Notes For MBA 3

It is found by a simple transformation of the firm's accounts receivable turnover :
Average Age of Debtors =

It can be calculated as follows also :
Average Collection Period = × No. of working days
The average of collection period should not exceed the standard or stated credit
period
in sales terms plus 1/3 of such days. If it happens, it will indicate either liberal
credit
policy or slackness of management in realising debts or accounts receivable.
Net credit sales
Average debtors
Net credit purchases
Average creditors
365
Debtors Trunover
Trade Debtors
Net Credit Sales
10
Illustration 3 : A manufacturer of stoves sells to retailers on terms 2½% discount
in 30 days, 60 days net. The debtors and receivables at the end of December of
past
two years and net sales for all these two years are as under :
2000 2001
Rs. Rs.
Debtors 33,932 85,582
Bills Receivables 3,686 9,242
Net Sales 3,37,392 4,43,126
Determine the average collection period for both years and comment.
Solution :
Average Collection Period = × No. of Working Days
2000 : × 365 = 41 days
2001 : × 365 = 78 days
Comment : The average collection period in both years has been within standard
period, i.e. 80 days (60+ É3 of 60 days), Hence it is good.
Illustration 4 : The comparative statement of income and financial position of a
company are given below :
1999 2000
Rs. Rs.
Net Sales 75,000 92,000
Less Cost of Sales 50,000 69,000
Gross Profit 25,000 23,000
Less Operating Expenses (including
Rs. 3,000p.a. for Depreciation) 22,000 21,000
Net Profit 3,000 2,000
Cash in hand 6,000 7,000
Debtors 30,000 18,000
Stock at cost 12,000 9,000
Fixed Assets (Net) 51,000 53,000
99,000 87,000
Creditors and Bills Payable 19,000 10,000
Debentures 20,000 15,000
Share Capital 50,000 58,000
Surplus (earned) 10,000 4,000
99,000 87,000
Trade Receivables
Net Credit Sales
37,618
3,37,392
94,824
4,43,126
11
During the year 1979, 10% Stock Dividend was declared and paid. The factors for
the change in earned surplus during 2000 are, inter-alia, profit and cash dividends.
Compare the following :
(i) Debtors turnover for two years
(ii) Liquidity Ratio for two years.
(iii) Current Ratio for two years.
(iv) Average collection period assuming all sales as credit sales.
(v) If desirable current ratio is 3:1 what should be the amount of current
liabilities at the end of 2000 ?
Solution :
(i) Debtors Turnover
×100 ×100 = 40% ×100= 19.56%
(ii) Liquidity Ratio = Liquid Assets/Current Liabilities
1999 : 36,000/19,000 = 1.9 :1
2000 : 25,000/10,000 = 2.5:1
(iii) Current Ratio = Current Assets/Current Liabilities
1999 : 48,000/19,000 = 2.5:1
2000 : 34,000/10,000 = 3.4:1
(iv) Average Collection Period = × No. of Working Days
1999 : × 365 = 146 days
2000 : × 365 = 71 days
(v) As the current assets for 2000 are Rs. 34,000 and the desirable Current
Ratio is 3:1, the current liability must be one-third of the current assets, i.e.,
Current
Liabilities = 34,000 × ÉÕ = Rs. 11,333.
5. Assets Turnover Ratio : This ratio is also known as the investment turnover
ratio. It is based on the relationship between the cost of goods sold and assets/
investments of a firm. A reference to this was made while working out the overall
profitability of a firm as reflected in its earning power. Depending upon the
different
concepts of assets employed, there are many variants of this ratio.
Thus,
Trade Receivables
Net Credit Sales
18,000
92,000 ()
Trade Receivables
Net Credit Sales
30,000
75,000
18,000
92,000
30,000
75,000
12
1. Total assets turnover =
2. Fixed assets turnover =
3. Capital turnover =
4. Current assets turnover =
Here, the total assets and fixed assets are net of depreciation and the assets are
exclusive of fictitious assets like debit balance of profit and loss account and
deferred expenditures and so on.
13.6.3 Leverage/Capital Structure Ratios : The second category of financial
ratios is leverage ratios. The long-term creditors would judge the soundness of a
firm on the basis of the long-term financial strength measured in terms of its
ability
to pay the interest regularly as well as repay the instalment of the principal on due
dates or in lump sum at the time of maturity. The long-term solvency of a firm can
be examined by using leverage or capital structure ratios. The leverage ratios may
be defined as financial ratios which throw light on the long-term solvency of a
firm
as reflected in its ability to assure the long-term creditors with regard to (i)
periodic
payment of interest during the period of the loan and (ii) repayment of principal on
maturity or in predetermined installments at due dates.
1. The Debt-equity Ratio – This ratio establishes the relationship between
the long-term funds provided by creditors and those provided by the firm's owners.
It is commonly used to measure the degree of financial leverage of the firm. It is
calculated as follows :
Debt-equity Ratio =
Some experts use the following formula to calculate this ratio :
Debt-equity Ratio =
Generally, a ratio of 2:1 is considered satisfactory.
2. Proprietary Ratio : This ratio is also known as Shareholders' Equity to
Total Equities Ratio or Net Worth to Total Assets Ratio. It indicates the
relationship
of Shareholders' equity to total assets or total equities. As per formula :
Proprietary Ratio =
Higher the ratio, better the financial position of the firm.
Long-term Debts
Shareholder's Equity
External Equities
Internal Equities
Shareholders' Funds
Total Assets or Total Equities
Cost of goods sold
Average total assets
Cost of goods sold
Average fixed assets
Cost of goods sold
Average capital employed
Cost of goods sold
Average current assets
13
3. The Solvency Ratio – It is also known as Debt Ratio. It is a difference of
100 and proprietary ratio. It measures the proportion of total assets provided by
the firm's creditors. This ratio is calculated as follows :
Solvency Ratio (or Debt Ratio) =
Interpretation :
Generally, lower the rate of total liabilities to total assets; more satisfactory or
stable is the long-term solvency position of a firm.
4. Fixed Assets to Net Worth Ratio – One of the important aspects of sound
financial position of a firm is that its fixed assets are totally financed out of
shareholders' funds. If aggregate of fixed assets exceeds the net worth (or
proprietors' funds), it proves that fixed assets have been financed with outsiders'
funds (or creditors' funds). It may create difficulty in the long-run. This ratio is
calculated as follows :
Fixed Assets-Net Worth Ratio =
This ratio should not exceed 1:1. On the contrary, lower the ratio, better the
position.
Usually, a ratio of 0.67 : 1 is considered satisfactory.
5. Proprietors' Liabilities Ratio : This ratio indicates the relationship of
proprietors' funds to total liabilities. It is calculated as follows :
Proprietors' Liabilities Ratio =
Higher the ratio, better is the position of creditors.
6. Fixed Assets Ratio
A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to all
long-term funds which is calculated as :
Fixed Assets Ratio = Fixed Assets (After depreciation)
Total long-term funds
Interpretation :
This ratio indicates the extent to which the total of fixed assets are financed by
logterm
funds of the firm. Generally, the total of the fixed assets should be equal to
total of the long-term funds or say the ratio should be 100%. And if total long-term
funds are more than total fixed assets, it means that part of working capital
requirement
is met out.
Total Liabilities
Total Assets
Fixed Assets (after depreciation)
Proprietors' Funds
Proprietros' Funds
Total Liabilities
14
7. Ratio of Current Assets to Proprietary's Funds
The ratio is calculated by dividing the total of current assets by the amount of
shareholder's funds. For example, if current assets are Rs. 2,00,000 and
shareholder's
Funds are Rs. 4,00,000 the ratio of current assets to proprietors funds in terms of
percentage would be
= × 100
= × 100
Interpretation :
This ratio indicates the extent to which proprietors funds are invested in current
assets. There is no rule of thumb for this ratio and depending upon the nature of
the
business there may be different ratios of different firms.
8. Debt-Service Ratio
Net income to debt service ratio or simply debt service ratio is used to test the
debt-servicing capacity of a firm. The ratio is also known as interest coverage ratio
or fixed charges cover or times interest earned. This ratio is calculated by dividing
the net profit before interest and taxes by fixed interest charges.
Debt Service or Interest Coverage Ratio =
Interpretation
Interest coverage ratio indicates the number of times interest is covered by the
profits available to pay the interest charges. Long-term creditors of a firm are
interested
in knowing the firm's ability to pay interest on their long-term borrowings.
Generally, higher the ratio, more safe are long term creditors because even if
earnings of the firm fall, the firm shall be able to meet its commitment of fixed
interest changes. But a too high interest coverage ratio may not be good for the
firm because it may imply that firm is not using debt as a source of finance so as to
increase the earnings per share.
Illustration 5 : Extracts from financial account of X, Y, Z Ltd. are given below :
Year I Year II
Assets Liabilities Assets Liabilities
Rs. Rs. Rs. Rs.
Stock 10,000 20,000
Debtors 30,000 30,000
Payment in advance 2,000 –
Cash in hand 20,000 10,000
Current Assets
Shareholders Funds
2,00,000
4,00,000
Net Profit (before interest and tax)
Fixed Interest Charges
15
Current Assets
Current Liabilities
10,000 + 30,000 + 2,000 + 20,000
25,000 + 15,000
20,000 + 30,000 + 15,000
30,000 + 12,000 + 5,000
Current Assets
Current Liabilities
10,000 + 30,000 + 2,000
25,000 + 15,000
Net Sales
Average Invntory
Sundry Creditors 25,000 30,000
Acceptances 15,000 12,000
Bank Overdraft – 5,000
62,000 40,000 65,000 47,000
Sales amounted to Rs. 3,50,000 in the first year and Rs. 3,00,000 in the second
year.
You are required to comment on the solvency position of the concern with the help
of accounting ratios.
Solution :
Short-term Solvency Analysis :
(1) Current Ratio =
Year I = = 1.55 :1
Year II = = 1.38 :1
(2) Liquid or Quick Ratio =
Year I = = 1.30 :1
Year II= = 1.07 :1
Note : Bank overdraft is not included in liquid liabilities, as it tends to become
some sort of a permanent mode of financing.
(3) Inventory Turnover Ratio =
Year I = = 35:1
Year II= = 20:1
(4) Inventory Current Assets Ratio = × 100
Year I = × 100 = 16%
Year II = × 100 = 31%
30,000 + 15,000
30,000 + 12,000
3,50,000
10,000
3,00,000
15,000
Inventory
Total Current Assets
10,000
62,000
20,000
65,000
16
(5) Average Collection Period = × No. of Working Days
Year I = × 365 = 31.3 days
Year II= × 365 = 36.5 days
The liquidity position (or shot-term solvency) of the company is not sound. The
current ratio in the first year, 1.55:1 does not appear to be good enough as it is
below the norm of 2:1. In the second year, the position has further deteriorated to
1.38:1. The latter ratio shows a definite weakening in the solvency position of the
company. As regards Acid Test Ratio, it is satisfactory in the first year and not
alarming in the second year, as it is above the generally accepted standard of 1:1.
However, the fall in the cash balance and appearance of bank overdraft in the
second
year show a definite deterioration in the financial position. Moreover, because of
factors concerning sales, stock and debtors, the quick ratio is likely to soon
deteriorate.
The inventory turnover ratio, indicates a deterioration in the second year. The
disproportionate rise in the percentage of stock of total current assets from 16%
in the first year to 31% in the second year is also a matter of concern. This shows
over-purchase of materials which needs a thorough investigation.
A comparison of debtors' turnover ratios of the two years indicates worsening of
the company's liquid position. There will be much cause of worry, if the sales is
only to a few customers.
Long-term Solvency Analysis
(1) Debt to Equity Ratio =
Year I : = = 1.82 :1
Year II : = = 2.61 :1
(2) Proprietary Ratio =
Year I = = 35 :1
Year II= = 28.1
Trade Receivables
Net Credit Sales
30,000
3,50,000
30,000
3,00,000
External Equities
Internal Equities
25,000 + 15,000
62,000 – 40,000
40,000
22,000
30,000 + 12,000, 5,000
65,000 – 47,000
47,000
18,000
Sharehodlers' Equities
Total Equities
22,000
62,000
18,000
65,000
17
To sum up, the financial position of the company is very unsatisfactory as the debt
to equity ratio and proprietary ratio are far off the norm in both the years. The
situation has worsened in the second year resulting in a serious decline in the
shareholders' equity. The company seems to be heavily banking upon creditors'
funds.
The overall conclusion of the above analysis is that the solvency position of the
company is not satisfactory and has deteriorated in the second year.
13.6.4 Coverage Ratios : The another category of leverage ratios are coverage
ratios. These ratios are computed from information available in the profit and loss
account. The coverage ratios measure the relationship between what is normally
available from operations of the firms and the claims of the outsiders. The
important
coverage ratios are as follows :
1. Interest Coverage Ratio : This ratio measures the debt servicing capacity
of a firm insofar as fixed interest on long-term loan is concerned. It is determined
by dividing the operating profits or earnings before interest and taxes (EBIT) by
the fixed interest charges on loans. Thus,
Interest coverage =
From the point of view of the creditors, the larger the coverage, the greater is the
ability of the firm to handle fixed-charge capabilities and the more assured is the
payment of interest to the creditors. However, too high a ratio may imply unused
debt capacity.
2. Dividend Coverage Ratio : It measures the ability of a firm to pay dividend
on preference shares which carry a stated rate of return. This ratio is computed as
under :
Dividend coverage =
The ratio, like the interest coverage ratio, reveals the safety margin available to the
preference shareholders. As a rule, the higher the coverage, the better it is from
their point of view.
3. Total Coverage Ratio : The total coverage ratio has a wider scope and takes
into account all the fixed obligations of a firm, that is, (i) interest on loan, (ii)
preference dividend, (iii) Lease payments, and (iv) repayment of principal.
Symbolically,
Total coverage =
4. Debt-Services Coverage Ratio (DSCR) : This ratio is considered more
comprehensive and apt measure to compute debt service capacity of a business
EBIT
Interest
EAT
Preference dividend
EBIT + Lease payment
Interest + Lease payments + (Preference
dividend + Instalment of principal)/(1-t)
18
firm. It provides the value in terms of the number of times the total debt service
obligations consisting of interest and repayment of principal in installments are
covered by the total operating funds, available after the payment of taxes.
Symbolically,
DSCR =
The higher the ratio, the better it is. In general, lending financial institutions
consider
2:1 as satisfactory ratio.
13.6.5 Profitability Ratios : Apart from the creditors, also interested in the
financial soundness of a firm are the owners and management or the company
itself.
The management of the firm is naturally eager to measure its operating efficiency.
Similarly, the owners invest their funds in the expectation of reasonable returns.
Profitability ratios can be determined on the basis of either sales or investments.
1. Profitability Ratios Related to Sales : These ratios are based on the
premise that a firm should earn sufficient profit on each rupee of sales. These
ratios consist of (1) profit margin, and (2) expenses ratio.
(i) Gross Profit Margin :
A high ratio of gross profit to sales is a sign of good management as it implies that
the cost of production of the firm is relatively low. It may also be indicative of a
higher sales price without a corresponding increase in the cost of goods sold.
EATt + Interestt + Depreciationt + OAt
Instalmentt
∑ n
n=1
∑ n
n=1
Gross Profit
Net Sales
Net Sales – Cost of Goods sold
Net Sales
Rs. 90,000 – Rs. 60,000
Rs. 90,000
Rs. 30,000
Rs. 90,00
Illustration 6 : Calculate the Gross Profit Ratio from the following figures :
Sales Rs. 1,00,000 Purchses Rs. 60,000
Sales Returns 10,000 Purchases Returns 15,000
Opening Stock 20,000 Closing Stock 5,000
Solution :
Gross Profit Ratio = × 100
= × 100
= × 100
= × 100 = 33.33%
19
A relatively low gross margin is definitely a danger signal, warranting a careful
and
detailed analysis of the factors responsible for it.
(ii) Net profit margin is also known as net margin. This measures the relationship
between net profits and sales of a firm. Depending on the concept of net profit
employed, this ratio can be computed in two ways :
1. Operating profit ratio =
2. Net profit ratio =
This ratio is indicative of management's ability to operate the business with
sufficient
success not only to recover from revenues of the period, the cost of merchandise
or services, the expenses of operating the business (including depreciation) and
the cost of the borrowed funds, but also to leave a margin of reasonable
compensation
to the owners for providing their capital at risk. The ratio of net profit (after
interest
and taxes) to sales essentially expresses the cost price effectiveness of the
operation.
A high net profit margin would ensure adequate return to the owners.
2. Expenses Ratio : Another profitability ratio related to sales is the expenses
ratio. It is computed by dividing expenses by sales.
1. Cost of goods sold ratio = × 100
2. Administrative expenses ratio = × 100
3. Selling expenses ratio = × 100
4. Operating ratio = × 100
The expenses ratio should be compared over a period of time with the industry
average as well as firms of similar type. As a working proposition, a low ratio is
favourable, while a high one is unfavourable.
3. Rate of Return on Equity Share Capital : This ratio is calculated by
dividing the net profits (after deducing income-tax and dividend on preference
share
capital) by the paid up amount of equity share capital. It is usually expressed in
percentage as below :
Rate of Return of Equity Share Capital =
Earnings before interest and taxes (EBIT)
Sales
Earnings after interest and taxes (EAT)
Sales
Cost of goods sold
Net sales
Administrative expenses
Net sales
Selling expenses
Net sales
Cost of goods sold + Operating expenses
Net sales
Net Profit (after tax and Pref. Div.)
Paid-up Equity Share Capital × 100
20
This ratio examines the earning capacity of equity share capital.
4. Return on Proprietors Funds on Return on Net Worth : Some experts
suggest to calculate return on net worth instead of calculating return on equity
share capital. The proprietors funds or net worth represents the total interest of
shareholders which include share capital (whether equity or preference) and all
accumulated profits. Alternatively, proprietors' funds may be taken equal to fixed
assets plus current assets minus all outside liabilities both long-term and current.
This ratio may be calculated as under :
Return on Proprietors' Funds =
This ratio helps the proprietors and potential investors to judge the earning of the
company in relation to others and the adequacy of the return on proprietors' funds.
5. Return on Investment (ROI) Ratio : This is one of the key profitability
ratios. It examines the overall operating efficiency or earning power of the
company
in relation to total investment in business. It indicates the percentage of return
on the capital employed in the business. It is calculated on the basis of the
following formula :
× 100
The term capital employed has been given different meanings by different
accountants.
Some of the popular meanings are as follows :
(i) Sum-total of all assets whether fixed or current.
(ii) Sum-total of fixed assets
(iii) Sum-total of long-term funds employed in the business, i.e.,
Share Capital + Reserves and Surplus + Long term Loans + Non-business
Assets + Fictitious Assets
In management accounting the term capital employed is generally used in the
meaning
given in the point third above.
The term Operating Profit means Profit before Interest and Tax. The term Interest
means Interest on long-term Borrowings. Interest on short-term borrowings will
be deducted for computing operating profit. Non-trading incomes such as interest
on Government securities or non-trading losses or expenses such as loss on
account
of fire, etc. will also be excluded.
The computation of ROI can be understood with the help of the following
illustration:
Net Profits (less taxes)
Proprietors' Funds
Operating Profit
Capital Employed
21
Illustration 7 : From the following figures extracted from the Income Statement
and Balance Sheet of Anu Sales Pvt. Ltd., calculate the Return on Total Capital
employed (ROI) :
Particulars Amount Particulars Amount
Rs. Rs.
Fixed Assets 4,50,000 Reserves 1,00,000
Current Assets 1,50,000 Debentures 1,00,000
Investment in Govt. Securities 1,00,000 Income from Investments 10,000
Sales 5,00,000 Interest on Debentures at 10%
Cost of goods sold 3,00,000 Provision for tax at 50% of
Share Capital : Net Profits
10% Preference 1,00,000
Equity 2,00,000
Solution : It will be appropriate to prepare the Profit and Loss Account and the
Balance Sheet of the company before computation of the returns on capital
employed.
Anu Sales Pvt. Limited
Profit and Loss Account
Particulars Amount Particulars Amount
Rs. Rs.
To Cost of goods sold 3,00,000 By Sales 5,00,000
To Interest on Debentures 10,000 By Income form Investments 10,000
To Provision for Taxation 1,00,000
To Net profit after tax 1,00,000
5,10,000 5,10,000
Balance Sheet as on ..........
Liabilities Rs. Assets Rs.
Share Capital Fixed Assets 1,50,000
10% Preference 1,00,000 Current Assets 1,50,000
Equity 2,00,000 Investment in govt. Securities 1,00,000
Reserves 1,00,000
10% Debentures 1,00,000
Profit and Loss Account 1,00,000
Provision for Taxation 1,00,000
7,00,000 7,00,000
Return on total capital employed= Net operating profit before interest and tax
Total capital employed
22
= × 100
= 40%
Net Operating Profit = Net Profit + Provision for Tax – Income from
Investments + Interest on Debentures
= Rs.1,00,000 + Rs.1,00,000–Rs.10,000 + Rs. 10,000
= Rs. 2,00,000
Capital employed = Fixed Assets + Current Assets – Provision for Tax
= Rs. 4,50,000 + Rs. 1,50,000–Rs. 1,00,000
= Rs. 5,00,000
Or = Share Capital + Reserves + Debentures+Profit &Loss
Account Balance – Investment in Govt. Securities
= Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,00,000 +
Rs. 1,00,000 – Rs. 1,00,000
= Rs. 5,00,000
Significance of ROI : The Return on Capital invested is a concept that measures
the profit which a firm earns on investing a unit of capital. Yield on capital is
another
term employed to express the idea. It is desirable to ascertain this periodically.
The profit being the net result of all operations, the return on capital expresses
all efficiencies or inefficiencies of a business collectively and thus is a
dependable basis for judging its overall efficiency or inefficiency. On this basis,
there can be comparison of the efficiency of one department with that of another
or one plant with that another, one company with that of another and one industry
with that of another. For this purpose, the amount of profits considered is that
before making deductions on account of interest, income-tax and dividends and
capital is the aggregate of all the capital at the disposal of the company, viz.,
equity
capital, preference capital, reserve, debentures, etc.
The Return on Capital when calculated in this manner would also show whether
the
company's borrowing policy was wise economically and whether the capital had
been employed fruitfully. Suppose, funds have been borrowed at 8% and the
Return
on Capital is 7½% it would have been better not to borrow (unless borrowing was
vital for survival). It would also show that the firm had not been employing the
funds efficiently.
Limitations of ROI : ROI is one of the very important measures for judging the
overall financial performance of a firm. However, it suffers from certain important
limitations. These limitations are :
(i) Manipulation is possible : ROI is based on earnings and investments. Both
these figures can be manipulated by management by adopting varying accounting
policies regarding depreciation, inventory valuation, treatment of provisions, etc.
2,00,000
5,00,000
23
The decision in respect of most of these matters is arbitrary and subject to whims
of the management.
(ii) Different bases for computation of Profit and Investments : There are
different bases for calculating both profit and investment as explained in the
preceding
pages. For example, fixed assets may be taken at gross or net values, earnings
may be taken before or after tax, etc.
(iii) Emphasis on short-term profit : ROI emphasises the generation of
shortterm
profits. The firm may achieve this objective by cutting down cost such as
those on research and development or sales promotion. Cutting down of such costs
without any justification may adversely affect the profitability of the firm in the
long run, though ROI may indicate better performance in the shortrun.
(iv) Poor Measure : ROI is a poor measure of a firm's performance since it is
also affected by many extraneous and non-controllable factors.
6. Return on Capital Employed (ROCE) : The ROCE is the second type of
ROI. It is similar to the ROA except in one respect. Here the profits are related to
the total capital employed. The term capital employed refers to long-tern funds
supplied by the creditors and owners of the firm. The higher the ratio, the more
efficient is the use of capital employed.
The ROCE can be computed in different ways as shown below :
1. ROCE = × 100
2. ROCE = × 100
(7) Earning Per Share (EPS) measures the profit available to the equity
shareholders on a per share basis, that is, the amount that they can get on every
share held. It is calculated by dividing the profits available to the shareholders by
the number of the outstanding shares. The profits available to be the ordinary
shareholders are represented by net profits after taxes and preference dividend.
Thus,
EPS =
8. Divided Per Share (DPS) is the dividends paid to shareholders on a per
share basis. In other words, DPS is the net distributed profit belonging to the
shareholders divided by the number of ordinary shares outstanding. That is,
Net profit after taxes/EBIT
Average total capital employed
Net profit after taxes + Interest + Tax advantage on interest
Average total capital employed
Net profit available to equity holders
Number of ordinary shares outstanding
24
DPS =
The DPS would be a better indicator than EPS as the former shows what exactly is
received by the owners.
9. Divided-Pay Out (D/P) Ratio : This is also known as pay-out ratio. It
measures the relationship between the earnings belonging to the ordinary
shareholders and the dividend paid to them. In other words, the D/P ratio shows
what percentage share of the net profits after taxes and preference dividend is paid
out as dividend to the equity holders.
D/P = × 100
If the D/P ratio is subtracted from 100, it will give that percentage share of the net
profits which are retained in the business.
10. Earnings and Dividend Yield : This ratio is closely related to the EPS and
DPS. While the EPS and DPS are based on the book value per share, the yield is
expressed in terms of the market value per share.
This ratio is calculated as follows :
1. Earning yield = × 100
2. Dividend yield = × 100
The earning yield is also called the earning-price ratio
Price Earnings (P/E) Ratio is closely related to the earnings yield/earnings price
ratio. It is actually the reciprocal of the latter. This ratio is computed by dividing
the market price of the shares by the EPS. Thus,
P/E ratio =
The P/E ratio reflects the price currently being paid by the market for each rupee
of currently reported EPS. In other words, the P/E ratio measures investors'
expectations and the market appraisal of the performance of a firm.
13.7 SUMMARY
Ratio analysis is a widely- used tool of financial analysis. The rational of ratio
analysis lies in the fact that it makes related information comparable. A single
Dividend paid to ordinary shareholders
Number of ordinary shares outstanding
Dividend per ordinary share (DPS)
Earnings per share (EPS)
EPS
Market value per share
DPS
Market value per share
Market price of share
EPS
25
figure by itself has no meaning but when expressed in terms of a related figure, it
yields significant inferences. Ratio analysis helps in financial forecasting, in
making
comparisons, in evaluating solvency position of a firm, etc.
Ratios can be classified into five broad groups : (i) Liquidity ratios (ii) Activity
ratios (iii) Long-term solvency/capital structure/leverage ratios (iv) coverage ratios
(v) Profitability ratios. In life insurance area, the ratios are calculated for each
operating unit i.e. each branch office, each divisional office (consolidated for
division as a whole), each zonal office (consolidated for zone as a whole) and for
the corporation as a whole. Ratios are calculated for two or more than two years
and compared; then they are compared with other units, and even with the
corporate
ratios , and interpreted and based on the indications received, corrective action is
taken. Sometimes some of the ratios are calculated monthly for observing the trend
of movement in various indices, and for taking remedial action promptly.
13.8 KEYWORDS
Ratio: A ratio is simply one number expressed in terms of another.
Liquidity ratios: Liquidity ratios are used to test the short-term solvency position
of the business.
Activity ratios: Activity ratios are concerned with measuring the efficiency in
asset management.
Profitability ratios: These indicate the profit earning capacity of a business.
Leverage ratios: There are financial ratios which throw light on the long-term
solvency of a firm as reflected in its ability to assure the long-term creditors with
respect to periodic payment of principal as well as interest.
13.9 SELF ASSESSMENT QUESTIONS
1. Discuss the significance of any three of the following ratios to financial
analyst :
(a) Current Ratio
(b) Liquidity Ratio
(c) Net Profit to Capital Employed Ratio
(d) Debt Equity Ratio
2. State the meaning of expression "Return on Capital Employed" and point out
the advantages the business would derive from its use.
3. Ratios like statistics have a set of principles and finality about them which
at times may be misleading." discuss with illustrations.
4. Discuss the importance of ratio analysis for inter-firm and intra-firm
comparison including circumstances responsible for its limitations, if any.
26
5. "The study of financial analysis is simply memorising a bunch of ratios and
gives the students very little opportunity for creative problem solving." Do
you agree with it ? Explain.
6. Discuss in detail and with illustrations the limitations of ratio analysis.
7. What do you understand by 'Ratio Analysis'? What are its objects? Discuss
the role of three important ratios to the management.
8. Discuss some of the important ratios usually worked from financial
statements showing how they would be useful to higher management.
9. What is Profitability and how is it measured? Which of the accounting ratios
serve as indication of profitability and how are they computed ?
10 From the following information of a textile company complete the proforma
balance sheet if its sales are Rs. 32,00,000.
Sales to Net worth 2.3 times
Current Debt to Net Worth 42%
Total Debt to Net Worth 75%
Current Ratio 2.9 times
Net Sales to Inventory 4.7 times
Average Collection Period 64 days
Fixed Assets to Net Worth 53.2%
Proforma Balance Sheet
Net Worth ? Fixed Assets ?
Long-term Debt ? Cash ?
Current Debt ? Stock ?
Sundry Debtors ?
11. From the following informations given below find out Debtors Turnover for
each year :
2000 2001
Rs. Rs.
Net Credit Sales 26,809 29,836
Total Debtors 5,644 6,089
If the Company increases its debtors turnover for the year 2001 to 6 times,
what would be the impact on profitability.
(Ans. 2000 – 4.75 times; 2001 – 4.90 times. If debtors turnover for 2001
increases to 6 times, working capital needs of the Company will be reduced
by Rs. 1,116. Assuming the cost of funds employed in debtors at 10%, the
company will save Rs. 111.60. Besides loss from bad debts will also be
reduced due to decrease in debtors).
27
12. From the following information, calculate average collection period :
Rs. Rs.
Total sales 1,05,000 Stock at the end 3,000
Sales Returns 5,000 Debtors at the end 3,000
Credit sales 60,000 B/R at the end 3,650
B/P at the end 3,000 Creditors at the end 7,000
Credit purchases 75,000 Provision for doubtful debt 15%
Also calculate number of days purchases in payables. Assume 360 days in a
year.
(Ans. 43.5 days, 48 day)
13. From the following Balance Sheet of Company A, you are required to
calculate : (a) Solvency Ratio (b) Liquidity Ratio
Balance Sheet of Company A
Liabilities Rs. Assets Rs.
Share Capital 5,00,000 Fixed Assets 6,00,000
Fixed Liabilities 2,50,000 Current Assets 4,00,000
Current Liabilities 2,50,000
10,00,000 10,00,000
[(Ans. (a) 5:1; (b) 1.6:1]
14. The Capital of Everest Co. Ltd. is as follows :
Rs.
9% Preference Shares of Rs. 10 each 3,00,000
Equity Shares of Rs. 10 each 8,00,000
11,00,000
The accountant has ascertained the following information :
Rs.
Profit after tax at 60 per cent 2,70,000
Depreciation 60,000
Equity Dividend Paid 20 per cent
Market Price of Equity Shares Rs. 40
(You are required to state the following, showing the necessary workings :
(a) The dividend yield on the Equity Shares.
(b) The cover for the Preference and Equity dividends.
(c) The earnings per share.
(d) The price-earnings ratio.
(e) The net cash flow
28
13.10 SUGGESTED READINGS
1. Nigam, B.M. Lall and Jain, I.C.; Cost Accounting, PHI, New Delhi.
2. Pau,, S.Kr.; Management Accounting, Central Book Agency, Calcutta.
3. Khan, M.Y. and Jain, P.K.; Financial Management, Tata McGraw, New Delhi.
4. Maheshwari, S.N.; Management Accounting and Financial Control.
1
Subject : Accounting for Managers Updated by: Dr. Mahesh Chand Garg
Course Code : CP-104
Lesson No. : 14
ANALYSIS AND INTERPRETATION OF FINANCIAL
STATEMENTS : FUNDS FLOW STATEMENT
STRUCTURE
14.0 Objective
14.1 Introduction
14.2 Meaning of Funds
14.3 Meaning of Flow of Funds
14.4 Funds Flow Statement
14.5 Hidden Transactions
14.6 Difference Between Funds Flow Statement and Income Statement
14.7 Uses of Funds Flow Statement
14.8 Limitations of Funds Flow Statement
14.9 Summary
14.10 Keywords
14.11 Self Assessment Questions
14.12 Suggested Readings
14.0 OBJECTIVE
After studying this lesson, you will be able to know :
(a) Meaning of Funds, Flow of Funds and Funds Flow Statement.
(b) Preparation of Funds Flow Statement.
(c) Uses and Limitations of Funds Flow Statement.
14.1 INTRODUCTION
The basic financial statements, i.e., the Balance Sheet and Profit and Loss
Account or Income Statement of business, reveal the net effect of the various
2
transactions on the operational and financial position of the company. The Balance
Sheet gives a summary of the assets and liabilities of an undertaking at a particular
point of time. It reveals the financial status of the company. The assets side of a
Balance
Sheet shows the deployment of resources of an undertaking while the liabilities
side
indicates its obligations, i.e., the manner in which these resources were obtained.
The
Profit and Loss Account reflects the results of the business operations for a period
of
time. It contains a summary of expenses incurred and the revenue realised in an
accounting period. Both these statements provide the essential basic information
on
the financial activities of a business, but their usefulness is limited for analysis and
planning purposes. The Balance Sheet gives a static view of the resources
(liabilities)
of a business and the uses (assets) to which these resources have been put at a
certain
point of time. It does not disclose the causes for changes in the assets and
liabilities
between two different points of time. The Profit and Loss Account, in a general
way,
indicates the sources provided by operations. But there are many transactions that
take
place in an undertaking and which do not operate through Profit and Loss
Account.
Thus, another statement has to be prepared to show the change in the assets and
liabilities
from the end of one period of time to the end of another period of time. The
statement
is called a Statement of Changes in Financial Position or a Funds Flow Statement.
The Funds Flow Statement is a statement which shows the movement of
funds and is a report of the financial operations of the business undertaking. It
indicates
various means by which funds were obtained during particular period and the
ways in
which these funds were employed. In simple words, it is a statement of sources
and
applications of funds.
14.2 MEANING OF FUNDS
The term 'funds' has been defined in a number of ways :
3
(a) In a narrow sense, it means cash and a Funds Flow Statement prepared on this
basis is called a cash flow statement. Such a statement enumerates net effects of
the
various business transactions on cash and takes into account receipts and
disbursements
of cash.
(b) In a broader sense, the term 'funds' refers to money values in whatever form it
may exist. Here funds means all financial resources, used in business whether in
the
form of men, material, money, machinery and others.
(c) In a popular sense, the term 'funds' means working capital, i.e., the excess of
current
assets over current liabilities. The working capital concept of funds has emerged
due to the
fact that total resources of a business are invested partly in fixed assets in the form
of fixed
capital and partly kept in form of liquid or near liquid form as working capital.
The concept of funds as working capital is the most popular one and in
this lesson we shall refer to 'funds' as working capital.
14.3 MEANING OF FLOW OF FUNDS
The term 'flow' means movement and includes both 'inflow' and 'outflow'.
The term 'flow of funds' means transfer of economic values from one asset or
equity
to another. Flow of funds is said to have taken place when any transaction makes
changes
in the amount of funds available before happening of the transaction. If the effect
of
transaction results in the increase of funds, it is called a source of funds and if it
results in the decrease of funds, it is known as an application of funds. Further, in
case
the transaction does not change funds, it is said to have not resulted in the flow of
funds. According to the working capital concept of funds, the term 'flow of funds'
refers to the movement of funds in the working capital. If any transaction results in
the
increase in working capital, it is said to be a source or inflow of funds and if it
results
in the decrease of working capital, it is said to be an application or outflow of
funds.
4
Rule of Flow of Funds
The flow of funds occurs when a transaction changes on the one hand a
non-current account and on the other a current account and vice-versa.
When a change in a non-current account e.g., fixed assets, long-term
liabilities, reserves and surplus, fictitious assets, etc., is followed by a change in
another
non-current account, it does not amount to flow of funds. This is because of the
fact that
in such cases neither the working capital increases nor decreases. Similar, when a
change
in one current account results in a change in another current account, it does not
affect
funds. Funds move from non-current to current transactions or vice-versa only. In
simple
language funds move when a transaction affects (i) current asset and a fixed asset,
or (ii)
a fixed and a current liability, or (iii) a current asset and a fixed liability, or (iv) a
fixed
liability and current liability; and funds do not move when the transaction affects
fixed
assets and fixed liability or current assets and current liabilities.
Examples
(a) Transactions which involve only the current accounts and hence do not
result in the flow of funds
1. Cash collected from debtors.
2. Bills receivables realised.
3. Cash paid to creditors.
4. Payment or discharge of bills payable.
5. Issued bills payable to trade creditors.
6. Received acceptances from customers.
7. Raising of short-term loans.
8. Sale of purchased for cash or credit.
9. Goods purchased for cash or credit.
5
(b) Transactions which involve only non-current accounts and hence do not
result in the flow of funds
1. Purchase of one new machine in exchange of two old machines.
2. Purchase of building or furniture in exchange of land.
3. Conversion of debentures into shares.
4. Redemption of preference shares in exchange of debentures.
5. Transfers to General Reserves, etc.
6. Payment of bonus in the form of shares.
7. Purchase of fixed assets in exchange of shares, debentures, bonds or
long-term loans.
8. Writing off of fictitious assets.
9. Writing off a accumulated losses or discount on issue of shares, etc.
(c) Transactions which involve both current and non-current accounts and
hence result in the flow of funds
1. Issue of shares for cash.
2. Issue of debentures for cash.
3. Raising of long-term loans.
4. Sale of fixed assets on cash or credit.
5. Sale of trade investments.
6. Redemption of Preference shares.
7. Redemption of debentures.
8. Purchase of fixed assets on cash or credit.
9. Purchase of long-term/trade investments.
10. Payment of bonus in cash.
11. Repayment of long-term loans.
12. Issue of shares against purchase of stock-in-trade.
6
14.4 FUNDS FLOW STATEMENT
The Funds Flow Statement is a financial statement which reveals the
methods by which the business has been financed and how it has used its funds
between
the opening and closing Balance Sheet dates. According to Anthony, "The Funds
Flow
Statement describe the sources from which additional funds were derived and the
uses
to which these funds were put". The analysis of such statements over periods of
time
clearly shows the sources from which past activities have been financed and brings
to
highlight the uses to which such funds have been put. The statement is known by
various
titles, such as, Statement of Sources and Applications of Funds, Statement of
Changes
in Working Capital, Where Got and Gone Statement and Statement of Resources
Provided and Applied.
Objectives of Funds Flow Statement
Generally a business prepares two financial statements i.e., Balance Sheet
and Profit and Loss Account. The former reflects the state of assets and liabilities
of
a company on a particular date whereas the latter tells about the result of
operations of
the company over a period of a year. These financial statements have great utility
but
they do not reveal the movement of funds during the year and their consequent
effect
on its financial position. For example, a company which has made substantial
profits
during the year, may discover to its surprise that there are not enough liquid funds
to
pay dividend and income tax because of profits tied up in other assets, and is
always
after the bank authorities to get the cash credit or bank overdraft facility. In order
to
remove this defect, another statement known as Funds Flow Statement is prepared.
The main purposes of such statement are :
(i) To help to understand the changes in assets and asset sources which are not
readily evident in the Income Statement or the financial position statement.
(ii) To inform as at how the loans to the business have been used, and
(iii) To point out the financial strengths and weaknesses of the business.
7
Procedure for Preparing a Funds Flow Statement
Funds flow statement is a method by which we study changes in the
financial position of a business enterprise between beginning and ending financial
statements dates. Hence, the Funds Flow Statement is prepared by comparing two
Balance Sheets and with the help of such other information derived from the
accounts
as may be needed. Broadly speaking, the preparation of a Funds Flow Statement
consists
of following two parts :
1. Statement or Schedule of Changes in Working Capital
2. Statement of Sources and Application of Funds
1. Statement or Schedule of Changes in Working Capital
Working Capital means the excess of current assets over current liabilities.
Statement of changes in working capital is prepared to show the changes in the
working
capital between the two Balance Sheet dates. This statement is prepared with the
help
of current assets and current liabilities derived from the two Balance Sheets.
The changes in the amount of any current asset or current liability in the
current Balance Sheet as compared to that of the previous Balance Sheet either
results
in increase or decrease in working capital. The difference is recorded for each
individual
current asset and current liability. In case a current asset in the current period is
more
than in the previous period, the effect is an increase in working capital and it is
recorded
in the increase column. But if a current liability in the current period is more than
in
the previous period, the effect is decrease in working capital and it is recorded in
the
decrease column or vice versa. The total increase and the total decrease are
compared
and the difference shows the net increase or net decrease in working capital. It is
worth noting that schedule of changes in working capital is prepared only from
current
assets and current liabilities and the other information is not of any use for
preparing
8
this statement. A typical form of statement or schedule of changes in working
capital
is as follows :
Statement or Schedule of Changes in Working Capital
Effect on
Particulars Previous Current Working Capital
Year Year Increase Decrease
Current Assets :
Cash in hand
Cash at bank
Bills Receivable
Sundry Debtors
Temporary Investments
Stock/Inventories
Prepaid Expenses
Accrued Incomes
Total Current Assets
Current Liabilities :
Bills Payable
Sundry Creditors
Outstanding Expenses
Bank Overdraft
Short-term advances
Dividends Payable
Proposed dividends*
Provision for taxation*
Total Current Liabilities
Working Capital (CA-CL)
Net Increase or Decrease in
Working Capital
* May or may not be a current liability
9
Illustration 1. Prepare a Statement of changes in Working Capital from the
following
Balance Sheets of Manjit and Company Limited.
BALANCE SHEETS
as on 31st March
Liabilities 2001 2002 Assets 2001 2002
Rs. Rs. Rs. Rs.
Equity Capital 5,00,000 5,00,000 Fixed Assets 6,00,000 7,00,000
Debentures 3,70,000 4,50,000 Long-term
Tax Payable 77,000 43,000 Investments 2,00,000 1,00,000
Accounts Payable 96,000 1,92,000 Work-in-Progress 80,000 90,000
Interest Payable 37,000 45,000 Stock-in-trade 1,50,000 2,25,000
Dividend Payable 50,000 35,000 Accounts Receivable 70,000 1,40,000
Cash 30,000 10,000
11,30,000 12,65,000 11,30,000 12,65,000
Solution :
Statement of Changes in Working Capital
Effect on
Working Capital
Particulars 2001 2002 Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets :
Cash 30,000 10,000 20,000
Accounts Receivable 70,000 1,40,000 70,000
Stock-in-trade 1,50,000 2,25,000 75,000
Work-in-progress 80,000 90,000 10,000
3,30,000 4,65,000
Tax Payable 77,000 43,000 34,000
Accounts Payable 96,000 1,92,000 96,000
Interest Payable 37,000 45,000 8,000
Dividend Payable 50,000 35,000 15,000
2,60,000 3,15,0000
Working Capital (CA-CL) 70,000 1,50,000
Net Increase in Working Capital 80,000 80,000
1,50,000 1,50,000 2,04,000 2,04,000
10
2. Statement of Sources and Application of Funds
Funds flow statement is statement which indicates various sources from
which funds (working capital) have been obtained during certain period and the
uses or
applications to which these funds have been put during that period. Generally, this
statement is prepared in two formats :
(a) Report Form
(b) T Form or An Account Form or Self Balancing Type.
Specimen of Report Form of Funds Flow Statement
Sources of Funds : Rs.
Funds from Operations
Issue of Share Capital
Raising of long-term loans
Receipts from partly paid shares, called up
Sales of non current (fixed) assets
Non-trading receipts, such as dividends received
Sale of Investments (long-term)
Decrease in working capital (as per Schedule of
Changes in Working Capital)
Total
Applications or Uses of Funds :
Funds Lost in Operations
Redemption of Preference Share Capital
Redemption of Debentures
Repayment of long-term loans
Purchase of non-current (fixed) assets
Purchase of long-term Investments
Non-trading payments
Payments of dividends*
Payment of tax*
Increase in Working Capital (as per Schedule of
Changes in Working Capital)
Total
11
T Form or An Account Form or Self Balancing Type
Funds Flow Statement
Sources Rs. Applications Rs.
Funds from Operations Funds lost in Operations
Issue of Share Capital Redemption of Preference
Issue of Debentures Share Capital
Raising of long-term loans Redemption of Debentures
Receipts from partly paid Repayment of long-term
shares, called up loans
Sale of non-current (fixed) Purchase of non-current
assets Investments
Sale of long-term Investments Non-trading payments
Net Decrease in Working Capital Payment of Dividends
Net Increase in Working Capital
* Note : Payment of dividend and tax will appear as an application of funds only
when
these items are appropriations of profits and not current liabilities.
Sources of Funds : The following are the sources from which funds generally
flow
(come), into the business :
1. Funds from operation or Trading Profits
Trading profits or the profits from operations of the business are the
most important and major source of funds. Sales are the main source of inflow of
funds into the business as they increase current assets (cash, debtors or bills
receivable)
but at the same time funds flow out of business for expenses and cost of goods
sold.
Thus, the net effect of operations will be a source of funds if inflow from sales
exceeds
the outflow for expenses and cost of goods sold and vice-versa. But it must be
12
remembered that funds from operations do not necessarily mean the profit as
shown
by the Profit and Loss Account of a firm, because there are many non-fund or
nonoperating
items which may have been either debited or credited to Profit and Loss
Account. The examples of such items on the debit side of a Profit and Loss
Accounts
are amortization of fictitious and intangible assets such as goodwill, preliminary
expenses and discount on issue of shares and debentures written off, appropriation
of
retained earnings, such as transfers to reserves, etc., depreciation and depletion,
loss
on sale of fixed assets, payment of dividend, etc. The non-fund items are those
which
may be operational expenses but they do not affect funds of the business, e.g., in
case
of depreciation charged to Profit and Loss Account, funds really do not move out
of
business. Non-operating items are those which although may result in the outflow
of
funds but are not related to the trading operations of the business, such as loss on
sale
of machinery or payment of dividends. There are two methods of calculating funds
from operations which are as follows :
(a) The first method is to prepaid the Profit and Loss Account afresh by taking into
consideration only fund and operational items which involve funds and are related
to
the normal operations of the business. The balancing figure in this case will be
either
funds generated from operations or funds lost in operations depending upon
whether
the income or credit side or Profit and Loss Account exceeds the expense or debit
side of Profit and Loss Account or vice-versa.
(b) The second method (which is generally used) is to proceed from the figure of
net profit or net loss as arrived at from the Profit and Loss Account already
prepared.
Funds from operations by this method can be calculate as under :
13
(a) Calculation of Funds from Operation
Closing Balance of Profit and Loss Account (as given in the Balance Sheet) Rs.
Add Non-fund and Non-operating items which have been already
debited to Profit and Loss Account :
(i) Depreciation and Depletion
(ii) Amortization of fictitious and Intangible Assets such as :
Goodwill/ Patents/Trade marks/Preliminary Expenses/
Discount on Issue of Shares, etc.
(iii) Appropriation of Retained Earnings, such as :
Transfer to General Reserve/ Dividend Equalisation Fund/
Transfer to Sinking Fund/ Contingency Reserve etc.
(iv) Loss on the Sale of any non-current (fixed) assets such as :
Loss on sale of land and building/Loss on sale of machinery/
Loss on sale of furniture/Loss on sale of long-term investments etc.
(v) Dividends including :
Interim Dividend/ Proposed Dividend (if it is an appropriation of profits
and not taken as current liability)
(vi) Provision for Taxation (if it is not taken as Current Liability)
(vii) Any other non-fund/non-operating items which have been debited
to Profit and Loss Account
Total (A)
Less Non-fund or Non-operating items which have already been credited to
(i) Profit or Gain from the sale of non-current (fixed) assets such as :
Sale of land and building/Sale of plant & machinery/
Sale of long-term investments, etc.
(ii) Appreciation in the value of fixed assets, such as increase in the
value of land if it has been credited to Profit and Loss Account
(iii) Dividends Received
(iv) Excess Provision retransferred to Profit and Loss Account or written off
(v) Any other non-operating item which has been credited to Profit and Loss Account
(vi) Opening balance of Profit and Loss Account or Retained Earnings
(as given in the Balance Sheet)
Total (B)
Total (A) – Total (B) = Funds generated by operations
14
(b) Funds from operations can also be calculated by preparing Adjusted Profit and
Loss Account as follows :
Adjusted Profit and Loss Account
Rs. Rs.
To Depreciation & Depletion By Opening Balance
or amortization of fictitious (of P&L A/c)
and intangible assets, such as : By Transfers from excess
Goodwill, Patents, Trade provisions
Marks, Preliminary Expenses By Appreciation in the
etc. value of fixed assets
To Appropriation of Retained By Dividends received
Earnings, such as : By Profit on sale of fixed
Transfers to General or non-current assets
Reserve, Dividend Equalisation By Funds from Operations
Fund, Sinking Fund, etc. (balancing figure in case
To Loss on Sales of any non-current debit side exceeds credit
or fixed assets side)
To Dividends (including
interim dividend)
To Proposed Dividend (if not
taken as a current liability)
To Provision for taxation (if
not taken as a current
liability)
To Closing balance (of P&L A/c)
To Funds lost in Operations
(balancing figure, in case
credit side exceeds the debit
side)
15
Illustration 2 : Nikhil Company presents the following information and you are
required to calculate funds from operations :
Particulars Rs. Particulars Rs.
To Expenses : By Gross Profit 2,00,000
Operation 1,00,000 By Gain on Sale of Plant 20,000
Depreciation 40,000
To Loss on Sale of building 10,000
To Advertisement written off 5,000
To Discount allowed to customers 500
To Discount on Issue of Shares
written off 500
To Goodwill 12,000
To Net Profit 52,000
2,20,000 2,20,000
Solution :
Calculation of Funds From Operations
Rs.
Net Profit (as given) 52,000
Add : Non-fund or non -operating items which have been
debited to Profit and Loss Account
Depreciation 40,000
Loss on sale of Building 10,000
Advertisement written off 5,000
Discount on issue of shares written off 500
Goodwill written off 12,000 67,500
1,19,500
Less : Non-fund or non-operating items which
have been credit to Profit and Loss Account :
Gain on sale of Plant 20,000 20,000
Funds from Operations 99,500
16
Alternatively :
Adjusted Profit and Loss Account
Rs. Rs.
To Depreciation 40,000 By Opening balance –
To Loss on sale of building 10,000 By Gain on sale of plant 20,000
To Advertisement written off 5,000 By Funds from Operations
To Discount on Issue of Shares 500 (balancing figure) 99,500
To Goodwill 12,000
To Closing balance 52,000
1,19,500 1,19,500
2. Issue of Share Capital and Debentures
If during the year there is any increase in the share capital, whether
preference or equity, it means capital has been raised during the year. Issue of
shares/
debentures is a source of funds as it constitutes inflow of funds. Even the calls
received
from partly paid shares/debentures constitutes an inflow of funds. It should also be
remembered that it is the net proceeds from the issue of share capital which
amounts
to a source of funds and hence in case shares are issued at premium, even the
amount
of premium collected shall become a source of funds. The same is true when
shares
are issued at discount; it will not be the nominal value of shares but the actual
realisation
after deducting discount that shall amount to inflow of funds. But sometimes
shares
are issued otherwise than in cash, the following rules must be followed :
(i) Issue of shares or making of partly paid shares as fully paid out of accumulated
profits in the form of bonus shares is not a source of funds.
(ii) Issues of shares for consideration other than current assets such as against
purchase of land, machines, etc. does not amount to inflow of funds.
17
(iii) Conversion of debentures or loans into shares also does not amount to inflow
of funds.
In all the three cases mentioned above, both the accounts involved are
non-current and do not involve any current assets or funds.
3. Sale of Fixed (non-current assets) and Long-term or Trade investments
When any fixed or non-current asset like land, building, plant and
machinery, furniture, long-term investments, etc. are sold it generates funds and
becomes a source of funds. However, it must be remembered that if one fixed
asset is
exchanged for another fixed asset, it does not constitute an inflow of funds
because no
current assets are involved.
4. Non-Trading Receipts
Any non-trading receipt like dividend received, refund of tax, rent
received, etc. also increases funds and is treated as a sources of funds because such
an
income is not included in the funds from operations.
5. Decrease in Working Capital
If the working capital decreases during the current period as compared
to the previous period, it means that there has been a release of funds from
working
capital and it constitutes a source of funds.
Application or Uses of Funds
1. Funds lost in operations
Sometimes the result of trading in a certain year is a loss and some funds
are lost during that period in trading operations. Such loss of funds in trading
amounts
to an outflow of funds and is treated as an application of funds.
18
2. Purchase of fixed assets
Purchase of fixed assets such as land, building, plant, machinery, longterm
investments, etc., results in decrease of current assets without any decrease in
current liabilities. Hence, there will be a flow of fund. But in case shares or
debentures
are issued for acquisition of fixed assets, there will be no flow of funds.
3. Payment of dividend
Payment of dividend results in decrease of a fixed liability and, therefore,
it affects funds. Generally, recommendation of directors regarding declaration of
dividend (i.e., proposed dividends) is simply taken as an appropriation of profits
and
not as an item affecting the working capital.
4. Payment of fixed liabilities
Payment of a long-term liability, such as redemption of debentures or
redemption of redeemable preference shares, results in reduction of working
capital
and hence it is taken as an application of funds.
5. Payment of tax liability
Provision for taxation is generally taken as an appropriation of profits
and not as application of funds. But if the tax has been paid, it will be taken as an
application of funds.
14.5 HIDDEN TRANSACTIONS
While preparing a Funds Flow Statement, one has to analyse the given
balance sheets. Items relating to current accounts, i.e., current assets and current
liabilities have to be shown in the Schedule of Changes in Working Capital. But
the
non-current assets and non-current liabilities have to be further analysed to find
out
the hidden information with regard to sale or purchase of non-current assets, issue
or
19
redemption of share capital, raising or repayment of long-term loans, transfer to
reserve
and provisions, etc. The following items require special care while preparing a
Funds
Flow Statement :
1. Fixed Assets
Sometimes there are certain adjustments or transactions of sale and
purchase of fixed assets which are given after two Balance Sheets. Under such
circumstances, it is desirable to prepare accounts relating to such fixed assets and
provisions or reserve for depreciation. The working of these accounts will be as
follows:
Fixed Asset Account
Particulars Rs. Particulars
Rs.
To Opening Balance b/d By Adjusted Profit & Loss
To Bank (Purchase of an (Dep.)
Asset : Bal. fig.) By Bank (Sale of an Asset)
To Adjusted Profit & Loss A/c By Adjusted Profit & Loss A/c
(Profit on Sale) (Loss on Sale)
By Balance c/d
Depreciation Account
To Fixed Asset A/c By Opening Balance b/d
(Accumulated depreciation relating By Adjusted Profit & Loss A/c
to asset transferred or sold) (New provision or reserve)
To Closing Balance c/d
20
Illustration 3 : The following figures are available from the records of a Company
:
2001 2002
Rs. Rs.
Plant and Machinery 80,000 1,20,000
Additional Information :
(i) Depreciation charged during the year 50,000
(ii) A part of the plant whose written down value is Rs. 12,000 has been sold for
Rs.
7,000
Prepare Plant and Machinery A/c.
Solution :
Plant and Machinery Account
Rs. Rs.
To Balance b/d 80,000 By Adjusted Profit & Loss A/c (Dep.) 50,000
To Bank A/c By Bank A/c (Sale) 7,000
(Purchase of Plant & Machinery) By Adjusted P/L A/c (Loss on Sale 5,000
(Bal. Fig.) 1,02,000 of Machinery)
By Balance c/d 1,20,000
1,82,000 1,82,000
Thus depreciation of Rs. 50,000 and loss on sale of machinery Rs. 5,000
will be shown on the debit side of Adjusted Profit and Loss Account. Rs. 7,000
realised
from the sale of plant will be shown as source and Rs. 1,02,000 i.e. purchased of
plant
and machinery as application in the Funds Flow Statement.
2. Proposed Dividend : It can be treated as an item of current liability or
noncurrent
liability but preferably it should be treated as non-current liability. For knowing
hidden transactions relating to dividend, it is desirable to prepare proposed
dividend
account as follows (in case treated as non-current liability) :
21
Proposed Dividend Account
Rs. Rs.
To Bank (Payment of dividend of By Opening Balance b/d
last year) By Adjusted Profit & Loss A/c
To Closing Balance c/d (Provision made for the current year)
(Bal. fig.)
If dividend paid during the year is not given, then it is assumed that last
year balance must have been paid during the year and provision made during the
year
must be equal to the closing balance. Interim dividend has nothing to do with
proposed
dividend account. If interim dividend is paid it will be shown on the debit side of
Adjusted
Profit and Loss Account and on the application side of Funds Flow Statement. If
treated
as current liability it will be shown in Schedule of Changes in Working Capital
and
dividend paid will be shown on the debit side of Profit and Loss Account and as an
application in the Funds Flow Statement.
3. Provision for Income tax. Like proposed dividend it can be treated as current
liabilities or non-current Liability. But preferably it should be treated as non-
current
liability. If income tax paid during the year is not given, then it is assumed that last
year
balance must have been paid during the year and will be shown as an application
in the
Funds Flow Statement. Provision made during the year must be the closing
balance of
such account and will be shown on the debit side of Adjusted Profit and Loss A/c.
Income Tax payable is a current liability. The provision for income tax account is
prepared as under (if treated as non-current liability) :
Provision for Taxation Account
Rs. Rs.
To Bank (Tax paid) By Opening Balance c/d
To Closing Balance c/d By Profit & Loss A/c
(Provision made) (Bal. fig.)
22
If treated as a current liability, it will be shown in the Schedule of Changes
in Working Capital and tax paid will be shown as an application in the Funds Flow
Statement and on the debit side of Profit and Loss Account.
4. Fictitious Assets : If there are certain fictitious assets shown in the Balance
Sheet such as discount on issue of shares or debentures, preliminary expenses,
underwriting commission, etc., then the balance to be written off to the Adjusted
Profit
and Loss Account can be calculated by preparing the fictitious asset account. It
will be
prepared as follows :
Fictitious Asset Account
Rs. Rs.
To Opening Balance c/d By Adjusted Profit & Loss A/c
(Bal. fig.) (written off)
By Balance c/d
5. Undistributed Reserves and Funds : If there are any undistributed profits in
the form of reserves and funds the difference of these reserves and funds will be
shown
on the debit or credit side of Adjusted Profit and Loss Account. If it increases, it
will
be shown on the debit side, if it decreases, will be shown on the credit side. The
account
is shown as under :
Reserve Account
Rs. Rs.
To Adjusted Profit & Loss A/c By Balance c/d
(reserve utilised) By Adjusted Profit and Loss A/c
To Balance c/d (new reserve)
23
Illustration 4 : From the following balances extracted from XYZ Company Ltd.
as
on 31st March, 2001 and 2002, you are required to prepare a schedule of changes
in
Working Capital and a Funds Flow Statement.
As on As on
Liabilities 31st March Assets 31st March
2001 2002 2001 2002
Share Capital 1,00,000 1,10,000 Building 40,000 38,000
General Reserve 14,000 18,000 Plant and Machinery 37,000 36,000
P & L A/c 16,000 13,000 Investment(L.T.) 10,000 21,000
Creditors 8,000 5,400 Stock 30,000 23,400
B/P 1,200 800 B/R 2,000 3,200
Provision for Tax 16,000 18,000 Debtors 18,000 19,000
Provision for Doubtful Debts 400 600 Cash at Bank 6,600 15,200
Preliminary Expenses 12,000 10,000
1,55,600 1,65,800 1,55,600 1,65,800
(i) Depreciation charged on Plant was Rs. 4,000.
(ii) Provision for taxation Rs. 19,000 was made during the year 2001-02.
(iii) Interim dividend of Rs. 8,000 was paid during the year.
(iv) A piece of machinery was sold for Rs. 8,000 during the year 2001-02. It had
costed Rs. 12,000, depreciation of Rs. 7,000 has been provided on it.
24
Solution :
Schedule of Changes in Working Capital
2001 2002 Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets :
Stock 30,000 23,400 6,600
B/R 2,000 3,200 1,200
Debtors 18,000 19,000 1,000
Cash at Bank 6,600 15,200 8,600
Creditors 8,000 5,400 2,600
B/P 1,200 800 400
Provision for Doubtful Debts 400 600 200
13,800 6,800
7,000
13,800 13,800
for the year ended 31.03.2002
Sources Rs. Uses Rs.
Funds from Operation(a) 33,000 Purchase of Machinery (b) 8,000
Sale of Machinery 8,000 Payment of Interim Divided 8,000
Issue of Share Capital 10,000 Purchase of Investment 11,000
Payment of Tax (c) 17,000
Increase in Working Capital 7,000
51,000 51,000
Working Notes :
(a) Adjusted Profit and Loss Account
Rs. Rs.
To Interim Divided 8,000 By Net Profit b/d 16,000
To Depreciation of Building 2,000 By Profit on Sale of Machinery 3,000
To Preliminary Expenses 2,000 By Fund from Operations 33,000
To General Reserves 4,000
To Depreciation on Plant and Machinery 4,000
To Provision for Tax A/c 19,000
To Net Profit c/d 13,000
52,000 52,000
25
(b) Plant and Machinery Account
Rs. Rs.
To Balance b/d 37,000 By Adjusted P & L A/c(Dep.) 4,000
To Adjusted P&L A/c (Profit) 3,000 By Bank A/c 8,000
To Bank (Purchase of Machinery) 8,000 By Balance c/d 36,000
(Bal. figure)
48,000 48,000
(c) Provision for Tax Account
Rs. Rs.
To Bank A/c (Bal. Fig.) 17,000 By Balance b/d 16,000
To Balance c/d 18,000 By Adjusted P&L A/c 19,000
35,000 35,000
6. Net Profit or Drawings. Sometimes in case of sole trader or partnership
concerns, capital of the proprietor or partners is given but figures of drawings or
net
profit may be missing. In order to find out these figures, capital account may
prepared
as follows :
Capital Account
Rs. Rs.
To Bank (Drawings) By Balance b/d
(Bal. fig.) By Adjusted P & L A/c
To Balance c/d (Net Profit) (Bal. fig.)
7. Intangible Assets. Intangible assets as goodwill, patents, copyrights, licences
are also written off from the Adjusted Profit and Loss Account. Till these assets
are
completely written off their balances will be shown in the Balance Sheet.
Sometimes
additions are also made to these assets. Balance to be written off will be the
balancing
figure. Such assets accounts are prepared as follows :
26
Intangible Asset Account
Rs. Rs.
To Balance b/d By Adjusted Profit & Loss A/c
To Bank Share Capital A/c (written off)
(purchase for cash or issue By Balance c/d
of share capital
8. Redemption of Debentures : When debentures are to be redeemed during a
specified period, it must be seen whether the total payment to be made is more or
less
than the face value of debentures. If it is more than the face value, the excess will
be
charged to Adjusted Profit and Loss Account as loss on redemption and if less
than the
face value, the difference will be profit on redemption and will be shown on the
credit
side of Adjusted Profit and Loss Account. Actual amount paid will be shown an
application in the Funds Flow Statement. The account will be prepared as under :
Debentures Account
Rs. Rs.
To Bank (Actual amount paid) By Opening Balance
To Adjusted Profit and Loss A/c By Adjusted Profit and Loss A/c
(Bal. Fig.) (loss on redemption)
(Profit on redemption) (Bal. Fig.)
9. Redemption of reference Share : Like redeemable debentures, the redeemable
preference shares can be redeemed by the company either at premium or at
discount.
Excess amount of premium paid alongwith the face value of the shares will be a
charge
to Adjusted Profit and Loss Account while discount gained on redemption will be
credited to Adjusted Profit and Loss Account. The account of redeemable shares
will
be prepared as under :
27
Redeemable Preference Share Capital Account
Rs. Rs.
To Bank By Opening Balance b/d
To Profit and Loss A/c By Profit and Loss A/c
(Gain on Redemption) (Premium on Redemption)
10. Bonus Shares : Bonus shares are those shares which are issued to the existing
shareholders in certain proportion without receiving anything in cash from them.
Such
shares are issued from existing balances of various accounts such as capital
redemption
reserve, shares premium, general reserve or Profit and Loss Account. If indication
to
this respect is given, then that account is prepared in order to see the net effect of
the
account to be taken to Adjusted Profit and Loss Account.
Is depreciation a source of funds?
Depreciation means decrease in the value of an asset due to wear and
tear, lapse of time, obsolescence, exhaustion and accident. Depreciation is taken as
an
operating expense while calculating funds from operations. The accounting entries
are
:
(i) Depreciation A/c Dr.
To Fixed Asset A/c
(ii) Profit and Loss A/c Dr.
To Depreciation A/c
Thus, effectively the Profit and Loss Account is debited while the Fixed
Asset Account is credited with the amount of depreciation. Since, both Profit and
Loss
Account and the Fixed Asset Account are non-current accounts, depreciation is a
nonfund
item. It is neither a source nor an application of funds. It is added back to
Operating
Profit to find out funds from operations since it has already been charged to profit
but
it does not decrease funds from operations. Depreciation should not, therefore, be
28
taken as a 'Source of Funds'. If depreciation were really a source of funds by itself,
any
enterprise could have improved its funds position at will by merely increasing the
periodical depreciation charge.
However, depreciation can be taken as a source of funds in a limited
sense because of three reasons :
(i) In case of manufacturing concern, when current assets include closing
inventory
is and the value of closing inventories includes the depreciation on fixed assets as
an
element of cost, depreciation acts as a source of funds in such a case.
(ii) Depreciation does not generate funds but it definitely save funds. For example,
if the business had taken the fixed assets on hire, it would have been required to
pay
rent for them. Since it owns fixed assets, it saves outflow of funds which would
have
otherwise gone out in the form of rent.
(iii) Depreciation reduces taxable income and therefore, income-tax liability for
the period is reduced. This will be clear with the following example.
Case I Case II
Income before depreciation Rs. 75,000 Rs. 75,000
Depreciation provided (A) Nil 15,000
Taxable income 75,000 60,000
Income tax say at 50 per cent 37,500 30,000
Net Income after (B) 37,500 30,000
Net flow of funds after tax (A) + (B) 37,500 45,000
The above example shows that in case II, the net flow of funds is more by
Rs. 7,500 as compared to case I. This is because on account of depreciation charge
being claimed as an expense, tax liability has been reduced by Rs. 7,500 in case of
case II. It may therefore be said that true funds flow from depreciation is the
opportunity
saving of cash outflow through taxation.
29
Illustration 5 : From the following details relating to the accounts of Kapil & Co.
Ltd., prepare Statement of Sources and Applications of Funds :
Liabilities 31.03.2002 31.03.2001 Assets 31.03.2002 31.03.2001
Share Capital 4,00,000 3,00,000 Goodwill 90,000 1,00,000
Reserve 1,00,000 80,000 Plant & Machinery 4,29,250 2,98,000
Profit & Loss A/c 50,000 30,000 Debentures Discount 5,000 8,000
Debentures 1,00,000 1,50,000 Prepaid Expenses 5,750 4,000
Income Tax Provision 40,000 50,000 Investments 60,000 1,00,000
Trade Creditors 70,000 90,000 Sundry Debtors 1,10,000 1,60,000
Proposed Dividend 40,000 30,000 Stock 80,000 50,000
Cash and Bank balances 20,000 10,000
8,00,000 7,30,000 8,00,000 7,30,000
(i) 15% depreciation has been charged in the accounts on Plant and Machinery
(ii) Old machines costing Rs. 50,000 (W.D.V. Rs. 20,000) have been sold for Rs.
35,000.
(iii) A machine costing Rs. 10,000 (W.D.V. Rs. 3,000) have been discarded.
(iv) Rs. 10,000 profit has been earned by sale of investments.
(v) Debentures have been redeemed at 5% premium.
(vi) Rs. 45,000 income tax has been paid and adjusted against Income-tax
Provision
Account.
Solution :
Rs. Rs.
Sale of Machine 35,000 Purchase of Machine (3) 2,30,000
Sale of Investments(4) 50,000 Payment of Debentures 52,500
Issue of Shares 1,00,000 Payment of Income Tax 45,000
Funds from Operations (2) 1,84,250 Payment of Dividend 30,000
Increase in working capital (1) 11,750
3,69,250 3,69,250
30
Working Notes :
(1) Schedule of Changes in Working Capital
Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets :
Stock 50,000 80,000 30,000
Sundry Debtors 1,60,000 1,10,000 50,000
Cash and Bank Balances 10,000 20,000 10,000
Prepaid Expenses 4,000 5,750 1,750
Trade Creditors 90,000 70,000 20,000
61,750 50,000
11,750
Increase in Working Capital 61,750 61,750
(2) Adjusted Profit and Loss Account
Rs. Rs.
To Goodwill 10,000 By Balance b/d 30,000
To Loss on Machine Discarded 3,000 By Profit on Sale of Machine 15,000
To Debenture Discount 3,000 By Profit on Sale of Investment 10,000
To General Reserve 20,000 By Funds from Operations 1,84,250
To Debentures (Premium) 2,500
To Income-tax Provision (5) 35,000
To Proposed Dividend 40,000
To Depreciation on Plant &
Machinery (3) 75,750
To Balance c/d 50,000
2,39,250 2,39,250
31
(3) Plant and Machinery Account
Rs. Rs.
To Balance b/d 2,98,000 By Bank A/c 35,000
To Profit and Loss A/c 15,000 By Profit and Loss A/c 3,000
To Bank (Purchase of Machinery) By Depreciation A/c
(Bal. fig.) 2,30,000 15% on Rs. 2,75,000 41,250
15% on Rs. 2,30,000 34,500
By Balance c/d 4,29,250
5,43,000 5,43,000
* Closing Balance 4,29,250
Less : W.D.V. of Old Machine (2,75,000-41,250) 2,33,750
W.D.V. of additions 1,95,500
So Depreciation charged on addition within the year = × 1,95,5000
= Rs. 34,500
(4) Investment Account
Rs. Rs.
To Balance b/d 1,00,000 By Bank 50,000
To Profit & Loss A/c 10,000 By Balance c/d 60,000
1,10,000 1,10,000
(5) Income Tax Provision Account
Rs. Rs.
To Bank A/c 45,000 By Balance b/d 50,000
To Bank c/d 40,000 By Profit and Loss A/c 35,000
85,000 85,000
15
85
32
14.6 DIFFERENCE BETWEEN FUNDS FLOW STATEMENT AND
INCOME
STATEMENT
A Funds Flow Statement differs from an Income Statement (i.e., Profit
and Loss Account) in several respects :
(i) A Funds Flow Statement deals with the financial resources required for running
the business activities. It explains how were the funds obtained and how were they
used. Whereas an Income Statement discloses the results of the business activities,
i.e., how much has been earned and how it has been spent.
(ii) A Funds Flow Statement matches the funds raised and funds applied during a
particular period. The sources and applications of funds may be of capital as well
as of
revenue nature. An Income Statement matches the incomes of a period with the
expenditure of that period which are both of a revenue nature. For example, when
shares
are issued for cash, it becomes a source of funds while preparing a Funds Flow
Statement
but it is not an item of income for an Income Statement.
(iii) Sources of funds are many besides operations such as share capital,
debentures,
sale of fixed assets, etc. An Incomes Statement which discloses the results of
operations
cannot even accurately tell about the funds from operations alone because of non-
fund
items (such as depreciation, writing off of fictitious assets etc.) being included
therein.
Thus, both Income Statement and Funds Flow Statement have different
functions to perform. Modern management needs both. One cannot be a substitute
for
the other rather they are complementary to each other.
14.7 USES OF FUNDS FLOW STATEMENT
The various uses of Funds Flow Statement are summarised as under :
(a) As a tool of historical analysis, it provides an answer to some of the important
financial questions such as :
33
(i) How was it possible to distribute dividend in excess of current earnings
or in the presence of a net loss for the period? (i.e. the firm might have
raised funds from other sources also in addition to funds from
operations).
(ii) Why has the net working capital decreased although the net income for
the period has gone up? (i.e. the firm might have applied the funds more
than the sources of funds).
(iii) Why has the net working capital increased even though there has been a
net loss for the period? (i.e., the firm might have raised the funds more
than the application of funds).
(iv) What happened to the proceeds of the sale of plant and equipment? (e.g.,
the firm might have purchased some fixed assets or it might have redeemed
the redeemable debentures or preference shares)
(v) Why did the firm resort to long-term borrowings inspite of large profits?
(vi) Why did the firm issue new equity or preference shares?
(vii) How was the retirement of long-term debts or redemption of redeemable
preference shares accomplished? (e.g. the firm might have issued new
shares).
(b) As a tool of planning, the Projected Fund Flow Statement enables the
management to plan its future investments, operating and financial activities
such as the repayment of long-term loans and interest thereon, modernisation
or expansion of plant, payment of cash dividend etc.
(c) Alongwith a Schedule of Changes in Working Capital, the Funds Flow
Statement
helps in managing and utilizing the working capital. The management can know
34
the adequacy or otherwise of the working capital and can plan for the effective
use of surplus working capital or can make arrangement in case of inadequacy
of working capital. Besides this, the management can identify the magnitude
and directions of changes in various components of working capital and if there
is any undesired situation such as heavy inventory accumulations, heavy funds
locked up in receivables than normally required, the necessary action may be
taken so as to achieve the desired level thereof.
14.8 LIMITATIONS OF FUNDS FLOW STATEMENT
The major limitations of Funds Flow Statement are summarised below :
(a) It ignores the non-fund transactions. In other words, it does not take into
consideration those transactions which do not affect the working capital e.g.,
issue of shares against the purchase of fixed assets, conversion of debentures
into equity shares.
(b) It is a secondary data based statement. It merely rearranges the primary data
already appearing in other statements viz. Income Statement and Balance Sheet.
(c) It is basically historical in nature, unless Projected Funds Flow Statements are
prepared to plan for the future.
14.9 SUMMARY
A funds flow statement is an essential tool for the financial analysis and
is of primary importance to the financial management. Now-a-days, it is being
widely
used by the financial analysts, credit granting institutions and financial managers.
The
basic purpose of a funds flow statement is to reveal the changes in the working
capital
on the two balance sheet dates. It also describes the sources from which additional
working capital has been financed and the uses to which working capital has been
applied.
35
Such a statement is particularly useful in assessing the growth of the firm, its
resulting
financial needs and in determining the best way of financing these needs. By
making
use of projected funds flow statements, the management can come to know the
adequacy
or inadequacy of working capital even in advance. One can plan the intermediate
and
long-term financing of the firm, repayment of long-term debts, expansion of the
business, allocation of resources, etc.
14.10 KEYWORDS
Fund: It refers to all financial resources or purchasing power or economic value
possessed by a firm at a point of time.
Fund flow statement: It is a technical device designed to analyse the changes in
the
financial condition of a business enterprise between two dates.
Flow of funds: The flow of fund refers to the changes in the existing financial
position
of a business caused by inflow of resources owing to receipts and payments.
1. Explain the terms 'Funds' and 'Flow in Funds' in respect of Funds Flow
Statement.
2. What is a 'Funds Flow Statement'? How is it prepared? What are the various
sources and uses of funds ?
3. What do you mean by 'funds from operation'? How will you determine it ?
4. Discuss the importance or significance of Funds Flow Statement. How do you
determine whether a particular change is in the nature of a source or of an
application of funds ?
5. Is depreciation a source of funds? Justify your answer.
6. Following are the summarised Balance Sheets of A Ltd. as on 31st March, 2001
and 2002 :
36
Assets 2001 2002 Liabilities 2001 2002
Rs. Rs. Rs. Rs.
Fixed Assets 4,00,000 3,20,000 Share Capital 4,50,000 4,50,000
Investments 50,000 60,000 General Reserve 3,00,000 3,10,000
Stock 2,40,000 2,10,000 Profit and Loss A/c 16,000 68,000
Debtors 2,10,000 4,55,000 Creditors 1,68,000 1,34,000
Bank 1,49,000 1,97,000 Provision for Taxation 75,000 10,000
Loan (short-term) – 2,70,000
10,49,000 12,42,000 10,49,000 12,42,000
(i) Investment costing Rs. 8,000 were sold during the year 2001-02 for Rs. 8,500
(ii) Provision for taxation made during the year 2001-02 was Rs. 9,000
(iii) During the year 2001-02, part of fixed assets costing Rs. 10,0000 were sold
for Rs. 12,000.
(iv) Dividend paid during the year 2001-02 amounted to Rs. 40,000.
Prepare Funds Flow Statement for the year ended, 2001-02.
1. M.Y. Khan & P.K. Jain, Management and Cost Accounting.
2. Ravi M. Kishore, Financial Management.
3. R.P. Rustagi, Financial Management
4. S.N. Maheshwari, Management Accounting and Financial Control.
1
Subject : Accounting for Managers
Course Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 15
BUDGETING AND BUDGETARY CONTROL
STRUCTURE
15.0 Objective
15.1 Introduction
15.2 Meaning of Budgetary Control
15.3 Advantages of Budgetary Control
15.4 Limitations of Budgetary Control
15.5 Requirements of a Sound Budgetary System
15.6 Budgetary Control Organsation
15.7 Types of Budgets
15.8 Fixed Budgets
15.9 Flexible Budget
15.10 Performance Budgeting
15.11 Zero-base Budgeting
15.12 Summary
15.13 Keywords
15.0 OBJECTIVE
After reading this lesson, you must be able to :
(a) define the terms 'budget' and 'budgetary control';
(b) explain the objectives, advantages and limitations of budgeting and budgetary
control;
(c) understand the requirements of a sound budgetary system;
(d) prepare various types of budgets;
(e) discuss different developments in the area of budgeting;
2
15.1 INTRODUCTION
Present business world is full of competition, uncertainty and exposed to different
types of risks. The complexity of managerial problems has led to the development
of various management control techniques and procedures useful for the
management in managing the business successfully. One of the essential features
of modern business management is planning and control. There are a number of
tools and devices which assist management in planning and controlling business
operations. Budgetary control is the most common, useful and widely used
standard
device of planning and control. Before defining the budgetary control let us first
understand the meaning of a 'budget' and 'control'.
Meaning of Budget
A budget is a detailed plan of operations for some specific future period. It is an
estimate prepared in advance of the period to which it applies. It acts as a business
barometer as it is complete programme of activities of the business for the period
covered. According to Gordon and Shillinglaw budget may be defined as "a
predetermined detailed plan of action developed and distributed as a guide to
current
operations and as a partial basis for the subsequent evaluation of performance".
The
Chartered Institute of Management Accountants, London defines a budget as "a
financial and/or quantitative statement, prepared prior to a defined period of time,
of the policy to be pursued during that period for the purpose of attaining a given
objective. Thus, the following are the essentials of a budget :
(a) It is prepared in advance and is based on a future plan of actions.
(b) It relates to a future period and is based on objectives to be attained.
(c) It is a statement expressed in monetary and/or physical units prepared for
the implementation of policy formulated by the management.
Meaning of Control
Control means, "some sort of systematic effort to compare current performance
to a predetermined plan or objective, presumably in order to take only remedial
action required". This is a very general definition of the term. However, as a
management function, it has been defined as "the process by which managers
assure
that resources are obtained and used effectively and efficiently in the
accomplishment of the organisation's goals".
Management control process involves two separate but closely related activities :
planning and control. Planing means deciding what is to be done and how it is to
be
done. Control is assuring that desired results are attained. Budget is imply a plan
of
action hence the technique of Budgetary Control is an important tool of
management
control.
3
15.2 MEANING OF BUDGETARY CONTROL
According to W.W. Bigg, "The term 'budgetary control' applies to a system of
management and accounting control by which all operations and output are
forecast
as far as ahead as possible and the actual results, when known, are compared with
the budget estimates." Thus, the term 'budgetary control' is designed to evaluate
the
performance in terms of goals budgeted through budget reports.
According to J. Batty, "Budgetary control is a system which uses budgets as a
means
of planning and controlling all aspects of producing and/or selling commodities or
services." Budgetary control consists of the following :
(a) Determination of the objective to be achieved. The objective may be higher
profits, better financial position, better position in the market etc.
(b) Knowing the steps necessary to achieve the objective, that is to say laying
down an exact and detailed course of action, month by month and over the whole
period.
(c) Translation of the course of action into quantitative and monetary terms.
This means drawing up budgets.
(d) Constant comparison of the actual with the budget (again both physical
achievement and money values involved), noting discrepancies and their reasons
and taking steps to remove causes of shortcoming, wastages, losses etc., and to
consolidate reasons leading to good results.
15.3 ADVANTAGES OF BUDGETARY CONTROL
Budgetary control has become an essential tool of management for controlling
costs and maximising profits. It acts as a friend, philosopher and guide to the
management. Its advantages to management can be summarised as follows :
1. Economy in working : It brings efficiency and economy in the working of
the business enterprise. Even though a monetary reward is not offered, the budget
becomes a game – a goal to achieve or a target to shoot at – and hence it is more
likely to be achieved or hit than if there was no predetermined goals or target.
"The
budget is an impersonal policeman that maintains ordered effort and brings about
efficiency in results".
2. Buck-passing avoided : It establishes divisional and departmental
responsibility. It thus prevents alibis and "buck-passing" when the budget figures
are not met.
3. Establishes coordination : It coordinates the various divisions of a
business, namely, the production, marketing, financial and administrative
divisions.
4
It "forces executives to think, and think as a group". This results in smoother
operation of the entire plant.
4. Acts as a safety signal : It acts as a safety signal for the management. It
shows when to proceed cautiously and when manufacturing or merchandising
expansion can be safety undertaken. It serves as an automatic check on the
judgement
of the executives as losses are revealed in time which is a caution to the
management
to stop wastage.
5. Adoption of uniform policy : Uniform policy without the disadvantage of
military type of business organisation can be pursued by all divisions of the
business
by means of centralisation of budgetary control.
6. Decrease in production costs : Seasonal variations in production can be
reduced by developing new "fill in" products. This results in decreasing the cost of
production by increasing volume of output.
7. Adoption of standard costing principles : The use of budget figures as
measures of operating performance and financial position makes possible the
adoption of the standard costing principles in divisions other than the production
division.
8. Optimum mix : It helps management in obtaining the most profitable
combination of different factors of production. This results in a more economical
use of capital.
9. Favour with credit agencies : Managements who have developed a well
ordered budget plan and who operate accordingly, receive greater favour from
credit
agencies.
15.4 LIMITATIONS OF BUDGETARY CONTROL
1. Based on estimates : The strength or weakness of the budgetary programme
depends to a large degree on the accuracy with which the basic estimates are
made.
The estimates must be based on all available facts and good judgement. The
forecasting of sales and expenses cannot be an exact science. However, there are
numerous statistical and Other techniques that may be efficiently applied to the
problem. These tempered with sound reasoning and judgement produce
satisfactory
results in most cases.
2. Need for continuous adaptation : A budgetary programme cannot be
installed and perfected in a short time. Budget techniques must be continuously
adapted not only for each particular concern but for changing conditions within the
concern.
5
3. No automatic execution of the budget : Once the budget is complete, it
will be effective only if all responsible executives get behind it and exert
continuous
and aggressive efforts towards its achievement. Departmental heads must feel the
responsibility for achieving and bettering department goals laid down in the
budget.
4. Only a tool of the management : The budget should be regarded not as a
master but as a servant. It is one of the best tools yet devised for advancing the
affairs of a company and the individuals in their various areas of managerial
activity.
15.5 REQUIREMENTS OF A SOUND BUDGETARY SYSTEM
An evaluation of successful budgetary programmes indicates that there are some
common practices to be observed. Failure to appreciate and observe these
essentials
will negate to a large extent the value of a budgetary program. These essentials or
pre-requisites for successful budgeting are listed below :
1. Support of top management : The budget should be sponsored by management
and it should have the active and whole-hearted support of top management.
2. Built-up by responsibility centres : For sound budgetary system, it is also
necessary that it should be built-up by responsibility centres and should show the
controllable costs in each responsibility centre.
3. Participation by responsible supervisors : The responsible supervisors should
participate in the process of setting the budget figures and should agree that the
budget goals are reasonable. If they are not consulted, their attitude towards the
budget is likely to be one of indifference and resentment. In other words, budget
targets should not be imposed by the management rather they should emanate
from
the organization itself.
4. Clear-cut organizational structure : A successful budgetary program
presupposes
a clear allocation of authority, duties and responsibilities in the
organisation. Everybody in the organization should know who is responsible to
whom.
5. Continuous budget education : If the budget is to be effective, all responsible
supervisors must be actively interested in it. This requires that the responsible
supervisors are aware of the entire budgeting process. The best way to assure this
is a program of continuous budget education through manuals, meetings, etc. to
discuss the preparation of budget and actual results achieved.
6. Reasonably attainable targets : The targets laid down in the budget should be
reasonably attainable. Too high a target will be frustrating and too low a target will
encourage complacency.
6
7. Thorough review of budget estimates : The review of budget estimates by
higher levels of management should be thorough. Casual review is a signal that
management is really not much interested in the budget process.
8. Proper communication : Final approval of the budget should be specific and
this approval should be communicated to the organisation. An attempt to operate
on the doctrine "silence gives consent" inevitably leads to misunderstanding.
9. Flexible : It is important that budgeting is flexible rather than static. Instead
of basing budgets on a single fixed level of activity, they should be prepared for
several levels of activity. Again, budget should be revised if market conditions
change.
15.6 BUDGETARY CONTROL ORGANISATION
The shape and design of budgetary control system is largely determined by the
size
and nature of the business organisation. In a large sized organization, an effective
budgetary control system can be organised on the following lines :
1. Creation of Budget Centres : The first step in the budget preparation is
the creation of budget centres. A budget centre is a section of the organisation of
an undertaking defined for the purposes of budgetary control. Generally different
departments organised on the basis of functions form budget centres and
department
heads work as responsibility centre. For example, production manager has to be
consulted for the preparation of production budget.
2. Provision of Adequate Accounting Record : An efficient budgetary
system requires the provision of appropriate and adequate accounting records also.
A chart of accounts corresponding with the budget centres should be maintained in
order to help in preparation and analyzing information.
3. Setting the Guidelines : The next step in the preparation of budget is
setting the guidelines. It is mainly concerned with determining management policy
with regard to range of products, stock levels, channels of distribution, investment
policies etc.
4. Establishment of a Budget Committee : In small organisations budget
may be prepared by one executive and he is made incharge of all budgetary
arrangements. But in large organisations, a budget committee may be created
under
the charge of a budget officer or the Director of Finance. Though individual
circumstances affect the actual composition of the committee, it has often been
found advisable to include various departmental heads as members of this
committee. This budget committee will prepare, review, discuss and co-ordinate
budget activities in the organization. The various departmental heads will be
members of this committee and they will prepare initial estimates for the budgets
7
of their respective departments. Then these budgets will be reviewed and
coordinated
by the budget committee. A good budget is the result of the combined
skill of the executives responsible for their own particular phase of the activities
of the organisation.
5. Budget Officer : A major step in introducing the budgetary control
programme is the appointment of an expert in budgeting, known as budget officer,
budget accountant, budget controller, or budget director (in some organisations
budgeting is taken care of by Finance Director also). He is responsible for
designing
the entire budgetary programme and furnishing the estimates of financial data to
help in the compilation of budget. He provides necessary technical assistance and
advice to the executives in utilizing the budget. The supervisory responsibility
concerning budget operations is delegated to him and through variance analysis he
prepares budget report. These reports are submitted to the line executives. He is
also responsible for bringing the technical analysis of the data when called for by
the various departments.
6. Preparation of a Budget Manual : To systematize the budget procedure
and provide the necessary guidelines for the preparation of various budgets a
Budget
Manual can be prepared. This manual would include such matters as the following
–
the functions and responsibilities of various members of the budget committee,
the objects and description of the budgetary control system, statement of the steps
in the preparation of a budget, the procedure of preparation and modification of
various accounting records for the budget period etc.
7. Determination of the 'Key Factor' : Key-factor is also known as a 'Limiting
Factor', Governing Factor' or 'Principal Budget Factor'. For the successful
implementation of a budgetary system, the individual budgets for each item should
be co-ordinated and inter-related. Because of this interlink, the limitation or
constraint affecting a particular budget has its influence on the rest of the budgets.
A factor which is of such importance that it affects almost all the other functional
budgets to a large extent is known as the Principal Budget Factor.
8. Laying Down the Levels of Activity : It is also essential to establish the
normal level of activity; i.e., the level of output/sales company can reasonably
expect
to achieve during the year.
9. Budget Reports : Installation of budgets is in itself of no use unless a
comparison is made regularly between the actual expenditure and the budgeted
allowances. The results of this comparison should be reported to the management
promptly. For this purpose, budget reports showing the comparison between the
actual and budgeted expenditure should be presented periodically.
8
10. Revision of Budgets : To be of maximum use to the management for planning
and operation, it is essential to revise budgets, as and when necessary, in order to
fit them with the changing business conditions.
15.7 TYPES OF FUNCTIONAL BUDGETS
In the case of a manufacturing business accounting information should be supplied
to management in the form of a series of budgets. The main functional budgets and
the methods of arranging for the compilation of these budgets are as set out
hereunder :
15.7.1 Sales Budget : These should be analysed as between products, periods and
areas. By reference to the trends disclosed by the past figures and with the aid of
information supplied by the sales department, a forecast of anticipated sales for
the forthcoming period can be made. In making such forecast regard must be had
to
general trading conditions, any special conditions affecting the particular business,
elasticity of demand, pricing policy, future advertising policy and the relevant
factors. The sales forecast or sales budget is the basic core budget on which other
budgets depend. As such rational efforts should be made to develop a proper sales
budget which can be reasonably accomplished.
Preparation of Sales Budget :
It has already been stated that the Sales Budget is prepared by the sales
manager. He is, therefore, to consider the following matters at the time of its
preparation :
(i) Analysis of Historical Sales : Analysis of past sales, with the help of
statistical measurements, cyclical trends, seasonal fluctuations etc., provides
valuable information which ultimately helps to predict future sales.
(ii) Reports by Salesmen : Salesmen also can submit a report to the sales
manager which is highly significant since they are in frequent contact with
customers
having an internal knowledge about the habits, tastes, and demand of the
customers.
(iii) Business Conditions : The general business conditions can also be studied
from the national as well as international economic statistics, political influences
etc.
(iv) Market Analysis : Market analysis may be employed by the large firms
whereas specialists are employed by the small firms for collecting necessary
information about the market demands, product-designs, fashion trends, degrees
of competition etc.
(v) Special condition : There are certain events which may influence sales
outside the firm e.g., introduction of electricity to a village will increase the
demand
for electrical appliances.
9
Illustration : 1
From the following information you are asked to prepare a Sales Budget for the
next
year :
(a) Budgeted Sales for the current year :
Product Colcatta Delhi Chandigarh
A 6,000 @ Rs. 10 8,000 @ Rs. 10 5,000@ Rs.10
B 3,000 @ Rs. 15 10,000@ Rs. 15 3,000 @ Rs.15
C 2,000 @ Rs. 20 12,000 @ Rs. 20 4,000 @ Rs.20
(b) Actual Sales for the current year :
Product :
A 7,000 @ Rs. 10 10,000 @ Rs. 20 6,000@Rs. 10
B 2,000 @ Rs. 15 10,000 @ Rs. 15 5,000 @ Rs. 15
C 1,000 @ Rs. 20 10,000 @ rs. 20 3,000 @ Rs. 20
After a careful market analysis and study, the following suggestions are
presented :
(i) Sales of product A can be increased by 30%, 40% and 80% in Colatta, Delhi
and Chandigarh, respectively.
(ii) Sales of product B can be increased by 20% in Delhi and 40% in Chandigarh
but will be reduced by 20% in Colcutta.
(iii) Sales of product C can be increased by 20% in Colcatta, 40% in Delhi and
50% in Chandigarh, provided that the budget committee approves a price
reduction.
(iv) The following prices are changed by the budget committee.
Product
A will be increased by 20%
B will be increased by 10%
C will be reduced by 10%
Solution :
Sales Budget
Period : For the next year ............
Cites Products Budgeted Sales for the Actual Sales for the Budgeted Sales for
current year current year next year
Units Rate Value Units RateValue Units Rates Value
Colcatta
A 6,000 10 60,000 7,000 10 70,000 7,800 12 93,600
B 3,000 15 45,000 2,000 15 30,000 2,400 16.5 39,600
C 2,000 20 40,000 1,000 20 20,000 2,400 18 43,200
Total 11,000 1,45,000 10,000 1,20,000 12,600 1,76,400
10
Delhi
A 8,000 10 80,000 10,000 20 2,00,000 11,200 12 1,34,400
B 10,00 15 1,50,00 10,000 15 1,50,000 12,000 16.5 1,98,000
C 12,000 20 2,40,000 10,000 20 2,00,000 16,800 18 3,02,400
Total 30,000 4,70,00 30,000 5,50,000 40,000 6,34,800
Chandigarh
A 5,000 10 50,000 6,000 60,000 9,000 12 1,08,000
B 3,00 15 45,00 5,000 75,000 4,200 16.5 69,300
C 4,000 20 80,000 3,000 60,000 6,000 18 1,08,000
Total 12,000 1,75,00 14,000 1,95,000 19,200 2,85,300
Total
A 19,000 1,90,000 23,000 3,30,000 28,000 3,36,000
B 16,000 2,40,000 17,000 2,55,000 18,600 3,06,900
C 18,000 3,60,000 14,000 2,80,000 25,200 4,53,600
Total 53,000 7,90,000 54,000 8,65,000 71,800 10,96,500
15.7.2 Purchase Budget : The purchase budget indicates, either in terms of
money
or of quantity, the expected purchases of raw materials to be made during the
budget
period. After ascertaining the proper requirement of different types of raw
materials,
it needs adjustment between the contract already made for the purchase of raw
materials and the existing level of stock (in order to maintain a balanced level of
stock of raw materials). In this respect, it may also be mentioned that internal
sources
of raw materials, if any, are also to be considered. However, this budget is based
on
Sales Budget, Production Cost Budget, Maximum and Minimum Stock, Stock
Level,
Economic Order Quantity (EOQ) etc.
Illustration :2
Prepare a Purchase Budget from the following particulars, when the estimated
price
per kg of material is : X Rs. 5, Y Rs.3 and 2 Rs. 4, respectively.
Materials Estimated consumption of materials
(in kg.)
X 0,80,000
Y 2,00,000
Z 2,50,000
Estimated Stock
(in kg)
on 1.1.2000 on 31.12. 2000
X 20,000 15,000
Y 40,000 20,000
Z 45,000 50,000
11
Solution :
Purchase Budget
Period : For the year ended
31st. Dec. 2000
Particulars Materials Materials Materials
XYZ
(in kg) (in kg) (in kg)
Estimated consumption of materials 80,000 2,00,000 2,50,000
Add : Stock to be required on 31.12.2000 15,000 20,000 50,000
Total requirement 95,000 2,20,000 3,00,000
Less : Estimated stock on 1.1.2000 20,000 40,000 45,000
Quantity to be purchased 75,000 1,80,00 2,5,000
Price per kg of material Rs. 5 Rs. 3 Rs. 4
Estimated cost of purchase of materials 1,75,000 5,40,000 1,20,000
15.7.3 Production Budget : Production budget is prepared after the preparation
of Sales Budget, to determine the quantity of goods which should be produced to
meet the budgeted sales. It is expressed in physical terms, such as : (a) Units of
output; (b) Labour hours and (c) Material requirement.
The Production Budget is prepared by the production management and is
submitted
to the budget committee for its approval. The following points are to be carefully
noted at the time of its preparation.
(i) To determine the quantity of each product which will be produced during the
budget period.
(ii) To prepare the production plan on the basis of the Sales Budget.
(iii) To consider the key factor or limiting factor, if any.
(iv) To consider the production plant capacity and production planning.
(v) To consider the volume of production.
Illustration 3 : From the following particulars of OM Ltd., prepare a Production
Budget for the year 2001
Product Sales as per budgeted Estimated Stocks
Sales (in units) (in units)
(2000) (2001)
A 5,00,000 20,000 30,000
B 3,00,000 40,000 40,000
C 8,00,000 60,000 45,000
12
Solution :
Production Budget
For the year 2001
ABC
(in units) (in units) (in units)
Budgeted 5,00,000 3,00,000 8,00,000
Add : Stock (1995) 30,000 40,000 45,000
5,30,000 3,40,000 8,45,000
Less : Stock (1994) 20,000 40,000 60,000
Estimated production 5,10,000 3,00,000 7,85,000
15.7.4 Raw Material Budget : This budget reveals the quantities of materials
which are needed to make the budgeted production. It also shows the anticipated
cost of materials to be purchased, terms of credit from suppliers, the time taken to
procure raw materials etc.
This budget serves :
(i) to provide information about the position of stock ;
(ii) to give an idea about the total requirement of raw materials;
(iii) to supply necessary data to the purchase department for their purchase
programme; and
(iv) to determine the cost of different types of raw materials.
Illustration : 4
From the given particulars presented by P. Ltd., you are asked to prepare a
Material
Budget. Estimated Sales 52,000 units.
(Each unit of the product requires 2 units of material X and 4 units of material Y.)
Estimated Opening Balance :
Finished goods 10,000 units
Material-X 15,000 units
Material-Y 25,000 units
Materials on order (Opening) :
Estimated Closing balances :
Finished goods 6,000 units
Materials on order (Closing) :
13
Solution :
Estimated Production : Expected Sales + Estimated Closing Stock– Estimated Opening
Stock
= 52,000 units + 6,000 units – 10,000 units
= 48,000 units
Raw Material Budget
(in quantity)
Period .......
Detail Material X Material Y
units units
Requirement of materials :
Material X @ 2 units for 48,000 finished goods 96,000
Material Y @ 4 units for 48,000 finished goods 1,92,000
Estimated closing balance of materials 16,000 30,000
Materials on order (closing) 6,000 8,000
1,18,000 2,30,000
Less : Estimated opening balance of materials 15,000 25,000
1,03,000 2,05,000
Less : Materials on order (opening) 8,000 12,000
95,000 1,93,000
15.7.5 Direct Labour Budget
The direct labour budget tells about the estimates of direct labour
requirements essential for carrying out the budgeted output. The direct labour cost
is estimated as a result of the evaluation of standard hours worked or the quantity
of work done by the individual worker in terms of certain average wage rate. This
average wage rate may be different for each department. For estimating the
average
wage rates the following different approaches can be used :
(i) The rates for the last budget period may be taken. Historical ratio may be
calculated. This is arrived at by taking the ratio of wages paid to the direct labour
hours worked. This ratio can be adjusted in the light of fresh changes, if any.
(ii) Wage rates may be fixed by the agreement with the trade union.
(iii) The current wage rate of the industry, trade or the national wage rate may be
taken as average wage rate.
14
The Direct Labour Budget serves many purposes. The personnel manager can plan
its requirements as per the budget requirements. The management can also control
the direct labour cost by viewing per unit cost of production. It helps in estimating
cash requirements for direct labour in preparing cash budget.
Following is the example of a Direct Labour budget.
Direct Labour Budget
For the year ending as on .............
Type of Units to be Standard Total Standard Average wage Total
Product Produced Labour hours Labour hours rate per hour Labour
(given) required (given) Cost
Rs. Rs.
A 2,50,000 1 2,50,000 1.00 2,50,000
B 1,50,000 2 3,00,000 1.50 4,50,000
4,00,000 5,50,000 7,00,000
15.7.6Manufacturing Overhead Budget : Manufacturing or Factory overhead
include the cost of indirect labour, indirect materials and indirect expenses. The
manufacturing overhead can be classified into three categories, (i) Fixed, i.e.
which
tend to remain constant irrespective of any change in the volume of output, (ii)
Variable, i.e. which tend to vary with the output and (iii) Semi-variable, i.e., which
are partly variable and partly fixed. The Manufacturing Overhead Budget will
provide
an estimate of all these overheads to be incurred in the budget period.
Illustration : 5
From the following average figures of previous quarters, prepare a manufacturing
overhead budget for the quarter ending on December 31, 2001. The budgeted
output
during the quarter is estimated at 4,000 units.
Rs.
Fixed overheads 25,000
Variable overheads 10,000 (varying @ Rs. 5 p.u.)
Semi-variable overheads 10,000 (40% fixed and 60% varying @ Rs. 3 p.u.)
15
Solution :
Manufacturing Overheads Budget
(For the quarter ending on December 31, 2001)
Rs.
Fixed Overheads 25,000
Variable Overheads @ Rs. 5 p.u. 20,000
Semi-variable Overheads
Fixed 4,000
Variable @ 3 Rs. 3 p.u. 12,000 16,000
Total Overheads Costs 61,000
15.7.7 Selling and distribution overheads budget : The selling expenses include
all items of expenditure on the promotion, maintenance and distribution of
finished
products. Sales office rent, salaries, depreciation and other miscellaneous expenses
are provided for as a fixed amount per month. Advertising, selling commission,
bad
debts, travelling and delivery expenses are provided for as a percentage of
budgeted
sales. Although selling expenses are not included as a part of product cost, these
are frequently analysed by lines of product, sales territories, customers, salesmen
or some such unit basis. Such an analysis of selling expenses can be applied in
planning sales activity. Besides, if selling costs are budgeted and computed on a
unit responsibility basis (products, territories, type of salesmen, customers etc.),
it may be possible to identify differences by sales territories, salesmen, customer
group etc. Thus, selling costs, like manufacturing costs, can be identified by area
of responsibility and can be used as a means for control. The selling and
distribution
overheads budget is closely linked with the sales budget and should be prepared
simultaneously with the sales budget. The sales manager, advertising manager and
sales office manager will cooperate with the budget officer in the preparation of
this budget.
15.7.8 Cash Budget : The cash budget is a summary of the firm's expected cash
inflows and outflows over a particular period of time. In other words, cash budget
involves a projection of future cash receipts and cash disbursements over various
time intervals. There must be a balance between cash and the cash demanding
activities/operations, capital expenditure and so on. Very often, the need for
additional cash is not realised until the situation becomes critical. The cash budget
consists of two parts :
1. The projected cash receipts (inflows) and;
2. The planned cash disbursements (outflows).
Cash receipts include collection from debtors, cash sales, dividends received, sale
of assets, loans received and issues of shares and debentures. Payments include
16
wages and salaries, payment to creditors and suppliers, rent and rates, taxes,
capital
expenditure, dividend payable, commission payable and repayment of loans and
debentures. The main purposes of the cash budget may be outlined as follows :
1. To indicate the probable cash position as a result of planned operations.
2. To indicate cash excess or shortages.
3. To indicate the need for borrowing or the availability of idle cash for
investment.
4. To make provision for the coordination of cash in relation to (a) total working
capital; (b) sales; (c) investment; and (d) debt.
5. To establish a sound basis for credit.
6. To establish a sound basis for exercising control over cash and liquidity of
the firm.
The format of cash budget is given below :
ABC Company Ltd.
Cash Budget
(for the period ending 31st December, 2001)
Details Month
July Aug. Sept. Oct. Nov. Dec.
Opening balance
Receipts
Cash sales
Collection from debtors
Capital (issue of shares
and debentures)
Dividend
Opening balance
Receipts - cash sales
collection from debtors
capital (issue of shares
and debentures)
Dividend
Total (A)
17
Payments
Materials (Cash purchase)
Creditors/Suppliers
Wages
Factory overheads
Administration overheads
Selling and Distribution
overheads
Commission
Capital (repayment of
shares, debentures etc.)
Taxation
Dividend
Capital expenditure
Total (B)
Surplus/(Defcit) (A–B)
Illustration : 6
A company expects to have Rs. 37,500 cash in hand on Ist April, 1999 and
requires
you to prepare an estimate of cash position during the three months. April to June,
1999. The following information is supplied to you.
Sales Purchases Wages Factory Office Selling
Expenses Expenses Expenses
February 75,000 45,000 9,000 7,500 6,000 4,500
March 84,000 48,000 9,750 8,250 6,000 4,500
April 90,000 52,500 10,500 9,000 6,000 5,250
May 1,20,000 60,000 13,500 11,250 6,000 6,570
June 1,35,000 60,000 14,250 14,000 7,000 7,000
Other Informations :
1. Period of credit allowed by suppliers–2 months.
2. 20% of sales is for cash and period of credit allowed to customers for credit
sales is one month.
18
3. Delay in payment of all expenses – 1 month.
4. Income tax of Rs. 57,500 is due to be paid on June 15,1999.
5. The company is to pay dividends to shareholders and bonus to workers of
Rs. 15,000 and Rs. 22,500 respectively in the month of April.
6. Plant has been ordered to be received and paid in May. It will cost Rs.
1,20,000.
Solutions :
Cash Budget
April 1999 May 1999 June 1999
Rs. Rs. Rs.
Opening balance (Cash in hand) 37,500 11,700 –91,050
Receipts from :
Cash Sale (20% of current
month's sales 18,000 24,000 27,000
Debtors (80% of previous
month's sales) 67,200 72,000 96,000
Total 1,22,700 1,07,700 31,950
Payments :
Creditors (2months'/previous 45,000 48,000 52,500
purchases)
Wages (Previous month's wages) 9,750 10,500 13,500
Factory expenses (Previous
months expenses) 8,250 9,000 11,250
Office expenses (Previous
month's expenses) 6,000 6,000 6,000
Selling expenses (Previous
month's expenses) 4,500 5,250 6,570
Dividend to shareholders 15,000
Bonus to workers 22,500
Purchase of plant 1,20,000
Income tax 57,500
Total of payments 1,11,000 1,98,750 1,47,320
Closing balance (Receipts-
Payments) 11,700 (-) 91,050 (-) 1,15,370
(1,22,700- (1,07,700- (31,950
1,11,000) (1,98,750) -1,47,320)
19
15.7.9 The Master Budget : The Institute of Cost and Management Accountings,
England, defines it as 'the Summary Budget; incorporating its component
functional
budgets, which is finally approved, adopted and employed'. In other words, it is a
summary budget which is prepared from and summarises all the functional
budgets.
This summarising is done in the form of :
(a) Budgeted Profit and Loss Account/Budgeted Profit and Loss Appropriation
Account,
(b) Budgeted Balance Sheet.
Budgeted Profit and Loss/Profit and Loss appropriation Account shows the
principal
items of revenue, expenses, loss as well as profit whereas the Budgeted Balance
Sheet reveals the principal items of Balance Sheet.
This budget is prepared by the budget officer. After its preparation, it is submitted
to the budget committee for its approval. If the budget committee does not find it
satisfactory, it makes suitable changes in this budget and puts it into action when
the final approval is given, However, once it is approved, the company seeks to a
achieve the targets during the budget period.
15.8 FIXED BUDGETS
It is a budget in which targets are rigidly fixed. According to I.C.M.A. London,
"Fixed budget is a budget which is designed to remain unchanged irrespective of
the level of activity actually attained". Such budgets are usually prepared from one
to three months in advance of the fiscal year to which they are applicable. Thus,
twelve months or more may elapse before figures forecast for the December
budget
are used to measure actual performance. Many things may happen during the
period
of twelve months and they may make the figures go widely out of line with the
actual figures. This defect may be removed by the revision of budgeted targets,
even then, the basic nature of such budget is of rigidly and it brings artificiality in
the control over costs and expenses. Such budgets are preferred only where sales
can be forecast with the greatest of accuracy, otherwise, it becomes an unrealistic
measuring yard in case the level of activity (volume of production or sales)
actually
attained does not conform to the one assumed for budgeting purpose. The
management will not be in a position to assess the performance of different
departments on its basis. On account of these defects of fixed budgeting, it has
become a common practice in case of concerns where sales and production can not
be estimated accurately to give up the concept of fixed budgeting as it does not
provide for automatic adjustments with volume changes.
20
15.9 FLEXIBLE BUDGET
Fixed or static Budget is generally rigid as it is based on one level of activity and
one set of conditions and hence not quite helpful for control purpose. A flexible
budget is therefore, designed to provide information as to sales, expenses and
profits
for different levels of activity which may be obtained. Such budgets are prepared
in
businesses where it is impossible to make a firm forecast of the future, not because
of the absence of a clear management policy but because circumstances being
entirely beyond the control of management, cannot be predicted.
It would be desirable to have a flexible budget for the following circumstances :
1. where sales cannot be predicted because of the nature of the business;
2. where the business is subject to variance of weather;
3. where progress depends upon an adequate supply of labour; and
4. in the case of a new business, where it is difficult to forecast the demand
accurately.
In these similar circumstances, a budget should be prepared for a series of possible
levels of activity.
In a flexible budgeting system, it is necessary to have the budgets quickly recast
and changed to suit the actual conditions. Analysis of the behaviour of costs and
expenses forms the bed rock of flexible budgeting system. With moderate changes
in output or sales, fixed expenses do not change. Variable expenses per unit also
remain the same. But there are a number of expenses, which are semi variable.
Such expenses will vary when output and sales change but their change will not be
in the same proportion as the change in output or sales nor will the proportion of
change be uniform for variable expenses. Every item of expense should be studied
to find out how it will behave if output or sales will change by say steps of 5%.
Only when all expenses have been studied in this manner, can a system of flexible
budgets be used. In short, flexible budgets mean new budgets to suit actual
conditions.
Illustration 6 : The expenses budgeted for production of 10,000 units in a factory
are furnished below :
Items Per unit (Rs.)
Materials 70
Labour 25
Variable Overheads 20
Fixed Overheads (direct) 10
Variable Expenses (direct) 5
Selling Expenses (10% fixed) 13
21
Distribution Expenses (20% fixed) 7
Administration Expenses (Rs. 50,000) 5
Total Cost per unit 155
Prepare a budget for prediction of :
(a) 8,000 units; and
(b) 6,000 units.
Assume that administration expenses are rigid for all levels of production.
Solution :
Flexible Budget
10,000 Units 8,000 Units 6,000 Units
Costs Per Unit Amount Per Unit Amount Per Unit Amount
Rs. Rs. Rs. Rs. Rs. Rs.
Production Costs :
Materials 70 7,00,000 70 5,60,000 70 4,20,000
Labour 25 2,50,000 25 2,00,000 25 1,50,000
Overheads 20 2,00,000 20 1,60,000 20 1,20,000
Direct Variable Exp. 5 50,000 5 40,000 5 30,000
Fixed overheads 10 1,00,000 12.5 1,00,000 16.67 1,00,000
Selling Expenses :
Fixed 1.3 13,000 1.63 13,000 2.17 13,000
Variable 11.7 1,17,000 11.70 93,600 11.70 70,200
Distribution Expenses
Fixed 1.4 14,000 1.75 14,000 2.33 14,000
Variable 5.6 56,000 5.60 44,800 5.60 33,600
Administrative Expenses 5.0 50,000 6.25 50,000 8.33 50,000
Total Costs 155.0 15,50,000 159.425 12,75,400 166.80 10,00,800
15.10 PERFORMANCE BUDGETING
Among the methods which relate costs to outputs or results, performance
budgeting
stands out the most prominent. It has emerged as a whole new way of considering
fiscal responsibility. Also sometimes called as performance, or programme
budgeting and planning, programming and budgeting system (PPBS), it focuses
attention on the physical aspects of achievement. It is a refined approach to
budgeting with an emphasis on work done or services rendered rather than being
based simply on spending limits. It establishes cost/output relationship. It is a
process of integrating inputs with outputs of a development programme.
Performance budgeting involves three levels of management.
1. Policy management – identification of needs, analysis of options, selection
of programmes and allocation of resources.
2. Resource management – establishment of basic support systems consisting
of budgeting structures and financial management practices.
22
3. Programme budgeting – implementation of policies and related operations,
accounting, reporting and evaluation.
Thus, a performance budget is one that presents the purposes and objectives of
which funds are required, the cost of achieving them, and the quantitative data
measuring the accomplishment and work performed under each programme.
Performance budgeting involves the following steps :
1. Activity classification in terms of functions, programmes and activities.
2. Financial and physical measurement of the activities.
3. Progress reporting of performance at periodic intervals.
4. Needed restructuring of the accounting system.
The main objectives of performance budgeting are : (a) to coordinate the physical
and financial aspects; (b) to improve the budget formulation, review and
decisionmaking
at all levels of management; (c) to facilitate better appreciation and review
by controlling authorities (legislatures, Board of Trustees or Governors, etc.); (d)
to make more effective performance audit possible; and (e) to measure progress
towards long-term objectives which are envisaged in a development plan.
Since the financial and physical results are interwoven, it facilitates management
control. It is of particular importance to government and non-profit oganisations.
With them, budgets have been essentially appropriation budgets with the focus
largely on spending resources rather than on obtaining results. At the year-end,
managers in these establishments are tempted to spend the appropriated amounts
even if they are not needed. Performance budgeting changes the emphasis as
budgets
get related to outputs since it integrates financial outlays with physical content of
programmes.
15.11 ZERO-BASE BUDGETING (ZBB)
The ZBB takes into account consequences that may flow if the project or
responsibility centre is scratched. In other words, the objects of the ZBB is to
formulate the budget so as to estimate the amount of expenditure likely to be
incurred if the existing project resumes operation after being scratched. This
method
is called Zero-Base Budgeting since the existing system is discontinued and a
fresh
is made or the existing system is reviewed on the assumption of 'Zero-Base'.
Generally, the following points are to be considered before introducing ZBB :
(i) Is it absolutely necessary ?
(ii) What should be the qualitative features of current activities?
23
(iii) Will production be continued according to the existing system ?
(iv) What is the cost of production under current conditions ?
In this way, cost reduction is possible in the enterprises after careful analysis.
However it takes a long time to implement this method although, through a minute
review of the present system, overheads can be controlled.
15.11.1 Application of ZBB : It is very useful where 'cost analysis' is taken into
consideration. Normally, the ZBB is applicable to those budgets which are not
involved with direct costs only, because, direct costs (e.g. Direct Material and
Direct
Labour) may be controlled by the normal prediction operation since it assumes
that each component of direct cost has been monitored and adjusted with
production.
That is why, ZBB is applicable to those budgets which involve overheads (e.g.
Administration, Selling and Distribution Overhead) i.e., it is more applicable to
discretionary cost areas. It is implied that ZBB is relevant where a budgeting
system
which has already been introduced, requires managers at the same time to develop
qualitative measures.
The significant advantages of ZBB are :
(i) It supplies the firm a systematic way in order to evaluate different
programmes which are undertaken by the management allocating resources
according to priority of the programmes and operations of the undertaking.
(ii) It helps the management to know different departmental budgets on the basis
of cost-benefit analysis, as such, no arbitrary increase or cuts in budget estimates
are done.
(iii) It is most appropriate both for the staff and supported areas of an organisation
since the output are not related directly to the finished products of the unit.
(iv) It also helps to locate the areas of wasteful expenditure, if any, and as such,
it can also suggest alternative courses of action, if so desired by the management.
15.11.2 Limitations of ZBB : ZBB suffers from the following :
(i) Introduction of ZBB system is no doubt expensive and time consuming
process.
(ii) ZBB also invites ranking process problems. It includes (a) Who will do the
ranking? (b) What method should be adopted for this purpose? and (c) To what
extent it will be ranked and how?
(iv) Since ZBB requires significant support from the top management level which
is practically not possible from different sources, its successful implementation
practically is very difficult.
24
(iv) ZBB involves a lot of training for managers, i.e., if the managers do not
understand properly the idea of ZBB, it cannot be successfully implemented.
(v) Moreover, the determination of performance measures is difficult.
15.11.3 Features of ZBB :
(i) Before its implementation justify 'why' is it so needed and not 'how' much.
(ii) All levels of management should participate in the discussion making process.
(iii) Corporate objectives and individual unit objectives should be linked.
15.12 SUMMARY
Budgeting is an all-important exercise. It pervades all organisations-public and
private, government and non-government. A budget is a blueprint for action. It is a
quantified plan of action in financial terms. Budgeting is a versatile tool, but is has
two main purposes: budgetary planning and budgetary control. In manufacturing
organisation is the process of budget setting starts with the sales budget.
Production
budget follows which, in turn, necessitates budget for materials, direct labour, and
overheads. These and some other budgets are assembled into a master budget. It
becomes a governing document, and virtually a forecasted profit and loss account.
Best budgets are the ones which are prepared on standard costs. To be meaningful,
budgets have to be flexible rather than static. A flexible budget is prepared for
several levels of activity but, at minimum, it is for at least three levels. These are
most optimistic, the most pessimistic, and the most likely levels. The two
approaches
followed in the preparation of flexible budgets are: formula method, and the
multiple-activity method. A few noteworthy recent trends in budgeting are towards
zero-base budgeting and performance budgeting. The former denotes an operating,
planning and budgeting process which requires each manager to justify his entire
budget in detail from scratch. The latter refers to a budget which specifies outputs
or results to be achieved along with the inputs or expenditures to be incurred
during
the budget period.
15.13 KEYWORDS
Budget: A budget is a quantitative expression of a plan of action prepared in
advance
for the period to which it relates.
Budgetary control: Budgetary control is a tool of management used to plan,
carryout and control the operations of the business.
Budget centre: It is a section of an organisation defined for the sake of budgetary
control.
Cash budget: Cash budget is a summary of the firm's expected cash inflows and
25
outflows over a particular period of time.
Performance budgeting: Performance budgeting is a process of integrating
inputs
with outputs of a development programme.
Zero-base budgeting: In zero-base budgeting, the budget is prepared by
considering
the base for the current year as zero and this eliminates the accrual of inefficiency
for preparing future years budget.
1. What is budgetary control ? State the main objectives of budgetary control.
2. Explain the term 'Budget' as used in the business. What are the essentials of
an effective budget system ?
3. "For planning, the manager wants information about the future, for control
about the past". Comment upon this statement and show how can budgeting
helps in this respect.
4. "Budgetary control means worrying before work rather than after. Its keynotes
are planning, co-ordination and control". Explain this statement.
5. What are functional budgets? Which functional budgets are most commonly
used by management.
6. Discuss briefly the procedure for the preparation of a sales budget.
7. Differentiate between Fixed Budgeting and Flexible Budgeting
8. Define Zero-Base Budgeting and distinguish it from traditional budgeting.
Enumerate the benefits to be achieved by a business organisation in
introducing Zero-Base Budgeting.
9. What do you understand by "Performance Budgeting"? What steps are
required to be taken for preparing performance budget?
10. Write short notes on :
(a) Budget Committee
(b) Zero Base Budgeting
(c) Limitations of budgets
(d) Master Budget
(e) Budget Review
(f) Budget Manual
(g) Budget Officer
26
11. From the following budgeted figures, prepare a Cash Budget in respect of
three months to June 30.
Months Sales Materials Wages Overheads
Rs. Rs. Rs. Rs.
January 60,000 40,000 11,000 6,200
February 56,000 48,000 11,600 6,600
March 64,000 50,000 12,000 6,800
April 80,000 56,000 12,400 7,200
May 84,000 62,000 13,000 8,600
June 76,000 50,000 14,000 8,000
Expected Cash Balance on Ist April Rs. 20,000. Other information :
(a) Materials and overheads are to be paid during the month following the month
of supply.
(b) Wages are to be paid during the month in which they are incurred.
(c) Terms of Sales : The terms of credit sales are payment by the end of the
month following the month of sales : ½ of the sales are paid when due, the other
half to be paid during the next month.
5% sales commission is to be paid within the month following actual sales.
(d) Preference dividend for Rs. 30,000 is to be paid on Ist May.
(e) Share call money for Rs. 25,000 is due on Ist April and Ist June.
(f) Plant and Machinery worth Rs. 10,000 is to be installed in the month of
January and the payment is to be made in the month of June.
12. The expenses budgeted for production of 10,000 units in a factory are
furnished below :
Items Per unit (Rs.)
Materials 70
Labour 25
Variable Overheads 20
Fixed Overheads (direct) 10
Variable Expenses (direct) 5
Selling Expenses (10% fixed) 13
Distribution Expenses (20% fixed) 7
Administration Expenses (Rs. 50,000) 5
Total Cost per unit 155
27
Prepare a budget for prediction of :
(a) 6,000 units; and
(b) 4,000 units.
Assume that administration expenses are rigid for all levels of production.
13. Ram Prasad & Sons Ltd. plans to prepare a Production Budget for its three
products A, B and C. The sales for their products is 83,200 units, 72,800
units and 88,400 units respectively. The estimated requirements of inventory
both at the beginning and at the end of the budget periods are shown in the
following schedule :
Inventory Schedule
Product
ABC
January 1 (units) 16,000 12,000 20,000
December 31 (units) 28,800 11,160 27,600
You are required to prepare the Production Budget for the Company.
14. West Bengal food Supplies Ltd. forecast their annual sales, 2,00,000 units
at Rs. 20 per units. The monthly sales on the basis of an index is expressed
as follows :
Units
January 8,000
February 8,000
March 16,000
April 15,000
May 20,000
June 25,000
July 30,000
August 20,000
September 25,000
October 9,000
November 10,000
December 14,000
2,00,000
The break-up of monthly sales for 6 months in three different districts shows
the following results :
24 Parghanas Nadia Hawrah
January 40% 10% 40%
February 20% 20% 15%
March 25% 30% 30%
April 30% 40% 20%
May 40% 25% 30%
June 30% 20% 25%
Prepare a Sales Forecasts for the 6 months (both in quantity and in value).
28
1. Nigam, B.M. Lall and Jain, I.C.; Cost Accounting, PHI, New Delhi.
2. Paul, S.Kr.; Management Accounting, Central Book Agency, Calcutta.
3. Khan, M.Y. and Jain, P.K.; Financial Management, Tata McGraw, New Delhi.
4. Maheshwari, S.N.; Management Accounting and Financial Control.
Code : CP-104 Updated by: Dr. M.C. Garg
Lesson : 16
MARGINAL COSTING: BREAK-EVEN ANALYSIS
AND DECISION-MAKING
STRUCTURE
16.0 Objective
16.1 Introduction
16.2 The Concept of Marginal Cost
16.3 Segregation of semi-variable costs
16.4 Contribution
16.5 Profit/Volume Ratio (P/V Ratio)
16.6 Key Factor
16.7 Profit Planning
16.8 Break-even Analysis
16.9 Concept of Decision-Making
16.10 Steps in Decision-Making
16.11 Summary
16.12 Keywords
16.0 OBJECTIVE
After reading this lesson, you should be able to
(a) Define marginal cost.
(b) Explain the methods of segregation of semi-variable cost.
1
(c) Discuss the significance of contribution, P/V ratio and key
factor.
(d) State the importance of break-even point.
(e) Illustrate the managerial applications of marginal costing.
16.1 INTRODUCTION
Marginal costing is a technique where only the variable costs are
considered while computing the cost of a product. The fixed costs are
met against the total fund arising out of excess of selling price over
total variable cost. This fund is known as ‘contribution’ in marginal
costing. According to the Institute of Cost and Management
Accountants, London, marginal costing is a technique where “only the
variable costs are charged to cost units, the fixed cost attributable being
written off in full against the contribution for that period.” Thus
marginal costing considers only the variable costs while computing the
cost of the product. As a matter of fact, it is not a system of cost finding
such as job, process or operating costing, but it is a special technique
concerned particularly with the effect affixed overheads on running the
business. This is being explained in the following pages while
explaining the difference between Marginal Costing and Absorption
Costing.
16.2 THE CONCEPT OF MARGINAL COST
The technique of Marginal Costing is concerned with “Marginal
Cost”. It is, therefore, very necessary that the term “Marginal Cost” is
correctly understood. According to the Institute of Cost and
Management Accountants, London, the term “Marginal Cost” means
‘the amounts at any given volume of output by which aggregate costs
2
are changed if the volume of output is increased/decreased by one unit’.
On analyzing this definition we can conclude that the term “Marginal
Cost” refers to increase or decrease in the amount of cost on account of
increase or decrease of production by a single unit. The unit may be a
single article or a batch of similar articles. This will be clear from the
following example.
Example: A factory produces 500 fans per annum. The variable
cost per fan is Rs. 50. The fixed expenses are Rs. 10,000 per annum.
Thus, the cost sheet of 500 fans will appear as follows:
Variable cost (500 × Rs. 50) Rs. 25,000
Fixed cost Rs. 10,000
Rs. 35,000
If production is increased by one unit i.e., it becomes 501 fans per
annum, the cost sheet will then appear as follows:
Variable cost (500 × Rs. 50) Rs. 25,000
Fixed cost Rs. 10,000
Rs. 35,000
Marginal cost per unit is, therefore, Rs. 50
Marginal cost is, thus, the total variable cost because within the
capacity of the organization, an increase of one unit in production will
cause an increase in variable cost only. The variable cost consists of
direct materials, direct labour, variable direct expenses and variable
overheads. The term “all variable overheads” includes variable
overheads plus the variable portion contained in semi-variable
overheads. This portion has to be segregated from the total semi-
3
variable overheads according to the methods discussed later in this
lesson.
The Accountant’s concept of marginal cost differs from the
Economist’s concept of marginal cost. According to economists, the cost
of producing one additional unit of output is the marginal cost of
production. This shall include an element of fixed cost also. Thus, fixed
cost is taken into consideration according to economist’s concept of
marginal cost but not according to accountant’s concept. Moreover, the
economist’s marginal cost per unit cannot be uniform with the
additional production since the law of diminishing (or increasing)
returns is applicable while accountant’s marginal cost shall be constant
per unit of output with the additional production.
Illustration 16.1: Following information relates to a factory
manufacturing fans:
Producti
on in
units
D
m
(R
D
la
(R
O
v
c
(
F
c
(
irect
aterial
s.)
irect
bour
s.)
ther
ariable
osts
Rs.)
ixed
osts
Rs.)
Total
costs
(Rs.)
500 1000 750 5 1 00 000 3250
1000 20 1 1 1 00 500 000 000 5500
1500 30 2 1 1 00 250 500 000 7750
2000 40 3 2 1 00 000 000 000 10000
2500 50 3 2 1 00 750 500 000 12250
Show the effect of increase in output on per unit cost of
production and calculate the marginal cost of production.
4
Solution
Production
units
Total variable
cost per unit
(Rs.)
Fixed cost per
unit (Rs.)
Total cost per
unit (Rs.)
500 4.50 2.00 6.50
1000 4.50 1.00 5.50
1500 4.50 0.67 5.17
2000 4.50 0.50 5.00
2500 4.50 0.40 4.90
The above table shows that with an increase in production, total
cost per unit is decreasing. This is because the fixed overheads are
constant at every level and their effect per unit goes on decreasing with
increase in volume of output. The marginal cost of production per unit
has remained constant and the fixed cost per unit has lowered down
from Rs. 2 to Rs. 0.40. This will affect to a great extent firm’s decision to
increase production in the present illustration. Marginal cost in the
present illustration can be calculated with the help of the following
formula:
Marginal cost = Direct Material Cost + Direct Labour Cost +
Other Variable Costs
Or
Total Cost – Fixed Cost
When the production is 500 units, the marginal cost of production
shall be equal to Rs. 1,000 + Rs. 750 + Rs. 500, i.e. Rs. 2,250 (or Rs.
5
3,250 – Rs. 1,000). Marginal cost at other levels of output can be known
in the similar fashion.
Illustration 16.2: XYZ Ltd. is currently working at 50% capacity
and produces 10,000 units.
1. At 60% working, raw material cost increases by 2% and
selling price falls by 2 per cent. At 80 per cent working, raw
material cost increases by 5 per cent and selling price falls
by 5 per cent.
2. At 50% capacity working, the product costs Rs. 180 per unit
and is sold at Rs. 200 per unit.
The unit cost of Rs. 180 is made up as follows:
Material Rs. 100
Wages Rs. 30
Factory overheads Rs. 30 (40% fixed)
Administration overheads Rs. 20 (50% fixed)
Prepare a marginal cost statement showing the estimated profit
of the business when it is operated at 60% and 80% capacity.
Solution
MARGINAL COST STATEMENT
60% capacity output
12,000 units
80% capacity output
16,000 units
Particulars
Total Per unit Total Per unit
Material 12,24,000 102 16,80,000 105
Wages 3,60,000 30 4,80,000 30
Variable factory overheads 2,16,000 18 2,88,000 18
6
Variable administration
overheads
1,20,000 10 1,60,000 10
Total M. cost (i) 19,20,000 160 26,08,000 163
Sales (ii) 23,52,000 196 30,40,000 190
Contribution (iii) 4,32,000 36 4,32,000 27
Fixed factory
Overheads 1,20,000 10 1,20,000 7.50
Fixed admn. Overheads 1,00,000 8.23 1,00,000 6.25
Fixed costs (iv) 2,20,000 18.23 2,20,000 13.75
Net Profit ((iii) – (iv)) 2,12,000 17.77 2,12,000 13.25
Working notes
(i) Material cost per unit at 50% capacity Rs. 100.00
Add: 2% at 60% capacity 2.00
Material cost per unit at 60% capacity Rs. 102.00
(ii) Material cost at 50% capacity Rs. 100.00
Add: 5% at 80% capacity 5.00
Material cost per unit at 80% capacity Rs. 105.00
(iii) Selling price per unit at 50% capacity Rs. 200.00
Less: 2% at 60% capacity 4.00
Selling price at 60% capacity Rs. 196.00
(iv) Selling price per unit at 50% capacity Rs. 200.00
Less: 5% at 80% capacity 10.00
Selling price at 80% Rs. 190.00
(v) Variable factory overheads:
Factory overheads per unit at 50% capacity Rs. 30.00
Less: Fixed factory overheads 12.00
Variable factory overheads per unit Rs. 18.00
Total fixed factory overheads (Rs. 12×10,000) Rs. 1,20,000.00
7
(vi) Variable administration overheads:
Administration overheads per unit Rs. 20.00
Less: Fixed administration overheads per unit Rs. 10.00
Variable administration overheads per unit Rs. 10.00
Total fixed administration overheads
(Rs. 10×10,000)
Rs. 1,00,000.00
16.3 SEGREGATION OF SEMI-VARIABLE COSTS
Marginal costing requires segregation of all costs between two
parts fixed and variable. This means that the semi-variable cost will
have to be segregated into fixed and variable elements. This may be
done by any one of the following methods:
1. Levels of output compared to levels of expenses method,
2. Range method,
3. Degree of variability method,
4. Scatter graph method,
5. Least squared method.
Each of the above methods has been discussed in detail with the
help of the following illustration:
Illustration 16.3
Production
Units
Semi-variable
expenses
July 2005 50 150
August 2005 30 132
September 2005 80 200
October 2005 60 170
8
November 2005 100 230
December 2005 70 190
During the month of January, 2006, the production is 40 units
only. Calculate the amount of fixed, variable and total semi-variable
expenses for the month.
1. Levels of output compared to levels of expenses
method: According to this method, the output at two different levels is
compared with corresponding level of expenses. Since the fixed
expenses remain constant, the variable overheads are arrived at by the
ratio of change in expense to change in output.
Solution: Taking the figures of the month of September and
November of the illustration given below:
Month Production
units
Semi-variable
expenses (Rs.)
Fixed
(Rs.)
Variable
(Rs.)
September 80 200 80* 120*
November 100 230 80** 150**
Difference 20 Rs. 30
Therefore, variable element would be
=
quantity or activity in Change
expense of amount in Change
=
20
30 = Rs. 1.50 per unit
* Variable overheads for
September
= 80×Rs. 1.50 = 120
Fixed overheads for September = Rs. 200–Rs. 120 = Rs. 80
9
** Similarly, Overheads for
November have been computed
Variable overheads for January 40×Rs. 1.50 = Rs. 60
Fixed overheads Rs. 80
Total semi-variable overheads Rs. 230
2. Range method: This method is similar to the previous
method except that only the highest and lowest points of output are
considered out of various levels. This method is also designated as ‘high
and low’ method.
Solution: The highest production in the illustration is in the
month of November while the lowest is in the month of August. The
figures of these two months, therefore, have been taken.
Month Production
units
Semi-variable
expenses (Rs.)
Fixed
(Rs.)
Variable
(Rs.)
August 30 132 90* 42*
November 100 230 90** 140**
Difference 70 98
Variable element: 98/70 = Rs. 1.4 per unit
* Variable overheads for August = 30 × Rs. 1.4 = Rs. 42
Fixed overheads for August = 132 – Rs. 42 = Rs. 90
**Similarly, the fixed and variable overheads for November have
been found out.
Variable overheads for January = 40 × Rs. 1.4 = Rs. 56/-
Fixed overheads Rs. 90
Total semi-variable overheads Rs. 146
10
3. Degree of variability method: In this method, degree of
variability is noted for each item of semi-variable expense. Some semivariable
items may have 30% variability while others may have 70%
variability. The method is easy to apply but difficulty is faced in
determining the degree of variability.
Solution: Assuming that degree of variability is 60% in semivariable
expenses and taking the month of October as basis, the
analysis shall be as under:
Variable element = (60% of Rs. 170), i.e. Rs. 102
Fixed element = Rs. 170 – 102 = Rs. 68.
On the basis of the variable expenses of Rs. 102 for the production
of 60 units the variable expenses for 40 units (the production for
January 2002) will be:
Rs.
60
102
×40 = Rs. 68.
Hence, the total Semi-variable expenses for January, 2005 will be
equal to Rs. 68 + Rs. 68 i.e., Rs. 136.
4. Scattered-graph method: In this method the given data
are plotted on a graph paper and line of best fit is drawn.
The method is explained below:
(i) The volume of production is plotted on the horizontal
axis and the costs are plotted on the vertical axis.
11
(ii) Corresponding to each volume of production are then
plotted on the paper, thus, several point are shown on
it.
(iii) A straight line of best fit is then drawn through the
point plotted. This is the total cost line. The point
where this line interests the vertical axis is taken to
be amount of fixed element.
(iv) A line parallel to the horizontal axis is drawn from
the point where the line of best fit intersects the
vertical axis. This is the fixed cost time.
(v) The variable cost at any level can be known by noting
difference between fixed cost and total cost lines.
Solution
An inspection of the above graph tells us that fixed expenses are
Rs. 85 approximately.
12
For the month of January, 2006, the semi-variable expenses (see
Graph) are Rs. 143 and, therefore, the variable expenses are Rs. 58 (Rs.
143-85).
5. Method of least squares: This method is based on the
mathematical technique of fitting an equation with the help of a
number of observations. The linear equation, i.e., a straight line
equation, can be assumed as:
y = a + bx and the various sub-equations shall be
ey = na + bex;
exy = aex + bex2
An equation of second order, i.e., a curvilinear equation can be
drawn as y = a + bx + cx2 and the various sub-equations to solve it (i.e.,
to find out the values of constants a, b and c, shall be:
Ey = naq + bex2:
Exy = aex + bex2 + cex3;
Ex2y = aex2 + bex3 + cex4.
Similarly, the equation can be fitted for any number of order or
degree depending upon the number of observations available and the
accuracy desired.
Solution: A linear equation can be obtained with the help of the
following values, thus:
Months Production
(Units)
Expenses
(Rs.)
Year 2005 x y x2 xy
July 50 150 2,500 7,500
13
August 30 132 900 3,960
September 80 200 6400 16,000
October 60 170 3600 10,200
November 100 230 10,000 23,000
December 70 190 4,900 13,300
Total ex = 390 ey = 1,072 ex2 = 28,300 exy = 73,960
Assuming, the equation as y = a + bx, we have to find the values
of constants a and b with the help of above figures. The other two
equations are:
ey = na + bex … (i)
exy = ax + bex2 … (ii)
Putting the values in these equations, we have
1,072 = 6a + 390 b … (iii)
73,960 = 390 a + 28,300 b … (iv)
Multiplying equation (iii) by 65 and deducting it from (iv), we get
4,280 = 2,950 b; : b = 1.45 (approx)
Putting the values of b in equation (iii), we can know the value of
a:
()
6
45 . 1 390 1072
a
×−
= = 84.42 (approx)
The desired equation is:
Y = 84.42 + 1.45x
14
Where Rs. 84.42 is the amount of fixed element and Rs. 1.45 is
the rate per unit for variable element.
Putting the value of x, i.e., 40 units for January, 2006, we get the
total semi-variable expenses for the month as
Rs. 84.42 + (Rs. 1.45 × 40), i.e., Rs. 142.42.
16.4 CONTRIBUTION
As stated earlier, the difference between selling price and
variable cost (i.e., the marginal cost) is known as ‘Contribution’ or
‘Gross Margin’. In other words, fixed costs plus the amount of profit is
equivalent to contribution. It can be expressed by the following formula:
Contribution = Selling Price – Variable Cost
Or
Fixed Cost + Profit
We can derive from it that profit cannot result unless
contribution exceeds fixed costs. In other words, the point of no profit no
loss shall be arrived at where contribution is equal to fixed costs.
Example
Variable cost = Rs. 50,000
Fixed cost = Rs. 20,000
Selling price = Selling price – Variable cost
= Rs. 80,000 – Rs. 50,000 = Rs. 30,000
Profit = Contribution – Fixed cost
= Rs. 30,000 – Rs. 20,000 = Rs. 10,000
15
Hence, contribution exceeds fixed cost and, therefore, the profit is
of the magnitude of Rs. 10,000. Suppose the fixed cost is Rs. 40,000
then the position shall be
Contribution – Fixed cost = Profit
= Rs. 30,000 – Rs. 40,000 = (-) Rs. 10,000
The amount of Rs. 10,000 represents the extent of loss since the
fixed costs are more than the contribution. At the level of fixed cost of
Rs. 30,000, there shall be no profit and no loss. The concept of the
break-even analysis emerge out of this theory.
16.5 PROFIT/VOLUME RATIO (P/V RATIO)
This term is important for studying the profitability of operations
of a business. Profit-volume ratio establishes is relationship between
the contribution and the sale value. The ratio can be shown in the form
of a percentage also. The formula can be expressed thus:
P/V Ratio =
Sales
Costs Variable Sales
Sales
on Contributi −
=
Or C/S =
S
VS−
or 1 –
Sales
Costs Variable
This ratio can also be called as ‘Contribution/Sales’ ratio. This
ratio can also be known by comparing the change in contribution to
change in sales or change in profit to change in sales. Any increase in
contribution would mean increase in profit only because fixed costs are
assumed to be constant at all levels of production. Thus,
16
P/V Ratio =
Sales in Change
on Contributi in Change
or
sales in Change
profits in Change
This ratio would remain constant at different levels of production
since variable costs as a proportion to sales remain constant at various
levels.
Example
Sales Rs. 2,00,000
Variable Costs Rs. 1,20,000
Fixed Costs 40,000
P/V Ratio =
2,00,000 Rs.
1,20,000 Rs. - 2,00,000 Rs.
= 0.4 or 40%
The ratio is useful for the determination of the desired level of
output or profit and for the calculation of variable costs for any volume
of sale. The variable costs can be expressed as under:
VC = S(1 – P/V ratio)
In the above example
If we know the P/V ratio and sales before head, the variable costs
can be computed as follows:
Variable Costs = 1 – 0.4 – 0.6, i.e., 60% of sales
= 1,20,000 (60% of Rs. 2,00,000)
Alternatively, by the formula S – V
17
Since P/V ratio =
S
VS−
= S × P/V Ratio
Or V = S – S × P/V ratio or S (1 – P/V ratio).
Comparison of different P/V ratios is usually made by the
management to find out which product is more profitable. Management
tries to increase the value of the ratio by reducing the variable cost or
by increasing the selling prices.
16.6 KEY FACTOR
Key factor is that factor which limits the volume of output in the
activities of an undertaking at a particular point of time or over a
period. The extent of its influence must be assessed first so as to
maximize the profits. Generally on the basis of contribution, the
decision regarding product mix is taken. It is not the maximization of
total contribution that matters, but the contribution in terms of the key
factor that is to be compared for relative profitability. Thus, it is the
limiting factor or the governing factor or principal budget factor. If
sales cannot exceed a given quantity, sales is regarded as the key
factor; if production capacity is limited, contribution per unit i.e., in
terms of output, has to be compared. If raw material is in short supply,
contribution has to be expressed in relation to per unit of raw material
required. There may be labour shortage and in such a case contribution
per labour is to be known. If machine capacity is a limitation,
contribution per machine hour is to be considered for appropriate
decision making. Thus, profitability can be measured by:
factor Key
on Contributi
18
The following illustration would clearly show how key factor
affects the relative profitability of difference products.
Illustration 16.4: Comments on the relative profitability of the
following two products:
Production cost per unit
Product A Product B
Materials Rs. 200 Rs. 150
Wages 100 200
Fixed overhead 350 100
Variable overhead 150 200
Profit 200 350
Selling price 1000 1000
Output per week 200 Units 100 Units
Solution
COMPARATIVE STATEMENT OF PROFITABILITY
Product A Product B
Sale price per unit Rs. 1,000 Rs. 1,000
Less: Variable cost per unit 450 550
Contribution per unit 550 450
Less: Fixed cost per unit 350 100
Profit per unit 200 350
Total Profit 40,000 35,000
P/V ratio 55% 45%
Contribution per unit and total profit is higher in case of product
A, though profit per unit of product B is higher. If output in terms of
19
units is the limiting factor, product A is more profitable. In case there is
no limit regarding units of output product B would prove to be more
profitable. Similarly, in case there is any other key factor, contribution
has to be expressed in relation to that factor and decision has to be
taken on that basis.
16.7 PROFIT PLANNING
The basic objective of running any business organization is to
earn profits. Profits determine the financial position, liquidity and
solvency of the company. Profits serve as a yardstick for judging the
competence and efficiency of the management. Profit planning is,
therefore, a fundamental part of the overall management function and
is a vital part of the total budgeting process. The management
determines the profit goals and prepares budgets that will lead them to
the realization of these goals. Profit planning can be done only when
the management has the information about the cost of the product, both
fixed and variable, and the selling price at which it will be in a position
to sell the products of the company. The management extensively
applies the concept of Marginal Costing as explained in the preceding
pages in profit planning.
The profit is affected by the several factors. Some of the
important factors are as follows:
(i) Selling price of the products.
(ii) Volume of sales.
(iii) Variable costs per unit.
(iv) Total fixed costs.
(v) Sales makes (or mix) of the different products.
20
The management can achieve their target profit goal by varying
one or more or the above variables. This will be clear with the help of
the following illustration:
Illustration 16.5: A firm has Rs. 10,00,000 invested in its plant
and sets a goal of a 15% annual return on investment. Fixed costs in
the factory presently amount to Rs. 4,00,000 per year and variable costs
amount to Rs. 15 per unit produced. In the past year the firm produced
and sold 50,000/- units at Rs. 25 each and earned a profit of Rs.
1,00,000. How can management achieve their target profit goal by
varying different variables like fixed costs, variable costs, quantity sold
or increasing the selling price per unit?
Solution: Profit to be earned is Rs. 1,50,000 (i.e. 15% of Rs.
10,00,000).
The equation of profit can be put as follows:
Profit = (Quantity × S.P. per unit) – (Quantity × variable cost
per unit) – Fixed costs.
(i) Achievement of target profit by varying fixed costs:
Let the fixed costs be X
1,50,000 = (50,000 × Rs. 25) – (50,000 × Rs. 15) – X
or 1,50,000 = (Rs. 12,50,000) – (Rs. 7,50,000) – X
X = Rs. 12,50,000 – 7,50,000 – 1,50,000
X = Rs. 3,50,000.
21
The present fixed costs are Rs. 4,00,000. The management
can earn the target profit of Rs. 1,50,000 by reducing the fixed
costs by Rs. 50,000 (i.e. Rs. 4,00,000 – Rs. 3,50,000).
(ii) Achievement of the target profit by varying variable costs:
Let the variable cost be X per unit.
Rs. 1,50,000 = (50,000×Rs. 25) – (50,000 × X) – Rs. 4,00,000
Or 1,50,000 = Rs. 12,50,000 – 50,000 X – Rs. 4,00,000
Or 50,000 X = Rs. 12,50,000 – Rs. 4,00,000 – Rs. 1,50,000
Or 50,000 X = 7,00,000
Or X = 14
The present variable cost per unit is Rs. 15 per unit. The
management can earn the target profit of Rs. 1,50,000 by reducing the
variable cost by Re. 1 per unit (i.e. Rs. 15 – Rs. 14).
(iii) Achievement of the target profit by varying quantity sold:
Let the quantity sold be X
Rs. 1,50,000 = (X × Rs. 25) – (X × Rs. 15) – Rs. 4,00,000
Or 1,50,000 = 25 X – 15 X – Rs. 4,00,000
Or 10 X = 5,50,000
X = 55,000
22
The present sales are 50,000 units. The management can earn
the target profit of Rs. 1,50,000 by increasing the units sold by 5,000.
(iv) Achievement of the target profit by varying selling price:
Let the selling price be X
Rs. 1,50,000 = (50,000×X) – (50,000 × Rs. 15) – Rs. 4,00,000
Or 1,50,000 = (50,000 X – Rs. 7,50,000 – Rs. 4,00,000)
Or – 50,000 X = - 7,50,000 – Rs. 4,00,000 – 1,50,000
Or – 50,000 X = 13,00,000
X = 26
The present selling price is Rs. 25 per unit. The management can
earn the target profit of Rs. 1,50,000 by increasing the selling price by
Re. 1 per unit.
16.8 BREAK-EVEN ANALYSIS
The narrower interpretation of the term break-even analysis
refers to a system of determination of that level of activity where total
cost equals total selling price. The broader interpretation refers to that
system of analysis which determines the probable profit at any level of
activity. The relationship among cost of production, volume of
production, the profit and the sales value is established by break-even
analysis. Hence, this analysis is also designated as ‘Cost-volume-profit’
analysis.
23
Such an analysis is useful to the management accountant in the
following respects:
(i) It helps him in forecasting the profit fairly accurately.
(ii) It is helpful in setting up flexible budgets, since on the basis
of this relationship, he can ascertain the costs, sales and
profits at different levels of activity.
(iii) It also assists him in performance evaluation for purposes
of management control.
(iv) It helps in formulating price policy by projecting the effect,
which different price structures will have on cost and
profits.
(v) It helps in determining the amount of overhead cost to be
charged at various levels of operations, since overhead rates
are generally pre-determined on the basis of a selected
volume of production.
Thus, cost volume-profit analysis is an important media through
which the management can have an insight into effects on profit on
account of variations in costs (both fixed and variable) and sales (both
volume and value) and take appropriate decisions.
Break-even point
The point, which breaks the total cost and the selling price evenly
to show the level of output or sales at which there shall be neither profit
nor loss, is regarded as break-even point. At this point, the income of
the business exactly equals its expenditure. If production is enhanced
24
beyond this level, profit shall accrue to the business, and if it is
decreased from this level, loss shall be suffered by the business.
It will be proper here to understand different concepts regarding
marginal cost and break-even point before proceeding further. This has
been explained below:
Marginal cost = Total variable cost
Or = Total cost – Fixed cost
Or = Direct Material + Direct labour
+ Direct Expenses (Variable)
+ Variable overheads
Contribution = Selling Price – Variable cost
Profit = Contribution – Fixed cost
Fixed cost = Contribution – Profit
Contribution = Fixed cost + Profit
Profit/Volume Ratio =
unit per price Selling
unit per on Contributi
Or =
sales Total
on contributi Total
In case P/V ratio is to be expressed as a percentage of sales, 100
as given above should multiply the figure derived from the formulae.
Break-even point =
cost Fixed
Or = Sales Total
on contributi Total
cost Fixed ×
Or = 1 –
unit per cost Variable
cost Fixed
25
Or =
Ratio P/V
cost Fixed
At break-even point the desired profit is zero, in case the volume
of output of sales is to be computed for ‘a desired profit’, the amount of
‘desired profit’ should be added to Fixed Costs in the formulae given
above. For example:
Units for a desired profit =
profit Desired cost Fixed +
Sales for a desired profit =
Ratio P/V
profit Desired cost Fixed +
This will be clear from the following illustrations:
Illustration 16.6: A factory manufacturing sewing machines has
the capacity to produce 500 machines per annum. The marginal
(variable) cost of each machine is Rs. 200 and each machine is sold for
Rs. 250. Fixed overheads are Rs. 12,000 per annum. Calculate the
break-even points for output and sales and show what profit will result
if output is 90% of capacity?
Solution: Contribution per machine is Rs. 250 – Rs. 200 = Rs. 50.
Break-even point for output (Output, which will give
‘contribution’ equal to fixed costs Rs. 12,000)
B.E.P. for output =
cost fixed Total
=
50
000 , 12
= 240 machines
26
Break-even point for sales
= Output × Selling price per unit
= 240 × Rs. 250 = Rs. 60,000
Break-even point for sales can also be calculated with the help of
any of the following formulae:
(i) B.E.P. = 1 –
unit per cost Variable
cost fixed Total
=1–
250
200
000 , 12
=
5
1
12000
= Rs. 60,000
or
B.E.P. =
unit per price Selling cost fixed Total ×
=
50
250 000 , 12 ×
= Rs. 60,000
or
B.E.P =
on contributi Total
sales Total Cost fixed Total ×
=
000 , 25
000 , 25 , 1 000 , 12 ×
= Rs. 60,000
or
B.E.P. =
Ratio P/V
cost fixed Total
=
% 20
000 , 12
= Rs. 60,000
27
P.V. Ratio =
Sales
on Contributi
× 100 =
000 , 25 , 1
000 , 25 ×100 = 20%
Profit at 90% of the capacity has been calculated as follows:
Capacity 500 machines
Output at 90% capacity 450 machines
Break-even point of output 240 machines
Since fixed overheads will be recovered in full at the break-even
point, the entire contribution beyond the break-even point will be the
profit. The profit on 450 units, therefore, will be:
Rs. 50 × (450-240) = Rs. 10,500
Illustration 16.7: The following are the budgeted data of Jai
Hind Company:
Sales (15,000 units @ Rs. 5) Rs. 75,000
Less: Fixed costs Rs. 28,000
Variable costs 15,000 Rs. 43,000
Operating profit 32,000
Add: Other incomes 9,000
Less: Other expenses 3,000 6,000
Net profit 38,000
How would you compute break-even points?
Solution: It is advisable to compute separate break-even points
(i) omitting other incomes and expenses, and (ii) including other
incomes and expenses, for management decision.
28
(i) When other incomes and expenses are not taken into
consideration:
BEP = 1 –
Sales
cost Variable
t cos Fixed
=
80 0
000 28
000 75
000 15
1
000 28
.
,
,
,
,=
−
= Rs. 35,000
(ii) When other incomes and expenses are taken into
consideration:
BEP = 1 –
Sales
cost Variable
incomes Other – cost Fixed
=
000 , 75
000 , 15
1
000 , 6 000 , 28
−
−
=
80 . 0
000 , 22
= Rs. 27,500
16.9 CONCEPT OF DECISION-MAKING
Decision-making is the essence of management since it may make
the success of the business as a whole. In general, it means taking the
final step in deliberations before acting. In management terms it has a
specific meaning. It means the process of choosing among alternative
courses of action, since if there is no choice; there is no decision to
make. Moreover, since business takes place in a probabilistic world,
every management decision deals with the future-whether it be ten
seconds ahead (the decision to adjust a dial), or eighty years ahead (the
decision to locate the factory). A decision always involves a prediction.
29
The function of decision maker is, therefore, to select courses of action
for the future. There is no opportunity to alter the past.
Future is risky: Of course, routine decisions do not involve much
of risk. However, most of the top management decisions are not of a
routine nature. They are generally of a crucial and critical nature on
account of their requiring huge investments and involving many
uncertainties. But they cannot be avoided. The Executive has taken
them. It has been correctly observed: “Uncertainty is his (executive’s)
opponent, overcoming it his mission. Whether the outcome is a
consequence of luck or wisdom, the moment of decision is without doubt
the most creative event in the life of the executive”.
Concept of Relevant Costs
It has already been stated that for managerial decision-making
the decision-maker must make use of relevant costs. The term’ relevant’
mean pertinent to decision at hand. Costs are relevant if they guide the
executive towards the decision that harmonies with top management’s
objectives. It will be ideal if the costs are not only relevant or pertinent
but also accurate or precise.
It may be noted that ‘relevance’ and ‘accuracy’ are not identical
concepts. Costs may be accurate but irrelevant or inaccurate but
relevant. For example, the sales manager’s salary may be precisely
Rs.60,500 per annum, however, this fact has no relevance in deciding
whether to add or drop a production line.
The following are the two fundamental characteristics of relevant
cost.
30
(i) They are future costs: Of course, all future costs are not
relevant to alternative choice decisions but all costs are not relevant
unless they are future. This is because past costs are the result of past
decisions and no current or future decision can change what has
already happened. For example, a company has to decide whether or
not to accept an order for a particular product. In calculating the cost of
this product to see if the order would benefit the company financially,
the company uses the expected cost at the time when intends to produce
the product. This could be quite different from the latest historical cost
or standard cost. Thus, in forward decision-making, data regarding
historical or standard cost is useful only as a basis for estimating future
costs.
(ii) They differ between alternatives: As stated above all
future costs are not relevant for decision-making. Only such future
costs are relevant which may be expected to differ between alternatives.
Those costs, which will not change between different alternatives, are
to be ignored. For example a company is considering the substitution of
an automatic process in place of a slow manual process. The material
consumption per unit would be Rs. 2 under both the processes but the
conversion cost would be Rs. 3 per unit under the new process in place
of Rs. 5 under the present process. In this case relevant cost for
decision-making is not the material cost, which will not change, but the
conversion cost, which will change. The cost of material should,
therefore, be ignored. Conversion cost should only be considered. The
proposal for automatic process should therefore be accepted since it will
result in saving of Rs. 2 per unit.
31
Concept of Differential Costs
The term differential cost means difference in cost between
alternatives. It satisfies both the conditions necessary for relevant
costs, i.e., it is a future cost as well as it changes between alternatives.
Mr. J.M. Clark has described the concept of differential costs as follows:
“When a decision has to be made involving an increase or
decrease of n-units of output, the difference in costs between two
policies may be considered to be the cost really incurred on account of
these n units of business, or of any similar units. This may be called the
differential cost of a given amount of business. It represents the cost
that must be incurred if that business is taken and which need not be
incurred if that business is not taken”.
Since the management’s objective is to maximize the profit (or
minimize the loss) of the firm, a comparison is made of differential costs
with differential revenue under the available alternatives, to find out
the most favourable alternative that will give the maximum possible
return of the incremental capital employed in the business.
16.10 STEPS IN DECISION-MAKING
Rational decision-making requires the taking of the following
steps:
1. Defining the problem: The problem must be clearly and
precisely defined so that quantitative amounts that are relevant to its
solution can be determined.
32
2. Identifying alternatives: The possible alternative
solutions to the problem should be identified. Sometimes consideration
of more alternative solutions may make the matters more complex. In
order to do away with this difficulty, after having identifies all
alternatives, the analysts should eliminate on a judgment basis those
that are clearly unattractive. A detailed analysis of the remaining
alternatives should then be done.
3. Evaluating quantitative factors: Each alternative is
usually associated with a number of advantages (relevant revenues)
and disadvantages (relevant costs). The decision-maker should evaluate
each of the relevant factors in quantitative terms to determine the
largest net advantage.
4. Evaluating qualitative factors: In most cases the
advantages and disadvantages associated with each alternative are
capable of being easily expressed in quantitative terms. However, in
certain cases there may be qualitative factors associated with certain
alternatives, which may not be capable of being expressed easily and
correctly in quantitative terms. Evaluating such qualitative factors
against the quantitative factors depends on the judgment of the
decision-maker. Sometimes on account of a single qualitative factor,
which though cannot be measured exactly and easily in monetary
terms, the decision may just be reverse than what it was generally
expected to be. For example, it is a known fact that many persons can
meet their transportation needs less expensively by using public
conveyances rather than by operating their own automobiles. In spite of
this people own and use their own automobiles for reasons of prestige,
33
convenience, or other factors, which cannot be measured in quantitative
terms.
5. Obtaining additional information: In case the decisionmaker
feels necessary, he may ask for additional information. As a
matter of fact many decisions could be improved by obtaining additional
information and it is usually possible to obtain such information.
6. Selection of an alternative: After having identifying,
evaluating, weighing and obtaining additional information (if
necessary), the decision-maker can select the alternative and act on it.
7. Appraisal of the results: Having implemented his
decision, the decision-maker should also from time to time carry out an
appraisal of the results. This will help him in correcting his mistakes,
revising his targets and making better predictions in the times to come.
In the following pages we shall explain how the above steps/rules
are taken/applied in making decisions relating to each of the following
matters.
(i) Determination of sales mix;
(ii) Exploring new markets;
(iii) Discontinuance of a production line;
(iv) Maker buy decisions;
(v) Equipment replacement decision;
(vi) Investment in asset;
(vii) Change versus status quo;
(viii) Expand or contract.
34
Determination of sales mix
Presuming that fixed costs will remain unaffected decision
regarding sales/production mix decision is taken on the basis of the
contribution per unit of each product. The product which gives the
highest contribution should be given the highest priority and the
product whose contribution is the least, should be given the least
priority. A product giving a negative contribution should be
discontinued or given up unless there are other reasons to continue its
production.
Illustration 16.8: Following information has been made
available from the cost records of United Automobiles Ltd.,
manufacturing spare parts:
Direct materials Per unit
X Rs. 8
Y Rs. 6
Direct wages
X 24 hours @ 25 paise per hour
Y 16 hours @ 25 paise per hour
Variable overheads 150% of direct wages
Fixed overheads (total) Rs. 750
Selling price
X Rs. 25
Y Rs. 20
The directors want to be acquainted with the desirability of
adopting any one of the following alternative sales mixes in the budget
for the next period.
35
(a) 250 units of X and 250 units of Y.
(b) 400 units of Y only.
(c) 400 units of X and 100 units of Y.
(d) 150 units of X and 350 units of Y.
State which of the alternative sales mixes you would recommend
to the management.
Solution:
MARGINAL COST STATEMENT (PER UNIT)
Products
XY
Direct materials 8 6
Direct wages 6 4
Variable overheads 9 6
Marginal cost 23 16
Contribution 2 4
Selling price 25 20
Selection of sales alternative
(a) 250 units of X and 250 units of Y
Contribution:
Product X 250 units × 2 Rs. 500
Product Y 250 units × 4 1000
1500
Less: Fixed overheads 750
Profit 750
(b) 400 units of product Y only
36
Contribution 400 × 4 Rs. 1600
Profit 850
(c) 400 units of X and 100 units of Y
Contribution:
Product X 400 × 2 Rs. 800
Product Y 100 × 4 400
1200
Profit 450
(d) 150 units of X and 350 units of Y
Contribution:
Product X 150 × 2 Rs. 300
Product Y 350 × 4 1400
1750
Profit 950
The alternative (d) is most profitable since it gives the maximum
profit of Rs. 950.
Exploring new markets
Decision regarding selling goods in a new market (whether Indian
or foreign) should be taken after considering the following factors:
(i) Whether the firm has surplus capacity to meet the new
demand?
37
(ii) What price is being offered by the new market? In any case,
it should be higher than the variable cost of the product
plus any additional expenditure to be incurred to meet the
specific requirements of the new market.
(iii) Whether the sale of goods in the new market will affect the
present market for the goods? It is particularly true in case
of sale of goods in a foreign market at a price lower than the
domestic market price. Before accepting such an order from
a foreign buyer, must be seen that the goods sold are not
dumped in the domestic market itself.
Illustration 16.9: A company annually manufactures 10000
units of a product at a cost of Rs. 4 per unit and there is home market
for consuming the entire volume of production at the sale price of Rs.
4.25 per unit. In the year 2005, there is a fall in the demand for home
market, which can consume 10000 units only at a sale price of Rs. 3.72
per unit. The analysis of the cost per 10000 units is:
Materials Rs. 15,000
Wages 11,000
Fixed overheads 8,000
Variable overheads 6,000
The foreign market is explored and it is found that this market
can consume 20,000 units of the product if offered at a sale price of
Rs. 3.55 per unit. It is also discovered that for additional 10,000 units of
the product (over initial 10,000 units) the fixed overheads will increase
by 10 per unit. It is worthwhile to try to capture the foreign market?
38
Solution: Statement showing the advisability of selling goods in
Foreign Market
Home market 10000 units
Home market
Year 2004 Year 2005
Foreign
market
20000 units
Total 30000
units
Material 15000 15000 30000 45000
Wages 11000 11000 22000 33000
Overheads:
Fixed 8000 8000 1600 9600
Variable 6000 6000 12000 18000
Total cost 40000 40000 65600 105600
Profit 2500 2800 5400 2600
Sales 42500 37200 71000 108200
From the above it is clear that it is advisable to sell goods in the
foreign market. It will compensate not only for the loss on account of
sale in domestic market but will also result in an overall profit of Rs.
2600.
Discontinuance of a product line
The following factors should be considered before taking a
decision about the discontinuance of a product line:
(i) The contribution given by the product. The contribution is
different from profit. Profit is arrived at after deducting
fixed cost from contribution. Fixed costs are apportioned
over different products on some reasonable basis, which
may not be very much correct. Hence contribution gives a
39
better idea about the profitability of a product as compared
to profit.
(ii) The capacity utilization, i.e., whether the firm is working to
full capacity or below normal capacity. In case a firm is
having idle capacity, the production of any product, which
can contribute towards the recovery of fixed costs, can be
justified.
(iii) The availability of product to replace the product, which the
firm wants to discontinue, and which is already accounting
for a significant proportion of total capacity.
(iv) The long-term prospects in the market for the product.
(v) The effect on sale of other products. In some cases the
discontinuance of one product may result in heavy decline
in sales of other products affecting the overall profitability
of the firm.
Illustration 16.10: A manufacturer is thinking whether he
should drop one item from his product line and replace it with another.
Below are given his present cost and output data:
Product Price Variable cost
per unit
Percentage of
sales
Book shelves 60 40 30%
Tables 100 60 20%
Beds 200 120 50%
40
Total fixed costs per year Rs. 750000
Sales last year Rs. 2500000
The change under consideration consists in dropping the line of
tables in favour of cabinets. If this dropping and change is made the
manufacture forecasts the following cost and output data:
Product Price Variable cost
per unit
Percentage of
sales
Book shelves 60 40 50%
Tables 100 60 10%
Beds 200 120 40%
Total fixed costs per year Rs. 750000
Sales last year Rs. 2600000
Solution: Comparative profit statement
Existing situation Proposed situation
Book
shelves
-
ss
Table Beds Total Bookshelves
Table Beds Total
750000 500000 1250000 2500000 1300000 260000 1040000 2500000
Less variable
costs
500000 300000 750000 1550000 866667 97500 624000 1588166
250000 200000 500000 950000 433333 162500 416000 1011833
Less: Fixed Cost 7,50,000 7,50,000
2,00,000 2,61,833
The above analysis shows that the manufacturer will stand to
gain in case he drops the production of tables in preference to cabinets.
However, the demand for cabinets should be of a permanent nature.
Working Notes
Existing situation: Computation of sales and variable costs
41
Sales Variable costs
Book-shelves 25,00,000 ×
100
36
7,50,000 ×
60
40
= Rs. 7,50,000 = Rs. 5,00,000
Tables 25,00,000 ×
200
20
5,00,000 ×
100
60
= Rs. 5,00,000 = Rs. 3,00,000
Beds 25,00,000 ×
100
50
12,50,000 ×
200
120
= Rs. 12,50,000 = Rs. 7,50,000
Proposed situation: Computation of sales and variable costs
Sales Variable costs
Book-shelves 26,00,000 ×
100
10
13,00,000 ×
60
40
= Rs. 13,00,000 = Rs. 8,66,667
Cabinets 26,00,000 ×
100
10
26,00,000 ×
160
60
= Rs. 2,60,000 = Rs. 97,500
Beds 26,00,000 ×
100
40
12,50,000 ×
200
120
= Rs. 10,40,000 = Rs. 6,24,000
Make or Buy Decision
A firm may be manufacturing a product by itself. It may receive
an offer from an outside supplier to supply that product. Comparing the
price that has to be paid will make the decision in such a case and the
saving that can be effected on cost. The saving will be only terms of
marginal cost of the product since generally no savings can be affected
in fixed costs.
42
Similarly, a firm may be buying a product from outside, it may be
considering to manufacture that product in the firm itself. Comparing
the price being paid to outsiders and all additional costs that will have
to be incurred for manufacturing the product will make the decision in
such a case. Such additional costs will comprise not only direct
materials and direct labour but also salaries of additional supervisors
engaged, rent for premises if required and interest on additional capital
employed. Besides that the firm must also take into account the fact
that the firm will be losing the opportunity of using surplus capacity for
any other purpose in case it decides to manufacture the product by
itself.
In case a firm decides to get a product manufactured from
outside, besides the savings in cost, it must also take into account the
following factors:
(i) Whether the outside supplier would be in a position to
maintain quality of the product?
(ii) Whether the supplier would be regular in his supplies?
(iii) Whether the supplier is reliable? In other words, he is
financially and technically sound.
In case the answer in “No” to any to these questions it will not be
advisable for the firm to buy the product from outside.
Illustration 16.11 The Managing Director of A Pvt. Ltd., asks
for our assistance in arriving at a decision as to whether to continue
manufacturing a component ‘X’ or to buy it from an outside supplier. The
43
component ‘X’ is used in the finished products of the company. The
following data are supplied:
1. The annual requirement of component ‘X’ is 10,000 units. The
lowest quotation from an outside supplier is Rs.8.00 per unit.
2. The component ‘X’ is manufactured in the machine shop. If
the component ‘X’ is bought out, certain machinery will be
sold at its book value and the residual capacity of the machine
shop will remain idle.
3. The total expenses of the Machine Shop for the year ending
31.3.2005 are as follows:
During that year the Machine shop manufactured 10,000 units of’
X’: Material
Rs.1,35,000
Direct Labour 1,00,000
Indirect Labour 40,000
Power and Fuel 6,000
Repairs and Maintenance 11,000
Rate, laxes and Insurance 16,000
Depreciation 20,000
Other Overhead Expenses 29,600
4. The following expenses of the Machine Shop apply to
manufacturing of component ‘X’:
Material Rs. 35,000
Direct labour 56,000
44
Power and Fuel 600
The sale of machinery used for the manufacture of
component ‘X’ would reduce:
Depreciation by Rs. 4000
And Insurance by Rs. 2000
5. If the component ‘X’ were bought out, the following
additional expenses would be incurred:
Freight Rs. 1.00 per unit
Inspection Rs. 10,000 per annum.
You are required to prepare a report to the Managing Director
showing the comparison of expenses of Machine Shop (I) when the
component ‘X’ is made, and (II) when bought out.
Solution: Comparative statement of cost
To make
Component ‘X’
(Rs.)
To buy
Component ‘X’
(Rs.)
Material 35,000
Direct Labour 56,000
45
Power and Fuel 600
Depreciation 4,000
Insurance 2,000
Total variable cost 1,10,600
Variable cost per unit 11.06
Purchase price per unit 8.00
Freight charge per unit 1.00
Inspection charge per unit 1.00
Cost per unit 11.06 10.00
It is preferable to buy component ‘X’ than to make it in the shop,
because the variable cost per unit is less by Rs.I.06. Only variable cost
is to be considered, since fixed costs would remain the same under both
the circumstances. Even if the production of component ‘X’ is
discontinued, fixed cost cannot be saved. Moreover, the capacity, which
would remain idle on account of buying this component from the
market, can be utilized for some other purpose in the near future.
Equipment Replacement Decision
While deciding about replacement of capital equipment, the firm
should take into consideration the resultant savings in operating costs
and the incremental investment in the new equipment. In case the
savings is more than the cost of raising additional funds for the new
equipment, the proposal may be accepted. Besides this the firm must
take into account the benefits the firm is likely to derive in the long run
by replacing old and obsolete equipment. The underpreciated book
value of the old equipment should be taken as irrelevant cost for this
46
purpose. Many accountants disapprove replacement of obsolete
equipment by a new one by pointing out ‘loss on disposal of old assets’.
Such a tendency is unfortunate since the past costs are sunk costs and
they should not be allowed to affect adversely the future decisions and
firm’s goal of maximizing long-term profits.
The items of differential costs and benefits to be considered while
deciding about the replacement of capital equipment call brief1y be
enumerated as follows:
Terms of differential costs
(i) Capital equipment and associated costs, viz., interest,
deprecation, etc.
(ii) Loss on sale of old equipment.
(iii) Increase in fixed overhead costs.
Items of differential benefits
(i) Saving in operating costs.
(ii) Increased volume and value of production.
(iii) Realizable value of old machine.
(iv) Tax benefits, if any.
Illustration 16.12: A company purchased a machine two years
ago at a cost of Rs.60,000. The equipment has no salvage value at the
end of its six years useful life and the company is charging depreciation
according to straight line method. The company learns that new
equipment can be purchased at a cost of Rs. 80,000 to do the same job
and having an expected economic life of 4 years without any salvage
value. The advantage of the new machine lies in its greater operating
47
efficiency, which will reduce the variable operating expenses from the
present level of Rs. l,65,000 to Rs. 1,30,000 per annum. The sales
volume is expected to continue at Rs. 2 lacs per annum for the next four
years.
You are required to evaluate the usefulness of the proposals.
Solution: A natural tendency on the part of most of the
accountants and the managers is to reject the proposal on the ground
that the present machine is functioning well and is expected to render
useful service for another four years. Its scrapping at the present time
would result in a loss of Rs.40,000- the underpreciated book value.
This is not really the correct approach. The book value of the old
machine is irrelevant while taking the decision for its replacement. It
represents a cost incurred as a result of the decision made two years
ago. The depreciation expenses merely reflect apportionment of that
past cost over the fiscal periods, whose income benefits from the use of
the asset. The book value of the old asset should, therefore, be
eliminated as a factor while deciding whether to buy or not to buy the
machine. Moreover, from the accounting point of view an immediate
write-off of Rs. 40,000 or as depreciation of Rs. 10,000 per annum for
four years, results in no difference in total cost and product’s profits for
the next 4 years when taken as a whole. The following table analyses
the profitability or otherwise of the new machine.
STATEMENT SHOWING THE PROFITABILITY OF THE PRESENT
AND THE NEW MACHINE OVER A PERIOD OF 4 YEARS
48
Present
Machine
(Rs.)
New
Machine
(Rs.)
Increase
(Decrease)
in costs (Rs.)
1. Sales 8,00,000 8,00,000
2. Variable cost 6,60,000 5,20,000 (1,40,000)
3. Loss on account of writing
off the old machine
40,000 40,000
4. Depreciation of new
machine
80,000 80,000
Total costs 7,00,000 6,40,000 60,000
Net Profits 1,00,000 1,60,000 60,000
Average annual incremental income Rs. 15,000
Incremental investment Rs. 80,000
Return on incremental investment Rs. 18.75%
The above data is an indicator of the fact that there will be
18.75% return on additional investment of Rs. 80,000/-. The return
seems to be quite reasonable and, therefore, it will be appropriate for
the company to go in for the replacement of the present machine by a
new machine.
16.11 SUMMARY
Marginal costing which is otherwise known as variable costing is
used as a tool for decision-making by the management. Marginal
costing is also known as direct costing and this new concept is gaining
wide popularity in the field of accounting. Marginal costing is a
technique through which variable costs are taken into account for the
purpose of product costing, inventory valuation and other important
49
management decisions. The fixed cost, variable costs, contribution, key
factor, profit volume ratio and break-even analysis are quite important
concepts in marginal costing.
Break-even analysis is one of the important tools in marginal
costing with the help of which we calculate the operating profits at a
given sales volume, sales volume at a desired level of profit, effects of
fixed cost and variable costs for the purpose of financial analysis of a
company/organization.
In decision-making analysis, we may make various types of
decisions with the help of marginal costing. These decisions mainly
include -Determination of sates mix; Exploring new markets,
Discontinuance of a production line, Make or buy decisions, Equipment
replacement decision, Investment in asset, Change versus status quo
and Expand or contract. Such a large number of decisions reveal the
vital significance of marginal costing with reference to break-even
analysis and decision-making alternative choices.
16.12 KEYWORDS
Marginal Cost: The cost incurred in producing an additional unit of
product is known as marginal cost.
Marginal costing: It is a technique of ascertaining cost of production
of goods or services manufactured.
Semi-variable cost: It is defined as a cost containing both fixed and
variable elements.
50
Break-even point: The point, which breaks the total cost and the
selling price evenly to show the level of output or sales at which there
shall be neither profit nor loss, is regarded as break-even point.
Differential cost: Differential cost means difference in cost between
alternatives.
1. Discuss the importance of marginal costing for managerial
decision-making. State briefly the difference between
contribution and profit volume ratio.
2. “Marginal costing is the presentation of accounting
information in such a way as to assist the management in
the creation of policy and in day to day operation of the
undertaking”. Elucidate.
3. Explain the tools of marginal costing. Discuss the methods of
segregating the fixed and variable costs.
4. How does marginal costing help in decision-making? Discuss
the different kind of decisions made through marginal costing.
Give suitable examples.
5. Write short notes on the following:
a) Break-even analysis
b) Key factor.
c) Differential costing.
6. By taking some imaginary figures, calculate contribution, key
factor, profit volume ratio, break-even point and margin of
safety.
7. Illustrate how decisions are made with help of marginal
costing. Take suitable examples. Give working notes.
51
1. S.N. Mittal, Management and Financial Accounting.
2. Ravi M. Kishore, Advanced Management Accounting.
3. I.M. Pandey, Management Accounting.
4. S.N. Maheshwari, Management Accounting and Financial
Control.
5. Vinayakam, Principles of Management Accounting.
52
1
Code : CP-104 Updated by: Dr. Mahesh Chand Garg
Lesson : 17
RECONCILIATION OF COST AND FINANCIAL ACCOUNTS
STRUCTURE
17.0 Objective
17.1 Introduction
17.2 Reasons for Disagreement in Profits
17.3 Effect of Various Items of Profit
17.4 Reconciliation Procedure
17.5 Summary
17.6 Keywords
17.0 OBJECTIVE
(a) Identify the reasons for difference in profit/loss between cost and
financial accounts.
(b) Explain the procedure for reconciliation of cost and financial accounts.
17.1 INTRODUCTION
When cost accounts and financial accounts are maintained in two
different sets of books, there will be prepared two Profit and Loss Accounts -
one for costing books and the other for financial books. The profit or loss
shown by costing books may not agree with that shown by financial books.
Such a system is termed as 'Non-Integral System' whereas under the integral
system of accounting, there are no separate cost and financial accounts.
Consequently, the problem of reconciliation does not arise under the integral
system. However, where two sets of accounting systems, namely, financial
2
accounting and cost accounting are being maintained, the profit shown by the
two sets of accounts may not agree with each other. Although both deal with
the same basic transactions like purchases, consumption of materials, wages
and other expenses, the difference of purpose leads to a difference in approach
in a collection, analysis and presentation of data to meet the objective of the
individual system. Financial accounts are concerned with the ascertainment of
profit or loss for the whole operation of the organisation for a relatively long
period, usually a year, without being too much concerned with cost
computation, whereas cost accounts are concerned with the ascertainment of
profit or loss made by manufacturing divisions or products for cost comparison
and preparation and use of a variety of cost statements. The difference in
purpose and approach in cost accounting generally results in a different profit
figure from what is disclosed by the financial accounts and thus arises the
need for the reconciliation of profit figures given by the cost accounts and
financial accounts. The reconciliation of the profit figures of the two sets of
books is necessary due to the following reasons :
1. It helps to identity the reasons for the difference in the profit or loss
shown by cost and financial accounts.
2. It ensures the arithmetical accuracy and reliability of cost accounts.
3. It contributes to the standardisation of policies regarding stock
valuation, depreciation and overheads.
4. Reconciliation helps the management in exercising a more effective
internal control.
17.2 REASONS FOR DISAGREEMENT IN PROFITS
Difference in profit or loss between cost and financial accounts
may arise due to following reasons :
3
1. Items shown only in financial accounts
There are a number of items which are included in financial accounts
but find no place in cost accounts. These may be items of expenditure or
appropriation of profit or items of income. The former reduces the profit while
the latter have the reverse effect. The items may be classified as under :
(a) Pure financial charges : (i) Loss arising from the sale of fixed assets,
(ii) Loss on investments, (iii) Discount on debentures, (iv) Interest on bank
loan, mortgages and debentures, (v) Expenses of the company's share transfer
office.
(b) Appropriation of Profit : (i) Donations and Charities, (ii) Incometax,
(iii) Dividend paid, (iv) Transfers to reserves and sinking funds.
(c) Purely financial incomes : (i) Rent receivable, (ii) Profits on the sale
of fixed assets, (iii) Transfer fees received, (iv) Interest received on bank
deposits, (v) Dividend received.
(d) Writing off intangible and fictitious assets : (i) Goodwill, Patents
and copyrights, (ii) Advertisement, preliminary expenses, organisation
expenses, etc.
2. Items shown only in cost accounts
There are certain items which are included in cost accounts but not in
financial accounts.
(i) Charge in lieu of rent where premises are owned.
(ii) Depreciation on an asset even when the book value of the asset is reduced
to a negligible figure.
(iii) Interest on capital employed in production but upon which no interest is
actually paid (this will be the case when the firm decides to include
interest in the overheads).
4
The above items will reduce the profits in Cost Accounts as
compared to that in Financial Accounts.
3. Estimates and actuals
Since cost accounts are meant to function as a control device it
will be appropriate to adopt estimated costing or preferably standard costing
system while preparing cost accounts. Estimates or standards can be nearer to
the actuals but in most cases they cannot be the same. This necessarily means
that the profit shown by the cost accounts is bound to be different from the
profit shown by the financial accounts.
Following are some of the important items the costs of which
may be different in financial books and costing books :
(a) Direct materials : The estimated or standard cost of the direct materials
purchased or consumed in the production process may be different from the
actual costs. This difference will be due to change in price or quantity or both.
(b) Direct Labour : The estimated or standard cost of direct labour may be
different from the actual costs because of difference in wage rates or hours of
work or both. Sometimes, workers might have to be paid more due to increased
dearness allowance, pay revisions, bonus etc. This will cause difference between
the profits shown by the two sets of books.
(c) Overheads : In cost accounts the recovery of overheads is generally
based on estimates while in financial accounts the actual expenses incurred
are recorded. This results in under or over-recovery of overheads.
The under-recovery or over-recovery of overheads may be carried
forward to the next period or may be charged by a supplementary rate (positive
or negative) or transferred to Costing Profit and Loss Account. In case the
under-recovery or over-recovery of overheads has been carried forward to the
5
next period, the profit as shown by the costing books will be different from
the profit as shown by the financial books. Such variation may be due to over
or under charging of factory, office or selling and distribution overheads.
(d) Depreciation : Different methods of charging depreciation may be
adopted in cost and financial books. In financial books, depreciation may be
charged according to fixed instalment method or diminishing balance method
etc. while in cost accounts machine hour rate or any other method may be
used. This is also an item of overheads and may be one of the reasons of
difference between the overheads charged in financial accounts and overheads
charged in cost accounts.
4. Valuation of stocks
(a) Raw materials : In financial accounts stock of raw materials is valued
at cost or market price, whichever is less, while in cost accounts stock can be
valued on the basis of FIFO or LIFO or any other method . Thus, the figure of
stock may be inflated in cost or financial accounts.
(b) Work-in-progress : Difference may also exist regarding mode of
valuation of work-in-progress. It may be valued at prime cost or factory cost
or cost of production. The most appropriate mode of valuing is at factory cost
in cost accounts. In financial accounts, work-in-progress may be valued after
considering a part of administrative expenses also.
(c) Finished goods : Under financial accounts, stock of finished goods is
valued at cost or market price whichever is lower. In cost accounts, finished
stock is generally valued at total cost of production. If the circumstances
warrant, prime cost or factory cost may also be taken as the basis for valuing
the stock of finished goods.
Thus, mode of valuation of stocks gives rise to different results
6
in the two sets of books. Greater valuation of opening stocks in cost accounts
means less profit as per cost accounts and vice versa. Greater valuation of
closing stocks in cost accounts means more profit as per cost accounts and
vice versa.
5. Abnormal gains and losses
Abnormal gains or losses may completely be excluded from cost
accounts or may be taken to Costing Profit and Loss Account. In financial
accounts such gains and losses are taken to Profit and Loss Account. As such,
in the former case costing profit/loss will differ from financial profit/loss
and adjustment will be required. In the latter case, there will be no difference
on this account between costing profit or loss and financial profit or loss.
Therefore, no adjustment will be required on this account. Examples of such
abnormal gains and losses are abnormal wastage of materials e.g. by theft or
fire etc., cost of abnormal idle time, cost of abnormal idle facilities,
exceptional bad debts, abnormal gain in manufacturing through processes (when
actual production exceeds normal production).
17.3 EFFECT OF VARIOUS ITEMS ON PROFIT
Now, let's examine the effect of various items, discussed above
on the profit figures revealed by cost accounts and financial accounts.
Causes of Differences Effect on Effect on
Profit as per Profit as per
Cost Accounts Financial
Accounts
1. Expenses/Losses included in More Less
financial accounts only
2. Pure Financial Charges More Less
3. Incomes and gains credited Less More
in financial accounts only
7
4. Items shown in Cost accounts only Less More
5. Under-recovery of overheads More Less
in cost accounts
6. Over-recovery of overheads
in cost accounts Less More
7. Stock Valuation :
Higher value of op. stock
and/or lower value of closing
stock in cost books when
compared to financial books Less More
Lower value of op. stock
and/or higher value of closing
stock in cost books when
compared to financial books More Less
8. Depreciation Methods :
Excess depreciation in cost
books when compared to
financial books Less More
Excess depreciation in financial
books More Less
17.4 RECONCILIATION PROCEDURE
Reconciliation of cost and financial accounts is done on the
principle of bank reconciliation statement. One may begin with profit as per
the financial books or cost books and thereafter items causing differences in
profit may be added or deducted depending on the circumstances. After all
such items have been considered, profit as per other books may be arrived at.
8
This reconciliation may be achieved through a mere statement (Reconciliation
Statement) or preparing a Memorandum Reconciliation Account. Both these
approaches are discussed below :
(a) Preparation of Reconciliation Statement
When there is a difference between the profits disclosed by cost
accounts and financial accounts, the following steps shall be taken to prepare
a Reconciliation Statement :
1 Ascertain the various reasons of disagreement (as discussed above)
between the profits disclosed by two sets of books of accounts.
2 If profit as per cost accounts (or loss as per financial accounts) is taken
as the base :
ADD :
(i) Items of income included in financial accounts but not in cost
accounts.
(ii) Items of expenditure (as interest on capital, rent on owned
premises, etc.) included in cost accounts but not in financial
accounts.
(iii) Amounts by which items of expenditure have been shown in excess
in cost accounts as compared to the corresponding entries in
financial accounts.
(iv) Amounts by which items of income have been shown in excess in
financial accounts as compared to the corresponding entries in cost
accounts.
(v) Over-absorption of overheads in cost accounts.
(vi) The amount by which closing stock of inventory is under-valued
in cost accounts.
(vii) The amount by which the opening stock of inventory is over-valued
in cost accounts.
DEDUCT :
(i) Items of income included in cost accounts but not in financial
accounts.
9
(ii) Items of expenditure included in financial accounts but not in
cost accounts.
(iii) Amounts by which item of income have been shown in excess in
cost accounts over the corresponding entries in financial accounts.
(iv) Amounts by which items of expenditure have been shown in excess
in financial accounts over the corresponding entries in cost
accounts.
(v) Under absorption of overheads in cost accounts.
(vi) The amount by which closing stock of inventory is over-valued in
cost accounts.
(vii) The amount by which the opening stock of inventory is undervalued
in cost accounts.
3. After making all the above additions and deductions, the resulting figure
will be profit as per financial accounts.
Note : If profit as per financial accounts (or loss as per cost accounts) is
taken as the base, then items added shall be deducted and items to be deducted
shall be added, i.e., the procedure shall be reversed.
Illustration 1 :
Rs.
Profit as per Cost Accounts 10,000
Works overheads under-recovered in cost accounts 500
Interest on capital included in financial accounts 500
Dividends received 1,000
Rent for owned building charged in cost accounts 300
Profit as per financial books 10,300
There is a difference of Rs. 300 between the profit as shown by
the financial books and the profit as shown by the cost books. A reconciliation
statement can be prepared to reconcile, on the following basis, the profits
shown by two sets of books :
10
(i) Profit as per cost accounts may be taken as the base. In other words, the
profit as shown by the financial books can be found out if suitable adjustments
are made in this figure of profit and after taking it account the above causes of
difference.
(ii) Works overheads have been charged more in financial accounts than those
in cost accounts. This means profit as shown by the financial accounts is less
than the profit as shown by the cost accounts by Rs. 500 (the amount of
underrecovery).
Since profit as per cost accounts has been taken as the base, the
amount of Rs. 500 should be subtracted from this base profit to arrive at the
profit as shown by the financial accounts.
(iii) The inclusion of interest on capital as an expense has resulted in decrease
in profits as shown by financial books. In other words, the profit as shown by
the cost books is more than the profit as shown by the financial books by Rs.
500 (the amount of interest). The amount should, therefore, the subtracted
from the base profit.
(iv) Dividend received has been credited in financial books. This means the
profit as shown by the financial books is more than the profit as shown by the
cost books by Rs. 1,000. The amount should, therefore, be added to the profit
as shown by the cost books.
(v) No charge is made in financial books for rent on owned buildings. The
amount has however been charged in the cost books. It means the profit as
shown by the financial books is higher than the profit as shown by the cost
books by this amount. The amount, therefore, should be added to the profit.
The reconciliation statement may now be conveniently presented
in the following form :
11
Reconciliation Statement
Particulars + –
Rs. Rs.
Profit as per Cost Accounts 10,000
Less : Works overheads under charged in cost accounts 500
Interest on Capital included in financial accounts 500
Add : Dividends received 1,000
Rent on owned buildings 300
11,300 1,000
Profit as per Financial Accounts 10,300
In case, in the above example, the cost accounts show a loss of
Rs. 10,000, in place of a profit, the amount of loss should be put in the 'minus'
column. The reconciliation statement should then be prepared on the same
pattern as if there is a profit in place of there being a loss.
Illustration 2: From the information given below prepare (i) a statement
showing costing profit or loss : and (ii) another statement reconciling the
costing profits with those shown by financial accounts :
Trading and Profit and Loss Account for the year ended 31 Dec. 2001
Rs. Rs.
To Materials consumed 1,00,000 By Sales (1,00,000 units) 2,00,000
To Direct wages 50,000
To Indirect factory expenses 30,000
To Office expenses 9,000
To Selling & dist. expenses 6,000
To Net profit 5,000
2,00,000 2,00,000
12
The normal output of the factory is 1,50,000 units. Factory
expenses of a fixed nature are Rs. 18,000. Office expenses are for all practical
purposes constant. Selling and distribution expenses are constant to the extent
of Rs. 3,000 and the balance varies with sales.
Solution :
(i) Statement of Cost and Profit
(as per cost Accounts)
Normal Production 1,50,000 units/Actual Production 1,00,000 units
Rs.
Material consumed 1,00,000
Direct wages 50,000
Prime Cost 1,50,000
Works overheads (1)
Fixed Rs. 12,000
Variable Rs. 12,000 24,000
Works Cost 1,74,000
Office overheads (2) 6,000
Cost of Production 1,80,000
Selling and distribution Overheads (3)
Fixed Rs. 2,000
Variable Rs. 3,000 5,000
Cost of Sales 1,85,000
Profit 15,000
Sales 2,00,000
(ii) Reconciliation Statement
Rs. Rs.
Profits as per Cost Accounts 15,000
Less : Under-recovery of works overheads in Cost Accounts 6,000
Under-recovery of office expenses in Cost Accounts 3,000
Under-recovery of Selling and distribution
expenses is cost Accounts 1,000 10,000
13
Working Notes :
(1) Factory Overhead : Total factory overhead are Rs. 30,000 comprising
of Rs. 18,000 fixed and Rs. 12,000 variable overhead. The normal output of
the factory is 1,50,000 units whereas actual output is 1,00,000 units. Thus the
fixed overhead will be proportionately charged for actual output which is
computed as follows :
× 18000 = Rs. 12,000 Fixed Overhead
Variable overheads of Rs. 12,000 are for actual output and thus
will be charged as such.
(2) Office overhead : These are completely fixed charges and thus will be
proportionally charged for actual output. It is computed as follows :
× 9,000 = Rs. 6,000
(3) Selling and Distribution Overhead : Fixed portion of these will be
proportionally charged. It is computed as follows :
× 3,000 = Rs. 2,000
(b) Preparation of Memorandum Reconciliation Account
This reconciliation procedure is in the form of account. The debit
side (Dr.) of the Memorandum Reconciliation Account shows items to be
deducted from the profit as per any set of books taken as a starting point. The
credit side of the this account shows profit figure accepted as a starting point
as well as items to be added to this profit figure. The difference between the
credit side and debit side will give profit as per the other set of books. A
proforma of Memorandum Reconciliation Account is shown as follows:
1,00,000
1,50,000
1,00,000
1,50,000
1,00,000
1,50,000
14
Memorandum Reconciliation Account
Dr. Cr.
To Financial Expenses Rs. By Profit as per Cost Accounts Rs.
Discount By Financial Income
Bank interest Rent
Donations Interest
Underwriter's commission Transfer fees
Fine & penalties Profit on sale of investments
Loss on sale of assets
Goodwill written off By items charged in Cost Accounts
To under-absorption of overheads Rent of own Building
To under-valuation of opening Interest on Capital
By over-absorption of overheads
To Over-valuation of closing By over-valuation of opening
Stock in Cost Accounts Stock in Cost Accounts
To Profit as per Financial By under valuation of closing
Accounts Stock Cost Accounts
Illustration 3 : The following is a summary of the Trading and Profit and
Loss Account of Messers Nikhil Manufacturing Co. Ltd., for the year ended
31st December, 2001;
Dr. Cr.
Rs. Rs.
To Materials Consumed 27,40,000 By Sales
To wages 15,10,000 (1,20,000 units) 60,00,000
To Factory Expenses 8,30,000 By Finished stock
To Administration Expenses 3,82,400 (4,000 units) 1,60,000
To Selling and Distribution By Work-in-progress :
To Expenses 4,50,000 Materials 64,000
To Preliminary Expenses Wages 36,000
(Written off) 40,000 Factory
To Goodwill (written off) 20,000
To Net Profit 3,25,600 By Dividends Received 18,000
62,98,000 62,98,000
Stock in Cost Accounts
Expenses 20,000 1,20,000
15
The company manufactures a standard unit. In the Cost Accounts :
(i) Factory expenses have been recovered from production at 20 per cent
on prime cost ;
(ii) Administration expenses at Rs. 3 per unit on units produced ;
(iii) Selling and distribution expenses at Rs. 4 per unit on units sold.
You are required to prepare a statement of cost and profit in cost
books of the company and to reconcile the profit disclosed with that shown in
the Financial Accounts.
Solution :
Rs. Rs.
Materials 27,40,000
Labour 15,10,000
Prime Cost 42,50,000
Factory Expenses applied (20% of Prime Cost) 8,50,000 51,00,000
Less : Closing work-in-progress 1,20,000
Works Cost 49,80,000
Add : Administration Expenses (1,20,000+4,000)×Rs.3 3,72,000
Cost of Production 53,52,000
Less : Cost of Closing Finished Stock
units (i.e., 1/3) of Rs. 53,52,000) 1,72,645
Cost of Goods sold 51,79,355
Add : Selling & Distribution Expenses (1,20,000×Rs.4) 4,80,000
56,59,355
Profit as per Cost Accounts 3,40,645
Sales (1,20,000×50) 60,00,000
4,000
1,24,000 (
16
Rs. Rs.
Profit as per costing books 3,40,645
Add : Over-recovery of selling expenses
(Rs. 4,80,000-4,50,000) 30,000
Over-recovery of factory expenses
(Rs. 8,50,000-8,30,000) 20,000
Dividend received 18,000 68,000
Less : Under-recovery of Administration Expenses 4,08,645
(Rs. 3,82,400-3,72,000) 10,400
Preliminary expenses written off 40,000
Goodwill written off 20,000
Difference in valuation of finished stock 12,645 83,045
Profit as per Financial Accounts 3,25,600
Illustration 4 : The following figures are extracted from the financial
accounts of a manufacturing firm for the first year of its operation :
Rs.
Direct material consumption 50,00,000
Direct wages 30,00,000
Factory overheads 16,00,000
Administration overheads 7,00,000
Selling and Distribution overheads 9,60,000
Bad debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000
Dividends received 1,00,000
Interest on Deposit received 20,000
Sales - 1,20,000 units 1,20,000
Closing stock :
Finished stock 4,000 units 3,20,000
Work-in-progress 2,40,000
17
The cost accounts for the same period reveal that the direct
material consumption was Rs. 56,00,000; Factory overhead is recovered at
20% on Prime Cost; Administration overhead is recovered @ Rs. 6 per unit of
production; Selling and Distribution overheads are recovered @ Rs. 8 per unit
sold.
You are required to prepare Costing and Financial Profit and Loss
Accounts and reconcile the difference in the profits as arrived at in the two
sets of accounts
Solution :
Costing Profit and Loss Account
Direct Materials 56,00,000
Direct Wages 30,00,000
Prime cost 86,00,000
Factory overhead 20% on Prime cost 17,20,000
1,03,20,000
Less Work-in-progress (Closing stock) 2,40,000
Works Cost 1,00,80,000
Administration overhead Rs. 6 per unit
of production : 1,20,000 + 4,000 7,44,000
Cost of Production 1,08,24,000
Less Closing stock ×4,000 3,49,161
1,04,74,839
Add Selling and distribution expenses @ Rs. 8
per unit i.e. 1,20,000×8 9,60,000
Cost of Goods sold 1,14,34,839
Profit 5,65,161
Sales 1,20,00,000
1,08,24,000
1,24,000
18
Financial Profit and Loss Account
Rs. Rs.
To Direct Materials 50,00,000 By Sales 1,20,00,000
To Direct Wages 30,00,000 By Closing stock :
To Factory Overheads 16,00,000 Finished Stock 3,20,000
To Gross Profit 29,60,000 WIP 2,40,000
1,25,60,000 1,25,60,000
To Administration By Gross Profit 29,60,000
Overheads 7,00,000 By Dividends 1,00,000
To Selling and Distribution 9,60,000 By Interest 20,000
To Bad debts 80,000
To Preliminary Expenses 40,000
To Legal Charges 10,000
To Net Profit 12,90,000
30,80,000 30,80,000
Rs. Rs.
Profit as per cost accounts 5,65,161
Add : Dividend not taken in costing 1,00,000
Interest not taken in costing 20,000
Excess of Direct materials consumed 6,00,000
Over-absorbed in Costing :
(a) Factory overheads 1,20,000
(b) Administration overheads 44,000 8,84,000
14,49,161
Less : Bad Debts taken in Financial
Accounts but not in costing 80,000
Preliminary expenses taken in Financial
Accounting, but not in costing 40,000
Legal charges taken in financial but not in costing 10,000
Different in closing stock
(3,49,161-3,20,000) 29,161 1,59,161
Profit as per Financial Accounts 12,90,000
19
Illustration 5 :
The Manufacturing, Trading, Profit and Loss and Profit and Loss
Appropriation Account of Jyoti Ltd. for the year ending December 31 are as
follows :
To Raw Materials : By Trading Account
Opening Stock 27,458 Cost of goods manufactured
Purchases 1,34,762 transferred 3,18,466
1,62,220
Less : Closing Stock 29,326 1,32,894
To Wages - direct 1,12,378
Prime Cost 2,45,272
Production overhead :
Power 23,246
Wages - Indirect 31,351
Rent and rates 10,724
Heating and lighting 2,841
Depreciation 6,015
Expenses 1,020 75,197
Gross Works Cost 3,20,469
Deduct Works-in-Progress :
Closing Stock 21,382
Less Opening stock 19,379 2,003
3,18,466 3,18,466
To Finished goods By Sales 5,00,000
Opening Stock 20,642
Goods manufactured 3,18,466
3,39,108
Less : Closing Stock 22,435 3,16,673
To Gross Profit c/d 1,83,327
5,00,000 5,00,000
20
To Office salaries 35,642 By Gross profit b/d 1,83,327
To Office expenses 20,326 By Dividend received 300
To Salesmen's salaries 18,421 By Interest on bank deposit 50
To Selling expenses 15,263
To Distribution expenses 13,248
To Loss on sale of plant 1,250
To Fines 200
To Interest on mortgage 150
To Net profit for the year 79,177
1,83,677 1,83,677
To Taxation 25,000 By Balance b/d 35,246
To General Reserve 10,000 By Net Profit for the year 79,177
To Equity Share dividend 20,000
To Preference share dividend 10,000
To Goodwill written off 4,000
To Balance c/d 45,423
1,14,423 1,14,423
The cost accounts revealed a profit of Rs. 1,27,411. In preparing
this figure, stocks had been valued as follows :
Raw materials : Opening stock Rs. 27,342
Closing stock Rs. 29,457
Work-in-Progress : Opening stock Rs. 19,488
Closing stock Rs. 21,296
Selling and distribution expenses had been ignored in the cost
accounts. Prepare a Reconciliation Account.
21
Solution :
Memorandum Reconciliation Account
Items not charged in cost accounts : Profits as per cost accounts 1,27,411
Rs. Rs. Items not credited in cost accounts :
Loss on sale of Plant 1,250 Rs.
Fines 200 Dividend received 300
Interest 150 1,600 Interest 50 350
Salesmen's salaries 18,421
Selling expenses 15,263 Difference in stocks :
Distribution expenses 13,248 46,932 48,532 Work-in-Progress
Difference in stocks : Opening 109
Raw materials Closing 86 195
Opening 116
Closing 131 247
Profit as per financial accounts 79,177
1,27,956 1,27,956
Particulars Rs. Rs.
Profit as per Cost Accounts 1,27,411
Less : Items not charged in cost accounts :
Loss on sale of plant 1,250
Fines 200
Interest 150 1,600
1,25,811
Add: Items not credited in cost accounts :
Dividend received 300
Interest 50 350
1,26,161
Less : Selling and distribution expenses :
Salesmen's salaries 18,421
Selling expenses 15,263
Distribution expenses 13,248 46,932
79,229
22
Add: Difference in stocks :
Work-in-Progress – Opening 109
Closing 86 195
79,424
Less : Difference in stocks :
Raw materials – Opening 116
Closing 131 247
17.5 SUMMARY
In case of Non-Integral system, separate books of accounts are
maintained for costing and financial transaction. Normally under this system
profit shown by the two sets of the books will be different. However, it is
possible per chance, that the overall profit shown by the two sets of the books
is the same. Nonetheless in such a case also the items and/or amounts
incorporated will be different. Hence, the results shown by two sets of books
are always required to be reconciled to identify the causes of difference and
to establish the accuracy of both sets of books. A reconciliation statement is
prepared simply to identify such causes. In case such reconciliation brings out
certain errors or discrepancies, they have to be separately rectified. However,
it is necessary that the classification of income and expenses both for financial
and cost accounts is on the same basis so that it is possible to compile them
on the same lines in both cases.
17.6 KEYWORDS
Non-integral system: When separate books of accounts are maintained for
costing and financial transaction, it is known as non-integral system.
Reconciliation statement: It is a statement prepared to know the reasons for
differences in financial and cost accounts.
23
1. "Reconciliation of Cost and Financial Accounts in the modern computer
age is relevant". Comment.
2. Why is it necessary to reconcile the profit shown by Cost Accounts and
Financial Accounts ? What is the procedure to be adopted for their
reconciliation ?
3. What is the purpose of reconciling Cost and Financial Accounts ?
Indicate the possible reasons for differences between profit shown in
the Cost Accounts and that shown in the Financial Accounts of a concern.
4. "An efficient system of costing will not necessarily produce accounts
which in their results will agree with the financial accounts". Comment
upon the statement.
5. At the end of an accounting period, it is found that the profit as shown
by the Financial Accounts falls considerably short of the profit according
to the Cost Accounts. Indicate how the discrepancy might have arisen.
6. From the following data prepare a reconciliation statement :
Rs.
Profit as per cost accounts 1,45,500
Works overheads under-recovered 9,500
Administrative overheads under-recovered 22,750
Selling overheads over-recovered 19,500
Overvaluation of opening stock in cost accounts 15,000
Overvaluation of closing stock in cost accounts 7,500
24
Interest earned during the year 3,750
Rent received during the year 27,000
Bad debts written off during the year 9,000
Preliminary expenses written of during the year 18,000
7. The financial profit and loss account of Pal Manufacturing Company for
the year ended 31st March 1999 is as follows :
To Materials Consumed 50,000 By Sales 1,24,000
To Carriage inwards 1,000
To Direct Wages 34,000
To Works expenses 12,000
To Administration expenses 4,500
To Selling and distribution 6,500
expenses
To Debenture Interest 1,000
To Net Profit 15,000
1,24,000 1,24,000
The net profit shown by the Cost accounts for the year is Rs.
16,270. Upon a detailed comparison of the two sets of accounts if is found
that :
(a) the amounts charged in the cost accounts in respect of overhead charges
are as follows :
Rs.
Works overhead charges 11,500
Office overhead charges 4,590
Selling and distribution expenses 6,640
25
(b) No Charge has been made in the cost accounts in respect of debenture
interest.
You are required to reconcile the profits shown by the two sets of
accounts.
8. During a particular year, the auditors certified the financial accounts,
showing a profit of Rs. 1,68,000, whereas the same as per costing books
was coming out to be Rs. 2,40,000. Given the following information you
are asked to prepare a reconciliation statement showing clearly the
reasons for the gap :
Dr. Trading and Profit and Loss A/c Cr.
To Opening Stock 8,20,000 By Sales 34,65,000
To Purchase 24,72,000 By Closing Stock 7,50,000
To Direct Wages 2,30,000
To Factory Overheads 2,10,000
To Gross Profit c/d 4,83,000
42,15,000 42,15,000
To Administration Exp. 95,000 By Gross Profit 4,83,000
To Selling Expenses 2,25,000 By Sundry Income 5,000
To Net Profit 1,68,000
4,88,000 4,88,000
The costing records show :
(a) Book value of costing stock Rs. 7,80,000.
(b) Factory overheads have been absorbed to the extent of Rs.
1,89,800
(c) Sundry Income is not considered.
(d) Administrative Expenses are recovered at 3% of selling price.
26
(e) Total absorption of direct wages Rs. 2,46,000.
(f) Selling prices include 5% for selling expenses.
9. Prepare a Memorandum Reconciliation Account from the following
particulars :
Profit shown by cost books Rs. 30,114 and by financial books Rs.
19,760. On reconciling the following information in available :
1) Overhead absorbed in cost books Rs. 7,500 and incurred Rs. 6,932
2) Director's fees not included in cost books Rs. 750.
3) Provision for bad debts Rs. 600.
4) A new work was taken for Rs. 12,000 and depreciation of 5% was
provided for only in the financial books.
5) Transfer fees Rs. 28.
6) Income tax Rs. 9,000
1. Cost Accounting by Jawahar Lal
2. Cost Accounting by Ravi M. Kishore
3. Cost Accounting by V.S.P. Rao
Lesson : 18
OVERHEADS
STRUCTURE
18.0 Objective
18.1 Introduction
18.2 Classifications of Overhead Costs
18.3 Allocation and Apportionment of Factory Overheads
18.4 Apportionment of Service Departments Overheads to
Producing Departments
18.5 Absorption of Factory Overheads
18.6 Depreciation
18.7 Plant Register and Other Fixed Assets Register
18.8 Using Asset after Fully Depreciated
18.9 Research and Development Costs and its Treatment
18.10 Treatment of Development Costs
18.11 Treatment of Special Items of Overheads in Cost Accounts
18.12 Interest on Capital
18.13 Selling and Distribution Overheads
18.14 Summary
18.15 Keywords
18.0 OBJECTIVE
1
(a) Make a classification of overhead costs.
(b) Explain the basis for allocation and apportionment of
overheads.
(c) Discuss the methods of absorption of overheads.
(d) Explain the treatment of special items of overheads in cost
accounts.
18.1 INTRODUCTION
Overheads are the indirect costs which cannot be allocated to any
specific job or process because they are not capable of being identified
with any specific job or process. Overheads include cost of indirect
material, indirect labour, indirect expenses which cannot be
conveniently charged to any job, process, cost unit etc. For example,
costs like rent, rates, administration and supervision, depreciation,
maintenance, selling and distribution expenses, cleaning materials etc.
cannot be directly attributed to cost units produced. The costing
treatment of overheads deals with methods whereby these indirect
expenses can be related to cost units. CIMA defines Overheads Cost as
“the total cost of indirect materials, indirect labour and indirect
expenses”.
The direct expenses refers to expenses that are specifically
incurred and charged for specific or particular job, process, service, cost
unit or cost centre. These expenses are also called chargeable expenses.
The sum of direct material, direct labour and direct expenses is called
prime cost. Sometimes, if the direct expenses are negligible or small
amount, it will be treated as overhead.
2
Direct expenses are directly allocable to a job, process, service,
cost unit or cost centre. It is not possible to allocate the overheads to
jobs etc. and only through apportionment and absorption, it can be
charged to different jobs, process, services, cost units or cost centres.
An expense is whether a direct expense or overhead depend on
the extent of departmentalisation and specific circumstances of a
particular expense. For example, a machine is hired for general
purpose, the hire charges are treated as overhead. But if that machine
is hired or used for specific job, then the hire charges will be direct
charge to that particular job. Another example is that power
consumption is normally treated as direct expense if it is consumed for
single plant or machinery. But if number of machines consume the
power, then power will be treated as overhead and will be apportioned
to the different machine centres on some equitable basis, which have
used power.
18.2 CLASSIFICATIONS OF OVERHEAD COSTS
Overhead costs may be classified according to:
(a) Functions,
(b) Element and
(c) Behaviour.
18.2.1 Classification According to Functions
The main groups of overheads on the basis of this classification
are:
(a) Production overhead,
(b) Administration overhead,
3
(c) Selling overheads,
(d) Distribution overhead.
Production Overhead: Also termed as factory overhead, works
overhead or manufacturing overhead, it means indirect expenditure
incurred in connection with production operations. It is the aggregate of
factory indirect material cost, indirect wages and indirect expenses.
Unlike direct materials and direct labour, production overhead is an
invisible part of the finished product. Examples of these costs are:
lubricants, consumable stores, indirect wages, factory power and light,
depreciation of plant and machinery.
Administration overhead: This consists of all expenses
incurred in the direction, control and administration (including
secretarial, accounting and financial control) of an undertaking which is
not related directly to production, selling and distribution function.
Examples are: general management salaries, audit fees, legal charges,
postage and telephone, stationary and printing, office rent and rates,
office lighting, and salaries of office staff etc.
Selling overhead: These are the cost of seeking to create and
stimulate demand or for scoring orders. Examples are advertising,
salaries and commission of sales personnel, showroom expenses,
travelling expenses, bad debts, catalogues and price lists etc.
Distribution overhead: It comprises all expenditure incurred
from the time product is completed in the factory until it reaches its
destination or customer. It includes: packing cost, carriage outward,
delivery van costs, warehousing costs, etc.
4
Both selling and distribution costs are incurred after the
production work is over and thus taken together, these are known as’
After Production Costs’.
18.2.2 Classification According to Elements
The main classes under this head are: indirect materials, indirect
wages, and indirect expenses.
18.2.3 Classification According to Behaviour
Different overhead costs behave in different ways when volume of
production changes. On the basis of behaviour, overheads may be
classified into: (a) Fixed overhead, (b) variable overhead, and (c) Semifixed
or semi-variable overhead.
Fixed overhead: These overheads remain unaffected or fixed in
total amount by fluctuations in volume of output. Examples are rent
and rates, managerial salaries, building depreciation, legal expenses
etc.
Variable overhead: This is the cost which, in aggregate, tends
to vary in direct proportion to changes in the volume of output. Variable
overhead per unit remain fixed. Examples are indirect materials,
indirect labour, salesmen’s commission, power, light, fuel, etc.
Semi-variable overhead: This overhead is partly fixed and
partly variable. In other words, such costs vary in part with the volume
of production and in part they are constant, whatever be the volume of
production. Examples: supervisory salaries, depreciation, repairs and
maintenance, etc.
5
18.2.4 Importance of Classifying Costs into Fixed and Variable
The fixed-variable cost classification is of great importance in
planning, decision making and control as discussed below:
1. Preparation of budgets: This classification helps in the
preparation of budgets. For instance, when flexible budgets
are prepared for different levels of activity, the fixed cost
remains constant at all levels of activity, whereas variable
cost varies according to the actual level of output.
2. Decision-making: As most problems of decision-making
relate to changes in volume, this classification acquires a
special importance in managerial decision-making. This is
so because fixed and variable costs behave in different ways
when volume of output changes.
3. Control of costs: From control point of view, cost may be
controllable or uncontrollable. The fixed costs are mostly
uncontrollable and if, at all, any control can be exercised, it
can be done by the top management. Variable costs, on the
other hand, are mostly controllable. For example, rent of
building (fixed) is not easily controllable but cost of
materials (variable) may be controlled by purchasing in
economic lots, seasonal purchasing, etc. Classifying costs
into fixed and variable, therefore, helps in the effective
control of costs by painting out where management should
concentrate to control costs.
6
4. Marginal costing and break-even analysis: This
technique is totally depends on segregation of cost into fixed
and variable.
5. Absorption of overhead: By classifying cost into fixed and
variable, separate rates of absorption of overhead may be
used for fixed and variable overheads. The under/over
absorption arising out of two types of overheads are
different in nature and need different managerial action.
For example, under-absorption of fixed overhead means the
existence of surplus or idle capacity so that suitable steps
may be taken to effectively utilise idle capacity.
6. Other uses: In addition to points stated above, fixedvariable
cost classification is useful in many other areas.
For example, while planning capital expenditure, effect of
the proposed project on total fixed and variable costs should
be studied. Moreover, differential and comparative cost
analyses are based on this classification.
18.3 ALLOCATION AND APPORTIONMENT OF FACTORY
OVERHEADS
Departmentalisation of Overhead: Generally, in big business
houses, several departments are involved in the manufacture of the
product or in rendering a service. In such cases, factory overhead costs
should be accumulated department-wise. Departmentalisation of
factory overhead means dividing the company into segments called
departments or cost centres where expenses are incurred. In a
manufacturing concern, there are mainly two types of cost centresproducing
departments and service departments. A production
7
department represents a submit of the company where manufacturing
activity takes place. Some typical examples of producing departments
include assembly, finishing, blending, painting and grinding
departments. Service departments represent cost centres which provide
support for the producing departments. Materials handling, personnel,
plant maintenance, imposition, storage, purchasing, receiving, shipping
medical and other similar activities which are not directly involved in
production are considered to be service activities.
No definite rules can be suggested which can be applicable to all
concerns for departmentalisation. Most commonly, the factory is
divided on the basis of functional activities with in each department
which performs a single activity or group of activities. Dividing the
factory into separate, inter-related and independently governed units is
important for the proper control of factory overhead and the accurate
costing of jobs and products. The following factors must be considered
while deciding the kind of departments or cost centres to be created for
factory overheads collections and cost control purposes:
1. Similarity of operations, processes and machinery.
2. Location of operations, process and machinery.
3. Responsibilities for production and costs incurrence.
4. Number of departments or cost centres.
Advantages: Departmentalisation serves two purposes: (i) closer
control of factory overheads costs, and (ii) more accurate costing of jobs
and products. Closer control is possible because departmentalisation
makes the incurrence of costs in department or cost centre, the
responsibility of someone who heads the department or the cost centre.
8
More accurate costing of jobs and products is possible, if products
are passed through more than one department. A job or product going
through a department is charged with factory overhead for work done
on that product in that department. Therefore, jobs or products are
charged with different amounts of factory overhead depending on the
number of departments through which they pass. This process results
in accurate and reliable cost figures for the products or job.
Primary distribution: Some factory overheads can be directly
identified with a particular department or cost centre as having been
incurred for that cost centre. Examples of such factory overheads are
repairs and maintenance expenses incurred in specific departments,
supervision, indirect labour, overtime, indirect materials and factory
supplies, equipment depreciation.
Expenses such as power, light, rent, depreciating of factory
building, expenses shared by all departments, cannot be charged
directly to a department, be it producing or service. These expenses do
not originate in any specific department. They are incurred for all and
must, therefore, be apportioned or prorated to any or all departments
using such items. Cost apportionment is the process of charging
expenses in an equitable proportion to the various cost centres or
departments. The Institute of Cost and Management Accountant (UK)
defines cost apportionment, “as the allotment of proportions of items of
cost to cost centres or cost units”. The apportionment should be done on
some rational and equitable tasks. In cost accounting this is known as
primary distribution of factory overhead.
9
It would be difficult to give a comprehensive list of the bases of
apportionment, but the following bases are in common use:
1. Floor area occupied- Overheads such as lighting and
heating, rent and rates, depreciation of building, building
repairs, caretaking, watching and patrolling.
2. Capital values- Depreciation on plant and machinery,
insurance on building, and plant and machinery,
maintenance of plant and machinery.
3. Direct labour hours and/or machine hours- Insurance
on jigs, tools and fixtures, power, works management
remuneration, repairs and maintenance cost.
4. Number of workers employed- Canteen, accident
insurance, medical, dental and first aid, pensions,
personnel department expenses, profit sharing payments,
recreation, supervision, time office, wages department.
5. Technical estimate- Fire prevention, oil and grease,
steam, water without meter.
Illustration 1: Hisar Ltd. has gensets and produces its own
power. Data for power costs are as follows:
Production
deptts.
Service
deptts.
Horse power hours
ABCD
Needed capacity production 10,000 20,000 12,000 8,000
Used during the month of May 8,000 13,000 7,000 6,000
10
During the month of May, costs for generating power amounted to
Rs. 9,300; of this Rs. 2,500 was considered to be fixed cost. Service
Deptt. C renders service to A, B and D in the ratio 13:6: 1, while D
renders services to A and B in the ratio 31:3. Given that the direct
labour hours in Deptt. A and B are 1,650 hours and 2,175 hours
respectively, find the power cost per labour hour in each of these two
Deptt.
Solution
HISAR LTD.
OVERHEADS DISTRIBUTION SUMMARY STATEMENT
(Amount in Rs.)
Total Production
Deptts.
Service
Deptts.
Particulars Basis of
charge
ABCD
Fixed Cost H.P. Hours
needed at
capacity
production
(5 : 10 : 6 : 4)
2,500 500 1,000 600 400
Variable Cost H.P. hours
used (8 : 13 :
7 : 6)
6,800 1,600 2,600 1,400 1,200
Total overheads 9,300 2,100 3,600 2,000 1,600
Service Deptt. C
overheads
apportioned to A, B
and D (13 : 6 : 1)
1,300 600 -2,000 100
11
Service Deptt. D
overheads
apportioned to A and
B (31 : 3)
1,550 150 -1,700
Total overheads of
production Deptts.
4,950 4,350 - -
Labour hours worked 1,650 2,175
Power cost per
labour hour
3.00 2.00
18.4 APPORTIONMENT OF SERVICE DEPARTMENTS
OVERHEADS TO
PRODUCING DEPARTMENTS
Secondary Distribution: It is necessary that overhead cost of
service departments (accumulated through direct allocation or primary
distribution) should be further assigned to producing departments. This
is due to the reason that service departments do not themselves
manufacture anything and it is the production department or cost
centres which are involved in manufacturing activities. The
reassignment or reapportionment of service departments overhead to
producing departments or centres is termed as secondary distribution.
Secondary distribution helps in determining the cost of products
or jobs sold and value of inventory. It is useful in determining the effect
of various managerial decisions and actions on the total cost of the
business firm. For example, decisions as to add or to drop a product line
require information about its cost effect, which can be estimated after
secondary distribution has been made. Secondary distribution also
helps subsequently in determining the price of the product or job. In
case of contracts based on cost in place of market price, secondary
12
distribution helps in fixing a selling price which is advantageous to the
parties concerned.
Bases of Secondary Distribution: The general basis for
apportioning service departments’ overheads to producing departments
are the following:
1. Services rendered- This is perhaps the most popular
method of apportioning service department. The services
rendered to different departments, i.e., benefits obtained by
them can be a suitable basis. If a producing department has
received large benefits, it must be charged for a share of
overheads costs incurred to provide that quantity of
benefits. This method is simple and economical.
2. Ability to pay- This method suggests that a large share of
servicing departments overhead costs should be assigned to
those producing departments whose product contributes the
most to the income of a business enterprise.
3. Surveyor analysis- This method is applied where a
suitable base is difficult to find or it would be too costly to
select a method which is considered suitable. For example,
the postage cost could be apportioned on a survey of postage
used during a year.
4. Efficiency or incentives- This method uses standards
and budgets and apportions the overhead costs on the basis
of a present budget or standard.
13
In selecting a suitable base for apportioning service department
overheads, considerations should be given to practicability, simplicity,
economy, theoretical soundness and assistance in accurate costing and
cost control.
Inter-departmental Services: While depreciation service
departments overheads, one may notice two situations: (i) The entire
amount of a servicing department is to be distributed to only the
producing departments. This does not involve any practical difficulty
and provides the simplest and quickest method for apportioning costs of
the servicing department (ii) Services provided by some servicing
departments are used partly by other servicing department. That is,
many service department serve each other. For example, the payroll
department in a firm prepares payroll for the entire organisation, but it
depends on the building maintenance department for repair and
maintenance services.
Illustration 2: The overhead of a manufacturing company has
been analysed to the point of primary distribution:
Rs.
Production departments: Machine
Assembly
Service departments Canteen
Powerhouse
10,000
4,000
2,000
3,000
The canteen is to be apportioned on the basis employees:
Employees %
Machine 240 60
Assembly 140 35
14
Powerhouse 20 5
400 100
The powerhouse is to be apportioned on the basis of electricity
used:
Thousand Kilowatts %
Machine 270 75
Assembly 36 10
Canteen 54 15
360 100
Solution: The apportionment would be done in the following
manner:
Machine Assembly Canteen Powerhouse
Primary apportionment 10,000 4,000 2,000 3,000
Apportion: Canteen 1,200 700 -2,000 100
Powerhouse 2,325 310 465 -3,100
Canteen 279 163 -465 23
Powerhouse 18 2 3 -23
Canteen 2 1 -3
Total Service Deptts. 4 1176
Total Production Overhead 13824 5176
18.5 ABSORPTION OF FACTORY OVERHEADS
Absorption of factory overheads refers to charging of the factory
overheads of a particular production department to various products
manufactured, or jobs completed, or orders executed in that
department. The methods for absorption of these overheads may be put
into two categories:
(i) Percentage methods
15
(ii) Hourly rate methods.
Choice of a particular method depends on the circumstances of
each individual case. As such the method of absorption may differ from
industry to industry, and from company to company also. As far as
possible, the method applied should be equitable so that the absorbed
overheads are not in much difference with the actual overheads.
Otherwise it will lead to excessive under or over absorption, simply
because of the adoption of a particular method.
Percentage methods
1. Direct material cost method: In this method the cost of
direct materials used in the manufacture of a product is
used as the basis for allocation of factory overheads. The
overhead rate is therefore, calculated on the basis of the
following formula:
Factory overhead rate=
used materials direct of Cost
overheads factory of Amount
× 100
This method may give satisfactory results in the following
circumstances:
(i) Where the amount of overheads is insignificant in relation
to cost of materials and wages and, therefore, a simple
method of allocation is desired.
(ii) Where output is uniform, i.e., one kind of article is
produced.
(iii) Where the prices of materials do not fluctuate quite widely
and frequently.
16
The method will not give satisfactory results except in the above
cases on account of the following reasons:
(i) Except a few items, factory overheads do not vary with
variations in the value of material. Normal wastage of materials or coal
or other sundry small stores used in manufacture naturally varies with
the value of materials used, otherwise other important items such as
works manager’s salary, factory rent, rates, insurance, lighting etc. do
not vary with every change in the value of materials. Consider the
following example:
The following were the constituents of cost of Product X in 2005
Rs.
Direct Material 25,000
Direct Labour 10,000
Factory Rent & Rates 5,000
Factory Manager’s Salary 15,000
Other Factory Expenses 1,000
Office Overheads 2,500
45,500
The factory overhead rate based on materials comes to:
25000
7500
× 100 = 30%
Suppose in 2006 the value of materials used in doubled on
account of doubling of the price level. If the factory overheads are
charged @ 30% on materials, it will result in excessive over-absorption
of works overheads, because most of the factory overheads are fixed.
17
(ii) This method will result in greater recovery of factory
overheads from those cost units which use superior quality of materials
in comparison to those which use materials of inferior quality. This
seems very illogical because actually reverse should have been the case.
(iii) This method does not make any distinction between jobs
done by skilled and unskilled workers, because works overheads not
only depend upon materials used but also on the type of workers
employed. Similarly it does not distinguish between manual and
machine work.
2. Direct labour cost method: The cost of direct labour
incurred in the manufacture of the product is used as a base for
allocation of factory overheads in this method. The formula for
calculating the factory overhead rate based on labour can be put as
follows:
Factory Overhead Rate =
labour direct of Cost
× 100
Merits: This method has the following advantages:
1. Factory overheads to a great extent depend upon the
number of workers employed and the rate of direct wages.
This method, therefore, gives satisfactory results in most
cases.
2. The method is widely adopted on account of its similarity
and of accuracy.
3. Direct wages normally do not fluctuate much. Therefore,
this method gives stable results.
Demerits: It has the following disadvantages:
18
1. The method is not suitable where both skilled and unskilled
workers are employed. As a matter of fact the amount of works
overheads is less for skilled workers in comparison to the unskilled
workers and, therefore, jobs done by the unskilled workers should be
charged with greater amount of factory overheads, but reverse happens
in case of this method.
2. Works overheads also depend upon time. The method
therefore, does not give satisfactory results where the workers are
remunerated on piece wage system.
3. Prime cost method: The method considers both direct
materials and direct labour for allocation of overheads. The formula for
calculating the factory overhead rate, therefore, can be put as follows:
Factory Overhead Rate =
cost Prime
× 100
The method has the advantage of simplicity. However, it suffers
the same drawbacks from which the first two methods suffer and,
therefore, is rarely used.
The method can give satisfactory results where a standard article
is produced, requiring a constant quantity of materials and number of
hours engaged upto its manufacture.
Hourly rate methods
(i) Machine hour rate method: The machine hour rate method
of allocation of factory overheads is used in those cases where the
processes of manufacture are carried out by machines and there is very
little or practically no manual labour. It is determined by dividing the
19
overhead cost to be apportioned or absorbed by the number of machine
hours expended or to be expended. The formula for calculating the
overhead rate may be put as follows:
Overhead rate =
hours Machine
The method thus estimates the cost of running a machine for one
hour and a job is debited with an amount of overheads equal to the
number of hours for which the machine was used on that job multiplied
by the hourly rate. The steps for computing the machine hour rate may
be put as follows:
1. All factory overheads are departmentalised as discussed
before. The overheads of the Service Department are also
apportioned among all Production Departments.
2. Each Production Department is divided into suitable cost
centres comprising groups of similar machines, and the
total factory overheads are apportioned among the different
cost centres suitably as discussed before.
3. Machine hour rate is to be calculated for each machine
separately and, therefore, overheads of one machine cost
centre will be apportioned among the different machines to
find out the amount of overheads per machine.
4. The overheads thus calculated will be divided between
(i) Fixed or Standing charges, (ii) variable or Machine
expenses. Fixed charges are those which remain constant
irrespective of the use of the machine, e.g., rent, insurance
charges etc. Variable expenses such as power, depreciation
etc. vary with the use of machine.
20
5. An hourly rate of fixed charges will be calculated by
totalling them and dividing by the number of normal hours
worked by the machine.
6. The total of the fixed charges rate and the machine
expenses rate will give the Machine Hour rate.
BASIS FOR APPORTIONMENT OF DIFFERENT EXPENSES
Expenses Basis
Standing Charges
1. Rent and Rates According to the floor area occupied by each
machine including the surrounding space.
2. Heating and
lighting
The number of points used plus cost of special
lighting or heating for any individual machine,
alternatively according to floor area occupied
by each machine.
3. Supervision Estimated time devoted by the supervisory
staff to each machine.
4. Lubricating oil
and consumable
stores
Capital values, machine hours, or past
experience.
5. Insurance Insured value of each machine.
6. Miscellaneous
expenses
Equitable basis depending upon facts.
Illustration 2: A machine cost Rs. 90,000 and is deemed to have
a scrap value 5% at the end of its effective life (19 years). Ordinarily the
machine is expected to run for 2,400 hours per annum but it is
estimated that 150 hours will be lost for normal repairs and
maintenance and further 750 hours will be lost due to staggering.
21
The other details in respect of the machine shop are:
(a) Wages, bonus and provident fund
contribution of each of two operators (each
operator is in charge of two machines)
Rs. 6,000 per year
(b) Rent and rates of the shop 3,000 per year
(c) General lighting of the shop 250 per month
(d) Insurance per annum for the machine 200 per month
(e) Cost of repairs and maintenance per
machine
250 per month
(f) Shop supervisor’s salary 500 per month
(g) Power consumption of machine per hour 20
units, rate of power per 100 units Rs. 10
(h) Other factory overheads attributable to the
shop, Rs. 4,000 per annum.
There are four identical machines in the shop. The supervisor is
expected to devote one-fifth of his time for supervising the machine.
Compute a comprehensive machine hour rate from the above details.
Solution
Computation of machine hour rate Rs. Per hour
Standing charges per annum
Rent and rates 750
General lighting 750
Insurance 800
Supervisor’s salary 1,200
Allocated overhead 1,000
4,500
22
Standing charges per hour, 4500 >> 1500 3.00
Machine expenses per hour wages, etc. 2.00
Power 2.00
Repairs and maintenance 2.00
Depreciation 2.00
Machine hour rate 12.00
Note: Effective machine hours are 1,500 (2,400 – 150 – 750).
Illustration 4: A machine was purchased on January 1, 2004 for
Rs. 5 lakhs. The total cost of all machinery inclusive of the new
machine was Rs. 75 lakhs. The following particulars are further
available:
Expected life of machine 10 years
Scrap value at the end of 10 years Rs. 5,000
Repairs and maintenance for the machine during the year
Rs. 2,000
Expected number of working hours of machines per year
4,000 hours
Insurance premium annually for all the machines Rs. 4,500.
Electricity consumption for the machine per hour (@ 75 paise per
unit) 25 units
Area occupied by the machine 100 sq. ft.
Area occupied by other machine 1,500 sq. ft.
Rent per month of the department Rs. 800.
Lighting charges for 20 points for the whole department, out of
which three points are for the machine Rs. 120 per month.
Compute the machine-hour rate for the new machine on the basis
of the data given above.
23
Solution: Computation of machine hour rate
Standing charges Rs. (p.a.) Rs.
(per hour)
Insurance Premium, (WN:2) 300
Repair and Maintenance 2,000
Rent (WN:3) 600
Light Charges (WN:4) 216
Total Standing Charges 3,116
Hourly Rate for Standing Charges
(Rs. 3,116/4,000 hours)
0.779
Machine Expenses
Depreciation (WN:1)*
12.375
Electricity Consumption 25 units per hour @
0.75 p. per unit
18.750
Machine Hour Rate 31.904
*Depreciation may also be taken as a standing charge.
Working Notes
Rs.
1. Depreciation of machine:
Cost of new machine 5,00,000
Less: Scrap value 5,000
4,95,000
Net cost of the machine
Life of the machine 10 years
Depreciation per hour =
4,000 years 10
4,95,000 Rs.
×
= 12.375
2. Insurance for the Machine:
24
Total cost of all the machines 75,00,000
Total insurance premium paid for
all the machines 4,500
Total annual insurance premium of
the new machine =
75,00,000 Rs.
5,00,000 Rs. n 4,500 Rs.
= Rs. 300
3. Rent for the Machine
Rent paid per annum Rs. 9,600
Total area occupied 1,600 sq. ft.
Rent for the area occupied by the new machine
=
ft. sq. 6000 , 1
ft. sq. 100 96000 Rs. ×
Rs. 600
4. Lighting Charges for the Machine:
Total annual light charges of 20 points for the whole
department is Rs. 1,400.
Light charges for the machine p.a.
=
points 20
points 3 1,440 Rs. ×
Rs. 216
2. Labour hour rate method: According to this method, the
overheads are charged to production on the basis of number of labour
hours of work put forth on every job. The overhead rate is calculated by
dividing the total works overheads for the shop or department for a
given period by the total estimated direct labour hours for the same
period. The formula for calculating the overhead rate may be put as
follows:
Overhead Rate =
Hours Labour Direct of Number Total
overheads of Amount
25
This method of allocating overhead is adopted for those
departments where hand labour is a predominating factor in
production. It gives very satisfactory results because incidence of most
overheads is proportional to time and this method give due
consideration to the time factor.
Illustration 5: The following information relates to the activities
of a production department for a certain period in a factory:
Rs.
Materials used 72,000
Direct wages 60,000
Hours of Machine operation 20,000
Labour hours worked 24,000
Overheads chargeable to the department 48,000
Prepare a comparative statement of cost of this order by using the
following three methods of recovery of overheads:
(i) Direct Labour Hour Rate Method;
(ii) Direct Labour cost Rate Method;
(iii) Machine Hour Rate Method.
Solution
(i) Direct Labour Hour Rate Method
Direct Labour Hour Rate=
worked rs Labour hou
department the to chargeable Overheads
(ii) Direct Labour Cost Method:
Percentage of Direct Labour Labour Cost
= 100
wages Direct
department the for Overheads ×
26
= % 80 100
000 , 60
000 , 48 = ×
(iii) Machine Hour Rate Method:
Machine Hour Rate =
operation machine of Hours
department the for Overheads
= 2.4 Rs.
000 , 60
000 , 48 =
COMPARATIVE STATEMENT OF COST OF ……. ORDER
Particulars Direct
Labour
Hour Rate
(Rs.)
Direct
Labour
Cost Rate
(Rs.)
Machine
Hour Rate
(Rs.)
Material used 4,000 4,000 4,000
Direct wages 3,300 3,300 3,300
Prime Cost 7,300 7,300 7,300
Factory overheads:
At Rs. 2 per hr. for 1,650
labour hrs.
3,300 - -
At 80% of Rs. 3,300
(direct labour cost)
- 2,640 -
At Rs. 2.4 per hr for 1,200
machine hours
- - 2,880
Works Cost 10,600 9,940 10,180
3. Dual hour rate method: Where in a shop both manual
labour and machines play an equally important roles overheads are
classified into two categories:
27
(i) those which relate to manual work, such as proportionate
charge for lighting and foreman’s salary, employee’s
insurance premium etc.;
(ii) those which relate to machines as depreciation, power,
repairs, operator’s wages etc.
The former [i.e. (i)] when divided by the number of direct labour
hours will give the direct labour hour rate, and the latter [i.e. (ii)] on
being divided by the number of machine hours will give the machinehour
rate. A job will be debited with the amount of overheads calculated
on the basis of these two rates. For example, if the direct labour-hour
rate is Re. 1 and machine-hour rate is 50 paise, a job requiring 10 direct
labour hours and 15 machine hours should be debited with Rs. 17.50
(i.e. 10 × 1 + 15 × 0.50) as overheads.
Illustration 6: The following information for the month of April
is extracted from the cost records of Ram and Shyam Ltd. which
specialises in the manufacture of automobile spares. The parts are
manufactured in Department R and assembled in Department S.
Total
(Rs.)
Deptt. R
(Rs.)
Deptt. S
(Rs.)
Direct Material 65,000 50,000 15,000
Direct Labour 90,000 40,00 50,000
Factory Rent 15,000
Supervision 6,000 2,500 3,500
Deprecation, on Machines 5,000
Power 4,000
Repairs to Machines 2,000 1,600 400
28
Indirect Labour 4,000 2,000 2,000
Direct Labour Hours Worked 80,000 30,000 50,000
Machine Hours worked 30,000 25,000 5,000
Machine Hours Power (H.P.) 400 353 47
Book Value of Machines (Rs.) 50,000 40,000 10,000
Floor Space (sq. ft.) 20,000 10,000 10,000
The Prime Cost of Batch B 401 has been booked as under:
Total
(Rs.)
Deptt. A
(Rs.)
Deptt. B
(Rs.)
Materials 3,200 2,700 500
Labour 7,500 3,000 4,500
Direct Labour Hours worked on batch S 401 were 2,500 in
Department R and 5,000 in Department S. Machine Hours worked in
this batch were 1,250 in Deptt. R and 600 in Deptt. S. Allocate overhead
expenditure and calculate in cost of each unit in batch S 401 which
consists of 1,000 units.
Solution: It seems both men and machines are playing equally
important roles in production, hence it will be appropriate to charge
overheads according to Dual Hour Rate Method. Consequently machine
costs have been absorbed on the basis of machine hour rate and other
overhead costs on the basis of direct labour hour rate.
RAM & SHYAM LTD.
DEPARTMENTALISATION OF OVERHEAD COSTS
Machine Costs: Basis Total
(Rs.)
Deptt. R
(Rs.)
Deptt. S
(Rs.)
29
Depreciation Plant Value
(4 : 1)
5,000 4,000 1,000
Power Hours power
(353 : 47)
4,000 3,530 470
Repairs of Machines Actual 2,000 1,600 400
Total Machine Cost 11,000 9,130 1,870
Other overhead costs
Factory Rent Floor Space
(1 : 1)
15,000 7,500 7,500
Supervision Actual 6,000 2,500 3,500
Indirect Labour Actual 4,000 2,000 2,000
Total: Other overhead Costs 25,000 12,000 13,000
Deptt. R Deptt. S
Machine Hour Rate =
25,000
9,130 Rs.
5,000
1,870 Rs.
= Rs. 0.3652 Rs. 0.374
Labour Hour Rate =
30,000
12,000 Rs.
50,000
13,000 Rs.
= Rs. 0.40 Rs. 0.26
COST SHEET OF BATCH S 401 (CONSISTING OF 1,000 UNITS)
Total (Rs.) Deptt. A (Rs.) Deptt. B (Rs.)
Materials 3,200 2,700 500
Labour 7,500 3,000 4,500
Overhead Costs 2,981 1,457 1,524
13,681 7,157 6,524
Cost of each unit =
1,000
13,681 Rs.
= Rs. 13.68
30
Working Notes
OVERHEAD COSTS ALLOCATION TO BATCH S 401
Rs.
(i) Deptt. R Machine Cost (1,250 × 0.3652) 456.50
Other Overhead Costs (2,500 × 0.40) 1,000.00
1,456.50
(ii) Deptt. S Machine Costs (600 × 0.374) 224.40
Other Overhead costs (5,000 × 0.26) 1,300.00
1,524.40
18.6 DEPRECIATION
Depreciation is provided in cost accounts before working out the
profitability of a job or cost unit. Depreciation is a gradual diminution,
loss, or shrinkage in the utility of value of an asset due to wear and tear
in use, affluxtion of time or obsolescence. Deprecation is the allocation
of the depreciable amount of an asset over its estimated useful life.
The cost of a product consists of not only normal expenses like
direct material, direct labour, factory cost etc. which involve in cash
outgo but also non-cash like depreciation which does not involve in cash
outgo.
CIMA defines depreciation as “the measure of wearing out,
consumption or other loss of value of fixed asset whether arising from
use, fluxion of time or obsolescence through technology and market
changes.” Depreciation does not mean set money aside for the future
replacement of assets. It is provided to match the use of asset, its
deterioration and obsolescence with the income it generates.
31
Depreciation and Cash Flow: Depreciation is neither a source
nor a use of funds. The use of funds obviously began when the fixed
asset was purchased. It would be double counting to regard each year’s
depreciation as a further use of funds. The relevant figure for profit
from operation profit before charging depreciation. The quantum of
operational funds flow cannot be influenced by the method of
depreciation charged.
Depreciation and inflation: Depreciation should be provided
irrespective of the increase in value of asset due to inflation. It is not
appropriate to omit charging depreciation of a fixed asset on the
grounds that its market value is greater than its net book value. If
account is taken of such increased value by writing up the net book
value of a fixed asset, then, an increased charge for depreciation will
become necessary.
Methods of Depreciation
The following are the methods of depreciation
1. Straight line method: This method provides for
depreciation by means of equal periodic charges over the life of the
asset. For example, suppose the cost of a plant is Rs. 1,00,000 and its
life is 10 years. Then the charge of depreciation per annum will be Rs.
10,000.
2. Diminishing balance method: This method tends to
write-off higher amounts in the beginning and comparatively lower
amounts in subsequent parts of the life of an asset. The amount of
depreciation is calculated at a constant rate at the balance of the value
32
of the asset after deducting the amounts of depreciation previously
provided. For example, taking the above illustration, the amounts of
depreciation at the rate of 10% p.a. would be Rs. 10,000 for the first
year, Rs. 9,000 for the second year, Rs. 8,100 for the third year, and so
on.
3. Production unit method: This method charges the
amount of depreciation by means of fixed rate per unit of production
calculated by dividing the value of the asset by the estimated number of
units to be produced during its life. The formula for calculating
depreciation under this method is as follows:
Depreciation (per unit) =
life its during output Estimated
value residual - cost Original
4. Annuity Method: This method assumes that the capital
used in the purchase of plant should have earned interest if invested
somewhere else. The amount of depreciation in this method is
calculated by dividing the aggregate of the cost of the asset depreciated
and interest at a given rate, at a constant rate, on the written doen
value of the asset.
5. Sinking fund method: Under the annuity method,
expected interest of the investment (equivalent to the cost of the asset)
is assumed. However, no actual investment is made. But under the
sinking fund method, the amount of depreciation written off every year
is invested in some securities, which would accumulate at compound
interest to provide, at the end of the life of the asset, a sum equal to its
costs. This method provide for depreciation of fixed periodic charges.
33
6. Endowment policy method: This method is similar to
the sinking fund method. It provides for depreciation by means of fixed
periodic charges equivalent to the premium on an endowment policy for
the amount required to provide, at the end of the life of the asset, a sum
equal to its cost. The amount of depreciation is equivalent to the
premium payable on the policy.
7. Production hour method: This method provides for
depreciation by means of a fixed rate per hour of production by using
the following formula:
Depreciation (per unit) =
life its of hours working of number Estimated
asset the of Cost
8. Sum of digits method: Under this method depreciation is
calculated by means of differing periodic rates computed according to
the following formula: If it is the estimated life of the asset, the rate is
calculated each period as a fraction in which the denominator is always
the sum of the series 1,2,3, … n and the numerator for the first period
is n, for the second n-1, and so on. In this method, depreciation is
highest in the year of purchase and go on reducing in the subsequent
accounting periods. This method is mainly used in assets like,
furniture, electronic goods, automobile vehicles etc. In this method
differing periodic rate are used.
18.7 PLANT REGISTER AND OTHER FIXED ASSETS REGISTER
A plant register is maintained keeping all details about the plant
and machinery. It generally contains the following details:
• Description of each individual machine, identification
number, original cost of the machine, name of supplier, date
34
of installation and commercial run, etc. Technical details
like speed, fuel consumption, capacity, grade and quality of
output etc.
• Details of the asset located in the factory. Details of
estimated economic life, estimated output or production run
hours during the economic life time, method of depreciation,
estimated residual or scrap value etc.
• Details of capital allowances, balancing charges or other
allowance.
• Details of major break-downs and maintenance.
• Details of additions and alterations.
• Details of disposal of asset.
A register is also maintained for other fixed assets like buildings,
vehicles, furniture and fixtures etc. similar to that of plant register.
These registers will enable calculation of depreciation, book
values etc. of each item and it will enable to allocate and apportion
depreciation charges and other overhead costs like, repairs and
maintenance, insurance etc.
18.8 USING ASSET AFTER FULLY DEPRECIATED
Sometime it will happen to continue in use of an asset after it is
fully depreciated. The main reason for early recovery of depreciation is
due to under estimation of economic life of the asset. In such situations
it is usual to continue to charge depreciation so as to maintain cost
comparability with previous accounting periods and current cost of the
product will reflect the cost of using the asset. The excess depreciation
so charged will either be kept in reserve against obsolescence or
35
credited to Costing Profit and Loss Account. If before the asset is fully
depreciated, its economic life is estimated to be further extended, then
the balance depreciation will spread over to such enhanced period, and
the problem of using asset after it is fully depreciated will not arise.
18.9 RESEARCH AND DEVELOPMENT COSTS AND ITS
TREATMENT
The Research and Development expenditure is a deferred charge
which is in the nature of non- recurring expenditures which are
expected to be of financial benefit to several accounting periods of
indeterminate total length. It is the expenditure incurred for searching
a new product or improved product or new methods of production and
improved technologies.
Research Costs are incurred for carrying basic research or applied
research. But the development costs start with decision taken to
produce new product or improved product and when the decision is
taken to adopt new technologies and new production methods. The
objective in carrying basic research is to improve the existing scientific
and/or technical knowledge. But the applied research is carried for a
purpose directed towards a specific practical aim or objective.
Treatment of Research Costs: The treatment of research costs
is studied under two heads:
1. Basic research costs (2) Applied research costs.
1. Basis Research Costs: These costs relate to all existing
product, methods of operation, techniques of production and, therefore,
the basic research costs should be treated as production overhead for
36
the period during which it has been incurred and has to be absorbed
into product costs.
2. Applied Research Costs: The applied research costs is
classified into two for absorption purpose:
(i) If applied research costs relate to improvement of existing
product and methods of production, it should be treated as
manufacturing overhead for the period and has to be
absorbed to the product cost.
(ii) In case, applied research costs are incurred for searching
new products or methods of production etc., then such costs
are amortised to the product that is newly invented or new
method of production adopted. The whole of such
expenditure should not be absorbed in the year in which
expenditure has been incurred but a part it should be
carried over the expenditure which, though of revenue
nature is spread over a number of years because its benefit
is derived during those years.
When the applied research aimed at improvement of
existing product or to invent a new product or development
of new technology, and if the research works appears
failure in getting the desired results, then such applied
research expenditure is charged against profit in the
Costing Profit and Loss Account of one or more years
depending upon the size of expenditure incurred.
37
18.10 TREATMENT OF DEVELOPMENT COSTS
Development costs begin with the implementation of the decision
to produce a new or improved product or to employ a new or improved
method. The treatment of development costs is similar to that of
treatment of applied research costs.
18.11 TREATMENT OF SPECIAL ITEMS OF OVERHEADS IN
COST ACCOUNTS
Material handling expenses: These expenses are incurred
while unloading the raw materials received from supplier, storing the
raw materials, handling the raw materials to work place, handling of
work- in-progress, storage of finished goods etc. It also includes costs
incurred for weighing salaries of personnel involved in material
handling, wear and tear of weighing equipment. These costs are
apportioned on the basis of physical quantities of different materials
and goods handled in the factory. The stores overhead costs are
apportioned to raw materials and finished goods as a percentage of
issue rates. Other handling expenses are recovered through overhead
recovery rates.
Market research expenses: Market research cost is an item of
selling overhead, incurred for market intelligence to ascertain the
tastes and habits, market penetration of product, increase in demand of
existing products, competitive situation, trading practices, distribution
channels, customers requirements, existing and potential market for
the product etc. If the market research expenses are incurred for a
single product it is absorbed into that particular product cost. If it is
incurred for the product range for the enterprise as a whole, then the
market research expenses are to be apportioned to different products in
38
the proportion of sales value and absorbed into respective product cost.
If the market research cost is substantial, it will be deferred revenue
expense and is taken into future period and absorbed when sales or
production takes place.
Sometimes market research expenses are incurred for raw
material availability, such expenses will be allocated or apportioned to
purchase department and it is recovered through overhead rate of
purchase department.
Subscriptions and donations
• If these expenses are incurred for the benefit of or welfare
of workers, it is treated as production overhead.
• If subscriptions and donations for any technical and
research institutions for obtaining data relating to
technical, production scientific nature, it is considered as
production overhead.
• If subscriptions to journals etc. for obtaining market data
which help in increase of sales, it is considered as selling
overhead.
• If the subscriptions and donations not incurred for the
benefit of employees or the organisation, it should be
excluded from the cost accounts.
After Sales Service Costs: The costs are incurred for providing
service to the customers after the sales took place during the warranty
period. If the costs are incurred during the period of guarantee given to
the customer, it is to be borne by the company, and hence it is treated
39
as production overhead absorbed into product cost by applying
predetermined absorption rates.
If the after sales services cost are incurred after the guarantee
period for which the organisation will charge for the services rendered,
then costs are treated as selling overhead.
Royalties and patent fees: The royalties and patent fees are
payable for the use of technology, skills, brand, intellectual property
rights etc. made in the form of periodical rent or based on the number of
units produced or sold. If it is based on sales, the expenditure is
charged to selling overhead. If it is fixed periodical rent, it is treated as
production overhead. If it is payable on number of units produced, the
expenditure is treated as a direct expenses or chargeable expenses and
is forming part of the prime cost of the product.
Training Costs: The training costs are incurred for training the
workers, apprentices, office, administrative and selling staff. The
training expenditure incurred for training the workers, apprentices and
other production staff is treated as production overhead. The expenses
incurred for training the sales staff is treated as selling overhead.
If there is any in house training college or centre, cost of running
the centre or college is apportioned to the cost centres based on the
number of personnel trained on the basis of wages and salaries paid etc.
Taxation: Taxation is an appropriation of profit earned by the
organisation and any payment of taxes is excluded from the cost
accounts. But the taxes will also be considered for planning and
40
decision making exercises wherever it is necessary and appropriate for
special purposes.
Financing charges for acquisition of fixed assets and
Inventories: The finance charges like interest on working capital
facilities from banks, interest on term loan for acquisition of fixed
assets, interest on debentures etc. is payable by the company.
Where financing charges are payable to outsiders on borrowings
for acquisition of fixed assets, these charges are included in cost of fixed
assets. If the financing charges are payable for financing working
capital then these charges are included in cost of inventories.
Interest on capital provided by the owners is excluded from cost
accounts except for comparing or evaluating profitability of alternative
investments.
If the charges are payable for storing the materials like timber,
wine etc. the charges are included in the cost of materials store.
Costs of Tools: Tools are classified into large tools and small
tools. The cost of large tools are capitalised like any other machine and
depreciation is provided on it in each accounting period over its useful
economic life.
The cost of small tools are treated in any of the following three
method in cost accounts:
• Capitalisation method: Under this method the cost of
small tools is capitalised and depreciation is recovered as
production overhead. If the life of small tools is relatively
small, this method is not suitable.
41
• Revaluation method: Under this method, the small tools
are revalued at the end of each accounting year and the
difference between original cost and the revalued cost is
charged as production overhead.
• Write off method: Under this method, the cost centre
drawing such tools is debited with the value thereof.
Alternatively, the total cost of tools is accumulated and
apportioned to various cost centres on suitable basis.
Bad Debts: When the company allow credit to its customers as
part of its selling policy, some credit sale may turn bad due to default
by the customers internationally or otherwise. As a safe guard, a part of
such default amount treated as bad debt is recovered as a selling
overhead and absorbed in product cost.
If the bad debt is abnormal in nature, the abnormal portion in
excess of the standard normal portion should be excluded from cost
accounts and transferred to Costing Profit and Loss Account.
Notional Rent: Notional rent is a cost included in the cost
accounts so as to represent a benefit enjoyed by the organisation even
though no actual cost is incurred for rent. The company owned premises
does pay rent, but it is considered as notional charge in the cost of
accounts for comparability of cost with different accounting period and
with other organisations. This would reflect the accurate cost of cost
centre or cost unit. It is a reasonable or nominal charge included in the
cost accounts for the owned premises as if it is a rented premises.
Packing expenses: The packing is classified into (i) Primary
Packing and (ii) Secondary packing.
42
The primary packing is done when the material is packed in
tines, bottles, jars, etc., without which a product cannot be sold. For
example, jam is packed in bottles, baby food packed in tin, beverages in
bottles etc. The costs incurred on primary packing materials is treated
as part of direct material cost.
If the packing is made to facilitate the transportation and
distribution of the finished product, it is called secondary packing and
the cost incurred for this is treated as distribution overhead.
Sometimes, cost is incurred on packing the product to make it
more attractive to the customers to increase sales. This cost is treated
as advertisement cost and is included in selling overhead.
Stores Overhead: The stores department in an organisation
perform the function like receipt of material and stores items
purchased, storing and issue of materials and stores items to different
departments. The stores is considered as a separate cost centre and the
store expenditure like rent of store, salaries and wages of stores
personnel, freight, carriage inwards, insurance etc., are collected
separately for the stores and will be apportioned to other cost centres.
The following bases are used in apportionment of stores overhead:
• Number of stores requisitions
• Value of material requisitioned
• Standard predetermined stores overhead absorption rate
Transport Cost: The classification of transport costs and their
treatment in cost accounts is given below:
• The costs incurred to bring the materials to the production
site is included in cost of materials.
43
• The costs incurred for bringing the plant and machinery,
equipment etc., is added to the capital cost of respective
asset and depreciation is recovered.
• The cost of despatch of finished goods is treated as
distribution overhead.
• The costs incurred for internal movements within work are
initially charged to specific cost centres and thereafter
apportioned to different production and service centres on
the basis of services rendered.
Insurance Cost: The treatment of insurances cost is categorised
into the following:
• Insurance premium on storage-cum erection and
commissioning is capitalised to the asset value.
• Premium on transit of materials is included in cost of
materials.
• Premium on transit of finished products is treated as
distribution overhead. Premium on loss of profit policy due
to tire and break down of machinery is treated as
production overhead.
• Premium on miscellaneous policies like vehicles, burglary,
accident etc. are treated as administration overhead.
• Premium on raw materials and stores is treated as
production overhead. Premium on warehouse and finished
stock is treated as distribution overhead.
44
18.12 INTEREST ON CAPITAL
There is a difference of opinion as to whether interest on capital
employed in manufacture should be treated as an item of cost. The
following arguments are given in support of treating interest as an item
of cost:
1. Interest is the reward of capital just as wages are the
reward of labour. Profit, in the true sense, cannot be
computed without considering interest.
2. The comparison of operations, different processes, etc.
without due consideration of the interest factor may lead to
unreliable conclusions.
3. Interest considers time factors as it is computed on the
basis of time and time is regarded as an important factor in
production.
4. The inclusion of interest is of particular importance where
articles of different values are produced and the capital
invested in each product line differs considerably.
5. The cost of carrying inventory cannot be determined
without giving due recognition to the interest on capital
employed in it.
The following arguments are against including interest in the
cost accounts:
1. Cost accounting considers only actual expenditures and can
include only interest paid.
2. The interest factor is in no way connected with cost of
manufacture. Whatever may be the method of raising
45
finances-owned capital loans, debentures, etc. does not
affect manufacturing cost. It only affects the profits of the
period.
3. Inclusion of interest in product costing will inflate the
values of inventory and work-in-progress and therefore will
tend to increase the profit unreasonably.
4. Interest is calculated on capital and the term “capital” has
many concepts such as total capital employed in business,
equity capital and borrowed capital both.
5. A reliable and correct rate of interest is difficult to
determine and is likely to be influenced by naked
fluctuations.
6. The cost accounting and product costing systems get
complicated unnecessarily by inclusion of interest on capital
and financial statements also become misleading.
There is one point upon which opinion is not divided. If interest is
to be considered at all, it must not be confined merely to such interest
as may actually have been paid by the business. Therefore, if it is
decided to exclude interest from the cost accounts, interest which has
been paid, must also be ignored.
Of late, cost accounts in India tend to agree that interest on
capital or funds borrowed from outside and paid or to be paid in cash
should be included in product cost. This has been supported of the
grounds that it implies cash outflow and affects the operating results of
a business firm. The Bureau of Industrial Cost and Price in India
includes actual interest on borrowed funds as an element of cost in cost
46
price studies. However, the Bureau does not considered the notional
type of interest on owned capital as an element of cost.
18.13 SELLING AND DISTRIBUTION OVERHEADS
Selling and distribution costs are usually incurred after the
production of products or services is completed, and therefore, such
costs are sometimes known as ‘After Production Costs’.
Selling cost is “the cost of seeking to create and stimulate demand
(sometimes termed marketing) and of securing order”. These costs are
thus incurred for increasing sales to the existing and potential
customers. Examples and advertisement, samples and free gifts, showroom
expenses etc.
Distribution cost is “the cost of sequence of operations which
begins with making the packed product available for despatch and ends
with making the re-conditioned retuned empty packages, if any,
available for re-use”. Thus distribution costs are incurred in placing the
articles in the possession of the customers. Examples are carriage
outwards, insurance of goods-in-transit, maintenance of delivery vans,
warehousing etc.
For costing purposes, selling costs and distribution costs are
generally considered together although in some circumstances, it is
desirable to deal with them separately.
Difference between selling overhead and distribution
overhead: Selling overhead and distribution overhead differ in their
nature and purpose. Selling overheads are incurred for promoting sales
and securing orders while distribution overheads are mainly incurred
47
in moving the goods from the company’s godown to customers’ place.
The object of selling overhead is to solicit orders and to make efforts to
find and retain customers. The object of distribution overhead is the
safe delivery of the goods to the customers.
Special Features
Selling distribution overhead costs have certain peculiar features
which have a bearing on the accounting and control of these costs.
These features are:
(a) Unlike production costs, most of the selling and distribution
costs cannot be identified with the units of products.
(b) Selling costs are incurred as a matter of policy of
management.
(c) Selling costs are not always related to the volume of sales.
(d) The characteristics and attitude of the customers also affect
the selling costs.
(e) The same product may be sold in near or distant market.
This will affect cost of packing and transportation.
(f) Selling costs vary widely depending upon the degree of
competition.
Accounting Treatment
The accounting procedure of selling and distribution cost is
comprised of
1. Classification, collection and analysis of these expenses.
2. Apportionment and allocation to cost centres.
3. Absorption by products or product groups.
48
These three stages are discussed below:
1. Classification, collection and analysis: This is first step
and is similar to classification and collection of production of overheads.
Selling and distribution overheads may be classified on the basis of
products, sales territories, channels of distribution, salesmen etc.
When classification of expenses is complete, expenses are
collected under standing order numbers provided for this purpose.
2. Apportionment and allocation to cost centres: In this
step, selling and distribution overheads are allocated or apportioned to
various products, sales territories or other cost centres. Selling of the
common basis used for distribution of selling and distribution
overheads are:
Expenses Basis for distribution
1. Remuneration of
salesmen
Direct allocation
2. Advertising Direct allocation or value of sales or
space used
3. Catalogues Direct allocation or space used
4. Showroom expenses Direct allocation or space used
5. Packing Direct allocation
6. Collection of overdue
accounts
No. of orders or sales value
7. Insurance Value of stocks
8. Transport-outside
carrier
Direct allocation
49
9. Own transport Drive allocation or Weight of product
carried
10. Warehousing Cubic ft. of product stores X times (days)
3. Absorption of selling and distribution overhead:
Absorption of selling and distribution overheads means charging of
these overheads to various product jobs or orders. Various methods for
absorption of selling and distribution overhead are as follows:
l. A rate per unit: This method is employed when the
company is selling one uniform type of product. The total selling and
distribution overheads to be absorbed are divided by the number of
units sold to arrive at a rate per unit.
For example, a company is manufacturing only type of TV picture
tube. During the month of May, its selling and distribution overhead
amounted to Rs. 75,000 and during this period, the number of picture
tubes sold is 1,000 the rate per unit for the absorption of selling and
distribution overhead will be Rs. 75,000 – 1,000 = Rs. 75.
2. A percentage of selling price: This method is
recommended when the concern is selling more than one type of
product. A percentage of selling and distribution overheads of selling
price is ascertained from an analysis of past records. Overhead rate is
calculated by the following formula:
Overhead Rate =
Sales
overhead dist. and Selling
× 100
Example: Selling and distribution overhead = Rs. 5,000
Total Sales = Rs. 1,00,000
50
Overhead Rate = 100
000 , 00 , 1
5000 ×
= 5% of selling price
3. A percentage of works cost: In this method, a percentage
of selling overheads to works cost is ascertained. This percentage rate is
applied for the absorption of selling and distribution overheads.
Overhead rate is calculated as follows:
Overhead Rate = 100
cost works Total
overhead Dist. and Selling ×
Selling and distribution overhead = Rs. 5,000
Total works cost = Rs. 40,000
Overhead Rate = % 5 . 12 100
000 , 40
000 , 5 = ×
Illustration 7: The works cost of certain article is Rs. 400 and
the selling price is Rs. 800. The following direct selling and distribution
expenses were incurred:
Rs.
Freight and Carriage 40
Insurance 10
Commission 60
Packing Cases 10
The estimated fixed selling and distribution expenses for the year
were Rs. 30,000 and the estimated value of sales for the year was Rs.
1,50,000.
51
You are required to set out the final cost of the article using the
method of percentage of sales to recoup fixed selling and distribution
expenses.
Solution: The percentage of fixed selling and distribution
expenses to the estimated value of sales is-
% 20 100
000 , 50 , 1
000 , 30 = ×
FINAL COST OF THE ARTICLE
Rs. Rs.
Work cost 400
Selling and Distribution Expenses:
Variable: Freight and Carriage 40
Insurance 10
Commission 60
Packing Cases 10
120
Fixed 20% of selling price 160
Total cost 680
Profit 120
Selling Price 800
Illustration 8: A company is producing three types of products
A, B and C. The sales territory of the company is divided into three
areas X, Y, Z. The estimated sales for the year 2005 are as under:
The budgeted advertising cost is as under-
X (Rs.) Y (Rs.) Z (Rs.) Total
52
Local Cost 3,200 4,500 4,200 11,900
General - - - 5,800
You are required to find the percentage of advertising cost on
sales for each area and product showing how you will present the
statement to management.
Solution: Apportionment and allocation of advertising cost areawise
Area Item Total
(Rs.) X (Rs.) Y (Rs.) Z (Rs.)
Local cost 11,900 3,200 4,500 4,200
General cost (2% on
estimated sales)
5,800 1,600 1,800 2,400
Total cost 17,700 4,800 6,300 6,600
Sales 2,90,000 80,000 90,000 1,20,000
Advertising cost as a
percentage of sales
- 6% 7% 5.5%
APPORTIONMENT OF ADVERTISEMENT COST PRODUCT-WISE
Area X (@ 6% of sales) 4,800 3,000 1,800 -
Area Y (@ 7% of sales) 6,300 1,400 - 4,900
Area Z (@ 5.5% of sales) 6,600 - 4,400 2,200
Total costs 17,700 4,400 6,200 7,100
Sales 2,90,000 70,000 1,10,000 1,10,000
Advertising cost as a
percentage of sales
- 6.34% 5.64% 6.45%
53
18.14 SUMMARY
Overheads constitute one of the important elements of cost of
production. Overheads may be classified according to functions element
and behaviour. In allocation of overheads, the entire amount is charged
to a department. In case of apportionment of overhead only a
proportionate amount is charged to a department. Though different
basis are available for apportionment, it is essential to satisfy that the
overhead is closely related to the basis selected. Absorption of factory
overhead refers to charging of the factory overheads of a particular
production department to various products manufactured or jobs
completed or orders executed in that department. There are broadly two
methods for absorption of factory overheads. The accounting procedure
of selling and distribution cost consists of (a) classification, collection
and analysis of expenses (b) apportionment and allocation to cost
centres and (c) absorption by products or product groups.
18.15 KEYWORDS
Overhead: Overhead is the aggregate of indirect material cost, indirect
labour cost and indirect expenses.
Allocation of overheads: It refers to identifying an item of overhead
and the allotment of whole amount to one department or cost centre.
Apportionment of overheads: The process of charging proportionate
amount of overheads to various department is known as apportionment
of overheads.
Absorption of overheads: The process of charging the overheads
from cost centre to cost units is known as absorption of overheads.
54
Machine hour rate: It refers to the overheads incurred for running a
machine for one hour.
1. What is meant by overhead expenses? Describe the steps
that are necessary for the computation of the direct labour
hour rate. In what respect is the direct labour hour rate
method of absorbing overhead different from the percentage
of direct wages method?
2. What are the requisites of a good method of absorption of
factory overhead?
3. Describe the different bases on which factory expenses can
be apportioned. Describe the merits and suitability of each
of them.
4. Write a detailed critical note on the direct labour cost
method of absorption of factory overheads.
5. What information is necessary to calculate a machine hour
rate for overhead absorption? State the conditions in which
the method is most effective.
6. Discuss the importance of machine hours as a basis for the
absorption of factory overheads.
7. What do you understand by classification, allocation and
apportionment in relation to overhead expenses? Explain
fully.
8. What is meant by absorption of overhead? Discuss briefly
the different methods for absorption of factory overheads?
9. Why do you consider departmentalisation of overheads
necessary?
55
10. Discuss the methods of absorption of selling and
distribution overheads.
11. How do you deal with the following in cost accounts:
(a) Advertising
(b) Research and development cost
(c) Bad debts
(d) Rent of factory buildings
12. The budget of a machine shop for 2004-05 is as follows:
Normal working week 42 hours
Number of machines 15
Hours spent on maintenance 5 hours per machine
in a week (Normal loss)
Estimated annual overhead Rs. 5,55,000
Estimated direct wages rate Rs. 3 per machine hour
Number of working weeks in 1984-85 50
The actuals in respect of a 4 week
period in 2004-05 are:
Overhead incurred Rs. 49,000
Wages paid Rs. 7,500
Machine hours operated 2,400
Calculate (i) the overhead rate per machine hour for 2004-
05 and (ii) the amount of under or over-absorption of
overhead and wages in respect of the 4 week period.
13. The following particulars relate to an electrical appliances
machine:
(a) The original cost of the machine used (purchased in
June 1982) was Rs. 10,000. Its estimated life is 10 years,
the estimated scrap value at the end of its life is Rs. 1000,
56
and the estimated working time per year (50 weeks of 44
hours) is 2,200 hours of which machine maintenances etc.,
is estimated to take-up 200 hours.
No other loss of working time is expected, setting up time
estimated at 5% of total productive time is regarded as
unproductive time. (Bank holidays are to be ignored).
(b) Electricity used by the machine during production is 10
units per hour at a cost of 10 p. per unit. No current is
taken during maintenance or setting up.
(c) The machine requires chemical solution which is
replaced at the end of each week at a cost of Rs. 20 each
time.
(d) The estimated cost of maintenance per year is Rs. 1,200.
(e) Two attendants control the operation of the machine
together with five other identical machines. Their combined
weekly wages, insurance and the employer’s contributions
to holiday pay amount to Rs. 120.
(f) Departmental and general works overheads allocated to
this machine for the year 1982-83 amount to Rs. 2,000.
You are required to calculate the machine hour rate
necessary to provide for recoupment of the cost of operating
the machine.
14. What is machine hour rate? Calculate the machine hour
rate for machine A from the following data:
Cost of machine Rs. 16,000
Estimated scrap value Rs. 1,000
Effective working life 10,000 hours
Running time for every 4-weekly period 160 hours
57
Average cost of repairs and maintenances
Changed per four-week period Rs. 40
Power used by machine 4 units per hour
at a cost of
5 paise per hour
1. Cost Accounting by Jawahar Lal.
2. Cost Accounting by V.S.P. Rao.
3. Cost Accounting by Ravi M. Kishore.
4. Cost Accounting by Khanal Jain.
58
1
Lesson : 19
JOB AND PROCESS COSTING
STRUCTURE
19.0 Objective
19.1 Introduction
19.2 Objectives of Job Costing
19.3 Advantages of Job Costing
19.4 Limitation of Job Costing
19.5 Job Costing Procedure
19.6 Work-in-progress in Job Costing
19.7 Features of Process Costing
19.8 Difference between Process Costing and Job Costing
19.9 Types of Processing
19.10 Advantages of Process Costing
19.11 Disadvantages of Process Costing
19.12 Costing Procedure
19.13 Process Losses and Wastages
19.14 Inter Process Profits
19.15 Work-in-Progress
19.16 Accounting for Joint Products
19.17 Accounting for By Products
19.18 Summary
19.19 Keywords
19.0 OBJECTIVE
(a) Explain the objectives, advantages and limitations of job costing.
(b) Discuss the procedure adopted for costing purposes in a firm using
job costing.
2
(c) Explain the features, advantages and limitations of process costing.
(d) Describe the costing procedure of process costing.
(e) Discuss the accounting for joint products and by products.
19.1 INTRODUCTION
All types of manufacturing concerns can broadly be classified
into two categories : (a) Mass production concerns and (b) Special order
concerns. In mass production, firms manufacture uniform types of
products. Since production is of standard products, it is on a mass scale
and on a continuous basis. No customer orders or specifications are
required for production. Examples of mass production concerns are textile
mills, chemical plants, paper manufacturing, tyre rubber companies etc.
On the other hand, special order concerns manufacture products in clearly
distinguishable lots in accordance with special orders and individual
specifications. Examples of specific order concerns are printing press,
construction of buildings, bridges, roads, ship building etc.
In case of mass production concerns the products when produced
are of the same type, and involve the same material and labour and pass
through the same set of processes. In such industries each process is
designated as a separate cost centre and the cost per unit is calculated by
dividing the total cost of the process with the total number of units
produced by the process. The cost of production of the product is obtained
by adding the unit costs of various processes through which the product
has passed. This method of costing is known as process costing.
Job costing or job order costing also called specific order
costing is a method of costing which is used when work is undertaken as
per the customer's special requirement (tailor-made). It is distinct from
contract costing in the sense that each job is of a comparatively short
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duration. The job may be carried out within the factory/workshop or on
the premises of the customer, depending on the nature of job.
The main features of job order costing are that in this method
of cost ascertainment, costs of materials, labour and overhead are
accumulated for each job and profit or loss on it is determined. When an
enquiry is received from the customer, costs expected to be incurred on
the job are estimated, and on the basis of this estimate, a price is quoted
to the customer. When the job has been completed, the actual costs can be
compared with the estimated costs (or standard costs if a system of
standard costing is in vogue). This serves as a tool of cost control.
Job costing is employed in the following cases :
1. Where the production is against the order of the customer or jobs
are executed for different customers according to their specifications.
2. Where each job needs special treatment and no two orders are
necessarily alike.
3. Where there is no uniformity in the flow of production from one
department to another.
4. Where the work-in-progress differs from period to period on the
basis of the number of jobs in hand.
Job costing is applicable to printing, furniture, hardware, shipbuilding,
heavy machinery, foundry, general engineering works, machine
tools, interior decoration, repairs and other similar work.
19.2 OBJECTIVES OF JOB COSTING
Job costing serves the following objectives :
4
1. It helps in finding out the cost of production of every order and
thus helps in ascertaining profit or loss made out on its execution.
The management can judge the profitability of each job and decide
its future course of action.
2. It helps management in making more accurate estimates about the
costs of similar jobs to be executed in future on the basis of past
records. The management can conveniently and accurately determine
and quote prices for orders of a similar nature which are in prospect.
3. It enables management to control operational inefficiency by
comparing actual costs with the estimated ones.
19.3 ADVANTAGES OF JOB COSTING
The following are the advantages of job costing :
1. It helps in identifying profitable and unprofitable jobs.
2. It helps in the preparation of estimates will submitting quotations
for similar jobs.
3. Cost data under job costing enable management in preparing budgets
for future.
4. It enables management to control operational efficiency by
comparing actual costs with estimated ones.
5. Spoilage and defective work can be identified with a specific job
and responsibility for the same can be fixed on individuals easily.
19.4 LIMITATIONS OF JOB COSTING
Job costing suffers from the following limitations :
1. It involves too much of clerical work (in estimating cost of material,
labour and overheads chargeable to each job). As such it is expensive
and laborious.
5
2. Being historical in nature, it has all the disadvantages of the
historical costing. Hence, it cannot be used as a means of cost control
unless it is used with techniques like standard costing.
19.5 JOB COSTING PROCEDURE
The following is the procedure adopted for costing purposes
in a concern using job costing :
1. Job Number : When an order has been accepted, an individual work
order number must be assigned to each such job so that separate orders
are capable of being identified at all stages of production. Assignment of
job numbers also facilities reference for costing purposes in the ledger
and is conveniently short for use on various forms and documents.
2. Production order : The Production Control Department then makes
out a production order thereby authorising to start work on the job. Several
copies of production order are prepared, the copies often being in different
colours to distinguish them more easily. These copies are passed on to the
following :
(i) All departmental foremen concerned with the job ;
(ii) Storekeeper for issuance of materials; and
(iii) Tool room-an advance notification of tools required.
Exhibit I shows a proforma of production order.
6
Production Order
Name of Customer.......................... Job No....................
Date of Commencement ................ Date ........................
Date of Completion Bill of Material No.......
Special instructions.......... Drawing attached Yes/No
Quantity Description Machines Tools
to be used required
(Sign) ..........
Production Authorised by :
Head of Production Control Deptt.
The columns provided in the production order differ widely,
depending largely upon the nature of production.
3. Job Cost Sheet : Job cost sheet is the most important document
used in the job costing system. A separate cost sheet or card is maintained
for each job in which all expenses regarding materials, labour and
overheads are recorded directly from costing records. Job cost sheets are
not prepared for specific periods but they are made out for each job
regardless of the time taken for its completion. However, material, labour
and overhead costs are posted periodically to the relevant cost sheet.
EXHIBIT-I
7
Job Cost Sheet
Customer.................... Job No..........................
Date of Commencement................. Date of completion.........
Material Cost Labour Cost Factory Overhead (Absorbed)
Date Material Amount Date Hours Rate Amt. Dept. Hours Rate Amt.
Req. No. Rs. Rs. Rs. Rs. Rs.
Total Total Total
Profit/Loss Cost Summary
Rs. Rs.
Price Quoted ............ Material
Less : Cost ............ Labour
______ Factory Overhead
Administrator Overhead
Profit or Loss ........... Selling Overhead
______
Total cost
EXHIBIT-II
A proforma Job Cost Sheet is shown at Exhibit-II
The material, labour and overhead to be absorbed into jobs are
collected and recorded in the following way :
(a) Direct Materials : The method of recording receipts and issues of
materials on material requisitions or bill of materials show the quantities
of materials issued to jobs from store. When copies of these documents
reach the cost office, they are priced and entered in the stores ledger
8
account in the 'Issues' column. Each requisition shows the job number to
which the material is to be charged. Summaries of material requisitions
are prepared at regular intervals on Materials Abstract or Materials Issue
Analysis Sheet. These summaries facilitate debiting the job with total cost
of materials rather than charging with many small items. These totals are
also used for entries in stores ledger control account and work-in-progress
control account.
(b) Direct Wages : These wages payable to workers are calculated on
clock cards, job cards, time sheets etc. The summaries of job cards are
made on Wages Abstract or Wages Analysis Sheets, which shows the direct
wages chargeable to each job. The total of wages chargeable to various
jobs is debited to work-in-progress control account.
(c) Direct expenses : Direct expenses which can be identified with
specific jobs are directly charged to these jobs, the total being debited to
work-in-progress control account.
(d) Overheads : Indirect materials, indirect wages and indirect expenses
which cannot be identified with specific jobs are apportioned to cost
centres. Absorption of overhead by the jobs passing through the cost
centres is based upon percentage of direct wages or direct material cost,
direct labour hours machine hours, etc.
4. Completion Report : A completion report is sent to the costing
department after the completion of a job. The actual cost recorded in the
job cost sheet is compared with the estimated cost. It will reveal the
efficiency or inefficiency in operation. It is a guide to the future course of
action.
5. Profit or Loss : Profit or loss on each job can be determined by
comparing the actual cost with the price obtained.
9
Illustration 1 : The following given below has been taken from the cost
records of an engineering works in respect of the Job No. 888.
Material: Rs. 4010
Wages : Department A-60 hours @ Rs. 3 per hour
Department B-40 hours @ Rs. 2 per hour
Department C-20 hours @ Rs. 5 per hour
The overhead expenses are as follows :
Variable: Department A-Rs. 5000 for 5000 hours
Department B-Rs. 3000 for 1500 hours
Department C - Rs. 2000 for 500 hours
Fixed expenses Rs. 20,000 for 10,000 working hours.
Calculate the cost of the Job no. 888 and the price for the job to give a
profit of 25 per cent on the selling price.
Solution :
Job Cost Sheet (Job No. 333)
Particulars Rs. Rs.
Materials 4,010
Wages :Dept. A (60×Rs. 3) 180
Dept. B(40×Rs. 2) 80
Dept. C(20×Rs. 5) 100 360
Overhead expenses :
Variable :
Deptt. A @ = =Re. 1×60=60
Dept. B@ = =Rs. 2×40=80
Dept. C @ = = Rs. 4×20=80 220
Fixed expenses :
=2×(60+40+20) 240
Cost of the job 4,830
Add : Profit 25% on selling price 1,610
Selling Price 6,440
5000
5000
3000
1500
2000
500
20,000
10,000
10
19.6 WORK-IN-PROGRESS IN JOB COSTING
The cost of an incomplete job, that is, a job on which some
manufacturing operation is still due is termed work-in-progress. If a
production order has not been duly completed by the end of an accounting
period, it is essential that the closing stock of the work-in-progress be
determined. Unless this is correctly done, the profits for the period will
be distorted. Determination of work-in-progress is frequently essential
where periodic Profit and Loss Account is required to be prepared for
control purposes without reference to the closure of the accounting period.
The account is respect of such jobs may be maintained in the
following ways :
1. A composite work-in-progress account for the entire factory.
2. A composite work-in-progress account for every department. For
example, if the factory has three departments A, B and C, a work-inprogress
for each of these three departments will be opened.
The work-in-progress account is periodically debited with all
costs direct and indirect incurred in execution of the jobs. At intervals of
month or so a summary of completed jobs is prepared and the work-inprogress
account is credited with the cost of completed jobs. In case workin-
progress account for each department of the factory has been opened,
it will be necessary to find out the cost of completed jobs regarding each
department. The balance in work-in-progress account at any time represents
the cost of jobs not yet completed.
Illustration 2 :
The following information for the last year is obtained from
the books and records of a factory :
11
Completed jobs Work-in-progress
Rs. Rs.
Raw materials supplied from stores 9,00,000 3,00,000
Wages 10,00,000 4,00,000
Chargeable expenses 1,00,000 40,000
Materials returned to stores Rs. 10,000
Factory overheads are 80% of wages and office and selling overheads 25% of
the factory cost.
The sales value of completed jobs during the year is Rs. 41,00,000.
You are required to prepare :
(i) A consolidated work-in-progress account, and
(ii) A cost of sales account showing profit made or loss incurred on the completed
jobs.
Solution :
Consolidated work-in-progress account
To Stores (Raw materials By Stores (Materials
supplied) 12,00,000 returned) 10,000
To Wages 14,00,000 By Cost of sales-jobs
To Chargeable expense 1,40,000 completed (1) 28,00,000
To Factory overheads
(80% of wages) 11,20,000 By Balance c/d 10,50,000
38,60,000 38,60,000
12
Cost of Sales account
To work-in-progress By Sales 41,00,000
(completed jobs) 28,00,000
To Office and selling
overheads (25% of
factory cost) 7,00,000
To Profit 6,00,000
41,00,000 41,00,000
Working note :
1. Factory cost of completed jobs :
Rs.
Raw materials 9,00,000
Wages 10,00,000
Chargeable expenses 1,00,000
Factory overheads (80% of wages) 8,00,000
28,00,000
19.7 FEATURES OF PROCESS COSTING
Process Costing is a method of costing used to ascertain the cost
of a product at each process or stage of manufacture. In this method, the costs
of materials, wages and overheads are accumulated for each process separately,
for a given period, and then carried forward cumulatively from one process to
the next process till the last process is completed. Records are also maintained
to account for process losses. These losses may be normal or abnormal. Separate
accounting is done for normal and abnormal losses, opening and closing workin-
progress and inter-process profits, if any. This method of costing is used in
those industries where mass production of identical units is undertaken on a
13
continuous basis and finished products are subjected to a number of production
stages called processes before completion.
The system of process costing is suitable for industries
involving continuous production of the same product or products through
the same process or set of processes. It is in use in plant producing paper,
rubber products, medicines, chemical products. It is also very much
common in flour mill, bottling companies, canning plants, breweries etc.
Process costing is that aspect of operation costing which is
used to ascertain the cost of the product at each process or stage of
manufacture, where processes are carried on having one or more of the
following features:
(i) Production is done having a continuous flow of identical products
except where plant and machinery is shut down for repairs, etc.
(ii) Clearly defined process cost centres and the accumulation of all
costs (materials, labour and overheads) by the cost centres.
(iii) The maintenance of accurate records of units and part units produced
and cost incurred by each process.
(iv) The finished product of one process becomes the raw material of
the next process or operation and so on until the final product is
obtained.
(v) Avoidable and unavoidable losses usually arise at different stages
of manufacture for various reasons. Treatment of normal and
abnormal losses or gains is to be studied in this method of costing.
(vi) Sometimes goods are transferred from one process to another process
not at cost price but at transfer price just to compare this with the
market price and to have a check on the inefficiency and losses
occurring in a particular process. Elimination of profit element from
stock is to be learnt in this method of costing.
(vii) In order to obtain accurate average costs, it is necessary to measure
the production at various stages of manufacture as all the input units
may not be converted into finished goods; some may be in progress.
Calculation of effective units is to be learnt in this method of costing.
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(viii)Different products with or without by-products are simultaneously
produced at one or more stages or processes of manufacture. The
valuation of by-products and apportionment of joint cost before point
of separation is an important aspect of this method of costing. In
certain industries, by-products may require further processing before
they can be sold. A main product of one firm may be a by-product of
another firm and in certain circumstances, it may be available in the
market at prices which are lower than the cost to the first mentioned
firm. It is essential, therefore, that this cost be known so that
advantages can be taken of these market conditions.
(ix) Output is uniform and all units are exactly identical during one or
more processes. So the cost per unit of production can be ascertained
only by averaging the expenditure incurred during a particular period.
19.8 DIFFERENCE BETWEEN PROCESS COSTING AND JOB
COSTING
Process costing and job costing differ on the following counts:
1. Applicability. Job costing is applicable in situations where the
objective is to identify costs with specific products or jobs. Process
costing, on the other hand, is used in case of mass production of
similar units that continuously pass through different departments
or processes.
2. Cost Collection : In job costing, manufacturing costs are
accumulated for particular jobs or batches of product using job cost
sheets. In process costing, manufacturing costs are accumulated for
entire departments or processes and the cost of particular jobs or
batches or products is not determinable.
3. Time period assumption : In job costing, costs are accumulated for
a specific product or job without taking into account the production
time which may be more than one accounting period. In process
costing, costs are accumulated for specific departments/processes
for a given time period (say a month). That is, production is
measured for specific time periods in process costing.
15
4. Purpose : In job costing production his generally dependent on
customers' orders and specifications. Under process costing,
production is done for storing stock of goods and for future sale.
5. Computation of unit costs : In job costing unit cost is obtained by
dividing the cost of the job order by units produced in the job order.
Under process costing, unit costs are obtained by dividing
departmental/process costs by process production.
6. Work-in-progress : In job costing, one work-in-progress account is
maintained. But in process costing, individual work-in-progress
accounts are prepared for each production/process department to
ascertain manufacturing costs by process.
19.9 TYPES OF PROCESSING
As stated above, process costing is used in case of industries,
which involve processing of a product through different stages. The various
types of processing are as follows :
(i) Continuous sequential processing : In case of this processing a
product has to pass through different cost centres or stages of manufacturing
continuously and in succession one after the other during a period. The
processing being continuous and identical, the costing units for each centre
or stage are identical during any period. Examples of this type of processing
are cement-making, paper-making, refining of crude petroleum, etc.
(ii) Discontinuous Processing : In case of this processing, a process is
independently operated for the individual product as such at frequent
intervals. The costing unit in case of this processing, dependent upon the
product may vary even for the same cost centre. Examples of this type of
processing are dye manufacturing, fruit preservation, vegetable canning,
yarn spinning, etc.
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(iii) Parallel Processing : In case parallel processing, the operations or
stages through which the product has to pass run parallel and separately. All
these parallel processes ultimately join with the end process. Examples of
this type of processing are manufacturing different components which
ultimately join in the assembly process to make a product, meat packing etc.
(iv) Selective Processing : In case of this processing, the combination
of the processes or stages of operation depend upon the end-product to be
commercialised. Examples of this type of processing are cooked meat,
chloride compounds like bleaching power of zinc chloride or hydrochloric
acid, etc.
19.10 ADVANTAGES OF PROCESS COSTING
The advantages of process costing can be summarised as
follows:
1. The cost of different processes as well as finished product can be
computed conveniently at short intervals, say, daily or weekly.
2. Control cost and production can be advantageously effected as predetermined
and actual data are available for each department or
process.
3. It involves less clerical work because of the simplicity of cost
records.
4. The average costs of homogeneous products can easily be computed.
5. Expenses can be allocated to different processes on rational basis
and accurate cost, thus, can be ascertained.
6. It enables the correct valuation of closing inventories.
19.11 DISADVANTAGES OF PROCESS COSTING
1. The cost ascertained at the end of the process is called historical
cost which is of very small use for managerial control. Since it is
based on historical costs, it has all the weaknesses of historical
costing.
17
2. The system of costing conceals weaknesses and inefficiencies in
processing.
3. It does not evaluate the efforts of individual workers or supervisors.
4. The valuation of work-in-progress on the basis of degree of
completion is merely a guess work.
5. If production is not homogeneous, as in the case of foundries making
castings of different sizes and shapes, the average cost may give an
incorrect picture of cost.
19.12 COSTING PROCEDURE
The factory or concern is divided into distinct processes or
operations and a separate account is opened for each process (cost centre).
The account is debited with the value of material, labour and overheads
relating to the process. The value of by products and scrap, if any, is
credited to the account and the balance of this account, representing the
cost of partially worked out product, is passed on to the next process
becomes the raw material of the next process. In some industries,
depending upon the plant arrangement, the partially worked out product
of a process may be transferred to a process stock account from which it
may be issued to the next process as and when required. The finished out
of the last process (i.e. finished product) is transferred to the Finished
Goods Account. All expenditure of materials, labour, direct expenses and
overheads are charged to the process concerned. In brief :
(i) Materials : Materials required for each process are drawn from store
against Materials Requisitions or Bill of Materials and debited to cost.
When the materials are issued in bulk, the person-incharge of the
department has to keep the account of materials consumed. When the
finished product of one process becomes the raw material of the next
process, the account of the receiving process should be debited with the
cost of transfer, in addition to the cost of additional materials, if any.
18
(ii) Labour : Wages paid to labourers and workmen who are engaged
in particular processes are directly allocated to the process. If workers are
engaged in a number of processes, the wages paid may be apportioned on
the basis of time-booking.
(iii) Direct Expense : Direct expenses such as depreciation, insurance,
electricity, repairs, etc. are directly allocated to the respective accounts.
(iv) Overheads : Rent, telephone, lighting, gas, water, etc. which are
some common expenses of one or more processes, may be apportioned to
the various processes on suitable basis. Generally, these overheads are
recovered at predetermined rates or based on direct wages or prime cost.
From the cost accounting point of view, there could be
processes which may or may not have process losses. Similarly, in respect
of each process, there may or may not be work-in-progress at the beginning
or at the end.
Illustration 3 : A company produces two products - P and R. They undergo
two processes, namely Factory and Finishing. Raw materials used in the
factory and general expenses incurred are apportioned in the ratio of output
of each class. The output for the year ended 2001 was : P-6,000 and R-
2,000. Other charges for each process are apportioned in the ratio of
finishing wages.
From the following particulars, prepare a statement of costs
per unit of each product in each process showing the cost of production
and profit per unit. The selling prices are - P Rs. 100 and R Rs. 120.
19
Factory (Rs.) Finishing (Rs.)
Opening stock of raw materials 92,000 18,000
Purchases of raw materials 2,67,750 84,250
Closing stock of raw materials 1,23,750 19,750
Wages : P 1,06,500 37,500
R 32,500 25,000
Expenses 93,125 41,250
General expenses amounted to Rs. 48,000 in all.
Solution :
Statement of Costs
P(6,000 units) R (2,000 units)
Particulars Total Total Per unit Total Per Unit
Rs. Rs. Rs. Rs. Rs.
Factory Process
Raw materials consumed (3:1) 2,36,000 1,77,000 29.50 59,000 29.50
Wages (Actual) 1,44,000 1,06,500 17.75 37,500 18.75
Factory expenses (3:2) 93,125 55,875 9.31 37,250 18.62
Cost of factory process 4,73,125 3,39,375 56.56 1,33,750 66.87
Finishing Process
Raw materials consumed (3:2) 82,500 49,500 8.25 33,000 16.50
Wages (Actual) 62,500 37,500 6.25 25,000 12.50
Finishing expenses (3:2) 41,250 24,750 4.12 16,500 8.25
Cost of finishing process 6,59,375 4,51,125 75.18 2,08,250 104.12
General expenses (3:1) 48,000 36,000 6.00 12,000 6.00
Total cost 7,07,375 4,87,125 81.18 2,20,250 110.12
Profit 1,32,680 1,12,920 18.82 19,760 9.88
Selling price 8,40,055 6,00,045 100.00 2,40,010 120.00
20
@ Rs. 78
19.13 PROCESS LOSSES AND WASTAGES
When materials are processed, they lose or gain in volume or
weight as a result of the process. It is common that process loss or scrap
or wastage occur in process industries. These process losses may be of
two types, viz. controllable and uncontrollable.
(a) Normal or uncontrollable loss : Because of the nature of the raw
materials, some loss is inherent and is unavoidable. This is known as
normal waste or normal loss. And this type of loss is expected in normal
condition for example, stamping process, evaporation, etc. The percentage
of such losses is anticipated from past experience by the management.
Loss of this type should be absorbed by good units produced, i.e. the cost
of units lost in charged to the good units output. Any value realisable on
the normal loss will be credited to the process account.
Illustration 4 : (Normal loss without scrap value)
The cost of production of 40 units consisting of materials
Rs. 1,500; Labour Rs. 1,300 and Overhead Rs. 164. The normal waste is
5% of input. Prepare the Process Account.
Solution :
Process Account
Particulars Units Amount Particulars Units Amount
Rs. Rs.
To Materials 40 1,500 By Normal Loss 2 –
To Labour – 1,300 By Final Product 38 2,964
To Overheads – 164
40 2,964 40 2,964
21
Rs. 2,964
(40-2)
Normal cost of normal production
Normal output
Note : The normal wastage reduces the quantity of output. But the
cost of normal loss, regarded as part of the cost of production process, in
which it occurs. The amount of loss is borne in the production cost of
good units. The cost per unit of output goes up to that extent. The quantity
of normal wastage is recorded in the Quantity Column and Nil figure is
shown in the amount column.
Per Rate = = Rs. 78
(or) Rs. 78 × 38 = Rs. 2,964
(b) Abnormal Loss or Controllable Loss : In certain cases, it can be
seen that the loss exceeds the predetermined normal loss. Any loss
exceeding the normal loss is called abnormal loss. Abnormal loss should
not affect the normal cost of production. It is caused by accidents, substandard
materials, carelessness etc. Therefore, abnormal loss is valued
just like good units and transferred to a separate account called Abnormal
Loss Account.
Value of Abnormal loss
= × Units of abnormal loss
The loss on account of abnormal loss or wastage is not borne
by production, but by Profit and Loss Account. Abnormal Wastage Account
is debited and Process Account is credited with the cost of abnormal
wastage. If the wastage is sold in the market, Abnormal Wastage Account
is credited with the realised price and the balance is transferred to Profit
and Loss Account.
Illustration 5 : (Normal loss and abnormal loss with scrap value)
In Process A, 100 units of raw materials were introduced at a
cost of Rs. 1,000. The other expenditure incurred by the process is Rs.
22
Rs. 1,530
90
600. Of the units introduced, 10% are normally scraped in the course of
manufacture and they possess a scrap value of Rs. 7 per unit. The output
of Process A was only 75 units. Calculate the value of abnormal loss.
Solution :
Process Account
Rs. Rs.
To Materiels 100 1,000 By Normal Loss 10 70
To Other 600 By Abnormal 15 255
Expenses Loss
– By Process B A/c 75 1,275
@ Rs. 17
100 1,600 100 1,600
Value of abnormal wastage = × Abnormal Loss
Normal Cost = Rs. 1,600 – Rs. 70 = Rs. 1,530
Amount of abnormal units = × 15 = Rs. 255
Amount of good units = × 75 = Rs. 1,275
The unit rate of abnormal loss and the unit rate of good units
are the same, i.e. Rs. 17
Note : Abnormal losses are valued as good units. The unit cost which is
used to value good units is also applied for valuation of abnormal loss
units. The cost of abnormal loss units computed in this manner is
Normal cost of normal output
Normal output
Rs. 1,530
90
23
Cost of Normal Output
Normal Output
transferred to a separate Account, called, Abnormal Loss Account and
credited to the relevant Process Account.
(c) Abnormal Gain or Effectiveness
Sometimes, the actual loss in a process may be smaller than
what so expected on the basis of experience. This represents an exceptional
or abnormal gain over what is normally anticipated. The value of abnormal
gain is calculated in the same manner as that of abnormal loss and is
credited to Abnormal Gain Account. The amount of scrap which would
otherwise have been realised, had there been normal loss and no abnormal
gain, is debited to the Abnormal Gain Account and the balance is credited
to Costing Profit and Loss Account.
Value of abnormal gain is calculated with the following formula :
= × Abnormal Gain (units)
= × Abnormal Gain (units)
Illustration 6 :
In process A, 1000 units of raw materials were introduced at
a cost of Rs. 15,000. Direct wages amounted to Rs. 7,500 and
manufacturing overheads to Rs. 5,000. 10% of the units introduced are
normally lost in the course of manufacture and these are sold @ Rs. 5 per
unit. The actual output of the process was 940 units.
Prepare Process A Account and Abnormal Gain Account.
Total Process Cost - R eliable Value of Normal Wastage
Input (units) - Normal Wastae (units)
24
Total Cost-Scrap Realised
Normal Output
27,500 – 500
900
overheads 5,000
Solution :
Process A Account
Rs. Rs.
To Materials 100 15,000 By Normal loss (10%) 100 500
To Direct wages – 7,500 By Finished Stock A/c 940 28,200
To Manufacturing
To Abnormal Gain A/c 40 1,200
1,040 28,700 1,040 28,700
Note : Calculation of Value of Abnormal Gain
Normal Output = Units Introduced - Normal Loss
= 100-100
= 900 units
Abnormal Gain = 940-900
= 40 units
Value of Abnormal Gain = ×Units of Abnormal Gain
= × 40
= Rs. 1,200
Abnormal Gain A/c
To Normal Loss 40 200 By Process A A/c 40 1,200
(Loss of income from scrap)
To Cost Profit & Loss A/c 1,000
40 1,200 40 1,200
25
(d) Scrap and Defective : Scrap is the incidental residue from certain
types of manufacture, usually of small amount and of low value, recoverable
without further processing. Scrap may be sold or reused. The amount realised
from sale of scrap is credited to the process account. Finished products that
are not upto the predetermined standard, are known as defective. If the
defective are sold, the amount realised is credited to process account. If the
defective are sought to be rectified by spending additional material, labour
etc. the extra amount spend is treated as overheads. If the defective units
(normal) are discarded the cost of output is increased (as in the case of
normal loss). For abnormal defective units the loss is transferred to Costing
Profit and Loss Account (like abnormal loss).
19.14 INTER PROCESS PROFITS
Sometimes the output of one process is transferred to a
subsequent process, not at cost, but at a price, showing a profit to the
transferer process. Transfer price may be made at a price corresponding
to current wholesale market price or at cost plus an agreed percentage.
The objects are :
(i) to know whether the cost of production competes with the market
prices; and
(ii) to make each process stand on its own efficiency and economies,
i.e., the transferee processes are not given the benefits of economies
effected in the earlier process.
This system involves a rather unnecessary complication of
the accounts, as the desired comparison could be prepared on separate
cost reports for each process or by adopting a standard costing system
when standards could be set for each process. The complexity brought
into the accounts arises from the fact that the inter-process profits so
26
Cost
Total
introduced remain included in the price of process stocks, finished stocks
and work-in-progress. For the balance sheet purpose, inter-process profits
cannot be included in stock, as a firm cannot make a profit by trading
itself. To avoid these complications a provision must be created to reduce
the stock to actual cost price. This problem arises only in respect of stocks
on hand at the end of the period, because goods sold will have realised
the internal profits.
In order to compute the profit element in closing inventories
and to obtain the net realised profit for a period, three columns have been
shown on each side of process accounts and closing stock have been
deducted from the debit side of the process accounts instead of showing it
on the credit side. Cost of closing stock can be easily obtained if we
compare the accumulated cost and total in any process. The cost of stock
can be obtained by the following formula :
= × Closing Stock
The profit on closing stock can then be easily obtained by
deducting the cost of stock thus arrived at from the value of stock.
Sometimes opening stock and production overheads are given.
We should add the opening stock at the beginning along with transfer
cost, materials and wages. From the total of these, closing stock should
be deducted to calculate prime cost. Then production overheads are added.
This becomes the total cost of the process to which is added the desired
percentage of profit.
Illustration 7 : A product passes through three processes before it is
completed. The output of each process is charged to the next process at a
price calculated to give a profit of 20% on transfer price. The output of
process III is charged to Finished Stock Account on a similar basis. These
27
was no work-in-progress at the beginning of the year and overheads have
been ignored. Stock in each process has been valued at the prime cost of
the process. The following data is obtained on 31st December 2001 :
Item Process I Process II Process III Finished Stock
Rs. Rs. Rs. Rs.
Direct Materials 3,000 2,000 4,000 –
Direct Wages 2,000 3,000 1,000 –
Stock on
31st December 1,000 2,000 3,000 3,000
Sales during the year – – – 17,000
You are required to :
a) prepare process cost accounts showing the profit element at each stage;
b) show actual profit realised; and
c) show stock valuation as it would appear in the Balance Sheet.
Solution :
Process I A/c
Total Cost Profit Total Cost Profit
To Materials 3,000 3,000 – By Process 5,000 4,000 1,000
II A/c
To Wages 2,000 2,000 –
Total 5,000 5,000 –
Less Closing Stock 1,000 1,000 –
Prime cost 4,000 4,000 –
To Gross Profit
(25% on cost) 1,000 – 1,000
5,000 4,000 1,000 5,000 4,000 1,000
To Opening
Stock b/d 1,000 1,000 –
28
Process II A/c
To Process I A/c 5,000 4,000 1,000 By Process
III A/c 10,000 7,200 2,800
To Materials 2,000 2,000 –
To Wages 3,000 3,000 –
Total 10,000 9,000 1,000
Less Closing Stock 2,000 1,800 200
Prime Cost 8,000 7,200 800
Add Gross Profit
(25% on cost) 2,000 – 2,000
10,000 7,200 2,800 10,000 7,200 2,800
To Opening
Stock b/d 2,000 1,800 200
Process III A/c
To Process II A/c 10,000 7,200 2,800 By Finished
Stock A/c 15,000 9,760 5,240
To Materials 4,000 4,000 –
To Wages 1,000 1,000 –
Total 15,000 12,200 2,800
Less Closing Stock 3,000 2,440 560
Prime Cost 12,000 9,760 2,240
Add Gross Profit
(25% on cost) 3,000 – 3,000
15,000 9,760 5,240 15,000 9,760 5,240
To Opening
Stock b/d 3,000 2,440 560
29
Cost
Total
9,000
10,000
12,200
15,000
9,760
15,000
Finished Stock A/c
To Process III A/c 15,000 9,760 5,240 By Sales 17,000 7,808 9,192
(transfer)
Less Closing Stock 3,000 1,952 1,048
12,000 7,808 4,192
To Gross Profit 5,000 – 5,000
17,000 7,808 9,192 17,000 7,808 9,192
To Opening
Stock b/d 3,000 1,952 1,048
Notes :
(a) Calculation of unrealised profit on closing stock
For this purpose, the cost of closing stock is calculated by
taking the figures in the cost and total columns for each process before
deducting the closing stock by applying the following formula :
Cost of Stock = × Closing Stock
Cost of closing stock Unrealised profit
Process I – Rs. 1000 (given) Nil
Process II = × 2000 = Rs. 1,800 Rs.2,000-1800 = Rs.200
Process III = × 3000 = Rs. 2,440 Rs.3000-2440 = Rs. 560
Finished Stock = × 3,000 = Rs. 1,952 Rs. 3000-1952 =Rs. 1048
30
(b) Actual Profit Realised
Apparent profit Unrealised profit Actual profit
from process from closing stock realised
(Rs.) (Rs.) (Rs.)
Process I 1,000 – 1,000
Process II 2,000 200 1,800
Process III 3,000 560 2,440
Finished Stock 5,000 1,048 3,952
11,000 1,808 9,192
(c) Stock Valuation for Balance Sheet Purposes
Cost of closing stock (Rs.)
Process I 1,000
Process II 1,800
Process III 2,440
Finished Stock 1,952
Total 7,192
19.15 WORK-IN-PROGRESS
The problem of ascertaining work-in-progress in process
industries is very important and generally difficult. In most firms,
production is on a continuous basis and so the problem of work-in-progress
is quite common. This problem can be solved by calculating equivalent
production (units) or equivalent completed (effective) units.
Equivalent Production : Equivalent production means converting the
incomplete production into its equivalent completed units. In each process,
an estimate is made of the percentage completion work-in-progress with
regard to different elements of cost, viz., material, labour and overhead. It
is most important that the estimate of percentage completion is as accurate
as possible. The formula for computing equivalent completed units is :
31
Actual number of units in Percentage of
process of manfacture work completed
Equivalent completed units = ×
The steps involved in the computation of equivalent
production are outlined below :
(i) Express the opening inventory of work-in-progress in equivalent
completed units : This may be done by multiplying the units of opening
work-in-progress by the percentage of work required to be done to
complete the unfinished work of the previous period.
(ii) Add to (i) above, the number of units completed out of the units
introduced during the period.
(iii) Then add (ii) above, the equivalent completed units of closing workin-
progress. This can be done by multiplying the units of closing work in
progress by the percentage of work done on the unfinished units at the
end of the period.
The equivalent units may be required to be computed in respect
of each element of cost, viz., material, labour and production overhead.
The cost of units completed from the unfinished units of the
previous period (opening work-in-progress) plus the units completed of
the current period's input, and the units still remaining uncompleted
(closing work-in-progress) should be shown separately.
Illustration 8 :
Opening stock of work-in-progress 4,000 units 40% complete.
Units put into process : 30,000
Units completed : 32,000
Closing stock of work-in-progress 2,00 units, 60% complete.
Calculate equivalent production.
32
Solution :
Rs.
Opening stock-work required to be completed
(4,000×60%) 2,400
Add : Units introduced and completed during the period
(30,000-2,000) 28,000
Add : Closing stock (work done i.e. 60%)
(2,000×60%) 1,200
Completed equivalent production 31,600
Alternatively Rs.
Units completed during the year 32,000
Add : Closing stock (work done i.e. 60%)
(2,000×60%) 1,200
33,200
Less : Opening work-in-progress
(percentage of work done in the previous period)
4,000×40% 1,600
Complete equivalent production 31,600
Alternatively Rs.
Opening stock of work incomplete 4,000×60% 2,400
Add : Put into production 30,000
Less : Closing work-in-progress incomplete (2,000×40%) 800
Complete equivalent production 31,600
In order to understand the equivalent production clearly,
illustrations on equivalent production may be divided into two groups.
I When there is only closing work-in-progress
II When there is opening as well closing work-in-progress.
Again, these may be further divided into two groups, i.e., (a)
When there are no process losses, and (b) when there are process losses
and gains.
33
I When There is only closing work-in-progress
(a) Without Process Losses
Under this case, the existence of process losses is ignored.
Closing work-in-progress is converted into equivalent units on the basis
of estimates as regards degree or completion of materials, labour and
production overhead. After calculating the equivalent units, it is not
difficult to evaluate closing work-in-progress.
Illustration 9 : Input 3,800 units ; closing work-in-progress 800 units and
degree of completion of Material 80%, Labour and Overhead 70%. The
Process Costs are : Material Rs. 7280, Labour and Overhead Rs. 17,800.
Find out Equivalent Production, Cost per unit of Equivalent
Production and prepare the Process A Account assuming that there is no
opening work-in-progress and process loss.
Solution :
Statement of Equivalent Production and Cost
Input Output Equivalent Production Units
Materials Labour and
Item Units Items Overhead
Units Units % Units %
Units Units com-
Intro- pleted &
duced 3,800 transferred 3,000 3,000 100 3,000 100
Work-in-
Progress 800 640 80 560 70
3,800 3,800 3,640 3,560
Current Cost 7,280 17,800 Total
Cost per Equivalent Unit Rs. 2 Rs. 5 Rs. 7
34
Statement of Evaluation
Finished Goods 3,000×7 = Rs. 21,000
Work-in-Progress
Materials 640×2 = 1,280
Labour and Overhead 560×5 = 2,800 Rs. 4,080
Process A Account
Rs. Rs.
To Materials 3,800 7,280 By Finished Stock A/c 3,000 21,000
To Labour & By Work-in-Progress 800 4,080
Overhead 17,800
3,800 25,080 3,800 25,080
b) With Process Losses : Generally, losses are inherent in process
operations. Normal process losses are ignored in ascertaining equivalent
production. But abnormal losses or gains should be treated as good units
having due regard to the degree of completion. If units scrapped have any
realisable value, that amount should be deducted from the cost of materiels
in the cost statement before dividing it by equivalent production units. As
regards abnormal loss, if the degree of completion is separately given, it
has to be duly considered while preparing the Equivalent Production
Statement. Otherwise, it may be assumed that the rejection (in respect of
units of abnormal loss) has taken place at the stage of final inspection and
abnormal loss units may, therefore, be taken to be 100% complete in all
respects. But in case of abnormal gain, the degree of completion should
always be taken at 100% as gain is represented by good production units.
35
Illustration 10 :
During the month of January, 4,000 units were introduced
into process A. The process costs were :
Rs.
Materials 30,000
Direct Wages 20,700
Factory Overheads 5% of Direct Wages.
The normal loss was estimated at 10% on input. At the end
of the month, 3200 units had been produced and transferred to process B.
500 units had been scrapped. The scrapped units had been completely
processed and realised Rs. 5 per unit. 300 units were incomplete and the
stage of completion in respect of these units was estimated to be - materials
75%, labour and overheads 50%
Find out (a) Equivalent production, (b) Cost per unit, (c) Value
of output to be transferred. Also show the necessary accounts.
Solution :
Statement of Equivalent Production
Input Output Units Equivalent Production
Material Labour & Overheads
%age Units %age Units
comp- completion
letion
4,000 Normal 400 – – – –
(10% of 4,000)
Abnormal loss 100 100 100 100 100
(500-400)
Finished production 3,200 100 3,200 100 3,200
Work-in-progress 300 75 225 50 150
4,000 Total 4,000 3,525 3,450
36
Statement of Cost
Elements of Cost Cost Equivalent Cost per
Production (Units) Unit
Materials 30,200
Less Scrap value of normal loss
(5×400) 2,000 28,200 3,525 8
Direct wages 20,700 3,450 6
Factory overheads (50% of direct wages) 10,350 3,450 3
Total 59,250 17
Statement of Evaluation
Finished Production
Materials 3,200 units @ Rs. 8 per unit = 25,600
Labour 3,200 units @ Rs. 6 per unit = 19,200
Overheads 3,200 Units @ Rs. 3 per unit = 9,600
Rs. 54,400
Work-in-progress
Materials 225 units @ Rs. 8 per unit = 1,800
Labour 150 units @ Rs. 6 per unit = 900
Overheads 150 units @ Rs. 3 per unit =450
Rs. 3,150
Abnormal Loss
Materials 100 units @ Rs. 8 per unit = 800
Labour 100 units @ Rs. 6 per unit = 600
Overheads 100 units @ Rs. 3 per unit = 300
1,700
Process A A/c
Particulars Units Amt. Particulars Units Amt.
(Rs.) (Rs.)
To Materials 4,000 30,200 By Normal loss(10% of 4,000) 400 2,000
To Direct wages 20,700 By Abnormal loss @ Rs. 17 100 1,700
To Factory overheads By Process B A/c @ Rs. 17 3,200 54,400
(50% of direct wages) 10,350 By Balance c/d 300 3,150
4,000 61,250 4,000 61,250
37
Process B A/c
(Rs.) (Rs.)
To Process A/c 3,200 54,400
(Transfer)
Abnormal Loss A/c
(Rs.) (Rs.)
To Process A A/c 100 1,700 By Cash 100 500
(Sale of scrap @ Rs. 5)
By Costing Profit & Loss A/c 1,200
100 1,700 100 1,700
II When There are Opening As Well as Closing Work-in-Progress
Often in a continuous process there will be opening as well
as closing work-in-progress which are to be converted into equivalent of
completed units before apportionment of process costs. The procedure of
conversion of opening work-in-progress will vary depending upon whether
average cost method or first in first out method of apportionment of costs
is followed. Problems of closing work-in-progress have already been
discussed in the previous pages. The following pages will discuss both
methods for valuation of work-in-progress one by one :
(a) FIFO Method : Under this method one assumes that the raw
materials issued to work-in-progress pass through the finished goods in a
progressive cycle, i.e. what comes first, goes out first. This method is
satisfactory when prices of raw materials and rates of direct labour and
overheads are relatively stable. Work-in-progress at the end of the period
becomes the opening work-in-progress for the next period, the closing
work-in-progress will be valued at costs ruling during the new period,
38
while the opening work-in-progress will valued at costs ruling during the
old period. Thus, where costs are more or less the same in each period,
this system is adequate. In this method opening incomplete work-inprogress
units are to be converted to equivalent production after taking
into consideration the percentage of work yet to be done and shown
separately in the statement of equivalent production.
(b) Average Cost Method : Simple average method may also be
employed to compute process costs in place of FIFO method. The principle
underlying it is that since it is not possible to identify or first complete
the opening work-in-progress, the work is carried on all units
simultaneously and the units to be transferred to next process may not
necessarily contain all the units of opening work-in-progress, or, so to
say, the closing work-in-progress need not compulsorily be out of units
introduced during this period. Moreover, the degree of completion of
opening work-in-progress may not be known. Under all such
circumstances, average method is to be used for computation of costs.
The cost of opening work-in-progress and the cost incurred during the
period are added up. The units completed and transferred and the
transferred and the equivalent units of closing work-in-progress on the
basis of degree of completion are added to arrive at total equivalent
production. The total cost is divided by the total equivalent production to
obtain the per unit cost. The evaluation may be done separately for material
cost, labour cost and overhead cost as per the stage of completion reached
in respect thereof.
Thus, the main difference between FIFO method and average
method is that units of opening work-in-progress and their cost are taken
in full under average method while under FIFO method only the remaining
work done now is considered.
39
Illustration 11 :In a process inventory in process at the beginning of a
period was valued at Rs. 2,950 made up of Rs. 1,400 towards materials,
Rs. 1,000 towards labour and Rs. 550 towards overheads for 100 units.
The value added during the period was Rs. 53,600 towards an introduction
of 4,100 units from the previous process besides Rs. 40,800 towards labour
and Rs. 19,400 towards overheads. Out of 3,600 units completed 3,300
units were transferred to the next process leaving the balance in stock.
400 units were held back in process with half completion towards labour
and overheads while 200 units were lost in processing considered normal
and hence should be borne by the entire inventory. Prepare a cost of
production statement using average cost basis.
Solution :
Statement of Equivalent Production And Cost
Input Output Materials Labour Overhead
% Units % Units % Units
Opening 100 Normal 200 – – – – – –
Stock Loss
Added Units
during Completed 3,600 100 3,600 100 3,600 100 3,600
the period 4,100 Closing 400 100 400 50 200 50 200
WIP
4,200 4,200 4,000 3,800 3,800
Current Cost 1,400 1,000 550
53,600 40,800 19,400
55,000 41,800 19,950
Total Rs. 30 Rs.13.75 Rs. 11 Rs. 5.25
40
Evaluation Statement
Rs.
Completed units 3,600×Rs. 30 = 1,08,000
Closing WIP Material 400×Rs. 13.75=5,500
Labour 200×Rs.11 = 2,200
Overhead 200×Rs. 5.25 = 1,050 8,750
Process II Account
Particulars Units Rs. Particulars Units Rs.
To Opening Inventory 100 2,950 By Normal Loss 200 –
To Input Materials 4,100 53,600 By Completed &
To Labour 40,800 transfer to process
To Overhead 19,400 III 3,300 99,000
By Finished Stock 300 9,000
By Closing WIP 400 8,750
4,200 1,16,750 4,200 1,16,750
19.16 ACCOUNTING FOR JOINT PRODUCTS
In certain industries, where process costing is used, the
processing of the basic raw material results in the production of more
than one product. These products are called joint products or by-products.
Joint products and by-products are simultaneously produced in natural
proportions. In other words, production of joint and by-products cannot
be avoided and their proportions cannot be changed by choice.
Joint products are products which by the very nature of the
production process cannot be produced separately, and which have more
or less equal economic importance. They represent "two or more products
separated in the course of the same processing operation, usually requiring
further processing, each product being in such proportion that no single
41
product can be designated as the major product". For example, gasoline,
diesel, kerosene, lubricating oil, coal tar, paraffin and asphalt are the joint
products obtained from crude oil in a refinery. Different grades of lumber
resulting from a lumbering operation are another example.
Sometimes a distinction is made between joint product and coproducts.
Co-products do not always arise from the same operation or raw
materials and the quantity of co-products is within the control of the
manufacturer. For example, in the automobile manufacturing industry, a number
of co-products such as cars, jeeps and trucks of various types may be produced
in different quantities according to the need of the concern, while in the oil
industry, the quantity of various joint products remains almost the same and
cannot be changed without changing the quantity of the rest of the items.
Generally the products are not identifiable as different individual
products until a certain stage of production known as split off point. All costs
incurred prior to the split off point are called joint product costs. Accounting
for joint products implies the assignment of a portion of the joint cost to
each of the joint products. Unless the joint product costs are properly and
reasonably apportioned to different joint products produced, the cost of joint
products will vary considerably and this will affect valuation of inventory,
pricing of products and profit or loss on sale of different products. Therefore,
the basic problem in respect of joint products is that of apportioning the joint
costs. The following methods of apportionment of total cost before separation
point are available for application :
(a) Average unit cost method.
(b) Physical measurement method.
(c) Survey method or points value method.
(d) Contribution or gross margin method.
(e) Market value method :
(i) At point of separation
(ii) After further processing.
(iii) Net realisable value or reverse cost method.
42
Joint Cost
Total Number of Units Produced
Rs. 1,40,000
70,000
The discussion on these methods is as follows :
(a) Average Unit Cost Method : This method is very simple and the
total costs are assessed, yielding an average unit cost with one net profit
for the total operation. This can be applied where processes are common
and inseparable for the joint products and where the resultant products
can be expressed in the same common unit. This means that all joint
products have the same unit cost and therefore, if price fixing is based on
cost of various products which may be of different grades or quality will
be sold at the same unit price, resulting in a customer's price advantage in
high grades. Moreover, where the end products cannot be expressed in
some common unit, this method breaks down.
Illustration 12 : Jyoti Corporation produces four products in a
manufacturing process. The Corporation produced 10,000 units of A,
20,000 units of B, 15,000 units of C and 25,000 units of D. The costs
before split off point for the four products were Rs. 1,40,000. Using the
average unit cost method (a) calculate the unit cost, and (b) show how the
joint cost would be apportioned among the products.
Solution :
(a) Average unit Cost =
= = Rs. 2 per unit
(b) Cost apportioned among different products :
Product A = 10,000×2= Rs. 20,000 Product C=15,000×2=30,000
Product B=20,000×2 = Rs. 40,000 Product D = 25,000×2=50,000
(b) Physical Measurement Method : A physical base such as raw
materials weight, linear measure volume etc., is applied in apportioning
pre-separation point costs to joint products. For example, if there is 40%
43
beef in product X and 60% beef in Product Y, 4/10 of the cost upto
separation point will be charged to X and 6/10 to Y. This method is not
suitable where, for example, one product is a gas and another is liquid.
This method presupposes that each joint product is equally valuable, which
is probably not the case in practice.
Illustration 13 : The following data have been extracted fro the books of
M/s India Coke Co. Ltd.
Joint Coke Coal Benzol Sulphate of Gas Total
Products Tar Ammonia
Yield in Lbs. of
recovered products
per tonne of coal 1,420 120 22 26 412 2,000
The price of coal is Rs. 80 per tonne. Direct labour and
overhead cost of point of split off are Rs. 40 and 60 respectively per tonne
of coal. Calculate the material, labour, overhead and total cost of each
product on the basis of weight.
Solution :
Particulars Yield (in Lbs. Percentage Apportioned Cost
of recovered of total Coal Direct Over- Total
products Labour head
per ton of
coal)
Coke 1,420 71.0 56.80 28.40 42.60 127.80
Coal Tar 120 6.0 4.80 2.40 3.60 10.80
Benzol 22 1.1 0.88 0.44 0.66 1.98
Sulphate of 26 1.3 1.04 0.52 0.78 2.34
Ammonia
Gas 412 20.6 16.48 8.24 12.36 37.08
Total 2,000 100 80.00 40.00 60.00 180.00
(c) Survey Method or Points Value Method : Under this method, the
common costs are apportioned to joint products after considering a number
44
13800
of factors such as volume, selling price, mixture, technical, engineering
and marketing processes. Accordingly, percentage or points values are
assigned to individual products to denote their relative importance and
costs are apportioned on the basis of total points. This method is generally
considered to be more equitable than other methods in as such as a
combination of related factors is considered. It can be used period after
period until there are changes in the methods of production and sale.
Illustration 14 : A canning merchant supplies you the following
information for a particular period :
Grade Units produced
A 1,000
B 1,600
C 2,000
The pre-separation costs incurred were Rs. 41,400. The joint
costs are apportioned on technical evaluation based in the proportion of 5:3:2
to the three grades respectively. You are required to apportion the joint costs.
Solution :
Apportionment of Joint Costs (Survey Method)
Items Units Points Equivalent Cost Per Apportioned Cost per
Attached Units Equivalent Cost (Rs.) Unit (Rs.)
(1) (2) (3) (4) =2×3 (5)=41400/ (6) =4×5 (7) =6/2
Grade A 1,000 5 5,000 3 15,000 15
Grade B 1,600 3 4,800 3 14,400 9
Grade C 2,000 2 4,000 3 12,000 6
4,600 13,800 41,400
(d) Contribution or Gross Margin Method : This method uses the
technique of marginal costing. The joint costs are segregated into two
45
parts-variable and fixed. The variable costs are apportioned over the joint
products on the basis of units produced or physical quantities. In case the
products are further produced after the point of separation, then all variable
costs incurred on such processing are added to the variable costs
determined earlier to ascertain the contribution of each product. The fixed
costs are then apportioned over the joint products on the basis of the
contribution ratio.
Illustration 15 : From the following information, apportion marginal
costs and fixed costs on suitable basis and ascertain profit or loss for each
of the joint products :
Sales : A 200 Kgs. @ Rs. 45 per kg.
B 240 Kgs. @ Rs. 25 per kg.
Total Cost : Variable or marginal Cost Rs. 8,800
Fixed Cost Rs. 3,100
Solution :
Particulars Sales Value Prorated Marginal Prorated Profit
Marginal Contribution Fixed Cost (Rs.)
Cost
Product A 9,000 4,000 5,00 2,500 2,500
Product B 6,000 4,800 1,200 600 600
Total 15,000 8,800 6,200 3,100 3,100
(e) Market Value Method : Under this method, joint costs are
apportioned after ascertaining "What the traffic can bear". In other words,
the products are made to bear a proportion of the joint costs on the basis
of their ability to absorb the same. Market value here means weighted
market value, that is, quantity produced multiplied by price per unit of
46
joint product. This is the most popular and convenient method because it
makes use of a realistic basis for apportioning joint costs.
(i) Market Value at the point of Separation or Relative Market
Value Method : Under this method, the separation point are ascertained
and joint costs are apportioned in the ratio of either selling prices or sales
value. The use of selling prices may result in completely invalid
apportionments and as such sales value becomes an equitable basis. This
method can be effectively used when disproportionate costs are incurred
on joint products after the point of separation.
Illustration 16 :
The joint cost of making 100 units of product A, 200 units of
product B and 300 units of product C is Rs. 2,700. The selling prices of
products A, B and C are Rs. 4, Rs. 6 and Rs. 8 respectively. The products
did not require any future processing after the split off point.
You are required to a portion the joint costs on (a) selling
price basis; and (b) sales value basis.
Solution :
a) Apportionment on Selling Price Basis
Product Selling Price per Cost Apportionment Apportioned
Units (Rs.) Ratio Cost (Rs.)
A 4 4/18 600
B 6 6/18 900
C 8 8/18 1,200
Total 18 2,700
47
a) Apportionment on Sales Value Basis
Product Quantity Selling Price Sales Cost Apportioned
Sold per Unit (Rs.) Value (Rs.) Apportioned Cost (Rs.)
A 100 4 400 1/10 270
B 200 6 1,200 3/10 810
C 300 8 2,400 6/10 1,620
4,000 2,700
(ii) Market value after further processing : This method is easy to
operate because selling prices of the various joint products will be readily
available. Further processing cost is deducted from the sales value in order
to calculate the ratio in which the joint costs are to be apportioned. Sales
value after deducting further expenses are used as the basis for
apportioning cost up to the point of separation.
Illustration 17 : X Co. Ltd. manufactures two joint products A and B and
sells them at Rs. 5 and Rs. 4 per unit respectively. During a particular period,
400 units of A and 500 units of B were produced and sold. The joint cost
incurred was Rs. 180 and further processing costs for products A and B are
Rs. 1,600 and Rs. 1,500 respectively. Apportion the joint cost.
Solution :
Product Units Selling Sales Less Sales value Ratio Apportioned
Produced Price further less further joint costs
per processing processing
unit cost cost
A 400 5 2,000 1,600 400 4/9 80
B 500 4 2,000 1,500 500 5/9 100
900 180
48
(iii) Net Realisable Value or Reverse Cost Method : From the selling
price of the finished products are deducted estimated net profit, direct
selling and distribution expenses and the cost of further processing after
the separation point. A ratio is established on the basis of which the total
costs before separation point is apportioned. Subsequent costs are added
to arrive at product costs. This method is extensively used in many
industries such as oil refineries, lumber mills, etc.
19.17 ACCOUNTING FOR BY-PRODUCTS
By-products refer to secondary or subsidiary products having
some saleable or usable value produced incidentally in the course of
manufacturing the main product. According to ICMA terminology, a byproduct
is "a product which is recovered incidentally from the material
used in the manufacture of recognised main products, such a by-product
having either a net realisable value or a usable value which is relatively
low in comparison with the saleable value of the main products. Byproducts
may be further processed to increase their realisable value". For
example, in sugar industries, sugar is the main product, and fibres from
sugarcane for lining materials, molasses for the manufacture of alcohol
are by-products. Similarly in coke ovens, gas and tar produced along with
the main product 'coke' are by-products.
Distinction between Joint Products and By-products
The classification of various products from the same process
into joint products and by-products depends upon the relative importance
of the products and their value. If the various end products are almost
equal in importance and their value is also more or less the same, they
may be identified as joint products. But, if one end-product has greater
importance and higher value and the other products are of less importance
49
and rather of low value, the latter may be classified as by-products. It
may be noted that the value of some end-products may be so insignificant
that they may be classified as waste or scrap. Further joint products are
produced simultaneously but by-products are produced incidentally in
addition to the main product.
However, cases are not uncommon where the main products
of one industry become the by-products of another. In such a case, the
following factors may be taken into consideration in making distinction
between joint products and by-products.
(i) Manufacturing Objective : If the objective of a concern is to
produce say, product A, other products, say B and C, produced incidentally,
will be treated as by-products because the plant objective is to produce
only one product i.e. product A. On the other hand, if the objective of
another concern is to produce products B and C and if product A emerges
incidentally, then products B and C will be treated as joint products while
Product A will be treated as a by-product. Again, if the objective of a
third concern is to produce products A, B and C simultaneously, then all
the three products will be termed joint products.
(ii) Value : If the value of one product is considerably low as compared
with that of another, which is simultaneously produced, then the former is
liable to be classified as a by-product. On the other hand, if the value of a
product, which is incidentally produced, is of considerable importance as
compared with that of the main product it may be classified as a joint product.
Accounting of by-products may broadly be classified into
the categories :
(i) Non-cost or sales value methods : These methods do not attempt
to cost by-products or its inventory. The following are the main methods
50
which are included in this group :
(a) Other Income or Miscellaneous Income Method.
(b) By-product's sales added to the main product's sales.
(c) By-product's value deducted from the total cost.
(d) Credit of sales value less selling and distribution expenses.
(e) Credit of sales value less selling and distribution expenses as well
as cost incurred after split off.
(f) Credit of sale value less selling and distribution expenses, cost
incurred after split off and estimated profit or Reverse Cost Method.
(ii) Cost Methods : These methods attempt to apportion some of the
joint cost to by-products. The following methods are included under this
category:
(a) Opportunity or replacement cost method,
(b) Standard cost method, and
(c) Apportionment on suitable basis.
These methods will now be discussed one by one.
(i) Non-cost or Sales Value Methods
(a) Other income or miscellaneous income method : Under this
method, the sales value of by-product, which is negligible, is credited to
the Profit and Loss Account treating it as other or miscellaneous income.
By-products which are not sold and are in stock are valued at nil value for
Balance Sheet purposes and thus vitiate the valuation of closing stock.
Accounting of by-products by this method is also inaccurate as there is a
time lag between the sale and production. There is also a possibility that
by-products may arise in one period but may be accounted in another
period and thus distort the profits of two periods.
(b) By-product's sales added to the main product's sales : Under
this method, all costs incurred on main and by-products are deducted from
51
the combined sales of the main product and by-products. This method is
generally adopted in those cases where either the value of the by-products
is very small or where the by-products are sold in the market in the state
in which they emerge from the main product. By-products in stock are
valued at nil value for balance sheet purposes.
(c) By-product's sales deducted from total cost. Under this method,
the sales value of by-products are deducted either from production costs or
from the cost of sales. Fluctuating costs of by-products also affect the costs
of the main product and may encourage to conceal the inefficiencies therein.
The stock in this case will be valued at total cost or cost of sales basis.
(d) Credit of sales value less selling and distribution expenses : Under
this method, the selling and distribution costs incurred for selling the byproducts
are deducted from the sales value of by-products and the net amount
is either credited to process account or is deducted from total cost.
The closing stock of by-products is valued at selling price
less an estimate of the cost likely to be incurred in selling the stock of byproducts.
(e) Credit of sales value less selling and distribution costs and its
incurred on further processing : Under this method, selling and
distribution costs and costs incurred on further processing the by-products
are deducted from the sale value of the by-products and net amount is
credited to the process account. The closing stock of by-products is valued
at selling price less an estimate of the cost likely to be incurred in selling
and processing the stock of such by-products. This method suffers from
the disadvantage that, if the market value of by-product fluctuates, the
credit to the Process Account of main product will fluctuate accordingly.
Owing to the fact that credit to the main product Process Account
fluctuates, inefficiencies in that process may be concealed.
52
Illustration 18 :
In the Manufacture of main product, 200 units of a certain
by-product were produced. The market value of the by-product was Rs.
40 per unit. The by-product required further processing costs amounting
to Rs. 3,000 and selling and distribution overheads amounting to Rs. 500
are incurred. Calculate the amount to be credited to the Process Account
in respect of the by-product.
Solution :
Rs. Rs.
Sales value of 200 units @ Rs. 40 8,000
Less : Further processing costs 3,000
Selling & distributing costs 500 3,500
Amount to be credited to Process Amount 4,500
(f) Reverse cost method : Under this method an estimated profit from
the sale of by-products, selling and distribution expenses and further
processing costs after the split off points are deducted from the sales value
of by-products and the net amount is credit to the main product.
(ii) Cost Methods
The following methods are included in this category :
(a) Opportunity or Replacement Cost Method : This method is
adopted where by-products are utilised in the undertaking itself as input
material for some other process. The opportunity cost, i.e., the cost which
would have been incurred, had the by-product been purchased from outside
suppliers is taken as the cost of the by-product. The Process Account is
credited with the value of the by-products so ascertained. For example, in
the production of a main product, 200 units of a by-product A are produced,
which are transferred to another product where they are consumed. If the
by-product were purchased from the market, the price would be Rs. 3 per
53
unit. Thus, the amount to be credited to the main product in respect of the
by-product under this method is 20 units × Rs.3 = Rs. 600.
(b) Standard Cost Method : Under this method, a standard cost is set
on the basis of technical assessment for each by-product and credit is given
to the process account on this basis. The standard may be arrived at on the
basis of past average price or may be fixed according to the principles of
standard costing. As credit in respect of the by-product cost is a stable
figure under this method, effective control can be exercised on the cost of
the main product.
(c) Apportionment on Suitable Basis : Where by-products are of major
significance, the cost should be apportioned on the most suitable basis.
This method is followed where by-products are processed (i) to dispose
of waste material more profitably, or (ii) to utilise idle plant. In the first
case, by-products after separation are charged with overheads at full rates,
whereas in the second case, by-product costs after separation will include
variable costs only.
Illustration 19 : 1,000 Kg. of 'X' is processed to give 700 kg. of A and
300 kg. of B. The joint cost before the separation point is Rs. 4,600. From
the following data, show the apportionment of the joint cost and the profit
of each product under : a) physical measurement : (b) market value at
separation point and (c) market value after further processing.
AB
Selling price at the point of separation 8.00 12.00
Further processing costs after separation 800 400
Selling price after further processing 12.00 18.00
54
700
1000
300
1000
Solution :
a) Physical Measurement Method
AB
Ratio for apportionment of the joint costs 700/1000 300/1000
Share in the Joint Cost ×4600 ×4600
= Rs. 3,220 Rs. 1,380
b) Market Value at Separation Point
A (Rs.) B(Rs.) Total (Rs.)
Sales (700×8) (300×12)
5,600 3,600 9,200
Less Joint Cost 2,800 1,800 4,600
Profit 2,800 1,800 4,600
c) Market Value after Separation Point
A (Rs.) B (Rs.) Total (Rs.)
Sales (700×12) (300×18)
8,400 5,400 13,800
Less Joint Cost 2,800 1,800 4,600
Profit 5,600 3,600 9,200
19.18 SUMMARY
In case of mass production concerns the products when
produced are of the same type, and involve the same material and labour
and pass through the same set of processes. In such industries each process
is designated as a separate cost-centre and the cost per unit is calculated
by dividing the total cost of the process with the total number of units
produced by the process. The cost of production of the product is obtained
55
by adding the unit costs of various processes through which the product
has passed. This method of costing is known as process costing.
In business where a product passes through different stages
of production, each distinct and well defined, process costing is employed.
A separate account for each process is opened and all expenditure
pertaining to a process is charged to that process account. Thus, the cost
of the product at each stage of manufacture is found out. The partially
worked product of process may either be transferred to a Process Stock
Account from where it will be sent to the next process as and when required
or may be sent directly to the next process. Thus, in process costing the
finished product of a preceding process becomes the raw material of the
next process.
19.19 KEYWORDS
Job costing: It is method of costing which is adopted to execute the work
strictly according to customers specification.
Process costing: Process costing refers to a method of accumulating cost
of production by process.
Normal loss: The loss which is inherent in the production process and
which cannot be controlled is known as normal loss.
Joint products: When two or more products of equal importance are
simultaneously produced from the same basic raw materials from a
common process, they are known as joint products.
By-product: By-products refer to any saleable or usable value incidentally
produced in addition to the main product.
56
1. What do you understand by job costing ? What are the main features
of this method ? Give a proforma cost sheet under such a system.
2. What do you mean by process costing ? In what types of industries
is process costing generally applied ?
3. Describe the features of Process Costing. How is unit cost
determined in process costing ?
4. What do you understand by the term "inter-process profits"? What
is the utility of transferring the output of one process to another
process at more than cost?
5. In a manufacturing concern with several departments, the finished
product of one department becomes the raw material of the next
department. Would you advocate inclusion of profit in the transfer
price of the material? What would be the effect of this in the profit
and loss account of the manufacturing concern as a whole?
6. Define and explain the terms 'joint Products' and 'by-products'.
Enumerate the methods which may be employed in costing 'joint
products'.
7. A factory uses a job costing system. The following cost data are
available from the books for the year ended 31st March :
Rs.
Direct material 9,00,000
Direct wages 7,50,000
Profit 6,09,000
Selling and distribution overheads 5,25,000
Administrative overheads 4,20,000
Factory overheads 4,50,000
Required :
(a) Prepare a cost sheet indicating the prime cost, works cost,
cost of sales and sales value.
57
(b) In the current year, the factory has received an order for a
number of jobs. It is estimated that the direct materials would cost
Rs. 12,00,000 and direct labour Rs. 7,50,000. What would be the
price for these jobs if the factory intends to earn the same rate of
profit on sales, assuming that the selling and distribution overheads
have gone up by 15%. The factory recovers its factory overheads as
a percentage of the direct wages and its administrative and selling
and distribution overheads as a percentage of works costs, based on
the cost rates prevalent in the previous year.
8. RK Ltd. has to quote for a price for job No. 450. The cost estimator
has produced the following data :
Direct materials : 34 units @ Rs. 2 per unit.
Direct : Deptt. A 12 hours @ Rs. 2 per hour
Deptt. B 20 hours @ Rs. 1.80 per hour
The following additional information is extracted from the
company's budgets :
Deptt. A Variable overheads Rs. 18,000
Hours to be worked 18,000
Deptt. B. Variable overhead Rs. 18,000
Hours to be worked 10,000
Fixed overhead for the company Rs. 1,00,000
Total hours to be worked 50,000
Profit is taken at 20% of the selling price.
You are required to prepare a job cost sheet.
9. The product of a manufacturing concern passes through two
processes, A and B then to the finished stock. It is ascertained that
in each process 5% of the total weight is normally lost and 10% is
scrap which from Processes A and B, realize Rs. 80 per qtl. and Rs.
58
120 per qtl., respectively.
The following are the figures relating to both the processes :
Process A Process B
Materials in qtls. 1,000 70
Cost of materials in rupees per qtl. 125 200
Wages in rupees 28,000 10,000
Manufacturing expenses in rupees 8,000 5,700
Output in qtls. 830 780
Prepare process cost accounts showing cost per qtl. for each
process. There was no stock or work-in-progress in either process
10. From the following details, prepare a statement of equivalent
production and a statement of cost and find the value :
(a) The output transferred; and
(b) The closing work-in-progress
Opening work-in-progress 2,000 unit
Rs.
Materials 7,500
Labour 3,000
Overheads 1,500
8,000 units were introduced into the process.
There are 2,000 units in process and the state of completion is
estimated to be :
Rs.
Materials 100%
Labour 50%
Overheads 50%
8,000 units are transferred to the next process
The process costs for the period are :
Materials 1,00,000
Labour 78,000
Overheads 39,000
59
11. A Ltd., produces 'AXE' which passes through two processes before
it is completed and transferred to the finished stock. The following
data relate to October :
Particulars Process Process Finished
I II Stock
Rs. Rs. Rs.
Opening stock 45,000 54,000 1,35,000
Direct materials 90,000 94,500 –
Direct wages 67,200 67,500 –
Factory overheads 63,000 27,000 –
Closing stock 22,200 27,000 67,500
Inter-process profit
included in the opening stock – 9,000 49,500
The Output of Process I is transferred to Process II at 25%
profit on the transfer price.
The output of Process II is transferred to the finished stock
at 20% profit on the transfer price. The stocks in processes are valued at
prime cost. The finished stock is valued at the price at which it is received
from process II. Sales during the period are Rs. 8,40,000.
You are required to prepare Process cost accounts and finished
goods account, showing the profit element at the each stage.
12. A certain process yields 75% of the material introduced as the main
product, 20% as a by-product and 5% being lost. The percentage of
material consumed by the main product and By-product is 80:20. The
time taken to produce one unit of by-product is half the time taken
for a main product units. The overheads have been allocated at 200%
of the wages for each product.
60
Rs. Units
Cost data
Raw Material 10,000 2,000
Labour 8,500
Overheads 17,000
Total 35,500
Ascertain the cost of the main product and by-product.
3. Cost Accounting by M.N. Arora
4. Cost Accounting by Khan and Jain
1
Course Code : CP-104 Updated by: Dr. Mahesh Chand Garg
Lesson No. : 20
COST CONTROL ACCOUNTS
STRUCTURE
20.0 Objective
20.1 Introduction
20.2 Non-Integral Cost Accounting System
20.3 Meaning of Control Accounts
20.4 Principal Accounts to be Maintained
20.5 Journal Entries
20.6 Summary
20.7 Keywords
20.0 OBJECTIVE
This lesson will make students familiar with the different accounts to be
maintained under Cost Control Accounting System.
20.1 INTRODUCTION
In many small firms, costing system is maintained on memorandum
statements whereby cost calculations are made on rough sheets, formal documents,
books, cards etc. which are not a part of a set of accounts maintained on double
entry principles. The recordings and computations of costs are thus outside the
formal accounting system. And there is no doubt that valuable information can be
obtained from such a system. But this type of system has the disadvantage of
absence of general control and the likelihood of these memorandum records not
being available when required. However, in those concerns which have a formal
2
system of cost accounting, cost book-keeping can be organised in either of the
following two ways :
(a) Cost accounting system independent of financial accounting, known as
Independent or Non-integral Cost Accounting; or
(b) An accounting system, which contains both cost and financial accounts in a
single set of account books, known as Integral Accounting.
Thus, the cost accounts may be integrated with or kept separately
from the financial accounts.
20.2 NON-INTEGRAL COST ACCOUNTING SYSTEM
In this system, cost accounts are distinct from financial accounts. In
other words, cost accounting department maintains a set of books of cost accounts
based on the principles of double entry book keeping which is separate from
financial books of accounts.
In financial books there are three types of accounts :
(a) Personal e.g. debtors and creditors.
(b) Real e.g. cash, stocks, fixed assets, etc.
(c) Nominal e.g. wages, lighting, heating, discounts, rent and rates, carriage etc.
In cost accounts, there are no personal accounts because cost
accounts do not show relationship with outsiders. In real accounts, only stocks
are shown in cost accounts. The main emphasis is on nominal accounts where
costs are analysed in detail. Thus cost accounting department is concerned mainly
with the ascertainment of income and expenditure of the business. It is particularly
interested in nominal accounts, to some extent in real accounts but in no way with
personal accounts.
3
Ledgers to be Maintained : The following four important ledgers are maintained
by the costing department :
1. Cost ledger : This is the principal leader in cost books which controls all
other ledgers in the costing department. It contains all impersonal accounts and
is similar to General Ledger of financial accounts. It contains, inter alia, a number
of control accounts like stores ledger control accounts, wages control account,
factory overhead control account etc. and also a cost ledger control account to
make the cost ledger self-balancing.
2. Stores ledger : This ledger maintains a separate account for each item of
store (raw material, components, consumable stores, etc.). It is used for recording
receipts, issues and balances of stores both in quantity and amount.
3. Work-in-progress ledger or job ledger : It contains a separate account
for each job in progress. Each such account is debited with the material costs,
wages and overhead chargeable to the jobs and credited with the cost of work
completed. The balance in this account represents the cost of unfinished work.
4. Finished goods ledger : It contains an account for each item of finished
product.
As stated above, the cost ledger is the principal ledger. Other ledgers,
i.e, stores ledger, work-in-progress ledger and finished goods ledger are referred
to as subsidiary ledgers of the cost accounting department. The cost ledger is made
self-balancing by opening a control account for each of these subsidiary ledgers.
20.3 MEANING OF CONTROL ACCOUNTS
Control accounts are the total accounts in the cost ledger. In these
accounts, entries are made once in each accounting period on the basis of the
periodical totals of transactions in related subsidiary ledgers and books. For
4
examples, stores ledger control account represents stores ledger in a summary
form. Purchases of individual items of stores shown in individual accounts in the
stores ledger are totalled and shown in stores ledger control account as total
purchases. Similarly, other individual debits and credits in individual accounts in
stores ledger are abstracted, totalled and taken to stores ledger control account.
Thus the opening balance of this control account should always equal the total of
opening balances on each individual account in the stores ledger. In the same way,
a control account is also kept for each of the other subsidiary ledgers i.e. job
ledger and finished goods ledger. In addition, a control account is opened for cost
ledger with the main object of completing the double entry.
The main advantages of control accounts are:
1. Control accounts present the management with a summary of detailed
information contained in various subsidiary ledgers.
2. It makes possible the division of accounting work among ledger keepers,
thereby resulting in specialisation in work.
3. It permits prompt preparation of Profit and Loss Account and Balance Sheet
at the end of each period by providing stock figures without delay.
4. It provides internal check leading to greater accuracy of records.
20.4 PRINCIPAL ACCOUNTS TO BE MAINTAINED
The principal accounts to be maintained in the cost ledger and their
functions are summarised below :
1. Stores Ledger Control Account : This account deals with material
transactions and is a summary of the value of stores received, issued and balance
in store. Receipts are posted from goods received note or invoices to the debit
5
side of this account. Similarly issues of materials are posted from material
requisitions or materials issue analysis sheet to the credit side of this account.
The balance of this account represents the total balance of stock which should
agree with the aggregate of the balances of individual accounts in the Stores
Ledger.
2. Wages Control Account : This account records wage transactions in
aggregate. Postings are made from wages analysis sheet. This account is debited
with gross wages (paid and accrued) and is closed by transfer of direct wages to
work-in-progress and indirect wages to factory, administration and selling and
distribution overhead control accounts.
3. Factory Overhead Control Account : This account deals with factory
overhead expenses in aggregate. It is debited with indirect material cost, indirect
wages and indirect expenses and is credited with overheads absorbed and
transferred
to work in-progress. The balance in this account represents under or over-absorbed
overheads and is transferred to Overhead Adjustment Account or Costing Profit
and Loss Account.
4. Work-in-progress Ledger Control Account : This account starts with
opening balance of work-in-progress and is debited with materials, labour and
factory overheads charged. It is credited with cost of finished goods. Closing
balance of this account shows the value of unfinished jobs.
5. Finished Goods Ledger Control Account : This account starts with
opening balance of finished goods. It is debited with cost of finished goods
transferred from work-in-progress control account and the amount of
administration overheads absorbed. This account is credited with cost of sales.
The closing balance of this account represents the cost of goods remaining unsold
at the end of the period.
6
5. Administration Overhead account : This account is debited with
administration overhead cost and is credited with overheads absorbed by finished
goods. The balance in this account represents under or over absorbed overheads
which is transferred to Overhead Adjustment Account or to Costing Profit and
Loss Account.
However, when administration overheads are excluded from costs,
the entire amount is straight away transferred to Costing Profit and Loss Account.
And when administration overheads are apportioned to production and selling and
distribution overheads, the amounts are transferred to the respective accounts.
6. Selling and Distribution Overhead Account : This account is debited
with selling and distribution overhead incurred and credited with selling and
distribution overhead absorbed. Its balance represents under or over absorbed
overhead.
7. Cost of Sales Account : This account is debited with the cost of goods
sold by transfer from finished goods ledger control account and selling and
distribution overheads absorbed. It is closed by transfer to Costing Profit and
Loss Account.
8. Overhead Adjustment Account : This account is debited with
underabsorbed overheads for factory, administration and selling and distribution
overheads and is credited with over-absorbed overheads. The balance in this
account
represents the net amount of over or under-absorption which is transferred to
Costing Profit and Loss Account.
Sometimes this account is not maintained and the amount of under
or overabsorbed overheads is directly transferred to Costing Profit and Loss
Account.
7
9. Costing Profit and Loss Account : This account is debited with the cost
of sales, abnormal losses and under-absorbed overheads. It is credited with sale
value of goods sold, abnormal gains and over-absorbed overheads. The balance in
this account represents costing profit or loss which is transferred to cost ledger
control account.
10. Cost Ledger Control Account : This account is also known as General
Ledger Adjustment Account or Financial Ledger Control Account. The purpose
of this account is to complete the double entry and make the cost ledger
selfbalancing.
As no personal accounts are kept in the cost books, then in order to
complete the double entry, all transactions which arise in financial accounts are
debited or credited to the cost ledger control account. For example, wages paid
amount to Rs. 250 and as no cash or bank account is maintained in the cost ledger,
then in order to complete the double entry, the following entry will be made so as
to credit cost ledger control account in place of cash or bank :
Wages Account Dr. Rs. 250
To Cost Ledger Control Account Rs. 250
This account is sometimes disrespectfully referred to as "dustbin
account" because it is for disposing of the odds and ends of double entry which
lack a home.
Thus the cost ledger control account is equivalent to debtors,
creditors and cash or bank accounts in the financial ledger. Sales are debited to
this account and net profit or loss is also transferred to this account. All transfer
entries of internal nature which affect only cost accounts and have no implications
in financial accounts do not appear in cost ledger control account. For example
transfer from stores ledger to work-in-progress, from work-in-progress to finished
8
goods, etc. are not shown in cost ledger control account. The balance of cost
ledger control account represents the total of all balances of impersonal accounts.
20.5 JOURNAL ENTRIES
The use of double entry system in costing records will help in the
preparation of trial balance for the costing transactions. The entries for various
transactions which can be made with the help of control accounts are mentioned
below :
Journal Entries in Cost Books
Particulars of Transactions Cost Journal Entries
12
1. Purchase of materials Stores Ledger Control A/c Dr.
To General Ledger Adjustment A/c
2. Returns to suppliers General Ledger Adjustment A/c Dr.
To Stores Ledger Control A/c
3. Material purchased specially Work in-progress Control A/c Dr.
for a job To General Ledger Adjustment A/c
4. Direct material issued from Work-in-progress Control A/c Dr.
stores to jobs, capital orders Capital Order No.. A/c Dr.
or service order. Service Order No... A/c Dr.
5. Issue of indirect materials Factory Overhead A/c Dr.
6. Materials returned from jobs Stores Ledger Control A/c Dr.
to stores To Work-in-progress Control A/c
7. Transfer of materials from Receiving Job A/c Dr.
one job to another To Giving Job A/c
8. Normal wastage of materials Factory Overhead A/c Dr.
and stores To Stores Ledger Control A/c
9
9. Abnormal waste of materials Costing P & L A/c Dr.
10. Payment of direct wages as Wages Control A/c Dr.
well as indirect wages To General Ledger Adjustment A/c
11. Allocation of direct labour Work-in-Progress Control A/c Dr.
Capital Order No... A/c Dr.
Service Order No... A/c Dr.
To Wages Control A/c
12. Allocation of indirect labour Factory Overhead Control A/c Dr.
Admn. Overhead Control A/c Dr.
Selling & Distr. Overhead Control A/c Dr.
13. Abnormal idle time cost Costing P & L Account Dr.
14. Normal idle time cost Factory Overhead Control A/c Dr.
15. Expenses incurred Factory Overhead Control A/c Dr.
Admn. Overhead Control A/c Dr.
Selling and Distr. overhead Control A/c Dr.
16. Allocation of works Work-in-Progress Control A/c Dr.
expenses To Factory Overhead Control A/c
17. Production expenses Factory Overhead Suspense A/c Dr.
chargeable to incomplete To Factory Overhead Control A/c
job or
Carry down the amount as debit
balance in the Factory Overhead A/c
18. Absorption of administration Finished Stock Ledger Control A/c Dr.
expenses To Adm. Overhead Control A/c
19. Administration Overheads Admn. Overhead Suspense A/c Dr.
applicable to incomplete To Admn. Overhead Control A/c
jobs. (or carry down as debit balance)
10
20. Absorption of selling and Cost of Sales A/c Dr.
distribution overheads To Selling & Distr. Overhead Control A/c
21. Overhead under-absorbed Overhead Adjustment A/c Dr.
To (Appropriate) Overhead A/c
22. Overhead over-absorbed (Appropriate) Overhead A/c Dr.
To Overhead Adjustment A/c
23. Transfer of balance on (i) In case of debit balance
Overhead Adj. A/c Costing P&LA A/c Dr.
To Overhead Adjustment A/c
(ii) In case of credit balance
Overhead Adjustment A/c Dr.
To Costing P & L A/c
24. Transfer of completed jobs Finished Stock Ledger Control A/c Dr.
Finished Goods Ledger To Work-in-Progress Control A/c
25. Transfer of cost of goods Cost of Sales A/c Dr.
sold To Finished Stock Ledger Control A/c
26. Transfer of cost of sales Costing P & L A/c Dr.
A/c to P & L A/c To Cost of Sales A/c
27. Sales General Ledger Adjustment Dr.
To Costing P & L A/c
28. Transfer of profit or loss In case of profit :
Costing P & L A/c Dr.
(Reserve the entry in the case of loss)
29. Transfer of capital order General Ledger Adjustment A/c Dr.
to financial books To Capital Order A/c
30. For service orders (Respective) Overhead A/c Dr.
To Service Order No... A/c
Illustration 1: Pass journal entries in the cost books (non-integrated system)
for the following transactions :
11
(i) Materials worth Rs. 25,000 returned to stores from job.
(ii) Gross total wages paid Rs. 48,000. Employer's contribution to PF and State
Insurance amount to Rs. 2,000. Wages analysis book detailed Rs. 20,000
direct labour, Rs. 12,000 towards indirect factory labour, Rs. 10,000 towards
salaries to office staff and Rs. 8,000 for salaries to selling and distribution
staff.
Solution :
Journal Entries
Particulars Dr. (Rs.) Cr. (Rs.)
(i) Stores Ledger Control A/c Dr. 25,000
To WIP Control A/c 25,000
(Being material returned from stores)
(ii) Wages Control A/c Dr. 50,000
To General Ledger Adjustment A/c 48,000
To Provident Fund and Employees
State Insurance Account 2,000
(Being gross total wages paid)
Work-in-Progress Control A/c Dr. 20,000
Factory Overheads Control A/c Dr. 12,000
Office Overheads Control A/c Dr. 10,000
Selling Overheads Control A/c Dr. 8,000
To Wages Control A/c 50,000
(Being wages allocated)
Illustration-2 : From the following figures ascertained from Costing Records
and Financial Books of a Factory, you are required to pass the necessary entries
in the Cost Journal (assume that a system of maintaining control accounts prevails
in the organisation).
12
Rs.
Purchases 3,90,000
Carriage inward 5,850
Stores issued 3,58,000
Productive wages paid and allocated 3,46,320
Unproductive labour 1,21,680
Other works overheads 2,48,400
Materials used in repairs 3,120
Cost of completed jobs 12,80,630
Solution :
Entries in the Cost Journal
Particulars Dr. (Rs.) Cr. (Rs.)
Stores Ledger Control A/c Dr. 3,90,000
To General Ledger Adjustment A/c 3,90,000
(Being the total amount of purchases as ascertained
from financial books)
Store Ledger Control A/c* Dr. 5,850
(Being the total amount of purchases as per
from financial books)
Work-in-Progress Ledger Control A/c Dr. 3,58,000
To Store Ledger Control A/c 3,58,000
(Being the amount of stores issued as per
material abstract)
Wages Control A/c Dr. 3,46,320
(Being the amount of direct wages paid)
13
Work-in-Progress Ledger Control A/c Dr. 3,46,320
To Wages Control A/c 3,46,320
(Being the amount of direct wages allocated to jobs)
Wages Control A/c Dr. 121,680
(Being the amount of indirect labour paid)
Factory Overheads Control A/c Dr. 1,21,680
To Wages Control A/c 1,21,680
(Being the amount of indirect labour allocated
to works overheads)
Factory Overheads Control A/c Dr. 2,48,400
(Being the amount of works expenses other than
indirect wages as per financial books)
Factory Overheads Control A/c Dr. 3,120
To Stores Ledger Control A/c 3,120
(Being the cost of materials used in repairs)
Finished Goods Ledger Control A/c Dr. 12,80,630
To Work-in-Progress Ledger Control A/c 12,80,630
(Being cost of completed jobs transferred from
work-in-progress A/c)
* The amount may be debited to Works Overheads Control Account in place of
Stores Ledger Control Account, if Carriage inwards is treated as works overhead.
Illustration -3 : The following balances are extracted from the books of Amrit
Manufacturing company :
1 Jan. 2001 31 Dec. 2001
Rs. Rs.
Stores on hand 3,200 4,506
Stock of finished goods 4,870 5,124
14
Work-in-progress 6,200 4,962
Purchases – 15,000
Carriage in ward 226
Stores issued 13,800
Wages-direct 13,320
Wages-indirect 4,680
Work expenses-including rent, power, etc. 13,400
Materials issued for repairs 120
Cost of completed production 49,254
Cost of finished goods sold 49,000
Office and administration expenses 2,650
The cost journal shows that Rs. 18,266 and Rs. 2,630 were allocated
to work-in-progress in respect of works overhead and office overhead respectively.
Pass the necessary journal entries in cost journal and prepare the
ledger accounts.
Solution :
Cost Journal
Particulars Dr. Cr.
Rs. Rs.
1. Stores Ledger Control A/c Dr. 15,000
(For purchase of materials)
2. Stores ledger control A/c Dr. 226
To General Ledger Adjustment A/c 226
(Carriage inwards charged to materials)
15
3. Work-in-progress ledger control A/c Dr. 13,800
To Stores ledger control A/c 13,800
(Materials issued to production)
4. Wages control A/c Dr. 18,000
(Wages paid i.e. 13320 + 4680)
To Wages control A/c 13,320
(Direct wages charged to production)
6. Factory overhead control A/c Dr. 4,680
To Wage control A/c 4,680
(Indirect wages charged to factory overheads
7. Factory overhead control A/c Dr. 13,400
To Cost ledger control A/c 13,400
(Works expenses paid)
8. Factory overhead control A/c Dr. 120
To Stores ledger control A/c 120
(Materials issued for repairs)
To Factory overhead control A/c 18,266
(Works overhead absorbed by production)
10. Administration overhead control A/c Dr. 2650
(Office and administration overhead paid)
11. Work-in-progress ledger control A/c Dr. 2630
To Administration overhead control A/c 2630
(Administration overheads absorbed by production)
12. Finished goods ledger control A/c Dr. 49,254
To Work-in-progress ledger control A/c 49,254
(Cost of completed production)
16
13. Cost of sales A/c Dr. 49,000
To Finished goods ledger control A/c 49,000
(Cost of goods sold)
14. Selling and distribution overhead control A/c Dr. 1134
(Selling expenses paid)
15. Cost of sales A/c Dr. 1134
To Selling and dist. overhead control A/c 1134
(Selling expenses absorbed by cost of sales)
16. General Ledger Adjustment A/c Dr. 50134
To Cost of sales A/c 50134
Cost Ledger
Stores Ledger Control A/c
To Balance b/d 3,200 By Work-in-progress control A/c 13,800
To General Ledger Adjustment A/c 15,000 By Factory overhead control A/c 120
To General Ledger Adjustment A/c 226 By balance c/d 4,506
18,426 18,426
Wages Control A/c
By work-in-progress ledger
To General Ledger Adjustment A/c 18000 control A/c 13,320
By Factory overhead control A/c 4,680
18000 18000
Factory Overhead Control A/c
To, wages control A/c 4,680 By work-in-progress ledger
To General Ledger Adjustment A/c 13,400 control A/c 18,266
To Stores ledger control A/c 120
To Overhead adjustment A/c 66
(B.F.) 18,266 18,266
17
Work-in-Progress Ledger Control A/c
To Balance b/d 6,200 By finished goods ledger
control A/c 49,254
To Stores ledger control A/c 13,800 By Balance c/d 4,962
To Wages control A/c 13,320
To Factory overhead control A/c 18266
To Admn. overhead control A/c 2,630
54,216 54,216
To balance b/d 4,962
Finished Stock Ledger Control A/c
To Balance b/d 4,870 By Cost of sales A/c 49,000
To Work-in-progress A/c 49,254 By Balance c/d 5,124
54,124 54,124
To Balance b/d 5,124
Administration Overhead Control A/c
To General Ledger Adjustment A/c 2,650 By Work-in-progress control A/c 2,630
By Overhead adjustment A/c (B.F.) 20
2,650 2,650
Selling and Distribution Overhead Control A/c
To General Ledger Adjustment A/c 1134 By Cost of sales A/c 1134
1134 1134
18
Cost of Sales A/c
To Finished goods ledger control A/c 49,000 By General Ledger Adjustment
A/c 50,134
To Selling and distribution overhead
control A/c 1,134
50,134 50,134
Overhead Adjustment A/c
To Adm. overhead control A/c 20 By Factory overhead control A/c 66
To Balance c/d 46
66 66
By balance b/d 46
General Ledger Adjustment A/c
To Cost of sales A/c 50,134 By Balance b/d 14,270
To Balance c/d 14,546 (Rs. 3200+4,870+6,200)
By Stores ledger control A/c 15,000
By Stores ledger control A/c 226
By Wages control A/c 13,320
By Factory overhead control A/c 4,680
By Factory control overhead A/c 13,400
By Selling and dist. overhead control A/c 1134
By Adm. overhead control A/c 2650
64,680 64,680
By balance b/d 14,546
19
Trial Balance as on 31 Dec. 2001
Dr. Cr.
Name of the Account Rs. Rs.
Stores ledger control A/c 4,506
Work-in progress ledger control A/c 4,962
Finished stock ledger control A/c 5,124
Overhead adjustment A/c 46
General Ledger Adjustment A/c 14546
14,592 14,592
20.6 SUMMARY
In cost accounting, the cost books are basically maintained under
the two systems namely (a) Non-Integral or Non-Integrated Cost Accounting and
(b) Integrated Cost Accounting. The system is called non-integral when cost and
financial transactions are kept separately. On the contrary, when cost and financial
transactions are integrated, the accounting system is known as integrated. Under
the system of non-integral accounting separate ledgers are maintained for cost
and financial transaction. The financial accountants look after financial
transactions
and the cost accountants are responsible for cost accounting transactions. The
cost accounting department maintains the stores ledger, work-in-progress ledger,
finished goods/stock ledger and cost ledger. Cost Ledger is main ledger and
records impersonal accounts i.e. accounts relating to income and expenditure.
20.7 KEYWORDS
Control accounts: Control accounts are the total accounts in the cost ledger.
Integrated cost accounting: When cost and financial transactions are integrated,
the accounting system is known as integrated cost accounting.
20
1. Non-integrated accounting is one of the systems of cost control accounting
to keep cost books.
(a) Define non-integrated accounting.
(b) Explain the system of non-integrated accounting and state the principal
ledgers that are to be maintained
2. You wish to institute control accounts in respect of materials purchased
and used in your factory. What purposes do control accounts serve? What
accounts would you institute and from what sources would the entries be
derived?
3. The Balance in a Company's Works-in-Progress Control Account, as on 31st
March, 2002 was Rs. 5,00,000. During the next month the following
transactions took place :
Rs.
Direct wages incurred 60,000
Direct materials issued 2,80,000
Completed work billed at cost 5,25,000
Factory overhead incurred 1,20,000
Special purchases for job 12,000
Sub-contract charges 8,000
Direct expenses 9,000
Materials returned to stores 4,000
You are required to write up the ledger account, carry down the balance and
state what the balance represents.
21
4. Journalise the following transactions in the cost journal of a company :
Rs.
Stores purchased 45,620
Manufacturing wages 25,440
Sales 66,870
Wages for plant repairs 470
Stores issued for plant repairs 250
Stores issued for production 36,630
Wages for stores department 690
Stores returned to suppliers 620
Indirect wages 2,950
Normal waste of stores 290
Wages for repairs to building 290
Normal idle time 560
Stores issued for repairs to building 85
Work on cost 6,100
Balance at end work-in-progress 6,500
Completed stock 2,875
Stores balance on hand 8,900
5. The balances in the Cost Ledger of a manufacturing company on January 1,
2001 were :
Rs.
Stores Ledger Control Account 35,000
Work-in-Progress Account 64,000
Finished Stock Account 10,000
Cost Ledger Control Account 1,09,000
The following data are supplied for the year 2001 :
Purchase of Materials 2,00,000
Materials issued to Production 1,86,000
Direct Factory Wages 3,00,000
Manufacturing expenses 1,73,000
22
Selling and Distribution expenses 27,000
Manufacturing expenses recovered 1,72,000
Goods finished 6,48,700
Selling and distribution expenses recovered 27,500
Goods sold at cost 6,35,200
Sales 7,55,700
You are required to show the accounts in the Cost Ledger for the year ended
31st December, 2001, to prepare the Costing Profit and Loss Account for
the year, and extract a Trial Balance.
2. Cost Accounting by V.S.P. Rao
4. Cost Accounting by Khan and Jain

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It is found by a simple transformation of the firm's accounts receivable turnover :

Average Age of Debtors =

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