SCHOOL OF MANAGEMENT STUDIES

UNIT – I – COST ACCOUNTING – SBA1601

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UNIT 1 INTRODUCTION TO COST ACCOUNTING

Cost Accounting – Meaning, Scope, Objectives - Advantages and Limitations –

Difference between Cost Accounting and Financial Accounting – Elements of
Cost – preparation of Cost Sheet.

Introduction
Cost Accounting is a branch of accounting and has been developed due to limitations of
financial accounting. Financial accounting is primarily concerned with record keeping directed
towards the preparation of Profit and Loss Account and Balance Sheet. It provides information
regarding the profit and loss that the business enterprise is making and also its financial position
on a particular date. The financial accounting reports help the management to control in a general
way the various functions of the business but it fails to give detailed reports on the efficiency of
various divisions. The limitations of Financial Accounting which led to the development of cost
accounting are as follows.
1.1 Limitations of Financial Accounting
1. No clear idea of operating efficiency: Sometimes profits in an organization may be less or
more because of inflation or trade depression and not due to efficiency or inefficiency. But
financial accounting does not give a clear reason for profit or loss.
2. Weakness not spotted out by collective results: Financial Accounting shows the net result of
an organization. When the profit and loss account of an organization, shows less profit or a loss,
it does not give the reason for it or it does not show where the weakness lies.

3. Does not help in fixing the price: In Financial Accounting, we get the total cost of production
but it does not aid in determining prices of the products, services, production order and lines of
products.
4. No classification of expense sand accounts: In Financial Accounting, we don‟t get data
relating to costs incurred by departments, processes separately or per unit cost of product lines,
or cost incurred in various sales territories. Further expenses are not classified as direct or
indirect, controllable and uncontrollable overheads and the value added in each process is not
reported.
5. No data for comparison and decision making: It does not supply useful data to management
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for comparison with previous period and for taking various financial decisions as introduction of
new products, replacement of labour by machines, price in normal or special circumstances,
producing a part in the factory or buying it from outside market, production of a product to be
continued or given up, priority accorded to different products, investment to be made in new
products or not etc.
6. No control on cost: Financial Accounting does not help to control materials, supplies, wages,
labour and overhead costs.
7. Does not provide standards to assess the performance: Financial Accounting does not help in
developing standards to assess the performance of various persons departments. It also does not
help in checking that costs do not exceed a reasonable limit for a given quantum of work of the
requisite equality.
8. Provides only historical information: Financial Accounting records only the historical costs
incurred. It does not provide day-to-day cost information to the management for making
effective plans for the future.

1.2 Features and Need of Accounting.

It is the Practice and body of knowledge concerned primarily with

1. methods for recording transactions,
2. Keeping financial records,
3. Performing internal audits,
4. reporting and analyzing financial information to the management, and
5. Advising on taxation matters.
It is a systematic process of identifying, recording, measuring, classifying, verifying,
summarizing, interpreting and communicating financial information. It reveals profit or loss for a
given period, and the value and nature of a firm's assets, liabilities and owners' equity.
Accounting provides information on the
1. resources available to a firm,
2. The means employed to finance those resources ,and
3. The results achieved through their use.

1.3 Types of accounting

1.Financial Accounting
2.Management Accounting
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3.CostAccounting
1.4 Cost Accounting
It is the recording of all the costs incurred in a business in a way that can be used to improve its
management.
Cost accounting is a type of accounting process that aims to capture a company's costs of
production by assessing the input costs of each step of production as well as fixed costs such
as depreciation of capital equipment. Cost accounting will first measure and record these costs
individually, then compare input results to output or actual results to aid company management
in measuring financial performance.

1.4 Definition:
Cost Accounting: Cost accounting is the method of accounting for cost. The I C W A defines
Cost Accounting as the technique and process of ascertainment of costs. Cost accounting begins
with the recording of all income and expenditure, and ends with the presentation of statistical
data.

Costing and Cost Accounting

The costing terminology of C.I.M.A ., London defines costing as the “the techniques and
processes of ascertaining costs”. These techniques consist of principles and rules which govern
the procedure of ascertaining cost of products or services. The techniques to be followed for the
analysis of expenses and the processes by which such an analysis should be related to different
products or services differ from industry to industry. These techniques are also dynamic and they
change with time.
The main object of traditional cost accounts is the analysis of financial records, so as to
subdivide expenditure and to allocate it carefully to selected cost centers, and hence to build up a
total cost for the departments, processes or jobs or contracts of the undertaking. The extent to
which the analysis of expenditure should be carried will depend upon the nature of business and
degree of accuracy desired. The other important objective of costing are cost control and cost
reduction.
Cost Accounting may be regarded as “a specialized branch of accounting which involves
classification, accumulation, assignment and control of costs.” The costing terminology of
C.I.M.A, London defines cost accounting as “the process of accounting for costs from the point
at which expenditure is incurred or committed to the establishment of its ultimate relationship

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with cost centers and cost units. In its widest usage, it embraces the preparation of statistical
data, the application of cost control methods and the ascertainment of profitability of activities
carried out or planned”.
We defines cost accounting as “classifying, recording and appropriate allocation of expenditure
for determination of costs of products or services and for the presentation of suitably arranged
data purposes of control and guidance of management”. It is thus a formal mechanism by means
of which costs of products or services are ascertained and controlled.
1.5 Objectives of Cost Accounting
Cost accounting aims at systematic recording of expenses and analysis of the same so as to
ascertain the cost of each product manufactured or service rendered by an organization.
Information regarding cost of each product or service would enable the management to know
where to economize on costs, how to fix prices, how to maximize profits and so on. Thus, the
main objectives of cost accounting are the following.

1. To analyse and classify all expenditure with reference to the cost of products and operations.
2. To arrive at the cost of production of every unit, job, operation, process, department or service
and to develop cost standard.
3. To indicate to the management any inefficiencies and the extent of various forms of waste,
whether of materials, time, expenses or in the use of machinery, equipment and tools. Analysis
of the causes of unsatisfactory results may indicate remedial measures.
4. Toprovidedataforperiodicalprofitandlossaccountsandbalancesheetsatsuchintervals,
e.g. weekly, monthly or quarterly as may be desired by the management during the financial
[School of Distance Education] Cost Accounting Page 8 year, not only for the whole business
but also by departments or individual products. Also, to explain in detail the exact reasons for
profit or loss revealed in total in the profit and loss accounts.
5. To reveal sources of economies in production having regard to methods, types of equipment,
design, output and layout. Daily, Weekly, Monthly or Quarterly information may be necessary to
ensure prompt constructive action.
6. To provide actual figures of costs for comparison with estimates and to serve as a guide for
future estimates or quotations and to assist the management in their price fixing policy.
7. To show, where Standard Costs are prepared, what the cost of production ought to be and with
which the actual costs which are eventually recorded may be compared.
8. To present comparative cost data for different periods and various volume of output and to
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provide guidance in the development of business. This is also helpful in budgetary control.
9. To record the relative production results of each unit of plant and machinery in use as a basis
for examining its efficiency. A comparison with the performance of other types of machines may
suggest the necessity for replacement.
10. To provide a perpetual inventory of stores and other materials so that interim Profit and Loss
Account and Balance Sheet can be prepared without stock taking and checks on stores and
adjustments are made at frequent intervals.
Also to provide the basis for production planning and for avoiding unnecessary wastages or
losses of materials and stores. Last but not the least, to provide information to enable
management to make short term decisions of various types, such as quotation of price to special
customers or during a slump, make or buy decision, assigning priorities to various products,etc
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Difference between Cost Accounting and Financial Accounting-

Both financial accounting and cost accounting are concerned with systematic recording and
presentation of financial data. Financial accounting reveals profits and losses of the business as a
whole during a particular period, while cost accounting shows, by analysis and localization, the
unit costs and profits and losses of different product lines. The main difference between financial
accounting and cost accounting are summarized below.
1. Financial accounting aims at safeguarding the interests of the business and its proprietors and
others connected with it. This is done by providing suitable information to various parties, such
as shareholders or partners, present or prospective creditors etc. Cost accounting on the other
hand, renders information for the guidance of the management for proper planning, operation,
control and decision making.
2. Financial accounts are kept in such a way as to meet the requirements of the Companies Act,
Income Tax Act and other statues. On the other hand cost accounts are generally kept voluntarily
to meet the requirements of the management. But now the Companies Act has made it obligatory
to keep cost records in some manufacturing industries.
3. Financial accounting emphasizes the measurement of profitability, while cost accounting
aims at ascertainment of costs and accumulates data for this very purpose.
4. Financial accounts disclose the net profit and loss of the business as a whole, whereas cost
accounts disclose profit or loss of each product, job or service. This enables the management to

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eliminate less profitable product lines and maximize the profits by concentrating on more
profitable ones.
5. Financial accounting provides operating results and financial position usually gives
information through cost reports to the management as and when desired.
6. Financial accounts deal mainly with actual facts and figures, but cost accounts deal partly with
facts and figures, but cost accounts deal with facts and figures and partly with estimates.

7.In case of financial accounts stress is on the ascertainment and exhibition of profits earned or
losses incurred in the business. On account of this reason in financial accounts, the transactions
are recorded, classified and analyzed in a subjective manner i.e. according to the nature of
expenditure. In cost accounts the emphasis is more on aspects of planning and control and
therefore transactions are recorded in an objective manner. Financial accounts are concerned
with external transactions i.e. transactions between the business concern on one side and third
parties on the other. These transactions form the basis for payment or receipt of cash. While cost
accounts are concerned with internal transactions which do not form the basis of payment or
receipt of cash.
8. The costs are reported in aggregate in financial accounts but costs are broken into unit basis in
cost accounts.
9. Financial accounts do not provide information on the relative efficiencies of various workers,
plants and machinery while cost accounts provide valuable information on the relative
efficiencies of various plants and machinery.
10. In financial accounts stocks are valued at cost or market price whichever is less, whereas
stocks are valued at cost price in cost accounts.

1.6 Difference between Management Accounting and Cost Accounting.

Objective:
The objective of cost accounting is the ascertainment and control of costs of products or services.
But the objective of management accounting is to help the management in the decision-making.
Scope:
Cost accounting deals with cost data. But management accounting deals with both cost and
revenue. It includes financial accounting, cost accounting, budgeting, reporting to
management and interpretation of financial data. Thus, the scope of management accounting is
wider than that of cost accounting,
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Data used:
In cost accounting only those transactions, which can be expressed in figures are taken. But
management accounting uses both quantitative and qualitative information.
Nature:
Cost accounting uses both Past and recent figures. But management accounting is concerned
with the projection of figures as guidelines.
Parties:
The facts and data, provided by cost accounting, are Preferred by both internal as well as external
parties whereas the furnished by management accounting is useful only the management .
Cost Analysis

1.7 Importance of Cost Accounting

The limitations of financial accounting have made the management to realize the importance of
cost accounting. Whatever may be the type of business, it involves expenditure on labour,
materials and other items required for manufacturing and disposing of the product. The
management has to avoid the possibility of waste at each stage. It has to ensure that no machine
remains idle, efficient labour gets due incentive, by-products are properly utilized and costs are
properly ascertained. Besides the management, the creditors and employees are also benefited in
numerous ways by installation of a good costing system. Cost accounting increases the overall
productivity of an organization and serves as an important tool, in bringing prosperity to the
nation, thus, the importance of cost accounting can be discussed under the following headings:
a) Costing as an aid to management:-Cost accounting provides invaluable aid to management.
It provides detailed costing information to the management to enable them to maintain effective
control over stores and inventory, to increase efficiency of the organization and to check wastage
and losses. It facilitates delegation of responsibility for important tasks and rating of employees.
For all these the management should be capable of using the information provided by cost
accounts in a proper way. The various advantages derived by the management from a good
system of costing are as follows:
1. Cost accounting helps in periods of trade depression and trade competition. In periods of trade
depression, the organization cannot afford to have wastages which pass unchecked. The
management must know areas where economies may be sought, waste eliminated and efficiency
increased. The organization must wage a war not only for its survival but also continued growth.

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The management should know the actual cost of their products before embarking on any scheme
of price reduction. Adequate system of costing facilitates this.
2. Cost accounting aids price fixation. Although the law of supply and demand determines the
price of the product, cost to the producer does play an important role. The producer can take
necessary guidance from his costing records in case he is in a position to fix or change the price
charged.
3. Cost accounting helps in making estimates. Adequate costing records provide a reliable basis
for making estimates and quoting tenders.

4. Cost accounting helps in channelizing production on right lines. Proper costing information
makes it possible for the management to distinguish between profitable and non-profitable
activities; profits can be maximized by concentrating on profitable operations and eliminating
non-profitable ones.
5. Cost accounting eliminates wastages. As cost accounting is concerned with detailed breakup
of costs, it is possible to check various forms of wastages or losses.
6. Cost accounting makes comparisons possible. Proper maintenance of costing records provides
various costing data for comparisons which in turn helps the management in formulating future
lines of action.
7. Cost accounting provides data for periodical Profit and Loss Account. Adequate costing
records provide the management with such data as may be necessary for preparation of Profit
and Loss Account and Balance Sheet at such intervals as may be desired by the management.
8. Cost accounting helps in determining and enhancing efficiency. Losses due to wastage of
materials, idle time of workers, poor supervision etc will be disclosed if the various operations
involved in the production are studied carefully. Efficiency can be measured, cost controlled and
various steps can be taken to increase the efficiency.
9. Cost accounting helps in inventory control. Cost accounting furnishes control which
management requires, in respect of stock of materials, work in progress and finished goods.
b) Costing as an aid to Creditors. Investors, banks and other money lending institutions have a
stake in the success of the business concern are therefore benefitted immensely by the
installation of an efficient system of costing. They can base their judgment about the profitability
and future prospects of the enterprise on the costing records.
c) Costingasanaidtoemployees.Employeeshaveavitalinterestintheiremployer‟senterprise in which
they are employed. They are benefited by a number of ways by the installation of an efficient
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system of costing. They are benefited, through continuous employment and higher remuneration
by way of incentives, bonus plans,etc
d) Costing as an aid to National Economy An efficient system of costing brings prosperity to
the business enterprise which in turn brings prosperity to the business enterprise which in turn
results in stepping up of the government revenue. The overall economic development o f a
country takes place as a consequence of increase in efficiency of production.Control of costs,

elimination of wastages and inefficiencies led to the progress of the industry and, in consequence
of the nation as a whole.

1.8 Classification of Cost

Costs can be classified or grouped according to their common characteristics. Proper
classification of costs is very important for identifying the costs with the cost centers or cost
units. The same costs are classified according to different ways of costing depending upon the
purpose to be achieved and requirements of a particular concern. The important ways of
classification are:
1. By Nature or Elements. According to this classification the costs are classified into three
categories i.e., Materials, Labour and Expenses. Materials can further be sub-classified as raw
materials components, spare parts, consumable stores, packing materials etc. This helps in
finding the total cost of production and the percentage of materials (labour or other expenses)
constituted in the total cost. It also helps in valuation ofwork-in-progress.
2. By Functions: This classification is on the basis of costs incurred in various functions of an
organization ie. Production, administration, selling and distribution. According to this
classification, costs are divided into Manufacturing and Production Costs and Commercial costs.
Manufacturing and Production Costs are costs involved in manufacture, construction and
fabrication of products. Commercial Costsare
(a) Administration costs
(b) Selling and distribution costs.
3. By Degree of Traceability to the Product : According to this, costs are divided indirect costs
and indirect costs. Direct Costs are those costs which are incurred for a particular product and
can be identified with a particular cost center or cost unit. Eg:- Materials, Labour. Indirect Costs
are those costs which are incurred for the benefit of a number of cost centre or cost units and
cannot be conveniently identified with a particular cost center or cost unit. Eg:- Rent of Building,
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electricity charges, salary of staff etc.
4. By Changes in Activity or Volume: According to this costs are classified according to their
behavior in relation to changes in the level of activity or volume of production. They are fixed,
variable and semi-variable. Fixed Costs are those costs which remain fixed in total amount with
increase or decrease in the volume of the output or productive activity for a given period of time.

Fixed Costs per unit decreases as production increases and vice versa. Eg:- rent, insurance of
factory building, factory manager‟s salary etc. Variable Costs are those costs which vary in direct
proportion to the volume of output. These costs fluctuate in total but remain constant per unit as
production activity changes. Eg:- direct material costs, direct labour costs, power, repairs etc.
Semi-variable Costs are those which are partly fixed and partly variable. For example;
Depreciation, for two shifts working the total depreciation may be only 50% more than that for
single shift working. They may change with comparatively small changes in output but not in the
same proportion.
5. Association with the Product: Cost can be classified as product costs and period costs.
Product costs are those which are traceable to the product and included in inventory cost, thus
product cost is full factory cost. Period costs are incurred on the basis of time such as rent,
salaries etc. thus it includes all selling and administration costs. These costs are incurred for a
period and are treated as expenses.
6. By Controllability: The CIMA defines controllable cost as “a cost which can be influenced
by the action of a specified member of an undertaking” and a non-controllable cost as “a cost
which cannot be influenced by the action of a specified member of an undertaking”.
7. By Normality: There are normal costs and abnormal costs. Normal costs are the costs which
are normally incurred at a given level of output under normal conditions. Abnormal costs are
costs incurred under abnormal conditions which are not normally incurred in the normal course
of production .Eg:- damaged goods due to machine break down, extra expenses due to disruption
of electricity, inefficiency of workers etc.
8. By Relationship with Accounting Period: There are capital and revenue expenses depending
on the length of the period for which it is incurred. The cost which is incurred in purchasing an
asset either to earn income or increasing the earning capacity of the business is called capital
cost, for example, the cost of a machine in a factory. Such cost is incurred at one point of time
but the benefits accruing from it are spread over a number of accounting years. The cost which is
incurred for maintaining an asset or running a business is revenue expenditure. Eg:- cost of
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materials, salary and wages paid, depreciation, repairs and maintenance, selling anddistribution.

9. By Time..Costs can be classifiedas

1) Historical cost and
2) Predetermined Costs

3) The costs which are ascertained and recorded after it has been incurred is called historical costs. They
are based on recorded facts hence they can be verified and are always supported by evidences.
Predetermined costs are also known as estimated costs as they are computed in advance of production
taking into consideration the previous periods ‟costs and the factors affecting such costs. Predetermined
costs when calculated scientifically become standard costs. Standard costs are used to prepare budgets
and then the actual cost incurred is later-on compared with such predetermined cost and the variance is
studied for future correction.

1.9 Types, Methods and Techniques of Costing

The general fundamental principles of ascertaining costs are the same in every system of cost
accounting, but the methods of analysis and presenting the costs vary from industry to
industry. Different methods are used because business enterprises vary in their nature and in the
type of products or services they produce or render. Basically, there are two principal methods of
costing, namely (i) Job Costing, and (ii) Process costing.
1. Job costing: It refers to a system of costing in which costs are ascertained in terms of
specific jobs or orders which are not comparable with each other. Industries where this method
of costing is generally applied are Printing Process, Automobile Garages, Repair Shops, Ship-
building, House building, Engine and Machine construction, etc. Job Costing includes the
following methods of costing:
(a) Contract Costing: Although contract costing does not differ in principle from job costing, it
is convenient to treat contract cost accounts separately. The term is usually applied to the costing
method adopted where large scale contracts at different sites are carried out, as in the case of
building construction.
(b) Bach Costing: This method is also a type of job costing. A batch of similar products is
regarded as one job and the cost of this complete batch is ascertained. It is then used to determine
the unit cost of the articles produced. It should, however, be noted that the articles produced
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(c) Terminal Costing: This method is also a type of job costing. This method emphasizes the
essential nature of job costing, ie, the cost can be properly terminated at some point and related
to a particular job.
(d) Operation Costing: This method is adopted when it is desired to ascertain the cost of
carrying out an operation in a department, for example, welding. For large undertaking, it is
frequently necessary to ascertain the cost of various operations.

2. Process Costing: Where a product passes through distinct stages or processes, the output of
one process being the input of the subsequent process, it is frequently desired to ascertain the
cost of each stage or process of production. This is known as process costing. This method is
used where it is difficult to trace the item of prime cost to a particular order because its identity is
lost in volume of continuous production. Process costing is generally adopted in textile
industries, chemical industries, oil refineries, soap manufacturing, paper manufacturing,
tanneries,etc.
3. Unit or single or output or single output costing:This method is used where a single
article is produced or service is rendered by continuous manufacturing activity. The cost of the
whole production cycle is ascertained as a process or series of processes and the cost per unit is
arrived at by dividing the total cost by the number of units produced. The unit of costing is
chosen according to the nature of the product. Cost statements or cost sheets are prepared under
which various items of expenses are classified and the total expenditure is divided by total
quantity produced in order to arrive at unit cost of production. This method is suitable in
industries like brick-making, collieries, flour mills, cement manufacturing, etc. this method is
useful for the assembly department in a factory producing a mechanical article eg.Bicycle.
4. Operating Costing: This method is applicable where services are rendered rather than
goods produced. The procedure is same as in the case of single output costing. The total
expenses of the operation are divided by the units and cost per unit of services is arrived at. This
method is employed in Railways, Road Transport, Water supply undertakings, Telephone
services, Electricity companies, Hospital services, Municipal services,etc.
5. Multiple or Complete Costing: Some products are so complex that no single system of
costing is applicable. It is used where there are a variety of components separately produced and

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subsequently assembled in a complex production. Total cost is ascertained by computing
component costs which are collected by job or process costing and then aggregating the costs
through use of the single or output costing system. This method is applicable to manufacturing
concerns producing Motor Cars, Aeroplanes, Machine tools, Type-writers, Radios, Cycles,
Sewing Machines, etc.
6. Uniform Costing: It is not a distinct method of costing by itself. It is the name given to a
common system of costing followed by a number of firms in the same industry. This helps in
comparing performance of one firm with that of another.
7. Departmental Costing: When costs are ascertained department by department, the method is
called “Departmental Costing”. Usually, for ascertaining the cost of various goods or services
produced by the department, the total costs will have to be analyzed, say, by the use of job
costing or unit costing.
In addition to the above methods of costing, mention can be made of the following techniques
of costing which can be applied to any one of the above method of costing for special purposes
of cost control and policymaking:
a) Standard or Predetermined Costs.
b) Margina lCosts

1.10 Installation of Costing System

While installing a cost system, the cost accountant should consider the following
factors:
(1) Objectives of Costing System: While installing a cost accounting system, it
should be ensured that it will aid in ascertainment of cost, determination of selling
price, cost control and cost reduction etc.
(2) Nature of Business: Cost Accounting system should be suited to the nature
of products and business. The nature of product and business is essential to determine
proper method of costing on the basis of types of product, methods and product life
cycle, quantity, qualityetc.
(3) Nature of Organization: It is essential to examine existing organization
structure of the company before introducing the costing system. Since the system is
to be designed to suit the organization it is necessary to ascertain the layout, nature
and size of the organization, scope of authority and responsibility.
(4) Methods and Procedures: Before introducing the costing system, the Cost

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 Accountant should carefully study the existing manufacturing procedures, processes,
methods, system of wage payments, receipts and issue of materials. This will help
him to select the proper method of costing.
(5) Communication: A good system of cost accounting will provide
information which helps in decision making. Cost information should be made available
promptly and regularly. It is necessary to examine the prompt reporting system.
(6) Standardization: The system should be introduced after a detailed study of the
standardization. Standard Forms should be used in order to reduce clerical work to the
minimum.
(7) Simplicity: The system to be adopted should be simple and easy to
adopt to the changing requirement. The costing system should be capable of being
understood by the operating personnel.
(8) Co-operation: There is need for co-operation and support of the various
departments involved in the cost accounting process for being successfully
implemented.
(9) Reconciliation: Emphasis should be on whether separate set of cost and
financial books are required or an integrated system has to be followed. This depends upon
the nature and size of the industry. Where cost books are maintained independetly of financial
records there must be provision for reconciliation between the cost and financial records.

Practical Difficulties in Installing Costing System

The following are the practical difficulties confronted in installing a costing system : (1)
Lack of top management support.
(2) Resistance from accounting departmental staff.(3) Non co-operation from
user departments.
(4) Shortage of trained staff in costing department.

(5) Heavy cost of installing the system.

Steps to Overcome Practical Difficulties

To overcome these difficulties, the steps required are given below:

(1) To sell the idea to top management to convince them of the utility of the system.

(2) Resistance and non co-operation can be overcome by behavioural approach to

deal with the staff concerned effectively.

(3) Proper training should be given to the staff at each level.

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(4) Regular meetings should beheld with the cost accounting staff, user departments staff
and top management to clarify points.

1.11 Characteristics of an Ideal Costing System (or) Requisites’ of good costing system

An ideal system of costing is that which achieves the objectives of a costing system and brings
all advantages of costing to the business. Following are the main characteristics which an ideal
system of costing should possess or the points which should be taken into consideration before
installing a costing system.
(i) Suitability to theBusiness:
A costing system should be tailor-made, practical and must be devised according to the nature,
conditions, requirements and size of the business. Any system which serves the purposes of the
business and supplies necessary information for running the business efficiently is an ideal
system.
(ii) Simplicity:
The system of costing should be simple and plain so that it may be easily understood even by a
person of average intelligence. The facts, figures and other information‟s provided by cost
accounting must be presented in the right form at the right time to the right person in order to
make it more meaningful.
(iii) Flexibility:
The system of costing must be flexible so that it may be changed according to changed
conditions and circumstances. The system without such flexibility will be outmoded because of
fast changes in business and industry. Thus, the system must have the capacity of expansion or
contraction without much change.
(iv) Economical:
A costing system is like other economic goods. It costs money just like economic goods. If the
system is too expensive, management may be unwilling to pay as buyers are not willing to pay
for the goods if these are expensive as compared to their utility. A costing system should not be
expensive and must be adapted according to the financial capacity of the business.

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The benefits to be derived from the system must be more than its costs as management will be
willing to install the system when it‟s perceived expected benefits exceed its perceived expected
costs. In short, the system must be economical taking into consideration the requirements of the
business. The cost of installing and operating the system should justify the results.
(v) Comparability:
The costing system must be such so that it may provide facts and figures necessary to
management for evaluating the performance by comparing it with the past figures, or figures of
other concerns or against the industry as a whole or other department of the same concern.
(vi) Capability of Presenting Information at the Desired Time:
The system must provide accurate and timely information so that it may be helpful to
management for taking decisions and suitable action for the purpose of cost control.
(vii) Necessary cooperation and participation of executives from various departments of the
concern is essential for development of a good system of cost accounting. Moreover,
management should have faith in the costing system and should also provide a helping hand for
its development and success.
(viii) The system of costing should not sacrifice the utility by introducing meticulous and
unnecessary details.
(ix) A carefully phased programme should be prepared by using network analysis for the
introduction of the system.
(x) Minimum Changes in the Existing SetUp:
The existing system of delegation and division of authority and responsibility must not be
disturbed with the costing system. As far as possible the system must be such so that it may least
disturb the existing organisational set up.
(xi) Uniformity of Forms:
All forms and proformas etc necessary to the system should be uniform in size and quality of
paper. Higher efficiency can be obtained by using colour of the paper to distinguish different
forms. Printed forms should contain instructions as to their use and disposal. Forms should be
suitably designed for collection and dissemination of cost data.

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(xii) Minimum Clerical Work:
The filling of the forms by foremen and workers should involve as little clerical work as possible
as most of workers are not well educated. To ensure reliable statistics, every original entry should
be supported by an examiner‟s signatures.
(xiii) Efficient System of Material Control:
There should be an efficient system of stores and stock control as materials usually account for a
greater proportion of the total cost. A good method of pricing material issued to production
should be followed.
(xiv) Adequate Wage Procedure:
There should be a well defined wage procedure for recording the time spent by workers on
different jobs, for preparing the wage sheets and for the payment of wages. Thus the introduction
of well defined wage system will help to control the cost of labour.
(xv) Departmentalization of Expenses:
A sound plan should be devised for the collection, allocation, apportionment and absorption of
overheads in order to ascertain the cost accurately.
(xvi) Reconciliation of Cost Accounts and Financial Accounts:
If possible the Cost accounts and financial accounts should be interlocked into one integral
accounting scheme. If this is not possible the systems should be so devised that the two sets of
accounts are capable of easy reconciliation.
(xvii) External Factors:
The installation of a costing system mainly depends on internal factors of a firm, but external
factors may also affect the structure of the system. For example, cost accounting rules applicable
to certain industries as notified by the Central Government require certain cost information to be
developed and included in the books of accounts. Therefore, an ideal system of costing should
take care of internal as well as external factors.
(xviii) Duties and Responsibilities of the Cost Accountant:
Under a good system of cost accounting the duties and responsibilities of the cost accountant
should be clearly defined. The cost accountant should have access to all works and departments

19
1.12 Cost analysis (CA), sometimes called benefit–cost analysis (BCA), is a systematic
approach to estimating the strengths and weaknesses of alternatives that satisfy transactions,
activities or functional requirements for a business.

Importance of Cost analysis

Evaluate Projects
A cost-benefit analysis is used to evaluate the risks and rewards of projects under consideration.
It can be used to project the potential benefits of investing in marketing ideas, product
development, infrastructure enhancements and operational changes. If all potential costs are
tallied accurately and the benefits outweigh the costs, the considered investment may be a good
choice.
Prepare Budgets and Sales Projections
The information obtained during a cost-benefit analysis makes budgeting easier. If you have all
the possible costs listed, you can project the budget needed to undertake the project. The
anticipated benefits can also be used to project sales if they can be quantified into financial goals.
Both of these considerations are useful when preparing budgets and sales projections.
Prioritize Investments
Cost-benefit analysis is useful for business owners who must choose among several potential
projects. After examining profitable projects for potential benefits, you can prioritize
investments, choosing the projects with the greatest benefit and lowest cost to invest in first. In
this way, you can achieve the fastest return on your investment and use remaining capital to fuel
additional projects.
Establish Goals
Once the benefits of possible projects are understood, they can be used to set benchmarks and
goals for the project itself. Quantifiable benefits can be used to set concrete revenue goals. Other
benefits can be used to set productivity, time or other management goals. Goals can be set for
various types of projects, including marketing, finance, management and human resources.

20
1.13 Cost center
According to Chartered Institute of Management Accountants, London, cost centre means “a
location, person or item of equipment (or group of these) for which costs may be ascertained and
used for the purpose of cost control”. Cost centre is the smallest organizational sub- unit for
which separate cost collection is attempted. Thus cost centre refers to one of the convenient unit
into which the whole factory organization has been appropriately divided for costing purposes.
Each such unit consists of a department or a sub-department or item of equipment or , machinery
or a person or a group of persons.

For example, although an assembly department may be supervised by one foreman, it may
contain several assembly lines. Some times each assembly line is regarded as a separate cost
centre with its own assistant foreman.
The selection of suitable cost centers or cost units for which costs are to be ascertained in an
undertaking depends upon a number of factors which are listed as follows.
1. Organization of the factory
2. Conditions of incidence of cost
3. Requirements of the costing system ie. Suitability of the units or centers for cost purposes.
4. Availability of information
5. Management policy regarding making a particular choice from several alternatives

Cost units- The Chartered Institute of Management Accountants, London, defines a unit of cost
as “a unit of quantity of product, service or time in relation to which costs may be ascertained or
expressed”.
The forms of measurement used as cost units are usually the units of physical measurements like
number, weight, area, length, value, time etc.
Following are some examples of cost unit.

21
Industry/product Cost unitbasis
Automobile Numbers
Brickworks per 1000bricks
Cement perTonne
Chemicals Litre, gallon, kilogram,ton
Steel Tonne
Sugar Tonne
Transport Passenger-kilometre, tonnekilometer

1.14 Profitcenter
A profit centre is that segment of activity of a business which is responsible for both revenue and
expenses and discloses the profit of a particular segment of activity. Profit centers are created to
delegate responsibility to individuals and measure their performance.
Difference between Profit centre and Cost centre
The various points of difference between Profit centre and cost centre are as follows. Cost centre
is the smallest unit of activity or area of responsibility for which costs are collected whereas a
profit centre is that segment of activity of a business which is responsible for both revenue and
expenses.
(i) Cost centers are created for accounting conveniences of costs and their control whereas as a
profit centreis created because of decentralization of operations i.e., to delegate responsibility to
individuals who have greater knowledge of local conditions etc.
(ii) Cost centers are not autonomous whereas profit centers are autonomous.
(iii) A cost centre does not have target cost but efforts are made to minimize costs, but each
profit centre has a profit target and enjoys authority to adopt such policies as are necessary to
achieve it s targets.
(iv) There may be a number of cost centers in a profit centre in a profit centre as production or
service cost centers or personal or impersonal but a profit centre may be a subsidiary company
within a group or division in a company.

22
2. Cost Sheet
Cost sheet is a statement, which shows various components of total cost of a product. It classifies and
analyses the components of cost of a product. Previous period’s data is given in the cost sheet for
comparative study. It is a statement which shows per unit cost in addition to Total Cost. Selling price is
ascertained with the help of cost sheet. The detail of total cost presented in the form of a statement is
termed as Cost sheet. Cost sheet is prepared on the basis of
1. Historical Cost
2. Estimated Cost.

Historical Cost
Historical Cost sheet is prepared on the basis of actual cost incurred. A statement of cost
prepared after incurring the actual cost is called Historical Cost Sheet.

Estimated Cost
Estimated cost sheet is prepared on the basis of estimated cost. The statement prepared before the
commencement of production is called estimated cost sheet. Such cost sheet is useful in quoting
the tender price of a job or a contract.

Importance of Cost Sheet

Cost ascertainment
The main objective of the cost sheet is to ascertain the cost of a product. Cost sheet helps in
ascertainment of cost for the purpose of determining cost after they are incurred. It also helps to
ascertain the actual cost or estimated cost of a Job.
Fixation of selling price
To fix the selling price of a product or service, it is essential to prepare the cost sheet. It helps in
fixing selling price of a product or service by providing detailed information of the cost.
Help in cost control
For controlling the cost of a product it is necessary for every manufacturing unit to prepare a cost
sheet. Estimated cost sheet helps in the control of material cost, labour cost and overheads cost at
every point of production.
Facilitates managerial decisions
It helps in taking important decisions by the management such as: whether to produce or buy a
23
component, what prices of goods are to be quoted in the tender, whether to retain or replace an
existing machine etc.
Elements of Cost
The management of an organization needs necessary data to analyze and classify costs for proper
control and for taking decisions for future course of action. Hence the total cost is analyzed by

elements of costs ie by the nature of expenses. The elements of costs are three and they are
By grouping the above elements of cost, the following divisions of cost are obtained.
1. Prime cost = Direct Materials + Direct Labour+ Direct Expenses
2. Works or Factory Cost = Prime Cost + Works or Factory Overheads
3. Cost of Production = Works Cost + Administration Overheads
4. Total Cost or Cost of Sales = Cost of Production + Selling and Distribution Overheads The
difference between the cost of sales and selling price represents profit or loss.

Working Problem 1.Find the Prime Cost, Works Cost, Cost of production, total Cost and profit
from the following:- Direct Materials Rs.20000; Direct Labour Rs. 10000; Factory Expenses Rs.
7000; Administration Expenses Rs. 5000; Selling Expenses Rs. 7000 and Sales Rs.60,000.
Solution:
Prime Cost = Direct Materials + Direct Labour = Rs.20,000 + Rs.10,000 = Rs.30,000. Works
Cost = Prime Cost + Factory Expenses = Rs.30,000 + Rs.7,000 = Rs.37,000. Cost of
Production = Works Cost + Administration Expenses=Rs.37000+ Rs.5, 000 = Rs.42, 000.

24
Total Cost or Cost of sales= Cost of Production + Selling Expenses = Rs.42, 000+ Rs.7, 000 =
Rs.49, 000. Profit = Sales - Total Cost = Rs.60,000 - Rs.49,000=Rs.11, 000.

These terms can be explained as follows

1. Direct Materials are those materials which can be identified in the product and can be
conveniently measured and directly charged to the product. For example, bricks in houses, wood
in furniture etc. Hence all raw materials, materials purchased specifically for a job or process like
glue for book making, parts or components purchased or produced like batteries for radios and
tires for cycles, and primary packing materials are direct materials.
2. Indirect Materials are those materials which cannot be classified as direct materials.
Examples are consumables like cotton waste, lubricants, brooms, rags, cleaning materials,
materials for repairs and maintenance of fixed assets, high speed diesel used in power generators
etc.
3.
4. Direct Labouris all labour expended in altering the construction, composition, confirmation
or condition of the product. Thus direct wages means the wages of labour which can be
conveniently identified or attributed wholly to a particular job, product or process or expended in
converting raw materials into finished goods. Thus payment made to groups of labourers
engaged in actual production, or carrying out of an operation or process, or supervision,
maintenance, tools setting, transportation of materials, inspection, analysis direct labour.
5. Direct Expenses are expenses directly identified to a particular cost centre. Hence expenses
incurred for a particular product, job, department etc are direct expenses. Example royalty,
excise duty, hire charges of a specific plant and equipment, cost of any experimental work
carried out especially for a particular job, travelling expenses incurred in connection with a
particular contract or job etc.
6. Overheads may be defined as the aggregate of the cost of indirect materials, indirect labour
and such other expenses including services as cannot conveniently be charged direct or specific
cost units. Overheads may be sub-divided into (i) Manufacturing Overheads; (ii) Administration
Overheads; (iii) Selling Overheads; (iv) Distribution Overheads; (v) Research and Development
Overheads.

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Types of Overheads
According to functions, classification of overhead expenses may be done as follows:

(i) Factory or Works Overhead

Factory or works overhead refers to all indirect expenses of a factory. It includes
the following:

Wages of all factory staff excluding those of direct workers

Indirect material
Rent for factory
Rates for factory
Taxes of factory
Depreciation of factory assets
Excise duty
Canteen expenses
Labor welfare expenses
(ii) Administration Overhead
It refers to all the expenses incurred in connection with general administration. In
administrative building, following things are included:

Salary of administrative staff

Rent for office
Rates for office
Taxes of administrative accommodation
Postage
Telegram and telephone
Stationery
Lighting of administrative building
Depreciation of office appliances

(iii) Selling Overhead

Selling overhead refers to all expenses incurred in connection with sales. In
selling overhead, following things are included:

Salary of sales staff

Traveler’s commission
Advertisement
Rent for showroom
26
 Rates for showroom or sales shop
Taxes of sales office
Depreciation of sales office appliances
Cost of participation in industrial fares and exhibitions
Cost of free gifts
Cost of free after sales service
Normal bad debt

(iv) Distribution Overhead

Distribution overhead refers to all the expenses incurred in connection with the
delivery of a product after the sale is affected. In distribution overhead, following
things are included:

Delivery van expenses

Fright and insurance
Packing for delivery loading and unloading
Salary of the deliverymen
Customs duty
According to behavior, classification of overhead expenses may be done as follows:
a. Variable Overhead
The overhead expenses that vary proportionately with the output are variable
overhead.
b. Semi-Variable or Semi-Fixed Overhead
The overhead expenses that vary with the output but not proportionately are semi- variable or
semi-fixed overhead.
It should be always kept in mind that in this connection direct materials, direct wages and
direct expenses are variable items of direct cost. Therefore, if we classify cost according to
behavior, we get the following classification:

a. Fixed Costs

Fixed costs include only those overhead expenses which remain fixed irrespective of the level of
output. Some of the items of fixed costs are as follows:
Rent and rate of building
Salary of work mangers, administrative manager, sales managers
Depreciation of buildings

27
 Insurance

b. Variable costs
Variable costs include prime cost and variable overheads. These costs vary proportionately with
the output. Some of the items of variable costs are as follows:
Direct material
Direct wages
Direct expenses
Consumable stores
Power
Fuel

c. Semi-Variable Costs
Semi-variable costs include overhead expenses that vary according to output but not
proportionately, so these costs are partly fixed and partly variable. Some of the items of semi-
variable costs are as follows:
Normal repairs and maintenance of building and plant
Salary of supervisors
Charge men
Foremen
Service department expenses
Depreciation of plant and machinery

Consider the element repairs. Normal repair is mostly fixed in nature because within a certain
degree of capacity, utilization is beyond that degree. More frequent repairs will be necessary
involving further cost. But still, such an increase in cost will not be proportionate to an increase
in output. This is why the element is semi-fixed or semi-variable.
Preparation of Cost sheet or Statement of Cost: When costing information is set out in the
form of a statement, it is called “Cost Sheet”. It is usually adopted when there is only one main
product and all costs almost are incurred for that product only. The information incorporated in
a cost sheet would depend upon the requirement of management for the purpose of control.
Raw materials are converted into finished products by a manufacturing concern with the help of
labor, plants etc. The elements that constitute the cost of manufacturing are known as

Direct material, direct labor and direct expenses are those which can be traced in relationship

28
 with a particular process, job, operation or product. Indirect material, indirect labor and indirect
expenses are those which are of general nature and cannot be traced in relationship with a
particular process, operation, job or product.

2.2 Specimen of Cost Sheet

Total Cost Cost per
Rs Unit Rs.
Direct Materials . xx
Direct Labour xx x
Prime cost x xx
xx x
Add: Works Overheads x
xxx xxx
Works Cost
xxx xxx
Add: Administrative Overheads xxx xxx
Cost of Production
xxx xxx
Add: Selling and Distribution Overheads xxx xxx
Total Cost or Cost of Sales
xxx xxx
xxx xxx

Working Problem : 2

A manufacturer has shown an amount of Rs. 16190 in his books as “establishment” which
includes the following expenses:

Agents commission-- Rs.5750

Warehouse wages-- Rs.1800
Warehouse repairs-- Rs.510
Lighting of office-- Rs.70
Office salaries-- Rs.1130
Director’s remuneration-- Rs.1400
Traveling expenses-- Rs.760
Rent, rates and insurance of warehouse-- Rs.310
Rent, rates and insurance of office-- Rs.230
Lighting of warehouse-- Rs.270
Printing and stationery-- Rs.1500
Trade magazines-- Rs.70
Donations-- Rs.150
Bank charges-- Rs.100
Discount allowed-- Rs.1970
Bad debts-- Rs.170

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From the above information, prepare a statement showing the following (in separate totals):

Selling expenses
Distribution expenses
Administration expenses
Expenses which you will exclude form total cost

Solution:

Statement of Cost
Rs. Rs.
Selling expenses:
Agents’ commission 5,750
Traveling expenses 760
Bad debts 170
6,680
Distribution expenses:
Warehouse wages 1,800
Warehouse repairs 510
Rent, rates and insurance of warehouse 310
Lighting of warehouse 270
2,890

Administration expenses:
Lighting of office 70
Office salaries 1,130
Directors’ remuneration 1,400
Rent, rates and insurance of office 230
Printing and stationery 1,500
Trade magazines 70
Bank charges 100
4,500
Total expenses to be considered in estimation costs 1,4,070
Expenses to be excluded form costs:
Donations
150
Discount allowed 1,970 2,120
Total 1,6,190

Working Problem: 3
ABC Ltd., a manufacturing company, incurred the following expenses during a certain
period. You are required to prepare a statement showing the subdivision of total cost.

30
 Rs. Rs.
Materials used on jobs 1,20,540 Depreciation of plant 3,800
Wages traceable to jobs 86,650 Depreciation of delivery vans 1,600
Wages paid to men for Insurance on finished goods 2,500
maintenance work 1,26,00 Lubrication oil 250
Salaries of sales men 15,100 Bad debts 300
Directors’ fees 10,000 Commission to salesmen 2,850
Carriage inwards on raw Cost of idle time in factory 510
materials 860 Auditors fees 3,800
Carriage outwards 2,800 Dividends paid 6,800
Factory rent and rates 8,300 Lighting of showroom 1,500
Works salaries 20,400 Office salaries and expenses 7,000
Hire of crane for work 1,300 Income tax 8,600
Consumable stores 340

Solution:

Statement of Cost

Rs. Rs.
Direct materials 120540
Add: carriage inwards 860 121400
Direct wages 86650
Direct expenses (hire of crane for work ) 1300
Prime Cost 209350
Works overhead
Wages paid to men on maintenance work 12600
Factory rent and rates 8300
Works salaries 20400
Consumable stores 340
Depreciation of plant 3800
Lubricating oil 250
Cost of idle time in factory 510 46200
Works cost 255550
Administration overhead
Directory fees 10000
Auditors fees 3800
Office salaries and expenses 7000 20800
Cost of production 276350
Selling and distribution overhead
Salaries of salesmen 15100

31
 Carriage outwards 2800
Depreciation of delivery vans 1600
Insurance of finished goods 2500
Commission to sales men 2850
Lighting of showroom 1500
Bad debts 300 26650

Total Cost 303000

Tender and Quotation

It is usually refers to the process whereby governments and financial institutions invite bids for
large projects that must be submitted within a finite deadline. The term also refers to the process
whereby shareholders submit their shares or securities to a takeover offer.

Definition:

A quotation is a document that offers to sell goods or services at a stated price, under specified
conditions. Quotations are used to let a potential buyer know how many your goods or services
will cost before committing to purchase them.

To invite bids for a project, or to accept a formal offer such as a takeover bid. Tender usually
refers to the process whereby governments and financial institutions invite bids for large projects
that must be submitted within a finite deadline.

In order to prepare the tender the following items to be analyzed

1.Raw materials,
2. Direct Labour
3.Chargable expenses
4.Work overheads
5.Office overheads
6.Selling overheads
7.Estimatedprofit
PREPARTION OF A PRICE LIST

Most businesses will need to draw up a price list at some stage. If you sell a fixed range of
products, this may be the only form of pricing you need. This type of standard price list can also
be used as the basis for pricing your non-standard orders.

32
It's a good idea to date your price lists - particularly if your customer is likely to keep it for a
long time. You should make it clear when any special offers expire. It can also be useful to
include a clause at the end of the price list stating that prices are subject to change.

We should make clear whether any delivery, packing or postage costs are included in your
prices. Additionally, although you don't have to indicate discounts for bulk purchases on your
price list, it might attract more business.

We may be able to use software packages such as Sage Simply Accounting to help you draw up
complex price lists.

THE DIFFERENCE BETWEEN A QUOTATION AND AN ESTIMATE

It's impossible for some businesses to give standard prices for goods and services. This may be
because the skills, time and materials required for each job vary depending on different
customers' needs.

This situation is more common in some trades than others - decorators or builders, for example,
rarely do exactly the same job twice. When it's not possible to work from a standard price list,
you have to give a quotation or an estimate instead.

A quotation is a fixed price offer that can't be changed once accepted by the customer. This
holds true even if you have to carry out much more work than you expected.

An estimate is an educated guess at what a job may cost - but it isn't binding. To take account of
possible unforeseen developments, you should provide several estimates based on various
circumstances, including the worst-case scenario. This will prevent your customer from being
surprised by the costs.

PREPARATION OF A WRITTEN ESTIMATE

When you prepare an estimate it's good practice to give the customer a written copy, including a
full breakdown of costs.

Our estimate should include the:

 Overall price
 Breakdown, listing the components of the price, schedule, detailing when work will be
done or products delivered
 Terms and conditions
 Time period the estimate is valid for

33
  Payment terms or schedule
We must include our full business contact details in our estimates. If we have letterhead, it's a
good idea to put our estimates on this.

Include a disclaimer stating clearly that the estimate's price is subject to change. Agree in
advance how any variations will be costed. These can arise if the client changes their
requirements or if a job turns out to be more complicated than expected.

PREPARATION OF A WRITTEN QUOTATION

Quotations commit you to the price you specify, so they are usually used when:

 The work you're quoting for has clear requirements - in terms of time, labour, materials,
etc. our costs are stable and our confident in the work won't turn out to be more
complicated than expected.
It's good practice to give your customers a written quotation. This should include the:

 Overall price
 Breakdown of the components of the price, indicating what is covered and what is not
 Period the quotation is valid for
 Schedule for when the work will be done or products delivered
 Full contact details of your business
 Payment terms or schedule
It's also advisable to get your customer's written confirmation that they're happy with the price
you have quoted and the work that this includes. This should be done before you carry out the
work, or provide the goods or services.

Computer software can be used to help you determine the costs involved in any work for which
you're drawing up a quotation. Many accounting and spreadsheet packages can be used for this.

Process of Inviting or preparing aTender

Invitations to tender should normally consist of the following sections; it will however depend
upon the complexity of the requirement.

Part 1 - Defines the contract, giving details of timescales for commencement and completion

Part 2 - Contains the “Conditions of Contract” wherein the commercial details are explained in
simple language; where appropriate the draft contract can be included.

34
Part 3 - Should be a pricing schedule

Part 4 - Will give details of the scope of the work or services or the quantity and frequency of
requirements of goods or services to be supplied.

Part 5 - Depending on the size of the contract, should highlight all procedural requirements, such
as third party inspection, variations if any, the communication route and names of people
involved in discharging contractual requirements and so on.

Part 6 - The specification; if a “Technical” specification this should give full details of the work,
supply or service to be undertaken; current preference is for this to be a “performance” or
“functional” specification, which allows freedom of choice to the bidder as to how best to meet
the requirement.

Part 7 - Any drawings and/or plans required to allow bidders to ensure their offered goods or
service comply, not only to the specification, but also to those drawings originally issued as part
of the Technical Specification.

Part 8 - Should contain details of free issue goods, if any, and the arrangement for such free
issue.

Part 9 - Gives details of submission of bids, such as time and precise location, that late bids will
not be accepted, the date of bid opening and whether it will be open or closed. Open bidding is
where all bidders have the option of being present to view and note total prices submitted by all
bidders. Often used overseas as a means of avoiding accusations of corrupt practices as only
those bids opened, registered, and with their total cost announced, will be considered in the
evaluation process. Where appropriate, information should be included on the tender evaluation
methods that should be adopted.

Part 10 - Will detail the terms and conditions anticipated in any resultant contract, so that
bidders may take any “special” conditions into consideration when compiling their tender. All
invitations to tender for a specific product or service must be identical onissue.

Tender opening

The Tender Board can be a standing group. It might consist of a board member as chairman, the
purchasing director, probably a technical expert, and a non-aligned person to act as secretary.

To ensure equality of treatment of all tenders, the Tender Board meets on the nominated day, at
the nominated time, in a location suitable to accommodate all interested parties, if a public
opening. If not, in a closed office. All bids are date and time stamped and recorded, with total
costs noted.

Late tenders or bids should preferably not be opened but should be date and time stamped and
returned to the bidder with a letter of explanation. It may be that in some companies ALL tenders

35
are opened and those which were late, annotated as such, and kept separate from valid bids,
submitted within the timescale stipulated.

Tender evaluation

The bid analysis team, as identified in the introduction to this guide (as the Procurement Project
Team), have now to assess all components of all bids. Firstly to ensure the bid is compliant, and
that all parts are complete, then to compare and assess all parts, to identify the best value for
money bid overall. It is most important to ensure that the necessary skills are included in the
team. For example, a financial expert, a technical expert, a purchasing expert and, if necessary, a
commercial or legal expert.

The process must follow a defined pattern to which all participants subscribe, to ensure all bids
are dealt with in exactly the same way. The methods for comparison have to be fair, thorough
and demonstrably so, should inspection take place.

Components of a tender

The following is a check list of some of the aspects which, depending on the nature of the
requirement, might need to be considered for inclusion in an invitation to tender:

• The scope and/or functions of the work or service required

• The output required
• The quality expected
• Estimated maintenance requirements when appropriate
• The number or amount
• Any standards required to be achieved, or applied
• Timescales • start date required
• Finish date if “time is of the essence”
• A schedule of deliveries
• Any inspection required and at what stages
• Details of free issue materials
• Accommodation details for installation
• Insurance cover required for contractors
• Costs in use of components or complete product where appropriate
• Response times
• Details of measurement of the work

36
 Reconciliation of Cost and Financial Accounts

Meaning
In business concern where Non-integrated Accounting System is followed.
cost and financial accounts are maintained separately, the difference between the
end result of these two are required to be reconciled. Reconciliation of cost and
financial accounts mean tallying the profit or loss revealed by both set of accounts.
The chief aim is to find out the reasons for the difference between the results shown
by Cost Accounts and Financial Accounts.
Reasons for the Difference
The various reasons which create difference between cost and financial profit or
loss shown by the two set of books may be listed under the following heads:
(1) Items shown only in Financial Accounts
(2) Items shown only in Cost Accounts
(3) Absorption of Overheads
(4) Methods of Stock Valuation
(5) Abnormal Loss and Gains
(1) Items shown only in Financial Accounts: Some items of income and
expenses which are included only in financial accounts but are not shown in cost
accounts and vice versa. The following items are shown in financial accounts but not in
cost accounts:
(A) Income:
(1) Profit on sale of fixed assets
(2) Interest received on investment
(3) Dividend received on investment
(4) Rent, brokerage and commission received
(5) Premium on issue of shares
(6) Transfer fees received.

(B). Expenditure:
(1) Loss on sale of fixed assets, e.g., Plant, Machinery,Building
(2) Interest paid
(3) Discount paid
(4) Dividend paid
(5) Losses due to scrapping of plant and machinery

37
 (6) Penalties and fines
(7) Expenses of shares' transfer fees
(8) Preliminary expenses written off
(9) Damages payable at law.
(2) Items shown only in Cost Accounts: There are some items which are recorded only in
Cost Accounts but are not included in financial accounts, national interest on capital, notional
rent of premises owned, salary to proprietor etc. are not recorded in financial account because the
amount is not actually spent or paid. These expenses reduced the profit in cost account while in
financial account it may be the reverse effect.
(3) Absorption of Overheads : In financial accounts actual amount of expenses paid
are recorded while in cost accounts overheads are charged at predetermined rates. If overhead
charged are not equal to the amount of overhead incurred the under or over absorption of
overhead leads to difference in profits of two accounts.
(4) Methods of Stock Valuation: The term stock refers to opening or closing stock of
raw materials, work in progress and finished goods. In financial accounts stocks are valued at
cost price or market price whichever is lower. In Cost Account; stock of raw materials can be
valued on the basis of FIFO, LIFO and Simple Average Method etc., and work in progress
may be valued at Prime Cost or Work Cost. Finished stocks are generally valued on the basis
of cost of production. Thus, the adaptation of different method of valuation of stock leads to
difference in profits of two sets of accounts.
(5) Abnormal Losses and Gains: Different items of abnormal wastages, losses or gains
which are included in financial accounts but are not recorded in cost accounts. Thus, the figures of
abnormal losses and gains may affect the results in financial accounts alone.

Importance of Reconciliation

Reconciliation of cost and financial a c c o u n t is necessary f o r the

following reasons:
 (1) To ensure arithmetical accuracy of both set of accounts for effective cost
ascertainment and cost control.
 (2) To identify t he reasons for different r esults .
 (3) To evaluate the reasons f o r variations
 (4)To enable the smooth co-operation and co-ordination between the
activities of cost and financial accounting departments.
 (5) To ensure the standardization of policies relating to stock valuation,
depreciation and absorption of overheads.

38
 Format of Reconciliation Statement

Particulars Amt.Rs. Amt.

Profit/Loss as per Cost Sheet (A) xxxx
ADD: (I) Financial Income which are ignored in Cost
Account
Interest received xxxx
Dividend received xxxx
Share transfer fee xxxx
Rent received xxxx
Profit of asset sold xxxx
(II) Over valuation of Overhead Expenses in Cost Account
Factory overheads xxxx
Administrative overheads xxxx
Selling & Distribution overheads xxxx
(III) Over valuation of closing stock in Cost Account(B) xxxx xxxx
Grand Total (A+B)=C xxxx
LESS : (I) Financial expenditure which are ignored in
Cost Acc.
Income Tax xxxx
Penalty xxxx
Donation xxxx
Goodwill written off xxxx
Preliminary expenses written off xxxx
Debenture discount written off xxxx
Bad debt reserve xxxx
Loss of Assets sold xxxx
(II) Under valuation of overhead expenses in Cost Account
Factory overheads xxxx
Administrative overheads xxxx
Selling & Distribution overheads xxxx
(III) Under valuation of closing stock in Cost Account (D) xxxx xxxx
Profit/Loss as per Financial Account(C-D) xxxx

Working problem: 4
From the following particulars, prepare a Cost Sheet showing (1) Cost of Materials
Consumed (2) Prime Cost (3) Factory Cost (4) Cost of Production and (5)Profit
Opening stock of raw materials 20,000
Opening stock of work in progress 10,000
Opening stock of finished goods 50,000
Raw materials purchased 5,00,000
39
 Direct wages 3,80,000
Sales for the year 12,00,000
Closing stock of raw materials 75,000
Closing stock of work in progress 15,000
Factory overhead 80,000
Direct expenses 50,000
Office and Administrative overhead 60,000
Selling and Distribution expenses 30,000
Solution:
Opening Stock of Raw Materials 20,000

Purchases 5,00,000
5,20,000
Less : Closing Stock of Raw Materials 75,000
Cost of Raw Materials Consumed (1) 4,45,000

Add : Direct Wages 3,80,000

Direct Expenses 50,000 4,30,000
Prime Cost (2) 8,75,000
Add : Factory overheads 80,000
Add: Opening stock of work in progress 10,000
90,000
Less: Closing stock of Work in Progress 15,000 75,000

Works Cost (or) Factory Cost (3) 9,50,000

Add: Office & Administrative Overhead 60,000
Cost of Production (4) 10,10,000
Add: Opening Stock of Finished Goods 50,000
10,60,000
Less: Closing Stock of Finished Goods 50,000
Cost of Goods Sold (5) 10,10,000
Add : Selling and Distribution Overhead 30,000
Cost of Sales (6) 10,40,000
Profit (7) 1,60,000
Sales for the year 12,00,000

40
Methods of Reconciliation

For reconciling the profit or loss as disclosed by the financial accounting with that
shown by the cost accounting. A Reconciliation Statement or Memorandum of
Reconciliation Account is prepared.
The following steps have to be taken for preparation of Reconciliation Statement
:
(I) Ascertain the extent of difference between the profit or loss disclosed by
two set of book of accounts.
(2) Take the base profit or loss as per any set of books (either cost or financial)
of accounts as the starting point.
(3) Prepare a statement by making suitable adjustment of items either added or
subtracted included in one set of accounts but not in the other set.
(4) In other words. balances as per cost account has been taken as the starting
point, then balance as per financial account is to be adjusted according to the
transaction recorded in the financial accounts and vice versa.

41
 Question Bank

UNIT –I
PART-A CO Blooms
Level
1 CO1 L1
Define the term ‘Costing’
2 CO1 L2
Summarize the types of accounting.
3 CO1 L2
Distinguish between fixed cost and variable cost.
4 CO1 L1
State the functions of cost accounting
5 CO1 L1
Highlight the objectives of cost accounting
6 CO1 L6
Facilitate the advantages of cost accounting
7 CO1 L1
Write short notes on profit center
8 CO1 L1
Compare controllable cost and uncontrollable cost
9 CO1 L2
Narrate the concept of cost center.
10 Show the elements of cost. CO1 L1
11 Extract the meaning of Tender and Quotation CO1 L2
12 Write a short note on Prime Cost CO1 L1

PART – B CO Blooms
Level
1 Briefly discuss the requisites of a good costingsystem. CO1 L5
2 CO1 L4
Explain the nature and scope of costaccounting.
3 CO1 L6
Conclude the necessary steps to install the costingsystem.
4 CO1 L3
Describe the advantages and disadvantages of cost accounting.
5 CO1 L4
Express in detail about the difficulties in installing a costingsystem.
6 CO1 L5
Broadly Classify the methods of cost with examples
7 CO1 L4
Compare financial accounting and cost accounting.
8 CO1 L4
Detail the procedure to overcome the practical difficulties in installing
a costing system.
9 You are require to compile a statement showing cost and profit from CO1 L6
the information given, showing clearly: (a) Material consumed, (b)
Prime cost ,(c) Work cost,(d) Cost of production , (e)Cost of sales, (f)
Profit and(g)sales.

42
 Material Consumed Rs.200000
Wages Rs.100000
Direct Expenses Rs.20000
Opening stock of materials Rs.40000
Closing stock of materials Rs.60000
Factory overheads are absorbed at 20% on wages,
Administration overheads is 25% on the work cost. Selling
and distribution overheads are 20% on the cost of
production. Profit is 25% on cost of sales.
10 CO1 L6
During the year 2018, X Ltd., produced 50000 units of product.
The following were the expenses:

Particulars Amount in Rs
Stock of raw materials on 1-1-2018 10000
Stock of raw materials on 31-12-2018 20000
Purchases of Material 160000
Direct wages 75000
Direct expenses 25000
Factory expenses 37500
Office expenses 62500
Selling expenses 25000
You are required to prepare a cost sheet showing cost per unit and total cost
at each stage.
11 The following details have been obtained from the cost records of TCS CO1 L6
ltd

Particulars Amount in Rs
Stock of raw materials on 1-1-2009 75000
Stock of raw materials on 31-12-2009 91500
Direct wages 52500
Indirect wages 2750
Sales 211000
Work in progress on 1-1-2009 28000
Work in progress on 31-12-2009 35000
Purchases of raw materials 66000
Factory rent, rates and power 15000
Depreciation of plant and machinery 3500
Expenses on purchases 1500
Carriage outwards 2500
Advertising 3500
Office rent and taxes 2500
Traveller’s wages and commission 6500
Stock of finished goods 1-1-2009 54000
Stock of finished goods 31-12-2009 31000
Prepare a cost sheet giving the maximum possible break up of

43
 costs and profit.
12 CO1 L5
Mr.X Company Ltd, are the manufactures of mobile batteries. The
following data relate to manufacture of batteries during the month
of March2005.

Raw material consumed Rs.20000

Direct wages Rs.12000
Machine Hours worked 9500 Hours
Machine Hour rate Rs.2
Office Overheads 20% of work cost
Selling overheads 50 paise per unit
Units produced 20000 units
Units Sold [email protected] per
Unit
Prepare cost sheet showing the cost and the profit per unit and the
total profit earned.

13 The following particulars have been extracted from the books of a CO1 L5
manufacturing company
Particulars Amount in Rs
Stock on materials on 1st Jan 2014 47000
st
Stock on Material on 31 Dec 2014 50000
Materials purchased 208000
Office salaries (factory) 9600
Counting house salaries 14000
Carriage In wards 8200
Carriage Outwards 5100
Cash discount allowed 3400
Bad dets written off 4700
Repairs to plant and machinery 10600
Rent –factory 3000
Rent-office 1600
Travelling expenses 3100
Travelling commission 8400
Production wages 140000
Depreciation –machinery 7100
Depreciation – office 600
Directors fees 6000
Water-factory 1500
Water –office 300
General charges 5000
Managers salary 12000

Out of 48 hours in a week, the time devoted by the managers to the

44
 factory and to the office was on average 40 hours and 8 hours
respectively, throughout the accounting year .prepare a statement
giving the following information (a) prime cost,(b) Factory on cost as
a percentages of production wages,(c) Factory cost ,(d) General on
cost as a percentage of factory cost and (e)Total cost
14 From the following information extract a cost sheet for the month of CO1 L6
Dec 2012.
Particulars Amount in Rs
Opening stock – Raw materials 25000
Opening stock – Finished goods 17300
Closing stock - Raw materials 26200
Closing stock - Finished goods 15700
Purchase of raw materials 21900
Carriage on purchases 1100
Working in progress on 1-1-2012 8200
Working in progress- 31-12-2012 910 0
Sale of finished goods 72300
Direct wages 17200
Non productive wages 800
Direct expenses 1200
Factory overheads 8300
Administrative overheads 3200
Selling and distribution overheads 4200
15 The cost accounts department of a company has supplied the following CO1 L4
data for the supply of 2000 units of product.
Particulars Amount in Rs
Direct materials 4000 tons at Rs.5 per ton
Direct wages 8000 labour hours at Rs50 per
hour
Overheads : Variable Factory Rs.10 per labour
hour Selling Rs.20 per
unit
Overheads : Fixed Factory Rs.100000
Office Rs.200000
Estimate a statement showing the price fixed which will fetch a
profit of 25% on cost of sales

45
Book References:

1. Jain. S.P, Narang , K.L&Simmi Agarwal, (2011) , Cost Accounting (2nd Ed.) Delhi, India,
Kalyani Publishes.
2. Arora M N (2012) methods and techniques of cost accounting (4th ed) India.
3. T.S Reddy and Murthy . Cost Accounting.Margham Publications. Chennai. 2007.
4.Banerjee ,B, (2006) Cost Accounting Theory and Practices (12th ed) PHI Learning Pvt Ltd.
5. Narang, J. & (2012) Advanced Cost Accounting, Delhi, Kalyani Publishing House

46
 SCHOOL OF MANAGEMENT STUDIES

UNIT – II – – SBA1601

UNIT – II – COST ACCOUNTING – SBA1601

1
UNIT 2 MATERIAL COST
Material cost – Purchase Procedure – Material controlling techniques –
Economic Order Quantity – Stores Ledger – Pricing of Issues – FIFO, LIFO,
Simple Average and Weighted Average Methods

Meaning of Materials

Materials cost is one of the important element s of cost of product or unit. It

constitutes a substantial proportion of the total cost of production. For material
cost control purposes, it is very essential to know the important aspects of material,
material control and material purchase control.

Materials: The term ‘ materials’refers to all commodities or components

which are consumed in the process of manufacture. The materials m a y be classified
into Direct Materials and Indirect Materials.
Direct Materials :Direct Materials f o r m part of the finished products.They
can be easily identified with a particular cost unit. For example, cotton used in
textile mills,timber used in furniture industries.

Indirect Materials : Indirect materials indirectly used for conversion

from raw materials into finished p r o d u c t s . They cannot be easily
identified with a particular cost unit. For example, spare parts, tools, nails,
lubrications etc.

Materials are further classified on the basis of the nature which have
to be used such as:
(a) Raw Materials, e.g., rubber, timber, steeletc.
(b) Components, e.g.,instruments
(c) Consumable stores,e.g.,cottonwaste,brushes
(d) Maintenance Materials, e.g., spare parts
(e) Tools, e.g., jigs and fixtures

2
 Materials Control

Materials control may be defined as the systematic control over the procurement,
storage and usage of materials so as to maintain an even flow of
materials and at the same time avoiding excessive investment in inventories.

From the above definition we can derive the following important Objectives:
(1) To ensure the smooth flow of production with out interruptions.
(2) Prevention of excessive investments in materials stock.

Functions of Materials Control

1. Purchasing of Materials
2. Receiving of Materials
3. Inspection of Materials
4. Storage of Materials
5. Issue of Materials
6. Maintenance of Stores Records
7. Stock Audit.

Methods of Purchasing
Purchasing can be broadly classified as centralized and localized purchasing.
(a) Centralized Purchasing: In a large organization, manufacturing units are many.
In such cases centralized purchasing is beneficial. The advantages of centralized
purchasing are:
1. Specialized and expert knowledge is available.
2. Advantages arise due to bulk purchases
3. The cost of purchasing can be reduced and selling price can be lowered.
4. As there is good knowledge of market conditions, greater control can be exercised.
5. When materials have to be imported, it is advantageous to centralize the buying.
6. Economy and ease in compilation and consultation of results.
7. It can take advantage of market changes.
8. Investment in inventories can be reduced.

3
 9. Other advantages include undivided responsibility, consistent buying policies.
Factors to be considered when decision regarding centralization has to be taken are
geographical separation of plants, homogeneity of products, type of material bought,
location of supplies etc.

(b) Decentralization of Purchases: The advantages of localized purchasing or

decentralization of purchases are:-
1. Each plant may have its own particular need. This can be given special attention.
2. Direct contact can be established with suppliers.
3. The time lag between indenting and receiving materials can be reduced.
4. Technical requirements of each plant can be ascertained

Advantages of Materials Control

(1) It ensures continuous flow of production.
(2) There is maximum utilization of stores resources.
(3) It facilitates economy of buying.
(4) It ensures optimum investments in inventories.
(5) There is possibility of reduction of loss of theft, leakage, obsolescence etc.
(6) It minimizes cost of materials during purchase, storage and issue of materials.
(7) It facilitates effective information system to management.

Materials Purchase Control

Materials Purchase is one of the important functions of stores department. The

basic objectives of the material purchasing is to ensure continuous supply of
raw materials to production and maximum reduction of cost product. In other
words, the chief aim of purchasing is to ensure, not only to procure the raw
materials at the lowest price but to reduce the cost of the finished product. In
order to achieve the above said objectives the following aspects and procedure
should be adapted:

4
 Organization of Purchasing

Materials may be purchased based on the size of the concern ,nature of materials to
be used, nature of operations a n d management polices etc. A large company will
have a separate purchase department while a small firm on the other hand may
have all functions including purchasing, carried out by the owner himself.
Materials maybe purchased through Centralized Organization or Decentralized
Organization.

Qualities of the Purchasing Manager

(1) Integrity: Personal integrity is the important quality of the purchase
manager because purchasing involves huge sums of company money.
(2) Dependability: He must have this personality trait because
continuous operations d e p e n d on the reliability o f the supplies.
(3) Initiative: He must have the ability of initiative to continuous
search for alternative sources of supply or alternative materials.
(4) Co-operation: Purchasing Manager must possess an unusual abilit y
y to co- operate.
(5) Tact: To maintain a sound and friendly relationship with suppliers
is considered to be an important characteristic of the purchasing manager.
(6) Ability to Learn: A Purchasing personnel must have an inquiring
mind. He must always be seeking information about company’s products,
materials and process.

(7) Ability to Work on Details: He must have ability to work on details

even though it is routine In nature.
(8) He must have the technical knowledge of materials and sources
acquired.

Need and essentials of material control

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 favorable terms to the firm.

5
 3. Use of standard forms for placing the order, noting receipt of goods, authorizing
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.

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.

Economic Ordering Quantity

Economic order quantity (EOQ) is the ideal order quantity a company should
purchase to minimize inventory costs such as holding costs, shortage costs, and
order costs. This production-scheduling model was developed in 1913 by Ford
W. Harris and has been refined over time.1

The formula assumes that demand, ordering, and holding costs all remain
constant.

Formula : EOQ=√2AB/CS
Whereas EOQ = Economic order quantity,

6
A = Annual Consumption usage of materials in units
B = Buying cost per order
C = Cost per unit
S = Storage cost and carrying cost percentage per annum.

Carrying cost: it is the cost of holding the materials in the store and includes:
1. Cost of storage pace which could have been utilized for some other purpose.
2. Cost of bins and racks
3. Cost of maintaining the materials to avoid deterioration.
4. Amount of interest pay able on the amount of money locked up in the materials.
5. Cos to spoilage in stores and handling.
6. Transportation cost in relation to stock.
7. Cost of obsolescence of materials due to change in process or product.
8. Insurance cost
9. Clerical cost etc.

Ordering cost: it is the cost of placing orders for the purchase of materials and includes:
1. Cost of staff posted in the purchasing department, inspection section and stores accounts
department.
2. Cost of stationary postage and telephone charges.

c) Minimum Level or Safety Stock level

The minimum level is the minimum quantity of the material which must be
maintained in hand at all times. The quantity is fixed so that the production is not
held up due to shortage of the materials. In fixing this level, the following factors
should be considered:
1. Lead time i.e. time lag between indenting and receiving of the material. It
is the time required to replenish the supply.
2. Rate of consumption of the material during the lead time.
3. Nature of the material. Minimum level is not required in case of a special
material which is required against customer’s specific order.

7
Formula for calculating minimum level or safety stock level given by
Wheldon is as follows: Minimum Stock Level = Re-ordering level – (Normal
consumption x Normal e-order period)
d) Maximum Level
It is the maximum of stock which should be held in stock at any time during the year.
The quantity is fixed so as to avoid overstocking as it leads to the following
disadvantages.
1. Overstocking leads to increase in working capital requirement which could
be profitable used some where else.
2. Overstocking will need more go down space, so more rent will have to be paid.
3. It may also lead to obsolescence on account of over stocking.
4. There are chances that the quality of materials will deteriorate because
large stock will require more time before they are consumed.
5. There may be fear of depreciation in market values of the over
stocked materials. According to Wheldon,
Maximum Stock level = Reordering level + Re-ordering
Quantity– (Minimum consumption x Minimum re-
ordering period)
e) Danger Level

This level means that level of stock at which normal issues of the material are
stopped and issues are made only under specific instructions. The purchase officer
will make special arrangements to get the materials which reach at their danger
levels so that the production may not stop due to shortage of materials.
Danger Level = Average consumption x Max.re-order period for emergency
purchases.

f) Average Stock Level

The average stock level is calculated by the following
formula: Average Stock Level = Minimum Stock Level +
½ of Re-order Quantity. Or ½ (Minimum Stock Level +
Maximum Stock Level)

8
 Inventory Control and its technique
 Economic order quantity
 ABC analysis
 VED analysis
 Perpetual inventory system
 Just in time(JIT)
 FNSD analysis
 Automatic ordering system
 Ordering cycle method
 Min-max method
 Inventory turn over ratio
 Input-Output ratio analysis
 Inventory cost reports

The ABC Analysis

In materials management, ABC analysis is an inventory categorization technique. ...

The ABC analysis suggests that inventories of an organization are not of equal value. Thus,
the inventory is grouped into three categories (A, B, and C) in order of their estimated
importance.

ABC analysis may be seen to share similar ideas as the Pareto principle, which states that 80% of
overall consumption value comes from only 20% of items. Plainly, it means that 20% of your
products will bring in 80% of your revenues.
ABC analysis works by breaking it down in the following ways:
 A-items: 20% of all goods contribute to 70-80% of the annual consumption value of the
items
 B-items: 30% of all goods contribute to 15-25% of the annual consumption value of the
items
 C-items: 50% of all goods contribute only 5% of the annual consumption value of the
items
In order to calculate the annual consumption value of any item or items:

9
Annual consumption value = annual demand x item cost per unit

The VED Analysis

The VED criticality analysis of all the listed items was performed by classifying the
items into vital (V), essential (E) and desirable (D) categories. The items critically
needed for the survival of the patients and those that must be available at all times were
included in the V category. The items with a lower criticality need and those that may
be available in the hospital were included in the E group. The remaining items with
lowest criticality, the shortage of which would not be detrimental to the health of the
patients, were included in the D group. The VED status of each item was discussed
with justification by a group comprising of physician, surgeon, pediatrician and
pharmacist.
Material costing
Material costing is the process of determining the costs at which inventory items are
recorded into stock, as well as their subsequent valuation in the accounting records. We
deal with these concept separately.
JUST IN TIME (JIT)
Just-in-time (JIT) is an inventory strategy companies employ to increase efficiency and
decrease waste by receiving goods only as they are needed in the production process,
thereby reducing inventory costs.

Methods of pricing material issues.

The most important being: FIFO, LIFO, simple and weighed average methods.

1) First in First Out (FIFO)

Under this method material is first issued from the earliest consignment on hand and priced at the cost
at which that consignment was placed in the stores. In other words, materials received first are issued first.
The units in the opening stock of materials are treated as if they are issued first, the units from the first
purchase issued next, and so on until the units left in the closing stock of materials are valued at the latest
10
cost of purchases.
2) Last in First Out (LIFO)
Under this method, issues are priced in the reverse order of purchase i.e., the prices of the latest available
consignment is taken. This method is suitable in times of rising prices because material will be issued
from the latest consignment at a price which is closely related to the current price levels. Valuing material
issues at the price of the latest available consignment will help the management in fixing the competitive
selling prices of the products.

3) Highest In, First Out(HIFO)

HIFO is an acronym of the words Highest In, First Out. Requirements / material are serviced
in order, from the most expensive items regardless of date of entry or acquisition. HIFO is
an acronym of the words Highest In, First Out.

4).SAM (Simple average method)

In this method, price is calculated by dividing the total of the prices of the materials in the stock from
which the material to be priced could be drawn by the number of the prices used in that total. This method
may lead to over-recovery or under-recovery of cost of materials from production because quantity
purchased in each lot is ignored.
5)Weighted Average Methods

In this method, price is calculated by dividing the total cost of materials in the stock from which the
materials to be priced could be drawn by the total quantity of materials in that stock.

Market price
The current price at which an asset or service can be bought or sold. Economic theory contends that
the market price converges at a point where the forces of supply and demand meet. Shocks to either the
supply side and/or demand side can cause the market price for a good or service to be re-evaluated.

11
In cost accounting, market-based pricing sets the product price based on customer
expectations and demand. You take a look at the customer’s perceived value of the product.
Based on the customer view, you estimate how much he or she would be willing to pay.

Base stock method

An accounting method of valuing inventories by carrying on the books a minimum quantity
of a commodity at the same low fixed price from year to year and valuing the quantity in
excess of the minimum at a separate price which is usually the lower of cost or market value

Standard price method

Under this method, all factors by which price may be effected are considered & before the actual price, standard
material price for the materials is generally fixed. At that standard price materials issued are valued. For establishing
standard price, the factors usually considered are-
(a) Due to possible changes in market conditions, apprehended changes in price. (b)
Depending upon the quantity to be ordered, the amount of discount that may be available from the suppliers.
(c) Expenses which are related to purchases i.e. freights & carriage, customs duty, godown expenses,
packing, handling etc.

Difference, if any, between the standard price & the actual purchase price, is known as material variance.
However, the variance which arises due to the difference between standard rate of purchase & the actual
rate of purchase is known as rate variance. On the other hand, variance due to difference between total
actual material cost & total standard material cost, there being no difference in rates, the variance is called
usage variance. Either at the time of actual purchase or at the end of accounting period, the variance may be
worked out. The variance is analyzed into causative reasons & by taking suitable measures its
recurrence is prevented.

Advantages:

(a) Efficiency of the purchase department can be

revealed. (b) As all the issues are charged at a standard price, the method is easy

12
to apply. (c) Even if standard costing method is not applied in any industry, the method can be
used there. (d) By setting the standard price, control on material cost may be exercised by the method,
which may be called the price that should be.

Disadvantages:

(a) At actual cost, the issues are not

charged.

(b) Profit or loss on materials may be

there.

(c) The purpose for which it is set may be spoiled by a very low or high
standard price.

(d) Fixing a reliable standard price is difficult, since upon a number of unknown variable factors,
the price depends.

Working Problems
MATERIALS
EOQ-Economic Ordering Quantity:
1. Calculate economic ordering quantity from the following
particulars: Annual requirement = 1,600units
Cost of materials per unit = Rs. 40
Cost of placing and receiving one order = Rs. 50
Annual carrying cost of inventory.10% of inventory value.

2. Calculate economic
order quantity: Annual
Consumption =
600units
Order cost = Rs.12 per order Cost price per unit =Rs.20
Storage & carrying cost=20%

13
 3. Calculate the economic ordering quantity from the following
particulars: Annual usage = 20,000units
Buying per
order= Rs.10
Cost per unit =Rs.100

4. F
rom the following information, determine
the EOQ: Annual Consumption =
90,000units
Cost per unit = Rs. 50 Buying Cost per order = Rs.10
Cost of carrying inventory = 10% of cost.

EOQ- Where material usage is given in rupees:

5.Find out the economic ordering quantity from the following
Particulars: Annual usage = Rs.1,20,000
Cost of placing and receiving one order = Rs. 60
Annual carrying Cost: 10% of inventory value.

6.You are required to compute the economic ordering quantity with the help of the
details given below:
Materials usage per month = Rs. 1,600. Buying Cost per order = Rs. 40.
Storage & carrying cost.15% of Inventory value.
7.Calculate the economic ordering quantity. Also state the number of orders to be
placed in a year.
Consumption of materials per annum = 10,000 Kg. Cost of materials per Kg= Rs. 2
Order placing costs per order =Rs. 50 Storage costs 8% on Average Inventory.

Stock levels for one material:

8.From the following information ,calculate:
(a) Maximum Stock level
(b) Minimum Stock level

14
 (c) Reorder level
(d) Average stock level
Minimum Consumption= 240 units per day Maximum Consumption =
420 units per day Normal Consumption= 300 units per day Reorder
quantity= 3,600 units, Reorder period = 10-15 days Normal Reorder
period = 12 days.

9.Calculate Maximum Stock level, Minimum Stock level and Re-ordering level

(1) Minimum Consumption= 100 units per day

(2) Maximum Consumption = 150 units per day
(3) Normal Consumption = 120 units per day
(4) Reorder period = 10-15 days
(5) Reorder quantity = 1,500units
(6) Normal Reorder period = 12days.

10. Calculate Reorder level, Minimum Stock level, Maximum Stock level and Average
Stock level from the following information:
Normal usage = 300 units per week Maximum usage= 450 units
per week Minimum usage =150 units per week
Reorder period = 4-6 weeks
Reorder quantity = 2,400 units.

11. Two components X and Y are used as follows:

Normal usage = 600 units per week each
Maximum usage = 900 units per week each
Minimum usage =350 units per week each
Reorder quantity:
X= 4,800 units,
Y= 7,200 units Reorder period:
X= 4-6weeks
Y= 2-4weeks

15
 Calculate for each component: Reorder level (b) Maximum level (c) Minimum
level (d) Average stock level

12. Two materials A and B are used as follows:

Normal Consumption = 50 units per week each Minimum
Consumption = 25units per week each Maximum
Consumption = 75units per week each
Reorder quantity:
A= 300 units
B= 500 units Reorder period:

A= 4-6weeks ,B= 2-4 weeks

Calculate for each component:

(a) Reorder level (b) Maximum level (c) Minimum level (d) Average stock level

13. Two materials A and B are used as follows:

Normal usage = 3,000 units per week each Minimum usage =
1,500 units per week each Maximum usage = 4,500 units per
week each Reorder quantity:
A= 13,000units
B= 14,000units
Reorder period: A= 4-6weeks
B= 2-4weeks
Calculate for each component:
(a) Reorder level (b) Maximum level (c) Minimum level (d) Average stock
level

A) FIRST IN FIRST OUT (FIFO)METHOD

14. Prepare a store ledger on FIFO METHOD
DATE RECEIPTS ISSUES
2001-March 1 600 units at Rs.5 per unit
16 400 units at Rs.6 per unit

16
 20 500 units
22 400 units at Rs.7 per unit
23 600 units
25 200 units at Rs.8 per units 200 units

15. Prepare a store ledger on FIFO Method of pricing issues.

2002-January 1 Opening balance 50 units at Rs.30 per unit
5 Issued 20 units
7 Purchased 48 units at Rs.40 per unit
9 Issued 20 units
19 Purchased 36 units at Rs.35 per unit
24 Received back 10 units out of the units issued on 9th January
27 Issued 15 units

16. Prepare a store ledger on LIFOMETHOD

DATE RECEIPTS ISSUES
2001-March 1 600 units at Rs.5 per unit
16 400 units at Rs.6 per unit
20 500 units
22 400 units at Rs.7 per unit
23 600 units
25 200 units at Rs.8 per units 200 units

17. Prepare a store ledger on LIFO Method of pricing issues.

2012-January 1 Opening balance 50 units at Rs.30 per unit
5 Issued 20 units
7 Purchased 48 units at Rs.40 per unit
9 Issued 20 units
19 Purchased 36 units at Rs.35 per unit
24 Received back 10 units out of the units issued on 9th January
27 Issued 15 units

17
 Question Bank

UNIT -II -MATERIALS

PART –A CO Blooms
Level
1 Express the need of Material Control in Production company CO 2 L2
2 L2
Write a short note of variable JIT. CO 2
3 L1
Narrate the term Stores ledger CO 2
4 L6
Write a note on EOQ CO 2
5 L2
Summarize on ABCanalysis CO 2
6 L2
Express the main objectives of VED analysis CO 2
7 L4
Extract the meaning of wastage. CO 2
8 L1
Label the meaning of inventory turnover ratio CO 2
9 L2
Reveal the meaning of Scrap CO 2
10 L1
Recall the term depreciation CO 2

PART B CO Blooms
Level
1
Highlight the advantages and dis-advantages of FIFO, LIFO,
and HIFO. CO 2 L4
2
Briefly differentiate the methods of SAM and WAM along with
its merits anddemerits. CO 2 L5
3
Broadly discuss the importances of EOQ, ABC analysis and
VED analysis. CO 2 L6
4 Two components A and B are used asfollows
Particulars Amount in Rs
Reordering quantity A -1200 units
B-1000 units
Reordering period A- 2 to 4weeks
B- 3 to 6weeks
Normal usage 300 units per week each
Minimum usage 150units per week each
Maximum usage 450 units per week each
You are required to calculate the following for each of the
components.(a) Reordering level, (b) Maximum level, (c)
Minimum level, (d) Averagestock. CO 2 L3
5 From the particulars given below write up the stores ledger card
on2002 CO 2 L4

18
 Month Particulars Units
January 1 Openingstock 1000 units at Rs.26 each
5 Purchased 500 units at Rs.24.50
each
7 Issued 750 units
10Purchased 1500 units at Rs.24 each
12 Issued 1100 units
15Purchased 1000 units
17 Issued 500 units
18 Issued 300 units
25Purchased 1500 units at Rs.26 each
29 Issued 1500 units

Adopt the FIFO and LIFO method of issue and find the value of
closing stock.
6 Draw the stores ledger card recording the following
transactions under (a) FIFO and (b) LIFO method for the year
of2013.
Month Particulars Units
1 Openingstock 2000 units at Rs.10 each
July 5 Purchased 1000 units at Rs.11each
6 Issued 500 units
10Purchased 5000units at Rs.12 each
12 Received back 50 units out of issue made on
6th July
14 Issued 600 units
18 Returnedtosupplier 100 units out of the goods
received on 5thJuly
19 Received back 100 units out of issue made on
14th July
20 Issued 150 units
25Purchased 500 units at Rs.14 each
28 Issued 300 units
CO 2 L5

19
 The stock verification report reveals that there was a shortage
of 10 units on 18th July and another shortage of 15 units on 26th
July.

7 Using information given, draft stores ledger account showing

quantities and value of receipts, issues and balances in hand under
LIFO method of pricing stores issues for the year of 2008.

Date Particulars
Jan 1 Balance in hand 1000 units at Rs.1 each
Jan 4 Received 500 units to be issued on request from
dept X, Rate Rs.2 each
Jan 15 Received 3000 units costing Rs.3300
Jan 30 Issued 2000 units
Feb 8 Issued 500 units (Received on Jan 4th ) to Dept X
Feb 12 Received 2000 units costing Rs.2400
Feb 27 Issued 3400 units
CO 2 L6
8 From the following particulars prepare the stores ledger account
showing the pricing of materials issue, by adopting the FIFO
method, with base stock of 400 units, out of opening stock.

Date Particulars
Dec 1 2001 Opening stock 1000 units at Rs.2 each
Dec 3 2001 Purchased 800 units at Rs.2.10 each
Dec 5 2001 Issued 800 units
Dec 122001 Purchased 1600 units at Rs.2.10 each
Dec 172001 Issued 1500 units
Dec 202001 Purchased 900 units at Rs.2.50 each
Dec 252001 Issued 600 units
CO 2 L3
9 Laxmi and Co, has purchased and issued material D as
under2011
Date Particulars
May 1 2011 Opening stock 2000 units at Rs.5 per unit
May 3 2011 Purchased 500 units at Rs.6 per unit
CO 2 L4

20
 May 5 2011 Purchased 700 units at Rs.6.5 per unit
May 10 2011 Issued 800 units
May 11 2011 Purchased 300 units at Rs.8 per unit
May 15 2011 Purchased 200 units at Rs.7 per unit
May 18 2011 Issued 400 units
May 25 2011 Purchased 200 units at Rs.9 per unit
May 28 2011 Purchased 150 units at Rs.8.5 per unit
May 30 2011 Issued 200 units
Ascertain the closing stock value under HIFO
method of pricing of issues.
10 From the following particulars , prepare stores ledger by adopting
(a) Simple average method and (b) Weighted average method of
pricing of material issues.
Month Particulars Units
1 Openingstock 300 units at Rs.10 per unit
January 10Purchased 200 units at Rs.12 per unit
2006 12Purchased 400 units at Rs.11 per unit
15 Issued 250 units
16 Issued 150 units
18Purchased 200 units at Rs.14 per unit
20 Issued 300 units
22Purchased 300 units at Rs.15 per unit
25Purchased 100 units at Rs.16 per unit
27 Issued 200 units
31 Issued 100 units
CO 2 L5

21
Book References:

1. Jain. S.P, Narang , K.L&Simmi Agarwal, (2011) , Cost Accounting (2nd Ed.) Delhi, India,
Kalyani Publishes.
2. Arora M N (2012) methods and techniques of cost accounting (4th ed) India.
3. T.S Reddy and Murthy . Cost Accounting.Margham Publications. Chennai. 2007.
4.Banerjee ,B, (2006) Cost Accounting Theory and Practices (12th ed) PHI Learning Pvt Ltd.
5. Narang, J. & (2012) Advanced Cost Accounting, Delhi, Kalyani Publishing House

22
 SCHOOL OF MANAGEMENT STUDIES

UNIT – II – COST ACCOUNTING – SBA1601

UNIT – III – COST ACCOUNTING – SBA1601

UNIT – II – – SBA1601
UNIT 3 LABOUR COST
Labour Cost – Importance – Various Methods of Labour Cost Control – Methods of Wage
Payment – Various Incentive Schemes – Labour Turnover.

Labor cost

The cost of labor is the sum of all wages paid to employees, as well as the cost of
employee benefits and payroll taxes paid by an employer. The cost of labor is broken into
direct and indirect (overhead)costs.

Meaning
Labor cost covers one of the major portion of the total cost of a product or job. It may
increase unnecessarily due to inefficiency of workers, wastage of materials by workers, idle
time, unusual overtime work and high labor turnover. Hence, the management should devise
effective techniques for controlling labor cost to ensure maximum outputs of better quality at
low cost through proper utilization of the labor force.
Basically, management is concerned with controlling labor cost. Labor cost control
involves such systems, procedures, techniques and tools used by the management in order to
keep the labor cost of the product or job as minimum as possible. Labor cost control consists of
a number of such regular activities which are carried on by various departments of the
organization in a coordinated manner to ensure the availability of the best employees and their

optimum utilization. It is the system followed by the management to maximize quality output
at a minimum cost. Labor cost control includes the process of developing various forms,
studying and recording the activities and performance of workers, calculating the correct
amount of wages and making payment in time. It also includes the process of analyzing and
reporting labor cost to the management for planning and decisionmaking.

Importance Or Needs Of Labor Cost Control

i. Labor cost control is important to make economic utilization of labor force in production
process.
ii. Labor cost control is important to obtain maximum quantity of output with the least
amount of materials and otherresources.
 iii. Labor cost control helps to obtain better quality output with the least effort and time of
workers.
iv. Labor cost control reduces the cost of production of products manufactured orservices
rendered.
v. Labor cost control ensures the satisfaction of the workers by creating a good working
environment in thefactory.
vi. Labor cost control helps to adopt the fair system of wage payment and to minimize labor
turnover.
vii. Labor cost control is helpful in minimizing wastage of materials by workers ,idle time
and unusual overtimework.
viii. Labor cost control is helpful to maintain safety workingenvironment.
ix. Labor cost control is important to keep complete records of the employees and to supply
information to the management regarding availability, efficiency, utilization and
absenteeism of theworkers.
x. Labor costcontrolis veryusefultoincreasetheprofitabilityandcompetitivenessofthe
organization.

Types of Labour Cost

The labour cost can be classified into

(1) Direct Labour Cost: Any labour cost that is specially incurred for or can be
readily charged to or identified with a specific job, contract, work order or any other
unit of cost is termed as direct labour cost. Wages for supervision, wages for foremen,
wages for labours who are actually engaged in operation or process are the examples
of direct labour cost.

(2) Indirect Labour Cost: Indirect l a b o u r is for work in general. The

importance of the distinction lies in the fact that whereas direct labour can be
identified with and charged to the job, indirect labour cannot be so charged and
has, therefore to be treated as part of the factory overheads to be included in the
cost of production. For example, salaries and wages of supervisors, storekeepers
and maintence labour etc.

Control of Labour Cost

Control of labour costis a significant influence on the growth, profitability and cost
of production. Labour cost may become unduly high rate due to inefficiency of labour,
ineffective supervision, ideal time, unusual overtime work etc. The primary objectives of the
management therefore is to efficiently utilize the labour as economically as possible.

Techniques of Labour Cost Control

In order to achieve the effective utilization of manpower resources, the

management has toapplyproper system of labour cost control.
(1) Scientific method of productionplanning.
(2) Use of labour budgets.
(3) Establishment of labour standards.
(4) Proper system of labour performance report.
(5) Effective system of job evaluation and jobanalysis.
(6) Devise a proper system of control over idealtime
(7) Establish a fairandequitable remuneration system.
(8) Effective cost accountingsystem.
The Department that using Labour cost
The objectives of proper control on labour cost is effectively achieved through
the functions of various departments responsible for controlling labour cost in an
organisation. The following are the important departments for control over labour
costs:
(1) PersonnelDepartments.
(2) Engineering and Works StudyDepartment.
(3) Time KeepingDepartments.
(4) Pay RollDepartment.
(5) Cost Accounting Department.

(1) PersonnelDepartment
Personnel department plays a very important role in control of labour costs. It is
primarily concerned with the recruitment of labours on the basis of employee
placement requisition and imparting training to them. And thereafter placing them to
the job for which they are best suited. In order to achieve the efficient utilization of
 manpower resources, this department is responsible to execution of labour policies
which have been laid down by topmanagement.

(2) Engineering and Works StudyDepartment

Engineering department isprimarily concerned with maintaining control over
working conditions and production methods for each job, process, operation or
departments. It is performed by undertaking the following functions:

(I) Preparation of planand specification of eachjob.

(2) Maintaining required safety and efficient workingconditions.
(3) Making time and motionstudies.
(4) Conducting job analysis, job evaluation and meritrating.
(5) Setting fair and equitable piece rate or time wagesystem.
(6) Conducting research and experimentalwork.
(7)
Methods to control the labor cost
.
(a) Method Study: It is one of the important components of work study. The chief
aims of this study isto find a scheme of least wastage. Method Study is defined as "a
systematic and scientific evaluation of existing and proposed plans and performance of any
work system and the evaluation of improvement, through analytical process of critical
examination."
(b) Motion Study: Frank Gilbreth, who is the real founder of Motion Study.
According to him motion study may be defined as the "science of eliminating wastefulness
resulting from ill-directed and inefficient motions. The following are the important objectives
of the motionstudy:

(1) Effective utlisation of material, machine and labours.

(2) Elimination of wastage of time and labours.
(3) Maintaining higher standards of safety andhealth.
(4) Reducing unnecessary movements in order to minimizewastages.
(5) Better design of work place layout for effective productionprocess.
 (6) Ensure fair remuneration with jobsatisfaction.

(c) Time Study: Time study is also called work measurement. Time study may be defined
as "the art of observing and recording the time required to do each detailed element of an
industrialoperation."

(e) Job Evaluation: Job evaluation may be defined as "a process of analyzing
and describing positions, grouping them and determining their relative value by
comparing the duties of different positions in terms of their different responsibilities
and other requirements." Job evaluation is determined on the basis of job description
and job analysis. The primary purpose of job evaluation is developing appropriate
wage and salary structure with internal pay equity between jobs.

(f) Merit Rating: Merit rating may be defined as "a systematic evaluation of an employee's
performance on the job in terms of the requirement of the job." Merit rating is a system of
measuring both qualitatively and quantitatively ofanemployee's capacity in relation to
hisjob.

Computation of Labor Cost

Step1
Calculate an average wage rate per hour for your manufacturing workforce. To do so, add all the
hourly wages together and average them. Then, add all the payroll tax you pay for these
employees and average this figure. Next, average the benefits you pay for your manufacturing
labors. Add these figures -- the hourly wage average, the payroll tax average and the benefits
average -- together to determine your workforce's average wage rate per hour .
Step2
Calculate average labor hours per unit. This is best done by observation. Find the average
amount of time it takes a laborer to produce a unit. Add an allowance for breaks and personal
needs. Add in some time for machine setup and machine downtime. The resulting figure is your
average labor hours perunit.
Step3
Multiply your average labor hours per unit by the average wage rate per hour. This is your
average labor cost per unit. Note that it is an average, and actual unit labor costs may be above
and below the average.
Step4
To make a standard labor cost card for each unit, write down your calculations in detail. That
way, if machine downtime increases, or average wages increase, you can make adjustments and
recalculate.

Methods of wage payment

Labourcost isone of the important elements of production. Wage, salaries and other
incentives of employee remuneration constitute a very large component of operating
costs. Remuneration of employees is a vital factor not only affecting the cost of
production but also industrial relations of the organization. No organization can expect
to attract and attain qualified and motivated employees unless it pays them fair
remuneration. Employee remuneration, therefore, influences vitally the growth and
profitability of thecompany.

Objectives of an IdealWageSystem
An ideal wage system is required to achieve the following objectives:
(1) The wage system should establish a fair and equitableremuneration.
(2) Asound wage system helps toattract qualified and efficient worker by
ensuring an adequatepayment.
(3) It assists to improve the motivation and moral of employees which in
turn lead to higherproductivity.
(4) It enables effective control of labourcost.
(5) An Ideal wage system helps to improve union-management relations.
It should reducegrievances arising out of wageinequities.
(6) It should facilitate job sequences and lines of promotion wherever
applicable.
(7) An ideal system seeks to project the image ofaprogressive employer and to
 comply with legalrequirements relating to wages andsalaries

Principles of an Ideal Wage System

The following principles should be adopted for an ideal wage system

(1) Differences in pay should be based on differences in jobrequirements.

(2) Follow the principle of equal pay for equalwork.
(3) The scheme should be based on work study, and the work contents of
various jobs should bestabilized.
(4) Recognize individual differences in ability andcontributions.
(5) The scheme should not be very costly inoperation.
(6) The scheme should beflexible.
(7) The scheme should encourageproductivity.
.(8) The scheme should notundermine co-operation amongst theworkers.
(9) The scheme should be sufficient to ensure for the worker and his family
reasonable standard ofliving.

Types of wags payment

The following aretheimportant methods ofremuneration which may be groupedinto

: (1) Time Rate Systems
(2) Piece Rate Systems
(3) Bonus System (or) Incentives Schemes.
(4) Indirect Monetary Incentives.
(5) Non-Monetary Incentives

These may be further classified as under:

(1) Time RateSystems:
(a) At OrdinaryLevels
(b) At High WageLevels
(c) Guaranteed TimeRates.
 (2) Piece RateSystems:
(a) Straight PieceRate
(b) Piece Rates with Guaranteed TimeRate
(c) Differential PieceRates:
(i) Taylor's Differential Piece RateSystem
(ii) Merrick Differential Piece RateSystem
(iii) Gantt Task and BonusPlan
(3) Bonus System or Incentive Schemes:
(1) Halsey PremiumPlan
(2) Halsey-Weir PremiumPlan
(3) RowanPlan
(4) Barth Variable SharingPlan
(5) Emerson EfficiencyPlan
(6) Bedaux Point Premium System
(7) Accelerating PremiumPlan
(8) Group orCollective BonusPlans.

(4) Indirect Monetary Incentives

(5) Non-Monetary Incentives

(1)Time rate System

(a) Time Rate at OrdinaryLevels:

This isalso termed as "Day Wage System" or "Flat Rate System." Under this
system, wages are paid to the workers on the basis of time spent on the job irrespective of
the quantity of work produced by the workers. Payment can bemade at a rate per day or
a week, a fortnight or amonth.
The formula for calculation of payment of time rate of ordinary levels is as follows:
Remuneration or Earnings = Hours Worked X Rate PerHour

Time rate system is suitable under the following conditions:

(1) Where the units of output are difficult to measurable, e.g.,watchman.
 (2) Where the quality of work is more important, e.g., furniture, finejewellery.
(3) Where machinery and materials used areverysophisticated andexpensive.
(4) Where supervision is effective and close supervision ispossible.
(5) Where the workers are new and learning thejob.
(6) Where the work is of a highly varied nature and standard of performance
cannot beestablished.

Advantages
(1) It is simple and easy tocalculate.
(2) Earning of workers are regular andfixed.
(3) Time rate system is accepted by tradeunions.
(4) Quality of the work is notaffected.
(5) This method also avoids inefficient handling of materials andtools.

Disadvantages

(1) No distinction between efficient and inefficient worker is made and hence
they get the sameremuneration.
(2) Cost ofsupervision are high due to strict supervision used for high
productivity of labour.
(3) Labour cost is difficult to control due to more payment may be made for the lesser
amount ofwork.
(4) No incentiveis given toefficient workers. It will depress the efficient
workers.
(5) There is no specific standards for evaluating the merit of different
employees forpromotions.

(b) Time Rat e at HighLevels:

Under this system, efficient workers are paid higher wages in order to increase
production. The main object of this method designed to remove the drawbacks of
time rate at ordinary levels. This systemis simple and easily understandable. When higher
rate of wages are paid, it not only reduces labour turnover but also increases production and
 efficiency.

(c) Guaranteed TimeRates:

Under this method, the wage rate is calculated by considering to changes in
cost of living index. Accordingly, the wage rate is varied for eachworker

according to the change in cost of living index. This systemis suitable during the period
of raisingprices.

(2) Piece RateSystem

This is also known as "Piece Wage System" or "Payment By Result." Under this
system, wages of a worker are calculated on the basis of amount of work done or output
of a worker. Accordingly, a worker is paid in direct proportion to hisoutput.

Piece Rate System is suitable under the following conditions:

(1) Quality andworkmanship are notimportant.
(2) Work can be measuredaccurately.
(3) Quantity of output directly depends upon the efforts of theworker.
(4) Production ofstandardized goods in afactory.
(5) Job is of a repetitivenature.

Advantages

(2) This encourages the efficient workers to increase

(3) Under this system efficient workers are recognized andrewarded.
(4) It helps to reduce the cost of supervision and idletime.
(5) Tenders or quotations can be prepared confidently andaccurately.

Disadvantages

(1) Where a concern is producing large quantities, itis difficult to fix a piece rate.
(2) In order to maximize their earnings, workers working with high speed may
affect theirhealth.
 (3) The quality of output cannot bemaintained.
(4) This systemis notencouraging to the inefficientworkers.
(5) Temporary delays or difficulties may affect the earnings of theworkers.
There are three important methods of paying labour remuneration falling under
thistype:
(a) Straight Piece Rate
(2) Piece Rates with Guaranteed Time Ratesand
(c) Differential PieceRates.

(a) Straight Piece Rate: Under this system, workers are paidaccording to the
number of units producedatagivenrateperunit.Thus,totalearningsof eachworker iscalculated on
the basis of his output irrespective of the time taken by him. The following formula is
used for measuring piece workearning:
Straight Piece Work Earnings = Units Produced x Rate Per Hour

(b) Piece Rates with Guaranteed Time Rates: Under this method, the
worker earning from piece work less than the guaranteed minimum wage, will get
the fixed amount of guaranteed time rate. A guaranteed rate would be paid per hour
rate or day rate or weekrate.

(c) Differential Piece Rates: This system is designed to provide for

variation of piece rates at different levels of output. Accordingly increase in wages is
proportionate to increase inoutput. Under thissystem, efficient workers get ample reward
and at the same timeinefficientworkersaremotivatedtoearnmore.The following are the three
important types of differential piece rates:

(a) Taylor's Differential Piece RatesSystem.

(b) Merrick's Differential Piece RatesSystem.
(c) Gantt Task BonusPlan.

(a) Taylor's Differential Piece RatesSystem

 FW.Taylor, who isthe father ofscientific management introduced this plan.
Under this system, two piece rates are applicable on the basis of standard of

performance established. Accordingly one ishigh rate and the other one is lower rate.
Thus high piece rate is applicable for standard and above the standard performance.
Lower piecerate for those workers with below the standard performance.

(b) Merrick Differential Piece RateSystem

This isalso termed as Multiple Piece Rate system. This planis 'designed to overcome the
drawback of Taylor's Differential Piece Rate System. Under this method, three piece rates
are applied with different levels ofperformance.

(c) Gantt's Task BonusPlan

This system is designed by Henry L. Gantt. Under this system, standard time for every
task is fixed through time and motion study. The mainfeature of this system is a
good combination of time rate, differential piece rate and bonus. In this system day
wages are guaranteed to allworkers.

Differences Between Piece Rate System And Time Rate System Of Wage Payment
1. Meaning
Piece rate system is a method of wage payment to workers based on the quantity of output they
have produced. Time rate system is a method of wage payment to workers based on time spent
by them for the production of output.

2. Nature OfPayment
Piece rate system pays the workers according to the units of output produced. Time rate system
pays the workers according to the time spent in the factory.

3. Emphasis
Piece rate system gives emphasis on larger quantity of output. Time rate system emphasis on
better quality of output.
4. Discrimination
Piece rate system discriminates the workers and pays more wages
to efficient and skilled workers. Time rate system does not discriminate the workers and pays
the same wages to efficient and inefficientworkers.

5. Supervision
Piece rate system requires strict supervision to get the required quality output. Time rate system
requires strict supervision to get required quantity of output.

6. Determination Of LaborCost
Piece rate system helps to fix per unit labor cost in advance. Time rate system does not help to
fix labor cost per unit inadvance.

7. Flow OfProduction
Piece rate system does not bring uniformity in the flow of production and causes an excessive
wastage of inputs. Time rate system helps maintain a uniform flow of production and ensures an
efficient use of materials, tools and equipments.

(3) Bonus or IncentivesSchemes

Incentive schemes of wage payment are also known as Premium Bonus Plans.
introduced in order to increase production with ensuring proper industrial climate.
Wage incentive plans may be of two types : (1) Individual Incentive Plans and (2)
Group Incentive Plans. Under individualincentive plans, remuneration can be measured on
the performance of the individualworker.

(1) Halsey Premium Plan: This Plan was developed by F. A. Halsey. This system
alsotermed as Split Bonus Plan or Fifty-Fifty Plan. Under this plan, standard time is fixed
for each job or operation on the basis of past performance. If a worker completes his job
within or more than the standard time then the worker is paid a guaranteed time wage. If a
worker completes his job within or less than the standard time, then he gets a bonus of 50% of the
time saved plus normalearnings.

(2) The Halsey- Weir Scheme: Under this system, the worker gets the bonus of 30% of thetime
saved instead of 50% of time saved under Halsey Plan. Except for this, Halsey Plan andHalsey-
Weir Systems are similar in all other respects

(3) Rowan Plan: This plan was introduced by James Rowan of England. It was similar to the
Halsey Plan in many respects except that it differs in calculation of bonus. Under this system.
bonusis determined as the proportion of the time taken which the time saved bears to the
standard timeallowed.

(4) Emerson's Efficiency Sharing Plan: Under this plan, earning of a worker is by
combining guaranteed day wages with a differential piece rate. Accordingly the level
of efficiency is determined on the basis of establishment of standard task for a unit of
time. If the level of worker's efficiency reaches 67% the bonus is paid to him at a
normal rate. The rate of bonus increases in a given rate as the output increases from
67% to 100% efficiency. Above 100% efficiency, the bonus increases to 20% of the
wage earned plus additional bonus of 1% is added for each increase of 1% inefficiency.

(5) Barth Variable Sharing Plan: This scheme introduced to attract newly
recruited and skilled employees who are motivated to learn work, It provides sufficient
incentives to inefficient workers who are motivated to increaseproductivity.

6) Bedaux Point Premium System: This plan was introduced by Charles E.Bedauxin
1911. Under this plan, standard time fixed for each operation or job is expressed in terms of
Bedaux point or'S.' For example, a standard time of 360 B means the operation or job should
be completed within 360 minutes. The chief advantage of this plan is that it can be
applied to any kind of a job. Under this system, worker is paid at the time for actual hours
worked, and 75% of the wages for the time saved are paid as bonus to the worker and 25%
to the foremen, supervisors etc
(7) Accelerating Premium Bonus Plan: Under this plan, bonus is determined on the
basis of time saved unlike a fixed percentage under Halsey Plan and as a decreasing
percentage under Rowan Plan. The bonusis paid to workers at an increased rate according to
more and more time saved. This provides increasing incentives toefficient workers.

Merits

(1) It is simple tounderstand.

(2) Total earnings of each worker can be easy tocalculate.
(3) Bothemployer andemployee get equal benefit of timesaved.
(4) This system not onlybenefits efficient worker but also provides
average worker to get guaranteed minimumwages.
(5) This system is based on time saved and it can reduce the labour cost.

Demerits

(1) Lack ofco-operation among theemployees.

(2) Under thissystem establishment of standard is verydifficult.
(3) Earning are reduced at high level ofefficiency.

Group or Collective Bonus Plan

The incentive schemes explained so far are applicable to individual performance

depending directly on production. However.it is not the individual worker who produce
the goods or services (operation) alone but group of several other workers are required to
jointly perform a single operation. It is, therefore, essential that a group incentive scheme
be introduced. Bonus is calculated for a group incentivescheme.
 The bonus is calculated for a group of workers and the total amount is
distributed among the group of workers onanyone of the following basis:

(a) Equally by all the workers of thegroup.

(b) Pro rata on the time ratebasis.
(c) Pre determined percentage basis.
(d) Specified proportionbasis.

Types ofGroup IncentivePlans

The following are the important types of group incentive bonus plans:
(1) Budgeted Expenses BonusPlan
(2) Priest Man BonusPlan
(3) Towne's Gain-sharing Plan
(4) ScanlonPlan

(1) Budgeted Expenses Bonus Plan: Under this method, bonus is determined on
the basis of savings in actual expenditure compared with total budgetedexpenditure.

(2) Priest Man Bonus Plan: Under this plan, standard performance is fixed by
the management and committee of workers. The group of workers get bonus when
actual performance exceeds the standard performance irrespective of individual's
efficiency orinefficiency.

(3) Towne's Gain-sharing Plan: Under this plan, bonus is calculated on the
basis of savings in labour cost. The group of workers get bonus when actual costs is
less than the standard costs, one-half of the savings is distributed among workers
including foremen in proportion with the wagesearned.

(4) Scanlon Plan: Scanlon Plan is designed with the chief aim of reducing the
cost of operations in order to increase the production efficiency. This plan is
generally applicable in industries where the operation cost ishigh.
(4)Indirect Monetary Incentives
Incentive schemes are regarded beneficial to both employers and workers. In
this regard, under indirect monetary incentives by giving them a share of profit and
introducing co-partnership schemes or as they have become partners in the business in order
to make a very profitableenterprise.

Profit Sharing: Profit sharing and bonus is also known as Profit sharing bonus.
Under this scheme, there is an agreement between the employer and employee by which
employee receives a share, fixedin advance of the profits. Accordingly profit sharing bonus
refers to the distribution of profit on the basis of a certain percentage of one's monthly
earnings. The amount to be distributed depends on the profits earned by an enterprise. The
proportion of the profits to be distributed amongthe employees is determined inadvance.

Co-partnership: This system provides not only a worker to become partner in

the business but also to share in the profits of the concern. There are different degrees
of partnership and share of responsibilities allowed to the workers to take part in its
control.

Non-Monetary Incentive Schemes: Under this system, employees are

provided better facilities, instead of additional monetary payments. Some of the
examples of non-monetary incentives are free education for children, rent free
accommodation, medical facilities, canteen facilities, welfare facilities, and
entertainment facilitiesetc.

Idle Time

Idle Time is that time during which the workers spend their time without giving
any production or benefit to the employer and concern. The idletime may arise
due to non-availability of raw materials, shortage of power, machine breakdownetc.
Types of Idle Time:
It refers that any loss of time is inherent in every situation which cannot be
avoided. Any cost associated with the normal idle time are mostly fixed in nature.
The normal idle time arises due to the following reasons:

(1) Time taken for personalaffairs.

(2) Time taken for lunch and teabreak.
(3) Time taken for obtainingwork.
(4) Time taken for changing from one job toanother.
(5) Waiting time for getting instructions, tools and or rawmaterials.
(6) Time taken bythe workers towalk between factory gate andplace of
work.

Abnormal IdleTime

Abnormal idle time refers that any loss of time which may occur due to some
abnormal reasons. Abnormal idle time can be prevented through effective planning andcontrol.
The abnormal idle time may arise due to the following avoidable reasons:

(1) Faultyplanning.
(2) Lack ofco-operation andco-ordination.
(3) Powerfailure.
(4) Time lost due to delayedinstructions.
(5) Time lost due to inefficiency ofworkers.
(6) Time lostduetonon-availability of raw materials, spare parts, toolsetc.
(7) Time lost due to strikes, lock outs andlay-off.
 Over Time: The term "over time" refers to when a worker works beyond the
normal working hours or scheduled time is known as 'overtime.' According to
Factories Act, the wage rate of overtime work to be paid at double the normal rate of
wages. The extra amountof remuneration is paid to the worker in addition to normal rate
of wages is said to be overtimepremium.

Effect of Over Time Payment on Productivity: The following are the effects
of over time payment onproductivity:

(I) Overtime premium is anextra payment over normal wages and hence
will increase the productioncost.
(2) The efficiency of workers during overtime work mayfall and hence output may
bereduced.
(3) To earn more, workers may notconcentrate on work during normal hours,
and thus the output during normal hours mayfall.
(4) Reduced output and increased premium will increase the cost ofproduction.

Control of Overtime: Control of overtimeis essential to minimize the cost of

production and increase the overall performance of the efficiency. Effective control of
overtime can be possible through the following ways:

(1) Effective sound planning ofproduction

(2) Adequatesupervision
(3) Ensuring availability of raw materials, spareparts
(4) Encouraging productivity
(5) Reducing labour turnover
(6) Ensuring effective system of repairsand maintenance, material handling and
smooth flow ofproduction
(7) Fair andequitable remuneration to efficient and inefficientworkers.
 Casual Workers: Casual workers are those who are engaged casually whenever
there is extra load of work or due to planned maintenance duringoff season.
System ofControl: In order to achieve the effective control of casual workers the
following system to beadopted:

(1) Assess work load, forexample, planned maintenance during offseason.

(2) Assesmanpowerrequirement.
(3) Obtain prior sanction for number of workers giving the period for which
engagement is to bedone.
(4) Obtain periodical report onperformance and compare with the plan to
ensure that there is no laggingbehind.
(5) Provide for automatic termination after the period for which sanction is
givenexpenses.

Out Workers: Out workers are those who are engaged in production operations
outside the factory. For example, works carried on construction andelectricity.

Control ofOut Workers : The following are the important aspects to be

considered for effective control of out workers:

(1) Keep a log book atreception.

(2) Record complaint specifying date and time of receipt ofcomplaint.
(3) Keep proper complaint slips and send the same to technical department.
(4) Prepare duty sheets in duplicate to note down time on and timeoff.
(5) Summarise time spent by each service mandaily.
(6) Summarise chargeable amount and non-chargeable amount.
(7) Adviseaccounts department forbilling.
 Labour Turnover: Labour Turnover may be defined as "the rate of changes
in labour force, i.e., the percentage of changes in the labour force of an organization
during aspecific period. Higher rate of labour turnover indicates that labouris not stable
and there are frequent changes in the labour force in the organization. It will affect the
efficiency of the workers and overall profitability of the firm. The determinant result
oflabour turnover is expressed in terms ofpercentage.

Types of labor turn over

(1) Labour turnover according to separationmethod:

This definition does not take into consideration the fact of surplus labour. This definition will
give incorrect result when the surplus workers are discharged because labour turnover calculated
in this way will be high.
(2) Labour turnover according to fluxmethod:

This definition will not be applicable when the organisationis expanding. In such a case, many
new workers are engaged and there may be no separation; even then labour turnover calculated
will be high.

This definition will misguide when an organisation has reached its optimum size and does not
require expansion at all. In such a case, labour turnover, as per this definition, will show half the
actual percentage of labour turnover.
(4) Labour turnover according to replacementmethod:

This definition takes into account the surplus labour. This definition will also give correct labour
turnover when the factory is expanding because all additions are not to be taken only workers
replaced due to leavers are to be taken. Therefore, this definition can be taken to be the most
reliable definition out of all the definitions given above.

Causes for Labour Turnover:

(1) AvoidableCauses
(2) Unavoidable Causes

(1) AvoidableCauses

(1) Lack of jobinvolvement

(2) Lack of co-operation among theemployees
(3) Lack of smooth relationship between employer andemployees
(4) Dissatisfaction with wages andincentives
(5) Bias attitude ofManagement
(6) Poor workingconditions
(7) Dissatisfaction with promotion, recognition, transferetc.
(8) Lack ofCo-ordination
(9) Non-availability of adequate protection, proper instructions, accommodationetc.

(2) UnavoidableCauses

(1) Retirement or Death ofemployer

(2) Marriage in the case of femaleworkers
(3) Permanent disability due to accident or illness
(4) Dismissal or discharged due to inefficiency or disciplinaryground
(5) Dissatisfaction with job
(6) Shortage of power, raw materialsetc.
(7) Personalresponsibilities
(8) Personal betterment with regard to newjob
(9) Changeinnatureofbusinessandplantlocation.
 Effect of Labour Turnover:
(1) Increased cost of recruitment, training andplacement
(2) Increased cost ofproduction
(3) Decrease in output due to inefficient or newly recruitedworkers
(4) Higher accident rate due to negligence or mishandlingof machines
(5) Lowteamspiritduetolackofco-operationandco-ordinationbetweentheworkersand
employers.

Cost of Labour Turnover:

The chief aim of the preventive costs which are incurred in order to keep the
workers satisfied and reduce the labour turnover rate as much as possible. These
preventive costs which include the following:

(a) Cost of providing medical facilities, canteen and other welfarefacilities

(b) Cost ofadministration
(c) Cost of providing better workingconditions
(d) Cost of pension, gratuity, provident fund and other retirementbenefits.

Working Problem
LABOUR COST
1. From the following data given by the Personnel department, calculate the labour turn
overrate by applying:
a) Separation method b) Replacement Method c)
Fluxmethod No of workers in thepayroll:
At the beginning of the month
900 At the end ofthemonth
1,
100
During the month 10 workers left; 40 workers were discharged and 150 workers were
recruited. Of these, 25 workers are recruited in the vacancies of those leaving while rests were
engaged for an expansion scheme.

2. Calculate the normal and overtime wages payable to a workman from the followingdata:
Days Hours worked
Monday 8
Tuesday 12
Wednesday 10
Thursday 10
Friday 9
Saturday 4
Total 53

Normal working hours-8 hours per day: on Saturday-4 hours. Normal rate Rs.2
per hour.Overtime rate up to 9 hours in a day at single rate and over 9 hours in a
day at double rate. Or up to 48 hours in a week at single rate and over 48 hours at
double rate, whichever is more beneficial to theworkers.

3. From the following data prepare statement showing the cost per day of 8 hours of
engaginga particular type oflabour:
a) Monthly salary (Basic plus dearness allowance)Rs.400
b) Leave salary payable to a workman 15% of basic and dearnessallowance.
c) Employee’s contribution to provident fund 8% of salary (items a andb)
d) Employer’s contribution to E.S.I 5% of salary (items a andb)
e) Pro rata expenditure an amenities to labour Rs25 per head permonth.
f) No. of working hours in a month200

4. Mr. A, a worker in a factory is paid on time basis. During the month of October, 2009 he
has worked for 200 hours. His hourly wage rate is Rs.10 perhour.
Mr. B, another employee of the company is paid on the basis of piece wages. During the
month of January 99 his output was 1,000 units. Rate of wages per piece is Rs.3.
Calculate the wages of respective workers for the month of October, 2009.
5. Calculate the earnings of workers X and Y under (A) straight piece rate system
and(B) Taylors differential piece rate system from thedetails:
Standard time per unit =12 minutes Standard rate per hour =Rs.60 Differentials
to be used 80% and 120%
In a particular day of 8 hours, workers ‘X’ produced 30 units and worker ‘Y’ produced 50
units.

6. Calculate the earnings of 3 workers A, B, and C under ‘Merrick’s multiple piece

ratesystem’, given thefollowing:
Standard production per day: 150 units Normal piece rate: Rs.0.50 per unit
Production of workers on a particular day: A-120 units
B-140units C-160 units

7. The following are the particulars applicable to a workprocess: Time Rate Rs.5 perhour
High task 40 units per week
Piece rate above the high task Rs.605 per unit
In a 40 hour week, the production of the workers was as follows: A 35 units B 52 units
Calculate the wages of the workers under Gantt’s task bonus plan.

8. A worker is paid at 25 paiseper hour for completing a work within 8 hours. If he

completes the work within 6 hours, calculate his wages under Halsey plan when the rate
of premium is 50%.Also ascertains the effective hourly rate of earning by theworker.

9. Calculate the total earnings from the following data under Halsey Plan and Halsey-
Weirplan. StandardTime : 10hours
Timetaken : 8hours
Timerate Rs.2.5 perhour
10. Calculatetheearningsofaworkerunder(A) HalseyPremiumplanand (B) Rowanscheme.
Time allowed = 48hours
Timetaken = 40hours
Rateperhour =Re.1
11. Asertain wages of a worker under Bedeaux’s point premium system fromthe
following details:
Standard output per day of 8 hours =160 units
Actual output during a day of 8 hours 200 units
Rate per hour is Rs.5.00
 Question Bank
UNIT –III –LABOUR
PART -A CO Blooms
Level
1 List out the Techniques for effective control of labour cost CO 3 L5
2 L1
List out Labour Cost Control Department in in Production
company. CO 3
3 L6
Facilitate the term job evaluation CO 3
4 L1
Narrate the idle time CO 3
5 L2
Extract the meaning of Overtime CO 3
6 L6
Write a short note on pay roll department. CO 3
7 L1
Recall the concept of Wages CO 3
8 L1
Rewrite the term piece rate system. CO 3
9 L6
Write a short note on Bonus. CO 3
10 L4
From the following data given by the Personnel department,
calculate Separation method
No of workers in the payroll:
At the beginning of the month 900
At the end of the month 1,100
During the month 10 workers left; 40 workers were
discharged and 150 workers were recruited. CO 3

PART B CO Blooms
Level
1 L4
Highlight the causes and effect of labour turn over. CO 3
2 L3
Briefly discuss the advantages and dis-advantages of time and
piece rate system in wages administration CO 3
3 Discuss the merits and demerits of Job evaluation and merit rating. CO 3 L5
4 Briefly classify the Methods of Wages Payment. CO 3 L6
5 L4
Explain the essentials of a good time – keeping system and wage
system. CO 3
6 L6
Discuss the scopes and types of work study and idletime. CO 3
7 L5
Discuss the different methods of bonus systems inIndia. CO 3
8 Find out the value wages under Time rate system with OVER TIME L4
Day No of Hours Worked CO 3
 Mon 4
Tue 4
Wed 4
Thu 7
Fri 6
Sat 4
Actual Standard hour is 4 hours in a day
Rate per Hour is Rs.150 and Over Time Rate is Rs.200 if crossed more
than 4 Hours in a day. (Standard hour)
9 Calculate the normal and overtime wages payable to a workman L4
from the following data.

Day Total No of Hours

Worked
Mon 8
Tue 12
Wed 10
Thu 10
Fri 9
Sat 4
Total 53

Normal Working Hours - 8 Hours per day ; on Saturday is 4

Hours.
Normal Rate Rs.2 per Hour.
Overtime rate – Upto9 Hours in a day at single rate and over 9
hours in a day at double rate. Or Upto 48 Hours in a week at single
rate and over 48 Hours at double rate, whichever is more beneficial
to the workers. CO 3
10 Calculate the earning of workers X and Y under (A) Straight L4
piece rate system and (B) Taylors Differential Piece rate
system from the following details:
Standard time per unit = 12 minute
Standard rate per hour = Rs.60
Differentials to be used 80% and 120%
In a particular day of 8 Hours, worker ’X’ Produced 30 units and
worker ‘Y’ Produced 50 Units.
CO 3
Book References:

1. Jain. S.P, Narang , K.L&Simmi Agarwal, (2011) , Cost Accounting (2nd Ed.) Delhi, India,
Kalyani Publishes.
2. Arora M N (2012) methods and techniques of cost accounting (4th ed) India.
3. T.S Reddy and Murthy . Cost Accounting.Margham Publications. Chennai. 2007.
4.Banerjee ,B, (2006) Cost Accounting Theory and Practices (12th ed) PHI Learning Pvt Ltd.
5. Narang, J. & (2012) Advanced Cost Accounting, Delhi, Kalyani Publishing House
 SCHOOL OF MANAGEMENT STUDIES

UNIT – IV – COST ACCOUNTING – SBA1601

UNIT – III – COST ACCOUNTING – SBA1601
UNIT – II – – SBA1601
UNIT 4 OVERHEADS
Overheads – Classification – Apportionment Of Overheads – Redistribution Of Overheads –
Absorption Of Overheads – Calculation of Machine Hour Rate

Overhead

Overhead expenses are all costs on the income statement except for direct labour, direct
materials, and direct expenses. Overhead expenses include accounting fees, advertising,
insurance, interest, legal fees, labor burden, rent, repairs, supplies, taxes, telephone bills,
travel expenditures, and utilities.

Cost pertaining to a cost centre or cost unit may be divided into two portions direct and
indirect. The indirect portion of the total cost constitutes the overhead cost which is the
aggregate of indirect material cost, indirect wages and indirect expenses. CIMA defines
indirect cost as “expenditure on labour, materials or services which cannot be
conveniently identified with a specific saleable cost per unit.”

Indirect costs are those costs which are incurred for the benefit of a number of cost
centers or costs units. Indirect cost, therefore, cannot be conveniently identified with a
particular cost centre or cost unit but it can be apportioned to or absorbed by cost centers
or cost units.
Importance of Overhead Costs:
In various five-year plans, industrialization was given due importance. The result is that
a large number of establishments have grown up both in the public and private
sectors for mass production for which use of improved and costlier and special type of
machines has become absolutely necessary. With the increasing trend towards plant
automation, heavy expenditure is being incurred which cannot be charged directly to any
particular unit and can be called as cost common to all units of production.
Overhead expenses being a significant proportion of the total cost have assumed an
added importance and require analysis for purposes of cost ascertainment and control by
function and for guidance in certain managerial decisions by the extent of the variability
with production.

Overhead costs cannot be allocated but have to be suitably apportioned and then
absorbed by suitable methods. The cost accountant is required to pay so much attention
to the accounting of overhead cost as prudence choice of various bases used for
apportionment and absorbing the overheads in the cost of products has to be made by
him.

Classification of Overhead Costs:

Cost classification is the process of grouping costs according to their common characteristics
and establishing a series of special groups according to which costs are classified.
Thus, it involves two steps:
(i) The determination of the class or groups in which the overhead costs are subdivided,
(ii) The actual process of classification of the various items of expenses into one or the
other of the groups.
The method to be adopted for the classification of overhead costs depends upon the type and
size of the business, nature of the product or services rendered and policy of the
management.
Classification Of Overheads

1. Classification Of Overheads Based On Function

(a) Manufacturing Overhead,
(b) Administration Overhead,
(c) Selling & Distribution Overhead,
(d) Research and Development Expenses

2. Classification Of Overheads Based On Behavior

* Fixed Overheads
*Variable Overheads
* Semi-variable Overheads
* Semi-fixed Overhead

3. Classification Of Overheads Based On Elements

* Indirect Materials
* Indirect labor (Wages)

4. Classification Of Overheads Based On Control & Nature

* Controllable Overheads
* Uncontrollable Overheads

A concern may adopt one or more of the above classifications. For example, the overhead
expenses in a concern may be first divided according to functions i.e. manufacturing,
administration, selling and distribution groups. The expenses pertaining to one group say
manufacturing may further be classified into fixed, variable and semi-variable.
Each of these groups may then be grouped into the elements i.e. indirect material, indirect
labour and indirect expenses and under each element, the expenses may be further
subdivided according to their nature i.e. depreciation, salary, repairs and maintenance
etc.
I. Functional Classification of Overheads
When overhead expenses are classified with reference to major activity divisions of a
concern, it is called functional classification of overhead. This classification is necessary for
the segregation of the cost of each of the principal functional division of the concern and for
having separate methods of accounting and control for the diverse nature of expenses in
each division.

The main groups forming the basis of the classification are

(a) Manufacturing Overhead: (also referred to as factory overhead, factory burden,
and manufacturing support costs) refers to indirect factory-related costs that are
incurred when a product is manufactured. Along with costs such as direct material and
direct labor, the cost of manufacturing overhead must be assigned to each unit
produced so that Inventory and Cost of Goods Sold are valued and reported according
to generally accepted accounting principles (GAAP).

(b) Administration Overheads

The overheads incurred for the overall administrative work of the organisation. They
include:
- Indirect Materials such as office supplies, stationery and printing items, brooms etc.
- Indirect Labour such as salaries payable to manager, clerk etc.
- Indirect Expenses such as lighting, bank charges, legal/audit charges, rent/insurance
of office.

(c) Selling Overheads

The overheads incurred from the stage of final manufacturing of finished goods till the
stage of goods sold in the market and collection of dues from the customers.
They include:

-Indirect Materials such as samples, packing materials, etc.

- Indirect Labour such as salaries and commission payable to sales manager, salesmen
etc.
- Indirect Expenses such as rent, carriage outwards, warehouse charges, discount offered
to
customers, advertising expenses, bad debts etc

(d) Research and Development Expenses:

Research and development (R&D) describes activity or expense associated with the
research and development of a company's goods or services. R&D expenses are a type of
operating expense and can be deducted as such on a business tax return. This type of
expense is incurred in the process of finding and creating new products or services.

II. Classification with Regard to Behaviour of Expenditure:

Under this overheads are classified with reference to their tendency to vary with
production/sales volume or activity level. Some expenses vary directly with the rise and
fall in output, some remain constant in spite of change in the level of activity of the concern
whereas there are some other items which are constant only upto a certain level and then
change their character to become variable or which vary with volume of output but less
than proportionately.

Based on this behaviour, the expenses may be classified into

1. Fixed Overheads

Fixed overheads are also called period costs or capacity costs. Fixed overheads are
incurred for creating an output capacity of the concern for a fixed period of time. They
are the costs which remain fixed or constant in total despite changes in the volume of
production or sales. Fixed overheads remain fixed in total up to a certain level of activity
which is known as relevant range of activity but fixed overheads per unit always vary
with the production or sales volume in an opposite direction. For example, per unit fixed
overheads decrease with an increase in the production or sales volume and vice verse.
Examples of fixed overheads are rent, salaries, depreciation, interest and legal expenses.

2. Variable Overheads
Variable overheads are those type of overheads which vary positively with the production
and sales volume. Hence, they vary directly in proportion to the volume. Variable
overheads increase in total with the increase in volume and vice versa. They, however,
remain constant in per unit. Examples of variable overheads are indirect materials,
indirect wages and power expenses.

3. Semi-variable overheads

Semi-variable overheads are neither completely fixed nor variable. Therefore, they are
also called semi-fixed costs. Semi-variable overheads comprise the quality of both the
fixed and variable costs. They vary disproportionately with the change in the volume of
output. They do not vary directly proportion to the volume. They are the mixed type of
overheads. The semi- variable overheads increase with the increase in output units but
not at the same rate. Telephone
, electricity, repair and maintenance, heating, lighting, supervision and inspection,
salesmen remuneration are some of the examples of semi-variable or semi-
fixed overheads.

4. Step Fixed Overheads

Step fixed overheads remain fixed within a certain range of output level and jump up
once the range of output level exceeds. Step fixed overheads remain constant for a given
volume, but increase by another fixed amount the moment there is addition of volume,
and keep on increasing by a fixed amount with the addition of volume. Hence, such
overheads increase step by step according to the relevant range of output level. For
example, a college bus driver is paid salary of $ 2500 a month which will remain constant
until another bus is bought or hired. But as soon as the number of college bus increases,
the salary cost will be increase by $2500 with every addition of such buses.
 Overhead Allocation
The allocation of certain overhead costs to produced goods is required under the rules of
various accounting frameworks. In many businesses, the amount of overhead to be
allocated is substantially greater than the direct cost of goods, so the overhead allocation
method can be of some importance.
There are two types of overhead, which are administrative overhead and manufacturing
overhead. Administrative overhead includes those costs not involved in the development
or production of goods or services, such as the costs of front office administration and
sales; this is essentially all overhead that is not included in manufacturing overhead.
Manufacturing overhead is all of the costs that a factory incurs, other than direct costs.

Advantages of Overhead Classification

1. It ensures effective cost control.

2. It helps the management for effective decision making.
3. The application of marginal costing is essentially for profit planning, cost
control, decision making etc. are based on the classification of overheads.
4. On the basis of classification of fixed and variable cost, flexible
budgets are prepared at different levels of activity.
5. It facilitates fixing of selling price.
6. Cost classification is useful for break-even analysis. Break-even analysis
mainly depends on overall. cost and profit which can be useful for
making or buying decision.
7. It helps to find out the unit cost of production.

Codification of Overhead

Codification is a process of representing each item by a number, the digits

of which indicate the group, the subgroup, the type and the dimension of the item.
Advantages of Codification

(1) It enables systematic grouping of similar items and avoids confusion caused
by long description of the items.
(2) It serves as the starting point of implication and standardization.
(3) It helps in avoiding duplication of items and results in the
minimisation of number of items,
(4) It helps in allocation and apportionment of overheads to different cost centers.
(5) It assists the grouping of overheads for cost control.
(6) It helps in reducing clerical efforts to the minimum

Methods of Codification

(1) Numerical Codes Method.

(2) Decimal Codes Method.
(3) Codes with a Combination of Numbers and Alphabets.

1) Numerical Method: Under this method, numerical codes are assigned to each
item of expenses.
(2) Decimal Codes: Under this method, the whole numbers are allotted to
indicate master group and the decimals indicate the sub-group
(3) Codes with a Combination of Numbers and Alphabet: Under this
method the alphabet indicates the main group and the type of expenses is indicated by
the numerical

Procedure or Steps in overhead

Overheads are incurred for work in general. Overhead is added to the prime
cost in order to measure the total cost of production or cost of goods sold. For allocation
and apportionment of overhead in the cost of production or cost of goods sold
the following procedures are involved:
 (1) Classification Overhead: We have already discussed the
classification of overhead in the preceding pages, and the discussion on other
procedures would follow in this chapter and the subsequent one.

(2) Collection of Overhead: The production overheads or factory

overheads are collected and identified under separate overhead code
numbers or standing order numbers. These overheads are collected from different
sources and documents. The following are the important sources and documents .

(3) Overhead Analysis :

(a) Allocation and Apportionment of Overhead to Cost Centers
The first step of overhead analysis is distribution of overhead to production
department and service department. Before analysing overhead, we should
know the concept of Allocation, Absorption and Apportionment.

Allocation: Cost allocation refers to the allotment of whole item of cost to cost
centers. The technique of charging the entire overhead expenses to a cost centre is
known as cost allocation.

Absorption: Cost absorption refers to the process of absorbing all

overhead costs allocated to apportioned over particular cost centre or production
department by the unit produced.

Apportionment: Apportionment is the process of distribution factory

overheads to cost centers or cost units on an equitable basis. The term
apportionment refers to the allotment of expenses which cannot be identified
wholly with a particular department. Such expenses require division and
apportionment over two or more cost centers in proportion to estimated benefits
received.
Allocation Vs Apportionment

(1) Allocation deals with whole amount of factory overheads while apportionmen

(2) The item of factory overhead directly allocated and identified with
specific cost centers. Whereas apportionment requires suitable and equitable basis. For
example, factory rent may be allocated to the factory and has to be apportioned
among the producing and service departments on an equitable basis.

(b) Re-apportionment (Re-distribution):

Re-distribution of overhead from various service departments to production
departments is known as Re-apportionment or Secondary distribution. Accordingly,
allocation and apportionment of overheads from service departments or centers to
production centers or departments.

Methods of Re-apportionment or Re-distribution

The following are the important methods of re-distribution of
service department overheads to production department :
(1) Direct Re-distribution Method
(2) Step Distribution Method
(3) Reciprocal Service Method - this method further grouped into:
(a) Repeated Distribution Method
(b) Simultaneous Equitation Method
(c) Trial and Error Method

(1) Direct Re-distribution Method: Under this method, the cost of service
department is directed to re-distribution to the production departments without
considering the services rendered by one service department to another service
department.

(2) Step Method: Under this method the cost of most serviceable department is first
 distributed to production departments and other service departments. Thereafter, the next
service department is distributed and later the last service department until the
cost of all the service departments are redistributed to the production department
(3) Reciprocal Service Method : This method recognizes the fact that if a service
department receives services from other department, the services should be charged
in the receiving department. Thus, the cost of inter departmental services is taken
into account on reciprocal basis. The following are the three important methods available
for dealing with reciprocal distribution :

(a) Simultaneous Equation Method: Under this method, the true cost of total
overhead of each
service department is ascertained with the help of Simultaneous or Algebraic
Equation. The obtained result reapportioned to production department on the basis
of given percentage.
(b) Repeated Distribution Method: Under this method, the total overhead
costs of the service departments are distributed to service and production
departments according to given percentage of the service departments are exhausted,
in tum repeatedly until the figures become too small to matter.
(c) Trial and Error Method: In this method, the cost of a service centre is
apportioned to another service centre. Then, the cost of another service centre
along with the apportioned cost from the first centre is again apportioned back to the
first service centre. This process is repeated till the amount to be apportioned
becomes zero or negligible.

Overhead Calculation
The typical procedure for allocating overhead is to accumulate all manufacturing
overhead costs into one or more cost pools, and to then use an activity measure to
apportion the overhead costs in the cost pools to inventory. Thus, the overhead allocation
formula is:
Cost pool / Total activity measure = Overhead allocation per unit
 Absorption of Overhead Meaning

Absorption of overhead is also termed as levy, recovery, or application of

overhead. Cost absorption refers to the process of absorbing all overhead costs
allocated to apportioned over particular cost centre or production department by
the unit produced. Accordingly, the distribution of the overhead cost 10 the
cost centres or cost units is known as Overhead Absorption.

Overhead Rate
The apportionment of overhead expenses is done by adopting suitable basis
such as output, materials, prime cost, labour hours, machine hours etc. In order to
determine the absorption of overhead in costs of jobs, products or process, a rate
is calculated and it is called as "Overhead Absorption Rate" or "OverheadRate."
Types of overhead rate
Different overhead rates are applied based on the features and objectives of the
business organization.
( 1) Actual Overhead Rate
(2) Predetermined Overhead Rate
(3) Blanket Overhead Rate
(4) Multiple Overhead Rate
(5) Normal Overhead Rate
(6) Supplementary Overhead Rate

(1) Actual Overhead Rate: Actual overhead rate as otherwise called the
historical rate. This rate is calculated by dividing the actual overhead absorbed by
the actual quantity or value of the base selected for a particular period.
(2) Predetermined Overhead Rate: Predetermined overhead rate is determined in
advance of actual production and the rate is computed by dividing the budgeted
overhead for the accounting period by the budgeted base for the period.

(3) Blanket Overhead Rate: Blanket overhead rate is also termed as Single
 Overhead Rate. A single overhead rate when computed for the entire factory is
known as Blanket Rate.
(4) Multiple Overhead Rate: Multiple overhead rates involve computation of
separate rates for each production department, service department, cost centre, each
product or line and for each production factor.
(5) Normal Overhead Rate: Normal Overhead Rate is a predetermined rate
calculated with reference to normal capacity.
(6) Supplementary Overhead Rates: These rates used to carry out adjustment
between overhead absorbed and overhead incurred.

Methods of Absorption of Overhead

There are number of methods applicable for computing overhead absorption
rate. The following are the various methods of absorbing "Manufacturing
Overhead" depending upon the suitable basis selected for the purpose :
(1) Direct Material Cost Method
(2) Direct Labour Cost Method
(3) Direct Labour Hours Method
(4) Prime Cost Method
(5) Unit of Output Method
(6) Machine Hour Rate Method

(1) Direct Material Cost Method: Under this method, the rate of absorption is
calculated on the basis of direct material cost method. The rate of manufacturing
overhead absorption is determined by dividing the manufacturing overhead by the direct
material cost. The result obtained the rate of absorption is expressed as percentage.
(2) Direct Labour Cost Method: Direct Labour Cost Method is also termed
as Direct Wages Method. Under this method direct wage rate can be determined
by dividing the estimated factory overhead cost apportioned by the predetermined
direct wages, and the result obtained is expressed as a percentage.

(3) Direct Labour Hours Method: Under this method the rate is determined by
dividing the production overheads by direct labour hours of each department. This
 method is designed to overcome the objections of direct labour cost method. This method
is most suitable in such industries where the production is carried out manually or by
skilled labours.
(4) Prime Cost Method: Under this method, both direct material cost and direct
labour cost are taken into account for determination of recovery rate. The actual or
predetermined rate of factory absorption is computed by dividing actual or budgeted
overhead expenses by the aggregate of direct material or direct labour cost of the
department.

(5) Unit of Output Method: This method is also termed as Production Unit
Method or Cost Unit Rate Method. Under this method absorption rate is determined
on the basis of number of units produced is known as Cost Unit Rate. The recovery
rate is calculated by dividing the actual or budgeted factory overheads by the number
of cost units produced.

(6) Machine Hour Rate: Machine hour rate means the cost or expenses
incurred in running a machine for one hour. It is one of the scientific
methods of absorbing factory expenses where the process of manufacturing are
carried out by machines. Under this method overhead costs are allocated on the
basis of the number of hours a machine or machines are used for a particular job.

According to the Institute of Cost and Management Accountants, England a

machine hour rate is "an actual or predetermined rate of cost apportionment or
overhead absorption, which is calculated by dividing the cost to be apportioned or
absorbed by the number of machine hours expended or to be expended."

Calculation Machine Hour Rate:

The following steps are required for computing the machine hour
(1) Identify the overhead expenses relating to a specific machine or group of
machine in order to require for computing machine hour rate
(2) Each machine or group of machine treated as a cost centre.
 (3) Manufacturing overhead or machine expenses are grouped into two types:
(a) Fixed or Standing Charges: Fixed or Standing Charges which remain
constant irrespective of the use of machine. For example, rent, insurance charges,
rates, supervision etc.
(b) Variable Machine Expenses: These expenses are variable with use of the
machine. For example, power, depreciation, repairs etc.

(4) An hourly rate of fixed or standing charges will be calculated by totaling

of fixed charges and dividing by the number of normal hours worked by machine.
(5) Normal working hours are calculated by adding the cost relating
to non- productive time, i.e., normal ideal time for maintenance
and setting up etc.
(6) Separate hourly rate for each machine expenses will be calculated.
(7) The total of the standing charges rate and the machine expenses
rates per hour will give the machine hour rate.

Advantages
(1) It helps to measure the relative efficiency of different machines.
(2) It facilitates comparison of cost of operating different machines.
(3) It helps to ascertain idle time of machines relating to non-productive time.
(4) It is the most desirable scientific method, where the time factor is taken into
account.
Disadvantages
(1) It involves more clerical labour in determining the number of machine hours
worked.
(2) It does not consider where the expenses not proportional to the working
hours of machines.
(3) It is very difficult to measure the machine hours where the works are
completed without operating any machinery.
 Question Bank

UNIT –IV-OVERHEADS
PART –A CO Blooms
Level
1 Define overheads. CO4 L1
2 CO4 L2
Compare fixed and variable overheads.
3 CO4 L1
Enumerate the different classification of overheads.

4 CO4 L2
Summarize apportionment of overheads
5 Revise the concept allocation of overhead CO4 L2
6 CO4 L2
Distinguish between selling and marketing over head cost
7 CO4 L6
List the need of research cost
8 CO4 L2
List the methods ofcodification.
9 CO4 L1
Recall the term cost segregation
10 CO4 L1
Describe semi variable cost.

PART B CO Bloom
s Level
1 Explain the different methods of overheads. CO L5
4
2 Discuss the differences between fixed, variable and semi-variable CO L4
overheads 4
3 CO L6
Discuss the methods of absorption of overhead along with merits
4
anddemerits.
4 A manufacturing company has three production department A,B and CO L5
C and two service departments D and E. The following figures are 4
extracted from the records of the company.
Particulars Amount in Rs
Rent 5000
Indirect wages 1500
Depreciation of machinery 10000
General lighting 600
Power 1500
Sundries (wages) 10000
 Following further details are available:
Basis Total A B C D E
Floor space in 10000 2000 2500 3000 2000 500
Sq.ft
Lighting points 60 10 15 20 10 5
Direct 10000 3000 2000 3000 1500 500
wages(Rs)
H.P.of 150 60 30 50 10 -
machine
Value of 250000 60000 80000 100000 5000 5000
machinery
Apportion the cost to various departments on the most equitable basis
by preparing a primary departmental distribution summary.
5 RMKV silks is divided into four departments: production department A,B CO L4
and C and service department D. The actual expenses as follows 4
Particulars Amount in Rs
Rent 10000
Repair to plant 6000
Depreciation of plant 4500
Lighting expenses 1000
Supervisory expenses 15000
Fire insurance (on Stock) 5000
Power 9000
Employer’s liability for insurance 1500
The following information is available in respect of four departments.
Basis A B C D
Area in Sq.ft 1500 1100 900 500
Number of Lights 75 11 9 5
Totalwages(Rs) 60000 40000 30000 20000
Number of 200 150 100 50
employees
Value of plant (Rs) 240000 180000 120000 60000
Value of stock (Rs) 150000 90000 60000 -

Apportion the cost to various departments on the most equitable basis

by preparing a primary departmental distribution summary.
6 . CO L4
4
 Calculate machine hour rate to cover overhead expenses indicated
below:
Per
Hour
(Rs.)
Electric
power 0.75 Rent 270
Steam 0.3 Repairs 550
Running
Water 0.2 hours 2000

Original cost of the machine is Rs.15000: book value Rs.3500:

Replacement value Rs.11500, depreciation 10% on original cost.

7 From the following particulars compute the machine Hour Rate CO L4

4
Cost of the machine 20000
Scrap value 0
Initialization charges 2000
Repairs for the effective working life 3000
Standing charges for 6 weekly period 60
Effective working life 20000 hours
5 units per hour
at 10 paise per
Power used: unit
Hours worked in 6 weekly period 240 hours
8 From the following particulars compute the machine hourrate CO L4
4
Particulars Amount in Rs
Cost of machine 11000
Scrap value 680
Repairs for the effective workinglife 1500
Standing charges for 4 weeklyperiod 40
Effective working life 10000 hours
Power used 6 units per hour @ 5 paise
per unit
Hours worked in 4 weekly period 120 hours
9 Workout the machine hour rate for the following machine whose scrap CO L4
value isnil 4
 Particulars Amount in Rs
Cost of machine 360000
Freight and initialization charges 40000
Working life 20 years
Working hours 8000 per year
Repair charges 50% of depreciation
Power 10 units per hour @10 paise perunit
Lubricating oil Rs.2 per day of 8 hours
Consumable stores Rs.10 per day of 8 hours
Wages of operator Rs.4 per day of 8 hours
1 A shop has four new machines, each occupying an equal area ofspace CO L4
0 4
and costing respectively
Rs.200000for(A);Rs.25000for(B);Rs.30000for(C)andRs.40000for(D).T
he following are the expenses for the year of machineshop.
Particulars Amount in Rs
Rent 10000
Water 4250
Light and heat 3150
Power : A 5100
B 5000
C 12000
D 14500
Administrative expenses 9500
Repair expenses 20000

Prepare the statement of machines hour rate for each of the

machines presuming 45 hours a week and 50 weeks in a
year;80% is the utilization. The machines are expected to last for
10 years , but do not have any scrap value.
Book References:

1. Jain. S.P, Narang , K.L&Simmi Agarwal, (2011) , Cost Accounting (2nd Ed.) Delhi, India,
Kalyani Publishes.
2. Arora M N (2012) methods and techniques of cost accounting (4th ed) India.
3. T.S Reddy and Murthy . Cost Accounting.Margham Publications. Chennai. 2007.
4.Banerjee ,B, (2006) Cost Accounting Theory and Practices (12th ed) PHI Learning Pvt Ltd.
5. Narang, J. & (2012) Advanced Cost Accounting, Delhi, Kalyani Publishing House
 SCHOOL OF MANAGEMENT STUDIES

UNIT – V – COST ACCOUNTING – SBA1601

UNIT – III – COST ACCOUNTING – SBA1601
UNIT – II – – SBA1601

1
UNIT 5 CONTRACT COSTING AND PROCESS COSTING
Difference between Job costing and Contract costing - Contract Ledger - Ascertainment of Profit / loss
on Contract - work in Progress and Balance Sheet- Cost Plus and Estimated Contracts Process Costing:
Normal Loss - Abnormal Loss/ gain - Preparation of Process Accounts and Joint and By-Products
(Reverse Cost Method Only)
CONTRACT COSTING

Contract costing is the tracking of costs associated with a specific contract with a customer.
For example, a company bids for a large construction project with a prospective customer, and
the two parties agree in a contract for a certain type of reimbursement to the company. This
reimbursement is based, at least in part, on the costs incurred by the company in order to fulfill
the terms of the contract. The company must then track the costs associated with that contract
so that it can justify its billings to the customer. The most typical types of cost reimbursement
are:

 Fixed price. The company is paid a fixed total amount for completing the project,
possibly including progress payments. Under this arrangement, the company will want
to engage in contract costing to compile all of the costs relevant to the construction
project, just to see if the company earned a profit on the deal.

 Cost plus. The company is reimbursed for the costs it incurred, plus a percentage profit
or fixed profit. Under this arrangement, the company will be forced under the terms of
the contract to track the costs related to the project, so that it can apply to the customer
for reimbursement. Depending on the size of the project, the customer may send an
auditor to examine the company's contract costs, and may disallow some of them.

 Time and materials. This approach is similar to the cost plus arrangement, except that
the company builds a profit into its billings, rather than being awarded a specific profit.
Again, the company must track all contract costs carefully, since the customer may
review them in some detail.

Contract costing can involve a considerable amount of overhead allocation work. Customer
contracts typically specify exactly which overhead costs can be allocated to their projects, and

2
this calculation may vary by contract.

In some industries, such as government contracting and commercial construction, contract

costing is the primary task of the accounting department, or may even be organized as an
entirely separate department. Proper contract costing can contribute a considerable amount of
profits, and so is typically staffed with more experienced contract managers and accountants.

Features of Contract Costing:

Contract costing has certain distinctive features. The important features of contract
costing are:

(1) Contracts are generally of large size and, therefore, a contractor usually carries out a small
number of contracts in the course of one year.

(2) A contract generally takes more than one year to complete.

(3) Work on contract is carried out at the site of contracts and not in factory premises.

(4) Each contract undertaken is treated as a cost unit.

(5) Separate Contract Account is prepared for each contract in the books of contractor to
ascertain profit or loss on each contract.

(6) Most of the materials are specially purchased for each contract. These will, therefore, be
charged direct from the supplier’s invites. Any materials drawn from the store are charged to
contract on the basis of material requisition notes.

(7) Generally, all labourers are treated as direct labourers.

(8) Most expenses, such as, electricity, telephone, insurance, etc. are also direct in nature.

(9) Plant and equipment may be purchased for the contract or may be hired for the duration of
the contract.

(10) Payments by the contractee are made at various stages of completion of the contract
based on architect’s certificate for the completed stage. An amount known as retention money
is withheld by the contractee as per agreed terms.

(11) Penalties may be incurred (paid) by the contractor for failing to complete the work within

3
the agreed period.

(12) Contract costing is less detailed and simpler than job costing.

(13) Each contract or work involved in contract costing is executed or done as per the
specifications given by the contractee. So one contract may be dissimilar to another contract.

Contract Costing Procedure:

The basic procedure for costing of contracts is as follows:

1. Contract Account:

Each contract is allotted a separate number and a separate account is opened for each contract

2. Direct Costs:

Most of the costs of a contract can be allocated direct to the contract. All such direct costs are
debited to the Contract Account.

Direct costs for contract include:

(i) Direct cost of materials,

(ii) Direct labour and supervision,

(iii) Direct Expenses,

(iv) Depreciation of Plant and Machinery,

(v) Sub-contract costs, etc.

3. Indirect Costs:

Contract cost is also debited with overheads which tend to be small in relation to direct costs.
Such costs are often absorbed on same arbitrary basis as a percentage on prime cost, or
material or wages, etc. Overheads are normally restricted to head office and storage costs.

4. Transfer of Materials or Plant:

When materials, plant or other items are transferred from the contract, the Contract Account is
credited by that amount.

4
5. Contract Price:

The Contract Account is also credited with the contract price. However, when a contract is not
complete at the end of financial year, the Contract Account is credited with the value (cost) of
work-in-progress as on that date. Work- in-progress includes value of work certified and the
cost of work uncertified.

6. Profit or Loss Account:

The balance of Contract Account represents profit or loss which is transferred to Profit and
Loss Account. However, when contract is not completed within the financial year, only the
part of the profit arrived is taken into account and the remaining profit is kept as reserve to
meet any contingent loss on the complete portion of the contract.

4. Computation of Profit or Loss on Contract:

There may be three situations in the computation of profit or loss on contracts.

They are:

(I) Profit on completed contracts,

(II) Profit on uncompleted contracts,

(III) Profit on likely to be completed contracts.

I. Profit on Completed Contracts:

If a contract is begun and completed in the same financial year, then, the entire profit or loss
made on such a contract should be transferred to the Profit and Loss Account. If there is profit,
the same should be credited to the Profit and Loss Account and debit should be given to
Contract Account. On the other hand, if there is loss, the same should be debited to the Profit
and Loss Account and credit being given to the Contract Account.

II. Profit on Uncompleted Contracts:

Contracts which are started and finished during the same financial year create no accounting
problems. But in case of those contracts which take more than one year to complete, a problem
arises whether profit on such contracts should be worked out only on the completion of the
contract or at the end of each financial year on the partly completed work. If profit is

5
computed only on the completion of the contract, profit will be high in the year of completion
of the contract, where as in other years of working on contract, profit will be nil.

This would result not only distorted profit pattern but also higher tax liability because income-
tax at higher rates may have to be paid. Therefore, when contracts extend beyond a year, it
becomes necessary to take into account the profit earned or loss incurred oh the work
performed during each year. This helps in avoiding distortion of the year-to-year profit trend
of the business.

PROCESS COSTING

Definition of Process Costing:

CIMA defines Process Costing as “the costing method applicable where goods or services
result from a sequence of continuous or repetitive operations or processes, costs are
averaged over the units produced during the period.”

Process costing is defined by Kohler as: “A method of accounting whereby costs are charged
to processes or operations and averaged over units produced; it is employed principally where
a finished product is the result of a more or less continuous operation, as in paper mills,
refineries, canneries and chemical plants; distinguished from job costing, where costs are
assigned to specific orders, lots or units.

Features/Characteristics of Process Costing:

1. Process Costing Method is applicable where the output results from a continuous or
repetitive operations or processes.

2. Products are identical and cannot be segregated.

3. It enables the ascertainment of cost of the product at each process or stage of manufacture.

4. The output consists of products, which are homogenous.

5. Production is carried on in different stages (each of which is called a process) having a

continuous flow.

6
6. The input will pass through two or more processes before it takes the shape of the output.
The output of each process becomes the input for the next process until the final product is
obtained, with the last process giving the final product.

7. The output of a process except the last may also be saleable in which case the process may
generate some profit.

8. The input of a process except the first may be capable of being acquired from the outside
sources.

9. The output of a process is transferred to the next process generally at cost to the process. It
may also be transferred at market price to enable checking efficiency of operations in
comparison to the market conditions.

10. Normal and abnormal losses may arise in the processes.

Advantages of Process Costing:

The following are the main advantages of Process Costing:

1. It is possible to determine process costs periodically at short intervals. Average unit cost can
be computed weekly or even daily.

2. It is simple and less expensive to find out the process costs.

3. It is possible to have managerial control by evaluating the performance of each process.

4. It is easy to allocate the expenses to processes in order to have accurate costs.

5. It is easy to quote the prices with standardization of process. Standard costing can be
established easily in process type of manufacture.

Disadvantages of Process Costing:

The following are the main disadvantages of Process Costing:

1. Cost obtained at the end of the accounting period are only of historical value and are not
very useful for effective control.

2. Valuation of work-in-progress is generally done of estimated basis which introduces further

inaccuracies in total cost.

7
3. Where different products arise in the same process, it is not possible to exactly ascertain the
total cost of the products.

4. If any error occurs while calculating average costs, it will be carried through all the
processes to the valuation of work in process and finished goods.

5. The computation of average cost is more difficult in those cases where more than one type
of product is manufactured and a division of the cost element is necessary.

Fundamental Principles of Process Costing:

The following are the fundamental principles of process costing:

1. Cost of material, wages and overheads expenses are collected for each process or operation
in a period.

2. Adequate records in respect of output and scrap of each processes or operation during the
period are kept.

3. The cost per unit of each process is obtained by dividing the total cost incurred during a
period by the number of units produced during that period after taking into consideration the
losses and amount realized from sale of scrap.

4. The finished product of one process is transferred as a raw material to the next process.

Treatment of losses in process costing

It is rare that the output of a process is equal to its input. In most of the cases, the output of a
process is less than the input. The difference between the input and output and output is called
process loss. The process loss may be in the form of loss in weight, scrapes or wastes. These
process losses may be classified into:

1. Normal Loss: The fundamental principle of costing is that the good units should bear the
amount of normal loss. Normal loss is anticipated and in a process it is inevitable. It is

8
included in total cost of the product due to which cost per unit is increases. The cost of normal
loss is therefore not worked out. The number of units of normal loss is credited to the Process
Account and if they have some scrap value or realizable value the amount is also credited to
the process account. If there is no scrap value or realizable value, only the units are credited to
the process account.

2. Abnormal Loss: If the units lost in the production process are more than the normal loss,
the difference between the two is the abnormal loss. It is excluded from total cost due to which
it does not affect the cost per unit of the product. The relevant process of account is credited
and abnormal loss account is debited with the abnormal loss valued at full cost of finished
output. The amount realized from sale of scrap of abnormal loss units is credited to the
abnormal loss account and the balance in the abnormal loss account is transferred to the
Costing Profit and Loss Account.

3. Abnormal Gain: If the actual production units are more than the anticipated units after
deducting the normal loss, the difference between the two is known as abnormal gain. It is
excluded from total cost due to which it does not affect the cost per unit of the product. The
valuation of abnormal gain is done in the same manner like that of the abnormal loss. The
units and the amount is debited to the relevant Process Account and credited to the Abnormal
Gain Account.

Application of Process Costing

There are number of industries where Process costing system can be used except where job,
Batch or Unit Operation Costing is necessary. The following are examples of industries where
process costing is applied:

1. Where the final product merges only after two or more process such as paper-the raw
material, bamboo is made into pulp; pulp is a made into paper and then it is finished, glazed
etc. for sale;

9
2. The product of one process becomes the raw material of another process or operation e.g.
refined groundnut oil is the material for making vegetable ghee and

3. Different products may have a common prior process e.g. brass goods will require melting
of brass commonly for all goods. Another example is petroleum products by the same refinery.

4. Some other industries where Process Costing is applied are:

5. Chemical works ,Textiles, weaving, spinning , Soap making, Food product, Box making,
Canning factory, Coke works, Paint, ink and varnishing etc.

Difference Between Job Costing And Contract Costing

The main dissimilarities or difference between job order costing and contract costing can be
pointed out as follows:

1. Meaning

Job Costing: It is a costing method used to determine the cost of specific work.

Contract Costing: It is a costing method used to determine the cost of specific contract or
construction work.

2. Size Of Job

Job Costing: Generally jobs are smaller in size

Contract Costing: Jobs are big and complex

3. Time/Period

Job Costing: Work can be completed in short time.

Contract Costing: It requires longer time for completion of work.

4. Cost/Expenditure

Job Costing: Less expenditure required

10
Contract Costing: It requires huge expenditure

5. Location/Premises

Job Costing: Job is performed inside a factory or within the premises.

Contract Costing: Job is performed outside the factory in construction site.

6. Payment

Job Costing: Payments are made immediately after the completion of work.

Contract Costing: Payments are made in installment.

7. Transfer of Job

Job Costing: Job cannot be transferred to other parties.

Contract Costing: Some part of contract can be given to other parties or other sub-
contractors.

There are two aspects of the profit computation under contract costing:

(1) Computation of notional profit or estimated profit, and

(2) Computation of the portion of such profit to be transferred to Profit and Loss Account.

The portion of the notional or estimated profit to be transferred to Profit and Loss Account
depends upon the stage of completion of the contract. Prudence requires that the total notional
profit should not be transferred to Profit and Loss Account but a portion of it should be
withheld as a reserve to meet any unforeseen future expenses or contingencies.

Rules:

There are no hard and fast rules in this regard.

However, the following general rules may be followed in this context:

1. First Rule:

When work certified is less than 1/4 of the contract price, no profit is transferred to Profit and
Loss Account. This is based on the principle that no profit should be taken into account unless
the contract has reasonably advanced.

2. Second Rule:

11
When work certified is 1/4 or more but less than 1/2 of the contract price, then generally 1/3 of
the profit is transferred to Profit and Loss Account. The balance amount is treated as reserve.
Thus, profit to be transferred to Profit and Loss Account is computed by the following formula
–

3. Third Rule:

When work certified is 1/2 (i.e. 50%) or more but less than 9/10 (i.e. 90%) of the contract
price, then the profit to be transferred to Profit and Loss Account is computed by the following
formula –

4. Fourth Rule:

When contract is near completion then the estimated profit should be calculated on the whole
contract. The proportion of estimated profit to be transferred to Profit and Loss Account is
computed by any one of the following formulas:

5. Fifth Rule – Loss on Uncompleted Contracts:

In the event of a loss on uncompleted contracts, this should be transferred in full to the Profit
and Loss Account. Whatever be the stage of completion of the contract.

5. Cost Plus Method of Contract:

Cost plus method of contract is that where contract price is not settled between contractor and

12
contractee, but it is agreed that contractor will be paid a fixed percentage of profit on the total
cost incurred by contractor on and above the total cost of the work done. Such type of contract
is entered into in war time or time of economic fluctuation or where contract is to be executed
in urgency and it is difficult to quote the price of the contract.

Application of Cost Plus Method of Contract:

Although, this type of contract is commonly entered into in war time or in time of economic
fluctuation.

But, in the following situations, it proves to be useful:

(i) Where the production work has to be completed urgently.

(ii) When it is difficult to estimate the cost of labour, material and other costs.

(iii) When plant and machinery have to be imported from foreign countries.

(iv) When the work to be done is of nature and estimation of cost is difficult for the contractor.

(v) If material, labour, machinery and expert is provided by the contractee and contractor is to
do the work of contract only.

Advantages of the Cost Plus Method of Contract:

(A) Advantages to the Contractor:

(i) Free from losses.

(ii) Certainty of profits in case of increasing prices of labour and material.

(iii) In times of uncertainty execution of contract becomes possible.

(iv) Free from getting approval of tender price.

(v) In case of urgency of execution of a contract.

(vi) Availability of the services of experts, raw materials and labour.

(B) Advantages to the Contractee:

(i) Quick completion of work.

(ii) Quality work.

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(iii) Easy to get the work done in emergency.

Disadvantages of Cost Plus Contract Method:

(i) Generally contract price is increased under this method.

(ii) Excessive increase in expenses, since contractor is not worried about increasing cost.

(iii) Uneconomic use of raw material and labour by contractor.

(iv) Limited income to the contractor.

(v) Monotonous in contractor.

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Specimen of Incomplete Contract:

Note: (1) If the total of debit side of Contract Account exceeds the total of the credit side of
Contract Account, the resultant will be loss, which will be transferred to P/L A/c and not to
Work-in- progress A/c.

(2) If contract is near to completion, then profit will be calculated by adopting the following
formula –

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16
Work-in-Progress Account:

If the contract is not completed by the end of financial year, then the uncompleted work is
recorded in Work-in-progress Account. Work-in-progress Account is prepared by debiting to
this account, the account of work certified and work uncertified and crediting it with the profit
in reserve i.e. the portion of the profit not transferred to the Profit and Loss Account. The
difference between the debit and credit side is Work-in-progress, while showing it in Balance
Sheet, all cash received on account of such uncompleted contracts is to be shown as a
deduction.

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18
Important Matters to be Taken into Considerations While Solving Problems of
Contract:

The following important matters must be taken into consideration while solving
problems concerning contracts:

1. First of all, the students should see that what accounts have been asked to be prepared. It is
only contract account or contract account along-with Work-in-progress Account and Contracts
Account. It should be further seen that balance sheet has been instructed to be prepared or only
work-in-progress account has been asked to be shown in Balance Sheet?

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2. Look at the date of beginning the contract and preparation of contract account, so that it can
be ensured that for how much duration the particular contract is being prepared.

3. Ensure whether the contract has been completed or is incomplete so far. In case of
incomplete contract, determine how much proportion of completed contract bears to contract
price. Is completed work less than 1/4 of contract price or is equal to 1/4 or more but less than
1/2 of contract price or is equal to 1/2 or more but less than 9/10 of contract price or is about
to be completed. This information is required to decide how much of profit earned could be
credited to Profit and Loss Account.

4. As regards depreciation read carefully whether the term ‘per annum’ (p.a.) has been used
with the rate of depreciation. If yes, then look at the period for which the plant and machinery
has been used on the contract. If the word ‘p.a.’ has been used, then depreciation shall be
calculated proportionately to the period the plant was in use on contract. If the term ‘p.a.’ is
not used, then depreciation shall be calculated for one year. In such a case, the period of use of
plant and machinery on contract shall not be considered.

5. If the contract is in the stage of completion, then estimated profit will have to be
ascertained.

6. If the amount of work certified is not given, it will have to be ascertained. It is ascertained
on the basis of amount received from contractee as a fixed percentage of work certified.

7. The value of uncertified work is always shown at cost, not at contract price. All expenses
incurred by the contractor on contract from the date of certification to the date of preparation
of contract account will be added to get the amount of uncertified work.

8. If material consumed as well as material in hand or at site are given, we can find out
material issued to contract account by adding these two figures. In other words –

Material Issued = Material consumed + Material in hand or at site

9. In case the contract price is not given in question, then 2/3 of notional profit should be
credited to Profit and Loss A/c.

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Process Costing is Applicable in Industries:

(1) Iron and Steel Industry

(2) Automobile Industry

(3) Cement Industry

(4) Chemical Industry

(5) Sugar Industry

(6) Plastic Industry

(7) Textile Industry

(8) Paper Industry

(9) Paints and Varnish Industries

(10) Industries Producing Drugs and Medicines

(11) Ice Plants

(12) Soap Industry

(13) Oil Industry

(14) Leather Industry

(15) Flour Milling Industry

(16) Biscuit Factories

(17) Aluminium Industry

(18) Mining of Gold, Silver, Zinc, Sulphur, etc.

(19) Timber Industry

(20) Perfumery Industry

(21) Glass Industry

(22) Box-making Industry

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(23) Meat Packing

(24) Concerns Producing Explosives

(25) Public Utilities Companies—Water supply, Electricity, etc.

Accumulation of Costs under Process Costing:

Under process costing, the costs of materials, labour direct expenses and overheads are
accumulated or collected as follows:

1. Materials:

Raw materials and sundry supplies required for each process are obtained from stores though
stores requisitions. So, the costs of materials and sundry supplies chargeable to any process
can be ascertained from stores requisitions.

In case the materials are issued in bulk to any process, the process concerned intimates to the
cost office the exact quantity of materials consumed in the process during the particular period
and with the help of this data, the cost of materials chargeable to the process is ascertained.

2. Labour:

Wages paid to workers engaged in a particular process are ascertained through the payrolls
maintained for the concerned process, and are allocated directly to the process concerned.

However, where workers are engaged in two or more processes, their wages, ascertained
through the relevant wage records, are apportioned among the different processes on the basis
of time spent.

3. Direct or Chargeable Expenses:

All direct or chargeable incurred in a particular process are directly allocated to that process.

4. Indirect Expenses or Overheads:

Indirect expenses or overheads incurred on two or more processes are apportioned on the basis
of direct wages or on any other suitable basis. Sometimes, overheads are recorded at
predetermined rates based on direct wages, prime cost, etc.

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CONTRACT LEDGER
A contract ledger is kept in which a separate account is opened for each contract undertaken. It
is usual to give each contract a distinguishing number. A contract account is debited with all
direct and indirect expenditure incurred in relation to the contract.
Recording Procedures of 7 Items in Contract Ledger
1. Materials:
Materials purchased directly or supplied from the store or transferred from other contracts will
appear on the debit side. Materials returned to store will appear on the credit side. Amount
received from the sale of surplus materials will appear on the credit side, any profit or loss
arising from the sale will be transferred to the Profit and Loss Account.
2. Labour or Wages:
All labour employed at the contract site should be regarded as direct labour and charged direct
to the contract concerned Where possible, separate wages sheets should be prepared for each
contract. If this is not possible, a Wages Analysis Sheet should be prepared wherein should be
entered the particulars of the daily or weekly time sheets.
The total of each column should be posted to be debit of the appropriate contract. Wages
accrued or outstanding at the end of the period should appear on the debit side of the contract
account.
3. Site Expenses:
All site expenses (other than materials and wages) are charged to individual contract as and
when they are incurred.
4. Indirect Expenses:
There are certain expenses (such as engineers, surveyors, supervisors etc. engaged on various
contracts) which cannot be directly charged to contracts. Such expenses may be distributed on
several contracts on some suitable basis as a percentage of materials or labour.
5. Plant and Machinery:
Careful records of plant and machinery must be maintained to ensure that none is lost or
improperly disposed of and that the contract is duly charged for the use of plant.

6. Sub-contracts:
Generally work of a specialised character e.g., the installation of lifts and special flooring, is
passed out to any other contractor by the main contractor. In such cases the work performed
by the sub-contractors forms a direct charge to the contracts concerned. Subcontract cost will

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be shown on the debit side of the Contract Account.
7. Extra Work:
In most of the contracts additional work or variations of the work originally contracted for, are
required by the contractee. The additional work, being outside the original contract, will be
subject to a separate charge. If the additional work is quite substantial, it should be treated as a
separate contract and a separate account should be opened for it.

Cost-plus contracts and estimated contracts

Cost-plus contracts are generally used if the party drawing up the contract has budgetary
restrictions or if the overall scope of the work can't be properly estimated in advance. In
construction, cost-plus contracts are drawn up so contractors can be reimbursed for almost
every expense actually incurred on a project.

Types of Cost-plus contracts

 Cost plus fixed-fee (CPFF) contracts pay a pre-determined fee that was agreed upon
at the time of contract formation.
 Cost-plus-incentive fee (CPIF) contracts have a larger fee awarded for contracts
which meet or exceed performance targets, including any cost savings.[1]
 Cost-plus-award fee (CPAF) contracts pay a fee based upon the contractor's work
performance. In some contracts, the fee is determined subjectively by an awards fee
board whereas in others the fee is based upon objective performance metrics. An
aircraft development contract, for example, may pay award fees if the contractor
achieves certain speed, range, or payload capacity goals.
 Cost plus percentage of cost pay a fee that rises as the contractor's cost rise. Because
this contract type provides no incentive for the contractor to control costs it is rarely
utilized in government contracts, although it is prevalent in private industry. The
U.S. Federal Acquisition Regulations specifically prohibit the use of this type for U.S.
Federal Government contracting

Advantages:
 A cost-plus contract is often used when performance, quality or delivery time is a
much higher concern than cost, such as in the United States space program.
 Final cost may be less than a fixed price contract because contractors do not have to
inflate the price to cover their risk, especially when the ability to estimate costs is low.

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  Final cost may be less than a fixed price contract when there is little market or price
competition.
 Allows more oversight and control over the quality of the contractor's work.
 Flexible, allowing for changes in specification.
Disadvantages:
 There is limited certainty as to what the final cost will be.
 Requires additional oversight and administration to ensure that only permissible costs
are paid and that the contractor is exercising adequate overall cost controls

Normal Loss:
Normal loss means that loss which is inherent in the processing operations. It can be expected
or anticipated in advance i.e. at the time of estimation.
The cost of normal loss is considered as part of the cost of production in which it occurs. If
normal loss units have any realisable scrap value, the process account is f credited by that
amount. If there is no abnormal gain, then there is no necessity to maintain a separate account for
normal loss.

Journal Entry:
(i) Normal Loss A/c …Dr.

To Process A/c

(ii) Cost Ledger Control A/c …Dr.

(Scrap value) To Normal Loss
Abnormal Loss:
Abnormal loss means that loss which is caused by unexpected or abnormal conditions such as
accident, machine breakdown, substandard material etc. From accounting point of view we
can say that abnormal loss is that loss which occurred over and above normal loss. These
losses are segregated from process costs and investigated to prevent their occurrence in future.
Process account is to be credited by abnormal loss account with cost of material, labour and
overhead equivalent to good units and the loss due to abnormal is transferred to Costing Profit
and Loss Account.
Journal Entries:
(i) Abnormal Loss A/c …Dr.

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To Process A/c
(ii) Cost Ledger Control A/c …Dr. (Scrap value)
Abnormal Gain:
If the actual loss of a Process is less than that of expected loss then the difference between the
two will be treated as abnormal gain. In another way we can define it as the difference
between actual production and expected production.
The value of abnormal gain is transferred to the debit side of the relevant process and
ultimately closed by crediting it to the Costing Profit and Loss Account.
Journal Entries:
(i) Process A/c ..Dr.
To Abnormal Gain

Procedure of Process Cost Accounting

1. Separate account is opened for each process or department. All costs (both direct and
indirect) are charged to each such process or department.
2. The physical units (quantity) of output in each process are recorded in the respective
process accounts.
3. The cost per unit of output is determined by dividing the total cost of each process by total
production at the end of each period.
4. The total cost of one process is transferred to the next process as an initial cost till the
production is completed. The cumulative costs of different processes determine the total cost
and per unit cost at the final stage.
5. When there is work in progress at the end of the period, the stage of completion of the
incomplete work is determined, and the computation of inventory is in terms of equivalent
production units. For example, if 100 units are 40% complete, they are taken as equivalent to
40 completed units. The total number of completed units divides the total cost and the unit
cost is obtained for the process.
6. In case of any normal loss in the process, the units produced in that process bear that loss.
Accordingly the average cost of that process is increased. In case of any abnormal loss, it is
treated as general business loss and transferred to costing profit and loss account.

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 Question Bank
UNIT –V-
PART –A CO Blooms
Level
1 Define the term ‘Contract Costing’. CO5 L1
2 Highlighting the meaning of Process Costing CO5 L1
3 Classify the method of Fixed Cost and Variable Cost CO5 L6
4 Compare Direct cost with Indirect cost CO5 L2
5 Summarize the list of direct cost components CO5 L2
6 Write a meaning of Contract price CO5 L2
7 Recall the concept of ‘ Abnormal Gain’ CO5 L2
8 Distinguish Abnormal Loss and Normal Loss CO5 L2
9 Extract the meaning of Contract ledger CO5 L1
10 Narrate the concept of Cost Plus contracts CO5 L1

PART B CO Blooms
Level
1 Broadly examine the features of Contract Costing CO5 L4
2 Enumerate the Characteristics of Process Costing CO5 L5
3 Discuss the Fundamental Principles of Process Costing CO5 L6
4 Extract the Advantages of Process Costing CO5 L4
5 Discuss the Specimen of Incomplete Contract CO5 L5
6 Debate the Difference Between Job Costing And Contract CO5 L6
Costing

7 Summarize Advantages & Disadvantages of Cost Plus Contract CO5 L6

Method
8 Discover aspects of the profit computation under contract costing CO5 L5
9 Examine the Types of Cost-plus contracts CO5 L5
10 Describe the Industries that adopt the Process costing CO5 L4
11 Discuss the Procedure of Process Cost Accounting CO5 L6

12 Discover the Recording Procedures of Contract CO5 L5

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Book References:

1. Jain. S.P, Narang , K.L&Simmi Agarwal, (2011) , Cost Accounting (2nd Ed.) Delhi, India,
Kalyani Publishes.
2. Arora M N (2012) methods and techniques of cost accounting (4th ed) India.
3. T.S Reddy and Murthy . Cost Accounting.Margham Publications. Chennai. 2007.
4.Banerjee ,B, (2006) Cost Accounting Theory and Practices (12th ed) PHI Learning Pvt Ltd.
5. Narang, J. & (2012) Advanced Cost Accounting, Delhi, Kalyani Publishing House

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