost of sales (12,200,000)

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Less: Over-absorbed overheads

[ 2,100,000 / 105,000 x 15,000] 300,000
(11,900,000)
Gross profit 6,100,000
Less: Selling expenses:
Variable [ 100,000 x 15] (1,500,000)
Fixed (800,000)
(2,300,000)
Net profit 3,800,000

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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5 MARGINAL COSTING AND ABSORPTION COSTING COMPARED

4.1 The difference in profit between marginal costing and absorption costing
The profit for an accounting period calculated with marginal costing is different from the profit calculated with
absorption costing if inventory level change over period. If opening and closing inventory level is same, then
profit of marginal and absorption is equal.
The difference in profit is entirely due to the differences in inventory valuation as fixed overheads are treated as
period cost in marginal costing and as product cost in absorption costing.
The main difference between absorption costing and marginal costing is that in absorption costing, inventory
cost includes a share of fixed production overhead costs.
• The opening inventory contains fixed production overhead that was incurred last period. Opening
AT A GLANCE

inventory is written off against profit in the current period. Therefore, part of the previous period’s costs
is written off in the current period income statement provided that the opening inventory is sold during
the current year.
• The closing inventory contains fixed production overhead that was incurred in this period. Therefore,
this amount is not written off in the current period income statement but carried forward to be written
off in the next period income statement.
The implication of this is as follows (assume costs per unit remain constant):
• When there is no change in the opening or closing inventory, exactly the same profit will be reported
using marginal costing and absorption costing.
• If inventory increases in the period (closing inventory is greater than opening inventory), the fixed
production overhead brought forward from last period will be less than share of production overhead
SPOTLIGHT

carried forward to next period, thus the absorption costing profit would be higher than marginal costing
profit.
• Similarly, if inventory decreases in the period (closing inventory is less than opening inventory),
marginal costing profit would be higher than absorption costing.
The difference in the two profit figures is calculated by preparing reconciliation statement and format of this
statement is given below.
Reconciliation statement Rs.
Profit under absorption costing X
Add: Difference in opening inventory (Units in opening inventory
x FOAR/unit) X
STICKY NOTES

Less: Difference in Closing inventory (Units in closing inventory x

FOAR/unit) (X)
Profit under marginal costing X
This concept is further explained with the help of following example.
 Example 07:
JSS Enterprises produces and sells a single product. Following budgeted information is related to this
product for first 3-months.
May June July
Units produced 6,000 5,000 7,000
Budgeted production 6,000 6,000 6,000
Units sold 5,500 5,300 7,000

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Data relating to cost and sales is given below.

Rs.
Direct material per unit 18
Direct labour per unit 11
Variable production overhead per unit 6
Fixed production overhead total per month 30,000
Variable selling & administration cost 20% of sales
Fixed production & administration cost 25,000
Selling price per unit 60
a) Preparation of income statement under marginal costing principle from May to July, is given below.

AT A GLANCE
Marginal costing income statement for 3-Months May June July
Rupees Rupees Rupees
Sales (5,500 x 60)/(5,300 x 60)/(7,000 x 60) 330,000 318,000 420,000
Variable cost of sales:
Opening inventory - (17,500) (7,000)
Variable production costs:
Direct materials (6,000 x 18)/(5,000x18)/(7,000x18) (108,000) (90,000) (126,000)
Direct labour (6,000 x 11)/(5,000x11)/(7,000x11) (66,000) (55,000) (77,000)
Variable POH (6,000 x 6)/(5,000x6)/(7,000x6) (36,000) (30,000) (42,000)

SPOTLIGHT
(210,000) (192,500) (252,000)
Less: Closing inventory W-1 17,500 7,000 7,000
(192,500) (185,500) (245,000)
Gross contribution 137,500 132,500 175,000
Variable selling and distribution costs (20% of sales) (66,000) (63,600) (84,000)
Contribution margin 71,500 68,900 91,000
Fixed costs:
Production fixed costs (30,000) (30,000) (30,000)

STICKY NOTES
Selling and administration costs (25,000) (25,000) (25,000)
(55,000) (55,000) (55,000)
Profit 16,500 13,900 36,000

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W-1 Closing inventory May June July

Units produced 6,000 5,000 7,000
Opening inventory (units) - 500 200
Units sold (5,500) (5,300) (7,000)
Closing inventory (units) A 500 200 200
Unit variable product cost:
Direct material per unit 18 18 18
Direct labour per unit 11 11 11
Variable production overheads 6 6 6
AT A GLANCE

Unit product cost B 35 35 35

Closing inventory (A x B) Rs. 17,500 7,000 7,000

b) Preparation of income statement under absorption costing principle from May to July, is given below.

Absorption costing income statement for 3-Months May June July

Rupees Rupees Rupees
Sales (5,500 x 60)/(5,300 x 60)/(7,000 x 60) 330,000 318,000 420,000
Cost of sales:
SPOTLIGHT

Opening inventory - (20,000) (8,000)

Production costs:
Direct materials (6,000 x 18)/(5,000x18)/(7,000x18) (108,000) (90,000) (126,000)
Direct labour (6,000 x 11)/(5,000x11)/(7,000x11) (66,000) (55,000) (77,000)
Variable POH (6,000 x 6)/(5,000x6)/(7,000x6) (36,000) (30,000) (42,000)
Absorbed Fixed POH (6,000 x 5)/(5,000x5)/(7,000x5) (30,000) (25,000) (35,000)
(240,000) (220,000) (288,000)
Less: Closing inventory W-2 20,000 8,000 8,000
STICKY NOTES

(220,000) (212,000) (280,000)

(Under) over absorbed overheads W-3 - (5,000) 5,000
(220,000) (217,000) (275,000)
Contribution profit 110,000 101,000 145,000
Non-production overheads:
Variable selling & administration cost- 20% of sales (66,000) (63,600) (84,000)
Fixed Selling and administration costs (25,000) (25,000) (25,000)
(91,000) (88,600) (109,000)
Profit 19,000 12,400 36,000

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c) Reconciliation statement of profit calculated under absorption and marginal costing, is given below.

Reconiliation Statement May June July

Rupees Rupees Rupees
Profit under marginal costing 16,500 13,900 36,000
Less: Difference in opening inventory
June 500 x 5; July 200 x 5 - (2,500) (1,000)
Add: Difference in closing inventory
May 500 x 5; June and July 200 x 5 2,500 1,000 1,000
Profit under absorption costing 19,000 12,400 36,000

AT A GLANCE
W-2 Closing inventory May June July
Closing inventory (units) A W-1 500 200 200
Unit product cost:
Unit variable cost as calculated in W-1 35 35 35
Fixed overhead per unit 5 5 5
Unit product cost B 40 40 40
Closing inventory (A x B) Rs. 20,000 8,000 8,000

SPOTLIGHT
W-3 Under over absorption of fixed overheads May June July
Units produced 6,000 5,000 7,000
Budget level of production in units (6,000) (6,000) (6,000)
(Less) Excess production - (1,000) 1,000
FOAR per unit (Rs. 30,000 / 6,000) 5 5 5
(Under) over absorption of fixed overheads - (5,000) 5,000

4.2 Summary: comparing marginal and absorption costing profit

STICKY NOTES
To calculate the difference between the reported profit using marginal costing and the reported profit using
absorption costing, you might need to make the following simple calculations.
• the increase or decrease in inventory during the period, in units.
• the fixed production overhead cost per unit.
• Multiplication of increase or decrease in inventory and fixed production overhead rate is equal to
difference in both profits
The important points to remember are:
• If there has been an increase in inventory, the absorption costing profit is higher. If there has been a
reduction in inventory, the absorption costing profit is lower.
• Ignore fixed selling overhead or fixed administration overhead. These are written off in full as a period
cost in both absorption costing and marginal costing, and only fixed production overheads are included
in inventory values.

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 Example 08:
A company uses marginal costing. In the financial period that has just ended, opening inventory
was Rs. 8,000 and closing inventory was Rs.15,000. The reported profit for the year was Rs.
96,000.
If the company had used absorption costing, opening inventory would have been Rs. 15,000 and
closing inventory would have been Rs. 34,000.
What would have been the profit for the year if absorption costing had been used?
In doing so, please see the following:
There was an increase in inventory. It was Rs. 7,000 using marginal costing (Rs. 15,000 – Rs.
8,000). It would have been Rs. 19,000 using absorption costing.
Rs.
AT A GLANCE

Increase in inventory, marginal costing 7,000

Increase in inventory, absorption costing 19,000
Difference (profit higher with absorption costing) 12,000
Profit with marginal costing 96,000
Profit with absorption costing 108,000

The profit is higher with absorption costing because there has been an increase in inventory
(production volume has been more than sales volume.)
 Example 09:
SPOTLIGHT

A company uses absorption costing. In the financial period that has just ended, opening inventory
was Rs. 76,000 and closing inventory was Rs. 49,000. The reported profit for the year was Rs.
183,000.
If the company had used marginal costing, opening inventory would have been Rs. 40,000 and
closing inventory would have been Rs. 28,000.
What would have been the profit for the year if marginal costing had been used?
There was a reduction in inventory. It was Rs.27,000 using absorption costing
(Rs.76,000 – Rs.49,000). It would have been Rs. 12,000 using marginal costing.

Rs.
STICKY NOTES

Reduction in inventory, absorption costing 27,000

Reduction in inventory, marginal costing 12,000
Difference (profit higher with marginal costing) 15,000
Profit with absorption costing 183,000
Profit with marginal costing 198,000

Profit is higher with marginal costing because there has been a reduction in inventory during
the period.

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 Example 10:
The following information relates to a manufacturing company for a period.

Production 16,000 units Fixed production costs Rs.80,000

Sales 14,000 units Fixed selling costs Rs.28,000

Using absorption costing, the profit for this period would be Rs.60,000. Assuming there is no
opening inventory
What would have been the profit for the year if marginal costing had been used?
Ignore the fixed selling overheads. These are irrelevant since they do not affect the difference in
profit between marginal and absorption costing.

AT A GLANCE
There is an increase in inventory by 2,000 units, since production volume (16,000 units) is higher
than sales volume (14,000 units).
If absorption costing is used, the fixed production overhead cost per unit is Rs.5
(Rs.80,000/16,000 units).
The difference between the absorption costing profit and marginal costing profit is therefore
Rs.10,000 (2,000 units × Rs.5).
Absorption costing profit is higher, because there has been an increase in inventory.
Marginal costing profit would therefore be Rs.60,000 – Rs.10,000 = Rs.50,000.
 Example 11:
Red Company is a manufacturing company that makes and sells a single product. The following

SPOTLIGHT
information relates to the company’s manufacturing operations in the next financial year.

Opening stock: Nil

Production: 18,000 units
Sales: 15,000 units
Fixed production overheads: Rs.117,000
Fixed sales overheads: Rs.72,000

Using absorption costing, the company has calculated that the budgeted profit for the year will

STICKY NOTES
be Rs.43,000.
What would be the budgeted profit if marginal costing is used, instead of absorption costing?
In completing the requirement, Production overhead per unit, with absorption costing, please
see below:
= Rs.117,000/18,000 units
= Rs.6.50 per unit.
The budgeted increase in inventory = 3,000 units (18,000 – 15,000).
Production overheads in the increase in inventory = 3,000 × Rs.6.50 = Rs.19,500.
With marginal costing, profit will be lower than with absorption costing, because there is an
increase in inventory levels.
Marginal costing profit = Rs.43,000 - Rs.19,500 = Rs.23,500.

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 Example 12:
Entity T manufactures a single product, and uses absorption costing. The following data relates
to the performance of the entity during October.

Profit Rs.37,000
Over-absorbed overhead Rs.24,000
Sales (48,000 units) Rs.720,000
Non-production overheads (all fixed costs) Rs.275,000
Opening inventory Rs.144,000
Closing inventory Rs.162,000
AT A GLANCE

Units of inventory are valued at Rs.9 each, consisting of a variable cost (all direct costs) of Rs.3
and a fixed overhead cost of Rs.6. All overhead costs are fixed costs.
a) When required to calculate the actual production overhead cost for October and the
profit that would have been reported in October if Entity T had used marginal costing,
see below working.

units
Opening inventory (Rs.144,000/Rs.9) 16,000
Closing inventory (Rs.162,000/Rs.9) 18,000
SPOTLIGHT

Increase in inventory in October 2,000

Sales 48,000
Production in October 50,000

Rs.
Absorbed production overhead (50,000 × Rs.6) 300,000
Over-absorbed overheads 24,000
Actual production overhead expenditure 276,000
STICKY NOTES

Since, inventory increased during October; therefore, the reported profit will be higher
with absorption costing than with marginal costing, as below

Rs.
Absorption cost profit 37,000
Increase inventory × fixed production overhead per unit
(2,000 × Rs.6) 12,000
Marginal costing profit 25,000

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Proof:

Rs. Rs.
Sales 720,000
Variable cost of sales (48,000 × Rs.3) 144,000
Contribution 576,000
Fixed production overheads (see above) 276,000

Other fixed overheads 275,000

Total fixed overheads 551,000

AT A GLANCE
Marginal costing profit 25,000

SPOTLIGHT
STICKY NOTES

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6 ADVANTAGES AND DISADVANTAGES OF ABSORPTION AND MARGINAL

COSTING
The previous sections of this chapter have explained the differences between marginal costing and absorption
costing as methods of measuring profit in a period. Some conclusions can be made from these differences.
• The amount of profit reported in the cost accounts for a financial period will depend on the method of
costing used.
• Since the reported profit differs according to the method of costing used, there are presumably reasons
why one method of costing might be used in preference to the other. In other words, there must be some
advantages (and disadvantages) of using either method.

6.1 Advantages and disadvantages of absorption costing

AT A GLANCE

Absorption costing has a number of advantages and disadvantages.

Advantages of absorption costing

• It helps to make pricing decision on the basis of cost as in absorption costing, cost of product is
calculated on full cost including variable and fixed.
• It enables for management to compute correct profit in the situation of seasonal sales if compared
to marginal costing.
• It helps to conform with accrual concept in which cost is matched with revenue for specified period
of time.
• It indicates efficient or inefficient utilization of capacity by indicating the under or over absorbed
production overheads.
SPOTLIGHT

Limitations of absorption costing

• Absorption costing is not useful tool for decision making such as make or buy decision, optimal
production mix in limiting factor situation. In such situation, marginal costing plays vital role in
realistic decisions.
• In absorption costing, portion of fixed cost included in closing inventory is transferred to next
period, as this closing inventory is treated opening inventory for next period.
• The validity of product cost under this method depends upon the correct apportionment of fixed
production overhead. But in practice, many fixed production overheads are apportioned on
arbitrary basis which might result inaccuracy in calculation of product cost. (Subho, 2020)
STICKY NOTES

5.2 Advantages and disadvantages of marginal costing

Marginal costing has a number of advantages and disadvantages.
Advantages of marginal costing
• It is easy to account for fixed overheads using marginal costing. Instead of being apportioned they are
treated as period costs and written off in full as an expense in the income statement for the period when
they occur.
• There is no under/over-absorption of overheads with marginal costing, and therefore no adjustment
necessary in the income statement at the end of an accounting period.
• Marginal costing provides useful information for decision making.

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Disadvantages of marginal costing

• Marginal costing does not value inventory in accordance with the requirements of financial reporting.
(However, for the purpose of cost accounting and providing management information, there is no reason
why inventory values should include fixed production overhead, other than consistency with the
financial accounts.)
• Marginal costing can be used to measure the contribution per unit of product, or the total contribution
earned by a product, but this is not sufficient to decide whether the product is profitable enough. Total
contribution has to be big enough to cover fixed costs and make a profit.

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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7 COMPREHENSIVE EXAMPLES
 Example 01:
Entity RH makes and sells one product. Currently, it uses absorption costing to measure profits
and inventory values. The budgeted production cost per unit is as follows:

Rs.
Direct labour 3 hours at Rs.6 per hour 18
Direct materials 4 kilograms at Rs.7 per kilo 28
Production overhead (Fixed cost) 20
66
AT A GLANCE

Normal output volume is 16,000 units per year and this volume is used to establish the fixed
overhead absorption rate for each year.
Costs relating to sales, distribution and administration are:
Variable 20% of sales value
Fixed Rs.180,000 per year.
There were no units of finished goods inventory at 1 October Year 5.
The fixed overhead expenditure is spread evenly throughout the year.
The selling price per unit is Rs.140.
SPOTLIGHT

For the two six-monthly periods detailed below, the number of units to be produced and sold
are budgeted as follows:

Six months ending Six months ending

31 March Year 6 30 September Year 6
Production 8,500 units 7,000 units
Sales 7,000 units 8,000 units

The entity is considering whether to abandon absorption costing and use marginal costing
instead for profit reporting and inventory valuation.
STICKY NOTES

a) Calculation of the budgeted fixed production overhead costs each year, is as follows.
Budgeted production overhead expenditure =
Normal production volume × Absorption rate per unit
= 16,000 units × Rs.20 = Rs.320,000.
Since expenditure occurs evenly throughout the year, the budgeted production overhead
expenditure is Rs.160,000 in each six-month period.
b) Statements for management showing sales, costs and profits for each of the six-monthly
periods using marginal and absorption costing would be prepared as follows
i. marginal costing
ii. absorption costing

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Workings Rs. per unit

Direct material 18
Direct labour 28
Marginal cost of sale 46

i. Marginal costing

Six months to Six months to 30

31 March September
Units sold 7,000 8,000

AT A GLANCE
Rs. Rs. Rs. Rs.
Sales at Rs.140 980,000 1,120,000
Marginal cost of sales (at Rs.46) 322,000 368,000
658,000 752,000
Variable admin & distribution
(20% of sales value) 196,000 224,000
Contribution 462,000 528,000
Fixed costs
Production (Rs.320,000/2) 160,000 160,000

SPOTLIGHT
Other (Rs.180,000/2) 90,000 250,000 90,000 250,000
Profit 212,000 278,000

ii. Absorption costing

The fixed overhead absorption rate is based on the normal volume of production. Since
budgeted output in each six-month period is different from the normal volume, there
will be some under- or over-absorption of production overhead in each six-month
period.

Six months to Six months to 30

31 March September

STICKY NOTES
Units sold 7,000 8,000
Rs. Rs. Rs. Rs.
Sales at Rs.140 980,000
Production cost of sales (at Rs.66) 462,000 528,000
518,000 592,000
Production overhead absorbed 170,000 140,000
(8,500 × Rs.20: 7,000 × Rs.20)
Actual production overhead 160,000 160,000
Over-/(under-) absorbed
10,000 (20,000)
overheads
528,000 572,000

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Six months to Six months to 30

31 March September
Sales, distribution, admin costs
Variable 196,000 224,000
(7,000 × Rs.28: 8,000 × Rs.28)
Other 90,000 90,000
286,000 314,000
Profit 242,000 258,000

c) An explanatory statement reconciling for each six-monthly period the profit using
marginal costing with the profit using absorption costing, is prepared below.
AT A GLANCE

Reconciliation of profit figures

Six months to 31 March Year 6
Increase in inventory (8,500 – 7,000 units) 1,500 units
Production overhead absorbed in these
Rs.20 per unit
units (absorption costing)
Therefore absorption costing profit
Rs.30,000
higher by
Six months to 30 SeptemberYear 6
Reduction in inventory (7,000 – 8,000 units) 1,000 units
SPOTLIGHT

Production overhead absorbed in these

Rs.20 per unit
units (absorption costing)
Therefore absorption costing profit
Rs.20,000
lower by
The difference in reported profits is due entirely to differences in the valuation of
inventory (and so differences in the increase or reduction in inventory during each
period).
 Example 02:
Zulfiqar Limited makes and sells a single product and has the total production capacity of 30,000
units per month. The company budgeted the following information for the month of January
STICKY NOTES

20X4:
Normal capacity (units) 27,000
Variable costs per unit:
Production (Rs.) 110
Selling and administration (Rs.) 25
Fixed overheads:
Production (Rs.) 756,000
Selling and administration (Rs.) 504,000

The actual operating data for January 20X4 is as follows:

Production 24,000 units

Sales @ Rs. 250 per unit 22,000 units
Opening stock of finished goods 2,000 units

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During the month of January 20X4, the variable factory overheads exceeded the budget by Rs.
120,000.
a) Preparation of profit statement for the month of January using marginal and
absorption costing would be as follows

Profitability Statement under Marginal Costing Rupees

Sales (22,000 units @ Rs. 250) 5,500,000
Variable Costs:
Production Costs:
Cost of productions (24,000 x Rs.110) 2,640,000
Additional Variable Costs. 120,000

AT A GLANCE
2,760,000
Less: Closing stocks (2,760,000 / 24,000 x 4,000) (460,000)
Add: Opening stocks (2,000 x Rs. 110) 220,000
2,520,000
Selling and administrative expenses (22,000 x 25) 550,000
3,070,000
Contribution Margin 2,430,000
Less: Fixed costs
Production 756,000

SPOTLIGHT
Selling and administrative expense 504,000
1,260,000
Net Profit 1,170,000

Profitability Statement under Absorption Costing Rupees

Sales (22,000 units @ Rs. 250) 5,500,000
Cost of Goods Sold
Cost of production (24,000 x Rs. 138 (W-1) 3,312,000
Additional variable costs. 120,000

STICKY NOTES
3,432,000
Less: Closing stocks (3,432,000 / 24,000 x 4,000) (572,000)
Add: Opening stocks (2,000 x Rs. 138) 276,000
3,136,000
Under applied factory overhead
84,000
(3,000 (W-2) x Rs.28 (W-1))
3,220,000
Gross Profit 2,280,000
Selling expenses
(Rs. 504,000 + 22,000 x Rs.25) 1,054,000
1,226,000

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W-1: Rupees
Variable overhead per unit 110
Fixed overhead per unit (Rs. 756,000 / 27,000) 28
138

W-2: Units
Budgeted production - Normal capacity 27,000
Actual production 24,000
Under-utilized capacity 3,000
AT A GLANCE

b) Then, if required to reconcile the difference in profits under the two methods, please
see below

Rupees
Profit under absorption costing 1,226,000
Less: Closing stock (under-valued in marginal costing)
(Rs. 572,000 - Rs. 460,000) (112,000)
Add: Opening stock (under-valued in marginal costing)
(Rs. 276,000 - Rs. 220,000) 56,000
SPOTLIGHT

Profit under marginal costing 1,170,000

 Example 03:
Following information has been extracted from the financial records of ATF Limited: Production
during the year units 35,000

Finished goods at the beginning of the year units 3,000

Finished goods at the end of the year units 1,500
Sale price per unit Rs. 200
STICKY NOTES

Fixed overhead cost for the year Rs. 1,000,000

Administration and selling expenses Rs. 200,000
Annual budgeted capacity of the plant units 40,000

The actual cost per unit, incurred during the year, was as follows:

Rupees
Material 70
Labour 40
Variable overheads 30

Company uses FIFO method for valuation of inventory. The cost of opening finished goods
inventory determined under the absorption costing method system was Rs. 450,000. Fixed
overhead constituted 16% of the total cost last year.

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a) Preparation of profit statements for the year, under absorption and marginal costing
systems, would be as follows

Absorption Marginal
Costing Costing
(Rs.) (Rs.)
Sales (3,000 + 35,000-1,500) × Rs. 200 7,300,000 7,300,000
Cost of goods manufactured
Opening Inventory 450,000 378,000*
Add: Cost of goods manufactured
5,775,000 4,900,000
(35,000 × 165) & (35,000 / 140)

AT A GLANCE
6,225,000 5,278,000
Less: Ending inventory
(247,500) (210,000)
(1,500 x 165) & (1,500 × 140)
(5,997,500) (5,068,000)
Gross profit / contribution margin 1,322,500 2,232,000
Less: unabsorbed overheads
(125,000) -
[1,000,000 – (Rs. 25 × 35,000)]
Less: Administration and selling expenses (200,000) (200,000)
Fixed overheads - (1,000,000)

SPOTLIGHT
Net Profit 997,500 1,032,000

*Cost of opening finished goods under marginal costing Rs. 450,000 × (100%-16%) = Rs.
378,000
Computation of Cost of goods manufactured (COGM) & Ending Inventory:

Rupees
Material Cost 70
Labour Cost 40

STICKY NOTES
Variable overhead 30
Cost per unit under marginal costing system 140
Fixed overhead (Rs. 1,000,000/40,000) 25
Cost per unit under absorption costing system 165

b) Then, if required to reconcile net profits determined under each system, following
computations would be required.

Rupees
Net Profit under Absorption Costing 997,500
Add: Difference in opening finished goods (Rs. 450,000 – 378,000) 72,000
Less: Difference in ending finished goods (Rs. 247,500 – 210,000) (37,500)
Net Profit under Marginal Costing 1,032,000

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 Example 04:
Francisco Limited (FL) is a manufacturer of product Z and has annual operational capacity of 82,500
machine hours. FL uses absorption costing.
Below is a summary of FL’s profit or loss statement for the years ended 31 August 2019 and 2020:

31 August 2020 31 August 2019

Rs. In Rs. In
Units Units
000 000
Sales 9,950 149,250 10,500 155,000
Opening inventory-Finished goods 3,500 31,000 2,500 20,000
AT A GLANCE

Cost of production 10,450 94,050 11,500 97,750

Closing inventory-Finished goods 4,000 (36,000) 3,500 (31,000)
Cost of goods sold (89,050) (86,750)
Gross profit 60,200 68,750
(Under) over absorbed production
overheads (400) 650
Selling and administrative cost (20,900) (22,475)
Net profit 38,900 46,925
SPOTLIGHT

In both years, the actual and standard machine usage per unit are 6 hours. However, the standard
machine usage was 80% and 82% of the operational capacity in 2019 and 2020 respectively.
Fixed overhead absorption rate of Rs. 700 per machine hour was applied in 2019. FL revises its fixed
overhead absorption rate for each year on the basis of prior year’s actual fixed overhead
expenditure.
(a) Calculation of budgeted and actual fixed overheads for 2019 and 2020, are computed below.
Budgeted and fixed overheads

August August
2020 2019
STICKY NOTES

Budgeted machine hours A=[82,500×82%,80%] 67,650 66,000

Budgeted fixed overheads A×OAR(W-2) 47,625,600 46,200,000
Fixed overheads applied [actual machine hours (W-1)×OAR(W-2)] 44,140,800 48,300,000
Under/(over) absorbed fixed overheads [given] 400,000 (650,000)
Actual fixed overheads 44,540,800 47,650,000

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(b) Profit and loss statement under marginal costing for the year ended 31 August 2020, is
calculated below.

Rs. 000
Sales 149,250
Opening inventory - finished goods W-3 (16,300)
Variable cost of production W-4 (49,909)
Closing inventory - finished goods W-5 19,104
Contribution margin 102,145
Less: Fixed overheads actual (44,541)

AT A GLANCE
Less: Selling and admin expense (20,900)
Net profit 36,704

(c) Reconciliation of profits under marginal and absorption costing are given below.

Rs. 000
Actual profit under marginal costing 34,704
Add: Fixed cost included in the closing stock (4,000×6×704) 16,896
Less: Fixed cost included in opening stock (3,500×6×700) (14,700)
Actual profit under absorption costing 38,900

SPOTLIGHT
Workings
W-1 Actual Machine hours

Hours
-2019 (11,500 x 6) 69,200
-2020 (10,450 x 6) 62,700

W-2 Overhead Absorption Rate

Hours

STICKY NOTES
2019 [given] 700
2020
Actual fixed overheads of 2019 (Rs.) 47,650,000
Budgeted machine hours 67,650
OAR – 2020 (Rs.) (47,650,000/67,650) 704

W-3 Opening inventory under marginal costing

Rs. In 000
Opening inventory [given] 31,000
Less: Fixed overheads absorbed (3,500×700×6) (14,700)
Opening inventory under marginal costing 16,300

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W-4 Cost of production under marginal costing

Rs. In 000
Cost of production [given] 94,050
Less: Applied fixed overheads (10,450×6×704) (44,141)
Cost of production under marginal costing 49,909

W-5 Closing inventory under marginal costing

Rs. In 000
Closing inventory [given] 36,000
AT A GLANCE

Less: Fixed overheads absorbed (4,000×704×6) (16,896)

Closing inventory under marginal costing 19,104

 Example 05:
Sigma Limited (SL) is a manufacturer of Product A. SL operates at a normal capacity of 90%
against its available annual capacity of 50,000 machine hours and uses absorption costing. The
following summarised profit statements were extracted from SL's budget for the year ending 31
December 2015.

Actual-2014 Budget-2015
Rs. In Rs. In
Units Units
000 000
SPOTLIGHT

Sales 4,125 49,500 4,600 56,580

Opening inventory 400 (3,400) 600 (5,400)
Cost of production 4,325 (38,925) 4,500 (44,325)
Closing inventory 600 5,400 500 4,925
Under absorbed production overheads (100)
Selling and administration cost (30% fixed) (3,000) (5,250)
Net Profit 9,475 6,530
STICKY NOTES

Other relevant information is as under:

2014 Budget-2015
Standard machine hours per unit 10 hours 10 hours
Standard production overhead rate per unit Rs. 2,000 Rs. 2,250
Estimated fixed production overheads at normal capacity Rs. 3,600,000 Rs. 4,050,000
Actual production overheads (Actual machine hours 44,000) Rs. 8,750,000 -

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(a) Budgeted profit and loss statement for the year ended 31 December 2015 under marginal
costing, is as follows:

Rs. In 000
Sales 56,580
Variable cost of sales:
Opening inventory (600 x 8,200 W-1) (4,920)
Cost of production (4,500 x 8,950 W-2) (40,275)
Closing inventory (500 x 8,950 W-2) 4,475
(40,720)

AT A GLANCE
Gross contribution margin 15,860
Variable selling and administration cost (5,250 x 70%) (3,675)
Contribution margin 12,185
Fixed cost:
Production cost (4,050)
Selling and administration cost (5,250 x 30%) (1,575)
(5,625)
Net profit 6,560

SPOTLIGHT
(b) Analysis of budgeted profit under marginal and absorption cost is calculated with the help of
following reconciliation statement.

Rs. In 000
Net profit under marginal costing 6,560
Less: Difference in opening inventory (600 x 800) (480)
Add: Difference in closing inventory (500 x 900) 450
Net profit under absorption costing 6,530

STICKY NOTES
W-1 Variable unit product cost under marginal costing -Opening inventory

Rs. In 000
Unit product cost under absorption costing (5,400,000/600) 9,000
Less: Fixed overhead cost per unit (3,600,000/4,500) (800)
Unit product cost under marginal costing 8,200

W-1 Variable unit product cost under marginal costing –Production cost & closing inventory

Rs. In 000
Unit product cost under absorption costing (44,325,000/4,500) 9,850
Less: Fixed overhead cost per unit (4,050,000/4,500) (900)
Unit product cost under marginal costing 8950

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 Example 06:
XY Limited manufactures and sells a single product. The selling price and costs for the year ended
31 December 2013 were as follows:

Rs. Per unit

Selling price 1,600
Direct material 630
Direct labour 189
Production overheads (40% fixed) 220
Selling and distribution overheads (60% fixed) 165
AT A GLANCE

Other information is as follows:

(i) During the year, 12,000 units were produced.
(ii) The opening and closing stocks were 4,000 and 3,000 units respectively
(iii) Fixed overhead cost per unit is based on normal capacity which is 15,000 units.
(iv) Overhead costs have increased by 10% over the previous year and raw material and
labour by 5%.
(v) The company uses FIFO method for costing its inventory.
(a) Profit and loss for the year ended 31 December 2013 under absorption costing and marginal
costing, is computed below.
SPOTLIGHT

Profit and loss statement under absorption costing

Rs. In 000
Sales (4,000+12,000-3,000 = 13,000 x 1,600) 20,800
Cost of sales:
Opening stock (4,000 x 980 W-1) (3,920)
Production cost (12,000 x 1,039 W-1) (12,468)
(16,388)
STICKY NOTES

Closing stock (3,000 x 1,039 W-1) 3,117

(13,271)
Under absorbed overheads (15,000-12,000) x 88 W-1 (264)
(13,535)
Gross profit 7,265
Selling and distribution overheads (13,000 x 165) (2,145)
Net profit 5,120

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Profit and loss statement under marginal costing

Rs. In 000
Sales (4,000+12,000-3,000 = 13,000 x 1,600) 20,800
Variable cost of sales:
Opening stock (4,000 x 900 W-1) (3,600)
Production cost (12,000 x 951 W-1) (11,412)
(15,012)
Closing stock (3,000 x 951 W-1) 2,853
(12,159)

AT A GLANCE
Gross contribution 8,641
Variable selling and distribution cost (13,000 x 165 x 40%) (858)
Contribution margin 7,783
Fixed cost:
Production (15,000 x 88 W-1) (1,320)
Selling and distribution cost (13,000 x 165 x 60%) (1,287)
(2,607)
Net profit 5,176

SPOTLIGHT
(b) Reconciliation of profit worked out under two methods as below.

Rs. In 000
Profit under marginal costing 5,176
Less: Difference in opening stock (4,000 x 80) (320)
Add: Difference in closing stock (3,000 x 88) 264
Profit under absorption costing 5,120

W-1 Cost of production per unit under both methods

STICKY NOTES
2013 2012
Calculation of per unit cost Rupees
Direct materials (2012: 630/1.05) 630 600
Direct labour (2012: 189/1.05) 189 180
Variable production overhead (2013: 220 x 60%)/ (2012:
132/1.10) 132 120
Product cost per unit for marginal costing 951 900
Fixed production overhead (2013: 220 x 40%)/ (2012:
88/1.10) 88 80
Product cost per unit for absorption costing 1,039 980

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 Example 07:
Ali Limited makes and sells one product, the standard production cost of which is as follows for
one unit:

Rupees
Direct labour (3 hours @ Rs. 6 each) 18
Direct material (4 Kilogram @ Rs. 7 per kg) 28
Variable production overheads 3
Fixed production overheads 20
Standard product cost per unit 69
AT A GLANCE

Normal output is 16,000 units per annum and this figure is used for the fixed production overhead
calculation.
Costs relating to selling, distribution and administration are:

Rupees

Variable 20% of sales price

Fixed per annum 180,000

The only variance is a fixed production overhead volume variance. There are no units in finished
goods stock at 1 October 2020. The fixed overhead expenditure is spread evenly throughout the
SPOTLIGHT

year. The selling price per unit is Rs. 140.

For each of the six monthly periods, the number of units to be produced and sold are budgeted as:

Six months ending Six months ending

31 March 2021 30 September 2021
Production (units) 8,500 7,000
Sales (Units) 7,000 8,000

(a) Statement for management showing sales, costs and profits for each of the six-monthly period
under marginal costing, is prepared as under.
STICKY NOTES

Six months Six months

ending 31 ending 30
March 2021 September 2021
Rupees Rupees
Sales (7,000 x 140)/ (8,000 x 140) 980,000 1,120,000
Variable cost of sales:
Opening stock - (73,500)
Direct labour (8,500 x 18)/(7,000 x 18) (153,000) (126,000)
Direct material (8,500 x 28)/(7,000 x 28) (238,000) (196,000)
Variable production OH (8,500 x 3)/(7,000 x 3) (25,500) (14,000)
(416,500) (409,500)
Closing stock (1,500 x 49)/ (500 x 49) 73,500 24,500

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(343,000) (385,000)
Gross contribution 637,000 735,000
Variable selling, distribution and administration cost
(20% of sales) (196,000) (224,000)
Contribution margin 441,000 511,000
Fixed cost:
Production (16,000 x 20 /2) (160,000) (160,000)
Selling, distribution & administration (180,000/2) (90,000) (90,000)
(250,000) (250,000)

AT A GLANCE
Net profit 191,000 261,000

(b) Statement for management showing sales, costs and profits for each of the six-monthly period
under absorption costing, is prepared as under.

Six months Six months

ending 31 ending 30
March 2021 September 2021
Rupees Rupees
Sales (7,000 x 140)/ (8,000 x 140) 980,000 1,120,000
Cost of sales:

SPOTLIGHT
Opening stock - (103,500)
Direct labour (8,500 x 18)/(7,000 x 18) (153,000) (126,000)
Direct material (8,500 x 28)/(7,000 x 28) (238,000) (196,000)
Variable production OH (8,500 x 3)/(7,000 x 3) (25,500) (14,000)
Fixed production OH (8,500 x 20)/(7,000 x 20) (170,000) (140,000)
(586,500) (579,500)
Closing stock (1,500 x 69)/ (500 x 69) 103,500 34,500

STICKY NOTES
(483,000) (545,000)
(Under) over absorbed OH (170,000-
160,000)/(140,000-160,000) 10,000 (20,000)
(473,000) (565,000)
Gross profit 507,000 555,000
Selling, distribution and administration cost:
Variable (196,000) (224,000)
Fixed (90,000) (90,000)
(286,000) (314,000)
Net profit 221,000 241,000

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(c) Explanatory statement reconciling for each six-monthly profit using marginal costing and
absorption costing is given below.

Six months Six months

ending 31 ending 30
March 2021 September 2021
Rupees Rupees
Profit under marginal costing 191,000 261,000
Less: Difference in opening stock (1,500 x 20) - (30,000)
Add: Difference in closing stock (1,500 x 20)/ (500 x
AT A GLANCE

20) 30,000 10,000

Profit under absorption costing 221,000 241,000

 Example 08:
Khan Company is a small business which has the following budgeted marginal costing profit and
loss account for the month ended June 30, 2020:

Rupees

Sales 96,000
Variable cost of sales:
SPOTLIGHT

Opening stock (6,000)

Production cost (72,000)
(78,000)
Closing stock 14,000
(64,000)
Gross contribution 32,000
Variable selling cost (6,400)
STICKY NOTES

Contribution margin 25,600

Fixed costs:
Production (8,000)
Administration (7,200)
Selling (2,400)
(17,600)
Net profit 8,000

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The standard cost per unit is:

Rupees

Direct material (1 kg) 16

Direct labour (3 hours) 18
Variable production overheads 6

Budgeted selling price per unit is Rs. 60.

The company’s normal level of activity is 4,000 units per month. It has budgeted fixed production
costs at Rs. 8,000 per month and absorbed them on the normal level of the activity of units
produced.

AT A GLANCE
Budgeted statement of profit and loss under absorption costing for the month ended June 30,
2020, is given below.

Rupees

Sales 96,000
Cost of sales:
Opening stock {6,000 +(6,000/40 x 2 W-1)} (6,300)
Production cost {72,000 +(72,000/40 x 2 W-1)} (75,600)
(81,900)

SPOTLIGHT
Closing stock {14,000 +(14,000/40 x 2 W-1)} 14,700
(67,200)
(Under) absorbed OH (72,000/40-4,000) x 2 (4,400)
(71,600)
Gross profit 24,400
Selling and administration cost:
Variable (6,400)

STICKY NOTES
Fixed (7,200 + 2,400) (9,600)
(16,000)
Net profit 8,400

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 CHAPTER 5: MARGINAL COSTING AND ABSORPTION COSTING CAF 8: CMA

STICKY NOTES

In marginal costing, cost of product is variable production cost only but in

absorption costing the cost of the product is variable plus fixed production cost

In marginal costing there is a concept of contribution margin i.e.

Contribution Margin = Sales – all variable cost (both production and non-
production)
AT A GLANCE

To arrive at profit all Fixed cost (both production and non-production) should
be deduced from contribution margin.

In Absorption costing the cost of the product includes variable production cost
plus fixed production overheads estimated by using predetermined absorption
rate

In absorption costing over / under absorbed overheads are calculated by

SPOTLIGHT

comparing absorbed overheads with actual overheads.

In marginal costing the stock is valued at variable production cost only but in
absorption costing it is valued at variable plus fixed production cost. This is the
reason that the profit figure is different in marginal and absorption costing.
STICKY NOTES

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 CHAPTER 10

STANDARD COSTING

AT A GLANCE
IN THIS CHAPTER
Standard costing is the preparation of standard costs to assist
AT A GLANCE setting budgets and evaluating managerial performance.

AT A GLANCE
A standard cost is carefully predetermined estimated unit cost,
SPOTLIGHT calculated at budgeted level of activity. It is usually a standard
cost per unit of production or per unit of service rendered.
1. Using And Deriving Standard
Costs A standard cost when established is an average expected unit
cost because it is only an average actual results will vary to some
2. Allowing For Waste And Idle extent above and below the average.
Time The difference between standard and actual is known as
variance. The process by which the total difference between
3. Comprehensive Examples standard and actual results is analyzed in known as variance
analysis.
STICKY NOTES

SPOTLIGHT
STICKY NOTES

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1. USING AND DERIVING STANDARD COSTS

1.1 Standard cost
A standard cost is a predetermined unit cost based on expected level of activity. A standard cost has two
components: first standard and second cost. Standard is defined as norm and whatever is considered normal can
generally be adopted as standard. A standard is expectation of usage of material in quantities, utilization of time
of labour and percentage of plant capacity to be used. In order to complete standard cost, expected costs are
assigned to it like expected cost of material per unit, expected rate per hour etc.
Standard costs of products are usually restricted to production costs only, not administration and selling and
distribution overheads.
Overheads are normally absorbed into standard production cost at an absorption rate per direct labour hour,
AT A GLANCE

depending company is using absorption costing.

A typical standard cost card includes the following:
Rs.
Direct materials:
Material A: X litres at Rs. X per litre X
Material B: X kilos at Rs. X per kilo X
X
Direct labour:
SPOTLIGHT

Skilled labour: X hours at Rs. X per hour X

Unskilled labour: X hours at Rs. X per hour X
X
Variable production overheads: X hours at Rs. X per hour X
Fixed production overheads: X hours at Rs. X per hour X
Standard cost of one unit of product X
 Example 01:
ABC company provides the following data for preparation of standard cost of Product M01.
STICKY NOTES

1. Product M01 requires two kg of material J and three liters of material K.

2. Standard price of material J and material K are Rs. 16 per kg and Rs. 7 per liter respectively
3. 90 minutes of unskilled labour and 45 minutes of skilled labour are required to produce one
unit of M01.
4. Standard labour rate of skilled and unskilled labour is Rs. 60 and Rs. 30 per hour respectively.
5. Variable production overheads are absorbed at Rs. 15 per labour hour.
6. Budgeted fixed production overhead are estimated at Rs. 600,000 and budgeted level of activity
are 50,000 skilled labour hours. Fixed production are absorbed on basis of skilled labour hours.

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The standard cost card of Product M01, is prepared as under.

Rs.
Direct materials:
Material J: 2 kg at Rs. 16 per kg 32
Material K: 3 liters at Rs. 7 per liter 21
53.00
Direct labour:
Skilled labour: 45 minutes at Rs. 60 per hour (45/60 x 60) 45.00
Unskilled labour: 90 hours at Rs. 30 per hour (90/60 x 30) 45.00

AT A GLANCE
90.00
Variable production overheads: 135 minutes at Rs. 15 per hour (135/60 x 15) 33.75
Fixed production overheads: 45 hours at Rs. 12 per skilled labour hour
(45/60 x 12) whereas FOAR/hour = (600,000/50,000) 9.00
Standard cost of one unit of product 185.75

1.2 Standard costing

Standard costing involves the establishment of predetermined estimates of the costs of products or services, the
collection of actual costs and the comparison of the actual results with the predetermined estimates. The

SPOTLIGHT
predetermined costs are known as standard costs and the difference between standard and actual is known as
variance.
Features of standard costing
• It is comprehensive system in which inventories are recorded at standard cost. For example, standard cost
card shows material price is Rs. 4.20 per kg, but actually purchased at Rs. 4.25 per kg. In standard costing,
we will record the Material inventory at standard cost i.e. Rs. 4.25.
• Standard costing is a control technique that reports variances by comparing actual costs to pre-set standards
so facilitating action through management by exception.
• The reasons for such variances are highlighted to judge whether these are due to controllable or
uncontrollable factors.

STICKY NOTES
• Corrective action is taken to avoid such variances in future.
Standard costing may be used with either a system of absorption costing or a system of marginal costing.

When is standard costing appropriate?

Standard costing can be used in a variety of situations.
• It is most useful when accounting for homogenous goods produced in large numbers, when there is a degree
of repetition in the production process.
• A standard costing system may be used when an entity produces standard units of product or service that
are identical to all other similar units produced.
• Standard costing is usually associated with standard products, but can be applied to standard services too.
A standard unit should have exactly the same input resources (direct materials, direct labour time) as all other
similar units, and these resources should cost exactly the same. Standard units should therefore have the same
cost.

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Who sets standard costs?

Standard costs are set by managers with the expertise to assess what the standard prices and rates should be.
Standard costs are normally reviewed regularly, typically once a year as part of the annual budgeting process.
• Standard prices for direct materials should be set by managers with expertise in the purchase costs of
materials. This is likely to be a senior manager in the purchasing department (buying department).
• Standard rates for direct labour should be set by managers with expertise in labour rates. This is likely to be
a senior manager in the human resources department (personnel department).
• Standard usage rates for direct materials and standard efficiency rates for direct labour should be set by
managers with expertise in operational activities. This may be a senior manager in the production or
operations department, or a manager in the technical department.
• Standard overhead rates should be identified by a senior management accountant, from budgeted overhead
costs and budgeted activity levels that have been agreed in the annual budgeting process.
AT A GLANCE

1.3 The purposes of standard costing

Standard costing systems are widely used because they provide cost information for variety of purposes and
these are given below.
• It provides prediction of future costs that can be used for decision making purposes.
• Standard costing system provides challenging target in order to motivate the individuals.
• It assists in setting budgets and evaluates the managerial performance. Variances are calculated and reasons
are identified, to measure the manager performance.
• It is very useful technique which promotes possible cost reduction.
When there are large adverse variances, this might indicate that actual performance is poor, and control action
SPOTLIGHT

is needed to deal with the weaknesses.

When there are large favorable variances, and actual results are much better than expected, management should
investigate to find out why this has happened, and whether any action is needed to ensure that the favorable
results continue in the future.
Variances and controllability
The principle of controllability should be applied in any performance management system.
When variances are used to measure the performance of an aspect of operations, or the performance of a
manager, they should be reported to the manager who is:
• responsible for the area of operations to which the variances relate, and
STICKY NOTES

• able to do something to control them.

The reasons of the variances are further analysed into controllable and uncontrollable factors. The managers are
accountable for any material controllable variance, means his performance is measured on these bases.
On the contrary, it is also unreasonable to make a manager accountable for performance that is outside his
control, and for variances that he can do nothing about.
1.4 Deriving a standard cost
A standard variable cost of a product is established by building up the standard materials, labour and production
overhead costs for each standard unit. This will be the standard cost in marginal costing system.
In a standard absorption costing system, the standard fixed overhead cost is a standard cost per unit, based on
budgeted data about fixed costs and the budgeted production volume.
Deriving the standard cost of materials
These are based on product specifications and derived from intensive study of input quantity. This study should
include most suitable material for each product after keeping in view the product design and processes. On above
study, the standard quantity for each material for different products is established.

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Standard price information is obtained from procurement and purchase department. It is based on assumption
that purchase and procurement department has made reasonable search for suppliers and price is based on most
competitive price, at required quality.
Deriving the standard cost of labour
In order to set the labour standard, it is vital that activities should be analysed by different operation, after
conducting the comprehensive study and implementing time and motion study. It helps to determine standard
time required to produce one unit.
The standard rate per hour information is taken from human resource department, and it is based on contract
made with employees, if already hired. Otherwise, market analysis should be carried out to gather information
about cost of labour.
Deriving the standard cost of production overheads

AT A GLANCE
The procedure for establishing standard manufacturing overhead rates for purpose of determination of overhead
absorption rate, is similar as discussed in chapter 3. Separate rates for fixed and variable production overheads
are determined in order to make better planning and control.
Selection of base for absorption of production overheads is of great immense. As we know that increase or
decrease in activity level, might largely affect overhead absorption rate, therefore, comprehensive study should
be taken place, before selection of base.
1.5 Types of standard & their behavioural aspects
Standards are predetermined estimates of unit costs but how is the level of efficiency inherent in the estimate
determined? Should it assume perfect operating conditions or should it incorporate an allowance for waste and
idle time? The standard set will be a performance target and if it seen as unattainable this may have a detrimental

SPOTLIGHT
impact on staff motivation. If the standard set is too easy to attain there may be no incentive to find
improvements.
There are four types of standard, and any of these may be used in a standard costing system. One of the purposes
of standard costing is to set performance standards that motivates employees to improve performance. The type
of standard used can have an effect on motivation and incentives. The types of standards and their behavioural
aspects are given below:
Ideal standards.
These assume perfect operating conditions. No allowance is made for wastage, labour inefficiency or machine
breakdowns. Standard cost in ideal standard represents minimum cost, as compared to other standards. The
ideal standard cost is the cost that would be achievable if operating conditions and operating performance were
perfect. In practice, the ideal standard is not achieved.

STICKY NOTES
Ideal standards are unlikely to be achieved. They may be very useful as long term targets and may provide senior
managers with an indication of the potential for savings in a process but generally the ideal standard will not be
achieved. Consequently, the reported variances will always be adverse. Employees may be becoming de-
motivated when their performance level is always worse than standard and they know that the standard is
unachievable.
Attainable standards.
These assume efficient but not perfect operating conditions. An allowance is made for waste, break down and
inefficiency. However, the attainable standard is set at a higher level of efficiency than the current performance
standard, and some improvements will therefore be necessary in order to achieve the standard level of
performance.
Attainable standards are the most likely to motivate employees to improve performance as they are based on
challenging but attainable targets. It is for this reason that standards are often based on attainable conditions.
However, a problem with attainable standards is deciding on the level of performance that should be the target
for achievement.

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Current standards.
These are based on current working conditions and what the entity is capable of achieving at the moment.
Current standards do not provide any incentive to make significant improvements in performance, and might be
considered unsatisfactory when current operating performance is considered inefficient.
Current standards may be useful for producing budgets as they are based on current levels of efficiency and may
therefore give a realistic guide to resources required in the production process. However current standards are
unlikely to motivate employees to improve their performance, unless there are incentives for achieving
favourable variances (for achieving results that are better than the standard), such as annual cash bonuses.
Basic standards.
These are standards which remain unchanged over a long period of time. Variances are calculated by comparing
actual results with the basic standard, and if there is a gradual improvement in performance over time, this will
AT A GLANCE

be apparent in an improving trend in reported variances.

Basic standards will not motivate employees to improve their performance as they are based on achievable
conditions at some time in the past. They are also not useful for budgeting because they will often be out of date.
In practice, they are the least common type of standard.
When there is waste in production, or when idle time occurs regularly, current standard costs may include an
allowance for the expected wastage or expected idle time. This is considered in more detail later.
 Example 02:
A company produces bookshelves. Each bookshelf requires three planks of wood. A box of wood
contains 15 planks and costs Rs.45.
Currently 20% of wood is wasted during production. Management would like to reduce this
wastage to 10%.
SPOTLIGHT

Calculate a standard material cost for a bookshelf based on

a) Ideal conditions
Standard cost per plank = Rs.45/15 planks = Rs.3 per plank
Ideal standard: 3 planks × Rs.3 = Rs.9 per bookshelf
b) Current conditions
Current standard: 3/0.80 planks = 3.75 planks at Rs.3 = Rs.11.25 per bookshelf
c) Attainable conditions
Attainable or target standard: 3/0.9 = 3.33 planks at Rs.3 = Rs.10 per bookshelf

1.6 Reviewing standards

STICKY NOTES

How often should standards be revised? There are several reasons why standards should be revised regularly.
Regular revision leads to standards which are meaningful targets that employees may be motivated to achieve
(for example, through incentive schemes).
Variance analysis is more meaningful because reported variances should be realistic.
In practice, standards are normally reviewed annually. Standards by their nature are long-term averages and
therefore some variation is expected over time. The budgeting process can therefore be used to review the
standard costs in use.
 Example 03:
Makhdoom Limited makes and sells a single product, Product Q, with the following standard
specification for material, labour and production overheads. The information is related to recently
prepared standard cost card.
1. Direct material X and Y are used in the quantities of 12kg and 8 kg respectively. Current price
of material X is Rs. 40 per kg while material Y is Rs. 32 per kg.

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2. It takes 20 hours of direct labour to produce one unit with standard direct labour rate of Rs. 10
per hour.
3. Annual sales/ production budget is 2,400 units evenly spread throughout the year. The
standard selling price is based on current price of Rs. 1,250 per unit.
4. The budgeted production overhead, all fixed, is Rs. 288,000 and expenditure is expected to
occur evenly over the year. Company’s policy is to absorb production overheads on direct
labour hours.
The senior management has gathered information and takes decisions for handling current
situation.
a. Due to increase in competition, it is expected that sales price will decline by 6%. In order to
increase the production and sales volume, specific marketing campaign will be launched. It is
expected that volume of production and sales will increase by 10%.

AT A GLANCE
b. The prices of material X is expected to increase by 3%. However, an agreement has been made
recently whereby 4% discount will be availed on purchase of material Y.
c. An agreement with trade union revealed that 8% increase in rate per hour will ensure 10%
savings in time for production in one unit.
d. Fixed production overhead, are expected to increase by 5% due to inflation.
Current and revised standard cost card, showing standard cost and profit per unit, is given below.
Current standard cost card and profit per unit Rs.
Direct materials:
Material X: 12 kg at Rs. 40 per kg 480.00
Material Y: 8 kg at Rs. 32 per kg 256.00

SPOTLIGHT
736.00
Direct labour: 20 hours at Rs. 10 per hour 200.00
Fixed production overhead: [288,000/(2,400 x 20)] = 20 hours at Rs. 6 per hour 120.00
Standard cost of production per unit 1,056.00
Selling price per unit 1,250.00
Standard gross profit per unit 194.00

Revised standard cost card and profit per unit Rs.

STICKY NOTES
Direct materials:
Material X: 12 kg at Rs. 40 x 1.03 = 41.20 per kg 494.40
Material Y: 8 kg at Rs. 32 x 0.96 = 30.72per kg 245.76
740.16
Direct labour: 20 x 0.90= 18 hours at Rs. 10 x 1.08= 10.80 per hour 194.40
Fixed production overhead: 18 hours at Rs. 6.36 per hour W-1 114.48
Standard cost of production per unit 1,049.04
Selling price per unit (1,250 x 0.94) 1,175.00
Standard gross profit per unit 125.96

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W-1 Fixed production overhead rate per hour Rs.

Revised budgeted production overheads (288,000 x 1.05) 302,400
Revised production in units (2,400 x 1.10) 2,640
Revised direct labour hours (2,640 x 18) 47,520
Fixed production overhead rate per hour (302,400/ 47,520) 6.36
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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2. ALLOWING FOR WASTE AND IDLE TIME

2.1 Materials wastage in standard costing
Waste is an unavoidable feature of some production processes. The actual amount of materials wasted may vary
from one period to another, but there may be a standard rate of wastage or a ‘normal’ rate of loss which is a
measure of the average rate of wastage or loss.
An allowance for expected loss can be included in a standard cost. The standard cost can be based on the expected
quantity of input materials required to produce one unit of output (which is the same principle as that used for
normal loss in process costing).
 Example 04:
A company manufactures a product in a process production system. There is some wastage in

AT A GLANCE
production, and normal loss is 10% of the number of units input to the process. One unit of raw
material is required to produce one unit of finished goods.
The standard price per unit of direct material is Rs.4.50 per unit.
a) If an ideal standard is used, and the standard does not provide for any loss in process,
standard direct material cost per unit of output would be as follows
Ideal standard
No loss; therefore, standard cost =
1 unit of direct materials at Rs.4.50 per unit of material = Rs.4.50 per unit of output.
b) If the standard cost allows for a loss of 10% of input materials in producing each unit of

SPOTLIGHT
output, then Standard Direct material cost per unit of output would be:
Attainable or current standard: allow for 10% loss
Standard input to produce one unit of = 1/0.9 units = 1.111 units.
Therefore, standard cost =
1.111 units of materials at Rs.4.50 per unit = Rs.5 per unit of output.
 Example 05:
A company produces sandwiches. Each sandwich requires two slices of bread and a loaf of bread
contains 24 slices. Each loaf of bread costs Rs.6. It is estimated that currently 20% of bread is
wasted. Management would like to reduce this wastage to 10%.

STICKY NOTES
Calculation of a standard material cost for a sandwich based on various conditions are given
below
a) Ideal conditions
Standard cost per slice of bread = Rs.6/24 slices = Rs.0.25 per slice
Ideal standard: 2 slices × Rs.0.25 = Rs.0.50
b) Current conditions
Current standard: 2/0.80 slices = 2.5 slices at Rs.0.25 = Rs.0.625
c) Attainable conditions
Attainable or target standard: 2/0.9 = 2.22 slices at Rs.0.25 = Rs.0.555.
Note that the current and attainable standard costs include an allowance for wastage, and a
materials usage variance will occur only if the actual wastage rate differs from the standard
wastage rate.

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2.2 Idle time and standard costing

Idle time occur when the direct labour employees are being paid but have no work to do. Idle time is also known
as non-productive time. The causes of idle time may be:
• A breakdown in production, for example a machine breakdown that halts the production process
• Time spent waiting for work due to a bottleneck or hold-up at an earlier stage in the production process or
due to machine cleanup process.
• Running out of a vital direct material, and having to wait for a new delivery of the materials from a supplier.
• A lack of work to do due to a lack of customer orders.
A feature of idle time is that it is recorded, and the hours ‘lost’ due to idle time are measured.
Sometimes idle time may be an unavoidable feature of the production process, so that an allowance for idle time
AT A GLANCE

is included in the standard cost.

Methods of including idle time in standard costs

There are different ways of allowing for idle time in a standard cost.
• Method 1. Include idle time as a separate element of the standard cost, so that the standard cost of idle time
is a part of the total standard cost per unit.
• Method 2. Allow for a standard amount of idle time in the standard hours per unit for each product. This is
the same approach described above for materials wastage and standard costing. The standard hours per unit
therefore include an allowance for expected idle time.
 Example 06:
SPOTLIGHT

A company manufactures Product X. Due to the nature of the production process, there is some
idle time and it has been estimated that the ‘normal’ amount of idle time is 10% of hours worked.
Ignoring idle time, the standard time to make 1 unit of Product X is 0.36 hours. Labour is paid
Rs.18 per hour.
This means that the labour time to make 1 unit of product X is 0.36/0.90 = 0.40 hours, of which
0.04 hours are idle time.
There are two ways of making an allowance for in the standard cost the expected idle time.
Method 1: Include idle time as a separate element of the standard cost. The standard cost per
unit will include the following items:
STICKY NOTES

Rs.
Active hours worked: 0.36 hours × Rs.18 per hour 6.48
Idle time: 0.04 hours × Rs.18 per hour 0.72
7.20

Method 2: Include an allowance for expected idle time in the standard hours per unit for each
product.
Standard cost = 0.40 hours × Rs.18 per hour = Rs.7.20

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3. COMPREHENSIVE EXAMPLES
 Example 01:
A company manufactures two products, X and Y. In Year 1 it budgets to make 2,000 units of
Product X and 1,000 units of Product Y. Budgeted resources per unit and costs are as follows:

Product X Product Y
Direct materials per unit:
Material A 2 units of material 1.5 units of material
Material B 1 unit of material 3 units of material
Direct labour hours per unit 0.75 hours 1 hour

AT A GLANCE
Costs
Direct material A Rs.4 per unit
Direct material B Rs.3 per unit
Direct labour Rs.20 per hour
Variable production overhead Rs.4 per direct labour hour

Fixed production overheads per unit are calculated by applying a direct labour hour absorption
rate to the standard labour hours per unit, using the budgeted fixed production overhead costs
of Rs.120,000 for the year.
The standard full production cost per unit of product X and Y are as follows
First calculate the budgeted overhead absorption rate.

SPOTLIGHT
Budgeted direct labour hours hours
Product X: (2,000 units × 0.75 hours) 1,500
Product Y (1,000 units × 1 hour) 1,000
2,500
Budgeted fixed production overheads Rs.120,000
Fixed overhead absorption rate/hour Rs.48

STICKY NOTES
Product X Product Y
Rs. Rs.
Direct materials
Material A (2 units × Rs.4) 8 (1.5 units × Rs.4) 6
Material B (1 unit × Rs.3) 3 (3 units × Rs.3) 9
Direct labour (0.75 hours × Rs.20) 15 (1 hour × Rs.20) 20
Variable production overhead (0.75 hours × Rs.4) 3 (1 hour × Rs.4) 4
Standard variable prod’n cost 29 39
Fixed production overhead (0.75 hours × Rs.48) 36 (1 hour × Rs.48) 48
Standard full production cost 65 87

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 Example 02:
A company manufactures two products, Laurel and Hardy. In Year 1 it budgets to make 6,000
units of Product Laurel and 2,000 units of Product Hardy. Budgeted resources per unit and costs
are as follows:

Laurel Hardy
Direct materials per unit:
Material X 3 kg 1kg
Material Y 2 kg 6 kg
Direct labour hours per unit 1.6 hours 3 hours
AT A GLANCE

Budgeted Costs
Direct material X Rs. 3 per unit
Direct material Y Rs. 4 per unit
Direct labour Rs. 25 per hour
Variable production overhead Rs. 5 per direct labour hour

Fixed production overheads per unit are calculated by applying a direct labour hour absorption
rate to the standard labour hours per unit, using the budgeted fixed production overhead costs
of Rs.187,200 for the year.
The standard full production cost per unit of product Laurel and Hardy are as follows
SPOTLIGHT

First calculate the budgeted overhead absorption rate.

Budgeted direct labour hours hours

Laurel: (6,000 units × 1.6 hours) 9,600
Hardy (2,000 units × 3 hours) 6,000
15,600
Budgeted fixed production overheads Rs. 187,200
Fixed overhead absorption rate/hour Rs. 12 / hour
STICKY NOTES

Laurel Hardy
Rs. Rs.
Direct materials
Material X (3 kg × Rs. 3) 9.00 (1 kg × Rs. 3) 3.00
Material Y (2 kg × Rs.4) 8.00 (6 kg × Rs. 4) 24.00
Direct labour (1.6 hrs × Rs.25) 40.00 (3 hrs × Rs.25) 75.00
Variable production overhead (1.6 hrs × Rs.5) 8.00 (3 hrs × Rs.5) 15.00
Standard variable prod’n cost 65.00 117.00
Fixed production overhead (1.6 hrs × Rs.12) 19.20 (3 hrs × Rs.12) 36.00
Standard full production cost 84.20 153.00

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 Example 03:
A company manufactures Product Y. Due to the nature of the production process, there is some
idle time and it has been estimated that the ‘normal’ amount of idle time is 20% of hours worked.
Ignoring idle time, the standard time to make 1 unit of Product Y is 0.56 hours. Labour is paid
Rs.30 per hour.
Calculate the standard cost of the expected idle time using each of the following two methods:
i. Include idle time as a separate element of the standard cost
ii. Include an allowance for expected idle time in the standard hours and standard
cost
The labour time to make 1 unit of product X is 0.56/0.80 = 0.70 hours, of which 0.14 hours are

AT A GLANCE
idle time.
i. Include idle time as a separate element of the standard cost.
The standard cost per unit will include the following items:

Rs.
Active hours worked: 0.56 hours × Rs.30 per hour 16.80
Idle time: 0.14 hours × Rs.30 per hour 4.20
21.00

ii. Include an allowance for expected idle time in the standard hours and in standard
cost.

SPOTLIGHT
Standard cost = 0.70 hours × Rs.30 per hour = Rs.21.00
 Example 04:
Omega Limited plans to sell its new skin care lotion, Lanosof, in 100ml bottle. Cost and production
studies show these standard costs of materials and ingredients.

Container: Description Cost Allowance for

waste and
breakage
Item 153 100ml bottle Rs. 3,600 per gross 3%
Item 253 Label Rs. 1,100 per pack of 500 labels 5%

STICKY NOTES
Materials Description Cost Quantity used
for batch of 1
liter
Item C3A Compound 3A Rs. 200 per 250 lbs. 550 lbs.
Item AG Alcohol Rs. 500 per 800 lbs. 750 lbs.
Item PO Perfume oil Rs. 5,000 per 100 lbs. 10 lbs.

Labour Time for batch Rate Idle time

of 1 liter
Skilled 12 hours Rs. 60 per hour 2%
Unskilled 30 hours Rs. 25 per hour 5%

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A standard prime cost card for one bottle of 100ml of new skin care lotion, Lanosof, is given below.

Standard cost card of 100ml bottle of Lanosof Rs.

Container:
Item 153 (3,600/144 = 25 / 0.97) 25.77
Item 253 (1,100/500 = 2.20/ 0.95) 2.32
28.09
Materials:
Item C3A (550 x 100/1,000= 55 lbs) x (200/250 = 0.80 per lb.) 44.00
Item AG (750 x 100/1,000= 75 lbs) x (500/800 = 0.625 per lb.) 16.88
AT A GLANCE

Item PO (10 x 100/1,000= 1 lb) x (5,000/100 = 50 per lb.) 50.00

110.88
Direct labour:
Skilled (12 x 100/1,000= 1.20/ 0.98= 1.22 hours) at rate of Rs. 60 per hour 73.20
Skilled (30 x 100/1,000= 3.00/ 0.95= 3.16 hours) at rate of Rs. 25 per hour 79.00
152.20
Standard prime cost of 100ml bottle 291.17
SPOTLIGHT
STICKY NOTES

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STICKY NOTES

A standard is a pre-determined unit of cost for stock valuation, budgeting and

control

A standard cost card shows full details of the standard cost of each product
AT A GLANCE

The standard for each type of cost (material, labour and Overhead) is made
up of a standard resource price and a standard resource usage

The difference between standard and actual is known as a variance. The

process by which the total difference between standard and actual results is
analyzed in known as variance analysis.

Performance standards are used to set efficiency targets. There are four
types: Ideal, Current, Basic and Attainable
SPOTLIGHT

There may be a standard rate of wastage or a ‘normal’ rate of loss which is a

measure of the average rate of wastage or loss. An allowance for expected
loss can be included in a standard cost.
STICKY NOTES

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 CHAPTER 11

VARIANCE ANALYSIS

AT A GLANCE
IN THIS CHAPTER
A budget is a standard, set to coordinate between different
AT A GLANCE departments and managers.

AT A GLANCE
We prepare budgets to motivate managers and to evaluate their
SPOTLIGHT performance.

1. Variance Analysis The original budget prepared at the beginning of a budget

period is known as the fixed budget. When we shift our fixed
2. Direct Material Variances budget to actual activity for control purposes, it is called flexed
budget.
3. Direct labour Variances Difference between flexed budget and actual result is called
variances.
4. Variable production overhead
Total Cost variances are to be calculated by comparing total
variances
standard cost with total actual cost.
5. Fixed production overhead cost Total material, labour and overhead variances can be calculated

SPOTLIGHT
variances: absorption costing by comparing total standard cost with total Actual cost
respectively.
6. Interelationship of Variances
Material variance can be divided into material Price and usage
variance.
7. Standard marginal costing
Labour variance can be divided into labour rate and efficiency
8. Materials mix and yield variance.
variances
Variable overhead can vary with number of units or with
number of hours.
9. Sales variances
Fixed overhead variances are Expenditure and volume

STICKY NOTES
10. Operating statements variances.
For all cost variances if actual cost is greater than standard it is
11. Comprehensive Examples
an adverse variance.
STICKY NOTES Variances can be interrelated for example an adverse material
usage variance may be due to favourable material price
variance.
Mix variances are to be calculated where there is more than one
type of material or labour involved.
Sales variances can be identified by comparing budgeted sales
and actual sales.
Sales variances include sales price and volume variance. If
actual sales exceed budget, the variance is favourable.

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 CHAPTER 11: VARIANCE ANALYSIS CAF 8: CMA

1. VARIANCE ANALYSIS
Variance analysis is quantitative result of difference between standard and actual results. This analysis is used
to put control over business activities through investigation of areas where performance was unexpectedly poor.
For example, the standard cost of raw material for 600 units was set at Rs. 30,000 but actual cost was Rs. 36,000;
thus creating adverse variance of Rs. 6,000. It showed adverse performance in this area, the reasons are most
important to see whether this variance was caused by controllable or uncontrollable factors. (Tools, 2021)
When we set standard cost, we have to determine the budgeted level as well. The standard cost at budgeted level
is known as fixed budget. The actual results cannot be compared with fixed budget because the actual activity
exceeds budgeted activity, thus creating useless variance. In order to calculate realistic variances, it is important
to compare the standard cost at actual activity, which is termed as flexed budget approach. This approach is
explained with example in following section.
AT A GLANCE

1.1. Budgets and actual results for a period:

1.1.1. Fixed budget

The original budget prepared at the beginning of a budget period is known as the fixed budget. A fixed budget is
a budget for a specific volume of output and sales activity, and it is the ‘master plan’ for the financial year that
the company tries to achieve.
 Example 01:
Mardan Manufacturing Limited has budgeted to make 1,200 units and sell 1,000 units in January.
The selling price per unit is budgeted at Rs. 15,000.
The standard costs of production are as given below.
SPOTLIGHT

Standard cost card (Mardan Manufacturing Limited)

Rs.
Direct materials 5 kg @ Rs.1,000 per kg 5,000
Direct labour 4 hours @ Rs. 500 per hour 2,000
Variable overhead 4 hours @ Rs. 200 per hour 800
Marginal production cost 7,800
Fixed production overhead 4 hours @ Rs. 600 per hour 2,400
Total absorption cost 10,200
The budget prepared for January is as follows:
STICKY NOTES

Unit sales 1,000

Unit production 1,200
Budget Rs. ‘000
Sales (1,000 units ×15,000) 15,000
Cost of sales:
Materials (1,200 units ×Rs. 5,000 per unit) 6,000
Labour (1,200 units ×Rs. 2,000 per unit) 2,400
Variable overhead (1,200 units ×Rs. 800 per unit) 960
Fixed overhead (1,200 units ×Rs. 2,400 per unit) 2,880
12,240
Closing inventory (200 units ×Rs. 10,200 per unit) (2,040)
Cost of sales (1,000 units ×Rs. 10,200 per unit) (10,200)
Gross Profit 4,800

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Note: Budgeted profit = 1,000 units × (Rs. 15,000 −Rs. 10,200 per unit) = Rs. 4,800,000
One of the main purposes of budgeting is budgetary control and the control of costs. Costs can be
controlled by comparing budgets with the results actually achieved.
Differences between expected results and actual results are known as variances. Variances can be either
favourable (F) or adverse (A) depending on whether the results achieved are better or worse than expected.
Consider the following:
 Example 02:
At the end of January Mardan Manufacturing Limited recorded its actual results as follows.

Budget Actual

AT A GLANCE
Unit sales 1,000 900
Unit production 1,200 1,000
Budget Rs. ‘000 Rs. ‘000
Sales 15,000 12,600

Cost of sales: Budget Actual

Materials 6,000 4,608
Labour 2,400 2,121
Variable overhead 960 945

SPOTLIGHT
Fixed overhead 2,880 2,500
12,240 10,174
Closing inventory (2,040) (1,020)
Cost of sales (10,200) (9,154)
Profit 4,800 3,446

Note: The actual closing inventory of 100 units is measured at the standard cost of Rs. 10,200
per unit. This is what happens in standard costing systems. (in exam if question is silent about
inventory measurement then actual closing inventory shall be measured at actual absorption

STICKY NOTES
cost.

What does this tell us?

The actual results (profit) was less than budgeted profit which indicates adverse situation. The profit was
declined by Rs. 1,354,000 when compared with budget. In order to see why it was happened, we have to see each
item separately. It looked obvious that major impact was caused by decline in sales by Rs. 2,400,000. However,
each item of cost showed different results. The actual cost of material, labour and production overheads was less
than budgeted cost which showed favourable results.
When we look into the units sold it was clear that actual sales in units was less than budgeted sales in units.
Similarly, budgeted cost was calculated on basis of production of 1,200 units whereas actual units produced were
less than budget i.e. 1,000. Is it realistic to compare the results of 1,200 units with cost of 1,000 units? Absolutely
not, in order to make realistic comparison, we have to revised the budget at actual level of activity. The revised
budget should be compared with actual results, to get realistic variances. This approach is further explained in
following section.

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1.1.2. Flexed budget

Variances are not calculated by comparing actual results to the fixed budget directly because the figures relate
to different levels of activity and the comparison would not be realistic. For the purpose of realistic comparison,
it is important to prepare another budget which is termed as Flexed Budget. This budget is prepared at actual
level of activity, however, basis used in preparation of budget are same as in fixed budget.
Following example explain the concept of flexed budget
 Example 03:
Continuing the example 02, the flexed budget prepared by Mardan Manufacturing Limited at the
end of January (based on actual levels of activity and standard revenue per unit and standard
cost per unit) is as follows:
AT A GLANCE

Unit sales 900

Unit production 1,000
Budget at 900 units Rs. ‘000
Sales (900 units ×15,000) 13,500

Cost of sales: Rs. ‘000

Materials (1,000 units ×Rs. 5,000 per unit) 5,000
Labour (1,000 units ×Rs. 2,000 per unit) 2,000
Variable overhead (1,000 units ×Rs. 800 per unit) 800
SPOTLIGHT

Fixed overhead (1,000 units ×Rs. 2,400 per unit) 2,400

10,200
Closing inventory (100 units ×Rs. 10,200 per unit) (1,020)
Cost of sales (900 units ×Rs. 10,200 per unit) (9,180)
Profit 4,320

This shows the amount that the company would have received for the actual number of units
sold if they had been sold at the budgeted revenue per item.
It shows what the actual number of units produced (1,000 units) would have cost if they had
STICKY NOTES

been made at the standard cost.

The flexed budget is a vital concept as variance analysis concept is purely based on it.

1.1.3. Comparison of actual results to the flexed budget.

After preparation of flexed budget, the actual results are compared with it to calculate variances. This practice is
also known as control statement, because reasons on the basis of variances were highlighted.
 Example 04:
At the end of January, Mardan Manufacturing Limited has recorded its actual results as follows
(together with the original fixed budget and the flexed budget for the month).
Fixed budget Flexed budget Actual
Unit sales 1,000 900 900
Unit production 1,200 1,000 1,000

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Budget Actual Actual

Budget Rs. ‘000 Rs. ‘000 Rs. ‘000
Sales 15,000 13,500 12,600
Cost of sales:
Materials 6,000 5,000 4,608
Labour 2,400 2,000 2,121
Variable overhead 960 800 945
Fixed overhead 2,880 2,400 2,500
12,240 10,200 10,174
Closing inventory (2,040) (1,020) (1,020)

AT A GLANCE
Cost of sales (10,200) (9,180) (9,154)
Profit 4,800 4,320 3,446

Note: The actual closing inventory of 100 units is measured at the standard total absorption cost
of Rs. 10,200 per unit. This is what happens in standard costing systems. (in exam if question is
silent about inventory measurement then actual closing inventory shall be measured at actual
absorption cost

1.2. Variance Analysis

Variance analysis explains the difference between the fixed budget profit and the actual profit in detail. This
paragraph provides an initial commentary for variances which will be explained in detail later.

SPOTLIGHT
The variance may cause due to change in volume or change in base (price, rate etc.). For example, difference
between material cost in flexed budget and actual results may cause due to usage of material or price of variance.
In order to interpret the variance in detail, it is important to know about variance relating to usage and price
separately. This technique is used not only for material, rather it is applied on all other cost and revenue items.

1.3. Cost variances

Adverse and favourable cost variances

In a standard costing system, all units of output are valued at their standard cost. Cost of production and cost of
sales are therefore valued at standard cost.

STICKY NOTES
Actual costs will differ from standard costs. A cost variance is the difference between an actual cost and a
standard cost.
• When actual cost is higher than standard cost, the cost variance is adverse (A) or unfavourable (U).
• When actual cost is less than standard cost, the cost variance is favourable (F).
Similarly, standard revenue and actual revenue might differ, and it is known as sales variance.
• When actual revenue is higher than standard revenue, the variance is Favourable (F).
• When actual revenue is less than standard revenue, the variance is adverse (A) or unfavourable (U).
In a cost accounting system, variances are adjusted to the profit in an accounting period.
• Favourable variances increase the reported profit.
• Adverse variances reduce the reported profit.

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1.4. Variances and performance reporting

Variance reports are produced at the end of each control period (say, at the end of each month).
• Large adverse variances indicate poor performance, provided they are due to factors controllable by
management, and the need for control action by management.
• Large favourable variances indicate unexpected good performance. Management might wish to consider
how this good performance can be maintained in the future.
Variances might be reported in a statement for the accounting period that reconciles the budgeted profit with
the actual profit for the period. This statement is known as an operating statement.
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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2. DIRECT MATERIALS VARIANCES

2.1 Direct materials: total cost variance
This section has three variances, the total direct material cost variance, direct material price variance and direct
material usage variance. Total direct material variance is the difference between the actual material cost in
producing units in the period and the standard material cost of producing those units.
 Calculation of direct material total cost variance:

Rs.
Standard material cost of actual production:
Actual units produced × Standard kgs per unit × Standard price per kg X

AT A GLANCE
Actual material cost of actual production:
Actual units produced × Actual kgs per unit × Actual price per kg (X)
Favourable (Adverse) X or (X)

The variance is adverse (A) if actual cost is higher than the standard cost, and favourable (F) if
actual cost is less than the standard cost.
 Example 05:
Following data is relevant to Jamal Limited for the month of January 2021.
Standard material cost per unit: (10 kgs @Rs. 100 per kg) = Rs. 1,000 per unit
Actual production in period = 600 units.

SPOTLIGHT
Materials purchased and used: 5,850 kgs at a cost of Rs. 5,740,000
Direct materials total cost variance is calculated as follows:
Rs. ‘000
Standard: 600 units should cost (@ Rs. 1.000 per unit) 6,000
Actual: 600 units did cost (5,740)
Total cost variance (F) 260

The direct materials total cost variance can be analyzed into a price variance and a usage variance.

2.2 Direct materials price variance

STICKY NOTES
A price variance measures the difference between the actual price paid for materials and the price that
should have been paid (the standard price).
The price variance may be calculated for the materials purchased or materials used. Usually it is calculated
at the point of purchase as this allows the material inventory to be carried at standard cost.
 Calculation of direct material price variance:

Rs.
Standard material cost of actual production:
Actual kgs purchased × Standard price per kg X
Actual material cost of actual purchases
Actual kgs purchased × Actual price per kg (X)
Favourable (Adverse) X or (X)

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 Formula to calculate direct material price variance:

Result
(SP – AP) x AQ F or (A)
Where:
SP = Standard price
AP = Actual price
AQ = Actual quantity purchased or used

Normally, actual quantity is quantity purchased in accordance to concept of standard costing

principle, however, it can be calculated on quantity used, if asked by examiner.
AT A GLANCE

 Example 06:
Standard material cost extracted from cost card of product A101, is given below.

Rupees
Standard cost of materials (20 liters at Rs. 8 per liter) 160

During the month of February 2021, 5,000 units were produced. Material of 99,300 liters was
purchased at cost of Rs. 814,260. There was no opening or closing material inventory.
Direct materials price variance is calculated as follows:

Rupees
Standard: 99,300 liters should cost (@ Rs. 8 per kg) 794,400
SPOTLIGHT

Actual: 4,850 kgs did cost (814,260)

Materials price variance (A) (19,860)
Formula Method: Rupees
(SP – AP) x AQ
(8 – [814,260/99,300 = 8.20]) x 99,300 (19,860) A

 Example 07:
A unit of Product P123 has a standard cost of 5 liters of Material A at Rs.3 per liter. The standard
direct material cost per unit of Product 123 is therefore Rs.15. In a particular month, 2,000 units
of Product 123 were manufactured. 11,000 liters of Material A was purchase at total cost of Rs.
STICKY NOTES

33,550 whereas 10,400 liters of Material A were actually used.

Management intends to record the material price variance at the time of usage of material.
The material price variance is calculated as follows:

Rs.
10,400 litres of materials should cost (× Rs.3) 31,200
They did cost (10,400 x 3.05) 31,720
Material price variance (520) A
Formula Method: Rupees
(SP – AP) x AQ
(3 – [33,550/11,000 = 3.05]) x 10,400 (520) A

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2.3 Direct materials usage variance

A usage variance measures the difference between the materials that were used in production and the materials
that should have been used (the standard usage).
The usage variance is calculated by comparing the actual quantity of material used to make the actual production
to the standard quantity that should have been used to produce those units. In other words, the actual usage of
materials is compared with the standard usage for the actual number of units produced,
The difference is the usage variance, measured as a quantity of materials. This is converted into a money value
at the standard price for the material.
 Calculation of direct material usage variance:

Material usage variance

AT A GLANCE
Standard quantity of material used to make the actual production X
Actual quantity of material used to make the actual production (X)
Usage variance (kgs) X (X)
Standard cost per kg (multiply by) X
Usage variance (Rs.) Favourable (Adverse) X (X)

 Formula for material usage variance:

Formula Rs.
(SQ x AQ) x SP

SPOTLIGHT
Whereas:
SQ = Standard Quantity at actual units produced
AQ = Actual quantity used
SP = Standard price

 Example 08:
Rana Enterprises makes a single product with the following standard material costs per unit:

Rupees

STICKY NOTES
Standard cost of materials (2 kg at Rs. 10 per kg) 20

Actual production in period = 1,000 units.

Materials purchased and used: 2,200 kg
Material cost Rs. 20,900
Direct materials usage variance is calculated as follows:

kgs
Standard:
Making 1,000 units should have used (@ 2 kg per unit) 2,000
Actual: Making 1,000 units did use (2,200)
Usage variance in kg (A) (200)
Standard price per kg in Rs. 10
Usage variance (Rs.) (A) (2,000)

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Formula Method: Rupees

(SQ – AQ) x SP
([1,000 x 2] – 2,200 x 10 (2,000) A

 Example 09:
Mansoori Limited makes and sells a single product. Each unit of the product requires 9kg of
material at Rs. 14 per kg.
The actual details for last period were that 1,200 units of finished goods were produced; 11,000
kg of material was purchased for Rs. 148,500 and 10,700 kg was used.
Mansoori limited maintains its raw materials inventory at standard cost
Material price and usage variances, are calculated as under.
AT A GLANCE

Material price variance Rs.

11,000 litres of materials should cost (× Rs. 14) 154,000
They did cost (148,500)
Material price variance 5,500 F

Formula Method: Rupees

(SP – AP) x AQ
(14 – [148,500/11,000 = 13.50]) x 11,000 5,500 F
SPOTLIGHT

Material usage variance kgs

Standard:
Making 1,200 units should have used (@ 9 kg per unit) 10,800
Actual: Making 1,200 units did use 10,700
Usage variance in kg (F) 100
Standard price per kg in Rs. 14
Usage variance (Rs.) (F) 1,400
STICKY NOTES

Formula Method: Rupees

(SQ – AQ) x SP
([1,200 x 9] – 10,700 x 14) 1,400 F

2.4 Direct materials: possible causes of variances

When variances occur and they appear to be significant, management should investigate the reason for the
variance. If the cause of the variance is something within the control of management, control action should be
taken. Some of the possible causes of materials variances are listed below.

Materials price variance: causes

Possible causes of favourable materials price variances include:
• Different suppliers were used and these charged a lower price than the usual supplier.
• Materials were purchased in sufficient quantities to obtain a bulk purchase discount.
• Materials were bought that were of lower quality than standard and so cheaper than expected.

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Possible causes of adverse materials price variances include:

• Different suppliers were used and these charged a higher price than the usual supplier.
• Suppliers increased their prices by more than expected. (Higher prices might be caused by an unexpected
increase in the rate of inflation.)
• There was a severe shortage of the materials, so that prices in the market were much higher than expected.
• Materials were bought that were better quality than standard and more expensive than expected.
Materials usage variance: causes
Possible causes of favourable materials usage variances include:
• Wastage rates were lower than expected.
• Improvements in production methods resulted in more efficient usage of materials.

AT A GLANCE
• Higher quality material was used resulting less wastage.
Possible causes of adverse materials usage variances include:
• Wastage rates were higher than expected.
• Poor materials handling resulted in a large amount of breakages. Breakages mean that a quantity of materials
input to the production process are wasted.
• Materials used were of cheaper quality than standard, with the result that more materials had to be thrown
away as waste.

2.5 Journal entries-direct materials in standard costing

Debit Credit

SPOTLIGHT
Description
-------- Rupees --------
Material price variance is recognised at the time of purchase
Materials Inventory (AQP x SP) X
Material price variance (If adverse) X
Material price variance (If favourable) X
Accounts payable X
(Record purchase of raw materials)
Material is issued to production
Work in progress control (SQ x SP) X

STICKY NOTES
Material usage variance (If adverse) X
Material usage variance (If favourable) X
Material Inventory (AQU x SP) X
Material price variance is recognised at the time of usage
Materials Inventory (AQP x AP) X
Accounts payable X
(Record purchase of raw materials)
Material is issued to production
Work in progress control (SQ x SP) X
Material usage variance (If adverse) X
Material price variance (If adverse)
Material usage variance (If favourable) X
Material price variance (If favourable)
Material Inventory (AQU x SP) X
It can be explained with the help of following example.

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 Example 10:
The Shawn Furniture House uses 12 meters of pipe at cost of Rs. 8 per meter as standard for the
production of one of its chairs Model No. CHRA12. During one month’s operations, 50,000 meters
of pipe were purchased at Rs. 7.80 a meter and 3,600 chairs were produced using 43,800 meters
of pipe.
a) Assuming that material price variance is recognized at the time of purchases. Calculation of
material price and usage variance along with journal entries are given below.
Material price variance Rupees
(SP – AP) x AQP
(8 – 7.80) x 50,000 10,000 F
Material usage variance Rupees
AT A GLANCE

(SQ – AQ) x SP
(3,600 x 12 – 43,800) x 8 4,800 A

Debit Credit
Description
-------- Rupees --------
Materials Inventory (50,000 x 8) 400,000
Material price variance 10,000
Accounts payable (50,000 x 7.80) 390,000
(Record purchase of raw materials)
Work in progress control (3,600 x 12 x 8) 345,600
SPOTLIGHT

Material usage variance 4,800

Material Inventory (43,800 x 8) 350,400
(Record issue of material to production)
b) Assuming that material price variance is recognized at the time of issue of materials.
Calculation of material price and usage variance along with journal entries are given below.
Material price variance Rupees
(SP – AP) x AQU
(8 – 7.80) x 43,800 8,760 F
Material usage variance Rupees
(SQ – AQ) x SP
STICKY NOTES

(3,600 x 12 – 43,800) x 8 4,800 A

Debit Credit
Description
-------- Rupees --------
Materials Inventory (50,000 x 7.80) 390,000
Accounts payable (50,000 x 7.80) 390,000
(Record purchase of raw materials)
Work in progress control (3,600 x 12 x 8) 345,600
Material usage variance 4,800
Material price variance 8,760
Material Inventory (43,800 x 7.80) 361,640
(Record issue of material to production)

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3. DIRECT LABOUR VARIANCES

3.1 Direct labour: total cost variance
In this section, we will discuss four variances related to labour i.e. total direct labour variance, labour rate
variance, labour efficiency variance and idle time variance.
The total direct labour cost variance is the difference between the actual labour cost in producing units in the
period and the standard labour cost of producing those units.
 Calculation of total direct labour variance:
Rs.
Standard labour cost of actual production:
Actual units produced × Standard hrs per unit × Standard rate per hr X

AT A GLANCE
Actual labour cost of actual production:
Actual units produced × Actual hours per unit × Actual rate per hour (X)
X
The variance is adverse (A) if actual cost is higher than the standard cost, and favourable (F) if actual cost is less
than the standard cost.
 Example 11:
Following standard labour cost per unit is related to Lahore Trading Company:
Standard labour cost per unit: (3 hours @Rs. 50 per hour) = Rs. 150 per unit
Actual production in period = 800 units.

SPOTLIGHT
Labour hours paid for: 2,500 hours at a cost of Rs. 128,500
Direct labour total cost variance is calculated as follows:
Rs.
Standard: 800 units should cost (@ Rs.150 per unit) 120,000
Actual: 800 units did cost (128,500)
Total cost variance (A) (8,500)
The direct labour total cost variance can be analyzed into a rate variance and an efficiency variance. These are
calculated in a similar way to the direct materials price and usage variances.
• A rate variance measures the difference between the actual wage rate paid to labour per hour and the rate

STICKY NOTES
that should have been paid (the standard rate of pay).
• An efficiency variance (or productivity variance) measures the difference between the time taken to make
the production output and the time that should have been taken (the standard time).
3.2 Direct labour rate variance
The actual labour cost of the actual hours paid for is compared with the standard cost for those hours. The
difference is the labour rate variance. The direct labour rate variance is calculated for the actual number of hours
paid for.
 Calculation of direct labour rate variance:
Rs.
Standard labour cost of actual production:
Actual hours paid for × Standard rate per hour X
Actual labour cost of actual purchases
Actual hours paid for × Actual rate per hour (X)
Favourable (Adverse) X (X)

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Formula Rs.
(SR x AR) x SH
Whereas:
SR = Standard Rate per hour
AR = Actual rate per hour
SH = Standard hours at actual units produced

 Example 12:
Standard cost of labour per unit is Rs. 30 (30 minutes at Rs. 60 per hour)
Actual production in period = 6,000 units.
AT A GLANCE

Labour hours paid for: 3,100 hours at a cost of Rs. 179,800

Direct labour rate variance is calculated as follows:

Labour rate variance Rs.

Standard: 3,100 hours should cost (@ Rs. 60 per hour) 186,000
Actual: 3,100 hours did cost (179,800)
Labour rate variance (F) 6,200
Formula method Rupees
(SR – AR) x AH
(60 – [179,800/3,100= 58]) x 3,100 6,200 F
SPOTLIGHT

3.3 Direct labour efficiency variance

The direct labour efficiency variance is calculated for the hours used on the units produced.
For the actual number of standard units produced, the actual hours worked is compared with the standard
number of hours that should have been worked to produce the actual output. The difference is the efficiency
variance, measured in hours. This is converted into a money value at the standard direct labour rate per hour.
 Calculation of direct labour efficiency variance:

Hours
STICKY NOTES

Standard labour hours used to make the actual production X

Actual labour hours used to make the actual production (X)
Efficiency variance (hours) X (X)
Standard cost per hour (multiply by) X
Efficiency variance (Rs.) Favourable (Adverse) X (X)
Formula Rs.
(SH x AH) x SR
Whereas:
SH = Standard hours to produce actual units
AH = Actual hours
SR = Standard rate per hour

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 Example 13:
For Modern Manufacturing Limited, standard labour cost per unit: (4 hours @Rs. 50 per hour) =
Rs. 200 per unit
Actual production in period = 1,000 units.
Labour hours paid for: 4,050 hours at a cost of Rs. 194,400
Direct labour efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 4 hours per unit) 4,000

AT A GLANCE
Actual: Making 1,000 units did use (4,050)
Efficiency variance (hours) (A) 50
Standard cost per hour Rs. 50
Efficiency variance (Rs.) (A) Rs. 2,500
Formula method Rupees
(SH – AH) x SR
(1,000 x 4 – 4,050) x 50 (2,500) A

 Example 14:
Product P234 has a standard direct labour cost per unit of:

SPOTLIGHT
0.5 hours × Rs.12 per direct labour hour = Rs.6 per unit.
During a particular month, 3,000 units of Product 234 were manufactured. These took 1,400
hours to make and the direct labour cost was Rs. 16,200.
The total direct labour cost variance, the direct labour rate variance and the direct labour
efficiency variance for the month, would be calculated as follows

Total direct labour cost variance Rs.

3,000 units of output should cost (×Rs.6) 18,000
They did cost 16,200

STICKY NOTES
Direct labour total cost variance 1,800 (F)

The variance is favourable, because actual costs were less than the standard cost.
The direct labour rate variance is calculated by taking the actual number of hours worked (and
paid for).

Direct labour rate variance Rs.

1,400 hours should cost (×Rs.12) 16,800
They did cost 16,200
Direct labour rate variance 600 (F)

The rate variance is favourable because the labour hours worked cost less than they should have
done.
The labour efficiency variance, like a materials usage variance, is calculated for the actual number
of units produced. The variance in hours is converted into a money value at the standard rate of
pay per hour.

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Direct labour efficiency variance hours

3,000 units of Product P234 should take (× 0.5 hours) 1,500
They did take 1,400
Efficiency variance in hours 100 (F)
Standard direct labour rate per hour Rs.12
Direct labour efficiency variance in Rs. Rs.1,200 (F)

The efficiency variance is favourable because production took less time than expected, which has
reduced costs.

Labour cost variances: summary Rs.

AT A GLANCE

Labour rate variance 600 (F)

Labour efficiency variance 1,200 (F)
Total direct labour cost variance 1,800 (F)

Alternate way of calculating the direct labour rate and efficiency variance, is using the formulas,
which are given as under.
Labour rate variance Rupees
(SR – AR) x AH
(12 – [16,200/1,400= 11.57143) x 1,400 600 F
SPOTLIGHT

Labour efficiency variance Rupees

(SH – AH) x SR
(3,000 x 0.50 – 1,400) x 12 1,200 F

3.4 Idle time variance

Idle time occurs when the direct labour employees are being paid but have no work to do. The causes of idle time
may be:
• A breakdown in production, for example a machine breakdown that halts the production process
• Time spent waiting for work due to a bottleneck or hold-up at an earlier stage in the production process
STICKY NOTES

• Time spent rearranging the production line for a new batch

• Running out of a vital direct material, and having to wait for a new delivery of the materials from a supplier.
• A lack of work to do due to a lack of customer orders.
A feature of idle time is that it is recorded, and the hours ‘lost’ due to idle time are measured. Idle time variance
is part of the efficiency variance.
Sometimes idle time might be a feature of a production process for example where there may be bottlenecks in
a process that might lead to idle time on a regular basis. In this case the expected idle time might be built into the
standard cost.
• If idle time is not built into the standard cost the idle time variance is always adverse.
• If it is built into the standard cost the idle time variance might be favourable or adverse depending on
whether the actual idle time is more or less than the standard idle time for that level of production.

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Idle time not part of standard cost

As stated above if the idle time is not included in the standard cost, any idle time is unexpected and leads to an
adverse variance. It is calculated simply by multiplying the idle time by standard rate per hour.
It is important that when idle time is calculated, direct labour efficiency is based on hours worked only, not the
paid hours because non-productive time is used in idle time variance.
 Calculation of idle time variance:

Hours
Actual hours paid for X
Actual hours worked (X)
Idle time (hours) X

AT A GLANCE
Standard cost per hour (multiply by) X
Idle time (Rs.) Adverse X

 Example 15:
ABC company has provided the following standard labour cost per unit.
Direct labour (2.5 hours at Rs. 40 per hour) = Rs. 100
During the month of September, 1,500 units were produced. Total 3,820 hours were paid at rate
of Rs. 41.50 per hour, including 90 idle hours.
Calculation of labour rate variance, labour efficiency variance and idle time variance, is given as
under.

SPOTLIGHT
Labour rate variance Rupees
(SR – AR) x AH
(40 – 41.50) x 3,820 (5,730) A

Labour efficiency variance Rupees

(SH – AH) x SR
[(1,500 x 2.50) – (3,820- 90)] x 40 800 F

Labour idle time variance Rupees

STICKY NOTES
Idle hours x SR
90 x 40 (3,600) A

3.5 Idle time variance where idle time is included in standard cost

Methods of including idle time in standard costs

There are different ways of allowing for idle time in a standard cost.
• Method 1. Include idle time as a separate element of the standard cost, so that the standard cost of idle time
is a part of the total standard cost per unit.
• Method 2. Allow for a standard amount of idle time in the standard hours per unit for each product. The
standard hours per unit therefore include an allowance for expected idle time. This is feasible when the idle
time is a necessary feature of the production process such as in batch processing.

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 Example 16:
For Marden Manufacturing Limited, standard labour rate = Rs. 500 per hour
A unit of production should take 3.6 hours to produce.
Expected idle time is 10% of total time paid for.
Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).
Idle time can be built into the standard as follows:
Method 1 Rs.
AT A GLANCE

Labour 3.6 hours ×Rs. 500 per hour 1,800

Idle time 0.4 hours ×Rs. 500 per hour 200
2,000
Method 2
Labour 4 hours ×Rs. 500 per hour 2,000
The two methods will result in the identification of the same overall variance for idle time plus
labour efficiency but the split of the number may differ.
For Marden Manufacturing, standard labour rate = Rs. 500 per hour
A unit of production should take 3.6 hours to produce.
SPOTLIGHT

Expected idle time is 10% of total time paid for.

Therefore 3.6 hours is 90% of the time that must be paid for to make 1 unit.
4 hours must be paid for (3.6/90%) to make 1 unit).
Expected idle time is 0.4 hours (10% of 4 hours).

Method 1
Idle time can be built into the standard as follows:

Rs.
Labour 3.6 hours ×Rs. 500 per hour 1,800
STICKY NOTES

Idle time 0.4 hours ×Rs. 500 per hour 200

2,000

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Labour hours worked: 4,100 hours
Direct labour idle time variance is calculated as follows:
Hours
Expected idle time (1,000 units × 0.4 hours per unit) 400
Actual idle time (4,200 hours − 4,100 hours) (100)
Idle time (hours) 300 F
Standard cost per hour (multiply by) Rs. 500
Idle time (Rs.) Rs. 150,000 F

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Direct labour efficiency variance is calculated as follows:

Hours
Standard:
Making 1,000 units should have used (@ 3.6 hours per unit) 3,600
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (500) A
Standard cost per hour Rs. 500
Efficiency variance (Rs.) Rs. 250,000 A
Method 2
Idle time can be built into the standard as follows:

AT A GLANCE
Rs.
Labour 4 hours ×Rs. 500 per hour 2,000

Actual production in period = 1,000 units.

Labour hours paid for: 4,200 hours at a cost of Rs. 2,121,000
Labour hours worked: 4,100 hours

Direct labour idle time variance is calculated as follows: Hours

Expected idle time (10% of 4,200 hours paid for) 420
Actual idle time (4,200 hours − 4,100 hours) (100)
Idle time (hours) 320 F

SPOTLIGHT
Standard cost per hour (multiply by) Rs. 500
Idle time (Rs.) Rs. 160,000 F

Direct labour efficiency variance is calculated as follows: Hours

Standard: 3,580
Making 1,000 units should have used (4 hours per unit less 10% of
the hours paid for = 4,000 – (10% of 4,200))
Actual: Making 1,000 units did use (4,100)
Efficiency variance (hours) (520) A
Standard cost per hour Rs. 500
A

STICKY NOTES
Efficiency variance (Rs.) Rs. 260,000
In summary the idle time variance is part of the efficiency variance. Different methods result in a
different split of the idle time variance and efficiency variance but the figures always sum to the
same total.
Revisiting the previous examples:
Sum of idle time and efficiency variances (Marden Manufacturing Limited)
Idle time Efficiency Total
variance variance
Idle time not recorded − 100 (A) 100 (A)
Idle time recorded:
not part of standard cost 50 (A) 50 (A) 100 (A)
part of standard cost (method 1) 150 (F) 250 (A) 100 (A)
part of standard cost (method 2) 160 (F) 260 (A) 100 (A)

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3.6 Direct labour: possible causes of variances

When labour variances appear significant, management should investigate the reason why they occurred, and
take control measures where appropriate to improve the situation in the future. Possible causes of labour
variances include the following.
Possible causes of favourable labour rate variances include:
• Using direct labour employees who were relatively inexperienced and new to the job.
• Change in method of production, where unskilled labour time enhanced while skilled labour time reduced.
• Actual pay increase turning out to be less than expected.
Possible causes of adverse labour rate variances include:
• An increase in pay for employees.
AT A GLANCE

• Working overtime hours paid at a premium above the basic rate.

• Using direct labour employees who were more skilled and experienced than the ‘normal’ and who are paid
more than the standard rate per hour.
Possible causes of favourable labour efficiency variances include:
• More efficient methods of working.
• Good morale amongst the workforce and good management with the result that the work force is more
productive.
• If incentive schemes are introduced to the workforce, this may encourage employees to work more quickly
and therefore give rise to a favourable efficiency variance.
• Previously unaccounted for learning and experience curves
SPOTLIGHT

• Using employees who are more experienced than ‘standard’, resulting in favourable efficiency variances as
they are able to complete their work more quickly than less-experienced colleagues.
Possible causes of adverse labour efficiency variances include:
• Using employees who are less experienced than ‘standard’, resulting in adverse efficiency variances.
• An event causing poor morale.

3.7 Journal Entries related to direct labour in standard costing

Debit Credit
Description
STICKY NOTES

-------- Rupees --------

Work in progress control (SH x SR) X

Adverse variances X

Favourable variances X

Payroll (Actual) X

(Record charging direct labour cost to production)

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 Example 17:
The standard cost card of Rashid Food Manufacturing Limited shows that the processing of a
product FDL560 requires 1 hour at a standard wage rate of Rs. 60 per hour.
The 2,000 units actually taken 1,975 hours at a cost of Rs. 122,450, including 25 idle hours.
Calculation of direct labour rate, efficiency and idle time variances and journal entry to charge
direct labour to production, is given below.
Labour rate variance Rupees
(SR – AR) x AH
(60 – [122,450/ 1,975 = 62) x 1,975 (3,950) A

Labour efficiency variance Rupees

AT A GLANCE
(SH – AH) x SR
[(2,000 x 1) – (1,975- 25)] x 60 3,000 F

Labour idle time variance Rupees

Idle hours x SR
25 x 60 (1,500) A

Journal entry to charge direct labour cost to production in standard costing is given below.

Debit Credit
Description

SPOTLIGHT
-------- Rupees --------
Work in progress control (2,000 x 60) 120,000
Labour rate variance 3,950
Labour idle time variance 1,500
Labour efficiency variance 3,000
Payroll 122,450
(Record charging direct labour cost to production)

STICKY NOTES

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4. VARIABLE PRODUCTION OVERHEAD VARIANCES

4.1 Variable production overhead: total cost variance
Three variances will be discussed in this section which includes total variable production overhead variance,
variable overhead expenditure variance and variable overhead efficiency variance.
The total variable production overhead cost variance is the difference between the actual variable production
overhead cost in producing units in the period and the standard variable production overhead cost of producing
those units.
 Calculation of total variable production overhead variance:

Rs.
AT A GLANCE

Standard variable production overhead cost of actual production:

Actual units produced × Standard hours per unit × Standard rate per hour X
Actual variable production overhead cost of actual production:
Actual units produced × Actual hours per unit × Actual rate per hour (X)
Favourable (Adverse) X (X)

The variance is adverse (A) if actual cost is higher than the standard cost, and favourable (F) if
actual cost is less than the standard cost.
 Example 18:
Irha Limited has provided extract of standard cost, which showed that standard variable cost of
SPOTLIGHT

one unit is Rs. 64 (4 hours at Rs. 16 per hour).

In the month of September, 2020; 5,200 units were produced
Total direct labour hours were 21,100 and actual variable production overhead was Rs. 331,700.

Total variable production overhead total cost variance is calculated as follows:

Rs.
Standard: 5,200 units should cost (@ Rs. 64 per unit) 332,800
Actual: 5,200 units did cost (331,700)
Total cost variance (F) 1,100
The variable production overhead total cost variance can be analyzed into an expenditure variance (spending
STICKY NOTES

rate per hour variance) and an efficiency variance.

• The expenditure variance is similar to a materials price variance or a labour rate variance. It is the difference
between actual variable overhead spending in the hours worked and what the spending should have been
(the standard rate).
• The variable overhead efficiency variance in hours is the same as the labour efficiency variance in hours
(excluding any idle time variance), and is calculated in a very similar way. It is the variable overhead cost or
benefit from adverse or favourable direct labour efficiency variances.

4.2 Variable production overhead expenditure variance

It is normally assumed that variable production overheads are incurred during hours actively worked, but not
during any hours of idle time.
• The variable production overhead expenditure variance is calculated by taking the actual number of hours
worked.
• The actual variable production overhead cost of the actual hours worked is compared with the standard cost
for those hours. The difference is the variable production overhead expenditure variance.

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 Calculation of variable production overhead expenditure variance:

Rs.
Standard variable production overhead cost of actual
production:
Actual hours worked × Standard rate per hour X
Actual variable production overhead cost of actual purchases
Actual hours worked × Actual rate per hour (X)
Favourable (Adverse) X (X)
Formula method Rupees
(AH x VOAR/hour) – Actual variable production overhead

AT A GLANCE
Where
AH = Actual hours worked
VOAR/hour = Standard variable overhead absorption rate per hour

 Example 19:
Irha Limited has provided extract of standard cost, which showed that standard variable cost of
one unit is Rs. 64 (4 hours at Rs. 16 per hour).
In the month of September, 2020; 5,200 units were produced
Total direct labour hours were 21,100 and actual variable production overhead was Rs. 331,700.

SPOTLIGHT
Variable production overhead expenditure variance is calculated as follows:

Rupees
Standard: 21,100 hours should cost (@ Rs. 16 per hour) 337,600
Actual: 21,100 hours did cost (331,700)
Variable production overhead expenditure variance (F) 5,900
Formula method Rupees
(AH x VOAR/hour) – Actual variable production overhead
(21,100 x 16) – 331,700 5,900 F

STICKY NOTES
4.3 Variable production overhead efficiency variance
The variable production overhead efficiency variance in hours is exactly the same as the direct labour efficiency
variance in hours.
It is converted into a money value at the standard variable production overhead rate per hour.
 Calculation of variable production overhead efficiency variance:

Variable overhead efficiency variance Hours

Standard hours used to make the actual production X
Actual hours used to make the actual production (X)
Efficiency variance (hours) X
Standard rate per hour (multiply by) X
Efficiency variance (Rs.) Favourable (Adverse) X (X)

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Formula method Rupees

(SH x AH) – VOAR/hour
Where
SH = Standard hours to produce actual units
AH = Actual hours worked
VOAR/hour = Standard variable overhead absorption rate per hour

 Example 20:
Irha Limited has provided extract of standard cost, which showed that standard variable cost of
one unit is Rs. 64 (4 hours at Rs. 16 per hour).
AT A GLANCE

In the month of September, 2020; 5,200 units were produced

Total direct labour hours were 21,100 and actual variable production overhead was Rs. 331,700.
Variable production overhead efficiency variance is calculated as follows:

Variable production overhead efficiency variance Hours

Standard:
Making 5,200 units should have used (@ 4 hours per unit) 20,800
Actual: Making 5,200 units did use (21,100)
Efficiency variance (hours) (A) (300)
Standard variable overhead rate per hour Rs. 16
SPOTLIGHT

Efficiency variance (Rs.) (A) Rs. (4,800)

Formula method Rupees

(SH x AH) – VOAR/hour
(5,200 x 4- 21,100) x 16 (4,800) A

 Example 21:
Product P123 has a standard variable production overhead cost per unit of: 1.5 hours × Rs.2 per
direct labour hour = Rs.3 per unit.
During a particular month, 2,000 units of Product 123 were manufactured. These took 2,780
STICKY NOTES

hours to make and the variable production overhead cost was Rs. 6,550.
The total variable production overhead cost variance, the variable production overhead
expenditure variance and the variable production overhead efficiency variance for the month
would be calculated as follows.

Total variable production overhead cost variance Rs.

2,000 units of output should cost (×Rs.3) 6,000
They did cost (6,550)
Total variable production overhead cost variance (550) (A)
Variable production overhead expenditure variance Rs.
2,780 hours should cost (×Rs.2) 5,560
They did cost (6,550)
Variable production overhead expenditure variance (990) (A)

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The expenditure variance is adverse because the expenditure on variable overhead in the hours
worked was more than it should have been.

Variable production overhead efficiency variance hours

2,000 units of Product P123 should take (× 1.5 hours) 3,000
They did take 2,780
Efficiency variance in hours 220 (F)
Standard variable production overhead rate per hour Rs.2
Variable production overhead efficiency variance in Rs.440 (F)

The efficiency variance is favourable because production took less time than expected, which has

AT A GLANCE
reduced costs.

Variable production overhead cost variances: summary Rs.

Variable production overhead expenditure variance 990 (A)
Variable production overhead efficiency variance 440 (F)
Total variable production overhead cost variance 550 (A)

Alternatively, variable production overhead efficiency and expenditure variances can be solved
with the help of following formulas.

Variable production overhead expenditure variance Rupees

(AH x VOAR/hour) – Actual variable production overhead

SPOTLIGHT
(2,780 x 2) – 6,550 (990) A

Variable production overhead efficiency variance Rupees

(SH x AH) – VOAR/hour
(2,000 x 1.5 x 2,780) x 2 440 F

4.4 Variable production overhead: possible causes of variances

Possible causes of favourable variable production overhead expenditure variances include:
• Variable production overheads include various items of cost like indirect material, indirect labour, electricity

STICKY NOTES
etc. The decline in cost of these items may cause favourable variable production overhead expenditure
variance.
• Individual items of overheads are used in more effective manner.
Possible causes of adverse variable production overhead variances include:
• Unexpected increases in prices of variable overhead items like increase in electricity rates, increase in rate
per hour of indirect labour.
• The activities which drive the variable overheads are not efficiently controlled like lack of supervision on
workers, due to which slow production process carried out and as a result, more resources are utilized.
Anything that causes labour efficiency variance will have an impact on variable production overhead efficiency
variances as variable production overhead is incurred as the labour force carries out production.
Possible causes of favourable variable production overhead efficiency variances include:
• More efficient methods of working.
• Good morale amongst the workforce and good management with the result that the work force is more
productive.

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• If incentive schemes are introduced to the workforce, this may encourage employees to work more quickly
and therefore give rise to a favourable efficiency variance.
• Using employees who are more experienced than ‘standard’, resulting in favourable efficiency variances as
they are able to complete their work more quickly than less-experienced colleagues.
Possible causes of adverse variable production overhead efficiency variances include:
• Using employees who are less experienced than ‘standard’, resulting in adverse efficiency variances.
• An event causing poor morale.

4.5 Journal Entries of variable production overhead cost charged to production in standard costing

Debit Credit
Description
AT A GLANCE

-------- Rupees --------

Work in progress control (SH x VOAR) X
Adverse variances X
Favourable variances X
Production overhead control X
(Record charging variable production overheads to production)

 Example 22:
The normal capacity of Rizwan manufacturing limited is 20,000 direct labour hours per month.
The standard cost card shows that 2 hours are required to produce one unit of product ABT. At
normal capacity the budgeted variable production overhead rate is Rs. 1.50 per direct labour
SPOTLIGHT

hour.
During July, the plant operated 18,000 direct labour hours, with variable production overhead of
Rs. 26,800. Actual production for the month of July is 9,200 units.
The expenditure variance is adverse because the expenditure on variable overhead in the hours
worked was more than it should have been.

Variable production overhead expenditure variance Rupees

(AH x VOAR/hour) – Actual variable production overhead
(18,000 x 1.50) – 26,800 200 F
STICKY NOTES

Variable production overhead efficiency variance Rupees

(SH x AH) – VOAR/hour
(9,200 x 2 - 18,000) x 1.50 600 F

Journal entry to applied variable production overheads to product cost in standard costing is
given as under:
Debit Credit
Description
-------- Rupees --------
Work in progress control (9,200 x 2 x 1.50) 27,600
Variable production overhead expenditure variance 200
Variable production overhead efficiency variance 600
Production overhead control 26,800
(Record charging variable production overheads to
production)

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5. FIXED PRODUCTION OVERHEAD COST VARIANCES: ABSORPTION

COSTING
5.1 Total Fixed production overhead variance
In standard absorption costing, the total fixed production overhead variance is the amount of over or under
absorbed overheads. The amount of fixed overhead absorbed for each unit of output is the standard fixed
overhead cost per unit. The total fixed overhead cost variance is the amount of:
• under-absorbed fixed production overhead is adverse variance or
• over-absorbed fixed production overhead is favourable variance.
Under or over absorption of production overheads has already been discussed in detail in Chapter 3.

AT A GLANCE
 Calculation of total fixed production overhead variance:

Fixed production overhead total variance Rs.

Actual units produced × Fixed production overhead per unit X
Actual fixed production overhead incurred in the period (X)
Total fixed production overhead variance Favourable (Adverse) X/(x)

The total fixed production overhead cost variance can be analyzed into an expenditure variance and a volume
variance. Together, these variances explain the reasons for the under- or over-absorption.
 Example 23:

SPOTLIGHT
Following is the fixed overheads standard cost of Shakeel Limited.
1.8 hours at Rs. 25 per hour = Rs. 45
The above standard cost is calculated at budgeted level of 7,500 units per month. In the month
of March 2021, 7,800 units were produced and actual fixed production overheads were Rs.
340,000.
The total cost variance for fixed production overhead (over/under absorption) is calculated as
follows:

Rs.

Fixed production overhead absorbed in the period:

STICKY NOTES
= Actual units produced × Fixed production overhead per unit 351,000
= 7,800 units ×Rs. 45 per unit

Actual fixed production overhead incurred in the period (340,000)

Fixed production overhead variance total (A) 11,000 F

The amount of fixed production overhead absorption rate is a function of the budgeted fixed production
overhead expenditure and the budgeted production volume.
The total variance can be explained in these terms.

5.2 Fixed production overhead expenditure variance

A fixed production overhead expenditure variance is very easy to calculate. It is simply the difference between
the budgeted fixed production overhead expenditure and actual fixed production overhead expenditure.

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 Calculation of fixed production overhead expenditure variance:

Rs.

Budgeted fixed production overhead X

Actual fixed production overhead incurred (X)

Fixed production overhead expenditure variance Favourable (Adverse) X (X)

An adverse expenditure variance occurs when actual fixed overhead expenditure exceeds the budgeted fixed
overhead expenditure.
AT A GLANCE

A favourable expenditure variance occurs when actual fixed overhead expenditure is less than budget.
 Example 24:
Following is the fixed overheads standard cost of Shakeel Limited.
1.8 hours at Rs. 25 per hour = Rs. 45
The above standard cost is calculated at budgeted level of 7,500 units per month. In the month
of March 2021, 7,800 units were produced and actual fixed production overheads were Rs.
340,000.
The fixed production overhead expenditure variance is calculated as follows:

Rs.
SPOTLIGHT

Budgeted fixed production overheads (7,500 x 45) 337,500

Actual fixed production overhead incurred in the period (340,000)

Fixed production overhead variance total (A) (2,500) A

5.3 Fixed production overhead volume variance

The fixed production overhead volume variance measures the amount of fixed overheads under- or over-
absorbed because of the fact that actual production volume differs from the budgeted production volume.
The volume variance is measured first of all in either unit of output or standard hours of the output units.
STICKY NOTES

The volume variance in units (or standard hours of those units) is converted into a money value, as appropriate,
at the standard fixed overhead cost per unit (or the standard fixed overhead rate
 Calculation of Fixed production overhead volume variance:

Units

Actual production volume (the number of units produced) X

Budgeted production volume (X)

Fixed production overhead volume variance (units) X

Standard absorption rate per unit X

Fixed production overhead volume variance(Rs.) Favourable (Adverse) X (X)

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Formula method Rupees

(AU – BU) x FOAR/unit
Where
AU = Actual units produced
BU = Budgeted units (production)
FOAR/unit = Standard fixed overhead absorption rate per unit

When actual activity volume exceeds the budget, there will be over-absorption of fixed overheads, which is a
‘favourable’ variance. When actual activity volume is less than budget, there will be under-absorption of fixed

AT A GLANCE
overhead, which is an ‘adverse’ variance.
When overheads are absorbed on the basis of direct labour hours or machine hours, the actual hours worked
might be higher or lower than budgeted. The reasons for a favourable or an adverse volume variance might
therefore be any of the following.
• Working more hours than budgeted might be caused by working overtime, or taking on additional direct
labour employees.
• Working fewer hours than budgeted might be caused by staff shortages (due to employees leaving or absence
from work), hold-ups in production or lack of customer orders.
 Example 25:
Following is the fixed overheads standard cost of Shakeel Limited.

SPOTLIGHT
1.8 hours at Rs. 25 per hour = Rs. 45
The above standard cost is calculated at budgeted level of 7,500 units per month. In the month of March
2021, 7,800 units were produced and actual fixed production overheads were Rs. 340,000.
The volume variance is calculated as follows:
Units
Actual number of units produced 7,800
Budgeted production 7,500
Fixed production overhead volume variance(units) (F) 300
Fixed production overhead per unit Rs. 45

STICKY NOTES
Fixed production overhead volume variance(Rs.) (A) Rs. 13,500
Alternate way of calculating the fixed production overhead volume variance is as under.
Fixed production overhead volume variance Rupees
(AU – BU) x FOAR/Unit
(7,800 – 7,500) x 45 13,500 F
Analysis of Total fixed production overhead variance, calculated in example 23-24 and 25 is given
below.
Summary of fixed production overhead variances Rs.
Expenditure variance (2,500) Adverse
Volume variance 13,500 Favourable
Total variance 11,000 Favourable

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 Example 26:
A company budgeted to make 5,000 units of a single standard product in Year 1.
Budgeted direct labour hours are 10,000 hours.
Budgeted fixed production overhead is Rs. 40,000.
Actual production in Year 1 was 5,200 units, and fixed production overhead was Rs. 40,500.
The total fixed production overhead cost variance, the fixed overhead expenditure variance and
the fixed overhead volume variance for the year, would be as follows
Standard fixed overhead cost per unit = Rs.8 (Rs. 40,000/Rs.5,000 units)
Fixed production overhead total cost variance Rs.
AT A GLANCE

5,200 units: standard fixed cost (×Rs.8) = fixed overhead absorbed 41,600
Actual fixed overhead cost expenditure (40,500)
Fixed production overhead total cost variance 1,100 (F)

The variance is favourable, because fixed overhead costs have been over absorbed.

Fixed overhead expenditure variance Rs.

Budgeted fixed production overhead expenditure 40,000
Actual fixed production overhead expenditure (40,500)
Fixed overhead expenditure variance (500) (A)
SPOTLIGHT

This variance is adverse because actual expenditure exceeds the budgeted expenditure.

Fixed overhead volume variance units of

production
Actual production volume in units 5,200
Budgeted production volume in units (5,000)
Fixed overhead volume variance in units 200 (F)
Standard fixed production overhead cost per unit Rs.8
Fixed overhead volume variance in Rs. Rs.1,600 (F)
STICKY NOTES

This variance is favourable because actual production volume exceeded the budgeted volume

Summary Rs.
Fixed overhead expenditure variance (500) (A)
Fixed overhead volume variance 1,600 (F)
Fixed overhead total cost variance 1,100 (F)

5.4 Fixed production overhead efficiency and capacity variances

Volume variance can be further analysed into two variances, termed as capacity variance and efficiency variance.
• The company has worked a different number of hours than budgeted for a variety of reasons. They have
operated at a different capacity.
• During the hours worked the company has operated at a different level of efficiency to that budgeted.

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Fixed production overhead efficiency variance

This is exactly the same, in hours, as the direct labour efficiency variance and the variable production overhead
efficiency variance.
It is converted into a money value at the standard fixed overhead rate per hour.
 Calculation of fixed production overhead efficiency variance:

Hours
Standard hours used to make the actual production X
Actual hours used to make the actual production (X)

AT A GLANCE
Efficiency variance (hours) X (X)
Standard Fixed production overhead rate per hour (multiply by) X
Efficiency variance (Rs.) Favourable (Adverse) X (X)

Formula method Rupees

(SH – AH) x FOAR/hour
Where
SH = Standard hours to produce actual units
AH = Actual hours

SPOTLIGHT
FOAR/hour = Standard fixed overhead absorption rate per hour

 Example 27:
Following is the fixed overheads standard cost of Shakeel Limited.
1.8 hours at Rs. 25 per hour = Rs. 45
The above standard cost is calculated at budgeted level of 7,500 units per month. In the month of
March 2021, 7,800 units were produced and actual fixed production overheads were Rs. 340,000.
Actual labour hours worked were 14,000.
Fixed production overhead efficiency variance is calculated as follows:

STICKY NOTES
Hours
Standard:
Making 7,800 units should have used (@ 1.8 hours per unit) 14,040
Actual: Making 1,000 units did use (14,000)
Efficiency variance (hours) (F) 40
Standard FOAR/ hour Rs. 25
Efficiency variance (Rs.) (F) Rs. 1,000

Fixed production overhead efficiency variance Rupees

(SH – AH) x FOAR/hour
(7,800 x 1.8 – 14,000) x 25 1,000 F

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Fixed production overhead capacity variance

This is the difference between the budgeted and actual hours worked (excluding any idle time hours). It is
converted into a money value at the standard fixed overhead rate per hour.
 Calculation of fixed production overhead capacity variance:

Fixed production overhead capacity variance Hours

Actual number of hours worked X
Budgeted hours to be worked (X)
Capacity variance (hours) X (X)
AT A GLANCE

Standard cost per hour (multiply by) X

Capacity variance (Rs.) Favourable (Adverse) X (X)

Formula method Rupees

(AH – BH) x FOAR/hour
Where
BH = Budgeted hours to produce budgeted units
AH = Actual hours
FOAR/hour = Standard fixed overhead absorption rate per hour
 Example 28:
SPOTLIGHT

Following is the fixed overheads standard cost of Shakeel Limited. 1.8 hours at Rs. 25 per hour
= Rs. 45
The above standard cost is calculated at budgeted level of 7,500 units per month. In the month
of March 2021, 7,800 units were produced and actual fixed production overheads were Rs.
340,000. Actual labour hours worked were 14,000.
The fixed production overhead capacity variance is calculated as follows:
Fixed overhead capacity variance Hours
Actual number of hours worked 14,000
Budgeted hours to be worked (7,500 x 1.8) (13,500)
STICKY NOTES

Capacity variance (hours) (F) 500

Standard FOAR per hour (multiply by) Rs. 25
Capacity variance y variance (Rs.) (F) Rs. 12,500
Alternate way of solving the fixed production capacity variance with the help of formula, is given
below.
Fixed production overhead capacity variance Rupees
(AH – BH) x FOAR/hour
(14,000 – 7,500 x 1.8) x 25 12,500 F
Summary of fixed production overhead volume variance, as calculated in example 25, is given
below.
Summary Rs.
Fixed overhead efficiency variance 1,000 F
Fixed overhead capacity variance 12,500 (F)

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Fixed overhead volume variance 13,500 (F)

 Example 29:
The budgeted capacity of Manju Company for product A and B were 9,000 and 12,000 units
respectively. At this level fixed production overhead rate was Rs. 10 and Rs. 15 per unit for
product A and B respectively. Fixed overhead absorption rate is Rs. 5 per labour hour.
During the month of January, actual data is given as under:
Product A Product B
Sales 10,000 units 12,000 units
Production 8,000 units 14,000 units

AT A GLANCE
Actual fixed production overhead for January was Rs. 260,000 and actual labour hours were recorded at
59,500 hours.
Calculation of total fixed production overhead variance and split it into fixed production overhead
expenditure and efficiency variances. Also prepare analysis table for calculated variances, is given below.

Fixed production overhead total cost variance Rs.

Produce A: 8,000 units: standard fixed cost (×Rs.10) 80,000
Produce B: 14,000 units: standard fixed cost (×Rs.15) 210,000
Total fixed production overhead absorbed 290,000
Actual fixed production overheads (260,000)

SPOTLIGHT
Fixed production overhead total variance (F) 30,000 (F)

Fixed overhead expenditure variance Rs.

Budgeted fixed production overheads:
Product A: 9,000 x 10 90,000
Product B: 12,000 x 15 180,000
270,000
Actual fixed production overheads (260,000)
Fixed overhead expenditure variance 10,000 (F)

STICKY NOTES
Fixed overhead volume variance Rupees
(AU – BU) x FOAR/unit
Product A:
(8,000 – 9,000) x 10 10,000 (A)
Product B:
(14,000 – 12,000) x 15 30,000 (F)
Fixed overhead volume variance 20,000 (F)

Summary Rs.
Fixed overhead expenditure variance 10,000 F
Fixed overhead volume variance 20,000 (F)

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Fixed overhead total cost variance 30,000 (F)

Calculation of fixed production overhead capacity and efficiency variances, and analysis of volume variance
in summary statement, is given below.

Fixed overhead capacity variance Rupees

(AH – BH) x FOAR/hour
(59,500 – 54,000) x 5 27,500 (F)
W-1 Calculation of budgeted hours
Product A (9,000 x 10/5) 18,000
AT A GLANCE

Product B (12,000 x 15/5) 36,000

Budgeted hours 54,000
Fixed overhead efficiency variance Rupees
(SH – AH) x FOAR/hour
(58,000 – 59,500) x 5 7,500 (A)
W-1 Calculation of standard hours
Product A (8,000 x 10/5) 16,000
Product B (14,000 x 15/5) 42,000
Budgeted hours 58,000
SPOTLIGHT

Summary Rs.
Fixed overhead capacity variance 27,500 F
Fixed overhead efficiency variance (7,500) (A)
Fixed overhead volume variance 20,000 (F)

5.5 Fixed production overheads: possible causes of variances

Some of the possible causes of fixed production overhead variances include the following.

Fixed overhead expenditure variance

STICKY NOTES

• Poor control over overhead spending (adverse variance) or good control over spending (favourable
variance).
• Poor budgeting for overhead spending. If the budget for overhead expenditure is unrealistic, there will be an
expenditure variance due to poor planning rather than poor expenditure control.
• Unplanned increases or decreases in items of expenditure for fixed production overheads, for example, an
unexpected increase in factory rent.

Fixed overhead volume variance

A fixed overhead volume variance can be explained by anything that made actual output volume different from
the budgeted volume. The reasons could be:
• Efficient working by direct labour: a favourable labour efficiency variance results in a favourable fixed
overhead efficiency variance.
• Working more hours or less hours than budgeted (capacity variance).
• An unexpected increase or decrease in demand for a product, with the result that shorter/longer hours were
worked (adverse/favourable capacity variance)

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• Strike action by the workforce, resulting in a fall in output below (adverse capacity variance).
• Extensive breakdowns in machinery, resulting in lost production (adverse capacity variance).

5.6 Journal Entries to absorb fixed production overhead to product cost in standard costing

Debit Credit
Description
-------- Rupees --------
Work in progress control (SH x FOAR) X
Adverse variances X
Favourable variances X

AT A GLANCE
Production overhead control X
(Record charging fixed production overheads to production)

 Example 29:
ST Company operates a standard costing system for its only product. The standard cost card
relating to fixed production overhead showed as 2 hours at Rs. 10 per hour.
Fixed production overhead are absorbed on the basis of labour hours. Fixed overhead costs are
budgeted at Rs. 12,000 per annum, arising at a constant rate during the year.
Actual production during this period was 60 units, with actual fixed production overhead costs
being Rs. 980.

SPOTLIGHT
Calculation of fixed production overhead expenditure and volume variance, along with entry to
absorb fixed production overhead in standard costing, is given below.

Fixed production overhead expenditure variance Rupees

Budgeted fixed cost – actual fixed cost
(12,000/12) – 980 20 F
Fixed production overhead volume variance Rupees
(AU- BU) x FOAR/ Unit
(60- [12,000/20= 600/12= 50) x 20 200 F

STICKY NOTES
Debit Credit
Description
-------- Rupees --------
Work in progress control (60 x 2 x10) 1,200
Fixed production overhead expenditure variance 20
Fixed production overhead volume variance 200
Production overhead control 980
(Record charging fixed production overheads to production)

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6. SALES VARIANCES
Sales variances are calculated to analyse the performance of the sales function or revenue center on broadly
similar terms to those for manufacturing costs as discussed in above ratios. The most significant feature of sales
variance calculation is that they are calculated in terms of profit or contribution margin (depending upon method
of costing whether absorption or marginal), instead of its sales value.
This section of sales variances is divided into two categories. The sales variances in both sections are same but
calculation is different in both because of different costing techniques. These are given as under.
6.1 Sales variances in marginal costing
As we have already discussed in previous chapters that in marginal costing only variable costs are accounted for
in order to calculate the contribution margin. Fixed cost is treated as period cost.
AT A GLANCE

In this section, two variances are calculated, first is known as sales price variance and sales contribution volume
variance. These are described in below sections.
6.1.1 Sales price variance
Sales price variance is the difference between actual and standard price. If actual price is greater than standard
price, then variance is favourable, otherwise it is treated as adverse. In order to calculate sales price variance for
the period, the result of above difference is multiplied with actual units sold.
 Calculation of sales price variance:

Sales price variance Rupees

Actual price per unit sold X
SPOTLIGHT

Standard price per unit to be sold (X)

Sales price variance per unit X (X)
Actual units sold (multiply by) X
Sales price variance (Rs.) Favourable (Adverse) X (X)

Formula method Rupees

(AP – SP) x AU
Where
AP = Actual price per unit
STICKY NOTES

SP = Standard price per unit

AU = Actual units sold

 Example 30:
J Limited operates a standard costing accounting system. The following information has been
extracted from its standard cost card and budgets:

Budgeted sales volume in units 5,000

Budgeted selling price per unit in Rs. 100
Standard variable cost per unit in Rs. 56
Standard total cost per unit in Rs. 75

J Limited is using marginal cost accounting system and its actual sales were 4,500 units at a
selling price of Rs. 120 per unit.

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Calculation of sales price variance, is calculated as under.

Sales price variance Rupees

Actual price per unit sold 120
Standard price per unit to be sold 100
Sales price variance per unit (F) 20
Actual units sold 4,500
Sales price variance (Rs.) Favourable 90,000

Formula method Rupees

AT A GLANCE
(AP – SP) x AU
(120-100) x 4,500 90,000 F

6.1.2 Sales contribution volume variance

To ascertain the changes in sales volume, we have to measure the difference between actual units sold and
budgeted sales in units. To convert it into monetary value, the result is multiplied by contribution per unit.
Contribution margin is derived after deducting the variable costs from sales.
 Calculation of sales contribution volume variance:

Sales contribution volume variance Rupees

Standard contribution generated from actual units sold X

SPOTLIGHT
Standard contribution to be generated from budgeted units sold (X)
Sales price variance (Rs.) Favourable (Adverse) X (X)

Formula method Rupees

(AU – BU) x SC/U
Where
AU = Actual units sold
BU = Budgeted units

STICKY NOTES
SC/U = Standard contribution per unit

 Example 31:
J Limited operates a standard costing accounting system. The following information has been
extracted from its standard cost card and budgets:

Budgeted sales volume in units 5,000

Budgeted selling price per unit in Rs. 100
Standard variable cost per unit in Rs. 56
Standard total cost per unit in Rs. 75

J Limited is using marginal cost accounting system and its actual sales were 4,500 units at a
selling price of Rs. 120 per unit.
Calculation of sales contribution volume variance, is calculated as under.

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Sales contribution volume variance Rupees

Standard contribution generated from actual units sold (4,500 x 44) 198,000
Standard contribution to be generated from budgeted units sold (5,000 x 44) (220,000)
Sales contribution volume variance (Rs.) (Adverse) (22,000)

Formula method Rupees

(AU – BU) x SC/U
(4,500 – 5,000) x 44 (22,000) A

6.2 Sales variances in absorption costing

AT A GLANCE

Absorption costing is technique in which fixed production cost is part of product cost.
In this section, two variances are calculated, first is known as sales price variance and sales profit volume
variance. The only difference is that standard profit per unit is used, instead of standard contribution per unit.
These are described in below sections.
6.2.1 Sales price variance
Sales price variance in absorption costing is same as discussed in marginal costing. There is no difference in sales
price variance whether marginal costing or absorption costing is in use.
6.2.2 Sales contribution volume variance
To ascertain the changes in sales volume, we have to measure the difference between actual units sold and
budgeted sales in units. To convert it into monetary value, the result is multiplied by profit per unit. Profit is
SPOTLIGHT

derived after deducting the variable cost and fixed production cost from sales.
 Calculation of sales profit volume variance:

Sales profit volume variance Rupees

Standard profit generated from actual units sold X
Standard profit to be generated from budgeted units sold (X)
Sales volume variance (Rs.) Favourable (Adverse) X (X)

Formula method Rupees

STICKY NOTES

(AU – BU) x SP/U

Where
AU = Actual units sold
BU = Budgeted units
SP/U = Standard profit per unit

 Example 32:
J Limited operates a standard costing accounting system. The following information has been
extracted from its standard cost card and budgets:

Budgeted sales volume in units 5,000

Budgeted selling price per unit in Rs. 100
Standard variable cost per unit in Rs. 56
Standard total cost per unit in Rs. 75

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J Limited is using marginal cost accounting system and its actual sales were 4,500 units at a
selling price of Rs. 120 per unit.
Calculation of sales contribution volume variance, is calculated as under.

Sales contribution volume variance Rupees

Standard contribution generated from actual units sold (4,500 x 25) 112,500
Standard contribution to be generated from budgeted units sold (5,000 x 25) (125,000)
Sales contribution volume variance (Rs.) (Adverse) (12,500)

Formula method Rupees

(AU – BU) x SC/U

AT A GLANCE
(4,500 – 5,000) x 25 (12,500) A

 Example 33:
Jolt Limited operates a standard costing system. The following information has been extracted
from its standard cost card and budgets:

Budgeted sales volume in units 150,000

Budgeted selling price per unit in Rs. 5
Standard variable cost per unit in Rs. 2.80

SPOTLIGHT
Standard total cost per unit in Rs. 3.75

The actual production during a period was 140,000 units and total revenue generated was Rs.
840,000.
Calculation of sales price variance and sales volume variance under both costing techniques, is
given below.

Sales price variance Rupees

(AP – SP) x AU
(6-5) x 140,000 140,000 F
Actual price (AP) = 270,000/140,000 = Rs. 6

STICKY NOTES
Sales contribution volume variance Rupees
(AU – BU) x Standard contribution per unit
(140,000-150,000) x 2.20 (22,000) A

Sales profit volume variance Rupees

(AU – BU) x Standard profit per unit
(140,000-150,000) x 1.25 (12,500) A

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7. INTERRELATIONSHIPS BETWEEN VARIANCES

7.1 The nature of interrelationships between variances
The reasons for variances might also be connected, and two or more variances might arise from the same cause.
This is known as an interrelationship between two variances. In simple words, a single reason might put impact
on two or more variances. For example, use of high quality material put adverse impact on material price
variance because of high price paid, but on other side, the material usage variance might be favourable because
of decline in wastage.
In this situation, the management should not analyse variance separately, rather the interrelated variances
should be analysed in combination. When this happens, management should look at the two variances together,
in order to assess their significance and decide whether control action is needed.
Few interrelationships between variances examples are given below.
AT A GLANCE

7.2 Materials price and usage

A materials price variance and usage variance might be interrelated. For example, if a company decides to use a
material for production that is more expensive than the normal or standard material, but easier to use and better
in quality, there will be an adverse price variance. However, a consequence of using better materials might be
lower wastage. If there is less wastage, there will be a favourable material usage variance. Therefore, using a
different quality of material can result in an adverse price variance and a favourable usage variance.
7.3 Labour rate and efficiency
If there is a change in the grade of workers used to do some work, both the rate and efficiency variances may be
affected.
For example, if a lower grade of labour is used instead of the normal higher grade:
• there should be a favourable rate variance because the workers will be paid less than the standard rate
SPOTLIGHT

• however, the lower grade of labour may work less efficiently and take longer to produce goods than the
normal higher grade of labour would usually take. If the lower grade of labour takes longer, then this will
give rise to an adverse efficiency variance.
Therefore, the change in the grade of labour used results in two ‘opposite’ variances, an adverse efficiency
variance and a favourable rate variance.
When inexperienced employees are used, they might also waste more materials than more experienced
employees would, due to mistakes that they make in their work. The result might be not only adverse labour
efficiency, but also adverse materials usage.
7.4 Labour rate and variable overhead efficiency
STICKY NOTES

When a production process operates at a different level of efficiency the true cost of that difference is the sum of
any costs associated with labour hours. Therefore, the issues described above also affect the variable overhead
efficiency variance.
7.5 Capacity and efficiency
If a production process operates at a higher level of efficiency that might mean that it does not have to operate
for as long to produce the budgeted production volume. The favourable fixed production overhead efficiency
variance would cause an adverse fixed production overhead capacity variance.
The reverse is also true. If a production process operates at a lower level of efficiency that might mean that it has
to operate for longer than was budgeted. The adverse efficiency fixed production overhead variance would cause
a favourable fixed production overhead capacity variance.
7.6 Footnote: the importance of reliable standard costs
It is important to remember that the value of variances as control information for management depends on the
reliability and accuracy of the standard costs. If the standard costs are inaccurate, comparisons between actual
cost and standard cost will have no meaning. Adverse or favourable variances might be caused by inaccurate
standard costs rather than by inefficient or efficient working.

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8. OPERATING STATEMENT
8.1 Standard marginal costing
Operating statement is control statement which represents all possible variances in order to reconcile the
budgeted profit with actual profit. In this statement, all variances related to sales, direct material, direct labour,
variable production overheads are added in it.
An operating statement starts off with the expected figure of budgeted contribution and ends up with the actual
contribution and then fixed production overhead actual is deducted to calculate the actual profit. Any favourable
variance is added in budgeted contribution and adverse variance is deducted.
Format of operating statement is given below.

Operating statement – Marginal costing Rupee

AT A GLANCE
s
Budgeted contribution (Budgeted sales in units x standard cont. per X
unit)
Sales price variance (Add: Favourable and Less: Adverse) X (X)
Sales contribution volume variance X (X)
X
Cost variances: Fav. Adv.
Material price variance
Material usage variance

SPOTLIGHT
Labour rate variance
Labour efficiency variance
Labour idle time variance
Variable production overhead expenditure variance
Variable production overhead efficiency variance X (X)
Actual contribution X
Less: Actual fixed production overhead (X)
Actual profit X

STICKY NOTES
The following comprehensive explains the concept of operating statement under marginal costing.
 Example 34:
MJ Limited manufactures one standard product and operates a system of variance accounting using a fixed
budget. As assistant management accountant, you are responsible for preparing the monthly operating
statements. Data from the budget, the standard product cost and actual data for the month of October are
given below.

Budgeted and standard cost data: Units

Budgeted sales and production 6,000
Standard cost for each unit of product: Rupees
Material MM (15 kg at Rs. 2 per kg) 30.00
Material NN (10 kg at Rs. 2.50 per kg) 25.00
Direct wages (7.5 hours at Rs. 10 per hour) 75.00
Variable production overhead (7.5 hours at Rs. 6 per hour) 45.00

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Fixed production overhead (80% of direct wages) 60.00

235.00
Budgeted profit (20% of sales price) 58.75
Budgeted sales price 293.75

Actual data for the month of October: Rs.

Production and sales 5,800 units at a price of Rs. 280 per unit. 1,624,000
Direct materials MM consumed 90,000 kg at Rs. 1.90 per kg 171,000
Direct materials NN consumed 55,000 kg at Rs. 2.70 per kg 148,500
Direct wages incurred 45,000 hours at Rs. 10.80 per hour 486,000
AT A GLANCE

Variable production overhead incurred 268,000

Fixed production overhead incurred 352,000
Operating statement along with all possible variances for the month of October under marginal costing is
given below.

Operating statement – Marginal costing Rs.

Budgeted contribution (6,000 x 118.75) 712,500
Sales price variance (79,750)
Sales contribution volume variance (23,750)
609,000
SPOTLIGHT

Cost variances: Fav. Adv.

Material price variance-MM 9,000
Material price variance-NN 11,000
Material usage variance-MM 6,000
Material usage variance-NN 7,500
Labour rate variance 36,000
Labour efficiency variance 15,000
Variable production overhead expenditure variance 2,000
STICKY NOTES

Variable production overhead efficiency variance 9,000

Actual contribution 18,500 77,000 (58,500)
550,500
Less: Actual fixed production overhead (352,000)
Actual profit 198,500

Calculation of all variances are given below.

Material price variance Rupees

(SP – AP) x AQ
MM- (2.00-1.90) x 90,000 9,000 F
NN- (2.50-2.70) x 55,000 (11,000) A

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Material usage variance Rupees

(SQ – AQ) x SP
MM- (87,000-90,000) x 2 (6,000) A
NN- (58,000-55,000)
Labour rate variancex 2.50 7,500 F
Rupees
(SR – AR) x AH
(10.00-10.80) x 45,000 (36,000) A

Labour efficiency variance Rupees

(SH – AH) x SR

AT A GLANCE
(43,500-45,000) x 10 (15,000) A

Variable production overhead expenditure variance Rupees

(AH x VOAR/H) – Actual Variable production overhead
(45,000 x 6) -268,000 2,000 F

Variable production overhead efficiency variance Rupees

(SH – AH) x VOAR/H
(43,500 – 45,000) x 6 (9,000) A

Sales price variance Rupees

SPOTLIGHT
(AP – SP) x AUS
(280-293.75) x 5,800 (79,750) A

Sales contribution volume variance Rupees

(AUS – BUS) x Standard contribution per unit
(5,800 – 6,000) x 118.75 (23,750) A

8.2 Standard absorption costing

STICKY NOTES
Operating statement is control statement which represents all possible variances in order to reconcile the
budgeted profit with actual profit. In this statement, all variances related to sales, direct material, direct labour,
variable production overheads and fixed production overheads are included in it.
An operating statement starts off with the expected figure of budgeted profit and ends up with the actual profit.
Only difference between statements under marginal and absorption is that in absorption costing, few additional
variances are included in operating statement which are fixed production overhead expenditure and volume. In
addition, sales profit volume variance is replaced to sales contribution volume variance.

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Format of operating statement is given below.

Operating statement – Absorption costing Rs.

Budgeted profit (Budgeted sales in units x standard profit per X
unit)
Sales price variance (Add: Favourable and Less: Adverse) X (X)
Sales profit volume variance X (X)
X
Cost variances: Fav. Adv.
Material price variance
Material usage variance
AT A GLANCE

Labour rate variance

Labour efficiency variance
Labour idle time variance
Variable production overhead expenditure variance
Variable production overhead efficiency variance
Fixed production overhead expenditure variance
Fixed production overhead volume variance
X X X (X)
Actual profit X
SPOTLIGHT

 Example 35:
MJ Limited manufactures one standard product and operates a system of variance accounting using a fixed
budget. As assistant management accountant, you are responsible for preparing the monthly operating
statements. Data from the budget, the standard product cost and actual data for the month of October are
given below.

Budgeted and standard cost data: Units

Budgeted sales and production 6,000
Standard cost for each unit of product: Rupees
STICKY NOTES

Material MM (15 kg at Rs. 2 per kg) 30.00

Material NN (10 kg at Rs. 2.50 per kg) 25.00
Direct wages (7.5 hours at Rs. 10 per hour) 75.00
Variable production overhead (7.5 hours at Rs. 6 per hour) 45.00
Fixed production overhead (80% of direct wages) 60.00
235.00
Budgeted profit (20% of sales price) 58.75
Budgeted sales price 293.75

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Actual data for the month of October: Rs.

Production and sales 5,800 units at a price of Rs. 280 per unit. 1,624,000
Direct materials MM consumed 90,000 kg at Rs. 1.90 per kg 171,000
Direct materials NN consumed 55,000 kg at Rs. 2.70 per kg 148,500
Direct wages incurred 45,000 hours at Rs. 10.80 per hour 486,000
Variable production overhead incurred 268,000
Fixed production overhead incurred 352,000

Operating statement along with all possible variances for the month of October under absorption costing is

AT A GLANCE
given below.

Operating statement – Absorption costing Rs.

Budgeted profit (6,000 x 58.75) 352,500
Sales price variance (79,750)
Sales profit volume variance (11,750)
261,000
Cost variances: Fav. Adv.
Material price variance-MM 9,000
Material price variance-NN 11,000

SPOTLIGHT
Material usage variance-MM 6,000
Material usage variance-NN 7,500
Labour rate variance 36,000
Labour efficiency variance 15,000
Variable production overhead expenditure variance 2,000
Variable production overhead efficiency variance 9,000
Fixed production overhead expenditure variance 8,000
Fixed production overhead volume variance 12,000

STICKY NOTES
26,500 89,000 (62,500)
Actual profit 198,500

The Calculation of all variances are given below.

Material price variance Rupees

(SP – AP) x AQ
MM- (2.00-1.90) x 90,000 9,000 F
NN- (2.50-2.70) x 55,000 (11,000) A

Material usage variance Rupees

(SQ – AQ) x SP
MM- (87,000-90,000) x 2 (6,000) A
NN- (58,000-55,000) x 2.50 7,500 F

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Labour rate variance Rupees

(SR – AR) x AH
(10.00-10.80) x 45,000 (36,000) A
Labour efficiency variance Rupees
(SH – AH) x SR
(43,500-45,000) x 10 (15,000) A

Variable production overhead expenditure variance Rupees

(AH x VOAR/H) – Actual Variable production overhead
AT A GLANCE

(45,000 x 6) -268,000 2,000 F

Variable production overhead efficiency variance Rupees

(SH – AH) x VOAR/H
(43,500 – 45,000) x 6 (9,000) A

Fixed production overhead Expenditure variance Rupees

Budgeted cost – Actual cost
(6,000 x 60 – 352,000) 8,000 F

Fixed production overhead volume variance Rupees

SPOTLIGHT

(AU – BU) x FOAR/U

(5,800 – 6,000) x 60 (12,000) A

Sales price variance Rupees

(AP – SP) x AUS
(280-293.75) x 5,800 (79,750) A

Sales profit volume variance Rupees

(AUS – BUS) x Standard profit per unit
STICKY NOTES

(5,800 – 6,000) x 58.75 (11,750) A

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9. MATERIALS MIX AND YIELD VARIANCES

9.1 Total material Usage Variance
When standard costing is used for products which contain two or more items of direct material, the total
materials usage variance can be calculated by calculating the individual usage variances in the usual way and
adding them up (netting them off).
 Example 36:
Product X is produced from three direct materials, A, B and C, that are mixed together in a
process. The following information relates to the budget and output for the month of January

Standard cost: Actual:

AT A GLANCE
Standard price Standard Quantity
Material Quantity
per kilo cost used
kg Rs. Rs. kg
A 1 20 20 160
B 1 22 22 180
C 8 6 48 1,760
10 90 2,100
Output 1 unit 200 units
Usage variances can be calculated in the usual way:

Making 200 units should have used: A (kgs) B (kgs) C (kgs)

SPOTLIGHT
200 × 1 kg of A 200
200 × 1 kg of B 200
200 × 8 kgs of C 1,600
Making 200 units did use: (160) (180) (1,760)
Usage variance in kgs 40 (F) 20 (F) (160) (A)
Standard cost per kg 20 22 6
Usage variance in Rs. 800 (F) 440 (F) (960) (A)
Total usage variance = Rs. 280 (F) (800 + 440 -960)

STICKY NOTES
Substitutable materials
If the materials are substitutable (i.e. less of one type of material can be compensated for by more of another)
the direct materials usage variance can be analyzed into:
• a materials mix variance; and
• a materials yield variance
The total of these two variances is the total material usage variance.
It is vital to understand that this further analysis should only be performed if the materials can be substituted
for each other. Mix and yield variances have a useful meaning only when the proportions (or ‘mix’) of the different
raw materials in the final product can be varied and so are subject to management control.
• In the above example fewer kilograms of A but more kilograms of B and C than expected were used to make
200 units. The mix changed and this had an effect on the yield.
• In contrast, if a company manufactured a car, no number of extra tyres could compensate for one less engine!
Mix and yield variances are irrelevant in this case.

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9.2 Direct materials mix variance

The materials mix variance measures how much of the total usage variance is attributable to the fact that the
actual combination or mixture of materials that was used was more expensive or less expensive than the
standard mixture for the materials.
The mix component of the usage variance therefore indicates the effect on costs of changing the combination (or
mix or proportions) of material inputs in the production process.
The materials mix variance is calculated as follows (making reference to the example above):
 Example 37:

Mix Mix
Std. cost
Material Actual mix (kgs) Standard mix variance variance
per kg
(kgs) (Rs.)
AT A GLANCE

A 160 (10% × 2,100) 50 (F) 20 1,000 (F)

210
B 180 (10% × 2,100) 30 (F) 22 660 (F)
210
C 1,760 (80% × 2,100) (80) (A) 6 (480) (A)
1,680
2,100 2,100 0 1,180 (F)

For each individual item of material, the mix variance is favourable when the actual mix is less
than the standard mix, and the mix variance is adverse when actual usage exceeds the standard
mix.
SPOTLIGHT

The total mix variance is favourable in this example because the actual mix of materials used is
cheaper than the standard mix.

9.3 Direct materials yield variance

The materials yield variance is the difference between the actual yield from a given input and the yield that the
actual input should have given in standard terms. It indicates the effect on costs of the total materials inputs
yielding more or less output than expected.
The yield variance can be calculated in several ways. No one method is better than any other (use the one that
makes most sense to you).
STICKY NOTES

Working
Based on the above example note that:
• The standard cost of each unit (kg) of input = Rs. 90/10kg = Rs. 9 per kg
• The standard cost of each unit of output = Rs. 90 per unit

Method 1: Based on output

This compares the actual yield to the expected yield from the material used. The difference is then valued at the
standard cost of output.
In the above example 10 kg of material in should result in 1 unit of output.
Therefore, 2,100 kg of material in should result in 210 units of output.
The difference between this figure and the actual output is the yield variance as a number of units. This is then
multiplied by the expected cost of a unit of output.

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 Example 38:

Units
2,100 kgs of input should yield (@10 kg per unit) 210
2,100 kgs of input did yield 200
Yield variance (units) 10 (A)
Standard cost of output Rs. 90
Materials yield variance (Rs.) Rs. 900 (A)

Method 2: Based on inputs

This compares the actual usage to achieve the yield to the expected usage to achieve the actual yield. The

AT A GLANCE
difference is then valued at the standard cost of input.
In the above example 1 unit should use 10 kg of input.
Therefore, 200 units should use 2,000 kg of input.
The difference between this figure and the actual input is the yield variance as a number of units. This is then
multiplied by the expected cost of a unit of output.
 Example 39 (Contd. From previous example 38):

Units
200 units of product X should use (× 10 kgs) 2,000
did use 2,100

SPOTLIGHT
Yield variance in quantities 100 (A)
Standard cost of input Rs. 9/kg
Yield variance in money value Rs. 900 (A)
Summary
Mix variance + yield variance = usage variance

Rs.
Mix variance 1,180 (F)
Yield variance (900) (A)

STICKY NOTES
Usage variance (= mix + yield variances) 280 (F)

9.4 Factors to consider when changing the mix

Identification of the optimum mix involves consideration of several factors:
• Cost. The cheapest mix may not be the most cost effective. Often a favourable mix variance is offset by an
adverse yield variance and the total cost per unit may increase.
• Quality. Using a cheaper mix may result in a lower quality product and the customer may not be prepared to
pay the same price. A cheaper product may also result in higher sales returns and loss of repeat business.
• The fall in quality would make the company vulnerable to reputational risk.

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10. WORKING BACKWARDS

10.1 Calculating actual cost from variances and standard cost
In your examination, you might be given a question where you are required to:
• calculate actual costs, given information about variances and standard costs, or
• calculate standard cost, given information about variances and actual costs.
This type of problem does not occur in practice, but it is a useful way of testing knowledge of variances.
Following examples will be used to illustrate the technique.
 Example 40:
AT A GLANCE

The standard direct materials cost of making Product B is Rs.20, consisting of 4 kilos of material
at Rs.5 per kilo.
During one period, 1,250 kilos of the material were purchased and the direct materials price
variance was Rs.250 (A).
The actual costs of direct materials purchased and used in the period, would be calculated as
follows
A table should be prepared showing how the total materials cost variance is calculated, and the
figures that are available should be entered in the table.
Rs.
(SP – AP) x AQ = (250)
(5.00 – AP) x 1,250 = (250)
SPOTLIGHT

Hence, Actual price is 5.20

Actual purchase costs were higher than standard cost because the price variance is adverse.
Actual purchase costs were therefore Rs.6,250 + Rs.250 = Rs.6,500.
 Example 41:
The standard direct material cost of Product C is Rs.21 (6 kilos of material at Rs.3.50 per kilo).
During a period when 400 units of Product C were made, the direct material usage variance was
Rs.630 (F).
The actual quantity of direct materials used in the period, would be calculated as follows:
A table should be prepared showing how the materials usage variance is calculated, and the
STICKY NOTES

figures that are available should be entered in the table.

Materials usage variance Rs.
(SQ – AQ) x SP = 630
(400x 6 – AQ) x 3.50 = 630
Hence, actual quantity = 2,220

 Example 42:
In the standard cost of Product D, the cost of Grade A labour is Rs.24 per unit (= 1.5 hours per
unit at Rs.16 per hour). During a month when 500 units of Product D were made and 780 hours
were worked, the labour rate variance for Grade A labour was Rs.1,560 (F).
The actual cost of Grade A labour in the month, would be calculated as follows

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Easy way is to calculate it by putting the given values in direct labour rate variance and then
calculate the equation to get the desired answer.
Direct labour rate variance
(SR – AR) x AH = 1,560
(16.00- AR) x 780 = 1,560
Hence, AR = 14.00
Actual labour cost (780 x 14) = Rs. 10,920

 Example 43:
In a standard absorption costing system, the standard fixed production overhead cost per unit of
Product E is Rs.36. This represents 3 direct hours at Rs.12 per hour.

AT A GLANCE
The budgeted production volume in the period was 6,000 units of Product E. The fixed
production overhead volume variance was Rs.12,600 (F).
The actual quantity of Product E that was produced, would be calculated as follows
A table should be prepared showing how the production overhead volume variance is calculated,
and the figures that are available should be entered in the table.
Fixed overhead volume variance units of production
Budgeted production volume in units 6,000
Actual production volume in units ?
Fixed overhead volume variance in units ? (F)

SPOTLIGHT
Standard fixed production overhead cost per unit Rs.36
Fixed overhead volume variance in Rs. Rs.12,600 (F)
We know the volume variance in Rs. The volume variance is valued at the standard fixed
overhead cost per unit. The volume variance in Rs. can therefore be converted into a volume
variance in units as follows:
Rs. 12,600(F)/Rs.36 per unit = 350 units (F).
Actual production volume is higher than the budgeted volume, because the volume variance is
favourable. The budgeted production volume was 6,000 units.
Actual production volume = 6,000 units + 350 units = 6,350 units.

STICKY NOTES
9.2 Calculating standard cost from variances and actual cost
The same approach can be used to calculate a standard cost or budget amount if you are given a variance and
data about actual costs (or sales revenues). Some further examples will illustrate the technique.
 Example 44:
Product F uses a direct material, material M. The standard price of material M is Rs.4 per kilo.
During one month, 2,500 units of Product F were manufactured. These required 12,000 kilos of
material M and the material usage variance was Rs.2,000 (A).
We know the standard price of material M, but we need to calculate the standard material usage.
This can be obtained from the data provided. A table should be prepared showing how the
material usage variance is calculated, and the figures that are available should be entered in the
table.
Materials usage variance kilos
2,500 units of Product F should use ?
They did use 12,000

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Material usage variance in kilos ?

Standard price per kilo Rs.4
Material usage variance in Rs. 2,000 (A)
We know the material usage variance in Rs.. The variance is valued at the standard price per unit
of material. From the information provided we can therefore calculate the material usage
variance in kilos:
Usage variance = Rs.2,000(A)/Rs.4 per kilo = 500 kilos (A).
The variance is adverse, which means that actual usage was more than the standard (expected)
usage. The standard material usage is therefore:
12,000 kilos – 500 kilos = 11,500 kilos.
This is the standard usage for 2,500 units of Product F, so the standard usage per unit is
AT A GLANCE

11,500/2,500 = 4.60 kilos per unit.

The standard material cost for Product F is therefore:
4.6 kilos of material M at Rs.4 per kilo = Rs.18.40.
 Example 45:
The standard time required to make one unit of Product G is 1.25 hours of direct labour. During
one month, total direct labour costs were Rs.119,000. The company made 6,800 units of Product
G. These took 9,100 direct labour hours and the direct labour rate variance was Rs.8,400 (F).
The standard direct labour cost per unit of Product G, would be calculated as follows
We know the standard direct labour time, which is 1.25 hours per unit, but we need to calculate
the standard direct labour rate per hour. This can be obtained from the data provided. A table
should be prepared showing how the labour rate variance is calculated, and the figures that are
SPOTLIGHT

available should be entered in the table.

Direct labour rate variance Rs.
9,100 hours should cost ?
They did cost 119,000
Direct labour rate variance 8,400 (F)
The rate variance is favourable, which means that actual costs were lower than standard costs.
The actual labour cost for the 9,100 hours was Rs.119,000. Expected costs are higher.
The 9,100 hours should therefore cost Rs.119,000 + Rs.8,400 = Rs.127,400.
The standard rate per hour is Rs.127,400/9,100 hours = Rs.14 per hour.
STICKY NOTES

The standard direct labour cost of Product G is:

1.25 hours at Rs.14 per hour = Rs.17.50
Tutorial note: It is easy to get confused about whether variances should be added or subtracted
in this type of calculation. You need to think carefully and logically, to avoid making a mistake.

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11. COMPREHENSIVE EXAMPLES

 Example 01:
A company makes a single product and uses standard absorption costing. The standard cost per
unit is as follows:

Rs. per unit

Direct materials 8
Direct labour 6
Fixed production overheads 12
26

AT A GLANCE
Budgeted production is 14,000 units per month. Last month, actual production was 14,800 units,
and actual costs were as follows:

Total costs Rs.

Direct materials 125,000
Direct labour 92,000
Fixed production overheads 170,000
387,000

A statement for the month that reconciles budgeted costs, standard costs and actual costs would
be prepared as follows

SPOTLIGHT
Reconciliation statement Rs.
Budgeted costs for the month (14,000 units × Rs.26) 364,000
Extra standard costs of additional production (800 units × Rs.26) 20,800
Standard costs of actual production (14,800 units × Rs.26) 384,800
Cost variances
Direct materials total cost variance 6,600 (A)
Direct labour total cost variance 3,200 (A)

STICKY NOTES
Fixed overheads expenditure variance 2,000 (A)
Fixed overheads volume variance 9,600 (F)
Actual total costs in the month 387,000

Workings: Direct materials total cost variance Rs.

14,800 units should cost (× Rs.8) 118,400
They did cost 125,000
Direct materials total cost variance 6,600 (A)

Direct labour total cost variance Rs.

14,800 units should cost (× Rs.6) 88,800
They did cost 92,000
Direct labour total cost variance 3,200 (A)

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Fixed production overheads total cost variance Rs.

14,800 units: standard fixed overhead cost (× Rs.12) 177,600

Actual fixed overhead cost 170,000

Fixed production overheads total cost variance 7,600 (F)

Note: The fixed overhead total cost variance can be divided into:
a) an expenditure variance
b) a volume variance

Fixed production overheads expenditure variance Rs.

AT A GLANCE

Budgeted fixed overhead expenditure (14,000 × Rs.12) 168,000

Actual fixed overhead expenditure 170,000
Fixed production overheads expenditure variance 2,000 (A)

Fixed production overheads volume variance units

Budgeted units of production 14,000
Actual units produced 14,800
Fixed production overheads volume variance in units 800 (F)
Standard fixed overheads per unit Rs.12
SPOTLIGHT

Fixed production overheads volume variance in Rs. Rs.9,600 (F)

 Example 02:
a) Z Company uses a standard costing system and has the following labour cost standard in relation
to one of its products:
4 hours of skilled labour at Rs.6.00 per hour: Rs.24.00
During October, 3,350 units of this products were made, which was 150 units less than budgeted.
The labour cost incurred was Rs.79,893 and the number of direct labour hours worked was
13,450.
The direct labour rate and efficiency variances for the month, would be as follows:
STICKY NOTES

Direct labour rate variance Rs.

13,450 hours should cost (× Rs.6) 80,700
They did cost 79,893
Labour rate variance 807 (F)

Direct labour efficiency variance hours

3,350 units should take (× 4 hours) 13,400
They did take 13,450
Efficiency variance in hours 50 (A)
Standard rate per hour Rs.6
Direct labour efficiency variance in Rs. Rs.300 (A)

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b) Company J uses a standard costing system and has the following data relating to one of its
products:

Rs. per unit Rs. per unit

Selling price 9.00
Variable cost 4.00
Fixed cost 3.00
7.00
Profit 2.00

The budgeted sales for October Year 5 were 800 units, but the actual sales were 850 units. The

AT A GLANCE
revenue earned from these sales was Rs. 7,480.
The sales price and sales volume variances for October using standard absorption costing and
standard marginal costing, would be as follows:

Sales price variance Rs.

850 units should sell for (× Rs.9) 7,650
They did sell for 7,480
Sales price variance 170 (A)

Sales volume variance, absorption costing units

SPOTLIGHT
Actual sales volume (units) 850
Budgeted sales volume (units) 800
Sales volume variance in units 50(F)
Standard profit per unit Rs.2
Sales volume variance (profit variance) in Rs. Rs.100 (F)

Sales volume contribution variance, marginal costing

Sales volume variance in units 50 (F)

STICKY NOTES
Standard contribution per unit (Rs.9 - Rs.4) Rs.5
Sales volume variance (contribution variance) Rs.250 (F)

c) The budget was to produce 15,000 units. The standard fixed production cost of a product is Rs.20,
which is 4 hours at a rate of Rs.5 per direct labour hour. Actual production was 14,600 units and
actual fixed production overhead expenditure was Rs. 325,000. The production output was
manufactured in 58,000 hours of work.
Calculations for the following variances are given below:
i. the fixed production overhead total cost variance
ii. the fixed production overhead expenditure variance and volume variance
iii. the fixed production overhead efficiency variance and capacity variance

(i) Fixed production overhead total cost variance Rs.

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Standard fixed overhead cost of 14,600 units (× Rs.20) 292,000

Actual fixed overhead expenditure 325,000
Fixed overhead total cost variance (under-absorption) 33,000 (A)

(ii) Fixed production overhead expenditure variance Rs.

Budgeted fixed overhead expenditure (15,000 × Rs.20) 300,000
Actual fixed overhead expenditure 325,000
Fixed overhead expenditure variance 25,000 (A)

Fixed production overhead volume variance units

AT A GLANCE

Budgeted production volume 15,000

Actual production volume 14,600
Volume variance in units 400 (A)
Standard fixed overhead rate per unit Rs.20
Fixed production overhead volume variance in Rs. Rs.8,000 (A)

(iii) Fixed production overhead efficiency variance hours

14,600 units should take × 4 hours) 58,400
They did take 58,000
SPOTLIGHT

Efficiency variance in hours 400 (F)

Standard fixed overhead rate per hour Rs.5
Fixed production overhead efficiency variance in Rs. Rs.2,000 (F)

Fixed production overhead capacity variance hours

Budgeted hours of work (15,000 × 4 hours) 60,000
Actual hours of work 58,000
Capacity variance in hours 2,000 (A)
Standard fixed overhead rate per hour Rs.5
STICKY NOTES

Fixed production overhead capacity variance in Rs. 10,000 (A)

 Example 03:
A company operates a standard overhead absorption costing system. The standard fixed
overhead rate per hour is Rs.25. The following data relate to last month:
Actual hours worked 8,250
Budgeted hours 9,000
Standard hours of actual production 7,800
Actual fixed overhead expenditure Rs. 211,000
For the month, calculations of the following variances are given below
o the fixed overhead capacity variance
o the fixed overhead efficiency variance

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o the fixed overhead expenditure variance.

Fixed production overhead capacity variance hours

Budgeted production hours of work 9,000
Actual production hours of work 8,250
Capacity variance inhours 750 (A)
Standard fixed overhead rate per hour Rs.25
Fixed production overhead capacity variance in Rs. Rs.18,750 (A)
Fixed production overhead efficiency variance hours
Standard hours produced 7,800

AT A GLANCE
Actual hours worked 8,250
Efficiency variance in hours 450 (A)
Standard fixed overhead rate per hour Rs.25
Fixed production overhead efficiency variance in Rs. Rs.11,250 (A)
Fixed production overhead expenditure variance Rs.
Budgeted fixed overhead expenditure (9,000 hours × Rs.25) 225,000
Actual fixed overhead expenditure 211,000
Fixed overhead expenditure variance 14,000 (F)

 Example 04:

SPOTLIGHT
A manufacturing company uses a standard absorption costing system in accounting for its
production costs.
The standard cost of a unit of product is as follows:

Standard Standard Standard

quantity price/rate cost
Rs. Rs.
Direct materials 5 kilos 6.00 30.00
Direct labour 20 hours 4.00 80.00
Variable production overhead 20 hours 0.20 4.00

STICKY NOTES
Fixed production overhead 20 hours 5.00 100.00

The following data relates to Period 1:

Budgeted output 25,000 units

Actual output - produced 20,000 units
Units sold 15,000 units
Materials put into production 120,000 kilos
Materials purchased 200,000 kilos
Direct labour hours paid 500,000 hrs

Due to a power failure 10,000 hours were lost.

Cost of materials used Rs.825,000

Rate per direct labour hour Rs.5

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Variable production overhead Rs.70,000

Fixed production overhead Rs.2,100,000

For Period 1, calculations for the following variances are given below:
o the material price variance
o the material usage variance
o the direct labour rate variance
o the direct labour idle time variance
o the direct labour efficiency variance
o the variable overhead total cost variance
AT A GLANCE

o the fixed overhead expenditure variance

o the fixed overhead volume variance
o the total manufacturing cost variance.

Material price variance Rs.

120,000 kilos of materials should cost (× Rs.6) 720,000
They did cost 825,000
Material price variance 105,000 (A)
Material usage variance kilos
SPOTLIGHT

20,000 units should use (× 5 kilos) 100,000

They did use 120,000
Material usage variance in kilos 20,000 (A)
Standard price per kilo of material Rs.6
Material usage variance in Rs. Rs.120,000 (A)
Direct labour rate variance Rs.
500,000 hours should cost (× Rs.4) 2,000,000
They did cost (× Rs.5) 2,500,000
STICKY NOTES

Labour rate variance 500,000 (A)

Direct labour idle time variance =
10,000 hours (A) × Rs.4 per hour = Rs.40,000 (A)
Direct labour efficiency variance hours
20,000 units should take (× 20 hours) 400,000
They did take (500,000 – 10,000) 490,000
Efficiency variance in hours 90,000 (A)
Standard rate per hour Rs.4
Direct labour efficiency variance in Rs. Rs.360,000 (A)

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Variable overhead total cost variance Rs.

20,000 units should cost (× Rs.4) 80,000
They did cost 70,000
Variable overhead total cost variance 10,000 (F)
Fixed production overhead expenditure variance Rs.
Budgeted fixed overhead expenditure (25,000 units × Rs.100) 2,500,000
Actual fixed overhead expenditure 2,100,000
Fixed overhead expenditure variance 400,000 (F)
Fixed production overhead volume variance units

AT A GLANCE
Budgeted production volume 25,000
Actual production volume 20,000
Volume variance in units 5,000 (A)
Standard fixed overhead rate per unit Rs.100
Fixed production overhead volume variance in Rs. Rs.500,000 (A)

Summary Favourable Adverse

Variance Rs. Rs.
Material price 105,000
Material usage 120,000

SPOTLIGHT
Direct labour rate 500,000
Direct labour idle time 40,000
Direct labour efficiency 360,000
Variable overhead cost 10,000
Fixed overhead expenditure 400,000
Fixed overhead volume 500,000
410,000 1,625,000
Manufacturing cost total variance Rs.1,215,000 (A)

STICKY NOTES
 Example 05:
A production manager is studying the cost report for the six-month period that has just ended.
The production department incurred overhead costs of Rs. 680,000 and had under-absorbed
overheads of Rs. 46,400. The actual direct labour hours worked in the department were 48,000
hours, which was 2,000 hours less than budgeted. Actual hours and standard hours are same,
For the given example, the budgeted absorption rate per direct labour hour, would be:

Rs.
Actual overhead expenditure 680,000
Under-absorbed overhead (46,400)
Absorbed overhead 633,600
Hours worked 48,000
Therefore budgeted absorption rate per hour (Rs.633,600/48,000) Rs.13.20

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The budgeted overhead expenditure, would be calculated as follows:

hours
Actual hours worked 48,000
This was less than budget by 2,000
Budgeted hours 50,000
Absorption rate per hour Rs.13.20
Budgeted overhead expenditure
(50,000 hours × Rs.13.20) Rs.660,000

The overhead expenditure and overhead volume variances in the period, would be,
AT A GLANCE

Volume variance in hours 2,000 hours Adverse

Absorption rate per hour Rs.13.20
Volume variance in Rs. Rs.26,400 Adverse

Rs.
Actual overhead expenditure 680,000
Budgeted overhead expenditure 660,000
Expenditure variance 20,000 Adverse

 Example 06:
SPOTLIGHT

Lettuce makes a product – the vegetable guard. It is the organic alternative to slug pellets and
chemical sprays.
For the forthcoming period budgeted fixed costs were Rs. 6,000 and budgeted production and
sales were 1,300 units.
The vegetable guard has the following standard cost:

Rs.
Selling price 50
Materials 5kg × Rs.4/kg 20
STICKY NOTES

Labour 3hours × Rs.4/hour 12

Variable overheads 3hours × Rs.3/hour 9
Actual results for the period were as follows:
1,100 units were made and sold, earning revenue of Rs. 57,200.
6,600kg of materials were bought at a cost of Rs. 29,700 but only 6,300 kg were used
3,600 hours of labour were paid for at a cost of Rs.14,220. The total cost for variable overheads
was Rs. 11,700 and fixed costs were Rs.4,000.
The company uses marginal costing and values all inventory at standard cost.
a) Assuming now that the company uses absorption costing, recalculating the fixed production
overhead variances, would be as follows:
Tutorial note: If the company uses absorption costing with a direct labour hour absorption rate,
we can calculate an expenditure, capacity and efficiency variance for fixed production overheads.
The first step is to calculate a budgeted absorption rate per hour
Budgeted labour hours: 1,300 × 3 = 3,900 hours

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Budgeted fixed cost Rs. 6,000

Budgeted absorption rate: Rs. 6,000 /3,900 = Rs.1.54
Fixed overhead expenditure variance
Same as in (a): Rs. 2,000 (F).
Fixed overhead capacity variance
hours
Budgeted hours of work 3,900
Actual hours worked 3,600
Capacity variance in hours 300 (A)
Standard fixed overhead rate per hour Rs.1.54

AT A GLANCE
Fixed overhead capacity variance in Rs. Rs.462 (A)
Fixed overhead efficiency variance
Efficiency variance in hours = 300 hours (A) – see answer to (a).
Fixed overhead efficiency variance = 300 hours (A) × Rs.1.54 = Rs.462 (A).
b) Possible causes for the labour variances that have been calculated are discussed below:
Labour rate
The labour rate variance is favourable indicating a lower rate per hour was paid than expected.
This is perhaps because more junior or less experienced staff were used during production.
Though less likely, it is possible that staff had a pay cut imposed upon them. Finally, an incorrect
or outdated standard could have been used.

SPOTLIGHT
Labour efficiency
This is significantly adverse, indicating staff took much longer than expected to complete the
output. This may relate to the favourable labour rate variance, reflecting employment of less
skilled or experienced staff. Staff demotivated by a pay cut are also less likely to work efficiently.
It may also relate to the reliability of machinery as staff may have been prevented from reaching
full efficiency by unreliable equipment
 Example 07:
Carat plc, a premium food manufacturer, is reviewing operations for a three-month period. The
company operates a standard marginal costing system and manufactures one product, ZP, for

STICKY NOTES
which the following standard revenue and cost data per unit of product is available:
Selling price Rs. 12.00
Direct material A 2.5 kg at Rs. 1.70 per kg
Direct material B 1.5 kg at Rs. 1.20 per kg
Direct labour 0.45 hours at Rs. 6.00 per hour
Fixed production overheads for the three-month period were expected to be Rs. 62,500.
Actual data for the three-month period was as follows:
Sales and production 48,000 units of ZP were produced and sold for Rs. 580,800
Direct material A 121,951 kg were used at a cost of Rs. 200,000
Direct material B 67,200 kg were used at a cost of Rs. 84,000
Direct labour Employees worked for 18,900 hours, but 19,200 hours were
paid at a cost of Rs. 117,120
Fixed production overheads Rs. 64,000

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Budgeted sales for the three-month period were 50,000 units of Product ZP.
a) The following variances are required to be calculated for the given example:
i. price, mix and yield variances for each material;
ii. labour rate, labour efficiency and idle time variances.
Sales volume contribution per unit

Rs. /unit Rs. /unit

Standard sales price 12·00
Material A (Rs. 1·70 × 2·50) 4·25
Material B (Rs. 1·20 × 1·50) 1·80
AT A GLANCE

Labour (Rs. 6·00 × 0·45) 2·70

8·75
Standard contribution 3·25

Direct material price variances

Material A price variance Rs.

Actual quantity × actual price 200,000
Actual quantity × standard price (Rs. 1·70 × 121,951) 207,317
Price variance 7,317 (F)
SPOTLIGHT

Material B price variance Rs.

Actual quantity × actual price 84,000
Actual quantity × standard price (Rs. 1·20 × 67,200) 80,640
Price variance 3,360 (A)

Materials mix and yield variances

Standard cost of input and output
kg Rs. /kg Standard cost
Material A = Rs. 1·70 × 2·5 = 2.5 Rs. 1.70 4·25
STICKY NOTES

Material B = Rs. 1·20 × 1·5 = 1.5 Rs. 1.20 1·80

4.0 6·05
Standard cost of input = Rs. 6.05/4kg
Standard cost of output = Rs. 6.05/unit
Material mix
Actual Standard Standard Mix Standard Mix
mix ratio mix variance cost per variance
(kg) kg (Rs.)
A 121,951 2.5 118,220 (3,731) 1.7 (6,343) (A)
B 67,200 1.5 70,931 3,731 1.2 4,477 (F)
189,151 189,151 (1,866) (A)

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Material yield variance

Units
189,151 did yield 48,000
189,151 should have yielded (÷ 4kg) 47,288
Extra yield 712
Standard cost of a unit Rs. 6.05
Yield variance Rs. 4,309 (F)
Labour variances
Labour rate variance Rs.
Actual hours × actual rate 117,120

AT A GLANCE
Actual hours × standard rate (19,200 × Rs. 6) 115,200
1,920 (A)
Labour efficiency variance Rs.
Actual hours worked × standard rate
18,900 hours × Rs. 6 113,400
Standard hours × standard rate
48,000 units × 0.45 hours × Rs. 6 129,600
16,200 (F)
Labour idle time variance Hours
Actual hours paid for 19,200

SPOTLIGHT
Actual hours worked 18,900
Idle time (hours) 300
Standard rate Rs. 6
Idle time (Rs. ) 1,800 (A)

b) Possible explanations for the following variances are also discussed below:
i. material price, mix and yield variances for material A;
ii. labour rate, labour efficiency and idle time variances.

STICKY NOTES
The favourable material A price variance indicates that the actual price per kilogram was less
than standard. Possible explanations include buying lower quality material, buying larger
quantities of material A and thereby gaining bulk purchase discounts, a change of supplier, and
using an out-of-date standard.
The adverse material A mix variance indicates that more of this material was used in the actual
input than indicated by the standard mix. The favourable material price variance suggests this
may be due to the use of poorer quality material (hence more was needed than in the standard
mix), or it might be that more material A was used because it was cheaper than expected.
The favourable material A yield variance indicates that more output was produced from the
quantity of material used than expected by the standard. This increase in yield is unlikely to be
due to the use of poorer quality material: it is more likely to be the result of employing more
skilled labour, or introducing more efficient working practices.

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It is only appropriate to calculate and interpret material mix and yield variances if quantities in
the standard mix can be varied. It has also been argued that calculating yield variances for each
material is not useful, as yield is related to output overall rather than to particular materials in
the input mix. A further complication is that mix variances for individual materials are inter-
related and so an explanation of the increased use of one material cannot be separated from an
explanation of the decreased use of another.
The unfavourable labour rate variance indicates that the actual hourly rate paid was higher than
standard. Possible explanations for this include hiring staff with more experience and paying
them more (this is consistent with the favourable overall direct material variance), or
implementing an unexpected pay increase. The favourable labour efficiency variance shows that
fewer hours were worked than standard. Possible explanations include the effect of staff training,
the use of better quality material (possibly on Material B rather than on Material A), employees
gaining experience of the production process, and introducing more efficient production
AT A GLANCE

methods. The adverse idle time variance may be due to machine breakdowns; or a higher rate of
production arising from more efficient working (assuming employees are paid a fixed number of
hours per week).
 Example 08:
Hexa Limited uses a standard costing system. The following profit statement summarizes the
performance of the company for August 20X3:

Rupees
Budgeted profit 3,500
Favourable variance:
SPOTLIGHT

Material price 16,000

Labour efficiency 11,040 27,040
Adverse variance:
Fixed overheads expenditure (16,000)
Material usage ((6,000)
Labour rate (7,520) (29,520)
Actual profit 1,020

The following information is also available:

STICKY NOTES

Standard material price per unit (Rs.) 4.00

Actual material price per unit (Rs.) 3.90
Standard wage rate per hour (Rs.) 6.00
Standard wage hours per unit 10
Actual wages (Rs.) 308,480
Actual fixed overheads (Rs.) 316,000
Fixed overheads absorption rate 100% of direct wages

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a) Budgeted output in units, actual number of units purchased, actual units produced,
actual hours worked and actual wage rate per hour would be calculated as follows:

(i) Budgeted output in units

Actual Fixed Overhead Rs. 316,000
Less: Adverse Fixed Overhead Variance Rs. 16,000
Budgeted Fixed Overhead Rs. 300,000
Direct wages per unit (Rs. 6 x 10 hours) Rs. 60
Budgeted output in units (Rs. 300,000/60) 5,000 units
(ii) Actual number of units purchased
Material Price Variance – Total Rs. 16,000

AT A GLANCE
Price Variance per unit (Rs. 4.00 – Rs. 3.90) Re. 0.10
Units purchased (Rs. 16,000 / 0.10) 160,000
(iii) Actual units produced
Standard Wages (308,480 – 7,520 + 11,040) Rs. 312,000
Standard Labour Cost (Rs. 6 x 10 hours) Rs. 60
Units produced (Rs. 312,000 / Rs. 60) 5,200
(iv) Actual hours worked
Actual Labour Costs Rs. 308,480
Less: Labour Rate Variance 7,520

SPOTLIGHT
Actual Labour Costs at Standard Rate 300,960
Standard Rate per hour Rs. 6.00
Actual hours worked (300,960 / 6) 50,160
(v) Actual Wages / Actual Hours = Rs. 308,480 / 50,160 = Rs. 6.15

b)

Possible causes of favourable material price variance

Fortunate buy
Inferior quality materials

STICKY NOTES
Unusual discount due to bulk quantity purchase
Drop in market price
Less costly method of transportation

Possible causes of unfavourable material quantity variance

Carelessness
Poorly adjusted machines
Unskilled workers
New equipment
Inferior quality materials

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Possible causes of favourable labour efficiency variance

Use of better skilled workers
High quality material
New equipment
Possible causes of unfavourable labour rate variance
Use of workers with better skills
Change in pay scales
Overtime

 Example 09:
AT A GLANCE

Excellent Limited makes and sells a single product. The standard cost card for the product, based
on normal capacity of 45,000 units per month is as under:
Rupees
Material 60 kg at Rs. 0.60 per kg 36.00
Labour ½ hour at Rs. 50.00 per hour 25.00
Variable factory overheads, 30% of direct labour cost 7.50
Fixed factory overheads 6.50
Total 75.00
SPOTLIGHT

Actual data for the month of August 20X3 is as under:

Work in process on August 1, 20X3 (60% converted) Units 10,000
Started during the month Units 50,000
Transferred to finished goods Units 48,000
Work in process on August 31, 20X3 (50% converted) Units 10,000
Material purchased at Rs. 0.50 per kg Rs. 1,750,000
Material issued to production Kg 3,100,000
Direct labour at Rs. 52 per hour Rs. 1,300,000
STICKY NOTES

Factory overheads (including fixed costs of Rs. 290,000) Rs. 600,000

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The company uses FIFO method for inventory valuation.

All materials are added at the beginning of the process. Conversion costs are incurred
evenly throughout the process. Inspection takes place when the units are 80% complete.
Under normal conditions, no spoilage should occur.
a) A quantity and equivalent production schedules for material and conversion costs would
be prepared as follows:
Preliminary working Rs.
Units in process at beginning 10,000
Units started during the month 50,000
Total possible units 60,000

AT A GLANCE
Normal loss −
Expected good output: 60,000
Actual good output:
Started in the previous period but finished in this period 10,000
Started and finished in this period (balance) 38,000
Finished in this period (given) (48,000)
Closing WIP (10,000)
Loss of units (Balance quantity) 2,000

Total Percentage Conversion

Equivalent Units Materials

SPOTLIGHT
units complete cost
Started last period
Opening WIP 10,000
Materials 0%
Conversion 40% 4,000
Started and finished in period 38,000 100% 38,000 38,000
Good output 48,000
Started but not finished
Closing WIP 10,000

STICKY NOTES
Materials 100% 10,000
Conversion 50% 5,000
Abnormal loss 2,000
Materials 100% 2,000
Conversion 80% 1,600
Units made in period 50,000 48,600

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b) Material, labour and variable overhead variances are calculated below. (Assuming that
the material price variance is calculated as materials are used rather than as they are
purchased).
Material, labour and variable overhead variances
1) Material price variance Rs.
3,100,000 kg should cost (@ 0.60 per kg) 1,860,000
3,100,000 kgs did cost (@ 0.50 per kg) 1,550,000
Material price variance (F) 310,000

2) Material quantity variance Kgs.

AT A GLANCE

Making 50,000 units should use (@60 kg per unit) 3,000,000

Making 50,000 units did use 3,100,000
Material quantity variance in kg (A) (100,000)
Standard cost per kg (Rs.) 0.60
Material quantity variance in Rs. (A) (60,000)
3) Labour rate variance Rs.
25,000 hours should cost (@ 50 per hr) 1,250,000
25,000 hours did cost (@ 52 per hr) 1,300,000
Labour rate variance (A) (50,000)
SPOTLIGHT

W: Labour hours worked = Rs.1,300,000 ÷ Rs. 52 = 25,000 hours

4) Labour efficiency variance hrs.
Making 48,600 units should use (@ 0.50 hrs per unit) 24,300
Making 48,600 units did use 25,000
Labour efficiency variance in hours (A) (700)
Standard rate per hour (Rs.) 50
Labour efficiency variance in Rs. (A) (35,000)
5) Variable overhead expenditure variance Rs.
STICKY NOTES

25,000 hrs should cost (@ 15 per hr) 375,000

25,000 hrs did cost (Rs.600,000 - Rs.290,000) 310,000
Variable overhead rate variance (F) 65,000
6) Variable overhead efficiency variance hrs.
Making 48,600 units should use (@ 0.50 hrs per unit) 24,300
Making 48,600 units did use 25,000
Variable overhead efficiency variance in hours (A) (as above) (700)
Standard rate per hour (Rs.) 15
Variable overhead efficiency variance in Rs. (A) (10,500)

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c) The over (under) absorption of fixed production overhead and analyze it into
expenditure variance and volume variance would be calculated below:

Over(under) absorption of fixed production overhead

Note: Fixed overhead absorption rate is Rs.6.50 per unit. Each unit takes 0.50 hrs.
Therefore, the fixed overhead absorption rate is Rs. 13 per hour.
1) Over(under) absorption Rs.
Amount absorbed (48,600 units at Rs. 6.50 per unit) 315,900
Actual expenditure 290,000
Over absorption (F) 25,900
2) Fixed production overhead expenditure variance Kg

AT A GLANCE
Budgeted expenditure (45,000 units @ Rs. 6.50 per unit) 292,500
Actual expenditure 290,000
Expenditure variance in Rs. (F) 2,500
3) Fixed production overhead volume variance Rs.
Budgeted volume 45,000
Actual volume 48,600
Volume variance in units (F) 3,600
Standard rate per unit (Rs.) 6.50
Labour efficiency variance in Rs. (F) 23,400

SPOTLIGHT
d) Analyze the fixed production overhead volume variance into efficiency and capacity
variances.

1) Fixed overhead efficiency variance hrs.

Making 48,600 units should use (@ 0.50 hours per unit) 24,300
Making 48,600 units did use 25,000
Fixed overhead efficiency variance in hours (A) (as above) (700)
Standard rate per hour (Rs.) 13
Fixed overhead efficiency variance in Rs. (A) (9,100)
2) Fixed overhead capacity variance Rs.

STICKY NOTES
Budgeted hours (45,000 hours at 0.50 hour per unit) 22,500
Actual hours worked 25,000
Capacity variance in hours (F) 2,500
Standard rate per hour (Rs.) 13
Capacity variance in Rs. (F) 32,500

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 Example 10:
You have recently been appointed as the Financial Controller of Watool Limited. Your
immediate task is to prepare a presentation on the company’s performance for the recently
concluded year. You have noticed that the records related to cost of production have not been
maintained properly. However, while scrutinizing the files you have come across certain details
prepared by your predecessor which are as follows:
i. Annual production was 50,000 units which is equal to the designed capacity of the plant.
ii. The standard cost per unit of finished product is as follows:
Raw material X 6 kg at Rs. 50 per kg
Raw material Y 3 kg at Rs. 30 per kg
Labour- skilled 1.5 hours at Rs. 150 per hour
AT A GLANCE

Labour- unskilled 2 hours at Rs. 100 per hour

Factory overheads Variable overheads per hour are Rs. 100 for skilled labour
and Rs. 80 for unskilled labour. Fixed overheads are Rs.
4,000,000.
iii. Data related to variation in cost of materials is as under:
Material X price variance Rs. 95,000 (Adverse)
Material Y actual price 6% below the standard price
Material X quantity variance Nil
Material Y quantity variance Rs. 150,000 (Adverse)
SPOTLIGHT

iv. Opening raw material inventories comprised of 25 days of standard consumption

whereas closing inventories comprised of 20 days of standard consumption.
v. Actual labour rate for skilled and unskilled workers was 10% and 5% higher
respectively.
vi. Actual hours worked by the workers were 168,000 and the ratio of skilled and unskilled
labour hours was 3:4 respectively.
vii. Actual variable overheads during the year amounted to Rs. 16,680,000. Fixed overheads
were 6% more than the budgeted amount.
a) Actual purchases of each type of raw materials is calculated as follows:
STICKY NOTES

Actual quantity purchased: Material X

Standard consumption quantities (50,000 units × 6kg per unit) 300,000
Usage variance 0
Actual usage 300,000
Opening inventory (300,000 kg × 25/365) (20,548)
Closing inventory (300,000 kg × 20/365) 16,438
Inventory movement (4,110)
Actual purchase quantity (kg) 295,890

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Actual cost of purchase:

Standard rate (Rs. per kg) 50
Actual quantity purchased at standard rate (Rs.) 14,794,500
Price paid above / (below) the standard rate
{adverse / (favourable) price variance} 95,000
Actual cost of purchase 14,889,500

Actual quantity purchased: Material Y

Standard consumption quantities (50,000 units × 3kg per unit) 150,000

AT A GLANCE
Usage variance (Rs.150,000 @Rs.30 per kg) 5,000
Actual usage 155,000
Opening inventory (150,000 kg × 25/365) (10,274)
Closing inventory (150,000 kg × 20/365) 8,219
Inventory movement (2,055)
Actual purchase quantity (kg) 152,945

Actual cost of purchase:

Standard rate (Rs. per kg) 30

SPOTLIGHT
Actual quantity purchased at standard rate (Rs.) 4,588,350
Price paid above / (below) the standard rate (6%) (275,301)
Actual cost of purchase 4,313,049

b) Labour rate and efficiency variances, variable overhead rate and efficiency variances and
fixed overhead expenditure variance, would be calculated as follows:

Labour and overhead variances:

Labour rate variances: Skilled Unskilled
labour labour
Actual hours at standard rate

STICKY NOTES
168,000×3/7 72,000
168,000×4/7 96,000
Standard rates per hour 150 100
Actual hours at standard rate 10,800,000 9,600,000
Price variances
10% (A) (1,080,000)
5% (A) (480,000)

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Labour efficiency variance:

50,000 units should use
@1.5 hours 75,000
@2 hours 100,000
50,000 units did use 72,000 96,000
Labour efficiency variance (hours) (F) 3,000 4,000
Standard rate per hour (Rs.) 150 100
Labour efficiency variance (Rs.) (F) 450,000 400,000

Variable overhead rate variances:

168,000 hours should cost Rs.
AT A GLANCE

168,000 × 3/7 × Rs.100 7,200,000

168,000 × 4/7 × Rs.80 7,680,000
14,880,000
168,000 hours did cost 16,680,000
Variable overhead rate variance (A) 1,800,000
Variable overhead efficiency variance: Skilled Unskilled
50,000 units should use Hrs Hrs
@1.5 hours 75,000
@2 hours 100,000
SPOTLIGHT

50,000 units did use 72,000 96,000

Labour efficiency variance (hours) (as before) 3,000 4,000
Standard rate per hour (Rs.) 100 80
Variable overhead efficiency variance (Rs.) (F) 300,000 320,000
Total (Rs.) (F) 620,000
Fixed overhead expenditure variance Rs.
Budgeted fixed overhead 4,000,000
Variance (6%) 240,000
STICKY NOTES

 Example 11:
The following data relates to actual output, actual costs and variances for the four-weekly
accounting period number 4 of a company which makes only one product.
The value of work-in-progress at the end of period 4 was the same as the value of work-in-
progress at the beginning of the month.

Actual production of Product XY 18,000 units

Actual costs incurred: Rs.000
Direct materials purchased and used (150,000 kg) 210
Direct labour costs (32,000 hours) 136
Variable production overhead 38

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Variances: Rs.000
Direct materials price 15 Favourable
Direct materials usage 9 Adverse
Direct labour rate 8 Adverse
Direct labour efficiency 16 Favourable
Variable production overhead expenditure 6 Adverse
Variable production overhead efficiency 4 Favourable

Variable production overhead varies with labour hours worked.

AT A GLANCE
A standard marginal costing system is operated.
A standard product cost sheet for one unit of Product XY, showing how the standard marginal
production cost of the product is made up is presented below:

Standard marginal production cost – Product XY Rs.

Direct materials (8 kilos at Rs.1.50 per kilo) 12.0
Direct labour (2 hours at Rs.4 per hour) 8.0
Variable production overhead (2 hours at Rs.1 per hour) 2.0
Standard marginal production cost 22.0

Tutorial note: This problem tests your understanding of the formulae for calculating variances.

SPOTLIGHT
Here, you are given the actual costs and the variances, and have to work back to calculate the
standard cost. The answer can be found by filling in the balancing figures for each variance
calculation.
Workings

Materials price variance Rs.

150,000 kilos of materials did cost 210,000
Material price variance 15,000 (F)
150,000 kilos of materials should cost 225,000

STICKY NOTES
(The variance is favourable, so the materials did cost less to buy than they should have cost.)
Therefore, the standard price for materials is Rs. 225,000/150,000 kilograms = Rs.1.50 per kilo.

Materials usage variance

Materials usage variance in Rs. = Rs.9,000 (A)
Standard price for materials = Rs.1.50
Materials usage variance in kilograms = 9,000/1.50 = 6,000 kilos (A)
kilos
18,000 units of the product did use 150,000
Material usage variance in kilos 6,000 (A)
18,000 units of the product should use 144,000

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Therefore, the standard material usage per unit of product = 144,000 kilos/18,000 units = 8 kilos
per unit.

Direct labour rate variance Rs.

32,000 hours of labour did cost 136,000
Direct labour rate variance 8,000 (A)
32,000 hours of labour should cost 128,000

Therefore, the standard direct labour rate per hour = Rs. 128,000/32,000 hours = Rs.4 per hour.
Direct labour efficiency variance
Labour efficiency variance in Rs. = Rs.16,000 (F)
AT A GLANCE

Standard rate per hour = Rs.4

Labour efficiency variance in hours = 16,000/4 = 4,000 hours (F)

hours

18,000 units of the product did take 32,000

Labour efficiency variance in hours 4,000 (F)

18,000 units of the product should take 36,000

Therefore, the standard time per unit of product = 36,000 hours/18,000 units = 2 hours per unit.
SPOTLIGHT

This number of hours per unit also applies to variable production overheads.

Variable overhead expenditure variance Rs.

32,000 hours did cost 38,000

Variable overhead expenditure variance 6,000 (A)

32,000 hours should cost 32,000

Therefore, the variable production overhead rate per hour = Rs. 32,000/32,000 hours = Rs.1 per
hour.
STICKY NOTES

 Example 12:
MZ Limited (MZL) manufactures a single product X and uses standard marginal costing system.
The standard cost card of product X is as follows:

Rupees
Raw material (13 kg @ Rs. 135 per kg) 1,755
Labour (14 hours @ Rs. 100 per hour) 1,400
Variable production overheads (Rs. 75 per labour hour) 1,050

Following data is available in respect of operations for the month of February 2018:
i. 55,000 units were put into process. 1,500 units were lost in process which were
considered to be normal loss. Process losses occur at the end of the process.
ii. 698,000 kg of material was purchased at Rs. 145 per kg. Material is added at the start of
the process and conversion costs are incurred evenly throughout the process.

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iii. 755,000 labour hours were worked during the month. However, due to certain labour
related issues, wages were paid at Rs. 115 per hour.
iv. Fixed production overheads are budgeted at Rs. 40 million for the month of February
2018. Total actual production overheads amounted to Rs. 95 million.
v. Actual fixed production overheads exceeded budgeted fixed overheads by Rs. 1.1
million.
vi. Inventory balances were as under:
01 February 2018 28 February 2018
Raw material (kg) 15,000 17,000
Work in process (units) 5,000 (60% converted) 6,000 (80% converted)

AT A GLANCE
Finished goods (units) 10,000 12,000

vii. MZL uses FIFO method for valuing the inventories.

Material, labour and overhead variances are computed as follows

Material, labour, overhead variances Rs. in '000

Cost variances under marginal costing
Material price variance Adv. (6,960.00)
[(135–145)×696,000]
Material usage variance Adv. (67.50)
{(53,500(W.3)×13)– 696,000(W.1)}×135

SPOTLIGHT
Labour rate variance Adv. (11,325.00)
(100–115)×755,000
Labour efficiency variance Fav. 520.00
{(14×54,300)(W.3)–755,000}×100
Variable overheads expenditure variance Fav. 2,725.00
(755,000×75)–Rs. 53,900,000(W.4)
Variable overheads efficiency variance Fav. 390.00
{(54,300(W.3)×14)–755,000}×75
Fixed overhead expenditure variance Adv. (1,100.00)

STICKY NOTES
(40,000–41,100) (W.4))

W-1:
Actual material usage (kg) (698,000+15,000–17,000) 696,000.00

W-2: Quantity schedule Units

WIP (opening) 5,000.00
Units started 55,000.00
Total units in production 60,000.00
Normal loss (1,500.00)
WIP (End) (6,000.00)
Finished goods/Transferred out 52,500.00

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Conversion
W-3: Equivalent production units Material
cost
---------- Units ----------
Finished goods/Transferred out (W-2) 52,500.00 52,500.00
Less: WIP (Opening) (5,000.00) (5,000.00)
Started and finished in this period 47,500.00 47,500.00
Add: WIP (Opening) (5,000×40%) 2,000.00
Add: WIP (Closing) (6,000×80%) 6,000.00 4,800.00
AT A GLANCE

Equivalent production units 53,500.00 54,300.00

W-4: Actual variable and fixed overheads Rs. in '000
Budgeted fixed overheads Given 40,000.00
Actual fixed overheads exceeded applied overheads Given 1,100.00
Actual fixed overheads 41,100.00
Less: Total actual variable and fixed overheads Given 95,000.00
Actual variable overheads 53,900.00

 Example 13:
SPOTLIGHT

Jack and Jill (JJ) manufactures various products. The following information pertains to one of its
main products:
i. Standard cost card per unit

Rupees
Direct material (5 kg at Rs. 40 per kg) 200
Direct labour (1.5 hours at Rs. 80 per hour) 120
Factory overheads 130% of direct labour

ii. Fixed overheads are budgeted at Rs. 3 million based on normal capacity of 75,000 direct
STICKY NOTES

labour hours per month.

iii. Actual data for the month of June 2015

Units
Opening work in process (80% converted) 8,000
Started during the month 50,000
Transferred to finished goods 48,000
Closing work in process (60% converted) 7,000

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Rupees
Material issued to production at: Rs. 38 per kg 1,900,000
Rs. 42 per kg 8,400,000
Direct labour at Rs. 84 per hour 6,048,000
Variable factory overheads 6,350,000
Fixed factory overheads 2,850,000

iv. Materials are added at the beginning of the process. Conversion costs are incurred
evenly throughout the process. Losses up to 3% of the input are considered as normal.
However, losses are determined at the time of inspection which takes place when units
are 90% complete.

AT A GLANCE
v. JJ uses FIFO method for inventory valuation.
a) “Equivalent production units” is calculated as follows

Equivalent production
Quantity units
Equivalent units using FIFO: schedule
(Units) Material Conversion
(Units) (Units)
Opening WIP (80% conversion) 8,000 (8,000) (6,400)
Units started during the month 50,000
58,000

SPOTLIGHT
Units transferred to finished goods 48,000 48,000 48,000
Closing WIP (60% conversion) 7,000 7,000 4,200
Normal loss 3% of input - -
(58,000-7,000) × 3% 1,530

Abnormal loss (90% conversion) Bal. 1,470 1,470 1,323

58,000 48,470 47,123
A B (A×B)

STICKY NOTES
b) Computation for the following variances for the month of June 2015 are given below
• Material rate and usage
• Labour rate and efficiency
• Variable factory overhead expenditure and efficiency
• Fixed factory overhead expenditure and volume

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Variances: kg/Hrs. (Standard- Fav./

/Rs. Actual) (adv.)
Rupees
Material price variance:
Actual material usage W.2 50,000 40 - 38 = Rs. 2.00 100,000
Actual material usage W.2 200,000 40 - 42 = (Rs. 2.00) (400,000)
(300,000)
Material usage variance:
Standard material rate per kg 40.00 242,350 - 250,000 (306,000)
= (7,650 kg)
Labour rate variance:
AT A GLANCE

Actual labour hours W.2 72,000 80 - 84 = (Rs. 4.00) (288,000)

Labour efficiency variance:
Standard labour rate per hour 80.00 70,685 - 72,000 = (105,200)
(1,315 Hours)
Variable overhead expenditure variance:
Actual labour hours at standard rate 72,000 (W.1) 64.00 4,608,000
Actual variable overheads (6,350,000)
(1,742,000)
Variable overhead efficiency variance:
Standard variable overhead rate per W.1 64.00 70,685 - 72,000 = (84,160)
SPOTLIGHT

hour (1,315 Hours)

Fixed overhead expenditure variance:
Budgeted fixed production overhead 3,000,000
Actual fixed production overhead (2,850,000)
150,000
Fixed overhead volume variance:
Standard fixed overhead rate per W.1 40.00 70,685 - 75,000 = (172,600)
hour (4,315 Hours)
STICKY NOTES

W.1: Statement of standard factory overhead rate per hour: Rs.

Standard factory overhead rate per hour (120×130%)÷1.5 104.00
Standard fixed factory overhead rate per hour 3,000,000÷75,000 40.00
Standard variable factory overhead rate per hour 104-40 64.00

Standard usage of Actual usage of material

W.2:
material/labour /labour/overheads
Eq. Per Kg/ Amount Per kg/ Kg
units unit hrs. hrs. (Rs.) /hrs.
Material 48,470 5.0 kg 242,350 1,900,000 38.00 50,000
8,400,000 42.00 200,000
10,300,000 250,000
D. labour 47,123 1.5 hours 70,685 6,048,000 84.00 72,000
V. overheads 6,350,000 88.1944 72,000

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 Example 14:
Hexal Limited is a manufacturer of various machine parts. Following information has been
extracted from the cost records of one of its products AXE for the month of June 2014:
i. Standard cost per unit:

Rupees
Raw material 170.00
Direct labour (1.25 hours) 150.00
Overheads 137.50
ii. Based on normal capacity of 128,000 direct labour hours, fixed overheads are estimated
at Rs. 2,560,000.

AT A GLANCE
iii. Following information pertains to production of 100,000 units of product AXE:

Actual direct labour hours worked 130,000

Unfavourable material usage variance Rs. 820,000
Unfavourable material price variance Rs. 600,000
Actual direct labour cost Rs. 16,250,000
Actual fixed and variable overheads Rs. 15,500,000

For the month of June 2014, actual material cost and labour variances are computed as follows

Actual direct material cost Rupees

SPOTLIGHT
Standard material cost 100,000x170 17,000,000

Un-favourable material usage variance 820,000

Un-favourable material price variance 600,000

18,420,000

Favourable/
Direct labour variances
(Adverse)

1 Direct labour rate variance

STICKY NOTES
(SR – AR) x AH

[(150/1.25)-(16,250,000/130,000)] x 130,000 (650,000)

2 Direct labour efficiency variance

(SH – AH) x SR

[(100,000 x 1.25)-130,000)] x 120 (600,000)

W-1
Standard total overheads rate per labour hour 137.5/1.25 110.00
Standard fixed overhead rate per labour hour 2,560,000/128,000 (20.00)
Standard variable overhead rate per labour Rs. 90.00
hour

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 Example 15:
Zamil Industries (ZI) produces and markets an industrial product Zeta. ZI uses standard
absorption costing system. The break-up of Zeta’s standard cost per unit is as under:

Rupees
Materials: Axe – 1 kg 160
Zee – 2 kg 210
Direct labour – 0.8 hours 200
Overheads – 0.8 hours 180

Production of Zeta for the month of August 2016 was budgeted at 15,000 units. Information
AT A GLANCE

pertaining to production of Zeta for August 2016 is as under:

i. Raw material inventory is valued at lower of cost and net realizable value. Cost is
determined under FIFO method. Stock cards of materials Axe and Zee are reproduced
below:

Axe Zee
Date Description Cost per Cost per
kg kg
kg (Rs.) kg (Rs.)
1-Aug Opening balance 9,000 150 4,000 120
8,000 122
3-Aug Purchase returns - - (2,000) 122
SPOTLIGHT

4-Aug Purchases 17,000 148 35,000 125

6-Aug Issues to production (16,000) - (29,000) -

ii. Actual direct wages for the month were Rs. 3,298,400 consisting of 11,780 direct labour
hours.
iii. Fixed overheads were estimated at Rs. 540,000 based on budgeted direct labour hours.
iv. The actual fixed overheads for the month were 583,000.
Actual sales of Zeta for the month of August 2016 was 12,000 units. Opening and closing finished
goods inventory of Zeta was 5,000 and 8,500 units respectively.
STICKY NOTES

a) Following variances are calculated as follows:

i. Material price, mix and yield variances
ii. Labour rate and efficiency variances

Material price variance:

Actual material usage at actual price using FIFO
Axe Zee Net
adverse
Issues Actual Issues Actual variance
Rs. Rs.
(kg) rate (kg) rate Rs.
9,000 150 1,350,000 4,000 120 480,000
7,000 148 1,036,000 6,000 122 732,000
- - - 19,000 125 2,375,000
16,000 2,386,000 29,000 3,587,000

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Actual material usage at standard price:

16,000 160 2,560,000 29,000 (210÷2) 3,045,000
105
Fav./(Adverse) variance 174,000 (542,000) (368,000)
Material mix variance
Actual usage at Mix quantity
Actual mix Std. cost
std. variance Rs.
(kg) per (kg)
mix ratio (kg) (Adv.)/Fav.
Axe 16,000 15,000 (1,000) 160 (160,000)
Zee 29,000 30,000 1,000 105 105,000

AT A GLANCE
45,000 45,000
Material mix variance – adverse (55,000)
Material yield variance
Per unit Std. raw
Yield
material usage at Rs.
(no. of units)
Std. price
Standard yield (45,000÷3) 15,000 (160+210) 370 5,550,000
Actual yield (12,000+8,500−5,000) 15,500 370 5,735,000
Yield variance – favourable 185,000
Labour variance Rs.

SPOTLIGHT
Labour rate variance
Actual hours at standard rate 11,780×(200÷0.8) 2,945,000
Actual hours at actual (3,298,400)
Labour rate variance – adverse (353,400)
Labour efficiency variance
Allowable hours at standard rate (15,500×0.8)×(200÷0.8) 3,100,000
Actual hours at standard rate 11,780×(200÷0.8) (2,945,000)
Labour efficiency variance – favourable 155,000

STICKY NOTES
a) Computation of applied fixed overheads and analysis ‘under/over applied fixed factory
overheads’ into expenditure, efficiency and capacity variances are as follows:

Analyses of under/over applied fixed overheads Rs.

Standard fixed overhead rate per hour (540,000÷15,000×0.8) 45

Applied fixed overheads (15,500×0.8×45) 558,000

Actual fixed overheads (583,000)
Under applied overheads (25,000)
Fixed overhead expenditure variance
Budgeted fixed overheads 540,000
Actual fixed overheads (583,000)
Fixed overhead expenditure variance – adverse (A) (43,000)

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Fixed overhead efficiency variance Rs.

Allowable hours for actual production at standard 15,500×0.8×45 558,000
cost
Actual hours worked at standard rate 11,780×45 (530,100)
Fixed overhead efficiency variance – favourable (B) 27,900
Fixed overhead capacity variance
Actual hours worked at standard rate 11,780×45 530,100
BU hours at standard rate 12,000×45 (540,000)
Fixed overhead capacity variance – adverse (C) (9,900)
AT A GLANCE

Under applied fixed overheads (A)+(B)+(C) (25,000)

 Example 16:
Hexo Limited is using a standard absorption costing system to monitor its costs. The
management is considering to adopt a marginal costing system. In this respect, following
information has been extracted from the records for the month of December 2016:
i. Actual as well as budgeted sale was 10,500 units at Rs. 2,000 per unit.
ii. Standard cost per unit is as follows:

Rupees
Direct material 5 kg @ Rs. 158 790
SPOTLIGHT

Direct labour 3 hours @ Rs. 150 450

Production overheads (fixed & variable) Rs. 120 per labour hour 360
1,600

iii. Budgeted fixed overheads were Rs. 1,650,000.

iv. Production and actual costs were as under:

Units
Production: Budgeted 11,000
STICKY NOTES

Actual 12,000

Actual variable costs: Rupees

Direct material (58,000 kg @ Rs. 160) 9,280,000
Direct labour (35,000 hours @ Rs. 155) 5,425,000
Variable overheads 2,975,000

v. Applied fixed overheads exceeded actual overheads by Rs. 200,000.

vi. There was no opening finished goods inventory. Closing finished goods inventory was
1,500 units.
a) The profit for the month of December 2016, using standard marginal costing, would be
computed as follows:

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Profit for the month of December 2016 - Standard marginal costing

Rupees
Sales 10,500×2,000 21,000,000
Production cost 12,000×(790+450+(W.1) 210) (17,400,000)
Closing stock 1,500×(790+450+(W.1) 210) 2,175,000
Variable cost of sales at standard rate (15,225,000)
Contribution margin 5,775,000
Budgeted fixed overheads (1,650,000)
Profit at standard rate 4,125,000
W-1: Production overhead rate: Per unit Per hour

AT A GLANCE
------------ Rupees ------------
Standard overhead rate (fixed & variable) 360 (360÷3) 120
Less: Standard fixed overhead rate (1,650,000÷11,000) 150 (150÷3) 50
Standard variable overhead rate per hour 210 70

b) Reconciliation for the profit computed above with actual profit under marginal costing,
by incorporating the related variances is given below:

Reconciliation of standard and actual profit under marginal costing: Rupees

Standard profit as above (A) 4,125,000

SPOTLIGHT
(Adverse)/favourable cost variances:
Direct material price (116,000)
(SR–AR)×AQ=(158–160)×58,000
Direct material usage 316,000
(SQ–AQ)×SR=[(5×12,000)–58,000]×158
Direct labour rate (175,000)
(SR–AR)×AH= (150–155)×35,000
Direct labour efficiency 150,000
(SH –AH)×SR= [(3×12,000)–35,000]×150

STICKY NOTES
Variable overheads expenditure (525,000)
Actual cost – (VOAR/H×AH)=2,975,000-(70×35,000)
Variable overheads efficiency 70,000
(SH–AH)×VOAR/H=(36,000–35,000)×70
Fixed overheads expenditure variance (BU overheads – Actual 50,000
overheads) [1,650,000–(12,000 ×150–200,000)]
Net adverse variance (B) (230,000)
Closing stock (Difference of standard and actual variable costs)
[(9,280,000+5,425,000+2,975,000)÷12,000×1,500]-[(1,600- 35,000
150)×1,500](C)
Actual profit under marginal costing A+B+C 3,930,000

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c) Reconciliation for the actual profit under marginal and absorption costing, is given
below:

Actual profit under absorption costing: Rupees

Actual profit under marginal costing – as above 3,930,000
Fixed cost carried forward to the next year with closing inventory 200,000
under absorption costing whereas under marginal costing fixed costs
are charged in the year of incurrence
(1,800,000-200,000)÷12,000)×1,500
Actual profit under absorption costing 4,130,000

 Example 17:
AT A GLANCE

Sigma Limited (SL) is a manufacturer of Product A. SL operates at a normal capacity of 90%

against its available annual capacity of 50,000 machine hours and uses absorption costing. The
following summarized profit statements were extracted from SL's budget for the year ending 31
December 2015.

Actual - 2014 Budget - 2015

Units Rs. In ‘000 Units Rs. In ‘000
Sales 4,125 49,500 4,600 56,580
Opening inventory 400 (3,400) 600 (5,400)
Cost of production 4,325 (38,925) 4,500 (44,325)
Closing inventory 600 5,400 500 4,925
SPOTLIGHT

Under absorbed production (100) -

overheads
Selling and administration cost (3,000) (5,250)
(30% fixed)
Net profit 9,475 6,530

Other relevant information is as under:

2014 Budget - 2015

Standard machine hours per unit 10 hours 10 hours
STICKY NOTES

Standard production overhead rate per unit Rs. 2,000 Rs. 2,250
Estimated fixed production overheads at normal capacity Rs. 3,600,000 Rs. 4,050,000
Actual production overheads Rs. 8,750,000 -
(Actual machine hours 44,000)

a) Under/over absorbed production overheads can be understood as:

Production overhead rate is predetermined at beginning of the year based on budgeted
annual overheads and budgeted annual production. Overhead are applied to actual
hours/units using predetermined overhead rate. However, actual overheads and actual
production may differ from the budgeted overheads and production, therefore, it would
result in under/over absorption of production overheads.

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b) Analysis for the under absorbed production overheads of SL for the year ended 31
December 2014, into spending and volume variances. Give two probable reasons for
each variance, would be as follows
(i) Spending variance
Hours allowed for actual production of 4,325 units 4,325×10 43,250
Rs. in ‘000
Budgeted variable overheads for hours allowed 43,250×0.12*1 5,190
Standard fixed overheads 3,600
8,790
Actual overheads 8,750
Favourable spending variance A 40

AT A GLANCE
(ii) Volume variance
Estimated fixed overheads at normal capacity 45,000×0.08*2 3,600
Fixed overheads for hours allowed for actual 43,250×0.08*2 3,460
production
Adverse volume variance B (140)
Under absorbed production overheads (A+B) (100)
*1Variable cost per hour [(2,000÷10)–(3,600,000÷(50,000×90%)]=120

*2Fixed cost per hour [(2,000÷10) –120]=80

Reasons for favourable spending variance:

(i) Lesser spending/decrease in price of overhead items as compared to budget.
(ii) Over-estimating overhead expenditure while preparing the budget.

SPOTLIGHT
Reasons for adverse volume variance:
(i) Under-utilization of available capacity
(ii) In-efficient use of machine hours
c) A budgeted Profit and Loss Statement for the year ending 31 December 2015, using
marginal costing would be prepared as follows:

For the year ending 31 December 2015 Rs. in '000

Sales 56,580
Variable cost of sales:

STICKY NOTES
Opening inventory 5,400-(600×0.8*3) (4,920)
Cost of production (44,325–4,050) (40,275)
Closing inventory 4,925-(500×0.9*4) 4,475
(40,720)
Gross contribution margin 15,860
Variable selling and administration cost 5,250×70% (3,675)
Net contribution margin 12,185
Fixed production overheads (4,050)
Fixed selling and distribution overheads 5,250×30% (1,575)
Net profit 6,560
*3 Fixed cost per unit – 2014 [3,600,000÷(50,000×90%÷10)=800
*4 Fixed cost per unit – 2015 [4,050,000÷(50,000×90%÷10)=900

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d) Analysis of the difference between budgeted profit determined under absorption and
marginal costing, for the year ending 31 December 2015, is given below.

Rs. in '000
Net profit under marginal costing 6,560
Under absorption costing:
 fixed overheads brought from the last year as (600×0.8) *3
included in the opening inventory (480)
 fixed overheads carried forward to the next year as (500×0.9) *4 450
included in the closing inventory
Net profit under absorption costing 6,530
AT A GLANCE

 Example 18:
Daisy Limited (DL) manufactures and markets product Zee. DL uses standard absorption costing.
Following information pertains to product Zee for the month of February 2019.
i. Data extracted from the budget for the month of February 2019:

Production Units 27,000

Cost of production: Rs. In ‘000
Direct material X: 16,000 kg @ Rs. 400 per kg 6,400
SPOTLIGHT

Y: 14,000 kg @ Rs. 300 per kg 4,200

Direct Labour 10,000 hours @ Rs. 220 per hour 2,200
Factory overheads (including fixed overheads of Rs. 900,000) 2,500
Rs. 250 per labour hour

ii. Actual input ratio of X and Y was 55:45 respectively.

iii. Direct materials are added at the beginning of the process. Actual process losses were
6% of the output. There is no change in the direct material prices during the month.
iv. DL increased wages by 12% as against the budgeted increase of 8% which improved
labour efficiency by 5%.
STICKY NOTES

v. Due to higher than expected inflation, actual factory overhead rate was 6% higher than
the budgeted rate.
vi. Conversion costs were incurred evenly throughout the process.
vii. 27,400 units of Zee were transferred to finished goods. There was no opening or closing
work in process. Finished goods inventory at the beginning and closing of the month was
1,000 units and 1,500 units respectively.
Computation for the following variances is given below
• Material price, mix and yield variances
• Labour rate and efficiency variances
• Over/under applied overheads and analyze it into:
o variable overhead expenditure and efficiency variances
o fixed overhead expenditure and volume variances

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Variances for the month of February 2019 Units

Budgeted production A 27,000
Actual production B 27,400
Allowable production from actual input A÷D×E C 26,140
kg
Total budget input quantity X 16,000+Y 14,000 D 30,000
Total actual input quantity B×1.06 E 29,044
Rs.
Standard material cost per finished unit (6,400,000+4,200,000)÷A F 392.59
Hours

AT A GLANCE
Allowable hours for actual production 10,000÷A×B G 10,148
Actual hours G×0.95 H 9,641
Rs.
Standard Fixed overhead rate per hour 900,000÷10,000 J 90
Standard variable overhead rate per hour 250–90 K 160

Material mix variance

Description Actual input Actual input in Rate Fav/
in standard 55:45 ratio (kg) per kg (Adverse)
mix ratio (kg) (Rs.) variance
(Rs. in '000)

SPOTLIGHT
X 16,000÷D×E 15,490.13 E×0.55 15,974.20 400.00 (193.63)
Y 14,000÷D×E 13,553.87 E×0.45 13,069.80 300.00 145.22
Total E 29,044.00 E 29,044.00 (A) (48.41)
Material yield variance:
(Actual yield - Allowable yield from actual input)×Standard material cost per unit
[(B–C)×F] (F) 494.66
Material price variance:
No variance as there is no change in prices of material. -

STICKY NOTES
Labour rate variance:
(Standard rate - Actual rate) × Actual hours (A) (78.56)
[220–(220÷1.08×1.12)]×H
Labour efficiency variance:
(Allowable hours - Actual hours) × Standard rate [G–H×220] (F) 111.54
Overheads over/(under) applied
Applied overheads G×250 2,537.00
Actual overheads:
- Variable overheads H×K×1.06 1,635.11
- Fixed overheads 900×1.06 954.00
2,589.11
Overheads under applied (A) (52.11)

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Analysis of under applied overheads:

(i) Variable overhead expenditure variance:
(Standard variable overheads rate – Actual variable overhead rate) × Actual hours
[K–(K×1.06)×H] (A) (92.55)
Variable overhead efficiency variance
(Allowable hours – Actual hours) × Standard variable overhead rate per hour
(G–H)×K (F) 81.12
(ii) Fixed overhead expenditure variance 900,000×6% (A) (54.00)
Fixed overhead volume variance:
(Allowable hours – Budgeted hours)×Standard fixed overhead rate
AT A GLANCE

per hour
(G–10,000)×J (F) 13.32

 Example 19:
Seema Enterprises (SE) produces various leather goods. It operates a standard marginal costing
system. For one of its products Bela, following information was extracted for the month of
December 2015 from SE's budget document for the year 2015.

Rs. In million
Sales 9,800 units 25.00
Cost of production of 10,000 units
SPOTLIGHT

Direct material 5,000 kg. 9.00

Direct Labour 24,000 hours 3.60
Variable overheads 2,000 machine hours 4.40
Fixed overheads 3.80
Actual production for the month of December 2015 was 12,000 units whereas SE earned revenue
of Rs. 30 million by selling 11,000 units of Bela. Following information pertains to actual cost of
production for the month:
i. 5,700 kg material was issued to production. Raw materials are valued using FIFO
method. Other details relating to the raw material used for Bela are as follows:
STICKY NOTES

Kg Rs. In million
1-Dec-2015 Opening balance 3,000 5.70
10-Dec-2015 Purchases 15,000 26.25
ii. To minimize labour turnover, SE increased production wages by 10% above the
standard rate, effective 1 December 2015. This improved labour efficiency by 5% as
compared to budget.
iii. 2,100 machine hours were worked. Details of overheads are as under:
• Depreciation amounted to Rs. 1.6 million (same as budgeted)
• Factory building rent amounted to Rs. 1.20 million (same as budgeted)
• All other overheads were 4% in excess of the budget
iv. Variances are treated as period cost and charged to cost of sales.
v. There was no opening finished goods inventory of Bela. Actual closing inventory may be
valued at standard marginal production costs.

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a) Budgeted and actual profits of Bela for the month of December 2015 using marginal
costing is computed below:
Rs. in
million
Budgeted profit:
Sales (9,800 units) 25.00
Variable costs (9+3.6+4.4) (17.00)
Closing finished goods inventory at standard cost 0.34
17÷10,000×200
Contribution margin 8.34
Fixed cost (3.80)

AT A GLANCE
4.54

Actual profit:
Sales (11,000 units) 30.00
Variable costs (W-1) (19.74)
Closing finished goods inventory at standard cost 1.70
17×1,000÷10,000
Contribution margin 11.96
Fixed cost 1.6+1.2+(3.8-1.6-1.2)×1.04 (3.84)
8.12

SPOTLIGHT
W-1: Actual variable cost
Material cost using FIFO 3,000 5.70
2,700 (2,700×26.25÷15,000) 4.73
Kg 5,700 10.43
Labour cost; Actual labour (24,000÷10,000×12,000×0.95) 27,360
hours
Actual hours at actual 27,360×(3.6÷24,000×1.1) 4.51
rate
Variable overheads:

STICKY NOTES
Actual machine hours at actual rate 2,100×(4.4÷2,000×1.04) 4.80
19.74

b) The budgeted profit with actual profit using relevant variances under marginal costing
would be reconciled as follows

Reconciliation of budgeted profit with actual profit Rs. in million

Budgeted profit (As computed in (a) above) 4.54
Favourable/(adverse) variances:
Sales volume (contribution margin) variance:
Actual sale quantity at standard contribution margin 9.36
8.34÷9,800×11,000
BU sale quantity at standard contribution margin 8.34
1.02

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Sales price variance Rs. in million

Actual sale quantity at actual price 30.00
Actual sale quantity at standard price 25÷9,800×11,000 28.06
1.94
Material price variance:
Actual usage at actual price (W-1) 10.43
Actual usage at standard price 5,700×(9÷5,000) 10.26
(0.17)
Material usage variance
Actual usage at standard rate 10.26
AT A GLANCE

Allowable usage at standard rate 10.80

(5,000÷10,000×12,000)×(9÷5,000)
0.54
Labour rate variance
Actual hours at actual rate (W-1) 4.51
Actual hours at standard rate 27,360(W-1)×(3.6÷24,000) 4.10
(0.41)
Labour efficiency variance
Actual hours at standard rate 4.10
SPOTLIGHT

Allowable hours at standard rate 4.32

24,000÷10,000×12,000×(3.6÷24,000)
0.22
Variable overhead expenditure variance
Actual machine hours at actual rate (W-1) 4.80
Actual machine hours at standard rate 4.62
2,100(W-1)×(4.4÷2,000)
(0.18)
STICKY NOTES

Variable overhead efficiency variance

Actual machine hours at standard rate 4.62
Allowable machine hours at standard rate 5.28
2,000÷10,000×12,000×(4.4÷2,000)
0.66
Fixed overhead expenditure variance
Actual fixed overheads (As computed in (a) above) 3.84
Standard fixed overheads 3.80
(0.04)
Fixed overhead volume variance
Under marginal costing, there is no fixed overhead volume variance -
as fixed costs are treated as period cost and not allocated to products.
Actual profit 8.12

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 Example 20:
Following information has been extracted from the records of Silver Industries Limited (SIL) for
the month of June 2017:

Production Direct labour Variable & fixed

units hours overheads (Rs.)
Available capacity 10,000 30,000 -
Budget 8,000 24,000 3,600,000
Actual 8,600 25,000 3,900,000

Fixed overheads were budgeted at Rs. 1,200,000. Applied fixed overheads exceeded actual fixed
overheads by Rs. 20,000.

AT A GLANCE
SIL uses standard absorption costing. Over/under applied factory overheads are charged to
profit and loss account.
i. Accounting entries to record the factory overheads would be prepared as follow:

Date Description Debit Credit

-------- Rupees --------
30-Jun- Work in process/Finished goods 3,870,000
17 [8,600×(24,000÷8,000)×150(W-1)
PL account (Under absorbed overheads) (Bal.) 30,000
Overhead control account 3,900,000

SPOTLIGHT
(Under-absorbed overheads charged to profit &
loss account)

ii. Analysis for under/over applied overheads into expenditure, efficiency and capacity
variances, would be as follows.

Rupees
Variable overhead expenditure variance
Actual hours at standard variable rate 25,000×100 2,500,000
Actual variable overheads (W-2) 2,630,000

STICKY NOTES
Adverse variance A (130,000)
Variable overhead efficiency variance
Allowable hours at standard rate 8,600×3×100 2,580,000
Actual hours at standard variable rate 25,000×100 2,500,000
Favourable variance B 80,000
Fixed overhead expenditure variance
Budgeted fixed overheads 1,200,000
Actual fixed overheads (W.2) 1,270,000
Adverse variance C (70,000)
Fixed overhead efficiency variance
Allowable hours at standard rate 8,600×3×50 1,290,000
Actual hours at standard rate 25,000×50 1,250,000
Favourable variance D 40,000

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Fixed overhead capacity variance

Budgeted hours at standard rate 24,000×50 1,200,000
Actual hours at standard rate 25,000×50 1,250,000
Favourable variance E 50,000
(A+B+C+D+E) (30,000)
W-1: Standard fixed and variable overhead rate per hour Rupees
Standard fixed and variable overhead rate per hour 3,600,000÷24,000 150
Less: Standard fixed overhead rate per hour 1,200,000÷24,000 50
Standard variable overhead rate per hour 100
W-2: Actual fixed overheads
AT A GLANCE

Applied fixed overheads 8,600×(24,000÷8,000)×50 1,290,000

Applied overheads exceeded actual overheads (20,000)
Actual fixed overheads 1,270,000
Actual variable overheads (Balancing) 2,630,000
Total variable overheads 3,900,000

iii. Comments on the difference between overhead variances under marginal and
absorption costing are given below:

All variable and fixed overhead variances under marginal and absorption costing are
same, except for the fixed overhead volume (efficiency and capacity) variances which
SPOTLIGHT

can be calculated only under absorption costing.

In absorption costing, fixed overheads are allocated to the products and these are
included in the inventory valuations. Therefore, fixed overhead volume variances can be
computed under absorption costing only.
In marginal costing, only variable overheads are assigned to the product; fixed
overheads are regarded as period costs and written off as a lump sum to the profit and
loss account. Therefore, fixed overhead volume variances cannot be computed under
marginal costing.

 Example 21:
STICKY NOTES

Siyara Pakistan Limited (SPL) manufactures and sells a single product Zeta. The product passes
through two processes before transferring to warehouse for sale. Following data pertains to Process
I for the month of August 2020:

Standard cost information:

(i) Direct material per unit – 1 kg at Rs. 75.

(ii) Direct labour per unit – 1.2 hours at Rs. 40 per hour.
(iii) Factory overheads per unit – 150% of direct labour. Factory overheads are budgeted on the
basis of 250,000 direct labour hours. 40% of factory overheads are variable

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Actual data for the month of August 2020:

Rs. In 000

Direct material issued: Rs. 75 per kg 6,750

Rs. 85 per kg 11,475
Direct labour paid for 235,000 hours 9,870
Variable factory overheads 6,345
Fixed factory overheads 11,250

AT A GLANCE
(i) Direct material is added at the beginning of the process. Conversion costs are incurred
evenly throughout the process. Losses up to 7% of the input are considered as normal.
However, losses are determined at the time of inspection which takes place when product
is 75% complete.
(ii) During the month, 225,000 kg of direct material was issued to Process I and 200,000 units
were transferred to Process II.
(iii) Opening and closing work in processes were 25,000 units (80% completed) and 35,000
units (60% completed) respectively.
(iv) 10% of direct labour hours were idle due to machine break-down but fully paid.
(v) SL uses FIFO method for inventory valuation.

(a) Computation of following variances for the month of August 2020 are given below.

SPOTLIGHT
• Material price and usage
• Labour rate, efficiency and idle time
• Variable factory overhead expenditure and efficiency
• Fixed factory overhead expenditure and volume

Material price and usage variance: Rupees

Price variance = (SP-AP) x AQ (75-81)x225,000 (1,350,000) A
Usage variance= (SQ-AQ) x SP (211,700-225,000)x75 (997,500) A

Labour rate, efficiency and idle

STICKY NOTES
Rupees
time variances
Rate variance = (SR-AR) x AH (40-42)x235,000 (470,000) A
Efficiency variance= (SH-AH) x SR (242,730-211,500)x40 1,249,200 F
Idle time variance= Idle hours x SR 23,500x40 (940,000) A

Variable factory overhead Rupees

expenditure and efficiency
variances
Expenditure variance =(SR-AR)xAH (24-30)x211,500 (1,269,000) A
Efficiency variance= (SH-AH) x SR (211,700-225,000)x24 (749,520) A

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Fixed factory overhead Rupees

expenditure and volume variances
Expenditure variance = (BC-AC) 9,000,000- (2,250,000) A
11,250,000
Volume variance= (AH-BH) x SR (242,730-250,000)x36 (261,720) A

W-1 Equivalent production units Quantity Equivalent Production Units

Schedule
Material Conversion
Opening WIP (80% conversion) 25,000 (25,000) (25,000)
AT A GLANCE

Material added 225,000

250,000
Units transferred to warehouse 200,000 200,000 200,000
Closing WIP (60% conversion) 35,000 35,000 21,000
Normal loss [(225,000–35,000)×7%] 13,300 - -
Abnormal loss - balancing figure 1,700 1,700 1,275
250,000 211,700 202,275

W-2 Material
SPOTLIGHT

Actual quantity (AQ) purchased and consumed 225,000

Standard quantity (SQ) allowed (211,700(W-1)×1) 211,700
Standard rate (SR) 75
Actual rate (AR) [(6,750+11,475)/225] 81

W-3 Labour
Actual hours (AH) paid 235,000
AH worked (235,000×0.9) 211,500
STICKY NOTES

Idle hours (235,000–211,500) 23,500

Standard hours (SH) allowed (202,275 (W-1)×1.2) 242,730
AR (9,870/235) 42
SR 40

W-4 Variable factory overheads

AR (6,345/211.5) 30
SR (40×1.5×0.4) 24
AH worked (235,000-0.9) 211,500
SH allowed (202,275×1.2) 242,730

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W-5 Fixed factory overheads

SR (40×1.5×0.6) 36
Budgeted expenditure (36×250,000) 9,000,000
Actual expenditure 11,250,000
Budgeted hours 250,000
SH allowed (202,275×1.2) 242,730
(b) Reconcile the budgeted expenditure with actual expenditure for the month of August 2020 by
using relevant variances calculated in part (a).

Reconciliation: Rupees

AT A GLANCE
Direct material (211,700×75) 15,877,500
Direct labour (202,275×1.2×40) 9,709,200
Variable overheads (202,275×1.2×24) 5,825,520
Fixed overheads (202,275×1.2×36) 8,738,280
Budgeted expenditure 40,150,500
Rupees
Add: Adverse material price variance 1,350,000
Add: Adverse material usage variance 997,500
Add: Adverse labour rate variance 470,000
Less: Favourable labour efficiency variance (1,249,200)

SPOTLIGHT
Add: Adverse labour idle time variance 940,000
Add: Adverse variable overhead expenditure variance 1,269,000
Less: Favourable variable overhead efficiency variance (749,520)
Add: Adverse fixed overhead expenditure variance 2,250,000
Add: Adverse fixed overhead volume variance 261,720
5,539,500
Actual expenditure 45,690,000

STICKY NOTES
 Example 22:
Hulk Limited (HL) produces and markets a single product. The company uses standard costing system.
Following is the standard cost card per unit of the finished product:

Direct material 2.8 kg at Rs. 6.75 per kg

Direct labour Rs. 150 per hour
Variable production overheads Rs. 12 per direct labour hour
Fixed production overheads Rs. 18 per direct labour hour
The standard labour hours required for producing one unit of finished product is 30 minutes
whereas HL’s standard operating capacity per month is 15,000 hours.

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Actual results for the month of February 2013 were as under:

Rupees
Direct material @ Rs. 6.25 per kg 504,000
Direct labour Rs. 160 per hour
Variable production overheads 175,000
Fixed production overheads Rs. 17 per direct labour hour
Actual labour hours consumed by HL for producing 27,000 units was 33 minutes per unit of finished
product.

a) Computation of direct material, labour and overhead variances, are given below.
AT A GLANCE

Material price variance Rupees

(SP- AP) x AQ
(6.75- 6.25) x [504,000/6.25= 80,640] 40,320 F

Material usage variance Rupees

(SQ- AQ) x SP
(27,000 x 2.8 – 80,640) x 6.75 (34,020) A

Labour rate variance Rupees

(SR- AR) x AH
SPOTLIGHT

(150- 160) x [27,000 x33/60= 14,850] (148,500) A

Labour efficiency variance Rupees

(SH- AH) x SR
[(27,000 x 30/60= 13,500)- 14,850] x 150 (202,500) A

Variable production overhead expenditure variance Rupees

(AH x VOAR/H) –Actual Variable Production OH
(14,850 x 12) – 175,000 3,200 F
STICKY NOTES

Variable production overhead efficiency variance Rupees

(SH- AH) x VOAR/H
[(27,000 x 30/60= 13,500)- 14,850] x 12 (16,200) A

Fixed production overhead expenditure variance Rupees

Budgeted cost – Actual cost
(15,000 x 18) – (14,850 x 17) 17,550 F

Fixed production overhead volume variance Rupees

(AU- BU) x FOAR/H
[27,000 - (15,000 x 60/30= 30,000)] x 36 (108,000) A

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b) At least FOUR reasons for adverse price variances are given below.
i. inaccurate standard prices
ii. inflationary cost increases
iii. scarcity in raw material supplies resulting in higher prices
iv. Purchasing department inefficiencies
v. Purchase of better quality products

 Example 23:
Pelican Limited produces and markets a single product Zeta. The company uses a standard costing
system. Following is the standard material mix for the production of 400 units of Zeta.

Material Weight Standard rate

per kg

AT A GLANCE
Kg
Material A 30 240
Material B 25 320
Actual costs on the production of 192 units of Zeta for the month of August 2011 were as follows:

Material Weight Actual rate

Kg per kg
Material A 16 230
Material B 13 308
Calculation of price variance, usage variance, Mix variance and yield variance, are given below.

SPOTLIGHT
Material price variance Rupees
(SP- AP) x AQ
Material A= (240- 230) x 16 160 F
Material B= (320- 308) x 13 156 F
Material price variance 316 F

Material usage variance Rupees

(SQ- AQ) x SP
Material A (30 x 192/400= 14.4 – 16) x 240 (384) A

STICKY NOTES
Material B (25 x 192/400= 12 – 13) x 320 (320) A
Material usage variance (704) A

Material Mix Actual Standard Mix Kg Mix Standard Mix var.

Variance Mix Kg Var. in price/ kg in Rs.
kg
Material A 16 29x 30/55= 15.82 (0.18) A 240 (43.20) A
Material B 13 29 x 25/55= 13.18 0.18 F 320 57.60 F
29 29 14.40 F

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Material Yield variance

Actual output in units 192
Expected output (55 /400= 0.1375), (29/0.1375) 210.91
Yield in units (A) 18.91
Weighted average cost per unit W-1 38
Material Yield variance (A) (718.60) A

W-1 Rupees
Material A (30 x 240) 7,200
Material B (25 x 320) 8,000
AT A GLANCE

Total cost of 400 units 15,200

Standard cost per unit (15,200/400) 38

 Example 24:
ABC Limited produces and markets a single product. The company operates a standard costing
system. The standard cost card for the product is as under:

Sales price Rs. 600 per unit

Direct material 2.5 kg per unit at Rs. 50 per kg
SPOTLIGHT

Direct labour 2.0 hours per unit at Rs. 100 per hour
Variable overheads Rs. 25 per direct labour hour
Fixed overheads Rs. 10 per unit
Budgeted production 500,000 units per month

The company maintains finished goods inventory at 25,000 units throughout the year. Actual
results for the month of August 2010 were as under:

Rs. In 000
Sales price 480,000 units 295,000
Direct material 950,000 kg 55,000
STICKY NOTES

Direct labour 990,000 hours 105,000

Variable overheads 26,000
Fixed overheads 5,100

Reconciliation of budgeted profit and actual profit using the all possible variances, is given
below.

Material price variance Rs. In 000

(SP- AP) x AQ
(50 - [55,000/950]) x 950,000 (7,500) A

Material usage variance Rs. In 000

(SQ- AQ) x SP
(480,000 x 2.5 – 950,000) x 50 12,500 F

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Labour rate variance Rs. In 000

(SR- AR) x AH
(100- [105,000 /990]) x 100 (6,000) A

Labour efficiency variance Rs. In 000

(SH- AH) x SR
(480,000 x 2- 990,000) x 100 (3,000) A

Variable production overhead expenditure variance Rs. In 000

(AH x VOAR/H) –Actual Variable Production OH

AT A GLANCE
(990,000 x 25) – 26,000,000 (1,250) A

Variable production overhead efficiency variance Rs. In 000

(SH- AH) x VOAR/H
(480,000 x 2- 990,000) x 25 (750) A

Fixed production overhead expenditure variance Rs. In 000

Budgeted cost – Actual cost
(500,000 x 10) – 5,100,000 (100) A

SPOTLIGHT
Fixed production overhead volume variance Rs. In 000
(AU- BU) x FOAR/H
(480,000 – 500,000) x 10 (200) A

Sales price variance Rs. In 000

(AP- SP) x AQ
([295,000/480]- 600) x 480,000 7,000 F

STICKY NOTES
Sales profit volume variance Rs. In 000
(AU- BU) x Standard profit per unit W-1
(480,000- 500,000) x 215 (4,300) A

W-1 Standard profit per unit Rupees

Sales price 600.00
Direct material (2.5 x 50) (125.00)
Direct labour (2 x 100) (200.00)
Variable overheads (2 x 25) (50.00)
Fixed overheads (10.00)
215.00

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Operating statement – Absorption costing Rs. 000

s Budgeted profit (500,000 x 215) 107,500
Sales price variance 7,000
Sales profit volume variance (4,300)
110,200
Cost variances: Fav. Adv.
Material price variance 7,500
Material usage variance 12,500
Labour rate variance 6,000
AT A GLANCE

Labour efficiency variance 3,000

Variable production overhead expenditure variance 1,250
Variable production overhead efficiency variance 750
Fixed production overhead expenditure variance 100
Fixed production overhead volume variance 200
12,500 18,800 (6,300)
Actual profit 103,900
SPOTLIGHT
STICKY NOTES

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STICKY NOTES

A budget is a plan expressed in money. It is prepared and approved prior to

the budget period.

In a flexible budget the aim is to decide what total cost should be at different
levels of output and sales. Fixed cost normally remain fixed, only variable
costs and revenues vary with increase or decrease in the level of activity.

AT A GLANCE
A Variance is the difference between planned or standard cost and actual cost.
The process by which the total difference between standard and actual results
is analyzed is known as variance analysis.

The direct material total cost variance is the difference between what the
output actually cost and what it should have cost in terms of materials. It can
be further divided in to material Price and Usage Variance.

SPOTLIGHT
The direct labour total cost variance is the difference between what the
output actually cost and what it should have cost in terms of labour. It can be
further divided in to labour rate and efficiency Variance.

The variable production overhead total variance can be subdivided in to the

variable production overhead expenditure variance and the variable
production overhead efficiency variance.

STICKY NOTES
The fixed production overhead total variance can be subdivided in to an
expenditure variance and a volume variance.

Mix variance can be divided in to price, mix and yield variances.

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AT A GLANCE
SPOTLIGHT
STICKY NOTES

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 CHAPTER 12

TARGET COSTING

AT A GLANCE
IN THIS CHAPTER
Target costing involves setting a target cost by subtracting a
desired profit margin from a Competitive Selling / market
AT A GLANCE
Price.

AT A GLANCE
SPOTLIGHT The target cost may be less than the planned initial product cost
but it is a target to be achieved by the time the product reaches
1. Target Costing the maturity stage of the product life cycle.
A cost gap is to be calculated by comparing current cost and the
2. Implementing & Determining
target cost. This cost gap is to be reduced over time by applying
Target Costing
effective cost reduction techniques, improving technologies
and processes.
3. Target costing and cost gap

4. Implications And Advantages

5. Comprehensive Examples

SPOTLIGHT
STICKY NOTES

STICKY NOTES

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 CHAPTER 12: TARGET COSTING CAF 8: CMA

1. TARGET COSTING
1.1 Target Costing – Defined
Target costing involves setting a target cost, after identification of target selling price and required profit margin.
Desired profit is subtracted from competitive sales price, to get value of target cost.

1.2 Target Costing – Explained

Target costing is used mainly for new product development. This is because whenever a new product is designed
and developed for a competitive market. In this situation, it is difficult to set price on tradition basis like cost plus
profit approach. In simple words, target costing is market price less desired profit approach.
A company might decide the price that it would like to charge for a new product under development, in order to
AT A GLANCE

win a target share of the market. The company then decides on the level of profitability that it wants to achieve
for the product, in order to make the required return on investment. Having identified a target price and a target
profit, the company then establishes a target cost for the product. This is the cost at which the product must be
manufactured and sold in order to achieve the target profits and return at the strategic market price. For instance,
after market study, it is evident that market price of product should be Rs. 80 per unit. Company intends to earn
15% profit on selling price which equals to Rs. 12 (80 x 15%) per unit. Target cost can be calculated by deducting
the desired profit from selling price i.e. Rs. 68 (Rs. 80- Rs. 12)

1.3 Target cost - Defined

Target cost is an estimate of a product cost which is determined by subtracting a desired profit margin from a
competitive selling / market price. This target cost may be less than the planned initial product cost but it is
expected to be achieved by the time the product reaches the maturity stage of the product life cycle.
SPOTLIGHT

1.4 Cost gap - Defined

Cost gap is the difference between the expected cost and the target cost. It can only be arising when expected
cost to produce one unit exceeds the target cost. It can be calculated as:

Cost gap = Expected cost – Target cost

1.5 Origins of target costing

Target costing was originated in Japan in the era of 1960s, though it remained secret for years. However, in 1980s
target costing was broadly recognised as major factor for the superior position of Japanese companies. Numerous
STICKY NOTES

large entities adopted target costing in Japan and North America for enhancement of its cost management and
also increase their competitiveness. As a result, many variations in target costing have been developed and
implemented in many countries globally. (Patrick Feil, Spring 2004)
Companies then became aware that a large proportion of the costs of making a product are committed at the
design stage, before the product goes into manufacture. The design stage was therefore critical for ensuring that
new products could be manufactured at a cost that would enable the product to make a profit for the company.
It is not just a cost control exercise but rather holistically redesigning the entire production process to eliminate
unnecessary costs, without reducing the value created by the product.

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2. IMPLEMENTING & DETERMINING TARGET COSTING

2.1 Implementing target costing
Steps involved in the implementation of target costing process are as follows:
Step 1 Determine a product specification of which an adequate sales volume is estimated.
Step 2 Determine a selling price at which the organization will be able to achieve a desired market share.
Step 3 Estimate the required profit based on return on sales or return on investment.
Step 4 Calculate Target cost, by deducting the target profit from competitive sales price.
Step 5 Compile an estimated cost for the product on the anticipated design specification and current cost
levels.

AT A GLANCE
Step 6 Calculate target cost gap, by deducting the target cost from estimated cost.
Step 7 Make efforts to close the gap by applying effective cost reduction techniques, improving
technologies and processes. (Newsletter, 1999)

2.2 Determining a Target cost

 Illustration:

New product design and development Rs.

Decide: The target sales price X
Deduct: The target profit margin (X)

SPOTLIGHT
Equals: The target cost (maximum cost in order to meet or exceed the X
target profit)

 Example 01:
A construction company wants to calculate a target cost for a new flat, the expected market price
is Rs. 5,000,000.
The company require a desired Profit Margin of 14%.
calculation of the target cost to achieve the desired Profit would be as follows:
Profit Required = Rs. 5,000,000 x 14% = Rs. 700,000

STICKY NOTES
Target Cost = Rs. (5,000,000 – 700,000) = Rs. 4,300,000
 Example 02:
RL Limited intends to launch new product as market is extensively competitive, therefore, survey
reveals that market price should be Rs. 400; at this level, estimated demand will be 500,000 units.
Company intends to earn 15% return on investment on this product. Total capital investment on
this product was Rs. 250 million.
The target cost per unit is calculated as under:
Return on investment = Rs. 250 million x 15% = Rs. 37.5 million
Desired profit per unit = Rs. 37,500,000/500,000 = Rs. 75
Target cost per unit = Rs. 400 – Rs. 75 = Rs. 325

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3. TARGET COSTING AND COST GAP

3.1 Target costing and the target cost gap
Target cost gap is calculated by deducted the target cost from estimated cost. It is important that target cost
gap can be calculated only where estimated cost exceeds the target cost.
 Example 03:
Atlas Gaming Company, a manufacturer of computer games, is in the process of introducing a
new game to the market and has undertaken market research to find out about customer’s view
on the value of the product. The results of this research have been used to establish a target
selling price of Rs. 6,000. This is the price that the company thinks it will have to sell the product
at to achieve the required sales volume.
AT A GLANCE

Cost estimates have been prepared based on the proposed product specification.

Manufacturing cost per unit Rupees

Direct material 321

Direct labour 2,403

Direct machinery cost 112

Ordering and receiving 23

Quality assurance 460

SPOTLIGHT

Non-manufacturing cost per unit

Marketing 815

Distribution 325

After sales service 130

The target profit margin for the game is 30% of target selling price.
The target cost gap is calculated as under:

Target cost gap Rupees

STICKY NOTES

Target selling price 6,000

Target profit (6,000 x 30%) (1,800)

Target cost 4,200

Estimated cost (Given in question) 4,589

Target cost gap 389

The estimated cost exceeds the target cost by Rs. 389 and it is the target cost gap.
 Example 04:
A company has designed a new product. NP8. It currently estimates that in the current market,
the product could be sold for Rs.70 per unit. A gross profit margin of at least 30% on the selling
price would be required, to cover administration and marketing overheads and to make an
acceptable level of profit.

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A cost estimation study has produced the following estimate of production cost for NP8.

Cost item

Direct material M1 Rs.9 per unit

Direct material M2 Each unit of product NP8 will require three metres of material M2,
but there will be loss in production of 10% of the material used.
Material M2 costs Rs.1.80 per metre.

Direct labour Each unit of product NP8 will require 0.50 hours of direct labour time.
However it is expected that there will be unavoidable idle time equal
to 5% of the total labour time paid for. Labour is paid Rs.19 per hour.

AT A GLANCE
Production It is expected that production overheads will be absorbed into product
overheads costs at the rate of Rs. 60 per direct labour hour, for each active hour
worked. (Overheads are not absorbed into the cost of idle time.)

a) The expected cost of Product NP8

Rs.
Direct material M1 9.0
Direct material M2: 3 meters × 100/90 × Rs.1.80 6.0
Direct labour: 0.5 hours × 100/95 × Rs.19 10.0
Production overheads: 0.5 hours × Rs.60 30.0

SPOTLIGHT
Expected full cost per unit 55.0

b) Target cost for NP8

Rs.
Sales price 70.0
Minimum gross profit margin (30%) 21.0
Target cost 49.0

c) The size of the cost gap

Rs.

STICKY NOTES
Expected cost per unit (a above) 55.0
Target cost per unit (b above) (49.0)
Target cost gap 6.0

The company needs to identify ways of closing this cost gap.

3.2 Closing the target cost gap

Target costs are rarely achievable when the product is first manufactured, target cost may be much lower than
the current cost determined by current technology and processes.
Target costing should involve a multi-disciplinary approach to close the cost gap. The management accountant
should be involved in measuring estimated costs. Ways of reducing costs might be in product design and
engineering, manufacturing processes used, selling methods and raw materials purchasing. Ideas for reducing
costs can therefore come from the sales, manufacturing, engineering or purchasing departments.

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Common methods of closing the target cost gap are:

• To re-design products to make use of common processes and components that are already used in the
manufacture of other products by the company.
• To discuss with key supplier’s methods of reducing materials costs. Target costing involves the entire ‘value
chain’ from original suppliers of raw materials to the customer for the end-product, and negotiations and
collaborations with suppliers might be an appropriate method of finding important reductions in cost.
• To eliminate non-value added activities or non-value added features of the product design. Something is
‘non-value added’ if it fails to add anything in value for the customer. The cost of non-value added product
features or activities can therefore be saved without any loss of value for the customer. Value analysis may
be used to systematically examine all aspects of a product cost to provide the product at the required quality
at the lowest possible cost. This is the crux of target costing.
• Using standardized components will reduce the cost but it might impact the innovation element for the
AT A GLANCE

product
• To train staff in more efficient techniques and working methods. Improvements in efficiency will reduce
costs.
 Example 05:
Scriba Company (SC) is trying to launch a new product into a competitive market in North
America. Test marketing has revealed the following demand curve for the product:
P = 600 – 0.005Q
The estimated market for the product is 500,000 units per year. The company would like to
capture 10% of this market.
The company has established a cost card, based on 50,000 units of sales each year:
SPOTLIGHT

Rs.
Direct materials 100
Direct labour 30
Fixed overhead 70
Total cost 200

The company wishes to achieve a target profit of Rs. 10,000,000 for sales of this product per year.
a) What price will the company have to charge to capture its required market share and
what is the target unit cost to achieve its target profit?
STICKY NOTES

Tutorial note: The company will need to sell 50,000 units to gain 10% of the market.
The first step is to calculate the price that the item has to be sold at to achieve this market
share. This can be calculated by using the demand curve:
P = 600 – 0.005Q
P = 600 – (0.005 × 50,000)
P = 600 – 250
P = Rs.350
Since the company wishes to generate Rs. 10,000,000 profit in total, this equates to a
unit profit of:
Rs. 10,000,000 / 50,000 = Rs.200 per unit.
Once target price and target profit are available it is possible to calculate target cost:
Target price – target profit = target cost
Rs.350 – Rs.200 = Rs.150 per unit

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b) What is the size of the target cost gap and how might Scriba Company seek to close this
gap?
The target cost gap is calculated as:

Rs.
Target unit cost 150
Current unit cost 200
Target cost gap 50

Currently actual cost is one third higher than it should be to reach the target profit.
The company can undertake various strategies to bring costs down to target:

AT A GLANCE
Product redesign
This is the most effective way of reducing costs. Once the design of a product has been
finalized it is difficult to reduce significantly the majority of a product's cost. If PC has
not yet finalized the design and production of the product, it would be very worthwhile
them revisiting the design and production planning stages of the product lifecycle.
Outsourcing
PC could seek a deal with a third party manufacturer to make the product. Complete
outsourcing would not only remove the variable cost element of production but could
also lead to huge fixed cost savings. This is a course of action worth exploring by the
company. Suitable controls over any patents and quality would need to be in place,
together with guarantees of delivery times and the ability to be flexible with production
volumes.

SPOTLIGHT
Cost reduction
PC has to be careful with cost cutting. If applied badly the company could damage the
value of the product, leading to a fall in market price. Cost reduction, however, seeks
ways of lowering cost without reducing the value of the product. PC would seek to
preserve those features of the product key to its customer value whilst seeking to reduce
the cost of other areas. This, for instance, could involve cutting down on the quality of
packaging.

STICKY NOTES

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4. IMPLICATIONS AND ADVANTAGES

4.1 Advantages of target costing
There are several possible advantages from the use of target costing.
• It helps to improve the understanding within a company of product costs.
• It recognizes that the most effective way of reducing costs is to plan and control costs from the product
design stage onwards.
• It helps to create a focus on the final customer for the product or service, because the concept of ‘value’ is
important: target costs should be achieved without loss of value for the customer.
• It is a multi-disciplinary approach, and considers the entire supply chain. It could therefore help to promote
co-operation, both between departments within a company and also between a company and its suppliers
AT A GLANCE

and customers.
• Target costing can be used together with recognized methods for reducing costs, such as value analysis, value
engineering, just in time purchasing and production, Total Quality Management and continuous
improvement i.e. Kaizen costing.
• Target costing recognizes that process improvement and cost cutting is not a top down process but rather
one where workers who actually work on the product could come up with valuable suggestions

4.2 The implications of using target costing

The use of a target costing system has implications for pricing, cost control and performance measurement.
Target costing can be used with pricing policy for a company’s products or services. A company might decide on
a target selling price for either a new or an existing product, which it considers necessary in order to win market
SPOTLIGHT

share or achieve a target volume of sales. Having identified the selling price that it wants for the product, the
company can then work out a target cost.
Cost control and performance measurement has a different emphasis when target costing is used.
• Cost savings are actively sought and made continuously over the life of the product
• There is joint responsibility for achieving benchmark savings. If one department fails to deliver the cost
savings expected, other departments may find ways to achieve the savings
• Staff are trained and empowered to find new ways to reduce costs while maintaining the required quality.
Target costing is more likely to succeed in a company where a culture of ‘continuous improvement’ exists.
STICKY NOTES

4.3 Target costing and services

Target costing can be used for services as well as products. Services vary widely in nature, and it is impossible
to make general statements that apply to all types of services. However, features of some service industries that
make them different from manufacturing are as follows.
• Some service industries are labour-intensive, and direct materials costs are only a small part of total cost.
Opportunities for achieving reductions in materials costs may therefore be small.
• Overhead costs in many services are very high. Effective target costing will therefore require a focus on how
to reduce overhead costs.
A service company might deliver a number of different services through the same delivery system, using the
same employees and assets. Introducing new services or amendments to existing services therefore means
adding to the work burden of employees and the diversity or complexity of the work they do.
• A system of target costing therefore needs to focus on quality of service and value for the customer.
Introducing a new service might involve a loss of value in the delivery of existing services to customers. For
example, adding a new service to a telephone call center could result in longer waiting times for callers.

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• New services might be introduced without proper consideration being given to whether the service is
actually profitable. For example, a restaurant might add additional items to its menu, in the belief that the
only additional cost is the cost of the food. In practice there would be implications for the purchasing and
preparation of the food and possibly also for the delivery of food from the kitchen to the restaurant dining
area. New items added to the menu might therefore make losses unless all aspects of cost are properly
considered.
• When a single delivery system is used for services, the cost of services will consist largely of allocated and
apportioned overheads. For target costing to be successful, there must be a consistent and ‘fair’ method of
attributing overhead costs to services (both existing services and new services).
• Services might be provided by not-for-profit entities. For example, health services might be provided free of
charge by the government. When services are provided free of charge, target costing can be used for new
services. However, it is doubtful whether concepts of ‘target price’ and ‘target profit’ can be used by a not-
for-profit entity. This raises questions about how to decide what the target cost should be and will probably

AT A GLANCE
be some arbitrary figure.
 Example 06:
A company wishes to introduce a new product to the market.
The company estimates the market for the product to be 50,000 units.
The company uses target costing.
Current projected costs are as follows:

Rs. ‘000
Manufacturing cost

SPOTLIGHT
Bought in parts (100 components) 50,000
Direct labour (assembly of components) 5,000
10 hours × Rs. 500 per hour
Machine costs (750,000,000 ÷ 50,000) 15,000
Ordering and receiving 500
(500 orders × 100 components ×Rs. 500 per order) ÷ 50,000 units
Quality assurance (10 hours × Rs. 800 per hour) 8,000
Rework costs 1,000
10% (probability of failure) × Rs. 10,000 (cost of rework)

STICKY NOTES
Non-manufacturing costs
Distribution 10,000
Warranty costs
10% (probability of recall) × Rs. 15,000 (cost to correct) 1,500
91,000
Target selling price (Rs.) 100,000
Target margin 20%
Target profit (Rs.) 20,000
Target cost (Rs.) 80,000

The company has undertaken market research which found that several proposed features of the
new product were not valued by customers. Redesign to remove the features leads to a reduction
in the number of components down to 80 components and a direct material cost reduction of
12%.

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The reduction in complexity has other impacts:

Assembly time will be reduced by 20%.
Quality assurance will only require 6 hours.
The probability of a failure at the inspection stage will fall to 5%.
The probability of an after-sales failure will also fall to 5%.
Cost of warranty corrections will fall by Rs. 2,000.
Reduced weight of the product will reduce shipping costs by Rs. 1,000 per unit.
The revised projected costs are as follows:

Before After
AT A GLANCE

Rs. ‘000 Rs. ‘000

Manufacturing cost
Bought in parts (100 components) 50,000
Bought in parts (80 components with 12% reduction) 44,000
Direct labour (assembly of components)
10 hours × Rs. 500 per hour 5,000
8 hours (20% reduction) × Rs. 500 per hour 4,000
Machine costs (750,000,000 ÷ 50,000) 15,000 15,000
Ordering and receiving
SPOTLIGHT

500 orders × 100 components × Rs. 500 per order/50,000 units 500
500 orders × 80 components × Rs. 500 per order/50,000 units 400
Quality assurance
10 hours × Rs. 800 per hour 8,000
6 hours × Rs. 800 per hour 4,800
Rework costs
10% × Rs. 10,000 1,000
5% × Rs. 10,000 500
STICKY NOTES

Non-manufacturing costs
Distribution 10,000 9,000
Warranty costs
10% × Rs. 15,000 1,500
5% × Rs. 13,000 650
91,000 78,350
The target cost is achieved as it covers the target cost gap of Rs.
11,000,000.

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5. COMPREHENSIVE EXAMPLES
 Example 01
Pollar Co assembles and sells a range of components for motor vehicles and it is considering a
proposal to add a new component to its product range. This is a component for electric motor
cars, which has been given the code number NP19. The company sees an opportunity to gain
market share in a market that is expected to grow considerably over time, but already
competition from rival producers is strong.
Component NP19 would be produced by assembling a number of parts bought in from external
suppliers, and would then be sold on to manufacturers of electric cars. Pollar Co would use its
current work force of assembly workers to make the component. Production overheads are
currently absorbed into production costs on an assembly hour basis.

AT A GLANCE
Pollar Co is considering the use of target costing for the new component.
a) Brief description for how target costing might be used in the development and
production of a new product, is as follows
When a company identifies a product that it wishes to make and sell, it must design the
product in a way that will appeal to customers. A product design and specification must
be prepared, based on a combination of technical considerations and market research.
The component will also consider the price at which the product will be sold. The price
that can be obtained will often depend on the price of similar rival products in the
market, or on market research into customer attitudes to price. This may be called the
target price.

SPOTLIGHT
The company should decide on the profit margin it would like to make from the product.
The desired margin is subtracted from the target price to obtain a target cost.
A cost estimate is then produced for the product if it is made to the planned design and
specification and this cost estimate is compared with the target cost. If the cost estimate
is higher than the target cost, the difference is called a cost gap.
When a cost gap exists, the company should re-consider the planned product design and
look for ways of reducing the estimated cost to the level of the target cost – in other
words, the aim should be to eliminate the cost gap before actual production of the new
product item begins.
b) The benefits of adopting a target costing approach at an early stage in the development
of a new product would be

STICKY NOTES
Target costing should begin at an early stage in the product design and development
process because the opportunity for reducing production costs is greatest at the design
stage. If there is a cost gap, the product design can be amended. Because the measures
to reduce costs are made at an early stage, it is easier to find ways of reducing costs that
do not take away significant value for the customer. (If costs are reduced in a way that
reduces value for the customer, the target sales price will probably not be achievable.)
If target costing is introduced at a later stage in the product development, for example
after the material components, product design features and production methods have
been finally agreed, there are fewer opportunities for cost reduction.
Early adoption of target costing also helps to create a general awareness of the need for
cost control, and it increases the probability that new products will be developed at a
cost that allows the company to sell them at a competitive price whilst making an
acceptable level of profit. It can therefore be argued that target costing improves the
probability of commercial success (profitability) for new products.

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c) If a target costing approach is used and a cost gap is identified for component NP19,
possible measures that Pollar Co might take to reduce the gap are suggested below
If a cost gap is identified early in the product design process, the team responsible for
the product development (which should include marketing staff as well as production
and R&D staff) should consider every aspect of the product design and planned
production method to consider ways of reducing the costs.
The aim should be to make changes in a way that does not remove significant value for
the customer. For example, some aspects of the product, such as the materials or parts
used, could be changed and parts that are less expensive used instead. Some features of
the product design might be removed without loss of significant value.
As an alternative (or in addition to) looking for cheaper or fewer parts to the product,
cost savings might be achieved by identifying suppliers who are willing to provide parts
AT A GLANCE

at a lower cost. Prices from suppliers might be re-negotiated, such as the fixed costs of
buying part 1922 in batches.
It might be possible to change the production process in some ways to reduce the
assembly time required per unit, or different assembly workers might be hired at a lower
rate of pay per hour.
Finding ways of reducing overhead costs can be difficult because indirect costs cannot
be identified directly with specific products. However, if Pollar Co uses target costing for
new products, it would be surprising if it did not also employ methods of looking for
savings in overhead costs (such as total quality management and continuous
improvement).
Now if Cost information for the new component NP19 is as follows:
SPOTLIGHT

1. Part 1922: Each unit of component NP19 requires one unit of part 1922. These bought-
in parts are purchased in batches of 5,000 units, and the purchase cost is Rs.5.30 each
plus delivery costs of Rs. 2,750 per batch.
2. Part 1940: Each unit of component NP19 requires 20 cm of part 1940, which costs
Rs.2.40 per meter to purchase. However, it is expected that there will be some waste due
to cutting and that 5% of the purchased part will be lost in the assembly process.
3. Other parts for component NP19 will also be bought in and will cost Rs.7.20 per unit of
the component.
4. Assembly labour. It is estimated that each unit of component NP19 will take 25 minutes
STICKY NOTES

to assemble. Assembly labour, which is not in short supply, is paid Rs.24 per hour. It is
also estimated that 10% of paid labour time will be idle time.
5. Production overheads. Analysis of recent historical costs for production overheads
shows the following costs:
Total production Total assembly labour hours
overhead worked
Rs.
Month 1 912,000 18,000
Month 2 948,000 22,000
Fixed production overheads are absorbed at a rate per assembly hour based on normal
activity levels. In a normal year, Pollar Co works 250,000 assembly hours.
Pollar Co estimates that it needs to sell component NP19 at a price of no more than Rs.56
per unit to be competitive, and it is considered that an acceptable gross profit margin on
components sold by the company is 25%. Gross margin is defined as the sales price
minus the full production cost of sales.

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d) The expected cost per unit of component NP19 and any cost gap that exists, would be
calculated as follows.
Workings: production overhead costs
Production overhead costs can be estimated using the high-low method.

Production overheads hours Rs.

Month 1: Total cost 18,000 912,000
Month 2: Total cost 22,000 948,000
Therefore variable cost 4,000 36,000
Variable production overhead cost per hour = Rs. 36,000/4,000 = Rs.9

AT A GLANCE
Production overheads Rs.
Month 1: Total cost of 18,000 hours 912,000
Variable cost (18,000 × Rs.9) (162,000)
Therefore fixed costs per month 750,000
Annual fixed production overhead costs = Rs.750,000 × 12 = Rs.9,000,000.
Fixed production overhead absorption rate = Rs. 9,000,000 / 250,000 = Rs.36

Cost estimate and cost gap estimate

Cost per unit of NP19 Rs.
Part 1922: Rs.5.30 + (Rs.2,750/5,000) 5.850

SPOTLIGHT
Part 1940: 0.20 × Rs.2.40 × 100/95 0.505
Other parts 7.200
Assembly labour cost: 25/60 × Rs.24 × 100/90 11.111
Variable overheads: 25/60 × Rs.9 3.750
Fixed overheads: 25/60 × Rs.36 15.000
Total estimated production cost 43.416
Target cost (75% of Rs.56) 42.000
Cost gap (1.416)

STICKY NOTES
 Example 02:
Hi-tech Limited (HL) assembles and sells various components of heavy construction equipment.
HL is working on a proposal of assembling a new component EXV-99. Based on study of the
product and market survey, the following information has been worked out:
Projected lifetime sale of the component EXV-99 Units 500,000
Selling price per unit Rs. 11,000
Target gross profit percentage 40%
Information about cost of production of the new component is as follows:
i. One unit of EXV-99 would require:
Parts no. Net quantity Cost per unit/kg (Rs.)
XX 1 unit 2,350
YY 1.5 kg 1,400
ZZ 1 unit 1,200

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The above parts would be imported in a lot, for production of 1,000 units of EXV-99.
Custom duty and other import charges would be 15% of cost price. HL is negotiating
with the vendor who has agreed to offer further discount.
ii. On average, assembling of one unit of EXV-99 would require 1.8 skilled labour hours at
Rs. 200 per hour. The production would be carried out in a single shift of 8 hours. At the
start of each shift, set-up of machines would require 30 minutes. 6% of the input quantity
of YY and ZZ would be lost during assembly process.
iii. HL works at a normal annual capacity of 4,000,000 skilled hours. Actual production
overheads and skilled labour hours for the last two quarters are as under:

Quarter ended Total assembly hours Production overheads (Rs)

30-Sep-2014 950,000 65,600,000
AT A GLANCE

31-Dec-2014 1,050,000 68,000,000

iv. A special machine that would be used exclusively for the production of EXV-99 would be
purchased at a cost of Rs. 1,500,000.
From the above information, determination of the discount that HL should obtain in order to
achieve the target gross profit, would involve following:

Discount required from vendors to achieve target gross profit from Rs. in million
sale of EXV-99
Total cost estimated W.1 3,624.27
Target cost [11,000×60%×500,000] 3,300.00
SPOTLIGHT

Cost gap 324.27

Discount amount to be obtained from the vendor [324.27÷1.15] 281.97
Required discount % [(281.97÷2,931(W.1)×100 9.62%

W.1: Cost estimate for 500,000 units of EXV-99:

Material XX (2,350×500,000) 1,175.00
Material YY (incl. process loss at 6%)(1.5÷0.94×1,400×500,000) 1,120.00
Material ZZ (incl. process loss at 6%)(1.0÷0.94×1,200×500,000) 636.00
STICKY NOTES

2,931.00
Custom duty and other import charges [2,931×15%] 439.65

Direct labour:
Labour cost (1.8×200×500,000) 180.00
Labour set up cost (1.8÷7.5×0.5×200×500,000) 12.00
Production overheads:
Variable [1.80×24.00(W.2)×500,000] 21.60
Fixed [1.80×42.80(W.3)×500,000] 38.52
Fixed – cost of machine 1.50
Total cost 3,624.27

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W.2: Variable overhead rate per hour: Hours Rupees

Quarter ended 31 December 2014 1,050,000 68,000,000
Quarter ended 30 September 2014 (950,000) (65,600,000)
100,000 2,400,000
Variable overhead rate per hour (using high-low method)
(2,400,000÷100,000 24.00

W.3: Fixed overhead rate per hour:

Cost for the quarter ended 30 September 2014 65,600,000
Less: Variable cost [950,000×24(W.3)] (22,800,000)

AT A GLANCE
Fixed overheads per quarter 42,800,000
Fixed overheads per annum [42,800,000×4] 171,200,000
Fixed overhead rate per hour at normal capacity of 4,000,000 hrs.
[171,200,000÷4,000,000] 42.80

 Example 03:
Fintech company assembles and sells many types of radios. It is considering to apply target costing
for one of its new product which includes technology advancement. Following data is provided for
calculation of estimated cost of production.
i. Selling price of Rs. 2,500 has been set in order to compete with the similar radio on the
market that has comparable features to Fintech Company’s intended product. The board

SPOTLIGHT
have agreed that the acceptable margin (after allowing for all production costs) should be
20%.
ii. Component 1- Circuit board: These are bought in and cost Rs. 410 each. They are bought in
batches of 4,000 and additional delivery costs are Rs. 240,000.
iii. Component 2- Wiring: In an ideal situation 25cm of wiring is needed for each completed
radio. However, there is some waste involved in the process as wire is occasionally cut to
the wrong length or is damaged in the assembly process. Fintech company estimates that
2% of the purchase wire is lost in the assembly process. Wire costs Rs. 50 per meter to buy.
iv. Other material: Other material cost Rs. 810 per radio.
v. Assembly Labour: these are skilled people who are difficult to recruit and retain. Fintech

STICKY NOTES
company has more staff of this type than needed but is prepared to carry this extra cost in
return for the security it gives the business. It takes 30 minutes to assemble a radio and the
assembly workers are paid Rs. 1,260 per hour. It is estimated that 10% of hours paid to
assembly workers is for idle time.
vi. Production overheads: Recent historic cost analysis has revealed the following production
overhead data:
Total Total
Production assembly
Month overheads Rs. labour hours
Month 1 62,000,000 190,000
Month 2 70,000,000 230,000
Fixed production overheads are absorbed on an assembly hour basis based on normally
annual activity levels. In a typical year 2,400,000 assembly hours will be worked by Fintech
Company.

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 CHAPTER 12: TARGET COSTING CAF 8: CMA

The expected cost per Radio and any cost gap that exists, would be calculated as follows.
Workings: production overhead costs
Production overhead costs can be estimated using the high-low method.

Production overheads Hours Rs.

Month 1: Total cost 190,000 62,000,000
Month 2: Total cost 230,000 70,000,000
Therefore variable cost 40,000 8,000,000
Variable production overhead cost per hour = Rs. 8,000,000/40,000 = Rs. 200

Production overheads Rs.

AT A GLANCE

Month 1: Total cost of 190,000 hours 62,000,000

Variable cost (190,000 × Rs.200) (38,000,000)
Therefore fixed costs per month 24,000,000
Annual fixed production overhead costs = Rs.24,000,000 × 12 = Rs.288,000,000.
Fixed production overhead absorption rate = Rs. 288,000,000 / 2,400,000 = Rs.120

Cost estimate and cost gap estimate

Cost per unit of NP19 Rs.
Circuit board: Rs. 410 + (Rs.240,000/4,000) 470.00
Wiring: 0.25 × Rs. 50 × 100/98 12.76
SPOTLIGHT

Other parts 810.00

Assembly labour cost: 30/60 × Rs. 1,260 × 100/90 700.00
Variable overheads: 30/60 × Rs. 200 100.00
Fixed overheads: 30/60 × Rs.120 60.00
Total estimated production cost 2,152.76
Target cost (80% of Rs. 2,500) 2,000.00
Cost gap (152.76)
STICKY NOTES

426 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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STICKY NOTES

Target costing involves setting a target cost by subtracting a desired profit

margin from a Competitive Selling / market Price.

Target cost = Market Price – Desired Profit Margin

Target cost gap = Expected Cost – Target cost

AT A GLANCE
Cost gap can be bridged by effective cost reduction techniques, better
technology and Improved Processes

Advantages of target costing are proactive approach towards cost reduction,

achievement of desired profit and Quality product in accordance with
customer requirements

SPOTLIGHT
STICKY NOTES

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 CHAPTER 12: TARGET COSTING CAF 8: CMA
AT A GLANCE
SPOTLIGHT
STICKY NOTES

428 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 13

COST-VOLUME-PROFIT (CVP) ANALYSIS

AT A GLANCE
IN THIS CHAPTER Cost-volume-profit analysis is used to show how costs and
profits change with changes in the volume of activity.
AT A GLANCE

AT A GLANCE
Contribution margin facilitates analysis of cost-volume-profit. It
SPOTLIGHT is equal to sales minus variable expenses. It also allows
approximation of profit for decision making. The same can also
1. The nature of CVP analysis be used in planning and evaluating profit resulting from change
in volume or cost. Hence aids in selection of optimize product
2. Break-even analysis mix and sales target.
Break-even point is often required to calculate the volume of
3. Break-even charts and profit- sales required in a period (such as the financial year) to ‘break
volume charts even’ and make neither a profit nor a loss. The break-even point
can therefore be calculated by dividing the total contribution
4. Multi-product CVP analysis required (total fixed costs) by the contribution per unit.
5. Comprehensive Examples Margin of safety is normally maintained to overcome problems

SPOTLIGHT
of adverse impact of variables. It is calculated by taking
STICKY NOTES difference between budgeted sales and break-even sales. When
converted in percentage, it shows margin of safety ratio.

STICKY NOTES

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 CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

1. THE NATURE OF CVP ANALYSIS

1.1 Introduction to CVP analysis
CVP analysis stands for cost-volume-profit analysis’. It is used to show how costs and profits change with
changes in the volume of activity. CVP analysis is an application of marginal costing concepts. It is a study of
interrelationships between cost, volume and profit at different levels of activity.

1.2 Assumptions in CVP analysis

• Costs are either fixed or variable. The variable cost per unit is the same at all levels of activity (output
and sales). Whereas total fixed costs are a constant amount in each period. Fixed costs are normally
assumed to remain unchanged at all levels of output at least in the short term.
AT A GLANCE

• The contribution per unit is constant for each unit sold (of the same product).
• The sales price per unit is constant for every unit of product sold; therefore, the contribution to sales
ratio is also a constant value at all levels of sales.
• Production volume is equal to sales volume.

1.3 Contribution
Contribution is a key concept. Contribution is measured as sales revenue less variable costs.
Profit is measured as contribution minus fixed costs.
 Illustration:
SPOTLIGHT

Rs.

Sales (Units sold × sales price per unit) X

Variable costs (Units sold × variable cost price per unit) (X)

Contribution X

Fixed costs (X)

Profit X

Total contribution = Contribution per unit × Number of units sold.

STICKY NOTES

Many problems solved using CVP analysis use either contribution per unit (CPU) or the CS (Contribution/Sales)
ratio.
Contribution per unit
It is assumed that contribution per unit (sales price minus variable cost) is a constant amount over all sales
volumes.
 Example 01:
A company makes and sells a single product. The product has a variable production cost of Rs.8
per unit and a variable selling cost of Rs.1 per unit.
Total fixed costs (production, administration and sales and distribution fixed costs) are expected
to be Rs. 500,000.
The selling price of the product is Rs.16.

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The profit at sales volumes of 70,000, 80,000 and 90,000 units can be calculated as follows.

70,000 units 80,000 units 90,000 units

Rs. Rs. Rs.
Sales revenue (Rs.16/unit) 1,120,000 1,280,000 1,440,000
Variable cost (Rs.9/unit) (630,000) (720,000) (810,000)
Contribution (Rs.7/unit) 490,000 560,000 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000

Notes

AT A GLANCE
A loss is incurred at 70,000 units of sales because total contribution is not large enough to cover
fixed costs. Profit increases as sales volume increases, and the increase in profit is due to the
increase in total contribution as sales volume increases.
Somewhere between 70,000 and 80,000 there is a number of units which if sold would result in
neither a profit nor a loss. This is known as the breakeven position.
The contribution line could have been completed without calculating the sales and variable costs
by simply multiplying the quantity sold by the CPU.
Considering facts as before, calculating total contribution as the number of units × contribution
per unit, would be as follows:

Contribution per unit Rs.

SPOTLIGHT
Sales price per unit 16
Variable production cost per unit (8)
Variable selling cost per unit (1)
Contribution per unit 7

70,000 units 80,000 units 90,000 units

Rs. Rs. Rs.
70,000 × Rs. 7 per unit 490,000

STICKY NOTES
80,000 × Rs. 7 per unit 560,000
90,000 × Rs. 7 per unit 630,000
Fixed costs (500,000) (500,000) (500,000)
Profit/(loss) (10,000) 60,000 130,000

Contribution to sales ratio

Contribution to sales ratio, also known as C/S ratio or C/M ratio, represents proportionate relationship between
contribution and sales. This ratio can be shown in term of percentage by multiplying the relationship of
contribution and sales.


Formula:

CS ratio (contribution to Contribution per unit

sales ratio) Selling price per unit

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 CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

 Example 02:
Jimco makes and sells a single product, Product P. It is currently producing 112,000 units per
month, and is operating at 80% of full capacity. Total monthly costs at the current level of
capacity are Rs. 611,000. At 100% capacity, total monthly costs would be Rs. 695,000. Fixed costs
would be the same per month at all levels of capacity between 80% and 100%.
At the normal selling price for Product P, the contribution/sales ratio is 60%.
The variable cost per unit of Product P and total fixed costs per month would be calculated as:
100% capacity each month = 112,000 units/0.80 = 140,000 units.
Using high/low analysis:

units Rs.
AT A GLANCE

High: Total cost of 140,000 695,000

Low: Total cost of 112,000 611,000
Difference: Variable cost of 28,000 84,000

Therefore, variable cost per unit = Rs. 84,000/28,000 units = Rs.3.

Substitute in high equation Cost (Rs)

Total cost of 140,000 units 695,000
Variable cost of 140,000 units (× Rs.3) 420,000
SPOTLIGHT

Therefore fixed costs per month 275,000

In addition, if it is required to calculate the current normal sales price per unit, and the
contribution per unit at the price, the same would require following calculations:
Contribution/sales ratio = 60%
Therefore, variable cost/sales ratio = 40%
The normal sales price per unit = Rs.3/0.40 = Rs.7.50
The contribution per unit at the normal selling price is Rs.7.50 – Rs.3 = Rs.4.50 per unit.
Using data of Example 01:
The contribution to sales ratio is calculated as under.
STICKY NOTES

Contribution to sales ratio:

Contribution per unit/Selling price per unit = 7/16 = 0.4375

70,000 units 80,000 units 90,000 units

Rs. Rs. Rs.
Contribution (Rs.7/unit) 490,000 560,000 630,000
CS ratio ÷0.4375 ÷0.4375 ÷0.4375
Sales revenue 1,120,000 1,280,000 1,440,000

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CAF 8: CMA CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS

2. BREAK-EVEN ANALYSIS
2.1 Break-even analysis
CVP analysis can be used to calculate a break-even point for sales.
Break-even point is the volume of sales required in a period (such as the financial year) to ‘break even’ and make
neither a profit nor a loss. At this level, company would able to recover its fixed cost from its contribution.
Management might want to know what the break-even point is in order to:
• identify the minimum volume of sales that must be achieved in order to avoid a loss, or
• assess the amount of risk in the budget, by comparing the budgeted volume of sales with the break-even
volume.

AT A GLANCE
• estimate the inflow of cash required by the business before it starts generating its own funds.

2.2 Calculating the break-even point

The break-even point can be calculated using simple CVP analysis.
At the break-even point, the profit is Rs.0. If the profit is Rs.0, total contribution is exactly equal to total fixed
costs.
We therefore need to establish the volume of sales at which fixed costs and total contribution are the same
amount.
There are a number of methods of calculating the break-even point when the total fixed costs for the period are
known:

SPOTLIGHT
Method 1: Breakeven point expressed as a number of units.
The first method is to calculate the break-even point using the contribution per unit. This method can be used
where a company makes and sells just one product.
 Formula:
Breakeven point expressed as a number of units
Total fixed costs
Break-even point in sales units =
Contribution per unit

Total fixed costs are the same as the total contribution required to break even, and the break-even point can
therefore be calculated by dividing the total contribution required (total fixed costs) by the contribution per unit.

STICKY NOTES
It is important that in calculating the break-even point, we should take total variable cost for generating
contribution per unit. Contribution per unit is sales price less variable production cost and variable non-
production costs. Likely, total fixed cost used in above formula includes both production and non-production
fixed costs.
Once the breakeven point is calculated as a number of units it is easy to express it in terms of revenue by
multiplying the number of units by the selling price per item.
 Example 03:
A company makes a single product that has a variable cost of sales of Rs.12 and a selling price of
Rs.20 per unit. Budgeted fixed costs are Rs. 600,000.
What volume of sales is required to break even?
Method 1

Total fixed costs

Break-even point in sales units
Contribution per unit

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 CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

Contribution per unit = Rs.20 – Rs.12 = Rs.8.

Therefore, break-even point:

/
In units: Rs. 600,000 Rs.8 per unit = 75,000 units of sales.
In sales revenue: 75,000 units × Rs.20 per unit = Rs. 1,500,000 of sales.
Method 2: Breakeven point expressed in sales revenue
If we intend to calculate breakeven point in sales revenue, then fixed cost is divided by CS ratio. It gives value of
sales value to breakeven.
 Formula:

Breakeven point expressed in sales revenue

AT A GLANCE

Fixed costs
Break-even point in revenue =
Contribution to sales ratio

Once the breakeven point is calculated as an amount of revenue it is easy to express it as a number of units by
dividing the revenue by the selling price per item.
 Example 04:
A company makes a single product that has a variable cost of sales of Rs.12 and a selling price of
Rs.20 per unit. Budgeted fixed costs are Rs .600,000.
What volume of sales is required to break even?
SPOTLIGHT

Method 2

Total fixed costs

Break-even point in revenue =
C/S ratio

C/S ratio = Rs.8/Rs.20 = 40%

Therefore, break-even point:
In sales revenue = Rs. 600,000/0.40 = Rs. 1,500,000 in sales revenue.
In units = Rs. 1,500,000 ÷ Rs.20 (sales price per unit) = 75,000 units.
 Example 05:
STICKY NOTES

A soft drink company is planning to produce mineral water. It is contemplating the purchase of
plant with a capacity of 100,000 bottles a month. For the first year of operation the company
expects to sell between 60,000 to 80,000 bottles. The budgeted costs at each of the two levels are
as follows:

Rupees
Particulars 60,000 bottles 80,000 bottles
Material 360,000 480,000
Labour 200,000 260,000
Factory overheads 120,000 150,000
Administration expenses 100,000 110,000
The production would be sold through retailers who will receive a commission of 8% of sale price.

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In order to calculate, the break-even point in rupees and units, if the company decides to fix
the sale price at Rs. 16 per bottle, please see below working
Calculation of variable and fixed cost
Total costs Variable cost
Fixed
Per 60,000 cost
60,000 80,000 20,000
bottle bottles
bottles bottles bottles (A – E)
C/20,000 D×60,000
A B C D E F
Material 360,000 480,000 120,000 6.00 360,000 -
Labour 200,000 260,000 60,000 3.00 180,000 20,000

AT A GLANCE
Factory overheads 120,000 150,000 30,000 1.50 90,000 30,000
Administration
expenses 100,000 110,000 10,000 0.50 660,000 70,000
780,000 1,000,000 220,000 11.00 660,000 120,000

Rupees
Variable cost per bottle as above 11.00
Commission to retailers (8% of Rs. 16.00) 1.28
Variable cost per bottle 12.28

SPOTLIGHT
Contribution per bottle (16.00 – 12.28) Rs. 3.72
CS ratio (contribution to sales ratio 3.72/16.00) 23.25%

Fixed cost 120,000

Break-even point (bottles) = = = 32,258 bottles
Contribution per bottle 3.72
Break-even point in Rupees = 32,258 × 16.00 = Rs. 516,128

In addition, computation of the break-even point in units if the company offers a discount of

STICKY NOTES
10% on purchase of 20 bottles or more, assuming that 20% of the sales will be to buyers who
will avail the discount, would be as follows:

Average sales price (before discount) Rs.16.00

Average discount per unit @ 10% on 20% of sales = 0.02 of Rs. 16.00 (0.32)
New average sales price 15.68
Variable cost per bottle as above 11.00
Commission to retailers (8% of Rs. 15.68) 1.25
Variable cost per bottle 12.25

Contribution per bottle (15.68 – 12.25) Rs. 3.43

Fixed cost 120,000
Break-even point (bottles) = = = 34,985 bottles
Contribution per bottle 3.43

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 CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

2.3 Margin of safety

The margin of safety is the difference between:
• the budgeted sales (in units or Rs.) and
• the break-even amount of sales (in units or Rs.).
It is usually expressed as a percentage of the budgeted sales. However, it may also be measured as:
• a quantity of units (= the difference between the budgeted sales volume in units and the breakeven sales
volume), or
• an amount of sales revenue (= the difference between the budgeted sales revenue and the total sales revenue
required to break even).
It is called the margin of safety because it is the maximum amount by which actual sales can be lower than
budgeted sales without incurring a loss for the period. A high margin of safety therefore indicates a low risk of
AT A GLANCE

making a loss.
The margin of safety is often expressed as a percentage of budgeted sales.
 Formula:

Margin of safety (units)

Margin of safety = × 100
Budgeted sales (units)

Margin of safety (revenue)

Margin of safety = × 100
Budgeted revenue

 Example 06:
SPOTLIGHT

Saadat sons has recently prepared budget for next year, and following data is extracted:

Particulars
Budgeted sales 80,000 units
Selling price Rs. 8 per unit
Variable cost Rs. 4 per unit
Fixed cost (annual) Rs. 200,000

The breakeven point and margin of safety is calculated below.

STICKY NOTES

The break-even point = Rs. 200,000/(Rs.8 – 4) = 50,000 units.

The budgeted sales are 80,000 units.
Margin of safety = Budgeted sales – break-even sales
= 80,000 – 50,000 = 30,000 units
Margin of safety ratio = 30,000 units/80,000 units =37.5% of budgeted sales
This means that sales volume could be up to 37.5% below budget, and the company should still
expect to make a profit.
 Example 07:
Auto Industries Limited (AIL) manufactures auto spare parts. Currently, it is operating at 70%
capacity. At this level, the following information is available:

Break-even sales Rs. 125 million

Margin of safety Rs. 25 million
Contribution margin to sales 20%

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AIL is planning to increase capacity utilization through the following measures:

Selling price would be reduced by 5% which is expected to increase sales volume by 30%.
Increase in sales would require additional investment of Rs. 40 million in distribution vehicles
and working capital. The additional funds would be arranged through a long-term loan at a cost
of 15% per annum. Depreciation on distribution vehicles would be Rs. 5 million.
As a result of increased production, economies of scale would reduce variable cost per unit by
10%.
a) Preparing for profit statements under current and proposed scenarios would involve
following calculations:
Auto Industries Limited Current Proposed
Profit statement Rs. in million

AT A GLANCE
Sales (125+25), 150*1.30*.95 150.00 185.25
Variable cost of sales
(150*80%), 120*90%*1.3) (120.00) (140.40)
Contribution margin 30.00 44.85
Fixed cost (125×20%), 25+5+
(40*15%) (25.00) (36.00)
Net profit 5.00 8.85

b) In addition, computing break-even sales and margin of safety after taking the above
measures would have following results.

SPOTLIGHT
Break-even sales
(36÷[44.85/185.25]) 148.70
Margin of safety (185.25-148.70) 36.55

2.4 Target profit

CVP analysis is helpful tool for determining the sales level where target profit is achieved. Target profit is a profit
which a company intend to earn. For calculation of target profit, the assumption given in CVP analysis shall
continue.
The volume of sales required must be sufficient to earn a total contribution that covers the fixed costs and makes

STICKY NOTES
the target amount of profit. In other words, the contribution needed to earn the target profit is the target profit
plus the fixed costs.
The sales volume that is necessary to achieve this, is calculated by dividing the target profit plus fixed costs by
the contribution per unit in the usual way.
 Formula:

Volume target expressed in units

Total fixed costs + target profit
Volume target (units) =
Contribution per unit

Once the volume target is calculated as a number of units it is easy to express it in terms of revenue by multiplying
the number of units by the selling price per item.
Similarly, the sales revenue that would achieve the target profit is calculated by dividing the target profit plus
fixed costs by the C/S ratio.

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 CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

 Formula:

target expressed in sales revenue

Total fixed costs + target profit
target in revenue(Rs.) =
Contribution to sales ratio
Once the volume target is calculated as an amount of revenue it is easy to express it as a number of units by
dividing the revenue by the selling price per item.
 Example 08:
A company makes and sells a product that has a variable cost of Rs.5 per unit and sells for Rs.9
per unit.
Budgeted fixed costs are Rs. 600,000 for the year, and the company wishes to make a profit of at
AT A GLANCE

least Rs. 100,000.

The sales volume required to achieve the target profit can be found as follows:
The total contribution must cover fixed costs and make the target profit.
Rs.
Fixed costs 600,000
Target profit 100,000
Total contribution required 700,000
Contribution per unit = Rs.9 – Rs.5 = Rs.4.
Sales volume required to make a profit of Rs. 100,000:
SPOTLIGHT

= Rs. 700,000/Rs.4 per unit = 175,000 units.

Therefore, the sales revenue required to achieve target profit
175,000 units × Rs.9 = Rs. 1,575,000
Alternatively:
C/S ratio = 4/9
Sales revenue required to make a profit of Rs. 100,000
= Rs.700,000 ÷ (4/9) = Rs.1,575,000.
Therefore, the number of units required to achieve target profit
STICKY NOTES

Rs. 1,575,000 ÷ Rs. 9 = 175,000 units

 Example 09:
A company makes a single product that it sells at Rs. 80 per unit. The total fixed costs are Rs.
360,000 for the period and the contribution/sales ratio is 60%. Company intends to earn profit
of Rs. 240,000 in coming period.
The break-even point and sales level to earn target profit, would be calculated as follows
Contribution per unit = 60% × Rs.80 = Rs.48
Fixed costs = Rs. 360,000
Break-even point = Rs. 360,000/Rs.48 per unit = 7,500 units
Budgeted sales = 8,000 units
Target profit + Fixed costs = Rs. 240,000 + Rs. 360,000 = Rs. 600,000
Desired sales level = Rs. 600,000 / 48 = 12,500 units.

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CAF 8: CMA CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS

 Example 10:
A company makes and sells a single product. The following data relates to the current year’s
budget.

Sales and production (units): 8,000

Variable cost per unit: Rs. 20
Fixed cost per unit: Rs. 25
Contribution/sales ratio: 60%

The selling price next year will be 6% higher than the price in the current year budget and the
variable cost per unit will be 5% higher than in the current year budget. Budgeted fixed costs
next year will be 10% higher than budgeted fixed costs in the current year.

AT A GLANCE
If required to calculate (i) the budgeted contribution per unit and (ii) the budgeted total profit
for the current year following working is required
i.

Contribution/sales ratio 60%

Therefore, variable cost/sales ratio 40%
Variable cost per unit Rs. 20
Sales price Rs. (20/0.40) 50

SPOTLIGHT
Contribution per unit Rs. (50-20) 30
Budgeted contribution (8,000 x 30) Rs. 240,000
Budgeted fixed cost (8,000 x 25) Rs. 200,000
Budgeted profit, current year Rs. 40,000

However, for the next year, in order to calculate the number of units that will have to be sold in
order to achieve a total profit that is equal to the budgeted profit in the current year please see
below.
ii.

STICKY NOTES
Sales price next year (50 x 1.06) 53
Next year variable cost (20 x 1.05) 21
Therefore, contribution per unit (53-21) 32
Rupees
Target profit next year 40,000
Fixed cost next year (200,000 x 1.10) 220,000
Target contribution required 260,000
Hence, target sales (260,000 / 32) units 8,125

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 CHAPTER 13: COST-VOLUME-PROFIT (CVP) ANALYSIS CAF 8: CMA

 Example 11:
From the books and records of the CDE Company, the cost analyst determined that sales were
Rs. 1,000,000 and costs were as follows:

Description Variable cost Fixed cost Rs. Total cost Rs.

Rs.
Direct material 300,000 - 300,000
Direct labour 300,000 - 300,000
Factory overhead 80,000 50,000 130,000
Marketing expenses 70,000 30,000 100,000
Administrative expenses 50,000 20,000 70,000
AT A GLANCE

The company is considering two alternative proposals that would change certain cost items.
Proposal 1 would increase fixed cost by Rs. 10,000, with sales and variable costs remaining the
same. Proposal 2 would modernize present equipment at an annual increase of fixed costs of Rs.
25,000, with the expectation of saving the same amount in each of the direct materials and direct
labour costs.
Calculation of (i) current contribution to sales ratio; (ii) current break-even point; (iii) the break-
even point and profit, if proposal 1 is adopted and (iv) contribution to sales ratio, the breakeven
point and profit, if proposal 2 is adopted, are given below.
i. Current contribution to sales ratio

Rupees
SPOTLIGHT

Current sales 1,000,000

Less: Variable cost:
Direct material (300,000)
Direct labour (300,000)
Variable factory overhead (80,000)
Variable marketing expenses (70,000)
Variable administrative expenses (50,000)
(800,000)
STICKY NOTES

Contribution margin 200,000

CS ratio (200,000/1,000,000) x 100 20%

ii. Current breakeven point, is calculated below.

Rupees
Fixed cost
Factory overhead 50,000
Marketing expenses 30,000
Administrative expenses 20,000
100,000
CS ratio 20%
Breakeven point in Rs. (100,000/0.20) 500,000

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iii. Breakeven point and profit, if proposal 1 is adopted.

Rupees
CS ratio (see-i) 20%
Fixed cost as given in ii 100,000
Incremental fixed cost 10,000
Fixed cost under proposal 1 110,000
Hence breakeven point (110,000/20%) 550,000
Profit under proposal 1

AT A GLANCE
Contribution (see-i) 200,000
Less: Fixed cost (110,000)
Profit 90,000

iv. CS ratio, breakeven point and profit, if proposal 2 is adopted.

Rupees
Sales 1,000,000
Less: Variable costs:
Direct material (300,000-25,000) (275,000)

SPOTLIGHT
Direct labour (300,000-25,000) (275,000)
Variable factory overhead (80,000)
Variable marketing expenses (70,000)
Variable administrative expenses (50,000)
(750,000)
Contribution margin 250,000
CS ratio (250,000/1,000,000) 25%

STICKY NOTES
Fixed cost as given in ii 100,000
Incremental fixed cost 25,000
Fixed cost under proposal 1 125,000
Hence breakeven point (125,000/25%) 500,000
Profit under proposal 1
Contribution 250,000
Less: Fixed cost (125,000)
Profit 125,000

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 Example 12:
Entity E has monthly sales of Rs. 128,000, but at this level of sales, its monthly profit is only Rs.
2,000 and its margin of safety is 6.25%.
From the above information we can calculate (i) fixed costs as well as (ii) the level of monthly
sales needed to increase the monthly profit to Rs.5000 as follows:
i. The margin of safety is 6.25%. Therefore, the break-even volume of sales = 93.75% of
budgeted sales = 0.9375 × Rs. 128,000 = Rs. 120,000
Budget (Rs.) Break-even (Rs.)
Sales 128,000 120,000
Profit 2,000 0
AT A GLANCE

Total costs 126,000 120,000

This gives us the information to calculate fixed and variable costs, using high/low
analysis.
Rs. Revenue Rs. Cost
High: Total cost at 128,000 126,000
Low: Total cost at 120,000 120,000
Difference: Variable cost of 8,000 6,000
Therefore, variable costs = Rs. 6,000/Rs. 8,000 = 0.75 or 75% of sales revenue.
SPOTLIGHT

Substitute in high or low equation Cost (Rs.)

Total cost at Rs.128,000 revenue 126,000
Variable cost at Rs.128,000 revenue (× 0.75) (96,000)
Therefore fixed costs 30,000
Alternate approach
i. At sales of Rs. 128,000, profit is Rs .2,000.
The contribution/sales ratio = 100% – 75% = 25% or 0.25.
To increase profit by Rs. 3,000 to Rs. 5,000 each month, the increase in sales must
STICKY NOTES

be:
(Increase in profit and contribution) ÷ C/S ratio
= Rs. 3,000/0.25 = Rs. 12,000.
Sales must increase from Rs. 128,000 (by Rs. 12,000) to Rs. 140,000 each month.
Alternative approach to the answer
Rs.
Target profit 5,000
Fixed costs 30,000
Target contribution 35,000
C/S ratio 0.25
Therefore sales required (Rs.35,000/0.25) Rs.140,000

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 Example 13:
Octa Electronics produces and markets a single product. Presently, the product is manufactured
in a plant that relies heavily on direct labour force. Last year, the company sold 5,000 units with
the following results:
Rupees
Sales 22,500,000
Less: Variable expenses (13,500,000)
Contribution margin 9,000,000
Less: Fixed expenses (6,300,000)
Net income 2,700,000
a) Break-even point in rupees and the margin of safety would be:

AT A GLANCE
Break-even point in Rupees
Fixed Expense
Break even point in Rupees =
Contribution margin%
6,300,000
= = Rs. 15,750,000
40% (W-1)

W-1: Rupees
Selling price 22,500,000
Less: variable expense 13,500,000
Contribution margin 9,000,000

SPOTLIGHT
Contribution margin % 40% (9,000,000 / 22,500,000)

Margin of safety = Current sales - Break even sales

Current sales
= 22,500,000 - 15,750,000 = 30%
22,500,000
b) For the contribution margin ratio and the break-even point in number of units if variable
cost increases by Rs. 600 per unit can be calculated. The selling price per unit if the
company wishes to maintain the contribution margin ratio achieved during the previous

STICKY NOTES
year involves following working.

New CM Ratio Rupees

Selling price 22,500,000
Less: variable expense (16,500,000) (Rs. 13,500,000 + 5,000 x Rs. 600)
Contribution margin 6,000,000
Contribution margin % 26.67% (Rs. 6,000,000 / Rs. 22,500,000)
Break-even point in units
Fixed Expense
Break-even point in units =
Contribution margin per unit
6,300,000
= = 5,250 units
Rs. 6,000,000 ÷ 5,000

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New Selling Price

Let S = new selling price per unit
S= Variable Costs per unit + S x 0.4
S= (Rs. 16,500,000 ÷ 5,000) + 0.4S
0.6 S = Rs. 3,300
S= Rs. 5,500

c) The company is also considering the acquisition of a new automated plant. This would
result in the reduction of variable costs by 50% of the amount computed in (b) above
whereas the fixed expenses will increase by 100%. If the new plant is acquired, units
that will have to be sold next year to earn net income of Rs. 3,150,000 would be
AT A GLANCE

No. of units to be sold next year to earn a profit of Rs. 3,150,000

New contribution per unit
Selling price Rs. 4,500
Less: variable expenses Rs. 1,650 (Rs. 16,500,000 / 5,000 x 50%)
Contribution margin Rs. 2,850
New breakeven point in units to achieve net income of Rs. 3,150,000t
Fixed Expense + Target Profit
Break even point in units =
Contribution margin per unit
(Rs. 6,300,000 x 2) + Rs. 3,150,000
SPOTLIGHT

= = 5,526 units
Rs. 2,850

 Example 14:
The following information pertains to Hope Limited for the latest financial year:

Rupees
Sales price per unit 1,600
Direct labour per unit 240
Variable cost (other than direct labour) per unit 960
STICKY NOTES

Fixed cost (no labour cost included) 850,000

Volume of sales and production was 6,000 units which represent 80% of normal capacity. The
management of the company is planning to increase wages of direct labour by 15% with effect
from next financial year.
i. In order to calculate the number of units to be sold to maintain the current profit if the sales
price remains at Rs. 1,600 and the 15% wage increase goes into effect, please see below:

Units to be sold to maintain the current profit: Rs.

Sales (6,000 units × 1,600) 9,600,000
Variable cost [6,000 × (960+240)] (7,200,000)
Contribution margin A 2,400,000
Revised contribution margin per unit [1,600–960–(240×1.15)] B 364
Units to be sold A÷B 6,593 Units

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ii. The management believes that an additional investment of Rs. 760,000 in machinery (to be
depreciated at 10% annually) will increase normal capacity by 25%. Determine the selling
price in order to earn a profit of Rs. 2 million assuming that all units produced at increased
capacity can be sold and that the wage increase goes into effect.

Selling price per unit to earn a profit of Rs. 2 million:

Revised capacity (6,000 ÷ 0.8 × 1.25) Units 9,375
Revised fixed cost 850,000 + (760,000 × 10%) Rs. 926,000
926,000+2,000,000
New selling price = + (240×1.15) + 960 Rs. 1,548
9,375

AT A GLANCE
SPOTLIGHT
STICKY NOTES

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3. BREAK-EVEN CHARTS AND PROFIT-VOLUME CHARTS

3.1 Break-even chart
A break-even chart is a chart or graph showing, for all volumes of output and sales:
• total costs, analyzed between variable costs and fixed costs
• sales
• profit (= the difference between total sales and total costs)
• the break-even point (where total costs = total sales revenue, and profit = 0).
The concept of a break-even chart is similar to a cost behaviour chart, but with sales revenue shown as well.
If the chart also indicates the budgeted volume of sales, the margin of safety can be shown as the difference
AT A GLANCE

between the budgeted volume and the break-even volume of sales.

The break-even chart can be prepared in two ways, first is conventional break-even chart and second is
contribution break-even chart.
• In the conventional break-even chart, breakeven point is calculated with intersection of total cost and total
revenue curves. The fixed costs are represented by the horizontal line of dashes as it remains same amount
at all volumes of sales. Variable costs are shown on top of fixed costs, by taking difference between total cost
curve and fixed cost curve. At point 0, the variable cost is also 0. But as volume increased the total variable
cost shows tendency of being increased. The gap between breakeven point and budgeted sales indicates the
margin of safety.
• In contribution break-even chart, breakeven point is calculated in similar way as discussed in conventional
breakeven chart. However, fixed cost horizontal line is not shown in it, rather total variable cost curve is
SPOTLIGHT

calculated. The difference between the total cost curve and variable cost curve indicates the fixed cost. We
can measure the fixed cost at any level of activity, as it shows equal. The margin of safety can be calculated
in same way as indicated in conventional break-even chart.
Because the sales price per unit is constant, the total sales revenue line rises in a straight line from the origin of
the graph (i.e. from x = 0, y = 0).
Conventional break-even chart:
 Illustration 01:
Rs.
Sales
STICKY NOTES

Break-even PROFIT
point Total costs

Variable
costs

Fixed LOSS Margin of

costs safety

Break-even Budgeted Sales volume

point sales

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 Illustration 02:
Rs.
Sales

Break-even PROFIT
point Total costs

Contribution
Fixed LOSS
costs Margin of
Variable safety

AT A GLANCE
costs
Break-even Budgeted Sales volume
point sales

Points to note
You should be able to identify the following points on these charts.
• The break-even point is shown on both charts as the volume of sales at which total revenue equals total costs.
• In the second chart, total contribution at the break-even point is shown as exactly equal to fixed costs.
• If budgeted sales are shown on the chart, the margin of safety can also be extracted, as the difference between
budgeted sales and the break-even point.

SPOTLIGHT
3.2 Profit/volume chart (P/V chart)
A profit volume chart (or P/V chart) is an alternative to a break-even chart for presenting CVP information. It is
a chart that shows the profit or loss at all levels of output and sales.
 Illustration:

Rs.
profit
Margin of
safety Profit

STICKY NOTES
Budgeted Sales
sales
Fixed
costs Break-even
point

Rs.
loss

At Rs.0 sales, there is a loss equal to the total amount of fixed costs. The loss becomes smaller as sales volume
increases, due to the higher contribution as sales volume increases. Break-even point is then reached and profits
are made at sales volumes above the break-even point.
We could draw a line on the graph to show fixed costs. This line should be drawn parallel to the x axis, starting
at the loss (= total fixed costs) at Rs.0 sales. By drawing this line for fixed costs, total contribution would be shown
as the difference between the line showing the profit (or loss) and the line for the fixed costs.

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 Example 15:
You are a management accountant for a business that develops specialist computers. You are
consulted to investigate the viability of marketing a new type of hand-held computer.
With the help of the manager of research and development, the production manager, the buyer
and the sales manager, you have made the following estimates of annual sales and profitability:

Sales Profit/(loss)
units Rs.
12,000 (30,000)
15,000 150,000
AT A GLANCE

18,000 330,000

The selling price will be Rs.150.

A traditional break-even chart using the information given above will be prepared as follows:
SPOTLIGHT

Workings
Sales
Sales Profit
STICKY NOTES

(at Rs.150)
units Rs. Rs.
18,000 2,700,000 330,000
12,000 1,800,000 (30,000)
Difference 6,000 900,000 360,000

An increase in sales from 12,000 units to 18,000 units results in an increase of Rs. 900,000 in
revenue and Rs. 360,000 in contribution and profit.
From this, we can calculate that the contribution is Rs.60 per unit (Rs. 360,000/6,000) and the
C/S ratio is 0.40 (Rs. 360,000/Rs. 900,000). Variable costs are therefore 0.6 or 60% of sales.
To draw a break-even chart, we need to know the fixed costs.

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Substitute in high or low equation

When sales are 18,000 units: Rs.
Sales (at Rs.150 each) 2,700,000
Variable cost (sales × 60%) 1,620,000

Contribution (sales × 40%) 1,080,000

Profit 330,000
Therefore fixed costs 750,000
When sales are 18,000 units: Rs.

AT A GLANCE
Fixed costs 750,000
Variable cost (see above) 1,620,000
Total costs 2,370,000

In addition, the margin of safety if annual sales are expected to be 15,000 units can be calculated
as
Break-even point = Fixed costs ÷ C/S ratio
= Rs. 750,000/0.40 = Rs. 1,875,000
Break-even point in units = Rs. 1,875,000/Rs.150 per unit = 12,500 units.

SPOTLIGHT
If budgeted sales are 15,000 units, the margin of safety is 2,500 units (15,000 – 12,500).
This is 1/6 or 16.7% of the budgeted sales volume.

STICKY NOTES

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4. MULTI PRODUCT CVP ANALYSIS

4.1 Breakeven analysis – Contribution per batch or per unit
The techniques for contribution margin can be extended to multi-product analysis. This approach is applied in
situation when more than one products are produced generating different CS ratios. However, fixed cost relating
to these products is common. In order to cater the complexity, one more assumption is added which is “There
shall be constant sales mix”. In simple words, the ratio of sales during specific period shall be same.
This assumption is that products are sold in a set ratio which does not change with volume. This assumption
allows us to calculate a weighted average contribution per unit or batch and/or CS ratio which can be used to
solve breakeven, margin of safety and target profit problems.

Formula: Breakeven point for batches

AT A GLANCE

Total fixed costs

Break-even point in batches =
Contribution per batch

Total fixed costs

Break-even point in revenue =
CS ratio for the batch

 Example 16:
The following budget information refers to the two products of a company.

X Y
SPOTLIGHT

Sales price per unit 100 120

Variable cost per unit (75) (111)
Contribution per unit 25 9
Sales volume 15,000 5,000
Sales mix 3 1
CS ratio 0.25 0.075
Fixed costs 315,000

In calculating the number of units at which the company will breakeven using the average
STICKY NOTES

contribution per batch and the average contribution per unit and the revenue, please see below
Average contribution per batch
X and Y are sold in the ratio of 3:1 (15,000:5,000) therefore the average contribution per batch
is: (3× 25) + (1×9) = Rs.84
Breakeven as a number of batches is given by:
Fixed costs/Contribution per batch = Rs. 315,000/Rs.84 = 3,750 batches

Units
Batches X Y
(3 per batch) (1 per batch)
Breakeven 3,750 11,250 3,750
Revenue per unit Rs.100 Rs.120
Revenue 1,125,000 450,000 = 1,575,000

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4.2 Breakeven analysis – C/S ratio

 Example 16 (Contd.):
The following budget information refers to the two products of a company.

X Y
Sales price per unit 100 120
Variable cost per unit (75) (111)
Contribution per unit 25 9
Sales volume 15,000 5,000
Sales mix 3 1

AT A GLANCE
CS ratio 0.25 0.075
Fixed costs 315,000

For breakeven revenue using the average C/S ratio and the unit sales first average contribution
and revenue per batch (as before) would be calculated that is
Average contribution per batch (as before): (3× 25) + (1×9) = Rs.84
Average revenue per batch: (3× 100) + (1×120) = 300 + 120 = Rs.420
Note that 300 out of every 420 will be revenue from selling X and 120 from selling Y.
Weighted average CS ratio: Rs.84/Rs.420 = 0.20
Breakeven in revenue is given by

SPOTLIGHT
Fixed costs/CS ratio = Rs. 315,000/0.20 = Rs. 1,575,000

Units
Revenue X (300/420) Y (120/420)
Breakeven 1,575,000 Rs.1,125,000 Rs.450,000
Revenue per unit ÷ Rs.100 ÷ Rs.120
Units 11,250 3,750 = 15,000 units

4.3 Margin of safety – Multi product

STICKY NOTES
The margin of safety is calculated in the same way as for single products by comparing the budgeted activity level
to the breakeven. The breakeven point can be compared to the budgeted activity level using batches, units or
revenue.
This will be illustrated using the previous example.
 Example 16 (Contd.):
Margin of safety
Batches Units Revenue
Budgeted activity 5,000 20,000 2,100,0001
Breakeven point 3,750 15,000 1,575,000
Margin of safety 1,250 5,000 525,000
Margin of safety as percentage of sales 25% 25% 25%
1 Budgeted revenue = (Rs.100 × 15,000) + (Rs.120 × 5,000) = Rs.2,100,000

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4.4 Target profit

The target profit is calculated in the same way as for single products. The necessary contribution to earn the
target profit is the target profit plus the fixed costs. The activity level required to achieve the necessary
contribution may be found using contribution per unit, contribution per batch or the CS ratio.
 Example 16 (Contd.):
The company wishes to make a profit of Rs. 189,000 on a fixed cost base of Rs. 315,000
Average contribution per batch = Rs.84
Average contribution per unit = Rs.21
Weighted average CS ratio = 0.20
Target profit
AT A GLANCE

Batches Units Revenue

Target profit (Rs.189,000 + Rs.315,000) Rs.504,000 Rs.504,000 Rs.504,000
Contribution per batch Rs.84
Contribution per unit Rs.21
C/S ratio 0.20
6,000 24,000 Rs.2,520,000
Sales of X (×3 and × ¾) 18,000 18,000
Sales of Y (×1 and × ¼) 1,000 6,000
SPOTLIGHT

Proof of revenue

X Y
Units to be sold 18,000 6,000
Selling price per unit 100 120
Revenue 1,800,000 720,000 Rs.2,520,000
STICKY NOTES

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5. COMPREHENSIVE EXAMPLES
 Example 01:
Sword Leather Limited (SLL) produces and sells shoes. The following information pertains to its
latest financial year:

Rs. in million
Sales (62,500 pairs) 187.5
Fixed production overheads 35.0
Fixed selling and distribution overheads 10.0

AT A GLANCE
Variable production cost (in proportion of 40:35:25 for material,
60% of sale
labour and overheads respectively)
Variable selling and distribution cost 15% of sale

To increase profitability, SLL has decided to introduce new design shoes and discontinue the
existing deigns. In this regard it has carried out a study whose recommendations are as follows:
i. Replace the existing fully depreciated plant with a new plant at an estimated cost of Rs.
50 million. The new plant would:
• reduce material wastage from 10% to 5%;
• decrease direct wages by 5%; and
• increase variable overheads by 6% and fixed overheads by Rs. 15 million

SPOTLIGHT
(including depreciation on the new plant).
ii. Improve efficiency of the staff by paying 1% commission to marketing staff and annual
bonus amounting to Rs. 1.5 million to other staff.
iii. Introduction of new designs would require an increase in variable selling and
distribution cost by 2%.
iv. Sell the newly designed shoes at 10% higher price.
v. Maintain finished goods inventory equal to one month’s sale.
Required: Compute the budgeted production for the first year if the budgeted sale has
been determined with the objective of maintaining 25% margin of safety on sale.
 Solution

STICKY NOTES
Budgeted production of the new design shoes for the first year Rs. per unit
Sales 187,500,000÷62,500×1.1 (A) 3,300.00
Variable costs:
Direct material (3,000×0.6×0.4)÷1.1×1.05 (687.27)
Direct wages 3,000×0.6×0.35×0.95 (598.50)
Production overheads 3,000×0.6×0.25×1.06 (477.00)
Selling and distribution 3,000×0.15×1.02 (459.00)
Sales commission to marketing staff 3,300×1% (33.00)
(B) (2,254.77)
Contribution margin (C) 1,045.23
Total fixed cost (Rs.) (35+10+15+1.5) (D) 61,500,000

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Budgeted production: No. of pairs

Break-even sales D÷C (E) 58,839
Margin of safety on sales at 25% E÷0.75×0.25 19,613
Budgeted sales (F) 78,452
Inventory - average one month's sales F ÷12 6,538
Budgeted production 84,990

 Example 02:
The manager of a small printing business has received enquires about printing of three different
types of advertising leaflet, type A, type B and type C. Selling price and cost information for these
AT A GLANCE

leaflets is shown below:

Leaflet type: Type A Type B Type C

Rs. Rs. Rs.
Selling price, per 1,000 leaflets 300 660 1,350
Estimate printing costs:
Variable costs, per 1,000 leaflets 120 210 390
Specific fixed costs per month 7,200 12,000 28,500

In addition to the specific fixed costs, Rs. 12,000 per month will be incurred in general fixed costs.
SPOTLIGHT

Required
Assuming that fixed orders have been received to print 50,000 of Leaflet A and 50,000 of Leaflet
B each month, calculate the quantity of Leaflet C that must be sold to produce an overall profit,
for all three leaflets combined, of Rs. 5,400 per month.
Solution
Tutorial note: The volume of sales required to achieve a target profit is an application of CVP
analysis.

Rs. Rs.
Target profit 5,400
STICKY NOTES

General fixed costs 12,000

Specific fixed costs:
Leaflet Type A 7,200
Leaflet Type B 12,000
Leaflet Type C 28,500
Total contribution required 65,100
Contribution from:
50,000 Leaflets Type A: (50 × (300 – 120)) 9,000
50,000 Leaflets Type B: (50 × (660 – 210)) 22,500
31,500
Contribution required from Leaflets Type C 33,600

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The contribution from Leaflets Type C is Rs. (1,350 – 390) = Rs.960 per 1,000 leaflets.
The sales quantity of Leaflets Type C required to achieve a target profit of Rs. 5,400 each month
is therefore Rs. 33,600/Rs.960 per 1,000 = 35,000 leaflets.
 Example 03:
Himalayan Rivers (HR) is planning to install a new plant. Planned production from the plant for
the next year is 150,000 units. Cost of production is estimated as under:
Rs. In million
Direct material 6.00
Direct Labour 5.00
Production overheads 10.29

AT A GLANCE
Production overheads include the following:
i. Factory premises would be acquired on rent at a cost of Rs. 1.8 million per annum.
ii. Indirect labour has been budgeted at 30% of direct labour cost, 50% of which would be
fixed.
iii. Depreciation of the plant would be Rs. 0.5 million.
iv. Total power and fuel cost has been budgeted at Rs. 3 million. 80% of power and fuel cost
would vary in accordance with the production.
v. All remaining production overheads are variable.
The sales and marketing budget includes the following:

SPOTLIGHT
i. Employment of two sales representatives at a monthly salary of Rs. 25,000 each and a
sales commission of 2% on sales achieved.
ii. Hiring of a delivery van at Rs. 70,000 per month.
iii. (iii) Launching an advertisement campaign at a cost of Rs. 1.5 million
Required
Calculate the breakeven sales revenue and quantity for the next year if HR expects to earn a
contribution margin of 40% on sales, net of 2% sales commission.
Solution

STICKY NOTES
Break-even sales revenue and quantity Rs. in million
Break even sales revenue 6.59(W-2)÷[(100–2)×40%] 16.81
Break even sales quantity [16,810,000÷200(W.1)] Units 84,050
W-1: Sales price per unit Rs. in million
Variable overheads (excluding 2% sales commission):
Direct material 6.00
Direct labour 5.00
Variable overheads 10.29-3.65 (W-2) 6.64
17.64
Variable overheads % to sales [100-(100-2)×40%]–2% 58.80%
Sales price per unit (17.64÷58.8%)÷150,000 Rs. 200.00
W-2: Fixed cost Rs. in million

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Production overheads:
Rent - factory premises 1.80
Indirect labour 5×30%×50% 0.75
Depreciation of plant 0.50
Power and fuel 3×20% 0.60
3.65
Sales and marketing expenses:
Employees’ salaries 25,000×2×12 0.60
Delivery van 70,000×12 0.84
Advertisement campaign 1.50
AT A GLANCE

Total fixed overheads 6.59

 Example 04:
Following information has been extracted from the projected results of Saffron Limited (SL) for
the year ending 31 March 2019:
Sales Rs. 160 million
Contribution margin 30%
Margin of safety 25%

Information for the next year ending 31 March 2020:

SPOTLIGHT

i. SL is planning to increase its sales by reducing sales prices by 5% and launching a sales
campaign at a cost of Rs. 5 million.
ii. Cost efficiency measures planned for the next year are expected to reduce variable cost
per unit by 10%.
iii. Inflation impact on all costs would be 8%, except depreciation. At present, depreciation
is 40% of the total fixed cost.
iv. Margin of safety would be maintained at 25%.
Required
a) Prepare a budgeted statement of profit or loss for the year ending 31 March 2020 based
on the above projections.
STICKY NOTES

b) The percentage increase in sales volume.

 Solution
a)

Budgeted statement of profit or loss for the year ending 31 March 2020
Rs. in million
Sales 152(W-2)÷43.14×56.97 200.73
Variable cost Balancing (143.76)
Contribution margin (CM) (at a safety margin of 25% and fixed cost of 56.97
Rs. 42.73 million) [42.73(W-1)÷0.75]
Fixed cost (W-1) (42.73)
Net profit 14.24
W-1: Fixed Cost

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- For 2019 (160×0.3×0.75) 36.00

- For 2020:
Depreciation (36×0.4) 14.40
Other fixed cost (36-14.40)×1.08+5 28.33
42.73
W-2: CM on revision of sales price and variable cost Rs. in million
Sales (160×0.95) 152.00
Variable cost (160×0.7)×1.08×0.9 (108.86)
Contribution margin 43.14

AT A GLANCE
b) The percentage increase in sales volume would be:
Increase in sales volume %:
Budgeted sales of 2019-20 at 2018-19 prices (200.73÷0.95) 211.29
Increase in sales volume (%) (211.29–160)÷160 32.06%

 Example 05:
Digital Industries Limited (DIL) incurred a loss for the year ended 30 June 2017 as it could
achieve sales amounting to Rs. 89.6 million which was 80% of the break-even sales. Contribution
margin on the sales was 25%. Variable costs comprised of 45% direct material, 35% direct labour
and 20% overheads.

SPOTLIGHT
During a discussion on the situation, the Marketing Director was of the view that no increase in
sales price was possible due to severe competition. However, sales volume can be increased by
reducing prices. The Production Director was of the view that since the plant is quiet old, the
production capacity cannot be increased beyond the current level of 70%.
Accordingly, the management has developed the following plan:
A new plant would be installed whose capacity would be 20% more than installed capacity of the
existing plant. The cost and useful life of the plant is estimated at Rs. 30 million and 10 years
respectively. The funds for the new plant would be arranged through a long-term bank loan at a
cost of 10% per annum. Capacity utilization of 85% is planned for the first year of the operation.
The new plant would eliminate existing material wastage which is 5% of the input and reduce

STICKY NOTES
direct labour hours by 8%.
The existing plant was installed fifteen years ago at a cost of Rs. 27 million. It has a remaining
useful life of three years and would be traded in for Rs. 2 million.
DIL depreciates its fixed assets on straight line basis over their estimated useful lives.
To sell the entire production, selling price would be reduced by 2%.
Material would be purchased in bulk quantity which would reduce direct material cost by 10%.
Direct wages would be increased by 8% which would increase production efficiency by 10%.
Impact of inflation on overheads would be 4%.
Required:
Compute the projected sales for the next year and the margin of safety percentage after
incorporating the effect of the above measures.

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 Solution
Digital Industries Limited
Projected sales and margin of safety % for the next year

Rs. in million
Projected sales for the next year (89.6÷0.7)×1.2×0.85×0.98 (A) 127.95
Margin of safety % to projected sales (A-B)÷A×100 8.66%
Break-even sales [A÷ (A-C) × D] (B) 116.87
Variable cost:
Variable cost – 2017 level of 75% [127.95(A)÷0.98]×0.75 97.92
AT A GLANCE

Variable cost on incorporating impact of changes:

Direct material (97.92×0.45)×0.95×0.9 37.67
Direct labour (97.92×0.35)×0.92×0.9×1.08 30.65
Overheads (97.92×0.20)×1.04 20.37
Variable cost – projected (C) 88.69

Fixed cost - projected:

Fixed cost – 2017 (equal to CM for break-even sales) (89.6÷0.8) ×0.25 28.00
SPOTLIGHT

Depreciation - old plant 27÷(15+3) (1.50)

26.50
Impact of 4% inflation 26.5×4% 1.06
Depreciation - new plant 30÷10 3.00
Long-term loan interest at 10% (30-2) ×10% 2.80
Loss on Disposal (4.5-2) 2.50
(D) 35.86

 Example 06:
STICKY NOTES

Washington Limited (WL) is a listed company having paid-up capital of Rs. 140 million. WL deals
in the manufacturing of washing machines. Following are the extracts from the budgeted
statement of profit or loss for the year ending 31 December 2018:

Rs. in ‘000
Sales revenue (Rs. 10,000 per unit) 168,000
Cost of goods sold (including fixed cost of Rs. 21.2 million) (127,000)
Gross profit 41,000
Operating expenses (including fixed cost of Rs. 4.5 million) (16,000)
Profit before taxation 25,000
Taxation @ 30% (7,500)
Profit after taxation 17,500

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Additional information:
i. An analysis of actual results for the first two months of the year 2018 shows that:
• Due to change in import duty structure, imported products have become available
in the market at much cheaper prices. Consequently, it was decided to reduce the
selling price to Rs. 9,500 per unit with effect from 1 January 2018.
• 1,500 washing machines were sold during the period.
• Due to increase in raw material prices with effect from 1 January 2018, variable
cost of sales has increased by 5%.
ii. To boost the sales, WL has decided to launch a promotion campaign at an estimated cost
of Rs. 5 million.

AT A GLANCE
iii. The directors of WL wish to pay 5% dividend to its ordinary shareholders. However,
according to the agreement with the bank, WL cannot pay dividend exceeding 80% of its
profit after taxation.
Required
Calculate the minimum number of units to be sold in remaining 10 months to enable WL to pay
the desired dividend.
 Solution

Washington Limited Rupees

Dividend needs to pay 140,000,000×5% 7,000,000
Profit after tax (required) (7,000,000÷0.8) 8,750,000

SPOTLIGHT
Required contribution margin in remaining 10 months
Profit before tax (required) 8,750,000 /70% 12,500,000
Add: Fixed cost (Jan - Dec) (21,200,000+4,500,000) 25,700,000
Add: Promotion campaign Given 5,000,000
Contribution margin required 43,200,000
Contribution margin recovered in 1st two months (W-1) (3,304,464)
Required contribution in remaining 10 months 39,895,536

STICKY NOTES
Rupees
Forecasted sales revenue to earn in next 10 months 172,037,670
39,895,536/23.19%(W-1)
Number of units to be sold 172,037,670/9,500 18,109
W-1: Actual results of first two months of 2018
Sales 1,500×9,500 14,250,000.00
Variable manufacturing cost 9,918,750.00
(127,000,000–21,200,000)/ 16,800*×1.05×1,500
Variable operating cost (16,000,000–4,500,000)/16,800×1,500 1,026,785.71
Contribution margin 3,304,464.29
Contribution margin % 23.19%
*Budgeted number of units to be sold 168,000,000/10,000 16,800

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 Example 07:
Basketball (Private) Limited (BPL) is in the process of planning for the next year. BPL is currently
operating at 70% of the production capacity. The management wants to achieve an increase of
Rs. 36 million in profit after tax of the latest year.
The summarized statement of profit or loss for the latest year is as follows:

Rs. in million
Sales 567
Cost of sales (60% variable) (400)
Gross profit 167
AT A GLANCE

Operating expenses (40% variable) (47)

Profit before tax 120
Tax (25%) (30)
Profit after tax 90

Following are the major assumptions/projections for the next year’s budget:
i. Selling price of all products would be increased by 8%. However, to avoid any adverse
impact of price increase, 10% discount would be offered to the large customers who
purchase about 30% of the total sales. Additionally, distributor commission would be
increased from 2% to 3% of net selling price.
SPOTLIGHT

ii. Average variable costs other than distributor commission are projected to increase by
4% while fixed costs other than depreciation are projected to increase by 5%.
iii. Depreciation for the latest year was Rs. 90 million and would remain constant.
Required:
(a) Compute the amount of sales required to achieve the target profit.
(b) Determine the production capacity that would be utilized to achieve the sales as computed in
(a) above.
 Solution
STICKY NOTES

Basketball Private Limited Rs. in million

Budgeted sales to achieve target profit
[361.11m (W-1)/53.7%(W-2)] 672.46
W-1: Contribution margin required in next year
Total existing fixed cost including depreciation
(400m×40%)+(47m×60%) 188.20
Add: Increase in fixed costs in next year (188.2m–90m)×5% 4.91
Add: Target profit for the next year (90m+36m)÷75% 168.00
Total contribution margin required in next year 361.11

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W-2: Budgeted Contribution margin (next year)

Budgeted sales [567m×1.08] 612.36
Less: Discount @ 10% on 30% of sales [612.36m×10%×30%] (18.37)
Net average sales 593.99
Less: Distributor commission on net average sales [593.99m×3%] (17.82)
Less: Variable cost [247.46m (W-3)×1.04] (257.36)
Budgeted contribution margin 318.81
Budgeted contribution margin ratio (318.81m/593.99m) 53.7%
W-3: Variable cost (existing)

AT A GLANCE
Distributor commission (567m×2%) 11.34
Variable cost [{(400m×60%)+(47m×40%)} –11.34m] 247.46
Average increase in selling price
(1.08×30%×90%)+(1.08×70%) OR [1.08–(1.08×10%×30%)] A 1.0476
Capacity to be utilized during next year
[(672.46m (part a)÷A) ÷ (567m÷70%)] 79.25%

 Example 08:
Solvent Limited has two divisions each of which makes a different product. The budgeted data
for the next year is as under:

SPOTLIGHT
Product A Product B
Rupees
Sales 200,000,000 150,000,000
Direct material 45,000,000 30,000,000
Direct labour 60,000,000 45,000,000
Factory overheads 35,000,000 15,000,000
Price per unit 20 25
Details of factory overheads are as follows:
i. Product A is stored in a rented warehouse whose rent is Rs. 0.25 million per month.

STICKY NOTES
Product B is required to be stored under special conditions. It is stored in a third party
warehouse and the company has to pay rent on the basis of space utilized (varies in
accordance with the production in units). The rent has been budgeted at Rs. 0.12 million
per month.
ii. Indirect labour has been budgeted at 20% of direct labour. 70% of the indirect labour is
fixed.
iii. Depreciation for assets pertaining to product A and B is Rs. 6.0 million and Rs. 2.0 million
respectively.
iv. 80% of the cost of electricity and fuel varies in accordance with the production in units
and the total cost has been budgeted at Rs. 4.0 million.
v. All other overheads are fixed.
Required
Compute the break-even sales assuming that the ratio of quantities sold would remain the same,
as has been budgeted above.

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 Solution

Solvent Limited Product A Product B Total

Sale – units 10,000,000 6,000,000 16,000,000
Sales price per unit 20 25
Sales in Rupees 200,000,000 150,000,000 350,000,000

Less: Variable costs Product A Product B Total

Direct material 45,000,000 30,000,000 -
Direct labour 60,000,000 45,000,000 -
Variable overheads (Note 1) 5,600,000 5,340,000 -
AT A GLANCE

110,600,000 80,340,000 190,940,000

Contribution margin Rs. 89,400,000 69,660,000 159,060,000
Contribution margin % to sales 45.446%

Break even sales revenue:

Total 39,060,000/0.45446 85,948,699

Budgeted sales ratio Revenue (Rs.) Ratio

Product A revenue 200,000,000 4
Product B revenue 150,000,000 3
SPOTLIGHT

Total revenue 350,000,000 7

Revenue from A at breakeven 49,113,542
85,948,699 × 4/7
Revenue from B at breakeven 36,835,157
85,948,699 × 3/7
Sales price per unit ÷20 ÷25
Quantity of A: 49,113,542/20 2,455,677
Quantity of A: 36,835,157/25 1,473,406
Note 1: Variable & fixed overheads:
STICKY NOTES

Total overheads as given 35,000,000 15,000,000 50,000,000

Variable overheads:
- Rent based on space utilized
120,000 x 12 - (1,440,000) -
- Indirect labour
60,000,000 x 20% x 30% (3,600,000)
45,000,000 x 20% x 30% (2,700,000) -
- Electricity & fuel
(4,000,000x80%)/16,000,000x10,000,000 (2,000,000) - -
(4,000,000x80%)/16,000,000x6,000,000 - (1,200,000) -
Variable overheads (5,600,000) (5,340,000) (10,940,000)
Fixed costs (Total overheads-Variable 29,400,000 9,660,000 39,060,000
overheads)

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 Example 09:
KPK Dairies Limited (KDL) is planning to introduce three energies flavored milk from 1 July 2015.
In this respect, following projections have been made:

C-Plus I-Plus V-Plus

Planned production (No. of packets) 540,000 275,000 185,000
Sales (No. of packets) 425,000 255,000 170,000
Production cost per packet: ----------- Rupees -----------
Direct material 100 98 97
Direct labour 15 13 12
Variable overheads 23 19 16

AT A GLANCE
Fixed overheads 25 22 20
Selling and distribution cost per packet:
Variable overheads 12 8 10
Fixed overheads 5 5 5
Total cost per packet 180 165 160
KDL will sell its products through a distributor at a commission of 5% of sale price and expects
to earn a contribution margin of 40% of net sales i.e. sales minus distributor's commission.
Required:
Compute break even sales in packets and rupees, assuming that ratio of quantities sold would be

SPOTLIGHT
as per projections.
 Solution
KPK Dairies Limited
Break-even sales: C-Plus I-Plus V-Plus Total
- In total – No. of packets(H÷G) A 287,660
- Product wise – No. of packets (A×C) B 143,830 86,298 57,532 287,660
- Product wise – Rupees (B×D) 37,850,303 20,893,609 13,625,879 72,369,791

W.1: Sales quantity ratio ----------------------------Liters----------------------------

STICKY NOTES
Projected sales 425,000 255,000 170,000 850,000
Sales quantity ratio C 0.5 0.3 0.2 1.0

W.2: Contribution margin per combination: -------------------------- Rupees --------------------------

Gross sales price per unit (E÷0.57*) D 263.16 242.11 236.84
Commission at 5% of sales (13.16) (12.11) (11.84)
Variable cost per unit E (150.00) (138.00) (135.00)
(100+15 (98+13+ (97+12+
+23+12) 19+8) 16+10)
Contribution margin (CM) per unit F 100.00 92.00 90.00
CM in sales quantity ratio(C×F) G 50.00 27.60 18.00 95.60
VC% to sales: (100-5%) × 60% = 57%*

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W-3: Fixed overheads

Production fixed 13,500,000 6,050,000 3,700,000
overheads (540,000×25) (275,000×22) (185,000×20) 23,250,000
Selling and distribution 2,125,000 1,275,000 850,000
fixed overheads (425,000×5) (255,000×5) (170,000×5) 4,250,000
H 27,500,000

 Example 10:
Fine Limited (FL) is involved in manufacturing and distribution of various consumer products.
Following information pertains to one of its products, FGH for the year ended 31 December 2020:
AT A GLANCE

Rs. In ‘000
Sales (500,000 units) 56,000
Material (Rs. 30 per kg) (22,500)
Skilled labour (Rs. 125 per hour) (10,000)
Semi-skilled labour (Rs. 100 per hour) (5,000)
Production overheads (50% variable) (4,500)
Gross profit 14,000

The management of FL has decided to take following measures with respect to production of FGH
for the next year:
SPOTLIGHT

i. Increase production volume by 10% to take advantage of increase in demand. Currently

the plant for FGH is operating at 80% of its capacity.
ii. Purchase 60% of the material from FL’s associated company that has offered a bulk
discount of 5%. Additional wastage from this material is expected to be 1%.
iii. Replace 40% of the skilled labour with semi-skilled labour. It is estimated that semi-
skilled labour will take 30% more time to do the work of skilled labour. Impact of
inflation on all costs would be 10%. FL’s management also wants to maintain the same
gross profit margin in 2021 as the previous year.
Required
STICKY NOTES

Compute selling price per unit of FGH for the next year.
 Solution

Units
Revised sales volume (500,000 x 1.1) 550,000
Rs. In ‘000
Material - from existing supplier (22,500×1.1×40%) 9,900
Material - from new supplier [22,500×1.1×60%×95%×(100/99)] 14,250
Skilled labour (10,000×1.1×0.6) 6,600
Semi-skilled labour [100,760(W-1)×100] 10,076
production overhead - variable (4,500×0.5×1.1) 2,475
production overhead - fixed (4,500×0.5) 2,250
Total costs 45,551

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Units
Add: Inflation @10% 4,555
Target cost 50,106
Add: Target gross profit @ 25% (50,106×25/75) 16,702
Target sales 66,808
Rupees
Target selling price (66,808,000/550,000) 121.47
W-1 Hours
Semi-skilled labour hours required:
- in replacement of skilled labour (10,000,000/125) ×1.1×40%×1. 3 45,760

AT A GLANCE
- existing requirement (50,000/100)×1.1 55,000
100,760
 Example 11:
Macchiato (Private) Limited (MPL) is planning to launch a new business of manufacturing
carpets and rugs. The extracts from the projected statement of profit or loss of the new business
are given below:

Rs. In ‘000
Sales 500,000
Cost of goods sold (360,000)

SPOTLIGHT
Gross profit 140,000
Operating expenses (90,000)
Profit before taxation 50,000
Taxation @ 35% (17,500)
Profit after taxation 32,500

Selling prices of carpets and rugs would be Rs. 24,000 and Rs. 4,000 per unit with contribution
margin of 25% and 20% respectively. Carpets and rugs would be sold in the ratio of 1:4.
a) Computation the sales revenue at break-even and the margin of safety in units, is shown below.

STICKY NOTES
Rs. In ‘000
Sales (given) 500,000
Less: Variable costs (W-1) (385,000)
Contribution margin 115,000
Combined CM [Contribution/Sales] 23.0%
Fixed cost (W-3) 65,000
Break-even sales [Fixed costs/Combined CM] 282,609

Sales at Existing Safety

BE Sales units
Carpets Break-even sales/D×B (W-2) 7,065 12,500 5,435
Rugs Break-even sales/D×B (W-2) 28,261 50,000 21,739

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a) Determination of number of carpets and rugs that must be sold if MPL wishes to maintain profit
after taxation equivalent to 10% of sales, is given below.

Sales revenue to yield desired net margin [65,000 (W-3)/0.0762 (W-4)] 853,018,373
Carpets Sales/D×B 21,325
Rugs 21,325×4 OR Sales/D×B 85,300
WORKINGS

W-1 Variable costs Carpets Rugs Total

Selling price per unit [given] 24,000 4,000
Contribution [Selling price × CM%] (6,000) (800)
AT A GLANCE

Variable cost per unit 18,000 3,200

Number of units sold (W-2) 12,500 50,000
Total variable costs (Rs. in '000) 225,000 160,000 385,000

W-2 Number of units sold Carpets Rugs Total

Sales (Rs.) A 500,000,000
Ratio B 1 4
Sale price (Rs.) C 24,000 4,000
Weighted average ratio D=B×C 24,000 16,000 40,000
SPOTLIGHT

No. of units sold A/D×B 12,500 50,000

W-3 Fixed costs Rs. In ‘000

Cost of goods sold [given] 360,000
Operating expenses [given] 90,000
Total costs 450,000
Less: Variable costs (W-1) (385,000)
Fixed costs 65,000
STICKY NOTES

W-4 Net margin %

Contribution margin [From (a)] 23.00%
Desired retained profit [0.1/(1–0.35)] (15.38%)
Net margin [CM– desired retained profit] 7.62%

 Example 12:
ABC Limited deals in manufacturing and marketing of perfumes. The company has three brands
to cater for different classes of customers. The selling prices and contribution margins for the
year 2013 were as follows:

A B C
----------Rs. Per u,nit----------
Sales price 10,000 8,000 5,000
Contribution margin 5,000 3,000 2,000

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Total sale for the year 2013 was Rs. 15,600 million and sales volume ratio for A, B and C was 2:3:5
respectively.
The following estimates pertain to the year ending 31 December 2014:
• The average sale prices and variable costs for the next year are expected to increase by
14% and 8% respectively.
• The normal market growth is estimated at 5% per annum. However, the company plans
to launch an aggressive marketing campaign for which additional advertising budget of
Rs. 250 million has been approved. With increased advertisement, increase in sales
volume for A, B and C has been forecasted at 15%, 12% and 10% respectively.
Required
Compute projected contribution margin for the year 2014 and the impact of advertising on profit

AT A GLANCE
of the company.
 Solution

Projected CM for 2014 A B C Total

Projected CM on sales for 2014 (after advertising)
Rs. in million C x K 3,120 2,827 3,058 9,005
CM on normal sales growth rate of 5% Rs. in million
CxH 2,850 2,649 2,920 8,419
Additional CM due to advertising 586
Advertising cost (250)

SPOTLIGHT
Net increase in profit due to advertising Rs. in
million 336
Working:
Sale price per unit Rs. (A) 10,000 8,000 5,000
CM per unit Rs. (5,000) (3,000) (2,000)
Variable cost per unit Rs. (B) 5,000 5,000 3,000
Revised sales price with 14% increase Rs. (A x
1.14) 11,400 9,120 5,700
Revised variable cost with 8% increase Rs. (B x
1.08)

STICKY NOTES
(5,400) (5,400) (3,240)
Projected CM per unit for 2014 Rs. (C) 6,000 3,720 2,460
Sales quantities for 2013 and 2014:
Sales volume ratio (D) 2 3 5 10
Sales ratio (E x [A x D]) 20,000 24,000 25,000 69,000
Total sales Rs. in million F(E÷69×15.6) 4,522 5,426 5,652 15,600
Total sales quantities for 2013 Units in million
G (F÷A) 0.452 0.678 1.130
Sales quantities for 2014 at estimated normal
growth of 5% Units in million H (G×1.05) 0.475 0.712 1.187
Sales volume increase % for 2014 with advertising
(J) 15% 12% 10%
Sale quantities for 2014 having advertising effect
Units in million K= G×(1+J)] 0.520 0.760 1.243

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 Example 13:
Altar Limited (AL) produces and markets a single product. Following information is available
from AL’s records for the month of February 2013:

Sales price Rs. 26 per unit

Direct material (2 kg at Rs. 5 per kg) Rs. 10 per unit
Direct labour Rs. 2 per unit
Variable overheads Rs. 4 per unit
Fixed overheads Rs. 3.50 per unit
AT A GLANCE

Selling expenses Rs. 295,000

Administration expenses Rs. 101,400
Production (Good units) 175,000 units
Closing inventory 30,000 units

Additional information:
(i) Inspection is performed at the end of production and defective units are estimated at
20% of the inspected units. The defective units are sold as scrap at Rs. 5 per unit.
(ii) Fixed overheads per unit are calculated on the basis of good units produced.
(iii) As compared to last month, selling expenses in February 2013 have decreased by Rs.
SPOTLIGHT

42,000.
(iv) In January 2013, AL produced and sold 180,000 units.
Required
Assuming there was no inventory at the beginning of February 2013, calculate break-even sales
in quantity for the month of February 2013.
 Solution

Breakeven sales in units for February 2013 Units

Contribution margin per unit (26 – 18.75 W-2 – 1.2 W-2) 6.05
STICKY NOTES

Break even quantity (834,900 W-3 ÷ 6.05) in units 138,000

W-1 Number of units sold Units

Units produced [175,000 ÷ 0.80] 218,750
Less: Defective units [218,750 – 175,000] OR [ 218,750 × 20%] (43,750)
Good units produced 175,000
Less: closing inventory (30,000)
Number of units sold 145,000

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W-2 Variable costs Per unit Rupees

Direct material (218,750 × 5 × 2) 10.00 2,187,500

Direct labour (218,750 × 2) 2.00 437,500

Variable overheads (218,750 × 4) 4.00 875,000

Less: Defective units sold (43,750 × 5) 5 × 20% (1.00) (218,750)

Total variable cost of production 15.00 3,281,250

Variable cost per good unit (3,281,250 ÷ 175,000) 15 ÷ 0.8 18.75

AT A GLANCE
Calculation of variable selling expenses per unit [using
high-low method]:

= (42,000/[180,000-145,000 ) 1.20

W-3 Fixed costs Units

Fixed overheads (175,000 × 3.5) 612,500

Selling expenses 295,000 – (145,000 × 1.2) 121,000

Administration expenses 101,400

SPOTLIGHT
Total fixed costs 834,900

 Example 14:
Zodiac Limited (ZL) produces a single product and has a maximum production capacity of
300,000 units per annum. Following information pertains to ZL’s estimated cost of production:
(i) Direct material Rs. 12 per unit.
(ii) Direct labour Rs. 8 per unit. However, based on guaranteed wages, the minimum total
cost of labour is Rs. 150,000 per month.

STICKY NOTES
(iii) Variable overheads Rs. 6 per unit.
(iv) Semi-variable overheads Rs. 450,000 per annum up to 55% capacity. An additional
amount of Rs. 180,000 per annum is estimated for every 20% increase in capacity or a
part thereof.
(v) Fixed overheads Rs. 750,000 per annum.
During the first five-months of the year 2012, ZL utilized 70% of its production capacity.
However, it is expected to utilize 92% capacity during the remaining seven-months. The actual
selling price during the first five-months was Rs. 34 per unit.
Required
Compute selling price per unit which should be charged by ZL for the remaining seven-months
to earn a total profit of Rs. 936,000 for the year 2012.

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 Solution
Zodiac Limited (ZL)
Statement of cost and sales for the year 2012
Maximum production capacity = 300,000 units per annum
Particulars 5 months 7 months
Capacity utilized 70% 92%
Production (300,000 x 5 x 70%)/12; (300,000 x 7 x 92%)/12 87,500 161,000
Rupees Rupees
Sales @ Rs. 34 per unit 2,975,000
Direct materials @ Rs. 12 per unit (1,050,000) (1,932,000)
AT A GLANCE

Direct wages @ 8 per unit or Rs. 150,000 per month

whichever is higher (750,000) (1,288,000)
Overheads:
Fixed (5:7) (312,500) (437,500)
Variable @ Rs. 6 per unit (525,000) (966,000)
Semi variable (W-1) (262,500) (472,500)
Total Cost (2,900,000) (5,096,000)
Profit during first 5 months 75,000
Desired profit during next 7 months (Rs. 936,000 – Rs.
75,000) 861,000
SPOTLIGHT

Sales required for next 7 months 5,957,000

Units to be produced in next 7 months 161,000
Required selling price for next 7 months
(5,957,000/161,000) 37.00
 Example 15:
Emerald Limited (EL) is engaged in the manufacture and sale of a single product. Following
statement summarizes the performance of EL for the first two quarters of the financial year 20X2:

Quarter 1 Quarter 2
Sales volume in units 580,000 540,000
STICKY NOTES

Rs. In 000
Sales revenue 493,000 464,400
Cost of Goods sold
Material (197,200) (183,600)
Labour (98,600) (91,800)
Factory overheads (84,660) (80,580)
(380,460) (355,980)
Gross Profit 112,540 108,420
Selling and distribution expenses (26,500) (25,500)
Administrative expenses (23,500) (23,500)
(50,000) (49,000)
Net Profit 62,540 59,420

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In the second quarter of the year EL increased the sale price, as a result of which the sales volume
and net profit declined. The management wants to recover the shortfall in profit in the third
quarter. In order to achieve this target, the product manager has suggested a reduction in per
unit price by Rs. 15.
The marketing director however, is of the opinion that if the price of the product is reduced
further, the field force can sell 650,000 units in the third quarter. It is estimated that to produce
more than 625,000 units the fixed factory overheads will have to be increased by Rs. 2.5 million.
Required
a) Compute the minimum number of units to be sold by EL at the reduced price, to recover the
shortfall in the second quarter profits.

Rupees

AT A GLANCE
Revised(reduced) Selling price (Rs.464,400 / 540,000 ×1000) – 15 845
Rs. in 000
Shortfall in profit of last quarter 3,120
Profit for the 1st quarter 62,540
Target profit for the third quarter 65,660
Add: Fixed cost
Administration cost 23,500
Fixed factory overhead (W–1) 25,500

SPOTLIGHT
Fixed selling and distribution expense (W–1) 12,000
61,000
Targeted contribution margin 126,660
Contribution margin per unit (845-637) (W–2) in Rs. 208
No. of units to be sold 608,942
W-1 Computation of Fixed cost Factory Selling and
overheads distribution
expenses

STICKY NOTES
At 580,000 volume 84,660,000 26,500,000
At 540,000 volume (A) 80,580,000 25,500,000
Difference (B) 4,080,000 1,000,000
Variable cost per unit (C) 102 25
Fixed cost [A – (540,000 × C) ] 25,500,000 12,000,000
W-2 Computation of variable cost per unit Rupees
Material (183,600 / 540,000) × 1000 340
Labour ( 91,800 / 540,000) × 1000 170
Factory overheads 102
Selling and distribution expenses 25
637

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b) Determine the minimum price which could be charged to maintain the profitability
calculated in (a) above, if EL wants to sell 650,000 units.

Minimum price that should be charged if EL wants to sell 650,000 Rs. In 000
units
Required contribution as above 126,660
Additional fixed cost 2,500
129,160
Number of units sold 650,000
Required contribution margin per unit 198.71
AT A GLANCE

Variable cost per unit 637.00

Minimum price 835.71

 Example 16:
Naseem (Private) Limited (NPL) is a manufacturer of industrial goods and is launching a new
product. The production will be carried out using existing facilities. However, the capacity of a
machine would have to be increased at a cost of Rs. 3.0 million.
The budgeted costs per unit are as under:

Imported material 1.3 kg at Rs. 750 per kg

Local material 0.5 kg at Rs. 150 per kg
SPOTLIGHT

Labour 2.0 hours at Rs. 300 per hour

Variable overheads Rs. 200 per labour hour
Selling & administration cost – variable Rs. 359

Other relevant details are as under:

(i) Net weight of each unit of finished product will be 1.6 kg.
(ii) During production, 5% of material input will evaporate. The remaining waste would be
disposed off at a rate of Rs. 80 per kg.
(iii) The cost of existing plant is Rs. 10 million. The rate of depreciation is 10% per annum.
STICKY NOTES

(iv) Administration and other fixed overheads amount to Rs. 150,000 per month. As a result
of the introduction of the new product, these will increase to Rs. 170,000 per month.
The management estimates that 20% of the facilities would be used for the new
product.
(v) The company fixes its sale price at variable cost plus 25%. (vi) Applicable tax rate for
the company is 35%.
Required
Compute sales quantity and value, required to achieve a targeted increase of Rs. 4.5 million in
after tax profit.

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Variable cost per unit Qty Rate Cost per

unit
Kg Rupees
Imported raw material 1.30 750 975.00
Local material 0.50 150 75.00
Total input 1.80 1,050.00
Sale of wastage {1.8-1.6-(0.05 x 1.8)} 0.11 80 (8.80)
Cost of material per unit 1,041.20

AT A GLANCE
Skilled labour (2 hours @ Rs.300) 600.00
Overheads (2 hours @ Rs. 200) 400.00
Selling and administration cost 359.20
2,400.20

Required contribution margin Rupees

Fixed overheads:
- Depreciation on cost of additional capacity (3,000,000 x 10%) 300,000

SPOTLIGHT
- Incremental administration and other fixed overheads (170,000-
150,000) x 12 240,000
Gross profit required before tax (4,500,000/0.65) 6,923,077
Total contribution margin 7,463,077
Sales price per unit at variable cost plus 25% (2,400.20 x 1.25) 3,000.25
Contribution margin per unit sale (3,000.25 – 2400.20) 600.05
Sales in units (7,463,077 / 600.05) 12,437 Units

STICKY NOTES

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STICKY NOTES

Cost-volume-profit analysis is used to how changes in costs and profits with

the change in volume activity.

Contribution is measured as sales revenue less total variable costs. And

profit is measured as contribution minus total fixed costs.
AT A GLANCE

Breakeven point is the point where total contribution is exactly equal to total
fixed cost. It is calculated by dividing total fixed costs with contribution per
unit.

Margin of safety is the difference between budgeted sales and the break-even
amount of sales. It is usually expressed as a percentage of the budgeted sales.

If the target profit is known, then the volume of sales desired to achieve the
SPOTLIGHT

target profit can be calculated using the formula as below:

Volume target (units) = (Total fixed costs + target profit)/contribution per
unit

Breakeven chart is a visual representation showing all volumes of output and

sales with their total costs, sales, profits and break-even points.
STICKY NOTES

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 CHAPTER 14

RELEVANT COSTS

AT A GLANCE
IN THIS CHAPTER Relevant cost is future cost, cash-based cost and incremental
cost. Any cost incurred in the past is not relevant cost.
AT A GLANCE

AT A GLANCE
Identifying relevant costs would involve cost of materials,
labour and overheads. In this respect, Relevant costs of
SPOTLIGHT
materials are the additional cash flows that will be incurred (or
benefits that will be lost) by using the materials for the purpose
1. The Concept of Relevant Costing
that is under consideration.
2. Identifying Relevant Costs Relevant cost of labour would involve some considerations. If
labour is not in restricted supply, the relevant cost of the labour
3. Comprehensive Examples is its variable cost. However, if labour is a fixed cost and there is
spare labour time available.
STICKY NOTES Only variable overhead costs are considered relevant for
decision making. This is because it is an estimate of cash
spending per hour for each additional hour. Although, fixed

SPOTLIGHT
overhead absorption rates are irrelevant, the only overhead
fixed costs that are relevant costs for a decision are extra cash
spending that will be incurred, or cash spending that will be
saved, as a direct consequence of making the decision.

1. THE CONCEPT OF RELEVANT COSTING

1.1 Definition and identification of relevant cost

STICKY NOTES
A relevant cost is defined as future cash flow arising as a direct consequence of a decision. As per this definition,
following points are important in measuring the relevant cost of specific decision.

• The cost shall be incurred in future as result of decision. It means that any cost that has already been
incurred before initiation of decision is not relevant cost and considered as “Sunk Cost”.

• The cost or benefit in relation to specific decision shall be in cash. There shall be cash inflows or outflows
as direct consequence of decision. The non-cash costs like depreciation and apportioned overheads are
treated as irrelevant cost.

• The cost shall be incremental means when decision is taken, the cost is incurred otherwise not. Any cost
that will happen anyway, regardless of the decision, cannot be a relevant cost. For example, if committed
to pay rent of machine for next six months is irrelevant cost because it will not affect the decision. This
cost is termed as “Committed cost.

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Relevant cost principle is used when a decision has to be made and the concern is whether the decision will
increase profit or not. It is based on minimum cost principle. Examples of application of relevant cost to specific
decisions are:

• Decision regarding acceptance of job or undertake some work at a stated price that customer is willing
to pay.

• Whether to sell joint products arising as result of common process, at split off point or to sell it after
processing further.

• Whether the products should be made in house or whether to subcontract or outsource the work to
external supplier.
Relevant costs should be used for assessing the economic or financial consequences of any decision by
AT A GLANCE

management. Only relevant costs and benefits should be taken into consideration when evaluating the financial
consequences of a decision.
As a relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision, it
is used for target profit analysis as well.

1.2 Concepts and terms used in relevant costing

The key concepts in this definition of relevant costs are as follows:

• Relevant costs are costs that will occur in the future. They cannot include any costs that have already
occurred in the past.
• Relevant costs of a decision are costs that will occur as a direct consequence of making the decision. Costs
SPOTLIGHT

that will occur anyway, no matter what decision is taken, cannot be relevant to the decision.
• Relevant costs are cash flows. Notional costs, such as depreciation charges, notional interest costs and
absorbed fixed costs, cannot be relevant to a decision.
Several terms are used in relevant costing, to indicate how certain costs might be relevant or not relevant to a
decision.

Incremental cost
STICKY NOTES

An incremental cost is an additional cost that will occur if a particular decision is taken. Provided that this
additional cost is a cash flow, an incremental cost is a relevant cost.
 Example 01:
A company has identified that each cost unit it produces has the following costs:
Rs. in ‘000
Direct materials 50
Direct labour 20
70
Fixed production overhead 30
Total absorption cost 100
The incremental cost of making one extra unit is Rs. 70,000. Making one extra unit would not affect the fixed cost
base. The fixed cost of Rs. 30,000 is irrelevant cost as it would not affect the decision.

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Differential cost
A differential cost is the amount by which future costs will vary, depending on which course of action is taken. A
differential cost is therefore an amount by which future costs will be higher or lower, if a particular course of
action is chosen. Provided that this additional cost is a cash flow, a differential cost is a relevant cost.
 Example 02:
A company needs to hire a photocopier for the next six months. It has to decide whether to
continue using a particular type of photocopier, which it currently rents for Rs.2,000 each month,
or whether to switch to using a larger photocopier that will cost Rs.3,600 each month. If it hires
the larger photocopier, it will be able to terminate the rental agreement for the current copier
immediately.
The decision is whether to continue with using the current photocopier, or to switch to the larger

AT A GLANCE
copier. One way of analyzing the comparative costs is to say that the larger copier will be more
expensive to rent, by Rs.1,600 each month for six months. The differential cost of hiring the larger
copier for six months would therefore be Rs.9,600.

Avoidable and unavoidable costs

An avoidable cost is a cost that could be saved (avoided), depending whether or not a particular decision is taken.
An unavoidable cost is a cost that will be incurred anyway.
Avoidable costs are relevant costs.
Unavoidable costs are not relevant to a decision.
 Example 03:

SPOTLIGHT
A company has one year remaining on a short-term lease agreement on a warehouse. The rental
cost is Rs.100,000 per year. The warehouse facilities are no longer required, because operations
have been moved to another warehouse that has spare capacity.
If a decision is taken to close down the warehouse, the company would be committed to paying
the rental cost up to the end of the term of the lease. However, it would save local taxes of
Rs.16,000 for the year, and it would no longer need to hire the services of a security company to
look after the empty building, which currently costs Rs.40,000 each year.
The decision about whether to close down the unwanted warehouse should be based on relevant
costs only.
Local taxes and the costs of the security services (Rs.56,000 in total for the next year) could be

STICKY NOTES
avoided and so these are relevant costs.
The rental cost of the warehouse cannot be avoided, and so should be ignored in the economic
assessment of the decision whether to close the warehouse or keep it open for another year.

Committed cost
Committed costs are a category of unavoidable costs. A committed cost is a cost that a company has already
committed to or an obligation already made, that it cannot avoid by any means.
Committed costs are not relevant costs for decision making.
 Example 04:
A company bought a machine one year ago and entered into a maintenance contract for Rs.
20,000 for three years.
The machine is being used to make an item for sale. Sales of this item are disappointing and are
only generating Rs, 15,000 per annum and will remain at this level for two years.
The company believes that it could sell the machine for Rs. 25,000.

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The relevant costs in this decision are the selling price of the machine and the revenue from sales
of the item.
If the company sold the machine it would receive Rs. 25,000 but lose Rs. 30,000 revenue over the
next two years – an overall loss of Rs. 5,000
The maintenance contract is irrelevant as the company has to pay Rs. 20,000 per annum whether
it keeps the machine or sells it.
Leases normally represent a committed cost for the full term of the lease, since it is extremely
difficult to terminate a lease agreement.

Sunk costs
Sunk costs are costs that have already been incurred (historical costs) or costs that have already been committed
by an earlier decision. Sunk costs must be ignored for the purpose of evaluating a decision, and cannot be relevant
AT A GLANCE

costs.
 Example 05:
A company must decide whether to launch a new product on to the market.
It has spent Rs.900,000 on developing the new product, and a further Rs.80,000 on market
research.
A financial evaluation for a decision whether or not to launch the new product should ignore the
development costs and the market research costs, because the Rs.980,000 has already been spent
and would not be recovered regardless to go ahead with the launch or not. The costs are sunk
costs.

1.3 Opportunity costs

SPOTLIGHT

Relevant costs can also be measured as an opportunity cost. An opportunity cost is a benefit that will be lost by
taking one course of action instead of the next-most profitable course of action.
 Example 06:
A company has been asked by a customer to carry out a special job. The work would require 20
hours of skilled labour time. There is a limited availability of skilled labour, and if the special job
is carried out for the customer, skilled employees would have to be moved from doing other work
that earns a contribution of Rs.60 per labour hour.
A relevant cost of doing the job for the customer is the contribution that would be lost by
switching employees from other work. This contribution forgone (20 hours × Rs.60 = Rs.1,200)
STICKY NOTES

would be an opportunity cost. This cost should be taken into consideration as a cost that would
be incurred as a direct consequence of a decision to do the special job for the customer. In other
words, the opportunity cost is a relevant cost in deciding how to respond to the customer’s
request.

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AT A GLANCE
SPOTLIGHT
STICKY NOTES

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2. IDENTIFYING RELEVANT COSTS

It is important to know about calculation of relevant cost of material, labour and overheads, which is explained
in detail in following paragraphs.

2.1 Relevant cost of materials

The relevant cost of raw material is generally their current replacement cost, unless material has already been
purchased and not available for use in regular terms or other contracts.
If none of the required materials are currently held as inventory, the relevant cost of the materials is simply
their current replacement cost. In other words, the relevant cost is the cash that will have to be paid to acquire
and use the materials.
If the required materials are currently held as inventory, the relevant costs are identified by applying the
AT A GLANCE

following rules:
SPOTLIGHT

Note that the historical cost of materials held in inventory cannot be the relevant cost of the materials, because
their historical cost is a sunk cost.
STICKY NOTES

The relevant costs of materials can be described as their ‘deprival value’. The deprival value of materials is the
benefit or value that would be lost if the company were deprived of the materials currently held in inventory.
• If the materials are regularly used, their deprival value is the cost of having to buy more units of the materials
to replace them (their replacement cost).
• If the materials are not in regular use, their deprival value is either the net benefit that would be lost because
they cannot be disposed of (their net disposal or scrap value) or the benefits obtainable from any alternative
use. In an examination question, materials in inventory might not be in regular use, but could be used as a
substitute material in some other work. Their deprival value might therefore be the purchase cost of another
material that could be avoided by using the materials held in inventory as a substitute.
 Example 07:
A company has been asked to quote a price for a one-off contract.
The contract would require 5,000 kilograms of material X. Material X is used regularly by the
company. The company has 4,000 kilograms of material X currently in inventory, which cost Rs.4
per kilogram. The price for material X has risen to Rs.4.20 per kilogram since last purchase.

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The contract would also require 2,000 kilograms of material Y. There are 1,500 kilograms of
material Y in inventory, but because of a decision taken several weeks ago, material Y is no longer
in regular use by the company. The 1,500 kilograms originally cost Rs.14,400, and have a scrap
value of Rs.3,600. New purchases of material Y would cost Rs.10 per kilogram.
For the relevant costs of the materials to assist management in identifying the minimum price to
charge for the contract, please see below:
Material X
This is in regular use. Any units of the material that are held in inventory will have to be replaced
for other work if they are used for the contract. The relevant cost is their replacement cost.
Relevant cost = replacement cost = 5,000 kilograms × Rs.4.20 = Rs.21,000.
Material Y

AT A GLANCE
This is not in regular use. There are 1,500 kilograms in inventory, and an additional 500
kilograms would have to be purchased. The relevant cost of material Y for the contract would be:

Rs.
Material held in inventory (scrap value) 3,600
New purchases (500 × Rs.10) 5,000
Total relevant cost of Material Y 8,600

 Example 08:
A company is considering whether to agree to do a job for a customer. It has sufficient spare
capacity to take on this job.

SPOTLIGHT
To do the job, three different direct materials will be required, Material X, Material Y and Material
Z. Data relating to these materials is as follows:

Quantity Original cost of

Quantity Current
currently units currently Current
needed disposal
Material held as held as purchase price
for the job value
inventory inventory
units units Rs. per unit Rs. per unit Rs. per unit
X 800 200 20 23 22

STICKY NOTES
Y 600 400 15 19 12
Z 500 300 30 40 20

Material X is regularly used by the company for other work. Material Y is no longer in regular use,
and the units currently held as inventory have no alternative use. Material Z is also no longer in
regular use, but if the existing inventory of the material is not used for this job, they can be used
as a substitute material on a different job, where the contribution would be Rs.25 per unit of
Material Z used.
For calculation of the total relevant costs of the materials for this job for the customer, please see
below:
Material X: This material is in regular use. Its relevant cost is therefore its current replacement
cost, because any existing inventory will be replaced if it is used on the job.
Materials Y and Z: The relevant cost of the additional quantities that will have to be purchased
is their current replacement cost.

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Material Y: units already held in inventory. The relevant cost of these units is their
opportunity cost, which is the cash that could be obtained by disposing of them.
Material Z: units already held in inventory. The relevant cost of these units is the higher value
of their disposal value (Rs.20 per unit) and the contribution that they would earn if they are used
as a substitute material on a different job (Rs.25 per unit)
Relevant costs Rs. Rs.
Material X: 800 units × Rs.23 18,400
Material Y:
Opportunity cost of units in inventory = disposal value
(400 units × Rs.12) 4,800
Purchase cost of additional units (200 units × Rs.19) 3,800
AT A GLANCE

8,600
Material Z:
Opportunity cost of units in inventory = (300 units × Rs.25) 7,500
Purchase cost of additional units (200 units × Rs.40) 8,000
15,500
Total relevant cost of materials 42,500

 Example 09:
R Ltd has been approached by a customer who would like a special job to be done for them. The
job would require the following materials.
SPOTLIGHT

Book value of
Total Already in Realisable Replacement
units in
Material required inventory value cost
inventory
units units Rs. Per unit Rs. per unit Rs. per unit
A 1,000 0 - - 6
B 1,000 600 2 2.50 5
C 1,000 700 3 2.50 4
D 200 200 4 6.00 9

a) Material B is used regularly by R Ltd and if units of B are required for this job, they would
STICKY NOTES

need to be replaced to meet other production demand.

b) Material C and D are in inventory as the result of previous overbuying, and they have a
restricted use. No other use could be found for material C, but the units of material D could
be used in another job as substitute for 300 units of material E, which currently costs Rs. 5
per unit (of which the company has no units in inventory at the moment).
The relevant costs of material, in deciding whether or not to accept the order, is calculated as
under, along with reasons.
Relevant costs Note Rs.
Material A (1,000 x 6) 6,000
Material B (1,000 x 5) 5,000
Material C (300 x 4) + (700 x 2.50) 2,950
Material D 1,500
15,450

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Note-1:
Material A is not owned and would have to be bought in full at the replacement cost of Rs. 6 per
unit.
Note-2:
Material B is used regularly by the company. There is existing inventory (600 units) but if these
are used on the contract under review, a further 600 units would be bought to replace them.
Relevant costs are therefore 1,000 units at the replacement cost of Rs. 5 per unit.
Note-3:
1,000 units of Material C are needed and 700 are already in inventory. If used for the contract, a
further 300 units must be bought at Rs. 4 each. The existing inventory of 700 units will not be
replaced, if they are used for the contract, they could not be sold at Rs. 2.50 each. The realizable

AT A GLANCE
value of these 700 units is an opportunity cost of sales revenue forgone.
Note-4:
Material D are already in inventory and will not be replaced. There is an opportunity cost of using
D in the contract because there are alternative opportunities either to sell the existing inventory
for Rs. 6 per unit (Rs. 1,200 in total) or avoid other purchases of material E, which would cost
300 x Rs. 5= Rs. 1,500. Since substitution for E is more beneficial, Rs. 1,500 is the opportunity
cost and thus relevant cost.

2.2 Relevant cost of labour

The relevant cost of labour for any decision is the additional cash expenditure (or saving) that will arise as a
direct consequence of the decision. However, if the labour force will be paid irrespective of the decision made, is

SPOTLIGHT
not relevant cost because it is not incremental. Details of labour cost is given below.
• If the cost of labour is a variable cost, and labour can be hired from market, the relevant cost of the labour
is its variable cost. For example, suppose that part-time employees are paid Rs.18 per hour, they are paid
only for the hours that they work and part-time labour is not in short supply. If management is considering
a decision that would require an additional 100 hours of part-time labour, the relevant cost of the labour
would be Rs.18 per hour or Rs.1,800 in total.
• If labour is a fixed cost and there is spare labour time available, the relevant cost of using labour is 0.
The spare time would otherwise be paid for idle time, and there is no additional cash cost of using the labour
to do extra work. For example, suppose that a new contract would require 30 direct labour hours, direct
labour is paid Rs.20 per hour, and the direct workforce is paid a fixed weekly wage for a 40-hour week. If
there is currently spare capacity, so that the labour cost would be idle time if it is not used for the new

STICKY NOTES
contract, the relevant cost of using 30 hours on the new contract would be Rs.0. The 30 labour hours must
be paid for whether or not the contract work is undertaken.
• If labour is in limited supply, the relevant cost of labour should include the opportunity cost of using the
labour time for the purpose under consideration instead of using it in its next-most profitable way.
 Example 10:
Department 1. The contract would require 200 hours of work in department 1, where the
workforce is paid Rs.16 per hour for a fixed 40-hour week. There is currently spare labour
capacity in department 1 and there are no plans to reduce the size of the workforce in this
department.
Department 2. The contract would require 100 hours of work in department 2 where the
workforce is paid Rs.24 per hour. This department is currently working at full capacity. The
company could ask the workforce to do overtime work, paid for at the normal rate per hour plus
50% overtime premium. Alternatively, the workforce could be diverted from other work that
earns a contribution of Rs.8 per hour.

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Department 3. The contract would require 300 hours of work in department 3 where the
workforce is paid Rs.24 per hour. Labour in this department is in short supply and all the
available time is currently spent making product Z, which earns the following contribution:
Rs. Rs.
Sales price 98
Labour (2 hours per unit) 48
Other variable costs 30
78
Contribution per unit of product Z 20

In evaluating the relevant cost for the contract of labour in the three departments, following
AT A GLANCE

working may be helpful

Department 1. There is spare capacity in department 1 and no additional cash expenditure
would be incurred on labour if the contract is undertaken.
Relevant cost = Rs.0.
Department 2. There is restricted labour capacity. If the contract is undertaken, there would be
a choice between:
• overtime work at a cost of Rs.36 per hour (Rs.24 plus overtime premium of 50%) – this
would be an additional cash expense, or
• diverting the labour from other work, and losing contribution of Rs.8 per hour – cost per
hour = Rs.24 basic pay + contribution forgone Rs.8 = Rs.32 per hour.
SPOTLIGHT

It would be better to divert the workforce from other work, and the relevant cost of labour is
therefore 100 hours × Rs.32 per hour = Rs.3,200.
Department 3. There is restricted labour capacity. If the contract is undertaken, labour would
have to be diverted from making product Z which earns a contribution of Rs.20 per unit or Rs.10
per labour hour (Rs.20/2 hours). The relevant cost of the labour in department 3 is:

Rs.
Labour cost per hour 24
Contribution forgone per hour 10
Relevant cost per hour 34
STICKY NOTES

Relevant cost of 300 hours = 300 × Rs.34 = Rs.10,200.

Summary of relevant costs of labour:

Rs.
Department 1 0
Department 2 3,200
Department 3 10,200
13,400

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 Example 11:
A one-year contract has been offered to Maliaka Industries which required the following labour
workforce.

Fix six Subsequent Subsequent six

Labour type Fix six months
months six months months
Hours required Normal wage rate per hour
Skilled 1,350 1,276 25.00 28.75
Semi-skilled 1,400 1,225 17.00 19.00
Unskilled 1,225 1,400 15.00 16.00

AT A GLANCE
It is expected that there will be shortage of skilled labour in the first six months only. Therefore,
for the purposes of the contract skilled labour will have to be diverted from other work from
which a contribution of Rs. 7.50 per hour is earned, net of wage costs. In subsequent six months,
the sufficient skilled labour will be available. The skilled labour is paid, irrespective, of workload.
The firm currently has a surplus of semi-skilled labour paid at full rate but doing unskilled work.
The labour concerned could be transferred to provide sufficient labour for the contract and
would be replaced by unskilled labour.
The relevant cost of labour is calculated as under.

Rs.
Skilled [(1,350 x 25.00+7.50)] 43,875

SPOTLIGHT
Semi-skilled -
Unskilled [(1,225 x 15.00) + (1,400 x 16)] 40,775
Relevant cost of labour 84,650

 Example 12:
A contract is under consideration which would require 1,400 hours of direct labour. There is
spare capacity of 500 hours of direct labour, due to the cancellation of another order by a
customer. The other time would have to be found by asking employees to work in the evenings
and at weekends, which would be paid at 50% above the normal hourly rate of Rs.15.
Alternatively, the additional hours could be found by switching labour from other work which
earns a contribution of Rs.5 per hour.

STICKY NOTES
Relevant cost of direct labour if the contract is accepted and undertaken would require:
A total of 900 hours would have to be found by either working overtime at a cost of Rs.15 × 150%
= Rs.22.50 per hour, or diverting labour from other work that earns a contribution of Rs.5 per
hour after labour costs of Rs.15 per hour. The opportunity cost of diverting labour from other
work is therefore Rs.20 per hour. This is less than the cost of working overtime. If the contract is
undertaken, labour will therefore be diverted from the other work.
It is assumed that the 500 hours of free labour time (idle time) available would be paid for
anyway, even if the contract is not undertaken. The relevant cost of these hours is therefore Rs.0

Relevant cost of labour Rs.

500 hours 0
900 hours (× Rs.20) 18,000
Total relevant cost of labour 18,000

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2.3 Relevant cost of overheads

Relevant costs of expenditures that might be classed as overhead costs should be identified by applying the
normal rules of relevant costing. Relevant costs are future cash flows that will arise as a direct consequence of
making a particular decision.
Fixed overhead absorption rates are therefore irrelevant, because fixed overhead absorption is not
overhead expenditure and does not represent cash spending. Similarly, depreciation on machinery or factory
asset is although overheads, but not relevant cost because it is not in cash.
However, it might be assumed that the overhead absorption rate for variable overheads is a measure of actual
cash spending on variable overheads. It is therefore often appropriate to treat a variable overhead hourly rate as
a relevant cost, because it is an estimate of cash spending per hour for each additional hour worked.
The only overhead fixed costs that are relevant costs for a decision are extra cash spending that will be incurred,
AT A GLANCE

or cash spending that will be saved, as a direct consequence of making the decision.
 Example 12:
A company bought a machine six years ago for Rs.125,000. Its written down value is now
Rs.25,000. The machine is no longer used for normal production work, and it could be sold now
for Rs.17,500. A project is being considered that would make use of this machine for six months.
After this time the machine would be sold for Rs.10,000.
Calculating the relevant cost of the machine to the project would involve:
Relevant cost = Difference between sale value now and sale value if it is used. This is the relevant
cost of using the machine for the project.
Relevant cost = Rs.17,500 - Rs.10,000 = Rs.7,500.
SPOTLIGHT

 Example 13:
Tychy Limited (TL) is engaged in the manufacture of Specialized motors. The company has been
asked to provide a quotation for building a motor for a large textile industrial unit in Punjab.
Following information has been obtained by TL’s technical manager in a one-hour meeting
with the potential customer. The manager is paid an annual salary equivalent to Rs. 2,500 per
eight-hour day.
i. The motor would require 120 ft. of wire-C which is regularly used by TL in production.
TL has 300 ft. of wire-C in inventory at the cost of Rs. 65 per ft. The resale value of wire-
C is Rs. 63 and its current replacement cost is Rs. 68 per ft.
ii. 50 kg of another material viz. Wire-D and 30 other small components would also be
STICKY NOTES

required by TL for the motor. Wire-D would be purchased from a supplier at Rs. 10 per
kg. The supplier sells a minimum quantity of 60 kg per order. However, the remaining
quantity of wire-D will be of no use to TL after the completion of the contract. The other
small components will be purchased from the market at Rs. 80 per component.
iii. The manufacturing process would require 250 hours of skilled labour and 30 machine
hours.
The skilled workers are paid a guaranteed wage of Rs. 20 per hour and the current spare
capacity available with TL for such class of workers is 100 direct labour hours. However,
additional labour hours may be obtained by either:
• Paying overtime at Rs. 23 per hour; or
• Hiring temporary workers at Rs. 21 per hour. These workers would require 5 hours
of supervision by AL’s existing supervisor who would be paid overtime of Rs. 20
per hour.

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The machine on which the motor would be manufactured was leased by TL last year at
a monthly rent of Rs. 5,000 and it has a spare capacity of 110 hours per month. The
variable running cost of the machine is Rs. 15 per hour.
iv. Fixed overheads are absorbed at the rate of Rs. 25 per direct labour hour.
The relevant cost of producing textile motor, together with reasons for the inclusion or
exclusion of any cost from your computation would be as follows

Tychy Limited (TL) Note Rs.

Technical manager – meeting 1 NIL

Wire – C 2 8,160

AT A GLANCE
Wire – D 3 600

Components 4 2,400

Direct labour 5 3,250

Machine running cost 6 450

Fixed overhead 7 NIL

Total relevant cost 14,860

Notes:
1. In case of technical manager’s meeting with the potential client, the relevant cost is NIL

SPOTLIGHT
because it is not only a past cost but also the manager is paid an annual salary and
therefore TL has incurred no incremental cost on it.
2. Since wire-C is regularly used by TL, its relevant value is its replacement cost. The
historical cost is not relevant because it is a past cost and the resale value is not relevant
since TL is not going to sell it.
3. Since wire-D is to be purchased for the contract therefore its purchase cost is relevant.
TL only requires 50 kg of wire-D but due to the requirement of minimum order quantity
TL will be purchasing 60 kg of the material and since TL has no other use for this
material, the full cost of purchasing the 60 kg is the relevant cost.
4. Since the components are to be purchased from the market at a cost of Rs. 80 each.

STICKY NOTES
Therefore, the entire purchase price is a relevant cost.
5. The 100 hours of direct labour are presently idle and hence have zero relevant cost. The
remaining 150 hours are relevant. TL has two choices: either use its existing employees
and pay them overtime at Rs. 23 per hour which is a total cost of Rs. 3,450: or engage the
temporary workers which would cost TL Rs. 3,250 including supervision cost of Rs. 100.
The relevant cost is the cheaper of the two alternatives i.e. Rs. 3250.
6. The lease cost of machine will be incurred regardless of whether it is used for the
manufacture of motors or remains idle. Hence, only the incremental running cost of Rs.
15 per hour is relevant.
7. Fixed overhead costs are incurred whether the work goes ahead or not so it is not a
relevant cost.

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 Example 14:
Fazal Industries Limited is currently negotiating a contract to supply its products to K-Mart, a
large chain of departmental stores. K-Mart finally offered to sign a one-year contract at a lump
sum price of Rs. 19,000,000.
The Cost Accountant of Fazal Industries Limited believes that the offered price is too low.
However, the management has asked you to re-assess the situation. The cost accountant has
provided you the following information:
Statement of Estimated Costs (Project: K-Mart)

Notes Rupees
Material:
AT A GLANCE

X (at historical cost) (i) 1,500,000

Y (at historical cost) (ii) 1,350,000
Z (iii) 2,250,000
Labour:
Skilled (iv) 4,050,000
Supervisory (v) 2,250,000
Overheads (vii) 8,500,000
Total cost 20,710,000
SPOTLIGHT

You have analyzed the situation and gathered the following information:
i. Material X is available in stock. It has not been used for a long time because a substitute
is currently available at 20% less than the cost of X.
ii. Material Y was ordered for another contract but is no longer required. Its net realizable
value is Rs. 1,470,000.
iii. Material Z is not in stock.
iv. Skilled labour can work on other contracts which are presently operated by semi- skilled
labour who have been hired on temporary basis at a cost of Rs. 325,000 per month. The
STICKY NOTES

company will need to give them a notice of 30 days before terminating their services.
v. Unskilled labour will have to be hired for this contract.
vi. Two new supervisors will be hired for this contract at Rs. 15,000 per month. The present
supervisors will remain employed whether the contract is accepted or not.
vii. These include fixed overheads absorbed at the rate of 100% of skilled labour. Fixed
production overheads of Rs. 875,000 which would only be incurred if the contract is
accepted, have been included for determining the above fixed overhead absorption rate.
Preparation of a revised statement of estimated costs using the opportunity cost approach, for
the management of Fazal Industries to state whether the contract should be accepted or not
would involve following analysis

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Revised Statement of Estimated Costs

Under the Opportunity Cost Approach
Rupees
Materials
X (1,500,000 x 80%) 1,200,000
Y (NRV) 1,470,000
Z (Purchase price) 2,250,000
Labour
Skilled 4,050,000
Unskilled 2,250,000

AT A GLANCE
Supervisory (Rs. 15,000 x 2 x 12) 360,000*

Overheads
Avoidable fixed overhead 875,000
Variable overheads (Rs. 8,500,000 – Rs. 4,050,000) 4,450,000

16,905,000
Conclusion:
The company should accept the order as it will give them incremental cash flows of Rs. 2,095,000
(Rs. 19,000,000-Rs. 16,905,000).

SPOTLIGHT
 Example 15:
The manager of a small printing business has received enquires about printing three different
types of advertising leaflet, type A, type B and type C. Selling price and cost information for these
leaflets is shown below:

Leaflet type: Type A Type B Type C

Rs. Rs. Rs.
Selling price, per 1,000 leaflets 300 660 1,350
Estimate printing costs:

STICKY NOTES
Variable costs, per 1,000 leaflets 120 210 390
Specific fixed costs per month 7,200 12,000 28,500

In addition to the specific fixed costs, Rs. 12,000 per month will be incurred in general fixed costs.
The printing business receives an enquiry from a customer about printing 30,000 of a different
type of leaflet. The customer is willing to pay Rs .25,000. The variable labour and overhead costs
of producing these leaflets would be Rs.80 per 1,000 leaflets.
The leaflets would be printed on a special type of paper. This costs Rs.500 per 1,000 leaflets.
However, there are already sufficient quantities of the paper in inventory for 20,000 of the
leaflets. This special paper was purchased three months ago for a customer who then cancelled
his order. The material has a disposal value of Rs. 1,500, but it could also be used to produce
20,000 units of leaflet C. The cost of normal paper for leaflet C is Rs.300 per 1,000 leaflets.

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For calculation of the relevant costs of making the leaflets for this special order and profit
increase as a result of undertaking the order would require following workings
Relevant costs Rs.
Materials
To be purchased: 10,000 × Rs.500/1,000 5,000
Currently held in inventory 6,000
(Relevant cost = higher of [Rs.1,500 and (20,000 × Rs.300/1,000)]
Variable costs of labour/overheads 2,400
(30,000 × Rs.80/1,000)
AT A GLANCE

Total relevant costs (13,400)

Contract price 25,000
Incremental profit 11,600
SPOTLIGHT
STICKY NOTES

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3. COMPREHENSIVE EXAMPLES
 Example 01:
BB Company has received an enquiry from a customer for the supply of 500 units of a new
product, product B22. Negotiations on the final price to charge the customer are in progress and
the sales manager has asked you to supply relevant cost information.
The following information is available:
1) Each unit of product B22 requires the following raw materials:
Raw material type
X 4 kg

AT A GLANCE
Y 6 kg
2) The company has 5,000 kg of material X currently in stock. This was purchased last year
at a cost of Rs.7 per kg. If not used to make product B22, this stock of X could either be
sold for Rs.7.50 per kg or converted at a cost of Rs.1.50 per kg, so that it could be used
as a substitute for another raw material, material Z, which the company requires for
other production. The current purchase price per kilogram for materials is Rs.9.50 for
material Z and Rs.8.25 per kg for material X.
3) There are 10,000 kilograms of raw material Y in inventory, valued on a FIFO basis at a
total cost of Rs.142,750. Of this current inventory, 3,000 kilograms were purchased six
months ago at a cost of Rs.13.75 per kg. The rest of the inventory was purchased last
month. Material Y is used regularly in normal production work. Since the last purchase
of material Y a month ago, the company has been advised by the supplier that the price

SPOTLIGHT
per kilogram has been increased by 4%.
4) Each unit of product B22 requires the following number of labour hours in its
manufacture:
Type of labour:
Skilled: 5 hours
Unskilled: 3 hours
Skilled labour is paid Rs.8 per hour and unskilled labour Rs.6 per hour.
5) There is a shortage of skilled labour, so that if production of B22 goes ahead it will be
necessary to transfer skilled workers from other work to undertake it. The other work

STICKY NOTES
on which skilled workers are engaged at present is the manufacture of product B16. The
selling price and variable cost information for B16 are as follows:

Rs./unit Rs./unit
Selling price 100
Less: variable costs of production
Skilled labour (3 hours) 24
Other variable costs 31
55
45

6) The company has a surplus of unskilled workers who are paid a fixed wage for a 37-hour
week. It is estimated that there are 900 hours of unused unskilled labour time available
during the period of the contract. The balance of the unskilled labour requirements could
be met by working overtime, which is paid at time and a half.

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7) The company absorbs production overheads by a machine hour rate. This absorption
rate is Rs.22.50 per hour, of which Rs.8.75 is for variable overheads and the balance is
for fixed overheads. If production of product B22 is undertaken, it is estimated that an
extra Rs.4,000 will be spent on fixed costs. Spare machining capacity is available and
each unit of B22 will require two hours of machining time in its manufacture using the
existing equipment. In addition, special finishing machines will be required for two
weeks to complete the B22. These machines will be hired at a cost of Rs.2,650 per week,
and there will be no overhead costs associated with their use.
8) Cash spending of Rs.3,250 has been incurred already on development work for the
production of B22. It is estimated that before production of the B22 begins, another
Rs.1,750 will have to be spent on development, making a total development cost of
Rs.5,000.
AT A GLANCE

The minimum price that the company should be prepared to accept for the 500 units of
product B22 would be calculated as follows together with brief explanation:
(Note: The minimum price is the price that equals the total relevant costs of producing
the items. Any price in excess of the minimum price will add to total profit).
Workings for relevant costs
Material X
The company has enough kilograms of material X in inventory for the contract. When it is used,
the inventory of material X will not be replaced. The relevant cost of the material is therefore its
opportunity cost, not its replacement cost. The opportunity cost is the higher of its current sale
value (Rs.7.50 per kg) or the net saving obtained if it is used as a substitute for material Z (Rs.9.50
– Rs.1.50 = Rs.8 per kg). The relevant cost of material X is therefore Rs.8 per kg.
SPOTLIGHT

Material Y
Material Y is in regular use, so its relevant cost is its current replacement cost.

kg Rs.
Total inventory 10,000 142,750
Purchased six months ago 3,000 (× Rs.13.75) 41,250
Purchased last month 7,000 101,500

Purchase price last month = Rs.101,500/7,000 kg = Rs.14.50 per kg.

STICKY NOTES

Current purchase price = 4% higher = Rs.14.50 × 1.04 = Rs.15.08.

Skilled labour
Skilled labour is in short supply. If it is used to make product B22, workers will have to be taken
off other work. The relevant cost of skilled labour is the wages for the skilled workers for the
time spent on B22, plus the lost contribution (net of skilled labour cost) from not being able to
make units of product B16.
Opportunity cost of skilled labour
Skilled labour cost per unit of Product B16 = Rs.24
Number of hours per unit = 3 hours
Contribution per unit of B16 = Rs.45
Contribution per skilled labour hour from B16 = Rs.15
Opportunity cost of skilled labour if it is used to make B22 = (500 × 5) × Rs.15 = Rs.37,500

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Unskilled labour
900 unskilled labour will be available at no incremental cost to the company (as it is already
being paid and is not fully employed). There is no relevant cost for these hours. The additional
600 hours required will involve extra wage payments, including overtime payments. The
relevant cost of these 600 hours is Rs.6 per hour × 150% = Rs.9 per hour, including the overtime
premium.
Overheads
Variable overheads are included as relevant costs because they will be additional costs if the units
of B22 are made. The only incremental fixed costs, however, are the extra cash costs of Rs.4,000.
The fixed overhead absorption rate is ignored. The additional costs of hiring special finishing
machinery are also included as a relevant cost.

AT A GLANCE
Development costs
Those costs already incurred are past costs (sunk costs) and are not relevant. The future
development costs involve additional expenditure and are included as relevant costs.
Minimum price for making 500 units of B22

Materials: Rs.
X (500 units × 4kg) × Rs.8 16,000
Y (500 units × 6kg) × Rs.15.08 45,240
Labour:
Skilled wages (500 units × 5 hours) × Rs.8 20,000

SPOTLIGHT
Opportunity cost (500 units × 5 hours) × Rs.15 37,500
Unskilled [(500 × 3) – 900] x 6 × 1.5 5,400
Overheads: Rs.
Variable (500 units × 2 hours) × Rs.8.75 8,750
Fixed Incremental spending 4,000
Machine hire (2 weeks × Rs.2,650) 5,300
Development costs 1,750

STICKY NOTES
Minimum price 143,940

 Example 02:
Topaz Limited (TL) is the manufacturer of consumer durables. Pearl Limited, one of the major
customers, has invited TL to bid for a special order of 150,000 units of product Beta.
Following information is available for the preparation of the bid.
i. Each unit of Beta requires 0.5 kilograms (kg) of material “C”. This material is produced
internally in batches of 25,000 kg each, at a variable cost of Rs. 200 per kg. The setup
cost per batch is Rs. 80,000. Material “C” could be sold in the market at a price of Rs. 225
per kg. TL has the capacity to produce 100,000 kg of material “C”; however, the current
demand for material “C” in the market is 75,000 kg.
ii. Every 100 units of product Beta requires 150 labour hours. Workers are paid at the rate
of Rs. 9,000 per month. Idle labour hours are paid at 60% of normal rate and TL currently
has 20,000 idle labour hours. The standard working hours per month are fixed at 200
hours.

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iii. The variable overhead application rate is Rs. 25 per labour hour. Fixed overheads are
estimated at Rs. 22 million. It is estimated that the special order would occupy 30% of
the total capacity. The production capacity of Beta can be increased up to 50% by
incurring additional fixed overheads. The fixed overhead rate applicable to enhanced
capacity would be 1.5 times the current rate. The utilized capacity at current level of
production is 80%.
iv. The normal loss is estimated to be 4% of the input quantity and is determined at the time
of inspection which is carried out when the unit is 60% complete. Material is added to
the process at the beginning while labour and overheads are evenly distributed over the
process.
v. TL has the policy to earn profit at the rate of 20% of the selling price.
In calculating the unit price that TL could bid for the special order to Pearl Limited would require
AT A GLANCE

following working:

Calculation of unit price to be quoted to Pearl Limited:

Material (25,000 × 200)+(53,125 × 225) + 80,000 W-1 17,033,125
Labour (20,000 ×45 × 40%) + (210,625 × 45) W-2 9,838,125
Variable overhead (230,625 × Rs. 25) 5,765,625
Incremental fixed cost (22m / 10 ×1.5) 3,300,000
35,936,875
Profit margin (25% of cost) 8,984,219
SPOTLIGHT

Sale price 44,921,094

Sale price per unit ( Rs. 44,921,094 / 150,000) 299
W-1: Material
Input units of material C (150,000 / 96%) × 0.5 78,125
W-2: Labour
Labour hours – completed units 150,000 x 1.50 225,000
– lost units {[(150,000 / 0.96) – 150,000] × 1.5 × 60%} 5,625
230,625
STICKY NOTES

 Example 03:
JD is a small specialist manufacturer of electronic components and much of its output is used by
the makers of aircraft. One of the small number of aircraft manufacturers has offered a contract
to Company JD for the supply of 400 identical components over the next twelve months.
The data relating to the production of each component is as follows:
a) Material requirements:
3 kilograms material M1: see note 1 below
2 kilograms material P2: see note 2 below
1 Part No. 678: see note 3 below
Note 1: Material M1 is in continuous use by the company. 1,000 kilograms are currently
held in stock at a carrying amount of Rs.4.70 per kilogram but it is known that future
purchases will cost Rs.5.50 per kilogram.

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Note 2: 1,200 kilograms of material P2 are held in inventory. The original cost of the
material was Rs.4.30 per kilogram but as the material has not been required for the last
two years it has been written down to Rs.1.50 per kilogram (scrap value). The only
foreseeable alternative use is as a substitute for material P4 (in current use) but this
would involve further processing costs of Rs.1.60 per kilogram. The current cost of
material P4 is Rs.3.60 per kilogram.
Note 3: It is estimated that the Part No. 678 could be bought for Rs.50 each.
b) Labour requirements
Each component would require five hours of skilled labour and five hours of semi-
skilled. An employee possessing the necessary skills is available and is currently paid
Rs.5 per hour. A replacement would, however, have to be obtained at a rate of Rs.4 per
hour for the work that would otherwise be done by the skilled employee. The current

AT A GLANCE
rate for semi-skilled work is Rs.3 per hour and an additional employee could be
appointed for this work.
c) Overhead
JD absorbs overhead by a machine hour rate, currently Rs.20 per hour of which Rs.7 is
for variable overhead and Rs.13 for fixed overhead. If this contract is undertaken it is
estimated that fixed costs will increase for the duration of the contract by Rs. 3,200.
Spare machine capacity is available and each component would require four machine
hours.
A price of Rs.145 per component has been suggested by the large aircraft manufacturer.
In stating whether or not the contract should be accepted, please see below calculations

SPOTLIGHT
with that supports conclusion with appropriate figures for presentation to management.
The contract should be accepted if the revenue from the contract will exceed the relevant
costs of the contract.
Workings
Material M1. This material is in continuous/regular use. The relevant cost of the 1,000
kilograms is their replacement cost.
Relevant cost = 400 components × 3 kilos × Rs.5.50 per kilo = Rs.6,600.
Material P2. The material held in inventory has a relevant cost that is the higher of its
scrap value (Rs.1.50) and the costs saved by putting it to an alternative use, which is Rs.2

STICKY NOTES
(Rs.3.60 – Rs.1.60).
There are more units held in stock than are needed for the contract. The excess quantity
should be ignored.
Relevant cost of material in stock = 400 components × 2 kilos × Rs.2 per kilo = Rs.1,600.
Part 678. Relevant cost = 400 components × Rs.50 = Rs.20,000.
Skilled labour. The relevant cost of skilled labour is the extra cash that would have to be
spent to hire additional labour.
Relevant cost = 400 components × 5 hours per component × Rs.4 per hour = Rs.8,000.
Semi-skilled labour. Relevant cost = 400 components × 5 hours per component × Rs.3 per
hour = Rs.6,000.
Variable overheads. It is assumed that the overhead absorption rate for variable
overheads is the rate at which cash expenditure is incurred on variable overheads.
Relevant cost = 400 components × 4 machine hours per component × Rs.7 per machine
hour = Rs.11,200.

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 CHAPTER 14: RELEVANT COSTS CAF 8: CMA

Relevant cost statement Rs.

Material M1 6,600
Material P2 1,600
Part 678 20,000
Skilled labour 8,000
Semi-skilled labour 6,000
Variable overheads 11,200
Incremental fixed costs 3,200
Total relevant costs 56,600
AT A GLANCE

Contract sales value (400 × Rs.145) 58,000

Incremental profit 1,400

Undertaking the contract will add Rs.1,400 to total profit. On a purely financial basis, this
means that the contract is worth undertaking. However, management might take the
view that a higher profit margin is desirable, and the suggested price of Rs.145 per
component might be negotiable.
 Example 04:
Rugby Limited (RL) is engaged in manufacturing of a product ‘B1’. Presently, RL is considering
to launch a new product B1–Extra which has a demand of 10,000 units per month. The estimated
SPOTLIGHT

selling price of B1–Extra is Rs. 2,000 per unit. Other relevant information is as follows:
i. Each unit of B1-Extra would require 2 kg of material X and 1.5 labour hours. Material X
is available in the market at Rs. 520 per kg. Alternatively, instead of material X, RL can
use 2.5 kg of a substitute material Y which can be produced internally. Production of
each kg of Y would require raw material costing Rs. 300 and 0.5 labour hour.
ii. Presently, about 14,000 labour hours remain idle each month and are paid at the rate of
50% of the normal wage rate of Rs. 250 per hour and such payments are charged to
administration expenses.
iii. Any shortfall in required labour hours can be met through overtime at the rate of 40%
above the normal wage rate.
STICKY NOTES

iv. Records of last 4 months show the following factory overheads (variable and fixed) at
different levels of direct labour hours:

Month 1 Month 2 Month 3 Month 4

Direct labour (Hours) 174,000 172,000 170,000 168,000
Factory overheads (Rs. in ‘000) 58,280 57,840 57,400 56,960

The expected relevant cost per unit of B1-Extra and determine the cost gap (if any) if RL requires
a margin of 30%, would be as follows:

Rugby Limited
Cost gap per unit Rs. per unit
Expected relevant cost per unit (15,800,000/10,000) 1,580.00
Less: Target cost per unit (2,000×70%) 1,400.00
Cost gap (1,580–1,400) 180.00

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Relevant costs of producing B1-Extra

Material cost 10,000×1,040 (W-1) 10,400,000
Direct labour cost (W-2) 2,100,000
Variable overheads 10,000×1.5×220 (W-4) 3,300,000
Total relevant cost 15,800,000

Rs. per unit of

W-1: Decision to use X or Y
B1-Extra

Cost of Y for each unit of B1-Extra

AT A GLANCE
Material cost (300×2.5) 750.00

Labour cost (Without overtime) (250×50%)×(0.5×2.5) 156.25

Variable factory overheads [(220(W-4)×0.5)×2.5] 275.00

Fixed (existing) (Not relevant) -

Cost of Y for each unit of B1-Extra 1,181.25

Cost of material X for each unit of B1-Extra (520×2.0)(Given) 1,040.00

Extra cost on producing Y internally (Not feasible) 141.25

SPOTLIGHT
W-2: Direct labour cost for B1-Extra Rupees

Labour cost – hours (14,000×250×50%) 1,750,000

Labour cost – overtime (1,000(W-3)×1.4×250) 350,000

Total direct labour cost 2,100,000

W-3: Overtime hours required Labour hours

Available labour hours 14,000

Labour hours required (10,000×1.5) 15,000

STICKY NOTES
Excess hours required - Overtime hours (1,000)

W-4: Variable factory overhead rate by

High Low Variable
high-low method

(a) (b) (a–b)

Factory overheads (Rs.) A 58,280,000 56,960,000 1,320,000

Labour hours B 174,000 168,000 6,000

Variable factory overheads rate per hour

(Rs.) (A÷B) 220

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 Example 05:
Ring Limited (RL) is engaged in the manufacture and sale of customized products. In January
2020, RL entered into an agreement with Gamma Limited (GL) for manufacture and supply of
3,500 units of a customized product ‘Zing’ at Rs. 4,000 per unit.
RL placed the order for raw material AA-2 and the supplier agreed to supply the material in
second week of March 2020. RL had also hired skilled labour for the production of Zing. However,
in February 2020, GL went bankrupt.
RL has recently been approached by Sigma Limited (SL) for supply of 3,500 units of D-Zing which
is a modified version of Zing. RL can use the ordered raw material and the hired skilled labour
for this product. The production of D-Zing will take three months. Following information has
been provided in this regard:
Machinery
AT A GLANCE

Specialized machinery will be needed to produce D-Zing. Following proposals are under
consideration:
(i) Lease machinery for three months at monthly lease rentals of Rs. 250,000 and an
upfront payment of refundable security deposit of Rs. 5,000,000. The upfront payment
will be financed through running finance @ 20% per annum. As per the lease terms,
monthly maintenance cost of Rs. 15,000 will be borne by the lessor.
(ii) Lease machinery at monthly lease rentals of Rs. 160,000 for a minimum period of six
months. In this case, monthly maintenance of Rs. 20,000 will be borne by RL which will
be incurred only in the months in which machinery is operative.
Direct material
Following raw materials will be required for manufacturing of each unit of D-Zing:
SPOTLIGHT

(i) 15 units of AA-2: RL had already ordered 50,000 units of AA-2 at Rs. 75 per unit under
the original contract of Zing. The current market price for AA-2 is Rs. 80 per unit. If the
contract is not fulfilled, a penalty at 20% of the contract value will be payable by RL.
(ii) 10 units of A-78: A-78 is available in market at Rs. 110 per unit. However, it can also be
produced internally at a variable cost of Rs. 80 per unit. Fixed cost would be absorbed
at Rs. 25 per unit. Internally produced A-78 would be subject to 20% normal loss.
(iii) 5 units of C-11: Market price of C-11 is Rs. 20 per unit. However, a substitute material
D-50 can also be used after processing it at a cost of Rs. 15 per unit. Presently 5,000
units of D-50 is available in stock as a result of over purchasing for a previous order. D-
50 was purchased at Rs. 5 per unit and can be sold back to the supplier at Rs. 3 per
STICKY NOTES

unit.
Direct labour
(i) RL had hired skilled labour from a third party at Rs. 1,000 per hour under the original
contract of Zing. If order from SL is not accepted, 200 labour hours would become idle
and RL will have to pay 50% of the contract rate.
(ii) If SL’s offer is accepted, then D-Zing would be produced in batches of 350 units and the
first batch would require 400 skilled labour hours. Learning curve effect is estimated at
80% but would remain effective for the first four batches only. The index of learning
curve is – 0.322.
(iii) 1.5 hours of semi-skilled labour is required for every unit of D-Zing. Since there is a
shortage of semi-skilled labour in the market, only 4,000 labour hours are available at
Rs. 600 per hour. However, labour is willing to do overtime at a 50% higher rate up to
maximum of 1,500 hours. Alternatively, unskilled labour can be hired at Rs. 200 per
hour, however, unskilled labour would require 300% of the time taken by semi-skilled
labour. This can be reduced to 250% if training is given to them at a cost of Rs.
300,000.

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Variable overheads
Variable overheads would be charged at Rs. 125 per skilled labour hour.
By using the relevant cost approach, computation of minimum price per unit that RL may quote,
is calculated below.
Relevant cost --------Rupees-------
Machinery:
Lower of:
Proposal 1
- Lease rentals [250,000×3] 750,000
- Finance cost [(5,000,000×20%)÷4] 250,000
1,000,000
AND

AT A GLANCE
Proposal 2
- Lease rentals (160,000×6) 960,000
- Maintenance [20,000×3] 60,000
1,020,000 1,000,000
Direct material
AA-2
Contract price [50,000×75] 3,750,000
Less: Savings from penalty amount [50,000×75×20%] (750,000)
Purchasing cost [{(3,500×15)–50,000}×80] 200,000 3,200,000
A-78
Lower of:

SPOTLIGHT
Purchasing cost [3,500×10×110 3,850,000
AND
Internal cost [(3,500×10×80)÷0.8] 3,500,000 3,500,000
C-11
Opportunity cost of selling back [5,000×3] 15,000
Further processing cost [5,000×15] 75,000
Purchasing cost [(3,500×5)–5,000]×20 250,000 340,000
Direct labour
Skilled
Idle hours saved [200×1,000×50%] (100,000)

STICKY NOTES
Labour for 10 batches [1,024(W-1)+1,092(W-1)]×1,000 2,116,000 2,016,000
Semi-skilled
Lower of:
Normal rate [4,000×600] 2,400,000
Overtime [(3,500×1.5)–4,000]×600×1.5 1,125,000
3,525,000
AND
Unskilled without training- Labour cost 3,150,000
AND
Unskilled training- Labour cost 2,625,000
Training cost 300,000
2,925,000 2,925,000
Variable overheads
Cost [{1,024(W-1)+(182×6)}×125] 264,500
Total relevant costs 13,245,500
Minimum price to be quoted (13,245,500÷3,500) 3,784

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W-1 Learning curve effects

Year-wise relevant cost Hours
For the first 4 batches [4×400×(4) –0.322] 1,024
For the first 3 batches [3×400×(3) –0.322] 842
For the 5th batch and onwards (1,024‒842) 182
Total hours (182×6) 1,092

 Example 06:
Global (Pvt.) Limited (GPL) is in the process of preparing bid documents for a special order of 5,000
units of a new product Zeta. In this respect, GPL’s technical department has worked-out the
AT A GLANCE

following projections/information:
(i) The order would be completed in 15 days.
(ii) GPL has sufficient stock of the required materials to produce Zeta. Some of the relevant
information is as follows:

Material A Material B Material C

Quantity required 5,000kg 3,000kg 2,000kg
Original purchase price Rs. 180 per kg Rs. 150 per kg Rs. 50 per kg
Current purchase price Rs. 200 per kg Rs. 175 per kg Rs. 160 per kg
SPOTLIGHT

Current disposal price Rs. 100 per kg Rs. 135 per kg -

• Material A is used by GPL in many products and therefore sufficient stock is
maintained.
• Material B has no use other than in the production of Zeta.
• The stock of material C was purchased several years ago for another project. It can
only be used in the production of Zeta. Otherwise, it will have to be disposed of at
a cost of Rs. 10 per kg to meet environmental legislation.
(iii) The production of Zeta would require:
• 800 skilled labour hours at Rs. 200 per hour. Presently, 1,440 labour hours remain
STICKY NOTES

idle during each month.

• 250 unskilled labour hours which can be hired at Rs. 120 per hour.
• 150 machine hours. If the machine is not used for Zeta, it may be leased out at Rs.
4,000 per day.
(iv) GPL absorbs overheads at Rs. 400 per skilled and unskilled labour hours. Based on normal
capacity of 50,000 hours, fixed overheads are estimated at Rs. 6,000,000. If GPL decides to
produce Zeta, fixed overheads would increase by Rs. 150,000.
(v) As a result of production of Zeta, general administration cost would increase by Rs. 100,000.
(vi) The planning department of GPL has incurred a cost of Rs. 20,000 on preparing feasibility
for production of Zeta.

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Computation of bid price that GPL should quote, if it wants to earn profit (based on relevant cost)
of 20% of selling price, is given below.

Computation of Bid Price Rupees

Material A - at current purchase price 5,000×200 1,000,000
Material B - at current selling price 3,000×135 405,000
Material C - disposal cost saving 2,000×10 (20,000)
Skilled labour hours - after using idle hours [800-(1440÷2)]×200 16,000
Unskilled labour hours 250×120 30,000
Machine hours 15 days×4000 60,000
Variable overheads (800+250)×[(400×50,000-

AT A GLANCE
6,000,000)÷50,000)]OR(800+250)×[400 - (6,000,000÷50,000)] 294,000
Incremental fixed overheads 150,000
Increase in general administration costs 100,000
Feasibility cost incurred by planning department - sunk cost -
Total production cost 2,035,000
Bid price - to earn 20% profit on selling price 2,035,000÷0.8 2,543,750

 Example 07:
The Telephone Co (T Co) is a company specialising in the provision of telephone systems for
commercial clients. There are two parts to the business:

SPOTLIGHT
– Installing telephone systems in businesses, either first time installations or replacement
installations;
– Supporting the telephone systems with annually renewable maintenance contracts.
T Co has been approached by a potential customer, Push Co, who wants to install a telephone
system in new offices it is opening. Whilst the job is not a particularly large one, T Co is hopeful
of future business in the form of replacement systems and support contracts for Push Co. T Co is
therefore keen to quote a competitive price for the job. The following information should be
considered:
1. One of the company's salesmen has already been to visit Push Co, to give them a
demonstration of the new system, together with a complimentary lunch, the costs of which

STICKY NOTES
amounting to Rs. 4,000.
2. The installation is expected to take one week to complete and would require three engineers,
each of whom is paid a monthly salary of Rs. 140, 000. The engineers have just had their
annually renewable contract renewed with T Co. One of the three engineers has spare
capacity to complete the work, but the other two would have to be moved from contract X in
order to complete this one. Contract X generates a contribution of Rs. 50 per engineer hour.
There are no other engineers available to continue with Contract X if these two engineers are
taken off the job. It would mean that T Co would miss its contractual completion deadline on
Contract X by one week. As a result, T Co would have to pay a one-off penalty of Rs. 5,000.
Since there is no other work scheduled for their engineers in one week's time, it will not be
a problem for them to complete Contract X at this point.
3. T Co's technical adviser would also need to dedicate eight hours of his time to the job. He is
working at full capacity, so he would have to work overtime in order to do this. He is paid an
hourly rate of Rs. 400 and is paid for all overtime at a premium of 50% above his usual hourly
rate.

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4. Two visits would need to be made by the site inspector to approve the completed work. He
is an independent contractor who is not employed by T Co, and charges Push Co directly paid
for the work. His cost is Rs. 20,000 for each visit made.
5. T Co's system trainer would need to spend one day at Push Co delivering training. He is paid
a monthly salary of Rs. 150,000 but also receives commission of Rs. 1,250 for each day spent
delivering training at a client's site.
6. 120 telephone handsets would need to be supplied to Push Co. The current cost of these is
Rs. 182 each, although T Co already has 80 handsets in inventory. These were bought at a
price of Rs. 168 each. The handsets are the most popular model on the market and frequently
requested by T Co's customers.
7. Push Co would also need a computerised control system called 'Swipe 2'. The current market
price of Swipe 2 is Rs. 10,800, although T Co has an older version of the system, 'Swipe 1', in
AT A GLANCE

inventory, which could be modified at a cost of Rs. 4,600. T Co paid Rs. 5,400 for Swipe 1
when it ordered it in error two months ago and has no other use for it. The current market
price of Swipe 1 is Rs. 5,450, although if Push Co tried to sell the one they have, it would be
deemed to be 'used' and therefore only worth Rs. 3,000.
8. 1,000 metres of cable would be required to wire up the system. The cable is used frequently
by T Co and it has 200 metres in inventory, which cost Rs. 12 per metre. The current market
price for the cable is Rs.13 per metre.
9. You should assume that there are four weeks in each month and that the standard working
week is 40 hours long.
Preparation of cost statement, using relevant cost principles, showing the minimum cost that T
Co. should charge for the contract, along with explanation of each cost item, is given below.
SPOTLIGHT

Computation of Minimum Cost Note Rupees

Demonstration and complimentary lunch 1 -
Engineers 2 5,000
Technical advisor 3 4,800
Site inspector visit 4 -
Training cost 5 1,250
Telephone handsets 6 21,840
Computerised control system 7 7,600
STICKY NOTES

Cable cost 8 13,000

Minimum price 53,490

Notes:
1. Demonstration and complimentary lunch
The salesman has already been to visit Push Co to demonstrate the new system. The
associated costs are sunk costs (they have already been incurred) and are therefore
excluded from the cost statement.
Relevant cost = Rs.0
2. Engineers
One of the three engineers has spare capacity to complete the installation and his/her salary
will be paid regardless of whether they work on the contract for Push Co. The relevant cost
is therefore Rs. Nil.

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The other two engineers are currently fully utilised and earn a contribution of Rs.5 per hour
each on Contract X. The engineers could be temporarily taken off of Contract X to work on
the contract for Push Co. Work on Contract X would recommence in one week's time when
there is no other scheduled work for the engineers.
Delaying the work on Contract X would result in T Co missing the contractual completion
deadline and having to pay a one-off penalty of Rs. 5,000.
Relevant cost = Rs. 5,000
3. Technical adviser
The technical adviser is working at full capacity so would need to work 8 hours overtime
on the contract for Push Co. All overtime is paid at a premium of 50% above his usual hourly
rate of Rs. 400 (Rs.400 × 1.5 = Rs. 600).

AT A GLANCE
Relevant cost = Rs. 600 × 8 hours = Rs. 4,800
4. Site inspector visits
The site inspector is an independent contractor who is not employed by T Co and charges
Push Co directly for the work. Since the site engineer charges Push, the relevant cost for T
Co is nil.
Relevant cost = Rs. Nil
5. Training costs
The system trainer is paid a monthly salary of Rs. 150,000. This is not a relevant cost, as it
is not incremental. The trainer is also paid Rs. 1,250 commission for each day spent

SPOTLIGHT
delivering training at a client's site. This cost will arise as a direct result of the decision and
is therefore included.
Relevant cost = Rs. 1,250 per day × 1 day = Rs. 1,250
6. Handsets
120 handsets would need to be supplied to Push Co. Though 80 handsets are already in
inventory, the handsets are frequently requested by T Co's customers and so would need to
be replaced if supplied to Push Co. The current cost of a handset is Rs.182.
Relevant cost = Rs.182 × 120 handsets = Rs. 21,840

STICKY NOTES
7. Computerised control system
The current market price of Swipe 2 is Rs. 10,800.
The original cost of Swipe 1 (Rs. 5,400) is a sunk cost and not relevant to the decision.
The current market price of Swipe 1 (Rs. 5,450) is also not relevant to the decision as T Co
has no intention of replacing Swipe 1.
The company could sell Swipe 1 for Rs. 3,000 if it does not use it for this contract. This
represents an opportunity cost.
In addition to the Rs. 3,000, Swipe 1 could be modified at a cost of Rs. 4,600, bringing the
total cost of converting Swipe 1 to Rs. 7,600.
The total cost of converting Swipe 1 (Rs. 7,600) is significantly less than purchasing Swipe
2 (Rs. 10,800). It is assumed that the company would choose the cheaper option.
Relevant cost = Rs. 7,600

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8. Cable costs
1,000 metres of cable is required. Although T Co has 200 metres of cable in inventory, it is
used frequently and so would need to be replaced. All 1,000 metres should be valued at the
current market rate (Rs. 13 per metre). The original purchase cost of Rs. 12 per metre is a
sunk cost and is not relevant to the decision.
Relevant cost = 1,000 metres × Rs.13 per metre = Rs. 13,000
AT A GLANCE
SPOTLIGHT
STICKY NOTES

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STICKY NOTES

Relevant costs are cash flows that will occur in the future as a direct
consequence of making the decision

Relevant costs include incremental costs (additional cost that will occur if a
particular decision is taken), differential costs (amount by which future costs
will be different), avoidable costs (cost that can be saved) and opportunity
costs (a benefit that will be lost by taking a course of action).

AT A GLANCE
Relevant costs of materials, labour or overheads are the additional cash
flows that will be incurred (or benefits that will be lost) by using the
materials for the purpose that is under consideration or arise as a direct
consequence of the decision.

SPOTLIGHT
STICKY NOTES

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AT A GLANCE
SPOTLIGHT
STICKY NOTES

458 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

 CHAPTER 15

DECISION MAKING TECHNIQUES

AT A GLANCE
IN THIS CHAPTER Management are often required to make decisions where
company is at stake. These decisions are required to make
AT A GLANCE where factors or sources are limited, Concepts of relevant
costing and cost-volume-profit analysis are used for such
SPOTLIGHT decisions.
One-off contract decisions, special pricing decisions, make or
1. Introduction To Decision
buy decisions and many other short term decisions including
Making
join product, discontinuation of operations, replacement of
equipment or plant and further processing decisions, are some
2. Limiting Factor Decisions
of the decision making areas that may need management’s
attention.
3. Make Or Buy Decisions:

4. Other Short Term Decisions

5. Comprehensive Examples

STICKY NOTES

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 CHAPTER 15: DECISION MAKING TECHNIQUES CAF 8: CMA

1. INTRODUCTION TO DECISION MAKING

1.1 Types of decision
Decisions in the entity can be one-off decision, short-term decision and long-term decision and brief description
of them is given below.
• Short-term decisions are decisions where the financial consequences occur soon after the decision is taken.
For example, a short-term decision may result in an immediate increase in profit (additional net cash
inflows), or an increase in annual profits and cash flows.
• A long-term decision is one where a capital investment may be required and the benefits of the investment
will be obtained over a period of several years.
AT A GLANCE

The concept of relevant costs (as discussed in chapter 14) is used for both short-term and long-term decisions,
except that for long-term decisions the time value of money should also be taken into consideration.
Examples of management decisions where relevant costing is used are:
• Limiting factor decisions- Optimal product mix to earn maximum profit under given situation.
• One-off contract decisions: management might want to decide whether or not to undertake a contract for a
specified fixed price. If it is a one-off contract, rather than regular production work, it would be worthwhile
undertaking the contract if the extra revenue from the contract is higher than the relevant costs of doing the
work (including any opportunity costs).
• Make-or-buy decisions- Should the company manufacture the products in-house or outsource them?
• Shutdown decisions- Whether specific product/s or segment/s be continued or discontinued?
•
SPOTLIGHT

Joint product further processing decisions- Decision about selling the joint product at split-off point or after
processing further.

1.2 Marginal costing and decision-making

It is often assumed that marginal costs are relevant costs for the purpose of decision-making.
• The marginal cost of a product is the extra cost that would be incurred by making and selling one extra unit
of the product.
• Similarly, the marginal cost of an extra hour of direct labour work is the additional cost that would be
incurred if a direct labour employee worked one extra hour. When direct labour is a variable cost, paid by
the hour, the marginal cost is the variable cost of the direct labour wages plus any variable overhead cost
related to direct labour hours.
STICKY NOTES

This chapter focuses on short-term decision-making when there are limiting factors that restrict operational
capabilities. Decision-making techniques for limiting factor situations are based on the following assumptions:
• The objective is to maximize profit and this is achieved by maximizing contribution;
• Marginal costs (variable costs) are the only relevant costs to consider in the model: and
Fixed costs will be the same whatever decision is taken; therefore, fixed costs are not relevant to the decision.

1.3 Incremental cost analysis

Incremental analysis helps companies to decide whether or not to accept a special order. This special order is
typically lower than its normal selling price. Incremental analysis also assists with allocating limited resources
to several product lines to ensure a scarce asset is used to maximum benefit.

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 Example 01:
A company sells an item for Rs. 500,000. The company pays Rs. 200,000 for labour, Rs. 100,000
for materials and Rs. 50,000 for variable overhead selling expenses. The company allocates Rs.
50,000 per item for fixed overhead costs.
The company is not operating at capacity and will not be required to invest in equipment or
overtime to accept a special order it receives. Then, a special order requests the purchase of 20
items for Rs. 400,000 each.
The sum of all variable costs and fixed costs per item is Rs. 400,000. However, the Rs. 50,000 of
allocated fixed overhead costs are a sunk cost as already spent. The company has excess capacity
and should only consider the relevant costs. Therefore, the cost to produce the special order is
Rs. 350,000 per item (Rs. 200,000 + Rs. 100,000 + Rs. 50,000) and the profit per item is Rs. 50,000
(Rs. 400,000 – Rs. 350,000).

AT A GLANCE
While the company is still able to make a profit on this special order, the company must consider
the consequences of operating at full capacity. If no excess capacity is present, additional
expenses to consider include investment in new fixed assets, overtime labour costs, and the
opportunity cost of lost sales.

SPOTLIGHT
STICKY NOTES

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2. LIMITING FACTOR DECISIONS

2.1 Limiting factor: definition and the issue
Limiting factor is any factor which is in scarce supply and which stops the entity to produce more units. In other
words, limiting factor limits the organisation’s activities. Most commonly examples of limiting factors are:
• Materials when there may be insufficient material availability to produce units in order to meet market
demand.
• Labour might be a limiting factor when insufficient labour available for specific skill.
• Every manufacturing plant has its own capacity and it cannot be enhanced in short-term. Sometimes,
machine hours at full capacity produced insufficient units i.e. not able to meet the market demand.
AT A GLANCE

In these circumstances, the factor setting a limit to the volume of sales and profit in a particular period is the
availability of the scarce resource, because sales are restricted by the amount that the company can produce.
If the company makes just one product and a production resource is in limited supply, profit is maximized by
making as many units of the product as possible with the limited resources available.
However, when a company makes and sells more than one products with the same scarce resource, a budgeting
problem is to decide how many of each different product to make and sell in order to maximize profits.

2.3 Maximizing profit when there is a single limiting factor

When there is a limiting factor and company is producing more than one products, then the challenge is to earn
maximum profit in this situation. In order to maximise the profit, decision of optimal production mix becomes
more important. Following steps should be followed in order to earn maximum contribution or profit.
SPOTLIGHT

Step I: Identify the limiting factor

There can be more than one potential limiting factor, therefore, the identification of limiting factor is important.
However, when single limiting factor is given in question, this step should not be applied in solution. When at
maximum demand, the required level of limiting factor exceeds its availability, it is stated as limiting factor. This
concept can be clarified from following example.
 Example 02:
A company manufactures and sells two products, Product X and Product Y which are both
manufactured using two different machines.
The time taken to make each product together with the maximum machine time availability and
contribution per unit and demands are as follows:
STICKY NOTES

Machines X Y Hours available

Machine type 1 10 minutes per unit 6 minutes per unit 3,000 hours
(6 units per hour) (10 units per hour)

Machine type 2 5 minutes per unit 12 minutes per unit 4,200 hours
(12 units per hour) (5 units per hour)

Sales demand in units 12,000 15,000

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Which machine is the limiting factor is identified by calculating the time needed to meet the total
demands for both goods and comparing that to the machine time available:
Machine type 1 Machine type 2
(hours) (hours)
Product X: 12,000 ÷ 6 per hour 2,000
Product X: 12,000 ÷ 12 per hour 1,000
Making 15,000 units of Y would use:
Product Y: 15,000 ÷ 10 per hour 1,500
Product Y: 15,000 ÷ 5 per hour 3,000

AT A GLANCE
Total hours needed to meet maximum demand 3,500 4,000
Total hours available 3,000 4,200
Therefore, machine 1 time is the limiting factor

Step II: Calculate contribution per unit of each product

Contribution per unit is calculated by deducting the variable production cost per unit from its sales
price for each product.
Step III: Calculate contribution per limiting factor resource of each product.
For example, Product A has contribution of Rs. 50 per unit and product B Rs. 60. Machine hour is
limiting factor (identified in step I). Product A and B required 4 and 5 machine hours respectively

SPOTLIGHT
to product one unit.
Therefore, the contribution per machine hour is calculated as:

Product A (50/ 4) Rs. 12.50

Product B (60 / 5) Rs. 12.00

Step IV: Rank the products on the basis of step III.

Taking the values given in example in Step III, even contribution per unit of product B is higher than
product A, but we should rank the products on the basis of contribution per machine hour. Hence,
product A should be produced first and then product B should be produced.
Step V: Calculate optimal production mix

STICKY NOTES
Optimal production mix is combination of products to be produced to get maximum profits under
given constraints. For calculating optimal production mix, it is important to follow ranking
calculated in Step IV.
 Example 03:
MS Limited makes two products, the M and S. Unit variable costs are as under.

M S
Rs. Rs.
Direct material 100 300
Direct labour (Rs. 50 per hour) 600 300
Variable production overheads 100 100

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The sales price per unit is Rs. 1,400 per M and Rs. 1,100 per S. During September, the available direct
labour is limited to 60,000 hours and material of Rs. 2,500,000 Sales demand in September is
expected to be as follows:
Product M 3,000 units
Product S 5,000 units
The optimal production mix, under limiting factor theory, is calculated as under.
Step I Identify the limiting factor
Labour hours
Product M (3,000 x 600/50) 36,000
Product S (5,000 x 300/50) 30,000
Required hours 66,000
Available hours 60,000
AT A GLANCE

Labour is limiting factor as available hours are

insufficient to produce all units of Product M and S.
Material Rs.
Product M (3,000 x 100) 300,000
Product S (5,000 x 300) 1,500,000
Required material 1,800,000
Available material 2,500,000
Material is not limiting factor, as sufficient material is
available to product all units of both products.
SPOTLIGHT

Step II to IV: The step II (calculation of contribution per unit), step III (calculation of contribution
per limiting factor) and step IV (rank the products), is calculated in single table given below.
Product M Product S
Sales price per unit Rs. 1,400 1,100
Less: Variable cost per unit Rs.
Direct materials (100) (300)
Direct labour (600) (300)
Variable production overheads (100) (100)
(800) (700)
STICKY NOTES

Contribution per unit 600 400

Labour hours per unit 12 6
Contribution per labour hour 50 66.67
Ranking II I
Step V: Optimal production mix table
Labour hours Units
Available labour hours 60,000
Product S (5,000 x 6) (30,000) 5,000
30,000
Product M (30,000 / 12) (30,000) 2,500
Hence 2,500 units of Product M and 5,000 units of Product S should be produced, in order to
maximise the profits.

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 Example 04:
A company makes four products, A, B, C and D, using the same direct labour work force on all the
products.
The company has no inventory of finished goods.
Direct labour is paid Rs. 12 per hour.
To meet the sales demand in full would require 12,000 hours of direct labour time.
Only 6,000 direct labour hours are available during the year.
Budgeted data for the company is as follows:
Product A B C D
Annual sales demand (units) 4,000 5,000 8,000 4,000

AT A GLANCE
Rs. Rs. Rs. Rs.
Direct materials cost 3.0 6.0 5.0 6.0
Direct labour cost 6.0 12.0 3.0 9.0
Variable overhead 2.0 4.0 1.0 3.0
Fixed overhead 3.0 6.0 2.0 4.0
Full cost 14.0 28.0 11.0 22.0
Sales price 15.5 29.0 11.5 27.0
Profit per unit 1.5 1.0 0.5 5.0
The optimal production plan would be calculated as follows:

SPOTLIGHT
Calculation of contribution per unit, per limiting factor and ranking
Product A B C D
Sales price 15.50 29.00 11.50 27.00
Direct materials cost (3.00) (6.00) (5.00) (6.00)
Direct labour cost (6.00) (12.00) (3.00) (9.00)
Variable overhead (2.00) (4.00) (1.00) (3.00)
Variable cost per unit (11.00) (22.00) (9.00) (18.00)
Contribution per unit 4.50 7.00 2.50 9.00
Labour hours per unit

STICKY NOTES
(total labour cost/labour cost per hour) 6/12 12/12 3/12 9/12

0.5 1 0.25 0.75

Contribution per labour hour
(contribution per unit/ labour hours per unit 4.5/0.5 7/ 1 2.5/0.25 9/0.75

Contribution per hour (Rs. ) 9 7 10 12

Ranking 3rd 4th 2nd 1st
The products should be made and sold in the order D, C, A and then B, up to the total sales
demand for each product and until all the available direct labour hours (limiting factor
resources) are used up
Step 6: Construct a production plan to maximize contribution

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Direct labour Contribution Total

Product Sales units
hours used per unit contribution
Rs. Rs.
D (1st) 4,000 (maximum) 3,000 9.00 36,000
C (2nd) 8,000 (maximum) 2,000 2.50 20,000
A (3rd) 2,000 (balance) 1,000 4.50 9,000
6,000 65,000
Note: The plan is constructed as follows:
D is ranked first so the company needs to make as many of these as possible. The most it can sell
is 4,000 units which would take 3,000 hours (0.75 hours per unit) to make. The company has
6,000 hours available so all of these can be made.
AT A GLANCE

The company now has 3,000 hours left. C is ranked second and the most of C that can be sold is
8,000 units. This would use 2,000 hours (0.25 hours per unit).
The company now has 1,000 hours left. A is ranked third and the most of these that can be sold
is 4,000 units. However, this would use 2,000 hours (0.5 hours per unit) so only half of these can
be made.
 Example 05:
A company makes four products, W, X, Y and Z, using the same single item of direct material in
the manufacture of all the products. Budgeted data for the company is as follows:
Product W X Y Z
Annual sales demand (units) 4,000 4,000 6,000 3,000
SPOTLIGHT

Rs. Rs. Rs. Rs.

Direct materials cost 5.00 4.00 8.00 6.00
Direct labour cost 4.00 6.00 3.00 5.00
Variable overhead 1.00 1.50 0.75 1.25
Fixed overhead 8.00 12.00 6.00 10.00
Full cost 18.00 23.50 17.75 22.25
Sales price 50.00 31.50 59.75 54.25
Profit per unit 32.00 8.00 42.00 32.00
Due to restricted supply, only Rs. 78,000 of direct materials will be available during the year. And
STICKY NOTES

it required to identify the quantities of production and sales of each product that would maximize
annual profit, please see below
This question does not tell you the amount of material but it does give you its value. The analysis
can proceed in the usual way using contribution per value of material rather than contribution
per amount of material.
W X Y Z
Rs. Rs. Rs. Rs.
Sales price/unit 50.00 31.50 59.75 54.25
Variable cost/unit (10.00) (11.50) (11.75) (12.25)
Contribution per unit 40.00 20.00 48.00 42.00
Direct materials per unit (Rs.) 5 4 8 6
Rs. contribution per Rs.1 direct 8.00 5.00 6.00 7.00
material
Priority for making and selling 1st 4th 3rd 2nd

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Profit-maximising budget

Direct Contribution Total contribution

Product Sales units
materials (Rs.) per unit (Rs.) (Rs.)

W (1st) 4,000 20,000 40 160,000

Z (2nd) 3,000 18,000 42 126,000

Y (3rd) - balance 5,000 40,000 48 240,000

78,000 526,000

 Example 06:

AT A GLANCE
a) Company X manufactures four liquids: A, B, C and D. The selling price and unit cost details
for these products are as follows:

Liquid A Liquid B Liquid C Liquid D

Rs. per litre Rs. per litre Rs. per litre Rs. per litre

Selling price 100 110 120 120

Costs:

Direct materials 24 30 16 21

SPOTLIGHT
Direct labour (Rs.6/hour) 18 15 24 27

Direct expenses 0 0 3 0

Variable overhead 12 10 16 18

Fixed overhead (note 1) 24 20 32 36

Total cost per litre 78 75 91 102

Profit per litre 22 35 29 18

Note 1

STICKY NOTES
Fixed overhead is absorbed on the basis of labour hours, based on a budget of 1,600 hours
per quarter (three months).
During the next three months the number of direct labour hours is expected to be limited to
1,345 hours. The same labour is used for all products.
The marketing director has identified the maximum demand for each of the four products
during the next three months as follows:
Liquid A 200 liters
Liquid B 150 liters
Liquid C 100 liters
Liquid D 120 liters
No inventories are held at the beginning of the period that could be used to satisfy demand
in the period.

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If the company requires to determine the number of liters of liquids A, B, C and D to be

produced and sold in the next three months in order to maximize profits and calculate the
profit that this would yield; working is given below:
A B C D
Rs. Rs. Rs. Rs.
Sales price 100 110 120 120
Variable cost per litre (54) (55) (59) (66)
Contribution per litre 46 55 61 54
Direct labour hours/unit 3 2.5 4 4.5
Contribution /direct labour hour (Rs.) 15.33 22.00 15.25 12.00
Priority for manufacture/sale 2nd 1st 3rd 4th
AT A GLANCE

The fixed overhead absorption rate is Rs.8 per hour. This can be calculated from the
overhead cost and direct labour hours for any of the four products.
The budgeted labour hours for calculating this absorption rate was 1,600 hours, therefore
budgeted fixed costs are 1,600 hours × Rs.8 = Rs.12,800.
The output and sales that will maximize contribution and profit is as follows:
Contribution Contribution
Product Litres Hours
/litre (Rs.) /profit (Rs.)
B 150.0 375 55 8,250.0
A 200.0 600 46 9,200.0
C (balance) 92.5 370 61 5,642.5
SPOTLIGHT

1,345 23,092.5
Fixed costs (see above) 12,800.0
Profit 10,292.5

b) Suppose that a contract has been made before the beginning of the period by Company
X and one of its customers, Company Y. Company X has agreed to supply Company Y
with supply of 20 liters of each A, B, C and D during the three-month period.
This sales demand from Company Y is included in the demand levels shown above in
part (a) of the question.
For the above scenario please see below working for following requirements
STICKY NOTES

Given the contract with Company Y, determine the number of liters of liquids A, B, C and
D to be produced and sold in the next three months in order to maximize profits, if the
maximum number of labour hours remain 1,345 hours for the period.
The profit that this would yield, would be calculated as follows:
In this situation, there is a minimum sales demand from Company Y that must be met:
Contribution Contribution
Product Litres Hours
/litre (Rs.) (Rs.)
A: (3 hours/litre) 20 60 46 920
B: (2.5 hours/litre) 20 50 55 1,100
C: (4 hours/litre) 20 80 61 1,220
D: (4.5 hours/litre) 20 90 54 1,080
280 4,320
Total hours available 1,345
Hours remaining 1,065

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The remaining 1,065 hours should be used to maximize contribution, using the same
priorities as before. However, maximum sales demand should be reduced by 20 liters for
each product, to allow for the sales to Company Y.
The output and sales that will maximize contribution and profit, allowing for the sales to
Company Y, are as follows:
Contribution/ Contribution/
Product Litres Hours
litre profit
Rs. Rs.
B 130 325 55 7,150
A 180 540 46 8,280
C (balance) 50 200 61 3,050
1,065 18,480

AT A GLANCE
Contribution from sales to Y 4,320
Total contribution 22,800
Fixed costs 12,800
Profit 10,000
 Example 07:
A company produces three products using the same raw material. The raw material is in short
supply and only 3,000 kilograms shall be available in April 2009, at a cost of Rs. 1,500 per
kilogram.
The budgeted costs and other data related to April 2009 are as follows:
X Y Z

SPOTLIGHT
Maximum demand (units) 1,000 800 1,200
Selling price per unit (Rs.) 3,750 3,500 4,500
Material used per unit (kg) 1.6 1.2 1.8
Labour hours per unit (Rs. 75 per hour) 12 16 15
The number of units that should be produced by the company to earn maximum profit would be
determined as follows:
X Y Z
Selling price A 3,750 3,500 4,500
Material cost per unit at Rs. 1,500 per kilogram B 2,400 1,800 2,700
Labour cost per unit at Rs. 75 per hour C 900 1,200 1,125

STICKY NOTES
Profit per unit (A – B – C) D 450 500 675
Material usage in kilograms per unit E 1.6 1.2 1.8
Profit per kg of material used (D ÷ E) F 281.25 416.67 375.00
Preferred order of manufacture 3 1 2
Maximum demand in units 1,000 800 1,200
Total raw material available – kgs 3,000
Less: consumption for 800 units of Y (800 x 1.2 kgs) 960
Balance available 2,040
Consumption for 1,200 units of Z = (1,200 x 1.8 kgs) 2,160
Limited to 1,133 units @ 1.8 kg per unit 2,040
Balance -
Therefore, the production should be as follows:
Y = 800 units
Z = 1,133 units

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3. MAKE OR BUY DECISIONS

3.1 Make-or-buy decisions: outsourcing
A make-or-buy decision is a decision about:
• whether to make an item internally or to buy it from an external supplier, or
• whether to do some work with internal resources, or to contract it out to another organization such as a sub-
contractor or an outsourcing organization.
The economic basis for the decision whether to make internally or whether to buy externally (outsource
production) should be based on relevant costs. The preferred option from a financial viewpoint should be the
one that has the lower relevant costs.
AT A GLANCE

A financial assessment of a make-or-buy decision typically involves a comparison of:

• the costs that would be saved if the work is outsourced or sub-contracted, and
• the incremental costs that would be incurred by outsourcing the work.
 Example 08:
A company manufactures a component that is included in a final product that it also
manufactures. Management have identified an external supplier who would be willing to supply
the component.
The variable cost of manufacturing the component internally is Rs.10 and the external supplier
would be prepared to supply the components for Rs.13 each. It has been estimated that cash
savings on general overhead expenditure will be Rs. 48,000 each year if internal production is
ended. The company needs 10,000 units of the component each year.
SPOTLIGHT

The decision regarding whether the company make or buy the component would require
following evaluations
The annual relevant costs and benefits of a decision to buy the components externally can be
presented as follows:
Rs.
Extra costs of purchasing externally (10,000 units × (Rs.13 - Rs.10)) (30,000)
Cash savings in overhead expenditures 48,000
Net benefit from external purchasing (outsourcing) per year 18,000
Conclusion: The company would increase its profit by purchasing externally instead of making
STICKY NOTES

the items in-house. The recommendation on financial considerations is therefore to buy

(outsource production), not make internally.
If the limiting factor situation exist, and current demand cannot be fulfilled by existing
customers, then remaining demand can be fulfilled by purchasing the units from external
supplier.
When there is limiting factor situation faced by entity, then following approach should be used
to calculate the units to make in house and units to buy from external supplier.
Step I Identify the limiting factor.
Step II Calculate variable cost of production per unit of each product.
Step III Calculate extra cost per unit to buy of each product, after comparing it with cost of
production per unit.
Step IV Calculate extra cost per limiting factor if bought for each product.
Step V Rank the products, if bought from external supplier (Lowest extra cost per unit to buy
should be ranked first)

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Step VI Rank the products from in house manufacturing point of view. (In reversal order as
calculated in Step V)
Step VII Determination of units to be make and buy. (Optimal solution)
The above steps can be explained with the help of following example.
 Example 09:
Rizwan Manufacturing Company (RMC) is engaged in production of three products. Due to
increase in demand of products, the RMC is facing difficulties in producing all units. The
maximum machine hours available in the month of March 2021 are 50,000. The relevant data is
given in following table.

Product J Product S Product A

Maximum demand Units 6,000 8,000 10,000

AT A GLANCE
Machine hours per unit Hr/U 4 3 2
Variable production cost per unit Rs. 60 100 120
Cost to purchase per unit from
external supplier Rs. 90 120 140
The optimal solution relating to make or buy, is calculated as under.
As there is only one limiting factor given in question, no need to calculate and identify the limiting
factor.

Product J Product S Product A

Variable production cost per unit 60 100 120

SPOTLIGHT
Cost to purchase per unit from external
supplier (90) (120) (140)
Extra cost per unit, if bought (30) (20) (20)
Machine hours per unit 4 3 2
Extra cost per machine hours, if bought (7.50) (6.67) (10.00)
Ranking, if bought II I III
Ranking, if make first II III I
The product A should be produced first, but product S should be bought first. We should first
make units in house, and remaining units should be bought from external supplier. The optimal

STICKY NOTES
table is given as under.

Machine hours Units to make Units to buy

Available machine hours 50,000
Product A (10,000 x 2) (20,000) 10,000
30,000
Product J (6,000 x 4) (24,000) 6,000
6,000
Product S (Note) (6,000) 2,000 6,000

Note: After producing product A and J, only 6,000 machine hours are available. These hours can
be utilized in the production of product S, which requires 3 hours to product one unit. Therefore,
only 2,000 units of product S can be produced in house. The maximum demand of product S is
8,000 units, hence, remaining 6,000 units should be bought from external supplier.

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 Example 10:
Super clean Company is a contract cleaning company. It provides three services; daily office
cleaning, intensive cleaning of office space and minor repairs. However, it has insufficient
resources to do all the work available, and wishes to use a sub-contractor to take on some of the
work.
Information relating to the different type of work is as follows:
Average Variable Budgeted Sub-contractor
labour cost per number of quote per job
hours per job(Rs.) jobs (Rs.)
job
Daily office cleaning 4 60 1,500 80
AT A GLANCE

Intensive cleaning 6 108 400 150

Minor repairs 3 56 640 100
There are 8,000 labour hours available. The service that should be sub-contracted would be
analyzed using following workings.
The company can do all three types of job more cheaply with its own staff than by hiring the sub-
contractor. However, provided that it earns more than Rs. 80 for a daily office cleaning job, Rs.
150 for an intensive cleaning job and Rs. 100 for a minor repairs job, it is profitable to use the
sub-contractor to make up the shortfall in in-house resources.
The problem is to decide which work to outsource/sub-contract. The ranking should be
established as follows:
SPOTLIGHT

Daily office Intensive Minor

cleaning cleaning repairs
Rs. Rs. Rs.
Cost of doing the work in-house 60 108 56
Cost of sub-contractor 80 150 100
Extra cost of outsourcing, per job 20 42 44
Hours saved by sub-contracting 4 6 3
Extra cost per hour saved Rs.5 Rs.7 Rs.14.
Priority for outsourcing 1st 2nd 3rd
Priority for doing work with own resources 3rd 2nd 1st
STICKY NOTES

It is cheaper to sub-contract office cleaning than intensive cleaning. It is most expensive to sub-
contract minor repairs and this is the first choice of job to be carried out in-house. The cost-
minimizing plan should be to carry out the following work:

Budgeted Total labour Total

jobs hours variable cost
Rs.
Minor repairs 640 1,920 35,840
Intensive cleaning 400 2,400 43,200
Office cleaning (balance) 920 3,680 55,200
Maximum labour hours available 8,000
Sub-contract: Office cleaning 580 46,400
180,640

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 Example 11:
Wombat Company makes four products, W, X, Y and Z. All four products are made on the same
machines, and the machine capacity for the year at Wombat’s factory is 3,500 hours. However, it
is able to obtain any of these products in unlimited quantities from a sub-contractor.
Budgeted data is as follows.

Product W X Y Z
Annual sales demand (units) 4,000 6,000 3,000 5,000
Rs. Rs. Rs. Rs.
Sales price per unit 15 20 18 17
Variable cost per unit, in-house manufacture 5 7 6 7

AT A GLANCE
Cost of external purchase (outsourcing) 8.0 11.8 10.5 11.0
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40

Which items should be produced in-house and which should be outsourced? The question would
require following calculations to reach the conclusion
The selling price for each product is higher than the variable cost of purchasing each product
externally; therefore, profit will be maximized by making the products in-house or purchasing
them externally, up to the full amount of the annual sales demand.

Product W X Y Z
Rs. Rs. Rs. Rs.

SPOTLIGHT
Variable cost per unit, in-house manufacture 5.00 7.00 6.00 7.00
Cost of external purchase (outsourcing) 8.00 11.80 10.50 11.00
Extra cost of outsourcing, per unit 3.00 4.80 4.50 4.00
Machine hours per unit, in-house production 0.25 0.50 0.30 0.40
Extra cost of outsourcing, per machine hour saved Rs.12 Rs.9.60 Rs.15 Rs.10
Priority for outsourcing 3rd 1st 4th 2nd
Priority for in-house production 2nd 4th 1st 3rd

The cost-minimizing and profit-maximizing budget is as follows.

STICKY NOTES
Product Total variable cost
Units Machine hours
In-house production: Rs.
Y 3,000 900 18,000
W 4,000 1,000 20,000
Z (balance) 4,000 1,600 28,000
3,500
Outsource:
Z (1,000 x 11) 1,000 11,000
X (6,000 x 11.80) 6,000 70,800
Total variable cost 147,800

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 Example 12:
An engineering company has been experiencing problems with restricted availability of
resources. The company manufactures a variety of casings. It makes four types of casing. Each
casing requires the same bought-in component and some high-grade steel. The standard costs
for the four types of casing are as follows:

Casing A B C D

Rs. Rs. Rs. Rs.

Steel 250 500 190 390

Bought-in component 50 50 50 50
AT A GLANCE

Direct labour 60 60 50 100

Variable production costs 40 50 40 50

Fixed production costs 180 240 150 270

Selling and administration costs 145 225 120 215

Profit 35 55 30 55

Selling price 760 1,180 630 1,130

All the selling and administration costs are fixed and the same single component is used for each
of the four products. Direct labour is paid Rs.8 per standard hour and each member of the
SPOTLIGHT

workforce is capable of producing any of the casings.

The company’s main customer has ordered 30 units of Casing A, 20 units of B, 30 units of C and
20 units of D for production and delivery in the next month. Senior management have agreed that
this order should be treated as a priority order and that these casings must be manufactured and
delivered to the customer next month. This is necessary to maintain the goodwill of the customer.
It is estimated that this order represents 10% of the total demand next month for each type of
casing.
The company operates a just in time system, and has no inventories of steel, components or
finished goods.
If the aim is to maximize profit for the month, establish the production and selling plan for the
STICKY NOTES

company next month in each of the following situations:

a) Situation 1. Supplies of steel are limited to Rs. 250,000.
b) Situation 2. Only 400 bought-in components are available from suppliers.
c) Situation 3. A labour dispute restricts available productive labour hours in the month to
2,125.
d) Situation 4. A labour dispute restricts available productive labour hours in the month to
2,125; but the manufacture of any quantities of the four casings could be sub-contracted to
an outside supplier. The cost of buying the casings externally would Rs.475, Rs.705, Rs.380
and Rs.640 for Casing A, Casing B, Casing C and Casing D respectively. In addition, it should
be assumed that the major customer insists that its order is completed by the company itself
and the manufacture should not be sub-contracted.

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Each of the restrictions on production should be treated independently, as four different

situations.

Working: contribution per A B C D

unit Rs./unit Rs./unit Rs./unit Rs./unit
Profit 35 55 30 55
Fixed costs:
Production 180 240 150 270
Selling 145 225 120 215
Contribution 360 520 300 540
Resources required for the priority order for the major customer

AT A GLANCE
Units
Casing Steel Direct labour
required
per unit Total per unit Total
Rs. Rs. hours hours
A 30 250 7,500 7.5 225.0
B 20 500 10,000 7.5 150.0
C 30 190 5,700 6.25 187.5
D 20 390 7,800 12.5 250.0
Total 31,000 812.5

SPOTLIGHT
a) Steel in short supply and restricted to Rs. 250,000
Casing A B C D
Rs. Rs. Rs. Rs.
Contribution/unit 360 520 300 540
Steel costs/unit 250 500 190 390
Contribution/Rs.1 steel cost 1.44 1.04 1.58 1.38
Ranking for manufacture 2nd 4th 1st 3rd

STICKY NOTES
It is assumed that the sales forecasts for the month are correct.
Profit-maximizing production schedule
Steel used A B C D
Rs. units units units units
Priority order 31,000 30 20 30 20
Sales of C 51,300 270
Sales of A 67,500 270
Sales of D 70,200 180
220,000
Balance: Sales of B 30,000 60
Total steel available 250,000
Total production/sales 300 80 300 200

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b) Components are in short supply and restricted to 400 units

A B C D
Contribution/unit Rs.360 Rs.520 Rs.300 Rs.540
Components/unit 1 1 1 1
Contribution/component Rs.360 Rs.520 Rs.300 Rs.540
Ranking for manufacture 3rd 2nd 4th 1st

Profit-maximizing production schedule

Components used A B C D
units units units units units
Priority order 100 30 20 30 20
AT A GLANCE

Sales of D 180 180

280
Balance: Sales of B 120 120
Total available 400
Total production/sales 30 140 30 200

c) Labour is in short supply and restricted to 2,125 hours

Casing A B C D
Contribution/unit Rs.360 Rs.520 Rs.300 Rs.540
Labour hours/unit 7.50 7.50 6.25 12.5
SPOTLIGHT

Contribution per hour Rs.48.00 Rs.69.33 Rs.48.00 Rs.43.20

Ranking for manufacture 2nd 1st 2nd 4th

Profit-maximizing production schedule

Labour hours A B C D
units units units units
Special order 812.5 30 20 30 20
Remaining hours 1,312.5 175
STICKY NOTES

Total hours 2,125.0

Total production/sales 30 195 30 20

d) Make or buy decision

A B C D
Rs. Rs. Rs. Rs.
Contribution if made 360 520 300 540
Contribution if bought in 285 475 250 490
Extra contribution if made 75 45 50 50
Labour hours 7.5 7.5 6.25 12.5
Extra contribution per hour Rs.10 Rs.6 Rs.8 Rs.4
Ranking/priority for making 1st 3rd 2nd 4th

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Profit-maximizing production schedule

Casing Hours A B C D
Special order 812.5 30 20 30 20
Remaining hours 1,312.5 175
Total hours 2,125.0
Made internally 205 20 30 20
Purchased externally 95 180 270 180
Total sales 300 200 300 200

 Example 13:

AT A GLANCE
Galaxy Engineers (GE) manufactures and sells a wide range of products. One of the raw materials
XPI is in short supply and only 80,000 kg are available in GE's stores. Following information
pertains to the products in which XPI is used:

Product A Product B Product C

Budgeted local sales/requirement Units 4,500 1,000 2,500
Committed export sales as per Units - 800 -
agreement
----------------- Per unit------------------
Sales price Rs. 20,000 14,100 For internal use

SPOTLIGHT
Material XPI (Rs. 500 per kg) kg 14 12 2
Other material (Rs. 300 per kg) kg 5 3 1
Direct labour hours (Rs. 100 per hours 20 15 5
hour)
Variable overheads based on % 80% 80% 80%
labour cost
Fixed overheads per direct labour Rs. 95 75 60
hour

STICKY NOTES
Product C is used in other products made by GE. If it could not be produced internally, it has to
be purchased from market at Rs. 3,000 per unit.
When required to determine the number of units of each product that should be manufactured,
to earn maximum profit, following analysis may be of some assistance.

Product Product Product Material

A B C XPI
---------- Units---------- kg
Budgeted sales/requirements 4,500 1,800 2,500
---------- Rupees ----------
For
internal
Sales price per unit 20,000 14,100 use only
Opportunity cost per unit (Purchase price) - - 3,000

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Product Product Product Material

A B C XPI
---------- Units---------- kg
Cost of production per unit:
Material XPI usage at Rs. 500 per kg (7,000) (6,000) (1,000)
Other material usage at Rs. 300 per kg (1,500) (900) (300)
Direct labour at Rs. 100 per hour (2,000) (1,500) (500)
Variable overheads at 80% of labour cost (1,600) (1,200) (400)
(12,100) (9,600) (2,200)
AT A GLANCE

CM/savings from own manufacturing (A) 7,900 4,500 800

Per unit usage of material XPI (B) kg 14 12 2
CM per one kg of material XPI (A)÷(B) Rs. 564 375 400
Ranking based on CM per XPI kg 1st 3rd 2nd
Production from available material XPI:
Production of committed export sales - 800 - 9,600
Production in ranking order 4,500 200 2,500 70,400
Optimal production Units 4,500 1,000 2,500 80,000

 Example 14:
SPOTLIGHT

Condaco produces two products with the following costs and revenue per unit:
Product A Product B
Rs. Rs.
Sales price 20 10
Variable cost 8 6
Fixed cost 4 3
units units
Sales demand 2,000 3,000
STICKY NOTES

There are only 7,000 machine hours available, and Product A requires 4 machine hours per unit
and Product B requires 1 machine hour per unit
Following calculations to be used when required calculate the profit-maximizing production and
sales mix.
Total machine hours required to meet sales demand = (2,000 × 4) + (3,000 × 1) = 11,000. Since
only 7,000 hours are available, machine hours are a limiting factor.
Product A Product B
Rs. Rs.
Sales price 20 10
Variable cost 8 6
Contribution 12 4
Machine hours per unit 4 1
Contribution per hour Rs.3 Rs.4
Priority for manufacture 2nd 1st

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Decision: produce and sell the following products:

Product Units Machine hours Contribution per unit Total contribution

Rs. Rs.
B 3,000 3,000 4 12,000
A (balance) 1,000 4,000 12 12,000
7,000 24,000

Now assume that all the data is the same, except that we are able to sub-contract the products
for an additional variable cost of Rs.1 per unit for A and Rs.0.50 per unit for B. The profit-
maximizing decision would be evaluated as follows:

AT A GLANCE
Product A Product B
Rs. Rs.
Extra cost of external purchase 1 0.50
Machine hours saved by external purchase 4 1
Extra cost per machine hour saved Rs.0.25 Rs.0.50
Priority for manufacture 1st 2nd
Number of Machine Contribution
Item Contribution
units hours per unit
Make Rs. Rs.

SPOTLIGHT
A 1,750 7,000 12 21,000
Buy
A (balance) 250 (12 – 1) 11 2,750
B 3,000 (4 – 0.5) 3.5 10,500
Total contribution 34,250

 Example 15:
NK Enterprises produces various components for telecom companies. The demand of these
components is increasing. However, NK’s production facility is restricted to 50,000 machine
hours only. Therefore, NK is considering to buy certain components externally. In this respect,

STICKY NOTES
the following information has been gathered:

Components
Description
X-1 X-2 X-3 X-4
Estimated demand in units 6,500 2,000 7,100 4,500
Machine hours required per unit 8 4 5 2
In-house cost per unit: ------------ Rupees ------------
Direct material 20.0 28.0 23.0 22.0
Direct labour 9.0 5.0 9.0 8.0
Factory overheads 16.0 8.0 8.5 5.0
Allocated administrative overheads 5.0 4.0 3.0 2.0
50.0 45.0 43.5 347.0
External price of the component per unit 35.0 40 34.0 33.0

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Factory overheads include fixed overheads estimated at Rs. 1.50 per machine hour.
The number of units to be produced in-house and bought externally, would be determined as
follows:

X-1 X-2 X-3 X-4

Demand in units (A) 6,500 2,000 7,100 4,500
Machine hours per unit (B) 8 4 5 2
------------------ Rupees ------------------
In-house cost 50.00 45.00 43.50 37.00

X-1 X-2 X-3 X-4

AT A GLANCE

Irrelevant cost for decision making

- Fixed overheads 1.5×B (12.00) (6.00) (7.50) (3.00)
- Allocated administrative overheads (5.00) (4.00) (3.00) (2.00)
Relevant production cost (C) 33.00 35.00 33.00 32.00
Per unit cost of buying externally (D) 35.00 40.00 34.00 33.00

X-1 X-2 X-3 X-4

Incremental cost in case of external buying:
- Per unit (C-D) (E) 2.00 5.00 1.00 1.00
- Per machine hour (E÷B) 0.25 1.25 0.20 0.50
SPOTLIGHT

Ranking for in-house production 3rd. 1st. 4th. 2nd.

No. of units for in-house production:
*[50,000–(2,000×4) – (4,500×2)]/8 (F) *4,125 2,000 - 4,500
No. of units to be bought externally A-F 2,375 - 7,100 -

3.2 Make-or-buy decisions: non-financial considerations

When relevant costs are used to make a decision, it is assumed that the decision should be based on financial
considerations and whether the decision will add to profit (cash flows).
In reality, however, managers are likely to think about non-financial issues as well as financial issues when
making their decisions as it is most critical decision. The non-financial considerations in any decision will depend
STICKY NOTES

on the circumstances, and will vary from one decision to another. Non-financial considerations can influence a
decision. In your examination, be prepared to identify relevant non-financial issues in a particular situation, and
discuss their potential implications.
Non-financial considerations that will often be relevant to a make-or-buy decision include the following.
• When work is outsourced, the entity loses some control over the work. It will rely on the external supplier
to produce and supply the outsourced items. There may be some risk that the external supplier will:
- produce the outsourced items to a lower standard of quality, or
- fail to meet delivery dates on schedule, so that production of the end-product may be held up by a lack
of components.
• The entity will also lose some flexibility. If it needs to increase or reduce supply of the outsourced item at
short notice, it may be unable to do so because of the terms of the agreement with the external supplier. For
example, the terms of the agreement may provide for the supply of a fixed quantity of the outsourced item
each month.

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• A decision to outsource work may have implications for employment within the entity, and it may be
necessary to make some employees redundant. This will have cost implications, and could also adversely
affect relations between management and other employees.
• It might be appropriate to think about the longer-term consequences of a decision to outsource work. What
might happen if the entity changes its mind at some time in the future and decides either (a) to bring the
work back in-house or (b) to give the work to a different external supplier? The problem might be that taking
the work from the initial external provider and placing it somewhere else might not be easy in practice, since
the external supplier might not be co-operative in helping with the removal of its work.
• The company cannot hope to maintain any competitive advantage from the work of the external supplier,
since the competitors can hire the same supplier.
The non-financial factors listed above are all reasons against outsourcing work. There might also be non-financial
benefits from outsourcing work to an external supplier.

AT A GLANCE
• If the work that is outsourced is not specialized, or is outside the entity’s main area of expertise, outsourcing
work will enable management to focus their efforts on those aspects of operations that the entity does best.
For example, it could be argued that activities such as the management of an entity’s fleet of delivery vehicles,
or the monthly payroll work, should be outsourced because the entity itself has no special expertise on these
areas.
• The external supplier, on the other hand, may have specialist expertise which enables it to provide the
outsourced products or services more efficiently and effectively. For example, a company might outsource
all its IT support operations, because it cannot recruit and retain IT specialists. An external service provider,
on the other hand, will employ IT specialists.

SPOTLIGHT
STICKY NOTES

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4. OTHER SHORT TERM DECISIONS

The principles of relevant costing can be applied to any type of management decision, not just make-or-buy
decisions. Examples of other types of management decision where relevant costing may be used are:
• One-off contract decisions (Already discussed in Chapter 14)
• Shutdown decisions
• Joint product further processing decisions.

4.1 Shutdown decisions

A shutdown decision is a decision about whether or not to shut down a part of the operations of a company. From
a financial viewpoint, an operation should be shut down if the benefits of shutdown exceed the relevant costs.
AT A GLANCE

A shutdown decision may be a long-term decision when there are large initial expenditures involved (for
example, costs of making the work force redundant). For the purpose of the examination, however, any shutdown
decision will be a short-term decision.
In order to consider this decision as short-term, it is assumed that cost of shut-down the process is approximately
equal to revenue generated from disposal of its assets. Therefore, we consider only the short-term related costs
in shut-down decision.
 Example 16:
Company V makes four products, P, Q, R and S. The budget for next year is as follows:

P Q R S Total
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000
SPOTLIGHT

Direct materials 300 500 400 700 1,900

Direct labour 400 800 600 400 2,200
Variable overheads 100 200 100 100 500
800 1,500 1,100 1,200 4,600
Sales 1,800 1,650 2,200 1,550 7,200
Contribution 1,000 150 1,100 350 2,600
Directly attributable fixed costs (400) (250) (300) (300) (1,250)
Share of general fixed costs (200) (200) (300) (400) (1,100)
STICKY NOTES

Profit/(loss) 400 (300) 500 (350) 250

‘Directly attributable fixed costs’ are cash expenditures that are directly attributable to each
individual product. These costs would be saved if operations to make and sell the product were
shut down.
Decision would be required regarding whether any of the products should be withdrawn from
the market. Following reasons and calculations may be observed:
From a financial viewpoint, a product should be withdrawn from the market if the savings from
closure exceed the benefits of continuing to make and sell the product. If a product is withdrawn
from the market, the company will lose the contribution, but will save the directly attributable
fixed costs.
Product P and product R both make a profit even after charging a share of general fixed costs. On
the other hand, product Q and product S both show a loss after charging general fixed costs, and
we should therefore consider whether it might be appropriate to stop making and selling either
or both of these products, in order to eliminate the losses.

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Effect of shutdown P Q R S
Rs.‘000 Rs.‘000 Rs.‘000 Rs.‘000
Contribution forgone (1,000) (150) (1,100) (350)
Directly attributable fixed costs saved 400 250 300 300
Increase/(reduction) in annual cash flows (600) 100 (800) (50)

Although product S makes a loss, shutdown would reduce annual cash flows because the
contribution lost would be greater than the savings in directly attributable fixed costs.
However, withdrawal of product Q from the market would improve annual cash flows by Rs.
100,000, and withdrawal is therefore recommended on the basis of this financial analysis.

AT A GLANCE
Decision recommended: Stop making and selling product Q but carry on making and selling
product S.

4.2 Joint product further processing decisions

Joint products are products manufactured from a common process. In some instances, a company might have a
choice between:
• selling the joint product as soon as it is output from the common process i.e. split-off point, or
• processing the joint product further before selling it (at a higher price).
This is a short-term decision, and the financial assessment should be made using relevant costs and revenues.
The financial assessment should compare:

SPOTLIGHT
• the revenue that will be obtained (less any selling costs) from selling the joint product as soon as it is output
from the common process, and
• the revenue that will be obtained if the joint product is processed further, less the incremental costs of
further processing and then selling the product.
Applying relevant costing, the costs of the common process are irrelevant to the decision, because these costs
will be incurred anyway, whatever the decision. The decision should be to further process the joint product if the
extra revenue from further processing exceeds the extra (relevant) costs of the further processing.
 Example 17:
A company produces two joint products from a common process. For every 100 kilograms of
input to the common process, output consists of 40 kilograms of joint product 1 (JP1) and 60

STICKY NOTES
kilograms of joint product 2 (JP2). The costs of the common process are Rs.400 per 100 kilograms
of input.
JP1 can be sold for Rs.10 per kilogram and JP2 can be sold for Rs.16 per kilogram.
Alternatively, JP1 can be processed to make a finished product, FP1. Costs of further processing
consist of variable costs of Rs.6 per kilogram and fixed costs of Rs. 120,000 per year. Of these
fixed costs, Rs. 96,000 would be directly attributable to the further processing operations, and
the remaining Rs. 24,000 would be an apportionment of general fixed overhead costs. The further
processed product (FP1) would have a selling price of Rs.28 per kilogram.
It is estimated that 15,000 kilograms of JP1 will be produced each year. There are no losses in
any process.
Should JP1 be sold as soon as it is produced from the common process, or should it be further
processed into Product FP1? Following may be the solution

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The common processing costs are irrelevant to the further processing decision. The annual
relevant costs and benefits of further processing JP1 are as follows:

Rs.
Revenue from selling FP1 (per kilogram) 28
Variable further processing cost (6)
Additional variable revenue from further processing 22
Opportunity cost: sales of JP1 forgone (10)
Benefit per kilogram from further processing 12
Number of kilograms produced each year 15,000
Total annual benefits before directly attributable fixed costs 180,000
AT A GLANCE

Directly attributable fixed costs of further processing (96,000)

Net annual benefits of further processing 84,000
Recommendation: The joint product should be processed to make FP1, because this will
increase annual profit by Rs. 84,000.

4.3 Equipment/Plant Replacement and investment decisions

Equipment buying or replacement decisions are capital investment decisions which require discounted cash flow
analysis. Moreover, book value of the replaced asset is irrelevant of sunk cost in this situation.
 Example 18:
SPOTLIGHT

Decimal World Limited manufactures and sells modems. It manufactures its own circuit boards
(CB), an important part of the modem.
The present cost to manufacture a CB is as follows:

Rupees
Direct material 440
Direct labour 210
Variable overheads 55
Fixed overheads
STICKY NOTES

Depreciation 60
General overheads 30
Total cost per unit 795

The company manufactures 400,000 units annually. The equipment being used for
manufacturing CB has worn out completely and requires replacement. The company is presently
considering the following options:
a) Purchase new equipment which would cost Rs. 240 million and have a useful life of six
years with no salvage value. The company uses straight-line method of depreciation. The
new equipment has the capacity to produce 600,000 units per year. It is expected that
the use of new equipment would reduce the direct labour and variable overhead cost by
20%.
b) Purchase from an external supplier at Rs.730 per unit under a two year contract.
The total general overheads would remain the same in either case. The company has no other
use for the space being used to manufacture the CBs.

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In analyzing company’s situation which course of action would you recommend to the company
assuming that 400,000 units are needed each year?

Differential Cost per Modem

Make Buy
Rs. Rs.
Outside supplier's costs 730
Direct materials 440
Direct labour (Rs. 210 x 80%) 168
Variable overheads (Rs. 55x80%) 44
Depreciation (Rs. 240,000,000 ÷ 6 years ÷ 400,000) 100

AT A GLANCE
752 730
The company should accept the offer of external supplier because the price offered is lower than
the variable costs of product.
Recommendation for the company when its annual requirements were 600,000 units would
require following analysis

Differential Cost per Modem

Make Buy
Rs. Rs.
Outside supplier's costs 730

SPOTLIGHT
Direct materials 440.00
Direct labour (Rs. 210 x 80%) 168.00
Variable overheads (Rs. 55 x 80%) 44.00
Depreciation (Rs. 240,000,000 ÷ 6 years ÷ 600,000) 66.67
718.67 730

The company should purchase the new equipment and make the modems if 600,000 modems
per year are needed.
However, there may be other factors that the company should consider, before making a decision.

STICKY NOTES
These are
i. Will volume in future years be increasing? If yes, then buying the new equipment
becomes more desirable.
ii. Will quality control be maintained if the CB purchased from external suppliers?
iii. Will the external supplier be dependable in making delivery schedules?
iv. Can the company begin making the CB again if the supplier proves to be unacceptable?
v. If the external supplier’s offer is accepted and the needs for CB increases in future years,
will the supplier have the added capacity to provide more than 400,000 CB per year?
vi. If the order size increases, will the supplier given any additional bulk quality discount.
vii. Will the external supplies be able to supply the CB after 2 years?

4.4 Decisions for Discontinuing operations

Some operations are more profitable than the others. In this respect, organizations may often consider less
profitable ventures to be discontinued for allocation of resources to those making more profits.

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 Example 19:
Stamba makes two components, A and B, for which costs in the next year are expected to be as
follows:

A B
Production (units) 30,000 20,000
Variable costs per unit: Rs. Rs.
Direct materials 6 5
Direct labour 3 9
Variable production overheads 1 3
AT A GLANCE

Variable production cost 10 17

Direct labour is paid Rs.12 per hour. There will be only 19,500 hours of direct labour time
available next year, and any additional components must be purchased from an external supplier.
Total fixed costs per annum are expected to be as follows:

Rs.
Incurred as a direct consequence of making A 40,000
Incurred as a direct consequence of making B 50,000
Other fixed costs 30,000
SPOTLIGHT

120,000
An external supplier has offered to supply units of A for Rs.12.50 and units of B for Rs.23.
a) Recommendation regarding whether Stamba should shut down internal production of
Component A or Component B and switch to external purchasing is given below.

Component A Component B
Rs. Rs.
Cost of making internally 10.0 17.0
STICKY NOTES

Cost of buying 12.5 23.0

Extra variable cost of buying 2.5 6.0
Quantities required next year 30,000 20,000
Total extra variable cost of buying 75,000 120,000
Fixed costs saved by closure 40,000 50,000
Net extra costs of buying 35,000 70,000

It appears that it would cost the company more each year to shut down internal
production of either component and switch to external purchasing.
b) Recommendation regarding the quantities that Stamba should make of the components,
and the quantities that it should buy externally, in order to obtain the required quantities
of both components at the minimum cost would be as follows.

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In addition, the total annual cost will be calculated below

Tutorial note. To answer part (b), you will need to consider that labour is a limiting
factor.
Production hours required hours
Component A (30,000 × 0.25 hours) 7,500
Component B (20,000 × 0.75 hours) 15,000
Total hours required 22,500
Total hours available 19,500
Shortfall 3,000
There are insufficient hours available to manufacture everything internally. Some

AT A GLANCE
components must be purchased externally.

Component A Component B
Rs. per unit Rs. per unit
Cost of making internally 10.0 17.0
Cost of buying 12.5 23.0
Cost saved by making 2.5 6.0
Hours required to make internally 0.25 hours 0.75 hours
(Rs.3/Rs.12 per hour: Rs.9/Rs.12 per hour)
Costs saved per hour by making Rs.10 Rs.8

SPOTLIGHT
(Rs.2.50/0.25 hours: Rs.6/0.75 hours)
It is better to make Component A internally than Component B.
Component Units Hours Cost/unit Cost
Rs. Rs.
A 30,000 7,500 10 300,000
B (balance) 16,000 12,000 17 272,000
Variable cost of internal manufacture 19,500 572,000
Cost of external purchase – balance
of units required 4,000 23 92,000

STICKY NOTES
Fixed costs 120,000
Total costs 784,000

c) Non-financial considerations relevant to make-or-buy decision are discussed below:

Risks of outsourcing work:
i. Supplier may produce items to a lower standard of quality.
ii. The supplier may fail to meet delivery dates and the buyer may dependent on the
supplier to commit onward delivery to its buyer. In case of buying of a component,
production process of the end-product may be held up by a lack of component.
Benefits of outsourcing work:
i. Outsourcing work will enable the management to focus all of its efforts on those
aspects of operation the entity does best.
ii. The external supplier may have specialist expertise which enables it to provide
outsourced products more efficiently and at a cheaper price.

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5. COMPREHENSIVE EXAMPLES
 Example 01:
Areesh Limited deals in various products. Relevant details of the products are as under:

AW AX AY AZ
Estimated annual demand (units) 5,000 10,000 7,000 8,000
Sales price per unit (Rs.) 150 180 140 175
Material consumption:
Q (kg) 2 2.5 1.5 1.75
S (kg) 0.5 0.6 0.4 0.65
AT A GLANCE

Labour hours 2 2.25 1.75 2.5

Variable overheads (based on labour cost) 75% 80% 100% 90%
Fixed overheads per unit (Rs.)
10 20 14 16
(based on 80% capacity utilization)
Machine hours required:
Processing machine hours 5 6 8 10
Packing machine hours 2 3 2 4

Company has a long term contract for purchase of material Q and S at a price of Rs. 15 and Rs. 20
per kg respectively. Wage rate for 8-hours shift is Rs. 200.
SPOTLIGHT

The estimated overheads given in the above table are exclusive of depreciation expenses. The
company provides depreciation on number of hours used basis. The depreciation on each
machine based on full capacity utilization is as follows:
Hours Rs.
Processing machine 150,000 150,000
Packing machine 100,000 50,000
The company has launched an advertising campaign to promote the sale of its products. Rs. 2
million have been spent on such campaign. This cost is allocated to the products on the basis of
sale.
STICKY NOTES

The number of units of each product that the company should produce in order to maximize the
profit and the product wise and total contribution at optimal product mix can be calculated as
follows:

AW AX AY AZ Total
Sale price 150.00 180.00 140.00 175.00
Less: Variable cost
Material Q at Rs 15 30.00 37.50 22.50 26.25
Material S at Rs 20 10.00 12.00 8.00 13.00
Labour cost at Rs. 25 per hour 50.00 56.25 43.75 62.50
Overheads 37.50 45.00 43.75 56.25
127.50 150.75 118.00 158.00
Contribution margin per unit 22.50 29.25 22.00 17.00
Annual demand (Units) 5,000 10,000 7,000 8,000

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AW AX AY AZ Total
Possible production under each machine:
Processing machine:
Machine hours required per unit 5.00 6.00 8.00 10.00
Average CM per hour 4.50 4.88 2.75 1.70
Production priority 2 1 3 4
No. of units that can be produced
in available hours in order of CM
priority (Restricted to annual
demand) 5,000 10,000 7,000 900

AT A GLANCE
Hours required 25,000 60,000 56,000 9,000 150,000
Contribution margin (Rs.) 112,500 292,500 154,000 15,300 574,300

Production for product ‘Z’ has to be restricted to 900 units due to limited number of machine
hours.

AW AX AY AZ Total
Packing machine:
Machine hours required per unit 2.00 3.00 2.00 4.00
Average CM per hour 11.25 9.75 11.00 4.25
Production priority 1 3 2 4

SPOTLIGHT
No. of units that can be produced
in available hours in order of CM
priority (Restricted to annual
demand) 5,000 10,000 7,000 8,000
Hours required 10,000 30,000 14,000 32,000 86,000
Conclusion:
The packing machine can meet the full demand but capacity of processing machine is limited.
Therefore, product mix of processing machine will be manufactured.
Assumption:
It has been assumed that the wage rate per eight hours is divisible.

STICKY NOTES
 Example 02:
Jaseem Limited manufactures a stationery item in three different sizes. All the sizes are
manufactured at a plant having annual capacity of 1,800,000 machine hours.
Relevant data for each product is given below:
Small Medium Large
Size Size Size
Sales price per unit (Rs.) 75 90 130
Direct material cost per unit (Rs.) 25 32 35
Labour hours per unit 3 4 5
Variable overheads per unit (Rs.) 5 7 8
Machine hours per unit 2 4 5
Demand (Units) 210,000 150,000 180,000
Minimum production required (Units) 100,000 100,000 100,000

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Other relevant information is as under:

i. Cost of the monthly payroll is Rs. 1,500,000.
ii. Fixed overheads are Rs. 110,000 per month and are allocated on the basis of machine
hours.
The number of units to be produced for each size may involve following calculations
Small size Medium size Large size
Sales price 75.00 90.00 130.00
Direct material cost (25.00) (32.00) (35.00)
Variable overheads (5.00) (7.00) (8.00)
Contribution margin 45.00 51.00 87.00
AT A GLANCE

Machine hours 2.00 4.00 5.00

Contribution margin per hour 22.50 12.75 17.40
Priority based on contribution per
machine hour 1 3 2

Small Medium Large Machine

Units to be produced:
size size size hours
Minimum production - Units 100,000 100,000 100,000
Hours consumed for minimum
production 200,000 400,000 500,000 1,100,000
SPOTLIGHT

Units in excess of minimum

production in CM priority:
Small size - Units 110,000 220,000
Large size - Units 80,000 400,000
Medium size – Units 20,000 80,000
Total 210,000 120,000 180,000 1,800,000

 Example 03:
Bauxite Limited (BL) is engaged in the manufacture and sale of three products viz. Pentagon,
Hexagon and Octagon. Following information is available from BL’s records for the month of
STICKY NOTES

February 2012:
Pentagon Hexagon Octagon
Sales price per unit (Rs.) 2,300 1,550 2,000
Material cost per Kg. (Rs.) 250 250 250
Labour time per unit (Minutes) 20 30 45
Machine time per unit (Hours) 4 2.5 3
Net weight per unit of finished product (Kg.) 6 4 5
Yield (%) 90 95 92
Estimated demand (Units) 10,000 20,000 9,000

Each worker is paid monthly wages of Rs. 15,000 and works a total of 200 hours per month. BL’s
total overheads are estimated at 20% of the material cost.

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Fixed overheads are estimated at Rs. 5 million per month and are allocated to each product on
the basis of machine hours. 100,000 machine hours are estimated to be available in February
2012.
Based on optimum product mix, computation of BL’s net profit for the month of February 2012
would be as follows:
Computation of net profit on the basis of optimum product mix:

Pentagon Hexagon Octagon

Selling price 2,300 1,550 2,000
Less: Variable Costs
Direct Material

AT A GLANCE
(250 × 6 /0.9) 1,666.67
(250 × 4 /0.95) 1,052.63
(250 × 5 /0.92) 1,358.70
Direct Labour
[15,000 /200 × (20/60)] 25.00
[15,000 /200 × (30/60)] 37.50
[15,000 /200 × (45/60)] 56.25
Variable Overheads
[1666.66 × 20% - (Rs. 50 × 4 hrs)] 133.33

SPOTLIGHT
[1052.63 × 20% - (Rs. 50 × 2.5 hrs)] 85.53
[1358.70 × 20% - (Rs. 50 × 3 hrs)] 121.74
Total Variable Cost 1,825.00 1,175.66 1,536.69
Contribution per unit 475.00 374.34 463.31
Machine Hours required per unit 4.0 2.5 3.0
Contribution per Machine Hour 118.75 149.74 154.44
Ranking 3 2 1

Now, the scarce Hours will be allocated as per ranking.

STICKY NOTES
Product Volume Hours required Hours used Balance unused
100,000
Octagon 9,000 3.0 27,000 73,000
Hexagon 20,000 2.5 50,000 23,000
Pentagon (Bal.) 5,750 4.0 23,000 -
Profit arising from above production plan
Contribution Contribution
Product Units
per unit margin
Octagon 9,000 463.31 4,169,790
Hexagon 20,000 374.34 7,486,800
Pentagon 5,750 475.00 2,731,250
Total Contribution 14,387,840
Less: Fixed costs (5,000,000)
Net Profit 9,387,840

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 Example 04:
The following projections are contained in the budget of Scientific Chemicals Limited for the year
ending 31 December 2014:
i. Annual local and export sales
Product C031 Product C032
Rs. Per unit Units Rs. Per unit Units
Local sales 1,965 40,000 1,410 50,000
Export sales 2,100 25,000 1,500 24,000
ii. Raw material and labour per unit
Product C031 Product C032
AT A GLANCE

Raw material-A at Rs. 25 per kg. (Kg.) 4.0 3.0

Raw material-B at Rs. 60 per kg. (Kg.) 3.5 2.6
Skilled labour hours at Rs. 250 per hour (Hours) 2.4 2.0
Semi-skilled hours at Rs. 120 per hour (Hours) 5.0 2.5
iii. Variable overheads for each unit of product C031 and D032 are estimated at Rs. 125 and
Rs. 60 respectively.
iv. Fixed overheads including admin & selling overheads would amount to Rs. 3 million per
month.
The company is faced with the under-mentioned constraints:
SPOTLIGHT

• The supplier of material-B can supply 27,700 kg. per month only.
• Only 35 skilled workers will be available for each shift of 8 hours while factory will be
operated for 25 days in a month on 3 shift basis.
Determination of optimal production plan for the next year assuming that the company cannot
afford to terminate the export sales contract because of the heavy damages payable in case of
default, is given below.
Product C031 Product C032
Rupees per unit
Sales price 1,965 1,410
Variable costs: 2,100 25,000 1,500 24,000
STICKY NOTES

Material A 4x25 3x25 (100) (75)

Material B 3.5x60 2.6x60 (210) (156)
Labour skilled 2.4x250 2x250 (600) (500)
Labour semi skilled 5x120 2.5x10 (600) (300)
Overheads (125) (60)
(1,635) (1,091)
Contribution per unit A 330 319
Contribution margin per limiting factor
Material B A/3.5 A/2.6 94.29 122.69
Skilled labour A/2.4 A/2.0 137.50 159.50
Priority 2 1

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Material B Skill labour

Optimal Production using limiting factors
Kg hours
Available resources per annum (27,700×12), 332,400 252,000
(35×3×25×12×8)
Total required resources:
C031 (40,000+25,000)×3.5, 2.4 (227,500) (156,000)
D032 (50,000+24,000)×2.6, 2.0 (192,400) (148,000)
Shortage of material B and skilled labour (87,500) (52,000)
Reduction in production of C031 (priority 2) (25,000) (21,667)
[(87,500÷3.5), (52,000÷2.4)]

AT A GLANCE
Production would be as under: C031 C032
Units
1st priority for export sales 25,000 24,000
Local sales – Product C031: (40,000-25,000) 15,000 50,000
 Example 05:
Alpha Limited (AL) manufactures and sells products A, B and C. In view of limited production
capacity, AL is meeting the demand for its products partly through imports.
The following information has been extracted from the budget for the next year:

A B C

SPOTLIGHT
Machine hours used in production 240,000 225,000 270,000
--------------- No. of units ---------------
Sale 42,000 35,000 26,500
Production 30,000 25,000 22,500
Imports 12,000 10,000 4,000
-------------- Rs. in million --------------
Sales 252.00 175.00 185.50
Cost of production:

STICKY NOTES
- Direct material 48.00 31.25 40.50
- Direct labour 45.00 40.00 56.25
- Variable overheads 33.00 25.00 29.25
- Fixed overheads 28.80 27.00 32.40
Cost of import of finished products 68.40 47.00 26.88

Additional information:
a) AL is working at 100% capacity.
b) AL believes that it can obtain substantial quantity discounts from foreign suppliers if it
increases the import volumes. Each product is supplied by a different supplier. After
intense negotiations, the suppliers have offered discounts of 15%, 10% and 12% for
products A, B and C respectively.
In preparing a product-wise plan of production/imports to maximize the company’s profitability,
please see below analysis

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Product-A Product-B Product-C

Capacity utilization Machine hours (A) 240,000 225,000 270,000
Sales of units to be produced (B) 30,000 25,000 22,500
Sales of units to be imported (C) 12,000 10,000 4,000
Total sale units 42,000 35,000 26,500

Rupees in million
Variable Cost of production:
Product-A Product-B Product-C
Direct material 48.00 31.25 40.50
AT A GLANCE

Direct labour 45.00 40.00 56.25

Overheads 33.00 25.00 29.25
Total cost (D) 126.00 96.25 126.00
Cost per produced unit E (D÷B) 4,200.00 3,850.00 5,600.00

Rupees in million
Cost of imports: Product-A Product-B Product-C
Existing cost of imported finished goods 68.40 47.00 26.88
Bulk discount offered 15% 10% 12%
SPOTLIGHT

Discounted price of imported

goods (F) 58.14 42.30 23.65

Rupees
Cost per imported unit G (F÷C) Rs. 4,845.00 4,230.00 5,912.00
Loss per unit on imports (G-F) (645.00) (380.00) (312.50)
Production Plan:
Machine hours per unit H (A÷B) 8.00 9.00 12.00
Loss per machine hour on imports Rs. (80.63) (42.22) (26.04)
STICKY NOTES

Production priority to save loss on imports 1st. 2nd. 3rd.

Production from available hours of 735,000 in
sequence of the above priority:
Product-A Units demand 42,000
Hours utilized (42,000×8) 336,000
Product-B Units demand 35,000
Hours utilized (35,000×9) 315,000
Product-C Units from remaining hours 7,000
Remaining hours [735-336-315] 84,000
Import plan:
Product-C:
Demand exceeding production (26,500-7,000) - - 19,500
Total units 42,000 35,000 26,500

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 Example 06:
Artery Limited (AL) produces and markets three products viz. Alpha, Beta and Gamma. Following
information is available from AL’s records for the manufacture of each unit of these products:
Alpha Beta Gamma
Selling price (Rs.) 66 88 106
Material-A (Rs.4 per kg) (Rs.) 8 0 12
Material-B (Rs.6 per kg) (Rs.) 12 18 24
Direct labour (Rs. 10 per hour) (Rs.) 25 30 25

Alpha Beta Gamma

Variable overhead based on:

AT A GLANCE
− Labour hours (Rs.) 1.5 1.8 1.5
− Machine hours (Rs.) 1.6 1.4 1.2
Total (Rs.) 3.1 3.2 2.7
Other data:
Machine hours 8 7 6
Maximum demand per month (units) 900 3,000 5,000
Additional information:
i. AL is also engaged in the trading of a fourth product Zeta, which is very popular in the
market and generates a positive contribution. AL currently purchases 600 units per
month of Zeta from a supplier at a cost of Rs. 40 per unit. In-house manufacture of Zeta

SPOTLIGHT
would require: 2.5 kg of material-B, 1 hour of direct labour and 2 machine hours.
ii. Materials A and B are purchased from a single supplier who has restricted the supply of
these materials to 22,000 kg and 34,000 kg per month respectively. This restriction is
likely to continue for the next 8 months.
iii. AL has recently accepted a Government order for the supply of 200 units of Alpha, 300
units of Beta and 400 units of Gamma each month for the next 8 months. These quantities
are in addition to the maximum demand stated above.
iv. There is no beginning or ending inventory.
In determining whether AL should manufacture Zeta internally or continue to buy it from the
supplier during the next 8 months, following are the required calculations
The internal manufacturing cost of Zeta would be as follows:

STICKY NOTES
Rs. per unit
Direct material-B (2.5 kg @ Rs. 6/kg) 15.00
Direct labour (1 hours @ Rs. 10/hour) 10.00
Variable overhead W-1
Direct labour (1 hour @ Rs. 0.60/hour) 0.60
Machine hours (2 hours @ Rs. 0.20/hour) 0.40
Total 26.00

The buying price of the component is Rs. 40 per unit so if resources are readily available the
company should manufacture the component. However, due to the scarcity of resources during
the next 8 months the contribution earned from the component needs to be compared with the
contribution that can be earned from the other products.

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W-1:
Using Alpha (though any product could be used) the variable overhead rate per hour can be
calculated:
Labour related variable overheads per unit = Rs 1.5
Direct labour hours per unit = Rs 25 / Rs 10 = 2.5 hours
Labour related variable overhead per hours = Rs. 1.5 / 2.5 hour = Rs 0.60 per hour
Machine related variable overhead per hour = Rs. 1.6 / 8 hour = Rs 0.2 per hour
Both material-A and material-B are limited in supply during the next 8 months, but calculations
are required to determine whether this scarcity affects the production plans of AL. The resources
required for the maximum demand must be compared with the resources available to determine
whether either of the materials is a binding constraint.
AT A GLANCE

Total quantity of each product to be manufactured:

Government order Market demand Total
Units
Alpha 200 900 1,100
Beta 300 3,000 3,300
Gamma 400 5,000 5,400
Zeta 0 600 600
All figures in kg:

Resource Available Requirement Alpha Beta Gamma Zeta

SPOTLIGHT

Direct material-A 22,000 18,400 2,200 0 16,200 0

Direct material-B 34,000 35,200 2,200 9,900 21,600 1,500

It can be seen from the above that the scarcity of material-B is a binding constraint and therefore
the contributions of each product and the component per kg of material-B must be compared.

Alpha Beta Gamma Zeta

Rupees
Contribution per unit 17.9 36.8 42.3 14.0
Contribution /kg of material-B 8.95 12.27 10.58 5.60
STICKY NOTES

Rank 3 1 2 4

AL should manufacture 120 units of Zeta and continue to purchase 480 units from the market.
 Example 07:
Snooker (Private) Limited (SNPL) manufactures a component ‘Beta’ which is used as input for
many products. The current requirement of Beta is 18,000 units per annum. Current production
cost of Beta is as follows:
Rs. per unit
Direct material 3,670
Direct labour 1,040
Variable manufacturing overheads 770
Fixed manufacturing overheads 870
Total cost 6,350

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A supplier has recently offered SNPL to supply Beta at Rs. 7,000 per unit. The management has
nominated a team to evaluate the offer which has gathered the following information:
1. There is a shortage of labour. However, some of the labour would become available due
to outsourcing of Beta, which would be utilized for production of a product ‘Zee’. The
estimated selling price of Zee is Rs. 5,800 per unit whereas production cost would be as
follows:
a. Direct material would cost Rs. 2,600 per unit.
b. Each unit of Zee would require 20% more labour as compared to each unit of
Beta.
c. Estimated variable manufacturing overheads would be Rs. 480 per unit.
2. Outsourcing of Beta and production of Zee would result in net reduction in fixed
manufacturing overheads by Rs. 1,900,000 per annum.

AT A GLANCE
The decision regarding outsourcing by SNPL would require following evaluation:

Snooker Private Limited Rupees

Additional cost of outsourcing of component Beta W-1 (27,360,000)

Additional contribution from utilizing spare capacity by producing

Zee W-2 22,080,000

Net savings of fixed factory overheads 1,900,000

Loss due to outsourcing (3,380,000)

SPOTLIGHT
Opinion: SNPL should not outsource the production of component X.

W-1: Difference between cost of production and cost of outsourcing

Rupees
of component Beta

Purchase cost (18,000×7,000) 126,000,000

Variable production costs saved [18,000×(3,670+1,040+770)] 98,640,000

Allocation of shared cost (irrelevant) Ignore -

Additional cost of outsourcing component Beta 27,360,000

STICKY NOTES
W-2: Profit from spare capacity - Production of Zee Rupees

Sales revenue of Zee [5,800×15,000 (W-3)] 87,000,000

Material [(2,600×15,000 (W-3)] (39,000,000)

Labour (1,040×15,000 (W-3)×1.2) (18,720,000)

Variable manufacturing overheads (480×15,000) (7,200,000)

Profit from Zee 22,080,000

W-3: Production of Zee Units

18,000 /1.2 15,000

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 Example 08:
Lily (Private) Limited (LPL) has two factories. LPL manufactures a product Delta in its Quetta
factory. One unit of Delta is assembled from three components P, Q and R which are produced in
the Hub factory. Monthly demand of Delta is estimated at 5,000 units.
Following information is available in respect of each component:
P Q R
Quantity required for one unit of Delta 2 2 3
Machine hours required for producing each component 4 3 5

Cost of production per unit: ----------Rupees---------

Direct material 900 800 300
AT A GLANCE

Direct Labour 270 250 240

Factory overheads 500 700 280
Allocated administrative overheads 40 30 50

Fixed factory overheads are charged at Rs. 20 per machine hour.

Production capacity at Hub factory is restricted to 100,000 machine hours per month. In order
to meet the demand, LPL is considering to purchase P, Q and R from a vendor at Rs. 1,700, Rs.
1,800 and Rs. 870 per unit respectively.
In determining how LPL can optimize its profit in the above situation, please see below working
P Q R
SPOTLIGHT

Quantity required to produce one unit of Delta A 2 2 3

Machine hours to produce the components B 4 3 5
Components required to produce 5,000 units of
C
Delta (5,000×A) 10,000 10,000 15,000

Relevant production cost per component: ----------- Rupees ---------

Direct material 900 800 300
Direct labour 270 250 240
Variable overheads
500–(B×20); 700–(B×20); 280–(B×20) 420 640 180
STICKY NOTES

Fixed overheads (Not relevant) - - -

Allocated administrative overheads (Not relevant) - - -
Total relevant cost D 1,590 1,690 720
----------- Rupees ---------
External purchase price per component E 1,700 1,800 870
Savings per component in case of in-house
production E–D = F 110 110 150
Savings per machine hour for in-house
production F÷B 27.50 36.67 30.00
Priority for in-house production 3rd. 1st. 2nd.
In-house production in sequence of
priority Units G - 10,000 14,000
Use of available hours G×B - 30,000 70,000
External purchase Units C–G 10,000 - 1,000

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 Example 09:
Qamber Limited (QL) is engaged in the manufacture and sale of textile products. In February
2013 QL received an order from JCP, a chain of stores, for the supply of 11,000 packed boxes of
its products per month at an agreed price of Rs. 8,000 per box. The boxes would be supplied every
month for a period of one year. It was further agreed that:
• Each box would contain a pillow cover, a bed sheet and a quilt cover.
• QL would be solely responsible for the quality of supplied products whether they are
being manufactured at its own facility or outsourced to third party, either wholly or
partially.
• JCP would provide its logo and printed materials for the packing of these boxes.
Following information is available for the manufacture of each unit of these products:

AT A GLANCE
Products
Pillow Bed Quilt
Cover Sheets Cover
Cloth required (Meters) 1 4 5
Cost of cloth per meter (Rs.) 200 300 400
Direct labour per meter (Minutes) 30 15 18
Machine time (Minutes) 30 75 120
Variable overheads per machine minute (Rs.) 5 4 3.75
Outsourcing cost (Rs.) 750 2,000 3,500

SPOTLIGHT
For in-house completion of the above order, a total of 45,000 machine hours and 25,500 labour
hours are estimated to be available each month. The labourers are paid at a uniform rate of Rs.
400 per hour. The cost incurred on quality check, before supply of the boxes to JCP, is estimated
at Rs. 300 per box. Fixed overheads are estimated at Rs. 10,000,000 per month.
Calculation of net profit for the month, assuming QL wants to produce as many products as
possible within the available resources, and outsource the rest to a third party, is given below.
Computation of limiting factor
Estimated labour hours available each month 25,500
Divided by : labour hours required per box [(30 × 1)+(15 × 4)+(18×5)] ÷ 60 3
No. of boxes that can be produced within available labour hours 8,500
Estimated machine hours available each month 45,000

STICKY NOTES
Divided by : machine hours required per box [(30 + 75 + 120)] ÷ 60 3.75
No. of boxes that can be produced within available machine hours 12,000
Therefore, limiting factor is labour hours.
Products
Pillow Bed Quilt
Cover Sheets Cover
Direct material [1×200],[4×300],[5×400] 200 1,200 2,000
Direct labour [400×30÷60×1],[400×15÷60×4],[400×18÷60×5] 200 400 600
Variable overhead [5×30],[4×75],[3.75×120] 150 300 450
Variable cost per product 550 1,900 3,050
Less: Outsourcing cost per product (750) (2,000) (3,500)
Cost saving from in-house production 200 100 450
Direct labour hours per unit 0.50 1.00 1.50
Cost saving per labour hour 400 100 300
Ranking 1 3 2

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Scarce hours allocated as per ranking

Labour hours Available

Quantity
used hours
25,500
First Produce – Pillow cover 11,000 5,500 20,000
Then Produce – Quilt cover 11,000 16,500 3,500
Finally produce – Bed sheet 3,500 3,500 -
No. of Bed sheets to be outsourced 7,500

Statement showing net profit for the month

AT A GLANCE

Products
Rs. In 000
Pillow Cover Bed Sheets Quilt Cover
----------Rupees-----------
Sales [11,000 × Rs. 8,000] 88,000
Less: Expenses:
Units produced 11,000 3,500 11,000
Variable manufacturing cost per
product 550 1,900 3,050
6,050,000 6,650,000 33,550,000 (46,250)
Units outsourced 7,500
SPOTLIGHT

Outsourced cost per bed sheet 2,000

15,000,000 (15,000)
Cost of quality check (11,000 x (3,300)
300)
Total variable costs (64,550)
Total contribution 23,450
Less: Fixed costs (10,000)
Net profit for the month 13,450
 Example 10:
STICKY NOTES

Zee Chemicals Limited (ZCL) produces two joint products, Alpha and Beta from a single
production process. Both products are processed up to split-off point and sold without any
further processing.
Presently, ZCL is considering the following proposals:
• Expansion of the existing facility by installing a new plant
• Installation of a refining plant to sell either Alpha or Beta after refining
To assess the above proposals, following data has been gathered:
i. Actual cost incurred in the month of December 2014:
Rs. in '000
Direct material 15,000
Variable conversion costs (Rs. 230 per hour) 4,890
Fixed overheads 2,600

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ii. Actual production and selling price for the month of December 2014:
Selling price
Liters per liter
(Rs.)
Alpha 11,300 1,000
Beta 14,700 1,125
iii. There is no process loss and joint costs are apportioned between Alpha and Beta
according to the weight of their output.
iv. Details of the proposed plans are as follows:
Expansion of Installation
existing of refining

AT A GLANCE
facility plant
Capacity in machine hours per month 5,000 5,000
------------ Rs. in '000 ------------
Cost of plant and its installation 20,000 25,000
Estimated residual value at the end of life 1,400 2,800
Estimated additional fixed overheads per month 250 500
Estimated useful life of the plant 20 Years 20 Years

v. Estimated variable cost of refining and sales price of refined products:

Alpha Beta
Rupees per liter

SPOTLIGHT
Direct material 90 125
Conversion cost (Rs. 150 per hour) 68 80
Selling price 1,380 1,525
vi. There would be no loss during the refining process. There is adequate demand for Alpha
and Beta at split-off point and after refining.
It is important to evaluate each of the above proposals and give recommendations. Following
calculations may be of some help:
Expansion Refining plant
(Sale at split-off point) (Sale after refining)

STICKY NOTES
Alpha Beta Alpha Beta
Sales/incremental sales value
1,000 1,125 380 400
per liter
(1,380–1,000) (1,525 – 1,125)
(765) (765) (158) (205)
Variable cost at split-off
point/cost of refining per liter (15,000+4,890) ÷
(90+68) (125+80)
(11,300+14,700)
Contribution margin per liter
A 235 360 222 195
CM from 5,000 hours:
Total hours worked in 21,261 Hrs.
December 2014 (4,890,000÷230)
Hours per liter for refining 0.453 Hrs. 0.533 Hrs.
(68÷150) (80÷150)

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Expansion Refining plant

(Sale at split-off point) (Sale after refining)
Alpha Beta Alpha Beta
Production from 5,000 hours 2,657 Ltrs. 3,457 Ltrs. 11,038 Ltrs. 9,381 Ltrs.
B (5,000/21,26 (5,000/21,261 (5,000÷0.453) (5,000÷0.533)
1×11,300) ×14,700)
Contribution margin 1,868,915 2,450,436 1,829,295
(A×B) (2,657×235)+(3,457×360) (11,038×222) (9,381×195)
Fixed overheads:
Depreciation per month
(20,000-1,400)÷20÷12 (77,500)
(25,000-2,800)÷20÷12 (92,500) (92,500)
AT A GLANCE

Additional fixed overheads per

month (250,000) (500,000) (500,000)
Net profit per month 1,541,415 1,857,936 1,236,795

Recommendations: As refining of Alpha produces the highest profit, ZCL should install refining
plant to refine and sell 11,038 liters of Alpha.
 Example 11:
Binary Ltd. (BL) manufactures three products, A, B and C. It is the policy of the company to
apportion the joint costs on the basis of estimated sales value at split off point. BL incurred the
following joint costs during the month of August 20X3:
SPOTLIGHT

Rs. in ‘000
Direct material 16,000
Direct labour 3,200
Overheads (including depreciation) 2,200
Total joint costs 21,400
During the month of August 20X3 the production and sales of Product A, B and C were 12,000,
16,000 and 20,000 units respectively. Their average selling prices were Rs. 1,200, Rs. 1,400 and
Rs. 1,850 per unit respectively.
In August 20X3, processing costs incurred on Product A after the split off point amounted to Rs.
STICKY NOTES

1,900,000.
Product B and C are sold after being packed on a specialized machine. The packing material costs
Rs. 40 per square foot and each unit requires the following:
Product Square feet
B 4.00
C 7.50
The monthly operating costs associated with the packing machine are as follows:
Rupees
Depreciation 480,000
Labour 720,000
Other costs 660,000
All the above costs are fixed and are apportioned on the basis of packing material consumption
in square feet.

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a) The joint costs to be apportioned to each product, would be calculated as follows:

Total joints costs as given in the question Rs. 21,400,000

Joint Costs (Rs.)

Product A:
Rs. 12,500,000 (W-1) / Rs. 61,480,000 (W-1) x Rs. 21,400,000 4,351,008
Product B:
Rs. 19,283,738 (W-1) / Rs. 61,480,000 (W-1) x Rs. 21,400,000 6,712,297
Product C:
Rs. 29,696,262 (W-1) / Rs. 61,480,000 (W-1) x Rs. 21,400,000 10,336,695

AT A GLANCE
21,400,000

W-1 : Computation of sales Product A Product B Product C Total

value at split off point Rs. Rs. Rs.
Sales value
Rs. 1,200 x 12,000 14,400,000
Rs. 1,400 x 16,000 22,400,000
Rs. 1,850 x 20,000 37,000,000

SPOTLIGHT
Less:
Further processing costs – A (1,900,000)
Packing costs - Fixed (556,262)
B: Rs. 1,860,000 (W2)×64,000 ÷
214,000 (W3)
C: Rs. 1,860,000 (W2)×150,000
÷ 214,000 (W3) (1,303,738)
Packing costs – Variable
B: 64,000 x Rs. 40 (2,560,000)

STICKY NOTES
C: 150,000 x Rs. 40 (6,000,000)
Estimated sales value at split
off point 12,500,000 19,283,738 29,696,262 61,480,000
W-2: Fixed costs relating to packing machine = 480,000 + 720,000 + 660,000 = Rs. 1,860,000
W-3: Total Volume in Square Feet

Product Square Feet per Unit Units produced Total Volume

B 4.00 16,000 64,000
C 7.50 20,000 150,000
214,000

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a) BL has received an offer from another company to purchase the total output of Product
B without packaging, at Rs. 1,200 per unit. Determine the viability of this offer.
To sell Product B without packaging for Rs. 1,200 per unit, following calculations would
be required:

Packaged (Rs.) Unpackaged (Rs.)

Selling price per unit 1400 1,200
Less: Variable cost of packing (Rs.40 x 4) 160 -
Contribution margin 1,240 1,200

Conclusion: Since the alternative option has a lower contribution margin, the decision
should be to continue to sell Product B with packaging at Rs. 1,400 per unit
AT A GLANCE

 Example 12:
Cappuccino Limited (CL), incorporated in January 2018, is engaged in manufacturing and
marketing of two types of products, S1 and S2. Due to strict quality standards at CL, the ratio of
damaged goods is high. Damaged units of S1 can only be identified at 100% completion whereas
damaged units of S2 can be identified at 60% completion. Damaged units of S1 and S2 can be sold
at 80% and 50% of market prices respectively.
CL’s production department believes that damaged units can be sold at full market price after
incurring per unit rectification costs of Rs. 150 and Rs. 450 on S1 and S2 respectively. Additional
information:
• Following information has been extracted from CL’s latest records:
SPOTLIGHT

S1 S2
Units
No. of units sold 347,000 218,000
Closing inventory 47,000 34,000
Rupees in ‘000
Sales 492,800 463,760
Cost of goods manufactured 431,430 349,370
STICKY NOTES

Closing inventory (51,465) (48,287)

Cost of goods sold 379,965 301,083
Gross profit 112,835 162,677

• Closing inventory includes units of S1 and S2 damaged during the year i.e. 15,000 and
22,500 units respectively.
• Fixed costs are incurred at the beginning of period and variable costs are incurred
throughout the manufacturing process.
• Cost of goods manufactured includes fixed cost of Rs. 80 million which is allocated on
the basis of total units produced.
• Selling expenses during the period was 1% of sales.

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a) Whether CL should sell damaged units of each product with or without further
processing, is calculated as under.

Conclusion

Without further processing With further processing

S1 S2 S1 S2
Sales price 1,136 1,064 1,420 2,127
[Sales/Quantity] (1,420×80%) (2,127×50%) (492,000/347) (463,760/218)
Costs:
Fixed cost - - - -
(Irrelevant)

AT A GLANCE
Variable cost (W-1) 971 786 971 1,309
Further processing - - 150 450
costs (given)
Selling Expense (1% 11 11 14 21
of sales price)
Cost of goods sold (982) (797) (1,135) (1,780)
Profit 154 267 285 347
Sell S1 after further processing

Sell S2 after further processing

SPOTLIGHT
b) Determination of value of damaged units of S1 and S2 included in the closing inventories,
under each of the following situations:
– If CL opts for further processing
– If CL does not opt for further processing
Without further processing With further processing
S1 S2 S1 S2
Without further
processing
NRV [Sales price less selling 1,125 1,053 1,256 1,656
costs] A

STICKY NOTES
Costs [Variable +Fixed 1,095 910 1,095 1,433
costs] B
Lower of costs or NRV 1,095 910 1,095 1,433
Value of damaged units 16,425,000 20,475,000 16,425,000 32,242,500
Adjustments requirement No No No No
in the books

W-1 Variable cost per unit S1 S2

Rupees in ‘000
Total costs (given) 431,430 349,370
Fixed cost (W-2) 48,793 31,207
Variable cost (Total cost – Fixed cost) 382,637 318,163
No. of units manufactured (W-3) 394 243
Variable cost per unit (382,637÷394, 318,163÷243) 971 1,|309

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W-2 Fixed cost per unit S1 S2 Total

Rupees in ‘000
Fixed costs (given) 80,000
No. of units produced (W-3) 394 252 646
Fixed cost per unit (80,000÷646) 124
Allocated fixed cost (394÷646×80,000, 48,793 31,207
252÷646×80,000)
W-3 No. of completed units manufactured S1 S2
No. of units sold [given 347,000 218,000
Closing stock [given] 47,000 34,000
No. of completed units manufactured [including 394,000 252,000
AT A GLANCE

damaged units]
Damaged stock [Damaged × 1 – Completion] - (9,000)
No. of completed units manufactured [excluding 394,000 243,000
damaged goods]

 Example 13:
DEL Limited manufactures radiators for car manufacturers. In normal operations, about 200,000
units are sold per annum at an average selling price of Rs. 15,000 per unit. Manufacturing process
is carried out by 500 highly skilled labours who work an average of 180 hours per month at Rs.
250 per hour. Raw material cost is Rs. 3,000 per unit. Annual factory overheads are estimated at
Rs. 540 million. Variable overheads are 150% of labour cost.
SPOTLIGHT

DEL had received an offer from TRU Limited to manufacture 4,000 units of radiators of trucks, at
Rs. 50,000 per unit. DEL had expected to earn significantly high margin on this order and had
planned to stop normal production for this purpose. It had already procured the raw material for
Rs. 60 million but before the start of manufacturing it came to know that TRU has gone into
liquidation.
To deal with the situation, DEL’s marketing department has negotiated with another truck
manufacturer, NTR Limited. NTR’s specifications are slightly different and the price offered by
NTR is Rs. 40,000 per unit.
The costs to be incurred on the new order and other relevant details are as follows:
STICKY NOTES

1. Additional raw material of Rs. 12 million would have to be purchased for NTR’s order.
2. DEL expects that first unit would take 10 hours. The labour time would be subject to a
95% learning rate upto 1,000 units. Thereafter, the learning rate would stop. The index
of 95% learning curve is -0.074.
3. Variable overheads would be 240% of the cost of labour.
4. Fixed overheads are to be applied at Rs. 400 per labour hour.
5. Total cost of preparing the plant for NTR’s order and resetting it to the normal
production would be Rs. 4 million.
If the order from NTR is not accepted, raw materials of Rs. 60 million already procured would
have to be sold at 70% of their cost. However, raw material worth Rs. 10 million can be utilized
in the car’s radiators after slight alteration at a cost of Rs. 1 million. The altered raw material can
produce 30% components of 10,000 car radiators.

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Whether DEL may accept the order from NTR would require following calculations:

DEL Limited
Acceptance of order from NTR Limited for truck radiators Rs. in million
Revenue from NTR Limited 40,000×4,000 160.00
Additional raw material (12.00)
Raw material already procured – sales value (60-10)×70% (35.00)
– use value for truck radiators (10,000×3,000×30%)-1 (8.00)
Labour cost [22,647.91 (W-1)×250] (5.66)

AT A GLANCE
Variable overheads (5.66×240%) (13.58)
Preparation and resetting cost of the plant (4.00)
Fixed overheads applied To be ignored -

81.76
Loss of CM for not producing car radiators 4,194 (W-2) ×8,625 (W-3) (36.17)
Profit on acceptance of the order from NTR 45.59

Conclusion: DEL should accept the order from NTR Limited

W-1: Direct labour hours for production of truck radiators Hours

SPOTLIGHT
Direct labour hours for 1,000 units [1,000×10×(1,000)-0.074] 5,997.91
Direct labour hours for 999 units [999×10×(999)-0.074] (5,992.36)
Hours per unit for 1,001 and onward 5.55
Direct labour hours for first 1,000 units 5,997.91
Direct labour hours for next 3,000 units (5.55×3,000) 16,650.00
22,647.91

W-2: No. of Car radiators to be produced if NTR's order is not

STICKY NOTES
accepted
Labour hours per unit of car radiator (500×180×12)÷200,000 Hrs. 5.40
No. of car radiators to be produced 22,647.91 (W-1) ÷ 5.40 Nos. 4,194
W-3: Contribution margin per unit/hour for car radiators Rupees
Selling price 15,000
Raw material cost (3,000)
Labour cost (500×180×250×12)÷200,000 (1,350)
Variable overheads 150%×1,350 (2,025)
Contribution margin per unit 8,625

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 CHAPTER 15: DECISION MAKING TECHNIQUES CAF 8: CMA

 Example 14:
In May 2015, the board of directors of Sahil Limited (SL) had decided to close one of SL’s
operating segments at the end of the next year. The sales and production for the next year were
budgeted at 50,000 units and on the basis thereof, the budget of the segment for the next year
was approved as follows:

Rs. in ‘000
Sales 5,000
Direct material (50,000 kg) (950)
Direct labour (1,000)
Variable production overheads (500)
AT A GLANCE

Fixed production overheads (1,750)

Administrative and selling overheads (500)
Budgeted net profit 300

However, rumors of the closure prompted majority of the segment’s skilled labour to leave the
company. Consequently, the management is considering the following alternatives to cope with
the issue:
• Close the segment immediately and rent the factory space for one year at a rent of Rs.
40,000 per month; or
• Employ contract labour which would be able to produce a maximum of 40,000 units in
the year. The quality of the product is however expected to suffer due to this change.
SPOTLIGHT

The following further information is available:

1. The sales manager estimates that a sales volume of 30,000 units could be achieved at the
current selling price whereas sales volume of 40,000 units would only be achieved if the
price was reduced to Rs. 90 per unit.
2. 25,000 kg of raw material is in stock. Any quantity of the material may be sold in the
market at a price of Rs. 19 per kg after incurring a cost of Rs. 2 per kg. Up to 15,000 kg
can be used in another segment of the company in place of a material which currently
costs Rs. 18 per kg.
3. Wages of contract labour would be Rs. 24 per unit. SL would also be required to spend
STICKY NOTES

Rs. 40,000 on the training of the contract labour.

4. Due to utilization of contract labour, variable production overheads per unit are
expected to increase by 20%.
5. Fixed production overheads include:
• Depreciation of three machines used in the segment amounting to Rs. 170,000.
These machines originally costed Rs. 1.7 million and could currently be sold for Rs.
830,000. If the machines are used for production in the next year, their sales value
would reduce by Rs. 5 per unit of production.
• All other costs included in ‘fixed production overheads’ represent apportionments
of general overheads.
6. 40% of administrative and selling overheads are variable whereas the remaining
amounts represent apportionment of general overheads.

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In advising the best course of action for Sahil Limited, please see below:

Available options
Immediate Operation using contract
closure and labour
renting of
factory bldg. To produce To produce
30,000 units 40,000 units
-------------- Rupees --------------
Incremental savings
Sales (30,000×100), 40,000×90) 3,000,000 3,600,000

AT A GLANCE
Rental income (40,000×12) 480,000
Proceeds from sale of machine
(830,000-30,000×5), (830,000-40,000×5) 830,000 680,000 630,000
Direct material - Use for other segment
(15,000×18) 270,000 - -
Direct material - sale externally
[10,000×(19-2)] 170,000 - -
Fixed production overheads; apportionment of
general overheads (1,750-170= 1580) - - -

SPOTLIGHT
Fixed admin and selling overheads;
apportionment of general overheads
(500×60%=300) - - -
Incremental costs
Purchase of direct material
(5,000×19), (15,000×19) - (95,000) (285,000)
Training of contract labour - (40,000) (40,000)
Contract labour cost
(30,000×24), (40,000×24) - (720,000) (960,000)

STICKY NOTES
Variable production overhead
(500÷50×1.2×30,000),(500÷50×1.2×40,000) - (360,000) (480,000)
Variable admin. & selling overheads:
[(500×40%)÷50×30], [(500×40%)÷50×40] - (120,000) (160,000)
Net savings 1,750,000 2,345,000 2,305,000

Conclusion: Since the highest savings occur with a production level of 30,000 units, SL should
operate the segment at this level of activity.
 Example 15:
Sarwar Limited (SL) manufactures two industrial products i.e. K2 and K9. It also manufactures
other products in accordance with the specification of customers. SL’s products require
specialized skilled labour. Maximum labour hours available with the company are 300,000 per
month.

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 CHAPTER 15: DECISION MAKING TECHNIQUES CAF 8: CMA

Following information has been extracted from SL’s budget:

K2 K9
---- Rs. per unit ----
Selling price 16,500 26,000
Direct material 6,000 8,000
Direct labour (Rs. 300 per hour) 4,500 7,500
Variable production overheads (based on labour hours) 1,875 3,125
Applied fixed production overheads (based on labour hours) 1,500 2,500
Monthly demand (Units) 5,000 8,000
AT A GLANCE

An overseas customer has offered to purchase 3,000 units of a customized industrial product ‘A-
1’ at a price of Rs. 35,000 each. The duration of contract would be one month.
The cost department has ascertained the following facts in respect of the contract:
i. Each unit of A-1 would require 3 units of raw material B-1 and 2 units of raw material C-3.
B-1 is available in the local market at Rs. 2,500 per unit. However, the required quantity of
C-3 is not available in the local market and would be imported from Srilanka at a landed cost
of Rs. 2.4 million.
ii. Each unit of A-1 would require 35 labour hours.
iii. A specialized machinery would be hired for five days. However, due to certain production
scheduling issues, it is difficult for SL to exactly predict when the machine would be required.
As a result of negotiations, SL has received the following offers:
SPOTLIGHT

Falah Modarba has quoted a rent of Rs. 0.9 million for the entire month. If accepted, SL would be
able to sublet the machine at Rs. 20,000 per day.
Tech Rentals has quoted a rent of Rs. 57,000 per day and guaranteed availability of machinery
when required.
The management believes that it can increase/decrease the production of K2 and K9, if required.
The maximum profit that can be earned by SL, in the above situation can be determined as below:
K2 K9 A-1
-------------------- Rs. per unit --------------------
Selling price Given 16,500.00 26,000.00 35,000.00
Variable cost 12,375.00 18,625.00 23,270.00
STICKY NOTES

(6,000+4,500+1,875) (8,000+7,500+3,125) (W-1)

Contribution per unit A 4,125.00 7,375.00 11,730.00
Labour hours required per unit 15 25 35
B (4,500/300) (7,500/300) Given
CM per labour hour (Rs.) 275.00 295.00 335.14
A/B
Ranking 3 2 1
Allocation of 300,000 hours C 195,000 105,000
(300,000–105,000) (35×3,000)
Units to be produced C/B 7,800.00 3,000.00

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Contribution margin for the month after accepting special contract Rs. in million
A-1 (3,000×11,730) 35.19 K-9 (7,800×7,375) 57.53
Contribution margin 92.72
Fixed cost (1,500/15)×300,000 30.00
Maximum profit 62.72
W-1: Relevant cost for A-1 Rs. per unit
Material cost - B1 (3×2,500) 7,500.00
Material cost - C3 (2,400,000/3,000) 800.00
Labour cost (35×300) 10,500.00

AT A GLANCE
Variable overheads [{1875÷(4,500÷300)}×35] 4,375.00
Machine hire cost [Lower of (57,000×5) and {900,000– 95.00
(20,000×25)}]/3,000
Variable cost per unit of A-1 23,270.00

 Example 16:
Ideal Chemicals (IC) blends and markets various cleaning chemicals. Presently, IC’s plant is
working at 70% capacity. To utilize its idle capacity, IC is planning to acquire rights to produce
and market a new brand of chemical namely Z-13 on payment of fee of Rs. 160,000 per month.
In this respect, the relevant information is summarized as under:
i. Z-13 would be produced using the existing plant whose cost is Rs. 81 million. Processing

SPOTLIGHT
would be carried out in batches of 2,000 liters of raw-materials.
Production costs per batch are estimated as under:

Raw material: Imported 1,200 liters @ Rs. 1,500 per liter

Local 800 liters @ Rs. 900 per liter
Direct labour 4,000 hours @ Rs. 165 per hour
Variable production overheads @ Rs. 120 per direct labour hour

1,700 liters of Z-13 is produced from each batch. 100 liters are lost by way of
evaporation whereas 200 liters of input is converted into solid waste. The approximate

STICKY NOTES
weight of the solid waste is 225 kg per batch.
ii. Net volume of each bottle of Z-13 would be 1.25 liters.
iii. The solid waste would be refined to produce a by-product, polishing wax. Refining would
cause an estimated loss of 2% of by-product output.
iv. Cost of refining and sales price of wax would be Rs. 250 and Rs. 400 per kg respectively.
Net sales revenue (sales less refining cost) from sale of wax is to be deducted from the
cost of the main product.
v. Variable selling overheads are estimated at Rs. 175 per unit.
vi. The plant is depreciated at 10% per annum. It is estimated that production of Z-13 would
utilize 20% capacity of the plant.
vii. To introduce Z-13, IC plans to launch a sales campaign at an estimated cost of Rs. 3.5
million.
viii. IC wishes to sell Z-13 at a contribution margin of 40% on sales.

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In determining Z-13’s sale price per unit and annual units to be sold, if IC intends to earn an
incremental profit before tax of Rs. 10 million from its sale; please see below:

Ideal Chemicals Units

Finished units per batch 1,700÷1.25 (A) 1,360
By-product units per batch 225÷1.02 221

Variable production cost per unit: Rupees

Material: Imports 1,200×1,500 1,800,000
Local 800×900 720,000
Direct labour 4,000×165 660,000
AT A GLANCE

Variable production overheads 4,000×120 480,000

Net sales revenue from sale of by-product 221×(400–250) (33,150)
(B) 3,626,850
Variable production cost per unit (B÷A) 2,666.80
Variable selling overheads per unit 175.00
Variable cost per unit (C) 2,841.80
Sales price per unit to earn 40% contribution on sale D=(C÷0.6) 4,736.33

No. of sale units to earn annual profit before tax of Rs. 10,000,000
SPOTLIGHT

Incremental fixed overheads and profit:

- Fee for blending and marketing of Z-13 160,000×12 1,920,000
- Sales promotion expenses 3,500,000
- Required incremental profit before tax 10,000,000
(E) 15,420,000
Required annual sales units No. of units E÷ (D-C) 8,139
 Example 17:
Jasmine Limited (JL) manufactures various products according to customers' specifications. In
March 2019, JL is required to submit a tender for supply of 5,000 plastic bodies of a washing
STICKY NOTES

machine. In this respect, following information has been gathered:

i. The production would be carried out on JL’s plant at its Sialkot factory. Cost of the plant
is Rs. 3,600,000. Its estimated useful life is 96,000 hours. Each plastic body (unit) would
require 2 machine hours.
ii. Production would be carried out in ten batches of 500 units each. Cost per unit for the
first batch has been estimated as under:
Rupees
Direct material 2 kg 150
Direct Labour 3 labour hours 300
*Overheads (based on direct labour hours):
Variable overheads 240
Fixed overheads 360
*Overheads do not include depreciation of the plant

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iii. Direct material consumption would reduce by 5% in each subsequent batch up to the
third batch and would become constant thereafter.
iv. Applicable learning curve effect is 95% but it will remain effective for the first six batches
only. The index of 95% learning curve is –0.074.
The bid amount that JL should quote to earn 30% contribution margin, would be calculated as
follows:
Rs. in '000
Direct material cost:
For first 3 batches 75,000+ (75,000×0.95) +[75,000×(0.95)2] 214
For last 7 batches 75,000×(0.95)2×7 474
A 688

AT A GLANCE
Direct labour cost:
For first 6 batches (W-1) 7,882×100 788
For last 4 batches (W-1) 1,224×4×100 490
B 1,278
Overheads
Variable overheads based on direct labour
hours 240÷3×1278 1,022
Variable overheads based on machine hours
(molding plant depreciation) 3,600÷96,000×(5,000×2) 375
1,397

SPOTLIGHT
Fixed overheads -
C 1,397
Bid amount to earn 30% contribution margin (A+B+C)÷0.7 4,804

W-1: Direct labour hours at 95% learning curve Hours

For the first 6 batches 6×(500 units × 3 hours)×(6)–0.074 7,882
For the first 5 batches 5×(500 units × 3 hours)×(5)–0.074 (6,658)
For the 7th. batch and onwards 1,224

STICKY NOTES
 Example 18:
Pizza Inc. has pizza outlets in all major shopping malls in the city. It prepares and sells
approximately 4,850 standard pizzas per week. A premium quality imported cheese (cheese), the
key ingredient for pizza preparation is purchased from a supplier at Rs. 1,200 per kg. Other costs
related to cheese are as follows:

Rupees
Administration cost per order 150,000
Transportation cost per order 22,500
Quality inspection cost per order 20,000
Refrigeration cost per kg 250
Warehouse cost per annum 4,420,000
Cost of financing the stock per month 1.5%

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 CHAPTER 15: DECISION MAKING TECHNIQUES CAF 8: CMA

Other information:
(i) The company places orders on the basis of Economic Order Quantity (EOQ).
(ii) Each standard size pizza requires 0.25 kg of cheese. However, 3% of cheese is lost in
refrigeration.
(iii) 80% of administration cost and 50% of warehouse cost are variable. All other costs are
fixed.
(iv) The company operates throughout the year which is 52 weeks.
The supplier has offered to reduce 5% price if the company agrees to double the size of order for
the coming year. However, it would have following implications:
(i) 4% of cheese would be lost in refrigeration.
AT A GLANCE

(ii) Variable cost of warehouse, transportation cost and inspection cost would increase by
50%.
(iii) Refrigeration cost would increase by 75%. Required: Advise whether Pizza Inc. should
accept offer of the supplier.
In order to measure whether Pizza Inc. should accept the offer or not, it is based on following
calculation.
For determining EOQ and warehouse cost:
Ordering cost = Carrying cost
Annual demand/EOQ × Per order cost = [250+216+{(4,420,000×0.5)/(EOQ/2)}] × EOQ/2
SPOTLIGHT

65,000/x × 162,500 = [250+216+{(4,420,000×0.5)/(x/2)}] × x/2

10,562,500,000/x = 233x + 2,210,000
10,562,500,000 = 233x2 + 2,210,000x
233x2 + 2,210,000x – 10,562,500,000 = 0
By using quadratic equation: x = 3,493 unit

Existing Proposed
19 10
Number of orders (65,000/3,493) W-4
STICKY NOTES

78,000,000 74,871,875
Purchase cost (65,000w-1x1,200) (65,677w-4x1,200x0.95)
3,087,500 1,837,500
Ordering cost (162,500w-2x19) (187,500w-5x10)
3,023,192 5,560,856
Holding cost (3,493/2×1,731(W-3)) (6,986/2×1,592(W-6))
84,110,692 82,270,231

Conclusion:
The company should accept the offer of supplier as it would save Rs. 1,840,461

540 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN

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W-1 Rupees
Annual Demand [(4,850×0.25×52)/0.97] 65,000
W-2 Ordering cost per order Rupees
- Administration cost (150,000×0.8) 120,000
- Transportation cost 22,500
- Quality inspection cost 20,000
162,500
W-3 Carrying cRost per unit Rupees
- Refrigeration cost 250
- Financing cost (1,200×0.015×12) 216
- Warehouse cost [(4,420,000×0.5)/(3,493/2)] 1,265

AT A GLANCE
1,731
W-4 Number of orders Rupees
Annual demand [(65,000×0.97)/0.96] 65,677
Order size (3,493×2) 6,986
Number of orders 10
W-5 Ordering cost per order Rupees
- Administration cost 150,000
- Transportation cost (22,500×1.5) 33,750
- Quality inspection cost (20,000×1.5) 30,000
183,750

SPOTLIGHT
W-6 carrying cost per kg Rupees
- Refrigeration cost (250×1.75) 438
- Financing cost (1,200×0.95×0.015×12) 205
- Warehouse cost [(4,420,000×0.5)/(6,986/2)] × 1.5 949
1,592
 Example 19:
Siyab Limited (SL) is involved in manufacturing and exporting of products BA, CA and DA.
Keeping in view the continuous operating losses in product BA, the management is considering
to discontinue the production of BA. Summarised operating results of BA for the year 2019 are
as follows:

STICKY NOTES
Units sold (2018: 156,250 units) 150,000
Rs. In 000
Sales revenue 30,000
Raw material consumption (12,000)
Labour (6,000)
Variable manufacturing overheads (3,000)
Fixed manufacturing overheads:
Directly attributable (2,800)
Allocated (30% of total) (750)
Selling expenses (2018: Rs. 8,050,000) (7,800)
Operating loss (2,350)
Chief Financial Officer (CFO) is of the view that discontinuance of BA would save all
manufacturing and selling expenses except allocated fixed manufacturing overheads. It is
estimated that total allocated fixed manufacturing overheads will be reduced by 10%.

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In a recent management meeting, SL’s sales director does not agree with the suggestion to
discontinue this product. She is of the view that BA is in high demand in the local market and the
management should consider to launch this product in the local market through an online
marketplace, Jamal Express (JE). She argues that this will not only minimize the selling expenses
but also allow SL to reach maximum customers.
Following information have been available in respect of launching an online store of BA at JE:
(i) Existing production capacity of BA is 172,000 units.
(ii) Existing demand of BA in the online market is sufficient to boost sales by 10% from the
previous year. However, for achieving this target level of sales, a digital marketing
service provider would be hired at an annual cost of Rs. 800,000.
(iii) BA would be sold at Rs. 180 per unit.
AT A GLANCE

(iv) SL would have to pay an annual subscription fee of Rs. 110,000 to JE to operate as a
seller. In addition, JE would charge 2% sales commission.
(v) JE also provides an additional facility of handling delivery and sales return to its clients.
This service can be availed by paying either an annual lump sum fee of Rs. 1,500,000 or
an additional commission of 5% of the selling price. If this service is availed, entire fixed
selling expenses will be saved.
(vi) Fixed and variable selling expenses pertaining to BA would be reduced by 10% and 80%
respectively.
(vii) Additional support staff would be hired at a cost of Rs 200,000 per month. This
additional hiring cost can be reduced to 80% if existing staff is given additional
responsibilities with overtime payment which would increase variable selling expense
SPOTLIGHT

by 10%.
Evaluation of suggestions of CFO and sales director and recommend the best course of action to
the management, is given below.
Optional 1: Discontinue BA Rupees
Contribution forgone (20(W-1)×150,000) 3,000,000
Savings from discontinuing BA
Directly attributable fixed cost 2,800,000
Reduction in joint fixed overheads (750,000/0.3×0.1) 250,000
Fixed selling expenses W-1.1 1,800,000
STICKY NOTES

4,850,000
Net benefit from discontinuing BA 1,850,000

Optional 2: Online marketing Existing Online Incremental

----------------Rupees in thousand--------------
Sales 30,000 29,700 (300)
Less: Commission 2% - (594) (594)
Less: Additional commission 5% W-2 - (1,485) (1,485)
Net sales 30,000 27,621 (2,379)
Less: raw materials (12,000) (13,200) (1,200)
Less: Labour (6,000) (6,600) (600)
Less: variable overheads (3,000) (3,300) (300)
Less: variable selling overhead (6,000) (1,320) 4,680
Less: increase in variable selling
overheads W-3 - (132) (132)
CM 3,000 3,069 69

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Existing Online Incremental

----------------Rupees in thousand--------------
Less: Fixed overheads:
-Directly attributable (2,800) (2,800) -
-Allocated (750) (750) -
Less: selling expense (1,800) - 1,800
Less: digital marketing cost - (800) (800)
Less: annual subscription - (110) (110)
Less: Additional support staff W-3 - (1,920) (1,920)
Operating loss (2,350) (3,311) (961)
Conclusion:
The benefit of discounting BA is Rs. 2,811,000 as compared to the option of selling through an

AT A GLANCE
online market place. Hence the management should discontinue production of BA.

W-1 Rupees
Sales (30,000/150) 200
Less: Variable costs
Raw material (12,000/150) 80
Labour (6,000/150) 40
Variable overheads (3,000/150) 20
Variable selling expense (W-1.1) 40
180

SPOTLIGHT
CM per unit 20

W-1.1 2018 2018 Difference

Units sold 156,250 150,000 6,250
Selling expense Rs. 8,050,000 7,800,000 250.000
Variable selling expense per unit (250,000/ 6,250) 40
Fixed selling expense [7,800,000- (40 x 150,000)] 1,800,000

W-2 Rupees

STICKY NOTES
Lump sum fee 1,500,000
Commission @ 5% (lowest) (180×150,000×1.1×5%) 1,485,000
Fixed selling expense (1,800,000×0.9) 1,620,000

W-3 Rupees
Option 1: Additional support staff (200,000×12) 2,400,000
Option 2: Combination of additional staff and overtime to the exiting
staff (lower)
- Additional support staff reduced (2,400,000×0.8) 1,920,000
- Increase in variable selling expense (150,000×40×1.1×0.2×0.1 ) 132,000
2,052,000

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 Example 20:
Design Limited (DL) produces and markets two products viz. Olive and Mint. Following
information is available from DL’s records for the year ended 30 June 2013:

Olive Mint
Selling price per unit Rs. 760 550
Variable production cost per unit Rs. 520 430
Selling and distribution cost per unit Rs. 40 20
Fixed cost Rs. 4,400,000 5,200,000
Number of units produced and sold 120,000 150,000
AT A GLANCE

The above sales volumes are based on the market demand for these products. DL is currently
operating at 75% of the installed capacity. Time required for producing each unit of Olive and
Mint is the same. In order to utilize the spare capacity of the plant, the marketing department has
suggested the following options to the management:
Option 1: Introduce a single pack of both the products Olive and Mint. The price of the single
pack would be 90% of the combined price of separate products. It would increase overall market
demand for these products resulting in utilisation of full capacity. However, it is estimated that
the sale of separate units of each product would reduce by 18%.
Option 2: To launch a new product Salsa at a price of Rs. 380 per unit. Salsa is estimated to have
a demand of 80,000 units per annum and a unit variable cost equal to 40% of the variable cost of
SPOTLIGHT

Olive. It would result in additional fixed costs of Rs. 3,200,000 per annum.
Evaluation of above options and advise the management about the most feasible option, is given
below.

Olive Mint
Sales price Rs. 760 550
Less: Variable production cost per unit Rs. (560) (450)
Contribution margin per unit Rs. 200 100
Number of units produced and sold 120,000 150,000
STICKY NOTES

Existing contribution margin (Rs. In 000) 24,000 15,000

Option 1: Additional profit from introduction of packaged Units

products
Quantity of packaged products:
Reduction in sale of Olive [120,000 × 18%] 21,600
Reduction in sale of Mint [ 150,000 × 18%] 27,000
Under-utilization of existing capacity [(120,000 + 150,000)÷75%] –270,000 90,000
138,600

Units of packaged products [138,600 ÷ 2] 69,300

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Rupees
Selling price per package (760 + 550) × 90% 1,179
Variable cost [ 560 + 450] 1,0,10
Contribution margin of packaged products 169
Contribution margin from sale of packaged products [69,300 × 169] 11,710,700
Less: Reduction in contribution margin [200 × 21,600] + [100 × 27,000] (7,020,000)
4,691,700
Option 2:

AT A GLANCE
Additional profit from Salsa
Contribution margin from Salsa [380 × 80,000] – [560 × 40% × 80,000] 12,480,000
Less: Additional fixed cost (3,200,000)
9,280,000
Additional profit [9,280,000 – 4,691,700] 4,588,300

Decision:
The management should produce Salsa as it would result in an additional profit of Rs. 4,588,300
as compared to the introduction of a single pack of both the products.

SPOTLIGHT
STICKY NOTES

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STICKY NOTES

In profitability decisions, limiting factors refer to the circumstances in which

in availability of production resources are scarce. Identifying the limiting
factor will help meet the sale or profit demand with the available resources.

Often companies have to go through make or buy decisions that is decisions

whether to make internally or to buy externally. These decisions involve
relevant costs that is lower from a financial point of view.
AT A GLANCE

Various non-financial considerations are involved in make or buy decisions

which may involve control, employee redundancy as well as maintaining a
competitive advantage of the company.
SPOTLIGHT
STICKY NOTES

546 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF PAKISTAN