Intermediate Course Study Material Paper:: Cost and Management Accounting

Intermediate Course
Study Material
(Modules 1 to 2)
Paper : 3
Cost and Management

Accounting
Module – 1
BOARD OF STUDIES
THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA
© The Institute of Chartered Accountants of India

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This Study Material has been prepared by the faculty of the Board of Studies. The
objective of the study material is to provide teaching material to the students to
enable them to obtain knowledge in the subject. In case students need any
clarifications or have any suggestions to make for further improvement of the
material contained herein, they may write to the Director of Studies.
All care has been taken to provide interpretations and discussions in a manner useful
for the students. However, the study material has not been specifically discussed by
the Council of the Institute or any of its Committees and the views expressed herein
may not be taken to necessarily represent the views of the Council or any of its
Committees.
Permission of the Institute is essential for reproduction of any portion of this
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All rights reserved. No part of this book may be reproduced, stored in a retrieval
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photocopying, recording, or otherwise, without prior permission, in writing, from the
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Revised Edition : July, 2019
Website : www.icai.org
E-mail : [email protected]
Committee/ : Board of Studies

Department
ISBN No. :
Price (All Modules) : ` (For All Modules)
Published by : The Publication Department on behalf of The Institute of

Chartered Accountants of India, ICAI Bhawan, Post Box
No. 7100, Indraprastha Marg, New Delhi 110 002, India.
Printed by : Sahitya Bhawan Publications, Hospital Road, Agra-282003

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BEFORE WE BEGIN….
The traditional role of a chartered accountant restricted to accounting and

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

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• Module- 2 Consisting of eight chapters namely:

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

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

Theoretical Questions and Practical Problems with solutions which test the
breadth and depth of your understanding of the topic.
8. Skill specification Assessment -An indicative skill specification Assessment
Grid has been incorporated in the study material for better understanding of the
students. An effort has been made to arrange the questions/illustrations/exercise
accordingly.
In this Study Material, formats of Financial Statements (i.e. Balance Sheet, Income
Statements etc) and financial terms used are for illustrative purpose only. For
appropriate format and applicability of various Standards, students are advised to
refer the study material of appropriate subject (s).
Further the solutions/answers contained in the study material are may be based
on certain assumptions and other logical alternative assumption/ approach/
presentation may be possible.
Every effort has been made to make the Study Material error free, however if
inadvertently any error is present and found by readers, they may send it to us
immediately, so that it can be rectified at our end.
In case you need any further clarification/ guidance, you may send your queries at
[email protected].

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SKILL SPECIFICATION ASSESSMENT GRID

Skill Level Manner of Assessment Illustrative verbs used
of Skills to construct learning
outcomes
Level-I: Understanding or List – Preparing a list of
Knowledge and grasping ability (Defining, State – Mentioning clearly
Comprehension stating, enlisting, or fully the details of.
identifying, and
Define – Explaining the
explaining concepts /
exact meaning of.
provisions / theories /
principles relating to the Describe – Giving detailed
relevant subject area.) narration of something or
key features.
Distinguish – Mentioning or
highlighting the difference
between.
Explain – Making the
meaning of.
Identify – Recognizing
something.
Illustrate – Explaining
something with the help of
an example.
and similar verbs
Combination of verbs:
Comprehend and Explain;
Identify and explain and
similar verbs.
Level-II: Applying and analyzing Application:
Application and the concepts learned Apply – Putting theoretical
Analysis during the grasping level. knowledge for practical
(Application: Applying purpose.
concepts / provisions / Calculate – Arriving at some
theories / principles in value by following
problem solving in non-

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complex scenarios.) numerical/ analytical

procedures.
Compute - Arriving at some
value by following
numerical/ analytical
procedures.
Determine- Ascertain or
establish exactly by
calculation or workings.
Find/ Find out- Ascertain or
establish exactly by
calculation or workings.
Demonstrate – Proving
something with certainty
using practical means.
Prepare – Making
something ready for any
use.
Reconcile – Making or
proving consistency/
compatibility.
Solve – Find an answer or
solution to something
Tabulate – Exhibiting the
required information in a
tabular form.
Compare and contrast and
similar verbs.

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(Analysis: Applying, Analysis:

comparing and analysing Analyze - Examining
concepts / provisions / something in detail.
theories / principles in
Categorize – Arranging
problem) solving in
something in a predefined
moderately complex
group or class or division.
scenarios.)
Compare - Examining the
differences or similarities
between.
Construct - Building or
compiling.
Discuss –Writing about or
examining in detail.
Interpret – Translating in
intelligible or familiar or
understandable terms.
Analyse and apply and
similar verbs.

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SYLLABUS
PAPER – 3: COST AND MANAGEMENT ACCOUNTING

(One Paper- Three hours- 100 Marks)
Objectives:
(a) To develop an understanding of the basic concepts and applications to
establish the cost associated with the production of products and provision
of services and apply the same to determine prices.
(b) To develop an understanding of cost accounting statements.
(c) To acquire the ability to apply information for cost ascertainment, planning,
control and decision making.
Contents:
1. Overview of Cost and Management Accounting
(i) Introduction to Cost and Management Accounting
a) Objectives and Scope of Cost and Management Accounting,
b) The users of Cost and Management accounting information,
Functions of management accounting.
c) Role of cost accounting department in an organisation and its
relation with other departments.
d) Installation of Costing System
e) Relationship of Cost Accounting, Financial Accounting,
Management Accounting and Financial Management.
f) Cost terms and Concepts
g) Cost Reduction and Cost Control
h) Elements of Costs
i) Cost behavior pattern, Separating the components of fixed,
variable, semi-variable and step costs.
j) Methods of Costing, Techniques of Costing.

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k) Cost Accounting with use of Information Technology.

(ii) Elements of Cost and preparation of Cost Sheets
a) Functional classification and ascertainment of cost
b) Preparation of Cost Sheets for Manufacturing sector and for
Service sector
2. Ascertainment of Cost and Cost Accounting System
(i) Material Cost
a) Procurement procedures- Store procedures and documentation
in respect of receipts and issue of stock, Stock verification,
b) Valuation of material receipts,
c) Inventory control-
- Techniques of fixing level of stocks- minimum, maximum, re-
order point, safety stock, determination of optimum stock level,
- Determination of Optimum Order quantity- Economic Order
Quantity (EOQ),
- Techniques of Inventory control- ABC Analysis, Fast, Slow
moving and Non moving (FSN), High, Medium, Low (HML), Vital,
Essential, Desirable (VED), Just-in-Time (JIT)- Stock taking and
perpetual inventory system, use of control ratios,
d) Inventory Accounting
(ii) Employee Cost
a) Attendance and Payroll procedures-
- Elements of wages- Basic pay, Dearness Allowance, Overtime,
Bonus, Holiday and leave wages, Allowances and perquisites.
b) Employee Cost Control
c) Employee Turnover- Methods of calculating employee turnover,
causes of employee turnover, effects of employee turnover.
d) Utilisation of Human Resource, Direct and indirect employee
Cost, charging of employee cost, Identifying employee hours
with work orders or batches or capital jobs.
e) Remuneration systems and incentive schemes- Premium Bonus
Method (Halsey Plan and Rowan Plan)

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(iii) Overheads
a) Functional analysis- Factory, Administration, Selling, Distribution,
Research and Development.
b) Behavioral analysis- Fixed, Variable and Semi- Variable.
c) Allocation and Apportionment of overheads using Absorption
Costing Method.
d) Factory Overheads- Primary and secondary distribution,
e) Administration Overheads- Method of allocation to cost centres
or products,
f) Selling & Distribution Overheads- Analysis and absorption of the
expenses in products/ customers, impact of marketing
strategies, cost effectiveness of various methods of sales
promotion.
g) Treatment of Research and development cost in cost accounting.
(iv) Concepts of Activity Based Costing (ABC)
(v) Recording and Accounting of Costs
a) Non-integrated Cost Accounting system- Ledger under non-
integral system
b) Integrated (Cost and Financial) Accounting system- Ledgers
under integral system.
c) Difference between the Non- integrated and Integrated
Accounting system.
d) Reconciliation of profit as per Cost and Financial Accounts
(under Non-Integrated Accounting System).
3. Methods of Costing
(i) Single Output/ Unit Costing
(ii) Job Costing: Job cost cards and databases, collecting direct costs of
each job, attributing overheads to jobs, Application of job costing.
(iii) Batch Costing: Determination of optimum batch quantity,
Ascertainment of cost for a batch, Preparation of batch cost sheet,
Treatment of spoiled and defective work.

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(iv) Contract Costing

a) Ascertainment of cost of a contract, Progress payment,
Retention money, Escalation clause, Cost plus contract, Value of
work certified, Cost of Work not certified.
b) Determination Value of work certified, Cost of work not certified,
Notional or Estimated profit from a contact.
(v) Process/ Operation Costing
a) Process cost recording, Process loss, Abnormal gains and losses,
Equivalent units of production, Inter-process profit, Valuation of
work in process.
b) Joint Products- Apportionment of joint costs, Methods of
apportioning joint cost over joint products,
c) By-Products- Methods of apportioning joint costs over by-
products, treatment of By-product cost.
(vi) Costing of Service Sectors
a) Determination of Costs and Prices of services.
4. Cost Control and Analysis
(i) Standard Costing
a) Setting up of Standards, Types of Standards, Standard Costing as
method of performance measurement.
b) Calculation and Reconciliation of Cost Variances-
- Material Cost Variance, employee Cost Variance, Variable
Overheads Variance and Fixed Overhead Variance.
(ii) Marginal Costing
a) Basic concepts of marginal costing, Contribution margin, Break-
even analysis, Break –even and profit volume charts,
Contribution to sales ratio, Margin of Safety, Angle of Incidence,
Cost-Volume-Profit Analysis (CVP), Multi- product break- even
analysis, Consideration of Limiting factor (key factor),
b) Determination of Cost of a product/ service under marginal
costing method, determination of cost of finished goods, work-
in-progress,

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c) Comparison of Marginal costing with absorption costing

method- Reconciliation of profit under the both methods,
d) Short term decision making using the above concepts (basic /
fundamental level).
(iii) Budget and Budgetary Control
a) Meaning of Budget, Essentials of Budget, Budget Manual,
Budget setting process, Preparation of Budget and monitoring
procedures.
b) The use of budget in planning and control
c) Flexible budget, Preparation of Functional budget for operating
and non- operating functions, Cash budget, Master budget,
d) Introduction to Principal/ Key budget factor, Zero Based
Budgeting (ZBB), Performance budget, Control ratios and Budget
variances.

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CONTENTS
MODULE – 1
Chapter 1 – Introduction to Cost and Management Accounting
Chapter 2 – Material Cost
Chapter 3 – Employee Cost and Direct Expenses
Chapter 4 – Overheads: Absorption Costing Method
Chapter 5 – Activity Based Costing
Chapter 6 – Cost Sheet
Chapter 7 – Cost Accounting System
MODULE – 2
Chapter 8 – Unit & Batch Costing
Chapter 9 – Job Costing and Contract Costing
Chapter 10 – Process & Operation Costing
Chapter 11 – Joint Products & By Products
Chapter 12 – Service Costing
Chapter 13 – Standard Costing
Chapter 14 – Marginal Costing
Chapter 15 – Budget and Budgetary Control

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DETAILED CONTENTS: MODULE-1
CHAPTER-1 : INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING
Learning Outcomes .............................................................................................................................. 1.1
Chapter Overview ................................................................................................................................ 1.2
1.1 Introduction ............................................................................................................................ 1.2
1.1.1 Meaning and Definitions ...................................................................................... 1.3
1.2 Objectives of Cost Accounting ........................................................................................ 1.4
1.2.1 Difference between Cost Control and Cost Reduction............................... 1.5
1.3 Scope of Cost Accounting ................................................................................................. 1.6
1.4 Relationship of Cost and Management Accounting with other

related disciplines ................................................................................................................. 1.7
1.4.1 Cost Accounting with Management Accounting ........................................ 1.7
1.4.2 Cost Accounting with Financial Accounting .................................................. 1.8
1.4.3 Cost and Management Accounting with Financial Management . ........ 1.9
1.5 Role & Functions of Cost and Management Accounting ...................................... 1.9
1.6 Users of Cost and Management Accounting ........................................................... 1.10
1.7 Essentials of a Good Cost Accounting System.......................................................... 1.12
1.8 Installation of Costing System ....................................................................................... 1.12
1.9 Cost Accounting with the use of Information Technology (IT) ......................... 1.14
1.10 Cost objects .......................................................................................................................... 1.15
1.10.1 Cost units .................................................................................................................. 1.16
1.10.2 Cost driver ................................................................................................................ 1.17
1.11 Responsibility centres ........................................................................................................ 1.17

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1.12 Limitations of Cost Accounting ..................................................................................... 1.19
1.13 Classification of costs ........................................................................................................ 1.19
1.13.1 By Nature or Element ........................................................................................... 1.20
1.13.2 By Functions ............................................................................................................. 1.22
1.13.3 By Variability or Behaviour ................................................................................. 1.22
1.13.4 By Controllability .................................................................................................... 1.28
1.13.5 By Normality ............................................................................................................ 1.28
1.13.6 By Costs for Managerial Decision Making ................................................... 1.28
1.14 Methods of Costing ........................................................................................................... 1.31
1.15 Techniques of Costing ...................................................................................................... 1.33
Summary ....................................................................................................................................... 1.34
Test Your Knowledge ........................................................................................................................ 1.36
MCQs based Questions ................................................................................................................... 1.36
Theoretical Questions ...................................................................................................................... 1.38
Answers to the MCQs based Questions .................................................................................... 1.38
Answers to the Theoretical Questions ....................................................................................... 1.38
CHAPTER-2 : MATERIAL COST
2.1 Introduction ............................................................................................................................ 2.2
2.2 Material Control .................................................................................................................... 2.3
2.2.1 Objectives of System of Material Control ........................................................ 2.3
2.2.2 Requirements of Material Control ..................................................................... 2.4
2.2.3 Elements of Material Control .............................................................................. 2.5

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2.3 Materials procurement procedure ................................................................................. 2.6
2.3.1 Bill of Materials ......................................................................................................... 2.7
2.3.2 Material Requisition Note .................................................................................... 2.7
2.3.3 Purchase Requisition .............................................................................................. 2.8
2.3.4 Inviting Quotation/Request for Proposal (RFP) ............................................ 2.9
2.3.5 Selection of Quotation/ Proposal .................................................................... 2.10
2.3.6 Preparation and execution of Purchase Orders ......................................... 2.10
2.3.7 Receipt and Inspection of Materials ............................................................. 2.10
2.3.8 Checking and passing of bills for payment ................................................ 2.11
2.4 Valuation of Material Receipts ....................................................................................... 2.11
2.5 Material Storage & Records ........................................................................................... 2.15
2.5.1 Duties of Store Keeper ......................................................................................... 2.16
2.5.2 Store Records ........................................................................................................... 2.16
2.6 Inventory Control ................................................................................................................ 2.19
2.6.1 inventory control- By Setting Quantitative Levels ..................................... 2.19
2.6.2 Inventory Stock- Out ............................................................................................ 2.28
2.6.3 Just in Time (JIT) Inventory Management ..................................................... 2.31
2.6.4 Inventory Control- On the basis of Relative Classification .....................2.31
2.6.5 Using Ratio Analysis ............................................................................................. 2.37
2.6.6 Physical Control ...................................................................................................... 2.39
2.7 Material issue procedure ................................................................................................. 2.41
2.8 Valuation of material issues ............................................................................................ 2.43
2.8.1 Cost Price Methods ............................................................................................... 2.44
2.8.2 Average Price Methods ....................................................................................... 2.52

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2.8.3 Market Price Methods .......................................................................................... 2.54
2.8.4 Notional Price Methods ...................................................................................... 2.54
2.9 Valuation of Returns & Shortages ................................................................................ 2.55
2.9.1 Valuation of materials returned to the vendor ........................................... 2.55
2.9.2 Valuation of materials returned to stores .................................................... 2.56
2.9.3 Valuation of shortages during physical verification ................................. 2.56
2.10 Treatment of normal and abnormal loss of materials ......................................... 2.56
2.11 Consumption of materials ............................................................................................... 2.60
2.11.1 Identification of materials ................................................................................... 2.60
2.11.2 Monitoring consumption of materials ........................................................... 2.61
2.11.3. Basis for consumption entries in Financial Accounts .............................. 2.62
Summary ....................................................................................................................................... 2.62
Test your Knowledge ........................................................................................................................ 2.65
Practical Problems ............................................................................................................................. 2.68
Answers to the Practical Problems .............................................................................................. 2.72
CHAPTER-3 : EMPLOYEE COST AND DIRECT EXPENSES
3.1 Introduction ............................................................................................................................ 3.2
3.2 Employee (Labour Cost) ..................................................................................................... 3.3

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3.3 Employee (labour) Cost Control ..................................................................................... 3.4
3.3.1 Important Factors for the Control of Employee Cost ................................ 3.5
3.3.2 Collection of Employee Costs.............................................................................. 3.5
3.4 Attendance & Payroll procedures.................................................................................... 3.6
3.4.1 Attendance Procedure / Time-keeping ........................................................... 3.6
3.4.2 Time-Booking ............................................................................................................ 3.8
3.4.3 Payroll Procedure ................................................................................................... 3.10
3.5 Idle Time ................................................................................................................................. 3.12
3.6 Overtime ................................................................................................................................ 3.15
3.7 Labour utilisation ................................................................................................................ 3.23
3.7.1 Identification of Utilisation of labours with Cost Centres .....................3.23
3.7.2 Identification of labour hours with work order or

batches or Capital Job ........................................................................................ 3.23
3.8 Systems of Wage Payment and Incentives .............................................................. 3.24
3.8.1 Time based (Time Rate System) ....................................................................... 3.24
3.8.2 Output Based (Piece Rate System) .................................................................. 3.24
3.8.3 Premium Bonus Method .................................................................................... 3.25
3.9 Absorption of Wages ........................................................................................................ 3.33
3.9.1 Elements of wages ............................................................................................... 3.33
3.9.2. Component of wages cost or wages for costing purposes ...................3.35
3.9.3 Holiday and leave wages .................................................................................... 3.36
3.9.4 Night shift allowance .......................................................................................... 3.37
3.9.5 Absorption rates of Employee Cost .............................................................. 3.37
3.10 Efficiency Rating Procedures ......................................................................................... 3.37

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3.10.1 Need for efficiency rating .................................................................................. 3.38
3.11 Employee (Labour) turnover .......................................................................................... 3.40
3.11.1 Employee (Labour) turnover .............................................................................. 3.40
3.11.2 Causes of Employee (Labour) turnover ....................................................... 3.43
3.11.3 Effects of Employee (Labour) turnover ........................................................ 3.44
Summary……. ....................................................................................................................................... 3.47
Theoretical Questions ......................................................................................................................3.51
Practical Problems ............................................................................................................................. 3.51
Answers to the Theoretcal Questions ........................................................................................ 3.52
CHAPTER-4 : OVERHEADS-ABSORPTION COSTING METHOD
4.1 Introduction ............................................................................................................................ 4.2
4.2 Classification of Overheads ............................................................................................... 4.3
4.2.1 Advantages of Classification of Overheads

into fixed and variable ........................................................................................... 4.5
4.3 Accounting and control of manufacrturing overheads ......................................... 4.7
4.4 Steps for the distribution of overheads ..................................................................... 4.10
4.4.1 Estimation and Collection of Manufacturing Overheads ....................... 4.10
4.4.2 Allocation of Overheads over various Departments or

Departmentalisation of Overheads ................................................................. 4.11

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4.4.3 Apportioning overhead expenses over various

departments ............................................................................................................ 4.12
4.4.4 Re-apportioning service department overheads

over production department ............................................................................. 4.15
4.4.5 Absorbing overheads over cost units, products, etc. ............................... 4.25
4.5 Methods of absorbing overheads to various products or jobs ....................... 4.25
4.5.1 Percentage of Direct Material Cost ................................................................. 4.26
4.5.2 Percentage of Prime Cost Method .................................................................. 4.26
4.5.3 Percentage of Direct Labour Cost ................................................................... 4.28
4.5.4 Labour hour rate ................................................................................................... 4.29
4.5.5 Machine hour rate ................................................................................................ 4.29
4.5.6 Rate per unit of Output Method ...................................................................... 4.31
4.6 Types Of Overhead Rates................................................................................................ 4.32
4.7 Treatment of under-absorbed and over-absorbed overheads

in Cost Accounting ............................................................................................................. 4.39
4.8 Accounting and control of administrative overheads ......................................... 4.44
4.8.1 Accounting of Administrative Overheads ..................................................... 4.44
4.8.2 Control of Administrative Overheads ............................................................ 4.46
4.9 Accounting and Control of Selling and Distribution Overheads ..................... 4.49
4.9.1 Accounting of Selling and Distribution Overheads ................................. 4.49
4.9.2 Control of Selling & Distribution Overheads .............................................. 4.51
4.10 Concepts related to capacity. .......................................................................................... 4.54
4.11 Treatment of certain items in costing ........................................................................ 4.55
Summary ..................................................................................................................................... 4.59

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Practical Questions ............................................................................................................................ 4.62
Answers to the MCQs ........................................................................................................................ 4.69
CHAPTER-5 : ACTIVITY BASED COSTING
Chapter Overview.................................................................................................................................. 5.1
5.1 Introduction.............................................................................................................................. 5.2
5.1.1 Factors prompting the development of ABC ................................................. 5.2
5.1.2 Usefulness/Suitability of ABC ............................................................................... 5.3
5.2 Meaning and Definition ..................................................................................................... 5.3
5.3 Meaning of terms used in ABC ......................................................................................... 5.3
5.4 Cost allocation under ABC .................................................................................................. 5.4
5.5 Traditional absorbtion costing Vs ABC ......................................................................... 5.5
5.6 Level of activities under abc Methodology/ Cost hierarchy .................................. 5.6
5.7 Stages in Activity based Costing (ABC) ........................................................................ 5.8
5.8 Advantages of activity based Costing ......................................................................... 5.14
5.9 Limitations of activity based Costing.......................................................................... 5.15
5.10 Requirments in ABC Implementation ......................................................................... 5.15
5.11 Practical applications of Activity based Costing .................................................... 5.15
5.11.1 As a Decision-Making Tool .............................................................................. 5.15
5.11.2 As Activity Based Management ...................................................................... 5.16

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5.11.3 Facilitate Activity Based Budgeting ............................................................... 5.18
Summary ....................................................................................................................................... 5.23
Answers to the MCQs based Questions ..................................................................................... 5.30
CHAPTER-6 : COST SHEET
6.1 Introduction ............................................................................................................................ 6.1
6.2 Functional classification of Elements of cost .............................................................. 6.2
6.3 Cost Heads in a Cost Sheet ................................................................................................ 6.2
6.3.1 Prime Cost ................................................................................................................... 6.3
6.3.2 Cost of Production .................................................................................................. 6.4
6.3.3 Cost of Goods Sold ................................................................................................. 6.5
6.3.4 Cost of Sales .............................................................................................................. 6.6
6.4 Cost sheet/statement .......................................................................................................... 6.7
6.4.1 Presentation of Cost Information ....................................................................... 6.7
6.4.2 Advantages of Cost Sheet or Cost Statements.............................................. 6.8
Summary ....................................................................................................................................... 6.11

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Answers to the MCQs based Questions ..................................................................................... 6.15
Answers to the Practical Problems ..............................................................................................6.16
CHAPTER 7- COST ACCOUNTING SYSTEMS
7.1 Introduction ............................................................................................................................ 7.2
7.2 Non-Integrated Accounting System .............................................................................. 7.2
7.2.1 Principal accounts ..................................................................................................... 7.3
7.2.2 Scheme of Entries .................................................................................................... 7.5
7.3 Integrated (or Integral) Accounting System ............................................................. 7.27
7.3.1 Advantages .............................................................................................................. 7.27
7.3.2 Essential pre-requisites for Integrated Accounts ........................................ 7.27
7.3.3 Features of Integrated Accounting System ................................................. 7.28
7.4 Reconciliation of Cost and Financial Accounts ......................................................... 7.39
7.4.1 Items included in the Financial Accounts but

not in Cost Accounts ........................................................................................... 7.39
7.4.2 Procedure for Reconciliation .............................................................................. 7.41
7.5 Accounting for Management Information and Cost Control .............................. 7.49
Summary ................................................................................................................................................ 7.52

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Answers to the MCQs based questions ...................................................................................... 7.61

CHAPTER 1
INTRODUCTION TO COST
AND MANAGEMENT
ACCOUNTING
LEARNING OUTCOMES
 State the meaning, objective and importance of cost and

management accounting.
 Discuss the functions and role of cost accounting department in an
organization.
 Discuss the essentials of cost and management accounting and to
know how a system of cost accounting is installed.
 Differentiate between cost accounting with financial accounting and
management accounting.
 List the various elements of cost and the way these are classified.
 Explain the methods of segregating semi-variable costs into fixed and
variable cost.
 Discuss the concept of cost reduction and cost control.
 Discuss the methods and techniques of costing.
 Discuss cost accounting with the use of information technology.

1.2 COST AND MANAGEMENT ACCOUNTING
Objectives of Cost
and Management
Cost Accounting
Accounting Cost Objects
using IT
Scope of Cost
Accounting Users of Cost and
Responsibility
Management
Centres
Accounting
Relationship of
Cost and
Role & Functions
Management
of Cost and
Accounting with Cost Classification
Management
other related
Accounting
desciplines
1.1 INTRODUCTION
Michael E. Porter in his theory of Generic Competitive Strategies has described ‘Cost
Leadership’ as one of the three strategic dimensions (others are ‘Product
differentiation’ and ‘Focus or Niche’) to achieve competitive advantage in industry.
Cost Leadership implies producing goods or provision of services at lowest cost
while maintaining quality to have better competitive price. In a business environment
where each entity is thriving to achieve apex position not only in domestic but global
competitive market, it is essential for the entity to fit into any of the three competitive
strategic dimensions. Cost Leadership, also in line with the subject Cost and
Management Accounting, can be achieved if an entity has a robust cost and
management accounting system in place. In this chapter, we will learn various aspects
of cost and management accounting and its application in different manufacturing and
service environment.

INTRODUCTION TO COST AND MANAGEMENT 1.3
ACCOUNTING
1.1.1 Meaning and Definition

(i) Cost- As a noun-The amount of expenditure (actual or notional) incurred
on or attributable to a specified article, product or activity.
As a verb- To ascertain the cost of a specified thing or activity.
(ii) Costing- Costing is defined as “the technique and process of ascertaining

costs”.
According to CIMA “an organisation’s costing system is the foundation of the
internal financial information system for managers. It provides the information
that management needs to plan and control the organisation’s activities and to
make decisions about the future.”
(iii) Cost Accounting- Cost Accounting is defined as "the process of
accounting for cost which begins with the recording of income and expenditure
or the bases on which they are calculated and ends with the preparation of
periodical statements and reports for ascertaining and controlling costs."
(iv) Cost Accountancy- Cost Accountancy has been defined as “the

application of costing and cost accounting principles, methods and
techniques to the science, art and practice of cost control and the ascertainment
of profitability. It includes the presentation of information derived there from for
the purpose of managerial decision making.”
(v) Management Accounting- As per CIMA Official Terminology “Management
accounting is the application of the principles of accounting and financial
management to create, protect, preserve and increase value for the stakeholders
of for-profit and not-for-profit enterprises in the public and private sectors.”
Management accounting is an integral part of management. It assists
management by provision of relevant information for planning, organising,
controlling, decision making etc.
(vi) Cost Management- It is an application of management accounting

concepts, methods of collections, analysis and presentation of data to provide the
information needed to plan, monitor and control costs.

1.2 OBJECTIVES OF COST ACCOUNTING

The main objectives of cost and management accounting are explained as below:
(i) Ascertainment of Cost: The main objective of cost accounting is
accumulation and ascertainment of cost. Costs are accumulated, assigned and
ascertained for each cost object.
(ii) Determination of Selling Price and Profitability: The cost accounting
system helps in determination of selling price and thus profitability of a cost
object. Though in a competitive business environment selling prices are
determined by external factors but cost accounting system provides a basis for
price fixation and rate negotiation.
(iii) Cost Control: Maintaining discipline in expenditure is one of the main
objective of a good cost accounting system. It ensures that expenditures are in
consonance with predetermined set standard and any variation from these
set standards is noted and reported on continuous basis. To exercise control
over cost, following steps are followed:
(a) Determination of pre-determined standard or results: Standard cost or
performance targets for a cost object or a cost centre is set before initiation of
production or service activity. These are desired cost or result that need to be
achieved.
(b) Measurement of actual performance: Actual cost or result of the cost object or
cost centre is measured. Performance should be measured in the same manner
in which the targets are set i.e. if the targets are set up operation-wise, and
then the actual costs should also be collected and measured operation-wise to
have a common basis for comparison.
(c) Comparison of actual performance with set standard or target: The actual
performance so measured is compared against the set standard and desired
target. Any deviation (variance) between the two is noted and reported to the
appropriate person or authority.
(d) Analysis of variance and action: The variance in results so noted are further
analysed to know the reasons for variance and appropriate action is taken to
ensure compliance in future. If necessary, the standards are further amended to
take developments into account.
(iv) Cost Reduction: It may be defined "as the achievement of real and
permanent reduction in the unit cost of goods manufactured or services

ACCOUNTING
rendered without impairing their suitability for the use intended or diminution in
the quality of the product."
Cost reduction is an approach of management where cost of an object is believed
to be further reduced. No cost is termed as lowest and every possibility of cost
reduction is explored. To do cost reduction, the following action is taken:
(a) Each activity within an entity is segmented to analyse and identify value added
and non- value added activities. All non-value added activities are eliminated
without affecting the essential characteristics of the product or process. Value
chain Analysis, a strategic tool, developed by Michael Porter, is one of the
method to do value analysis.
(b) Conducting continuous research and study to know better way to do anything.
The three-fold assumptions involved in the definition of cost reduction may be
summarised as under:
(a) There is a saving in unit cost.
(b) Such saving is of permanent nature.
(c) The utility and quality of the goods and services remain unaffected, if not
improved.
(v) Assisting management in decision making: Cost and Management
accounting by providing relevant information, assist management in planning,
implementing, measuring, controlling and evaluation of various activities. A
robust cost and management accounting system not only provides information
internal to industry but external also.
1.2.1 Difference between Cost Control and Cost Reduction
Cost Control Cost Reduction
1. Cost control aims at 1. Cost reduction is concerned with reducing
maintaining the costs in costs. It challenges all standards and
accordance with the established endeavours to better them continuously
standards.
2. Cost control seeks to attain 2. Cost reduction recognises no condition as
lowest possible cost under permanent, since a change will result in
existing conditions. lower cost.
3. In case of cost control, emphasis 3. In case of cost reduction, it is on present
is on past and present and future.

4. Cost control is a preventive 4. Cost reduction is a corrective function. It

function operates even when an efficient cost
control system exists.
5. Cost control ends when targets 5. Cost reduction has no visible end.
are achieved.
1.3 SCOPE OF COST ACCOUNTING

Scope of cost accounting consists of the following functions:
(i) Costing: Costing is the technique and process of ascertaining costs of
products or services. The cost ascertainment procedure is governed by some cost
accounting principles and rules. Generally, cost is ascertained using some
arithmetical process.
(ii) Cost Accounting: This is a process of accounting for cost which begins
with the recording of expenditure and ends with the preparation of periodical
statement and reports for ascertaining and controlling cost. Cost Accounting is a
formal mechanism of cost ascertainment.
(iii) Cost Analysis: It involves the process of finding out the factors
responsible for variance in actual costs from the budgeted costs and
accordingly fixation of responsibility for cost differences. This also helps in better
cost management and strategic decisions.
(iv) Cost Comparisons: Cost accounting also includes comparisons of cost
from alternative courses of action such as use of different technology for
production, cost of making different products and activities, and cost of same
product/ service over a period of time.
(v) Cost Control: It involves a detailed examination of each cost in the light
of advantage received from the incurrence of the cost. Thus, we can state that
cost is analyzed to know whether cost is not exceeding its budgeted cost and
whether further cost reduction is possible or not.
(vi) Cost Reports: This is the ultimate function of cost accounting. These
reports are primarily prepared for use by the management at different levels. Cost
Reports helps in planning and control, performance appraisal and managerial
decision making.
(vii) Statutory Compliances: Maintaining cost accounting records as per the
rules prescribed by the statute to maintain cost records relating to utilization of

ACCOUNTING
materials, labour and other items of cost as applicable to the production of goods
or provision of services as provided in the Act and these rules.
1.4 RELATIONSHIP OF COST AND MANAGEMENT

ACCOUNTING WITH OTHER RELATED
DISCIPLINES
Cost and Management Accounting as a discipline is interrelated and dependent
of other disciplines of accounting.
1.4.1 Cost Accounting with Management Accounting:
As we already studied that though Cost Accounting and Management Accounting
is used synonymously but there are few differences. Management Accounting is
open ended discipline which enables managers to take informed decision.
Management Accounting takes inputs from cost accounts, financial accounts,
statistical and operation management tools etc.
Difference between Cost Accounting and Management Accounting
Basis Cost Accounting Management Accounting

(i) Nature It records the quantitative It records both qualitative and
aspect only. quantitative aspect.
(ii) Objective It records the cost of It Provides information to
producing a product and management for planning
providing a service. and co-ordination.
(iii) Area It only deals with cost It is wider in scope as it includes
Ascertainment. financial accounting, budgeting,
taxation, planning etc.
(iv) Recording of It uses both past and It is focused with the
data present figures. projection of figures for future.
(v) Development Its development is related It develops in accordance to
to industrial revolution. the need of modern business
world.
(vi) Rules and It follows certain It does not follow any specific
Regulation principles and procedures rules and regulations.
for recording costs of
different products.

1.4.2 Cost Accounting with Financial Accounting:

Cost accounting accumulates and ascertain costs for goods sold and inventories.
It provides inputs to record costs in financial accounting system.
Difference between Financial Accounting and Cost Accounting
Basis Financial Accounting Cost Accounting
(i) Objective It provides information Ascertainment of cost for

about the financial the purpose of cost control
performance of an entity. and decision making.
(ii) Nature It classifies records, present It classifies, costs records,

and interprets transactions present, and interprets it
in monetary terms. in a significant manner.
(iii) Recording It records Historical data. It makes use of both

of data historical and pre-
determined costs.
(iv) Users of The users of financial The cost accounting

information accounting statements are information is generally
shareholders, creditors, used by internal
financial analysts and management. But some
government and its time regulatory authorities
agencies, etc. also.
(v) Analysis of It shows profit or loss of the It provides the cost details
cost and organization either segment for each cost object i.e.
profit wise or as a whole. product, process, job,
contracts, etc.
(vi) Time period Financial Statements are Reports and statements

prepared usually for a year. are prepared as and when
required.
(vii) Presentation A set format is used for In general, no set formats

of presenting financial for presenting cost
information information. information is followed.

ACCOUNTING
1.4.3 Cost and Management Accounting with Financial Management:

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

MANAGEMENT ACCOUNTING
The role of a cost and management accounting system is to:
• Provide relevant information to management for decision making,
• Assist management for planning, measurement, evaluation and controlling of
business activities,
• Help in allocation of cost to products and inventories for both external and
internal users.
Though the term cost accounting and management accounting is used by various
authors synonymously but in actual, cost accounting is concerned with
accumulation and allocation of costs to different cost objects. Whereas,
management accounting concerned with provision of information to internal
users for decision making.
The functions of cost and management accounting includes:
(i) Collection and accumulation of cost for each element of cost.

(ii) Assigning costs to cost objects to ascertain cost.

(iii) Cost and management accounting department (whatever nomenclature may
be used to denote the department) sets budget and standards for a particular
period or activity beforehand and these are compared with the assigned and
ascertained cost. Any deviation with the set standards are analysed and reported.
All these mechanism is done to control costs.
(iv) The main function of cost and management accounting is provision of
relevant information to the management for decision making. An Information
system environment is set up which is popularly known as management
information system (MIS). The MIS provides relevant and timely information
related to both internal and external to the organisation to enable management
at all levels to take decisions. Decisions include cost optimisation, price fixation,
implementation of any plan related with product, process, marketing etc.
(v) The performance of a responsibility centre is measured and evaluated
against the set standards. The function of cost and management accounting is to
gather data like time taken, wastages, process idleness etc., analyse the data,
prepare reports and take necessary actions.
1.6 USERS OF COST AND MANAGEMENT

ACCOUNTING
Cost and management accounting information which are generated or collected
are used by different stakeholders. The users of the information can be broadly
categorised into internal and external to the entity.
Internal Users
Internal users, which use the cost and management accounting information may
include the followings:
(a) Managers- The managers use the information
(i) to know the cost of a cost object and cost centre
(ii) to price for the product or service
(iii) to measure and evaluate performance of responsibility centres
(iv) to the know the profitability- product-wise, department-wise, customer-wise
etc.

ACCOUNTING
(v) to evaluate the strategic options and to make decisions

(b) Operational level staffs- The operational level staffs like supervisors,
foreman, team leaders are requiring information
(i) to know the objectives and performance goals for them
(ii) to know product and service specifications like volume, quality and process etc.
(iii) to know the performance parameters against which their performance is
measured and evaluated.
(iv) to know divisional (responsibility centre) profitability etc.
(c) Employees- Employees are concerned with the information related with
time and attendance, incentives for work, performance standards etc.
External Users
External users, which use the cost and management accounting information may
include the followings:
(a) Regulatory Authorities- Regulatory Authorities are concerned with cost
accounting data and information for different purpose which includes tariff
determination, providing subsidies, rate fixation etc. To do this the regulatory
bodies require information on the basis of some standards and format in this
regard.
(b) Auditors- The auditors while conducting audit of financial accounts or for
some other special purpose audit like cost audit etc. requires information related
with costing and reports reviewed by management etc.
(c) Shareholders- Shareholders are concerned with information that effect
their investment in the entity. Management communicate the shareholders
through periodic communique, annual reports etc. regarding new orders received,
product expansion, market share for products etc.
(d) Creditors and Lenders- Creditor and lenders are concerned with data and
information which affects an entity’s ability to serve lenders or creditors. For
example, any financial institutions which provides loan to an entity against book
debts and stocks are more concerned with regular reporting on net debt position
and stock balances.

1.7 ESSENTIALS OF A GOOD COST ACCOUNTING

SYSTEM
The essential features, which a good cost accounting system should possess, are
as follows:
(a) Informative and simple: Cost accounting system should be tailor-made,
practical, simple and capable of meeting the requirements of a business concern.
The system of costing should not sacrifice the utility by introducing inaccurate
and unnecessary details.
(b) Accurate and authentic: The data to be used by the cost accounting
system should be accurate and authenticated; otherwise it may distort the output
of the system and a wrong decision may be taken.
(c) Uniformity and consistency: There should be uniformity and consistency
in classification, treatment and reporting of cost data and related information. This
is required for benchmarking and comparability of the results of the system for
both horizontal and vertical analysis.
(d) Integrated and inclusive: The cost accounting system should be integrated
with other systems like financial accounting, taxation, statistics and operational
research etc. to have a complete overview and clarity in results.
(e) Flexible and adaptive: The cost accounting system should be flexible
enough to make necessary amendment and modifications in the system to
incorporate changes in technological, reporting, regulatory and other
requirements.
(f) Trust on the system: Management should have trust on the system and its
output. For this, an active role of management is required for the development of
such a system that reflect a strong conviction in using information for decision
making.
1.8 INSTALLATION OF COSTING SYSTEM

As in the case of every other form of activity, it should be considered whether it
would be profitable to have a cost accounting system. Management of an
organisation needs complete and accurate information to make decisions. A well-
established Costing system should provide all relevant information as and when
required by management as well as various stakeholders.

ACCOUNTING
Before setting up a system of cost accounting the under mentioned factors

should be studied:
(a) Objective: The objective of costing system, for example whether it is being
introduced for fixing prices or for establishing a system of cost control.
(b) Nature of Business or Industry: The Industry in which business is
operating. Every business industry has its own peculiarity and objectives.
According to its cost information requirement cost accounting methods are
followed. For example, an oil refinery maintains process wise cost accounts
to find out cost incurred on a particular process say in crude refinement
process etc.
(c) Organisational Hierarchy: Costing system should fulfil the information
requirements of different levels of management. Top management is
concerned with the corporate strategy, strategic level management is
concerned with marketing strategy, product diversification, product pricing
etc. Operational level management needs the information on standard
quantity to be consumed, report on idle time etc.
(d) Knowing the product: Nature of product determines the type of costing
system to be implemented. The product which has by-products requires
costing system which accounts for by-products as well. In case of perishable
or short self- life products, marginal costing is appropriate to know the
contribution and minimum price at which products could be sold.
(e) Knowing the production process: A good costing system can never be
established without the complete knowledge of the production process.
Cost apportionment can be done on the most appropriate and scientific
basis if a cost accountant can identify degree of effort or resources
consumed in a particular process. This also includes some basic technical
know-how and process peculiarity.
(f) Information synchronisation: Establishment of a department or a system
requires substantial amount of organisational resources. While drafting a
costing system, information needs of various other departments should be
taken into account. For example, in a typical business organisation accounts
department needs to submit monthly stock statement to its lender bank,
quantity wise stock details at the time of filing returns to tax authorities etc.
(g) Method of maintenance of cost records: The manner in which Cost and
Financial accounts could be inter-locked into a single integral accounting

system and how the results of separate sets of accounts i.e. cost and
financial, could be reconciled by means of control accounts.
(h) Statutory compliances and audit: Records are to be maintained to comply
with statutory requirements and applicable cost accounting standards to be
followed.
(i) Information Attributes: Information generated from the Costing system
should possess all the attributes of information i.e. complete, accurate,
timeliness, relevant etc. to have an effective management information
system (MIS).
1.9 COST ACCOUNTING WITH THE USE OF

INFORMATION TECHNOLOGY (IT)
The information technology in a business organisation has become essential for
today’s business environment. With the expansion of e-commerce and increasing
competitive business environment, information technology is becoming an
integral part of each activity in an organisation including cost and management
accounting. Information technology has changed the cost and management
accounting functions dramatically with the introduction of Enterprise Resource
Planning (ERP) system. Cost accounting and management information system
got automated and improved. The new industrial revolution in the form of
digital innovation which is popularly known as Industry 4.0, has more
emphasis on digitisation and automation of business process to have a better
control over cost to maintain market competitiveness. Cost Accounting system has
seen lots of savings in terms of time, money and efforts. The impact of IT in cost
accounting may include the followings:
(i) After the introduction of ERPs, different functional activities get
integrated and as a consequence a single entry into the accounting system
provides custom made reports for every purpose and saves an organisation from
preparing different sets of documents. Reconciliation process of results of both
cost and financial accounting systems become simpler and less sophisticated.
(ii) A move towards paperless environment can be seen where documents like
Bill of Material, Material Requisition Note, Goods Received Note, labour utilisation
report etc. are no longer required to be prepared in multiple copies, the related
department can get e-copy from the system.

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

Cost object is anything for which a separate measurement of cost is required.
Cost object may be a product, a service, a project, a customer, a brand category,
an activity, a department or a programme etc.
Examples of cost object are:
Product Smart phone, Tablet computer, SUV Car, Book etc.

Service An airline flight from Delhi to Mumbai, Concurrent audit
assignment, Utility bill payment facility etc.
Project Metro Rail project, Road projects etc.
Activity Quality inspection of materials, Placing of orders etc.

Process Refinement of crudes in oil refineries, melting of billets or ingots

in rolling mills etc.
Department Production department, Finance & Accounts, Safety etc.
1.10.1 Cost Units

It is a unit of product, service or time (or combination of these) in relation to
which costs may be ascertained or expressed.
We may for instance determine the cost per ton of steel, per ton-kilometre of a
transport service or cost per machine hour. Sometime, a single order or a contract
constitutes a cost unit. A batch which consists of a group of identical items and
maintains its identity through one or more stages of production may also be
considered as a cost unit.
Cost units are usually the units of physical measurement like number, weight, area,
volume, length, time and value.
A few typical examples of cost units are given below:
Industry or Product Cost Unit Basis

Automobile Number
Cement Ton/ per bag etc.
Chemicals Litre, gallon, kilogram, ton etc.
Power Kilo-watt hour (kWh)
Steel Ton
Transport Passenger- kilometer
Gas Cubic feet
Some examples from the CIMA terminology are as follows:
Industry Sector Cost unit

Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)

ACCOUNTING
Engineering Contract, job

Oil Barrel, tonne, litre
Hotel/Catering Room/meal
Professional services Chargeable hour, job, contract
Education Course, enrolled student, successful
student
Hospitals Patient day
Activity Cost unit

Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials storage/handling Requisition unit issued/received, material
movement, value issued/received
Personnel administration Personnel record
1.10.2 Cost Driver

A Cost driver is a factor or variable which effect level of cost. Generally, it is an
activity which is responsible for cost incurrence. Level of activity or volume of
production is the example of a cost driver. An activity may be an event, task, or
unit of work etc.
CIMA Official terminology defines cost driver as “Factor influencing the level of
cost. Often used in the context of ABC to denote the factor which links activity
resource consumption to product outputs, for example the number of purchase
orders would be a cost driver for procurement cost.”
Examples of cost drivers are number of machines setting ups, number of purchase
orders, hours spent on product inspection, number of tests performed etc.
1.11 RESPONSIBILITY CENTRES

With the growth of an organisation, its functions, organisational structure and
other related functions are also growing in terms of volume and complexity. To
have a better control over the organisation, management delegates its

responsibility and authority to various departments or persons. These

departments or persons are known as responsibility centres and are held
responsible for performance in terms of expenditure, revenue, profitability and
return on investment. Performance of these responsibility centres are measured
against some set standards (input-output ratio, budgets etc.) and evaluated
against organisational goal and performance targets. There are four types of
responsibility centres:
(i) Cost Centres
(ii) Revenue Centres
(iii) Profit Centres
(iv) Investment Centres
(i) Cost Centres: The responsibility centre which is held accountable for
incurrence of costs which are under its control. The performance of this
responsibility centre is measured against pre-determined standards or budgets.
The cost centres are of two types:
(a) Standard Cost Centre and (b) Discretionary Cost Centre
(a) Standards Cost Centres: Cost Centre where output is measurable and input
required for the output can be specified. Based on a well-established study, an
estimate of standard units of input to produce a unit of output is set. The actual
cost for inputs is compared with the standard cost. Any deviation (variance) in
cost is measured and analysed into controllable and uncontrollable cost. The
manager of the cost centre is supposed to comply with the standard and held
responsible for adverse cost variances. The input-output ratio for a standard cost
centre is clearly identifiable.
(b) Discretionary Cost Centre: The cost centre whose output cannot be
measured in financial terms, thus input-output ratio cannot be defined. The cost of
input is compared with allocated budget for the activity. Example of discretionary
cost centres are Research & Development department, Advertisement department
where output of these department cannot be measured with certainty and co-
related with cost incurred on inputs.
(ii) Revenue Centres: The responsibility centres which are accountable for
generation of revenue for the entity. Sales Department for example, is the
responsible for achievement of sales target and revenue generation. Though,
revenue centres does not have control on expenditures it incurs but some time

ACCOUNTING
expenditures related with selling activities like commission to sales person etc. are
incurred by revenue centres.
(iii) Profit Centres: These are the responsibility centres which have both
responsibility of generation of revenue and incurrence of expenditures. Since,
managers of profit centres are accountable for both costs as well as revenue,
profitability is the basis for measurement of performance of these responsibility
centres. Examples of profit centres are decentralised branches of an organisation.
(iv) Investment Centres: These are the responsibility centres which are not only
responsible for profitability but also has the authority to make capital investment
decisions. The performance of these responsibility centres are measured on the
basis of Return on Investment (ROI) besides profit. Examples of investment
centres are Maharatna, Navratna and Miniratna companies of Public Sector
Undertakings of Central Government.
11.12 LIMITATIONS OF COST ACCOUNTING

Like other branches of accounting, cost accounting is also having certain
limitations. The limitations of cost accounting are as follows:
1. Expensive: It is expensive because analysis, allocation and absorption of
overheads require considerable amount of additional work, and hence additional
money.
2. Requirement of Reconciliation: The results shown by cost accounts differ
from those shown by financial accounts. Thus Preparation of reconciliation
statements is necessary to verify their accuracy.
3. Duplication of Work: It involves duplication of work as organization has to
maintain two sets of accounts i.e. Financial Account and Cost Account.
4. Inefficiency: Costing system itself does not control costs but its usage
does.
1.13 CLASSIFICATION OF COSTS

It means the grouping of costs according to their common characteristics. The
important ways of classification of costs are:
(i) By Nature or Element
(ii) By Functions

(iii) By Variability or Behaviour

(iv) By Controllability
(v) By Normality
(vi) By Costs for Managerial Decision Making
1.13.1 By Nature or Element
This type of classification is useful to determine the total cost.
A diagram as given below shows the elements of cost described as under:
ELEMENT OF COST
Material Cost Employee (Labour) Cost Other Expenses
Direct Material Indirect Direct Indirect Direct Indirect

Cost Material Cost Employee Employee Expenses Expenses
(Labour) Cost (Labour) Cost
Overheads
Production Administration Selling and

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

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

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

According to this classification costs are classified into three group viz., fixed,
variable and semi-variable.
(a) Fixed costs– These are the costs which are incurred for a period, and which,
within certain output and turnover limits, tend to be unaffected by
fluctuations in the levels of activity (output or turnover). They do not tend to
increase or decrease with the changes in output. For example, rent,

ACCOUNTING
insurance of factory building etc., remain the same for different levels of
production.
Fixed Cost
40000
35000
30000
25000
Cost (`)
20000
15000
Fixed Cost
10000
5000
0
0 100 200 300 400 500 600
Output (in units)
(b) Variable Costs– These costs tend to vary with the volume of activity. Any
increase in the activity results in an increase in the variable cost and vice-
versa. For example, cost of direct labour, etc.
Variable Cost
60000
50000
40000
Cost (`)
30000
20000
10000
0
0 100 200 300 400 500 600
Output (in units)

(c) Semi-variable costs– These costs contain both fixed and variable
components and are thus partly affected by fluctuations in the level of
activity. Examples of semi variable costs are telephone bills, gas and
electricity etc. Such costs are depicted graphically as follows:
1.13.3.1 Methods of segregating Semi-variable costs into fixed and variable costs
Semi- Variable Cost

90000
80000
70000
60000
Cost (`)
50000
40000
30000
20000
10000
0
0 100 200 300 400 500 600
Output (in units)
The segregation of semi-variable costs into fixed and variable costs can be carried
out by using the following methods:
(a) Graphical method
(b) High points and low points method
(c) Analytical method
(d) Comparison by period or level of activity method
(e) Least squares method
(a) Graphical Method: Under this method, the following steps are
followed:
i. A large number of observations regarding the total costs at
different levels of output are plotted on a graph with the output
on the X-axis
ii. The total cost is plotted on the Y-axis.

ACCOUNTING
iii. Then, by judgment, a line of “best-fit”, which passes through all

or most of the points, is drawn.
iv. The point at which this line cuts the Y-axis indicates the total
fixed cost component in the total cost.
v. If a line is drawn at this point parallel to the X-axis, this indicates
the fixed cost.
vi The variable cost, at any level of output, is derived by deducting
this fixed cost element from the total cost.
The following graph illustrates this:
(b) High points and Low Points Method: Under this method difference
between the total cost at highest and lowest volume is divided by the
difference between the sales value at the highest and lowest volume. The
quotient thus obtained gives us the rate of variable cost in relation to
sales value.
ILLUSTRATION 1: (Segregation of fixed cost and variable cost)
Sales value Total cost

(`) (`)
At the Highest volume 1,40,000 72,000
At the Lowest volume 80,000 60,000
60,000 12,000
Thus, Variable Cost (` 12,000/` 60,000)

= 1/5 or 20% of sales value = ` 28,000 (at highest volume)

Fixed Cost ` 72,000 – ` 28,000 i.e., (20% of ` 1,40,000) = ` 44,000.
Alternatively, ` 60,000 – ` 16,000 (20% of ` 80,000) = ` 44,000.
(c) Analytical Method: Under this method an experienced cost
accountant tries to judge empirically what proportion of the semi-
variable cost would be variable and what would be fixed. The degree
of variability is ascertained for each item of semi-variable expenses.
For example, some semi-variable expenses may vary to the extent of
20% while others may vary to the extent of 80%. Although it is very
difficult to estimate the extent of variability of an expense, the method
is easy to apply. (Go through the following illustration for clarity).
Suppose, last month the total semi-variable expenses amounted to
` 3,000. If the degree of variability is assumed to be 70%, then variable
cost = 70% of ` 3,000 = ` 2,100. Fixed cost = ` 3,000 – ` 2,100 =
` 900.Now in the future months, the fixed cost will remain constant,
but the variable cost will vary according to the change in production
volume. Thus, if in the next month production increases by 50%, the
total semi-variable expenses will be: Fixed cost of ` 900, plus variable
cost viz., ` 3,150 i.e., (` 2,100 (V.C.) plus 50% increase of V.C. i.e.,
` 1,050) i.e., ` 4,050.
(d) Comparison by period or level of activity method: Under this
method, the variable overhead may be determined by comparing two
levels of output with the amount of expenses at those levels. Since the
fixed element does not change, the variable element may be
ascertained with the help of the following formula.
Change in the amount of expense
Change in the quantity of output
Suppose the following information is available:
Production Units Semi-variable expenses

(`)
January 100 260
February 140 300
Difference 40 40

ACCOUNTING
The variable cost:

Change in Semi-variable expenses ` 40
= = ` 1/unit
Change in production volume 40 units
Thus, in January, the variable cost will be 100 × ` 1 = ` 100 and the
fixed cost element will be (` 260 – ` 100) or ` 160. In February, the
variable cost will be 140 × ` 1 = ` 140 whereas the fixed cost element
will remain the same, i.e., ` 160.
(e) Least Square Method: This is the best method to segregate semi-
variable costs into its fixed and variable components. This is a
statistical method and is based on finding out a line of best fit for a
number of observations.
The method uses the linear equation y = mx + c, where
‘m’ represents the variable element of cost per unit, ‘c’ represents the
total fixed cost, ‘y’ represents the total cost, ‘x’ represents the volume
of output.
The total cost is thus split into its fixed and variable elements by
solving this equation.
Level of activity
Capacity % 60% 80%
Volume (Labour hours) or ‘x’ 150 200
Semi-variable expenses (maintenance of plant) or ‘y’ ` 1,200 ` 1,275
Substituting the values of ‘x’ and ‘y’ in the equation, y = mx + c, at

both the levels of activity, we get
1,200 = 150 m + c
1,275 = 200 m + c
On solving the above equations, we get the value of ‘c’
Fixed cost or ‘c’ = ` 975 and Variable cost or ‘m’ = ` 1.50 per labour
hour.

1.13.4 By Controllability
Costs here may be classified into controllable and uncontrollable costs.
(a) Controllable Costs: - Cost that can be controlled, typically by a cost, profit
or investment centre manager is called controllable cost. Controllable costs
incurred in a particular responsibility centre can be influenced by the action
of the executive heading that responsibility centre. For example, direct costs
comprising direct labour, direct material, direct expenses and some of the
overheads are generally controllable by the shop level management.
(b) Uncontrollable Costs - Costs which cannot be influenced by the action of a
specified member of an undertaking are known as uncontrollable costs. For
example, expenditure incurred by, say, the tool room is controllable by the
foreman in-charge of that section but the share of the tool-room
expenditure which is apportioned to a machine shop is not to be controlled
by the machine shop foreman.
Distinction between Controllable Cost and Uncontrollable Cost: The
distinction between controllable and uncontrollable costs is not very sharp and is
sometimes left to individual judgement. In fact, no cost is uncontrollable; it is only
in relation to a particular individual that we may specify a particular cost to be
either controllable or uncontrollable.
1.13.5 By Normality
According to this basis cost may be categorised as follows:
(a) Normal Cost - It is the cost which is normally incurred at a given level of
output under the conditions in which that level of output is normally
attained.
(b) Abnormal Cost - It is the cost which is not normally incurred at a given
level of output in the conditions in which that level of output is normally
attained. It is charged to Costing Profit and loss Account.
1.13.6 By Costs for Managerial Decision Making
According to this basis cost may be categorised as follows:
(a) Pre-determined Cost - A cost which is computed in advance before produc-
tion or operations start, on the basis of specification of all the factors
affecting cost, is known as a pre-determined cost.

ACCOUNTING
(b) Standard Cost -A pre-determined cost, which is calculated from

managements ‘expected standard of efficient operation’ and the relevant
necessary expenditure. It may be used as a basis for price fixation and for
cost control through variance analysis.
(c) Marginal Cost -The amount at any given volume of output by which
aggregate costs are changed if the volume of output is increased or
decreased by one unit.
(d) Estimated Cost - Kohler defines estimated cost as “the expected cost of
manufacture, or acquisition, often in terms of a unit of product computed
on the basis of information available in advance of actual production or
purchase”. Estimated costs are prospective costs since they refer to
prediction of costs.
(e) Differential Cost - (Incremental and decremental costs). It represents the
change (increase or decrease) in total cost (variable as well as fixed) due to
change in activity level, technology, process or method of production, etc.
For example, if any change is proposed in the existing level or in the
existing method of production, the increase or decrease in total cost or in
specific elements of cost as a result of this decision will be known as
incremental cost or decremental cost.
(f) Imputed Costs - These costs are notional costs which do not involve any
cash outlay. Interest on capital, the payment for which is not actually made,
is an example of imputed cost. These costs are similar to opportunity costs.
(g) Capitalized Costs -These are costs which are initially recorded as assets and
subsequently treated as expenses. Example, installation expenses on the
erection of a machine are added to the cost of a machine.
(h) Product Costs - These are the costs which are associated with the purchase
and sale of goods (in the case of merchandise inventory). In the production
scenario, such costs are associated with the acquisition and conversion of
materials and all other manufacturing inputs into finished product for sale.
Hence, under marginal costing, variable manufacturing costs and under
absorption costing, total manufacturing costs (variable and fixed) constitute
inventoriable or product costs.
(i) Opportunity Cost - This cost refers to the value of sacrifice made or benefit
of opportunity foregone in accepting an alternative course of action. For
example, a firm financing its expansion plan by withdrawing money from its

bank deposits. In such a case the loss of interest on the bank deposit is the
opportunity cost for carrying out the expansion plan.
(j) Out-of-pocket Cost - It is that portion of total cost, which involves cash
outflow. This cost concept is a short-run concept and is used in decisions
relating to fixation of selling price in recession, make or buy, etc. Out–of–
pocket costs can be avoided or saved if a particular proposal under
consideration is not accepted.
(k) Shut down Costs - Those costs, which continue to be, incurred even when a
plant is temporarily shut-down e.g. rent, rates, depreciation, etc. These costs
cannot be eliminated with the closure of the plant. In other words, all fixed
costs, which cannot be avoided during the temporary closure of a plant, will
be known as shut down costs.
(l) Sunk Costs - Historical costs incurred in the past are known as sunk costs.
They play no role in decision making in the current period. For example, in
the case of a decision relating to the replacement of a machine, the written
down value of the existing machine is a sunk cost and therefore, not
considered.
(m) Absolute Cost - These costs refer to the cost of any product, process or unit
in its totality. When costs are presented in a statement form, various cost
components may be shown in absolute amount or as a percentage of total
cost or as per unit cost or all together. Here the costs depicted in absolute
amount may be called absolute costs and are base costs on which further
analysis and decisions are based.
(n) Discretionary Costs – Such costs are not tied to a clear cause and effect
relationship between inputs and outputs. They usually arise from periodic
decisions regarding the maximum outlay to be incurred. Examples include
advertising, public relations, executive training etc.
(o) Period Costs - These are the costs, which are not assigned to the products
but are charged as expenses against the revenue of the period in which they
are incurred. All non-manufacturing costs such as general & administrative
expenses, selling and distribution expenses are recognised as period costs.
(p) Engineered Costs - These are costs that result specifically from a clear
cause and effect relationship between inputs and outputs. The relationship is
usually personally observable. Examples of inputs are direct material costs,
direct labour costs etc. Examples of output are cars, computers etc.

ACCOUNTING
(q) Explicit Costs - These costs are also known as out of pocket costs and refer
to costs involving immediate payment of cash. Salaries, wages, postage and
telegram, printing and stationery, interest on loan etc. are some examples of
explicit costs involving immediate cash payment.
(r) Implicit Costs - These costs do not involve any immediate cash payment.
They are not recorded in the books of account. They are also known as
economic costs.
1.14 METHODS OF COSTING

Different industries follow different methods of costing because of the differences
in the nature of their work. The various methods of costing are as follows:
Methods Description
Single or Here the cost of a product is ascertained, the product being

Output Costing the only one produce like bricks, coals, etc.
Batch Costing It is the extension of job costing. A batch may represent a

number of small orders passed through the factory in batch.
Each batch here is treated as a unit of cost and thus separately
costed. Here cost per unit is determined by dividing the cost of
the batch by the number of units produced in the batch.
Job Costing In this method of costing, cost of each job is ascertained

separately. It is suitable in all cases where work is undertaken
on receiving a customer’s order like a printing press, motor
workshop, etc.
Contract Here the cost of each contract is ascertained separately. It is

Costing suitable for firms engaged in the construction of bridges,
roads, buildings etc.
Process Costing Here the cost of completing each stage of work is ascertained,
like cost of making pulp and cost of making paper from pulp.
In mechanical operations, the cost of each operation may be
ascertained separately; the name given is operation costing.
Operating It is used in the case of concerns rendering services like

Costing transport, supply of water, retail trade etc.

Multiple It is a combination of two or more methods of costing outlined

Costing above. Suppose a firm manufactures bicycles including its
components; the parts will be costed by the system of job or
batch costing but the cost of assembling the bicycle will be
computed by the Single or output costing method. The whole
system of costing is known as multiple costing.
The following table summarises the various methods of costing applied in

different industries:
Nature of Output Method Cost Examples of

Industries
A Series of Processes Process costing For each Sugar

or Operation process
Costing
Construction of building Contract For each Real estate

Costing contract
Similar units of a Single Unit or output For the entire Cold Drinks
Product, produced by or Single activity, but
Single Process Costing averaged for
the output
Rendering of Services Operating For all services Hospitals

Costing
Customer Specifications: Job Costing For each order/ Advertising

single Unit assignment/job
Consisting of multiple Multiple Combination of Car

varieties of activities and Costing any method Assembly
processes

ACCOUNTING
1.15 TECHNIQUES OF COSTING

For ascertaining cost, following types of costing are usually used.
Techniques Description
Uniform When a number of firms in an industry agree among
Costing themselves to follow the same system of costing in detail,
adopting common terminology for various items and proc-
esses they are said to follow a system of uniform costing.
Advantages of such a system are that
i. A comparison of the performance of each of the firms
can be made with that of another, or with the average
performance in the industry.
ii. Under such a system it is also possible to determine the
cost of production of goods which is true for the
industry as a whole. It is found useful when tax-relief or
protection is sought from the Government.
Marginal It is defined as the ascertainment of marginal cost by
Costing differentiating between fixed and variable costs. It is used to
ascertain effect of changes in volume or type of output on profit.
Standard It is the name given to the technique whereby standard
Costing and costs are pre-determined and subsequently compared with
Variance the recorded actual costs. It is thus a technique of cost
Analysis ascertainment and cost control. This technique may be used
in conjunction with any method of costing. However, it is
especially suitable where the manufacturing method
involves production of standardised goods of repetitive
nature.
Historical It is the ascertainment of costs after they have been
Costing incurred. This type of costing has limited utility.
• Post Costing: It means ascertainment of cost after
production is completed.
• Continuous costing: Cost is ascertained as soon as the
job is completed or even when the job is in progress.
Absorption It is the practice of charging all costs, both variable and
Costing fixed to operations, processes or products. This differs from
marginal costing where fixed costs are excluded.

SUMMARY
♦ Cost: The amount of expenditure (actual or notional) incurred on or
attributable to a specified article, product or activity. (as a noun)
♦ To ascertain the cost of a specified thing or activity. (as a verb)
♦ Costing: Costing is the technique and process of ascertaining costs.
♦ Cost Accounting: The process of accounting for cost which begins with the
recording of income and expenditure or the bases on which they are
calculated and ends with the preparation of periodical statements and
reports for ascertaining and controlling costs.
♦ Cost Accountancy: Cost Accountancy has been defined as “the application

of costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of
profitability. It includes the presentation of information derived there from
for the purpose of managerial decision making.”
♦ Management Accounting: As per CIMA Official Terminology “Management

accounting is the application of the principles of accounting and financial
management to create, protect, preserve and increase value for the
stakeholders of for-profit and not-for-profit enterprises in the public and
private sectors.”
♦ Cost Management: It is an application of management accounting

concepts, methods of collections, analysis and presentation of data to
provide the information needed to plan, monitor and control costs.
♦ Cost Control: Maintaining discipline in expenditure is one of the main

objective of a good cost and management accounting system. It ensures
that expenditures are in consonance with predetermined set standard and
any variation from these set standards is noted and reported on continuous
basis.
♦ Cost Reduction: It may be defined "as the achievement of real and

permanent reduction in the unit cost of goods manufactured or services
rendered without impairing their suitability for the use intended or
diminution in the quality of the product."

ACCOUNTING
♦ Cost Objects: Cost object is anything for which a separate measurement of

cost is required. Cost object may be a product, a service, a project, a
customer, a brand category, an activity, a department or a programme etc.
♦ Cost Units: It is a unit of product, service or time (or combination of these)

in relation to which costs may be ascertained or expressed.
♦ Cost Drivers: A Cost driver is a factor or variable which effect level of cost.
Generally, it is an activity which is responsible for cost incurrence. Level of
activity or volume of production is the example of a cost driver. An activity
may be an event, task, or unit of work etc.
♦ Responsibility Centres: To have a better control over the organisation,

management delegates its responsibility and authority to various
departments or persons. These departments or persons are known as
responsibility centres and are held responsible for performance in terms of
expenditure, revenue, profitability and return on investment.
♦ Cost Centres: The responsibility centre which is held accountable for

incurrence of costs which are under its control. The performance of this
responsibility centre is measured against pre-determined standards or
budgets.
♦ Revenue Centres: The responsibility centres which are accountable for

generation of revenue for the entity.
♦ Profit Centres: These are the responsibility centres which have both
responsibility of generation of revenue and incurrence of expenditures.
Since, managers of profit centres are accountable for both costs as well as
revenue, profitability is the basis for measurement of performance of these
responsibility centres.
♦ Investment Centres: These are the responsibility centres which are not only
responsible for profitability but also has the authority to make capital
investment decisions. The performance of these responsibility centres are
measured on the basis of Return on Investment (ROI) besides profit.

TEST YOUR KNOWLEDGE

MCQs based Questions
1. ___________is anything for which a separate measurement is required.
(a) Cost unit
(b) Cost object
(c) Cost driver
(d) Cost centre
2. Which of the following is true about Cost control:
(a) It is a corrective function
(b) It challenges the set standards
(c) It ends when targets achieved
(d) It is concerned with future
3. Cost units used in power sector is:
(a) Kilo meter (K.M)
(b) Kilowatt-hour (kWh)
(c) Number of electric points
(d) Number of hours
4. Processes Costing method is suitable for
(a) Transport sector
(b) Chemical industries
(c) Dam construction
(d) Furniture making
5. Distinction between direct cost and indirect cost is an example of
______classification
(a) By Element
(b) By Function
(c) By Controllability

ACCOUNTING
(d) By Variability
6. The advantage of using IT in Cost Accounting does not include:
(a) Integration of various functions
(b) Stock needs to be reconciled with Goods Received Note
(c) Reduction in multicity of documents
(d) Customised reports can be prepared.
7. A taxi provider charges minimum `80 thereafter `12 per kilometer of distance
travelled, the behaviour of conveyance cost is:
(a) Fixed Cost
(b) Semi-variable Cost
(c) Variable Cost
(d) Administrative cost.
8. A Ltd. has three production department and each department has two machines,
which of the following cannot be treated as cost centre for cost allocation:
(a) Machines under the production department
(b) Production departments
(c) Both Production department and machines
(d) A Ltd.
9. Which of the following is an example of functional classification of cost:
(a) Direct Material Cost
(b) Fixed Cost
(c) Administrative Overheads
(d) Indirect Overheads.
10. Ticket counter in a Railway Station is an example of
(a) Cost Centre
(b) Revenue Centre
(c) Profit Centre
(d) Investment Centre

Theoretical Questions
1. DESCRIBE the main objectives of introduction of a Cost and Management
Accounting System in a manufacturing organization
2. WHAT is meant by cost centre?
3. DISCUSS cost classification based on variability and controllability.
4. DISCUSS the essential features of a good cost accounting system?
5. DESCRIBE the factors which are to be considered before installing a system of
cost accounting.
6. DISCUSS the four different methods of costing alongwith their applicability to
concerned industry?
7. STATE the method of costing and the suggestive unit of cost for the following
industries:
(a) Transport (b) Power (c) Hotel
(d) Hospital (e) Steel (f) Coal
(g) Bicycles (h) Bridge Construction (i) Interior Decoration
(j) Advertising (k) Furniture (l) Brick-works
ANSWERS/ SOLUTIONS
Answers to the MCQs based Questions
1. (b) 2. (c) 3. (b) 4. (b) 5. (a) 6. (b)
7. (b) 8. (d) 9. (c) 10. (b)
Answers to the Theoretical Questions
1. Please refer paragraph 1.2
7. Please refer paragraph 1.14 & 1.10

CHAPTER 2
MATERIAL COST
LEARNING OUTCOMES
After studying this chapter, you would be able to-
 State the meaning, need and importance of materials,
 Discuss the procedures and documentations involved in
procuring, storing and issuing material.
 Discuss the various inventory control techniques and
determination of various stock levels.
 Compute Economic Order Quantity (EOQ) and apply the
EOQ to determine the optimum order quantity.
 Discuss the various methods of inventory accounting and
Prepare stock ledger/ account.
 Identify and explain normal and abnormal loss and its
accounting treatment.

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

MATERIAL COST 2.3
necessary that the principle of 3Es (Economy, Efficiency and Effectiveness) i.e.
economy in procurement, efficiency in handling and processing the material and
effectiveness in producing desired output as per the standard, is also applied for
this cost element. Importance of proper recording and control of material are as
follows:
(a) Quality of final product: The quality of output depends on the quality of
inputs.
(b) Price of the final product: Material constitute a significant part of any
product and the cost of final product is directly related with cost of materials
used to produce the product.
(c) Production continuity: The production process should run smoothly and
should not be paused for the want of materials. To avoid production
interruptions, an adequate level of stock of materials should be maintained.
(d) Cost of Stock holding and stock-out: An entity has to incur stock holding
costs in the form of interest and/or opportunity cost for the fund used, stock
handling losses like evaporation, obsolescence etc. Under-stocking causes in loss
of revenue due to stock-out and breach of commitment.
(e) Wastage and other losses: While handling and processing of materials,
some wastage and loss arise. Based on the nature of material and process, these
are classified as normal and abnormal for efficient utilisation and control.
(f) Regular information about resources: A regular and updated information
on availability and utilisation of materials are necessary for the entity for timely
and informed decision making.
2.2 MATERIAL CONTROL

In previous chapter, we have discussed the term Cost Control, which means all
activities and control mechanism which are necessary to keep the cost in
adherence to the set standards. Material, being the one of the total cost
elements, are also required to be controlled so that the overall cost control
objective can be fulfilled.
2.2.1 Objectives of system of material control
The objectives of a system of material control are the following:
(i) Minimising interruption in production process: Ensuring that no activity,
particularly production, suffers from interruption for want of materials and stores.

It should be noted that this requires constant availability of every item that may
be needed howsoever small its cost may be.
(ii) Optimisation of Material Cost: Seeing to it that all the materials and
stores are acquired at the lowest possible price considering the quality that is
required and considering other relevant factors like reliability in respect of
delivery, etc. Holding cost should also required to be minimized.
(iii) Reduction in Wastages: Avoidance of unnecessary losses and wastages
that may arise from deterioration in quality due to defective or long storage or
from obsolescence. It may be noted that losses and wastages in the process of
manufacture, concern the production department.
(iv) Adequate Information: Maintenance of proper records to ensure that reliable
information is available for all items of materials and stores that not only helps in
detecting losses and pilferages but also facilitates proper production planning.
(v) Completion of order in time: Proper material management is very
necessary for fulfilling orders of the firm. This adds to the goodwill of the firm.
2.2.2 Requirements of material control
Material control requirements can be summarised as follows:
1. Proper co-ordination of all departments involved viz., finance, purchasing,
receiving, inspection, storage, accounting and payment.
2. Determining purchase procedure to see that purchases are made, after making
suitable enquiries, at the most favourable terms to the firm.
3. Use of standard forms for placing the order, noting receipt of goods,
authorising issue of the materials etc.
4. Preparation of budgets concerning materials, supplies and equipment to
ensure economy in purchasing and use of materials.
5. Operation of a system of internal check so that all transactions involving
materials, supplies and equipment purchases are properly approved and
automatically checked.
6. Storage of all materials and supplies in a well designated location with proper
safeguards.
7. Operation of a system of perpetual inventory together with continuous stock
checking so that it is possible to determine at any time the amount and
value of each kind of material in stock.

MATERIAL COST 2.5
8. Operation of a system of stores control and issue so that there will be

delivery of materials upon requisition to departments in the right amount at
the time they are needed.
9. Development of system of controlling accounts and subsidiary records which
exhibit summary and detailed material costs at the stage of material receipt
and consumption.
10. Regular reports of materials purchased, issue from stock, inventory balances,
obsolete stock, goods returned to vendors, and spoiled or defective units.
2.2.3 Elements of Material Control
Material control is a systematic control over the procurement, storage and usage
of material so as to maintain an even flow of material.
Material Control
Material Procurement Material Storage

Material Usage Control
Control Control
Material control involves efficient functioning of the following operations:

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

2.3 MATERIALS PROCUREMENT PROCEDURE

Material procurement procedure can be understood with help of the following
diagram. Documents required and the departments who initiate these documents
are shown sequentially.
Diagram: Material Procurement Procedure
[The name of the departments and documents shown in the diagram are for illustrative purpose only]

MATERIAL COST 2.7
2.3.1 Bill of Materials

It is also known as Materials Specification List or Materials List. It is a detailed
list specifying the standard quantities and qualities of materials and
components required for producing a product or carrying out of any job. The
materials specification list is prepared by the product development team
commonly known as engineering or planning department in a standard form. This
is shared with other concerned departments like Marketing, Production, Store,
and Cost/ Accounting department.
Format and content of a Bill of Materials vary on the basis of industrial
peculiarities, management information system (MIS) and accounting system in
place.
Uses of Bill of Material
Marketing Production Dept. Stores Dept. Cost/ Accounting
(Purchase) Dept.
Dept.
Materials are Production is planned It is used as a It is used to estimate
procured according to the reference cost and profit. Any
(purchased) on nature, volume of the document while purchase, issue and
the basis of materials required to issuing materials usage is compared
specifications be used and to the against this
mentioned in it. accordingly Material requisitioning document.
requisition lists are department.
prepared.
2.3.2 Material Requisition Note

It is also known as material requisition slip, It is a voucher of authority used to
get materials issued from store. Generally, it is prepared by the production
department and materials are withdrawn on the basis of material requisition list
or bill of materials. If no material list has been prepared, it is desirable that the
task of the preparation of material requisition notes be left to the planning
department or by the department requires the materials. The note is shared with
Store and Cost/ Accounting department.
Format of a Material requisition note may vary on the basis of industrial
place.

Difference between Bill of Materials and Material Requisition Note:
Bill of Materials Material Requisition Note

1. It is the document prepared by the 1. It is prepared by the production
engineering or planning dept.. or other consuming department.
2. It is a complete schedule of 2. It is a document authorizing
component parts and raw materials Store-keeper to issue materials
required for a particular job or work to the consuming department.
order.
3. It often serves the purpose of a 3. It cannot replace a bill of
material requisition as it shows the materials.
complete schedule of materials
required for a particular job i.e. it can
replace material requisition.
4. It can be used for the purpose of 4. It is useful in arriving historical
quotations. cost only.
5. It helps in keeping a quantitative 5. It shows the material actually
control on materials drawn through drawn from stores.
material requisition.
2.3.3 Purchase Requisition

This is a document which authorises the purchase department to order for the
materials specified in the note. Since the materials purchased will be used by the
production departments, there should be constant co-ordination between the
purchase and production departments. A purchase requisition is a form used for
making a formal request to the purchasing department to purchase
materials. This form is usually filled up by the store keeper for regular materials
and by the departmental head for special materials (not stocked as regular items).
At the beginning a complete list of materials and stores required should be drawn
up, which should be reviewed periodically for any addition or deletion. On the
basis of standing order, once an item is included in the standard list, it becomes
the duty of the purchase department to arrange for fresh supplies before existing
stocks are exhausted. Any change in the consumption pattern should be informed
to the purchase department for necessary action from their end.
For control over buying of regular store materials, Inventory control system is to
determine stock levels to be maintained and the number of quantities to be

MATERIAL COST 2.9
ordered. In respect of special materials, required for a special order or purpose, it

is desirable that the concerned technical department should prepare materials
specifications list specifying the quantity, size and order for the materials.
Purchase requisition note may either be originated by the stores department in
connection with regular materials or by the production planning or other
technical departments in respect of special materials.
Format of a purchase requisition note may vary on the basis of industrial
place.
2.3.4 Inviting Quotation/Request for Proposal (RFP)
After receipt of duly authorised purchase requisition from the store department
or other departments, role of purchase department comes into play. If a concern
can afford or the size of the concern is big enough, there should be a separate
purchase department for all purchases to be made on behalf of all other
departments. Such a department is bound to become expert in the various
matters to be attended to, for examples— units of materials to be purchased and
licences to be obtained, transport, sources of supply, probable price etc.
Materials purchase department in a business house is confronted with the
following issues:
(i) What to purchase?
(ii) When to purchase?
(iii) How much to purchase?
(iv) From where to purchase.
(v) At what price to purchase.
To overcome these questions, purchase department make an enquiry into the
market for the required material. The process of gathering information about the
rate, quantity, technology, services and support etc., purchase department sent
RFP to selected vendors in case if purchase policy allows this practice. Some
organizations follow the open and transparent purchase policy and invite
quotations from the interested vendors. This process is called Tender
Notification or Invitation of Tender.

2.3.5 Selection of Quotation/ Proposal

After invitation of tender from the vendors, interested vendors who are fulfilling
all the criteria mentioned in the tender notice send their price quotations/
proposals to the purchase department. On the receipt of quotations, a
comparative statement is prepared. For selecting material suppliers, the factors
which the purchase department keeps in its mind are—price, quantity, quality
offered, time of delivery, mode of transportation, terms of payment, reputation of
supplier etc. In addition to the above listed factors purchase manager obtains
other necessary information for final selection of material suppliers.
2.3.6 Preparation and execution of Purchase Orders
Having decided on the best quotation that should be accepted, the purchase
manager or concerned officer proceeds to issue the formal purchase order. It is a
written request to the supplier to supply specified materials at specified rates and
within a specified period. Generally, copies of purchase order are given to Store
or order indenting department, receiving department and cost accounting
department. A copy of the purchase order with relevant purchase requisitions, is
held in the file of the department to facilitate the follow-up of the delivery and
also for approval of the invoice for payment.
2.3.7 Receipt and inspection of materials
After execution of purchase order and advance payment (if terms of quotation so
specify), necessary arrangement is made to receive the delivery of materials After
receipt of materials along with relevant documents or/ and invoice, receiving
department (store dept.) arrange to inspect the materials for its conformity with
purchase order. After satisfactory inspection materials are received and Goods
Received Note is issued. If some materials are not found in good condition or are
not in conformity with the purchase order are returned back to the vendor along
with a Material Returned Note.
2.3.7.1 Goods Received Note
If everything is in order and the supply is considered suitable for acceptance, the
Receiving department prepares a Receiving Report or Material Inward Note or
Goods Received Note. Generally, it is prepared in quadruplicate, the copies being
distributed to purchase department, store or order indenting department,
receiving department and accounting department.

MATERIAL COST 2.11
2.3.7.2 Material Returned Note

Sometimes materials have to be returned to suppliers after these have been
received in the factory. Such returns may occur before or after the preparation of
the receiving report. If the return takes place before the preparation of the
receiving report, such material obviously would not be included in the report and
hence not shown in the stores ledgers. In that case, no adjustment in the account
books would be necessary. But if the material is returned after its entry in the
receiving report, a suitable document must be drawn up in support of the issue so
as to exclude from the Stores of Material Account the value of the materials
returned back. This document usually takes the form of a Material Returned Note
or Material outward return note.
2.3.8 Checking and passing of bills for payment:
The invoice received from the supplier is sent to the accounts section to check
authenticity and mathematical accuracy. The quantity and price are also checked
with reference to goods received note and the purchase order respectively. The
accounts section after checking its accuracy finally certifies and passes the invoice
for payment.
2.4 VALUATION OF MATERIAL RECEIPTS

2
After the procurement of materials from the supplier actual material cost is
calculated. Ascertainment of cost of material purchased is called valuation of
materials of material receipts. Cost of material includes cost of purchase net of
trade discounts, rebates, duty draw-back, input credit availed, etc. and other costs
incurred in bringing the inventories to their present location and condition.
Invoice of material purchased from the market sometime contain items such as
trade discount, quantity discount, freight, duty, insurance, cost of containers,
taxes, cash discount etc.
Treatment of items associated with purchase of materials is tabulated as below
Sl No. Items Treatment

Discounts and Subsidy
(i) Trade Trade discount is deducted from the purchase
Discount price if it is not shown as deduction in the invoice.
(ii) Quantity Like trade discount quantity discount is also shown
Discount as deduction from the invoice. It is deducted from

the purchase price if not shown as deduction.

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

MATERIAL COST 2.13
authority. It is an abnormal cost and not included

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

ILLUSTRATION 1
An invoice in respect of a consignment of chemicals A and B provides the following
information:
(`)
Chemical A: 10,000 kgs. at ` 10 per kg. 1,00,000
Chemical B: 8,000 kgs. at ` 13 per kg. 1,04,000
Basic custom duty @ 10% (Credit is not allowed) 20,400
Railway freight 3,840
Total cost 2,28,240
A shortage of 500 kgs. in chemical A and 320 kgs. in chemical B is noticed due to
normal breakages. You are required to COMPUTE the rate per kg. of each chemical,
assuming a provision of 2% for further deterioration.
SOLUTION
Working:
Computation of effective quantity of each chemical available for use
Chemical A (kg.) Chemical B (kg.)

Quantity purchased 10,000 8,000
Less: Shortage due to normal breakages 500 320
9,500 7,680
Less: Provision for deterioration 2% 190 153.6
Quantity available 9,310 7,526.4
Statement showing the computation of rate per kg. of each chemical
Chemical A (`) Chemical B (`)

Purchase price 1,00,000 1,04,000 1,00,000 1,04,000
Add: Basic Custom Duty @10% 10,000 10,400
Add: Railway freight
(in the ratio of quantity purchased i.e., 5:4) 2,133 1,707
Total cost (A) 1,12,133 1,16,107
Effective Quantity (see working) (B) 9,310 kg. 7,526.4 kg.
Rate per kg. (A ÷ B) 12.04 15.43

MATERIAL COST 2.15
ILLUSTRATION 2
At WHAT price per unit would Part No. A 32 be entered in the Stores Ledger, if the
following invoice was received from a supplier:
Invoice (` )
200 units Part No. A 32 @ ` 5 1,000.00
Less: 20% discount (200.00)
800.00
Add: CGST @ 12% 96.00
896.00
Add: Packing charges (5 non-returnable boxes) 50.00
946.00
(i) A 2 per cent cash discount will be given if payment is made in 30 days.
(ii) Documents substantiating payment of CGST is enclosed for claiming Input
credit.
SOLUTION
Computation of cost per unit
(`)
Net purchase Price 800.00
Add: Packing charges (5 non-returnable boxes) 50.00
850.00
No. of units purchased 200 units
Cost per unit 4.25
Note: (i) Cash discount is treated as interest and finance charges hence, it is not
considered for valuation of material.
(ii) Input credit is available for SGST paid; hence it will not be added to purchase cost.
2.5 MATERIAL STORAGE & RECORDS

2
Proper storing of materials is of primary importance. It is not enough only to
purchase material of the required quality. If the purchased material subsequently
deteriorates in quality because of bad storage, the loss is even more than what

might arise from purchase of bad quality of materials. Apart from preservation of
quality, the store-keeper also ensure safe custody of the material. It should be the
function of store-keeper that the right quantity of materials always should be
available in stock.
2.5.1 Duties of store keeper
These can be briefly set out as follows:
(i) General control over store: Store keeper should keep control over all
activities in Stores department. He should check the quantities as mentioned in
Goods received note and with the purchased materials forwarded by the receiving
department and to arrange for the storage in appropriate places.
(ii) Safe custody of materials: Store keeper should ensure that all the
materials are stored in a safe condition and environment required to preserve the
quality of the materials.
(iii) Maintaining records: Store keeper should maintain proper record of
quantity received, issued, balance in hand and transferred to/ from other stores.
(iv) Initiate purchase requisition: Store keeper should initiate purchase
requisitions for the replacement of stock of all regular stores items whenever the
stock level of any item of store approaches the re-order level fixed.
(v) Maintaining adequate level of stock: Store keeper should maintain
adequate level of stock at all time. He/ she should take all necessary action so
that production could not be interrupted due to lack of stock. Further he/ she
should take immediate action for stoppage of further purchasing when the stock
level approaches the maximum limit. To reserve a particular material for a specific
job when so required.
(vi) Issue of materials: Store keeper should issue materials only against the
material requisition slip approved by the appropriate authority. He/ she should
also refer to bill of materials while issuing materials to requisitioning department.
(vii) Stock verification and reconciliation: Store keeper should verify the book
balances with the actual physical stock at frequent intervals by way of internal
control and check the any irregular or abnormal issues, pilferage, etc.
2.5.2 Store Records
The record of stores may be maintained in three forms:
 Bin Cards

MATERIAL COST 2.17
 Stock Control Cards

 Store Ledger
Bin Cards: It is a quantitative record of inventory which shows the quantity of
inventory available in a particular bin. Bin refers to a box/ container/ space where
materials are kept. Card is placed with each of the bin (space) to record the
details of material like receipt, issue and return. It is maintained by store
department.
Stock Control Cards: It is also a quantitative record of inventory maintained by
stores department for every item of material. In other words, it is a record which
shows the overall inventory position in store. Recording includes receipt, issue,
return, in hand and order given.
Advantages and Disadvantages of Bin Cards
Advantages:
(i) There would be fewer chances of mistakes being made as entries are made
at the same time as goods received or issued by the person actually
handling the materials.
(ii) Control over stock can be more effective, in as much as comparison of the
actual quantity in hand at any time with the book balance is possible.
(iii) Identification of the different items of materials is facilitated by reference to
the Bin Card the bin or storage receptacle.
Disadvantages
(i) Store records are dispersed over a wide area.
(ii) The cards are liable to be smeared with dirt and grease because of
proximity to material and also because of handling materials.
(iii) People handling materials are not ordinarily suitable for the clerical work
involved in writing Bin Cards.
Advantages and disadvantages of Stock Control Cards
Advantages:
(i) Records are kept in a more compact manner so that reference to them is
facilitated.
(ii) Records can be kept in a neat and clean way by men solely engaged in
clerical work so that a division of workers between record keeping and

actual material handling is possible.

(iii) As the records are at one place, it is possible to get an overall idea of the
stock position without the necessity of going round the stores.
Disadvantages:
(i) On the spot comparison of the physical stock of an item with its book
balance is not facilitated.
(ii) Physical identification of materials in stock may not be as easy as in the case
of bin cards, as the Stock Control Cards are housed in cabinets or trays.
Stores Ledger: A Stores Ledger is maintained to record of both quantity and
cost of materials received, issued and those in stock. It’s being a subsidiary
ledger to the main cost ledger, it is maintained by the Cost/ Accounts
Department. The source documents for posting the ledger are Goods received
notes, Materials requisition notes etc.
The first two forms are records of quantities received, issued and those in
balance, but in the third record i.e. store ledger, value of receipts, issues and
closing balance is also maintained. Usually, records of quantities i.e. Bin cards and
Store Control Cards are kept by the store keeper in store department while record of
both quantity and value is maintained by cost accounting department.
Difference between Bin Card & Stores Ledger
Bin Card Stores Ledger

It is maintained by the storekeeper in It is maintained in cost accounting
the store. department.
It contains only quantitative details of It contains information both in
material received, issued and quantity and value.
returned to stores.
Entries are made when transaction It is always posted after the
takes place. transaction.
Each transaction is individually Transactions may be summarized and
posted. then posted.
Inter-department transfers do not Material transfers from one job to
appear in Bin Card. another job are recorded for costing
purposes.

MATERIAL COST 2.19
2.6 INVENTORY CONTROL

The Chartered Institute of Management Accountants (CIMA) defines Inventory
Control as “The function of ensuring that sufficient goods are retained in stock to
meet all requirements without carrying unnecessarily large stocks.”
The objective of inventory control is to make a balance between sufficient stock
and over-stock. The stock maintained should be sufficient to meet the production
requirements so that uninterrupted production flow can be maintained.
Insufficient stock not only pause the production but also cause a loss of revenue
and goodwill. On the other hand, Inventory requires some funds for purchase,
storage, maintenance of materials with a risk of obsolescence, pilferage etc. A
trade-off between Stock-out and Over-stocking is required. The management
may employ various methods of Inventory control to have a balance.
Management may adopt the following basis for Inventory control:
Inventory Control
By Setting On the basis of

Using Ratio
Quantitative Relative Physical Control
Analysis
Levels Classification
2.6.1 Inventory Control- By Setting Quantitative Levels
Re-order Stock Level •When to Order
Re-order Quantiy/ EOQ •How Much to Order
Maximum Stock Level •Upto How much to stock
Minimum Stock Level •Atleast How much to stock
Average Stock Level •Stock normally kept
Danger Stock Level •Kept for emergency requirement
Buffer Stock •To meetigate sudden demand

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

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

order period)
Minimum Stock Level = Minimum Stock level that must be maintained

all the time.
Average Rate of Consumption = Average rate of material consumption in
production activity. It is also known as normal
consumption/ usage
Average Re-order period = Average time to get an order from supplier to
the stores. It is also known as normal period.
(Re-order period is also known as Lead time)
(ii) Re-Order Quantity: Re-order quantity is the quantity of materials for which
purchase requisition is made by the store department. While setting the quantity
to be re-ordered, consideration is given to the maintenance of minimum level of
stock, re-order level, minimum delivery time and the most important the cost.
Hence, the quantity should be where, the total of carrying cost and ordering
cost be at minimum. For this purpose, an economic order quantity should be
calculated.
Economic Order Quantity (EOQ): The size of an order for which total of ordering
and carrying cost are at minimum.

MATERIAL COST 2.21
Ordering Cost: The costs which are associated with the purchase or order of
materials. It includes cost to invite quotations, documentation works like
preparation of purchase orders, employee cost directly attributable to the
procurement of material, transportation and inspection cost etc.
Carrying Cost: The costs for holding/ carrying of inventories in store. It includes
the cost of fund invested in inventories, cost of storage, insurance cost,
obsolescence etc.
The Economic Order Quantity (EOQ) is calculated as below:
2 × Annual Requirement (A) ×Cost per order(O)

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

ILLUSTRATION 3
CALCULATE the Economic Order Quantity from the following information. Also
state the number of orders to be placed in a year.
Consumption of materials per annum : 10,000 kg.
Order placing cost per order : ` 50
Cost per kg. of raw materials : `2
Storage costs : 8% on average inventory
SOLUTION
2× A ×O
EOQ =
C
A = Units consumed during year
O = Ordering cost per order
C = Inventory carrying cost per unit per annum.
2 ×10,000 × 50 = 2 × 10,000 × 50 × 25
EOQ = = 2,500 kg.
2×8 4
100
Total consumption of materials per annum
No. of orders to be placed in a year =
EOQ
= 10,000 kg. = 4 Orders per year

2,500 kg.
ILLUSTRATION 4
(i) COMPUTE E.O.Q. and the total variable cost for the following:
Annual Demand = 5,000 units
Unit price = ` 20.00
Order cost = ` 16.00
Storage rate = 2% per annum
Interest rate = 12% per annum
Obsolescence rate = 6% per annum

MATERIAL COST 2.23
(ii) DETERMINE the total cost that would result for the items if an incorrect price
of ` 12.80 is used.
SOLUTION
(i) Carrying cost (C) = Storage rate = 2%
Interest Rate = 12%
Obsolescence Rate = 6%
Total = 20% per annum
C= 20% of ` 20 = ` 4 per unit per annum.
2AO 2×5000×16
E.O.Q = = = 40,000 = 200 units
C 4
Total cost:
Purchase price of 5,000 units @ ` 20.00 per unit = ` 1,00,000
5000
Ordering cost = =25 orders @ ` 16 = ` 400
200
200
Carrying cost of average Inventory = =100 units @ ` 4 = ` 400
2
Total cost ` 1,00,800
(ii) If an incorrect price of ` 12.80 is used:
C = 20% of 12.80 = ` 2.56 per unit per annum.
2×5,000×16
E.O.Q. = = 250 units
2.56
Total cost:
Purchase price of 5,000 units @ ` 12.80 per unit = ` 64,000
5,000
Ordering cost = = 20 orders @ ` 16 = ` 320
250
250
Carrying cost (of average inventory) = =125 units @ ` 2.56= ` 320
2
Total variable cost ` 64,640

(iii) Minimum Stock Level: It is lowest level of material stock, which must be
maintained in hand at all times, so that there is no stoppage of production due to
non-availability of inventory.
It is calculated as below:
Minimum Stock Level = Re-order Stock Level - (Average Consumption Rate ×

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

Consumption Rate × Minimum Re-order Period)
Here, Re-order Quantity may be EOQ

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

Maximum Stock Level + Minimum StockLevel
Average Stock Level =
2
(vi) Danger level: It is the level at which normal issues of the raw material
inventory are stopped and emergency issues are only made.
Danger Level = Average Consumption* × Lead time for emergency purchase
*Some time minimum consumption is also used.

(vii) Buffer Stock: Some quantity of stock may be kept for contingency to be
used in case of sudden order, such stock is known as buffer stock.

MATERIAL COST 2.25
All the above stock levels can be understood with the help of the following
diagram:
Stock Control Chart
Quantity
ILLUSTRATION 5
Two components, A and B are used as follows:
Normal usage 50 per week each
Maximum usage 75 per week each
Minimum usage 25 per week each
Re-order quantity A: 300; B: 500
Re-order period A: 4 to 6 weeks
B: 2 to 4 weeks
CALCULATE for each component (a) Re-ordering level, (b) Minimum level, (c)
Maximum level, (d) Average stock level.
SOLUTION
(a) Re-ordering level:
Maximum usage per week × Maximum delivery period.
Re-ordering level for component A = 75 units × 6 weeks = 450 units

Re-ordering level for component B = 75 units × 4 weeks = 300 units

(b) Minimum level:
Re-order level – (Normal usage × Average period)
Minimum level for component A = 450 units – (50 units × 5 weeks) = 200 units
Minimum level for component B = 300 units – (50 units × 3 weeks) = 150 units
(c) Maximum level:
Re-order level + Re-order quantity – (Min. usage × Minimum period)
Maximum level for component A = (450 units + 300 units) – (25 units × 4
weeks) = 650 units
Maximum level for component B = (300 units + 500 units) – (25 units × 2
weeks) = 750 units
(d) Average stock level:
½ (Minimum + Maximum) stock level
Average stock level for component A = ½ (200 units + 650 units) =425 units.
Average stock level for component B = ½ (150 units + 750 units) =450 units.
ILLUSTRATION 6
From the details given below, CALCULATE:
(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level.
Re-ordering quantity is to be calculated on the basis of following information:
Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.
Details of lead time : Average- 10 days, Maximum- 15 days, Minimum- 5 days.
For emergency purchases- 4 days.

MATERIAL COST 2.27
Rate of consumption : Average: 15 units per day,

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

2×5,000 units×` 20
2. Re-order Quantity (ROQ) = = 200 units
5
2.6.2 Inventory Stock- Out
Stock out said to be occurred when an inventory item could not be supplied
due to insufficient stock in the store. The stock- out situation costs to the entity
not only in financial terms but in non-financial terms also. Due to stock out an
entity not only loses overheads costs and profit but reputation (goodwill) also
due to non-fulfilment of commitment. Though it may not be a monetary loss in
short term but in long term it could be a reason for financial loss.
While deciding on the level of inventory, a trade-off between the stock out cost
and carrying cost is made so that overall inventory cost can be minimized.
ILLUSTRATION 7:
M/s Tyrotubes trades in four wheeler tyres and tubes. It stocks sufficient quantity of
tyres of almost every vehicle. In year end 20X8-X9, the report of sales manager
revealed that M/s Tyrotubes experienced stock-out of tyres.
The stock-out data is as follows:
Stock-out of Tyres No. of times

100 2
80 5
50 10
20 20
10 30
0 33
M/s Tyrotubes loses ` 150 per unit due to stock-out and spends ` 50 per unit on
carrying of inventory.
DETERMINE optimum safest stock level.

MATERIAL COST 2.29
SOLUTION
Computation of Stock-out and Inventory carrying cost
Safety Stock- Probability Stock- Expected Inventory Total
Stock out (3) out cost stock-out carrying cost cost (`)
Level (units) (`) cost (`) (`) (7) =
(units) (2) (4) = (2) (5)=(3)x(4) (6) =(1)x`50 (5)+(6)
(1) x `150
100 0 0.00 0 0 5,000 5,000
80 20 0.02 3,000 60 4,000 4,060
50 50 0.02 7,500 150
30 0.05 4,500 225
12,000 375 2,500 2,875
20 80 0.02 12,000 240
60 0.05 9,000 450
30 0.10 4,500 450
25,500 1,140 1,000 2,140
10 90 0.02 13,500 270
70 0.05 10,500 525
40 0.10 6,000 600
10 0.20 1,500 300
31,500 1,695 500 2,195
0 100 0.02 15,000 300 2,700
80 0.05 12,000 600
50 0.10 7,500 750
20 0.20 3,000 600
10 0.30 1,500 450
39,000 2,700 0 2,700
At safety stock level of 20 units, total cost is least i.e. ` 2,140.
Working Note:
Computation of Probability of Stock-out
Stock-out (units) 100 80 50 20 10 0 Total

Nos. of times 2 5 10 20 30 33 100
Probability 0.02 0.05 0.10 0.20 0.30 0.33 1.00

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

level
100 units Any unexpected demand upto 100 units can be met.
80 units Stock out will only arise if unexpected demand will be for 100
units. In this case 20 units will remain unsatisfied. The
probability of any unexpected demand for 100 units is 0.02.
50 units Any unexpected demand beyond 50 units will be remain
unsatisfied. If unexpected demand for 100 units arises
(probability is 0.02) 50 units will be unsatisfied. Similarly, if
unexpected demand for 80 units arises (probability is 0.05), 30
units will be unsatisfied.
(probability is 0.02), 80 units will remain unsatisfied. If
units will remain unsatisfied. Similarly, when unexpected
demand for 50 units arises (probability is 0.10), 30 units will
remain unsatisfied.
units will remain unsatisfied. If unexpected demand for 50 units
arises (probability is 0.10), 40 units will remain unsatisfied.
Similarly, when unexpected demand for 20 units arises
(probability is 0.20), 10 units will remain unsatisfied.
0 unit When no safety stock level is maintained, any unexpected
demand cannot be satisfied. If unexpected demand for 100
units arises (probability is 0.02), 100 units will remain

MATERIAL COST 2.31

units will remain unsatisfied. If unexpected demand for 20 units
arises (probability is 0.20), 20 units will remain unsatisfied.
Similarly, unexpected demand for 10 units (probability is 0.30),
10 units will remain unsatisfied.
2.6.3 Just in Time (JIT) Inventory Management

JIT is a system of inventory management with an approach to have a zero
inventories in stores. According to this approach material should only be
purchased when it is actually required for production.
JIT is based on two principles
(i) Produce goods only when it is required and
(ii) the products should be delivered to customers at the time only when they want.
It is also known as ‘Demand pull’ or ‘Pull through’ system of production. In
this system, production process actually starts after the order for the products is
received. Based on the demand, production process starts and the requirement
for raw materials is sent to the purchase department for purchase. This can be
understood with the help of the following diagram:
Production Materail Order for

Supplier
Demand starts to Requirement raw
sent the
for final process the is sent to materials
material for
product demad for Purchase sent to
production
product department supplier
2.6.4 Inventory Control- On the basis of Relative Classification
•On the basis of value and frequency of inventory

ABC Analysis
•On the basis of inventory turnover

Fast, Slow and Non Moving (FSN)
Vital, Essential and Desirable (VED) •On the basis of importance of inventory
High, Medium and Low (HML) •On the basis of price of an item of inventory

(1) ABC Analysis: This system exercises discriminating control over different
items of inventory on the basis of the investment involved. Usually the items are
classified into three categories according to their relative importance, namely,
their value and frequency of replenishment during a period.
(i) ‘A’ Category: This category of items consists of only a small percentage i.e.,
about 10% of the total items handled by the stores but require heavy investment
about 70% of inventory value, because of their high prices or heavy requirement
or both. Items under this category can be controlled effectively by using a regular
system which ensures neither over-stocking nor shortage of materials for
production. Such a system plans its total material requirements by making
budgets. The stocks of materials are controlled by fixing certain levels like
maximum level, minimum level and re-order level.
(ii) ‘B’ Category: This category of items is relatively less important; they may be
20% of the total items of material handled by stores. The percentage of investment
required is about 20% of the total investment in inventories. In the case these
items, as the sum involved is moderate, the same degree of control as applied in
‘A’ category of items is not warranted. The orders for the items, belonging to this
category may be placed after reviewing their situation periodically.
(iii) ‘C’ Category: This category of items does not require much investment; it
may be about 10% of total inventory value but they are nearly 70% of the total
items handled by store. For these category of items, there is no need of exercising
constant control. Orders for items in this group may be placed either after six
months or once in a year, after ascertaining consumption requirements. In this
case the objective is to economies on ordering and handling costs.
Cost

MATERIAL COST 2.33
ILLUSTRATION 8
From the following details, DRAW a plan of ABC selective control:
Item Units Unit cost (`)

1 7,000 5.00
2 24,000 3.00
3 1,500 10.00
4 600 22.00
5 38,000 1.50
6 40,000 0.50
7 60,000 0.20
8 3,000 3.50
9 300 8.00
10 29,000 0.40
11 11,500 7.10
12 4,100 6.20
SOLUTION
Statement of Total Cost and Ranking
Item Units % of Total Unit cost Total % of Total Ranking
units (`) cost (`) cost
1 7,000 3.1963 5.00 35,000 9.8378 4
2 24,000 10.9589 3.00 72,000 20.2378 2
3 1,500 0.6849 10.00 15,000 4.2162 7
4 600 0.2740 22.00 13,200 3.7103 8
5 38,000 17.3516 1.50 57,000 16.0216 3
6 40,000 18.2648 0.50 20,000 5.6216 6
7 60,000 27.3973 0.20 12,000 3.3730 9
8 3,000 1.3699 3.50 10,500 2.9513 11
9 300 0.1370 8.00 2,400 0.6746 12
10 29,000 13.2420 0.40 11,600 3.2605 10

11 11,500 5.2512 7.10 81,650 22.9502 1

12 4,100 1.8721 6.20 25,420 7.1451 5
2,19,000 100 3,55,770 100
Basis for selective control (Assumed)

` 50,000 & above -- ‘A’ items
` 15,000 to 50000 -- ‘B’ items
Below ` 15,000 -- ‘C’ items
On this basis, a plan of A B C selective control is given below:
Ranking Item % of Total Cost (`) % of Total Category
Nos. units Cost
1 11 5.2512 81,650 22.9502
2 2 10.9589 72,000 20.2378
3 5 17.3516 57,000 16.0216
Total 3 33.5617 2,10,650 59.2096 A
4 1 3.1963 35,000 9.8378
5 12 1.8721 25,420 7.1451
6 6 18.2648 20,000 5.6216
7 3 0.6849 15,000 4.2162
Total 4 24.0181 95,420 26.8207 B
8 4 0.2740 13,200 3.7103
9 7 27.3973 12,000 3.3730
10 10 13.2420 11,600 3.2605
11 8 1.3699 10,500 2.9513
12 9 0.1370 2,400 0.6746
Total 5 42.4202 49,700 13.9697 C
Grand Total 12 100 3,55,770 100
(1) Advantages of ABC analysis: The advantages of ABC analysis are the
following:
(i) Continuity in production: It ensures that, without there being any
danger of interruption of production for want of materials or stores,
minimum investment will be made in inventories of stocks of materials
or stocks to be carried.

MATERIAL COST 2.35
(ii) Lower cost: The cost of placing orders, receiving goods and main-
taining stocks is minimised specially if the system is coupled with the
determination of proper economic order quantities.
(iii) Less attention required: Management time is saved since attention
need be paid only to some of the items rather than all the items as
would be the case if the ABC system was not in operation.
(iv) Systematic working: With the introduction of the ABC system, much of
the work connected with purchases can be systematized on a routine
basis to be handled by subordinate staff.
ILLUSTRATION 9
A factory uses 4,000 varieties of inventory. In terms of inventory holding and
inventory usage, the following information is compiled:
No. of varieties of % % value of % of inventory

inventory inventory holding usage (in end-
(average) product)
3,875 96.875 20 5
110 2.750 30 10
15 0.375 50 85
4,000 100.00 100 100
CLASSIFY the items of inventory as per ABC analysis with reasons.

SOLUTION
Classification of the items of inventory as per ABC analysis
1. 15 number of varieties of inventory items should be classified as ‘A’
category items because of the following reasons:
(i) Constitute 0.375% of total number of varieties of inventory handled by
stores of factory, which is minimum as per given classification in the
table.
(ii) 50% of total use value of inventory holding (average) which is
maximum according to the given table.
(iii) Highest in consumption about 85% of inventory usage (in end-
product).

2. 110 number of varieties of inventory items should be classified as ‘B’

(i) Constitute 2.750% of total number of varieties of inventory items
handled by stores of factory.
(ii) Requires moderate investment of about 30% of total use value of
inventory holding (average).
(iii) Moderate in consumption about 10% of inventory usage (in end–
product).
3. 3,875 number of varieties of inventory items should be classified as ‘C’
(i) Constitute 96.875% of total varieties of inventory items handled by
stores of factory.
(ii) Requires about 20% of total use value of inventory holding (average).
(iii) Minimum inventory consumption i.e. about 5% of inventory usage (in
end-product).
(2) Fast Moving, Slow Moving and Non Moving (FSN) Inventory: It is also
known as FNS (Fast, Normal and Slow moving) classification of inventory Analysis.
Under this system, inventories are controlled by classifying them on the basis of
frequency of usage. The classification of items into these three categories
depends on the nature and managerial discretion. A threshold range on the basis
of inventory turnover is decided and classified accordingly.
(i) Fast Moving- This category of items are placed nearer to store issue point
and the stock is reviewed frequently for making of fresh order.
(ii) Slow Moving- This category of items are given stored little far and stock is
reviewed periodically for any obsolescence and may be shifted to Non-moving
category.
(iii) Non Moving- This category of items are kept for disposal. This category of
items is reported to the management and an appropriate provision for loss may
be created.
(3) Vital, Essential and Desirable (VED): Under this system of inventory
analysis, inventories are classified on the basis of its criticality for the
production function and final product. Generally, this classification is done for
spare parts which are used for production.

MATERIAL COST 2.37
(i) Vital- Items are classified as vital when its unavailability can interrupt the
production process and cause a production loss. Items under this category are
strictly controlled by setting re-order level.
(ii) Essential- Items under this category are essential but not vital. The
unavailability may cause sub standardisation and loss of efficiency in production
process. Items under this category are reviewed periodically and gets the second
priority.
(iii) Desirable- Items under this category are optional in nature, unavailability
does not cause any production or efficiency loss.
(4) High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike ABC
analysis where inventories are classified on the basis of overall value of inventory.
A range of cost is used to classify the inventory items into the three categories.
High Cost inventories are given more priority for control, whereas Medium cost
and Low cost items are comparatively given lesser priority.
2.6.5 Using Ratio Analysis
(i) Input Output Ratio: Inventory control can also be exercised by the use of
input output ratio analysis. Input-output ratio is the ratio of the quantity of
input of material to production and the standard material content of the
actual output.
This type of ratio analysis enables comparison of actual consumption and
standard consumption, thus indicating whether the usage of material is
favourable or adverse.
(ii) Inventory Turnover Ratio: Computation of inventory turnover ratios for
different items of material and comparison of the turnover rates provides a useful
guidance for measuring inventory performance. High inventory turnover ratio
indicates that the material in the question is a fast moving one. A low turnover
ratio indicates over-investment and locking up of the working capital in inventories.
Inventory turnover ratio may be calculated by using the following formulae: -
Inventory Turnover Ratio = Cost of materials consumed during the period

Cost of average stock held duirng the period
Average stock = 1/2 (opening stock + closing stock)

360days /12months
Average no. of days of Inventory holding =
Inventory TurnoverRatio
By comparing the number of days in the case of two different materials, it is
possible to know which is fast moving and which is slow moving. On this basis,
attempt should be made to reduce the amount of capital locked up, and prevent
over-stocking of the slow moving items.
ILLUSTRATION 10
The following data are available in respect of material X for the year ended 31st
March, 20X9.
(`)
Opening stock 90,000
Purchases during the year 2,70,000
Closing stock 1,10,000
CALCULATE:
(i) Inventory turnover ratio, and
(ii) The number of days for which the average inventory is held.
SOLUTION
Inventory turnover ratio
Cost of stock of raw material consumed
(Refer to working note) =
Average stock of raw material
`2,50,000
= = 2.5
`1,00,000
Average number of days for which the average inventory is held
365 365 days
= =
Inventory turnover ratio 2.5
= 146 days
Working Note:
(`)
Opening stock of raw material 90,000

MATERIAL COST 2.39
Add: Material purchases during the year 2,70,000

Less: Closing stock of raw material 1,10,000
Cost of stock of raw material consumed 2,50,000
ILLUSTRATION 11
From the following data for the year ended 31st December, 20X9, CALCULATE the
inventory turnover ratio of the two items and put forward your comments on them.
Material A (`) Material B (`)

Opening stock 1.1.20X9 10,000 9,000
Purchase during the year 52,000 27,000
Closing stock 31.12.20X9 6,000 11,000
SOLUTION
First of all it is necessary to find out the material consumed:
Cost of materials consumed Material A Material B

(`) (`)
Opening stock 10,000 9,000
Add: Purchases 52,000 27,000
62,000 36,000
Less: Closing stock 6,000 11,000
Materials consumed 56,000 25,000
Average inventory: (Opening Stock + Closing Stock) ÷ 8,000 10,000
2
Inventory Turnover ratio: (Consumption ÷ Average 7 times 2.5 times
inventory)
Inventory Turnover (Number of Days in a year/IT 52 days 146 days
ratio)
Comments: Material A is moving faster than Material B.
2.6.6 Physical Control
(i) Two Bin System: Under this system each bin is divided into two parts - one,
smaller part, should stock the quantity equal to the minimum stock or even the
re-ordering level, and the other to keep the remaining quantity. Issues are made

out of the larger part; but as soon as it becomes necessary to use quantity out of
the smaller part of the bin, fresh order is placed. “Two Bin System” is
supplemental to the record of respective quantities on the bin card and the stores
ledger card.
(ii) Establishment of system of budgets: To control investment in the
inventories, it is necessary to know in advance about the inventories requirement
during a specific period usually a year. The exact quantity of various types of
inventories and the time when they would be required can be known by studying
carefully production plans and production schedules. Based on this, inventories
requirement budget can be prepared. Such a budget will discourage the
unnecessary investment in inventories.
(iii) Perpetual inventory records and continuous stock verification:
Perpetual inventory represents a system of records maintained by the stores
department. It in fact comprises: (i) Bin Cards, and (ii) Stores Ledger.
The success of perpetual inventory depends upon the following:
(a) The Stores Ledger−(showing quantities and amount of each item).
(b) Stock Control cards (or Bin Cards).
(c) Reconciling the quantity balances shown by (a) & (b) above.
(d) Checking the physical balances of a number of items every day
systematically and by rotation.
(e) Explaining promptly the causes of discrepancies, if any, between physical
balances and book figures.
(f) Making corrective entries where called for after step (e) and
(g) Removing the causes of the discrepancies referred to in step (e)
Advantages of perpetual inventory: The main advantages of perpetual
inventory are as follows:
(1) Physical stocks can be counted and book balances adjusted as and when
desired without waiting for the entire stock-taking to be done.
(2) Quick compilation of Profit and Loss Account (for interim period) due to
prompt availability of stock figures.
(3) Discrepancies are easily located and thus corrective action can be promptly
taken to avoid their recurrence.

MATERIAL COST 2.41
(4) A systematic review of the perpetual inventory reveals the existence of

surplus, dormant, obsolete and slow-moving materials, so that remedial
measures may be taken in time.
(5) Fixation of the various stock levels and checking of actual balances in hand
with these levels assist the Store keeper in maintaining stocks within limits
and in initiating purchase requisitions for correct quantity at the proper
time.
(iv) Continuous Stock Verification: The checking of physical inventory is an
essential feature of every sound system of material control. The system of
continuous stock-taking consists of physical verification of items of inventory.
The stock verification may be done by internal audit department but are
independent of the store and production staff. Stock verification are done at
appropriate interval of time without prior notice. The element of surprise, that is
essential for effective control of the system.
Advantages of continuous stock-taking: The advantages of continuous stock-
taking are:
1. Closure of normal functioning is not necessary.
2. Stock discrepancies are likely to be brought to the notice and corrected
much earlier than under the annual stock-taking system.
3. The system generally has a sobering influence on the stores staff because of
the element of surprise present therein.
4. The movement of stores items can be watched more closely by the stores
auditor so that chances of obsolescence buying are reduced.
5. Final Accounts can be ready quickly. Interim accounts are possible quite
conveniently.
Disadvantages: Annual stock-taking, however, has certain inherent shortcomings
which tend to detract from the usefulness of such physical verification. For
instance, since all the items have to be covered in a given number of days, either
the production department has to be shut down during those days to enable
thorough checking of stock or else the verification must be of limited character.
2.7 MATERIAL ISSUE PROCEDURE

2
Issue of material must not be made except under properly authorised requisition
slip; usually it is the foreman of a department who has the authority to draw

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

Note
Department Making Transfer
No copy is required for the Store as no entry in the stores records would be called
for. The Cost Accounting Department would use its copy for the purpose of
making the necessary entries in the cost ledger accounts for the jobs affected.
Format of a material requisition note may vary on the basis of industrial
place.

MATERIAL COST 2.43
(iii) Return of Material: Sometimes, it is not possible before hand to make any
precise estimate of the material requirements or units of production. Besides, at
times due to some technical or other difficulty, it is not practicable to measure
exactly the quantity of material required by a department. In either case, material
may have to be issued from stores in bulk, often in excess of the actual quantity
required. Where such a condition exists, it is of the utmost importance from the
point of view of materials control that any surplus material left over on the
completion of a job should be promptly hand over to the storekeeper for
safe and proper custody.
Unless this is done, the surplus material may be misappropriated or misapplied to
some purpose, other than that for which it was intended. The material cost of the
job against which the excess material was originally drawn in that case, would be
overstated unless the job is given credit for the surplus arising thereon.
The surplus material, when it is returned to the storeroom, should be
accompanied by a document known either as a Shop Credit Note or
alternatively as a Stores Debit Note. This document should be made out, by the
department returning the surplus material and it should be in triplicate to be used
as follows:
Store Room
Shop Credit Note Cost Accounting Department
Department Returnign it
Format of a shop credit note may vary on the basis of industrial peculiarities,
management information system (MIS) and accounting system in place.
2.8 VALUATION OF MATERIAL ISSUES

Materials issued from stores should be priced at the value at which they are
carried in stock. But there can be a situation where the material may have been
purchased at different times and at different prices with varying discounts, taxes
etc. Because of this the problem arises as to how the material issues to
production are to be valued. There are several methods for tackling this situation.
The cost accountant should select the proper method based on following factors:
1. The frequency of purchases, price fluctuations and its range.

2. The frequency of issue of materials, relative quantity etc.

3. Nature of cost accounting system.
4. The nature of business and type of production process.
5. Management policy relating to valuation of closing stock.
Several methods of pricing material issues have been evolved in an attempt to
satisfactorily answer the problem. These methods may be grouped and explained
as follows:
2.8.1 Cost Price Methods
(i) Specific Price Method: This method is useful, specially when materials are
purchased for a specific job or work order, and as such these materials are
issued subsequently to that specific job or work order at the price at which they
were purchased.
To use this method, it is necessary to store each lot of material separately and
maintain its separate account.
Advantages and Disadvantages
Advantages Disadvantages
• The cost of materials issued for • This method is difficult to operate,
production purposes to specific jobs specially when purchases and
represent actual and correct costs. issues are numerous.
• This method is best suited for non-
standard and specific products.
(ii) First-in First-out (FIFO) method: It is a method of pricing the issues of

materials, in the order in which they are purchased. In other words, the
materials are issued in the order in which they arrive in the store or the items
longest in stock are issued first. Thus each issue of material only recovers the
purchase price which does not reflect the current market price.
This method is considered suitable in times of falling price because the
material cost charged to production will be high while the replacement cost of
materials will be low. But, in the case of rising prices, if this method is adopted,
the charge to production will be low as compared to the replacement cost of
materials. Consequently, it would be difficult to purchase the same volume of
material (as in the current period) in future without having additional capital
resources.

MATERIAL COST 2.45
Advantages and disadvantages

• It is simple to understand and • If the prices fluctuate frequently, this
easy to operate. method may lead to clerical error.
• Material cost charged to • Since each issue of material to production
production represents actual is related to a specific purchase price, the
cost with which the cost of costs charged to the same job are likely to
production should have been show a variation from period to period.
charged.
• In the case of falling prices, • In the case of rising prices, the real profits
the use of this method gives of the concern being low, may not be
better results. adequate to meet the materials purchase
demand at the current market price.
• Closing stock of material will
be represented very closely
at current market price.
The application of FIFO method is illustrated below:
Material Received and Issued
Lot Date Quantity Lot Rate Amount
No. Kg. No. (`) (`)
1. July 3 600 1.00 600.00
2. July 13 800 1.20 960.00
3. July 23 600 0.90 540.00
4. August 5 400 1.10 440.00
5. August 6 1200 0.80 960.00
July 8 400 Kgs. out of (1) 1.00 400.00
July 12 200 Kgs. out of (1) 1.00 200.00
July 22 600 Kgs. out of (2) 1.20 720.00
July 25 200 Kgs. out of (2) 1.20 240.00
200 Kgs. out of (3) 0.90 180.00
August 8 400 Kgs. out of (3) 0.90 360.00
400 Kgs. out of (4) 1.10 440.00
200 Kgs. out of (5) 0.80 160.00

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

MATERIAL COST 2.47
to be more competitive and are at the principle of stock valuation,

market price. i.e., the cost or the market price
whichever is lower.
• Over a period, the use of LIFO helps to • This method of valuation of
iron out the fluctuations in profits. material is not acceptable to the
income tax authorities.
• In the period of inflation LIFO will tend
to show the correct profit and thus avoid
paying undue taxes to some extent.
It may be noted that Last in First out (LIFO) is not permitted under Accounting
Standard (AS)-2: Valuation of Inventories and Ind AS- 2: Inventories. However,
for the purpose of academic knowledge LIFO method is included in this Study
Material
ILLUSTRATION 12
The following transactions in respect of material Y occurred during the six months
ended 30th June, 20X8:
Month Purchase Price per unit Issued

(units) (` ) Units
January 200 25 Nil
February 300 24 250
March 425 26 300
April 475 23 550
May 500 25 800
June 600 20 400
Required:
(a) The Chief Accountant argues that the value of closing stock remains the same
no matter which method of pricing of material issues is used. Do you agree?
Why or why not? EXPLAIN. Detailed stores ledgers are not required.
(b) STATE when and why would you recommend the LIFO method of pricing
material issues?

SOLUTION
(a) The Closing Stock at the end of six months’ period i.e., on 30th June, 20X8
will be 200 units, whereas up to the end of May 20X8, total purchases coincide
with the total issues i.e., 1,900 units. It means that at the end of May 20X8, there
was no closing stock. In the month of June 20X8, 600 units were purchased out of
which 400 units were issued. Since there was only one purchase and one issue in
the month of June, 20X8 and there was no opening stock on 1st June 20X8, the
Closing Stock of 200 units is to be valued at ` 20 per unit.
In view of this, the argument of the Chief Accountant appears to be correct.
Where there is only one purchase and one issue in a month with no opening
stock, the method of pricing of material issues becomes irrelevant. Therefore, in
the given case one should agree with the argument of the Chief Accountant that
the value of Closing Stock remains the same no matter which method of pricing
the issue is used.
It may, however, be noted that the argument of Chief Accountant would not
stand if one finds the value of the Closing Stock at the end of each month.
(b) LIFO method has an edge over FIFO or any other method of pricing material
issues due to the following advantages:
(i) The cost of the materials issued will be either nearer or will reflect the
current market price. Thus, the cost of goods produced will be related to the
trend of the market price of materials. Such a trend in price of materials
enables the matching of cost of production with current sales revenues.
(ii) The use of the method during the period of rising prices does not reflect
undue high profit in the income statement, as it was under the first-in-first-
out or average method. In fact, the profit shown here is relatively lower
because the cost of production takes into account the rising trend of
material prices.
(iii) In the case of falling prices, profit tends to rise due to lower material cost,
yet the finished products appear to be more competitive and are at market
price.
(iv) During the period of inflation, LIFO will tend to show the correct profit and
thus, avoid paying undue taxes to some extent.

MATERIAL COST 2.49
ILLUSTRATION 13
The following information is provided by Sunrise Industries for the fortnight of April,
20X9:
Material Exe:
Stock on 1-4-20X9 100 units at ` 5 per unit.
Purchases
5-4-20X9, 300 units at ` 6
8-4-20X9, 500 units at ` 7
12-4-20X9, 600 units at ` 8
Issues
6-4-20X9, 250 units
10-4-20X9,400 units
14-4-20X9,500 units
Required:
(A) CALCULATE using FIFO and LIFO methods of pricing issues:
(a) the value of materials consumed during the period
(b) the value of stock of materials on 15-4-20X9.
(B) EXPLAIN why the figures in (a) and (b) in part A of this question are different
under the two methods of pricing of material issues used. You need not draw
up the Stores Ledgers.
SOLUTION
(A) (a) Value of Material Exe consumed during the period
1-4-20X9 to 15-4-20X9 by using FIFO method.
Date Description Units Qty. (Units) Rate Amount

(`) (`)
1-4-20X9 Opening balance 100 5 500
5-4-20X9 Purchased 300 6 1,800
6-4-20X9 Issued 100 5
150 6 1,400

8-4-20X9 Purchased 500 7 3,500

10-4-20X9 Issued 150 6
250 7 2,650
12-4-20X9 Purchased 600 8 4,800
14-4-20X9 Issued 250 7
250 8 3,750
15-4-20X9 Balance 350 8 2,800
Total value of material Exe consumed during the period under FIFO
method comes to (` 1,400 + ` 2,650 + ` 3,750) ` 7,800 and balance on
15-4-20X9 is of ` 2,800.
Value of material Exe consumed during the period 01-4-20X9 to
15-4-20X9 by using LIFO method
Date Description Qty. Rate Amount

(Units) (`) (`)
1-4-20X9 Opening balance 100 5 500
5-4-20X9 Purchased 300 6 1,800
6-4-20X9 Issued 250 6 1,500
8-4-20X9 Purchased 500 7 3,500
10-4-20X9 Issued 400 7 2,800
12-4-20X9 Purchased 600 8 4,800
14-4-20X9 Issued 500 8 4,000
15-4-20X9 Balance 350 — 2,300*
Total value of material Exe issued under LIFO method comes to (`

1,500 + ` 2,800 + ` 4,000) ` 8,300.
*The balance 350 units on 15-4-20X9 of ` 2,300, relates to opening
balance on 1-4-20X9 and purchases made on 5-4-20X9, 8-4-20X9 and
12-4-20X9. (100 units @ ` 5, 50 units @ ` 6, 100 units @ ` 7 and 100
units @ ` 8).
(b) As shown in (a) above, the value of stock of materials on 15-4-20X9:
Under FIFO method ` 2,800
Under LIFO method ` 2,300

MATERIAL COST 2.51
(B) Total value of material Exe issued to production under FIFO and LIFO
methods comes to ` 7,800 and ` 8,300 respectively. The value of closing
stock of material Exe on 15-4-20X9 under FIFO and LIFO methods comes to
` 2,800 and ` 2,300 respectively.
The reasons for the difference of ` 500 (` 8,300 – ` 7,800) as shown by the
following table in the value of material Exe, issued to production under FIFO
and LIFO are as follows:
Date Quantity Value Total Value Total
Issued FIFO LIFO
(Units) (`) (`) (`) (`)
6 - 4-20X9 250 1,400 1,500
10-4-20X9 400 2,650 2,800
14-4-20X9 500 3,750 7,800 4,000 8,300
1. On 6-4-20X9, 250 units were issued to production. Under FIFO their
value comes to ` 1,400 (100 units × ` 5 + 150 units × ` 6) and under
LIFO ` 1,500 (250 × ` 6). Hence, ` 100 was more charged to
production under LIFO.
value comes to ` 2,650 (150 × ` 6 + 250 × ` 7) and under LIFO ` 2,800
(400 × ` 7). Hence, ` 150 was more charged to production under
LIFO.
value comes to ` 3,750 (250 × ` 7 + 250 × ` 8) and under LIFO ` 4,000
(500 × ` 8). Hence, ` 250 was more charged to production under
LIFO.
Thus the total excess amount charged to production under LIFO comes to
` 500.
The reasons for the difference of ` 500 (` 2,800 – ` 2,300) in the value of
350 units of Closing Stock of material Exe under FIFO and LIFO are as
follows:
1. In the case of FIFO, all the 350 units of the closing stock belongs to
the purchase of material made on 12-4-20X9, whereas under LIFO
these units were from opening balance and purchases made on 5-4-
20X9, 8-4-20X9 and 12-4-20X9.

2. Due to different purchase price paid by the concern on different days

of purchase, the value of closing stock differed under FIFO and LIFO.
Under FIFO 350 units of closing stock were valued @ ` 8 p.u. Whereas
under LIFO first 100 units were valued @ ` 5 p.u., next 50 units @ ` 6
p.u., next 100 units @ ` 7 p.u. and last 100 units @ ` 8 p.u.
Thus under FIFO, the value of closing stock increased by ` 500.
(iv) Base Stock Method: Minimum quantity of stock under this method is
always held at a fixed price as reserve in the stock, to meet a state of
emergency, if it arises. This minimum stock is known as base stock and is valued
at a price at which the first lot of materials is received and remains unaffected by
subsequent price fluctuations.
This method of valuing inventory is different from other methods of valuing
issues, as the base stock of materials are valued at the original cost, whereas,
materials other than the base are valued using other methods like FIFO, LIFO etc.
This method is not an independent method as it uses FIFO or LIFO.
Advantages and disadvantages of this method depend upon the use of the other
method viz., FIFO or LIFO.
2.8.2 Average Price Methods
(i) Simple Average Price Method: Under this method, materials issued are
valued at average price, which is calculated by dividing the total of rates at which
different lot of materials are purchased by total number of lots. In this method
quantity purchased in each lot is ignored.
Example: During the month of April, a company has made five purchases as
follows:
1st April, 200 units @ `10 each;
5th April, 150 units @ `12 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ `11 each.
The issue price under Simple Average Price Method would be calculated as below:
`10 + `12 + `12 + `15 + `11
= ` 12 each
5 lots

MATERIAL COST 2.53
This method is suitable when the materials are received in uniform lots of similar
quantity, and prices do not fluctuate considerably.
Advantages and Disadvantages:
• This method is simple to use for • This method does not provide right
an entity which orders materials in stock valuation when standard
a lot of standard quantity, as only quantity for purchase in a lot is not
price per lot is taken to calculate specified.
average price
• In a stable price environment, this • When price of materials fluctuates and
method gives a price which the entity choses to customise the
approximates to the current order quantity, in this situation price
market price. under this method may differs
substantially from current market
price.
(ii) Weighted Average Price Method: Unlike Simple Average Price method,
this method gives due weightage to quantities also. Under this method, issue
price is calculated dividing sum of products of price and quantity by total number
quantities.
Example: During the month of April, a company has made five purchases as
follows:
1st April, 200 units @ `10 each;
21st April, 50 units @ `15 each and
28th April, 140 units @ `11 each.
The issue price under Weightage Average Price Method would be calculated as
below:
{(` 10×200 units)+(` 12×150 units)+(` 12×210 units)+(` 15×50 units)+(` 11×140 units)}
(200+150+210+50+140) units

` 8,610
= ` 11.48 each
750 units
This method is useful in case when quantity purchased under each lot is different
and price fluctuates frequently.
Advantages and Disadvantages:
• It smoothens the price • Material cost does not represent
fluctuations if at all it is there due actual cost price and therefore, a
to material purchases. profit or loss will arise out of such a
pricing method.
• Issue prices need not be • It may be difficult to compute since
calculated for each issue unless every time lot received would require
new lot of materials is received. re-computation of issue prices.
2.8.3 Market Price Methods

(i) Replacement Price Method: Replacement price is defined as the price at
which it is possible to purchase an item, identical to that which is being
replaced or revalued. Under this method, materials issued are valued at the
replacement cost of the items. This method pre-supposes the determination of
the replacement cost of materials at the time of each issue; viz., the cost at which
identical materials could be currently purchased. The product cost under this
method is at current market price, which is the main objective of the
replacement price method.
This method is useful to determine true cost of production and to value material
issues in periods of rising prices, because the cost of material considered in cost
of production would be able to replace the materials at the increased price.
(ii) Realisable Price Method: Realisable price means a price at which the
material to be issued can be sold in the market. This price may be more or may
be less than the cost price at which it was originally purchased. Like replacement
price method, the stores ledger would show profit or loss in this method too.
2.8.4 Notional Price Methods
(i) Standard Price Method: Under this method, materials are priced at some
predetermined rate or standard price irrespective of the actual purchase cost of
the materials. Standard cost is usually fixed after taking into consideration the

MATERIAL COST 2.55
following factors:
(i) Current prices,
(ii) Anticipated market trends, and
(iii) Discount available and transport charges etc.
Standard prices are fixed for each material and the requisitions are priced at the
standard price. This method is useful for controlling material cost and
determining the efficiency of purchase department. In the case of highly
fluctuating prices of materials, it is difficult to fix their standard cost on long-term
basis.
• The use of the standard price • The use of standard price does not
method simplifies the task of reflect the market price and thus
valuing issues of materials. results in a profit or loss.
• It facilitates the control of • The fixation of standard price
material cost and the task of becomes difficult when prices
judging the efficiency of fluctuate frequently
purchase department.
• It reduces the clerical work.
(ii) Inflated Price Method: In case material suffers loss in weight due to
natural or climatic factors, e.g., evaporation, the issue price of the material is
inflated to cover up the losses.
(iii) Re-use Price Method: When materials are rejected and returned to the
stores or a processed material is put to some other use, then for the purpose it is
meant, then such materials are priced at a rate quite different from the price paid
for them originally. There is no final procedure for valuing use of material.
2.9 VALUATION OF RETURNS & SHORTAGES

2.9.1 Valuation of Materials Returned to the Vendor
Materials which do not meet quality and other specifications and are considered
to be unfit for production and are usually returned to the vendor. These materials
can be returned to the vendor before they are sent to the stores. In case materials
reach store and then are noticed of a sub-standard quality, then also they can be
returned to vendor.

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

LOSS OF MATERIALS
Loss of materials during handling, storage, process may occur any of the
following forms:
Loss of Material
Waste Scrap Spoilage Defectives Obsolescence
(i) Waste: The portion of raw material which is lost during storage or
production and discarded. The waste may or may not have any value.

MATERIAL COST 2.57
Treatment of Waste
Normal- Cost of normal waste is absorbed by good production units.
Abnormal- The cost of abnormal loss is transferred to Costing Profit and loss
account.
(ii) Scrap: The materials which are discarded and disposed-off without further
treatment. Generally, scrap has either no value of insignificant value. Some time it
may reintroduced into the process as raw material.
Treatment of Scrap
Normal- The cost of scrap is borne by good units and income arises on account
realisable value is deducted from the cost.
Abnormal- The scrap account should be charged with full cost. The credit is
given to the job or process concerned. The profit or loss in the scrap account, on
realisation, will be transferred to the Costing Profit and Loss Account.
(iii) Spoilage: It is the term used for materials which are badly damaged in
manufacturing operations, and they cannot be rectified economically and hence
taken out of process to be disposed of in some manner without further
processing.
Treatment of Spoilage
Normal- Normal spoilage (i.e., which is inherent in the operation) costs are
included in costs either charging the loss due to spoilage to the production order
or by charging it to production overhead so that it is spread over all products.
Any value realised from spoilage is credited to production order or production
overhead account, as the case may be.
Abnormal- The cost of abnormal spoilage (i.e., arising out of causes not inherent
in manufacturing process) is charged to the Costing Profit and Loss Account.
When spoiled work is the result of rigid specification, the cost of spoiled work is
absorbed by good production while the cost of disposal is charged to production
overhead.
(iv) Defectives: It signifies those units or portions of production which do not
meet the quality standards. Defectives arise due to sub-standard materials, bad-
supervision, bad-planning, poor workmanship, inadequate-equipment and
careless inspection.

Defectives which can be re-made as per the quality standard by using additional
materials are known as reworks. Reworks includes repairs, reconditioning and
refurbishing.
Defectives which cannot be brought up to the quality standards are known as
rejects. The rejects may either be disposed- off or re-cycled for production
process.
Treatment of Defectives:
Normal- The cost less realisable value on sale of defectives are charged to
material cost of good production.
Abnormal- Material Cost of abnormal defectives are not included in material cost
but treated as loss after giving credit to the realisable value of such defectives.
The material cost of abnormal loss is transferred to costing profit and loss
account.
Reclamation of loss from defective units
In the case of articles that have been spoiled, it is necessary to take steps to
reclaim as much of the loss as possible. For this purpose:
(i) All defective units should be sent to a place fixed for the purpose;
(ii) These should be dismantled;
(iii) Goods and serviceable parts should be separated and taken into stock;
(iv) Parts which can be made serviceable by further work should be separated
and sent to the workshop for the purpose and taken into stock after the
defects have been removed; and
(v) Parts which cannot be made serviceable should be collected in one place for
being melted or sold.
Printed forms should be used to record quantities for all purposes
aforementioned.
Difference between Waste and Scrap
Waste Scrap
1. It is connected with raw material 1. It is connected with output
or inputs to the production
process.
2. Waste of materials may be visible 2. Scraps are generally identifiable

MATERIAL COST 2.59
or invisible. and has physical substance.

3. Generally waste has no 3. Scraps are termed as by-products
recoverable value. and has small recoverable value.
Difference between Scrap and Defectives
Scrap Defectives
1. It is loss connected with output 1. This type of loss connected with the
output but it can be in the input as
well.
2. Scraps are not intended but 2. Defectives also are not intended but
cannot be eliminated due to can be eliminated through proper
nature of material or process control.
itself.
3. Generally scraps are not used or 3. Defectives can be used after
rectified. rectification.
4. Scraps have insignificant 4. Defectives are sold at lower value
recoverable value. from that of good one.
Distinction between spoilage and defectives: The difference between spoilage

and defectives is that while spoilage cannot be repaired or reconditioned,
defectives can be rectified and transferred, either back to standard production or
to seconds.
The problem of accounting for defective work is the problem of accounting of the
costs of rectification or rework.
(v) Obsolescence: Obsolescence is defined as “the loss in the intrinsic value of
an asset due to its supersession”.
Treatment: Materials may become obsolete under any of the following circum-
stances:
(i) where it is a spare part or a component of a machinery used in manufacture
and that machinery becomes obsolete;
(ii) where it is used in the manufacture of a product which has become
obsolete;
(iii) where the material itself is replaced by another material due to either
improved quality or fall in price.

In all three cases, the value of the obsolete material held in stock is a total loss
and immediate steps should be taken to dispose it off at the best available price.
The loss arising out of obsolete materials on abnormal loss does not form part of
the cost of manufacture.
2.11 CONSUMPTION OF MATERIALS

Any product that is manufactured in a firm entails consumption of resources like
material, labour etc. The management for planning and control must know the
cost of using these resources in manufacturing. The consumption of materials
takes place say when the material is used in the manufacture of the product.
It is important to note that the amount of materials consumed in a period by a
cost object need not be equal to the amount of material available with the
concern. For example, during any period the total of raw material stock available
for use in production may not be equal to the amount of materials actually
consumed and assigned to the cost object of the production. The difference
between the material available and material consumed represents the stock of
material at the end of the period.
2.11.1 Identification of Materials
For the identification of consumption of materials with products of cost centres
the followings points should be noted:
1. It is required that the concern should follow coding system for all materials
so that each material is identified by unique code number.
2. It is required that each product of a cost centre should be given a unique
code number so that the direct material issued for production of particular
product of a cost centre can be collected against the code number of that
product.
However, it may not be possible to allocate all materials directly to
individual product of a cost centre e.g. maintenance materials, inspection
and testing materials etc. The consumption of these materials are collected
for cost centre and then charged to individual product by adopting suitable
overhead absorption rate of cost centre.
Cost for cost centre
Overhead absorption rate of cost centre = Base relating to cost centre
(e.g.labou r hrs. or machine hrs.)

MATERIAL COST 2.61
3. Each issue of materials should be recorded. One way of doing this is to use
a material requisition note. This note shows the details of materials issued
for product of cost centre and the cost centre which is to be charged with
cost of materials.
4. A material return note is required for recording the excess materials
returned to the store. This note is required to ensure that original product
of cost centre is credited with the cost of material which was not used and
that the stock records are updated.
5. A material transfer note is required for recording the transfer of materials
from one product of cost centre to other or from one cost centre to other
cost centre.
6. The cost of materials issued would be determined according to stock
valuation method used.
2.11.2 Monitoring Consumption of Materials
For monitoring consumption of materials, a storekeeper should periodically
analyse the various material requisitions, material return notes and material
transfer notes. Based on this analysis, a material abstracts or material issue
analysis sheet is prepared, which shows at a glance the value of material
consumed in manufacturing each product. This statement is also useful for
ascertaining the cost of material issued for each product.
Format of Material Abstract
Week Ending............
Material Amount Product Nos. Total Overheads
requisition (`) for (Indirect
or Transfer Product Material
Note or charged)
Returned
101 102 103 104 105 106
Note No.
(`) (`) (`) (`) (`) (`) (`)
— — — — — — — — —
Total

The material abstract statement serves a useful purpose. It in fact shows the
amount of material to be debited to various products & overheads. The total
amount of stores debited to various products & overheads should be the same as
the total value of stores issued in any period.
2.11.3. Basis for consumption entries in Financial Accounts
Every manufacturing organisation assigns material costs to products for two
purposes.
Firstly, for external financial accounting requirements, in order to allocate the
material costs incurred during the period between cost of goods produced and
inventories; secondly to provide useful information for managerial decision
making requirements. In order to meet external financial accounting
requirements, it may not be necessary to accurately trace material costs to
individual products.
Some products costs may be overstated and others may be understated but this
may not matter for financial accounting purposes as long as total of individual
materials costs transactions are recorded i.e., transactions between cost centre
within the firm are recorded in a manner that facilitates analysis of costs for
assigning them to cost units.
The consumption entries in financial accounts are made on the basis of total cost
of purchases of materials after adjustment for opening and closing stock of
materials. The stock of materials is taken at cost or net realisable value whichever
is less.
SUMMARY
♦ Material Control: It is the systematic control over the procurement,
storage and usage of materials to maintain even flow of materials and
avoiding at the same time excessive investment in inventories.
♦ Material Requisition Note: Document used to authorize and record the
issue of materials from store.
♦ Purchase Requisition Note: Document is prepared by the storekeeper to
initiate the process of purchases.
♦ Purchase Order: It is a written request to the supplier to supply certain
specified materials at specified rates and within a specified period.
♦ Goods Received Note: This document is prepared by receiving department

MATERIAL COST 2.63
which unpacks the goods received and verify the quantities and other
details.
♦ Material Transfer Note: This document is prepared when the material is
transferred from one department to another.
♦ Material Return Note: It is a document given with the goods being
returned from Factory back to the stores.
♦ Bin Card: A prime entry record of the quantity of stocks, kept on
in/out/balance, held in designated storage areas.
♦ Stores Ledger: A ledger containing a separate account for each item of
material and component stocked in store giving details of the receipts,
issues and balance both in terms of quantity and value.
♦ Minimum Level: It is the minimum quantity, which must be retained in
stock
ROL- (Avg. consumption × Avg. Lead time)
♦ Maximum Level: It is the maximum limit upon which stock can be stored at
any time
ROL + ROQ – (Min consumption × Min Lead Time)
♦ Re order Level: It is the level, when reached the order needs to be placed
Maximum lead time × Maximum Usage
Or
Minimum level + (Average rate of consumption × Average time to obtain
fresh supplies).
♦ Average Inventory Level = Minimum level + 1/2 Re-order quantity
Or
Maximum level+Minimum level

=
2
♦ Danger Level: level where normal issue of materials is stopped, and only
emergency materials are issued.
Danger level = Average consumption × Lead time for emergency purchases.

♦ Stock-out = Stock out said to be occurred when an inventory item could

not be supplied due to insufficient stock in the store.
♦ Just-in-time (JIT) Inventory management = JIT is a system of inventory
management with an approach to have a zero inventories in stores.
According to this approach material should only be purchased when it is
actually required for production.
♦ ABC analysis: Items are classified into the following categories:
A Category: Quantity less than 10 % but value more than 70 %
B Category; Quantity less than 20 % but value about 20 %
C Category: Quantity about 70 % but value less than 10%
♦ Fast Moving, Slow Moving and Non Moving (FSN) Inventory: Under this
system, inventories are controlled by classifying them on the basis of
frequency of usage.
♦ Vital, Essential and Desirable (VED): Under this system of inventory
analysis, inventories are classified on the basis of its criticality for the
production function and final product.
♦ High Cost, Medium Cost, Low Cost (HML) Inventory: Under this system,
inventory is classified on the basis of the cost of an individual item, unlike
ABC analysis where inventories are classified on the basis of overall value of
inventory.
♦ Two bin system: If one bin items exhausts, new order is placed and till the
mean time quantity from the other bin is purchased.
♦ First-in First-out method: The materials received first are to be issued first
when material requisition is received. Materials left as closing stock will be
at the price of latest purchases.
♦ Last-in First-out method: The materials purchased last are to be issued
first when material requisition is received. Closing stock is valued at the
oldest stock price.
♦ Simple Average Method: Material Issue Price
Total of unit price of each purchase
=
Total Nos of Purchases

MATERIAL COST 2.65
♦ Weighted Average Price Method: This method gives due weightage to

quantities purchased and the purchase price to determine the issue price.
Total cost of material in stock

Weighted Average Price =
Total quantity of materials
♦ Various Material Losses

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

1. Direct material can be classified as
(a) Fixed cost
(b) Variable cost
(c) Semi-variable cost.
(d) Prime Cost
2. In most of the industries, the most important element of cost is
(a) Material
(b) Labour
(c) Overheads
(d) Administration Cost
3. Which of the following is considered to be the normal loss of materials?
(a) Loss due to accidents
(b) Pilferage

(c) Loss due to breaking the bulk

(d) Loss due to careless handling of materials.
4. In which of following methods of pricing, costs lag behind the current
economic values?
(a) Last-in-first out price
(b) First-in-first out price
(c) Replacement price
(d) Weighted average price
5. Continuous stock taking is a part of
(a) Annual stock taking
(b) Perpetual inventory
(c) ABC analysis.
(d) Bin Cards
6. In which of the following methods, issues of materials are priced at pre-
determined rate ?
(a) Inflated price method
(b) Standard price method
(c) Replacement price method
(d) Specific price method.
7. When material prices fluctuate widely, the method of pricing that gives
absurd results is
(a) Simple average price
(b) Weighted average price
(c) Moving average price
(d) Inflated price.
8. When prices fluctuate widely, the method that will smooth out the effect of
fluctuations is
(a) Simple average
(b) Weighted average

MATERIAL COST 2.67
(c) FIFO
(d) LIFO
9. Under the FSN system of inventory control, inventory is classified on the
basis of:
(a) Volume of material consumption
(d) Frequency of usage of items of inventory
(c) Criticality of the item of inventory for production
(d) Value of items of inventory
10. Materials are issued to from one process to another, on the basis of:
(a) Material Transfer Note
(b) Material Requisition Note
(c) Bill of Materials
(d) Purchase Requisition Note
1. STATE how normal and abnormal loss of material arising during storage are
treated in Cost Accounts?
2. DISTINGUISH clearly between Bin cards and Stores Ledger.
3. DISCUSS the accounting treatment of defectives in Cost Accounts.
4. EXPLAIN the concept of "ABC Analysis" as a technique of inventory control.
5. DISTINGUISH between Re-order level and Re-order quantity.
6. EXPLAIN how is slow moving and non-moving item of stores detected and
what steps are necessary to reduce such stocks?
7. Write short notes on any three of the following:
(i) Re-order quantity
(ii) Re-order level
(iii) Maximum stock level
(iv) Minimum stock level

Practical Problems
1. Anil & Company buys its annual requirement of 36,000 units in 6
instalments. Each unit costs ` 1 and the ordering cost is ` 25. The inventory
carrying cost is estimated at 20% of unit value. FIND the total annual cost
of the existing inventory policy. CALCULATE ,How much money can be
saved by Economic Order Quantity?
2. A Company manufactures a special product which requires a component
‘Alpha’. The following particulars are collected for the year 20X1:
(i) Annual demand of Alpha 8,000 units
(ii) Cost of placing an order ` 200 per order
(iii) Cost per unit of Alpha ` 400
(iv) Carrying cost p.a. 20%
The company has been offered a quantity discount of 4 % on the purchase
of ‘Alpha’ provided the order size is 4,000 components at a time.
Required:
(i) COMPUTE the economic order quantity
(ii) STATE whether the quantity discount offer can be accepted.
3. The complete Gardener is deciding on the economic order quantity for two
brands of lawn fertilizer. Super Grow and Nature’s Own. The following
information is collected:
FERTILIZER
Super Grow Nature’s Own
Annual demand 2,000 bags 1,280 bags
Relevant ordering cost per purchase ` 1,200 ` 1,400
order
Annual relevant carrying cost per bag ` 480 ` 560
Required:
(i) COMPUTE EOQ for Super Grow and Nature’s own.
(ii) For the EOQ, WHAT is the sum of the total annual relevant ordering
costs and total annual relevant carrying costs for Super Grow and
Nature’s own?

MATERIAL COST 2.69
(iii) For the EOQ, COMPUTE the number of deliveries per year for Super
Grow and Nature’s own.
4. A Company uses three raw materials A, B and C for a particular product for
which the following data apply:
Raw Usage per Re-order Price Delivery period Re- Minimu
Material unit of quantity per (in weeks) order m level
Product (Kgs.) Kg. level (Kgs.)
(Kgs.) (Kgs)
Minimum Average Maximum
A 10 10,000 10 1 2 3 8,000 ?
B 4 5,000 30 3 4 5 4,750 ?
C 6 10,000 15 2 3 4 ? 2,000
Weekly production varies from 175 to 225 units, averaging 200 units of the
said product. COMPUTE the following quantities:
(i) Minimum stock of A,
(ii) Maximum stock of B,
(iii) Re-order level of C,
(iv) Average stock level of A.
5. (a) EXE Limited has received an offer of quantity discounts on its order of
materials as under:
Price per ton (`) Ton (Nos.)

1,200 Less than 500
1,180 500 and less than 1,000
1,160 1,000 and less than 2,000
1,140 2,000 and less than 3,000
1,120 3,000 and above.
The annual requirement for the material is 5,000 tons. The ordering
cost per order is ` 1,200 and the stock holding cost is estimated at
20% of material cost per annum. You are required to COMPUTE the
most economical purchase level.
(b) WHAT will be your answer to the above question if there are no
discounts offered and the price per ton is ` 1,500?

6. From the details given below, CALCULATE:

(i) Re-ordering level
(ii) Maximum level
(iii) Minimum level
(iv) Danger level.
Re-ordering quantity is to be calculated on the basis of following
information:
Cost of placing a purchase order is ` 20
Number of units to be purchased during the year is 5,000
Purchase price per unit inclusive of transportation cost is ` 50
Annual cost of storage per units is ` 5.
Details of lead time: Average- 10 days, Maximum- 15 days, Minimum- 5 days.
For emergency purchases- 4 days.
Rate of consumption: Average: 15 units per day,
Maximum: 20 units per day.
7. G. Ltd. produces a product which has a monthly demand of 4,000 units. The
product requires a component X which is purchased at ` 20. For every
finished product, one unit of component is required. The ordering cost is
` 120 per order and the holding cost is 10% p.a.
You are required to CALCULATE:
(i) Economic order quantity.
(ii) If the minimum lot size to be supplied is 4,000 units, what is the extra
cost, the company has to incur?
(iii) What is the minimum carrying cost, the company has to incur?
8. ‘AT’ Ltd. furnishes the following store transactions for September, 20X8:
1-9-X8 Opening balance 25 units value ` 162.50
4-9- X8 Issues Req. No. 85 8 units
6-9- X8 Receipts from B & Co. GRN No. 26 50 units @ ` 5.75 per unit

MATERIAL COST 2.71
10-9- X8 Return to B & Co. 10 units

15-9- X8 Receipts from M & Co. GRN. No. 33 25 units @ ` 6.10 per unit
19-9- X8 Received replacement from B & Co.
GRN No. 38 10 units
20-9- X8 Returned from department, material of
M & Co. MRR No. 4 5 units
22-9- X8 Transfer from Job 182 to Job 187 in the
dept. MTR 6 5 units
29-9- X8 Transfer from Dept. “A” to
Dept. “B” MTR 10 5 units
30-9- X8 Shortage in stock taking 2 units
PREPARE the priced stores ledger on FIFO method and STATE how would
you treat the shortage in stock taking.
9. The following information is extracted from the Stores Ledger:
Material X
Opening Stock Nil
Purchases:
Jan. 1 100 @ ` 1 per unit
Jan. 20 100 @ ` 2 per unit
Issues:
Jan. 22 60 for Job W 16
Jan. 23 60 for Job W 17
Complete the receipts and issues valuation by adopting the First-In-First-
Out, Last-In-First-Out and the Weighted Average Method. TABULATE the

values allocated to Job W 16, Job W 17 and the closing stock under the
methods aforesaid and discuss from different points of view which method
you would prefer.
ANSWERS/SOLUTIONS
1. (b) 2. (a) 3. (c) 4. (b) 5. (b) 6. (b)
7. (a) 8. (b) 9. (b) 10. (b)
4. Please refer paragraph 2.6.4
Answers to the Practical Problems
1. (a) Total Annual Cost in Existing Inventory Policy
(`)
Ordering cost (6 orders @ ` 25) 150
Carrying cost of average inventory (36,000 ÷ 6) = 6,000 units per order
Average inventory = 3,000 units
Carrying cost = 20% of ` 1 × 3,000 = 3,000 × 0.20 600
Total cost A 750
(b) Total Annual Cost in E.O.Q
2×36,000×25
EOQ = = 3000 units
` 1×20%

MATERIAL COST 2.73
(`)
No. of orders = 36,000 ÷3,000 units = 12 orders
Ordering cost (12 × ` 25) = 300
Carrying cost of average inventory (3,000 × 0.20) ÷ 2 = 300
Total Cost B 600
Savings due to E.O.Q ` (750 – 600) (A – B) 150
Note: As the units purchase cost of ` 1 does not change in both the
computation, the same has not been considered to arrive at total cost
of inventory for the purpose of savings.
2. (i) Calculation of Economic Order Quantity
2AO 2 ×8,000 units×`200

EOQ = = = 200 units
C ` 400×20 / 100
(ii) Evaluation of Profitability of Different Options of Order Quantity

(a) When EOQ is ordered
(`)
Purchase Cost (8,000 units × ` 400) 32,00,000
Ordering Cost [(8,000 units/200 units) × ` 200] 8,000
Carrying Cost (200 units × `400 × ½ × 20/100) 8,000
Total Cost 32,16,000
(b) When Quantity Discount is accepted
(`)
Purchase Cost (8,000 units × `384) 30,72,000
Ordering Cost [(8,000 units/4000 units) × `200] 400
Carrying Cost (4000 units × `384 × ½ × 20/100) 1,53,600
Total Cost 32,26,000
Advise – The total cost of inventory is lower if EOQ is adopted.

Hence, the company is advised not to accept the quantity
discount.

2AO
3. EOQ =
C
Where,
A = Annual Demand
O = Ordering cost per order
C = Inventory carrying cost per unit per annum
(i) Calculation of EOQ

2 × 2,000 × 1,200 2 × 1,280 × 1,400
EOQ = EOQ =
480 560
= 10,000 or 100 bags = 6, 400 or or 80 bags
(ii) Total annual relevant cost = Total annual relevant ordering costs +
Total annual relevant carrying cost

= (2,000/100 × `1,200) + (½ × = (1,280/80 × `1,400) + (½ × 80
100 bags × `480) bags × ` 560)
= ` 24,000 + ` 24,000 = = ` 22,400 + ` 22,400 =
` 48,000 ` 44,800
(iii) Number of deliveries for Super Grow and Nature’s own fertilizer per
Annual demand for fertilizer bags
year =
EOQ

2,000 bags = 1,280 bags = 16 orders.
= = 20 orders
100 bags 80 bags
4. (i) Minimum stock of A

Re-order level – (Average rate of consumption × Average time
required to obtain fresh delivery)
= 8,000 – (200 × 10 × 2) = 4,000 kgs.

MATERIAL COST 2.75
(ii) Maximum stock of B

Re-order level + Re-order quantity – (Minimum consumption ×
Minimum delivery period)
= 4,750 + 5,000 – (175 × 4 × 3)
= 9,750 – 2,100 = 7,650 kgs.
(iii) Re-order level of C
Maximum delivery period × Maximum usage
= 4 × 225 × 6 = 5,400 kgs.
OR
Re-order level of C
= Minimum stock of C + [Average rate of consumption × Average
time required to obtain fresh delivery]
= 2,000 + [(200 × 6) × 3] kgs.= 5,600 kgs.
(iv) Average stock level of A
= Minimum stock level of A + ½ Re-order quantity of A
= 4,000 + ½ × 10,000 = 4,000 + 5,000 = 9,000 kgs.
OR
Average Stock level of A
Minimum stock level of A + Maximum stock level of A
(Refer to working
2
note)
4,000 + 16,250
= 10,125 kgs.
2
Working note:
Maximum stock of A= ROL+ ROQ – (Minimum consumption ×
Minimum re-order period)
= 8,000 + 10,000 – [(175 × 10) × 1] = 16,250 kgs.

5. (a)
Total Order No. of Cost of Ordering Carrying cost Total Cost
annual size orders inventory cost p.t. p.a (4+5+6)
require (Ton) A/q A × Per ton cost A/q × (`)
1/2× q × 20%
ment (q) (`) `1200 of cost p.t. (`)
(A) (`)
1 2 3 4 5 6 7
5,000 400 12.5 60,00,000 15,000 48,000 60,63,000
Ton (5,000×`1200) (200 × ` 240)
500 10 59,00,000 12,000 59,000 59,71000
(5,000 × ` 1180) (250 × ` 236)
1,000 5 58,00,000 6,000 1,16,000 59,22,000
(5,000× ` 1160) (500 × ` 232)
2,000 2.5 57,00,000 3,000 2,28,000 59,31,000
(5,000×` 1140) (1,000×`228)
3,000 1.666 56,00,000 2,000 3,36,000 59,38,000
(5,000×` 1120) (1,500×`224)
The above table shows that the total cost of 5,000 units including
ordering and carrying cost is minimum (` 59,22,000) when the order
size is 1,000 units. Hence the most economical purchase level is 1,000
units.
(b) If there will are no discount offer then the purchase quantity should
be equal to EOQ. The EOQ is as follows:
2AO
EOQ = C
where A is the annual inventory requirement,
O is the ordering cost per order and
C is the carrying cost per unit per annum.
2×5,000units × `1,200
= 200 units
= 20% × `1,500
6. Basic Data:
A (Number of units to be purchased annually) = 5,000 units

MATERIAL COST 2.77
C (Annual cost of storage per unit) = `5

Purchase price per unit inclusive of transportation cost = ` 50.
Computations:
(i) Re-ordering level = Maximum usage per period × Maximum
lead time
(ROL) = 20 units per day × 15 days = 300 units
(ii) Maximum level = ROL + ROQ – [Min. rate of consumption ×
Min. lead time] (Refer to working notes 1 and 2)
= 300 units+200units – [10 units per day×5 days]
= 450 units
(iii) Minimum level = ROL–Average rate of consumption×
Average re-order-period
= 300 units – (15 units per day × 10 days)
= 150 units
(iv) Danger level = Average consumption × Lead time for
emergency purchases
= 15 units per day × 4 days = 60 units
Working Notes:
1. Minimum rate of consumption per day
Minimum rate of Maximum rate of
+
Av. rate of consumption consumption
=
consumption 2
X units/day + 20 units per day
15 units per day = or X = 10 units per day.
2
2×5,000 units×`20
2. Re-order Quantity (ROQ) = = 200 units
5

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

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

E.O.Q. = = = 2,400 units
C 10% of `20
i
(ii) Extra cost incurred by the company:
A. Total cost when order size is equal 4,000 units:
Total cost = Total ordering cost + Total carrying cost
A 1
= × O + Q (Ci)
Q 2
=  48,000 units ×`120  +  1 × 4,000 units ×10% × ` 20 

 4,000 units  2 
= ` 1,440 + ` 4,000 = ` 5,440
B. Total cost when order size is equal EOQ i.e. 2,400 units:
 48,000 units  1 
Total cost =  ×`120  +  × 2,400 units × 10% × ` 20 
 2,400 units  2 
= ` 2,400 + ` 2,400 = ` 4,800

Extra cost that the company has to incur = (A) – (B) = ` 5,440 –
` 4,800 = ` 640
(iii) Minimum carrying cost: Carrying cost depends upon the size
of the order. It will be minimum on the least order size. (In this
part of the question the two order sizes are 2,400 units and
4,000 units. Here 2,400 units is the least of the two order sizes.
At this order size carrying cost will be minimum.)

MATERIAL COST 2.79
The minimum carrying cost in this case can be computed as

under:
1
Minimum carrying cost = × 2,400 units × 10% × ` 20 = ` 2,400.
2
8. Working Notes:
1. The material received as replacement from vendor is treated as fresh
supply.
2. In the absence of information the price of the material received from
within on 20-9-X8 has been taken as the price of the earlier issue
made on 17-9-X8. In FIFO method physical flow of the material is
irrelevant for pricing the issues.
3. The issue of material on 26-9-X8 is made out of the material received
from within.
4. The entries for transfer of material from one job and department to
other on 22-9-X8 and 29-9-X8 are book entries for adjusting the cost
of respective jobs and as such they have not been shown in the stores
ledger account.
5. The material found short as a result of stock taking has been written
off.

2.80
Stores Ledger of AT Ltd. for the month of September, 20X8 (FIFO Method)
RECEIPT ISSUE BALANCE
Date GRN
2.80
Qty. Rate Amount Requisi- Qty. Rate Amount Qty. Rate Amount
No Units (`) (`) tion No Units (`) (`) Units (`) (`)
MRR
No.
1 2 3 4 5 6 7 8 9 10 11 12
1-9-X8 — — — — — — — — 25 6.50 162.50

4-9-X8 — — — — 85 8 6.50 52 17 6.50 110.50
6-9-X8 26 50 5.75 287.50 — — — — 17 6.50
398.00
50 5.75

7-9-X8 — — — — 97 12 6.50 78 5 6.50
320.00
50 5.75
10-9-X8 — — — — Nil 10 5.75 57.50 5 6.50
262.00
40 5.75
12-9-X8 — — — — 108 5 6.50
10 5.75 90 30 5.75 172.50
13-9-X8 — — — — 110 20 5.75 115 10 5.75 57.50
15-9-X8 33 25 6.10 152.50 — — — — 10 5.75
COST AND MANAGEMENT ACCOUNTING
210.00
25 6.10
17-9-X8 — — — — 121 10 5.75 57.50 25 6.10 152.50
19-9-X8 38 10 5.75 57.50 — — — — 25 6.10
210.00
10 5.75
5 5.75
20-9-X8 4 5 5.75 28.75 — — — — 25 6.10 258.75
10 7.75
26-9-X8 — — — — 146 5 5.75 20 6.10
59.25 179.50
5 6.10 10 5.75
30-9-X8 — — — — Shortage 2 6.10 12.20 18 6.10
167.30
10 5.75

MATERIAL COST
2.81
2.82
9. From the point of view of cost of material charged to each job, it is

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

Statement of receipts and issues by adopting First-in-First-Out Method
Date Particulars Receipts Issues Balance
Units Rate Value Units Rate Value Units Rate Value
No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
Jan. 20 Purchase 100 2 200 — — — 100 1 100
100 2 200
Jan. 22 Issue to Job W 16 — — — 60 1 60 40 1 40
100 2 200
Jan. 23 Issue to Job W 17 — — — 40 1 40
20 2 80 80 2 160
Statement of receipts and issues by adopting Last-In-First-Out method

Unit Rate Value Units Rate Value Units Rate Value
s (`) (`) No. (`) (`) No. (`) (`)
No.
Jan. 1 Purchase 100 1 100 — — — 100 1 100
MATERIAL COST
Jan. 20 Purchase 100 2 200 — — — 100 1 100

100 2 200
Jan. 22 Issue to Job W 16 — — — 60 2 120 100 1 100
40 2 80
Jan. 23 Issue to Job W 17 — — — 40 2 80 80 1 80
2.83
20 1 20
Statement of Receipt and Issues by adopting Weighted Average method

2.84
Units Rate Value Units Rate Value Units Rate Value

No. (`) (`) No. (`) (`) No. (`) (`)
Jan. 1 Purchase 100 1 100 — — — 100 1 100
Jan. 20 Purchase 100 2 200 — — — 200 1.50 300
Jan. 22 Issue to Job W 16 — — — 60 1.50 90 140 1.50 210
Jan. 23 Issue to Job W 17 — — — 60 1.50 90 80 1.50 120
Statement of Material Values allocated to Job W 16, Job 17 and Closing Stock, under aforesaid methods

FIFO LIFO Weighted Average
(`) (`) (`)
Material for Job W 16 60 120 90
Material for Job W 17 80 100 90
Closing Stock 160 80 120
300 300 300
CHAPTER 3
EMPLOYEE COST AND

DIRECT EXPENSES
LEARNING OUTCOMES

 State the meaning and importance of employee (labour)
cost in an organisation.
 Discuss the attendance and payroll procedures.
 State the meaning and treatment of idle time and overtime
cost.
 Compute employee (labour) turnover discuss its meaning,
reasons, methods of measurement and cost impacts.
 Discuss and apply the various methods of remuneration and
incentive system in calculation of wages, bonus etc.
 Discuss the efficiency rating procedures.

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

EMPLOYEE COST AND DIRECT EXPENSES 3.3
3.2 EMPLOYEE (LABOUR) COST

Employee (Labour) cost: Benefits paid or payable to the employees of an entity,
whether permanent, or temporary for the services rendered by them. Employee cost
includes payments made in cash or kind. Employee cost includes the following:
(i) Wages and salary;
(ii) Allowances and incentives;
(iii) Payment for overtimes;
(iv) Employer’s contribution to Provident fund and other welfare funds;
(v) Other benefits (leave with pay, free or subsidised food, leave travel
concession etc.) etc.
Classification of Employee (Labour) cost: Employee cost are broadly
classified as direct and indirect employee cost.
(i) Direct Employee (Labour) Cost
Benefits paid or payable to the employees which can be attributed to a cost
object in an economically feasible manner. This can be easily identified and
allocated to an activity, contract, cost centre, customer, process, product etc.
(ii) Indirect Employee (Labour) Cost
Benefits paid or payable to the employees, which cannot be directly
attributable to a particular cost object in an economically feasible manner.
Distinction between Direct and Indirect Employee Cost:
Direct employee cost Indirect employee cost
1. It is the cost incurred in payment 1. Cost incurred for payment of
of employees who are directly employee who are not directly
engaged in the production engaged in the production
process. process.
2. Direct employee cost can be easily 2. Indirect employee cost is
identified and allocated to cost apportioned on some
unit. appropriate basis.
3. Direct employee cost varies with 3. Indirect employee cost may not
the volume of production and vary with the volume of
has positive relationship with the production.
volume.

3.3 EMPLOYEE (LABOUR) COST CONTROL

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

vi) Conducts job evaluation.

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

(ii) the amount treated as indirect employee and thus included in overheads;
and
(iii) the amount treated as the cost of idle time and hence loss.
(iv) the amount treated as abnormal loss/ gain and to be transferred to profit
and loss account.
Through this process costs of various jobs are ascertained. Naturally, in this the
proper recording of time spent by the employees is essential.
3.4 ATTENDANCE & PAYROLL PROCEDURES

3.4.1 Attendance Procedure / Time-keeping
It refers to correct recording of the employees’ attendance time. Students may
note the difference between “time keeping” and “time booking”. The latter refers
to break up of time on various jobs while the former implies a record of total time
spent by the employees in a factory.
Objectives of Time-keeping: Correct recording of employees’ attendance time is

of utmost importance where payment is made on the basis of time worked.
Where payment is made by results viz; straight piece work, it would still be
necessary to correctly record attendance for the purpose of ensuring that proper
discipline and adequate rate of production are maintained. The objectives of
time-keeping are as follows:
(i) For the preparation of payrolls.

(ii) For calculating overtime.
(iii) For ascertaining and controlling employee cost.
(iv) For ascertaining idle time.
(v) For disciplinary purposes.
(vi) For overhead distribution.
Methods of Time-keeping: There are various methods of time-keeping, which
may be categorized into manual and mechanical methods. The choice of a
particular method depends upon the requirements and policy of an entity; but
whichever method is followed, it should make a correct record of the time by

incurring minimum possible expenditure and it should minimise the risk of

fraudulent payments of wages. The examples of time keeping methods are
follows:
1. Manual Methods
(a) Attendance Register method- Under this method, an attendance register
is kept to record the arrival and departure time of an employee. This method
is simple and expensive and is suitable for small organisations. However, this
method may lead to dishonest practice of time manipulation by way of recording
wrong time and back date entry in collusion with time keeper.
(b) Metal Disc/ Token method- This method of time recording is very old and
is almost obsolete in practice. Under this method, each employee is allotted a
metal disc or a token with a hole bearing his identification number. The token is
kept or handed to the time keeper who record the token number in his register. Like
attendance register method, this method also has some disadvantages like error
in recording, proxy attendance etc.
2. Mechanical/ Automated Methods
(a) Punch Card Attendance- Under this method, each employee is provided a
card for marking attendance. A punch card contains data related with the
employee in digital form. In punch card attendance system, an employee needs
to either insert or wave his card to a card reader which then ensures whether the
correct person is logging in and/or out. This system does not require to employ
any time keeper and minimises the risk of recording error and time manipulation.
(b) Bio- Metric Attendance system- Under bio-metric attendance system
attendance is marked by recognizing an employee on the basis of physical
and behavioral traits. An employee’s unique identity like finger print, face and
retina image etc. are kept in a database which is matched at the time of marking
of attendance before the attendance device for this purpose. Bio-metric
attendance system includes fingerprint recognition system, face recognition
system, Time and attendance tracking technology etc. This system reduces the
risk of time manipulation and proxy attendance. However, it may not be suitable
for small organisations due to cost associated with set-up and maintenance.
Requisites of a Good Time-keeping System: A good time-keeping system
should have following requisites:
1. System of time-keeping should be such which should not allow proxy for
another employee under any circumstances.

2. There should also be a provision of recording of time of piece employees so

that regular attendance and discipline may be maintained. This is necessary
to maintain uniformity of flow of production.
3. Time of arrival as well as time of departure of employees should be
recorded so that total time of employees may be recorded and wages may
be calculated accordingly.
4. As far as possible, method of recording of time should be mechanical so
that chances of disputes regarding time may not arise between employees
and the time-keeper.
5. Late-comers should record late arrivals. Any relaxation by the time-keeper
in this regard will encourage indiscipline.
6. The system should be simple, smooth and quick. Unnecessary queuing for
marking attendance should be avoided.
7. The system should be reviewed and maintained periodically to prevent any
error.
3.4.2 Time-Booking
Time keeping just records the time spent by an employee in the premises for
production but it does not show how much time a person spent on a particular
job. Time booking refers to a method wherein each activity of an employee is
recorded. This data recorded is further used for measure the time spent on a
particular job for costing, measurement of efficiency, fixation of responsibility etc.
Time booking for costing: The time spent on a particular job or activity is used
to compute the cost of the job or activity.
Time booking to measure efficiency: The efficiency of the employees is

measures by comparing the actual time taken by an employee with the standard
time that should have been taken.
Time booking for fixation of responsibility: The time booked data is used to
analyse the variance in time taken by an employee on a particular job or process
with respect to standard time to see the reasons for the variance. The reasons for
variance is further classified as controllable and uncontrollable. The controllable
reasons are those which can be avoided by due care and efficiency. On the other
hand, uncontrollable reasons cannot be avoided under the normal circumstances.

Employees or any other concerned person or departments are made accountable

for variance under controllable reasons.
For the collection of all such data, a separate record, generally known as Time (or
Job) card, is kept.
The time (or job) card can be of two types—

• One containing analysis of time with reference to each job: A separate
job card is employed in respect of a job undertaken; where a job involves
several operations, a separate entry is made in respect of each operation.
Thus the job card would record the total time spent on a particular job or
operation. If a number of people are engaged on the same job or operation,
the time of all those employees would be booked on the same card.
One advantage of this method is that it provides complete data on the
employee content of job or operation collectively so that the computation
of employee cost is greatly facilitated.
But this method has drawbacks as well. Since an employee’s job timing is
scattered over a number of job cards the time spent on all these jobs and
idle time must be abstracted periodically for finding each employee’s total
time spent on different jobs and the time for which he remained idle during
the period. The total of these two times (job and idle) must obviously equal
his total attendance time, as shown by his attendance record.
• The other with reference to each employee: In this case, it would greatly
facilitate reconciliation of the employee’s job time with his attendance time
recorded.
Under this system, a separate card would be used for each employee for each
day or for each week and the time which he spends on different jobs (and also
any idle time) would be recorded in the same card so that the card would
have a complete history on it as to how his time had been spent during the
period.
The format of job or time may vary industry to industry and according to
the accounting system into used.

3.4.3 Payroll Procedure

Steps included in this process are as under:
Time -keeping Personnel/ HR

Department Department
1. Time and Attendance
2. Employee Details
Payroll
Department
3. Wage and Salary sheet
5. Deposit of deductions and

Cost/ Accounting contributions
Department
4. Payment after deductions and

contributions
Statutory Bodies
Employees
Diagram: Payroll Procedures
1. Attendance and Time details: A detailed sheet of number of days or hours

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

3. Computation of wages and other incentives: Payroll department based

on the details provided by the time keeping department and personnel
department calculate wages/ salary to be paid to the employees. Payroll
department prepares pay slip for all employees authorized by the personnel
department and forward the same to the cost/ accounting department for
further deductions and payment.
4. Payment to the employees: Cost/ accounting department deduct all
statutory deduction such as employee’s contribution to provident fund and
employee state insurance (ESI) scheme, TDS on salary etc. After all
deductions wages/ salary is paid to the employees.
5. Deposit of all statutory liabilities: All statutory deduction made from
wages/ salary of the employees alongwith employer’s contributions such as
provident fund and employee state insurance scheme are paid to the
respective statutory bodies.
The followings are generally deducted from the payroll
Type of deductions Description
Statutory Deductions
1. Provident fund Employee’s contribution to the Provident
fund is deducted from the salary/ wages of
the concerned employee.
2. Employee State Insurance Employee’s contribution to the ESI is
Scheme (ESI) deducted from the salary/ wages.
3. Tax Deduction at Source Employer is obliged to deduct tax at source if
(TDS) it will be paying to the employee net salary
exceeding maximum exemption limit, in equal
monthly installments to the income tax
department.
4. Professional Tax Professional tax is a state level tax imposed for
carrying on business, profession or service.
Other Deductions
1. Voluntary contribution to If any employee so desires may contribute
Provident fund over and above the contribution payable by
the employer.
2. Contribution to any An employee may contribute to any
benevolent fund. benevolent fund voluntarily by putting a

request to the payroll department.

3. Loan deductions Installments of any loan taken by the
employee.
4. Other advances and dues Other advances like festival advance and
unadjusted advances taken.
3.5 IDLE TIME

The time during which no production is carried-out because the worker remains
idle but are paid. In other words, it is the difference between the time paid and the
time booked. Idle time can be normal or abnormal. The time for which employees
are paid includes holidays, paid leaves, allowable rest or off time etc.
Normal idle time: It is the time which cannot be avoided or reduced in the normal
course of business.
Causes Treatment
1. The time lost between factory It is treated as a part of cost of
gate and the place of work, production. Thus, in the case of direct
workers an allowance for normal idle
time is considered setting of standard
hours or standard rate.
In case of indirect workers, normal idle
2. The interval between one job and
time is considered for the computation
another,
of overhead rate.
3. The setting up time for the
machine,
4. Normal rest time, break for lunch
etc.
Abnormal idle time: Apart from normal idle time, there may be factors which give
rise to abnormal idle time.
Causes Treatment
1. Idle time may also arise due to Abnormal idle time cost is not included
abnormal factors like lack of as a part of production cost and is
coordination shown as a separate item in the Costing
2. Power failure, Breakdown of Profit and Loss Account.
machines The cost of abnormal idle time should

3. Non-availability of raw materials, be further categorised into controllable

strikes, lockouts, poor and uncontrollable. For each category,
supervision, fire, flood etc. the break-up of cost due to various
4. The causes for abnormal idle factors should be separately shown.
time should be further analysed This would help the management in
into controllable and fixing responsibility for controlling idle
uncontrollable. time.
i) Controllable abnormal idle time Management should aim at eliminating
refers to that time which could controllable idle time and on a long-
have been put to productive use term basis reducing even the normal
had the management been more idle time. This would require a detailed
alert and efficient. All such time analysis of the causes leading to such
which could have been avoided is idle time.
controllable idle time.
ii) Uncontrollable abnormal idle time
refers to time lost due to
abnormal causes, over which
management does not have any
control e.g., breakdown of
machines, flood etc. may be cha-
racterised as uncontrollable idle
time.
ILLUSTRATION 1
‘X’ an employee of ABC Co. gets the following emoluments and benefits:
(a) Basic pay ` 10,000 p.m.
(b) Dearness allowance ` 2,000 p.m.
(c) Bonus 20% of salary and D.A.
(d) Other allowances ` 2,500 p.m.
(e) Employer’s contribution to P.F. 10% of salary and D.A.
‘X’ works for 2,400 hours per annum, out of which 400 hours are non-productive
and treated as normal idle time. You are required to COMPUTE the effective hourly
cost of employee ‘X’.

SOLUTION
Statement showing computation of effective hourly cost of employee ‘X’
Per month (`) Per annum (`)

(A) Earning of Employee ‘X’:
Basic pay 10,000 1,20,000
Dearness Allowance 2,000 24,000
Bonus 2,400 28,800
Employer’s contribution to provident fund 1,200 14,400
Other allowances 2,500 30,000
18,100 2,17,200
(B) Effective working hours (refer workings) 2,000 hours
(C) Effective hourly cost {(A) ÷ (B)} `108.60
Workings:
Calculation of effective working hours:
Annual working hours less Normal idle time = 2,400 hours – 400 hours = 2,000 hours.
ILLUSTRATION 2
In a factory working six days in a week and eight hours each day, a worker is paid
at the rate of ` 100 per day basic plus D.A. @ 120% of basic. He is allowed to take
30 minutes off during his hours shift for meals-break and a 10 minutes recess for
rest. During a week, his card showed that his time was chargeable to :
Job X 15 hrs.
Job Y 12 hrs.
Job Z 13 hrs.
The time not booked was wasted while waiting for a job. In Cost Accounting, STATE
how would you allocate the wages of the workers for the week?
SOLUTION
Working notes:
(i) Total effective hours in a week:
[(8 hrs. – (30 mts. + 10 mts.)] × 6 days = 44 hours

(ii) Total wages for a week:

(` 100 + 120% of ` 100) × 6 days = ` 1,320
(iii) Wage rate per hour = ` 30
(iv) Time wasted waiting for job (Abnormal idle time):
= 44 hrs. – (15 hrs. + 12 hrs. + 13 hrs.) = 4 hrs.
Allocation of wages in Cost Accounting
(`)
Allocated to Job X : 15 hours × ` 30 450
Allocated to Job Y : 12 hours × ` 30 360
Allocated to Job Z : 13 hours × ` 30 390
Charged to Costing Profit & Loss A/c : 4 hours × ` 30 120
Total 1,320
3.6 OVERTIME
Work done beyond normal working hours is known as ‘overtime work’.
Overtime payment is the amount of wages paid for working beyond normal working
hours. Overtime payment consist of two elements- (i) Normal wages for overtime work
and (ii) Premium payment for overtime work.
Overtime Payment = Wages paid for overtime at normal rate + Premium (extra)
payment for overtime work
Overtime premium: The rate for overtime work is higher than the normal time rate;
usually it is at double the normal rates. The extra amount so paid over the normal rate
is called overtime premium.
Rate and conditions for overtime premium may either be fixed by an entity itself or it
may be required by any statute in force. The overtime premium should not be less
than the premium calculated as per the statute.
As per the Factories Act 1948 “Where a worker works in a factory for more than
nine hours in any day or for more than fourty eight hours in any week, he shall,
in respect of overtime work, be entitled to wages at the rate of twice his ordinary
rate of wages.”

Where any workers in a factory are paid on a piece-rate basis, the time rate shall
be deemed to be equivalent to the daily average of their full-time earnings for
the days on which they actually worked on the same or identical job during the
month immediately preceding the calendar month during which the overtime
work was done, and such time rates shall be deemed to be the ordinary rates of
wages of those workers
Ordinary rate of wages means the basic wages plus such allowances, including
the cash equivalent of the advantage accruing through the concessional sale to
workers of food grains and other articles, as the worker is for the time being
entitled to, but does not include a bonus and wages for overtime work.
Occasional overtime is a healthy sign as it indicates that the firm has the optimum
capacity and that the capacity is being fully utilised. But persistent overtime is rather a
bad sign because it may indicate either (a) that the firm needs larger capacity in men
and machines, or (b) that men have got into the habit of postponing their ordinary
work towards the evening so that they can earn extra money in the form of overtime
wages.
Causes of Overtime and Treatment of Overtime premium in cost accounting
Causes Treatment
(1) The customer may agree to (1) If overtime is resorted to at the
bear the entire charge of desire of the customer, then
overtime because urgency of overtime premium may be
work. charged to the job directly.
(2) Overtime may be called for to (2) If overtime is required to cope
make up any shortfall in with general production
production due to some programmes or for meeting
unexpected development. urgent orders, the overtime
premium should be treated as
overhead cost of the particular
department or cost centre which
works overtime.
(3) Overtime work may be (3) If overtime is worked in a
necessary to make up a department due to the fault of
shortfall in production due to another department, the overtime
some fault of management. premium should be charged to the
latter department.

(4) Overtime work may be resorted (4) Overtime worked on account of

to, to secure an out-turn in abnormal conditions such as
excess of the normal output to flood, earthquake etc., should not
take advantage of an be charged to cost, but to Costing
expanding market or of rising Profit and Loss Account.
demand
ILLUSTRATION 3
CALCULATE the earnings of A and B from the following particulars for a month and
allocate the employee cost to each job X, Y and Z:
A B
(i) Basic Wages (`) 10,000 16,000
(ii) Dearness Allowance 50% 50%
(iii) Contribution to provident Fund (on basic wages) 8% 8%
(iv) Contribution to Employee’s State Insurance (on basic wages) 2% 2%
(v) Overtime (Hours) 10 --
The normal working hours for the month are 200. Overtime is paid at double the
total of normal wages and dearness allowance. Employer’s contribution to state
Insurance and Provident Fund are at equal rates with employees’ contributions.
The two workers were employed on jobs X, Y and Z in the following proportions:
Jobs X Y Z
Worker A 40% 30% 30%
Worker B 50% 20% 30%
Overtime was done on job Y.

SOLUTION
Statement showing Earnings of Workers A and B
A (`) B (`)
Basic wages 10,000 16,000
Dearness Allowance (50% of Basic Wages) 5,000 8,000
Overtime wages (Refer to Working Note 1) 1,500 --
Gross wages earned 16,500 24,000

Less: Contribution to Provident fund (800) (1,280)

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

ILLUSTRATION 4
It is seen from the job card for repair of the customer’s equipment that a total of 154
labour hours have been put in as detailed below:
Worker ‘A’ paid Worker ‘B’ paid Worker ‘C’ paid
at ` 200 per day at ` 100 per at ` 300 per day
of 8 hours day of 8 hours of 8 hours
Monday (hours) 10.5 8.0 10.5
Tuesday (hours) 8.0 8.0 8.0
Wednesday (hours) 10.5 8.0 10.5
Thursday (hours) 9.5 8.0 9.5
Friday (hours) 10.5 8.0 10.5
Saturday (hours) -- 8.0 8.0
Total (hours) 49.0 48.0 57.0
In terms of an award in an employee conciliation, the workers are to be paid dearness
allowance on the basis of cost of living index figures relating to each month which works out
@ ` 968 for the relevant month. The dearness allowance is payable to all workers
irrespective of wages rate if they are present or are on leave with wages on all working days.
Sunday is a weekly holiday and each worker has to work for 8 hours on all week days and
4 hours on Saturdays; the workers are however paid full wages for Saturday (8 hours for 4
hours worked).
Workers are paid overtime according to the Factories Act, 1948. Excluding holidays, the
total number of hours works out to 176 in the relevant month. The company’s contribution
to Provident Fund and Employees State Insurance Premium are absorbed into overheads.
CALCULATE the wages payable to each worker.
SOLUTION
(1) Calculation of hours to be paid for worker A :
Normal Extra Overtime Equivalent normal Total

hours hours hours hours for normal
overtime worked hours
Monday 8 1 1½ 3 12
Tuesday 8 -- -- -- 8
Wednesday 8 1 1½ 3 12

Thursday 8 1 ½ 1 10
Friday 8 1 1½ 3 12
Saturday -- -- -- -- --
Total 40 4 5 10 54
Calculation of hours to be paid for worker B :

hours hours hours hours for overtime normal
worked hours
Monday 8 --- --- --- 8
Tuesday 8 --- --- --- 8
Wednesday 8 --- --- --- 8
Thursday 8 --- --- --- 8
Friday 8 --- --- --- 8
Saturday 4 4* --- --- 8
Total 44 4 --- --- 48
(*Worker-B has neither worked more than 9 hours in any day nor more than
48 hours in the week)
Calculation of hours to be paid for worker C :
hours hours hours hours for overtime normal
worked hours
Monday 8 1 1½ 3 12
Tuesday 8 --- --- --- 8
Wednesday 8 1 1½ 3 12
Thursday 8 1 ½ 1 10
Friday 8 1 1½ 3 12
Saturday 4 --- 4* 8 12
Total 44 4 9 18 66
(*Worker-C has worked more than 48 hours in the week)

Wages payable:
A B C
Basic Wages per hour (`) 25.00 12.50 37.50
Dearness allowance per hour (`) 5.50 5.50 5.50
Hourly rate (`) 30.50 18.00 43.00
Total normal hours 54.00 48.00 66.00
Total Wages payable (`) 1,647.00 864.00 2,838.00
ILLUSTRATION 5
In a factory, the basic wage rate is ` 100 per hour and overtime rates are as follows:
Before and after normal working hours 175% of basic wage rate
Sundays and holidays 225% of basic wage rate
During the previous year, the following hours were worked
- Normal time 1,00,000 hours
- Overtime before and after working hours 20,000 hours
Overtime on Sundays and holidays 5,000 hours
Total 1,25,000 hours
The following hours have been worked on job ‘Z’

Normal 1,000 hours
Overtime before and after working hrs. 100 hours.
Sundays and holidays 25 hours.
Total 1,125 hours
You are required to CALCULATE the labour cost chargeable to job ‘Z’ and overhead in
each of the following instances:
(a) Where overtime is worked regularly throughout the year as a policy due to the
workers’ shortage.
(b) Where overtime is worked irregularly to meet the requirements of production.
(c) Where overtime is worked at the request of the customer to expedite the job.

SOLUTION
Workings
Basic wage rate : ` 100 per hour
Overtime wage rate before and after working hours : ` 100 × 175% = ` 175 per hour
Overtime wage rate for Sundays and holidays : ` 100 × 225% = ` 225 per hour
Computation of average inflated wage rate (including overtime premium):
Particulars Amount (`)
Annual wages for the previous year for normal time 1,00,00,000
(1,00,000 hrs. × `100)
Wages for overtime before and after working hours 35,00,000
(20,000 hrs. × ` 175)
Wages for overtime on Sundays and holidays 11,25,000
(5,000 hrs. × ` 225)
Total wages for 1,25,000 hrs. 1,46,25,000
` 1, 46,25,000
Average inflated wage rate = = `117
1,25,000 hours
(a) Where overtime is worked regularly as a policy due to workers’ shortage:
The overtime premium is treated as a part of employee cost and job is charged
at an inflated wage rate. Hence, employee cost chargeable to job Z
= Total hours × Inflated wage rate = 1,125 hrs. × ` 117 = ` 1,31,625
(b) Where overtime is worked irregularly to meet the requirements of
production:
Basic wage rate is charged to the job and overtime premium is charged to
factory overheads as under:
Employee cost chargeable to Job Z: 1,125 hours @ `100 per hour =
` 1,12,500
Factory overhead: {100 hrs. × ` (175 – 100)} + {25 hrs. × ` (225 – 100)} =
{`7,500 + `3,125} = ` 10,625
(c) Where overtime is worked at the request of the customer, overtime premium
is also charged to the job as under:

(`)
Job Z Employee cost 1,125 hrs. @ ` 100 = 1,12,500
Overtime premium 100 hrs. @ ` (175 – 100) = 7,500
25 hrs. @ ` (225 – 100) = 3,125
Total 1,23,125
3.7 LABOUR UTILISATION

For identifying utilisation of labour a statement is prepared (generally weekly) for
each department / cost centre. This statement should show the actual time paid
for, the standard time (including normal idle time) allowed for production and the
abnormal idle time analysed for causes thereof.
3.7.1 Identification of Utilisation of labours with Cost Centres:
For the identification of utilisation of labour with the cost centre, a wage analysis
sheet is prepared. Wage analysis sheet is a statement in which total wages paid
are analysed according to cost centre, jobs, work orders etc. The data for analysis is
provided by wage sheet, time card, piece work cards and job cards.
The preparation of such sheet serves the following purposes:
(i) It analyse the labour time into direct and indirect labour by cost centres,
jobs, work orders.
(ii) It provides details of direct labour cost comprises of wages, overtime to be
charged as production cost of cost centre, jobs or work orders.
(iii) It provides information for treatment of indirect labour cost as overhead
expenses.
3.7.2 Identification of labour hours with work order or batches or capital job:
For identification of labour hours with work order or batches or capital jobs or
overhead work orders the following points are to be noted:
(i) The direct labour hours can be identified with the particular work order or
batches or capital job or overhead work orders on the basis of details
recorded on source document such as time sheet or job cards.
(ii) The indirect labour hours cannot be directly identified with the particular
work order or batches or capital jobs or overhead work orders. Therefore,

they are traced to cost centre and then assigned to work order or batches
or capital jobs or overhead work orders by using overhead absorption rate.
3.8 SYSTEMS OF WAGE PAYMENT AND

INCENTIVES
There exist several systems of employee wage payment and incentives, which can
be classified under the following heads:
Time based
System of Wages Payment
Output based
Combination of time and output based
Premium Bonus method
Group bonus scheme
Incentives for indirect workers
3.8.1 Time based (Time Rate System)

Straight Time Rate System: Under this system, the workers are paid on time
basis i.e. hour, day, week, or month. The amount of wages due to a worker are
arrived at by multiplying the time worked (including normal idle period) by rate for
the time.
Time based wages payment is suitable for the employees (i) whose services
cannot be directly or tangibly measured, e.g., general helpers, supervisory and
clerical staff etc. (ii) engaged in highly skilled jobs, (iii) where the pace of output is
independent of the operator, e.g., automatic chemical plants.
Wages under time rate system is calculated as under:
Wages = Time Worked (Hours/ Days/ Months) × Rate for the time
3.8.2 Output Based (Piece Rate System)

Straight Piece Rate System: Under this system, each operation, job or unit of
production is termed a piece. A rate of payment, known as the piece rate or piece
work rate is fixed for each piece. The wages of the worker depend upon his

output and rate of each unit of output; it is in fact independent of the time taken
by him. The wages paid to a worker are calculated as:
Wages = Number of units produced × Rate per unit
3.8.3 Premium Bonus Method

Under these methods, standard time is established for performing a job. The
worker is guaranteed his daily wages (except in Barth System), if his output is
below and upto standard. In case the task is completed in less than the standard
time, the saved time is shared between the employee and the employer.
(i) Halsey Premium Plan: Under Halsey premium plan a standard time is fixed
for each job or process. If there is no saving on this standard time allowance, the
worker is paid only his day rate. He gets his time rate even if he exceeds the
standard time limit, since his day rate is guaranteed.
If, however, he does the job in less than the standard time, he gets a bonus equal
to 50 percent of the wages of time saved; the employer benefits by the other 50
percent. The scheme also is sometimes referred to as the Halsey fifty percent plan.
Earnings under Halsey Premium plan is calculated as under:
Wages = Time taken × Time rate + 50% of time saved × Time rate
Advantages and Disadvantages of Halsey Premium Plan
1. Time rate is guaranteed while there is 1. Incentive is not so strong as
opportunity for increasing earnings by with piece rate system. In fact
increasing production. the harder the worker works,
2. The system is equitable in as much as the lesser he gets per piece.
the employer gets a direct return for 2. The sharing principle may not
his efforts in improving production be liked by employees.
methods and providing better
equipment.
ILLUSTRATION 6
CALCULATE the earnings of a worker under Halsey System. The relevant data is as below:
Time Rate (per hour) ` 60
Time allowed 8 hours

Time taken 6 hours

Time saved 2 hours
SOLUTION
Calculation of total earnings:
= Time taken × Time rate + 50% (Time Allowed – Time Taken) × Time rate
= 6 hrs. × `60 + 1/2 × (2 hrs. × ` 60) or ` 360 + `60 = ` 420
Of his total earnings, ` 360 is on account of the time worked and `60 is on
account of his share of the premium bonus.
(ii) Rowan Premium Plan: According to this system a standard time allowance
is fixed for the performance of a job and bonus is paid if time is saved.
Under Rowan System the bonus is that proportion of the time wages as time
saved bears to the standard time.
Time Saved
Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed
Advantages and Disadvantages of Rowan Premium Plan
1. It is claimed to be a fool-proof system 1. The system is a bit
in as much as a worker can never complicated.
double his earnings even if there is bad
rate setting.
2. It is admirably suitable for encouraging 2. The incentive is weak at a
moderately efficient workers as it high production level where
provides a better return for moderate the time saved is more than
efficiency than under the Halsey Plan. 50% of the time allowed.
3. The sharing principle appeals to the 3. The sharing principle is not
employer as being equitable. generally welcomed by
employees.
ILLUSTRATION 7
CALCULATE the earnings of a worker under Rowan System. The relevant data is given
as below:
Time rate (per Hour) ` 60
Time allowed 8 hours.

Time taken 6 hours.

Time saved 2 hours.
SOLUTION
Calculation of total earnings:
Time Saved
=Time taken × Rate per hour + × Time taken × Rate per hour
Time Allowed
2 hours
= 6 hours × `60 + × 6 hours × `60 = ` 360 + `90 = ` 450
8 hours
ILLUSTRATION 8
Two workmen, ‘A’ and ‘B’, produce the same product using the same material. Their
normal wage rate is also the same. ‘A’ is paid bonus according to the Rowan
system, while ‘B’ is paid bonus according to the Halsey system. The time allowed to
make the product is 50 hours. ‘A’ takes 30 hours while ‘B’ takes 40 hours to
complete the product. The factory overhead rate is ` 5 per man-hour actually
worked. The factory cost for the product for ‘A’ is ` 3,490 and for ‘B’ it is ` 3,600.
Required:
(a) COMPUTE the normal rate of wages;
(b) COMPUTE the cost of materials cost;
(c) PREPARE a statement comparing the factory cost of the products as made by the
two workmen.
SOLUTION
Step 1 : Let X be the cost of material and Y be the normal rate of wages per hour.
Step 2 : Factory Cost of Workman ‘A’
(`)
A. Material Cost X
B. .Wages 30 Y
C. Bonus = 30 × (50 - 30) × Y 12 Y

50
D. Overheads (30 × `5) 150
E. Factory Cost 3,490
Or, X + 42 Y = `3,490 (Given) – `150 = `3,340……………………………...equation (i)

Step 3 : Factory Cost of Workman ‘B’

(`)
A. Material Cost X
B. Wages 40 Y
C. Bonus = 50% of (SH - AH) × R 5Y
= 50% of (50 - 40) × R
D. Overheads (40 × `5) 200
E. Factory Cost 3,600
Or, X + 45 Y = `3,600 (Given) – `200 = `3,400………………………….equation (ii)
Step 4 : Subtracting equation (i) from equation (ii)

3Y = `60
Y = ` 60/3 = ` 20 per hour.
(a) The normal rate of wages: ` 20 per hour
(b) The cost of material: X + 45 × ` 20 = ` 3,400 or,X = ` 3,400 – ` 900 = ` 2,500
(c) Comparative Statement of the Factory Cost of the product made by the
two workmen.
‘A’ (`) ‘B’ (`)

Material cost 2,500 2,500
Direct Wages 600 800
(30 × ` 20) (40 × ` 20)
Bonus 240 100
(12 × ` 20) (5 × ` 20)
Factory Overhead 150 200
Factory Cost 3,490 3,600
ILLUSTRATION 9
(a) Bonus paid under the Halsey Plan with bonus at 50% for the time saved equals
the bonus paid under the Rowan System. When will this statement hold good?
(Your answer should contain the proof).
(b) The time allowed for a job is 8 hours. The hourly rate is ` 8. PREPARE a statement
showing:

i. The bonus earned

ii. The total earnings of employee and
iii. Hourly earnings.
Under the Halsey System with 50% bonus for time saved and Rowan System for
each hour saved progressively.
SOLUTION
50
(a) Bonus under Halsey Plan = × (SH - AH) × R (i)
100
AH
Bonus under Rowan Plan : = × (SH - AH) × R (ii)
SH
Bonus under Halsey Plan will be equal to the bonus under Rowan Plan when
the following condition holds good:
50 AH
× (SH - AH) × R = × (SH - AH) × R
100 SH
50 AH
=
100 SH
Hence, when the actual time taken (AH) is 50% of the time allowed (SH),
the bonus under Halsey and Rowan Plans is equal.
(b) Statement of Bonus, total earnings of Employee and hourly earnings under
Halsey and Rowan Systems.
SH AH Time Basic Bonus Bonus Total Total Hourly Hourly
saved wages under under Earning Earnin Earning Earnings
(AH x Halsey Rowan s under gs s under under
`8) (B x System system Halsey under Halsey Rowan
`8)  50  B  System Rowan System System
100 ×C×8  A ×C ×8  D+E Syste G/B H/B
m D+F
A B C= D E F G H I J
Hours hours (A-B) ` ` ` ` ` ` `
hours
8 8 - 64 - - 64 64 8.00 8.00
8 7 1 56 4 7 60 63 8.57 9.00
8 6 2 48 8 12 56 60 9.33 10.00

8 5 3 40 12 15 52 55 10.40 11.00
8 4 4 32 16 16 48 48 12.00 12.00
8 3 5 24 20 15 44 39 14.67 13.00
8 2 6 16 24 12 40 28 20.00 14.00
8 1 7 8 28 7 36 15 36.00 15.00
ILLUSTRATION 10
A skilled worker in XYZ Ltd. is paid a guaranteed wage rate of ` 30 per hour. The standard
time per unit for a particular product is 4 hours. Mr. P, a machine man, has been paid
wages under the Rowan Incentive Plan and he had earned an effective hourly rate of
` 37.50 on the manufacture of that particular product.
STATE what could have been his total earnings and effective hourly rate, had he been put
on Halsey Incentive Scheme (50%)?
SOLUTION
Total earnings (under 50% Halsey Scheme) = Hours worked × Rate per hour + ½
× time saved × Rate per hour
= 3 hours × ` 30 + ½ × 1 hour × `30
= ` 105
Total earnings ` 105
Effective hourly rate = = = ` 35
Hours taken 3 hours
Working Note:
Let T hours be the total time worked in hours by the skilled workers (machine man P),
` 30 is the rate per hour; standard time is 4 hours per unit and effective hourly
earnings rate is ` 37.50 then
Time saved
Earning (under Rowan plan) = Hours worked × Rate per hr + ×
Time allowed
Time taken × Rate per hr

(4 − T)
` 37.5 T = T × `30 + × T × ` 30
4
(both sides are divided by T)
` 37.5 = ` 30 + (4 – T) × ` 7.5
` 37.5 = ` 30 + `30 - 7.5T

or, ` 7.5 T = `60-`37.5

or, ` 7.5 T = ` 22.5
or, T = 3 hours.
ILLUSTRATION 11
A factory having the latest sophisticated machines wants to introduce an incentive scheme
for its workers, keeping in view the following:
(i) The entire gains of improved production should not go to the workers.
(ii) In the name of speed, quality should not suffer.
(iii) The rate setting department being newly established are liable to commit mistakes.
You are required to PREPARE a suitable incentive scheme and DEMONSTRATE by an
illustrative numerical example how your scheme answers to all the requirements of the
management.
SOLUTION
Rowan Scheme of premium bonus (variable sharing plan) is a suitable incentive
scheme for the workers of the factory. If this scheme is adopted, the entire gains due
to time saved by a worker will not pass to him.
Another feature of this scheme is that a worker cannot increase his earnings or bonus
by merely increasing its work speed. The reason for this is that the bonus under Rowan
Scheme is maximum when the time taken by a worker on a job is half of the time
allowed. As this fact is known to the workers, therefore, they work at such a speed
which helps them to maintain the quality of output too.
Lastly, Rowan System provides a safeguard in the case of any loose fixation of the
standards by the rate-setting department. It may be observed from the following
illustration that in the Rowan Scheme the bonus paid will be low due to any loose
fixation of standards. Workers cannot take undue advantage of such a situation. The
above three features of Rowan Plan can be discussed with the help of the following
illustration:
(i) Time allowed = 4 hours
Time taken = 3 hours
Time saved = 1 hour
Rate = ` 5 per hour

Time taken
Bonus = × Time saved × Rate
Time allowed
3 hours
= × 1 hour × ` 5 = ` 3.75
4 hours
In the above illustration time saved is 1 hour and, therefore, total gain is ` 5.
Out of ` 5 according to Rowan Plan only ` 3.75 is given to the worker in the
form of bonus and the remaining ` 1.25 remains with the management. In
other words, a worker is entitled for 75 percent of the time saved in the form of
bonus.
(ii) The figures of bonus in the above illustration when the time taken is 2 hours
and 1 hour respectively are as below:
Time taken
Bonus = × Time saved × Rate
Time allowed
2 hours
= × 2 hours × ` 5 = ` 5
4 hours
1hours
= × 3 hours × ` 5 = ` 3.75
4 hours
The above figures of bonus clearly show that when time taken is half of the
time allowed, the bonus is maximum. When the time taken is reduced from 2
to 1 hour, the bonus figure fell by ` 1.25. Hence, it is quite apparent to workers
that it is of no use to increase speed of work. This feature of Rowan Plan thus
protects the quality of output.
(iii) If the rate-setting department erroneously sets the time allowed as 10 hours
instead of 4 hours, in the above illustration; then the bonus paid will be as follows:
3 hours
Bonus = × 7 hours × ` 5 = ` 10.50
10 hours
The bonus paid for saving 7 hours thus is ` 10.50 which is approximately equal to the
wages of 2 hours. In other words, the bonus paid to the workers is low. Hence
workers cannot take undue advantage of any mistake committed by the time setting
department of the concern.

3.9 ABSORPTION OF WAGES

3.9.1 Elements of wages
In common parlance, the term ‘wages’ represents monetary payment which an
employee receives at regular intervals for the services rendered. Strictly speaking,
however, from the point of view of the employer and the cost to the industry,
wages should be taken to include also non-monetary benefits which an employee
receives by virtue of employment. Such non-monetary benefits may include:
(i) Medical facilities;
(ii) Educational and training facilities;

(iii) Recreational and sports facilities;

(iv) Housing and social welfare; and
(v) Cost of subsidised canteen and co-operative societies.
Such benefits are generally given in an industrial establishment. In some cases,
the provision of benefits is compulsory. Therefore, while computing the wage cost
per worker, the monetary value of such non-monetary benefits should also be
taken into account.
The monetary part of a worker’s remuneration includes the basic wages, dearness
allowance, overtime wages, other special allowance, if any, production bonus,
employer’s contribution to the provident fund, Employees State Insurance scheme
premium, contribution to pension fund, leave pay, etc.
The basic wage is the payment for work done, measured in terms of hours
attended or the units produced, as the case may be. The basic wage rate is not
normally altered unless there is a fundamental change in the working conditions
or methods of manufacture.
Dearness allowance is an allowance provided to cover the increase in cost of living
from one period to another. This allowance is calculated either as percentage of
the basic wage or as a fixed amount for the days worked. In either case, the
percentage or the fixed amount is subject to revision whenever the cost of living
index or consumer price Index rises or falls by a certain figure as agreed to by the
employer with the Employee union. When permanent rise in the cost of living
index occurs, a part of the dearness allowance is often absorbed in the basic
wage.
Overtime allowance is an allowance paid for the extra hours worked at the rates
laid down in the Factories Act. In certain industries, where special allowance for
the working conditions, tool maintenance, etc., are paid they are also considered
as part of wages.
Production Bonus is an incentive payment made to workers for efficiency that
results in production above the standard. There are different methods of
computing incentives. Under the Payment of Bonus Act, a worker is entitled to
compulsory bonus of 8.33% wages earned in the relevant year or ` 100
(whichever is greater). The bonus may be upto 20% of wages depending upon the
quantum of profits calculated as per the Act.

3.9.2. Component of wages cost or wages for costing purposes

In addition to wages (including allowances, such as D.A.) that are paid to workers,
a firm may have to spend on many other items (such as premium to the ESI or
provident fund or bonus).
Further, the worker does not spend all the time for which he is paid on productive
work.
This is because he is entitled to weekly holiday and various type of leave. There is
also a certain amount of unavoidable idle time. The question is to what extent
such additional payment or cost in respect of Employee can be charged directly
to unit of cost as part of direct Employee cost? Of course, in the case of indirect
Employee, all such payments as also the wages paid to them, must be treated as
part of overheads.
But in the case of direct workers, two alternatives are possible. The additional
charges may be treated as overheads. Alternatively, the wage rates being charged
to job may be computed by including such payments; automatically then, such
payments will be charged to the work done alongwith wages of the worker. (It
should be remembered that such wage rate will be only for costing purposes and
not for payment to workers). The total of wages and additional payment should
be divided by effective hours of work to get such wage rates for costing purposes.
ILLUSTRATION 12
A worker is paid `10,000 per month and a dearness allowance of ` 2,000 p.m.
Worker contribution to provident fund is @ 10% and employer also contributes the
same amount as the employee. The Employees State Insurance Corporation
premium is 6.5% of wages of which 1.75% is paid by the employees. It is the firm’s
practice to pay 2 months’ wages as bonus each year.
The number of working days in a year are 300 of 8 hours each. Out of these the worker is
entitled to 15 days leave on full pay. CALCULATE the wage rate per hour for costing
purposes.
SOLUTION
(`)
Wages paid to worker during the year {(` 10,000 +2,000) × 12} 1,44,000
Add: Employer Contribution to:
Provident Fund @ 10% 14,400

E.S.I. Premium @ 4.75% (6.5 – 1.75) 6,840

Bonus at 2 months’ wages (Basic + DA) 24,000
Total 1,89,240
Effective hours per year: 285 days × 8 hours = 2,280 hours

Wage-rate per hour (for costing purpose): ` 1,89,240/2,280 hours = `83
3.9.3 Holiday and leave wages
One alternative to account for wages paid on account of paid holiday and leave
can be to include them as departmental overheads. In such a case, it is necessary
to record such wages separately from “worked for wages”. Such a segregation can
be made possible by providing a separate column in the payroll for holiday and
leave wages in the same way as there are columns for dearness allowance,
provident fund deductions, etc. If, however, a separate or additional column
cannot be provided for this purpose it would be necessary to analyse the payroll
periodically to ascertain how much of the total payment pertains to “worked for
wages” and how much is attributed to leave and holiday wages.
Another way could be to inflate the wage rate for costing purposes to include
holiday and leave wages. This can be done only in the case of direct workers.
ILLUSTRATION 13
CALCULATE the Employee hour rate of a worker X from the following data:
Basic pay ` 10,000 p.m.
D.A. ` 3,000 p.m.
Fringe benefits ` 1,000 p.m.
Number of working days in a year 300. 20 days are availed off as holidays on full pay
in a year. Assume a day of 8 hours.
SOLUTION
(i) Effective working days in a year 300
Less: Leave days on full pay 20
Effective working days 280 days
Total effective working hours (280 days × 8 hours) 2,240
(ii) Total wages paid in a year (`)
Basic pay 1,20,000
D.A. 36,000

Fringe benefits 12,000

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

Efficiency is usually related with performance and may be computed by
comparing the time taken with the standard time allotted to perform the given
job/task.

If the time taken by a worker on a job equals or less than the standard time,
then he is rated efficient.
In case he takes more time than the standard time he is rated as inefficient.
Time allowed as per standard
Efficiency in % = ×100
Time Taken
For efficiency rating of employees the following procedures may be followed:
1. Determining standard time/performance standards: The first step is to
determine the standard time taken by a worker for performing a particular
job/task. The standard time can be determined by using Time & Motion study or
Work study techniques. While determining the standard time for a job/task a
heterogeneous group of workers is taken and contingency allowances are added
for determining standard time.
2. Measuring Actual Performance of workers: For computing efficiency
rating it is necessary to develop a procedure for recording the actual performance
of workers. The system developed should record the output of each worker along
with the time taken by him.
3. Computation of efficiency rating: The efficiency rating of each worker can
be computed by using the above mentioned Formula.
3.10.1 Need for efficiency rating
1. As discussed earlier when a firm follows a system of payment by results, the
payment has a direct relationship with the output given by a worker. The
firm for making payment to worker is required to ascertain his efficiency
level. For instance, under Taylor's differential piece work system the lower
rate i.e. 83% of piece rate is given to a worker when his efficiency rating is
less than 100% and higher rate viz., 125% of piece rate is offered at efficiency
level of either 100% or more. Similarly, under Emersion efficiency plans bonus
is paid at rising scale at various level of efficiency, ranging from 66.67% to
150%.
2. The efficiency rating also helps the management in preparing employee
requirement budget or for preparing manpower requirements.
Example: P Ltd. manufactures two products by using one grade of
employees. The following estimates are available:

Product- A Product- B
Budgeted production (units) 3,480 4,000
Standard hours allowed per product 5 4
It is further worked out that the efficiency rating (efficiency ratio) for productive
hours worked by direct workers in actually manufacturing the production is
80% then the exact standard employee-hours requirement can be worked out
as follows:
Product- A Product- B Total

Budgeted production 3,480 4,000
(units)
Standard hours allowed 17,400 16,000 33,400
for budgeted production (3,480 units × 5 hours) (4,000 units × 4 hours)
Since efficiency ratio is given as 80% therefore standard employee hours

 100 
required for 100% efficiency level is  33, 400 hours×  = 41,750 hours.
 80 
Employee Productivity: Productivity is generally determined by the input/output
ratio. In case of employees, it is calculated as below:
Standard timefor doing actual work
Actual timetaken
Employee productivity is used for measuring the efficiency of individual workers.

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

4. Taking appropriate measures to avoid the situation of excess or shortage of

employees.
5. Carrying out work study for fixation of wages and for the simplification and
standardisation of work.
3.11 EMPLOYEE (LABOUR) TURNOVER

3.11.1 Employee (Labour) Turnover
Employee turnover or labour turnover in an organisation is the rate of
change in the composition of employee force during a specified period
measured against a suitable index.
The standard of usual employee turnover in the industry or locality or the
employee turnover rate for a past period may be taken as the index or norm
against which actual turnover rate is compared.
There are three methods of calculating Employee turnover which are given below:
(i) Replacement Method: This method takes into consideration actual
replacement of employees irrespective of number of persons leaving the
organisation. Employee Turnover under this method is calculated as under:
Number of employees Replaced during the period
×100
Average number of employees during the period on roll
New employees appointed on account of expansion plan of the

organisation are not included in number of replacements.
(ii) Separation Method: In this method employee turnover is measured by
dividing the total number of employees separated during the period by the
average total number of employees on payroll during the same period.
Employee Turnover under this method is calculated as under:
Number of employees Separated during the period
×100
(iii) Flux Method: This method takes both the number of replacements as well
as the number of separations during the period into account for calculation
of employee turnover. Employee Turnover under this method is calculated as
under:

Number of employeesSeparated+
Number of employees Replaced during the period
×100
Employee turnover due to new recruitment: Generally, employees recruited on

account of expansion of an organisation, are not considered for calculation of
employee turnover. But it is considered that the newly recruited employees are
also responsible for changes in the composition or work force. Due to this
feature, some management accountants feel to take new recruitment for
calculating employee turnover.
The total number of workers joining, including replacements, is called
accessions.
When number of accessions are considered for measuring employee turnover, the
employee turnover rate by Flux method may be computed by using any one of
the following expressions:
No. of Separation+ No. of Replacements+No. of new Joinings
×100
Average no. of employees duringthe period on roll
Or
No. of Separations+No. of Accessions
×100
Average no. of employees during the period on roll
Average number of employees during the period is calculated as follows:

No.of employees at begining +No. of employees at end of the period
=
2
Equivalent Employee (Labour) Turnover rate:
If in the above computations, the data given is for a period other than a year, the
employee turnover rate so computed may be converted into equivalent annual
employee turnover rate by using the following formula:
Employee Turnover rate for the period

×365
Number of days inthe period

ILLUSTRATION 14
The Accountant of Y Ltd. has computed employee turnover rates for the quarter ended
31st March, 20X1 as 10%, 5% and 3% respectively under ‘Flux method’, ‘Replacement
method’ and ‘Separation method’ respectively. If the number of workers replaced
during that quarter is 30, FIND OUT the number of workers for the quarter
(i) recruited and joined and (ii) left and discharged and (iii) Equivalent employee
turnover rates for the year.
SOLUTION
Working Note:
Average number of workers on roll (for the quarter):
Employee Turnover rate using Replacement method
No. of replacements
= ×100
Average number of workers on roll
5 30
Or, =
100 Average number of workers on roll
30×100
Or, Average number of workers on roll = = 600
5
(i) Number of workers recruited and joined:
Employee turnover rate (Flux method)
No. of Separations * (S)+No. of Accessions(A)
=
Average number of workers on roll
10 18 *+A  6000 
Or, = Or, A = − 80  = 42
100 600  100 
No. of workers recruited and joined 42.
(ii) Number of workers left and discharged:
Employee turnover rate (Separation method)
No. of Separations(S) 3 S
= × 100 = = Or, S* = 18
Average number of workers on roll 100 600
Hence, number of workers left and discharged comes to 18

(iii) Calculation of Equivalent employee turnover rates:

Employee Turnoverratefor thequarter(s)
= ×4 quarters
Number of quarter(s)
10%
Using Flux method = ×4 = 40%
1
5%
Using Replacement method = ×4 = 20%
1
3%
Using Separation method = ×4 = 12%
1
3.11.2 Causes of Employee (Labour) Turnover:
The reasons for employee turnover in an organisation can be classified under the
following three heads:
(a) Personal Causes;
(b) Unavoidable Causes; and
(c) Avoidable Causes.
(a) Personal causes: All the personal reasons which induce or compel an
employee to leave his job; such causes include the following:
(i) Change of jobs for betterment.
(ii) Premature retirement due to ill health or old age.
(iii) Domestic problems and family responsibilities.
(iv) Discontent over the jobs and working environment.
In all the above cases the employee leaves the organisation at his will and,
therefore, it is difficult to suggest any possible remedy in the first three cases.
But the last one can be overcome by creating conditions leading to a healthy
working environment. For this, officers should play a positive role and make sure
that their subordinates work under healthy working conditions.
(b) Unavoidable Causes: Unavoidable causes are those under which it
becomes obligatory on the part of management to ask one or more of their
employees to leave the organisation; such causes are summed up as listed below:
(i) Seasonal nature of the business;

(ii) Shortage of raw material, power, slack market for the product etc.;
(iii) Change in the plant location;
(iv) Disability, making a worker unfit for work;
(v) Disciplinary measures;
(vi) Marriage (generally in the case of women).
(c) Avoidable Causes: Avoidable causes are those which require the attention
of management on a continuous basis so as to keep employee turnover ratio as
low as possible. The main causes under this case are indicated below:
(1) Dissatisfaction with job, remuneration, hours of work, working conditions, etc.,
(2) Strained relationship with management, supervisors or fellow workers;
(3) Lack of training facilities and promotional avenues;
(4) Lack of recreational and medical facilities;
(5) Low wages and allowances.
Proper and timely management action can reduce the employee turnover
appreciably so far as avoidable causes are concerned.
3.11.3 Effects of Employee (Labour) Turnover:
High employee turnover increases the cost of production in the following ways:
(i) Even flow of production is disturbed;
(ii) Efficiency of new workers is low; productivity of new but experienced workers is
low in the beginning;
(iii) There is increased cost of training and induction;
(iv) New workers cause increased breakage of tools, wastage of materials, etc.
(v) Cost of recruitment and training increases.
Cost of Employees (Labour) Turnover: Two types of costs which are associated
with employee turnover are:
(a) Preventive Costs: The cost incurred to prevent employee turnover or keep
it as lowest as possible. Cost incurred for prevention of employee turnover
includes the following:
(i) Cost of medical benefit provided to the employees;

(ii) Cost incurred on employees’ welfare like pension etc.

(iii) Cost on other benefits with an objective to retain employees.
(b) Replacement Costs: These are the costs which arise due to employee
turnover. If employees leave soon after they acquire the necessary training and
experience of good work, additional costs will have to be incurred on new
workers, i.e., cost of recruitment, training and induction, abnormal breakage and
scrap and extra wages and overheads due to the inefficiency of new workers.
It is obvious that a company will incur very high replacement costs if the rate of
employee turnover is high. Similarly, only adequate preventive costs can keep
Employee turnover at a low level. Each company must, therefore, work out the
optimum level of Employee turnover keeping in view its personnel policies and
the behaviour of replacement cost and preventive costs at various levels of
Employee turnover rates.
ILLUSTRATION 15
The management of B.R Ltd. is worried about their increasing employee turnover in
the factory and before analyzing the causes and taking remedial steps, it wants to
have an idea of the profit foregone as a result of employee turnover in the last year.
Last year sales amounted to ` 83,03,300 and P/V ratio was 20 per cent. The total number
of actual hours worked by the direct employee force was 4.45 lakhs. As a result of the
delays by the Personnel Department in filling vacancies due to employee turnover,
1,00,000 potentially productive hours were lost. The actual direct employee hours included
30,000 hours attributable to training new recruits, out of which half of the hours were
unproductive.
The costs incurred consequent on employee turnover revealed, on analysis, the
following:
Settlement cost due to leaving ` 43,820
Recruitment costs ` 26,740
Selection costs ` 12,750
Training costs ` 30,490
Assuming that the potential production lost as a consequence of employee turnover
could have been sold at prevailing prices, FIND the profit foregone last year on
account of employee turnover.

SOLUTION
Workings:
Computation of productive hours and contribution foregone
Actual hours worked (given) 4,45,000
Less: Unproductive training hours 15,000
Actual productive hours 4,30,000
The potentially productive hours lost are 1,00,000
` 83,03,300
Sales lost for 1,00,000 hours = × 1,00,000 hours = ` 19,31,000
4,30,000 hrs
` 19,31,000
Contribution lost for 1,00,000 hours = ×20 = ` 3,86,200
100
Computation of profit forgone on account of employee turnover
(`)
Contribution foregone (as calculated above) 3,86,200
Settlement cost due to leaving 43,820
Recruitment cost 26,740
Selection cost 12,750
Training costs 30,490
Profit foregone 5,00,000

SUMMARY
Employee Cost: Benefits paid or payable to the employees of an entity, whether
permanent or temporary for the services rendered by them. Employee cost
includes payments made in cash or kind.
Direct Employee (Labour) Cost: Benefits paid or payable to the employees
which can be attributed to a cost object in an economically feasible manner.
Indirect Employee (Labour) Cost: Benefits paid or payable to the employees,
which cannot be directly attributable to a particular cost object in an
economically feasible manner.
Idle Time: The time for which the employer pays but obtains no direct benefit or
for no productive purpose.
Normal Idle Time: Time which cannot be avoided or reduced in the normal
course of business. The cost of normal idle time should be charged to the cost of
production.
Abnormal Idle Time: It arises on account of abnormal causes and should be
charged to Costing Profit and Loss account.
Time Keeping: It refers to recording and keeping of the employees’ attendance
time.
Time Booking: It is basically recording the details of work done and the time
spent by an employee on each job or process.
Overtime: Payment to employees, when an employee works beyond the normal
working hours. Usually overtime has to be paid at double the rate of normal
hours.
Overtime Premium: It’s the amount of extra payment paid to an employee for
extra work.
Employee (Labour) Turnover: It is the rate of change in employee force during a
specified period due to resignation, retirement and retrenchment. If the employee
turnover is high, it’s a sign of instability and may affect the profitability of the
firm.
Employee (Labour) turnover can be measured through the following
methods:
(i) Replacement Method:

Number of employees replaced

×100
Average number of employees on roll
(ii) Separation Method:

Number of employees separated during the year
×100
Average number of employees on rolls during the period
(iii) Flux Method

Number of employees separated+number of employees replacements
×100
Average number of employees on rolls during the period
(iv) Employee turnover due to new recruitment:

Number of new employees joining in a period (excluding replacements)
×100
Average number of employees on the roll in a period
(v) Employee turnover including accessions:

Number of new employees joining in a period (excluding replacements)
×100
Average number of employees on the roll in a period
OR
Number of separations + number of accessions
×100
Average number of employees
Time Rate System: The system of wage payment where wages to an employee is
paid on the basis of time irrespective of production volume.
Straight Piece Work: The system of wage payment where wages is paid on the
basis of number of units produced irrespective of time spent for production.
Calculation takes number of units produced by the employee multiplied by rate
per unit.
Halsey System: Time taken × Time rate + 50% of time saved × Time rate.
Time Saved
Rowan System: Time taken × Rate per hour + × 100 × Time taken ×
Time allowed
Rate per hour

TEST YOUR KNOWLEDGE

1. Idle time is the time under which
(a) Full wages are paid to workers
(b) No productivity is given by the workers
(c) Both (a) and (b)
(d) None of the above
2. Cost of idle time due to non- availability of raw material is
(a) Charged to overhead costs
(b) Charged to respective jobs
(c) Charged to costing profit and loss account
3. Time and motion study is conducted by
(a) Time keeping department
(b) Personal department
(c) Payroll department
(d) Engineering department
4. Identify, which one of the following, does not account for increasing labour
productivity
(a) Job satisfaction
(b) Motivating workers
(c) High labour turnover
(d) Proper supervision and control
5. Labour turnover is measured by
(a) Number of persons replaced/ average number of workers
(b) Numbers of persons separated / number of workers at the beginning of the
year

(c) (Number of persons replaced + number of persons separated)/(number of

persons at the beginning +the number of persons at the end of the year)
6. Labour productivity is measured by comparing
(a) Actual time and standard time
(b) Total output with total man-hours
(c) Added value for the product with total wage cost
(d) All of the above
7. Employee Cost includes
(a) Wages and salaries
(b) Allowances and incentives
(c) Payment for overtime
8. If the time saved is less than 50% of the standard time, then the wages under
Rowan and Halsey premium plan on comparison gives
(a) More wages to workers under Rowan plan than Halsey plan
(b) More wages to workers under Halsey plan than Rowan plan
(c) Equal wages under two plans
9. Standard time of a job is 60 hours and guaranteed time rate is `0.30 per hour.
What is the amount of wages under Rowan plan if job is completed in 48
hours?
(a) ` 16.20
(b) ` 17.28
(c) ` 18.00
(d) ` 14.40
10. Important factors for control of employee cost can be
(a) Time and Motion Study

(b) Control over idle time and overtime

(c) Control over employee turnover
1. DISCUSS the accounting treatment of Idle time and overtime wages.
2. DISCUSS the effect of overtime payment on productivity.
3. STATE the circumstances in which time rate system of wage payment can be
preferred in a factory.
4. DISCUSS the objectives of time keeping & time booking.
5. DISCUSS the two types of cost associated with labour turnover.
6. DESCRIBE briefly, how wages may be calculated under the following systems:
(i) Rowan system
(ii) Halsey system
Practical Questions
1. Mr. A. is working by employing 10 skilled workers. He is considering the
introduction of some incentive scheme - either Halsey Scheme (with 50%
bonus) or Rowan Scheme - of wage payment for increasing the Employee
productivity to cope with the increased demand for the product by 25%. He
feels that if the proposed incentive scheme could bring about an average 20%
increase over the present earnings of the workers, it could act as sufficient
incentive for them to produce more and he has accordingly given this
assurance to the workers.
As a result of the assurance, the increase in productivity has been observed as
revealed by the following figures for the current month:
Hourly rate of wages (guaranteed) `40
Average time for producing 1 piece by one worker at the 2 hours
previous performance (This may be taken as time allowed)
No. of working days in the month 25
No. of working hours per day for each worker 8
Actual production during the month 1,250 units

Required:
(i) CALCULATE effective rate of earnings per hour under Halsey Scheme and
Rowan Scheme.
(ii) CALCULATE the savings to Mr. A in terms of direct labour cost per piece
under the schemes.
2. Wage negotiations are going on with the recognised employees’ union, and
the management wants you as an executive of the company to formulate an
incentive scheme with a view to increase productivity.
The case of three typical workers A, B and C who produce respectively 180,
120 and 100 units of the company’s product in a normal day of 8 hours is
taken up for study.
Assuming that day wages would be guaranteed at ` 75 per hour and the
piece rate would be based on a standard hourly output of 10 units,
CALCULATE the earnings of each of the three workers and the employee
cost per 100 pieces under (i) Day wages, (ii) Piece rate, (iii) Halsey scheme,
and (iv) The Rowan scheme.
Also CALCULATE under the above schemes the average cost of labour for
the company to produce 100 pieces.
ANSWERS/ SOLUTIONS
1. (c) 2. (b) 3. (d) 4. (c) 5. (d) 6. (d)
7. (d) 8. (a) 9. (b) 10. (d)
1. Please refer paragraph 3.5 & 3.6

Practical Questions
1. Working Notes:
1. Total time wages of 10 workers per month:
= No. of working days in the month × No. of working hours per day of
each worker × Hourly rate of wages × No. of workers
= 25 days × 8 hrs. × ` 40 × 10 workers = ` 80,000
2. Time saved per month:
Time allowed per piece to a worker 2 hours
No. of units produced during the month by 10 workers 1,250 pieces
Total time allowed to produce 1,250 pieces (1,250 × 2 hours) 2,500 hours
Actual time taken to produce 1,250 pieces 2,000 hours
Time saved (2,500 hours – 2,000 hours) 500 hours
3. Bonus under Halsey scheme to be paid to 10 workers:
Bonus = (50% of time saved) × hourly rate of wages
= 50/100 × 500 hours × ` 40 = ` 10,000
Total wages to be paid to 10 workers are (` 80,000 + ` 10,000) ` 90,000,
if Mr. A considers the introduction of Halsey Incentive Scheme to
increase the employee productivity.
4. Bonus under Rowan Scheme to be paid to 10 workers:
Time taken
Bonus = × Time saved × hourly rate
Time allowed
2,000hours
= × 500 hours × ` 40 = `16,000
2,500hours
Total wages to be paid to 10 workers are (` 80,000 + ` 16,000)

` 96,000, if Mr. A considers the introduction of Rowan Incentive Scheme
to increase the Employee productivity.
(i). (a) Effective hourly rate of earnings under Halsey scheme:
(Refer to Working Notes 1, 2 and 3)

Total time wages of 10 workers+Total bonus under Halsey scheme

=
Total hours worked
` 80,000 + ` 10,000
= = ` 45
2,000 hours
(b) Effective hourly rate of earnings under Rowan scheme:
(Refer to Working Notes 1, 2 and 4)

Total time wages of 10 workers+ Total bonus under Rowan scheme
=
Total hours worked
` 80,000+`16,000
= = ` 48
2,000 hours
(ii). (a) Saving in terms of direct Employee cost per piece under
Halsey scheme:
(Refer to Working Note 3)
Employee cost per piece (under time wage scheme)
= 2 hours × ` 40 = ` 80.
Employee cost per piece (under Halsey scheme)

Total wages paid under the scheme ` 90,000
= = = ` 72
Total number of units produced 1,250
Saving per piece: (` 80 – ` 72) = ` 8
(b) Saving in terms of direct Employee cost per piece under

Rowan Scheme:
(Refer to Working Note 4)
Employee cost per piece under Rowan scheme

= ` 96,000/1,250 units = ` 76.80
Saving per piece = ` 80 – ` 76.80 = ` 3.20

2. Calculation of earnings under different wage schemes:

(i) Day wages
Worker Day wages (`) Actual Output Labour cost per
(Units) 100 pieces (`)
A 600 180 333.33
B 600 120 500.00
C 600 100 600.00
Total 1,800 400
Average labour cost to produce 100 pieces:
Total wages paid ` 1,800
= × 100 = ×100 = ` 450
Total output 400 units
(ii) Piece rate
Worker Actual Output Piece Wages Labour cost per

(Units) rate (`) earned (`) 100 pieces (`)
A 180 7.50 1,350 750.00
B 120 7.50 900 750.00
C 100 7.50 750 750.00
Total 400 3,000
Average cost of labour for the company to produce 100 pieces:

` 3,000
= ×100 = ` 750
400 units
(iii) Halsey Scheme
Worker Actual Std. Actual Time Bonus Rate Total wages Labour cost
Output time time saved hours per (`) per 100
(Units) (Hrs.) (Hrs.) (Hrs.) (50% of hour pieces (`)
time (`)
saved)
A B C D=B-C E F G=F×(C+D) H=G/A*100
A 180 18 8 10 5 75 975 541.67
B 120 12 8 4 2 75 750 625.00

C 100 10 8 2 1 75 675 675.00
Total 400 2,400
Average cost of labour for the company to produce 100 pieces =

` 2, 400
×100 = `600
400 units
(iv) Rowan Scheme:

Worker Actual Std. Actual Time Bonus Rate Total wages Labour cost
Output time time saved hours* per including per 100
(Units) (Hrs.) (Hrs.) (Hrs.) hour bonus (`) pieces (`)
(`)
A B C D=B-C E F G=F×(C+D) H=G/A*100
A 180 18 8 10 4.44 75 933 518.33
B 120 12 8 4 2.67 75 800 666.67
C 100 10 8 2 1.60 75 720 720.00
Total 400 2,453
TimeSaved
* Bonus hours = ×Actualtime
Std. Time
Average cost of labour for the company to produce 100 pieces

` 2, 453
= ×100 = `613.25
400 units

CHAPTER 4
OVERHEADS –
ABSORPTION COSTING
METHOD
LEARNING OUTCOMES

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

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

OVERHEADS- ABSORPTION COSTING METHOD 4.3
Overheads are incurred not only in the factory of production but also on
administration, selling and distribution.
4.2 CLASSIFICATION OF OVERHEADS

Description Example
By Function
Factory or Manufacturing overhead is (i) Stock keeping expenses,
Manufacturing the indirect cost incurred for (ii) Repairs and maintenance
or Production manufacturing or production of plant, (iii) Depreciation of
Overhead activity in a factory. factory building, (iv) Indirect
Manufacturing overhead labour, (v) cost of primary
includes all expenditures packing (vi) Insurance of plant
incurred from the and machinery etc. Production
procurement of materials to overhead include
the completion of finished administration costs relating
product. to production, factory, works
or manufacturing.
Office and Office and Administrative (i) Salary paid to office
Administrative overheads are expenditures staffs, (ii) Repairs and
Overheads incurred on all activities maintenance of office
relating to general building, (iii) Depreciation of
management and office building (iv) postage
administration of an and stationery, (v) Lease rental
organisation. It includes in case of operating lease (in
formulating the policy, case of finance lease, lease
directing the organisation rental excluding finance cost)
and controlling the (vi) accounts and audit
operations of an undertaking expenses etc.
which is not related directly
to production, selling,
distribution, research or
development activity or
function.
Selling and (i) Selling overhead: expenses (i) Salesmen commission, (ii)
Distribution related to sale of products Advertisement cost, (iii) Sales
Overheads and include all indirect office expenses etc.

expenses in sales
management for the
organisation. (i) Delivery van expenses,
(ii) Distribution overhead: (ii) Transit insurance, (iii)
cost incurred on making warehouse and cold storage
product available for sale in expenses, (iv) secondary
the market. packing expenses etc.
By Nature
Fixed These are the costs which are (i) Salary paid to permanent
Overhead incurred for a period, and employees,
which, within certain output (ii) Depreciation of building
and turnover limits, tend to and plant and equipment, (iii)
be unaffected by fluctuations Interest on capital, (iv)
in the levels of activity Insurance
(output or turnover). They do
not tend to increase or de-
crease with the changes in
output.
Variable These costs tend to vary with (i) Indirect materials, (ii) Power
Overhead the volume of activity. Any and fuel, (iii) lubricants, (iv)
increase in the activity results tools and spares etc.
in an increase in the variable
cost and vice-versa.
Semi-Variable These costs contain both fixed (i) Electricity cost, (ii) water
Overheads and variable components and cost, (iii) telephone and
are thus partly affected by internet expenses etc.
fluctuations in the level of
activity.
By Element
Indirect Materials which do not (i) Stores used for maintaining
materials normally form part of the machines and buildings
finished product (cost object) (lubricants, cotton waste,
are known as indirect bricks etc.) (ii) Stores used by
materials. service departments like
power house, boiler house,
canteen etc.

Indirect Employee costs which cannot (i) Salary paid to foreman and
employee cost be allocated but can be supervisor
apportioned to or absorbed (ii) Salary paid to
by cost units or cost centres administration staff etc.
is known as indirect
employee.
Indirect Expenses other than direct (i) Rates & taxes, (ii) insurance,
expenses expenses are known as (iii) depreciation, (iv)
indirect expenses, that advertisement expenses etc.
cannot be directly,
conveniently and wholly
allocated to cost centres.
By Control
Controllable These are those costs which (i) Materials cost, (ii) wages
costs can be controlled by the and salary, (iii) power and fuel
implementation of etc.
appropriate managerial
influence and proper policies.
Uncontrollable Overhead costs which cannot (i) Rates and taxes, (ii)
costs be controlled by the Depreciation, (iii) Interest on
management even after the borrowings
implementation of
appropriate managerial
influence and proper polices
are known as uncontrollable
costs.
4.2.1 Advantages of Classification of Overheads into Fixed and
Variable
The primary objective of segregating semi-variable expenses into fixed and
variable is to ascertain marginal costs. Besides this, it has the following
advantages also.
(a) Controlling Expenses: The classification of expenses into fixed and variable
components helps in controlling expenses. Fixed costs are generally policy
costs, which cannot be easily reduced. They are incurred irrespective of the
output and hence are more or less non controllable. Variable expenses vary
with the volume of activity and the responsibility for incurring such expenditure

is determined in relation to the output. The management can control these

costs by giving proper allowances in accordance with the output achieved.
(b) Preparation of Budget Estimates: The segregation of overheads into fixed
and variable part helps in the preparation of flexible budget. It enables a firm
to estimate costs at different levels of activity and make comparison with the
actual expenses incurred.
Suppose in October, 20X8 the output of a factory was 1,000 units and the
expenses were:
(`)
Fixed 5,00,000
Variable 4,00,000
Semi-variable (40% fixed) 6,00,000
15,00,000
In November, 20X8 the output was likely to increase to 1,200 units. In that case
the budget or estimate of expenses will be:
(`)
Fixed 5,00,000
 ` 4,00,000 ×1,200 units 
Variable   4,80,000
 1,000 units 
Semi-variable
Fixed, 40% of ` 6,00,000 2,40,000
 ` 3,60,000 ×1,200 units 

Variable :   4,32,000
 1,000 units 
16,52,000
It would be a mistake to think that with the output going up from 1,000 units
to 1,200 units the expenses would increase proportionately to `18,00,000. This
would be wrong budgeting.
(c) Decision Making: The segregation of semi variable cost between fixed and
variable overhead also helps the management to take many important
decisions. For example, decisions regarding the price to be charged during

depression or recession or for export market. Likewise, decisions on make or

buy, shut down or continue, etc., are also taken after separating fixed costs
from variable costs.
In fact, when any change is contemplated, say, increase or decrease in production,
change in the process of manufacture or distribution, it is necessary to know the
total effect on cost (or revenue) and that would be impossible without a correct
segregation of fixed and variable costs. The technique of marginal costing, cost
volume profit relationship and break-even analysis are all based on such
segregation.
4.3 ACCOUNTING
4 AND CONTROL OF
MANUFACTURING OVERHEADS
We have already seen that overheads are by nature those costs which cannot be
directly related to a product or to any other cost unit. Yet for working out the
total cost of a product or a unit of service, the overheads must be included. Thus
we have to find out a way by which the overheads can be distributed over the
various units of production.
One method of working out the distribution of overheads over the various
products could be to ascertain the amount of actual overheads and distribute
them over the products. This however, creates a problem since the actual amount
of overheads can be known only after the financial accounts are closed. If we wait
that long, the cost sheets lose their main advantages and utility to the
management. All the decisions for which cost sheets are prepared are immediate
decisions and cannot be postponed till the actual overheads are known.
Therefore, some method has to be found by which overheads can be included in
the cost of the products, as soon as prime cost, the cost of raw materials, direct
employees and other direct expenses, is ascertained.
One method is to work out pre-determined rates for absorbing overheads.
These rates are worked out before an accounting period begins by estimating the
amount of overheads and the level of activity in the ensuing period. Thus, as soon
as the prime cost of a product or a job is available, the various overheads are
charged by these rates. Of course, this implies that the overheads are charged on
an estimated basis. Later, when the actual overheads are known, the difference
between the overheads charged to the products and actual overheads is worked
out and adjusted.

Manufacturing Overheads: Generally manufacturing overheads form a

substantial portion of the total overheads. It is important, that such overheads
should be properly absorbed over the cost of production. The following
procedure may be adopted in this regard. The steps given below shows how
factory overhead rates are estimated and overheads absorbed on that basis and
the last one shows how actual are compared with the absorbed amount.
(Students should carefully note the distinction between the various terms used).
1. Estimation and collection of manufacturing overheads: The first stage is

to estimate the amount of overheads, keeping in view the past figures and
adjusting them for known future changes. The sources available for the collection
of factory overheads may include(a) Invoices, (b) Stores requisition, (c) Wage
analysis book (d) Journal entries. etc.
2. Assignment of Manufacturing Overheads: The guiding principle for
assignment of manufacturing overheads to a cost object is the traceability of the
overheads in an economically feasible manner.
Assignment of the manufacturing overhead is done on the basis of either of the
following two principles:
(i) Cause and Effect: Cause is the process or operation or activity and effect is
the incurrence of cost.
(ii) Benefit received: Manufacturing overheads are to be apportioned to
various cost objects in proportion to the benefits received by them.
(a) Cost Allocation: The term ‘allocation’ refers to the direct assignment of
cost to a cost object which can be traced directly. It implies relating overheads
directly to the various departments. The estimated amount of various items of
manufacturing overheads should be allocated to various cost centres or
departments. For example- if a separate power meter has been installed for a
department, the entire power cost ascertained from the meter is allocated to that
department. The salary of the works manager cannot be directly allocated to any
one department since he looks after the whole factory. It is, therefore, obvious
that many overhead items will remain unallocated after this step.
(b) Cost Apportionment: There are some items of estimated overheads (like
the salary of the works manager) which cannot be directly allocated to the various
departments and cost centres. Such unallocable expenses are to be spread over
the various departments or cost centres on the basis of two principles. This is

called apportionment. Thus apportionment implies “the allotment of proportions

of items of cost to cost centres or departments”. After this stage, all the overhead
costs would have been either allocated to or apportioned over the various
departments.
(c) Re-apportionment: Upto the last stage all overheads are allocated and
apportioned to all the departments- both production and service departments.
Service departments are those departments which do not directly take part
in the production of goods or providing services. Such departments provide
auxiliary services across the entity and renders services to other cost centres and
in some cases to outside parties. Examples of such departments are engineering,
quality control and assurance, laboratory, canteen, stores, time office, dispensary
etc. The overheads of these departments are to be shared by the production
departments since service departments operate primarily for the purpose of
providing services to production departments. The process of assigning service
department overheads to production departments is called reassignment or
re-apportionment. At this stage, all the factory overheads are collected under
production departments.
3. Absorption: After completing the distribution as stated above the overheads
charged to department are to be recovered from the output produced in respective
departments. This process of recovering overheads of a department or any other
cost center from its output is called recovery or absorption.
Absorption of manufacturing overheads shall be as follows:
(i) Variable Manufacturing overheads: The variable manufacturing overheads
shall be absorbed on the basis of actual production.
(ii) Fixed Manufacturing overheads: The fixed manufacturing overhead shall
be absorbed on the basis of normal capacity.
The overhead expenses can be absorbed by estimating the overhead (as assigned
above) and then working out an absorption rate. When overheads are estimated,
their absorption is carried out by adopting a pre-determined overhead absorption
rate. This rate can be ca
lculated by using any one method as discussed in this chapter at the end.
As the actual accounting period begins, each unit of production automatically
absorbs a certain amount of factory overheads through pre-determined rates.
During the year a certain amount will be absorbed over the various products. This
is known as the total amount of absorbed overheads.

4. Treatment of over and under absorption of overheads: After the year

end the total amount of actual factory overheads is known. There is bound to be
some difference between the actual amount of overheads and the absorbed
amount of overheads. So the overheads are generally either under-absorbed or
over-absorbed. The difference has to be adjusted keeping in view of such
differences and the reasons therefore.
Students will thus see that the whole discussion as above is meant to serve the
following two purposes:
(a) to charge various products and services with an equitable portion of the total
amount of factory overheads; and
(b) to charge factory overheads immediately as the product or the job is
completed without waiting for the figures of actual factory overheads.
4.4 STEPS FOR THE DISTRIBUTION OF

OVERHEADS
The various steps for the distribution of overheads have been discussed in detail
as below:
4.4.1 Estimation and Collection of Manufacturing Overheads
The amount of factory overheads is required to be estimated. The estimation is
usually done with reference to past data adjusted for known future changes. The
overhead expenses are usually collected through a system of standing
orders.
Standing Orders: In every manufacturing business, expenses are incurred on
direct materials and direct labour in respect of several jobs or other units of
production, manufacture of which is undertaken. The incurring of these expenses
is authorised by production orders or work orders. The work order numbers are
not ordinarily fixed or permanent. They are generally allotted in a serial order
according to the number of manufacturing jobs undertaken by the business. In
addition, indirect expenses are incurred in connection with the rendering of
services to the production departments, or to the manufacturing process. The
term “Standing Order” denotes sanction for indirect expenses under various heads
of expenditure.
In large factories, usually the classification of indirect expenditures is combined
with a system of Standing Orders (sometimes also referred as Service “Orders”). It

is a system under which a number is allotted to each item of expense for the
purpose of identification, and the same is continued from year to year. All the
indirect expenditure in such a case, is charged to one or the other of the Standing
Orders and periodical summaries, giving total of each Standing Order, are
prepared for comparison with budgets, as well as for apportioning them among
the various departments. The extent of such analysis and the nomenclature
adopted are settled by the management according to the needs of the industry.
4.4.2 Allocation of Overheads over various Departments or
Departmentalisation of Overheads
Most of the manufacturing processes functionally are different and are performed
by different departments in the factory. Where such a division of functions had
been made, some of the departments should be engaged in actual production of
goods, and others in providing services ancillary thereto. At this stage, the factory
overheads which can be directly related to the various production or service
departments are allocated in this manner.
It may, sometime, become necessary to sub-divide a manufacturing organisation
into several cost centres, so that a closer distribution of expenses and a more
detailed control is practicable.
It is thus obvious that the principal object of setting up cost centres is to collect
data, in respect of similar activities more conveniently. This avoids a great deal of
cost analysis. When costs are collected by setting up cost centres, several items
can be ascertained definitely and the element of estimation is reduced
considerably. For instance, the allowance of the normal idle time or the amount to
be spent on consumable stores, etc. There are two main types of cost centres -
machine or personal - depending on whether the process of manufacture is
carried on at a centre by man or machine. For the convenience of recording of
expenditure, cost centres are sometimes allotted a code number.
Advantages of Departmentalisation: The collection of overheads department
wise gives rise to the following advantages:
(a) Better Estimation of Expenses: Some expenses which relate to the
departments will be estimated almost on an exact basis and, to that extent,
the accuracy of estimation of overheads will be higher.
(b) Better Control: For the purpose of controlling expenses in a department, it is
obviously necessary that the figures in relation to each department should
be separately available. It is one of the main principles of control that one

should know for each activity how much should have been spent and how
much is actually spent. If information about expenses is available only for
factory as a whole, it will not be possible to know which department has
been over spending.
(c) Ascertainment of Cost for each department: From the point of view of
ascertaining the cost of each job, the expenses incurred in the departments
through which the job or the product has passed should be known. It is only
then that the cost of the job or the product can be charged with the
appropriate share of indirect expenses. It is not necessary that a job must
pass through all the departments or that the work required in each
department should be the same for all jobs. It is, therefore, necessary that
only appropriate charge in respect of the work done in the department is
made. This can be done only if overheads for each department are known
separately.
(d) Suitable Method of Costing: A suitable method of costing can be followed
differently for each department e.g., batch costing when a part is manu-
factured, but single or output costing when the product is assembled.
4.4.3 Apportioning overhead expenses over various departments
After the allocable overheads are related to the departments, expenses incurred
for several departments have to be apportioned over each department, e.g. rent,
power, lighting, insurance and depreciation. For distributing these overheads over
different departments benefiting thereby, it is necessary at first to determine the
proportion of benefit received by each department and then distribute the total
expenditure proportionately on that basis. But the same basis of apportionment
cannot be followed for different items of overheads since the benefit of service to
a department in each case has to be measured differently. Some of the bases that
may be adopted for the apportionment of expenses are stated below:
Overhead Cost Bases of Apportionment

1. (i) Rent and other building Floor area, or volume of department
expenses
(ii) Lighting and heating
(conditioning)
(iii) Fire precaution service
(iv) Air- conditioning
2. (i) Perquisites Number of workers

(ii) Labour welfare expenses

(iii) Time keeping
(iv) Personnel office
(v) Supervision
3. (i) Compensation to workers Direct wages
(ii) Holiday pay
(iii) ESI and PF contribution
(iv) Perquisites
4. General overhead Direct labour hour, or Direct wages, or
Machine hours.
5. (i) Depreciation of plant and Capital values
machinery
(ii) Repairs and maintenance
of plant and machinery
(iii) Insurance of stock
6. (i) Power/steam Technical estimates
consumption
(ii) Internal transport
(iii) Managerial salaries
7. Lighting expenses (light) No. of light points, or Area or Metered
units
8. Electric power (machine Horse power of machines, or Number
operation) of machine hour, or value of machines
or units consumed.
9. (i) Material handling Weight of materials, or volume of
(ii) Stores overhead materials, or value of materials or unit
of materials.
Some other basis of apportioning overhead costs: We have considered already

that the benefit received by the department generally is the principal criterion on
which the costs of service departments or common expenses are apportioned. But
other bases of apportionments which may be used are mentioned below:
(a) Analysis or survey of existing conditions.
(b) Ability to pay.

(c) Efficiency or incentive.

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

On the other hand, apportionment deals with the proportions of an item of

cost for example; the cost of the benefit of a service department will be divided
between those departments which has availed those benefits.
(2) Allocation is a direct process of charging expenses to different cost centres
whereas apportionment is an indirect process because there is a need for the
identification of the appropriate portion of an expense to be borne by the
different departments benefited.
(3) The allocation or apportionment of an expense is not dependent on its nature,
but the relationship between the expense and the cost centre decides that
whether it is to be allocated or apportioned.
(4) Allocation is a much wider term than apportionment.
4.4.4 Re-apportioning service department overheads over production
department
The re-apportionment of the service department cost to the production
department is known as secondary distribution. The suggestive bases that may be
adopted for re-apportionment are given below:
Cost of the Service Departments: Basis

1. Maintenance and Repair shop Direct labour hours, Machine hours,
2. Planning and progress Direct labour wages, Asset value x
3. Tool room Hours worked
4. Canteen and Welfare No of direct workers

5. Hospital and Dispensary No. of employees etc.
6. Personnel Department
7. Time-keeping No. of card punched, No. of employees
8. Computer Section Computer hours, Specific allocation to
departments
9. Power House (electric lighting Floor area, Cubic content, No. of
cost) electric Points, Wattage.
10. Power House (electric power cost) Horse power, Kwh, Horse power ×
Machine hours, Kwh × Machine hours
11. Stores Department No. of requisitions, Weight or value of
Materials issued.

12. Transport Department Crane hours, Truck hours, Truck

mileage, Truck tonnage, Truck ton-
hours, Tonnage handled. No. of
packages of Standard size
13. Fire Protection Capital values
14. Inspection Inspection hours
Notes:
(1) Repairs included in repairs shop cost, building maintenance cost included in
maintenance shop cost etc. should be apportioned on the basis of capital
values.
(2) Economy, practicability, equitability and reliability are the matters of
consideration for selection of the base.
Methods for Re-apportionment: The re-apportionment of service department
expenses over the production departments may be carried out by using any one
of the following methods:
(i) Direct re-distribution method.
(ii) Step method of secondary distribution or non-reciprocal method.
(iii) Reciprocal Service method.
Direct re-distribution
method
Methods for Re- Step method or non- Simultaneous Equation

apportionment reciprocal method. method
Reciprocal Service
Trial and error method
method.
Repeated distribution
method
(i) Direct Re-Distribution Method: Service department costs under this method
are apportioned over the production departments only, ignoring the services
rendered by one service department to the other. To understand the applications
of this method, go through the illustration which follows.

ILLUSTRATION 1
XL Ltd., has three production departments and four service departments. The expenses
for these departments as per Primary Distribution Summary are as follows:
Production Departments: (`) (`)
A 30,00,000
B 26,00,000
C 24,00,000 80,00,000
Service Departments: (`) (`)
Stores 4,00,000
Time-keeping and Accounts 3,00,000
Power 1,60,000
Canteen 1,00,000 9,60,000
The following information is also available in respect of the production departments:

Dept. A Dept. B Dept. C
Horse power of Machine 300 300 200
Number of workers 20 15 15
Value of stores requisition in (`) 2,50,000 1,50,000 1,00,000
PREPARE a statement apportioning the costs of service departments over the

SOLUTION
Secondary Overhead Distribution Statement
Items of cost Basis of Total Production Departments
(as per primary apportionment (`) A (`) B (`) C (`)
distribution
summary)
Cost as per 80,00,000 30,00,000 26,00,000 24,00,000
primary
distribution
summary
Stores (5:3:2) Value of Store 4,00,000 2,00,000 1,20,000 80,000
requisition

Time-keeping and No. of workers 3,00,000 1,20,000 90,000 90,000

Accounts (4:3:3)
Power (3:3:2) H.P. of Machine 1,60,000 60,000 60,000 40,000
Canteen (4:3:3) No. of workers 1,00,000 40,000 30,000 30,000
89,60,000 34,20,000 29,00,000 26,40,000
(ii) Step Method or Non-reciprocal method: This method gives cognizance to
the services rendered by service department to another service department.
Therefore, as compared to previous method, this method is more complicated
because a sequence of apportionments has to be selected here. The sequence here
begins with the department that renders maximum number of services to the
other service department(s). In other words, the cost of the service department
that serves the largest number of services to the other service department(s) and
production department(s) is distributed first. After this, the cost of service
department serving the next largest number of departments is apportioned.
This process continues till the cost of last service department is apportioned. The cost
of last service department is apportioned among production departments only.
Some authors are of the view that the cost of service department with largest
amount of cost should be distributed first.
ILLUSTRATION 2
Suppose the expenses of two production departments A and B and two service
departments X and Y are as under:
Amount (`) Apportionment Basis
Y A B
X 2,00,000 25% 40% 35%
Y 1,50,000 — 40% 60%
A 3,00,000
B 3,20,000
SOLUTION
Summary of Overhead Distribution
Departments X (`) Y (`) A (`) B (`)
Amount as given above 2,00,000 1,50,000 3,00,000 3,20,000
Expenses of X Dept. (2,00,000) 50,000 80,000 70,000
apportioned over Y, A

and B Dept. in the ratio

(5:8:7)
2,00,000 3,80,000 3,90,000
Expenses of Y Dept. - (2,00,000) 80,000 1,20,000
apportioned over A and
B Dept. in the ratio (2:3)
Total Nil Nil 4,60,000 5,10,000
(iii) Reciprocal Service Method: This method recognises the fact that where there
are two or more service departments they may render services to each other and,
therefore, these inter-departmental services are to be given due weight while re-
distributing the expenses of the service departments.
The methods available for dealing with reciprocal services are:
(a) Simultaneous equation method;
(b) Trial and error method;
(c) Repeated distribution method.
(a) Simultaneous Equation Method:
According to this method firstly, the costs of service departments are ascertained.
These costs are then re-distributed to production departments on the basis of
given percentages. (Refer to the following illustration to understand the method)
ILLUSTRATION 3
Service departments’ expenses
( `)
Boiler House 3,00,000
Pump Room 60,000
3,60,000
The allocation is :
Production Departments Boiler House Pump Room
A B
Boiler House 60% 35% – 5%
Pump Room 10% 40% 50% –

SOLUTION
The total expenses of the two service departments will be determined as follows:
Let B stand for Boiler House expenses and P for Pump Room expenses.
Then
B = 3,00,000 + 1/2 P
P = 60,000 + 1/20 B
Substituting the value of B,
P = 60,000 + 1/20 (3,00,000 + 1/2 P)
= 60,000 + 15,000 + 1/40 P
= 75,000 + 1/40 P
40 P = 30,00,000 + P
39 P = 30,00,000
P = `76,923
The total of expenses of the Pump Room are `76,923 and that of the Boiler House
is `3,38,462 i.e., `3,00,000 + 1/2 × ` 76,923.
The expenses will be allocated to the production departments as under:
Production departments: A B
(`) (`)
Boiler House (60% and 35% of ` 3,38,462) 2,03,077 1,18,462
Pump Room (10% and 40% of ` 76,923) 7,692 30,769
Total 2,10,769 1,49,231
The total of expenses apportioned to A and B is ` 3,60,000.
(b) Trial and Error Method:
According to this method the cost of one service cost centre is apportioned to
another service cost centre. The cost of another service centre plus the share
received from the first cost centre is again apportioned to the first cost centre.
This process is repeated till the amount to be apportioned becomes negligible,
that means repeated distribution method is followed to the extent of service
departments only. All apportioned amounts for each service cost centre are

added to get the total apportioned cost. These total service cost centre costs are
redistributed to the production departments. Trial and error method and
Simultaneous equation method gives the same result. (Refer to the following
illustration to understand this method.)
ILLUSTRATION 4
Sanz Ltd., is a manufacturing company having three production departments, ‘A’, ‘B’ and
‘C’ and two service departments ‘X’ and ‘Y’. The following is the budget for December 20X3:
Total (`) A (` ) B (`) C (`) X (` ) Y (` )
Direct material 1,00,000 2,00,000 4,00,000 2,00,000 1,00,000

Direct wages 5,00,000 2,00,000 8,00,000 1,00,000 2,00,000
Factory rent 4,00,000
Power 2,50,000
Depreciation 1,00,000
Other overheads 9,00,000
Additional information:
Area (Sq. ft.) 500 250 500 250 500
Capital value of assets 20 40 20 10 10
(` lakhs)
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25
A technical assessment of the apportionment of expenses of service departments is as

under:
A B C X Y
Service Dept. ‘X’ (%) 45 15 30 – 10

Service Dept. ‘Y’ (%) 60 35 – 5 –
Required:
(i) PREPARE a statement showing distribution of overheads to various departments.
(ii) PREPARE a statement showing re-distribution of service departments expenses to
production departments using Trial and error method.

SOLUTION
(i) Overhead Distribution Summary
Basis Total (`) A (`) B (`) C (`) X (`) Y (`)

Direct Direct – – – – 2,00,000 1,00,000
materials
Direct wages Direct – – – – 1,00,000 2,00,000
Factory rent Area 4,00,000 1,00,000 50,000 1,00,000 50,000 1,00,000
Power H.P. × 2,50,000 50,000 80,000 80,000 15,000 25,000
Machine
Hrs.
Depreciation Capital 1,00,000 20,000 40,000 20,000 10,000 10,000
value
Other Machine 9,00,000 1,00,000 2,00,000 4,00,000 1,00,000 1,00,000
overheads hrs.
16,50,000 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
(ii) Redistribution of Service Department’s expenses:
Service Departments
X (`) Y (`)
Overheads as per primary distribution 4,75,000 5,35,000
(i) Apportionment of Dept-X expenses to Dept-Y
--- 47,500
(10% of ` 4,75,000)
--- 5,82,500
(ii) Apportionment of Dept-Y expenses to Dept-X
29,125 ---
[5% of (` 5,35,000 + ` 47,500)]
(i) Apportionment of Dept-X expenses to Dept-Y
--- 2,913
(10% of ` 29,125)
(ii) Apportionment of Dept-Y expenses to Dept-X
146 ---
(5% of ` 2,913)
Total 5,04,271 5,85,413

Distribution of Service departments’ overheads to Production departments

Production Departments
A (`) B (`) C (`)
Overhead as per primary distribution 2,70,000 3,70,000 6,00,000
Dept- X (90% of ` 5,04,300) 2,26,900 75,600 1,51,300
Dept- Y (95% of ` 5,85,400) 3,51,300 2,04,900 ---
8,48,200 6,50,500 7,51,300
(c) Repeated Distribution Method:
Under this method, service departments’ costs are distributed to other service
and production departments on agreed percentages and this process continues
to be repeated, till the figures of service departments are either exhausted or
reduced to too small a figure. (Refer to the following illustration to understand
this method)
ILLUSTRATION 5
PH Ltd., is a manufacturing company having three production departments, ‘A’, ‘B’
and ‘C’ and two service departments ‘X’ and ‘Y’. The following is the budget for
December 20X8:
Total (`) A (`) B (`) C (`) X (`) Y (`)
Direct material 1,00,000 2,00,000 4,00,000 2,00,000 1,00,000
Direct wages 5,00,000 2,00,000 8,00,000 1,00,000 2,00,000
Factory rent 4,00,000
Power 2,50,000
Other overheads 9,00,000
Area (Sq. ft.) 500 250 500 250 500
Capital value of assets 20 40 20 10 10
(` lakhs)
Machine hours 1,000 2,000 4,000 1,000 1,000
Horse power of machines 50 40 20 15 25
A technical assessment of the apportionment of expenses of service departments is as

under:

A B C X Y
Service Dept. ‘X’ (%) 45 15 30 – 10

Service Dept. ‘Y’ (%) 60 35 – 5 –
Required:
(i) PREPARE a statement showing distribution of overheads to various departments.
(ii) PREPARE a statement showing re-distribution of service departments expenses to
(iii) CALCULATE machine hour rates of the production departments ‘A’, ‘B’ and ‘C’.
SOLUTION
(i) Overhead Distribution Summary
Basis Total (`) A (`) B (`) C (`) X (`) Y (`)

Direct Direct – – – – 2,00,000 1,00,000
materials
Direct wages Direct – – – – 1,00,000 2,00,000
Factory rent Area 4,00,000 1,00,000 50,000 1,00,000 50,000 1,00,000
Power H.P. × 2,50,000 50,000 80,000 80,000 15,000 25,000
Machine
Hrs.
Depreciation Capital 1,00,000 20,000 40,000 20,000 10,000 10,000
value
Other Machine 9,00,000 1,00,000 2,00,000 4,00,000 1,00,000 1,00,000
overheads hrs.
16,50,000 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
(ii) Redistribution of Service Department’s expenses
A (`) B (`) C (`) X (`) Y (`)

Total overheads 2,70,000 3,70,000 6,00,000 4,75,000 5,35,000
Dept. X overhead apportioned 2,13,750 71,250 1,42,500 (4,75,000) 47,500
in the ratio (45:15:30: —:10)
Dept. Y overhead apportioned 3,49,500 2,03,875 − 29,125 (5,82,500)
in the ratio (60:35: —:5: —)

Dept. X overhead apportioned 13,106 4,369 8,738 (29,125) 2,912

in the ratio (45:15:30: —:10)
Dept. Y overhead apportioned 1,747 1,019 − 146 (2,912)
in the ratio (60:35: —:5: —)
Dept. X overhead apportioned 65 22 44 (146) 15
in the ratio (45:15:30: —:10)
Dept. Y overhead apportioned 9 6 - - (15)
in the ratio (60:35: —:5: —)
8,48,177 6,50,541 7,51,282 − −
(iii) Machine hour rate:
A B C
A Total overheads (`) 8,48,177 6,50,541 7,51,282
B Machine hours 1,000 2,000 4,000
C Machine hour rate (`) [A ÷ 848.18 325.27 187.82
B]
4.4.5 Absorbing overheads over cost units, products, etc.
Collection of the figure of overheads for the factory as a whole or for various
departments is not enough. It is clearly necessary to ascertain how much of the
overheads is to be debited to the cost of the various jobs, products etc. This process
is called absorbing the overhead to cost units. We take up below the various
implications of this process. However, if only one uniform type of work is done,
the task is easy and under such a situation the overhead expenses to be absorbed
may be calculated by dividing actual overheads by the number of units of work
done or estimated overheads by the estimated output.
4.5 METHODS OF ABSORBING OVERHEADS TO

VARIOUS PRODUCTS OR JOBS
The method selected for charging overheads to products or jobs should be such
as will ensure:
(i) that the total amount charged (or recovered) in a period does not differ
materially from the actual expenses incurred in the period. and

(ii) that the amount charged to individual jobs or products is equitable. In case of
factory overhead, this means:
(a) that the time spent on completion of each job should be taken into
consideration;
(b) that a distinction should be made between jobs done by skilled workers
and those done by unskilled workers. and
(c) that jobs done by manual labour and those done by machines should be
distinguished.
In addition, the methods should be capable of being used conveniently; and yield
uniform result from period to period as far as possible; any change that is
apparent should reflect a change in the underlying situation such as substitution
of human labour by machines.
Several methods are commonly employed either individually or jointly for
computing the appropriate overhead rate. The more common of these are:
(1) Percentage of direct materials,
(2) Percentage of prime cost,
(3) Percentage of direct labour cost,
(4) Labour hour rate,
(5) Machine hour rate and
(6) Rate per unit of Output
4.5.1 Percentage of Direct material cost
Under this method, the cost of direct material consumed is the base for calculating the
amount of overhead absorbed. This overhead rate is computed by the following
formula:
Total Production Overheads of a Department
Overhead rate = ×100
Budgeted Direct Material cost of all products
4.5.2 Percentage of Prime cost method

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


Prime cost
Example for the above two methods:

Suppose for a given period, actual figures are estimated as follows:
`
Direct materials 2,00,000
Direct labour 1,00,000
Factory overheads 90,000
The percentage of factory overheads to direct materials will be 45%, to prime cost
30%. If, on a job, material cost is ` 10,000 and direct labour is `7,000 the cost,
after absorbing factory overhead, will be as follows :
(i) ` 17,000 + 45% ` 10,000 or ` 21,500,
(ii) ` 17,000 + 30% ` 17,000 or ` 22,100, and
One can see how, with a different method, the works cost comes out to be
different. Of these methods, the first and second are generally considered to be
unsuitable on account of the following reasons:
(i) Manufacturing overhead expenses are mostly a function of time i.e., time is the
determining factor for the incurrence and application of manufacturing
overhead expenses. That they are so would be clear if we recall that overhead
expenses, specially manufacturing expenses, can in the ultimate analysis be
regarded as expenditure incurred in providing the necessary facilities and
service to workers employed in the productive process. The question of
facilities and service made available to workers naturally is dependent on the
length of time during which workers make use of the facilities. It may,
therefore, be said that the job or product on which more time has been spent
would entail larger manufacturing expenses than the job requiring less time. The
factor is ignored altogether by the first method and largely by the second
method.
(ii) Overheads are neither related to the prime cost nor to direct material cost
except to a very small extent. Thus, if the percentage of material cost is used
when there are two jobs requiring the same operational time but using

material having varying prices, their manufacturing overhead cost would be

different whereas this should not normally be so.
The method of absorbing overhead costs on the basis of prime cost also does
not take into consideration the time factor. The fact that the amount includes
labour cost in addition to material cost does not render the prime cost to be
more suitable; infact, the results are liable to be more misleading because of
the cumulative error of using both the labour and material cost as the basis of
allocation of overhead expenses, on neither of which they are already
dependent.
(iii) Since material prices are prone to frequent and wide fluctuations, the
manufacturing overheads, if based on material cost or prime cost, also would
fluctuate violently from period to period.
(iv) The skill of the workers involved and whether machines were used or not, are
ignored when these methods are used.
Percentage of materials cost may, however, be used for the limited purpose of
absorbing material handling and store overheads.
4.5.3 Percentage of direct labour cost
Formula to be used under this method is-
Direct Labour Cost Percentage Rate

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

4.5.4 Labour hour rate

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

Direct Labour Hour Rate = ×100
4.5.5 Machine hour rate Direct Labour Hour
4.5.5 Machine hour rate

Machine hour rate implies, cost of running a machine for an hour to produce
goods. There are two methods of computing machine hour rates:
(i) Direct Machine hour rate: According to the first method, only the expenses
directly or immediately connected with the operation of the machine are taken into
account e.g., power, depreciation, repairs and maintenance, insurance, etc. The
rate is calculated by dividing the estimated total of these expenses for a period by
the estimated number of operational hours of the machines during the period.
(ii) Comprehensive Machine hour rate: It will be obvious, however, that in
addition to the expenses stated above there may still be other manufacturing
expenses such as supervision charges, shop cleaning and lighting, consumable
stores and shop supplies, shop general labour, rent and rates, etc. incurred for the
department as a whole and, hence, not charged to any particular machine or
group of machines. In order to see that such expenses are not left out of
production costs, one should include a portion of such expenses to compute the
machine hour rate. Alternatively, the overheads not directly related to machines
may be absorbed on the basis of Productive Labour Hour Rate Method or any
other suitable method.

Note: Some people even prefer to add the wages paid to the machine operator in
order to get a comprehensive rate of working a machine for one hour.
By the machine hour rate method, manufacturing overhead expenses are charged
to production on the basis of number of hour machines are used on jobs or work
orders. Here each machine or group of machines are treated as a cost centre.
Overheads apportioned to a production department is further apportioned to
machines or group of machines. These apportioned costs are divided by the
estimated productive machine hour to get machine hour rate.
The steps involved in determining of Machine hour rate is as follows:
Step1: Calculate total of overheads apportioned to a production department (as

discussed earlier in this chapter)
Step 2: Apportion further these overheads to machines or group of machines in

the department.
Step 3: Allocate machine specific costs (directly identifiable with the machine)
Step 4: Estimate total productive hours for the machine
Step 5: Aggregate overheads as apportioned in step-2 and allocated in step-3

and divide it by Estimated total productive hours
Step 6: The resultant figure is machine hour rate

The above costs are further divided into fixed cost or standing charges and variable
cost. Costs which remain constant irrespective of operation machine are treated as
fixed cost or standing charges. Examples of fixed cost include insurance premium
for machine, rent for premises, supervisor’s salary, depreciation (if relates to
effluxion of time) etc.
Costs which vary with the operation of the machine are treated as variable cost.
Examples of variable cost include cost for power, cost for consumables (lubricants,
oils etc.), repairs and maintenance, depreciation (if it relates to activity) etc.
Advantages and disadvantages of Machine hour rate:
(1) Where machines are the main (1) Additional data concerning the
factor of production, it is usually operation time of machines, not
the best method of charging otherwise necessary, must be
machine operating expenses to recorded and maintained.
production. (2) As general department rates for
(2) The under-absorption of all the machines in a depart-
machine overheads would ment may be suitable, the
indicate the extent to which the computation of a separate
machines have been idle. machine hour rate for each
(3) It is particularly advantageous machine or group of machines
where one operator attends to would mean further additional
several machines (e.g. automatic work.
screw manufacturing machine),
or where several operators are
engaged on the machine e.g.
the belt press used in making
conveyer belts.
4.5.6 Rate per unit of output method

This is the simplest of all the methods. In this method overhead rate is determined by
the following formula:
Amount of overheads
Overheads Rate=
Number of units

4.6 TYPES OF OVERHEAD RATES

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

Normal overhead Rate =
Actual base
2. Pre-determined Overhead Rate: This rate is determined in advance by

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

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

This overhead rate is computed as follows:

Total overheads for the factory
Blanket Rate =
Total number of units of base for the factory
A blanket rate should be applied in the following cases:

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

Departmental overhead Rate =
Corresponding base
ILLUSTRATION 6
A Ltd., manufactures two products A and B. The manufacturing division consists of
two production departments P1 and P2 and two service departments S1 and S2.
Budgeted overhead rates are used in the production departments to absorb factory
overheads to the products. The rate of Department P1 is based on direct machine
hours, while the rate of Department P2 is based on direct labour hours. In applying
overheads, the pre-determined rates are multiplied by actual hours.
For allocating the service department costs to production departments, the basis
adopted is as follows:
(i) Cost of Department S1 to Department P1 and P2 equally, and
(ii) Cost of Department S2 to Department P1 and P2 in the ratio of 2 : 1 respectively.

The following budgeted and actual data are available:

Annual profit plan data:
Factory overheads budgeted for the year:
Departments P1 25,50,000 S1 6,00,000
P2 21,75,000 S2 4,50,000
Budgeted output in units:

Product A 50,000; B 30,000.
Budgeted raw-material cost per unit:
Product A ` 120; Product B ` 150.
Budgeted time required for production per unit:
Department P1 : Product A : 1.5 machine hours
Product B : 1.0 machine hour

Department P2 : Product A : 2 Direct labour hours
Product B : 2.5 Direct labour hours

Average wage rates budgeted in Department P2 are:
Product A - ` 72 per hour and Product B – ` 75 per hour.

All materials are used in Department P1 only.
Actual data: (for the month of July, 20X8)

Units actually produced: Product A : 4,000 units
Product B : 3,000 units
Actual direct machine hours worked in Department P1:
On product A 6,100 hours, Product B 4,150 hours.

Actual direct labour hours worked in Department P2:
on product A 8,200 hours, Product B 7,400 hours.

Costs actually incurred:

Product A Product B
` `
Raw materials 4,89,000 4,56,000
Wages 5,91,900 5,52,000
` `
Overheads: Department P1 2,31,000 S1 60,000
P2 2,04,000 S2 48,000
You are required to :

(i) COMPUTE the pre-determined overhead rate for each production department.
(ii) PREPARE a performance report for July, 20X8 that will reflect the budgeted costs
and actual costs.
SOLUTION
(i) Computation of predetermined overhead rate for each
production department from budgeted data
Production Service
Department Department
P1 P2 S1 S2
Budgeted factory overheads for the 25,50,000 21,75,000 6,00,000 4,50,000
year in (`)
Allocation of service department 3,00,000 3,00,000 (6,00,000) --
S1’s costs to production
departments P1 and P2 equally in
(`)
Allocation of service department 3,00,000 1,50,000 – (4,50,000)
S2’s costs to production
departments P1 and P2 in the ratio
of 2:1 in (`)
Total 31,50,000 26,25,000 -- --

Budgeted machine hours in 1,05,000 --

department P1 (working note-1)
Budgeted labour hours in -- 1,75,000

department P2 (working note-1)
Budgeted machine/ labour hour 30.00 15.00

rate (`)
(ii) Performance report for July, 20X8

(When 4,000 and 3,000 units of products A and B respectively were actually produced)
Budgeted Actual
(`) (`)
Raw materials used in Dept. P1:
A : 4,000 units × ` 120 4,80,000 4,89,000

B : 3,000 units × ` 150 4,50,000 4,56,000
Direct labour cost
(on the basis of labour hours worked in department P2)
A : 4,000 units × 2 hrs. × ` 72 5,76,000 5,91,900

B : 3,000 units × 2.5 hrs. × ` 75 5,62,500 5,52,000
Overhead absorbed on machine hour basis in Dept.
P1:
A : 4,000 units × 1.5 hrs. × ` 30 1,80,000 1,74,400*

B : 3,000 units × 1 hr. × ` 30 90,000 1,18,649
Overhead absorbed on labour hour basis in Dept. P2:
A : 4,000 units × 2 hrs. × ` 15 1,20,000 1,31,364

B : 3,000 units × 2.5 hrs. × ` 15 1,12,500 1,18,548
25,71,000 26,31,861
* (Refer to working note 4)** (Refer to working note 5)

Working notes:
1.
Product A Product B Total

Budgeted output (in units) 50,000 30,000
Budgeted machine hours in Dept. P1 75,000 30,000 1,05,000
(50,000×1.5 hrs.) (30,000×1 hr.)
Budgeted labour hours in Dept. P2 1,00,000 75,000 1,75,000

(50,000×2 hrs.) (30,000×2.5 hrs.)
2.
Product A Product B Total
Actual output (in units) 4,000 3,000
Actual machine hours utilized in Dept. P1 6,100 4,150 10,250
Actual labour hours utilised in Dept. P2 8,200 7,400 15,600
3. Computation of actual overhead rates for each production department

from actual data
Production Department Service Department

P1 P2 S1 S2
Actual factory overheads for the 2,31,000 2,04,000 60,000 48,000
month of July, 20X1 in (`)
Allocation of service Dept. S1’s costs 30,000 30,000 (60,000) −
to production Dept. P1 and P2
equally in (`)
Allocation of service Dept. S2’s costs 32,000 16,000 − (48,000)
to production Dept. P1 and P2 in the
ratio of 2:1 in (`)
Total 2,93,000 2,50,000 -- --
Actual machine hours in Dept. P1 10,250 --
(working note-2)

Actual labour hours in Dept. P2 -- 15,600

(working note-2)
Actual machine/ labour hour rate (`) 28.59 16.02
4. Actual overheads absorbed (based on machine hours)

A : 6,100 hrs × ` 28.59 = ` 1,74,400
B : 4,150 hrs × ` 28.59 = ` 1,18,649
5. Actual overheads absorbed (based on labour hours)
A : 8,200 hrs × ` 16.02 = ` 1,31,364
B : 7,400 hrs × ` 16.02 = ` 1,18,548
ILLUSTRATION 7
A machine costing ` 1,00,00,000 is expected to run for 10 years. At the end of this
period its scrap value is likely to be ` 9,00,000. Repairs during the whole life of the
machine are expected to be ` 18,00,000 and the machine is expected to run 4,380
hours per year on the average. Its electricity consumption is 15 units per hour, the
rate per unit being ` 5. The machine occupies one-fourth of the area of the
department and has two points out of a total of ten for lighting. The foreman has to
devote about one sixth of his time to the machine. The monthly rent of the
department is ` 30,000 and the lighting charges amount to ` 8,000 per month. The
foreman is paid a monthly salary of ` 19,200. FIND OUT the machine hour rate,
assuming insurance is @ 1% p.a. and the expenses on oil, etc., are ` 900 per month.
SOLUTION
Total number of hours per annum- 4,380
Total number of hours per month- 365
Computation of Machine Hour Rate
Per month (`) Per hour (`)

Fixed costs (Standing Charges)
Depreciation (Refer working note-1) 75,833
Rent (`30,000 × ¼ ) 7,500
Lighting charges {(`8,000 × 2 points) ÷ 10 points} 1,600

Foreman’s salary (`19,200 × 1/6) 3,200

Sundry expenses (oil etc.) 900
Insurance {(1% of `9,10,000) ÷ 12 months} 758
89,791 246.00
Variable costs:
Repairs (Refer working note -2) 41.10
Electricity (15 units × `5) 75.00
Machine Hour rate 362.10
Working Notes:
Cost of Machine-Scrap value
(1) Depreciation per month =
Lifeof themachine
` 1,00,00,000 - ` 9,00,000
= =` 75,833
(10 years ×12months) *
*In the question the life of the machine is given as 10 years and it is also
mentioned the machine will run for 4,380 hours per annum. The depreciation
can be calculated either on the basis of time i.e. 10 years or on the basis of
activity of 43,800 hours (4,380 hours p.a.)
(2) Repairs for the whole life is `18,00,000, which can be linked to activity level of
`18,00,000
43,800 hours. Thus, Repairs cost per hour = = ` 41.10
43,800 hours
4.7 TREATMENT OF UNDER-ABSORBED AND

OVER–ABSORBED OVERHEADS IN COST
ACCOUNTING
Overhead expenses are usually applied to production on the basis of pre-
determined rates. Production overheads are to be determined in advance as
follows for fixing selling price, quote tender price and to formulate budgets etc.

Estimated / Normal overheads for the period

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

Is there any under/over

absorption of
overheads?
Yes
Amount of under/over Yes

absorption is small
No Costing P&
L A/c
Due to wrong Yes

estimation and
abnormal reasons
No
Calculate Supplementary Rate and

Charge to Cost of Sales A/c. Finished
Goods A/c and W-I-P A/c.
Treatment of Under-absorbed and Over-absorbed of overheads in Cost

Accounting
As regards the treatment of such debit or credit balances, the general view is
that if the balances are small they should be transferred to the Costing Profit
and Loss Account and the cost of individual products should not be increased or
reduced as these would be representing normal cost.
Where, however the difference is large and due to wrong estimation, it would be
desirable to adjust the cost of products manufactured, as otherwise the cost figures
would convey a misleading impression. Such adjustments usually take the form of

supplementary rates where there is a debit balance in the overhead account and a
credit in the other case.
Now, the production of any period can be identified in three forms, goods
finished and sold, goods finished but held in stock (not yet sold) and semi-
finished goods (work in progress). So far as the first category of goods is
concerned, it is arguable that the post-mortem of the costs of individual products
long after they have been sold may have some academic utility but it is frequently
devoid of any practical significance. Therefore, it is suggested that the total
variance concerning goods finished and sold should be adjusted by transferring
the amount to the Cost of Sale Account, the costs of the individual items of such
goods not being affected.
As regards the variance pertaining to goods finished and held in stock (i.e. not yet
sold), it would be necessary to adjust the value of the stock; similarly, the value of
work-in-progress should be adjusted.
However, over or under recovery of overheads due to abnormal reasons (such as
abnormal over or under capacity utilisation) should be transferred to the Costing
Profit and Loss Account.
ILLUSTRATION 8
A light engineering factory fabricates machine parts to customers. The factory
commenced fabrication of 12 Nos. machine parts to customers’ specifications and
the expenditure incurred on the job for the week ending 21st August, 20X8 is given
below:
(` ) (` )
Direct materials (all items) 780.00
Direct labour (manual) 20 hours @` 15 per hour 300.00
Machine facilities :
Machine No. I : 4 hours @ ` 45 180.00
Machine No. II : 6 hours @ ` 65 390.00 570.00
Total 1,650.00
Overheads @ ` 8 per hour on 20 manual hours 160.00
Total cost 1,810.00

The overhead rate of ` 8 per hour is based on 3,000 man hours per week; similarly,
the machine hour rates are based on the normal working of Machine Nos. I and II
for 40 hours out of 45 hours per week.
After the close of each week, the factory levies a supplementary rate for the
recovery of full overhead expenses on the basis of actual hours worked during the
week. During the week ending 21st August, 20X8, the total labour hours worked
was 2,400 and Machine Nos. I and II had worked for 30 hours and 32.5 hours
respectively.
PREPARE a Cost Sheet for the job for the fabrication of 12 Nos. machine parts duly
levying the supplementary rates.
SOLUTION
Fabrication of 12 Nos. machine parts (job No......) Date of commencement: 16
August, 20X8 Date of Completion. Cost sheet for the week ending, August 21,
20X8:
(`) (`)
Direct materials (all items) 780.00
Direct labour (manual) 20 hours @` 15 per hour 300.00
Machine facilities:
Machine No. I : 4 hours @ ` 45 180.00
Machine No. II : 6 hours @ ` 65 390.00 570.00
Total 1,650.00
Overheads @ ` 8 per hour on 20 manual hours 160.00
Total cost 1,810.00
Supplementary Rates
Overheads 20 hours @ ` 2 per hour 40.00
Machine facilities:
Machine No. I - 4 hours @ ` 15 60.00
Machine No. II - 6 hours @ ` 15 90.00 190.00
Cost 2,000.00
Working notes:
Overheads budgeted: 3,000 hours × `8 =`24,000
Actual hours: 2,400

Actual rate per hour `24,000 ÷ 2,400 hours = `10

Supplementary charge ` 2 (`10 – ` 8) per hour
Machine facilities:
Machine No. I Machine No. II
Budgeted `1,800 `2,600
(40 × `45) (40 × `65)
Actual number of hours 30 32.5
Actual rate per hour `60.00 `80.00
Supplementary rate per hour ` 15.00 ` 15.00
(`60.00 – `45.00) (`80.00 – `65.00)
4.8 ACCOUNTING AND CONTROL OF ADMINIS-

TRATIVE OVERHEADS
Definition - According to CIMA Terminology, Administrative overhead is defined
as “The sum of those costs of general management and of secretarial accounting
and administrative services, which cannot be directly related to the production,
marketing, research or development functions of the enterprise.” According to this
definition, administrative overhead constitutes the expenses incurred in
connection with the formulation of policy directing the organisation and
controlling the operations of an undertaking. These overheads are also collected
and classified in the same way as the factory overheads.
4.8.1 Accounting of Administrative Overheads
There are three distinct methods of accounting of administrative overheads,
which are briefly discussed below:
(a) Apportioning Administrative Overheads between Production and Sales
Departments: According to this method administrative overheads are
apportioned over production and sales departments. The reason for the
apportionment of overhead expenses over these departments, recognises the fact
that administrative overheads are incurred for the benefit of both of these
departments. Therefore, each department should be charged with the proportion-
ate share of the same. When this method is adopted, administrative overheads
lose their identity and get merged with production and selling and distribution
overheads.

Disadvantages:
(1) It is difficult to find suitable bases of administrative overhead apportionment
over production and sales departments.
(2) Lot of clerical work is involved in apportioning overheads.
(3) It is not justified to apportion total administrative overheads only over
production and sales departments when other equally important department
like finance is also there.
(b) Charging to Profit and Loss Account: According to this method
administrative overheads are charged to Costing Profit & Loss Account. The
reason for charging to Costing Profit & Loss are firstly, the administrative
overheads are concerned with the formulation of policies and thus are not
directly concerned with either the production or the selling and distribution
functions. Secondly, it is difficult to determine a suitable basis for apportioning
administrative overheads over production and sales departments. Lastly, these
overheads are the fixed costs. In view of these arguments, administrative
overheads should be charged to Profit and Loss Account.
Disadvantages:
(1) Cost of products is understated as administrative overheads are not charged to
costs.
(2) The exclusion of administrative overheads from cost of products is against
sound accounting principle.
(c) Treating Administrative Overheads as a separate addition to Cost of
Production/ Sales: This method considers administration as a separate function
like production and sales and, as such costs relating to formulating the policy,
directing the organisation and controlling the operations are taken as a separate
charge to the cost of the jobs or a product, sold along with the cost of other
functions. The basis which are generally used for apportionment are:
(i) Works cost
(ii) Sales value or quantity
(iii) Gross profit on sales
(iv) Quantity produced
(v) Conversion cost, etc.

4.8.2 Control of Administrative Overheads

Mostly administrative overheads are of fixed nature, and they arise as a result of
management policies. These fixed overheads are generally non-controllable. But
at the same time these overheads should not be allowed to grow
disproportionately. Some degree of control has to be exercised over them. The
methods usually adopted for controlling administrative overheads are as follows:
(i) Classification and analysis of overheads by administrative departments
according to their functions, and a comparison with the accomplished results:
According to this method the expenses incurred by each administrative
department are collected under standing order numbers for each class of
expenditure. These are compared with similar figures of the previous period
in relation to accomplishment. Such a comparison will reveal efficiency or
inefficiency of the concerned department.
However, this method provides only a limited degree of control and
comparison does not give useful results if the level of activity is not
constant during the periods under comparison. To overcome this difficulty,
overhead absorption rates may also be compared from period to period; the
extent of over or under absorption will reveal the efficiency or otherwise of
the department. It may be possible to compare the cost of a service
department with that of similar services obtainable from outside and a
decision may be taken whether it is economical to continue the department
or entrust the work to outsiders.
(ii) Control through Budgets - According to this method, administration budgets
(monthly or annually) are prepared for each department. The budgeted
figures are compared with actual ones to determine variances. The variances
are analysed and responsibility assigned to the concerned department to
control these variances.
(iii) Control through Standard - Under this method, standards of performance
are fixed for each administrative activity, and the actual performance is
compared with the standards set. In this way, standards serve not only as
yardstick of performance but also facilitate control of costs.

ILLUSTRATION 9 (Reverse Calculation of Factory Overhead and

Administrative overheads)
In an engineering company, the factory overheads are recovered on a fixed
percentage basis on direct wages and the administrative overheads are absorbed on
a fixed percentage basis on factory cost.
The company has furnished the following data relating to two jobs undertaken by it
in a period:
Job 101 Job 102

(` ) (` )
Direct materials 54,000 37,500
Direct wages 42,000 30,000
Selling price 1,66,650 1,28,250
Profit percentage on Total Cost 10% 20%
Required:
(i) COMPUTATION of percentage recovery rates of factory overheads and
administrative overheads.
(ii) CALCULATION of the amount of factory overheads, administrative overheads
and profit for each of the two jobs.
(iii) Using the above recovery rates FIX the selling price of job 103. The additional
data being:
Direct materials ` 24,000
Direct wages ` 20,000
Profit percentage on selling price 12-½%
SOLUTION
(i) Let factory overhead recovery rate, as percentage of direct wages be F and
administrative overheads recovery rate, as percentage of factory cost be A.
Factory Cost of Jobs:
Job 101 = `96,000 + `42,000F
Job 102 = `67,500 + `30,000F
Total Cost of Jobs:
Job 101 = (` 96,000 + `42,000F) + (`96,000+ `42,000F) A = ` 1,51,500

Job-102 = (` 67,500 + ` 30,000F) + (`67,500+ `30,000F) A = ` 1,06,875

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

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

Direct wages 20,000

Prime cost 44,000
Factory overheads (60% of Direct Wages) 12,000
Factory cost 56,000
Administrative overheads 14,000
(25% of factory cost)
Total cost 70,000
Profit margin (balancing figure) 10,000
 Total Cost 
Selling price   80,000
 87.5% 
4.9 ACCOUNTING AND CONTROL OF SELLING

AND DISTRIBUTION OVERHEADS
Selling cost or overhead expenses are the expenses incurred for the purpose of
promoting the marketing and sales of different products. Distribution expenses, on
the other hand, are expenses relating to delivery and dispatch of goods sold.
Examples of selling and distribution expenses have been considered earlier in this
booklet. From the definitions it is clear that the two type of expenses represent
two distinct type of functions. Some concerns group together these two type of
overhead expenses into one composite class, namely, selling and distribution
overhead, for the purpose of Cost Accounting.
4.9.1 Accounting of selling and distribution overheads
The collection and accumulation of each expense is made by means of
appropriate standing order numbers in the usual way. Where it is decided to
apportion a part of the administrative overhead to the selling division the same
should also be collected through appropriate standing order numbers.
As in the case of administrative overheads, it is not easy to determine an entirely
satisfactory basis for computing the overhead rate for absorbing selling
overheads. The bases usually adopted are:
(a) Sales value of goods;
(b) Cost of goods sold;

(c) Gross Profit on sales; and

(d) Number of orders or units sold.
It is considered that the sale value is ordinarily the most logical basis, there being
some connection between the amount of sales and the amount of expenses
incurred to achieve them. The cost of production, however, is not as satisfactory
on basis as it may not have any direct relationship with the selling and
distribution cost.
The basis of gross profit on sales results in a larger share of the selling overhead
being applied to goods yielding a large margin of profit and vice versa. The basis
therefore follows the principle of ‘ability to pay, it may not reflect costs or in-
curred efforts.
An estimated amount per unit - The best method for absorbing selling and
distributing expenses over various products is to separate fixed expenses from
variable expenses. Apportion the fixed expenses according to the benefit derived
by each product and thus ascertaining the fixed expenses per unit. We give below
some of the fixed expenses and the basis of apportionment:
Expenses Basis
Salaries in the Sales Department Estimated time devoted to the sale of
and of the sales men. various products.
Advertisement Actual amount incurred for each product
since these days it is usual to advertise
each product separately; common
expenses, such as in an exhibition,
should be apportioned on the basis of
advertisement expenditure on each
product.
Show Room expenses Average space occupied by each
product.
Rent of finished goods godowns Average quantities delivered during a
and Expenses on own delivery period.
vans
If a suitable basis for apportioning expenses does not exist it may be apportioned
in the proportion of sales of various products.

The total of fixed expenses apportioned in this manner, divided by the number of
units sold or likely to be sold, will give the fixed expenses per unit. To this should
be added the variable expenses which will be different for each product. These
expenses are, packaging, freight outwards, insurance in transit, commission
payable to salesmen, rebate allowed to customers, etc. All these items will be
worked out per unit for each product separately. These items added to fixed
expenses per unit will give an estimated amount of the selling and distribution
expenses per unit.
4.9.2 Control of Selling & Distribution Overheads
Control of selling and distribution expenses is a difficult task. The reasons for this
are as follows:
1. The incidence of selling and distribution overheads depends mainly on
external factors, such as distance of market, extent and nature of competition,
terms of sales, etc. which are beyond the control of management.
2. These overheads are dependent upon the customers, behaviour, their liking
and disliking, tastes etc. Therefore, as such control over the overheads may result
in loss of customers.
3. These expenses being of the nature of policy costs, are not amenable to
control.
In spite of the above difficulties, the following methods may be used for
controlling them.
(a) Comparison with past performance - According to this method, selling and
distribution overheads are compared with the figures of the previous period.
Alternatively, the expenses may be expressed as a percentage of sales, and the
percentages may be compared with those of the past period. This method is
suitable for small concerns.
(b) Budgetary Control - A budget is set up for selling and distribution expenses.
The expenses are classified into fixed and variable. If necessary, a flexible
budget may be prepared indicating the expenses at different levels of sales.
The actual expenses are compared with the budgeted figures and in the case of
variances suitable actions are taken.
(c) Standard Costing - Under this method standards are set up in relation to the
standard sales volume. Standards may be set up for salesmen, territories,

products etc. Once the standards are set up, comparison is made between the
actuals and standards: variances are enquired into and suitable action taken.
ILLUSTRATION 10
A company which sells four products, some of them unprofitable, proposes
discontinuing the sale of one of them. The following information is available
regarding income, costs and activity for the year ended 31st March, 20X9.
Products
A B C D
Sales (`) 30,00,000 50,00,000 25,00,000 45,00,000
Cost of sales (`) 20,00,000 45,00,000 21,00,000 22,50,000
Area of storage (Sq.ft.) 50,000 40,000 80,000 30,000
Number of parcels sent 1,00,000 1,50,000 75,000 1,75,000
Number of invoices sent 80,000 1,40,000 60,000 1,20,000
Selling and Distribution overheads and the basis of allocation are:

(` ) Basis of allocation
to products
Fixed Costs
Rent & Insurance 3,00,000 Square feet
Depreciation 1,00,000 Parcel
Salesmen’s salaries & expenses 6,00,000 Sales Volume
Administrative wages and salaries 5,00,000 No. of invoices
Variable Costs:
Packing wages & materials ` 2 per parcel
Commission 4% of sales
Stationery ` 1 per invoice
You are required to PREPARE Costing Profit & Loss Statement, showing the
percentage of profit or loss to sales for each product.

SOLUTION
Statement of Profit or Loss on Various Products during the year ended March 31,
20X9.
Total (`) Products
A (`) B (`) C (`) D (`)
Sales 1,50,00,000 30,00,000 50,00,000 25,00,000 45,00,000
Variable costs:
Cost of sales 1,08,50,000 20,00,000 45,00,000 21,00,000 22,50,000
Commissions 4% of sales 6,00,000 1,20,000 2,00,000 1,00,000 1,80,000
Packing wages & 10,00,000 2,00,000 3,00,000 1,50,000 3,50,000
materials @ ` 2 per
parcel
Stationery @ `1 per 4,00,000 80,000 1,40,000 60,000 1,20,000
invoice
Total variable costs 1,28,50,000 24,00,000 51,40,000 24,10,000 29,00,000
Contribution 21,50,000 6,00,000 (1,40,000) 90,000 16,00,000
(Sales – variable cost)
Fixed Costs:
Rent & Insurance 3,00,000 75,000 60,000 1,20,000 45,000
(5:4:8:3)
Depreciation (4:6:3:7) 1,00,000 20,000 30,000 15,000 35,000
Salesmen’s salaries & 6,00,000 1,20,000 2,00,000 1,00,000 1,80,000
expenses (6:10:5:9)
Administrative wages & 5,00,000 1,00,000 1,75,000 75,000 1,50,000
salaries (4:7:3:6)
Total Fixed costs 15,00,000 3,15,000 4,65,000 3,10,000 4,10,000
Profit or Loss 6,50,000 2,85,000 (6,05,000) (2,20,000) 11,90,000
(Contribution–fixed
Costs)
Percentage of profit or 4.33 9.50 (12.10) (8.80) 26.4
Loss on sales (%)

4.10 CONCEPTS RELATED TO CAPACITY

(i) Installed/ Rated capacity: It refers to the maximum capacity of producing
goods or providing services. Installed capacity is determined either on the basis
of technical specification or through a technical evaluation. It is also known as
theoretical capacity and is could not be achieved in normal operating
circumstances.
(ii) Practical capacity: It is defined as actually utilised capacity of a plant. It
is also known as operating capacity. This capacity takes into account loss of
time due to repairs, maintenance, minor breakdown, idle time, set up time,
normal delays, Sundays and holidays, stock taking etc. Generally, practical
capacity is taken between 80 to 90% of the rated capacity. It is also used as a base
for determining overhead rates. Practical capacity is also called net capacity or
available capacity.
(iii) Normal capacity: Normal capacity is the volume of production or
services achieved or achievable on an average over a period under normal
circumstances taking into account the reduction in capacity resulting from
planned maintenance.
Normal capacity is determined as under:
Installed capacity xxx
Adjustments for:
(i) Time lost due to scheduled preventive or planned maintenance xxx
(ii) Number of shifts or machine hours or man hours
(iii) Holidays, normal shut down days, normal idle time xxx
(iv) Normal time lost in batch change over xxx xxx
Normal Capacity xxx
(iv) Actual capacity: It is the capacity actually achieved during a given period. It
is presented as a percentage of installed capacity.
(v) Idle capacity: It is that part of the capacity of a plant, machine or
equipment which cannot be effectively utilised in production.
(a) Normal Idle Capacity: It is the difference between Installed capacity and
Normal capacity.

(b) Abnormal Idle Capacity: It is the difference between Normal capacity and
Actual capacity utilization where the actual capacity is lower than the normal
capacity.
The idle capacity may arise due to lack of product demand, non-availability of raw
material, shortage of skilled labour, absenteeism, shortage of power fuel or
supplies, seasonal nature of product etc.
Installed Capacity
Normal Idle Capacity
Normal Capacity
Abnormal Idle Capacity
Actual Capacity
Treatment of Idle capacity costs: Idle capacity costs can be treated in product
costing, in the following ways:
(a) If the idle capacity cost is due to unavoidable reasons such as repairs,
maintenance, changeover of job etc. a supplementary overhead rate may be
used to recover the idle capacity cost. In this case, the costs are charged to the
production capacity utilised.
(b) If the idle capacity cost is due to avoidable reasons such as faulty planning,
power failure etc.; the cost should be charged to costing profit and loss
account.
(c) If the idle capacity cost is due to seasonal factors, then, the cost should be
charged to the cost of production by inflating overhead rates.
4.11 TREATMENT OF CERTAIN ITEMS IN

COSTING
(i) Interest and financing charges: It includes any payment in nature of
interest for use of non- equity funds and incidental cost that an entity incurs in
arranging those funds. Example of interest and financing charges are interest on
borrowings, financing charges in respect of finance leases, cash discount allowed
to customers. The term interest and financing charges, finance costs and
borrowing costs are used interchangeably. It does not include imputed costs.
Interest and financing charges shall be presented in the cost statement as a
separate item of cost of sales.

(ii) Depreciation: Depreciation “is the diminution in the intrinsic value of an

asset due to use and/or the lapse of time.” Depreciation is thus the result of two
factors viz., the use, and the lapse of time. We know that each fixed asset loses its
intrinsic value due to their continuous use and as such the greater the use the
higher is the amount of depreciation. The loss in the intrinsic value may also arise
even if the asset in question is not in service.
Assignment of Depreciation:
It shall be traced to the cost object to the extent economically feasible. Where it is
not directly traceable it should be assigned using either or two principles i.e. (i)
Cause and Effect and (ii) Benefit received.
(iii) Packing expenses: Cost of primary packing necessary for protecting the
product or for convenient handling, should become a part of the production
cost. The cost of packing to facilitate the transportation of the product from
the factory to the customer should become a part of the distribution cost. If the
cost of special packing is at the request of the customer, the same should be
charged to the specific work order or the job. The cost of fancy packing necessary
to attract customers is an advertising expenditure. Hence, it is to be treated as a
selling overhead.
(iv) Fringe benefits: These are the additional payments or facilities provided to
the workers apart from their salary and direct cost-allowances like house rent,
dearness and city compensatory allowances. These benefits are given in the form
of overtime, extra shift duty allowance, holiday pay, pension facilities etc.
These indirect benefits stand to improve the morale, loyalty and stability of
employees towards the organisation. If the amount of fringe benefit is
considerably large, it may be recovered as direct charge by means of a
supplementary wage or labour rate; otherwise these may be collected as part of
production overheads.
(v) Expenses on removal and re-erection of machines: Expenses are
sometime incurred on removal and re-erection of machinery in factories. Such
expenses may be incurred due to factors like change in the method of production;
an addition or alteration in the factory building, change in the flow of production,
etc. All such expenses are treated as production overheads. When amount of
such expenses is large, it may be spread over a period of time.
If such expenses are incurred due to faulty planning or some other abnormal
factor, then they may be charged to costing Profit and Loss Account.

(vi) Bad debts: There is no unanimity among different authors of Cost

Accounting about the treatment of bad debts. One view is that ‘bad debts’ should
be excluded from cost. According to this view bad debts are financial losses and
therefore, they should not be included in the cost of a particular job or product.
According to another view it should form part of selling and distribution
overheads, especially when they arise in the normal course of trading. Therefore
bad debts should be treated in cost accounting in the same way as any other selling
and distribution cost. However extra ordinarily large bad debts should not be
included in cost accounts.
(vii) Training expenses: Training is an essential input for industrial workers.
Training expenses in fact includes wages of workers, costs incurred in running
training department, loss arising from the initial lower production, extra spoilage
etc. Training expenses of factory workers are treated as part of the cost of production.
The training expenses of office; sales or distribution workers should be treated as office;
sales or distribution overhead as the case may be. These expenses can be spread over
various departments of the concern on the basis of the number of workers on roll.
Training expenses would be abnormally high in the case of high labour turnover
such expenses should be excluded from costs and charged to the costing profit and
loss account.
(viii) Canteen expenses: The subsidy provided or expenses borne by the firm in
running the canteen should be regarded as a production overhead. If the canteen
is meant only for factory workers therefore this expenses should be apportioned
on the basis of the number of workers employed in each department. If office
workers also take advantage of the canteen facility, a suitable share of the
expenses should be treated as office overhead.
(ix) Carriage and cartage expenses: It includes the expenses incurred on the
movement (inward and outwards) and transportation of materials and goods.
Transportation expenses related to direct material may be included in the cost of
direct material and those relating to indirect material (stores) may be treated as
factory overheads. Expenses related to the transportation of finished goods may
be treated as distribution overhead.
(x) Expenses for welfare activities: All expenses incurred on the welfare
activities of employees in a company are part of general overheads. Such
expenses should be apportioned between factory, office, selling and distribution
overheads on the basis of number of persons involved.

(xi) Night shift allowance: Workers in the factories, which operate during night
time are paid some extra amount known as ‘night shift allowance’. This extra
amount is generally incurred due to the general pressure of work beyond normal
capacity level and is treated as production overhead and recovered as such.
If this allowance is treated as part of direct wages, the jobs/production carried at
night will be costlier than jobs/production performed during the day. However, if
additional expenditure on night shift is incurred to meet some specific customer
order, such expenditure may be charged directly to the order concerned. If night
shifts are run due to abnormal circumstances, the additional expenditure should
be charged to the costing profit and loss account.
(xii) Research and Development Expenses: The Terminology defines research
expenses as “the expenses of searching for new or improved products, new
application of materials, or new or improved methods.” Similarly, development
expenses are defined as “the expenses of the process which begins with the
implementation of the decision to produce a new or improved product.”
If research is conducted in the methods of production, the research expenses
should be charged to the production overhead; while the expenditure becomes a
part of the administration overhead if research relates to administration. Similarly,
market research expenses are charged to the selling and distribution overhead.
Development costs incurred in connection with a particular product should be
charged directly to that product. Such expenses are usually treated as “deferred
revenue expenses,” and recovered as a cost per unit of the product when
production is fully established.
General research expenses of a routine nature incurred on new or improved
methods of manufacture or the improvement of the existing products should be
charged to the general overhead.
Even in this case, if the amount involved is substantial it may be treated as a
deferred revenue expenditure, and spread over the period during which the benefit
would accrue. Expenses on fundamental research, not relating to any specific
product, are treated as a part of the administration overhead. Where research
proves a failure, the cost associated with it should be excluded from costs and
charged to the costing Profit and Loss Account.

SUMMARY
♦ Overheads: Overheads represent expenses that have been incurred in
providing certain ancillary facilities or services which facilitate or make
possible the carrying out of the production process; by themselves these
services are not of any use.
♦ Cost allocation: The term ‘allocation’ refers to assignment or allotment of
an entire item of cost to a particular cost center or cost unit.
♦ Cost apportionment: Apportionment implies the allotment of proportions
of items of cost to cost centres or departments.
♦ Re-apportionment: The process of assigning service department overheads
to production departments is called reassignment or re-apportionment.
♦ Absorption- The process of recovering overheads of a department or any
other cost center from its output is called recovery or absorption.
♦ Direct re-distribution method: Under this method service department
costs are apportioned over the production departments only, ignoring the
services rendered by one service department to the other.
♦ Step Method or Non-reciprocal method: This method gives cognizance to
the service rendered by service department to another service department.
The sequence here begins with the department that renders service to the
maximum number of other service departments.
♦ Reciprocal Service Method: These methods are used when different
service departments render services to each other, in addition to rendering
services to production departments. In such cases various service
departments have to share overheads of each other. The methods available
for dealing with reciprocal services are
(a) Simultaneous equation method;
(b) Repeated distribution method;
(c) Trial and error method.
♦ Blanket overhead rates: Blanket overhead rate refers to the computation
of one single overhead rate for the whole factory. It is to be distinguished
from the departmental overhead rate which refers to a separate rate for
each individual cost centre or department.
Overhead costs for the whole factory
Blanket Overhead rate = ×100
Total units of the selected base

TEST YOUR KNOWLEDGE

1. “Fixed overhead costs are not affected in monetary terms during a given period by
a change in output”. But this statement holds good provided
(a) Increase in output is not substantial
(b) Increase in output is substantial
(c) Both (a) and (b)
2. The concept of ‘idle capacity of plant’ as used in cost accounting is its
(a) Best capacity for normal production
(b) Capacity used for standard setting
(c) Theoretical maximum capacity
(d) Capacity below which production should not fall
3. The allotment of whole items of cost to cost centres or cost units is called
(a) Overhead absorption
(b) Cost apportionment
(c) Cost allocation
4. Primary packing cost is a part of
(a) Direct material cost
(b) Production Cost
(c) Selling overheads
(d) Distribution overheads
5. Director’s remuneration and expenses form part of
(a) Production overhead
(b) Administration overhead
(c) Selling overhead
(d) Distribution overhead

6. In case, the output of a factory is doubled, the depreciation should be treated as

(a) Fixed cost
(b) Variable cost
(c) Semi- variable cost
7. Bad debt is an example of
(a) Distribution overhead
(b) Production overhead
(c) Selling overhead
(d) Administration overhead
8. Normal capacity of a plant refers to the difference between
(a) Maximum capacity and practical capacity
(b) Practical capacity and normal capacity
(c) Practical capacity and estimated idle capacity as revealed by long term sales
trend.
(d) Maximum capacity and actual capacity
9. The difference between actual factory overhead and absorbed factory overhead will
be usually at the minimum level, provided pre- determined overhead rate is based
on
(a) Maximum capacity
(b) Direct labour hours
(c) Machine hours
(d) Normal capacity
10. Identify among the following a scientific and accurate method of factory overhead
absorption
(a) Percentage of direct material cost method
(b) Percentage of direct labour cost method
(c) Percentage of prime cost method
(d) Machine hour rate method

1. STATE what is blanket overhead rate? In which situations, blanket rate is to
be used and why?
2. DISCUSS the step method and reciprocal service method of secondary
distribution of overheads.
3. DISCUSS the problems of controlling the selling and distribution overheads.
4. DISTINGUISH between cost allocation and cost absorption.
5. EXPLAIN Single and Multiple Overhead Rates.
6. EXPLAIN how would you treat the idle capacity costs in Cost Accounts?
7. DISCUSS the difference between allocation and apportionment of overhead.
8. EXPLAIN what are the methods of re-apportionment of service department
expenses over the production departments? Discuss.
Practical Questions
1. The ABC Company has the following account balances and distribution of
direct charges on 31st March, 20X1.
Total Production Depts. Service Depts.
Machine Packing Gen. Store &
shop Plant Maintenance
(`) (`) (`) (`) (`)
Allocated Overheads:
Indirect labour 14,650 4,000 3,000 2,000 5,650
Maintenance 5,020 1,800 700 1,020 1,500
material
Misc. supplies 1,750 400 1,000 150 200
Superintendent’s 4,000 – – 4,000 –
salary
Cost & payroll salary 10,000 – – 10,000 –
Overheads to be apportioned:
Power 8,000
Rent 12,000
Fuel and heat 6,000
Insurance 1,000

Taxes 2,000
1,64,420 6,200 4,700 17,170 7,350
The following data were compiled by means of the factory survey made in
the previous year:
Floor Radiator No. of Investment H.P
Space Sections Employees ` hours
Machine Shop 2,000 Sq. ft. 45 20 640,000 3,500
Packing 800 ” ” 90 10 200,000 500
General Plant 400 ” ” 30 3 10,000 –
Store & Maint. 1,600 ” ” 60 5 150,000 1,000
4,800 ” ” 225 38 1,000,000 5,000
Expenses charged to the stores and maintenance departments are to be
distributed to the other departments by the following percentages:
Machine shop 50%; Packing 20%; General Plant 30%; General Plant overheads is
distributed on the basis of number of employees:
(a) PREPARE an overhead distribution statement with supporting schedules
to show computations and basis of distribution including distribution of
the service department expenses to producing department.
(b) DETERMINE the service department distribution by the method of
continued distribution. Carry through 3 cycles. Show all calculations to
the nearest rupees.
2. Modern Manufactures Ltd. has three Production Departments P1, P2, P3 and two
Service Departments S1and S2 details pertaining to which are as under:
P1 P2 P3 S1 S2
Direct wages (` ) 3,000 2,000 3,000 1,500 195

Working hours 3,070 4,475 2,419 - -
Value of machines (`) 60,000 80,000 1,00,000 5,000 5,000
H.P. of machines 60 30 50 10 -
Light points 10 15 20 10 5
Floor space (sq. ft.) 2,000 2,500 3,000 2,000 500
The following figures extracted from the Accounting records are relevant:

(`)
Rent and Rates 5,000
General Lighting 600
Indirect Wages 1,939
Power 1,500
Depreciation on Machines 10,000
Sundries 9,695
The expenses of the Service Departments are allocated as under :
P1 P2 P3 S1 S2
S1 20% 30% 40% - 10%
S2 40% 20% 30% 10% -
FIND OUT the total cost of product X which is processed for manufacture in
Departments P1, P2 and P3 for 4, 5 and 3 hours respectively, given that its Direct
Material Cost is ` 50 and Direct Labour Cost is ` 30.
3. Deccan Manufacturing Ltd., have three departments which are regarded as
production departments. Service departments’ costs are distributed to these
production departments using the “Step Ladder Method” of distribution.
Estimates of factory overhead costs to be incurred by each department in the
forthcoming year are as follows. Data required for distribution is also shown
against each department:
Department Factory overhead Direct labour No. of Area in
(`) hours employees sq.m.
Production:
X 1,93,000 4,000 100 3,000
Y 64,000 3,000 125 1,500
Z 83,000 4,000 85 1,500
Service:
P 45,000 1,000 10 500
Q 75,000 5,000 50 1,500
R 1,05,000 6,000 40 1,000
S 30,000 3,000 50 1,000
The overhead costs of the four service departments are distributed in the same
order, viz., P, Q, R and S respectively on the following basis.

Department Basis
P Number of employees
Q Direct labour hours
R Area in square metres
S Direct labour hours
You are required to:
(a) PREPARE a schedule showing the distribution of overhead costs of the
four service departments to the three production departments; and
(b) CALCULATE the overhead recovery rate per direct labour hour for each of
the three production departments.
4. Gemini Enterprises undertakes three different jobs A, B and C. All of them
require the use of a special machine and also the use of a computer. The
computer is hired and the hire charges work out to ` 4,20,000 per annum. The
expenses regarding the machine are estimated as follows:
(`)
Rent for the quarter 17,500
Depreciation per annum 2,00,000
Indirect charges per annum 1,50,000
During the first month of operation the following details were taken from the
job register:
Job
A B C
Number of hours the machine was used :
(a) Without the use of the computer 600 900 —
(b) With the use of the computer 400 600 1,000
You are required to COMPUTE the machine hour rate:
(a) For the firm as a whole for the month when the computer was used and
when the computer was not used.
(b) For the individual jobs A, B and C.
5. A machine shop has 8 identical Drilling machines manned by 6 operators. The
machine cannot be worked without an operator wholly engaged on it. The

original cost of all these machines works out to ` 8 lakhs. These particulars are
furnished for a 6 months period:
Normal available hours per month 208
Absenteeism (without pay) hours 18
Leave (with pay) hours 20
Normal idle time unavoidable-hours 10
Average rate of wages per worker for 8 hours a day. ` 20
Production bonus estimated 15% on wages
Value of power consumed ` 8,050
Supervision and indirect labour ` 3,300
Lighting and electricity ` 1,200
These particulars are for a year
Repairs and maintenance including consumables 3% of value of machines.
Insurance ` 40,000
Depreciation 10% of original cost.
Other sundry works expenses ` 12,000
General management expenses allocated ` 54,530.
You are required to WORK OUT a comprehensive machine hour rate for the machine
shop.
6. Job No. 198 was commenced on October 10, 20X8 and completed on
November 1, 20X8. Materials used were ` 600 and labour charged directly to
the job was ` 400. Other information is as follows:
Machine No. 215 used for 40 hours, the machine hour rate being ` 3.50.
Machine No. 160 used for 30 hours, the machine hour rate being ` 4.00. 6
welders worked on the job for five days of 8 hours each : the Direct labour hour
per welder is ` 0.20.
Expenses not included for CALCULATING the machine hour or direct labour
hour rate total led ` 2,000, total direct wages for the period being ` 20,000.
Ascertain the works costs of job No. 198.
7. In a factory, overheads of a particular department are recovered on the basis of
` 5 per machine hour. The total expenses incurred and the actual machine

hours for the department for the month of August were ` 80,000 and 10,000
hours respectively. Of the amount of ` 80,000, ` 15,000 became payable due to
an award of the Labour Court and ` 5,000 was in respect of expenses of the
previous year booked in the current month (August). Actual production was
40,000 units, of which 30,000 units were sold. On analysing the reasons, it was
found that 60% of the under-absorbed overhead was due to defective planning
and the rest was attributed to normal cost increase. EXPLAIN how would you
treat the under-absorbed overhead in the cost accounts?
8. In a manufacturing unit, factory overhead was recovered at a pre-determined
rate of ` 25 per man-day. The total factory overhead expenses incurred and the
man-days actually worked were ` 41.50 lakhs and 1.5 lakh man-days respectively.
Out of the 40,000 units produced during a period, 30,000 were sold.
On analysing the reasons, it was found that 60% of the unabsorbed overheads
were due to defective planning and the rest were attributable to increase in
overhead costs.
EXPLAIN how would unabsorbed overheads be treated in Cost Accounts?
9. A factory has three production departments. The policy of the factory is to
recover the production overheads of the entire factory by adopting a single
blanket rate based on the percentage of total factory overheads to total factory
wages. The relevant data for a month are given below:
Department Direct Direct Factory Direct Machine
Materials Wages Overheads Labour hours hours
(`) (`) (`)
Budget:
Machining 6,50,000 80,000 3,60,000 20,000 80,000
Assembly 1,70,000 3,50,000 1,40,000 1,00,000 10,000
Packing 1,00,000 70,000 1,25,000 50,000 −
Actual:
Machining 7,80,000 96,000 3,90,000 24,000 96,000
Assembly 1,36,000 2,70,000 84,000 90,000 11,000
Packing 1,20,000 90,000 1,35,000 60,000 −
The details of one of the representative jobs produced during the month are as
under:

Job No. CW 7083 :

Department Direct Direct Direct Machine
Materials Wages Labour hours hours
(`) (`)
Machining 1,200 240 60 180
Assembly 600 360 120 30
Packing 300 60 40 −
The factory adds 30% on the factory cost to cover administration and selling
overheads and profit.
Required :
(i) CALCULATE the overhead absorption rate as per the current policy of the
company and determine the selling price of the Job No. CW 7083.
(ii) Suggest any suitable alternative method(s) of absorption of the factory
overheads and CALCULATE the overhead recovery rates based on the
method(s) so recommended by you.
(iii) DETERMINE the selling price of Job CW 7083 based on the overhead
application rates calculated in (ii) above.
(iv) CALCULATE the department-wise and total under or over recovery of
overheads based on the company’s current policy and the method(s)
recommended by you.
10. The total overhead expenses of a factory are ` 4,46,380. Taking into account
the normal working of the factory, overhead was recovered in production at `
1.25 per hour. The actual hours worked were 2,93,104. STATE how would you
proceed to close the books of accounts, assuming that besides 7,800 units
produced of which 7,000 were sold, there were 200 equivalent units in work-in-
progress?
On investigation, it was found that 50% of the unabsorbed overhead was on
account of increase in the cost of indirect materials and indirect labour and the
remaining 50% was due to factory inefficiency. Also give the profit implication
of the method suggested.
11. ABC Ltd. manufactures a single product and absorbs the production overheads
at a pre-determined rate of ` 10 per machine hour.

At the end of financial year 20X8-X9, it has been found that actual production
overheads incurred were ` 6,00,000. It included ` 45,000 on account of ‘written
off’ obsolete stores and ` 30,000 being the wages paid for the strike period
under an award.
The production and sales data for the year 20X8-X9 is as under :
Production :
Finished goods 20,000 units
Work-in-progress 8,000 units
(50% complete in all respects)
Sales :
Finished goods 18,000 units
The actual machine hours worked during the period were 48,000. It has been
found that one-third of the under-absorption of production overheads was due
to lack of production planning and the rest was attributable to normal increase
in costs.
(i) CALCULATE the amount of under-absorption of production overheads
during the year 20X8-X9; and
(ii) SHOW the accounting treatment of under-absorption of production overheads.
ANSWERS/ SOLUTIONS
MCQs
1. (a) 2. (c) 3. (c) 4. (b) 5. (b) 6. (c)
7. (c) 8. (c) 9. (d) 10 (d)

Practical Problems
1. (a) Overhead Distribution Statement
Production Departments Service Departments
Machine Packing General Stores &
Allocated Expenses: Shop Plant Maintenance
Indirect labour 4,000 3,000 2,000 5,650
Maintenance material 1,800 700 1,020 1,500
Superintendent’s salary − − 4,000 −
Misc. supplies 400 1,000 150 200
Cost & payroll salaries − − 10,000 −
Total 6,200 4,700 17,170 7,350

Apportioned expenses
(See schedule below) 77,720 25,800 2,830 22,650
Total 83,920 30,500 20,000 30,000

Schedule of Apportioned Expenses
Item Basis Machine Packing General Stores &
Plant Maintenance
(`) (`) (`) (`)
Power Horse Power Hrs. 5,600 800 – 1,600
Rent Floor Space 5,000 2,000 1,000 4,000
Fuel & Heat Radiator Secs. 1,200 2,400 800 1,600
Insurance Investment 640 200 10 150
Taxes Investment 1,280 400 20 300
Depreciation Investment 64,000 20,000 1,000 15,000
Total 77,720 25,800 2,830 22,650

(b) Distribution of Service Department Expenses

Production Departments Service Departments
Machine Packing General Stores &
Plant Maintenance
(`) (`) (`) (`)
Total Expense [as per (a)] 83,920 30,500 20,000 30,000
Transfer from Stores &
Maintenance 15,000 6,000 9,000 –30,000
Transfer from General Plant 16,571 8,286 –29,000 4,143
Maintenance 2,072 829 1,242 –4,143
Transfer from General Plant 710 355 –1,242 177
Maintenance 88 36 53 –177
Transfer from General Plant 35 18 –53 —
Total 1,18,396 46,024 — —
2. Statement Showing Distribution of Overheads of Modern Manufactures Ltd.
Production Service
Departments Departments
Particulars Basis Total P1 P2 P3 S1 S2

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

Redistribution of Service Department’s Expenses over Production

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

3. (a) Deccan Manufacturing Limited

Schedule Showing the Distribution of Overhead Costs among
Departments
Service Production
P Q R S X Y Z
(`) (`) (`) (`) (`) (`) (`)
Overhead costs 45,000 75,000 1,05,000 30,000 1,93,000 64,000 83,000
Distribution of over-
head cost of Dept. ‘P’(45,000) 5,000 4,000 5,000 10,000 12,500 8,500
head costs of Dept. ‘Q’ (80,000) 24,000 12,000 16,000 12,000 16,000
head cost of Dept. ‘R’ - (1,33,000)19,000 57,000 28,500 28,500
head costs of Dept. ‘S’ - - (66,000) 24,000 18,000 24,000
Total (A) 3,00,000 1,35,000 1,60,000
(b) Direct labour hours (B) 4,000 3,000 4,000
(A)
Overhead recovery rate per hour ` 75 ` 45 ` 40
(B)
4. Working notes: (`)

(i) Total machine hours used 3,500
(600 + 900 + 400 + 600 + 1,000)
(ii) Total machine hours without the use of computers 1,500
(600 + 900)
(iii) Total machine hours with the use of computer 2,000
(400 + 600 + 1,000)
(iv) Total overheads of the machine per month
Rent (` 17,500 ÷ 3 months) 5,833.33
Depreciation (` 2,00,000 ÷ 12 months) 16,666.67
Indirect Charges (` 1,50,000 ÷ 12 months) 12,500.00
Total 35,000.00

(v) Computer hire charges for a month = ` 35,000

(` 4,20,000 ÷ 12 months)
(vi) Overheads for using machines without computer
` 35,000
= × 1,500 hrs. = ` 15,000
3,500 hrs.
(vii) Overheads for using machines with computer
` 35,000
= 2,000 hrs. + ` 35,000 = ` 55,000
3,500 hrs.
(a) Machine hour rate of Gemini Enterprises for the firm as a whole for a
month.
` 55,000
(1) When the Computer was used: = ` 27.50 per hour
2,000 hours
` 15,000
(2) When the computer was not used: = ` 10 per hour
1,500 hrs.
(b) Machine hour rate for individual job
Rate per hr. Job
A B C
(`) Hrs. (`) Hrs. (`) Hrs. (`)
Overheads
Without Computer 10.00 600 6,000 900 9,000 − −
With computer 27.50 400 11,000 600 16,500 1,000 27,500
1,000 17,000 1,500 25,500 1,000 27,500
Machine hour rate ` 17 ` 17 ` 27.50
5. Computation of comprehensive machine hour rate of machine shop
( `)
Operator’s wages 17,100
(Refer to working note 2)
Production bonus 2,565
(15% on wages)
Power consumed 8,050
Supervision and indirect labour 3,300

Lighting and electricity 1,200

Repairs and maintenance 12,000
Insurance 20,000
Depreciation 40,000
Sundry works expenses 6,000
General management expenses 27,265
1,37,480
Total overheads of machine shop
Machine hour rate =
Hours of machines operation
` 1,37, 480
= (Refer to working note 1) = ` 23.87
5,760 hours
Working notes
1. Computation of hours, for which 6 operators are available for 6 months.
Normal available hours p.m. 208
per operator.
Less: Absenteeism hours 18
Less: Leave hours 20
Less: Idle time hours 10
48
Utilisable hours p.m. per operator 160
Total utilisable hours for 6 operators and for 6 months are = 160 × 6 × 6
= 5,760 hours
As machines cannot be worked without an operator wholly engaged on
them therefore, hours for which 6 operators are available for 6 months
are the hours for which machines can be used. Hence 5,760 hours
represent total machine hours.
2. Computation of operator’s wages
` 20
Average rate of wages : = ` 2.50 per hour
8
Hours per month for which wages are paid to a worker (208 hours – 18 hours)
= 190 hours.

Total wages paid to 6 operators for 6 months = 190 hours × 6 × 6 ×

` 2.50 = ` 17,100
6. ( `)
Materials 600.00
Direct labour 400.00
1,000.00
Factory overheads : ( `)
Machine No. 215 : 40 hours @ ` 3.50 140.00
Machine No. 160 : 30 hours @ ` 4.00 120.00
240 hours of welders @ ` 0.20 per hr. 48.00
General2 10% of wages 40.00 348.00

Works cost 1,348.00
1. 6 welders × 5 days × 8 hours = 240 hours
2. Un apportioned expenses ` 2,000 which works out at 10% of direct
wages.
7. Under-absorbed overhead expenses during the month of August
( `) ( `)
Total expenses incurred in the month of August: 80,000
Less: The amount paid according to labour
court award (Assumed to be non-recurring) 15,000
Expenses of previous year 5,000 20,000
Net overhead expenses incurred for the month 60,000
Overhead recovered for 10,000 hours @ ` 5 per hour 50,000
Under-absorbed overheads 10,000
` 4,000 may be distributed over Finished Goods and Cost of Sales as
follows:
Finished Goods * `1,000
Cost of Sales * `3,000

*Working notes
Under-absorbed overhead : `4,000
Units produced : 40,000
Rate of under-absorbed overhead recover ` 0.10 per unit
Amount of under-absorbed overheads
charged to finished goods (10,000 × ` 0.10) ` 1,000
Amount of under-absorbed overheads
charged to cost of sales : (30,000 × ` 0.10) ` 3,000
8. Computation of unabsorbed overheads
Man-days worked 1,50,000
(`)
Overhead actually incurred 41,50,000
Less: Overhead absorbed @ ` 25 per man-day 37,50,000
(` 25 × 1,50,000) ________
Unabsorbed overheads 4,00,000
Unabsorbed overheads due to defective
planning (i.e. 60% of ` 4,00,000) 2,40,000
Balance of unabsorbed overhead 1,60,000
Treatment of unabsorbed overheads in Cost Accounts
(i) The unabsorbed overheads of ` 2,40,000 due to defective planning to be
treated as abnormal and therefore be charged to Costing Profit and Loss
Account.
(ii) The balance unabsorbed overheads of ` 1,60,000 be charged to
production i.e., 40,000 units at the supplementary overhead absorption
rate i.e., ` 4 per unit (Refer to Working Note)
(`)
Charge to Costing Profit and Loss Account as part of
the cost of unit sold 1,20,000
(30,000 units @ ` 4 p.u.)

Add: To closing stock of finished goods 40,000

(10,000 units @ ` 4 p.u.) _______
Total 1,60,000
Working Note :
` 1,60,000
Supplementary overhead absorption rate = = ` 4 p.u.
40,000 units
9. (i) Computation of overhead absorption rate
(as per the current policy of the company)
Department Budgeted factory Budgeted direct
Overheads wages
(`) (`)
Machinery 3,60,000 80,000
Assembly 1,40,000 3,50,000
Packing 1,25,000 70,000
Total 6,25,000 5,00,000
Budgeted factory overheads
Overhead absorption rate = × 100
Budgeted direct wages
` 6,25,000
= × 100 = 125% of Direct wages
` 5,00,000
Selling Price of the Job No. CW-7083
(`)
Direct materials (` 1,200 + ` 600 + ` 300) 2,100.00
Direct wages (` 240 + ` 360 + ` 60) 660.00
Overheads (125% × ` 660) 825.00
Total factory cost 3,585.00
Add: Mark-up (30% × ` 3,585) 1,075.50
Selling price 4,660.50

(ii) Methods available for absorbing factory overheads and their

overhead recovery rates in different departments
1. Machining Department
In the machining department, the use of machine time is the
predominant factor of production. Hence machine hour rate should be
used to recover overheads in this department. The overhead recovery
rate based on machine hours has been calculated as under:—
Machine hour rate =
Budgeted machine hours
` 3,60,000
= = ` 4.50 per hour
80,000 hours
2. Assembly Department
In this department direct labour hours is the main factor of
production. Hence direct labour hour rate method should be used
to recover overheads in this department. The overheads recovery
rate in this case is:
Direct labour hour rate =
Budgeted direct labour hours
` 1, 40,000
= = ` 1.40 per hour
1,00,000 hours
3. Packing Department
Labour is the most important factor of production in this department.
Hence direct labour hour rate method should be used to recover
overheads in this department.
The overhead recovery rate in this case comes to:
Budgeted factory overhead
Direct labour hour rate =
Direct labour hours
` 1,25,000
= = ` 2.50 per hour
50,000 hours

(iii) Selling Price of Job CW-7083 [based on the overhead application

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

(b) As per methods suggested

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

Finished goods 4,000

(800 units × ` 5)
Work-in progress 1,000
(200 units × ` 5)
40,000
The use of cost of sales figure, would reduce the profit for the period by
` 35,000 and will increase the value of stock of finished goods and work-
in-progress by ` 4,000 and ` 1,000 respectively.
2. The balance amount of unabsorbed overheads viz. of ` 40,000 due to
factory inefficiency should be charged to Costing Profit & Loss Account,
as this is an abnormal loss.
11. (i) Amount of under-absorption of production overheads during the
year 20X8-X9
(`)
Total production overheads actually incurred 6,00,000
during the year 20X8-X9
Less : ‘Written off’ obsolete stores ` 45,000
Wages paid for strike period ` 30,000 75,000
Net production overheads actually incurred : (A) 5,25,000
Production overheads absorbed by 48,000 machine
hours @ ` 10 per hour : (B) 4,80,000
Amount of under – absorption of production overheads : [(A) – (B)] 45,000
(ii) Accounting treatment of under absorption of production overheads
It is given in the statement of the question that 20,000 units were
completely finished and 8,000 units were 50% complete, one third of the
under-absorbed overheads were due to lack of production planning and the
rest were attributable to normal increase in costs.
(`)
1. (33 – 1/3% of ` 45,000) i.e., ` 15,000 of under-absorbed
overheads were due to lack of production planning.
This being abnormal, should be debited to the Costing
Profit and Loss A/c. 15,000

2. Balance (66–2/3% of ` 45,000) i.e., ` 30,000

of under-absorbed overheads should be distributed
over work-in-progress, finished goods and cost of
sales by using supplementary rate. 30,000
Total under-absorbed overheads 45,000
Apportionment of unabsorbed overheads of ` 30,000 over, work-in
progress, finished goods and cost of sales
Equivalent (`)
Completed Units
Work-in-Progress 4,000 5,000
(4,000 units × ` 1.25)
Finished goods 2,000 2,500
(2,000 units × ` 1.25)
Cost of sales 18,000 22,500
(18,000 units × ` 1.25)
24,000 30,000
Working Note
` 30,000
Supplementary rate per unit = = ` 1.25
24,000

CHAPTER 5
ACTIVITY BASED
COSTING
LEARNING OUTCOMES

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

5.1 INTRODUCTION
5
As discussed in chapter 4 i.e. Overhead, in traditional costing system, overhead costs
are grouped together under cost center and then absorbed into product costs on one
of the basis such as direct labour hours, machine hours, volume etc. In certain cases
this traditional costing system gives inaccurate cost information. Though, It should not
be assumed that all traditional absorption costing systems are not accurate enough to
give adequate information for pricing purposes or other long-run management
decision purposes. Some traditional systems treat overheads in a detailed way and
relate them to service cost centres as well as production cost centres. The service
centre overheads are then spread over the production cost centres before absorption
rates are calculated. The main cause of inaccuracy is in the calculation of the overhead
rate itself, which is usually based on direct labour hours or machine hours. These rates
assume that products that take longer to make, generate more overheads and so on.
Organisations, who do not wish to know how much it costs to make a product
with precise accuracy, may be happy with traditional costing system. Others
however fix their price on cost and need to be able to determine it with
reasonable accuracy. The latter organisations have been greatly benefitted from
the development of activity based costing (ABC), which is more a modern
absorption costing method, and was evolved to give more accurate product costs.
5.1.1 Factors prompting the development of ABC
Various factors lead to the development of ABC include:
1. Growing overhead costs because of increasingly automated production
2. Increasing market competition which necessitated more accurate product
costs.
3. Increasing product diversity to secure economies of scope & increased market share.
4. Decreasing costs of information processing because of continual
improvements and increasing application of information technology.
5.1.2 Usefulness/Suitability of ABC
ABC is particularly needed by organisations for product costing in the following
situation:
1. High amount of Overhead: When Production overheads are high and
significant cost, ABC will be very much useful instead of traditional costing
system.

ACTIVITY BASED COSTING 5.3
2. Wide range of products: ABC is most suitable, when, there is a diversity in

the product range or there are multiple products.
3. Presence of Non-volume related activities: When non-volume related
activities e.g. material handling, inspection set-up, are present significantly
and traditional system cannot be applied, ABC is a superior and better
option. ABC will identify non-value-adding activities in the production process
that might be a suitable focus for attention or elimination.
4. Stiff competition: When the organisation is facing stiff competition and
there is an urgent requirement to compute cost accurately and to fix the
selling price according to the market situation, ABC is very useful. ABC also
can facilitate in reducing cost by identifying non-value-adding activities in
the production process that might be a suitable focus for attention or
elimination.
5.2 MEANING AND DEFINITION

Activity Based Costing is an accounting methodology that assigns costs to
activities rather than products or services. This enables resources & overhead
costs to be more accurately assigned to products & services that consume them.
ABC is a technique which involves identification of cost with each cost
driving activity and making it as the basis for apportionment of costs over
different cost objects/ jobs/ products/ customers or services.
ABC assigns cost to activities based on their use of resources. It then assigns cost
to cost objects, such as products or customers, based on their use of activities.
ABC can track the flow of activities in organization by creating a link between the
activity (resource consumption) and the cost object.
CIMA defines ‘Activity Based Costing’ as “An approach to the costing and
monitoring of activities which involves tracing resource consumption and costing
final outputs. Resources are assigned to activities, and activities to cost objects
based on consumption estimates. The latter utilise cost drivers to attach activity
costs to outputs.”
5.3 MEANING OF TERMS USED IN ABC

5
(i) Activity – Activity, here, refers to an event that incurs cost.
(ii) A Cost Object–It is an item for which cost measurement is required e.g. a
product or a customer.

(iii) A Cost Driver–It is a factor that causes a change in the cost of an activity.
There are two categories of cost driver. Example Production runs
• A Resource Cost Driver– It is a measure of the quantity of resources consumed
by an activity. It is used to assign the cost of a resource to an activity or cost
pool.
• An Activity Cost Driver–It is a measure of the frequency and intensity of
demand, placed on activities by cost objects. It is used to assign activity costs
to cost objects.
(iv) Cost Pool-It represents a group of various individual cost items. It consists
of costs that have same cause effect relationship. Example Machine set-up.
Examples of Cost Drivers:
Business functions Cost Driver
Research and Development • Number of research projects
• Personnel hours on a project
Design of products, services and • Number of products in design
procedures • Number of parts per product
• Number of engineering hours
Customer Service • Number of service calls
• Number of products serviced
• Hours spent on servicing
products
Marketing • Number of advertisements
• Number of sales personnel
• Sales revenue
Distribution • Number of units distributed
• Number of customers
5.4 COST ALLOCATION UNDER ABC

5
Under activity based cost allocation overheads are attributed to products on an
activity base. Traditionally, overhead costs are grouped together under cost
centre and then absorbed into product costs on some basis such as direct labour
hours. Activity based costing identifies the activities which cause cost to be
incurred and searches for fundamental cost drivers of these activities. Once the

activities and there cost drivers have been identified this information can be used
to assign overheads to cost objects (e.g. products) which have actually caused
cost to be incurred.
5.5 TRADITIONAL ABSORBTION COSTING VS ABC

5
Cost Allocation under Traditional and Activity Based Costing system
Direct Cost
Tracing of Product/
Cost Ascertainment Service
Cost
Indirect Cost
Cost
Allocation
Traditional Costing Activity based Costing
Based on Machine
hours, labour Hours, Based on Cost Driver
Volume etc.
Cost Allocation under Traditional and Activity Based Costing system

In traditional absorption costing overheads are first related to cost centres
(Production & Service Centres) and then to cost objects, i.e., products. In ABC
overheads are related to activities or grouped into cost pools. Then they are
related to the cost objects, e.g., products. The two processes are, therefore, very
similar, but the first stage is different as ABC uses activities instead of functional
departments (cost centres). The problem with functional departments is that they
tend to include a series of different activities, which incur a number of different
costs that behave in different ways. Activities also tend to run across functions; for
instance, procurement of materials often includes raising a requisition note in a
manufacturing department or stores. It is not raised in the purchasing department
where most procurement costs are incurred. Activity costs tend to behave in a
similar way to each other i.e., they have the same cost driver. Therefore, ABC gives

a more realistic picture of the way in which costs behave.
Activity Based Costing Traditional Absorption Costing

1. Overheads are related to 1. Overheads are related to cost
activities and grouped into centers/departments.
activity cost pools.
2. Costs are related to activities 2 Costs are related to cost centers
and hence are more realistic. and hence not realistic of cost
behaviour.
3 Activity–wise cost drivers are 3. Time (Hours) are assumed to be
determined. the only cost driver governing
costs in all departments.
4. Activity–wise recovery rates are 4. Either multiple overhead recovery
determined and there is no rate (for each department) or a
concept of a single overhead single overhead recovery rate may
recovery rate. be determined for absorbing
overheads.
5. Cost are assigned to cost 5. Costs are assigned to Cost Units
objects, e.g. customers, i.e. to products, or jobs or hours.
products, services, departments,
etc.
6. Essential activities can be 6. Cost Centers/ departments cannot
simplified and unnecessary be eliminated. Hence not suitable
activities can be eliminated. Thus for cost control.
the corresponding costs are also
reduced/ minimized. Hence ABC
aids cost control.
5.6 LEVEL OF ACTIVITIES UNDER ABC METHO-

DOLOGY/COST HIERARCHY
These categories are generally accepted today but were first identified by Cooper
(1990). The categories of activities help to determine the type of activity cost
driver required.

The categories of activities are:
Level of Meaning Example

Activities
1.Unit level These are those activities • The use of indirect
activities for which the materials/consumables tends to
consumption of resources increase in proportion to the
can be identified with the number of units produced.
number of units • The inspection or testing of every
produced. item produced, if this was deemed
necessary or, perhaps more likely,
every 100th item produced.
2.Batch level The activities such as • Material ordering–where an order
activities setting up of a machine is placed for every batch of
or processing a purchase production
order are performed each • Machine set-up costs–where
time a batch of goods is machines need resetting between
produced. The cost of each different batch of production.
batch related activities • Inspection of products where the
varies with number of first item in every batch is
batches made, but is inspected rather than every 100th
common (or fixed) for all item quoted above.
units within the batch.
3. Product These are the activities • Designing the product,
level which are performed to • Producing parts specifications
activities support different • keeping technical drawings of
products in product line products up to date.
4.Facilities These are the activities • Maintenance of buildings
level which cannot be directly • Plant security
activities attributed to individual
products. These activities
are necessary to sustain
the manufacturing
process and are common
and joint to all products
manufactured

5.7 STAGES IN ACTIVITY BASED COSTING (ABC)

The different stages in ABC calculations are listed below:
(1) Identify the different activities within the organisation: Usually the
number of cost centres that a traditional overhead system uses are quite
small, say up to fifteen. In ABC the number of activities will be much more,
say 200; the exact number will depend on how the management subdivides
the organisation’s activities. It is possible to break the organisation down into
many very small activities. But if ABC is to be acceptable as practical system
it is necessary to use larger groupings, so that, say, 40 activities may be
used in practice. The additional number of activities over cost centres means
that ABC should be more accurate than the traditional method regardless of
anything else. Some activities may be listed as follows:-
• Production schedule changes
• Customer liaison
• Purchasing
• Production process set up
• Quality control
• Material handling
• Maintenance
(2) Relate the overheads to the activities, both support and primary, that
caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done
using resource cost drivers that reflect causality.
(3) Support activities are then spread across the primary activities on some
suitable base, which reflects the use of the support activity. The base is the
cost driver that is the measure of how the support activities are used.
(4) Determine the activity cost drivers that will be used to relate the
overheads collected in the cost pools to the cost objects/products. This is
based on the factor that drives the consumption of the activity. The
question to ask is – what causes the activity to incur costs? In production
scheduling, for example, the driver will probably be the number of batches
ordered.
(5) Calculate activity cost driver rates for each activity, just as an overhead
absorption rate would be calculated in the traditional system.

Activity cost driver rate = Total cost of activity

Activity driver
The activity driver rate can be used to cost products, as in traditional

absorption costing, but it can also cost other cost objects such as
customers/customer segments and distribution channels. The possibility of
costing objects other than products is part of the benefit of ABC. The
activity cost driver rates will be multiplied by the different amounts of each
activity that each product/other cost object consumes.
Cost allocation under ABC

Let us take a small example to understand the steps stated above:
Assume that a company makes widgets and the management decides to install an
ABC system. The management decides that all overhead costs will have only three
cost drivers viz. Direct labour hours, Machine hours and number of purchase
orders and the general ledger of the company shows the following overhead
costs –
General Ledger Amount (`)

Payroll taxes 1,000
Machine maintenance 500
Purchasing Dept. labour 4,000
Fringe benefits 2,000
Purchasing Dept. Supplies 250
Equipment depreciation 750
Electricity 1,250
Unemployment insurance 1,500
Total 11,250
So, which overheads do you think are driven by direct labour hours?

The answer is
Payroll taxes ` 1,000
Fringe benefits ` 2,000
Unemployment insurance ` 1,500
Total ` 4,500
Similarly, overheads driven by machine hours include Machine maintenance,

depreciation and Electricity totaling ` 2,500 and finally overheads driven by
number of purchase orders include purchasing department labour and purchasing
department supplies totaling ` 4,250.
Now, overhead rate is calculated by the formula total cost in the activity pool /
Base, base being the total number of labour hours, machine hours and total
number of purchase orders in the given case.
Assume that the total number of labour hours be 1,000 hours, machine hours be
250 hours and total purchase orders be 100 orders.
So, Cost driver rate would be
Cost Driver Rate (`)
` 4,500/ 1,000 ` 4.50 per labour hour
` 2,500/ 250 ` 10 per machine hour
` 4,250/ 100 ` 42.50 per purchase order
Now, let’s allocate the overheads between two widgets A and B the details of
which are given below:
Particulars Widget A Widget B

Labour hours 400 600
Machine Hours 100 150
Purchase Orders 50 50
So, total overhead costs applied to widget A = (400×4.50) + (100×10) +

(50×42.50) = ` 4,925
And total overheads applied to widget B = (600×4.50) + (150×10) + (50×42.50) =
` 6,325
So total overheads = ` 4,925 + ` 6,325 = ` 11,250.

Generally, in the traditional costing method, overheads are applied on the basis
of direct labour hours (total 1,000 labour hours in the given case). So, in that case
the overhead absorption rate would be – ` 11,250/ 1000 = ` 11.25 per hour and
the total overheads applied to Widget A would have been = 400 × 11.25 =
` 4,500 and to Widget B = 600 ×11.25 = ` 6,750.
Hence Widget A would have been undervalued and Widget B overvalued by
` 425.
Example of cost drivers for different activity pools in a production department can
be explained below:
Activity Cost Pools Related Cost Drivers

Ordering and Receiving Materials cost Number of purchase orders
Setting up machines costs Number of set-ups
Machining costs Machine hours
Assembling costs Number of parts
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours
ILLUSTRATION 1
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The
budgeted costs and production for the year ending 31st March, 20X8 are as follows:
A B C
Production quantity (Units) 4,000 3,000 1,600
Resources per Unit:
- Direct Materials (Kg.) 4 6 3
- Direct Labour (Minutes) 30 45 60
The budgeted direct labour rate was `10 per hour, and the budgeted material cost
was ` 2 per kg. Production overheads were budgeted at ` 99,450 and were
absorbed to products using the direct labour hour rate. ABC Ltd. followed an
Absorption Costing System.
ABC Ltd. is now considering to adopt an Activity Based Costing system. The
following additional information is made available for this purpose.

1. Budgeted overheads were analysed into the following:
(`)
Material handling 29,100
Storage costs 31,200
Electricity 39,150
2. The cost drivers identified were as follows:
Material handling Weight of material handled

Storage costs Number of batches of material
Electricity Number of Machine operations
3. Data on Cost Drivers was as follows:
A B C
For complete production:
Batches of material 10 5 15
Per unit of production:
Number of Machine operators 6 3 2
You are requested to:
1. PREPARE a statement for management showing the unit costs and total costs
of each product using the absorption costing method.
2. PREPARE a statement for management showing the product costs of each
product using the ABC approach.
3. STATE what are the reasons for the different product costs under the two
approaches?
SOLUTION
1. Traditional Absorption Costing
A B C Total
(a) Quantity (units) 4,000 3,000 1,600 8,600
(b) Direct labour (minutes) 30 45 60 -
(c) Direct labour hours (a × b)/60 minutes 2,000 2,250 1,600 5,850

Overhead rate per direct labour hour:

= Budgeted overheads ÷Budgeted labour hours
= ` 99,450 ÷ 5,850 hours
= ` 17 per direct labour hour
Unit Costs:
A (`) B (`) C (`)

Direct Costs:
- Direct Labour 5.00 7.50 10.00
- Direct Material 8.00 12.00 6.00
Production Overhead: 8.50 12.75 17.00
 17×30   17×45   17×60 
     
 60   60   60 
Total unit costs 21.50 32.25 33.00
Number of units 4,000 3,000 1,600
Total costs 86,000 96,750 52,800
2. Activity Based Costing
A B C Total
Quantity (units) 4,000 3,000 1,600 -
Weight per unit (Kg.) 4 6 3 -
Total weight 16,000 18,000 4,800 38,000
Machine operations per unit 6 3 2 -
Total operations 24,000 9,000 3,200 36,200
Total batches of Material 10 5 15 30
Material handling rate per kg. = ` 29,000 ÷ 38,800 kg. = ` 0.75 per kg.
Electricity rate per machine operations = ` 39,150 ÷ 36,200
= ` 1,082 per machine operations
Storage rate per batch = ` 31,200 ÷ 30 batches
= ` 1,040 per batch

Unit Costs:
A (`) B (`) C (`)

Direct Costs:
Direct Labour 5.00 7.50 10.00
Direct material 8.00 12.00 6.00
Production Overheads:
Material Handling 3.00 4.50 2.25
(`0.75 × 4) (`0.75 × 6) (`0.75 × 3)
Electricity 6.49 3.25 2.16
(`1.082 × 6) (`1.082 × 3) (`1.082 × 2)
Storage 2.60 1.73 9.75
 ` 1,040   `1,040   `1,040 
 `10 ×   `5×   `15× 
 4,000   3,000   1,600 
Total unit costs 25.09 28.98 30.16
Number of units 4,000 3,000 1,600
Total costs ` 1,00,360 ` 86,940 ` 48,256
3. Comments: The difference in the total costs under the two systems is due
to the differences in the overheads borne by each of the products. The Activity
Based Costs appear to be more precise.
5.8 ADVANTAGES OF ACTIVITY BASED COSTING

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

5.9 LIMITATIONS OF ACTIVITY BASED COSTING

The main limitations using Activity Based Costing are:
(i) It is more expensive particularly in comparison with Traditional costing
system.
(ii) It is not helpful to small Organization.
(iii) It may not be applied to organization with very limited products.
(iv) Selection of most suitable cost driver may not be useful.
5.10 REQUIRMENTS IN ABC IMPLEMENTATION

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

BASED COSTING
5.11.1 As a Decision-Making Tool
ABC can act as a decision making tools in the following ways:
(i) ABC along with some other Cost Management technique can be utilized to
improve performance and profitability of an organization.

(ii) Wholesale distributors can gain significant advantage in the decision-

making process through implementation of ABC concepts by correlating costs to
various activity. Introduction of new product or vendor can be better decided
through ABC.
(iii) ABC can assist in decisions related to facility and resource expansion. Often
the basis for relocation or opening of a new distribution center is based on cost
associations. Reduction in freight or other logistic costs can offset the expense of
the new facility, staff or equipment. The ABC model can identify the specific cost
elements being targeted, providing a much clearer picture from which
management can act.
(iv) Decision support for human resources can be augmented by ABC. Where
activity, and therefore cost, can be associated to an individual, new levels of
financial performance can be determined. This might be appropriate in cases of
branch management or sales.
(v) Companies who wish to determine price based on cost plus markup basis
find ABC method of costing very relevant and are able to determine competitive
prices for their products.
5.11.2 As Activity Based Management
Meaning of Activity Based Management
The term Activity based management (ABM) is used to describe the cost
management application of ABC. The use of ABC as a costing tool to manage
costs at activity level is known as Activity Based Cost Management (ABM).
ABM is a discipline that focuses on the efficient and effective management of
activities as the route to continuously improving the value received by customers.
ABM utilizes cost information gathered through ABC.
Various analysis in Activity Based Management
The various types of analysis involved in ABM are as follows:
(1) Cost Driver Analysis: The factors that cause activities to be performed need
to be identified in order to manage activity costs. Cost driver analysis identifies
these causal factors.
(2) Activity Analysis.
(a) Value-Added Activities (VA): The value-added activities are those
activities which are indispensable in order to complete the process.
The customers are usually willing to pay (in some way) for these

services. For example, polishing furniture by a manufacturer dealing in

furniture is a value added activity.
(b) Non-Value-Added Activities (NVA): The NVA activity represents work
that is not valued by the external or internal customer. NVA
activities do not improve the quality or function of a product or
service, but they can adversely affect costs and prices. Moving
materials and machine set up for a production run are examples of
NVA activities.
(3) Performance Analysis: Performance analysis involves the identification of
appropriate measures to report the performance of activity centres or other
organisational units, consistent with each unit’s goals and objectives.
Activity Based Management in Business
Activity based management can be used in the following ways
(i) Cost Reduction: ABM helps the organisation to identify costs against
activities and to find opportunities to streamline or reduce the costs or eliminate
the entire activity, especially if there is no value added.
(ii) Business Process Re-engineering: Business process re-engineering
involves examining business processes and making substantial changes to
how organisation currently operates. ABM is a powerful tool for measuring
business performance, determining the cost of business output and is used as a
means of identifying opportunities to improve process efficiency and
effectiveness.
(iii) Benchmarking: Benchmarking is a process of comparing of ABC-derived
activity costs of one segment of company with those of other segments. It
requires uniformity in the definition of activities and measurement of their costs.
(iv) Performance Measurement: Many organisations are now focusing on
activity performance as a means of facing competitors and managing costs by
monitoring the efficiency and effectiveness of activities.
Area Measure
Quality of purchased component Zero defects
Quality of output % yield
Customer awareness Orders; number of complaints

5.11.3 Facilitate Activity Based Budgeting

Meaning of Activity Based Budgeting (ABB)
Activity based budgeting analyse the resource input or cost for each activity. It
provides a framework for estimating the amount of resources required in
accordance with the budgeted level of activity. Actual results can be compared
with budgeted results to highlight both in financial and non-financial terms those
activities with major discrepancies from budget for potential reduction in supply
of resources. It is a planning and control system which seeks to support the
objectives of continuous improvement. It means planning and controlling the
expected activities of the organization to derive a cost-effective budget that meet
forecast workload and agreed strategic goals. ABB is the reversing of the ABC
process to produce financial plans and budgets.
Key Elements of ABB
The three key elements of activity based budgeting are as follows:-
♦ Type of work to be done
♦ Quantity of work to be done
♦ Cost of work to be done
Benefits of ABB
Few benefits of activity based budgeting are as follows:-
1. Activity Based Budgeting (ABB) can enhance accuracy of financial forecasts
and increasing management understanding.
2. When automated, ABB can rapidly and accurately produce financial plans
and models based on varying levels of volume assumptions.
3. ABB eliminates much of the needless rework created by traditional
budgeting techniques.
ILLUSTRATION 2
MST Limited has collected the following data for its two activities. It calculates
activity cost rates based on cost driver capacity.
Activity Cost Driver Capacity Cost

Power Kilowatt hours 50,000 kilowatt hours `2,00,000
Quality Inspections Number of Inspections 10,000 Inspections ` 3,00,000

The company makes three products M, S and T. For the year ended March 31, 20X9,
the following consumption of cost drivers was reported:
Product Kilowatt hours Quality Inspections

M 10,000 3,500
S 20,000 2,500
T 15,000 3,000
Required:
(i) COMPUTE the costs allocated to each product from each activity.
(ii) CALCULATE the cost of unused capacity for each activity.
(iii) DISCUSS the factors the management considers in choosing a capacity level
to compute the budgeted fixed overhead cost rate.
SOLUTION
(i) Statement of cost allocation to each product from each activity
Product
M (`) S (`) T (`) Total
(`)
Power (Refer 40,000 80,000 60,000 1,80,000
to working (10,000 kWh (20,000 kWh (15,000 kWh
note) × `4) ×`4) ×`4)
Quality 1,05,000 75,000 90,000 2,70,000
Inspections (3,500 (2,500 (3,000
(Refer to inspections × inspections × inspections ×
working note) `30) ` 30) ` 30)
Working note
Rate per unit of cost driver:
Power (` 2,00,000 / 50,000 kWh) ` 4/kWh

Quality Inspection (` 3,00,000 / 10,000 ` 30 per inspection
inspections)

(ii) Computation of cost of unused capacity for each activity:
(`)
Power (`2,00,000 – ` 1,80,000) 20,000
Quality Inspections (`. 3,00,000 – ` 2,70,000) 30,000
Total cost of unused capacity 50,000
(iii) Factors management consider in choosing a capacity level to compute

the budgeted fixed overhead cost rate:
- Effect on product costing & capacity management
- Effect on pricing decisions.
- Effect on performance evaluation
- Effect on financial statements
- Regulatory requirements.
- Difficulties in forecasting chosen capacity level concepts.
ILLUSTRATION 3
ABC Ltd. Manufactures two types of machinery equipment Y and Z and
applies/absorbs overheads on the basis of direct-labour hours. The budgeted
overheads and direct-labour hours for the month of December, 20X8 are
` 12,42,500 and 20,000 hours respectively. The information about Company’s
products is as follows:
Equipment Equipment
Y Z
Budgeted Production volume 2,500 units 3,125 units
Direct material cost ` 300 per unit ` 450 per unit
Direct labour cost
Y : 3 hours @ ` 150 per hour
X : 4 hours @ ` 150 per hour ` 450 ` 600
ABC Ltd.’s overheads of ` 12,42,500 can be identified with three major activities:
Order Processing (` 2,10,000), machine processing (` 8,75,000), and product
inspection (` 1,57,500). These activities are driven by number of orders processed,
machine hours worked, and inspection hours, respectively. The data relevant to

these activities is as follows:

Orders processed Machine hours worked Inspection hours
Y 350 23,000 4,000
Z 250 27,000 11,000
Total 600 50,000 15,000
Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production,
COMPUTE the unit manufacturing cost of the equipment Y and Z, if the
budgeted manufacturing volume is attained.
(ii) Assuming use of activity-based costing, COMPUTE the unit manufacturing costs
of the equipment Y and Z, if the budgeted manufacturing volume is achieved.
(iii) ABC Ltd.’s selling prices are based heavily on cost. By using direct-labour
hours as an application base, CALCULATE the amount of cost distortion
(under-costed or over-costed) for each equipment.
SOLUTION
(i) Overheads application base: Direct labour hours
Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Overheads* 186.38 248.50
936.38 1,298.50
Budgeted overheads ` 12, 42,500

*Pre-determined rate = = = `62.125
Budgeted direct labour hours 20, 000 hours
(ii) Estimation of Cost-Driver rate
Overhead cost Cost-driver level Cost driver rate

Activity
(`) (`)
Order processing 2,10,000 600 350
Orders processed

Machine 8,75,000 50,000 17.50

processing Machine hours
Inspection 1,57,500 15,000 10.50
Inspection hours
Equipment Equipment
Y (`) Z (`)
Direct material cost 300 450
Direct labour cost 450 600
Prime Cost 750 1,050
Overhead Cost
Order processing 350 : 250 1,22,500 87,500
Machine processing 23,000 : 27,000 4,02,500 4,72,500
Inspection 4,000 : 11,000 42,000 1,15,500
Total overhead cost 5,67,000 6,75,500
Per unit cost

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

costed using direct labour hours for overhead absorption.

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

TEST YOUR KNOWLEDGE

1. A cost driver is:
(a) An item of production overheads
(b) A common cost which is shared over cost centres
(c) Any cost relating to transport
(d) An activity which generates costs
2. In activity based costing, costs are accumulated by activity using:
(a) Cost drivers
(b) Cost objects
(c) Cost pools
(d) Cost benefit analysis
3. A cost driver:
(a) Is a force behind the overhead cost
(b) Is an allocation base
(c) Is a transaction that is a significant determinant of cost
4. Which of the following is not a correct match:
Activity Cost Driver

a) Production Scheduling Number of Production runs
b) Despatching Number of dispatch orders
c) Goods receiving Goods received orders
d) Inspection Machine hours
5. Transactions undertaken by support department personnel are the

appropriate cost drivers. They are:
(a) The number of purchase, supplies and customers’ orders drives the
cost associated with new material inventory, work-in-progress and
finished goods inventory

(b) The number of production runs undertaken drives production

scheduling, inspection and material handling
(c) The quality of raw material issued drives the cost of receiving
department costs
(d) The number of packing orders drives the packing costs
6. Steps in ABC include:
(a) Identification of activities and their respective costs
(b) Identification of cost driver of each activity and computation of an
allocation rate per activity
(c) Allocation of overhead cost to products/ services based on the
activities involved
7. Which of the following is not a benefit of ABC?
(a) Accurate cost allocation
(b) Improved decision making
(c) Better control on activity and costs
(d) Reduction of prime cost
8. The steps involved for installation of ABC in a manufacturing company
include the following except:
(a) Borrowing fund
(b) Feasibility study
(c) Building up necessary IT infrastructure and training of line employees
(d) Strategy and value chain analysis
9. Which of the following statements are true: (1) Activity based Management
involves activity analysis and performance measurement. (2) Activity based
costing serves as a major source of information in ABM.
(a) (1) True; (2) False
(b) (1) True; (2) True
(c) (1) False; (2) True

(d) (1) False; (2) False

10. The key elements of activity based budgeting are:
(a) Type of activity to be performed
(b) Quantity of activity to be performed
(c) Cost of activity to be performed
Theoretical Questions:
1. DEFINE the following terms:
(i) Cost driver
(ii) Activity cost pool
2. EXPLAIN in brief the problems of traditional costing where overhead costs
are allocated based on volume
3. STATE what is Activity based costing? How are product costs determined in
ABC?
4. A manufacturing company in India wants to replace its traditional costing
system by ABC. It produces a number of products, each having complex
production process of different degree. SUGGEST various requirements for
installing activity based costing.
5. DESCRIBE various level of activities under ABC.
6. STATE what are the benefits of ABC?
7. STATE what are the limitations of ABC?
8. STATE what are the practical application of ABC?
9. STATE what is Activity based Management? How does ABC help ABM?
10. DEFINE Activity based Budgeting. STATE what are its key elements?
Practical Problems
1. RST Limited specializes in the distribution of pharmaceutical products. It
buys from the pharmaceutical companies and resells to each of the three
different markets.
(i) General Supermarket Chains

(ii) Drugstore Chains

(iii) Chemist Shops
The following data for the month of April, 20X9 in respect of RST Limited
has been reported:
General Drugstore Chemist

Supermarket Chains Shops
Chains
(`) (`) (`)
Average revenue per delivery 84,975 28,875 5,445
Average cost of goods sold 82,500 27,500 4,950
per delivery
Number of deliveries 330 825 2,750
In the past, RST Limited has used gross margin percentage to evaluate the
relative profitability of its distribution channels.
The company plans to use activity –based costing for analysing the
profitability of its distribution channels.
The Activity analysis of RST Limited is as under:
Activity Area Cost Driver

Customer purchase order processing Purchase orders by customers
Line-item ordering Line-items per purchase order
Store delivery Store deliveries
Cartons dispatched to stores Cartons dispatched to a store
per delivery
Shelf-stocking at customer store Hours of shelf-stocking
The April, 20X9 operating costs (other than cost of goods sold) of RST
Limited are ` 8,27,970. These operating costs are assigned to five activity
areas. The cost in each area and the quantity of the cost allocation basis
used in that area for April, 20X9 are as follows:

Activity Area Total costs Total Units of

in April, Cost Allocation
20X9 (`) Base used in
April, 20X9
Customer purchase order processing 2,20,000 5,500 orders
Line-item ordering 1,75,560 58,520 line items
Store delivery 1,95,250 3,905 store
deliveries
Cartons dispatched to store 2,09,000 2,09,000 cartons
Shelf-stocking at customer store 28,160 1,760 hours
Other data for April, 20X9 include the following:
General Drugstore Chemist

Supermarket Chains Shops
Chains
Total number of orders 385 990 4,125
Average number of line items per 14 12 10
order
Total number of store deliveries 330 825 2,750
Average number of cartons 300 80 16
shipped per store delivery
Average number of hours of 3 0.6 0.1
shelf-stocking per store delivery
Required:
(i) COMPUTE for April, 20X9 gross-margin percentage for each of its
three distribution channels and compute RST Limited’s operating
income.
(ii) COMPUTE the April, 20X9 rate per unit of the cost-allocation base for
each of the five activity areas.
(iii) COMPUTE the operating income of each distribution channel in April,
20X9 using the activity-based costing information. Comment on the
results. What new insights are available with the activity-based cost
information?

(iv) DESCRIBE four challenges one would face in assigning the total April,
20X9 operating costs of ` 8,27,970 to five activity areas.
2. Alpha Limited has decided to analyse the profitability of its five new
customers. It buys bottled water at ` 90 per case and sells to retail
customers at a list price of ` 108 per case. The data pertaining to five
customers are:
Customers
A B C D E
Cases sold 4,680 19,688 1,36,800 71,550 8,775
List Selling Price ` 108 ` 108 `. 108 ` 108 ` 108
Actual Selling Price ` 108 ` 106.20 ` 99 ` 104.40 ` 97.20
Number of Purchase 15 25 30 25 30
orders
Number of Customer 2 3 6 2 3
visits
Number of deliveries 10 30 60 40 20
Kilometers travelled 20 6 5 10 30
per delivery
Number of expedited 0 0 0 0 1
deliveries
Its five activities and their cost drivers are:
Activity Cost Driver Rate

Order taking ` 750 per purchase order
Customer visits ` 600 per customer visit
Deliveries ` 5.75 per delivery Km travelled
Product handling ` 3.75 per case sold
Expedited deliveries ` 2,250 per expedited delivery
Required:
(i) COMPUTE the customer-level operating income of each of five retail
customers now being examined (A, B, C, D and E). Comment on the
results.
(ii) STATE what insights are gained by reporting both the list selling price
and the actual selling price for each customer?

ANSWERS/SOLUTIONS
1. (d) 2. (c) 3. (d) 4. (d) 5. (c) 6. (d)
7. (d) 8. (a) 9. (b) 10. (d)
3. Please refer paragraph 5.2 and 5.5
Practical Questions
1. (i) RST Limited’s
Statement of operating income and gross margin percentage
for each of its three distribution channel
General Super Drugstore Chemist Shops Total
Market Chains Chains
Revenues: (`) 2,80,41,750 2,38,21,875 1,49,73,750 6,68,37,375
(330 × ` 84,975) (825 × ` 28,875) (2,750 × `5,445)
Less: Cost of 2,72,25,000 2,26,87,500 1,36,12,500 635,25,000
goods sold: (`) (330 × ` 82,500) (825 × ` 27,500) (2,750 × ` 4,950)
Gross Margin: (`) 8,16,750 11,34,375 13,61,250 33,12,375
Less: Other
operating costs:
(`) 8,27,970

Operating 24,84,405
income: (`)
Gross Margin 2.91% 4.76 % 9.09% 4.96%
Operating 3.72
income %
(ii) Computation of rate per unit of the cost allocation base for
each of the five activity areas for April 20X9
(`)
Customer purchase order processing 40 order
(`. 2,20,000/ 5,500 orders)
Line item ordering 3 line item order
(`. 1,75,560/ 58,520 line items)
Store delivery 50 delivery
(`. 1,95,250/ 3,905 store deliveries)
Cartons dispatched 1 dispatch
(`. 2,09,000/ 2,09,000 dispatches)
Shelf-stocking at customer store ( ` ) 16 hour
(` 28,160/ 1,760 hours)
(iii) Operating Income Statement of each distribution channel
in April-20X9 (Using the Activity based Costing information)
General Super Drugstore Chemist

Market Chains Chains Shops
Gross margin (`.) : (A) 8,16,750 11,34,375 13,61,260
(Refer to (i) part of the answer)
Operating cost (`.): (B) 1,62,910 1,90,410 4,74,650
Operating income (`.) : (A–B) 6,53,840 9,43,965 8,86,600
Operating income (in %) 2.33 3.96 5.96
(Operating income/ Revenue)
× 100
Comments and new insights: The activity-based cost information

highlights, how the ‘Chemist Shops’ uses a larger amount of RST Ltd.’s

resources per revenue than do the other two distribution channels. Ratio of
operating costs to revenues, across these markets is:
General supermarket chains 0.58%
(` 1,62,910/ `. 2,80,00,750) × 100
Drug store chains 0.80%
(` 1,90,410/ ` 2,38,21,875) × 100
Chemist shops 3.17%
(` 4,74,650/ ` 1,49,73,750) ×100
Working note:
Computation of operating cost of each distribution channel:
General Super Drugstore Chemist Shops
Market Chains Chains
(`) (`) (`)
Customer 15,400 39,600 1,65,000
purchase (` 40 × 385 (` 40 × 990 (` 40 ×4125 orders)
order orders) orders)
processing
Line item 16,170 35,640 1,23,750
ordering (` 3 × 14 x 385) (` 3 × 12 x 990) (` 3 × 10 × 4125)
Store 16,500 41,250 1,37,500
delivery (` 50 × 330 (` 50 × 825 (` 50 × 2750
deliveries) deliveries) deliveries)
Cartons 99,000 66,000 44,000
dispatched ( ` 1× 300 cartons ( ` 1 × 80 cartons ( ` 1 × 16 cartons ×
× 300 deliveries) × 825 deliveries) 2,750 deliveries)
Shelf 15,840 7,920 4,400
stocking (`16 × 330 (` 16 × 825 (` 16 × 2,750
deliveries × 3 Av. deliveries × 0.6 deliveries × 0.1 Av.
hrs.) Av. hrs) hrs)
Operating 1,62,910 1,90,410 4,74,650
cost
(iv) Challenges faced in assigning total operating cost of ` 8,27,970 :

- Choosing an appropriate cost driver for activity area.

- Developing a reliable data base for the chosen cost driver.

- Deciding, how to handle costs that may be common across several
activities.
- Choice of the time period to compute cost rates per cost driver.
- Behavioural factors.
2. Working note:
Computation of revenues (at listed price), discount, cost of goods sold
and customer level operating activities costs:
Customers
A B C D E
Cases sold: 4,680 19,688 1,36,800 71,550 8,775
(a)
Revenues (at 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
listed price)
(`): (b)
{(a) × ` 108)}
Discount - 35,438 12,31,200 2,57,580 94,770
( ` ): (c) (19,688 cases (1,36,800 (71,550 (8,775
{(a) × × cases × cases × cases ×
Discount per ` 1.80) ` 9) ` 3.60) ` 10.80)
case}
Cost of 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
goods sold
(`) : (d)
{(a) × ` 90}
Customer level operating activities costs
Order taking 11,250 18,750 22,500 18,750 22,500
costs (`):
(No. of
purchase ×
`750)
Customer 1,200 1,800 3,600 1,200 1,800
visits costs
(`)

(No. of
customer
visits ×
` 600)
Delivery 1,150 1,035 1,725 2,300 3,450
vehicles
travel costs
(`)
(` 5.75 per
km)
(Kms
travelled by
delivery
vehicles × `
5.75 per km.)
Product 17,550 73,830 5,13,000 2,68,313 32,906
handling
costs (`)
{(a) ×` 3.75}
Cost of - - - - 2,250
expediting
deliveries (`)
{No. of
expedited
deliveries ×
` 2,250}
Total cost of 31,150 95,415 5,40,825 2,90,563 62,906
customer
level
operating
activities (`)
(i) Computation of Customer level operating income

Customers
A (`) B (`) C (`) D (`) E (`)
Revenues 5,05,440 21,26,304 1,47,74,400 77,27,400 9,47,700
(At list price)
(Refer to
working note)

Less: Discount - 35,438 12,31,200 2,57,580 94,770

(Refer to
working note)
Revenue 5,05,440 20,90,866 1,35,43,200 74,69,820 8,52,930
(At actual
price)
Less: Cost of 4,21,200 17,71,920 1,23,12,000 64,39,500 7,89,750
goods sold
(Refer to
working note)
Gross margin 84,240 3,18,946 12,31,200 10,30,320 63,180
Less: 31,150 95,415 5,40,825 2,90,563 62,906
Customer
level
operating
activities costs
(Refer to
working note)
Customer 53,090 2,23,531 6,90,375 7,39,757 274
level
operating
income
Comment on the results:
Customer D is the most profitable customer, despite having only 52.30% of
the unit volume of customer C. The main reason is that C receives a ` 9 per
case discount while customer D receives only a ` 3.60 discount per case.
Customer E is less profitable, in comparison with the small customer A
being profitable. Customer E received a discount of ` 10.80 per case, makes
more frequent orders, requires more customer visits and requires more
delivery kms. in comparison with customer A.
(ii) Insight gained by reporting both the list selling price and the actual
selling price for each customer:
Separate reporting of both-the listed and actual selling prices enables Alpha
Ltd. to examine which customer has received what discount per case,

whether the discount received has any relationship with the sales volume.
The data given below provides us with the following information;
Sales volume Discount per case (`)

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

CHAPTER 6
COST SHEET
LEARNING OUTCOMES
 Classify and ascertain cost on the basis of function.

 Prepare cost sheet/statement for production of goods and
providing of services.
Cost Sheet
Functional Head of Costs in Format of Cost Advantages of

Classification Cost Sheet Sheet Cost Sheet
6.1 INTRODUCTION
One of the objectives of cost accounting system is ascertainment of cost for a
cost object. The cost objects may be a product, service or any cost centre.
Ascertainment of cost includes elementwise collection of costs, accumulation

of the costs so collected for a certain volume or period and then arrange all
these accumulated costs into a sheet to calculate total cost for the cost
object. In this chapter, a product or a service will be the cost object for cost
calculation and cost ascertainment. A Cost Sheet or Cost Statement is “a
document which provides a detailed cost information. In a typical cost sheet,
cost information are presented on the basis of functional classification. However,
other classification may also be adopted as per the requirements of users of the
information.
6.2 FUNCTIONAL CLASSIFICATION OF ELEMENTS

6
OF COST
Under this classification, costs are divided according to the function for which
they have been incurred. The following are the classification of costs based on
functions:
(i) Direct Material Cost
(ii) Direct Employee (labour) Cost
(iii) Direct Expenses
(iv) Production/ Manufacturing Overheads
(v) Administration Overheads
(vi) Selling Overheads
(vii) Distribution Overheads
(viii) Research and Development costs etc.
6.3 COST HEADS IN A COST SHEET

6
The costs as classified on the basis of functions are grouped into the following
cost heads in a cost sheet:
(i) Prime Cost
(ii) Cost of Production
(iii) Cost of Goods Sold
(iv) Cost of Sales

COST SHEET 6.3
6.3.1 Prime Cost

Prime cost represents the total of direct materials costs, direct employee
(labour) costs and direct expenses. The total of cost for each element has to be
calculated separately.
Direct Material Cost xxx

Direct Employees (labour) Cost Xxx
Direct Expenses Xxx
Prime Cost: Xxxx
(i) Direct Material Cost: It is the cost of direct material consumed. The cost
of direct material consumed is calculated as follows:
Opening Stock of Material Xxx

Add: Additions/ Purchases Xxx
Less: Closing stock of Material (xxx)
Direct materials consumed Xxxx
The valuation of materials purchased and issued for production shall be done as
per methods discussed in the ‘Chapter- 2 Material Cost’.
(ii) Direct Employee (labour) Cost: It is the total of payment made to the
employees who are engaged in the production of goods and provision of
services. Employee cost is also known as labour cost; it includes the following:
(a) Wages and salary;
(b) Allowances and incentives;
(c) Payment for overtimes;
(d) Employer’s contribution to Provident fund and other welfare funds;
(e) Other benefits (leave with pay, free or subsidised food, leave travel
concession etc.)
(iii) Direct Expenses: Expenses other than direct material cost and direct
employee cost, which are incurred to manufacture a product or for provision of
service and can be directly traced in an economically feasible manner to a cost
object. The following costs are examples for direct expenses:
(a) Royalty paid/ payable for production or provision of service;

(b) Hire charges paid for hiring specific equipment;

(c) Cost for product/ service specific design or drawing;
(d) Cost of product/ service specific software;
(e) Other expenses which are directly related with the production of goods or
provision of service.
6.3.2 Cost of Production

In a conventional cost sheet, this item of cost can be seen. It is the total of
prime cost and factory related costs and overheads.
Prime Cost Xxx

Add : Factory Overheads Xxx
Gross Works Costs Xxxx
Add: Opening stock of Work-in-process Xxx
Less: Closing stock of Work-in-process (xxx)
Factory or Works Costs Xxxx
Add: Quality Control Cost Xxx
Add: Research & Development cost (Process related) Xxx
Add: Administrative Overheads related with production Xxx
Less: Credit for recoveries (miscellaneous income) (xxx)
Add: Packing Cost (Primary packing) Xxx
Cost of Production Xxxx
(i) Factory Overheads: It is also known as works/ production/

manufacturing overheads. It includes the following indirect costs:
(a) Consumable stores and spares
(b) Depreciation of plant and machinery, factory building etc.
(c) Lease rent of production assets
(d) Repair and maintenance of plant and machinery, factory building etc.
(e) Indirect employees cost related with production activities
(f) Drawing and Designing department cost.

COST SHEET 6.5
(g) Insurance of plant and machinery, factory building, stock of raw material &
WIP etc.
(h) Amortized cost of jigs, fixtures, tooling etc.
(i) Service department cost such as Tool Room, Engineering & Maintenance,
Pollution Control etc.
(ii) Stock of Work-in-process: The cost of opening and closing stock of
work-in-process is adjusted to arrive at factory/ works cost. The WIP stock is
valued on the basis of percentage of completion in respect of each element of
cost. Students may refer the ‘Chapter- Process & Operation Costing’ to know the
WIP valuation methods.
(iii) Quality Control Cost: This is the cost of resources consumed towards
quality control procedures.
(iv) Research & Development cost: It includes only those research and
development related cost which is incurred for the improvement of process,
system, product or services.
(v) Administrative Overheads: It includes only those administration
overheads which are related to production. The general administration overhead
is not included in production cost.
(vi) Credit for recoveries: The realised or realisable value of scrap or waste is
deducted as it reduces the cost of production.
(vii) Packing Cost (primary): Packing material which is essential to hold and
preserve the product for its use by the customer.
6.3.3 Cost of Goods Sold

It is the cost of production for goods sold. It is calculated after adjusting the
values of opening and closing stocks of finished goods. It can be calculated as below:
Cost of Production Xxx
Add: Cost of Opening stock of finished goods Xxx
Less: Cost of Closing stock of finished goods (xxx)
Cost of Goods Sold xxxx

6.3.4 Cost of Sales

It is the total cost of a product incurred to make the product available to the
customer or consumer. It includes Cost of goods sold, administration and
marketing expenses. It is calculated as below:
Cost of Goods Sold xxx

Add: Administrative Overheads (General) xxx
Add: Selling Overheads xxx
Add: Packing Cost (secondary) xxx
Add: Distribution Overheads xxx
Cost of Sales xxxx
(i) Administrative Overheads: It is the cost related with general

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

COST SHEET 6.7
(b) Transportation and insurance costs related with distribution.

(c) Depreciation, hire charges, maintenance and other operating costs
related with distribution vehicles etc.
6.4 COST SHEET/STATEMENT

6.4.1 Presentation of cost information
The cost items in the cost statement shall be presented on ‘basis of relevant
classification’.
Specimen Format of Cost Sheet for a Manufacturing entity
Particulars Total Cost per

Cost (`) unit (`)
1. Direct materials consumed:
Opening Stock of Raw Material xxx
Add: Additions/ Purchases xxx
Less: Closing stock of Raw Material xxx
xxx
2. Direct employee (labour) cost xxx
3. Direct expenses xxx
4. Prime Cost (1+2+3) xxx
5. Add: Works/ Factory Overheads xxx
6. Gross Works Cost (4+5) xxx
7. Add: Opening Work in Process xxx
8. Less: Closing Work in Process (xxx)
9. Works/ Factory Cost (6+7-8) xxx
10. Add: Quality Control Cost xxx
11. Add: Research and Development Cost xxx
12. Add:Administrative Overheads (relating to xxx
production activity)

13. Less:Credit for Recoveries/Scrap/By-Products/ (xxx)

misc. income
14. Add: Packing cost (primary) xxx
15. Cost of Production (9+10+11+12-13+14) xxx
16. Add: Opening stock of finished goods xxx
17. Less: Closing stock of finished goods (xxx)
18. Cost of Goods Sold (15+16-17) xxx
19. Add: Administrative Overheads (General) xxx
20. Add: Marketing Overheads :
Selling Overheads xxx
Distribution Overheads xxx
21. Cost of Sales (18+19+20) xxx
6.4.2 Advantages of Cost sheet or Cost Statements

The main advantages of a Cost Sheet are as follows:
(i) It provides the total cost figure as well as cost per unit of production.
(ii) It helps in cost comparison.
(iii) It facilitates the preparation of cost estimates required for submitting
tenders.
(iv) It provides sufficient help in arriving at the figure of selling price.
(v) It facilitates cost control by disclosing operational efficiency.
ILLUSTRATION 1
The following data relates to the manufacture of a standard product during the
month of April, 20X8:
Raw materials ` 1,80,000

Direct wages ` 90,000
Machine hours worked (hours) 10,000
Machine hour rate (per hour) `8

COST SHEET 6.9
Administration overheads ` 35,000

Selling overheads (per unit) `5
Units produced 4,000
Units sold 3,600
Selling price per unit ` 125
You are required to PREPARE a cost sheet in respect of the above showing:
(i) Cost per unit
(ii) Profit for the month
SOLUTION
(i) Cost Sheet Output: 4,000 units
Total Cost per

Cost (`) (unit) (`)
Raw materials 1,80,000 45.00
Direct wages 90,000 22.50
Prime cost 2,70,000 67.50
Add: Factory overheads (10,000 hrs × ` 8 per hour) 80,000 20.00
Cost of Production 3,50,000 87.50
Less: Closing Stock of finished goods (4,000 – (35,000) --
3,600 units)
Cost of Goods Sold 3,15,000 87.50
Add: Administration overheads 35,000 8.75
Add: Selling Overheads (3,600 units × ` 5 unit) 18,000 5.00
Cost of sales (total Cost) 3,68,000 101.25
(ii) Statement of Profit
Total Cost
(`)
Sales revenue (3,600 units @ ` 125) 4,50,000
Less: Cost of sales 3,68,000
Profit 82,000

ILLUSTRATION 2
The following information has been obtained from the records of ABC
Corporation for the period from June 1 to June 30, 20X8.
On June On June
1, 20X8 30, 20X8
(` ) (` )
Cost of raw materials 60,000 50,000
Cost of work-in-process 12,000 15,000
Cost of stock of finished goods 90,000 1,10,000
Purchase of raw materials during June’ 20X8 4,80,000
Wages paid 2,40,000
Factory overheads 1,00,000
Administration overheads (related to production) 50,000
Selling & distribution overheads 25,000
Sales 10,00,000
PREPARE a statement giving the following information:

(a) Raw materials consumed;
(b) Prime cost;
(c) Factory cost;
(d) Cost of goods sold; and
(e) Net profit.
SOLUTION
Statement of Cost & Profit
(for the month of June 20X8)
Amount (`)
Opening stock of raw materials 60,000
Add: Purchase of raw materials during June’ 20X8 4,80,000
Less: Closing stock of raw materials (50,000)
(a) Raw materials consumed 4,90,000

COST SHEET 6.11
Add: Direct wages 2,40,000

(b) Prime cost 7,30,000
Add: Factory overheads 1,00,000
Works cost 8,30,000
Add: Opening work-in-process 12,000
Less: Closing work-in-process (15,000)
(c) Factory cost 8,27,000
Add: Administration overheads 50,000
Cost of production 8,77,000
Add: Opening stock of finished goods 90,000
Less: Closing stock of finished goods (1,10,000)
(d) Cost of goods sold 8,57,000
Add: Selling & distribution overheads 25,000
Cost of sales 8,82,000
(e) Net Profit 1,18,000
Sales 10,00,000
SUMMARY
♦ Cost Sheet: A Cost Sheet or Cost Statement is “a document which provides a
detailed cost information. In a typical cost sheet, cost information are
presented on the basis of functional classification. However, other classification
may also be adopted as per the requirements of users of the information.
♦ Prime Cost: Prime cost represents the total of direct materials costs, direct
employee (labour) costs and direct expenses.
♦ Direct Expenses: Expenses other than direct material cost and direct
employee cost, which are incurred to manufacture a product or for
provision of service and can be directly traced in an economically feasible
manner to a cost object.
♦ Cost of Sales: It is the total cost of a product incurred to make the product
available to the customer or consumer.

TEST YOUR KNOWLEDGE

1. Generally, for the purpose of cost sheet preparation, costs are classified on
the basis of:
(a) Functions
(b) Variability
(c) Relevance
(d) Nature
2. Which of the following does not form part of prime cost:
(a) Cost of packing
(b) Cost of transportation paid to bring materials to factory
(c) GST paid on raw materials (input credit can be claimed)
(d) Overtime premium paid to workers.
3. A Ltd. received an order, for which it purchased a special frame for
manufacturing, it is a part of:
(a) Direct Materials
(b) Direct expenses
(c) Factory Overheads
(d) Administration Overheads
4. Salary paid to plant supervisor is a part of
(a) Direct expenses
(b) Factory overheads
(c) Quality control cost
(d) Administration cost
5. Depreciation of director’s laptop is treated as a part of:
(a) Administration Overheads
(b) Factory Overheads
(c) Direct Expenses

COST SHEET 6.13
(d) Research & Development cost.

6. A manufacture has set-up a lab for testing of products for compliance with
standards, salary of this lab staffs are part of:
(a) Works overheads
(b) Quality Control Cost
(c) Direct Expenses
(d) Research & Development Cost.
7. Audit fees paid to auditors is part of:
(a) Administration Cost
(b) Production cost
(c) Selling & Distribution cost
(d) Not shown in cost sheet.
8. Salary paid to factory store staff is part of:
(a) Factory overheads
(b) Production Cost
(c) Direct Employee cost
(d) Direct Material Cost.
9. Canteen expenses for factory workers are part of:
(a) Factory overhead
(b) Administration Cost
(c) Marketing cost
(d) None of the above.
10. A company pays royalty to State Government on the basis of production, it
is treated as:
(a) Direct Material Cost
(b) Factory Overheads
(c) Direct Expenses
(d) Administration cost.

1. DESCRIBE how costs are classified on the basis of function?
2. EXPLAIN the treatment of administration overheads.
3. STATE the advantages of a cost sheet
Practical Questions
1. The books of Adarsh Manufacturing Company present the following data
for the month of April, 20X9:
Direct labour cost ` 17,500 being 175% of works overheads.
Cost of goods sold excluding administrative expenses ` 56,000.
Inventory accounts showed the following opening and closing balances:
April 1 (`) April 30 (`)

Raw materials 8,000 10,600
Work-in-progress 10,500 14,500
Finished goods 17,600 19,000
Other data are:
(`)
Selling expenses 3,500
General and administration expenses 2,500
Sales for the month 75,000

(i) COMPUTE the value of materials purchased.
(ii) PREPARE a cost statement showing the various elements of cost and
also the profit earned.
2. A Ltd. Co. has capacity to produce 1,00,000 units of a product every month.
Its works cost at varying levels of production is as under:
Level Works cost per unit (`)

10% 400
20% 390

COST SHEET 6.15
30% 380
40% 370
50% 360
60% 350
70% 340
80% 330
90% 320
100% 310
Its fixed administration expenses amount to ` 1,50,000 and fixed marketing

expenses amount to ` 2,50,000 per month respectively. The variable
distribution cost amounts to ` 30 per unit.
It can sell 100% of its output at ` 500 per unit provided it incurs the
following further expenditure:
(a) it gives gift items costing ` 30 per unit of sale;
(b) it has lucky draws every month giving the first prize of ` 50,000; 2nd
prize of ` 25,000, 3rd prize of ` 10,000 and three consolation prizes of
` 5,000 each to customers buying the product.
(c) it spends ` 1,00,000 on refreshments served every month to its
customers;
(d) it sponsors a television programme every week at a cost of ` 20,00,000
per month.
It can market 30% of its output at ` 550 per unit without incurring any of
the expenses referred to in (a) to (d) above.
PREPARE a cost sheet for the month showing total cost and profit at 30%
and 100% capacity level.
ANSWERS/ SOLUTIONS
1. (a) 2. (a) 3. (b) 4. (b) 5. (a) 6. (b)
7. (a) 8. (a) 9. (a) 10. (c)


Answers to the Practical Questions

1. (i) Computation of the value of materials purchased
(`)
Cost of goods sold 56,000
Add: Closing stock of finished goods 19,000
Less: Opening stock of finished goods (17,600)
Cost of goods manufactured 57,400
Add: Closing stock of work-in-progress 14,500
Less: Opening stock of work-in-progress (10,500)
Works cost 61,400
100 (10,000)
Less: Factory overheads: [ of Direct labour cost]
175
Prime cost 51,400
Less: Direct labour (17,500)
Raw material consumed 33,900
Add: Closing stock of raw materials 10,600
Raw materials available 44,500
Less: Opening stock of raw materials ( 8,000)
Value of materials purchased 36,500
(ii) Cost statement
(`)
Raw material consumed [Refer to statement (i) above] 33,900
Add: Direct labour cost 17,500
Prime cost 51,400
Add: Factory overheads 10,000
Works cost 61,400

COST SHEET 6.17
Add: Opening work-in-progress 10,500

Less: Closing work-in-progress (14,500)
Cost of goods manufactured 57,400
Add: Opening stock of finished goods 17,600
Less: Closing stock of finished goods (19,000)
Cost of goods sold 56,000
Add: General and administration expenses 2,500
Add: Selling expenses 3,500
Cost of sales 62,000
Profit (Balance figure ` 75,000 – ` 62,000) 13,000
Sales 75,000
2. (a) Cost Sheet (For the month)
Level of Capacity 30% 100%

30,000 units 1,00,000 units
Per Total Per unit Total (`)
unit (`) (`) (`)
Works Cost 380.00 1,14,00,000 310.00 3,10,00,000
Add: Fixed administration 5.00 1,50,000 1.50 1,50,000
expenses
Add:Fixedmarketing 8.33 2,50,000 2.50 2,50,000
expenses
Add: Variable distribution 30.00 9,00,000 30.00 30,00,000
cost
Add: Special Costs:
- Gift items costs - - 30.00 30,00,000
- Customers’ prizes* - - 1.00 1,00,000
- Refreshments - - 1.00 1,00,000
- Television
programme
sponsorship cost - - 20.00 20,00,000

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

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

CHAPTER 7
COST ACCOUNTING
SYSTEMS
LEARNING OUTCOMES
 Discuss the Cost Accounting System.

 Differentiate between Integral and Non- Integral system of
accounting.
 Identify the ledgers maintained under Integral and Non-
Integral accounting system.
 Analyse the reasons for differences in profit under financial
and cost accounts.
 Prepare reconciliation statement for profit under financial
and cost accounts.
 Discuss the accounting for management information and
cost control.

7.1 INTRODUCTION
7
To operate business operations efficiently and successfully, it is necessary to make
use of an appropriate accounting system. Such a system should state in clear terms
whether cost and financial transactions should be integrated or kept separately
(Non-integrated). Where cost and financial accounting records are integrated,
the system so evolved is known as integrated or integral accounting. In case
cost and financial transactions are kept separately, the system is called Non-
Integrated Accounting or Cost Control System. While non-integrated system of
accounting necessitates reconciliation between financial and cost accounts, no
reconciliation between two sets of accounts is required under integrated accounting.
7.2 NON-INTEGRATED ACCOUNTING SYSTEM

7
It is a system of accounting under which separate ledgers are maintained for cost
and financial accounts by Accountants. This system is also referred to as cost
ledger accounting system. Under such a system the cost accounts restrict itself
to recording only those transactions which relate to the product or service being
provided. Hence items of expenses which have a bearing with sales or, production
or for that matter any other items which are under the factory management are
the ones dealt with in such accounts. This leads to the exclusion of certain
expenses like interest, bad debts and revenue/income from ‘other than the sale of
product or service’.

COST ACCOUNTING SYSTEMS 7.3
A special feature of the non-integrated system of accounts is its ability to

deal with notional expenses like rent or interest on capital tied up in the stock.
The accounting of notional rent facilitates comparisons amongst factories (some
owned and some rented).
Non-Integrated Accounting Systems contain fewer accounts when compared with
financial accounting because of the exclusion of purchases, expenses and also
Balance Sheet items like fixed assets, debtors and creditors. Items of accounts
which are excluded are represented by an account known as Cost ledger
control account.
The important ledgers to be maintained under non-integrated accounting
system in the Cost Accounting department are the following:
(a) Cost Ledger - This is the principle ledger of the cost department in which
impersonal accounts are recorded. This ledger is made self-balancing by
maintaining therein a Control Account for each subsidiary ledger.
(b) Stores Ledger - It contains an account for each item of stores. The entries in
each account maintained in this ledger are made from the invoice, goods received
note, material requisitions, material received note etc. Accounts in respect of each item
of stores show receipt, issue and balance in physical as well as in monetary terms.
(c) Work-in-Process Ledger - This ledger is also known as job ledger, it
contains accounts of unfinished jobs and processes. All material costs, wages and
overheads for each job in process are posted to the respective job account in this
ledger. The balance in a job account represents total balance of job/work-in-
process, as shown by the job account.
(d) Finished Goods Ledger - It contains an account for each item of finished
product manufactured or the completed job. If the finished product is transferred
to stock, a credit entry is made in the work-in-process ledger and a
corresponding debit entry is made in this ledger.
7.2.1 Principal Accounts
The main accounts which are usually prepared when a separate Cost Ledger is
maintained are as follows:
(1) Cost Ledger Control Account - This account is also known as General
Ledger Adjustment Account. This account is made to complete double
entry. All items of expenditure are credited to this account. Sales are
debited to this account and net profit/loss from Costing Profit & Loss

Account is transferred to this account. The balance in this account at the

end of the particular period represents the net total of all the balances of
the impersonal account
(2) Stores Ledger Control Account – This account is debited for the purchase
of material and credited for issue of materials from stores. The balance
in this account indicates the total balance of all the individual stores
accounts. Abnormal losses or gains if any in this account, are transferred to
Costing Profit & Loss Account. Entries are made on the basis of goods
received notes and stores requisitions etc.
(3) Wages Control Account - This account is debited with total wages paid
(direct and indirect). Direct wages are further transferred to Work-in-
Process Control Account and indirect wages to Production Overhead;
Administration Overhead or Selling & Distribution Overhead Control
Accounts, as the case may be. Wages paid for abnormal idle time are
transferred to Costing Profit & Loss Account either directly or through
Abnormal Loss Account.
(4) Manufacturing/Production/Works/ Factory Overhead Control Account -
This account is debited with indirect costs of production such as indirect
material, indirect employee, indirect expenses (carriage inward etc.).
Overhead recovered is credited to this Account. The difference between
overhead incurred and overhead recovered (i.e. Under Absorption or Over
Absorption of Overheads) is transferred to Overheads Adjustment Account.
(5) Work-in-Process Control Account - This account is debited with the total
cost of production, which includes—direct materials, direct employee,
direct expenses, production overhead recovered, and is credited with the
amount of finished goods completed and transferred. The balance in this
account represents total balances of jobs/works-in-process, as shown by
several job accounts.
(6) Administrative Overhead Control Account - This account is debited with
overhead incurred and credited with overhead recovered. The overhead
recovered are debited to Finished Goods Control Account, if administrative
overhead is related with production activities otherwise to Cost of Sales A/c.
The difference between administrative overheads incurred and recovered is
transferred to Overhead Adjustment Account.
(7) Finished Goods Control Accounts - This account is debited with the value
of goods transferred from Work-in-process Control Account,

administration costs recovered (if relates to production activities). This

account is credited with Cost of Sales Account. The balance of this account
represents the value of goods unsold at the end of the period..
(8) Selling and Distribution Overhead Control Account - This account is debited
with selling and distribution overheads incurred and credited with the selling and
distribution overheads recovered. The difference between overheads incurred and
recovered is transferred usually to Overhead Adjustment Account.
(9) Cost of Sales Account - This account is debited with the cost of finished
goods transferred from Finished Goods Control Account for sale,
General Administrative overhead recovered, Selling and distribution
overhead recovered. The balance of this account is ultimately transferred to
Sales Account or Costing Profit & Loss Account.
(10) Costing Profit & Loss Account – This account is debited with cost of
goods sold, under-absorbed overheads and abnormal losses and is credited
with sales value, over-absorbed overhead and abnormal gains. The net
profit or loss in this account is transferred to Cost Ledger Control Account.
(11) Overhead Adjustment Account - This account is to be debited for under-
recovery of overhead and credited with over-recovery of overhead
amount. The net balance in this account is transferred to Costing Profit &
Loss Account.
Note: Sometimes, Overhead Adjustment Account is dispensed with and
under/over absorbed overheads is directly transferred to Costing Profit & Loss
Account from the respective overhead accounts.
7.2.2 Scheme of Entries
The manner in which the Cost Ledger, when maintained on a double entry basis,
would operate is illustrated by the following statements of various journal entries
as would appear in the cost books.
Material:
(a) Purchase—` 5,000 (credit or cash) (`) (`)
(i) Material Control A/c …………………………….. Dr. 5,000
To Cost Ledger Control A/c 5,000
(ii) Stores Ledger Control A/c ……………………… Dr. 5,000
To Material Control A/c 5,000

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

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

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


(n) Production overhead recovered—` 1,000
Work-in-Process Ledger Control A/c…………………... Dr. 1,000
To Production Overhead Control A/c 1,000
(o) Administrative Overhead recovered ` 500 from finished goods
Finished Goods Ledger Control A/c…………………….. Dr. 500
To Administrative Overhead Control A/c 500
(p) Selling and Distribution Overhead ` 100 recovered from sales
Cost of Sales A/c………………………………………….. Dr. 100
To Selling & Dist. Overhead Control A/c 100
(q) Under recovery of overheads
Costing Profit & Loss A/c…………………………………. Dr. xxx
To Administrative Overhead Control A/c xxx
(r) Over recovery of overheads
Production Overheads Control A/c…………………….. Dr. xxx
To Costing Profit & Loss A/c xxx
Sales:
(s) Cost Ledger Control A/c………………………………….. Dr. xxx
Profit/ Loss:
(t) In case of Profit
(i) Costing Profit & Loss A/c…………………………… Dr. xxx
To Cost Ledger Control A/c xxx
(u) In case of Loss
(ii) Cost Ledger Control A/c…………………………… Dr. xxx

Non-Integrated Accounting System-flowchart
Administrative overhead is assumed to be related with production

ILLUSTRATION 1
As on 31st March, 20X8, the following balances existed in a firm’s Cost Ledger:
Dr. Cr.
(` ) (` )
Stores Ledger Control A/c 3,01,435
Work-in-Process Control A/c 1,22,365
Finished Stock Ledger Control A/c 2,51,945
Manufacturing Overhead Control A/c 10,525
Cost Ledger Control A/c 6,65,220
6,75,745 6,75,745
During the next three months the following items arose:

(` )
Finished product (at cost) 2,10,835
Manufacturing overhead incurred 91,510
Raw materials purchased 1,23,000
Factory Wages 50,530
Indirect Labour 21,665
Cost of Sales 1,85,890
Material issued to production 1,27,315
Sales returned at Cost 5,380
Material returned to suppliers 2,900
Manufacturing overhead charged to production 77,200
You are required to PASS the Journal Entries; write up the accounts and schedule
the balances, stating what each balance represents.
SOLUTION
Journal entries are as follows:
Dr. Cr.
(`) (`)
1. Finished stock ledger Control A/c Dr. 2,10,835
To Work-in-Process Control A/c 2,10,835
2. Manufacturing Overhead Control A/c Dr. 91,510
3. Stores Ledger Control A/c Dr. 1,23,000
To Cost Ledger Control A/c 1,23,000
4. (i) Wage Control A/c Dr. 72,195
(ii) Work-in-Process Control A/c Dr. 50,530
To Wages Control A/c 50,530
(iii) Manufacturing Overhead Control A/c Dr. 21,665

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

To Finished Stock Ledger A/c 1,85,890
6. Work-in-Process Control A/c Dr. 1,27,315
To Stores Ledger Control A/c 1,27,315
7. Finished Stock Ledger Control A/c Dr. 5,380
To Cost of Sales A/c 5,380
8. Cost Ledger Control A/c Dr. 2,900
To Stores Ledger Control A/c 2,900
9. Work-in-Process Control A/c Dr. 77,200
To Manufacturing Overhead Control A/c 77,200
COST LEDGERS
Cost Ledger Control Account
(`) (`)
To Stores Ledger Control 2,900 By Balance b/d 6,65,220
A/c (return)
” Balance c/d 9,49,025 ” Manufacturing OH Control A/c 91,510
” Stores Ledger Control A/c 1,23,000
” Wages Control A/c 72,195
9,51,925 9,51,925
Stores Ledger Control Account
(` ) (` )
To Balance b/d 3,01,435 By Work in Process Control 1,27,315
A/c
” Cost Ledger Control A/c 1,23,000 ” Cost Ledger Control A/c 2,900
” Balance c/d 2,94,220
4,24,435 4,24,435

Work-in-Process Control Account
(` ) (` )
To Balance b/d 1,22,365 By Finished Stock Ledger 2,10,835
Control A/c
” Wages Control A/c 50,530 ” Balance c/d 1,66,575
” Stores Ledger Control 1,27,315
A/c
” Manufacturing OH 77,200
Control A/c
3,77,410 3,77,410
Finished Stock Ledger Control Account

(` ) (` )
To Balance b/d 2,51,945 By Cost of Sales Control A/c 1,85,890
” Work in Process 2,10,835 ” Balance c/d 2,82,270
Control A/c
” Cost of Sales Control 5,380
A/c (Return at cost)
4,68,160 4,68,160
Manufacturing Overhead Control Account
(` ) (` )
To Cost Ledger Control 91,510 By Balance b/d 10,525
A/c
” Wages Control A/c 21,665 ” Work in Process Control A/c 77,200
” Balance c/d 25,450
1,13,175 1,13,175
Wages Control Account
(` ) (` )
To Cost Ledger Control A/c 72,195 By Work in Process Control A/c 50,530
” Manufacturing OH Control 21,665
A/c
72,195 72,195

Cost of Sales Account
(` ) (` )
To Finished Stock Ledger 1,85,890 By Finished Stock Ledger 5,380
Control Control (Return)
” Balance c/d 1,80,510
1,85,890 1,85,890
Trial Balance
Dr. Cr.
(`) (`)
Stores Ledger Control A/c 2,94,220
Work-in-Process Control A/c 1,66,575
Finished Stock Ledger Control A/c 2,82,270
Manufacturing Overhead Control A/c 25,450
Cost of Sales A/c 1,80,510
9,49,025 9,49,025
ILLUSTRATION 2
From the following details PREPARE the necessary accounts in the Cost Ledger
Materials (`) Work-in-Process (` ) Finished Stock (`)

Opening balance 8,000 5,000 10,000
Closing balance 11,000 9,000 12,000
Transactions during the period: (` )

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

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

Finished Stock Account
(` ) (` )
To Balance b/d 10,000 By Cost of Sales A/c 33,000
(balancing figure)
” Work-in-Process Control A/c 35,000 ” Balance c/d 12,000
45,000 45,000
(`) (`)
To Cost Ledger Control A/c 10,000 By Work-in-process Control A/c 8,000
” Overheads A/c 2,000
10,000 10,000
Overheads Control Account
(` ) (` )
To Cost Ledger Control A/c 8,000 By Work-in-process Control A/c 9,000
” Wages Control A/c 2,000 ” Costing P&L A/c* 1,000
10,000 10,000
* [(Overhead incurred + Indirect wages) – Overheads absorbed]

[(` 8,000 + ` 2,000) - ` 9,000] = ` 1,000 (under-absorption)
Cost of Sales Account
(` ) (` )
To Finished Stock A/c 33,000 By Costing P&L A/c 33,000
33,000 33,000
Costing P & L Account
(` ) (` )
To Cost of Sales A/c 33,000 By Cost Ledger Control 50,000
A/c (Sales A/c)
” Overheads Control 1,000
(under-absorbed)

” Cost Ledger Control A/c 16,000

(Profit) (balancing figure)
50,000 50,000
ILLUSTRATION 3
On 31st March, 20X8 the following balances were extracted from the books of the
Supreme Manufacturing Company:
Dr. (` ) Cr. (` )
Stores Ledger Control A/c 35,000
Work-in-Process Control A/c 38,000
Finished Goods Control A/c 25,000
Cost Ledger Control A/c 98,000
98,000 98,000
The following transactions took place in April 20X8:
Dr. (` )
Raw Materials:
- Purchased 95,000
- Returned to suppliers 3,000
- Issued to production 98,000
- Returned to stores 3,000
Productive wages 40,000
Indirect wages 25,000
Factory overhead expenses incurred 50,000
Selling and Administrative expenses 40,000
Cost of finished goods transferred to warehouse 2,13,000
Cost of Goods sold 2,10,000
Sales 3,00,000
Factory overheads are applied to production at 150% of direct wages, any

under/over absorbed overhead being carried forward for adjustment in the
subsequent months. All administrative and selling expenses are treated as period
costs and charged off to the Profit and Loss Account of the month in which they are

incurred.
PREPARE the following Accounts:
(a) Cost Ledger Control A/c
(b) Stores Ledger Control A/c
(c) Work-in-Process Control A/c
(d) Finished Goods Stock Control A/c
(e) Factory Overhead Control A/c
(f) Costing Profit and Loss A/c
(g) Trial Balance as at 30th April, 20X3.
SOLUTION
(a) Cost Ledger Control A/c
(`) (`)
To Costing P&L A/c 3,00,000 By Balance b/d 98,000
(sales)
” Stores Ledger 3,000 ” Stores Ledger Control A/c 95,000
Control A/c
(Productive + Indirect
wages)
” Factory OH Control A/c 50,000
” Selling & Admn. OH A/c 40,000
” Balance c/d 95,000 ” Costing P&L A/c (profit) 50,000
3,98,000 3,98,000
(b) Stores Ledger Control A/c
(` ) (` )
To Balance b/d 35,000 By Cost Ledger Control A/c 3,000
” Cost Ledger 95,000 ” Work-in-process 98,000
Control A/c Control A/c
” Work-in-process 3,000 ” Balance c/d 32,000
Control A/c
1,33,000 1,33,000

(c) Work-in-Process Control A/c
(` ) (` )
To Balance b/d 38,000 By Stores Ledger Control A/c 3,000
” Store Ledger 98,000 ” Finished Goods Control 2,13,000
Control A/c A/c
” Factory OH Control 60,000 ” Balance c/d 20,000
A/c
2,36,000 2,36,000
(d) Finished Goods Control A/c

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

” Work-in-process 2,13,000 ” Balance c/d 28,000
Control A/c
2,38,000 2,38,000
(e) Factory Overhead Control A/c
(` ) (` )
To Wages Control A/c (Indirect 25,000 By Work-in-process A/c 60,000
wages) (150% of `40,000)
” Cost Ledger Control A/c 50,000 ” Balance c/d 15,000
75,000 75,000
(f) Costing Profit and Loss A/c
(` ) (` )
To Cost of Goods Sold A/c 2,10,000 By Cost Ledger 3,00,000
” Selling and Admn. OH 40,000 Control A/c (Sales)
Control A/c
” Cost Ledger Control 50,000
A/c (Profit) (balancing
figure)
3,00,000 3,00,000

(g) Trial Balance (as at 30th April, 20X8)
Dr. (`) Cr. (`)

Stores Ledger Control A/c 32,000
Factory Overhead Control A/c 15,000
Cost Ledger Control A/c 95,000
95,000 95,000
Working Notes:
(1) Wages Control A/c
(` ) (` )
To Cost Ledger Control A/c 65,000 By Work-in-process 40,000
Control A/c
” Factory OH Control A/c 25,000
65,000 65,000
(2) Cost of Goods Sold A/c
(` ) (` )
To Finished Goods Control A/c 2,10,000 By Costing P&L A/c 2,10,000
2,10,000 2,10,000
(3) Selling & Administrative Expenses A/c
(` ) (` )
To Cost Ledger Control A/c 40,000 By Costing P&L A/c 40,000
40,000 40,000
ILLUSTRATION 4
Acme Manufacturing Co. Ltd. opens the costing records, with the balances as on 1st
July, 20X8 as follows:

(` ) (` )
Material Control A/c 1,24,000
Finished Goods Control A/c 1,24,000
Production Overhead Control A/c 8,400
Administrative Overhead Control A/c 12,000
Selling & Distribution Overhead Control A/c 6,250
3,25,150 3,25,150
The following are the transactions for the quarter ended 30th September 20X8:
(` )
Materials purchased 4,80,100
Materials issued to jobs 4,77,400
Materials to works maintenance 41,200
Materials to administration office 3,400
Materials to selling department 7,200
Wages direct 1,49,300
Wages indirect 65,000
Transportation for indirect materials 8,400
Production overheads 2,42,250
Absorbed production overheads 3,59,100
Administration overheads 74,000
Administration allocation to production 52,900
Administration allocation to sales 14,800
Sales overheads 64,200
Sales overheads absorbed 82,000
Finished goods produced 9,58,400
Finished goods sold 9,77,300
Sales 14,43,000
Make up the various accounts as you envisage in the Cost Ledger and PREPARE a
Trial Balance as at 30th September, 20X8.

SOLUTION
Cost Ledgers
Material Control A/c*
(` ) (` )
To Balance b/d 1,24,000 By Work-in-process Control 4,77,400
A/c
” Cost Ledger Control 4,80,100 ” Production OH Control A/c 41,200
A/c (purchase)
” Admn. OH Control A/c 3,400
” S&D OH Control A/c 7,200
6,04,100 6,04,100
*Material Control A/c may also be written as Stores Ledger Control A/c
Wages Control A/c
(` ) (` )
To Cost Ledger Control A/c 2,14,300 By Work-in-process 1,49,300
Control A/c
” Production OH Control 65,000
A/c
2,14,300 2,14,300
Work-in-Process Control A/c
(` ) (` )
To Balance b/d 62,500 By Finished goods 9,58,400
Control A/c
” Material Control A/c 4,77,400
” Wages Control A/c 1,49,300
” Production OH Control 3,59,100
A/c
” ” Balance c/d 89,900
10,48,300 10,48,300

Production Overhead Control A/c
(` ) (` )
To Balance b/d 8,400 By Work-in-process 3,59,100
Control A/c
” Cost Ledger Control A/c:
- Transportation 8,400
- Production OH 2,42,250
” Material Control A/c 41,200 ” Balance c/d 6,150
3,65,250 3,65,250
Administration Overhead Control A/c
(` ) (` )
To Cost Ledger Control A/c 74,000 By Balance b/d 12,000
” Material Control A/c: 3,400 ” Finished Goods 52,900
Control A/c
” Balance c/d 2,300 ” Cost of sales A/c 14,800
79,700 79,700
Selling and Distribution Overhead Control A/c
(` ) (` )
To Balance b/d 6,250 By Cost of Sales A/c 82,000
” Cost Ledger Control A/c: 64,200
” Material Control A/c 7,200
82,000 82,000
Finished Goods Control A/c
(` ) (` )
To Balance b/d 1,24,000 By Cost of Sales A/c 9,77,300
“ ADMINISTRATION 52,900
OVERHEAD CONTROL A/C

” Work-in-process Control A/c 9,58,400 ” Balance c/d 1,58,000
11,35,300 11.35.300
Cost of Sales A/c
(` ) (` )
To Finished Goods Control A/c 9,77,300 By Costing P&L A/c 10,74,100
” Admn. OH Control A/c 14,800
10,74,100 10,74,100
Cost Ledger Control A/c
(` ) (` )
To Costing P&L A/c (Sales) 14,43,000 By Balance b/d 3,13,150
” Material Control A/c 4,80,100
” Wages Control A/c 2,14,300
” Production OH Control A/c 2,50,650
” Administrative OH A/c 74,000
” Balance c/d 3,22,300 ” Costing P&L A/c 3,68,900
17,65,300 17,65,300
Costing Profit & Loss A/c
(` ) (` )
To Cost of sales A/c 10,74,100 By Cost Ledger Control 14,43,000
” Cost Ledger Control A/c 3,68,900 A/c (sales)
(profit) (balancing
figure)
14,43,000 14,43,000

Trial Balance as at 30th September, 20X8
Dr. (` ) Cr. (` )
Material Control A/c 74,900
Production OH Control A/c 6,150
Administrative OH Control A/c 2,300
Selling & Distribution OH Control A/c 4,350
Work-in-process Control A/c 89,900
Finished Goods Control A/c 1,58,000
3,28,950 3,28,950
ILLUSTRATION 5
(a) A fire destroyed some accounting records of a company. You have been able
to collect the following from the spoilt papers/records and as a result of
consultation with accounting staff in respect of January, 20X8:
(i) Incomplete Ledger Entries:
Materials Control A/c
(` ) (` )
To Balance b/d 32,000
(` ) (` )
To Balance b/d 9,200 By Finished Goods 1,51,000
Control A/c
Payables (Creditors) A/c
(` ) (` )
By Balance b/d 16,400
To Balance c/d 19,200

Manufacturing Overheads Control A/c
(` ) (` )
To Cost Ledger Control 29,600
A/c (Amount spent)
(` ) (` )
To Balance b/d 24,000
By Balance c/d 30,000
(ii) Additional Information:

(1) The cash-book showed that ` 89,200 have been paid to creditors for
raw-material.
(2) Ending inventory of work-in-process included material ` 5,000 on
which 300 direct labour hours have been booked against wages and
overheads.
(3) The job card showed that workers have worked for 7,000 hours. The
wage rate is ` 10 per labour hour.
(4) Overhead recovery rate was ` 4 per direct labour hour.
You are required to COMPLETE the above accounts in the cost ledger of the
company:
SOLUTION
Materials Control A/c
(` ) (` )
To Balance b/d 32,000 By Work-in-process 53,000
Cost Ledger Control A/c 92,000 control A/c
(Purchases) (refer By Balance c/d 71,000
working note)
1,24,000 1,24,000

(` ) (` )
To Balance b/d 9,200 By Finished Goods Control 1,51,000
A/c
To Materials Control A/c 53,000 By Balance c/d:
(Bal. fig.)
To Wages Control A/c 70,000 Material 5,000
(`10 × 7,000 hours)
Wages (`10 × 3,000
300 hours)
To Overheads Control A/c 28,000 Overheads (`4 1,200 9,200
(`4 × 7,000 hours) × 300 hours)
1,60,200 1,60,200
(` ) (` )
To Balance b/d 24,000 By Cost of sales A/c (Bal. 1,45,000
fig.)
To Work-in-process 1,51,000 By Balance c/d 30,000
Control A/c (as above)
1,75,000 1,75,000
Manufacturing Overheads A/c
(` ) (` )
To Cost Ledger Control 29,600 By Work-in-process control 28,000
A/c A/c (`4 × 7,000 hours)
By Costing P/L A/c 1,600
(Under-absorbed OH)
29,600 29,600
Working Note:
(` ) (` )
To Cash or Bank 89,200 By Balance b/d 16,400

To Balance c/d 19,200 By Purchases 92,000

(Balancing fig.)
1,08,400 1,08,400
7.3 INTEGRATED (OR INTEGRAL) ACCOUNTING

7
SYSTEM
Integrated Accounts is the name given to a system of accounting, whereby cost
and financial accounts are kept in the same set of books. Obviously, then
there will be no separate sets of books for Costing and Financial records.
Integrated accounts provide or meet out fully the information requirement for
Costing as well as for Financial Accounts. For Costing it provides information
useful for ascertaining the cost of each product, job, process, operation of any
other identifiable activity and for carrying necessary analysis. Integrated
accounts provide relevant information which is necessary for preparing
profit and loss account and the balance sheets as per the requirement of law
and also helps in exercising effective control over the liabilities and assets of its
business.
7.3.1 Advantages
The main advantages of Integrated Accounts are as follows:
(a) No need for Reconciliation- The question of reconciling costing profit and
financial profit does not arise, as there is only one figure of profit.
(b) Less efforts- Due to use of one set of books, there is a significant saving in
efforts made.
(c) Less time consuming- No delay is caused in obtaining information as it is
provided from books of original entry.
(d) Economical process- It is economical also as it is based on the concept of
“Centralisation of Accounting function”.
7.3.2 Essential pre-requisites for Integrated Accounts
The essential pre-requisites for integrated accounts include the following steps:
1. The management’s decision about the extent of integration of the two sets
of books. Some concerns find it useful to integrate up to the stage of prime

cost or factory cost while other prefer full integration of the entire
accounting records.
2. A suitable coding system must be made available so as to serve the
accounting purposes of financial and cost accounts.
3. An agreed routine, with regard to the treatment of provision for accruals,
prepaid expenses, other adjustment necessary for preparation of interim
accounts.
4. Perfect coordination should exist between the staff responsible for the
financial and cost aspects of the accounts and an efficient processing of
accounting documents should be ensured.
Under this system there is no need for a separate cost ledger. Of course, there will
be a number of subsidiary ledgers; in addition to the useful Customers’ Ledger
and the Bought Ledger, there will be: (a) Stores Ledger; (b) Stock Ledger and (c)
Job Ledger.
7.3.3 Features of Integrated Accounting System: Following are the main
points of integrated accounting:
(a) Complete analysis of cost and sales are kept.
(b) Complete details of all payments in cash are kept
(c) Complete details of all assets and liabilities are kept and this system does
not use a notional account to represent all impersonal accounts
In non-integrated system, a cost ledger control account or general ledger
adjustment account is used in cost ledger. In this system, general ledger
adjustment account is eliminated and detailed accounts for assets and liabilities
are maintained. In other words, following accounts are used for “General Ledger
Adjustment Account/ Cost Ledger Control Account” of non-integrated system:
(a) Bank account
(b) Receivables (Debtors) account
(c) Payables (Creditors) account
(d) Provision for depreciation account etc.
In integrated system, all accounts necessary for showing classification of cost will
be used but the cost ledger control account of non-integrated accounting is
replaced by use of following accounts:
(a) Bank account

(b) Receivables (Debtors) account

(c) Payables (Creditors) account
(d) Provision for depreciation account
(e) Fixed assets account
(f) Share capital account
If the illustration given below is to be worked out on integrated account basis, the
journal entries would be as follows:
ILLUSTRATION 6
JOURNALISE the following transactions assuming that cost and financial
transactions are integrated:
(` )
Raw materials purchased 2,00,000
Direct materials issued to production 1,50,000
Wages paid (30% indirect) 1,20,000
Wages charged to production 84,000
Manufacturing expenses incurred 84,000
Manufacturing overhead charged to production 92,000
Selling and distribution costs 20,000
Finished products (at cost) 2,00,000
Sales 2,90,000
Closing stock Nil
Receipts from debtors 69,000
Payments to creditors 1,10,000
SOLUTION
Journal entries are as follows:
DR. (`) CR. (`)

Stores Ledger Control A/c……………………………… Dr. 2,00,000
To Payables (Creditors) A/c 2,00,000
(Materials purchased)

Work-in-Process Control A/c…………………………… Dr. 1,50,000

(Materials issued to production)
Wages Control A/c………………………………………. Dr. 1,20,000
To Bank A/c 1,20,000
(Wages paid)
Factory Overhead Control A/c…………………………. Dr. 36,000
(30% of wages paid being indirect charged to
overhead)
Work-in-Process Control A/c…………………………… Dr. 84,000
(Direct wages charged to production)
Factory Overhead Control A/c………………………… Dr. 84,000
To Bank A/c 84,000
(Manufacturing overhead incurred)
Work-in-Process Control A/c…………………………… Dr. 92,000
To Factory Overhead Control A/c 92,000
(Manufacturing overhead charged to production)
Selling and Distribution Overhead Control Dr. 20,000
A/c………. 20,000
To Bank A/c
(Selling and distribution costs incurred)
Finished Goods Control A/c……………………………. Dr. 2,00,000
(Cost of finished goods)
Cost of Sales A/c………………………………………… Dr. 2,20,000
To Finished Goods Control A/c 2,00,000
To Selling and Distribution Control A/c 20,000
(Costs of goods sold)
Receivables (Debtors) A/c……………………………… Dr. 2,90,000
To Sales A/c 2,90,000
(Finished stock sold)
Bank A/c…………………………………………………... Dr. 69,000
To Receivables (Debtors) A/c 69,000

(Receipts from receivables)

Payables (Creditors) A/c………………………………... Dr. 1,10,000
(Payment made to payables)
ILLUSTRATION 7
Bangalore Petrochemicals Co. keeps books on integrated accounting system. The
following balances appear in the books as on 1st January, 20X8.
DR. (`) CR. (`)

Stores Ledger control A/c 18,000
Bank A/c 10,000
Creditors A/c 8,000
Fixed assets A/c 55,000
Debtors A/c 12,000
Share capital A/c 80,000
Provision for depreciation A/c 5,000
Profit and loss A/c 32,000
1,25,000 1,25,000
Transaction for the year ended 31st Dec., 20X8 were as given below:
(` ) (` )
Wages-direct 87,000
Wages-indirect 5,000 92,000
Purchase of materials (on credit) 1,00,000
Materials issued to production 1,10,000
Materials for repairs 2,000
Goods finished during the year (at cost) 2,15,000
Sales (credit) 3,00,000
Cost of goods sold 2,20,000
Production overhead absorbed 48,000

Production overhead incurred 40,000

Administration overhead incurred (production) 12,000
Selling overhead incurred 14,000
Payments of creditors 1,01,000
Payments of debtors 2,90,000
Depreciation on machinery 1,300
Prepaid rent (included in factory overheads) 300
PREPARE accounts in the integrated ledger.

SOLUTION
(`) (`)
To Balance b/d 18,000 By Work-in-process 1,10,000
Control A/c
To Payables (Creditors) A/c 1,00,000 By Production OH 2,000
Control A/c
1,18,000 1,18,000
(`) (`)
To Bank A/c 92,000 By Work-in-process A/c 87,000
By Production OH A/c 5,000
92,000 92,000
(` ) (` )
To Balance b/d 17,000 By Finished Goods 2,15,000
Control A/c
To Stores Ledger Control A/c 1,10,000 By Balance c/d 47,000
To Production OH A/c 48,000
2,62,000 2,62,000

Production Overhead Control A/c
(`) (`)
To Wages Control A/c 5,000 By Work-in-process 48,000
Control A/c
To Stores Ledger Control A/c 2,000 By Prepaid Rent A/c 300
To Bank A/c 40,000
To Prov. for Depreciation 1,300
48,300 48,300
(`) (`)
To Balance b/d 13,000 By Cost of Sales A/c 2,20,000
(Cost of goods sold)
To Work-in-process 2,15,000 By Balance c/d 20,000
Control A/c
To Administrative OH 12,000
Control A/c
2,40,000 2,40,000
Administration Overheads Control A/c
(`) (`)
To Bank A/c 12,000 By Finished Goods 12,000
Control A/c
12,000 12,000
Cost of Sales A/c
(`) (`)
To Finished Goods 2,20,000 By Sales A/c 2,34,000
Control A/c
To Selling & Dist. OH A/c 14,000
2,34,000 2,34,000

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

(` ) (` )
To Bank A/c 1,01,000 By Balance b/d 8,000
To Balance c/d 7,000 By Stores Ledger Control 1,00,000
A/c
1,08,000 1,08,000
Bank A/c
(`) (`)
To Balance b/d 10,000 By Payables 1,01,000
(Creditors) A/c
To Receivables (Debtors) A/c 2,90,000 By Wages Control A/c 92,000
By Production OH A/c 40,000
By Administration OH 12,000
A/c
By Selling & Dist. OH 14,000
A/c
3,00,000 3,00,000
Fixed Assets A/c
(`) (`)
To Balance b/d 55,000 By Balance c/d 55,000
55,000 55,000
Share Capital A/c
(`) (`)
To Balance c/d 80,000 By Balance b/d 80,000
80,000 80,000
ILLUSTRATION 8
In the absence of the Chief Accountant, you have been asked to prepare a month’s
cost accounts for a company which operates a batch costing system fully integrated
with the financial accounts. The following relevant information is provided to you:

(`) (`)
Balances at the beginning of the month:
Stores Ledger Control Account 25,000
Work-in-Process Control Account 20,000
Finished Goods Control Account 35,000
Prepaid Production Overheads brought forward from 3,000
previous month
Transactions during the month:
Materials Purchased 75,000
Materials Issued:
To production 30,000
To factory maintenance 4,000 34,000
Materials transferred between batches 5,000
Total wages paid:
To direct workers 25,000
To indirect workers 5,000 30,000
Direct wages charged to batches 20,000
Recorded non-productive time of direct workers 5,000
Selling and Distribution Overheads Incurred 6,000
Other Production Overheads Incurred 12,000
Sales 1,00,000
Cost of Finished Goods Sold 80,000
Cost of Goods completed and transferred into finished 65,000
goods during the month
Physical value of work-in-Process at the end of the month 40,000
The production overhead absorption rate is 150% of direct wages charged to work-
in-Process.
Required:
PREPARE the following accounts for the month:
(a) Stores Ledger Control Account.

(b) Work-in-Process Control Account.

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

(`) (`)
To Balance b/d 35,000 By Cost of Goods Sold* A/c 80,000
” Work-in-Process 65,000 ” Balance c/d 20,000
Control A/c
1,00,000 1,00,000
* Alternatively, Costing Profit & Loss Account

(d) Production Overhead Control Account
(`) (`)
To Balance b/d 3,000 By Work-in-Process 30,000
(Prepaid amount) Control A/c (150% of
direct wages)
” Stores Ledger 4,000
Control A/c
” Wages Control 10,000
A/c
(`5,000 + `5,000)
” Bank A/c 12,000
” Costing P&L A/c* 1,000
(Over-absorption,
balancing figure)
30,000 30,000
* Alternatively the over absorbed overhead may be carried forward.
(e) Costing Profit & Loss Account
(`) (`)
To Finished goods 80,000 By Sales A/c 1,00,000
control A/c or Cost of
Goods Sold A/c
” Selling & distribution 6,000 ” Production OH 1,000
OH A/c Control A/c
” Balance c/d 20,000 ” Work-in-Process 5,000
Control A/c
(Stock gain)
1,06,000 1,06,000
Notes:
(1) Materials transferred between batches will not affect the Control
Accounts.
(2) Non-production time of direct workers is a production overhead and
therefore will not be charged to work-in-Process control A/c.

(3) Production overheads absorbed in work-in-Process Control A/c will

then equal ` 30,000 (150% of ` 20,000).
(4) In the work-in-Process Control A/c the excess physical value of stock
is taken resulting in stock gain. Stock gain is transferred to Profit &
Loss A/c.
7.4 RECONCILIATION OF COST AND FINANCIAL

7
ACCOUNTS
When the cost and financial accounts are kept separately, it is imperative that
those should be reconciled, otherwise the cost accounts would not be reliable. In
this connection, it is necessary to remember that a reconciliation of the two sets
of accounts only can be made if both the sets contain sufficient details as would
enable the causes of differences to be located. It is, therefore, important that in
the financial accounts, the expenses should be analysed in the same way as in the
cost accounts.
In the text book, there appears a General Ledger Adjustment Account as would
appear in the Cost Ledger, students should study the entries therein as well as a
discussion that follows to explain the manner in which the details of items
included therein could be reconciled with the corresponding items appearing in
the financial accounts. They would thus realise that the reconciliation of the
balances generally, is possible preparing a Memorandum Reconciliation
Account. In this account, the items charged in one set of accounts but not in the
other or those charged in excess as compared to that in the other are collected
and by adding or subtracting them from the balance of the amount of profit
shown by one of the accounts, shown by the other can be reached. The
procedure is similar to the one followed for reconciling the balance with a
bank that shown by the cash book or the ledger.
It is important, however, to know the causes which, generally, give rise to
differences in the Cost and Financial Accounts. These are briefly summarised
below:
7.4.1 Causes of differences in Financial and Cost Accounts :
1. Items included in Financial Accounts only-
(a) Purely Financial Expenses:
(i) Interest on loans or bank mortgages.

(ii) Expenses and discounts on issue of shares, debentures etc.

(iii) Other capital losses i.e., loss by fire not covered by insurance etc.
(iv) Losses on the sales of fixed assets and investments
(v) Goodwill written off
(vi) Preliminary expenses written off
(vii) Income tax, donations, subscriptions
(viii) Expenses of the company’s share transfer office, if any.
(b) Purely Financial Income
(i) Interest received on bank deposits, loans and investments
(ii) Dividends received
(iii) Profits on the sale of fixed assets and investments
(iv) Transfer fee received.
(v) Rent receivables
2. Item included in Cost Accounts only (notional expenses):
(i) Charges in lieu of rent where premises are owned
(ii) Interest on capital at notional figure though not incurred
(iii) Salary for the proprietor at notional figure though not incurred
(iv) Notional Depreciation on the assets fully depreciated for which book
value is nil.
3. Items whose treatment is different in the two sets of accounts: The
objective of cost accounting is to provide information to management for
decision making and control purposes while financial accounting conforms
to external reporting requirements. Hence there are chances that certain
items are treated differently in the two sets of accounts. For example, LIFO
method is not allowed for inventory valuation in India as per the Accounting
Standard 2 issued by the Council of the ICAI. However, this method may be
adopted for cost accounts as it is more suitable for arriving at costs which
shall be used as a base for deciding selling prices. Similarly cost accounting
may use a different method of depreciation than what is allowed under
financial accounting.
4. Varying basis of valuation: It is another factor which sometimes is
responsible for the difference. It is well known that in financial accounts

stock are valued either at cost or market price, whichever is lower. But in
Cost Accounts, stocks are only valued at cost.
7.4.2 Procedure for reconciliation: There are 3 steps involved in the
procedure for reconciliation.
1. Ascertainment of profit as per financial accounts
2. Ascertainment of profit as per cost accounts
3. Reconciliation of both the profits (similar to the bank reconciliation
statement)
Circumstances where reconciliation statement can be avoided: When the Cost and
Financial Accounts are integrated - there is no need to have a separate reconciliation
statement between the two sets of accounts. Integration means that the same set of
accounts fulfil the requirement of both i.e., Cost and Financial Accounts.
ILLUSTRATION 9
The following figures are available from the financial records of ABC Manufacturing
Co. Ltd. for the year ended 31-3-20X8.
(` )
Sales (20,000 units) 25,00,000
Materials 10,00,000
Wages 5,00,000
Factory Overheads 4,50,000
Office and administrative Overhead (production related) 2,60,000
Selling and distribution Overheads 1,80,000
Finished goods (1,230 units) 1,50,000
(` ) (` )
Work-in-Process:
Materials 30,000
Labour 20,000
Factory overheads 20,000 70,000
Goodwill written off 2,00,000
Interest on capital 20,000

In the Costing records, factory overhead is charged at 100% of wages,

administration overhead 10% of factory cost and selling and distribution overhead
at the rate of ` 10 per unit sold.
PREPARE a statement reconciling the profit as per cost records with the profit as per
financial records.
SOLUTION
Profit & Loss Account of ABC Manufacturing Co. Ltd.
(for the year ended 31-3-20X8)
(`) (`)
To Opening Stock Nil By Sales (20,000 units) 25,00,000
To Materials 10,00,000 By Closing Stock:
To Wages 5,00,000 Finished goods 1,50,000
(1,230 units)
To Factory Overheads 4,50,000 Work-in-Process 70,000
To Office & Admn. 2,60,000
Overheads
To Selling & Dist. 1,80,000
Overheads
To Goodwill written off 2,00,000
To Interest on Capital 20,000
To Net Profit 1,10,000
27,20,000 27,20,000
Cost Sheet
(` )
Materials 10,00,000
Wages 5,00,000
Direct Expenses Nil
Prime Cost 15,00,000
Add: Factory overhead @ 100% of wages 5,00,000
Gross Factory Cost 20,00,000
Less: Closing WIP (70,000)
Factory Cost of (20,000 + 1,230) units 19,30,000

Add Office & Admn. Overhead @ 10% of Factory cost 1,93,000

21,23,000
Less: Closing Stock of finished goods (1,230 units) (1,23,000)*
Production Cost of 20,000 units 20,00,000
Add: Selling & Dist. Overhead @ ` 10 per unit 2,00,000
Cost of sales of 20,000 units 22,00,000
Sales of 20,000 units 25,00,000
Profit 3,00,000
* (` 21,23,000 x 1,230 units/ 21,230 units)
Reconciliation Statement
(`) (`)
Profit as per Cost Accounts 3,00,000
Add: Factory overheads over-absorbed 50,000
(` 5,00,000 – ` 4,50,000)
Selling & Dist. Overhead over-absorbed 20,000
(` 2,00,000 – ` 1,80,000)
Difference in the valuation of closing stock of 27,000 97,000
finished goods (` 1,50,000 – ` 1,23,000)
3,97,000
Less: Office & Admn. overhead under-absorbed 67,000
(` 2,60,000 – ` 1,93,000)
Goodwill written off taken in financial 2,00,000
accounts
Interest on capital 20,000 2,87,000
Profit as per financial accounts 1,10,000
ILLUSTRATION 10
Following are the figures extracted from the Cost Ledger of a manufacturing unit.
(` )
Stores:
Opening balance 15,000
Purchases 80,000

Transfer from WIP 40,000

Issue to WIP 80,000
Issue to repairs and maintenance 10,000
Sold as a special case at cost 5,000
Shortage in the year 3,000
Work-in-Process:
Opening inventory 30,000
Direct labour cost charged 30,000
Overhead cost charged 1,20,000
Closing Balance 20,000
Finished Products:
Entire output is sold at 10% profit on actual cost from work-in-
process.
Others:
Wages for the period 35,000
Overhead Expenses 1,25,000
ASCERTAIN the profit or loss as per financial account and cost accounts and
reconcile them.
SOLUTION
Stores Ledger Control A/c
(`) (`)
To Balance b/d 15,000 By Work-in-process Control 80,000
A/c (Issued to WIP)
To Cost Ledger Control 80,000 By Overhead Control A/c 10,000
A/c (Purchases) (Issued for repairs)
To Work-in-process 40,000 By Cost Ledger Control A/c 5,000
Control A/c (Sold at cost)
(Return from WIP)
By Overheads Control A/c* 3,000
(Shortages)
1,35,000 1,35,000
* Assumed normal

Wages Control A/c
(` ) (` )
Control A/c
By Overhead Control A/c 5,000
35,000 35,000
Overhead Control A/c
(` ) (` )
To Stores Ledger Control A/c 10,000 By Work-in-process 1,20,000
To Stores Ledger Control A/c 3,000 Control A/c
To Cost Ledger Control A/c 1,25,000
To Wages Control A/c 5,000 By Balance c/d 23,000
1,43,000 1,43,000
WIP Control A/c
(`) (`)
To Balance b/d 30,000 By Stores Ledger 40,000
Control A/c
To Stores Ledger Control A/c 80,000 By Finished goods 2,00,000*
Control A/c
To Overheads Control A/c 1,20,000 By Balance c/d 20,000
2,60,000 2,60,000
* Finished output at cost 2,00,000
Profit at 10% on actual cost from WIP Sales 20,000
2,20,000
Statement of Profit as per Costing Records

(`)
Direct material Cost 40,000
Direct wages 30,000
Prime Cost 70,000

Production Overheads 1,20,000

Works Cost 1,90,000
Add: Opening WIP 30,000
2,20,000
Less: Closing WIP (20,000)
Cost of finished goods 2,00,000
Profit (10% of cost) 20,000
Sales 2,20,000
Profit & Loss A/c
(`) (`)
To Material (Op. bal. + 90,000 By Sales A/c 2,20,000
Purchases - Sale)
To Work-in-process 30,000 By Closing Work-in- 20,000
Control A/c process
To Wages Control A/c 35,000 By Closing Finished 37,000
goods
To Overheads Control A/c 1,25,000 By Net loss 3,000
2,80,000 2,80,000
Reconciliation Statement
(` )
Profit (loss) as per Financial Accounts (3,000)
Add: Overheads over absorbed in Cost A/c 23,000
Net Profit as per Accounts 20,000
ILLUSTRATION 11
The following figures have been extracted from the Financial Accounts of a
manufacturing firm for the first year of its operation:
(` )
Direct Material Consumption 50,00,000
Direct Wages 30,00,000
Factory Overhead 16,00,000

Administration Overheads (production related) 7,00,000

Selling and Distribution Overheads 9,60,000
Bad Debts 80,000
Preliminary Expenses written off 40,000
Legal Charges 10,000
Dividends Received 1,00,000
Interest Received on Deposits 20,000
Sales (1,20,000 units) 1,20,00,000
Closing Stock:
Finished Goods (4,000 units) 3,20,000
Work-in-Process 2,40,000
The cost accounts for the same period reveal that the direct material consumption
was ` 56,00,000. Factory overhead is recovered at 20% on prime cost.
Administration overhead is recovered at ` 6 per unit of production. Selling and
distribution overheads are recovered at ` 8 per unit sold.
PREPARE the Profit and Loss Accounts both as per financial records and as per cost
records. RECONCILE the profits as per the two records.
SOLUTION
Profit and Loss Account
(As per financial records)
(`) (`)
To Direct Material 50,00,000 By Sales (1,20,000 1,20,00,000
units)
To Direct Wages 30,00,000 By Closing Stock
To Factory Overheads 16,00,000 Work-in-process 2,40,000
To Gross Profit c/d 29,60,000 Finished Goods 3,20,000
(4,000 units)
1,25,60,000 1,25,60,000
To Administration 7,00,000 By Gross Profit b/d 29,60,000
Overheads
To Selling and Dist. 9,60,000 By Dividend 1,00,000

OH
To Bad Debts 80,000 By Interest 20,000
To Preliminary 40,000
Expenses written
off
To Legal Charges 10,000
To Net Profit 12,90,000
30,80,000 30,80,000
Statement of Cost and Profit

(As per Cost Records)
Total (`)
Direct Material 56,00,000
Direct Wages 30,00,000
Prime Cost 86,00,000
Factory Overhead (20% of `86,00,000) 17,20,000
1,03,20,000
Less: Closing Stock (WIP) (2,40,000)
Works Cost (1,24,000 units) 1,00,80,000
Administration overhead (1,24,000 units @ ` 6 p.u.) 7,44,000
Cost of production of (1,24,000 units) 1,08,24,000
Less: Finished Goods (4,000 units @ ` 87.29) (3,49,160)
Cost of goods sold (1,20,000 units) 1,04,74,840
Selling and Distribution Overhead (1,20,000 @ ` 8 p.u.) 9,60,000
Cost of Sales 1,14,34,840
Net profit (Balancing figure) 5,65,160
Sales Revenue 1,20,00,000
Statement of Reconciliation of profit as obtained under Cost and Financial
Accounts
(`) Total (`)
Profit as per Cost Records 5,65,160
Add: Excess of Material Consumption 6,00,000
Factory Overhead 1,20,000

Administration Overhead 44,000

Dividend Received 1,00,000
Interest Received 20,000 8,84,000
14,49,160
Less: Bad debts 80,000
Preliminary expenses written off 40,000
Legal Charges 10,000
Over-valuation of stock in cost book 29,160
(` 3,49,160 – ` 3,20,000) (1,59,160)
Profit as per Financial Records 12,90,000
7.5 ACCOUNTING FOR MANAGEMENT

INFORMATION AND COST CONTROL
With a view to control costs, standard cost for each element of cost is set. The
standard costs so set are used to measure and compare the actual costs. This
enable the management to trace cost variances from the standard cost. The
variances so obtained are analysed and necessary actions are taken. This ensures
that standard costs are adhered.
For cost control purpose, the management needs specific accounting system
which fulfils the management objective of controlling costs. On the basis of
timing of variance analysis, two main types of management accounting
systems are followed:
(I) SINGLE PLAN:
Under this system of management accounting, the variances in costs from the set
standards are reported at its happenings without waiting for books closing.
Timely analysis is done so that much time is not lost in taking corrective action
wherever needed.
The single plan system envisages the posting of all items in the debit side of the
work-in-progress account at the standard cost leaving the credit side to represent
the standard cost of finished production and work-in-progress.
This system enables the ascertainment of variances as and when the
transaction is posted to work-in-progress account. In other words, the
analysis of variances is done from the original documents like invoices, labour

sheets, etc., and this method of analysis is known as analysis at source.

Since, the single plan system contemplates the analysis of variances at source, the
installation of this system requires more planning so that effective documentation
at each stage is introduced for proper recording and analysis of variance.
Thus for example, the issue of bill of materials to the stores enables the
storekeeper to calculate the standard value of materials. If any material is
requisitioned beyond the standard, he can mark the same for material usage
variance account. In the production department, as and when the finished output
is recorded, the standard waste and actual waste can be compared and necessary
entries can be made by the shop supervisors for posting the excessive usage to
appropriate variance accounts.
Scheme of entries: So far as materials are concerned, material price variances
are recorded at the time of receipt of the material and the material quantity
variances are recorded as far as possible when excess materials are used. The
entries will be as illustrated below:
1. Material Control A/c …………………………….Dr.
Material Price Variance A/c ……………….…Dr.
(Actual Cost > Standard Cost)
To Creditors/ Cost Ledger Control A/c.
To Material Price Variance A/c
(Actual Cost < Standard Cost)
This entry enables the firm to debit the material control account with the actual
purchases at standard cost and credit the creditor’s account at the actual cost of
actual prices thereby transferring the variances to price variance account.
2. Work-in-progress Control A/c …………….Dr.
Material Usage Variances A/c………………Dr.
(Actual usage > Standard usage)
To Material Control A/c
To Material Usage Variances A/c
(Actual usage < Standard usage)
This entry charges the work-in-progress control account with the standard cost of
standard quantity and credit the material control account at the standard cost of

actual issue, the variance being transferred to usage variance account.

3. Wages Control A/c ……………………….…….Dr.
Labour Rate Variances A/c ………….….….Dr.
(Actual wage rate > Standard wage rate)
To Cash/ Cost Ledger Control A/c
To Labour Rate Variances A/c
(Actual wage rate < Standard wage rate)
This entry is passed to record the wages at standard rate thereby transferring rate
variances to the appropriate account.
4. Work-in-progress Control A/c ……………..Dr.
Overhead Expense Variances A/c ……..….Dr.
(Actual OH > Standard OH)
To Overhead Expense Control A/c.
To Overhead Expense Variances A/c
(Actual OH < Standard OH)
(II) PARTIAL PLAN:
In the partial plan, variances are analysed at the end of period. Under this
method the work-in-progress account is charged at the actual cost of production
for the period and is credited with the standard cost of the period’s production of
finished product.
The closing balance of work-in-progress is also shown at standard cost. The
balance after making the credit entries represent the variance from standard for
the period. The analysis of the variance is done after the end of the period. This
method is simple in operation because variances are analysed after the end of
period but may present difficulties if the firm makes a variety of products.
Recapitulation:
(1) Current standards are used in both the systems.
(2) Under the partial plan, material stocks are carried at actual cost whereas the
same are carried out at standard cost under the single plan.

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

TEST YOUR KNOWLEDGE

MCQS BASED QUESTIONS
1. Under non-integrated accounting system
(a) Same ledger is maintained for cost and financial accounts by
accountants
(b) Separate ledgers are maintained for cost and financial accounts
(c) (a) and (b) both
2. Notional costs
(a) May be included in integrated accounts
(b) May be included in non- integrated accounts
(c) Cannot be included in non-integrated accounts
3. Under non-integrated accounting system, the account made to complete
double entry is
(a) Stores ledger control account
(b) Work in progress control account
(c) Finished goods control account
(d) General ledger adjustment account
4. Integrated systems of accounts are maintained
(a) In separate books of accounts for costing and financial accounting
purposes
(b) In same books of accounts
(c) Both (a) & (b)
5. Under non-integrated system of accounting, purchase of raw material is
debited to which account
(a) Material control account / stores ledger control account
(b) General ledger adjustment account

(c) Purchase account

6. Under control accounts, if material worth ` 1500 is purchased for a special
job, then which account will be debited
(a) Special job account / work in progress account
(b) Material control account
(c) Cost control account
7. Which account is to be debited if material worth ` 500 is returned to vendor
under control accounts
(a) Cost ledger control account
(b) Stores ledger control account
(c) WIP control account
8. Which of the following items is included in cost accounts?
(a) Notional rent
(b) Donations
(c.) Transfer to general reserve
(d) Rent receivable
9. When costing loss is ` 5,600, administrative overhead under-absorbed
being ` 600, the loss as per financial accounts should be
(a) ` 5,600
(b) ` 6,200
(c) ` 5,000
10. Which of the following items should be added to costing profit to arrive at
financial profit?
(a) Over-absorption of works overhead
(b) Interest paid on debentures
(c) Income tax paid


1. EXPLAIN what are the essential pre-requisites of integrated accounting
system?
2. STATE what are the advantages of integrated accounting?
3. EXPLAIN why is it necessary to reconcile the Profits between the Cost
Accounts and Financial Accounts?
4. STATE what are the reasons for disagreement of profits as per cost accounts
and financial accounts? Discuss.
5. LIST the Financial expenses which are not included in cost.
6. STATE when is the reconciliation statement of Cost and Financial accounts
not required?
Practical Problems
1. The following incomplete accounts are furnished to you for the month
ended 31st October, 20X8.
1.10.20X8 To Balance ` 54,000
Work in Process Control Account
1.10. 20X8 To Balance ` 6,000
Finished Goods Control Account
1.10. 20X8 To Balance ` 75,000
Factory Overheads Control Account
Total debits for October, 20X8` 45,000
Factory Overheads Applied Account
Cost of Goods Sold Account
Creditors for Purchases Account

1.10. 20X8 By Balance ` 30,000

(i) The factory overheads are applied by using a budgeted rate based on
direct labour hours. The budget for overheads for 20X8 is ` 6,75,000
and the budget of direct labour hours is 4,50,000.
(ii) The balance in the account of creditors for purchases on 31.10.20X8 is
` 15,000 and the payments made to creditors in October, 20X8
amount to ` 1,05,000.
(iii) The finished goods inventory as on 31st October, 20X8 is ` 66,000.
(iv) The cost of goods sold during the month was ` 1,95,000.
(v) On 31st October, 20X8 there was only one unfinished job in the
factory. The cost records show that ` 3,000 (1,200 direct labour hours)
of direct labour cost and ` 6,000 of direct material cost had been
charged.
(vi) A total of 28,200 direct labour hours were worked in October, 20X8.
All factory workers earn same rate of pay.
(vii) All actual factory overheads incurred in October, 20X8 have been
posted.
You are required to FIND:
(a) Materials purchased during October, 20X8.
(b) Cost of goods completed in October, 20X8.
(c) Overheads applied to production in October, 20X8.
(d) Balance of Work-in-process Control A/c on 31st October, 20X8.
(e) Direct materials consumed during October, 20X8.
(f) Balance of Stores Ledger Control Account on 31st October, 20X8.
(g) Over absorbed or under absorbed overheads for October, 20X8.
2. A company operates on historic job cost accounting system, which is not
integrated with the financial accounts. At the beginning of a month, the
opening balances in cost ledger were:
` (in lakhs)
Stores Ledger Control Account 80
Work-in-Process Control Account 20
Finished Goods Control Account 430

Building Construction Account 10

Cost Ledger Control Account 540
During the month, the following transaction took place:
Materials − Purchased 40
Issued to production 50
Issued to factory maintenance 6
Issued to building construction 4
Wages − Gross wages paid 150
Indirect wages 40
For building construction 10
Works Overheads− Actual amount incurred 160
(excluding items shown above)
Absorbed in building construction 20
Under absorbed 8
Royalty paid (related to production) 5
Selling, distribution and administration overheads 25
Sales 450
At the end of the month, the stock of raw material and work-in-Process was
` 55 lakhs and ` 25 lakhs respectively. The loss arising in the raw material
accounts is treated as factory overheads. The building under construction
was completed during the month. Company’s gross profit margin is 20% on
sales.
PREPARE the relevant control accounts to record the above transactions in
the cost ledger of the company.
3. Dutta Enterprises operates an integral system of accounting. You are
required to PASS the Journal Entries for the following transactions that took
place for the year ended 30th June, 20X8.
(Narrations are not required.)
(` )
Raw materials purchased (50% on Credit) 6,00,000
Materials issued to production 4,00,000
Wages paid (50% Direct) 2,00,000

Wages charged to production 1,00,000

Factory overheads incurred 80,000
Factory overheads charged to production 1,00,000
Selling and distribution overheads incurred 40,000
Finished goods at cost 5,00,000
Sales (50% Credit) 7,50,000
Closing stock Nil
Receipts from debtors 2,00,000
Payments to creditors 2,00,000
4. The following figures are extracted from the Trial Balance of Go-getter Co.
on 30th September, 20X8:
Dr. Cr.
(` ) (` )
Inventories:
Finished Stock 80,000
Raw Materials 1,40,000
Office Appliances 17,400
Plant & Machinery 4,60,500
Building 2,00,000
Sales 7,68,000
Sales Return and Rebates 14,000
Materials Purchased 3,20,000
Freight incurred on Materials 16,000
Purchase Returns 4,800
Direct employee cost 1,60,000
Indirect employee cost 18,000
Factory Supervision 10,000
Repairs and Upkeep Factory 14,000
Heat, Light and Power 65,000

Rates and Taxes 6,300

Miscellaneous Factory Expenses 18,700
Sales Commission 33,600
Sales Travelling 11,000
Sales Promotion 22,500
Distribution Deptt.—Salaries and Expenses 18,000
Office Salaries and Expenses 8,600
Interest on Borrowed Funds 2,000
Further details are available as follows:
(i) Closing Inventories:

Finished Goods 1,15,000
Raw Materials 1,80,000
(ii) Accrued expenses on:
Direct employee cost 8,000
Indirect employee cost 1,200
Interest on Borrowed Funds 2,000
(iii) Depreciation to be provided on:
Office Appliances 5%
Plant and Machinery 10%
Buildings 4%
(iv) Distribution of the following costs:
Heat, Light and Power to Factory, Office and Distribution in the
ratio 8 : 1 : 1.
Rates and Taxes two-thirds to Factory and one-third to Office.
Depreciation on Buildings to Factory, Office and Selling in the ratio
8 : 1 : 1.
With the help of the above information, you are required to PREPARE a
condensed Profit and Loss Statement of Go-getter Co. for the year ended
30th September, 20X8 along with supporting schedules of:

(i) Cost of Sales.

(ii) Selling and Distribution Expenses.
(iii) Administration Expenses.
5. The following information is available from the financial books of a
company having a normal production capacity of 60,000 units for the year
ended 31st March, 20X8:
(i) Sales ` 10,00,000 (50,000 units).
(ii) There was no opening and closing stock of finished units.
(iii) Direct material and direct wages cost were ` 5,00,000 and ` 2,50,000
respectively.
(iv) Actual factory expenses were ` 1,50,000 of which 60% are fixed.
(v) Actual administrative expenses related with production activities were
` 45,000 which are completely fixed.
(vi) Actual selling and distribution expenses were ` 30,000 of which 40%
are fixed.
(vii) Interest and dividends received ` 15,000.
(a) FIND OUT profit as per financial books for the year ended 31st
March,20X8;
(b) PREPARE the cost sheet and ascertain the profit as per cost accounts for
the year ended 31st March, 20X8 assuming that the indirect expenses
are absorbed on the basis of normal production capacity; and
(c) PREPARE a statement reconciling profits shown by financial and cost books.
6. M/s. H.K. Piano Company showed a net loss of ` 4,16,000 as per their
financial accounts for the year ended 31st March, 20X8. The cost accounts,
however, disclosed a net loss of ` 3,28,000 for the same period. The
following information was revealed as a result of scrutiny of the figures of
both the sets of books:
(` )
(i) Factory overheads under-recovered 6,000
(ii) Administration overheads over-recovered 4,000
(iii) Depreciation charged in financial accounts 1,20,000

(iv) Depreciation recovered in costs 1,30,000

(v) Interest on investment not included in costs 20,000
(vi) Income-tax provided 1,20,000
(vii) Transfer fees (credit in financial books) 2,000
(viii) Stores adjustment (credit in financial books) 2,000
PREPARE a Memorandum reconciliation account.
ANSWERS/ SOLUTIONS
Answers to the MCQs Based Questions
1. (b) 2. (c) 3. (d) 4. (b) 5. (a) 6. (a)
7. (a) 8. (a) 9. (b) 10. (a)
Answer to the Practical Problems
1. Working Notes:
(i) Overhead recovery rate per direct labour hour:
Budgeted factory overheads : ` 6,75,000
Budgeted direct labour hours : 4,50,000
Overhead recovery rate : =
Budgeted direct labour hours
` 6,75,000
=
4,50,000 hours
= ` 1.50 per direct labour

(ii) Direct wage rate per hour:

Direct labour cost of WIP : ` 3,000
(on 31st October 20X2)
Direct labour hours of WIP : 1,200 hours
Direct labour cost on WIP
Direct wage rate per hour : =
Direct labour hours on WIP
` 3,000
= = `2.50
1,200 hours
(iii) Total direct wages charged to production:
Total direct labour hours spent on production × Direct wage rate per
hour
= 28,200 hours × ` 2.50 = ` 70,500
(a) Material purchased during October, 20X8
(` )
Payment made to creditors 1,05,000
Add: Closing balance in the account of creditors for 15,000
purchase
Less: Opening balance (30,000)
Material Purchased 90,000
(b) Cost of goods completed in October, 20X8
(` )
Cost of goods sold during the month 1,95,000
Add: Closing finished goods inventory 66,000
Less: Opening finished goods inventory (75,000)
Cost of goods completed during the month 1,86,000
(c) Overhead applied to production in October, 20X8

= 28,200 hours × ` 1.50 = ` 42,300

(d) Balance of Work-in-Process on 31st October, 20X8

(` )
Direct material cost 6,000
Direct labour cost 3,000
Overheads (` 1.50 × 1,200 hours) 1,800
10,800
(e) Direct material consumed during October, 20X8 ’78,00078,000

(Refer to following Account)
Work in Process Control A/c
(` ) (` )
To Balance b/d 6,000 By Finished goods 1,86,000
stock
To Wages Control A/c 70,500 By Balance c/d 10,800
[Refer working note (iii)] [Refer (d) above]
To Factory OH Control A/c 42,300
[Refer (c) above]
To Material consumed 78,000
(Balancing fig.)
1,96,800 1,96,800
(f) Balance of Stores Control Account on 31st October, 20X8 ` 66,000

(Refer to following Account)
(` ) (` )
To Balance b/d 54,000 By Work-in-process 78,000
Control A/c
[Refer (e) above]
To Cost Ledger Control A/c 90,000 By Balance c/d 66,000
[Refer (a) above} (Balancing fig.)
1,44,000 1,44,000

(g) Over-absorbed or under-absorbed overheads for October, 20X8:

Balance in Factory Overhead Account below showing that ` 2,700 is
under-absorbed.
Factory Overhead Account
(` ) (` )
Control A/c (Factory
OH applied)
By Costing P/L A/c 2,700
(Under-absorbed)
45,000 45,000
2. Amount (in lakhs)

Cost Ledger Control A/c
(` ) (` )
To Costing P&L A/c 450 By Balance b/d 540
To Building Construction A/c 44 By Stores Ledger Control A/c 40
To Balance c/d 483 By Wages Control A/c 150
By Works OH Control A/c 160
By Royalty A/c 5
By Admn. OH and S&D OH A/c 25
By Costing P&L A/c 57
977 977
Stores Ledger Control A/c
(` ) (` )
To Balance b/d 80 By Work-in-process A/c 50
To Cost Ledger Control A/c 40 By Works OH Control A/c 6
By Building Const. A/c 4
By Works OH Control A/c 5
(Bal. fig.) (loss)
By Balance c/d 55
120 120

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

(` ) (` )
To Stores Ledger Control A/c 6 By Building Const. A/c 20
To Wages Control A/c 40 By Work-in-process Control A/c 183
(Balancing figure)
To Cost Ledger Control A/c 160 By Costing P&L A/c (under- 8
absorption)
(loss)
211 211
Wages Control A/c
(` ) (` )
To Cost Ledger Control A/c 150 By Works OH Control A/c 40
By Building Const. A/c 10
By Work-in-process Control A/c 100
(Balancing figure)
150 150
Royalty A/c
(` ) (` )
To Cost Ledger Control A/c 5 By Work-in-process Control A/c 5
5 5

(` ) (` )
To Balance b/d 430 By Cost of Goods Sold A/c 360
(80% of ` 450)
To Work-in-process Control A/c 333 By Balance c/d 403
763 763
Cost of Goods Sold A/c
(` ) (` )
To Finished Goods Control A/c 360 By Cost of sales A/c 360
360 360
Selling, Distribution and Administration Overhead A/c
(` ) (` )
To Cost Ledger Control A/c 25 By Cost of sales A/c 25
25 25
Cost of Sales A/c

(` ) (` )
To Cost of Goods Sold 360 By Costing P&L A/c 385
To Admn. OH and S&D OH A/c 25
385 385
Costing P & L A/c
(` ) (` )
To Cost of Sales A/c 385 By Cost Ledger Control 450
A/c (Sales)
To Works Overhead Control A/c 8
(Profit) (Balancing figure)
450 450

Building Construction A/c
(` ) (` )
To Balance b/d 10 By Cost Ledger Control A/c 44
To Works OH Control A/c 20
44 44
Trial Balance (` in lakhs)
DR. (` ) CR. (` )
Stores control A/c 55
Work-in-Process A/c 25
Finished goods A/c 403
Cost Ledger Adjustment A/c 483
483 483
3. Journal entries are as follows:
DR. (` ) CR. (` )
Stores Ledger Control A/c…………………………… Dr. 6,00,000
To Payables (Creditors) A/c 3,00,000
To Cash or Bank 3,00,000
Work-in-Process Control A/c…………………… Dr. 4,00,000
Wages Control A/c………………………………………. Dr. 2,00,000
Factory Overhead Control A/c…………………… Dr. 1,00,000
To Wages Control A/c 1,00,000
Work-in-Process Control A/c……………………… Dr. 1,00,000
To Wages Control A/c 1,00,000
Factory Overhead Control A/c………………… Dr. 80,000
80,000

To Bank A/c
Work-in-Process Control A/c…………………… Dr. 1,00,000
To Factory Overhead Control A/c 1,00,000
Selling and Distribution Overhead Control Dr. 40,000
A/c 40,000
To Bank A/c
Finished Goods Control A/c…………………… Dr. 5,00,000
Cost of Sales A/c………………………………………… Dr. 5,40,000
To Finished Goods Control A/c 5,00,000
To Selling and Distribution Control A/c 40,000
Receivables (Debtors) A/c……………………………… Dr. 3,75,000
Bank or Cash A/c………………………………………… Dr. 3,75,000
To Sales A/c 7,50,000
Bank A/c…………………………………………………... Dr. 2,00,000
To Receivables (Debtors) A/c 2,00,000
Payables (Creditors) A/c………………………………... Dr. 2,00,000
4. Profit and Loss Statement of Go-getter Company
for the year ended 30th September, 20X8
(` ) (` )
Gross Sales 7,68,000
Less: Returns (14,000) 7,54,000
Less: Cost of Sales [Refer to Schedule (i)] (7,14,020)
Net Operating Profit 39,980
Less: Interest on borrowed funds (4,000)
Net Profit 35,980
(i) Schedule of Cost of Sales
(` ) (` )
Raw Material (Inventory opening balance) 1,40,000
Add: Material Purchased 3,20,000

Add: Freight on Material 16,000

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

Schedule (ii)]

(ii) Schedule of Selling and Distribution Expenses
(` )
Sales Commission 33,600
Sales Travelling 11,000
Sales Promotion 22,500
Distribution Deptt.—Salaries and Expenses 18,000
Depreciation of Buildings 800
92,400
(iii) Schedule of Administration Expenses
(` )
Office Salaries and Expenses 8,600
Depreciation of Office Appliances 870
Depreciation of Buildings 800
Rates and Taxes 2,100
18,870
5. Working Note:
Profit & Loss Account
(for the year ended 31st March, 20X8)
(` ) (` )
To Direct Material 5,00,000 By Sales (50,000 units) 10,00,000
To Direct Wages 2,50,000 By Interest and dividends 15,000
To Factory expenses 1,50,000
To Administrative 45,000
expenses
To Selling & Dist. 30,000
Expenses
To Net Profit 40,000
10,15,000 10,15,000
(a) Profit as per financial books for the year ended 31st March, 20X8 is
` 40,000 (Refer to above Working note).

(b) Cost Sheet

(for the year ended 31st March, 20X8)
(` ) (` )
Direct material 5,00,000
Direct wages 2,50,000
Prime cost 7,50,000
Factory expenses:
Variable (40% of ` 1,50,000) 60,000
Fixed (` 90,000 × 50,000/60,000) 75,000 1,35,000
Works cost 8,85,000
Administrative expenses: (` 45,000 × 37,500
50,000/60,000)
Selling & distribution expenses:
Variable (60% of ` 30,000) 18,000
Fixed* (` 12,000 × 50,000/60,000) 10,000 28,000
Profit (Balancing figure) 49,500
Sales revenue 10,00,000
*It is assumed that the company sells what it generally produces i.e. normal
production.
(c) Statement of Reconciliation
(Reconciling profit shown by Financial and Cost Accounts)
(` ) (` )
Profit as per Cost Account 49,500
Add : Income from interest and dividends 15,000
64,500
Less: Factory expenses under-charged in
Cost Accounts (` 1,50,000 – ` 1,35,000) 15,000
Administrative expenses under-charged in 7,500

Cost Accounts (` 45,000 – ` 37,500)

Selling & distribution expenses under—
charged in Cost Accounts (` 30,000 –
` 28,000) 2,000 24,500
Profit as per Financial Accounts 40,000
6. Memorandum Reconciliation Account
(` ) (` )
To Net loss as per 3,28,000 By Administration 4,000
costing books overhead- over-
recovered in costs
To Factory overheads 6,000 By Depreciation 10,000
under-recovered overcharged in
in costs costs
To Income-tax not 1,20,000 By Interest on invest- 20,000
provided in costs ments not
included in costs
By Transfer fees in 2,000
financial books
By Stores adjustment 2,000
By Net loss as per
financial books 4,16,000
4,54,000 4,54,000

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Intermediate Course

Cost and Management

© The Institute of Chartered Accountants of India

© The Institute of Chartered Accountants of India

Revised Edition : July, 2019

Committee/ : Board of Studies

Price (All Modules) : ` (For All Modules)

Published by : The Publication Department on behalf of The Institute of

Printed by : Sahitya Bhawan Publications, Hospital Road, Agra-282003

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The traditional role of a chartered accountant restricted to accounting and

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• Module- 2 Consisting of eight chapters namely:

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

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SKILL SPECIFICATION ASSESSMENT GRID

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complex scenarios.) numerical/ analytical

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(Analysis: Applying, Analysis:

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PAPER – 3: COST AND MANAGEMENT ACCOUNTING

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k) Cost Accounting with use of Information Technology.

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© The Institute of Chartered Accountants of India

(iv) Contract Costing

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c) Comparison of Marginal costing with absorption costing

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DETAILED CONTENTS: MODULE-1

CHAPTER-1 : INTRODUCTION TO COST AND MANAGEMENT ACCOUNTING

Learning Outcomes .............................................................................................................................. 1.1

Chapter Overview ................................................................................................................................ 1.2

1.1 Introduction ............................................................................................................................ 1.2

1.1.1 Meaning and Definitions ...................................................................................... 1.3

1.2 Objectives of Cost Accounting ........................................................................................ 1.4

1.2.1 Difference between Cost Control and Cost Reduction............................... 1.5

1.3 Scope of Cost Accounting ................................................................................................. 1.6

1.4 Relationship of Cost and Management Accounting with other

1.4.1 Cost Accounting with Management Accounting ........................................ 1.7

1.4.2 Cost Accounting with Financial Accounting .................................................. 1.8

1.6 Users of Cost and Management Accounting ........................................................... 1.10

1.7 Essentials of a Good Cost Accounting System.......................................................... 1.12

1.8 Installation of Costing System ....................................................................................... 1.12

1.10 Cost objects .......................................................................................................................... 1.15

1.10.1 Cost units .................................................................................................................. 1.16

1.10.2 Cost driver ................................................................................................................ 1.17

1.11 Responsibility centres ........................................................................................................ 1.17

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1.12 Limitations of Cost Accounting ..................................................................................... 1.19

1.13 Classification of costs ........................................................................................................ 1.19

1.13.1 By Nature or Element ........................................................................................... 1.20

1.13.2 By Functions ............................................................................................................. 1.22

1.13.3 By Variability or Behaviour ................................................................................. 1.22

1.13.4 By Controllability .................................................................................................... 1.28

1.13.5 By Normality ............................................................................................................ 1.28