CHAPTER 1 BASIC COST CONCEPTS 1. BASICS 1. Define · PDF filevary with the volume of activity....

Abhimanyyu Agarrwal Jai Mata Di

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CHAPTER 1

BASIC COST CONCEPTS

1. BASICS

1. Define the term “Cost”. Compare it with “Value” and “Price”.

1) Meaning of Cost:

(a) Cost refers to the expenditure incurred in producing a product or in rendering a

service.

(b) Cost is a measurement, in monetary terms, of the amount of resources used for the

purpose of production of goods or rendering services.

(c) Cost is expressed from the producer or manufacturer‟s viewpoint, (i.e. not that of

consumer / end user).

(d) Cost ascertainment is based on uniform principles and techniques.

2) Comparative Analysis between Value, Price and Cost

Particulars Value Price Cost

(a) Meaning Relative Worth of

a commodity to an

individual at a

particular point of

time.

Amount paid by

consumer in

exchange for a

product / service.

Expenditure

incurred in

producing a

product or in

rendering a service.

(b) Ascertainment User‟s viewpoint. Consumer‟s

viewpoint

Producer‟s

viewpoint

(c) Differentiation /

Subjectivity

Different persons

attach different

values to a product

at different points

of time.

Price differentiation

/ discrimination is

possible on

customer / time

basis.

Ascertained on the

basis of uniform

principles. Hence it

is objectively

determined.

(d) Inference Opinion Policy Fact

2. Define the terms “Costing”, “Cost Accounting” and “Cost Accountancy”.

1) Costing: The technique and process of ascertaining costs.

2) Cost Accounting: The process of accounting for cost which begins with recording of

income and expenditure or the bases on which they are calculated and ends with the

preparation of periodical statements and reports for ascertaining and controlling costs.

3) Cost Accountancy: The application of costing and cost accounting principles, methods

and techniques to the science, art and practice of cost control and the ascertainment of

profitability. It includes the presentation of information derived there from for the

purpose of managerial decision-making.

3. List the objectives of Cost Accounting

The primary objective of study of cost is to contribute to profitability through Cost Control

and Cost Reduction. The following objectives of Cost Accounting can be identified –

1) Ascertainment of Cost: This involves collection of cost information, by recording them

under suitable heads or account, and reporting such information on a periodical basis.

2) Determination of Selling Price: Selling Prices are influenced by internal and external

factors. However, generally, prices cannot be fixed below cost. Hence, Cost Accounting

is required for determination of appropriate Selling Prices.

3) Ascertaining the profit of each activity: Profit of each department / activity / product

can be determined by comparing its revenue with appropriate cost. So, Cost Accounting

ensures profit measurement on an objective basis.


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4) Assisting Management in decision – making: Business decisions are taken after

analyzing cost and benefits of each option, and the Manager chooses the least cost option.

Thus, Cost Accounting and reporting system assists Managers in their decision – making

process.

5) Cost Control and Cost Reduction: In the long run, higher profits can be achieved only

through Cost Control and Cost Reduction. Cost Accounting seeks to ensure profit by

providing support for cost control / reduction decisions.

4. Distinguish between Cost Reduction and Cost Control.

Particulars Cost Reduction Cost Control

1. Permanence Permanent, Real and genuine savings

in cost.

Could be a temporary saving

also.

2. Saving Focus Saving in Cost per unit. Saving either in Total Cost

or Cost per unit.

3. Product

Quality

Product‟s Utility, Quality &

Characteristics are retained.

Quality Maintenance is not a

guarantee.

4. Performance

Evaluation

It is not concerned with maintenance

of performance according to

standards.

The process involves setting

up a target, investigating

variances and taking

remedial measures to correct

them.

5. Nature of

Standards

Continuous process of critical

examination includes analysis and

challenge of standards.

Control is achieved through

compliance with standards.

Standards by themselves are

not examined.

6. Dynamism Fully dynamic approach. Less dynamic than Cost

Reduction.

7. Coverage Universally applicable to all areas of

business. Does not depend upon

standards, though target amounts may

be set.

Limited applicability to

those items of cost for which

standards can set.

8. Nature of

Costs

Emphasis here is partly on present

costs and largely on future costs.

Emphasis on present and

past behavior of costs.

9. Analysis To find out substitute ways and new

means.

Competitive analysis of

actual results with

established norms.

10. Nature of

Function

(a)Value Engineering, (b)

Standardization and Simplication, (c)

Work Study, (d) Variety Reduction,

(e) Quality Measurement & Research,

(f) Operations Research, (g) Market

Research, (h) Job Evaluation and

Merit Rating, (i) Improvement in

Product Design, (j) Mechanisation and

Automation, etc.

Budgetary Control and

Standard Costing.

5. Compare Cost Accounting with Financial Accounting. Does Cost Accounting

supplement Financial Accounting? Discuss.

The broad areas of difference between Financial and Cost Accounting are –

Particulars Financial Accounting Cost Accounting

1. Users of

Information

Financial Statements are used by

Internal management and also

outside parties like Government,

Detailed cost information is

presented to internal management

for proper planning, decision –


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Creditors, Customers, Employees,

etc.

making and cost control.

2. Statutory

Compliance

Requirements of Statutes like

Companies Act, Income Tax Act,

etc. are met through Financial

Accounting.

Generally Cost Accounting is

voluntary, except in cases where

Cost Accounting Records Rules

mandatorily apply to the

enterprise.

3. Nature /

Objectivity

Transactions are recorded in a

subjective manner. Accounting

Policies may differ from one Firm

to another Firm.

Expenditure is recorded in an

objective manner. Costing

principles and techniques are

generally uniform to all Firms.

4. Focus Focus of accounting is on recording

the transactions.

Focus of accounting is to control

cost.

5. Nature of

Cost

Generally Historical Costs are used

for recording purposes. Projected

Financial Statements may also be

drawn for budgeting purposes.

It considers both historical costs

and predetermined, i.e. Standard

Costs. It also extends to plans and

policies to improve future

performance.

6. Stock

Valuation

Stocks are valued at Cost or Net

Realisable Value whichever is less.

Stocks are valued generally at

Cost.

7. Cost

Analysis

Cost / Expenditure and Profits are

generally shown as a whole for the

period.

Costs are analysed product – wise,

department – wise, activity – wise,

etc.

8. Time Period Financial Statements are generally

prepared at the end of the financial

period, usually one year, for

reporting purposes.

Cost data and reports are

presented on a continuous basis

for the Cost Period. The cost

period (also called Control Period)

may be shorter than the financial

year.

9. Forecasting

& Planning

Has limited use for forecasting and

planning. Only broad parameters

like GP, NP, ROI, EPS, etc. can be

laid down.

Specific and detailed plan for each

product / activity / sub – level can

be laid down. Hence, more useful

for budgeting.

10. Utility for

decisions

Helps only for future decisions with

respect to product pricing, make or

buy, asset retainment vs

replacement, etc.

Helps Current & future decisions,

e.g. product price reduction and

higher volume in order to earn

target profit, resource re –

allocation, etc.

11. Control and

Assessment

Financial Accounting suffers from

limitations of lack of analysis of

information, and absence of

detailed control and assessment

parameters.

Better tools of control, analysis

and assessment are available,

some examples are Variance

Analysis, Budgetary Control, &

Marginal Costing.

Note: Cost Accounting supplements Financial Accounting for analysis and decision – making

purposes, as described above.


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COST CLASSIFICATION BASES

6. How are Costs analysed based on Behaviour / Nature / Variability?

On the basis of Behaviour / Nature / Variability, Costs are classified as under –

Type and Description Examples

1. Fixed Cost is the cost which does not vary with the change in

the volume of activity in the short – run. These costs are not

affected by temporary fluctuation in activity of an enterprise.

These are also known as Period Costs.

Salaries, Rent, Insurance,

Audit Fees, Depreciation,

etc.

2. Variable Cost is the cost of elements which tends to directly

vary with the volume of activity. Variable Cost has two parts –

(a) Variable Direct Cost, and (b) Variable Indirect Costs.

Variable Indirect Costs are termed as Variable Overhead.

Materials Consumed,

Direct Labour, Sales

Commission, Utilities,

Freight, Packing, etc.

3. Semi Variable Costs contain both fixed and variable

elements. They are partly affected by fluctuation in the level

of activity.

Factory Supervision,

Maintenance, Power,

Telephone, etc.

7. Distinguish between Committed Fixed Costs and Discretionary Fixed Costs.

Particulars Committed Fixed Costs Discretionary Fixed Costs

1. Meaning These are Fixed Costs that arise from

the possession of –

Assets, i.e. Plant, Building and

Equipment (e.g. Depreciation,

Rent, Taxes, Insurance Premium

etc.) or

A basic organization (e.g. Salaries

of Staff)

These are Fixed Costs

incurred as a result of

Management‟s discretion /

decision.

It arises from periodic

(usually yearly) decisions

regarding the maximum

outlay to be incurred. (e.g.

advertising)

2. Short Run

control

These costs remain unaffected by any

short –term changes in volume of

production.

These cannot be changed or

altered in the very short – run.

Time – Period based

Current

Historical

Pre – determined

Variability based

Fixed

Variable

Semi –

variable

Elements based

Materials

Labour

Expenses

Relationship based

Direct

Indirect

Functions – based

Production

Administration

Selling

Distribution

R & D

Pre – production

Conversion

Controllability based

Controllable

Non – Controllable

Normality based

Normal

Abnormal

Payment – based

Explicit

Implicit

Cause & Effect based

Engineered

Discretionary

Decision – making

based

Relevant

Irrelevant

Attributabillity

based

Product

Period

COST


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3. Effect on

Long – term

Objectives

Any reduction in Committed Fixed

Costs under normal activities of the

concern would have adverse effects on

the concern‟s long – term objectives.

Discretionary Fixed Costs can

change from year to year, without

disturbing the long – term

objectives. So, these are

“escapable” costs.

4. Control Such costs cannot be controlled. These costs can be controlled.

5. Inference Also known as “Unavoidable” Fixed

Costs.

Also known as “Avoidable”

Fixed Costs.

8. How are Costs classified on the basis of Elements?

On the basis of elements, Costs are classified as under –

Type and Description Explanation

1. Material Cost is the cost of

material of any nature used for

the purpose of production of a

product or a service.

Material Cost includes cost of Procurement,

Freight Inwards, Taxes & Duties, Insurance, etc,

directly attributable to the acquisition.

Trade Discounts, Rebates, Duty Drawbacks,

Refunds on account of MODVAT, CENVAT,

Sales Tax and other similar items are deducted

in determining the costs of material.

2. Labour Cost means the

payment made to the employees,

permanent or temporary, for

their services. (N 01)

Labour Cost includes Salaries and Wages paid

to permanent employees, temporary employees

and also to employees of the contractor.

Salaries & Wages include all Fringe Benefits

like PF Contribution, Gratuity, ESI, Overtime,

Incentives, Bonus, Ex-Gratia, Leave

Encashment, Wages for Holidays and Idle Time,

etc.

3. Expenses are other than Material

Cost or Labour Cost, which are

involved in an activity.

Expenditure on account of utilities, payment for

bought – out services, job processing charges, etc. can

be termed as Expenses.

9. How are Costs classified on the basis of Relationship?

Based on Relationship, costs are classified into –

Type and Description Components

1. Direct Costs:

Costs which are directly related to / identified with /

allocated to a Cost Centre or a Cost Object, in an

economically feasible way, are called Direct Cost.

Total of all Direct Costs is called Prime Cost.

Direct Material Cost,

Direct Labour Cost, and

Direct Expenses.

2. Indirect Costs:

All Costs other than Direct Costs are called Indirect Costs.

Total of all Indirect Costs is called as Overheads (or

Oncost), since they are generally incurred over various

products (Cost Units), various departments (Cost Centres)

and over various heads of expenditure accounts.

Indirect Material,

Indirect Labour, and

Indirect Expenses.

A summary of Direct and Indirect Costs is given below –

Item and Description Example

1. Direct Material: Costs of Material which can

be directly allocated to a Cost Centre or a Cost

Object in an economically feasible way.

Raw Materials Consumed for production for

a product or service, which are identifiable

in the product or service.

2. Direct Labour: Cost of Wages of workers Wages include all Fringe Benefits like PF


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who are readily identified or linked with a

Cost Centre or Cost Object.

Contribution, Gratuity, ESI, Overtime,

Incentives, Bonus, Ex – Gratia, Leave

Encashment, Wages for holidays and idle

time, etc.

3. Direct Expenses: Expenses other than Direct

Material or Direct Labour, which can be

identified or linked with the Cost Centre or

Cost Object.

Expenses for special moulds used in a

particular Cost Centre, Hire Charges for

tools & equipments for a Cost Centre,

Royalties in connection to a product, Job

Processing Charges, etc.

4. Indirect Material: Cost of Material which

cannot be directly allocable to a particular


Consumable Spares and Parts, Lubricants,

etc, i.e. materials which are of small value

and cannot be identified in or allocated to a

product / service.

5. Indirect Labour: Wages of Employees which

are not directly allocable to a particular Cost

Centre.

Salaries of Staff in the Administration and

Accounts Department, Salaries of Security

Staff, etc. (N 01)

6. Indirect Expenses: Expenses other than of

the nature of Material or Labour, and cannot

be directly allocable to a particular Cost

Centres.

Insurance, Taxes and Duties, etc. not being

allocable to a particular Cost Centre.

10. Distinguish between Controllable & Uncontrollable Costs.

One the basis of controllability, Costs are classified into –

1) Controllable Costs: These are costs which can be influenced and controlled by managerial

action.

2) Non – Controllable Costs: These are costs that cannot be influenced and controlled by a

specific member(s) of the organization.

Note: The line of difference between controllable and non – controllable costs is very thin. No

cost is uncontrollable. Controllability is a relative term and is subject to the following factors –

(a) Time: Certain costs are controllable in the long – run and not in the short – run.

(b) Location: Certain costs are not influenced and decided at a particular location / cost centre.

For example, if rent agreements of all factory premises are executed centrally at the Head

Office, Factory Mangers cannot control the incurrence of Rent Cost.

(c) Product / Output: Certain costs are controllable by reference to one product or market

segment and not by reference to the other. For example, some products require more

advertising and sales promotion efforts than other products.

11. How are Costs classified on the basis of Normality?

On the basis of Normality / Expectation, Costs are classified into –

Type Description Treatment

1. Normal

Cost Costs which can be reasonably expected to be

incurred under normal, routine and regular

operating conditions.

Cost that is normally incurred at a given of

output in the conditions in which that level of

output is achieved.

They are included in

the Cost Sheet as

regular cost and used

for decision - making

purpose.

2. Abnormal

Cost Costs over and above normal cost, which is not

incurred under normal operating conditions, e.g.

fines and penalties, abnormal wastages, etc.

Unusual or a typical cost whose occurrence is

usually irregular and unexpected and due to some

abnormal situation of production.

They are not

considered in the cost

of production for

decision – making,

and are charged to

Profit & Loss A/c.


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12. Distinguish between Product Cost and Period Cost.

Why should Product Costs be computed?

On the basis of attributability to the product, Costs are classified as under –

Particulars Product Cost Period Cost (N 08)

1. Meaning These are costs which are assigned to the

product and are included in inventory

valuation. These are also called as

Inventoriable Costs.

These are costs which are not

assigned to the products but

are charged as expenses

against the revenue of the

period in which they are

incurred.

2. Examples Manufacturing Costs, e.g. Cost of Raw

Materials, Direct Wages, Production OH,

Depreciation of Plant, Equipments, etc.

Non – Manufacturing Costs,

e.g. General Administration

Costs, Salesmen Salary,

Depreciation of Office

Assets, etc.

3. Inclusion in

Inventory

Valuation

These are included in inventory valuation.

They are treated as assets till the goods to

which they are assigned are actually sold.

These are not included in

Inventory Valuation. They

are written off as expense in

the period in which they are

incurred.

Note:

Absorption vs Marginal Costing: Under Absorption Costing System, Total

Manufacturing Costs (i.e. Variable and Fixed) are regarded as Product Costs. However,

under Marginal Costing system, only variable Manufacturing Costs are considered as

Product Costs.

Purposes of computing Product Costs are as under –

(a) Preparation of Financial Statements – focus on Inventory Valuation and reporting

profits.

(b) Product Pricing – focus on costs assigned & incurred on the product till it is made

available to customer / user.

(c) Cost – plus – Contracts with Government Agencies – focus is on reimbursement

of costs specifically assigned to the particular job / contract.

13. List the various items of costs on the basis of relevance to decision-making.

On the basis of relevance to decision – making, Costs are classified into (A) Relevant, and (B)

Irrelevant Costs.

(A) Relevant Costs: These are costs which are relevant and useful for decision – making

purposes. (N 07)

1) Marginal Cost: Marginal Cost is the total Variable Cost, i.e. Prime Cost plus Variable

Overheads. It is assumed that variable Cost varies directly with production whereas Fixed

Cost remains constant irrespective of volume of production. Marginal Cost is relevant for

decision – making, as this cost will be incurred in future for additional units of production.

2) Differential Cost: It is the change in costs due to change in the level of activity or pattern or

method of production. Where the change results in increase in cost it is called Incremental

Cost, whereas if costs are reduced due to decrease of output, the difference is called

Decremental Costs. (RTP, M 08)

3) Opportunity Cost: This refers to the value of sacrifice made or benefit of opportunity

foregone in accepting an alternative course of action. For example, a Firm may finance its

expansion plan by withdrawing money from its bank deposits. Then, interest lost on the Bank

Deposit is the opportunity cost for carrying out the expansion plan. Similarly, if a person quits

his job and enters into business, the salary forgone from employment constitutes opportunity


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cost. Opportunity Cost is a relevant cost where alternatives are available. However,

opportunity cost is not recorded in formal accounts and is computed only for decision –

making and analytical purposes. (RTP, M 03, M 08, M 09)

4) Out – of – pocket Costs: These are costs which entail current or near future outlays of cash

for the decision at hand. Such costs are relevant for decision – making, as these will occur in

near future. This cost concept is a short – run concept and is used in decisions relating to

fixation of selling price in recession, make or buy, etc. Out – of – pocket Costs can be avoided

or saved, if a particular proposal under consideration is not accepted. (M 09)

5) Replacement Cost: It is the cost at which there could be purchase of an asset or material

identical to that which is being replaced or revalued. It is the cost of replacement at current

market price and is relevant for decision – making.

6) Imputed Costs: These are notional costs appearing in the cost accounts only, e.g. notional

rent charges, interest on capital for which no payment has been made. Where alternative

capital investment projects are being evaluated, it is necessary to consider the imputed interest

on capital before a decision is arrived at, as to which is the most profitable project. These

costs are similar to Opportunity Costs. (RTP, N 95, N 09)

(B) Irrelevant Costs: These are costs which are not relevant or useful for decision – making.

1) Sunk Cost: It is a cost which has already been incurred or sunk in the past. It is not relevant

for decision – making. Thus, if a Firm has obsolete stock of materials originally purchased for

Rs.50,000 which can be sold as scrap now for Rs.18,000 or can be utilized in a special job,

the value of stock already available Rs.50,000 is a sunk cost and is not relevant for decision –

making. (N 00, M 03, M 05)

2) Absorbed Fixed Cost: Fixed Costs do not change due to increase or decrease in activity.

Although such Fixed Costs are absorbed in cost of production at a normal rate, they are

irrelevant for managerial decision – making. However, if Fixed Costs are specific, they

become relevant.

3) Committed Cost: It is a cost in respect of which decision has already been taken, and such

decision cannot be altered, e.g. entering into irrevocable agreements for Rent, Technical

Collaboration, etc. Committed Costs are not relevant for decision – making. This should be

contrasted with Discretionary Costs, which are avoidable costs.

14. Write short notes on explicit and Implicit Costs.

Define Explicit Costs. How is it different from Implicit Costs?

Particulars Explicit Costs Implicit Costs

1. Meaning Costs which involve some cash

payment or outflow of resources.

Cost which do not involve any

cash payment at all.

2. Also known as Out – of – Pocket Costs. Economic / Notional / Imputed

Costs.

3. Measurement These are actually incurred,

and hence can be easily and

objectively measured.

They are not actually incurred.

They cannot be easily measured

and involve subjective

estimation.

4. Recording in books Recorded in books of account. Not recorded in books of

account.

5. Purposes Accounting, Reporting, Cost

Control & Decision Making.

Decision – Making like asset

replacement, make or buy, etc.

6. Examples Salaries, Wages, Advertisement,

etc.

Interest on own Capital, Rent of

own premises, Salary of

Proprietor, etc. which are not

actually paid.

Note: Depreciation is considered as “Deemed Explicit Cost”, since the cost of Assets purchased (by

making a cash outlay in the past) is written off / apportioned during the life – time of those assets.


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15. Enumerate the types of costs on the basis of Functions.

On the basis of Functions to which they relate, Costs are classified as under –

1) Production Cost: The cost of the set of operations commencing with supply of materials,

labour and services and ending with the primary packing of product. Thus it is equal to the

total of Direct Materials, Direct Labour, Direct Expenses and Production Overheads. In a

wider sense, it includes all Direct Costs and all Indirect Costs related to the production

(including Research and Development Cost apportioned, if any)

2) Administration Cost: The cost of formulating the policy, directing the organization and

controlling the operations of the undertaking, which is not directly related to Production,

Selling, Distribution, Research or Development activity or function. Examples: Office Rent,

Accounts and Secretarial Department Expenses, Audit and Legal Expenses, Directors

Remuneration, etc. (N 96)

3) Selling Cost: The cost of seeking to create and stimulate demand and of securing orders.

These are also called Marketing Costs. Examples: Market Research, Advertisement, Salaries,

Commission and Travel Expenses of Salesmen, Show – room Expenses, Cost of Samples, etc.

(N 99)

4) Distribution Cost: The cost of the sequence of operations which begins with making the

packed product available for dispatch and ends with making the reconditioned returned empty

package, if any, available for re – use. Examples: Distribution Packing (secondary packing),

Carriage Outwards, Maintenance of Delivery Vans, cost of transporting articles to central or

local storage, cost of moving articles to and from prospective customers (as in Sale or

Return), cost of warehousing saleable products, etc. (N 99)

5) Research Cost: Cost of development of new product and manufacturing process,

improvement of existing products, process and equipment, finding new uses for known

products, solving technical problems arising in manufacture and application of products, etc.

(N 92, M 96, N 98, N 00) 6) Development Cost: The cost of the process which begins with the implementation of the

decision to produce a new improved product, or to employ a new or improved method and

ends with commencement of formal production of that product or by that method, i.e. cost

incurred for commercialization / implementation of research findings. (N 92, M 96, N 98,

N 00) 7) Pre – Production Cost: The part of Development Cost incurred in making a trial production

run prior to formal production. (N 00)

8) Conversion Cost: The total of Direct Wages, Direct Expenses and Production Overhead,

Cost of converting Raw Materials to the finished stage or converting a material from one

stage of production to the other. (M 03)

Special Note as regards Distribution Costs:

Primary Packaging Cost is included in Production Cost. Secondary Packaging Cost is

Distribution Cost.

In exceptional cases, e.g. in case of Heavy Industries Equipment supply, installation cost at

delivery site for Heavy Equipments which involves assembling of parts, testing, etc is

included in Production Cost but not Distribution Cost. For example, Installation Cost of a

Gas Turbine at Plant Site is included in the Cost of Production of Gas Turbine.

16. Distinguish between Conversion Cost and Added Value.

Particulars Conversion Cost Added Value

1. Meaning It is the cost of converting Raw Materials

to the finished stage, or converting a

material from one stage of production to

the other.

It is the change in market value

resulting from any alteration in the

form, location or availability of a

product or service, excluding the cost

of bought – out materials or services.


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2. Included

Items

Direct Wages + Direct Expenses +

Production Overheads.

Difference in Sales Value of product

or service between two places, two

versions, two markets, etc.

3. Excluded

Items

It totally excludes Materials and

Components Cost, but includes cost

resulting from variations in Direct

Materials weight or volume.

It excludes only cost of purchased

bought – out components and

services, but includes profit element.

17. Distinguish between Production / Manufacturing A/c & Cost Sheet.

Particulars Production / Manufacturing A/c Cost Sheet

1. Basic It is prepared on the basis of

double – entry system of book –

keeping.

It is only a statement and hence double –

entry system is not applicable.

2. Purpose The primary objective of

preparation is Reporting.

The primary objective is decision –

making.

3. Parts It has two parts – one showing the

cost of manufacture and the other

part showing Sales and Gross

Profit.

It is a step – by – step presentation of

total cost and shows Prime Cost, Works

Cost, Cost of Production, Cost of Goods

Sold, Cost of Sales and Profit.

4. Analysis Total Cost is shown in aggregate.

Product – wise or Location – wise

analysis is not generally given.

Cost Sheet shows costs in a detailed and

analytical manner, which facilitates cost

comparison.

5. Quotations This is not useful for preparing

tenders or quotations.

Estimated Cost Sheets can be prepared

based on past experience, and useful for

submitting quotations.

18. What is a Cost Centre? Discuss the various types of Cost Centres. N 91, N 92, M

95, M 97, N 02, M 08, M 11

1) Cost Centre: It is defined as –

(a) A location – e.g. Chennai Factory, Kolkata Factory, etc.

(b) A person – e.g. Sales Manager L, M, etc.

(c) An item of equipment – e.g. Machinery P, Q or Process I, II, etc.

Or a group these, for which cost may be ascertained and used for the purpose of Cost

Control.

2) Classification : cost Centres can be classified as under –

(a) Based on Type:

Personal Cost Centre Impersonal Cost Centre

It consists of a person or group of persons. It consists of a location or an item

equipment (or group of these).

(b) Based on Role:

Production Cost Centre Service Cost Centre

It is a Cost Centre where Raw Material is

processed and converted into Finished

Product.

It is a Cost Centre which serves as an

ancillary unit and renders services to a

Production Cost Centre.

Here, both Direct and Indirect Costs are

incurred.

Here, only Indirect Costs are incurred.

There are no Direct Costs, as there is no

measurable and saleable output.

Examples: Machine Shops, Welding

Shops and Assembly Shops, etc.

Examples: Power – House, Gas Production

Plant, Material Service Centres, Plant

Maintenance Centres, etc.


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(c) Based on Activity:

Operation Cost Centre Process Cost Centre

It consists of machines and / or persons,

carrying out similar operations.

It consists of machines and / or persons,

engaged on a specific process or a

continuous sequence of operations.

All machines / operators performing the

same operation are brought together under

a Cost Centre, the purpose being

ascertainment of cost of each operation

irrespective of its location inside the

factory.

Cost is analysed and related to a series of

operations in sequence. Generally, these

constitute a single location, as in Oil

Refineries and other process industries.

19. What is a Responsibility Centre? What are its types?

Distinguish between Profit Centre and Investment Centres.

1. Meaning: It is an activity centre of a business organization entrusted with a special task. It is a

unit of function of a business organization headed by an executive responsible for its

performance.

2. Types of Responsibility Centres:

Particulars Cost Centres Revenue Centres Profit Centres Investment

Centres

(a) Meaning A centre for

which a

standard

amount of cost

is pre-

determined and

used for

control.

A centre devoted

to raising revenue

(no responsibility

for production).

A centre whose

performance is

measured in

terms of income

earned and cost

incurred (profit

earning).

A centre

responsible for

earning profits

and also for

asset utilization.

(b) Primary

Responsibilit

y

Cost Reduction

& Cost

Control.

Generation of sale

Revenue.

Profit Earning. Earning Return

on Investments.

(c) Performance

Evaluation

Standard Cost

Less: Actual

Cost

Budgeted

Revenue

Less: Actual

Revenue

Budgeted Profits

Less: Actual

Profits

Budgeted ROI

Less: Actual

ROI

(d) Other Points Control of cost

is subject to –

1. Time

2. Location

3. Product

Also responsible

for some

expenses related

with marketing of

products.

It may mean that

one division

sells its output to

another division

within the firm.

(Inter –

divisional

transfer pricing.)

ROCE or ROI

(Return on

Capital

Employed or

Return on

Investment) may

be considered

for evaluation.

20. Define a Cost Unit. Give suitable illustrations.

1) Cost Unit is a unit of production, service or time or combination of these, in relation to which

costs may be ascertained or expressed. It should be one with which expenditure can be most

readily associated.

2) Cost Unit is a form of measurement of volume of production or service. This unit is generally

adopted on the basis of convenience and practice in the Industry concerned.


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3) Cost Units differ from one business to the other. They are usually units of physical

measurement, e.g. number, weight, area, volume, time, length and value. [Refer Question 33

for illustrations of Cost Units.]

21. Define a Cost object. Give suitable illustrations.

1. Cost object is anything for which a separate measurement of cost is desired.

2. Cost object is defined as any unit of Cost Accounting selected with a view to accumulating all

cost under that unit.

3. Cost objects may be a product, a service, a project, a customer, a brand category, an activity, a

programmed, a division or department, a group of Plant and Machinery, a group of employees

or a combination of several units.

22. Write short notes on the various methods of costing.

Businesses vary in their nature and in the type of products or services they produce. Hence,

different methods of cost ascertainment are used in different businesses. Costing methods to

be employed are determined based on – (a) the method of production and (b) the unit of cost

used. The various methods of costing are –

METHODS OF COSTING

For Goods For Services- Operating Costing

Specialized Production Standardised Production

Job Batch Contract Single / Unit Process / Joint

Costing Costing Costing /Output Operation and By-

Costing Costing Product

Costing

Work is

undertaken

on receiving

a customer‟s

order /

assignment.

Output under a

Job consists of

similar units, it

is not feasible

to ascertain

cost per unit.

Execution of

work is

distributed

over two or

more

financial

years.

Product(s) is

produced

from single

process.

One product is

produced from

a series of

sequential

processes.

Many

products are

produced

from many

sequential &

parallel

processes.

Multiple Costing: It represents a combination of two or more methods of costing given above. For

example, if a Company manufactures Cars including its components, the component parts will be

costed by Batch Costing System, but the cost of assembling the Car will be computed by the Single or

Output Costing method. The whole system of costing is known as Multiple Costing.

The following table summarizes the various methods of costing applied in different industries-

Nature of Output Method Cost Ascertainment Examples of Industries

A. Based on

customer

specifications:

- Single Unit Job Costing For each order / job /

assignment.

Automobile Workshops,

Interior Decoration, etc.

- No. of similar

units

Batch costing For each batch / lot of

units produced.

Pharmaceuticals, Printing

Press i.e. visiting cards,

invitations, etc.


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- Execution of

works

Contract Costing For each contract. Roads, Brickworks,

Colliery, Paint

Manufacturing, etc.

B. Similar units of

single product,

from:

- Single Process

(N 95)

Unit or Output

or Single Costing

For the entire activity,

but averaged for the

output.

Quarries, Brickworks,

Colliery, Paint

Manufacturing, etc.

- Series of

Processes

Process or

Operation

Costing

For each process or

operation.

Oil Refining, Breweries,

etc.

C. Multiple

varieties of

activities and

processes

Multiple Costing Combination of any of

the methods listed

above.

Production of TVs,

Computers etc, Automobile

Assembly.

D. Rendering

Services

Operating

Costing

For every type of

service (no identifiable

tangible cost unit).

Transport, Hotels, Cinema,

Banks, Hospitals,

Professional Institutions,

etc.

23. List the Method of Costing and Cost Unit applicable for the following industries.

Industry Method of Costing Unit of Cost

1. Interior Decoration Job Per Job

2. Advertising Job Per Job

3. Toy Making Batch Per Batch

4. Pharmaceuticals Batch / Unit Per Unit / Box

5. Ship Building Contract Per Ship

6. Bridge Construction Contract Per Contract

7. Cement Unit Per Tonne or Per Bag

8. Coal Single / Unit Per Tonne

9. Brick Works Single / Unit Per 1,000 Bricks

10. Steel Process Per Tonne

11. Oil Refining Process Per Tonne

12. Soap Process Per Unit

13. Sugar Company having own

sugarcane fields

Process Per Tonne or Per Quintal

14. Hospital / Nursing Home Operating Per Patient-Day or Room-Day

15. Road Transport Operating Per Tonne-Km / Passenger- Km

16. Radio Multiple Per Unit or Per-Batch

17. Bicycles Multiple Per Unit or Per Batch

18. Furniture Multiple Per Unit

24. List the reports provided by Cost Accounting Department for decision-making purpose.

The following is an illustrative list of reports and statements provided by the Cost Accounting

Department for the use of managers for decision-making purpose-

1. General (a) Cost Sheets – setting out the total cost, analyzed into various

elements of cost, giving comparative figures for various

periods and / or various departments.

(b) Reconciliation of actual profit earned with estimated or

budgeted profit.

(c) Report of Capital Expenditure, R & D Expenditure etc.

compared with budgets.


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2. Materials (a) Materials Consumption Statements, showing total quantity of

materials issued for production, materials actually used in

production and wastage.

(b) Total cost of abnormally spoiled work in the factory and

abnormal losses in the store.

(c) Total cost of inventory carried of Raw Materials, Work-In-

Process and Finished Stock, the number of months for which

stocks would be sufficient (on the basis of average

consumption).

3. Labour (a) Labour Utilization Statements providing details about the

total number of hours paid for, standard hours for the output

produced, idle time-hours, cost and causes thereof.

(b) Labour Turnover, cost of recruitment and training of new

employees.

(c) Labour Overtime Payment Statement and the causes thereof.

4. Overheads (a) Overheads actually incurred compared with budgets.

(b) Overheads actually charged to production and the difference

between the amount actually incurred (Actual Overheads) and

the amount charged (Absorbed Overheads).

5. Sales (a) Actual Sales compared with budgets.

(b) Statement of reasons for difference between Budgeted &

Actual Sales, viz. Price, Quantity, Mix, etc.

25. Discuss briefly the role of the Cost Accountant in a manufacturing Firm.

The cost Accountant performs the following functions in a manufacturing organization –

1. Accounting and MIS: The Cost Accountant establishes the Cost Accounting Department in

the Firm. He ascertains the information requirements of Managers at different levels in the

organizational hierarchy. He defines the system to account for costs and to transmit relevant

cost information on a timely basis to all Managers.

2. Costing Manual: The Cost Accountant develops the Cost Accounting Manual. The manual

specifies the functions of the Cost Accounting Department. It also provides the format of

various documents, vouchers, forms and reports for compilation, accounting and

dissemination of cost information.

3. Cost Ascertainment: Cost of products, services, departments etc. are ascertained by effective

implementation of the Cost Accounting System. The Cost Accountant supervises the

operation of the accounting system and is thus responsible for cost ascertainment.

4. Cost Reports: The Cost Accountant is responsible for preparation of various cost reports.

These reports assist Managers in reviewing their own performance and in identifying critical

areas where control measures should be taken to avoid cost escalation.

5. Cost Comparison: The Cost Accountant provides cost comparison information which is

useful for decision making. Some bases of comparison may be- (a) Standard Costs with

Actual Costs, (b) Budget and Actual activity levels, (c) Financial and Costing Profits, etc.

6. Cost Analysis: The Cost Accountant analyses costs based on information available internally

and externally. Such analysis is useful for decisions such as acceptance of additional orders,

quotations for new products and orders, make or buy of components, sub-contractor own

make, etc.

7. Cost Control: The Cost Accountant suggests techniques for cost reduction and cost control.

He may also supervise the implementation of the cost control techniques.


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26. What are the advantages / objectives of a Cost Accounting System?

A Factory manufactures only one product in one quality and size. Its owner states that

he does not need a cost accounting system. State your arguments to convince him the

need to introduce a cost accounting system.

Discuss briefly how synergetic effect helps Cost Reduction.

The primary advantages of a Cost Accounting System are –

1. Profit Measurement and Analysis: Costs should be accurately ascertained and matched

with revenues to measure profits of a Firm. Further, Cost Accounting is useful for

identifying the exact causes for decrease or increase in the profit / loss of the business.

2. Cost Reduction: The application of cost reduction techniques like Value Analysis, Value

Engineering and Operations Research techniques helps in achieving economy in

operations. Continuous efforts are taken by the Firm, to find new and improved methods

for reducing costs.

3. Cost Comparison and Cost Control: Cost comparison helps in cost control. Such a

comparison may be made from period to period by using the figures in respect of the

same firm or of several units in any industry by employing uniform costing and inter-firm

comparison methods.

4. Identification of losses and inefficiencies: A good Cost Accounting System helps in

identifying unprofitable activities, losses or inefficiencies in any form, so that appropriate

actions are taken. The use of Standard Costing and Variance Analysis techniques points

out the deviations from pre-determined level and thus demands suitable action to

eliminate its recurrence. Also, the cost of idle capacity can be easily worked out, when a

concern is not working to full capacity.

5. Price Determination: Cost Accounting is very useful for price fixation. It serves as guide

to test the adequacy or selling prices. The price determined is used for preparing estimates

or submitting tenders.

6. Financial Decision-Making: Managers can obtain relevant information from the Cost

Accounting System, that help in making decisions involving financial considerations, viz.

whether to purchase or manufacture a given component, whether to accept orders below

cost, which machine to purchase when a number of choices are available, etc.

7. Dispute and Issue-solving: A good cost accounting system provides cost figures for the

use of Government, Wage Tribunals and other bodies for dealing and solving issues like

price fixation, price control, tariff protection, wage level fixation, etc.

27. List the essential features of a good Cost Accounting System.

To be successful, a good Cost Accounting System should possess the following essential

features-

1. Simple and easy to operate: The system should be tailor-made, practical, simple and

capable of meeting the requirements of a business concern.

2. Accuracy of data: The data to be used by the Cost Accounting System should be

accurate. Otherwise it may distort the output of the system.

3. Relevance of data: The System should handle and report relevant data for use of

managers for decision making. It should not sacrifice its utility by introducing meticulous

and unnecessary details.

4. Management‟s Role: The Top Management should have a faith in the Costing System

and should also provide a helping hand for its development and success.

5. Participative Role of Executives: Necessary co-operation and participation of

executives from various departments of the concern is essential for developing a good

system of Cost Accounting.

6. Cost-effective: The cost of installing and operating the system should justify the results.

The benefits from the system should exceed the amount to be spent on it.


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7. Smooth implementation: The system should be effectively implemented. A carefully

phased programme should be prepared by using network analysis for the introduction of

the system.

28. What are the essential factors for installing a Cost Accounting System?

What are the areas of preliminary enquiry before a cost Accounting System is installed?

Before setting up a system of cost accounting, the under mentioned factors should be studied-

1. Objective: The objective of the system, e.g. whether it is being introduced for fixing

prices or for insisting a system of cost control.

2. Scope and Extent of Coverage: The areas of operation of business where the

Management‟s action will be most beneficial. The system of costing in each case should

be designed to highlight, in significant areas, factors considered important for improving

the efficiency of operations in that area.

3. Organizational Set-up: The general organization of the business, to find out the manner

in which the system of cost control could be introduced, without altering or extending the

organizational set-up significantly.

4. Technical aspects: The technical aspects of the Firm, like methods and techniques of

production used, extent of services rendered to Manufacturing Departments by other

Service Departments, standards of production efficiency.

5. Psycho-social aspects: The attitude and behaviour of people in the organization, the

manner in which the benefits of introducing Cost Accounting could be explained to

various persons in the concern, especially those in charge of production department and

an awareness created for the necessity of promptitude, frequency and regularity in

collection of cost data.

6. Impact of expansion: The manner in which Cost and Financial accounts could be inter-

locked into a single integral accounting system and in which results of separate sets of

accounts, cost and financial, could be reconciled by means of control accounts.

7. Information requirements: The maximum amount of information that would be

sufficient and how the same should be secured without much clerical labour, degree of

accuracy of data collected, responsibility for verification of data etc.

29. You have been asked to install a Costing System in a manufacturing business. What

practical difficulties, apart from technical costing problems, would you expect to meet

and how would you propose to overcome them? Apart from technical costing problems, there are other practical difficulties which arise during

installation of a costing system. Some difficulties and the ways to overcome them are as

under-

Problem Description of Problem Remedial Measure

1. Lack of

Support from

Top

Management

Top Management may not fully

support the costing system. Line

Managers may view the costing

procedures as interference in their

work or additional work. Also

Managers may not view it

seriously if top management does

not endorse the system.

Before installation, the top

management should be made

cost conscious. They must be

made aware of the need for

operating a costing system and

their full support and co-

operation to the costing system

should be obtained.

2. Resistance

from

Accounting

Staff

Existing accounting staff may

feel that they would lose their

importance. Hence, they may

resist the system as they may be

unsure of their position in the

Firm.

Staff must be made to

understand that the costing

system is only supplementary

and not a substitute to the

financial accounting system.

Participative approaches and

positive confidence-building

measures should be used.


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3. Lack of co-

operation at

operating

levels

The successful operation of the

costing system depends upon the

active participation of staff like

foremen, supervisors, time-

keepers, stores officials etc.

These staff may not immediately

provide basic activity data in

various documents and reports.

The Cost Accountant should

educate the staff on the

importance of the data to be

provided from their

department. They should be

made to understand that

providing data is not additional

work but only part of their

routine work. Attitudinal

problems, if any, should be set

right first.

4. Shortage of

Trained Staff

Sufficient staff may not be

available to perform specialized

functions like Cost ascertainment,

analysis and control, which calls

for technical knowledge,

adequate knowledge support &

training.

The personnel department

should recruit adequate staff

possessing the requisite skills.

Shortage of staff may be

overcome by devising and

implementing a good overall

personnel policy.

5. Costs of

operating the

system

The costing system involves

initial installation cost and regular

operating cost. Use of new forms

and documents may lead to

duplication of efforts and

frustration among the employees.

Some reports may provide

unnecessary and redundant data.

The costing system should be

implemented only when the

benefits exceed costs thereof.

Also, forms, procedures and

documents should be designed

so as to effectively capture the

required information without

much difficulty. Reports

should provide timely,

adequate and reliable

information.

30. What items are generally included in a good Uniform Costing Manual?

Uniform Costing Manual is a written document in the form of a booklet or bulletin,

containing the principles methods and procedures for the ascertainment and control of cost in

uniform costing. It provides guidelines to participating Firms to organize their cost accounting

systems on a uniform basis. Its contents include-

1. Statement of objectives, Purposes and Scope of the system, advantages and extent of co-

operation necessary.

2. General principles of accounting, nature of coding, terminology to be followed,

classification & description of accounts.

3. Details of Stock, Labour, OH – methods of cost allocation and procedures of cost control

are contained.

4. Essential cost data and various ratios to be computed for cost collection and procedures

and efficiency in the operation of the participating units.

5. Mode, format and time for presenting cost data and reports and to the Management.

6. Guidelines on the treatment of depreciation, interest on capital, waste, scrap, by-products,

etc.

31. Write short noted on Direct Expenses.

1. Direct Expenses or Chargeable Expenses: These are expenses other than materials and

labour which can be allocated directly to jobs, products, processes, cost centers‟ or cost

units. Direct Expenses are “cost other than material and wages which are incurred for a

specific product or saleable services”.


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2. Nature of Direct Expenses: (a) These are expenses other than Direct Materials and

Direct Labour, (b) These are either allocated or charged completely to Cost Centres or

Cost Units, (c) These are included in the Prime Cost of a product.

3. Examples:

(a) Hire Charges of special machinery

or plant for a particular production

order or job.

(b) Payment of Royaties.

(c) Cost of special moulds, designs &

patterns.

(d) Sub-Contracting Expenses or

outside work costs, where jobs are

sent out for special processing.

(e) Experimental cost before

undertaking the job.

(f) Travel & Conveyance Expenses for

a particular job.

4. Documentation: The basic document which is used for charging of Direct Expenses to

products or batches or work order, is the Invoice received from Suppliers of such service.

The payment to supplier of service is made on the basis of the Invoice, and the expenses

are booked in the accounts.

5. Identification of Direct Expenses: For the identification of Direct Expenses with the

main product or service, the code number of that product or service should be inscribed

on invoice received from supplier of services. For example, if a machine is hired to

complete a particular product, then the Hire Charges paid for that machine is a Direct

Expenses of that particular product. For charging these Hire Charges to that particular

product, the invoice / bill received towards Hire Charges should be coded / inscribed with

the Product Code, to ensure that this expense is charged to that particular product.

Alternatively, if cash is paid, then the Cash Book Analysis will show the Product Code

which is to be charged with the cost of hiring machinery.

CHAPTER 2

MATERIALS

1. What is Just in Time (JIT) Purchases? What are its advantages?

Just in Time (JIT) Purchases means organizing the purchase of goods or materials such that

their receipt in Stores Department immediately precedes their use. The advantages of JIT

purchases are-

1. Cost Savings: JIT purchases results in cost savings. The costs of stock-out, inventory

carrying, materials handling and breakage are reduced.

2. Cost of consumption: due to frequent purchases of Raw Materials, its issue price will be

equal to the replacement price. The method of pricing for valuing materials issues will be

realistic to reflect current costs.

3. Supplier Co-ordination: Suppliers of Raw Materials co-operate with the Company and

supply requisite quantity of goods or materials for which order is placed just before the

start of production.

4. Materials Management: Goods spend less time in warehouses or on store shelves before

they are exhausted. Risk of obsolescence is thereby reduced.

2. What is ABC Analysis?

1. Meaning: ABC Analysis is a form of inventory control wherein different degrees of

control are exercised over different items of materials, on the basis of the investment

(value) involved. For example, in the making of aircraft, cryogenic engines involving

high costs will be monitored closely, while cost of tyres, nuts and bolts, etc. will be given

comparatively lesser attention.


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2. Categorization: Under this system, Raw Materials Items are divided into three categories

according to their importance in terms of value and frequency of replenishment during a

period. These categories are –

(a) A Category –Highly Important.

(b) B Category - Moderately important.

(c) C Category – Least Important.

3. Analysis & Control: The three categories are classified and differential control is

established as under-

Category % in Total

Value

% in Total

Quantity

Extent of Control

A 70% 10% Constant and Strict Control through

Budgets, Ratios, Stock Levels, EOQ,

Procedural checks, etc.

B 20% 20% Need based selective control – periodic

review – not strict or excessive.

C 10% 70% Little control – focus on saving associated

costs.

Note: ABC Analysis is also called by other names such as HML (High Moderate Low)

Analysis, (or) 70-20-10 Analysis, (or) Pareto Analysis, (or) Selective Stock Control.

3. What are the advantages of ABC analysis? The advantages of ABC analysis are –

1. Smooth Flow: ABC analysis ensures that minimum investment will be made in

inventories of stocks of materials or stocks to be carried, without affecting the production

schedule.

2. Cost Savings: The cost of placing orders, receiving goods and maintaining stocks is

minimized, specially if the system is coupled with the determination of proper economic

order quantities.

3. Control by exception: Management time is saved, since attention need be paid only to

some of the items rather than all the items.

4. Standardization of work: With the introduction of the ABC system, much of the work

connected with purchases can be systematized on a routine basis to be handled by sub-

ordinate staff.

4. What is meant by Bill of Materials (BOM)?

1. Meaning: (a) Bill of Materials (BOM) is a schedule of standard quantities of materials required for

any job or other unit of production. It is also known as “Materials Specification

List” or just “Material List”.

(b) It lays down the exact description and specifications of all materials and quantities

required for a job or product.

2. Prepared by: BOM is prepared by the Engineering or Planning Department, in a

standard form.

3. Copies: 5 copies to be used as given in the following table-

Department Purposes of BOM

Stores

Department

(a) To provide a basis for preparing material Purchase

Requisitions.

(b) To act as authorization for issuing total material

requirement.

(c) To reduce paperwork / clerical activity in verification of

every item of materials to be issued.

Purchase

Department

To compare with purchase requisition and place the purchase order.


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Cost Accounting

Department

(a) To prepare budgets or estimates of material cost for jobs /

processes / products.

(b) To account for standard cost, compute material cost

variances, analyze reasons, and control excess cost of

material used.

Production

control Dept

(a) To control usage of materials.

(b) To save time otherwise spent in preparing separate

requisitions of materials.

Engineering or

Planning Dept

For record, reference and control purposes.

5. Write a brief note on Purchase Requisitions.

1. Meaning: Purchase Requisition is a form used for making a formal request to the

Purchasing Department, to procure the specified items of materials.

2. Prepared by: Purchase Requisition is usually prepared by – (a) Store-Keeper (for regular

materials), and (b) Head of production planning or Technical Department (for special

materials). It should be signed and approved by a responsible official, (e.g. Works

Manager), in addition to the one originating it.

3. Copies: 4 copies to be used by – (a) Purchase, (b) Planning, (c) Cost Accounting, and (d)

Stores Departments.

4. Pre-conditions: The following conditions should have been fulfilled in order to initiate

the purchase procedure-

(a) The item of material should be included in the Standard List (BOM) of the Purchase

Department as “Regular Item”. If a new item is required, suitable sanction and

approval shall be obtained.

(b) The stock of the item should have reached the Re-Order Level. This is the level at

which action can be taken to initiate the purchase procedure.

(c) There should be proper co-ordination between Purchase, Stores and Production

Departments.

6. What is meant by a Purchase Order?

1. Meaning:

(a) Purchase order is a written request to the supplier to supply certain specified materials

at specified prices within a specified period, and as per the terms and conditions

specified therein.

(b) The objective of the Purchase Order is to confirm the terms of supply already quoted

by the Supplier and agreed to, by the Firm. It should preferably be written. An oral or

telephonic Purchase Order made initially should be confirmed by a written order sent

by fax or mail, within a short time.

2. Prepared by: Purchase Order is prepared by the Purchase Department.

3. Copies: 5 Copies of to be used as under-

(a) Supplier – for laying down the terms and conditions of purchase.

(b) Stores or Requisitioning Department – for follow-up and file purposes.

(c) Inspection and Receiving Department – for verification at the time of receipt and

inspection.

(d) Cost Accounting Department – for reference and record.

(e) Purchase Department – to facilitate follow-up of delivery, and also for approving the

invoice for payment.

7. What is Material Requisition Note (MRN)?

1. Meaning:

(a) Materials Requisition Note (MRN) is the document for issue of materials from Stores

to Production Department.

(b) MRN authorizes the Store-Keeper to issue the requisitioned materials and record the

same in Bin Card.


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(c) The purpose of Material Requisition Note is to draw material from the Stores by the

concerned departments.

2. Origination:

(a) Where a “Materials List” (i.e. BOM) has been prepared: MRN can be prepared

by the production Department. Such requisition can be either for the whole of all

specified materials or in different lots, drawn upto the limit specified in the BOM

List.

(b) Where a “Materials List” (i.e. BOM) has been prepared: MRN should ideally be

prepared by the Planning Department. If there is no Planning Department, it may be

prepared by the concerned Production Department. In all cases, it should be duly

approved by a responsible official.

3. Copies: 3 Copies to be used by-

(a) Stores Department – for issuing materials

(b) Cost Accounting Department – to account for cost thereof.

(c) Receiving Department, i.e. department requiring the material – for control purposes.

8. How does a BOM differ from a MRN? Explain the purpose of each.

Particulars Bill of Materials (BOM) Materials Requisition Note (MRN)

1. Meaning It is a comprehensive list of

materials with exact description

and specifications required for a

job or other production units.

It is a formal written demand /

request, usually from the Production

Department to Stores Department, for

the supply of specified materials,

stores, etc.

2. Information

contents

This provides information about

required quantities and if there is

any deviation from the

standards, it can easily be

detected.

It provides information on actual

quantities of materials consumed by

Production Department.

3. Prepared by Engineering or Planning

Department.

Production Department, and is

further signed by Store-Keeper for

actual issue of materials.

4. Purposes Refer Q. No. 4 above Refer Q. No. 7 above

9. Write short notes on Classification and Codification of materials.

When the numbers of items handled are higher, classification and codification of items becomes

necessary.

1. Classification: Items of materials may be classified on any of the following basis-

(a) Nature: Raw Materials, Consumable Stores, Spare Parts, Lubricating Oil, Catalysts, etc.

(b) Usage: Fast moving and regular material, moderately used material, non-moving

materials, etc.

2. Codification: To facilitate computerized inventory accounting, materials may be allotted

code numbers. Codes may be given using alphabetic, numerical or alphanumeric approaches.

Each item of material is given a distinctive code number.

10. Briefly describe the procedures of receipt and inspection of materials.

1. The Receiving Department is responsible for taking charge of the incoming materials,

checking and verifying their quantities, inspecting them as regards their grade, quality or

other technical specifications.

2. Where there is a separate Inspection Department, it carries out a technical appraisal of

receipts.

3. If the materials are found acceptable, these are officially received by preparing a “Goods

Received Note” and “Inspection Report”. They are then passed on to Stores (or other

departments for which these might have been purchased).


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4. In case the quality is not the same as ordered, the goods are not accepted. They are returned to

the Supplier.

5. The Goods Received Note (GRN) is prepared in 4 copies to be used as under-

(a) Purchase Department – for verifying Supplier‟s bill for payment.

(b) Stores or Intending Department – for acknowledgement and record.

(c) Cost Accounting Department – for reference and record.

(d) Retained for use by the Receiving Department – for acknowledgement and file.

11. What is meant by Two-bin System? 1. It is a system of storage wherein each Bin (or Container) is divided into two parts-

(a) The Base Part or smaller part, where the quantity equal to Minimum Stock or Re-Order

Level is kept.

(b) The Issue Part, where the remaining quantity is stored.

2. Issues are made out of the larger part (Issue Part), but as soon as it becomes necessary to use

quantity from the Base Part, fresh order is placed. This concept is similar to the fuel tank level

indicator found in automobiles.

3. This system is supplemental to the record of respective quantities on the Bin Card and Stores

Ledger.

12. Compare between Bin Cards and Stock Control Cards? Give their merits and demerits.

Particulars Bin Cards Stock Control Cards

1. Meaning Bin cards are quantitative

records of stores showing

quantities received, issued to

production and balance stock

available.

They are quantitative records of

stores showing quantities received,

issued to production and balance

stock available. These contain

further information as regards

stocks on order.

2. Location These are kept attached to the bins

to assist in the identification of

stock.

Stock Control Cards are kept in

cabinets or trays or loose binders,

and not along with the bin.

3. Merits Fewer chances of mistakes.

Effective control over stock.

Easy identification of different

items of materials.

Records kept in compact

manner.

Division of labour between

record keeping and actual

material handling.

Possible to get an overall idea

of the stock position, easily.

4. Demerits Records dispersed over a wide

area.

Cards are liable to be smeared

with dirt and grease.

Need for both clerical and

handling staff.

No comparison of the physical

stock with its book balance.

No easy physical identification

of materials in stock.

5. Points of

difference Does not contain information on

material ordered, expected date

of receipt, etc.

Kept attached to the bins or

receptacles in which the

materials are stored, hence

distributed availability.

Shows further information on

the re-order quantity.

Kept in a tray or file on the

Store-Keeper‟s desk, hence

concentrated availability of all

records in one place.


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13. Distinguish between Bin Card and Stores Ledger.

Particulars Bin Card Stores Ledger

1. Maintained by Store- Keeper. Cost Accounting Department.

2. Nature Stores Recording Document Accounting Record.

3. Contents Quantitative only. Quantitative cum Financial

Record.

4. Time of recording At the time of transaction. After the transaction takes place.

5. Source documents Recorded at source. No separate

source document required.

Posted from Material Requisition

Slips, Goods Received Notes, etc.

6. Manner of posting Each transaction is recorded

separately.

Transactions are posted on

summary basis.

14. What are the advantages of Perpetual Inventory Records?

Perpetual Inventory Records refer to the inventory records, i.e. Bin Card and Stores Ledger,

that are maintained on a upto date basis at all points of time. The following are its advantages-

1. Physical stocks can be counted and book balances adjusted as and when desired without

waiting for the entire stock- taking to be done.

2. Interim Financial Statements can be quickly prepared as stock figures are readily available.

3. Discrepancies are easily located and corrective action can be promptly taken to avoid their

recurrence.

4. A systematic review of the perpetual inventory reveals the existence of surplus, dormant,

obsolete and slow-moving materials, so that remedial measures are taken in time.

5. Fixing various stock levels and checking actual balances in hand with them, assist the Store

Keeper to maintain stock within limits and initiate purchase requisitions for correct quantity at

the proper time.

15. Distinguish between Periodic and Continuous Stock Verification.

Stock verification involves physical counting of actual stock available and comparing the same

with books and records to ascertain discrepancies if any. There are two methods of stock

verification- (1) Periodic, and (2) Continuous Stock Verification. The differences between these

two methods are –

Particulars Periodic Stock Taking Continuous Stock Taking

1. Timing Stock Verification takes place at

the end of a financial period, say

a year.

Stocks are verified at regular

intervals during the year. Since

stock-taking takes place regularly, it

is called continuous stock-taking.

2. Coverage All items of stocks are covered

in a single stretch of verification,

say over two or three days.

In each verification, two or three

items are covered on random basis.

In the entire period, all items are

covered on rotation basis.

3. Effect on work Regular stores procedures like

materials receipts, issues, etc.

may have to be stopped to

facilitate stock-taking.

There is no interference with regular

work flow.

4. Control Discrepancies can be known

only at the end of the period.

Responsibility cannot be easily

fixed.

Discrepancies are ascertained

immediately in order to take

corrective action and avoid

recurrence.

5. Records Inventory Records may also be

updated periodically, say weekly

or monthly, in fact, at any time

before physical verification.

Due to surprise element involved,

Inventory records must be

maintained up-to-date at all times.

Such records are called Perpetual

Inventory Records.


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6. Interim results This does not facilitate or help

the quick compilation of interim

or final financial results.

It provides stock figures on real-

time basis. Hence final accounts can

be compiled quickly. Interim

Results can also be prepared easily.

16. Enumerate the advantages of Continuous Stocktaking.

Continuous Stock Taking is akin (similar) to the concept of preventive maintenance in

workshop management, discuss.

The advantages of continuous stock-taking are-

1. Stoppage of Normal workflow like receipt and issue of materials is not necessary.

2. Stock verification work is spread throughout the year.

3. Discrepancies can be detected and corrected much earlier.

4. Surprise element involved in checking keeps the stores staff on their guard and duty-

conscious.

5. Obsolete and slow-moving items can be detected immediately and their overstocking can be

avoided.

6. Final Accounts can be compiled quickly. Interim accounts are prepared quite conveniently.

DOCUMENTATION SUMMARY

Name of Document Prepared in Copies to

Bill of Materials Engineering / Planning

Dept.

1.Stores, 2. Purchase, 3. Accounting,

4. Production Control.

Purchase Requisition Stores Department 1.Purchase, 2. Planning, 3. Accounting

Purchase Order Purchase Department 1.Supplier, 2. Stores, 3. Inspection,

4. Accounting

Inspection Report Inspection Department 1.Stores, 2. Accounting

Goods Received Note Receiving Department 1.Purchase, 2. Stores, 3. Accounting

Material Outward Return Note Stores or Despatch Dept. 1.Supplier, 2. Stores, 3. Accounting

Materials Requisition Note Production Department 1.Stores, 2. Accounting

Material Return Note / Shop

Credit Note / Stores Debit

Note

Production Department 1.Stores, 2. Accounting

Material Transfer Note Production Department 1.Transferee, 2. Accounting

Note: In all the above cases, the department preparing the document will retain one copy for file,

record, reference, follow-up and control purposes.

17. Outline the significance and formulae of various Stock Levels.

Level Formula Significance / Purposes

Re-Order

Level

1. Maximum Usage Rate X Maximum

Lead Time [or]

2. Safety Stock + Lead Time

Consumption

Level at which the next purchase

procedure must be initiated by

preparing Purchase Requisition.

Level to maintain sufficient stock

cushion to meet most efficient

production facilities and

requirements.

Minimum

Level

Re-Order Level – (minus) (Average

Usage Rate X Average Lead Time) Lowest quantity of inventory to be

maintained at all times, to avoid

stock-out situations.

Minimum Investment in Raw

Material Inventory.

Level to follow-up on the status on

the Purchase Requisition previously

made at the Re-Order Level.


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Maximum

Level

Re-Order Level + Re-Order Quantity –

(minus) [Minimum Usage Rate X Min.

Lead Time]

Maximum or upper limit on

investment in Raw Material

inventory. Hence, it is the level

beyond which Raw Materials

should not be piled up.

Average

Level

1. Maximum Level + Maximum Level

[or]

2

2. Maximum Level + ½ of Re-Order

Qtty [or]

3. Opening Stock + Closing Stock

2

Average of maximum and minimum,

used in determining value of stocks for-

Stock Insurance purposes.

Submission of Stock Statements to

Bank

Preparation of Interim Financial

Statements.

Danger

Level

1. Min. Usage Rate x Min. Lead Time

[or]

2. Avg. Usage Rate x Min. Lead Time

[or]

3. Minimum Usage Rate x Average Lead

Time

Level at which emergency purchase

action is taken, to replenish stocks

upto Minimum Level.

Level at which stocks are issued

only on “most needed” or “priority”

basis.

Note: For ROL, Average & Danger Levels, the alternative formula may be used when the first

formula cannot be applied. Also, Re-Order Quantity (ROQ) is generally taken as the Economic

Order Quantity (EOQ).

18. What are the important points considered in fixing the Maximum Level?

The major points to be borne in mind while fixing the Maximum Stock Level are-

1. The fixation of Maximum Level of an inventory item requires information about its Re-Order

Level. Hence, Re-Order Level should be known and pre-determined.

2. Knowledge about minimum consumption and minimum delivery period for each inventory

item.

3. Economic Ordering Quantity (EOQ) or the Re-Order Quantity should be known.

4. Requirement of funds, storage space, nature of items and their purchase prices per unit should

be known.

5. In the case of imported materials having irregular supply, the Maximum Level should be set

high enough considering the high lead-time involved.

Maximum Level

Average Level

Re-Order Level

Minimum Level

Danger Level

Zero Level

Note: Average Level may lie anywhere between Max. and Min. Levels. Also, ROL may lie either

above or below the Average Level.

19. What are the main considerations for fixing the Minimum Stock Level?

The main considerations for the fixation of minimum level of inventory are –

1. Maximum consumption and Maximum Lead Time in respect of each item to determine its

ROL.

2. Average rate of consumption for each inventory item.

3. Average Lead-Time for each item, i.e. ½ of Maximum and Minimum Lead-Times.


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20. Distinguish between ROL and ROQ.

Particulars ROL ROQ

1. Meaning It is the stock level at which next

purchase procedure should be initiated.

It is the quantity that should be

placed in the Purchase Order.

2. Question It answers the question when to

purchase

It answers the question what

quantity to purchase.

3. Formula ROL = Max. Usage x Maximum Lead

Time

ROQ = EOQ = 2AB

C

21. Distinguish between Re-Order Level and Margin of Safety.

Particulars Re-Order Level (ROL) Margin of Safety(MOS)

1. Meaning It refers to the level of stock at which

the next purchase procedure is initiated

by preparing a Purchase Requisition.

It is a term used in “Marginal Costing”

technique. It is the excess of Actual

Sales over Break-Even Sales.

2. Purpose It indicates the level of stock sufficient

to meet the maximum production

requirements.

It indicates the level of profitability of

the concern. A high MOS indicates

good profits and vice-versa.

3. Factors It depends on- (a) Maximum Usage

Rate and (b) Maximum Lead Time.

It depends on the extent of Actual

Sales, Fixed Costs, Contribution etc.

4. Formula ROL = Max. Usage x Max. Lead Time MOS = Profit [See Chapter 12]

PVR

22. What are the costs associated with the EOQ?

In addition to the price paid, i.e. cost of raw materials, the following costs are associated with

EOQ-

Particulars Buying or Ordering Costs Carrying or Stockholding Costs

1. Meaning These are costs associated with every

purchase order and are incurred every

time a purchase order is made out.

These are costs associated with

carrying one unit of the Raw Materials

in stock.

2. Examples (a) Cost of paperwork, stationery –

Purchase Requisition, Purchase

Order.

(b) Cost of placing advertisements in

newspapers inviting quotations

from suppliers.

(c) Cost of administration –

negotiation and liaison with

suppliers.

(d) Cost of inspection, sample testing,

etc.

(a) Interest on Working Capital

blocked in Raw Material

Inventory.

(b) Storage Insurance.

(c) Warehousing Charges.

(d) Loss due to deterioration of

materials during storage.

(e) Increased risk of obsolescence,

theft, etc.

3. Nature As the number of Purchase Orders

increases, Buying Costs also rise.

Hence, the firm would try to reduce the

number of purchase orders in order to

reduce the annual Buying Costs. This

will result in purchase of bulk

quantities, with fewer Purchase Orders.

To reduce carrying costs, the firm

would like to reduce the quantity

bought every time. Hence, the number

of Purchase Orders per annum will

increase, with smaller lots / quantities

purchased every time.


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23. What is Economic Order Quantity? How is it computed?

“Optimum level of inventory is that which minimizes the total costs”. Discuss.

1. Meaning: Economic Order Quantity (EOQ) refers to the quantity to be purchased every time,

so as to minimize the total of all costs associated with purchase. The size of the order for

which the total purchase-related costs (i.e. Total of (a) Ordering Costs p.a. (b) Carrying Costs

p.a. and (c) Purchase Price p.a. are minimum, is known as the EOQ.

2. Computation: By applying Wilson‟s formula-

EOQ = 2AB/C, where A = Annual Requirement of Raw Materials (in units)

B = Buying Cost per order

C = Carrying Cost per unit of Raw Materials per annum.

3. Note:

(a) Associated Costs of EOQ = (b) Associated Costs of EOQ may also be computed as = 2ABC

(c) At EOQ under Wilson‟s Formula, Buying Costs p.a. = Carrying Costs p.a. = ½ of

Associated Costs p.a.

24. What are the assumptions underlying the computation of EOQ using Wilson‟s formula?

To be able to calculate a basic EOQ certain assumptions are necessary. Comment . N 95

Wilsons‟s formula for computing EOQ is based on the following assumptions –

1) Annual Requirement of Raw Material is pre – determined and fixed.

2) Buying Cost per order is proportional for every additional order. It is fixed and known in advance.

3) Carrying Cost per unit per annum is fixed and known in advance.

4) Raw Materials are available uniformly throughout the year.

5) Production Schedule is uniform throughout the year.

6) Cost per unit of the Raw Material is constant. There are no discounts based on quantity purchased.

7) Lead Time is Zero.

8) Minimum Stock Level is Zero.

9) There are no transportation costs (or) transportation costs are constant.

Total Cost

Carrying Cost

Buying Cost

EOQ

Quantity

25. Write a brief note on Inventory Turnover Ratio. Why would Management try to maintain

Inventory T/O at higher levels? M89

1) Formula: Raw Material Inventory Turnover Ratio (expressed in times) is computed as under –

(a) Cost – based Computation (b) Quantity – based Computation

RM Turnover Ratio=Cost of Raw Materials Consumed Quantity of Raw Materials Issued/Consumed

Average Stock of Raw Materials Average Quantity of Raw Materials in Stock

Note: Cost of Raw Materials Consumed = Opening Stock + Purchases – Closing Stock

Average Stock of Raw Materials = ½ x [Opening Stock + Closing Stock] [or] ½ x [Max. Level +

Min. Level]

Number of Days average inventory is held = 365

Cost

in R

s.


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Material Turnover Ratio

2) Significance / Interpretation:

Material Turnover

Ratio

No. of days average inventory

held

Nature of Material

High (≥ 4 times) Less (≤ 90 days) Fast moving, i.e. regularly used

Low (< 4 times) Higher (> 90 days) Slow moving, i.e. rarely used

3) Conclusion:

(a) High Material Turnover Ratio reduces the investment funds in inventory, and contributes to

the effective use of financial resources. It also ensures increase in profitability of the Firm.

(b) However, a very high Material Turnover due to very low stock levels will lead to stock – out

costs like disruption of production schedule, non – compliance with supply deadlines, loss of

customers, market image and goodwill, etc.

(c) Hence, Management‟s endeavour is to maintain the inventory turnover at manageably high

levels.

26. How is slow moving and non – moving items of stores detected? What steps are necessary to

reduce such stocks? N 01

1) Indicators: Slow and non – moving items are identified by reference to the following indicators –

(a) Stock Levels always near Maximum Level or much above Re – order Level.

(b) Low Material Turnover Ratio (< 4 times).

(c) High Average Stockholding Period (> 90 days).

2) Remedial Action: These items mean that the firm has blocked huge sum of money unnecessarily

in raw materials. This problem may be overcome by –

(a) Restricting new purchase requisitions, till the existing stock is exhausted.

(b) Finding out possibilities of exchange with regularly used materials, re – use or substitution.

(c) Early disposal of the non – moving items by scrap sale.

(d) If scrapping is not possible, discarding the materials to save storage costs.

27. Write short notes on the First – in – First – Out Method (FIFO).

1) Features:

(a) It is a method of pricing the issues of materials, in the order in which they are purchased.

(b) The prices at which earliest lots / consignments of materials were received are used firs,

before subsequent prices are used for pricing issues.

2) Advantages:

(a) Simple to understand and easy to operate.

(b) Gives better results in case of falling prices.

(c) Closing Stock of Material will reflect Current Market Prices.

(d) Cost of Consumption will be at actual cost, i.e. Opening Stock + Purchases (-) Closing Stock.

3) Disadvantage:

(a) Leads to complicated calculations and clerical errors, when the prices fluctuate frequently.

(b) Costs charged to the same job may show a variation from period to period, as each issue of

material to production is related to a specific purchase price.

(c) In case of rising prices and real profits of the Firm being low, this method will inflate profits,

since Cost of Raw Materials Consumed will be taken at old (lower) prices.

28. What do you understand by Last-In-First-Out (LIFO)? What are its advantages?

1. Features:

(a) It is a method of pricing the issues of materials, in the reverse order in which they are

purchased.


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(b) The prices of the most recently received consignments, i.e. immediately last available

consignment, are exhausted first before previous consignment prices are taken up.

2. Advantages:

(a) Cost of Materials Consumed will reflect Current Market Prices approximately. This will

lead to better matching

(b) Does not inflate profits during periods of rising prices, unlike FIFO Method.

(c) In case of falling prices, profit tends to rise due to lower material cost, yet the finished

products appear to be more competitive and are at Market Price.

(d) In the long run, the use of LIFO helps to iron out the fluctuations in profits.

(e) During inflation, LIFO will tend to show the correct profit and thus there is some tax

saving.

3. Disadvantages:

(a) Leads to complicated calculations and clerical errors, when the prices fluctuate

frequently.

(b) Cost of different similar batches of production carried on at the same time may differ a

great deal.

(c) In time of falling prices, there will be need for writing off stock value considerably, to

stick to the principle of stock valuation, i.e. Cost or Market Price whichever is lower.

(d) This method is not acceptable under the Accounting Standards or to the Income Tax

Authorities.

29. Write short notes on Base Stock Method.

1. Under this method, a minimum quantity of stock is always valued at a fixed price, based upon

the earliest lot of materials. It is used as Base Stock or Reserve Stock to meet emergency

consumption requirements.

2. The quantity in excess of the Base Stock may be valued either on FIFO or LIFO basis.

3. This is more a method of valuing inventory than a method of valuing issues, since Base Stock

is valued at earliest price and balance stock is valued using FIFO or LIFO.

4. This method is not an independent method as it uses FIFO or LIFO. Its advantages and

disadvantages therefore will depend upon the use of the other method, viz. FIFO or LIFO.

30. Briefly describe the Simple Average Price Method.

1. Features: Materials issued are valued at Average Price, which is calculated by dividing the

total of all units rate by the number of unit rates.

Simple Average Price = Total of unit prices of each purchase

Total number of purchases

Example: If Materials issued are from 3 consignments with prices of Rs. 20, Rs. 27 and Rs.

22, the Simple Average Price would be (20+27+22) /3 = Rs. 23

2. Advantages:

(a) Useful when materials are received in uniform lots of similar quantity, else, it will give

wrong results.

(b) Useful when purchase prices do not fluctuate considerably.

(c) Simple to understand and easy to operate.

3. Disadvantages:

(a) Materials Issue Cost does not represent actual cost price. Since the materials are issued at

a price obtained by averaging cost prices, a profit or loss may arise from such type of

pricing.

(b) Gives incorrect results, if the prices of material fluctuate frequently.

(c) Price determination in unscientific, since there is averaging of prices without considering

quantity.

31. Write short notes on the Weighted Average Price Method.


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1. Meaning: Weighted Average Price Method gives due weight age to quantities purchased and

the purchase price to determine the issue price.

Weighted Average Price = Total Cost of Materials received

Total Quantity Purchased

Note: Weighted Average Issue Price is calculated by dividing the Total Cost of Materials in

Stock, by the Total Quantity of Materials prior to each issue.

2. Advantages:

(a) It smoothens the price fluctuations, if any, due to material purchases.

(b) Issue prices need not be calculated for each issue unless new lot of materials is received.

3. Disadvantages:

(a) Materials Cost does not represent actual cost price, but only an approximate average.

(b) It may be difficult to operate, since every new lot received would require re-computation

of issue prices.

32. How is the Periodic Simple Average Price Method applied?

1. Features:

(a) At the end of each period, the price paid during that period for various consignments are

added up, and this total is divided by the number of purchases made during the period.

(b) The rate so computed is then used to price all materials issues made during the period,

and also for valuing the Closing Stock of Raw Materials.

Periodic Simple Average Price = Total of Prices paid in a period

No. of purchases in the period

Note: This method is similar to Simple Average Price Method. However, the Average is

calculated only at the end of the concerned period.

2. Advantages:

(a) It is simple to operate, as it avoids calculation of issue price after every receipt.

(b) This method can usefully be employed in costing continuous processes where each

individual order is absorbed into the general cost of producing large quantities of articles.

3. Disadvantages:

(a) This method cannot be applied in jobbing industry where each individual job order is to

be priced at each stage of its completion.

(b) It is unscientific, as it does not take into consideration the quantities purchased at

different prices.

(c) It also suffers from all disadvantages of Simple Average Price Method.

33. Describe the treatment of the following transactions in the Stores Ledger.

1) Materials Returned to Vendor.

2) Surplus Materials returned to Stores from Production Department.

3) Receipt of replacement materials from vendor, in place of those returned earlier.

4) Transfer of material from one job to another.

5) Shortages detected during Stock Verification. RTP

Transaction Entry Price at which recorded

Materials returned to

Vendor

Issue This is shown in the Stores Ledger at Landed Cost. However

Invoice Price is debited to Supplier Account. The difference

between Landed Cost and Invoice Price is treated as Overhead.

[See Note]

Materials Returned

from Production

Department to Stores

Department

Receipt This is shown at the same price at which they were originally

issued. These materials are generally kept in suspense and first in

the queue, to be issued at the same price against the next

requisition. Alternatively, they can also be treated as a fresh

purchase.

Receipt of

Replacement Materials

Receipt This is recorded at the earlier landed cost of materials originally

purchased. In case of extra cost of modification charged to the


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from Vendor Company, such costs shall be treated as Overheads.

Transfer of Materials

from one job to

another

No

entry

No entry is made in the Stores Ledger as the materials are

directly transferred, and not routed through Stores.

Shortages in Stock –

taking

Issue These are valued at the rate applicable as per the method

adopted, i.e. FIFO or any other method.

Note: Suppose 100 units at a landed cost of Rs.25 each [Rs.23 Invoice Price + Rs.2 towards freight

and insurance] are available in Stores. If 40 units are returned, they shall be returned at Rs.23, the

difference of Rs.2 per unit shall not be debited to the Supplier, but charged as Production Overheads.

But in the Stores Ledger, the rate in the issue column shall be Rs.25 only.

34. How will you deal with the following items in Material Cost?

1. Material Handling Cost (M 99) 2. Insurance on Stocks of Materials (N 83, N 98) 3. Cash

Discount RTP, N 83

Item Treatment

Material

Handling

Cost

Material Handling Cost refers to the expenses involved in receiving, storing, issuing

and handling materials. The two approaches for its treatment are –

1. Landed Cost: Include as part of Direct Material Cost, by using a Material

Handling Rate based either on the cost or the weight of materials issued (e.g. 2% of

Material cost, or Re.1.50 per kg, etc.)

2. Overhead: Include as Manufacturing OH, and charged to products based on

Percentage of Raw Material Consumed or Labour Hour Rate or other suitable

method of absorption.

Insurance

on Stock

of Raw

Materials

1. Stock Insurance Premium (meant for covering the risk which may arise due to fire,

theft, riot, etc. during storage) should be apportioned over the various items of

materials based on their value.

2. Transit Insurance Premium (i.e. incurred before materials are received in Stores

Department) is added as part of Landed Cost of materials.

Cash

Discount

Received

Approaches available for treating the Cash Discount Received are –

1. Financial Expense: Cash Discount may be treated as an item of financial nature,

and kept outside the purview of Cost Accounting.

2. Reduction from Materials Cost: Cash Discount received in the course of purchase

may be deducted from the Invoice Price of the materials. In this manner, the

Purchase Price of materials will be reduced.

3. Discount Loss Accounting: The full Invoice Price may be debited to Purchase

Account crediting the Supplier‟s Account with the Net Invoice Price, and the

Discount Earned Account with amount of Cash Discount Available. If prompt

payment could not be made, the Discount lost (i.e. not earned) is debited to the

Discount Lost Account. Any difference between Discount Available and Discount

Lost may be treated as an item of Administrative Overhead.

35. Describe the treatment for Normal and Abnormal Loss of Materials. [or] M 01

How are discrepancies between Actual Physical Stock & Book Stock accounted? N 83

Differences between Physical Stock and Book Stock are dealt with as under –

Reduction / Difference in Material Quantity, i.e. Shortage = Material Losses

Normal Loss Abnormal Loss

i.e. Expected, Unavoidable, Non – Controllable i.e. Beyond Expectations,

Standards set based on part data Above Normal

Treated as Regular Cost Treated as Loss


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(a) As Direct Materials by inflating Issue Price [or] Charged off, i.e. Debited to

(b) As Production Overheads Costing Profit and Loss A/c.

Example: Suppose 100 kgs of Materials are bought at Rs.9 per kg. The Normal Storage Loss is 10%.

Hence Total Material Cost of Rs.9 x 100 = Rs.900 may be distributed over net quantity (100 kg – 10%

= 90 kgs.). Hence Price per kg for costing purposes will be Rs.900 ÷ 90 kgs = Rs.10 per kg.

Alternatively, Cost of 10 kgs Normal Loss x Rs.9 = Rs.90 may be treated as Production Overheads.

36. At the time of physical stock taking it was found that actual stock level was different from

the clerical or computer records. What can be the possible reasons for such differences?

How will you deal with such differences? M 99

1) Possible reasons for differences arising at the time of physical stock taking may be as follows –

Clerical Errors Abnormal Reasons

(a) Wrong entry in the Stores Ledger Account or Bin Card.

(b) Placement of materials in the wrong physical location

in the Stores.

(c) Arithmetical errors in calculating the stores balance on

the Bin Cards or Stores Ledger.

(a) Theft of stock.

(b) Loss due to fire, flooding, etc.

(c) Loss of quality due to careless

handling, improper storage

conditions, etc.

2) Accounting Treatment:

(a) Transfer to Adjustment A/c: When a discrepancy is found at the time of stock – taking, the

Stores Ledger Account and the Bin Card must be adjusted so that they are in agreement with

the actual stock. The difference may be transferred to “Inventory Adjustment Account” for

further analysis into normal and abnormal loss.

(b) Normal Loss: If the difference is considered as normal, it should be transferred to Overhead

Control A/c. Alternative, price of the material issued to production may be inflated so as to

cover the Normal Loss.

(c) Abnormal Loss: If the difference is abnormal, it should be debited to Costing P & L

Account.

37. Explain the accounting treatment for Waste. RTP, M 86

1) Waste:

(a) It represents the portion of basic raw materials lost in processing, having no recoverable

value.

(b) Waste may be – (i) visible – remnants of basic raw materials, or (ii) invisible – disappearance

of basic raw materials through evaporation, smoke, etc.

(c) Shrinkage of material due to natural causes may also be a form of a material wastage.

2) Accounting Treatment:

(a) Waste may be classified into Normal and Abnormal Waste.

(b) Cost of Normal Waste is absorbed in the cost of net output, whereas Abnormal Waste is

transferred to the Costing Profit and Loss Account, as a Loss.

38. Explain the accounting treatment for Scrap. RTP, M 86, N 08

1) Meaning: Scrap is the incidental residue from certain types of manufacture, usually of small

amount and low value, recoverable without further processing.

2) Control Measures: Measures to control Scrap Losses and obtain maximum gainful utilization of

raw material are –

(a) Proper product designing by the Production Planning Department.

(b) Use of standardized materials, equipment, personnel and efficiency by the Production

Department.

(c) Preparation of periodical scrap reports, comparison of actual with standards and identifying

deviations and corrective action taken by the Cost Control Department.


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3) Accounting Treatment: Scrap may be treated in cost accounts in the following ways –

(a) Other Income: Where the value of scrap is negligible, such value may be excluded from

costs. Hence, the cost of scrap is borne by good units. Income / Receipt from Scrap

Realisation is treated as Other Income.

(b) NRV of Scrap: The Net Realisable Value (NRV) of Scrap, i.e. Sales Value less Selling and

Distribution Cost, is deducted from Overheads. Alternatively, the NRV can be reduced from

Materials Cost. This method is followed when scrap cannot be aggregated job or process –

wise.

(c) Specific Identification: When scrap is identifiable with a particular job or process and its

value is significant, the Scrap Account is charged with full cost. The credit is given to the job

or process concerned. The profit or loss in the Scrap Account, on realization, will be

transferred to the Costing Profit and Loss Account.

39. Write short notes on accounting treatment for material spoilage. RTP, M 86, M 03, M 05,

M 07, N 07, M 09

1) Meaning: Spoilage refers to materials which are badly damaged in manufacturing operations, and

they cannot be rectified economically, and hence taken out of process to be disposed of in some

manner without further processing.

2) Classification: For accounting purposes, Spoilage is classified into Normal and Abnormal, and

dealt as under –

(a) Normal Spoilage Costs (i.e. which is inherent in the operation and hence unavoidable) are

included in costs either charging spoilage loss to the job / Process or by charging it to

Production OH so that it is spread over all products. Any value realized from spoilage is

credited to Job / Process a/c or OH a/c, as the case may be.

(b) Costs of Abnormal Spoilage (i.e. arising out of causes not inherent in manufacturing

process) are charged to the Costing P & L Account. When spoiled work is the result of rigid

specification, the cost of spoiled work is absorbed by good production while the cost of

disposal is charged to Production OH.

40. What is meant by “Defective Work”? Explain the accounting treatment for Defective Work.

RTP, M 86, M 00, M 03, N 03, M 05, M 07, N 07, N 08, M 09

1) Meaning: Defective Work signifies those units of production which can be rectified and turned

out as good units by the application of additional material, labour or other service, e.g. duplication

of pages or omission of some pages in a book.

2) Reasons: Defective arise due to sub – standard materials, bad supervision, improper planning,

poor workmanship, inadequate equipment and careless inspection. To some extent, defectives

may be unavoidable, but with proper care it is possible to avoid defect in the goods produced.

3) Reclamation of loss from defective units: In the case of articles that have been spoiled, it is

necessary to take steps to reclaim as much of the loss as possible. For this purpose –

(a) All defective units should be sent to a place fixed for the purpose,

(b) These should be dismantled,

(c) Goods and serviceable parts should be separated and taken into stock,

(d) Parts which can be made serviceable by further work should be separated and sent to the

workshop and taken into stock after the defects have been removed, and

(e) Parts which cannot be made serviceable should be collected in one place for being melted or

sold.

4) Treatment of Defectives: Defectives are generally treated in two ways –

(a) They can be brought upto the standard by incurring further costs – additional material and

labour,

(b) They can be sold as inferior products (seconds) at lower prices, where possible.

5) Control over Defectives: Control of defectives may cover the following two areas –

(a) Control over defectives produced.

(b) Control over re – working costs.


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For exercising effective control over defectives produced and the cost of re – working, standards

for normal percentage of defectives and reworking costs should be established.

6) Spoilage vs Defectives: Spoilage cannot be repaired or re – conditioned. However, Defectives

can be either rectified and transferred into standard production or sold as seconds.

41. Give the accounting treatment for Rectification Costs of Defective Work. M 86, M 00

The costs of rectification or re –work may be treated in the following ways –

1) When Defectives are normal and inherent in the process, they are –

(a) Charged to good products: The loss is absorbed by goods units. This method is used when

“second” have a normal value and defectives rectified into “seconds” or “first” are normal.

(b) Charged to Jobs: When defectives are normal and are easily identifiable with specific jobs,

the work costs are debited to the job.

(c) Charged to General Overheads: When the defectives caused in one department are

reflected only on further processing, the rework costs are charged to general overheads.

(d) Charged to the Department Overheads: If the department responsible for defectives can be

identified then the rectification costs should be charged to that department.

2) When Defectives are Abnormal: If defectives are abnormal and are due to causes beyond the

control of the Firm, the rework cost should be charged to Costing Profit and Loss Account.

CHAPTER 3

LABOUR COST

1. What do you understand by Time and Motion Study / Work Study? RTP, M 99

1) Meaning: Work Study is a technique of cost reduction, which seeks to reduce labour cost by

reducing unnecessary movements during the course of work and by determining the standard time

to be spent on a job.

2) Procedure:

(a) Observation of workers to record their movements.

(b) Classification of movements into – (a) Necessary, and (b) Wasteful.

(c) Elimination of wasteful movements and improvisation of necessary movements.

(d) Provision of standard tools and equipment to workers.

(e) Observation of workers and recording time taken for necessary movements.

(f) Determination of average time required for the job, taking efficiency / rating factor into

account.

(g) Determination of Standard time = Average Time + Idle Time Allowance (Contingencies,

Rest, etc.)

(h) Addition of incentive margin, if any, to attract efficient workers.

3) Objectives:

(a) To determine the best way of doing things, by avoiding wasteful movements.

(b) To reduce stress and strain in job performance.

(c) To determine standard time for completion of a job.

(d) To lay down norms for efficiency and performance evaluation.

(e) To determine fair rate of wages, based on output achievable per day.

2. What is Time – Keeping? What are its objectives? M 94

1) Meaning: Time – Keeping means keeping a record of the total time spent by worker inside a

factory. For example, if a worker enters the factory at 9:00 AM and leaves by 6:00 PM, the total

time spent by him for 9 hours inside the factory, is ascertained from Time – Keeping Records.

2) Objectives of Time – Keeping:

(a) Payroll: Employee payrolls are prepared based on the time – keeping records e.g. attendance

registers.


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(b) Ascertainment & Control of Labour Cost: From payrolls, total labour cost can be

ascertained. It is further classified into Direct and Indirect, in order to facilitate control.

(c) Calculation of Overtime: Overtime entitlement of workers is calculated on the basis of total

time spent, and the excess time over and above regular working hours.

(d) Calculation of Idle Time: Difference between total time spent (as per Time – Keeping

Records) and total productive time (as per Time – Booking Records) constitutes Idle Time.

(e) Disciplinary purposes: Time - Keeping constitutes part of organization procedures. This is to

reflect the order and discipline prevalent in the Firm.

(f) Statutory Compliance: Registers and Records relating to time keeping are required to be

maintained under Labour Laws like Factories Act, etc. This will ensure compliance with

statutory provisions.

(g) Overhead Distribution: Production OH is absorbed over jobs or products using Labour Hour

Rate as the basis.

3. What are the various methods of Time – Keeping?

The two major methods of time – keeping are – (A) Manual (Attendance Register or Metal Disc

Method), or (B) Mechanical (Time Recording Clocks, Dial Time Recorders, Smart Cards, etc.). These

are described below –

A. MANUAL METHODS

1) Attendance Register: An Attendance Register is kept at the Factory Gate or in each department

for workers engaged therein. This Register shows – (a) Name of the worker, (b) his Employee

Number, (c) Department, (d) Time of Arrival, (e) Time of Departure, and (f) Overtime, if any.

The time of arrival of each worker is noted by the Time Keeper.

Advantages Disadvantages

(a) Simple and Inexpensive.

(b) Useful when number of employees is not

large.

(c) Useful for recording time of workers who

work at customer‟s premises.

(a) Possibility of dishonest practices by way of

collusion between workers and time-keeper.

(b) Inclusion of dummy workers.

(c) Possibility of mistakes.

(d) No authentic proof of presence or absence

of workers.

2) Metal Disc Method: Each worker is allotted a metal disc / token bearing his identification

number. These tokens / discs are placed on a board at the gate. Upon arrival, the worker removes

his token and hangs it in the board. The Timekeeper records the attendance immediately after the

scheduled time, on the basis of the tokens in the box. Latecomers are required to hand over their

token personally to the Timekeeper, to record the exact time of arrival. The tokens still lying on

the board at the Factory Gate denotes absenting workers. Attendance and time of workers arrival

is recorded in the Daily Muster Roll, which is then handed over to the Payroll Department.


(a) Simple – even illiterate workers can

recognize their tokens and put them in the

box.

(b) Relatively inexpensive.

(a) Possibility of dishonest practices by workers,

e.g. removal of companions‟ tokens, etc.

(b) Inclusion of Dummy workers in Muster Roll.

(c) Possibility of mistakes.

(d) No authentic proof of presence or absence of

workers.

B. MECHANICAL METHODS

1) Time Recording Clocks: Each worker is given a Time Card which is valid for a particular

duration, e.g. one week. Time cards are serially arranged in a tray near the factory gate. At the

time of entry, the worker picks up his Time Card and puts it in the Time Recording Clock. The

time of arrival is printed against the particular date. The same process of recording time is

adopted for recording time of departure for lunch, return from lunch, leaving the factory at the end


9874311319

of the day etc. Late arrivals, early leavings and overtime may be printed in red, to attract the

attention of the management.


(a) Exact time of arrival / departure is

recorded.

(b) Possibility of disho9nest practices is

partly eliminated since the machine

records the time.

(c) Useful when number of workers is fairly

large.

(a) Expensive to install Dial Time Recorders.

(b) Possibility of misuse exists, e.g. a worker

recording his companion‟s attendance.

(c) Fails when the recorder goes out of order.

(d) Restricted to a limited number of workers

since the maximum number of holes / dials

will be around 150.

2) Dial Time Recorder: The Dial Time Recorder is a machine, which has a dial around the clock.

This dial has a number of holes and each hole bears a number, each corresponding to the

identification number of workers. There is one radial arm at the centre of the dial. Upon arrival,

the worker presses the radial arm after placing it at the hole of his number. The time will be

automatically recorded against his number on a roll of paper inside the machine. The paper roll

provides the report on arrival times of workers during the day.


(a) Exact time of arrival / departure is

recorded.

(b) Possibility of dishonest practices is

partly eliminated since the machine

records the time.

(c) Useful when number of workers is not

large.

(d) Arrival time data can be easily

transcribed into wage sheets for wage

computation.

(a) Expensive to install Dial Time Recorders.

(b) Possibility of misuse exists, e.g. a worker

recording his companion‟s attendance.

(c) Fails when the Recorder goes out of order.

(d) Restricted to a limited number of workers

since the maximum number of holes /dials

will be around 150.

3) Other Methods: There are other methods of time-keeping and time-booking like use of Smart

Cards which are swiped in the machine placed at the Factory Gate and also at the entrances to the

respective departments, use of Biometric Devices (in case of sensitive locations, R & D Units),

etc.

4. What is Time-Booking? What are its objectives?

1. Meaning: Time-Booking means analyzing / charging / booking the total time spent on

various jobs, day-by-day and person-by-person, e.g. if a worker spends 9 hours inside the

factory, the total time of 9 hours spent may be analyzed as 4 hours on Job A, 3 hours on Job

B, 1 hour on Job C and 1 hour Normal Idle time for lunch, recess, etc. This is generally based

on Time Cards or Job Cards.

2. Objectives of Time-Booking:

(a) Cost Ascertainment: Cost of each job can be ascertained from the time spent on it by the

workers.

(b) Cost Control: Time Booking ensures that the time paid for, is properly utilized on

different jobs.

(c) Idle Time Calculation: Difference between total time spent (as per Time-Keeping

Records) and total productive time (as per Time-Booking Records) constitutes Idle Time.

(d) OH Distribution: POH are absorbed either as a percentage of Direct Labour Cost or at a

rate per Labour Hour.

5. What is Idle Time? Explain the causes leading to Idle Time.

1. Idle Time: Idle Time = Unproductive Time, i.e. time during which the worker is not

engaged in production, but paid for. So, Idle Time = Total Time (as per Time Keeping

Records) Less Productive Time (as per Time Booking Records).


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2. Causes of Idle Time:

Normal Causes Abnormal Causes

(a) Time taken by workers to reach the

Production Department from the Factory Main

Gate.

(b) Time lost between the finish of one job and

starting of next job.

(c) Time spent to overcome fatigue and tiredness.

(d) Time spent on workers‟ personal needs like

taking lunch, tea, etc.

(e) Time required to set up machinery, receipt of

materials, initial processing of materials, etc.

(a) Machine break-downs, power

failure, equipment non-availability,

etc.

(b) Non-availability of raw materials

and tools.

(c) Waiting time for jobs due to

defective planning.

(d) Strikes, Lock-outs, poor supervision,

fire, floods, accidents etc.

6. How is Idle Time Cost treated in Cost Accounts? RTP, N 85, M 93, M 94, M 00,

M 03, M 06, N 08

Classification and Analysis: For Cost Accounting and analysis purposes, Idle Time is classified into

–

Particulars Normal Idle Time Abnormal Idle Time

1. Meaning It refers to the idle time inherent in every

work situation. It is estimated in advance.

It refers to the idle time over and

above normal idle time. Abnormal

= Actual Less Normal.

2. Nature It is unavoidable and cannot be eliminated

totally.

It is avoidable. It is further sub –

classified into – (i) Controllable,

and (ii) Non – Controllable.

3. Treatment Cost of Normal Idle Time is treated as a

regular part of cost of production. It is treated

–

(a) Either as Direct Wages by inflating the

Wage Rate (for Direct Workers) or

(b) As Production OH (for Indirect Workers).

Cost of Abnormal Idle Time

constitutes a Loss, which should

be debited to Costing Profit and

Loss A/c. If it is controllable, the

responsibility should be fixed on

the person in default.

4. Focus In the long run, normal idle time may be

reduced through improved technologies,

methods & procedures.

Controllable Idle time should be

eliminated through proper

managerial action.

7. What is Overtime Work? Why does it arise? M 85, N 95

1) Overtime Work: Work done beyond normal working hours is called as „Overtime Work‟. Under

the Factories Act, 1948, a worker is eligible for overtime pay, if he works for more than 9 hours a

day or more than 48 hours a week.

2) Significance: Overtime, if worked occasionally, indicated that the Firm is operating at its

optimum capacity. It is considered as a healthy indicator. But, persistent overtime may signify the

following –

(a) Understaffing – labour force employed is less than those required for meeting production

schedule.

(b) Limited production facilities – machinery is inadequate to meet production targets within

normal time.

(c) Labour inefficiency – postponement of work to overtime, in order to claim overtime wages.

3) Causes of Overtime: Overtime may arise due to any of the following reasons –

(a) Genuine labour shortage, which leads to the Firm being understaffed.

(b) Pressure of immediate / urgent delivery by a customer.

(c) Making up shortfall in production targets, due to some fault of management, or uncontrollable

factors, etc.

(d) Increase in production targets than budgeted, to meet rise in market demand.


9874311319

8. Overtime means increased costs. In what ways Overtime leads to increase in Costs? M 85

Discuss the effect of Overtime on productivity. RTP, N 01

Overtime work leads to increase in costs in the following ways –

1) Premium: The payment for Overtime Work is higher than (generally double) the normal rate.

This extra payment is called Overtime Premium, and is an addition to the total labour cost.

2) Reduced Output: The efficiency during overtime may not be as high as during normal work (due

to fatigue). Also, the workers may not concentrate on work during normal time, but work

overtime to earn more. As the overall output falls, cost per unit increases.

Thus, Overtime Work leads to increase in total costs and also reduction in rate of output, thereby

leading to increase in cost per unit. Hence, Overtime Work should be resorted to only when it is

extremely essential.

9. How is Overtime Premium treated in Cost Accounting? RTP, M 85, N 95, M 02, M 03, N

04, M 06, M 08

Overtime Premium is generally treated on the basis of the situation demanding Overtime Work –

Situation Accounting Treatment of Overtime Premium

1. Due to genuine labour shortage. Treated as Regular Cost of Production, as Direct

Labour, by inflating normal wage rate.

2. At Customer‟s desire, e.g. immediate

delivery, etc.

Charged to the Job directly. Such amount will be

suitably recovered from the customer by charging at a

higher rate.

3. Irregular overtime to meet production

requirements due to unexpected

developments.

Charged to Job – treated as Factory Overheads.

4. Due to fault of a particular department,

e.g. non – availability of materials

during normal time.

Charged to the department in default, in order to fix

responsibility and prevent recurrence.

5. Due to abnormal conditions, e.g. strike,

etc.

Charged to Costing Profit and Loss Account as Loss.

10. What are the measures for controlling Overtime Cost? M 85, N 95

The following procedural and administrative measures may be adopted for minimizing overtime –

1) Proper Supervision: Work done during normal hours should be monitored carefully. This will

ensure that there is no spillover from normal time to overtime, when the output can be achieved in

regular time itself.

2) Sanction: Overtime work should have the prior sanction of the competent authority. The reasons

justifying the overtime should be specified and considered acceptable.

3) Efficiency Comparison: Overtime efficiency should be compared with regular time efficiency. If

the overtime efficiency is very low, it may not be worthwhile to work overtime.

4) Periodical Reporting: Report on overtime work, output achieved, efficiency, reasons for

overtime work etc. should be sent periodically to top management for review and action.

5) Revised / Flexible Standards for job performance: Sometimes, the time allowed for

completion of job may be set without any specification as to normal time and overtime. For

example, in software development, if the project duration is set as 12 weeks, the exact hours of

work – night or day – need not be specified upon, as long as the work is completed within the

total time allowed.

6) Restriction on overtime: Sometimes, an upper limit may be fixed on overtime for each category

of workers, e.g. maximum 15 hours of overtime per month per worker.

11. What is Labour Turnover? What are the terms associated with Labour Turnover? RTP, N

85, N 94, M 96, M 03, N 04


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1) Meaning: Labour Turnover is the rate of change in the composition of labour force during a

particulars period, measured against a suitable index. It arises because every Firm is a dynamic

entity and not a static one.

2) Terms: The terms associated with computation of Labour Turnover are – (a) Separation, (b)

Replacement, (c) New Recruitment, (d) Accession, and (e) Average Labour Force. These

concepts are as under –

Term (a) Separation (b) Replacement (c) New Recruitment

Explanation Left and discharged Substitutions New additions due to

expansion, etc.

Old Worker Goes Out Goes Out -

New Worker - Comes In Comes In

(d) Accessions represent the total number of

new workers joining the Firm, whether

by way of replacement or otherwise.

So, Accessions = Replacements + New Recruitments.

(e) Average Labour Force=[Number of workers at the beginning + Number of workers at the end]

2

12. List the various methods of computing Labour Turnover. N 85, M 03, N 04, N 07

The methods of computing Labour Turnover are classified as under – [Note: Labour Turnover is

expressed in percentage.]

Labour Turnover Without Expansion Labour Turnover With Expansion

1. Separation Method: = S

L

1. Separation Method: = S

L

2. Replacement Method: = R

L

2. Accession Method: = A = R+N

L L

3. Mixed Method: = S+R

L

3. Flux Method: = S+A = S+R+N

L L

Note:

S = Number of Separations, R = Number of Replacements, N = Number of New Recruitments, A

= Number of Accessions, L = Average Labour Force.

Expansion refers to an increase in production facilities by which new workers are recruited, e.g.

diversification, plant capacity increase, commencement of new factory, introduction of additional

shift, etc.

Expansion may take place in a Firm once in 3 – 5 years. In those years, the Labour Turnover

Rates with expansion are computed. In other years, Labour Turnover Rates without expansion are

computed, and compared with industry norms.

If date is given for a period other than a year, Labour Turnover Rate is converted into the annual

rate as under –

Equivalent Annual Labour Turnover Rate = Turnover Rate for the period X 365

Number of days in the period

13. What are the causes of Labour Turnover? N 85, M 11

The major causes of labour turnover are – (1) Unavoidable Causes, and (2) Avoidable Causes.

1. Unavoidable Causes 2. Avoidable Causes

These are causes under which it becomes

obligatory on the part of management to ask one

These are causes that require the attention of

management on a continuous basis so as to keep

Alternatively, Accessions =

Number of Workers at the end

of the period

Add: Number of Separations during

that period

Less: Number of Workers at the

beginning of the period.


9874311319

or more of their employees to leave the Firm, e.g.

–

(a) Seasonal nature of the business,

(b) Shortage of Materials, Power, low product

demand, etc.

(c) Change in the Plant location,

(d) Disability, making a worker unfit for work,

(e) Disciplinary measures,

(f) Personal reasons, e.g. ill health, premature

retirement, family responsibilities, etc.

the labour turnover ratio as low as possible, e.g.

–

(a) Dissatisfaction with job, remuneration, hours

of work, working conditions, etc.

(b) Strained relationship with management,

supervisors or fellow workers,

(c) Lack of training facilities and promotional

avenues,

(d) Lack of recreational and medical facilities,

(e) Low wages and allowances.

14. Discuss the effects of High & Low Labour T/O. Why is Low Labour T/O preferred? M 89

The effect of High and Low Labour Turnover is summarized below –

1. High Labour Turnover 2. Low Labour Turnover

(a) Increase in cost of selection, recruitment and

training,

(b) Increase in material wastage, tool breakage, and

chances of breakdown of machinery at the shop –

floor level,

(c) Increase in the number of accidents,

(d) Disruption of regular flow and production schedule,

(e) Loss of customers and their brand loyalty due to (a)

non supply of the finished goods, or (b) sub –

standard production of finished goods.

(a) Low cost of selection, recruitment and

training,

(b) Minimum material wastage, tool

breakage and breakdown of machines,

(c) Reduction in number of accidents,

(d) Achievement of production targets,

(e) No loss of customers due to timely and

prompt supply of quality finished

goods.

Thus, High Labour Turnover causes increase in the cost of production / process / service, leading to

reduced profits. Hence, it becomes necessary to keep the Labour Turnover at a low level.

15. What are the costs associated with Labour Turnover? RTP, N 94, N 98, N 99, N 03

The two types of costs associated with Labour Turnover are – Preventive Cost

1) Preventive Costs: These are costs incurred to keep the

labour turnover at a low level, e.g. cost of medical

services, welfare schemes and pension schemes. If the

Firm incurs high preventive costs, its rate of labour

turnover is usually low.

2) Replacement Costs: These are costs arising due to

high labour turnover, and represent the amount spent

on new workers. Some examples are cost of

employments, training and induction, abnormal

breakage and scrap, extra wages and overheads due to

inefficiency of new workers. The Company will incur

high replacement costs if its rate of labour turnover is

high.

The behaviour of the two types of costs is given in the above diagram. Hence, every Company must

aim to keep the Labour Turnover at an optimum level, considering its personnel policies and

behaviour of Replacement and Preventive Costs at various levels of Labour Turnover Rates.

16. What are the steps to minimize Labour Turnover? N 85, N 94, M 96, N 07

The following remedial steps may be adopted to minimize labour turnover –

1) Exit interview with each outgoing employee to ascertain the reasons for his leaving the Firm.

2) Job Analysis & Evaluation carried out even before recruitment to ascertain the requirements of

each job.

Cost

in

Rs.

Replacement

cost

Optimum

Level

Labour Turnover Rate


9874311319

3) Scientific system of recruitment, placement and promotion, by fitting the right person in the

right job.

4) Enlightened attitude of management – Mental Revolution on the part of management, by

taking workers into confidence and creating a healthy working atmosphere, with measures such

as –

(a) Framing Service Rules after discussion between Management and Workers‟ Union.

(b) Provision of facilities for education, training and development of workers.

(c) Introduction of procedures for settlement of workers‟ grievances.

5) Use of Committee, comprising of members from management and workers, to handle issues

concerning workers‟ grievance, requirements, etc.

17. List the major factors to be considered in introducing an Incentive System. RTP, N 87

Incentive is “the stimulation for effort and effectiveness by offering monetary inducement or

enhanced facilities.” It may be – (a) monetary in the form of a bonus, or (b) non – monetary, e.g.

improved living and working conditions.

Factors: Factors to be considered before introducing a system of incentives include –

1) Industry Norms: The Firm‟s Incentive Scheme should be comparable with the industry norms and

prevalent practices in the locality / similar occupations.

2) Standards of Performances: Standards should be clearly defined in order to introduce appropriate

incentive schemes.

3) Measurability: When the quantity of work done cannot be measured precisely, incentive schemes

cannot be offered. For example, the output of Direct Workers can be measured, while the

performances of Indirect Workers, Supervisors, etc. cannot be measured quantitatively.

4) Quality Control: In case of high quality goods, or items having very good workmanship or finish,

Incentive System based on piece rate should be introduced, only if the system of quality control is

efficient and effectively in operation.

5) Production Quantity: The need to maximize / increase production should be considered. If

workmanship is more important than quantity of output, Incentive Schemes are not suitable.

6) Nature of Tasks: If the quantity of output is within the control of the worker, he should be offered

suitable incentives. Incentive Scheme is not suitable when the output is not dependent on the

workers‟ effect, e.g. Chain Assembly Work.

7) Role of Workers and Management: When the work is repetive, workers should be offered good

incentives to achieve high efficiency. But if Management is constantly required to plan the work,

as in the case of job work, the management should share the benefits of extra efficiency achieved.

8) Effect on earnings: The effect of an incentive scheme for one set of workers on other workers on

other workers should be analysed. If for instance, an incentive scheme makes it possible for

unskilled workers to earn high wages, the wage rates for skilled workers must also be raised (if

they are paid on time basis) to avoid dissatisfaction among them. In such case, the incentive

scheme may raise labour cost instead of lowereing it.

9) Attitude of Trade Unitosn: The attitude of labour and trade unions towards incentive scheme

should be considered before introducing of the scheme. Workers usually like to have a certain

guaranteed time – based wages, but also like to earn extra through an incentive scheme.

18. How are wages computed under Gantt‟s Task and Bonus System?

1. Meaning: Gantt‟s Task & Bonus system is a combination of Time and Piece Rate work

systems. Here, wages payable to workers are calculated as under-

Percentage of Efficiency Payment under Gantt‟s System

Less than 100%, i.e. output below standard Guaranteed Time Rate

i.e. (Hours worked x Rate per hour)

Equal to 100%, i.e. output at standard Time Rate + 20% Bonus on Time Rate

i.e. (Hours worked x Rate per hour) + 20%

thereon


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Above 100%, i.e. output above standard High Piece Rate, which includes 20% Bonus

of Time Rate i.e. (Actual Output x 120% of

Piece Rate per unit)

2. Advantages:

(a) It provides good incentive for efficient workers, and at the same time protects the less

efficient by guaranteeing them time rate.

(b) It is simple to understand and easy to operate.

(c) It encourages better supervision and planning.

3. Disadvantages: Guaranteed Time Rate may not give adequate motivation for the slow

worker to increase his output.

19. Write short notes on Emerson‟s Efficiency System of wage payment. 1. Meaning: Emerson‟s Efficiency system recognizes workers efficiency levels, and also

guarantees them their time-based wages. Wages payable to workers is computed as under-

% age of Efficiency Piece Rate

Less than 66.67% Guaranteed Time Rate, i.e. (Hours worked x Rate per hour)

Above 66.67% up to

100%

Time Rate + Increasing Bonus based on actual efficiency, from

0.01% to a maximum bonus of 20% on Time Rate.

Above 100% 120% of Time Rate + 1% increase for every 1% increase in output

beyond 100%

2. Advantages: (a) It encourages the slow worker to do a little better than before, than under Differential

Piece Rate System.

(b) Workers are assured of their time-based wages.

3. Disadvantage: It does not set a high degree of average performance as 2/3rd

efficiency is

rewarded with time wages.

20. How are wages computed under Halsey – Weir, Halsey and Rowan Systems?

These are Premium Bonus Methods of wage payment, where Total Wages = Basic + Bonus.

A comparative analysis of the three systems is given below:

System Basic Component Bonus Component

Halsey- Weir Hours Worked x Rate per hour 30% x Time Saved x Rate per hour

Halsey Hours Worked x Rate per hour 50% x Time Saved x Rate per hour

Rowan Hours Worked x Rate per hour Actual Hours x Time Saved x Rate per hour

Standard Hours

Merits Demerits

Halsey Time Rate is guaranteed.

Workers can earn more by saving

time.

Employer gets 50% share of time

saved.

Incentive is not as strong as piece

rate system.

Rate per piece is lower than under

simple piece rate.

Worker gets reward for only 50% of

the time saved.

Rowan Time Rate is guaranteed.

Workers can earn more by saving

time.

Share between employer and worker

is just and equitable.

Moderately efficient workers are

rewarded reasonably than Halsey

Plan.

Incentive is not as strong as piece

rate system.

It is difficult to compute than Halsey

System.

Sharing principle is not welcomed

by employees.

Where time saved is more than 50%

of time allowed, the incentive is

lower.


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Note: Total Wages will be equal in the following situations-

Equal Wages under Halsey & Rowan Systems,

if

Equal Wages under Halsey-Weir & Rowan

Systems, if

There is no time saved (i.e. no Bonus).

Actual Time = Time Saved = ½ of Standard

Time.

There is no time saved (i.e. no Bonus).

Actual Time = 30% of Standard Time = 3/7th

of Time Saved.

Rowan System gives maximum Bonus when Actual Time = ½ of Standard Time = Time Saved.

However, under Halsey System, bonus increases progressively as time saved increases. (M 10)

21. A Factory having the latest sophisticated machines wants to introduce an incentive scheme

for its workers, keeping in view the following-

1. The entire gains of improved production should not go to the workers.

2. In the name of speed, quality should not suffer.

3. The rate setting department being newly established, is liable to commit mistakes.

You are required to demonstrate how Rowan Scheme of incentive answers to all the

requirements of the Management.

Under the Rowan Scheme of Wage Payment, Total Wages = Basic + Bonus, where –

Basic = Actual Hours x Rate p.h. and Bonus = Actual Hours x Time Saved x Rate per hour

Standard Hours

The Rowan Scheme satisfies all the requirements of the Management. This is explained as under-

1. Requirement 1: The entire gains of improved production should not go to the workers.

Rowan Scheme provides incentive to workers to the extent of Time Saved, multiplied by the

ratio of Actual Hours to Standard Hours. This ratio will always be less than 100% (since there

will be no bonus if Actual Hours exceed Standard Hours). Hence, the entire gains due to time

saved by a worker will not pass to him.

2. Requirement 2: Under Rowan Scheme, a worker cannot increase his earnings or bonus by

merely increasing his work speed. For this purpose, we consider the following illustration –

Particulars X Y Z

Basic Wages

Bonus

18 x 10 = 180

18/20 x 2 x 10 = 18

10 x 10 = 100

10/20 x 10 x 10 = 50

6 x 10 = 60

6/20 x 14 x 10 = 42

Total Wages Rs. 198 Rs. 150 Rs. 102

Bonus per hour of

time saved

Rs. 9 Rs. 5 Rs. 3

A worker‟s bonus under Rowan Scheme will be maximum only when Actual Hours = ½ of

Standard Time = Time Saved. Hence, if he takes much less time to complete the job, he will

actually end up earning less bonus. Hence, more speed does not guarantee more bonus /

wages under Rowan Scheme and therefore, in the name of speed, quality is not bound to

suffer.

3. Requirement 3: Rowan System provides a safeguard in the case of any error in the fixation

of standard time by the rate setting department. If in the above situation, instead of 20 hours,

the standard time was erroneously set as 25 hours, the wages earned by each worker will be

as under –

Particulars X Y Z

Basic Wages

Bonus

18 x 10 = 180.00

18/20 x 7 x 10 = 50.40

10 x 10 = 100

10/25 x 15 x 10 = 60

6 x 10 = 60

6/25 x 19 x 10 = 45.60

Total Wages Rs. 230.40 Rs. 160 Rs. 105.60

Bonus per hour

of time saved

Rs. 7.20 Rs. 4.00 Rs. 2.40


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Prima facie, the workers may earn more wages due to higher time saved, but the effective

bonus per hour of time saved is low. So, workers cannot take undue advantage of any mistake

committed by the rate setting department.

22. Under the Rowan system, a less efficient worker can obtain the same bonus as a high

efficient worker. Discuss.

To analyze the effect of Rowan System on wages of efficient & inefficient workers, we consider

an example-

Hours Rate = Rs. 40, Std Time = 10 hours, Actual Time taken by Worker X and Y are 6 hours

and 8 hours.

Worker Basic Bonus Total Wages Effective Cost p.h.

X 6 x 40 = Rs. 240 6/10 x 4 x 40 = Rs. 96 Rs. 336 336/6 = Rs. 56

Y 8 x 40 = Rs. 320 8/10 x 2 x 40 = Rs. 64 Rs. 384 384/8 = Rs. 48

It is observed that the total wages of the inefficient worker Y is higher than that of X. Thus, under

the Rowan System, a less efficient worker can obtain higher wages than a highly efficient worker.

This flaw is due to the design of the incentive plan. However, effective cost per hour for Worker

Y is lower.

If workers are engaged on monthly basis, the total wages of efficient workers may be higher. This

is due to the fact that all workers will earn the same basic wages ( for the time spent) rather than

the time required for each job.

23. When is Barth System of wage payment suitable?

Barth System is one of the Premium Bonus Methods, where Total Wages = Rate per hour x

[Standard Hours x Actual Hours]

This system is suitable for – (a) Trainees and Beginners, and also for (b) Unskilled workers. This

is because, for lower production efficiency, earnings are higher than in the piece rate system.

However, as efficiency increases, the rate of increase in incentive falls and piece rate system is

more attractive.

24. What is Group Bonus? What are the objectives of Group Bonus Schemes?

1. Meaning: Group Bonus refers to the bonus paid for the collective efforts made by a group of

workers, such a scheme is introduced, when individual efficiency cannot be established /

measured for the payment of bonus. The quantum of bonus is determined on the basis of

productivity / output of the team as a whole. Bonus is shared by the individual workers in

specified proportions, e.g. on proportions of time based wages.

2. Objectives of Group Bonus Schemes: (a) To create collective interest and team spirit among workers.

(b) To create interest among supervisors and improve performance.

(c) To reduce wastage in materials and idle time.

(d) To achieve optimum output at minimum cost.

(e) To encourage individual members of a team, where output of the team as a whole is alone

measured.

25. Distinguish between Casual Worker and Outworker.

Distinguish how you will deal with Casual Worker and workers employed on outdoor work

in Cost Accounting.

Particulars Casual Worker Out Worker

1. Meaning A casual worker is appointed for a

short duration to carry on normal

A worker who does not work in the

factory premises but either works in


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business activities in place of a

regular but temporarily absent

worker.

his home or at a site outside the

factory is known as an Outworker.

2. Remuneration He is paid on daily time basis. He

is also known as daily wage or

badlies.

An Outworker who works in his

home is usually compensated on the

basis of his output.

3. Nature of

work

He is engaged for the regular work

inside the factory.

He is supplied with raw materials

and tools necessary for carrying out

the job. An Outworker (outside the

factory) is usually engaged on

specialized jobs / contract work.

26. Explain the meaning and objectives of Job Evaluation and Merit Rating.

1. Job Evaluation 2. Merit Rating

Mea

nin

g

It is a process by which the following aspects of a job are

analysed & evaluated –

(a) Nature and importance of tasks to be performed.

(b) Skill Requirements of Job Holder like technical

background, experience, etc.

(c) Responsibilities of the Job Holder, superior – subordinate

reporting relationships, etc.

(d) Importance of the job in relation to other jobs.

Merit Rating is the systematic

evaluation of the performance

of each employee. Performance

Evaluation, i.e. Merit Rating,

may be done by the supervisor

or other qualified person.

Ob

ject

ives

(a) To assess the importance of each job.

(b) To determine the skill requirements of the job holder and

fit the right person in the right job.

(c) To provide a basis for determining wage and salary

structure for various job positions in the Firm.

(d) To provide a basis for superior – subordinate

relationships, i.e. managerial hierarchy.

(a) To identify efficient workers

and reward them suitably.

(b) To determine training and

development needs.

(c) To provide a basis for

promotion and transfers.

(d) To assess the worth of the

worker to the Firm.

27. Distinguish between Job Evaluation and Merit Rating.

Job Evaluation Merit Rating

1. It means rating or evaluating the job itself. It means rating or evaluating the workers on their

jobs.

2. It is intended to create a rational wage and

salary structure.

It provides a basis for providing incentives to

workers on the basis of their ability and

performance.

3. It simplifies wage administration by

bringing uniformity in wage rates.

It determines the total wages payable to workers,

which includes performance – linked bonus.

28. Give the accounting treatment of the following items in Cost Records.

1. Fringe Benefits

2. Training Expenses

3. Expenses for Welfare Activities

4. Canteen Expenses

5. Night Shift Allowance

6. Holiday and Leave Wages

Item Meaning Treatment

Fringe

Benefits

These are additional payments / facilities

provided to workers apart from their

(a) If the amount of Fringe benefits is

considerably large, it may be


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Salary & Direct Cost Allowances like

House Rent, Dearness and City

Compensatory Allowances.

These benefits are given in the form of

Overtime, Extra Shift Duty Allowance,

Holiday Pay, Pension Facilities, etc. These

benefits lead to higher morale, loyalty and

stability of employees towards the Firm.

recovered as direct charge by means

of a supplementary Wage or Labour

Rate.

(b) Otherwise these may be treated as part

of Production OH.

Training

Expenses

Training Expenses include wages of

workers, costs incurred in running training

department, loss arising from the initial

lower production, extra spoilage, etc.

Note: Abnormally high Training Expenses

due to high Labour Turnover is excluded

from Cost, & Charged to Costing P & L

A/c.

Training Expenses of Factory Workers /

Office Staff / Salesmen are treated POH /

AOH / SOH respectively. These are

apportioned over various departments of

the Firm, based on the number of workers.

Expenses

for

Welfare

Activities

All expenses incurred on the welfare

activities of employees in a Company are

part of General Overheads. Some

examples are Canteen, Hospital,

Playgrounds, Staff Quarters Maintenance,

etc.

They may be specially recorded under the

head “Welfare Department Costs”. Such

expense should be apportioned between

Factory, Office, Selling and Distribution

OH on the basis of number of employees

involved.

Canteen

Expenses

An Enterprise / Factory may operate a

canteen within its premises, to provide

lunch and refreshments to workers, as part

of its staff welfare measures. Sometimes, a

small amount (say Rs.2.00 per meal) may

also be recovered from the workers.

Loss / Subsidy incurred by the Firm in

running the canteen is regarded as

Overhead Expense. If the Canteen is

meant only for factory workers, the

expense should be apportioned on the

basis of the number o workers employed

in each department. If Office Staff also

use the canteen facility, a suitable share of

the expense should be treated as AOH.

Night

Shift

Allowance

Workers in Factories operating during

night time are paid some extra amount

known as „Night Shift Allowance‟. This is

generally incurred due to the pressure of

work beyond normal capacity level.

Note: If Night Shift Allowance is treated

as part of Direct Wages, then jobs carried

out at night will be costlier than jobs

performed during the day, leading to a

cost anomaly.

(a) General: Generally Night Shift

Allowance is treated as POH and

recovered as such.

(b) Specific Order: If additional

expenditure on night shift is incurred

to meet some specific customer order,

it should be charged directly to the

order concerned.

(c) Abnormal: If night shifts are run due

to abnormal circumstances, such

expense should be charged to Costing

P & L A/c.

Holiday

and Leave

Wages

These costs can be ascertained by – (a)

providing a separate column in the Payroll

for “Holiday and Leave Wages”, or (b)

analyzing the payroll periodically to

ascertain how much of the total payment

pertains to “worked for wages” and how

much is attributed to Leave and Holiday

Wages.

(a) Paid Holiday and Leave Wages can

be included in Departmental OH, by

recording such wages separately.

(b) Alternatively, the wage rate for

costing purposes can be inflated, so as

to include Holiday and Leave Wages.

This can be done only in the case of

Direct Workers.

29. For each of the Labour Costs given below, state the accounting treatment that you would

recommend, giving reasons


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(i) Holiday Pay These costs can be ascertained by – (a) providing a separate column in

the Payroll for “Holiday and Leave Wages”, or (b) analyzing the payroll

periodically to ascertain how much of the total payment pertains to

“worked for wages” and how much is attributed to Leave and Holiday

Wages.

(a) Paid Holiday and Leave Wages can be included in Departmental

OH, by recording such wages separately.

(b) Alternatively, the wage rate for costing purposes can be inflated, so

as to include Holiday and Leave Wages. This can be done only in

the case of Direct Workers.

(ii) Supervisor‟s Wages Included in Departmental OH, being Indirect Costs.

(iii) Overtime in the

Lubricating

Department caused

by general pressure

of work

Irregular overtime to meet production requirements due to unexpected

developments.

Charged to Job – treated as Factory Overheads.

CHAPTER 4

OVERHEADS

1. What is Overhead Cost?

1) Meaning: Overheads comprise of Indirect Materials, Indirect Employee Costs and Indirect

Expenses, which are not directly identifiable or allocable to a cost object in an economically

feasible way. So, the total of all Indirect Costs, viz. Indirect Materials, Indirect Labour and

Indirect Expenses, is collectively called as “Overheads” (or on cost).

2) Exclusions: (a) expenditure arising out of abnormal situation in business activity, (b) Items not

related to business activities, e.g. Donation, Loss / Profit on Sale of assets, etc. and (c) Borrowing

Cost and other financial charges including foreign exchange fluctuations, will not form part of

OH.

3) Nature of OH: Indirect Costs are called Overheads, since they are incurred generally (and not

specifically) –

(a) Over various products,

(b) Over various Departments or Cost Centres, and

(c) Over various heads of account.

2. How are Overheads classified on the basis of functions?

Based on functions, Overheads are classified into four types, viz. –

Classification Sub – Classification

1. Factory or

Manufacturin

g or

Production

OH

(a) Stores Overheads (expenses connected with purchasing & handling of

materials)

(b) Labour Overheads (expenses connected with labour and amenities), and

(c) Factory Administration Overheads (expenses connected with

administration of Factory).

2. Office and

Administrativ

e OH

(a) Office Expenses (incurred on routine office work – Telephone, Stationery,

etc. ), and

(b) Administrative Expenses (incurred on Office Personnel, i.e. their Salaries,

Facilities, etc.)

3. Selling and

Distribution

OH

(a) Selling Expenses (incurred to persuade customers to purchase the Firm‟s

products and / or engage its services, that is to maintain & expand the

market), and

(b) Distribution Expenses (incurred to execute orders).

4. R&D OH (a) Research Expenses and (b) Development Expenses.


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3. List the methods of segregating Semi – Variable Costs into Fixed & Variable Costs.

Semi – Variable Expenses usually have two parts – a fixed part and a variable part. By a systematic

analysis, all Semi–Variable expenses can be segregated into variable and fixed portions. The

following methods can be applied for segregation of Semi-Variable Costs into Fixed and Variable

portions.

1) Graphical Method (or) “Line of Best Fit” Method.

2) Analytical Method (or) Best Judgement Method.

3) High and Low Points Method.

4) Comparison by Period or Level of Activity Method.

5) Least Squares Method.

4. Write short notes on the High and Low Points method of segregating Semi-Variable Costs.

1) Determine the Sales Value and Total Costs at the highest volume and lowest volume.

2) Compute Variable Costs as a % of Sales Value = Difference in Total Costs

Difference in Sales Value

3) Compute Variable Costs at either highest or lowest volume as Sales x Variable Cost % computed

above.

4) Compute Fixed Costs = Total Costs less Variable Costs as computed above.

5. “The more kilometers you travel with your own vehicle, the cheaper it becomes”. Comment

briefly on this statement.

1) In addition to Fuel and Other Costs (which are variable based on the distance covered), Fixed

Costs are incurred for running and maintaining vehicles.

2) Fixed Costs per unit decrease, as the level of activity increases. Hence, the component of Fixed

Costs per kilometer goes on decreasing with an increase in kilometer travel.

3) So, the Total Cost per kilometer, (if one travels in his own vehicle) will decline when he travels

more kilometers.

6. What are the advantages of Departmentalization? [OR] How does departmentalization help

the process of proper absorption of Production Overheads?

The collection of Overheads for each Cost Centre or Department offers the following advantages –

1) Proper Allocation: Expenses that relate to a particular department will be estimated on an exact

basis. Hence, the accuracy of estimation of overheads is higher.

2) Control: Availability of separate cost figures for each department facilitates control. For efficient

control, the manager should know for each activity, how much should have been spent and how

much is actually spent. If overall information should know for each activity, how much should

have been spent and how much is actually spent. If overall information is available, proper

control or responsibility fixation can be done.

3) Proper Absorption: The processing times of different products in different departments may

vary. Hence, expenses of each department should be known for ascertaining the appropriate share

of OH expenses.

4) Cost Ascertainment: A suitable method of costing can be followed differently for each

department, e.g. Batch Costing when a part is manufactured, but single or output costing when

the product is assembled.

7. What is meant by Codification of Overheads? What are its objectives?

1. Meaning 2. Objectives

Code is a system of symbols designed to be

applied to a classified set of items to give a brief

account reference, facilitating entry collation and

(a) To group items of similar nature that are

amenable to apportionment of Overhead

Expenses on the same basis.


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analysis.

Codification is a technique of intelligently

describing in number/ letters or a combination of

both, the lengthy description of numerous cost

accounting heads for ease of recording and

controlling of the costs date generated.

(b) To facilitate the task of allocation and

apportionment of OH over different

departments or cost centres.

(c) To carry out an analysis of OH for control

purposes.

(d) To reduce the task of maintaining a large

number of accounts.

(e) To assist the computerized accounting system

in large Firms.

8. What are the methods of Codification of Overheads?

The major methods of Codification of overheads are –

1) Straight Numbering System: Each type of expenditure is allotted a fixed number. This number

is sometimes referred to as the Standing Order Number, e.g. 10 – Indirect materials, 11- Indirect

Labour, etc.

2) Number Blocks System: A block of numbers is generally set aside or earmarked to indicate the

major heads of expenditure e.g. 1 – 50 for Service Labour, 51 – 100 for Maintenance, 101 – 150

for Fringe Benefits, etc. Different type of expenses are accounted under this number block – e.g.

108 – House Rent Allowance, 109 – Special Cash Allowance, 110 – Medical Allowance, etc.

within the Block 101 – 150 for Fringe Benefits.

3) Combination of Symbols and Numbers: A code is developed using a combination of alphabets

and numbers. The alphabet generally stands for the main head of expenditure and the number

represents the concerned department. e.g. if R stands for repairs and (1) and (2) are codes for

Factory and Office respectively, R – 1 will indicate Factory Repairs while R – 2 will indicate

Office Repairs.

4) Field Method or Numerical Code: A string of numbers is used for codification. The string of

numbers, usually of nine digits, has specific sub – elements. For example, the first two digits

may indicate the nature of expenses viz, Variable or Fixed. The next three digits may indicate

head of expense, the next two digits may stand for the analysis of expenses and the last two digits

may indicate the cost centre. E.g. Code No. 306387438 may be interpreted as 30 – Variable

Expenses, 638 – Sales Commission, 74 – Product X, 38 – Sales Department M.

5) Mnemonic Method: Under this method, English alphabets are used for coding, e.g. R. F. B. may

be used as code for Repairs for Factory Building.

Of the above, the Field Method is considered to be most advantageous for large organizations

because-

(a) Many characteristics of the expenditure are analyzed, e.g. variable or fixed, cost centre, etc.

(b) A large number of items of overhead expenses can be accommodated under this method of

codification.

(c) It is easy to operate with a computerized system of accounting.

9. What are the steps involved in the study of Manufacturing Overheads?

Explain how Department OH Rates are arrived at.

Distinguish between Cost Allocation and Cost Absorption.

Manufacturing or production or Factory Overheads are linked to output in a two-phase manner-

Phase One – Overheads related to the Department or Cost Centre,

Phase Two – Overheads of each Cost Centre related / linked to the output of that department.

The linking process involves the following six steps –

1. Collection: It means the pooling of indirect items of expenses from books of account and

supportive / corroborative records in logical groups, having regard to their nature and

purpose. Collection involves accumulation of data relating to overheads based on past

information and adjusted for known current trends and projected into the future. The


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information is collected from – (a) Invoices and Stores Requisitions (for Indirect Materials),

(b) Wage Analysis Book (for Indirect Labour), and (c) Journal Entries (for Indirect

Expenses).

2. Classification: Overheads are classified according to nature, viz, Fixed, Variable and Semi-

Variable expenses. This facilities decision-making and proper budgeting.

3. Allocation: Allocation of OH is assigning a whole item of cost directly to a Cost Centre. All

specific Expenses are related to Cost Centres in this step.

4. Apportionment: Apportionment of OH is distribution of OH to more than one Cost Centre,

on some equitable basis. Unallocated or Common Overheads are distributed in this fashion,

e.g. Rent based on Floor Area, Depreciation based on value of assets, etc. All OH would have

been related to various cost centres after this step.

5. Re-apportionment: This involves re-=distribution of Service Department Expenses to

Production Department. Since output is produced only in Production Department, all

overheads should be identified thereto. So, Service Department Expenses are re-apportioned

to Production Department, based on three different assumptions as to inter-relationship

between Service Departments.

6. Recovery / Absorption: (a) Absorption: Absorption of OH is charging of OH from Cost Centres to products or

services, by means of Absorption Rates for each Cost Centre. OH Absorption Rate =

Total OH of a Cost Centre / Total Quantum of Base.

(b) Base: The base (Denominator) is selected on the basis of type of the Cost Centre and its

contribution to the products or services, e.g. machine hours, labour hours, quantity

produced, etc.

(c) Absorbed OH: Overhead Absorbed = Overhead Absorption Rate x Units of base in

product or service.

Note: Apportionment is called Primary Distribution, and Re-Apportionment is called as

Secondary Distribution.

10. Distinguish between Allocation and Apportionment.

The differences between Allocation and Apportionment are –

Particulars Allocation Apportionment

1. Meaning Assigning a whole item of cost

directly to a Cost Centre.

Distribution of OH to more than

one Cost Centre, on some equitable

basis.

2. Nature of Expenses Specific, Identifiable and Direct. Unallocable, General and Common

3. Number of

Departments

One Many

4. Amount of OH Charged of Full Charged in Parts or Proportions

11. List some common expenses and the methods of apportioning the same.

Common Expense, i.e. Overhead Basis of Apportionment

1. Rent / Maintenance / Insurance on Building Floor Space

2. Factory Lighting Expenses Number of Light Points or Floor Space

3. Depreciation and Insurance of Assets Value of Assets

4. Power for machines Horse Power (HP) Rating or (HP Rating x

Machine Hours operated)

5. Indirect Wages Direct Wages

6. Supervision Time Spent, or Number of Employees, or Direct

Wages

7. Material Handling Expenses Value of Materials consumed

8. Purchase Department Expenses Number of Purchase Orders or Value of Purchases

9. Miscellaneous Production Expenses Direct Wages


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10. General Administration Expenses Works Cost

11. Personnel Department Expenses Number of Employees

12. Credit Department Expenses Value of Credit Sales

13. Carriage Outwards / Delivery Expenses Volume of units sold, weight or distance, etc.

14. Advertisement, Sales Commission, etc. Sales (Actuals)

15. Sales Assistants Salaries Time devoted for various products

12. What are the methods of re-apportionment of Service Department Expenses to Production

Department? Of these which method is conceptually preferable?

Explain Step Method and Reciprocal Services Method of Secondary Distribution of

Overheads.

Based on the nature of services provided by Service Departments, there are three methods of re-

apportionment of expenses to Production Departments. The methods and their underlying

assumptions are –

Let A and B be Production Departments, X and Y be Service Departments.

Assumption Relationship Method used

1. Service Departments

do not serve one

another.

X serves A, B, Y serves A, B.

X does not serve Y and vice – versa.

Direct Distribution Method.

2. One Service

Department serves the

other, but does not take

back services in

return.

X serves Y, A and B.

Y serves A and B only (not X).

So, X serves Y, but Y does not serve X.

Step Ladder Method, or

Step Method, or

Non – Reciprocal Services

Method.

3. Service Departments

serve one another.

X serves Y, A and B,

Y serves X, A and B.

Reciprocal Services Method

–

Repeated Redistribution

Technique (or Trial and

Error Technique), (or )

Simultaneous Equations

Technique.

Of the above, the third assumption, i.e. Service Departments serve one another, is considered the most

practical.

13. Explain the various concepts relating to Capacity.

Capacity Explanation

1. Licensed

Capacity

Licensed Capacity is the production capacity of the Plant for which license has

been issued by an appropriate authority / Government Agency.

2. Installed

Capacity

(a) Installed Capacity is the maximum productive capacity according to the

Manufacturers‟ specification of machines / equipment. If manufacturers‟

technical specifications are not available, Installed Capacity is ascertained

using estimates by Technical Experts.

(b) Installed Capacity is determined based on – (i) Manufacturers‟ Technical

specifications, (ii) Capacities of individual or inter – related Production

Centres, (iii) Operational constraints / capacity of critical machines, (iv)

Number of Shifts, and (v) Any other factor.

(c) If a product passes through different production processes and each process

is having different capacity, then the process which brings effective or

ultimate production shall be considered for deciding Installed Capacity.

(d) Installed Capacity is also known as – (i) Maximum Capacity, or (ii) Rated

Capacity, or (iii) Theoretical Capacity, or (iv) Nominal Capacity.

3. Practical

Capacity

(a) Practical Capacity = Maximum Capacity minus Normal / Unavoidable

Time Loss. So, the following adjustments are made to the Maximum


9874311319

Capacity, in order to get Practical Capacity –

Available Production Hours considering holidays, normal shut down

days and normal idle time.

Normal Time Loss in batch changeover, break downs of machines,

repairs, etc.

Loss in efficiency due to ageing of the machines / equipment, etc.

(b) Practical Capacity is also known as – (i) Operating Capacity, or (ii) Net

Capacity, or (iii) Available Capacity, or (iv) Achievable Capacity.

4. Normal

Capacity

(a) Normal Capacity is the capacity of a Plant, which is expected to be utilized

over a long period based on sales expectations.

(b) Normal Capacity = Practical Capacity minus Loss of productive capacity

due to external factors.

(c) Normal Capacity is determined based on the productive capacity achieved

over a period of time, say average of 3 normal years out of preceding 5

years or expected to be achieved over a period of time, say next 3 to 5 years.

The periods influenced by abnormalities should be excluded for this

purpose.

(d) Normal Capacity is also known as – (i) Average Capacity, or (ii) Capacity

based on Sales Expectancy.

5. Actual

Capacity

Actual Capacity Utilization is the volume of production achieved, or actual

operating hours worked, in relation to installed capacity.

14. What is meant by Idle Capacity?

1) Idle Capacity vs Excess Capacity:

Situation Difference is called ……

(a) Actual Capacity Utilization < Installed

Capacity

Idle Capacity (or) Forecast Plant Idle

Capacity.

(b) Actual Capacity Utilization > Installed

Capacity Excess Capacity Utilization

2) Abnormal Idle Capacity is the difference between Practical Capacity and Normal Capacity or

Actual Capacity Utilization whichever is higher. So, Abnormal Idle Capacity = Practical (or

sometimes Normal) Capacity minus Actual Capacity Utilization.

3) Causes: Idle Capacity may arise due to reasons like lack of product demand, non – availability of

raw material, shortage of skilled labour, absenteeism, shortage of power or fuel or suppliers,

seasonal nature of product, etc. These are identified into Normal & Abnormal and also as

Controllable & Non – Controllable.

15. Explain the treatment of Idle Capacity Costs.

1) Nature: Costs associated with Idle Capacity are mostly fixed in nature. These include

depreciation, repairs and maintenance charges, insurance premium, rent, rates, management and

supervisory costs. These costs remain unabsorbed or unrecovered due to under – utilization of

plant and service capacity.

2) Idle Capacity Costs = Aggregate Overhead related to Plant x Idle Capacity

Normal Plant Capacity

3) Treatment: Idle Capacity Costs can be treated in product costing, in the following ways –

(a) Normal and Unavoidable Reasons: Such costs arising due to normal reasons like repairs,

maintenance shut – down, job changeover, etc. should be treated as regular cost and included

as Overhead. Supplementary Overhead Rate should be used to recover the Idle Capacity Cost.

(b) Abnormal and Avoidable Reasons: Such costs arising due to avoidable reasons like faulty

planning, power failure, etc. should be charged to Profit and Loss Account.


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(c) Seasonal Factors: If the Idle Capacity Cost is due to seasonal factors, then, the cost should

be charged to the cost of production by inflating overhead rates.

16. Write a brief note on Idle Facility.

1) Facilities may be provided by fixed assets such as building space, plant equipment capacity, etc.

or by various functions such as material services, production services, personal services, etc.

2) If a Firm fails to make full use of the facilities at its disposal, the Firm may be said to have idle

facilities.

3) Idle Facilities refer to that part of total facilities which remain unutilized due to any reason such

as non – availability of raw material, power, lack of demand, etc.

4) In Cost Accounting, Idle Facilities are treated in the same way as Idle Capacity.

17. How can Pre – Determined Overhead Absorption Rates be determined?

Pre – determined Overhead Absorption or Recovery Rates may be determined in any of the following

methods.

Data used for rate determination Formula for OH Recovery Rate

1. Last Year Actuals Overhead Recovery Rate = Last Year Actual Overhead

Last Year Actual Output

2. Current Year Estimates Overhead Recovery Rate = Current Year Budgeted Overhead

Current Year Budgeted Output

3. Normal Activity Levels Overhead Recovery Rate = Normal Overhead Costs

Normal Volume of Output (or Hours)

18. What are the various bases of Overhead Absorption?

Overhead Absorption methods / bases are classified as under –

OH Recovery Rate =

Total Overheads

Direct Method (Based on Output)

Indirect Methods

(Based on factors other than Output of Product)

Method OH Recovery Rate

=

Applicability

1. Percentage

of Direct

Materials

Total Overheads

Direct Material Cost

Material – cost – related

expenses like Material

Handling Expenses,

Stores Overheads,

Indirect Materials, etc.

2. Percentage

of Direct

Labour

Total Overheads

Direct Labour Cost

When conversion process

is labour – intensive and

wage rates are

substantially uniform.

3. Percentage

of Prime

Cost

Total Overheads

Prime Cost

Rarely used method.

4. Labour

Hour Rate

Total Overheads

Direct Labour Hours


is labour – intensive.

5. Machine

Hour Rate

[See Note

2]

Total Overheads

Machine Hours


is capital – intensive or

production mainly

depends on performance

of the base.


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Units of Production

Applicable when single

product is produced or

various products are

similar in specification.

Note:

1) ABC Method: In addition to the above methods of Recovery, Activity Based Costing (ABC)

Method can also be used for OH absorption.

2) Machine Hour Rate = Total Overheads

Machine Hours

, where Total Overheads can be computed in any of the following ways –

If Total OH include Examples Machine Hour Rate is called

(a) Machine – related

Direct Costs only

Overheads directly or immediately

connected with the machines, e.g.

Power, Depreciation, Insurance,

Maintenance expenses, etc.

Direct Machine Hour Rate

(b) Machine – related

Direct and

Indirect Costs

Direct machine – related expenses plus

share of General Expenses, e.g. Rent,

Supervision, Indirect Labour,

Consumables, etc.

Simple Machine Hour Rate

(c) All Machine -

related Costs +

Operators‟ wages

All expenses of working a machine, i.e.

Total OH = Directly Related OH +

General OH apportioned + Wages of

Operator for the machine.

Comprehensive Machine Hour

Rate

19. Highlight the advantages disadvantages of the various of Overhead Absorption.

Method Advantages Disadvantages

1. Percentage

of Direct

Materials

Suitable for absorption of Material – cost –

related expenses like Material Handling

Expenses, Stores Overheads, Indirect

Materials, etc.

(a) Most OH (e.g. Depreciation,

Rent, etc.) are not related to the

cost of materials.

(b) Leads to fluctuations due to

change in Materials Prices.

(c) Ignores Time Factor which is

highly relevant for OH

absorption.

(d) Ignores activity aspects like

conversion process, skills of

workers, use of machines, etc.

2. Percentage

of Direct

Labour

(a) Simple and economical to apply.

(b) Recognizes time factor indirectly, if we

pressure same wage rates for all

departments.

(c) Leads to lower absorption differences,

as total wages paid will not fluctuate

much.

(a) Leads of inaccuracies, as time

factor is not given full

importance. The assumption of

uniform wage rates for all

departments may not be

practical.

(b) Ignores differences in workers‟

skills and performance abilities.

(c) Does not recognize the extent of

mechanical effort (machine

hours spent) in production

process.

(d) Results in wide absorption

differences due to changes in


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Direct Wages.

3. Percentage

of Prime

Cost

Rarely used method. Similar to those for Percentage of

Direct Materials.

4. Labour

Hour Rate

(a) Simple and economical to apply.

(b) More preferable than %age of Direct

Labour, for labour-intensive work,

since OH Expenses are generally a

function of time (RTP, N 95)

(a) Does not recognize the extent of

mechanical effort (machine

hours spent) in production

process.

(b) May lead to higher absorbed

costs in case of inefficient or

slow production work.

5. Machine

Hour Rate

(a) Ideal method for Capital Intensive

Departments, where labour hours spent

are not much.

(b) Helps in identifying Machine‟s Idle

Capacity. Extent of under absorption

indicates Idle Capacity.

(c) Useful when a worker attends to two or

more machines at a time, and labour

hours spent per unit cannot be

accurately determined.

(a) Data relating to operation time

of machines may not be readily

available.

(b) All departments may not be

capital – intensive.

20. What are Blanket and Departmental Overhead Recovery Rates? When should they be

used?

1) Single or Blanket or Factory Overhead Rate: It involves computation of one single overhead

absorption rate for the whole factory, as under –

Blanket OH Rate = Overhead Costs for the entire Factory

Total Output or DLH or Machine Hours for all departments in the Factory

Note: Blanket Rate should be used only in the following circumstances –

(a) Where only one major product is being produced.

(b) Where several products are produced, but –

All products pass through all departments, and

All products are processed for the same time duration in each department.

2) Multiple or Departmental OH Rates: It involves computation o separate rates for each

Department, Cost Centre and each product, for both fixed and variable overheads. It may be

computed as follows –

Multiple OH Rates = Overhead allocated / apportioned to each Department or Product

Output or DLH or Machine Hours of that Department or Product

Using multiple overhead rates, jobs or products are charged with varying amount of factory OH,

depending on the type and number of departments through which they pass. However, the number

of overhead rates which a Firm may compute would depend upon two opposing factors, viz. the

degree of accuracy desired and the clerical cost involved.

Note: Departmental Overhead Rates are used in situations where Blanket Rate cannot be applied.

21. Describe the accounting treatment of Under–absorption of Production Overheads.

Describe the accounting treatment for Over–absorption of Production Overheads.

DIFFERENCE IN ABSORPTION = OH Variance = Absorbed OH Less Actual OH

Absorbed OH is greater than Actual OH

(Credit Balance in OH Control A/c )

OVERABSORPTION

(represents Savings in OH Expenditure)

Absorbed OH is less than Actual OH

(Debit Balance in OH Control A/c)

UNDERABSORPTION

(represents Increase in OH Expenditure)


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Accounting Treatment (any one of the following) Analysed as due to –

1. Write Off: Small

amounts may be credited

to Costing P & L A/c.

2. Deferral: May be carried

over to next year, by

transfer to OH Reserve

A/c or Suspense A/c.

3. Cost Reversal: In case of

large amounts, cost of

jobs may be reduced /

adjusted by passing

reversal journal entries.

Normal Reasons

e.g. genuine planning errors,

changes in assumptions, etc.

Treated as increase COSTS

(using Supplementary OH

Recovery Rate), and

apportioned to production, i.e.

–

Abnormal Reasons

e.g. Strike Period Wages,

Labour Court Award,

Obsolete Stores, Penalties

paid etc.

Treated as LOSS and debited

to Costing P & L Account.

(Also see Note below)

Units Sold Closing Stock of

Finished Goods

Closing Stock of WIP

Debited to Cost of Sales A/c FG Control A/c WIP Control A/c

Note: When underabsorption is small and immaterial, it is fully debited / transferred to Costing P & L

A/c, irrespective of whether it is due to normal or abnormal reasons.

Reasons for Absorption Differences: OH Absorption Rates for any period are pre – determined

based on the normal activity data. However, there may be differences between Absorbed OH and

Actual OH due to the following reasons –

1) Difference between Budgeted and Actual Expenditure. (This is called as Expenditure Variance.)

2) Difference between Budgeted and Actual Output (Volume Variance), which may arise due to –

(a) Difference between planned and actual hours. (This is called as Capacity Variance),

(b) Difference between planned and actual quantity of output per hour. (This is called as

Efficiency Variance), or

(c) Difference between planned and actual days worked (This is called as Calendar Variance.)

22. What are the methods of accounting for Administrative Overheads?

Administrative Overheads may be accounted in any of the following ways –

Method Accounting Treatment Disadvantages

1. Apportioned

to

Production

and Sales

OH

(a) Administrative OH are to be collected in

different cost pools such as – (i) General

Office, (ii) Personnel Department, (iii)

Accounts Department, (iv) Legal Department,

(v) Secretarial Department, etc.

(b) Costs collected under the cost pools indicated

above are to be distributed to administrative

OH relating to production activities and

administrative OH relating to selling and

distribution activities on rational basis for

each cost pool.

(c) AOH relating to production activities are

apportioned to different Production

Departments based on Conversion Costs of

Production Departments. Such apportioned

OH are absorbed to products on the basis of

the Normal Capacity or Actual Capacity,

(a) Difficulty in finding

suitable bases of

apportionment over

production and sales

departments.

(b) Clerical work is

involved apportioning

overheads.

(c) Non-consideration of

other important

functions like finance,

research etc.


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whichever is higher. Under-absorption or

over-absorption of AOH relating to

production shall be adjusted with Costing

Profit & Loss Account.

2. Charge to

Profit and

Loss

Account

Under this method, it is considered that AOH is a

period cost, and is not related to production or

sales, since –

(a) AOH is incurred for formulation of broad

policies and not directly concerned with

production or sales.

(b) AOH cannot be equitably apportioned to

production and sales functions.

(c) AOH is mostly Fixed Costs and relate only to

the period.

(a) Costs of products are

understated, as AOH is

not charged to costs.

(b) Exclusion of AOH from

cost of products is

against sound

accounting principles.

3. Separate

addition to

Cost of

Production /

Sales

This method recognizes Administration as a

separate function like Production and Sales. So,

AOH is added separately in the Cost Sheet, to

derive Total Cost of Production. Some basis for

apportionment of AOH over products are – (a)

Works Cost, (b) Sales Value or Quantity Sold, (c)

Gross Profit on Sales, (d) Production Quantity, or

(e) Conversion Costs.

Some AOH may relate to

sales activities, and may get

included in inventory

valuation, which is against

proper a/cing principles.

23. Write a brief note on absorption / accounting of Selling and Distribution Overheads.

1) Cost Pools:

(a) Selling OH are collected under different cost like – Sales Employees Cost, Rent, Travelling

Expenses, Warranty Claim, Brokerage & Commission, Advertisement relating to Sales and

Sales Promotion, Sales Incentive, Bad Debt, etc.

(b) Distribution OH are collected under different cost pools like – Secondary Packaging, Freight

& Forwarding, Warehousing & Storage, Insurance, etc.

2) Absorption: Some items of S&D OH are directly identified and absorbed to products or services

and remaining part of S&D OH along with the with share of AOH relating to Selling &

Distribution activities are to be apportioned to various products or jobs or services on the basis of

net actual sales value (i.e. Gross Sales Value less Excise Duty, Sales Tax and other Government

levies). There are various bases in which S&D OH can be absorbed over units sold. Some

illustrative bases are –

(a) Sales Value of goods: It is considered that the Sale Value is the most logical basis, due to the

connection between the amount of sales and the amount of expenses incurred to achieve

them.

(b) Cost of Goods Sold: Not a generally used method, this can be used as an alternative to Sales

Value, only if all products have identical Selling Prices and Gross Margins.

(c) Gross Profit on Sales: This method follows the “ability to pay” principle. Hence products

yielding high profit margins are charged with higher share of Selling Overheads.

(d) Number of orders or units sold: Under this basis, expenses are classified into fixed and

variable. Fixed expense per unit is ascertained by apportioning fixed costs on the basis of

benefits received and dividing the same by the quantities sold. Some Fixed Selling Expenses

and the basis of apportionment based on benefits received are –

Expenses Basis

Sales Department / Salesmen Salaries Estimated time devoted to the sale of various

products.

Advertisement:

Specific Product Advertisement

General Company Advertisement, e.g.

To be taken at actual.

Specific advertisement on each product.


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Exhibition Expenses, Show Room

Expenses

Rent of Finished Goods Godowns Average space occupied by each product

Expenses on own Delivery Vans Average quantities delivered during a period.

Other Sales Expenses Sales Value of products (if suitable basis is not

available)

Variable Selling expenses like Packaging, Freight Outwards, Transit Insurance, Salesmen

Commission, Customers Rebate, etc. can be estimated per unit for each product separately.

Total Selling and Distribution Expenses per unit is the sum of variable expenses and fixed

expenses per unit.

24. List some arguments for including Interest & Financial Charges as OH Expenses.

The following arguments can be put forth in favour of interest to be included in Overhead Expenses –

1) Total Costs: Total Cost cannot be computed unless interest is taken into account. For example, a

timber merchant, if he buys standing trees and seasons the timber himself, would incur a large

amount of costs as interest. Another merchant who buys his timber already seasoned would

automatically have to pay a higher price, obviously, this price includes interest.

2) Capital as Factor of Production: Interest is the cost to be paid for the use of capital, and capital

is also a factor of production just as labour. Thus, if wages are included in cost, interest payment

cannot be omitted.

3) Decision – making: Wrong decisions may be taken if interest is excluded in cost calculation.

Thus a where a decision involves replacement of labour with expensive machinery; the question

of interest assumes importance. If interest is not included, the Cost Accountant may conclude that

acquisition of machinery is cheaper.

4) Processing Time Differences: When processing times for jobs differ, inclusion of interest also

allows comparison of profit on different jobs. Thus, if a job takes 3 months and another takes 6

months, the cost of the jobs must include a charge by way of interest, before profit can be

compared.

5) Inventory Control: In inventory control, interest is an important item to be considered. Where

large stocks are kept, the advantage of one time purchase is offset by increase in interest charges.

6) Quotations: While submitting tenders for cost plus contracts, etc. interest must be taken into

account.

25. Write a short note on Depreciation included as Overheads.

1) Treatment: In Cost Accounting, Depreciation is charged to the cost of production. Depreciation

of assets used in the sales function (e.g. Delivery Vans) are treated as Selling and Distribution

Overheads.

2) Reasons: The reasons for including Depreciation charges in Cost Accounting are –

(a) To show a true and fair picture in the Balance Sheet.

(b) To ascertain the true cost of production.

(c) To keep the asset intact by distributing losses / diminution in its value over a number of

years.

(d) To keep capital intact & to make a provision out of the resources for replacement of the asset

in future.

26. What is the accounting treatment of Carriage and Cartage expenses?

Expenses incurred on the transportation (inwards and outwards) of materials and goods is treated as

under –

1) Carriage inwards: Carriage Expenses related to Direct Material should be included in the cost of

Direct Material (i.e. Landed Cost), those relating to Indirect Material (Stores) should be treated

as Production OH.


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2) Carriage Outwards: Expenses related to the transportation of Finished Goods shall be treated as

Distribution OH.

27. Discuss the treatment of the cost of small tools having very short effective life.

1) Meaning: Just as Plant and Machinery are Fixed Assets employed in production, there are also

quasi – fixed assets, i.e. small tolls used for production purposes e.g. hammer, jigs, dies, etc.

However, unlike Fixed Assets, such tools have very short effective life.

2) Treatment:

(a) If the tools have a useful life of one year or less, they are treated as expense of that period and

included in Production Overheads.

(b) Where the tools have a useful life slightly above one year, the cost may be amortized over the

useful life. Alternatively, the cost of loose tools purchased is debited to Loose Tools Account.

At the end of every financial year, the loose tools are re –valued. The difference between

purchase price and year – end value is treated as expense of the year and included in

Production OH, as Loose Tools Written Off.

28. How do you deal with R&D Expenses in Cost Accounts?

1) Research Expenses: It is incurred for searching new or improved products, production methods /

techniques or plants / equipments. Research relates to original investigations to gain from new

scientific or technical knowledge and understanding. It may be –

(a) Basic Research: that which is general, and not directed towards any specific practical aim.

(b) Applied Research: that which is directed towards a specific practical aim or objective.

2) Treatment:

Basic Research Applied Research

(a) If continuous: Charged to revenue as an

expense of the period, or as a separate

functional overhead like AOH and SOH.

(b) If not continuous: Spread over a number

of years (like Deferred Revenue

Expenditure, if the amount is large).

(a) For specific existing products: Directly

charged / allocated to the product.

(b) For all existing products / methods: Treated as Manufacturing OH and absorbed

over all products.

(c) For new products: Charged to the product

if the venture is successful. Otherwise

written off to Costing P & L A/c either in

lumpsum or by amortization.

3) Development Expenses: It begins with the implementation of the decision to produce a new or

improved product or to employ a new or improved method. Treatment of Development Expenses

is the same as that of applied Research.

4) Unsuccessful Research: If Research is unsuccessful, it is appropriate to charge off that

expenditure to Costing P & L Account.

29. Should Bad Debts be included in costs?

The following views may be considered –

1) Exclusion View: One view is that „Bad Debts‟ should be excluded from cost. According to this

view, Bad Debts are financial losses, and therefore, should not be included in the cost of a

particular job or product.

2) Inclusion View: According to another view, Bad Debts should form part of S&D OH, especially

when they arise in the normal course of trading. So, Bad Debts should be treated in cost

accounting in the same way as any other Selling and Distribution Cost.

However, extraordinarily large Bad Debts should not be included in cost accounts.

30. Indicate giving reasons, whether the following items are to be dealt with in Cost Accounts

mentioning whether and how any of these items is to be included in the Total Cost.


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(i) Royalties paid on Patents of other party

used in own manufacturing process 1. Direct Expenses or Chargeable

Expenses: These are expenses

other than materials and labour

which can be allocated directly

to jobs, products, processes, cost

centers‟ or cost units. Direct

Expenses are “cost other than

material and wages which are

incurred for a specific product or

saleable services”.

2. Nature of Direct Expenses: (a)

These are expenses other than

Direct Materials and Direct

Labour, (b) These are either

allocated or charged completely

to Cost Centres or Cost Units, (c)

These are included in the Prime

Cost of a product.

3. Examples: (g) Hire Charges of special machinery or

plant for a particular production order or

job.

(h) Payment of Royaties.

(i) Cost of special moulds, designs &

patterns.

(j) Sub-Contracting Expenses or outside

work costs, where jobs are sent out for

special processing.

(k) Experimental cost before undertaking the

job.

(l) Travel & Conveyance Expenses for a

particular job.

4. Documentation: The basic

document which is used for

charging of Direct Expenses to

products or batches or work

order, is the Invoice received

from Suppliers of such service.

The payment to supplier of

service is made on the basis of

the Invoice, and the expenses are

booked in the accounts.

5. Identification of Direct

Expenses: For the identification

of Direct Expenses with the main

product or service, the code

number of that product or service

should be inscribed on invoice

received from supplier of

services. For example, if a

machine is hired to complete a

particular product, then the Hire

Charges paid for that machine is

a Direct Expenses of that

particular product. For charging


9874311319

these Hire Charges to that

particular product, the invoice /

bill received towards Hire

Charges should be coded /

inscribed with the Product Code,

to ensure that this expense is

charged to that particular

product. Alternatively, if cash is

paid, then the Cash Book

Analysis will show the Product

Code which is to be charged with

the cost of hiring machinery.

Based on Relationship, costs are classified

into –

Type and

Description

Components

3. Direct Costs:

Costs which are

directly related to /

identified with /

allocated to a Cost

Centre or a Cost

Object, in an

economically

feasible way, are

called Direct Cost.

Total of all Direct

Costs is called

Prime Cost.

Direct

Material

Cost,

Direct

Labour

Cost, and

Direct

Expenses.

4. Indirect Costs:

All Costs other than

Direct Costs are

called Indirect

Costs.

Total of all Indirect

Costs is called as

Overheads (or

Oncost), since they

are generally

incurred over

various products

(Cost Units),

various departments

(Cost Centres) and

over various heads

of expenditure

accounts.

Indirect

Material,

Indirect

Labour,

and

Indirect

Expenses.

A summary of Direct and Indirect Costs is

given below –

Item and Description

Example

7. Direct Material: Costs of Material which

can be directly allocated to a Cost Centre or a

Cost Object in an economically feasible way.


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Raw Materials Consumed for production for a

product or service, which are identifiable in the

product or service.

8. Direct Labour: Cost of Wages of workers



Wages include all Fringe Benefits like PF



Encashment, Wages for holidays and idle time,

etc.




Cost Object.

Expenses for special moulds used in a particular

Cost Centre, Hire Charges for tools &

equipments for a Cost Centre, Royalties in

connection to a product, Job Processing Charges,

etc.




Consumable Spares and Parts, Lubricants, etc,

i.e. materials which are of small value and cannot

be identified in or allocated to a product / service.

11. Indirect Labour: Wages of Employees

which are not directly allocable to a

particular Cost Centre.


Accounts Department, Salaries of Security Staff,

etc. (N 01)




Centres.



(ii) Fines recovered from Workers Either ignored, or Reduction from Labour Cost.

(iii) Handling Expenses of Material & Stores Based on Relationship, costs are classified

into –

Type and

Description

Components

1. Direct Costs:

Costs which are

directly related to /

identified with /

allocated to a Cost

Centre or a Cost

Object, in an

economically

feasible way, are

called Direct Cost.

Direct

Material

Cost,

Direct

Labour

Cost, and

Direct

Expenses.


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Total of all Direct

Costs is called

Prime Cost.

2. Indirect Costs:

All Costs other

than Direct Costs

are called Indirect

Costs.

Total of all Indirect

Costs is called as

Overheads (or

Oncost), since

they are generally

incurred over

various products

(Cost Units),

various

departments (Cost

Centres) and over

various heads of

expenditure

accounts.

Indirect

Material,

Indirect

Labour,

and

Indirect

Expenses.

A summary of Direct and Indirect Costs is

given below –

Item and Description

Example

1. Direct Material: Costs of Material

which can be directly allocated to a Cost

Centre or a Cost Object in an

economically feasible way.

Raw Materials Consumed for production for a

product or service, which are identifiable in the

product or service.

2. Direct Labour: Cost of Wages of workers



Wages include all Fringe Benefits like PF



Encashment, Wages for holidays and idle time,

etc.




Cost Object.

Expenses for special moulds used in a particular

Cost Centre, Hire Charges for tools &

equipments for a Cost Centre, Royalties in

connection to a product, Job Processing Charges,

etc.




Consumable Spares and Parts, Lubricants, etc,


9874311319

i.e. materials which are of small value and cannot

be identified in or allocated to a product / service.

5. Indirect Labour: Wages of Employees

which are not directly allocable to a

particular Cost Centre.


Accounts Department, Salaries of Security Staff,

etc. (N 01)




Centres.



Based on functions, Overheads are classified into

four types, viz. –

Classification Sub – Classification

1. Factory or

Manufactu

ring or

Production

OH

(d) Stores Overheads (expenses connected

with purchasing &

handling of materials)

(e) Labour Overheads (expenses connected

with labour and

amenities), and

(f) Factory

Administration

Overheads (expenses

connected with

administration of

Factory).

2. Office and

Administra

tive OH

(c) Office Expenses (incurred on routine

office work –

Telephone, Stationery,

etc. ), and

(d) Administrative

Expenses (incurred on

Office Personnel, i.e.

their Salaries, Facilities,

etc.)

3. Selling and

Distributio

n OH

(c) Selling Expenses (incurred to persuade

customers to purchase

the Firm‟s products and

/ or engage its services,

that is to maintain &

expand the market), and

(d) Distribution Expenses (incurred to execute

orders).

4. R&D OH (b) Research Expenses and

(b) Development

Expenses.


9874311319

(iv) Loss of stores Differences between Physical Stock and Book

Stock are dealt with as under –

Reduction / Difference in Material

Quantity, i.e. Shortage = Material Losses

Normal Loss Abnormal Loss

i.e. Expected, Unavoidable, Non – Controllable

i.e. Beyond Expectations,

Standards set based on part data Above Normal

Treated as Regular Cost Treated as Loss

(a) As Direct Materials by

inflating Issue Price [or] Charged off, i.e.

Debited to

(b) As Production Overheads

Costing Profit and Loss A/c.

Example: Suppose 100 kgs of Materials are

bought at Rs.9 per kg. The Normal Storage Loss

is 10%. Hence Total Material Cost of Rs.9 x 100

= Rs.900 may be distributed over net quantity

(100 kg – 10% = 90 kgs.). Hence Price per kg for

costing purposes will be Rs.900 ÷ 90 kgs = Rs.10

per kg. Alternatively, Cost of 10 kgs Normal

Loss x Rs.9 = Rs.90 may be treated as Production

Overheads.

CHAPTER 5

COST ACCOUNTING SYSTEMS

1. Briefly describe about the Non-Integrated Accounting System.

1) Meaning: The Non – Integrated or Cost Control System seeks to recognize the movements and

flows of Cost within the Firm. For example, materials issued to production, Production OH

absorbed, abnormal costs etc. are not recognized and recorded specifically in the financial

accounting system. These cost transactions within the Firm are recorded under the cost

accounting system.

2) Ledgers: The following Ledgers are maintained under the Non – Integrated Accounting System –

(a) Stores Ledger or Raw Material Ledger – for every item of Raw Materials and Stores items.

(b) Job Ledger or Work in Progress Ledger – for showing item of Raw Materials and Stores

items.

(c) Stock Ledger or Finished Goods Ledger – for every item of Finished Product manufactured.

(d) Cost Ledger – for preparing Control Accounts in respect of the above Subsidiary Ledgers,

and also for impersonal accounts.

2. What are the features of the Non – Integrated Accounting System?

Write short notes on General Ledger Adjustment A/c Cost Ledger Control A/c.

1) Entity Aspect: Cost Flows / movements within the Firm as well as transactions with outsiders

(Suppliers, Customers) are captured by the system, e.g. issue of materials from Stores to

Production Department is recognized as a transaction, even if no outsider is involved.


9874311319

2) No Personal Accounts: The Non – Integrated System involves the use of Nominal Accounts and

three Real Accounts (Stores Ledger Control A/c, WIP Control A/c, and Finished Goods Control

A/c). Personal and other Real Accounts are not used in this system.

3) General Ledger Adjustment Account: For completing contra – posting involving Personal

Accounts and other Real Accounts (Cash, Bank, Assets, etc.), the General Ledger Adjustment

Account is used. This account is also called as Cost Ledger Adjustment, or Cost Ledger Control,

or General Ledger Control A/c.

4) Costing P&L A/c: A Trial Balance is drawn under this System. The Costing P&L Account is

prepared, to ascertain the Profits as per Cost Records. Balance Sheet is not prepared under this

System.

5) Reconciliation: Non – cost transactions are not fully recorded by this System. Hence, whenever

Non – Integrated System is in use, regular Financial Accounting should also be done in parallel.

This creates the need for reconciling between Profits as per Cost Records and Profits as per

Finished Records.

3. What are the features of the Integrated or Integral System of Accounting?

1) Integrated or Integral Accounting System is the system of accounting, wherein Cost and Financial

accounts are kept in the same set of books.

2) Integrated Accounts provide the entire information requirements of costing as well as Financial

A/cs.

3) For Costing purposes, the system will provide information useful for ascertaining the Cost of

each product, job, process, operation or any other identifiable activity and for carrying necessary

analysis.

4) Further, the system will provide all the information necessary for preparing Profit and Loss A/c

and the Balance Sheet as per legal requirements. It also helps in exercising effective control over

the liabilities and assets of the business.

5) The General Ledger Adjustment Account is not used, since the contra entry postings are made in

the respective Real and Personal Accounts.

4. What are the advantages of the Integrated System of Accounting?

1) The question of reconciling costing and financial profit does not arise, as there is one figure of

profit only.

2) There is a significant extent of saving in efforts made, (in recording and audit / verification) due

to use of one set of books.

3) No delay is caused in obtaining information as it is provided from books of original entry.

4) It is economical as it is based on the concept of “Centralisation of Accounting function”.

5. What are the essential pre – requisites to install the Integrated Accounting Systems?

The pre – requisites of Integrated Accounts include –

1) Extent of Integration: The management should decide on the extent of integration of costing and

financial books. Some concerns find it useful to integrate upto the stage of Prime Cost or Factory

Cost while others prefer full integration of the accounting records.

2) Codification: A suitable coding system must be made available so as to serve the accounting

purposes of financial and cost accounts.

3) Account Closing Procedures: There should be an agreed routine or scheme of action as regards

annual account closing procedures, with regard to the treatment of provision for accruals, prepaid

expenses, other adjustments relevant for preparation of interim accounts.

4) Co – ordination: A high degree of co – ordination should exist between the staff responsible for

the financial and cost aspects of accounts. Efficient processing of accounting documents should

also be ensured.


9874311319

6. List some items causing difference between Cost & Financial Books.

Why is it necessary to reconcile the profits between Cost Accounts and Financial Accounts?

“Reconciliation of Cost & Financial Accounts in the modern computer age is redundant”.

Comment.

The Chief Accountant of K Ltd found that the profit was the same as per Cost as well as

Financial Accounts. State whether reconciliation is necessary in such a case.

The major causes that give rise to differences in the Cost and Financial Accounts and hence affect

profits reported under the two accounting systems include –

1) Differences in Stock Valuation: In Financial Records, Stocks are valued at Cost or Net

Realisable Value (NRV), whichever is lower. However, in Cost Books, stocks may be valued

only at cost, based on the assumption that Cost is lower than NRV.

2) Differences in Absorption: Actual expenditure incurred during the period is charged to Profit

and Loss Account under the Financial Accounting system. In the Cost books, Absorbed

Overheads are related to production. There may be overhead variances or differences, due to

various reasons. Hence over – absorption or under – absorption leads to differences in profits

reported.

3) Items included in the financial accounts but not in cost accounts: Some examples are –

(a) Appropriation of Profits, e.g. Dividends, Transfer to General Reserve or Dividend

Equalization Reserve.

(b) Amounts written off on Goodwill, Preliminary Expenses, Underwriting Commission, etc.

(c) Non – Operating Incomes like Rent, Interest and Dividends, Transfer Fee Received, etc.

(d) Matters of pure finance like Interest paid, Provision for Bad Debts, etc.

(e) Special items like Losses on sale of assets, Expenses of Company‟s Share Transfer Office, if

any, Damages and penalties payable for contravention of law, etc.

4) Items included in the cost accounts only, but not in the financial accounts: These are notional

expenses or imputed costs, which are not considered in the financial accounts. Some examples are

–

(a) Charges in lieu of rent when premises are owned.

(b) Interest on capital employed in production, but upon which no interest is actually paid if the

Firm decided to treat interest as part of cost.

(c) Salary for Proprietor where he works but does not take a salary.


9874311319

OVERVIEW OF THE NON – INTEGRATED SYSTEM

RM Purchased

Raw Material

Control Account

RM Issued

WIP

Control

Account

Sales Account

FG Prodn

at Factory

Cost

Sales made Wages Control

Account

Finished

Goods

Control

Account

General Ledger

Adjustment

Account

Indirect Wages

Cost of Fin.

Goods Sold Factory OH

Control Account

Cost of

Sales

Account

Sales transfer to

P&L

Administration

OH Control

Account

Costing P & L

Account

Profit transfer to

GLA S & D OH

Control Account

Total

Wages

Paid

POH

incurred

AOH

incurred

SOH incurred

SOH absorbed

AOH absorbed

POH

absorbed

Dir

Wages

Indirect

Material

issued


9874311319

OVERVIEW OF THE INTEGRATED SYSTEM

Sal

es

Led

ger

Deb

tors

Co

ntr

ol

Sal

es

Acc

ou

nt

Pro

fit

and

Lo

ss

Acc

ou

nt

Cost

of

Sal

es

Fin

ish

ed G

ood

s

Led

ger

Job /

Pro

cess

Led

ger

WIP

Contr

ol

Fin

ished

Goods

Contr

ol

A/c

Sto

res

Led

ger

Pu

rchas

e

Led

ger

Raw

Mat

eria

l

Contr

ol

A/c

C

redit

ors

Co

ntr

ol

Wag

es

Co

ntr

ol

OH

Co

ntr

ol

Ex

pen

ses

ger

Cas

h B

ook

Pla

nt

Led

ger

Fix

ed A

sset

Contr

ol

A/c

Mis

cell

aneo

us

Acc

oun

ts

Loan

s, A

dvan

ces,

Dep

osi

ts,

Lia

bil

itie

s

Acc

oun

ts

Pro

fit


9874311319

CHAPTER 6

CONTRACT COSTING

1. What do you mean by Contract Costing?

1) Contract: Contract refers to a large job / assignment / work order, where the execution of work is

spread over two or more financial years. Generally, a Contract commences in one financial year,

but ends in a different year.

2) Contract Costing: Contract or Terminal Costing involves ascertainment of costs of contract. It is

an extension of principles of job costing for long – term projects like Civil Construction, Ship

Building, Interior Decoration, etc.

2. List out the features of Contract Costing.

The following are the major features of Contract Costing –

1) Parties Involved: The parties to a contract are – (a) Contractor – One who undertakes and

executes work under a contract, and (b) Contractee – One for whom the work is undertaken.

2) Site Work: Major part of the work in each contract is generally carried out at the site of the

contract.

3) Direct Expenses: Most of the expenses incurred by the Contractor are directly relatable to the

site.

4) Indirect Expenses: Indirect Expenses, e.g. Administrative Office Expenses and common

expenses are apportioned to various contracts on appropriate basis. For example, depreciation of

common equipment used on various contracts is apportioned on the basis of the number of days

the equipment has been used on various contracts.

5) Separate Accounts: A separate account is maintained for each contract, to ascertain Profit or

Loss.

6) Cost Centre and Cost Unit: The Cost Centre (place) and Cost Unit (output) in Contract Costing

is the Contract itself, e.g. Building Construction.

7) Recognition of Profit: A contract usually takes long time periods for completion. In certain

years, no contract might be completed, while in others, many contracts may be completed.

Recognition of Profits after full completion of contract might lead to wide fluctuations in profit

every year. To avoid these fluctuations, profits are generally recognized every year on the basis of

percentage of completion and the amount of Notional Profit.

3. Distinguish between Job Costing and Contract Costing.

Job Costing Contract Costing

i. Job refers to any specific assignment, contract or

work order wherein work is executed as per

customer‟s requirements.

Contract refers to a large job / assignment /

work order. The execution of work is

spread over two or more financial years.

ii. Job Costing is applied in Printing Press, Furniture

works, Interior Decoration and other similar work.

Contract Costing is applied in activities like

Civil Construction, Ship Building, etc.

4. What do you mean by Cost plus Contract? List its merits and demerits.

1) Meaning: A Cost plus Contract is one where the Contract Price is ascertained by adding a

percentage of profit to the total cost of the work. Such type of contracts is entered into when

contract costs cannot be estimated with reasonable accuracy due to unstable conditions e.g.

material prices, labour, etc.

2) Advantages and Disadvantages:


(a) The Contractor is assured of a fixed

percentage of profit. There is no risk of

(a) There is no incentive to the Contractor to

avoid wastages and achieve economy in


9874311319

incurring any loss on the contract.

(b) It is useful particularly when the work to be

done is not definitely fixed at the time of

making the estimate.

(c) Contractee can ensure himself about the

cost of the contract, as he is empowered to

examine the books and documents of the

Contractor, to ascertain the accuracy of the

costs.

production.

(b) The Contractee may not know the actual

cost of contract till its completion, unlike a

Fixed Price Contract, where his outflow /

cost is pre – determined.

5. What do you mean by Fixed Price Contract? What are its advantages and disadvantages?

1) Meaning: A Fixed Price Contract is one where the Contract Price is fixed and determined in

advance at the time of entering into the agreement. Such type of contracts is entered into when

contract costs can be reasonably estimated with a degree of certainty.

2) Advantages and Disadvantages:


(a) The Contractee‟s outflow on the contract is

known and determined in advance.

(b) It is useful specially when the costs of

work to be done can be determined with

certainty.

(a) Contractor may resort to the use of

materials of lesser quality / price to increase

his profit margin.

(b) Contractor may incur losses if he had not

estimated the contract costs properly or if

price levels increase due to abnormal

reasons, after entering into the agreement.

(c) Contractee cannot have any idea about the

real costs since he cannot examine the

books of the Contractor.

6. What do you mean by Escalation Clause?

1) In Fixed Price Contracts, the Contract Price is fixed and pre – determined. If there is an increase

in prices of materials, rates of labour, etc. during the period of execution of a contract, the Total

Contract Costs may rise and the Contractor‟s profit may be reduced.

2) This increase in prices may induce the Contractor to use materials of lower quality and price in

order to maintain his profit margin on the contract.

3) To overcome such a situation, the agreement generally contains a stipulation that the Contract

Price will be increased by an agreed amount or percentage, if the prices of materials, wages etc.

rise beyond a particular limit. Such a stipulation / condition is called Escalation Clause.

4) Accounting Treatment: The amount of reimbursement due should be determined by reference to

the Escalation Clause. The amount due from the Contractee should be recorded by the following

Journal Entry in the Contractor‟s Book, at the end of every each year –

Contractee‟s Account Dr.

To Contract Account

7. What is meant by – (1) Value of Work Certified, and (2) Cost of Work Uncertified?

Income on a Contract = Value of Work Certified + Cost of Work Uncertified

These two terms are explained below –

Value of Work Certified Cost of Work Uncertified

(a) As per the prevailing business practices in contract

activity, the Contractor raises periodical bills on

(a) It represents the cost of work, which has

been carried out by the Contractor but is

Note: Alternatively, the amount due under Escalation Clause can

be added to the value of Work – in – Progress at the end of every

year.


9874311319

the Contractee. Such bills are raised on the basis

of Architect‟s or Surveyor‟s Certificates stating

the extent and value of work completed.

(b) Hence, that portion of the work which has been

completed by the Contractor and certified by the

Architect / Surveyor is called as Work Certified.

(c) Value of Work Certified constitutes Income on the

Contract, and is credited to the Contract A/c and

debited to Work – in – Progress A/c (if the

contract is in progress) or to Contractee‟s A/c (if

the contract is completed).

not certified by the Architect / Surveyor.

(b) It constitutes the work completed from

the date of the earlier certification will

the end of the accounting year. The Cost

of Work Uncertified is also credited to

Contract A/c under the head “Work in

Progress”.

(c) Cost of Work Uncertified = Total Cost to

date Less Cost of Work Certified Les

Material in Hand Less Plant at Site (at

WDV).

Total Work done during the period

Date of

commencement of

contract work e.g.

12th May

Work Certified Date of last certificate

by Architect / e.g. 10th

Dec.

Work Uncertified End of

financial year

e.g. 31st Dec.

8. Distinguish between Work Certified and Work Uncertified.

Work Certified Work Uncertified

1. It represents work done during the period, and

also certified by the Architect / Surveyor.

It represents work done during the period but

not yet certified by the Architect / Surveyor.

2. The amount of Work Certified is based on

Architect‟s Certificates.

Cost of Work Certified is based on the

Contractor‟s own estimate.

3. It includes profit element, since it is based on

Contract Price.

It is a conservative cost estimate and does not

include any profit element.

4. It is considered for calculating percentage of

completion.

It is not considered in calculation of percentage

of completion.

5. It provides the basis for claiming periodical

Progress Payments from the Contractee.

It arises due to time gap between the date of

previous certificate to the close of the financial

year.

Note: Value of Work Certified and Cost of Work Uncertified constitute Income on a Contract, and is

credited to the Contract Account in the books of the Contractor.

9. What is meant by (a) Progress Payments and (b) Retention Money?

1) Progress Payments / Cash Received:

(a) Payments received by the Contractors when the contract is “in – Progress” are called Progress

Payments or Running Payments.

(b) Such payments are released by the Contractee on the basis of Architect‟s Certificates and as

per the terms of the Contract.

(c) Generally, the entire amount of work certified is not fully paid. A percentage of the amount

due (called Retention Money) is retained and only the balance is paid to the Contractor.

2) Retention Money:

(a) The amount withheld by the Contractee while making progress payments, is called Retention

Money.

(b) Retention Money = Value of Work Certified Less Progress Payments.

(c) Retention Money is withheld for the following purposes –

To ensure completion of entire contract and compliance with the terms of the Contract.

To act as security for any defective work, which may be discovered later within guarantee

period.


9874311319

To meet repair costs arising due to defective work in case contractor does not rectify it at

his cost.

To provide a safeguard against the risk of loss due to faulty workmanship.

Note:

10. What is meant by Notional Profit?

1) Actual Profit on a Contract can be ascertained only after it is entirely completed. However for

recognition of profits during the course of contract, the concept of Notional Profit is used.

2) Notional Profit is the excess of Income till date over Expenditure till date on a contract. Notional

Profit can be ascertained as under –

Notional Profit = Income till date

(i.e. Value of Work

Certified + Cost of Work

Uncertified)

Less

Expenditure till date

(Total Costs on Contract, after adjusting

Materials at Site, WDV of Plant at Site,

Prepaid / Accrued Expenses, etc.)

11. List the rules / principles for recognition of profit on incomplete contracts.

Profit on Incomplete Contracts is recognized based on the Notional Profit and Percentage of

Completion. The rules of recognition are –

Description Percentage of Completion Profit to be transferred to P & L A/c

1. Initial Stages ≤ 25% NIL

2. Work Performed

but not substantial

26% to 50% 1 x Notional Profit x Cash Received

3 Work Certified

3. Substantially

completed

51% to 90%

(See Note c)

2 x Notional Profit x Cash Received

3 Work Certified

4. Almost complete 91% to 99%

(See Note c)

Profit is recognized on the basis of

Estimated Total Profit (See Question 16)

5. Fully complete 100% Notional Profit x Cash Received

Work Certified (See Note d)

Notes:

(a) Percentage of Completion = Work Certified

Contract Price

(b) If there is a loss at any stage, i.e. irrespective of percentage of completion, such loss should be

fully transferred to the Profit and Loss Account.

(c) Substantially completed can also be considered as 51% to 95% completed. In such case, the

next slab of Almost Complete contracts will be taken as 95% to 99% completed.

(d) For fully complete contracts, the balance portion of profit is recognized only upon receipt of

Retention Money. If entire amount is fully received, the whole of profit can be recognized.

(e) The principle of prudence / conservatism is generally followed for recognizing profit. Hence,

for exact 50% completion, 1/3rd

of Notional Profit will be recognized (and not 2/3rd

).

12. How will you recognize profits on almost complete contracts (91% - 99% completion)?

Discuss the process of estimating profits / losses on incomplete contracts.

Profits on almost complete contracts are recognized on the basis of Estimated Total Profits (ETP).

Suppose a contract (Value = Rs.100 Lakhs) is 95% complete by the close of a financial year and gets

completed on 18th May. The accounts for the period ending 31

st March are finalized only in the month

of May. By the time the accounts are finalized, the contract is fully complete and the costs thereof can

be obtained. Thus, the following profits are calculated –

Close of Financial

Year e.g. 31st

March

Additional Costs

incurred on the

contract

Date of Completion of

Contract e.g. 18th May

Date of finalization of

accounts for last financial

year e.g. 31st May

Work Certified = Progress Payments + Retention Money.


9874311319

Cost till date Rs.82

Lakhs

Rs. 9 Lakhs Estimated Total Costs

82 + 9 = Rs.91 Lakhs

Notional Profit = Work Certified Less Cost incurred till date = (100 x 95%) – 82 = Rs.13

Lakhs.

Estimated Total Profit = Contract Price Less Estimated Total Contract Costs = 100 – 91 = Rs.9

Lakhs.

Any of the following alternative formula may be used for recognition of profit –

(a) Estimated Total Profit x Work Certified

Contract Price i.e. ETP x Percentage of Completion

(b) Estimated Total Profit x Work Certified x Cash Received

Contract Price Work Certified i.e. ETP X Percentage of Completion

x %age of Payment

(c) Estimated Total Profit x Cost till date

Estimated Total Costs i.e. ETP x Percentage of Costs incurred

(d) Estimated Total Profit x Cost till date x Cash Received

Estimated Total Costs Work Certified i.e. ETP x %age of Cost

Incurred x %age of Payment

(e) Notional Profit x Work Certified

Contract Price i.e. Notional Profit x Percentage of Completion

(f) 2 x Notional Profit x Cash Received (See Note 4)

3 Work Certified i.e. Formula relating to substantially

Complete contracts.

Note:

1) ETP based formula can be applied –

(a) For almost complete contracts (91% - 99%), or

(b) For any other contract above 25% complete, if future costs can be reasonably estimated.

2) In the absence of any specific requirement or other information, Formula (b) may be applied.

3) Even where the ETP related information is available, Notional Profit may also be used to

recognize profit. Hence, Formula (e) & (f) may be applied for profit recognition.

4) Formula (f) shall be modified as 1 x Notional Profit x Cash Received,

3 Work Certified in case of 26% to 50%

complete contracts

5) The Profit recognized / transferred to the P & L Account should be determined on prudence /

conservatism basis, i.e. if all the formulae are applied, the least of the resulting profits should be

considered.

6) If the amount of Notional Profit is less than the amount to be recognized by applying the above

formula, then profit transferred to P & L A/c shall be the least of the two. (e.g. If Profit to be

recognized based on ETP is Rs.48,000, but Notional Profit is only Rs.36,000, then the amount

transferred to P & L A/c shall be Rs.36,000 only).

13. How is WIP displayed in the Balance Sheet till a contract is completed?

WIP is generally displayed as under – (only Balance Sheet abstract is given here)

Liabilities Rs. Assets Rs.

CURRENT ASSETS: Contract Work – In – Progress

Value of Work Certified

Add: Cost of Work Uncertified

Add: WDV of Plant at Site

Add: Cost of Materials at Site

Sub – Total

Less: Reserve Profit

Net Balance

Less: Balance in Contractee‟s Personal A/c

Net Value of Contract WIP


9874311319

CHAPTER 7

JOINT PRODUCTS AND BY PRODUCTS

1. What do you mean by Joint Products?

Meaning: Joint Products are - Example

1. Two or more products,

2. Produced from the same process or operation,

3. Considered to be of relatively equal

importance.

In refining Crude Petroleum, gasoline, fuel oil,

lubricants, paraffin, coal tar, asphalt and

kerosene are all produced. These are known as

Joint Products.

2. What are Co–Products?

Meaning: Co-Products are - Example

1. Two or more products,

2. Belonging to the same line of activity, but

arising from different processes or

operations,

3. Considered to be of relatively equal

importance.

Rice and Wheat are agricultural produce, but

they arise from different cultivation processes.

So, they are Co-Products. Similarly Timber

Boards made from different trees are Co-

Products.

3. What are By-Products?

1) Definition: By-Products are “products recovered from material discarded in a main process, or

from the production of some major products, where the material value is to be considered at the

time of severance from the main product.”

2) Meaning: By-Product refers to incidental waste, arising during the course of manufacture, which

has a commercial name and value. It refers to secondary or subsidiary product incidentally arising

during the manufacturing process.

3) Examples: (a) Molasses arising in the manufacture of sugar, (b) Tar, Ammonia and Benzole

obtained on carbonization of coal, and (c) Glycerine obtained in the manufacture of soap.

4. Distinguish between Joint Products and By-Products.

Particulars Joint Products By-Products

1. Meaning Two or more products, separated in the

course of the same processing operation,

considered as relatively equally important.

Products recovered from material

discarded in a main process.

2. Nature Internationally manufactured. Incidentally arises during process.

3. Importance Comparatively higher Sale Value. Comparatively lower Sale Value.

5. Distinguish between Joint Products and Co-Products.

Particulars Joint Products Co-Products

1. Process Joint Products are produced from

the same process or operation.

Co-Products arise from different processes or

operations, but belong to the same line of

activity.

2. Materials Joint Products are produced from

common Raw Material only.

Co-Products may arise from – (a) common raw

material (e.g. Chairs, Tables made from same

wood), or (b) different raw material (e.g. Rice

and Wheat).


9874311319

6. What meant by Split-Off Point? What is its significance?

Split Off Point refers to the stage or point of production, wherein common raw material gets split or

identified into two or more Finished Products. The Split-Off point is significant is Joint Product

Costing, since costs are classified and ascertained by reference to the Split-Off Point as under –

1) Common Costs – pre-split off point – generally incurred for all products and hence apportioned

to the products. (Since finished products are not identified before the split – off point).

2) Specific Costs – post-split off point – specifically identified for each product.

7. What are the methods of apportionment of Joint Costs?

The following are the methods of apportionment of joint costs over Joint Products-

1) Physical Quantities Method,

2) Average Unit Cost Method,

3) Survey / Technical Evaluation / Points Method,

4) Market Value Methods.

Note: Under Market Value Methods, there are options as to Market Value, viz.-

(a) Market Value at Split off,

(b) Market Value after Further processing,

(c) Net Realisable Value at Split-Off where NRV = Final Sales Value Less Profit Margin Less

S&D OH Less Further Processing Costs.

8. How Joint Costs are apportioned using the Average Unit Cost Method?

1) Meaning: Under this method, Total Joint Costs upto the split off point are divided by total units

of joint products produced. Costs are apportioned in the ratio of quantities produced.

2) Suitability: If this method is used as the basis for price fixation, then all the products may have

more or less the same price. Hence, customers of high quality items will derive benefit as they

pay less price on their purchase.

3) Disadvantages: Here, all Joint Products will have uniform cost per unit. Relative importance is

not considered.

9. Briefly describe the contribution Margin Method.

This method involves the following steps-

Step Procedure

1 Classify Joint Process Costs into- (a) Variable Costs and (b) Fixed Costs.

2 Apportion Variable costs to Joint Products using any of the earlier 3 methods i.e. (a) Physical

Quantities, (b) Average Unit Cost or (c) Survey Method.

3 Compute Total Variable Costs = Apportioned Variable Costs + Post Split Off Variable Costs.

4 Compute Contribution = Final Sales Value Less Total Variable Costs.

5 Apportion Fixed Joint Costs on the basis of contributions.

10. How are Joint Costs apportioned based on Market Values?

Joint Costs may also be apportioned based on Sale Values of products. This has the advantage of – (a)

being the most popular and convenient method and (b) using a realistic basis for apportioning Joint

Costs since apportionment is based on “what the traffic can bear”.

1) Market Value at Split-Off Point: Sale Value at Split off point is used if Joint Products are

marketable at the Split off Point, without further processing. It is a useful method where further

processing. It is a useful method where further processing costs are not proportional. However, it

cannot be used when the products are not marketable as such, at the split-off point.

2) Market Value after Further Processing: Under this method, Sale Value after further

processing, i.e. Final Sales Value is considered. It is useful for products, which are volatile and

not marketable at the split-off point. However, this method cannot be used when –

(a) Further Processing Costs of various products are disproportionate, and

(b) All Joint Products are not subjected to further processing.

3) Net Realisable Value (NRV) method: Joints Costs are apportioned in the ratio of Net Realisable

Value at Split – Off Point. NRV is computed by deducting the following from the Final Sales


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Value – (a) Estimated Profit Margins, (b) Selling and Distribution Expenses, if any, and (c)

Further Processing Costs.

11. When a By-Product is also produced, how are the costs of the Main Product ascertained?

How are Joint Costs associated with By-Products?

Explain the treatment of By-Product Cost in Cost Accounting.

The following methods may be adopted for recognizing Joint Costs in relation to By-Product and in

determining the cost of main product –

1) Market Value of By-Product: To arrive at the cost of the main product, the amount realized on

sale of the by-product is deducted from the total cost of production. For example, the amount

realized by the sale of molasses in a sugar factory goes to reduce the cost of sugar produced in the

factory. (Note: In Process Costing, Normal Loss is accounted for in this manner.)

2) Net Realisable Value: Under this method, the NRV of the By-Product (at Split-Off Point) is

deducted from the cost of production, instead of the Gross Sales Realization of the By-Product.

This is suitable when the By-Product requires additional processing and additional expenses are

incurred in making it saleable.

3) Standard Cost of By-Product: Since market values may fluctuate, in order to ascertain the

normal cost of the main product, By-Products may be valued at standard costs. These standards

are determined by scientific estimated based on past experience and technical data. This method

may be adopted where the By-Product is not saleable in the condition in which it emerges or

comparative prices of similar products are not available.

4) Comparative Price: Here, the value of the By-Product is ascertained by reference to the price of

a similar or an alternative material.

5) Re-use or Opportunity Costs basis: Sometimes, the By-Product may be reprocessed in the same

process as part of the input of the process. In such a case, it should be valued at the cost of

materials introduced into the process. If, however, the By-Product can be put into an earlier

process only, the value should be the same as for the materials introduced into the process.

12. How are By-Product Costs / Revenues treated in Cost Accounts?

By-Product Accounting may be in any of the following methods –

1) When they are of small total value: In such case, the sale realization of By-Products is treated as

under –

(a) Credit to the P & L Account either as Miscellaneous Income or as Additional Sales Revenue.

(b) Reduction from Total Costs (either cost of production or cost of sales) of the main product.

2) When the By-Products are of considerable total value: When the sale value is considerable,

they should be treated as Main / Joint Products. The Joint costs of production should then be

ap0portioned using appropriate methods like physical quantities or average unit cost or market

value methods etc.

3) When they require further processing: In such a case, the Net Realisable Value of the By-

Product at the split – off point should be derived.

NRV at Split-Off = Final Sales Value Less Profit Margin Less Selling Overheads Less

Further Processing Cost.

If such NRV is small, it may be treated as credit to P & L Account or Joint Process Cost

Account.

If such NRV is considerable, the By-Product it should be treated as a Joint Product.

CHAPTER 8

PROCESS COSTING

1. What is a Process? What is Process Costing?

1) Process: Process is a district stage in manufacturing or production, wherein Raw Material is

converted from one identifiable form into another, before it is finally converted into the saleable

final product.


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2) Process Costing:

(a) It is a method of costing, whereby costs are charged to processes or operations, and averaged

over units produced.

(b) This method is useful in the manufacturing of products like steel, soap, chemicals, rubber,

vegetable oil, paints, varnish, etc. For these products, the production process is continuous

and the output of one process becomes the input of the following process till completion.

2. Compare Process Costing and Job Costing.

Particulars Job Costing Process Costing

1. Meaning Job refers to specific contract work order

or arrangement, where work is executed

as per customers‟ requirements.

Process refers to a stage in

manufacture where raw materials are

converted from on form to another.

2. Nature of

work

Specialized production based on

customers‟ specifications.

Standardized mass production.

3. Quantity of

Output

Each job is distinct from the other.

Output consists of one or a few items

only.

Output of each process consists of

similar (homogeneous) units, in

large quantities.

4. Cost Centre Job itself. Process itself.

5. Cost Unit Job itself. Output of the process

6. Cost

Compilation

Costs are compiled by reference to job,

irrespective of its time of completion.

Costs are compiled by reference to

processes, for a specific time period.

7. Cost

Assignment

Cost is computed for each job or unit of

work. It is not averaged.

Cost is first ascertained for the

process, and then averaged over the

number of units produced.

8. Cost

Transfers

There is no transfer of costs from one job

to another.

Cost of one process is transferred to

next process, by reference to Process

Flow.

9. WIP

valuation

Different jobs might be complete at

different degrees. Hence, WIP consists of

job-wise cost incurred till date.

The concept of equivalent

production is applied. It is presumed

that all units of closing WIP are

uniformly semi-complete on an

average.

10. Supervision

& Control

Close supervision is necessary, since

each job is distinct from the other.

Comparatively easier, since

processes are standardized.

11. Cost

reduction

Comparatively less scope for Cost

Reduction, and required active

management decisions.

Cost Reduction scope is high, due to

mass production and economic of

scale.

3. What do you mean by Process Loss? How is it analyzed?

Explain the meaning & accounting treatment of Normal Process Loss.

Explain the meaning & accounting treatment of Abnormal Loss and Abnormal Gain in

process.

Meaning of Terms

Term Explanation

Process Loss Process Loss is defined as the loss of material arising during the course of a

processing operation.

Process Loss = Input Quantity Less Output Quantity.


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Term Explanation

Normal Loss Normal Loss (NL) is the loss of material due to inherent and unavoidable

reasons. It can be anticipated based on nature of material, nature of operation,

past experience and technical data.

Normal Loss can be calculate in any of the following ways-

(a) Based on Input: Normal Loss Percentage x Input Quantity.

(b) Based on Production: Normal Loss Percentage x (Opening WIP + Fresh

Units – Closing WIP).

Abnormal

Loss Abnormal Loss is the loss in excess of the pre-determined loss. It occurs due to

avoidable reasons and cannot be anticipated, e.g. carelessness of workers, a bad

plant design or operation etc.

Abnormal Loss = Total Process Loss Less Normal Loss. (only when process

loss > Normal Loss)

Abnormal

Gain Abnormal Gain is the unexpected gain in production under normal conditions.

Abnormal Gain can be calculated in any of the following ways-

(a) Abnormal Gain = Actual Production Less Expected Production, or

(b) Abnormal Gain = Normal Loss Less Process Loss. (when Process Loss <

Normal Loss)

Accounting Procedure for Process Losses

Stage A: LOSS ANALYSIS

Step Procedure

1 Compute Process Loss = Input Quantity Less Output Quantity.

2 Determine Normal Loss Quantity, either based on Input or Expected Production.

3 Compute Abnormal Loss or Abnormal Gain, as the case may be. [Step 1 Less Step 2]

Stage B: COST ANALYSIS

Step Procedure

1 Determine –

(a) Gross Cost, i.e. Total of Debit Side of Process Account, and

(b) Gross Input Quantity, i.e. Total Input Quantity for the Process.

2 Determine Normal Loss Quantity, and Scrap Value, if any, of Normal Loss.

3 Compute –

(a) Net Cost = Gross Cost Less Scrap Value of Normal Loss.

(b) Net Expected Output = Gross Input Quantity Less Normal Loss Quantity.

4 Compute Effective Cost per unit = Net Cost = Step 3(a). (This is called as

Net Expected Output Step 3(b) Good Unit Rate)

Stage C: VALUATION: The various items are valued as under –

Item Basis of Valuation

1 Unit Produced & Transferred Effective Cost per unit as per B (4) above.

2 Normal Loss Scrap Value only.

3 Abnormal Loss Effective Cost per unit as per B (4) above. (Note: Abnormal

Loss is considered as Deemed Good Production, and is

valued, as if it were good units produced.)

4 Abnormal Gain Effective Cost per unit as per B (4) above. (Note: Abnormal

Gain constitutes Actual (excessive) Good Production.)


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Stage D: SCRAP REALISATION ENTRIES (Abnormal Loss / Gain Accounting)

Item Treatment

1 Normal Loss A/c Debit with Normal Loss Quantity and Scrap Value thereon.

Credit with amount realized by way of sale of scrap.

When Process Loss < Normal Loss, the difference is transferred to

Abnormal Gain A/c.

2 Abnormal Loss A/c Debit with Abnormal Loss Quantity and Cost thereon at Effective Cost

pu, as per Process A/c.

Credit with amount realized by way of sale of scrap.

Net Abnormal Loss is transferred / debited to Costing P & L A/c.

3 Abnormal Gain A/c Credit with Abnormal Gain Quantity and Value thereon.

Debit Adjust Normal Loss Value, when Process Loss < Normal Loss.

Net Abnormal Gain is transferred / credit to Costing P & L A/c.

4. “The value of Scrap generated in a Process should be credited to the Process Account”. Do

you agree with this statement? Explain.

1) The scrap value of Normal Loss (received from its sale) is credited to the Process Account.

2) The scrap value of Abnormal Loss is credited to Abnormal Loss Account.

3) Hence the value of all scrap is not always fully credited to Process A/c. So the statement is not

fully correct.

ACCOUNTING FLOW OF PROCESS LOSSES

Normal Loss Account

Particulars Qtty Rs. Particulars Qtty. Rs.

To Process A/c – transfer as

per contra

AA BB By Bank – Scrap Realisation

(Normal Loss or Process

Loss, whichever is Less)

By Abnormal Gain –

transfer, if any

Abnormal Loss Account


To Process A/c – transfer as

per contra

XX YY By Bank – Scrap Realisation

for Abnormal Loss Quantity

By Costing P & L A/c – tfr

(bal. fig)

Total Total

Abnormal Gain Account


To Normal Loss – adjustment

transfer

To Costing P & L A/c –

transfer (bal. fig)

By Process A/c – transfer as

per contra

PP QQ

Total Total

Format of Process Account


To Opening WIP

To Previous Process – transfer

in, if any

To Direct Labour

By Subsequent Process –

Production

By FG Control (in case of

last process)


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To Direct Expenses

To Production OH

To Abnormal Gain, if any

PP

QQ

By Normal Loss

By Abnormal Loss, if any

By Closing WIP

AA

XX

BB

YY

Total Total

5. Outline the need for valuation of WIP in processes. What are the bases of valuation of WIP

in processes?

1) Need for Valuation of WIP:

(a) If all units introduced into a process during a period are fully completed and transferred to

the next process,

Average Cost per unit can be computed as Total Process Costs/ Total Output Quantity.

(b) However, when all units introduced into a process are not fully completed, i.e. when there

are units lying as Closing Work-in-Progress, the cost incurred during a period represents

the cost of – (i) completing the Opening Work-in-Progress, (ii) work done on completed

units, and (iii) part work on Closing Work-in-Progress.

(c) So, to ascertain the cost of each completed unit, it is necessary to ascertain the cost of

WIP in the beginning and at the end of the process.

2) Bases of Valuation of WIP:

(a) Based on Actual: WIP can be valued on actual basis, i.e. materials used on the

unfinished units and the actual amount of labour expenses involved. However, this

method does not ensure accuracy.

(b) Based on Equivalent Production: In order to provide a higher measure of accuracy, an

alternative method of WIP valuation is based on converting partly finished un its into

equivalent finished units.

3) Methods of Valuation:

(a) First-in-First Out (FIFO) Method.

(b) Last-in-First Out (LIFO) Method.

(c) Weighted Average Cost (WAC) Method.

Note: Of the three methods given here, FIFO and WAC Methods are the generally adopted methods

of valuation.

6. Write short notes on Equivalent Production.

1) Equivalent Production means converting the incomplete production units into their equivalent

completed units. Equivalent Units = Physical Units (partly complete) x Percentage of

Completion.

2) Example: Closing WIP consists of 2,500 units each 20% complete. Hence, Equivalent Units

= 2,500 x 20% = 500 units. Hence cost of Closing WIP is equal to cost of 500 fully completed

units.

7. Write short notes on Operation Costing.

Operation Costing is defined as refinement of Process Costing. Explain it.

1) Where a process consists of distinct operations, the method of costing applied is called

Operation Costing. It is concerned with the determination of the cost of each operation rather

than the process.

2) Operation Costing is a refinement of Process Costing used in industries where processes may

not be continuous or where input-output tracing may be possible.

3) Operation Costing offers betters scope for control. It facilitates the computation of unit

operation cost at the end of each operation by dividing the total Operation Cost by total output

units.


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4) Sometimes Operation Costing is considered as the basic costing method for standardized

output or services. Process costing and service costing are then considered as its sub-methods.

CHAPTER 9

OPERATING COSTING

1. What is Operating Costing?

1) Meaning: Operating Costing is the method of asetaining the costs of providing / operating /

rendering a service.

2) Applicability: It is applicable to undertakings that provide services rather than produce

commodities. This method is usually adopted in the case of – (a) Transport Companies, (b)

Gas and Water Works Departments, (c) Electricity Supply Companies, (d) Canteens, (e)

Hospitals, (f) Theatres, (g) Schools etc. that are engaged in the provision of services.

2. How are cost units determined in the rendering of services?

The principle of Operating Costing is to accumulate costs under suitable headings and to express

them in terms of number of units of service rendered. Unlike production activities where cost unit is

readily ascertainable, operating costing requires the determination of cost units / denominator factors

for expression of costs.

The factors that have a bearing on cost are identified based on study of technical and operating data.

Thereafter, the cost units that are unique to a specific service are identified as the denominator factors.

Some illustrations of cost units usually used in various service undertakings are as below –

1. Hospitals - Patient –Days, Room – Days, Operations. (M 02)

2. Hotels - guest Days, Room Days. (M 02)

3. Passenger Transport - Kilometres, or Passsenger – Kilometres. (M 02)

4. Cargo Transport - Quintal – Kilometres or Tonne – Kilometres.

5. Canteens - Number of meals served, Number of tea cups sold etc.

6. Electricity Supply – Kilowatt Hours.

7. Boiler Houses - Quantity of Steam raised.

8. Cinema House - Number of Tickets, Number of Shows.

3. Write short notes on Absolute and Commercial Tonne – Kilometres.

Composite units like Tonne – Kilometres, Quintal – Kilometres etc. may be computed in two ways –

1. Absolute (Weighted Average) Tonne – Kilometres: This is the sum total of Tonne –

Kilometres, arrived at by multiplying various distances by respective load quantities carried.

2. Commercial (Simple Average) Tonnes – Kilometres: It is derived by multiplying total

distance (i.e. Kilometres), by average load quantity (Tonnes).

4. How is the Operating Cost Sheet prepared?

An Operating Cost Sheet is prepared in the following manner –

1. Cost Collection: Costs are accumulated for a specified period viz, a month, a quarter, or a

year, etc.

2. Cost Classification: The costs so accumulated are classified under the following three heads

–

(a) Fixed Costs or Standing Charges,

(b) Variable Costs or Running Charges,

(c) Semi – Variable Costs or Maintenance Costs.

When information about interest is specially given, it is treated as a Fixed Cost.

3. Cost Expression: The total of costs so collected is divided by the denominator factor / cost

unit, applicable for the particular service, to determine the cost per unit of service rendered.


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5. Write short notes on Standard Load.

1) Where the goods to be transported are of varying bulk and weight, the calculation of actual

number of Tonne – Kilometres may not be easy. For example, if a business delivers its own

products by its own transport, the cost per Tonne – Kilometre may be most misleading, for an

article may have a bulk which is twice that of the other, through of the same weight.

2) In such a case, the „Standard Load‟ is selected as the unit, i.e., the load which a lorry would

carry. This would have reference both to bulk and weight and would give an efficient method

for distributing the cost of transport over different departments.

3) Thus, if the turnover of various departments is reduced to the „Standard Load‟ by first

calculating their weight and then the bulk of article produced the costs of distributing the

product can be easily ascertained.

4) This principle also can be extended for associating cost with convenient units of service

rendered by an organization, so that management is able to judge whether the organization is

running efficiently and in the manner in which the service requires to be improved or be made

more economical.

5) The cost of generation of electricity on the same principle is correlated with units generated

and also with units sold, in hospitals the cost of their maintenance is co – related to units of

„available bed – days‟.

6. Distinguish between Operation Cost and Operating Cost.

Particulars Operation Cost Operating Cost

1. Meaning Operation refers to a stage in

manufacturing activity where output is

converted from one form into another. Cost

of each operation is called Operation Cost.

Operating Cost refers to the total

cost of providing a utility or service

or intangible product e.g. transport

undertakings, educational

institutions etc.

2. Nature of

Output

Output of each operation is tangible,

measurable and homogeneous. It becomes

the input of the subsequent operation.

Only services are provided. There

is no tangible output.

3. Cost

Classification

Costs are classified into Direct Materials,

Direct Labour, Direct Expenses and

Production Overheads.

Costs are classified into Fixed or

Standing Charges, Variable or

Running Charges and Semi –

Variable or Maintenance Charges.

4. Cost

Expression

At the end of each operation, the unit

operation cost may be computed by

dividing the total operation cost by total

output.

Emphasis is on the ascertainment

of cost of rendering service rather

on the cost of manufacturing a

product.

CHAPTER 10

STANDARD COSTING

1. Define the term Standard Cost. Is it the same as Estimated Cost?

1) Standard Cost is the pre – determined operating cost calculated from Management‟s standards

of efficient operation and the relevant necessary expenditure.

2) It is used as a basis for – (a) Price Fixing, and (b) Cost Control through variance analysis.

3) It reflects – (a) quantities of material and labour expected to be used, (b) prices expected to be

paid for materials and labour during the coming year, and (c) Factory Expenses applicable to

production based on good performance and practical capacity operation of the factory.


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2. Define the term Standard Costing and outline the steps involved therein.

1. Definition: Standard Costing refers to “the preparation and use of Standard Costs, their

comparison with Actual Costs and the Analysis of Variances to their causes and points of

incidence.”

2. Steps: Standard Costing involves the following steps –

(a) Setting up of Standards,

(b) Ascertainment of Actual Costs,

(c) Comparison of Actual and Standard costs to determine Variance, and

(d) Investigation of variances and taking appropriate action wherever necessary.

3. What are the preliminary steps prior to the installation of a Standard Costing System?

Installation of a Standard Costing System involves the following preliminary steps-

1. Responsibility Centres: The key areas of operation in the Firm should be indentified into

Responsibility Centres with clearly defined roles, e.g. Cost Control, Revenue Maximization

etc.

2. Classification of Accounts: The various heads of expense accounts should be classified and

codified for collection and comparison of Actual Costs with Standard Costs. The will also

help the process of computerized accounting.

3. Selection of Standards: For operational requirements, a suitable type of standard should be

selected.

4. Length of period: The duration, for which the standards are to be used, should be

determined.

4. Distinguish between Standard Costing and Budgetary Control

Describe and contrast the scope and techniques of Standard Costing and Budgetary

Control.

Particulars Standard Costing Budgetary Control

1. Meaning Standards Costs are pre-determined

costs representing what the costs

should be, at the level of efficient

conditions of production and

operation.

Budgets are financial and / or

quantitative statements, prepared

and approved prior to a defined

period of time, of the policy to be

pursued during that period for

achieving that objective.

2. Coverage They are generally restricted to

Costs.

They include estimates of Income,

Costs and employment of Capital.

3. Scope The scope of Standard Costing is

comparatively narrow, since it

covers mainly Production Costs.

Budgeting is more wide-ranging as

it relates to the operations of the

business as a whole. It covers

capital, sales and financial

expenses in addition to production.

4. Basis These are determined by the

collection of technical data related to

production and applying costs to

each element of production.

These are determined based on

Management‟s plans of what

should b e done to achieve a certain

objective and how to actually

achieve it.

5. Cost Objective Standard Costing is concerned with

the ascertainment and control of each

element of cost for each unit.

Budgetary Control is concerned

with the origin of expenditure at

functional levels.

6. Control Focus Control is exercised by comparing

sales and production units values at

standard cost with actual costs, i.e.

actual costs are compared with

standard cost of actual output.

Control over budgetary figures is

exercised by comparing actual

figures with those budgeted.


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Particulars Standard Costing Budgetary Control

7. Finance vs

Cost

Standard Cost is a projection of Cost

Accounts.

Budget is a projection of Financial

Accounts.

8. Variance

Reporting

Under the Standard Costing system,

variances are usually revealed

through different accounts.

Control is exercised by statistically

putting budgets and actual side by

side. Variances are normally not

revealed in the accounts in case of

Budgetary Control.

9. Scope of

Variance

Analysis

Standard Costing System is a more

technically improved system by

which various causes of variances for

each cost element can be analyzed in

minute detail and corrective action

taken accordingly.

Under Budgetary Control System,

Co9ntrol over expenses is general

and broad in nature, and not in as

detailed manner as in Standard

Costing.

10. Effect of

temporary

conditions

Standard Costs are usually semi-

permanent in nature and may not be

changed unless and until there are

changes in the basic price structure or

in the methods of operations.

Budgeted Costs are estimated

considering actual conditions and

attainable targets of a period, in

view of the conditions that are likely

to be prevalent in that year. The

effect of short-term changes in cost

structure, etc. will be fully reflected

in Budgeted Costs.

11. Permanence Standard Costs are usually semi-

permanent in nature and may not be

changed unless and until there are

changes in the basic price structure or

in the methods of operations.

They are estimated usually for one

year and take into account the

practical problems of operations and

are kept at a level, which the Firm

hopes to achieve in the year for

which the budget is being prepared.

12. Parts vs

Whole

A Standard Costing System cannot be

operated in parts. All items of

expenditure included in cost units are

to be considered.

Budgetary control is possible even

in parts or for particular type of

expense according to the attitude of

management, e.g. Advertising or

R&D Expenses Budget.

5. Outline the relationship between Standard Costing and Budgetary Control.

1. Budgeted and Standard Costs are intended to exercise cost control and judge performance by

setting up targets.

2. Both systems provide benchmarks against which the actual performance and costs are

compared, variances are calculated and the reasons for the variances ascertained.

3. A Budgetary Control System can operate without Standard Costs. The two systems are not

inter-dependent, i.e. they can exist independently.

4. However, when Budgets are being developed, Standard Costs are of immense help since they

are long-term estimates of the same activity and represent Management‟s view of the level of

efficiency that should prevail. Similarly, for determination of standards, information on past

budgeted and actual costs is useful.

Though the two are not independent, they are inter-related & function well as complementary to one

another.


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Chapter 11

MARGINAL COSTING

1. What is Marginal Costing?

1. Marginal Costing is a technique of decision-making, which involves-

(a) Ascertainment of Total Costs,

(b) Classification of Costs into – (i) Fixed and (ii) Variable, and,

(c) Use of such information for analysis and decision-making.

2. Marginal Costing is the ascertainment of Marginal Cost, and of the effect on Profit of changes

in volume or type of output, by differentiating between Fixed Costs and Variable Costs.

2. What do you understand by Differential Cost?

Distinguish between Marginal Costing and Differential Costing.

Differential Cost is “the increase or decrease in total cost or the change in specific elements of cost

that result from any variation in operations”. It represents an increase or decrease in total cost

resulting out of-

1. Producing or distributing a few more or few less of the products,

2. A change in the method of production or of distribution,

3. An addition or deletion of a product or a territory, and

4. Selection of an additional sales channel.

Differential Cost includes Fixed and Semi-Variable expenses. It is the difference between the total

costs of two alternatives. Differential cost may be either incremental or decremental.

3. Explain the concepts of Variable Cost and Fixed Cost, in the context of Marginal Costing.

Particulars Variable Cost Fixed Cost

1. Meaning Variable Cost is that portion of cost,

which changes or varies

proportionately based on output /

volume/ quantity.

Fixed Costs are costs which are assumed to

remain constant, for a given period of

time, irrespective of level of output during

that period.

2. Items Variable Cost = Direct Materials +

Direct Labour + Direct Expenses +

Variable Production OH + Variable

S&D OH.

Fixed Cost = Fixed Production OH +

Administrative OH + Fixed S&D OH.

3. Examples Raw Materials, Labour (based on

number of units produced), Power,

Royalty (based on production), etc.

Rent, Salary, Insurance, etc.

4. Cost per

unit

Variable Cost per unit is assumed to

remain constant at all levels of

output.

Fixed Cost per unit of output will vary

inversely with changes in the level of

output. As output increases, Fixed Cost per

unit decreases, and vice-versa.

5. Point of

incurrence

Variable Costs are incurred only

when production takes place.

Hence, no production means any

Variable Costs.

Fixed Costs are incurred even at zero level

of output. Hence, even at Nil Activity

Level, Fixed Costs will be incurred.

6. Cost

Behaviour

Once incurred, variable Costs will

increase proportionately based on

the level of output / quantity.

Fixed Costs, once incurred, will be

constant at all output levels.

7. Nature Variable Costs are considered as

product-related costs.

Fixed Costs are treated as period-related

costs.


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8. Inclusion

in

Inventory

Variable Costs are Product Costs,

and hence included in inventory

valuation. So, Inventory Value

comprises Direct Materials + Direct

Labour + Direct Expenses +

Variable Production OH.

Fixed Costs are not included in Inventory

Valuation. They are charged off fully to the

Profit and Loss Account in the period in

which it is incurred.

4. Distinguish between Variable Cost and Cost Variance.

Variable Cost Cost Variance

Cost which varies directly in proportion to

every increase or decrease in the volume of

output or production is known as Variable

Cost.

Cost Variance is the difference between Standard

Cost and comparable Actual Cost incurred during a

period. Variances are computed under each element

of cost for which standards have been established.

5. Distinguish between Marginal Costing and Absorption Costing.

Particulars Marginal Costing Absorption Costing

1. Cost

Recognition

Only Variable Costs are included

for product costing & inventory

valuation.

All product-related costs, whether Fixed or

Variable, are considered for product costing

& inventory valuation.

2. Classification Classification of expenses is

based on nature, i.e. Fixed and

Variable.

Classification of expenses is based on

functions, i.e. Production, Administration,

Selling and Distribution.

3. Treatment of

Fixed Costs

Fixed Costs are regarded as a

Period Cost. Profitability of

different products is analyzed by

their PV Ratio (and not Net Profit

Ratio).

Fixed Costs are charged to cost of

production. Each product bears a reasonable

share of Fixed Cost and thus the profitability

of a product is influence by the

apportionment of Fixed Costs.

4. Presentation Cost data presented highlight the

Total Contribution and

contribution of each product.

Cost data are presented on conventional

pattern. Net Profit of each product is

determined after subtracting Fixed Cost

along with their variable costs.

5. Effect of

Stockholding

on Cost pu

Difference in the quantity of

Opening Stock and Closing Stock

does not affect the unit cost of

production.

Difference in the quantity of Opening and

Closing Stock affects the unit cost of

production due to the impact of related

Fixed Cost.

6. Variance

Reporting

Only Fixed OH Expenditure

Variance can be computed.

There is no Volume Variance

since Fixed Overheads are not

“absorbed”.

All Fixed OH Variances (Expenditure,

Volume, etc.) can be computed and reported.

6. C & Co. a manufacturer of glass bottles, reports its monthly profit on Absorption Costing

basis. The Accountant has been criticized for reporting widely different profits from month

to month. To counteract this criticism, he has proposed to report profit on Marginal Costing

basis. In support of his proposal, he has put forward the following reason:

“It eliminates the distortion of Interim Profit Statements, which occur when there are

seasonal fluctuations in sales volume although production is at fairly constant levels.”

Comment briefly on the Accountant‟s reason.

1. Under Absorption Costing, Fixed POH is included in inventory valuation. Hence, such Fixed

POH is carried forward in Stock, for charging against the sales when they are made. So, when

production is constant but sales fluctuate, Absorption Costing will tend to produce a more

stable profit profile.


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2. Under Marginal Costing principle, Fixed POH is treated as Period Cost and is written off as

they are incurred. So, when sales fluctuate, due to the constant of Fixed POH, reported profit

will vary widely. For example, when Sales are low the Fixed Overhead charge will be

relatively high and profit will fall significantly.

3. Hence, the Accountant‟s reasoning is not valid in the above case.

7. What do you mean by Contribution?

1. Contribution is the excess of Sales Revenue over Variable Cost, i.e. Contribution = Sales

Less Variable Costs.

2. Contribution is called so, since it initially contributes towards recovery of Fixed Cost and

thereafter towards Profit of the business. The Contribution earned by a business, forms a fund

for Fixed Expenses and Profit.

3. The Contribution concept is based on the theory that the Fixed Expenses of a business is a

„Joint Cost‟, which cannot be equitably apportioned to different segments of the business.

Hence, Contribution serves as a measure of efficiency of operations of various segments of

the business.

8. Write a brief note on Profit Volume Ratio (PV Ratio).

1. Meaning: Profit Volume Ratio (PV Ratio) is the relationship between contribution and Sales

Value. It is also termed as Contribution to Sales Ratio.

2. Formula: PV Ratio = Total Contribution x 100 (or) Contribution per unit x 100 (or)

Total Sales Value Sales Price per unit

= Change in Contribution x 100 (or) Change in Profit x 100 (or)

Change in Sales Change in Sales

3. Significance of PV Ratio:

(a) PV Ratio is considered to be the basic indicator of the profitability of the business.

(b) The higher the PV Ratio, the better it is for a business. In the case of a Firm enjoying

steady business conditions over a period of years, the PV Ratio will also remain stable

and steady.

(c) If PV Ratio is improved, it will result in higher profits.

4. Improvement of PV Ratio:

(a) By reducing the Variable Cost,

(b) By increasing the Selling Price, or

(c) By increasing the share of products with higher PV Ratio in the overall sales mix. (where

a Firm produces a number of products)

5. Uses of PV Ratio:

(a) To compute the Variable Costs for any volume of Sales.

(b) To measure the efficiency or to choose a most profitable line. The Overall Profitability

line. The Overall Profitability of the Firm can be improved by increasing the sales /

output of a product giving a higher PV Ratio.

(c) To determine Break-Even Point and the level of output required to earn a desired profit.

(d) To decide the most profitable sales-mix.

9. Write short notes on the Break Even Point (BEP).

1. Meaning: Break-Even Point (BEP) is the level of Sales at which Total Contribution equals

Fixed Costs. Hence, at that level, there is neither a Profit nor a Loss to the Firm (Total

Revenue = Total Costs, and Profit / (Loss) = Zero).

2. Formula:

(a) Break Even Point (in Rs.) = Fixed Costs

PV Ratio

This is denoted as BES. (Break Even Sales Value)

(b) Break Even Point (Qtty) = Fixed Costs

Contribution per unit

This is denoted as BEQ. (Break Even Quantity)


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Total Revenue

Actual Sale Value

Total Costs

MOS Value

Costs and Profit

Revenues BES BEP 0

in Rs.

Loss Fixed Costs

BEQ MOS Qtty Actual Sale Qtty

Quantity

3. Assumptions underlying Break Even Analysis: (a) Total Costs can be easily classified into Fixed and Variable categories.

(b) Selling Price per unit remains constant, irrespective of quantity sold.

(c) Variable Costs per unit remain constant. However Total Variable Costs increases with

increase in output levels.

(d) Fixed Costs remain the same for a period, irrespective of output.

(e) Productivity or Efficiency of the factors of production will remain the same.

(f) The state of technology, process of production and quality of output will remain

unchanged.

(g) There will be no significant change in the level of Opening and Closing Inventory.

(h) The Company manufactures and sells a single product. In the case of a multi-product

Company, the sales-mix remains unchanged.

(i) Both Revenue and Cost functions are linear over the range of activity under

consideration.

(j) All resources required for production are abundantly available.

4. Significance of BEP: BEP represents the Cut-Off Point for Profit or Loss of the business. At

the BEP, the Profit or Loss equals zero. The significance of BEP may be summarized as-

Level of Sales Impact on Profits

Less than BEP Firm incurs Losses. [Contribution < Fixed Cost]

Equal to BEP No Profit & No Loss. [Contribution = Fixed Cost]

Greater than BEP Firm earns Profits. [Contribution > Fixed Cost]

Note: A Firm should operate above the Break-Even Point in order to earn Profits.

10. What are the limitations of Break-Even Chart?

1. The Variable Cost line need not necessarily be a straight line because of the possibility of

operation of law of increasing returns or law of decreasing returns.

2. The Selling Price may not be a constant factor. Any increase or decrease in output is likely to

have an influence on the Selling Price per unit.

3. When a number of products are produced, separate Break-Even Charts will have to be

prepared. This poses a problem of apportionment of Fixed Expenses to each product.

4. Break-Even Charts ignore the Capital Employed in business, which is one of the important

guiding factors in the determination of profitability and returns.

5. The Break Even Chart assumes that business conditions will not change. This assumption is

not realistic.

11. What are the different types of Break-Even Charts?

1. Contribution Break-Even Chart: This chart shows Contribution earned by the Firm at

different levels of activity.


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2. Cash Break-Even Chart: In this chart, Variable Costs are assumed to be payable in cash.

Besides this, the Fixed Expenses are divided into two groups, viz. (a) those expenses which

involve cash

3. Control Break-Even Chart: Both budgeted and actual cost data are depicted in this chart.

This chart is useful in comparing the actual performance of the Firm with the budgeted

performance, for exercising control.

4. Analytical Break-Even Chart: This chart shows the break-up of Variable Expenses into

important elements of cost, viz., Direct Materials, Direct Labour, Variable Overheads, etc.

Also the appropriations of Profit such as Equity Dividends, Preference Dividends, Reserves,

etc are depicted in this chart.

5. Product wise Break-Even Chart: Separate Break-Even Charts for different products can

also be prepared to compare the profitability of the products or their contribution.

6. Profit Graph: Profit Graph is a special type of Break-Even Chart, with shows the Profit or

Loss at different levels of output.

Contribution Break Even Chart

BEP

Total Sales

Total Costs

Total Contribution

Fixed Costs

Output

Cash Break Even Chart (M 01)

Total Sales

Total Costs

Total Cash

Cost

Total Fixed Costs

Cash Fixed Costs

Total BEP

Cash BEP

Actual BEP

Control Break Even Chart

Total Sales

Actual Total Costs

Budgeted Total Cost

Output

Output

Budgeted BEP

Analytical Break Even Chart

Total Sales

Total Costs

Reserves

Equity & Pref

Dividends

Variable OH

Direct Labour

Direct Matls

Fixed Costs

Output Product Wise Break Even Chart

BEP

Product A

BEP

Product B

Loss Area

Profit

Area

Profit Graph

BEP


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12. What do you understand by Margin of Safety?

1. Meaning: Margin of Safety (MOS) represents the difference between the Actual Sales and

Break-Even Point Sales. It can be expressed as a percentage of Total Sales, or in Value, or in

terms of quantity.

2. Formula:

(a) Margin of Safety (in Rs.) = Total Sales Less BEP Sales

(or)

= Profit

PV Ratio

(b) Margin of Safety (Qtty) = Total Sales Qtty Less BEQ

(or)

= Profit

Contribution per unit

Total Revenue

Actual Sale Value

Total Costs

MOS Value

Costs and Profit

Revenues BES BEP 0

in Rs.

Loss Fixed Costs

BEQ MOS Qtty Actual Sale Qtty

Quantity

3. Significance:

(a) Upto BEP, the Contribution earned by the Firm is sufficient only to recover Fixed Costs.

However, beyond the BEP, the Contribution is called Profit (since Fixed Costs are fully

recovered by then).

(b) Profit is the Contribution earned out of Margin of Safety Sales.

(c) The size of the Margin of Safety shows the strength of the business.

(d) A low MOS indicates that the Firm has large Fixed Expenses and is more vulnerable to

changes in Sales.

4. Improvement in Margin of Safety:

(a) Increase in Selling Price, provided the demand is inelastic so as to absorb the increased

prices.

(b) Reduction in Fixed Expenses.

(c) Reduction in Variable Expenses.

(d) Increasing the Sales Volume provided capacity is available.

(e) Substitution or introduction of a product mix such that more profitable lines are

introduced.

13. Discuss the relationship between Angle of Incidence, BEP and MOS.

ϴ ϴ ϴ

ϴ

BEP

Total Sales

Total Cost

Fixed Cost

Total Sales Total Sales

Total Sales

BEP BEP BEP

Fixed Cost

Total Cost

Fixed Cost Fixed Cost

Total Cost Total Cost


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Condition 1: Low BEP & Large AOI: Fixed Costs are low and the rate of profit earning is high.

Large MOS shows that the Firm enjoys financial stability. Low BEP indicates that the business could

be run profitably even if there is a fall in Sales, unless the Sales are very low.

Condition 2: Low BEP & Small AOI: In this case, the conclusions are same as in Condition 1,

except that the rate of profit earning is not so high as in Condition 1. The Firm breaks – even quickly

and its Fixed Costs are low but it does not have a high rate of profit earning.

Condition 3: High BEP & Small AOI: This shows that the Fixed Costs are high and MOS is low.

The business is very vulnerable, even a small drop in activity may result in a loss.

Condition 4: High BEP & Large AOI: This shows that Fixed Costs are high and MOS is low. The

business is likely to incur losses through a small reduction in activity. However, after the BEP, the

business makes the profits at a high rate.

14. Write a brief note on Indifference Point.

1. Meaning: Indifference Point is the level of Sales at which Total Costs (and hence Total Profits)

of two options are equal. The decision-maker is indifferent as to option chosen, since both

options will result in the same amount of profit.

2. Formula:

(a) Indifference Point (in Rs.)

= Difference in Fixed Costs

Difference in PV Ratio

(or)


Difference in Variable Cost Ratio

(b) Indifference Point (in units) = Difference in Fixed Costs

Difference in Contribution per unit

(or)


Difference in Variable Cost per unit

Note: Indifference Point may also be

called the Cost Break Even Point.

Profit of Option Y

Indifference Point

Profit of

Option X

Amount

In Rs.

Quantity

3. Significance: Indifference Point represents a cut-off indicator for deciding on the most

profitable option. At that level of Sales (i.e. Indifference Point), Costs and Profits of two options

are equal. The profitability of different options are –

Level of Sales Most Profitable Option to be chosen Reason

Below

Indifference Point

Option with Lower Fixed Cost Lower the Fixed Costs, lower will

be the BEP. Hence, more profits

beyond BEP.

At Indifference

Point

Both options are equally profitable. Indifference Point

Above

Indifference Point

Option with Higher PV Ratio (lower

Variable Cost)

The higher the PV Ratio, the

better it is.

Note: Indifference Point is calculated only in respect of two options. Where more than two

options are considered, Indifference Point can be calculated on a comparative basis for two

combinations.


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15. Distinguish between Indifference Point and Break-Even Point.

Particulars Indifference Point Break-Even Point

1. Definition Indifference Point is the level of Sales

at which Total Costs and Profits of

two options are equal.

BEP is the level of Sales at which

the Total Contribution equals Fixed

Costs. Hence, there is neither a

Profit nor a Loss to the Firm.

2. Formula Indifference Point (in Rs.)


Difference in PV Ratio see Qn 14

Break Even Point (in Rs.) =

Fixed Costs

PV Ratio

3. Significance It is the activity level at which Total

Cost under two alternatives are equal.

It is activity level at which the

Total Revenue from a product or

product mix is equal to its Total

Cost.

4. Purpose Used to choose between two

alternative options for achieving the

same objective.

Used for profit planning.

16. Write a brief note on Shut Down Point.

1. Meaning: Shut Down Point indicates the level of operations (Sales), below which it is not

justifiable to pursue operations. For this purpose, Fixed Costs of a business are classified into –

(a) Avoidable or Discretionary Fixed Costs, and (b) Unavoidable or Committed Fixed Costs. A

firm has to close down if its Contribution is insufficient to recover even the Avoidable Fixed

Costs. [Note: Avoidable Fixed Costs = Total Fixed Costs Less Minimum (Unavoidable) Fixed

Costs.]

2. Focus: The focus of Shut Down Point calculation is to recover the Avoidable Fixed Costs in the

first place. By suspending the operations, the Firm may save as also incur some additional

expenditure. The decision is based on whether Contribution is more than the difference between

the Fixed Expenses incurred in normal operation and the Fixed Expenses incurred when the

Plant is shut down.

3. Formula: Shut Down Point (Rs.) = Avoidable Fixed Costs Shut Down Point (Qtty) = Avoidable Fixed Costs

PV Ratio Contribution per unit

4. Significance: The significance of Shut Down point and consequent decisions are –

Level of Sales Decision Reason

Below Shut Down Point Close down Operations Avoidable Fixed Costs are not fully

recovered. It is better to close down and

save additional expenses.

At Shut Down Point Continue Operations Avoidable Fixed Costs are just recovered.

Above Shut Down Point Continue Operations Avoidable Fixed Costs are recovered.

Further, Contribution leads to recovery of

the balance Fixed Costs also.

17. What do you understand by Key Factor or Limiting Factor?

1. Key Factor represents a resource whose availability is less than its requirement. It denotes

the Resource Constraint situation. It is a factor, which at a particular time or over a period

limits the activities of a Firm.

2. It is also called Critical Factor (since it is vital or critical to the Firm‟s success) and Budget

Factor (since budgets are formulated by reference to such limitations or restraints).

3. Some examples of Key Factors are – (a) Shortage of Raw Materials, (b) Labour Shortage, (c)

Restrictions in Plant Capacity, (d) Demand or Sales Expectancy, (e) Cash availability, etc.

4. In case of Key Factor situation, the procedure for decision-making is as under-

Step Description

1 Identify the Key Factor

2 Compute Total Contribution or Contribution per unit of the product.


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3 Compute Contribution Per Unit of the Key Factor, i.e. Contribution per Direct Labour

Hour, Contribution per kg of Raw Material, etc.

4 Rank the products based on Contribution per unit of the Key Factor.

5 Allocate the key resources based on Ranks given above, and other conditions specified in

the question.

18. What are the important factors to be considered in Marginal Costing decisions?

In Marginal Costing decisions, the following factors are to be considered-

1. Contribution: Whether the product or option under consideration makes a Contribution or

not, is the basic consideration. If there is no Contribution or Negative Contribution, the

proposal is not acceptable.

2. Specific Fixed Cost, if any: Where a choice is to be made between two courses of action, the

additional Fixed Overhead, if any, should be taken into account.

3. CVP Analysis: The effect of increase in volume on Profits, and the rate of earning additional

profits, should be analysed.

4. Incremental Contribution: Where additional quantities can be sold only at reduced prices,

Incremental Contribution will be more effective in decision making, as it takes into account

the Additional Sale Quantity and Additional Contribution per unit.

5. Capacity: Whether acceptance of the incremental order or additional product line is within

the Firm‟s capacity or whether Key Factor comes into play, should be analyzed.

6. Non-Cost Factors: Non-Cost Factors should also be considered, wherever applicable.

19. What are the important decision-making areas where Marginal Costing technique is used?

Some areas where Marginal Costing technique is used by for decision-making are-

1. Determination of Selling Price- (a) under normal circumstances, (b) for special market or

for a special customer, (c) during recession, (d) at Marginal Cost or below Marginal Cost, (e)

price-mix and price-discrimination decisions.

2. Product Mix Decisions, viz. – (a) Selection of Optimal product mix, (b) Substitution of one

product with another, (c) Discontinuing or dropping of a product line, etc.

3. Production vs Outsourcing Decisions – whether to Make or Buy a certain component /

product.

4. Shut-down or Continue decision, or determination of output level in period of recession or

depression.

5. Marketing Decisions, viz. – Selling in the Domestic Market or in the Export Market,

acceptance of Export Officers, etc.

6. Change vs. Status Quo, Retaining or replacing a Machine / Process, etc.

7. Expanding or Contracting decisions, etc.

20. Indicate five instances when you will permit to fix a Price, which is less than the Marginal

Cost of the product.

1. When goods are of perishable nature

2. When the Firm has already purchased huge

quantities of Raw Materials, and the prices of

these Materials is falling considerably in the

Market.

3. To launch or introduce a new product in the

market.

4. To eliminate Competitors from the market.

5. To obviate shut-down costs.

6. To push up sales of another highly profitable

product.

7. To capture future market.

8. To capture foreign market.

21. What is Cost-Volume-Profit Analysis? What are its objectives?

1. Cost-Volume-Profit Analysis (CVP Analysis) is the analysis of three variables, viz. Cost,

Volume and Profit, which explores the relationship existing amongst Costs, Revenue,

Activity Levels and the resulting profit.

2. CVP Analysis aims at measuring variations of Profits and Costs with Volume, which is

significant to business profit planning.


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3. CVP Analysis makes use of the Marginal Costing principles for planning and for making

short-run decisions.

22. What are the limitations of Marginal Costing?

1. Difficult to classify: It is difficult to classify exactly the expenses into Fixed and Variable

category. Most of the expenses are neither totally variable nor wholly fixed.

2. Contribution is not final: Contribution of a product itself is not a guide for optimum

profitability unless it is linked with the Key Factor.

3. Wrong pricing decisions: Sales Staff may mistake Marginal Cost for Total Cost and sell at a

price, which will result in loss or low profits. Hence, Sales Staff should be cautioned against

incorrect pricing decisions, while giving them information on Marginal Cost.

4. Stock Valuation: Overheads of fixed nature cannot altogether be excluded particularly in

large contracts, while valuing the WIP. This aspect is not considered in Marginal Costing.

5. Naïve assumptions: Some assumptions regarding the behaviour of Revenues and Costs are

not necessarily true in a realistic situation. For example, additional output can be sold only by

reducing sale prices.

6. Ignores time value: Marginal Costing ignores time factor and investment. For example, the

Marginal Cost of two jobs may be the same but the time taken for their completion and the

cost of machines used may differ. The true cost of a job, which takes longer time and uses

costlier machine, would be higher. The effect of time value of money is not analyzed by

Marginal Costing.

Chapter 12

BUDGETARY CONTROL

1. Define the term Budget.

1. Definition: Budget is a financial and / or quantitative statement, prepared and approved prior

to a defined period of time of the policy to be pursued during that period for the purpose of

attaining a given objective. It may include income, expenditure and employment of capital.

2. Features:

(a) Financial and / or Quantitative Statement.

(b) Futuristic – prepared and approved prior to a defined period of time.

(c) Goal Oriented – for the purpose of attaining a given objective.

(d) Components – Income, Expenditure and Employment of Capital.

2. What are the objectives of Budgeting / Performance Budgeting?

The objectives of Budgeting are –

1. To encourage self-study in all aspects of a Company‟s operations.

2. To get all members of management to “put their heads” to the basic question of how the

business should be run, to make them of a co-ordinated team operating in unison towards

clearly defined objectives.

3. To promote the planning process and provide a sense of direction to every member of the

organization.

4. To force a definition and crystallization of Company policies and aims.

5. To increase the effectiveness with which people and capital are employed.

6. To disclose areas of potential improvement in the Company‟s operations.

7. To stimulate study of relationship of the Company to its external economic environment for

improving the effectiveness of its direction.

8. To direct and co – ordinate business activities and units to achieve stated targets of

performance.


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9. To facilate the control process, by comparing actual results with plan, and provide feedback

to the employees about their performance.

3. Define the term Budgetary Control. What are its salient features?

1. Definition: Budgetary Control is defined as “the establishment of budgets, relating the

responsibilities of executives to the requirements of a policy, and the continuous comparison

of actual with budgeted results either to secure by individual action the objective of that

policy or to provide a base for its revision.”

2. Salient features:

(a) Objectives: Determining the objectives to be achieved, over the budget period, and the

policy(ies) that might be adopted for the achievement of these ends.

(b) Activities: Determining the variety of activities that should be undertaken for

achievement of the objectives.

(c) Plans: drawing up a plan or a scheme of operation in respect of each class of activity, in

physical as well as monetary terms for the full budget period and its parts.

(d) Performance Evaluation: Laying out a system of comparison of actual performance by

each person, section or department with the relevant budget and determination of causes

for the discrepancies, if any.

(e) Control Action: Ensuring that when the plans are not achieved, corrective action are

taken, and when corrective actions are not possible, ensuring that the plans are revised

and objective achieved.

4. What are the objectives of Budgetary Control System?

The objectives of a Budgetary Control System are –

1. Definition of Goals: Portraying with precision, the overall aims of the business and

determining targets of performance for each section or department or department of the

business.

2. Defining Responsibilities: Laying down the responsibilities of each individual so that

everyone knows what is expected of him and how he will be judged.

3. Basis of Performance Evaluation: Providing basis for the comparison of actual performance

with the predetermined targets and investigation of deviation, if any, of actual performance

and expenses from the budgeted figures. It helps to take timely correctively measures.

4. Optimum use of Resources: Ensuring the best use of all available resources to maximize

profit or production, subject to the limiting factors.

5. Co – ordination: Co – ordinating the various activities of the business and centralizing

control, but also making a facility for the Management to decentralize responsibility and

delegate authority.

6. Planned action: Engendering a spirit of careful forethought, assessment of what is possible

and an attempt at it. It leads to dynamism without recklessness. It also helps to draw up long

range plans with a fair measure of accuracy.

7. Basis for policy: Providing a basis for revision of current and future policies.

5. What are the disadvantages / limitations of the Budgetary Control System?

1. Estimates: Budgets may or may not be true, as they are based on estimates. The assumptions

about future events may or may not actually happen.

2. Rigidity: Budgets are considered as rigid document. Too much emphasis on budgets may

affect day – to – day operations and ignores the dynamic state of organizational functioning.

3. False Sense of Security: Mere budgeting cannot lead to profitability. Budgets cannot be

executed automatically. It may create a false sense of security that everything has been taken

care of in the budgets.

4. Lack of co – ordination: Staff co – operation is usually not available during Budgetary

Control exercise.

5. Time and Cost: The introduction and implementation of the system may be expensive.


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6. What is Budget Manual? What matters are included in its Manual?

Meaning: Budget Manual is a schedule, document or booklet which shows in written form, the

budgeting organization and procedures. A copy of the manual is given to each departmental head for

guidance.

The Manual indicates the following matters –

1. Brief explanation of the principles of Budgetary Control System, its objectives and benefits.

2. Procedure to be adopted in operating the system – in the form of instructions and steps.

3. Definition of duties & responsibilities of – (a) Operational Executives, (b) Budget Committee,

and (c) Budget Controller.

4. Nature, type and specimen forms of various reports, persons responsible for preparation of the

Reports and the programme of distribution of these reports to the various officers.

5. Account Code and Chart of Accounts used by the Company.

6. Budget Calendar showing the dates of completion of each part of the budget and submission

of Reports.

7. Budget Periods and Control Periods.

8. Follow – up procedures.

7. What are the different types of Budgets?

Distinguish between Fixed and Flexible Budgets.

Budgets may be classified on the following bases –

1. Time – Period 2. Conditions 3. Capacity 4. Coverage

(a) Long – term Budget & (a) Basic Budget and (a) Fixed Budget and (a) Functional Budget and

(b) Short – term Budget (b) Current Budget. (b) Flexible Budget. (b) Master Budget.

1. BASED ON TIME PERIOD:

Long Term Budget Short Term Budget

(a) Budgets which are prepared for periods

longer than a year are called Long – Term

Budgets.

(b) Such Budgets are helpful in business

forecasting and forward planning.

(c) Examples: Capital Expenditure, R&D

Budget.

(a) Budgets which are prepared for periods less

than a year are known as Short – Term

Budgets.

(b) Such Budgets are prepared in cases where a

specific action has to be immediately taken

to bring any variation under control.

(c) Example: Cash Budget.

2. BASED ON CONDITIONS:

Basic Budget Current Budget

A Budget, which remains unaltered over a long

period of time, is called Basic Budget.

A Budget, which is established for use over a

short period of time and is related to the current

conditions, is called Current Budget.

3. BASED ON CAPACITY:

Particulars Fixed Budget Flexible Budget

a) Definition It is a Budget designed to remain unchanged

irrespective of the level of activity actually

attained.

It is a Budget, which by

recognizing the difference

between fixed, semi –

variable and variable costs is

designed to change in

relation to level of activity

attained.


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b) Rigidity It does not change with actual volume of

activity achieved. Thus it is known as a Rigid

or Inflexible budget.

It can be re – casted on the

basis of activity level to be

achieved. Thus it is not rigid.

c) Level of

Activity

It operates on one level of activity and under

one set of conditions. It assumes that there

will be change in the prevailing conditions,

which is unrealistic.

It consists of various budgets

for different levels of

activity.

d) Effective of

variance

analysis

Variance Analysis does not give useful

information as all Costs (fixed, variable and

semi – variable) are related to only one level

of activity.

Variance Analysis provides

useful information as each

cost is analysed according to

its behaviour.

e) Performance

Evaluation

Comparison of actual performance with

budgeted targets will be meaningless,

especially when there is a difference between

two activity levels.

It provides a meaningful

basis of comparison of the

actual performance with the

targets.

4. BASED ON COVERAGE:

Functional Budget Master Budget (M 97)

Budgets, which relate to the individual

functions in an organization, are known as

Functional Budgets, e.g. Purchase Budget,

Sales Budget, Production Budget, Plant

Utilisation Budget and Cash Budget.

It is a consolidated summary of the various

functional budgets. It serves as the basis upon

which budgeted Profit & Loss Account and

forecasted Balance Sheet are built up.

8. Write short notes on Flexible Budgets.

1. Meaning: It is a Budget, which by recognizing the difference between fixed, semi – variable

and variable costs, is designed to change in relation to level of activity.

2. Need: The need for the preparation of Flexible Budgets arises in the following circumstances

–

(a) Seasonal fluctuations in sales and / or production.

(b) Introduction of new products, product designs and versions on a frequent basis,

(c) Industries engaged in make – to – order business like shipbuilding,

(d) An industry which is influenced by changes in fashion, and

(e) General changes in sales.

3. Situations: Flexible Budgeting may be resorted to in the following situations –

(a) New Business: In case of new business venture, due to its typical nature, it may be

difficult to forecast the demand of a product accurately.

(b) Uncertain Environment: Where the business is dependent upon the mercy of nature.

(c) Factor market conditions: In the case of labour intensive industry where the production

of the concern is dependent upon the availability of labour.

9. What are the types of Functional Budgets?

Functional Budgets are broadly grouped under the following heads –

1. Physical Budgets: Budgets that contain information in terms of physical units about sales,

production, etc. For example, Quantity of Sales, Quantity of Production, Inventories,

Manpower Budgets.

2. Cost Budgets: Budgets which provide Cost Information in respect of manufacturing, Selling,

Administration, etc. for example, Manufacturing Costs, Selling Costs, Administration Cost, R

& D Cost Budgets.

3. Profit Budgets: Budgets that enable the ascertainment of Profit, for example, Sales Budget,

Profit & Loss Budget, etc.


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4. Financial Budgets: A Budget, which facilitates to ascertain the Financial Position of a

concern, for example, Cash Budgets, Capital Expenditure Budget, Budgeted Balance Sheet,

etc.

10. List the commonly used Functional Budgets.

1. Sales Budget.

2. Production Budget.

3. Plant Capacity Utilisation Budget.

4. Direct Materials – Usage & Purchase Budgets.

5. Direct Labour – Requirement & Recruitment Budgets.

6. Overhead Cost Budgets – Factory OH, Administration OH, and S&D OH Budgets.

7. Cost Summary Budgets – Primary Cost Budget, Cost of Production Budget, Ending –

inventory Budget, Cost – of – Goods – Sold Budget.

8. Specific Budgets – R&D Cost Budget, Capital Expenditure Budget, Cash Budget.

9. Budget Summaries / Master Budget – Budgeted Income Statement and Budgeted Balance

Sheet.

11. What are the factors to be considered in preparing the Sales Budget?

1. Sales Forecast and Sales Budget: Sales forecast is the initial stage of budgeting. A Sales

forecast is a projection or estimate of the available customer demand. A Forecast reflects the

environmental or competitive situation facing the Company, whereas the Sales Budget shows

how the Management intends to react to this environmental and competitive situation. Thus,

the Sales Budget is active rather than passive.

2. Factors: The following factors have to be considered for preparing the Sales Budget –

(a) Reports by Salesmen who have first – hand information about the local conditions

prevailing in their areas, competition, etc.

(b) Past Sales Analysis – statistical forecasting techniques are used to project the sales

volume based on past sales data.

(c) General economic and political conditions.

(d) Relative product profitability.

(e) Market Research studies which provide information like state of the market, fashion

changes, consumer preferences, activities of competitors, ability of the consumers to pay

etc.

(f) Pricing Policies.

(g) Advertising and Sales Promotion.

(h) Quality of sales force.

(i) Competition, Market size and Market Share.

(j) Seasonal and cyclical variations.

(k) Production Capacity of the plant.

(l) Change in Company‟s policy like introduction of a new product or design.

(m) Special conditions affecting the business. For example, an increase in the production of

automobiles with increase in demand of tyres.

3. Classification: The Sales Budget is prepared on the following bases to facilitate control –

(a) Products or groups of products.

(b) Areas, Towns, Salesmen and Agents.

(c) Types of customers e.g. (i) Government, (ii) Export, (iii) Local Sales, (iv) Retail Depots.

(d) Period – months, weeks, etc.

12. What are the purposes of Plant Utilisation Budget?

Plant Utilisation Budget represents, in terms of working hours, weight or other convenient units of

plant facilities required to carry out the programme laid down in the Production Budget. Its main

purposes are –


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1. To determine the loads on each process, cost or groups of machines for the Budget Period.

2. To indicate the processes or cost centres which are overloaded so that corrective action may

be taken, e.g. (i) working overtime, (ii) sub – contracting, (iii) expansion of production

facility, etc.

3. To adjust and alter the Sales Production Budgets where it is not possible to increase the

capacity of any of the overloaded processes.

4. To take steps to increase sales in order to utilize available surplus capacity.

13. Write short notes on Budget Ratios.

Explain three Control Ratios used for performance evaluation.

The following Control Rations are used in Performance Evaluation –

Ratio Meaning Time – Based Formula Output – Based Formula

1. Budgeted

Capacity

Usage

Ratio

Relationship

between the

budgeted

number of

working hours

and the

maximum

possible

number of

working hours

in a budget

period.

Budgeted Hours

Practical Plant Capacity Hours

Budgeted Output

Practical Plant Capacity Output

2. Actual

Capacity

Utilisation

Ratio

Indicates the

extent to

which

facilities were

actually

utilized during

the budget

period. [See

Note 2]

(a) Actual Hours (or)

Budgeted Hours

(b) Actual Hours

Possible Hours

(a) Standard Output (or)

Budgeted Output

(b) Standard Output

Possible Output

3. Efficiency

Ratio

Standard

Hours

equivalent of

work

produced

expressed as a

percentage of

the Actual

Hours spent in

producing the

work.

Standard Hours

Actual Hours

Actual Output

Standard Output

4. Calendar

Ratio

Relationship

between the

number of

working days

in a period and

the number of

working days

in the relative

budget period.

Actual Days (or)

Budgeted Days

Possible Hours

Budgeted Hours

Possible Output

Budgeted Output


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5. Volume or

Level of

activity

Ratio

Number of

standard

Hours

equivalent to

work

produced

expressed as a

percentage of

the budget of

Standard

Hours.

Standard Hours

Budgeted Hours

Actual Output

Budgeted Output

Notes:

1. For Actual Capacity Utilization Ratio, Formula (a) is generally applied. Formula (b) will be

used only when there is a difference between Actual Days and Budgeted Days, i.e. when

Calendar Ratio is also applicable.

2. If the ratio is 100% or more, the performance is considered favourable, and if ratio is less than

100% the performance is considered as unfavorable.

3. Volume Ratio = Capacity Ratio x Efficiency Ratio x Calendar Ratio.

4. Also refer Fixed OH Variance Analysis in Chapter 10 for computation of Capacity,

Efficiency and Calendar Variances.

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