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Cost & Management Accounting



Cost & Management Accounting

© 2015, Author

For private circulation Students’ Study Material of ADDOE.

All rights reserved. No part of this book may be reproduced, stored in a retrieval system,or copied in any form or by any means, electronic, mechanical, photographic or otherwise, without the priorwritten permission of the author and the publisher.

Published by: Amity Directorate of Distance & Online Education, Noida



Summary

Check Your Progress

Questions and Exercises

Key Terms

Further Readings

Unit-5: Overhead Costing 96

Introduction

Concept of Overhead

Procedure for Accounting and Control of Overheads

Allocation and Apportionment of Overheads

Apportionment of Service Department Costs to Production Departments

Summary

Check Your Progress


Key Terms

Further Readings

Unit-6: Absorption of Overheads 111

Introduction

Determination of Overhead Rates

Methods of Absorption of Overheads

Summary

Check Your Progress


Key Terms

Further Readings

Unit-7: Job and Batch Costing 124

Introduction

Job Costing

Preparation of Job Cost Sheet

Batch Costing

Summary

Check Your ProgressQuestions and Exercises

Key Terms

Further Readings

Unit-8: Contract Costing 143

Introduction

Concept of Contract Costing

Contract Costing Procedure

Contract Ledger

Preparation of Contract AccountImportant Points in Contract Costing



Summary

Check Your Progress


Key Terms

Further Readings

Unit-9: Process Costing and Service Costing 162

Introduction

Process Costing

Difference between Process Costing and Job Costing

Preparation of Process Accounts

Treatment of Normal Loss, Abnormal Loss and Abnormal Gain

Joint Products and By-Products

Service Costing

Summary

Check Your Progress


Key Terms

Further Readings

Unit-10: Reconciliation of Cost and Financial Accounts 187

Introduction

Need for Reconciliation

Reasons for Differences In Profit

Method or Procedure of Reconciliation

Summary

Check Your Progress


Key Terms

Further Readings



Cost Accounting 1

Notes

Amity Directorate of Distance and Online Education

Unit 1: Cost Accounting

Structure

1.1 Introduction

1.2 Concept of Cost Accounting

1.2.1 Cost

1.2.2 Costing

1.2.3 Cost Accounting

1.2.4 Applications of Cost Accounting

1.3 Comparison between Financial Accounting and Cost Accounting

1.4 Designing and Installating a Cost Accounting System

1.4.1 Designing a Cost Accounting System

1.4.2 Installing a Cost Accounting System

1.5 Cost Concepts

1.5.1 Cost Unit

1.5.2 Cost Centre

1.5.3 Classification of Cost

1.5.4 Elements of Cost

1.6 Cost Sheet

1.7 Tenders and Quotations

1.7.1 Estimation of profit for a tender or quotation

1.8 Summary

1.9 Check Your Progress

1.10 Questions and Exercises

1.11 Key Terms

1.12 Further Readings

Objectives

After studying this unit, you should be able to: Understand the meaning of cost, costing and cost accounting

Discuss the comparison between financial accounts and cost accounts

Explain the application of cost accounting

Discuss the designing and installing a cost accounting system

Explain the concepts and classification of costs

Discuss the cost module, cost center and the elements of cost

Learn the preparation of cost sheet

Explain tenders and quotations



2 Cost & Management Accounting

Notes


1.1 Introduction

Cost accounting is a branch of accounting and has been developed due to limitations offinancial accounting. The financial accounting is primarily concerned with recordkeeping directed towards the preparation of gross profit account, profit and loss accountand balance sheet. It provides information regarding the gross profit, profit and loss that

the business or enterprise is making and also its financial position on a particularperiod. The information concerning the business or enterprise is helpful to themanagement to control on business.

The management of every business enterprise is interested to know much morethan the usual information supplied to outsiders. In order to carry out its functions ofplanning, decision-making and control, it requires additional cost data. The financialaccounts fail, to some extent, to provide required cost data to management and hence anew system of accounting which could provide internal report to management wasconceived of.

In this unit, we shall study the concept and nature of cost accounting. We will alsodiscuss the classification of cost, cost centers. At the end of the unit we will study about

preparation of cost sheet, tenders and quotations and problems associated with costsheet.

1.2 Concept of Cost Accounting

This section will help you understand the meaning of cost, costing and the costaccounting.

1.2.1 Cost

Cost can be defined as the value attributed to a resource. There are three resources ofa cost, i.e. material, labour and services for a manufacturing organisation. Cost is theamount of expenditure incurred on a given thing. The committee on cost concepts andstandards of American Accounting Association has defined “cost is foregoing measured

in monetary terms incurred or potentially to be incurred to achieve a specific objective”.In this way, cost indicates a foregoing of something of value in consideration ofobtaining some sort of benefit. The term ‘cost’ connotes different meanings to differentpeople. But in cost accounting it is used in a special sense.

According to Crowningshield cost represents, “an expenditure made to secure aneconomic benefit, generally resources that promise to produce revenue. The resourcesmay have tangible substance (material) or they may take the form of labour andservices”.

Cost has been defined in terminology given by the Institute of Cost andManagement Accountants as “the amount of expenditure incurred or attributed on agiven thing”. More simply, it can be defined as that cost which is given or scarified to

obtain something. Thus, the cost of an article is its purchase or manufacturing price,i.e., it would consist of its direct material cost, direct labour cost, direct and indirectexpenses allocated or apportioned to it.

The term cost is denoted by “expenses” when the cost is incurred after deriving thebenefit. The AICPA Committee on terminology defined expenses as “all expired costwhich is deductible from revenue”. In a narrow sense, expense refers to such items asproduction, administrative and selling expenses.

1.2.2 Costing

Costing is the system of calculating the cost of production by allocating expenditures todifferent stages of production or operations of the firm.

It is a managerial accounting method that describes when all fixed and variablecosts, including manufacturing costs, are used to compute the total cost per unit.



Cost Accounting 3

Notes


Costing includes these costs when computing the amount of money it takes to produceand distribute one unit of output.

1.2.3 Cost Accounting

Cost accounting is a very wide term. It embraces many subjects within its folds. In

general usage, it is the application of costing and cost accounting principles, methodsand techniques to the science, art and practice of cost control and ascertainment ofprofitability of business. The Institute of Cost and Management Accountants, Englandhas defined cost accounting as “the application of costing and cost accountingprinciples, methods and techniques to the science, art and practice of cost control. Itincludes the presentation of information derived there from for the purpose ofmanagerial decision-making.” Thus, cost accounting is the science, art and practice of acost accountant. It is a science because it consists of organised body of knowledge,which a cost accountant must possess for proper discharge of his responsibilities.

Cost accounting involves the application of costing principle, methods andtechniques for ascertaining costs and their control by comparing actual costs with thebudget or standard. Cost accounting is an art also, because it includes the ability and

skill with which a cost accountant has to apply his basic knowledge to particularcircumstances. It involves the use of various costing techniques and methods such asmarginal costing, standard costing, budgetary control etc. The applications of thesetechniques help him in dealing with various problems such as cost reduction, costcontrol, ascertainment of profitability etc.

Cost accounting is also the practice of a cost accountant because he has to makeconstant efforts in the field of cost accounting. Such efforts include the informationpresentation to the top management for the purpose of managerial decision-making andkeeping various records of business.

Cost accounting is an important development in the field of accounting. It is theprocess of accounting for costs. It embraces the accounting procedures relating torecording of all income and expenditure and the preparation of various statements and

reports with the object of ascertaining and controlling costs. On analysis of the abovemeaning and definitions, the following features of cost accounting become evident:

(i) Cost accounting is used in the very wide sense when compared to costaccountancy and costing. This is so because cost accounting is concerned with theformulation of principles, methods and techniques to be applied for ascertainingcost and profit.

(ii) Having ascertained cost and profit, cost accounting is concerned with presentationof information to management. To enable management to carry out its functions,reports must be promptly made available at the right time, to the right person and ina proper form.

(iii) The information so provided is to serve the purpose of managerial decision-makingsuch as introducing a new line of product, replacement of manual labour by

machines, make or buy decisions, etc.

1.2.4 Applications of Cost Accounting

According to Weltemer and Blocker, cost accounting is to serve management in theexecution of various policies and in comparison of actual and estimated results in orderthat the value of each policy may be appraised and changed to meet the futureconditions. Following are the main functions of cost accounting:

1. To establish various cost centres in the business or industry.

2. To provide necessary data to the management for fixing the selling price.

3. To prepare various reports on wastages, loss of labour, idle capacity of machinesso as to improve profitability of business or industry.

4. To ascertain the cost of every product, job or process both in terms of total cost andper unit cost of product.




Notes


5. To implement various cost control techniques such as budgetary control, historicalcosting and standard costing.

6. To design suitable system for defining responsibilities and controlling cost.

7. To prepare cost schedules to assist management in decision-making.

8. To prepare cost statements and profit and loss account for giving advice tomanagement.

9. To assist management in the valuation of closing stock of raw materials and work-in-progress so that too much of capital is not locked up in unnecessary inventories.

10. To help in supervising the working of punched card accounting or data processingthrough computers.

11. To organise cost reduction programmes with the help of departmental managers.

12. To organise the internal audit systems to ensure effective working of differentdepartments.

13. To undertake cost audit programmes as per the directives issued by the centralgovernment and the provisions of Indian Companies Act.

14. To design suitable forms for organising an effective cost system of reporting.

1.3 Comparison between Financial Accounting and CostAccounting

The cost accounting is very closely-related to financial accounting. Few authorities ofaccounting consider cost accounting to be the branch of financial accounting. But it maybe said that cost accounting is complementary to financial accounting. Financialaccounting and cost accounting are both similar in various ways. The main relationshipbetween financial accounting and cost accounting are given as under:

1. The fundamental principles of double entry system are applicable in financialaccounting as well as cost accounting.

2. The results of business or organisation are revealed by both the systems ofaccounts.

3. The determination of future business activities and policy is guided by bothaccounting systems.

4. A basis for comparison of expenditures is being provided by both the accountingsystems.

5. The invoices and vouchers constitute the common basis for recording transactionsunder both the systems of accounting.

6. The causes for losses and wastages of a business or industry are provided byfinancial and cost accounting.

The main differences between financial accounting and cost accounting are given

as under:Basis of

DifferencesFinancial Accounting Cost Accounting

Purpose andObjective

The purpose and objective offinancial accounting is externalreporting mainly to owners,creditors, tax authorities,government and investors.

The purpose and objective of costaccounting is internal reporting tomanagement.

Maintenance of Accounts

This is to be maintainedcompulsorily by forms of businessorganisations. The preparation ofaccounts must be in accordancewith the statutory provisions of

Companies Act and Income Tax Act.

Cost accounting is maintainedvoluntarily. In some casesgovernment has directed somecompanies to maintain costaccounts to improve efficiency of

business or industry.

Contd…



Cost Accounting 5

Notes


Profit Analysis Financial accounting discloses profitfor the entire business as a whole.

Cost accounting shows the profitfor each product, process oroperation.

Recording It classifies, records and analysesthe transactions in a subjectivemanner, i.e., according to thenature of expenses.

Cost accounting records theexpenditure in an objectivemanner, i.e., according topurpose for which costs areincurred.

Use of ControlTechniques

It does not make use of any type ofcontrol techniques.

It makes use of some importantcontrol techniques such a MarginalCosting, Historical Costing,Budgetary Control, StandardCosting, etc., in order to controlcost.

Stock Valuation Stock is valued at cost or marketprice whichever is less.

Stock is always valued of costprice.

Pricing Policy It fails to guide the formulation ofpricing policy.

It provides adequate data forformulating of pricing policy.

Facts and Figures Financial accounting deals mainlywith actual facts and figures.

Cost accounting deals partly withfacts and figures and partly withestimates.

Duration ofInformationReporting

Generally, financial accountingprovides financial information once ayear.

Cost accounting furnishes costdata at frequent intervals i.e.,reports are daily, weekly andmonthly.

Evaluation ofEfficiency

The information provided byfinancial accounting is not sufficientto evaluate the efficiency of thebusiness activities.

The cost data helps in evaluatingthe efficiency of the businessactivities.

1.4 Designing and Installating a Cost Accounting System At the outset it is to be understood that a common cost accounting system cannot bedesigned and installed for all types of business enterprises. The cost accounting systemdepends upon the nature of business or industry and the product. Before a suitablesystem of cost accounting is designed and installed it is necessary to undertake apreliminary investigation so as to know the feasibility of designing and installing costaccounting system to such business activities. While introducing a system of costaccounting it should be borne in mind that cost accounting system must suit thebusiness. This means the system must be simple and it must lead to savings throughthe control of cost, i.e., materials, labour and overheads.

For the successful functioning of the costing system, the following conditions areessential:

The duties and responsibilities of cost accountant must be clear.

There must be an efficient system of material control in business or industry.

A sound and well-designed method of wage payment must be set up in business orindustry.

Printed forms must be used for quick compilation of various types of cost reports.

The existence of sound basis for collection of overheads and a basis for itsapportionment to various production departments.




Notes


1.4.1 Designing a Cost Accounting System

The organization should consider the following factors while designing a Cost Accounting System:

A thorough understanding of – Organizational structure; manufacturing procedure(i.e. methods of production) and process; selling and distribution procedure; andtype of cost information required.

Selection of a suitable costing technique (Standard or actual, marginal or absorptionetc.)

Suitable Pricing method, for the material, to be issued to production.

Method suitable for booking labour cost on jobs.

A sound plan should be devised for the collection, allocation, apportionment andabsorption of overheads.

Deciding on ways of treating waste, scrap and idle time.

Designing of suitable forms to be used for collecting and dissemination of Cost

data/information. To consider the need to have budgetary control technique for the comparison of

actual performance with budgeted figures and variances being properly analyze toenable management to make correct decisions.

1.4.2 Installing a Cost Accounting System

The following main factors are to be considered before installing a cost accountingsystem:

1. Nature of Business: The nature of a business implies the duration of its existence,position in the industry or factory, the rate of growth and policy of management andthe like. The nature of business serves as the basis for designing the cost accountsin respect of simplicity, necessity and investment involved in installing costaccounting system.

2. Organisational Factors: The problem of installing cost accounting is somewhatdifficult in case of an existing business organisation when compared to newbusiness. However, the existing set up of the business organisation should be leastdisturbed should the need arise. In order to fix up responsibility to the executives, itmay be necessary to group the departments. The organisational factors to beconsidered are: size and type of organisation, the levels of management, delegationand responsibility, centralisation and decentralisation, departmentalisation,availability of modern office equipments, and number of supervisory or managerialstaff.

3. Accounting Aspects: The factors to be considered in respect of accounting are:number of financial records, existing forms, registers used in business and number

of copies required in business activities.

4. Area of Control: The area where cost control is to be exercised is to be identifiedso that each manager may take action relevant to his business activities. If materialand labour control occupies significant area of control, it must be given topmostpriority for exercising control over materials and labour.

5. Product Price: The price or range of products manufactured and sold alsodetermines the method of costing to be selected. Accordingly price or range ofproducts must be analysed in terms of size, models, fashions, market area,competitors and whether the products are made to customer’s specification or forstocking and selling.

6. Reporting: The cost accounting system to be installed must ensure frequency andpromptitude in reporting cost data to the management. It must also to be pointedout that duplication of reporting is to be avoided. Further, only that information



Cost Accounting 7

Notes


which is relevant for the management in a particular context alone should bereported.

7. Selling and Distribution: The chief factors to be considered with regard todistribution process are the warehousing facilities, internal and external transport,market survey and other relevant measures, terms and conditions of sale and

procurement of orders from customers.8. Use of Electronic Data Processing: In modern time, it has become a common

practice to use electronic data processing equipments and computers. In thissituation, it is essential to ensure that the equipment meets the needs of the systembut not the other way round.

9. Technical Considerations: Technical considerations that influence the installationof cost accounts are size of factory, flow of production, existence of departmentsand laboratories, capacity of machines and equipments, cost control techniques,internal transport, etc.

10. Uniformity: The practice of adopting uniform costing facilitates interfirmcomparison among various firms belonging to the same industry of factory. Further,it also has the benefit of adopting common costing practice if a holding company

has number of subsidiaries.

Steps involved in the Installation of Cost Accounting System

1. Understanding of the process flow: In any type of organisation whether it ismanufacturing or service, understanding of product or service process flow will beimportant to install the costing system, this process involves study the entire flow ofthe product or process from input stage to output stage of the product or service.This starts from the order receiving from the customer and how the same will beprocessed inside the organisation, what and all activities involved in the processand how it will be delivered to the customer. Understanding of process flow firststeps to install the costing system in any organization

2. Understanding of the costing methods: each industry has got different costing

methods involving in the operations. Costing methods are process costing, jobcosting, batch costing, service costing, contract costing, etc. Manufacturingindustries mostly apply process costing, job & batch costing system. Service costingand contract costing will apply for the service industries. So to study andunderstand the applicable method of costing is the next step to install the costingsystem.

3. Identifying the cost of an each activity: Based on the study of process flow asmentioned in the point no.1, we need to examine and identify the cost of on eachactivity, this method also called Activity Based Costing system (ABC). Each andevery activity need to be linked with the output product and service and also need tobe examined the value addition of that activity to the end product and process. It willhelp to install the costing system effectively towards help to control the cost.

4. Understanding of the prime cost structure: In any costing system we can havethe prime cost which directly related to the activity of the operations. Prime costwhich includes the Material, labour and other direct expenses which related to themanufacturing or operations. This is very basic understanding to install any costingsystem.

5. Understanding the nature of cost & over head cost behavior: After identifiedthe cost of activities and prime cost structure, we need to examine and understandthe nature of cost like fixed cost, variable cost, semi-fixed or semi-variable. Eachcost has different nature with its related activity, nature purely based on the activityrelated. Based on this cost can be categorized as variable, fixed or semi-fixed orsemi-variable. So carefully examine the activities and decide the nature of cost.This is very important step for further all the costing and management relatedanalysis about the cost and profitability of the product or service.




Notes


6. Setting of proper allocation and apportionment methods: All the costs may notbe possible to identify the specific activity. Some of the cost we unable to identify tothe specific sector, like shared services department cost we unable to identify thespecific activity, so while setting costing system we need to decide the correct costallocation and apportionment method in the organistion.

7. Creating cost awareness: Costing is not only the function of cost department,costing is the collective function of all the departments. Also costing system not onlyfor identify the cost of the product or process it also covers the cost control and costoptimization, so only costing team will not do this job, all the department shouldinvolve this process, example the cost of designing of the product should aware thedesigning team then only the cost control or optimization can be done, soinstallation of costing system should create the cost awareness to all in theorganisation.

Difficulties at the time of installation of cost accounting system

1. Resistance by existing accounting staff: Very often the existing accounting staffresists the installation of the cost accounting system on two grounds. Firstly, theyfeel that the new system of accounting might lead to excess work. Secondly, they

are afraid of their job security. But this difficulty may be overcome by encouragingthem about the usefulness of cost accounting as a supplement to financial accountsand the generation of more employment opportunities from the installation of costaccounting system.

2. Non-cooperation from middle and bottom level management: At times themiddle and bottom level managers such as foremen, supervisors and inspectorsalso fail to extend their wholehearted cooperation fearing additional work which maybe entrusted to them this problem may be overcome by suggesting them about thesimplicity of the system and the existence of a separate cost accounting departmentto look after costing matters. However, they may be required to provide necessaryreports concerning their area of activity so as to enable functioning of costaccounting department efficiently.

3. Lack of support from management: Wherever costing system is installed, it isessential to seek the support of various departmental managers. Very often themanagers show hostile attitude towards the costing system. They feel that thissystem will interfere in their routine work and probably as a means of checking theirefficiency. Under such circumstances it is better to convince them about the utility ofcosting system for the business as a whole.

4. Heavy expenses in installing and maintaining the system: The setting up of aseparate costing department with staff often poses a problem. In addition toinstallation, the operating expenses in the form of printing and stationery, heatingand lighting, depreciation and insurance, rent and rates are to be incurred.However, as was mentioned earlier, the system of cost accounting must be a usefulinvestment, i.e., benefits derived from it must be more than the investment made onit. If this is not possible, for the time being the system must be discarded.

5. Lack of trained staff: This was no doubt a problem in olden days. Today thisproblem is overcome, thanks to the establishment of the institute of cost and worksaccountant of India in our country which offers professional course in costing andalso offers training facilities through various companies to the candidatesundergoing the course. In spite of this facility, it is somewhat difficult to get thecompetent and experienced staff at the time of installation. This problem can beovercome by paying attractive salaries to the cost accountants.

Measures to overcome difficulties

1. Simplicity: Cost accounting system involves detailed analysis of cost to avoidcomplications in the procedure of cost ascertainment an elaborate system ofcosting should be avoided and every care must be taken to keep it as simple as

possible.



Cost Accounting 9

Notes


2. Comparability: The records to be maintained must facilitate comparison over aperiod of time. The past records must serve as a basis to guide the future.

3. Reconciliation with financial accounts: The system of cost accounts must becapable of reconciling with financial accounts so as to check accuracy of both thesystem of accounts.

4. Accuracy: The system of cost accounting must provide for accuracy in terms ofboth cost ascertainment and presentation. Otherwise it will prove to be misleading.

1.5 Cost Concepts

This section will help you understand the cost unit, cost centers, classification of costand different elements of cost.

1.5.1 Cost Unit

Cost unit is defined by the ICMA as “a quantitative unit of product or service in relationto which costs are ascertained”. A cost unit is a device used for the purpose of splittingtotal cost into smaller sub-divisions attributable to products or service. A cost unit simply

stated is a unit of finished product, service of these in relation to which cost isascertained and expressed. The following are some of the examples of cost unitsselected from different industries or organisation:

Table 1.1 Cost Units selected from Different Industries

Name of the Industry or Organisation Product Cost Unit

Brick Industry Bricks Per 1,000 bricks

Power Industry Electricity Per kilo-watt hour

Cement Industry Cement Per tonne

Pharmaceutical Industry Tablets Per 1,000 tablets

Sugar Industry Sugar Per tonne

Furniture Industry Table Per tableHardware Industry Bolts and nuts Per 1,000 pieces

Cotton Textile Industry Yarn Per Kg

Construction Company House Per contract

Transport Companies Service Per passenger mile

Hospital Service Per bed-day

Canteen Service Per meal

1.5.2 Cost Centre

A cost centre refers to a part of a factory for which costs are accumulated separately. In

order to facilitate charging of costs to cost units, it is necessary to divide the factory orindustry into various parts which can be used to accumulate costs for subsequentdistribution. Each such part of a factory or industry is known as cost centre. This alsofacilitates fixation of responsibility for every officer-in-charge of part of department orsection. Hence cost centre is also known as responsibility centre. Cost centre has beendefined by ICMA as “a location, person or item of equipment or group of these inrespect of which costs may be ascertained and related to cost units”.

Kinds of Cost Centre

The main kinds of cost centre are given below:

1. Operation and process cost centre,

2. Production and service cost centre, and

3. Personal and impersonal cost centre.




Notes


These kinds of cost centre have been shown in the figure given as:

Cost Centres

Operation and processcost centre

Production and servicecost centre

Personal and impersonalcost centre

Figure 1.1: Cost Centers

(i) Operation and Process Cost Centre: Operation cost centre consist of thosemachines which carry out the same operation.

A process cost centre is a cost centre in which a specific process or a continuousprocess of operation is carried out.

(ii) Production and Service Cost Centre: A production cost centre is one whereactual production process is carried out. The manufacturing and non-manufacturingcosts are charged to production cost centre.

A service cost centre is one which provides services to other cost centre. Only non-manufacturing costs are charged to service cost centre.

(iii) Personal and Impersonal Cost Centre: Personal cost centre consists of a personor group of persons. Personal cost centre follows the organisational structure of afactory or organisation. Under this type of cost centre, costs are analysed andaccumulated according to; say, factory manager, sales manager, store keeper, etc.

Impersonal cost centre consists of a location of equipment. A cost centre relating tolocation may represent an area of sales, warehouse. Cost centre relating to an item ofequipment could be a machine or group of machines.

Whatever may be the kinds of cost centre, it is determined by taking intoconsideration the following factors:

Responsibilities and accountabilities to be identified,

Volume of work to be performed,

Uses of cost centres, and

Cost control activities exercised.

1.5.3 Classification of Cost

Classification is the process of grouping like facts under a common designation on thebasis of similarities of nature, scope, attributes or relations. The National Association of Accountants Committee defines classification as “the identification of each item and thesystematic placement of like items together according to their common features. Itemsgrouped together under common heads are further defined according to theirfundamental differences”.

Methods of Cost Classification

Cost classification is the process of grouping costs according to their common featuresor characteristics. Classification of cost is necessary for detailed recording and accuratecost ascertainment. There are a number of basis for classification of costs. However,the selection and use of a particular base or method for classification of costs dependsupon a number of factors including the purpose or objective of classification. Theimportant bases are element, nature, function, behaviour, identifiability, controllability,normality, time, relevancy, etc.



Cost Accounting 11

Notes


The costs are classified on the basis of large number of methods. Following are themain methods or basis of classification of cost:

On the Basis of Elements of Cost,

On the Basis of Nature and Variability,

On the Basis of Function,

On the Basis of Normality,

On the Basis of Controllability,

On the Basis of Time and Period, and

On the Basis of Decision-making.

The detailed discussion of classification of cost is as follows:

Methods of Cost Classification

On the basisof elements of

cost

On the basis ofnature andvariability

On the basis offunction

On thebasis of

normality

On thebasis ofcontrol-ability

On the basisof time and

period

On the basisof decision-

making

Material cost

Labour cost

Expenses

Overheads

Production orManufacturing cost

Administrative cost

Selling and distribution cost

Finance cost

Research and development cost

Controllable cost

Non-controllable cost

Opportunitycost

Replacementcost

Marginal cost

Conversioncost

Fixed cost

Semi-variablecost

Variable cost

Normal cost

Abnormalcost

Historical cost

Product cost

Period cost

Predeterminedcost

Figure 1.2: Classification of Cost

(i) On the Basis of Elements of Cost: On the basis of element, costs can beclassified into the following:

(a) Material cost: Materials cost may be either direct material cost or indirectmaterial cost. The terminology of ICMA defines direct material cost as “the costof materials entering into and becoming constituent element of a product”.Examples of direct materials are cotton, in cotton textiles, timber in furnituremaking industries, etc. Indirect material cost means “materials cost other thandirect material cost”. Examples of indirect materials are consumable storessuch as oil, cotton waste, etc.

(b) Labour cost: Labour cost may relate to direct labour cost and indirect labourcost. Direct labour cost as “the cost of remuneration or wages for employees’efforts and skills applied directly to a product or service”. Examples of directlabour are wages to inspectors and analysts, supervision charges, labourengaged in maintenance, tool setting, transportation of materials, etc. Indirectlabour or wages cost has been defined as “indirect labour cost or wage cost

other than direct labour cost or wages cost”. Examples of indirect labour arelabour of watchman, time keepers, office staff, trainees, etc.




Notes


(c) Expenses: Expenses may relate to direct or indirect expense. Direct expensesdefine as “costs other than materials or wages which are incurred for a specificproduct or service”. Examples of direct expenses are royalty, excise duty,experimental charges, etc. Indirect expense has been defined by theterminology as “expenses other than direct expense”. Examples of indirectexpenses are labour welfare expenses, rent, rates, insurance, lighting,depreciation of factory, office and administrative division, selling and distributiondivision, etc.

(d) Overheads: The terminology defines overheads as “the total cost of indirectmaterials, wages and expenses”. There are five types of overheads, which areas follows: factory overheads, office and administrative overheads, sellingoverheads, distribution overheads, research and development overheads.

(ii) On the Basis of Nature and Variability: On the basis of nature and variability,costs are classified into three types, e.g., fixed cost, semi-variable cost and variablecost.

(a) Fixed cost: A cost that does not vary at all with volume is called fixed cost.Overtime, the level of a fixed cost may change, but the change is independent

of the volume of activity. Building rent is usually a fixed cost. The rent paid isindependent of the number of units of product or service produced in thebuilding or the number of customers served. Fixed costs can be often bechanged by management decisions, but they do not change simply because thevolume of activity changes. Other examples of fixed cost are salaries of theoffice staff, salary to manager, factory rent, insurance of building, plant andmachinery, etc. Fixed expenses are not considered while calculating marginalcosting. This is shown in figure 1.3

Fixed Cost

Y

5

4

3

2

1

0

1 3 5 7 9

X

C o s t i n R s .

Output in Units

Figure 1.3: Fixed Cost

(b) Semi-variable cost: Many costs include a combination of fixed cost and variablecost. The total amount of these costs varies in the same direction as volume, asbut less than proportionately with changes in volume. The terminology definessemi-variable cost as “a cost containing both fixed and variable elements, whichis, therefore, partly affected by fluctuations in the volume of output or turnover”.Examples of semi-variable costs are telephone expenses (as telephone rent isfixed and calls charges are variable) depreciation (for efflux of time is fixed, forwear and tear it is variable), supervision, maintenance and repairs,compensation for accidents, light and power expenses, etc. This is shown inFigure 1.4



Cost Accounting 13

Notes


Semi-variable Cost

Y

5

4

3

2

1

0

1 3 5 7 9

X

C o s t i n R s .

Volume of Production in Units

Figure 1.4: Semi Variable Cost

(c) Variable cost: A cost which changes in strict proportionality with volume iscalled variable costs, i.e., if volume increases by 60% as well. Raw materials

used to create a product are a common example of a variable cost item. Thetotal cost of materials to manufacture 20 units is double the cost to manufacture10 units. Examples of variable cost are material, depreciation and repairs ofmachines, salesmen commission, fuel and packing expenses, etc. This isshown in Figure 1.5

Variable Cost

Y

25

20

15

10

5

0

1

X

C o s

t i n R s .

Volume of Production in Units

3 5 7 9 11

Figure 1.5: Variable Cost

(iii) On the Basis of Function: According to this basis, costs are classified into asfollowing:

(a) Production or manufacturing cost: Production or manufacturing costs refer tothose costs incurred in fabricating and assembling units of products. Examplesof production or manufacturing costs are material cost, labour cost and indirectexpenses of factory.

(b) Administrative cost: These are indirect costs and cover all expenditure incurredin formulating the policy, directing the organisation and controlling theoperations of a concern, which is not related to research, development,production, distribution and selling functions. These include indirect materialscost, indirect labour cost and indirect expenses connected with the office andgeneral administration.

(c) Selling and distribution cost: Selling cost is the cost of seeking to create and

stimulate demand, e.g., advertisement, market research etc. Distribution cost isthe expenditure incurred which begins with making the package produced




Notes


available for dispatch and ends with making the reconditioned packagesavailable for reuse e.g., warehousing, cartage etc. It includes expenditureincurred in transporting articles to local storage. Expenditure incurred in movingarticles to and from prospective customers as in the case of goods on sale orreturn basis is also distribution cost.

(d) Finance cost: Finance costs are those costs associated with using externalsources of funds of the organisation to finance.

(e) Research and development cost: The research cost is defined as a “the cost ofseeking new or improved products, applications of materials or methods”.Development cost has been defined as the cost of the process which beginswith the implementation of the decision to produce a new or improved methodand ends with the commencement of formal production of that product.

(iv) On the Basis of Normality: According to on the basis of normality, costs areclassified into following two types:

(a) Normal cost: Normal cost is defined as a “cost which is normally incurred at agiven level of output in the condition in which that level of output is normally”.This cost is a part of cost of production.

(b) Abnormal cost: It is defined as a “cost which is not normally incurred at a givenlevel of output in the conditions in which that level of output is abnormally”.Such cost is over and above the normal cost and is not treated as a part of thecost of production. Abnormal cost is charged to costing profit and loss account.

(v) On the Basis of Controllability: On this basis cost is classified into controllablecost and non-controllable cost.

(a) Controllable cost: Controllable cost is defined as a “cost chargeable to a costcentre, which can be influenced by the actions of the person in whom control ofthe centre is vested”. Practically all variable costs are controllable costs. Forexample, cost of raw materials may be controlled by purchasing in largerquantities.

(b) Non-controllable cost: The ICMA terminology defines non-controllable cost as a“cost chargeable to a cost centre which cannot be influenced by the actions ofthe person in whom control of the centre is vested”. Practically all fixed costsand semi-variable costs are non-controllable cost. For example, it is verydifficult to control costs like factory rent, managerial salaries, light charges, etc.

(vi) On the Basis of Time and Period: On this basis of time and period, the costs areclassified into four types: historical cost, predetermined cost, product cost andperiod cost.

(a) Historical cost: This refers to costs which are incurred after the event takesplace. Historical costs are thus, nothing but actual costs. These costs are notavailable until after the completion of the manufacturing operations.

(b) Product cost: These are the costs which are directly associated with the

product. These costs provide no benefit until the product is sold. When theproducts are sold, the total product costs are recovered as an expense. Thisexpense is called the cost of goods sold. These consist of direct materials,direct labour and some of the factory overheads.

(c) Period cost: Period costs are those costs that can be associated with aparticular accounting period rather than with the products delivered to thecustomers. Such costs are incurred for a time period and are charged to profitand loss account of the particular period. For example, salary to companyexecutives, showroom rent, travels expenses, etc.

(d) Predetermined cost: This refers to a cost which is computed in advance ofproduction on the basis of a specification of all the factors affecting cost.Predetermined costs are costs which are set up from analysis and forecast

made before the event and represent not what has happened but what isexpected to happen. Predetermined costs take a number of forms such as



Cost Accounting 15

Notes


budgeted cost, estimated cost, standard cost, etc. These costs are extensivelyused for the purpose of planning and control.

(vii) On the Basis of Decision-making: The following costs are classified on the basisof decision-making:

(a) Opportunity cost: Opportunity cost is “the value of benefit sacrificed in favour of

an alternative course of action”. Edwards Hermanson and Salmonson define itas “the benefit lost by rejecting the best competing alternatives to the onechosen”. The benefit lost is usually the net earnings or profit that might haveearned from the rejected alternative. Opportunity costs are not recorded in thebooks. It is a pure decision making cost and in comparing various alternativesto decide the best alternative. For example, ABC Company has deposited ` 5lakhs in a bank at 8 percent of interest rate. Now, it is considering a proposal toinvest this amount in debentures where the yield is 15% per annum. If the ABCCompany decides to invest in debentures, it will have to forego bank interest of ` 40,000 per annum, which is the opportunity cost.

(b) Replacement cost: It refers to the cost of replacing an asset at current marketvalue. For example, when the cost of replacing machinery is considered, it

means the cost of purchasing the machinery at the current market price and notat which it was purchased. For example, machinery purchased in the year 2000at ` 15,000 is discarded in the year 2008 and a new machinery of the samecategory is purchased for ` 25,000. So, the replacement cost of the machineryis ` 25,000.

(c) Marginal cost: The terminology of ICMA defines marginal cost as “the variablecost of one unit of product, i.e., a cost which would be avoided if the unit wasnot produced or provided. In other words, marginal cost is the additional cost ofproducing one additional unit. Marginal cost is the same of variable cost.Marginal cost is also a very important analytical and decision-making tool in thehand of management.

(d) Conversion cost: This is the aggregate of direct labour cost and overheads.Such costs assume more importance where material value is negligible as inthe case of brick manufacturing industries. In other words, conversion cost isthe factory cost minus direct material cost. It is the total cost of “converting” araw material into finished goods.

1.5.4 Elements of Cost

The correct of interpretation of the term ‘cost’ may also be understood by havingknowledge about basic elements of cost. These elements have been shown in thefollowing figure:

Elements of Cost

Material Labour Expenses

Direct

Material

Indirect

Material

Direct Labour Indirect Labour Direct

Expenses

Indirect

Expenses

Overheads

Factory or Works

Overheads

Office and Administrative

Overheads

Selling

Overheads

Distribution Overheads

Figure 1.6: Elements of Cost




Notes


The following is the brief description of these elements of cost:

(i) Direct Material: Direct material is material that can be directly identified with eachunit of the product. Direct material can be conveniently measured and directlycharged to the product. For example, raw cotton in textile manufactures, sugarcanein sugar industry and leather for shoe-making industry. The cost of direct material

includes the following: All type of raw materials issued from the store,

Raw materials specifically purchased for the specific job or project,

Raw materials transferred from one cost centre to another cost centre.

Primary packing material, like cartons, cardboard boxes etc.

(ii) Indirect Material: They are those materials which do not normally form a part of thefinished product. It has been defined as “materials which cannot be allocated butwhich can be apportioned to or absorbed by cost centres or cost units”. These are:

Stores used in maintenance of machinery, buildings etc., like lubricants, cottonwaste, bricks and cements.

Stores used by the service departments i.e., non-productive departments likePower house, Boiler house and Canteen etc.

Materials which due to their cost being small, are not considered worth while tobe treated as direct materials.

(iii) Direct Labour: Direct labour is labour that can be identified directly with a unit offinished product. All the labour charges expended in altering the construction,composition, confirmation or condition of the product is included in it. It includes thepayment of direct wages made to the following groups of direct labour :

Direct labour engaged on the actual production of the product.

Direct labour engaged in adding this manufacture by way of supervision,maintenance and tool setting, etc.

Inspectors, analysts, etc. specially required for such production.

(iv) Indirect Labour: The wages of that labour which cannot be allocated but which canbe apportioned to or absorbed by, cost centres or cost units is known as indirectlabour. In other words, wages paid to labour which are employed other than orproduction constitute indirect labour costs. Examples of indirect labour are: chargehands and supervisors, maintenance workers, labour employed in servicedepartments, material handling and internal transport, apprentices, trainees andinstructors, factory clerical staff and labour employed in time and security office etc.

(v) Direct or Chargeable Expenses: They include all expenditures other than directmaterial and direct labour that are specifically incurred for a particular product or job. Such expenses are charged directly to the particular cost account concerned aspart of the prime cost. Examples of direct expenses are: excise duty, royalty,surveyor’s fees, cost of rectifying defective work, travelling expenses to the job,experimental expenses of projects, expenses of designing or drawings, repairs andmaintenance of plant obtained on hire and hire of special equipment obtained for acontract.

(vi) Indirect Expenses: Indirect expenses are expenses which can not be allocated butwhich can be apportioned to or absorbed by cost centres or cost units as rent,insurance, municipal taxes, salary of manager, canteen and welfare expenses,power and fuel, cost of training for new employees, lighting and heating, telephoneexpenses, etc.

(vii) Overheads: Overheads may be defined as the cost of indirect materials, indirectlabour and such other expenses including services as cannot conveniently becharged direct to specific cost units. Thus, overheads are all expenses other thandirect expenses. Overheads may be divided into following categories:



Cost Accounting 17

Notes


(a) Factory or works overheads cover all indirect expenditure incurred by theundertaking from the receipt of the order until its completion is ready fordispatch either to the customer or to the finished goods store. The overheadsalso include: depreciation on plant and machinery, buildings and equipments,insurance charges on fixed assets, repairs and maintenance of fixed assets,electricity charges, coal and other fuel charges, rent, rates and taxes of works,etc.

(b) Office and administrative overhead consists of all expenses incurred in thedirection, control and administration of a factory. Examples are the expenses inrunning the general office e.g., office rent, light, heat, salaries, salary tosecretaries and accountants, general managers, directors, executives,investigations and experiments and miscellaneous fixed charges.

(c) Selling overheads comprise the cost of products or distributors of soliciting andrecurring orders for the articles of commodities dealt in and of efforts to find andretain customers. It includes sales office expenses, salesmen’s salaries andcommission, showroom expenses, advertisement charges, fancy packing,samples and free gifts, after sales service expenses and demonstration andtechnical advice to potential customers.

(d) Distribution overheads comprise all expenditure incurred from the time theproduct is completed in the work until it reaches its destination. It includeswarehouse rent, warehouse staff salaries, insurance, expenses on deliveryvans and trucks, expenses on special packing for bulk transport, losses inwarehouse stocks and finished goods damaged in transit and cost of repairing,etc.

1.6 Cost Sheet

Cost sheet is a document that provides for the assembly of an estimated detailed costin respect of cost centers and cost units. It analyzes and classifies in a tabular form theexpenses on different items for a particular period. Additional columns may also be

provided to show the cost of a particular unit pertaining to each item of expenditure andthe total per unit cost.

Cost sheet may be prepared on the basis of actual data (historical cost sheet) or onthe basis of estimated data (estimated cost sheet), depending on the techniqueemployed and the purpose to be achieved.

Cost sheet serves the following purposes:

It discloses various elements of cost,

It discloses the per unit cost as well as total cost of production,

It facilitates preparation of tender price, and

It facilitates comparison of total cost.

Specimen of cost sheet or cost statement on the basis of the nature of the question,is given as under:

Cost Sheet or Cost StatementCost Sheet for the period of ..............

Output : ……….. Units

Particulars Amount

( )

Cost ofper unit

( )

Direct Material Cost :

Opening stock of raw materials during the year xxx

Add : Purchases of raw materials during the year xxx

Add: Carriage inwards xxx




Notes


xxx

Less : Closing stock of raw materials xxx

Cost of raw materials consumed xxx xxx

Direct labour xxx xxx

Direct expenses xxx xxx

Prime Cost xxx xxx

Factory Overheads : xxx

xxx

xxx xxx xxx

xxx xxx

Add: Opening stock of work-in-progress xxx

xxx

Less: Closing stock of work-in-progress xxx

Factory or Works Cost xxx xxx

Office and Administrative Overheads : xxx

xxx

xxx xxx xxx

Office Cost or Cost of Production xxx xxx

Add: Opening stock of finished goods xxx

xxx

Less : Closing stock of finished goods xxx

Cost of Goods Sold xxx xxx

Selling and Distribution Overheads : xxx

xxx

xxx xxx xxx

Total Cost or Cost of Sales xxx xxx

Add : Profit xxx xxx

Sales or Selling Price xxx xxx

Problem 1: Calculate the prime cost, factory cost, cost of production, cost of sales andprofit from the following particulars.

Direct Materials 2,00,000 Office stationery 1000

Direct wages 50,000 Telephone charges 250

Direct expenses 10,000 Postage and telegrams 500

Wages of foreman 5,000 Salesmen’s salaries 2500

Electric power 1,000 Travelling expenses 1,000

Lighting: Factory 3,000 Repairs and renewal Plant 7,000Office 1,000 Office premises 1,000

Storekeeper’s wages 2,000 Carriage outward 750

Oil and water 10,00 Transfer to reserves 1,000

Rent: Factory 10,000 Discount on shares written off 1000

Office 5,000 Advertising 2,500

Depreciation: Plant 1000 Warehouse charges 1000

Office 2,500 Sales 3,79,000

Consumable store 5,000 Income tax 20,000

Managers’ salary 10,000 Dividend 4,000

Directors’ fees 2,500



Cost Accounting 19

Notes


Solution:

Cost statement/Cost Sheet

Particulars

Direct materials 2,00,000

Direct wages 50,000

Direct expenses 10,000

PRIME COST 2,60,000

Factory Overheads:

Wages of foreman 5,000

Electric power 1,000

Lighting: Factory 3,000

Storekeeper’s wages 2,000

Oil and water 1000

Rent: Factory 10,000

Depreciation plant 1000

Consumable store 5,000

Repairs and renewal plant 7,000

35,000

FACTORY COST 2,95,000

Administration overheads

Rent: office 5,000

Depreciation office 2,500

Managers’ salary 10,000

Directors’ fees 2,500

Office stationery 1000

Telephone charges 250

Postage and telegrams 500

Office premises 1,000

Lighting Office 1,000

23,750

COST OF PRODUCTION 3,18,750

Selling and distribution overheads

Carriage outward 750

Sales mens’ salaries 2500

Travelling expenses 1,000

Advertising 2500

Warehouse charges 1000

7,750

COST OF SALES 3,26,500

PROFIT 52,500

Sales 3,79,000




Notes


Problem 2: Following information has been obtained from the records of left centercorporation for the period from June 1 to June 30, 2008.

Cost of raw materials on June 1,2008 30,000

Purchase of raw materials during the month 4,50,000

Wages paid 2,30,000Factory overheads 92,000

Cost of work in progress on June 1, 2008 12,000

Cost of raw materials on June 30, 2008 15,000

Cost of stock of finished goods on June 1, 2008 60,000

Cost of stock of finished goods on June 30, 2008 55,000

Selling and distribution overheads 20,000

Sales 9,00,000

Administration overheads 30,000

Prepare a statement of cost.

Solution:

Statement of cost of production of goods manufactured for the period ending onJune 30, 2008.

Opening stock of raw materials

Add: Purchase

Less: Closing stock of raw material

Value of raw materials consumed

Wages

Prime costFactory overheads

Add: Opening stock of work in progress

Less: Closing stock of work in progress

Factory cost

Add: Administration overhead

Cost of production of goods manufactured

Add: Opening stock of finished goods

Less: Closing stock of finished goods

Cost of production of goods sold

Add: Selling and distribution overheads

Cost of sales

Profit

Sales

30,000

4,50,000

4,80,000

15,000

4,65,000

2,30,000

6,95,00092,000

7,87,000

12,000

7,99,000

---

7,99,000

30,000

8,29,000

60,000

8,89,000

55,000

8,34,000

20,000

8,54,000

46,000

9,00,000



Cost Accounting 21

Notes


Problem 3: From the following information, prepare a cost sheet showing the total costper ton for the period ended on December 31, 2008.

Raw materialsProductive wagesDirect expensesUnproductive wagesFactory rent and taxesFactory lightingFactory heatingMotive power HaulageDirector’s fees (works)Directors fees (office)Factory cleaningSundry office expensesExpensesFactory stationeryOffice stationeryLoose tools written off

33,00035,000

3,00010,500

2,2001,5004,4003,0001,0002,000

500200800750900600

Rent and taxes (office)Water supplyFactory insuranceOffice insuranceLegal expensesRent of warehouseDepreciation--Plant and machineryOffice buildingDelivery vansBad debt

AdvertisingSales department salariesUp keeping of delivery vansBank chargesCommission on sales

5001,2001,100

500400300

2,0001,000

200100300

1,500700

501,500

The total output for the period has been 10000 tons.

Solution:

Cost sheet for the period ended on December 31, 2008

Raw materials 33,000

Production wages 35,000

Direct expenses 3,000

Prime cost 71,000

Add: Works overheads:

Unproductive wages 10,500

Factory rent and taxes 7,500

Factory lighting 2,200

Factory heating 1,500

Motive power 4,400

Haulage 300

Directors’ fees (works) 100

Factory cleaning 500

Estimating expenses 800

Factory stationery 750

Loses tools written off 600

Water supply 1,200

Factory insurance 1,100

Depreciation of plant and machinery 200 37.050

Works cost 1,08,050

Add: Office overhead

Directors’ fees (office) 2000

Sundry office expenses 200

Office stationery 900

Rent and taxes (office) 500

Office insurance 500




Notes


Legal expenses 400

Depreciation of office building 1000

Bank charges 50 5,550

Office cost 1,13,600

Add: Selling and distribution overheadsRent of warehouse 300

Depreciation on delivery vans 200

Bad debts 100

Advertising 300

Sales department salaries 1,500

Commission on sales 1,500

Upkeep of delivery vans 700 4,600

Total cost 1,18,200

Cost per ton ` 1,18,200/10,000 = ` 11.82

Problem 4: From the following information extracted from the records of the M/sSundaram &Co.

The stock position of the firm is:

Particulars 1-4-1994 ( ) 31-3-1995 ( )

Stock of raw materials 80,000 1,00,000

Stock of finished goods 2,00,000 3,00,000

Stock of work in progress 20,000 28,000

Particulars Particulars

Indirect labour 1,00,000 Administrative expenses 2,00,000Oil 20,000 Electricity 60,000

Insurance on fixtures 6,000 Direct labour 6,00,000

Purchase of rawmaterials

8,00,000 Depreciation onMachinery

1,00,000

Sale commission 1,20,000 Factory rent 1,20,000

Salaries of salesmen 2,00,000 Property tax on building 22,000

Carriage outward 40,000 Sales 24,00,000

Prepare cost statement of M/s Sundaram & Co.

Solution:

Cost Sheet

Particulars

Opening stock of raw materials on 1st April,1994 80,000

(+)Purchase of raw materials 8,00,000

(-)Closing stock of raw materials on 31st Jan 1,00,000

Raw materials consumed during the year 7,80,000

(+)Direct labour 6,00,000

Prime Cost 13,80,000

Factory overheads:

Indirect labour 1,00,000Oil 20,000



Cost Accounting 23

Notes


Insurance on fixtures 6,000

Electricity 60,000

Depreciation on machinery 1,00,000

Factory rent 1,20,000

Property tax on factory building 22,000 4,28,000

(+)Opening stock of semi-finished goods 20,000

(-)Closing stock of semi-finished goods 28,000

Factory Cost 18,00,000

(+)Administration overheads 2,00,000

Cost of Production 20,00,000

(+)Opening stock of finished goods 2,00,000

(-)Closing stock of finished goods 3,00,000

Cost of goods sold 19,00,000

Selling overheads:Sales commission 1,20,000

Salaries of salesmen 2,00,000

Carriage outward 40,000

Cost of sales 22,60,000

Profit margin 1,40,000

Sales 24,00,000

Note: Property tax on the plant is to be included under the factory overheads. Thetax is paid by the firm on the plant which is engaged in the production process.

Problem 5: Prepare the cost sheet to show the total cost of production and cost per unit

of goods manufactured by a company for the month of January, 2005. Also find the costof sale and profit.


Stock of rawmaterials1.1.2005

6,000 Factory rent and rates 6,000

Raw materials procured 56,000 Office rent 1,000

Stock of raw material31.1.2005

9,000 General expenses 800

Direct wages 14,000 Discount on sales 600

Plant depreciation 3,000 Advertisement expenses 1,200

Loss on the sale of plant 600 Income tax paid 2000

Sales ` 1,00,000

Solution:

The number of units produced during January 2005 was 6,000.

The stock of finished goods was 400 and 800 units on 1st January, 2005 and 31stJanuary, 2005 respectively. The total cost of the units on hand on 1st January 2005 is ` 5,600. All these had been sold during the month.

The first and foremost step is to find out the cost per unit i.e. cost of production perunit. The opening stock and their values are given, but at the same time the value of theclosing stock is ascertained by ` 3.




Notes


Particulars Units

Stock of Raw materials 1.1.2005 6,000

(+)Raw materials procured 56,000

(-)Closing stock of raw material 9,000

Materials consumed 53,000Direct wages 14,000

Prime cost 67,000

Factory overheads:

Depreciation on plant 3,000

Factory rent and rates 6,000

Factory cost 76,000

Office and Administration overheads:

Office rent 1,000

General expenses 4,800

Cost of production = ` 12.97 per unit 6,000 77,800

(+)Opening stock of finished goods 400 5,600

(-)closing stock of finished goods 800 10,376

Cost of goods sold 5600 73,024

Selling and distribution expenses

Advertisement expenses 1200

Cost of sales 74,224

Net profit 25,776

Sales 1,00,000

1.7 Tenders and Quotations

Generally, production cost is ascertained after the completion of production work. Butsometimes it becomes necessary to ascertain the production cost before commencingthe production work. For example, a contractor will have to estimate his contract costbefore commencing the contract work. Often, the manufacturer is required to quote theestimated price by adding some profit for getting the orders from customers. Suchestimated price is known as ‘Tender price or Quotation price’. Tender or quotation priceis a price at which the manufacturer is ready to supply his goods to the customers.Generally, this price is fixed after considering various factors such as (I) past costfigures (ii) variations in cost in the current period (iii) expected margin of profit and (iv)number of competitors in the field. Since the lowest tender price is accepted by theintending buyer, the manufacturer has to carefully consider all the above factors. Aslight difference in calculation of the tender price may result in losing the tender. Hence,

the following items are to be analysed while preparing the tender:1. Direct materials

2. Direct wages

3. Factory overheads

4. Administrative overheads

5. Selling and Distribution overheads

6. Expected Profit

An estimated cost is taken as the basis for fixing the tender price; it has to bedeveloped on the basis of present costs with due regard to likely changes in theensuing period to which they are to be applied. The general procedure of estimation

may be summarised as follows:



Cost Accounting 25

Notes


Direct materials: The cost of direct materials can be estimated by multiplying thequantity required for a unit of output by the probable purchase cost of materials.Purchase cost of materials will be estimated in the light of future changes in marketconditions.

Direct wages: It can be estimated on the basis of job requirements and anticipated

changes in wage rate.

Overheads: The amount of overheads is to be estimated on the basis of pastexperience as a percentage as given below:

(a) Percentage of works on cost on direct wages

×Works on Cost

100Direct Wages

(b) Percentage of office on cost on works cost

×Office on Cost

100Works Cost

(c) Percentage of selling and distribution overheads on works cost

×Selling and Distribution overheads

100Works cost

Alternatively the percentage can be calculated on cost of production:

×Selling and Distribution overheads

100Cost of Production

1.7.1 Estimation of profit for a tender or quotation

The tender price is determined after adding the amount of profit to total cost. Generally,instead of giving the amount of profit, the percentage of profit is given in the questions.On the basis of such percentage, the amount of profit is determined. The following twoconditions may be possible:

If the expected profit for a tender is given as a percentage of cost, it has to becomputed as under:

Profit = ×Percentage of Profit

Total cost100

If the expected profit is given as a percentage of selling price of the tender, it has tobe computed as under:

Profit =×Total cost Percentage of profit on sales

100- Percentage of profit on sales

Problem 6: The following figures relate to the costing of a Tarpaulin manufactured inrespect of a certain type of a sheet for a period of three months:

`

Stock of materials (1-1-2001) 11,000

Stock of materials (31-3-2001) 7,000

Productive wages 1,66,000

Materials purchased 1,23,000

Sales 2,87,100

Indirect expenses 26,000

Completed stock (1-1-2001) NILCompleted stock (3 1-3-2001) 58,000




Notes


The number of sheets manufactured during three months was 4,400 and the priceis to be quoted for 1,296 sheets in order to realise the same percentage of profit as forthe period under review, assuming no alteration in rates of wages and cost of materials.

Prepare a statement of cost for the manufacture of 4,400 sheets and quotation for1,296 sheets.

Solution

Statement of cost and profit for the three months ending 31-3-2001

(Output: 4400 sheets)

Particulars Total ( ) Per Sheet ( )

Opening Stock of Raw Materials 11,000

Add: Purchases of Materials 1,23,000

1,34,000

Less: Closing Stock of Raw Materials 7,000

Cost of Raw Material Consumed 1,27,000 28.86

Add: Productive Wages 1,66,000 37.73

Prime Cost 2,93,000 66.59

Add: Indirect Expenses 26,000 5.91

Cost of Production 3,19,000 72.50

Less: Closing Stock of Finished Goods

(58,000/72.50= 800 sheets)

58,000 -

Cost of Production of Goods Sold 2,61,000 72.50

Profit (Balancing Figure) 26,100 7.25

Sales

(4,400-800= 3,600)

2,87,100 79.75

Notes:

(i) Indirect Expenses are assumed to include all overheads

(ii) Profit percentage

On Sales = ×

26,100100

2,87,100 = 9.09%

Or On Cost = ×

26,100100

2,61,000= 10%

Statement showing quotations for 1,296 sheets

Particulars Total ( ) Per Unit ( )

Materials (1,27,000/4,400*1,296) 37,407 28.86

Productive wages ( 1,66,000/4,400*1,296) 48,895 37.73

Prime Cost 86,302 66.59

Add: Indirect Expenses (26,000/4,400*1,296) 7,658 5.91

Cost of Production or Cost of Sales 93,960 72.50

Add: Profit at 9.09% on sales or 10% on cost 9,396 7.25

Selling Price 1,03,356 79.75



Cost Accounting 27

Notes


1.8 Summary

Cost accounting is a branch of accounting and has been developed due to limitations offinancial accounting. The financial accounting is primarily concerned with recordkeeping directed towards the preparation of gross profit account, profit and loss accountand balance sheet. It provides information regarding the gross profit, profit and loss that

the business or enterprise is making and also its financial position on a particularperiod. The information concerning the business or enterprise is helpful to themanagement to control on business.

According to Weltemer and Blocker, cost accounting is to serve management in theexecution of various policies and in comparison of actual and estimated results in orderthat the value of each policy may be appraised and changed to meet the futureconditions. The cost accounting system depends upon the nature of business orindustry and the product. Before a suitable system of cost accounting is designed andinstalled it is necessary to undertake a preliminary investigation so as to know thefeasibility of designing and installing cost accounting system to such business activities.While introducing a system of cost accounting it should be borne in mind that costaccounting system must suit the business.

Classification of cost is necessary for detailed recording and accurate costascertainment. There are a number of basis for classification of costs. However, theselection and use of a particular base or method for classification of costs dependsupon a number of factors including the purpose or objective of classification. Theimportant bases are element, nature, function, behaviour, identifiability, controllability,normality, time, relevancy, etc. The different elements of cost are materials, labour andexpenses.

Often, the manufacturer is required to quote the estimated price by adding someprofit for getting the orders from customers. Such estimated price is known as ‘Tenderprice or Quotation price’. The tender price is determined after adding the amount ofprofit to total cost. Generally, instead of giving the amount of profit, the percentage ofprofit is given in the questions. On the basis of such percentage, the amount of profit isdetermined.


Multiple Choice Questions

1. Direct materials is

(a) Opening stock + Purchases

(b) Purchases + Closing stock

(c) Opening stock + Purchases – Closing stock

(d) Purchases – Closing stock

2. Salary paid to Supervisor is(a) Manufacturing overheads

(b) Administrative overheads

(c) Direct labour

(d) Selling & distribution overheads

3. Fixed cost is the cost under the classification of

(a) Variability

(b) Normality

(c) Controllability

(d) Functions




Notes


4. The cost classifications in the cost sheet is based on

(a) Functions

(b) Variability

(c) Controllability

(d) None of these5. Standard costing is brought under the classification of

(a) Controllability

(b) Functions

(c) Planning and control

(d) Both (a) & (c)

6. Marginal costing is classified on the basis of

(a) Variability

(b) Managerial decisions

(c) Time

(d) Both (a) & (b)

7. ` 10, 000 paid on every month to the owner of the factory site is

(a) Fixed cost

(b) Semi-variable cost

(c) Variable cost

(d) Semi-fixed cost

8. Electricity charges incurred by the firm is

(a) Fixed cost

(b) Semi-variable cost

(c) Variable cost

(d) None of the above

9. Labour engaged on the actual production of the product is

(a) Indirect Expense

(b) Direct Expense

(c) Direct Labour

(d) Indirect Labour

10. The estimated price for getting the orders from customers is :

(a) Cost Price

(b) Tender Price(c) Lock Price

(d) Contract Price


1. What is the relationship between financial accounting and cost accounting?

2. Discuss the applications of cost accounting.

3. Write short note on cost and cost accounting.

4. What factors need to be considered before installing a cost accounting system in anorganization?

5. What do you understand by cost center? Explain the different types of cost centres.6. Explain the different types of cost on the basis of variability.



Cost Accounting 29

Notes


7. Discuss the different elements of cost.

8. “A slight difference in calculation of the tender price may result in losing the tender”.Discuss.

1.11 Key Terms

Cost: Cost can be defined as the value attributed to a resource. There are threeresources of a cost, i.e. material, labour and services for a manufacturingorganisation.

Costing: Costing is the system of calculating the cost of production by allocatingexpenditures to different stages of production or operations of the firm.

Cost accounting: Cost accounting involves the application of costing principle,methods and techniques for ascertaining costs and their control by comparingactual costs with the budget or standard.

Cost unit: A cost unit is a device used for the purpose of splitting total cost intosmaller sub-divisions attributable to products or service.

Cost center: A cost center refers to a part of a factory for which costs are

accumulated separately. Cost sheet: Cost sheet is a document that provides for the assembly of an

estimated detailed cost in respect of cost centers and cost units.

Fixed Cost: It is cost, which do not vary irrespective level of an activity orproduction, Rent of the factory, salary to the manager and so on.

Variable Cost: It is a cost, which varies in along with the level of an activity orproduction.

Check Your Progress: Answers

1. (c) Opening stock + Purchases – Closing stock

2. (a) Manufacturing overheads

3. (a) Variability

4. (a) Functions

5. (c) Planning and control

6. (a) Controllability

7. (a) Fixed cost

8. (b) Semi-variable cost

9. (c) Direct Labour

10. (b) Tender Price


S.P. Gupta, Ajay Sharma, Dr.Satish Ahuja, Cost Accounting, VK Publications, 2011

J K Mitra, Advanced Cost Accounting, New Age International, 2009

Jawahar Lal, Seema Srivastava, Cost Accounting, McGraw-Hill Education, 2013

Rajasekaran V, Cost Accounting, Pearson Education India, 2010

M N Arora, Cost Accounting: Principles & Practice, Vikas Publishing House Pvt Ltd,2009




Notes


CASE STUDY: MHLUME SUGAR COMPANY LIMITED: A CASE STUDY INCOSTING & PRICING

hlume’s operation is set up in two basic parts. The estate operation is concernedwith cultivating and harvesting the sugar cane and transferring it to the mill; themill operation then takes the raw sugar cane and processes it into brown sugar.

(Making white sugar involve further processing which the Mhlume mill is not equipped todo at this time.)

The estate’s harvesting cycle begins roughly around 1 May each year and ends roughly inNovember or December. (The company’s fiscal year also coincides with its physicaloperations.) Harvesting the cane involves two basic steps. First, the standing fields ofsugarcane are burned. Burning removes the leaves from the standing cane and facilitatesthe harvesting process. Without the process of burning the fields, the cane would have tobe harvested with its leaves intact; the leaves would then have to be removed during themill process. Further, burning the fields heats up the sucrose inside the cane, making iteasier to work with. In addition, burning the fields drives away the native snakes, making itsafer for the workers to cut the cane. Eventually, environmental laws in Swaziland mayprohibit burning the fields prior to harvest; at that time, Mhlume and other sugarprocessing plants will have to revise their harvesting and milling procedures. After burningthe fields, the sugar cane is harvested. Migrant workers are engaged each year to cutdown the cane by hand. Workers are paid a fixed daily salary with the possibility of earningincentive pay for cutting more than their daily quota. Harvesting the cane is a very laborintensive process, making it well-suited to the Swazi economy, where labor resources areplentiful but machinery is not. The cut cane is transported to Mhlume’s mill. On arrival atthe mill, the cut cane is crushed to extract the liquid from its core. (The crushed cane canthen be burned, producing the byproduct bagasse, which is used to fuel the mill’smachinery.) The liquid is heated, causing the sucrose to fall to the bottom where it can becollected for further processing. At this point, the sucrose itself is dark and thick,resembling molasses (indeed, molasses is the other by product of the process). Chemicalsare added to the sucrose to cause crystallization into the brown sugar that is the mill’sprincipal product. With good soil, sugar cane is a perennial; that is, the cane will grow backevery year without replanting. However, because the Mhlume estates have poor soil, thecane must be replanted approximately every five years. A specially grown seed cane is

used to re-plant the fields on a rotating basis. Mhlume produces about one-third ofSwaziland’s total sugar output annually (the kingdom’s total annual sugar output is about450,000 tons). Approximately one third of the kingdom’s total output is used internally, withthe remaining two-thirds being sold on the world market.

Activity-based Costing Systems

Costs in most manufacturing operations can be divided into three categories: materialslabor, and overhead. Materials, sometimes referred to as direct materials, are the majorraw inputs that go into producing a product or service for sale. For example, Mhlume’smain raw material is sugar cane. Labor, sometimes referred to as direct labor, representsthe salaries/wages and related costs of employing the workers directly involved withphysical production. In Mhlume’s case, the wages paid to the workers who harvest thecane is an example of a direct labor cost. Through time-and-motion studies and relatedphysical measures of a firm’s overall operation, it is a relatively simple matter to link directmaterials and direct labor costs to the final product. The third category of cost, factoryoverhead, is more problematic. Factory overhead, sometimes referred to as factoryburden, comprises all the related costs of producing product or service. For example,Mhlume would incur the following overhead costs in it operation: equipment depreciation,processing chemicals, water, power for the factory, and supervisor salaries. Unlike directmaterials and direct labor costs, which can be linked to the product by direct attribution,overhead costs must be linked through a process of allocation. Naturally, that allocationmust be done in some consistent, rational, logical manner. Activity-based costing is oneway to allocate overhead to a product or service. Activity-based costing begins withestablishing cost pools. Cost pools are groups of related costs in a production operation.Some of the cost pools employed at Mhlume include: land preparation, fertilizing, weedcontrol, and irrigating. Costs are assigned to a cost pool on the basis of a common costdriver. In activity-based costing, a cost driver is anything which causes (drives) a cost inthe production operation. For example, in a typical company purchasing costs might be acost pool, with number of purchase orders processed being the cost driver. Once the cost

pools and cost drivers are established, accountants can determine the amount of costabsorbed by each unit of the cost driver. For example, if the total cost of a purchasing

M



Cost Accounting 31

Notes


department during a period was $10,000, and the department processed 5,000 purchaseorders, the cost per purchase order would be $2. To tie purchasing costs to the product orservice, then, accountants (working with production staff) must determine how manypurchase orders were processed to move a certain group of goods through the factory. Ifgiven lot of goods required five purchased orders, the accounting system would allocate inpurchasing costs to that order. A similar process would be performed for each cost pool,

thus building up the overhead costs associated with a given group of goods.Accounting Issues at Mhlume

Mhlume’s operation raises at least three accounting issues: (1) the application of activitybased costing, (2) product pricing and cost control, and (3) transfer pricing.

Activity-based Costing

In general, companies establish activity-based costing systems to gain a more accurateperception of their product’s cost. Knowing a product’s cost, naturally, is key to setting itsprice in the market. However, in Mhlume’s case, the motivation for establishing an ABCsystem was different. As previously noted, cultivating, harvesting and processing sugar isa labor-intensive operation. In other words, most of Mhlume’s costs are labor costs (Priorto the introduction of activity-based costing in the harvesting operation, all of Mhlume’sharvesting labor costs were aggregated in a single general ledger account. Thus,managers had a difficult time determining which parts of the cultivating operation were

more expensive and which were relatively less expensive. Mhlume introduced ABC to helpmanagers of the cultivating operation control their costs more effectively and efficiently.(Note, however, that activity-based costing has only been applied to cultivating the sugarcane. The harvesting and milling operations have not adopted ABC, nor have they askedfor it to be introduced.) For external accounting purposes, salaries and wages are stillreported as a single line item on the profit and loss statement. However, for internalaccounting purposes, salary and wage costs from cultivating the sugar cane are allocatedto one of several cost pools: land preparation, planting, post-harvest management,fertilizing, weed control, pest & disease control, ripening, irrigating, canal construction,drainage sub-surface, or drainage maintenance. Those cost pools are reported clearly onMhlume’s internal profit and loss statements, allowing managers to see clearly how muchcost was incurred in each area. Costs are allocated to the pools on the basis of laborhours.

Product Pricing and Cost Control

As mentioned previously, Mhlume introduced ABC to give managers better control overtheir costs. Cost control is critical in Mhlume’s operation, as they have very little controlover product pricing in their markets. Sugar is traded on the world commodity markets,much like soybeans and pork bellies. The world market, then, determines the price basedon supply and demand factors. Any individual company, therefore, cannot influence theworld price of sugar in any significant way. Mhlume operates in the Kingdom of Swaziland.Situated in south-eastern Africa, Swaziland is surrounded on three sides by South Africa; italso shares a border with Mozambique. As a developing nation, Swaziland receives aspecial concession when it sells sugar to external markets. Specifically, Swazi sugar issold on the world market at three times the established world price for sugar; that is, ifsugar is sold on the world market at $5 per ton, Swazi sugar is sold for $15 per ton. One ofthe main factors influencing the world price for sugar is its supply in the world market.Each sugar producing company in Swaziland receives a quota (allowance) for sugarproduction each year. For production up to the quota, Mhlume receives a fixed price. For

production over the quota, Mhlume receives a price which is always less than the “quota”price. The two types of revenue are reported separately on Mhlume’s internal profit andloss statement as “unsegregated” (amounts up to the quota) and “segregated” (amountsover the quota).

Transfer Pricing

Mhlume’s operation also raises some interesting transfer pricing issues. Basically, transferpricing is concerned with setting prices for purely internal transactions where market rulesand constraints do not apply. Transfer pricing was pioneered by the U.S. automobilemanufacturer General Motors when its divisions had to do business with one another.Normal laws of supply and demand do not apply to purely internal transactions, and muchhas been written about the options for establishing transfer prices and the consequencesof the various options. Mhlume confronts transfer pricing issues for two of its major inputs:sugar cane and water. Mhlume does not actually own most of the fields where its sugarcane is grown. Rather, the fields are owned by private individuals, who agree to sell alltheir output to Mhlume at a fixed price. In return, Mhlume assists the individual farmers




Notes


with crop maintenance. Since the farmers have no option but to sell their output toMhlume, and since Mhlume must buy all the farmers’ output, a transfer price must be setwhich satisfies both parties. In this particular case, the transfer pricing problem issomewhat alleviated by Mhlume’s participation in the cultivation and harvesting of thegrain. Water is one of the principal indirect materials used in processing sugar. All ofMhlume’s water comes from IYSIS, a firm which has many common shareholders with

Mhlume. Thus, IYSIS has a lot of control over the price Mhlume pays for water. With noexternal market forces governing the price, IYSIS could potentially raise the price of waterto an exorbitant level, creating severe cost control problems for Mhlume’s overalloperation. In this case, however, the strong relationship between the two firms alleviatesthe potential problem, and IYSIS basically passes on its direct costs to Mhlume in thetransfer price.

Questions

1. Which type of costing is best suited to resolve the accounting issues at Mhlume?

2. Analyse the activity based costing method adopted by the company.



Material Costing 33

Notes


Unit 2: Material Costing

Structure

2.1 Introduction

2.2 Classification of Materials

2.3 Purchasing Procedure

2.3.1 Purchase Procedure

2.4 Store Keeping

2.4.1 Objectives of Storekeeping

2.4.2 Functions of Storekeeping

2.4.3 Types of Stores

2.4.4 Working of the Stores

2.5 Material Control

2.5.1 Objectives of Material Control

2.5.2 Techniques of Material/ Inventory Control

2.6 Methods of Pricing Material Issues

2.6.1 Last-in-First-out Method (LIFO)

2.6.2 First-in-First-out Method (FIFO)

2.6.3 Weighted Average Method

2.6.4 Simple Average Method

2.7 Summary



2.10 Key Terms


Objectives

After studying this unit, you should be able to:

Discuss the classification of materials

Understand the material control

Explain the purchasing procedure

Discuss the store keeping

Explain the techniques of inventory control

Learn the setting of stock levels

Explain the concept of EOQ

Describe the methods of pricing materials issues




Notes


2.1 Introduction

Material is a very important factor of production in a manufacturing organization. It is thefirst and the most important element of cost. Materials account for nearly 50-60 per centof the cost of production. This fact can be inferred from an analysis of the financialstatements of a large number of organizations.

Uninterrupted supply of materials of acceptable quality and in required quantity asand when required by the production department is a pre-requisite for carrying outproduction activities uninterruptedly, because the non-availability of materials will bringthe entire production activities to a standstill. And, the implications of productionstoppage are very well known. Further, the cost of materials forms a major part of totalcost of production and sales as it ranges from 50-60% depending upon the nature ofindustries. Besides, this element of cost provides a number of avenues for cost controlsuch as at the time of purchase, during the process of manufacturing. Hence, greateremphasis is to be laid on the control of material and material cost as the success of anycompany depends, to a greater extent, upon the efficient purchase, storage and usageof materials.

In this unit, we shall study the classification of materials, materials control, andprocedure of purchasing. We will also discuss the store keeping, techniques ofinventory control and setting of stock levels. At the end of the unit, we will study aboutthe methods of pricing materials issues.

2.2 Classification of Materials

One of the important functions of the store-keeper in the stores department is theclassification and codification of materials. Classification refers to grouping of materialsinto three or four categories on the basis of material nature. And codification refers tothe procedure of assigning symbols to each item of material stored. Since the symbolsare shorter and simple and they are used in names of materials. There are a number ofmethods of codification of the materials. Following are main methods of codification of

materials:(i) Numerical Method,

(ii) Alphabetical Method, and

(iii) Decimal Method.

(i) Numerical Method: Under this method, materials are codified with the help of thenumber such as,

Material X : 101

Material Y : 102

Material Z : 103

(ii) Alphabetical Method: Under this method, each material will be allotted analphabet such as,

Plastic Material : X

Glassware : AB

Rubber Materials : KLM

(iii) Decimal Method: Decimal method is similar to numerical method. Under thismethod, decimal are used to codify the different types of materials.

Plastic Material X1 : 101.1





Material Costing 35

Notes


2.3 Purchasing Procedure

Material cost is a major portion of production cost. This material cost can significantly bereduced by acquiring the right quantity, of the right quality, for the right price, at the righttime, and from the right sources. Decision of the manager of purchase with respect toeach of these aspects will have a significant effect not only on the regularity in

production but also on both the quality of the end product and the cost of materials, costof production, cost of sales and therefore, on the profit and profitability. Hence,purchase function plays a pivotal role. In this regard, the top management of theorganization has to take an important decision.

2.3.1 Purchase Procedure

A systematic and well-defined procedure is to be followed to make the purchase ofmaterials as any lapse in the procedure may result in the stoppage of production whoseill-effects are incalculable. The purchasing department follows the following purchaseprocedure:

(i) Purchase Requisitions or Indenting for Materials,

(ii) Selection of Suppliers or Choosing the Suppliers,(iii) Purchase Order,

(iv) Receiving and Inspecting Materials,

(v) Verification/Checking and Passing of Bills for Payment.

(i) Purchase Requisitions: The purchase department initiates actions for thepurchase of materials only after the receipt of purchase requisitions from the store-keeper. The purchase requisitions are prepared by the officers who need thematerials for production and other activities of business and will be sent to thepurchase department for making purchases. Of the parties who prepare thepurchase requisitions, store-keeper is the important functionary. Further, heprepares the purchase requisitions on the basis of bills of materials received fromthe competent authorities. If the materials listed in the bill of materials are notavailable in the store in adequate quantity, the store-keeper will prepare thepurchase requisition.

On the basis of the stock levels and/or bills of materials, the store-keeper preparesthe purchase requisition in triplicate copies. The original copy is sent to thepurchase department, duplicate copy to the production control department and thethird copy to be retained in the stores department itself for its office record. Theformat of the purchase requisition is given below.

Kartik Company Limited

Purchase Requisition

No.: ………… Date: …………

S. No. Material Code No. Description of

Articles

Quantity

Required

Remarks

Requested by : …………. Checked by : …………… Approved by: ……………..




Notes


For Use by Purchase Department

Date Purchase OrderNumber

Name ofSupplier’s

Delivery Dateof Materials

Remarks (If any)

Signature of Purchase Manager/Officer

Figure 2.1: Format of a Purchase Requisition

The store-keeper must be very careful while preparing the purchase requisition.Because, any lapse on the part of the store-keeper may put the company into avery sizable loss.

(ii) Selection of Suppliers: Once the purchase department receives the purchaserequisition, it has to take necessary steps to purchase the required materials. Thefirst step in this regard is to decide about the supplier(s) to whom purchase ordermay be sent. For selection purpose, it has to examine its records about the previousperformances of suppliers who had supplied materials to the company and also thesuppliers who have been supplying the materials to the company. Further, it has toupdate the list of suppliers by collecting the information about the new suppliers. After that, the purchase department has to decide about whether the quotations areto be invited only from one source of supply, or from a very few selected sources ofsupply, or from all sources of supply through advertisement. On the receipt oftenders in sealed envelopes which will be opened and a comparative statement of

all the quotations will be prepared. This statement is called comparative statementof quotations. The specimen forms of comparative statement of quotations are asfollows:


Comparative Statement of Quotation

Material : ………………. Date : ……………….

Tender No. : ……………….

Serial

No.

Name of theSuppliers

Quantity Rate or

Price

Date ofDelivery

Termsof

Delivery

OtherTerms

Remarks

(If any)

Figure 2.2: Comparative Statement of Quotations

Usually, the purchase department selects the supplier who has quoted the lowestprice and if he satisfies the other conditions. If the purchase department wants todeviate from this method of selecting the lowest quoted supplier, supporting

reasons are to be given in the comparative statement of quotations.



Material Costing 37

Notes


(iii) Purchase Order: After choosing the supplier, the purchase department will preparethe purchase order to be placed with the supplier. The purchase order is in the formof an agreement with the suppliers which binds both the purchaser and supplier.Because, when the order is placed, the supplier is bound to supply the necessarymaterials as per the terms and conditions of the order. On the other hand, thepurchase order also binds the purchase manager to accept the delivery ofnecessary materials and to make necessary arrangement for payments, because itis the purchase manager who has placed the order. A figure of the purchase orderis given below.


Purchase Order

To, Purchase Reg. No. : ………………….

The Supplier, Date : ………………….

…………………. Quotation No. : ………………….

…………………. Purchase Order No. : ………………….

Dear Supplier,

Your Quotation No. …………………. dated …………………. has been accepted. Hence youare requested to supply the following materials in accordance with the terms and conditions.

SerialNo.

Descriptionof

Materials

Quantity Rate or Price Amount ( ) DeliveryDate

Remark(If any)

Place of Delivery : ………………….

Terms of Payment : ………………….

Packing Charges : ………………….

Excise Duty : ………………….

Other Conditions : ………………….

For Kartik Company Limited

Signature of Purchase Manager

Figure 2.3: Purchase Order

Five copies of the purchase order will be prepared by purchase manager, One eachto the supplier, store-keeper, receiving and inspection department, accountsdepartment and to the office record of the purchase department itself.

(iv) Receiving and Inspecting of Materials: In large organization, a separate receiptand inspection department independent of stocking locations should be set up toreceive and inspect the materials. But in small unit, the work of receiving thematerials may be entrusted to the storekeeper. However, these two receiving andinspection are important functions. The receiving department receives, unloads,unpacks and marks the materials. It also checks the quantity of materials receivedand compares it with the quantity mentioned in the purchase order. Any differencebetween the quantity ordered and the quantity received will be recorded in theremarks. On the basis of this, receiving department will prepare the materials

received note in the following format:




Notes



Materials Received Note

From: Purchase Order No. & Date: …………………...

The Supplier Delivery Note No. & Date : …………………...

…………………… Date : …………………...

……………………

QuantityItem

No.

Description ofMaterials

Code

No. Ordered Received Diff.

Remarks

(If any)

Received by: …………………... Checked by : …………………...

Figure 2.4: Material received Note

Any shortage will be noted in materials received and brought to the notice of thepurchase department or manager which will take up the matter with the supplier. Inthe same way, excess supplies may be either retained or returned to the supplier bythe store-keeper of the purchase department. Receiving department will preparefive copies of the materials received note-one each to purchase department,accounts department, store-keeper, inspection department, and to the file of thereceiving department itself.

The important function of the inspection department is to check the quality andspecifications of materials received as per purchase order. After the completion ofinspection, the inspection department will prepare its report called materialsinspection report mentioning clearly the quality of materials received and inspectedand the reasons for the rejection or shortage of material, if any. Inspection report

will be prepared in four copies - one each to purchase department, storesdepartment, accounts department and for the file of inspection department itself. A format of the materials inspection report is as follows:


Materials Inspection Report

From: GR Note No. : ………………………

The Supplier, Purchase Order No.: ……………………….

………………………... GIR No. : ……………………….

………………………... Date : ……………………….

QuantityItemNo.


CodeNo.

Received &Inspected

Passed Rejected

Reasonsfor

Rejections

Inspected by : ……………………….. Special Remarks : ………………………...

Figure 2.5: Materials Inspection Report



Material Costing 39

Notes


On the basis of the materials received note and the materials inspection report, thepurchase department will initiate steps for the discrepancies in the materialreceived. In case, the invoice sent by the supplier includes the cost for materials notreceived, then the purchase department will issue a note called material debit noteto the supplier and the accounting department will be informed to make thepayment only for the actual quantity of materials received.

(v) Verification/Checking and Passing of Bills for Payment: When the invoice isreceived from the supplier, it is sent to the stores accounting section to check boththe authenticity as well as the arithmetical accuracy. The quantity and pricementioned in the invoice are checked with reference to stores received note and thepurchase order respectively. For a comprehensive verification, the purchasedepartment has to take into consideration the purchase order; materials receivednote, materials inspection report, materials returned note, etc. After this scrutiny, ifthe invoice is found to be correct by the purchase department, then a suitableendorsement is to be made by the purchase department to this effect and it is to bepassed on to the accounts department for payment. A format of invoice is given asunder:

ABC CompanyInvoice

To,

The Purchase Manager Purch. Ord. No .: …………. Delivery Note No. : ………..

Kartik Company Ltd., Date: …………………….. Date of Dispatch :…………..

Invoice No. : ………………. Date : ……………..…………

ItemNo.


Quantity Rate orPrice

Amount

( )

Remarks(If any)

Signature of Supplier

Purchase Department

(it may use overleaf of invoice or a separate sheet may be used)

Purchase Order No. & Date: ……. Details of Debit or Credit Note No.: ………………………..

G.R.No. & Date : ………………. Delivery Note No. : ………………………………………….

Ins. Rep. No. & Date : …………. Passed for Payment of ` : ……………………….....…….

Checked by : …………………...

Signature of Purchase Manager

Figure 2.6: Invoice

2.4 Store Keeping

Storekeeping is the next important aspect of materials management after thecompletion of purchase procedure.

A storehouse is a building provided for preserving materials, stores and finishedgoods. The in-charge of store is called storekeeper or stores manager. The organisationof the stores department depends upon the size and layout of the factory, nature of thematerials stored and frequency of purchases and issue of materials.

According to Alford and Beatty “storekeeping is that aspect of material control

concerned with the physical storage of goods.” In other words, storekeeping relates toart of preserving raw materials, work-in-progress and finished goods in the stores.




Notes


2.4.1 Objectives of Storekeeping

To ensure uninterrupted supply of materials and stores without delay to variousproduction and service departments of the organisation.

To prevent over and under stocking of materials,

To protect materials from pilferage, theft fire and other risks. To minimise the storage costs.

To ensure proper and continuous control over materials.

To ensure most effective utilisation of available storage space and workersengaged in the process of storekeeping.

2.4.2 Functions of Storekeeping

Issuing purchase requisitions to Purchase Department as and when necessity formaterials in stores arises.

Receiving purchased materials from the purchase department and to confirm theirquality and quantity with the purchase order.

Storing and preserving materials at proper and convenient places so that itemscould be easily located.

Storing the materials in such a manner so as to minimise the occurrence of risksand to prevent losses due to defective storage handling.

Issuing materials to various departments against material requisition slips dulyauthorized by the respective departmental heads.

Undertaking a proper system of inventory control, taking up physical inventory of allstores at periodical intervals and also to maintain proper records of inventory.

Providing full information about the availability of materials and goods etc.,whenever so necessary by maintaining proper stores records with the help of bincards and stores ledger etc.

2.4.3 Types of Stores

There are two types of stores:

Centralised Store: Under this system a single store is there for the wholeorganization. It ensures:

better layout and control of stores

economical use of storage space,

saving in storage costs and appointment of experts for handling storageproblems.

continuous stock checking.

Apart from various benefits, centralised stores suffers from certain drawbacks

also.

It leads to higher cost of materials handling

Delay in issue of materials to respective departments

Exposure of materials to risks of fire and accident losses are practical difficultiesin managing big stores.

Decentralised Store: Under this system independent small stores are attached tovarious departments. It involves:

lesser costs and time in moving bulky materials to distant departments

helpful in avoiding overcrowding in central store.

However, it too suffers from certain drawbacks viz.,

uniformity in storage policy of goods cannot be achieved under decentralisedstorekeeping,



Material Costing 41

Notes


more staff is needed and experts may not be appointed.

2.4.4 Working of the Stores

There are four sections in the process of storekeeping viz.

Receiving Section: There are four kinds of inventories received by stores viz.,

raw materials,

stores and supplies,

tools and equipments,

work-in- progress or semi-finished goods.

Following procedure is followed in receiving these inventories:

Receiving these incoming materials in stores.

Checking and inspection of these incoming materials and stores etc.

Recording the incoming materials in goods received book.

Preparing and forwarding goods inwards note to purchasing section.

Informing the purchase department about damaged and defective goods andsurplus or deficit supplies etc. along with rejection forms and notes.

Returning damaged or defective goods to the suppliers in accordance with theinstructions of the purchase department.

Forwarding the materials to respective stores and locations where these are tobe stored or preserved.

Storage Section: The store room should be located at a convenient andappropriate place. It should have ample facilities to store the materials properly viz.bins, racks and shelves etc. There can be a single store room in case of a smallorganisation, but a large scale concern can have different or multiple stock rooms inaddition to general or main store.

The separate stockrooms may be used for different classes of inventories. Thematerial should be stored in such a manner as to protect it against the risks ofdamage, destruction and any kind of loss. Each article should have identifyingmarks viz., stamping, embossing, colour, coding and painting etc. These risks arevery useful in locating or identifying an article in the stores.

Accounting Section: This section is concerned with keeping proper records withregard to receipt and issue of materials. The primary task of this section is toundertake the process of inventory control.

Issue Section: The materials should be issued to respective departments onreceiving duly authorised requisition slips. An entry should be made immediately onthe bin card attached with the bin from where the material has been issued.

Bin cards contain valuable information with regard to receipt and issue of materials,which is greatly helpful in exercising a system of inventory control. These cards arefurther helpful in determining various levels of materials viz., maximum, minimum, andre-ordering level.

2.5 Material Control

The success of any industry or enterprise depends, to a greater extent, upon thesuccessful control of material/ inventory. Further, this input provides a number ofavenues and wide scope for improvement of overall performance of the industry.Inventory control, therefore, aims at ensuring the availability of required quality materialin required quantity, at required time or period and place with minimum cost. Inventoryinvolves investment of money and locking up of precious space which has alternate

uses. It is said that inventory is a necessary evil. As a result, proper control has to beexercised over it. In controlling inventory, firms or industries use a number of techniques




Notes


and models. Inventory control is generally exercised over raw materials and work inprogress. The basic purpose of inventory control is to maintain optimum level ofinventory.

2.5.1 Objectives of Material Control

The objectives of material control are as follows:

(i) Proper estimation of inventory requirements-quantity, quality, specifications ofinventory, etc. This will help the purchase manager to quality and quantity ofmaterials. The purchase department has to exercise utmost care to procure thequality materials at lower prices.

(ii) The stores department has also an effective role to play for stock levels. By keepingonly the required quantities of materials, excess employment of capital on materialscan be avoided. Further, it can reduce the loss of materials during the storageperiod and keep the materials in good condition.

(iii) It is the production departments which are capable of extracting the maximumoutput from each unit of materials thereby contributing heavily to minimize the lossof materials during the production period and to maximize the productivity.

2.5.2 Techniques of Material/ Inventory Control

There are many methods and techniques of inventory control, the most important being:

ABC Analysis,

Inventory or Stock Levels,

Economic Order Quantity (EOQ),

Inventory Turnover Ratio, and

Stock Verification or Stock Checking.

ABC Analysis

The concept of ABC analysis was coined by Pareto, an Italian philosopher, in the 19thcentury. ABC analysis is based on the principle ‘Vital few-Trivial money’. For theobjective of exercising proper and effective control on materials, materials arecategorized into three broad categories, under ABC analysis, on the basis of their value.This helps to lay greater emphasis on the most valuable items at the time of purchase,storage and usage.

Materials are divided, under ABC analysis, into three categories, designated as ‘A’category material, ‘B’ category material and ‘C’ category materials. The features of A, B,C materials can be stated as under:

A Category – Small in number, High in usage value and the ‘Vital few’ from a financialpoint of view.

B Category – Medium number, Medium usage value, andC Category – High number, Low usage value.

The ABC analysis is a selective control of materials. This is so because it is unwiseto give equal attention to all items or materials in stock. The items are listed and rankedin the order of their descending importance showing quantity and value of each item.The above analysis becomes clear from the following percentage table:

Table 2.1: ABC Analysis

Category ofmaterials

Percentage of totalvalue

Percentage oftotal quantity

Type of control

A

B

C

70-75

15-20

5-10

5-10

20-25

70-75

High and effective control

Medium control

Loose control



Material Costing 43

Notes


In Table 2.1 it is shown that 5-10 per cent of the total items account for as much as70-75 per cent of the total value. These are A category items which need very high andeffective control. The second type of items represents 20-25 per cent of the totalquantity by account for 15-20 per cent of the total value. These are B items which needroutine or medium type of control. Finally, the item representing 70-75 per cent of totalquantity but, account only for 5-10 per cent of total value. These C items are kept undersimple or loose control.

Advantages of ABC Analysis

Following are the main advantages of ABC analysis:

(a) A strict control is exercised on costlier items of materials while exercising moderatecontrol over less costlier materials,

(b) Selective control helps in maintaining high stock turnover rate,

(c) Investment on materials is judiciously utilized,

(d) It helps in maintaining safety stock for C category items, and

(e) Quick purchase of materials can be ensured by concentrating on fewer items that

are required at one time.

Problem 1: XYZ company is considering a selective inventory control using thefollowing data:

Items 1 2 3 4 5 6 7 8 9 10 11 12

Units

6 ,

0 0 0

6 1 ,

0 0 0

1 6 ,

8 0 0

3 ,

0 0 0

6 0 ,

0 0 0

2 2 ,

0 0 0

2 6 ,

0 0 0

1 4 ,

0 0 0

2 0 ,

0 0 0

9 0 ,

0 0 0

2 9 ,

9 4 0

2 4 ,

6 6 0

UnitsCost( ` )

3.00 0.05 2.00 6.00 0.20 0.50 0.65 0.40 0.40 0.10 0.30 0.50

The intention is to have the ABC plan of selective control. Arrange the data forpresentation to management.

Solution:

Statement of Annual Consumption Value and Classification of Items under ABC Analysis

Items Units Unit Cost ( ) Annual Consumption

Value ( )

Category

18,000

3,050

33,600

18,000

12,000

11,000

16,900

5,600

8,000

9,000

8,982

12,330

1

2

3

4

5

6

7

8

9

10

11

12

6,000

61,000

16,800

3,000

60,000

22,000

26,000

14,000

20,000

90,000

29,940

24,660

3.00

0.05

2.00

6.00

0.20

0.50

0.65

0.40

0.40

0.10

0.30

0.50

1,56,462

A

C

A

A

B

B

A

C

C

C

C

B

Statement Showing the Percentage of Units and Associated Costs of Different

Categories




Notes


Percentage of TotalCategory

of Methods

Item Units Units

Cost ( )

Total Cost

( )

Units Cost

A 1 6,000 3.00 18,000 1.61 11.50

3 16,800 2.00 33,600 4.50 21.474 3,000 6.00 18,000 0.80 11.50

7 26,000 0.65 16,900 6.96 10.80

A 51,800 86,500 13.87 55.27

B 5 60,000 0.20 12,000 16.07 7.67

6 22,000 0.50 11,000 5.89 7.04

12 24,660 0.50 12,330 6.60 7.88

B 1,06,660 35,330 28.56 22.59

C 2 61,000 0,05 3,050 16.34 1.95

8 14,000 0.40 5,600 3.75 3.58

9 20,000 0.40 8,000 5.36 5.1110 90,000 0.10 9,000 24.10 5.75

11 29,940 0.30 8,982 8.02 5.75

C 2,14,940 34,632 57.57 22.14

Total 3,73,400 1,56,462 100.00 100.00

A Category : ` 15,000 and above

B Category : ` 10,000 to ` 15,000

C Category : Below ` 10,000

Inventory or Stock Levels

This technique of material control is helpful in avoiding overstocking and under stockingof materials in store. The stock levels are fixed by the purchase manager and it is theduty of storekeeper to observe them. In order to requisition the stores for replenishment,the store-keeper should have a complete idea about different stock levels. The variousstock or inventory levels are as follows:

(a) Maximum Stock Level,

(b) Minimum Stock Level,

(c) Danger Level,

(d) Re-order Level, and

(e) Average Stock Level.

(a) Maximum Stock Level: The maximum stock level represents the upper limitbeyond which the quantity of any item is not normally allowed to rise. The objectivebehind this is to ensure that the working capital is not blocked in storesunnecessarily. This is normally equal to the aggregate of minimum stock level andthe economic order quantity. It is computed the following formula:

Maximum Stock Level = (Re-order level – Re-order quantity)

– (Minimum consumption × Minimum re-ordering period)

OR

Maximum Stock Level = (Re-order level – Minimum consumption) + Re-orderquantity

(b) Minimum Stock Level: It is that level below which stock should not normally beallowed to fall. Minimum stock level is also called safety or buffer stock. The



Material Costing 45

Notes


objective behind this is to see that production activities are not stopped for want ofmaterial. Minimum level is computed by the following formula:

Minimum Stock Level = Re-order level – (Normal consumption per unit of time × Average lead time)

ORMinimum Stock Level = Re-order level – (Normal consumption × Normal re-orderperiod)

(c) Danger Level: This is a level at which normal issues of materials are stopped andmaterials are issued for important works or projects only. Normally, stock levelshould not be allowed to fall below minimum level. If it falls below the minimumlevel, then it indicates that urgent action for replenishment of stock must be taken toavoid stock-out situation. Danger level is normally fixed below the minimum stocklevel. It is calculated with the following formula :

Danger Level = Minimum consumption per unit of time × Maximum lead time foremergency purchases

OR

Danger Level = Normal consumption × Maximum re-order period under emergencyconditions

(d) Re-order Level: The Re-order stock level at which the fresh order is placed forpurchase of material is called the re-order inventory level. When the stock of amaterial reaches this level, the store-keeper should initiate action for the purchaseof material. This is fixed between maximum and minimum stock levels and it will be,normally, higher than the minimum stock level. It is calculated with the help offollowing formula:

Re-order Level = Maximum consumption per unit of time × Maximum lead time

OR

Re-order Level = Maximum consumption × Maximum re-order period

(e) Average Level: This is the average of maximum and minimum levels. It iscalculated with the help of following formula:

Average level =Minimum level + Maximum level

2

Problem 2: From the following particulars, calculate the various stock levels:

Normal consumption 300 units per day

Maximum consumption 420 units per day

Minimum consumption 240 units per day

Re-order period 10-15 days

Re-order quantity 3,600 units

Normal re-order period 12 days

Solution:

Re-order Level = Maximum usage × Maximum re-order period

= 420 units × 15 days = 6,300 units

Minimum Level = Re-order level – Normal consumption × Normal re-orderperiod

= 6,300 – (300 units per day × 12 days)




Notes


= 6,300 – 3,600 = 2,700 units

Maximum Level = (Re-order level + Re-order quantity) – (Minimum consumption× Minimum re-order period)

= (6,300 + 3,600) – (240 × 10)

= 9,900 – 2,400 = 7,500 units

Problem 3: From the following data for the last twelve months, compute the averagestock level for the said component:

Consumption

Maximum usage in a month 300 Units

Minimum usage in a month 200 Units

Average usage in a month 225 Units

Time lag for procurement of material: Maximum – 6 months ; Minimum – 2 months.

Re-ordering quantity: 750 units.

Solution:

Re-order Level = Maximum usage × Maximum lead time

= 300 Units × 6 months

= 1,800 Units

Maximum Level = [ROL – (Minimum usage × Minimum lead time)] + ROQ

= [1,800 – (200 × 2)] + 750

= 2,150 Units

Minimum Level = ROL – (Average usage × Average lead time)

= 1,800 – (225 × (6 + 2) ÷ 2

= 1,800 – (225 × 4)

= 900 Units

Therefore,

Average Level = (Maximum level + Minimum level ) ÷ 2

= (2,150 + 900) ÷ 2

= 1,525 Units

Economic Order Quantity (EOQ)

This is one of the important decision-making area. The purchase department has todecide about the number of units of each type of required raw materials to bepurchased at a time. A strategic factor in inventory or stock control is computing theoptimum size of a normal purchase order. It is the quantity of inventory which can bereasonable ordered at a time and purchased economically. It is also known as StandardOrder Quantity, Optimum Quantity or Economic Lot Size. By definition, economic orderquantity is that size of order for which the total cost is minimum.

Computation of EOQ: In determining the economic order quantity the problem isone to set a balance between two opposing costs, namely ordering costs and carryingcosts. The ordering costs are basically the costs of getting an item into the firm’s

inventory. They are also known as acquisition costs or procurement costs. Carryingcosts sometimes also known as holding costs or cost of possessing of the materials.



Material Costing 47

Notes


These costs are combined known as ‘Associated Costs’. The management is temptedon one hand to order huge quantity but, holding costs are also to be considered. Eitherof these two courses will have an adverse effect on the profits of the firm. Hence themanagement tries to reconcile them and this reconciliation point is economic orderquantity. The nature of cost of carrying (holding cost) and cost of not carrying enough isquite opposite as follows:

Cost of Carrying or Holding Cost Cost of not Carrying Enough

(i) Interest on investment in inventory. Foregone quantity discounts.

(ii) Taxes and insurance. Distribution in production hence loss in earnings.

(iii) Warehousing and storageexpenses.

Contribution margin on lost sales.

(iv) Material handling and clericalcharges.

Extra cost of uneconomic production runs.

(v) Deterioration and spoilage. Loss of customer’s goodwill.

(vi) Obsolescence. Extra purchasing and transportation costs.

(vii) Personal property taxes. Foregone fortuitous purchases.

The costs of carrying costs can be estimated by the management on the basis ofsales of past years but costs of not carrying enough are only estimated.

EOQ can be computed with the help of following formula:

=

2ASEOQ

I OR =

2ABEOQ

CS

Here : EOQ = Economic Order Quantity.

A = Annual consumption of materials in units or rupees.

S = Cost of placing an order.

I = Cost of holding one unit for one year or Annual carrying cost ofstoring one Unit.

Problem 4: Calculate the Economic Order Quantity if the annual demand for theproduct is 5,000 units, the ordering cost is ` 30 per order and the holding cost is ` 6 perunit per annum.

Solution:

EOQ =2AS

I

EOQ =

× ×2 5000 30

6

EOQ = 500000 = 224 or 225 units.

Problem 5: The annual demand for a product is 6,400 units. The unit cost is ` 6 andinventory carrying cost per unit per annum is 25% of the average inventory cost. If thecost of procurement is ` 75. Calculate: (a) Economic order quantity, (b) Number oforders per annum, and (c) Time between two consecutive order.

Solution:

(a) EOQ =2AB

CS




Notes


EOQ =× ×

×

2 6400 75

256

100

EOQ =

× × ×

×

2 6400 75 100

6 25

EOQ = 800 Units

(b) Number of orders per annum = Annual Usage

EOQ

=6400

800

= 8 orders per annum

(c) Time between two orders =Number of Months in a year

No. of orders

=12 Months

8 order

= 15 Months

Inventory Turnover Ratio

Inventory turnover ratio or material turnover ratio as a technique of material control isuseful to avoid unnecessary investment on these materials whose consumption is muchless. It indicates the speed with which the raw materials have been consumed forproduction. Further, it is possible to find out whether the inventory comprises ofobsolete stock of raw materials. Inventory turnover ratio can be computed with the help

of following formula:

Inventory Turnover Ratio =Cost of material consumed during the year

Average stock of materials during the year

Inventory turnover may be denoted in terms of number of days in which the averageinventory is consumed. This is obtained by using the following formula:

Inventory turnover ratio in terms of days =365 day

Inventory turnover ratio

In this case, if the period of the stock or inventory is short, material is said to be fastmoving.

Problem 6: From the following information’s, calculate the following for each material :

(i) Materials consumed,

(ii) Average inventory held, and

(iii) Inventory turnover.

Material A Material B

( ` ) ( ` )

Opening Stock 10,000 12,000

Purchases during the period 52,000 46,000

Closing stock 6,000 16,000



Material Costing 49

Notes


Solution:

(i) Statement of Materials Consumed

Particulars Material A ( ` ) Material B ( ` )

10,000 12,000

52,000 46,000

62,000 58,000

6,000 16,000

Opening stock

Add : PurchaseValue of materials

Less : Closing stock

Materials consumed 56,000 42,000

Average Inventory Held =Opening Stock + Closing Stock

2

Therefore, Material A =10,000 + 6,000

2 = ` 8,000

Material B =12,000 + 16,000

2 = ` 14,000

Inventory Turnover =Cost of materials consumed

Average inventory

Therefore, Material A =56,000

8,000

`

` = 7 times

Material B =42,000

14,000

`

` = 3 times

Stock Verification or Stock Checking

Verification in the form of either counting, measurement of materials and supplies heldin the stores department and its comparison with the stores records are necessary forthe purpose of detecting discrepancies. This, therefore, necessitates the maintenanceof proper records reflecting the physical movement of inventory and their currentbalance which is known as Perpetual Inventory. Perpetual inventory is a system ofstock control in which continuous record of receipt and issue of materials is maintainedby the stores department. It shows the physical movement of stocks and their currentbalance. There are following two alternative methods of stock verification:

(a) Periodic Stock Verification: Under this method, stock checking or verification isdone periodically i.e., quarterly, half-yearly or yearly. For instance, for a few items,quarterly verification may be carried out and for the rest, yearly verification may bedone. It is usually influenced by the value of the material. In some cases, the

production activities may be stopped for a few days to facilitate the stockverification. Of course, the stoppage of production, even for a minimum period, isnot desirable as it will have a number of ill effects. After verification, the details willbe recorded in inventory tags which will be attached to the bins which have beenchecked. After checking all the materials, a report will be prepared to find out thediscrepancies.

(b) Continuous Stock Verification: Under this method, continuous stock verificationand the comparison of actual physical quantity of various items of materials withtheir figures in the records will be undertaken. Continuous verification is possibleand effective only when the stores records are maintained on continuous basis. Asthe verification is carried out throughout the year, a proper plan and procedure forverification is to be evolved. This has to list out the items to be counted, weighed or

measured. Another important aspect is that the checking is carried out withoutaffecting the normal production activities. Even under this system, inventory tags




Notes


are used to record the actual quantity of materials in the stores department. On thebasis of the physical verification and its comparison with the stores records, stockverification reports will be prepared showing both the quantity as revealed by thephysical verification and the quantity as per the bin cards. However, the continuousstock verification ensures a number of benefits. The benefits are mentioned hereinunder:

Continuous stock verification method ensures a comprehensive and reliablecheck of materials,

Discrepancies of materials can be immediately be detected and set right,

It does not affect the activities of normal production,

In this method, the personnel in stores department will always be alert andcareful about their responsibilities, and

Facilitate the preparation of financial statement at short notice by furnishing theinventory details.

2.6 Methods of Pricing Material Issues

Some of the more commonly used methods of pricing material issues are discussedbelow:

2.6.1 Last-in-First-out Method (LIFO)

Under this method, it is presumed that latest receipts are used first. The cost of the lastlot of materials received is used to price requisition until that consignment is exhausted.Then, the next lot pricing is used and so on through successive lots. This method, thus,takes note on fluctuations in price.

This method uses the price of the last batch received for all issues until all unitsfrom this batch have been issued, when the price is the previous batch received isused. Usually, however, a new delivery received before the first batch is fully issued, in

which case the new delivery price becomes the “last-in” price and is used for pricingissues until either the batch is exhausted or a new delivery received. In this case, thereare two points to be noted:

The method can result in many batches being only partially ‘written off ’.

This is a book keeping method and must not be confused with the physical methodof issue used by the storekeeper, who will always issue the oldest stock first.

Advantages of LIFO Method

The following advantages are claimed for LIFO method:

(a) It tends to level profits and losses during periods of rising and falling prices,

(b) This method is also quite simple to operate, particularly when prices are fairly

steady, and(c) It keeps value of issues close to current economic values.

Disadvantages of LIFO Method

The main disadvantages of this method are:

(a) It is cumbersome and shows out of date figures in the balance sheet,

(b) Valuation of stock balance may not be acceptable for income-tax purposes, and

(c) This method can be used satisfactorily where following conditions exist:

Price fluctuations are considerable for most of the materials, and

The relative value of materials is large in comparison to the total cost of the

product.



Material Costing 51

Notes


2.6.2 First-in-First-out Method (FIFO)

This is the reverse of the LIFO method. This method which is popularly known as FIFOmethod is based on the assumption that the units which are acquired first are issuedfirst. The materials are issued in order of their purchases and at the price of the originalpurchase.

This method uses the price of first batch received from all issues until all units fromthis batch have been issued after which the price of the next batch received becomesthe issue price. Upon that batch being fully issued the price of the next batch received isused, and so on.

Advantages of FIFO Method

The main advantages of this method are:

(a) The method is very simple and it is easy to operate,

(b) It is claimed that since the materials are charged into production at actual cost inorder of receipt,

(c) It is more accurate method,

(d) It is also realistic since items are issued to shop in order of receipt, and

(e) Valuation of stock balance is a fair commercial value.

Disadvantages of FIFO Method

This method suffers from the following disadvantages:

(a) It is cumbersome and shows inflated profits during a period of rising prices,

(b) This method can, therefore, be used satisfactory where the following conditionsexist:

Where inventories turn over rapidly, and

Where the inventory is not a major factor in the profit or current asset situation.

Problem 7: Mahesh and Sons have purchased the material as under:

Jan. 3, 2006 500 Kg. of crude oil @ ` 2 per kg.

Jan.18, 2006 350 Kg. of crude oil @ ` 3 per kg.

Jan. 25, 2006 600 Kg. of crude oil @ ` 2.50 per kg.

Feb. 4, 2006 500 Kg. of crude oil @ ` 2.75 per kg.

Issue there from are as under:

Jan 19, 2006 600 Kg. of crude oil

Jan. 27, 2006 450 Kg. of crude oil

Feb. 5, 2006 500 Kg. of crude oil

Feb. 7, 2006 150 Kg. of crude oil

Prepare the Stores Ledger Account using the following methods of pricing materialsissue.

(a) Fist-in-First-out method, and

(b) Last-in-First-out method.

Solution:

(a) FIFO Method:




Notes


Stores Ledger Account

Dateandyear

ParticularsQty.

Kg.

Rate

( )

Amount

( )

Dateandyear

Particular s

Qty.

Kg.

Rate

( )

Amount

( )

2006 2006

Jan.3 To Purchase 500 2.00 1000 Jan.19 By Issue 500 2.00 1000.00

Jan.18 To Purchase 350 3.00 1050 By Issue 100 3.0 300.00

600

Jan.25 To Purchase 600 2.50 1500 Jan.27 By Issue 250 3.00 750.00

By Issue 200 2.50 50.00

450

Feb.4 To Purchase 500 2.75 1375 Feb.5 B y Issue 400 2.50 1000.00

By Issue 100 2.75 275.00

500

Feb.7 By Issue 150 2.75 412.50

To Balanceb/d

250 2.75 687.50

1950 4925 1950 4925.00

(b) LIFO Method:


Dateandyear

ParticularsQty.

Kg.

Rate

( )

Amount

( )

Dateandyear

ParticularsQty.

Kg.

Rate

( )

Amount

( )

2006 2006

Jan.3 To

Purchase

500 2.00 1000 Jan.19 By Issue 350 3.00 1050

By Issue 250 2.00 500

600

Jan.18 ToPurchase

350 3.00 1050 Jan.27 By Issue 450 2.50 1125

Jan.25 ToPurchase

600 2.50 1500 Feb.5 By Issue 500 2.75 1375

Feb.4 ToPurchase

500 2.75 1375 Feb.7 By Issue 150 2.50 375

To Balanceb/d

250 2.00 500

1950 4925 1950 4925

2.6.3 Weighted Average Method

Under this method consider both the cost of materials and the number of units ofmaterial. In brief, the Weighted Average Price is calculated by dividing the total cost ofmaterial on the date of issue, by the total quantity of available material. It is, therefore,necessary, under this method, to compute the issue price as soon as fresh consignmentis received. Any number of issues can be priced at the same rate until the receipt of anew consignment which necessitates the calculation of issue price afresh.

Advantages of Weighted Average Price Method

Following are the main advantages of this method:

(a) This method is simple and easy to operate as the computation of issue price,



Material Costing 53

Notes


(b) Value of closing stock is not distorted under this method,

(c) This method evens out even the wide fluctuations in the price, and

(d) It reduces the clerical work as the computation of new issue price.

Disadvantage of Weighted Average Price Method

Following are the some disadvantages of this method:

(a) If the material is purchased again and again at short intervals, the calculation workincreases, and

(b) As the material is issued at average price, the production cost cannot be correctlyestimated.

Problem 8: Prepare the stores ledger account based on the weighted average methodof pricing issues from the following informations:

July 2008,

2 Opening balance 24,000 kgs @ ` 7,500 per tonne

2 Purchase 44,000 kgs @ ` 7,600 per tonne

2 Issue 10,000 kgs

4 Issue 1 6,000 kgs

10 Issue 24,000 kgs


16 Issue 24,000 kgs


25 Issue 30,000 kgs

31 Issue 22,000 kgs

Solution:


Receipts Issues Balance

Date Qty.Units

Rate

( )Amount ( )

Qty.Units

Rate ( )Amount

( )

Qty.Units

Amount ( )

July2008, 2

– – – – – – 24,000 1,80,000(a)

2 44,000 7.60 3,34,440 – – 68,000 5,14,400

2 – – – 10,000 7.5647(b)

75,647 58,000 4,38,753

4 – – – 16,000 7.5647 1,21,035 42,000 3,17,718

10 – – – 24,000 7.5647 1,81,553 18,000 1,36,165

11 10,000 7.80 78,000 – – – 28,000 2,14,165

16 – – – 24,000 7.64875(c)

1,83,570 4,000 30,595

20 50,000 8.00 4,00,000 – – – 54,000 4,30,595

25 – – – 30,000 7.97398(d)

2,39,219 24,000 1,91,376

31 – – – 22,000 7.974 1,75,428 2,000 15,948

Working notes:

(a) 24000 × 7.5

(b) 5,14,400 ÷ 68,000

(c) 2,14,165 ÷ 28,000

(d) 4,30,595 ÷ 54,000




Notes


2.6.4 Simple Average Method

ICMA, England defines the simple average price as “a price which is calculated bydividing the total of the prices of the materials in the stock from which the material to bepriced could be drawn, by the number of prices used in that total”. Under this method,for determining the issue price, the quantity of material purchased is not considered.

The average price is calculated by adding the prices at which materials on differentdates were purchased during the year or period and dividing the total of these prices bythe number of prices.

Advantages of Simple Average Method

The main advantages of this method are:

(a) It is comparatively easy to compute the issue price, and

(b) This method smoothens out fluctuations in price provided the price fluctuations arewithin narrow limits.

Disadvantages of Simple Average Method

This method suffers from a few disadvantages. They are:(a) This method does not attach any importance to the quantity in each consignment,

(b) Since, the value of closing stock is ascertained by finding out the differencebetween the value of materials before the issue and the total price of that issue, itmay assign an absurd value to the closing stock,

(c) As the issues are not priced at the actual costs, usually profit or loss will arise if thismethod is used.

Problem 9: From the following particulars, prepare stores ledger account using Simple Average Method

January 2006,

2 Purchased 400 units @ `

40 per unit4 Purchased 500 units @ ` 50 per unit

6 Issued 200 units

7 Purchased 600 units @ ` 60 per unit

10 Issued 400 units

15 Issued 100 units

18 Issued 200 units

24 Purchased 450 units @ ` 55 per unit

31 Issued 250 units

Solution:


Receipts Issues Balance

DateUnits

Rate

(

)

Amount

(

)Units

Rate

(

)

Amount

(

)Units

Rate

(

)

Amount

(

)

2006

Jan., 2 400 40 16,000 – – – 400 40 16,000

4 500 50 25,000 – – – 400 40

500 50 41,000

6 – – – 200 45 9,000 200 40

500 50 32,000



Material Costing 55

Notes


7 600 60 36,000 – – – 200 40

500 50

600 60 68,000

10 – – – 200 50 10,,000

200 50 10,000 300 50

600 60 48,000

15 – – – 100 55 5,500 200 50

600 60 42,500

18 – – – 200 55 11,000 600 60 31,500

24 450 55 24,750 – – – 600 60

450 55 56,250

31 – – – 250 57.5 14,375 350 60

450 55 41,875

2.7 Summary

Material is a very important factor of production in a manufacturing organization. It is thefirst and the most important element of cost. Materials account for nearly 50-60 per centof the cost of production. This fact can be inferred from an analysis of the financialstatements of a large number of organizations.

One of the important functions of the store-keeper in the stores department is theclassification and codification of materials. Classification refers to grouping of materialsinto three or four categories on the basis of material nature. And codification refers tothe procedure of assigning symbols to each item of material stored.

A systematic and well-defined procedure is to be followed to make the purchase ofmaterials as any lapse in the procedure may result in the stoppage of production whoseill-effects are incalculable. The purchasing department follows the following purchaseprocedure: Purchase Requisitions or Indenting for Materials, Selection of Suppliers or

Choosing the Suppliers, Purchase Order, Receiving and Inspecting Materials andVerification/Checking and Passing of Bills for Payment.

According to Alford and Beatty “storekeeping is that aspect of material controlconcerned with the physical storage of goods.” In other words, storekeeping relates toart of preserving raw materials, work-in-progress and finished goods in the stores.

The basic purpose of inventory control is to maintain optimum level of inventory.There are many methods and techniques of inventory control, the most important being: ABC Analysis, Inventory or Stock Levels, Economic Order Quantity (EOQ), InventoryTurnover Ratio, and Stock Verification or Stock Checking.

ABC analysis is based on the principle ‘Vital few-Trivial money’. For the objective ofexercising proper and effective control on materials, materials are categorized into three

broad categories, under ABC analysis, on the basis of their value. This helps to laygreater emphasis on the most valuable items at the time of purchase, storage andusage. In order to requisition the stores for replenishment, the store-keeper should havea complete idea about different stock levels. EOQ is the quantity of inventory which canbe reasonable ordered at a time and purchased economically. It is also known asStandard Order Quantity, Optimum Quantity or Economic Lot Size. By definition,economic order quantity is that size of order for which the total cost is minimum. Inventory turnover ratio or material turnover ratio as a technique of material controlis useful to avoid unnecessary investment on these materials whose consumption ismuch less. It indicates the speed with which the raw materials have been consumed forproduction. Verification in the form of either counting, measurement of materials andsupplies held in the stores department and its comparison with the stores records arenecessary for the purpose of detecting discrepancies.




Notes


Some of the more commonly used methods of pricing material issues are LIFO,FIFO, Simple average and weighted average method.


Multiple Choice Questions1. The basic purpose of inventory control is to maintain………………

(a) Reduce the cost

(b) Optimum level of inventory

(c) To keep it latest

(d) To ascertain the material cost

2. Inventory control is generally exercised over raw materials and…………….

(a) Work in progress

(b) Finished goods

(c) Both a and b

(d) None of the above

3. The purchase department has to exercise utmost care to procure the qualitymaterials at………………..

(a) Market prices

(b) Higher prices

(c) Lower prices

(d) Average prices

4. By keeping only the required quantities of materials, excess employment of……………can be avoided.

(a) Staff

(b) Capital on materials

(c) Funds

(d) Warehouses

5. In …………….entry is normally be made after the transaction takes place.

(a) Material Requisition Order

(b) Purchase Order

(c) Bin Card

(d) Stores Ledger Account

6. Document prepared by the stores department is ………………..

(a) Bin Card

(b) Stores Ledger

(c) Material Requisition Notes

(d) Stock Requirement Detail

7. The……………….. is in the form of an agreement with the suppliers which bindsboth the purchaser and supplier.

(a) Credit Note

(b) Debit Note

(c) Bills of Exchange

(d) Purchase order



Material Costing 57

Notes


8. .....................Price is calculated by dividing the total cost of material on the date ofissue, by the total quantity of available material.

(a) Simple Average

(b) Weighted Average

(c) LIFO(d) FIFO

9. Inventory turnover ratio as a technique of material control is useful to avoidunnecessary investment on these materials whose consumption ismuch……………..

(a) Less

(b) High

(c) More

(d) Regular

10. ………………. is periodical or continuous.

(a) Stock valuation(b) Stock calculation

(c) Stock verification

(d) Stock analysis


1. Briefly explain the procedure to be followed by the purchase department for thepurchase of a material till arranging for payment of the bill.

2. Discuss the importance of good stores keeping in an organization. What are theduties of a store-keeper?

3. ‘Of all the method of pricing material issue the FIFO method is the best and the

simplest’. Explain this statement.

4. Indicate and briefly explain the two different methods usually followed in pricingstores other than the ‘Last-In First-Out’ method.

5. Why is it necessary to fix various levels for materials?

6. From the following transactions, prepare separately the stores ledger account,using the FIFO and LIFO methods of pricing:

January 1 Opening Balance 100 units @ ` 5 each.

’’ 5 Received 500 units @ ` 6 each.

’’ 20 Issued 300 units.

February 5 Issued 200 units.

’’ 6 Received 600 units @ ` 5 each.

March 10 Issued 300 units.

’’ 12 Issued 250 units.

7. Explain the different methods of materials issue and show their relative merits anddemerits.

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

Normal usage 500 p.w. each

Minimum usage 250 p.w. each

Maximum usage 750 p.w. each

Reorder quantity A : 3,000 B : 5,000

Reorder period A : 4 to 6 weeks B : 2 to 4 weeks




Notes


Calculate for each material:

(a) Reorder level, (c) Maximum level, and

(b) Minimum level, (d) Average stock level.

9. What is meant by the weighted average method of valuing stores issues? How is it

different from the simple average method? Explain the statement pointing out theelements for which estimates have to be made.

10. Prepare a stores ledger account from the following information’s adopting FIFOmethod of pricing material issues:

June 01 Opening Balance 500 tonnes @ ` 200.

03 Issues 70 tonnes.



13 Received from supplier 200 tonnes @ ` 190.

14 Returned (issued on 3rd June) from department A 15 tonnes.






27 Returned (issued on 26th June) from department B 35 tonnes.


2.10 Key Terms

Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished

Goods and Stock of Spares, but not Stock of Loose tools.

E.O.Q: Economic Order Quantity of materials to be ordered/procured.

Carrying cost: Cost incurred for carrying the materials from the place of purchaseto place of production centre/profit centre.

Ordering Cost: Cost incurred at the moment of placing the order of goods ormaterials, administration costs, cost of communication and so on.

ABC Analysis: Analysis of exercising the control on the inventory on the basis ofvalue. Always Better Control Analysis; A- High control for high value goods; B-Moderate control for lesser value goods and C- Little control on the least valuegoods.

Check Your Progress: Answers1. (b) Optimum level of inventory

2. (a) Work in progress

3. (c) Lower prices

4. (b) Capital on materials

5. (d) Stores Ledger Account

6. (a) Bin Card

7. (d) Purchase order

8. (b) Weighted Average

9. (a) Less

10. (c) Stock verification



Material Costing 59

Notes











Notes


CASE STUDY: PENNILA & CO.: A CASE STUDY FOR PRICING MATERIALISSUES

ennila & Co. is a direct exporter as well as market leader in the domestic marketamong acute competition. The firm is expected to have an opening stock of 2000 kgof raw materials at the rate of ` 4 per kg. The firm should have to price the issue of

materials in two different ways, one for the domestic market and another one for the exportorder which was already obtained.

Date Receipts Qty kg Rate per kg Issue Qty kg

Jan6 400

Jan10 800 4.40

Jan15 600 4.80.

Jan20 1000

Jan21 400

Jan 24 1000 5.20

Jan 25 600

Jan 28 400

Questions

1. Which method of stores ledger is most suitable to the domestic market? How are theissue prices of materials going to penetrate the perfect competition at the domesticlevel?

2. Which method is considered to be most suitable for the export of goods? How will theissue price of materials help the firm to reap greater profits through the export ofgoods?

P



Labour Costing 61

Notes


Unit 3: Labour Costing

Structure

3.1 Introduction

3.2 Labour Turnover

3.2.1 Causes of Labour Turnover

3.2.2 Effects of Labour Turnover

3.3 Labour Cost Control

3.3.1 Departments for Labour Control

3.3.2 Scope of Control

3.4 Labour Cost Management

3.4.1 Recruitment

3.4.2 Time Keeping

3.4.3 Time Booking

3.4.4 Work Study

3.4.5 Job Analysis

3.4.6 Merit Rating

3.5 Idletime and Overtime

3.5.1 Idle Time

3.5.2 Overtime

3.6 Summary



3.9 Key Terms


Objectives


Understand the labour turnover

Discuss the labour cost control

Explain the labour cost management

Learn the causes of idle time and its treatment

Discuss the concept of overtime

3.1 Introduction

Labour is an important element of cost of production. It plays an important role inproduction even in the modern machine age where there is extensive use of machines.Labour cost may be divided into:

(a) Direct labour cost, and(b) Indirect labour cost.




Notes


The distinction between direct labour and indirect labour is important because ithelps to:

(i) Determine accurate production cost,

(ii) Measure efficiency of performance of labour,

(iii) Ensure better cost analysis for decision-making, and(iv) Minimize error in overhead allocation and control.

Labour cost occupies a significant portion of the total cost of a product or servicesrendered. In India, labour cost is predominantly fixed cost: it is not variable; only aninsignificant portion is variable. Economic utilization of labour is, therefore, a need of thepresent-day industry or organisation. To this end, everything right from recruitmentshould be directed. It goes without saying that management is interested in theaccumulation and analysis of labour cost because they serve as a basis for:

(i) Control over direct and indirect labour cost,

(ii) Inventory costing, fixation of selling price and determination of profit, and

(iii) Managerial decisions and control.

In this unit, we shall study the concept of labour turnover and control of labour cost.We will also study the management of labour cost. At the end of the unit we will alsodiscuss the concepts of idle time and overtime.

3.2 Labour Turnover

Labour turnover is a peculiar problem of industry or organisation and leads to high costsand low productivity. It may be defined as the engagement and losses in the labourforce as related to the total numbers employed at the beginning of the period. It is acommon thing that the workers frequently change their jobs either for betterenvironment or they are forced to leave a concern due to other reasons. In any case,the industry or organisation loses trained and experienced hands and has to recruit andtrain new persons. This all increases the labour costs. The extent of labour turnovervaries according to industry, proportion of male and female in labour force, structure ofemployment in country, and physical conditions within a particular industry ororganisation. As the consequences of a high rate of labour turnover are many, everyfactory or organisation must endeavour to measure it, to study the causes and to keeplabour turnover rate at a minimum as far as possible.

3.2.1 Causes of Labour Turnover

A study into the causes of labour turnover helps the management in proper planningand action for reducing this rate. The reasons may be divided into two categories:

(a) Avoidable Causes, and

(b) Unavoidable Causes.

(a) Avoidable Causes of Labour Turnover: The various avoidable causes are:

(i) Lower wages being paid in the organisation,

(ii) Lack of planning of higher management,

(iii) Unsatisfactory working conditions in the factory,

(iv) Lack of job satisfaction,

(v) Lack of medical and transport facilities,

(vi) Discrimination between one worker and another worker,

(vii) Bad relationship with supervisors and management,

(viii) Lack of proper adjustment with workers,

(ix) Unauthorized long absence from duty,



Labour Costing 63

Notes


(x) Migratory character of Indian industrial workers, and

(xi) Lack of safety measures.

(b) Unavoidable Causes of Labour Turnover: The various unavoidable causesresponsible for labour turnover are:

(i) Death, retirement disablement of the worker,(ii) Domestic disputes of the workers,

(iii) Illness or accidents making the worker permanently handicapped,

(iv) Discharge due to unsuitability,

(v) Marriage and pregnancy in case of female workers,

(vi) Inefficiency of the workers,

(vii) Other reasons such as lack of housing and transport facilities, and

(viii)Immoral character of worker.

3.2.2 Effects of Labour Turnover

It results an increase in cost of production due to the following reasons:1. Cost of replacing workers, i.e., cost of selection,

2. Cost of training for new workers,

3. Loss arising out of defective work and increased wastage in production process,

4. Newly employed workers are likely to mishandle of machines and equipments, and

5. With frequent changes, production planning cannot be properly executed and as aresult, there is loss in production.

3.3 Labour Cost Control

Labour cost also forms a significant part of cost of production. Therefore, it is essential

that there should be proper and effective control over labour cost. Labour cost controlwill, in effect, lead to minimization of cost of labour per unit. In India, a major part oflabour cost is fixed and not variable for production process. It may be pointed out, in thisconnection, that labour is not a commodity or product and it does not behave like acommodity and product. From this angle, the task of exercising control over labour costis even more difficult than that of material cost or other chargeable expenses. Then,human element in labour cost control should be given due consideration in order tomake any control effective. A large number of non-financial factors affect the efficiencyand capacity of labour. The general cleanliness of the working area, lighting, ventilation,temperature, measures for the safety devices, impact of noise, working space in thefactory, etc., will have an effect on the labour efficiency. Therefore, labour cost control isthe important tool for the organisation.

3.3.1 Departments for Labour Control

The following departments will help to exercise control over labour cost:

Personnel and Administrative Department,

Engineering and Works Department,

Time-keeping Department,

Purchase Department,

Production and Maintenance Department,

Payroll Department, and

Accounting and Finance Department.




Notes


3.3.2 Scope of Control

Control over labour cost will include control over the following activities:

(i) Recruitment, Increments and Promotions,

(ii) Formulation of Wage Policy, Incentive Schemes and Method of Wage Payment,

and(iii) Allocation of Labour Costs.

These are now discussed in brief:

(i) Recruitment, Increments and Promotion: Recruitment is a crucial function forultimate success in attainment of labour cost control. A well-defined recruitmentpolicy, a sound agency for execution of policy, a systematic approach for tappingappropriate sources of recruitment and continuous evaluation of policies are amongthe essential requisites for control over recruitment. It should be noted that anotherpolicy of recruitment is bound to retard efficiency and hence increase labour cost.Increments are generally granted on a basis of scale for workers and promotions tobetter higher positions will lead to improvement of internal relationship andattainment of more efficiency.

(ii) Formulation of Wage Policy, Incentive Schemes and Method of WagePayment: A sound wages policy and incentive scheme can make a positivecontribution towards improving employee-employer relationships in the industry ororganisation, increasing productivity of labour and reducing labour turnover.

(iii) Allocation of Labour Costs: Control over allocation of labour cost aims atsecuring that each job or work or process undertaken bears its own share of cost,so that production cost represents true cost. It has been stated earlier that recordsof time spent for each job or work or process done are to be kept for properallocation of labour costs.

3.4 Labour Cost Management

Labour cost management is a complex process because it represents a sensitive areainvolving human behaviour. In labour cost management, we discuss:

1. Recruitment,

2. Time Keeping,

3. Time Booking,

4. Work Study,

5. Job Analysis, and

6. Merit Rating.

3.4.1 Recruitment

Every business or industry should have a recruitment policy of its own. However, certainfactors will govern the recruitment policies of an industry or organization. These factorsare:

(i) Categories of manpower required,

(ii) Type of activities undertaken,

(iii) Seasonal nature of activities,

(iv) Volume of operations,

(v) Rate of labour turnover,

(vi) Legal restrictions arising out of a labour legislation, and

(vii) Promotions and retirement.



Labour Costing 65

Notes


Having decided upon recruitment policies, the next step is to set up a properagency for carrying out these policies. This function is usually assigned to theestablishment or personnel department. Sometimes, there is a separate recruitmentcommittee which is composed of several departmental heads. Again, in a small industryor organization, recruitment procedures are likely to be informal and may often beexecuted by the top management of the industry or organization personally.

Upon recruitment, a copy of the recruitment letter containing all the terms andconditions must be forwarded to:

(i) Time office for recording attendance, and

(ii) Payroll department for authorizing enrolment in the payroll.

One copy of the appointment letter is usually retained in the personnel departmentof the organisation for maintaining the service record. As in the case of othermanagement activities, recruitment policies should be reviewed and evaluatedperiodically. A comprehensive evaluation programme will seek to assess the relativesuccess in performance of various categories of employees with reference to the sourceof their recruitment.

3.4.2 Time Keeping

Time-keeping is concerned with recording of worker's time. The recording of time put inby workers is required not only for attendance and wage calculation purpose but alsofor the purpose of cost calculation. Following are the main features of time keeping:

1. Employees’ attendance in and out of a particular department, and

2. Employees’ attendance in and out of the factory gate,

Time-keeping will serve the following objectives:

1. Ascertainment of labour cost of a job,

2. Preparation of payrolls,

3. Determining productivity and control of labour cost,4. Meeting for statutory requirements, and

5. Apportionment of overhead costs.

Usually, recording of time is the responsibility of personnel department or securitydepartment of the organisation or industry.

Methods of Time-Keeping

The two methods used for recording time may be grouped into two categories:

(i) Manual Methods: This method is very simple and in this method these will beincluded:

(a) Attendance Register Method, and

(b) Disc Method

(a) Attendance Register Method: Under this method, an attendance register is keptat the entrance of the factory or organisation and the workers’ attendance inand out of the factory gate or organisation gate is being noted. The noting downof arrival and departure time of the workers may be done by the workersthemselves or by an employee appointed for this purpose. Thereafter, theentries are made to individual attendance records from the attendance register.

The disadvantages of attendance register method are:

There will be hold-ups of workers at the time of arrival and departure,

It cannot reasonably act as a check on the dishonest practice of noting

down wrong time by the workers, and It involves extra clerical costs for maintaining individual attendance records.




Notes


(b) Disc Method: This method is generally used in a small organization or factorywhich has limited financial resources. Under this method, metal discs bearingthe numbers of the workers are placed on hooks on a board provided at theentrance of the department or organisation. While entering into the departmentand factory, as the case may be, the workers remove their respective discs andplace them in a box on empty tray provided nearby. After a short while of thescheduled time of the department or organisation or factory, the original box ortray is removed and a late box or tray is substituted. The late box or tray is alsotaken at the end of the maximum late time allowed by the personneldepartment. The time-keeper records the attendances in a register or bookwhich is subsequently passed on to the payroll department for the payment ofworkers.

(ii) Mechanical Methods: For recording the ‘In’ and ‘Out’ times of workers enteringand leaving the factory, the machines that are generally used are of the followingtwo categories:

(a) Dial Time Recorders or Time Recording Clocks, and

(b) Card Time Recorders.

(a) Dial Time Recorders or Time Recording Clocks: The time recording clock is amechanical device which automatically records the time of the workers. Thismethod has been developed to obviate some of the difficulties experienced incase of manual methods and this method is useful when the number of workersis fairly large. There is a radial arm at the centre of the dial. When a workerenters into the factory or department, he is to press the radial arm after placingit at the appropriate hole. The time recorder will then automatically record thetime on a roll of paper within the machine against the number of the worker. Itmay be noted that the sheet of paper in which the time is recorded provides arunning account of the worker’s time.

The advantages of the method are stated below:

Avoids the necessity of recopying attendance time in the payroll, and

Allows greater accuracy and avoids much loss of time.

The disadvantages of dial time recorders method are:

Capacity is limited of the machine, and

Presence of time-keeper is necessary to prevent fraud and irregularities.

(b) Card Time Recorders: Under card time recorders method, a clock card isallotted to each worker in which his attendance is recorded. In this latest type ofcard time recorder, the worker is to insert his clock card into the machine; thetime is then automatically stamped in the correct position. Late arrivals, earlyleavings, overtime, etc. are printed in red to attract attention. It enjoys all theadvantages of the dial time recorders.

3.4.3 Time Booking

In addition to recording of employees’ attendance in and out of the organisation orfactory or department, it is also necessary to record the time spent on each work order, job or operation as well as the particulars of work done. This is what is known as time-booking. Large organizations or factories keep time-recording clocks for maintainingrecords of time spent on each work, job or operation but in small organizations, this maybe done manually. The nature of documents maintained for this purpose will varydepending upon the size of the factory or organization. The following documents aregenerally in use:

(i) Daily Time Sheets,

(ii) Weekly Time Sheets, and

(iii) Job Cards or Job Tickets.



Labour Costing 67

Notes


(i) Daily Time Sheets: Each worker is given a daily time sheet in which he records theparticulars of his time spent on each job or work order. Daily Time Sheets aremaintained in small works which do not go to the expense of a card time recorder.The worker completes the sheets everyday and hands it over to the foreman forsignature. This acts as a check on the correctness since the foreman puts hissignature daily. Daily time sheet consists of the following particulars:

Name of worker,

Worker clock card number,

Name of the department,

Date of work done,

Machine number,

Type of job or Work order,

Starting and finishing time of the job or work,

Signature of foreman, etc.

The specimen of this sheet is given below:

Name of Worker : ........................................ Date : ..........................

Clock Card No. : ........................................ Week No.: ..........................

Machine No. : ........................................

Department : ........................................

Time For Cost OfficeJob/WorkOrder No.

Workdone

Description

On Off

Hours

Rate Amount

Signature of worker : ........................ Signature of foreman : ......................

Figure 3.1: Daily Time Sheet

(ii) Weekly Time Sheets: These sheets record the same particulars for a week as thedaily time sheets for a day. These sheets are an improvement over the daily timesheets. The main difference is that the worker enters all the particulars of workcarried out for a complete week at the end of the week. The specimen of weeklytime sheet can be given as below:

Worker's Name : ........................................ Date : ....................

Clock Card No. : ........................................ Week Ending : ....................

Department : ........................................

Time For Cost OfficeDate Job

No.

Work

done

Description

On Off

Hours

Rate Amount

Monday

Tuesday

Wednesday

Thursday

Friday

Saturday

Sunday

Signature of worker : ...................... Signature of foreman : ...................

Figure 3.2: Weekly Time Sheet




Notes


(iii) Job Cards or Job Tickets: Under job card method a card is made used of forrecording the time spent by workers on various jobs instead of sheets of paper. A job card is used to keep a close check on the time spent by an operator on each jobwhich he does during the day. Usually, one card is issued to an operator by thesupervisor at a time. When the operator starts the work, he records the time throughthe time recording clock on the card. The card is punched again when the work isfinished or the operation is over. If the work or operation of the job is too long andthe worker has to break off for meals or for personal needs, he should record outand in again to keep record of the time not spent on the job or operation. When the job or operation is finished, the card is deposited with the timekeeper and whosends it to the payroll department. When a job is completed, another job card isissued to the operator and he repeats the time-recording process. Specimen of jobcard is as follows:

Works Order No. : ............................... Date : ................

Department : ............................... Time : ................

Operation No. : ............................... Starting : ................

Machine No. : ............................... Finishing : ................

Time For Cost OfficeJob No. Description

On OffHours

Rate Amount

Worker's No. : .............................

Signature : ..............................

Signature of foreman : ....................................

Figure 3.3: Job Card

3.4.4 Work Study

It may be defined as any method of investigation designed to provide better job ormachine performance within a required operation. Thus, the objectives of work studymay be:

Material conservation,

Time saving,

Changes in quality,

Lowest cost, etc.

Methods of Work Study

Work study is divided into two methods:

(i) Motion Study: It is a systematic procedure for the analysis of work or job with aview to reducing or eliminating unnecessary work, arranging the remaining work inthe best order possible and standardizing the usage of proper work methods. Thesteps involved are:

(a) Systematic recording in detail of existing methods of work,

(b) Developing and applying new and improved methods of work for simplificationand better utilization of available resources, and

(c) Analysis and examination of existing and proposed methods of performing awork.

In brief, the motion study aims at finding out the most scientific and simple way ofperforming an operation or doing a job. Thus, the technique should take into



Labour Costing 69

Notes


consideration not only the human element in the job but also materials, plant andmachinery, tools and equipments, etc., to be used.

Advantages of Motion Study

The advantages of motion study are as follows:

It improves methods of performing a work or job by reducing all unnecessaryelements involved,

It aims at better utilization of available resources in the factor, and

As a result of reduction of wasteful elements, highest level of activity can beachieved all round.

(ii) Time Study: The concept of time study was introduced by F.W. Talyor. It refers tothe analysis and determination of the time necessary to perform a given task. Itreplaces the old practice of using past performance as a method of establishing thetime followed for the performance of a task.

Advantages of Time Study:

The advantages of time study are as follows: Exercising cost control through proper planning,

Assessing the labour requirements correctly,

Fixation of wage rates and introduction of incentive schemes, and

Standardizing jobs, equipments, etc., by giving guidance as to the best methodof operating in the time allowed.

3.4.5 Job Analysis

Job Analysis is a systematic exploration, study and recording the responsibilities,duties, skills, accountabilities, work environment and ability requirements of a specific job. It also involves determining the relative importance of the duties, responsibilities

and physical and emotional skills for a given job. All these factors identify what a jobdemands and what an employee must possess to perform a job productively.

Uses of Job Analysis

A comprehensive job analysis program can be used as a foundation and as anessential ingredient for all the functions and areas of personnel management andindustrial relations. A brief description of uses of job analysis is as follows:

1. Employment: Job analysis is useful as a guide in every phase of employmentprocess like manpower planning, recruitment selections, placement, orientationinduction, and in performance appraisal as it gives the information about duties,tasks and responsibilities etc.

For Example:

Job Grade: Middle Management

Job Title: Credit Manager

Age: Between 35 and 45 years

Sex: Preferably male

Educational Qualification: B.E. (Industrial Engineering) or B.Sc., Ag., with post-graduate diploma or degree in Bank management. Completion of CAIIB is anadditional qualification.

Training received: Should undergo training on the job/off the job for a period ofone year.

Experience: Experience as credit/field officer in a commercial bank for about five

years.




Notes


Physical specification: Normal height (above 5â€™-5â€?)

Social specification: Member of social organizations

Extra-curricular activities: Should have participated in sports/games at the districtor inter university level.

2. Organization Audit: Job information obtained by job analysis often revealsinstances of poor organization in terms of the factors affecting job design. Theanalysis process, therefore, constitutes a kind of organization audit.

3. Training and Development Program: Needs of training and developing areidentified with the help of job description. Further the training programs are alsoevaluated with the standards of job analysis.

4. Performance Appraisal: Instead of rating an employee on characteristics such asdependability there is now a tendency towards establishing job goals andappraising the work done toward those goals. In this type of appraisal, a jobdescription is useful in defining the areas in which job goals should be established.

5. Wage and Salary Administration: Job analysis is the basis for job evaluation.Basically wage and salary levels are fixed on the basis of job evaluation which

takes into consideration the content of the job in terms of tasks, duties,responsibilities, risks, hazards etc.

6. Employee Development: Job Analysis provides the necessary information foremployee development. When considering an employee for promotion, job analysismay facilitate his easy consideration for the job.

3.4.6 Merit Rating

Merit rating refers to a systematic analysis of merits of employees according to certaincharacteristics to ascertain the worth of each employee or a suitable class of themrelative to all others. Certain factors are taken into account in rating merits of employeesand points are assigned under each of these factors. Following are the main factors ofmerit rating:

Quality of work,

Sense of responsibility,

Quantity of work,

Initiative and effort,

Discipline,

Co-operation, honesty and integrity,

Sense of judgment,

Experience, skill, knowledge and aptitude for work or job,

Extraordinary personal features, and

Attendance and regularity.In ordinary words, merit rating is the impartial evaluation of merit and qualities of

each person of a work group. Different authors have defined it in different ways. Hereare some definitions:

According to Edwin B. Flippo, “Merit rating is a systematic periodic and so far ashumanly possible, an impartial rating of our employee’s excellence in matters pertainingto his present job and to his potentialities for a better job”.

According to Scot, Clotheir and Spriegal, “Merit rating of an employee is theprocess of evaluating the employee’s performance on the job in terms of therequirements of the job”.

According to Allford and Beatty, “Employees or personnel rating is the evaluation or

appraisal of the relative worth to the organisation of a man’s services on his job”.



Labour Costing 71

Notes


Methods of Merit Rating

For effective evaluation of any employee, these methods are generally followed:

(i) Straight Ranking Method: This is the oldest method. Here, employee is notseparately treated from his job. One person is compared with the other. Thisseparates the efficient from the inefficient but this is not practical as all personshave separate qualities. If a person is efficient in one job, the other is efficient forthe other; hence comparison is difficult between the two. To solve the problempersons are evaluated in pairs. This is known as paired comparison method. This isevaluation of a person with pair or other persons of the group.

This method is simple but it is defective. Firstly, to compare one person is difficultwith the other as every person has his own personal qualities. Secondly, onegroup’s persons are compared but they are not compared with other groups if this ispossible any how, then efficiency and inefficiency is known but no measure ofefficiency is possible. Thirdly, there is no basis for serial assessment, hence there ispartiality. Hence, this method is not used much.

(ii) Man-to-man Comparison: In this method for merit rating more variables areascertained like leadership, qualifications faithfulness. After this, for each variable, a

master scale is prepared in which for execution of each job, 5 strata are maintainedaccording to qualities. For that work most efficient and least efficient person areselected. These two persons are the two ends of the scale. After that as a mediumpoint, an average person is selected. Later on the two points are market below andover the average. In this way five points are ascertained. Comparing these points,other person’s qualities are known.

In performance appraisal, though this method is used to know the qualified personby the comparison of variables but the preparation of master scale is a difficultproblem.

(iii) Graphic Rating Method: In this method, a form is used which an index of thequalities for performance of work is given. A scale is given in front of each merit onwhich this evaluation is noted that this merit is found in the employee to what

quantity and how much of it he uses in working. On this basis, a progress report ismade ready. This method is like that of used in Montessori classes, used for theirprogress evaluation. This is more used in Eastern countries.

(iv) Checklist Method: This is also known as Questionnaire Method. In this method, forthe accomplishment of job, an index is prepared of the necessary merits. Evaluatorreads that list to a person and those merits which are found in him are (+) markedwhile those which are not in him are marked with (-) sign. Or at times ‘yes’ or ‘no’ isused to entries. If he is doubtful about a merit, he marks with (?).

This method has the possibility of partiality as evaluator does the work himself.Secondly, each department or work needs separate forms as nature of job or work,character and responsibilities have vast differences.

(v) Force Choice Description Method: In this method, employees are divided intogroups on the basis of certain tests. Then, evaluator selects two phrases from thephrases of merits which contains one more descriptive and other less descriptive.

This is a simple method and is an improvement over the grading procedure. Thereis no partiality, but this method is not able to cast directions on the futuredevelopment of the worker. At times, evaluator has to take such decisions which hedoes not prefer.

(vi) Selection of Critical Incident Method: In this method, such specific events areselected which are related to his job like overcoming with anger at the working time,disinclination to co-operate, suggestion for improvement in work procedure,prohibition of future training. After that, these could be weighted in the order ofimportance and graded. Job superintendent edits these events while executing the job and sends to personnel department on the basis of which the personneldepartment evaluates them.




Notes


(vii) Field Review Method: Under this method, evaluator asks the supervisor questionsabout the workers working under him and gets his opinion and records it. These aresigned by the supervisor and keep it for future reference as a context.

Advantages of Merit Rating

Merit rating method is the important instrument of personnel management. Itsadvantages are as follows:

(i) The scientific basis is available by the merit rating for all persons. On the basis ofthis information, their abilities are, comparatively known.

(ii) Because of the merit rating, personnel know their abilities; they try to improve in it. Ifthey have some defects, they improve and thereby earn more.

(iii) By performance evaluation personnel are developed. Development policies likeconstruction of promotion lines, transfer, training and their development are mostimportant instrument by which these programmes are prepared logical andthoughtful.

(iv) Generally, every worker is eager to know the management’s opinion about his work

and ability. A properly planned merit programme gives chances to a person to knowabout him and motivates them for development. This increases their mentalstrength and gets self-satisfaction.

(v) The main advantage of the merit rating goes to management. They know theabilities of the persons and on that basis, the management sets right theprogramme for their promotion, transfer, forced leave and discharge. It’s service indetermining a sound and suitable wage structure. Appraisals can be used toevaluate the training programmes also.

(vi) By right merit rating, the supervisor knows the efficiency of the personnel workingunder him and he knows his weaknesses and how to avoid them, he suggests themanagement on one hand and the tries to improve the weaknesses of the workerson the other hand.

(vii) Merit rating is helpful in the placement of the personnel. This means that thepersonnel should be placed on the right job. Besides, the workers kept on probationcan be decided at to his abilities so that he may be kept at proper place afterprobation or be discharged or by increasing the probation period, necessaryimprovements be done in him.

Disadvantages of Merit Rating

Following are the disadvantages of merit rating:

(i) Judgment of raters may be influenced by past rating records,

(ii) Incentive method introduced on the basis of merit rating may not be always strongenough to attract better performance from workers, and

(iii) Since human opinion is involved in rating, it may be arbitrary and consequently leadto labour unrest.

3.5 Idletime and Overtime

This section will help you understand the concepts of idle time and overtime.

3.5.1 Idle Time

Usually, there is bound to be some difference between the time booked to different jobsor work orders and gate time. The difference of this is known as idle time. Idle time isthat time for which the employer pays, but from which he obtains no production. Idletime is of two types:

(a) Normal idle time, and

(b) Abnormal idle time



Labour Costing 73

Notes


Normal Idle Time

This represents the wastage of time that cannot be avoided and, therefore, theemployer must bear the labour cost of this time. Following are some examples ofnormal idle time:

1. The time taken in going from the factory gate to the department in which the workeris to work, and then again the time coming from the department to the factory gateat the end of the day.

2. The time taken in packing up the work for the day.

3. The time which elapses between the completion of the job and the commencementof the next job.

4. The time taken for personal needs and tea breaks.

5. The time lost when production is interrupted for machine maintenance.

Treatment of Normal Idle Time

As it is unavoidable cost and as such should be included in cost of production. The cost

of normal idle time can be treated as an item of factory expenses and recovered as anindirect charge or added to labour cost.

Abnormal Idle Time

It is that time wastage which can be avoided if proper precautions are taken. Examplesof abnormal idle time can be cited as below:

1. The time wasted due to breakdown of machinery on account of the inefficiency ofthe work engineers.

2. Time wasted on account of the failure of the power supply.

3. The time wasted due to strike or lockouts in the factory.

Treatment of Abnormal Idle Time

It is a principle of costing that all abnormal expenses and losses should not be includedin costs and as such wages paid for abnormal idle time should not form part of the costof production. Hence it is debited to Costing Profit and Loss Account.

3.5.2 Overtime

It is the work done beyond the normal working period in a day or week. For overtimedone, the workers are given double the wages for the overtime done. The additionalamount paid on account of overtime is known as overtime premium.

Overtime increases the cost of production and should not be encouraged as it hasthe following disadvantages.

1. Overtime is paid at higher rate.

2. Overtime is done at late hours when workers have become tired and efficiency will itbe as much as during the normal working hours.

3. Workers will develop the habit of working slowly during normal hours and completethe work using overtime to earn more wages.

4. Expenses like lighting, cost of supervision, and wear and tear of machines willincrease disproportionately.

Overtime should be recorded separately and thoroughly investigated to see that it isincurred only when genuinely required. Overtime is normally permitted on by thesupervisors or departmental heads. There is a form called ‘request for overtime’wherein the details of job and reason for extra hours beyond nor-mal working hours arementioned. If though fit, such working may be permitted. The reasons for overtime may

be:-




Notes


Illness of some workers may force other to work extra and complete the work

It may be at the request of customers to complete an order in quick time

There could be receipt of more orders than planned and it may not be possible toimmediately employ additional workers

Receipt of rush orders

Treatment of Overtime Cost

If overtime is worked on specific jobs at the request of the customer, the cost isbooked as a direct labour cost on that job

In other cases, normal payment for overtime hours may be taken as cost ofproduction and the premium portion is treated as overheads. The idea of doing so isthat the prime cost comparison should not get vitiated due to inclusion of premiumin the cost. Some concerns allocate the overtime premium on all jobs done duringthe period.

If overtime is worked to recoup the lost hours due to fire, floods etc., the premiumportion is charged to P & L account

3.6 Summary

Labour is an important element of cost of production. It plays an important role inproduction even in the modern machine age where there is extensive use of machines.Labour cost may be divided into direct labour cost, and indirect labour cost. It is acommon thing that the workers frequently change their jobs either for betterenvironment or they are forced to leave a concern due to other reasons. In any case,the industry or organisation loses trained and experienced hands and has to recruit andtrain new persons. This all increases the labour costs. Labour cost also forms asignificant part of cost of production. Therefore, it is essential that there should beproper and effective control over labour cost. Labour cost control will, in effect, lead tominimization of cost of labour per unit.

Control over labour cost will include control over the Recruitment, Increments andPromotions, Formulation of Wage Policy, Incentive Schemes and Method of WagePayment, and Allocation of Labour Costs. The two methods of time keeping are manualmethods (Attendance Register Method, and Disc Method) and mechanical methods(Dial Time Recorders or Time Recording Clocks, and Card Time Recorders). In additionto recording of employees’ attendance in and out of the organisation or factory ordepartment, it is also necessary to record the time spent on each work order, job oroperation as well as the particulars of work done which is known as time-booking.

The motion study aims at finding out the most scientific and simple way ofperforming an operation or doing a job. Thus, the technique should take intoconsideration not only the human element in the job but also materials, plant andmachinery, tools and equipments, etc., to be used. The concept of time study was

introduced by F.W. Talyor. It refers to the analysis and determination of the timenecessary to perform a given task. It replaces the old practice of using pastperformance as a method of establishing the time followed for the performance of atask.

A comprehensive job analysis program can be used as a foundation and as anessential ingredient for all the functions and areas of personnel management andindustrial relations. Merit rating refers to a systematic analysis of merits of employeesaccording to certain characteristics to ascertain the worth of each employee or asuitable class of them relative to all others.

Usually, there is bound to be some difference between the time booked to different jobs or work orders and gate time. The difference of this is known as idle time. Idle timeis that time for which the employer pays, but from which he obtains no production.

Overtime is the work done beyond the normal working period in a day or week. For



Labour Costing 75

Notes


overtime done, the workers are given double the wages for the overtime done. Theadditional amount paid on account of overtime is known as overtime premium.


Multiple Choice Questions1. Lack of planning of higher management………………….of labour turnover

(a) Avoidable cause

(b) Unavoidable cause

(c) Inevitable cause

(d) Necessary cause

2. ………………….are generally granted on a basis of scale for workers andpromotions to better higher positions

(a) Remuneration

(b) Increments

(c) Pay

(d) Bonus

3. …………………is concerned with recording of worker's time.

(a) Book-keeping

(b) Merit Rating

(c) Time-keeping

(d) Work Study

4. Under ………………method a card is made used of for recording the time spent byworkers on various jobs instead of sheets of paper.

(a) Job card

(b) Weekly Time Sheets

(c) Daily Time Sheets

(d) Attendance Register

5. The ……………..study aims at finding out the most scientific and simple way ofperforming an operation or doing a job.

(a) Work

(b) Time

(c) Motion

(d) Daily

6. ………………….involves determining the relative importance of the duties,responsibilities and physical and emotional skills for a given job.

(a) Job analysis

(b) Job evaluation

(c) Job specification

(d) Job description

7. Which is the oldest method of merit rating?

(a) Man-to-Man Comparison

(b) Graphic Rating

(c) Straight Ranking

(d) Checklist




Notes


8. By right merit rating, the supervisor knows the ………………of the personnelworking under him.

(a) Punctuality

(b) Efficiency

(c) Regularity(d) Personality

9. The difference between the time booked to different jobs or work orders and gatetime is known as ……………time.

(a) Abnormal

(b) Normal

(c) Overtime

(d) Idle

10. Overtime is paid at …………….rate.

(a) Higher

(b) Lower

(c) Marginal

(d) Average


1. What do you understand by labour turnover? Discuss the causes of labour turnover.

2. “Control over labour cost will include control over the Recruitment, Increments andPromotions”. Discuss.

3. Explain the different methods of time keeping.

4. What do you understand by time booking? Which documents are generally required

for time booking?5. Discuss the methods of work study. Also discuss their advantages.

6. Explain the uses of job analysis.

7. Explain merit rating system and the different methods of merit ratings.

8. Discuss the treatment of idle time and overtime in the books of accounts.

3.9 Key Terms

Labour Turnover: It may be defined as the engagement and losses in the labourforce as related to the total numbers employed at the beginning of the period.

Time Keeping: Time-keeping is concerned with recording of worker's time. Therecording of time put in by workers is required not only for attendance and wage

calculation purpose but also for the purpose of cost calculation.

Time Booking: It means to record the time spent on each work order, job oroperation as well as the particulars of work done.

Motion Study: It is a systematic procedure for the analysis of work or job with aview to reducing or eliminating unnecessary work, arranging the remaining work inthe best order possible and standardizing the usage of proper work methods.

Job Analysis: It is a systematic exploration, study and recording theresponsibilities, duties, skills, accountabilities, work environment and abilityrequirements of a specific job.


1. (a) Avoidable cause2. (b) Increments



Labour Costing 77

Notes


3. (c) Time-keeping

4. (a) Job card

5. (c) Motion

6. (a) Job analysis

7. (c) Straight Ranking8. (b) Efficiency

9. (d) Idle

10. (a) Higher





J K Mitra, Advanced Cost Accounting, New Age International, 2009 Jawahar Lal, Seema Srivastava, Cost Accounting, McGraw-Hill Education, 2013




Notes


CASE STUDY: AN INDUSTRIAL CASE IN CHINA – EASYWELD WELDINGEQUIPMENT COMPANY

Hong Kong-invested industrial enterprises are now mainly located in China, especially thePearl River Delta, where around 55,200 such enterprises operate. Easyweld WeldingEquipment Company is one of the Hong Kong-invested industrial enterprises and thecompany makes welding equipment in Pun Yu District, Guangzhou.

There are 30 factory workers, one assistant supervisor and one supervisor in the plant.Their daily work is to construct welding equipment on an individual or group basis. Theworkforce comprises three levels of workers, and the classification is by work experienceand skills level. The remuneration structure is mainly based on time worked.

Level 1: Fresh workers: Newly recruited workers are offered a probation period of 3months. The daily wages are RMB20, and the workers work 8 hours a day and 6 full daysa week. As the quality of work is of prime concern, the factory accounts for its labour coston a time basis rather than on a piece-work basis.

Level 2: Workers with less than one year’s experience on the post: Once workers havetheir employment confirmed after the 3-month probation period, they are paid monthlysalaries. The factory adopts a merit rating, and the workers’ salaries depend on their skill

levels. Workers at a low to medium skill level are paid RMB500 to 600 a month, whileworkers at a high skill level are paid up to RMB 1,000 a month. In addition, a meritpayment of RMB50 a month is offered to certain workers, depending on their attitude.

Level 3: Workers with more than one year’s experience at the post: These workers, whoinclude the assistant supervisor and the supervisor, are paid RMB1,000 to 1,500 a month.In addition, they are offered a group bonus. Since product quality is of prime concern inengineering production, there is no incentive scheme for pushing up production volume.Nevertheless, if there is premium production in any one month, these level 3 workers aregranted a group bonus of RMB 3 to 8 per piece of welding equipment manufactured.

In order to maintain work quality, overtime work is not encouraged. Under the ChineseGovernment Labour Ordinance, the factory pays an overtime work premium that rangesfrom 25% to 50% basing on the duration of overtime work. By regulations, all factoryworkers are paid for time-anda-quarter for overtime carried out between 6pm and 10 pm

on weekdays. They are paid time-and-a-half for overtime carried out after 10 pm onweekdays and on Sundays. In addition, the factory flexibly offers extra payment to workersso as to ensure the fulfillment of minimum staff salary enforced by the Labour Ordinance.(A minimum monthly salary of RMB780 is set for the rural Guangzhou.)

For all levels of workers the factory pays for food and accommodation on top of labourwages or salaries. Both the food costs and accommodation costs are around RMB200 amonth for each worker. The factory also pays RMB10 a month as social welfarecontribution for each worker. This social welfare contribution by employers is mandatory inChina. A pension fund contribution is not mandatory in China; it is established on mutually-agreed basis by both employers and employees. The factory also contributes RMB4 amonth as medical insurance for each worker. In addition, the employer and workerscontribute an equal payment for social insurance; the amount is around RMB80 to 90 amonth from each side.

In order to encourage staff development, the factory offers a work-related education

sponsorship of RMB600 to RMB1,000 to workers. Workers usually take work-relatedcourses like electronic engineering, computer aided design, and/or software skills. In orderto maintain the strength of the labour force, workers can have their course fee reimbursedonly after completion of the course.

Bonus Scheme for Maintaining Labour

High labour turnover is a significant problem in Guangdong. In recent years, Easyweld hassuffered a labour turnover rate of around 20% a year. Usually, this turnover happens whenworkers do not return to work after the Chinese New Year (CNY) holidays. To rememdythis situation, the factory offers an annual bonus to its level 3 workers. Half of the annualbonus is paid before the CNY holidays, with the rest paid after the holidays. This type ofarrangement provides a useful financial incentive to help the enterprise maintain itsworkforce.



Labour Costing 79

Notes


Concluding Remarks

Labour cost accounting involves the study of the behaviour of labour, performancemeasurement, time and motion studies, control on attendance and governmentregulations. In modern industrial enterprises the worker’s wage is based upon jobevaluation, merit rating, incentive remuneration schemes and government ordinances.

Questions1. Discuss the impact of remuneration structure adopted by the company on the

performance of employees.

2. Analyse the impact of bonus scheme on employee’s performance? Are they satisfiedwith the bonus scheme of the company?




Notes


Unit 4: Methods of Wage Payment

Structure

4.1 Introduction

4.2 Methods of Remuneration

4.2.1 Time Rate Method

4.2.2 Piece Rate Method

4.2.3 Incentive Plans/Schemes

4.3 Summary



4.6 Key Terms


Objectives


Understand the concept and methods of time rate method of wage payment

Discuss the concept and methods of piece rate method of wage payment

Explain the concept and methods of different incentive schemes

4.1 IntroductionRemuneration to workers is the most complex problem in a democratic country likeIndia because there is no effective single method of wage payment which is acceptableboth to the employers and the workers. Wages as a means of providing income for theworkers become the only source of income which determines their economic survival inthe society, so they try to force the employers to follow a method of wage orremuneration payment.

Remuneration for labour is wages as remuneration for capital is interest, for land isrent and for organization is profit. Both direct and indirect labour employed in a factoryor industry will have to be paid remuneration for the services rendered by them. Theamount of wages or remuneration payable to each of the employees depends on anumber of factors. The terms of employment generally specify the rate or pay scale and

other allowances payable to workers. In the modern industrial organisation of massproduction, a worker’s wages are eased upon incentive, job evaluation, negotiatedlabour contracts, wages plans and profit-sharing, etc.

In this unit we will discuss the concepts of time rate, piece rate and incentiveschemes method of wage payment. We will also study the different methods of wagepayment under time rate, piece rate and incentive scheme method of wage payment.

4.2 Methods of Remuneration

There are three basic methods of wage payment or remuneration, i.e. time rate method,piece rate method and incentive plans or schemes. The different methods ofremuneration or wage payment can be classified into:

1. Time Rate Method,



Methods of Wage Payment 81

Notes


2. Piece Rate Method, and

3. Incentive Plans/Schemes.

Methods ofRemuneration or Wage

Payment

Time Rate Method Piece Rate MethodIncentive

Plans/Schemes

Flat Time RateMethod

Straight Piece RateMethod

Combination ofTime and PieceRates

High Day RateMethod

Taylor DifferentialPiece Rate Method

Premium BonusSchemes

Graduated Time rateMethod

Piece GraduatedTime Rates

Group BonusSchemes

Merrick Multiple PieceRate Method

Other IncentivePlans

Figure 4.1: Methods of Remuneration

4.2.1 Time Rate Method

Under time rate method of wage payment, the worker is paid at an hourly, daily, weeklyand monthly rate. The general features of all the time rate method is that the workers donot get anything beyond their time wages. There are three types of this method, theyare as follows:

(i) Flat Time Rate Method: It is the oldest method of wage payment. Under thismethod, workers or employees are paid at a flat rate on the basis of time they areemployed. The flat rate may be hour, day, week and month basis. This method ofwage payment is most suitable for the skilled and unskilled workers. When paymentis made on the basis of hours worked by the employees, wages are to be calculatedfrom the following formula:

Wages = Hours worked × Rate per hour

(ii) High Rate Method: This method is similar to the previous method except that theday rates are made high enough, so that in return a much higher standard ofperformance from the workers is ensured. According to Henry Ford, the time ratesat high wage levels are equally effective like other incentive plans.

(iii) Graduated Time Rate Method: Under this method, the wages are paid at timerates which vary with changes in local cost of living index. In India, the basic wagerates normally remain fixed and it is the dearness allowance, other allowances, etc.that varies with the cost of living. Sometimes, wage rates are adjusted with changesin the selling price of the product.

Advantages of Time Rate Method

The following are the main advantages of this method:

(i) Simplicity: It is the most simple method. Wages can be easily calculated byworkers as well as by the management. As the system is very simple to understand,the workers are also satisfied with it.

(ii) Best Work: As there is no hurry to the worker for completing the work, he handles

work with his all ability and cares the job. Hence, this method is useful for artisticand fine jobs.




Notes


(iii) Safety of Wages: The timely prescription of wages is very safe. Sickness, accidentor less work has no effect on the wages.

(iv) Economy in Costs: As labourer and producer are is no hurry for the work, it isdone properly and accurately with care so there is no need of control, hence, thereis economy in administration costs as less supervision is required.

(v) Easy Counting: Workers can calculate their wages easily. Working for a certainperiod gives them knowledge as to what they have earned as wages.

(vi) Feeling of Unity: Workers engaged in the same kind of work with equal wageshave the feeling of unity and makes the union strong.

(vii)Appropriate Use of Factors of Production: As there is no rush of work andmachines, instruments and materials are properly handled and wastes are avoided.

(viii) Possibility of Exhibiting Efficiency: Worker performs the job with care and ablyhence he has enough chances to show his job efficiency.

Disadvantages of Time Rate Method

This method has following disadvantages also:

(i) Need of More Inspection: Times wages make the labour costly. They do not carefor time and consume time uselessly. Hence to make it disciplined, they need morecontrol and inspection.

(ii) Fatal to Efficiency: Efforts and rewards are not correlated in this system. Thisworks as a disincentive to efficient and skilled workers. They feel frustrated. Itleaves a bad moral influence on them in the long run.

(iii) Dissatisfaction Among Workers: Inefficient and efficient persons get equalwages, hence efficient workers lose their enthusiasm for work. They are dissatisfiedbecause of less wages and he finds other outlets for working.

(iv) Employer’s Complaint: Employer is unsatisfied with the work of workers even if hemay do much work. He expects always more work from them.

(v) Higher Cost of Production: As there is no check on the quantity of production byworkers, more supervision is required. Thus, the additional cost of supervisionincreases the labour cost per unit.

(vi) Slow Production: Worker has no hurry to work hence, there is slow work andproduction slackens.

4.2.2 Piece Rate Method

The second important method of wage payment is piece rate method. Under thismethod, the wages are paid on the basis of output of workers without considering thetime taken in performing the work. Thus, the workers are paid on the basis of quantity ofwork.

This quantity of work is expressed in terms of units e.g. per meter, per tonne, perpiece etc. In this method, the wages are to be calculated from the following formula:

Wage = No. of units produced × Rate per unit

Types of Piece Rate Method

Following are the main types of piece rate method:

(i) Straight Piece Rate Method: Under this system, payment is made on the basis ofa fixed amount per unit or number of units produced without regard to time taken.The wages are to be calculated from the following formula:

Wages = Number of units × Rate per unit

The piece rate is usually fixed with the help of work study. Standard time for each

job is ascertained first. Piece rate is then ascertained with reference to hourly ordaily rate of pay.




Notes


(ii) Taylor Differential Piece Rate Method: In the Taylor differential method, piecerates were determined by time and motion study. Day wages were not guaranteed.There were two rates: very low piece rate and high piece rate. Thus, the systemwas designed to:

Reward the efficient workers by setting a high piece rate for high level production,

andDiscourage below-average workers by providing no guaranteed wages and settinglow piece rate for low level production.

Problem 1: Calculate the earnings of workers A and B under Straight Piece-rateSystem and Taylor’s Differential Piece-rate System form the following particulars.

Normal rate per hour = ` 1.80

Standard time per unit = 20 seconds

Differentials to be applied:

80 % of piece rate below standard

120% of piece rate at or above standard.

Worker A produces 1,300 units per day and worker B produces 1,500 units per day.

Solution:

Standard production per 20 seconds = 1 unit

Standard production per minute = 60/20= 3 units

Standard production per hour = 3 x 60 = 180 units

Standard production per day of 8 hrs(assumed) = 180 x 8 = 1440 units


Normal piece rate = ` 1.80/ 180 units = 1 paisa

Low piece rate below standard production (1P x 80) /100 = 0.8 paise

High piece rate at or above standard (1P x 12) /100 = 1.2 paise

Earning of worker A

Under straight piece rate system

1300 units @ 1P =×1300 1

100= ` 13

Under Taylor’s Differential Piece-rate System

1300 units @ 0.8 P = ×1300 0.8

100= ` 10.40

Low piece rate has been applied because worker A’s daily production of 1300 unitsis less than the standard daily production of 1,440 units.

Earnings of Worker B

Under Straight Piece-rate System

1500 units @ 1P = ×1500 0.1

100= ` 15

Under Taylor’s Differential Piece-rate System




Notes


1500 units @ 1.2P = ×1500 1.2

100= ` 18

High piece-rate has been applied because worker B’s daily production of 1500 unitsis more than the standard daily production of 1440 units.

(iii) Piece Graduated Time Rate: Under this method, workers are paid minimumwages on the basis of time rates. A piece rate method with graduated time rate mayinclude any one of the following:

Guaranteed wages according to time rate plus a piece rate payment for units abovea required minimum,

Piece rate with a fixed dearness allowance or cost of living bonus, and

If earning on the basis of piece rate is less than the guaranteed minimum wages,the workers will be paid on the basis of time rate.

(iv) Merrick Multiple Piece Rate Method: Merrick afterwards modified the Taylor’sdifferential piece rate method. Under this method, the punitive lower rate is notimposed for performance below standard. On the other hand, performance above acertain level is rewarded by more than one higher differential rate. Thus, thismethod rewards the efficient workers and encourages the less efficient workers toincrease their output by not penalizing them for performance. This method alsodoes not guarantee day wages.

Problem 2: Calculate the earnings of workers A, B and C under straight piece ratesystem and Merrick’s multiple piece rate system from the following particulars:

Normal rate per hour ` 1.8

Standard time per unit1 minute

Output per day is as follows:

Worker A : 384 units

Worker B : 450 units

Worker C : 552 units

Wording hours per day are 8

Solution:

Standard output per minute = 1 unit

Standard production per hour = 60 units

Standard production per day of 8 hours= 480 units (8 x 60)


Normal output per hour = 60 units

Normal piece rate =1.80

60= 3 paise

Calculation of level of performance:

Standard output per day = 480 units

Worker A’s output per day = 384 units

Worker A’s level of performance = ×384

100480

= 80%

Worker B’s output per day = 450 units




Notes


(ii) The worker may be tempted to have quantity even at the cost of his health.

(iii) The workers always attempt to maximize their output and in doing so they use themachines and tools recklessly and thus, the breakage cost may increase.

(iv) Determination of the piece rate is a difficult task and generally disputes take placebetween employer and employees due to it.

(v) As more output means more wages, the workers are always in a hurry to producemore. They are encouraged to have quantity at the costs of quality; bad qualitymeans wastage of material and other resources on the same products.

(vi) The method will frustrate the less efficient workers. The efficiency may furtherdecrease because of discontent.

4.2.3 Incentive Plans/Schemes

The basic purpose of incentive plans to introduce for workers to produce more to earnhigher wages. The various incentive plans are available for wage payment to workers.Following are main incentive plans and discussed are as follows:

(i) Combination of Time and Piece Rates,

(ii) Premium Bonus Schemes,

(iii) Group Bonus Schemes, and

(iv) Other Incentive Plans.

Combination of Time and Piece Rates

Under this scheme the following methods are important for wage payment:

(a) Emerson Efficiency Bonus Scheme, and

(b) Gantt Task Bonus Scheme.

(a) Emerson Efficiency Bonus Scheme: This scheme is designed to giveencouragement to the slow works to perform batter than before. Under this system,

time wage is guaranteed. The main features of plan are: Day wages are guaranteed,

A standard time is fixed for each production or output,

Below 66 2/3 per cent efficiency, the worker is paid his hourly rate and from 662/3 per cent upto 100 per cent efficiency, payments are made on the basis ofstep bonus rates, and

Above 100 per cent efficiency, an additional bonus of 1 per cent of the hourlyrate is paid for each 1 per cent increase in efficiency.

The formula for calculating earnings under this scheme is:

Earnings = AT × R + (Percentage of Bonus × AT × R)

Problem 3: Standard time 8 hours, standard output 8 units, rate per hour ` 3, unitsproduced 5, 6, 7, 8 and 10. The table of premium is as under:

Efficiency (%) Bonus (%)

67-70

71-80

81-90

91-99

100

5

7

10

15

20

Calculate total wage payment and cost of per unit under Emerson plan.




Notes


Solution:

Statement for Total Wage Payment and Cost of Per Unit

BonusUnitoutput

Timehours

Rate perhours

Dailywages

(

)

Workcapacity

(%)

Percentage Amount

( )

Totalwages

(

)

Costper unit

(

)

5 8 3 24 62.5 - - 24.0 4.8

6 8 3 24 75.0 7 1.68 25.68 4.28

7 8 3 24 87.5 10 2.40 26.40 3.77

8 8 3 24 100.0 20 4.80 28.80 3.60

10 8 3 24 125.0 45 10.80 34.80 3.48

(b) Gantt Task Bonus Scheme: This method combines time rates, high piece ratesand bonus. The day wage under this method is guaranteed. The main features ofthis method are:

Day wages are guaranteed,

Standards are set and bonus is paid if a work is completed within the standardtime,

Performance below standard is paid on the basis of time rate, and

Performance above standard is paid at high piece rate. The workers may alsoreceive bonus if the workers under him qualify for it.

The time and bonus rates are fixed for each work, and when a work is completedthe worker goes on with the next. Thus, this plan provides an incentive for efficientworker to reach a high level of performance and also protects and encourages theless efficient workers by ensuring the payment of their minimum wages in case theirperformance is below the standard level.

Premium Bonus Schemes

The various schemes under premium bonus scheme combine time wages with piecerates. There are three main schemes under this method:

(a) Halsey Premium Scheme,

(b) Halsey-Weir Scheme, and

(c) Rowan Premium Scheme.

(a) Halsey Premium Scheme: This plan was introduced by F.A. Halsey in the year1981. It is a simple combination of time and piece rate method. The main featuresof this scheme are:

Standard time is fixed for each work or operation,

Time rate is guaranteed and the worker receives the guaranteed wages, and

If the work is completed in less than standard time, a worker is paid a bonus of50% of the time saved at time rate in addition to his normal time wages.

The formula for calculating bonus and earnings is as follows:

Bonus = 50% of (Time saved × Time rate)

Earnings = Time rate × Time taken + 50% of (Time saved × Time rate)

Problem 4: Calculate total earnings from the following data:

Normal hourly rate ` 4

Time allowed for a job 20 hours

Time taken 16 hours




Notes


Solution:

Total earnings = Time rate × Time taken + 50% of (Time saved × Time rate)

= (16 × ` 4) + ½ (20 – 16) × ` 4

= ` 64 + 4

= ` 68

Problem 5:

Rate per hour = ` 1.50 per hour

Time allowed for job = 20 hours

Time taken = 15 hours

Calculate the total earnings of the worker under the Halsey Plan. Also find outeffective rate of earnings.

Solution:

Standard time (S) = 20 hours

Time taken (T) = 15 hours

Rate per hour (R) = ` 1.50 per hour

Total Earnings = T x R + 50% (S-T) x R

=50

15 1.50+ (20 15) 1.50100

× − × ` ` = ` 26.25

Total wages for 15 hours = ` 26.25

Therefore, effective rate of earning per hour =

Total Wages

Actual Time Taken

=26.25

15 ` 1.75

(The percentage of bonus is taken as 50% when not given)

(b) Halsey-Weir Scheme: Under this scheme, a worker will get a bonus of 30% of timesaved as against 50% in the case of previous scheme. In other respects, bothHalsey and Halsey-Weir Schemes are similar.

Problem 6: Continuing the previous problem, the earnings under this scheme will be:

= (16 × ` 4) + 30/100 (20 – 16) × ` 2

= ` 64 + 2.40

= ` 66.40

(c) Rowan Premium Scheme: This scheme was introduced by D. Rowan in 1901. Asbefore, the bonus is paid on the basis of time saved. This plan is also similar toHalsey plan except in calculation of bonus. The formula for calculating wages is:

(i) Total Wages = Time wages + (Time wages × Bonus ratio)

(ii) Total Wages = Time taken × (Hourly rate + Hourly rate × Bonus ratio)

Time Saved = Time allowed – Time taken




Notes


Problem 7: Calculate total earnings from the following data:

Time taken 8 hours

Time allowed 10 hours

Rate per hour ` 2

Solution:

Bonus ratio is10 8 2 1

10 10 5

−= = =

Total earnings by method (i)

= 8 hrs. × ` 2 + ` 16 × 1/5

= ` 16 + 3.20

= ` 19.20

Total earnings from method (ii)

= 8 hrs. × ( ` 2 + 2 × 1/5)

= 8 hrs. × ` 2.40

= ` 19.20

Advantages of Rowan Premium Scheme

(i) It is suitable for learners and beginners,

(ii) The workers share the benefit with the employer, and

(iii) This scheme provides a safeguard against loose fixation of standard.

Disadvantages of Rowan Premium Scheme

(i) It is more complicated than the Halsey premium scheme,

(ii) The employers share the bonus earned by workers, and

(iii) Incentive is not as attractive as it is with his piece work rate.

Problem 8: A worker completes a job in a certain number of hours. The standard timeallowed for the job is 10 hours, and the hourly rate of wages is ` 1. The worker earns a50% rate of bonus of ` 2 under Halsey Plan. Ascertain his total wages under the RowanPremium Plan.

Solution:

The worker earns ` 2 as bonus at 50%; so total bonus at 100% should be ` 4. The hourly

rate of wages being Re.1, the time saved should be 4 hours.Standard time allowed 10 hours

Less: Time Saved 4 hours

Time Taken 6 hours

Earnings under the Rowan Premium Plan

Earnings =(S T)

T R T RS

−× + × ×

Where, T = 6 hours

S = 10 hours

R = Re.1 per hour




Notes


Earnings =(10 6)

6 1 6 110

−× + × × = ` 8.40

Group Bonus Schemes

In all the premium schemes discussed so far, the bonus payable to as individual was

ascertained. But bonus scheme for a group of workers working together may also beintroduced where:

(a) It is necessary to have a team work,

(b) It is difficult to measure the output of individual workers because the outputdepends upon the combined effort of a team of workers, and

(c) It is required to reward not only the direct workers but also the indirect workers.

Types of Group Bonus Plans

Some of the group bonus plans are described below:

(a) Priestman’s Production Bonus: Under this plan, a standard is fixed in terms of units.If actual output, measured similarly, exceeds standard, the workers will receive abonus in proportion to the increase. Therefore, this method can operate in aindustry where there is mass production of a standard product with little.

(b) Towne Gain Sharing Plan: According to this plan, 50% of savings in cost is paid toindividual workers in addition to their basic wages. In this plan the bonus iscalculated on the basis of reduction in labour cost. The supervisory staff may alsoreceive a share of the bonus.

(c) Scanlon Plan: Under this plan a constant proportion (ratio of wages to sales value)of the added value of output is paid to the workers who are responsible for theaddition of the value. The added value is the change in market value.

Advantages of Group Bonus Schemes

(i) It creates a team spirit for high output or high production,

(ii) It guarantees time wages to the members of a group,

(iii) Harmonious working in a group leads to increased output and lower cost ofproduction, and

(iv) It eliminates excessive waste of time.

Disadvantage of Group Bonus Schemes

(i) The effort of more efficient workers are not properly rewarded,

(ii) The production of a group should be independent of any other group, and

(iii) It is difficult to fix the amount of incentive and its principle of distribution among theworkers.

Other Incentive Plans

Other incentive plans may be divided in to two incentive plans.

(a) Indirect Monetary Plans: These plans are further divided into:

Profit-sharing Plan: Under this plan, the employees are entitled, by virtue of anagreement, to a share of profits at an agreed percentage in addition to theirwages. This type of plan recognizes the principle that every worker contributessomething towards profits and hence he should be paid a percentage thereof.

Co-partnership Plan: Under this plan, employees are allowed to have a share inthe capital of the industry or organisation and thereby to have a share of theprofit, when co-partnership operates in conjunction with the profit sharing. Theemployees are allowed to leave their bonus with the industry or organisation asshares or as a loan carrying minimum interest.




Notes


(c) Piece Graduated Time

(d) Merrick Multiple Piece

3. ……………….afterwards modified the Taylor’s differential piece rate method.

(a) Fayol

(b) Merrick(c) Rowan

(d) Halsey

4. As compared to the time rate method, under piece rate method the supervisioncosts are ………………

(a) Low

(b) High

(c) Average

(d) Maximum

5. The basic purpose of …………………to introduce for workers is to produce more to

earn higher wages.

(a) Time Rate method

(b) Piece Rate method

(c) Incentive plans

(d) Differential Rate method

6. ……………………Bonus Scheme is designed to give encouragement to the slowworks to perform batter than before.

(a) Emerson Efficiency

(b) Halsey Premium

(c) Gantt Task

(d) Group Bonus

7. ……………..Scheme combines time rates, high piece rates and bonus.

(a) Time Rate

(b) Emerson Efficiency

(c) Incentive

(d) Gantt Task Bonus

8. Under Halsey premium scheme Time rate is guaranteed and the worker receives……………….wages.

(a) Guaranteed

(b) Maximum(c) Minimum

(d) No

9. Under ……………….Plan, the employees are entitled, by virtue of an agreement, toa share of profits at an agreed percentage in addition to their wages.

(a) Club facilities

(b) Co-partnership

(c) Profit-sharing

(d) Emerson Efficiency

10. ………………..plans are provided by the undertaking to make the conditions of

employment more attractive, and to promote better health and atmosphere in theworkers.




Notes


(a) Non-monetary

(b) Monetary

(c) Profit- sharing

(d) Co-partnership


1. Describe the methods of remunerating labour.

2. Define time rates and its advantages and disadvantages.

3. What are the objectives of a group bonus scheme? Enumerate the circumstanceswhere group bonus schemes may be successfully operated.

4. Standard time is 24 hours. The hourly rate of guaranteed wage is ` 3. Because oftime saved, a worker Mr. Rajesh gets an effective hourly wage rate of ` 3.75 underRowan Premium Plan. For the same saving in time, calculate the effective hourlyrate of wages for a worker Mr. Rajesh under Halsey System.

5. During one week, the workman A manufactured 200 units. He received wages for a

guaranteed 45 hours week at the rate of ` 15 per hour. The time allowed to produceone unit is 15 minutes which is increased by 20% in case of piece rate system.Calculate his gross wages under each of the following methods of remuneratinglabour:

(a) Time Rate, (b) Piece Rate,

(c) Halsey Premium Plan, (d) Rowan Premium Plan.

6. Briefly distinguish between: straight piece rates, piece rates with guaranteed dayrates, differential piece rates.

7. Discuss the advantages and disadvantages of the piece rate method of payment ofwages. Do you consider that workers remunerated by reference to this methodshould be required to maintain time records?

8. Write short note on Merrick’s differential piece rate system.

4.6 Key Terms

Flat Time Rate Method: Under this method, workers or employees are paid at aflat rate on the basis of time they are employed.

Graduated Time Rate Method: Under this method, the wages are paid at timerates which vary with changes in local cost of living index.

Straight Piece Rate Method: Under this system, payment is made on the basis ofa fixed amount per unit or number of units produced without regard to time taken.

Merrick Multiple Piece Rate Method: Under this method, the punitive lower rate isnot imposed for performance below standard. On the other hand, performance

above a certain level is rewarded by more than one higher differential rate. Priestman’s Production Bonus: Under this plan, a standard is fixed in terms of

units. If actual output, measured similarly, exceeds standard, the workers willreceive a bonus in proportion to the increase.


1. (a) Taylor Differential Piece Rate Method

2. (c) Piece Graduated Time

3. (b) Merrick

4. (a) Low

5. (c) Incentive plans

6. (a) Emerson Efficiency




Notes


7. (d) Gantt Task Bonus

8. (a) Guaranteed

9. (c) Profit-sharing

10. (a) Non-monetary










Notes


CASE STUDY: A CASE STUDY OF REMUNERATION/INCENTIVES OF TCFINFO

The company

A medium sized mortgage broker with 10 sales staff and 4 administration staff - two ofwhich handle complaints.

Current practice

Currently the firm’s consultants earn commission for reaching sales targets, and bonuseson top when certain milestones are passed. No other incentive system operates, but staffis required to follow FSA rules on complaint turnaround times.

The TCF problem

As a result of the sales incentive programme, consultants are encouraged to complete asmany sales as possible in a given timeframe. The risk to customers is that, in theireagerness to meet targets, advisers may be tempted to sell a suitable product with whichthey are familiar when there are others equally or more suitable available for the particularindividual in question. As a result customer choice – and therefore fair treatment - may becompromised.

At the same time, opportunities to encourage other staff members to implement TCF arebeing lost. For example, as things stand staff who deal with customer complaints have noincentives to spot and report opportunities to improve service and reduce futurecomplaints. Their only incentive is to turn complaints around within the FSA timeframes.

TCF solution

Sales

To encourage a more balanced approach to sales, the firm could include risk and serviceperformance targets in its rewards programme and make it known that it monitors sales ofindividual product type against each adviser.

The additional targets might require the consultant to document the range of suitableproducts discussed with the client and the reason for the final choice out of these.Consultants would only qualify for commission on satisfactory completion of these details -which will be open to scrutiny during file checks and/or if sale statistics suggest undueemphasis of a broker selling one product type. By making consultants aware that MI willmonitor sales of individual product by consultant the firm will further encourage them toconsider a wider range of similar products and be ready to justify the final choices theymake.

Complaints

On the complaints side, a simple reward programme to encourage staff to suggest ways toprevent complaints re-occurring would benefit both customers and the broker. The rewardprogramme could include points for the number of recommendations made and a financialreward where a recommendation is implemented and shown through MI to reducecomplaints and improve service in that area.

Questions

1. Analyse the impact of problems on the goodwill of the company.

2. Discuss the impact of solution adopted by the company on the performance ofemployees.




Notes


Unit 5: Overhead Costing

Structure

5.1 Introduction

5.2 Concept of Overhead

5.2.1 Classification of Overheads

5.3 Procedure for Accounting and Control of Overheads

5.4 Allocation and Apportionment of Overheads

5.4.1 Allocation of Overhead

5.4.2 Apportionment of Overhead

5.4.3 Distinction between Allocation and Apportionment

5.4.4 Basis of Apportionment of Factory Overheads

5.5 Apportionment of Service Department Costs to Production Departments

5.5.1 Repeated Distribution Method

5.5.2 Simultaneous Equation Method

5.6 Summary



5.9 Key Terms


Objectives


Understand the meaning of cost, costing and cost accounting

Discuss the comparison between financial accounts and cost accounts

Explain the application of cost accounting

Discuss the designing and installing a cost accounting system

Explain the concepts and classification of costs

Discuss the cost module, cost center and the elements of cost

Learn the preparation of cost sheet Explain tenders and quotations

5.1 Introduction

Cost related to a cost center or cost unit may be divided into two i.e. Direct and Indirectcost.

The Indirect cost is the overhead cost and is the total of indirect material cost,indirect labour cost, indirect expenses. CIMA defines indirect cost as “expenditure onlabour, materials or services which cannot be economically identified with a specificsalable cost per unit”. Indirect costs are those costs which are incurred for the benefit ofa number of cost centers or cost units. So any expenditure over and above prime cost is

known as overhead. It is also called ‘burden’, ‘supplementary costs’, ‘on costs’, ‘indirectexpenses’.



Overhead Costing 97

Notes


In this chapter, we shall study the concept and nature of cost accounting. We willalso discuss the classification of cost, cost centers. At the end of the chapter we willstudy about preparation of cost sheet, tenders and quotations and problems associatedwith cost sheet.

5.2 Concept of OverheadOverhead has been defined by the Institute of Cost and Work Accountants, London as“the aggregate of indirect material cost, indirect wages and indirect expenses”. Byindirect, it means one “which cannot be allocated, but which can be apportioned to orabsorbed by cost centre or cost unit”. Overheads are those indirect costs which cannotbe directly related to any product, job or process, because they cannot be directlyattached to production activities. A major part of the total cost is overheads. The totalcost is divided into: Prime Cost, Factory Cost and Administrative Cost. Overheadcomprises of indirect material, indirect labour and indirect expenses.

Blocker has defined the overhead costs as “Operating of a business enterprisewhich cannot be traced directly to a particular unit of output”. Overheads are the indirectcosts which cannot be directly allocated to any particular job and production activity or

process as they are not capable of being specifically identified to any particular activity.

5.2.1 Classification of Overheads

The overhead classification depends upon the type and size of the business, nature ofproduct, services of the product and various policies of the management regardingproduct or output. The following are the important basis of classification of overheads:

(i) Nature-wise Classification,

(ii) Function-wise Classification,

(iii) Variability-wise Classification,

(iv) Controllability-wise Classification, and

(v) Normality-wise Classification.

The following chart shows their classification at a glance:

Classification of Overheads

Nature-wiseClassification

Function-wiseClassification

Variability-wiseClassification

Controllability-wiseClassification

Normality-wiseClassification

IndirectMaterial

IndirectLabour

IndirectExpenses

Production orManufacturingOverheads

Office and AdministrationOverheads

SellingOverheads

DistributionOverheads

Research andDevelopmentOverheads

FixedOverheads

VariableOverheads

Semi-variableOverheads

ControllableOverheads

UncontrollableOverheads

NormalOverheads

AbnormalOverheads

Figure 5.1: Classification of Overheads




Notes


(i) Nature-wise Classification: Under this classification, expenditures are classifiedinto three categories:

(a) Indirect Material: Indirect materials which are used in the manufacturingprocess, which cannot be allocated to a particular job or production but isabsorbed by cost centers or cost units. The examples of indirect materials are

consumable stores, lubricating oil, loose tools, cotton waste, etc.(b) Indirect Labour: It includes such wages which cannot be allocated, but which

can be apportioned by cost centre or cost unit. The examples of indirect labourare salary of foremen, supervisors, works manager, store-keepers, wage ofmaintenance, idle time cost, holiday pay, workers compensation, employer’scontribution to provident fund, overtime wages, etc.

(c) Indirect Expenses: The expenses which cannot be allocated directly but whichcan be apportioned to or absorbed by cost centre or cost unit. The examples ofindirect expenses are factory rent charge, charges of lighting and heating,depreciation, insurance, factory expenses, administration, selling anddistribution expenses, etc.

(ii) Function-wise Classification: Under this classification, the various functions

performed by the industry or organization. In this classification overheads areclassified as follows:

(a) Production or Manufacturing Overheads: It is also known as factory overhead,works overhead or manufacturing overhead. The production overhead is theindirect cost which includes indirect material, indirect labour and indirect factoryexpenses. It includes all overheads incurred from the stage of production ofmaterials till the completion of the manufacture. Following are the productionoverheads e.g. rent, municipal taxes, depreciation, insurance of the factory,machines and equipments, factory lighting, heating and air-conditioning, fueland power, drawing expenses, factory manager salary, consumable stores,small tools, repairs of factory buildings, plant, machines and equipments, store-keeping expenses, cost of idle time, overtime, holiday pay, workers’ training andwelfare expenses, inspection, factory telephone and stationery expenses.

(b) Office and Administration Overheads: These are also known as generaloverheads. It is the indirect expenditure incurred in formulating the policy,directing the organization and controlling the operations of an undertakingwhich is not related directly to research and development or production andselling activities. The administrative overhead costs may include the following:account office expenses, audit fees, office staff salaries, postage, stationery,telephone and telegrams, legal expenses, depreciation, insurance, rent of theoffice building, office equipments and office furniture, bank charges, salary togeneral manager and office electricity expenses.

(c) Selling Overheads: It is the expenditure incurred in promoting sales andretaining customers. It includes: advertisement, bad debts, quotations, pricelists, salaries and commission of salesmen, selling agents, travelling expenses,

postage, telephones, stationery of sales office, salary of sales manager andsales office staff, window-dressing expenses, etc.

(d) Distribution Overheads: The expenses pertaining to delivery of goods to thecustomers fall under this distribution overhead. It includes: packing material andexpenses, carriage outward, transport expenses, maintenance, repairs,depreciation of delivery vans, depreciation, repairs of the warehouse, salary ofwarehouse staff, insurance of warehouse, losses in warehouse, wastage offinished goods, etc.

(e) Research and Development Overheads: The research expenses are the cost ofsearching for new and improved products, new applications of products andimproved methods and techniques. The development cost is the cost of theprocess which begins with the implementation of the decision to produce a new

or improved method and ends with the commencement of formal production ofthe product.



Overhead Costing 99

Notes


(iii) Variability-wise Classification: The overheads can be classified according tovariability into:

(a) Fixed Overheads: Fixed overhead is one which tends to be unaffected byvariation in volume of output. But they are fixed upto a level of production. Thefixed overheads are related to the periods, and so the fixed costs are also

known as Period Costs. The examples of fixed overheads are: rent and taxes ofthe factory and office buildings, insurance charge of plant, machine and buildingof factory and office, depreciation of building and machine of factory and office,salaries of foreman, works manager and other managerial staff, interest oncapital, watchman’s salary, monthly repairing charges, fixed charges oftelephone, depreciation of office furniture, salaries of permanent staff of salesdepartment, rent and depreciation of the sales office or the warehouse,depreciation on delivery vans, fixed expenses of guest house, etc.

A feature of the fixed overhead is that the rate of output per unit reduces as theproduction increases and vice versa. For example, the fixed overhead cost is ` 4,000. If 100 units are produced, the cost per unit will be ` 40 and if theproduction increases to 200 units, the cost per-unit will go down to ` 20 per unit.

The cost per unit changes but the total cost remains the same.

Fixed Overhead

Y

200

O

10

X

C o s t i n R s .

Units of Production

20 30 40 50

400

600

800

Figure 5.2: Fixed Overheads

(b) Variable Overheads: These costs change in the same ratio in which the outputchanges. It means, the variable overhead is one which tends to vary directlywith volume of output. The variable cost increases in direct proportion with theincrease in production and decreases in the same proportion with decrease inproduction. It is known as direct cost. The examples of variable overhead are:fuel and power, lighting, hearing, overtime, small tools, store expenses,postage, stationery, salesman’s commission, discounts to customers, baddebts, branch expenses, travelling salesman’s expenses, packing charges,carriage outward, variable expenses on delivery vans, etc.

Y

200

O

10

X

C o s t i n R s .

Units of Production

20 30 40 50

400

600

800Variable Overhead

Fixed Overhead

Figure 5.3: Variable Overheads




Notes


On making a comparison between fixed cost and variable cost, we find that thetotal fixed cost remains constant, while the total variable cost changesproportionately.

(c) Semi-variable Overheads: Semi-variable overheads are also known as Semi-fixed overheads. It is an overhead which is partly fixed and partly variable.

There is hardly any difference between these two terms. However, if the-fixedpart of the item of expense is more than the variable, it may be called Semi-fixed. Similarly, where variable part is greater than the fixed part, it may becalled semi-variable. Examples of Semi-variable overheads are charges oftelephone and electric. The following figure shows the semi-variable overheads:

Y

200

O

10

X

C o s t i n R s .

Units of Output

20 30 40 50

400

600

800

Semi-variable Overheads

Figure 5.4: Semi Variable Overheads

(iv) Controllability-wise Classification: On the basis of controllability, overheads maybe classified into two categories. They are:

(a) Controllable Overheads: Those overhead costs which can be controlled bymanagerial influence fall under this category. All variable costs are controllable.

(b) Uncontrollable Overhead: The overhead costs which are beyond the control ofmanagerial decisions are uncontrollable costs. All fixed overhead costs fallunder this category.

(v) Normality-wise Classification: On the basis of normality, overheads may beclassified into two categories. They are:

(a) Normal Overheads: Normal overheads refer to such overheads which areexpected to be incurred in attaining a given output. These overheads areunavoidable. They are, therefore, included in production costs.

(b) Abnormal Overheads: They refer to those overhead costs which are notexpected to be incurred in attaining a given output, e.g. cost of abnormal idletime. Such costs are charged to costing profit and loss account.

5.3 Procedure for Accounting and Control of Overheads

Under a normal costing approach, actual overhead costs arc never assigned to jobs.Overhead is applied to each individual job using a predetermined overhead rate. Evenwith this system, however, a company must still account for actual overhead costsincurred. Thus, we will first describe how to account for applied overhead and thendiscuss accounting for actual overhead.

Accounting for Overhead Application

Assume that Bob has estimated overhead costs for the year at ` 9,600. Additionally,since he expects business to increase throughout the year as he becomes established,he estimates 2,400 total direct labour hours. Accordingly, the predetermined overheadrate is as follows:



Overhead Costing 101

Notes


Overhead rate= ` 9,600/2,400 hrs.= ` 4 per direct labour hour

Overhead costs flow into Work-in-process inventory via the predetermined rate.Since direct labour hours are used to assign overhead into production, the time ticketsserve as the source documents for assigning overhead to individual jobs and to thecontrolling work-in-process inventory account.

For Job 101, with a total of 60 hours worked, the amount of overhead cost posted is ` 240 ( ` 4 X 60). For lob 102, the overhead cost is ` 100 ( ` 4 X 25). A summary entryreflects a total of ` 340 (i.e. all overhead applied to jobs worked on during January) inapplied overhead.

Work-in-Process inventory 340

Overhead Control 340

The credit balance in the overhead control account equals the total appliedoverhead at a given point in time. In normal costing, only applied overhead ever entersthe work in-process inventory account.

Accounting for Actual Overhead CostsTo illustrate how actual overhead costs arc recorded, assume that All Signs Companyincurred the following indirect Costs for January:

Lease payment ` 200

Utilities 50

Equipment depreciation 100

Indirect Labour 65

Total Overhead Costs ` 415

The usual procedure is to record actual overhead costs on the debit side of theoverhead control account. For example, the actual overhead costs would be recorded

as follows:

Overhead Control ` 415

Lease Payable 200

Utilities Payable 50

Accumulated Depreciation- Equipment 100

Wages Payable 65

Thus, the amount of the debit side of the overhead control gives the total actualoverhead costs at a given point in time. Since actual overhead costs are on the debitside of this account and applied overhead costs are on the credit side, the balance inoverhead control is the overhead variance at a given point in time. For all Signs

company at the end of January, the actual overhead of ` 415 and applied overhead of ` 340 produce under applied overhead variance of ` 75 ( ` 415- 340).

5.4 Allocation and Apportionment of Overheads

This section will help you understand the meaning of allocation and apportionment ofoverheads, difference between allocation and apportionment of overheads and basis ofapportionment of factory overheads.

5.4.1 Allocation of Overhead

Allocation of overhead cost refers to “the allotment of whole items of overhead costs tocost centre or cost unit”. In other words, allocation implies the identification of theoverhead costs with reference to particular cost centre, i.e., production and servicedepartments to which they relate. It involves charging to a cost centre those overheads




Notes


which arise solely from the existence of that centre. Obviously, prior to chargingoverhead to a particular department or cost centre or cost unit, the exact amount ofoverhead expense attributable to it must be known allocation of overheads. Allocation ofoverheads is, therefore, the process of distribution of overhead expenses on adepartmental basis. Some items like wages paid to maintenance workers cannot bedirectly attributed to product but can be specifically attributed to the maintenanceservice department. Such items of cost as indirect materials, indirect labour, etc., canalso be allocated to different departments or cost centre.

5.4.2 Apportionment of Overhead

Apportionment refers to the distribution of overheads among different departments orcost centre on suitable basis. It involves charging a share of the total overhead cost to anumber of cost centres, Indirect expense such as rent, lighting and telephone charges,general managers salary, etc., incurred for the entire factory need to be apportionedbetween different production and service departments on an equitable basis. Theservice department overhead costs, in turn, need to be apportioned among theproduction departments. Finally, the aggregate overhead cost of each productiondepartment is charged to the cost centre or cost unit, i.e., products, processes or jobs.

This type of apportionment is known as absorption of overhead.

5.4.3 Distinction between Allocation and Apportionment

The terms allocation and apportionment are often used interchangeably. Although, thepurpose of both is the identification and allotment of overheads to cost centre or costunit, but there is difference between the two. The following points will make thedistinction clear:

(i) Allocation refers to the distribution of overheads on departmental basis, whileapportionment is a process of distribution of overhead costs of one department tothe other department.

(ii) Allocation is a much wider term than apportionment, as it leads to apportionment.

Overheads cannot be usually allocated to products as they cannot be identifiedeasily, but they can be apportioned to products on some equitable basis.

(iii) Certain overheads like telephone and electricity charges can only be allocated toproducts, if they are apportioned on sound equitable basis,

(iv) Allocation needs no basis for the distribution of overheads among production andservice departments, while apportionment needs a equitable basis for thedistribution of one department overhead cost to other departments or cost centresor cost units.

(v) Cost allocation deals with whole items, whereas cost apportionment is concernedwith charging a share of the aggregate overhead to a number of departments orcost centres or cost units.

Thus, both allocation and apportionment are concerned with the distribution ofoverheads. Whereas allocation is the direct allotment of identifiable overheads to therelevant cost centre, apportionment is the proportionate allotment of one departmentoverhead to other departments on an equitable basis.

5.4.4 Basis of Apportionment of Factory Overheads

The following are the basis of apportionment of factory overheads:

(a) Floor Area of Departmental Buildings: The overheads are apportioned on thebasis of floor area occupied by each department. This is a simple and bettermethod. The values of the buildings are not uniform, to cover expenses like lighting,heating, rent, etc.

(b) Number of Employees in Each Department: Overheads like canteen expenses,

labour, labour welfare expenses, wages of time-keepers, wages of factory manager,




Notes


Problem 1: The Kartik Company is divided into four departments. A, B and C areproducing departments, and D is a service department. The actual costs for a periodare as follows:

Expenses `

Rent 10,000

Repairs 6,000

Depreciation of plant 4,500

Light expenses 1,000

Supervision 1 5,000

Fire insurance 5,000

Power 9,000

Employer’s liability insurance 1,500

The following information is available in respect of the four departments:

Departments

Area

Sq.ft.

No. of

Employees

Total

Wages (

)

Value of Plant

( )

Value of Stock

( )

A 1,500 200 60,000 2,40,000 1,50,000

B 1,100 150 40,000 1,80,000 90,000

C 900 100 30,000 1,20,000 60,000

D 500 50 20,000 60,000 –

Apportion the costs to the various departments on the most equitable method.

Solution:

Statement of Departmental Overhead Primary Distribution

ProductionDepartmentsItems of Expenses

Basis ofApportionment A

( )

B

( )

C

( )

ServiceDept. D

Total

(

)

Rent Floor area 3,750 2,750 2,250 1,250 10,000

Repairs of Plant Plant value 2,400 1,800 1,200 600 6,000

Dep. of Plant Plant value 1,800 1,350 900 450 4,500

Light exp. Floor area 375 275 225 125 1,000

Supervision No. of employees 6,000 4,500 3,000 1,500 15,000

Fire Insurance Stock value 2,500 1,500 1,000 – 5,000

Power Plant value 3,600 2,700 1,800 900 9,000

Employer’s LiabilityInsurance

Total wages 600 300 400 200 1,500

Total 21,025 15,275 10,675 5,025 52,000

Working note: Lighting should always be apportioned on the basis of the numberof light points. In the absence of this information, the floor space occupied may be usedas the basis. In this case, fire insurance is assumed to relate to only stock and has beenapportioned on the basis of value of stock.

5.5 Apportionment of Service Department Costs to ProductionDepartments

It is important to take into account costs incurred on service departments to computefactory overheads application rate of production departments.




Notes


A service department is a department which provides benefits to producingdepartments and/or service departments. For instance, maintenance department(responsible for the upkeep of the machinery and building), utility department(responsible for providing power and electricity for a factory), personnel department(responsible for keeping records of personnel employed), are the examples of servicedepartments. Since the output of such service departments is not sold to outsidecustomers, their costs must be covered by production departments, receiving theirservices.

Accordingly, apportioned service department costs to production departments (inwhich material conversion or production takes place) can be construed similar toindirect manufacturing costs.

The different methods used to apportion total budgeted costs of service departmentto production departments (also known as secondary distribution of factory overheads;allocation of indirect manufacturing costs like indirect labour and indirect materials toproduction departments is referred as primary distribution) are discussed below.

5.5.1 Repeated Distribution Method

Under this method, service departments’ costs are distributed to other service andproduction departments on agreed percentages and this process continues to berepeated, till the figures of service departments are either exhausted or reduced to toosmall a figure.

Problem 2: PH Ltd. is a manufacturing company having three production departments,‘A’, ‘B’ and ‘C’ and two service departments ‘X’ and ‘Y’. The following is the budget forDecember 2011:

Particulars Total ( ) A ( ) B ( ) C ( ) X ( ) Y ( )

Direct Material 1,000 2,000 4,000 2,000 1,000

Direct Wages 5,000 2,000 8,000 1,000 2,000

Factory Rent 4,000Power 2,500

Depreciation 1,000

Other Overheads 9,000

Additional Information:

Area (Sq. ft) Capital Value 500 250 500 250 500

( ` Lakhs) of Assets 20 40 20 10 10

Machine Hours 1,000 2,000 4,000 1,000 1,000

Horse Power of Machines 50 40 20 15 25

A technical assessment of the apportionment of expenses of service departments is

as under:

A B C X Y

Service Department ‘X’ (%) 45 15 30 - 10

Service Department ‘Y’ (%) 60 35 - 5 -

Required:

(i) A statement showing distribution of overheads to various departments.

(ii) A statement showing re-distribution of service departments expenses to productiondepartments.

(iii) Machine hour rates of the production departments ‘A’, ‘B’ and ‘C’.




Notes


Solution:

(i) Overhead Distribution Summary

Basis Total (

) A (

) B(

) C (

) X (

) Y (

)

Direct

Materials

Direct - - - - 2,000 1,000

DirectWages

Direct - - - - 1,000 2,000

FactoryRent

Area 4,000 1,000 500 1,000 500 1,000

Power H.P.*M/cHrs.

2,500 500 800 800 150 250

Depreciation Cap.Value

1,000 200 400 200 100 100

Otheroverheads

M/c Hrs. 9,000 1,000 2,000 4,000 1,000 1,000

16,500 2,700 3,700 6,000 4,750 5,350

(ii) Redistribution of Service Department’s Expenses

A ( ) B ( ) C ( ) X ( ) Y ( )

Total Overheads 2,700 3,700 6,000 4,750 5,350

Dept. X overhead apportioned in theratio (45:15:30:-:10)

2,138 712 1,425 -4,750 475

Dept. Y overhead apportioned in theratio (60:35:-:5:-)

3,495 2,039 - 291 -5,825

Dept. X overhead apportioned in theratio (45: 15: 30:- :10)

131 44 87 -291 29

Dept. Y overhead apportioned in the

ratio (60:35:-:5:-)

17 10 - 2 -29

Dept. X overhead apportioned in theratio (45:15:30:-:10)

1 - 1 -2 -

8,482 6,505 7,513 - -

(iii) Machine Hour Rate:

Machine Hours 1,000 2,000 4,000

Machine Hour rate 8.48 3.25 1.88

( ` 8,482/1,000 hrs) ( ` 6,505/2,000 hrs) ( ` 7,513/4,000 hrs)

5.5.2 Simultaneous Equation Method

Under this method, the true cost of the service departments are ascertained first withthe help of simultaneous equations; these are then redistributed to productiondepartments on the basis of given percentage. The following illustration may be taken todiscuss the application of this method.

Problem 3: A company has three production departments and two servicedepartments, and for a period the departmental distribution summary has the followingtotals.

`

Production Departments

P1- ` 800; P2- ` 700; P3- ` 500 2000

Service Departments:

S1 – ` 234; S2- ` 300 5342534




Notes


The expenses of the service departments are charged out on a percentage basis asfollows;

P1 P2 P3 S1 S2

Service Department S1 20% 40% 30% - 10%

Service Department S2 40% 20% 20% 20% -Prepare a statement showing the apportionment of two service departments

expenses to production departments by Simultaneous Equation Method.

Solution:

Let x = total overheads of department S1

y = total overheads of department S2

Then,

x = ` 234 +. 2y

y = ` 300 +. 1x

Rearranging and multiplying to eliminate decimals;

10x – 2y = ` 2,340 …(1)

–x + 10y = ` 3,000 …(2)

Multiplying equation (1) by 5 and add result to (2), we get

49x = ` 14,700

X = ` 300

Substituting this value in equation (1), we get

Y = ` 330

All that now remains to be done is to take these values x= ` 300 and y= ` 330 andapportion them on the basis of the agreed percentage to the three productiondepartments; thus:

Total P1 P2 P3

Per distribution summary 2,000 800 700 500

Service department S1 270 60 120 90

Service department S2 264 132 66 66

2,534 992 886 656

This method is recommended in more than two service departments if the data is

processed with computers and in two service departments only where the data isprocessed manually.

5.6 Summary

Overhead has been defined by the Institute of Cost and Work Accountants, London as“the aggregate of indirect material cost, indirect wages and indirect expenses”. Byindirect, it means one “which cannot be allocated, but which can be apportioned to orabsorbed by cost centre or cost unit”.

The overhead classification depends upon the type and size of the business, natureof product, services of the product and various policies of the management regardingproduct or output. The important basis of classification of overheads are Nature-wiseClassification, Function-wise Classification, Variability-wise Classification,Controllability-wise Classification, and Normality-wise Classification.




Notes


Under a normal costing approach, actual overhead costs arc never assigned to jobs. Overhead is applied to each individual job using a predetermined overhead rate.Overhead costs flow into Work-in-process inventory via the predetermined rate. Sincedirect labour hours are used to assign overhead into production, the time tickets serveas the source documents for assigning overhead to individual jobs and to the controllingwork-in-process inventory account.

Allocation of overhead cost refers to “the allotment of whole items of overhead coststo cost centre or cost unit”. Apportionment refers to the distribution of overheads amongdifferent departments or cost centre on suitable basis. It involves charging a share ofthe total overhead cost to a number of cost centres,

The basis of apportionment of factory overheads is Floor Area of DepartmentalBuildings, Number of Employees in Each Department, Percentage or Proportion ofBuildings and Plants, Departmental Production Hours and Technical Basis.



1. Overheads are those ………………….. which cannot be directly related to anyproduct

(a) Indirect Costs

(b) Direct Materials

(c) Direct Costs

(d) Direct Labour

2. …………….comprises of indirect material, indirect labour and indirect expenses.

(a) Expenses

(b) Prime Cost

(c) Factory Cost(d) Overhead

3. Indirect materials which are used in the manufacturing process cannot be allocatedto a particular job or production but is ………………by cost centers or cost units.

(a) Allocated

(b) Absorbed

(c) Apportioned

(d) Appointed

4. Salary of foremen, supervisors and works manager are examples of …………

(a) Direct Labour

(b) Direct Cost(c) Indirect Labour

(d) Indirect Cost

5. Production or Manufacturing Overheads is also known as…………………….,

(a) Factory overhead

(b) Selling overhead

(c) Distribution overhead

(d) Administrative overhead

6. ………………..Overheads is the expenditure incurred in promoting sales andretaining customers.

(a) Marketing




Notes


(b) Selling

(c) Distribution

(d) Factory

7. The fixed overheads are also known as ……………..

(a) Period costs(b) Manufacturing costs

(c) Selling costs

(d) Semi fixed costs

8. Fuel and power, lighting and overtime are the examples of…………….overhead

(a) Fixed

(b) Semi variable

(c) Variable

(d) Controllable

9. Semi-variable overheads are also known as ………………overheads.

(a) Semi-fixed

(b) Semi-normal

(c) Semi-controllable

(d) Semi-functional

10. A ………………department is a department which provides benefits to producingdepartments.

(a) Marketing

(b) Manufacturing

(c) Selling

(d) Service


1. What are overheads? How are they classified? Discuss in detail with a chart.

2. Describe the advantages of classification of factory overheads.

3. Define fixed, variable and semi-variable expenses giving examples of each.

4. Classify the Overheads according to Nature, Functions and Variability-wise andexplain in detail.

5. Explain the system and basis of apportionment of factory overheads on machines.

6. What is the difference between allocation of overheads and apportionment ofoverheads?

7. Discuss the accounting treatment of actual overhead costs.

8. Classify the overhead according to controllability and normality wise.

5.9 Key Terms

Production Overhead: The production overhead is the indirect cost which includesindirect material, indirect labour and indirect factory expenses.

Office and Administration Overheads: It is the indirect expenditure incurred informulating the policy, directing the organization and controlling the operations of anundertaking which is not related directly to research and development or productionand selling activities.

Distribution Overheads: The expenses pertaining to delivery of goods to thecustomers fall under this distribution overhead.




Notes


Development Cost: The development cost is the cost of the process which beginswith the implementation of the decision to produce a new or improved method andends with the commencement of formal production of the product.

Fixed Overheads: Fixed overhead is one which tends to be unaffected by variationin volume of output.


1. (a) Indirect Costs

2. (d) Overhead

3. (b) Absorbed

4. (c) Indirect Labour

5. (a) Factory Overhead

6. (b) Selling

7. (a) Period Costs

8. (c) Variable

9. (a) Semi-fixed

10. (d) Service









Absorption of Overheads 111

Notes


Unit 6: Absorption of Overheads

Structure

6.1 Introduction

6.2 Determination of Overhead Rates

6.3 Methods of Absorption of Overheads

6.4 Summary



6.7 Key Terms


Objectives


Understand the meaning of absorption of overheads

Discuss the determination of overhead rates

Describe the different methods of absorption

6.1 Introduction

According of ICMA, London, “Overhead absorption is the allotment of overhead to costunits”. The apportionment of overhead expenses of the cost centres to cost units on

some equitable basis is referred to as overhead absorption. Generally, all products, jobs, processes or services pass through one or more producing cost centre. Theoverhead expenses relating to a cost centre are ultimately to be charged to theproducts, jobs, etc., which pass through that centre. Thus, charging of overheads of acost centre to the cost units in such a way that the cost of each unit of production of thecost centre includes an equitable share of the total overhead of that cost centre. This isknown as Absorption of overheads.

In this chapter, we shall study the determination of overhead rates. At the end of thechapter we will study about the different methods of absorption.

6.2 Determination of Overhead Rates

The rate at which overheads are to be absorbed in cost units is referred to as overheadabsorption rate. There are several methods in use for determining overhead rates.Fixing of overhead rates is necessary for absorption of overheads to cost units on alogical and equitable basis. The total overheads divided by the quantity or the value ofthe base selected determines the overhead rate. The following are the overhead rates:

(i) Actual overhead rate,

(ii) Predetermined overhead rate, and

(iii) Standard rate.

(i) Actual overhead rate is determined by dividing the overhead expenses incurredduring the accounting period by the actual quantum of the base selected, such asunit of products, direct wages, direct material cost, labour hours, or machine hours.The basic principle in costing is that the recovery of overhead should be made on

actual basis, as for as possible, so that overheads may be directly charged to jobs,processes, operations, or products.




Notes


Actual Rate = Actual overhead expenses incurred during a period

Actual quantity or value of the base for the period

OR

Actual Rate = Actual overheads

Actual base

Actual overhead rate method is not helpful as the actual rate can be ascertainedonly after the accounting period is over when the actual figures would be available.This calculation is delay in finding out the costs of present production.

(ii) Predetermined overhead rates are those which are established well in advancebefore commencement of production. Predetermined overhead rate is computed bydividing the budgeted overhead expenses by the budgeted base. Predeterminationof overhead rates is of practical use in regard to managerial control over costs. Onthe basis of predetermined overhead rates, prompt preparation of cost estimate andquotations as well as fixation of sales prices is possible. Adoption of predeterminedoverhead absorption rates is practically useful in organizations following abudgetary control system.

Estimated factory overhead for the budgeted period

Estimated direct material cost of production= × 100

Predetermined overhead rate is practical use in costing. Predetermined overheadrate calculated as follows:

Predetermined Rate =Estimated or Budgeted overheads

Estimated or Budgeted base

(iii) Standard rate is used in place of predetermined rate and calculated from thefollowing formulas:

Standard Rate =

Standard overheads

Standard base

6.3 Methods of Absorption of Overheads

The following are the important methods of absorption of overheads:

(i) Direct Material Cost Method,

(ii) Direct Wage Method,

(iii) Direct Labour Hour Method,

(iv) Prime Cost Method,

(v) Machine Hour Rate Method, and

(vi) Production Unit Method.(i) Direct Material Cost Method: It is a simple method. The total estimated overheads

of a department are divided by the total cost of direct material and the rate ofabsorption is usually expressed as a percentage of direct material cost.

For example, the anticipated overhead expenses of a department are ` 20,000 andthe estimated cost of direct materials is ` 80,000, then the overhead rate as apercentage of direct materials would be 25% or (20,000 ÷ 8,000) × 100 = 25%

(ii) Direct Wages Method: This method is also known as “direct labour cost” method.Under this method, wages are adopted as the base for the absorption of overheadcosts. The overhead absorption rate is usually expressed as a percentage of directlabour cost or direct wages, and is obtained by dividing the total overhead expensesby the aggregate of direct labour cost of a cost centre and multiplying the result by

100.




Notes


For example, if the estimated overhead of a department is ` 5,000 and the directwages are ` 10,000, the overhead absorption rate would be 50% or (5,000 ÷10,000) × 100 = 50%.

This method is suitable for industries where direct labour cost is predominant, andthe rates of pay and the method of payment are the same for majority of workers in

the organization.(iii) Direct Labour Hour Method: Where labour is the most predominant cost factor,

adoption of this method is suitable for absorbing manufacturing overheads toproduction centre. Since, most of the overheads like rent, depreciation, supervision,lighting, power, taxes, insurance, repairs, etc., accrue on the basis of time, the mostequitable basis for their absorption should necessarily be the time factor involved inproduction. The rate is determined by dividing the overhead cost by the totalproduction hours of direct labour. The formula for direct labour hour rate can beexpressed as:

Rate Per Hour of Direct Labour

=Estimated factory overheads for the budget period

Estimated direct labour hours

Problem 1: From the following particulars find out “Direct Labour Rate”.

(a) Total number of labourers working in the department 400

(b) Total working days in a year 300

(c) Number of working hours per day 8

(d) Total departmental overheads per year ` 1,82,400

(e) Normal idle time allowed. 5%

Solution:

Calculation of Direct Labour Rate for Departmental Overheads

Total working days in a year 300

Number of working hours per day 8

Total working hours available per worker per year (300 x 8) 2,400

Less: normal idle time allowed (5% of 2,400hrs) 120

Effective working hours per worker per year (2400-120) 2,280

Number of workers working in the department 400

Total effective working hours in the department (2280 x 400) 9,12,000

Total departmental overheads per year ` 1,82,000

Direct Labour Rate for absorption of overheads per hour ` 0.20

( ` 182,400 ÷ 9,12,000hrs = ` 0.20)

(iv) Prime Cost Method: Under this method, prime cost is adopted as the basis ofoverhead absorption. In order to overcome the disadvantages of the direct materialsand direct labour cost absorption method, prime cost is taken as the basis ofabsorption of overhead costs. Since, prime cost gives rise to overhead, there issome logic in adopting second methods. Overhead absorption related is obtainedby dividing the overhead cost of a cost centre by its prime cost and by multiplyingthe result by 100, so as to express the same in percentage. This method may beadopted where a standard article is produced requiring a constant quantity ofmaterials and labour cost. This method is simple and easy to operate, since thebasic data require computing the overhead rate is readily available. The formula forcalculating the rate can be expressed as:

Overhead Rate =

Estimated factory overheads for the budgeted period

Estimated prime cost for normal output × 100




Notes


(v) Machine Hour Rate Method: Under this method, overhead absorption rate isdetermined by dividing the actual or predetermined overhead cost to be absorbedby the number of hours for which the machine or machines are operated orexpected to be operated. This method is most suitable:

Where work is performed predominantly on machine,

Where the production is not uniform or continuous during the period, and

Where it is desired to charge each individual job with its share of indirectexpenses.

The procedure adopted for the machine-hour rate is as follows:-

(i) The various factory overhead such as rent, repairs, depreciation, insurance,power, lighting, consumable stores, supervision, etc., are departmentalized onsame equitable basis.

(ii) The share of factory overheads charged to each department is furtherapportioned different machines or groups of machines on some suitable basis,treating each machine or a group of machines as a cost centre. Whilecomputing the rate for a group of machines, it is assumed that all the machines

are similar and bear the same cost of operation.

(iii) Machine-hour rates may be computed separately for fixed and variableoverhead expenses pertaining to the particular machine cost centre. This wouldenable the absorption of idle time cost in the machine hour rate. The need for aseparate machine-hour rate for fixed and variable cost arises due to the factthat certain items of overhead like supervision, rent, insurance, taxes, etc., arefixed in nature and arise even when the machines are idle, whereas othervariable overheads like depreciation, repairs, power, consumable stores, etc.,are directly related to machine operation.

(iv) The working hours for which a machine is expected to run are calculated for theperiod for which overheads are to be apportioned and absorbed. Whilecomputing the number of hours for the given period, an allowance is made for

the idle time or hours lost due to tool-setting, machine-cleaning, etc. The cost ofidle time is either spread over the jobs actually completed, or separate rates arecomputed for the ‘running time’ or ‘setting up’ time. This ensures the absorptionof idle time overhead cost by the machine cost centre.

(v) Where a job is performed by a single machine, the overhead cost chargeable tothe job is determined by multiplying the hours spent on that machine forcompleting the job by the machine-hour rate. If a job is worked by two or moremachines, the hours worked on each machine are multiplied by thecorresponding rates of each machine and the aggregate overhead cost of allmachine constitute the overhead chargeable to the job.

(vi) Production Unit Method: It is the simplest of all the methods. The overheads ofthe department are divided by the units produced by the respective department and

thus a rate per unit is ascertained. This method is good. The overhead absorptionrate is obtained by dividing the overheads to be absorbed by the number of unitsproduced. It is expressed in the form of formula as follows:

Overhead Rate =Overhead to be absorbed

No. of units produced

Problem 2: From the budgeted figures of Gwalior Soap Factory:

(i) Prepare Normal Overhead Application Rates using the:

(a) Direct Labour Rate Method

(b) Direct Labour Cost Method, and

(c) Machine Hours Rate Method.




Notes


Budgeted figures for the year:

Estimated factory overheads ` 58,000

Estimated direct labour hours ` 1,34,600

Estimated direct labour cost ` 97,800

Estimated Machine-hours ` 50,500

(ii) Prepare a comparative statement of cost showing the result of the application ofeach of the above rates of Batch No. 488 from the data given below:

Direct materials consumed ` 42

Direct labour ` 45

Direct labour hours 30

Machine hours 20

Solution:

(i) Computation of Normal Overhead Application Rates from the following Methods:

(a) Direct Labour Hour Rate Method:

Estimated Factory Overheads ` 58,000

Estimated Direct Labour Hours 1,34,600

Overhead Application Rate =58,000

1,34,600 = ` 0.431

(b) Direct Labour Cost Method:


Estimated Labour Cost ` 97,800

Overhead Application Rate = 58,00097,800

× 100 = 59.3%

(c) Machine Hour Rate Method:


Estimated Machine Hours ` 50,500

Overhead Application Rate =58,000

50,500 = Re. 1.149

(ii) Comparative Statement of Cost of Batch No. 488

Particulars Direct LabourRate Method

Direct LabourCost Method

Machine HourRate Method

Direct Materials Consumed 42 42 42

Direct Labour 45 45 45

Prime Cost 87 87 87

Factory Overhead 12.93 26.68 22.98

99.93 113.68 109.98

Problem 3: The following annual expenses are incurred in respect of a machine whereannual labour is almost zero and where the work is done by means of five machines ofexactly similar type and specifications.




Notes


`

Rent and rates (Proportioned to the floor space occupied for the shop) 4,830

Depreciation on each machine 500

Repairs and maintenance for five machines 1,000

Power (as per metre) @ ` 1 per 16 units consumed for the shop 3,750 Electric charges for light in the shop 540

Attendant: There are two attendants for the five machines and theyare each paid ` 60 per month

Supervision: There is one supervisor for the five machines whose salaryare ` 250 per month

Sundry supplies, such as lubricants, jute and cotton waste, etc., for the shop 494

Hire-purchase installment payable for the machines (including ` 300as interest)

The machine uses 10 units of power per hour 1,200

Solution:

Computation of Machine Hour Rate

Particulars Amount ( )

961

108

288

600

90

60

2,116

1.76

0.42

0.17

0.62

(A) Standing Charges:

Rent and Rates per machine ( ` 4,830 ÷ 5 machines)

Lighting charges in shop per machine ( ` 540 ÷ 5)

Attendants salary per machine ( ` 60 × 2 × 12 ÷ 5)

Supervision per machine ( ` 250 × 12 ÷ 5)

Sundry supplies per machine (494 ÷ 5)

Hire-purchase interest per machine ( ` 300 ÷ 5)

Total Standing ChargesHourly Rate for Standing Charges

( ` 2,116 ÷ 1,200 hours) = 1.76

(B) Hourly Machine Expenses:

Depreciation ( ` 500 ÷ 1,200 hours)

Repairs and Maintenance ( ` 200 ÷ 1,200 hours)

Power ( ` 750 ÷ 1,200 hours)

Machine Hour Rate 2.97

Note: It is objected to include higher-purchase installment and interest in computingmachine-hour rate, as these are matters of financial nature. Thus, excluding ` 60towards hire-purchase, the machine-hour rate would be ` 1.92.

Working notes:

(a) Working hours of the machine have been calculated as under:

Re. 1 is incurred for consuming 16 units of power.

` 3,750 will have to incur for consuming

( ` 3,750 × 16 units) 60,000 units.

But, these 60,000 units are for all the five machines.

Power consumption per machine = 60,000 units ÷ 5 = 12,000 units

Since, machine consumes 10 units per hour

The number of machine-hours worked during the year

= 12,000 units ÷ 10 units per hour




Notes


= 1,200 hours.

(b) Hourly rate of power consumption is calculated as follows:

Power consumption per machine during the year

= ` 3,750 ÷ 5 = ` 750.

Hourly power consumption by the machine during the year

= ` 750 ÷ 12,000 hours = Re. 0.62

Problem 4: A machine costing ` 10,000 is expected to run for 100 years at the end ofwhich period, its scrap value is likely to be ` 900. Repairs during the whole life of themachine are expected to be ` 1,800 and the machine is expected to run 4,380 perhours per year on an average. Its electricity consumption is 15 units per hour, the rateper unit being 5 paise. The machine occupies one-fourth of the area of the department,and has two points out of a total of 10 for lighting. The foreman has to devote aboutone-third of his time to the machine. The monthly rent of the department is ` 300 andthe lighting charges amount of ` 80 per month. The foreman is paid a monthly salary of ` 480.

Compute the Machine-hour Rate assuming insurance at 1% per annum and theexpenses on oil etc., are ` 9 per month.

Solution:

Computation of Machine Hour Rate


900

192

1,920

100

1083,220

0.73

0.21(1)

0.04(2)

0.75

(A) Standing Charges (Annual) :

Rent ( ` 300 × 12 month × 1/4th area occupied)

Lighting ( ` 80 × 12 months × 2/10th light points)

Foreman’s Salary ( ` 480 × 12 months × 1/3 time occupied)

Insurance (10% on ` 10,000

Expenses on Oil, etc. ( ` 9 × 12 months)

Total Standing Charges

Hourly Rate for Standing Charges

( ` 3,220 ÷ 4,380 hours) = 0.73

(B) Variable Charges:

Depreciation

Repairs and Maintenance

Electricity (15 units per hour @ Re. 0.05)

Machine Hour Rate

1.73

Working notes:

(1) Hourly Rate of Dep. =Cost of Machine Scrap value

Total life × Yearly no. of working hours

−

=10,000 900

10 × 4,380

− ` ` = ` 0.21

(2) Hourly Rate of Repair and Maintenance:

=Cost of repairs during the working life

Hours of working life

=1,800

10 × 4,380

` = ` 0.04




Notes


Departmental annual overheads

(a) Rent ` 50,000

(b) Heating and lighting ` 20,000

(c) Supervision ` 1,30,000

Departmental area 70,000 sq.ft.

Machine area 2,500 sq.ft.

26 machines in the department

Annual cost of reserve equipment for the machine ` 1,500

Hours run on production 1,800

Hours for setting and adjusting 200

Power cost ` 0.50 per hour of running time

Labour:

(a) When setting and adjusting Full time attention

(b) When machine is producing One man look-after

3 machines

Labour Rate ` 600 per hour

Solution:

Computation of Comprehensive Machine-hour Rate

ParticularsAnnual

( )

Per Hours

( )

(A) Standing Charges :

Depreciation (2,30,000 – scrap nil) ÷ 10 years 23,000.00

Rent ( ` 50,000 × 20,500 sq.ft./ 70,000 sq.ft.) 1,785.71

Heating and Lighting ( ` 20,000 × 2,500 sq.ft.

/ 70,000 sq ft)

714.28

Supervision ( ` 1,30,000 ÷ 26 machines) 5,000.00

Reserve Equipment ( ` 1,500 ÷ 26 machines) 57.69

Labour cost : Setting & Adjusting time

(200 hours @ ` 6)

1,200.00

Total Standing Charges for the Year 31,757.68

Hours Rate of Standing Charges :

( ` 31,757.68 ÷ 1,800 hours) 17.64

(B) Variable Charges :

Power (Re. 50 per hour for running time) 900Labour cost : Running time

(1,800 hours × ` 6 ÷ 3 machines)

3,600

Total Variable Charges 4,500

Hourly Rate for Variable Charges (4,500 ÷ 1,800 hours) 2.50

Machine Hour Rate (composite or comprehensive) 20.14

6.4 Summary

According of ICMA, London, “Overhead absorption is the allotment of overhead to costunits”. The apportionment of overhead expenses of the cost centres to cost units onsome equitable basis is referred to as overhead absorption.




Notes


There are several methods in use for determining overhead rates. Fixing ofoverhead rates is necessary for absorption of overheads to cost units on a logical andequitable basis. The total overheads divided by the quantity or the value of the baseselected determines the overhead rate. The following are the overhead rates i.e. Actualoverhead rate, predetermined overhead rate, and Standard rate.

The different methods of overhead absorption are: Direct Material Cost Method,Direct Wage Method, Direct Labour Hour Method, Prime Cost Method, Machine HourRate Method, and Production Unit Method.



1. The basic principle in costing is that the recovery of overhead should be made on…………………basis.

(a) Actual

(b) Estimated

(c) Budgeted(d) Cash

2. The formula for the determination of actual overhead rate is

(a)Standard Overhead

ActualBase

(b)Predetermined overhead

ActualBase

(c) Actual Overhead

ActualBase

(d)Estimated Overhead

ActualBase

3. ……………….overhead rates are those which are established well in advancebefore commencement of production.

(a) Actual

(b) Standard

(c) Budgeted

(d) Predetermined

4. Predetermined overhead rate is computed by ……………..the budgeted overheadexpenses by the budgeted base.

(a) Dividing

(b) Multiplying

(c) Subtracting

(d) Adding

5. ………………….rate is used in place of predetermined rate.

(a) Standard

(b) Actual

(c) Budgeted

(d) Estimated

6. Direct Wages Method is also known as ……………….method.

(a) Direct labour hour rate




Notes


(b) Direct machine hour rate

(c) Direct production rate

(d) Direct labour cost

7. Where labour is the most predominant cost factor, adoption of …………method is

suitable for absorbing manufacturing overheads to production centre.(a) Direct Labour Cost

(b) Direct Labour Hour

(c) Direct Unit Cost

(d) Direct Production Hour

8. ………………….method may be adopted where a standard article is producedrequiring a constant quantity of materials and labour cost.

(a) Prime Cost

(b) Machine Hour Rate

(c) Production Unit

(d) Direct Wages

9. Machine hour rate is most suitable where work is performed predominantlyon……………..

(a) Jobs

(b) Units

(c) Machines

(d) Plans

10. Under……………….method the overheads of the department are divided by theunits produced by the respective department and thus a rate per unit is ascertained.

(a) Production Unit

(b) Material Cost

(c) Direct Wages

(d) Prime Cost


1. Explain the different methods of Absorption of Factory Overheads.

2. What is Machine Hour Rate method? Explain and describe its areas of application.

3. What do you understand by Machine Hour Rate? How is it calculated? Give thecircumstances under which it may be suitably used in cost accounting.

4. The following figures relate to a manufacturing concern. All jobs pass through two

departments:Production Dept. Finishing Dept.

Material used ` 6,000 ` 500

Direct labour ` 3,000 ` 1,500

Factory overheads ` 1,800 ` 1,200

Labour hours 12,000 5,000

Machine hours 10,000 2,000

The following information relates to Job No. 430:

Production Dept. Finishing Dept.

Direct material ` 240 ` 20

Direct wages ` 130 ` 50




Notes


Labour hours 530 140

Machine hours 510 50

You are required to prepare a statement showing the different cost results of JobNo. 430 by using five different method of absorption of factory overheads.5.

5. Calculate Machine-hour Rate for Machine No. 5 which is one of five machines inoperation in a department of a factory.

You are furnished with the following information:

(a) Cost of Machine No. 5, ` 1,000

(b) Estimated Scrap Value at finish of working life (10 years) ` 100

(c) Normal running hours per annum, 1,800.

(d) Machine No. 5 occupies one-fifth of the floor space of the department, the rent,rates, lighting, etc. of which amount to ` 350 per annum.

(e) Charges for Electric Power supplied to Machine No. 5, ` 200 per annum.

(f) Charges for oil, waste, etc. supplied to Machine No. 5, ` 30 per annum.

(g) Repairs and Maintenance throughout working life of machine estimated at ` 360.

(h) Cost of supervision and other expenses applicable to Machine No. 5 estimatedat ` 150 per annum.

(i) Labour cost of operating the machine is to be ignored in making yourcalculations.

6. From the following particulars, compute Machine-hour Rate:

Cost of Machine ` 90,000

Establishment Charges, etc. ` 10,000

Life of the Machine 10 years

Working Hours per year 2,000 hoursRepairs: 50% of depreciation

Consumption of Electric Power 10 unit p.h. @ 25 paise per unit

Lubricating Oil per day ` 4 for 8 hours

Consumable Stores ` 10 per day for 8 hours

Wages of Operator ` 12 per day for 8 hours

7. From the following informations, compute Machine-hour Rate:


Scrap Value ` 500

Working Life 16,000 hours

Time taken for maintenance 250 hours

Time for Settings 5%

Power 20 units @ 10 paise per unit

Cost of Repairs ` 1,600 p.a.

Workers engaged on two machines 2

Wages per man ` 200 p.m.

Requirement of Chemical ` 25 p.m.

Overhead Chargeable to this machine ` 225 p.m.

Insurance Premium 1% p.a.

Productive Working Hours 2,200 hours p.a.




Notes


8. From the under noted data, calculate the Machine-hour Rate:


Scrap Value ` 2,500

Estimated life of the Machine 12 years

Working days per year 200 days of 8 hours; 100 days of 6 hoursMaintenance and Repairs 7.5% of the cost of machine

Stores Issued ` 1,000

Power Consumption ` 2 per operative hour

Insurance Premium 1% of cost of the machine

Supervision Expenses per year ` 7,500

Idle Time estimate 10%

6.7 Key Terms

Absorption of overheads: It means charging of overheads of a cost centre to thecost units in such a way that the cost of each unit of production of the cost centre

includes an equitable share of the total overhead of that cost centre. Overhead absorption rate: The rate at which overheads are to be absorbed in

cost units is referred to as overhead absorption rate.

Predetermined overhead rate: Predetermined overhead rates are those which areestablished well in advance before commencement of production.

Machine Hour Rate Method: Under this method, overhead absorption rate isdetermined by dividing the actual or predetermined overhead cost to be absorbedby the number of hours for which the machine or machines are operated orexpected to be operated.

Production Unit Method: Under this method, overheads of the department aredivided by the units produced by the respective department and thus a rate per unitis ascertained.


1. (a) Actual

2. (c) Actual Overhead

ActualBase

3. (d) Predetermined

4. (a) Dividing

5. (a) Standard

6. (d) Direct labour cost

7. (b) Direct labour hour8. (a) Prime cost

9. (c) Machines

10. (a) Production unit










Notes


Unit 7: Job and Batch Costing

Structure

7.1 Introduction

7.2 Job Costing

7.2.1 Features of Job Costing

7.2.2 Objectives of Job Costing

7.2.3 Advantages and Disadvantages of Job Costing

7.2.4 Procedure of Job Costing

7.3 Preparation of Job Cost Sheet

7.4 Batch Costing

7.4.1 Essentials of Batch Costing

7.4.2 Advantages and Disadvantages of Batch Costing

7.4.3 Economic Batch Quantity

7.5 Summary



7.8 Key Terms


Objectives


Understand the meaning and features of job costing.

Explain the objectives, advantages and limitations of job costing.

Describe the procedure of job costing.

Preparation of job cost sheet.

Understand the concept and essentials of batch costing.

State the advantages and disadvantages of batch costing.

Understand the economic batch quantity.

7.1 Introduction

Different industries follow different methods to establish the cost of their product. Thisvaries by the nature and specifics of each business. There are different principles andprocedures for performing the costing. However, the basic principles and procedures ofcosting remain the same. Some of the common methods of costing are unit costing, jobcosting, batch costing, process costing, service costing.

Job costing is a method of costing applied in industries where production ismeasured in terms of completed jobs. Industries where job costing is generally appliedare printing press, ship building, repair workshops, foundry, automobile garage andother similar manufacturing units which manufacture to customer’s specificrequirements. Under batch costing, the cost of a batch or group of products is

ascertained. The unit of cost is a batch or group of identical products, instead of a single



Job and Batch Costing 125

Notes


job, order or contract. The method is applicable to general engineering industries whichproduce components in convenient economical batches for subsequent assembly ormanufacture on mass scale, comparatively small items of products. Except for thedifference that in batch costing, a batch instead of a job constitute the cost unit forwhich costs are compiled, the procedure for batch costing is similar to that of jobcosting. Separate job cost sheets are maintained for each batch of componentsmanufactured and for the assembly of finished products. When products are stocked forsale, a greater degree of control is required.

In this unit, we shall study the concept of job costing, the procedure of job costingand the preparation of job cost sheet. We will also study the concept and essentials ofbatch costing and the economic batch quantity.

7.2 Job Costing

Job costing is usually adopted by the concerns where a specific job is done for astipulated price. CIMA terminology defines job costing as “a form of specific ordercosting which applies where work is undertaken to customer’s special requirement. Asdistinct from contract costing, each job is a comparatively short duration”. It implies that

under job costing, production is always against the customer’s special requirement.

Kohler in his ‘Dictionary for Accounts’ defines job costing as “a method of costaccounting whereby cost is compiled for a specific quantity of product, equipment,repair on other service that moves through the production process as a continuouslyidentifiable unit, applicable material, direct labour, direct expense and usually acalculated portion of the overhead being charged to a job order”.

From the above definition, it is clear that job costing is a method of costing underwhich the cost of each job is ascertained separately. It is that form of specific ordercosting which applies where work is undertaken to customer’s special requirements.

7.2.1 Features of Job Costing

The main features of job costing are as under:

1. The production is generally against customer’s order and not for stocks,

2. Under job costing method, production is intermittent and not continuous,

3. Each job has its own characteristics and needs special treatment,

4. Each job is treated as a cost unit under this method of costing,

5. The work-in-progress differs from period to period according to the number of jobsis hand,

6. There is no uniformity in the flow of production from department to department,

7. The emphasis is on the between division the direct and indirect expenses is laidupon,

8. Job costing is adopted by manufacturing organizations as well as non-manufacturing organizations,

9. Under this method, the profit and loss can be ascertained in respect of each job,and

10. Each job is distinctively identified by a production order throughout the productionstage.

7.2.2 Objectives of Job Costing

The following are the main objectives of job costing:

1. The important objective of job costing is to ascertain the cost as well as the profit orloss for each job,

2. It provides a basis for determining the cost of similar jobs undertaken in future. Itthus helps in future production planning,




Notes


3. Job costing is to find out hose jobs which are more profitable and those which arenot profitable or less profitable, and

4. It helps the management in controlling costs by comparing the actual costs with thebudgeted costs.

7.2.3 Advantages and Disadvantages of Job Costing

The various advantages of job costing are as follows:

1. Job costing is useful in quoting cost plus contract,

2. Job costing facilitates identification and control of spoilages and defectives,

3. Job costing facilitates estimation of cost of similar jobs,

4. It helps the management to know about the profitability of the jobs,

5. Job costing is helpful to ascertain the cost as well as the profit or loss for each jobseparately,

6. The data of the job costing are quite helpful for the future planning, and

7. Job costing helps in making detailed analysis of cost of materials, labour, direct

expenses and overheads.

The disadvantages or weaknesses of job costing are as follows:

1. It is expensive to operate as it requires considerable detailed official or clericalwork,

2. With the increase in the official or clerical works the chances of errors or mistakesare increased,

3. Job costing does not facilitate control of cost unless it is used with standard orbudgetary costing,

4. Job costing cannot be efficiently operated without highly developed productioncontrol system. The job costing method requires intricate factory organisationsystem,

5. To get accurate results, job costing requires some pre-requisites. In its absence jobcosting will not give accurate results,

6. It is expensive as cost is accumulated and ascertained for each job separately, and

7. When drastic economic changes take place cost comparison becomes difficult.

7.2.4 Procedure of Job Costing

The procedure that is commonly applicable to a normal sale transaction equally appliesin case of job costing. The procedure for job costing involves the following:

1. Receiving an Enquiry: First of all a customer seeks an enquiry about the price,quality and other terms and conditions of the job before placing an order.

2. Estimation of the Price of the Job: The cost accountant estimates the cost of jobafter considering the various elements of cost and keeping in mind the specificationof customer. This is based on the cost of execution of similar job in the past yearsand considering the possible changes in the various elements of the cost.Estimated costs are also compared with the actual costs to find out the variation inthe actual profit.

3. Receiving of Order: The customer will then place the order if he is satisfied withthe quotation price, other terms and conditions of executing the job.

4. Job Order Number: When an order is received from the customer, it is allotted acertain number. Every job order is known by its number throughout its productionprocess.

5. Production Order: When a job is accepted, the production planning department

prepares a production order or job order. Production order or job order is a written




Notes


A job cost sheet facilitates the determination of profit or loss on every job. Estimatedcosts are also recorded on the job cost sheet which facilitates comparison of actualcosts with the estimated cost and variation in the cost is known.

A specimen form of job cost sheet is given below:

ABC Company Limited

Job Cost Sheet

Job No. : ......................... Quantity : .........................

Job Description : ......................... Date of Completion : .........................

Name of the Customer : ......................... Date of Commencement : .........................

Particulars of Job : ......................... Production Order No. : .........................

Material Cost Labour Cost Overheads

Date Deptt.MRNo.

Amt.

(

)Date Deptt.

TimeTicket

No.

Amt.

(

)Date Deptt.

Rate

(

)

Amt.

(

)

Total

Summary of Cost

Estimated Cost ( ) Actual Cost ( ) Variance ( ) (+)/(-)

Material cost

Labour cost

Overheads

Total

Explanation of Variance : ................................... Prepared by : ...................................

Remarks : ................................... Checked by : ...................................

Figure 7.2: Job Cost Sheet

Problem 1: The following information is extracted from the job ledger of NeelamEnterprises in respect of Job Number 510:

Materials ` 7,000

Wages 100 hours @ ` 7

Variable overheads incurred for all jobs ` 15,000 for 5,000 labour hours.

Find the profit if the job is billed for ` 9,000.Solution:

Job Cost Sheet for Job No. 510

Particulars Amount (

)

Materials 7,000

Wages 100 hours @ ` 7 700

Variable overheads : 100 hours @ ` 3(1)

300

Total Cost 8,000

Profit 1,000

Billed Amount 9,000

Working note: (1) Rate of variable overheads per hour = 15,000/5,000 = ` 3




Notes


Problem 2: The following informations have been obtained from the costing records ofKartik Metal is respect of Job No. 264:

Materials ` 5,200

Wages:

Department X 180 hours @ `

3 per hourDepartment Y 120 hours @ ` 5 per hour

Department Z 60 hours @ ` 2 per hour

Variable Overheads:

Department X ` 10,000 for 5,000 direct labour hours

Department Y ` 9,000 for 3,000 direct labour hours

Department Z ` 4,000 for 2,000 direct labour hours

Fixed Overheads:

Estimated ` 30,000 for 10,000 normal working hours.

Calculate the cost of Job No. 264 and also find the price to be charged so as toearn a profit 25% on selling price.

Solution:



)

Materials 5,200

Wages :

Department X 180 hrs. × ` 3 540

Department Y 120 hrs. × ` 5 600

Department Z 60 hrs. × ` 2 120 1,260

Prime Cost 6,460

Overheads :

Variable :

Department X 180 hrs. @ ` 2 360

Department Y 120 hrs. @ ` 3 360

Department Z 60 hrs. @ ` 2 120 840

Fixed : 360 hours @ ` 3(2)

per hr. 1,080

Total Cost 8,380

Profit (25% on selling price or1

33 %

3

on Cost Price)2,793

Selling Price 11,173

Working notes:

(1) Calculation of variable overheads:

Department ‘X’: Total Overheads/Total Direct Labour Hours

` 10,000/ 5,000 hrs. = ` 2 per hour

Department ‘Y’: ` 9,000 /3,000 hrs. = ` 3 per hour

Department ‘Z’: ` 4,000 /2,000 hrs. = ` 2 per hour

(2) Calculation of fixed overheads =Total Fixed Overheads

Total Direct Hours

= 30,000/10,000 = ` 3 per hour




Notes


Problem 3: The information given below has been taken from the cost records ofHolani Engineering Works in respect of the job number 224:

Materials ` 3,200

Wages: Department A 60 hours @ ` 2 per hour

Department B 40 hours @ `

5 per hourDepartment C 20 hours @ ` 3 per hour

The overhead expenses are as follows:

Variable: Department A ` 10,000 for 5,000 hours

Department B ` 4,500 for 1,500 hours

Department C ` 1,500 for 500 hours

Fixed expenses: ` 30,000 for 10,000 working hours.

Calculate the cost of the Job No. 224 and the price from the job to give a profit 25%on the selling price.

Solution:



Materials 3,200

Wages :

Department A 60 × ` 2 120

Department B 40 × ` 5 200

Department C 20 × ` 3 60 380

Prime Cost 3,580

Overheads expenses : Fixed 360(2)

Variable :

Department A 60 hrs. @ ` 2 120

Department B 40 hrs. @ ` 3 120

Department C 20 hrs. @ ` 3 60 300

Total Cost of the Job 4,240

Profit (25% on selling price) 1,413

Selling Price 5,653

Working notes:

(1) Variable overhead rates have been arrived at as follows:

Department A = Overheadsfor departmentADirectlabourhours

= 10,0005,000

= ` 2

Department B =Overheadsfor departmentB

Directlabourhours =

4,500

1,500 = ` 3

Department C =Overheadsfor departmentC

Directlabourhours =

1,500

500 = ` 3

(2) Fixed overhead rate has been ascertained as under:

=Fixedexpenses

Workinghours =

30,000

10,000 = ` 3

Fixed overhead for the job would be `

3 × 120 (60 + 40 + 20) = `

360(3) Profit on sale = 1/4 = Profit on cost = 1/3




Notes


Problem 4: A factory uses a job costing system. The following cost data are availablefrom the books for the year ended 31st March, 2008:

`

Direct materials 90,000

Direct wages 75,000Profit 60,900

Selling and distribution overhead 52,500

Administrative overhead 42,000

Factory overhead 45,000

Required:

(1) Prepare a cost sheet indicating the prime cost, works cost, production cost, costof sales and sales value.

(2) In 2008-09 the factory has received an order for a number of jobs. It isestimated that the direct materials would be ` 10,00,000 and direct labour

would cost `

6,00,000. What would be the price for these jobs if the factoryintends to earn the same rate of profit on sales, assuming that the selling anddistribution overhead has gone up by 15%. The factory recovers factoryoverhead as a percentage of direct wages and administration and selling anddistribution overheads as percentage of works cost based on the cost ratesprevalent in the previous year.

Solution:

Job Cost Sheet for the Year Ending 31st March, 2008


Direct materials 90,000

Direct wages 75,000

Prime Cost 1,65,000

Factory overhead 45,000

Works or Factory Cost 2,10,000

Administration overhead 42,000


Selling and Distribution overhead 52,500

Cost of Sales 3,04,500

Profit 60,900

Sales 3,65,400

Working notes: Overhead recovery rates have been ascertained as under:

(1) Percentage of factory overhead on direct wages =45,000

10075,000

× = 60%

(2) Percentage of administrative overhead on works cost =42,000

1002,10,000

× = 20%

(3) Percentage of selling and distribution overhead on works cost=52,500

1002,10,000

×

= 25%

(4) Percentage of profit on sales =60,900

1003,65,400

× =2

16 %3




Notes


Statement of Cost of a Work Order for the Year 2009


Materials 40,000

Labour 25,000

Prime Cost 65,000Factory overhead (55.55% of wages + 20%, thereof i.e. 66.66 on labour) 16,665

Works Cost 81,665

Administrative overhead (32.17% of factory cost + 12½%, thereof i.e. 36.19%on factory cost)

29,555


Selling expenses (22.83% of factory cost + 12½%, thereof i.e. 25.69% onfactory cost)

20,980

Distribution charges (15.83% of factory cost – 10%, thereof i.e. 14.25% onfactory cost)

11,637

Total Cost 1,43,837

Profit (20% on cost) 28,767Selling Price 1,72,604

7.4 Batch Costing

Under this method the cost is ascertained in respect of a batch of goods or componentsmanufactured. There are certain products whose cost of production cannot beascertained in isolation, i.e., for each and every unit of article produced. Examples ofsuch products are hardware (such as nuts, bolts, pins, screws, etc.) and Bakeryproducts (such as breads, cakes, biscuits, etc.). So industries which manufactureproducts of this nature make use of batch costing. Other examples of industries whichadopt batch costing are shoe manufacture, toys, readymade garments, tyres and tubes,drugs and pharmaceuticals, spare parts and component parts as in the case of

automobiles, radios, TV’s, refrigerators, machineries, etc.

In order to know the cost of production of a batch of articles, a batch cost sheet isprepared.

Difference between Batch Costing and Job Costing

Batch costing does not differ from job costing in respect of accounting procedure. Thereare two points of differences between batch costing and job costing. They are:

(a) Under batch costing, a batch of articles produced constitutes a cost unit. But under job costing, each and every job is treated as a cost, and

(b) Under batch costing, production is taken up to be held in stock sold on demand andalso a receiving specific order from customers. On the other hand, under jobcosting, production is undertaken only against specific orders.

7.4.1 Essentials of Batch Costing

The main essentials of batch costing are as under:

(i) This method is used where small parts of considerable number are produced, suchas industries producing machinery parts, machine tools, etc.,

(ii) No special costing principles are involved, each batch constituting a separate unitdivided into sub-units of each piece produced,

(iii) Entire production is divided into economic groups or batches and usual andappropriate costing methods are applied to each batch or group,




Notes


(iv) The advantages of the method are that the unit cost of every group is determinedso that the total production cost is broken down into its constituent parts and profitand loss of each and every batch is known separately, and

(v) As production cost and volume of sales vary considerably from batch to batch, itsometimes becomes difficult to allocate overhead charges equitably. It is main

drawback of the method.

7.4.2 Advantages and Disadvantages of Batch Costing

Following are the main advantages of batch costing:

(i) The accounting work is considerable reduced as a group of homogeneous jobsconstitute a batch,

(ii) It takes the benefit of reduced cost of production arising out of economic batchquantity,

(iii) The loss of time under job costing arising out of inter-job transfer of materials,labours and tools is minimised under batch costing,

(iv) There is the advantages of consistent cost of production of every article produced in

a batch under batch costing, and

(v) Supervision becomes easy and more effective by means of spreading over thesupervision’s time over all the units constituting the batch. Thus, the idle time ofsupervisor’s as well as workers are eliminated.

The main disadvantages or limitations of batch costing are:

(i) Determination of a batch from various jobs often pose problem. It is difficult to comeacross absolute homogeneity of jobs,

(ii) If the production of a batch is wrongly undertaken, say, owing to sub-standardmaterials or defective operations, the whole batch of articles is to be discardedwhich will become a great loss to the manufacturer. Pharmaceutical and drugsproducts offer best example to this point of disadvantage, and

(iii) When quantity of goods to be manufactured differs from customer to customer,again it becomes difficult to determine the batch.

7.4.3 Economic Batch Quantity

The concept of economic batch quantity is quite similar to economic order quantity. Inbatch costing, the determination of economic batch quantity assumes more importance.In fact, determining the size of the batch is a problem by itself under batch costing. Thisis so because, if the batches are many, the (i.e., quantity of production is less in every job) economies arising out of large scale production is not taken advantage of.Therefore, it is always necessary to determine the optimum size of the batch oreconomic batch quantity before the production is started. The economic batch quantityalso helps in eliminating the setting up time involved whenever a batch of articles is

produced.

Thus, it can be said that the concept of economic batch quantity is an example ofthe law of increasing returns and takes advantage of economies of large scaleproduction. By producing the goods in an optimum batch, it reduces the cost ofproduction, thereby maximising the profit. In determining the economic batch quantity,two conflicting forces operate. They are:

Production cost which include set up cost and other factors such as loss of time dueto change of work, loss of speed of work when work is frequently changed on different jobs, wastage in materials, increased supervision cost, all these forces are responsiblefor increased cost of production, and




Notes


Production in a very large batch quantity will lead to certain disadvantages such as,increased wear and tear of machines, breakdown of machines, problem of inspection,excess defectives of goods, large inventory, locked up capital and so on. Thuseconomic batch quantity strikes a balance between these two factors in order to takemaximum benefit from production process.

Different formulas are developed to determine the economic batch quantity. Onesuch formula is given below:

EBQ =2US

C

Where, EBQ = Economic batch quantity

U = No. of units to be produced in a year

S = Set up cost per batch

C = Carrying cost per unit of production

Where rate of interest and cost of production per unit is given, the following formulais applicable:

EBQ =2US

I C×

Where, EBQ = Economic batch quantity

U = No. of units to be produced in a year

S = Set up cost per batch

I = Interest rate per year

C = Cost of manufacture per unit

Problem 6: Compute the economic batch quantity for a company using batch costingwith the following information:

Annual demand for the component 12,000

Set-up cost per batch ` 120

Carrying cost per unit of production ` 0.36

Solution:

Economic Batch Quantity =2US

C

=2 12,000 120

0.36

× ×

EBQ = 2,828 units

Problem 7: The annual demand of a product is 24,000 units. It is produced in batchesand the largest size of a single batch is 6,000 units. After each batch is complete, theset up cost is ` 750. The annual carrying cost is ` 2.25 per unit.

Assume average inventory as one-half of the number of units made in each batch.Selecting 4, 6, 8, 12 and 24 batches per annum, determine annual costs of each andstate the optimum number of batches to minimize the total costs.




Notes


Solution:

No. of batches 4 6 8 12 24

Size of batch units 6,000 4,000 3,000 2,000 1,000

Average stock 3,000 2,000 1,500 1,000 500

Costs :

Set up costs 3,000 4,500 6,000 9,000 18,000

Carrying cost 6,750 4,500 3,375 2,250 1,125

Total Cost 9,750 9,000 9,375 11,250 19,125

Optimum number is 6 batches per annum.

Economic Batch Quantity =2US

C

=2 24,000 750

2.25

× ×

EBQ = 4,000 units

Problem 8: M/s MBO Bearings Limited is committed to supply 24,000 bearings perannum to M/s Ashok Fans on a steady daily basis. It is estimated that it costs 10 paiseas inventory holding cost per bearing per month and that the set up cost per run ofbearing manufacture is ` 324.

(a) What should be the optimum run size bearing manufacture?

(b) What would be the interval between two consecutive optimum runs?

(c) Find out the minimum inventory holding cost.

Solution:

(a) Economic Batch Quantity (EBQ) =

2US

C

=2 24,000 324

0.10 12

× ××

EBQ = 3,600 units

(b) Interval between two consecutive optimum runs:

=3,600

302,000

× = 54 days

(c) Minimum inventory cost per annum:

=

AnnualProduction

×SetupcostEBQ

⎛ ⎞⎜ ⎟⎝ ⎠

+ (Average inventory × Holding cost per unit × 12)

=24,000 Rs.324 3,600

Rs.0.10 123,600 2

×+ × ×

= ` 2,160 + ` 2,160 = ` 4,320

Problem 9: Component ‘Mee’ is made entirely in cost centre 100. Material cost is 6paise per component and each component takes 10 minutes to produce. The machineoperator is paid 0.72 paise per hour, and the machine hour rate is ` 1.50. The setting upof the machine to produce component ‘Mee’ takes 2 hours 20 minutes.




Notes


On the basis of this information prepare cost sheets showing the production andsetting-up costs, both in total and per component, assuming that a batch of (i) 10components, (ii) 100 components, and (iii) 1,000 components and produced.

Solution:

(i) Cost Sheet for a Batch of 10 ComponentsParticulars Cost of the

batch ( )

Cost per

unit ( )

Setting up cost :

Wages : 2 hrs. and 20 mins. @ ` 0.72 per hr. 1.68

Overheads : 2 hrs. and 20 mins. @ ` 1.50 per hr. 3.50

5.18 0.518

Production cost :

Materials cost : 10 @ ` 0.06 0.60 0.060

Wages : 1 hr. and 40 mins. @ ` 0.72 per hr. 1.20 0.120

Overheads : 1 hr. and 40 mins. @ ` 1.50 per hr. 2.50 0.250

Total Production and Setting Up Cost 9.48 0.948

(ii) Cost Sheet for a Batch of 100 Components

Particulars Cost of the

batch ( )

Cost per

unit ( )

Setting up cost :



5.18 0.052

Production cost :

Material cost : 100 @ `

0.06 6.00 0.06Wages : 16 hrs. and 40 mins. @ ` 0.72 per hr. 12.00 0.12

Overheads : 16 hrs. and 40 mins. @ ` 1.50 per hr. 25.00 0.25

Total Production and Setting Up Cost 48.18 0.482

(iii) Cost Sheet for a Batch of 1,000 Components

Particulars Cost of the

batch ( )

Cost per

unit ( )

Setting up cost :



5.18 0.005Production cost :

Material cost : 1,000 @ ` 0.06 60.00 0.060

Wages : 166 hrs. and 40 mins. @ ` 0.72 per hr. 120.00 0.120

Overheads : 166 hrs. and 40 mins. @ ` 1.50 per hr. 250.00 0.250

Total Production Cost and Setting Up Cost 435.18 0.435

7.5 Summary

Job costing is usually adopted by the concerns where a specific job is done for astipulated price. CIMA terminology defines job costing as “a form of specific ordercosting which applies where work is undertaken to customer’s special requirement. As




Notes


distinct from contract costing, each job is a comparatively short duration”. It implies thatunder job costing, production is always against the customer’s special requirement.

Job costing is useful in quoting cost plus contract; it facilitates identification andcontrol of spoilages and defectives, estimation of cost of similar jobs. It helps themanagement to know about the profitability of the jobs and is helpful to ascertain the

cost as well as the profit or loss for each job separately. The data of the job costing arequite helpful for the future planning, and helps in making detailed analysis of cost ofmaterials, labour, direct expenses and overheads. Job costing cannot be efficientlyoperated without highly developed production control system. The job costing methodrequires intricate factory organisation system,

A job cost sheet facilitates the determination of profit or loss on every job. Estimatedcosts are also recorded on the job cost sheet which facilitates comparison of actualcosts with the estimated cost and variation in the cost is known.

Under batch costing method the cost is ascertained in respect of a batch of goodsor components manufactured. There are certain products whose cost of productioncannot be ascertained in isolation, i.e., for each and every unit of article produced.Examples of such products are hardware (such as nuts, bolts, pins, screws, etc.) andBakery products (such as breads, cakes, biscuits, etc.). The concept of economic batchquantity is quite similar to economic order quantity. In batch costing, the determinationof economic batch quantity assumes more importance. In fact, determining the size ofthe batch is a problem by itself under batch costing. This is so because, if the batchesare many, the (i.e., quantity of production is less in every job) economies arising out oflarge scale production is not taken advantage of.



1. The main feature of job costing is that the:

(a) Production is generally against customer’s order(b) Production is generally against stocks

(c) Production is generally against batch

(d) Production is generally against lot size

2. Under job costing each job is treated as a:

(a) Unit

(b) Cost

(c) Market unit

(d) Lot unit

3. The important objective of job costing is to:

(a) Ascertain the cost as well as investment for each job

(b) Ascertain the cost as well as the profit or loss for each job

(c) Ascertain the profit or loss for each job

(d) Ascertain the cost for each job

4. ……………………helps the management to know about the profitability of the jobs.

(a) Job costing

(b) Batch costing

(c) Economic batch costing

(d) Service costing




Notes


5. The cost accountant estimates the cost of job after considering the variouselements of cost and ……………………….

(a) The specification of creditors

(b) The specification of management

(c) The specification of customer(d) The specification of debtors

6. Materials are classified into direct and indirect on the basis of …………….ofmaterials to the job.

(a) Specifications

(b) Traceability

(c) Cost

(d) Profit or loss

7. Under ………………method the cost is ascertained in respect of a batch of goods orcomponents manufactured.

(a) Batch costing(b) Job costing

(c) Service costing

(d) Economic batch costing

8. Under job costing production is undertaken only against …………..

(a) Stock sold

(b) Specific orders

(c) Cost Unit

(d) Management decisions

9. Batch costing takes the benefit of ……………cost of production arising out of

economic batch quantity

(a) Increased

(b) Marginal

(c) Nominal

(d) Reduced

10. The economic batch quantity helps in eliminating the ……………..time involvedwhenever a batch of articles is produced.

(a) Setting up

(b) Abnormal

(c) Idle

(d) Machine


1. Define job costing. What are the main features of job costing? Give a proforma ofcost sheet under such a system.

2. What is the concept of job costing? Discuss its advantages and limitations.

3. What is a job cost sheet? What kind of data generally appear on job cost sheet?

4. What is job costing? How does it differ from contract costing? Explain.

5. What is batch costing? How does it differ from job costing? Explain.

6. Write an explanatory note on job cost sheet by providing a proforma cost sheet.




Notes


7. Briefly explain the purpose of job costing and the procedure for ascertaining the jobcosts.

8. What is batch costing? What are its salient features?

9. What is meant by Economic Batch Quantity? How is it computed?

10. The following information was obtained from the books of Kartik Company inrespect of Job No. 222:

Materials ` 10,000

Wages:

Deptt. X: 81 hours @ ` 4 per hour

Deptt. Y: 54 hours @ ` 3 per hour

Deptt. Z: 27 hours @ ` 3 per hour

Variable overheads:

Deptt. X: 5,400 man hours ` 10,800

Deptt. Y: 2,000 man hours ` 4,000

Deptt. Z: 1,000 man hours ` 1,000

Fixed overheads: ` 6,000 for 12,000 man hours worked normally.

Calculate cost of Job No. 222 and also its selling price if profit is assumed to be10% on selling price.

7.8 Key Terms

Job costing: Job costing is “a method of cost accounting whereby cost is compiledfor a specific quantity of product, equipment, repair on other service that movesthrough the production process as a continuously identifiable unit, applicablematerial, direct labour, direct expense and usually a calculated portion of theoverhead being charged to a job order”.

Job Order Number: When an order is received from the customer, it is allotted acertain number. Every job order is known by its number throughout its productionprocess.

Production order: Production order or job order is a written order issued to themanufacturing department to proceed with the job.

Job cost sheet: A job cost sheet facilitates the determination of profit or loss onevery job. Estimated costs are also recorded on the job cost sheet which facilitatescomparison of actual costs with the estimated cost and variation in the cost isknown.

Batch Costing: Batch costing is the identification and assignment of those costsincurred in completing the manufacture of a specified batch of components. Havingarrived at the batch cost, the unit cost is simply derived by dividing it by the numberof components in the batch.


1. (a) Production is generally against customer’s order

2. (b) Cost

3. (b) Ascertain the cost as well as the profit or loss for each job

4. (a) Job costing

5. (c) The specification of customer

6. (b) Traceability

7. (a) Batch costing

8. (b) Specific orders




Notes


9. (d) Reduced

10. (a) Setting up









Contract Costing 143

Notes


Unit 8: Contract Costing

Structure

8.1 Introduction

8.2 Concept of Contract Costing

8.2.1 Meaning of Contract Costing

8.2.2 Features of Contract Costing

8.2.3 Distinction between Contract Costing and Job Costing

8.3 Contract Costing Procedure

8.4 Contract Ledger

8.5 Preparation of Contract Account

8.6 Important Points in Contract Costing

8.7 Summary



8.10 Key Terms


Objectives


Understand the meaning and features of contract costing.

Distinguish between contract and Job Costing

Describe the contract costing procedure

Understand the contract ledger

Preparation of contract account

Explain the important points in contract costing

8.1 Introduction

In principle, contract costing is similar to job costing as it follows the principles of jobcosting. Contract costing is, therefore, a type of job costing and the entire contract,

instead of job, constitutes cost unit.

This method of costing which is also known as Terminal Costing is applied inindustries engaged in the construction of buildings roads, dams, bridges, banks, parts,etc. In this method, a separate number is allotted for every contract and all related costsare accumulated for each contract. The person who undertakes the work to complete isknown as ‘contractor’ and the person who gets the work done through contractor isknown as ‘contractee’.

In this unit, we shall study the concept of contract costing, distinguish betweencontract and job costing, the contract costing procedure and the contract ledger. We willalso study the preparation of contract account and the important points in contractcosting.




Notes


8.2 Concept of Contract Costing

This section will help you understand the meaning and features of contract costing anddistinction between contract costing and job costing.

8.2.1 Meaning of Contract Costing

Contract costing is the method or technique of ascertaining cost of a contract. TheICMA, London defines contract costing as, “that form of specific order costing whichapplies where work is undertaken to customer’s special requirements and each order isof long duration or period.” In other words, “contract costing is the technique ofascertaining cost of a contract.

From the above definitions, it is clear that contract costing is a type of specific ordercosting under which there is a attribution of costs to individual contracts. The importantobjectives of contract costing are as follows:

To determine the total cost of the contract,

To determine the profit or loss for each or every contract, and

To facilitate control of cost of each contract.

8.2.2 Features of Contract Costing

The main features of contract costing are as follows:

1. A contract generally takes more than one year to complete,

2. Work is generally carried out at a site other than the contractor’s own premises,

3. Each contract undertaken is treated as a cost unit,

4. Contract is done for a specific consideration which is known as contract price,

5. Separate contract account is prepared for each contract in the books of contractorto ascertain profit or loss on each contract,

6. Most of the raw materials are specially purchased for each contract,7. The contractor is paid in installments which is done after the work completed has

been certified,

8. Most expenses, such as, insurance, telephone, electricity, etc. are also direct,

9. Plant, machinery and equipment may be purchased for the contract or may be hiredfor the duration of the contract,

10. In case of large contracts, the contractor may employ sub-contractors for a part ofthe contract work,

11. Penalties may be incurred by the contractor for failing to complete the work withinthe contract period,

12. Contract costing is concerned with the costing of construction work on repair work

and not with the costing of any goods,

13. There is no heavy investments on assets initially in the case of contract costing,

14. Nearly all labour is direct, and

15. Each contract or work involved in contract costing is executed or done as per thespecifications given by the contractee.

8.2.3 Distinction between Contract Costing and Job Costing

Main points of distinction between contract costing and job costing are as follows:

1. Contract is big in size whereas a job is small in size.

2. Contract work is done at site whereas jobs are usually carried out in factory

premises.




Notes


3. A contract takes more time to complete whereas a job usually takes less time tocomplete.

4. In contract costing, most of the costs are chargeable direct to contract accounts,whereas under job costing, direct allocation to such an extent is not possible.

5. In contract costing, no heavy investment on assets whereas job costing involves

heavy investment on assets initially.

6. Under contract costing, the price is paid in various installments depending upon theprogress of work. In job costing, the selling price of a job is paid after completing the job in full.

7. Contract costing pertains to construction while the job costing is confined toproduction.

8. In contract costing, the cost computation is simple while in the job costing it iscomplex because of the overheads.

9. Contract costing is adopted in long-term contracts whereas the job costing isconfined to finished goods for a small duration of time.

10. In contract costing, the profit and loss can be ascertained in either completed or

uncompleted stages while in the job costing it’s done only on the stage ofcompletion.

8.3 Contract Costing Procedure

The procedure for costing of contracts is as follows:

1. Contract Account: Every contract is allotted a separate number and a separateaccount 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 contractsinclude:

(a) Cost of direct materials,

(b) Cost of direct labour,

(c) Cost of direct expenses,

(d) Cost of supervision,

(e) Depreciation of plant and machinery, and

(f) Sub-contract costs.

3. Indirect Costs: Contract account is also debited with overheads which tend to besmall in relation to direct costs. Indirect costs are often absorbed on some arbitrarybasis as a percentage on prime cost or materials or wages, etc. Overheads arenormally restricted to head office and storage costs.

4. Transfer of Materials or Plant: When materials, plant, etc. are transferred from thecontract, the contract account is credited by that amount.

5. Contract Price: The contract account is also credited with the contract price.However, when a contract is not completed at the end of financial year, the contractaccount is credited with the cost/value of the work-in-progress as on that date.Work-in-progress includes value of certified work and the cost of uncertified work.

6. Profit or Loss Account: The balance of contract account represents profit or losswhich is transferred to profit and loss account. However, when contract is notcompleted within the financial period, only the part of the profit arrived is taken intoaccount and the remaining profit (balance profit) is kept as reserve to meet anycontingent loss on the complete portion of the contract.




Notes


8.4 Contract Ledger

A contract ledger book if kept in which a separate account for each contract is opened. A contract is known by the number allotted to it, as for instance, Contract No. 401,Contract No. 402 and so on. This number and the terms and conditions of the contractpertaining to it are recorded in the contract ledger. A specimen of the contract ledger is

given below:

Figure 8.1: Contract Ledger

8.5 Preparation of Contract Account

In contract ledger, a separate contract account is prepared for each individual contract,so that for a specific contract all cost can be accumulated at one particular place. All theexpenses likely to be incurred on contract, such as direct materials, direct labour, directexpenses, indirect expenses, cost of specific plant, outstanding expenses, sub-contractcost and the depreciation of the common plant being used at the same time on othercontract etc., are debited.

In the credit side of the contract account, the cost of raw material returned tosupplier, to store, transferred to other contracts, material sold, material damaged,material in hand, material stolen, plant returned to store, plant sold, plant transferred toother contracts, plant at site are shown. The material and plant which are stolen are

treated as abnormal loss and hence, transferred to profit and loss account.

In addition to above items, if the contract is completed then contract account iscredited by the contract price. If at the end of the financial year the contract remains incomplete then contract account is credited by cost of work-in-progress amount. In thiswork-in-progress, the cost of certified work and uncertified work are included. At theend, the profit or loss on contract is determined as per rules stated ahead in respect tocontract account.

Contract Ledger

Contract No. : ....................... Contract Price : .......................

Date of Completion : ....................... Terms of Payment : .......................

Site : ....................... Work Certified : .......................

Remark : ....................... Date : .......................

Date ParticularsMaterials

(

)

Wages

(

)

DirectCharges

( )

Plant

(

)

IndirectExpenses

( )

Total

(

)

Total




Notes


A specimen of the contract account is presented showing the debit and credit items:

The Kartik Housing Construction Limited

Contract No. : ............................. Date Started : .............................

Terms of Contract : .............................. Date Completed : .............................Contract Price : .............................. Place of Work : .............................

Terms of Payment : .............................. Escalation Clause, if any : .............................

Dr. Contract Account No. ................. Cr.

Particulars Amount

( )

Particulars Amount

( )

To Materials : By Materials :

Direct material purchased .... Returned to suppliers ....

Issued from stores .... Returned to stores ....

Transferred from othercontract

.... .... Transferred to othercontract

....

To Wages .... Material sold ...

Add : Outstanding wages .... .... Material at site/in hand .... ....

To Direct Expenses .... By Plant :

To Indirect Expenses .... Returned to stores ....

To Plant : Transferred to othercontract

....

Cost of specific plant ifused in the contract

....

Plant sold ....

Depreciation of plant ifused in other contracts

....

To Profit and loss account ....

Plant at site/in hand(the depreciated valueof plant, if used in thecontract)

....

.... (profit on sale of plant ormaterial) By Profit and Loss Account :

To Costs of sub-contract .... ....

To Cost of extra workdone

....

Material lost, stolen ordestroyed

.... Plant lost, stolen ordestroyed ....

To Profit and Lossaccount (if the contract iscomplete balancing figure) .... ....

Or

Loss on sale of plant/material

To WIP account (if workcertified is less than 1/4

th of

contract price – balancingfigure)

.... By Contractee account(contract price in caseof completed contract +extra work price)

....

Or Or

By WIP account : To Balance c/d (if workcertified is more than 1/4

th

of contract price)

....

Value of work certified ....

Cost of work uncertified(in case of anincomplete contract) .... ....

.... ....

To Profit and loss account(profit and loss credited atthe end of the year)

.... By Balance b/d ....

To WIP account (profitkept as reserve)

....

.... ....




Notes


8.6 Important Points in Contract Costing

The preparation of contract account is the essence of contract costing. The contractaccount is prepared by the contractor in his books. In addition to this account thecontractor also prepares contractee’s account. The purpose of preparing a contractaccount is to know the profit or loss on each contract executed. Some of the important

points in contract costing are now discussed in detail.

(i) Materials Cost: Materials required for the execution of contract in most of thecases are ordered specifically and then used on the contract. The following entriesare passed to record the materials cost:

When materials are specifically purchased for the contract.

Materials a/c Dr.

To Cash or supplier’s a/c

(Note: Usually the materials bought are sent to the store room of thecontractor.)

When materials are sent to site by the contractor.

Contract a/c Dr.To Materials a/c

When any materials are sold at work site.

Cash a/c Dr.

To Contract a/c

When materials are transferred from one contract to another.

Transferee contract a/c Dr.

To Transferor contract a/c

When materials are sent to stores.

Stores control a/c Dr.

To contract

For recording materials remaining at site at the end of the year.

(a) At the end of the current year:

Materials at site a/c Dr.

To Contract a/c

(b) At the beginning of the next year:

Contract a/c Dr.

To Materials on site a/c

For recording accidental loss of materials.

Insurance company a/c Dr. (with the admitted claim)

Profit and loss a/c Dr. (with the residue)

To Contract a/c

When materials are supplied by the contractee, the value of such materials shouldnot be charged to the contract account. Instead, a separate record for suchmaterials should be kept because the unused materials will have to be returnedback to the contractee.

(ii) Labour Cost: All wages of workers engaged on a particular contract are chargeddirect to the contract account. When several contracts are running at differentareas, payroll is normally sectionalised so as to have separate payroll for everycontract. Difficulties in costing may be encountered when some workers may have

to move from one site to another when a number of small contracts are undertaken.




Notes


In such situations, it becomes necessary to provide time sheets from whichallocation can be made. In order to control labour utilisation and prevent fraud in thepayment of wages, surprise visits by head office personnel will necessary. If there isany outstanding wages, it is also charged to contract account and in balance sheetas a liability, if it is required.

(iii) Direct Expenses: The expenses incurred exclusively for a particular contract aretreated as direct expenses and are chargeable to that contract for which incurred.For example, a plant hired for a special contract will be charged by the hire chargesor fees paid to expert for consulting him as regard to a specific contract would betreated as direct expense.

(iv) Indirect Expenses: When a contractor undertakes more than one contractsimultaneously, he will set up a common office and engages common supervisorystaff. The administration expenses incurred and the supervisor’s salary isapportioned among the contracts on some suitable basis.

(v) Plant and Machinery: Some of the assets that are to be depreciated while on useon a contract are bulldozers, cement mixer, mobile crane, tractors, lorries and tiles-polishing machines. There are two ways of dealing with the plant and machineries

used on a contract.Where a plant or machinery is specially purchased for a particular contract to beused for longer duration, the contract account is debited with the value of plant. Atthe end of the accounting period, the depreciated value of the plant or machinery iscredited to the contract account.

When the plant or machinery is used relatively for a shorter duration on a contract,the contract account is charged with the depreciation of the plant or machinery.

(vi) Sub-contract Cost: Work of specialised character, for which facilities are notinternally available, is offered to a sub-contractor. For example, steel work, glasswork, electric fittings, doors and furniture fittings, painting, etc., are usually carriedout by the sub-contractors who are accountable to the main contractor. The cost ofsuch work is charged to the contract account.

(vii) Cost of Extra Work: Sometimes the contractor is required to do some extra worklike additions or alterations in the work originally done as per contract or agreement.The contractor will charge extra money for such extra work. The cost of such extrawork or job is debited to the contract account and extra price realised is credited tothe contract account.

(viii) Retention Money: Usually the contractee stipulates in the contract deed that hewould withhold a part of the contract price to be paid at a later stage aftercompletion of the contract. This is to make sure that the contractor has performedall work relating to contract on the most satisfactory manner and that no repair workarises within a prescribed time limit. The amount so withheld by the contractee isknown as retention money. It safeguards the interest of the contractee against thecontractor, who may at time perform sub-standard work and gain there from.

(ix) Cost of Maintenance Periods: Sometimes contractors are required to maintain thework during a specified period after completion, the cost of maintenance is alsodebited to the contract account.

(x) Progress Payment: In large contract, which takes longer duration to complete, thecontractee pays to the contractor a certain amount from time depending upon thestage of satisfactory completion of work. The progress of work from time to time willbe certified by the architect or civil engineer of the contractee. Thus, everyinstallment of money paid by the contractee to the contractor depending upon theprogress of work is known as progress payment.

(xi) Escalation Clause: This clause is often provided in contracts to cover any likelychanges in the price of materials, labour etc. Thus, a contractor is entitled tosuitable enhance the contract price if the cost rises beyond a given percentage. The

objective of this clause is to safeguard the interest of contractor againstunfavourable changes in cost. The escalation clause is of particular importance




Notes


where prices of materials and labour are anticipated to increase or where quantityof materials and labour time cannot be accurately estimated.

Just as an escalation clause safeguards the interest of the contractor by upwardrevision of the contract price or contract value, a de-escalation clause may beinserted to look after the interest of the contractee by providing for downward

revision of the contract price or contract value in the event of cost going downbeyond an agreed level.

(xii) Cost-plus Contract: This is a modified method of contract costing. Cost-pluscontract method of costing is resorted to when it is not possible to determine thecost of the contract in advance with a reasonable degree of accuracy. Under suchcircumstance, the contractee agrees to pay to the contractor, the actual costincurred together with an agreed amount of profit which the contractor earns in theusual course of business. This type of contract is mostly followed during the periodof urgency when certain types of products are to be manufactured and supplied asin the case of defence products, component parts and son on.

Advantages: Cost-plus contracts offer the following advantages:

To the Contractor: There is no risk of loss on such contract.

There is bargain in the contract price in future under this type of contract.

It simplifies the work of preparing tenders or quotation.

Procurement of the services of the experts.

It protects him from the risk of fluctuations in market prices of materials, labour,etc.

Earliest completion of the work.

To the Contractee:

Since the contract price is governed by the contract, the contractees will also

not suffer from risk of loss. Under this method, the contractor can know in advance the profit that can

expect to work on the contract on its completion.

In the case of cost-plus contracts, generally, the quality of the work does notsuffer.

By giving to the contractee the right to inspect the accounting records of thecontractor, a cost-plus contract ensures a fair price to the contractee.

Disadvantages: The disadvantages of cost-plus contracts are:

To the Contractor:

The contractor has to suffer for his own efficiency. This is because profit is

usually based as a percentage of cost and efficient working resulting lower costalso leads to lower profits.

The contractor is deprived of the advantages which would have accrued due tofavourable market prices.

To the Contractee:

Misuse of materials and labour by the contractor.

The price a contractee has to pay is unknown until after the completion of work.

Generally the contract price is widely increased.

The contractee has to pay more for the efficiency of the contractor as thecontractor has no incentive to reduce costs.

(xiii) Work Certified and Work Uncertified: Work certified represents that portion ofthe contract that has been duly approved by the architect of the contractee. This is




Notes


denoted in terms of money value in contract account and appears on the credit sideof the contract account.

Work uncertified refers to that portion of work completed by the contractor bydisapproved by the architect on the ground that it has not reached a stipulatedstage. The value of work uncertified also appears on the credit side of the contract

account.(xiv) Work-in-Progress: The work-in-progress represents the value of work which is in

progress as a contract and requires further completion. The value of WIP appearson the asset side of the balance sheet and is ascertained as under:

Amount of work certified ......................

Amount of work uncertified ...................... ......................

___________

Less: Profit transferred to WIP ......................

Less: Cash received ...................... ......................

___________ ___________

Amount of Work-in-Progress ......................

(xv)Contractee’s Account: The contractee’s account is prepared by the contractor inhis books. When the various installments of contract price is received from thecontractee, the following entry is passed:

Cash a/c Dr.

To Contractee’s a/c

When the contract is fully completed the following entry is passed:

Contractee’s a/c Dr.

To Contract a/c

Thus, it is clear that the contractee’s account will show a debit balance indicatingthe amount due from him to the contractor till it is paid fully.

(xvi) Loss of Completed Contract and Incomplete Contract: Every loss on contract,whether completed or incomplete, should be transferred to profit and loss accountin full. This treatment is justified on the basis of prudence concept. While accountingthe loss on contract, stage of completion of contract work is not considered. In caseof incomplete contract, if it is expected that is future also contract is subject tolosses, it is advisable to make a provision for contingencies.

(xvii) Notional Profit: Notional profit is the difference between the value of work-in-progress certified and the cost of work-in-progress certified. It is computed asfollows:


Value of certified work 10,00,000

Add : Cost of work not yet certified 1,00,000

11,00,000

Less : Cost of work to date 9,00,000

Notional Profit 2,00,000

If in any year, cost of work done exceeds the value of certified work and uncertified,the result will be a notional loss.

(xviii) Profit on Incomplete Contract: Profit can be accurately calculated only whencontract is complete. If a contract extends two, three or more years, the contractorwill have to wait for calculation of profit till the contract is completed. This is notdesirable; hence, profit has to be calculated on the contract even if the contract isnot completed. But profit on incomplete contract should be calculated afterproviding adequate sums for meeting unknown contingencies. For calculating profit

on incomplete contract abundant caution and conservative approach are required




Notes


so as to cover risk and uncertainty during the balance of period of execution ofcontract.

There are no hard and fast rules regarding the calculation of profit of incompletecontract. However, profit should be taken only in respect of certified work anduncertified work should be valued at cost. When profit is based on the basis of

certified work, it is known as ‘profit earned’. Following rules may be followed forcalculating profit to be taken to profit and less account:

(a) If the work certified is less then ¼th of the contract, no profit should betransferred to profit and loss account. It means that entire notional profit shouldbe treated as reserve for future contingencies.

(b) It the work certified is 1/4th of contract price or more but less then ½ of thecontract price, the profit transferred to profit and loss account should be 1/3rd ofthe notional profit:

Profit = Notional profit × 1/3

If it is desired to transfer the realised profit to profit and loss account it will becalculated as under:

Profit = 1/3 × National profit × (Cash received/Work certified)

(c) If the work certified is ½ or more than of the contract price, the profit transferredto profit and loss account would be 2/3rd of the notional profit:

Profit = Notional profit × 2/3rd

If it is desired to transfer the realised profit to profit and loss account, it will becalculated as under:

Profit = 2/3 × National profit × (Cash received/Work certified)

(d) Sometimes a contract is nearing completion, say, its physical progress is morethan 90% and the contractor is in a position to estimate the future costs withhigh degree of accuracy. In such a case, it would the desirable to calculate theprofit with reference to total estimated profit. Total estimated profit is excess of

contract price over total estimated cost. The profit to be transferred to profit andloss account will be calculated as under:

Profit = Estimated profit × (Work certified/Contract price)

If it is desired to transfer the realised profit to profit and loss account, it will becalculated as under:

Profit = Estimated profit × (Work certified/Contract price) × (Cash received/Workcertified)

Where,

Estimated Profit = Contract price – Total estimated cost

Total Estimated Cost = Costs incurred upto date + Estimated costs for

completion of contract.

[Important note: If nothing is given in the problem, students are advised to usethe concept of realised profit.]

(xix) Balance Sheet: At the time of preparation of balance sheet, the contractee’saccount deserves a special mention. The contractee’s account is not to be shownas a debtor for the full contract price unless the work has been completed. Likewisethe sum received from the contractee under various installments should not beshown as a liability on the balance sheet. On completion of contract, if thecontractee still owes the amount to the contractor, his account is shown as a debtorfor the amount due from him. When the contractee pays full amount, his account isclosed and his account will not appear in the balance sheet.

(xx) Target Costing: This is a variation of cost-plus contract. Under target costing

method, the contractee agrees to pay the profit as per the agreement or contract on




Notes


the total contract price. In addition to the profit, some times, it is agreed upon by thecontractor to complete the contract within a target price.

In case, if he completes the contract within the target price, he is entitled to receivea bonus which is in proportion to the savings made, saving being difference betweenoriginal contract price and target price.

Problem 1: Show how would you deal with plant in Udai Contract Account with thefollowing information:

Plant issued to contract on 1st June, 2008 costing ` 2,00,000, Plant costing ` 16,000 was transferred to Vikas Contract on 30.11.2008, Plant costing ` 6,000 wasstolen and another costing ` 5,000 was destroyed by fire. The plant was insured againstfire to the full value. Plant costing ` 20,000 was sold for ` 19,000. Plant at the end of theyear was valued by charging depreciation @20% per annum on 31st March, 2009.

Solution:

Contract Account

Particulars ParticularsTo Plant account 2,00,000 By Vikas contract account

Plant transferred

Cost 16,000

Less : Dep. @20%for 6 months

1,600 14,400

By Profit & loss account (Plantstolen)

6,000

By Fire insurance company (Plantdestroyed by fire)

5,000

By Sale of plant 19,000

By Profit and loss account (Loss onplant sold)

Cost 20,000

Less : Sold 19,000 1,000

By Plant at site

Cost

(2,00,000– 47,000)

1,53,000

Less : Dep. @20%for 10 months 25,500 1,27,500

Problem 2: The contract price of a contract undertaken by Kartik Limited on 1st July,

2008 was ` 3,00,000. Following expenses were incurred on the contract:Materials consumed ` 72,500

Materials in hand on 31st March, 2009 ` 30,000

Direct wages ` 40,000

Direct expenses ` 42,000

Plant purchased ` 50,000

The contract was completed on 31st March, 2009 and the contract price was dulyreceived. Provide depreciation on plant @10% per year and charge indirect expenses@20% on direct wages. Prepare Contract Account and Contractee’s Account in thebooks of Kartik Limited.




Notes


Solution:

Contract AccountIn the Books of Kartik Limited

Date Particulars Date Particulars

To Plant purchased 50,000 By Material in hand 30,000To Materials issued : By Plant in hand :

Materialsconsumed 72,500

Cost 50,000

Less : Dep. 3,750(1) 46,250

2008,1

st

July

Add :Material

in hand 30,000 1,02,500

2009,31

st

March

By Contractee's account 3,00,000

To Direct wages 40,000

To Direct expenses 42,000

To Indirect expenses(20% of direct wages)

8,000

2009,31

st

March

To Profit and lossaccount

1,33,750

3,76,250 3,76,250

Working note: (1) Calculating of depreciation on plant:

Depreciation =10 9

50,000100 12

⎛ ⎞× ×⎜ ⎟⎝ ⎠ = ` 3,750.

Contractee’s Account

Date Particulars Date Particulars

2009,31st March

To Contract account 3,00,000 2009,31st March

By Cash account 3,00,000

3,00,000 3,00,000

Problem 3: The following expenses relate to a contract:

Materials issued to contract ` 85,349

Labour engaged ` 74,375

Plant at cost ` 15,000

Direct expenses ` 3,169

Establishment charges ` 4,126

Materials returned to stores ` 549Work certified ` 1,95,000

Cost of work uncertified ` 4,500

Materials in hand on 31st December, 2012 ` 1,883

Wages accrued due at 31st December, 2012 ` 2,400

Direct expenses accrued due at 31st December, 2012 ` 240

Value of plant at 31st December, 2012 ` 11,000

The contract price has been agreed at ` 2,50,000. Cash received from thecontractee was ` 1,80,000. The accounting year closes on 31st December, 2012.

Prepare Contract Account and Contractee’s Account for the year 2012.




Notes


Solution:

Contract Account


To Material 85,349 By Materials returned 549

To Labour 74,375 By Materials in hand 1,883

To Plant 15,000 By Plant at site 11,000

To Direct expenses 3,169 By Work-in-progress :

To Establishment charges 4,126 Work certified 1,95,000

To Wages accrued 2,400 Work uncertified 4,500

To Direct expenses accrued 240

To Profit c/d 28,273

2,12,932 2,12,932

To Profit & loss account 17,399(1)

By Profit b/d 28,273

To Work-in-progress 10,874

28,273 28,273



1,80,000 1,80,000To Balance c/d

1,80,000

By Bank

1,80,000

Working note: (1) Profit to profit and loss account

=2 1,80,000

28,2733 1,95,000

× × = ` 17,399

Problem 4: Mr. Saxena undertook a contract for ` 1,35,000 which took 13 weeks in itscompletion. From the following details, prepare Contract Account and Contractee’s Account assuming the amount due from the contractee to be received:

The value of loose tools and stores returned at the end of the period were ` 300and ` 4,500 respectively. The plant returned at the value of ` 24,000 after chargingdepreciation at 20%. The value of tractor was ` 30,000 on which depreciation @15%per annum was to be charged. The administration and office expenses are to beprovided at 20% on works cost.

Solution:

Contract Account


To Direct materials 30,375 By Store returned 4,500

To Direct wages 23,250 By Loose tools returned 300

To Stores issued 15,750 By Plant returned

30,000

To Loose tools 3,600 Less : Dep. @20% 6,000 24,000

To Tractor expenses : By Tractor returned 30,000

Fuel etc. 3,450 Less : Dep. @15%

Driver's wages 4,500 p.a. for 13 weeks 1,125 28,875

Other expenses 3,975 11,925 87,225

To Plant issued

100

24,000× 80 30,000(1)

By Works cost c/d (Balancingfigure)




Notes


To Cost of tractor 30,000

1,44,900 1,44,900

To Works cost b/d 87,225 1,35,000

To Administration exp. 20% ofworks cost

17,445

By Contractee's account (workfinished)

To Profit & loss account 30,330

1,35,000 1,35,000

Working note: (1) Plant depreciated at 20% and not @20% per annum. So, originalcost of plant would be 24,000 × (100/80) = ` 30,000.



1,35,000 1,35,000To Contract account

1,35,000

By Bank account

1,35,000

Problem 5: From the following data relating to a contract extracted from the books of a

company, prepare Contract Account as on 31st March, 2013:

Materials issued ` 1,35,000 Small plant used ` 5,275

Wages ` 75,000 Contract price ` 3,50,000

Office expenses 20% of works cost

You are further informed that: (a) Work commenced on 1st October, 2012; (b)Wages of workers for one week and salary of the supervisory staff for one month weredue at the end of the period; (c) Depreciation to be charged @10% per annum on plant;(d) Materials at site on 31st March, 2013 was ` 6,300.

Solution:

Contract Account

For the year ended 31st March, 2013


To Materials issued 1,35,000 By Material at site 6,300

To Wages 75,000 By Plant at site 1,12,500

To Wages accrued 3,000(1)

Less : Dep.

To Plant issued 1,12,500 @10% p.a. forsix months 5,625 1,06,875

To Supervisor's salary By Contractee's account 3,50,000

8,250

Add : Accruedfor one month

1,650(2) 9,900

To Cost of extra work done 2,500

To Sub-contract cost 10,000

To Small plant used 5,275

To Office expenses (20% of ` 2,40,000(3))

48,000

To Profit & loss account 62,000

4,63,175 4,63,175

Working notes:

(1) Wages accrued: Wages paid for 25 weeks ` 75,000. Hence, wages for oneweek = ` 75,000/ 25 = ` 3,000.




Notes


(2) Salary accrued: Salary for 5 months ` 8,250. Hence, salary for 1 month = ` 8,250/5 = ` 1,650.

(3) Office expenses are 20% of works cost being [1,35,000 + 75,000 + 3,000 +1,12,500 + 9,900 + 2,500 + 10,000 + 5,275] – [6,300 + 1,06,875] = ` 2,40,000.

(4) Cost of extra work done ` 2,500 is considered as the cost of original contract

because it is very much low amount in this case.

8.7 Summary

In principle, contract costing is similar to job costing as it follows the principles of jobcosting. Contract costing is, therefore, a type of job costing and the entire contract,instead of job, constitutes cost unit. This method of costing which is also known asTerminal Costing is applied in industries engaged in the construction of buildings roads,dams, bridges, banks, parts, etc. In this method, a separate number is allotted for everycontract and all related costs are accumulated for each contract.

A contract generally takes more than one year to complete, Work is generallycarried out at a site other than the contractor’s own premises, and each contract

undertaken is treated as a cost unit. Contract is done for a specific consideration whichis known as contract price and separate contract account is prepared for each contractin the books of contractor to ascertain profit or loss on each contract. Most of the rawmaterials are specially purchased for each contract.

Under contract costing, the price is paid in various installments depending upon theprogress of work. In job costing, the selling price of a job is paid after completing the jobin full. The preparation of contract account is the essence of contract costing. Thecontract account is prepared by the contractor in his books. In addition to this accountthe contractor also prepares contractee’s account. The purpose of preparing a contractaccount is to know the profit or loss on each contract executed.

All wages of workers engaged on a particular contract are charged direct to thecontract account. When several contracts are running at different areas, payroll is

normally sectionalised so as to have separate payroll for every contract. When acontractor undertakes more than one contract simultaneously, he will set up a commonoffice and engages common supervisory staff. The administration expenses incurredand the supervisor’s salary is apportioned among the contracts on some suitable basis.

Target Costing is a variation of cost-plus contract. Under target costing method, thecontractee agrees to pay the profit as per the agreement or contract on the totalcontract price. In addition to the profit, some times, it is agreed upon by the contractor tocomplete the contract within a target price.



1. Contract costing is a basic method of

(a) Historical costing

(b) Specific order costing

(c) Process costing

(d) Standard costing

2. Contract costing usually applicable in

(a) Constructional Works

(b) Textile Mills

(c) Cement Industries

(d) Chemical Industries




Notes


3. In contract costing, determination of work in progress include:

(a) Work Certified

(b) Work Uncertified

(c) Retention Money

(d) Both a and b4. Work Certified is valued at

(a) Cost price

(b) Market price

(c) Cost or market price whichever is less

(d) Estimate price

5. The degree of completion of work is determined by comparing the work certifiedwith

(a) Contract price

(b) Work in progress

(c) Cash received on contract

(d) Retention money

6. In contract costing credit is taken only for a part of the profit on

(a) Completed contract

(b) In complete contract

(c) Cost-plus contract

(d) Work Certified

7. Escalation Clause in a contract to prefect the interest of

(a) Contractor

(b) Contractee(c) Surveyor

(d) Contractee's Architect

8. In contract costing payment of cash to the contractor is made on the basis of

(a) Uncertified work

(b) Certified work

(c) Work in progress

(d) Estimated value

9. Materials returned under material return note credited to

(a) Contract account

(b) Work in progress account

(c) Plant and machinery account

(d) Profit and loss A/C

10. Cash received on contract is credited to

(a) Contract Account

(b) Plant Account

(c) Work in Progress Account

(d) Contractee's Account




Notes



1. What is contract costing? To which industries is it found suitable?

2. What do you understand by contract costing? How does it differ form job costing?Discuss contract costing procedure in detail.

3. Explain the various features of contract costing.4. What are the main features of cost-plus contract? Discuss its advantages and

disadvantages.

5. Write short notes on the following:

(a) Cost-plus contract, (b) Escalation clause,

(c) Sub-contract cost, and (d) Work-in-progress.

6. What is the treatment of sub-contract cost in contract account?

7. Rajendra took a contract on 1st April, 2007. The contract price was ` 7,50,000. Theexpenses were made upto its completion i.e. 30th September, 2008 as follows:

` `

Material purchased 50,000 Establishment charge 6,000Material issued from stores 1,50,000 Plant issued 3,00,000

Materials from other contract 1,00,000 Material returned to stores 20,000

Wages 2,50,000 Material at the end 8,000

Direct expenses 10,000 Plant in the end 2,00,000

8. Explain the different methods of computing profits in contract accounts.

8.10 Key Terms

Contractor: The person who undertakes the work to complete is known as‘contractor.

Contractee: The person who gets the work done through contractor is known as‘contractee’.

Contract costing: Contract costing is the technique of ascertaining cost of acontract.

Contract Price: Contract is done for a specific consideration which is known ascontract price.

Contract Account: In contract ledger, a separate contract account is prepared foreach individual contract, so that for a specific contract all cost can be accumulatedat one particular place.

Materials Cost: Materials required for the execution of contract in most of thecases are ordered specifically and then used on the contract.


1. (b) Specific order costing

2. (a) Constructional Works

3. (d) Both a and b

4. (a) Cost price

5. (a) Contract price

6. (b) In complete contract

7. (b) Contractee

8. (b) Certified work

9. (a) Contract account10. (d) Contractee's Account




Notes





Rajasekaran V, Cost Accounting, Pearson Education India, 2010 Jawahar Lal, Seema Srivastava, Cost Accounting, McGraw-Hill Education, 2013





Notes


CASE STUDY: A CASE STUDY ON CONTRACT COSTING

andey & Co. Ltd. was formed in 1973 to introduce specialist new products andservices to the sewage treatment plant. Pandey & co. ltd. has been at the forefrontof developing innovative solutions manufacturing a wide range of products for a

variety of applications.

Pandey & Co. Ltd. undertook a contract for erecting a sewerage treatment plant for a cityfor a total value of ` 2.4 crores. It was expected that the contract would be completed by31" March 2015. The following particulars are available related to the contract:

` (a) Materials 30 Lakhs

(b) Wages 60 Lakhs

(c) Overheads 12 Lakhs

(d) Special plant 20 Lakhs

(e) Depreciation @ 10% to be provided on plant.

(f) Materials laying at site on 31.12.2014 ` 4 lakhs

(g) Work certified was to the extent of ` 1.6 crores and 80% of the same was received incash.

(h) 5% of the value of material issued and 6% of wages may be taken to have beenincurred for the portion of the work completed but not yet certified.

(i) Overheads are charged as a percentage of direct wages.

(j) Ignore depreciation on plant for use on uncertified portion of the work.

(k) Ascertain the amount to be transferred to Profit & Loss Alc on the basis of realizedprofit.

Questions

1. Prepare the contract account for the year ending 31st March 2014.

2. Determine the amount to be transferred to profit and loss account.

P




Notes


Unit 9: Process Costing and Service Costing

Structure

9.1 Introduction

9.2 Process Costing

9.3 Difference between Process Costing and Job Costing

9.4 Preparation of Process Accounts

9.5 Treatment of Normal Loss, Abnormal Loss and Abnormal Gain

9.5.1 Normal Loss/ Wastage

9.5.2 Abnormal Loss

9.5.3 Abnormal Gain or Abnormal Effectives

9.6 Joint Products and By-Products

9.6.1 Costing of Joint Products

9.6.2 Costing of By-products

9.7 Service Costing

9.7.1 Transport Service

9.7.2 Power House Costing

9.7.3 Hotel Costing

9.7.4 Hospital Costing

9.8 Summary



9.11 Key Terms


Objectives


Understand the meaning and application of process costing

Describe the principles of process costing

Differentiate process and job costing

Describe the accounting procedure of costing.

Understand normal loss, abnormal loss and abnormal gain

Describe the joint products, by-products

Understand the concept of service costing

9.1 Introduction

Industries which are engaged in the manufacture of products which involve continuousoperation or process are known as process industries. These industries have theirspecial features. The costing system should be designed bearing in mind the salientfeatures.



Process Costing and Service Costing 163

Notes


Process costing is also one important method of costing. It refers to costing ofoperation(s) or process(es) involved in converting raw materials into finished goods orproducts. Its main objective is to provide an average cost of product.

In this unit, we shall study the meaning and application of process costing, theprinciples of process costing. You will be able to differentiate process and job costing.

We will also study the accounting procedure of costing, normal loss, abnormal loss,abnormal gain, the joint products and by-products. At the end of this unit you will studythe concept of service costing.

9.2 Process Costing

Process costing represents a type of cost procedure for continuous productionindustries. In such industries, output consists of like units, each unit being processed inthe same manner. Therefore, it is assumed that the same amount of raw materials,labour and overhead is chargeable to each unit processed. The cost of unit at the endof any manufacturing process can be easily determined provided costs are accumulatedon a process basis and record of units produced is available.

According to CIMA, “The costing method applicable where products or servicesresult from a sequence of continuous operations or processes. Costs are arranged overthe units produced during the period”.

According to Kohler, “A method of accounting whereby costs are charged toprocesses or operations and averaged over units produced; it is employed principallywhere a finished product is the result of a more or less continuous operation, as inpaper mills, refineries, canneries and chemical plants; distinguished from job costing,where costs are assigned to specific orders, lots or units”.

Characteristics of Process Costing

The main characteristics of process costing are:

(i) The products or goods are processed in one or more processes,

(ii) The products are distinguishable in processing stage,

(iii) The products or goods are standardized, and

(iv) When a product is produced through various processes, the output of each processin transferred to the next process and that of last process is transferred to thefinished goods or finished stocks.

Application of Process Costing

Process costing may be used in a wide number of industries. The following types ofindustries may be used process costing:

(a) Production or manufacturing industries, such as cement, rubber, glass, textiles,paper, iron, steel, aluminium, milk-dairy, biscuits, soap-making, flour milling

industries, etc.

(b) Public utility services, such as water supply, generation of electricity, healthservices, etc.

(c) Mining industries, such as coal, steam, gas, oil, coking industries, etc.

(d) Chemical and distilleries industries, etc.

Principles of Process Costing

The following are the fundamental principles of process costing:

(a) Cost of material, wages and overheads expenses are collected for each process oroperation in a period.

(b) Adequate records in respect of output and scrap of each processes or operationduring the period are kept.




Notes


(c) The cost per unit of each process is obtained by dividing the total cost incurredduring a period by the number of units produced during that period after taking intoconsideration the losses and amount realized from sale of scrap.

(d) The finished product of one process is transferred as a raw material to the nextprocess.

9.3 Difference between Process Costing and Job Costing

The main differences between process costing and job costing are as follows:

S.No. Process Costing Job Costing

(i) In process costing production is acontinuous flow and the products arestandardized.

In job costing, production is carried onby specific order.

(ii) Processes are related to each other.Products also lose their individual entity.

Various jobs are separate andindependent.

(iii) In process costing, costs are calculatedat the end of period under each process.

In job costing, costs are calculated whena job is completed or finished.

(iv) In process costing, transfer from oneprocess to another is an usual feature.

In job costing, there is normally no transferfrom one job to another. It will be only whenthere is surplus or excess production.

(v) Cost are compiled on time basis: forproduction, for a given accountingperiod, for each process.

Costs are determined by Jobs or batchesof products.

(vi) In process costing, production ishomogeneous, stable and controllable.

In job costing, each product unit isdifferent and therefore more managerialattention is needed for proper control.

(vii) The unit cost of a process, which iscomputed by dividing the total cost forthe period into the output of the processduring that period, is an average cost for

the period.

In job costing, unit cost of a job iscalculated by dividing the total cost byunits produced in the lot or batch in theperiod.

(viii) Production in process costing iscontinuous and therefore there isnormally work-in-progress at beginningand closing.

In job costing, there may not be openingor closing work-in-progress in anaccounting period.

9.4 Preparation of Process Accounts

If the products are produced by different processes, cost of previous process istransferred to the next process, so that total and unit cost of products are accumulated.In short, cost of products will comprise all costs incurred in all the processes uptofinished stage. There is no departure from the principles regarding direct and indirectexpenditures. The costs of processing will include:

Materials,

Labour,

Direct Expenses, and

Indirect Overheads.

Materials issued for a particular process are debited direct to it and so also labourengaged only on that process. If two or more processes are carried on in the samedepartment, the department expenses will be apportioned among the processes carriedon there.

Apart from direct expenses, some indirect overheads, common to all process, arebound to be incurred. The salary of the works manager, for example, will have to be

allocated to all the process. The normal practice is to do that on the base of direct




Notes


9.5 Treatment of Normal Loss, Abnormal Loss and Abnormal Gain

This section will help you understand how the losses i.e. normal and abnormal andabnormal gains are treated in process costing.

9.5.1 Normal Loss/ Wastage

This is the amount of loss which is unavoidable because of the nature of raw materialsor the production technique and is inherent in the normal course of production e.g., lossof weight because of evaporation or melting etc. Such wastage may also take placewhile stamping product components out of a big metal sheet. This wastage is normallyexpressed as a percentage of the quantity of output. This percentage of normalwastage of a particular process is determined on the basis of the experience of previousyears.

In the case of normal wastage, all production expenses incurred are charged to thegood units of output. Thus, normal wastage becomes the part of cost of production andincreases the cost of output. If the normal wastage takes place at the beginning of theprocess or during it, it is supposed that the lost units were never introduced in the

process and thus normal wastage is charged to the units completed as well as to thework in process.

9.5.2 Abnormal Loss

Sometimes the percentage of wastage or loss may exceed the determined standardpercentage of normal wastage. Any wastage exceeding the normal percentage istermed abnormal loss or wastage. Such loss or wastage is not a part of production. It iscredited out of the concerned process account as a loss to the costing profit and lossaccount. The value of abnormal wastage is calculated with the help of the followingformula:

=Normalcost

Unitsof abnormallossNormaloutput

×

9.5.3 Abnormal Gain or Abnormal Effectives

If the quantum of wastage is less than the predetermined percentage of normalwastage, the difference is called as abnormal gain or effectives. This does not effect thecost of production. The value of the abnormal effectives is debited to the concernedprocess account and credited to the abnormal effectives account. This value iscalculated at the rate at which the effective output would have been valued if normalwastage had taken place according to expectation. This formula for calculation of thevalue of abnormal gain or effectives is:

=Normal cost of normal production

Units of normal production × Units of abnormal effectives

At the end of the accounting year, the abnormal effectives account is transferred tothe credit side of profit and loss account.

Problem 2: The XYZ manufacturing company’s product passes through two distinctprocesses I and II and then to finished stock. It is known from past experience thatwastage occurs in the processes as under:

In process I 5% of the units entering the process.

In process II 10% of the units entering the process.

The scrap value of the wastage in process I is ` 8 per 100 units and process II is ` 10 per 100 units.

The process figures are:




Notes


Process I ( ` ) Process II ( ` )

Materials consumed 3,000 1,500

Wages 3,500 2,000

Manufacturing expenses 1,000 1,000

5000 units were brought into process I costing ` 2,500. The outputs were:Process I 4,700 Units

Process II 4,150 Units

Prepare process cost accounts showing the cost of the output.

Solution:

Process Account I

Particulars Units

( )

Amount

( )

Particulars Units

( )

Amount

( )

To Units brought in 5,000 2,500 By Normal wastage 250 20

To Materialsconsumed

3,000 By Abnormal wastage 50 105

To Wages 3,500 [(9,980÷4,750)x50]

To Manufacturingexpenses

1,000 By Transfer toprocess II

4,700 9,875

5,000 10,000 5,000 10,000

Process Account II

Particulars Units

( )

Amount

( )Particulars Units

( )

Amount

( )

To Transferred fromProcess I

4,700 9,875 By Normal wastage 470 47

To Materialsconsumed

1,500 By Abnormal wastage 80 271

To Wages 2,000 [(14,328÷4,230)x80]

To Manufacturingexpenses

1,000 By Finished stock 4,150 14,057

4,700 14,375 4,700 14,375

Problem 3: The product of a factory passes through three processes of manufacture.The output of each process is transferred to the next process at cost on completion.The stocks which consist of raw materials are to be valued at cost per unit of thepreceding process.

From the following particulars prepare process cost account showing the cost of theoutput and the cost per unit at each stage of production.

Processes

I ( ` ) II ( ` ) III ( ` )

Direct wages 6,400 12,000 29,250

Machine expenses 3,600 3,000 3,600

Factory on cost 2,000 2,250 2,400

Raw materials consumed 24,000 — —

Production (Gross) in units 37,000 — —

Wastage in units 1,000 1,500 500

Stock 1st June, 2007 (in units) 4,000 16,500

Stock 30th June, 2007 (in units) 1,000 5,500




Notes


Solution:

Process Account I

Particulars Units

( )

Amount

( )

Particulars Units

( )

Amount

( )

To Raw materials 37,000 24,000 By Wastage 1,000 --

To Direct wages 6,400 36,000 36,000

To Machine expenses 3,600

To Factory on cost 2,000

By Transfer to process II(cost ` 1 per unit)

37,000 36,000 37,000 36,000

Process Account II

Particulars Units

( )

Amount


( )

Amount

( )

To Transferred from 36,000 36,000 By Wastage 1,500 --

Process I By Transfer to Process 37,500 56,250

To Stock 1st June 2007 4,000 4,000 III ( ` 1.50 per unit)

To Direct wages 12,000 1,000 1,000

To Machine expenses 3,000

To Factory on cost 2,250

By Stock on 30 June2007(@ Re. 1 per unit)

40,000 57,250 40,000 57,250

Process Account III

Particulars Units

( )

Amount


( )

Amount

( )

To Stock 1st June

200716,500 24,750 By Wastage 500 --

To Transferred fromProcess II

37,500 56,250 By Stock on 30th June

2007 @ ` 1.505,500 8,250

To Direct wages 29,250 per unit

To Machineexpenses

3,600 By Finished goods a/c 48,000 1,08,000

To Factory on cost 2,400 (cost ` 2.25 per units)

54,000 1,16,250 54,000 1,16,250

Problem 4: Pramod Limited produce a patent materials used in building in the

manufacture of which three processes are involved. The material is produced in threeconsecutive grades, namely, soft, medium and hard. Figure relating to production forthe first six months of 2007 are as follows:

Process I Process II Process III

Raw materials used tons 1,000 — —

Cost of per ton 200 — —

Manufacturing wages and 72,500 40,800 10,710expenses

Weight lost 5% 10% 20%

Scrap (sold at ` 50 per ton) 50 tons 30 tons 51 tons

Two-third of process I and one-half of process II are passed to the next process andthe balance are sent to the warehouse for sale.




Notes


The brief description of these methods is as follows:

(i) Average Unit Cost Method: It is the most simple method. The total costs areassessed, yielding an average unit cost with one net profit for the total operation.This method can be applied where processes are common and inseparable for the joint products and where the resultant products can be expressed in same common

unit. This means that all joint products have the same unit cost and, therefore, ifprice fixing is based on cost of various products which may be of different grades orquality will be sold at the same unit price, resulting in a customer’s price advantagein grades. Moreover, where the end products cannot be expressed in somecommon unit, this method breaks down.

(ii) Physical Unit Method: Under this method, a physical base such as raw materialsweight, linear measure volume etc., is applied in apportion pre-separation pointcosts to joint products. This method presupposes that each joint product is equallyvaluable, which is probably not the case in practice.

(iii) Survey Method: Under this method, all the important factors such as volume,selling price, technical aspects, marketing process etc., affecting costs areascertained by means of extensive survey. Point’s values or percentages are given

to individual products according to their relative importance and costs areapportioned on the basis of total points. These ratios should be revised from time totime depending upon the factors affecting production and sales.

(iv) Market Value Method: This method of apportioning joint costs to products on thebasis of relative value is the most popular and convenient method. The joint costsare split in the ratio of selling price of individual products.

9.6.2 Costing of By-products

By-products are relatively considered less important. For example, molasses obtainedfrom production of sugar or ash available when boilers are run would be by-products.

Accounting Treatment when By-products have Market Value

If the by-products have relatively unimportant market value, it is neither feasible norpracticable to attempt to apportion to the by-products any part of the joint costs ofproduction upto the point of split off. The possible treatments in this condition may be asfollows:

All income received from the sale of by-products may be considered as income andcredited to the Profit and Loss Account. The major product bears the whole cost ofproduction and its sales are considered while determining operating income.

The sale proceeds of by-products may be credited to the account of main productand thus it can be deducted from the cost of production of main product.

The income realised from the sale of by-products is reduced by the selling costsincurred on the sale and manufacturing costs applied to the by-products after theyachieve a separate existence. The remaining amount is deducted from the cost ofproduction of the major product.

Accounting Treatment when By-products Need Further Processing

In this case, obviously the by-product is of some importance and it would be necessaryto determine the cost of by-product at the point it is separated from the main product.This cost should be determined on the basis of physical management or the marketvalue at the separation point. After having ascertained the share of joint costs on the by-product, it will be necessary to have a separate account for it in which the expenses forfurther processing will be charged. The total of this account will be the cost of rawmaterials for the other products.

Problem 5: A particular brand of cough syrup passed through three processes for

production. During the month ended August, 2007. 600 gross of bottles were produced.The following information is obtained.




Notes


Processes

I ( ` ) II ( ` ) III ( ` )

Materials 4,000 2,000 1,500

Labour 3,000 2,500 2,500

Direct expenses 600 200 500Cost of bottles — 2,030 —

Cost of casks and spoons — — 325

The indirect expenses were ` 1,600 to be apportioned as ` 600 in I process, ` 500in II process, and ` 500 in III process. The by-products were sold for ` 240 in process IIand the residue sold ` 125 in process III.

Prepare process accounts.

Solution:

Process Account I

Particulars Qty. Amount( )


To Materials 600 4,000 600 8,200

" Labour 3,000

" Direct expenses 600

By Transfer to ProcessII (Cost of per bottle ` 13.67)

" Indirect expenses 600

600 8,200 600 8,200

Process Account II



To Process I a/c 600 8,200 By By-product sold 240

" Material 2,000 600 15,190

" Labour 2,500

" Transfer to Process III@ ` 25.32



" Cost of bottles 2,030

600 15,430 600 15,430

Process Account III



To Process II a/c 600 15,190 By Residue sold 125

" Materials 1,500 600 20,390

" Labour 2,500


" Finished goods a/c @ ` 33.98


" Cost of casks andspoons

325

600 20,515 600 20,515

Problem 6: From the following information, find out the cost of X and Y the latter beingby the product on whose sale a profit of 20% on selling price is obtained usually.




Notes


Joint Expenditure ( ` ) Separate Expenditure

X ( ` ) Y ( ` )

Materials 9,000 2,000 1,000

Labour 4,000 800 300

Other expenses 2,000 1,000 400

Total amount realised by sale of Y is ` 1,100.

Solution:

Joint Expenses Account

Particulars Amount ( ) Particulars Amount ( )

To Materials 9,000 By X's Production a/c 13,900

" Labour 4,000 " Y's Production a/c 1,100

" Other expenses 2,000

15,000 15,000

X’s Production Account


To Joint expenses a/c 13,900 By Cost of production 17,700

" Materials 2,000

" Labour 800

" Other expenses 1,000

17,700 17,700

Y’s Production Account


To Joint expenses a/c 1,100 By Cost of production 2,800

" Materials 1,000

" Labour 300

" Other expenses 400

2,800 2,800

9.7 Service Costing

Service costing is a special method of cost computation which is suitable for theindustries which render services as distinct from these which manufacture goods. Thecost of operating a service is known as operating cost and the method of ascertaining

the operating cost is known as operating costing.The service or function, having public utilities, covers water supply service,

electricity supply service, transport service, hospital service, library service, canteenservice, park service, hostel service etc. Each service is unique and needs a differentaccounting treatment. An intelligent selection of unit cost is required to obtain ameaningful cost comparison. A correct choice of unit cost provides correct cost analysisfor decision making destined for effective cost control and reduction.

Types of Services

The diverse nature of services offered to the public poses a difficulty to make a sharpdivision of services. However, services are categorised into the following four majorcategories on the basis of their common features.

Transport services




Notes


Supply services

Welfare services

Municipal services

Nature and Characteristics of Operating Costing

The nature and characteristics of operating costing are as follows:

(i) Operating costing method is related to provide various types of services tocustomers,

(ii) Costs are generally computed period-wise and order-wise,

(iii) In operating costing, standing or fixed, maintenance and running charges arecalculated,

(iv) The services of a industry or organization may be sold to the public or may be usedwithin the organization, and

(v) The demand for the services of enterprises or organizations or industries adoptingoperating cost method for costing fluctuates.

Operating Cost Unit

Following are some examples of Operating cost unit:

Service Organisations Cost Unit

Goods transport

Passenger transport

Electricity

Hotel

Hospital and Nursing homes

Canteen

Cinema

Water supplyBoiler houses

Road maintenance

Per tonne km.

Per passenger km.

Per kilowatt hour (kwh)

Per room per day

Per bed per day

Per meal or per lunch or per dinner or perdish

Per sheet per show

Per 1000 gallon water

Kilograms of steam supplied

Per kilometre

Classification of Cost

Service costs are classified into the following three categories:

(i) Fixed or Standing Charges: These are expenses which are more or less fixednature. For example, in case transport service, road licence fee, garage rent,insurance premium, taxes, depreciation, interest on capital, salary to driver-conductors-cleaners, general supervision charges, establishment expenses, etc.are standing charges. In case of Nursing home and Hospital, the depreciations

pertaining to the cost of building, equipment, beds, insurance, etc. are fixedcharges. These expenses are constant and are incurred irrespective of the extent ofservice.

(ii) Maintenance or Semi-variable Charges: They are semi-variable or semi-fixed innature. They include expenditure on repairs and maintenance, spares andaccessories, tyres and tubes, painting charges, telephone charges, etc.

(iii) Running or Variable Charges: These are variable cost and variable nature.Running charges are expenses which are incurred on the actual running of thevehicle. For example in case of hospital, the cost of medicine, laundry, etc., willrepresent the running charges. In case of transport service petrol, diesel, grease,oil, salaries and wages to drivers, conductors and cleaners on the basis of distance,depreciation calculated on the basis of mileage or kilometres run are running or

variable charges.




Notes


The classification of various items of costs into the above three categories shouldnot be attempted as a matter of rule. It depends basically on the nature of each case.

9.7.1 Transport Service

The transport costing refers to the determination of the cost per unit of service i.e., cost

of per passenger – kilometre and the cost of per tonne – kilometre.

Suppose the following information is given:

Number of trucks 10 of 5 tons each

Number of km. run per day 50 km.

Effective days in a month 25

Wastage on loading capacity 10%

Percentage of trucks laid for maintenance 10%

Now, number of effective km. = 10 × 5 × 50 × 25 × 90/100 × 90/100 = 50,625 km.

If the total cost of running these 10 trucks in month comes to ` 4,00,000, the cost of

per ton per km. = 4,00,000 ÷ 50,625 = ` 7.90

Objectives of Transport Costing

The following are main objectives of transport costing:

(i) Collection and analysis of cost for cost control,

(ii) Comparison of the cost of running and semi-variable of different vehicles,

(iii) Assignment of costs to services provided by each vehicle or group of vehicle,

(iv) To decide whether to own a vehicle or to hire a vehicle,

(v) Cost comparisons and analysis for decision-making, and

(vi) To help to apportion the cost of transport between different departments.

Collection of Costs

Each vehicle is given a distinct number and all the basic documents will contain theassigned number of respective vehicles. A separate Daily Log Sheet for each vehicle ismaintained by the driver.

Daily Log Sheet

A daily log sheet or log book is maintained for each vehicle to record details of each trip.This sheet is completed by the driver and is handed over to the manager. The logbookalso contains records relating to repair expenses incurred during journeys performed. Aspecimen of daily log sheet is given below:

Daily Log Sheet

Vehicle No.: …………… Date : ……………………...

License No.: …………… Departure Time : ……………………...

Route: …………………. Arrival Time : ……………………...

Details of Trip

Station Goods/Packages TimeTrip No.

FromTo

Out Collected

on route

Km.

Out In

Remarks




Notes


Suppliers Time of Workers Analysis of Last Time

Petrol : ……..…… Driver : ………...…… Traffic delays : ………………

Oil : ……..…… Conductor : ………..……. Accidents : ………………

Grease : ……..…… Cleaner : ……………... Loading : ………………

Unloading : ………………

Figure 9.1: Daily Log Sheet

Statement of Operating Cost

The cost data of a transport are presented periodically, say monthly or quarterly, inthe form of a cost sheet or statement of cost. A specimen of statement of operating costis given below:

Kartik Transport Company LimitedOperating Cost Sheet for the month of ……………………………

Vehicle No.: …………………… Capacity: ……………………..

Particulars of ExpensesTotal

( )

Cost of per km.

( )

(A) Standing Charges or Fixed Costs:

Garage Rent

Insurance Premium

Interest on Capital

Depreciation

Rates and Taxes

Drivers Wages

License Fee

General Supervision

Total

(B) Maintenance Cost or Semi-variable Charges:Tyres and Tubes

Repairs

Servicing and Cleaning

Garage Staff Salary

Total

(C) Running or Operating Charges :

Petrol or Diesel

Engine Oil and Grease

Salary to Running Staff’

Depreciation

Insurance on Transit Goods

Total

(D) Total Operating Cost (A + B + C)

(E) Total Ton-Kilometre

(F) Operating Cost per ton-km.

Problem 7: From the following particulars, find out total passenger kilometre per dayand per month:

Distance: 25 kilometres

A vehicle makes 2 trips round daily carrying 45 passengers and working every day.




Notes


Solution:

Total km. per day = No. of vehicle × No. of days × Trips × 2 (Round) × Km. in a trip

Total km. per day = 1 × 1 × 2 × 2 × 25

Total km. per day = 100

Total passengers km. per day = 100 × 45

Total passengers km. per day = 4,500

Total passengers km. per month = 4,500 × 30 days

Total passengers km. per month = 1,35,000

Problem 8: The Kartik Transport Company which keeps a fleet of lorries, show thefollowing information:

Kilometres run for 2005 1,50,000

Wages for the month of March ` 10,000

Petrol, Oil expenses for March ` 20,000

Cost of vehicle ` 5,00,000

Depreciation @ 20% on cost of vehicle —

Repairs and maintenance for the month of March ` 30,000

Garage rent for the month of March ` 5,000

Licence, insurance for the year ` 30,000

Prepare a statement for March, 2005 showing the operating cost per running km.

Solution:

Operating Cost Sheet for Kartik Transport Company

Period: March, 2005 Kilometres Run: 1,50,000Particulars of Expenses Total ( )

(A) Standing or Fixed Charges :

Depreciation @ 20% p.a. (5,00,000 × 20 × 1) ÷ (100 × 12)

Wages for the month of March

Garage rent for the month of March

Licence (30,000 ÷ 12)

8,333

10,000

5,000

2,500

Total 25,833


Petrol, Oil expenses

Repairs and maintenance

20,000

30,000Total 50,000

(C) Total Opening Cost (A + B)

(D) Cost per running kilometre (75,833/1,50,000 = 0.505)

75,833

0.505

9.7.2 Power House Costing

The generation of electricity requires the use of fuel oil or steam. Where steam is usedfor the purpose of generating electricity, it is possible to compute the cost of electricitygenerated by aggregating the steam production costs with other related costs ofelectricity generation. Generation of power or electricity or gas is carried on and theseare made available to outsiders or to own production departments.

A statement of cost is prepared to find out the cost of per unit. This may be perKWT or KWH. The costs are normally classified into: Steam production cost and




Notes


Electricity generation costs or Fixed charges, Maintenance charges and Variablecharges. Following are two specimens of statement of cost for power house costing:

Statement of Operating Cost for Electricity generation for the month of ………………Steam Produced:………………………………………………………………………

Units of Electricity Generated:………….Steam Used for Generation:………………....

Particulars of Expenditure Total Cost ( )Cost per unit

( )

(A) Cost of Steam Generation :

Coal

Labour

Water

Fixed overhead


Supervision charges

Total Cost of steam generation/Total production

Less: Used in heating

Cost of Steam Used for Electricity GeneratorTotal

(B) Cost of Electricity Generation :

Cost of steam used

Wages

Depreciation

Stores

Supervision

Repairs and Maintenance

Total

(C) Total Operating Cost (A+B)

(D) Cost of per unit =

Total Operating Cost ÷ Total Units Generated

Operating Cost Sheet for Electricity GenerationUnits of Electricity Generated: …………

Particulars of Expenditure Total Cost ( ) Cost per unit ( )

(A) Fixed Charges :

Depreciation

Supervision

Administrative overhead

Interest on capital

Total

(B) Variable and Maintenance Charges :Cost of steam used

Cost of coal

Wages to operators

Lubricants, spares and stores


Total

(C) Total Operating Cost (A+B)

(D) Cost of per unit =

Total Operating Cost ÷ Total Units Generated




Notes


Problem 9: The following cost data pertaining to the year 2005-2006 are collected fromthe books of Prakash Power Company Limited. Prepare a operating cost sheet showingthe cost of generation of power per unit of Kwh.

Total units generated 15,00,000 units

Operating labour ` 16,500

Plant supervision ` 5,250

Lubricants & supplies ` 10,500

Repairs and maintenance ` 21,000

Administrative overheads ` 9,000

Capital cost ` 1,50,000

Coal consumed per kwh. For the year is 1.5 lbs. and cost of coal delivered to thepower station is ` 33.06 per metric tonne. Depreciation rate chargeable is 4% perannum and interest on capital is to be taken as at 7%.

Solution:

Statement of Operating Cost of Praksh Power Company Limited for the Year 2005-2006

Total Units Generated: 15,00,000

Particulars of Expenses Amount ( )

5,250

9,000

6,000

10,500

30,750

33,735(1)

10,500

21,000

16,500

81,735

(A) Fixed Charges :

Plant supervision

Administrative overheads

Depreciation (4% on ` 1,50,000)

Interest on capital (7% on ` 1,50,000)

Total


Coal usedLubricants & supplies


Operating labour

Total

(C) Total Cost of Generation (A +B)

(D) Cost of Generation of per unit of kwh.(1,12,485 ÷ 15,00,000) 1,12,485

0.075 paise

Working note:

(1) Cost of one tonne (2,205 lbs) = ` 33.06

For 1 kwh the coal consumption is 1.5 lbs for 15,00,000 kwh the coal consumption

is = 1.5 × 15,00,000 = 22,50,000 lbsCost of 22,50,000 kwh = ` 33.06 × 22,50,000 ÷ 2,205

= ` 33,735

9.7.3 Hotel Costing

Hotel services include boarding and lodging. For providing rooms and accommodations,hotels have to calculate cost per room-per day.

Objectives of Hotel Costing

The main objectives of hotel costing are:

(i) Ascertainment of cost per unit,

(ii) Inter-firm comparisons,




Notes


(iii) Analysis of cost of hotel for decision-making,

(iv) Collection of cost data and its analysis for cost control, and

(v) It is advisable to select different cost units.

Specimen for Hotel Costing

A Specimen of Operating Cost of Hotel is given below:

Operating Cost Sheet of Vikas Hotel for the Year……………


(A) Fixed Charges :

Staff salaries

Wages for attendants

Repairs

Depreciation

Interest on investment

Interior decoration

Rent of premises Administrative expenses

Linen

Total


Lighting and heating

Power

Sundries

Total

(C) Total Operating Cost (A +B)

(D) Total Room Days

(E) Rent per room day = Total Operating Cost ÷Total Room Days

Problem 10: Following are the information given by an owner of a Udai Hotel. You arerequired to advise him what rent should be charged from the customers per day, so thathe is able to earn 25% on cost other than interest:

(i) Managerial staff salaries ` 1,80,000 p.a.

(ii) Repairs to building ` 10,000.p.a.

(iii) Cost of building ` 4,00,000

(iv) Rate of depreciation 5% p.a.

(v) Room attendant’s salary ` 2 per day. The salary is paid on daily basis and servicesof room attendants are needed only when the room is occupied. There is one roomfor one attendant.

(vi) Lighting, heating and power charges: The normal lighting expenses for a room if it isoccupied for the whole month is ` 50 per room. Power is used in winter only andnormal charges are ` 20 p.m. for a room, if room is occupied.

(vii) Equipments ` 1,00,000

(viii) Rate of depreciation 10%

(ix) Internal decoration ` 20,000 p.a.

(x) Interest @ 5% may be charged on its investment of ` 5,00,000 in the building andequipment.

(xi) Linen ` 14,800 p.a.

(xii) Sundries ` 16,600 p.a.

(xiii) There are 100 rooms in the hotel and 80% of the rooms are normally occupied insummer and 30% of the rooms are occupied in winter. You may assume that period




Notes


of summer and winter is six months each. Normal days in a month may be assumedto be 30.

Solution:

Operating Cost Sheet of Udai Hotel

Particulars of Expenses Amount in

( )

1,80,000

14,800

20,000

10,000

39,600

36,600

20,000

14,800

16,600

25,000

3,72,600

Managerial staff salaries

Repairs to building

Depreciation on building @ 5%

Depreciation on equipment @ 10%

Room attendant’s salaries :

Summer: ` 2 × 100 rooms × 80% × 30 days × 6 months = 28,800

Winter: ` 2 × 100 rooms × 30% × 30 days × 6 months = 10,800

Lighting, heating and power charges:

Summer: ` 50 × 6 months × 100 rooms × 80% = 24,000

Winter: `

50 × 6 months × 100 rooms ×30% = 9,00033,000

Power: ` 20 × 6 months × 100 rooms × 30% = 3,600

Internal decoration

Linen

Sundries

Interest on investment @ 5% on ` 5,00,000

Total Operating Cost

Add: Profit 25% on Cost other than interest

(25% on ` 3,47,600 (3,72,600 – 25,000) = ` 86,90086,900

Total Rooms Rent for the year 4,59,500Total Room Days 19,800

(1)

Rent per room per day = Total Room Rent ÷ Total Room Days 23.00(2)

Working notes:

(1) Calculation of Total Room Days:

Summer: 100 rooms × 6 months × 30 days × 80% = 14,400

Winter: 100 rooms × 6 months × 30 days × 30% = 5,400

Total Room Days = 19,800

(2) Rent per room per day = 4,59,500 ÷ 19,800 = 23.21 or ` 23 (Approx.)

9.7.4 Hospital Costing

Costing of hospital may relate to ascertaining the cost of medical services rendering bya Nursing home or dispensary belonging to an industry or organisation.

Objectives of Hospital Costing

The main objectives of hospital costing are:

(i) To calculate cost of per patient per day,

(ii) Inter comparison between two or more hospitals or nursing homes,

(iii) Analysis of cost of hospital or nursing home for decision-making, and

(iv) Collection of cost data for cost control.




Notes


Problem 11: Gwalior Hospital runs an intensive medical care unit. For this purpose, ithas hired a building at a rent of ` 30,000 p.m. with the understanding that it would bearthe repairs and maintenance charges also.

The unit consists of 25 beds and 5 more beds can be comfortably accommodatedwhen the occasion demands. The permanent staff attached to the intensive medical

care unit is as follows:

Doctor’s fee ` 6,000 p.m.

Salary to 4 Supervisors ` 800 p.m. each

Salary to 6 Nurses ` 500 p.m. each

Salary to 4 Ward boys ` 300 p.m.

The unit is open for patients all the 365 days, scrutiny of accounts reveals that onlyfor 120 days in the year, the unit has the full capacity of 25 patients per day and foranother 80 days, it has on an average 20 beds only occupied per day in the year. But,there are occasions when the beds are full in the year. Extra beds are hired at a chargeof ` 4 per day-per bed and this does not come to more than 5 beds extra above thenormal capacity on any day. The total hire charge for the extra beds incurred for thewhole year amounts to ` 5,000. The other expenses for the year are as follows:

Repairs ` 16,000

Medicines ` 50,000

Food to patients ` 65,000

Expenses on Oxygen, X-ray ` 65,000

Expense of generator ` 24,000

Laundry charges ` 41,600

Administration expenses ` 50,000

If the unit recovers an overall amount of ` 200 per day on an average from eachpatient, what is the profit per patient day made by the unit?

Solution:

Statement of Cost and Profit for Gwalior Hospital


(A) Earnings :

Income received (5,850 × 200) 11,70,000

Total 11,70,000

(B) Fixed Charges :

Staff salaries : (4 × 800) + (6 × 500) + (4 × 300) × 12 88,800Rent ( 30,000 × 12) 3,60,000

Repairs 16,000

Administration expenses 50,000

Cost of Oxygen , X-ray 65,000

Total 5,79,800

(C) Variable Costs:

Food to patients 65,000

Expenses of generator 24,000

Laundry charge 41,600

Medicines 50,000




Notes


Doctor’s Fee (6,000 × 12) 72,000

Hire Charges for Extra Beds 5,000

Total 2,57,600

(D) Total Cost of Hospital ( B+C) 8,37,400

(E) Profit ( A - D) i.e. 11,70,000–8,37,4000 3,32,600

(F) Profit per patient day =3,32,600

5,850 = 56.854 or ` 59 (approx.)

59.00

Working note:

(1) Calculation of Total Patient Days:

25 Beds × 120 days = 3,000

20 Beds × 80 days = 1,600

Extra bed days = ` 5,000 ÷ 4 = 1,250

Total Patient Days 5,850

9.8 Summary

Process costing represents a type of cost procedure for continuous productionindustries. In such industries, output consists of like units, each unit being processed inthe same manner. According to CIMA, “The costing method applicable where productsor services result from a sequence of continuous operations or processes. Costs arearranged over the units produced during the period”.

The basic principles of process costing are that the cost of material, wages andoverheads expenses are collected for each process or operation in a period, adequaterecords in respect of output and scrap of each processes or operation during the periodare kept, the cost per unit of each process is obtained by dividing the total cost incurredduring a period by the number of units produced during that period after taking into

consideration the losses and amount realized from sale of scrap and the finishedproduct of one process is transferred as a raw material to the next process.

If the products are produced by different processes, cost of previous process istransferred to the next process, so that total and unit cost of products are accumulated.In short, cost of products will comprise all costs incurred in all the processes uptofinished stage. There is no departure from the principles regarding direct and indirectexpenditures.

Normal loss is the amount of loss which is unavoidable because of the nature ofraw materials or the production technique and is inherent in the normal course ofproduction e.g., loss of weight because of evaporation or melting etc. Such wastagemay also take place while stamping product components out of a big metal sheet. Anywastage exceeding the normal percentage is termed abnormal loss or wastage. Suchloss or wastage is not a part of production. It is credited out of the concerned processaccount as a loss to the costing profit and loss account.

Costing for joint products implies the assignment of a portion of the joint cost toeach of the joint product. Unless the joint costs are properly and reasonablyapportioned to different joint products produced, the cost of joint products will varyconsiderably and this will affect valuation of inventory, pricing of products and profit orloss on sale of different products. By-products are relatively considered less important.For example, molasses obtained from production of sugar or ash available when boilersare run would be by-products.

Service costing is a special method of cost computation which is suitable for theindustries which render services as distinct from these which manufacture goods. The

cost of operating a service is known as operating cost and the method of ascertainingthe operating cost is known as operating costing.




Notes


7. Materials issued for a particular process are …………..direct to it.

(a) Debited

(b) Credited

(c) Transferred

(d) Processed8. Hotel services include boarding and…………..

(a) Parking

(b) Canteen

(c) Lodging

(d) Recreation

9. The value of the abnormal effectives is ……………..to the abnormal effectivesaccount.

(a) Posted

(b) Debited

(c) Credited

(d) Transferred

10. Cost of per passenger – kilometer is computed under:

(a) Transport costing

(b) Hotel costing

(c) Hospital costing

(d) Power House costing


1. Define Process Costing and explain its working procedure.

2. Distinguish between Process Costing and Job Costing.

3. Write short notes on abnormal gain or abnormal effective in process costing.

4. How would you account for wastage in the cost of production? Define normalwastage and abnormal effective and distinguish between them.

5. What is the By-product? How should it be treated in the ascertainment of the cost ofmain product?

6. Define joint products, by-products and give example of each.

7. A product passes though Process A, Process B and Process C. From the undermentioned figures, prepare process accounts concerned indicating the cost of eachprocess and the cost per article produced. The production was 480 units per month.

Process A ( ` ) Process B ( ` ) Process C ( ` )

Direct materials 30,000 10,000 4,000

Direct labour 16,000 40,000 12,000

Expenses 5,200 14,400 5,000

Indirect expenses amounted to ` 17,000, which should be apportioned on the basisof direct labour. Ignore stocks in hand and work-in-progress at beginning and end ofthe month.

8. A product is obtained after passing it through three processes. The followinginformation is collected for August, 2005:

Process A Process B Process C

Materials ` 5,200 ` 3,960 ` 5,924Wages ` 4,000 ` 6,000 ` 8,000




Notes


Output in units during the month 950 840 750

Normal loss 5% 10% 15%

Value of scrap per unit ` 4 ` 8 ` 10

Additional information are given below:

1,000 units @ ` 6 each were introduced in Process A. There was no stock ofmaterials or WIP at the beginning or at the end of that month. The productionoverhead was ` 18,000 for that month.

Prepare the necessary process accounts indicating normal loss, abnormal loss andabnormal gain.

9. What do you understand by service costing? Discuss the objectives of servicecosting.

10. What are the objectives of Transport Costing? Explain.

9.11 Key Terms

Process costing: It refers to costing of operation(s) or process(es) involved in

converting raw materials into finished goods or products. Its main objective is toprovide an average cost of product.

Normal Loss/ Wastage: This is the amount of loss which is unavoidable becauseof the nature of raw materials or the production technique and is inherent in thenormal course of production.

Abnormal gain: If the quantum of wastage is less than the predeterminedpercentage of normal wastage, the difference is called as abnormal gain oreffectives.

Joint products: Joint products represent two or more products separated in thecourse of the same processing operations, usually requiring further processing, andeach product being in such proportion that no single product can be designated asa major product.

By-products: By-products have been defined as “any saleable or usual valueincidentally produced in addition to the main product”.

Operating Costing: The cost of operating a service is known as operating cost andthe method of ascertaining the operating cost is known as operating costing.


1. (b) Process

2. (d) The equivalent units of production for materials and conversion cost are thesame.

3. (c) Joint products are two or more products arising from a process, one of whichhas a significant sales value

4. (c) A by-product is a product arising from a process where the sales value isinsignificant by comparison with that of the main product or products

5. (a) The product is composed of mass-produced homogeneous units.

6. (b) Finished stock

7. (a) Debited

8. (c) Lodging

9. (c) Credited

10. (a) Transport costing




Notes





J K Mitra, Advanced Cost Accounting, New Age International, 2009 Jawahar Lal, Seema Srivastava, Cost Accounting, McGraw-Hill Education, 2013




Reconciliation of Cost and Financial Accounts 187

Notes


Unit 10: Reconciliation of Cost and FinancialAccounts

Structure

10.1 Introduction

10.2 Need for Reconciliation

10.3 Reasons for Differences In Profit

10.4 Method or Procedure of Reconciliation

10.5 Summary



10.8 Key Terms


Objectives


Understand the need for reconciliation.

State the reasons for differences in profits.

Describe the method or procedure of reconciliation.

Make reconciliation between two profits.

10.1 Introduction

When cost accounts and financial accounts are separately maintained in two differentsets of books, two profit and loss accounts will be prepared—one for costing books andsecond for financial books. The profit or losses shown by the cost accounts may notagree with the profit or loss shown by financial accounts or books. Therefore, itbecomes necessary that profit or loss shown by the two sets of accounts is reconciled.

According to Wheldon, “No system is complete unless it is linked up with thefinancial accounting, that results shown by both cost and financial accounting may bereconciled.” In the words of Eric L. Kohler, “Reconciliation is the determination of theitems necessary to bring the balances of two or more related accounts or statements,into agreement.”

It is important to note that the question of reconciliation of cost and financialaccounts arises only under non-integral system. However, under the integral accounts,since cost accounts and financial accounts are integrated into one set of books and onlyone profit and loss account is prepared, the problem of reconciliation does not arise.

In this unit, we shall study the need for reconciliation and reasons for difference inprofits. At the end of the unit we will study the problems on preparation of reconciliationstatements including memorandum reconciliation account.

10.2 Need for Reconciliation

The need for reconciliation arises due to the following reasons:

(i) To find out the reasons for the difference in the profit or loss in cost and financialaccounts,




Notes


(ii) To ensure the mathematical accuracy and reliability of cost accounts in order tohave cost ascertainment, cost control and to have a check on the financialaccounts,

(iii) Reconciliation helps in formulation of various policies regarding overheads,depreciation and valuation of stock, and

(iv) It promotes co-ordination and co-operation between departments of cost accountsand financial accounts.

10.3 Reasons for Differences In Profit

Difference in profit or loss between cost and financial accounts may arise due to thefollowing reasons:

Figure 10.1: Reasons for Differences in Profit

1. Items of Incomes Shown Only in Financial Accounts: There are a number ofitems which are included in financial accounts but find no place in cost accounts.While reconciling any items under this category must be considered. Such items areclassified into three categories as under:

(i) Purely Financial Charges: Under this category, the following charges orexamples are considered:

(a) Loss on investments

(b) Discount on debentures and bonds

(c) Loss on the sale of capital assets

(d) Expenses of the company’s share transfer office

(e) Interest on bank loan and mortgages

(f) Capital expenditure

(g) Commission to partners and managing agents

(h) Damages payable at low

(i) Fines and penalties

(j) Goodwill written off, preliminary expenses

(k) Loss due to theft, fire, accident etc.

(l) Debit balance of profit and loss account written off

(m) Excess provision for depreciation

(n) Commission on issue of shares and debentures

(o) Cash discount allowed.

(ii) Purely Financial Incomes: Under this category, the following items of incomeare included:

(a) Rent receivable

(b) Transfer fees received




Notes


(c) Dividend and interest received on investments

(d) Profits on the sale of fixed assets

(e) Interest received on bank deposits

(f) Income tax refund

(g) Commission received(h) Cash discount received

(i) Brokerage received

(j) Damages received.

(iii) Appropriations of Profit: Under this category, the following items areincluded:

(a) Donations and charities

(b) Income tax

(c) Dividend paid

(d) Transfers to reserves and sinking funds

(e) Any other items which appear in profit and loss appropriation account.

2. Items Shown Only in Cost Accounts: There are certain items which are includedin cost accounts but not in financial accounts. Following are the examples of suchitems:

(a) Nation depreciation on assets fully depreciated in the books

(b) National rent of the owned building and no rent is payable

(c) Interest on capital employed but not actually paid

(d) National salaries

3. Over or Under-absorption of Overheads: Overheads absorbed in cost accountson the basis of estimation like percentage on direct materials, percentage on direct

wages, etc. may be more or less than the actual amount incurred. If overheads arenot fully absorbed, i.e. the amount in cost accounts is less than the actual amount,the shortfall is called under-absorption. On the other hand, if overhead expenses incost accounts are more than the actual, it is called over-absorption. Thus, under orover-absorption of overheads leads to difference in two accounts. Sometimes,selling and distribution expenses are ignored in cost accounts and as such costingprofit will be higher and thus requires reconciliation.

4. Different Bases of Stock Valuation: In cost accounting, stock are valuedaccording to the method adopted in stores accounts i.e., FIFO, LIFO, etc. On theother hand, valuation of stock in financial accounts is invariably based on the costor market price, whichever is less. Different stock values result in some difference inprofit or loss shown by the two sets of account books.

5. Different Bases for Depreciation: In cost accounts, the assets may bedepreciated on the straight line method, whereas in financial accounts, a differentmethod of depreciation such as reducing balance method or sinking policy methodor a different method is followed. The difference in the method of depreciationfollowed in these systems of accounts results in a difference of profit.

6. Abnormal Loss and Gain: Abnormal losses and abnormal gains are completelykept separate from cost accounts or they are transferred to costing profit and lossaccount. If they are not included in cost accounts then the profit shown by these twosets of book will vary and adjustment for which has to be done. If these losses aretransferred to costing profit and loss account then the profit will tally with the profitas shown by financial accounts. These losses are like—theft, loss by fire, idle timeloss etc.

7. Different Bases for Valuing Work-in-progress: Work-in-progress is valued eitherat the stage of prime cost, works cost or cost of production. In cost accounts, the




Notes


basis followed may be quite different than that followed in financial accounts. Thisdifference in the method of valuing work-in-progress gives rise to preparation ofreconciliation statement.

10.4 Method or Procedure of Reconciliation

The cost and financial accounts are reconciled by preparing a Reconciliation Statementor a Memorandum Reconciliation Account.

Reconciliation Statement

Reconciliation statement is a popular and important method of cost accounts andfinancial accounts.

The following method or procedure is recommended for preparing a ReconciliationStatement:

(i) Ascertain the reasons/points of difference between cost accounts and financialaccounts.

(ii) Start with the profit as shown by the cost accounts.

(iii) (a) Regarding items of expenses and losses:

Add: Items over-charged in cost accounts.

Less: Items under-charged in cost accounts.

For example, depreciation in cost accounts is ` 3,000 and that in financialaccounts is ` 3,400. This has the effect of increasing costing profit by ` 400 ascompared to financial profit. Then in order to reconcile, ` 400 will be deductedfrom costing profit.

(b) Regarding items of income:

Add: Items under-recorded in cost accounts.

Less: Items over-recorded in cost accounts.

For example, interest on investments received amounting to ` 3,000 is notrecorded in cost accounts. This will have the effect of reducing profit by ` 3,000.Then in order to reconcile, this amount of ` 3,000 for interest should be addedin the costing profit.

(c) Regarding stock valuation:

Opening stock

Add: Over-valuation in cost accounts.

Less: Under-valuation in cost accounts.

Closing stock

Add: Under-valuation in cost accounts.

Less: Over-valuation in cost accounts.

(iv) The above treatment of items will be reversed when the starting point in thereconciliation statement is the profit as per financial accounts or loss as per costaccounts.

(v) After making all the above additions and deductions in costing profit, the resultingfigure shall be the profit as per financial books.

(vi) At some places, ‘Memorandum Reconciliation Account’ is prepared in place of‘Reconciliation Statement.’

(vii) The following formula for easy reconciliation (with cost profit):

For Expenses items: Add the excess, deduct the shortage.

For Income items: Add the shortage, deduct the excess.




Notes


Following is the proforma of a reconciliation statement:

Proforma of Reconciliation StatementFor the year ending ...........

Particulars Amount

(

) (+)

Amount

(

) (

)

Profit as per Cost Accounts ...

Add : (i) Expenses over-charged in cost account ...

(ii) Income not included in cost account ...

(iii) Over-valuation of opening stock in cost account ...

(iv) Under-valuation of closing stock in cost account ...

(v) Expenses recorded in cost account but not chargedin financial account

...

(vi) Income recorded in financial books but not recordedin cost books

...

(vii) Items credited in financial books but not recorded incost books

...

(viii) Depreciation over-charged in cost account ... ...

...

Less : (i) Expenses under-charged in cost account

(ii) Expenses not charged in cost account ...

(iii) Under-valuation of opening stock in cost account ...

(iv) Over-valuation of closing stock in cost account ...

(v) Expenses not recorded in cost books but recordedin financial books

...

(vi) Items debited in financial books but not recorded incost books

... ...

Profit as per Financial Accounts ...

Memorandum Reconciliation Account

This account is presented in debit and credit form but it is not a part of double entrysystem of book-keeping. So it is kept as a memorandum account only.

The procedure of its preparation is similar to that of reconciliation statement, theonly difference is that items shown under “+” column are shown on the credit side anditems shown under “–” column are shown on the debit side of the memorandumreconciliation account.

Following is the proforma of memorandum reconciliation account:

Memorandum Reconciliation AccountAs on ..........................

Particulars (

) Particulars (

)

To Expenses not recorded incost accounts

... By Profits as per costaccounts

...

To Overheads under-absorbed incost accounts

... By Incomes not recorded incost accounts

...

To Under-valuation of openingstock in cost accounts

... By Expenses not recorded inprofit and loss account

...

To Over-valuation of closingstock in cost accounts

... By Overheads over-absorbedin cost accounts

...




Notes


To Profits as per profit and lossaccounts

... By Over-valuation of openingstock in cost accounts

...

By Under-valuation of closingstock in cost accounts

...

... ...

Problem 1: The cost books of a company show a profit of ` 50,000 while the net profitas per financial books is ` 29,500. On the basis of the following information, prepare astatement remitting the two profits for the year ended 31st March, 2007.

Particulars Cost Books (

) Financial Books (

)

Factory expenses 20,000 22,000

Office expenses 12,000 10,000

Selling and distribution expenses 8,000 7,000

Dividend received -- 5,000

Loss on sale of furniture -- 1,500

Income-tax -- 10,000

Goodwill written-off -- 5,000

Interest on capital -- 10,000

Solution:

Reconciliation Statement for the year ending 31st March, 2007

Particulars Amount

(

)

Profit as per cost account 50,000

Add : Office expenses over-charged in cost books 2,000

Selling and distribution expenses over-charged in cost books 1,000

Dividend received not recorded in cost books 5,000 8,000

58,000

Less : Factory expenses under-charged in cost accounts 2,000

Loss on sale of furniture not recorded in cost accounts 1,500

Income tax not charged in cost books 10,000

Goodwill written-off not charged in cost books 5,000

Interest on capital not charged in cost accounts 10,000 28,500

Profit as per Financial Accounts 29,500

Problem 2: Following is the trading and profit and loss account of Jain Traders for theyear ended 31st March, 2009:


To Material consumed 12,000 By Sale (350 units) 70,000

To Wages 4,000 By Finished stock (50 units) 3,500

To Factory expenses 12,000 By Interest received 1,500

To Administrative expenses 12,000

To Goodwill written-off 4,000

To Discount of debentures written-off 3,000

To Net profit 28,000

75,000 75,000




Notes


The company’s cost records show that:

(a) Factory overheads have been recovered at 100% on prime cost.

(b) Administrative overheads have been recovered at 25% of factory cost.

Prepare:

(a) A statement of cost indicating net profit, and(b) A statement reconciling the profit as disclosed by cost accounts and that shown

in financial accounts.

Solution:

Statement of Cost and Profit


)

Material consumed 12,000

Wages 4,000

Prime Cost 16,000

Factory overheads (100% of prime cost) 16,000Factory Cost 32,000

Administrative overheads (25% of factory cost) 8,000

Cost of Production 40,000

Less : Closing finished stock (40,000 x 50) ÷ 400(1)

5,000(2)

Cost of Goods Sold 35,000

Profit (70,000 – 35,000) 35,000

Sales 70,000


For the year ending 31st March, 2009

Particulars Amount ( ) Amount

( )

Profit as per cost accounts 35,000 --

Add : Over-absorption of factory overheads in cost accounts 4,000 --

Interest received excluded from cost accounts 1,500 --

Less : Administration overheads under-recovered in cost accounts -- 4,000

Goodwill written off excluded from cost accounts -- 4,000

Discount on debentures excluded from cost accounts -- 3,000

Finished stock over-valued in cost accounts -- 1,500

40,500 12,500

Profit as per Financial Accounts -- 28,000(3)

40,500 40,500

Working notes:

(1) Number of units produced = Number of units sold + Units of closing stock

= 350 + 50 = 400 units

(2) In cost accounts, closing stock is valued at cost of production, i.e. value ofclosing stock:

=Cost of production

× Units in closing stockNumber of units produced

= 40,000 5050

× = ` 5,000




Notes


(3) Profit as per financial accounts = 40,500 – 12,500 = 28,000

Problem 3: The net profit of ABC Manufacturing Company for the year ended 31stMarch, 2007 was ` 5,15,020 as shown by financial books. The cost accounts discloseda profit of ` 6,89,600 for the same period. The following details are discovered:

Loss due to depreciation in stock value

charged in financial accounts only ` 27,000

Bank interest and dividend received ` 4,900

Works overhead under recovered in cost account ` 12,480

Depreciation charged in financial accounts ` 44,800

Depreciation recovered in cost accounts ` 50,000

Interest on investments ` 32,000

Obsolescence loss charged in financial accounts ` 22,800

Administrative overheadrecovered in excess in cost accounts ` 6,800

Income tax paid ` 1,61,200

Prepare a statement reconciling the profits shown in both the books.

Solution:

Reconciliation StatementFor the year ending 31st March, 2007


Net profit as per cost accounts 6,89,600

Add : Interest on investments 32,000

Bank interest and dividend received 4,900

Depreciation over recovered in cost accounts ( ` 50,000 – 44,800)

5,200

Administrative overhead over recovered 6,800 48,900

7,38,500

Less : Loss due to depreciation in stock value provided infinancial accounts only

27,000

Works overhead under recovered 12,480

Obsolescence loss charged in financial accounts 22,800

Income tax provided in financial books 1,61,200 2,23,480

Net Profit as per Financial Accounts 5,15,020

Problem 4: The net profit of Kartik Company Limited appeared at ` 60,652 as perfinancial records for the year ending 31st March, 2008. The cost books, however,showed a net profit of ` 86,200 for the same period. A scrutiny of the figures from boththe sets of accounts revealed the following facts:

Works overhead under-recovered in costs ` 1,560

Administrative overheads over-recovered in costs ` 850

Depreciation charged in financial accounts ` 5,600

Depreciation recovered in costs ` 6,250

Interest on investments not included in costs ` 4,000

Loss due to obsolescence charged in financial accounts ` 2,850

Income-tax provided in financial accounts `

20,150Bank interest and transfer fee in financial books ` 375




Notes


Stores adjustment (credit in financial books) ` 237

Value of opening stock in: Cost accounts ` 24,800

Financial accounts ` 26,300

Value of closing stock in: Cost accounts ` 25,000

Financial accounts ` 23,000

Interest charged in cost accounts ` 2,000

Goodwill written off ` 5,000

Loss on the sale of furniture ` 600

Prepare a statement showing the reconciliation between the figure of net profit asper cost accounts and the figure of net profit as shown in the financial books.

Solution:

Reconciliation StatementFor the year ending 31st March, 2008

Particulars Amount( )

Amount( )

Profit as per cost accounts 86,200

Add : Administration overheads over recovered in costaccounts

850

Depreciation overcharged in cost books :

Cost books 6,250

Financial books 5,600 650

Receipts and gains credited in financial books but notshown in cost books :

Interest on investments 4,000

Bank interest and transfer fee 375Stores adjustments 237

Interest charged in cost accounts 2,000 8,112

94,312

Less : Works overhead under-recovered in cost books 1,560

Expenses and losses debited in financial books but excludedfrom cash books :

Income tax 20,150

Loss due to obsolescence 2,850

Goodwill written-off 5,000

Under-valuation of opening stock in cost accounts 1,500

Over-valuation of closing stock in cost accounts 2,000

Loss on the sale of furniture 600 33,660


Problem 5: From the following particulars, prepare:

(a) A statement of cost of manufacture for the year, 2013,

(b) A statement of profit as per cost accounts, and

(c) Profit and loss account in the financial books and show how you would attribute thedifference in the profit as shown by (b) and (c).

Opening stock of raw materials ` 30,000

Opening stock of finished goods ` 60,000Purchases of raw materials ` 1,80,000




Notes


Stock of raw materials at the end ` 45,000

Stock of finished goods at the end ` 15,000

Direct wages ` 75,000

Calculate the factory expenses at 25% on prime cost, and office expenses at 75%

on factory expenses.

Actual factory expenses amounted to ` 58,125 and actual office expensesamounted at ` 45,750. The selling price was fixed at a profit of 25% on cost.

Solution:

(a) Statement of Cost of Manufacture for the year 2013


Opening stock of raw materials 30,000

Add : Purchases of raw materials 1,80,000

2,10,000

Less : Closing stock of raw materials 45,000Cost of raw materials consumed 1,65,000

Direct wages 75,000

Prime Cost 2,40,000

Factory expenses (25% on prime cost) 60,000

Works or Factory Cost 3,00,000

Office expenses (75% on factory expenses) 45,000

Total Cost of Production 3,45,000

(b) Statement of Profit


Total cost of production 3,45,000

Add : Opening stock of finished goods 60,000

4,05,000

Less : Closing stock of finished goods 15,000

Cost of Goods Sold 3,90,000

Profit (25% on cost) 97,500

Sales 4,87,500

(c) Profit and Loss Account


To Opening stock of finished

goods

60,000 By Sales 4,87,500

To Raw materials consumed 1,65,000 By Closing stock offinished goods

15,000

To Direct wages 75,000

To Factory expenses 58,125

To Office expenses 45,750

To Net profit 98,625

5,02,500 5,02,500




Notes




Profit as per cost accounts 97,500

Add : Factory expenses overcharged in cost account ( ` 60,000 – 58,125) 1,875

99,375

Less : Office expenses under charged in cost account ( ` 45,750 – ` 45,000) 750


10.5 Summary

When cost accounts and financial accounts are separately maintained in two differentsets of books, two profit and loss accounts will be prepared—one for costing books andsecond for financial books. The profit or losses shown by the cost accounts may notagree with the profit or loss shown by financial accounts or books. Therefore, itbecomes necessary that profit or loss shown by the two sets of accounts is reconciled.

According to Wheldon, “No system is complete unless it is linked up with thefinancial accounting, that results shown by both cost and financial accounting may bereconciled.” The need for reconciliation arises due to find out the reasons for thedifference in the profit or loss in cost and financial accounts.

There are a number of items which are included in financial accounts but find noplace in cost accounts. While reconciling any items under this category must beconsidered. Overheads absorbed in cost accounts on the basis of estimation likepercentage on direct materials, percentage on direct wages, etc. may be more or lessthan the actual amount incurred. If overheads are not fully absorbed, i.e. the amount incost accounts is less than the actual amount, the shortfall is called under-absorption.

Abnormal losses and abnormal gains are completely kept separate from costaccounts or they are transferred to costing profit and loss account. Work-in-progress is

valued either at the stage of prime cost, works cost or cost of production. In costaccounts, the basis followed may be quite different than that followed in financialaccounts. This difference in the method of valuing work-in-progress gives rise topreparation of reconciliation statement.

The procedure of memorandum reconciliation account preparation is similar to thatof reconciliation statement, the only difference is that items shown under “+” column areshown on the credit side and items shown under “–” column are shown on the debit sideof the memorandum reconciliation account.



1. Which subsidiary ledger is maintained in cost accounts:

(a) Work-in-progress ledger

(b) Sundry debtor’s ledger

(c) Sundry creditor’s ledger

(d) None of these

2. The need for reconciling financial and cost accounts arise:

(a) To comply with statutory obligations

(b) To facilitate audit work

(c) To fix standards

(d) To ensure the reliability of cost accounts




Notes


3. Which of the following cost control account is not maintained in cost ledger?

(a) Profit control A/c

(b) Factory overhead control A/c

(c) Stores ledger control A/c

(d) Cost of sales A/c4. The reconciliation can be done by preparing

(a) Profit and loss A/c

(b) Trial balance

(c) Memorandum reconciliation statement

(d) Balance sheet

5. Which one is not the reason for difference between two sets of accounts books(cost and financial)?

(a) Items of purely financial manure

(b) Capital expenditure

(c) Items appearing only in cost accounts

(d) None of these

6. National charges in cost accounts:

(a) Increase financial accounts profit

(b) Decrease financial accounts profit

(c) Decrease costing profit

(d) Increase costing profit

7. The reconciliation statement may be presented in the following ways:

(a) Memorandum reconciliation account

(b) Adjustment method reconciliation statement(c) Contribution approach

(d) Both a and b

8. The reasons for the difference may be grouped under

(a) Purely labour items

(b) Purely material items

(c) Purely financial items

(d) Purely economic items

9. The procedure of memorandum reconciliation account preparation is similar to thatof:

(a) Reconciliation statement

(b) Profit and Loss Account

(c) Trading Account

(d) Ledger Account

10. With cost profit, for Expenses items the easy formula for reconciliation is:

(a) Deduct the excess, deduct the shortage

(b) Add the excess, deduct the shortage

(c) Add the shortage, deduct the excess

(d) Deduct the excess, add the shortage




Notes



1. What is the concept of reconciliation statement? What is the need for reconciliationstatement?

2. Explain ‘reasons for difference’ between cash profit and financial profit.

3. Discuss the causes of difference between costing profits and financial profits.4. What value do you attach to the reconciliation of cost accounts and financial

accounts? Explain the main reasons for the difference in the net profits shown bythe two sets of accounts.

5. Explain the reconciliation procedure. Under what circumstances, a reconciliationstatement can be avoided?

6. Enumerate the items which are generally excluded from cost accounts.

7. What is memorandum reconciliation account?

8. Calculate the amount of profit as per profit and loss account on the basis of thefollowing information:

Profit as per cost account ` 16,000.

Factory overheads were under-recorded in cost account by ` 320.

Depreciation charges were over recovered in cost account by ` 200.

Administrative exp. was under recorded in financial accounts by ` 400.

Provision for income-tax made in financial books is ` 9,600.

Goodwill written-off ` 250 was not recorded in financial book.

Interest received on investment during the year ` 300.

Transfer fee amounting to ` 100 were received during the year in connection withregistration of transfer of shares.

9. Net profits of Kartik Industries for the year ended 31st March, 2009 as per costaccounts was ` 1,60,000. However, financial records showed a different net profit.

Scrutiny of the books of accounts revealed the following information:Depreciation charged in financial a/c ` 18,650

Depreciation charged in cost a/c ` 21,250

Interest on investments ` 10,000

Income tax provided ` 48,000

Works overhead under-recovered in cost a/c ` 3,540

Share transfer fees received ` 6,750

Loss due to obsolescence ` 6,800

Bank interest and transfer fees in financial a/c onlyas expenditure ` 1,250

Prepare a reconciliation statement and show the amount of net profit as perfinancial accounts.

10. The net profit of the Mahesh Engineering Company Limited appeared at ` 15,194as per financial records for the year ended 31st March, 2008. The cost book,however, showed a profit of ` 15,080 for the same period. The difference was dueto the following reasons:

Valuation of work-in-progress (financial books) ` 1,920

Valuation of work-in-progress (cost books) ` 2,000

Closing stock of finished goods (financial books) ` 2,900

Closing stock of finished goods (cost books) ` 2,820

Stores adjustment (credit - financial books) `

114Prepare a reconciliation statement.




Notes

10.8 Key Terms

Reconciliation: Reconciliation is the determination of the items necessary to bringthe balances of two or more related accounts or statements, into agreement.

Reconciliation of cost and financial accounts: Reconciliation of cost andfinancial accounts mean tallying the profit or loss revealed by both set of accounts.

Memorandum Reconciliation Account: This account is presented in debit andcredit form but it is not a part of double entry system of book-keeping.

Under absorbed overheads: If overhead is under absorbed, this means that moreactual overhead costs were incurred than expected, with the difference beingcharged to expense as incurred.

Over absorbed overheads: If overhead is over absorbed, this means that feweractual overhead costs were incurred than expected, so that more cost is applied tocost objects than were actually incurred.


1. (a) Work-in-progress ledger

2. (d) To ensure the reliability of cost accounts

cost & management accounting_amity (1).pdf

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