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COST AND MANAGEMENT ACCOUNTING

UNIT - I :

1.1 COST ACCOUNTING

Introduction

Cost Accounting is a branch of accounting and has been developed due to limitations of financial
accounting. Financial accounting is primarily concerned with record keeping directed towards the
preparation of Profit and Loss Account and Balance Sheet. It provides information regarding the
profit and loss that the business enterprise is making and also its financial position on a particular
date. The financial accounting reports help the management to control in a general way the various
functions of the business but it fails to give detailed reports on the efficiency of various divisions.

1.1.1 Meaning of Cost Accounting

Cost Accounting implies a branch of accounting which deals with recording, classifying,
accumulation, allocation and control of the cost of production. It captures the incomes and
expenditures and prepares statements and reports for the respective period, so as to determine
and control costs.

Definition of Cost Accounting

According to Van Sickle ; “Cost Accounting is the science of recording and

presenting business transactions pertaining to the production of goods and
services, whereby these records become a method of measurement and means of
control”.

According to Kohler ; “It is that branch of accounting dealing with the

classification, recording, allocation, summarisation and reporting of current and
prospective costs”.

According to Wheldon; “It is the classifying, recording and appropriate allocation

of expenditure for the determination of the costs of products or services, the
relation of these costs to sales values and the ascertainment of profitability”.

Objectives of cost accounting

1 Cost control: The first function is to control the cost within the budgetary
constraints management has set for a particular product or service. This is important
since management allocates limited resources to particular projects or production
processes.

2 Cost computation: It is the source of all other functions of cost accounting as

we can calculate the cost of sales per unit for a particular product.

3 Cost reduction: Cost computation helps the company reduce costs on projects

and processes. Reduction in costs means more profits since the margin will

naturally increase.

Types of Cost Accounting

1  Standard cost accounting: It is a method of alternating the estimated cost with an actual cost and showing the periodic
variances of the estimated cost with its actual costs.

2  Activity-based costing: It is a method of identifying the activities performed by a company and allocates the indirect costs
to the products and services based on the actual consumption by each product or service.

3  Resource consumption accounting: It is a management theory that explains the comprehensive management accounting
approach which helps the management to make decisions for the company's overall growth.

4  Throughput accounting: It is an accounting approach which helps the management to make decisions for the company's
profitability growth.

5  Life Cycle Costing: It is a measure used to analyze the pending and future costs and find out alternative measure that
would have a positive impact on such costs. It compares the initial investment possibilities and evaluates the least cost courses
of actions for a period of twenty years.

5  Environmental Accounting: It is an accounting that identifies the use of natural resources, analyze the costs associated
with it and its impact on the environment and provides the detailed cost information with alternative course of actions.

6 Target Costing: It is an accounting method to evaluate the cost of product's life cycle which would be effective,

functional, qualitative and able to generate expected profit.

SCOPE OF COST ACCOUNTING

Scope of cost accounting consists of the following functions:

(i) Costing: Costing is the technique and process of ascertaining costs of products or

services. The cost ascertainment procedure is governed by some cost accounting principles

and rules. Generally, cost is ascertained using some arithmetical process.

(ii) Cost Accounting: This is a process of accounting for cost which begins with the recording

of expenditure and ends with the preparation of periodical statement and reports for

ascertaining and controlling cost. Cost Accounting is a formal mechanism of cost

ascertainment.

(iii) Cost Analysis: It involves the process of finding out the factors responsible for variance

in actual costs from the budgeted costs and accordingly fixation of responsibility for cost

differences. This also helps in better cost management and strategic decisions.

(iv) Cost Comparisons: Cost accounting also includes comparisons of cost from alternative

courses of actions such as use of different technology for production, cost of making

different products and activities, and cost of same product/ service over a period of time.

(v) Cost Control: It involves a detailed examination of each cost in the light of advantage

received from the incurrence of the cost. Thus, we can state that cost is analyzed to know

whether cost is exceeding its budgeted cost and whether further cost reduction is possible.

(vi) Cost Reports: This is the ultimate function of cost accounting. These reports are

primarily prepared for the use by the management at different levels. Cost Reports helps in

planning and control, performance appraisal and managerial decision making.

(vii) Statutory Compliances: Maintaining cost accounting records as per the rules prescribed

by the statute to maintain cost records relating to utilization of materials, labour and other

items of cost as applicable to the production of goods or provision of services as provided in

the Act and these rules.

Procedures of Cost Accounting

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The advantages of cost accounting

Cost accounting is the process of collecting and interpreting information to determine how an organization earns

and uses funds. There are multiple advantages to using cost accounting, since it provides vastly more actionable

information than the financial statements produced through financial accounting . The key advantages of cost

accounting are:

1 Cost object analysis. Revenues and expenses can be clustered by cost object , such as by product, product

line , and distribution channel , to determine which ones are profitable or require further support.

2 Investigate causes. An effective cost accountant not only locates problems within a company, but also drills

down through the data to determine the exact cause of the issue, and also recommends solutions to

management.

3 Trend analysis. Costs can be tracked on a trend line to discover expense surges that may be indicative of

long-term trends.

4 Modeling. Costs can be modeled at different activity levels. For example, if management is contemplating

the addition of a second shift, cost accounting can be used to derive the additional costs associated with that

shift.

5 Acquisitions. The cost structures of possible acquisition candidates can be examined to see if costs can be

pruned in some areas, thereby justifying the cost of the acquisition.

6 Project billings. If a company is billing a customer based on costs incurred, cost accounting can be used

to accumulate costs by project and roll this information into customer billings.

7 Budget compliance. Actual costs incurred can be compared to budgeted or standard costs , to see if any part

of a business is spending more than expected.

8 Capacity. The ability of a business to support increased sales levels can be examined by exploring the

amount of its excess capacity . Conversely, equipment that is idle can be sold off, thereby reducing the asset

base of the organization.

9 Outsourcing. One can determine whether certain tasks or processes should be handled in-house or

outsourced, based on an analysis of the relevant costs.

10 Inventory valuation. The cost accountant is usually tasked with accumulating the cost of inventory for

financial reporting purposes. This includes charging direct labor to inventory, as well as allocating factory

overhead to inventory.
 Limitations of Cost Accounting:
Cost Accounting like other branches of accounting is not an exact science but  is an art which based on reasoning and
common sense. Thus, it may have some limitations. The main limitations of cost accounting are as follows:

(i) Dependent: Cost Accounting is not an independent system of accounts. It always depends on date provided by the Financial
Accounting.

(ii) Based on estimates: It is largely based on estimates like absorption of direct expenses or apportionment of expenses on estimate
basis.

(iii) Subjective: There is a scope for subjectivity on items like depreciation, valuation of closing stock etc.

(iv) Ignore some important items: It dos not take into consideration of all items of expenses and incomes, e.g. items of purely
financial  nature such as interest , financial changes, discount and loss on issue of shares and debentures.

(v) Lack of uniform procedure: Different results may be arrived from the same information due to lack of uniform procedure.

(vi) Expensive: Installation of Cost Accounting System is costly and expensive for small manufacturers.

1.2 Essentials of Good Cost Accounting system

The essential features, which a good cost accounting system should possess, are as follows:

(a) Informative and simple: Cost accounting system should be tailor-made, practical, simple and
capable of meeting the requirements of a business concern. The system of costing should not
sacrifice the utility by introducing meticulous and unnecessary details.

(b) Accurate and authentic: The data to be used by the cost accounting system should be accurate
and authenticated; otherwise it may distort the output of the system and a wrong decision may be
taken.

(c) Uniformity and consistency: There should be uniformity and consistency in classification,
treatment and reporting of cost data and related information. This is required for benchmarking and
comparability of the results of the system for both horizontal and vertical analysis.

(d) Integrated and inclusive: The cost accounting system should be integrated with other systems
like financial accounting, taxation, statistics and operational research etc. to have a complete
overview and clarity in results.

(e) Flexible and adaptive: The cost accounting system should be flexible enough to make necessary
amendment and modifications in the system to incorporate changes in technological, reporting,
regulatory and other requirements.

(f) Trust on the system: Management should have trust on the system and its output. For this, an
active role of management is required for the development of such a system that reflect a strong
conviction in using information for decision making.

 Requisites of a Good Cost Accounting System

To achieve the objectives of a business organization a good Cost Accounting
system should be.

1. Simple and Easy to Operate – The system of Cost Accounting should be

simple to be understood by an average person. All important informations, facts
and figures must be provided with cost records to make it more meaningful and
enable the managers to exercise the cost control.

2. Suitable to the Business – A Cost Accounting system should be designed

according to the nature, type and size of the business. It should serve the business
by providing all necessary information’s.

3. Flexible – A Cost Accounting system should be flexible enough to be changed

according to the business environment and conditions. For example, if a business
expands this system should absorb in it. This feature is necessary because
business environment is not stable.

4. Economy – The cost of operating costing system must be minimum. Its

benefits should exceed its cost.

5. Comparability – The cost records should be maintained in such a way to

facilitate comparison between present and past figures.

1.3 Methods and Techniques of Costing

Introduction

It is necessary to understand the difference between the costing methods and techniques. Costing
methods are those which help a firm to compute the cost of production or services offered by it. On
the other hand, costing techniques are those which help a firm to present the data in a particular
manner so as to facilitate the decision making as well as cost control and cost reduction. Costing
methods and techniques are explained below.

METHODS OF COSTING

The fundamental principles of cost ascertainment remain the same but the methods of
analysing and presenting theses costs differ from industry to industry. Broadly, there are two
main methods used to determine costs viz. Job Cost Method and Process Cost Method.
However, the different methods of costing can be further bifurcated and can be explained in
detail as follows:
1. JOB COSTING This method is used for tracing specific costs to individual jobs especially
where production is not highly repetitive. The cost ascertainment is for specific jobs or orders
which are not comparable with each other. Job costing is commonly used in printing press,
automobile garage, repair shops, etc.

2. CONTRACT COSTING Principally, there is no difference between job and contract

costing but it is convenient to prepare and maintain separate contract accounts when large
scale contracts are carried out at different sites like in the case of building construction, ship
builders, etc. A contract is a big job while a job is a small contract.

3. COST PLUS COSTING In some contracts, an agreed sum or percentage besides cost 'to
cover overheads and profit is paid to the contractor. This system of costing is termed as cost
plus costing. The system is used generally where Government is the contractee.

4. BATCH COSTING In this method of costing, a batch of similar products is considered as

one job and the cost of the complete batch is ascertained. Thereafter, the cost of each unit is
determined. Pharmaceutical industries, brick manufacturing companies generally use this
method.

5. PROCESS COSTING If a product passes through different stages, each distinct and well-
defined, with the output of one process becoming the input for the other, it is desirable to
know the cost of production at each stage. Process costing is employed to ascertain the same.
The system of costing is suitable for the extractive industries, e.g., chemical manufacture,
paints, foods, explosives, soap making etc.

6. OPERATION COSTING; The procedure of operation costing is broadly the same as for
process costing except that cost unit is an operation instead of a process. For large
undertakings involving a number of operations, it is important to compute the cost of each
operation. For example, the manufacturing of handles for bicycles will make use of operation
costing as it involves many operations like cutting steel sheets into proper strips, moulding,
machining and finally polishing.

7. UNIT COSTING (OUTPUT COSTING OR SINGLE COSTING) Under this method of

costing, cost of a single product produced by a continuous manufacturing process is
computed in addition to amount of each element of cost. The method is suitable in industries
such as flour mills, paper mills, cement manufacturing etc.

8. OPERATING COSTING

Also known as service costing, this method is employed to ascertain the cost of services
rendered like transport companies, electricity companies, or railway companies. The total
expenses regarding operation are divided by the units as may be appropriate (e.g., total
number of passenger-kms. in case of bus company) and cost per unit of service is calculated.

9. DEPARTMENTAL COSTING Departmental Costing aims to ascertain the cost of output

of each department of the company separately.
10. MULTIPLE COSTING (COMPOSITE COSTING) Application of more than one method
of costing for the same product is done under multiple costing. Herein, the costs of different
sections of production are combined after finding out the cost of every part manufactured. It
is applicable where a product comprises of many assembled parts, e.g., motor cars, engines,
machine tools, typewriters, radios, cycles etc.

B TECHNIQUES OF COSTING

In addition to the above stated methods, the following techniques of costing are used by
management for the purpose of managerial decision making and controlling costs.

1. MARGINAL COSTING Marginal costing has been defined as ‗the accounting system in
which variable costs are charged to cost units and the fixed costs of the period are written-off
in full against the aggregate contribution. 'Fixed overheads are excluded on the ground that in
cases where production varies, the inclusion of fixed overheads may give misleading results.

2 . DIRECT COSTING The practice of charging all direct costs to operation, process or
products, excluding all indirect costs to be written off against profits in the period in which
they arise, is referred to as direct costing. Direct costing The technique considers some fixed
costs as direct costs in appropriate circumstances, thus differentiating it from marginal
costing.

3 . ABSORPTION COSTING The Institute of Cost and Management Accountant of India

defines absorption costing as ―a method of costing by which all direct costs and applicable
overheads are charged in products or cost centres for finding out the total cost of production.
Absorbed cost includes production cost as well as administrative and other costs.Absorption
costing does not make any difference between variable and fixed cost in the calculation of
profits. It charges all costs, both variable and fixed, to operations, products or processes.

4 . UNIFORM COSTING Uniform costing refers to a technique of costing wherein

standardised principles and methods of cost accounting are employed by a number of
different companies and firms, thus, facilitating inter-firm comparisons, establishment of
realistic pricing policies etc.

5. ACTIVITY BASED COSTING The Chartered Institute of Management Accountants

(CIMA), London, defines it as a technique of cost attribution to cost units on the basis of
benefits received from indirect activities e.g. ordering, setting up, assuring quality.‖ In other
words, it is a method of assigning organisation‘s resource costs through activities (called cost
drivers) to the products and services. It is generally used by a company having products that
differ in volume and complexity of production for the purpose of apportionment of overhead
costs.

1.4 Importance of Cost Accounting

1. Trade depression and trade competition: In periods of trade depression the business cannot afford to
have leakages which pass unchecked. The management should know where economies may be
sought, waste eliminated and efficiency increased. The management should distinguish the actual cost
of their products before embarking on any scheme of reducing the prices on giving tenders.
2. Facilitates in price fixation: Though economic law and supply and demand and activities of the
competitors, determine the price of the article, cost to the producer does play an important part. The
producer can take necessary guidance from his costing records.

3. Cost accounting helps in estimate: Appropriate costing records provide a reliable basis upon which
tenders and estimates may be prepared. The chances of losing a contract on account of over rating or
losing in the execution of a contract due to under rating can be minimized. In this way, "ascertained
costs provide a measure for estimates, a guide to policy, and a control over current production.

4. Channelling production on right lines: Costing enables the management to distinguish between
profitable and non-profitable activities. Profit can be maximized by focusing on profitable operations and
eliminating non-profitable ones.

5. Wastages are eliminated: As it is possible to know the cost of the article at every stage, it becomes
possible to block various forms of waste, such as time, expenses etc. or in the use of machine,
equipment and tools.

6. Costing makes comparison possible: If the costing records are constantly maintained, comparative
cost data for different periods and various volumes of production will be available. It will help the
management to develop future lines of action.

7. Data for periodical profit and loss accounts: Passable costing records supply to the management
such data which may be needed for preparation of profit and loss account and balance sheet, at such
intervals as may be desired by the management. It also describes in detail the sources of profit or loss
revealed by the financial accounts thus helps in presentation of better information before the
management.

8. Determining and enhancing efficiency: Losses due to wastage of material, idle time of workers, poor
supervision will be disclosed if the various operations involved in manufacturing a product are studied by
a cost accountant. The efficiency can be measured and costs controlled and through it various devices
can be framed to increase the efficiency.

9. Controlling inventory: Costing provides control which management requires in respect of stock of
materials, work-in-progress and finished goods.

10. Cost reduction: Costs can be reduced in the long run when alternatives are provided.
 11. Enhance productivity: Productivity of material and labour is required to be increased to have growth
and more profitability in the organisation costing renders great assistance in measuring productivity and
suggesting ways to improve it.

12 Determining selling price. It controls material and supplies. Management get more
benefit with the initiating of cost accounting. It helps to ascertain the cost and selling price of
the product. Cost data help management to develop the business policies.
13 Beneficial for investors. Investors want to know the financial conditions and earning
capacity of the business. An investor must collect information about organization before
making investment decision and investor can gather such information from cost accounting.

1.5 Elements of cost

1.6 Classification of Costs.

It means the grouping of costs according to their common characteristics. The important ways of
classification of costs are:

(i) By Nature or Element

(ii) By Functions

(iii) By Variability or Behaviour

(iv) By Controllability

(v) By Normality

(vi) By Costs for Managerial Decision Making

1 By Nature or Element

This type of classification is useful to determine the total cost.

A diagram as given below shows the elements of cost described as under:

(i) Direct Materials: Materials which are present in the finished product(cost object) or can be
economically identified in the product are called direct materials. For example, cloth in dress
making; materials purchased for a specific job etc. However, in some cases a material may be direct
but it is treated as indirect, because it is used in small quantities, it is not economically feasible to
identify that quantity and those materials which are used for purposes ancillary to the business.
 (ii) Direct Employee (Labour): Labour which can be economically identified or attributed wholly to a
cost object is called direct labour. For example, employee engaged on the actual production of the
product or in carrying out the necessary operations for converting the raw materials into finished
product.

(iii) Direct Expenses: It includes all expenses other than direct material or direct labour which are
specially incurred for a particular cost object and can be identified in an economically feasible way.
For example, hire charges for some special machinery, cost of defective work.

(iv) Indirect Materials: Materials which do not normally form part of the finished product (cost
object) are known as indirect materials. These are —

• Stores used for maintaining machines and buildings (lubricants, cotton waste, bricks etc.)

• Stores used by service departments like power house, boiler house, canteen etc.

(v) Indirect Labour: Labour costs which cannot be allocated but can be apportioned to or absorbed
by cost units or cost centres is known as indirect labour. Examples of indirect employees include
foreman and supervisors; maintenance workers; etc.

(vi) Indirect Expenses: Expenses other than direct expenses are known as indirect expenses, that
cannot be directly, conveniently and wholly allocated to cost centres. Factory rent and rates,
insurance of plant and machinery, power, light, heating, repairing, telephone etc., are some
examples of indirect expenses.

(vii)Overheads: It is the aggregate of indirect material costs, indirect labour costs and indirect
expenses. The main groups into which overheads may be subdivided are the following:

• Production or Works Overheads: Indirect expenses which are incurred in the factory and for the
running of the factory. E.g.: rent, power etc.

• Administration Overheads: Indirect expenses related to management and administration of

business. E.g.: office rent, lighting, telephone etc.

• Selling Overheads: Indirect expense incurred for marketing of a commodity. E.g.: Advertisement
expenses, commission to sales persons etc.

• Distribution Overheads: Indirect expense incurred to despatch of the goods E.g.: warehouse
charges, packing and loading charges.

2 By Functions Under this classification

costs are divided according to the function for which they have been in-curred. It includes the
following: (i) Direct Material Cost (ii) Direct Employee (labour) Cost (iii) Direct Expenses (iv)
Production/ Manufacturing Overheads (v) Administration Overheads (vi) Selling Overheads (vii)
Distribution Overheads (viii) Research and Development costs etc.

3 By Variability or Behaviour
According to this classification costs are classified into three group viz., fixed, variable and semi-
variable.

(a) Fixed costs– These are the costs which are incurred for a period, and which, within certain
output and turnover limits, tend to be unaffected by fluctuations in the levels of activity (output or
turnover). They do not tend to increase or decrease with the changes in output. For example, rent,
insurance of factory building etc., remain the same for different levels of production.

(b) Variable Costs– These costs tend to vary with the volume of activity. Any increase in the activity
results in an increase in the variable cost and vice-versa. For example, cost of direct labour, etc.

(c) Semi-variable costs– These costs contain both fixed and variable components and are thus partly
affected by fluctuations in the level of activity. Examples of semi variable costs are telephone bills,
gas and electricity etc.

4 By Controllability

Costs here may be classified into controllable and uncontrollable costs.

(a) Controllable Costs: - Cost that can be controlled, typically by a cost, profit or investment centre
manager is called controllable cost. Controllable costs incurred in a particular responsibility centre
can be influenced by the action of the executive heading that responsibility centre. For example,
direct costs comprising direct labour, direct material, direct expenses and some of the overheads are
generally controllable by the shop level management.

(b) Uncontrollable Costs - Costs which cannot be influenced by the action of a specified member of
an undertaking are known as uncontrollable costs. For example, expenditure incurred by, say, the
tool room is controllable by the foreman in-charge of that section but the share of the tool-room
expenditure which is apportioned to a machine shop is not to be controlled by the machine shop
foreman.

5 By Normality

According to this basis cost may be categorised as follows:

(a) Normal Cost - It is the cost which is normally incurred at a given level of output under the
conditions in which that level of output is normally attained.

(b) Abnormal Cost - It is the cost which is not normally incurred at a given level of output in the
conditions in which that level of output is normally attained. It is charged to Costing Profit and loss
Account.

6 By Costs for Managerial Decision Making

According to this basis cost may be categorised as follows:

(a) Pre-determined Cost - A cost which is computed in advance before production or operations
start, on the basis of specification of all the factors affecting cost, is known as a pre-determined cost.
(b) Standard Cost - A pre-determined cost, which is calculated from managements ‘expected
standard of efficient operation’ and the relevant necessary expenditure. It may be used as a basis for
price fixation and for cost control through variance analysis.

(c) Marginal Cost -The amount at any given volume of output by which aggregate costs are changed
if the volume of output is increased or decreased by one unit.

(d) Estimated Cost - Kohler defines estimated cost as “the expected cost of manufacture, or
acquisition, often in terms of a unit of product computed on the basis of information available in
advance of actual production or purchase”. Estimated costs are prospective costs since they refer to
prediction of costs.

(e) Differential Cost - (Incremental and decremental costs). It represents the change (increase or
decrease) in total cost (variable as well as fixed) due to change in activity level, technology, process
or method of production, etc. For example, if any change is proposed in the existing level or in the
existing method of production, the increase or decrease in total cost or in specific elements of cost
as a result of this decision will be known as incremental cost or decremental cost.

(f) Imputed Costs - These costs are notional costs which do not involve any cash outlay. Interest on
capital, the payment for which is not actually made, is an example of imputed cost. These costs are
similar to opportunity costs.

(g) Capitalised Costs -These are costs which are initially recorded as assets and subsequently
treated as expenses.

(h) Product Costs - These are the costs which are associated with the purchase and sale of goods (in
the case of merchandise inventory). In the production scenario, such costs are associated with the
acquisition and conversion of materials and all other manufacturing inputs into finished product for
sale. Hence, under marginal costing, variable manufacturing costs and under absorption costing,
total manufacturing costs (variable and fixed) constitute inventoriable or product costs.

(i) Opportunity Cost - This cost refers to the value of sacrifice made or benefit of opportunity
foregone in accepting an alternative course of action. For example, a firm financing its expansion
plan by withdrawing money from its bank deposits. In such a case the loss of interest on the bank
deposit is the opportunity cost for carrying out the expansion plan.

(j) Out-of-pocket Cost - It is that portion of total cost, which involves cash outflow. This cost concept
is a short-run concept and is used in decisions relating to fixation of selling price in recession, make
or buy, etc. Out–of–pocket costs can be avoided or saved if a particular proposal under
consideration is not accepted.

(k) Shut down Costs - Those costs, which continue to be, incurred even when a plant is temporarily
shutdown e.g. rent, rates, depreciation, etc. These costs cannot be eliminated with the closure of
the plant. In other words, all fixed costs, which cannot be avoided during the temporary closure of a
plant, will be known as shut down costs.

(l) Sunk Costs - Historical costs incurred in the past are known as sunk costs. They play no role in
decision making in the current period. For example, in the case of a decision relating to the
replacement of a machine, the written down value of the existing machine is a sunk cost and
therefore, not considered.

(m) Absolute Cost - These costs refer to the cost of any product, process or unit in its totality. When
costs are presented in a statement form, various cost components may be shown in absolute
amount or as a percentage of total cost or as per unit cost or all together. Here the costs depicted in
absolute amount may be called absolute costs and are base costs on which further analysis and
decisions are based.

(n) Discretionary Costs – Such costs are not tied to a clear cause and effect relationship between
inputs and outputs. They usually arise from periodic decisions regarding the maximum outlay to be
incurred. Examples include advertising, public relations, executive training etc.

(o) Period Costs - These are the costs, which are not assigned to the products but are charged as
expenses against the revenue of the period in which they are incurred. All non-manufacturing costs
such as general &administrative expenses, selling and distribution expenses are recognised as period
costs.

(p) Engineered Costs - These are costs that result specifically from a clear cause and effect
relationship between inputs and outputs. The relationship is usually personally observable. Examples
of inputs are direct material costs, direct labour costs etc. Examples of output are cars, computers
etc.

(q) Explicit Costs - These costs are also known as out of pocket costs and refer to costs involving
immediate payment of cash. Salaries, wages, postage and telegram, printing and stationery, interest
on loan etc. are some examples of explicit costs involving immediate cash payment.

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

FILLING THE BLANKS

1. Anything for which a separate measurement of cost is desired may be defined as __________.

2. __________ refers to an activity which generates cost.

3. __________ measures both the inputs and outputs in monetary terms.

4. The elements of cost include _________, _________, ________ and _________.

5. Certain items which are included in financial accounts but not in cost accounts can be broadly
categorized into _________, _________ and ________ .

6. A component of cost which includes all direct costs is ________ .

7. ________ summarises the components of cost in the form of a statement.

8. ________ are costs which can be influenced by the budget holder.

9. ________costs are irrelevant for decision making as they cannot be changed by any decision that
will be made in the future.

10. _______is the process of computing costs on the basis of actual data.

Ans: (1) (Cost object), (2) (Cost driver), (3) (Profit Centre), (4) (Direct Material, Direct Labour, Direct
Expenses and Overheads ), (5) (Appropriation of profits, Matters of pure finance, Abnormal gains
and losses), (6) (Prime cost), (7) (Cost Sheet), (8)(Controllable costs) (9)(Sunk), (10)(Cost
ascertainment)

MULTIPLE CHOICE QUESTTIONS AND CHOICES

1. The two main methods used to determine costs are:

a. Job Cost Method and Process Cost Method.

b. Unit costing and contract costing

c. Job costing and batch costing

d. Process costing and contract costing

2. In case of building construction, ______ method of costing will be used.

a. Batch costing b. Job costing c. Process costing d. Contract costing

3. Unit costing is also known as_______.

a. Output costing b. Batch costing c. Process costing d. Contract costing

4. ________ and operating costing are the same.

a. Job costing b. Process costing c. Contract costing d. Service costing.

5. Cost of each department is ascertained under:

a. Batch costing b. Departmental costing c. Process costing d. Contract costing

6. ________ costing excludes fixed cost from consideration

a. Job costing b. Absorption costing c. Contract costing d. Marginal costing.

Ans: (1) (a), (2) (d), (3) (a), (4) (d), (5) (b), (6) (d)

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USERS OF COST AND MANAGEMENT ACCOUNTING

Cost and management accounting information which are generated or collected are used by
different stakeholders. The users of the information can be broadly categorised into internal and
external to the entity.

A Internal Users

Internal users, which use the cost and management accounting information may include the
followings:

(a) Managers- The managers use the information (i) to know the cost of a cost object and a cost
centre (ii) to price for the product or service (iii) to measure and evaluate performance of
responsibility centres (iv) to know the profitability- product-wise, department-wise, customer-wise
etc. (v) to evaluate the strategic options and to make decisions

(b) Operational level staffs- The operational level staffs like supervisors, foreman, team leaders are
requiring information (i) to know the objectives and performance goals for them (ii) to know product
and service specifications like volume, quality and process etc. (ii) to know the performance
parameters against which their performance is measured and evaluated. (iii) to know divisional
(responsibility centre) profitability etc.

(c) Employees- Employees are concerned with the information related with time and attendance,
incentives for work, performance standards etc.

B External Users

External users, which use the cost and management accounting information, may include the
followings:

(a) Regulatory Authorities- Regulatory Authorities are concerned with cost accounting data and
information for different purpose which includes tariff determination, providing subsidies, rate
fixation etc. To do this the regulatory bodies require information on the basis of some standards and
format in this regard.

(b) Auditors- The auditors while conducting audit of financial accounts or for some other special
purpose audit like cost audit etc., requires information related with costing and reports reviewed by
management etc.
(c) Shareholders- Shareholders are concerned with information that effect their investment in the
entity. Management communicate the shareholders through periodic communique, annual reports
etc. regarding new orders received, product expansion, market share for products etc.

(d) Creditors and Lenders- Creditor and lenders are concerned with data and information which
affects an entity’s ability to serve lenders or creditors. For example, any financial institutions which
provides loan to an entity against book debts and stocks are more concerned with regular reporting
on net debt position and stock balances.

UNIT - II
2.2 Costing Methods

Different industries follow different methods of costing because of the differences in the nature of
their work. The various methods of costing are as follows:

1 Single or Output Costing

Here the cost of a product is ascertained, the product being the only one produce like bricks, coals,
etc.

2 Batches Costing

It is the extension of job costing. A batch may represent a number of small orders passed through
the factory in batch. Each batch here is treated as a unit of cost and thus separately costed. Here
cost per unit is determined by dividing the cost of the batch by the number of units produced in the
batch.

3 Job Costing

In this method of costing, cost of each job is ascertained separately. It is suitable in all cases where
work is undertaken on receiving a customer’s order like a printing press, motor workshop, etc.

4 Contract Costing

Here the cost of each contract is ascertained separately. It is suitable for firms engaged in the
construction of bridges, roads, buildings etc.

5 Process Costing

Here the cost of completing each stage of work is ascertained, like cost of making pulp and cost of
making paper from pulp. In mechanical operations, the cost of each operation may be ascertained
separately; the name given is operation costing.

6 Operating Costing

It is used in the case of concerns rendering services like transport, supply of water, retail trade etc.
7 Multiple Costing

It is a combination of two or more methods of costing outlined above. Suppose a firm manufactures
bicycles including its components; the parts will be costed by the system of job or batch costing but
the cost of assembling the bicycle will be computed by the Single or output costing method. The
whole system of costing is known as multiple costing.

2.2 Collection of Costs

2.3 Valuation of Materials ---issues and Overheads

MEANING OF MATERIAL:

The first and the most important element of the product cost is material. Material is a substance, an
integral part, from which the product is made. And constitutes a significant component of total cost.
Depending upon the type of product manufactured, the material cost may go up to 70-80% of the
total cost.

Material may be classified in three broad categories:

1. RAW MATERIAL: Materials entering the production process at the very beginning in their natural
or raw form. The materials might be appearing in the final product, for example raw cotton (KAPAS)
in the Production of Cotton textile or disappearing in the production process without forming a
tangible part of the output, for example, Coal.

2. SEMI FINISHED MATERIAL: Partly finished materials purchased from outside or produced within
the organization for assembling into a final product, e.g., unpolished furniture purchased from
outside and polished in-house before sale.

3. FINISHED MATERIAL: Finished Material are products that are used in the form they are
manufactured without any further value addition, e.g., an automobile is a finished product used
directly by the consumer. However, finished components can also be used as raw materials or semi-
finished materials for manufacturing of the final product e.g. Tyres, batteries, engine, and other
components are finished material used by automobile manufacturers.

Material Cost may be either direct or indirect:

1 DIRECT MATERIAL:

Direct Materials are those that can be conveniently and wholly identified with specific units of
output/ product/Job/ contract/ processor operations. These become the part of finished product
itself. Example: Leather in leather products, Wood in Furniture production etc. At times, certain
materials of small value though traceable to specific cost unit are treated as indirect material
because the time, energy and cost involved in record keeping of such small value is not worth
achieving a slightly higher accuracy in ascertaining the coste.g. Glue, nails, nut bolt etc.in furniture
production. However, material, of whatever value, used in contracts performed as special sales
outside the factory are ascertained as direct materials as they are for specific contract only

2 INDIRECT MATERIAL:

All those materials that cannot be classified as direct material are called indirect materials. Indirect
materials, generally, do not physically constitute a part of the product as direct material do. Indirect
materials include:

1. Materials, though used in production, which have so small or complex consumption that it is not
feasible to try to trace them to specific products.

2. Production supplies & materials which cannot be identified with specific cost units e.g. Grease,
Lubricating oil, scrap, small tools etc. used in a factory.

Material forms an important part of the cost of the product and, therefore, proper control over
material is necessary from the time the order is placed with the supplier till they are consumed.The
segregation of materials into direct and indirect categories facilitates control. The direct material
having high value, require direct control while indirect materials having low value need not require
excessive controls. An efficient material control system leads to significant reduction in production
cost.

VALUATION OF MATERIALS

1 ISSUING OF MATERIALS

Various products, jobs, processes, contracts, etc. are charged with the cost of materials used by
them. In case, the materials have been exclusively purchased for a job or a contract, these can be
charged at the same rate at which these materials were purchased. But if, the raw materials have
been issued from the stores it becomes necessary to decide about the price which is to be charged
for a material requisition to be used for a particular job or a contract.

2 MATERIAL REQUISITION:

It is a formal request by the user department to the store keeper for the issue of material. This
request should be duly signed by an officer authorized to make such request. It serves as an
authority to the store keeper to issue materials. It is prepared in triplicate. All the three copies are
signed by the store keeper. One copy is returned to the requisitioning department along with the
materials. Second copy is retained by the store keeper which helps him completing its own record of
issue in Bin Cards/ Store Ledger. The third copy is send to the costing department as a basis of
debiting the requisitioning department. This copy facilitates the ascertainment of the cost of the job,
products and processes for which these materials have been used.

3 BILL OF MATERIAL:
 A bill of material is a schedule of materials needed for job or unit of production. It is prepared
generally by the production department or an engineering department as soon as the order is
received. It is prepared for non-standardized jobs where exact material requirement differs from job
to job and there is a need to prepare an advance estimate of cost expected to be incurred on the
job. Commonly followed format is as follows:

A bill of material serves the purpose of material requisition also and therefore must be duly
authorized. It is also prepared in triplicate. One copy is returned to the requisitioning department,
one copy to the costing department and one copy is retained by the storekeeper for completing his
records.

COMPARISON BETWEEN BILL OF MATERIAL AND MATERIAL REQUISITION:

1. Material requisition is an authorization for the store keeper to issue materials. Bill of materials is a
list of materials with complete specification required for a job, contract or order.

2. Bill of material can serve as a material requisition but material requisition cannot serve as bill of
material.

3. Bill of material helps in exercising quantitative control over issues through material requisition.
Withdrawal of material for a job in excess of bill of material may be indicative of wastage requiring
investigations.

4. Bill of material facilitates preparation of quotation for a job. Material requisition cannot be used
for this purpose.

5. Both can be used as material requisition.

6. Both contain description of materials required by the production department.

Under the following situation both material requisition and bill of material should be prepared:

1. In case if the job or process requires longer time for completion, bill of material is prepared in
advance while material requisition is prepared as and when certain materials are required.

2. In case system of standard costing is adopted, bill of material can be prepared based on standard
cost and material requisition can be prepared on actual use of material.

3. Material requisition can be made for issues of material over and above that stated in Bill of
material.

MATERIAL RETURN NOTE:

Sometimes a production department may have materials left over either due to wrong estimation of
requirement for a job or material defect. This excess material should be returned to stores without
delay. Department returning the materials prepares a material return note in triplicate. One copy,
duly signed, is returned by the store keeper to the returning department, one copy is sent to the
costing department as a basis for giving credit to the returning department and the third copy is
retained by the store keeper for completing his own records. Material returned note contains
particulars similar to a material requisition note.

MATERIAL TRANSFER NOTE:

Direct transfer of material from one department to another is generally discouraged due to control
considerations. However, in cases where the transfer of material from one job to stores and from
there to another job is costly and inconvenient on account of heavy transport and handling charges,
material may be directly transferred from one job to another provided they are accompanied with
the “material transfer note.” The note will contain the details regarding materials and the job
involved. It will be signed by the foreman of the receiving job and then sent to the cost office for
making appropriate entries. A specimen of material transfer note is given below:

VALUATION OF INCOMING MATERIALS

The receipt of materials means incoming materials meant for conversation into final product. The
incoming materials are to be valued at invoice price subject to trade or quantity discount plus all
expenses incurred up to the point of placing materials in a condition suitable for issuance from the
stores. These Expenses includes:

Transportation including cartage expenses.

Receiving unpacking and inspecting costs.

Insurance and storage costs.

Accounting and purchasing costs.

The basic price of Materials is to be adjusted upwards considering the cost of containers and the
discount availed. The supplier of materials may charge separately for the containers that he has used
for supplying materials. In case these containers are not returnable, their cost must be added to the
cost of materials received. If the containers are returnable at a price less than the cost charged the
difference must be charged to the cost of material received. In case they are to be returned at full
cost charged their cost should not be added to the cost of incoming materials. Sales Tax, excise duty,
custom duty, Insurance etc. are to be added to the purchase price. The price of material is to be
adjusted with respect to discount too. Discount is of three types:

Trade Discount: It refers to allowance which is permitted by the vendor to a purchaser who must
resell the articles. The allowance is permitted to compensate the purchaser for storage, bulk
breaking and delivering small quantities.
Quantity Discount: Such discount is allowed by the supplier to the buyer to encourage him to place
large orders. Both trade and quantity discounts should be taken into account while valuing the
incoming materials.

Cash Discount: Such discount is allowed by the vendor to the buyer to encourage him to make
prompt payment of invoice. It is given only when the debtor gives the payment within the stipulated
period. As it is a financial incentive, it is not to be included in valuing the incoming cost of materials.

Illustration 13:
Vinayak Limited quotes for material M as under:

Lot size (kg) Rate (Rs.)

500 20.00

1,250 14.00

2,000 12.00

The supplier allows a trade discount of 25% and cash discount of 4% if payment is made within two
weeks. One container is required for every 50 Kg of materials, and the containers are charged at Rs.
15 each but credited at Rs. 10 on return. The buyer decides to buy 2000 Kgs. of materials from
Vinayak Limited. Transport charges of Rs. 1,000 are charged by the supplier. Calculate the price of
2,000 Kgs. of materials.

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METHODS OF PRICING ISSUES:

The problem of pricing the issues arises only when large quantities of materials purchased at
different prices remain in the stock for a period of time making it difficult to identify which unit of
material was purchased at what price and hence which price is to be charged for which issue. The
pricing of issues only deals with the assigning of pricing to the issues. It has nothing to do with the
actual physical movement of materials. The objective of material pricing are:

1. To provide satisfactory basis for the evaluation of closing stock to prepare the final accounts.

2. To charge the cost of material used for measuring the cost of production and cost of sales. When
materials are issued from the stores to the various production departments, the pricing of the issued
materials can be done according to different methods. Each method has its own area of suitability
depending on the nature of materials, price trends and the management policy.

A FIRST IN FIRST OUT (FIFO):

Under this method, issues are priced on the assumption that materials purchased first are issued
first. The actual physical movement may or may not follow this pattern. Materials issued are priced
at the oldest price recorded in stores lodger for materials in stock. So the closing stock of material is
valued at the price of the latest purchases. The method is particularly suitable in case of perishable
materials and in the period of falling prices. The issues are priced at oldest prices which are higher
and hence facilitate the recovery of higher costs. The closing stock is valued at the latest prices
which are lower. These results in lower value of closing stock and hence lower book profits thereby
lower tax liability. In case of rising prices, the effect is the reverse.

Advantages:

1. Most suitable in Perishable product as pricing method more on less corresponds with actual
movement of Materials.

2. Simple to understand.

3. All issues are priced at cost price, hence entire cost of materials are recovered.

4. The method results in lower book profits and hence lower tax liability during the period of falling
prices.

5. The value of closing stock is realistic as it is valued at the price of latest purchases.

Disadvantages:

1. The issue price differs for different issues of the same quality of raw material at the same time.
Therefore cost comparisons get distorted.

2. During the period of rising prices, it results in higher book profits and therefore high tax liability.
This is because closing stock appearing on the credit side is valued at higher prices and the cost of
production appearing on the debit side is valued lower prices.

3. For pricing one material requisition more than one price may be involved and hence leads to
higher probability of clerical errors.

B LAST IN FIRST OUT (LIFO):

Under this method, issues are priced on the assumption that material purchased last are issued first,
though the actual physical movement of materials may not follow this pattern. Issues are priced at
the price of latest purchases of materials remaining unissued at per records. As a result the closing
stock gets priced at the price of the earliest purchases of materials lying unutilized as per records.
The method is particularly useful in the case of rising prices. The production is charged at the price of
latest purchases while the closing stock at the earliest prices which are lower. This leads to lower
book profit and hence less tax liability. In case of falling prices the effect is reverse.

Advantage:

1. Method gives good matching of sales and cost of sales.

2. Method is simple to understand. 3. Issues are priced at cost and hence entire cost of material used
is recovered from production.

4. It results in lower book profits and hence lower tax.

Disadvantages:

1. The issue price differs in different issues and hence distorts cost comparison.

2. During the period of falling prices this method gives high profits and higher tax liability.

3. For pricing are material requisition more than one prices may be involved and hence higher
probability of clerical errors in calculations.

C AVERAGE COST METHOD:

Average costs methods are based on the assumptions that the material purchased in different lots
are stored together and their identity gets lost. Therefore these materials should be charged to
production at an average price. This issue price can be calculated either on the basis of simple
average method or on the basis of weighted average method.

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CLASSIFICATION OF OVERHEADS
Overheads, also termed as indirect or supplementary costs, are those costs which cannot be
identified with a particular cost center or cost unit. Overheads are the aggregate of indirect material,
indirect labour and indirect expenses. These indirect costs are incurred not for one product unit or
cost center, but for multiple cost units or cost centers. The cost of overheads should be
appropriately apportioned to these multiple cost units or cost centers at the time of determination
of the total cost of different products.

Overheads may be classified on the basis of their nature, variability, function and other
characteristics. A summary of the classification can be depicted as follows:
1. On the basis of NATURE or ELEMENTS

a) Indirect Material refers to that category of materials which do not form a part of the finished
product or cannot be identified to the product conveniently. For example: consumable stores, loose
tools, nuts, bolts, lubricating oil, threads, fuel, stationery

b) Indirect Labour refers to the cost of labour which is not engaged directly for production of goods
and services. For example: salary of supervisor, electrician, works manager, watchman.

c) Indirect Expenses are costs other than indirect materials and indirect labour which cannot be
directly identified with a job or product. For example: rent, repairs, taxes, depreciation, insurance.

2. According to NORMALITY

a) Normal Overheads are overheads which are expected to be incurred in attaining a given level of
output in the normal course of business, and are thus, included in the cost of production.

b) Abnormal Overheads are generally not expected to be incurred in attaining a given level of output
in the normal course of business, and are thus, charged to costing profit and loss account.

3. On the basis of CONTROLLABILITY

a) Controllable Overheads are those which can be controlled by executive action at the point of
their occurrence.

b) Uncontrollable Overheads are those indirect expenses which are beyond the control of the
management. Examples; factory rent, office salaries, depreciation and legal expenses.

For example, cost of power used in a particular department can be controlled by the departmental
manager but the share of general lighting costs in the factory cannot be controlled by him.

4. According to VARIABILITY

a) Fixed Overheads, also called period costs or capacity costs, remain fixed or constant in total
despite changes in the volumes of production or sale. These costs are not affected during a given
period by a change in output provided such change in output is not substantial in nature. For
example: rent, interest.

b) Variable Overheads vary proportionately i.e. in the same ratio with the production and sales
volume. They increase in total with the increase in volume and vice versa. For example, sales
commission
c) Semi-variable Overheads are neither completely fixed nor entirely variable. They vary
disproportionately with the change in the volume of output. For example, depreciation will increase
due to wear and tear of machine if output is doubled, but the increase in depreciation will not be
proportionate to the increase in the output.

5. On the basis of FUNCTION

a) Factory Overheads, also known as production or works or manufacturing overheads, are indirect
expenses incurred in converting raw material into finished goods. For example, power, factory rent,
factory insurance

b) Administration Overheads are incurred in connection with the general administration of the
company. For example, office salaries, office rent, printing and stationery, telephone expenses

c) Selling & Distribution Overheads

• Selling Overheads are incurred for creating demand, attracting potential customers and retaining
old customers. For example, free gift, advertisement

• Distribution Overheads are incurred in maintaining stocks and delivering the goods to customers.
For example, carriage and freight out, warehouse expenses.

This functional classification is a conventional method of classifying overheads so as to ascertain the

cost of each function for controlling costs.

SOURCES OF OVERHEAD INFORMATION

Stores Requisition

1 Invoices

2 Cash Book

3 Wages analysis sheet

4 Miscellaneous Reports

5 Journal Entries
Information regarding overheads can be collected from any or all of the above sources like cost of
stores can be computed from the invoices for store purchases with the purchase department and
wages analysis sheet will give a fair picture of the indirect wages incurred. Stores Requisition
Invoices Cash Book Wages analysis sheet Miscellaneous Reports Journal Entries

Fill in the blanks with appropriate words:

1. Overheads are also termed as __________ or __________.

2. Overheads can be classified as ________ and _______ on the basis of normality.

3. ________, _______ and ________ overheads are included under functional classification.

4. Overheads incurred for creating demand, attracting potential customers and retaining old
customers are known as _________.

5. _________ are incurred for converting raw material into finished goods.

Ans: (1) (indirect costs, supplementary costs), (2) (normal overheads, abnormal overheads), (3)
(Factory, Office and Administration, Selling & Distribution), (4) (selling overheads), (5) (Factory
Overheads)

DIFFERENT ITEMS OF OVERHEADS IN COST ACCOUNTING

Before understanding the treatment of various items of overheads, it is imperative to identify the
inclusion of these items under respective categories of overhead. Firstly, factory overheads and their
treatment have been elucidated.

FACTORY OVERHEADS Works overheads or manufacturing overheads refer to indirect factory-

related costs that are incurred when a product is manufactured. They consist of :

2.4 Preparation of cost Sheet

A Cost Sheet or Cost Statement is “a document which provides a detailed cost information. In a
typical cost sheet, cost information are presented on the basis of functional classification. However,
other classification may also be adopted as per the requirements of users of the information.
2.5 Process Costing
Process Costing is a method of costing used in industries where the material has to pass through two
or more processes for being converted into a final product .A separate account for each process is
opened and all expenditure pertaining to a process is charged to that process account. Such type of
costing method is useful in the manufacturing of products like steel, paper, medicines, soaps,
chemicals, rubber, vegetable oil, paints, varnish etc. where the production process is continuous and
the output of one process becomes the input of the following process till completion.

This can be understood with the help of the following diagram:

Raw Material --Process‐I --Process‐II--- Process‐III----- Finished Goods

Definition of Process Costing

Kohler, in his book “Dictionary for Accountants” defines process costing as

A method of cost accounting whereby costs are charged to processes or operations and
averaged over units produced.
S.P. Iyengar defines the process costing as,

A form of operation costing which applies where standardized goods are produced.

Objectives of Process Costing

The chief objectives of process costing are listed below.

1. To determine the unit cost.

2. To determine the method of allocation of manufacturing costs incurred during

a given period.

3. To allocate the accumulated materials, labour and factory overhead costs to

process cost centers.

4. To express incomplete units in terms of completed units.

5. To give accounting treatment to process losses such as waste, scrap, defective

goods and spoiled goods.

6. To differentiate the main product from by-product and joint product.

7. To give accounting treatment to joint product and by-product.

8. To calculate the cost of main product accurately.

COSTING PROCEDURE IN PROCESS COSTING

 The Cost of each process comprises the cost of:

(i) Materials (ii) Employee Cost (Labour) (iii) Direct expenses, and (iv) Overheads of
production.

1 Materials - Materials and supplies which are required for each process are drawn against
Material Requisitions Notes from the stores. Each process for which the materials areused,
are debited with the cost of materials consumed on the basis of the information received from
the Cost Accounting department. The finished product of first process generally become the
raw materials of second process; under such a situation the account of second process is
debited with the cost of transfer from the first process and also with the cost of any additional
material used in process.

2 Employee Cost (Labour)- Each process account should be debited with the labour cost or
wages paid to labour for carrying out the processing activities. Sometimes the wages paid are
apportioned over the different processes after selecting appropriate basis.

3 Direct expenses- Each process account should be debited with direct expenses like
depreciation, repairs, maintenance, insurance etc. associated with it.

4 Production Overheads- Expenses like rent, power expenses, lighting bills, gas and water
bills etc. are known as production overheads. These expenses cannot be allocated to a
process. The suitable way-out to recover them is to apportion them over different processes
by using suitable basis. Usually, these expenses are estimated in advance and the processes
debited with these expenses on a pre-determined basis.

Types of Process Costing

There are three types of process costing, which are:

1. Weighted average costs. This version assumes that all costs, whether from a preceding period or the

current one, are lumped together and assigned to produced units. It is the simplest version to calculate.

2. Standard costs. This version is based on standard costs. Its calculation is similar to weighted average

costing, but standard costs are assigned to production units, rather than actual costs; after total costs are

accumulated based on standard costs, these totals are compared to actual accumulated costs, and the difference

is charged to a variance account.

3. First-in first-out costing (FIFO). FIFO is a more complex calculation that creates layers of costs, one

for any units of production that were started in the previous production period but not completed, and another

layer for any production that is started in the current period.

2.6 Nature of process costing

Industries, where process costing can be applied, have normally one or more of the following
features:

1. Each plant or factory is divided into a number of processes, cost centres or departments, and each
such division is a stage of production or a process.

2. Manufacturing activity is carried on continuously by means of one or more process run

sequentially, selectively or simultaneously.

3. The output of one process becomes the input of another process.

4. The end product usually is of like units not distinguishable from one another.

5. It is not possible to trace the identity of any particular lot of output to any lot of input materials.
For example, in the sugar industry, it is impossible to trace any lot of sugar bags to a particular lot of
sugarcane fed or vice versa.

6. Production of a product may give rise to Joint and/or By-Products.

Features of Process Costing

In the case of process costing, production follows a series of sequential processes. Since the product
manufactured passes through various processes, production is a continuous activity. Units produced
are uniform and, therefore, product differentiation is not possible. Following are the main features
of process costing:

1. Process costing is used by the industries where the goods are produced through the sequence of
several processes. Process costing is suitable for industries like paint, oil refining, rubber, chemicals,
sugar, paper, soap-making, textiles, etc. This method is also employed where it is not possible to
ascertain the prime cost of specific order.

2. Units of production are uniform and homogeneous. As a result, unit cost of each process is
obtained by averaging the total cost of each process.

3. Costs are ascertained for each process at the end of the cost period. 4. Costs follow the
production process, i.e., costs incurred in one process are transferred to the next process along with
the output.

5. The entire production activity is characterised by a number of stages of production, i.e.,

processes. Each process includes a number of operations. The boundaries of the process are
determined by similarity of work performed, supervision and physical location of men and machines
in the plant.

6. The products and processes are standardised.

7. Production is in continuous flow and the output of Process I becomes the input of Process II and
so on until the finished product is obtained.

8. Total cost of the process is adjusted with normal losses, abnormal losses, abnormal gains and
scrap of the process.

2.7 Important aspects of process Accounts

2.8 Costing of Equivalent Production Units.

UNIT - III :

3.1 JOINT PRODUCTS AND BY PRODUCTS

Joint Products
In a manufacturing process, a raw material may be converted into finished
product. During the process of conversion, there is an emergence of waste, scrap,
joint products and by products. This is the significance of processing industries. If
the output of a process has very less value or no value, they may be regarded as
scrap or waste. Sometimes, the output of a process may get its value after further
processing. They are regarded as joint product or by product.

There is no exact classification of the output as joint product or by product. The

joint product of one concern may be a by-product of another concern.

Meaning of Joint Product

Joint product means the production of two or more products from the same basic
raw material and separated in the course of same processing operation usually
requiring further processing, no single product can be designated as a major
product.

Definition of Joint Product

According to the ICMA Terminology,

Joint products are two or more products separated in the course of processing, each
having a sufficiently high saleable value to merit recognition as a main product.
Jain and Narang,

Joint products that are produced from the same basic raw materials, are
comparatively of equal importance, are produced, simultaneously by a common
process and may require further processing after the point of separation.
Jawaharlal,

Joint products are distinctly different major products that are inevitably produced
simultaneously from common inputs or by common processing.

By products
WORD

3.2 Distinguish between Joint Products and By products

Joint products are the products which are produced simultaneously, with the same
raw material and process, and requires further processing to become a finished product
after they get separated.

On the other hand, the by-product is nothing but the subsidiary product which
emerges out, in the course of manufacturing of the main product.

BASIS FOR
JOINT PRODUCT BY-PRODUCT
COMPARISON

Meaning When the production of The term by-product

two or more products of means a product which is
similar value, are made incidentally produced,
together with same input during the processing
and process, is called joint operation of another
product. product.

Economic Value Joint products have same Economic value of by-

economic value. product is lower than the
main product.

Production Consciously Consequently

Input Raw material Waste or scrap of the main

product.
 BASIS FOR
JOINT PRODUCT BY-PRODUCT
COMPARISON

Further Required to turn the joint Not required.

Processing products into finished
product.

3.3 Joint costs and Subsequent Costs

WORD

3.4 Methods of allocating Joint Costs

Methods to allocate joint production cost

A true joint cost has a characteristic of indivisibility. The methods used to apportion or allocate a joint cost
are therefore arbitrary and not perfect. The four acceptable joint cost allocation methods are given below:

1. Market or sales value method

The market or sales value method allocates a joint production cost on the basis of relative market or sales
values of individual joint products.

2. Quantitative or physical unit method

This method uses some physical measurement units (such as volume, weight etc.) to allocate joint
production cost.

3. Average unit cost method

The average unit cost method, as the name implies, uses average unit cost to allocate the cost before split-
off point.

4. Weighted average method

This method assigns predetermined weight factors to joint products based on various factors such as price,
production complexity and unit size of the product.

3.5 Accounting for Joint costs, by products

 UNIT - IV :
4.1 MANAGEMENT ACCOUNTING

Management Accounting is the presentation of accounting information in such a way as to assist

management in the creation of policy and the day-to-day operation of an undertaking. Thus, it relates
to the use of accounting data collected with the help of financial accounting and cost accounting for
the purpose of policy formulation, planning, control and decision-making by the management.

Management accounting links management with accounting as any accounting information required
for taking managerial decisions is the subject matter of management accounting.

Definitions of Management Accounting

ACCORDING TO R.N. Anthony

“Management Accounting is concerned with accounting information that is useful to management.”

ACCORDING TO Batty

“Management Accounting is the term used to describe accounting methods, systems and
techniques which coupled with special knowledge and ability, assists management in its task
of maximising profits or minimising losses. Management Accountancy is the blending
together into a coherent whole, financial accounting, cost accountancy and all aspects of
financial management.”

ACCORDING TO ICWA of India

“Management accounting is a system of collection and presentation of relevant economic information

relating to an enterprise for planning, controlling and decision-making.” .

ACCORDING TO CIMA London

“Management accounting is the provision of information required by management for such purposes
as formulation of policies, planning and controlling the activities of the enterprise, decision-making on
the alternative courses of action, disclosure to those external to the entity (shareholders and others),
disclosure to employees and safeguarding of assets.” 

ACCORDING TO American Accounting Association

Management Accounting is “the application of appropriate techniques and concepts in processing

historical and projected economic data of an entity to assist management in establishing plans for
reasonable economic objectives and in the making of rational decisions with a view towards these
objectives”. 
Nature of Management Accounting:

(i) Technique of Selective Nature:

Management Accounting is a technique of selective nature. It takes into consideration only that data
from the income statement and position state merit which is relevant and useful to the management.
Only that information is communicated to the management which is helpful for taking decisions on
various aspects of the business.

(ii) Provides Data and not the Decisions:

The management accountant is not taking any decision by provides data which is helpful to the
management in decision-making. It can inform but cannot prescribe. It is just like a map which guides
the traveller where he will be if he travels in one direction or another. Much depends on the efficiency
and wisdom of the management for utilizing the information provided by the management accountant.

(iii) Concerned with Future:

Management accounting unlike the financial accounting deals with the forecast with the future. It helps
in planning the future because decisions are always taken for the future course of action.

(iv) Analysis of Different Variables:

Management accounting helps in analysing the reasons as to why the profit or loss is more or less as
compared to the past period. Moreover, it tries to analyse the effect of different variables on the profits
and profitability of the concern.

(v) No Set Formats for Information:

Management accounting will not provide information in a prescribed proforma like that of financial
accounting. It provides the information to the management in the form which may be more useful to
the management in taking various decisions on the various aspects of the business.

Scope of Management Accounting:

The scope of management accounting is very wide and broad-based. It includes all information which
is provided to the management for financial analysis and interpretation of the business operations.

(i) Financial Accounting:

Financial accounting though provides historical information but is very useful for future planning and
financial forecasting. Designing of a proper financial accounting system is a must for obtaining full
control and co-ordination of operations of the business.

(ii) Cost Accounting:

It provides various techniques of costing like marginal costing, standard costing, differential and
opportunity cost analysis, etc., which play a useful role n t operation and control of the business
undertakings.

(iii) Budgeting and Forecasting:

Forecasting on the various aspects of the business is necessary for budgeting. Budgetary control
controls the activities of the business through the operations of budget by comparing the actual with
the budgeted figures, finding out the deviations, analysing the deviations in order to pinpoint the
responsibility and take remedial action so that adverse things may not happen in future.

Both the techniques are necessary for management accountant.

(iv) Cost Control Procedures:

These procedures are integral part of the management accounting process and includes inventory
control, cost control, labour control, budgetary control and variance analysis, etc.

(v) Reporting:

The management accountant is required to submit reports to the management on the various aspects
of the undertaking. While reporting, he may use statistical tools for presentation of information as
graphs, charts, pictorial presentation, index numbers and other devices in order to make the
information more impressive and intelligent.

(vi) Methods and Procedures:

It includes in its study all those methods and procedures which help the concern to use its resources
in the most efficient and economical manner. It undertakes special cost studies and estimations and
reports on cost volume profit relationship under changing circumstances.

(vii) Tax Accounting:

It is an integral part of management accounting and includes preparation of income statement,

determination of taxable income and filing up the return of income etc.

(viii) Internal Financial Control:

Management accounting includes the internal control methods like internal audit, efficient office
management, etc.

(ix) Interpretation:

Management accounting is closely related to the interpretation of financial data to the management
and advising them on decision-making.

(x) Office Services:

The management accountant may be required to maintain and control office services in some
organizations. This function includes data processing, reporting on best use of mechanical and
electronic devices, communication, etc.

(xi) Evaluating the Performance of the Management:

Management accounting provides methods and techniques for evaluating the performance of the
management. It evaluates the performance of the management in the light of the objectives of the
organisation. Thus, it helps in the implementation of the principle of management by exception.

Functions of Management Accounting
Managerial accounting involves collecting, analyzing, and reporting information about the operations
and finances of a business. These reports are generally directed to the managers of a business,
rather than to any external entities, such as shareholders or lenders. The functions of managerial
accounting include:

1 Margin Analysis: Determining the amount of profit or cash flow that a business generates from a specific
product, product line, customer, store, or region.

2 Break even Analysis: Calculating the mix of contribution margin and unit volume at which a business
exactly breaks even, which is useful for determining price points for products and services.

3 Constraint Analysis: Understanding where the primary bottlenecks are in a company, and how they
impact the ability of the business to earn revenues and profits.

4 Target Costing: Assisting in the design of new products by accumulating the costs of new designs,
comparing them to target cost levels, and reporting this information to management.

5 Inventory Valuation: Determining the direct costs of cost of goods sold and inventory items, as well as
allocating overhead costs to these items.

6 Trend Analysis: Reviewing the trend line of various costs incurred to see if there are any unusual
variances from the long-term pattern, and reporting the reasons for these changes to management.

7 Transaction Analysis: After spotting a variance through trend analysis, a person engaged in managerial
accounting might dive deeper into the underlying information and examine individual transactions, in order
to understand exactly what caused the variance. This information is then aggregated into a report to
management.

8 Capital Budgeting Analysis: Examining proposals to acquire fixed assets, both to determine if they are
needed, and what the appropriate form of financing may be with which to acquire them.

4.2 The users of Accounting Information

4.3 Differences between management Accounting, cost Accounting and Financial

Accounting

4.4 Elements of Functions of Management Accounting

FUNCTIONS OF MANAGEMENT ACCOUNTING The basic function of management accounting is to

assist the management in performing its functions effectively. The functions of the management are
planning, organizing, directing and controlling. Management accounting helps in the performance of
each of these functions in the following ways:

(i) Provides data: Management accounting serves as a vital source of data for management
planning. The accounts and documents are a repository of a vast quantity of data about the past
progress of the enterprise, which are a must for making forecasts for the future.
 (ii) Modifies data: The accounting data required for managerial decisions is properly compiled and
classified. For example, purchase figures for different months may be classified to know total
purchases made during each period product-wise, supplier-wise and territory-wise.

(iii) Analyses and interprets data: The accounting data is analyzed meaningfully for effective
planning and decision-making. For this purpose the data is presented in a comparative form. Ratios
are calculated and likely trends are projected.

(iv) Serves as a means of communicating: Management accounting provides a means of

communicating management plans upward, downward and outward through the organization.
Initially, it means identifying the feasibility and consistency of the various segments of the plan. At
later stages it keeps all parties informed about the plans that have been agreed upon and their roles
in these plans.

(v) Facilitates control: Management accounting helps in translating given objectives and strategy
into specified goals for attainment by a specified time and secures effective accomplishment of these
goals in an efficient manner. All this is made possible through budgetary control and standard
costing which is an integral part of management accounting.

(vi) Uses also qualitative information: Management accounting does not restrict itself to financial
data for helping the management in decision making but also uses such information which may not
be capable of being measured in monetary terms. Such information may be collected form special
surveys, statistical compilations, engineering records, etc.

SCOPE OF MANAGEMENT ACCOUNTING

Management accounting is concerned with presentation of accounting information in the most
useful way for the management. Its scope is, therefore, quite vast and includes within its fold almost
all aspects of business operations. However, the following areas can rightly be identified as falling
within the ambit of management accounting:

(i) Financial Accounting: Management accounting is mainly concerned with the rearrangement of
the information provided by financial accounting. Hence, management cannot obtain full control and
coordination of operations without a properly designed financial accounting system.

(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential
costing and other cost techniques play a useful role in operation and control of the business
undertaking.

(iii) Revaluation Accounting: This is concerned with ensuring that capital is maintained intact in real
terms and profit is calculated with this fact in mind. (iv) Budgetary Control: This includes framing of
budgets, comparison of actual performance with the budgeted performance, computation of
variances, finding of their causes, etc.

(v) Inventory Control: It includes control over inventory from the time it is acquired till its final
disposal.
(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other statistical
methods make the information more impressive and intelligible.

(vii) Interim Reporting: This includes preparation of monthly, quarterly, half-yearly income
statements and the related reports, cash flow and funds flow statements, scrap reports, etc.

(viii) Taxation: This includes computation of income in accordance with the tax laws, filing of returns
and making tax payments.

(ix) Office Services: This includes maintenance of proper data processing and other office
management services, reporting on best use of mechanical and electronic devices.

(x) Internal Audit: Development of a suitable internal audit system for internal control.

4.5 C-V-P Analysis- assumptions, inter relationships of cost, volume and profits

COST-VOLUME-PROFIT (CVP) ANALYSIS

Meaning of C-V-P Analysis

It is a managerial tool showing the relationship between various ingredients of profit planning viz.,
cost, selling price and volume of activity. As the name suggests, cost volume profit (CVP) analysis is
the analysis of three variables cost, volume and profit. Such an analysis explores the relationship
between costs, revenue, activity levels and the resulting profit. It aims at measuring variations in
cost and volume.

Assumptions of C-V-P Analysis

1. Changes in the levels of revenues and costs arise only because of changes in the number of
product (or service) units produced and sold – for example, the number of television sets produced
and sold by Sony Corporation or the number of packages delivered by Overnight Express. The
number of output units is the only revenue driver and the only cost driver. Just as a cost driver is any
factor that affects costs, a revenue driver is a variable, such as volume, that causally affects
revenues.

2. Total costs can be separated into two components; a fixed component that does not vary with
output level and a variable component that changes with respect to output level. Furthermore,
variable costs include both direct variable costs and indirect variable costs of a product. Similarly,
fixed costs include both direct fixed costs and indirect fixed costs of a product

3. When represented graphically, the behaviours of total revenues and total costs are linear
(meaning they can be represented as a straight line) in relation to output level within a relevant
range (and time period).

4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period)
are known and constant.
 5. The analysis either covers a single product or assumes that the proportion of different products
when multiple products are sold will remain constant as the level of total units sold changes. 6. All
revenues and costs can be added, subtracted, and compared without taking into account the time
value of money. (Refer to the FM study material for a clear understanding of time value of money).

Importance of C-V-P Analysis

1. It provides the information about the following matters:

2. The behaviour of cost in relation to volume.

3. Volume of production or sales, where the business will break-even.

4. Sensitivity of profits due to variation in output.

5. Amount of profit for a projected sales volume.

6. Quantity of production and sales for a target profit level.

Impact of various changes on profit:

An understanding of CVP analysis is extremely useful to management in budgeting and profit

planning. It elucidates the impact of the following on the net profit:

(i) Changes in selling prices,

(ii) Changes in volume of sales,

(iii) Changes in variable cost,

(iv) Changes in fixed cost.

Marginal Cost Equation

The contribution theory explains the relationship between the variable cost and selling price. It tells
us that selling price minus variable cost of the units sold is the contribution towards fixed expenses
and profit. If the contribution is equal to fixed expenses, there will be no profit or loss and if it is less
than fixed expenses, loss is incurred. Since the variable cost varies in direct proportion to output,
therefore if the firm does not produce any unit, the loss will be there to the extent of fixed expenses.
These points can be described with the help of following marginal cost equation:

4.5.1 Constructing the breakeven (graphical approach).

Break-Even Analysis

Break-even analysis is a generally used method to study the CVP analysis. This technique can be
explained in two ways:

(i) In narrow sense it is concerned with computing the break-even point. At this point of production
level and sales there will be no profit and loss i.e. total cost is equal to total sales revenue.

(ii) In broad sense this technique is used to determine the possible profit/loss at any given level of
production or sales.

METHODS OF BREAK -EVEN ANALYSIS

Break even analysis may be conducted by the following two methods:

(A) Algebraic computations

(B) Graphic presentations

Key words
1 Marginal Cost : Marginal cost as understood in economics is the incremental cost of production
which arises due to one-unit increase in the production quantity. marginal cost is measured by the
total variable cost attributable to one unit.

2 Marginal Costing : It is a costing system where products or services and inventories are valued at
variable costs only. It does not take consideration of fixed costs.

3 Absorption Costing : a method of costing by which all direct cost and applicable overheads are
charged to products or cost centers for finding out the total cost of production. Absorbed cost
includes production cost as well as administrative and other cost.

4 Contribution : Contribution or contribution margin is the difference between sales revenue and
total variable costs irrespective of manufacturing or nonmanufacturing.

5 Cost-Volume-Profit (CVP) Analysis : It is an analysis of reciprocal effect of changes in cost, volume

and profitability. Such an analysis explores the relationship between costs, revenue, activity levels
and the resulting profit. It aims at measuring variations in cost and volume.

6 Contribution to Sales Ratio (Profit Volume Ratio or P/V ratio) : This ratio shows the proportion of
sales available to cover fixed costs and profit. Contribution represent the sales revenue after
deducting variable costs.
7 Break-even Point (BEP) : The level of sales where an entity neither earns profit nor incurs loss. BEP
is indicated in both quantity and monetary value terms.

8 Margin of Safety (MOS) : The margin between sales and the break-even sales is known as margin
of safety. It can either be indicated in quantitative or monetary terms.

9 Angle of Incidence: This angle is formed by the intersection of sales line and total cost line at the
break-even point. This angle shows the rate at which profits is earned once the break-even point is
reached.

10 Limiting (Key) factor: Limiting factor is anything which limits the activity of an entity. The factor is
a key to determine the level of sale and production, thus it is also known as Key factor.

ADVANTAGES OF MARGINAL COSTING

1. Simplified Pricing Policy: The marginal cost remains constant per unit of output whereas the fixed
cost remains constant in total. Since marginal cost per unit is constant from period to period within a
short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit
cost will change from day to day depending upon the volume of output. This will make decision
making task difficult.

2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of pre-
determined rates. If fixed overheads are included on the basis of predetermined rates, there will be
under- recovery of overheads if production is less or if overheads are more. There will be over-
recovery of overheads if production is more than the budget or actual expenses are less than the
estimate. This creates the problem of treatment of such under or over-recovery of overheads.
Marginal costing avoids such under or over recovery of overheads.

3. Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing
technique, the stock of finished goods and work-in-progress are carried on marginal cost basis and
the fixed expenses are written off to profit and loss account as period cost. This shows the true profit
of the period.

4. How much to produce: Marginal costing helps in the preparation of break-even analysis which
shows the effect of increasing or decreasing production activity on the profitability of the company.

5. More control over expenditure: Segregation of expenses as fixed and variable helps the
management to exercise control over expenditure. The management can compare the actual
variable expenses with the budgeted variable expenses and take corrective action through analysis
of variances.

6. Helps in Decision Making: Marginal costing helps the management in taking a number of
business decisions like make or buy, discontinuance of a particular product, replacement of
machines, etc.

7. Short term profit planning: It helps in short term profit planning by B.E.P charts
LIMITATIONS OF MARGINAL COSTING

1. Difficulty in classifying fixed and variable elements: It is difficult to classify exactly the expenses
into fixed and variable category. Most of the expenses are neither totally variable nor wholly fixed.
For example, various amenities provided to workers may have no relation either to volume of
production or time factor.

2. Dependence on key factors: Contribution of a product itself is not a guide for optimum
profitability unless it is linked with the key factor.

3. Scope for Low Profitability: 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 while giving marginal
cost.

4. Faulty valuation: Overheads of fixed nature cannot altogether be excluded particularly in large
contracts, while valuing the work-in- progress. In order to show the correct position fixed overheads
have to be included in work-in-progress.

5. Unpredictable nature of Cost: Some of the assumptions regarding the behaviour of various costs
are not necessarily true in a realistic situation. For example, the assumption that fixed cost will
remain static throughout is not correct. Fixed cost may change from one period to another. For
example, salaries bill may go up because of annual increments or due to change in pay rate etc. The
variable costs do not remain constant per unit of output. There may be changes in the prices of raw
materials, wage rates etc. after a certain level of output has been reached due to shortage of
material, shortage of skilled labour, concessions of bulk purchases etc.

6. Marginal costing ignores time factor and investment: 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. This fact is not
disclosed by marginal costing.

7. Understating of W-I-P: Under marginal costing stocks and work in progress are understated.
 UNIT - V

5.1 MANAGEMENT CONTROL SYSTEMS:

5.2 Control at different organizational levels

5.2.1 Different types of controls

5.2.3 Responsibility centres

With the growth of an organisation, its functions, organisational structure and other related
functions also grows in terms of volume and complexity. To have a better control over the
organisation, management delegates its responsibility and authority to various departments or
persons. These departments or persons are known as responsibility centres and are held responsible
for performance in terms of expenditure, revenue, profitability and return on investment.
Performance of these responsibility centres are measured against some set standards (input-output
ratio, budgets etc.) and evaluated against organisational goal and performance targets.

Types of responsibility centres

There are four types of responsibility centres:

(i) Cost Centres

(ii) Revenue Centres

(iii) Profit Centres

(iv) Investment Centres

(i) Cost Centres: The responsibility centre which is held accountable for incurrence of costs which
are under its control. The performance of this responsibility centre is measured against pre-
determined standards or budgets. The cost centres are of two types: (a) Standard Cost Centre and
(b) Discretionary Cost Centre

(a) Standards Cost Centres: Cost Centre where output is measurable and input required for the
output can be specified. Based on a well-established study, an estimate of standard units of input to
produce a unit of output is set. The actual cost for inputs is compared with the standard cost. Any
deviation (variance) in cost is measured and analysed into controllable and uncontrollable cost. The
manager of the cost centre is supposed to comply with the standard and held responsible for
adverse cost variances. The input-output ratio for a standard cost centre is clearly identifiable.

(b) Discretionary Cost Centre: The cost centre whose output cannot be measured in financial terms,
thus input-output ratio cannot be defined. The cost of input is compared with allocated budget for
the activity. Example of discretionary cost centres are Research & Development department,
Advertisement department where output of these department cannot be measured with certainty
and co-related with cost incurred on inputs.

(ii) Revenue Centres: The responsibility centres which are accountable for generation of revenue for
the entity. Sales Department for example, is responsible for achievement of sales target and revenue
generation. Though, revenue centres does not have control on expenditures it incurs but some time
expenditures related with selling activities like commission to sales person etc. are incurred by
revenue centres.

(iii) Profit Centres: These are the responsibility centres which have both responsibility of generation
of revenue and incurrence of expenditures. Since, managers of profit centres are accountable for
both costs as well as revenue, profitability is the basis for measurement of performance of these
responsibility centres. Examples of profit centres are decentralised branches of an organisation.

(iv) Investment Centres: These are the responsibility centres which are not only responsible for
profitability but also has the authority to make capital investment decisions. The performance of
these responsibility centres are measured on the basis of Return on Investment (ROI) besides profit.
Examples of investment centres are Maharatna, Navratna and Miniratna companies of Public Sector
Undertakings of Central Government.

5.2.4 The nature of management control systems

5.3 Budget

5.3.1 Concept of Budget

Meaning and definition of budget

A budget is a plan of action for a future period. It simply means a financial plan expressed in terms of
money. The budget pertaining to any of the activities of business is always forward looking. The term
‘budget’ has been derived from the French word, ”bougette”, which means a leather bag into which
funds are appropriated to meet the anticipated expenses.

The CIMA Official Terminology defines a budget as “ A quantitative statement, for a defined period
of time, which may include planned revenues, expenses, assets, liabilities and cash flows.”
Budgeting and Budgetary control:

Budgeting simply means preparing budgets. It is a process of preparation, implementation and the
operation of budget. Being a plan of action, a budget guides every manager in the decision making
process.

In the words of Rowland Harr, “Budgeting is the process of building budgets”.

Budgetary control is a system of using budgets for planning and controlling costs.

The official terminology of CIMA defines the term ‘budgetary control , as “ the establishment of
budgets relating to the responsibilities of executives to the requirement of a policy, and the
continuous comparison of actual with budgetary result, either to secure by individual action the
objectives of that policy or to provide a basis for its revision.”

Thus, when plans are embodied in a budget and the same is used as the basis for regulating
operations, we have budgetary control. As such budgetary control starts with budgeting and ends
with control.

Objectives of Budget and Budgetary control

The following points reveal the objectives of Budget and budgetary control:-

1. To aid the planning of annual operations

2. To co ordinate the activities of the various parts of the organization

3. To communicate plans to the various responsibility centre managers

4. To motivate managers to strive to achieve the organizational goals.

5. To control activities

6. To eliminates the wastes of all kinds

7. To provide a yard stick against which actual results can be compared

8. To evaluate the performance of managers.

9. To reduce the uncertainties

Steps involved in the budgetary control technique

There are certain steps involved in the budgetary control technique. They
are as follows:
(i) Definition of objectives: A budget being a plan for the achievement of
certain operational objectives, it is desirable that the same are defined
precisely. The objectives should be written out; the areas of control
demarcated; and items of reve-nue and expenditure to be covered by the
budget stated.
(ii) Location of the key (or budget) factor: There is usually one factor
(sometimes there may be more than one) which sets a limit to the total
activity. Such a factor is known as key factor. For proper budgeting, it must
be located and estimated properly.
(iii) Appointment of controller: Formulation of a budget usually required
whole time services of a senior executive known as budget controller; he
must be assisted in this work by a Budget Committee, consisting of all the
heads of department along with the Managing Director as the Chairman.
 (iv) Budget Manual: Effective budgetary planning relies on the provision
of adequate information which are contained in the budget manual. A
budget manual is a collection of documents that contains key information
for those involved in the planning process.
  (v) Budget period: The period covered by a budget is known as budget
period. The Budget Committee determines the length of the budget period
suitable for the business. It may be months or quarters or such periods as
coincide with period of trading activity.
 (vi) Standard of activity or output: For preparing budgets for the future,
past statistics cannot be completely relied upon, for the past usually
represents a combination of good and bad factors. Therefore, though
results of the past should be studied but these should only be applied
when there is a likelihood of similar conditions repeating in the future.

Essentials of a Budgetary Control system:

Successful implementation of a budgetary control system depends up on the following essentials.

1. Support by top management: The wholehearted support of all managerial persons is very
necessary for the success of a budgetary control system.

2. Formal organization: The existence of a formal and sound organizational structure is of an

absolute necessity for an effective system of budgetary control.

3. Budget centers: For budgetary control purposes, the entire organization will be split into a
number of departments, area or functions, known as ‘centres’, and budgets will be prepared for
each such centers
4. Clear cut objectives and reasonably attainable goals:- If goals are too high to be attained, the
purpose of budgeting is defeated. On the other hand, if the goals are so low that they can be
attained very easily, there will be no incentive to special effort.

5. Participative budgeting: Every executive responsible for the implementation of budgets should be
given an opportunity to take part in the preparation of budgets.

6. Budget committee: The work of preparing a budget manual should be entrusted to a Budget
committee. The work of scrutinizing the budgets as well as approving of the same should be the
work of this committee.

7. Comprehensive budgeting: Budgeting should not be partial, it should cover all the functions .

8. Adequate accounting system: There should be an adequate accounting system for the successful
budgetary control system, because those who are involved in the preparation of estimates depend
heavily on the accounting department.

9. Periodic reporting: - There should be a prompt and timely communication and reporting system
for the effective implementation of a budgetary control system.

Advantages and Disadvantages of budgeting

word

Fixed and Flexible Budgets

Difference between Fixed Budget and Flexible Budget.

  Fixed Budget Flexible Budget

1. Flexible Budget It can be re-casted on the basis of

activity level to be achieved. Thus it
is not rigid.
 2. It operates on one level of activity and under one set It consists of various budgets for
of conditions different level of activity.

3. If the budgeted and actual activity levels differ It facilitates the cost ascertainment
significantly, then cost ascertainment and price and price fixation at different levels
fixation do not give a correct picture. of activity.

4. Comparisons of actual and budgeted targets are It provided meaningful basis of

meaningless particularly when there is difference comparison of actual and budgeted
between two levels. targets.

Budget manual:
CIMA England, defines a budget manual as “ a document , schedule or booklets which sets out; inter
alia, the responsibilities of the persons engaged in the routine of and the forms and records required
for budgetary control”. In other words, it is a written document which guides the executives in
preparing various budgets. Budget period: This may be defined as the period for which a budget is
prepared and employed. The budget period will depend on the type of business and the control
aspects. There is no general rule governing the selection of the budget period.

Classification of Budget
1. Classification according to time factor

2. Classification according to flexibility factor

3. Classification according to function.

I. Classification according to time factor: - On this basis, budgets can be of three types: 1. Long term
budget – for a period of 5 to 10 years 2. Short term budgets – Usually for a period of one to two
years 3. Current budgets - Usually covers a period of one month or so,

II. Classification according to flexibility: It includes 1. Flexible budgets and 2. Fixed budgets

Flexible budgets: It is a dynamic budget. It gives different budgeted cost for different levels of
activity. It is prepared after making an intelligent classification of all expenses between fixed , semi
variable and variable because the usefulness of such a budget depends up on the accuracy with
which the expenses can be classified.

Steps in preparing flexible budgets:

1. Identifying the relevant range of activity

2. Classify cost according to variability

3. Determine variable cost

4. Determine fixed cost

5. Determine semi variable cost

6. Prepare the budget for selected levels of activity

Fixed Budget

It is a budget which is designed to remain unchanged irrespective of the level of activity attained. It
does not change with the change in the level of activity. This type of budget are most suited for fixed
expenses. It is a single budget with no analysis of cost.

III. Classification according to function: It includes: 1. Functional budgets and 2. Master budgets
Functional budgets are those which are prepared by heads of functional department s for their
respective departments and are subsidiary to the master budget. Functional budget may be
Operating budgets or financial budget. Operating budgets are those budgets which relate to the
different activities or operations of a firm. These are the primary budgets. Financial budgets are
those which incorporate financial decisions of an organization. They show in detail the inflow and
outflow of cash and the overall financial position.

Master budget is the summary of all functional budgets. It summarizes sales, production, purchase,
labour, finance budgets etc. It is considered as the overall budget of the organization.

5.4 Cost Management – Life cycle costing, Target costing, and

Kaizen Costing.
Cost management in accounting is a form of management accounting that is designed to help business owners
predict how much business expenses. The purpose of this form of accounting is to avoid going over budget so that
businesses can hold onto as much of their revenues as possible. If you would like to work in management accounting
and you are trying to learn more about cost management and planning budgets, read on and find out what you need
to know about cost management plans within the over-all business model.

Techniques for Cost Estimating

 
Cost estimating can be done in a variety of ways.  Accurate cost estimating is one
of the main elements involved in cost management.  The following is a list of
estimating techniques that may be used for an organization:
 1 Analogous Estimating (Top-Down Estimating) - Using the cost of a
previous, similar project as a reference for predicting the cost of the current
project.  This is a form of expert judgment and is used when there is a
limited amount of information about the project.

2 Parametric Modeling - Using mathematical parameters to predict project

costs.  Models can be simple or complex.  They are most reliable when (1)
the historical information is correct, (2) the parameters are quantifiable, and
(3) the model can be applied to both large and small scale projects.

3 Bottom-Up Estimating - This involves estimating the cost of work items

and them summing the estimates to get a project total.  Smaller work items
increase the cost and accuracy.

4 Computerized Tools - Project management software and spreadsheets aid

in project estimation.

Techniques for Cost Control in Cost Management

The following are cost control techniques:
1 Performance Measurement - This helps assess the magnitude of any
variations that occur within performance when compared with similiar
projects/services.  An important part of cost management is to determine
what is causing the variance and decide if the variance determines corrective
action.
2 Additional Planning - There are few projects that go as planned. 
Revisions may occur regarding alternative approaches.
3 Computerized Tools - These are used to track planned costs versus actual
costs and to predict cost changes.

Benefits of Effective Cost Management

    1.  Improve pricing decisions
    2.  Identify the source of costs
    3.  Link corporate strategies
    4.  Evaluate the effectiveness of activities for investment